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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF

THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended June 30, 2012

Commission File No. 001-34453

 

 

HUDSON VALLEY HOLDING CORP.

(Exact name of registrant as specified in its charter)

 

 

 

NEW YORK		13-3148745
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

21 Scarsdale Road, Yonkers, NY 10707

(Address of principal executive office with zip code)

914-961-6100

(Registrant’s telephone number including area code)

 

 

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

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

 

Large accelerated filer		¨		Accelerated filer		þ
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  þ

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

 

Class		Outstanding at August 1, 2012
Common stock, par value $0.20 per share		19,636,301

 

 

 

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FORM 10-Q

TABLE OF CONTENTS

 

				Page No.
PART I:  FINANCIAL INFORMATION
ITEM 1		CONDENSED FINANCIAL STATEMENTS			2
ITEM 2		MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS			30
ITEM 3		QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK			50
ITEM 4		CONTROLS AND PROCEDURES			50
PART II:  OTHER INFORMATION
ITEM 1A		RISK FACTORS			51
ITEM 6		EXHIBITS			51
SIGNATURES					52

 

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PART 1 — FINANCIAL INFORMATION

Item 1.    Condensed Financial Statements

HUDSON VALLEY HOLDING CORP. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)

Dollars in thousands, except per share amounts

 

		Three Months Ended Jun 30
		2012				2011
Interest Income:
Loans, including fees		$	22,663			$	27,941
Securities:
Taxable			3,140				3,147
Exempt from Federal income taxes			1,010				1,150
Federal funds sold			9				23
Deposits in banks			298				201
Total interest income			27,120				32,462
Interest Expense:
Deposits			1,414				2,290
Securities sold under repurchase agreements and other short-term borrowings			16				57
Other borrowings			182				501
Total interest expense			1,612				2,848
Net Interest Income			25,508				29,614
Provision for loan losses			1,894				1,546
Net interest income after provision for loan losses			23,614				28,068
Non Interest Income:
Service charges			1,529				1,552
Investment advisory fees			2,512				2,753
Recognized impairment charge on securities available for sale (includes $395 of total gains and $184 of total losses in 2012 and 2011, respectively, less $445 of gains and $141 of losses on securities available for sale, recognized in other comprehensive income in 2012 and 2011, respectively)			(50	)			(43	)
Losses on sales and revaluation of loans held for sale and other real estate owned, net			(15	)			(1,000	)
Other income			813				569
Total non interest income			4,789				3,831
Non Interest Expense:
Salaries and employee benefits			11,360				11,263
Occupancy			2,210				2,202
Professional services			2,040				1,749
Equipment			1,161				1,107
Business development			837				590
FDIC assessment			726				686
Other operating expenses			2,700				3,051
Total non interest expense			21,034				20,648
Income Before Income Taxes			7,369				11,251
Income Taxes			2,408				3,819
Net Income		$	4,961			$	7,432
Basic Earnings Per Common Share		$	0.25			$	0.38
Diluted Earnings Per Common Share		$	0.25			$	0.38

See notes to condensed consolidated financial statements

 

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HUDSON VALLEY HOLDING CORP. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)

Dollars in thousands, except per share amounts

 

		Six Months Ended Jun 30
		2012				2011
Interest Income:
Loans, including fees		$	51,578			$	54,273
Securities:
Taxable			6,453				6,097
Exempt from Federal income taxes			1,996				2,311
Federal funds sold			17				49
Deposits in banks			354				365
Total interest income			60,398				63,095
Interest Expense:
Deposits			3,164				4,564
Securities sold under repurchase agreements and other short-term borrowings			67				104
Other borrowings			363				1,345
Total interest expense			3,594				6,013
Net Interest Income			56,804				57,082
Provision for loan losses			3,253				6,997
Net interest income after provision for loan losses			53,551				50,085
Non Interest Income:
Service charges			3,396				3,592
Investment advisory fees			4,910				5,359
Recognized impairment charge on securities available for sale (includes $105 and $957 of total losses in 2012 and 2011, respectively, less $423 of gains and $753 of losses on securities available for sale, recognized in other comprehensive income in 2012)			(528	)			(204	)
Gains (losses) on sales and revaluation of loans held for sale and other real estate owned, net			15,920				(873	)
Other income			1,445				1,176
Total non interest income			25,143				9,050
Non Interest Expense:
Salaries and employee benefits			22,178				22,081
Occupancy			4,442				4,547
Professional services			3,907				3,202
Equipment			2,229				2,117
Business development			1,354				1,096
FDIC assessment			1,354				1,797
Other operating expenses			6,446				6,258
Total non interest expense			41,910				41,098
Income Before Income Taxes			36,784				18,037
Income Taxes			13,810				5,781
Net Income		$	22,974			$	12,256
Basic Earnings Per Common Share		$	1.17			$	0.63
Diluted Earnings Per Common Share		$	1.17			$	0.63

See notes to condensed consolidated financial statements

 

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HUDSON VALLEY HOLDING CORP. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (UNAUDITED)

Dollars in thousands

 

		Three Months Ended Jun 30								Six Months Ended Jun 30
		2012				2011				2012				2011
Net Income		$	4,961			$	7,432			$	22,974			$	12,256
Other comprehensive income (loss), net of tax:
Net change in unrealized gains (losses):
Other-than-temporarily impaired securities available for sale:
Total gains (losses)			395				(184	)			(105	)			(957	)
Losses recognized in earnings			50				43				528				204
Gains (losses) recognized in comprehensive income			445				(141	)			423				(753	)
Income tax effect			(182	)			58				(173	)			309
Unrealized holding gains (losses) on other-than-temporarily impaired securities available for sale, net of tax			263				(83	)			250				(444	)
Securities available for sale not other-than-temporarily impaired:
(Losses) gains arising during the year			(184	)			333				(2,565	)			(2,200	)
Income tax effect			73				(119	)			864				870
Unrealized holding (losses) gains on securities available for sale not other-than-temporarily-impaired , net of tax			(111	)			214				(1,701	)			(1,330	)
Unrealized holding gain (losses) on securities, net			152				131				(1,451	)			(1,774	)
Accrued benefit liability adjustment			144				74				288				155
Income tax effect			(57	)			(30	)			(115	)			(62	)
			87				44				173				93
Other comprehensive income (loss)			239				175				(1,278	)			(1,681	)
Comprehensive Income		$	5,200			$	7,607			$	21,696			$	10,575

See notes to condensed consolidated financial statements

 

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HUDSON VALLEY HOLDING CORP. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS (UNAUDITED)

Dollars in thousands, except share amounts

 

		Jun 30 2012				Dec 31 2011
ASSETS
Cash and non interest earning due from banks		$	46,047			$	43,743
Interest earning deposits in banks			595,263				34,361
Federal funds sold			22,250				16,425
Securities available for sale, at estimated fair value (amortized cost of $453,993 in 2012 and $503,584 in 2011)			456,165				507,897
Securities held to maturity, at amortized cost (estimated fair value of $12,217 in 2012 and $13,819 in 2011)			11,458				12,905
Federal Home Loan Bank of New York (FHLB) stock			4,827				3,831
Loans (net of allowance for loan losses of $28,733 in 2012 and $30,685 in 2011)			1,523,833				1,541,405
Loans held for sale			2,387				473,814
Accrued interest and other receivables			35,360				40,405
Premises and equipment, net			25,130				25,936
Other real estate owned			250				1,174
Deferred income tax, net			19,379				19,822
Bank owned life insurance			38,458				37,563
Goodwill			23,842				23,842
Other intangible assets			1,277				1,651
Other assets			10,318				12,896
TOTAL ASSETS		$	2,816,244			$	2,797,670
LIABILITIES
Deposits:
Non interest bearing		$	964,372			$	910,329
Interest bearing			1,475,476				1,514,953
Total deposits			2,439,848				2,425,282
Securities sold under repurchase agreements and other short-term borrowings			42,173				53,056
Other borrowings			16,447				16,466
Accrued interest and other liabilities			25,177				25,304
TOTAL LIABILITIES			2,523,645				2,520,108
STOCKHOLDERS’ EQUITY
Preferred Stock, $0.01 par value; authorized 15,000,000 shares; no shares outstanding in 2012 and 2011, respectively			—				—
Common stock, $0.20 par value; authorized 25,000,000 shares: outstanding 19,633,977 and 19,516,490 shares in 2012 and 2011, respectively			4,186				4,163
Additional paid-in capital			348,114				347,764
Retained earnings (deficit)			(2,585	)			(18,527	)
Accumulated other comprehensive income			448				1,726
Treasury stock, at cost; 1,299,414 shares in 2012 and 2011			(57,564	)			(57,564	)
TOTAL STOCKHOLDERS’ EQUITY			292,599				277,562
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY		$	2,816,244			$	2,797,670

See notes to condensed consolidated financial statements

 

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HUDSON VALLEY HOLDING CORP. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (UNAUDITED)

Six Months Ended June 30, 2012 and 2011

Dollars in thousands, except share amounts

 

		Number of Shares Outstanding				Common Stock				Treasury Stock				Additional Paid-in Capital				Retained Earnings (Deficit)				Accumulated Other Comprehensive Income (Loss)				Total
Balance at January 1, 2012			19,516,490			$	4,163			$	(57,564	)		$	347,764			$	(18,527	)		$	1,726			$	277,562
Net income																			22,974								22,974
Comprehensive loss																							(1,278	)			(1,278	)
Stock option expense and exercises of stock options, net of tax			14,207				2								242												244
Restricted stock awards			103,280				21								108												129
Cash dividends ($0.36 per share)																			(7,032	)							(7,032	)
Balance at June 30, 2012			19,633,977			$	4,186			$	(57,564	)		$	348,114			$	(2,585	)		$	448			$	292,599

 

		Number of Shares Outstanding				Common Stock				Treasury Stock				Additional Paid-in Capital				Retained Earnings (Deficit)				Accumulated Other Comprehensive Income (Loss)				Total
Balance at January 1, 2011			17,665,908				3,793				(57,564	)			346,750				(3,989	)			927				289,917
Net income																			12,256								12,256
Comprehensive loss																							(1,681	)			(1,681	)
Stock option expense and exercises of stock options, net of tax			23,141				5								495												500
Cash dividends ($0.28 per share)																			(5,306	)							(5,306	)
Balance at June 30, 2011			17,689,049			$	3,798			$	(57,564	)		$	347,245			$	2,961			$	(754	)		$	295,686

See notes to condensed consolidated financial statements

 

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HUDSON VALLEY HOLDING CORP. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

Dollars in thousands

 

		Six Months Ended June 30
		2012				2011
Operating Activities:
Net Income		$	22,974			$	12,256
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for loan losses			3,253				6,997
Depreciation and amortization			1,924				1,979
Recognized impairment charge on securities available for sale			528				204
Amortization of premiums on securities, net			1,033				1,259
Realized loss (gain) on sale and revaluation of OREO			15				(127	)
Increase in cash value of bank owned life insurance			(686	)			(535	)
Amortization of other intangible assets			374				411
Stock option expense			25				76
Realized (gain) on sale of loans held-for-sale			(15,935	)			—
Deferred taxes (benefit)			1,017				(1,001	)
Increase (decrease) in deferred loan fees, net			(841	)			9
Decrease in accrued interest and other receivables			5,045				3,269
Decrease in other assets			2,578				2,181
Excess tax benefits from share-based payment arrangements			—				(7	)
(Decrease) increase in accrued interest and other liabilities			(170	)			3,315
Net cash provided by Operating Activities			21,134				30,286
Investing Activities:
Net (increase) decrease in short term investments			(5,825	)			35,630
(Increase) decrease in FHLB stock			(996	)			2,278
Proceeds from maturities of securities available for sale			128,835				124,616
Proceeds from maturities of securities held to maturity			1,448				1,784
Purchases of securities available for sale			(80,346	)			(147,130	)
Proceeds from sales of and payments of loans held for sale			487,241				—
Net decrease (increase) in loans			15,282				(204,124	)
Proceeds from sales of OREO			909				9,635
Premiums paid on bank owned life insurance			(209	)			(259	)
Net purchases of premises and equipment			(1,118	)			(586	)
Net cash provided by (used in) Investing Activities			545,221				(178,156	)
Financing Activities:
Proceeds from issuance of common stock			219				424
Excess tax benefits from share-based payment arrangements			—				7
Net increase in deposits			14,566				183,979
Cash dividends paid			(7,032	)			(5,306	)
Repayment of other borrowings			(19	)			(51,267	)
Net (decrease) increase in securities sold under repurchase agreements and short-term borrowings			(10,883	)			7,079
Net cash (used in) provided by Financing Activities			(3,149	)			134,916
Increase (decrease) in Cash and Due from Banks			563,206				(12,954	)
Cash and Due from Banks, beginning of period			78,104				284,156
Cash and Due from Banks, end of period		$	641,310			$	271,202
Supplemental disclosures:
Interest paid		$	4,449			$	6,542
Income tax payments			19				2,550
Transfers from loans held for sale back to loan portfolio			121				2,305
Transfers to other real estate owned			—				850

See notes to condensed consolidated financial statements

 

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HUDSON VALLEY HOLDING CORP. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

Dollars in thousands, except per share and share amounts

1.    Description of Operations

Hudson Valley Holding Corp. (the “Company”) is a New York corporation founded in 1982. The Company is registered as a bank holding company under the Bank Holding Company Act of 1956.

The Company provides financial services through its wholly-owned subsidiary, Hudson Valley Bank, N.A. (“HVB” or “the Bank”), a national banking association established in 1972, with operational headquarters in Westchester County, New York. The Bank has 18 branch offices in Westchester County, New York, 5 in Manhattan, New York, 4 in Bronx County, New York, 2 in Rockland County, New York, 1 in Kings County, New York, 5 in Fairfield County, Connecticut and 1 in New Haven County, Connecticut.

The Company provides investment management services through a wholly-owned subsidiary of HVB, A.R. Schmeidler & Co., Inc. (“ARS”), a Manhattan, New York based money management firm.

Our principal executive offices are located at 21 Scarsdale Road, Yonkers, New York 10707.

We derive substantially all of our revenue and income from providing banking and related services to businesses, professionals, municipalities, not-for-profit organizations and individuals within our market area, primarily Westchester County and Rockland County, New York, portions of New York City, Fairfield County and New Haven County, Connecticut. We are dedicated to providing personalized service to customers and focusing on products and services for selected segments of the market. We believe that our ability to attract and retain customers is due primarily to our focused approach to our markets, our personalized and professional services, our product offerings, our experienced staff, our knowledge of our local markets and our ability to provide responsive solutions to customer needs. We provide these products and services to a diverse range of customers and do not rely on a single large depositor for a significant percentage of deposits. We anticipate that we will continue to expand in our current market and surrounding area through various means which include acquiring other banks and related businesses, adding staff, opening loan production offices and continuing to open new branch offices.

2.    Basis of Presentation

In the opinion of management, the accompanying unaudited condensed consolidated financial statements include all adjustments (comprising only normal recurring adjustments) necessary to present fairly the financial position of the Company at June 30, 2012 and December 31, 2011 and the results of its operations and comprehensive income for the three and six month periods ended June 30, 2012 and 2011 and cash flows and changes in stockholders’ equity for the six month periods ended June 30, 2012 and 2011. The results of operations for the three and six month periods ended June 30, 2012 are not necessarily indicative of the results of operations to be expected for the remainder of the year.

The unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and predominant practices used within the banking industry. Certain information and note disclosures normally included in annual financial statements have been omitted.

In preparing such financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the dates of the consolidated balance sheets and statements of income for the periods reported. Actual results could differ significantly from those estimates.

Estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses, the determination of the fair value of securities available for sale, the

 

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determination of other-than-temporary impairment of investments and the carrying amounts of goodwill and deferred tax assets. In connection with the determination of the allowance for loan losses, management utilizes the work of professional appraisers for significant properties.

Intercompany items and transactions have been eliminated in consolidation. Certain prior period amounts have been reclassified to conform to the current period’s presentation.

These unaudited condensed consolidated financial statements should be read in conjunction with our audited consolidated financial statements as of and for the year ended December 31, 2011 and notes thereto.

Cash and Cash Equivalents — For purposes of reporting cash flows, cash and cash equivalents include cash on hand, amounts due from banks and interest bearing deposits in other banks (including the Federal Reserve Bank of New York).

Securities — Securities are classified as either available for sale, representing securities the Company may sell in the ordinary course of business, or as held to maturity, representing securities that the Company has determined that it is more likely than not that it would not be required to sell prior to maturity or recovery of cost. Securities available for sale are reported at fair value with unrealized gains and losses (net of tax) excluded from operations and reported in other comprehensive income. Securities held to maturity are stated at amortized cost. Interest income includes amortization of purchase premium and accretion of purchase discount. The amortization of premiums and accretion of discounts is determined by using the level yield method. Securities are not acquired for purposes of engaging in trading activities. Realized gains and losses from sales of securities are determined using the specific identification method. The Company regularly reviews declines in the fair value of securities below their costs for purposes of determining whether such declines are other-than-temporary in nature. In estimating other-than-temporary impairment (“OTTI”), management considers adverse changes in expected cash flows, the length of time and extent that fair value has been less than cost and the financial condition and near term prospects of the issuer. The Company also assesses whether it intends to sell, or it is more likely than not that it will be required to sell, a security in an unrealized loss position before recovery of its amortized cost basis. If either of these criteria is met, the entire difference between amortized cost and fair value is recognized as impairment through earnings. For securities that do not meet the aforementioned criteria, the amount of impairment is split into two components as follows: 1) OTTI related to credit loss, which must be recognized in the income statement and 2) OTTI related to other factors, which is recognized in other comprehensive income. The credit loss is defined as the difference between the present value of the cash flows expected to be collected and the amortized cost basis.

Loans Held for Sale — Loan sales occur in limited circumstances as part of strategic business or regulatory compliance initiatives. Loans held for sale, including deferred fees and costs, are reported at the lower of cost or fair value as determined by expected bid prices from potential investors. Loans held for sale are segregated into pools based on distinct criteria and the lower of cost or fair value analysis is performed at the pool level. Loans are sold without recourse and servicing released. When a loan is transferred from portfolio to held for sale and the fair value is less than cost, a charge off is recorded against the allowance for loan loss. Subsequent declines in fair value, if any, are recorded as a valuation allowance and charged against earnings.

Loans — Loans are reported at their outstanding principal balance, net of the allowance for loan losses, and deferred loan origination fees and costs. Loan origination fees and certain direct loan origination costs are deferred and recognized over the life of the related loan or commitment as an adjustment to yield, or taken directly into income when the related loan is sold or commitment expires.

Allowance for Loan Losses — The Company maintains an allowance for loan losses to absorb probable losses incurred in the loan portfolio based on ongoing quarterly assessments of the estimated losses. The Company’s methodology for assessing the appropriateness of the allowance consists of a specific component for identified problem loans, and a formula component which addresses historical loan loss experience together with other relevant risk factors affecting the portfolio. This methodology applies to all portfolio segments.

The specific component incorporates the Company’s analysis of impaired loans. These accounting standards prescribe the measurement methods, income recognition and disclosures related to impaired loans. A loan is recognized as impaired when it is probable that principal and/or interest are not collectible in accordance with the loan’s contractual terms. In addition, a loan which has been renegotiated with a borrower experiencing financial

 

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difficulties for which the terms of the loan have been modified with a concession that the Company would not otherwise have granted are considered troubled debt restructurings and are also recognized as impaired. Measurement of impairment can be based on the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s observable market price or the fair value of the collateral, if the loan is collateral dependent. This evaluation is inherently subjective as it requires material estimates that may be susceptible to significant change. If the fair value of an impaired loan is less than the related recorded amount, a specific valuation component is established within the allowance for loan losses or, if the impairment is considered to be permanent, a partial charge-off is recorded against the allowance for loan losses. Individual measurement of impairment does not apply to large groups of smaller balance homogenous loans that are collectively evaluated for impairment such as portions of the Company’s portfolios of home equity loans, real estate mortgages, installment and other loans.

The formula component is calculated by first applying historical loss experience factors to outstanding loans by type. The Company uses a three year average loss experience as the starting base for the formula component. This component is then adjusted to reflect additional risk factors not addressed by historical loss experience. These factors include the evaluation of then-existing economic and business conditions affecting the key lending areas of the Company and other conditions, such as new loan products, credit quality trends (including trends in nonperforming loans expected to result from existing conditions), collateral values, loan volumes and concentrations, recent charge-off and delinquency experience, specific industry conditions within portfolio segments that existed as of the balance sheet date and the impact that such conditions were believed to have had on the collectibility of the loan portfolio. Senior management reviews these conditions quarterly. Management’s evaluation of the loss related to each of these conditions is quantified by portfolio segment and reflected in the formula component. The evaluations of the inherent loss with respect to these conditions is subject to a higher degree of uncertainty due to the subjective nature of such evaluations and because they are not identified with specific problem credits.

Actual losses can vary significantly from the estimated amounts. The Company’s methodology permits adjustments to the allowance in the event that, in management’s judgment, significant factors which affect the collectibility of the loan portfolio as of the evaluation date have changed.

Management believes the allowance for loan losses is the best estimate of probable losses which have been incurred as of June 30, 2012. There is no assurance that the Company will not be required to make future adjustments to the allowance in response to changing economic conditions, particularly in the Company’s service area, since the majority of the Company’s loans are collateralized by real estate. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company’s allowance for loan losses. Such agencies may require the Company to recognize additions to the allowance based on their judgments at the time of their examinations.

Loan Charge-Offs — The Company’s charge-off policy covers all loan portfolio classes. Loans are generally charged-off at the earlier of when it is determined that collection efforts are no longer productive or when they have been identified as losses by management, internal loan review and/or bank examiners. Factors considered in determining whether collection efforts are no longer productive include any amounts currently being collected, the status of discussions or negotiations with the borrower, the principal and/or guarantors, the cost of continuing efforts to collect, the status of any foreclosure or legal actions, the value of the collateral, and any other pertinent factors.

Income Recognition on Loans — Interest on loans is accrued monthly. Net loan origination and commitment fees are deferred and recognized as an adjustment of yield over the lives of the related loans. Loans, including impaired loans, are placed on a non-accrual status when management believes that interest or principal on such loans may not be collected in the normal course of business. When a loan is placed on non-accrual status, all interest previously accrued, but not collected, is reversed against interest income. Interest received on non-accrual loans generally is either applied against principal or reported as interest income, in accordance with management’s judgment as to the collectibility of principal. Loans can be returned to accruing status when they become current as to principal and interest, demonstrate a period of performance under the contractual terms, and when, in management’s opinion, they are estimated to be fully collectible. This methodology applies to all loan classes.

 

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Premises and Equipment — Premises and equipment are stated at cost less accumulated depreciation and amortization. Depreciation is computed using the straight-line method over the estimated useful lives of the related assets, generally 3 to 5 years for furniture, fixtures and equipment and 31.5 years for buildings. Leasehold improvements are amortized over the lesser of the term of the lease or the estimated useful life of the asset.

Other Real Estate Owned (“OREO”) — Real estate properties acquired through loan foreclosure are recorded at estimated fair value, net of estimated selling costs, at time of foreclosure establishing a new cost basis. Credit losses arising at the time of foreclosure are charged against the allowance for loan losses. Subsequent valuations are periodically performed by management and the carrying value is adjusted by a charge to expense to reflect any subsequent declines in the estimated fair value. Routine holding costs are charged to expense as incurred.

Goodwill and Other Intangible Assets — Goodwill and identified intangible assets with indefinite useful lives are not subject to amortization. Identified intangible assets that have finite useful lives are amortized over those lives by a method which reflects the pattern in which the economic benefits of the intangible asset are used up. Goodwill is subject to impairment testing on an annual basis, or more often if events or circumstances indicate that impairment may exist. Identifiable intangible assets are subject to impairment if events or circumstances indicate that impairment may exist. If such testing indicates impairment in the values and/or remaining amortization periods of the intangible assets, adjustments are made to reflect such impairment. The Company’s goodwill impairment evaluations as of December 31, 2011 did not indicate any impairment. The Company is not aware of any events or circumstances that existed with the identified intangible assets that would indicate impairment as of June 30, 2012.

Loss Contingencies — Loss contingencies, including claims and legal actions arising in the ordinary course of business, are recorded as liabilities when the likelihood of loss is probable and an amount or range of loss can be reasonably estimated. Legal fees associated with loss contingencies are included in loss contingency accruals.

Income Taxes — Income tax expense is the total of the current year income tax due or refundable and the change in deferred tax assets and liabilities. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities from a change in tax rates is recognized in income in the period the change is enacted.

Stock-Based Compensation — Compensation costs relating to share-based payment transactions are recognized in the financial statements with measurement based upon the fair value of the equity or liability instruments issued. Compensation costs related to share based payment transactions are expensed over their respective vesting periods. The fair value (present value of the estimated future benefit to the option holder) of each option grant is estimated on the date of grant using the Black-Scholes option pricing model. See Note 7 “Stock-Based Compensation” herein for additional discussion.

Earnings per Common Share — Basic earnings per common share are computed by dividing net income by the weighted average number of common shares outstanding during the period. The computation of diluted earnings per common share is similar to the computation of basic earnings per share except that the denominator is increased to include the number of additional common shares that would have been outstanding if the dilutive potential common shares, consisting solely of stock options, had been issued.

Other — Certain 2011 amounts have been reclassified to conform to the 2012 presentation.

 

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3.    Securities

The following tables set forth the amortized cost, gross unrealized gains and losses and the estimated fair value of securities classified as available for sale and held to maturity at June 30, 2012 and December 31, 2011 (in thousands):

 

		($000’s)
		June 30, 2012																December 31, 2011
		Amortized Cost				Gross Unrealized								Estimated Fair Value				Amortized Cost				Gross Unrealized								Estimated Fair Value
						Gains				Losses												Gains				Losses
Classified as Available for Sale
Mortgage-backed securities — residential		$	351,991			$	6,890			$	312			$	358,569			$	385,206			$	8,430			$	218			$	393,418
Obligations of states and political subdivisions			80,240				3,567				—				83,807				96,091				4,508				—				100,599
Other debt securities			11,695				7				8,419				3,283				12,220				—				8,888				3,332
Total debt securities			443,926				10,464				8,731				445,659				493,517				12,938				9,106				497,349
Mutual funds and other equity securities			10,067				567				128				10,506				10,067				617				136				10,548
Total		$	453,993			$	11,031			$	8,859			$	456,165			$	503,584			$	13,555			$	9,242			$	507,897

 

		Amortized				Gross Unrecognized								Estimated				Amortized				Gross Unrecognized								Estimated
		Cost				Gains				Losses				Fair Value				Cost				Gains				Losses				Fair Value
Classified as Held to Maturity
Mortgage-backed securities — residential		$	6,319			$	501				—			$	6,820			$	7,767			$	607				—			$	8,374
Obligations of states and political subdivisions			5,139				258				—				5,397				5,138				307				—				5,445
Total		$	11,458			$	759				—			$	12,217			$	12,905			$	914				—			$	13,819

Included in other debt securities are investments in six pooled trust preferred securities with amortized costs and estimated fair values of $11,183 and $2,768 respectively, at June 30, 2012. These investments represent trust preferred obligations of banking industry companies. The value of these investments has been severely negatively affected by the recent downturn in the economy and increased investor concerns about recent and potential future losses in the financial services industry. These investments are rated below investment grade by Moody’s Investor Services at June 30, 2012 with ratings ranging from Caa 2 to C. In light of these conditions, these investments were reviewed for other-than-temporary impairment.

In estimating OTTI losses, the Company considers: (1) the length of time and extent that fair value has been less than cost, (2) the financial condition and near term prospects of the issuers, (3) whether the Company intends to sell or whether it is more likely than not that the Company would be required to sell the investments prior to recovery of cost and (4) evaluation of cash flows to determine if they have been adversely affected.

 

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The Company uses a discounted cash flow (“DCF”) analysis to provide an estimate of an OTTI loss. Inputs to the discount model included known defaults and interest deferrals, projected additional default rates, projected additional deferrals of interest, over-collateralization tests, interest coverage tests and other factors. Expected default and deferral rates were weighted toward the near future to reflect the current adverse economic environment affecting the banking industry. The discount rate was based upon the yield expected from the related securities. Significant inputs to the cash flow models used in determining credit related other-than-temporary impairment losses on pooled trust preferred securities as of June 30, 2012 included the following:

 

Annual Prepayment		1.00%
Projected specific defaults/deferrals		33.1% - 73.6%
Projected severity of loss on specific defaults/deferrals		55.8% - 86.8%
Projected additional defaults:
Year 1		2.00%
Year 2		1.00%
Thereafter		0.25%
Projected severity of loss on additional defaults		85.00%
Present value discount rates		3m LIBOR + 1.60% - 2.25%

The following table summarizes the change in pretax OTTI credit related losses on securities available for sale for the six months ended June 30, 2012 and 2011 (in thousands):

 

		2012				2011
Balance at beginning of period:
Total OTTI credit related impairment charges beginning of period		$	9,478			$	9,110
Increase to the amount related to the credit loss for which other-than-temporary impairment was previously recognized			528				204
Credit related impairment not previously recognized			—				—
Balance at end of period:		$	10,006			$	9,314

During the six month period ended June 30, 2012, pretax OTTI losses of $4, $53, $2, $468 and $1, respectively, were recognized on five pooled trust preferred securities which prior to the 2012 charges had amortized costs of $2,088, $5,696, $919, $2,228 and $662, respectively. These OTTI losses resulted from adverse changes in the expected cash flows of these securities which indicated that the Company may not recover the entire cost basis of these investments. Continuation or worsening of current adverse economic conditions may result in further impairment charges in the future.

At June 30, 2012 and December 31, 2011, securities having a stated value of approximately $344,000 and $365,000, respectively, were pledged to secure public deposits, securities sold under agreements to repurchase and for other purposes as required or permitted by law.

The following tables reflect the Company’s investment’s fair value and gross unrealized loss, aggregated by investment category and length of time the individual securities have been in a continuous unrealized loss position, as of June 30, 2012 and December 31, 2011 (in thousands):

June 30, 2012

 

		Duration of Unrealized Loss
		Less Than 12 Months								Greater than 12 Months								Total
		Fair Value				Gross Unrealized Loss				Fair Value				Gross Unrealized Loss				Fair Value				Gross Unrealized Loss
Classified as Available for Sale
Mortgage-backed securities — residential		$	46,566			$	300			$	2,059			$	12			$	48,625			$	312
Other debt securities			—				—				2,248				8,419				2,248				8,419
Total debt securities			46,566				300				4,307				8,431				50,873				8,731
Mutual funds and other equity securities			—				—				108				128				108				128
Total temporarily impaired securities		$	46,566			$	300			$	4,415			$	8,559			$	50,981			$	8,859

 

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There were no securities classified as held to maturity in an unrealized loss position at June 30, 2012.

December 31, 2011

 

		Duration of Unrealized Loss
		Less Than 12 Months								Greater than  12 Months								Total
		Fair Value				Gross Unrealized Loss				Fair     Value				Gross Unrealized     Loss				Fair Value				Gross Unrealized Loss
Classified as Available for Sale
Mortgage-backed securities — residential		$	41,421			$	218				—				—			$	41,421			$	218
Other debt securities			460				50			$	2,816			$	8,838				3,276				8,888
Total debt securities			41,881				268				2,816				8,838				44,697				9,106
Mutual funds and other equity securities			—				—				92				136				92				136
Total temporarily impaired securities		$	41,881			$	268			$	2,908			$	8,974			$	44,789			$	9,242

There were no securities classified as held to maturity in an unrealized loss position at December 31, 2011.

The total number of securities in the Company’s portfolio that were in an unrealized loss position was 82 at both June 30, 2012 and December 31, 2011. The Company has determined that it does not intend to sell, or it is more likely than not that it will be required to sell, its securities that are in an unrealized loss position prior to the recovery of its amortized cost basis. With the exception of the investment in pooled trust preferred securities discussed above, the Company believes that its securities continue to have satisfactory ratings, are readily marketable and that current unrealized losses are primarily a result of changes in interest rates. Therefore, management does not consider these investments to be other-than-temporarily impaired at June 30, 2012. With regard to the investments in pooled trust preferred securities, the Company has decided to hold these securities as it believes that current market quotes for these securities are not necessarily indicative of their value. The Company has recognized impairment charges on five of the pooled trust preferred securities. Management believes that the remaining impairment in the value of these securities to be primarily related to illiquidity in the market and therefore not credit related at June 30, 2012.

The contractual maturity of all debt securities held at June 30, 2012 is shown below. Actual maturities may differ from contractual maturities because some issuers have the right to call or prepay obligations with or without call or prepayment penalties.

 

		Available for Sale								Held to Maturity
		Amortized Cost				Fair Value				Amortized Cost				Fair Value
Contractual Maturity
Within 1 year		$	8,488			$	8,508				—				—
After 1 year but within 5 years			40,175				41,838			$	5,139			$	5,397
After 5 year but within 10 years			31,580				33,464				—				—
After 10 years			11,692				3,280				—				—
Mortgage-backed securities — residential			351,991				358,569				6,319				6,820
Total		$	443,926			$	445,659			$	11,458			$	12,217

 

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4. Loans

The loan portfolio, excluding loans held for sale, is comprised of the following:

 

		June 30 2012				December 31 2011
Real Estate:
Commercial		$	633,581			$	690,837
Construction			96,211				110,027
Residential			559,144				514,828
Commercial & Industrial			231,140				218,500
Individuals & lease financing			35,510				41,760
Total loans			1,555,586				1,575,952
Deferred loan fees			(3,020	)			(3,862	)
Allowance for loan losses			(28,733	)			(30,685	)
Loans, net		$	1,523,833			$	1,541,405

In March 2012, the Company purchased $65,795 of adjustable rate residential loans as a partial redeployment of proceeds from the loan sales completed during the first quarter of 2012.

Risk characteristics of the Company’s portfolio segments include the following:

Commercial Real Estate Loans — In underwriting commercial real estate loans, the Company evaluates both the prospective borrower’s ability to make timely payments on the loan and the value of the property securing the loan. Repayment of such loans may be negatively impacted should the borrower default or should there be a substantial decline in the value of the property securing the loan, or a decline in general economic conditions. Where the owner occupies the property, the Company also evaluates the business’s ability to repay the loan on a timely basis. In addition, the Company may require personal guarantees, lease assignments and/or the guarantee of the operating company when the property is owner occupied. These types of loans may involve greater risks than other types of lending, because payments on such loans are often dependent upon the successful operation of the business involved, therefore, repayment of such loans may be negatively impacted by adverse changes in economic conditions affecting the borrowers’ business.

Construction Loans — Construction loans are short-term loans (generally up to 18 months) secured by land for both residential and commercial development. The loans are generally made for acquisition and improvements. Funds are disbursed as phases of construction are completed. Most non-residential construction loans require pre-approved permanent financing or pre-leasing by the Company or another bank providing the permanent financing. The Company funds construction of single family homes and commercial real estate, when no contract of sale exists, based upon the experience of the builder, the financial strength of the owner, the type and location of the property and other factors. Construction loans are generally personally guaranteed by the principal(s). Repayment of such loans may be negatively impacted by the builders’ inability to complete construction, by a downturn in the new construction market, by a significant increase in interest rates or by a decline in general economic conditions.

Residential Real Estate Loans — Various loans secured by residential real estate properties are offered by the Company, including 1-4 family residential mortgages, multi-family residential loans and a variety of home equity line of credit products. Repayment of such loans may be negatively impacted should the borrower default, should there be a significant decline in the value of the property securing the loan or should there be a decline in general economic conditions.

Commercial and Industrial Loans — The Company’s commercial and industrial loan portfolio consists primarily of commercial business loans and lines of credit to businesses and professionals. These loans are usually made to finance the purchase of inventory, new or used equipment or other short or long-term working capital purposes. These loans are generally secured by corporate assets, often with real estate as secondary collateral, but are also offered on an unsecured basis. In granting this type of loan, the Company primarily looks to the borrower’s cash flow as the source of repayment with collateral and personal guarantees, where obtained, as a secondary source. Commercial loans are often larger and may involve greater risks than other types of loans

 

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offered by the Company. Payments on such loans are often dependent upon the successful operation of the underlying business involved and, therefore, repayment of such loans may be negatively impacted by adverse changes in economic conditions, management’s inability to effectively manage the business, claims of others against the borrower’s assets which may take priority over the Company’s claims against assets, death or disability of the borrower or loss of market for the borrower’s products or services.

Lease Financing and Other Loans — The Company originates lease financing transactions which are primarily conducted with businesses, professionals and not-for-profit organizations and provide financing principally for office equipment, telephone systems, computer systems, energy saving improvements and other special use equipment. Payments on such loans are often dependent upon the successful operation of the underlying business involved and, therefore, repayment of such loans may be negatively impacted by adverse changes in economic conditions, and management’s inability to effectively manage the business. The Company also offers installment loans and cash reserve lines of credit to individuals. Repayment of such loans is often dependent on the personal income of the borrower which may be negatively impacted by adverse changes in economic conditions. The Company does not place an emphasis on originating these types of loans.

The following table presents the allowance for loan losses by portfolio segment for the three and six month periods ended June 30, 2012 and 2011 (in thousands):

 

		Three Months Ended June 30, 2012
		Total				Commercial Real Estate				Construction				Residential Real Estate				Commercial & Industrial				Lease Financing & Other
Balance at beginning of period		$	31,856			$	13,049			$	6,568			$	8,786			$	2,761			$	692
Charge-offs			(5,784	)			—				(1,580	)			(1,270	)			(2,372	)			(562	)
Recoveries			767				—				—				(208	)			476				499
Net Charge-offs			(5,017	)			—				(1,580	)			(1,478	)			(1,896	)			(63	)
Provision for loan losses			1,894				(1,457	)			(492	)			1,481				2,555				(193	)
Net change during the period			(3,123	)			(1,457	)			(2,072	)			3				659				(256	)
Balance at end of period		$	28,733			$	11,592			$	4,496			$	8,789			$	3,420			$	436
		Six Months Ended June 30, 2012
		Total				Commercial Real Estate				Construction				Residential Real Estate				Commercial & Industrial				Lease Financing & Other
Balance at beginning of period		$	30,685			$	12,776			$	6,470			$	8,093			$	2,650			$	696
Charge-offs			(6,909	)			(398	)			(1,580	)			(1,828	)			(2,497	)			(606	)
Recoveries			1,704				298				1				326				565				514
Net Charge-offs			(5,205	)			(100	)			(1,579	)			(1,502	)			(1,932	)			(92	)
Provision for loan losses			3,253				(1,084	)			(395	)			2,198				2,702				(168	)
Net change during the period			(1,952	)			(1,184	)			(1,974	)			696				770				(260	)
Balance at end of period		$	28,733			$	11,592			$	4,496			$	8,789			$	3,420			$	436

 

		Three Months Ended June 30, 2011
		Total				Commercial Real Estate				Construction				Residential Real Estate				Commercial & Industrial				Lease Financing & Other
Balance at beginning of period		$	40,287			$	16,673			$	7,130			$	10,959			$	4,615			$	910
Charge-offs			(1,372	)			—				(120	)			(818	)			(376	)			(58	)
Recoveries			1,428				448				436				465				71				8
Net Charge-offs			56				448				316				(353	)			(305	)			(50	)
Provision for loan losses			1,546				(9	)			(1,006	)			2,555				(64	)			70
Net change during the period			1,602				439				(690	)			2,202				(369	)			20
Balance at end of period		$	41,889			$	17,112			$	6,440			$	13,161			$	4,246			$	930

 

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		Six Months Ended June 30, 2011
		Total				Commercial Real Estate				Construction				Residential Real Estate				Commercial & Industrial				Lease Financing & Other
Balance at beginning of period		$	38,949			$	16,736			$	7,140			$	9,851			$	4,290			$	932
Charge-offs			(6,627	)			(156	)			(856	)			(3,013	)			(2,544	)			(58	)
Recoveries			2,570				686				575				1,019				276				14
Net Charge-offs			(4,057	)			530				(281	)			(1,994	)			(2,268	)			(44	)
Provision for loan losses			6,997				(154	)			(419	)			5,304				2,224				42
Net change during the period			2,940				376				(700	)			3,310				(44	)			(2	)
Balance at end of period		$	41,889			$	17,112			$	6,440			$	13,161			$	4,246			$	930

Impaired loans, including all troubled debt restructurings, and the related recorded investment, as of June 30, 2012 and December 31, 2011 were as follows:

 

		June 30, 2012												December 31, 2011
		Unpaid Principal Balance				Recorded Investment				Allowance for Loan Losses Allocated				Unpaid Principal Balance				Recorded Investment				Allowance for Loan Losses Allocated
With no related allowance recorded:
Commercial		$	30,866			$	29,353				—			$	31,877			$	30,762			$	—
Construction			5,981				4,238				—				2,690				1,723				—
Residential			14,261				12,336				—				4,599				3,824				—
Commercial & industrial			13,607				12,535				—				8,560				7,803				—
Lease financing & other			—				—				—				—				—				—
With an allowance recorded:
Commercial			—				—				—				—				—				—
Construction			—				—				—				3,758				3,758			$	2,374
Residential			—				—				—				—				—				—
Commercial & industrial			—				—				—				—				—				—
Lease financing & other			—				—				—				—				—				—
Total loans		$	64,715			$	58,462				—			$	51,484			$	47,870			$	2,374

The carrying value of impaired loans was determined using either the fair value of the underlying collateral of the loan or by an analysis of the expected cash flows related to the loan. There were no allocations of specific reserves during the six month period ended June 30, 2012. The $2,374 specific reserve allocated to impaired loans as of December 31, 2011 was charged off in June 2012 upon completion of a restructuring for which the specific reserve was originally established. The above tables as of June 30, 2012 and December 31, 2011 include $32,308 and $28,256, respectively, of loans considered to be troubled debt restructurings (“TDRs”). There were two additional loan modifications classified as TDRs during the six month period ended June, 2012. The Company is not committed to extend any additional credit to borrowers whose loans are classified as TDRs. For the six month period ended June 30, 2012, eight TDRs with carrying amounts of $19,158 were on accrual status and four loans with carrying amounts of $12,756 on nonaccrual status that were performing in accordance with their modified terms. At June 30, 2012, there was one TDR with a recorded investment of $400 in which there were payment defaults within twelve months following the modification. This loan has remained in nonaccrual status since prior to the restructuring. The Company’s policy states that a loan is considered to be in payment default once it is 45 days contractually past due under the modified terms. The TDRs described above resulted in $2,595 charge-offs during the six month period ended June 30, 2012.

 

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The following table presents the average recorded investment in impaired loans including other troubled debt restructurings by class of loans and interest recognized on impaired loans for the three and six month periods ended June 30, 2012 and 2011 (in thousands):

 

		Three Months Ended June 30																Six Months Ended June 30
		2012								2011								2012								2011
		Average Recorded Investment				Interest Income				Average Recorded Investment				Interest Income				Average Recorded Investment				Interest Income				Average Recorded Investment				Interest Income
Loans:
Commercial Real Estate:
Owner occupied		$	23,775			$	152			$	16,128			$	14			$	22,238			$	266			$	11,098			$	14
Non owner occupied			12,848				85				18,171				45				10,927				149				17,607				45
Construction:
Commercial			2,448				—				10,208				—				3,669				—				9,830				—
Residential			1,828				—				4,336				—				914				—				5,191				—
Residential:
Multifamily			1,331				—				5,339				—				1,002				—				4,386				—
1-4 family			5,651				12				4,945				—				3,778				21				4,905				—
Home equity			1,626				—				3,467				—				1,701				—				2,954				—
Commercial & industrial			10,005				—				7,431				—				8,886				—				6,310				—
Other:
Lease financing and other			128				—				319				—				64				—				355				—
Overdrafts			—				—				—				—				—				—				—				—
Total		$	59,640			$	249			$	70,344			$	59			$	53,179			$	436			$	62,636			$	59

The difference between interest income recognized and interest income collected on impaired loans for the three and six month periods ended June 30, 2012 and 2011 was not significant. Gross interest income that would have been recorded if these borrowers had been current in accordance with their original loan terms was $565 and $868, respectively, for the three and six month periods ended June 30, 2012 and $303 and $836, respectively, for the three and six month periods ended June 30, 2011.

The following tables present the allowance for loan losses and the recorded investment in loans by portfolio segment based on impairment method as of June 30, 2012 and December 31, 2011 (in thousands):

 

		June 30, 2012
		Total				Commercial Real Estate				Construction				Residential Real Estate				Commercial & Industrial				Lease Financing & Other
Allowance for loan losses:
Ending balance attributed to loans:
Collectively evaluated for impairment		$	28,733			$	11,592			$	4,496			$	8,789			$	3,420			$	436
Individually evaluated for impairment			—				—				—				—				—				—
Total ending balance of allowance		$	28,733			$	11,592			$	4,496			$	8,789			$	3,420			$	436
Total loans:
Ending balance of loans:
Collectively evaluated for impairment		$	1,497,124			$	604,228			$	91,973			$	546,808			$	218,605			$	35,510
Individually evaluated for impairment			58,462				29,353				4,238				12,336				12,535				—
Total ending balance of loans		$	1,555,586			$	633,581			$	96,211			$	559,144			$	231,140			$	35,510

 

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		December 31, 2011
		Total				Commercial Real Estate				Construction				Residential Real Estate				Commercial & Industrial				Lease Financing & Other
Allowance for loan losses:
Ending balance attributed to loans:
Collectively evaluated for impairment		$	28,311			$	12,776			$	4,096			$	8,093			$	2,650			$	696
Individually evaluated for impairment			2,374				—				2,374				—				—				—
Total ending balance of allowance		$	30,685			$	12,776			$	6,470			$	8,093			$	2,650			$	696
Total loans:
Ending balance of loans:
Collectively evaluated for impairment		$	1,528,082			$	660,075			$	104,546			$	511,004			$	210,697			$	41,760
Individually evaluated for impairment			47,870				30,762				5,481				3,824				7,803				—
Total ending balance of loans		$	1,575,952			$	690,837			$	110,027			$	514,828			$	218,500			$	41,760

The following table presents the recorded investment in non-accrual loans and loans past due 90 days and still accruing by class of loans as of June 30, 2012 and December 31, 2011 (in thousands):

 

		June 30, 2012								December 31, 2011
		Non-Accrual				Past Due 90 Days  and Still Accruing				Non-Accrual				Past Due 90 Days and Still Accruing
Loans:
Commercial Real Estate:
Owner occupied		$	10,058				—			$	3,856				—
Non owner occupied			2,164				—				9,356				—
Construction:
Commercial			582				—				5,481				—
Residential			2,077				—				—				—
Residential:
Multifamily			1,318				—				—				—
1-4 family			8,944				—				1,470				—
Home equity			1,626				—				1,926				—
Commercial & industrial			12,535				—				7,803				—
Other:
Lease financing and other			—				—				—				—
Overdrafts			—				—				—				—
Total		$	39,304				—			$	29,892				—

 

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The following table presents the aging of loans (including past due and non-accrual loans) as of June 30, 2012 and December 31, 2011 by class of loans (in thousands):

 

		June 30, 2012
		Total				31-59 Days Past Due				60-89 Days Past Due				90 Days Or More Past Due				Total Past Due				Current
Loans:
Commercial Real Estate:
Owner occupied		$	228,914				—			$	5,469			$	6,541			$	12,010			$	216,904
Non owner occupied			404,667				—				1,386				1,836				3,222				401,445
Construction:
Commercial			43,457				—				—				582				582				42,875
Residential			52,754				—				—				—				—				52,754
Residential:
Multifamily			212,655				—				—				1,318				1,318				211,337
1-4 family			237,440			$	416				119				8,944				9,479				227,961
Home equity			109,049				1,278				—				1,626				2,904				106,145
Commercial & industrial			231,140				—				252				1,421				1,673				229,467
Other:
Lease financing and other			34,408				95				297				—				392				34,016
Overdrafts			1,102				—				—				—				—				1,102
Total		$	1,555,586			$	1,789			$	7,523			$	22,268			$	31,580			$	1,524,006

 

		December 31, 2011
		Total				31-59 Days Past Due				60-89 Days Past Due				90 Days Or More Past Due				Total Past Due				Current
Loans:
Commercial Real Estate:
Owner occupied		$	243,862			$	1,801				—			$	3,489			$	5,290			$	238,572
Non owner occupied			446,975				1,917				—				5,108				7,025				439,950
Construction:
Commercial			56,933				—				—				4,883				4,883				52,050
Residential			53,094				900				—				—				900				52,194
Residential:
Multifamily			227,595				—				—				—				—				227,595
1-4 family			174,714				—				—				1,470				1,470				173,244
Home equity			112,519				—			$	97				1,926				2,023				110,496
Commercial & industrial			218,500				197				50				4,403				4,650				213,850
Other:
Lease financing and other			39,898				1				10				—				11				39,887
Overdrafts			1,862				—				—				—				—				1,862
Total		$	1,575,952			$	4,816			$	157			$	21,279			$	26,252			$	1,549,700

The Company categorizes loans into risk categories based on relevant information about the ability of the borrowers to service their debt such as: value of underlying collateral, current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. The Company analyzes non-homogeneous loans individually and classifies them as to credit risk. This analysis is performed on a quarterly basis. The Company uses the following definitions for risk ratings:

Special Mention — Loans classified as special mention have potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of repayment prospects for the asset or in the institution’s credit position at some future date.

Substandard — Loans classified as substandard asset are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified must have a well-

 

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defined weakness, or weaknesses, that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected.

Doubtful — Loans classified as doubtful have all the weaknesses inherent in one classified as substandard with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently known facts, conditions and values, highly questionable and improbable.

Loans not meeting the above criteria that are analyzed individually as part of the above described process are considered to be pass rated loans.

The following table presents the risk category by class of loans as of June 30, 2012 and December 31, 2011 of non-homogeneous loans individually classified as to credit risk as of the most recent analysis performed (in thousands):

 

		June 30, 2012
		Total				Pass				Special Mention				Substandard				Doubtful
Commercial Real Estate:
Owner occupied		$	228,914			$	174,657			$	24,385			$	29,872				—
Non owner occupied			404,667				393,477				5,763				5,427				—
Construction:
Commercial			43,457				29,682				9,764				4,011				—
Residential			52,754				47,827				900				4,027				—
Residential:
Multifamily			212,655				211,003				334				1,318				—
1-4 family			101,692				79,070				13,196				9,426				—
Home equity			1,825				—				—				1,825				—
Commercial & Industrial			231,140				213,363				4,207				13,570				—
Other:
Lease Financing & Other			33,043				31,633				1,144				266				—
Total loans		$	1,310,147			$	1,180,712			$	59,693			$	69,742				—

 

		December 31, 2011
		Total				Pass				Special Mention				Substandard				Doubtful
Commercial Real Estate:
Owner occupied		$	243,862			$	177,921			$	32,144			$	33,797				—
Non owner occupied			446,975				422,402				14,924				9,649				—
Construction:
Commercial			56,933				42,641				5,382				8,910				—
Residential			53,094				38,956				7,274				6,864				—
Residential:
Multifamily			227,595				226,224				—				1,371				—
1-4 family			90,033				72,594				15,109				2,330				—
Home equity			2,174				—				—				2,174				—
Commercial & Industrial			218,500				204,305				5,410				8,785				—
Other:
Lease Financing & Other			38,441				37,619				523				299				—
Total loans		$	1,377,607			$	1,222,662			$	80,766			$	74,179				—

Loans not individually rated, primarily consisting of certain 1-4 family residential mortgages and home equity lines of credit, are evaluated for risk in groups of homogeneous loans. The primary risk characteristic evaluated on these pools is delinquency.

 

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The following table presents the delinquency categories by class of loans as of June 30, 2012 and December 31, 2011 for loans evaluated for risk in groups of homogeneous loans (in thousands):

 

		June 30, 2012
		Total				31-59 Days Past Due				60-89 Days Past Due				90 Days Or More Past Due				Total Past Due				Current
Residential:
1-4 family		$	135,748			$	92				—				—			$	92			$	135,656
Home equity			107,224				1,278			$	119				—				1,397				105,827
Other:
Other loans			1,365				—				—				—				—				1,365
Overdrafts			1,102				—				—				—				—				1,102
Total loans		$	245,439			$	1,370			$	119				—			$	1,489			$	243,950

 

		December 31, 2011
		Total				31-59 Days Past Due				60-89 Days Past Due				90 Days Or More Past Due				Total Past Due				Current
Residential:
1-4 family		$	84,681				—				—				—				—			$	84,681
Home equity			110,345				—			$	97				—			$	97				110,248
Other:
Other loans			1,457			$	1				10				—				11				1,446
Overdrafts			1,862				—				—				—				—				1,862
Total loans		$	198,345			$	1			$	107				—			$	108			$	198,237

Loans Held for Sale

On February 1, 2012, the Company announced plans to sell a total of $474 million in performing and non-performing loans in two tranches by mid-2012, as a significant step toward reducing the bank’s concentrations of commercial real estate loans and classified assets. These loans were transferred to loans held-for-sale at December 31, 2011 and both tranche sales were completed in March 2012.

The first tranche included $200 million in performing and non-performing loans. The carrying value of these commercial real estate loans was reduced by $60 million at December 31, 2011. These loans were primarily all commercial real estate credits, including classified assets totaling $53 million net of the market value adjustment. The recorded sales price, net of broker fees and expenses, exceeded the carrying value of this portfolio, resulting in a pre-tax gain of approximately $7.9 million.

The second tranche included $274 million in performing, non-classified multifamily loans. No market value adjustment was recorded when this portfolio was transferred to held-for-sale at December 31, 2011, as they were expected to be sold at or above par value. The sale of these loans in March 2012 resulted in a pre-tax gain of approximately $8.0 million.

 

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5.    Earnings Per Share

The following table sets forth the computation of basic and diluted earnings per common share for each of the periods indicated:

 

		Three Months Ended Jun 30								Six Months Ended Jun 30
		2012				2011				2012				2011
		(000’s except share data)
Numerator:
Net income (loss) available to common shareholders for basic and diluted earnings per share		$	4,961			$	7,432			$	22,974			$	12,256
Denominator:
Denominator for basic earnings per common share —weighted average shares			19,633,732				19,457,918				19,586,033				19,452,195
Effect of diluted securities:
Stock options			2,948				64,980				11,355				68,199
Denominator for diluted earnings per common share —adjusted weighted average shares			19,636,680				19,522,898				19,597,388				19,520,394
Basic earnings per common share		$	0.25			$	0.38			$	1.17			$	0.63
Diluted earnings per common share		$	0.25			$	0.38			$	1.17			$	0.63
Dividends declared per share		$	0.18			$	0.14			$	0.36			$	0.28

Stock options of 475,904 and 291,712 were not considered in computing diluted earnings per share at June 30, 2012 and 2011, respectively, because they were anti dilutive. In November 2011, the Company declared a 10% stock dividend. Share and per share amounts for 2011 have been retroactively restated to reflect the issuance of the additional shares.

6.    Benefit Plans

In addition to defined contribution pension and savings plans which cover substantially all employees, the Company provides additional retirement benefits to certain officers and directors pursuant to unfunded supplemental defined benefit plans. The following table summarizes the components of the net periodic pension cost of the defined benefit plans (in thousands).

 

		Three Months Ended Jun 30								Six Months Ended Jun 30
		2012				2011				2012				2011
Service cost		$	111			$	96			$	221			$	191
Interest cost			156				147				309				294
Amortization of prior service cost			(58	)			(58	)			(116	)			(116	)
Amortization of net loss			167				139				335				279
Net periodic pension cost		$	376			$	324			$	749			$	648

The Company makes contributions to the unfunded defined benefit plans only as benefit payments become due. The Company disclosed in its 2011 Annual Report on Form 10-K that it expected to contribute $813 to the unfunded defined benefit plans during 2012. For the three and six month periods ended June 30, 2012, the Company contributed $153 and $312, respectively, to these plans.

7.    Stock-Based Compensation

In accordance with the provisions of the Hudson Valley Holding Corp. 2010 Omnibus Incentive Plan, approved by the Company’s shareholders on May 27, 2010, the Company may grant eligible employees, including directors, consultants and advisors, incentive stock options, non-qualified stock options, restricted stock awards, restricted stock units, stock appreciation rights, performance awards and other types of awards. The 2010 Plan provides for the issuance of up to 1,331,000 shares of the Company’s common stock. Prior to the 2010 Plan, the Company had stock option plans that provided for the granting of options to directors, officers, eligible

 

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employees, and certain advisors, based upon eligibility as determined by the Compensation Committee. Under the prior plans, options were granted for the purchase of shares of the Company’s common stock at an exercise price not less than the market value of the stock on the date of grant, vested over various periods ranging from immediate to five years from date of grant, and had expiration dates up to ten years from the date of grant.

Compensation costs relating to stock-based payment transactions are recognized in the financial statements with measurement based upon the fair value of the equity or liability instruments issued. Stock-based payments are expensed over their respective vesting periods.

The following table summarizes stock-based compensation activity for the six month period ended June 30, 2012:

 

Prior Option Plans:		Shares				Weighted Average Grant or Exercise Price				Aggregate Intrinsic Value(1) ($000’s)				Weighted Average Remaining Contractual Term
Outstanding at December 31, 2011			625,256			$	22.81
Granted			—				—
Exercised			(5,798	)			16.57
Cancelled or Expired			(8,979	)			24.67
Outstanding at June 30, 2012			610,479			$	22.85			$	245				2.0
Exercisable at June 30, 2012			601,897			$	22.66			$	245				2.1
Nonvested at June 30, 2012			8,582			$	35.96
2010 Omnibus Incentive Plan:
Outstanding at December 31, 2011			—				—
Granted at fair value			112,432			$	16.68
Restriction released			(7,543	)			17.10
Cancelled			(9,152	)			16.74
Nonvested at June 30, 2012			95,737			$	16.64
Available for grant at December 31, 2011			1,331,000
Restricted stock awards			(112,432	)		$	16.68
Cancelled			9,152				16.74
Available for future grant			1,227,720

 

1)

The aggregate intrinsic value of a stock option in the table above represents the total pre-tax intrinsic value (the amount by which the current fair value of the underlying stock exceeds the exercise price of the option) that would have been received by the option holders had all option holders exercised their options on June 30, 2012. This amount changes based on changes in the fair value of the Company’s stock.

The fair value (present value of the estimated future benefit to the option holder) of each option grant is estimated on the date of grant using the Black-Scholes option pricing model. There were no stock options granted in the six month period ended June 30, 2012 or the year ended December 31, 2011. The restricted stock awards during the six month period ended June 30, 2012 were the initial awards under the 2010 Plan.

Net compensation expense of $25 and $69 related to the Company’s stock option plans was included in net income for the six month periods ended June 30, 2012 and 2011, respectively. The total tax effect related thereto was $(2) and $(2), respectively. Unrecognized compensation expense related to non-vested share-based compensation granted under the Company’s stock option plans totaled $26 at June 30, 2012. This expense is expected to be recognized over a remaining weighted average period of 0.1 years.

8.    Fair Value

Fair Value is the exchange price that would be received for 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 on the measurement date. There are three levels of inputs that may be used to measure fair values:

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.

 

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

Level 3:    Significant unobservable inputs that reflect a reporting entity’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.

A description of the valuation methodologies used for assets and liabilities measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy, is set forth below. While management believes the Company’s valuation methodologies are appropriate and consistent with other financial institutions, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date.

Investment Securities — The fair values of investment securities are determined by obtaining quoted prices on nationally recognized securities exchanges, if available (Level 1), or matrix pricing, which is a mathematical technique widely used 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 benchmark quoted securities, which is a Level 2 input. The Company’s available for sale securities at June 30, 2012 and December 31, 2011 include several pooled trust preferred instruments. The recent severe downturn in the overall economy and, in particular, in the financial services industry has created a situation where significant observable inputs (Level 2) are not readily available for these instruments. As an alternative, the Company combined Level 2 input of market yield requirements of similar instruments together with certain Level 3 assumptions addressing the impact of current market illiquidity to estimate the fair value of these instruments. The fair values of Level 3 investment securities are determined by the Controller and Investment Officer who report to the Chief Financial Officer. See Note 3 “Securities” for further discussion of pooled trust preferred securities.

Impaired Loans — At the time a loan is considered impaired, it is valued at lower of cost or fair value. Impaired loans carried at fair value generally are partially charged off or receive specific allocations of the allowance for loan losses. For collateral dependent loans, fair value in commonly based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the independent appraiser to adjust for differences between the comparable sales and the income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining value. Non real estate collateral may be valued using an appraisal, net book value per the borrower’s financial statements, or aging reports, adjusted or discounted based on management’s historical knowledge, changes in market conditions from the time of the valuation, and management’s expertise and knowledge of the client and the client’s business, resulting in a Level 3 fair value classification. Impaired loans are evaluated on a quarterly basis for additional impairment and adjusted accordingly.

Other Real Estate Owned (“OREO”) — Real estate properties acquired through loan foreclosure are recorded at estimated fair value, net of estimated selling costs, at time of foreclosure establishing a new cost basis. Fair value is commonly based on real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a level 3 classification of the inputs used in determining fair value.

Loans Held for Sale — Loans held for sale are carried at lower of cost or fair value. The fair value of loans held for sale is determined using average bid indicators from third parties expected to participate in the loan sales, in some cases adjusted for specific attributes of that loan or other observable market data. Such bids and adjustments often vary significantly and typically result in level 3 classification of the inputs used in determining fair value.

 

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The following table presents quantitative information about Level 3 fair value measurements for financial instruments measured at fair value on a non-recurring basis at June 30, 2012:

 

Asset		Fair Value				Valuation Technique		Unobservable Inputs		Range of Inputs
Impaired loans		$	12,407			Sales comparison and income based appraisals		Capitalization rates		7.00% -7.75%
								Discount for dated appraisal		0% - 20%
								Discount for costs to sell		0% - 30%
Other real estate owned		$	250			Sales comparison and income based appraisals		Discount for costs to sell		30%
Loans held for sale		$	2,387			Third party bids		Bids from interested third parties		64% - 65%

The following table presents quantitative information about Level 3 fair value measurements for financial instruments measured at fair value on a recurring basis at June 30, 2012:

 

Asset		Fair Value				Valuation Technique		Unobservable Inputs		Range of Inputs
Trust preferred securities		$	2,768			Discounted cash flow		Specific issuer default rates		33% - 74%
								Specific issuer default severity		56% - 87%
								Annual prepayment rate		1%
								Projected annual nonspecific issuer default rates		0.25% - 2.00%
								Projected annual nonspecific issuer default severity		85%
								Present value discount rate		22.5%

Assets and liabilities measured at fair value are summarized below:

 

		Fair Value Measurements at June 30, 2012
		Quoted Prices in Active Markets for Identical Assets (Level 1)				Significant Other Observable Inputs (Level 2)				Significant Unobservable Inputs (Level 3)				Total
		(000’s)
Measured on a recurring basis:
Available for sale securities:
Mortgage-backed securities — residential			—			$	358,569				—			$	358,569
Obligations of states and political subdivisions			—				83,807				—				83,807
Other debt securities			—				515			$	2,768				3,283
Mutual funds and other equity securities			—				10,506				—				10,506
Total assets at fair value			—			$	453,397			$	2,768			$	456,165
Measured on a non-recurring basis:
Impaired loans:(1)
Commercial Real Estate			—				—			$	1,012			$	1,012
Construction			—				—				4,237				4,237
Residential			—				—				5,379				5,379
Commercial & Industrial			—				—				1,779				1,779
Other			—				—				—				—
Loans held for sale			—				—				2,387				2,387
Other real estate owned			—				—				250				250
Total assets at fair value			—				—			$	15,044			$	15,044

 

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		Fair Value Measurements at December 31, 2011
		Quoted Prices in Active Markets for Identical Assets (Level 1)				Significant Other Observable Inputs (Level 2)				Significant Unobservable Inputs (Level 3)				Total
		(000’s)
Measured on a recurring basis:
Available for sale securities:
Mortgage-backed securities — residential			—				393,418				—			$	393,418
Obligations of states and political subdivisions			—				100,599				—				100,599
Other debt securities			—				516			$	2,816				3,332
Mutual funds and other equity securities			—				10,548				—				10,548
Total assets at fair value			—			$	505,081			$	2,816			$	507,897
Measured on a non-recurring basis:
Impaired loans:(1)
Commercial Real Estate			—				—			$	1,410			$	1,410
Construction			—				—				3,107				3,107
Residential			—				—				1,529				1,529
Commercial & Industrial			—				—				2,145				2,145
Other			—				—				—				—
Loans held for sale			—				—				473,814				473,814
Other real estate owned			—				—				1,174				1,174
Total assets at fair value			—				—			$	483,179			$	483,179

 

(1)

The recorded investments in impaired loans subject to fair value reporting at June 30, 2012 and December 31, 2011 were $12,407 and $10,565, respectively. There were no specific allowances established within the allowance for loan losses at June 30, 2012. A specific allowance of $2,374 had been established within the allowance for loan losses as of December 31, 2011.

The table below presents a reconciliation and income statement classification of gains and losses for securities available for sale measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the three and six month periods ended June 30, 2012 and 2011:

 

		Level 3 Assets Measured on a Recurring Basis
		Three Months Ended June 30								Six Months Ended June 30
		2012				2011				2012				2011
		(000’s)								(000’s)
Balance at beginning of period		$	2,422			$	3,016			$	2,816			$	3,687
Additions to Level 3			102				94				208				196
Net unrealized gain (loss) included in other comprehensive income			445				(141	)			423				(753	)
Principal payments			(151	)			(3	)			(151	)			(3	)
Recognized impairment charge included in the statement of income			(50	)			(43	)			(528	)			(204	)
Balance at end of period		$	2,768			$	2,923			$	2,768			$	2,923

 

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9.    Fair Value of Financial Instruments

The Company follows the “Financial Instruments” topic of the FASB Accounting Standards Codification which requires the disclosure of the estimated fair value of certain financial instruments. These estimated fair values as of June 30, 2012 and December 31, 2011 have been determined using available market information and appropriate valuation methodologies. Considerable judgment is required to interpret market data to develop estimates of fair value. The estimates presented are not necessarily indicative of amounts the Company could realize in a current market exchange. The use of alternative market assumptions and estimation methodologies could have had a material effect on these estimates of fair value.

Carrying amount and estimated fair value of financial instruments, not previously presented, at June 30, 2012 and December 31, 2011 were as follows:

June 30, 2012

 

		Fair Value Measurements
		Carrying Amount				Total Fair Value				Quoted Prices in Active Markets for Identical Assets (Level 1)				Significant Other Observable Inputs (Level 2)				Significant Unobservable Inputs (Level 3)
Assets:
Financial assets for which carrying value approximates fair value		$	663.6			$	663.6			$	663.6
Held to maturity securities and accrued interest			11.5				12.2								12.2
FHLB Stock			4.8				N/A				N/A
Loans and accrued interest			1,546.3				1,588.2												1,588.2
Liabilities:
Deposits with no stated maturity and accrued interest			2,300.9				2,300.9				2,300.9
Time deposits and accrued interest			139.2				139.6								139.6
Securities sold under repurchase agreements and other short-term borrowing and accrued interest			42.2				42.2				42.2
Other borrowings and accrued interest			16.6				14.0								14.0

December 31, 2011

 

		Fair Value Measurements
		Carrying Amount				Total Fair Value				Quoted Prices in Active Markets for Identical Assets (Level 1)				Significant Other Observable Inputs (Level 2)				Significant Unobservable Inputs (Level 3)
Assets:
Financial assets for which carrying value approximates fair value		$	94.5			$	94.5			$	94.5
Held to maturity securities and accrued interest			13.0				13.9								13.9
FHLB Stock			3.8				N/A				N/A
Loans and accrued interest			1,571.3				1,609.2												1,609.2
Liabilities:
Deposits with no stated maturity and accrued interest			2,274.7				2,274.7				2,274.7
Time deposits and accrued interest			151.7				152.1								152.1
Securities sold under repurchase agreements and other short-term borrowing and accrued interest			53.1				53.1				53.1
Other borrowings and accrued interest			16.6				14.0								14.0

 

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The estimated fair value of the indicated items was determined as follows:

Financial assets for which carrying value approximates fair value — The estimated fair value approximates carrying amount because of the immediate availability of these funds or based on the short maturities and current rates for similar deposits. Cash and due from banks as well as Federal funds sold are reported in this line item.

Held to maturity securities and accrued interest — The fair value of securities held to maturity was estimated based on quoted market prices or dealer quotations. Accrued interest is stated at its carrying amounts which approximates fair value.

FHLB Stock — It is not practicable to determine its fair value due to restrictions placed on its transferability.

Loans and accrued interest — The fair value of loans was estimated by discounting projected cash flows at the reporting date using current rates for similar loans. Accrued interest is stated at its carrying amount which approximates fair value. The methods utilized to estimate the fair value of loans do not necessarily represent an exit price.

Deposits with no stated maturity and accrued interest — The estimated fair value of deposits with no stated maturity and accrued interest, as applicable, are considered to be equal to their carrying amounts.

Time deposits and accrued interest — The fair value of time deposits has been estimated by discounting projected cash flows at the reporting date using current rates for similar deposits. Accrued interest is stated at its carrying amount which approximates fair value.

Securities sold under repurchase agreements and other short-term borrowings and accrued interest — The estimated fair value of these instruments approximate carrying amount because of their short maturities and variable rates. Accrued interest is stated at its carrying amount which approximates fair value.

Other borrowings and accrued interest — The fair value of callable FHLB advances was estimated by discounting projected cash flows at the reporting date using the rate applicable to the projected call date option. Accrued interest is stated at its carrying amount which approximates fair value.

 

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

This section presents discussion and analysis of the Company’s consolidated financial condition at June 30, 2012 and December 31, 2011, and the consolidated results of operations for the three and six month periods ended June 30, 2012 and 2011. The Company is consolidated with its wholly owned subsidiaries Hudson Valley Bank, N.A. and its subsidiaries (collectively “HVB” or “the Bank”) and HVHC Risk Management Corp. This discussion and analysis should be read in conjunction with the financial statements and supplementary financial information contained in the Company’s 2011 Annual Report on Form 10-K.

Overview of Management’s Discussion and Analysis

This overview is intended to highlight selected information included in this Quarterly Report on Form 10-Q. It does not contain sufficient information for a complete understanding of the Company’s financial condition and operating results and, therefore, should be read in conjunction with this entire Quarterly Report on Form 10-Q and the Company’s 2011 Annual Report on Form 10-K.

The Company derives substantially all of its revenue from providing banking and related services to businesses, professionals, municipalities, not-for profit organizations and individuals within its market area, primarily Westchester County and Rockland County, New York, portions of New York City and Fairfield County and New Haven County, Connecticut. The Company’s assets consist primarily of loans and investment securities, which are funded by deposits, borrowings and capital. The primary source of revenue is net interest income, the difference between interest income on loans and investments, and interest expense on deposits and borrowed funds. The Company’s basic strategy is to grow net interest income and non interest income by the retention of its existing customer base and the expansion of its core businesses and branch offices within its current market and surrounding areas. Considering current economic conditions, the Company’s primary market risk exposures are interest rate risk, the risk of deterioration of market values of collateral supporting the Company’s loan portfolio, particularly commercial and residential real estate and potential risks associated with the impact of regulatory changes that may take place in reaction to the current crisis in the financial system. Interest rate risk is the exposure of net interest income to changes in interest rates. Commercial and residential real estate are the primary collateral for the majority of the Company’s loans.

The Company recorded net income for the three month period ended June 30, 2012 of $5.0 million or $0.25 per diluted share, a decrease of $2.4 million compared to net income of $7.4 million or $0.38 per diluted share for the same period in the prior year. Net income for the six month period ended June 30, 2012 was $23.0 million or $1.17 per diluted share, an increase of $10.7 million compared to net income of $12.3 million or $0.63 per diluted share for the same period in the prior year. Per share amounts for the 2011 periods have been adjusted to reflect the effects of the 10 percent stock dividend issued in December 2011.

The decrease in earnings for the three month period ended June 30, 2012, compared to the same period in the prior year, was primarily due to a $4.1 million decrease in net interest income, the anticipated result of excess liquidity remaining from the proceeds of the loan sales conducted in the first quarter of 2012. The loan sales were conducted as part of the Company’s efforts to reduce the levels of nonperforming and other classified loans, and also to reduce the overall concentration in commercial real estate loans. In addition to the decrease in net interest income, income from the second quarter of 2012 was lower, compared to the same period in the prior year, as a result of higher provision for loan losses and lower fee income, partially offset by lower loss on sales and revaluations of loans and other real estate owned and slightly higher non interest expenses. The increase in earnings for the six month period ended June 30, 2012, compared to the same period in the prior year, resulted primarily from pretax gain of $15.9 million resulting from the successful completion of $474 million of loan sales announced in the fourth quarter of 2011 and completed at the end of the first quarter of 2012. In addition to the gains on the loan sales, income for the six month period ended June 30, 2012 was higher, compared to the same period in the prior year, as a result of higher non interest income and a lower provision for loan losses, partially offset by lower net interest income, higher impairment charges on securities available for sale and slightly higher non interest expenses.

Total loans, excluding loans held for sale, decreased $89.2 million and $20.4 million, respectively, during the three and six month periods ended June 30, 2012 compared to the prior year end. The overall decrease was

 

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primarily the result of pay downs and payoffs of existing loans exceeding new production and additional loan sales conducted in the second quarter of 2012, partially offset by the purchase of adjustable rate residential loans in the first quarter of 2012, which were purchased as partial redeployment of proceeds from sales of loans held for sale. The Company continues to provide lending availability to both new and existing customers.

Nonperforming assets decreased to $39.6 million at June 30, 2012, compared to $58.9 million at December 31, 2011. Overall asset quality continued to be adversely affected by the current state of the economy and the real estate market. Although there is evidence that the current economic downturn may have begun to slowly turn around, higher than normal levels of delinquent and nonperforming loans, slowdowns in repayments and declines in the loan-to-value ratios on existing loans continued during the first half of 2012. Despite recent reductions in classified and nonperforming loans, the Company’s loan portfolio continued to be adversely impacted by the effects of declines in the demand for and values of virtually all commercial and residential real estate properties. These declines, together with the limited availability of residential mortgage financing, resulted in some continuing weakness in the overall asset quality of the Company’s loan portfolio. As a result of these factors, the Company has continued to follow aggressive strategies for resolving problem assets and has maintained the allowance for loan loss at an elevated level. The provision for loan losses totaled $1.9 million and $3.3 million, respectively, for the three and six month periods ended June 30, 2012, compared to $1.5 million and $7.0 million, respectively, for the same periods in the prior year. The year to date 2012 provision is significantly lower than in 2011 reflecting improvements achieved in the resolutions of classified and nonperforming loans, however, the provisions in both 2012 and 2011 are reflective of continued weakness in the overall economy, and the related effects of this weakness on the Company’s overall asset quality.

Total deposits increased slightly by $14.6 million during the six month period ended June 30, 2012, compared to the prior year end. The Company continued to emphasize its core deposit growth, while placing less emphasis on non core deposits including deposits which are obtained on a bid basis.

Liquidity from deposit growth, the proceeds from loan sales, and excess loan and investment repayments over new production was retained in the Company’s short-term liquidity portfolios, available to fund future loan growth. With interest rates remaining at historical low levels, this increase in liquidity contributed to significant margin compression. The net interest margin was 3.93 percent and 4.34 percent, respectively, for the three and six month periods ended June 30, 2012, compared to 4.55 percent and 4.47 percent, respectively, for the same periods in the prior year. The Company expects some additional net interest margin compression in future quarters due to maturing loans and investments being reinvested at lower interest rates and until redeployment of the excess proceeds from the recent loan sales and other maturing assets can be completed in a manner consistent with the Company’s risk management policies. Regardless of the timing of the aforementioned redeployment, if interest rates continue at current levels, we expect that additional downward pressure on net interest margin will continue.

As a result of the aforementioned activities, tax equivalent basis net interest income decreased by $4.1 million or 13.6 percent to $26.1 million for the three month period ended June 30, 2012, compared to $30.2 million for the same period in the prior year. Tax equivalent basis net interest income decreased by $0.4 million or 0.7 percent to $57.9 million for the six month period ended June 30, 2012, compared to $58.3 million for the same period in the prior year. The effect of the adjustment to a tax equivalent basis was $0.6 million and $1.1 million, respectively, for the three and six month periods ended June 30, 2012, compared to $0.6 million and $1.2 million, respectively, for the same periods in the prior year.

The Company’s non interest income was $4.8 million and $25.1 million, respectively, for the three and six month periods ended June 30, 2012. This represented increases of $1.0 million and $16.0 million, respectively, compared to $3.8 million and $9.1 million, respectively, for the same periods in the prior year. The increase in the three month period ended June 30, 2012, compared to the same period in the prior year, resulted from higher other income and lower other losses, partially offset by lower service fees and lower investment advisory fees. The increase in the six month period ended June 30, 2012, compared to the same period in the prior year, resulted from a $15.9 million pretax gain on sales of loans completed in the first quarter of 2012 and higher other income, partially offset by lower service fees, lower investment advisory fees and higher impairment charges on securities available-for-sale. Investment advisory fee income was lower in 2012 primarily as a result of the effects of

 

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continued fluctuation in both domestic and international equity markets. Service charges decreased slightly due to decreased activity. Pre-tax impairment charges on securities available for sale were $0.5 million for the six month period ended June 30, 2012 and $0.2 million for the same period in the prior year. The impairment charges were related to the Company’s investments in pooled trust preferred securities. The increase in non interest income was also affected by other losses of $1.0 million and $0.9 million, respectively, for the three and six month periods ended June 30, 2011. These losses related to sales and revaluations of other real estate owned and loans held for sale.

Non interest expense was $21.0 million and $41.9 million, respectively, for the three and six month periods ended June 30, 2012. This represented increases of $0.4 million or 1.9 percent and $0.8 million or 1.9 percent, respectively, compared to $20.6 million and $41.1 million, respectively, for the same periods in the prior year. The increase in non interest expense resulted primarily from an additional provision of $1.3 million related to the previously announced investigations and settlement discussions with the Securities and Exchange Commission (SEC) and the Department of Labor (DOL) relating to issues surrounding the brokerage practices and policies and disclosures about such practices of the Company’s investment advisory subsidiary, A.R. Schmeidler & Co., Inc. Based on ongoing settlement discussions with the SEC and the DOL, the Company believes it has substantially accrued for any penalties and related costs anticipated in the final resolution of this matter although, until final agreement is reached, the complete accrual cannot be determined. Other changes in non interest expense included decreases in costs associated with problem loan resolution and decreases in FDIC insurance, partially offset by increases in investments in technology and personnel to accommodate expanding risk management requirements and growth and the expansion of services and products available to new and existing customers.

The Office of Comptroller of the Currency (OCC) has directed greater scrutiny to banks with higher levels of commercial real estate loans. During the fourth quarter of 2009, the OCC required HVB to maintain, by December 31, 2009, a total risk-based capital ratio of at least 12.0%, a Tier 1 risk-based capital ratio of at least 10.0%, and a Tier 1 leverage ratio of at least 8.0%. These capital levels are in excess of “well capitalized” levels generally applicable to banks under current regulations. The Company and HVB have continuously exceeded all required regulatory capital ratios.

On February 1, 2012, Hudson Valley announced that during a routine exam and discussions with the OCC, HVB was made aware that it would be required to reduce its concentration in commercial real estate loans, including multi-family lending, as well as classified loans. As previously disclosed, the Company’s response to these discussions with the OCC included a commitment to reduce concentrations of CRE loans and classified assets to less than 400 percent and 25 percent of risk-based capital, respectively, in the near term.

As a result of the loan sales completed in the first quarter of 2012, and other resolution efforts, the Company reduced CRE loans to 365 percent of risk-based capital from 558 percent at the end of last year, while lowering classified assets to 24.6 percent of risk-based capital. Classified assets ranged between 56 percent and 67 percent of risk-based capital in 2011, before the impact of loan marks at December 31, 2011.

On April 24, 2012, the board of directors of Hudson Valley Bank signed a formal written agreement with the OCC. With this agreement, Hudson Valley is committing to adopt best practices modeled on those of the nation’s larger financial institutions, as well as evolving expectations of regulatory agencies on community banks. Included in the agreed-upon commitments are enhancements to HVB’s procedures, systems, policies, programs, plans, training and resources. The agreement is consistent with the CRE lending and classified asset concentration commitments Hudson Valley announced on February 1. The written agreement imposes no specific capital ratio mandates or other quantitative conditions or obligations on Hudson Valley and does not impose any limit on HVB board’s ability to pay dividends to its parent, except those imposed by the law. During the second quarter of 2012, the Bank submitted a capital plan to the OCC, which included provisions regarding the payment of dividends by HVB, as required under the written agreement. The Bank is operating in accordance with its capital plan without supervisory objection from the OCC.

Critical Accounting Policies

Application of Critical Accounting Policies — The Company’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States (“GAAP”). The

 

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Company’s significant accounting policies are more fully described in Note 2 to the Consolidated Financial Statements. Certain accounting policies require management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenue and expense during the reporting period. On an on-going basis, management evaluates its estimates and assumptions, and the effects of revisions are reflected in the financial statements in the period in which they are determined to be necessary. The accounting policies described below are those that most frequently require management to make estimates and judgments, and therefore, are critical to understanding the Company’s results of operations. Senior management has discussed the development and selection of these accounting estimates and the related disclosures with the Audit Committee of the Company’s Board of Directors.

Results of Operations for the Three and Six Month Periods Ended June 30, 2012 and 2011

Summary of Results

The Company recorded net income of $5.0 million or $0.25 per diluted share and $23.0 million or $1.17 per diluted share for the three and six month periods ended June 30, 2012, compared to $7.4 million or $0.38 per diluted share and $12.3 million or $0.63 per diluted share for the same periods in the prior year. Per share amounts for the 2011 periods have been adjusted to reflect the effects of the 10% stock dividend issued in December 2011. The decrease in earnings for the three month period ended June 30, 2012, compared to the same period in the prior year, was primarily due to a $4.1 million decrease in net interest income, the anticipated result of excess liquidity remaining from the proceeds of the loan sales conducted in the first and second quarters of 2012. In addition to the decrease in net interest income, income from the second quarter of 2012 was lower, compared to the same period in the prior year, as a result of higher provision for loan losses and lower fee income, partially offset by lower loss on sales and revaluations of loans and other real estate owned and slightly higher non interest expenses. The increase in earnings for the six month period ended June 30, 2012, compared to the same period in the prior year, resulted primarily from pretax gain of $15.9 million resulting from the successful completion of $474 million of loan sales announced in the fourth quarter of 2011 and completed at the end of the first quarter of 2012. The loan sales were conducted as part of the Company’s efforts to reduce the levels of nonperforming and other classified loans, and also to reduce the overall concentration in commercial real estate loans. In addition to the gains on the loan sales, income for the six month period ended June 30, 2012 was higher, compared to the same period in the prior year, as a result of higher non interest income and a lower provision for loan losses, partially offset by lower net interest income, higher impairment charges on securities available for sale and slightly higher non interest expenses. The provision for loan losses totaled $1.9 million and $3.3 million, respectively, for the three and six month periods ended June 30, 2012, compared to $1.5 million and $7.0 million, respectively, for the same periods in the prior year. The 2012 provision is significantly lower than in 2011 reflecting improvements achieved in the resolutions of classified and nonperforming loans, however, the provisions in both 2012 and 2011 are reflective of continued weakness in the overall economy, and the related effects of this weakness on the Company’s overall asset quality.

Annualized returns on average stockholders’ equity and average assets were 6.7 percent and 0.7 percent for the three month period ended June 30, 2012, compared to 10.1 percent and 1.1 percent for the same period in the prior year. Annualized returns on average stockholders’ equity and average assets were 15.9 percent and 1.6 percent for the six month period ended June 30, 2012, compared to 8.4 percent and 0.9 percent for the same period in the prior year. Returns on adjusted average stockholders’ equity were 6.8 percent and 16.0 percent for the three and six month periods ended June 30, 2012, compared to 10.1 percent and 8.4 percent for the same periods in the prior year. Adjusted average stockholders’ equity excludes the effects of average net unrealized gains on securities available for sale, net of tax, of $2.0 million and $2.4 million for the three and six month periods ended June 30, 2012, and $0.2 million and $0.3 million for the same period in the prior year. The annualized return on adjusted average stockholders’ equity is, under SEC regulations, a non-GAAP financial measure. Management believes that this non-GAAP financial measure more closely reflects actual performance, as it is more consistent with the Company’s stated asset/liability management strategies, which do not contemplate significant realization of market gains or losses on securities available for sale which were primarily related to changes in interest rates or illiquidity in the marketplace.

 

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Average Balances and Interest Rates

The following tables set forth the average balances of interest earning assets and interest bearing liabilities for the periods indicated, as well as total interest and corresponding yields and rates (dollars in thousands):

 

		Three Months Ended June 30,
		2012												2011
		Average Balance				Interest(3)				Yield/ Rate				Average Balance				Interest(3)				Yield/ Rate
		(Unaudited)
ASSETS
Interest earning assets:
Deposits in banks		$	532,009			$	298				0.22	%		$	250,408			$	201				0.32	%
Federal funds sold			16,658				9				0.22	%			41,988				23				0.22	%
Securities:(1)
Taxable			373,009				3,140				3.37	%			358,474				3,147				3.51	%
Exempt from federal income taxes			96,953				1,554				6.41	%			110,642				1,769				6.40	%
Loans, net(2)			1,577,190				22,663				5.75	%			1,840,076				27,941				6.07	%
Total interest earning assets			2,595,819				27,664				4.26	%			2,601,588				33,081				5.09	%
Non interest earning assets:
Cash and due from banks			46,279												50,110
Other assets			150,049												140,332
Total non interest earning assets			196,328												190,442
Total assets		$	2,792,147											$	2,792,030
LIABILITIES AND STOCKHOLDERS’ EQUITY
Interest bearing liabilities:
Deposits:
Money market		$	856,977			$	917				0.43	%		$	969,145			$	1,603				0.66	%
Savings			126,547				148				0.47	%			112,632				115				0.41	%
Time			140,963				211				0.60	%			169,824				384				0.90	%
Checking with interest			358,670				138				0.15	%			290,163				188				0.26	%
Securities sold under repo & other s/t borrowings			44,715				16				0.14	%			45,350				57				0.50	%
Other borrowings			16,450				182				4.43	%			46,379				501				4.32	%
Total interest bearing liabilities			1,544,322				1,612				0.42	%			1,633,493				2,848				0.70	%
Non interest bearing liabilities:
Demand deposits			925,569												841,503
Other liabilities			28,830												23,804
Total non interest bearing liabilities			954,399												865,307
Stockholders’ equity(1)			293,426												293,230
Total liabilities and stockholders’ equity		$	2,792,147											$	2,792,030
Net interest earnings						$	26,052											$	30,233
Net yield on interest earning assets											4.01	%											4.65	%

 

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		Six Months Ended June 30,
		2012												2011
		Average Balance				Interest(3)				Yield/ Rate				Average Balance				Interest(3)				Rate Yield/
		(Unaudited)
ASSETS
Interest earning assets:
Deposits in banks		$	327,322			$	354				0.22	%		$	263,609			$	365				0.28	%
Federal funds sold			16,647				17				0.20	%			43,318				49				0.23	%
Securities:(1)
Taxable			384,002				6,453				3.36	%			349,276				6,097				3.49	%
Exempt from federal income taxes			98,806				3,071				6.22	%			112,988				3,555				6.29	%
Loans, net(2)			1,787,290				51,578				5.77	%			1,784,059				54,273				6.08	%
Total interest earning assets			2,614,067				61,473				4.70	%			2,553,250				64,339				5.04	%
Non interest earning assets:
Cash and due from banks			47,850												45,591
Other assets			154,651												146,736
Total non interest earning assets			202,501												192,327
Total assets		$	2,816,568											$	2,745,577
LIABILITIES AND STOCKHOLDERS’ EQUITY
Interest bearing liabilities:
Deposits:
Money market		$	919,917			$	2,156				0.47	%		$	919,924			$	3,142				0.68	%
Savings			121,171				261				0.43	%			113,695				242				0.43	%
Time			142,953				465				0.65	%			177,107				819				0.92	%
Checking with interest			329,671				282				0.17	%			285,510				361				0.25	%
Securities sold under repo & other s/t borrowings			49,150				67				0.27	%			42,545				104				0.49	%
Other borrowings			16,455				363				4.41	%			60,642				1,345				4.44	%
Total interest bearing liabilities			1,579,317				3,594				0.46	%			1,599,423				6,013				0.75	%
Non interest bearing liabilities:
Demand deposits			923,730												830,784
Other liabilities			27,016												23,260
Total non interest bearing liabilities			950,746												854,044
Stockholders’ equity(1)			286,505												292,110
Total liabilities and stockholders’ equity		$	2,816,568											$	2,745,577
Net interest earnings						$	57,879											$	58,326
Net yield on interest earning assets											4.43	%											4.57	%

 

(1)

Excludes unrealized gains (losses) on securities available for sale. Management believes that this presentation more closely reflects actual performance, as it is more consistent with the Company’s stated asset/liability management strategies, which have not resulted in significant realization of temporary market gains or losses on securities available for sale which were primarily related to changes in interest rates. Effects of these adjustments are presented in the table below.

 

(2)	Includes loans classified as non-accrual and loans held-for-sale.

 

(3)

The data contained in the table has been adjusted to a tax equivalent basis, based on the Company’s federal statutory rate of 35 percent. Management believes that this presentation provides comparability of net interest income and net interest margin arising from both taxable and tax-exempt sources and is consistent with industry practice and SEC rules. Effects of these adjustments are presented in the table below.

 

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Average Balances and Interest Rates Non-GAAP Reconciliation to GAAP

 

		Three Months Ended June 30								Six Months Ended June 30
		2012				2011				2012				2011
		(000’s)								(000’s)
Total interest earning assets:
As reported		$	2,598,762			$	2,601,546			$	2,617,656			$	2,553,508
Unrealized gain on securities available for sale(1)			2,943				(42	)			3,589				258
Adjusted total interest earning assets		$	2,595,819			$	2,601,588			$	2,614,067			$	2,553,250
Net interest earnings:
As reported		$	25,508			$	29,614			$	56,804			$	57,082
Adjustment to tax equivalency basis(2)			544				619				1,075				1,244
Adjusted net interest earnings		$	26,052			$	30,233			$	57,879			$	58,326
Net yield on interest earning assets:
As reported			3.93	%			4.55	%			4.34	%			4.47	%
Effects of (1) and (2) above			0.08	%			0.10	%			0.09	%			0.10	%
Adjusted net yield on interest earning assets			4.01	%			4.65	%			4.43	%			4.57	%
Average stockholders’ equity:
As reported		$	295,378			$	293,390			$	288,918			$	292,413
Effects of (1) and (2) above			1,952				160				2,413				303
Adjusted average stockholders’ equity		$	293,426			$	293,230			$	286,505			$	292,110

Interest Differential

The following table sets forth the dollar amount of changes in interest income, interest expense and net interest income between the three and six month periods ended June 30, 2012 and 2011:

 

		(000’s)												(000’s)
		Three Month Period Increase (Decrease) Due to Change in												Six Month Period Increase (Decrease) Due to Change in
		Volume				Rate				Total(1)				Volume				Rate				Total(1)
Interest income:
Deposits in Banks		$	226			$	(129	)		$	97			$	88			$	(99	)		$	(11	)
Federal funds sold			(14	)			—				(14	)			(30	)			(2	)			(32	)
Securities:
Taxable			128				(135	)			(7	)			606				(250	)			356
Exempt from federal income taxes			(219	)			4				(215	)			(446	)			(38	)			(484	)
Loans, net			(3,992	)			(1,286	)			(5,278	)			98				(2,793	)			(2,695	)
Total interest income			(3,871	)			(1,546	)			(5,417	)			316				(3,182	)			(2,866	)
Interest expense:
Deposits:
Money market			(186	)			(500	)			(686	)			—				(986	)			(986	)
Savings			14				19				33				16				3				19
Time			(65	)			(108	)			(173	)			(158	)			(196	)			(354	)
Checking with interest			44				(94	)			(50	)			56				(135	)			(79	)
Securities sold under repo & other s/t borrowings			(1	)			(40	)			(41	)			16				(53	)			(37	)
Other borrowings			(323	)			4				(319	)			(980	)			(2	)			(982	)
Total interest expense			(517	)			(719	)			(1,236	)			(1,050	)			(1,369	)			(2,419	)
(Decrease) increase in interest differential		$	(3,354	)		$	(827	)		$	(4,181	)		$	1,366			$	(1,813	)		$	(447	)

 

(1)	Changes attributable to both rate and volume are allocated between the rate and volume variances based upon their absolute relative weight to the total change.

 

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(2)	Equivalent yields on securities exempt from federal income taxes are based on a federal statutory rate of 35 percent in 2012 and 2011.

Net Interest Income

For purposes of the financial information included in this section, the Company adjusts average interest earning assets to exclude the effects of unrealized gains and losses on securities available for sale and adjusts net interest income to a tax equivalent basis. Management believes that this alternate presentation more closely reflects actual performance, as it is consistent with the Company’s stated asset/liability management strategies. The effects of these non-GAAP adjustments to tax equivalent basis net interest income and adjusted average assets are included in the table presented in “Average Balances and Interest Rates” section herein.

Net interest income, the difference between interest income and interest expense, is the most significant component of the Company’s consolidated earnings. As previously noted in the Company’s 2011 Annual Report on Form 10-K, the Company has experienced an extended period of severe negative economic conditions and historically low interest rates. These conditions have resulted in sharp declines in the value of collateral securing many of the Company’s loans, elevated levels of classified and nonperforming loans, weak loan demand and declining margins. In addition, a dynamically changing regulatory landscape has resulted in greater scrutiny of the historic business models of smaller community-based institutions. This has resulted in greater pressure on many community banks to reduce loan concentrations, particularly commercial real estate loans, and to accelerate the reduction of levels of nonperforming and classified loans. During this period of economic difficulty and low interest rates, the Company took various steps to address these issues. These steps included repositioning its securities portfolio, reducing higher cost term borrowings and, during the first half of 2012, executing significant loan sales for the purpose of reducing commercial real estate concentrations and overall levels of classified and nonperforming loans. These actions have resulted in significant margin compression, particularly in the second quarter of 2012, as a result of the impact of only partial redeployment of proceeds from loan sales completed in the first quarter of 2012 together with the continuation of historically low interest rate levels. As a result of these differentials in redeployment and average yields, together with the current historically low interest rate environment, the Company expects additional margin compression will result in the near term, particularly during the period of redeployment of the remaining proceeds from the loan sales. Management believes that the results of these efforts has enabled the Company, given the difficulties encountered during the recent financial crisis, to maximize its net interest income, address regulatory concerns, and effectively reposition its portfolios from both asset composition and interest rate risk perspectives.

Net interest income, on a tax equivalent basis, decreased by $4.1 million or 13.6 percent to $26.1 million and by $0.4 million or 0.7 percent to $57.9 million, respectively, for the three and six month periods ended June 30, 2012, compared to $30.2 million and $58.3 million, respectively, for the same periods in the prior year. Net interest income for the 2012 periods was lower primarily due to decreases in the tax equivalent basis net interest margin to 4.01 percent and 4.43 percent, respectively, for the three and six month periods ended June 30, 2012, compared to 4.65 percent and 4.57 percent, respectively, for the same periods in the prior year. The declines in the 2012 net interest margins were primarily caused by significant increases in short term liquidity balances resulting from the proceeds of loan sales, together with the continuing effects of the current low interest rates on the redeployment of maturing loans and investments. The decreases in 2012 net interest income were also affected by increases in the excess of adjusted average interest earning assets over average interest bearing liabilities of $83.4 million or 8.6 percent to $1,051.5 million, and $80.9 million or 8.5 percent to $1,034.8 million, respectively, for the three and six month periods ended June 30, 2012, compared to $968.1 million and $953.9 million, respectively, for the same periods in the prior year.

The Company’s overall asset quality has improved as a result of actions taken by management to reduce concentrations and classified assets. However, asset quality has continued to be adversely affected by the current state of the economy and has continued to experience elevated levels of delinquent and nonperforming loans, and declines in the loan-to-value ratios on existing loans. Changes in the levels of nonperforming loans have a direct impact on net interest income.

The Company’s short-term liquidity remains at elevated levels, resulting from continued deposit growth, soft loan demand and proceeds from recent loan sales which have not as yet been redeployed. This

 

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excess liquidity contributed to margin compression. The Company has made efforts throughout the extended period of severe economic uncertainty and fluctuating interest rates to minimize the impact on its net interest income by appropriately repositioning its securities portfolio and funding sources while maintaining prudence and awareness of the potential consequences that the current economic crisis could have on its asset quality and interest rate risk profiles. The Company continues to increase the number of loans originated with interest rate floors and exercise caution in reinvestment of excess liquidity provided from continued strong deposit growth and proceeds from loan sales. These actions are being conducted partially to maintain flexibility in reaction to the continuation of historically low interest rates. The Company’s ability to make changes in its asset mix allows management to capitalize on more desirable yields, as available, on various interest earning assets. Management believes that the result of these efforts has enabled the Company, given the difficulties being encountered in the current economic crisis, to maximize the effective repositioning of its portfolios from both asset and interest rate risk perspectives.

Interest income is determined by the volume of, and related rates earned on, interest earning assets. Average volume decreases in loan and federal funds sold and lower average yield on interest earning assets, partially offset by average volume increases in interest bearing deposits and investments, resulted in lower interest income for the three month period ended June 30, 2012, compared to the same period in the prior year. Average volume decreases in federal funds sold and lower average yield on interest earning assets, partially offset by volume increases in interest bearing deposits and investments and a slight increase in the average volume of loans, resulted in lower interest income for the six month period ended June 30, 2012, compared to the same period in the prior year. Adjusted average interest earning assets for the three and six month periods ended June 30, 2012 decreased $5.8 million or 0.2 percent to $2,595.8 million and increased $60.8 million or 2.4 percent to $2,614.1, respectively, from $2,601.6 million and $2,553.3 million, respectively, for the same periods in the prior year.

Loans are the largest component of interest earning assets. Average net loans decreased $262.9 million or 14.3 percent to $1,577.2 million, for the three month period ended June 30, 2012, compared to $1,840.1 million for the same period in the prior year. The average yield on loans was 5.75 percent for the three month period ended June 30, 2012, compared to 6.07 percent for the same period in the prior year. As a result, interest income on loans was lower for the three month period ended June 30, 2012, compared to the same period in the prior year, due to lower average volume and lower average interest rates. Average net loans increased slightly by $3.2 million or 0.2 percent to $1,787.3 million, for the six month period ended June 30, 2012, compared to $1,784.1 million for the same period in the prior year. The average yield on loans was 5.77 percent for the six month period ended June 30, 2012, compared to 6.08 percent for the same period in the prior year. As a result, interest income on loans was lower for the three month period ended June 30, 2012, compared to the same period in the prior year, due to lower average interest rates, partially offset by slightly higher average volume.

Average total securities, including Federal Home Loan Bank (“FHLB”) stock and excluding net unrealized gains and losses, increased $0.9 million or 0.2 percent to $470.0 million for the three month period ended June 30, 2012, compared to $469.1 million for the same period in the prior year. The average tax equivalent basis yield on securities was 4.00 percent for the three month period ended June 30, 2012, compared to 4.19 percent for the same period in the prior year. As a result, tax equivalent basis interest income on securities decreased for the three month period ended June 30, 2012, compared to the same period in the prior year, due to lower average interest rates, partially offset by slightly higher average volume. Average total securities, including Federal Home Loan Bank (“FHLB”) stock and excluding net unrealized gains and losses, increased $20.5 million or 4.4 percent to $482.8 million for the six month period ended June 30, 2012, compared to $462.3 million for the same period in the prior year. The average tax equivalent basis yield on securities was 3.95 percent for the six month period ended June 30, 2012, compared to 4.18 percent for the same period in the prior year. As a result, tax equivalent basis interest income on securities decreased for the six month period ended June 30, 2012, compared to the same period in the prior year, due to lower average interest rates, partially offset by slightly higher average volume. Increases or decreases in average FHLB stock result from purchases or redemptions of stock in order to maintain required levels to support FHLB borrowings.

Interest expense is a function of the volume of, and rates paid for, interest bearing liabilities, comprised of deposits and borrowings. Interest expense decreased $1.2 million or 42.9 percent to $1.6 million for the three month period ended June 30, 2012, compared to $2.8 million for the same period in the prior year. Average

 

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interest bearing liabilities decreased $89.2 million or 5.5 percent to $1,544.3 million for the three month period ended June 30, 2012, compared to $1,633.5 million for the same period in the prior year. The decrease in average interest bearing liabilities for the three month period ended June 30, 2012, compared to the same period in the prior year, was due to average volume decreases in interest bearing demand deposits, time deposits, securities sold under repurchase agreements and other short-term borrowings and other borrowings. The average interest rate paid on interest bearing liabilities was 0.42 percent for the three month period ended June 30, 2012, compared to 0.70 percent for the same period in the prior year. As a result of these factors, interest expense on average interest bearing liabilities was lower for the three month period ended June 30, 2012, compared to the same period in the prior year due to lower average volume and lower average interest rates. Interest expense decreased $2.4 million or 40.0 percent to $3.6 million for the six month period ended June 30, 2012, compared to $6.0 million for the same period in the prior year. Average interest bearing liabilities decreased $20.1 million or 1.3 percent to $1,579.3 million for the six month period ended June 30, 2012, compared to $1,599.4 million for the same period in the prior year. The decrease in average interest bearing liabilities for the six month period ended June 30, 2012, compared to the same period in the prior year, was due to average volume decreases in time deposits and other borrowings, partially offset by volume increases in interest bearing demand deposits and securities sold under agreements to repurchase and other short-term borrowings. The average interest rate paid on interest bearing liabilities was 0.46 percent for the six month period ended June 30, 2012, compared to 0.75 percent for the same period in the prior year. As a result of these factors, interest expense on average interest bearing liabilities was lower for the six month period ended June 30, 2012, compared to the same period in the prior year due to lower average volume and lower average interest rates. . The decrease in other borrowings for the three and six month periods ended June 30, 2012, compared to the same periods in the prior year, resulted from management’s decision to utilize cash flow from deposit growth and maturing investment securities to reduce borrowings as part of the Company’s ongoing asset/liability management efforts.

Average non interest bearing demand deposits increased $84.1 million or 10.0 percent to $925.6 million, and $92.9 million or 11.2 percent to $923.7 million, respectively, for the three and six month period ended June 30, 2012, compared to $841.5 million and $830.8 million, respectively for the same periods in the prior year. Non interest bearing demand deposits are an important component of the Company’s ongoing asset liability management, and also have a direct impact on the determination of net interest income.

The interest rate spread on a tax equivalent basis for the three and six month periods ended June 30, 2012 and 2011 is as follows:

 

		Three Months Ended Jun 30								Six Months Ended Jun 30
		2012				2011				2012				2011
Average interest rate on:
Total average interest earning assets			4.26	%			5.09	%			4.70	%			5.04	%
Total average interest bearing liabilities			0.42	%			0.70	%			0.46	%			0.75	%
Total interest rate spread			3.84	%			4.39	%			4.24	%			4.29	%

Interest rate spreads increase or decrease as a result of the relative change in average interest rates on interest earning assets compared to the change in average interest rates on interest bearing liabilities. Management cannot predict what impact market conditions will have on its interest rate spread and future compression of net interest spread may occur.

Provision for Loan Losses

The Company recorded provisions for loan losses of $1.9 million and $3.3 million for the three and six month periods ended June 30, 2012, compared to $1.5 million and $7.0 million for the same periods in the prior year. The provision for loan losses is charged to income to bring the Company’s allowance for loan losses to a level deemed appropriate by management. See “Allowance for Loan Losses” for further discussion.

 

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Non Interest Income

The Company’s non interest income was $4.8 million and $25.1 million, respectively, for the three and six month periods ended June 30, 2012. This represented increases of $1.0 million and $16.0 million, respectively, compared to $3.8 million and $9.1 million, respectively, for the same periods in the prior year. The increase in the three month period ended June 30, 2012, compared to the same period in the prior year, resulted from higher miscellaneous income and lower other losses, partially offset by lower service fees and lower investment advisory fees. The increase in the six month period ended June 30, 2012, compared to the same period in the prior year, resulted from a $15.9 million pretax gain on sales of loans completed in the first quarter of 2012 and higher other income, partially offset by lower service fees, lower investment advisory fees and higher impairment charges on securities available-for-sale. Non interest income also included recognized pre-tax impairment charges on securities available for sale of $0.5 million and $0.1 million, respectively, for the three and six month periods ended June 30, 2012 and $0.1 million and $0.2 million, respectively, for the same periods in the prior year. The impairment charges were related to the Company’s investments in pooled trust preferred securities. Non interest income also included other losses of $1.0 million and $0.9 million, respectively, for the three and six month periods ended June 30, 2011. These losses related to sales and revaluations of other real estate owned and loans held for sale.

Non Interest Expense

Non interest expense was $21.0 million and $41.9 million, respectively, for the three and six month periods ended June 30, 2012. This represented increases of $0.4 million or 1.9 percent and $0.8 million or 1.9 percent, respectively, compared to $20.6 million and $41.1 million, respectively, for the same periods in the prior year. The increase in non interest expense resulted primarily from an additional provision of $1.3 million related to the previously announced investigations and settlement discussions with the SEC and DOL relating to issues surrounding the brokerage practices and policies and disclosures about such practices of the Company’s investment advisory subsidiary, A.R. Schmeidler & Co., Inc. Based on ongoing settlement discussions with the SEC and the DOL, the Company believes it has substantially accrued for any penalties and related costs anticipated in the final resolution of this matter although, until final agreement is reached, the complete accrual cannot be determined. Other changes in non interest expense included decreases in costs associated with problem loan resolution and decreases in FDIC insurance, partially offset by increases in investments in technology and personnel to accommodate expanding risk management requirements, growth and the expansion of services and products available to new and existing customers.

Salaries and employee benefits expense, the largest component of non interest expense, for the three and six month periods ended June 30, 2012 increased $0.1 million or 0.9 percent to $11.4 million and $0.1 million or 0.5 percent to $22.2 million, respectively, compared to $11.3 million and $22.1 million for the same periods in the prior year. Increases in salaries in 2012 were offset by the partial reduction of previously accrued officers’ incentive compensation in March 2012.

Occupancy expense for the three month period ended June 30, 2012 was unchanged from the same period in the prior year. Occupancy expense for the six month period ended June 30, 2012 decreased $0.1 million or 2.2 percent to $4.4 million compared to $4.5 million for the same period in the prior year. The slight decrease reflected lower maintenance costs during the current period.

Professional services expense for the three and six month periods ended June 30, 2012 increased $0.3 million or 17.6 percent to $2.0 million and $0.7 million or 21.9 percent to $3.9 million, respectively, compare to $1.7 million and $3.2 million for the same periods in the prior year. The increases was primarily due to costs related to the engagement of consultants to assist with new systems implementations and legal costs related to the aforementioned SEC and DOL investigations of A.R. Schmeidler & Co., Inc.

Equipment expense for the three and six month periods ended June 30, 2012 increased $0.1 million or 9.1 percent to $1.2 million and $0.1 million or 4.8 percent to $2.2 million, respectively, compared to $1.1 million and $2.1 million for the same periods in the prior year. The increases were due to increased equipment and software maintenance costs.

 

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Business development expense for the three and six month periods ended June 30, 2012 increased $0.2 million or 33.3 percent to $0.8 million and $0.3 million or 27.3 percent to $1.4 million, respectively, compared to $0.6 million and $1.1 million for the same periods in the prior year. The increases were due to increased business development efforts and expenses related to the celebration of the Bank’s 40^th anniversary.

The FDIC assessment for the three month period ended June 30, 2012 was unchanged compared to the prior year period. The FDIC assessment for the six month period ended June 30, 2012 decreased $0.4 million or 22.2 percent to $1.4 million compared to $1.8 million for the same period in the prior years. The decrease was due to the change in the premium calculation base by the FDIC.

Significant changes in other components of non interest expense for the three and six month periods ended June 30, 2012 compared to the same periods in the prior year were due to the following:

 

•

Increases of $129,000 (218.6 %) and $103,000 (735.7%), respectively, in other insurance expense, resulting from increases in blanket bond insurance costs partially offset by reductions in the estimates of the net cost of certain life insurance policies,

 

•

Increase of $51,000 (26.3%) and a decrease of $57,000 (12.2%), respectively, in courier expenses due to increased utilization during the second quarter of 2012,

 

•

Decreases of $412,000 (64.8%) and $410,000 (39.4%), respectively, in other loan expenses due to lower expenses related to OREO and loans in the asset recovery portfolio,

 

•

Increase of $11,000 (1.0%) and decrease of $148,000 (6.5%), respectively, in outside services. The slight increase for the three month period was due to the completion of a systems implementation during the second quarter of 2012. The decrease for the six month period in outside services, was due to outsourcing of several data processing functions

 

•

Decreases of $49,000 (37.7%) and $87,000 (33.2%), respectively, in meetings and seminars, reflecting reduced participation in such events in 2012,

 

•

Decrease of $75,000 (11.0%) and increase of $769,000 (50.5 %) in other expenses, resulting from the additional contingency provision of $1.2 million, recorded during the first quarter of 2012, related to the aforementioned SEC investigation of A.R. Schmeidler & Co., Inc.

Income Taxes

Income taxes of $2.4 million and $13.8 million, respectively, were recorded in the three and six month periods ended June 30, 2012, compared to $3.8 million and $5.8 million, respectively, for the same period in the prior year. The overall effective tax rate of 37.5 percent for the six month period ended June 30, 2012 was higher compared to 32.0 percent for the same period in the prior year. The 2012 effective rate was higher primarily due to the fact that the tax effect of the $15.9 million gain on loan sales resulted in tax-exempt income representing a lower percentage of pretax income in 2012 compared to 2011. The Company is subject to a Federal statutory rate of 35 percent, a New York State tax rate of 7.1 percent plus a 17 percent surcharge, a Connecticut State tax rate of 7.5 percent and a New York City tax rate of 9 percent.

Financial Condition

Assets

The Company had total assets of $2,816.2 million at June 30, 2012, an increase of $18.5 million or 0.6 percent from $2,797.7 million at December 31, 2011.

Cash and Due from Banks

Cash and due from banks was $641.3 million at June 30, 2012, an increase of $563.2 million or 721.1 percent from $78.1 million at December 31, 2011. Included in cash and due from banks is interest earning deposits of $595.3 million at June 30, 2012 and $34.4 million at December 31, 2011. The increase was due to the proceeds from the sale of loans held for sale not being fully deployed.

 

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Federal Funds Sold

Federal funds sold totaled $22.3 million at June 30, 2012, an increase of $5.9 million or 36.0 percent from $16.4 million at December 31, 2011. The increase was a result of the proceeds from the sale of loans held for sale not being fully deployed.

Securities Portfolio

Securities are selected to provide safety of principal, liquidity, pledging capabilities (to collateralize certain deposits and borrowings), income and to leverage capital. The Company’s investment strategy focuses on maximizing income while providing for safety of principal, maintaining appropriate utilization of capital, providing adequate liquidity to meet loan demand or deposit outflows and to manage overall interest rate risk. The Company selects individual securities whose credit, cash flow, maturity and interest rate characteristics, in the aggregate, affect the stated strategies.

Securities are classified as either available for sale, representing securities the Company may sell in the ordinary course of business, or as held to maturity, representing securities the Company has the ability and positive intent to hold until maturity. Securities available for sale are reported at fair value with unrealized gains and losses (net of tax) excluded from operations and reported in other comprehensive income. Securities held to maturity are stated at amortized cost.

The available for sale portfolio totaled $456.2 million at June 30, 2012 which was a decrease of $51.5 million or 10.1 percent from $507.9 million at December 31, 2011. The decrease resulted from a $34.8 million decrease in mortgage-backed securities and a decrease of $16.7 million of obligations of state political subdivisions. Included in other debt securities are pooled trust preferred securities, which had an aggregate cost basis of $11.2 million at June 30, 2012 and $11.6 million at December 31, 2011. These pooled trust preferred securities have suffered severe declines in the prior periods in estimated fair value primarily as a result of both illiquidity in the marketplace and declines in the credit ratings of a number of issuing banks underlying these securities. Management cannot predict what effect that continuation of such conditions could have on potential future value or whether there will be additional impairment charges related to these securities.

The held to maturity portfolio totaled $11.5 million at June 30, 2012, which was a decrease of $1.4 million or 10.9 percent from $12.9 million at December 31, 2011. The decrease was due to a decrease in mortgage-backed securities.

The Bank, as a member of the FHLB, invests in stock of the FHLB as a prerequisite to obtaining funding under various programs offered by the FHLB. The Bank must purchase additional shares of FHLB stock to obtain increases in such borrowings. Shares in excess of required amounts for outstanding borrowings are generally redeemed by the FHLB. The investment in FHLB stock totaled $4.8 million and $3.8 million, respectively, at June 30, 2012 and December 31, 2011.

The Company continues to exercise a conservative approach to investing by purchasing high credit quality investments with various maturities and cash flows to provide for liquidity needs and prudent asset liability management. The Company’s securities portfolio provides for a significant source of income, liquidity and is utilized in managing Company-wide interest rate risk. These securities are used to collateralize borrowings and deposits to the extent required or permitted by law. Therefore, the securities portfolio is an integral part of the Company’s funding strategy.

There were no obligations of any single issuer which exceeded ten percent of stockholders’ equity at June 30, 2012 or December 31, 2011.

Loan Portfolio

Net loans totaled $1,523.8 million at June 30, 2012, a decrease of $17.6 million or 1.1 percent from $1,541.4 million at December 31, 2011. The decrease resulted principally from a $57.2 million decrease in commercial real estate loans, a $13.8 million decrease in construction loans and a $6.3 million decrease in lease financing and other loans, These decreases were partially offset by a $44.3 increase in residential real estate loans

 

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and a $12.6 million increase is commercial and industrial loans. The increase in residential loans was primarily the result the purchase of adjustable rate residential loans, which were purchased as partial redeployment of proceeds from sales of loans held for sale.

The loan portfolio, excluding loans held for sale, is comprised of the following:

 

		June 30 2012				December 31 2011
Real Estate:
Commercial		$	633,581			$	690,837
Construction			96,211				110,027
Residential			559,144				514,828
Commercial & Industrial			231,140				218,500
Individuals & lease financing			35,510				41,760
Total loans			1,555,586				1,575,952
Deferred loan fees			(3,020	)			(3,862	)
Allowance for loan losses			(28,733	)			(30,685	)
Loans, net		$	1,523,833			$	1,541,405

The following table illustrates the trend in nonperforming assets, delinquency and net charge-offs from June 2011 to June 2012 (in thousands):

 

		Jun 30 2012				Mar 31 2012				Dec 31 2011				Sep 30 2011				Jun 30 2011
Non-Accrual Loans:
Real Estate:
Commercial			12,222				11,372				13,212				20,614				20,778
Construction			2,659				4,317				5,481				17,237				13,785
Residential			11,888				4,440				3,396				12,248				13,755
Total Real Estate			26,769				20,129				22,089				50,099				48,318
Commercial & Industrial			12,535				7,730				7,803				8,196				9,050
Lease Financing and Individuals			—				—				—				241				249
Total Non-Accrual Loans			39,304				27,859				29,892				58,536				57,617
Other Real Estate Owned			250				1,174				1,174				924				2,370
Nonperforming Assets excluding loans held for sale			39,554				29,033				31,066				59,460				59,987
Nonperforming loans held for sale			—				—				27,848				2,244				4,506
Total Nonperforming Assets including loans held for sale		$	39,554			$	29,033			$	58,914			$	61,704			$	64,493
Net charge-offs (recoveries) during quarter		$	5,017			$	188			$	66,086			$	2,276			$	(56	)
Nonperforming assets to total assets:
Excluding loans held for sale			1.40	%			1.03	%			1.11	%			2.03	%			2.13	%
Including loans held for sale			1.40	%			1.03	%			2.11	%			2.11	%			2.29	%

Non-accrual loans increased $9.4 million to $39.3 million at June 30, 2012 from $29.9 million at December 31, 2011. There was no interest income on non-accrual loans included in net income for the six month period ended June 30, 2012 and the year ended December 31, 2011. Gross interest income that would have been recorded if these borrowers had been current in accordance with their original loan terms was $0.9 million and $1.1 million for the six month period ended June 30, 2012 and the year ended December 31, 2011, respectively.

Net income is adversely impacted by the level of nonperforming assets caused by the deterioration of the borrowers’ ability to meet scheduled interest and principal payments. In addition to forgone revenue, the Company must increase the level of provision for loan losses, incur higher collection costs and other costs associated with the management and disposition of foreclosed properties.

 

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The high level of nonperforming assets has primarily resulted from the current severe economic slowdown, which has had negative effects on real estate values, sales and available financing, particularly in the commercial and residential real estate sectors. Continuation of this condition could result in additional increases in nonperforming assets and charge-offs in the future.

During the six month period ended June 30, 2012:

 

•

Non-accrual commercial real estate loans decreased $1.0 million resulting from the transfer of two loans totaling $4.8 million to non-accrual residential loans due to changes in the underlying collateral securing those loans, the charge-off of three loans totaling $3.6 million, the payoffs of six loans totaling $6.7 million, principal payments of $0.1 million, which was partially offset by the addition of fifteen loans totaling $14.2 million.

 

•

Non-accrual construction loans decreased $2.8 million, resulting from the payoff of two loans totaling $5.0 million, a partial charge-off of one loan totaling $1.0 million and principal payments of $0.1 million, which was partially offset by the addition of two loans totaling $3.3 million

 

•

Non-accrual residential loans increased $8.5 million resulting transfer of two loans totaling $4.8 million from non-accrual commercial real estate loans and one loan totaling $0.1 million from non-accrual commercial and industrial loans due to changes in the underlying collateral securing those loans and the addition of five loans totaling $5.4 million, which was partially offset by the partial charge-off of one loan totaling $1.2 million and the charge-off of four loans totaling $0.6 million.

 

•

Non-accrual commercial and industrial loans increased $4.7 million resulting from the addition of sixteen loans totaling $7.7 million and the transfer of one loan totaling $0.1 million from non-accrual commercial and industrial loans due to changes in the underlying collateral securing that loan, which was partially offset by charge-offs of $2.9 million and principal payments of $0.2 million.

There were no loans past due 90 days or more and still accruing at June 30, 2012 and December 31, 2011. In addition, the Company had $5.4 million and $5.0 million of loans that were 31-89 days delinquent and still accruing at June 30, 2012 and December 31, 2011, respectively.

Loans considered by the Company to be impaired totaled $58.5 million and $47.9 million at June 30, 2012 and December 31, 2011, respectively, for which no specific reserve and specific reserves of $2.4 million had been established.

There were thirteen loans totaling $32.3 million at June 30, 2012 and sixteen loans totaling $29.0 million at December 31, 2011 that were considered troubled debt restructurings (TDRs). Of the June 30, 2012 TDRs, eight loans totaling $19.2 million on accrual status and four loans totaling $12.7 million on non-accrual status were performing in accordance with their restructured terms. The remaining $0.4 million loan was in default and on non-accrual status. Of the December 2011 TDRs, seven loans totaling $18.0 were on accrual status and nine loans totaling $11.0 million were on non-accrual status. At December 31, 2011 all TDRs were performing in accordance with their restructured terms. At June 30, 2012, the Company had no commitments to lend additional funds to non-accrual loans or TDRs.

The Company performs extensive ongoing asset quality monitoring by both internal and independent loan review functions. In addition, the Company conducts timely remediation and collection activities through a network of internal and external resources which include an internal asset recovery department, real estate and other loan workout attorneys and external collection agencies. In addition, during the second quarter of 2010, the Company decided to implement a more aggressive workout strategy for the resolution of problem assets in light of a sluggish economic recovery, continued weakness in local real estate activity and market values and growing difficulty in resolving problem loans in a timely fashion through traditional foreclosure proceedings due to increased bankruptcy filings and overcrowded court systems. See “Allowance for Loan Losses” below for further discussion of this strategy. Management believes that these efforts are appropriate for accomplishing either successful remediation or maximizing collections related to nonperforming assets.

Allowance for Loan Losses

The Company maintains an allowance for loan losses to absorb probable losses incurred in the loan portfolio based on ongoing quarterly assessments of the estimated losses. The Company’s methodology for assessing the

 

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appropriateness of the allowance consists of a specific component for identified problem loans and a formula component to consider historical loan loss experience and additional risk factors affecting the portfolio.

See Note 2 to the Company’s condensed consolidated financial statements presented in this Form 10-Q for a detailed description of the methodology employed by the Company in determining the specific and formula components of the allowance for loan losses.

A summary of the components of the allowance for loan losses, changes in the components and the impact of charge-offs/recoveries on the resulting provision for loan losses for the dates indicated is as follows:

 

		(000’s)												(000’s)
		June 30 2012				Change During 2012				Dec 31 2011				June 30 2011				Change During 2011				Dec 31 2010
Components
Specific:
Real Estate:
Commercial			—				—				—				—				—				—
Construction			—			$	(2,374	)		$	2,374			$	907			$	57			$	850
Residential			—				—				—				—				(17	)			17
Commercial and Industrial			—				—				—				25				—				25
Lease Financing and other			—				—				—				—				—				—
Total Specific Component			—				(2,374	)			2,374				932				40				892
Formula:
Real Estate:
Commercial		$	11,592				(1,184	)			12,776				17,112				376				16,736
Construction			4,496				400				4,096				5,533				(757	)			6,290
Residential			8,789				696				8,093				13,161				3,327				9,834
Commercial and Industrial			3,420				770				2,650				4,221				(44	)			4,265
Lease Financing and other			436				(260	)			696				930				(2	)			932
Total Formula Component			28,733				422				28,311				40,957				2,900				38,057
Total Allowance		$	28,733							$	30,685			$	41,889							$	38,949
Net Change							(1,952	)											2,940
Net Charge-offs							5,205												4,057
Provision for loan losses						$	3,253											$	6,997

The specific component of the allowance for loan losses is the result of our analysis of impaired loans and our determination of the amount required to reduce the carrying amount of such loans to estimated fair value. Accordingly, such allowance is dependent on the particular loans and their characteristics at each measurement date, not necessarily the total amount of such loans. The Company usually records partial charge-offs as opposed to specific reserves for impaired loans that are real estate collateral dependent and for which independent appraisals have determined the fair value of the collateral to be less than the carrying amount of the loan. During the six months ended June 30, 2012, the Company recorded $6.9 million of charge-offs, of which $5.5 million were partial charge-offs related to nonaccrual loans. At June 30, 2012, the Company had no specific reserves allocated. There was a $2.4 million specific reserve allocated to one impaired loan as of December 31, 2011. This reserve was charged off in the second quarter of 2012 upon completion of the restructure of the related loan for which it was established. The Company’s analyses as of June 30, 2012 and December 31, 2011 indicated that impaired loans were principally real estate collateral dependent and that, with the exception of those loans for which specific reserves were assigned, there was sufficient underlying collateral value or guarantees to indicate expected recovery of the carrying amount of the loans.

The changes in the formula component of the allowance for loan losses are the result of the application of historical loss experience to outstanding loans by type. Loss experience for each year is based upon average

 

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charge-off experience for the prior three year period by loan type. The formula component is then adjusted to reflect changes in other relevant factors affecting loan collectability. Management periodically adjusted the formula component to an amount that, when considered with the specific component, represented its best estimate of probable losses in the loan portfolio as of each balance sheet date.

Actual losses can vary significantly from the estimated amounts. The Company’s methodology permits adjustments to the allowance in the event that, in management’s judgment, significant factors which affect the collectibility of the loan portfolio as of the evaluation date have changed. By assessing the estimated losses inherent in the loan portfolio on a quarterly basis, the Bank is able to adjust specific and inherent loss estimates based upon any more recent information that has become available. Additional information related to the Company’s allowance for loan losses is contained in Note 4 to the Company’s condensed consolidated financial statements presented in this Form 10-Q.

Management believes the allowance for loan losses is the best estimate of probable losses which have been incurred as of June 30, 2012. There is no assurance that the Company will not be required to make future adjustments to the allowance in response to changing economic conditions or regulatory examinations.

Deposits

Deposits totaled $2,439.8 million at June 30, 2012, an increase of $14.6 million or 0.6 percent from $2,425.3 million at December 31, 2011. The following table presents a summary of deposits at June 30, 2012 and December 31, 2011:

 

		(000’s)
		June 30 2012				Dec 31 2011				Increase (Decrease)
Demand deposits		$	964,372			$	910,329			$	54,043
Money market accounts			762,026				963,390				(201,364	)
Savings accounts			122,526				114,371				8,155
Time deposits of $100,000 or more			100,860				110,967				(10,107	)
Time deposits of less than $100,000			38,305				40,634				(2,329	)
Checking with interest			451,759				285,591				166,168
Total Deposits		$	2,439,848			$	2,425,282			$	14,566

The Company experienced growth in both new and existing customers, including growth from new branches added during 2010 and 2011 which was partially offset by seasonal decreases in municipal deposits. This growth was partially offset by planned reductions in certain deposits, primarily higher cost municipal demand deposits.

Borrowings

Total borrowings were $58.6 million at June 30, 2012, a decrease of $10.9 million or 15.7 percent from $69.5 million at December 31, 2011. The decrease resulted from a $10.9 million decrease in short-term repurchase agreements. Borrowings are utilized as part of the Company’s continuing efforts to effectively leverage its capital and to manage interest rate risk.

Stockholders’ Equity

Stockholders’ equity totaled $292.6 million at June 30, 2012, an increase of $15.0 million or 5.4 percent from $277.6 million at December 31, 2011. The increase in stockholders’ equity resulted from net income of $23.0 million and a net increase related to exercises of stock options of $0.3 million, which was partially offset by cash dividends paid on common stock of $7.0 million and a decrease in accumulated other comprehensive income of $1.3 million.

 

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The Company’s and the Bank’s capital ratios at June 30, 2012 and December 31, 2011 are as follows:

 

		June 30 2012				Dec 31 2011				Minimum to  be Considered Well Capitalized				Enhanced Capital Requirements  Effective as of December 31, 2009
Leverage ratio:
Company			9.6	%			8.8	%			5.0	%			N/A
HVB			9.5	%			8.4	%			5.0	%			8.0	%
Tier 1 capital:
Company			15.8	%			11.3	%			6.0	%			N/A
HVB			15.6	%			10.8	%			6.0	%			10.0	%
Total capital:
Company			17.0	%			12.6	%			10.0	%			N /A
HVB			16.8	%			12.1	%			10.0	%			12.0	%

Since the fourth quarter of 2009, the Office of the Comptroller of the Currency (“OCC”) required HVB to maintain a total risk-based capital ratio of at least 12.0%, a Tier 1 risk-based capital ratio of at least 10.0%, and a Tier 1 leverage ratio of at least 8.0%. These capital levels are in excess of “well capitalized” levels generally applicable to banks under current regulations. In addition, the Bank has established internal minimum capital ratios under its capital plan of a total risk-based capital ratio of 13.0%, a Tier 1 risk-based capital ratio of 10.0% and a Tier 1 leverage ratio of 8.5%.

Liquidity

The Asset/Liability Strategic Committee (“ALSC”) of the Board of Directors of HVB establishes specific policies and operating procedures governing the Company’s liquidity levels and develops plans to address future liquidity needs, including contingent sources of liquidity. The primary functions of asset liability management are to provide safety of depositor and investor funds, assure adequate liquidity and maintain an appropriate balance between interest earning assets and interest bearing liabilities. Liquidity management involves the ability to meet the cash flow requirement of depositors wanting to withdraw funds or borrowers needing assurance that sufficient funds will be available to meet their credit needs. Interest rate sensitivity management seeks to manage fluctuating net interest margins and to enhance consistent growth of net interest income through periods of changing interest rates.

The Company’s liquid assets at June 30, 2012 include cash and due from banks of $46.0 million, $595.3 million of interest earning deposits and Federal funds sold of $22.3 million. Interest earning deposits and Federal funds sold represent the Company’s excess liquid funds which are invested with other financial institutions and are available daily.

Other sources of liquidity include maturities and principal and interest payments on loans and securities. The loan and securities portfolios are of high credit quality and of mixed maturity, providing a constant stream of maturing and re-investable assets, which can be converted into cash should the need arise. The ability to redeploy these funds is an important source of medium to long term liquidity. The amortized cost of securities having contractual maturities, expected call dates or average lives of one year or less amounted to $240.0 million at June 30, 2012. This represented 51.6 percent of the amortized cost of the securities portfolio. Excluding installment loans to individuals, real estate loans other than construction loans and lease financing, $386.9 million, or 40.3 percent of loans at June 30, 2012, mature in one year or less. The Company may increase liquidity by selling certain residential mortgages, or exchanging them for mortgage-backed securities that may be sold in the secondary market.

Non interest bearing demand deposits and interest bearing deposits from businesses, professionals, not-for-profit organizations and individuals are relatively stable, low-cost sources of funds. The deposits of the Bank generally have shown a steady growth trend as well as a generally consistent deposit mix. However, there can be no assurance that deposit growth will continue or that the deposit mix will not shift to higher rate products.

HVB is a member of the FHLB. As a member, HVB is able to participate in various FHLB borrowing programs which require certain investments in FHLB common stock as a prerequisite to obtaining funds. As of

 

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June 30, 2012, HVB had short-term borrowing lines with the FHLB of $200 million with no amounts outstanding. These and various other FHLB borrowing programs available to members are subject to availability of qualifying loan and/or investment securities collateral and other terms and conditions.

HVB also has unsecured overnight borrowing lines totaling $70 million with three major financial institutions which were all unused and available at June 30, 2012. In addition, HVB has approved lines under Retail Certificate of Deposit Agreements with three major financial institutions totaling $1.0 billion of which no balances were outstanding as at June 30, 2012. Utilization of these lines are subject to product availability and other restrictions.

Additional liquidity is also provided by the Company’s ability to borrow from the Federal Reserve Bank’s discount window. In response to the current economic crisis, the Federal Reserve Bank has increased the ability of banks to borrow from this source through its Borrower-in-Custody (“BIC”) program, which expanded the types of collateral which qualify as security for such borrowings. HVB has been approved to participate in the BIC program. There were no balances outstanding with the Federal Reserve at June 30, 2012.

As of June 30, 2012, the Company had qualifying loan and investment securities totaling approximately $351 million which could be utilized under available borrowing programs thereby increasing liquidity.

Management considers the Company’s sources of liquidity to be adequate to meet any expected funding needs and to be responsive to changing interest rate markets.

Contractual Obligations and Off-Balance Sheet Arrangements

The Company has outstanding, at any time, a significant number of commitments to extend credit and provide financial guarantees to third parties. These arrangements are subject to strict credit control assessments. Guarantees specify limits to the Company’s obligations. Because many commitments and almost all guarantees expire without being funded in whole or in part, the contract amounts are not estimates of future cash flows. The Company is also obligated under leases or license agreements for certain of its branches and equipment. There have been no material changes to those obligations or arrangements outside the ordinary course of business since the most recent fiscal year end.

Forward-Looking Statements

The Company has made, and may continue to make, various forward-looking statements with respect to earnings, credit quality and other financial and business matters for periods subsequent to December 31, 2011. The Company cautions that these forward-looking statements are subject to numerous assumptions, risks and uncertainties, and that statements relating to subsequent periods increasingly are subject to greater uncertainty because of the increased likelihood of changes in underlying factors and assumptions. Actual results could differ materially from forward-looking statements.

Factors that may cause actual results to differ materially from those contemplated by such forward-looking statements, in addition to those risk factors disclosed in the Hudson Valley’s Annual Report on Form 10-K for the year ended December 31, 2011 include, but are not limited to, statements regarding:

 

•

our ability to comply with the formal agreement entered into with the Office of the Comptroller of the Currency (the “OCC”) and any additional restrictions placed on us as a result of future regulatory exams or changes in regulatory policy implemented by the OCC or other bank regulators;

 

•

the OCC and other bank regulators may require us to further modify or change our mix of assets, including our concentration in certain types of loans, or require us to take further remedial actions;

 

•

the results of the investigation of A.R. Schmeidler & Co., Inc. by the Securities and Exchange Commission (the “SEC”) and the Department of Labor (the “DOL”) and the possibility that our management’s attention will be diverted to the SEC and DOL investigations and settlement discussions and we will incur further costs and legal expenses;

 

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•

the adverse affects on the business of A.R. Schmeidler & Co., Inc. and our trust department arising from a settlement with the SEC and DOL investigations;

 

•

our inability to pay quarterly cash dividends to shareholders in light of our earnings, the current and future economic environment, Federal Reserve Board guidance, our Bank’s capital plan and other regulatory requirements applicable to Hudson Valley or Hudson Valley Bank;

 

•

the possibility that we may need to raise additional capital in the future and our ability to raise such capital on terms that are favorable to us;

 

•

further increases in our non-performing loans and allowance for loan losses;

 

•

ineffectiveness in managing our commercial real estate portfolio;

 

•

lower than expected future performance of our investment portfolio;

 

•

a lack of opportunities for growth, plans for expansion (including opening new branches) and increased or unexpected competition in attracting and retaining customers;

 

•

continued poor economic conditions generally and in our market area in particular, which may adversely affect the ability of borrowers to repay their loans and the value of real property or other property held as collateral for such loans;

 

•

lower than expected demand for our products and services;

 

•

possible impairment of our goodwill and other intangible assets;

 

•

our inability to manage interest rate risk;

 

•

increased expense and burdens resulting from the regulatory environment in which we operate and our inability to comply with existing and future regulatory requirements;

 

•

our inability to maintain regulatory capital above the minimum levels Hudson Valley Bank has set as its minimum capital levels in its capital plan provided to the OCC, or such higher capital levels as may be required;

 

•

proposed legislative and regulatory action may adversely affect us and the financial services industry;

 

•

future increased Federal Deposit Insurance Corporation, or FDIC, special assessments or changes to regular assessments;

 

•

potential liabilities under federal and state environmental laws;

 

•

regulatory limitations on dividends payable by Hudson Valley or Hudson Valley Bank.

Hudson Valley does not undertake to update or revise any of its forward-looking statements even if experience shows that the indicated results or events will not be realized.

Impact of Inflation and Changing Prices

The Condensed Consolidated Financial Statements and Notes thereto presented herein have been prepared in accordance with GAAP, which requires the measurement of financial position and operating results in terms of historical dollar amounts or estimated fair value without considering the changes in the relative purchasing power of money over time due to inflation. The impact of inflation is reflected in the increased cost of the Company’s operations. Unlike industrial companies, nearly all of the assets and liabilities of the Company are monetary in nature. As a result, interest rates have a greater impact on the Company’s performance than do the effects of general levels of inflation. Interest rates do not necessarily move in the same direction or to the same extent as the price of goods and services.

 

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Item 3.    Quantitative and Qualitative Disclosures About Market Risk

Quantitative and qualitative disclosures about market risk at December 31, 2011 were previously reported in the Company’s 2011 Annual Report on Form 10-K. There have been no material changes in the Company’s market risk exposure at June 30, 2012 compared to December 31, 2011.

The Company’s primary market risk exposure is interest rate risk since substantially all transactions are denominated in U.S. dollars with no direct foreign exchange or changes in commodity price exposure.

All market risk sensitive instruments are classified either as available for sale or held to maturity with no financial instruments entered into for trading purposes. The Company from time to time uses derivative financial instruments to manage risk. The Company did not enter into any new derivative financial instruments during the three month period ended June 30, 2012. The Company had no derivative financial instruments in place at June 30, 2012 and December 31, 2011.

The Company uses a simulation analysis to evaluate market risk to changes in interest rates. The simulation analysis at June 30, 2012 shows the Company’s net interest income increasing slightly if interest rates rise and decreasing slightly if interest rates fall, considering a continuation of the current yield curve. A change in the shape or steepness of the yield curve will impact our market risk to change in interest rates.

The Company also prepares a static gap analysis which, at June 30, 2012, shows a positive cumulative static gap of $493.9 million in the one year time frame.

The following table illustrates the estimated exposure under a rising rate scenario and a declining rate scenario calculated as a percentage change in estimated net interest income assuming a gradual shift in interest rates for the next 12 month measurement period, beginning June 30, 2012.

 

Gradual Change in Interest Rates		Percentage Change Percentage Change in Estimated Net Interest Income from June 30, 2012				Policy Limit
+200 basis points			3.3	%			(5.0	)%
-100 basis points			(1.6	)%			(5.0	)%

Beginning on March 31, 2008, a 100 basis point downward change was substituted for the 200 basis point downward scenario previously used, as management believes that a 200 basis point downward change is not a meaningful analysis in light of current interest rate levels. The percentage change in estimated net income in the +200 and -100 basis points scenario is within the Company’s policy limits.

Item 4.    Controls and Procedures

Our disclosure controls and procedures are designed to ensure that information the Company must disclose in its reports filed or submitted under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), is recorded, processed, summarized, and reported on a timely basis. Any controls and procedures, no matter how well designed and operated, can only provide reasonable assurance of achieving the desired control objectives. We carried out an evaluation, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) or Rule 15d-15(e) of the Exchange Act) as of June 30, 2012. Based on this evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that, as of June 30, 2012, the Company’s disclosure controls and procedures were effective in bringing to their attention on a timely basis information required to be disclosed by the Company in reports that the Company files or submits under the Exchange Act. Also, during the quarter ended June 30, 2012, there has not been any change that has materially affected or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

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PART II — OTHER INFORMATION

Item 1A.    Risk Factors

Our business is subject to various risks. These risks are included in our 2011 Annual Report on Form 10-K under “Risk Factors”.

There have been no material changes in such risk factors since the date of such report.

Item 6.    Exhibits

(A) Exhibits

 

3.1		Restated Certificate of Incorporation of Hudson Valley Holding Corp.(1)
3.2		Amended and Restated By-Laws of Hudson Valley Holding Corp.(2)
31.1		Certification of the Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (filed herewith).
31.2		Certification of the Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (filed herewith).
32.1		Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (filed herewith).
32.2		Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (filed herewith).

 

(1)	Incorporated herein by reference in this document to the Form 10-Q filed on October 20, 2009.

 

(2)	Incorporated herein by reference in this document to the Form 8-K filed on April 28, 2010.

 

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SIGNATURES

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

 

August 9, 2012

 

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