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EX-32 - EXHIBIT 32 - SHORE BANCSHARES INCv317990_ex32.htm
EX-31.2 - EXHIBIT 31.2 - SHORE BANCSHARES INCv317990_ex31-2.htm
EX-31.1 - EXHIBIT 31.1 - SHORE BANCSHARES INCv317990_ex31-1.htm

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

_______________________________

 

FORM 10-Q

 

 

 

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

 

For the Quarterly Period Ended June 30, 2012

 

OR

 

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

 

For the transition period from ________ to ________

 

Commission file number 0-22345

 

SHORE BANCSHARES, INC.

(Exact name of registrant as specified in its charter)

 

  Maryland   52-1974638  
  (State or Other Jurisdiction of   (I.R.S. Employer  
  Incorporation or Organization)   Identification No.)  

 

  18 East Dover Street, Easton, Maryland    21601  
  (Address of Principal Executive Offices)    (Zip Code)  

  

(410) 763-7800

Registrant’s Telephone Number, Including Area Code

 

  N/A  
Former name, former address and former fiscal year, if changed since last report.

  

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

 

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

 

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

 

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

 

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

 

APPLICABLE ONLY TO CORPORATE ISSUERS

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: 8,457,359 shares of common stock outstanding as of July 31, 2012.

 

 
 

 

INDEX

 

  Page
   
Part I. Financial Information 2
   
Item 1. Financial Statements 2
   
Consolidated Balance Sheets -  
June 30, 2012 (unaudited) and December 31, 2011 2
   
Consolidated Statements of Operations -  
For the three and six months ended June 30, 2012 and 2011 (unaudited) 3
   
Consolidated Statements of Comprehensive Income (Loss) -  
For the three and six months ended June 30, 2012 and 2011 (unaudited) 4
   
Consolidated Statements of Changes in Stockholders’ Equity -  
For the six months ended June 30, 2012 and 2011 (unaudited) 5
   
Consolidated Statements of Cash Flows -  
For the six months ended June 30, 2012 and 2011 (unaudited) 6
   
Notes to Consolidated Financial Statements (unaudited) 7
   
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations 27
   
Item 3. Quantitative and Qualitative Disclosures about Market Risk 37
   
Item 4. Controls and Procedures 37
   
Part II. Other Information 38
   
Item 1A. Risk Factors 38
   
Item 6. Exhibits 38
   
Signatures 38
   
Exhibit Index 39

 

1
 

 

PART I – FINANCIAL INFORMATION

Item 1. Financial Statements.

SHORE BANCSHARES, INC.

CONSOLIDATED BALANCE SHEETS

(Dollars in thousands, except per share amounts)

 

   June 30,   December 31, 
   2012   2011 
ASSETS   (Unaudited)      
Cash and due from banks  $23,037   $22,986 
Interest-bearing deposits with other banks   137,267    99,776 
Federal funds sold   9,269    4,980 
Investment securities:          
Available for sale, at fair value   133,244    129,780 
Held to maturity, at amortized cost – fair value of $5,425 (2012) and $6,732 (2011)   5,168    6,480 
           
Loans   809,958    841,050 
Less:  allowance for credit losses   (12,990)   (14,288)
Loans, net   796,968    826,762 
           
Premises and equipment, net   15,398    14,662 
Goodwill   12,454    12,454 
Other intangible assets, net   3,986    4,208 
Other real estate and other assets owned, net   11,499    9,385 
Other assets   27,043    26,720 
TOTAL ASSETS  $1,175,333   $1,158,193 
           
LIABILITIES          
Deposits:          
Noninterest-bearing  $149,472   $133,801 
Interest-bearing   883,231    876,118 
Total deposits   1,032,703    1,009,919 
           
Short-term borrowings   13,826    17,817 
Other liabilities   8,882    8,753 
Long-term debt   455    455 
TOTAL LIABILITIES   1,055,866    1,036,944 
           
STOCKHOLDERS’ EQUITY          
Common stock, par value $.01 per share; shares authorized – 35,000,000; shares issued and outstanding – 8,457,359 (2012 and 2011)   85    85 
Additional paid in capital   32,087    32,052 
Retained earnings   87,973    90,801 
Accumulated other comprehensive loss   (678)   (1,689)
TOTAL STOCKHOLDERS’ EQUITY   119,467    121,249 
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY  $1,175,333   $1,158,193 

 

See accompanying notes to Consolidated Financial Statements.   

 

2
 

 

SHORE BANCSHARES, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)

(Dollars in thousands, except per share amounts)

 

   For the Three Months Ended   For the Six Months Ended 
   June 30,   June 30, 
   2012   2011   2012   2011 
                 
INTEREST INCOME                    
Interest and fees on loans  $10,890   $11,896   $21,901   $23,897 
Interest and dividends on investment securities:                    
Taxable   707    782    1,464    1,439 
Tax-exempt   32    40    70    78 
Interest on federal funds sold   2    5    4    21 
Interest on deposits with other banks   61    12    109    18 
Total interest income   11,692    12,735    23,548    25,453 
                     
INTEREST EXPENSE                    
Interest on deposits   2,643    2,769    5,284    5,602 
Interest on short-term borrowings   11    13    26    26 
Interest on long-term debt   5    11    10    21 
Total interest expense   2,659    2,793    5,320    5,649 
                     
NET INTEREST INCOME   9,033    9,942    18,228    19,804 
Provision for credit losses   3,525    5,395    11,895    11,785 
                     
NET INTEREST INCOME AFTER PROVISION FOR CREDIT LOSSES   5,508    4,547    6,333    8,019 
                     
NONINTEREST INCOME                    
Service charges on deposit accounts   622    744    1,270    1,448 
Trust and investment fee income   446    418    869    794 
Gains on sales of investment securities   -    2    -    81 
Insurance agency commissions   2,406    2,475    5,095    4,985 
Other noninterest income   1,103    742    1,917    1,468 
Total noninterest income   4,577    4,381    9,151    8,776 
                     
NONINTEREST EXPENSE                    
Salaries and wages   4,376    4,104    8,792    8,350 
Employee benefits   956    886    2,126    2,039 
Occupancy expense   638    568    1,325    1,164 
Furniture and equipment expense   212    291    463    563 
Data processing   694    680    1,360    1,531 
Directors’ fees   127    112    236    219 
Amortization of other intangible assets   96    128    222    257 
Insurance agency commissions expense   344    357    729    732 
FDIC insurance premium expense   344    404    617    864 
Other noninterest expenses   1,876    1,664    4,291    3,366 
Total noninterest expense   9,663    9,194    20,161    19,085 
                     
INCOME (LOSS) BEFORE INCOME TAXES   422    (266)   (4,677)   (2,290)
Income tax expense (benefit)   129    (33)   (1,934)   (974)
                     
NET INCOME (LOSS)  $293   $(233)  $(2,743)  $(1,316)
                     
Basic net income (loss) per common share  $0.03   $(0.03)  $(0.32)  $(0.16)
Diluted net income (loss) per common share  $0.03   $(0.03)  $(0.32)  $(0.16)
Dividends paid per common share  $-   $0.01   $0.01   $0.07 

 

See accompanying notes to Consolidated Financial Statements.               

 

3
 

 

SHORE BANCSHARES, INC.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) (Unaudited)

(Dollars in thousands)

 

   For the Three Months Ended
June 30,
   For the Six Months Ended
June 30,
 
   2012   2011   2012   2011 
                 
Net income (loss)  $293   $(233)  $(2,743)  $(1,316)
                     
Other comprehensive income                    
Securities available for sale:                    
Unrealized holding gains on available-for-sale securities   534    1,204    915    832 
Tax effect   (216)   (490)   (369)   (340)
Reclassification of gains recognized in net income   -   (2)   -    (81)
Tax effect   -    1    -    33 
Net of tax amount   318    713    546    444 
                     
Cash flow hedging activities:                    
Unrealized holding gains (losses) on cash flow hedging activities   421    (714)   780    (337)
Tax effect   (170)   288    (315)   135 
Net of tax amount   251    (426)   465    (202)
Total other comprehensive income   569    287    1,011    242 
Comprehensive income (loss)  $862   $54   $(1,732)  $(1,074)

 

See accompanying notes to Consolidated Financial Statements.                                

             

4
 

                   

SHORE BANCSHARES, INC.

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (Unaudited)

For the Six Months Ended June 30, 2012 and 2011

(Dollars in thousands, except per share amounts)

 

                   Accumulated     
           Additional       Other   Total 
   Common       Paid in   Retained   Comprehensive   Stockholders’ 
   Stock   Warrant   Capital   Earnings   Income (Loss)   Equity 
Balances, January 1, 2012  $85   $-   $32,052   $90,801   $(1,689)  $121,249 
                               
Comprehensive loss:                              
Net loss   -    -    -    (2,743)   -    (2,743)
Unrealized gains on available-for-sale securities, net of taxes   -    -    -    -    546    546 
Unrealized gains on cash flow hedging activities, net of taxes   -    -    -    -    465    465 
Total comprehensive loss                            (1,732)
                               
Stock-based compensation   -    -    35    -    -    35 
                               
Cash dividends paid ($0.01 per share)   -    -    -    (85)   -    (85)
                               
Balances, June 30, 2012  $85   $-   $32,087   $87,973   $(678)  $119,467 
                               
Balances, January 1, 2011  $84   $1,543   $30,242   $92,458   $(1,814)  $122,513 
                               
Comprehensive loss:                              
Net loss   -    -    -    (1,316)   -    (1,316)
Unrealized gains on available-for-sale securities, net of taxes   -    -    -    -    444    444 
Unrealized losses on cash flow hedging activities, net of taxes   -    -    -    -    (202)   (202)
Total comprehensive loss                            (1,074)
                               
Shares issued for employee stock-based awards   1    -   (1)   -    -    - 
                               
Stock-based compensation   -    -    93    -    -    93 
                               
Cash dividends paid ($0.07 per share)   -    -    -    (591)   -    (591)
                               
Balances, June 30, 2011  $85   $1,543   $30,334   $90,551   $(1,572)  $120,941 

 

See accompanying notes to Consolidated Financial Statements.                                

 

5
 

 

SHORE BANCSHARES, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

(Dollars in thousands)

 

    For the Six Months Ended  
     June 30,  
    2012     2011  
CASH FLOWS FROM OPERATING ACTIVITIES:                
Net loss   $ (2,743 )   $ (1,316 )
Adjustments to reconcile net loss to net cash provided by operating activities:                
Provision for credit losses     11,895       11,785  
Depreciation and amortization     1,324       1,269  
Discount accretion on debt securities     (39 )     (44 )
Stock-based compensation expense     141       137  
Excess tax expense from stock-based arrangements     (106 )     (44 )
Deferred income tax expense (benefit)     238       (1,306 )
Gains on sales of investment securities     -       (81 )
Gains on disposals of premises and equipment     (226 )     (3 )
Losses on sales of other real estate owned     862       235  
Net changes in:                
Accrued interest receivable     289       807  
Other assets     (972 )     (88 )
Accrued interest payable     19       15  
Other liabilities     110       (699 )
Net cash provided by operating activities     10,792       10,667  
                 
CASH FLOWS FROM INVESTING ACTIVITIES:                
Proceeds from maturities and principal payments of investment securities available for sale     21,308       25,058  
Proceeds from sales of investment securities available for sale     -       12,073  
Purchases of investment securities available for sale     (24,238 )     (44,418 )
Proceeds from maturities and principal payments of investment securities held to maturity     1,305       186  
Net change in loans     13,529       3,365  
Purchases of premises and equipment     (1,381 )     (420 )
Proceeds from sales of premises and equipment     307       4  
Proceeds from sales of other real estate owned     1,395       644  
Net cash provided by (used in) investing activities     12,225       (3,508 )
                 
CASH FLOWS FROM FINANCING ACTIVITIES:                
Net change in noninterest-bearing deposits     15,671       6,601  
Net change in interest-bearing deposits     7,113       (12,674 )
Net change in short-term borrowings     (3,991 )     2,210  
Excess tax expense from stock-based arrangements     106       44  
Common stock dividends paid     (85 )     (591 )
Net cash provided by (used in) financing activities     18,814       (4,410 )
Net increase in cash and cash equivalents     41,831       2,749  
Cash and cash equivalents at beginning of period     127,742       77,964  
Cash and cash equivalents at end of period   $ 169,573     $ 80,713  
                 
Supplemental cash flows information:                
Interest paid   $ 5,302     $ 5,635  
Income taxes paid   $ 109     $ 1,861  
Transfers from loans to other real estate owned   $ 4,371     $ 5,055  

 

See accompanying notes to Consolidated Financial Statements.                

                 

6
 

 

Shore Bancshares, Inc.

Notes to Consolidated Financial Statements

For the Three and Six Months Ended June 30, 2012 and 2011

(Unaudited)

 

Note 1 - Basis of Presentation

 

The consolidated financial statements include the accounts of Shore Bancshares, Inc. and its subsidiaries with all significant intercompany transactions eliminated. The consolidated financial statements conform to accounting principles generally accepted in the United States of America (“GAAP”) and to prevailing practices within the banking industry. The accompanying interim financial statements are unaudited; however, in the opinion of management all adjustments necessary to present fairly the consolidated financial position at June 30, 2012, the consolidated results of operations and comprehensive income (loss) for the three and six months ended June 30, 2012 and 2011, and changes in stockholders’ equity and cash flows for the six months ended June 30, 2012 and 2011, have been included. All such adjustments are of a normal recurring nature. The amounts as of December 31, 2011 were derived from the 2011 audited financial statements. The results of operations for the three and six months ended June 30, 2012 are not necessarily indicative of the results to be expected for any other interim period or for the full year. This Quarterly Report on Form 10-Q should be read in conjunction with the Annual Report of Shore Bancshares, Inc. on Form 10-K for the year ended December 31, 2011. For purposes of comparability, certain reclassifications have been made to amounts previously reported to conform with the current period presentation.

 

When used in these notes, the term “the Company” refers to Shore Bancshares, Inc. and, unless the context requires otherwise, its consolidated subsidiaries.

 

Recent Accounting Pronouncements

 

Accounting Standards Update (“ASU”) 2011-03, “Reconsideration of Effective Control for Repurchase Agreements.” ASU 2011-03 affects all entities that enter into agreements to transfer financial assets that both entitle and obligate the transferor to repurchase or redeem the financial assets before their maturity. The amendments in ASU 2011-03 remove from the assessment of effective control the criterion relating to the transferor’s ability to repurchase or redeem financial assets on substantially the agreed terms, even in the event of default by the transferee. ASU 2011-03 also eliminates the requirement to demonstrate that the transferor possesses adequate collateral to fund substantially all the cost of purchasing replacement financial assets. ASU 2011-03 became effective for the Company on January 1, 2012 and did not have a significant impact on the Company’s financial statements.

 

ASU 2011-04, "Fair Value Measurement - Amendments to Achieve Common Fair Value Measurements and Disclosure Requirements in U.S. GAAP and IFRSs." ASU 2011-04 amends Topic 820, "Fair Value Measurements and Disclosures," to converge the fair value measurement guidance in U.S. Generally Accepted Accounting Principles and International Financial Reporting Standards. ASU 2011-04 clarifies the application of existing fair value measurement requirements, changes certain principles in Topic 820 and requires additional fair value disclosures. ASU 2011-04 became effective for the Company on January 1, 2012 and, aside from new disclosures included in Note 8 – Fair Value Measurements, did not have a significant impact on the Company’s financial statements.

 

ASU 2011-08, "Intangibles - Goodwill and Other - Testing Goodwill for Impairment." ASU 2011-08 amends Topic 350, "Intangibles – Goodwill and Other," to give entities the option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If, after assessing the totality of events or circumstances, an entity determines it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, then performing the two-step impairment test is unnecessary. However, if an entity concludes otherwise, then it is required to perform the first step of the two-step impairment test by calculating the fair value of the reporting unit and comparing the fair value with the carrying amount of the reporting unit. ASU 2011-08 became effective for the Company on January 1, 2012 and did not have a significant impact on the Company's financial statements.

 

7
 

 

Note 2 – Earnings/(Loss) Per Share

 

Basic earnings/(loss) per common share is calculated by dividing net income/(loss) available to common stockholders by the weighted average number of common shares outstanding during the period. Diluted earnings/(loss) per common share is calculated by dividing net income/(loss) available to common stockholders by the weighted average number of common shares outstanding during the period, adjusted for the dilutive effect of common stock equivalents (stock-based awards and the warrant). There is no dilutive effect on the loss per share during loss periods. The following table provides information relating to the calculation of earnings/(loss) per common share:

 

   For the Three Months Ended   For the Six Months Ended 
   June 30,   June 30, 
(In thousands, except per share data)  2012   2011   2012   2011 
Net income (loss)  $293   $(233)  $(2,743)  $(1,316)
Weighted average shares outstanding - Basic   8,457    8,446    8,457    8,445 
Dilutive effect of common stock equivalents   -    -    -    - 
Weighted average shares outstanding - Diluted   8,457    8,446    8,457    8,445 
Earnings (loss) per common share - Basic  $0.03   $(0.03)  $(0.32)  $(0.16)
Earnings (loss) per common share - Diluted  $0.03   $(0.03)  $(0.32)  $(0.16)

 

The calculations of diluted earnings/(loss) per share for the three and six months ended June 30, 2012 excluded 57 thousand and 37 thousand weighted average common stock equivalents, respectively, because the effect of including them would have been antidilutive. The calculations of diluted earnings/(loss) per share for the three and six months ended June 30, 2011 each excluded 180 thousand weighted average common stock equivalents because the effect of including them would have been antidilutive.

 

8
 

 

Note 3 – Investment Securities

 

The following table provides information on the amortized cost and estimated fair values of investment securities.

 

       Gross   Gross   Estimated 
   Amortized   Unrealized   Unrealized   Fair 
(Dollars in thousands)  Cost   Gains   Losses   Value 
Available-for-sale securities:                    
June 30, 2012:                    
Obligations of U.S. Government agencies and corporations  $34,300   $914   $1   $35,213 
Mortgage-backed securities   95,146    2,303    35    97,414 
Equity securities   585    32    -    617 
Total  $130,031   $3,249   $36   $133,244 
                     
                     
December 31, 2011:                    
Obligations of U.S. Government agencies and corporations  $41,360   $803   $15   $42,148 
Mortgage-backed securities   85,545    1,587    99    87,033 
Equity securities   577    22    -    599 
Total  $127,482   $2,412   $114   $129,780 
                     
                     
Held-to-maturity securities:                    
June 30, 2012:                    
Obligations of states and political subdivisions  $5,168   $257   $-   $5,425 
                     
 
December 31, 2011:
                    
Obligations of states and political subdivisions  $6,480   $252   $-   $6,732 

 

The following table provides information about gross unrealized losses and fair value by length of time that the individual available-for-sale securities have been in a continuous unrealized loss position at June 30, 2012.

 

   Less than
12 Months
   More than
12 Months
   Total 
(Dollars in thousands)  Fair
Value
   Unrealized Losses   Fair
Value
   Unrealized Losses   Fair
Value
   Unrealized Losses 
Available-for-sale securities:                              
U.S. Gov’t. agencies and corporations  $3,999   $1   $-   $-   $3,999   $1 
Mortgage-backed securities   13,421    35    -    -    13,421    35 
Total  $17,420   $36   $-   $-   $17,420   $36 

 

Total available-for-sale securities have a fair value of approximately $133.2 million. Of these securities, approximately $17.4 million have unrealized losses when compared to their amortized cost. All of the securities with the unrealized losses in the available-for-sale portfolio have modest duration risk, low credit risk, and minimal losses (approximately 0.03%) when compared to total amortized cost. The unrealized losses on debt securities that exist are the result of market changes in interest rates since original purchase. Because the Company does not intend to sell these debt securities and it is not more likely than not that the Company will be required to sell these securities before recovery of their amortized cost bases, which may be at maturity, the Company considers the unrealized losses in the available-for-sale portfolio to be temporary. There were no unrealized losses in the held-to-maturity securities portfolio at June 30, 2012.

 

9
 

 

The following table provides information on the amortized cost and estimated fair values of investment securities by maturity date at June 30, 2012.

 

   Available for sale   Held to maturity 
   Amortized   Estimated   Amortized   Estimated 
(Dollars in thousands)  Cost   Fair Value   Cost   Fair Value 
Due in one year or less  $8,012   $8,047   $1,976   $1,989 
Due after one year through five years   14,238    14,284    1,680    1,748 
Due after five years through ten years   4,995    5,157    502    575 
Due after ten years   102,201    105,139    1,010    1,113 
    129,446    132,627    5,168    5,425 
Equity securities   585    617    -    - 
Total  $130,031   $133,244   $5,168   $5,425 

 

The maturity dates for debt securities are determined using contractual maturity dates.

 

Note 4 – Loans and allowance for credit losses

 

The Company makes residential mortgage, commercial and consumer loans to customers primarily in Talbot County, Queen Anne’s County, Kent County, Caroline County and Dorchester County in Maryland and in Kent County, Delaware. The following table provides information about the principal classes of the loan portfolio at June 30, 2012 and December 31, 2011.

 

(Dollars in thousands)  June 30, 2012   December 31, 2011 
Construction  $111,067   $119,883 
Residential real estate   306,093    321,604 
Commercial real estate   315,644    315,439 
Commercial   63,004    69,485 
Consumer   14,150    14,639 
Total loans   809,958    841,050 
Allowance for credit losses   (12,990)   (14,288)
Total loans, net  $796,968   $826,762 

 

Loans are stated at their principal amount outstanding net of any deferred fees and costs. Interest income on loans is accrued at the contractual rate based on the principal amount outstanding. Fees charged and costs capitalized for originating loans are being amortized substantially on the interest method over the term of the loan. A loan is placed on nonaccrual when it is specifically determined to be impaired or when principal or interest is delinquent for 90 days or more, unless the loan is well secured and in the process of collection. Any unpaid interest previously accrued on those loans is reversed from income. Interest payments received on nonaccrual loans are applied as a reduction of the loan principal balance unless collectability of the principal amount is reasonably assured, in which case interest is recognized on a cash basis. Loans are returned to accrual status when all principal and interest amounts contractually due are brought current and future payments are reasonably assured.

 

A loan is considered impaired if it is probable that the Company will not collect all principal and interest payments according to the loan’s contractual terms. An impaired loan may show deficiencies in the borrower’s overall financial condition, payment history, support available from financial guarantors and/or the fair market value of collateral. The impairment of a loan is measured at the present value of expected future cash flows using the loan’s effective interest rate, or at the loan’s observable market price or the fair value of the collateral if the loan is collateral dependent. Generally, the Company measures impairment on such loans by reference to the fair value of the collateral. Income on impaired loans is recognized on a cash basis, and payments are first applied against the principal balance outstanding (i.e., placing impaired loans on nonaccrual status). Generally, interest income is not recognized on specific impaired loans unless the likelihood of further loss is remote. The allowance for credit losses includes specific reserves related to impaired loans. Impaired loans do not include groups of smaller balance homogenous loans such as residential mortgage and consumer installment loans that are evaluated collectively for impairment. Reserves for probable credit losses related to these loans are based on historical loss ratios and are included in the formula portion of the allowance for credit losses.

 

10
 

 

Loans are evaluated on a case-by-case basis for impairment. Once the amount of impairment has been determined, the uncollectible portion is charged off. As seen in the table below, the difference between the unpaid principal balance and the recorded investment is the amount of partial charge-offs that have been taken. In some cases, a specific allocation within the allowance for credit losses is made until such time that a charge-off is made.

 

A loan is considered a troubled debt restructuring if a borrower is experiencing financial difficulties and a creditor has granted a concession. Concessions may include interest rate reductions or below market interest rates, principal forgiveness, restructuring amortization schedules and other actions intended to minimize potential losses.

 

The following tables provide information on impaired loans and any related allowance by loan class as of June 30, 2012 and December 31, 2011.

 

(Dollars in thousands)  Unpaid principal balance   Recorded investment with no allowance   Recorded investment with an allowance   Related allowance   Average recorded investment 
June 30, 2012                         
Impaired nonaccrual loans:                         
Construction  $23,220   $14,258   $-   $-   $15,214 
Residential real estate   24,948    19,588    812    420    20,221 
Commercial real estate   15,398    9,376    2,260    500    12,968 
Commercial   2,178    1,609    -    -    1,905 
Consumer   59    55    -    -    46 
Total   65,803    44,886    3,072    920    50,354 
                          
Impaired accruing restructured loans:                         
Construction   17,078    17,078    -    -    12,704 
Residential real estate   5,008    5,008    -    -    3,580 
Commercial real estate   15,077    15,077    -    -    12,510 
Commercial   68    68    -    -    51 
Consumer   -    -    -    -    - 
Total   37,231    37,231    -    -    28,845 
                          
Total impaired loans:                         
Construction   40,298    31,336    -    -    27,918 
Residential real estate   29,956    24,596    812    420    23,801 
Commercial real estate   30,475    24,453    2,260    500    25,478 
Commercial   2,246    1,677    -    -    1,956 
Consumer   59    55    -    -    46 
Total  $103,034   $82,117   $3,072   $920   $79,199 

 

11
 

 

(Dollars in thousands)  Unpaid principal balance   Recorded investment with no allowance   Recorded investment with an allowance   Related allowance   Average recorded investment 
December 31, 2011                         
Impaired nonaccrual loans:                         
Construction  $22,883   $14,005   $1,550   $170   $16,555 
Residential real estate   22,431    16,925    3,181    1,296    15,430 
Commercial real estate   17,372    14,012    -    -    14,624 
Commercial   2,119    1,669    -    -    2,539 
Consumer   30    28    -    -    32 
Total   64,835    46,639    4,731    1,466    49,180 
                          
Impaired accruing restructured loans:                         
Construction   11,781    11,781    -    -    10,663 
Residential real estate   3,792    3,792    -    -    6,093 
Commercial real estate   9,566    9,566    -    -    7,960 
Commercial   69    69    -    -    111 
Consumer   -    -    -    -    - 
Total   25,208    25,208    -    -    24,827 
                          
Total impaired loans:                         
Construction   34,664    25,786    1,550    170    27,218 
Residential real estate   26,223    20,717    3,181    1,296    21,523 
Commercial real estate   26,938    23,578    -    -    22,584 
Commercial   2,188    1,738    -    -    2,650 
Consumer   30    28    -    -    32 
Total  $90,043   $71,847   $4,731   $1,466   $74,007 

 

12
 

 

The following tables provide information on troubled debt restructurings by loan class as of June 30, 2012 and December 31, 2011. The amounts include nonaccrual troubled debt restructurings.

 

(Dollars in thousands)  Number of contracts   Premodification outstanding recorded
investment
   Postmodification outstanding recorded
investment
 
Troubled debt restructurings:               
June 30, 2012               
Construction   14   $21,873   $18,366 
Residential real estate   26    13,530    12,283 
Commercial real estate   19    21,814    18,633 
Commercial   2    125    114 
Consumer   1    30    28 
Total   62   $57,372   $42,218 
                
December 31, 2011               
Construction   9   $12,981   $12,539 
Residential real estate   20    11,471    10,359 
Commercial real estate   20    15,874    14,175 
Commercial   1    69    69 
Consumer   -    -    - 
Total   50   $40,395   $37,142 

 

 

(Dollars in thousands)  Number of contracts   Recorded investment 
Troubled debt restructurings that subsequently defaulted:          
June 30, 2012          
Construction   4   $1,288 
Residential real estate   12    8,163 
Commercial real estate   5    3,557 
Commercial   1    46 
Consumer   1    28 
Total   23   $13,082 
           
December 31, 2011          
Construction   3   $758 
Residential real estate   10    7,353 
Commercial real estate   5    6,751 
Commercial   -    - 
Consumer   -    - 
Total   18   $14,862 

 

13
 

 

Management uses risk ratings as part of its monitoring of the credit quality in the Company’s loan portfolio. Loans that are identified as special mention, substandard and doubtful are adversely rated and are assigned higher risk ratings than favorably rated loans.

 

The following tables provide information on loan risk ratings as of June 30, 2012 and December 31, 2011.

 

(Dollars in thousands)  Pass/Performing   Special mention   Substandard   Doubtful   Nonaccrual   Total 
June 30, 2012                              
Construction  $47,029   $26,633   $23,147   $-   $14,258   $111,067 
Residential real estate   249,611    17,208    18,438    436    20,400    306,093 
Commercial real estate   257,072    19,447    27,489    -    11,636    315,644 
Commercial   56,049    3,669    1,616    61    1,609    63,004 
Consumer   13,846    185    64    -    55    14,150 
Total  $623,607   $67,142   $70,754   $497   $47,958   $809,958 

 

(Dollars in thousands)  Pass/Performing   Special mention   Substandard   Doubtful   Nonaccrual   Total 
December 31, 2011                              
Construction  $50,403   $30,373   $23,552   $-   $15,555   $119,883 
Residential real estate   261,910    13,467    25,676    445    20,106    321,604 
Commercial real estate   257,247    16,001    28,179    -    14,012    315,439 
Commercial   59,178    3,813    4,748    77    1,669    69,485 
Consumer   14,520    32    59    -    28    14,639 
Total  $643,258   $63,686   $82,214   $522   $51,370   $841,050 

 

14
 

 

The following tables provide information on the aging of the loan portfolio as of June 30, 2012 and December 31, 2011.

 

   Accruing         
(Dollars in thousands)  Current   30-59 days past due   60-89 days past due   90 days or more past due   Total past due   Non-accrual   Total 
June 30, 2012                                   
Construction  $95,937   $-   $872   $-   $872   $14,258   $111,067 
Residential real estate   279,299    4,133    1,029    1,232    6,394    20,400    306,093 
Commercial real estate   297,782    2,287    1,898    2,041    6,226    11,636    315,644 
 Commercial   61,278    46    9    62    117    1,609    63,004 
 Consumer   13,837    51    23    184    258    55    14,150 
Total  $748,133   $6,517   $3,831   $3,519   $13,867   $47,958   $809,958 
Percent of total loans   92.4%   0.8%   0.5%   0.4%   1.7%   5.9%     

 

   Accruing         
(Dollars in thousands)  Current   30-59 days past due   60-89 days past due   90 days or more past due   Total past due   Non-accrual   Total 
December 31, 2011                                   
Construction  $102,441   $1,246   $316   $325   $1,887   $15,555   $119,883 
Residential real estate   289,459    4,417    5,291    2,331    12,039    20,106    321,604 
Commercial real estate   289,760    10,073    1,594    -    11,667    14,012    315,439 
 Commercial   64,581    1,350    1,819    66    3,235    1,669    69,485 
 Consumer   14,492    112    6    1    119    28    14,639 
Total  $760,733   $17,198   $9,026   $2,723   $28,947   $51,370   $841,050 
Percent of total loans   90.5%   2.0%   1.1%   0.3%   3.4%   6.1%     

 

15
 

 

The Company has established an allowance for credit losses, which is increased by provisions charged against earnings and recoveries of previously charged-off debts and is decreased by current period charge-offs of uncollectible debts. Management evaluates the adequacy of the allowance for credit losses on a quarterly basis and adjusts the provision for credit losses based on this analysis. Allocation of a portion of the allowance to one loan class does not preclude its availability to absorb losses in other loan classes.

 

The following tables provide a summary of the activity in the allowance for credit losses allocated by loan class for the three months ended June 30, 2012 and 2011.

 

(Dollars in thousands)  Construction   Residential real estate   Commercial real estate   Commercial   Consumer   Unallocated   Total 
For the three months ended
June 30, 2012
                                   
Allowance for credit losses:                                   
Beginning balance  $3,344   $4,448   $3,549   $1,539   $581   $83   $13,544 
                                    
Charge-offs   (714)   (1,554)   (745)   (1,085)   (162)   -    (4,260)
Recoveries   -    43    -    133    5    -    181 
Net charge-offs   (714)   (1,511)   (745)   (952)   (157)   -    (4,079)
                                    
Provision   215    1,300    1,148    476    61    325    3,525 
Ending balance  $2,845   $4,237   $3,952   $1,063   $485   $408   $12,990 

 

(Dollars in thousands)  Construction   Residential real estate   Commercial real estate   Commercial   Consumer   Unallocated   Total 
For the three months ended
June 30, 2011
                                   
Allowance for credit losses:                                   
Beginning balance  $3,324   $5,420   $5,280   $2,776   $591   $80   $17,471 
                                    
Charge-offs   (728)   (2,390)   (2,265)   (1,525)   (40)   -    (6,948)
Recoveries   -    34    5    380    21    -    440 
Net charge-offs   (728)   (2,356)   (2,260)   (1,145)   (19)   -    (6,508)
                                    
Provision   937    1,120    2,231    1,079    33    (5)   5,395 
Ending balance  $3,533   $4,184   $5,251   $2,710   $605   $75   $16,358 

 

16
 

 

The following tables provide a summary of the activity in the allowance for credit losses allocated by loan class for the six months ended June 30, 2012 and 2011.

 

(Dollars in thousands)  Construction   Residential real estate   Commercial real estate   Commercial   Consumer   Unallocated   Total 
For the six months ended
June 30, 2012
                                   
Allowance for credit losses:                                   
Beginning balance  $3,745   $5,014   $3,415   $1,498   $594   $22   $14,288 
                                    
Charge-offs   (1,786)   (5,673)   (1,435)   (4,440)   (177)   -    (13,511)
Recoveries   -    94    7    208    9    -    318 
Net charge-offs   (1,786)   (5,579)   (1,428)   (4,232)   (168)   -    (13,193)
                                    
Provision   886    4,802    1,965    3,797    59    386    11,895 
Ending balance  $2,845   $4,237   $3,952   $1,063   $485   $408   $12,990 

 

(Dollars in thousands)  Construction   Residential real estate   Commercial real estate   Commercial   Consumer   Unallocated   Total 
For the six months ended
June 30, 2011
                                   
Allowance for credit losses:                                   
Beginning balance  $3,327   $4,833   $3,665   $1,422   $637   $343   $14,227 
                                    
Charge-offs   (1,414)   (4,481)   (2,493)   (1,771)   (115)   -    (10,274)
Recoveries   49    68    5    457    41    -    620 
Net charge-offs   (1,365)   (4,413)   (2,488)   (1,314)   (74)   -    (9,654)
                                    
Provision   1,571    3,764    4,074    2,602    42    (268)   11,785 
Ending balance  $3,533   $4,184   $5,251   $2,710   $605   $75   $16,358 

 

17
 

 

The following tables include impairment information relating to loans and the allowance for credit losses as of June 30, 2012 and 2011.

 

(Dollars in thousands)  Construction   Residential real estate   Commercial real estate   Commercial   Consumer   Unallocated   Total 
June 30, 2012                                   
Loans individually evaluated for impairment  $31,336   $25,408   $26,713   $1,677   $55   $-   $85,189 
Loans collectively evaluated for impairment   79,731    280,685    288,931    61,327    14,095    -    724,769 
Total loans  $111,067   $306,093   $315,644   $63,004   $14,150   $-   $809,958 
                                    
Allowance for credit losses allocated to:                                   
Loans individually evaluated for impairment  $-   $420   $500   $-   $-   $-   $920 
Loans collectively evaluated for impairment   2,845    3,817    3,452    1,063    485    408    12,070 
Total allowance for credit losses  $2,845   $4,237   $3,952   $1,063   $485   $408   $12,990 

 

(Dollars in thousands)  Construction   Residential real estate   Commercial real estate   Commercial   Consumer   Unallocated   Total 
June 30, 2011                                   
Loans individually evaluated for impairment  $18,129   $12,187   $15,141   $2,990   $29   $-   $48,476 
Loans collectively evaluated for impairment   110,011    319,947    312,166    71,495    15,236    -    828,855 
Total loans  $128,140   $332,134   $327,307   $74,485   $15,265   $-   $877,331 
                                    
Allowance for credit losses allocated to:                                   
Loans individually evaluated for impairment  $-   $289   $506   $567   $-   $-   $1,362 
Loans collectively evaluated for impairment   3,533    3,895    4,745    2,143    605    75    14,996 
Total allowance for credit losses  $3,533   $4,184   $5,251   $2,710   $605   $75   $16,358 

 

18
 

 

Note 5 – Other Assets

 

The Company had the following other assets at June 30, 2012 and December 31, 2011.

 

(Dollars in thousands)  June 30, 2012   December 31, 2011 
Nonmarketable investment securities  $2,874   $2,866 
Insurance premiums receivable   563    876 
Accrued interest receivable   3,644    3,933 
Income taxes receivable   2,711    719 
Deferred income taxes   8,113    9,036 
Interest rate caps (1)   68    250 
Prepaid expenses   3,060    3,641 
Other assets   6,010    5,399 
Total  $27,043   $26,720 

 

(1) See Note 9 for further discussion.

 

Note 6 – Other Liabilities

 

The Company had the following other liabilities at June 30, 2012 and December 31, 2011.

 

(Dollars in thousands)  June 30, 2012   December 31, 2011 
Accrued interest payable  $588   $569 
Other liabilities   8,294    8,184 
Total  $8,882   $8,753 

 

19
 

 

Note 7 - Stock-Based Compensation

 

As of June 30, 2012, the Company maintained the Shore Bancshares, Inc. 2006 Stock and Incentive Compensation Plan (“2006 Equity Plan”) under which it may issue shares of common stock or grant other equity-based awards. The Company’s ability to grant options under the Shore Bancshares, Inc. 1998 Stock Option Plan (the “1998 Option Plan”) expired on March 3, 2008 and all of the remaining 7,125 outstanding options expired on May 9, 2012.

 

Stock-based awards granted to date generally are time-based, vest in equal installments on each anniversary of the grant date over a three- to five-year period of time, and, in the case of stock options, expire 10 years from the grant date. Stock-based compensation expense is recognized ratably over the requisite service period for all awards, is based on the grant-date fair value and reflects forfeitures as they occur.

 

During the first quarter of 2012, the Company granted options to purchase 54,216 shares of the Company’s common stock pursuant to the 2006 Equity Plan. The options have an exercise price of $6.64 and vest 50% after two years from date of grant and 50% after three years from date of grant.

 

The following tables provide information on stock-based compensation expense for the first three and six months of 2012 and 2011.

 

   For the Three Months Ended   For the Six Months Ended 
   June 30,   June 30, 
(Dollars in thousands)  2012   2011   2012   2011 
Stock-based compensation expense  $44   $68   $141   $137 

 

   June 30, 
(Dollars in thousands)  2012   2011 
Unrecognized stock-based compensation expense  $211   $368 
Weighted average period unrecognized expense is expected to be recognized   2.3 years    1.1 years 

 

The following table summarizes restricted stock award activity for the Company under the 2006 Equity Plan for the six months ended June 30, 2012.

 

   Number   Weighted Average Grant 
   of Shares   Date Fair Value 
Nonvested at beginning of period   45,779   $13.20 
Granted   -    - 
Vested   (39,231)   12.92 
Cancelled   -    - 
Nonvested at end of period   6,548   $14.89 

 

The following table summarizes stock option activity for the Company under the 2006 Equity Plan for the six months ended June 30, 2012.

 

       Weighted   Aggregate   Weighted Average 
   Number   Average   Intrinsic   Grant Date 
   of Shares   Exercise Price   Value   Fair Value 
Outstanding at beginning of period   -   $-        $- 
Granted   54,216    6.64         3.44 
Exercised   -    -         - 
Expired/Cancelled   -    -         - 
Outstanding at end of period   54,216   $6.64   $-   $3.44 
                     
Exercisable at end of period   -   $-   $-   $- 

 

20
 

 

The Company estimates the fair value of stock options using the Black-Scholes valuation model with weighted average assumptions for dividend yield, expected volatility, risk-free interest rate and expected contract life (in years). The expected dividend yield is calculated by dividing the total expected annual dividend payout by the average stock price. The expected volatility is based on historical volatility of the underlying securities. The risk-free interest rate is based on the Federal Reserve Bank’s constant maturities daily interest rate in effect at grant date. The expected contract life of the options represents the period of time that the Company expects the awards to be outstanding based on historical experience with similar awards. The following weighted average assumptions were used as inputs to the Black-Scholes valuation model for options granted in 2012.

 

Dividend yield 0.60%
Expected volatility 58.65%
Risk-free interest rate 1.69%
Expected contract life (in years) 5.83

 

There was no aggregate intrinsic value of the options outstanding under the 2006 Equity Plan based on the $5.98 market value per share of Shore Bancshares, Inc.’s common stock at June 30, 2012. Since there were no options exercised during the first six months of 2012 or 2011, there was no intrinsic value associated with stock options exercised and no cash received on exercise of options. At June 30, 2012, the weighted average remaining contract life of options outstanding was 9.7 years.

 

Note 8 – Fair Value Measurements

 

Accounting guidance under GAAP defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. This accounting guidance also establishes a fair value hierarchy, which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.

 

The Company utilizes fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. Securities available for sale and derivative assets and liabilities are recorded at fair value on a recurring basis. Additionally, from time to time, the Company may be required to record at fair value other assets on a nonrecurring basis, such as impaired loans and other real estate and other assets owned (foreclosed assets). These nonrecurring fair value adjustments typically involve application of lower of cost or market accounting or write-downs of individual assets.

 

Under fair value accounting guidance, assets and liabilities are grouped at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine their fair values. These hierarchy levels are:

 

Level 1 inputs – Unadjusted quoted prices in active markets for identical assets or liabilities that the entity has the ability to access at the measurement date.

 

Level 2 inputs – Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. These might include quoted prices for similar assets or liabilities in active markets, and inputs other than quoted prices that are observable for the asset or liability, such as interest rates and yield curves that are observable at commonly quoted intervals.

 

Level 3 inputs – Unobservable inputs for determining the fair values of assets or liabilities that reflect an entity’s own assumptions about the assumptions that market participants would use in pricing the assets or liabilities.

 

Below is a discussion on the Company’s assets measured at fair value on a recurring basis.

 

Investment Securities Available for Sale

Fair value measurement for investment securities available for sale is based on quoted prices from an independent pricing service. The fair value measurements consider observable data that may include present value of future cash flows, prepayment assumptions, credit loss assumptions and other factors. The Company classifies its investments in U.S. Treasury securities as Level 1 in the fair value hierarchy, and it classifies its investments in U.S. Government agencies securities and mortgage-backed securities issued or guaranteed by U.S. Government sponsored entities as Level 2.

 

Derivative Assets

Derivative instruments held by the Company for risk management purposes are traded in over-the-counter markets where quoted market prices are not readily available. For those derivatives, the Company measures fair value using third-party models that use primarily market observable inputs, such as yield curves and option volatilities, and include the value associated with counterparty credit risk. The Company classifies its derivative instruments held for risk management purposes as Level 2 in the fair value hierarchy. As of June 30, 2012 and December 31, 2011, the Company’s derivative instruments consisted solely of interest rate caps. These derivative assets are included in other assets in the accompanying consolidated balance sheets.

 

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The tables below present the recorded amount of assets measured at fair value on a recurring basis at June 30, 2012 and December 31, 2011. No assets were transferred from one hierarchy level to another during the first six months of 2012 or 2011.

 

           Significant     
           Other   Significant 
       Quoted   Observable   Unobservable 
       Prices   Inputs   Inputs 
(Dollars in thousands)  Fair Value   (Level 1)   (Level 2)   (Level 3) 
June 30, 2012                    
Securities available for sale:                    
 U.S. Government agencies  $35,213   $-   $35,213   $- 
 Mortgage-backed securities   97,414    -    97,414    - 
 Other equity securities   617    -    617    - 
Total  $133,244   $-   $133,244   $- 
                     
Interest rate caps  $68   $-   $68   $- 

 

           Significant     
           Other   Significant 
       Quoted   Observable   Unobservable 
       Prices   Inputs   Inputs 
(Dollars in thousands)  Fair Value   (Level 1)   (Level 2)   (Level 3) 
December 31, 2011                    
Securities available for sale:                    
 U.S. Government agencies  $42,148   $-   $42,148   $- 
 Mortgage-backed securities   87,033    -    87,033    - 
 Other equity securities   599    -    599    - 
Total  $129,780   $-   $129,780   $- 
                     
Interest rate caps  $250   $-   $250   $- 

 

Below is a discussion on the Company’s assets measured at fair value on a nonrecurring basis.

 

Loans

The Company does not record loans at fair value on a recurring basis; however, from time to time, a loan is considered impaired and a valuation allowance may be established if there are losses associated with the loan. Loans are considered impaired if it is probable that payment of interest and principal will not be made in accordance with contractual terms. The fair value of impaired loans can be estimated using one of several methods, including the collateral value, market value of similar debt, liquidation value and discounted cash flows. At June 30, 2012 and December 31, 2011, substantially all impaired loans were evaluated based on the fair value of the collateral and were classified as Level 3 in the fair value hierarchy.

 

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Other Real Estate and Other Assets Owned (Foreclosed Assets)

Foreclosed assets are adjusted for fair value upon transfer of loans to foreclosed assets. Subsequently, foreclosed assets are carried at the lower of carrying value and fair value. Fair value is based on independent market prices, appraised value of the collateral or management’s estimation of the value of the collateral. At June 30, 2012 and December 31, 2011, foreclosed assets were classified as Level 3 in the fair value hierarchy.

 

The tables below summarize the changes in the recorded amount of assets measured at fair value on a nonrecurring basis for the six months ended June 30, 2012 and June 30, 2011. All assets measured at fair value on a nonrecurring basis were classified as Level 3 in the fair value hierarchy for the periods presented.

 

(Dollars in thousands)  Construction   Residential real estate   Commercial real estate   Commercial   Consumer   Total 
For the six months ended June 30, 2012                              
Impaired loans:                              
Beginning balance  $27,166   $22,602   $23,578   $1,738   $28   $75,112 
Charge-offs   (1,775)   (5,356)   (1,435)   (1,264)   -    (9,830)
Payments   (715)   (3,185)   (1,375)   (80)   (3   (5,358)
Transfers to other real estate owned   (1,620)   (763)   (1,334)   (30)   -    (3,747)
Returned to performing status   -    -    -    -    -    - 
Changed to nonaccrual status   (666)   (786)   -    -    -    (1,452)
Additions   8,776    11,600    7,279    1,313    30    28,998 
Changes in allowance   90    876    (500)   (30)   -    436 
Ending balance  $31,256   $24,988   $26,213   $1,647   $55   $84,159 

 

(Dollars in thousands)  Construction   Residential real estate   Commercial real estate   Commercial   Consumer   Total 
For the six months ended June 30, 2011                              
Impaired loans:                              
Beginning balance  $28,175   $15,327   $13,280   $4,374   $30   $61,186 
Charge-offs   (1,396)   (4,300)   (2,487)   (1,769)   -    (9,952)
Payments   (837)   (4,931)   (2,329)   (542)   (1   (8,640)
Transfers to other real estate owned   (1,719)   (522)   (2,577)   (184)   -    (5,002)
Returned to performing status   -    (1,907)   -    -    -    (1,907)
Changed to nonaccrual status   (419)   (2,162)   (1,800)   -    -    (4,381)
Additions   4,403    18,391    15,723    1,111    -    39,628 
Changes in allowance   -    (86)   (506)   (567)   -    (1,159)
Ending balance  $28,207   $19,810   $19,304   $2,423   $29   $69,773 

 

   For the Six Months Ended 
(Dollars in thousands)  June 30, 
   2012   2011 
Other real estate owned:          
Beginning balance  $9,385   $3,702 
Sales   (1,404)   (712)
Write-downs   (853)   (168)
Additions   4,371    5,055 
Ending balance  $11,499   $7,877 

 

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The following information relates to the estimated fair values of financial assets and liabilities that are reported in the Company’s consolidated balance sheets at their carrying amounts. The discussion below describes the methods and assumptions used to estimate the fair value of each class of financial asset and liability for which it is practicable to estimate that value.

 

Cash and Cash Equivalents

Cash equivalents include interest-bearing deposits with other banks and federal funds sold. For these short-term instruments, the carrying amount is a reasonable estimate of fair value.

 

Investment Securities Held to Maturity

For all investments in debt securities, fair values are based on quoted market prices. If a quoted market price is not available, then fair value is estimated using quoted market prices for similar securities.

 

Loans

The fair values of categories of fixed rate loans, such as commercial loans, residential real estate, and other consumer loans, are estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities. Other loans, including variable rate loans, are adjusted for differences in loan characteristics.

 

Financial Liabilities

The fair values of demand deposits, savings accounts, and certain money market deposits are the amounts payable on demand at the reporting date. The fair value of fixed-maturity certificates of deposit is estimated using the rates currently offered for deposits of similar remaining maturities. These estimates do not take into consideration the value of core deposit intangibles. Generally, the carrying amount of short-term borrowings is a reasonable estimate of fair value. The fair values of securities sold under agreements to repurchase (included in short-term borrowings) and long-term debt are estimated using the rates offered for similar borrowings.

 

Commitments to Extend Credit and Standby Letters of Credit

The majority of the Company’s commitments to grant loans and standby letters of credit are written to carry current market interest rates if converted to loans. In general, commitments to extend credit and letters of credit are not assignable by the Company or the borrower, so they generally have value only to the Company and the borrower. Therefore, it is impractical to assign any value to these commitments.

 

The following table provides information on the estimated fair values of the Company’s financial assets and liabilities that are reported at their carrying amounts. The financial assets and liabilities have been segregated by their classification level in the fair value hierarchy.

 

   June 30, 2012   December 31, 2011 
       Estimated       Estimated 
   Carrying   Fair   Carrying   Fair 
(Dollars in thousands)  Amount   Value   Amount   Value 
Financial assets                    
Level 2 inputs                    
Cash and cash equivalents  $169,573   $169,573   $127,742   $127,742 
Investment securities held to maturity   5,168    5,425    6,480    6,732 
Level 3 inputs                    
Loans, net   796,968    826,149    826,762    856,917 
                     
Financial liabilities                    
Level 2 inputs                    
Deposits  $1,032,703   $1,036,353   $1,009,919   $1,013,964 
Short-term borrowings   13,826    13,826    17,817    17,817 
Long-term debt   455    460    455    470 

 

Note 9 – Derivative Instruments and Hedging Activities

 

Accounting guidance under GAAP defines derivatives, requires that derivatives be carried at fair value on the balance sheet and provides for hedge accounting when certain conditions are met. Changes in the fair values of derivative instruments designated as “cash flow” hedges, to the extent the hedges are highly effective, are recorded in other comprehensive income, net of taxes. Ineffective portions of cash flow hedges, if any, are recognized in current period earnings. The net interest settlement on cash flow hedges is treated as an adjustment of the interest income or interest expense of the hedged assets or liabilities. The Company uses derivative instruments to hedge its exposure to changes in interest rates. The Company does not use derivatives for any trading or other speculative purposes.

 

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During the second quarter of 2009, as part of its overall interest rate risk management strategy, the Company purchased interest rate caps for $7.1 million to effectively fix the interest rate at 2.97% for five years on $70 million of the Company’s money market deposit accounts. The interest rate caps qualified for hedge accounting. The aggregate fair value of these derivatives was an asset of $68 thousand at June 30, 2012 and $250 thousand at December 31, 2011. The change in fair value included a $780 thousand adjustment to record unrealized holding gains on the interest rate caps and a $962 thousand charge to interest expense associated with the hedged money market deposit accounts. For the first six months of 2011, the change in fair value included a $337 thousand adjustment to record unrealized holding losses and a $559 thousand charge to interest expense. The Company expects that the charge to interest expense associated with the hedged deposits over the next 12 months will be approximately $2.1 million.

 

By entering into derivative instrument contracts, the Company exposes itself, from time to time, to counterparty credit risk. Counterparty credit risk is the risk that the counterparty will fail to perform under the terms of the derivative contract. When the fair value of a derivative contract is in an asset position, the counterparty has a liability to the Company, which creates credit risk for the Company. The Company attempts to minimize this risk by selecting counterparties with investment grade credit ratings, limiting its exposure to any single counterparty and regularly monitoring its market position with each counterparty. Collateral required by the counterparties, recorded in other liabilities, was $428 thousand at both June 30, 2012 and December 31, 2011.

 

Note 10 – Financial Instruments with Off-Balance Sheet Risk

 

In the normal course of business, to meet the financial needs of its customers, the Company’s bank subsidiaries enter into financial instruments with off-balance sheet risk. These financial instruments include commitments to extend credit and standby letters of credit. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. Letters of credit and other commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Because many of the letters of credit and commitments are expected to expire without being drawn upon, the total commitment amount does not necessarily represent future cash requirements.

 

The following table provides information on commitments outstanding at June 30, 2012 and December 31, 2011.

 

(Dollars in thousands)  June 30, 2012   December 31, 2011 
Commitments to extend credit  $146,547   $136,222 
Letters of credit   12,013    11,311 
Total  $158,560   $147,533 

 

Note 11 – Segment Reporting

 

The Company operates two primary business segments: Community Banking and Insurance Products and Services. Through the Community Banking business, the Company provides services to consumers and small businesses on the Eastern Shore of Maryland and Delaware through its 18-branch network. Community banking activities include small business services, retail brokerage, trust services and consumer banking products and services. Loan products available to consumers include mortgage, home equity, automobile, marine, and installment loans, credit cards and other secured and unsecured personal lines of credit. Small business lending includes commercial mortgages, real estate development loans, equipment and operating loans, as well as secured and unsecured lines of credit, credit cards, accounts receivable financing arrangements, and merchant card services.

 

Through the Insurance Products and Services business, the Company provides a full range of insurance products and services to businesses and consumers in the Company’s market areas. Products include property and casualty, life, marine, individual health and long-term care insurance. Pension and profit sharing plans and retirement plans for executives and employees are available to suit the needs of individual businesses.

 

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The following table includes selected financial information by business segments for the first six months of 2012 and 2011.

 

   Community   Insurance Products   Parent   Consolidated 
(Dollars in thousands)  Banking   and Services   Company   Total 
2012                    
Interest income  $23,509   $39   $-   $23,548 
Interest expense   (5,309)   -   (11   (5,320)
Provision for credit losses   (11,895)   -    -    (11,895)
Noninterest income   3,706    5,395    50    9,151 
Noninterest expense   (12,157)   (4,967)   (3,037)   (20,161)
Net intersegment (expense) income   (2,687)   (257)   2,944    - 
(Loss) income before taxes   (4,833)   210    (54)   (4,677)
Income tax benefit (expense)   2,001    (89)   22    1,934 
Net (loss) income  $(2,832)  $121   $(32)  $(2,743)
                     
Total assets  $1,156,644   $16,903   $1,786   $1,175,333 
                     
                     
2011                    
Interest income  $25,387   $66   $-   $25,453 
Interest expense   (5,628)   -    (21)   (5,649)
Provision for credit losses   (11,785)   -    -    (11,785)
Noninterest income   3,422    5,284    70    8,776 
Noninterest expense   (11,390)   (4,743)   (2,952)   (19,085)
Net intersegment (expense) income   (2,876)   (244)   3,120    - 
(Loss) income before taxes   (2,870)   363    217    (2,290)
Income tax benefit (expense)   1,220    (154)   (92)   974 
Net (loss) income  $(1,650)  $209   $125   $(1,316)
                     
Total assets  $1,102,389   $18,933   $2,869   $1,124,191 

 

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

 

Unless the context clearly suggests otherwise, references to “the Company”, “we”, “our”, and “us” in the remainder of this report are to Shore Bancshares, Inc. and its consolidated subsidiaries.

 

Forward-Looking Information

Portions of this Quarterly Report on Form 10-Q contain forward-looking statements within the meaning of The Private Securities Litigation Reform Act of 1995. Statements that are not historical in nature, including statements that include the words “anticipate”, “estimate”, “should”, “expect”, “believe”, “intend”, and similar expressions, are expressions about our confidence, policies, and strategies, the adequacy of capital levels, and liquidity and are not guarantees of future performance. Such forward-looking statements involve certain risks and uncertainties, including economic conditions, competition in the geographic and business areas in which we operate, inflation, fluctuations in interest rates, legislation, and governmental regulation. These risks and uncertainties are described in detail in the section of the periodic reports that Shore Bancshares, Inc. files with the Securities and Exchange Commission (the “SEC”) entitled “Risk Factors” (see Item 1A of Part II of this report). Actual results may differ materially from such forward-looking statements, and we assume no obligation to update forward-looking statements at any time except as required by law.

 

Introduction

The following discussion and analysis is intended as a review of significant factors affecting the Company’s financial condition and results of operations for the periods indicated. This discussion and analysis should be read in conjunction with the unaudited consolidated financial statements and related notes presented in this report, as well as the audited consolidated financial statements and related notes included in the Annual Report of Shore Bancshares, Inc. on Form 10-K for the year ended December 31, 2011.

 

Shore Bancshares, Inc. is the largest independent financial holding company located on the Eastern Shore of Maryland. It is the parent company of The Talbot Bank of Easton, Maryland located in Easton, Maryland (“Talbot Bank”) and CNB located in Centreville, Maryland (together with Talbot Bank, the “Banks”). Until January 1, 2011, the Company also served as the parent company to The Felton Bank located in Felton, Delaware. On January 1, 2011, The Felton Bank merged into CNB, with CNB as the surviving bank. The Banks operate 18 full service branches in Kent County, Queen Anne’s County, Talbot County, Caroline County and Dorchester County in Maryland and Kent County, Delaware. The Company engages in the insurance business through three insurance producer firms, The Avon-Dixon Agency, LLC, Elliott Wilson Insurance, LLC and Jack Martin Associates, Inc.; a wholesale insurance company, TSGIA, Inc.; and two insurance premium finance companies, Mubell Finance, LLC and ESFS, Inc. (all of the foregoing are collectively referred to as the “Insurance Subsidiary”). Each of these entities is a wholly-owned subsidiary of Shore Bancshares, Inc. The Company engages in the mortgage brokerage business under the name “Wye Mortgage Group” through a minority series investment in an unrelated Delaware limited liability company.

 

The shares of common stock of Shore Bancshares, Inc. are listed on the NASDAQ Global Select Market under the symbol “SHBI”.

 

Shore Bancshares, Inc. maintains an Internet site at www.shbi.com on which it makes available free of charge its Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and all amendments to the foregoing as soon as reasonably practicable after these reports are electronically filed with, or furnished to, the SEC.

 

Critical Accounting Policies

Our financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). The financial information contained within the financial statements is, to a significant extent, financial information contained that is based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability.

 

Allowance for Credit Losses

The allowance for credit losses is an estimate of the losses that may be sustained in the loan portfolio. The allowance is based on two basic principles of accounting: (i) Topic 450, “Contingencies”, of the Financial Accounting Standards Board’s Accounting Standards Codification (“ASC”), which requires that losses be accrued when they are probable of occurring and estimable; and (ii) ASC Topic 310, “Receivables”, which requires that losses be accrued based on the differences between the loan balance and the value of collateral, present value of future cash flows or values that are observable in the secondary market. Management uses many factors to estimate the inherent loss that may be present in our loan portfolio, including economic conditions and trends, the value and adequacy of collateral, the volume and mix of the loan portfolio, and our internal loan processes. Actual losses could differ significantly from management’s estimates. In addition, GAAP itself may change from one previously acceptable method to another. Although the economics of transactions would be the same, the timing of events that would impact the transactions could change.

 

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Three basic components comprise our allowance for credit losses: (i) a specific allowance; (ii) a formula allowance; and (iii) a nonspecific allowance. Each component is determined based on estimates that can and do change when the actual events occur. The specific allowance is established against impaired loans (i.e., nonaccrual loans and troubled debt restructurings) based on our assessment of the losses that may be associated with the individual loans. The specific allowance remains until charge-offs are made. An impaired loan may show deficiencies in the borrower’s overall financial condition, payment history, support available from financial guarantors and/or the fair market value of collateral. The formula allowance is used to estimate the loss on internally risk-rated loans, exclusive of those identified as impaired. Loans are grouped by type (construction, commercial real estate, residential real estate, commercial or consumer). Each loan type is assigned an allowance factor based on management’s estimate of the risk, complexity and size of individual loans within a particular category. Loans identified as special mention, substandard, and doubtful are adversely rated. These loans are assigned higher allowance factors than favorably rated loans due to management’s concerns regarding collectability or management’s knowledge of particular elements regarding the borrower. The nonspecific allowance captures losses that have impacted the portfolio but have yet to be recognized in either the specific or formula allowance.

 

Management has significant discretion in making the adjustments inherent in the determination of the provision and allowance for credit losses, including in connection with the valuation of collateral, the estimation of a borrower’s prospects of repayment, and the establishment of the allowance factors on the formula allowance and unallocated allowance components of the allowance. The establishment of allowance factors is a continuing exercise, based on management’s ongoing assessment of the totality of all factors, including, but not limited to, delinquencies, loss history, trends in volume and terms of loans, effects of changes in lending policy, the experience and depth of management, national and local economic trends, concentrations of credit, the quality of the loan review system and the effect of external factors such as competition and regulatory requirements, and their impact on the portfolio. Allowance factors may change from period to period, resulting in an increase or decrease in the amount of the provision or allowance, based on the same volume and classification of loans. Changes in allowance factors will have a direct impact on the amount of the provision, and a corresponding effect on net income. Errors in management’s perception and assessment of these factors and their impact on the portfolio could result in the allowance not being adequate to cover losses in the portfolio, and may result in additional provisions or charge-offs.

 

Goodwill and Other Intangible Assets

Goodwill represents the excess of the cost of an acquisition over the fair value of the net assets acquired. Other intangible assets represent purchased assets that also lack physical substance but can be distinguished from goodwill because of contractual or other legal rights or because the asset is capable of being sold or exchanged either on its own or in combination with a related contract, asset or liability. Goodwill and other intangible assets with indefinite lives are tested at least annually for impairment, usually during the third quarter, or on an interim basis if circumstances dictate. Intangible assets that have finite lives are amortized over their estimated useful lives and also are subject to impairment testing.

 

Impairment testing requires that the fair value of each of the Company’s reporting units be compared to the carrying amount of its net assets, including goodwill. The Company’s reporting units were identified based on an analysis of each of its individual operating segments. If the fair value of a reporting unit is less than book value, an expense may be required to write down the related goodwill or purchased intangibles to record an impairment loss.

 

Fair Value

The Company measures certain financial assets and liabilities at fair value. Significant financial assets measured at fair value on a recurring basis are investment securities and interest rate caps. Impaired loans and other real estate owned are significant financial assets measured at fair value on a nonrecurring basis. See Note 8, “Fair Value Measurements”, in the Notes to Consolidated Financial Statements for a further discussion of fair value.

 

 

OVERVIEW

 

The Company reported net income of $293 thousand for the second quarter of 2012, or diluted income per common share of $0.03, compared to a net loss of $233 thousand, or diluted loss per common share of $(0.03), for the second quarter of 2011. For the first quarter of 2012, the Company reported a net loss of $3.0 million, or diluted loss per common share of $(0.36). The provision for credit losses for the second quarter of 2012 was $3.5 million, which was $1.9 million and $4.8 million lower than the provision for the second quarter of 2011 and the first quarter of 2012, respectively. Annualized return on average assets was 0.10% for the three months ended June 30, 2012, compared to (0.08)% for the same period in 2011. Annualized return on average stockholders’ equity was 0.99% for the second quarter of 2012, compared to (0.77)% for the second quarter of 2011. For the first quarter of 2012, annualized return on average assets was (1.05)% and return on average equity was (10.04)%.

 

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For the first six months of 2012, the Company reported a net loss of $2.7 million, or diluted loss per common share of $(0.32), compared to a net loss of $1.3 million, or diluted loss per common share of $(0.16), for the first six months of 2011. Annualized return on average assets was (0.47)% for the six months ended June 30, 2012, compared to (0.24)% for the same period in 2011. Annualized return on average stockholders’ equity was (4.59)% for the first six months of 2012, compared to (2.18)% for the first six months of 2011.

 

 

RESULTS OF OPERATIONS

 

Net Interest Income

Net interest income for the second quarter of 2012 was $9.0 million, compared to $9.9 million for the second quarter of 2011 and $9.2 million for the first quarter of 2012. The decrease in net interest income when compared to the second quarter of 2011 and the first quarter of 2012 was primarily due to lower yields earned on average earning assets and a decline in higher-yielding average loan balances. The net interest margin was 3.36% for the second quarter of 2012, 3.80% for the second quarter of 2011 and 3.42% for the first quarter of 2012, a decrease of 44 basis points and 6 basis points, respectively. Loan charge-offs continued to negatively impact our net interest income and net interest margin.

 

Interest income was $11.7 million for the second quarter of 2012, a decrease of 8.2% from the second quarter of 2011. Average earning assets (loans, investment securities, federal funds sold and interest-bearing deposits with other banks) increased 2.8% during the second quarter of 2012 when compared to the same period in 2011, while yields earned decreased 51 basis points to 4.35%, mainly due to loan activity. Average loans decreased 7.4% and the yield earned on loans decreased 5 basis points from 5.43% to 5.38%. Loans comprised 75.2% of total average earning assets for the second quarter of 2012, compared to 83.5% for the second quarter of 2011. Taxable investment securities grew $23.9 million, or 22.4%, although yields declined 76 basis points because the reinvestment rates on investment securities purchased during 2012 were lower than the yields on the investment securities that matured during the period. Excess cash shifted from federal funds sold (decreasing $13.1 million) to interest-bearing deposits (increasing $85.0 million) to take advantage of higher yields on interest-bearing deposits. Interest income decreased 1.4% when compared to the first quarter of 2012. Average earning assets remained relatively unchanged during the second quarter of 2012 when compared to the first quarter of 2012, and yields earned declined 5 basis points.

 

Interest expense was $2.7 million for the three months ended June 30, 2012, a decrease of 4.8% when compared to the same period last year. Average interest-bearing liabilities (deposits and borrowings) increased 2.8% while rates paid decreased 9 basis points to 1.20%, primarily due to changes in time deposits (certificates of deposit $100,000 or more and other time deposits). For the three months ended June 30, 2012, the average balance of certificates of deposit $100,000 or more and other time deposits each decreased approximately 1.0% when compared to the same period last year, and the average rate paid on these time deposits decreased 21 and 29 basis points, respectively, reflecting current market conditions. The decrease in average time deposits was more than offset by an increase in interest-bearing demand deposits (10.8%) and money market and savings deposits (5.6%), reflecting a shift in customer investment needs. Interest on money market and savings deposits included an adjustment to expense related to interest rate caps and the hedged deposits associated with them. This adjustment increased interest expense $502 thousand for the second quarter of 2012 and $299 thousand for the second quarter of 2011. See Note 9, “Derivative Instruments and Hedging Activities”, in the Notes to Consolidated Financial Statements for additional information. When comparing the second quarter of 2012 to the first quarter of 2012, interest expense remained relatively unchanged with average balances of total interest-bearing liabilities decreasing less than 1.0% and the interest rate paid on interest-bearing liabilities staying at 1.20%.

 

Net interest income for the six months ended June 30, 2012 was $18.2 million, a decrease of 8.0% when compared to the same period last year. As with the quarterly results, the decrease was mainly due to lower yields earned on average earning assets and a decline in higher-yielding average loan balances. The net interest margin was 3.39% for the first six months of 2012 and 3.79% for the first six months of 2011.

 

Interest income was $23.5 million for the first six months of 2012, a decrease of 7.5% when compared to the first six months of 2011. Average earning assets increased 2.6% during the six months ended June 30, 2012 when compared to the same period in 2011, while yields earned decreased 50 basis points to 4.37% primarily due to the impact of loan activity. When comparing the six-month period ended June 30, 2012 to the same period of last year, average loans decreased 6.8% and the yield earned on loans decreased 11 basis points. Loans comprised 75.9% and 83.5% of total average earning assets for the first six months of 2012 and 2011, respectively.

 

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Interest expense was $5.3 million for the six months ended June 30, 2012, a decrease of 5.8% when compared to the same period last year. Average interest-bearing liabilities increased 2.4%, while rates paid decreased 11 basis points to 1.20% primarily due to time deposit activity. For the six months ended June 30, 2012, the average balance of certificates of deposit $100,000 or more and other time deposits decreased 4.1% and 1.9%, respectively, when compared to the same period last year, and the average rate paid on these deposits decreased 23 and 28 basis points, respectively.

 

Analysis of Interest Rates and Interest Differentials

The following table presents the distribution of the average consolidated balance sheets, interest income/expense, and annualized yields earned and rates paid for the three months ended June 30, 2012 and 2011.

 

   For the Three Months Ended   For the Three Months Ended 
   June 30, 2012   June 30, 2011 
   Average   Income(1)/   Yield/   Average   Income(1)/   Yield/ 
(Dollars in thousands)  Balance   Expense   Rate   Balance   Expense   Rate 
Earning assets                              
Loans (2), (3)  $816,553   $10,917    5.38%  $881,976   $11,935    5.43%
Investment securities                              
Taxable   130,528    707    2.18    106,609    782    2.94 
Tax-exempt   3,771    49    5.32    4,581    60    5.27 
Federal funds sold   11,200    2    0.10    24,310    5    0.09 
Interest-bearing deposits   124,171    61    0.20    39,182    12    0.12 
Total earning assets   1,086,223    11,736    4.35%   1,056,658    12,794    4.86%
Cash and due from banks   21,424              18,327           
Other assets   70,458              68,190           
Allowance for credit losses   (14,507)             (17,962)          
Total assets  $1,163,598             $1,125,213           
                               
Interest-bearing liabilities                              
Demand deposits  $152,685    68    0.18%  $137,775    76    0.22%
Money market and savings deposits (4)   276,527    813    1.18    261,869    633    0.97 
Certificates of deposit $100,000 or more   242,662    880    1.46    244,805    1,022    1.67 
Other time deposits   205,046    882    1.73    206,310    1,038    2.02 
Interest-bearing deposits   876,920    2,643    1.21    850,759    2,769    1.31 
Short-term borrowings   13,818    11    0.31    15,020    13    0.36 
Long-term debt   455    5    4.63    932    11    4.51 
Total interest-bearing liabilities   891,193    2,659    1.20%   866,711    2,793    1.29%
Noninterest-bearing deposits   144,210              126,081           
Other liabilities   9,421              11,234           
Stockholders’ equity   118,774              121,187           
Total liabilities and stockholders’ equity  $1,163,598             $1,125,213           
                               
Net interest spread       $9,077    3.15%       $10,001    3.57%
Net interest margin             3.36%             3.80%
                               
Tax-equivalent adjustment                              
Loans       $27             $39      
Investment securities        17              20      
Total       $44             $59      

 

(1) All amounts are reported on a tax equivalent basis computed using the statutory federal income tax rate of 34.0% for 2012 and 2011 exclusive of the alternative minimum tax rate and nondeductible interest expense.
(2) Average loan balances include nonaccrual loans.
(3) Interest income on loans includes amortized loan fees, net of costs, and all are included in the yield calculations.
(4) Interest on money market and savings deposits includes an adjustment to expense related to interest rate caps and the hedged deposits associated with them.  This adjustment increased interest expense $502 thousand for the second quarter of 2012 and $299 thousand for the second quarter of 2011.

 

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The following table presents the distribution of the average consolidated balance sheets, interest income/expense, and annualized yields earned and rates paid for the six months ended June 30, 2012 and 2011:

 

   For the Three Months Ended   For the Three Months Ended 
   June 30, 2012   June 30, 2011 
   Average   Income(1)/   Yield/   Average   Income(1)/   Yield/ 
(Dollars in thousands)  Balance   Expense   Rate   Balance   Expense   Rate 
Earning assets                                                
Loans (2), (3)   $ 824,569     $ 21,957       5.35 %   $ 884,738     $ 23,975       5.46 %
Investment securities                                                
Taxable     130,148       1,464       2.26       104,131       1,439       2.79  
Tax-exempt     4,020       106       5.34       4,596       118       5.18  
Federal funds sold     10,497       4       0.08       35,499       21       0.12  
Interest-bearing deposits     117,931       109       0.19       30,432       18       0.12  
Total earning assets     1,087,165       23,640       4.37 %     1,059,396       25,571       4.87 %
Cash and due from banks     19,799                       18,819                  
Other assets     69,310                       66,711                  
Allowance for credit losses     (14,692 )                     (16,811 )                
Total assets   $ 1,161,582                     $ 1,128,115                  
                                                 
Interest-bearing liabilities                                                
Demand deposits   $ 152,988       142       0.19 %   $ 134,719       149       0.22 %
Money market and savings deposits (4)     277,941       1,591       1.15       261,358       1,228       0.95  
Certificates of deposit $100,000 or more     241,591       1,751       1.46       251,953       2,108       1.69  
Other time deposits     203,394       1,800       1.78       207,300       2,117       2.06  
Interest-bearing deposits     875,914       5,284       1.21       855,330       5,602       1.32  
Short-term borrowings     15,720       26       0.33       14,595       26       0.36  
Long-term debt     455       10       4.63       932       21       4.53  
Total interest-bearing liabilities     892,089       5,320       1.20 %     870,857       5,649       1.31 %
Noninterest-bearing deposits     140,235                       124,201                  
Other liabilities     9,042                       11,234                  
Stockholders’ equity     120,216                       121,823                  
Total liabilities and stockholders’ equity   $ 1,161,582                     $ 1,128,115                  
                                                 
Net interest spread           $ 18,320       3.17 %           $ 19,922       3.56 %
Net interest margin                     3.39 %                     3.79 %
                                                 
Tax-equivalent adjustment                                                
Loans           $ 56                     $ 78          
Investment securities             36                       40          
Total           $ 92                     $ 118          

 

(1) All amounts are reported on a tax equivalent basis computed using the statutory federal income tax rate of 34.0% for 2012 and 2011 exclusive of the alternative minimum tax rate and nondeductible interest expense.
(2) Average loan balances include nonaccrual loans.
(3) Interest income on loans includes amortized loan fees, net of costs, and all are included in the yield calculations.
(4) Interest on money market and savings deposits includes an adjustment to expense related to interest rate caps and the hedged deposits associated with them.  This adjustment increased interest expense $962 thousand for the first six months of 2012 and $559 thousand for the first six months of 2011.

 

Noninterest Income

Noninterest income for the second quarter of 2012 increased $196 thousand, or 4.5%, when compared to the second quarter of 2011. The higher amount was primarily the result of an increase in other noninterest income which included a $217 thousand gain on the sale of a bank branch building. This increase was partially offset by a decline in insurance agency commissions and service charges on deposit accounts which were impacted by a decrease in customer use of overdraft protection programs. Total noninterest income for the second quarter of 2012 remained relatively unchanged when compared to the first quarter of 2012. The slightly higher amount when compared to the first quarter of 2012 was primarily the result of the $217 thousand gain on the sale of a bank branch building which was mainly offset by a decrease in insurance agency commissions due to the fact that contingency payments are typically received in the first quarter of the year.

 

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Total noninterest income for the six months ended June 30, 2012 increased $375 thousand, or 4.3%, when compared to the same period in 2011, primarily due to higher insurance agency commissions ($110 thousand) and other noninterest income ($449 thousand). Other noninterest income included the $217 thousand gain on the sale of a bank branch building and a $96 thousand increase in rental income from other real estate owned properties. Partially offsetting the increase in noninterest income was a decline in service charges on deposit accounts.

 

Noninterest Expense

Noninterest expense for the second quarter of 2012 increased $469 thousand, or 5.1%, when compared to the second quarter of 2011, mostly due to higher salaries and wages and other noninterest expenses. Salaries and wages increased $272 thousand, mainly due to the hiring of a new executive vice president at The Talbot Bank of Easton, Maryland during the second quarter of last year as part of that bank’s succession plan, and a new lender at CNB for the Delaware region during the third quarter of last year. Other noninterest expenses increased $212 thousand, primarily due to higher expenses related to other real estate owned activities. Total noninterest expense for the second quarter of 2012 decreased $835 thousand, or 8.0%, when compared to the first quarter of 2012, primarily due to lower employee benefits and other noninterest expenses. Other employee benefits decreased $214 thousand, mainly due to lower payroll taxes. Other noninterest expenses decreased $539 thousand, mostly due to lower expenses related to other real estate owned activities ($323 thousand) and employee training ($96 thousand), primarily on the use of upgraded insurance software during the first quarter of 2012.

 

Total noninterest expense for the six months ended June 30, 2012 increased $1.1 million, or 5.6%, when compared to the same period in 2011. The increase was primarily due to higher salaries and wages and other noninterest expenses which included larger expenses relating to other real estate owned activities and employee training. These expenses were partially offset by lower FDIC insurance premiums and data processing charges due to the merger of The Felton Bank into CNB during the first quarter of 2011.

 

Income Taxes

The Company reported income tax expense of $129 thousand for the second quarter of 2012 and an income tax benefit of $33 thousand for the second quarter of 2011. The effective tax rate was a 30.6% expense for the second quarter of 2012 and a 12.4% benefit for the second quarter of 2011. The effective tax rate for the second quarter of 2011 was impacted by a disallowed exclusion for U.S. Government agency securities income. The Company reported an income tax benefit of $1.9 million and $974 thousand for the first six months of 2012 and 2011, respectively. The effective tax rate for the six months ended June 30, 2011 was a 41.4% benefit, compared to a 42.5% benefit for the same period of 2011.

 

 

ANALYSIS OF FINANCIAL CONDITION

 

Loans

Loans totaled $810.0 million at June 30, 2012, a $31.1 million, or 3.7%, decrease from the $841.1 million at December 31, 2011. Loans included deferred costs net of deferred fees of $225 thousand at June 30, 2012 and $188 thousand at December 31, 2011. Residential real estate loans declined the most ($15.5 million) followed by construction ($8.8 million) and commercial loans ($6.5 million). Commercial real estate loans remained relatively unchanged since the end of 2011 while consumer loans decreased $489 thousand. Fewer high-quality loan opportunities and our level of loan charge-offs continue to deter loan growth. See Note 4, “Loans and Allowance for Credit Losses”, in the Notes to Consolidated Financial Statements and below under the caption “Allowance for Credit Losses” for additional information.

 

Our loan portfolio has a commercial real estate loan concentration, which is defined as a combination of construction and commercial real estate loans. Construction loans were $111.1 million, or 13.7% of total loans, at June 30, 2012, compared to $119.9 million, or 14.3% of total loans, at December 31, 2011. Commercial real estate loans were approximately $315.6 million, or 39.0% of total loans, at June 30, 2012, compared to $315.4 million, or 37.5% of total loans, at December 31, 2011. We do not engage in foreign or subprime lending activities.

 

Because most of our loans are secured by real estate, the lack of a meaningful upturn in real estate related activities in our local real estate market and construction industry and slow improvement in general economic conditions have had a material adverse effect on the performance of our loan portfolio and the value of the collateral securing that portfolio. Factors impeding our loan performance and overall financial performance include our levels of loan charge-offs and provisions for credit losses.

 

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Allowance for Credit Losses

We have established an allowance for credit losses, which is increased by provisions charged against earnings and recoveries of previously charged-off debts and is decreased by current period charge-offs of uncollectible debts. Management evaluates the adequacy of the allowance for credit losses on a quarterly basis and adjusts the provision for credit losses based on this analysis. The evaluation of the adequacy of the allowance for credit losses is based primarily on a risk rating system of individual loans, as well as on a collective evaluation of smaller balance homogenous loans, each grouped by loan type. Each loan type is assigned allowance factors based on criteria such as past credit loss experience, local economic and industry trends, and other measures which may impact collectibility. Please refer to the discussion above under the caption “Critical Accounting Policies” for an overview of the underlying methodology management employs to maintain the allowance.

 

The provision for credit losses was $3.5 million for the second quarter of 2012, $5.4 million for the second quarter of 2011 and $8.4 million for the first quarter of 2012, respectively. The lower level of provision for credit losses was primarily in response to lower loan charge-offs. The provision for credit losses for the first six months of 2012 and 2011 was $11.9 million and $11.8 million, respectively. Because most of our loans are secured by real estate, historically low property values and real estate sales are negatively impacting credi