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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: SEPTEMBER 30, 2014

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 No. 000-13580

SUFFOLK BANCORP
(Exact Name of Registrant as Specified in Its Charter)

NEW YORK
 
11-2708279
(State or Other Jurisdiction of Incorporation or Organization)
 
(I.R.S. Employer Identification No.)

4 WEST SECOND STREET, P.O. BOX 9000, RIVERHEAD, NY 11901
(Address of Principal Executive Offices) (Zip Code)

(631) 208-2400
(Registrant’s Telephone Number, Including Area Code)

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

Yes x    No ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes x    No ¨

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

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

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes ¨    No x

As of October 15, 2014, there were 11,667,752 shares of registrant’s Common Stock outstanding.
 


SUFFOLK BANCORP
Form 10-Q
For the Quarterly Period Ended September 30, 2014

Table of Contents

   
Page
 
PART I
 
     
Item 1.
Financial Statements
 
     
 
2
     
 
3
     
 
4
     
 
4
     
 
5
     
 
6
     
Item 2.
30
     
Item 3.
42
     
Item 4.
43
     
 
PART II
 
     
Item 1.
43
     
Item 1A.
43
     
Item 2.
43
     
Item 3.
43
     
Item 4.
43
     
Item 5.
43
     
Item 6.
44
     
 
45

PART I
ITEM 1. – FINANCIAL STATEMENTS

SUFFOLK BANCORP AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CONDITION (UNAUDITED)
September 30, 2014 and December 31, 2013
(dollars in thousands, except per share data)

   
September 30, 2014
   
December 31, 2013
 
ASSETS
       
Cash and cash equivalents
       
Cash and non-interest-bearing deposits due from banks
 
$
49,618
   
$
69,065
 
Interest-bearing deposits due from banks
   
20,534
     
62,287
 
Federal funds sold
   
1,000
     
1,000
 
Total cash and cash equivalents
   
71,152
     
132,352
 
Interest-bearing time deposits in other banks
   
10,000
     
10,000
 
Federal Reserve Bank,  Federal Home Loan Bank and other stock
   
3,200
     
2,863
 
Investment securities:
               
Available for sale, at fair value
   
308,589
     
400,780
 
Held to maturity (fair value of $63,942 and $12,234, respectively)
   
62,323
     
11,666
 
Total investment securities
   
370,912
     
412,446
 
Loans
   
1,262,061
     
1,068,848
 
Allowance for loan losses
   
18,800
     
17,263
 
Net loans
   
1,243,261
     
1,051,585
 
Loans held for sale
   
-
     
175
 
Premises and equipment, net
   
23,901
     
25,261
 
Bank owned life insurance
   
44,791
     
38,755
 
Deferred taxes
   
13,217
     
13,953
 
Income tax receivable
   
252
     
-
 
Accrued interest and loan fees receivable
   
6,227
     
5,441
 
Goodwill and other intangibles
   
2,987
     
2,978
 
Other assets
   
3,142
     
4,007
 
TOTAL ASSETS
 
$
1,793,042
   
$
1,699,816
 
                 
LIABILITIES & STOCKHOLDERS' EQUITY
               
Demand deposits
 
$
681,306
   
$
628,616
 
Saving, N.O.W. and money market deposits
   
675,037
     
656,366
 
Time certificates of $100,000 or more
   
165,337
     
158,337
 
Other time deposits
   
59,089
     
66,742
 
Total deposits
   
1,580,769
     
1,510,061
 
Borrowings
   
10,000
     
-
 
Capital leases
   
4,538
     
4,612
 
Other liabilities
   
14,538
     
17,945
 
TOTAL LIABILITIES
   
1,609,845
     
1,532,618
 
COMMITMENTS AND CONTINGENT LIABILITIES
               
STOCKHOLDERS' EQUITY
               
Common stock (par value $2.50; 15,000,000 shares authorized; 13,833,328 shares and 13,738,752 shares issued at September 30, 2014 and December 31, 2013, respectively; 11,667,590 shares and 11,573,014 shares outstanding at September 30, 2014 and December 31, 2013, respectively)
   
34,583
     
34,348
 
Surplus
   
43,934
     
43,280
 
Retained earnings
   
112,803
     
102,273
 
Treasury stock at par (2,165,738 shares)
   
(5,414
)
   
(5,414
)
Accumulated other comprehensive loss, net of tax
   
(2,709
)
   
(7,289
)
TOTAL STOCKHOLDERS' EQUITY
   
183,197
     
167,198
 
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY
 
$
1,793,042
   
$
1,699,816
 

See accompanying notes to unaudited condensed consolidated financial statements.

SUFFOLK BANCORP AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
For the Three and Nine Months Ended September 30, 2014 and 2013
(dollars in thousands, except per share data)

   
Three Months Ended September 30,
   
Nine Months Ended September 30,
 
   
2014
   
2013
   
2014
   
2013
 
INTEREST INCOME
               
Loans and loan fees
 
$
13,396
   
$
11,464
   
$
39,476
   
$
33,796
 
U.S. Government agency obligations
   
553
     
592
     
1,772
     
1,405
 
Obligations of states and political subdivisions
   
1,428
     
1,477
     
4,422
     
4,466
 
Collateralized mortgage obligations
   
198
     
386
     
672
     
1,767
 
Mortgage-backed securities
   
474
     
518
     
1,475
     
1,357
 
Corporate bonds
   
38
     
92
     
215
     
305
 
Federal funds sold and interest-bearing deposits due from banks
   
35
     
140
     
123
     
502
 
Dividends
   
42
     
36
     
115
     
111
 
Total interest income
   
16,164
     
14,705
     
48,270
     
43,709
 
INTEREST EXPENSE
                               
Saving, N.O.W. and money market deposits
   
291
     
308
     
870
     
888
 
Time certificates of $100,000 or more
   
227
     
280
     
695
     
874
 
Other time deposits
   
95
     
145
     
309
     
486
 
Borrowings
   
2
     
-
     
7
     
-
 
Total interest expense
   
615
     
733
     
1,881
     
2,248
 
Net interest income
   
15,549
     
13,972
     
46,389
     
41,461
 
Provision for loan losses
   
250
     
-
     
750
     
-
 
Net interest income after provision for loan losses
   
15,299
     
13,972
     
45,639
     
41,461
 
NON-INTEREST INCOME
                               
Service charges on deposit accounts
   
887
     
964
     
2,834
     
2,839
 
Other service charges, commissions and fees
   
778
     
928
     
2,349
     
2,451
 
Fiduciary fees
   
265
     
279
     
824
     
815
 
Net gain (loss) on sale of securities available for sale
   
11
     
3
     
(12
)
   
395
 
Net gain on sale of portfolio loans
   
217
     
-
     
217
     
445
 
Net gain on sale of mortgage loans originated for sale
   
51
     
142
     
214
     
973
 
Net gain on sale of premises and equipment
   
-
     
-
     
752
     
-
 
Gain on Visa shares sold
   
-
     
3,836
     
-
     
3,836
 
Income from bank owned life insurance
   
316
     
357
     
1,036
     
399
 
Other operating income
   
25
     
78
     
106
     
215
 
Total non-interest income
   
2,550
     
6,587
     
8,320
     
12,368
 
OPERATING EXPENSES
                               
Employee compensation and benefits
   
8,628
     
8,709
     
25,977
     
24,037
 
Occupancy expense
   
1,295
     
1,585
     
4,141
     
4,787
 
Equipment expense
   
418
     
616
     
1,301
     
1,745
 
Consulting and professional services
   
693
     
735
     
1,883
     
1,881
 
FDIC assessment
   
202
     
373
     
737
     
1,414
 
Data processing
   
549
     
607
     
1,681
     
1,823
 
Branch consolidation costs
   
-
     
460
     
(449
)
   
460
 
Reserve and carrying costs related to Visa shares sold
   
57
     
474
     
172
     
474
 
Other operating expenses
   
1,394
     
1,531
     
4,254
     
4,962
 
Total operating expenses
   
13,236
     
15,090
     
39,697
     
41,583
 
Income before income tax expense
   
4,613
     
5,469
     
14,262
     
12,246
 
Income tax expense
   
875
     
1,557
     
3,033
     
2,856
 
NET INCOME
 
$
3,738
   
$
3,912
   
$
11,229
   
$
9,390
 
EARNINGS PER COMMON SHARE - BASIC
 
$
0.32
   
$
0.34
   
$
0.97
   
$
0.81
 
EARNINGS PER COMMON SHARE - DILUTED
 
$
0.32
   
$
0.34
   
$
0.96
   
$
0.81
 
WEIGHTED AVERAGE COMMON SHARES - BASIC
   
11,661,544
     
11,573,014
     
11,611,790
     
11,569,961
 
WEIGHTED AVERAGE COMMON SHARES - DILUTED
   
11,716,286
     
11,606,702
     
11,667,991
     
11,583,044
 

See accompanying notes to unaudited condensed consolidated financial statements.
SUFFOLK BANCORP AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) (UNAUDITED)
For the Three and Nine Months Ended September 30, 2014 and 2013
(in thousands)

   
Three Months Ended September 30,
   
Nine Months Ended September 30,
 
   
2014
   
2013
   
2014
   
2013
 
                 
Net income
 
$
3,738
   
$
3,912
   
$
11,229
   
$
9,390
 
Other comprehensive (loss) income, net of tax and reclassification adjustments:
                               
Net change in unrealized (loss) gain on securities available for sale arising during the period
   
(601
)
   
(1,445
)
   
4,580
     
(11,887
)
Pension and post-retirement plan benefit obligation
   
-
     
-
     
-
     
(277
)
Total other comprehensive (loss) income, net of tax
   
(601
)
   
(1,445
)
   
4,580
     
(12,164
)
Total comprehensive income (loss)
 
$
3,137
   
$
2,467
   
$
15,809
   
$
(2,774
)

See accompanying notes to unaudited condensed consolidated financial statements.
 
SUFFOLK BANCORP AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF
CHANGES IN STOCKHOLDERS' EQUITY (UNAUDITED)
For the Nine Months Ended September 30, 2014 and 2013
(in thousands, except per share data)

   
Nine Months Ended September 30,
 
   
2014
   
2013
 
Common stock
       
Balance, January 1
 
$
34,348
   
$
34,330
 
Dividend reinvestment
   
5
     
-
 
Stock options exercised
   
46
     
18
 
Stock-based compensation
   
184
     
-
 
Ending balance
   
34,583
     
34,348
 
Surplus
               
Balance, January 1
   
43,280
     
42,628
 
Dividend reinvestment
   
38
     
-
 
Stock options exercised
   
200
     
74
 
Stock-based compensation
   
416
     
367
 
Ending balance
   
43,934
     
43,069
 
Retained earnings
               
Balance, January 1
   
102,273
     
89,555
 
Net income
   
11,229
     
9,390
 
Cash dividend on common stock ($0.06 per share in 2014)
   
(699
)
   
-
 
Ending balance
   
112,803
     
98,945
 
Treasury stock
               
Balance, January 1
   
(5,414
)
   
(5,414
)
Ending balance
   
(5,414
)
   
(5,414
)
Accumulated other comprehensive (loss) income, net of tax
               
Balance, January 1
   
(7,289
)
   
2,886
 
Other comprehensive income (loss)
   
4,580
     
(12,164
)
Ending balance
   
(2,709
)
   
(9,278
)
Total stockholders' equity
 
$
183,197
   
$
161,670
 

See accompanying notes to unaudited condensed consolidated financial statements.
SUFFOLK BANCORP AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
For the Nine Months Ended September 30, 2014 and 2013
(in thousands)

   
Nine Months Ended September 30,
 
   
2014
   
2013
 
NET INCOME
 
$
11,229
   
$
9,390
 
ADJUSTMENTS TO RECONCILE NET INCOME TO NET CASH PROVIDED BY OPERATING ACTIVITIES
               
Provision for loan losses
   
750
     
-
 
Depreciation and amortization
   
1,775
     
2,221
 
Stock-based compensation
   
600
     
367
 
Net amortization of premiums
   
889
     
1,002
 
Originations of mortgage loans for sale
   
(10,745
)
   
(38,438
)
Proceeds from sale of mortgage loans originated for sale
   
11,134
     
43,378
 
Gain on sale of mortgage loans originated for sale
   
(214
)
   
(973
)
Gain on sale of portfolio loans
   
(217
)
   
(445
)
Increase in other intangibles
   
(9
)
   
(313
)
Deferred tax (benefit) expense
   
(1,914
)
   
2,434
 
(Increase) decrease in income tax receivable
   
(252
)
   
363
 
Increase in accrued interest and loan fees receivable
   
(786
)
   
(1,083
)
Decrease in other assets
   
865
     
2,337
 
Decrease in other liabilities
   
(3,407
)
   
(1,447
)
Income from bank owned life insurance
   
(1,036
)
   
(399
)
Gain on Visa shares sold
   
-
     
(3,836
)
Gain on sale of premises and equipment
   
(752
)
   
-
 
Loss on sale of other real estate owned ("OREO")
   
-
     
47
 
Loss (gain) on sale of securities available for sale
   
12
     
(395
)
Net cash provided by operating activities
   
7,922
     
14,210
 
CASH FLOWS FROM INVESTING ACTIVITIES
               
Principal payments on investment securities
   
9,692
     
49,307
 
Proceeds from sale of investment securities - available for sale
   
20,604
     
13,427
 
Maturities of investment securities - available for sale
   
20,807
     
22,001
 
Purchases of investment securities - available for sale
   
(800
)
   
(115,803
)
Maturities of investment securities - held to maturity
   
994
     
1,481
 
Purchases of investment securities -  held to maturity
   
(3,434
)
   
(600
)
Increase in interest-bearing time deposits in other banks
   
-
     
(10,000
)
(Increase) decrease in Federal Reserve Bank, Federal Home Loan Bank and other stock
   
(337
)
   
127
 
Proceeds from sale of portfolio loans
   
25,371
     
1,349
 
Loan originations - net
   
(217,580
)
   
(223,288
)
Proceeds from sale of Visa shares
   
-
     
3,836
 
Proceeds from sale of premises and equipment
   
1,064
     
-
 
Proceeds from sale of OREO
   
-
     
1,525
 
Increase in bank owned life insurance
   
(5,000
)
   
(38,000
)
Purchases of premises and equipment - net
   
(727
)
   
(917
)
Net cash used in investing activities
   
(149,346
)
   
(295,555
)
CASH FLOWS FROM FINANCING ACTIVITIES
               
Net increase in deposit accounts
   
70,708
     
106,136
 
Net increase in borrowings
   
10,000
     
-
 
Proceeds from stock options exercised
   
246
     
92
 
Cash dividends paid on common stock
   
(699
)
   
-
 
Proceeds from shares issued under the dividend reinvestment plan
   
43
     
-
 
Decrease  in capital lease payable
   
(74
)
   
(53
)
Net cash provided by financing activities
   
80,224
     
106,175
 
NET DECREASE IN CASH AND CASH EQUIVALENTS
   
(61,200
)
   
(175,170
)
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD
   
132,352
     
385,806
 
CASH AND CASH EQUIVALENTS, END OF PERIOD
 
$
71,152
   
$
210,636
 
SUPPLEMENTAL DATA:
               
Interest paid
 
$
1,892
   
$
2,263
 
Income taxes paid
 
$
5,264
   
$
53
 
Loans transferred to held-for-sale
 
$
25,221
   
$
-
 
Investment securities transferred from available for sale to held to maturity
 
$
48,147
   
$
-
 

See accompanying notes to unaudited condensed consolidated financial statements.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. FINANCIAL STATEMENT PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES
The unaudited interim condensed consolidated financial statements include the accounts of Suffolk Bancorp (the “Company”) and its wholly owned subsidiaries, the Suffolk County National Bank of Riverhead and its subsidiaries (the “Bank”) and Suffolk Trust Company. The Bank formed Suffolk Greenway, Inc. (the “REIT”), a real estate investment trust, and owns 100% of an insurance agency and two corporations used to acquire foreclosed real estate. The insurance agency and the two corporations used to acquire foreclosed real estate are immaterial to the Company’s operations. Suffolk Bancorp and subsidiaries are collectively referred to hereafter as the “Company.” All material intercompany accounts and transactions have been eliminated in consolidation.

In the opinion of the Company’s management, the preceding unaudited interim condensed consolidated financial statements contain all adjustments, consisting of normal accruals, necessary for a fair presentation of its condensed consolidated statements of condition as of September 30, 2014 and December 31, 2013, its condensed consolidated statements of operations for the three and nine months ended September 30, 2014 and 2013, its condensed consolidated statements of comprehensive income (loss) for the three and nine months ended September 30, 2014 and 2013, its condensed consolidated statements of changes in stockholders’ equity for the nine months ended September 30, 2014 and 2013 and its condensed consolidated statements of cash flows for the nine months ended September 30, 2014 and 2013.

The preceding unaudited interim condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X, as well as in accordance with predominant practices within the banking industry. They do not include all of the information and footnotes required by U.S. GAAP for complete financial statements. The preparation of the financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and the accompanying notes. Actual results could differ from those estimates. The results of operations for the three and nine months ended September 30, 2014 are not necessarily indicative of the results of operations to be expected for the remainder of the year. For further information, please refer to the audited consolidated financial statements and footnotes thereto included in the Company’s 2013 Annual Report on Form 10-K.

Earnings Per Share - Basic earnings per share is computed based on the weighted average number of common shares and unvested restricted shares outstanding for each period. The Company’s unvested restricted shares are considered participating securities as they contain rights to non-forfeitable dividends and thus they are included in the basic earnings per share computation. Diluted earnings per share includes the dilutive effect of additional potential common shares issuable under stock options. In the event a net loss is reported, restricted shares and stock options are excluded from earnings per share computations.

The reconciliation of basic and diluted weighted average number of common shares outstanding for the three and nine months ended September 30, 2014 and 2013 follows.

   
Three Months Ended September 30,
   
Nine Months Ended September 30,
 
   
2014
   
2013
   
2014
   
2013
 
                 
Weighted average common shares outstanding
   
11,586,564
     
11,573,014
     
11,578,350
     
11,569,961
 
Weighted average unvested restricted shares
   
74,980
     
-
     
33,440
     
-
 
Weighted average shares for basic earnings per share
   
11,661,544
     
11,573,014
     
11,611,790
     
11,569,961
 
                                 
Additional diluted shares:
                               
Stock options
   
54,742
     
33,688
     
56,201
     
13,083
 
Weighted average shares for diluted earnings per share
   
11,716,286
     
11,606,702
     
11,667,991
     
11,583,044
 

Loans and Loan Interest Income Recognition - Loans that management has the intent and ability to hold for the foreseeable future or until maturity or payoff are reported at the principal balance outstanding, net of unearned discounts, deferred loan fees and costs. Unearned discounts on installment loans are credited to income using methods that result in a level yield. Loan origination fees, net of certain direct origination costs, are deferred and recognized in interest income over the respective term of the loan without anticipating prepayments.
Interest income is accrued on the unpaid loan principal balance. Recognition of interest income is discontinued when reasonable doubt exists as to whether principal or interest due can be collected. Loans of all classes will generally no longer accrue interest when over 90 days past due unless the loan is well-secured and in process of collection. When a loan is placed on non-accrual status, all interest previously accrued, but not collected, is reversed against current-year interest income. Interest received on such loans is applied against principal or interest, according to management’s judgment as to the collectability of the principal, until qualifying for return to accrual status. Loans may start accruing interest again when they become current as to principal and interest for at least six months, and when, after a well-documented analysis by management, it has been determined that the loans can be collected in full.  For all classes of loans, an impaired loan is defined as a loan for which it is probable that the lender will not collect all amounts due under the contractual terms of the loan agreement. Loans for which the terms have been modified resulting in a concession, and for which the borrower is experiencing financial difficulties are considered troubled debt restructurings (“TDRs”) and are classified as impaired. Generally, TDRs are initially classified as non-accrual until sufficient time has passed to assess whether the restructured loan will continue to perform. For impaired, accruing loans, interest income is recognized on an accrual basis with cash offsetting the recorded accruals upon receipt.

Allowance for Loan Losses - The allowance for loan losses is a valuation allowance for probable incurred losses, increased by the provision for loan losses and recoveries, and decreased by loan charge-offs. For all classes of loans, when a loan, in full or in part, is deemed uncollectible, it is charged against the allowance for loan losses. This happens when the loan is past due and the borrower has not shown the ability or intent to make the loan current, or the borrower does not have sufficient assets to pay the debt, or the value of the collateral is less than the balance of the loan and is not considered likely to improve soon. The allowance for loan losses is determined by a quarterly analysis of the loan portfolio. Such analysis includes changes in the size and composition of the portfolio, the Company’s own historical loan losses, industry-wide losses, current and anticipated economic trends, and details about individual loans. It also includes estimates of the actual value of collateral, other possible sources of repayment and estimates that are susceptible to significant changes due to changes in appraisal values of collateral, national and regional economic conditions and other relevant factors. All non-accrual loans over $250 thousand in the commercial and industrial, commercial real estate and real estate construction loan classes and all TDRs are evaluated individually for impairment. All other loans are generally evaluated as homogeneous pools with similar risk characteristics. In assessing the adequacy of the allowance for loan losses, management reviews the loan portfolio by separate classes that have similar risk and collateral characteristics. These classes are commercial and industrial, commercial real estate, multifamily, mixed use commercial, real estate construction, residential mortgages, home equity and consumer loans.

The allowance for loan losses consists of specific and general components. The specific component relates to loans that are individually classified as impaired. Specific reserves are established based on an analysis of the most probable sources of repayment or liquidation of collateral. Impaired loans that are collateral dependent are reviewed based on the fair market value of collateral and the estimated time required to recover the Company’s investment in the loans, as well as the cost of doing so, and the estimate of the recovery. Non-collateral dependent impaired loans are reviewed based on the present value of estimated future cash flows, including balloon payments, if any, using the loan’s effective interest rate. While every impaired loan is evaluated individually, not every loan requires a specific reserve. Specific reserves fluctuate based on changes in the underlying loans, anticipated sources of repayment, and charge-offs. The general component covers non-impaired loans and is based on historical loss experience for each loan class from a rolling twelve quarter period and modifying those percentages, if necessary, after adjusting for current qualitative and environmental factors that reflect changes in the estimated collectability of the loan class not captured by historical loss data.  These factors augment actual loss experience and help estimate the probability of loss within the loan portfolio based on emerging or inherent risk trends. These qualitative factors are applied as an adjustment to historical loss rates and require judgments that cannot be subjected to exact mathematical calculation. These adjustments reflect management’s overall estimate of the extent to which current losses on a pool of loans will differ from historical loss experience. These adjustments are subjective estimates and management reviews them on a quarterly basis. TDRs are also considered impaired with impairment generally measured at the present value of estimated future cash flows using the loan’s effective interest rate at inception or using the fair value of collateral, less estimated costs to sell, if repayment is expected solely from the collateral.

Loans Held For Sale – Loans held for sale are carried at the lower of aggregate cost or fair value, based on observable inputs in the secondary market. Changes in fair value of loans held for sale are recognized in earnings.

Bank Owned Life Insurance (“BOLI”) - BOLI is recorded at the lower of the cash surrender value or the amount that can be realized under the insurance policy and is included as an asset in the consolidated statements of condition. Changes in the cash surrender value and insurance benefit payments are recorded in non-interest income in the consolidated statements of operations.

Derivatives - Derivatives are contracts between counterparties that specify conditions under which settlements are to be made. The only derivatives held by the Company are swap contracts with the purchaser of its Visa Class B shares. The Company records its derivatives on the balance sheet at fair value. The Company’s derivatives do not qualify for hedge accounting. As a result, changes in fair value are recognized in earnings in the period in which they occur. (See also Note 3. Investment Securities contained herein.)
Recent Accounting Guidance – In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2014-09, Revenue from Contracts with Customers (Topic 606), “Revenue from Contracts with Customers,” which supersedes nearly all existing revenue recognition guidance under U.S. GAAP. The core principle of the ASU is to recognize revenues when promised goods or services are transferred to customers in an amount that reflects the consideration to which an entity expects to be entitled for those goods or services. The ASU defines a five step process to achieve this core principle and, in doing so, more judgment and estimates may be required within the revenue recognition process than are required under existing U.S. GAAP. The ASU is effective for annual periods beginning after December 15, 2016, and interim periods therein, using either of the following transition methods: (i) a full retrospective approach reflecting the application of the standard in each prior reporting period with the option to elect certain practical expedients, or (ii) a retrospective approach with the cumulative effect of initially adopting the ASU recognized at the date of adoption (which includes additional footnote disclosures). The Company has not yet determined the method by which it will adopt ASU 2014-09 in 2017 and does not believe that the adoption will have a material effect on the Company’s consolidated financial statements.

In January 2014, the FASB issued ASU 2014-04, Receivables—Troubled Debt Restructurings by Creditors (Topic 310), “Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure,” to clarify when an in substance repossession or foreclosure occurs, that is, when a creditor should be considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan such that the loan receivable should be derecognized and the real estate property recognized. The ASU requires interim and annual disclosure of both (1) the amount of foreclosed residential real estate property held by the creditor and (2) the recorded investment in consumer mortgage loans collateralized by residential real estate property that are in the process of foreclosure according to local requirements of the applicable jurisdiction. The ASU is effective for fiscal years, and interim periods within those years, beginning after December 15, 2014. Management intends to adopt ASU 2014-04 on January 1, 2015 and does not believe that the adoption will have a material effect on the Company’s consolidated financial statements.

In July 2013, the FASB issued ASU 2013-11, Income Taxes (Topic 740), “Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists,” to clarify the balance sheet presentation of an unrecognized tax benefit when a net operating loss carryforward, a similar tax loss, or a tax credit carryforward exists. The ASU requires an unrecognized tax benefit, or a portion of an unrecognized tax benefit, to be presented in the financial statements as a reduction to a deferred tax asset for a net operating loss carryforward, a similar tax loss, or a tax credit carryforward, except as follows. To the extent a net operating loss carryforward, a similar tax loss, or a tax credit carryforward is not available at the reporting date under the tax law of the applicable jurisdiction to settle any additional income taxes that would result from the disallowance of a tax position or the tax law of the applicable jurisdiction does not require the entity to use, and the entity does not intend to use, the deferred tax asset for such purpose, the unrecognized tax benefit should be presented in the financial statements as a liability and should not be combined with deferred tax assets. The ASU is effective for fiscal years, and interim periods within those years, beginning after December 15, 2013. The Company’s adoption of ASU 2013-11 on January 1, 2014 did not have a material effect on the Company’s consolidated financial statements.

Reclassifications — Certain reclassifications have been made to prior period information in order to conform to the current period’s presentation. Such reclassifications had no impact on the Company’s consolidated results of operations or financial condition.

2. ACCUMULATED OTHER COMPREHENSIVE INCOME (“AOCI”)
The changes in the Company’s AOCI by component, net of tax, for the three and nine months ended September 30, 2014 and 2013 follow (in thousands).

   
Three Months Ended September 30, 2014
   
Three Months Ended September 30, 2013
 
   
Unrealized Gains and
Losses on Available
for Sale Securities
   
Pension and Post-
Retirement Plan
Items
   
Total
   
Unrealized Gains and
Losses on Available
for Sale Securities
   
Pension and Post-
Retirement Plan
Items
   
Total
 
Beginning balance
 
$
1,086
   
$
(3,194
)
 
$
(2,108
)
 
$
111
   
$
(7,944
)
 
$
(7,833
)
Other comprehensive loss before reclassifications
   
(594
)
   
-
     
(594
)
   
(1,443
)
   
-
     
(1,443
)
Amounts reclassified from AOCI
   
(7
)
   
-
     
(7
)
   
(2
)
   
-
     
(2
)
Net other comprehensive loss
   
(601
)
   
-
     
(601
)
   
(1,445
)
   
-
     
(1,445
)
Ending balance
 
$
485
   
$
(3,194
)
 
$
(2,709
)
 
$
(1,334
)
 
$
(7,944
)
 
$
(9,278
)

   
Nine Months Ended September 30, 2014
   
Nine Months Ended September 30, 2013
 
   
Unrealized Gains and
Losses on Available
for Sale Securities
   
Pension and Post-
Retirement Plan
 Items
   
Total
   
Unrealized Gains and
Losses on Available
for Sale Securities
   
Pension and Post-
Retirement Plan
Items
   
Total
 
Beginning balance
 
$
(4,095
)
 
$
(3,194
)
 
$
(7,289
)
 
$
10,553
   
$
(7,667
)
 
$
2,886
 
Other comprehensive income (loss) before reclassifications
   
4,573
     
-
     
4,573
     
(11,635
)
   
(277
)
   
(11,912
)
Amounts reclassified from AOCI
   
7
     
-
     
7
     
(252
)
   
-
     
(252
)
Net other comprehensive income (loss)
   
4,580
     
-
     
4,580
     
(11,887
)
   
(277
)
   
(12,164
)
Ending balance
 
$
485
   
$
(3,194
)
 
$
(2,709
)
 
$
(1,334
)
 
$
(7,944
)
 
$
(9,278
)

The table below presents reclassifications out of AOCI for the three and nine months ended September 30, 2014 and 2013 (in thousands).

   
Amount Reclassified from AOCI
   
   
Three Months Ended September 30,
 
Affected Line Item in the Statement
Details about AOCI Components
 
2014
   
2013
 
Where Net Income is Presented
Unrealized gains and losses on available for sale securities
 
$
11
   
$
3
 
Net gain (loss) on sale of securities available for sale
                      
     
(4
)
   
(1
)
Income tax expense
                      
Total reclassifications, net of tax
 
$
7
   
$
2
   

   
Amount Reclassified from AOCI
   
   
Nine Months Ended September 30,
 
Affected Line Item in the Statement
Details about AOCI Components
 
2014
   
2013
 
Where Net Income is Presented
Unrealized gains and losses on available for sale securities
 
$
(12
)
 
$
395
 
Net gain (loss) on sale of securities available for sale
                      
     
5
     
(143
)
Income tax expense
                      
Total reclassifications, net of tax
 
$
(7
)
 
$
252
   

3. INVESTMENT SECURITIES
At the time of purchase of a security, the Company designates the security as either available for sale or held to maturity, depending upon investment objectives, liquidity needs and intent. Securities held to maturity are stated at cost, adjusted for premium amortized or discount accreted, if any. The Company has the positive intent and ability to hold such securities to maturity. Securities available for sale are stated at estimated fair value. Unrealized gains and losses are excluded from income and reported net of tax in AOCI as a separate component of stockholders’ equity until realized. Changes in unrealized gains and losses are reported, net of tax, in the consolidated statements of comprehensive income (loss). Interest earned on securities is included in interest income. Realized gains and losses on the sale of securities are reported in the consolidated statements of operations and determined using the adjusted cost of the specific security sold.

During the first nine months of 2014, investment securities totaling $48 million were transferred from available for sale to held to maturity. At the time of transfer, the securities were carried at unrealized losses. In accordance with ASC 320-10-35-10, the securities were transferred at fair value, which became the amortized cost. The discount will be accreted to interest income over the remaining life of the security. The unrealized holding losses at the date of transfer remained in AOCI and will be amortized simultaneously against interest income. Those entries will offset or mitigate each other. For regulatory capital purposes, the unamortized AOCI related to these securities is treated in the same manner as an available for sale debt security.
The amortized cost, estimated fair value and gross unrealized gains and losses of the Company’s investment securities available for sale and held to maturity at September 30, 2014 and December 31, 2013 were as follows (in thousands):

   
September 30, 2014
   
December 31, 2013
 
       
Gross
   
Gross
   
Estimated
       
Gross
   
Gross
   
Estimated
 
   
Amortized
   
Unrealized
   
Unrealized
   
Fair
   
Amortized
   
Unrealized
   
Unrealized
   
Fair
 
   
Cost
   
Gains
   
Losses
   
Value
   
Cost
   
Gains
   
Losses
   
Value
 
Available for sale:
                               
U.S. Government agency securities
 
$
42,473
   
$
-
   
$
(1,465
)
 
$
41,008
   
$
109,315
   
$
-
   
$
(9,220
)
 
$
100,095
 
Obligations of states and political subdivisions
   
138,222
     
7,951
     
-
     
146,173
     
148,664
     
8,499
     
-
     
157,163
 
Collateralized mortgage obligations
   
22,736
     
636
     
(627
)
   
22,745
     
30,335
     
557
     
(788
)
   
30,104
 
Mortgage-backed securities
   
94,959
     
16
     
(2,662
)
   
92,313
     
103,332
     
19
     
(5,584
)
   
97,767
 
Corporate bonds
   
6,349
     
32
     
(31
)
   
6,350
     
15,565
     
264
     
(178
)
   
15,651
 
Total available for sale securities
   
304,739
     
8,635
     
(4,785
)
   
308,589
     
407,211
     
9,339
     
(15,770
)
   
400,780
 
Held to maturity:
                                                               
U.S. Government agency securities
   
48,299
     
782
     
(15
)
   
49,066
     
-
     
-
     
-
     
-
 
Obligations of states and political subdivisions
   
14,024
     
852
     
-
     
14,876
     
11,666
     
655
     
(87
)
   
12,234
 
Total held to maturity securities
   
62,323
     
1,634
     
(15
)
   
63,942
     
11,666
     
655
     
(87
)
   
12,234
 
Total investment securities
 
$
367,062
   
$
10,269
   
$
(4,800
)
 
$
372,531
   
$
418,877
   
$
9,994
   
$
(15,857
)
 
$
413,014
 

At September 30, 2014 and December 31, 2013, investment securities carried at $268 million and $292 million, respectively, were pledged for trust deposits, public funds on deposit and as collateral for the derivative swap contracts.

The amortized cost, contractual maturities and estimated fair value of the Company’s investment securities at September 30, 2014 (in thousands) are presented in the table below. Collateralized mortgage obligations (“CMOs”) and mortgage-backed securities (“MBS”) assume maturity dates pursuant to average lives.

   
September 30, 2014
 
   
Amortized
   
Estimated
 
   
Cost
   
Fair Value
 
Securities available for sale:
       
Due in one year or less
 
$
11,653
   
$
11,868
 
Due from one to five years
   
155,455
     
160,425
 
Due from five to ten years
   
137,631
     
136,296
 
Total securities available for sale
   
304,739
     
308,589
 
Securities held to maturity:
               
Due in one year or less
   
1,667
     
1,714
 
Due from one to five years
   
5,564
     
6,057
 
Due from five to ten years
   
31,988
     
32,140
 
Due after ten years
   
23,104
     
24,031
 
Total securities held to maturity
   
62,323
     
63,942
 
Total investment securities
 
$
367,062
   
$
372,531
 

The proceeds from sales of securities available for sale and the associated realized gains and losses are shown below for the periods indicated (in thousands). Realized gains are also inclusive of gains on called securities.
   
Three Months Ended September 30,
   
Nine Months Ended September 30,
 
   
2014
   
2013
   
2014
   
2013
 
                 
Proceeds
 
$
-
   
$
-
   
$
20,604
   
$
13,427
 
                                 
Gross realized gains
 
$
11
   
$
3
   
$
240
   
$
395
 
Gross realized losses
   
-
     
-
     
252
     
-
 
Net realized gains (losses)
 
$
11
   
$
3
   
$
(12
)
 
$
395
 
 
Information pertaining to securities with unrealized losses at September 30, 2014 and December 31, 2013, aggregated by investment category and length of time that individual securities have been in a continuous loss position, follows (in thousands):
 
   
Less than 12 months
   
12 months or longer
   
Total
 
   
Estimated
   
Unrealized
   
Estimated
   
Unrealized
   
Estimated
   
Unrealized
 
September 30, 2014
 
Fair value
   
Losses
   
Fair value
   
Losses
   
Fair value
   
Losses
 
U.S. Government agency securities
 
$
12,016
   
$
15
   
$
41,008
   
$
1,465
   
$
53,024
   
$
1,480
 
Collateralized mortgage obligations
   
-
     
-
     
8,442
     
627
     
8,442
     
627
 
Mortgage-backed securities
   
5,957
     
29
     
86,123
     
2,633
     
92,080
     
2,662
 
Corporate bonds
   
-
     
-
     
2,969
     
31
     
2,969
     
31
 
Total
 
$
17,973
   
$
44
   
$
138,542
   
$
4,756
   
$
156,515
   
$
4,800
 

   
Less than 12 months
   
12 months or longer
   
Total
 
   
Estimated
   
Unrealized
   
Estimated
   
Unrealized
   
Estimated
   
Unrealized
 
December 31, 2013
 
Fair value
   
Losses
   
Fair value
   
Losses
   
Fair value
   
Losses
 
U.S. Government agency securities
 
$
86,590
   
$
7,726
   
$
13,505
   
$
1,494
   
$
100,095
   
$
9,220
 
Obligations of states and political subdivisions
   
3,932
     
87
     
-
     
-
     
3,932
     
87
 
Collateralized mortgage obligations
   
2,935
     
160
     
5,713
     
628
     
8,648
     
788
 
Mortgage-backed securities
   
84,869
     
4,850
     
12,637
     
734
     
97,506
     
5,584
 
Corporate bonds
   
8,681
     
178
     
-
     
-
     
8,681
     
178
 
Total
 
$
187,007
   
$
13,001
   
$
31,855
   
$
2,856
   
$
218,862
   
$
15,857
 

The Company’s management evaluates securities for other-than-temporary impairment (“OTTI”) at least on a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. All of the Company’s investment securities classified as available for sale or held to maturity are evaluated for OTTI under FASB ASC 320, “Accounting for Certain Investments in Debt and Equity Securities.” In determining OTTI under ASC 320, management considers many factors, including: (1) the length of time and the extent to which the fair value has been less than amortized cost, (2) the financial condition and near-term prospects of the issuer, (3) whether the market decline was affected by macroeconomic conditions, and (4) whether the Company has the intent to sell the debt security or more likely than not will be required to sell the debt security before its anticipated recovery. The assessment of whether an OTTI decline exists involves a high degree of subjectivity and judgment and is based on information available to management at a point in time. An OTTI is deemed to have occurred if there has been an adverse change in the remaining expected future cash flows.

When an OTTI occurs, the amount of the OTTI recognized in earnings depends on whether an entity intends to sell the security or more likely than not will be required to sell the security before recovery of its amortized cost basis less any current-period credit loss. If an entity intends to sell or more likely than not will be required to sell the security before recovery of its amortized cost basis less any current-period credit loss, the OTTI is recognized in earnings equal to the entire difference between the investment’s amortized cost and its estimated fair value at the balance sheet date. If an entity does not intend to sell the security and it is not more likely than not that the entity will be required to sell the security before recovery of its amortized cost less any current-period loss, the OTTI is separated into the amount representing the credit loss and the amount related to all other factors. The amount of the total OTTI related to the credit loss is determined based on the present value of cash flows expected to be collected and is recognized in earnings. The amount of the total OTTI related to other factors is recognized in AOCI, net of applicable tax benefit. The previous amortized cost basis less the OTTI recognized in earnings becomes the new amortized cost basis of the investment.
The corporate bonds at unrealized losses for twelve months or longer in the table above carry investment grade ratings by all major credit rating agencies including both Moody’s and Standard  & Poor’s. The unrealized losses on these bonds were a result of the current interest rate environment and the corresponding shape of the yield curve. The losses were not related to a deterioration of the quality of the issuer or any company-specific adverse events. All other securities at unrealized losses for twelve months or longer are issued or guaranteed by U.S. Government agencies or sponsored enterprises and the related unrealized losses resulted solely from the current interest rate environment and the corresponding shape of the yield curve.

Upon review of the considerations mentioned here, no OTTI was deemed to be warranted at September 30, 2014.

The Bank was a member of the Visa USA payment network and was issued Class B shares upon Visa’s initial public offering in March 2008. The Visa Class B shares are transferable only under limited circumstances until they can be converted into shares of the publicly traded class of stock. This conversion cannot happen until the settlement of certain litigation, which is indemnified by Visa members. Since its initial public offering, Visa has funded a litigation reserve based upon a change in the conversion ratio of Visa Class B shares into Visa Class A shares. At its discretion, Visa may continue to increase the conversion rate in connection with any settlements in excess of amounts then in escrow for that purpose and reduce the conversion rate to the extent that it adds any funds to the escrow in the future. Based on the existing transfer restriction and the uncertainty of the litigation, the Company has recorded its Visa Class B shares on its balance sheet at zero value.

During the third and fourth quarters of 2013, the Bank sold 100,000 Visa Class B shares to another Visa USA member financial institution at a gross pre-tax gain of approximately $7.8 million which was recorded in non-interest income in the Company’s statement of operations. In conjunction with the sale, the Company entered into derivative swap contracts with the purchaser of these Visa Class B shares which provide for settlements between the purchaser and the Company based upon a change in the conversion ratio of Visa Class B shares into Visa Class A shares. Also during the third and fourth quarters of 2013, the Company recorded a total of $932 thousand in operating expenses and in other liabilities on the balance sheet, representing the estimate of the Company’s exposure to the settlement of the Visa litigation or the derivative liability.

In October 2014, the Bank received notification of a change in the conversion ratio of Visa Class B shares into Visa Class A shares. As a result of this change, in the fourth quarter of 2014 the Bank was required to make a payment of $180 thousand to the purchaser of the Visa Class B shares it sold in 2013. This payment reduced the Company’s previously recorded $932 thousand estimate of the derivative liability to $752 thousand.

The present value of estimated future fees to be paid to the derivative counterparty, or carrying costs, calculated by reference to the market price of the Visa Class A shares at a fixed rate of interest are expensed as incurred. For the three and nine months ended September 30, 2014, $57 thousand and $172 thousand, respectively, in such carrying costs was expensed. The Company has pledged U.S. Government agency securities held in its available for sale portfolio, with a market value of approximately $3 million at September 30, 2014, as collateral for the derivative swap contracts.

Subjectivity has been used in estimating the fair value of both the derivative liability and the associated fees, but management believes that these fair value estimates are adequate based on available information. However, future developments in the litigation could require potentially significant changes to these estimates.

At September 30, 2014, the Company still owned 38,638 Visa Class B shares subsequent to the sales described here. Upon termination of the existing transfer restriction and settlement of the litigation, and to the extent that the Company continues to own such Visa Class B shares in the future, the Company expects to record its Visa Class B shares at fair value.
4. LOANS
At September 30, 2014 and December 31, 2013, net loans disaggregated by class consisted of the following (in thousands):

   
September 30, 2014
   
December 31, 2013
 
Commercial and industrial
 
$
180,399
   
$
171,199
 
Commercial real estate
   
512,341
     
464,560
 
Multifamily
   
274,352
     
184,624
 
Mixed use commercial
   
27,476
     
4,797
 
Real estate construction
   
21,615
     
6,565
 
Residential mortgages
   
185,856
     
169,552
 
Home equity
   
52,001
     
57,112
 
Consumer
   
8,021
     
10,439
 
Gross loans
   
1,262,061
     
1,068,848
 
Allowance for loan losses
   
(18,800
)
   
(17,263
)
Net loans at end of period
 
$
1,243,261
   
$
1,051,585
 

The following summarizes the activity in the allowance for loan losses disaggregated by class for the periods indicated (in thousands).

   
Three months ended September 30, 2014
   
Three months ended September 30, 2013
 
   
Balance at
beginning of
period
   
Charge-
offs
   
Recoveries
   
(Credit)
provision
for loan
losses
   
Balance at
end of
period
   
Balance at
beginning of
period
   
Charge-
offs
   
Recoveries
   
(Credit)
provision
for loan
losses
   
Balance at
end of
period
 
Commercial and industrial
 
$
2,932
   
$
(104
)
 
$
160
   
$
(1,121
)
 
$
1,867
   
$
4,778
   
$
(60
)
 
$
390
   
$
(1,870
)
 
$
3,238
 
Commercial real estate
   
7,899
     
-
     
11
     
(499
)
   
7,411
     
6,521
     
(70
)
   
12
     
611
     
7,074
 
Multifamily
   
2,444
     
-
     
-
     
238
     
2,682
     
529
     
-
     
-
     
903
     
1,432
 
Mixed use commercial
   
212
     
-
     
-
     
(6
)
   
206
     
180
     
-
     
-
     
(126
)
   
54
 
Real estate construction
   
230
     
-
     
-
     
36
     
266
     
278
     
-
     
-
     
(4
)
   
274
 
Residential mortgages
   
2,650
     
-
     
4
     
193
     
2,847
     
2,341
     
-
     
4
     
218
     
2,563
 
Home equity
   
761
     
-
     
3
     
(55
)
   
709
     
1,059
     
-
     
5
     
17
     
1,081
 
Consumer
   
166
     
(15
)
   
13
     
13
     
177
     
247
     
(11
)
   
56
     
(59
)
   
233
 
Unallocated
   
1,184
     
-
     
-
     
1,451
     
2,635
     
1,360
     
-
     
-
     
310
     
1,670
 
Total
 
$
18,478
   
$
(119
)
 
$
191
   
$
250
   
$
18,800
   
$
17,293
   
$
(141
)
 
$
467
   
$
-
   
$
17,619
 

   
Nine months ended September 30, 2014
   
Nine months ended September 30, 2013
 
   
Balance at
beginning of
period
   
Charge-
offs
   
Recoveries
   
(Credit)
provision
for loan
losses
   
Balance at
end of
period
   
Balance at
beginning of
period
   
Charge-
offs
   
Recoveries
   
(Credit)
provision
for loan
losses
   
Balance at
end of
period
 
Commercial and industrial
 
$
2,615
   
$
(419
)
 
$
663
   
$
(992
)
 
$
1,867
   
$
6,181
   
$
(1,687
)
 
$
1,600
   
$
(2,856
)
 
$
3,238
 
Commercial real estate
   
6,572
     
-
     
508
     
331
     
7,411
     
5,965
     
(70
)
   
85
     
1,094
     
7,074
 
Multifamily
   
2,159
     
-
     
-
     
523
     
2,682
     
150
     
-
     
-
     
1,282
     
1,432
 
Mixed use commercial
   
54
     
-
     
-
     
152
     
206
     
34
     
-
     
-
     
20
     
54
 
Real estate construction
   
88
     
-
     
-
     
178
     
266
     
141
     
-
     
-
     
133
     
274
 
Residential mortgages
   
2,463
     
(32
)
   
12
     
404
     
2,847
     
1,576
     
(74
)
   
5
     
1,056
     
2,563
 
Home equity
   
745
     
-
     
48
     
(84
)
   
709
     
907
     
-
     
7
     
167
     
1,081
 
Consumer
   
241
     
(19
)
   
26
     
(71
)
   
177
     
189
     
(133
)
   
105
     
72
     
233
 
Unallocated
   
2,326
     
-
     
-
     
309
     
2,635
     
2,638
     
-
     
-
     
(968
)
   
1,670
 
Total
 
$
17,263
   
$
(470
)
 
$
1,257
   
$
750
   
$
18,800
   
$
17,781
   
$
(1,964
)
 
$
1,802
   
$
-
   
$
17,619
 

The allowance for loan losses is a valuation allowance for probable incurred credit losses. Loan losses are charged against the allowance when management believes a loan, in full or in part, is uncollectible. Subsequent recoveries, if any, are credited to the allowance. Management estimates the allowance balance required using past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions, and other factors.  Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management’s judgment, should be charged off. The allowance consists of specific and general components. The specific component relates to loans that are individually classified as impaired.
A loan is impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement.  Loans for which the terms have been modified resulting in a concession, and for which the borrower is experiencing financial difficulties, are considered TDRs and classified as impaired. Generally, TDRs are initially classified as non-accrual until sufficient time has passed to assess whether the restructured loan will continue to perform. Generally, the Company returns a TDR to accrual status upon six months of performance under the new terms.

Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired.  Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed.

All non-accrual loans over $250 thousand in the commercial and industrial, commercial real estate and real estate construction loan classes and all TDRs are evaluated individually for impairment. All other loans are generally evaluated as homogeneous pools with similar risk characteristics. If a loan is impaired, a specific reserve may be recorded so that the loan is reported, net, at the present value of estimated future cash flows including balloon payments, if any, using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral. Large groups of homogeneous loans with smaller individual balances, such as consumer and residential real estate loans, are generally evaluated collectively for impairment, and accordingly, are not separately identified for impairment disclosures. TDRs are separately identified for impairment disclosures and are measured at the present value of estimated future cash flows using the loan’s effective rate at inception. If a TDR is considered to be collateral-dependent, the loan is reported at the fair value of the collateral net of estimated costs to sell.  For TDRs that subsequently default, the Company determines the allowance amount in accordance with its accounting policy for the allowance for loan losses.

The general component of the allowance covers non-impaired loans and is based on historical loss experience, adjusted for qualitative factors.  The historical loss experience is determined by loan class, and is based on the actual loss history experienced by the Company over a rolling twelve quarter period. This actual loss experience is supplemented with other qualitative factors based on the risks present for each loan class. These qualitative factors include consideration of the following:  levels of and trends in delinquencies and impaired loans; levels of and trends in charge-offs and recoveries; trends in volume and terms of loans; effects of any changes in risk selection and underwriting standards; other changes in lending policies, procedures and practices; experience, ability, and depth of lending management and other relevant staff; local, regional and national economic trends and conditions; industry conditions; and effects of changes in credit concentrations. The following loan classes have been identified: commercial and industrial, commercial real estate, multifamily, mixed use commercial, real estate construction, residential mortgages, home equity and consumer loans.

The Company recorded a $250 thousand provision for loan losses for the three months ended September 30, 2014 due to growth in the loan portfolio. The Company did not record a provision for loan losses in the third quarter of 2013.

For the three months ended September 30, 2014, the ending balance of the Company’s allowance for loan losses increased by $322 thousand when compared to June 30, 2014. During the third quarter of 2014, the Company decreased its allowance for loan losses allocated to commercial and industrial loans (“C&I”) and commercial real estate loans (“CRE”) by $1.1 million and $488 thousand, respectively, while increasing the amount allocated to multifamily loans by $238 thousand.

The reductions in the allowance for loan losses allocated to C&I and CRE loans were primarily due to decreases of 0.58% and 0.16%, respectively, versus June 30, 2014, in the ASC 450-20 average combined historical loss and environmental factors rates on unimpaired pass rated C&I and CRE loans, partially offset by increases of $2 million and $25 million, respectively, in the balances of such unimpaired pass rated loans.

The increase in the allowance for loan losses allocated to multifamily loans during the third quarter of 2014 largely reflected an increase of $29 million in the balance of unimpaired pass rated multifamily loans.

The ASC 450-20 loss factors rates incorporate a rolling twelve quarter look back period used in calculating historical losses for each loan segment. In an effort to more accurately represent the Company’s incurred and expected losses by individual loan segment, a twelve quarter period is used to improve the granularity of individual loan segment charge-off history and reduce the volatility associated with improperly weighting short-term trends in the calculation.
For the three months ended September 30, 2014, the ending balance of the Company’s unallocated portion of the allowance for loan losses increased $1.5 million versus June 30, 2014. Loan portfolio growth was strong during the third quarter of 2014, primarily in multifamily and CRE loans. Loan growth, including multifamily loans, is expected to continue throughout 2014. An unallocated portion of the reserve is considered a prudent option until these loans to new borrowers establish satisfactory payment patterns.

At September 30, 2014 and December 31, 2013, the ending balance in the allowance for loan losses disaggregated by class and impairment methodology is as follows (in thousands). Also in the tables below are total loans at September 30, 2014 and December 31, 2013 disaggregated by class and impairment methodology (in thousands).

   
Allowance for Loan Losses
   
Loan Balances
 
September 30, 2014
 
Individually
evaluated for
impairment
   
Collectively
evaluated for
impairment
   
Ending balance
   
Individually
evaluated for
impairment
   
Collectively
evaluated for
impairment
   
Ending balance
 
Commercial and industrial
 
$
21
   
$
1,846
   
$
1,867
   
$
6,536
   
$
173,863
   
$
180,399
 
Commercial real estate
   
-
     
7,411
     
7,411
     
10,215
     
502,126
     
512,341
 
Multifamily
   
-
     
2,682
     
2,682
     
-
     
274,352
     
274,352
 
Mixed use commercial
   
-
     
206
     
206
     
-
     
27,476
     
27,476
 
Real estate construction
   
-
     
266
     
266
     
-
     
21,615
     
21,615
 
Residential mortgages
   
706
     
2,141
     
2,847
     
5,182
     
180,674
     
185,856
 
Home equity
   
96
     
613
     
709
     
904
     
51,097
     
52,001
 
Consumer
   
92
     
85
     
177
     
327
     
7,694
     
8,021
 
Unallocated
   
-
     
2,635
     
2,635
     
-
     
-
     
-
 
Total
 
$
915
   
$
17,885
   
$
18,800
   
$
23,164
   
$
1,238,897
   
$
1,262,061
 

   
Allowance for Loan Losses
   
Loan Balances
 
December 31, 2013
 
Individually
evaluated for
impairment
   
Collectively
evaluated for
impairment
   
Ending balance
   
Individually
evaluated for
impairment
   
Collectively
evaluated for
impairment
   
Ending balance
 
Commercial and industrial
 
$
41
   
$
2,574
   
$
2,615
   
$
7,754
   
$
163,445
   
$
171,199
 
Commercial real estate
   
-
     
6,572
     
6,572
     
11,821
     
452,739
     
464,560
 
Multifamily
   
-
     
2,159
     
2,159
     
-
     
184,624
     
184,624
 
Mixed use commercial
   
-
     
54
     
54
     
-
     
4,797
     
4,797
 
Real estate construction
   
-
     
88
     
88
     
-
     
6,565
     
6,565
 
Residential mortgages
   
709
     
1,754
     
2,463
     
5,049
     
164,503
     
169,552
 
Home equity
   
93
     
652
     
745
     
1,082
     
56,030
     
57,112
 
Consumer
   
102
     
139
     
241
     
284
     
10,155
     
10,439
 
Unallocated
   
-
     
2,326
     
2,326
     
-
     
-
     
-
 
Total
 
$
945
   
$
16,318
   
$
17,263
   
$
25,990
   
$
1,042,858
   
$
1,068,848
 

The following table presents the Company’s impaired loans disaggregated by class at September 30, 2014 and December 31, 2013 (in thousands).

   
September 30, 2014
   
December 31, 2013
 
   
Unpaid
Principal
Balance
   
Recorded
Balance
   
Allowance
Allocated
   
Unpaid
Principal
Balance
   
Recorded
Balance
   
Allowance
Allocated
 
With no allowance recorded:
                       
Commercial and industrial
 
$
6,473
   
$
6,473
   
$
-
   
$
6,711
   
$
6,711
   
$
-
 
Commercial real estate
   
10,633
     
10,215
     
-
     
12,239
     
11,821
     
-
 
Residential mortgages
   
2,452
     
2,323
     
-
     
2,305
     
2,176
     
-
 
Home equity
   
714
     
714
     
-
     
891
     
891
     
-
 
Consumer
   
139
     
139
     
-
     
25
     
9
     
-
 
Subtotal
   
20,411
     
19,864
     
-
     
22,171
     
21,608
     
-
 
                                                 
With an allowance recorded:
                                               
Commercial and industrial
   
63
     
63
     
21
     
1,043
     
1,043
     
41
 
Residential mortgages
   
2,859
     
2,859
     
706
     
2,873
     
2,873
     
709
 
Home equity
   
327
     
190
     
96
     
328
     
191
     
93
 
Consumer
   
188
     
188
     
92
     
274
     
275
     
102
 
Subtotal
   
3,437
     
3,300
     
915
     
4,518
     
4,382
     
945
 
Total
 
$
23,848
   
$
23,164
   
$
915
   
$
26,689
   
$
25,990
   
$
945
 

The following table presents the Company’s average recorded investment in impaired loans and the related interest income recognized disaggregated by class for the three and nine months ended September 30, 2014 and 2013 (in thousands). No interest income was recognized on a cash basis on impaired loans for the periods presented.

   
Three Months Ended September 30,
   
Nine Months Ended September 30,
 
   
2014
   
2013
   
2014
   
2013
 
   
Average
recorded
investment in
impaired
loans
   
Interest
income
recognized on
impaired
loans
   
Average
recorded
investment in
impaired
loans
   
Interest
income
recognized on
impaired
loans
   
Average
recorded
investment in
impaired
loans
   
Interest
income
recognized on
impaired
loans
   
Average
recorded
investment in
impaired
loans
   
Interest
income
recognized on
impaired
loans
 
Commercial and industrial
 
$
7,061
   
$
128
   
$
12,695
   
$
47
   
$
7,304
   
$
679
   
$
12,799
   
$
279
 
Commercial real estate
   
10,424
     
49
     
8,406
     
224
     
11,045
     
204
     
8,635
     
369
 
Real estate construction
   
-
     
-
     
-
     
80
     
-
     
-
     
683
     
94
 
Residential mortgages
   
5,148
     
24
     
5,202
     
73
     
5,069
     
100
     
5,098
     
167
 
Home equity
   
811
     
6
     
1,174
     
4
     
767
     
26
     
1,092
     
8
 
Consumer
   
289
     
7
     
183
     
-
     
222
     
14
     
192
     
8
 
Total
 
$
23,733
   
$
214
   
$
27,660
   
$
428
   
$
24,407
   
$
1,023
   
$
28,499
   
$
925
 

TDRs are modifications or renewals where the Company has granted a concession to a borrower in financial distress. The Company reviews all modifications and renewals for determination of TDR status. The Company allocated $698 thousand and $586 thousand of specific reserves to customers whose loan terms have been modified as TDRs as of September 30, 2014 and December 31, 2013, respectively. These loans involved the restructuring of terms to allow customers to mitigate the risk of default by meeting a lower payment requirement based upon their current cash flow. These may also include loans that renewed at existing contractual rates, but below market rates for comparable credit.

A total of $250 thousand was committed to be advanced in connection with TDRs at September 30, 2014 and December 31, 2013, representing the amount the Company is legally required to advance under existing loan agreements. These loans are not in default under the terms of the loan agreements and are accruing interest. It is the Company’s policy to evaluate advances on such loans on a case by case basis. Absent a legal obligation to advance pursuant to the terms of the loan agreement, the Company generally will not advance funds for which it has outstanding commitments, but may do so in certain circumstances.
Outstanding TDRs, disaggregated by class, at September 30, 2014 and December 31, 2013 are as follows (dollars in thousands):
 
   
September 30, 2014
   
December 31, 2013
 
TDRs Outstanding
 
Number of
Loans
   
Outstanding
Recorded
Balance
   
Number of
Loans
   
Outstanding
Recorded
Balance
 
Commercial and industrial
   
36
   
$
4,926
     
43
   
$
6,022
 
Commercial real estate
   
8
     
10,172
     
7
     
6,022
 
Residential mortgages
   
19
     
4,089
     
17
     
3,891
 
Home equity
   
3
     
205
     
-
     
-
 
Consumer
   
7
     
285
     
3
     
150
 
Total
   
73
   
$
19,677
     
70
   
$
16,085
 

The following presents, disaggregated by class, information regarding TDRs executed during the three and nine months ended September 30, 2014 and 2013 (dollars in thousands):

   
Three Months Ended September 30,
 
   
2014
   
2013
 
       
Pre-Modification
   
Post-Modification
       
Pre-Modification
   
Post-Modification
 
   
Number
   
Outstanding
   
Outstanding
   
Number
   
Outstanding
   
Outstanding
 
   
of
   
Recorded
   
Recorded
   
of
   
Recorded
   
Recorded
 
New TDRs
 
Loans
   
Balance
   
Balance
   
Loans
   
Balance
   
Balance
 
Commercial and industrial
   
-
   
$
-
   
$
-
     
1
   
$
228
   
$
228
 
Residential mortgages
   
-
     
-
     
-
     
1
     
19
     
19
 
Home equity
   
1
     
98
     
98
     
-
     
-
     
-
 
Consumer
   
1
     
46
     
46
     
-
     
-
     
-
 
Total
   
2
   
$
144
   
$
144
     
2
   
$
247
   
$
247
 

   
Nine Months Ended September 30,
 
   
2014
   
2013
 
       
Pre-Modification
   
Post-Modification
       
Pre-Modification
   
Post-Modification
 
   
Number
   
Outstanding
   
Outstanding
   
Number
   
Outstanding
   
Outstanding
 
   
of
   
Recorded
   
Recorded
   
of
   
Recorded
   
Recorded
 
New TDRs
 
Loans
   
Balance
   
Balance
   
Loans
   
Balance
   
Balance
 
Commercial and industrial
   
10
   
$
1,877
   
$
1,877
     
5
   
$
1,120
   
$
1,120
 
Commercial real estate
   
2
     
5,161
     
5,161
     
-
     
-
     
-
 
Residential mortgages
   
3
     
273
     
273
     
4
     
924
     
924
 
Home equity
   
3
     
207
     
207
     
-
     
-
     
-
 
Consumer
   
4
     
145
     
145
     
1
     
17
     
17
 
Total
   
22
   
$
7,663
   
$
7,663
     
10
   
$
2,061
   
$
2,061
 

Presented below and disaggregated by class is information regarding loans modified as TDRs that had payment defaults of 90 days or more within twelve months of restructuring during the nine months ended September 30, 2014 and 2013 (dollars in thousands). There were no such loans during the three months ended September 30, 2014 and 2013.

   
Nine Months Ended September 30,
 
   
2014
   
2013
 
       
Outstanding
       
Outstanding
 
   
Number
   
Recorded
   
Number
   
Recorded
 
Defaulted TDRs
 
of Loans
   
Balance
   
of Loans
   
Balance
 
Commercial real estate
   
2
   
$
1,536
     
-
   
$
-
 
Total
   
2
   
$
1,536
     
-
   
$
-
 

Not all loan modifications are TDRs. In some cases, the Company might provide a concession, such as a reduction in interest rate, but the borrower is not experiencing financial distress. This could be the case if the Company is matching a competitor’s interest rate.

The following presents information regarding modifications executed during the three and nine months ended September 30, 2014 and 2013 that are not considered TDRs (dollars in thousands):

   
Three Months Ended September 30,
 
   
2014
   
2013
 
       
Outstanding
       
Outstanding
 
   
Number
   
Recorded
   
Number
   
Recorded
 
Non-TDR Modifications
 
of Loans
   
Balance
   
of Loans
   
Balance
 
Commercial and industrial
   
1
   
$
67
     
11
   
$
2,240
 
Commercial real estate
   
2
     
11,017
     
11
     
6,367
 
Multifamily
   
-
     
-
     
1
     
410
 
Total
   
3
   
$
11,084
     
23
   
$
9,017
 

   
Nine Months Ended September 30,
 
   
2014
   
2013
 
       
Outstanding
       
Outstanding
 
   
Number
   
Recorded
   
Number
   
Recorded
 
Non-TDR Modifications
 
of Loans
   
Balance
   
of Loans
   
Balance
 
Commercial and industrial
   
1
   
$
67
     
19
   
$
6,741
 
Commercial real estate
   
14
     
34,798
     
31
     
32,485
 
Multifamily
   
-
     
-
     
1
     
410
 
Total
   
15
   
$
34,865
     
51
   
$
39,636
 

The following table presents a summary of non-performing assets for each period (in thousands):

   
September 30, 2014
   
December 31, 2013
 
Non-accrual loans
 
$
14,654
   
$
15,183
 
Non-accrual loans held for sale
   
-
     
-
 
Loans 90 days past due and still accruing
   
-
     
-
 
OREO
   
-
     
-
 
Total non-performing assets
 
$
14,654
   
$
15,183
 
TDRs accruing interest
 
$
8,194
   
$
10,647
 
TDRs non-accruing
 
$
11,483
   
$
5,438
 

At September 30, 2014 and December 31, 2013, non-accrual loans disaggregated by class were as follows (dollars in thousands):

   
September 30, 2014
   
December 31, 2013
 
   
Non-
accrual
loans
   
% of
Total
   
Total Loans
   
% of Total
Loans
   
Non-
accrual
loans
   
% of
Total
   
Total Loans
   
% of Total
 Loans
 
Commercial and industrial
 
$
4,946
     
33.7
%
 
$
180,399
     
0.4
%
 
$
5,014
     
33.0
%
 
$
171,199
     
0.4
%
Commercial real estate
   
6,650
     
45.4
     
512,341
     
0.5
     
7,492
     
49.3
     
464,560
     
0.7
 
Multifamily
   
-
     
-
     
274,352
     
-
     
-
     
-
     
184,624
     
-
 
Mixed use commercial
   
-
     
-
     
27,476
     
-
     
-
     
-
     
4,797
     
-
 
Real estate construction
   
-
     
-
     
21,615
     
-
     
-
     
-
     
6,565
     
-
 
Residential mortgages
   
2,457
     
16.8
     
185,856
     
0.2
     
1,897
     
12.5
     
169,552
     
0.2
 
Home equity
   
557
     
3.8
     
52,001
     
0.1
     
647
     
4.3
     
57,112
     
0.1
 
Consumer
   
44
     
0.3
     
8,021
     
-
     
133
     
0.9
     
10,439
     
-
 
Total
 
$
14,654
     
100.0
%
 
$
1,262,061
     
1.2
%
 
$
15,183
     
100.0
%
 
$
1,068,848
     
1.4
%

Additional interest income of approximately $185 thousand and $208 thousand would have been recorded during the three months ended September 30, 2014 and 2013, respectively, and $824 thousand and $894 thousand during the nine months ended September 30, 2014 and 2013, respectively, if non-accrual loans had performed in accordance with their original terms.

The following table presents the collateral value securing non-accrual loans for each period (in thousands):

   
September 30, 2014
   
December 31, 2013
 
   
Principal
Balance
   
Collateral
Value
   
Principal
Balance
   
Collateral
Value
 
Commercial and industrial (1)
 
$
4,946
   
$
2,500
   
$
5,014
   
$
3,750
 
Commercial real estate
   
6,650
     
9,960
     
7,492
     
13,050
 
Residential mortgages
   
2,457
     
5,279
     
1,897
     
3,764
 
Home equity
   
557
     
3,476
     
647
     
3,072
 
Consumer
   
44
     
-
     
133
     
-
 
Total
 
$
14,654
   
$
21,215
   
$
15,183
   
$
23,636
 
(1) Repayment of commercial and industrial loans is expected primarily from the cash flow of the business. The collateral typically securing these loans is a lien on all corporate assets via a blanket UCC filing and does not usually include real estate. For purposes of this disclosure, the Company has ascribed no value to the non-real estate collateral for this class of loans.
 

At September 30, 2014 and December 31, 2013, past due loans disaggregated by class were as follows (in thousands).

   
Past Due
         
September 30, 2014
 
30 - 59 days
   
60 - 89 days
   
90 days and over
   
Total
   
Current
   
Total
 
Commercial and industrial
 
$
95
   
$
-
   
$
4,946
   
$
5,041
   
$
175,358
   
$
180,399
 
Commercial real estate
   
-
     
-
     
6,650
     
6,650
     
505,691
     
512,341
 
Multifamily
   
-
     
-
     
-
     
-
     
274,352
     
274,352
 
Mixed use commercial
   
-
     
-
     
-
     
-
     
27,476
     
27,476
 
Real estate construction
   
-
     
-
     
-
     
-
     
21,615
     
21,615
 
Residential mortgages
   
1,684
     
297
     
2,457
     
4,438
     
181,418
     
185,856
 
Home equity
   
1,014
     
75
     
557
     
1,646
     
50,355
     
52,001
 
Consumer
   
40
     
33
     
44
     
117
     
7,904
     
8,021
 
Total
 
$
2,833
   
$
405
   
$
14,654
   
$
17,892
   
$
1,244,169
   
$
1,262,061
 
% of Total Loans
   
0.2
%
   
0.0
%
   
1.2
%
   
1.4
%
   
98.6
%
   
100.0
%

   
Past Due
         
December 31, 2013
 
30 - 59 days
   
60 - 89 days
   
90 days and over
   
Total
   
Current
   
Total
 
Commercial and industrial
 
$
13
   
$
-
   
$
5,014
   
$
5,027
   
$
166,172
   
$
171,199
 
Commercial real estate
   
631
     
-
     
7,492
     
8,123
     
456,437
     
464,560
 
Multifamily
   
-
     
-
     
-
     
-
     
184,624
     
184,624
 
Mixed use commercial
   
-
     
-
     
-
     
-
     
4,797
     
4,797
 
Real estate construction
   
-
     
-
     
-
     
-
     
6,565
     
6,565
 
Residential mortgages
   
1,535
     
339
     
1,897
     
3,771
     
165,781
     
169,552
 
Home equity
   
795
     
100
     
647
     
1,542
     
55,570
     
57,112
 
Consumer
   
75
     
-
     
133
     
208
     
10,231
     
10,439
 
Total
 
$
3,049
   
$
439
   
$
15,183
   
$
18,671
   
$
1,050,177
   
$
1,068,848
 
% of Total Loans
   
0.3
%
   
0.0
%
   
1.4
%
   
1.7
%
   
98.3
%
   
100.0
%

The Bank utilizes an eight-grade risk-rating system for commercial and industrial loans, commercial real estate and construction loans. Loans in risk grades 1- 4 are considered pass loans. The Bank’s risk grades are as follows:

Risk Grade 1, Excellent - Loans secured by liquid collateral such as certificates of deposit, reputable bank letters of credit, or other cash equivalents; loans that are guaranteed or otherwise backed by the full faith and credit of the United States government or an agency thereof, such as the Small Business Administration; or loans to any publicly held company with a current long-term debt rating of A or better.

Risk Grade 2, Good -  Loans to businesses that have strong financial statements containing an unqualified opinion from a CPA firm and at least three consecutive years of profits; loans supported by un-audited financial statements containing strong balance sheets, five consecutive years of profits, a five-year satisfactory relationship with the Bank, and key balance sheet and income statement trends that are either stable or positive; loans secured by publicly traded marketable securities where there is no impediment to liquidation; loans to individuals backed by liquid personal assets, established credit history, and unquestionable character; or loans to publicly held companies with current long-term debt ratings of Baa or better.

Risk Grade 3, Satisfactory - Loans supported by financial statements (audited or un-audited) that indicate average or slightly below average risk and having some deficiency or vulnerability to changing economic conditions; loans with some weakness but offsetting features of other support are readily available; loans that are meeting the terms of repayment, but which may be susceptible to deterioration if adverse factors are encountered. Loans may be graded Satisfactory when there is no recent information on which to base a current risk evaluation and the following conditions apply:

· At inception, the loan was properly underwritten, did not possess an unwarranted level of credit risk, and the loan met the above criteria for a risk grade of Excellent, Good, or Satisfactory.

· At inception, the loan was secured with collateral possessing a loan value adequate to protect the Bank from loss.

· The loan has exhibited two or more years of satisfactory repayment with a reasonable reduction of the principal balance.

· During the period that the loan has been outstanding, there has been no evidence of any credit weakness. Some examples of weakness include slow payment, lack of cooperation by the borrower, breach of loan covenants or the borrower is in an industry known to be experiencing problems. If any of these credit weaknesses is observed, a lower risk grade may be warranted.

Risk Grade 4, Satisfactory/Monitored - Loans in this category are considered to be of acceptable credit quality, but contain greater credit risk than satisfactory loans due to weak balance sheets, marginal earnings or cash flow, or other uncertainties. These loans warrant a higher than average level of monitoring to ensure that weaknesses do not advance. The level of risk in a Satisfactory/Monitored loan is within acceptable underwriting guidelines so long as the loan is given the proper level of management supervision.

Risk Grade 5, Special Mention - Loans in this category possess potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or in the institution’s credit position at some future date. Special Mention loans are not adversely classified and do not expose an institution to sufficient risk to warrant adverse classification. The key distinctions of a Special Mention classification are that (1) it is indicative of an unwarranted level of risk and (2) weaknesses are considered potential not defined impairments to the primary source of repayment.
Risk Grade 6, Substandard - One or more of the following characteristics may be exhibited in loans classified Substandard:

· Loans which possess a defined credit weakness. The likelihood that a loan will be paid from the primary source of repayment is uncertain. Financial deterioration is under way and very close attention is warranted to ensure that the loan is collected without loss.

· Loans are inadequately protected by the current net worth and paying capacity of the obligor.

· The primary source of repayment is gone, and the Bank is forced to rely on a secondary source of repayment, such as collateral liquidation or guarantees.

· Loans have a distinct possibility that the Bank will sustain some loss if deficiencies are not corrected.

· Unusual courses of action are needed to maintain a high probability of repayment.

· The borrower is not generating enough cash flow to repay loan principal; however, it continues to make interest payments.

· The lender is forced into a subordinated or unsecured position due to flaws in documentation.

· Loans have been restructured so that payment schedules, terms, and collateral represent concessions to the borrower when compared to the normal loan terms.

· The lender is seriously contemplating foreclosure or legal action due to the apparent deterioration in the loan.

· There is a significant deterioration in market conditions to which the borrower is highly vulnerable.

Risk Grade 7, Doubtful - One or more of the following characteristics may be present in loans classified Doubtful:
 
· Loans have all of the weaknesses of those classified as Substandard. However, based on existing conditions, these weaknesses make full collection of principal highly improbable.
 
· The primary source of repayment is gone, and there is considerable doubt as to the quality of the secondary source of repayment.

· The possibility of loss is high but because of certain important pending factors which may strengthen the loan, loss classification is deferred until the exact status of repayment is known.

Risk Grade 8, Loss - Loans are considered uncollectible and of such little value that continuing to carry them as assets is not feasible. Loans will be classified Loss when it is neither practical nor desirable to defer writing off or reserving all or a portion of a basically worthless asset, even though partial recovery may be possible at some time in the future.
The following presents the Company’s loan portfolio credit risk profile by internally assigned grade disaggregated by class of loan at September 30, 2014 and December 31, 2013 (in thousands).

   
September 30, 2014
   
December 31, 2013
 
   
Grade
       
Grade
     
   
Pass
   
Special mention
   
Substandard
   
Total
   
Pass
   
Special mention
   
Substandard
   
Total
 
Commercial and industrial
 
$
170,467
   
$
1,308
   
$
8,624
   
$
180,399
   
$
158,536
   
$
2,934
   
$
9,729
   
$
171,199
 
Commercial real estate
   
487,532
     
8,985
     
15,824
     
512,341
     
440,505
     
2,817
     
21,238
     
464,560
 
Multifamily
   
274,352
     
-
     
-
     
274,352
     
184,624
     
-
     
-
     
184,624
 
Mixed use commercial
   
27,476
     
-
     
-
     
27,476
     
4,797
     
-
     
-
     
4,797
 
Real estate construction
   
21,615
     
-
     
-
     
21,615
     
6,565
     
-
     
-
     
6,565
 
Residential mortgages
   
181,147
     
-
     
4,709
     
185,856
     
164,559
     
-
     
4,993
     
169,552
 
Home equity
   
51,347
     
-
     
654
     
52,001
     
56,379
     
-
     
733
     
57,112
 
Consumer
   
7,692
     
-
     
329
     
8,021
     
10,156
     
-
     
283
     
10,439
 
Total
 
$
1,221,628
   
$
10,293
   
$
30,140
   
$
1,262,061
   
$
1,026,121
   
$
5,751
   
$
36,976
   
$
1,068,848
 
% of Total
   
96.8
%
   
0.8
%
   
2.4
%
   
100.0
%
   
96.0
%
   
0.5
%
   
3.5
%
   
100.0
%

The Bank annually reviews the ratings on all commercial and industrial, commercial real estate and real estate construction loans greater than $1 million. Semi-annually, the Bank engages an independent third-party to review a significant portion of loans within these loan classes. Management uses the results of these reviews as part of its ongoing review process.

5. EMPLOYEE BENEFITS

Retirement Plan - The Company’s retirement plan is noncontributory and covers substantially all eligible employees. The plan conforms to the provisions of the Employee Retirement Income Security Act of 1974, as amended, and the Pension Protection Act of 2006, which requires certain funding rules for defined benefit plans. The Company’s policy is to accrue for all pension costs and to fund the maximum amount allowable for tax purposes. Actuarial gains and losses that arise from changes in assumptions concerning future events are amortized over a period that reflects the long-term nature of pension expense used in estimating pension costs.

The Company accounts for its retirement plan in accordance with ASC 715, “Compensation – Retirement Benefits” and ASC 960, “Plan Accounting – Defined Benefit Pension Plans,” which require an employer that is a business entity and sponsors one or more single-employer defined benefit plans to recognize the funded status of a benefit plan on its balance sheet; recognize as a component of other comprehensive income, net of tax, the gains or losses and prior service costs or credits that arise during the period but are not recognized as components of net periodic benefit cost; measure defined benefit plan assets and obligation as of the date of fiscal year-end statement of financial position (with limited exceptions); and disclose in the notes to financial statements additional information about certain effects of net periodic benefit cost for the next fiscal year that arise from delayed recognition of the gains or losses, prior service costs or credits, and transition asset and obligation. Plan assets and benefit obligations shall be measured as of the date of its statement of financial position and in determining the amount of net periodic benefit cost. An employer is required to use the same date for the measurement of plan assets as for the statement of condition.

On December 31, 2012, certain provisions of the Company’s retirement plan were changed which affected all participants in this plan and froze the participation of new entrants into the pension plan for all remaining employees in 2012. These changes froze the plan such that no additional pension benefits would accumulate.

The following table summarizes the net periodic pension credit (in thousands):

   
Three Months Ended September 30,
   
Nine Months Ended September 30,
 
   
2014
   
2013
   
2014
   
2013
 
Interest cost
 
$
540
   
$
499
   
$
1,619
   
$
1,495
 
Expected return on plan assets
   
(637
)
   
(577
)
   
(1,911
)
   
(1,727
)
Net amortization
   
6
     
62
     
19
     
184
 
Net periodic pension credit
 
$
(91
)
 
$
(16
)
 
$
(273
)
 
$
(48
)

In December 2012, the Company made an annual minimum contribution of $1 million for the plan year ended September 30, 2013. There was no additional minimum required contribution for the plan year ended September 30, 2013. The Company does not expect to contribute to its pension plan in 2014.

Post-Retirement Benefits other than Pension - The Company formerly provided life insurance benefits to employees meeting eligibility requirements. Employees hired after December 31, 1997 were not eligible for retiree life insurance. No other welfare benefits were provided. In the second quarter of 2013, the Company terminated all post-retirement life insurance benefits and recorded a non-recurring gain of $1.7 million as a credit to employee compensation and benefits expense in the Company’s consolidated statement of operations.

6. STOCK-BASED COMPENSATION
Stock Options
Under the terms of the Company’s stock option plans adopted in 1999 and 2009, options have been granted to key employees and directors to purchase shares of the Company’s stock. Options are awarded by the Compensation Committee of the Board of Directors. Both plans provide that the option price shall not be less than the fair value of the common stock on the date the option is granted. All options are exercisable for a period of ten years or less.

No options were granted during the first nine months of 2014. Options granted in 2013 and 2012 are exercisable over a three-year period commencing one year from the date of grant at a rate of one-third per year. Options granted in 2011 are exercisable over a three-year period commencing three years from the date of grant at a rate of one-third per year.

The total intrinsic value of options exercised during the first nine months of 2014 and 2013 was $145 thousand and $15 thousand, respectively. The total cash received from such option exercises was $246 thousand and $92 thousand, respectively, excluding the tax benefit realized. In exercising those options, 18,735 shares and 6,667 new shares, respectively, of the Company’s common stock were issued.

Both plans provide for but do not require the grant of stock appreciation rights (“SARs”) that the holder may exercise instead of the underlying option. At September 30, 2014, there were 6,000 SARs outstanding related to options granted before 2011. The SARs had no intrinsic value at September 30, 2014. When the SAR is exercised, the underlying option is canceled. The optionee receives shares of common stock or cash with a fair market value equal to the excess of the fair value of the shares subject to the option at the time of exercise (or the portion thereof so exercised) over the aggregate option price of the shares set forth in the option agreement. The exercise of SARs is treated as the exercise of the underlying option.

A summary of stock option activity follows:

       
Weighted-Average
 
   
Number
   
Exercise Price
 
    
of Shares
   
Per Share
 
Outstanding, January 1, 2014
   
291,000
   
$
16.18
 
Granted
   
-
     
-
 
Exercised
   
(18,735
)
 
$
13.18
 
Forfeited or expired
   
(19,165
)
 
$
16.82
 
Outstanding, September 30, 2014
   
253,100
   
$
16.35
 

The following summarizes shares subject to purchase from stock options outstanding and exercisable as of September 30, 2014:

   
Outstanding
   
Exercisable
 
     
 Weighted-Average
       
 Weighted-Average
   
Range of
     
 Remaining
 
Weighted-Average
     
 Remaining
 
Weighted-Average
 
Exercise Prices
   
Shares
 
 Contractual Life
 
Exercise Price
   
Shares
 
 Contractual Life
 
Exercise Price
 
$
10.00 - $14.00
     
120,000
 
 7.4 years
 
$
11.97
     
46,669
 
 7.5 years
 
$
12.81
 
$
14.01 - $20.00
     
106,100
 
 8.8 years
 
$
17.35
     
30,604
 
 8.7 years
 
$
17.02
 
$
20.01 - $30.00
     
5,000
 
 4.3 years
 
$
28.30
     
5,000
 
 4.3 years
 
$
28.30
 
$
30.01 - $40.00
     
22,000
 
 1.8 years
 
$
32.69
     
22,000
 
 1.8 years
 
$
32.69
 
         
253,100
 
 7.4 years
 
$
16.35
     
104,273
 
 6.5 years
 
$
18.99
 

Restricted Stock Awards
Under the Company’s Amended and Restated 2009 Stock Incentive Plan (the “2009 Plan”), the Company can award options, SARs and restricted stock. During the first nine months of 2014, the Company awarded 77,000 shares of restricted stock to certain key employees. The restricted stock awards currently outstanding vest over a three-year period commencing one year from the date of grant at a rate of one-third per year. A summary of restricted stock activity follows:

       
Weighted-Average
 
   
Number
   
Grant-Date
 
   
of Shares
   
Fair Value
 
Nonvested, January 1, 2014
   
-
     
-
 
Granted
   
77,000
   
$
22.51
 
Vested
   
-
     
-
 
Forfeited or expired
   
(3,450
)
 
$
22.51
 
Nonvested, September 30, 2014
   
73,550
   
$
22.51
 

The Company accounts for stock-based compensation on a modified prospective basis with the fair value of grants of employee stock options and restricted stock awards recognized in the financial statements. Compensation expense related to stock-based compensation amounted to $599 thousand and $367 thousand for the nine months ended September 30, 2014 and 2013, respectively. The remaining unrecognized compensation cost of approximately $1.8 million at September 30, 2014 will be expensed over the remaining weighted average vesting period of approximately 2.3 years.

Under the 2009 Plan, a total of 500,000 shares of the Company’s common stock were reserved for issuance, of which 204,948 shares remain for possible issuance at September 30, 2014. There are no remaining shares reserved for issuance under the 1999 Stock Option Plan.

7. INCOME TAXES
The deferred tax assets and liabilities are netted and presented in a single amount which is included in deferred taxes in the accompanying consolidated statements of condition. The realization of deferred tax assets (“DTAs”) (net of a recorded valuation allowance) is largely dependent upon future taxable income, future reversals of existing taxable temporary differences and the ability to carry back losses to available tax years. In assessing the need for a valuation allowance, the Company considers positive and negative evidence, including taxable income in carryback years, scheduled reversals of deferred tax liabilities, expected future taxable income and tax planning strategies. At September 30, 2014 the Company had no remaining Federal net operating loss carryforwards and had net operating loss carryforwards of approximately $15.5 million for New York State (“NYS”) income tax purposes, which may be applied against future taxable income. The Company has a full valuation allowance of $360 thousand, tax effected, on the NYS net operating loss carryforward due to the Company’s significant tax-exempt investment income. The valuation allowance may be reversed to income in future periods to the extent that the related DTAs are realized or when the Company returns to consistent, taxable earnings in NYS. The NYS unused net operating loss carryforwards are expected to expire in varying amounts through the year 2032.

On March 31, 2014, Governor Andrew Cuomo signed legislation to implement the New York State fiscal plan for 2014 – 2015.   This legislation encompasses significant changes to New York’s bank tax regime, most notably by merging the bank tax into the general corporate tax law.  In addition, the new budget law simplifies the code by setting forth a single apportionment factor.  The corporate tax rate will be lowered from 7.1% to 6.5% in 2016.  Furthermore, for community banks (all banks and thrifts with $8 billion or less in assets) there is a subtraction modification for a portion of interest earned on all residential and small business loans with a principal amount of up to $5 million made to New York borrowers. All banks in this category that have a REIT on April 1, 2014, and in the applicable tax year would instead get a deduction based on their REIT's dividends paid deduction. The Company had a qualifying REIT on April 1, 2014 and is less than $8 billion in assets. If a change in a tax law or rate occurs, any existing deferred tax liability or asset must be adjusted. The effect is reflected in operations in the period of the enactment of the change in the tax law or rate. As such, the Company made an adjustment to increase its DTAs resulting in a net income tax credit of $612 thousand in 2014.

Offsetting the net income tax credit, was a $454 thousand income tax expense related to an adjustment of the Company’s stock based compensation included in the DTAs primarily for stock options that had expired or been forfeited by former employees. The adjustment relates primarily to prior periods, but management has determined that it is not material, and as such, included it in the 2014 first quarter’s results.

The Company had unrecognized tax benefits including interest of approximately $34 thousand for all periods presented.
The Company recognizes interest and penalties accrued relating to unrecognized tax benefits in income tax expense. There is no accrued interest relating to uncertain tax positions as of September 30, 2014. The Company files income tax returns in the U.S. federal jurisdiction and in New York State. Federal returns are subject to audits by tax authorities and the Company was audited for the tax years 2010 through 2012. The Company does not expect a significant change in income taxes as a result of this audit as the tax authorities have tentatively accepted the tax returns with no proposed changes.  In 2012, New York State audited the Company and Suffolk Greenway, Inc., a subsidiary of the Bank, for the years 2008, 2009 and 2010 and there was no change as a result of these audits. It is not anticipated that the unrecognized tax benefits will significantly change over the next 12 months.

8. REGULATORY MATTERS
The Company and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital requirements that involve quantitative measures of the Company’s and the Bank’s assets, liabilities and certain off-balance-sheet items calculated under regulatory accounting practices. The Company’s and the Bank’s capital amounts and the Bank’s classification are also subject to qualitative judgments by the regulators about components, risk weighting and other factors.

Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios of total and tier 1 capital, as defined in the federal banking regulations, to risk-weighted assets and of tier 1 capital to adjusted average assets (leverage). Management believes, as of September 30, 2014, that the Company and the Bank met all such capital adequacy requirements to which it is subject.

The Bank’s capital amounts (in thousands) and ratios are as follows:

           
Minimum
   
Minimum to be Well
 
           
for capital
   
Capitalized under prompt
 
   
Actual capital ratios
   
adequacy
   
corrective action provisions
 
   
Amount
   
Ratio
   
Amount
   
Ratio
   
Amount
   
Ratio
 
September 30, 2014
                       
Total capital to risk-weighted assets
 
$
195,388
     
13.97
%
 
$
111,863
     
8.00
%
 
$
139,829
     
10.00
%
Tier 1 capital to risk-weighted assets
   
177,890
     
12.72
%
   
55,932
     
4.00
%
   
83,897
     
6.00
%
Tier 1 capital to adjusted average assets (leverage)
   
177,890
     
10.11
%
   
70,350
     
4.00
%
   
87,938
     
5.00
%
                                                 
December 31, 2013
                                               
Total capital to risk-weighted assets
 
$
181,952
     
14.92
%
 
$
97,542
     
8.00
%
 
$
121,927
     
10.00
%
Tier 1 capital to risk-weighted assets
   
166,683
     
13.67
%
   
48,771
     
4.00
%
   
73,156
     
6.00
%
Tier 1 capital to adjusted average assets (leverage)
   
166,683
     
9.74
%
   
68,454
     
4.00
%
   
85,567
     
5.00
%

The Company’s tier 1 leverage, tier 1 risk-based and total risk-based capital ratios were 10.21%, 12.84% and 14.09%, respectively, at September 30, 2014 versus 9.81%, 13.77% and 15.02%, respectively, at December 31, 2013.

The ability of the Bank to pay dividends to the Company is subject to certain regulatory restrictions. Generally, dividends declared in a given year by a national bank are limited to its net profit, as defined by regulatory agencies, for that year, combined with its retained net income for the preceding two years, less any required transfer to surplus or to fund for the retirement of any preferred stock. In addition, a national bank may not pay dividends in an amount greater than its undivided profits or declare any dividends if such declaration would leave the bank inadequately capitalized.

In July 2013, the OCC approved new rules on regulatory capital applicable to national banks, implementing Basel III. Most banking organizations are required to apply the new capital rules on January 1, 2015. The final rules set a new common equity tier 1 requirement and higher minimum tier 1 requirements for all banking organizations. They also place limits on capital distributions and certain discretionary bonus payments if a banking organization does not maintain a buffer of common equity tier 1 capital above minimum capital requirements. The rules revise the prompt corrective action framework to incorporate the new regulatory capital minimums. They also enhance risk sensitivity and address weaknesses identified over recent years with the measure of risk-weighted assets, including through new measures of creditworthiness to replace references to credit ratings, consistent with section 939A of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”). Based on our capital levels and balance sheet composition at September 30, 2014, we believe implementation of the new rules will not have a material impact on our capital needs.
9. FAIR VALUE
Fair value measurement is determined based on the assumptions that market participants would use in pricing the asset or liability in an exchange. The definition of fair value includes the exchange price which is the price in an orderly transaction between market participants to sell an asset or transfer a liability in the principal market for the asset or liability. Market participant assumptions include assumptions about risk, the risk inherent in a particular valuation technique used to measure fair value and/or the risk inherent in the inputs to the valuation technique, as well as the effect of credit risk on the fair value of liabilities. The Company uses three levels of the fair value inputs to measure assets, as described below.

Basis of Fair Value Measurement:

Level 1 – Valuations based on quoted prices in active markets for identical investments.

Level 2 – Valuations based on quoted prices in markets that are not active or for which all significant inputs are observable, either directly or indirectly. Level 2 inputs include: (i) quoted prices for similar investments in active markets, (ii) quoted prices for identical investments traded in non-active markets (i.e., dealer or broker markets) and (iii) inputs other than quoted prices that are observable or inputs derived from or corroborated by market data for substantially the full term of the investment.

Level 3 – Valuations based on inputs that are unobservable, supported by little or no market activity, and significant to the overall fair value measurement.

The types of instruments valued based on quoted market prices in active markets include most U.S. Treasury securities. Such instruments are generally classified within Level 1 and Level 2 of the fair value hierarchy. The Company does not adjust the quoted price for such instruments.

The types of instruments valued based on quoted prices in markets that are not active, broker or dealer quotations, or alternative pricing sources with reasonable levels of price transparency include U.S. Government agency securities, state and municipal obligations, MBS, CMOs and corporate bonds. Such instruments are generally classified within Level 2 of the fair value hierarchy.

The types of instruments valued based on significant unobservable inputs that reflect the Company’s own assumptions about the assumptions that market participants would use in pricing an asset or liability are generally classified within Level 3 of the fair value hierarchy.

ASC 820, “Fair Value Measurements and Disclosures,” presents requirements for measuring fair value and for disclosing information about fair value measurements, including a consistent meaning of the term fair value. ASC 820 provides additional guidance in determining fair values when the volume and level of activity for the asset or liability have significantly decreased, particularly when there is no active market or where the price inputs being used represent distressed sales. It also provides guidelines for making fair value measurements more consistent with principles, reaffirming the need to use judgment to ascertain if a formerly active market has become inactive and in determining fair values when markets become inactive.
The following table presents the carrying amounts and estimated fair values of the Company’s financial instruments (in thousands).

Level in
 
September 30, 2014
   
December 31, 2013
 
Fair Value
 
Carrying
   
Estimated
   
Carrying
   
Estimated
 
Hierarchy
 
Amount
   
Fair Value
   
Amount
   
Fair Value
 
Cash and due from banks
Level 1
 
$
70,152
   
$
70,152
   
$
131,352
   
$
131,352
 
Cash equivalents
Level 2
   
1,000
     
1,000
     
1,000
     
1,000
 
Interest-bearing time deposits in other banks
Level 2
   
10,000
     
10,020
     
10,000
     
10,000
 
Federal Reserve Bank, Federal Home Loan
 
                               
Bank and other stock
N/A
   
3,200
     
N/A
   
2,863
     
N/A
Investment securities held to maturity
Level 2
   
62,323
     
63,942
     
11,666
     
12,234
 
Investment securities available for sale
Level 2
   
308,589
     
308,589
     
400,780
     
400,780
 
Loans held for sale
Level 2
   
-
     
-
     
175
     
175
 
Loans, net of allowance
Level 2, 3 (1)
   
1,243,261
     
1,235,732
     
1,051,585
     
1,056,279
 
Bank owned life insurance
Level 3
   
44,791
     
44,791
     
38,755
     
38,755
 
Accrued interest and loan fees receivable
Level 2
   
6,227
     
6,227
     
5,441
     
5,441
 
Non-maturity deposits
Level 2
   
1,356,343
     
1,356,343
     
1,284,982
     
1,284,982
 
Time deposits
Level 2
   
224,426
     
224,860
     
225,079
     
225,946
 
Accrued interest payable
Level 2
   
149
     
149
     
160
     
160
 

(1) Impaired loans are generally classified within Level 3 of the fair value hierarchy.

Fair value estimates are made at a specific point in time and may be based on judgments regarding losses expected in the future, risk, and other factors that are subjective in nature. The methods and assumptions used to produce the fair value estimates follow.

The Company records investments available for sale and mortgage servicing rights at fair value. For cash and due from banks, cash equivalents, bank owned life insurance, accrued interest and loan fees receivable, non-maturity deposits and accrued interest payable, the carrying amount is a reasonable estimate of fair value. Interest-bearing time deposits in other banks and time deposits are valued using a replacement cost of funds approach.

Fair values are estimated for portfolios of loans with similar characteristics. The fair value of performing loans was calculated by discounting projected cash flows through their estimated maturity using market discount rates that reflect the general credit and interest rate characteristics of the loan category. The maturity horizon is based on the Bank’s history of repayments for each type of loan and an estimate of the effect of current economic conditions. Fair value for significant non-performing loans is based on recent external appraisals of collateral, if any. If appraisals are not available, estimated cash flows are discounted using a rate commensurate with the associated risk. Assumptions regarding credit risk, cash flows, and discount rates are made using available market information and specific borrower information.

Loans identified as impaired are measured using one of three methods: the loan’s observable market price, the fair value of collateral less estimated costs to sell or the present value of expected future cash flows. Those measured using the loan’s observable market price or the fair value of collateral are recorded at fair value. For each period presented, no impaired loans were measured using the loan’s observable market price. If an impaired loan has had a charge-off or if the fair value of the collateral is less than the recorded investment in the loan, the Company establishes a specific reserve and reports the loan as non-recurring Level 3. The fair value of collateral of impaired loans is generally based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value.

The fair value of loans held for sale is based on observable inputs in the secondary market.

OREO properties are initially recorded at fair value, less estimated costs to sell when acquired, establishing a new cost basis. Adjustments to OREO are measured at fair value, less estimated costs to sell. Fair values are generally based on third party appraisals or realtor evaluations of the property. These appraisals and evaluations may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification. In cases where the carrying amount exceeds the fair value, less estimated costs to sell, an impairment loss is recognized through a valuation allowance, and the property is reported as non-recurring Level 3.
The fair value of commitments to extend credit is estimated by either discounting cash flows or using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the current creditworthiness of the counter-parties. The estimated fair value of written financial guarantees and letters of credit is based on fees currently charged for similar agreements. The fees charged for the commitments were not material in amount.

During the third and fourth quarters of 2013, the Company entered into derivative swap contracts with the purchaser of its Visa Class B shares. The fair value of these derivatives is measured using an internal model that includes the use of probability weighted scenarios for estimates of Visa’s aggregate exposure to the litigation matters, with consideration of amounts funded by Visa into its escrow account for this litigation. As a result, the Company estimates a fair value for these derivatives at 12% of the net sale proceeds from the Company’s sale of the related Visa Class B shares. Since this estimation process requires application of judgment in developing significant unobservable inputs used to determine the possible outcomes and the probability weighting assigned to each scenario, these derivatives have been classified as Level 3 within the valuation hierarchy. (See also Note 3. Investment Securities contained herein.)

The following presents fair value measurements on a recurring basis at September 30, 2014 and December 31, 2013 (in thousands):
 
       
Fair Value Measurements Using
 
       
Significant Other
   
Significant
 
       
Observable Inputs
   
Unobservable Inputs
 
Assets:
 
September 30, 2014
   
(Level 2)
   
(Level 3)
 
U.S. Government agency securities
 
$
41,008
   
$
41,008
   
$
-
 
Corporate bonds
   
6,350
     
6,350
     
-
 
Collateralized mortgage obligations
   
22,745
     
22,745
     
-
 
Mortgage-backed securities
   
92,313
     
92,313
     
-
 
Obligations of states and political subdivisions
   
146,173
     
146,173
     
-
 
Loans held for sale
   
-
     
-
     
-
 
Mortgage servicing rights
   
2,173
     
-
     
2,173
 
Total
 
$
310,762
   
$
308,589
   
$
2,173
 
                         
Liabilities:
                       
Derivatives
   
932
   
$
-
   
$
932
 
Total
 
$
932
   
$
-
   
$
932
 

       
Fair Value Measurements Using
 
       
Significant Other
   
Significant
 
       
Observable Inputs
   
Unobservable Inputs
 
Assets:
 
December 31, 2013
   
(Level 2)
   
(Level 3)
 
U.S. Government agency securities
 
$
100,095
   
$
100,095
   
$
-
 
Corporate bonds
   
15,651
     
15,651
     
-
 
Collateralized mortgage obligations
   
30,104
     
30,104
     
-
 
Mortgage-backed securities
   
97,767
     
97,767
     
-
 
Obligations of states and political subdivisions
   
157,163
     
157,163
     
-
 
Loans held for sale
   
175
     
175
     
-
 
Mortgage servicing rights
   
2,163
     
-
     
2,163
 
Total
 
$
403,118
   
$
400,955
   
$
2,163
 
                         
Liabilities:
                       
Derivatives
   
932
   
$
-
   
$
932
 
Total
 
$
932
   
$
-
   
$
932
 

Reconciliations for assets and liabilities measured at fair value on a recurring basis using significant unobservable inputs (Level 3) follow (in thousands).
 
Fair Value Measurements Using Significant Unobservable Inputs (Level 3)
 
   
Three Months Ended September 30,
 
   
2014
   
2013
 
   
Assets
   
Liabilities
   
Assets
   
Liabilities
 
   
Mortgage
Servicing Rights
   
Derivatives
   
Mortgage
Servicing Rights
   
Derivatives
 
Balance, July 1
 
$
2,172
   
$
932
   
$
2,136
   
$
-
 
Net increase
   
1
     
-
     
33
     
460
 
Balance, September 30
 
$
2,173
   
$
932
   
$
2,169
   
$
460
 

Fair Value Measurements Using Significant Unobservable Inputs (Level 3)
 
   
Nine Months Ended September 30,
 
   
2014
   
2013
 
   
Assets
   
Liabilities
   
Assets
   
Liabilities
 
   
Mortgage
 Servicing Rights
   
Derivatives
   
Mortgage
Servicing Rights
   
Derivatives
 
Balance, January 1
 
$
2,163
   
$
932
   
$
1,856
   
$
-
 
Net increase
   
10
     
-
     
313
     
460
 
Balance, September 30
 
$
2,173
   
$
932
   
$
2,169
   
$
460
 

Assets measured at fair value on a non-recurring basis are as follows (in thousands):

Assets:
 
September 30, 2014
   
Fair Value
Measurements Using
Significant Unobservable
Inputs (Level 3)
 
Impaired loans
 
$
16,361
   
$
16,361
 
Total
 
$
16,361
   
$
16,361
 

Assets:
 
December 31, 2013
   
Fair Value
Measurements Using
Significant Unobservable
Inputs (Level 3)
 
Impaired loans
 
$
16,942
   
$
16,942
 
Total
 
$
16,942
   
$
16,942
 
 
10. LEGAL PROCEEDINGS
Certain lawsuits and claims arising in the ordinary course of business have been filed or are pending against us or our affiliates. In accordance with applicable accounting guidance, we establish accruals for all lawsuits, claims and expected settlements when we believe it is probable that a loss has been incurred and the amount of the loss is reasonably estimable. When a loss contingency is not both probable and estimable, we do not establish an accrual. Any such loss estimates are inherently uncertain, based on currently available information and are subject to management’s judgment and various assumptions. Due to the inherent subjectivity of these estimates and unpredictability of outcomes of legal proceedings, any amounts accrued may not represent the ultimate resolution of such matters.
To the extent we believe any potential loss relating to such lawsuits and claims may have a material impact on our liquidity, consolidated financial position, results of operations, and/or our business as a whole and is reasonably possible but not probable, we disclose information relating to any such potential loss, whether in excess of any established accruals or where there is no established accrual. We also disclose information relating to any material potential loss that is probable but not reasonably estimable. Where reasonably practicable, we will provide an estimate of loss or range of potential loss. No disclosures are generally made for any loss contingencies that are deemed to be remote.

Based upon information available to us and our review of lawsuits and claims filed or pending against us to date, we have not recognized a material accrual liability for these matters, nor do we currently expect it is reasonably possible that these matters will result in a material liability to the Company. However, the outcome of litigation and other legal and regulatory matters is inherently uncertain, and it is possible that one or more of such matters currently pending or threatened could have an unanticipated material adverse effect on our liquidity, consolidated financial position, results of operations, and/or our business as a whole, in the future.

ITEM 2. - MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Safe Harbor Statement Pursuant to the Private Securities Litigation Reform Act of 1995 - Certain statements contained in this discussion are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. These can include remarks about the Company, the banking industry, the economy in general, expectations of the business environment in which the Company operates, projections of future performance, and potential future credit experience. These remarks are based upon current management expectations, and may, therefore, involve risks and uncertainties that cannot be predicted or quantified and are beyond the Company’s control and are subject to a variety of uncertainties that could cause future results to vary materially from the Company’s historical performance, or from current expectations. These remarks may be identified by such forward-looking statements as “should,” “expect,” “believe,” “view,” “opportunity,” “allow,” “continues,” “reflects,” “typically,” “usually,” “anticipate,” or similar statements or variations of such terms. Factors that could affect the Company include particularly, but are not limited to: increased capital requirements mandated by the Company’s regulators; the Company’s ability to raise capital; competitive factors, including price competition; changes in interest rates; increases or decreases in retail and commercial economic activity in the Company’s market area; variations in the ability and propensity of consumers and businesses to borrow, repay, or deposit money, or to use other banking and financial services; results of regulatory examinations or changes in law, regulations or regulatory practices; the Company’s ability to attract and retain key management and staff; any failure by the Company to maintain effective internal control over financial reporting; larger-than-expected losses from the sale of assets; and the potential that net charge-offs are higher than expected or for further increases in our provision for loan losses. Further, it could take the Company longer than anticipated to implement its strategic plans to increase revenue and manage non-interest expense, or it may not be possible to implement those plans at all. Finally, new and unanticipated legislation, regulation, or accounting standards may require the Company to change its practices in ways that materially change the results of operations. We have no obligation to update any forward-looking statements to reflect events or circumstances after the date of this document. For more information, see the risk factors described in the Company’s Annual Report on Form 10-K and other filings with the Securities and Exchange Commission.

Non-GAAP Disclosure - This discussion includes non-GAAP financial measures of the Company’s tangible common equity (“TCE”) ratio, tangible common equity and tangible assets. A non-GAAP financial measure is a numerical measure of historical or future financial performance, financial position or cash flows that excludes or includes amounts that are required to be disclosed in the most directly comparable measure calculated and presented in accordance with U.S. GAAP. The Company believes that these non-GAAP financial measures provide both management and investors a more complete understanding of the underlying operational results and trends and the Company’s marketplace performance. The presentation of this additional information is not meant to be considered in isolation or as a substitute for the numbers prepared in accordance with U.S. GAAP and may not be comparable to similarly titled measures used by other financial institutions.

Executive Summary - The Company is a one-bank holding company incorporated in 1985. The Company operates as the parent for its wholly owned subsidiary, the Bank, a national bank founded in 1890. The income of the Company is primarily derived through the operations of the Bank and the REIT.

The Bank is a full-service bank serving the needs of its local residents through 26 branches, in Nassau and Suffolk Counties, New York and loan production offices in Garden City and Melville, New York. The Bank’s 26 branches include the two recently opened in Melville and Garden City in June 2014 and December 2013, respectively. The Bank offers a full line of domestic commercial and retail banking services and wealth management services. The Bank’s primary lending area includes all of Suffolk County and the adjacent markets of Nassau County and New York City. The Bank makes commercial real estate floating and fixed rate loans, commercial and industrial loans to manufacturers, wholesalers, distributors, developers/contractors and retailers and agricultural loans. The Bank also makes loans secured by residential mortgages, and both fixed and floating rate second mortgage loans with a variety of plans for repayment. Real estate construction loans are also offered.
In order to expand the Company geographically into western Suffolk and Nassau Counties and to diversify the lending business of the Company, loan production offices were opened in Garden City and Melville in 2013 and 2012, respectively. As part of our strategy to move westward, the loan production office in Garden City serves the major business markets in central and western Long Island. Consistent with that strategy, we have identified Long Island City, Queens, as our next expansion market. We intend to open a loan production office coupled with a small branch in Long Island City to serve Queens and nearby Brooklyn within the next few months. Seasoned banking professionals have joined the Company to augment both interest and fee income through the origination of commercial and industrial loans, the generation of high quality multifamily and jumbo mortgages to be retained in the portfolio and conforming mortgages for sale in secondary markets. The Bank finances most of its activities with deposits, including demand, saving, N.O.W. and money market deposits, as well as time deposits. It may also rely on other sources of funds, including inter-bank overnight loans. The Company’s chief competition includes local banks within its market area, as well as New York City money center banks and regional banks.
 
Financial Performance Summary
As of or for the quarters and nine months ended September 30, 2014 and 2013
(dollars in thousands, except per share data)

           
Over/
             
Over/
   
   
Quarters ended September 30,
   
(under)
     
Nine months ended September 30,
   
(under)
   
 
 
2014
   
2013
   
2013
     
2014
   
2013
   
2013
   
Revenue (1)
 
$
18,099
   
$
20,559
     
(12.0
%)
   
$
54,709
   
$
53,829
     
1.6
%
 
Operating expenses (2)
 
$
13,236
   
$
15,090
     
(12.3
%)
   
$
39,697
   
$
41,583
     
(4.5
%)
 
Provision for loan losses
 
$
250
   
$
-
     
N/
M
(4)
 
$
750
   
$
-
     
N/
M
(4)
Net income
 
$
3,738
   
$
3,912
     
(4.4
%)
   
$
11,229
   
$
9,390
     
19.6
%
 
Net income per common share - diluted
 
$
0.32
   
$
0.34
     
(5.9
%)
   
$
0.96
   
$
0.81
     
18.5
%
 
Return on average assets
   
0.84
%
   
0.92
%
   
(8
)
bp
   
0.87
%
   
0.76
%
   
11
 
bp
Return on average stockholders' equity
   
8.18
%
   
9.72
%
   
(154
)
bp
   
8.51
%
   
7.70
%
   
81
 
bp
Tier 1 leverage ratio
   
10.21
%
   
9.66
%
   
55
 
bp
   
10.21
%
   
9.66
%
   
55
 
bp
Tier 1 risk-based capital ratio
   
12.84
%
   
13.94
%
   
(110
)
bp
   
12.84
%
   
13.94
%
   
(110
)
bp
Total risk-based capital ratio
   
14.09
%
   
15.19
%
   
(110
)
bp
   
14.09
%
   
15.19
%
   
(110
)
bp
Tangible common equity ratio (non-GAAP)
   
10.07
%
   
9.21
%
   
86
 
bp
   
10.07
%
   
9.21
%
   
86
 
bp
Total stockholders' equity/total assets (3)
   
10.22
%
   
9.37
%
   
85
 
bp
   
10.22
%
   
9.37
%
   
85
 
bp

bp - denotes basis points; 100 bp equals 1%.
(1) Represents net interest income plus total non-interest income.
(2) Results for the 2013 nine-month period are net of a $1,659 non-recurring gain arising from the termination of post-retirement life insurance benefits during the second quarter of 2013.
(3) The ratio of total stockholders' equity to total assets is the most comparable GAAP measure to the non-GAAP tangible common equity ratio presented herein.
(4) N/M - denotes % variance not meaningful for statistical purposes.

At September 30, 2014, the Company, on a consolidated basis, had total assets of $1.8 billion, total deposits of $1.6 billion and stockholders’ equity of $183 million. The Company recorded net income of $3.7 million, or $0.32 per diluted common share, for the third quarter of 2014, compared to $3.9 million, or $0.34 per diluted common share, for the same period in 2013. The 4.4% reduction in third quarter 2014 reported earnings versus 2013 resulted principally from a $3.8 million pre-tax gain recorded in the third quarter of 2013 on the sale of Visa Class B shares owned by the Company, coupled with a $250 thousand provision for loan losses in 2014. The Company did not record a provision for loan losses in the third quarter of 2013. Partially offsetting these negative factors was a $1.6 million increase in net interest income in 2014, coupled with a $1.9 million reduction in operating expenses when compared to the comparable 2013 period.

The Company’s return on average assets and return on average common stockholders’ equity were 0.84% and 8.18%, respectively, in the third quarter of 2014 versus 0.92% and 9.72%, respectively, in the third quarter of 2013.

The Company experienced an increase in the total loan portfolio of $67 million, from $1.20 billion at June 30, 2014 to $1.26 billion at September 30, 2014, a 5.6% quarterly growth rate. The geographic and product diversification strategies implemented in our lending businesses continue to work well. Each of our lending businesses, commercial, multifamily and residential, have contributed. The Company is increasing market share by preserving our eastern Suffolk lending franchise while simultaneously expanding west. Third quarter loan growth was net of the September 2014 sale of $25 million in performing multifamily loans.
The credit quality of the Company’s loan portfolio remains strong. Notwithstanding the strong loan growth we are experiencing and while we can compete aggressively on price due to the competitive advantage we enjoy on funding costs, we will not compromise on credit quality. Total non-accrual loans on September 30, 2014 were $15 million, or 1.16% of total loans, and a substantial majority of these loans are both well collateralized and performing under negotiated workout agreements with cooperative borrowers. Early delinquencies (30-89 days past due), which are managed aggressively as a potential harbinger of future credit issues, continue to be well controlled at $3.2 million, or 0.25% of total loans. We also believe we are well reserved given the risks in our loan portfolio and the improving economic conditions in our markets. Our allowance for loan losses at September 30, 2014 was $18.8 million, or 1.49% of total loans and 128% of non-accrual loans.

The Company’s core deposit franchise continues to be among the best in the region. Core deposits, consisting of demand, N.O.W., saving and money market deposits, totaled $1.4 billion at September 30, 2014, representing 86% of total deposits at that date. Demand deposits totaled $681 million at September 30, 2014 and represented 43% of total deposits at that date. The deposit product mix continues to be an important strength of the Company and resulted in an average cost of funds of 16 basis points during the third quarter of 2014.

Critical Accounting Policies, Judgments and Estimates - The Company’s accounting and reporting policies conform to U.S. GAAP and general practices within the banking industry. The preparation of the financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and the accompanying notes. Actual results could differ from those estimates.

Allowance  for Loan  Losses - In management’s opinion, one of the most critical accounting policies impacting the Company’s financial statements is the evaluation of the allowance for loan losses. The allowance for loan losses is a valuation allowance for probable incurred losses, increased by the provision for loan losses and recoveries, and decreased by loan charge-offs. For all classes of loans, when a loan, in full or in part, is deemed uncollectible, it is charged against the allowance for loan losses. This happens when the loan is past due and the borrower has not shown the ability or intent to make the loan current, or the borrower does not have sufficient assets to pay the debt, or the value of the collateral is less than the balance of the loan and is not considered likely to improve soon. The allowance for loan losses is determined by a quarterly analysis of the loan portfolio. Such analysis includes changes in the size and composition of the portfolio, the Company’s own historical loan losses, industry-wide losses, current and anticipated economic trends, and details about individual loans. It also includes estimates of the actual value of collateral, other possible sources of repayment and estimates that are susceptible to significant changes due to changes in appraisal values of collateral, national and regional economic conditions and other relevant factors. All non-accrual loans over $250 thousand in the commercial and industrial, commercial real estate and real estate construction loan classes and all TDRs are evaluated individually for impairment. All other loans are generally evaluated as homogeneous pools with similar risk characteristics. In assessing the adequacy of the allowance for loan losses, management reviews the loan portfolio by separate classes that have similar risk and collateral characteristics. These classes are commercial and industrial, commercial real estate, multifamily, mixed use commercial, real estate construction, residential mortgages, home equity and consumer loans.

The allowance for loan losses consists of specific and general components. The specific component relates to loans that are individually classified as impaired. Specific reserves are established based on an analysis of the most probable sources of repayment or liquidation of collateral. Impaired loans that are collateral dependent are reviewed based on the fair market value of collateral and the estimated time required to recover the Company’s investment in the loans, as well as the cost of doing so, and the estimate of the recovery. Non-collateral dependent impaired loans are reviewed based on the present value of estimated future cash flows, including balloon payments, if any, using the loan’s effective interest rate. While every impaired loan is evaluated individually, not every loan requires a specific reserve. Specific reserves fluctuate based on changes in the underlying loans, anticipated sources of repayment, and charge-offs. The general component covers non-impaired loans and is based on historical loss experience for each loan class from a rolling twelve quarter period and modifying those percentages, if necessary, after adjusting for current qualitative and environmental factors that reflect changes in the estimated collectability of the loan class not captured by historical loss data.  These factors augment actual loss experience and help estimate the probability of loss within the loan portfolio based on emerging or inherent risk trends. These qualitative factors are applied as an adjustment to historical loss rates and require judgments that cannot be subjected to exact mathematical calculation. There are no formulas for translating them into a specific basis point adjustment of the Company’s historical loss rate for a pool of loans having similar risk characteristics. These adjustments reflect management’s overall estimate of the extent to which current losses on a pool of loans will differ from historical loss experience. These adjustments are subjective estimates and management reviews them on a quarterly basis. TDRs are also considered impaired with impairment generally measured at the present value of estimated future cash flows using the loan’s effective interest rate at inception or using the fair value of collateral, less estimated costs to sell, if repayment is expected solely from the collateral.

Deferred Tax Assets and Liabilities – Deferred tax assets and liabilities are the expected future tax consequences of temporary differences between the carrying amounts and the tax bases of assets and liabilities, computed using enacted tax rates. Deferred tax assets are recognized if it is more likely than not that a future benefit will be realized. A valuation allowance, if needed, reduces deferred tax assets to the amount expected to be realized.  The realization of deferred tax assets (net of a recorded valuation allowance) is largely dependent upon future taxable income, future reversals of existing taxable temporary differences and the ability to carryback losses to available tax years. In assessing the need for a valuation allowance, the Company considers all relevant positive and negative evidence, including taxable income in carryback years, scheduled reversals of deferred tax liabilities, expected future taxable income and available tax planning strategies.
OTTI of Investment Securities – Management evaluates securities for OTTI on at least a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. For securities in an unrealized loss position, management considers the extent and duration of the unrealized loss, and the financial condition and near-term prospects of the issuer. Management also assesses whether it intends to sell, or it is more likely than not that it will be required to sell, a security in an unrealized loss position before recovery of its amortized cost basis. If either of the criteria regarding intent or requirement to sell is met, the entire difference between amortized cost and fair value is recognized as impairment through earnings. For debt securities that do not meet the aforementioned criteria, the amount of impairment is split into two components as follows: 1) OTTI related to credit loss, which must be recognized in the statement of operations and 2) OTTI related to other factors, which is recognized in other comprehensive income (loss). The credit loss is defined as the difference between the present value of the cash flows expected to be collected and the amortized cost basis. For equity securities, the entire amount of impairment is recognized through earnings.

Material Changes in Financial Condition - Total assets of the Company were $1.8 billion at September 30, 2014. When compared to December 31, 2013, total assets increased by $93 million. This change largely reflects an increase in loans of $193 million, partially offset by a decline in cash and cash equivalents of $61 million as redeployment of lower-yielding overnight interest-bearing deposits into higher yielding assets continued, coupled with a decline in investment securities of $42 million. Total loans were $1.26 billion at September 30, 2014 compared to $1.07 billion at December 31, 2013. The increase in the loan portfolio largely reflects growth of multifamily, CRE, mixed use commercial, residential mortgage and C&I loans of $90 million, $48 million, $23 million, $16 million and $9 million, respectively, during the first nine months of 2014.

Total investment securities were $371 million at September 30, 2014 and $412 million at December 31, 2013. The decrease in the investment portfolio largely reflects sales of corporate bonds, MBS of U.S. Government-sponsored enterprises and U.S. Government agency securities of $9 million, $6 million and $5 million, respectively. In addition, principal paydowns of CMOs and MBS of U.S. Government-sponsored enterprises totaled $10 million and maturities and calls of municipal obligations and U.S. Government agency securities totaled $22 million during the first nine months of 2014. These were partially offset by purchases of municipal obligations totaling $4 million. A reduction in interest rates in 2014 had a positive impact of $4 million on the fair value of the Company’s available for sale investment portfolio.

At September 30, 2014, total deposits were $1.6 billion, an increase of $71 million when compared to December 31, 2013. This increase was primarily due to higher balances of demand deposits, money market deposits and higher-cost time certificates of $100,000 or more of $53 million, $13 million and $7 million, respectively. Core deposit balances, which consist of demand, saving, N.O.W. and money market deposits, represented 86% and 85% of total deposits at September 30, 2014 and December 31, 2013, respectively. Demand deposit balances represented 43% and 42% of total deposits at September 30, 2014 and December 31, 2013, respectively. At September 30, 2014, the Company had $10 million in overnight borrowings outstanding. The Company had no borrowed funds outstanding at December 31, 2013.

Liquidity and Capital Resources - Liquidity management is defined as both the Company’s and the Bank’s ability to meet their financial obligations on a continuous basis without material loss or disruption of normal operations. These obligations include the withdrawal of deposits on demand or at their contractual maturity, the repayment of borrowings as they mature, funding new and existing loan commitments and the ability to take advantage of business opportunities as they arise. Asset liquidity is provided by short-term investments and the marketability of securities available for sale. The Company may also leave excess reserve balances at the FRB if the rate being paid is higher than would be available from other short-term investments. Liquid assets, consisting of federal funds sold, securities available for sale and balances at the FRB, decreased to $328 million at September 30, 2014 compared to $462 million at December 31, 2013 as the Company continued to redeploy its lower-yielding cash balances into loans. These liquid assets may include assets that have been pledged against municipal deposits or short-term borrowings. In addition, the Company has pledged U.S. Government agency securities held in its available for sale portfolio, with a market value of approximately $3 million at September 30, 2014, as collateral for the derivative swap contracts. Liquidity is also provided by the maintenance of a base of core deposits, maturing short-term assets including cash and due from banks, the ability to sell or pledge marketable assets and access to lines of credit.

Liquidity is continuously monitored, thereby allowing management to better understand and react to emerging balance sheet trends, including temporary mismatches with regard to sources and uses of funds. After assessing actual and projected cash flow needs, management seeks to obtain funding at the most economical cost. These funds can be obtained by converting liquid assets to cash or by attracting new deposits or other sources of funding. Many factors affect the Company’s ability to meet liquidity needs, including variations in the markets served, loan demand, its asset/liability mix, its reputation and credit standing in its markets and general economic conditions. Borrowings and the scheduled amortization of investment securities and loans are more predictable funding sources. Deposit flows and securities prepayments are somewhat less predictable as they are often subject to external factors. Among these are changes in the local and national economies, competition from other financial institutions and changes in market interest rates.
The Company’s primary sources of funds are cash provided by deposits and borrowings, proceeds from maturities and sales of securities available for sale and cash provided by operating activities. At September 30, 2014, total deposits were $1.6 billion, an increase of $71 million when compared to December 31, 2013. Of the total time deposits at September 30, 2014, $190 million are scheduled to mature within the next 12 months. Based on historical experience, the Company expects to be able to replace a substantial portion of those maturing deposits with comparable deposit products. At September 30, 2014, there were $10 million in borrowings outstanding which were repaid the next business day. At December 31, 2013, there were no borrowings outstanding. For the nine months ended September 30, 2014 and 2013, proceeds from sales and maturities of securities available for sale totaled $41 million and $35 million, respectively.

The Company’s primary uses of funds are for the origination of loans and the purchase of investment securities. For the nine months ended September 30, 2014, the Company had net loan originations for portfolio of $218 million compared to $223 million for the same period in 2013. The Company purchased investment securities totaling $4 million and $116 million during the nine months ended September 30, 2014 and 2013, respectively.

The Bank’s Asset/Liability and Funds Management Policy establishes specific policies and operating procedures governing liquidity levels to assist management in developing plans to address future and current liquidity needs. Management monitors the rates and cash flows from the loan and investment portfolios while also examining the maturity structure and volatility characteristics of liabilities to develop an optimum asset/liability mix. Available funding sources include retail, commercial and municipal deposits, purchased liabilities and stockholders’ equity. At September 30, 2014, access to approximately $432 million in Federal Home Loan Bank (“FHLB”) lines of credit for overnight or term borrowings with maturities of up to thirty years was available. At September 30, 2014, approximately $60 million and $10 million in unsecured and secured lines of credit, respectively, extended by correspondent banks were also available to be utilized, if needed, for short-term funding purposes. At September 30, 2014, $10 million in overnight borrowings were outstanding with the FHLB. No borrowings were outstanding under lines of credit with correspondent banks.

The Bank also has the ability to access the brokered deposit market. Deposits gathered through the Certificate of Deposit Account Registry Service (“CDARS”) are considered for regulatory purposes to be brokered deposits. At September 30, 2014, the Bank had $4 million in CDARS deposits outstanding.

The Company strives to maintain an efficient level of capital, commensurate with its risk profile, on which a competitive rate of return to stockholders will be realized over both the short and long term. Capital is managed to enhance stockholder value while providing flexibility for management to act opportunistically in a changing marketplace. Management continually evaluates the Company’s capital position in light of current and future growth objectives and regulatory guidelines. Total stockholders’ equity amounted to $183 million at September 30, 2014 and $167 million at December 31, 2013. The increase in stockholders’ equity versus December 31, 2013 was due to a combination of net income, net of dividends paid, recorded during the first nine months of 2014 coupled with a $5 million decrease in accumulated other comprehensive loss, net of tax. The decrease in accumulated other comprehensive loss at September 30, 2014 resulted primarily from the positive impact of a reduction in interest rates in 2014 on the value of the Company’s available for sale investment portfolio.

The Company and the Bank are subject to regulatory capital requirements. The Company’s tier 1 leverage, tier 1 risk-based and total risk-based capital ratios were 10.21%, 12.84% and 14.09%, respectively, at September 30, 2014. The Company’s capital ratios exceeded all regulatory requirements at September 30, 2014. The Bank’s tier 1 leverage, tier 1 risk-based and total risk-based capital ratios were 10.11%, 12.72% and 13.97%, respectively, at September 30, 2014. Each of these ratios exceeds the regulatory guidelines for a well-capitalized institution, the highest regulatory capital category.

The Company did not repurchase any shares of its common stock during the first nine months of 2014. Repurchase of shares will occur only if management believes that the purchase will be at prices that are accretive to earnings per share and is the most efficient use of the Company’s capital.

The Company’s tangible common equity ratio was 10.07% at September 30, 2014 compared to 9.68% at December 31, 2013 and 9.21% at September 30, 2013. The ratio of tangible common equity to tangible assets, or TCE ratio, is calculated by dividing total common stockholders’ equity by total assets, after reducing both amounts by intangible assets. The TCE ratio is not required by GAAP or by applicable bank regulatory requirements, but is a metric used by management to evaluate the adequacy of our capital levels. Since there is no authoritative requirement to calculate the TCE ratio, our TCE ratio is not necessarily comparable to similar capital measures disclosed or used by other companies in the financial services industry. Tangible common equity and tangible assets are non-GAAP financial measures and should be considered in addition to, not as a substitute for or superior to, financial measures determined in accordance with GAAP or as required by bank regulatory agencies. Set forth below are the reconciliations of tangible common equity to GAAP total common stockholders’ equity and tangible assets to GAAP total assets at September 30, 2014 (in thousands):
Total stockholders' equity
 
$
183,197
 
Total assets
 
$
1,793,042
     
10.22
%
(1)
Less: intangible assets
   
(2,987
)
Less: intangible assets
   
(2,987
)
         
Tangible common equity
 
$
180,210
 
Tangible assets
 
$
1,790,055
     
10.07
%
 

(1) The ratio of total stockholders' equity to total assets is the most comparable GAAP measure to the non-GAAP tangible common equity ratio presented herein.

All dividends must conform to applicable statutory requirements. The Company’s ability to pay dividends to stockholders depends on the Bank’s ability to pay dividends to the Company. Under 12 USC 56-9, a national bank may not pay a dividend on its common stock if the dividend would exceed net undivided profits then on hand. Further, under 12 USC 60, a national bank must obtain prior approval from the OCC to pay dividends on either common or preferred stock that would exceed the bank’s net profits for the current year combined with retained net profits (net profits minus dividends paid during that period) of the prior two years. The ability of the Bank to pay dividends to the Company is subject to certain regulatory restrictions. Generally, dividends declared in a given year by a national bank are limited to its net profit, as defined by regulatory agencies, for that year, combined with its retained net income for the preceding two years, less any required transfer to surplus or to fund for the retirement of any preferred stock. In addition, a national bank may not pay dividends in an amount greater than its undivided profits or declare any dividends if such declaration would leave the bank inadequately capitalized.

Off-Balance Sheet Arrangements - The Bank is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby and documentary letters of credit. Those instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the consolidated financial statements. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments.

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. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Bank evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Bank upon extension of credit, is based on management’s credit evaluation of the customer. Collateral required varies, but may include accounts receivable, inventory, equipment, real estate and income-producing commercial properties. At September 30, 2014 and December 31, 2013, commitments to originate loans and commitments under unused lines of credit for which the Bank is obligated amounted to approximately $159 million and $113 million, respectively.

Letters of credit are conditional commitments guaranteeing payments of drafts in accordance with the terms of the letter of credit agreements. Commercial letters of credit are used primarily to facilitate trade or commerce and are also issued to support public and private borrowing arrangements, bond financing and similar transactions. Collateral may be required to support letters of credit based upon management’s evaluation of the creditworthiness of each customer. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Most letters of credit expire within one year. At September 30, 2014 and December 31, 2013, letters of credit outstanding were approximately $19 million and $18 million, respectively.

The Company has recorded a liability of $255 thousand for unfunded commitments at September 30, 2014.

Material Changes in Results of Operations – Comparison of the Quarters Ended September 30, 2014 and 2013 - The Company recorded net income of $3.7 million during the third quarter of 2014 versus $3.9 million in the comparable 2013 period. The decline in third quarter 2014 net income resulted principally from a $4.0 million decrease in non-interest income coupled with a $250 thousand provision for loan losses in 2014. The Company did not record a provision for loan losses in the third quarter of 2013. Partially offsetting these negative factors was a $1.6 million increase in net interest income, a $1.9 million reduction in total operating expenses and a lower effective tax rate in the third quarter of 2014.
The $1.6 million or 11.3% improvement in third quarter 2014 net interest income resulted from a $91 million increase in average total interest-earning assets, coupled with an 18 basis point improvement in the Company’s net interest margin to 4.00% in 2014 versus 3.82% in 2013. The Company’s third quarter 2014 average total interest-earning asset yield was 4.14% versus 4.00% for the comparable 2013 period. Despite a lower average yield on the Company’s loan portfolio, down 48 basis points, in 2014 versus 2013, the Company’s average balance sheet mix continued to improve as average loans increased by $286 million (30.7%) versus third quarter 2013 and low-yielding overnight interest-bearing deposits declined by $143 million (77.3%) during the same period. Liquid investments represented 3% of average total interest-earning assets in the third quarter of 2014 versus 12% a year ago. The average securities portfolio decreased by $52 million to $376 million in the third quarter of 2014 versus the comparable 2013 period. The average yield on the investment portfolio was 3.71% in the third quarter of 2014 versus 3.66% a year ago.

The Company’s average cost of total interest-bearing liabilities declined by six basis points to 0.27% in the third quarter of 2014 versus 0.33% in the third quarter of 2013. The Company’s total cost of funds, historically among the lowest in the industry, declined to 0.16% in the third quarter of 2014 from 0.19% a year ago. The Company’s lower funding cost resulted largely from average core deposits of $1.3 billion in 2014, with average demand deposits representing 43% of third quarter average total deposits. Average total deposits increased by $62 million or 4.1% during the third quarter of 2014 versus 2013. Average core deposit balances represented 85% of total deposits during the same 2014 period.

NET INTEREST INCOME ANALYSIS
For the Three Months Ended September 30, 2014 and 2013
(unaudited, dollars in thousands)

   
2014
   
2013
 
   
Average
       
Average
   
Average
       
Average
 
   
Balance
   
Interest
   
Yield/Cost
   
Balance
   
Interest
   
Yield/Cost
 
Assets:
                       
Interest-earning assets:
                       
Investment securities (1)
 
$
376,097
   
$
3,521
     
3.71
%
 
$
427,867
   
$
3,945
     
3.66
%
Federal Reserve Bank,  Federal Home Loan Bank and other stock
   
2,990
     
42
     
5.57
     
2,916
     
36
     
4.90
 
Federal funds sold and interest-bearing deposits
   
41,978
     
35
     
0.33
     
185,324
     
140
     
0.30
 
Loans (2)
   
1,218,738
     
13,532
     
4.41
     
932,578
     
11,506
     
4.89
 
Total interest-earning assets
   
1,639,803
   
$
17,130
     
4.14
%
   
1,548,685
   
$
15,627
     
4.00
%
Non-interest-earning assets
   
130,711
                     
143,177
                 
Total assets
 
$
1,770,514
                   
$
1,691,862
                 
                                                 
Liabilities and stockholders' equity:
                                               
Interest-bearing liabilities:
                                               
Saving, N.O.W. and money market deposits
 
$
668,850
   
$
291
     
0.17
%
 
$
642,982
   
$
308
     
0.19
%
Time deposits
   
228,207
     
322
     
0.56
     
243,207
     
425
     
0.69
 
Total saving and time deposits
   
897,057
     
613
     
0.27
     
886,189
     
733
     
0.33
 
Borrowings
   
1,957
     
2
     
0.37
     
-
     
-
     
-
 
Total interest-bearing liabilities
   
899,014
     
615
     
0.27
     
886,189
     
733
     
0.33
 
Demand deposits
   
673,441
                     
622,342
                 
Other liabilities
   
16,818
                     
23,650
                 
Total liabilities
   
1,589,273
                     
1,532,181
                 
Stockholders' equity
   
181,241
                     
159,681
                 
Total liabilities and stockholders' equity
 
$
1,770,514
                   
$
1,691,862
                 
Total cost of funds
                   
0.16
%
                   
0.19
%
Net interest rate spread
                   
3.87
%
                   
3.67
%
Net interest income/margin
           
16,515
     
4.00
%
           
14,894
     
3.82
%
Less tax-equivalent basis adjustment
           
(966
)
                   
(922
)
       
Net interest income
         
$
15,549
                   
$
13,972
         

(1) Interest on securities includes the effects of tax-equivalent basis adjustments of $830 and $880 in 2014 and 2013, respectively.
(2) Interest on loans includes the effects of tax-equivalent basis adjustments of $136 and $42 in 2014 and 2013, respectively.
The $250 thousand provision for loan losses recorded during the third quarter of 2014 was due to the growth in the loan portfolio experienced during the past twelve months. The Company did not record a provision for loan losses in the third quarter of 2013. The adequacy of the provision and the resulting allowance for loan losses, which was $18.8 million at September 30, 2014, is determined by management’s ongoing review of the loan portfolio, including identification and review of individual problem situations that may affect a borrower’s ability to repay, delinquency and non-performing loan data including the current status of criticized and classified loans, collateral values and changes in the size and mix of the loan portfolio. (See also Critical Accounting Policies, Judgments and Estimates and Asset Quality contained herein.)

Non-interest income decreased by $4.0 million in the third quarter of 2014 versus the comparable 2013 period principally the result of a $3.8 million pre-tax gain recorded on the sale of Visa Class B shares owned by the Company in 2013. No Visa shares were sold in the 2014 period. Excluding this gain, non-interest income declined by $201 thousand or 7.3% in 2014. This decline was due to reductions in several categories, most notably deposit service charges and other service charges, commissions and fees.  The reduction in other service charges, commissions and fees resulted from a decision to outsource the Company’s investment sales function at the end of the second quarter of 2014. The reduction in fee income associated with this strategic realignment will be more than offset by a reduction in operating expenses from staff eliminations resulting from the outsourcing. Partially offsetting the foregoing reductions in non-interest income was a $217 thousand gain recorded in the third quarter of 2014 from the sale of performing multifamily loans. The Company may opportunistically choose to sell other performing loans in future periods based upon loan growth, interest rates, the shape of the yield curve and other asset/liability factors.

Non-Interest Income
For the quarters and nine months ended September 30, 2014 and 2013
(dollars in thousands)

           
Over/
             
Over/
   
   
Quarters ended September 30,
   
(under)
     
Nine months ended September 30,
   
(under)
   
 
 
2014
   
2013
   
2013
     
2014
   
2013
   
2013
   
Service charges on deposit accounts
 
$
887
   
$
964
     
(8.0
)%
   
$
2,834
   
$
2,839
     
(0.2
)%
 
Other service charges, commissions and fees
   
778
     
928
     
(16.2
)
     
2,349
     
2,451
     
(4.2
)
 
Fiduciary fees
   
265
     
279
     
(5.0
)
     
824
     
815
     
1.1
   
Net gain (loss) on sale of securities available for sale
   
11
     
3
     
266.7
       
(12
)
   
395
     
(103.0
)
 
Net gain on sale of portfolio loans
   
217
     
-
     
N/
M
(1)
   
217
     
445
     
(51.2
)
 
Net gain on sale of mortgage loans originated for sale
   
51
     
142
     
(64.1
)
     
214
     
973
     
(78.0
)
 
Net gain on sale of premises and equipment
   
-
     
-
     
N/
M
(1)
   
752
     
-
     
N/
M
(1)
Gain on Visa shares sold
   
-
     
3,836
     
(100.0
)
     
-
     
3,836
     
(100.0
)
 
Income from bank owned life insurance
   
316
     
357
     
(11.5
)
     
1,036
     
399
     
159.6
   
Other operating income
   
25
     
78
     
(67.9
)
     
106
     
215
     
(50.7
)
 
Total non-interest income
 
$
2,550
   
$
6,587
     
(61.3
)%
   
$
8,320
   
$
12,368
     
(32.7
)%
 

(1) N/M - denotes % variance not meaningful for statistical purposes.

Total operating expenses decreased by $1.9 million or 12.3% in the third quarter of 2014 versus 2013 as a result of expenses recorded in the third quarter of 2013 incurred in closing two branch offices ($596 thousand) and a reserve, excluding carrying costs,  established for potential future reductions in the Visa Class B conversion ratio ($461 thousand). Of the 2013 branch closing costs totaling $596 thousand, the amounts recorded in branch consolidation costs (primarily lease termination costs and severance), occupancy expense and equipment expense were $460 thousand, $84 thousand and $52 thousand, respectively. Excluding these items, total operating expenses would have declined by $797 thousand or 5.7% in the third quarter of 2014 versus 2013. Expense reductions were reflected in several expense categories in the third quarter of 2014, most notably occupancy (down $290 thousand), equipment expense (down $198 thousand), FDIC assessment (down $171 thousand) and other operating expenses (down $137 thousand). The lower occupancy and equipment costs in 2014 were largely due to the recent consolidation of the Company’s branch network. The lower FDIC assessment expense in the third quarter of 2014 versus 2013 reflected the Bank’s lower assessment rate as it is no longer under a regulatory formal agreement. The reduction in other operating expenses resulted primarily from reduced costs associated with fees and subscriptions and telephone systems.

The Company recorded income tax expense of $875 thousand in the third quarter of 2014 resulting in an effective tax rate of 19.0% versus an income tax expense of $1.6 million and an effective tax rate of 28.5% in the comparable period a year ago. The 2013 effective tax rate reflected the change in the projected annualized effective tax rate from the cumulative 19% for the first six months of 2013 to an estimated 23% for the full year, primarily due to the actual and projected gains on the sale of Visa Class B shares during the last half of 2013.
Operating Expenses
For the quarters and nine months ended September 30, 2014 and 2013
(dollars in thousands)

           
Over/
           
Over/
 
   
Quarters ended September 30,
   
(under)
   
Nine months ended September 30,
   
(under)
 
 
 
2014
   
2013
   
2013
   
2014
   
2013
   
2013
 
Employee compensation and benefits (1)
 
$
8,628
   
$
8,709
     
(0.9
)%
 
$
25,977
   
$
24,037
     
8.1
%
Occupancy expense
   
1,295
     
1,585
     
(18.3
)
   
4,141
     
4,787
     
(13.5
)
Equipment expense
   
418
     
616
     
(32.1
)
   
1,301
     
1,745
     
(25.4
)
Consulting and professional services
   
693
     
735
     
(5.7
)
   
1,883
     
1,881
     
0.1
 
FDIC assessment
   
202
     
373
     
(45.8
)
   
737
     
1,414
     
(47.9
)
Data processing
   
549
     
607
     
(9.6
)
   
1,681
     
1,823
     
(7.8
)
Branch consolidation costs
   
-
     
460
     
(100.0
)
   
(449
)
   
460
     
(197.6
)
Reserve and carrying costs related to Visa shares sold
   
57
     
474
     
(88.0
)
   
172
     
474
     
(63.7
)
Other operating expenses
   
1,394
     
1,531
     
(8.9
)
   
4,254
     
4,962
     
(14.3
)
Total operating expenses
 
$
13,236
   
$
15,090
     
(12.3
)%
 
$
39,697
   
$
41,583
     
(4.5
)%

(1) Results for the 2013 nine-month period are net of a $1,659 non-recurring gain arising from the termination of post-retirement life insurance benefits during the second quarter of 2013.

Material Changes in Results of Operations – Comparison of the Nine Months Ended September 30, 2014 and 2013 - The Company recorded net income of $11.2 million during the first nine months of 2014 versus $9.4 million in the comparable 2013 period. The improvement in 2014 net income resulted principally from a $4.9 million increase in net interest income coupled with a $1.9 million reduction in total operating expenses and a lower effective tax rate in the September year-to-date 2014 period. Partially offsetting these positive factors was a $4.0 million reduction in non-interest income in the first nine months of 2014 versus the comparable 2013 period and a $750 thousand provision for loan losses in 2014. The Company did not record a provision for loan losses in the comparable 2013 period.

The $4.9 million or 11.9% improvement in September year-to-date 2014 net interest income resulted from a $75 million increase in average total interest-earning assets, coupled with a 25 basis point improvement in the Company’s net interest margin to 4.11% in 2014 versus 3.86% in 2013. The Company’s average total interest-earning asset yield during the first nine months of 2014 was 4.27% versus 4.06% for the comparable 2013 period. Despite lower average yields on the Company’s investment and loan portfolios, down four basis points and 64 basis points, respectively in 2014 versus 2013, the Company’s average balance sheet mix continued to improve as average loans increased by $293 million (34.1%) versus the first nine months of 2013 and low-yielding overnight interest-bearing deposits declined by $193 million (79.2%) over the same period. Liquid investments represented 3% of average total interest-earning assets during the first nine months of 2014 versus 16% a year ago. The average securities portfolio decreased by $26 million to $399 million in the first nine months of 2014 versus the comparable 2013 period.

The Company’s average cost of total interest-bearing liabilities declined by seven basis points to 0.28% in the first nine months of 2014 versus 0.35% in the same 2013 period. The Company’s total cost of funds declined to 0.16% over the first nine months of 2014 from 0.21% a year ago. The Company’s lower funding cost resulted largely from average core deposits of $1.3 billion in 2014, with average demand deposits representing 42% of average total deposits over the first nine months of 2014. Average total deposits increased by $80 million or 5.5% during the first nine months of 2014 versus 2013. Average core deposit balances represented 85% of total deposits during the same 2014 period.
NET INTEREST INCOME ANALYSIS
For the Nine Months Ended September 30, 2014 and 2013
(unaudited, dollars in thousands)

   
2014
   
2013
 
   
Average
       
Average
   
Average
       
Average
 
   
Balance
   
Interest
   
Yield/Cost
   
Balance
   
Interest
   
Yield/Cost
 
Assets:
                       
Interest-earning assets:
                       
Investment securities (1)
 
$
399,261
   
$
11,129
     
3.73
%
 
$
424,832
   
$
11,965
     
3.77
%
Federal Reserve Bank,  Federal Home Loan Bank and other stock
   
3,099
     
115
     
4.96
     
2,961
     
111
     
5.01
 
Federal funds sold and interest-bearing deposits
   
50,629
     
123
     
0.32
     
243,369
     
502
     
0.28
 
Loans (2)
   
1,150,810
     
39,824
     
4.63
     
858,078
     
33,840
     
5.27
 
Total interest-earning assets
   
1,603,799
   
$
51,191
     
4.27
%
   
1,529,240
   
$
46,418
     
4.06
%
Non-interest-earning assets
   
130,189
                     
116,082
                 
Total assets
 
$
1,733,988
                   
$
1,645,322
                 
                                                 
Liabilities and stockholders' equity:
                                               
Interest-bearing liabilities:
                                               
Saving, N.O.W. and money market deposits
 
$
664,386
   
$
870
     
0.18
%
 
$
617,990
   
$
888
     
0.19
%
Time deposits
   
228,885
     
1,004
     
0.59
     
246,370
     
1,360
     
0.74
 
Total saving and time deposits
   
893,271
     
1,874
     
0.28
     
864,360
     
2,248
     
0.35
 
Borrowings
   
2,619
     
7
     
0.36
     
8
     
-
     
0.34
 
Total interest-bearing liabilities
   
895,890
     
1,881
     
0.28
     
864,368
     
2,248
     
0.35
 
Demand deposits
   
644,042
                     
592,907
                 
Other liabilities
   
17,592
                     
24,899
                 
Total liabilities
   
1,557,524
                     
1,482,174
                 
Stockholders' equity
   
176,464
                     
163,148
                 
Total liabilities and stockholders' equity
 
$
1,733,988
                   
$
1,645,322
                 
Total cost of funds
                   
0.16
%
                   
0.21
%
Net interest rate spread
                   
3.99
%
                   
3.71
%
Net interest income/margin
           
49,310
     
4.11
%
           
44,170
     
3.86
%
Less tax-equivalent basis adjustment
           
(2,921
)
                   
(2,709
)
       
Net interest income
         
$
46,389
                   
$
41,461
         

(1) Interest on securities includes the effects of tax-equivalent basis adjustments of $2,573 and $2,665 in 2014 and 2013, respectively.
(2) Interest on loans includes the effects of tax-equivalent basis adjustments of $348 and $44 in 2014 and 2013, respectively.

The $750 thousand provision for loan losses recorded in the first nine months of 2014 was due to the growth in the loan portfolio experienced during the past twelve months. The Company did not record a provision for loan losses in the comparable 2013 period.

Non-interest income declined by $4.0 million in the first nine months of 2014 versus the comparable 2013 period. This decline was principally due to the $3.8 million gain on the sale of Visa Class B shares recorded in the third quarter of 2013. No Visa shares have been sold in 2014. Also contributing to the lower level of non-interest income in 2014 versus 2013 were reductions in net gain on the sale of mortgage loans originated for sale (down $759 thousand), net gain on the sale of securities available for sale (down $407 thousand) and net gain on the sale of portfolio loans (down $228 thousand). Offsetting a portion of these reductions in 2014 were improvements in net gain on the sale of premises and equipment (up $752 thousand) and income from BOLI (up $637 thousand).

Total operating expenses declined by $1.9 million in the first nine months of 2014 versus 2013 as the result of reductions in several categories, most notably branch consolidation costs (down $909 thousand), other operating expenses (down $708 thousand), FDIC assessment (down $677 thousand), occupancy (down $646 thousand), equipment (down $444 thousand) and the reserve and carrying costs related to Visa shares sold (down $302 thousand). The reduction in other operating expenses resulted primarily from lower OREO expenses, fees and subscriptions and property appraisals. The reduction in branch consolidation costs in 2014 resulted from better than expected outcomes on lease termination negotiations for two of the Bank’s closed branches where an expense had previously been recorded in the fourth quarter of 2013. The reductions in occupancy and equipment expenses are directly attributable to the six branch offices closed during the past twelve months. The lower FDIC assessment expense for the first nine months of 2014 compared to the same period in 2013 reflected the Bank’s lower assessment rate as it is no longer under a regulatory formal agreement. Largely offsetting the foregoing improvements was a $1.9 million increase in employee compensation and benefits expense due principally to a $1.7 million expense credit recorded in 2013 due to the termination of a post-retirement life insurance plan in that period.
The Company recorded income tax expense of $3.0 million in the first nine months of 2014 resulting in an effective tax rate of 21.3% versus an income tax expense of $2.9 million and an effective tax rate of 23.3% in the comparable period a year ago.

Asset Quality - Non-accrual loans totaled $15 million or 1.16% of total loans outstanding at September 30, 2014 versus $15 million or 1.42% of loans outstanding at December 31, 2013 and $23 million or 2.26% of loans outstanding at September 30, 2013. The allowance for loan losses as a percentage of total non-accrual loans amounted to 128% at September 30, 2014 versus 114% at December 31, 2013 and 78% at September 30, 2013.

The Company held no loans 90 days or more past due and still accruing at any of the reported dates. Total loans 30 - 89 days past due and accruing amounted to $3 million or 0.25% of loans outstanding at September 30, 2014 versus $3 million or 0.33% of loans outstanding at December 31, 2013 and $5 million or 0.46% of loans outstanding at September 30, 2013. The Company held no OREO at any of the reported periods.

Total criticized and classified loans were $40 million at September 30, 2014, $43 million at December 31, 2013 and $64 million at September 30, 2013. Criticized loans are those loans that are not classified but require some degree of heightened monitoring. Classified loans were $30 million at September 30, 2014, $37 million at December 31, 2013 and $53 million at September 30, 2013. The allowance for loan losses as a percentage of total classified loans was 62%, 47% and 34%, respectively, at the same dates.

At September 30, 2014, the Company had $20 million in TDRs, primarily consisting of commercial and industrial loans, commercial real estate loans and residential mortgages totaling $5 million, $10 million and $4 million, respectively. At September 30, 2014, $11 million of the TDRs were on non-accrual status. The Company had TDRs amounting to $16 million and $15 million at December 31, 2013 and September 30, 2013, respectively.

Net loan recoveries of $72 thousand were recorded in the third quarter of 2014 versus net loan recoveries of $491 thousand and $326 thousand in the second quarter of 2014 and the third quarter of 2013, respectively. As a percentage of average total loans outstanding, these net amounts represented, on an annualized basis, (0.02%) for the third quarter of 2014, (0.17%) for the second quarter of 2014 and (0.14%) for the third quarter of 2013.
At September 30, 2014, the Company’s allowance for loan losses amounted to $18.8 million or 1.49% of period-end loans outstanding. The allowance as a percentage of loans outstanding was 1.62% at December 31, 2013 and 1.76% at September 30, 2013.
 
 
The Company recorded a $250 thousand provision for loan losses for the three months ended September 30, 2014, as compared to no provision for the comparable 2013 period, largely due to growth in the loan portfolio experienced during the past twelve months. The adequacy of the provision and the resulting allowance for loan losses, which was $18.8 million at September 30, 2014, is determined by management’s ongoing review of the loan portfolio, including identification and review of individual problem situations that may affect a borrower’s ability to repay, delinquency and non-performing loan data including the current status of criticized and classified loans, collateral values and changes in the size and mix of the loan portfolio.

Management has determined that the current level of the allowance for loan losses is adequate in relation to the probable inherent losses present in the portfolio. Loan portfolio growth was strong during the third quarter of 2014, primarily in multifamily and CRE loans. At September 30, 2014, the Company’s allowance for loan losses included an unallocated portion totaling $2.6 million. Loan growth, including multifamily loans, is expected to continue throughout 2014. An unallocated portion of the reserve is considered a prudent option until these loans to new borrowers establish satisfactory payment patterns.

Management considers many factors in this analysis, among them credit risk grades, delinquency trends, concentrations within segments of the loan portfolio, recent charge-off experience, local and national economic conditions, current real estate market conditions in geographic areas where the Company’s loans are located, changes in the trend of non-performing loans, changes in interest rates and loan portfolio growth. Changes in one or a combination of these factors may adversely affect the Company’s loan portfolio resulting in increased delinquencies, loan losses and future levels of loan loss provisions. Due to these uncertainties, management expects to record loan charge-offs in future periods. (See also Critical Accounting Policies, Judgments and Estimates contained herein.)
ANALYSIS OF NON-PERFORMING ASSETS
AND THE ALLOWANCE FOR LOAN LOSSES
September 30, 2014 versus December 31, 2013 and September 30, 2013
(dollars in thousands)

NON-PERFORMING ASSETS BY TYPE:

   
At
 
   
9/30/2014
   
12/31/2013
   
9/30/2013
 
Non-accrual loans
 
$
14,654
   
$
15,183
   
$
22,577
 
Non-accrual loans held for sale
   
-
     
-
     
-
 
Loans 90 days or more past due and still accruing
   
-
     
-
     
-
 
OREO
   
-
     
-
     
-
 
Total non-performing assets
 
$
14,654
   
$
15,183
   
$
22,577
 
                         
Gross loans outstanding
 
$
1,262,061
   
$
1,068,848
   
$
999,329
 
Total loans held for sale
 
$
-
   
$
175
   
$
613
 
                         
ANALYSIS OF THE ALLOWANCE FOR LOAN LOSSES:
 
   
Quarter Ended
 
   
9/30/2014
   
12/31/2013
   
9/30/2013
 
Beginning balance
 
$
18,478
   
$
17,619
   
$
17,293
 
Provision
   
250
     
1,250
     
-
 
Charge-offs
   
(119
)
   
(2,136
)
   
(141
)
Recoveries
   
191
     
530
     
467
 
Ending balance
 
$
18,800
   
$
17,263
   
$
17,619
 
                         
KEY RATIOS:
 
   
At
 
   
9/30/2014
   
12/31/2013
   
9/30/2013
 
Allowance as a % of total loans (1)
   
1.49
%
   
1.62
%
   
1.76
%
                         
Non-accrual loans as a % of total loans (1)
   
1.16
%
   
1.42
%
   
2.26
%
                         
Non-performing assets as a % of total loans, loans held for sale and OREO
   
1.16
%
   
1.42
%
   
2.26
%
                         
Allowance for loan losses as a % of non-accrual loans (1)
   
128
%
   
114
%
   
78
%
                         
Allowance for loan losses as a % of non-accrual loans and loans 90 days or more past due and still accruing (1)
   
128
%
   
114
%
   
78
%

(1) Excludes loans held for sale.

ITEM 3. - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The Company originates and invests in interest-earning assets and solicits interest-bearing deposit accounts. The Company’s operations are subject to market risk resulting from fluctuations in interest rates to the extent that there is a difference between the amounts of interest-earning assets and interest-bearing liabilities that are prepaid, withdrawn, mature, or repriced in any given period of time. The Company’s earnings or the net value of its portfolio will change under different interest rate scenarios. The principal objective of the Company’s asset/liability management program is to maximize net interest income within an acceptable range of overall risk, including both the effect of changes in interest rates and liquidity risk. The Company’s assessment of market risk at September 30, 2014 indicated there were no material changes in the quantitative and qualitative disclosures from those in the Company’s Annual Report on Form 10-K for the year ended December 31, 2013.
ITEM 4. – CONTROLS AND PROCEDURES

The Company carried out an evaluation, under the supervision and with the participation of its principal executive officer and principal financial officer, of the effectiveness of the design and operation of its disclosure controls and procedures as defined in Rule 13a-15(e) and Rule 15d-15(e) under the Securities Exchange Act of 1934, as amended (“Exchange Act”). Based on this evaluation, the Company’s principal executive officer and principal financial officer concluded that, as of the end of the period covered by this report, the Company’s disclosure controls and procedures were effective in ensuring information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is i) recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms and ii) accumulated and communicated to the Company’s management, including the Company’s principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure. There have been no changes in the Company’s internal controls or in other factors that have materially affected, or are reasonably likely to materially affect, internal controls subsequent to the date the Company carried out its evaluation.

There were no changes to the Company’s internal control over financial reporting as defined in Rule 13a-15(f) and Rule 15d-15(f) under the Exchange Act that occurred in the third quarter of 2014 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
 
PART II

ITEM 1. - LEGAL PROCEEDINGS
 
See the information set forth in Note 10—Legal Proceedings in the Notes to Unaudited Condensed Consolidated Financial Statements under Part I, Item I, which information is incorporated by reference in response to this item.

ITEM 1A. – RISK FACTORS

There are no material changes from the risks disclosed in the Risk Factors section of our annual report on Form 10-K for the year ended December 31, 2013, except as discussed below.

The Company’s loan portfolio has a high concentration of commercial real estate loans (exclusive of multifamily and mixed use commercial loans) and its business may be adversely affected by credit risk associated with commercial real estate and a decline in property values.

At September 30, 2014, $512 million, or 41% of the Company’s total gross loan portfolio, was comprised of commercial real estate (exclusive of multifamily and mixed use commercial loans). This type of lending is generally sensitive to regional and local economic conditions that significantly impact the ability of borrowers to meet their loan payment obligations, making loss levels difficult to predict. Although real estate prices have shown signs of improvement, a decline in real estate values may reduce the value of the real estate collateral securing these types of loans and increase the risk that the Company would incur losses if borrowers default on their loans.

ITEM 2. – UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

Not applicable.

ITEM 3. – DEFAULTS UPON SENIOR SECURITIES

Not applicable.

ITEM 4. – MINE SAFETY DISCLOSURES

Not applicable.

ITEM 5. – OTHER INFORMATION

Not applicable.
ITEM 6. – EXHIBITS

31.1
Certification of principal executive officer pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
   
31.2
Certification of principal financial officer pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
   
32.1
Certification of principal executive officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
   
32.2
Certification of principal financial officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
   
101.INS
XBRL Instance Document
   
101.SCH
XBRL Taxonomy Extension Schema Document
   
101.CAL
XBRL Taxonomy Extension Calculation Linkbase Document
   
101.LAB
XBRL Taxonomy Extension Label Linkbase Document
   
101.PRE
XBRL Taxonomy Extension Presentation Linkbase Document
   
101.DEF
XBRL Taxonomy Extension Definition Linkbase Document

SIGNATURES

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

SUFFOLK BANCORP

Date: October 30, 2014
/s/ Howard C. Bluver
 
Howard C. Bluver
 
President & Chief Executive Officer
 
(principal executive officer)
   
Date: October 30, 2014
/s/ Brian K. Finneran
 
Brian K. Finneran
 
Executive Vice President & Chief Financial Officer
 
(principal financial and accounting officer)

EXHIBIT INDEX

Exhibit
Number
 
Description
 
Certification of principal executive officer pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
   
Certification of principal financial officer pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
   
Certification of principal executive officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
   
Certification of principal financial officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
   
101.INS
XBRL Instance Document
   
101.SCH
XBRL Taxonomy Extension Schema Document
   
101.CAL
XBRL Taxonomy Extension Calculation Linkbase Document
   
101.LAB
XBRL Taxonomy Extension Label Linkbase Document
   
101.PRE
XBRL Taxonomy Extension Presentation Linkbase Document
   
101.DEF
XBRL Taxonomy Extension Definition Linkbase Document