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Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

FORM 10-K

 

 

(Mark One)

x

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

For the Fiscal Year Ended December 31, 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: 001-33033

 

 

PORTER BANCORP, INC.

(Exact name of registrant as specified in its charter)

 

 

 

Kentucky   61-1142247

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

2500 Eastpoint Parkway,

Louisville, Kentucky

  40223
(Address of principal executive offices)   (Zip Code)

Registrant’s telephone number, including area code: (502) 499-4800

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

 

Title of each class

 

Name of each exchange on which registered

Common Stock, no par value   NASDAQ Capital 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 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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  ¨

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 “accelerated filer”, “large accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer

 

¨

  

Accelerated filer

 

¨

Non-accelerated filer

 

¨

  

Smaller reporting company

 

x

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

The aggregate market value of the voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold as of the close of business on June 30, 2014, was $12,842,756 based upon the last sales price reported for such date on the NASDAQ Capital Market.

The number of shares outstanding of the registrant’s Common Stock, no par value, as of March 15, 2015, was 18,944,090.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrant’s Proxy Statement for the Annual Meeting of Shareholders to be held May 20, 2015 are incorporated by reference into Part III of this Form 10-K.

 

 

 


Table of Contents

TABLE OF CONTENTS

 

          Page No.  

PART I

        1   

Item 1.

  

Business

     1   

Item 1A.

  

Risk Factors

     12   

Item 1B.

  

Unresolved Staff Comments

     22   

Item 2.

  

Properties

     22   

Item 3.

  

Legal Proceedings

     22   

Item 4.

  

Mine Safety Disclosures

     22   

PART II

        23   

Item 5.

  

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

     23   

Item 6.

  

Selected Financial Data

     25   

Item 7.

  

Management’s Discussion and Analysis of Financial Condition and Results of Operation

     26   

Item 7A.

  

Quantitative and Qualitative Disclosures About Market Risk

     57   

Item 8.

  

Financial Statements and Supplementary Data

     59   

Item 9.

  

Changes in and Disagreements With Accountants on Accounting and Financial Disclosure

     108   

Item 9A.

  

Controls and Procedures

     108   

Item 9B.

  

Other Information

     108   

PART III

        108   

Item 10.

  

Directors, Executive Officers and Corporate Governance

     108   

Item 11.

  

Executive Compensation

     109   

Item 12.

  

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

     109   

Item 13.

  

Certain Relationships and Related Transactions, and Director Independence

     109   

Item 14.

  

Principal Accounting Fees and Services

     109   

PART IV

        110   

Item 15.

  

Exhibits and Financial Statement Schedules

     110   
  

Signatures

     111   
  

Index to Exhibits

     112   


Table of Contents

PART I

Preliminary Note Concerning Forward-Looking Statements

This report contains statements about the future expectations, activities and events that constitute forward-looking statements. Forward-looking statements express our beliefs, assumptions and expectations of our future financial and operating performance and growth plans, taking into account information currently available to us. These statements are not statements of historical fact. The words “believe,” “may,” “should,” “anticipate,” “estimate,” “expect,” “intend,” “objective,” “seek,” “plan,” “strive” or similar words, or the negatives of these words, identify forward-looking statements.

Forward-looking statements involve risks and uncertainties that may cause our actual results to differ materially from the expectations of future results we expressed or implied in any forward-looking statements. These risks and uncertainties can be difficult to predict and may be beyond our control. Factors that could contribute to differences in our results include, but are not limited to deterioration in the financial condition of borrowers resulting in significant increases in loan losses and provisions for those losses; changes in the interest rate environment, which may reduce our margins or impact the value of securities, loans, deposits and other financial instruments; changes in loan underwriting, credit review or loss reserve policies associated with economic conditions, examination conclusions, or regulatory developments; general economic or business conditions, either nationally, regionally or locally in the communities we serve, may be worse than expected, resulting in, among other things, a deterioration in credit quality or a reduced demand for credit; the results of regulatory examinations; any matter that would cause us to conclude that there was impairment of any asset, including intangible assets; the continued service of key management personnel; our ability to attract, motivate and retain qualified employees; factors that increase the competitive pressure among depository and other financial institutions, including product and pricing pressures; the ability of our competitors with greater financial resources to develop and introduce products and services that enable them to compete more successfully than us; inability to comply with regulatory capital requirements and to secure any required regulatory approvals for capital actions; legislative or regulatory developments, including changes in laws concerning taxes, banking, securities, insurance and other aspects of the financial services industry; and fiscal and governmental policies of the United States federal government.

Other risks are detailed in Item 1A. “Risk Factors” of this Form 10-K all of which are difficult to predict and many of which are beyond our control.

Forward-looking statements are not guarantees of performance or results. A forward-looking statement may include the assumptions or bases underlying the forward-looking statement. We have made our assumptions and bases in good faith and believe they are reasonable. We caution you however, that estimates based on such assumptions or bases frequently differ from actual results, and the differences can be material. The forward-looking statements included in this report speak only as of the date of the report. We do not intend to update these statements unless applicable laws require us to do so.

 

Item 1. Business

Overview

Porter Bancorp, Inc. (the “Company”) is a bank holding company headquartered in Louisville, Kentucky. We operate the ninth largest bank domiciled in the Commonwealth of Kentucky based on total assets through our wholly-owned subsidiary PBI Bank (the “Bank”). We operate 17 banking offices in twelve counties in Kentucky. Our markets include metropolitan Louisville in Jefferson County and the surrounding counties of Henry and Bullitt. We serve south central Kentucky and southern Kentucky from banking offices in Butler, Green, Hart, Edmonson, Barren, Warren, Ohio, and Daviess Counties. We also have an office in Lexington, the second largest city in Kentucky. The Bank is a community bank with a wide range of commercial and personal banking products. As of December 31, 2014, we had total assets of $1.0 billion, total loans of $625.0 million, total deposits of $926.8 million and stockholders’ equity of $33.5 million.

History

We were organized in 1988, and historically conducted our banking business through separate community banks. On December 31, 2005, we completed a reorganization in which we consolidated our subsidiary banks into a single bank. We renamed our consolidated subsidiary PBI Bank to create a single brand name for our banking operations throughout our market area. We completed our initial public offering in September 2006.

On November 21, 2008, we issued to the U.S. Treasury (“UST”), in exchange for cash consideration of $35.0 million, (i) 35,000 shares of Fixed Rate Cumulative Perpetual Preferred Stock, Series A, with a liquidation preference of $1,000 per share (the “Series A Preferred Stock”), and (ii) a warrant to purchase up to 330,561 shares of our common stock for $15.88 per share.

 

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In 2010, we completed a $32.0 million private placement to accredited investors. Following completion of the transactions involved, the Company issued (i) 2,465,569 shares of common stock, (ii) 317,042 shares of Non-Voting Cumulative Mandatorily Convertible Perpetual Preferred Shares, Series C (“Series C Preferred Stock”) and (iii) warrants to purchase 1,163,045 shares of non-voting common stock at a price of $11.50 per share. See Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation – Capital.

On June 24, 2011, the Bank entered into a Consent Order with the Federal Deposit Insurance Corporation (“FDIC”) and the Kentucky Department of Financial Institutions (“KDFI”). The consent order requires the Bank to improve its asset quality, reduce its loan concentrations, and maintain a minimum Tier 1 leverage ratio of 9% and a minimum total risk based capital ratio of 12%.

On September 21, 2011, the Company entered into a written agreement with the Federal Reserve Bank of St. Louis. The Company made formal commitments to use its resources to serve as a source of strength for the Bank, to assist the Bank in addressing weaknesses identified by the FDIC and the KDFI, to pay no dividends without prior written approval, to pay no interest on subordinated debentures or principal on trust preferred securities without written approval, and to submit a plan to maintain sufficient capital.

In October 2012, the Bank entered into a revised Consent Order with the FDIC and KDFI again agreeing to maintain a minimum Tier 1 leverage ratio of 9% and a minimum total risk based capital ratio of 12%. The Bank also agreed that if it should be unable to reach the required capital levels, and if directed in writing by the FDIC, then the Bank would within 30 days develop, adopt and implement a written plan to sell or merge itself into another federally insured financial institution or otherwise immediately obtain a capital investment into the Bank sufficient to fully meet the capital requirements. We have not been directed by the FDIC to implement such a plan. The Consent Order also requires the Bank to continue to adhere to the plans implemented in response to the June 2011 Consent Order, and includes the substantive provisions of the June 2011 Consent Order.

In December 2014, we completed a non-cash equity exchange transaction with the accredited investors who acquired all of our issued and outstanding Series A Preferred Shares from UST in a public auction. We acquired and cancelled all of the issued and outstanding Series A Preferred Shares, the accrued dividends thereon, all of the issued and outstanding Series C Preferred Shares, and warrants to purchase 798,915 shares of common stock together having an aggregate book value of approximately $45.7 million. In exchange, we issued common and preferred shares having a fair value of approximately $9.6 million. The effect of this exchange transaction was to increase common stockholders’ equity by approximately $36.1 million and total stockholders’ equity by approximately $7.4 million.

In the exchange transaction, we issued 1,821,428 common shares, 40,536 mandatorily convertible Series B Preferred Shares and 64,580 mandatorily convertible Series D Preferred Shares, which automatically converted into 4,053,600 common shares and 6,458,000 non-voting common shares after shareholder approval on February 25, 2015. We also issued 6,198 Series E Preferred Shares and 4,304 Series F Preferred Shares, both of which series are not convertible into common shares, have a liquidation preference of $1,000 per share, and are entitled to a 2% noncumulative annual dividend if and when declared. Series E and Series F Preferred Shares rank senior to, and have liquidation and dividend preferences over, our common shares and non-voting common shares.

Our Markets

We operate in markets that include the four largest cities in Kentucky – Louisville, Lexington, Bowling Green and Owensboro – and in other communities along the I-65 corridor.

 

  ¡

Louisville/Jefferson, Bullitt and Henry Counties: Our headquarters are in Louisville, the largest city in Kentucky. We also have banking offices in Bullitt County, south of Louisville, and Henry County, east of Louisville. Our six banking offices in these counties also serve the contiguous counties of Spencer, Shelby and Oldham to the east and northeast of Louisville. The area’s major employers are diversified across many industries and include the air hub for United Parcel Service (“UPS”), two Ford assembly plants, General Electric’s Consumer and Industrial division, Humana, Norton Healthcare, Brown-Forman, YUM! Brands, Papa John’s Pizza, and Texas Roadhouse.

 

  ¡

Lexington/Fayette County: Lexington, located in Fayette County, is the second largest city in Kentucky. Lexington is the financial, educational, retail, healthcare and cultural hub for Central and Eastern Kentucky. It is known worldwide for its horse farms and Keeneland Race Track, and proudly boasts of itself as “The Horse Capital of the World.” It is also the home of the University of Kentucky and Transylvania University. The area’s major employers include Toyota, Lexmark, IBM Global Services and Valvoline.

 

  ¡

Southern Kentucky: This market includes Bowling Green, the third largest city in Kentucky, located about 60 miles north of Nashville, Tennessee. Bowling Green, located in Warren County, is the home of Western Kentucky University and is the economic hub of the area. This market also includes thriving communities in the contiguous Barren County, including the city of Glasgow. Major employers in Barren and Warren Counties include GM’s Corvette plant, several other automotive facilities, and R.R. Donnelley’s regional printing facility.

 

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  ¡

Owensboro/Daviess County: Owensboro, located on the banks of the Ohio River, is Kentucky’s fourth largest city. The city is called a festival city, with over 20 annual community celebrations that attract visitors from around the world, including its world famous Bar-B-Q Festival which attracts over 80,000 visitors giving Owensboro recognition as “The Bar-B-Q Capital of the World”. It is an industrial, medical, retail and cultural hub for Western Kentucky and the area employers include Owensboro Medical System, US Bank Home Mortgage and Toyotetsu.

 

  ¡

South Central Kentucky: South of the Louisville metropolitan area, we have banking offices in Butler, Edmonson, Green, Hart, and Ohio Counties. This region includes stable community markets comprised primarily of agricultural and service-based businesses. Each of our banking offices in these markets has a stable customer and core deposit base.

Our Products and Services

We meet our customers’ banking needs with a broad range of financial products and services. Our lending services include real estate, commercial, mortgage and consumer loans to small to medium-sized businesses, the owners and employees of those businesses, as well as other executives and professionals. We complement our lending operations with an array of retail and commercial deposit products. In addition, we offer our customers drive-through banking facilities, automatic teller machines, night depository, personalized checks, credit cards, debit cards, internet banking, mobile banking, treasury management services, remote deposit services, electronic funds transfers through ACH services, domestic and foreign wire transfers, cash management, vault services, lock box services, along with loan and deposit sweep accounts.

Employees

At December 31, 2014, the Company had 264 full-time equivalent employees. Our employees are not subject to a collective bargaining agreement, and management considers the Company’s relationship with employees to be good.

Competition

The banking business is highly competitive, and we experience competition from many other financial institutions. Competition among financial institutions is based upon interest rates offered on deposit accounts, interest rates charged on loans, other credit and service charges relating to loans, the quality and scope of the services offered, the convenience of banking facilities and, in the case of loans to commercial borrowers, relative lending limits. We compete with commercial banks, credit unions, savings and loan associations, mortgage banking firms, consumer finance companies, securities brokerage firms, insurance companies, money market funds and other mutual funds, as well as super-regional, national and international financial institutions that operate offices within our market area and beyond.

Supervision and Regulation

Consent Order and Formal Written Agreement. On June 24, 2011, the Bank entered into a Consent Order with the FDIC and the KDFI. The Bank agreed to obtain the written consent of both agencies before declaring or paying any future dividends. As a practical matter, the Bank will not be able to pay dividends to Porter Bancorp for the foreseeable future. The Consent Order also establishes benchmarks for the Bank to improve its asset quality, reduce its loan concentrations, and maintain a minimum Tier 1 leverage ratio of 9% and a minimum total risk based capital ratio of 12%. At December 31, 2014, the Bank’s Tier 1 leverage ratio was 5.78% and its total risk-based capital ratio was 10.57%, which are below the minimums of 9.0% and 12.0% required by the Bank’s Consent Order.

On September 21, 2011, we entered into a formal written agreement with the Federal Reserve Bank of St. Louis. The Company made formal commitments in the agreement to use its financial and management resources to serve as a source of strength for the Bank and to assist the Bank in addressing weaknesses identified by the FDIC and the KDFI, to pay no dividends without prior written approval, to pay no interest or principal on subordinated debentures or trust preferred securities without written approval, and to submit an acceptable plan to maintain sufficient capital.

In October 2012, the Bank entered into a revised Consent Order with the FDIC and KDFI again agreeing to maintain a minimum Tier 1 leverage ratio of 9% and a minimum total risk based capital ratio of 12%. The Bank also agreed that if it should be unable to reach the required capital levels, and if directed in writing by the FDIC, then the Bank would within 30 days develop, adopt and implement a written plan to sell or merge itself into another federally insured financial institution or otherwise obtain a capital investment into the Bank sufficient to recapitalize the bank. We have not been directed by the FDIC to implement such a plan.

 

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We continue to work with our regulators toward capital ratio compliance. The revised Consent Order also requires the Bank to continue to adhere to the plans implemented in response to the June 2011 Consent Order, and includes the substantive provisions of the June 2011 Consent Order. As of December 31, 2014, the capital ratios required by the Consent Order were not met.

Bank and Holding Company Laws, Rules and Regulations. The following is a summary description of the relevant laws, rules and regulations governing banks and bank holding companies. The descriptions of, and references to, the statutes and regulations below are brief summaries and do not purport to be complete. The descriptions are qualified in their entirety by reference to the specific statutes and regulations discussed.

The Dodd-Frank Act. On July 21, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank Act”) was signed into law. The Dodd-Frank Act imposed new restrictions and an expanded framework of regulatory oversight for financial institutions, including depository institutions. Because the Dodd-Frank Act requires various federal agencies to adopt a broad range of regulations with significant discretion, certain of the details of the law and the effects it will have on the Company are not known at this time.

The Dodd-Frank Act represents a comprehensive overhaul of the financial services industry within the United States. There are a number of reform provisions that significantly impact the ways in which banks and bank holding companies, including us, do business. For example, the Dodd-Frank Act changed the assessment base for federal deposit insurance premiums by modifying the assessment base calculation to be based on a depository institution’s consolidated assets less tangible capital instead of deposits, and permanently increased the standard maximum amount of deposit insurance per customer to $250,000. The Dodd-Frank Act also imposed more stringent capital requirements on bank holding companies by, among other things, imposing leverage ratios on bank holding companies and prohibits new trust preferred security issuances from counting as Tier I capital. The Dodd-Frank Act also repealed the federal prohibition on the payment of interest on demand deposits, thereby permitting depository institutions to pay interest on business transaction and other accounts. The Act codified and expanded the Federal Reserve’s source of strength doctrine, which requires that all bank holding companies serve as a source of financial strength for its subsidiary banks. Other provisions of the Dodd-Frank Act include, but are not limited to: (i) the creation of a new financial consumer protection agency that is empowered to promulgate new consumer protection regulations and revise existing regulations in many areas of consumer protection; (ii) enhanced regulation of financial markets, including derivatives and securitization markets; (iii) reform related to the regulation of credit rating agencies; (iv) the elimination of certain trading activities by banks; and (v) new disclosure and other requirements relating to executive compensation and corporate governance.

Many provisions of the Dodd-Frank Act require interpretation and rule- making by federal agencies. The Company monitors all relevant sections of the Dodd-Frank Act to ensure continued compliance with laws and regulations. While the ultimate effect of the Dodd-Frank Act on the Company is not fully known, the law is likely to result in greater compliance costs and higher fees paid to regulators, along with possible restrictions on the Company’s operations.

Porter Bancorp. The Company is registered as a bank holding company under the Bank Holding Company Act of 1956, as amended, and is subject to supervision and regulation by the Board of Governors of the Federal Reserve System. As such, we must file with the Federal Reserve Board annual and quarterly reports and other information regarding our business operations and the business operations of our subsidiaries. We are also subject to examination by the Federal Reserve Board and to operational guidelines established by the Federal Reserve Board. We are subject to the Bank Holding Company Act and other federal laws on the types of activities in which we may engage, and to other supervisory requirements, including regulatory enforcement actions for violations of laws and regulations.

Acquisitions. A bank holding company must obtain Federal Reserve Board approval before acquiring, directly or indirectly, ownership or control of more than 5% of the voting stock or all or substantially all of the assets of a bank, merging or consolidating with any other bank holding company and before engaging, or acquiring a company that is not a bank but is engaged in certain non-banking activities. Federal law also prohibits a person or group of persons from acquiring “control” of a bank holding company without notifying the Federal Reserve Board in advance, and then only if the Federal Reserve Board does not object to the proposed transaction. The Federal Reserve Board has established a rebuttable presumptive standard that the acquisition of 10% or more of the voting stock of a bank holding company would constitute an acquisition of control of the bank holding company. In addition, any company is required to obtain the approval of the Federal Reserve Board before acquiring 25% (5% in the case of an acquirer that is a bank holding company) or more of any class of a bank holding company’s voting securities, or otherwise obtaining control or a “controlling influence” over a bank holding company.

Permissible Activities. A bank holding company is generally permitted under the Bank Holding Company Act to engage in or acquire direct or indirect control of more than 5% of the voting shares of any bank, bank holding company or company engaged in any activity that the Federal Reserve Board determines to be so closely related to banking as to be a proper incident to the business of banking.

 

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Under current federal law, a bank holding company may elect to become a financial holding company, which enables the holding company to conduct activities that are “financial in nature.” Activities that are “financial in nature” include securities underwriting, dealing and market making; sponsoring mutual funds and investment companies; insurance underwriting and agency; merchant banking activities; and activities that the Federal Reserve Board has determined to be closely related to banking. No regulatory approval will be required for a financial holding company to acquire a company, other than a bank or savings association, engaged in activities that are financial in nature or incidental to activities that are financial in nature, as determined by the Federal Reserve Board. We have not filed an election to become a financial holding company.

U.S. Treasury Capital Purchase Program. On November 21, 2008, pursuant to the UST’s Capital Purchase Program established under the Emergency Economic Stabilization Act of 2008, the Company issued and sold to the UST (i) 35,000 shares of Series A Preferred Stock with an aggregate liquidation preference of $35.0 million and (ii) a warrant to purchase 330,561 shares of the Company’s common stock, at an exercise price of $15.88 per share, subject to certain anti-dilution and other adjustments, for an aggregate purchase price of $35.0 million in cash. Both the number of shares subject to the warrant and price per share reflect adjustments for stock dividends distributed after issuance.

On December 4, 2014, the UST sold the Series A Preferred Stock in a public auction. Promptly thereafter, the Company acquired and retired the Series A Preferred Stock in a non-cash equity exchange transaction with the accredited investors who purchased the Series A Preferred Stock in the auction, which is described in greater detail above under “History.”

Capital Adequacy Requirements. The Federal Reserve Board has adopted a system using risk-based capital guidelines to evaluate the capital adequacy of bank holding companies. Under the guidelines, specific categories of assets are assigned different risk weights, based generally on the perceived credit risk of the asset. These risk weights are multiplied by corresponding asset balances to determine a “risk-weighted” asset base. The guidelines require a minimum total risk-based capital ratio of 8.0%. At least half of the total capital must be composed of common equity, retained earnings, senior perpetual preferred stock, qualifying perpetual preferred stock, and certain hybrid capital instruments, less certain intangible assets (“Tier 1 capital”). The remainder may consist of certain subordinated debt, certain hybrid capital instruments, qualifying preferred stock and a limited amount of the allowance for loan losses (“Tier 2 capital”). Total capital is the sum of Tier 1 and Tier 2 capital. To be considered well-capitalized under the risk-based capital guidelines, an institution must maintain a total capital to total risk-weighted assets ratio of at least 10% and a Tier 1 capital to total risk-weighted assets ratio of 6% or greater. We are under a Consent Order with our primary regulators as previously discussed, and therefore cannot be considered well-capitalized. Please see “Supervision and Regulation” above for our capital requirements.

In addition to the risk-based capital guidelines, the Federal Reserve Board uses a leverage ratio as an additional tool to evaluate the capital adequacy of bank holding companies. The leverage ratio is a company’s Tier 1 capital divided by its average total consolidated assets. Certain highly rated bank holding companies may maintain a minimum leverage ratio of 3.0%, but other bank holding companies may be required to maintain a leverage ratio of 4.0%.

The federal banking agencies’ risk-based and leverage ratios are minimum supervisory ratios generally applicable to banking organizations that meet certain specified criteria, assuming that they have the highest regulatory rating. Banking organizations not meeting these criteria are expected to operate with capital positions well above the minimum ratios. The federal bank regulatory agencies may set capital requirements for a particular banking organization that are higher than the minimum ratios when circumstances warrant. Federal Reserve Board guidelines also provide that banking organizations experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory levels, without significant reliance on intangible assets.

Changes to Capital Requirements Resulting from BASEL III. In July 2013, the Federal Reserve Board and the FDIC approved final rules that substantially amend the regulatory risk-based capital rules applicable to Bancorp and Bank. The final rules implement the regulatory capital reforms of the Basel Committee on Banking Supervision reflected in “Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems” (Basel III) and changes required by the Dodd-Frank Act. The final rules implementing the Basel III regulatory capital reforms became effective for the Company and Bank on January 1, 2015, and include new minimum risk-based capital and leverage ratios. These rules refine the definition of what constitutes “capital” for purposes of calculating those ratios, including the definitions of Tier 1 capital and Tier 2 capital.

The new minimum capital level requirements applicable to bank holding companies and banks subject to the rules are a new common equity Tier 1 capital ratio of 4.5%, a Tier 1 risk-based capital ratio of 6% (increased from 4%), a total risk-based capital ratio of 8% (unchanged from current rules), and a Tier 1 leverage ratio of 4% for all institutions.

The rules also establish a “capital conservation buffer” of 2.5%, to be phased in over three years, above the new regulatory minimum risk-based capital ratios, and the minimum ratios once the capital conservation buffer is fully phased in are a common equity Tier 1 risk-based capital ratio of 7.0%, a Tier 1 risk-based capital ratio of 8.5%, and a total risk-based capital ratio of 10.5%.

 

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The capital conservation buffer requirement is to be phased in beginning in January 2016 at 0.625% of risk-weighted assets and will increase each year until fully implemented in January 2019. An institution will be subject to limitations on paying dividends, engaging in share repurchases and paying discretionary bonuses if capital levels fall below minimum levels plus the buffer amounts. These limitations establish a maximum percentage of eligible retained income that could be utilized for such actions. Under these new rules, Tier 1 capital will generally consist of common stock (plus related surplus) and retained earnings, limited amounts of minority interest in the form of additional Tier 1 capital instruments, and non-cumulative preferred stock and related surplus, subject to certain eligibility standards, less goodwill and other specified intangible assets and other regulatory deductions. The definition of Tier 2 capital is generally unchanged for most banking organizations, subject to certain new eligibility criteria. Common equity Tier 1 capital will generally consist of common stock (plus related surplus) and retained earnings plus limited amounts of minority interest in the form of common stock, less goodwill and other specified intangible assets and other regulatory deductions. Proceeds of trust preferred securities are excluded from Tier 1 capital unless issued before 2010 by an institution with less than $15 billion of assets.

The final rules allow banks and their holding companies with less than $250 billion in assets a one-time opportunity to opt-out of a requirement to include unrealized gains and losses in accumulated other comprehensive income in their capital calculation. The Company and the Bank expect to opt-out of this requirement.

Dividends. Under Federal Reserve policy, bank holding companies should pay cash dividends on common stock only out of income available over the past year and only if prospective earnings retention is consistent with the organization’s expected future needs and financial condition. The policy provides that bank holding companies should not declare a level of cash dividends that undermines the bank holding company’s ability to serve as a source of strength to its banking subsidiaries.

The Company is a legal entity separate and distinct from the Bank. Historically, the majority of our revenue has been from dividends paid to us by the Bank. The Bank is subject to laws and regulations that limit the amount of dividends it can pay. If, in the opinion of a federal regulatory agency, an institution under its jurisdiction is engaged in or is about to engage in an unsafe or unsound practice, the agency may require, after notice and hearing, that the institution cease such practice. The federal banking agencies have indicated that paying dividends that deplete an institution’s capital base to an inadequate level would be an unsafe and unsound banking practice. Under the Federal Deposit Insurance Corporation Improvement Act (FDICIA), an insured institution may not pay any dividend if payment would cause it to become undercapitalized or if it already is undercapitalized. Moreover, the Federal Reserve and the FDIC have issued policy statements providing that bank holding companies and banks should generally pay dividends only out of current operating earnings. A bank holding company may still declare and pay a dividend if it does not have current operating earnings if the bank holding company expects profits for the entire year and the bank holding company obtains the prior consent of the Federal Reserve. The Company and the Bank must obtain the prior written consent of each of their primary regulators prior to declaring or paying any future dividends.

Under Kentucky law, dividends by Kentucky banks may be paid only from current or retained net profits. Before any dividend may be declared for any period (other than with respect to preferred stock), a bank must increase its capital surplus by at least 10% of the net profits of the bank for the period until the bank’s capital surplus equals the amount of its stated capital attributable to its common stock. Moreover, the KDFI must approve the declaration of dividends if the total dividends to be declared by a bank for any calendar year would exceed the bank’s total net profits for such year combined with its retained net profits for the preceding two years, less any required transfers to surplus or a fund for the retirement of preferred stock or debt. We are also subject to the Kentucky Business Corporation Act, which generally prohibits dividends to the extent they result in the insolvency of the corporation from a balance sheet perspective or in the corporation becoming unable to pay its debts as they come due. The Bank did not pay any dividends in 2014 or 2013.

With respect to the payment of dividends, Porter Bancorp’s issued and outstanding Series E and Series F Preferred Shares rank senior to its common shares and non-voting common shares.

Imposition of Liability for Undercapitalized Subsidiaries. Bank regulators are required to take “prompt corrective action” to resolve problems associated with insured depository institutions whose capital declines below certain levels. In the event an institution becomes “undercapitalized,” it must submit a capital restoration plan. The capital restoration plan will not be accepted by the regulators unless each company having control of the undercapitalized institution guarantees the subsidiary’s compliance with the capital restoration plan up to a certain specified amount. Any such guarantee from a depository institution’s holding company is entitled to a priority of payment in bankruptcy.

The aggregate liability of the holding company of an undercapitalized bank is limited to the lesser of 5% of the institution’s assets at the time it became undercapitalized or the amount necessary to cause the institution to be “adequately capitalized.” The bank regulators have greater power in situations where an institution becomes “significantly” or “critically” undercapitalized or fails to submit a capital restoration plan. For example, a bank holding company controlling such an institution can be required to obtain prior Federal Reserve Board approval of proposed dividends, or might be required to consent to a consolidation or to divest the troubled institution or other affiliates.

 

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Source of Financial Strength. Under Federal Reserve policy, a bank holding company is expected to act as a source of financial strength to, and to commit resources to support, its bank subsidiaries. This support may be required at times when, absent such a policy, the bank holding company may not be inclined to provide it. In addition, any capital loans by the bank holding company to its bank subsidiaries are subordinate in right of payment to deposits and to certain other indebtedness of the bank subsidiary. In the event of a bank holding company’s bankruptcy, any commitment by the bank holding company to a federal bank regulatory agency to maintain the capital of subsidiary banks will be assumed by the bankruptcy trustee and entitled to a priority of payment. The Federal Reserve’s “Source of Financial Strength” policy was codified in the Dodd-Frank Act.

PBI Bank. The Bank, a Kentucky chartered commercial bank, is subject to regular bank examinations and other supervision and regulation by both the FDIC and the KDFI. Kentucky’s banking statutes contain a “super-parity” provision that permits a well-rated Kentucky banking corporation to engage in any banking activity which could be engaged in by a national bank operating in any state; a state bank, a thrift or savings bank operating in any other state; or a federal chartered thrift or federal savings association meeting the qualified thrift lender test and operating in any state could engage, provided the Kentucky bank first obtains a legal opinion specifying the statutory or regulatory provisions that permit the activity.

Capital Requirements. Similar to the Federal Reserve Board’s requirements for bank holding companies, the FDIC has adopted risk-based capital requirements for assessing state non-member banks’ capital adequacy. The FDIC’s risk-based capital guidelines require that all banks maintain a minimum ratio of total capital to total risk-weighted assets of 8.0% and a minimum ratio of Tier 1 capital to total risk-weighted assets of 4.0%. To be well-capitalized, a bank must have a ratio of total capital to total risk-weighted assets of at least 10.0% and a ratio of Tier 1 capital to total risk-weighted assets of 6.0%.

The Bank has agreed with its primary regulators to maintain a ratio of total capital to total risk-weighted assets of at least 12.0% and a Tier 1 leverage ratio of 9%. As of December 31, 2014, the Bank’s ratio of total capital to total risk-weighted assets was 10.57% and its Tier I leverage ratio was 5.78%, both under the ratios required by the Consent Order.

The FDIC also requires a minimum leverage ratio of 3.0% of Tier 1 capital to total assets for the highest rated banks and an additional cushion of approximately 100-200 basis points for all other banks. The leverage ratio operates in tandem with the FDIC’s risk-based capital guidelines and places a limit on the amount of leverage a bank can undertake by requiring a minimum level of capital to total assets.

Prompt Corrective Action. Pursuant to the Federal Deposit Insurance Act (“FDIA”), the FDIC must take prompt corrective action to resolve the problems of undercapitalized institutions. FDIC regulations define the levels at which an insured institution would be considered “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized” and “critically undercapitalized.” A “well-capitalized” bank has a total risk-based capital ratio of 10.0% or higher; a Tier 1 risk- based capital ratio of 6.0% or higher; a leverage ratio of 5.0% or higher; and is not subject to any written agreement, order or directive requiring it to maintain a specific capital level for any capital measure. An “adequately capitalized” bank has a total risk-based capital ratio of 8.0% or higher; a Tier 1 risk-based capital ratio of 4.0% or higher; a leverage ratio of 4.0% or higher (3.0% or higher if the bank was rated a composite 1 in its most recent examination report and is not experiencing significant growth); and does not meet the criteria for a well-capitalized bank. A bank is “undercapitalized” if it fails to meet any one of the ratios required to be adequately capitalized. A depository institution may be deemed to be in a capitalization category that is lower than is indicated by its actual capital position if it receives an unsatisfactory examination rating. The degree of regulatory scrutiny increases and the permissible activities of a bank decrease, as the bank moves downward through the capital categories. Depending on a bank’s level of capital, the FDIC’s corrective powers include:

 

   

requiring a capital restoration plan;

 

   

placing limits on asset growth and restriction on activities;

 

   

requiring the bank to issue additional voting or other capital stock or to be acquired;

 

   

placing restrictions on transactions with affiliates;

 

   

restricting the interest rate the bank may pay on deposits;

 

   

ordering a new election of the bank’s board of directors;

 

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requiring that certain senior executive officers or directors be dismissed;

 

   

prohibiting the bank from accepting deposits from correspondent banks;

 

   

requiring the bank to divest certain subsidiaries;

 

   

prohibiting the payment of principal or interest on subordinated debt; and

 

   

ultimately, appointing a receiver for the bank.

If an institution is required to submit a capital restoration plan, the institution’s holding company must guarantee the subsidiary’s compliance with the capital restoration plan up to a certain specified amount. Any such guarantee from a depository institution’s holding company is entitled to a priority of payment in bankruptcy. The aggregate liability of the holding company of an undercapitalized bank is limited to the lesser of 5% of the institution’s assets at the time it became undercapitalized or the amount necessary to cause the institution to be “adequately capitalized.” The bank regulators have greater power in situations where an institution becomes “significantly” or “critically” undercapitalized or fails to submit a capital restoration plan. For example, a bank holding company controlling such an institution can be required to obtain prior Federal Reserve Board approval of proposed dividends, or might be required to consent to a consolidation or to divest the troubled institution or other affiliates.

Deposit Insurance Assessments. The deposits of the Bank are insured by the Deposit Insurance Fund (DIF) of the FDIC up to the limits set forth under applicable law and are subject to the deposit insurance premium assessments of the DIF. The FDIC imposes a risk-based deposit premium assessment system, which was amended pursuant to the Federal Deposit Insurance Reform Act of 2005 (the “Reform Act”). Under this system, as amended, the assessment rates for an insured depository institution vary according to the level of risk incurred in its activities. To arrive at an assessment rate for a banking institution, the FDIC places it in one of four risk categories determined by reference to its capital levels and supervisory ratings. The assessment rate schedule can change from time to time, at the discretion of the FDIC, subject to certain limits.

The Dodd-Frank Act imposed additional assessments and costs with respect to deposits. Under the Dodd-Frank Act, the FDIC is directed to impose deposit insurance assessments based on total assets rather than total deposits, as well as make permanent the increase of deposit insurance to $250,000. Effective April 1, 2011, the FDIC revised the deposit insurance assessment system to comply with Dodd-Frank and implemented a revised assessment rate process with the goal of differentiating insured depository institutions who pose greater risk to the DIF. The first assessments under the new rule were payable in the third quarter of 2011.

Safety and Soundness Standards. The FDIA requires the federal bank regulatory agencies to prescribe standards, by regulations or guidelines, relating to internal controls, information systems and internal audit systems, loan documentation, credit underwriting, interest rate risk exposure, asset growth, asset quality, earnings, stock valuation and compensation, fees and benefits, and such other operational and managerial standards as the agencies deem appropriate. Guidelines adopted by the federal bank regulatory agencies establish general standards relating to these matters. In general, the guidelines require, among other things, appropriate systems and practices to identify and manage the risk and exposures specified in the guidelines. The guidelines prohibit excessive compensation as an unsafe and unsound practice and describe compensation as excessive when the amounts paid are unreasonable or disproportionate to the services performed by an executive officer, employee, director or principal shareholder. In addition, the agencies adopted regulations that authorize, but do not require, an agency to order an institution that has been given notice by an agency that it is not satisfying any of such safety and soundness standards to submit a compliance plan. If, after being so notified, an institution fails to submit an acceptable compliance plan or fails in any material respect to implement an acceptable compliance plan, the agency must issue an order directing action to correct the deficiency and may issue an order directing other actions of the types to which an undercapitalized institution is subject under the “prompt corrective action” provisions of FDIA. See “Prompt Corrective Actions” above. If an institution fails to comply with such an order, the agency may seek to enforce such order in judicial proceedings and to impose civil money penalties.

Branching. Kentucky law permits Kentucky chartered banks to establish a banking office in any county in Kentucky. A Kentucky bank may also establish a banking office outside of Kentucky. Well capitalized Kentucky banks that have been in operation at least three years and satisfy certain criteria relating to, among other things, their composite and management ratings, may establish a banking office in Kentucky without the approval of the KDFI upon notice to the KDFI and any other state bank with its main office located in the county where the new banking office will be located. Branching by all other banks requires the approval of the KDFI, which must ascertain and determine that the public convenience and advantage will be served and promoted and that there is reasonable probability of the successful operation of the banking office. The transaction must also be approved by the FDIC, which considers a number of factors, including financial history, capital adequacy, earnings prospects, character of management, needs of the community and consistency with corporate powers.

 

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Section 613 of the Dodd—Frank Act effectively eliminated the interstate branching restrictions set forth in the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994. Banks located in any state may now de novo branch in any other state, including Kentucky. Such unlimited branching power will likely increase competition within the markets in which the Company and the Bank operate.

Insider Credit Transactions. The restrictions on loans to directors, executive officers, principal shareholders and their related interests (collectively referred to as “insiders”) contained in the Federal Reserve Act and Regulation O apply to all insured depository institutions and their subsidiaries. These restrictions include limits on loans to one borrower and conditions that must be met before such a loan can be made. There is also an aggregate limitation on all loans to insiders and their related interests, which may not exceed the institution’s total unimpaired capital and surplus.

Automated Overdraft Payment Regulation. The Federal Reserve and FDIC have enacted consumer protection regulations related to automated overdraft payment programs offered by financial institutions. In November 2009, the Federal Reserve amended its Regulation E to prohibit financial institutions from charging consumers fees for paying overdrafts on automated teller machine and one-time debit card transactions, unless a consumer consents, or opts in, to the overdraft service for those types of transactions. The Regulation E amendments also require financial institutions to provide consumers with a notice that explains the financial institution’s overdraft services, including the fees associated with the service and the consumer’s choices.

In November 2010, the FDIC supplemented the Regulation E amendments by requiring FDIC-supervised institutions to implement additional changes relating to automated overdraft payment programs by July 1, 2011. One material change required financial institutions to monitor overdraft payment programs for “excessive or chronic” customer use and to undertake “meaningful and effective” follow-up action with customers that overdraw their accounts more than six times during a rolling 12-month period. The new guidance also imposes daily limits on overdraft charges, requires institutions to review and modify check-clearing procedures, prominently distinguish account balances from available overdraft coverage amounts and requires increased board and management oversight regarding overdraft payment programs.

Consumer Protection Laws. We are subject to a number of federal and state laws designed to protect borrowers and promote lending to various sectors of the economy and population. These laws include, among others, the Equal Credit Opportunity Act, the Fair Credit Reporting Act, the Truth in Lending Act, the Home Mortgage Disclosure Act, and the Real Estate Settlement and Procedures Act, and state law counterparts.

Equal Credit Opportunity Act. This statute prohibits discrimination against an applicant in any credit transaction, whether for consumer or business purposes, on the basis of race, color, religion, national origin, sex, marital status, age (except in limited circumstances), receipt of income from public assistance programs or good faith exercise of any rights under the Consumer Credit Protection Act. Under the Fair Housing Act, it is unlawful for any lender to discriminate in its housing-related lending activities against any person because of race, color, religion, national origin, sex, handicap or familial status. Among other things, these laws prohibit a lender from denying or discouraging credit on a discriminatory basis, making excessively low appraisals of property based on racial considerations, or charging excessive rates or imposing more stringent loan terms or conditions on a discriminatory basis. In addition to private actions by aggrieved borrowers or applicants for actual and punitive damages, the U.S. Department of Justice and other regulatory agencies can take enforcement action seeking injunctive and other equitable relief or sanctions for alleged violations.

Fair Credit Reporting Act (“FCRA”). FCRA requires the Bank to adopt and implement a written identity theft prevention program, paying particular attention to several identified “red flag” events. The program must assess the validity of address change requests for card issuers and for users of consumer reports to verify the subject of a consumer report in the event of notice of an address discrepancy. FCRA gives consumers the ability to challenge banks with respect to credit reporting information provided by the bank. FCRA also prohibits banks from using certain information it may acquire from an affiliate to solicit the consumer for marketing purposes unless the consumer has been given notice and an opportunity to opt out of such solicitation for a period of five years.

Truth in Lending Act (“TILA”). TILA is designed to ensure that credit terms are disclosed in a meaningful way so that consumers may compare credit terms more readily and knowledgeably. As result of TILA, all creditors must use the same credit terminology and expressions of rates, and disclose the annual percentage rate, the finance charge, the amount financed, the total of payments and the payment schedule for each proposed loan. Violations of TILA may result in regulatory sanctions and in the imposition of both civil and, in the case of willful violations, criminal penalties. In certain circumstances, TILA also provides a consumer with a right of rescission, which if exercised within three business days would require the creditor to reimburse any amount paid by the consumer to the creditor or to a third party in connection with the loan, including finance charges, application fees, commitment fees, title search fees and appraisal fees. Consumers may also seek actual and punitive damages for violations of TILA.

 

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Home Mortgage Disclosure Act (“HMDA”). HMDA has grown out of public concern over credit shortages in certain urban neighborhoods. One purpose of HMDA is to provide public information that will help show whether financial institutions are serving the housing credit needs of the neighborhoods and communities in which they are located. HMDA also includes a “fair lending” aspect that requires the collection and disclosure of data about applicant and borrower characteristics, as a way of identifying possible discriminatory lending patterns and enforcing anti-discrimination statutes. HMDA requires institutions to report data regarding applications for loans for the purchase or improvement of single family and multi-family dwellings, as well as information concerning originations and purchases of such loans. Federal bank regulators rely, in part, upon data provided under HMDA to determine whether depository institutions engage in discriminatory lending practices. The appropriate federal banking agency, or in some cases the Department of Housing and Urban Development, enforces compliance with HMDA and implements its regulations. Administrative sanctions, including civil money penalties, may be imposed by supervisory agencies for violations of HMDA.

Real Estate Settlement Procedures Act (“RESPA”). RESPA requires lenders to provide borrowers with disclosures regarding the nature and cost of real estate settlements. RESPA also prohibits certain abusive practices, such as kickbacks, and places limitations on the amount of escrow accounts. Violations of RESPA may result in imposition of penalties, including: (1) civil liability equal to three times the amount of any charge paid for the settlement services or civil liability of up to $1,000 per claimant, depending on the violation; (2) awards of court costs and attorneys’ fees; and (3) fines of not more than $10,000 or imprisonment for not more than one year, or both.

Loans to One Borrower. Under current limits, loans and extensions of credit outstanding at one time to a single borrower and not fully secured generally may not exceed 15% of an institution’s unimpaired capital and unimpaired surplus. Loans and extensions of credit fully secured by certain readily marketable collateral may represent an additional 10% of unimpaired capital and unimpaired surplus.

Consumer Financial Protection Bureau (“CFPB”). The Dodd-Frank Act created a new, independent federal agency called the Consumer Financial Protection Bureau, which is granted broad rulemaking, supervisory and enforcement powers under various federal consumer financial protection laws. The CFPB has examination and primary enforcement authority with respect to depository institutions with $10 billion or more in assets. Smaller institutions will be subject to rules promulgated by the CFPB, but will continue to be examined and supervised by federal banking regulators for consumer compliance purposes. The CFPB has authority to prevent unfair, deceptive or abusive acts or practices in connection with the offering of consumer financial products. The Dodd-Frank Act authorizes the CFPB to establish certain minimum standards for the origination of residential mortgages including a determination of the borrower’s ability to repay. In addition, the Dodd-Frank Act allows borrowers to raise certain defenses to foreclosure if they receive any loan other than a “qualified mortgage” as defined by the CFPB.

The Dodd-Frank Act also permits states to adopt consumer protection laws and standards that are more stringent than those adopted at the federal level and, in certain circumstances, permits state attorneys general to enforce compliance with both the state and federal laws and regulations. Federal preemption of state consumer protection law requirements, traditionally an attribute of the federal savings association charter, has also been modified by the Dodd-Frank Act and now requires a case-by-case determination of preemption by the Office of the Comptroller of the Currency (“OCC”) and eliminates preemption for subsidiaries of a bank. Depending on the implementation of this revised federal preemption standard, the operations of the Bank could become subject to additional compliance burdens in the states in which it operates.

Volcker Rule. On December 10, 2013, the final Volcker Rule under the Dodd-Frank Act was approved and implemented by the FRB, the FDIC, the SEC, and the Commodity Futures Trading Commission. The Volcker Rule attempts to reduce risk and banking system instability by restricting U.S. banks from investing in or engaging in proprietary trading and speculation and imposing a strict framework to justify exemptions for underwriting, market-making and hedging activities. U.S. banks will be restricted from investing in funds with collateral comprised of less than 100% loans that are not registered with the SEC and from engaging in hedging activities that do not hedge a specific identified risk. We do not believe the Volcker Rule will have a significant effect on the Bank’s operations.

Privacy. Federal law currently contains extensive customer privacy protection provisions. Under these provisions, a financial institution must provide to its customers, at the inception of the customer relationship and annually thereafter, the institution’s policies and procedures regarding the handling of customers’ nonpublic personal financial information. These provisions also provide that, except for certain limited exceptions, an institution may not provide such personal information to unaffiliated third parties unless the institution discloses to the customer that such information may be so provided and the customer is given the opportunity to opt out of such disclosure. Federal law makes it a criminal offense, except in limited circumstances, to obtain or attempt to obtain customer information of a financial nature by fraudulent or deceptive means.

 

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Community Reinvestment Act. The Community Reinvestment Act (“CRA”) requires the FDIC to assess our record in meeting the credit needs of the communities we serve, including low- and moderate-income neighborhoods and persons. The FDIC’s assessment of our record is made available to the public. The assessment also is part of the Federal Reserve Board’s consideration of applications to acquire, merge or consolidate with another banking institution or its holding company, to establish a new banking office or to relocate an office.

Bank Secrecy Act. The Bank Secrecy Act of 1970 (“BSA”) was enacted to deter money laundering, establish regulatory reporting standards for currency transactions and improve detection and investigation of criminal, tax and other regulatory violations. BSA and subsequent laws and regulations require us to take steps to prevent the use of the Bank in the flow of illegal or illicit money, including, without limitation, ensuring effective management oversight, establishing sound policies and procedures, developing effective monitoring and reporting capabilities, ensuring adequate training and establishing a comprehensive internal audit of BSA compliance activities. In recent years, federal regulators have increased the attention paid to compliance with the provisions of BSA and related laws, with particular attention paid to “Know Your Customer” practices. Banks have been encouraged by regulators to enhance their identification procedures prior to accepting new customers in order to deter criminal elements from using the banking system to move and hide illegal and illicit activities.

USA Patriot Act. The USA Patriot Act of 2001 (the “Patriot Act”) contains anti-money laundering measures affecting insured depository institutions, broker-dealers and certain other financial institutions. The Patriot Act requires financial institutions to implement policies and procedures to combat money laundering and the financing of terrorism. This includes standards for verifying customer identification at account opening, as well as rules to promote cooperation among financial institutions, regulators and law enforcement entities in identifying parties that may be involved in terrorism or money laundering. It grants the Secretary of the Treasury broad authority to establish regulations and to impose requirements and restrictions on the operations of financial institutions. In addition, the Patriot Act requires the federal bank regulatory agencies to consider the effectiveness of a financial institution’s anti-money laundering activities when reviewing bank mergers and bank holding company acquisitions.

Effect on Economic Environment. The policies of regulatory authorities, including the monetary policy of the Federal Reserve Board, have a significant effect on the operating results of bank holding companies and their subsidiaries. Among the means available to the Federal Reserve Board to affect the money supply are open market operations in U.S. government securities, changes in the discount rate on member bank borrowings and changes in reserve requirements against member bank deposits. These means are used in varying combinations to influence overall growth and distribution of bank loans, investments and deposits. Their use may affect interest rates charged on loans or paid for deposits.

Federal Reserve Board monetary policies have materially affected the operating results of commercial banks in the past and are expected to continue to do so in the future. The nature of future monetary policies and the effect of such policies on our business and earnings and those of our subsidiaries cannot be predicted.

Recently Enacted and Future Legislation. Various laws, regulations and governmental programs affecting financial institutions and the financial industry are from time to time introduced in Congress or otherwise promulgated by regulatory agencies. Such measures may change the operating environment of Porter Bancorp and its subsidiaries in substantial and unpredictable ways. The nature and extent of future legislative, regulatory or other changes affecting financial institutions is unpredictable at this time.

We cannot predict what other legislation or economic policies of the various regulatory authorities might be enacted or adopted or what other regulations might be adopted or the effects thereof. Future legislation, policies and the effects thereof might have a significant influence on overall growth and distribution of loans, investments and deposits, as well as affect interest rates charged on loans or paid on time and savings deposits. Such legislation and policies have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future.

Available Information

We file periodic reports with the SEC including our annual report on Form 10-K, quarterly reports on Form 10-Q, current event reports on Form 8-K and proxy statements. The public may read and copy any materials we file with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an internet site that contains reports, proxy and information statements and other information regarding issuers that file electronically with the SEC at http://www.sec.gov. Our SEC reports filed are accessible at no cost on our web site at http://www.pbibank.com, under the Investors Relations section, once they are electronically filed with or furnished to the SEC. A shareholder may also request a copy of our Annual Report on Form 10-K free of charge upon written request to: Chief Financial Officer, Porter Bancorp, Inc., 2500 Eastpoint Parkway, Louisville, Kentucky 40223.

 

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Item 1A. Risk Factors

An investment in our common stock involves a number of risks. Realization of any of the risks described below could have a material adverse effect on our business, financial condition, results of operations, cash flow and/or future prospects.

We are subject to a Consent Order with the FDIC and the KDFI and a formal agreement with the Federal Reserve that restrict the conduct of our operations and may have a material adverse effect on our business.

Our good standing with bank regulatory agencies is of fundamental importance to the continuation of our businesses. In June 2011, the Bank agreed to a Consent Order with the FDIC and KDFI in which the Bank agreed, among other things, to improve asset quality, reduce loan concentrations, and maintain a minimum Tier 1 leverage ratio of 9% and a minimum total risk based capital ratio of 12%. The Consent Order was included in our Current Report on 8-K filed on June 30, 2011.

On September 21, 2011, we entered into a Written Agreement with the Federal Reserve Bank of St. Louis. Pursuant to the Agreement, we made formal commitments to, among other things, use our financial and management resources to serve as a source of strength for the Bank and to assist the Bank in addressing weaknesses identified by the FDIC and the KDFI, to pay no dividends without prior written approval, to pay no interest or principal on subordinated debentures or trust preferred securities without prior written approval, and to submit an acceptable plan to maintain sufficient capital.

In October 2012, the Bank entered into a revised Consent Order with the FDIC and KDFI again agreeing to maintain a minimum Tier 1 leverage ratio of 9% and a minimum total risk based capital ratio of 12%. The Bank also agreed that if it should be unable to reach the required capital levels, and if directed in writing by the FDIC, then the Bank would within 30 days develop, adopt and implement a written plan to sell or merge itself into another federally insured financial institution or otherwise immediately obtain a capital investment into the Bank sufficient to fully meet the capital requirements. The revised Consent Order also requires the Bank to continue to adhere to the plans implemented in response to the June 2011 Consent Order, and includes the substantive provisions of the June 2011 Consent Order. We did not meet the capital ratios required by the Consent Order as of December 31, 2014.

Bank regulatory agencies can exercise discretion when an institution does not meet minimum regulatory capital levels and the other terms of a consent order. The agencies may initiate changes in management, issue mandatory directives, impose monetary penalties or refrain from formal sanctions, depending on individual circumstances. Any action taken by bank regulatory agencies could damage our reputation and have a material adverse effect on our business. Compliance with the Consent Order also increases our operating expense, and adversely affects our financial performance.

We have made commitments to the banking regulators to raise additional capital. Our inability to increase our capital to the levels required by our bank regulatory agreements could have a material adverse effect on our business.

We incurred a net loss of $11.2 million and $1.6 million in 2014 and 2013, respectively. Losses, non-performing loan costs, expenses for other real estate owned (“OREO”), and asset impairments have reduced our capital below the levels we agreed to maintain with our banking regulators. While we believe we have recognized the probable losses in our portfolio, further credit deterioration could result in additional losses and a reduction in capital levels.

In its consent order with the FDIC and the KDFI, the Bank has agreed to maintain a ratio of total capital to total risk-weighted assets of at least 12.0% and a ratio of Tier 1 capital to average assets of 9.0%. As of December 31, 2014, the Bank’s ratio of total capital to total risk-weighted assets was 10.57% and its ratio of Tier 1 capital to average assets was 5.78%, both below the ratios required by the consent order.

We have agreed with the FDIC, the KDFI and the Federal Reserve Bank of St. Louis to restore our capital ratios to levels that comply with our regulatory agreements. We are evaluating various specific initiatives to increase our regulatory capital and reduce our non-performing assets. Strategic alternatives include divesting of branch offices, selling loans and raising capital by selling stock.

Our ability to raise additional capital will depend on, among other things, conditions in the capital markets at that time (which are outside of our control) and our financial performance, including the management of our revenue, expenses, levels of average assets, credit quality, levels of OREO, and contingent liability risks. We may not have access to capital on acceptable terms or at all. Our inability to raise additional capital on acceptable terms when needed could have a material adverse effect on our businesses, financial condition, and results of operations. In addition, if we are unable to comply with our regulatory capital requirements, it could result in more stringent enforcement actions by the bank regulatory agencies, which could damage our reputation and have a material adverse effect on our business.

 

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Regulatory restrictions have prevented us from paying interest on the junior subordinated debentures that relate to our trust preferred securities since the fourth quarter of 2011. If we cannot pay accrued and unpaid interest on these securities for more than twenty consecutive quarters, we will be in default.

Effective with the fourth quarter of 2011, we began deferring interest payments on the junior subordinated debentures relating to our trust preferred securities. Deferring interest payments on the junior subordinated debentures resulted in a deferral of distributions on our trust preferred securities.

If we defer distributions on our trust preferred securities for 20 consecutive quarters, we must pay all deferred distributions in full or we will be in default. Our deferral period expires in the third quarter of 2016. Deferred distributions on our trust preferred securities, which totaled $2.2 million as of December 31, 2014, are cumulative, and unpaid distributions accrue and compound on each subsequent payment date. If as a result of a default we become subject to any liquidation, dissolution or winding up, holders of the trust preferred securities will be entitled to receive the liquidation amounts to which they are entitled, including all accrued and unpaid distributions, before any distribution can be made to our shareholders. In addition, the holders of our Series E and Series F Preferred Shares will be entitled to receive liquidation distributions totaling more than $10.5 million before any distribution can be made to the holders of our common shares.

As a bank holding company, we depend on dividends and distributions paid by our banking subsidiary.

The Company is a legal entity separate and distinct from the Bank and our other subsidiaries. Our principal source of cash flow, from which we would fund any dividends paid to our shareholders, has historically been dividends the Company receives from the Bank. Regulations of the FDIC and the KDFI govern the ability of the Bank to pay dividends and other distributions to us, and regulations of the Federal Reserve govern our ability to pay dividends or make other distributions to our shareholders. In its consent order with the FDIC and the KDFI, the Bank agreed not to pay dividends to us without the prior consent of those regulators. During 2011, the Company contributed $13.1 million to the Bank. The contribution, which was made to strengthen the Bank’s capital in an effort to help it comply with its capital ratio requirements under the consent order, also substantially decreased the liquid assets of the Company. Liquid assets decreased from $20.3 million at December 31, 2010 to $1.9 million at December 31, 2014. Since the Bank is unlikely to be in a position to pay dividends to the Company for the foreseeable future, cash inflows for the Company are limited to earnings on investment securities, sales of investment securities, and interest on its deposits held at the Bank. These cash inflows, along with the liquid assets held at December 31, 2014, are needed to cover ongoing operating expenses of the Company, which are forecasted at approximately $1.0 million for 2015. See the “Supervision-Porter Bancorp-Dividends” section of Item 1. “Business” and the “Dividends” section of Item 5. “Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities” of this Annual Report on Form 10-K.

We are effectively precluded from paying any dividends for the forseeable future.

Our agreement with the holders of our trust preferred securities provides that we cannot pay dividends until we pay all deferred distributions in full and resume paying quarterly distributions. We have also agreed with the Federal Reserve to obtain its written consent prior to declaring or paying any future dividends. As a practical matter, we cannot pay dividends for the foreseeable future. In addition, the dividend preferences of our Series E and Series F Preferred Shares entitle our preferred shareholders to receive an annual, noncumulative 2% dividend before we can pay a dividend on our non-voting common shares and voting common shares.

Our holding company debt could make it difficult to raise capital.

At December 31, 2014, we had an aggregate obligation of $27.2 million relating to the principal and accrued unpaid interest on our four issues of junior subordinated debentures, which has resulted in a deferral of distributions on our trust preferred securities. Although we are permitted to defer payments on these securities for up to five years (and we commenced doing so in 2011), the deferred interest payments continue to accrue until paid in full.

Our holding company debt could make it difficult to recapitalize or enter into a business combination transaction because any investor or purchaser would effectively assume the outstanding liability on the debt in addition to the amount of funds such investors or purchaser would need to provide in order to recapitalize the Bank and the Company.

 

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We are defendants in various legal proceedings.

The Company and the Bank are involved in judicial proceedings and regulatory investigations concerning matters arising from our business activities. Although we believe we have a meritorious defense in all significant litigation pending against us, we cannot assure you as to the ultimate outcome. Litigation is subject to inherent uncertainties and unfavorable rulings could occur. We record contingent liabilities resulting from claims against us when a loss is assessed to be probable and the amount of the loss is reasonably estimable. Assessing probability of loss and estimating probable losses requires analysis of multiple factors, including in some cases judgments about the potential actions of third party claimants and courts. Recorded contingent liabilities are based on the best information available and actual losses in any future period are inherently uncertain. Accruals are not made in cases where liability is not probable or the amount cannot be reasonably estimated. We provide disclosure of matters where we believe liability is reasonably possible and which may be material to our consolidated financial statements. If we do not prevail, the ultimate outcome of litigation matter could have a material adverse effect on our financial condition, results of operations, or cash flows. For more information about ongoing legal proceedings, see “Note 24 – Contingencies” of the Notes to Consolidated Financial Statements.

The Bank previously has served as trustee for Employee Stock Ownership Plans (“ESOP”) which engaged in transactions that under review are the subject of litigation initiated by the Department of Labor (“DOL”), subjecting us to certain financial risks.

From 2007 until the first quarter of 2013, the Bank served as trustee for certain ESOPs that purchased the stock of companies from prior owners in purchase transactions. Stock purchase transactions by ESOPs are subject to regular and routine reviews by the DOL for compliance with ERISA. Failure to fulfill our fiduciary duties under ERISA with respect to any such plan would subject us to certain financial risks such as claims for damages as well as fines and penalties assessable under ERISA. The Bank is a defendant in legal proceedings initiated by the DOL with respect to two stock purchase transactions by ESOPs for which the Bank served as trustee. A ruling that the Bank failed to fulfill its fiduciary duties under ERISA with respect to an ESOP, including stock purchases by the ESOP, would subject us to certain financial risks, including claims for damages as well as fines and penalties assessable under ERISA. See “Note 24 – Contingencies” of the Notes to Consolidated Financial Statements.

Investigations into and heightened scrutiny of our operations could result in additional costs and damage our reputation.

The U.S. Attorney’s office for the Eastern District of Virginia is conducting an investigation concerning possible violations of federal laws, including, among other things, possible violations related to false bank entries, bank fraud and securities fraud. The investigation concerns allegations that Bank personnel engaged in practices intended to delay or avoid disclosure of the Bank’s asset quality at the time of and following the United States Treasury’s purchase of preferred stock from the Company in November 2008. We are cooperating with this investigation. Heightened scrutiny of the operations of the Company and the Bank by federal and state officials may subject us to governmental or regulatory inquiries, investigations, actions, penalties and fines, which could adversely affect our reputation and result in costs to us in excess of current reserves and management’s estimate of the aggregate range of possible loss for litigation matters.

Our business has been and may continue to be adversely affected by conditions in the financial markets and by economic conditions generally.

Ongoing weakness in business and economic conditions generally or specifically in our markets has had, and could continue to have one or more of the following adverse effects on our business:

 

   

A decrease in the demand for loans and other products and services offered by us;

   

A decrease in the value of collateral securing our loans;

   

An impairment of certain intangible assets, such as core deposit intangibles; and

   

An increase in the number of customers who become delinquent, file for protection under bankruptcy laws or default on their loans.

Adverse conditions in the general business environment have had an adverse effect on our business in the past. Although the general business environment has improved, we can give no assurance that such improvement can be sustained. In addition, the improvement of certain economic indicators, such as real estate asset values, rents, and unemployment, may vary between geographic markets and may continue to lag behind improvement in the overall economy. These economic indicators typically affect the real estate and financial services industries, in which we have a significant number of customers, more significantly than other economic sectors. Furthermore, we have a substantial lending business that depends upon the ability of borrowers to make debt service payments on loans. Should economic conditions worsen, our business, financial condition or results of operations could be adversely affected.

 

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A large percentage of our loans are collateralized by real estate, and prolonged weakness in the real estate market may result in losses and adversely affect our profitability.

Approximately 84.0% of our loan portfolio as of December 31, 2014, was comprised of commercial and residential loans collateralized by real estate. Adverse economic conditions could decrease demand for real estate and depress real estate values in our markets. Persistent weakness in the real estate market could significantly impair the value of our collateral and our ability to sell the collateral upon foreclosure. The real estate collateral in each case provides an alternate source of repayment in the event of default by the borrower and may deteriorate in value during the time the credit is extended. If real estate values decline further, it will become more likely that we would be required to increase our allowance for loan losses. If during a period of depressed real estate values, we are required to liquidate the collateral securing a loan to satisfy the debt or to increase our allowance for loan losses, it could materially reduce our profitability and adversely affect our financial condition.

We offer real estate construction and development loans, which carry a higher degree of risk than other real estate loans. Weakness in the residential construction and commercial development real estate markets has in the past increased the non-performing assets in our loan portfolio and our provision expense for losses on loans. These impacts have had, and could in the future have a material adverse effect on our capital, financial condition and results of operations.

Approximately 5.3% of our loan portfolio as of December 31, 2014 consisted of real estate construction and development loans, down from 6.1% at December 31, 2013 and 7.8% at December 2012. These loans generally carry a higher degree of risk than long-term financing of existing properties because repayment depends on the ultimate completion of the project and usually on the sale of the property. If we are forced to foreclose on a project prior to its completion, we may not be able to recover the entire unpaid portion of the loan or we may be required to fund additional money to complete the project, or hold the property for an indeterminate period of time. Any of these outcomes may result in losses and adversely affect our profitability and financial condition.

Residential construction and commercial development real estate activity in our markets were affected by challenging economic conditions following the financial crisis of 2008. Weakness in these sectors could lead to additional valuation adjustments to our loan portfolios and real estate owned as we continue to reassess the fair value of our non-performing assets, the loss severity of loans in default and the fair value of real estate owned. We also may realize additional losses in connection with our disposition of non-performing assets. A weak real estate market could further reduce demand for residential housing, which, in turn, could adversely affect real estate development and construction activities. Consequently, the longer challenging economic conditions persist, the more likely they are to adversely affect the ability of residential real estate development borrowers to repay these loans and the value of property used as collateral for such loans. These economic conditions and market factors have negatively affected some of our larger loans in the past, causing our total net-charge offs to increase and requiring us to significantly increase our allowance for loan losses. Any further increase in our non-performing assets and related increases in our provision expense for losses on loans could negatively affect our business and could have a material adverse effect on our capital, financial condition and results of operations.

Our decisions regarding credit risk may not be accurate, and our allowance for loan losses may not be sufficient to cover actual losses, which could adversely affect our business, financial condition and results of operations.

We maintain an allowance for loan losses at a level we believe is adequate to absorb probable incurred losses in our loan portfolio based on historical loan loss experience, economic and environmental factors, specific problem loans, value of underlying collateral and other relevant factors. If our assessment of these factors is ultimately inaccurate, the allowance may not be sufficient to cover actual future loan losses, which would adversely affect our operating results. Our estimates are subjective, and their accuracy depends on the outcome of future events. Changes in economic, operating, and other conditions that are generally beyond our control could cause actual loan losses to increase significantly. In addition, bank regulatory agencies, as an integral part of their supervisory functions, periodically review the adequacy of our allowance for loan losses. Regulatory agencies have from time to time required us to increase our provision for loan losses or to recognize additional loan charge-offs when their judgment has differed from ours. Any of these events could have a material negative impact on our operating results.

 

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Our levels of classified loans and non-performing assets may increase in the foreseeable future if economic conditions cause more borrowers to default. Further, the value of the collateral underlying a given loan, and the realizable value of such collateral in a foreclosure sale, may decline, making us less likely to realize a full recovery if a borrower defaults on a loan. Any additional increases in the level of our non-performing assets, loan charge-offs or provision for loan losses, or our inability to realize the estimated net value of underlying collateral in the event of a loan default, could negatively affect our business, financial condition, results of operations and the trading price of our securities.

If we experience greater credit losses than anticipated, our operating results may be adversely affected.

As a lender, we are exposed to the risk that our customers will be unable to repay their loans according to their terms and that any collateral securing the payment of their loans may not be sufficient to assure repayment. Credit losses are inherent in the business of making loans and could have a material adverse effect on our operating results. Our credit risk with respect to our real estate and construction loan portfolio will relate principally to the creditworthiness of borrowers and the value of the real estate serving as security for the repayment of loans. Our credit risk with respect to our commercial and consumer loan portfolio will relate principally to the general creditworthiness of businesses and individuals within our local markets.

We make various assumptions and judgments about the collectability of our loan portfolio and provide an allowance for estimated loss losses based on a number of factors. We believe that our allowance for loan losses is adequate. However, if our assumptions or judgments are wrong, our allowance for loan losses may not be sufficient to cover our actual loan losses. We may have to increase our allowance in the future in response to the request of one of our primary banking regulators, to adjust for changing conditions and assumptions, or as a result of any deterioration in the quality of our loan portfolio. The actual amount of future provisions for loan losses cannot be determined at this time and may vary from the amounts of past provisions.

We continue to hold and acquire a significant amount of OREO properties, which could increase operating expenses and result in future losses to the Company.

During recent years, we have acquired a significant amount of real estate as a result of foreclosure or by deed in lieu of foreclosure that is listed on our balance sheet as OREO. An increase in our OREO portfolio increases the expenses incurred to manage and dispose of these properties, which sometimes includes funding construction required to facilitate sale. We expect that our operating results in 2015 will continue to be adversely affected by expenses associated with OREO, including insurance and taxes, completion and repair costs, as well as by the funding costs associated with OREO assets.

Properties in our OREO portfolio are recorded at the lower of the recorded investment in the loans for which the properties previously served as collateral or “fair value,” which represents the estimated sales price of the properties on the date acquired less estimated selling costs. Generally, in determining “fair value” an orderly disposition of the property is assumed, except where a different disposition strategy is expected. Significant judgment is required in estimating the fair value of OREO, and the period of time within which such estimates can be considered current may change during periods of market volatility.

Any decreases in market prices of real estate in our market areas may lead to additional OREO write downs, with a corresponding expense in our statement of operations. We evaluate OREO property values periodically and write down the carrying value of the properties if and when the results of our analysis require it.

In response to market conditions and other economic factors, we may utilize alternative sale strategies other than orderly disposition as part of our OREO disposition strategy, such as bulk sales. In this event, as a result of the significant judgments required in estimating fair value and the variables involved in different methods of disposition, the net proceeds realized from such sales transactions could differ significantly from appraisals, comparable sales, and other estimates used to determine the fair value of our OREO properties. In addition, our disposition of OREO through alternative sales strategies could impact the fair value of comparable OREO properties remaining in our portfolio.

Our profitability depends significantly on local economic conditions.

Because most of our business activities are conducted in central Kentucky and most of our credit exposure is in that region, we are at risk from adverse economic or business developments affecting this area, including declining regional and local business and employment activity, a downturn in real estate values and agricultural activities and natural disasters. To the extent the central Kentucky economy weakens, the rates of delinquencies, foreclosures, bankruptcies and losses in our loan portfolio will likely increase. Moreover, the value of real estate or other collateral that secures our loans could be adversely affected by the economic downturn or a localized natural disaster. Events that adversely affect business activity and real estate values in Central Kentucky have had and may continue to have a negative impact on our business, financial condition, results of operations and future prospects.

 

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Our small to medium-sized business portfolio may have fewer resources to weather a downturn in the economy.

Our portfolio includes loans to small and medium-sized businesses and other commercial enterprises. Small and medium-sized businesses frequently have smaller market shares than their competitors, may be more vulnerable to economic downturns, often need substantial additional capital to expand or compete and may experience substantial variations in operating results, any of which may impair a borrower’s ability to repay a loan. In addition, the success of a small or medium-sized business often depends on the management talents and efforts of one or two persons or a small group of persons. The death, disability or resignation of one or more of these persons could have a material adverse impact on the business and its ability to repay our loan. A continued economic downturn may have a more pronounced negative impact on our target market, causing us to incur substantial credit losses that could materially harm our operating results.

Our profitability is vulnerable to fluctuations in interest rates.

Changes in interest rates could harm our financial condition or results of operations. Our results of operations depend substantially on net interest income, the difference between interest earned on interest-earning assets (such as investments and loans) and interest paid on interest-bearing liabilities (such as deposits and borrowings). Interest rates are highly sensitive to many factors, including governmental monetary policies and domestic or international economic or political conditions. Factors beyond our control, such as inflation, recession, unemployment and money supply may also affect interest rates. If, as a result of decreasing interest rates, our interest-earning assets mature or reprice more quickly than our interest-bearing liabilities in a given period, our net interest income may decrease. Likewise, our net interest income may decrease if interest-bearing liabilities mature or reprice more quickly than interest-earning assets in a given period as a result of increasing interest rates.

Fixed-rate loans increase our exposure to interest rate risk in a rising rate environment because interest-bearing liabilities would be subject to repricing before assets become subject to repricing. Adjustable-rate loans decrease the risk associated with changes in interest rates but involve other risks, such as the inability of borrowers to make higher payments in an increasing interest rate environment. At the same time, for secured loans, the marketability of the underlying collateral may be adversely affected by higher interest rates. In a declining interest rate environment, there may be an increase in prepayments on loans as the borrowers refinance their loans at lower interest rates, which could reduce net interest income and harm our results of operations.

If we cannot obtain adequate funding, we may not be able to meet the cash flow requirements of our depositors and borrowers, or meet the operating cash needs of the Company.

Our liquidity policies and limits are established by the Board of Directors of the Bank, with operating limits set by the Asset Liability Committee (“ALCO”), based upon analyses of the ratio of loans to deposits and the percentage of assets funded with non-core or wholesale funding. The ALCO regularly monitors the overall liquidity position of the Bank and the Company to ensure that various alternative strategies exist to meet unanticipated events that could affect liquidity. Liquidity is the ability to meet cash flow needs on a timely basis at a reasonable cost. If our liquidity policies and strategies do not work as well as intended, then we may be unable to make loans and to repay deposit liabilities as they become due or are demanded by customers. The ALCO follows established board approved policies and monitors guidelines to diversify our wholesale funding sources to avoid concentrations in any one-market source. Wholesale funding sources include Federal funds purchased, securities sold under repurchase agreements, and Federal Home Loan Bank (“FHLB”) advances that are collateralized with mortgage-related assets.

We maintain a portfolio of securities that can be used as a secondary source of liquidity. There are other available sources of liquidity, including additional collateralized borrowings such as FHLB advances, the issuance of debt securities, and the issuance of preferred or common shares in public or private transactions. If we were unable to access any of these funding sources when needed, we might not be able to meet the needs of our customers, which could adversely impact our financial condition, our results of operations, cash flows, and our level of regulatory-qualifying capital.

We may need to raise additional capital in the future by selling capital stock. Future sales or other dilution of our equity may adversely affect the market price of our common shares.

We are not restricted from issuing additional common shares, including securities that are convertible into or exchangeable for, or that represent the right to receive, common shares. The issuance of additional shares of common shares or the issuance of convertible securities would dilute the ownership interest of our existing common shareholders. The market price of our common shares could decline as a result of such an offering as well as other sales of a large block of shares of our common shares or similar securities in the market after such an offering, or the perception that such sales could occur.

Our common shares have traded from time-to-time at a price below our book value per share. Accordingly, a sale of common shares at or below our book value would be dilutive to current shareholders.

 

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We may not be able to realize the value of our tax losses and deductions.

Due to our losses, we have a net operating loss carry-forward of $32.1 million, credit carry-forwards of $900,000, and other net deferred tax assets of $17.6 million. In order to realize the benefit of these tax losses, credits and deductions, we will need to generate substantial taxable income in future periods. We established a 100% valuation allowance for all deferred tax assets in 2011. Should the Company issue a sufficient number of new shares to raise additional capital, a change in control could be triggered, as defined by Section 382 of the Internal Revenue Code, which could negatively impact or limit the ability to utilize our net operating loss carry-forwards, credit loss carry-forwards, and other net deferred tax assets.

Higher FDIC deposit insurance premiums and assessments could significantly increase our non-interest expense.

Our deposits are insured by the FDIC up to legal limits and, accordingly, we are subject to FDIC deposit insurance premiums and assessments. Pursuant to the Dodd-Frank Act, the FDIC amended its regulations regarding assessment for federal deposit insurance to base such assessments on the average total consolidated assets of the insured institution during the assessment period, less the average tangible equity of the institution during the assessment period. Prior to this change, we were assessed only on deposit balances. The FDIC adopted a rule implementing this change, as well as adopting a revised risk-based assessment calculation in February 2011. The FDIC has also proposed a rule tying assessment rates of FDIC-insured institutions to the institution’s employee compensation programs. The exact nature and cumulative effect of these recent changes are not yet known, but they are expected to increase the amount of premiums we must pay for FDIC insurance. Any such increase may adversely affect our business, financial condition or results of operations.

We face strong competition from other financial institutions and financial service companies, which could adversely affect our results of operations and financial condition.

We compete with other financial institutions in attracting deposits and making loans. Our competition in attracting deposits comes principally from other commercial banks, credit unions, savings and loan associations, securities brokerage firms, insurance companies, money market funds, and other mutual funds. Our competition in making loans comes principally from other commercial banks, credit unions, savings and loan associations, mortgage banking firms, and consumer finance companies. In addition, competition for business in the Louisville and Lexington metropolitan area has grown in recent years as changes in banking law have allowed several banks to enter the market by establishing new branches.

Competition in the banking industry may also limit our ability to attract and retain banking clients. We maintain smaller staffs of associates and have fewer financial and other resources than larger institutions with which we compete. Financial institutions that have far greater resources and greater efficiencies than we do may have several marketplace advantages resulting from their ability to:

 

   

offer higher interest rates on deposits and lower interest rates on loans than we can;

 

   

offer a broader range of services than we do;

 

   

maintain more branch locations than we do; and

 

   

mount extensive promotional and advertising campaigns.

In addition, banks and other financial institutions with larger capitalization and other financial intermediaries may not be subject to the same regulatory restrictions as we are and may have larger lending limits than we do. Some of our current commercial banking clients may seek alternative banking sources as they develop needs for credit facilities larger than we can accommodate. If we are unable to attract and retain customers, we may not be able to maintain growth and our results of operations and financial condition may otherwise be negatively impacted.

We depend on our senior management team, and the unexpected loss of one or more of our senior executives could impair our relationship with customers and adversely affect our business and financial results.

Our future success significantly depends on the continued services and performance of our key management personnel. Our future performance will depend on our ability to motivate and retain these and other key officers. The Dodd-Frank Act, and the policies of bank regulatory agencies have placed restrictions on our executive compensation practices. Such restrictions and standards may further impact our Company’s ability to compete for talent with other businesses and financial institutions that are not subject to the same limitations as we are. The loss of the services of members of our senior management or other key officers or our inability to attract additional qualified personnel as needed could materially harm our business.

 

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Our reported financial results depend on management’s selection of accounting methods and certain assumptions and estimates.

Our accounting policies and assumptions are fundamental to our reported financial condition and results of operations. Our management must exercise judgment in selecting and applying many of these accounting policies and methods so they comply with generally accepted accounting principles and reflect management’s judgment of the most appropriate manner in which to report our financial condition and results. In some cases, management must select the accounting policy or method to apply from two or more alternatives, any of which may be reasonable under the circumstances, yet may result in our reporting materially different results than would have been reported under a different alternative.

Certain accounting policies are critical to presenting our reported financial condition and results. They require management to make difficult, subjective or complex judgments about matters that are uncertain. Materially different amounts could be reported under different conditions or using different assumptions or estimates. These critical accounting policies include the allowance for loan losses, valuation of OREO, valuation of securities and valuation of deferred income taxes. Because of the uncertainty of estimates involved in these matters, we may be required, among other things, to significantly increase the allowance for credit losses, sustain credit losses that are significantly higher than the reserve provided, recognize significant impairment on our OREO, or permanently impair deferred tax assets.

While management continually monitors and improves our system of internal controls, data processing systems, and corporate wide processes and procedures, we may suffer losses from operational risk in the future.

Management maintains internal operational controls, and we have invested in technology to help us process large volumes of transactions. However, we may not be able to continue processing at the same or higher levels of transactions. If our systems of internal controls should fail to work as expected, if our systems were to be used in an unauthorized manner, or if employees were to subvert the system of internal controls, significant losses could occur.

We process large volumes of transactions on a daily basis and are exposed to numerous types of operational risk, which could cause us to incur substantial losses. Operational risk resulting from inadequate or failed internal processes, people, and systems includes the risk of fraud by employees or persons outside of our company, the execution of unauthorized transactions by employees, errors relating to transaction processing and systems, and breaches of the internal control system and compliance requirements. This risk of loss also includes potential legal actions that could arise as a result of the operational deficiency or as a result of noncompliance with applicable regulatory standards.

We establish and maintain systems of internal operational controls that provide management with timely and accurate information about our level of operational risk. While not foolproof, these systems have been designed to manage operational risk at appropriate, cost effective levels. We have also established procedures that are designed to ensure that policies relating to conduct, ethics and business practices are followed. Nevertheless, we experience loss from operational risk from time to time, including the effects of operational errors, and these losses may be substantial.

Our information systems may experience an interruption or security breach.

Failure in or breach of our operational or security systems or infrastructure, or those of our third party vendors and other service providers, including as a result of cyber attacks, could disrupt our businesses, result in the disclosure or misuse of confidential or proprietary information, damage our reputation, increase our costs and cause losses. As a large financial institution, we depend on our ability to process, record and monitor a large number of customer transactions on a continuous basis. As customer, public and regulatory expectations regarding operational and information security have increased, our operational systems and infrastructure must continue to be safeguarded and monitored for potential failures, disruptions, and breakdowns. Our business, financial, accounting, data processing systems or other operating systems and facilities may stop operating properly or become disabled or damaged as a result of a number of factors including events that are wholly or partially beyond our control. For example, there could be sudden increases in customer transaction volume, electrical or telecommunications outages, natural disasters such as earthquakes, tornadoes, and hurricanes; disease pandemics, events arising from local or larger scale political or social matters, including terrorist acts, and, as described below, cyber attacks. Although we have business continuity plans and other safeguards in place, our business operations may be adversely affected by significant and widespread disruption to our physical infrastructure or operating systems that support our businesses and customers.

 

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Information security risks for financial institutions have generally increased in recent years in part because of the proliferation of new technologies, the use of the Internet and telecommunications technologies to conduct financial transactions, and the increased sophistication and activities of organized crime, hackers, terrorists, activists, and other external parties. As noted above, our operations rely on the secure processing, transmission and storage of confidential information in our computer systems and networks. In addition, to access our products and services, our customers may use personal smartphones, tablet PC’s, and other mobile devices that are beyond our control systems. Although we believe we have robust information security procedures and controls, our technologies, systems, networks, and our customers’ devices may become the target of cyber attacks or information security breaches. These events could result in the unauthorized release, gathering, monitoring, misuse, loss or destruction of our customers’ confidential, proprietary and other information or that of our customers, or otherwise disrupt the business operations of ourselves, our customers or other third parties.

Third parties with which we do business or that facilitate our business activities, could also be sources of operational and information security risk to us, including from breakdowns or failures of their own systems or capacity constraints. Although to date we have not experienced any material losses relating to cyber attacks or other information security breaches, we can give no assurance that we will not suffer such losses in the future. Our risk and exposure to these matters remains heightened because of, among other things, the evolving nature of these threats and the prevalence of Internet and mobile banking. As cyber threats continue to evolve, we may be required to expend significant additional resources to continue to modify or enhance our protective measures or to investigate and remediate any information security vulnerabilities. Disruptions or failures in the physical infrastructure or operating systems that support our businesses and customers, or cyber attacks or security breaches of the networks, systems or devices that our customers use to access our products and services could result in customer attrition, regulatory fines, penalties or intervention, reputational damage, reimbursement or other compensation costs, and/or additional compliance costs, any of which could materially adversely affect our business, results of operations or financial condition.

We operate in a highly regulated environment and, as a result, are subject to extensive regulation and supervision that could adversely affect our financial performance and our ability to implement our growth and operating strategies.

We are subject to examination, supervision and comprehensive regulation by federal and state regulatory agencies, which is described under “Item 1 – Business—Supervision and Regulation.” Regulatory oversight of banks is primarily intended to protect depositors, the federal deposit insurance funds, and the banking system as a whole, not our shareholders. Compliance with these regulations is costly and may make it more difficult to operate profitably.

Federal and state banking laws and regulations govern numerous matters including the payment of dividends, the acquisition of other banks, and the establishment of new banking offices. We must also meet specific regulatory capital requirements. Our failure to comply with these laws, regulations, and policies or to maintain our capital requirements could affect our ability to pay dividends on common shares, our ability to grow through the development of new offices, our ability to make acquisitions, and our ability to remain independent. These limitations may prevent us from successfully implementing our growth and operating strategies.

In addition, the laws and regulations applicable to banks could change at any time, which could significantly impact our business and profitability. For example, new legislation or regulation could limit the manner in which we may conduct our business, including our ability to attract deposits and make loans. Events that may not have a direct impact on us, such as the bankruptcy or insolvency of a prominent U.S. corporation, can cause legislators and banking regulators and other agencies such as the Financial Accounting Standards Board, the SEC, the Public Company Accounting Oversight Board and various taxing authorities to respond by adopting and or proposing substantive revisions to laws, regulations, rules, standards, policies, and interpretations. The nature, extent, and timing of the adoption of significant new laws and regulations, or changes in or repeal of existing laws and regulations may have a material impact on our business and results of operations. Changes in regulation may cause us to devote substantial additional financial resources and management time to compliance, which may negatively affect our operating results.

Changes in banking laws could have a material adverse effect on us.

We are subject to changes in federal and state laws as well as changes in banking and credit regulations, and governmental economic and monetary policies. We cannot predict whether any of these changes could adversely and materially affect us. The current regulatory environment for financial institutions entails significant potential increases in compliance requirements and associated costs. Federal and state banking regulators also possess broad powers to take supervisory actions as they deem appropriate. These supervisory actions may result in higher capital requirements, higher insurance premiums and limitations on our activities that could have a material adverse effect on our business and profitability.

 

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Recent legislation regarding the financial services industry may have a significant adverse effect on our operations.

The Dodd-Frank Act was signed into law on July 21, 2010. The Dodd-Frank Act has had a significant impact the U.S. financial system, including among other things:

 

   

new requirements on banking, derivative and investment activities, including the repeal of the prohibition on the payment of interest on business demand accounts, and debit card interchange fee requirements;

 

   

the creation of the Consumer Financial Protection Bureau with supervisory authority, including the power to conduct examinations and take enforcement actions with respect to financial institutions with assets of $10 billion or more and implement regulations that will affect all financial institutions;

 

   

provisions affecting corporate governance and executive compensation of all companies subject to the reporting requirements of the Securities and Exchange Act of 1934, as amended; and

 

   

a provision that would require bank regulators to set minimum capital levels for bank holding companies that are as strong as those required for their insured depository subsidiaries, subject to a grandfather clause for holding companies with less than $15 billion in assets as of December 31, 2009.

Many provisions in the Dodd-Frank Act remain subject to regulatory rule-making, implementation, and interpretation, the effects of which are not yet known. As a result, it is difficult to gauge the ultimate impact of certain provisions of the Dodd-Frank Act because the implementation of many concepts is left to regulatory agencies. For example, the CFPB is given the power to adopt new regulations to protect consumers and is given control over existing consumer protection regulations adopted by federal banking regulators. The CFPB has begun the rule-making process but it is not known at this time when all rules will be finalized and implemented.

The provisions of the Dodd-Frank Act and any rules adopted to implement those provisions, as well as any additional legislative or regulatory changes may impact the profitability of our business activities and costs of operations, require that we change certain of our business practices, materially affect our business model or affect retention of key personnel, require us to raise additional regulatory capital, including additional Tier 1 capital, and could expose us to additional costs (including increased compliance costs). These and other changes may also require us to invest significant management attention and resources to make any necessary changes and may adversely affect our ability to conduct our business as previously conducted or our results of operations or financial condition.

 

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Item 1B. Unresolved Staff Comments

Not applicable.

 

Item 2. Properties

The Bank operates 17 banking offices located in Kentucky. The following table shows the location, square footage and ownership of each property. We believe that each of these locations is adequately insured. Support operations are located in the Main office in Louisville and the Glasgow office building on Columbia Avenue.

 

Markets

   Square Footage      Owned/
Leased
 

Louisville/Jefferson, Bullitt and Henry Counties

     

Main Office: 2500 Eastpoint Parkway, Louisville

     30,000         Owned   

Eminence Office: 645 Elm Street, Eminence

     1,500         Owned   

Hillview Office: 11998 Preston Highway, Hillview

     3,500         Owned   

Pleasureville Office: 5440 Castle Highway, Pleasureville

     10,000         Owned   

Shepherdsville Office: 340 South Buckman Street, Shepherdsville

     10,000         Owned   

Conestoga Office: 155 Conestoga Parkway, Shepherdsville

     3,900         Owned   

Lexington/Fayette County

     

Lexington Office: 2424 Harrodsburg Road, Suite 100, Lexington

     8,500         Leased   

South Central Kentucky

     

Brownsville Office: 113 East Main, Brownsville

     8,500         Owned   

Greensburg Office: 202-04 North Main Street, Greensburg

     11,000         Owned   

Horse Cave Office: 210 East Main Street, Horse Cave

     5,000         Owned   

Morgantown Office: 112 West Logan Street, Morgantown

     7,500         Owned   

Munfordville Office: 949 South Dixie Highway, Munfordville

     9,000         Owned   

Beaver Dam Office: 1300 North Main Street, Beaver Dam

     3,200         Owned   

Wal-Mart Office: 1701 North Main Street, Beaver Dam

     500         Leased   

Owensboro/Daviess County

     

Owensboro Office: 1819 Frederica Street, Owensboro

     3,000         Owned   

Southern Kentucky

     

Campbell Lane Office: 751 Campbell Lane, Bowling Green

     7,500         Owned   

Glasgow Office: 1006 West Main Street, Glasgow

     12,000         Owned   

Other Properties

     

Office Building: 701 Columbia Avenue, Glasgow

     19,000         Owned   

 

Item 3. Legal Proceedings

We are defendants in various legal proceedings. Litigation is subject to inherent uncertainties and unfavorable outcomes could occur. See Note 24, “Contingencies” in the Notes to our consolidated financial statements for detail regarding ongoing legal proceedings and other matters.

 

Item 4. Mine Safety Disclosures

Not applicable.

 

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PART II

 

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

Market Information

Our common shares are traded on the NASDAQ Capital Market under the ticker symbol “PBIB”. The following table presents the high and low sales prices for our common shares reported on the NASDAQ Capital Market for the periods indicated.

 

     2014  
     Market Value     

 

 
Quarter Ended    High      Low      Dividend  

Fourth Quarter

   $ 1.03       $ 0.48       $ 0.00   

Third Quarter

     1.08         0.95         0.00   

Second Quarter

     1.18         0.90         0.00   

First Quarter

     1.24         0.94         0.00   

 

     2013  
     Market Value     

 

 
Quarter Ended    High      Low      Dividend  

Fourth Quarter

   $ 1.24       $ 0.97       $ 0.00   

Third Quarter

     2.23         0.80         0.00   

Second Quarter

     0.90         0.79         0.00   

First Quarter

     1.59         0.66         0.00   

As of January 31, 2015, we had approximately 1,204 shareholders, including 360 shareholders of record and approximately 844 beneficial owners whose shares are held in “street” name by securities broker-dealers or other nominees.

 

LOGO

 

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Dividends

We will not be able to pay dividends on our common shares for the foreseeable future. We historically paid quarterly cash dividends on our common shares until we suspended dividend payments in October 2011. As a bank holding company, our ability to declare and pay dividends depends on certain federal regulatory considerations, including the guidelines of the Federal Reserve regarding capital adequacy and dividends. We have agreed with the Federal Reserve to obtain its written consent prior to declaring or paying any future dividends.

Our principal source of revenue with which to pay dividends on our common shares is the dividends that the Bank may declare and pay to us out of funds legally available for payment of dividends. Currently, the Bank must obtain the prior written consent of its primary regulators prior to declaring or paying any dividends. In addition to this current restriction, various laws applicable to the Bank also limit its payment of dividends to us. A Kentucky chartered bank may declare a dividend of an amount of the bank’s net profits as the board deems appropriate. The approval of the KDFI is required if the total of all dividends declared by the bank in any calendar year exceeds the total of its net profits for that year combined with its retained net profits for the preceding two years, less any required transfers to surplus or a fund for the retirement of preferred stock or debt. As a practical matter, the Bank will not be able to pay dividends to us for the foreseeable future.

Effective with the fourth quarter of 2011, we began deferring interest payments on the junior subordinated notes relating to our trust preferred securities. Deferring interest payments on the junior subordinated notes resulted in the deferral of distributions on our trust preferred securities. If we defer interest payments on our trust preferred securities for 20 consecutive quarters, we must pay all deferred interest or we will be in default.

We will not be able to pay cash dividends on our common shares until we have paid all deferred distributions on our trust preferred securities. Deferred distributions on our trust preferred securities are cumulative, and distributions accrue and compound on each subsequent payment date. If we become subject to any liquidation, dissolution or winding up of affairs, holders of the trust preferred securities and then holders of the preferred stock will be entitled to receive the liquidation amounts to which they are entitled including the amount of any accrued and unpaid distributions and dividends, before any distribution can be made to the holders of our common shares or preferred stock. Our Series E and Series F preferred shares have priority over our common shares and non-voting common shares with respect to any payment of dividends.

Purchase of Equity Securities by Issuer

Except for the exchange transaction in December 2014, described in greater detail in “Item 1 – Business – History”, the Company did not repurchase any of its issued and outstanding equity securities in 2014 or 2013.

 

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Item 6. Selected Financial Data

The following table summarizes our selected historical consolidated financial data from 2010 to 2014. You should read this information in conjunction with Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Item 8. “Financial Statements and Supplementary Data.”

Selected Consolidated Financial Data

 

     As of and for the Years Ended December 31,  

(Dollars in thousands except per share data)

   2014     2013     2012     2011     2010  

Income Statement Data:

          

Interest income

   $ 39,513      $ 43,228      $ 57,729      $ 73,554      $ 86,407   

Interest expense

     9,795        11,143        15,774        22,039        28,841   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net interest income

  29,718      32,085      41,955      51,515      57,566   

Provision for loan losses

  7,100      700      40,250      62,600      30,100   

Non-interest income

  4,079      5,919      9,590      7,833      11,582   

Non-interest expense

  39,435      38,890      44,292      104,273      46,478   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Loss before income taxes

  (12,738   (1,586   (32,997   (107,525   (7,430

Income tax benefit

  (1,583   —        (65   (218   (3,046
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net loss

  (11,155   (1,586   (32,932   (107,307   (4,384

Less:

Dividends and accretion on preferred stock

  2,362      2,079      1,929      1,927      1,987   

Effect of exchange of preferred stock for common stock

  (36,104   —        —        —        —     

Earnings (loss) allocated to participating securities

  3,159      (267   (1,429   (4,080   (184
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income (loss) attributable to common

$ 19,428    $ (3,398 $ (33,432 $ (105,154 $ (6,187
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Common Share Data (1):

Basic earnings (loss) per common share

$ 1.59    $ (0.29 $ (2.85 $ (8.98 $ (0.60

Diluted earnings (loss) per common share

  1.59      (0.29   (2.85   (8.98   (0.60

Cash dividends declared per common share

  0.00      0.00      0.00      0.02      0.49   

Book value per common share (2)

  1.67      (0.18   0.74      3.74      12.76   

Tangible book value per common share (2)

  1.61      (0.29   0.58      3.54      10.33   

Balance Sheet Data (at period end):

Total assets

$ 1,017,989    $ 1,076,121    $ 1,162,631    $ 1,455,424    $ 1,723,952   

Debt obligations:

FHLB advances

  15,752      4,492      5,604      7,116      15,022   

Junior subordinated debentures

  25,000      25,000      25,000      25,000      25,000   

Subordinated capital note

  4,950      5,850      6,975      7,650      8,550   

Average Balance Data:

Average assets

$ 1,049,232    $ 1,098,400    $ 1,341,565    $ 1,659,959    $ 1,747,648   

Average loans

  662,442      788,176      1,033,320      1,243,474      1,353,295   

Average deposits

  961,671      1,004,052      1,217,083      1,434,462      1,459,041   

Average FHLB advances

  4,473      4,990      6,325      15,315      47,800   

Average junior subordinated debentures

  25,000      25,000      25,000      25,000      25,000   

Average subordinated capital note

  5,508      6,404      7,309      8,208      8,941   

Average stockholders’ equity

  33,881      42,631      75,679      159,434      188,015   

 

(1)

Common share data has been adjusted to reflect a 5% stock dividend effective December 14, 2010.

(2)

After shareholder approval on February 25, 2015, the mandatorily convertible Series B preferred shares converted into 4,053,600 common shares and the mandatorily convertible Series D preferred shares converted into 6,458,000 non-voting common shares. Assuming conversion as of December 31, 2014, the proforma book value per common share would have been $1.21 per share and the proforma tangible book value per common share would have been $1.17 per share.

 

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

Management’s discussion and analysis of financial condition and results of operations analyzes the consolidated financial condition and results of operations of Porter Bancorp, Inc. (the “Company”) and its wholly owned subsidiary, PBI Bank (the “Bank”). The Company is a Louisville, Kentucky-based bank holding company which operates banking offices in twelve counties through its wholly-owned subsidiary, the Bank. Our markets include metropolitan Louisville in Jefferson County and the surrounding counties of Henry and Bullitt. We serve south central Kentucky and southern Kentucky from banking offices in Butler, Green, Hart, Edmonson, Barren, Warren, Ohio, and Daviess Counties. We also have an office in Lexington, the second largest city in Kentucky. The Bank is a community bank with a wide range of commercial and personal banking products.

Historically, we have focused on commercial and commercial real estate lending, both in markets where we have banking offices and other growing markets in our region. Commercial, commercial real estate and real estate construction loans accounted for 55.5% of our total loan portfolio as of December 31, 2014, and 56.3% as of December 31, 2013. Commercial lending generally produces higher yields than residential lending, but involves greater risk and requires more rigorous underwriting standards and credit quality monitoring.

The following discussion should be read in conjunction with our consolidated financial statements and accompanying notes and other schedules presented elsewhere in the report.

Overview

For the year ended December 31, 2014, we reported a net loss of $11.2 million compared with net loss of $1.6 million for the year ended December 31, 2013 and $32.9 million for the year ended December 31, 2012. After deductions for dividends and accretion on preferred stock, allocating losses to participating securities, and the effect of the exchange of preferred stock for common stock, net income attributable to common shareholders was $19.4 million for the year ended December 31, 2014, compared with a net loss attributable to common shareholders of $3.4 million for the year ended December 31, 2013. Basic and diluted income per common share were $1.59 for the year ended December 31, 2014, compared with loss per common share of $(0.29) for 2013.

Our financial performance in 2014 continued to be negatively impacted by the Bank’s high level of non-performing assets. Asset quality remediation, capital restoration, and lowering the risk profile of the Company remain our major objectives for 2015.

Non-performing loans were 7.57% of total loans and non-performing assets were 9.19% of total assets, at December 31, 2014. We remain diligent in the management of our loan portfolio and are striving to improve credit quality by working throughout our markets to balance selective new customer acquisition, customer service for our existing clients and prudent risk management.

The following significant items are of note for the year ended December 31, 2014:

 

   

In December 2014, we completed a non-cash equity exchange transaction with the accredited investors who acquired all of our issued and outstanding Series A preferred shares from UST in a public auction. We acquired and cancelled all of the issued and outstanding Series A Preferred Stock, the accrued dividends thereon, all of the issued and outstanding Series C Preferred Stock, and warrants to purchase 798,915 shares of common stock together having an aggregate book value of approximately $45.7 million. In exchange, we issued common and preferred shares having a fair value of approximately $9.6 million. The effect of the exchange was to increase common shareholders’ equity by approximately $36.1 million.

 

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In the exchange transaction, we issued 1,821,428 common shares, 40,536 mandatorily convertible Series B Preferred Shares and 64,580 mandatorily convertible Series D Preferred Shares, which automatically converted into 4,053,600 common shares and 6,458,000 non-voting common shares after shareholder approval on February 25, 2015. We also issued 6,198 Series E Preferred Shares and 4,304 Series F Preferred Shares, both of which series are not convertible into common shares, have a liquidation preference of $1,000 per share, and are entitled to a 2% noncumulative annual dividend if and when declared. Series E and Series F Preferred Shares rank senior to, and have liquidation and dividend preferences over, our common shares and non-voting common shares.

 

   

The net effect of the exchange transaction and subsequent conversion of mandatorily convertible Series B Preferred and mandatorily convertible Series D Preferred shares was an increase in total shareholders’ equity of $7.4 million, and an increase in voting and non-voting common shares issued and outstanding of 12,333,028 shares.

 

   

We have reduced the size of our balance sheet in accordance with our capital plan. Average assets were $1.049 billion for the year ended December 31, 2014, compared with $1.098 billion for the year ended December 31, 2013. This reduction was accomplished primarily by reducing our commercial real estate and construction and development loans within our loan portfolio and through the redemption of higher cost certificates of deposit accounts.

 

   

Net interest margin decreased one basis point to 3.09% for the year ended December 31, 2014, compared with 3.10% for the year ended December 31, 2013. Average loans decreased 16.0% to $662.4 million in 2014, compared with $788.2 million in 2013. Net loans decreased 11.1% to $605.6 million at December 31, 2014, compared with $681.2 million at December 31, 2013.

 

   

Provision for loan losses expense increased to $7.1 million for 2014, compared with $700,000 for the year ended December 31, 2013. Net charge-offs were $15.9 million in 2014, compared with $29.3 million in 2013 and $36.1 million in 2012.

 

   

We continued to execute on our strategy to reduce our exposure to commercial real estate and construction and development loans. Construction and development loans totaled $33.2 million, or 45% of total risk-based capital, at December 31, 2014, compared with $43.3 million, or 52% of total risk-based capital, at December 31, 2013. Non-owner occupied commercial real estate loans, construction and development loans, and multi-family residential real estate loans as a group totaled $193.0 million, or 262% of total risk-based capital, at December 31, 2014 compared with $237.0 million, or 284% of total risk-based capital, at December 31, 2013.

 

   

Loan proceeds received from the repayment of our commercial real estate and construction and development loans were used primarily to redeem maturing certificates of deposit during 2014. Deposits decreased 6.2% to $926.8 million compared with $987.7 million at December 31, 2013. Certificate of deposit balances declined $105.3 million during 2014 to $574.7 million at December 31, 2014, from $680.0 million at December 31, 2013.

 

   

Total loans past due and nonaccrual loans decreased to $52.3 million at December 31, 2014 from $113.5 million at December 31, 2013.

 

   

Non-performing loans decreased $54.7 million to $47.3 million at December 31, 2014, compared with $102.0 million at December 31, 2013. The decrease in non-performing loans was due to the migration of non-performing loans to the OREO portfolio, as well as $27.5 million in paydowns. Net charge-offs were $15.9 million for the year ended December 31, 2014.

 

   

Loans past due 30-59 days decreased from $10.7 million at December 31, 2013 to $4.0 million at December 31, 2014 and loans past due 60-89 days increased from $775,000 at December 31, 2013 to $980,000 at December 31, 2014.

 

   

Foreclosed properties increased to $46.2 million at December 31, 2014, compared with $30.9 million at December 31, 2013. During the year ended December 31, 2014, the Company acquired $32.3 million and sold $13.1 million of OREO. In addition, we recorded fair value write-downs of $4.3 million during the year reflecting declines in appraisal valuations and changes in pricing strategies. Our ratio of non-performing assets to total assets decreased to 9.19% at December 31, 2014, compared with 12.35% at December 31, 2013.

These items are discussed in further detail throughout this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” Section.

 

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Going Concern Considerations and Future Plans

Our consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business for the foreseeable future. However, the events and circumstances described in this discussion create substantial doubt about the Company’s ability to continue as a going concern.

For the year ended December 31, 2014, we reported a net loss of $11.2 million. The net loss was primarily attributable to loan loss provision of $7.1 million, OREO expense of $5.8 million resulting from fair value write-downs driven by new appraisals and reduced marketing prices, and ongoing operating expense, along with $3.0 million in loan collection expenses. We also had lower net interest margin due to lower average loans outstanding, loans re-pricing at lower rates, and the level of non-performing loans in our portfolio. After deductions for dividends and accretion on preferred stock of $2.4 million, allocating losses to participating securities of $3.2 million, and the effect of the exchange of preferred stock for common stock of $36.1 million, net income attributable to common shareholders was $19.4 million for the year ended December 31, 2014, compared with a net loss attributable to common shareholders of $3.4 million for the year ended December 31, 2013.

For the year ended December 31, 2013, we reported net loss attributable to common shareholders of $3.4 million. This loss was attributable primarily to loan collection expenses of $4.7 million and OREO expense of $4.5 million resulting from fair value write-downs driven by new appraisals and reduced marketing prices, net loss on sales, and ongoing operating expenses. We also had lower net interest margin due to lower average loans outstanding, loans re-pricing at lower rates, and the level of non-performing loans in our portfolio. Net loss to common shareholders of $3.4 million for the year ended December 31, 2013, compares with net loss to common shareholders of $33.4 million for year ended December 31, 2012.

In June 2011, the Bank entered into a Consent Order with the FDIC and KDFI in which the Bank agreed, among other things, to improve asset quality, reduce loan concentrations, and maintain a minimum Tier 1 leverage ratio of 9% and a minimum total risk based capital ratio of 12%. The Consent Order was included in our Current Report on 8-K filed on June 30, 2011. In October 2012, the Bank entered into a revised Consent Order with the FDIC and KDFI, again agreeing to maintain a minimum Tier 1 leverage ratio of 9% and a minimum total risk based capital ratio of 12%. The Bank also agreed that if it should be unable to reach the required capital levels, and if directed in writing by the FDIC, then the Bank would within 30 days develop, adopt and implement a written plan to sell or merge itself into another federally insured financial institution or otherwise immediately obtain a capital investment into the Bank sufficient to fully meet the capital requirements.

We continue to work with our regulators toward capital ratio compliance. The revised Consent Order also requires the Bank to continue to adhere to the plans implemented in response to the June 2011 Consent Order, and includes the substantive provisions of the June 2011 Consent Order. The revised Consent Order was included in our Current Report on 8-K filed on September 19, 2012. As of December 31, 2014, the capital ratios required by the Consent Order were not met.

In order to meet these capital requirements, the Board of Directors and management are continuing to evaluate strategies to achieve the following objectives:

 

   

Increasing capital through a possible public offering or private placement of common stock to new and existing shareholders. We have engaged a financial advisor to assist our Board in this evaluation.

 

   

Continuing to operate the Company and Bank in a safe and sound manner. This strategy will require us to reduce our lending concentrations, remediate non-performing loans, and reduce other noninterest expense through the disposition of OREO.

 

   

Evaluating and implementing improvements to our internal processes and procedures, distribution of labor, and work-flow to ensure we have adequately and appropriately deployed resources in an efficient manner in the current environment.

 

   

Executing on our commitment to improve credit quality and reduce loan concentrations and balance sheet risk.

 

   

We have reduced our loan portfolio significantly from $1.3 billion at December 31, 2010 to $625.0 million at December 31, 2014.

 

   

We have reduced our construction and development loans to less than 75% of total risk-based capital at December 31, 2014, and have now been in compliance with the Consent Order for eleven quarters.

 

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We have reduced our non-owner occupied commercial real estate loans, construction and development loans, and multi-family residential real estate loans. Compliance with our Consent Order requires those loans represent less than 250% of total risk-based capital. These loans represented 262% of total risk-based capital at December 31, 2014, down from 284% at December 31, 2013.

 

   

Executing on our commitment to sell OREO and reinvest in quality income producing assets.

 

   

Our acquisition of real estate assets through the loan remediation process increased during 2014, as we acquired $32.3 million of OREO in 2014 compared with $20.6 million during 2013. This coincides with the reduction of nonaccrual loans from $101.8 million at the end of 2013, to $47.2 million at the end of 2014, as many of these loans were resolved by foreclosure.

 

   

We incurred OREO losses totaling $3.9 million during the 2014, comprised of $4.3 million in fair value write-downs to reflect declines in appraisal valuations and changes in our pricing strategies, offset by $306,000 in net gain on sales.

 

   

We continually evaluate opportunities to maximize the value we receive from the sale of OREO. We pursue multiple sales channels with focus primarily on internal marketing and the use of brokers.

 

   

Real estate construction represents 40% of the OREO portfolio at December 31, 2014 compared with 62% at December 31, 2013. Commercial real estate represents 31% of the OREO portfolio at December 31, 2014 compared with 19% at December 31, 2013, and 1-4 family residential properties represent 17% of the portfolio at December 31, 2014 compared with 16% at December 31, 2013.

Bank regulatory agencies can exercise discretion when an institution does not meet the terms of a consent order. Based on individual circumstances, the agencies may issue mandatory directives, impose monetary penalties, initiate changes in management, or take more serious adverse actions such as require an institution to sell or merge itself into another institution or require the Bank to be taken into receivership.

Liquid assets were $1.9 million at December 31, 2014. Since the Bank is unlikely to be in a position to pay dividends to the parent company for the foreseeable future, cash inflows for the parent are limited to earnings on investment securities, sales of investment securities, and interest on deposits with the Bank. These cash inflows along with the liquid assets held at December 31, 2014, are needed to cover ongoing operating expenses of the parent company which are forecasted at approximately $1.0 million for 2015. Parent company liquidity could be improved through a sale of common or preferred shares.

Effective with the fourth quarter of 2011, we began deferring interest payments on the junior subordinated debentures relating to our trust preferred securities. Deferring interest payments on the junior subordinated debentures resulted in a deferral of distributions on our trust preferred securities.

If we defer distributions on our trust preferred securities for 20 consecutive quarters, we must pay all deferred distributions in full or we will be in default. Our deferral period expires in the third quarter of 2016. Deferred distributions on our trust preferred securities, which totaled $2.2 million as of December 31, 2014, are cumulative, and unpaid distributions accrue and compound on each subsequent payment date. If as a result of a default we become subject to any liquidation, dissolution or winding up, holders of the trust preferred securities will be entitled to receive the liquidation amounts to which they are entitled, including all accrued and unpaid distributions, before any distribution can be made to our shareholders. In addition, the holders of our Series E and Series F Preferred Shares will be entitled to receive liquidation distributions totaling $10.5 million before any distribution can be made to the holders of our common shares.

Our consolidated financial statements do not include any adjustments that may result should the Company be unable to continue as a going concern.

Application of Critical Accounting Policies

Our accounting and reporting policies comply with GAAP and conform to general practices within the banking industry. We believe that of our significant accounting policies, the following may involve a higher degree of management assumptions and judgments that could result in materially different amounts to be reported if conditions or underlying circumstances were to change.

Allowance for Loan Losses – The Bank maintains an allowance for loan losses believed to be sufficient to absorb probable incurred credit losses existing in the loan portfolio. The Board of Directors evaluates the adequacy of the allowance for loan losses on a quarterly basis. We evaluate the adequacy of the allowance using, among other things, historical loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of the underlying collateral and current economic conditions and trends. The allowance may be allocated for specific loans or loan categories, but the entire allowance is available for any loan that, in management’s judgment, should be charged off. The allowance consists of specific and general components. The specific component relates to loans that are individually evaluated and measured for impairment. The general component is based on historical loss experience adjusted for qualitative environmental factors. We develop allowance estimates based on actual loss experience adjusted for current economic conditions and trends. Allowance estimates are a prudent measurement of the risk in the loan portfolio which we apply to individual loans based on loan type. If the mix and amount of future charge-off percentages differ significantly from those assumptions used by management in making its determination, we may be required to materially increase our allowance for loan losses and provision for loan losses, which could adversely affect our results.

 

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Other Real Estate Owned – OREO is real estate acquired as a result of foreclosure or by deed in lieu of foreclosure. It is classified as real estate owned until such time as it is sold. When property is acquired as a result of foreclosure or by deed in lieu of foreclosure, it is recorded at its fair market value less estimated cost to sell. Any write-down of the property at the time of acquisition is charged to the allowance for loan losses. Subsequent reductions in fair value are recorded as non-interest expense. To determine the fair value of OREO for smaller dollar single family homes, we consult with internal real estate sales staff and external realtors, investors, and appraisers. If the internally evaluated market price is below our underlying investment in the property, appropriate write-downs are recorded. For larger dollar residential and commercial real estate properties, we obtain a new appraisal of the subject property or have staff from our special assets group or in our centralized appraisal department evaluate the latest in-file appraisal in connection with the transfer to OREO. We typically obtain updated appraisals within five quarters or the anniversary date of ownership unless a sale is imminent.

Intangible Assets – We evaluate intangible assets for impairment at least annually and more frequently if circumstances indicate their value may not be recoverable. Identifiable intangible assets that are subject to amortization are amortized on an accelerated basis over the years expected to be benefited, which we believe is 10 years. We review these amortizable intangible assets for impairment if circumstances indicate their value may not be recoverable based on a comparison of fair value to carrying value. Based on our annual review, management does not believe our intangible assets are impaired at December 31, 2014.

Stock-based Compensation – Compensation cost is recognized for restricted stock awards issued to employees, based on the fair value of these awards at the date of grant. The market price of the Company’s common shares at the date of grant is used for restricted stock awards. Compensation cost is recognized over the required service period, generally defined as the vesting period. For awards with graded vesting, compensation cost is recognized on a straight-line basis over the requisite service period for the entire award.

Valuation of Deferred Tax Asset – We evaluate deferred tax assets for impairment on a quarterly basis. We established a 100% deferred tax valuation allowance of $31.7 million in December 2011 based upon the analysis of our past performance and our expected future performance. When evaluating our deferred tax assets for realizability during 2014 and 2013, we concluded that a full valuation allowance was still necessary at December 31, 2014 and 2013, due to the additional losses incurred during those years. A return to profitability would enable us to reduce the valuation allowance and thereby offset income tax expense that would otherwise be recognized. Examinations of our income tax returns or changes in tax law may impact our deferred tax assets and liabilities as well as our provision for income taxes.

Contingencies – We are defendants in various legal proceedings. We record contingent liabilities resulting from claims against us when a loss is assessed to be probable and the amount of the loss is reasonably estimable. Assessing probability of loss and estimating probable losses requires analysis of multiple factors, including in some cases judgments about the potential actions of third party claimants and courts. Recorded contingent liabilities are based on the best information available and actual losses in any future period are inherently uncertain.

Results of Operations

The following table summarizes components of income and expense and the change in those components for 2014 compared with 2013:

 

     For the Years Ended
December 31,
     Change from
Prior Period
 
     2014      2013      Amount      Percent  
     (dollars in thousands)  

Gross interest income

   $ 39,513       $ 43,228       $ (3,715      (8.6 )% 

Gross interest expense

     9,795         11,143         (1,348      (12.1

Net interest income

     29,718         32,085         (2,367      (7.4

Provision for credit losses

     7,100         700         6,400         914.3   

Non-interest income

     3,987         5,196         (1,209      (23.3

Gains on sale of securities, net

     92         723         (631      (87.3

Non-interest expense

     39,435         38,890         545         1.4   

Net loss before taxes

     (12,738      (1,586      (11,152      703.2   

Income tax benefit

     (1,583      —           (1,583      —     

Net loss

     (11,155      (1,586      (9,569      603.3   

Dividends and accretion on preferred stock

     (2,362      (2,079      (283      13.6   

Effect of exchange of preferred stock for common stock

     36,104         —           36,104         100.0   

Losses (earnings) attributable to participating securities

     (3,159      267         (3,426      (1283.1

Net income (loss) attributable to common shareholders

     19,428         (3,398      22,826         (671.7

 

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Net loss of $11.2 million for the year ended December 31, 2014 increased by $9.6 million from net loss of $1.6 million for 2013. This was primarily due to a $2.4 million decrease in net interest income driven by lower average earning assets, an increase of $6.4 million in provision for loan losses expense, and reductions in non-interest income from our exit of trust services in 2013 and lower gains on the sale of securities. Net income attributable to common shareholders of $19.4 million for the year ended December 31, 2014, improved $22.8 million from net loss to common shareholders of $3.4 million for 2013. This increase was primarily attributable to the $36.1 million effect of the exchange of preferred stock for common stock.

The following table summarizes components of income and expense and the change in those components for 2013 compared with 2012:

 

     For the Years Ended
December 31,
     Change from
Prior Period
 
     2013      2012      Amount      Percent  
     (dollars in thousands)  

Gross interest income

   $ 43,228       $ 57,729       $ (14,501      (25.1 )% 

Gross interest expense

     11,143         15,774         (4,631      (29.4

Net interest income

     32,085         41,955         (9,870      (23.5

Provision for credit losses

     700         40,250         (39,550      (98.3

Non-interest income

     5,196         6,354         (1,158      (18.2

Gains on sale of securities, net

     723         3,236         (2,513      (77.7

Non-interest expense

     38,890         44,292         (5,402      (12.2

Net loss before taxes

     (1,586      (32,997      31,411         (95.2

Income tax benefit

     —           (65      65         (100.0

Net loss

     (1,586      (32,932      31,346         (95.2

Dividends on and accretion on preferred stock

     (2,079      (1,929      (150      7.8   

Losses attributable to participating securities

     267         1,429         (1,162      (81.3

Net loss attributable to common shareholders

     (3,398      (33,432      30,034         (89.8

Net loss before taxes of $1.6 million for the year ended December 31, 2013, improved by $31.4 million from net loss of $33.0 million for 2012. Net loss to common shareholders of $3.4 million for the year ended December 31, 2013, decreased $30.0 million from net loss to common shareholders of $33.4 million for 2012. This decrease in net loss was attributable primarily to lower provision for loan losses expense and decreased non-interest expense associated with our OREO, partially offset by lower net gain on sales of securities and lower net interest income.

Net Interest Income – Our net interest income was $29.7 million for the year ended December 31, 2014, a decrease of $2.4 million, or 7.4%, compared with $32.1 million for the same period in 2013. Net interest spread and margin were 2.98% and 3.09%, respectively, for 2014, compared with 2.97% and 3.10%, respectively, for 2013. Average nonaccrual loans were $63.1 million and $107.3 million in 2014 and 2013, respectively. The decrease in net interest income was primarily the result of lower average earning assets coupled with lower rates on those assets. In addition, net interest income and net interest margin were adversely affected by $3.3 million and $5.6 million of interest lost on nonaccrual loans during 2014 and 2013, respectively.

Our average interest-earning assets were $979.2 million for 2014, compared with $1.05 billion for 2013, a 6.8% decrease, primarily attributable to lower average loans and partially offset by higher average investment securities and interest bearing deposits with financial institutions. Average loans were $662.4 million for 2014, compared with $788.2 million for 2013, a 16.0% decrease. Average interest bearing deposits with financial institutions were $87.0 million in 2014, compared with $65.1 million in 2013, a 33.7% increase. Average investment securities were $220.5 million for 2014, compared with $184.2 million for 2013, a 19.7% increase. Our total interest income decreased 8.6% to $39.5 million for 2014, compared with $43.2 million for 2013.

Our average interest-bearing liabilities decreased by 5.5% to $885.8 million for 2014, compared with $937.4 million for 2013. Our total interest expense decreased by 12.1% to $9.8 million for 2014, compared with $11.1 million during 2013, due primarily to lower interest rates paid on and lower volume of certificates of deposit. Our average volume of certificates of deposit decreased 10.2% to $632.0 million for 2014, compared with $704.0 million for 2013. The average interest rate paid on certificates of deposit decreased to 1.29% for 2014, compared with 1.35% for 2013, as the result of continued re-pricing of certificates of deposit at maturity to lower interest rates. Our average volume of NOW and money market deposit accounts increased 16.1% to $179.7 million for 2014, compared with $154.8 million for 2013. The average interest rate paid on NOW and money market deposit accounts increased to 0.36% for 2014, compared with 0.35% for 2013.

 

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Our net interest income was $32.1 million for the year ended December 31, 2013, a decrease of $9.9 million, or 23.5%, compared with $42.0 million for the same period in 2012. Net interest spread and margin were 2.97% and 3.10%, respectively, for 2013, compared with 3.16% and 3.31%, respectively, for 2012. Average nonaccrual loans were $107.3 million and $90.8 million in 2013 and 2012, respectively. The decrease in net interest income was primarily the result of lower average earning assets. In addition, net interest income and net interest margin were adversely affected by $5.6 million and $4.9 million of interest lost on nonaccrual loans during 2013 and 2012, respectively.

Our average interest-earning assets were $1.05 billion for 2013, compared with $1.28 billion for 2012, an 18.1% decrease, primarily attributable to lower average loans and partially offset by higher average investment securities and interest bearing deposits with financial institutions. Average loans were $788.2 million for 2013, compared with $1.03 billion for 2012, a 23.7% decrease. Average interest bearing deposits with financial institutions were $65.1 million in 2013, compared with $62.1 million in 2012, a 4.7% increase. Average investment securities were $184.2 million for 2013, compared with $173.1 million for 2012, a 6.4% increase. Our total interest income decreased 25.1% to $43.2 million for 2013, compared with $57.7 million for 2012. The change was due primarily to lower interest rates on loans, lower volume of loans and lower interest rates on investment securities.

Our average interest-bearing liabilities decreased by 18.1% to $937.4 million for 2013, compared with $1.14 billion for 2012. Our total interest expense decreased by 29.4% to $11.1 million for 2013, compared with $15.8 million during 2011, due primarily to lower interest rates paid on and lower volume of certificates of deposit, NOW and money market deposits. Our average volume of certificates of deposit decreased 22.8% to $704.0 million for 2013, compared with $912.1 million for 2012. The average interest rate paid on certificates of deposit decreased to 1.35% for 2013, compared with 1.52% for 2012, as the result of continued re-pricing of certificates of deposit at maturity to lower interest rates. Our average volume of NOW and money market deposit accounts increased 1.1% to $154.8 million for 2013, compared with $153.0 million for 2012. The average interest rate paid on NOW and money market deposit accounts decreased to 0.35% for 2013, compared with 0.42% for 2012.

 

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Average Balance Sheets

The following table sets forth the average daily balances, the interest earned or paid on such amounts, and the weighted average yield on interest-earning assets and weighted average cost of interest-bearing liabilities for the periods indicated. Dividing income or expense by the average daily balance of assets or liabilities, respectively, derives such yields and costs for the periods presented.

 

     For the Years Ended December 31,  
     2014     2013  
     Average
Balance
    Interest
Earned/
Paid
     Average
Yield/
Cost
    Average
Balance
    Interest
Earned/
Paid
     Average
Yield/
Cost
 
     (dollars in thousands)  

ASSETS

       

Interest-earning assets:

       

Loans receivables (1)(2)

       

Real estate

   $ 562,829      $ 27,654         4.91   $ 696,785      $ 32,591         4.68

Commercial

     60,419        3,002         4.97        50,990        2,772         5.44   

Consumer

     12,786        1,087         8.50        16,982        1,402         8.26   

Agriculture

     25,806        1,321         5.12        22,639        1,229         5.43   

Other

     602        26         4.32        780        21         2.69   

U.S. Treasury and agencies

     32,459        755         2.33        23,685        546         2.31   

Mortgage-backed securities

     114,103        2,780         2.44        83,160        1,552         1.87   

State and political subdivision securities (3)

     30,428        936         4.73        30,292        933         4.74   

State and political subdivision securities

     24,873        757         3.04        24,861        787         3.17   

Corporate bonds

     18,041        607         3.36        20,864        745         3.57   

FHLB stock

     7,760        337         4.34        10,072        421         4.18   

Other debt securities

     572        46         8.04        572        46         8.04   

Other equity securities

     21        —           —          744        30         4.03   

Federal funds sold

     1,502        2         0.13        2,640        3         0.11   

Interest-bearing deposits in other financial institutions

     86,986        203         0.23        65,076        150         0.23   
  

 

 

   

 

 

      

 

 

   

 

 

    

Total interest-earning assets

  979,187      39,513      4.09   1,050,142      43,228      4.16 %

Less: Allowance for loan losses

  (25,390 )   (40,343 )

Non-interest-earning assets

  95,435      88,601   
  

 

 

        

 

 

      

Total assets

$ 1,049,232    $ 1,098,400   
  

 

 

        

 

 

      

LIABILITIES AND STOCKHOLDERS’ EQUITY

Interest-bearing liabilities

Certificates of deposit and other time deposits

$ 632,020    $ 8,125      1.29 $ 703,982    $ 9,482      1.35 %

NOW and money market deposits

  179,698      653      0.36      154,759      541      0.35   

Savings accounts

  36,803      89      0.24      39,158      114      0.29   

Federal funds purchased and repurchase agreements

  2,255      3      0.13      3,113      6      0.19   

FHLB advances

  4,473      124      2.77      4,990      157      3.15   

Junior subordinated debentures

  30,508      801      2.63      31,404      843      2.68   
  

 

 

   

 

 

      

 

 

   

 

 

    

Total interest-bearing liabilities

  885,757      9,795      1.11   937,406      11,143      1.19 %

Non-interest-bearing liabilities

Non-interest-bearing deposits

  113,150      106,153   

Other liabilities

  16,444      12,210   
  

 

 

        

 

 

      

Total liabilities

  1,015,351      1,055,769   

Stockholders’ equity

  33,881      42,631   
  

 

 

        

 

 

      

Total liabilities and stockholders’ equity

$ 1,049,232    $ 1,098,400   
  

 

 

        

 

 

      

Net interest income

$ 29,718    $ 32,085   
    

 

 

        

 

 

    

Net interest spread

  2.98   2.97 %
       

 

 

        

 

 

 

Net interest margin

  3.09   3.10 %
       

 

 

        

 

 

 

Ratio of average interest-earning assets to average interest-bearing liabilities

  110.55   112.03 %
       

 

 

        

 

 

 

 

(1)

Includes loan fees in both interest income and the calculation of yield on loans.

(2)

Calculations include non-accruing loans of $63.1 million and $107.3 million in average loan amounts outstanding.

(3)

Taxable equivalent yields are calculated assuming a 35% federal income tax rate.

 

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Table of Contents
     For the Years Ended December 31,  
     2013     2012  
     Average
Balance
    Interest
Earned/
Paid
     Average
Yield/
Cost
    Average
Balance
    Interest
Earned/
Paid
     Average
Yield/
Cost
 
     (dollars in thousands)  

ASSETS

       

Interest-earning assets:

       

Loans receivables (1)(2)

       

Real estate

   $ 696,785      $ 32,591         4.68   $ 921,314      $ 46,179         5.01

Commercial

     50,990        2,772         5.44        64,252        3,510         5.46   

Consumer

     16,982        1,402         8.26        22,720        1,903         8.38   

Agriculture

     22,639        1,229         5.43        24,196        1,304         5.39   

Other

     780        21         2.69        838        22         2.63   

U.S. Treasury and agencies

     23,685        546         2.31        6,588        199         3.02   

Mortgage-backed securities

     83,160        1,552         1.87        111,637        1,986         1.78   

State and political subdivision securities (3)

     30,292        933         4.74        26,631        887         5.12   

State and political subdivision securities

     24,861        787         3.17        17,363        563         3.24   

Corporate bonds

     20,864        745         3.57        8,957        482         5.38   

FHLB stock

     10,072        421         4.18        10,072        447         4.44   

Other debt securities

     572        46         8.04        572        46         8.04   

Other equity securities

     744        30         4.03        1,359        57         4.19   

Federal funds sold

     2,640        3         0.11        3,109        2         0.06   

Interest-bearing deposits in other financial institutions

     65,076        150         0.23        62,127        142         0.23   
  

 

 

   

 

 

      

 

 

   

 

 

    

Total interest-earning assets

  1,050,142      43,228      4.16   1,281,735      57,729      4.54 %

Less: Allowance for loan losses

  (40,343 )   (53,484 )

Non-interest-earning assets

  88,601      113,314   
  

 

 

        

 

 

      

Total assets

$ 1,098,400    $ 1,341,565   
  

 

 

        

 

 

      

LIABILITIES AND STOCKHOLDERS’ EQUITY

Interest-bearing liabilities

Certificates of deposit and other time deposits

$ 703,982    $ 9,482      1.35 $ 912,061    $ 13,828      1.52 %

NOW and money market deposits

  154,759      541      0.35      153,032      641      0.42   

Savings accounts

  39,158      114      0.29      38,665      154      0.40   

Federal funds purchased and repurchase agreements

  3,113      6      0.19      2,088      7      0.34   

FHLB advances

  4,990      157      3.15      6,325      207      3.27   

Junior subordinated debentures

  31,404      843      2.68      32,309      937      2.90   
  

 

 

   

 

 

      

 

 

   

 

 

    

Total interest-bearing liabilities

  937,406      11,143      1.19   1,144,480      15,774      1.38 %

Non-interest-bearing liabilities

Non-interest-bearing deposits

  106,153      113,325   

Other liabilities

  12,210      8,081   
  

 

 

        

 

 

      

Total liabilities

  1,055,769      1,265,886   

Stockholders’ equity

  42,631      75,679   
  

 

 

        

 

 

      

Total liabilities and stockholders’ equity

$ 1,098,400    $ 1,341,565   
  

 

 

        

 

 

      

Net interest income

$ 32,085    $ 41,955   
    

 

 

        

 

 

    

Net interest spread

  2.97   3.16 %
       

 

 

        

 

 

 

Net interest margin

  3.10   3.31 %
       

 

 

        

 

 

 

Ratio of average interest-earning assets to average interest-bearing liabilities

  112.03   111.99 %
       

 

 

        

 

 

 

 

(1)

Includes loan fees in both interest income and the calculation of yield on loans.

(2)

Calculations include non-accruing loans of $107.3 million and $90.8 million in average loan amounts outstanding.

(3)

Taxable equivalent yields are calculated assuming a 35% federal income tax rate.

 

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Rate/Volume Analysis

The table below sets forth information regarding changes in interest income and interest expense for the periods indicated. For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to (1) changes in rate (changes in rate multiplied by old volume); (2) changes in volume (changes in volume multiplied by old rate); and (3) changes in rate-volume (change in rate multiplied by change in volume). Changes in rate-volume are proportionately allocated between rate and volume variance.

 

     Year Ended December 31, 2014 vs. 2013      Year Ended December 31, 2013 vs. 2012  
     Increase (decrease)
due to change in
     Increase (decrease)
due to change in
 
     Rate      Volume      Net Change      Rate      Volume      Net Change  
     (in thousands)  

Interest-earning assets:

                 

Loan receivables

   $ 1,316       $ (6,241    $ (4,925    $ (2,935    $ (11,967    $ (14,902

U.S. Treasury and agencies

     5         204         209         (35      382         347   

Mortgage-backed securities

     554         674         1,228         93         (528      (435

State and political subdivision securities

     (32      5         (27      (81      351         270   

Corporate bonds

     (41      (97      (138      (206      469         263   

FHLB stock

     16         (100      (84      (26      —           (26

Other equity securities

     (15 )      (15      (30      (2      (25      (27

Federal funds sold

     0         (1      (1      1         —           1   

Interest-bearing deposits in other financial institutions

     1         52         53         1         7         8   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total increase (decrease) in interest income

  1,804      (5,519   (3,715   (3,190   (11,311   (14,501
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Interest-bearing liabilities:

Certificates of deposit and other time deposits

  (418   (939   (1,357   (1,427   (2,919   (4,346

NOW and money market accounts

  22      90      112      (107   7      (100

Savings accounts

  (18   (7   (25   (42   2      (40

Federal funds purchased and repurchase agreements

  (1   (2   (3   (3   2      (1

FHLB advances

  (18   (15   (33   (8   (42   (50

Junior subordinated debentures

  (18   (24   (42   (69   (25   (94
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total increase (decrease) in interest expense

  (451 )   (897   (1,348   (1,656   (2,975   (4,631
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Increase (decrease) in net interest income

$ 2,255    $ (4,622 $ (2,367 $ (1,534 $ (8,336 $ (9,870
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Non-interest Income – The following table presents for the periods indicated the major categories of non-interest income:

 

     For the Years Ended
December 31,
 
     2014      2013      2012  
     (in thousands)  

Service charges on deposit accounts

   $ 1,988       $ 2,058       $ 2,239   

Income from fiduciary activities

     —           517         1,177   

Bank card interchange fees

     765         718         727   

Other real estate owned rental income

     256         399         420   

Net gain on sales of securities

     92         723         3,236   

Income from bank owned life insurance

     276         534         312   

Other

     702         970         1,479   
  

 

 

    

 

 

    

 

 

 

Total non-interest income

$ 4,079    $ 5,919    $ 9,590   
  

 

 

    

 

 

    

 

 

 

Non-interest income decreased by $1.8 million to $4.1 million for 2014 compared with $5.9 million for 2013. This was due primarily to decreased gain on sales of investment securities of $631,000, or 87.3%, due to lower volume of sales. This decrease was also caused by a reduction in income from fiduciary activities as we transitioned away from providing trust services, including ESOP and employee benefit plan services throughout our markets in 2013.

 

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Non-interest income decreased by $3.7 million to $5.9 million for 2013 compared with $9.6 million for 2012. This was due primarily to decreased gain on sales of investment securities of $2.5 million, or 77.7%, due to lower volume of sales. This decrease was also caused by a reduction in income from fiduciary activities as we transitioned away from providing trust services, including ESOP and employee benefit plan services throughout our markets. This decrease was offset partially by an increase in income from bank owned life insurance, which increased by 71.2% from 2012.

Non-interest Expense – The following table presents the major categories of non-interest expense:

 

     For the Years Ended
December 31,
 
     2014      2013      2012  
     (in thousands)  

Salary and employee benefits

   $ 15,658       $ 15,501       $ 16,648   

Other real estate owned expense

     5,839         4,516         10,549   

Occupancy and equipment

     3,497         3,583         3,642   

Loan collection expense

     2,994         4,707         2,442   

Professional fees

     2,771         1,892         1,985   

FDIC insurance

     2,272         2,378         2,835   

State franchise tax

     1,445         1,944         2,174   

Data processing expense

     1,106         184         96   

Communications

     752         711         710   

Postage and delivery

     407         423         454   

Insurance expense

     575         648         373   

Advertising

     563         308         154   

Other

     1,556         2,095         2,230   
  

 

 

    

 

 

    

 

 

 

Total non-interest expense

$ 39,435    $ 38,890    $ 44,292   
  

 

 

    

 

 

    

 

 

 

Non-interest expense for the year ended December 31, 2014 of $39.4 million represented a 1.4% increase from $38.9 million for the same period last year. The increase in non-interest expense was attributable primarily to increases in OREO expenses, professional fees and data processing expenses, offset by decreases in loan collection expenses and state franchise tax. In late 2013, we began outsourcing out data processing functions, leading to an increase in expense year over year. Expenses related to OREO include:

 

     2014      2013  
     (in thousands)  

Net (gain) loss on sales

   $ (306    $ 132   

Provision to allowance for declining market values

     4,255         2,466   

Operating expense

     1,890         1,918   
  

 

 

    

 

 

 

Total

$ 5,839    $ 4,516   
  

 

 

    

 

 

 

During 2014, we recorded approximately $4.3 million of provision to OREO allowance related to fair value writedowns resulting from declines in the fair value of the real estate based upon updated appraisals and reduced marketing prices. This compares with $2.5 million of provision related to new appraisals received for properties in the portfolio during 2013.

Loan collection expenses declined by $2.7 million, or 36.4%, but this improvement was offset by a $1.3 million increase in OREO expenses primarily as a result of fair value writedowns resulting from declines in the fair value of the real estate based upon updated appraisals and reduced marketing prices.

 

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Non-interest Expense Comparison – 2013 to 2012

Non-interest expense for the year ended December 31, 2013 of $38.9 million represented a 12.2% decrease from $44.3 million for the same period last year. The decrease in non-interest expense was attributable primarily to decreased other real estate owned expense due to lower loss on sales of OREO and lower valuation write-downs. Expenses related to other real estate owned include:

 

     2013      2012  
     (in thousands)  

Net loss on sales

   $ 132       $ 1,672   

Provision to allowance

     2,466         7,154   

Operating expense

     1,918         1,723   
  

 

 

    

 

 

 

Total

$ 4,516    $ 10,549   
  

 

 

    

 

 

 

During 2013, we recorded approximately $2.5 million of provision to OREO allowance related to new appraisals received for properties in the portfolio during the year. This compares with $7.2 million of provision related to new appraisals received for properties in the portfolio during 2012.

FDIC insurance assessments decreased $457,000, or 16.1%, to $2.4 million in 2013 from $2.8 million in 2012 due to decreased average total consolidated assets, less the average tangible equity during the assessment period. Salary and employee benefit expenses decreased by $1.1 million, or 6.9% to $15.5 million from $16.6 million in 2012.

These improvements were offset partially by an increase in loan collection expense of $2.3 million, or 92.8%, due primarily to continued remediation of problem loans.

Income Tax Expense – No income tax expense was recorded for 2014 or 2013, with an income tax benefit of $1.6 million recorded for 2014. The December 31, 2014 tax benefit is entirely due to gains in other comprehensive income that are presented in current operations in accordance with the applicable accounting standards. Our deferred tax valuation allowance increased to $50.6 million at December 31, 2014. Our statutory federal tax rate was 35% in both 2014 and 2013. The effective tax rate for 2014 and 2013 is not meaningful due to the reduction of income tax benefit as the result of the establishment of the deferred tax valuation allowance.

The valuation allowance for our deferred tax assets does not have any impact on our liquidity, nor does it preclude us from using the tax losses, tax credits or other timing differences in the future. To the extent we generate taxable income in a given quarter, the valuation allowance may be reduced to offset fully or partially the corresponding income tax expense. Any remaining deferred tax asset valuation allowance may be reversed through income tax expense once we can demonstrate a sustainable return to profitability and conclude it is more likely than not the deferred tax asset will be utilized.

See Note 14, “Income Taxes”, for additional discussion of our income taxes.

No income tax benefit was recorded for 2013, compared with $65,000 for 2012. Our deferred tax valuation allowance increased to $47.8 million at December 31, 2013. Our statutory federal tax rate was 35% in both 2013 and 2012. The effective tax rate for 2013 and 2012 is not meaningful due to the reduction of income tax benefit as the result of the establishment of the deferred tax valuation allowance.

 

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Analysis of Financial Condition

Total assets at December 31, 2014 were $1.018 billion compared with $1.076 billion at December 31, 2013, a decrease of $58.1 million or 5.4%. This decrease was attributable primarily to a decrease of $75.6 million in net loans and a decrease in cash and cash equivalents of $31.0 million, which were offset by increases in investment securities of $26.1 million and OREO of $15.3 million. The decrease in loans was attributable to principal reductions by customers outpacing loan originations and advances, as well as $15.9 million in loan charge-offs and the transfer of loan balances totaling $32.3 million to OREO.

The Bank’s total risk-based capital was $73.2 million at December 31, 2014. The Bank’s consent order with its primary regulators required its Board of Directors to adopt and implement a plan to reduce its construction and development loans to not more than 75% of total risk-based capital. These loans totaled $33.2 million, or 45% of total risk-based capital, at December 31, 2014. The consent order also required a plan to reduce non-owner occupied commercial real estate loans, construction and development loans, and multifamily residential real estate loans as a group, to not more than 250% of total risk-based capital. These loans totaled $193.0 million, or 262% of total risk-based capital, at December 31, 2014.

Total assets at December 31, 2013 were $1.076 billion compared with $1.163 billion at December 31, 2012, a decrease of $86.5 million or 7.4%. This decrease was attributable primarily to a decrease of $189.8 million in loans. The decrease in loans was attributable to principal reductions by customers outpacing loan originations and advances, as well as $32.6 million in loan charge-offs and the transfer of loan balances totaling $20.6 million to OREO.

Loans Receivable – Loans receivable decreased $84.3 million, or 11.9%, during the year ended December 31, 2014, to $625.0 million. Our commercial, commercial real estate and real estate construction portfolios decreased by an aggregate of $52.4 million, or 13.1%, during 2014 and comprised 55.5% of the total loan portfolio at December 31, 2014.

Loans receivable decreased $189.8 million, or 21.1%, during the year ended December 31, 2013, to $709.3 million. Our commercial, commercial real estate and real estate construction portfolios decreased by an aggregate of $126.9 million, or 24.1%, during 2013, comprising 56.3% of the total loan portfolio at December 31, 2013.

Loan Portfolio Composition – The following table presents a summary of the loan portfolio at the dates indicated, net of deferred loan fees, by type. There are no foreign loans in our portfolio and other than the categories noted, there is no concentration of loans in any industry exceeding 10% of total loans, with the exception of loans for retail facilities (included in other commercial real estate below). Those loans totaled $71.1 million at December 31, 2014 and $98.5 million at December 31, 2013.

 

     As of December 31,  
     2014     2013  
     Amount      Percent     Amount      Percent  
     (dollars in thousands)  

Commercial

   $ 60,936         9.75   $ 52,878         7.45

Commercial Real Estate:

          

Construction

     33,173         5.31        43,326         6.11   

Farmland

     77,419         12.39        71,189         10.04   

Other

     175,452         28.07        232,026         32.71   

Residential Real Estate:

          

Multi-family

     41,891         6.70        46,858         6.61   

1-4 Family

     197,278         31.56        228,505         32.21   

Consumer

     11,347         1.82        14,365         2.03   

Agriculture

     26,966         4.31        19,199         2.71   

Other

     537         0.09        980         0.13   
  

 

 

    

 

 

   

 

 

    

 

 

 

Total loans

$ 624,999      100.0 $ 709,326      100.00
  

 

 

    

 

 

   

 

 

    

 

 

 

 

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Table of Contents
     As of December 31,  
     2012     2011     2010  
     Amount      Percent     Amount      Percent     Amount      Percent  
     (dollars in thousands)  

Commercial

   $ 52,567         5.85   $ 71,216         6.27   $ 90,290         6.93

Commercial Real Estate:

               

Construction

     70,284         7.82        101,471         8.93        199,524         15.32   

Farmland

     80,825         8.99        90,958         8.01        85,523         6.56   

Other

     322,687         35.89        423,844         37.31        441,844         33.92   

Residential Real Estate:

               

Multi-family

     50,986         5.67        60,410         5.31        74,919         5.75   

1-4 Family

     278,273         30.95        337,350         29.70        353,418         27.13   

Consumer

     20,383         2.27        26,011         2.29        31,913         2.45   

Agriculture

     22,317         2.48        23,770         2.09        24,177         1.86   

Other

     770         0.08        993         0.09        1,060         0.08   
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Total loans

$ 899,092      100.00 $ 1,136,023      100.00 $ 1,302,668      100.00
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Our lending activities are subject to a variety of lending limits imposed by state and federal law. The Bank’s secured legal lending limit to a single borrower was approximately $18.1 million at December 31, 2014.

At December 31, 2014, we had three loan relationships each with aggregate extensions of credit in excess of $10.0 million, all of which were classified as pass by the Bank’s internal loan review process. In 2013, we had four loan relationships each with aggregate extensions of credit in excess of $10.0 million. At December 31, 2013, two of the four relationships included loans that had been classified as substandard by the Bank’s internal loan review process. For further discussion of classified loans refer to the asset quality discussion in our “Allowance for Loan Losses” section.

Our real estate construction portfolio declined approximately $10.2 million from 2013 to 2014. This decrease was the result of construction projects being completed and sold to end users or refinanced under permanent financing arrangements and loans in this category being transferred to OREO through the normal progression of collection, workout, and ultimate disposition.

As of December 31, 2014, we had $7.0 million of loan participations purchased from, and $28.0 million of loan participations sold to, other banks. As of December 31, 2013, we had $7.2 million of loan participations purchased from, and $38.2 million of loan participations sold to, other banks.

 

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Loan Maturity Schedule – The following table sets forth information at December 31, 2014, regarding the dollar amount of loans, net of deferred loan fees, maturing in the loan portfolio based on their contractual terms to maturity:

 

     As of December 31, 2014  
     Maturing
Within
One
Year
     Maturing
1 through
5 Years
     Maturing
Over 5
Years
     Total
Loans
 
     (dollars in thousands)  

Loans with fixed rates:

           

Commercial

   $ 4,026       $ 19,549       $ 681       $ 24,256   

Commercial Real Estate:

           

Construction

     5,837         11,525         402         17,764   

Farmland

     10,065         15,968         6,257         32,290   

Other

     48,088         60,305         20,692         129,085   

Residential Real Estate:

           

Multi-family

     757         26,116         7,030         33,903   

1-4 Family

     19,607         83,563         45,301         148,471   

Consumer

     1,516         8,164         1,333         11,013   

Agriculture

     2,408         2,431         294         5,133   

Other

     74         206         237         517   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total fixed rate loans

$ 92,378    $ 227,827    $ 82,227    $ 402,432   
  

 

 

    

 

 

    

 

 

    

 

 

 

Loans with floating rates:

Commercial

$ 11,602    $ 16,285    $ 8,793    $ 36,680   

Commercial Real Estate:

Construction

  4,266      10,563      580      15,409   

Farmland

  3,221      3,675      38,233      45,129   

Other

  2,680      22,444      21,243      46,367   

Residential Real Estate:

Multi-family

  46      6,218      1,724      7,988   

1-4 Family

  5,382      6,630      36,795      48,807   

Consumer

  176      109      49      334   

Agriculture

  8,177      13,560      96      21,833   

Other

  —        —        20      20   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total floating rate loans

$ 35,550    $ 79,484    $ 107,533    $ 222,567   
  

 

 

    

 

 

    

 

 

    

 

 

 

Loan Portfolio by Risk CategoryThe following table presents a summary of the loan portfolio at the dates indicated, by risk category.

 

     As of December 31,  
     2014      2013      2012      2011      2010  
     (in thousands)  

Pass

   $ 461,126       $ 369,529       $ 437,886       $ 713,822       $ 984,636   

Watch

     68,200         144,316         177,419         143,247         130,335   

Special Mention

     4,189         5,865         34,700         48,922         18,988   

Substandard

     91,484         189,616         248,691         229,641         168,691   

Doubtful

     —           —           396         391         18   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

$ 624,999    $ 709,326    $ 899,092    $ 1,136,023    $ 1,302,668   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Our loans receivable decreased $84.3 million, or 11.9%, during the year ended December 31, 2014. All loan risk categories have decreased since December 31, 2013, with the exception of pass graded loans. The pass category increased approximately $91.6 million, the watch category declined approximately $76.2 million, the special mention category declined approximately $1.7 million, and the substandard category declined approximately $98.1 million. During the first quarter of 2014, management instituted a new risk category within its pass classification. The purpose was to better identify certain loans where the borrower’s sustained satisfactory repayment history was deemed a more relevant predictor of future loss than certain underwriting criteria at origination. The establishment of this new pass risk category helps to ensure the watch risk category remains transitory and event driven in nature. A total of $24.2 million in commercial, $8.5 million in residential, and $2.2 million in agriculture loans were reclassified from watch to the new pass risk category during the first quarter of 2014.

 

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In December 2014, the Company identified and transferred certain substandard accruing loans to loans held for sale. The loans were transferred to held for sale at the lower of cost or fair value. The Company identified $10.7 million of loans to sell and recorded a $1.8 million charge to the allowance for loan losses to reduce the loan balances to the estimated fair value. Loans held for sale total $8.9 million at December 31, 2014, comprised of $6.0 million in commercial real estate, $1.9 million in 1-4 family residential real estate, and $1.0 million in multi-family real estate. These loans were not past due at December 31, 2014.

Loan DelinquencyThe following table presents a summary of loan delinquencies at the dates indicated.

 

     As of December 31,  
     2014      2013      2012      2011      2010  
     (in thousands)  

Past Due Loans:

        

30-59 Days

   $ 3,960       $ 10,696       $ 38,219       $ 17,346       $ 20,956   

60-89 Days

     980         775         20,303         3,947         6,148   

90 Days and Over

     151         232         86         1,350         594   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total Loans Past Due 30-90+ Days

  5,091      11,703      58,608      22,643      27,698   

Nonaccrual Loans

  47,175      101,767      94,517      92,020      59,799   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total Past Due and Nonaccrual Loans

$ 52,266    $ 113,470    $ 153,125    $ 114,663    $ 87,497   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Loans past due 30-59 days decreased from $10.7 million at December 31, 2013 to $4.0 million at December 31, 2014, and loans past due 60-89 days increased from $775,000 at December 31, 2013 to $980,000 at December 31, 2014. This represents a $6.5 million decrease from December 31, 2013 to December 31, 2014, in loans past due 30-89 days. We considered this trend in delinquency levels during the evaluation of qualitative trends in the portfolio when establishing the general component of our allowance for loan losses.

Loans more than 90 days past due decreased $81,000, and nonaccrual loans decreased $54.6 million, respectively, from December 31, 2013 to December 31, 2014. The $47.2 million in non-performing loans at December 31, 2014, and $102.0 million at December 31, 2013, were primarily construction, land development, other land, commercial real estate, and residential real estate loans. Weakness in housing unit sales and loss of tenants or inability to lease vacant office and retail space placed inordinate stress on these borrowers and their ability to repay according to the contractual terms of the loans. As such, we have placed these credits on nonaccrual and have begun the appropriate collection actions to resolve them. Management believes it has established adequate loan loss reserves for these credits.

Non-Performing Assets – Non-performing assets consist of certain restructured loans for which interest rate or other terms have been renegotiated, loans past due 90 days or more still on accrual, loans on which interest is no longer accrued, real estate acquired through foreclosure and repossessed assets. Loans, including impaired loans, are placed on nonaccrual status when they become past due 90 days or more as to principal or interest, unless they are adequately secured and in the process of collection. Loans are considered impaired if full principal or interest payments are not anticipated in accordance with the contractual loan terms. Impaired loans are carried at the present value of expected future cash flows discounted at the loan’s effective interest rate or at the fair value of the collateral less cost to sell if the loan is collateral dependent. Loans are reviewed on a regular basis and normal collection procedures are implemented when a borrower fails to make a required payment on a loan. If the delinquency on a mortgage loan exceeds 120 days and is not cured through normal collection procedures or an acceptable arrangement is not worked out with the borrower, we institute measures to remedy the default, including commencing a foreclosure action. Consumer loans generally are charged off when a loan is deemed uncollectible by management and any available collateral has been disposed of. Commercial business and real estate loan delinquencies are handled on an individual basis by management with the advice of legal counsel.

Interest income on loans is recognized on the accrual basis except for those loans placed on nonaccrual status. The accrual of interest on impaired loans is discontinued when management believes, after consideration of economic and business conditions and collection efforts, that the borrowers’ financial condition is such that collection of interest is doubtful, which typically occurs after the loan becomes 90 days delinquent. When interest accrual is discontinued, existing accrued interest is reversed and interest income is subsequently recognized only to the extent cash payments are received on well-secured loans.

 

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Real estate acquired as a result of foreclosure or by deed in lieu of foreclosure is classified as real estate owned until such time as it is sold. New and used automobiles and other motor vehicles acquired as a result of foreclosure are classified as repossessed assets until they are sold. When such property is acquired it is recorded at its fair market value less cost to sell. Any write-down of the property at the time of acquisition is charged to the allowance for loan losses. Subsequent gains and losses are included in non-interest expense.

The following table sets forth information with respect to non-performing assets as of the dates indicated:

 

     As of December 31,  
     2014     2013     2012     2011     2010  
     (dollars in thousands)  

Past due 90 days or more still on accrual

   $ 151      $ 232      $ 86      $ 1,350      $ 594   

Loans on nonaccrual status

     47,175        101,767        94,517        92,020        59,799   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total non-performing loans

  47,326      101,999      94,603      93,370      60,393   

Real estate acquired through foreclosure

  46,197      30,892      43,671      41,449      67,635   

Other repossessed assets

  —        —        —        5      52   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total non-performing assets

$ 93,523    $ 132,891    $ 138,274    $ 134,824    $ 128,080   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Non-performing loans to total loans

  7.57   14.38   10.52   8.22   4.63

Non-performing assets to total assets

  9.19   12.35   11.89   9.26   7.43

Allowance for non-performing loans

$ 1,253    $ 2,285    $ 13,250    $ 11,382    $ 7,977   

Allowance for non-performing loans to non-performing loans

  2.7   2.2   14.0   12.2   13.2

Troubled Debt Restructuring – A troubled debt restructuring (TDR) occurs when the Company has agreed to a loan modification in the form of a concession to a borrower who is experiencing financial difficulty. The majority of the Company’s TDRs involve a reduction in interest rate, a deferral of principal for a stated period of time, or an interest only period. All TDRs are considered impaired, and the Company has allocated reserves for these loans to reflect the present value of the concessionary terms granted to the borrower. If the loan is considered collateral dependent, it is reported net of allocated reserves, at the fair value of the collateral less cost to sell.

We do not have a formal loan modification program. Rather, we work with individual borrower on a case-by-case basis to facilitate the orderly collection of our principal and interest before a loan becomes a non-performing loan. If a borrower is unable to make contractual payments, we review the particular circumstances of that borrower’s situation and negotiate a revised payment stream. In other words, we identify performing borrowers experiencing financial difficulties, and through negotiations, we lower their interest rate, most typically on a short-term basis for three to six months. Our goal when restructuring a credit is to afford the borrower a reasonable period of time to remedy the issue causing cash flow constraints within their business so that they can return to performing status over time.

Our loan modifications have taken the form of reduction in interest rate and/or curtailment of scheduled principal payments for a short-term period, usually three to six months, but in some cases until maturity of the loan. In some circumstances we restructure real estate secured loans in a bifurcated fashion whereby we have a fully amortizing “A” loan at a market interest rate and an interest-only “B” loan at a reduced interest rate. The majority of our restructured loans are collateral secured loans. If a borrower fails to perform under the modified terms, we place the loan(s) on nonaccrual status and begin the process of working with the borrower to liquidate the underlying collateral to satisfy the debt.

At December 31, 2014, we had 52 restructured loans totaling $42.5 million with borrowers who experienced deterioration in financial condition compared with 98 loans totaling $91.3 million at December 31, 2013. In general, these loans were granted interest rate reductions to provide cash flow relief to borrowers experiencing cash flow difficulties. Of these restructured loans for 2014, four loans totaling approximately $3.9 million were also granted principal payment deferrals until maturity. There were no concessions made to forgive principal relative to these loans, although we have recorded partial charge-offs for certain restructured loans. In general, these loans are secured by first liens on 1-4 residential or commercial real estate properties, or farmland. Restructured loans also included $883,000 of commercial loans for 2014. At December 31, 2014, $22.0 million of TDRs were performing according to their modified terms.

 

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The following table sets forth information with respect to TDRs, non-performing loans, real estate acquired through foreclosure, and other repossessed assets.

 

     As of December 31,  
     2014     2013     2012     2011     2010  
     (dollars in thousands)  

Total non-performing loans

   $ 47,326      $ 101,999      $ 94,603      $ 93,370      $ 60,393   

TDRs on accrual

     21,985        44,346        77,344        74,144        25,543   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total non-performing loans and TDRs on accrual

$ 69,311    $ 146,345    $ 171,947    $ 167,514    $ 85,936   

Real estate acquired through foreclosure

  46,197      30,892      43,671      41,449      67,635   

Other repossessed assets

  —        —        —        5      52   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total non-performing assets and TDRs on accrual

$ 115,508    $ 177,237    $ 215,618    $ 208,968    $ 153,623   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total non-performing loans and TDRs on accrual to total loans

  11.09   20.63   19.12   14.75   6.60

Total non-performing assets and TDRs on accrual to total assets

  11.35   16.47   18.55   14.36   8.91

We consider any loan that is restructured for a borrower experiencing financial difficulties due to a borrower’s potential inability to pay in accordance with contractual terms of the loan to be a troubled debt restructure. Specifically, we consider a concession involving a modification of the loan terms, such as (i) a reduction of the stated interest rate, (ii) reduction or deferral of principal, or (iii) reduction or deferral of accrued interest at a stated interest rate lower than the current market rate for new debt with similar risk all to be troubled debt restructurings. When a modification of terms is made for a competitive reason, we do not consider that to be a troubled debt restructuring. A primary example of a competitive modification would be an interest rate reduction for a performing customer’s loan to a market rate as the result of a market decline in rates.

Management periodically reviews renewals/modifications of previously identified TDRs for which there was no principal forgiveness, to consider if it is appropriate to remove the TDR classification. If the borrower is no longer experiencing financial difficulty and the renewal/modification did not contain a concessionary interest rate or other concessionary terms, management considers the potential removal of the TDR classification. If deemed appropriate, the TDR classification is removed as the borrower has complied with the terms of the loan at the date of renewal/modification and there was a reasonable expectation that the borrower would continue to comply with the terms of the loan after the date of the renewal/modification. In this instance, the TDR was originally considered a restructuring in a prior year as a result of a modification with an interest rate that was not commensurate with the risk of the underlying loan. Additionally, TDR classification can be removed in circumstances in which the Company performs a non-concessionary re-modification of the loan at terms that were considered to be at market for loans with comparable risk. Management expects the borrower will continue to perform under the re-modified terms based on the borrower’s past history of performance.

At December 31, 2014 and 2013, TDRs totaled $42.5 million and $91.3 million, respectively. During the twelve months ended December 31, 2014, TDRs were reduced as a result of $17.1 million in payments, the transfer of $4.5 million to loans held for sale, and the transfer of $16.7 million to OREO. In addition, the TDR classification was removed from two loans that met the requirements discussed above in the second quarter of 2014. These two loans totaled $7.3 million at December 31, 2013. These loans are no longer evaluated individually for impairment.

If the borrower fails to perform, we place the loan on nonaccrual status and seek to liquidate the underlying collateral. Our nonaccrual policy for restructured loans is identical to our nonaccrual policy for all loans. Our policy calls for a loan to be reported as nonaccrual if it is maintained on a cash basis because of deterioration in the financial condition of the borrower, payment in full of principal and interest is not expected, or principal or interest is past due 90 days or more unless the assets are both well secured and in the process of collection. Changes in value for impairment, including the amount attributed to the passage of time, are recorded entirely within the provision for loan losses. Upon determination that a loan is collateral dependent, the loan is charged down to the fair value of collateral less estimated costs to sell.

 

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See Footnote 4, “Loans”, to the financial statements for additional disclosure related to troubled debt restructuring.

Interest income that would have been earned on non-performing loans was $3.3 million, $5.6 million, and $4.9 million for the years ended December 31, 2014, 2013, and 2012, respectively. Interest income recognized on accruing non-performing loans was $785,000, $895,000, and $460,000 for the years ended December 31, 2014, 2013, and 2012, respectively.

Allowance for Loan Losses – The allowance for loan losses is based on management’s continuing review and evaluation of individual loans, loss experience, current economic conditions, risk characteristics of various categories of loans and such other factors that, in management’s judgment, require current recognition in estimating loan losses.

Management has established loan grading procedures that result in specific allowance allocations for any estimated inherent risk of loss. For loans not individually evaluated, a general allowance allocation is computed using factors developed over time based on actual loss experience. The specific and general allocations plus consideration of qualitative factors represent management’s estimate of probable losses contained in the loan portfolio at the evaluation date. Although the allowance for loan losses is comprised of specific and general allocations, the entire allowance is available to absorb any credit losses.

The following table sets forth an analysis of loan loss experience as of and for the periods indicated:

 

     As of December 31,  
     2014     2013     2012     2011     2010  
     (dollars in thousands)  

Balances at beginning of period

   $ 28,124      $ 56,680      $ 52,579      $ 34,285      $ 26,392   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Loans charged-off:

Real estate

  17,943      28,879      31,437      38,538      19,261   

Commercial

  1,099      2,828      3,784      4,197      2,675   

Consumer

  354      773      1,130      1,070      496   

Agriculture

  30      128      1,164      841      29   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total charge-offs

  19,426      32,608      37,515      44,646      22,461   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Recoveries:

Real estate

  2,726      1,622      1,040      184      114   

Commercial

  614      1,212      129      69      28   

Consumer

  213      266      125      87      104   

Agriculture

  13      252      72      —        8   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total recoveries

  3,566      3,352      1,366      340      254   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net charge-offs

  15,860      29,256      36,149      44,306      22,207   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Provision for loan losses

  7,100      700      40,250      62,600      30,100   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at end of period

$ 19,364    $ 28,124    $ 56,680    $ 52,579    $ 34,285   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Allowance for loan losses to period-end loans

  3.10   3.96   6.30   4.63   2.63

Net charge-offs to average loans

  2.39   3.71   3.50   3.56   1.64

Allowance for loan losses to non-performing loans

  40.92   27.57   59.91   56.31   56.77

Allowance for loan losses for loans individually evaluated for impairment

$ 752    $ 3,471    $ 21,034    $ 12,314    $ 5,119   

Loans individually evaluated for impairment

  71,993      149,883      188,808      150,727      71,726   

Allowance for loan losses to loans individually evaluated for impairment

  1.04   2.32   11.14   8.17   7.14

Allowance for loan losses for loans collectively evaluated for impairment

$ 18,612    $ 24,653    $ 35,646    $ 40,265    $ 29,166   

Loans collectively evaluated for impairment

  553,006      559,443      710,284      985,296      1,230,942   

Allowance for loan losses to loans collectively evaluated for impairment

  3.37   4.41   5.02   4.09   2.37

 

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Our allowance for loan losses is a reserve established through charges to earnings in the form of a provision for loan losses. The allowance for loan losses is comprised of general reserves and specific reserves. Our loan loss reserve, as a percentage of total loans at December 31, 2014, decreased to 3.10% from 3.96% at December 31, 2013. The change in our loan loss reserve as a percentage of total loans between periods is attributable to the decline in historical loss experience, qualitative factors, fewer loans migrating downward in risk grade classifications, charge-off levels, and provision expense. Our allowance for loan losses to non-performing loans was 40.92% at December 31, 2014, compared with 27.57% at December 31, 2013. Net charge-offs in 2014 totaled $15.9 million of which $13.7 million were the result of charging off the allowance for individually evaluated loans deemed to be collateral dependent during the period. This resulted in the decline in our allowance for loan losses for loans individually evaluated for impairment.

The following table sets forth the net charge-offs (recoveries) for the periods indicated:

 

     Year Ended
December 31,
2014
     Year Ended
December 31,
2013
     Year Ended
December 31,
2012
 
     (in thousands)  

Commercial

   $ 485       $ 1,616       $ 3,655   

Commercial Real Estate

     11,878         20,045         21,531   

Residential Real Estate

     3,339         7,212         8,866   

Consumer

     167         507         1,005   

Agriculture

     17         (124      1,092   

Other

     (26      —           —     
  

 

 

    

 

 

    

 

 

 

Total net charge-offs

$ 15,860    $ 29,256    $ 36,149   
  

 

 

    

 

 

    

 

 

 

We maintain a general reserve for each loan type in the loan portfolio. In determining the amount of the general reserve portion of our allowance for loan losses, management considers factors such as our historical loan loss experience, the growth, composition and diversification of our loan portfolio, current delinquency levels, loan quality grades, the results of recent regulatory examinations and general economic conditions. Based on these factors, we apply estimated percentages to the various categories of loans, not including any loan that has a specific allowance allocated to it, based on our historical experience, portfolio trends and economic and industry trends. This information is used by management to set the general reserve portion of the allowance for loan losses at a level it deems prudent.

Generally, all loans that have been identified as impaired are reviewed on a quarterly basis in order to determine whether a specific allowance is required. A loan is considered impaired when, based on current information, it is probable that we will not receive all amounts due in accordance with the contractual terms of the loan agreement. Once a loan has been identified as impaired, management measures impairment in accordance with ASC 310.10, “Impairment of a Loan.” When management’s measured value of the impaired loan is less than the recorded investment in the loan, the amount of the impairment is recorded as a specific reserve or charged-off if the loan is deemed collateral dependent. These specific reserves are determined on an individual loan basis based on management’s current evaluation of our loss exposure for each credit given the payment status, financial condition of the borrower and value of any underlying collateral. Loans for which specific reserves have been provided are excluded from the general reserve calculations described below. Changes in specific reserves from period to period are the result of changes in the circumstances of individual loans such as charge-offs, pay-offs, changes in collateral values or other factors.

The allowance for loan losses represents management’s estimate of the amount necessary to provide for probable losses in the loan portfolio in the normal course of business. Due to the uncertainty of risks in the loan portfolio, management’s judgment of the amount of the allowance necessary to absorb loan losses is approximate. The allowance for loan losses is also subject to regulatory examinations and may be adjusted in response to a determination by the regulatory agencies as to its adequacy in comparison with peer institutions.

We make specific allowances for each impaired loan based on its type and risk classification as discussed above. At year-end 2014, our allowance for loan losses to total non-performing loans increased to 40.9% from 27.6% at year-end 2013. It is important to look more closely at this ratio as a significant portion of our impaired loans are collateral dependent and have been charged down to the estimated fair value of the underlying collateral less cost to sell. Please see the next table for comparison and disclosure of our recorded investment less allocated allowance relative to the unpaid principal balance. We have assessed these impaired loans for collectability and considered, among other things, the borrower’s ability to repay, the value of the underlying collateral, and other market conditions to ensure that the allowance for loan losses is adequate to absorb probable incurred losses.

 

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The following table presents the unpaid principal balance, recorded investment and allocated allowance related to loans individually evaluated for impairment in the commercial real estate and residential real estate portfolios as of December 31, 2014 and 2013.

 

     December 31, 2014     December 31, 2013  
     Commercial
Real Estate
    Residential
Real Estate
    Commercial
Real Estate
    Residential
Real Estate
 
     (in thousands)  

Unpaid principal balance

   $ 65,899      $ 24,633      $ 116,740      $ 56,665   

Prior charge-offs

     (17,758     (3,249     (22,410     (7,153
  

 

 

   

 

 

   

 

 

   

 

 

 

Recorded investment

  48,141      21,384      94,330      49,512   

Allocated allowance

  (491   (227   (2,345   (827
  

 

 

   

 

 

   

 

 

   

 

 

 

Recorded investment, less allocated allowance

$ 47,650    $ 21,157    $ 91,985    $ 48,685   
  

 

 

   

 

 

   

 

 

   

 

 

 

Recorded investment, less allocated allowance/ Unpaid principal balance

  72.31   85.89   78.79   85.92

Based on previous charge-offs, our current recorded investment in the commercial real estate and residential real estate segments are significantly below the unpaid principal balance for the loans. Consideration of the recorded investment and allocated allowance further indicated, we are at 72.31% and 85.89% of the unpaid principal balance in the commercial real estate and residential real estate segments of the portfolio, respectively, at December 31, 2014.

The following table illustrates recent trends in loans collectively evaluated for impairment and the related allowance for loan losses by portfolio segment:

 

     December 31, 2014     December 31, 2013  
     Loans      Allowance      % to
Total
    Loans      Allowance      % to
Total
 
     (dollars in thousands)  

Commercial

   $ 58,914       $ 2,013         3.42   $ 47,883       $ 2,931         6.12

Commercial real estate

     237,903         10,440         4.39        252,211         14,069         5.58   

Residential real estate

     217,785         5,560         2.55        225,851         6,935         3.07   

Consumer

     11,286         273         2.42        14,272         407         2.85   

Agriculture

     26,703         319         1.19        18,877         305         1.62   

Other

     415         7         1.69        349         6         1.72   
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

    

 

 

 

Total

$ 553,006    $ 18,612      3.37 $ 559,443    $ 24,653      4.41
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

    

 

 

 

Loans collectively evaluated for impairment and the related allowance for loan losses trended downward from 4.41% at December 31, 2013 to 3.37% at December 31, 2014 as a result of declining historical charge-off levels and improving trends in loan category risk ratings. The residential real estate segment constitutes approximately 39% of total loans collectively evaluated for impairment. The related allowance for the residential real estate segment trended downward from 3.07% at December 31, 2013 to 2.55% at December 31, 2014 as our net charge-offs declined from approximately $7.2 million in 2013 to $3.3 million in 2014. The commercial real estate segment constitutes approximately 43% of total loans collectively evaluated for impairment. The related allowance for the commercial real estate segment trended downward from 5.58% at December 31, 2013 to 4.39% at December 31, 2014. This is consistent with our net charge-off experience in the commercial real estate segment of the portfolio which totaled approximately $20.0 million in 2013 and $11.9 million in 2014. The decreasing allowance also reflects improving past due trends, nonaccrual trends, and loan classification trends within the portfolio.

A significant portion of our portfolio is comprised of loans secured by real estate. A decline in the value of the real estate serving as collateral for our loans may impact our ability to collect those loans. In general, we obtain updated appraisals on property securing our loans when circumstances are warranted such as at the time of renewal or when market conditions have significantly changed. We use qualified licensed appraisers approved by our Board of Directors. These appraisers possess prerequisite certifications and knowledge of the local and regional marketplace.

Based on an evaluation of the loan portfolio, management presents a quarterly review of the allowance for loan losses to our Board of Directors, indicating any change in the allowance for loan losses since the last review and any recommendations as to adjustments in the allowance for loan losses.

 

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Table of Contents

This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available or as events change. We decreased the allowance for loan losses as a percentage of loans outstanding to 3.10% at December 31, 2014 from 3.96% at December 31, 2013. This decline is the result of declining historical charge-off levels and improving trends in loan category risk ratings. The level of the allowance is based on estimates and the ultimate losses may vary from these estimates.

We follow a loan grading program designed to evaluate the credit risk in our loan portfolio. Through this loan grading process, we maintain an internally classified watch list which helps management assess the overall quality of the loan portfolio and the adequacy of the allowance for loan losses. Loans categorized as watch list loans show warning elements where the present status exhibits one or more deficiencies that require attention in the short-term or where pertinent ratios of the loan account have weakened to a point where more frequent monitoring is warranted. These loans do not have all of the characteristics of a classified loan (substandard or doubtful) but do show weakened elements as compared with those of a satisfactory credit. We review these loans to assist in assessing the adequacy of the allowance for loan losses.

In establishing the appropriate classification for specific assets, management considers, among other factors, the borrower’s ability to repay, the borrower’s repayment history, the current delinquent status, and the estimated value of the underlying collateral. As a result of this process, loans are categorized as special mention, substandard or doubtful.

Loans classified as “special mention” do not have all of the characteristics of substandard or doubtful loans. They have one or more deficiencies which warrant special attention and which corrective action, such as accelerated collection practices, may remedy.

Loans classified as “substandard” are those loans with clear and defined weaknesses such as a highly leveraged position, unfavorable financial ratios, uncertain repayment sources or poor financial condition which may jeopardize the repayment of the debt as contractually agreed. They are characterized by the distinct possibility that we will sustain some losses if the deficiencies are not corrected.

Loans classified as “doubtful” are those loans which have characteristics similar to substandard loans but with an increased risk that collection or liquidation in full is highly questionable and improbable.

Specific reserves may be carried for accruing TDRs in compliance with restructured terms. Once a loan is deemed impaired or uncollectible as contractually agreed (other than performing TDRs), the loan is charged-off either partially or in-full against the allowance for loan losses, based upon the expected future cash flows discounted at the loan’s effective interest rate, or the fair value of collateral less estimated cost to sell with respect to collateral-based loans if collateral dependent.

As of December 31, 2014, we had $91.5 million of loans classified as substandard, $4.2 million classified as special mention and none classified as doubtful or loss. This compares with $189.6 million of loans classified as substandard, $5.9 million classified as special mention and none classified as doubtful or loss as of December 31, 2013. The $98.1 million decrease in loans classified as substandard was primarily driven by $40.7 in principal payments received, $30.6 in migration to OREO, and $19.1 in charge-offs. In addition, the Company transferred $8.9 million in substandard accruing loans to loans held for sale in December 2014. Substandard loans are primarily concentrated in the commercial real estate portfolio. As of December 31, 2014, we had allocations of $4.0 million in the allowance for loan losses related to these substandard loans. This compares to allocations of $12.5 million in the allowance for loan losses related to substandard loans at December 31, 2013.

 

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The following table depicts management’s allocation of the allowance for loan losses by loan type. Allowance funding and allocation is based on management’s current evaluation of risk in each category, economic conditions, past loss experience, loan volume, past due history and other factors. Since these factors and management’s assumptions are subject to change, the allocation is not necessarily predictive of future portfolio performance. The allocation is made by analytical purposes and is not necessarily indicative of the categories in which future losses may occur. The total allowance is available to absorb losses from any segment of loans.

 

     As of December 31,  
     2014     2013  
     Amount of
Allowance
     Percent of
Loans to
Total

Loans
    Amount of
Allowance
     Percent of
Loans to
Total

Loans
 
     (dollars in thousands)  

Commercial

   $ 2,046         9.75   $ 3,221         7.45

Commercial Real Estate:

          

Construction

     739         5.31        2,149         6.11   

Farmland

     1,094         12.39        1,623         10.04   

Other

     9,098         28.07        12,642         32.71   

Residential Real Estate:

          

Multi-family

     886         6.70        1,449         6.61   

1-4 Family

     4,901         31.56        6,313         32.21   

Consumer

     274         1.82        416         2.03   

Agriculture

     319         4.31        305         2.71   

Other

     7         0.09        6         0.13   
  

 

 

    

 

 

   

 

 

    

 

 

 

Total

$ 19,364      100.0 $ 28,124      100.00
  

 

 

    

 

 

   

 

 

    

 

 

 

 

     As of December 31,  
     2012     2011     2010  
     Amount of
Allowance
     Percent of
Loans to
Total

Loans
    Amount
of

Allowance
     Percent of
Loans to
Total

Loans
    Amount
of

Allowance
     Percent of
Loans to
Total

Loans
 
     (dollars in thousands)  

Commercial

   $ 4,402         5.85   $ 4,207         6.27   $ 2,147         6.93

Commercial Real Estate:

               

Construction

     5,989         7.82        13,920         8.93        11,164         15.32   

Farmland

     2,600         8.99        2,023         8.01        702         6.56   

Other

     26,179         35.89        17,081         37.31        12,209         33.92   

Residential Real Estate:

               

Multi-family

     2,464         5.67        1,797         5.31        517         5.75   

1-4 Family

     13,771         30.95        12,420         29.70        6,707         27.13   

Consumer

     857         2.27        792         2.29        701         2.45   

Agriculture

     403         2.48        325         2.09        134         1.86   

Other

     15         0.08        14         0.09        4         0.08   

Unallocated

     —           —          —           —          —           —     
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Total

$ 56,680      100.0 $ 52,579      100.0 $ 34,285      100.00
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Provision for Loan LossesProvision expense of $7.1 million was recorded for the year ended December 31, 2014, compared with $700,000 for 2013 and $40.3 million for 2012. The total allowance for loan losses was $19.4 million, or 3.10% of total loans, at December 31, 2014, compared with $28.1 million, or 3.96% of total loans, at December 31, 2013, and $56.7 million, or 6.30% of total loans, at December 31, 2012. The decreased allowance is consistent with the decrease in our classified loans of $175.9 million from December 31, 2013 to December 31, 2014 and loan charge-off trends. Net charge-offs were $15.9 million for the year ended December 31, 2014, compared with $29.3 million for 2013 and $36.1 million for 2012. Charge-offs for 2014 were concentrated in the loans secured by real estate category of the portfolio. Real estate net charge-offs represent 95.95% of our net charge-offs for 2014. These net charge-offs consisted of $10.9 million of commercial real estate loans, $3.3 million of residential real estate loans, and $1.0 million of construction and land development loans. During the first quarter of 2014, management instituted a new risk category within its pass classification. The purpose was to better identify certain loans where the borrower’s sustained satisfactory repayment history was deemed a more relevant predictor of future loss than certain underwriting criteria at origination. The establishment of this new pass risk category helps to ensure the watch risk category remains transitory and event driven in nature. A total of $24.2 million in commercial, $8.5 million in residential, and $2.2 million in agriculture loans were reclassified from watch to the new pass risk category during the first quarter. We consider the size and volume of our portfolio as well as the credit quality of our loan portfolio based upon risk category classification when determining the loan loss provision for each period and the allowance for loan losses at period end.

 

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Table of Contents

Foreclosed Properties – Foreclosed properties at December 31, 2014 were $46.2 million compared with $30.9 million at December 31, 2013. See Footnote 6, “Other Real Estate Owned”, to the financial statements. During 2014, we acquired $32.3 million of OREO properties and sold properties totaling approximately $13.1 million. We value foreclosed properties at fair value less estimated cost to sell when acquired and expect to liquidate these properties to recover our investment in the due course of business.

OREO is recorded at fair market value less estimated cost to sell at time of acquisition. Any write-down of the property at the time of acquisition is charged to the allowance for loan losses. Subsequent reductions in fair value are recorded as non-interest expense. To determine the fair value of OREO for smaller dollar single family homes, we consult with internal real estate sales staff and external realtors, investors, and appraisers. If the internally evaluated market price is below our underlying investment in the property, appropriate write-downs are recorded.

For larger dollar commercial real estate properties, we obtain a new appraisal of the subject property or have staff in our special assets group or centralized appraisal department evaluate the latest in-file appraisal in connection with the transfer to OREO. In some of these circumstances, an appraisal is in process at quarter end and we must make our best estimate of the fair value of the underlying collateral based on our internal evaluation of the property, our review of the most recent appraisal, and discussions with the currently engaged appraiser. We typically obtain updated appraisals within five quarters of the anniversary date of ownership unless a sale is imminent.

The following table presents the major categories of OREO at the year-ends indicated:

 

     2014      2013      2012  
     (in thousands)  

Commercial Real Estate:

        

Construction, land development, and other land

   $ 18,325       $ 19,049       $ 22,323   

Farmland

     654         690         602   

Other

     14,525         4,888         15,175   

Residential Real Estate:

        

Multi-family

     4,875         246         195   

1-4 Family

     7,818         6,019         5,376   
  

 

 

    

 

 

    

 

 

 
$ 46,197    $ 30,892    $ 43,671   
  

 

 

    

 

 

    

 

 

 

Net activity relating to other real estate owned during the years indicated is as follows:

 

     2014      2013      2012  
     (in thousands)  

OREO Activity

        

OREO as of January 1

   $ 30,892       $ 43,671       $ 41,449   

Real estate acquired

     32,338         20,606         33,528   

Valuation adjustments for declining market values

     (4,255      (2,466      (7,154

Improvements

     —           —           1   

Net gain (loss) on sale

     306         (132      (1,672

Proceeds from sale of properties

     (13,084      (30,787      (22,481
  

 

 

    

 

 

    

 

 

 

OREO as of December 31

$ 46,197    $ 30,892    $ 43,671   
  

 

 

    

 

 

    

 

 

 

Net loss on sales, write-downs, and operating expenses for OREO totaled $5.8 million for the year ended December 31, 2014, compared with $4.5 million for the same period of 2013.

During the year ended December 31, 2014, fair value write-downs of $4.3 million were recorded to reflect declining values evidenced by new appraisals and our reduction of marketing prices in connection with our sales strategies compared with $2.5 million for the year ended December 31, 2013. We were successful in selling OREO totaling $13.1 million and $30.9 million during 2014 and 2013, respectively. We continue to have an elevated level of real estate secured non-performing loans. We expect to resolve a significant level of these non-performing loans through the acquisition and sale of the underlying real estate collateral.

 

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Investment Securities – The securities portfolio serves as a source of liquidity and earnings and contributes to the management of interest rate risk. We have the authority to invest in various types of liquid assets, including short-term United States Treasury obligations and securities of various federal agencies, obligations of states and political subdivisions, corporate bonds, certificates of deposit at insured savings and loans and banks, bankers’ acceptances and federal funds. We may also invest a portion of our assets in certain commercial paper and corporate debt securities. We are also authorized to invest in mutual funds and stocks whose assets conform to the investments that we are authorized to make directly. The investment portfolio increased by $26.2 million, or 12.6%, to $233.1 million at December 31, 2014, compared with $207.0 million at December 31, 2013.

The following table sets forth the carrying value of our securities portfolio at the dates indicated.

 

     December 31, 2014      December 31, 2013  
     Amortized
Cost
     Gross
Unrealized
Gains
     Gross
Unrealized
Losses
    Fair
Value
     Amortized
Cost
     Gross
Unrealized
Gains
     Gross
Unrealized
Losses
    Fair
Value
 
     (dollars in thousands)  

Securities available for sale

                     

U.S. Government and federal agencies

   $ 35,725       $ 308       $ (590   $ 35,443       $ 31,026       $ 284       $ (1,444   $ 29,866   

Agency mortgage-backed:

                     

residential

     121,985         1,970         (357     123,598         102,435         458         (1,950     100,943   

State and municipal

     11,690         722         (8     12,404         12,965         608         (28     13,545   

Corporate

     18,087         853         (252     18,688         18,002         769         (610     18,161   

Other debt

     572         86         —          658         572         60         —          632   

Equity

     —           —           —          —           135         62         —          197   
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

Total available for sale

$ 188,059    $ 3,939    $ (1,207 $ 190,791    $ 165,135    $ 2,241    $ (4,032 $ 163,344   
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

Securities held to maturity

State and municipal

$ 42,325    $ 2,173    $ —      $ 44,498    $ 43,612    $ 3    $ (668 $ 42,947   
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

Total held to maturity

$ 42,325    $ 2,173    $ —      $ 44,498    $ 43,612    $ 3    $ (668 $ 42,947   
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

The following table sets forth the contractual maturities, fair values and weighted-average yields for our available for sale securities held at December 31, 2014:

 

     Due Within
One Year
    After One Year
But Within
Five Years
    After Five Years
But Within
Ten Years
    After Ten Years     Total  
     Amount      Yield     Amount      Yield     Amount      Yield     Amount      Yield     Amount      Yield  

Available for sale

                         

U.S. Government and federal agencies

   $ 90         5.27   $ 979         1.92   $ 14,673         2.44   $ 19,701         2.21   $ 35,443         2.30

Agency mortgage-backed:

                         

residential

     —           —          212         5.18        1,870         2.54        121,516         2.47        123,598         2.48   

State and municipal

     1,235         5.44        2,075         5.00        8,711         5.05        383         6.19        12,404         5.12   

Corporate bonds

     —           —          5,533         5.77        1,131         5.14        12,024         2.18        18,688         3.35   

Other debt

     —           —          —           —          —           —          658         6.50        658         6.50   
  

 

 

      

 

 

      

 

 

      

 

 

      

 

 

    

Total available for sale

$ 1,325      5.43 $ 8,799      5.11 $ 26,385      3.39 $ 154,282      2.44 $ 190,791      2.70
  

 

 

      

 

 

      

 

 

      

 

 

      

 

 

    

The following table sets forth the contractual maturities, amortized cost and weighted-average yields for our held to maturity securities held at December 31, 2014:

 

     Due Within
One Year
    After One Year
But Within
Five Years
    After Five Years
But Within
Ten Years
    After Ten Years     Total  
     Amount      Yield     Amount      Yield     Amount      Yield     Amount      Yield     Amount      Yield  

Held to maturity

                         

State and municipal

   $ —           —     $ 446         1.76   $ 24,984         3.63   $ 19,068         4.52   $ 44,498         4.00
  

 

 

      

 

 

      

 

 

      

 

 

      

 

 

    

Total held to maturity

$ —        —   $ 446      1.76 $ 24,984      3.63 $ 19,068      4.52 $ 44,498      4.00
  

 

 

      

 

 

      

 

 

      

 

 

      

 

 

    

 

Average yields in the table above were calculated on a tax equivalent basis using a federal income tax rate of 35%. Mortgage-backed securities are securities that have been developed by pooling a number of real estate mortgages. These securities are issued by federal agencies such as Government National Mortgage Association (“Ginnie Mae”), Fannie Mae and Freddie Mac, as well as non-agency company issuers. These securities are deemed to have high credit ratings, and minimum regular monthly cash flows of principal and interest. Cash flows from agency backed mortgage-backed securities are guaranteed by the issuing agencies.

 

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Unlike U.S. Treasury and U.S. government agency securities, which have a lump sum payment at maturity, mortgage-backed securities provide cash flows from regular principal and interest payments and principal prepayments throughout the lives of the securities. Mortgage-backed securities that are purchased at a premium will generally return decreasing net yields as interest rates drop because home owners tend to refinance their mortgages. Thus, the premium paid must be amortized over a shorter period. Therefore, those securities purchased at a discount will obtain higher net yields in a decreasing interest rate environment. As interest rates rise, the opposite will generally be true. During a period of increasing interest rates, fixed rate mortgage-backed securities do not tend to experience heavy prepayments of principal and consequently, average life will not be shortened. If interest rates begin to fall, prepayments will generally increase. Non-agency issuer mortgage-backed securities do not carry a government guarantee. We limit our purchases of these securities to bank qualified issues with high credit ratings. We regularly monitor the performance and credit ratings of these securities and evaluate these securities, as we do all of our securities, for other-than-temporary impairment on a quarterly basis. At December 31, 2014, 98.3% of the agency mortgage-backed securities we held had contractual final maturities of more than ten years with a weighted average life of 23.7 years.

Deposits – We attract both short-term and long-term deposits from the general public by offering a wide range of deposit accounts and interest rates. In recent years, we have been required by market conditions to rely increasingly on short to mid-term certificate accounts and other deposit alternatives, including brokered and wholesale deposits, which are more responsive to market interest rates. We use forecasts based on interest rate risk simulations to assist management in monitoring our use of certificates of deposit and other deposit products as funding sources and the impact of their use on interest income and net interest margin in various rate environments. Our remaining brokered deposits matured during 2013. We are currently restricted from accepting, renewing, or rolling-over brokered deposits without the prior receipt of a waiver on a case-by-case basis from our regulators.

We primarily rely on our banking office network to attract and retain deposits in our local markets and leverage our online Ascencia division to attract out-of-market deposits. Market interest rates and rates on deposit products offered by competing financial institutions can significantly affect our ability to attract and retain deposits. During 2014, total deposits decreased $60.9 million compared with 2013. During 2013, total deposits decreased $77.4 million compared with 2012. The decrease in deposits for 2014 and 2013 was primarily in certificates of deposit balances.

To evaluate our funding needs in light of deposit trends resulting from continually changing conditions, we evaluate simulated performance reports that forecast changes in margins along with other pertinent economic data. We continue to offer attractively priced deposit products along our product line to allow us to retain deposit customers and reduce interest rate risk during various rising and falling interest rate cycles.

We offer savings accounts, NOW accounts, money market accounts and fixed rate certificates with varying maturities. The flow of deposits is influenced significantly by general economic conditions, changes in interest rates and competition. Our management adjusts interest rates, maturity terms, service fees and withdrawal penalties on our deposit products periodically. The variety of deposit products allows us to compete more effectively in obtaining funds and to respond with more flexibility to the flow of funds away from depository institutions into outside investment alternatives. However, our ability to attract and maintain deposits and the costs of these funds has been, and will continue to be, significantly affected by market conditions.

The following table sets forth the average daily balances and weighted average rates paid for our deposits for the periods indicated:

 

     For the Years Ended December 31,  
     2014     2013     2012  
     Average
Balance
     Average
Rate
    Average
Balance
     Average
Rate
    Average
Balance
     Average
Rate
 
     (dollars in thousands)  

Demand

   $ 113,150         $ 106,153         $ 113,325      

Interest Checking

     83,504         0.15     84,917         0.23     89,820         0.37

Money Market

     96,194         0.55        69,842         0.50        63,212         0.49   

Savings

     36,803         0.24        39,158         0.29        38,665         0.40   

Certificates of Deposit

     632,020         1.29        703,982         1.35        912,061         1.52   
  

 

 

      

 

 

      

 

 

    

Total Deposits

$ 961,671    $ 1,004,052    $ 1,217,083   
  

 

 

      

 

 

      

 

 

    

Weighted Average Rate

  0.92   1.01   1.20

 

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The following table sets forth the average daily balances and weighted average rates paid for our certificates of deposit for the periods indicated:

 

     For the Years Ended December 31,  
     2014     2013     2012  
     Average
Balance
     Average
Rate
    Average
Balance
     Average
Rate
    Average
Balance
     Average
Rate
 
     (dollars in thousands)  

Certificates of Deposit

        

Less than $100,000

   $ 354,250         1.22   $ 405,758         1.28   $ 478,502         1.40

$100,000 or more

     277,770         1.37        298,224         1.44        433,559         1.64   
  

 

 

      

 

 

      

 

 

    

Total

$ 632,020      1.29 $ 703,982      1.35 $ 912,061      1.52
  

 

 

      

 

 

      

 

 

    

The following table shows at December 31, 2014 the amount of our time deposits of $100,000 or more by time remaining until maturity:

 

Maturity Period

 
(in thousands)       

Three months or less

   $ 50,811   

Three months through six months

     41,836   

Six months through twelve months

     93,658   

Over twelve months

     66,767   
  

 

 

 

Total

$ 253,072   
  

 

 

 

We strive to maintain competitive pricing on our deposit products which we believe allows us to retain a substantial percentage of our customers when their time deposits mature.

Borrowing – Deposits are the primary source of funds for our lending and investment activities and for our general business purposes. We can also use advances (borrowings) from the FHLB of Cincinnati to supplement our pool of lendable funds, meet deposit withdrawal requirements and manage the terms of our liabilities. Advances from the FHLB are secured by our stock in the FHLB, and substantially all of our first mortgage residential loans. At December 31, 2014, we had $15.8 million in advances outstanding from the FHLB and the capacity to increase our borrowings an additional $13.0 million. The FHLB of Cincinnati functions as a central reserve bank providing credit for savings banks and other member financial institutions. As a member, we are required to own capital stock in the FHLB and are authorized to apply for advances on the security of such stock and certain of our home mortgages and other assets (principally, securities which are obligations of, or guaranteed by, the United States) provided that we meet certain standards related to creditworthiness.

The following table sets forth information about our FHLB advances as of and for the periods indicated:

 

     December 31,  
     2014     2013     2012  
     (dollars in thousands)  

Average balance outstanding

   $ 4,473      $ 4,990      $ 6,325   

Maximum amount outstanding at any month-end during the period

     16,940        5,517        7,015   

End of period balance

     15,752        4,492        5,604   

Weighted average interest rate:

      

At end of period

     1.02     3.07     3.21

During the period

     2.77     3.15     3.27

Subordinated Capital Note – At December 31, 2014, the Bank had a subordinated capital note outstanding in the amount of $5.0 million. The note is unsecured, bears interest at the BBA three-month LIBOR floating rate plus 300 basis points, and qualifies as Tier 2 capital. Interest only was due quarterly through September 30, 2010, at which time quarterly principal payments of $225,000 plus interest commenced. The note matures July 1, 2020. At December 31, 2014, the interest rate on this note was 3.24%.

 

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Junior Subordinated Debentures – At December 31, 2014, we had four issues of junior subordinated debentures outstanding totaling $25.0 million as shown in the table below.

 

Description

   Liquidation
Amount

Trust
Preferred

Securities
     Issuance
Date
     End of 20
Quarter
Deferral
Period (1)
     Interest Rate (2)     Junior
Subordinated

Debt and
Investment

in Trust
     Maturity
Date
 
     (dollars in thousands)             (dollars in thousands)  

Porter Statutory Trust II

   $ 5,000         2/13/2004         9/19/2016         3-month LIBOR + 2.85   $ 5,155         2/13/2034   

Porter Statutory Trust III

     3,000         4/15/2004         9/18/2016         3-month LIBOR + 2.79     3,093         4/15/2034   

Porter Statutory Trust IV

     14,000         12/14/2006         9/1/2016         3-month LIBOR + 1.67     14,434         3/1/2037   

Ascencia Statutory Trust I

     3,000         2/13/2004         9/19/2016         3-month LIBOR + 2.85     3,093         2/13/2034   
  

 

 

            

 

 

    
$ 25,000    $ 25,775   
  

 

 

            

 

 

    

 

(1)

Accrued and unpaid interest totaled $2.2 million at December 31, 2014.

(2)

As of December 31, 2014, the 3-month LIBOR was 0.26%.

The trust preferred securities are subject to mandatory redemption, in whole or in part, upon repayment of the subordinated debentures at maturity or their earlier redemption at the liquidation preference. The subordinated debentures, which mature February 13, 2034, April 15, 2034, and March 1, 2037, are redeemable before the maturity date at our option at their principal amount plus accrued interest.

We have the option to defer interest payments on the subordinated debentures from time to time for a period not to exceed 20 consecutive quarters. After such period, we must pay all deferred interest or we will be in default. Effective with the fourth quarter of 2011, we began deferring interest payments on our junior subordinated debentures. The deferral period ends September 30, 2016 at which time we will be required to pay all accrued interest or be in default.

Deferring interest payments on our junior subordinated notes resulted in the deferral of distributions on our trust preferred securities. We are prohibited from paying cash dividends on our preferred and common shares until such time as we have paid all deferred distributions on our trust preferred securities.

The trust preferred securities issued by our subsidiary trusts are currently included in our Tier 1 capital for regulatory purposes. On March 1, 2005, the Federal Reserve Board adopted final rules that continue to allow trust preferred securities to be included in Tier 1 capital, subject to quantitative and qualitative limits. Currently, no more than 25% of our Tier 1 capital can consist of trust preferred securities and qualifying perpetual preferred stock. To the extent the amount of our trust preferred securities exceeds the 25% limit, the excess would be includable in Tier 2 capital. The new quantitative limits were effective March 31, 2011. As of December 31, 2014, the Company’s trust preferred securities totaled 25% of its Tier 1 capital and 49% of its Tier 2 capital.

Each of the trusts issuing the trust preferred securities holds junior subordinated debentures we issued with a 30-year maturity. The final rules provide that in the last five years before the junior subordinated debentures mature, the associated trust preferred securities will be excluded from Tier 1 capital and included in Tier 2 capital. In addition, the trust preferred securities during this five-year period would be amortized out of Tier 2 capital by one-fifth each year and excluded from Tier 2 capital completely during the year before maturity.

Liquidity

Liquidity risk arises from the possibility we may not be able to satisfy current or future financial commitments, or may become unduly reliant on alternative funding sources. The objective of liquidity risk management is to ensure that we meet the cash flow requirements of depositors and borrowers, as well as our operating cash needs, taking into account all on- and off-balance sheet funding demands. Liquidity risk management also involves ensuring that we meet our cash flow needs at a reasonable cost. We maintain an investment and funds management policy, which identifies the primary sources of liquidity, establishes procedures for monitoring and measuring liquidity, and establishes minimum liquidity requirements in compliance with regulatory guidance. Our Asset Liability Committee continually monitors and reviews our liquidity position.

 

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Funds are available from a number of sources, including the sale of securities in the available for sale portion of the investment portfolio, principal pay-downs on loans and mortgage-backed securities, customer deposit inflows, brokered deposits and other wholesale funding. Historically, we have utilized brokered and wholesale deposits to supplement our funding strategy. We are currently restricted from accepting, renewing, or rolling-over brokered deposits without the prior receipt of a waiver on a case-by-case basis from our regulators. At December 31, 2014, we had no brokered deposits.

Traditionally, we have borrowed from the FHLB to supplement our funding requirements. At December 31, 2014, we had an unused borrowing capacity with the FHLB of $13.0 million. Our borrowing capacity is under a detailed loan listing requirement and is based on the market value of the underlying pledged loans rather than the unpaid principal balance of the pledged loans. The listing requirement also increases the level of collateral required for borrowings.

We also have available on a secured basis federal funds borrowing lines from correspondent banks totaling $5.0 million. Management believes our sources of liquidity are adequate to meet expected cash needs for the foreseeable future, however, the availability of these lines could be affected by our financial position. We are also subject to FDIC interest rate restrictions for deposits. As such, we are permitted to offer up to the “national rate” plus 75 basis points as published weekly by the FDIC.

We have used cash to pay dividends on common shares, if and when declared by the Board of Directors, and to service debt. The Company’s main sources of funding include dividends paid by the Bank and financing obtained in the capital markets. During 2011, Porter Bancorp contributed $13.1 million to its subsidiary, the Bank, which substantially decreased its liquid assets. The contribution was made to strengthen the Bank’s capital in an effort to help it comply with its capital ratio requirements under the consent order. Liquid assets decreased from $20.3 million at December 31, 2010 to $1.9 million at December 31, 2014. Since the Bank is unlikely to be in a position to pay dividends to the parent company for the foreseeable future, cash inflows for the parent are limited to earnings on investment securities, sales of investment securities, and interest on deposits with the Bank. These cash inflows along with the liquid assets held at December 31, 2014, are needed to cover ongoing operating expenses of the parent company which are forecasted at $1.0 million for 2015. Parent company liquidity could be improved through a sale of common or preferred shares. See the “Supervision-Porter Bancorp-Dividends” section of Item 1. “Business” and the “Dividends” section of Item 5. “Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities” of this Annual Report on Form 10-K.

Capital

In the fourth quarter of 2011, we began deferring interest payments on our junior subordinated notes, which resulted in a deferral of distributions on our trust preferred securities. Therefore, we will not be able to pay cash dividends on our common shares until such time that we have paid all deferred distributions on our trust preferred securities. If we defer interest payments on our trust preferred securities for 20 consecutive quarters (through September 30, 2016), we must pay all deferred interest or we will be in default. At December 31, 2014, cumulative accrued and unpaid interest on our junior subordinated notes totaled $2.2 million.

Stockholders’ equity decreased $2.5 million to $33.5 million at December 31, 2014, compared with $35.9 million at December 31, 2013. The decrease was due to the current year net loss, offset by the conversion of a $7.4 million dividend liability into stockholders’ equity in the exchange transaction and an increase in the fair value of our securities portfolio of $3.1 million.

In 2010, we completed a $32.0 million private placement to accredited investors. In the transactions involved, the Company issued (i) 2,465,569 common shares, (ii) 317,042 Series C Preferred Shares and (iii) warrants to purchase 1,163,045 non-voting common shares at a price of $11.50 per share.

The Series C Preferred Shares had no voting rights (except when required by law), had a liquidation preference over our common shares, and dividend rights equivalent to our common shares. Each Series C Preferred Share would have automatically converted into 1.05 common shares if transferred by the holder in certain transactions in accordance with the policy of the Federal Reserve.

On November 21, 2008, we issued to the UST 35,000 shares of our Series A Preferred Stock and a warrant to purchase up to 330,561 of our common shares for $15.88 per share for aggregate consideration of $35.0 million.

In December 2014, we completed a non-cash equity exchange transaction with the accredited investors who acquired all of our issued and outstanding Series A Preferred Shares from UST in a public auction. We acquired and cancelled all of the issued and outstanding Series A Preferred Shares, the accrued dividends thereon, all of the issued and outstanding Series C Preferred Shares, and warrants to purchase 798,915 shares of common stock together having an aggregate book value of approximately $45.7 million. In exchange, we issued common and preferred shares having a fair value of approximately $9.6 million. The effect of this exchange transaction was to increase common stockholders’ equity by approximately $36.1 million, and total stockholders’ equity by $7.4 million.

 

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In the exchange transaction, we issued 1,821,428 common shares, 40,536 mandatorily convertible Series B Preferred Shares and 64,580 mandatorily convertible Series D Preferred Shares, which automatically converted into 4,053,600 common shares and 6,458,000 non-voting common shares after shareholder approval on February 25, 2015. We also issued 6,198 Series E Preferred Shares and 4,304 Series F Preferred Shares, both of which series are not convertible into common shares, have a liquidation preference of $1,000 per share, and are entitled to a 2% noncumulative annual dividend if and when declared. Series E and Series F Preferred Shares rank senior to, and have liquidation and dividend preferences over, our common shares and non-voting common shares.

Kentucky banking laws limit the amount of dividends that may be paid to a holding company by its subsidiary banks without prior approval. These laws limit the amount of dividends that may be paid in any calendar year to current year’s net income, as defined in the laws, combined with the retained net income of the preceding two years, less any dividends declared during those periods. During 2015, the amount available to be paid by the Bank to the Company would be equal to 2015 earnings to date. However, the Bank has agreed with its primary regulators to obtain their written consent prior to declaring or paying any future dividends.

Each of the federal bank regulatory agencies has established risk-based capital requirements for banking organizations. See Item 1. Business – Supervision and Regulation – Porter Bancorp – Capital Adequacy Requirements and PBI Bank – Capital Requirements. In addition, the Bank has agreed with its primary regulators to maintain a ratio of total capital to total risk-weighted assets (“total risk-based capital ratio”) of at least 12.0%, and a ratio of Tier 1 capital to average assets (“leverage ratio”) of 9.0%.

The following table shows the ratios of Tier 1 capital and total capital to risk-adjusted assets and the leverage ratios for the Company and the Bank at December 31, 2014:

 

     Regulatory
Minimums
    Well-
Capitalized

Minimums
    Minimum
Capital
Ratios
Under

Consent
Order
    Porter
Bancorp
    PBI
Bank
 

Tier 1 Capital

     4.0     6.0     N/A        6.70     8.59

Total risk-based capital

     8.0        10.0        12.0     10.61        10.57   

Tier 1 leverage ratio

     4.0        5.0        9.0        4.51        5.78   

At December 31, 2014, the Bank’s Tier 1 leverage ratio was 5.78% and its total risk-based capital ratio was 10.57%, which are both below the 9% minimum leverage ratio and the 12% minimum risk-based capital ratio required by the Consent Order shown in the table above. Bank regulatory agencies can exercise discretion when an institution does not maintain minimum capital levels or meet the other terms of a consent order. The agencies may initiate changes in management, issue mandatory directives, impose monetary penalties or refrain from formal sanctions, depending on individual circumstances. Any action taken by bank regulatory agencies could damage our reputation and have a material adverse effect on our business.

Off Balance Sheet Arrangements

In the normal course of business, we enter into various transactions, which, in accordance with GAAP, are not included in our consolidated balance sheets. We enter into these transactions to meet the financing needs of our customers. These transactions include commitments to extend credit and standby letters of credit, which involve, to varying degrees, elements of credit risk and interest rate risk in excess of the amounts recognized in the consolidated balance sheets.

 

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Our commitments associated with outstanding standby letters of credit and commitments to extend credit as of December 31, 2014 are summarized below. Since commitments associated with letters of credit and commitments to extend credit may expire unused, the amounts shown do not necessarily reflect our actual future cash funding requirements:

 

     One year
or less
     More than 1
year but less
than 3 years
     3 years or
more but less
than 5 years
     5 years
or more
     Total  
     (dollars in thousands)  

Commitments to extend credit

   $ 22,755       $ 18,622       $ 5,484       $ 21,409       $ 68,270   

Standby letters of credit

     2,320         —           —           —           2,320   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

$ 25,075    $ 18,622    $ 5,484    $ 21,409    $ 70,590   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Standby Letters of Credit – Standby letters of credit are written conditional commitments we issue to guarantee the performance of a borrower to a third party. If the borrower does not perform in accordance with the terms of the agreement with the third party, we may be required to fund the commitment. The maximum potential amount of future payments we could be required to make is represented by the contractual amount of the commitment. If the commitment is funded, we would be entitled to seek recovery from the borrower. Our policies generally require that standby letter of credit arrangements contain security and debt covenants similar to those contained in loan agreements.

Commitments to Extend Credit – We enter into contractual commitments to extend credit, normally with fixed expiration dates or termination clauses, at specified rates and for specific purposes. Substantially all of our commitments to extend credit are contingent upon borrowers maintaining specific credit standards at the time of loan funding. We minimize our exposure to loss under these commitments by subjecting them to credit approval and monitoring procedures.

Contractual Obligations

The following table summarizes our contractual obligations and other commitments to make future payments as of December 31, 2014:

 

     One year
or less
     More than 1
year but less
than 3 years
     3 years or
more but less
than 5 years
     5 years or
more
     Total  
     (dollars in thousands)  

Time deposits

   $ 416,486       $ 107,684       $ 50,509       $ 2       $ 574,681   

FHLB borrowing (1)

     12,709         1,166         451         1,426         15,752   

Subordinated capital note

     900         1,800         1,800         450         4,950   

Junior subordinated debentures

     —           —           —           25,000         25,000   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

$ 430,095    $ 110,650    $ 52,760    $ 26,878    $ 620,383   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

(1)

Fixed rate mortgage-matched borrowings with rates ranging from 0% to 5.25%, and maturities ranging from 2015 through 2033, averaging 1.02%.

Impact of Inflation and Changing Prices

The financial statements and related data presented herein have been prepared in accordance with U.S. generally accepted accounting principles, which require the measurement of financial position and operating results in historical dollars without considering changes in the relative purchasing power of money over time due to inflation.

We have an asset and liability structure that is essentially monetary in nature. As a result, interest rates have a more significant impact on our performance than the effects of general levels of inflation. Periods of high inflation are often accompanied by relatively higher interest rates, and periods of low inflation are accompanied by relatively lower interest rates. As market interest rates rise or fall in relation to the rates earned on our loans and investments, the value of these assets decreases or increases respectively.

 

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Item 7A. Quantitative and Qualitative Disclosures About Market Risk

To minimize the volatility of net interest income and exposure to economic loss that may result from fluctuating interest rates, we manage our exposure to adverse changes in interest rates through asset and liability management activities within guidelines established by our Asset Liability Committee (“ALCO”). The ALCO, which is comprised of senior management representatives, has the responsibility for approving and ensuring compliance with asset/liability management policies. Interest rate risk is the exposure to adverse changes in the net interest income as a result of market fluctuations in interest rates. The ALCO, on an ongoing basis, monitors interest rate and liquidity risk in order to implement appropriate funding and balance sheet strategies. Management considers interest rate risk to be our most significant market risk.

We utilize an earnings simulation model to analyze net interest income sensitivity. We then evaluate potential changes in market interest rates and their subsequent effects on net interest income. The model projects the effect of instantaneous movements in interest rates of both 100 and 200 basis points that are sustained for one year. Assumptions based on the historical behavior of our deposit rates and balances in relation to changes in interest rates are also incorporated into the model. These assumptions are inherently uncertain and, as a result, the model cannot precisely measure future net interest income or precisely predict the impact of fluctuations in market interest rates on net interest income. Actual results will differ from the model’s simulated results due to timing, magnitude and frequency of interest rate changes as well as changes in market conditions and the application and timing of various management strategies.

Our interest sensitivity profile was liability sensitive at December 31, 2014 and asset sensitive at December 31, 2013. Given an instantaneous 100 basis point increase in interest rates our base net interest income would decrease by an estimated 3.2% at December 31, 2014 compared with an increase of 2.5% at December 31, 2013.

The following table indicates the estimated impact on net interest income under various interest rate scenarios for the year ended December 31, 2014, as calculated using the static shock model approach:

 

     Change in Future
Net Interest Income
 
     Dollar
Change
     Percentage
Change
 
     (dollars in thousands)  

+ 200 basis points

   $ (1,613 )      (5.86 )% 

+ 100 basis points

     (868 )      (3.15

We did not run a model simulation for declining interest rates as of December 31, 2014, because the Federal Reserve’s federal funds target rate currently stands between 0.00% to 0.25%. Therefore, further short-term rate reductions are not practical. As we implement strategies to mitigate the risk of rising interest rates in the future, these strategies will lessen our forecasted “base case” net interest income in the event of no interest rate changes.

Our interest sensitivity at any point in time will be affected by a number of factors. These factors include the mix of interest sensitive assets and liabilities as well as their relative pricing schedules. It is also influenced by market interest rates, deposit growth, loan growth, decay rates and prepayment speed assumptions.

The following table sets forth the amounts of our interest-earning assets and interest-bearing liabilities outstanding at December 31, 2014, which we anticipate, based upon certain assumptions, to reprice or mature in each of the future time periods shown. The projected repricing of assets and liabilities anticipates prepayments and scheduled rate adjustments, as well as contractual maturities under an interest rate unchanged scenario within the selected time intervals. While we believe such assumptions are reasonable, we cannot assure you that assumed repricing rates will approximate our actual future activity.

 

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Table of Contents
     Volume Subject to Repricing Within  
     0 – 90
Days
    91 – 181
Days
    182 – 365
Days
    1 – 5
Years
    Over 5
Years
    Non-
Interest
Sensitive
    Total  
     (dollars in thousands)  

Assets:

            

Federal funds sold and short-term investments

   $ 66,011      $ —        $ —        $ —        $ —        $ —        $ 66,011   

Investment securities

     30,635        6,784        16,669        85,795        85,718        7,515        233,116   

FHLB stock

     7,323        —          —          —          —          —          7,323   

Loans held for sale

     8,926        —          —          —          —          —          8,926   

Loans, net of allowance

     226,686        62,466        94,296        174,686        66,865        (19,364     605,635   

Fixed and other assets

     —          —          —          —          —          96,978        96,978   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total assets

$ 339,581    $ 69,250    $ 110,965    $ 260,481    $ 152,583    $ 85,129    $ 1,017,989   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Liabilities and Stockholders’ Equity

Interest-bearing checking, savings, and money market accounts

$ 237,250    $ —      $ —      $ —      $ —      $ —      $ 237,250   

Certificates of deposit

  116,909      101,885      195,412      159,576      899      —        574,681   

Borrowed funds

  43,471      182      368      2,286      736      —        47,043   

Other liabilities

  —        —        —        —        —        125,550      125,550   

Stockholders’ equity

  —        —        —        —        —        33,465      33,465   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total liabilities and stockholders’ equity

$ 397,630    $ 102,067    $ 195,780    $ 161,862    $ 1,635    $ 159,015    $ 1,017,989   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Period gap

$ (58,049 ) $ (32,817 $ (84,815 ) $ 98,619    $ 150,948   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

     

Cumulative gap

$ (58,049 ) $ (90,866 ) $ (175,681 ) $ (77,062 ) $ 73,886   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

     

Period gap to total assets

  (5.70 )%    (3.22 )%    (8.33 )%    9.69   14.83
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

     

Cumulative gap to total assets

  (5.70 )%    (8.93 )%   (17.26 )%    (7.57 )%    7.26
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

     

Cumulative interest-earning assets to cumulative interest-bearing liabilities

  85.40   81.82 %   74.74 %   91.01 %   108.60
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

     

Our one-year cumulative gap position as of December 31, 2014 was negative $ 175.7 million or 17.3% of total assets. This is a one-day position that is continually changing and is not necessarily indicative of our position at any other time. Any gap analysis has inherent shortcomings because certain assets and liabilities may not move proportionally as interest rates change.

 

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Table of Contents
Item 8. Financial Statements and Supplementary Data

The following consolidated financial statements and reports are included in this section:

Management’s Report on Internal Control Over Financial Reporting

Report of Independent Registered Public Accounting Firm

Consolidated Balance Sheets as of December 31, 2014 and 2013

Consolidated Statements of Operations for the Years Ended December 31, 2014, 2013, and 2012

Consolidated Statements of Comprehensive Income (Loss) for the Years Ended December 31, 2014, 2013, and 2012

Consolidated Statements of Change in Stockholders’ Equity for the Years Ended December 31, 2014, 2013, and 2012

Consolidated Statements of Cash Flows for the Years Ended December 31, 2014, 2013, and 2012

Notes to Consolidated Financial Statements

 

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LOGO

MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING

The management of Porter Bancorp, Inc. is responsible for establishing and maintaining adequate internal control over financial reporting. Internal control over financial reporting is defined in Rule 13a-15(1) promulgated under the Securities Exchange Act of 1934 as a process designed by, or under the supervision of; our principal executive and principal financial officers and effected by the board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles and includes those policies and procedures that:

Pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of our assets;

Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with U.S. generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with authorizations of our management and directors; and

Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

Management assessed the effectiveness of our internal control over financial reporting as of December 31, 2014. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) in the 1992 Internal Control-Integrated Framework. Based on that assessment, we believe that, as of December 31, 2014, our internal control over financial reporting is not effective based on those criteria. See “Item 9A. Controls and Procedures” for further discussion of the material weakness related to controls over the initial recording of an other real estate owned transaction at fair value less cost to sell. This annual report does not include an attestation report of our registered public accounting firm regarding internal controls over financial reporting. Management’s report was not subject to attestation by our registered public accounting firm pursuant to rules of the Securities and Exchange Commission that permit us to provide only management’s report in this annual report.

 

/s/ John T. Taylor

/s/ Phillip W. Barnhouse

John T. Taylor

Chief Executive Officer

Phillip W. Barnhouse

Chief Financial Officer

March 30, 2015

 

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LOGO

Crowe Horwath LLP

Independent Member Crowe Horwath International

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

Porter Bancorp, Inc.

Louisville, Kentucky

We have audited the accompanying consolidated balance sheets of Porter Bancorp, Inc. as of December 31, 2014 and 2013, and the related consolidated statements of operations, comprehensive income (loss), changes in stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2014. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of express