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EX-32.2 - EXHIBIT 32.2 - FRANKLIN FINANCIAL SERVICES CORP /PA/v320644_ex32-2.htm
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EX-31.1 - EXHIBIT 31.1 - FRANKLIN FINANCIAL SERVICES CORP /PA/v320644_ex31-1.htm
EX-31.2 - EXHIBIT 31.2 - FRANKLIN FINANCIAL SERVICES CORP /PA/v320644_ex31-2.htm

 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-Q

(Mark One)

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

 

For the quarterly period ended June 30, 2012,

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 0-12126

 

FRANKLIN FINANCIAL SERVICES CORPORATION

(Exact name of registrant as specified in its charter)

 

PENNSYLVANIA    25-1440803
(State or other jurisdiction of   (I.R.S. Employer
incorporation or organization)   Identification No.)

 

20 SOUTH MAIN STREET (P.O. BOX 6010), CHAMBERSBURG, PA 17201-0819

(Address of principal executive offices)

 

717/264-6116

(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 x No ¨

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨

 

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

 

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

 

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

 

There were 4,078,356 outstanding shares of the Registrant’s common stock as of July 31, 2012.

 

 
 

 

INDEX

 

Part I - FINANCIAL INFORMATION 3
   
Item 1 - Financial Statements 3
   
Consolidated Balance Sheets as of June 30, 2012 and December 31, 2011 (unaudited) 3
   
Consolidated Statements of Income for the Three and Six Months ended June 30, 2012 and 2011 (unaudited) 4
   
Consolidated Statements of Comprehensive Income for the Three and Six Months ended June 30, 2012 and 2011 (unaudited) 5
   
Consolidated Statements of Changes in Shareholders’ Equity for the Six Months ended June 30, 2012 and 2011 (unaudited) 6
   
Consolidated Statements of Cash Flows for the Six Months ended June 30, 2012 and 2011 (unaudited) 7
   
Notes to Consolidated Financial Statements (unaudited) 8
   
Item 2 - Management’s Discussion and Analysis of Results of Operations and Financial Condition 31
   
Item 3 – Quantitative and Qualitative Disclosures about Market Risk 59
   
Item 4 – Controls and Procedures 59
   
Part II - OTHER INFORMATION 59
   
Item 1 – Legal Proceedings 59
   
Item 1A – Risk Factors 59
   
Item 2 – Unregistered Sales of Equity Securities and Use of Proceeds 59
   
Item 3 – Defaults Upon Senior Securities 59
   
Item 4 – Mine Safety Disclosures 60
   
Item 5 – Other Information 60
   
Item 6 – Exhibits 60
   
SIGNATURE PAGE 61
   
EXHIBITS  

 

2
 

 

Part I FINANCIAL INFORMATION

 

Item 1 Financial Statements

 

Consolidated Balance Sheets

(Dollars in thousands, except per share data)

(unaudited)

 

   June 30   December 31 
   2012   2011 
         
Assets          
Cash and due from banks  $17,739   $16,932 
Interest-bearing deposits in other banks   73,365    17,212 
Total cash and cash equivalents   91,104    34,144 
Investment securities available for sale, at fair value   132,804    125,301 
Restricted stock   4,535    5,022 
Loans held for sale   795    - 
Loans   768,364    766,410 
Allowance for loan losses   (9,627)   (9,723)
Net loans   758,737    756,687 
Premises and equipment, net   16,083    16,041 
Bank owned life insurance   20,607    20,273 
Goodwill   9,016    9,016 
Other intangible assets   1,340    1,558 
Other real estate owned   3,290    3,224 
Deferred tax assets   6,169    6,384 
Other assets   12,421    12,598 
Total assets  $1,056,901   $990,248 
           
Liabilities          
Deposits          
Demand (non-interest bearing)  $109,023   $104,245 
Savings and interest checking   550,742    495,426 
Time   196,881    188,315 
Total deposits   856,646    787,986 
Securities sold under agreements to repurchase   51,028    53,103 
Long-term debt   46,292    48,336 
Other liabilities   13,007    13,641 
Total liabilities   966,973    903,066 
           
Shareholders' equity          
Common stock $1 par value per share, 15,000,000 shares authorized with 4,471,917 shares issued and 4,075,743 shares outstanding at June 30, 2012 and 4,419,258 shares issued and 4,023,084 shares outstanding at December 31, 2011   4,472    4,419 
Capital stock without par value, 5,000,000 shares authorized with no shares issued or outstanding   -    - 
Additional paid-in capital   35,385    34,698 
Retained earnings   61,775    60,280 
Accumulated other comprehensive loss   (4,620)   (5,131)
Treasury stock, 396,174 shares at cost at June 30, 2012 and December 31, 2011, respectively   (7,084)   (7,084)
Total shareholders' equity   89,928    87,182 
Total liabilities and shareholders' equity  $1,056,901   $990,248 

 

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

 

3
 

 

Consolidated Statements of Income

(Dollars in thousands, except per share data)

(unaudited)

 

   For the Three Months Ended   For the Six Months Ended 
   June 30   June 30 
   2012   2011   2012   2011 
         
Interest income                    
Loans, including fees  $9,112   $9,483   $18,210   $18,825 
Interest and dividends on investments:                    
Taxable interest   451    635    885    1,218 
Tax exempt interest   366    330    732    674 
Dividend income   18    26    34    51 
Deposits and obligations of other banks   55    19    91    25 
Total interest income   10,002    10,493    19,952    20,793 
                     
Interest expense                    
Deposits   1,304    1,755    2,758    3,424 
Securities sold under agreements to repurchase   19    39    39    73 
Short-term borrowings   -    -    -    1 
Long-term debt   488    614    980    1,315 
Total interest expense   1,811    2,408    3,777    4,813 
Net interest income   8,191    8,085    16,175    15,980 
Provision for loan losses   825    1,767    2,775    2,667 
Net interest income after provision for loan losses   7,366    6,318    13,400    13,313 
                     
Noninterest income                    
Investment and trust services fees   1,059    1,058    2,026    1,990 
Loan service charges   269    231    541    712 
Mortgage banking activities   (27)   (45)   20    (35)
Deposit service charges and fees   479    597    954    1,134 
Other service charges and fees   213    124    448    250 
Debit card income   295    260    570    495 
Increase in cash surrender value of life insurance   167    175    334    340 
Other   17    81    142    106 
                     
OTTI losses on securities   -    (370)   -    (370)
Loss recognized in other comprehensive income (before taxes)   -    (315)   -    (315)
Net OTTI losses recognized in earnings   -    (55)   -    (55)
                     
Securities gains, net   21    -    21    11 
Total noninterest income   2,493    2,426    5,056    4,948 
                     
Noninterest Expense                    
Salaries and benefits   4,157    3,883    7,956    7,596 
Net occupancy expense   493    496    1,011    1,028 
Furniture and equipment expense   218    214    427    437 
Advertising   396    351    710    643 
Legal and professional fees   260    244    539    515 
Data processing   440    487    853    868 
Pennsylvania bank shares tax   187    173    373    337 
Intangible amortization   109    111    218    224 
FDIC insurance   267    256    528    567 
Other   1,070    1,218    1,991    2,239 
Total noninterest expense   7,597    7,433    14,606    14,454 
Income before federal income taxes   2,262    1,311    3,850    3,807 
Federal income tax (benefit) expense   356    (447)   575    199 
Net income  $1,906   $1,758   $3,275   $3,608 
                     
Per share                    
Basic earnings per share  $0.47   $0.45   $0.81   $0.92 
Diluted earnings per share  $0.47   $0.45   $0.81   $0.92 
Cash dividends declared per share  $0.17   $0.27   $0.44   $0.54 

 

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

 

4
 

 

Consolidated Statements of Comprehensive Income

(Dollars in thousands)

(unaudited)

 

The components of comprehensive income and related tax effects are as follows:

 

   For the Three Months Ended   For the Six Months Ended 
   June 30   June 30 
   2012   2011   2012   2011 
Net Income  $1,906   $1,758   $3,275   $3,608 
                     
Securities:                    
Unrealized gains arising during the period   238    1,254    500    1,992 
Reclassification adjustment for losses (gains) included in net income   (21)   55    (21)   44 
Net unrealized gains   217    1,309    479    2,036 
Tax effect   (74)   (445)   (163)   (693)
Net of tax amount   143    864    316    1,343 
                     
Derivatives:                    
Unrealized losses arising during the period   (93)   (345)   (63)   (279)
Reclassification adjustment for losses included in net income   178    180    358    356 
Net unrealized gains (losses)   85    (165)   295    77 
Tax effect   (29)   57    (100)   (27)
Net of tax amount   56    (108)   195    50 
                     
Total other comprehensive income   199    756    511    1,393 
Total Comprehensive Income  $2,105   $2,514   $3,786   $5,001 

 

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

 

5
 

 

Consolidated Statements of Changes in Shareholders' Equity

For the Six Months Ended June 30, 2012 and 2011

(Dollars in thousands, except per share data)

(unaudited)

 

               Accumulated         
       Additional       Other         
   Common   Paid-in   Retained   Comprehensive   Treasury     
   Stock   Capital   Earnings   Loss   Stock   Total 
                         
Balance at December 31, 2010  $4,317   $33,096   $57,984   $(5,642)  $(7,116)  $82,639 
                               
Comprehensive income:                              
Net income   -    -    3,608    -    -    3,608 
Unrealized gain on securities, net of reclassification adjustments and taxes   -    -    -    1,343    -    1,343 
Unrealized loss on hedging activities, net of reclassification adjustments and taxes   -    -    -    50    -    50 
                               
Cash dividends declared, $.54 per share   -    -    (2,122)   -    -    (2,122)
Treasury shares issued under stock option plans: 1,611 shares   -    (2)   -    -    29    27 
Treasury shares issued to dividend reinvestment plan: 34,837 shares   35    615    -    -    -    650 
Balance at June 30, 2011  $4,352   $33,709   $59,470   $(4,249)  $(7,087)  $86,195 
                               
Balance at December 31, 2011  $4,419   $34,698   $60,280   $(5,131)  $(7,084)  $87,182 
                               
Comprehensive income:                              
Net income   -    -    3,275    -    -    3,275 
Unrealized gain on securities, net of reclassification adjustments and taxes   -    -    -    316    -    316 
Unrealized gain on hedging activities, net of reclassification adjustments and taxes   -    -    -    195    -    195 
                               
Cash dividends declared, $.44 per share   -    -    (1,780)   -    -    (1,780)
Common stock issued to dividend reinvestment plan: 52,659 shares   53    687    -    -    -    740 
Balance at June 30, 2012  $4,472   $35,385   $61,775   $(4,620)  $(7,084)  $89,928 

 

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

 

6
 

 

Consolidated Statements of Cash Flows

(Dollars in thousands)

(unaudited)

 

   For the Six Months Ended June 30 
   2012   2011 
Cash flows from operating activities          
Net income  $3,275   $3,608 
Adjustments to reconcile net income to net cash provided by operating activities:          
Depreciation and amortization   702    704 
Net amortization of loans and investment securities   676    332 
Amortization and net change in mortgage servicing rights valuation   56    128 
Amortization of intangibles   218    224 
Provision for loan losses   2,775    2,667 
Net realized gains on sales of securities   (21)   (11)
OTTI losses on securities   -    55 
Loans originated for sale   (4,473)   - 
Proceeds from sale of loans   3,678    - 
Net gain on sale or disposal of other real estate/other repossessed assets   (20)   (22)
Increase in cash surrender value of life insurance   (334)   (340)
Contribution to pension plan   (576)   (922)
(Increase) decrease in interest receivable and other assets   (97)   126 
Increase (decrease) in interest payable and other liabilities   151    (1,084)
Other, net   (12)   (584)
Net cash provided by operating activities   5,998    4,881 
           
Cash flows from investing activities          
Proceeds from sales of investment securities available for sale   471    880 
Proceeds from maturities and paydowns of investment securities available for sale   18,239    10,710 
Purchase of investment securities available for sale   (26,107)   (24,676)
Net decrease in restricted stock   487    598 
Net increase in loans   (5,136)   (25,264)
Proceeds from sale of other real estate/other repossessed assets   195    142 
Capital expenditures   (688)   (398)
Net cash used in investing activities   (12,539)   (38,008)
           
Cash flows from financing activities          
Net increase in demand deposits, interesting-bearing checking and savings accounts   60,094    54,503 
Net increase in time deposits   8,566    6,066 
Net (decrease) increase in securities sold under agreements to repurchase   (2,075)   14,097 
Long-term debt payments   (2,044)   (21,581)
Dividends paid   (1,780)   (2,122)
Common stock issued to dividend reinvestment plan   740    650 
Common stock issued under stock option plans   -    27 
Net cash provided by financing activities   63,501    51,640 
Increase in cash and cash equivalents   56,960    18,513 
Cash and cash equivalents at beginning of period   34,144    22,106 
Cash and cash equivalents at end of period  $91,104   $40,619 
           
Supplemental Disclosures of Cash Flow Information          
Cash paid during the year for:          
Interest on deposits and other borrowed funds  $3,862   $4,953 
Income taxes  $-   $1,750 
Noncash Activities          
Loans transferred to Other Real Estate  $241   $484 

 

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

 

7
 

 

FRANKLIN FINANCIAL SERVICES CORPORATION and SUBSIDIARIES

UNAUDITED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

Note 1 - Basis of Presentation

 

The consolidated financial statements include the accounts of Franklin Financial Services Corporation (the Corporation), and its wholly-owned subsidiaries, Farmers and Merchants Trust Company of Chambersburg (the Bank) and Franklin Future Fund Inc. Farmers and Merchants Trust Company of Chambersburg is a commercial bank that has one wholly-owned subsidiary, Franklin Financial Properties Corp. During the first quarter of 2012, Franklin Realty Services Corporation (an inactive real-estate brokerage company and subsidiary of the Bank as of December 31, 2011) merged with Franklin Financial Properties Corp. (a subsidiary of the Corporation at December 31, 2011) with Franklin Financial Properties Corp. becoming the surviving entity and subsidiary of the Bank. Franklin Financial Property Corp. holds real estate assets that are leased by the Bank. Franklin Future Fund Inc. is a non-bank investment company. The activities of non-bank entities are not significant to the consolidated totals. All significant intercompany transactions and account balances have been eliminated.

 

In the opinion of management, all adjustments (which include only normal recurring adjustments) necessary to present fairly the consolidated financial position, results of operations, and cash flows as of June 30, 2012, and for all other periods presented have been made.

 

Certain information and footnote disclosures normally included in consolidated financial statements prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) have been condensed or omitted. It is suggested that these consolidated financial statements be read in conjunction with the audited consolidated financial statements and notes thereto included in the Corporation’s 2011 Annual Report on Form 10-K. The consolidated results of operations for the period ended June 30, 2012 are not necessarily indicative of the operating results for the full year. Management has evaluated subsequent events for potential recognition and/or disclosure through the date these consolidated financial statements were issued.

 

The consolidated balance sheet at December 31, 2011 has been derived from the audited consolidated financial statements at that date, but does not include all of the information and footnotes required by GAAP for complete consolidated financial statements.

 

For purposes of reporting cash flows, cash and cash equivalents include cash and due from banks, interest-bearing deposits in other banks and federal funds sold. Generally, federal funds are purchased and sold for one-day periods.

 

Earnings per share is computed based on the weighted average number of shares outstanding during each period end. A reconciliation of the weighted average shares outstanding used to calculate basic earnings per share and diluted earnings per share follows:

 

8
 

 

   For the Three Months Ended   For the Six Months Ended 
   June 30   June 30 
(In thousands, except per share data)  2012   2011   2012   2011 
Weighted average shares outstanding (basic)   4,066    3,942    4,053    3,934 
Impact of common stock equivalents   -    3    -    4 
Weighted average shares outstanding (diluted)   4,066    3,945    4,053    3,938 
Anti-dilutive options excluded from the calculation   100    70    104    70 
Net income  $1,906   $1,758   $3,275   $3,608 
Basic earnings per share  $0.47   $0.45   $0.81   $0.92 
Diluted earnings per share  $0.47   $0.45   $0.81   $0.92 

 

Note 2 – Recent Accounting Pronouncements

 

There were no new accounting pronouncements affecting the Corporation during the period that were not already incorporated into the disclosures.

 

Note 3 – Accumulated Other Comprehensive Loss

 

The components of accumulated other comprehensive loss included in shareholders' equity are as follows:

 

(Dollars in thousands)  June 30,   December 31, 
   2012   2011 
         
Net unrealized gains on securities  $1,906   $1,427 
Tax effect   (648)   (485)
Net of tax amount   1,258    942 
           
Net unrealized losses on derivatives   (1,443)   (1,738)
Tax effect   490    590 
Net of tax amount   (953)   (1,148)
           
Accumulated pension adjustment   (7,462)   (7,462)
Tax effect   2,537    2,537 
Net of tax amount   (4,925)   (4,925)
Total accumulated other comprehensive loss  $(4,620)  $(5,131)

 

Note 4 – Guarantees

 

The Corporation does not issue any guarantees that would require liability recognition or disclosure, other than its standby letters of credit. Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Generally, all letters of credit, when issued, have expiration dates within one year. The credit risk involved in issuing letters of credit is essentially the same as those that are involved in extending loan facilities to customers. The Bank generally holds collateral and/or personal guarantees supporting these commitments. The Bank had $30.6 million and $28.2 million of standby letters of credit as of June 30, 2012 and December 31, 2011, respectively. Management believes that the proceeds obtained through a liquidation of collateral and the enforcement of guarantees would be sufficient to cover the potential amount of future payments required under the corresponding guarantees. The amount of the liability as of June 30, 2012 and December 31, 2011 for guarantees under standby letters of credit issued was not material.

 

9
 

 

Note 5 – Investments

 

The amortized cost and estimated fair value of investment securities available for sale as of June 30, 2012 and December 31, 2011 are:

 

(Dollars in thousands)      Gross   Gross     
   Amortized   Unrealized   Unrealized   Fair 
June 30, 2012  Cost   Gains   Losses   Value 
Equity securities  $2,105   $90   $(272)  $1,923 
U.S. Government agency securities   12,219    105    (26)   12,298 
Municipal securities   54,684    2,902    (118)   57,468 
Corporate debt securities   2,251    26    (52)   2,225 
Trust preferred securities   5,898    -    (1,352)   4,546 
Agency mortgage-backed securities   50,788    1,044    (121)   51,711 
Private-label mortgage-backed securities   2,890    -    (304)   2,586 
Asset-backed securities   63    -    (16)   47 
   $130,898   $4,167   $(2,261)  $132,804 

 

       Gross   Gross     
(Dollars in thousands)  Amortized   Unrealized   Unrealized   Fair 
December 31, 2011  Cost   Gains   Losses   Value 
Equity securities  $2,105   $11   $(357)  $1,759 
U.S. Government agency securities   13,159    75    (5)   13,229 
Municipal securities   42,490    2,598    (7)   45,081 
Corporate debt securities   2,484    49    (119)   2,414 
Trust preferred securities   5,890    -    (1,272)   4,618 
Agency mortgage-backed securities   54,314    1,159    (188)   55,285 
Private-label mortgage-backed securities   3,366    1    (500)   2,867 
Asset-backed securities   66    -    (18)   48 
   $123,874   $3,893   $(2,466)  $125,301 

 

The amortized cost of securities pledged as collateral to secure various funding sources was $103.1 million at June 30, 2012 and $112.1 million at December 31, 2011.

 

The amortized cost and fair value of debt securities as of June 30, 2012, by contractual maturity are shown below. Actual maturities may differ from contractual maturities because of prepayment or call options embedded in the securities.

 

10
 

 

   Amortized   Fair 
(Dollars in thousands)  Cost   Value 
Due in one year or less  $5,291   $5,318 
Due after one year through five years   13,964    14,741 
Due after five years through ten years   17,582    18,425 
Due after ten years   38,278    38,100 
    75,115    76,584 
Mortgage-backed securities   53,678    54,297 
           
   $128,793   $130,881 

 

The following table provides additional detail about trust preferred securities as of June 30, 2012:

 

Trust Preferred Securities
(Dollars in thousands)
Deal Name  Single
Issuer or
Pooled
  Class  Amortized
Cost
   Fair
Value
   Gross
Unrealized
Gain (Loss)
   Lowest
Credit
Rating
Assigned
     Number of
Banks
Currently
Performing
   Deferrals
and Defaults
as % of
Original
Collateral
  Expected Deferral/
Defaults as a
Percentage of
Remaining Performing
Collateral
 
                                  
Huntington Cap Trust  Single  Preferred Stock  $931   $714   $(217)  B    1   None  None 
Huntington Cap Trust II  Single  Preferred Stock   878    685    (193)  B    1   None  None 
BankAmerica Cap III  Single  Preferred Stock   958    709    (249)  BB    1   None  None 
Wachovia Cap Trust II  Single  Preferred Stock   274    228    (46)  Baa2    1   None  None 
Corestates Captl Tr II  Single  Preferred Stock   927    765    (162)  Baa1    1   None  None 
Chase Cap VI JPM  Single  Preferred Stock   958    711    (247)  BBB    1   None  None 
Fleet Cap Tr V  Single  Preferred Stock   972    734    (238)  BB    1   None  None 
         $5,898   $4,546   $(1,352)                

 

The following table provides additional detail about private label mortgage-backed securities as of June 30, 2012:

 

Private Label Mortgage Backed Securities 
(Dollars in thousands)             Gross             Cummulative 
   Orgination  Amortized   Fair   Unrealized   Collateral  Lowest Credit  Credit   OTTI 
Decscription  Date  Cost   Value   Gain (Loss)   Type  Rating Assigned  Support %   Charges 
RALI 2004-QS4 A7  3/1/2004  $379   $376    (3)  ALT A  AA   12.38    - 
MALT 2004-6 7A1  6/1/2004   583    548    (35)  ALT A  B   11.61    - 
RALI 2005-QS2 A1  2/1/2005   502    484    (18)  ALT A  CC   7.16    - 
RALI 2006-QS4 A2  4/1/2006   804    636    (168)  ALT A  D   -    218 
GSR 2006-5F 2A1  5/1/2006   202    188    (14)  Prime  C   1.26    - 
RALI 2006-QS8 A1  7/28/2006   420    354    (66)  ALT A  D   -    172 
      $2,890   $2,586   $(304)             $390 

 

At June 30, 2012, the investment portfolio contained 65 securities with $34.1 million of temporarily impaired fair value and $2.3 million in unrealized losses. The unrealized loss position is less than at year-end 2011, but there are more securities with an unrealized loss and the temporarily impaired fair value is higher due to an increase in the fair value of municipal bonds with an unrealized loss. The trust preferred sector continues to show the largest unrealized loss at $1.4 million on seven securities, virtually unchanged from the prior-year end.

 

11
 

 

For securities with an unrealized loss, Management applies a systematic methodology in order to perform an assessment of the potential for “other-than-temporary” impairment. In the case of debt securities, investments considered for “other-than-temporary” impairment: (1) had a specified maturity or repricing date; (2) were generally expected to be redeemed at par, and (3) were expected to achieve a recovery in market value within a reasonable period of time. In addition, the Bank considers whether it intends to sell these securities or whether it will be forced to sell these securities before maturity. Equity securities are assessed for other-than-temporary impairment based on the length of time of impairment, dollar amount of the impairment and general market and financial conditions relating to specific issues. Accordingly, the impairments identified on debt and equity securities and subjected to the assessment at June 30, 2012 were deemed to be temporary and required no further adjustment to the financial statements, unless otherwise noted.

 

The following table reflects temporary impairment in the investment portfolio (excluding restricted stock), aggregated by investment category, length of time that individual securities have been in a continuous unrealized loss position and the number of securities in each category as of June 30, 2012 and December 31, 2011:

 

   June 30, 2012 
   Less than 12 months   12 months or more   Total 
   Fair   Unrealized       Fair   Unrealized       Fair   Unrealized     
(Dollars in thousands)  Value   Losses   Number   Value   Losses   Number   Value   Losses   Number 
                                              
Equity securities  $129   $(5)   3   $1,205   $(267)   13   $1,334   $(272)   16 
U.S. Government agency securities   4,944    (24)   5    1,257    (2)   5    6,201    (26)   10 
Municipal securities   4,854    (118)   5    -    -    -    4,854    (118)   5 
Corporate debt securities   -    -    -    1,954    (52)   2    1,954    (52)   2 
Trust preferred securities   -    -    -    4,546    (1,352)   7    4,546    (1,352)   7 
Agency mortgage-backed securities   7,008    (42)   8    5,613    (79)   8    12,621    (121)   16 
Private-label mortgage-backed securities   924    (38)   2    1,662    (266)   4    2,586    (304)   6 
Asset-backed securities   -    -    -    47    (16)   3    47    (16)   3 
Total temporarily impaired securities  $17,859   $(227)   23   $16,284   $(2,034)   42   $34,143   $(2,261)   65 

 

   December 31, 2011 
   Less than 12 months   12 months or more   Total 
   Fair   Unrealized       Fair   Unrealized       Fair   Unrealized     
(Dollars in thousands)  Value   Losses   Number   Value   Losses   Number   Value   Losses   Number 
                                     
Equity securities  $394   $(111)   3   $864   $(246)   13   $1,258   $(357)   16 
U.S. Government agency securities   6,068    (3)   5    1,321    (2)   5    7,389    (5)   10 
Municipal securities   579    (7)   1    -    -    -    579    (7)   1 
Corporate debt securities   -    -    -    1,889    (119)   2    1,889    (119)   2 
Trust preferred securities   -    -    -    4,618    (1,272)   7    4,618    (1,272)   7 
Agency mortgage-backed securities   12,452    (156)   12    1,174    (32)   1    13,626    (188)   13 
Private-label mortgage-backed securities   1,057    (36)   2    1,636    (464)   4    2,693    (500)   6 
Asset-backed securities   -    -    -    48    (18)   3    48    (18)   3 
Total temporarily impaired securities  $20,550   $(313)   23   $11,550   $(2,153)   35   $32,100   $(2,466)   58 

 

12
 

 

The trust preferred portfolio contains the largest unrealized loss in the portfolio. At June 30, 2012 this sector contained seven securities with a fair value of $4.5 million and an unrealized loss of $1.4 million. These values are virtually unchanged from the prior year-end. Trust-preferred securities held by the Bank are single entity issues, not pooled trust preferred securities. Therefore, the impairment review of these securities is based only on the issuer and the security cannot be impaired by the performance of other issuers as if it was a pooled trust-preferred bond. All of the Bank’s trust preferred securities are single issue, variable rate notes with long maturities (2027 – 2028) from companies that received money (and in some cases paid back) from the Troubled Asset Relief Program (TARP), continue to pay dividends and have raised capital. None of these bonds have suspended or missed a dividend payment. At June 30, 2012, the Bank believes it will be able to collect all interest and principal due on these bonds and no other-than-temporary-impairment charges were recorded. See the Trust Preferred Securities table for additional information.

 

The private label mortgage backed securities (PLMBS) sector shows an unrealized loss of $304 thousand, an improvement over the $500 thousand unrealized loss at December 31, 2011. These bonds were all rated AAA at time of purchase, but have since experienced rating declines. Some have experienced increased delinquencies and defaults, while others have seen the credit support increase as the bonds paid-down. The Bank monitors the performance of the PLMBS investments on a regular basis and reviews delinquencies, default rates, credit support levels and various cash flow stress test scenarios. In determining the credit related loss, Management considers all principal past due 60 days or more as a loss. If additional principal moves beyond 60 days past due, it will also be considered a loss. As a result of the analysis on PLMBS it was determined that no impairment charges were required at June 30, 2012. The Bank has recorded $390 thousand of cumulative impairment charges on this portfolio. Management continues to monitor these securities and it is possible that additional write-downs may occur if current loss trends continue. The Bank is currently participating in a class-action lawsuit against one PLMBS servicer that centers on defective warranties and representations made as part of the underwriting process. See the PLMBS table above for additional information.

 

The Bank held $4.5 million of restricted stock at June 30, 2012. Except for $30 thousand, this investment represents stock in FHLB Pittsburgh. The Bank is required to hold this stock to be a member of FHLB and it is carried at cost of $100 per share. In December 2008, FHLB announced it would suspend its regular cash dividend and the regular repurchase of excess capital stock from its members as part of its capital restoration plan. However, FHLB has made stock repurchases of $487 thousand during the year. In addition, FHLB paid a small dividend during the year. Despite these actions, it does not appear as if FHLB has resumed its past practice of redeeming excess capital stock on a regular basis or paying a regular dividend. FHLB stock is evaluated for impairment primarily based on an assessment of the ultimate recoverability of its cost. As a government sponsored entity, FHLB has the ability to raise funding through the U.S. Treasury that can be used to support its operations. There is not a public market for FHLB stock and the benefits of FHLB membership (e.g., liquidity and low cost funding) add value to the stock beyond purely financial measures. Management intends to remain a member of the FHLB and believes that it will be able to fully recover the cost basis of this investment.

 

13
 

 

Note 6 – Loans

 

A summary of loans outstanding, by primary collateral, at the end of the reporting period is as follows:

 

           Change 
(Dollars in thousands)  June 30, 2012   December 31, 2011   Amount   % 
Residential Real Estate 1-4 Family                    
Consumer first liens  $85,255   $86,767   $(1,512)   (1.7)
Consumer junior liens and lines of credit   38,774    40,290    (1,516)   (3.8)
Total consumer   124,029    127,057    (3,028)   (2.4)
                     
Commercial first lien   57,708    55,130    2,578    4.7 
Commercial junior liens and lines of credit   7,472    7,846    (374)   (4.8)
Total   65,180    62,976    2,204    3.5 
Total residential real estate 1-4 family   189,209    190,033    (824)   (0.4)
                     
Residential real estate - construction                    
Consumer purpose   1,596    1,381    215    15.6 
Commercial purpose   14,384    19,901    (5,517)   (27.7)
Total residential real estate construction   15,980    21,282    (5,302)   (24.9)
                     
Commercial, industrial and agricultural real estate   372,068    358,974    13,094    3.6 
Commercial, industrial and agricultural   179,382    182,694    (3,312)   (1.8)
Consumer   11,725    13,427    (1,702)   (12.7)
    768,364    766,410    1,954    0.3 
Less:  Allowance for loan losses   (9,627)   (9,723)   96    (1.0)
Net Loans  $758,737   $756,687   $2,050    0.3 
                     
Included in the loan balances are the following:                    
Net unamortized deferred loan costs  $271   $426           
Unamortized discount on purchased loans  $(150)  $(167)          
                     
Loans pledged as collateral for borrowings and commitments from:                    
FHLB  $602,555   $679,272           
Federal Reserve Bank   108,402    27,435           
   $710,957   $706,707           

 

14
 

 

Note 7 – Loan Quality

 

The following table presents, by loan segment, the Allowance for Loan Losses (ALL) for the periods ended:

  

               Commercial             
   Residential Real Estate 1-4 Family   Industrial &   Commercial         
       Junior Liens &       Agricultural   Industrial &         
(Dollars in thousands)  First Liens   Lines of Credit   Construction   Real Estate   Agricultural   Consumer   Total 
                             
ALL at March 31, 2012  $932   $311   $878   $5,792   $1,388   $206   $9,507 
Charge-offs   (144)   -    -    (262)   (312)   (36)   (754)
Recoveries   -    25    -    1    5    18    49 
Provision   (11)   (15)   47    308    483    13    825 
ALL at June 30, 2012  $777   $321   $925   $5,839   $1,564   $201   $9,627 
                                    
ALL at December 31, 2011  $1,049   $308   $1,222   $5,257   $1,651   $236   $9,723 
Charge-offs   (180)   (65)   -    (2,254)   (345)   (122)   (2,966)
Recoveries   -    25    -    9    7    54    95 
Provision   (92)   53    (297)   2,827    251    33    2,775 
ALL at June 30, 2012  $777   $321   $925   $5,839   $1,564   $201   $9,627 
                                    
ALL at March 31, 2011  $612   $292   $2,342   $4,216   $1,447   $289   $9,198 
Charge-offs   (45)   (172)   (337)   (261)   (41)   (50)   (906)
Recoveries   17    5    -    47    4    18    91 
Provision   (55)   188    387    642    451    154    1,767 
ALL at June 30, 2011  $529   $313   $2,392   $4,644   $1,861   $411   $10,150 
                                    
ALL at December 31, 2010  $600   $352   $2,596   $3,358   $1,578   $317   $8,801 
Charge-offs   (152)   (177)   (737)   (422)   (41)   (114)   (1,643)
Recoveries   28    5    -    240    4    48    325 
Provision   53    133    533    1,468    320    160    2,667 
ALL at June 30, 2011  $529   $313   $2,392   $4,644   $1,861   $411   $10,150 
                                    
ALL at December 31, 2010  $600   $352   $2,596   $3,358   $1,578   $317   $8,801 
Charge-offs   (324)   (202)   (2,352)   (3,817)   (115)   (237)   (7,047)
Recoveries   30    10    -    306    11    88    445 
Provision   743    148    978    5,410    177    68    7,524 
ALL at December 31, 2011  $1,049   $308   $1,222   $5,257   $1,651   $236   $9,723 

 

15
 

 

The following table presents, by loan segment, loans that were evaluated for the ALL under the specific reserve (individually) and those that were evaluated under the general reserve (collectively) as of June 30, 2012 and December 31, 2011.

 

               Commercial             
   Residential Real Estate 1-4 Family   Industrial &   Commercial         
       Junior Liens &       Agricultural   Industrial &         
(Dollars in thousands)  First Liens   Lines of Credit   Construction   Real Estate   Agricultural   Consumer   Total 
                             
June 30, 2012                                   
Loans evaluated for allowance:                                   
Individually  $3,962   $714   $575   $23,784   $3,868   $-   $32,903 
Collectively   139,001    45,532    15,405    348,284    175,514    11,725    735,461 
Total  $142,963   $46,246   $15,980   $372,068   $179,382   $11,725   $768,364 
                                    
ALL established for loans evaluated:                                   
Individually  $2   $-   $-   $493   $657   $-   $1,152 
Collectively   775    321    925    5,346    907    201    8,475 
ALL at June 30, 2012  $777   $321   $925   $5,839   $1,564   $201   $9,627 
                                    
December 31, 2011                                   
Loans evaluated for allowance:                                   
Individually  $3,899   $162   $43   $21,622   $2,308   $-   $28,034 
Collectively   137,998    47,974    21,239    337,352    180,386    13,427    738,376 
Total  $141,897   $48,136   $21,282   $358,974   $182,694   $13,427   $766,410 
                                    
ALL established for loans evaluated:                                   
Individually  $495   $3   $-   $1,591   $870   $-   $2,959 
Collectively   554    305    1,222    3,666    781    236    6,764 
ALL at December 31, 2011  $1,049   $308   $1,222   $5,257   $1,651   $236   $9,723 

 

16
 

 

The following table shows additional information about those loans considered to be impaired at June 30, 2012 and December 31, 2011:

 

   Impaired Loans 
   With No Allowance   With Allowance 
(Dollars in thousands)      Unpaid       Unpaid     
   Recorded   Principal   Recorded   Principal   Related 
    Investment   Balance   Investment   Balance   Allowance 
June 30, 2012                    
Residential Real Estate                         
First liens  $3,924   $4,157   $38   $41   $2 
Junior liens and lines of credit   656    660    58    62    - 
Total   4,580    4,817    96    103    2 
Residential real estate - construction   575    836    -    -    - 
Commercial, industrial and agricultural real estate   20,534    24,746    3,250    3,972    493 
Commercial, industrial and agricultural   2,458    2,540    1,410    1,783    657 
Consumer   -    -    -    -    - 
Total  $28,147   $32,939   $4,756   $5,858   $1,152 
                          
December 31, 2011                    
Residential Real Estate                         
First liens  $176   $177   $3,723   $3,867   $495 
Junior liens and lines of credit   28    30    134    134    3 
Total   204    207    3,857    4,001    498 
Residential real estate - construction   -    -    43    43    - 
Commercial, industrial and agricultural real estate   11,072    12,092    10,550    12,050    1,591 
Commercial, industrial and agricultural   94    109    2,214    2,352    870 
Consumer   -    -    -    -    - 
Total  $11,370   $12,408   $16,664   $18,446   $2,959 

 

The following table shows the average of impaired loans and related interest income for the three and six months ended June 30, 2012 and 2011:

 

   Three Months Ended   Six Months Ended 
   June 30, 2012   June 30, 2012 
(Dollars in thousands)  Average   Interest   Average   Interest 
   Recorded   Income   Recorded   Income 
   Investment   Recognized   Investment   Recognized 
Residential Real Estate 1-4 Family                    
First liens  $4,283   $8   $4,442   $52 
Junior liens and lines of credit   722    1    770    1 
Total   5,005    9    5,212    53 
Residential real estate - construction   692    -    350    - 
Commercial, industrial and agricultural real estate   24,218    36    24,297    93 
Commercial, industrial and agricultural   4,219    36    4,267    72 
Consumer   -    -    -    - 
Total  $34,134   $81   $34,126   $218 

 

17
 

 

   Three Months Ended   Six Months Ended 
   June 30, 2011   June 30, 2011 
   Average   Interest   Average   Interest 
   Recorded   Income   Recorded   Income 
   Investment   Recognized   Investment   Recognized 
Residential Real Estate 1-4 Family                    
First liens  $556   $1   $787   $11 
Junior liens and lines of credit   350    -    326    1 
Total   906    1    1,113    12 
Residential real estate - construction   10,933    27    10,214    63 
Commercial, industrial and agricultural real estate   18,666    38    18,574    155 
Commercial, industrial and agricultural   1,323    7    1,827    18 
Consumer   -    -    1    - 
Total  $31,828   $73   $31,729   $248 

 

The following table presents a summary of nonperforming assets as of June 30, 2012 and December 31, 2011:

 

   June 30, 2012   December 31, 2011 
       % of Loan       % of Loan 
(Dollars in thousands)  Balance   Segment   Balance   Segment 
                 
Nonaccrual loans                    
Residential Real Estate                    
First liens  $3,951    2.8%  $1,749    1.2%
Junior liens and lines of credit   882    1.9%   282    0.6%
Total   4,833    2.6%   2,031    1.1%
Residential real estate - construction   575    3.8%   -    - 
Commercial, industrial and agricultural real estate   20,965    5.7%   14,278    4.0%
Commercial, industrial and agricultural   1,397    0.8%   1,447    0.8%
Consumer   -    -    -    - 
Total nonaccrual loans  $27,770        $17,756      
                     
Loans past due 90 days or more and still accruing                    
Residential Real Estate                    
First liens  $345        $2,516      
Junior liens and lines of credit   45         301      
Total   390         2,817      
Residential real estate - construction   112         121      
Commercial, industrial and agricultural real estate   1,082         1,627      
Commercial, industrial and agricultural   102         100      
Consumer   28         107      
Total loans past due 90 days or more and still accruing   1,714         4,772      
                     
Total nonaccrual and loans past due 90 days or more   29,484         22,528      
                     
Repossessed assets   7         6      
Other real estate owned   3,290         3,224      
                     
Total nonperforming assets  $32,781        $25,758      

 

18
 

 

The following table presents the aging of payments of the loan portfolio:

 

       Loans Past Due and  Still Accruing       Total 
(Dollars in thousands)  Current   30-59 Days   60-89 Days   90 Days+   Total   Non-Accrual   Loans 
June 30, 2012                                   
Residential Real Estate                                   
First liens  $137,112   $690   $865   $345   $1,900   $3,951   $142,963 
Junior liens and lines of credit   44,960    202    157    45    404    882    46,246 
Total   182,072    892    1,022    390    2,304    4,833    189,209 
Residential real estate - construction   14,507    786    -    112    898    575    15,980 
Commercial, industrial and agricultural real estate   343,812    1,169    5,040    1,082    7,291    20,965    372,068 
Commercial, industrial and agricultural   177,862    21    -    102    123    1,397    179,382 
Consumer   11,262    384    51    28    463    -    11,725 
Total  $729,515   $3,252   $6,113   $1,714   $11,079   $27,770   $768,364 
                                    
December 31, 2011                                   
Residential Real Estate                                   
First liens  $134,105   $2,574   $953   $2,516   $6,043   $1,749   $141,897 
Junior liens and lines of credit   46,311    1,121    121    301    1,543    282    48,136 
Total   180,416    3,695    1,074    2,817    7,586    2,031    190,033 
Residential real estate - construction   21,161    -    -    121    121    -    21,282 
Commercial, industrial and agricultural real estate   337,462    2,961    2,646    1,627    7,234    14,278    358,974 
Commercial, industrial and agricultural   179,907    113    1,127    100    1,340    1,447    182,694 
Consumer   12,917    287    116    107    510    -    13,427 
Total  $731,863   $7,056   $4,963   $4,772   $16,791   $17,756   $766,410 

 

The following table reports the internal credit rating for the loan portfolio. Consumer purpose loans (mortgage, home equity and installment) are assigned a rating of either pass or substandard. Substandard consumer loans are comprised of loans 90 days or more past due and still accruing and nonaccrual loans. Commercial loans may be assigned any rating in accordance with the Bank’s internal risk rating system.

 

       Special             
(Dollars in thousands)  Pass   Mention   Substandard   Doubtful   Total 
                     
June 30, 2012                         
Residential Real Estate                         
First liens  $132,810   $1,850   $8,303   $-   $142,963 
Junior liens and lines of credit   44,849    287    1,110    -    46,246 
Total   177,659    2,137    9,413    -    189,209 
Residential real estate - construction   13,617    921    1,442    -    15,980 
Commercial, industrial and agricultural real estate   296,160    34,871    41,037    -    372,068 
Commercial, industrial and agricultural   159,545    8,692    11,145         179,382 
Consumer   11,697    -    28    -    11,725 
Total  $658,678   $46,621   $63,065   $-   $768,364 
                          
December 31, 2011                         
Residential Real Estate                         
First liens  $130,680   $3,733   $7,484   $-   $141,897 
Junior liens and lines of credit   47,329    377    430    -    48,136 
Total   178,009    4,110    7,914    -    190,033 
Residential real estate - construction   19,253    941    1,088    -    21,282 
Commercial, industrial and agricultural real estate   291,967    41,675    25,332    -    358,974 
Commercial, industrial and agricultural   168,207    7,649    6,838    -    182,694 
Consumer   13,320    -    107    -    13,427 
Total  $670,756   $54,375   $41,279   $-   $766,410 

 

19
 

 

The following table presents information on the Bank’s Troubled Debt Restructuring (TDR) loans:

 

           Troubled Debt Restructings 
   Total   That Have Defaulted on 
(Dollars in thousands)  Troubled Debt Restructings   Modified Terms YTD 
   Number of   Recorded   Number of   Recorded 
   Contracts   Investment   Contracts   Investment 
June 30, 2012                    
Real estate construction   3   $1,523    -   $- 
Residential real estate   3    238           
Commercial, industrial and agricultural   2    1,681    -    - 
Commercial, industrial and agricultural real estate   10    6,116    -    - 
Total   18   $9,558    -   $- 
                     
December 31, 2011                    
Residential real estate   2   $93    -   $- 
Commercial, industrial and agricultural real estate   9    8,023    -    - 
Total   11   $8,116    -   $- 

 

The following table reports the performing status of TDR loans. The performing status is determined by the loans compliance with the modified terms.

 

   June 30, 2012   December 31, 2011 
   Performing   Nonperforming   Performing   Nonperforming 
Real estate construction  $1,523   $-   $-   $- 
Residential real estate   238         93      
Commercial, industrial and agricultural   1,681    -    -    - 
Commercial, industrial and agricultural real estate   6,116    -    8,023    - 
Total  $9,558   $-   $8,116   $- 

 

20
 

 

The following table reports new TDR loans during the six months ended June 30, 2012.

 

   New TDR Loans in 2012   June 30, 2012 
   Number of   Pre-TDR   After-TDR   Recorded 
   Contracts   Modification   Modification   Investment 
Real estate construction   3   $2,073   $1,897   $1,523 
Residential real estate   1    150    150    148 
Commercial, industrial and agricultural   2    2,223    2,223    1,681 
Commercial, industrial and agricultural real estate   2    700    1,091    1,074 
Total   8   $5,146   $5,361   $4,426 

 

The type of loan concession granted for new TDR loans during the six months ended June 30, 2012.

 

   New TDR Loans in 2012   June 30, 2012 
   Number of   Pre-TDR   After-TDR   Recorded 
   Contracts   Modification   Modification   Investment 
Maturity   2   $2,223   $2,223   $1,681 
Rate   -    -    -    - 
Payment   -    -    -    - 
Multiple   6    2,923    3,138    2,745 
    8   $5,146   $5,361   $4,426 

 

There were no new TDR loans recorded during the second quarter of 2012.

 

The following table reports new TDR loans during the six months ended June 30, 2011.

 

   New TDR Loans in 2011   June 30, 2012 
   Number of   Pre-TDR   After-TDR   Recorded 
   Contracts   Modification   Modification   Investment 
Residential real estate   1   $64   $64   $61 
Commercial, industrial and agricultural   1    2,856    2,856    - 
Commercial, industrial and agricultural real estate   5    1,847    1,847    2,043 
Total   7   $4,767   $4,767   $2,104 

 

The type of loan concession granted for new TDR loans during the six months ended June 30, 2011

 

   New TDR Loans in 2011   June 30, 2012 
   Number of   Pre-TDR   After-TDR   Recorded 
   Contracts   Modification   Modification   Investment 
Maturity   1   $263   $263   $252 
Rate   2    2,920    2,920    61 
Payment   4    1,584    1,584    1,791 
Multiple   -    -    -    - 
    7   $4,767   $4,767   $2,104 

 

21
 

 

Note 8 – Pensions

 

The components of pension expense for the periods presented are as follows:

 

   Three months ended   Six months ended 
   June 30   June 30 
(Dollars in thousands)  2012   2011   2012   2011 
Components of net periodic (benefit) cost:                    
Service cost  $115   $84   $230   $187 
Interest cost   179    180    358    362 
Expected return on plan assets   (197)   (188)   (394)   (376)
Recognized net actuarial loss   171    91    342    180 
Net periodic cost  $268   $167   $536   $353 

 

The Bank expects its pension expense to increase to approximately $1.1 million in 2012 compared to $705 thousand in 2011. The Bank expects to contribute $1.2 million to its pension plan in 2012. This contribution will meet the minimum funding requirements.

 

In June 2012, Congress approved the Highway Expenditures Bill that included pension funding relief. The relief is in the form of interest rate stabilization by allowing the use of a 25-year average rate to calculate pension funding compared to a 2-year average rate currently used. This change is expected to reduce pension contributions, but will have no affect on the Corporation’s financial statements for accounting purposes. The change is effective in 2013 with the option to implement in 2012. The Bank is currently reviewing the potential effects of this change.

 

22
 

 

Note 9 – Mortgage Servicing Rights

 

Activity pertaining to mortgage servicing rights and the related valuation allowance follows:

 

   Six Months Ended 
   June 30 
(Dollars in thousands)  2012   2011 
Cost of mortgage servicing rights:          
Beginning balance  $730   $933 
Originations   -    - 
Amortization   (100)   (97)
Ending balance  $630   $836 
           
Valuation allowance:          
Beginning balance  $(362)  $(330)
Valuation charges   (17)   (43)
Valuation reversals   61    12 
Ending balance  $(318)  $(361)
           
Mortgage servicing rights cost  $630   $836 
Valuation allowance   (318)   (361)
Carrying value  $312   $475 
           
Fair value  $312   $475 

 

Note 10 – Fair Value Measurements

 

Fair value is defined as the exchange price that would be received to sell an asset or paid to transfer a liability (exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants at the measurement date. Fair value estimates are based on quoted market prices, if available, quoted market prices of similar assets or liabilities, or the present value of expected future cash flows, and other valuation techniques. There are certain assumptions made in the valuation process and Management uses its best judgment in estimating the fair value of the Corporation’s financial instruments; however, there are inherent weaknesses in any estimation technique. Therefore, for substantially all financial instruments, the fair value estimates herein are not necessarily indicative of the amounts the Corporation could have realized in a sales transaction on the dates indicated.

 

Fair Value Hierarchy

 

Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Topic 820, Fair Value Measurements and Disclosures, established a fair value hierarchy that prioritizes the inputs to valuation methods used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). The three levels of the fair value hierarchy under FASB ASC Topic 820 are as follows:

 

23
 

 

Level 1: Valuation is based on unadjusted, quoted prices in active markets that are accessible at the measurement date for identical assets or liabilities.

 

Level 2: Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market.

 

Level 3: Valuation is generated from model based techniques that use significant assumptions not observable in the market. These unobservable assumptions reflect the Corporation’s assumptions regarding what market participants would assume when pricing a financial instrument.

 

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.

 

The following methods and assumptions were used to estimate the fair values of the Corporation’s financial instruments at June 30, 2012 and December 31, 2011:

 

Cash and cash equivalents: For these short-term instruments, the carrying amount is a reasonable estimate of fair value.

 

Investment securities available for sale: The fair value of securities available-for-sale which are measured on a recurring basis are determined primarily by obtaining quoted prices on nationally recognized securities exchanges or matrix pricing, which is a mathematical technique used widely in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities’ relationship to other similar securities. These securities are classified within Level 1 or 2 of the fair value hierarchy as appropriate. There may be substantial differences in the assumptions used for securities within the same level. For example, prices for U.S. Agency securities have fewer assumptions and are closer to Level 1 valuations than the private label mortgage backed securities that require more assumptions and are closer to Level 3 valuations.

 

Restricted stock: The carrying value of restricted stock approximates its fair value based on redemption provisions for the restricted stock.

 

Net loans (excluding held for sale): The fair value of fixed-rate loans is estimated for each major type of loan (e.g. real estate, commercial, industrial and agricultural and consumer) by discounting the future cash flows associated with such loans using rates currently offered for loans with similar terms to borrowers of comparable credit quality. The model considers scheduled principal maturities, repricing characteristics, prepayment assumptions and interest cash flows. The discount rates used are estimated based upon consideration of a number of factors including the treasury yield curve, expense and service charge factors. For variable rate loans that reprice frequently and have no significant change in credit quality, carrying values approximate the fair value.

 

Loans held for sale: The fair value of loans held for sale is determined by the price set between the Bank and the purchaser prior to origination. These loans are usually sold at par.

 

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

 

24
 

 

Mortgage servicing rights: The fair value of mortgage servicing rights is based on observable market prices when available or the present value of expected future cash flows when not available. Assumptions used to calculate the present value include loan default rates, costs to service, and prepayment speeds. These inputs are provided by a third-party pricing service without adjustment. Mortgage servicing rights are carried at the lower of cost or fair value.

 

Deposits: The fair value of demand deposits, savings accounts, and money market deposits is the amount payable on demand at the reporting date. The fair value of fixed-rate certificates of deposit is estimated by discounting the future cash flows using rates approximating those currently offered for certificates of deposit with similar remaining maturities.

 

Securities sold under agreement to repurchase: These variable rate liabilities are priced on a short-term market interest rate. Therefore, the carrying value is a reasonable estimate of the fair value.

 

Long-term debt: The fair value of long-term debt is estimated by discounting the future cash flows using rates approximating those currently offered for borrowings with similar remaining maturities.

 

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

 

Interest rate swaps: The interest rate swaps are valued using a discounted cash flow model that uses verifiable market environment inputs to calculate the fair value. This method is not dependent on the input of any significant judgments or assumptions by Management.

  

25
 

  

The fair value of the Corporation's financial instruments are as follows:

 

   June 30, 2012 
   Carrying   Fair   Fair Value Measurements 
(Dollars in thousands)  Amount   Value   Level 1   Level 2   Level 3 
                     
Financial assets:                         
Cash and cash equivalents  $91,104   $91,104   $91,104   $-   $- 
Investment securities available for sale   132,804    132,804    1,923    130,881    - 
Restricted stock   4,535    4,535    -    4,535    - 
Loans held for sale   795    795    -    795    - 
Net loans   758,737    772,166    -    -    772,166 
Accrued interest receivable   3,582    3,582    3,582    -    - 
Mortgage servicing rights   312    312    -    -    312 
                          
Financial liabilities:                         
Deposits  $856,646   $859,428   $659,765   $199,663   $- 
Securities sold under agreements to repurchase   51,028    51,028    51,028    -    - 
Long-term debt   46,292    48,451    -    48,451    - 
Accrued interest payable   476    476    476    -    - 
Interest rate swaps   1,443    1,443    -    1,443    - 

 

   December 31, 2011                         
   Carrying   Fair                         
(Dollars in thousands)  Amount   Value                         
                                 
Financial assets:                                  
Cash and cash equivalents  $34,144   $34,144                         
Investment securities available for sale   125,301    125,301                         
Restricted stock   5,022    5,022                         
Net loans   756,687    765,707                         
Accrued interest receivable   3,391    3,391                         
Mortgage servicing rights   368    368                         
                                   
Financial liabilities:                                  
Deposits  $787,986   $790,887                         
Securities sold under agreements to repurchase   53,103    53,103                         
Long-term debt   48,336    51,015                         
Accrued interest payable   561    561                         
Interest rate swaps   1,738    1,738                         

  

26
 

  

Recurring Fair Value Measurements

  

For financial assets and liabilities measured at fair value on a recurring basis, the fair value measurements by level within the fair value hierarchy are as follows:

 

(Dollars in Thousands)  Fair Value at June 30, 2012 
    Level 1   Level 2   Level 3   Total 
Asset Description                    
Equity securities  $1,923   $-   $-   $1,923 
U.S. Government agency securities   -    12,298    -    12,298 
Municipal securities   -    57,468    -    57,468 
Corporate debt securities   -    2,225    -    2,225 
Trust Preferred Securities   -    4,546    -    4,546 
Agency mortgage-backed securities   -    51,711    -    51,711 
Private-label mortgage-backed securities   -    2,586    -    2,586 
Asset-backed securities   -    47    -    47 
Total assets  $1,923   $130,881   $-   $132,804 
                     
Liability Description                    
Interest rate swaps  $-   $1,443   $-   $1,443 
Total liabilities  $-   $1,443   $-   $1,443 

 

(Dollars in Thousands)  Fair Value at December 31, 2011 
    Level 1   Level 2   Level 3   Total 
Asset Description                    
Equity securities  $1,759   $-   $-   $1,759 
U.S. Government agency securities   -    13,229    -    13,229 
Municipal securities   -    45,081    -    45,081 
Corporate debt securities   -    2,414    -    2,414 
Trust Preferred Securities   -    4,618    -    4,618 
Agency mortgage-backed securities   -    55,285    -    55,285 
Private-label mortgage-backed securities   -    2,867    -    2,867 
Asset-backed securities   -    48    -    48 
Total assets  $1,759   $123,542   $-   $125,301 
                     
Liability Description                    
Interest rate swaps  $-   $1,738   $-   $1,738 
Total liabilities  $-   $1,738   $-   $1,738 

  

For financial assets and liabilities measured at fair value on a recurring basis, there were no transfers of assets or liabilities between Level 1 and Level 2 during the period ending June 30, 2012.

 

The methods and significant assumptions used to estimate the fair value for assets and liabilities measured on a recurring basis are the same as previously presented for the same asset or liability.

  

27
 

  

Nonrecurring Fair Value Measurements

 

For financial assets and liabilities measured at fair value on a nonrecurring basis, the fair value measurements by level within the fair value hierarchy are as follows:

 

(Dollars in Thousands)  Fair Value at June 30, 2012 
Asset Description  Level 1   Level 2   Level 3   Total 
Impaired loans (1)  $-   $-   $10,390   $10,390 
Other real estate owned (1)   -    -    3,290    3,290 
Mortgage servicing rights   -    -    312    312 
                     
Total assets  $-   $-   $13,992   $13,992 

 

(Dollars in Thousands)  Fair Value at December 31, 2011 
Asset Description  Level 1   Level 2   Level 3   Total 
Impaired loans (1)  $-   $-   $13,705   $13,705 
Other real estate owned (1)   -    -    3,224    3,224 
Mortgage servicing rights   -    -    368    368 
Total assets  $-   $-   $17,297   $17,297 

 

(1) Includes assets directly charged-down to fair value during the year-to-date period

 

The Corporation used the following methods and significant assumptions to estimate the fair value of assets and liabilities measured on a nonrecurring basis:

 

Impaired loans: Impaired loans are carried at the lower of cost or the fair value of the collateral for collateral-dependent loans. Collateral may be in the form of real estate or business assets including equipment, inventory and accounts receivable. The use of independent appraisals, costs to sell, and management’s best judgment are significant inputs in arriving at the fair value measure of the underlying collateral and impaired loans are therefore classified within the Level 3 of the fair value hierarchy. Appraisals may be adjusted for qualitative factors such as economic conditions, and liquidation expenses. Appraisal adjustments reflect discounts that are specific to each credit.

 

Other real estate owned: Other real estate owned is carried at the lower of the investment in the asset or the fair value less estimated costs to sell. The fair value of other real estate owned is generally determined through independent appraisals of the underlying collateral, which generally included various Level 3 inputs. Appraisals may be adjusted for qualitative factors such as economic conditions or other factors Management believes are relevant to a specific asset.

 

Mortgage servicing rights: The fair value of mortgage servicing rights is estimated using a valuation model that calculates the present value of estimated future net servicing income. The model incorporates Level 3 assumptions such as cost to service, discount rate, prepayment speeds, default rates and losses. These inputs are provided by a third-party pricing service without adjustment. Mortgage servicing rights are carried at the lower of cost or fair value.

 

28
 

 

The following table presents additional quantitative information about Level 3 assets measured at fair value on a nonrecurring basis.

 

   Quantitative Information about Level 3 Fair Value Measurements  
(Dollars in Thousands)  at June 30, 2012  
Asset Description  Fair Value   Valuation Technique  Unobservable Input  Range
Weighted Average
 
Impaired loans (1)  $10,390   Appraisal  Appraisal Adjustments (2)  0% - 70% (22%)  
           Cost to sell  5% - 25%  (8%)  
Other real estate owned   3,290   Appraisal  Appraisal Adjustments (2)     
           Cost to sell  8% (8%)  
Mortgage servicing rights   312   Discounted Cash Flow (3)        

 

(1) Includes loans directly charged-down to fair value during the year-to-date period.

(2) Qualitative adjustments are discounts specific to each asset and are made as needed.

(3) Valuation and inputs are determined by a third-party pricing service without adjustment.

 

Note 11 Financial Derivatives

 

The Board of Directors has given Management authorization to enter into derivative activity including interest rate swaps, caps and floors, forward-rate agreements, options and futures contracts in order to hedge interest rate risk. The Bank is exposed to credit risk equal to the positive fair value of a derivative instrument, if any, as a positive fair value indicates that the counterparty to the agreement is financially liable to the Bank. To limit this risk, counterparties must have an investment grade long-term debt rating and individual counterparty credit exposure is limited by Board approved parameters. Management anticipates continuing to use derivatives, as permitted by its Board-approved policy, to manage interest rate risk. In 2008, the Bank entered into two interest rate swap transactions in order to hedge the Corporation’s exposure to changes in cash flows attributable to the effect of interest rate changes on variable rate liabilities.

 

Information regarding the interest rate swaps as of June 30, 2012 follows:

 

(Dollars in thousands)           Amount Expected to 
                be Expensed into 
Notional   Maturity   Interest Rate   Earnings within the 
Amount   Date   Fixed   Variable   next 12 Months 
                       
$10,000   5/30/2013    3.60%   0.10%  $350 
$10,000   5/30/2015    3.87%   0.10%  $377 

 

The variable rate is indexed to the 91-day Treasury Bill auction (discount) rate and resets weekly.

 

Derivatives with a positive fair value are reflected as other assets in the consolidated balance sheet while those with a negative fair value are reflected as other liabilities. As short-term interest rates decrease, the net expense of the swap increases. As short-term rates increase, the net expense of the swap decreases.

 

29
 

 

Fair Value of Derivative Instruments in the Consolidated Balance Sheets as of June 30, 2012 and December 31, 2011 are as follows:

 

Fair Value of Derivative Instruments  
(Dollars in thousands)       Balance Sheet      
Date   Type   Location   Fair Value  
June 30, 2012   Interest rate contracts   Other liabilities   $ 1,443  
December 31, 2011   Interest rate contracts   Other liabilities   $ 1,738  

 

The Effect of Derivative Instruments on the Statement of Income for the Three and Six Months Ended June 30, 2012 and 2011 follows:

 

Derivatives in ASC Topic 815 Cash Flow Hedging Relationships 
(Dollars in thousands)                  
       Location of  Amount of Gain        
       Gain or (Loss)  or (Loss)        
   Amount of Gain or (Loss)   Reclassified from  Reclassified from   Location of  Gain or  Amount of Gain or 
   Recognized in OCI   Accumulated OCI  Accumulated OCI   (Loss) Recognized in  (Loss) Recognized in 
   net of tax on Derivative   into Income  into Income   Income on Derivative  Income on Derivative 
Type / Date  (Effective Portion)   (Effective Portion)  (Effective Portion)   (Ineffective Portion)  (Ineffective Portion) 
                   
Interest Rate Contracts                     
                      
Three months ended:                     
June 30, 2012  $56   Interest Expense  $(178)  Other income (expense)  $- 
June 30, 2011  $(108)  Interest Expense  $(180)  Other income (expense)  $- 
                      
Six months ended:                     
June 30 2012  $195   Interest Expense  $(358)  Other income (expense)  $- 
June 30, 2011  $50   Interest Expense  $(356)  Other income (expense)  $- 

 

Note 12 – Reclassifications

 

Certain prior period amounts may have been reclassified to conform to the current year presentation. Such reclassifications did not affect reported net income.

 

30
 

 

Item 2

 

Management’s Discussion and Analysis of Results of Operations and Financial Condition

For the Three and Six Month Periods Ended June 30, 2012 and 2011

 

Forward Looking Statements

 

Certain statements appearing herein which are not historical in nature are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements refer to a future period or periods, reflecting management’s current views as to likely future developments, and use words such as “may,” “will,” “expect,” “believe,” “estimate,” “anticipate,” or similar terms. Because forward-looking statements involve certain risks, uncertainties and other factors over which the Corporation has no direct control, actual results could differ materially from those contemplated in such statements. These factors include (but are not limited to) the following: general economic conditions, changes in interest rates, changes in the Corporation’s cost of funds, changes in government monetary policy, changes in government regulation and taxation of financial institutions, changes in the rate of inflation, changes in technology, the intensification of competition within the Corporation’s market area, and other similar factors.

 

Critical Accounting Policies

 

Management has identified critical accounting policies for the Corporation to include Allowance for Loan Losses, Mortgage Servicing Rights, Financial Derivatives, Temporary Investment Impairment and Stock-based Compensation. There were no changes to the critical accounting policies disclosed in the 2011 Annual Report on Form 10-K in regards to application or related judgements and estimates used. Please refer to Item 7 of the Corporation’s 2011 Annual Report on Form 10-K for a more detailed disclosure of the critical accounting policies.

 

Results of Operations

 

Year-to-Date Summary

At June 30, 2012, total assets were $1.057 billion, an increase of $67.3 million from December 31, 2011. Net loans increased to $758.7 million and total deposits increased to $856.6 million. The Corporation reported net income for the first six months of 2012 of $3.3 million. This is a 9.2% decrease versus net income of $3.6 million for the same period in 2011. Total revenue (interest income and noninterest income) decreased $733 thousand year-over-year. Interest income decreased $841 thousand, but was more than offset by a decrease of $1.0 million in interest expense, resulting in a $195 thousand increase in net interest income. Noninterest income improved 2.2% due to an increase in ATM fees and debit card income. Noninterest expense remained relatively flat year over year. The provision for loan losses was $2.8 million for the period, $108 thousand more than in 2011. Diluted earnings per share decreased to $.81 in 2012 from $.92 in 2011.

 

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Key performance ratios as of, or for the six months ended June 30, 2012 and 2011 are listed below:

 

   June 30 
   2012   2011 
         
Performance measurements          
Return on average assets*   0.64%   0.74%
Return on average equity*   7.49%   8.64%
Return on average tangible assets (1)*   0.67%   0.77%
Return on average tangible equity (1)*   8.82%   10.23%
Efficiency ratio (2)   66.49%   66.22%
Net interest margin*   3.54%   3.72%
Current dividend yield*   5.18%   6.07%
           
Shareholders' Value (per common share)          
Diluted earnings per share  $0.81   $0.92 
Regular cash dividends paid  $0.44   $0.54 
Book value  $22.00   $21.79 
Tangible book value (3)  $19.52   $19.19 
Market value  $13.12   $17.80 
Market value/book value ratio   59.64%   81.69%
Price/earnings multiple*   8.10    9.67 
           
Safety and Soundness          
Leverage ratio (Tier 1)   8.10%   8.10%
Total risk-based capital ratio   12.19%   11.82%
Equity ratio   8.51%   8.59%
Tangible equity ratio (4)   7.60%   7.62%
Nonperforming loans/gross loans   3.83%   4.24%
Nonperforming assets/total assets   3.10%   2.79%
Allowance for loan losses as a % of loans   1.25%   1.31%
Net charge-offs/average loans*   0.75%   0.35%
           
Trust assets under management (market value)  $503,537   $508,531 

 

* Annualized

(1) Excludes goodwill, intangibles and intangible amortization expense, net of tax

(2)Noninterest expense / tax equivalent net interest income plus noninterest income less net securities gains

(3) Total shareholders' equity less goodwill and intangibles / shares outsanding

(4)Total shareholders' equity less goodwill and intangibles / total assets less goodwill and intangibles

 

GAAP versus Non-GAAP Presentations. The Corporation supplements its traditional GAAP measurements with Non-GAAP measurements. The Non-GAAP measurements include Return on Average Tangible Assets and Return on Average Tangible Equity. As a result of merger transactions, intangible assets (primarily goodwill and core deposit intangibles) were created. The Non-GAAP disclosures are intended to eliminate the effects of the intangible assets and allow for better comparisons to periods when such assets did not exist. The following table shows the adjustments made between the GAAP and NON-GAAP measurements:

 

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GAAP Measurement   Calculation
Return on Average Assets   Net Income / Average Assets
Return on Average Equity   Net Income / Average Equity
     
Non- GAAP Measurement   Calculation
Return on Average Tangible Assets   Net Income plus Intangible Amortization / Average Assets less Average Intangible Assets
Return on Average Tangible Equity   Net Income plus Intangible Amortization / Average Equity less Average Intangible Assets
Efficiency Ratio   Noninterest Expense / Tax Equivalent Net Interest Income plus Noninterest Income (excluding Security Gains/Losses and Other Than Temporary Impairment)

 

Comparison of the three months ended June 30, 2012 to the three months ended June 30, 2011:

 

Net Interest Income

 

The most important source of the Corporation’s earnings is net interest income, which is defined as the difference between income on interest-earning assets and the expense of interest-bearing liabilities supporting those assets. Principal categories of interest-earning assets are loans and securities, while deposits, securities sold under agreements to repurchase (Repos), short-term borrowings and long-term debt are the principal categories of interest-bearing liabilities. Demand deposits enhance net interest income because they are noninterest-bearing deposits. For the purpose of this discussion, balance sheet items refer to the average balance for the period and net interest income is adjusted to a fully taxable-equivalent basis. This tax-equivalent adjustment facilitates performance comparisons between taxable and tax-free assets by increasing the tax-free income by an amount equivalent to the Federal income taxes that would have been paid if this income were taxable at the Corporation’s 34% Federal statutory rate.

 

Tax equivalent interest income for the second quarter of 2012 decreased $753 thousand quarter-over-quarter. Average interest-earning assets increased $47.9 million from 2011, but the yield on these assets decreased by 54 basis points to 4.25%. The average balance of investment securities decreased $1.8 million while average loans decreased $25 thousand quarter-over-quarter. Average commercial loans increased $15.6 million, but the increase was partially offset by a decrease in the average balance of mortgage and consumer loans. Average mortgage loans decreased $5.6 million, as the majority of new mortgage originations are sold in the secondary market and the portfolio continues to runoff. Average consumer loans, including home equity loans, decreased $10.0 million, as consumers continue to borrow less.

 

Interest expense was $1.8 million for the second quarter, a decrease of $597 thousand from the 2011 total of $2.4 million. Average interest-bearing liabilities increased $43.6 million to $841.2 million for 2012 from an average balance of $797.6 million in 2011. The average cost of these liabilities decreased from 1.21% in 2011 to .86% in 2012. Average interest-bearing deposits increased $67.5 million, due to increases in interest checking and savings accounts ($12.6 million), and money management deposits ($63.5 million). The cost of interest-bearing deposits decreased from 1.04% to .70%. Securities sold under agreements to repurchase (Repos) decreased $11.9 million on average over the prior year quarter while the average rate decreased from .25% in 2011 to .15% in 2012. The average balance of long-term debt decreased by $12.0 million due to scheduled amortization and maturities.

 

The changes in the balance sheet and interest rates resulted in a decrease in tax equivalent net interest income of $156 thousand to $8.6 million in 2012 from $8.7 million in 2011. The Bank’s net interest margin decreased from 3.76% in 2011 to 3.51% in 2012. The decrease in the net interest margin is the result of a decrease in the rate on interest-earning assets of 54 basis points, while the yield on interest-bearing liabilities only decreased 35 basis points. Net interest income increased $106 thousand during the quarter, with $77 thousand of the increase from volume and $29 thousand from rates.

 

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With interest rates forecast to remain at current levels through at least 2014, the Bank does not expect any increase in the yield for several years. As a result, it is likely that the cost of interest-bearing deposits will continue to be reduced in an effort to maintain the net interest margin.

 

The following table shows a comparative analysis of average balances, asset yields and funding costs for the three months ended June 30, 2012 and 2011. These components drive changes in net interest income.

 

   For the Three Months Ended June 30 
   2012   2011 
   Average   Income or   Average   Average   Income or   Average 
(Dollars in thousands)  balance   expense   yield/rate   balance   expense   yield/rate 
                         
Interest-earning assets:                              
Interest-bearing obligations of other banks and federal funds sold  $80,054   $55    0.28%  $30,284   $19    0.25%
Investment securities:                              
Taxable   92,097    469    2.04%   99,787    661    2.66%
Nontaxable   39,250    539    5.51%   33,392    486    5.84%
Loans:                              
Commercial, industrial and agricultural   629,700    7,247    4.62%   614,124    7,625    4.98%
Residential mortgage   57,207    819    5.74%   62,838    939    5.99%
Home equity loans and lines   68,457    1,042    6.11%   78,314    1,200    6.15%
Consumer   12,437    209    6.74%   12,550    203    6.49%
Loans   767,801    9,317    4.87%   767,826    9,967    5.21%
                               
Total interest-earning assets   979,202    10,380    4.25%   931,289    11,133    4.79%
Other assets   74,134              71,381           
Total assets  $1,053,336             $1,002,670           
                               
Interest-bearing liabilities:                              
Deposits:                              
Interest-bearing checking  $121,435    22    0.07%  $112,514    27    0.10%
Money Management   370,020    621    0.67%   306,567    839    1.10%
Savings   55,321    16    0.12%   51,607    19    0.15%
Time   196,364    645    1.32%   204,986    870    1.70%
Total interest-bearing deposits   743,140    1,304    0.70%   675,674    1,755    1.04%
                               
Securities sold under agreements to repurchase   51,622    19    0.15%   63,509    39    0.25%
Short- term borrowings   -    -    -    -    -    0.73%
Long- term debt   46,434    488    4.22%   58,427    614    4.22%
Total interest-bearing liabilities   841,196    1,811    0.86%   797,610    2,408    1.21%
Noninterest-bearing deposits   110,169              105,999           
Other liabilities   13,441              13,758           
Shareholders' equity   88,530              85,303           
Total liabilities and shareholders' equity  $1,053,336             $1,002,670           
Tax equivalent net interest income/Net interest margin        8,569    3.51%        8,725    3.76%
Tax equivalent adjustment        (378)             (640)     
Net interest income       $8,191             $8,085      

 

All nontaxable interest income has been adjusted to a tax-equivalent basis, using a tax rate of 34%.

 

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Provision for Loan Losses

 

For the second quarter of 2012, the provision expense was $825 thousand versus $1.8 million in 2011. For more information refer to the Loan Quality and Allowance for Loan Losses discussion in the Financial Condition section.

 

Noninterest Income

 

For the second quarter of 2012, noninterest income increased $67 thousand from the same period in 2011. Investment and trust service fees were unchanged, while loan service charges increased $38 thousand due to the volume of mortgage refinancing. Mortgage banking fees increased $18 thousand, as the 2012 impairment charge was $27 thousand less than the prior year’s impairment charge. Deposit service charges decreased $118 thousand due to lower retail overdraft fees and less retail checking service charge fees. Other service charges and fees increased $89 thousand primarily due to an increase in ATM fees, while debit card income increased $35 thousand due to increased volume. Other income decreased due to several nonrecurring items. Securities gains of $21 thousand were recorded during 2012 from bonds called prior to maturity, compared to none during the three months ended June 30, 2011. There were no other than temporary impairment charges recorded in 2012, compared to $55 thousand on two bonds in 2011.

 

The following table presents a comparison of noninterest income for the three months ended June 30, 2012 and 2011:

 

   For the Three Months Ended     
(Dollars in thousands)  June 30   Change 
   2012   2011   Amount   % 
Noninterest Income                    
Investment and trust services fees  $1,059   $1,058   $1    0.1 
Loan service charges   269    231    38    16.5 
Mortgage banking activities   (27)   (45)   18    (40.0)
Deposit service charges and fees   479    597    (118)   (19.8)
Other service charges and fees   213    124    89    71.8 
Debit card income   295    260    35    13.5 
Increase in cash surrender value of life insurance   167    175    (8)   (4.6)
Other   17    81    (64)   (79.0)
OTTI losses on securities   -    (370)   370    - 
Less: Loss recognized in other comprehensive income (before taxes)   -    (315)   315    - 
Net OTTI losses recognized in earnings   -    (55)   55    - 
Securities gains (losses), net   21    -    21    - 
Total noninterest income  $2,493   $2,426   $67    2.8 

 

Noninterest Expense

 

Noninterest expense for the second quarter of 2012 was $7.6 million compared to $7.4 million in 2011. The increase in salaries and benefits was primarily due to annual salary adjustments ($230 thousand) and pension expense ($101 thousand), but these increases were partially offset by a $28 thousand decrease in health insurance expense, due to lower claims expense during the quarter from the Bank’s participation in a self-insured health insurance plan. Occupancy expense remained flat quarter-over-quarter, while advertising expense increased $45 thousand, due to a marketing campaign to take advantage of the disruptions in our local market from mergers and institutions with regulatory issues. Legal and professional expenses increased $16 thousand due to expenses from matters arising in the ordinary course of business, while data processing fees decreased $47 thousand from cost savings due to the core system conversion. Other expenses decreased $148 thousand due to a prepayment penalty of $172 thousand on an FHLB term loan in the second quarter of 2011.

 

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The following table presents a comparison of noninterest expense for the three months ended June 30, 2012 and 2011:

 

(Dollars in thousands)  For the Three Months Ended         
   June 30   Change 
Noninterest Expense  2012   2011   Amount   % 
Salaries and benefits  $4,157   $3,883   $274    7.1 
Net occupancy expense   493    496    (3)   (0.6)
Furniture and equipment expense   218    214    4    1.9 
Advertising   396    351    45    12.8 
Legal and professional fees   260    244    16    6.6 
Data processing   440    487    (47)   (9.7)
Pennsylvania bank shares tax   187    173    14    8.1 
Intangible amortization   109    111    (2)   (1.8)
FDIC insurance   267    256    11    4.3 
Other   1,070    1,218    (148)   (12.2)
Total noninterest expense  $7,597   $7,433   $164    2.2 

 

Income Taxes

 

For the second quarter of 2012 the Corporation recorded a Federal income tax expense of $356 thousand compared to a tax benefit of $447 thousand for the same quarter in 2011. For the second quarter of 2011, the Corporation recorded a Federal income tax benefit of $447 thousand. During the second quarter of 2011, an internal review discovered that tax-exempt commercial loans booked in the fourth quarter of 2008, during 2009 and 2010 and in the first quarter of 2011 were not properly coded as tax-exempt in the Bank’s core processing system. This resulted in the income from these loans being recorded as taxable income and the benefit of the tax-exempt status was not reflected in the Corporation’s income tax calculation. After a thorough review of the affected loans to determine the unrecorded tax benefit, and consultation with the Corporation’s internal and external audit firms, the Corporation deemed the adjustment to be immaterial to the consolidated financial statements for the current and prior year and therefore, no prior period adjustment was required. The Corporation recorded the past income tax benefits during the second quarter of 2011. The adjustment to income tax expense for the second quarter was a credit of approximately $660 thousand attributable to the years 2008, 2009 and 2010 and approximately $95 thousand attributable to the first quarter of 2011. The effective tax rate for the second quarter of 2012 was 15.7% compared to a tax-credit in the second quarter of 2011. Without the adjustments for past periods, the effective tax rate for the second quarter of 2011 would have been 16.2%. All taxable income for the Corporation is taxed at a rate of 34%.

 

Comparison of the six months ended June 30, 2012 to the six months ended June 30, 2011:

 

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Net Interest Income

 

Tax equivalent interest income for the first half of 2012 decreased by $936 thousand compared to 2011. Average interest-earning assets increased $47.3 million from 2011, but the yield on these assets decreased by 46 basis points. The average balance of investment securities was flat year over year. Total average loans increased $2.3 million year over year. Average commercial loans increased $20.2 million, but the increase was partially offset by a decrease in the average balance of mortgage and consumer loans. Average mortgage loans decreased $7.4 mi