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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
  For the quarterly period ended September 30, 2014
  OR
¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
  For the transition period from  ___________________  to  ___________________

 

Commission File Number 000-27905

 

MutualFirst Financial, Inc.
(Exact name of registrant as specified in its charter)

 

Maryland   35-2085640
(State or other jurisdiction of incorporation or organization)   (I.R.S. Employer Identification No.)
     
110 E. Charles Street, Muncie, Indiana   47305-2419
(Address of principal executive offices)   (Zip Code)

 

Registrant’s telephone number, including area code: (765) 747-2800

 

Securities registered pursuant to Section 12(b) of the Act:

 

Title of each class Name of each exchange on which registered
Common Stock, par value $.01 per share Nasdaq Global Market

 

Securities Registered Pursuant to Section 12(g) of the Act:

None

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ¨ No x

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ¨ No x

 

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

 

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

 

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

 

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

 

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

 

Indicate the number of shares outstanding of each of the registrant’s classes of common stock as of the latest practicable date. As of November 6, 2014, there were 7,198,991 shares of the registrant’s common stock outstanding. 

 

 
 

 

MutualFirst Financial, Inc.

 

Form 10-Q Quarterly Report for the Period Ended September 30, 2014

 

Table of Contents

 

  Page
  Number
PART I – FINANCIAL INFORMATION  
     
Item 1. Financial Statements  
  Consolidated Condensed Balance Sheets 1
  Consolidated Condensed Statements of Income 2
  Consolidated Condensed Statements of Comprehensive Income 3
  Consolidated Condensed Statement of Stockholders’ Equity 4
  Consolidated Condensed Statements of Cash Flows 5
  Notes to Unaudited Consolidated Condensed Financial Statements 6
     
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations 40
     
Item 3. Quantitative and Qualitative Disclosures about Market Risk 55
     
Item 4. Controls and Procedures 58
     
PART II – OTHER INFORMATION  
     
Item 1. Legal Proceedings 59
     
Item 1A. Risk Factors 59
     
Item 2. Unregistered Sales of Equity Changes in Securities and Use of Proceeds 59
     
Item 3. Defaults Upon Senior Securities 59
     
Item 4. Mine Safety Disclosure 59
     
Item 5. Other Information 59
     
Item 6. Exhibits 60
     
Signature Page 62
     
Exhibits   63
 
 

 

MutualFirst Financial, Inc.

Consolidated Condensed Balance Sheets
(In Thousands, Except Share and Per Share Data)

 

   September 30,   December 31, 
   2014   2013 
   (Unaudited)     
Assets          
Cash and due from banks  $7,814   $8,013 
Interest-bearing demand deposits   12,685    17,272 
Cash and cash equivalents   20,499    25,285 
Investment securities available for sale   264,056    264,348 
Loans held for sale   6,440    1,888 
Loans, net of allowance for loan losses of $13,249 and $13,412, at September 30, 2014 and December 31, 2013, respectively   995,468    965,966 
Premises and equipment, net   30,765    31,471 
Federal Home Loan Bank stock   14,391    14,391 
Investment in limited partnerships   1,709    2,092 
Deferred tax asset   14,114    17,002 
Cash value of life insurance   50,709    49,843 
Goodwill   1,800    - 
Core deposit and other intangibles   1,250    1,629 
Other assets   15,439    17,490 
Total assets  $1,416,640   $1,391,405 
           
Liabilities and Stockholders' Equity          
Liabilities          
Deposits          
Noninterest-bearing  $157,464   $144,195 
Interest-bearing   941,385    968,889 
Total deposits   1,098,849    1,113,084 
Federal Home Loan Bank advances   168,523    142,928 
Other borrowings   10,353    10,890 
Other liabilities   16,773    12,861 
Total liabilities   1,294,498    1,279,763 
           
Commitments and Contingencies          
           
Stockholders' Equity          
Common stock, $.01 par value          
Authorized - 20,000,000 shares          
Issued and outstanding - 7,197,891 and 7,117,179 shares   72    71 
Additional paid-in capital   74,286    73,336 
Retained earnings   47,290    41,650 
Accumulated other comprehensive income (loss)   494    (3,415)
Total stockholders' equity   122,142    111,642 
Total liabilities and stockholders' equity  $1,416,640   $1,391,405 

 

See notes to consolidated condensed financial statements.

 

1
 

 MutualFirst Financial, Inc.

Consolidated Condensed Statements of Income
(Unaudited)

(In Thousands, Except Share and Per Share Data)

 

   Three Months Ended   Nine Months Ended 
   September 30,   September 30, 
   2014   2013   2014   2013 
Interest and Dividend Income                    
Loans receivable  $10,904   $11,080   $32,488   $33,142 
Investment securities   1,760    1,833    5,320    5,283 
Federal Home Loan Bank stock   134    124    464    377 
Deposits with financial institutions   5    4    13    18 
Total interest and dividend income   12,803    13,041    38,285    38,820 
                     
Interest Expense                    
Deposits   1,450    2,333    4,677    7,253 
Federal Home Loan Bank advances   571    320    1,562    882 
Other   142    148    430    446 
Total interest expense   2,163    2,801    6,669    8,581 
                     
Net Interest Income   10,640    10,240    31,616    30,239 
Provision for loan losses   -    750    850    2,250 
Net Interest Income After Provision for Loan Losses   10,640    9,490    30,766    27,989 
                     
Other Income                    
Service fee income   1,518    1,447    4,398    4,382 
Net realized gain on sales of available-for-sale securities   75    453    436    835 
Commissions   1,228    1,041    3,488    3,196 
Equity in losses of limited partnerships   (124)   (84)   (309)   (338)
Net gains on sales of loans   444    84    929    654 
Net servicing fees   66    63    45    471 
Increase in cash value of life insurance   295    321    866    942 
Loss on sale of other real estate and repossessed assets   (81)   (108)   (321)   (53)
Other income   153    57    329    282 
Total other income   3,574    3,274    9,861    10,371 
                     
Other Expenses                    
Salaries and employee benefits   6,088    5,282    17,461    16,365 
Net occupancy expenses   494    244    1,763    1,472 
Equipment expenses   450    453    1,344    1,377 
Data processing fees   373    326    1,180    1,081 
Advertising and promotion   387    386    993    1,095 
ATM expense   370    296    976    806 
Deposit insurance   239    251    779    891 
Professional fees   376    318    1,254    973 
Software subscriptions and maintenance   418    391    1,220    1,070 
Other real estate and repossessed assets   161    180    447    529 
Other expenses   1,052    1,073    3,090    3,355 
Total other expenses   10,408    9,200    30,507    29,014 
                     
Income Before Income Tax   3,806    3,564    10,120    9,346 
Income tax expense   1,112    1,092    2,906    2,786 
                     
Net Income   2,694    2,472    7,214    6,560 
Preferred stock dividends and accretion   -    271    -    911 
                     
Net Income Available to Common Shareholders  $2,694   $2,201   $7,214   $5,649 
                     
Earnings Per Share                    
Basic  $0.38   $0.31   $1.01   $0.80 
Diluted  $0.36   $0.30   $0.98   $0.78 
                     
Dividends per common share  $0.08   $0.06   $0.22   $0.18 

 

See notes to consolidated condensed financial statements.

 

2
 

 

MutualFirst Financial, Inc.

Consolidated Condensed Statements of Comprehensive Income
(Unaudited)

(In Thousands)

 

   Three Months Ended   Nine Months Ended 
   September 30,   September 30, 
   2014   2013   2014   2013 
Net Income  $2,694   $2,472   $7,214   $6,560 
Other Comprehensive Income                    
Net unrealized holding gain (loss) on securities available-for-sale   (415)   (397)   5,430    (7,108)
Net unrealized gain (loss) on securities available-for-sale for which a portion of an other-than-temporary impairment has been recognized in income   (4)   2    835    467 
Reclassification adjustment for realized gains included in net income   (75)   (453)   (436)   (835)
Net unrealized gain on derivative used for cash flow hedges   78    14    127    105 
    (416)   (834)   5,956    (7,371)
Income tax (expense) benefit related to other comprehensive income   152    280    (2,047)   2,556 
Other comprehensive income (loss)   (264)   (554)   3,909    (4,815)
                     
Comprehensive Income  $2,430   $1,918   $11,123   $1,745 

 

See notes to consolidated condensed financial statements.

 

3
 

 

MutualFirst Financial, Inc.

Consolidated Condensed Statements of Stockholders’ Equity
For the Period Ended September 30, 2014

(Unaudited)

(In Thousands, Except Share and Per Share Data)

 

   Common Stock   Paid-in Capital
Common
   Retained
Earnings
   Accumulated Other
Comprehensive Income
(Loss)
   Total 
Balances December 31, 2013  $71   $73,336   $41,650   $(3,415)  $111,642 
Net income             7,214         7,214 
Other comprehensive income, net of taxes                  3,909    3,909 
Stock options, exercised   1    950              951 
Cash dividends, common stock ($.22 per share)             (1,574)        (1,574)
Balances September 30, 2014  $72   $74,286   $47,290   $494   $122,142 

  

See notes to consolidated condensed financial statements.

 

4
 

 

MutualFirst Financial, Inc.

Consolidated Condensed Statements of Cash Flows
(Unaudited)

(In Thousands, Except Share and Per Share Data)

 

   Nine Months Ended 
   September 30, 
   2014   2013 
Operating Activities          
Net income  $7,214   $6,560 
Items not requiring cash          
Provision for loan losses   850    2,250 
Depreciation and amortization   3,162    3,683 
Deferred income tax   840    730 
Loans originated for sale   (41,260)   (55,250)
Proceeds from sales of loans held for sale   37,424    59,623 
Gain on sale of loans held for sale   (929)   (654)
Gain on sale of securities - available for sale   (436)   (835)
Loss on sale of other real estate and repossessed assets   321    53 
Loss on sale and disposal of premises and equipment   127    - 
Prepaid FDIC premium   -    1,647 
Change in          
Interest receivable and other assets   318    368 
Interest payable and other liabilities   3,015    1,751 
Cash value of life insurance   (866)   (942)
Other equity adjustments   (1)   341 
Other adjustments   415    378 
Net cash provided by operating activities   10,194    19,703 
           
Investing Activities          
Purchases of securities, available for sale   (43,844)   (99,166)
Proceeds from maturities and paydowns of securities, available for sale   23,743    45,748 
Proceeds from sales of securities, available for sale   26,047    53,179 
Net change in loans   (32,771)   (845)
Purchases of premises and equipment   (669)   (754)
Cash paid in acquisition, net   (900)   - 
Proceeds from real estate owned sales   3,246    3,113 
Net cash provided by (used in) investing activities   (25,148)   1,275 
           
Financing Activities          
Net change in          
Noninterest-bearing, interest-bearing demand and savings deposits   40,014    36,918 
Certificates of deposit   (54,249)   (71,210)
Proceeds from FHLB advances   403,300    220,675 
Repayment of FHLB advances   (377,705)   (198,622)
Repayment of other borrowings   (569)   (569)
Redemption of preferred stock   -    (7,231)
Cash dividends   (1,574)   (2,187)
Other financing activities   951    410 
Net cash provided by (used in) financing activities   10,168    (21,816)
Net Change in Cash and Cash Equivalents   (4,786)   (838)
Cash and Cash Equivalents, Beginning of Period   25,285    32,778 
Cash and Cash Equivalents, End of Period  $20,499   $31,940 
           
Additional Cash Flows Information          
Interest paid  $6,548   $8,579 
Income tax paid   1,200    1,800 
Transfers from loans to foreclosed real estate   1,620    2,770 
Mortgage servicing rights capitalized   213    394 

 

See notes to consolidated condensed financial statements.

 

5
 

  

MutualFirst Financial, Inc.

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(Unaudited)

(In Thousands, Except Share and Per Share Data)

 

Note 1:  Basis of Presentation

 

The consolidated condensed financial statements include the accounts of MutualFirst Financial, Inc. (MutualFirst or the “Company”), its wholly owned subsidiary MutualBank, an Indiana commercial bank (“Mutual” or the “Bank”), Mutual’s wholly owned subsidiaries, First MFSB Corporation, Mishawaka Financial Services, Summit Mortgage, Inc. (“Summit”), Mutual Federal Investment Company (“MFIC”), and MFIC majority owned subsidiary, Mutual Federal REIT, Inc. All significant inter-company accounts and transactions have been eliminated in consolidation.

 

Certain information and note disclosures normally included in the Company’s annual financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted. These consolidated condensed financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s Form 10-K annual report for the year ended December 31, 2013, filed with the Securities and Exchange Commission on March 14, 2014.

 

The interim consolidated condensed financial statements at September 30, 2014, have not been audited by independent accountants, but in the opinion of management, reflect all adjustments (which include only normal recurring adjustments) necessary to present fairly the financial position, results of operations and cash flows for such periods. The results of operations for the period are not necessarily indicative of the results to be expected for the full year.

 

The Consolidated Condensed Balance Sheet of the Company as of December 31, 2013 has been derived from the Audited Consolidated Balance Sheet of the Company as of that date.

 

6
 

  

Note 2: Earnings Per Share

 

Earnings per share were computed as follows:

  

   Three Months Ended September 30, 
   2014   2013 
   Income   Weighted-
Average
Shares
   Per-
Share
Amount
   Income   Weighted-
Average
Shares
   Per-
Share
Amount
 
Basic Earnings Per Share                        
Net income  $2,694    7,178,055        $2,472    7,088,660      
Dividends and accretion on preferred stock   -              (271)          
Income available to common stockholders   2,694    7,178,055   $0.38    2,201    7,088,660   $0.31 
Effect of Dilutive Securities                              
Stock options   -    229,089         -    176,447      
Diluted Earnings Per Share                              
Income available to common stockholders and assumed conversions  $2,694    7,407,144   $0.36   $2,201    7,265,107   $0.30 

 

   Nine Months Ended September 30, 
   2014   2013 
   Income   Weighted-
Average
Shares
   Per-
Share
Amount
   Income   Weighted-
Average
Shares
   Per-
Share
Amount
 
Basic Earnings Per Share                        
Net income  $7,214    7,143,597        $6,560    7,066,670      
Dividends and accretion on preferred stock   -              (911)          
Income available to common stockholders   7,214    7,143,597   $1.01    5,649    7,066,670   $0.80 
Effect of Dilutive Securities                              
Stock options   -    230,147         -    172,205      
Diluted Earnings Per Share                              
Income available to common stockholders and assumed conversions  $7,214    7,373,744   $0.98   $5,649    7,238,875   $0.78

 

Options to purchase 44,161 and 82,000 shares of common stock were outstanding at September 30, 2014 and 2013, respectively, but were not included in the computation of diluted EPS because the options’ exercise price was greater than the average market price of the common shares.

 

7
 

 

Note 3: Impact of Accounting Pronouncements

 

In August 2014, Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2014-15, Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern. The Update provides U.S. GAAP guidance on management’s responsibility in evaluating whether there is substantial doubt about a company’s ability to continue as a going concern and about related footnote disclosures. For each reporting period, management will be required to evaluate whether there are conditions or events that raise substantial doubt about a company’s ability to continue as a going concern within one year from the date the financial statements are issued.

 

The amendments in this Update are effective for annual reporting periods ending after December 15, 2016, and for annual and interim periods thereafter. Early adoption is permitted. The Company 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.

 

In August 2014, FASB, issued ASU 2014-14, Classification of Certain Government-Guaranteed Mortgage Loans upon Foreclosure. The objective of this Update is to reduce diversity in practice by addressing the classification of foreclosed mortgage loans that are fully or partially guaranteed under government programs. Currently, some creditors reclassify those loans to real estate as with other foreclosed loans that do not have guarantees; others reclassify the loans to other receivables. The amendments affect creditors that hold government-guaranteed mortgage loans, including those guaranteed by the FHA and the VA.

 

The amendments in this Update are effective for annual reporting periods ending after December 15, 2015 and interim periods beginning after December 15, 2015. An entity should adopt the amendments in this Update using either a prospective transition method or a modified retrospective transition method. For prospective transition, an entity should apply the amendments in this Update to foreclosures that occur after the date of adoption. For the modified retrospective transition, an entity should apply the amendments in the Update by means of a cumulative-effect adjustment (through a reclassification to a separate other receivable) as of the beginning of the annual period of adoption. Prior periods should not be adjusted. However, a reporting entity must apply the same method of transition as elected under ASU No. 2014-04. Early adoption, including adoption in an interim period, is permitted if the entity already has adopted Update 2014-04. The Company 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.

 

In June 2014, (FASB) issued (ASU) 2014-12 “Compensation – Stock Compensation”. This update defines the accounting treatment for share-based payments and “resolves the diverse accounting treatment of those awards in practice.” The new requirement mandates that “a performance target that affects vesting and that could be achieved after the requisite service period be treated as a performance condition.” Compensation cost will now be recognized in the period in which it becomes likely that the performance target will be met.

 

The amendments in this Update are effective for annual reporting periods beginning after December 15, 2015. Early adoption is permitted. The Company 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.

 

In June 2014, FASB, issued ASU 2014-11 “Transfers and Servicing”. This update addresses the concerns of stakeholders’ by changing the accounting practices surrounding repurchase agreements. The new guidance changes 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.”

 

8
 

  

The amendments in this Update are effective for annual reporting periods beginning after December 15, 2015. Early adoption is prohibited. The Company 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.

 

In May 2014, FASB, in joint cooperation with IASB, issued ASU 2014-09 “Revenue from Contracts with Customers”. The topic of Revenue Recognition had become broad, with several other regulatory agencies issuing standards which lacked cohesion. The new guidance establishes a “common framework” and “reduces the number of requirements to which an entity must consider in recognizing revenue” and yet provides improved disclosures to assist stakeholders reviewing financial statements.

 

The amendments in this Update are effective for annual reporting periods beginning after December 15, 2016. Early adoption is not permitted. The Company 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.

 

In April 2014, FASB issued ASU 2014-08 “Reporting Discontinued Operations and Disclosures of Disposals of Components of an Entity. This update seeks to better define the groups of assets which qualify for discontinued operations, in order to ease the burden and cost for prepares and stakeholders. This issue changed “the criteria for reporting discontinued operations” and related reporting requirements, including the provision for disclosures about the “disposal of and individually significant component of an entity that does not qualify for discontinued operations presentation.”

 

The amendments in this Update are effective for fiscal years beginning after December 15, 2014. Early adoption is permitted only for disposals or classifications as held for sale. The Company 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.

 

In January 2014, FASB issued ASU 2014-04, "Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure,” to reduce diversity by clarifying when a creditor should be considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan such that the loan receivable should be derecognized and the real estate property recognized. The ASU is effective for fiscal years, and interim periods within those years, beginning after December 15, 2014.  Adoption of the ASU is not expected to have a significant effect on the Company’s consolidated financial statements.

 

In January 2014, the FASB issued ASU 2014-01, "Accounting for Investments in Qualified Affordable Housing Projects,” to permit entities to make an accounting policy election to account for their investments in qualified affordable housing projects using the proportional amortization method if certain conditions are met.  The ASU modifies the conditions that an entity must meet to be eligible to use a method other than the equity or cost methods to account for qualified affordable housing project investments. The ASU is effective for fiscal years, and interim periods within those years, beginning after December 15, 2014.  Adoption of the ASU is not expected to have a significant effect on the Company’s consolidated financial statements.

 

9
 

  

Recently the FASB and the Internal Accounting Standards Board (IASB) (the Boards) have published for public comment revised Exposure Drafts outlining proposed changes to the accounting for leases. The proposals aim to improve the quality and comparability of financial reporting by providing greater transparency about leverage, the assets an organization uses in its operations and the risks to which it is exposed from entering into leasing transactions. Under existing accounting standards, a majority of leases are not reported on a lessee’s balance sheet. The amounts involved can be substantial. Additionally, the existing accounting models for leases require lessees and lessors to classify their leases as either capital leases (e.g., a lease of equipment for nearly all of its economic life) or operating leases (e.g., a lease of office space for 10 years) and to account for those leases differently.

 

For capital leases, a lessee recognizes lease assets and liabilities on the balance sheet. For operating leases, a lessee does not recognize lease assets or liabilities on the balance sheet. The existing standards have been criticized for failing to meet the needs of users of financial statements because they do not always provide a complete representation of leasing transactions. In response to this criticism, in 2006 the Boards initiated a joint project to improve the financial reporting of leasing activities under International Financial Reporting Standards (IFRSs) and U.S. GAAP. The Boards have developed an approach to lease accounting that would require a lessee to recognize assets and liabilities for the rights and obligations created by leases. A lessee would recognize assets and liabilities for leases of more than 12 months.

 

Stakeholders have informed the Boards that there are a wide variety of lease transactions with different economics. To better reflect those differing economics, the revised Exposure Drafts propose a dual approach to the recognition, measurement, and presentation of expenses and cash flows arising from a lease. For most real estate leases, a lessee would report a straight-line lease expense in its income statement. For most other leases, such as equipment or vehicles, a lessee would report amortization of the asset separately from interest on the lease liability. The Boards are also proposing disclosures that should enable investors and other users of financial statements to understand the amount, timing, and uncertainty of cash flows arising from leases.

 

The leases project is a converged effort between the Boards. The revised Exposure Drafts for both organizations are nearly identical. The differences between the two proposals are primarily related to existing differences between U.S. GAAP and IFRS and decisions the FASB made related to nonpublic entities.

 

The Boards are also proposing changes to how equipment and vehicle lessors would account for leases that are off balance sheet. Those changes would provide greater transparency about such lessors’ exposure to credit risk and asset risk.

 

Comments were due by September 13, 2013.

 

10
 

 

Note 4: Investment Securities

 

The amortized costs and approximate fair values, together with gross unrealized gains and losses on securities, are as follows:

 

   September 30, 2014 
   Amortized Cost   Gross Unrealized
Gains
   Gross Unrealized
Losses
   Fair Value 
Available for Sale Securities                    
Mortgage-backed securities                    
Government-sponsored agencies  $113,082   $2,269   $(598)  $114,753 
Collateralized mortgage obligations                    
Government-sponsored agencies   98,705    1,199    (1,298)   98,606 
Federal agencies   4    -    -    4 
Municipal obligations   27,259    1,711    (15)   28,955 
Corporate obligations   24,150    94    (2,506)   21,738 
Total investment securities  $263,200   $5,273   $(4,417)  $264,056 

 

   December 31, 2013 
   Amortized Cost   Gross Unrealized
Gains
   Gross Unrealized
Losses
   Fair Value 
Available for Sale Securities                    
Mortgage-backed securities                    
Government-sponsored agencies  $104,006   $1,700   $(2,189)  $103,517 
Collateralized mortgage obligations                    
Government-sponsored agencies   108,305    1,207    (1,934)   107,578 
Federal agencies   5,005    -    (231)   4,774 
Municipal obligations   27,357    257    (276)   27,338 
Corporate obligations   24,648    18    (3,525)   21,141 
Total investment securities  $269,321   $3,182   $(8,155)  $264,348 

 

The amortized cost and fair value of securities available for sale at September 30, 2014, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties.

 

   Available for Sale 
Description Securities  Amortized Cost   Fair Value 
Security obligations due          
One to five years  $9,598   $9,634 
Five to ten years   10,778    10,864 
After ten years   31,037    30,199 
    51,413    50,697 
Mortgage-backed securities          
Government-sponsored agencies   113,082    114,753 
Collateralized mortgage obligations          
Government-sponsored agencies   98,705    98,606 
Totals  $263,200   $264,056 

  

11
 

  

The carrying value of securities pledged as collateral, to secure public deposits and for other purposes, was $0 and $2.5 million at September 30, 2014 and December 31, 2013, respectively.

 

Proceeds from sales of securities available for sale for the three and nine months ended September 30, 2014 and 2013 were $2.8 million and $26.0 million compared to $21.7 million and $53.2 million, respectively. Gross gains of $75,000 and $643,000 compared to $436,000 and $898,000 for the three and nine months ended September 30, 2014 and 2013, respectively, were recognized on those sales. Gross losses of $0 and $207,000 compared to $0 and $63,000 for the three and nine months ended September 30, 2014 and 2013, respectively, were recognized on those sales.

 

All mortgage-backed securities and collateralized-mortgage obligations held by the Company as of September 30, 2014 were in government-sponsored or federal agency securities.

 

Certain investments in debt securities are reported in the financial statements at an amount less than their historical cost. Total fair value of these investments at September 30, 2014 and December 31, 2013 was $96.4 million and $147.8 million, which is approximately 36.5 percent and 55.9 percent of the Company’s investment portfolio at those dates.

 

Based on our evaluation of available evidence, including recent changes in market interest rates, management believes the declines in fair value for these securities, for the periods presented, are temporary.

 

Should the impairment of any of these securities become other than temporary, the cost basis of the investment will be reduced and the resulting loss recognized in net income in the period the other-than-temporary impairment is identified.

 

During the first nine months of 2014 and 2013, the Bank determined that its holdings in trust preferred securities had no further other-than-temporary impairment.

 

The following tables show the gross unrealized losses and fair value of the Company’s investments, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at September 30, 2014 and December 31, 2013:

12
 

 

   September 30, 2014 
   Less than 12 Months   12 Months or More   Total 
   Fair Value   Unrealized
Losses
   Fair Value   Unrealized
Losses
   Fair Value   Unrealized
Losses
 
Available for Sale                              
Mortgage-backed securities                              
Government-sponsored agencies  $10,387   $(98)  $29,284   $(500)  $39,671   $(598)
Collateralized mortgage obligations                              
Government-sponsored agencies   12,910    (168)   34,981    (1,130)   47,891    (1,298)
Federal agencies   4    -    -    -    4    - 
Municipal obligations   -    -    623    (15)   623    (15)
Corporate obligations   -    -    8,188    (2,506)   8,188    (2,506)
Total temporarily impaired securities  $23,301   $(266)  $73,076   $(4,151)  $96,377   $(4,417)

 

   December 31, 2013 
   Less than 12 Months   12 Months or More   Total 
   Fair Value   Unrealized
Losses
   Fair Value   Unrealized
Losses
   Fair Value   Unrealized
Losses
 
Available for Sale                              
Mortgage-backed securities                              
Government-sponsored agencies  $67,130   $(2,189)  $-   $-   $67,130   $(2,189)
Collateralized mortgage obligations                              
Government-sponsored agencies   51,753    (1,934)   -    -   $51,753   $(1,934)
Federal agencies   4,769    (231)             4,769    (231)
Municipal obligations   11,264    (245)   741    (31)   12,005    (276)
Corporate obligations   8,849    (151)   3,336    (3,374)   12,185    (3,525)
Total temporarily impaired securities  $143,765   $(4,750)  $4,077   $(3,405)  $147,842   $(8,155)

  

Mortgage-Backed Securities (MBS), Collateralized Mortgage Obligations (CMO) and Federal Agencies

 

The unrealized losses on the Company’s investment in MBSs, CMOs and Federal Agencies were caused by interest rate changes. The Company expects to recover the amortized cost basis over the term of the securities. Because (1) the decline in market value is attributable to changes in interest rates and not credit quality, (2) the Company does not intend to sell the investments and (3) it is more likely than not the Company will not be required to sell the investments before recovery of their amortized cost bases, which may be at maturity, the Company does not consider these investments to be other-than-temporarily impaired at September 30, 2014.

 

Corporate Obligations

 

The Company’s unrealized loss on investments in corporate obligations primarily relates to investments in pooled trust preferred securities. The unrealized losses were primarily caused by (1) a decrease in performance and regulatory capital resulting from exposure to subprime mortgages and (2) a sector downgrade by several industry analysts. The Company currently expects some of the securities to settle at a price less than the amortized cost basis of the investment (that is, the Company expects to recover less than the entire amortized cost basis of the security). The Company has recognized a loss equal to the credit loss for these securities, establishing a new, lower amortized cost basis. The credit loss was calculated by comparing expected discounted cash flows based on performance indicators of the underlying assets in the security to the carrying value of the investment. Because the Company does not intend to sell these investments and it is likely that the Company will not be required to sell the investments before recovery of its new, lower amortized cost basis, which may be at maturity, it does not consider the remainder of the investments to be other-than-temporarily impaired at September 30, 2014.

13
 

 

Other-Than-Temporary Impairment (OTTI)

 

Upon acquisition of a security, the Company decides whether it is within the scope of the accounting guidance for beneficial interests in securitized financial assets or whether it will be evaluated for impairment under the accounting guidance for investments in debt and equity securities.

 

The accounting guidance for beneficial interests in securitized financial assets provides incremental impairment guidance for a subset of the debt securities within the scope of the guidance for investments in debt and equity securities. For securities that are a beneficial interest in securitized financial assets, the Company uses the beneficial interests in securitized financial asset impairment model. For securities where the security is not a beneficial interest in securitized financial assets, the Company uses debt and equity securities impairment model.

 

The Company conducts periodic reviews to identify and evaluate each investment security to determine whether an other-than-temporary impairment has occurred. Economic models are used to determine whether an other-than-temporary impairment has occurred on these securities. While all securities are considered, the securities primarily impacted by other-than-temporary impairment testing are private-label mortgage-backed securities and trust preferred securities.

 

MutualFirst Financial uses market-based yield indicators as a baseline for determining appropriate discount rates, and then adjusts the resulting discount rates on the basis of its credit and structural analysis of specific trust preferred securities. The primary focus is on the returns a fixed income investor would require in order to allocate capital on a risk adjusted basis. There is currently no active market for pooled trust preferred securities; however, the Company looks principally to market yields for stand-alone trust preferred securities issued by banks, thrifts and insurance companies for which there is an active and liquid market. The next step is to make a series of adjustments to reflect the differences that exist between these products (both credit and structural) and, most importantly, to reflect idiosyncratic credit performance differences (both actual and projected) between these products and the underlying collateral in the specific trust preferred security. Importantly, as part of the analysis described above, MutualFirst considers the fact that structured instruments frequently exhibit leverage not present in stand-alone instruments, and make adjustments as necessary to reflect this additional risk.

 

14
 

  

Credit Losses Recognized on Investments

 

Certain debt securities have experienced fair value deterioration due to credit losses, as well as due to other market factors, but are not otherwise other-than-temporarily impaired.

 

The following table provides information about debt securities for which only a credit loss was recognized in income and other losses are recorded in other comprehensive income.

 

   Accumulated Credit Losses 
   Three Months Ended 
   September 30, 
   2014   2013 
Credit losses on debt securities held          
Beginning of period  $705   $1,205 
Reductions related to actual losses incurred   -    - 
As of September 30,  $705   $1,205 

  

   Accumulated Credit Losses 
   Nine Months Ended 
   September 30, 
   2014   2013 
Credit losses on debt securities held          
Beginning of year  $1,205   $1,205 
Reductions related to actual losses incurred   (500)   - 
As of September 30,  $705   $1,205 

  

15
 

 

Pooled Trust Preferred Securities. The Company has invested in pooled trust preferred securities. At September 30, 2014, the current book balance of our pooled trust preferred securities was $6.2 million. The original par value of these securities was $7.0 million prior to the OTTI write-downs in 2011 and earlier, based on valuations by a third party. OTTI taken on trust preferred securities previously was the result of deterioration in the performance of the underlying collateral. The deterioration was the result of increased defaults and deferrals of dividend payments in that year, creating credit impairment along with weakening financial performance of performing collateral, increasing the risk of future deferrals of dividends and defaults. No additional OTTI was determined in the first nine months of 2014. All pooled trust preferred securities owned by the Bank are exempt from the Volcker Rule.

 

The following table provides additional information related to the Bank’s investment in trust preferred securities as of September 30, 2014.

 

Deal Name  Class  Original
Par
   Book
Value
   Fair
Value
   Unrealized
gain (loss)
   Realized
Losses 
YTD
   Lowest
Ratings
  Number of
Banks /
Insurance
Cos.
Currently
Performing
   Total
Number
of Banks
and
Insurance 
Cos. In
Issuance
(Unique)
   Actual
Deferrals/
Defaults
(as a % of
 original 
collateral)
   Total
Projected
Defaults
 (as a % of
 performing 
collateral)
 (1)
   Excess
subordination
 (after taking 
into account
best estimate
of future
deferrals/
 defaults) (2)
 
   (Dollars in Thousands)
Alesco Preferred Funding IX  B+   1,000    909    559    (350)   -   B2   41    52    14.69%   15.78%   54.50%
Preferred Term Securities XIII  Caa1   1,000    767    423    (344)   -   Ca   44    61    25.75%   20.21%   4.36%
Preferred Term Securities XVIII  Ca   1,000    917    430    (487)   -   Ca   52    72    22.51%   10.03%   6.43%
Preferred Term Securities XXVII  Caa3   1,000    710    386    (324)   -   C   33    46    22.62%   16.29%   10.02%
U.S. Capital Funding I  B3   3,000    2,891    1,936    (955)   -   Caa1   28    33    9.44%   8.60%   8.90%
      $7,000   $6,194   $3,734   $(2,460)  $-                             

 

 

(1)A 10% recovery is applied to all projected defaults by depository institutions. A 15% recovery is applied to all projected defaults by insurance companies. No recovery is applied to current defaults.
(2)Excess subordination represents the additional defaults in excess of both current and projected defaults that the CDO can absorb before the bond experiences any credit impairment. Excess subordinated percentage is calculated by (a) determining what percentage of defaults a deal can experience before the bond has credit impairment, and (b) subtracting from this default breakage percentage both total current and expected future default percentages.

 

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Note 5: Accumulated Other Comprehensive Income (Loss)

 

The components of accumulated other comprehensive income, included in stockholders’ equity, are as follows:

 

   September 30,   December 31, 
   2014   2013 
Net unrealized gain (loss) on securities available-for-sale  $2,966   $(2,029)
Net unrealized loss on securities available-for-sale for which a portion of an other-than-temporary impairment has been recognized in income   (2,110)   (2,945)
Net unrealized loss on derivative used for cash flow hedges   (132)   (259)
Net unrealized gain relating to defined benefit plan liability   100    100 
    824    (5,133)
Tax expense (benefit)   330    (1,718)
Net of tax amount  $494   $(3,415)

 

The following table presents the reclassification adjustments out of accumulated other comprehensive income (loss) that were included in net income in the Consolidated Statements of Income for the three months ended September 30, 2014 and 2013.

 

   Amount Reclassified from
Accumulated Other
Comprehensive Income For the
Three Months Ended
September 30,
    
Details about Accumulated Other Comprehensive
Income Components
  2014   2013   Affected Line Item in the Statements of
Income
Unrealized gains (losses) on available-for-sale securities             
Realized securities gains reclassified into income  $75   $453   Other income - net realized gains on sale of available-for-sale securities
Related income tax expense   (26)   (154)  Income tax expense
              
Total reclassifications for the period, net of tax  $49   $299    

  

   Amount Reclassified from
Accumulated Other
Comprehensive Income For the
 Nine Months Ended September 
30,
    
Details about Accumulated Other Comprehensive
Income Components
  2014   2013   Affected Line Item in the Statements of
Income
Unrealized gains (losses) on available-for-sale securities             
Realized securities gains reclassified into income  $436   $835   Other income - net realized gains on sale of available-for-sale securities
Related income tax expense   (148)   (284)  Income tax expense
              
Total reclassifications for the period, net of tax  $288   $551    

 

17
 

 

Note 6: Fair Values of Financial Instruments

 

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value measurements must maximize the use of observable inputs and minimize the use of unobservable inputs. There is a hierarchy of three levels of inputs that may be used to measure fair value:

 

Level 1Quoted prices in active markets for identical assets or liabilities

 

Level 2Observable 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 for substantially the full term of the assets or liabilities

 

Level 3Unobservable inputs supported by little or no market activity and are significant to the fair value of the assets or liabilities

 

Items Measured at Fair Value on a Recurring Basis

 

Following is a description of the valuation methodologies and inputs used for instruments measured at fair value on a recurring basis and recognized in the accompanying comparative balance sheet, as well as the general classification of such instruments pursuant to the valuation hierarchy.

 

Available-for-Sale Securities

 

Where quoted market prices are available in an active market, securities are classified within Level 1 of the valuation hierarchy. The Company uses a third-party provider to provide market prices on its securities. Prices are evaluated by a third party. Level 1 securities include marketable equity securities. 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. Level 2 securities include mortgage-backed, collateralized mortgage obligations, small business administration, marketable equity, municipal, federal agency and certain corporate obligation securities. In certain cases where Level 1 or Level 2 inputs are not available, securities are classified within Level 3 of the hierarchy and include certain corporate obligation securities.

 

Third party vendors compile prices from various sources and may apply such techniques as matrix pricing to determine the value of identical or similar investment securities (Level 2). Matrix pricing is a mathematical technique widely used in the banking industry to value investment securities without relying exclusively on quoted prices for specific investment securities but rather relying on investment securities relationship to other benchmark quoted investment securities. Any investment security not valued based upon the methods above are considered Level 3.

18
 

  

The following table presents the fair value measurements of assets measured at fair value on a recurring basis and level within the ASC 820 fair value hierarchy in which the fair value measurements fall:

  

       Fair Value Measurements Using 
   Fair Value   Level 1   Level 2   Level 3 
September 30, 2014                
Mortgage-backed securities                    
Government sponsored agencies  $114,753   $-   $114,753   $- 
Collateralized mortgage obligations                    
Government sponsored agencies   98,606    -    98,606    - 
Federal agencies   4    -    4    - 
Municipal obligations   28,955    -    28,955    - 
Corporate obligations   21,738    -    18,004    3,734 
Available-for-sale securities  $264,056   $-   $260,322   $3,734 

  

       Fair Value Measurements Using 
   Fair Value   Level 1   Level 2   Level 3 
December 31, 2013                    
Mortgage-backed securities                    
Government sponsored agencies  $103,517   $-   $103,517   $- 
Collateralized mortgage obligations                    
Government sponsored agencies   107,578    -    107,578    - 
Federal agencies   4,774    -    4,774    - 
Municipal obligations   27,338    -    27,338    - 
Corporate obligations   21,141    -    17,805    3,336 
Available-for-sale securities  $264,348   $-   $261,012   $3,336 

 

The following is a reconciliation of the beginning and ending balances for the three months ended September 30, 2014 and 2013 of recurring fair value measurements recognized in the accompanying balance sheets using significant unobservable (Level 3) inputs:

 

   2014   2013 
Beginning balance  $3,738   $3,000 
Total realized and unrealized gains (losses)          
Included in net income   -    - 
Included in other comprehensive income (loss)   (4)   1 
Purchases, sales, issuances and settlements   -    (30)
Ending balance  $3,734   $2,971 
Total gains or losses for the period included in net income attributable to the change in unrealized gains or losses related to assets still held at the reporting date  $0   $0 

 

 

The following is a reconciliation of the beginning and ending balances for the nine months ended September 30, 2014 and 2013 of recurring fair value measurements recognized in the accompanying balance sheets using significant unobservable (Level 3) inputs:

19
 

  

   2014   2013 
Beginning balance  $3,336   $2,475 
Total realized and unrealized gains (losses)          
Included in net income   56    - 
Included in other comprehensive income (loss)   916    526 
Purchases, issuances and settlements   (574)   (30)
Ending balance  $3,734   $2,971 
Total gains or losses for the period included in net income attributable to the change in unrealized gains or losses related to assets still held at the reporting date  $0   $0 

  

Items Measured at Fair Value on a Non-Recurring Basis

 

From time to time, certain assets may be recorded at fair value on a non-recurring basis. These non-recurring fair value adjustments typically are a result of the application of lower of cost or fair value accounting or a write-down occurring during the period. The following is a description of the valuation methodologies used for certain assets that are recorded at fair value.

 

Impaired Loans (Collateral Dependent)

 

Loans for which it is probable that the Bank will not collect all principal and interest due according to contractual terms are measured for impairment. Allowable methods for determining the amount of impairment include estimating fair value using the fair value of the collateral for collateral dependent loans.

 

If the impaired loan is identified as collateral dependent, then the fair value method of measuring the amount of impairment is utilized. This method requires obtaining a current independent appraisal of the collateral and applying a discount factor to the value.

 

Impaired loans that are collateral dependent are classified within Level 3 of the fair value hierarchy when impairment is determined using the fair value method.

 

Other Real Estate Owned

 

The fair value of real estate is generally determined based on appraisals by qualified licensed appraisers. The appraisers typically determine the value of the real estate by utilizing an income or market valuation approach. If an appraisal is not available, the fair value may be determined by using a cash flow analysis.

 

Other real estate owned is classified within Level 3 of the fair value hierarchy.

 

Mortgage-Servicing Rights

 

We initially measure our mortgage servicing rights at fair value, and amortize them over the period of estimated net servicing income. They are periodically assessed for impairment based on fair value at the reporting date. Mortgage-servicing rights do not trade in an active market with readily observable prices. Accordingly, the fair value is estimated based on a valuation model which calculates the present value of estimated future net servicing income. The model incorporates assumptions that market participants use in estimating future net servicing income, including estimates of prepayment speeds, market discount rates, cost to service, float earnings rates and other ancillary income, including late fees. The fair value measurements are classified as Level 3.

20
 

  

The following table presents the fair value measurement of assets measured at fair value on a nonrecurring basis and the level within the ASC 820 fair value hierarchy in which the fair value measurements fall:

 

       Fair Value Measurements Using 
   Fair Value   Level 1   Level 2   Level 3 
September 30, 2014                
Other real estate owned  $251   $-   $-   $251 

  

       Fair Value Measurements Using 
   Fair Value   Level 1   Level 2   Level 3 
December 31, 2013                    
Impaired loans  $925   $-   $-   $925 
Other real estate owned   1,677    -    -    1,677 
Mortgage-servicing rights   2,106    -    -    2,106 

 

21
 

  

The following table presents quantitative information about unobservable inputs used in recurring and nonrecurring Level 3 fair value measurements.

 

September 30, 2014  Fair
Value
   Valuation Technique  Unobservable Inputs  Range 
Trust Preferred Securities  $3,734   Discounted cash flow  Discount rate   8.0-14.0%
           Constant prepayment rate   2.0%
           Cumulative projected prepayments   40.0%
           Probability of default   1.8-2.8%
           Projected cures given deferral   0-15.0%
           Loss severity   35.4-70.4%
Other real estate owned  $251   Third party valuations  Discount to reflect realizable value less estimated selling costs   10.0-36.7%

 

December 31, 2013  Fair
Value
   Valuation Technique  Unobservable Inputs  Range 
Trust Preferred Securities  $3,336   Discounted cash flow  Discount rate   10.0-17.0%
           Constant prepayment rate   2.0%
           Cumulative projected prepayments   40.0%
           Probability of default   1.5-2.7%
           Projected cures given deferral   0-15.0%
           Loss severity   46.9-73.7%
Impaired loans (collateral dependent)  $925   Third party valuations  Discount to reflect realizable value   7.3-78.3%
Other real estate owned  $1,677   Third party valuations  Discount to reflect realizable value less estimated selling costs   0-25.0%
Mortgage-servicing rights  $2,106   Third party valuations  Prepayment speeds   105-700%
           Discount rates   10.0%
           Servicing fee   0.25%

 

22
 

  

The following methods and assumptions were used to estimate the fair value of all other financial instruments recognized in the accompanying balance sheets at amounts other than fair value:

 

Cash and Cash Equivalents - The fair value of cash and cash-equivalents approximates carrying value.

 

Loans Held For Sale - Fair values are based on quoted market prices.

 

Loans - The fair value for loans is estimated using discounted cash flow analyses using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality.

 

FHLB Stock - Fair value of FHLB stock is based on the price at which it may be resold to the FHLB.

 

Interest Receivable/Payable - The fair values of interest receivable/payable approximate carrying values.

 

Deposits - The fair values of noninterest-bearing, interest-bearing demand and savings accounts are equal to the amount payable on demand at the balance sheet date. Fair values for fixed-rate certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on such time deposits.

 

FHLB Advances - The fair value of these borrowings is estimated using a discounted cash flow calculation, based on current rates for similar debt for periods comparable to the remaining terms to maturity of these advances.

 

Other Borrowings - The fair value of these borrowings is estimated using discounted cash flow analyses using interest rates for similar financial instruments.

 

Off-Balance Sheet Commitments - Commitments include commitments to purchase and originate mortgage loans, commitments to sell mortgage loans, and standby letters of credit and are generally of a short-term nature. The fair values of such commitments are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standing. The fair value of these instruments is insignificant.

 

The estimated fair values of the Company’s financial instruments not carried at fair value in the consolidated balance sheets as of the dates noted below are as follows:

 

           Fair Value Measurements Using 
September 30, 2014  Carrying
Amount
   Fair Value   Level 1   Level 2   Level 3 
Assets                         
Cash and cash equivalents  $20,499   $20,499   $20,499   $-   $- 
Loans held for sale   6,440    6,523    -    6,523    - 
Loans, net   995,468    993,302    -    -    993,302 
FHLB stock   14,391    14,391    -    14,391    - 
Interest receivable   3,665    3,665    -    3,665    - 
Liabilities                         
Deposits   1,098,849    1,061,159    636,955    -    424,204 
FHLB advances   168,523    167,425    -    167,425    - 
Other borrowings   10,353    10,353    -    10,353    - 
Interest payable   278    278    -    278    - 

 

23
 

 

           Fair Value Measurements Using 
December 31, 2013  Carrying
Amount
   Fair Value   Level 1   Level 2   Level 3 
Assets                         
Cash and cash equivalents  $25,285   $25,285   $25,285   $-   $- 
Loans held for sale   1,888    1,905    -    1,905    - 
Loans, net   965,966    935,414    -    -    935,414 
FHLB stock   14,391    14,391    -    14,391    - 
Interest receivable   3,775    3,775    -    3,775    - 
Liabilities                         
Deposits   1,113,084    1,068,422    593,457    -    474,965 
FHLB advances   142,928    141,526    -    141,526    - 
Other borrowings   10,890    10,890    -    10,890    - 
Interest payable   157    157    -    157    - 

 

Note 7: Loans and Allowance

 

Classes of loans at September 30, 2014 and December 31, 2013 include:

 

   September 30,   December 31, 
   2014   2013 
Real estate          
Commercial  $192,534   $200,817 
Commercial construction and development   29,267    13,321 
Consumer closed end first mortgage   519,312    531,272 
Consumer open end and junior liens   71,001    69,354 
    812,114    814,764 
Other loans          
Consumer loans          
Auto   14,464    14,856 
Boat/RVs   95,093    79,419 
Other   5,363    5,766 
Commercial and industrial   87,663    75,402 
    202,583    175,443 
Total loans   1,014,697    990,207 
Undisbursed loans in process   (9,425)   (13,346)
Unamortized deferred loan costs, net   3,445    2,517 
Allowance for loan losses   (13,249)   (13,412)
Net loans  $995,468   $965,966 

 

 

24
 

  

The risk characteristics of each loan portfolio segment are as follows:

 

Commercial

 

Real estate

 

These loans are viewed primarily as cash flow loans and secondarily as loans secured by real estate. Commercial real estate lending typically involves higher loan principal amounts and the repayment of these loans is generally dependent on the successful operation of the property securing the loan or the business conducted on the property securing the loan. Commercial real estate loans may be more adversely affected by conditions in the real estate markets or in the general economy. The properties securing the Company’s commercial real estate portfolio are diverse in terms of type and geographic location. Management monitors and evaluates commercial real estate loans based on collateral, geography and risk grade criteria. As a general rule, the Company avoids financing single purpose projects unless other underwriting factors are present to help mitigate risk. In addition, management tracks the level of owner-occupied commercial real estate loans versus non-owner occupied loans.

 

Construction and Development

 

Construction loans are underwritten utilizing feasibility studies, independent appraisal reviews, sensitivity analyses of absorption and lease rates and financial analyses of the developers and property owners. Construction loans are generally based on estimates of costs and value associated with the complete project. These estimates may be inaccurate. Construction loans often involve the disbursement of substantial funds with repayment substantially dependent on the success of the ultimate project. Sources of repayment for these types of loans may be pre-committed permanent loans from approved long-term lenders, sales of developed property or an interim loan commitment from the Company until permanent financing is obtained. These loans are closely monitored by on-site inspections and are considered to have higher risks than other real estate loans due to their ultimate repayment being sensitive to interest rate changes, governmental regulation of real property, general economic conditions and the availability of long-term financing.

 

Commercial and Industrial

 

Commercial loans are primarily based on the identified cash flows of the borrower and secondarily on the underlying collateral provided by the borrower. The cash flows of borrowers, however, may not be as expected and the collateral securing these loans may fluctuate in value. Most commercial loans are secured by the assets being financed or other business assets such as accounts receivable or inventory and may incorporate a personal guarantee; however, some short-term loans may be made on an unsecured basis. In the case of loans secured by accounts receivable, the availability of funds for the repayment of these loans may be substantially dependent on the ability of the borrower to collect amounts due from its customers.

 

25
 

 

Consumer Real Estate and Other Consumer Loans

 

With respect to residential loans that are secured by consumer closed end first mortgages and are primarily owner occupied, the Company generally establishes a maximum loan-to-value ratio and requires PMI if that ratio is exceeded. Consumer open end and junior lien loans are typically secured by a subordinate interest in 1-4 family residences, and other consumer loans are secured by consumer assets such as automobiles or recreational vehicles. Some consumer loans are unsecured such as small installment loans and certain lines of credit. Repayment of these loans is primarily dependent on the personal income of the borrowers, which can be impacted by economic conditions in their market areas such as unemployment levels. Repayment can also be impacted by changes in property values on residential properties. Risk is mitigated by the fact that the loans are of smaller individual amounts and spread over a large number of borrowers.

 

Nonaccrual Loans and Past Due Loans

 

Loans are considered past due if the required principal and interest payments have not been received as of the date such payments were due. Loans are placed on non-accrual status when, in managements’ opinion, the borrower may be unable to meet payment obligations as they become due, as well as when required by regulatory provisions, but never greater than 90 days past due. When interest accrual is discontinued, all unpaid accrued interest is reversed. Interest income is subsequently recognized only to the extent cash payments are received in excess of principal due. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.

 

All interest accrued but not collected for loans that are placed on nonaccrual or charged off is reversed against interest income. The interest on these loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured and generally only after nine months of satisfactory performance.

 

Nonaccrual loans, segregated by class of loans, as of September 30, 2014 and December 31, 2013 are as follows:

 

   September 30,   December 31, 
   2014   2013 
Real estate          
Commercial  $2,073   $1,349 
Commercial construction and development   613    1,103 
Consumer closed end first mortgage   4,334    4,057 
Consumer open end and junior liens   199    421 
Consumer loans          
Auto   1    10 
Boat/RVs   289    339 
Other   51    12 
Commercial and industrial   637    1,109 
   $8,197   $8,400 

 

Nonaccrual commercial and consumer closed end first mortgage loans increased due to three new loans that went on non-accrual during the quarter. Management continues to monitor these and all other nonaccrual loans.

 

26
 

 

An age analysis of the Company’s past due loans, segregated by class of loans, as of September 30, 2014 and December 31, 2013 are as follows:

  

   September 30, 2014 
   30-59
Days Past
Due
   60-89
Days Past
Due
   90 Days
or More
Past Due
   Total
Past Due
   Current   Total
Loans
Receivable
   Total
Loans 90
Days or
More and
Accruing
 
Real estate                                   
Commercial  $1,294   $8   $1,541   $2,843   $189,691   $192,534   $- 
Commercial construction and development   -    -    457    457    28,810    29,267    - 
Consumer closed end first mortgage   6,260    1,217    2,971    10,448    508,864    519,312    217 
Consumer open end and junior liens   257    563    129    949    70,052    71,001    - 
Consumer loans                                   
Auto   49    -    -    49    14,415    14,464    - 
Boat/RVs   1,004    115    169    1,288    93,805    95,093    - 
Other   31    28    5    64    5,299    5,363    - 
Commercial and industrial   207    202    464    873    86,790    87,663    - 
   $9,102   $2,133   $5,736   $16,971   $997,726   $1,014,697   $217 

  

   December 31, 2013 
   30-59
Days Past
Due
   60-89
Days Past
Due
   90 Days
or More
Past Due
   Total
Past Due
   Current   Total
Loans
Receivable
   Total
Loans 90
Days or
More and
Accruing
 
Real estate                                   
Commercial  $763   $196   $1,196   $2,155   $198,662   $200,817   $- 
Commercial construction and development   333    -    915    1,248    12,073    13,321    - 
Consumer closed end first mortgage   11,680    2,122    3,515    17,317    513,955    531,272    175 
Consumer open end and junior liens   609    185    394    1,188    68,166    69,354    - 
Consumer loans                                   
Auto   54    8    9    71    14,785    14,856    - 
Boat/RVs   1,410    262    202    1,874    77,545    79,419    13 
Other   61    3    -    64    5,702    5,766    - 
Commercial and industrial   67    393    531    991    74,411    75,402    - 
   $14,977   $3,169   $6,762   $24,908   $965,299   $990,207   $188 

 

Impaired Loans

 

Loans are considered impaired in accordance with the impairment accounting guidance (ASC 310-10-35-16), when based on current information and events, it is probable the Company will be unable to collect all amounts due from the borrower in accordance with the contractual terms of the loan. Impaired loans include nonperforming commercial loans but also include loans modified in troubled debt restructurings where concessions have been granted to borrowers experiencing financial difficulties. These concessions could include a reduction in the interest rate on the loan, payment extensions, forgiveness of principal, forbearance or other actions intended to maximize collection.

 

Interest on impaired loans is recorded based on the performance of the loan. All interest received on impaired loans that are on nonaccrual is accounted for on the cash-basis method until qualifying for return to accrual. Interest is accrued per the contract for impaired loans that are performing.

 

27
 

 

The following tables present impaired loans as of September 30, 2014 and 2013 and the year ended December 31, 2013:

 

   September 30, 2014 
   Recorded
Balance
   Unpaid
Principal
Balance
   Specific
Allowance
   Average
Investment 
in

Impaired
Loans -
Quarter
   Average
Investment 
in

Impaired
Loans -
YTD
   Interest
Income
Recognized
 - Quarter
   Interest
Income
Recognized 
- YTD
 
Loans without a specific valuation allowance                                   
Real estate                                   
Commercial  $4,088   $4,088   $-   $3,475   $3,262   $38   $102 
Commercial construction and development  $1,196   $2,567   $-   $1,235   $1,421   $7   $23 
Consumer closed end first mortgage  $1,639   $1,639   $-   $1,243   $1,144   $1   $6 
Consumer open end and junior liens  $-   $-   $-   $-   $125   $-   $3 
Commercial and industrial  $1,659   $1,659   $-   $1,203   $1,189   $-   $11 

  

There were no loans with a specific valuation allowance as of September 30, 2014.

 

   December 31, 2013 
   Recorded
Balance
   Unpaid
Principal
Balance
   Specific
Allowance
   Average
Investment
in Impaired
Loans
   Interest
Income
Recognized
 
Loans without a specific valuation allowance                         
Real estate                         
Commercial  $3,148   $3,660   $-   $3,894   $160 
Commercial construction and development   1,294    3,218    -    5,386    46 
Consumer closed end first mortgage   1,483    2,071    -    2,582    33 
Commercial and industrial   764    764    -    897    2 
                          
Loans with a specific valuation allowance                         
Real estate                         
Commercial construction and development   344    371    100    344    - 
Commercial and industrial   424    624    235    566    20 
                          
Total                         
Real estate                         
Commercial  $3,148   $3,660   $-   $3,894   $160 
Commercial construction and development  $1,638   $3,589   $100   $5,730   $46 
Consumer closed end first mortgage  $1,483   $2,071   $-   $2,582   $33 
Commercial and industrial  $1,188   $1,388   $235   $1,463   $22 

  

28
 

 

   September 30, 2013 
   Recorded
Balance
   Unpaid
Principal
Balance
   Specific
Allowance
   Average
Investment
 in

Impaired
Loans -
Quarter
   Average
Investment
in

Impaired
Loans -
YTD
   Interest
Income
Recognized
 - Quarter
   Interest
Income
Recognized 
- YTD
 
Loans without a specific valuation allowance                                   
Real estate                                   
Commercial  $2,894   $3,958   $-   $2,953   $3,545   $40   $109 
Commercial construction and development   3,331    7,332    -    4,782    6,112    23    57 
Consumer closed end first mortgage   1,700    2,639    -    2,167    2,732    11    45 
Consumer open end and junior liens   250    250    -    250    125    1    3 
Commercial and industrial   679    679    -    798    876    10    18 
                                    
Loans with a specific valuation allowance                                   
Real estate                                   
Commercial   204    204    100    205    206    3    9 
Commercial construction and development   622    2,020    200    622    640    -    - 
Commercial and industrial   424    624    235    429    601    6    15 
                                    
Total                                   
Real estate                                   
Commercial  $3,098   $4,162   $100   $3,158   $3,751   $43   $118 
Commercial construction and development  $3,953   $9,352   $200   $5,404   $6,752   $23   $57 
Consumer closed end first mortgage  $1,700   $2,639   $-   $2,167   $2,732   $11   $45 
Consumer open end and junior liens  $250   $250   $-   $250   $125   $1   $3 
Commercial and industrial  $1,103   $1,303   $235   $1,227   $1,477   $16   $33 

 

The following information presents the credit risk profile of the Company’s loan portfolio based on rating category and payment activity as of September 30, 2014.

 

Commercial Loan Grades

 

Definition of Loan Grades. Loan grades are numbered 1 through 8. Grades 1-4 are "pass" credits, grade 5 [Special Mention] loans are "criticized" assets, and grades 6 [Substandard], 7 [Doubtful] and 8 [Loss] are "classified" assets. The use and application of these grades by the Bank conform to the Bank's policy and regulatory definitions.

 

Pass. Pass credits are loans in grades prime through fair. These are at least considered to be credits with acceptable risks and would be granted in the normal course of lending operations.

 

Special Mention. Special mention credits have potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the credits or in the Bank’s credit position at some future date. If weaknesses cannot be identified, classifying as special mention is not appropriate. Special mention credits are not adversely classified and do not expose the Bank to sufficient risk to warrant an adverse classification. No apparent loss of principal or interest is expected.

29
 

 

 

Substandard. Substandard credits are inadequately protected by the current sound worth and paying capacity of the obligor or by the collateral pledged. Financial statements normally reveal some or all of the following:  poor trends, lack of earnings and cash flow, excessive debt, lack of liquidity, and the absence of creditor protection. Credits so classified must have a well-defined weakness, or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the Bank will sustain some loss of the deficiencies are not corrected.

 

Doubtful. A doubtful extension of credit has all the weaknesses inherent in a substandard asset with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable. The possibility of loss is extremely high, but because of certain important and reasonably specific pending factors that may work to the advantage and strengthening of the asset, its classification as an estimated loss is deferred until its more exact status may be determined. Pending factors include proposed merger, acquisition, or liquidation procedures, capital injection, perfecting liens on additional collateral, and refinancing plans. Doubtful classification for an entire credit should be avoided when collection of a specific portion appears highly probable with the adequately secured portion graded Substandard.  

 

Retail Loan Grades

 

Pass. Pass credits are loans that are currently performing as agreed and are not troubled debt restructurings.

 

Special Mention. Special mention credits have potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the credits or in the Bank’s credit position at some future date. If weaknesses cannot be identified, classifying as special mention is not appropriate. Special mention credits are not adversely classified and do not expose the Bank to sufficient risk to warrant an adverse classification. No apparent loss of principal or interest is expected.

 

Substandard. Substandard credits are loans that have reason to be considered to have a weakness and placed on non-accrual. This would include all retail loans over 90 days and troubled debt restructurings.

 

30
 

 

September 30, 2014
Commercial Credit Exposure Credit Risk Profile
Internal Rating  Real Estate   Construction
and
Development
   Commercial
and Industrial
 
Pass  $181,595   $25,890   $82,821 
Special Mention   3,329    1,728    368 
Substandard   7,610    1,649    4,010 
Doubtful   -    -    464
Total  $192,534   $29,267   $87,663 

 

Consumer Credit Exposure Credit Risk Profile
Internal Rating  Closed End
First
Mortgage
   Real Estate Open
End and Junior
Liens
   Auto   Boat/RV   Other 
Pass  $510,555   $70,683   $14,454   $94,598   $5,280 
Special Mention   1,719    -    -    -    - 
Substandard   7,038    318    10    495    83 
Total  $519,312   $71,001   $14,464   $95,093   $5,363 

 

December 31, 2013
Commercial Credit Exposure Credit Risk Profile
Internal Rating  Real Estate   Construction
and
Development
   Commercial and
Industrial
 
Pass  $190,041   $9,910   $73,648 
Special Mention   3,308    1,659    223 
Substandard   7,468    1,752    1,000 
Doubtful   -    -    531 
Total  $200,817   $13,321   $75,402 

 

Consumer Credit Exposure Credit Risk Profile
Internal Rating  Closed End
First
Mortgage
   Real Estate Open
End and Junior
Liens
   Auto   Boat/RV   Other 
Pass  $522,352   $68,445   $14,834   $78,863   $5,415 
Special Mention   1,783    -    -    -    - 
Substandard   7,137    909    22    556    351 
Total  $531,272   $69,354   $14,856   $79,419   $5,766 

  

31
 

 

Allowance for Loan Losses.

 

We maintain an allowance for loan losses to absorb losses inherent in the loan portfolio. The allowance is based on ongoing, quarterly assessments of the estimated losses inherent in the loan portfolio.  Our methodology for assessing the appropriateness of the allowance consists of several key elements, including the general allowance and specific allowances for identified problem loans and portfolio segments.  In addition, the allowance incorporates the results of measuring impaired loans as provided in FASB ASC 310, Receivables.  These accounting standards prescribe the measurement methods, income recognition and disclosures related to impaired loans. The general allowance is calculated by applying loss factors to outstanding loans based on the internal risk evaluation of such loans or pools of loans. Changes in risk evaluations of both performing and nonperforming loans affect the amount of the general allowance. Loss factors are based on our historical loss experience as well as on significant factors that, in management’s judgment, affect the collectability of the portfolio as of the evaluation date.

 

The appropriateness of the allowance is reviewed by management based upon its evaluation of then-existing economic and business conditions affecting our key lending areas and other conditions, such as credit quality trends (including trends in non-performing loans expected to result from existing conditions), collateral values, loan volumes and concentrations, specific industry conditions within portfolio segments and recent loss experience in particular segments of the portfolio that existed as of the balance sheet date and the impact that such conditions were believed to have had on the collectability of the loan.  Senior management reviews these conditions quarterly in discussions with our senior credit officers.  To the extent that any of these conditions is evidenced by a specifically identifiable problem credit or portfolio segment as of the evaluation date, management’s estimate of the effect of such condition may be reflected as a specific allowance applicable to such credit or portfolio segment.  Where any of these conditions is not evidenced by a specifically identifiable problem credit or portfolio segment as of the evaluation date, management’s evaluation of the loss related to this condition is reflected in the general allowance for loan losses.  The evaluation of the inherent loss with respect to these conditions is subject to a higher degree of uncertainty because they are not identified with specific problem credits or portfolio segments.

 

The allowance for loan losses is based on estimates of losses inherent in the loan portfolio.  Actual losses can vary significantly from the estimated amounts.  Our methodology as described permits adjustments to any loss factor used in the computation of the general allowance in the event that, in management’s judgment, significant factors which affect the collectability of the portfolio as of the evaluation date are not reflected in the loss factors.  By assessing the probable incurred losses inherent in the loan portfolio on a quarterly basis, we are able to adjust specific and inherent loss estimates based upon any more recent information that has become available.  

 

The following table details activity in the allowance for loan losses by portfolio segment for the three and nine month periods ended September 30, 2014 and 2013 and year ended December 31, 2013.  Allocation of a portion of the allowance to one category of loans does not preclude its availability to absorb losses in other segments.

 

32
 

 

   Three Months Ended September 30, 2014 
   Commercial   Mortgage   Consumer   Total 
Allowance for loan losses:                    
Balance, beginning of period  $7,763   $3,344   $2,136   $13,243 
Provision charged to expense   (914)   935    (21)   - 
Losses charged off   -    (141)   (49)   (190)
Recoveries   105    23    68    196 
Balance, end of period  $6,954   $4,161   $2,134   $13,249 

 

   Nine Months Ended September 30, 2014 
   Commercial   Mortgage   Consumer   Total 
Allowance for loan losses:                    
Balance, beginning of year  $8,148   $3,124   $2,140   $13,412 
Provision charged to expense   (1,101)   1,400    551    850 
Losses charged off   (244)   (391)   (767)   (1,402)
Recoveries   151    28    210    389 
Balance, end of period  $6,954   $4,161   $2,134   $13,249 
Ending balance:                    
Individually evaluated for impairment  $-   $-   $-   $- 
Collectively evaluated for impairment   6,954    4,161    2,134    13,249 
Total allowance for loan losses  $6,954   $4,161   $2,134   $13,249 
                     
Loans:                    
Ending balance                    
Individually evaluated for impairment  $6,943   $1,639   $-   $8,582 
Collectively evaluated for impairment   302,521    517,673    185,921    1,006,115 
Total Loans  $309,464   $519,312   $185,921   $1,014,697 

 

   Year Ended December 31, 2013 
   Commercial   Mortgage   Consumer   Total 
Allowance for loan losses:                    
Balance, beginning of year  $9,908   $3,394   $2,736   $16,038 
Provision charged to expense   884    343    73    1,300 
Losses charged off   (2,713)   (886)   (940)   (4,539)
Recoveries   69    273    271    613 
Balance, end of period  $8,148   $3,124   $2,140   $13,412 
Ending balance:                    
Individually evaluated for impairment  $335   $-   $-   $335 
Collectively evaluated for impairment   7,813    3,124    2,140    13,077 
Total allowance for loan losses  $8,148   $3,124   $2,140   $13,412 
                     
Loans:                    
Ending balance                    
Individually evaluated for impairment  $5,974   $1,483   $-   $7,457 
Collectively evaluated for impairment   283,566    529,789    169,395    982,750 
Total Loans  $289,540   $531,272   $169,395   $990,207 

 

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   Three Months Ended September 30, 2013 
   Commercial   Mortgage   Consumer   Total 
Allowance for loan losses:                    
Balance, beginning of period  $9,633   $3,662   $2,406   $15,701 
Provision charged to expense   1,004    (215)   (39)   750 
Losses charged off   (1,713)   (274)   (104)   (2,091)
Recoveries   10    30    54    94 
Balance, end of period  $8,934   $3,203   $2,317   $14,454 

 

   Nine Months Ended September 30, 2013 
   Commercial   Mortgage   Consumer   Total 
Allowance for loan losses:                    
Balance, beginning of year  $9,908   $3,394   $2,736   $16,038 
Provision charged to expense   1,675    469    106    2,250 
Losses charged off   (2,681)   (716)   (764)   (4,161)
Recoveries   32    56    239    327 
Balance, end of period  $8,934   $3,203   $2,317   $14,454 

 

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Management’s general practice is to proactively charge down loans individually evaluated for impairment to the fair value of the underlying collateral.

 

For all loan portfolio segments except consumer real estate and other consumer loans, the Company promptly charges-off loans, or portions thereof, when available information confirms that specific loans are uncollectible based on information that includes, but is not limited to, (1) the deteriorating financial condition of the borrower, (2) declining collateral values, and/or (3) legal action, including bankruptcy, that impairs the borrower’s ability to adequately meet its obligations. For impaired loans that are considered to be solely collateral dependent, a partial charge-off is recorded when a loss has been confirmed by an updated appraisal or other appropriate valuation of the collateral.

 

The Company charges-off consumer real estate and other consumer loans, or portions thereof, when the Company reasonably determines the amount of the loss. The Company adheres to timeframes established by applicable regulatory guidance which provides for the charge-down of 1-4 family first and junior lien mortgages to the net realizable value less costs to sell when the loan is 180 days past due, charge-off of unsecured open-end loans when the loan is 180 days past due, and charge-down to the net realizable value when other secured loans are 120 days past due. Loans at these respective delinquency thresholds for which the Company can clearly document that the loan is both well-secured and in the process of collection, such that collection will occur regardless of delinquency status, need not be charged-off.

 

Information on non-performing assets, excluding performing restructured loans, is provided below:

 

   September 30, 
   2014   2013 
Non-performing assets          
Non-accrual loans  $8,197   $13,112 
Accruing loans delinquent 90 days or more and past due   217    390 
Total non-performing loans   8,414    13,502 
Foreclosed real estate   6,334    6,750 
Other repossessed assets   504    312 
Total non-performing assets  $15,252   $20,564 

 

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Troubled Debt Restructurings

 

Certain categories of impaired loans include loans that have been modified in a troubled debt restructuring, that involves granting economic concessions to borrowers who have experienced financial difficulties. These concessions typically result from our loss mitigation activities and could include reductions in the interest rate, payment extensions, forgiveness of principal, forbearance or other actions. Modifications of terms for our loans and their inclusion as troubled debt restructurings are based on individual facts and circumstances.

 

When we modify loans in a troubled debt restructuring, we evaluate any possible impairment similar to other impaired loans based on the present value of expected future cash flows, discounted at the contractual interest rate of the original loan agreement, or we use the current fair value of the collateral, less selling costs for collateral dependent loans. If we determine that the value of the modified loan is less than the recorded investment in the loan (net of previous charge-offs, deferred loan fees or costs and unamortized premium or discount), impairment is recognized through a specific reserve or a charge-off to the allowance.

 

Loans retain their accrual status at the time of their modification. As a result, if a loan is on nonaccrual at the time it is modified, it stays as nonaccrual until a period of satisfactory performance, generally nine months, is obtained. If a loan is on accrual at the time of the modification, the loan is evaluated to determine the collection of principal and interest is reasonably assured and generally stays on accrual.

 

At September 30, 2014, the Company had a number of loans that were modified in troubled debt restructurings and impaired. The modification of terms of such loans included one or a combination of the following: an extension of maturity, a reduction of the stated interest rate or a permanent reduction of the recorded investment in the loan.

 

The following tables describe troubled debts restructured during the three and nine month periods ended September 30, 2014 and 2013.

 

   Three Months Ended September 30, 2014 
   No. of Loans   Pre-Modification
Outstanding
Recorded
Balance
   Post-Modification
Outstanding
Recorded Balance
 
Real estate               
Commercial   4   $968   $987 
Consumer closed end first mortgage   4    665    285 
Consumer open end and junior liens   1    14    15 

 

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   Three Months Ended September 30, 2013 
   No. of Loans   Pre-Modification
Outstanding
Recorded
Balance
   Post-Modification
Outstanding
Recorded Balance
 
Real estate               
Commercial   1   $192   $260 
Consumer closed end first mortgage   4    460    492 
Consumer open end and junior liens   8    274    272 
Consumer loans               
Boat/RVs   2    45    45 

 

   Nine Months Ended September 30, 2014 
   No. of Loans   Pre-Modification
Outstanding
Recorded
Balance
   Post-Modification
Outstanding
Recorded Balance
 
Real estate               
Commercial   5   $1,218   $1,237 
Consumer closed end first mortgage   11    1,379    1,026 
Consumer open end and junior liens   4    48    49 
Commercial and industrial   2    193    223 

 

   Nine Months Ended September 30, 2013 
   No. of Loans   Pre-Modification
Outstanding
Recorded
Balance
   Post-Modification
Outstanding
Recorded Balance
 
Real estate               
Commercial   3   $1,532   $1,593 
Consumer closed end first mortgage   21    1,462    1,812 
Consumer open end and junior liens   26    945    955 
Consumer loans               
Auto   2    22    22 
Boat/RVs   6    172    171 
Other   1    11    11 
Commercial and industrial   3    1,122    834 

  

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The impact on the allowance for loan losses was insignificant as a result of these modifications.

 

Newly restructured loans by type for the three and nine months ended September 30, 2014 and 2013 are as follows:

 

   Three Months Ended September 30, 2014 
   Interest Only   Term   Combination   Total
Modification
 
Real Estate                
Commercial  $-   $689   $298   $987 
Consumer closed end first mortgage   101    -    184    285 
Consumer open end junior lien   -    -    15    15 

 

   Three Months Ended September 30, 2013 
   Interest Only   Term   Combination   Total
Modification
 
Real Estate                    
Commercial  $-   $-   $260   $260 
Consumer closed end first mortgage   -    -    492    492 
Consumer open end junior lien   -    128    144    272 
Consumer Loans                    
Boat/RVs   -    14    31    45 

 

   Nine Months Ended September 30, 2014 
   Interest Only   Term   Combination   Total
Modification
 
Real Estate                    
Commercial  $-   $689   $548   $1,237 
Consumer closed end first mortgage   101    -    925    1,026 
Consumer open end junior lien   -    19    30    49 
Commercial and industrial   -    223    -    223 

 

   Nine Months Ended September 30, 2013 
   Interest Only   Term   Combination   Total
Modification
 
Real Estate                    
Commercial  $-   $-   $1,593   $1,593 
Consumer closed end first mortgage   -    -    1,812    1,812 
Consumer open end junior lien   250    402    303    955 
Consumer Loans                    
Auto   -    4    18    22 
Boat/RVs   -    135    36    171 
Other   -    -    11    11 
Commercial and industrial   -    200    634    834 

 

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Defaults of any loans modified as troubled debt restructurings made in the three and nine months ended September 30, 2014 and 2013, respectively, are listed in the table below. Defaults are defined as any loans that become 90 days past due.

 

   Three Months Ended September 30, 2014 
   No. of Loans   Post-Modification
Outstanding Recorded
Balance
 
Real Estate          
Consumer closed end first mortgage   1   $231 

 

   Three Months Ended September 30, 2013 
   No. of Loans   Post-Modification
Outstanding Recorded
Balance
 
Real Estate          
Consumer closed end first mortgage   2   $187 

 

   Nine Months Ended September 30, 2014 
   No. of Loans   Post-Modification
Outstanding Recorded
Balance
 
Real Estate          
Consumer closed end first mortgage   4   $663 
Consumer open end and junior liens   1    23 

 

   Nine Months Ended September 30, 2013 
   No. of Loans   Post-Modification
Outstanding Recorded
Balance
 
Real Estate          
Consumer closed end first mortgage   3   $196 

 

There were no modified loans that defaulted during the third quarter of 2013.

 

Note 8: Acquisition

 

On August 1, 2014, the Company acquired Summit Mortgage, Inc., a mortgage broker in Ft. Wayne, Indiana. The acquisition of Summit resulted in the acquisition of insignificant assets, generated goodwill of $1.8 million and no additional material intangible assets. This acquisition allows the Bank to enter a new market and look at more efficient methods of increasing non-interest income and is not expected to have a material impact on the operations of the Company.

 

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation

 

The following should be read in conjunction with the Management’s Discussion and Analysis in Item 7 of the Company’s Annual Report on Form 10-K for the year ended December 31, 2013, which was filed with the SEC on March 14, 2014.

 

The Company is a Maryland corporation and a bank holding company headquartered in Muncie, Indiana, with operations in Delaware, Elkhart, Grant, Kosciusko, Randolph, St. Joseph and Wabash counties in Indiana. It owns MutualBank, an Indiana commercial bank with 30 bank branches in Indiana, trust offices in Carmel and Crawfordsville, Indiana and a loan origination office in New Buffalo, Michigan. MutualBank also operates a wholly owned subsidiary of Summit Mortgage which operates out of Fort Wayne, Indiana. The Company is subject to regulation, supervision and examination by the Board of Governors of the Federal Reserve System (“FRB”), and the Bank is subject to regulation, supervision and examination by the Indiana Department of Financial Institutions and the Federal Deposit Insurance Corporation.

 

Our principal business consists of attracting retail and commercial deposits from the general public and businesses, including some brokered deposits, and investing those funds primarily in loans secured by consumer closed end first mortgages and consumer open end and junior liens on owner-occupied, one- to four-family residences, a variety of other consumer loans, loans secured by commercial real estate, commercial construction and development and commercial and industrial loans. Funds not invested in loans generally are invested in investment securities, including mortgage-backed and mortgage-related securities. We also obtain funds from FHLB advances and other borrowings.

 

Our results of operations depend primarily on the level of our net interest income, which is the difference between interest income on interest-earning assets, such as loans, mortgage-backed securities and investment securities, and interest expense on interest-bearing liabilities, primarily deposits and borrowings. The structure of our interest-earning assets versus the structure of interest-bearing liabilities, along with the shape of the yield curve, has a direct impact on our net interest income. Historically, our interest-earning assets have been longer term in nature (i.e., fixed-rate mortgage loans) and interest-bearing liabilities have been shorter term (i.e., certificates of deposit, regular savings accounts, etc.). This structure would impact net interest income favorably in a decreasing rate environment, assuming a normally shaped yield curve, as the rates on interest-bearing liabilities would decrease more rapidly than rates on interest-earning assets. Conversely, in an increasing rate environment, assuming a normally shaped yield curve, net interest income would be impacted unfavorably as rates on interest-earning assets would increase at a slower rate than rates on interest-bearing liabilities.

 

Third Quarter Highlights. At September 30, 2014, we had $1.4 billion in assets, $995.5 million in loans, $1.1 billion in deposits and $122.1 million in stockholders’ equity. The Company’s total risk-based capital ratio at September 30, 2014 was 12.8%, exceeding the 10.0% requirement for a well-capitalized institution. Tangible common equity increased to 8.4% as of September 30, 2014 compared to 7.9% and 7.8% at December 31, 2013 and September 30, 2013, respectively. For the quarter ended September 30, 2014, net income available to common shareholders was $2.7 million, or $.38 per basic and $.36 per diluted share, compared with net income available to common shareholders of $2.2 million, or $0.31 per basic and $0.30 per diluted share for the quarter ended September 30, 2013.

 

Other highlights for the third quarter ended September 30, 2014 included:

·MutualBank completed the acquisition of Summit Mortgage, Inc. in the third quarter.
·Gross loan balances increased by $14.4 million, or 5.8% on an annualized basis in the third quarter of 2014.
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·Deposits increased $19.5 million in the third quarter of 2014.
·Tangible common equity to total assets is 8.42% and tangible book value per share is $16.55 as of September 30, 2014 compared to tangible common equity to total assets of 7.92% and tangible book value per share of $15.46 as of December 31, 2013.
·Net interest income increased $400,000 compared to the third quarter of 2013 and increased $82,000 on a linked quarter basis.
·Non-interest income increased $300,000 compared to the third quarter of 2013 and $160,000 on a linked quarter basis.
·Non-interest expense increased $1.2 million compared to the third quarter of 2013 and $555,000 on a linked quarter basis.

 

The Management’s Discussion and Analysis in Item 7 of the Company’s Annual Report on Form 10-K for the year ended December 31, 2013, contains a summary of our management strategy. The financial highlights of our strategy during the quarter include: increasing commercial and non-real estate consumer lending by $34.8 million since year-end 2013; core deposits increased to 62%, from 58% at year-end 2013, and decreasing non-performing assets to total assets from 1.22% at year-end 2013 to 1.08% at the end of the quarter. 

 

Critical Accounting Policies

 

Note 1 to the Consolidated Financial Statements in Item 8 of the Form 10-K for the year ended December 31, 2013 contains a summary of the Company’s significant accounting policies. Certain of these policies are important to the portrayal of the Company’s financial condition, since they require management to make difficult, complex or subjective judgments, some of which may relate to matters that are inherently uncertain. Management believes that its critical accounting policies include determining the allowance for loan losses, the valuation of foreclosed assets, mortgage servicing rights, valuation of intangible assets and securities, deferred tax asset and income tax accounting.

 

The determination of the adequacy of the allowance for loan losses is based on estimates that are particularly susceptible to significant changes in the economic environment and market conditions. A worsening or protracted economic decline would increase the likelihood of additional losses due to credit and market risk and could create the need for additional loss reserves.

 

Allowance for Loan Losses. The allowance for loan losses is a significant estimate that can and does change based on management’s assumptions about specific borrowers and current general economic and business conditions, among other factors. Management reviews the adequacy of the allowance for loan losses on at least a quarterly basis. The evaluation by management includes consideration of past loss experience, changes in the composition of the loan portfolio, the current condition and amount of loans outstanding, identified problem loans and the probability of collecting all amounts due.

 

Foreclosed Assets. Foreclosed assets are carried at the lower of cost or fair value less estimated selling costs. Management estimates the fair value of the properties based on current appraisal information. Fair value estimates are particularly susceptible to significant changes in the economic environment, market conditions, and real estate market. A worsening or protracted economic decline would increase the likelihood of a decline in property values and could create the need to write down the properties through current operations.

 

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Mortgage Servicing Rights. Mortgage servicing rights (“MSRs”) associated with loans originated and sold, where servicing is retained, are capitalized and included in other assets in the consolidated balance sheet. The value of the capitalized servicing rights represents the fair value of the right to service loans in the portfolio. Critical accounting policies for MSRs relate to the initial valuation and subsequent impairment tests. The methodology used to determine the valuation of MSRs requires the development and use of a number of estimates, including anticipated principal amortization and prepayments of that principal balance. Events that may significantly affect the estimates used are changes in interest rates, mortgage loan prepayment speeds and the payment performance of the underlying loans. The carrying value of the MSRs is periodically reviewed for impairment based on a determination of fair value. For purposes of measuring impairment, the servicing rights are compared to a valuation prepared based on a discounted cash flow methodology, utilizing current prepayment speeds and discount rates. Impairment, if any, is recognized through a valuation allowance and is recorded as a reduction in loan servicing fee income.

 

Intangible Assets. MutualFirst periodically assesses the impairment of its core deposit intangible. Impairment is the condition that exists when the carrying amount exceeds its implied fair value. If actual external conditions and future operating results differ from MutualFirst’s judgments, impairment and/or increased amortization charges may be necessary to reduce the carrying value of these assets to the appropriate value.

 

Securities. Under FASB Codification Topic 320 (ASC 320), Investments-Debt and Equity Securities, investment securities must be classified as held-to-maturity, available-for-sale or trading. Management determines the appropriate classification at the time of purchase. The classification of securities is significant since it directly impacts the accounting for unrealized gains and losses on securities. Debt securities are classified as held-to-maturity and carried at amortized cost when management has the positive intent and the Company has the ability to hold the securities to maturity. Securities not classified as held-to-maturity are classified as available-for-sale and are carried at fair value, with the unrealized holding gains and losses, net of tax, reported in other comprehensive income and do not affect earnings until realized.

 

The fair values of the Company’s securities are generally determined by reference to quoted prices from reliable independent sources utilizing observable inputs. Certain of the Company’s fair values of securities are determined using models whose significant value drivers or assumptions are unobservable and are significant to the fair value of the securities. These models are utilized when quoted prices are not available for certain securities or in markets where trading activity has slowed or ceased. When quoted prices are not available and are not provided by third party pricing services, management judgment is necessary to determine fair value. As such, fair value is determined using discounted cash flow analysis models, incorporating default rates, estimation of prepayment characteristics and implied volatilities.

 

The Company evaluates all securities on a quarterly basis, and more frequently when economic conditions warrant additional evaluations, for determining if an other-than-temporary impairment (“OTTI”) exists pursuant to guidelines established in ASC 320. In evaluating the possible impairment of securities, consideration is given to the length of time and the extent to which the fair value has been less than cost, the financial condition and near-term prospects of the issuer, and the ability and intent of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. In analyzing an issuer’s financial condition, the Company may consider whether the securities are issued by the federal government or its agencies or government sponsored agencies, whether downgrades by bond rating agencies have occurred, and the results of reviews of the issuer’s financial condition.

 

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If management determines that an investment experienced an OTTI, management must then determine the amount of the OTTI to be recognized in earnings. If management does not intend to sell the security and it is more likely than not that the Company will not be required to sell the security before recovery of its amortized cost basis less any current period loss, the OTTI will be separated into the amount representing the credit loss and the amount related to all other factors. The amount of 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 OTTI related to other factors will be recognized in other comprehensive income, net of applicable taxes. The previous amortized cost basis less the OTTI recognized in earnings will become the new amortized cost basis of the investment. If management intends to sell the security or more likely than not will be required to sell the security before recovery of its amortized cost basis less any current period credit loss, the OTTI will be recognized in earnings equal to the entire difference between the investment’s amortized cost basis and its fair value at the balance sheet date. Any recoveries related to the value of these securities are recorded as an unrealized gain (as other comprehensive income (loss) in stockholders’ equity) and not recognized in income until the security is ultimately sold.

 

The Company from time to time may dispose of an impaired security in response to asset/liability management decisions, future market movements, business plan changes, or if the net proceeds can be reinvested at a rate of return that is expected to recover the loss within a reasonable period of time.

 

Deferred Tax Asset. The Company has evaluated its deferred tax asset to determine if it is more likely than not that the asset will be utilized in the future. The Company’s most recent evaluation indicated that it is more likely than not that the asset will be fully utilized. The Company has generated average positive pre-tax pre-provision earnings of $14.5 million, or 1.0% of pre-tax pre-provision ROA over the previous five calendar years. These earnings would be sufficient to utilize the net operating losses, tax credit carryforwards and temporary tax differences over the allowable periods. The valuation allowances established from 2009 through 2013 were the result of capital losses sustained in those years with no tax benefit recorded. The analyses at September 30, 2014 and December 31, 2013 supported no additional valuation allowance was necessary.

 

At the end of 2013, the Company had $548,000 in capital losses, a decrease from $557,000 in capital losses in 2012 as capital gains from the sale of available for sale securities were generated. The Company has avoided and will continue to avoid taking any book tax benefit on future capital losses without capital gains to offset the current capital losses. See Note 14 to the Consolidated Financial Statements in Item 8 of the Form 10-K for the year ended December 31, 2013.

 

Income Tax Accounting. We file a consolidated federal income tax return. The provision for income taxes is based upon income in our consolidated financial statements, rather than amounts reported on our income tax return. Deferred tax assets and liabilities are recognized for future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect of a change in tax rates on our deferred tax assets and liabilities is recognized as income or expense in the period that includes the enactment date.

 

Forward-Looking Statements

 

This Form 10-Q contains and our future filings with the SEC, Company press releases, other public pronouncements, stockholder communications and oral statements made by or with the approval of an authorized executive officer, will contain “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. You can identify these forward-looking statements through our use of words such as “may,” “will,” “anticipate,” “assume,” “should,” “indicate,” “would,” “believe,” “contemplate,” “expect,” “estimate,” “continue,” “plan,” “project,” “could,” “intend,” “target” and other similar words and expressions of the future. These forward-looking statements include, but are not limited to: (i) statements of our goals, intentions and expectations; (ii) statements regarding our business plans, prospects, growth and operating strategies; (iii) statements regarding the asset quality of our loan and investment portfolios; and (iv) estimates of our risks and future costs and benefits. These forward-looking statements are based on current beliefs and expectations of our management and are inherently subject to significant business, economic and competitive uncertainties and contingencies, many of which are beyond our control. In addition, these forward-looking statements are subject to assumptions with respect to future business strategies and decisions that are subject to change. The Company does not undertake and specifically declines any obligation to publicly release the result of any revisions that may be made to any forward-looking statements to reflect events or circumstances after the date of such statements or to reflect the occurrence of unanticipated events.

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The following factors, among others, could cause actual results to differ materially from the anticipated results or other expectations expressed in the forward-looking statements: (i) the credit risks of lending activities, including changes in the level and trend of loan delinquencies and write-offs and changes in our allowance for loan losses and provision for loan losses that may be impacted by deterioration in the housing and commercial real estate markets; (ii) changes in general economic conditions, either nationally or in our market areas; (iii) changes in the levels of general interest rates and the relative differences between short- and long-term interest rates, deposit interest rates, our net interest margin and funding sources; (v) fluctuations in the demand for loans, the number of unsold homes, land and other properties and fluctuations in real estate values in our market areas; (vi) decreases in the secondary market for the sale of loans that we originate; (vii) results of examinations of us by the IDFI, FDIC, FRB or other regulatory authorities, including the possibility that any such regulatory authority may, among other things, require us to increase our reserve for loan losses, write-down assets, change our regulatory capital position or affect our ability to borrow funds or maintain or increase deposits, which could adversely affect our liquidity and earnings; (viii) legislative or regulatory changes that adversely affect our business including the effect of Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act”), changes in regulatory policies and principles, or the interpretation of regulatory capital or other rules, including changes that increase our capital requirements; (ix) our ability to attract and retain deposits; (x) increases in premiums for deposit insurance; (xi) management’s assumptions in determining the adequacy of the allowance for loan losses; (xii) our ability to control operating costs and expenses; (xiii) the use of estimates in determining fair value of certain of our assets, which estimates may prove to be incorrect and result in significant declines in valuation; (xiv) difficulties in reducing risks associated with the loans on our balance sheet; (xv) staffing fluctuations in response to product demand or the implementation of corporate strategies that affect our workforce and potential associated charges; (xvi) a failure or security breach in the computer systems on which we depend; (xvii) our ability to retain key members of our senior management team; (xviii) costs and effects of litigation, including settlements and judgments; (xix) our ability to successfully integrate any assets, liabilities, customers, systems, and management personnel we may in the future acquire into our operations and our ability to realize related revenue synergies and cost savings within expected time frames and any goodwill charges related thereto; (xx) increased competitive pressures among financial services companies; (xxi) changes in consumer spending, borrowing and savings habits; (xxii) the availability of resources to address changes in laws, rules, or regulations or to respond to regulatory actions; (xxiii) adverse changes in the securities markets; (xxiv) inability of key third-party providers to perform their obligations to us; (xv) changes in accounting policies and practices, as may be adopted by the financial institution regulatory agencies, the Public Company Accounting Oversight Board or the Financial Accounting Standards Board; and (xvi) other economic, competitive, governmental, regulatory, and technological factors affecting our operations, pricing, products and services and the other risks described elsewhere in this report.

 

The Company wishes to advise readers that these factors could affect the Company's financial performance and could cause the Company's actual results for future periods to differ materially from any opinions or statements expressed with respect to future periods in any current statements. 

 

44
 

 

Financial Condition

 

General. Total assets at September 30, 2014 were $1.4 billion, reflecting a $25.2 million increase since December 31, 2013, primarily as a result of a $29.5 million increase in net loans. Average interest-earning assets decreased $4.6 million, or .4%, to $1.29 billion for the nine months ended September 30, 2014 reflecting a decrease in available-for-sale securities. Average interest-bearing liabilities decreased by $2.6 million, or .2% to $1.11 billion for the nine months ended September 30, 2014 reflecting a decrease in term deposits. Average stockholders’ equity decreased by $17.2 million or 12.8% for the nine months ended September 30, 2014 due to the redemption of the preferred stock associated with the United State Treasury’s Small Business Lending Fund program near the end of 2013.

 

Loans. Our gross loan portfolio, excluding loans held for sale, increased to $1.0 billion at September 30, 2014 from $990.2 million at December 31, 2013. The following table reflects the changes in the gross amount of loans, excluding loans held for sale, by type during the nine month period:

 

   At       
   September 30,   December 31,   Amount   Percent 
   2014   2013   Change   Change 
   (Dollars in thousands) 
Real estate                    
Commercial  $192,534   $200,817   $(8,283)   (4.12)%
Commercial construction and development   29,267    13,321    15,946    119.71 
Consumer closed end first mortgage   519,312    531,272    (11,960)   (2.25)
Consumer open end and junior liens   71,001    69,354    1,647    2.37 
Total real estate loans   812,114    814,764    (2,650)   (0.33)
                     
Consumer loans                    
Auto   14,464    14,856    (392)   (2.64)
Boat/RV   95,093    79,419    15,674    19.74 
Other   5,363    5,766    (403)   (6.99)
Total consumer other   114,920    100,041    14,879    14.87 
Commercial and industrial   87,663    75,402    12,261    16.26 
Total other loans   202,583    175,443    27,140    15.47 
                     
Total Loans  $1,014,697   $990,207   $24,490    2.47%

 

The Bank’s strategy to increase commercial and consumer loans remains a primary focus as we continued to see growth in these areas during the first nine months of 2014 as commercial and non-real estate consumer loans grew by $34.8 million. We continue to seek opportunities to provide sound commercial borrowers opportunities for new loans to meet their growing demands, refinance loans currently served by other financial institutions and build relationships with commercial clients in our footprint. The increase in the commercial and other consumer portfolios was partially offset by the 10.3 million decrease in the consumer real estate portfolios during the period. Lower rates have allowed consumers to refinance their mortgage loans; however recently we have seen a significant decrease in those activities. The Bank continues to sell longer term fixed-rate mortgage loans to reduce related interest rate risk.

 

45
 

 

Delinquencies and Non-performing Assets. As of September 30, 2014, our total loans delinquent 30-to-89 days were $11.2 million or 1.1% of total loans, compared to $18.1 million or 1.8% of total loans at the end of 2013.

 

At September 30, 2014, our non-performing assets totaled $15.3 million or 1.08% of total assets, compared to $17.0 million or 1.22% of total assets at December 31, 2013. This $2.3 million, or 13.4% decrease was primarily due to a reduction in foreclosed assets. The table below sets forth the amounts and categories of non-performing assets in our loan portfolio at the dates indicated.

 

   At         
   September 30,   December 31,   Amount   Percent 
   2014   2013   Change   Change 
   (Dollars in thousands) 
Non-accruing loans  $8,197   $8,400   $(203)   (2.45)%
Accruing loans delinquent 90 days   217    188    29    15.43 
Foreclosed assets   6,838    8,433    (1,595)   (24.89)
Total  $15,252   $17,021   $(1,769)   (13.37)%

 

Our non-performing assets experienced an increase during the third quarter of 2014 due to performance issues related to one significant commercial real estate loan and two consumer closed-end first mortgage loans totaling $2.4 million. The Bank diligently monitors and writes down loans that appear to have irreversible weaknesses. The Bank works to ensure possible problem loans have been identified and steps have been taken to reduce loss by restructuring loans to improve cash flow or by increasing collateral. In addition to the decrease in non-performing assets since year-end, the Company saw improvement in total classified assets. Total classified assets decreased by 2.8% from $35.1 million at December 31, 2013 to $34.1 million at September 30, 2014.

 

At September 30, 2014, foreclosed commercial real estate totaled $2.2 million and consisted of nine commercial properties in our existing lending footprint. The Bank has seen a decrease in this area as overall real estate owned sales volumes are up. At September 30, 2014, the Bank had 27 residential properties with a book value of $4.1 million. Two properties, one commercial construction and development and the other is residential real estate, account for $4.1 million of the total REO balance. As of September 30, 2014, the Bank also held $504,000 in other repossessed assets, such as autos, boats, RVs and horse trailers.

 

46
 

 

Allowance for Loan Loss. Allowance for loan losses decreased $1.2 million from $14.5 million at September 30, 2013 to $13.2 million at September 30, 2014 as reflected below:

 

   At and For the Nine Months Ended 
   September 30, 
   2014   2013 
   (Dollars in thousands) 
Balance at beginning of period  $13,412   $16,038 
Charge-offs   1,402    4,161 
Recoveries   389    327 
Net charge-offs   1,013    3,834 
Provisions charged to operations   850    2,250 
Balance at end of period  $13,249   $14,454 
           
Ratio of net charge-offs during the period to          
average loans outstanding during the period   0.14%   0.52%
           
Allowance as a percentage of non-performing loans   157.46%   107.05%
Allowance as a percentage of total loans (end of period)   1.31%   1.48%

 

Allowance for loan losses was $13.2 million as of September 30, 2014 compared to $13.4 million as of December 31, 2013. Net recoveries in the third quarter were $6,000 and net charge offs for the first nine months of 2014 were $1.0 million, or .14% of total loans on an annualized basis. The allowance for loan losses to non-performing loans as of September 30, 2014 was 157.5% compared to 216.7% as of June 30, 2014 and 156.2% as of December 31, 2013. Non-performing loans increased $2.3 million on a linked quarter basis primarily due to three loans totaling $2.2 million. The allowance for loan losses to total loans as of September 30, 2014 was 1.31% compared to 1.33% as of June 30, 2014 and 1.37% as of December 31, 2013.

 

Deposits. Deposits decreased by $14.2 million in the first nine months of 2014. The decrease in deposits has been primarily in certificates of deposit, which decreased $54.2 million, while core transactional deposits increased $40.0 million in the first nine months of 2014. Core transactional deposits increased to 62% of the Bank’s total deposits as of September 30, 2014 compared to 58% as of December 31, 2013. These changes are consistent with the Bank’s strategy to grow and strengthen core deposit relationships.

 

   At 
   September 30, 2014   December 31, 2013 
   Amount   Weighted
Average
Rate
   Amount   Weighted
Average
Rate
 
   (Dollars in thousands) 
Type of Account:                
Non-interest Checking  $157,465    0.00%  $144,195    0.00%
Interest-bearing NOW   252,964    0.23    262,114    0.23 
Savings   123,525    0.01    119,380    0.01 
Money Market   147,320    0.23    115,600    0.24 
Certificates of Deposit   417,575    1.14    471,795    1.39 
Total  $1,098,849    0.52%  $1,113,084    0.67%

 

47
 

 

Borrowings. Total borrowings increased to $178.9 million at September 30, 2014, up $25.1 million, or 16.3%, since year-end 2013 primarily due to a $25.6 million increase in FHLB advances to help fund increasing loan demand. Other borrowings, consisting of a bank loan and subordinate debenture, decreased $537,000 to $10.4 million at September 30, 2014 due to regular loan payments.

 

The Company has a $1.0 million revolving line of credit expiring in December 2017. At September 30, 2014, there were no amounts borrowed against this line. The line is collateralized by the Bank’s stock. The rate on this line of credit is the three month LIBOR plus 2.75%.

 

In 2013, the Company borrowed $7.6 million from First Tennessee Bank, N.A. to refinance existing long-term debt. The loan was originated at a variable rate of LIBOR plus 2.80%; however the Company entered into an interest rate swap that fixed the rate of the note at 3.915% for the term of the note. The balance of the loan at September 30, 2014 was $6.3 million and it matures in December 2017.

 

The Company acquired $5.0 million of issuer trust preferred securities in a 2008 acquisition of another financial institution, which had a net balance of $4.1 million at September 30, 2014 due to the purchase accounting adjustment in the acquisition. These securities mature 30 years from the date of issuance, or September 15, 2035. The securities bore a fixed rate of interest of 6.22% through July 2010 and thereafter were to reset quarterly at the prevailing three-month LIBOR rate plus 170 basis points. In December 2009, the Company entered into a cash flow hedge with FTN Financial to fix the floating portion of the issued trust preferred security at 5.15% for the next five years starting on September 15, 2010. The Company has had the right to redeem the trust preferred securities, in whole or in part, without penalty, since establishing the cash flow hedge.

 

Stockholders’ Equity. Stockholders’ equity was $122.1 million at September 30, 2014, an increase of $10.5 million from December 31, 2013. The increase was primarily a result of net income of $7.2 million, an increase in other comprehensive income of $3.9 million and $951,000 from exercised stock options. These increases were partially offset by $1.6 million of common stock dividends returned to shareholders. The Company’s tangible book value per share as of September 30, 2014 increased to $16.55 compared to $15.46 as of December 31, 2013 and its tangible common equity ratio increased to 8.42% as of September 30, 2014 compared to 7.91% as of December 31, 2013.

 

Comparison of Results of Operations for the Three Months Ended September 30, 2014 and 2013.

 

General. Net income available to common shareholders for the three months ended September 30, 2014 was $2.7 million, or $.38 basic and $.36 diluted earnings per common share compared to net income available to common shareholders of $2.2 million, or $.31 basic and $.30 diluted earnings per common share for the three months ended September 30, 2013. Annualized return on assets was .76% and return on average tangible common equity was 9.07% for the third quarter of 2014 compared to .71% and 8.17% respectively, for the same period of last year. 

 

Interest Income. Total interest income decreased $238,000, or 1.8%, to $12.8 million during the three months ended September 30, 2014 from $13.0 million during the same period in 2013, reflecting an 11 basis point decrease in the average yield on interest-earning assets during the quarter ended September 30, 2014, primarily due to the decrease in rates in our loan portfolio.

 

Interest Expense. Interest expense decreased $638,000, or 22.8%, to $2.2 million during the three months ended September 30, 2014 compared to $2.8 million during the three months ended September 30, 2013. The primary reason for this decrease was a decline of 24 basis points in the average rate paid on interest-bearing liabilities from 1.01% as of September 30, 2013 to 0.77% at September 30, 2014, which was primarily due to continued re-pricing of deposit accounts and a changing mix of the deposits to a larger amount of transaction accounts as a percentage of interest-bearing liabilities.

 

48
 

 

Net Interest Income. Net interest income before the provision for loan losses increased $400,000 for the quarter ended September 30, 2014 compared to the same period in 2013. The increase was a result of an $11.5 million increase in average earning assets and an increase of 9 basis points in the net interest margin to 3.26%. The increase in average earning assets was primarily an increase of $26.2 million in loans, partially funded by a $16.6 million decline in investments On a linked quarter basis, net interest income before the provision for loan losses increased $82,000 as average earning assets increased by $15.4 million, partially offset by a 2 basis point reduction in net interest margin. For more information on our asset/liability management especially as it relates to interest rate risk, see “Item 7A - Quantitative and Qualitative Disclosures About Market Risk” in this Form 10-K.

 

Provision for Loan Losses. No provision for loan loss was recorded for the third quarter of 2014 compared to $750,000 during last year’s comparable period. The decrease was due to management’s ongoing evaluation of the adequacy of the allowance for loan losses, which was partially attributable to improving credit quality and declining net charge offs. Recoveries exceeded charge offs by $6,000 in the third quarter of 2014 compared to net charge offs of $2.0 million in the third quarter of 2013. Non-performing loans to total loans at September 30, 2014 were .83% compared to 1.38% at September 30, 2013. Non-performing assets to total assets was 1.08% at September 30, 2014 compared to 1.46% at September 30, 2013.

 

Other Income. Other (non-interest) income increased by $300,000 to $3.6 million in the third quarter of 2014 compared to $3.3 million in the third quarter of 2013.

 

   Three Months Ended   Amount   Percent 
   9/30/2014   9/30/2013   Change   Change 
   (Dollars in thousands) 
Non-Interest Income:                    
Service fee income  $1,518   $1,447   $71    4.91%
Net realized gain on sale of available-for-sale securities   75    453    (378)   (83.44)
Commissions   1,228    1,041    187    17.96 
Equity in losses of limited partnerships   (124)   (84)   (40)   (47.62)
Net gains on sales of loans   444    84    360    428.57 
Net servicing fees   66    63    3    4.76 
Increase in cash value of life insurance   295    321    (26)   (8.10)
Gain (loss) on sale of other real estate and repossessed assets   (81)   (108)   27    (25.00)
Other income   153    57    96    168.42 
Total  $3,574   $3,274   $300    9.16%

 

Increases in non-interest income included increased gain on sale of loans of $360,000 and increased other income of $96,000 partially as a result of the acquisition of Summit Mortgage, Inc. Service fee income on deposit accounts also increased $71,000, which was primarily due to increased interchange income. Commission income also increased by $187,000 mainly due to increases in wealth management, trust and brokerage lines of business. These increases were offset primarily by a decline in gain on sale of investments of $378,000. On a linked quarter basis, non-interest income increased $160,000, primarily due to the income from Summit Mortgage, Inc. which was partially offset by a decline in gain on sale of investments.

 

49
 

 

Other Expense. Other (non-interest) expense increased $1.2 million to $10.4 million for the third quarter 2014. 

 

   Three Months Ended   Amount   Percent 
   9/30/2014   9/30/2013   Change   Change 
   (Dollars in thousands) 
Non-Interest Expense:                    
Salaries and employee benefits  $6,088   $5,282   $806    15.26%
Net occupancy expenses   494    244    250    102.46 
Equipment expenses   450    453    (3)   (0.66)
Data processing fees   373    326    47    14.42 
Advertising and promotion   387    386    1    0.26 
ATM expense   370    296    74    25.00 
Deposit insurance   239    251    (12)   (4.78)
Professional fees   376    318    58    18.24 
Software subscriptions and maintenance   418    391    27    6.91 
Other real estate and repossessed assets   161    180    (19)   (10.56)
Other expenses   1,052    1,073    (21)   (1.96)
Total  $10,408   $9,200   $1,208    13.13%

  

This increase was partially due to one-time expense reductions in the third quarter of 2013 that were not repeated in 2014. These included a reduction in health insurance expense of $300,000 and property tax refunds of $350,000. The increase in non-interest expense excluding the one-time reductions in 2013 was $558,000. Salaries and benefits increased by $506,000, without the health insurance expense reduction in 2013, primarily due to the acquisition of Summit Mortgage, Inc. and increases in accrual for commission and incentive expenses. On a linked quarter basis, non-interest expense increased $555,000 primarily due to an increase of $588,000 in salaries and benefits resulting from the acquisition of Summit Mortgage, Inc. and increases in commission and incentive expenses during the third quarter of 2014.

 

Income Tax Expense. Income tax expense for the third quarter 2014 increased by $20,000 due to an increase in taxable income compared to the same period in 2013. The Company’s effective tax rate decreased to 29.2% for the three months ended September 30, 2014 compared to 30.6% for the three months ended September 30, 2013 because of an increase in non-taxable income.

 

Comparison of Results of Operations for the Nine months Ended September 30, 2014 and 2013.

 

General. Net income available to common shareholders for the nine months ended September 30, 2014 was $7.2 million or $1.01 basic and $.98 diluted earnings per common share compared to net income available to common shareholders of $5.6 million, or $.80 basic and $.78 diluted earnings per common share for the nine months ended September 30, 2013. Annualized return on assets was .69% and return on average tangible common equity was 8.30% for the first nine months of 2014 compared to .62% and 7.00% respectively, for the same period of last year.

 

Interest Income. Total interest income decreased $535,000, or 1.4%, to $38.3 million during the nine months ended September 30, 2014 from $38.8 million during the same period in 2013, reflecting the $4.6 million decline in average interest-earning assets during the nine months ended September 30, 2014, primarily due to the decrease in our mortgage-backed securities.

 

50
 

 

Interest Expense. Interest expense decreased $1.9 million, or 22.3%, to $6.7 million during the nine months ended September 30, 2014 compared to $8.6 million during the nine months ended September 30, 2013. The primary reason for this decrease was a decline of 22 basis points in the average rate paid on interest-bearing liabilities from 1.02% as of September 30, 2013 to 0.80% at September 30, 2014, which was primarily due to continued re-pricing of deposit accounts and a changing mix of deposits to a larger amount of transaction accounts as a percentage of interest-bearing liabilities.

 

Net Interest Income. Net interest income before the provision for loan losses increased $1.4 million for the first nine months of 2014 compared to the same period in 2013. The increase was a result of a 16 basis point increase in net interest margin. The increase was partially offset by a $4.6 million decline in average earning assets due to a decrease in average investments of $15.2 million primarily offset by average loan growth of $11.2 million. For more information on our asset/liability management especially as it relates to interest rate risk, see “Item 7A - Quantitative and Qualitative Disclosures About Market Risk” in this Form 10-K.

 

Provision for Loan Losses. The provision for loan losses for the first nine months of 2014 decreased to $850,000 compared to $2.3 million during last year’s comparable period. The decrease was primarily due to a decline in net charge offs and improving asset quality. Net charge offs through the first nine months of 2014 have been $1.0 million compared to $3.8 million over the comparable period in 2013. Non-performing loans to total loans at September 30, 2014 were .83% compared to .88% at December 31, 2013. This decrease in non-performing loans was primarily in commercial business loans.

 

Other Income. Non-interest income for the first nine months of 2014 was $9.9 million, a decrease of $510,000 compared to the first nine months of 2013.

 

   Nine Months Ended   Amount   Percent 
   9/30/2014   9/30/2013   Change   Change 
   (Dollars in thousands) 
Non-Interest Income:                    
Service fee income  $4,398   $4,382   $16    0.37%
Net realized gain on sale of available-for-sale securities   436    835    (399)   (47.78)
Commissions   3,488    3,196    292    9.14 
Equity in losses of limited partnerships   (309)   (338)   29    8.58 
Net gains on sales of loans   929    654    275    42.05 
Net servicing fees   45    471    (426)   (90.45)
Increase in cash value of life insurance   866    942    (76)   (8.07)
Loss on sale of other real estate and repossessed assets   (321)   (53)   (268)   505.66 
Other income   329    282    47    16.67 
Total  $9,861   $10,371   $(510)   (4.92)%

 

The decrease was primarily due to a reduction of $426,000 in net servicing fees primarily due to mortgage servicing right valuation recoveries in 2013 that were not repeated in 2014. Other declines were in gain on sale of investments of $399,000 and increased loss on real estate owned sales of $268,000. These declines were offset by increased commission income of $292,000 from wealth management, trust and brokerage services and gain on sale of loans of $275,000 from increased loan production as a result of the acquisition of Summit Mortgage, Inc.

51
 

 

Other Expense. Non-interest expense increased $1.5 million when comparing the first nine months of 2014 with the same period in 2013.

 

   Nine Months Ended   Amount   Percent 
   9/30/2014   9/30/2013   Change   Change 
   (Dollars in thousands) 
Non-Interest Expense:                    
Salaries and employee benefits  $17,461   $16,365   $1,096    6.70%
Net occupancy expenses   1,763    1,472    291    19.77 
Equipment expenses   1,344    1,377    (33)   (2.40)
Data processing fees   1,180    1,081    99    9.16 
Advertising and promotion   993    1,095    (102)   (9.32)
ATM expense   976    806    170    21.09 
Deposit insurance   779    891    (112)   (12.57)
Professional fees   1,254    973    281    28.88 
Software subscriptions and maintenance   1,220    1,070    150    14.02 
Other real estate and repossessed assets   447    529    (82)   (15.50)
Other expenses   3,090    3,355    (265)   (7.90)
Total  $30,507   $29,014   $1,493    5.15%

 

Non-interest expense increased $1.5 million when comparing the first nine months of 2014 with the same period in 2013. This increase was partially due to one-time expense reductions in the third quarter of 2013 that were not repeated in 2014. These included a reduction in health insurance expense of $300,000 and property tax refunds of $350,000. The increase in non-interest expense excluding the one-time reductions in 2013 was $850,000. Salaries and benefits increased by $1.1 million without the health insurance expense reduction in 2013, primarily due to the acquisition of Summit, increases in accrual for commissions, incentive expenses and general salary and benefit increases.

 

Income Tax Expense. Income tax expense for the first nine months of 2014 increased by $120,000 compared to the same period in 2013 primarily due to an increase in income before income tax expense. The Company’s effective tax rate decreased to 28.7% for the nine months ended September 30, 2014 compared to 29.8% for the nine months ended September 30, 2013 because of the increase in non-taxable income.

 

Liquidity

 

We are required to have enough cash and investments that qualify as liquid assets in order to maintain sufficient liquidity to ensure safe and sound operation. Liquidity may increase or decrease depending upon the availability of funds and comparative yields on investments in relation to the return on loans. Historically, we have maintained liquid assets above levels believed to be adequate to meet the requirements of normal operations, including potential deposit outflows. Cash flow projections are regularly reviewed and updated to assure that adequate liquidity is maintained. Since 2011, we have maintained higher levels of liquidity as we grew our deposits and marketable equity securities and received paydowns within our loan portfolio.

 

Liquidity management involves the matching of cash flow requirements of customers, who may be either depositors desiring to withdraw funds or borrowers needing assurance that sufficient funds will be available to meet their credit needs and the ability of the Company to manage those requirements. The Company strives to maintain an adequate liquidity position by managing the balances and maturities of interest-earning assets and interest-bearing liabilities so that the balance it has in short-term investments at any given time will cover adequately any reasonably anticipated, immediate need for funds. Additionally, the Bank maintains relationships with correspondent banks, which could provide funds on short-term notice if needed. Our liquidity, represented by cash and cash-equivalents and investment securities, is a product of our operating, investing and financing activities.

52
 

 

Liquidity management is both a daily and long-term function of the management of the Company and the Bank. It is overseen by the Asset and Liability Management Committee. The Board of Directors required the Bank to maintain a minimum liquidity ratio of 10% of deposits. At September 30, 2014, our ratio was 26.5%. The Company is currently in excess of the minimum liquidity ratio set by the Board due to a larger than historical investment portfolio. Management continues to seek to utilize liquidity off of the investment portfolio to fund loan growth over the next few years as demand for loans increase. Excess liquidity is generally invested in short-term investments, such as overnight deposits and federal funds. On a longer term basis, we maintain a strategy of investing in various lending products and investment securities, including mortgage-backed securities. The Bank uses its sources of funds primarily to meet its ongoing commitments, pay maturing deposits, fund deposit withdrawals and fund loan commitments.

 

We maintain cash and investments that qualify as liquid assets to maintain adequate liquidity to ensure safe and sound operation and meet demands for funds (particularly withdrawals of deposits). At September 30, 2014, on a consolidated basis, the Company had $284.6 million in cash and investment securities available for sale and $6.4 million in loans held for sale generally available for its cash needs. We can also generate funds from borrowings, primarily FHLB advances, and, to a lesser degree, third party loans. At September 30, 2014, the Bank had the ability to borrow an additional $103.7 million in FHLB advances. In addition, we have historically sold 15- and 30-year long-term, fixed-rate mortgage loans in the secondary market in order to reduce interest rate risk and to create another source of liquidity. The Company is a separate legal entity from the Bank and must provide for its own liquidity. In addition to its own operating expenses (many of which are paid to the Bank), the Company is responsible for paying amounts owed on its trust preferred securities, any dividends declared to its common stockholders, and interest and principal on outstanding debt. The Company’s primary source of funds is Bank dividends, the payment of which is subject to regulatory limits. At September 30, 2014, the Company, on an unconsolidated basis, had $2.0 million in cash, interest-bearing deposits and liquid investments generally available for its cash needs.

 

Our liquidity, represented by cash and cash equivalents and investment securities, is a product of our operating, investing and financing activities. Our primary sources of funds are deposits, amortization, prepayments and maturities of outstanding loans and mortgage-backed securities, maturities of investment securities and other short-term investments and funds provided from operations. While scheduled payments from the amortization of loans and mortgage-backed securities and maturing investment securities and short-term investments are relatively predictable sources of funds, deposit flows and loan prepayments are greatly influenced by general interest rates, economic conditions and competition. In addition, we invest excess funds in short-term interest-earning assets, which provide liquidity to meet lending requirements. We also generate cash through borrowings. We utilize FHLB advances to leverage our capital base and provide funds for our lending and investment activities, and to enhance our interest rate risk management.

 

We use our sources of funds primarily to meet ongoing commitments, pay maturing deposits and fund withdrawals, and to fund loan commitments. At September 30, 2014, the approved outstanding loan commitments, including unused lines of credit, amounted to $195.9 million. Certificates of deposit scheduled to mature in one year or less at September 30, 2014, totaled $198.5 million. It is management’s policy to offer deposit rates that are competitive with other local financial institutions. Based on this management strategy, we believe that a majority of maturing deposits will remain with the Bank.

 

53
 

 

Except as set forth above, management is not aware of any trends, events, or uncertainties that will have, or that are reasonably likely to have a material impact on liquidity, capital resources or operations. Further, management is not aware of any current recommendations by regulatory agencies, which, if they were to be implemented, would have this effect.

 

Off-Balance Sheet Activities

 

In the normal course of operations, the Bank engages in a variety of financial transactions that are not recorded in our financial statements. These transactions involve varying degrees of off-balance sheet credit, interest rate and liquidity risks. These transactions are used primarily to manage customers’ requests for funding and take the form of loan commitments and lines of credit. We also have off-balance sheet obligations to repay borrowings and deposits. For the quarter ended September 30, 2014, we engaged in no off-balance sheet transactions likely to have a material effect on our financial condition, results of operations or cash flows. At September 30, 2014, the Bank had $95.2 million in commitments to make loans, $11.1 million in undisbursed portions of closed loans, $87.4 million in unused lines of credit and $2.3 million in standby letters of credit. In addition, on a consolidated basis, at September 30, 2014, the Company had $178.9 million in outstanding non-deposit borrowings, of which $42.1 million is due in the next twelve months.

 

Capital Resources

 

The Bank is subject to minimum capital requirements imposed by the FDIC. See ‘Item 1 - Business- How We Are Regulated - Regulatory Capital Requirements.” The FDIC may require the Bank to have additional capital above the specific regulatory levels if it believes the Bank is subject to increased risk due to asset problems, high interest rate risk and other risks. The Company is subject to minimum capital requirements imposed by the FRB, which are substantially similar to those imposed on the Bank, including guidelines for bank holding companies to be considered well-capitalized. The FDIC and FRB have issued revisions to these capital requirements, which would increase the levels required, particularly if the Bank and the Company want to continue paying dividends or executive bonuses. These new rules will be phased in starting January 2015.

 

At September 30, 2014, the Bank’s regulatory capital exceeded the FDIC regulatory requirements, and the Bank was well-capitalized under regulatory prompt corrective action standards. In addition, at September 30, 2014, the Company’s capital levels exceeded the FRB’s requirements, and the Company was considered well-capitalized under FRB guidelines. Consistent with our goals to operate a sound and profitable organization, our policy is for the Bank to maintain well-capitalized status.

 

54
 

 

Our capital ratios at September 30, 2014 are reflected below:

 

   Actual Capital
Levels
   Minimum Regulatory
Capital Levels
   Minimum Required To
be Considered Well-
Capitalized
 
   Amount   Ratio   Amount   Ratio   Amount   Ratio 
Leverage Capital Level(1):                        &nbs