UNITED STATES OF AMERICA
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 

FORM 10-Q

 

(Mark One)

 

S

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 Number: 000-11486

 

CONNECTONE BANCORP, INC.

(Exact Name of Registrant as Specified in Its Charter)

 

New Jersey		52-1273725
(State or Other Jurisdiction of Incorporation or Organization)		(IRS Employer Identification No.)

 

301 Sylvan Avenue
Englewood Cliffs, New Jersey 07632

(Address of Principal Executive Offices) (Zip Code)

 

201-816-8900

(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 S 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 S No £

 

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

 

Large accelerated filer  £

Accelerated filer  S

Non-accelerated filer £ (Do not check if smaller reporting company)

Smaller reporting company  £

 

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

 

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

 

Common Stock, no par value:	29,665,075 shares
(Title of Class)	(Outstanding as of November 10, 2014)

Table of Contents

 

		Page
PART I – FINANCIAL INFORMATION
Item  1.	Financial Statements
	Consolidated Statements of Condition at September 30, 2014 (unaudited) and December 31, 2013	3
	Consolidated Statements of Income for the three and nine months ended September 30, 2014 and 2013 (unaudited)	4
	Consolidated Statements of Comprehensive Income for the three and nine months ended September 30, 2014 and 2013 (unaudited)	5
	Consolidated Statements of Changes in Stockholders’ Equity for the nine months ended September 30, 2014 (unaudited) and for the year ended December 31, 2013	6
	Consolidated Statements of Cash Flows for the nine months ended September 30, 2014 and 2013 (unaudited)	7
	Notes to Consolidated Financial Statements	8
Item  2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	39
Item  3.	Qualitative and Quantitative Disclosures about Market Risks	53
Item  4.	Controls and Procedures	54
PART II – OTHER INFORMATION
Item  1.	Legal Proceedings	54
Item 1a.	Risk Factors	54
Item  6.	Exhibits	55
SIGNATURES		56

 

 

Item 1. Financial Statements

 

CONNECTONE BANCORP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CONDITION

 

(in thousands, except for share data)		September 30, 2014				December 31, 2013
		(Unaudited)
ASSETS
Cash and due from banks		$	41,041			$	82,692
Interest-bearing deposits with banks			96,972				—
Cash and cash equivalents			138,013				82,692
Investment securities:
Available-for-sale			307,502				323,070
Held-to-maturity (fair value of $222,393 and $210,958)			217,567				215,286
Loans held for sale			920				—
Loans receivable			2,426,765				960,943
Less: Allowance for loan losses			12,118				10,333
Net loans receivable			2,414,647				950,610
Investment in restricted stock, at cost			17,922				8,986
Bank premises and equipment, net			20,900				13,681
Accrued interest receivable			10,976				6,802
Bank-owned life insurance			51,999				35,734
Other real estate owned			1,442				220
Due from brokers for investment securities			—				8,759
Goodwill			145,909				16,804
Core deposit intangibles			5,070				24
Other assets			23,390				10,414
Total assets		$	3,356,257			$	1,673,082
LIABILITIES
Deposits:
Noninterest-bearing		$	471,151			$	227,370
Interest-bearing			1,998,017				1,114,635
Total deposits			2,469,168				1,342,005
Borrowings			420,960				146,000
Subordinated debentures			5,155				5,155
Other liabilities			19,135				11,338
Total liabilities			2,914,418				1,504,498
COMMITMENTS AND CONTINGENCIES
STOCKHOLDERS’ EQUITY
Preferred stock, $1,000 liquidation value per share, authorized 5,000,000 shares; issued and outstanding 11,250 shares of Series B preferred stock at September 30, 2014 and December 31, 2013; total liquidation value of $11,250,000 at September 30, 2014 and December 31, 2013			11,250				11,250
Common stock, no par value, authorized 50,000,000 shares; issued 31,728,997 shares at September 30, 2014 and 18,477,412 at December 31, 2013; outstanding 29,665,075 shares at September 30, 2014 and 16,369,012 at December 31, 2013			374,287				110,056
Additional paid-in capital			5,818				4,986
Retained earnings			66,623				61,914
Treasury stock, at cost (2,063,922 common shares at September 30, 2014 and 2,108,400 at December 31, 2013)			(16,717	)			(17,078	)
Accumulated other comprehensive income (loss)			578				(2,544	)
Total stockholders’ equity			441,839				168,584
Total liabilities and stockholders’ equity		$	3,356,257			$	1,673,082

 

See accompanying notes to unaudited consolidated financial statements.

 

CONNECTONE BANCORP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

(Unaudited)

 

		Three Months Ended September 30,								Nine Months Ended September 30,
(in thousands, except for share data)		2014				2013				2014				2013
Interest income
Interest and fees on loans		$	28,098			$	10,148			$	48,670			$	29,963
Interest and dividends on investment securities:
Taxable			2,916				3,116				8,840				8,973
Tax-exempt			892				1,151				2,840				3,308
Dividends			349				126				639				378
Interest on federal funds sold and other short-term investments			88				—				88				2
Total interest income			32,343				14,541				61,077				42,624
Interest expense
Deposits			2,725				1,330				5,343				3,897
Borrowings			2,072				1,489				4,914				4,407
Total interest expense			4,797				2,819				10,257				8,304
Net interest income			27,546				11,722				50,820				34,320
Provision for loan losses			1,300				—				2,209				—
Net interest income after provision for loan losses			26,246				11,722				48,611				34,320
Noninterest income
Service charges, commissions and fees			315				780				1,645				1,890
Annuities and insurance commissions			94				92				299				338
Bank-owned life insurance			401				265				912				1,104
Net gains on sale of loans held for sale			65				26				144				255
Net gains on sales of investment securities			111				343				2,100				1,286
Other income			187				37				322				222
Total other income			1,173				1,543				5,422				5,095
Noninterest expense
Salaries and employee benefits			6,243				3,247				13,153				10,072
Occupancy and equipment			1,781				839				3,658				2,556
FDIC insurance			504				283				1,092				804
Professional and consulting			530				352				1,289				801
Marketing and advertising			209				94				276				257
Data processing			902				362				1,761				1,058
Merger expenses			8,784				—				10,573				—
Loss on extinguishment of debt			4,550				—				4,550				—
Amortization of core deposit intangible			248				6				260				19
Other expenses			1,649				1,022				3,028				3,252
Total other expense			25,400				6,205				39,640				18,819
Income before income tax expense			2,019				7,060				14,393				20,596
Income tax expense			253				1,966				3,851				5,655
Net Income			1,766				5,094				10,542				14,941
Less: Preferred stock dividends			28				28				84				112
Net income available to common stockholders		$	1,738			$	5,066			$	10,458			$	14,829
Earnings per common share
Basic		$	0.06			$	0.31			$	0.50			$	0.91
Diluted			0.06				0.31				0.49				0.91
Weighted average common shares outstanding
Basic			29,636,001				16,349,480				20,819,241				16,348,875
Diluted			30,108,103				16,385,155				21,285,452				16,380,970
Dividends per common share		$	0.075			$	0.075			$	0.225			$	0.185

 

See accompanying notes to unaudited consolidated financial statements.

 

CONNECTONE BANCORP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Unaudited)

 

		Three Months Ended September 30,								Nine Months Ended September 30,
(in thousands)		2014				2013				2014				2013
Net income		$	1,766			$	5,094			$	10,542			$	14,941
Other comprehensive (loss) income, net of tax:
Unrealized gains and losses on securities available-for-sale:
Unrealized holding (losses) gains on available-for-sale securities			(1,171	)			383				5,656				(10,771	)
Tax effect			584				(118	)			(1,882	)			4,371
Net of tax amount			(587	)			265				3,774				(6,400	)
Reclassification adjustment of OTTI losses included in income			—				—				—				24
Tax effect			—				—				—				(6	)
Net of tax amount			—				—				—				18
Reclassification adjustment for net gains arising during the period			(111	)			(343	)			(2,100	)			(1,286	)
Tax effect			42				96				601				353
Net of tax amount			(69	)			(247	)			(1,499	)			(933	)
Amortization of unrealized holding gains on securities transferred from available-for-sale to held-to-maturity			57				(42	)			156				32
Tax effect			(24	)			15				(67	)			(13	)
Net of tax amount			33				(27	)			89				19
Pension plan:
Actuarial gains			—				—				1,281				—
Tax effect			—				—				(523	)			—
Net of tax amount			—				—				758				—
Total other comprehensive (loss) income			(623	)			(9	)			3,122				(7,296	)
Total comprehensive income		$	1,143			$	5,085			$	13,664			$	7,645

 

See accompanying notes to unaudited consolidated financial statements.

 

CONNECTONE BANCORP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

(Unaudited)

 

(in thousands, except for share and per share data)		Preferred Stock				Common Stock				Additional Paid In Capital				Retained Earnings				Treasury Stock				Accumulated Other Comprehensive Income (Loss)				Total Stockholders’ Equity
Balance as of January 1, 2013		$	11,250			$	110,056			$	4,801			$	46,753			$	(17,232	)		$	5,063			$	160,691
Net income			—				—				—				19,925				—				—				19,925
Other comprehensive loss, net of tax			—				—				—				—				—				(7,607	)			(7,607	)
Dividend on series B preferred stock			—				—				—				(169	)			—				—				(169	)
Issuance cost of common stock			—				—				—				(13	)			—				—				(13	)
Cash dividends declared on common stock ($0.260 per share)			—				—				—				(4,581	)			—				—				(4,581	)
Issuance of restricted stock awards (18,829 shares)			—				—				91				—				152				—				243
Dividend on restricted stock declared			—				—				—				(1	)			—				—				(1	)
Stock issued for options exercised (2,268 shares)			—				—				19				—				2				—				21
Stock-based compensation											75																75
Balance as of December 31, 2013			11,250				110,056				4,986				61,914				(17,078	)			(2,544	)			168,584
Net income			—				—				—				10,542				—								10,542
Other comprehensive income, net of tax			—				—				—				—				—				3,122				3,122
Dividend on series B preferred stock			—				—				—				(84	)			—				—				(84	)
Issuance cost of common stock			—				—				—				(7	)			—				—				(7	)
Cash dividends declared on common stock ($0.225 per share)			—				—				—				(5,742	)			—				—				(5,742	)
Stock issued for options exercised (74,911 shares)			—				—				424				—				361				—				785
Stock issued (13,221,152 shares) and options acquired (783,732 shares) in acquisition of Legacy ConnectOne			—				264,231				—				—				—				—				264,231
Stock-based compensation			—				—				408				—				—				—				408
Balance as of September 30, 2014		$	11,250			$	374,287			$	5,818			$	66,623			$	(16,717	)		$	578			$	441,839

 

See accompanying notes to unaudited consolidated financial statements.

 

CONNECTONE BANCORP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

 

(in thousands)		Nine Months Ended September 30,
		2014				2013
Cash flows from operating activities:
Net income		$	10,542			$	14,941
Adjustments to reconcile net income to net cash provided by operating activities:
Amortization of premiums and accretion of discounts on investment securities, net			1,966				2,665
Depreciation and amortization			1,717				650
Provision for loan losses			2,209				—
Stock-based compensation (excluding tax benefit)			51				41
Other-than-temporary impairment losses on investment securities			—				24
Gains on sales of investment securities, net			(2,100	)			(1,286	)
Net loss on sale of other real estate owned			23				75
Loans originated for resale			(7,316	)			(14,045	)
Proceeds from sale of loans held for sale			6,730				15,690
Gains on sale of loans held for sale			(144	)			(255	)
Decrease in accrued interest receivable			296				277
Increase in cash surrender value of bank-owned life insurance			(912	)			(813	)
Life insurance death benefit			—				(291	)
Decrease (increase) in other assets			1,128				(2,351	)
(Decrease) increase in other liabilities			(3,791	)			2,446
Net cash provided by operating activities			10,399				17,768
Cash flows from investing activities:
Investment securities available-for-sale:
Purchases			(31,550	)			(137,152	)
Sales			66,738				90,773
Maturities, calls and principal repayments			20,951				38,634
Investment securities held-to-maturity:
Purchases			(8,310	)			(23,531	)
Maturities and principal repayments			6,235				3,248
Net (purchases) redemption of restricted investment in bank stocks			4,710				(22	)
Net increase in loans			(167,314	)			(68,099	)
Purchases of premises and equipment			(2,199	)			(535	)
Proceeds from bank-owned life insurance death benefits			—				592
Proceeds from sale of other real estate owned			1,562				1,230
Cash acquired in acquisition of Legacy ConnectOne			70,318				—
Net cash used in investing activities			(38,859	)			(94,862	)
Cash flows from financing activities:
Net increase in deposits			75,821				7,395
Net increase in borrowings			11,590				—
Cash dividends on preferred stock			(84	)			(112	)
Cash dividends paid on common stock			(4,681	)			(3,025	)
Issuance of restricted stock awards			—				243
Issuance cost of common stock			(7	)			(9	)
Tax benefit of options exercised			357				—
Proceeds from exercise of stock options			785				21
Net cash provided by financing activities			83,781				4,513
Net change in cash and cash equivalents			55,321				(72,581	)
Cash and cash equivalents at beginning of period			82,692				106,138
Cash and cash equivalents at end of period		$	138,013			$	33,557
Supplemental disclosures of cash flow information:
Cash payments for:
Interest paid on deposits and borrowings		$	10,222			$	8,357
Income taxes		$	4,653			$	2,195

 

See accompanying notes to unaudited consolidated financial statements.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

Note 1.  Nature of Operations and Principles of Consolidation

 

The consolidated financial statements of ConnectOne Bancorp, Inc. (the “Parent Corporation”) are prepared on an accrual basis and include the accounts of the Parent Corporation and its wholly-owned subsidiary, ConnectOne Bank (the “Bank” and, collectively with the Parent Corporation and the Parent Corporation’s other direct and indirect subsidiaries, the “Corporation”). All significant intercompany accounts and transactions have been eliminated from the accompanying consolidated financial statements.

 

The Bank is a community-based, full-service New Jersey-chartered commercial bank that was founded in 2005. The Bank operates from its headquarters located at 301 Sylvan Avenue in the Borough of Englewood Cliffs, Bergen County, New Jersey, through its twenty-three other banking offices. Substantially all loans are secured by specific items of collateral including business assets, consumer assets, and commercial and residential real estate. Commercial loans are expected to be repaid from cash flow from business operations. There are no significant concentrations of loans to any one industry or customer. However, the customers’ ability to repay their loans is dependent on the cash flows, real estate and general economic conditions in the area.

 

The following unaudited consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X, and, accordingly, do not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements. However, in the opinion of management, all adjustments (consisting only of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three and nine months ended September 30, 2014 are not necessarily indicative of the results that may be expected for the full year ending December 31, 2014, or for any other interim period. The Corporation’s 2013 Annual Report on Form 10-K, should be read in conjunction with these financial statements.

 

In preparing the consolidated financial statements, management has made estimates and assumptions that affect the reported amounts of assets and liabilities as of the dates of the consolidated statements of condition and that affect the results of operations for the periods presented. Actual results could differ significantly from those estimates. Material estimates that are particularly susceptible to change in the near term relate to the determination of the allowance for loan losses, the other-than-temporary impairment evaluation of securities, the evaluation of the impairment of goodwill and the evaluation of deferred tax assets.

 

The consolidated financial statements have been prepared in conformity with U.S. generally accepted accounting principles (“U.S. GAAP”). Some items in the prior year financial statements were reclassified to conform with current presentation. Reclassifications had not effect on prior year net income for stockholders’ equity.

 

Note 2. Recent Accounting Pronouncements

 

FASB ASU 2014-04: Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans Upon Foreclosure. EITF Issue 13-E sought to define “in substance repossession or foreclosure” because of the diversity in practice regarding when entities were reclassifying loans receivable to other real estate owned instead of as a loan receivable. The timing of loan reclassifications to OREO may be qualitatively significant to regulators and other financial statement users. “In substance repossession or foreclosure” is clarified by the ASU. A creditor is considered to have received physical possession (resulting from an in substance repossession) of residential real estate property collateralizing a consumer mortgage loan only upon the occurrence of either of the following: a) The creditor obtains legal title to the residential real estate property upon completion of a foreclosure. A creditor may obtain legal title to the residential real estate property even if the borrower has redemption rights that provide the borrower with a legal right for a period of time after a foreclosure to reclaim the real estate property by paying certain amounts specified by law; or b) The borrower conveys all interest in the residential real estate property to the creditor to satisfy the loan through completion of a deed in lieu of foreclosure or through a similar legal agreement. The deed in lieu of foreclosure or similar legal agreement is completed when agreed-upon terms and conditions have been satisfied by both the borrower and the creditor. The ASU is effective for fiscal years beginning after December 15, 2014, and interim periods therein. Early adoption is permitted. The Corporation will adopt the methodologies prescribed by this ASU by the date required, and does not anticipate that the ASU will have a material effect on its financial position or results of operations.

 

FASB ASU No. 2014-09: Revenue from Contracts with Customers. In May 2014, the FASB issued an update creating FASB Topic 606, Revenue from Contracts with Customers. The guidance in this update affects any entity that either enters into contracts with customers to transfer goods or services or enters into contracts for the transfer of nonfinancial assets unless those contracts are within the scope of other standards (for example, insurance contracts or lease contracts). The core principle of the guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The guidance provides steps to follow to achieve the core principle. An entity should disclose sufficient information to enable users of financial statements to understand the nature, amount, timing and uncertainty of revenue and cash flows arising from contracts with customers. Qualitative and quantitative information is required about contracts with customers, significant judgments and changes in judgments, and assets recognized from the costs to obtain or fulfill a contract. The amendments in this update become effective for annual periods and interim periods within those annual periods beginning after December 15, 2016. We are currently evaluating the impact of adopting the new guidance on the consolidated financial statements, but it is not expected to have a material impact.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

FASB ASC ASU No. 2014-11, Repurchase-to-Maturity Transactions, Repurchase Financings, and Disclosures. In September 2014, the FASB issued an update impacting FASB ASC 860, Transfers and Servicing. The amendments in this update change the accounting for repurchase-to-maturity transactions and linked repurchase financings to secured borrowing accounting, which is consistent with the accounting for other repurchase agreements. The amendments also require new disclosures. An entity is required to disclose information on transfers accounted for as sales in transactions that are economically similar to repurchase agreements. An entity must also provide additional information about the types of collateral pledged in repurchase agreements and similar transactions accounted for as secured borrowings. An entity is required to present changes in accounting for transactions outstanding on the effective date as a cumulative-effect adjustment to retained earnings as of the beginning of the period of adoption. The amendments in this update become effective for the first interim or annual period beginning after December 15, 2014. We are currently evaluating the impact of adopting the new guidance on the consolidated financial statements, but it is not expected to have a material impact.

 

FASB ASC ASU No. 2014-12, Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved after the Requisite Service Period. In September 2014, the FASB issued an update impacting FASB ASC 860, Transfers and Servicing. Generally, an award with a performance target also requires an employee to render service until the performance target is achieved. In some cases, however, the terms of an award may provide that the performance target could be achieved after an employee completes the requisite service period. The amendments in this update require that a performance target that affects vesting and that could be achieved after the requisite service period be treated as a performance condition. An entity should apply guidance in Topic 718 as it relates to awards with performance conditions that affect vesting to account for such awards. As such, the performance target should not be reflected in estimating the grant-date fair value of the award. Compensation cost should be recognized in the period in which it becomes probable that the performance target will be achieved and should represent the compensation cost attributable to the period for which the service has already been rendered. The amendments in this update become effective for annual periods and interim periods within those annual periods beginning after December 15, 2015. We are currently evaluating the impact of adopting the new guidance on the consolidated financial statements.

 

FASB issued ASU 2014-14, Classification of Certain Government-Guaranteed Mortgage Loans upon Foreclosure. This update requires the creditors to reclassify loans that are within the scope of the ASU to “other receivables” upon foreclosure, rather than reclassifying them to other real estate owned. The separate other receivable recorded upon foreclosure is to be measured based on the amount of the loan balance (principal and interest) the creditor expects to recover from the guarantor. The new guidance is effective for public business entities for annual periods, and interim periods within those annual periods, beginning after December 15, 2014. The impact of adoption of this ASU by the Corporation is not expected to be material.

 

Note 3. Acquisition

 

On January 20, 2014, the Parent Corporation entered into an Agreement and Plan of Merger (the “Merger Agreement”) with ConnectOne Bancorp, Inc., a New Jersey corporation (“Legacy ConnectOne”). Effective July 1, 2014 (the “Effective Time”), the Parent Corporation completed the merger contemplated by the Merger Agreement (the “Merger”) with Legacy ConnectOne. At closing, Legacy ConnectOne merged with and into the Parent Corporation, with the Parent Corporation as the surviving corporation. Also at closing, the Parent Corporation changed its name from “Center Bancorp, Inc.” to “ConnectOne Bancorp, Inc.” and changed its NASDAQ trading symbol to “CNOB” from “CNBC.”

 

Pursuant to the Merger Agreement, holders of Legacy ConnectOne common stock, no par value per share (the “Legacy ConnectOne Common Stock”), received 2.6 shares of common stock of the Parent Corporation, no par value per share (the “Company Common Stock”), for each share of Legacy ConnectOne Common Stock held immediately prior to the effective time of the Merger, with cash to be paid in lieu of fractional shares. Each outstanding share of Company Common Stock remained outstanding and was unaffected by the Merger. Each option granted by Legacy ConnectOne to purchase shares of Legacy ConnectOne Common Stock was converted into an option to purchase Company Common Stock on the same terms and conditions as were applicable prior to the Merger (taking into account any acceleration or vesting by reason of the consummation of the Merger and its related transactions), subject to adjustment of the exercise price and the number of shares of Company Common Stock issuable upon exercise of such option based on the 2.6 exchange ratio.

 

Immediately following the Merger, Union Center National Bank, a bank organized pursuant to the laws of the United States, and a wholly owned subsidiary of the Parent Corporation (“UNCB”), merged (the “Bank Merger”) with and into ConnectOne Bank, a New Jersey state-chartered commercial bank and a wholly owned subsidiary of Legacy ConnectOne, with ConnectOne Bank as the surviving entity (the “Bank”). The Bank now conducts business only in the name of and under the brand of ConnectOne.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

The assets acquired and liabilities assumed have been accounted for under the acquisition method of accounting. The assets and liabilities, both tangible and intangible, were recorded at their fair values as of July 1, 2014 based on management’s best estimate using the information available as of the Merger date. The application of the acquisition method of accounting resulted in the recognition of goodwill of $129,105,000 and a core deposit intangible of $5,308,000. As of July 1, 2014, Legacy ConnectOne had assets with a carrying value of approximately $1.5 billion, including loans with a carrying value of approximately $1.2 billion, and deposits with a carrying value of approximately $1.1 billion. The table below summarizes the amounts recognized as of the Merger date for each major class of assets acquired and liabilities assumed, the estimated fair value adjustments and the amounts recorded in the Corporation’s financial statements at fair value at the Merger date (in thousands):

 

Consideration paid through Center Bancorp, Inc. common stock issued to Legacy ConnectOne shareholders and fair value of stock options acceleration was										$	264,231
		Legacy ConnectOne carrying value				Fair value adjustments				As recorded at acquisition
Cash and cash equivalents		$	70,318			$	—			$	70,318
Investment securities			28,436				16	(a)			28,452
Restricted stock			13,646				—				13,646
Loans held for sale			190				—				190
Loans			1,304,600				(5,316)	(b)			1,299,284
Bank owned life insurance			15,481				—				15,481
Premises and equipment			7,380				(905)	(c)			6,475
Accrued interest receivable			4,470				—				4,470
Core deposit and other intangibles			—				5,308	(d)			5,308
Other real estate owned			2,455				—				2,455
Other assets			10,636				3,650	(e)			14,286
Deposits			(1,049,666	)			(1,676)	(f)			(1,051,342	)
FHLB borrowings			(262,046	)			(1,324)	(g)			(263,370	)
Other liabilities			(10,527	)			—				(10,527	)
Total identifiable net assets		$	135,373			$	(247	)		$	135,126
Goodwill recorded in the Merger										$	129,105

 

The following provides an explanation of certain fair value adjustments presented in the above table:

 

a)

Represents the fair value adjustment on investment securities held to maturity.

b)

Represents the elimination of Legacy ConnectOne’s allowance for loan losses, deferred fees, deferred costs and an adjustment of the amortized cost of loans to estimated fair value, which includes an interest rate mark and credit mark.

c)

Represent an adjustment to reflect the fair value of below-market rent on leased premises. The below market rent intangible asset will be amortized on a straight-line basis over the remaining term of the leases.

d)

Represents intangible assets recorded to reflect the fair value of core deposits and below market rent leased premises. The core deposit asset was recorded as an identifiable intangible asset and will be amortized on an accelerated basis over the estimated average life of the deposit base.

e)

Consist primarily of adjustments in net deferred tax assets resulting from the fair value adjustments related to acquired assets, liabilities assumed and identifiable intangibles recorded.

f)

Represents fair value adjustment on time deposits as the weighted average interest rates of time deposits assumed exceeded the costs of similar funding available in the market at the time of the Merger, as well as the elimination of fees paid on brokered time deposits.

g)

Represents the fair value adjustment on FHLB borrowings as the weighted average interest rate of FHLB borrowings assumed exceeded the cost of similar funding available in the market at the time of the Merger.

 

The amount of goodwill recorded reflects the increased market share and lending capabilities; greater access to best-in-class banking technology, and related synergies that are expected to result from the acquisition, and represents the excess purchase price over the estimated fair value of the net assets acquired by ConnectOne.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

Except for collateral dependent loans with deteriorated credit quality, the fair values for loans acquired from Legacy ConnectOne were estimated using cash flow projections based on the remaining maturity and repricing terms. Cash flows were adjusted by estimated future credit losses and the rate of prepayments. Projected monthly cash flows were then discounted to present value using a risk-adjusted market rate for similar loans. For collateral dependent loans with deteriorated credit quality, fair value was estimated by analyzing the value of the underlying collateral, assuming the fair values of the loan were derived from the eventual sale of the collateral. These values were discounted using marked derived rate of returns, with consideration given to the period of time and costs associated with the foreclosure and disposition of the collateral. There was no carryover of Legacy ConnectOne allowance for loan losses associated with the loans that were acquired, as the loans were initially recorded at fair value on the date of the Merger.

 

The acquired loan portfolio subject to purchased credit impairment accounting guidance (ASC 310-30) as of July 1, 2014 was comprised of collateral dependent loans with deteriorated credit quality as follows (in thousands):

 

		ASC 310-30 Loans
Contractual principal and accrued interest at acquisition		$	23,284
Principal not expected to be collected (non-accretable discount)			(6,942	)
Expected cash flows at acquisition			16,342
Interest component of expected cash flows (accretable discount)			(5,013	)
Fair value of acquired loans		$	11,329

 

The core deposit intangible asset recognized is being amortized over its estimated useful life of approximately 10 years utilizing the accelerated method. Other intangibles consist of below market rents, which are amortized over the remaining life of each lease using the straight-line method.

 

Goodwill is not amortized for book purposes; however, it is reviewed at least annually for impairment and is not deductible for tax purposes.

 

The fair value of retail demand and interest bearing deposit accounts was assumed to approximate the carrying value as these accounts have no stated maturity and are payable on demand. The fair value of time deposits was estimated by discounting the contractual future cash flows using market rates offered for time deposits of similar remaining maturities. The fair value of borrowed funds was estimated by discounting the future cash flows using market rates for similar borrowings.

 

Direct acquisition and integration costs of the Merger were expensed as incurred and totaled $10.6 million. These items were recorded as merger-related expenses on the statement of operations.

 

The following table presents selected unaudited pro forma financial information reflecting the Merger assuming it was completed as of January 1, 2014 and January 1, 2013. The unaudited pro forma financial information is presented for illustrative purposes only and is not necessarily indicative of the financial results of the combined companies had the Merger actually been completed at the beginning of the periods presented, nor does it indicate future results for any other interim or full fiscal year period. Pro forma basic and diluted earnings per common share were calculated using the Corporation’s actual weighted average shares outstanding for the periods presented, plus the incremental shares issued, assuming the Merger occurred at the beginning of the periods presented. The unaudited pro forma information is based on the actual financial statements of the Corporation for the periods presented, and on the actual financial statements of the Corporation for the 2013 period presented and in 2014 until the date of the Merger, at which time Legacy ConnectOne’s results of operations were included in the Corporation’s financial statements.

 

The unaudited pro forma information, for the nine months ended September 30, 2014 and 2013, set forth below reflects the adjustments related to (a) purchase accounting fair value adjustments; (b) amortization of core deposit and other intangibles; and (c) adjustments to interest income and expense due to amortization of premiums and accretion discounts. The unaudited pro forma information give effect to the Merger as if it occurred on January 1, 2014 with respect to the pro forma information for the nine months ended September 30, 2014 and on January 1, 2013 with respect to the pro forma information for the nine months ended September 30, 2013. In the table below, merger-related expenses of $13.5 million were excluded from pro forma non-interest expenses for the nine months ended September 30, 2014. Income taxes were also adjusted to exclude income tax benefits of $3.9 million related to the merger expenses for the nine months ended September 30, 2014. Furthermore, the unaudited pro forma information does not reflect management’s estimate of any revenue enhancement opportunities or anticipated cost savings.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

		Pro Forma for the Nine Months Ended September 30,
		2014				2013
		(in thousands, except per share amounts)
Net interest income		$	78,872			$	71,091
Noninterest income			6,168				5,948
Noninterest expense			(41,073	)			(34,352	)
Net income			26,490				26,125
Pro forma earnings per share from continuing operations:
Basic		$	0.89			$	0.91
Diluted			0.88				0.90

 

The Corporation has determined that it is impractical to report the amounts of revenue and earnings of legacy ConnectOne since the acquisition date, July 1, 2014.  The back-office systems conversion of the combined entity took place on July 21, 2014.  Accordingly, reliable and separate complete revenue and earnings information are no longer available. In addition, such amounts would require significant estimates related to the proper allocation of merger cost saves that cannot be objectively made.

 

Note 4. Earnings per Common Share

 

Basic earnings per common share (“EPS”) is computed by dividing income available to common stockholders by the weighted average number of common shares outstanding. Diluted EPS includes any additional common shares as if all potentially dilutive common shares were issued (e.g., stock options). The Corporation’s weighted average common shares outstanding for diluted EPS include the effect of stock options and restricted stock awards outstanding using the Treasury Stock Method, which are not included in the calculation of basic EPS.

 

Earnings per common share have been computed as follows:

 

		Three Months Ended September 30,								Nine Months Ended  September 30,
(in thousands, except share amounts)		2014				2013				2014				2013
Net income		$	1,766			$	5,094			$	10,542			$	14,941
Preferred stock dividends			(28	)			(28	)			(84	)			(112	)
Net income available to common stockholders		$	1,738			$	5,066			$	10,458			$	14,829
Basic weighted average common shares outstanding			29,636,001				16,349,480				20,819,241				16,348,875
Effect of dilutive options			472,102				35,675				466,211				32,095
Diluted weighted average common shares outstanding			30,108,103				16,385,155				21,285,452				16,380,970
Earnings per common share:
Basic		$	0.06			$	0.31			$	0.50			$	0.91
Diluted			0.06				0.31				0.49				0.91

 

Note 5. Investment Securities

 

The Corporation’s investment securities are classified as available-for-sale and held-to-maturity at September 30, 2014 and December 31, 2013. Investment securities available-for-sale are reported at fair value with unrealized gains or losses included in equity, net of tax. Accordingly, the carrying value of such securities reflects their fair value at the balance sheet date. Fair value is based upon either quoted market prices, or in certain cases where there is limited activity in the market for a particular instrument, assumptions are made to determine their fair value. See Note 7 of the Notes to Consolidated Financial Statements for a further discussion.

 

Transfers of debt securities from the available-for-sale category to the held-to-maturity category are made at fair value at the date of transfer. The unrealized holding gain or loss at the date of transfer remains in accumulated other comprehensive income and in the carrying value of the held-to-maturity investment security. Premiums or discounts on investment securities are amortized or accreted using the effective interest method over the life of the security as an adjustment of yield. Unrealized holding gains or losses that remain in accumulated other comprehensive income are amortized or accreted over the remaining life of the security as an adjustment of yield, offsetting the related amortization of the premium or accretion of the discount.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

The following tables present information related to the Corporation’s investment securities at September 30, 2014 and December 31, 2013.

 

		September 30, 2014
		Amortized Cost				Gross Unrealized Gains				Gross Unrealized Losses				Fair Value
		(dollars in thousands)
Investment Securities Available-for-Sale:
U.S. Treasury and agency securities		$	11,517			$	—			$	(132	)		$	11,385
Federal agency obligations			33,110				75				(193	)			32,992
Residential mortgage pass-through securities			58,459				1,332				(100	)			59,691
Commercial mortgage pass-through securities			3,057				—				(41	)			3,016
Obligations of U.S. states and political subdivisions			8,204				225				—				8,429
Trust preferred securities			16,085				465				(236	)			16,314
Corporate bonds and notes			129,550				6,300				(10	)			135,840
Asset-backed securities			21,603				151				(1	)			21,753
Certificates of deposit			2,098				32				(6	)			2,124
Equity securities			376				—				(87	)			289
Mutual funds and money market funds			15,808				—				(139	)			15,669
Total		$	299,867			$	8,580			$	(945	)		$	307,502
Investment Securities Held-to-Maturity:
U.S. Treasury and agency securities		$	28,212			$	251			$	—			$	28,463
Federal agency obligations			21,119				112				(74	)			21,157
Residential mortgage pass-through securities			2,616				7				—				2,623
Commercial mortgage pass-through securities			4,304				38				(19	)			4,323
Obligations of U.S. states and political subdivisions			123,379				3,914				(151	)			127,142
Corporate bonds and notes			37,937				762				(14	)			38,685
Total		$	217,567			$	5,084			$	(258	)		$	222,393
Total investment securities		$	517,434			$	13,664			$	(1,203	)		$	529,895

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

		December 31, 2013
		Amortized Cost				Gross Unrealized Gains				Gross Unrealized Losses				Fair Value
		(dollars in thousands)
Investment Securities Available-for-Sale:
U.S. Treasury and agency securities		$	14,344			$	—			$	(825	)		$	13,519
Federal agency obligations			20,567				29				(655	)			19,941
Residential mortgage pass-through securities			48,312				791				(229	)			48,874
Commercial mortgage pass-through securities			7,145				3				(157	)			6,991
Obligations of U.S. states and political subdivisions			30,804				711				(55	)			31,460
Trust preferred securities			19,763				150				(510	)			19,403
Corporate bonds and notes			154,182				4,930				(482	)			158,630
Asset-backed securities			15,733				246				—				15,979
Certificates of deposit			2,250				32				(20	)			2,262
Equity securities			376				—				(89	)			287
Mutual funds and money market funds			5,671				68				(15	)			5,724
Total		$	319,147			$	6,960			$	(3,037	)		$	323,070
Investment Securities Held-to-Maturity:
U.S. Treasury and agency securities		$	28,056			$	—			$	(1,019	)		$	27,037
Federal agency obligations			15,249				23				(389	)			14,883
Residential mortgage-backed securities			2,246				—				(64	)			2,182
Commercial mortgage-backed securities			4,417				41				(62	)			4,396
Obligations of U.S. states and political subdivisions			127,418				1,303				(3,688	)			125,033
Corporate bonds and notes			37,900				149				(622	)			37,427
Total		$	215,286			$	1,516			$	(5,844	)		$	210,958
Total investment securities		$	534,433			$	8,476			$	(8,881	)		$	534,028

 

The following table presents information for investment securities available-for-sale at September 30, 2014, based on scheduled maturities. Actual maturities can be expected to differ from scheduled maturities due to prepayment or early call options of the issuer.

 

		September 30, 2014
		Amortized Cost				Fair Value
		(in thousands)
Investment Securities Available-for-Sale:
Due in one year or less		$	14,395			$	14,543
Due after one year through five years			43,153				44,425
Due after five years through ten years			110,494				115,594
Due after ten years			54,125				54,275
Residential mortgage pass-through securities			58,459				59,691
Commercial mortgage pass-through securities			3,057				3,016
Equity securities			376				289
Mutual funds and money market funds			15,808				15,669
Total		$	299,867			$	307,502
Investment Securities Held-to-Maturity:
Due in one year or less		$	7,059			$	7,140
Due after one year through five years			7,907				8,056
Due after five years through ten years			69,114				70,359
Due after ten years			126,567				129,892
Residential mortgage-backed securities			2,616				2,623
Commercial mortgage pass-through securities			4,304				4,323
Total		$	217,567			$	222,393
Total investment securities		$	517,434			$	529,895

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

For the nine months ended September 30, 2014, proceeds of available-for-sale investment securities sold amounted to approximately $67.0 million.

 

Gross gains and losses from the sales of investment securities for the three-month and nine-month periods ended September 30, 2014 and 2013 were as follows:

 

		Three Months Ended September 30,								Nine Months Ended September 30,
(in thousands)		2014				2013				2014				2013
Gross gains on sales of investment securities		$	111			$	343			$	2,122			$	1,375
Gross losses on sales of investment securities			—				—				22				89
Net gains on sales of investment securities			111				343				2,100				1,286
Less: tax provision on gross gains			42				96				601				353
Gross gains on sales of investments, net of tax		$	69			$	247			$	1,499			$	933

 

The following summarizes OTTI charges for the periods indicated.

 

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
(in thousands)		2014				2013				2014				2013
Other than temporary impairment charges		$	—			$	—			$	—			$	—
Principal losses on a variable rate CMO			—				—				—				24
Total other-than-temporary impairment charges		$	—			$	—			$	—			$	24

 

The Corporation performs regular analysis on all its investment securities to determine whether a decline in fair value indicates that an investment is other-than-temporarily impaired in accordance with FASB ASC 320-10. FASB ASC 320-10 requires companies to record OTTI charges through earnings if they have the intent to sell, or if it is more likely than not that they will be required to sell an impaired debt security before recovery of its amortized cost basis. If the Corporation intends to sell or it is more likely than not it will be required to sell the security before recovery of its amortized cost basis, the OTTI is recognized in earnings equal to the entire difference between the investment’s amortized cost basis and its estimated fair value at the balance sheet date. If the Corporation 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 basis, the OTTI is separated into the amount representing the credit loss and the amount related to all other factors. The amount of the 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 other comprehensive income, net of applicable taxes. The previous amortized cost basis less the OTTI recognized in earnings becomes the new amortized cost basis of the investment.

 

The Corporation’s assessment of whether an impairment is other than temporary includes factors such as whether the issuer has defaulted on scheduled payments, announced a restructuring and/or filed for bankruptcy, has disclosed severe liquidity problems that cannot be resolved, disclosed a deteriorating financial condition or sustained significant losses. The Corporation maintains a watch list for the identification and monitoring of securities experiencing problems that require a heightened level of review. This could result from credit rating downgrades.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

The following table presents detailed information for each trust preferred security held by the Corporation at September 30, 2014 which has at least one rating below investment grade.

 

Issuer		Single Issuer or Pooled		Class/ Tranche		Amortized Cost				Fair Value				Gross Unrealized Gain (Loss)				Lowest Credit Rating Assigned		Number of Banks Currently Performing				Deferrals and Defaults as % of Original Collateral		Expected Deferral/Defaults as % of Remaining Performing Collateral
		(dollars in thousands)
Countrywide Capital IV		Single		n/a		$	1,771			$	1,813				42			BB			1			None		None
Countrywide Capital V		Single		n/a			2,747				2,827				80			BB			1			None		None
Countrywide Capital V		Single		n/a			250				257				7			BB			1			None		None
Nationsbank Cap Trust III		Single		n/a			1,575				1,339				(236	)		BB			1			None		None
Morgan Stanley Cap Trust IV		Single		n/a			2,500				2,517				17			BB			1			None		None
Morgan Stanley Cap Trust IV		Single		n/a			1,742				1,760				18			BB			1			None		None
Goldman Sachs		Single		n/a			1,000				1,137				137			BB			1			None		None
Stifel Financial		Single		n/a			4,500				4,664				164			BBB-			1			None		None
Total						$	16,085			$	16,314				229

 

Credit Loss Portion of OTTI Recognized in Earnings on Debt Securities

 

		Nine Months Ended September 30, 2014				Year Ended December 31, 2013
		(in thousands)
Balance of credit-related OTTI at January 1,		$	—			$	4,450
Addition:
Credit losses on investment securities for which other-than-temporary impairment was not previously recognized			—				652
Reduction:
Credit losses on investment securities sold during the period			—				(5,102	)
Balance of credit-related OTTI at period end		$	—			$	—

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

Temporarily Impaired Investments

 

For all securities, the Corporation does not believe that the unrealized losses, which were comprised of 84 investment securities as of September 30, 2014, represent an other-than-temporary impairment. The gross unrealized losses of $1.2 million associated with U.S. Treasury and agency securities, federal agency obligations, mortgage-backed securities, corporate bonds, tax-exempt securities, asset-backed securities, mutual funds and equity securities are not considered to be other than temporary because these unrealized losses are related to changes in interest rates and do not affect the expected cash flows of the underlying collateral or issuer.

 

Factors affecting the market price include credit risk, market risk, interest rates, economic cycles, and liquidity risk. The magnitude of any unrealized loss may be affected by the relative concentration of the Corporation’s investment in any one issuer or industry. The Corporation has established policies to reduce exposure through diversification of concentration of the investment portfolio including limits on concentrations to any one issuer. The Corporation believes the investment portfolio is prudently diversified.

 

The decline in value is related to a change in interest rates and subsequent change in credit spreads required for these issues affecting market price. All issues are performing and are expected to continue to perform in accordance with their respective contractual terms and conditions. Short to intermediate average durations and in certain cases monthly principal payments should reduce further market value exposure to increases in rates.  

 

The Corporation evaluates all securities with unrealized losses quarterly to determine whether the loss is other than temporary. Unrealized losses in the corporate debt securities category consists primarily of senior unsecured corporate debt securities issued by large financial institutions, insurance companies and other corporate issuers and single issuer corporate trust preferred securities. None of the corporate issuers have defaulted on interest payments. The unrealized loss in equity securities consists of losses on other bank equities. The decline in fair value is due in large part to the lack of an active trading market for these securities, changes in market credit spreads and rating agency downgrades. Management concluded that these securities were not other-than-temporarily impaired at September 30, 2014. Future deterioration in the credit quality of these large financial institution issuers of TRUP debt securities could result in impairment charges in the future.

 

In determining that the securities giving rise to the previously mentioned unrealized losses were not other-than-temporarily impaired, the Corporation evaluated the factors cited above, which the Corporation considers when assessing whether a security is other-than-temporarily impaired. In making these evaluations the Corporation must exercise considerable judgment. Accordingly there can be no assurance that the actual results will not differ from the Corporation’s judgments and that such differences may not require the future recognition of other-than-temporary impairment charges that could have a material effect on the Corporation’s financial position and results of operations. In addition, the value of, and the realization of any loss on an investment security are subject to numerous risks as cited above.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

The following tables indicate gross unrealized losses not recognized in income and fair value, aggregated by investment category and the length of time individual securities have been in a continuous unrealized loss position at September 30, 2014 and December 31, 2013:

 

		September 30, 2014
		Total								Less than 12 Months								12 Months or Longer
		Fair Value				Unrealized Losses				Fair Value				Unrealized Losses				Fair Value				Unrealized Losses
		(in thousands)
Investment Securities Available-for-Sale:
U.S. Treasury and agency securities		$	9,488			$	(132	)		$	4,744			$	(57	)		$	4,744			$	(75	)
Federal agency obligations			22,682				(193	)			18,601				(113	)			4,081				(80	)
Residential mortgage pass-through securities			16,327				(100	)			16,327				(100	)			—				—
Commercial mortgage pass-through securities			3,016				(41	)			—				—				3,016				(41	)
Trust preferred securities			1,338				(236	)			—				—				1,338				(236	)
Corporate bonds and notes			3,002				(10	)			3,002				(10	)			—				—
Asset-backed securities			1,952				(1	)			1,952				(1	)			—				—
Certificates of deposit			216				(6	)			216				(6	)			—				—
Equity securities			289				(87	)			—				—				289				(87	)
Mutual funds and money market funds			11,361				(139	)			10,379				(122	)			982				(17	)
Total			69,671			$	(945	)		$	55,221			$	(409	)		$	14,450			$	(536	)
Investment Securities Held-to-Maturity:
Federal agency obligations		$	8,325			$	(74	)		$	8,325			$	(74	)		$	—			$	—
Commercial mortgage pass-through securities			1,392				(19	)			—				—				1,392				(19	)
Obligations of U.S. states and political subdivisions			14,789				(151	)			3,336				(4	)			11,453				(147	)
Corporate bonds and notes			2,700				(14	)			2,700				(14	)			—				—
Total			27,206				(258	)			14,361				(92	)			12,845				(166	)
Total Temporarily Impaired Securities		$	96,877			$	(1,203	)		$	69,582			$	(501	)		$	27,295			$	(702	)

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

		December 31, 2013
		Total								Less than 12 Months								12 Months or Longer
		Fair Value				Unrealized Losses				Fair Value				Unrealized Losses				Fair Value				Unrealized Losses
		(in thousands)
Investment Securities Available-for-Sale:
U.S. Treasury and agency securities		$	13,519			$	(825	)		$	13,519			$	(825	)		$	—			$	—
Federal agency obligation			17,200				(655	)			17,200				(655	)			—				—
Residential mortgage pass-through securities			18,293				(229	)			18,293				(229	)			—				—
Commercial mortgage pass-through securities			2,924				(157	)			2,924				(157	)			—				—
Obligations of U.S. states and political subdivisions			4,199				(55	)			4,199				(55	)			—				—
Trust preferred securities			5,306				(510	)			4,031				(211	)			1,275				(299	)
Corporate bonds and notes			32,498				(482	)			30,533				(448	)			1,965				(34	)
Certificates of deposit			552				(20	)			552				(20	)			—				—
Equity securities			287				(89	)			—				—				287				(89	)
Mutual funds and money market funds			985				(15	)			—				—				985				(15	)
Total			95,763				(3,037	)			91,251				(2,600	)			4,512				(437	)
Investment Securities Held-to-Maturity:
U.S. Treasury and agency securities		$	27,037			$	(1,019	)		$	27,037			$	(1,019	)		$	—			$	—
Federal agency obligation			13,492				(389	)			13,197				(388	)			295				(1	)
Residential mortgage pass-through securities			2,182				(64	)			2,182				(64	)			—				—
Commercial mortgage pass-through securities			1,395				(62	)			1,395				(62	)			—				—
Obligations of U.S. states and political subdivisions			66,034				(3,688	)			57,072				(2,957	)			8,962				(731	)
Corporate bonds and notes			27,210				(622	)			27,210				(622	)			—				—
Total			137,350				(5,844	)			128,093				(5,112	)			9,257				(732	)
Total Temporarily Impaired Securities		$	233,113			$	(8,881	)		$	219,344			$	(7,712	)		$	13,769			$	(1,169	)

 

Investment securities having a carrying value of approximately $232.9 million and $109.3 million at September 30, 2014 and December 31, 2013, respectively, were pledged to secure public deposits, borrowings, Federal Reserve Discount Window, and Federal Home Loan Bank advances and for other purposes required or permitted by law.

 

At September 30, 2014 and December 31, 2013, there were no holdings of securities of any one issuer, other than the U.S. Government and its agencies, in an amount greater than 10% of stockholders’ equity.

 

Note 6. Loans and the Allowance for Loan Losses

 

Loans are stated at their principal amounts inclusive of net deferred loan origination fees. Interest income is credited as earned except when a loan becomes past due 90 days or more and doubt exists as to the ultimate collection of interest or principal. In those cases the recognition of income is discontinued. Past due status is based on the contractual terms of the loan. Loans that are past due 90 days or more that are both well secured and in the process of collection will remain on an accruing basis. When a loan is placed on non-accrual status, interest accruals cease and uncollected accrued interest is reversed and charged against current income.

 

Payments received on non-accrual loans are generally applied against principal. A loan may only be restored to an accruing basis when it again becomes well secured and in the process of collection or all past due amounts have been collected. Loan origination fees and certain direct loan origination costs are deferred and recognized over the life of the loan as an adjustment to the loan’s yield using the level yield method.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

Portfolio segments are defined as the level at which an entity develops and documents a systematic methodology to determine its allowance. Management has determined that the Corporation has two portfolio segments of loans and leases (commercial and consumer) in determining the allowance. Both quantitative and qualitative factors are used by management at the portfolio segment level in determining the adequacy of the allowance for the Corporation. Classes of loans and leases are a disaggregation of the Corporation’s portfolio segments. Classes are defined as a group of loans and leases, which share similar initial measurement attributes, risk characteristics, and methods for monitoring and assessing credit risk. Management has determined that the Corporation has five classes of loans and leases: commercial (including lease financing), commercial real estate, commercial construction, residential real estate (including home equity) and consumer.

 

Impaired Loans

 

The Corporation accounts for impaired loans in accordance with FASB ASC 310-10-35. The value of impaired loans is based on the present value of expected future cash flows discounted at the loan’s effective interest rate or, as a practical expedient, at the loan’s observable market price or at the fair value of the collateral if the loan is collateral dependent.

 

A loan is considered impaired when, based on current information and events, it is probable that the Corporation will not be able to collect all amounts due from the borrower in accordance with the contractual terms of the loan, including scheduled interest payments. The Corporation has defined its population of impaired loans to include all classes of non-accrual, troubled debt restructuring (“TDR”) loans and loans with a specific reserve. As part of the evaluation of impaired loans, the Corporation individually reviews for impairment all non-homogeneous loans internally classified as substandard or below. Generally, smaller impaired non-homogeneous loans and impaired homogeneous loans are collectively evaluated for impairment.

 

When a loan has been identified as being impaired, the amount of impairment is measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s observable market price, or the estimated fair value of the collateral, less any selling costs, if the loan is collateral-dependent. If the measurement of the impaired loan is less than the recorded investment in the loan (including accrued interest, net of deferred loan fees or costs and unamortized premiums or discounts), impairment is recognized by creating or adjusting an existing allocation of the allowance, or by recording a partial charge-off of the loan to its fair value. Interest payments made on impaired loans are typically applied to principal unless collectability of the principal amount is reasonably assured, in which case interest income may be accrued or recognized on a cash basis.

 

Loans Modified in a Troubled Debt Restructuring

 

Loans are considered to have been modified in a TDR when due to a borrower’s financial difficulties; the Corporation makes certain concessions to the borrower that it would not otherwise consider. Modifications may include interest rate reductions, principal or interest forgiveness, forbearance, and other actions intended to minimize economic loss and to avoid foreclosure or repossession of collateral. Generally, a non-accrual loan that has been modified in a TDR remains on non-accrual status for a period of nine months to demonstrate that the borrower is able to meet the terms of the modified loan. However, performance prior to the modification, or significant events that coincide with the modification, are included in assessing whether the borrower can meet the new terms and may result in the loan being returned to accrual status at the time of loan modification or after a shorter performance period. If the borrower’s ability to meet the revised payment schedule is uncertain, the loan remains on non-accrual status.

 

Reserve for Credit Losses

 

The Corporation’s reserve for credit losses is comprised of two components, the allowance for loan losses and the reserve for unfunded commitments (the “Unfunded Commitments”).

 

Allowance for Loan Losses

 

The allowance reflects management’s best estimate of probable losses within the existing loan portfolio. The allowance, in the judgment of management, is necessary to reserve for estimated loan losses and risk inherent in the loan portfolio. Additions to the allowance for loan losses are made by charges to the provision for loan losses. Credit exposures deemed to be uncollectible are charged against the allowance for loan losses. Recoveries of previously charged-off amounts are credited to the allowance for loan losses.

 

The Corporation’s allowance for loan losses includes (1) specific valuation allowances for impaired loans evaluated in accordance with FASB Codification Topic 310: Receivables; (2) formulaic allowances based on historical loss experience by loan category, adjusted, as necessary, to reflect the impact of current conditions; and (3) unallocated general valuation allowances determined in accordance with FASB Codification Topic 450: Contingencies based on general economic conditions and other qualitative risk factors both internal and external to the Corporation.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

Material estimates that are particularly susceptible to significant change in the near-term relate to the determination of the allowance for loan losses. In connection with the determination of the allowance for loan losses, management obtains independent appraisals for significant properties.

 

The ultimate collectability of a substantial portion of the Corporation’s loan portfolio is susceptible to changes in the real estate market and economic conditions in the State of New Jersey and the impact of such conditions on the creditworthiness of the borrowers.

 

Purchase Credit Impaired Loans

 

The Corporation purchases individual loans and groups of loans, some of which have shown evidence of credit deterioration since origination. These purchased credit impaired loans are recorded at the amount paid, such that there is no carryover of the seller’s allowance for loan losses. After acquisition, losses are recognized by an increase in the allowance for loan losses.

 

Such purchased credit impaired loans are accounted for individually. The Corporation estimates the amount and timing of expected cash flows for each loan or pool, and the expected cash flows in excess of amount paid is recorded as interest income over the remaining life of the loan (accretable yield). The excess of the loan’s contractual principal and interest over expected cash flows is not recorded (nonaccretable difference).

 

Over the life of the loan , expected cash flows continue to be estimated. If the present value of expected cash flows is less than the carrying amount, a loss is recorded. If the present value of expected cash flows is greater than the carrying amount, it is recognized as part of future interest income.

 

Reserve for Unfunded Commitments

 

The reserve for unfunded commitments is maintained at a level believed by management to be sufficient to absorb estimated probable losses related to unfunded credit facilities and is included in other liabilities in the consolidated statements of condition. The determination of the adequacy of the reserve is based upon an evaluation of the unfunded credit facilities, including an assessment of historical commitment utilization experience, and credit risk. Net adjustments to the reserve for unfunded commitments are included in other expense.

 

Composition of Loan Portfolio

 

The following table sets forth the composition of the Corporation’s loan portfolio, including net deferred fees and costs, at September 30, 2014 and December 31, 2013:

 

		September 30,				December 31,
		2014				2013
		(in thousands)
Commercial		$	470,510			$	229,688
Commercial real estate			1,570,854				536,539
Construction			141,844				42,722
Residential real estate			241,387				150,571
Consumer			2,640				1,084
Subtotal			2,427,235				960,604
Net deferred loan (fees) costs			(470	)			339
Loans receivable		$	2,426,765			$	960,943

 

At September 30, 2014 and December 31, 2013, loan balances of approximately $987.5 million and $564.7 million, respectively, were pledged to secure borrowings from the Federal Home Loan Bank of New York.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

Purchase Credit Impaired Loans

 

The Corporation holds purchased loans for which there was, at their acquisition date, evidence of deterioration of credit quality since their origination and it was probable, at acquisition, that all contractually required payments would not be collected. The carrying amount of those loans is as follows at September 30, 2014 and December 31, 2013.

 

		September 30,				December 31,
		2014				2013
		(in thousands)
Commercial		$	7,255			$	—
Commercial real estate			1,835				—
Construction			—				—
Residential real estate			2,262				—
Consumer			—				—
Total carrying amount		$	11,352			$	—

 

For those purchased loans disclosed above, the Corporation did not increase the allowance for loan losses for the nine months ended September 30, 2014, nor did it increase the allowance for loan losses for purchased impaired loans during the nine months ended September 30, 2013.

 

The accretable yield, or income expected to be collected, on the purchased loans above is as follows at September 30, 2014 and December 31, 2013.

 

		September 30,
		2014
Balance at July 1		$	5,013
New loans purchased			—
Accretion of income			(76	)
Reclassifications from non-accretable difference			—
Disposals			—
Balance at September 30		$	4,937

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

The following table presents information about the recorded investment in loan receivables on non-accrual status by class at September 30, 2014 and December 31, 2013:

 

Loans Receivable on Non-Accrual Status
		September 30, 2014				December 31, 2013
		(in thousands)
Commercial		$	634			$	753
Commercial real estate			3,765				744
Residential real estate			1,684				1,640
Total loans receivable on non-accrual status		$	6,083			$	3,137

 

Non-accrual loans and loans past due 90 days still on accrual include both smaller balance homogenous loans that are collectively evaluated for impairment and individually classified impaired loans.

 

The Corporation continuously monitors the credit quality of its loans receivable. In addition to its internal staff, the Corporation utilizes the services of a third party loan review firm to rate the credit quality of its loans receivable. Credit quality is monitored by reviewing certain credit quality indicators. Assets classified “Pass” are deemed to possess average to superior credit quality, requiring no more than normal attention. Assets classified as “Special Mention” have generally acceptable credit quality yet possess higher risk characteristics/circumstances than satisfactory assets. Such conditions include strained liquidity, slow pay, stale financial statements, or other conditions that require more stringent attention from the lending staff. These conditions, if not corrected, may weaken the loan quality or inadequately protect the Corporation’s credit position at some future date. Assets are classified “Substandard” if the asset has a well-defined weakness that requires management’s attention to a greater degree than for loans classified special mention. Such weakness, if left uncorrected, could possibly result in the compromised ability of the loan to perform to contractual requirements. An asset is classified as “Doubtful” if it is inadequately protected by the net worth and/or paying capacity of the obligor or of the collateral, if any, that secures the obligation. Assets classified as doubtful include assets for which there is a “distinct possibility” that a degree of loss will occur if the inadequacies are not corrected. The following table presents information, excluding net deferred costs, about the Corporation’s loan credit quality at September 30, 2014 and December 31, 2013:

 

Credit Quality Indicators

 

		September 30, 2014
		Pass				Special Mention				Substandard				Doubtful				Total
		(in thousands)
Commercial		$	449,688			$	15,447			$	5,073			$	302			$	470,510
Commercial real estate			1,533,499				17,521				19,834				—				1,570,854
Construction			140,365				—				1,479				—				141,844
Residential real estate			238,516				—				2,871				—				241,387
Consumer			2,534				—				106				—				2,640
Total loans		$	2,364,602			$	32,968			$	29,363			$	302			$	2,427,235

		December 31, 2013
		Pass				Special Mention				Substandard				Doubtful				Total
		(in thousands)
Commercial		$	226,013			$	1,719			$	1,284			$	672			$	229,688
Commercial real estate			509,679				14,544				12,316				—				536,539
Construction			41,492				—				1,230				—				42,722
Residential real estate			147,379				978				2,214				—				150,571
Consumer			964				—				120				—				1,084
Total loans		$	925,527			$	17,241			$	17,164			$	672			$	960,604

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

The following table provides an analysis of the impaired loans, by class, at September 30, 2014 and December 31, 2013:

 

		September 30, 2014
		Recorded Investment				Unpaid Principal Balance				Related Allowance
		(in thousands)
No Related Allowance Recorded
Commercial		$	890			$	663			$	—
Commercial real estate			5,005				5,654				—
Residential real estate			1,957				2,288				—
Consumer			106				106				—
Total		$	7,958			$	8,711				—
With An Allowance Recorded
Commercial real estate		$	3,600			$	3,600			$	323
Total		$	3,600			$	3,600			$	323
Total
Commercial		$	890			$	663			$	—
Commercial real estate			8,605				9,254				—
Residential real estate			1,957				2,288				—
Consumer			106				106				—
Total		$	11,558			$	12,311			$	323

 

		December 31, 2013
		Recorded Investment				Unpaid Principal Balance				Related Allowance
		(in thousands)
No Related Allowance Recorded
Commercial		$	449			$	449			$	—
Commercial real estate			10,482				10,783				—
Residential real estate			1,858				2,000				—
Consumer			120				120				—
Total		$	12,909			$	13,352			$	—
With An Allowance Recorded
Commercial		$	672			$	672			$	300
Commercial real estate			4,344				4,344				115
Total		$	5,016			$	5,016			$	415
Total
Commercial		$	1,121			$	1,121			$	300
Commercial real estate			14,826				15,127				115
Residential real estate			1,858				2,000				—
Consumer			120				120				—
Total		$	17,925			$	18,368			$	415

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

The following table provides an analysis related to the average recorded investment and interest income recognized on impaired loans by class as of and for the three and nine months ended September 30, 2014 and 2013.

 

		Three Months Ended September 30,																Nine Months Ended September 30,
		2014								2013								2014								2013
		Average Recorded Investment				Interest Income Recognized				Average Recorded Investment				Interest Income Recognized				Average Recorded Investment				Interest Income Recognized				Average Recorded Investment				Interest Income Recognized
Impaired loans with no related allowance recorded:
Commercial		$	897			$	—			$	—			$	—			$	778			$	30			$	—			$	—
Commercial real estate			5,046				31				1,275				19				5,313				74				1,275				57
Residential real estate			1,975				0				—				—				2,044				31				—				—
Consumer			106				2				—				—				106				5				—				—
Total		$	8,024				32			$	1,275			$	19			$	8,241			$	140			$	1,275			$	57
Impaired loans with an allowance recorded:
Commercial		$	—			$	—			$	—			$	—			$	—			$	—			$	—			$	—
Commercial real estate			3,600				37				175				—				3,600				122				2,302				68
Residential real estate			—				—				1,226				10				—				—				1,226				31
Consumer			—				—				—								—				—				—				—
Total		$	3,600			$	37			$	1,401			$	10			$	3,600			$	122			$	3,428			$	99
Total impaired loans:
Commercial		$	897			$	—			$	—			$	—			$	778			$	30			$	—			$	—
Commercial real estate			8,646				68				1,450				19				8,913				196				3,477				125
Residential real estate			1,975				0				1,226				10				2,044				31				1,226				31
Consumer			106				2				—				—				106				5				—				—
Total		$	11,624			$	69			$	2,676			$	29				11,841			$	262			$	4,703			$	156

 

Included in impaired loans at September 30, 2014 are loans that are deemed troubled debt restructurings. The recorded investment in loans include accrued interest receivable and other capitalized costs such as real estate taxes paid on behalf of the borrower and loan origination fees, net, when applicable. Cash basis interest and interest income recognized on accrual basis approximate each other.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

The following table provides an analysis of the aging of the recorded investment of loans, excluding net deferred costs that are past due at September 30, 2014 and December 31, 2013 by class:

 

Aging Analysis

 

		September 30, 2014
		30-59 Days Past Due				60-89 Days Past Due				90 Days or Greater Past Due				Total Past Due				Current				Total Loans Receivable				Loans Receivable > 90 Days Past Due and Accruing
		(in thousands)
Commercial		$	405			$	—			$	752			$	1,157			$	469,353			$	470,510			$	—
Commercial real estate			951				2,044				4,020				7,015				1,563,839				1,570,854				—
Construction			—				—				—				—				141,844				141,844				—
Residential real estate			347				1,763				3,403				5,513				235,874				241,387				—
Consumer			17				—				—				17				2,623				2,640
Total		$	1,720			$	3,807			$	8,175			$	13,702			$	2,413,533			$	2,427,235			$	—

 

		December 31, 2013
		30-59 Days Past Due				60-89 Days Past Due				90 Days or Greater Past Due				Total Past Due				Current				Total Loans Receivable				Loans Receivable > 90 Days Past Due and Accruing
		(in thousands)
Commercial		$	18			$	—			$	753			$	771			$	228,917			$	229,688			$	—
Commercial Real Estate			221				—				744				965				535,574				536,539				—
Construction			—				—				—				—				42,722				42,722				—
Residential real estate			990				258				1,640				2,888				147,683				150,571				—
Consumer			5				—				—				5				1,079				1,084
Total		$	1,234			$	258			$	3,137			$	4,629			$	955,975			$	960,604			$	—

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

The following table details the amount of loans receivable that are evaluated individually, and collectively, for impairment (excluding net deferred costs), acquired, and the related portion of the allowance for loan loss that is allocated to each loan portfolio class:

 

		September 30, 2014
		Commercial				Commercial real estate				Construction				Residential real estate				Consumer				Unallocated				Total
		(in thousands)
Allowance for loan and lease losses:
Individually evaluated for impairment		$	—			$	323			$	—			$	—			$	—			$	—			$	323
Collectively evaluated for impairment			2,478				6,699				524				1,052				5				1,037				11,795
Acquired with deteriorated credit quality			—				—				—				—				—				—				—
Total		$	2,478			$	7,022			$	524			$	1,052			$	5			$	1,037			$	12,118
Loans Receivable
Individually evaluated for impairment		$	68			$	5,983			$	—			$	1,733			$	106			$	—			$	7,890
Collectively evaluated for impairment			463,187				1,563,036				141,844				237,391				2,534				—				2,407,992
Acquired with deteriorated credit quality			7,255				1,835				—				2,263				—				—				11,353
Total		$	470,510			$	1,570,854			$	141,844			$	241,387			$	2,640			$	—			$	2,427,235

 

The tables above include approximately $1,275,000,000 of acquired loans for the period ended September 30, 2014 reported as collectively evaluated for impairment.

 

		December 31, 2013
		Commercial				Commercial real estate				Construction				Residential real estate				Consumer				Unallocated				Total
		(in thousands)
Allowance for loan and lease losses:
Individually evaluated for impairment		$	300			$	115			$	—			$	—			$	—			$	—			$	415
Collectively evaluated for impairment			1,398				5,631				362				990				146				1,391				9,918
Total		$	1,698			$	5,746			$	362			$	990			$	146			$	1,391			$	10,333
Loans Receivable
Individually evaluated for impairment		$	1,121			$	14,826			$	—			$	1,858			$	120			$	—			$	17,925
Collectively evaluated for impairment			228,567				521,713				42,722				148,713				964				—				942,679
Total		$	229,688			$	536,539			$	42,722			$	150,571			$	1,084			$	—			$	960,604

 

The tables above include approximately $34,000,000 of acquired loans for the period ended December 31, 2013 reported as collectively evaluated for impairment.

 

The Corporation’s allowance for loan losses is analyzed quarterly. Many factors are considered, including growth in the portfolio, delinquencies, nonaccrual loan levels, and other factors inherent in the extension of credit. There have been no material changes to the allowance for loan loss methodology as disclosed in the Corporation’s Annual Report on Form 10-K for the year ended December 31, 2013.

 

A summary of the activity in the allowance for loan losses is as follows:

 

		Three Months Ended September 30, 2014
		Commercial				Commercial real estate				Construction				Residential real estate				Consumer				Unallocated				Total
		(in thousands)
Balance at July 1,		$	2,142			$	5,741			$	504			$	1,011			$	63			$	1,364			$	10,825
Charge offs			—				—				—				—				(18	)			—				(18	)
Recoveries			—				—				—				—				11				—				11
Provision			336				1,281				20				41				(51	)			(327	)			1,300
Balance at September 30,		$	2,478			$	7,022			$	524			$	1,052			$	5			$	1,037			$	12,118

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

		Nine Months Ended September 30, 2014
		Commercial				Commercial real estate				Construction				Residential real estate				Consumer				Unallocated				Total
		(in thousands)
Balance at January 1,		$	1,698			$	5,746			$	362			$	990			$	146			$	1,391			$	10,333
Charge offs			(333	)			—				—				(108	)			(7	)			—				(448	)
Recoveries			—				—				—				11				13				—				24
Provision			1,113				1,276				162				159				(147	)			(354	)			2,209
Balance at September 30,		$	2,478			$	7,022			$	524			$	1,052			$	5			$	1,037			$	12,118

		Three Months Ended September 30, 2013
		Commercial				Commercial real estate				Construction				Residential real estate				Consumer				Unallocated				Total
		(in thousands)
Balance at July 1,		$	2,422			$	5,333			$	318			$	1,341			$	29			$	759			$	10,202
Charge offs			(6	)			—				—				—				(4	)			—				(10	)
Recoveries			—				—				—				—				2				—				2
Provision			(702	)			455				51				(37	)			67				166				—
Balance at September 30,		$	1,714			$	5,788			$	369			$	1,304			$	94			$	925			$	10,194

		Nine Months Ended September 30, 2013
		Commercial				Commercial real estate				Construction				Residential real estate				Consumer				Unallocated				Total
		(in thousands)
Balance at January 1,		$	2,424			$	5,323			$	313			$	1,532			$	113			$	532			$	10,237
Charge offs			(6	)			(50	)			—				—				(20	)			—				(76	)
Recoveries			21				8				—				—				4				—				33
Provision			(725	)			507				56				(228	)			(3	)			393				—
Balance at September 30,		$	1,714			$	5,788			$	369			$	1,304			$	94			$	925			$	10,194

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

Troubled Debt Restructurings

 

At September 30, 2014, there were no commitments to lend additional funds to borrowers whose loans were on non-accrual status or were contractually past due in excess of 90 days and still accruing interest, or whose terms have been modified in troubled debt restructurings.

 

The policy of the Corporation generally is to grant commercial, mortgage and consumer loans to residents and businesses within its market area. The borrowers’ abilities to repay their obligations are dependent upon various factors, including the borrowers’ income and net worth, cash flows generated by the borrowers’ underlying collateral, value of the underlying collateral, and priority of the lender’s lien on the property. Such factors are dependent upon various economic conditions and individual circumstances beyond the control of the Corporation. The Corporation is therefore subject to risk of loss. The Corporation believes its lending policies and procedures adequately minimize the potential exposure to such risks and that adequate provisions for loan losses are provided for all known and inherent risks. Collateral and/or personal guarantees are required for virtually all loans. A loan is considered to be in payment default once it is 90 days contractually past due under the modified terms.

 

Loans modified in a troubled debt restructuring totaled a recorded investment of $2.8 million at September 30, 2014, of which $1.0 million were on non-accrual status. The remaining loans modified were current and have complied with the terms of their restructure agreement. At December 31, 2013, loans modified in a troubled debt restructuring totaled $6.6 million, of which $826,000 was on non-accrual status. The remaining loans modified were current at the time of the restructuring and have complied with the terms of their restructure agreement. The Corporation has allocated no specific allocations with respect to loans whose loan terms had been modified in troubled debt restructurings as of September 30, 2014 and December 31, 2013.

 

The following table presents loans by class modified as troubled debt restructurings that occurred during the nine months ended September 30, 2014 (dollars in thousands):

 

					Pre-Modification			Post-Modification
					Outstanding			Outstanding
		Number of			Recorded			Recorded
		Loans			Investment			Investment
Troubled debt restructurings:
Commercial			1		$	672		$	315
Commercial real estate			1			136			93
Construction			—			—			—
Residential real estate			2			275			273
Total			4		$	1,083		$	681

 

The Corporation had a $333,000 charge-off in connection with a loan modification at the time of modification during the nine months ended September 30, 2014. There were no troubled debt restructurings for which there was a payment default within twelve months following the modification during the nine months ended September 30, 2014.

 

There were no troubled debt restructurings that occurred during the year ended December 31, 2013. The Corporation had no loans charged-off in connection with a loan modification at the time of the modification during the year ended December 31, 2013. There were no troubled debt restructurings for which there was a payment default within twelve months following the modification during the year ended December 31, 2013.

 

In an effort to proactively manage delinquent loans, the Corporation has selectively extended to certain borrowers concessions such as rate reductions, extension of maturity dates, principal or interest forgiveness, adjusted repayment terms, forbearance agreements, or combinations of two or more of these concessions. As of September 30, 2014, loans on which concessions were made with respect to adjusted repayment terms amounted to $2.0 million, and deemed troubled debt restructurings. Loans on which combinations of two or more concessions were made amounted to $1.3 million. The concessions granted included principal concessions, rate reduction, adjusted repayment, extended maturity and payment deferral. 

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

Note 7.  Fair Value Measurements and Fair Value of Financial Instruments

 

Fair Value Measurements

 

Management uses its best judgment in estimating the fair value of the Corporation’s financial instruments; however, there are inherent weaknesses in any estimation technique. The estimated fair value amounts have been measured as of September 30, 2014 and December 31, 2013, and have not been re-evaluated or updated for purposes of these consolidated financial statements subsequent to those respective dates. As such, the estimated fair values of these financial instruments subsequent to the respective reporting dates may be different than the amounts reported at each period end.

 

Fair value is the exchange price that would be received for an asset or paid to transfer a liability (exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. There are three levels of inputs that may be used to measure fair values:

 

·

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

 

·

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

 

·

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

 

An asset’s or liability’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement.

 

Investment Securities Available-for-Sale

 

Where quoted prices are available in an active market, investment securities are classified in Level 1 of the valuation hierarchy. Level 1 inputs include investment securities that have quoted prices in active markets for identical assets. If quoted market prices are not available, then fair values are estimated by using pricing models, quoted prices of securities with similar characteristics, or discounted cash flows. Examples of instruments, which would generally be classified within Level 2 of the valuation hierarchy, include municipal bonds and certain agency collateralized mortgage obligations. In certain cases where there is limited activity in the market for a particular instrument, assumptions must be made to determine its fair value and it is classified as Level 3. Due to the inactive condition of the markets amidst the financial crisis, the Corporation treated certain investment securities as Level 3 assets in order to provide more appropriate valuations. For assets in an inactive market, the infrequent trades that do occur are not a true indication of fair value. When measuring fair value, the valuation techniques available under the market approach, income approach and/or cost approach are used. The Corporation’s valuations are based on market data and the Corporation employs combinations of these approaches for its valuation methods depending on the asset class. In certain cases where there were limited or less transparent information provided by the Corporation’s third-party pricing service, fair value was estimated by the use of secondary pricing services or through the use of non-binding third-party broker quotes.

 

On a quarterly basis, management reviews the pricing information received from the Corporation’s third-party pricing service. This review process includes a comparison to non-binding third-party broker quotes, as well as a review of market-related conditions impacting the information provided by the Corporation’s third-party pricing service.

 

Management primarily identifies investment securities which may have traded in illiquid or inactive markets by identifying instances of a significant decrease in the volume and frequency of trades, relative to historical levels, as well as instances of a significant widening of the bid-ask spread in the brokered markets. Investment securities that are deemed to have been trading in illiquid or inactive markets may require the use of significant unobservable inputs. For example, management may use quoted prices for similar investment securities in the absence of a liquid and active market for the securities being valued. As of September 30, 2014 and December 31, 2013, management made no adjustments to prices provided by the third-party pricing service as a result of illiquid or inactive markets.

 

The Corporation determined that an income approach valuation technique (present value technique) that maximizes the use of relevant observable inputs and minimizes the use of unobservable inputs will be equally or more representative of fair value than the market approach valuation technique used at the prior measurement dates. As a result, the Corporation used the discount rate adjustment technique to determine fair value.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

Assets and Liabilities Measured at Fair Value on a Recurring Basis

 

For financial assets and liabilities measured at fair value on a recurring basis, the fair value measurements by level within the fair value hierarchy used at September 30, 2014 and December 31, 2013 are as follows: 

 

						Fair Value Measurements at Reporting Date Using
Assets Measured at Fair Value on a Recurring Basis		September 30, 2014				Quoted Prices in Active Markets for Identical Assets (Level 1)				Significant Other Observable Inputs (Level 2)				Significant Unobservable Inputs (Level 3)
						(in thousands)
U.S. Treasury & agency securities		$	11,385			$	11,385			$	—			$	—
Federal agency obligations			32,992				—				32,992				—
Residential mortgage pass-through securities			59,691				—				59,691				—
Commercial mortgage pass-through securities			3,016				—				3,016				—
Obligations of U.S. states and political subdivisions			8,429				—				8,429				—
Trust preferred securities			16,314				—				16,314				—
Corporate bonds and notes			135,840				—				135,840				—
Asset-backed securities			21,753				—				21,753				—
Certificates of deposit			2,124				—				2,124				—
Equity securities			289				289				—				—
Mutual funds and money market funds			15,669				15,669				—				—
Investment securities available-for-sale		$	307,502			$	27,343			$	280,159			$	—

 

						Fair Value Measurements at Reporting Date Using
Assets Measured at Fair Value on a Recurring Basis		December 31, 2013				Quoted Prices in Active Markets for Identical Assets (Level 1)				Significant Other Observable Inputs (Level 2)				Significant Unobservable Inputs (Level 3)
						(in thousands)
U.S. Treasury and agency securities		$	13,519			$	13,519			$	—			$	—
Federal agency obligations			19,941				—				19,941				—
Residential mortgage pass-through securities			48,874				—				48,874				—
Commercial mortgage pass-through securities			6,991				—				6,991				—
Obligations of U.S. states and political subdivisions			31,460				—				31,460				—
Trust preferred securities			19,403				—				19,403				—
Corporate bonds and notes			158,630				—				158,630				—
Asset-backed securities			15,979				—				15,979				—
Certificates of deposit			2,262				—				2,262				—
Equity securities			287				287				—				—
Mutual funds and money market funds			5,724				5,724				—				—
Investment securities available-for-sale		$	323,070			$	19,530			$	303,540			$	—

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

The fair values used by the Corporation are obtained from an independent pricing service and represent either quoted market prices for the identical securities (Level 1 inputs) or fair values determined by pricing models using a market approach that considers observable market data, such as interest rate volatilities, LIBOR yield curve, credit spreads and prices from market makers and live trading systems (Level 2).

 

The following tables present the changes in investment securities available-for-sale with significant unobservable inputs (Level 3) for the three months ended September 30, 2014 and 2013.

 

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2014				2013				2014				2013
						(in thousands)
Balance, beginning of the period		$	—			$	72			$	—			$	36
Interest payment deferrals			—				14				—				43
Principal repayments			—				—				—				—
Total net losses included in net income			—				—				—				—
Total net unrealized (losses) gains			—				8				—				15
Balance, end of the period			—			$	94				—			$	94

 

For the nine months ended September 30, 2014, there were no transfers of investment securities available-for-sale into or out of Level 1, Level 2, or Level 3 assets.

 

Assets Measured at Fair Value on a Non-Recurring Basis

 

For assets measured at fair value on a non-recurring basis, the unobservable inputs used to derive fair value measurements at September 30, 2014 and December 31, 2013 were as follows:

 

Impaired Loans		Valuation Techniques		Range of Unobservable Inputs
Residential		Appraisals of collateral value		Adjustment for age of comparable sales, generally a decline of 0% to 25%
Commercial		Discounted cash flow model		Discount rate from 0% to 6%
Commercial real estate		Appraisals of collateral value		Market capitalization rates between 8% to 12%. Market rental rates for similar properties
Other Real Estate Owned
Residential		Appraisals of collateral value		Adjustment for age of comparable sales, generally a decline of 0% to 25%

 

						Fair Value Measurements at Reporting Date Using
Assets Measured at Fair Value on a Non-Recurring Basis		September 30, 2014				Quoted Prices in Active Markets for Identical Assets (Level 1)				Significant Other Observable Inputs (Level 2)				Significant Unobservable Inputs (Level 3)
						(in thousands)
Impaired Loans
Commercial real estate		$	3,277			$	—			$	—			$	3,277
Other Real Estate Owned
Residential			1,442				—				—				1,442

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

						Fair Value Measurements at Reporting Date Using
Assets Measured at Fair Value on a Non-Recurring Basis		December 31, 2013				Quoted Prices in Active Markets for Identical Assets (Level 1)				Significant Other Observable Inputs (Level 2)				Significant Unobservable Inputs (Level 3)
						(in thousands)
Impaired Loans
Commercial		$	372			$	—			$	—			$	372
Commercial real estate			4,229				—				—				4,229
Other Real Estate Owned
Residential			220				—				—				220

 

The following methods and assumptions were used to estimate the fair values of the Corporation’s assets measured at fair value on a non-recurring basis at September 30, 2014 and December 31, 2013.

 

Impaired Loans. The value of an impaired loan is measured based upon the present value of expected future cash flows discounted at the loan’s effective interest rate, or the fair value of the collateral if the loan is collateral dependent. Smaller balance homogeneous loans that are collectively evaluated for impairment, such as residential mortgage loans are specifically excluded from the impaired loan portfolio. The Corporation’s impaired loans are primarily collateral dependent. Impaired loans are individually assessed to determine that each loan’s carrying value is not in excess of the fair value of the related collateral or the present value of the expected future cash flows. Impaired loans at September 30, 2014 that required a valuation allowance during 2014 were $3.6 million with a related valuation allowance of $323,000 compared to $5.0 million with a related valuation allowance of $415,000 at December 31, 2013. Additional provision for loan losses of $0 and $210,500 for the third quarter and first nine months of 2014, respectively, were recorded. Additional provision for loan losses of $415,000 for the year ended December 31, 2013 were recorded.

 

Other Real Estate Owned.  Other real estate owned (“OREO”) is measured at fair value less costs to sell, generally a decline of 0% to 25% for residential OREO and a decline of 0% to 15% for commercial OREO. The Corporation believes that the fair value component in its valuation follows the provisions of FASB ASC 820-10-05. The fair value of OREO is determined by sales agreements or appraisals by qualified licensed appraisers approved and hired by the Corporation. Costs to sell associated with OREO are based on estimation per the terms and conditions of the sales agreements or appraisals.

 

Fair Value of Financial Instruments

 

FASB ASC 825-10 requires all entities to disclose the estimated fair value of their financial instrument assets and liabilities. For the Corporation, as for most financial institutions, the majority of its assets and liabilities are considered financial instruments as defined in FASB ASC 825-10. Many of the Corporation’s financial instruments, however, lack an available trading market as characterized by a willing buyer and willing seller engaging in an exchange transaction. It is also the Corporation’s general practice and intent to hold its financial instruments to maturity and not to engage in trading or sales activities except for loans held-for-sale and investment securities available-for-sale. Therefore, significant estimations and assumptions, as well as present value calculations, were used by the Corporation for the purposes of this disclosure.

 

Cash and due from banks and interest bearing deposits: The carrying amounts of cash and short-term instruments approximate fair values and care classified as Level 1.

 

Investment in Restricted Stock: It is not practical to determine the fair value of FHLB Stock due to restrictions placed on its transferability.

 

Investment Securities Held-to-Maturity. The fair value of the Corporation’s investment securities held-to-maturity was primarily measured using information from a third-party pricing service. If quoted prices were not available, fair values were estimated primarily by obtaining quoted prices for similar assets in active markets or through the use of pricing models. In cases where there may be limited or less transparent information provided by the Corporation’s third-party pricing service, fair value may be estimated by the use of secondary pricing services or through the use of non-binding third-party broker quotes.

 

Loans Held-for-Sale. Fair value is estimated using the prices of the Corporation’s existing commitments to sell such loans and/or the quoted market price for commitments to sell similar loans.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

Loans. The fair value of the Corporation’s loans was estimated by discounting the expected future cash flows using the current interest rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities. Loans were segregated by types such as commercial, residential and consumer loans. Expected future cash flows were projected based on contractual cash flows, adjusted for estimated prepayments.

 

Noninterest-Bearing Deposits. The fair value for noninterest-bearing deposits is equal to the amount payable on demand at the reporting date.

 

Interest-Bearing Deposits. The fair values of the Corporation’s interest-bearing deposits were estimated using discounted cash flow analyses. The discounted rates used were based on rates currently offered for deposits with similar remaining maturities. The fair values of the Corporation’s interest-bearing deposits do not take into consideration the value of the Corporation’s long-term relationships with depositors, which may have significant value.

 

Term Borrowings and Subordinated Debentures. The fair value of the Corporation’s long-term borrowings and subordinated debentures were calculated using a discounted cash flow approach and applying discount rates currently offered based on weighted remaining maturities.

 

Accrued Interest Receivable/Payable. The carrying amounts of accrued interest approximate fair value resulting in a Level 2 or Level 3 classification based on the level of the asset or liability with which the accrual is associated.

 

The following presents the carrying amount, fair value, and placement in the fair value hierarchy of the Corporation’s financial instruments as of September 30, 2014 and December 31, 2013.

 

										Fair Value Measurements
		Carrying Amount				Fair Value				Quoted Prices in Active Markets for Identical Assets (Level 1)				Significant Other Observable Inputs (Level 2)				Significant Unobservable Inputs (Level 3)
		(in thousands)
September 30, 2014
Financial assets:
Cash and cash equivalents		$	138,013			$	138,013			$	138,013			$	—			$	—
Investment securities available-for-sale			307,502				307,502				27,343				280,159				—
Investment securities held-to-maturity			217,567				222,393				28,463				175,105				18,825
Investment in restricted stock, at cost			17,922				n/a				n/a				n/a				n/a
Net loans			2,414,647				2,427,263				—				—				2,427,263
Accrued interest receivable			10,976				10,976				278				3,176				7,522
Financial liabilities:
Noninterest-bearing deposits		$	471,151			$	471,151			$	471,151			$	—			$	—
Interest-bearing deposits			1,998,017				2,004,084				—				2,004,084				—
Borrowings			420,960				436,366				—				436,366				—
Subordinated debentures			5,155				4,786				—				4,786				—
Accrued interest payable			3,811				3,811				—				3,811				—

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

										Fair Value Measurements
		Carrying Amount				Fair Value				Quoted Prices in Active Markets for Identical Assets (Level 1)				Significant Other Observable Inputs (Level 2)				Significant Unobservable Inputs (Level 3)
		(in thousands)
December 31, 2013
Financial assets:
Cash and due from banks		$	82,692			$	82,692			$	82,692			$	—			$	—
Investment securities available-for-sale			323,070				323,070				19,530				303,540				—
Investment securities held-to-maturity			215,286				210,958				27,037				164,940				18,981
Investment in restricted stock, at cost			8,986				n/a				n/a				n/a				n/a
Net loans			950,610				948,606				—				—				948,606
Accrued interest receivable			6,802				6,802				102				4,034				2,666
Financial liabilities:
Noninterest-bearing deposits			227,370				227,370				227,370				—				—
Interest-bearing deposits			1,114,635				1,115,781				—				1,115,781				—
Borrowings			146,000				157,440				—				157,440				—
Subordinated debentures			5,155				5,143				—				5,143				—
Accrued interest payable			963				963				—				963				—

 

Note 8. Accumulated Other Comprehensive Income

 

Accumulated other comprehensive income (loss) at September 30, 2014 and December 31, 2013 consisted of the following:

 

		September 30, 2014				December 31, 2013
		(in thousands)
Net unrealized gain on investment securities available-for-sale, net of tax		$	4,650			$	2,374
Unamortized component of securities transferred from available-for-sale to held-to-maturity, net of tax			(1,336	)			(1,425	)
Defined benefit pension and post-retirement plans, net of tax			(2,736	)			(3,493	)
Total accumulated other comprehensive income (loss)		$	578			$	(2,544	)

 

Note 9.  Stock-Based Compensation

 

The Corporation maintains two stock-based compensation plans from which new grants could be issued. The Corporation’s stock-based compensation plans permit Parent Corporation common stock to be issued to key employees and directors of the Corporation and its subsidiaries. The options granted under the plans are intended to be either incentive stock options or non-qualified options. Under the 2009 Equity Incentive Plan, a total of 363,081 shares are available for grant and issuance as of September 30, 2014. Under the 2003 Non-Employee Director Stock Option Plan, a total of 380,644 shares remain available for grant and issuance under the plan as of September 30, 2014. In addition, a total of 237,621 shares remain available for grant and issuance under Legacy ConnectOne equity plans. Options may be exercised with shares issued from Treasury shares, newly issued shares or a combination of both.

 

Options have been granted to purchase common stock principally at the fair market value of the stock at the date of grant. Options are exercisable over a three-year vesting period starting one year after the date of grant and generally expire ten years from the date of grant.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

Stock-based compensation expense for share-based payment awards is based on the grant date fair value estimated on the date of grant. The Corporation recognizes compensation costs for those shares expected to vest on a straight-line basis over the requisite service period of the award, which is generally the option vesting term of three years. The Corporation estimates the forfeiture rate based on its historical experience during the preceding seven fiscal years.

 

For the nine months ended September 30, 2014 and September 30, 2013, total stock compensation (excluding tax benefit) was $51,000 and $60,000, respectively.

 

Under the principal stock-based compensation plans, the Corporation may also grant stock awards to certain employees. Stock awards are independent of option grants and are generally subject to forfeiture if employment terminates prior to the release of any applicable restrictions. Unless fully vested at the time of grant, such awards generally vest within 30 days to five years from the date of grant. During that period, ownership of the shares cannot be transferred. Restricted stock and stock awards that are fully vested at the time of grant have the same cash dividend and voting rights as other common stock and are considered to be currently issued and outstanding. The Corporation expenses the cost of stock awards, which is determined to be the fair market value of the shares at the date of grant, ratably over the period during which any restrictions lapse.

 

There were 52,467 and 18,829 restricted stock awards outstanding at September 30, 2014 and September 30, 2013, respectively. These awards were issued with an award price equal to the market price of the Corporation’s common stock on the award date and with a three year vesting period. Forfeiture provisions exist for personnel that separate employment before the vesting period expires. A total of 37,110 shares of restricted stock became fully vested on July 1, 2014.

 

There were 0 and 31,257 shares of common stock underlying options that were granted during the three and nine months ended September 30, 2014 and 2013, respectively. The fair value of share-based payment awards was estimated using the Black-Scholes option pricing model with the following assumptions and weighted average fair values at the time the grants were awarded: 

 

		Nine Months Ended September 30,
		2014				2013
Weighted average fair value of grants			n/a			$	3.34
Risk-free interest rate			n/a				1.97	%
Dividend yield			n/a				1.32	%
Expected volatility			n/a				25.84	%
Expected life in months			n/a				74

 

Activity under the stock-based compensation plans as of September 30, 2014 and changes during the ninth months ended September 30, 2014 were as follows: 

 

		Shares				Weighted- Average Exercise Price				Weighted- Average Remaining Contractual Term (Years)				Aggregate Intrinsic Value
Outstanding at December 31, 2013			214,263			$	10.59
Options assumed in merger			783,732				4.73
Exercised			(74,911	)		$	10.48
Canceled/expired			—
Forfeited			—
Outstanding at September 30, 2014			923,084			$	5.58				3.12			$	12,522,584
Exercisable at September 30, 2014			923,084			$	5.58				3.12			$	12,522,584

 

The aggregate intrinsic value of options above represents the total pre-tax intrinsic value (the difference between the Corporation’s closing stock price on the last trading day of the second quarter of 2014 and the exercise price, multiplied by the number of in-the-money options) that would have been received by the option holders had all option holders exercised the