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EX-32 - EXHIBIT 32 - COMMUNITY FINANCIAL CORP /MD/v423319_ex32.htm
EX-31 - EXHIBIT 31 - COMMUNITY FINANCIAL CORP /MD/v423319_ex31.htm

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

x     QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the Quarterly Period Ended September 30, 2015

 

OR

 

¨     TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from ______ to ______

 

Commission File Number 0-18279

 

The Community Financial Corporation

(Exact name of registrant as specified in its charter)

 

  Maryland   52-1652138  
  (State of other jurisdiction of   (I.R.S. Employer  
  incorporation or organization)   Identification No.)  

 

  3035 Leonardtown Road, Waldorf, Maryland 20601  
  (Address of principal executive offices) (Zip Code)  

 

(301) 645-5601

(Registrant's telephone number, including area code)

 

Not applicable

(Former name, former address and former fiscal year, if changed since last report)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter 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 during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes x                   No ¨

 

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

 

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

 

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

Yes ¨                   No x

 

As of October 29, 2015, the registrant had 4,710,414 shares of common stock outstanding.

 

 

 

 

THE COMMUNITY FINANCIAL CORPORATION

FORM 10-Q

 

INDEX 

   
  Page
PART I - FINANCIAL INFORMATION  
   
Item 1 – Financial Statements (Unaudited)  
   
Consolidated Balance Sheets – September 30, 2015 and December 31, 2014 1
   
Consolidated Statements of Income -  Three and Nine Months Ended September 30, 2015 and 2014 2
   
Consolidated Statements of Comprehensive Income - Three and Nine Months Ended September 30, 2015 and 2014 3
   
Consolidated Statements of Cash Flows -  Nine Months Ended September 30, 2015 and 2014 4
   
Notes to Consolidated Financial Statements 6
   
Item 2 – Management’s Discussion and Analysis of Financial Condition  and Results of Operations 31
   
Item 3 – Quantitative and Qualitative Disclosures about Market Risk 56
   
Item 4 – Controls and Procedures 57
   
PART II - OTHER INFORMATION  
   
Item 1 –    Legal Proceedings 58
   
Item 1A – Risk Factors 58
   
Item 2 –    Unregistered Sales of Equity Securities and Use of Proceeds 58
   
Item 3 –    Defaults Upon Senior Securities 58
   
Item 4 –    Mine Safety Disclosures 58
   
Item 5 –    Other Information 58
   
Item 6 –    Exhibits 58
   
SIGNATURES 59

 

 

 

 

PART 1 - FINANCIAL INFORMATION

ITEM 1 – FINANCIAL STATEMENTS

 

CONSOLIDATED BALANCE SHEETS

 

   September 30, 2015   December 31, 2014 
(dollars in thousands)  (Unaudited)     
Assets          
Cash and due from banks  $12,345   $17,275 
Federal funds sold   425    965 
Interest-bearing deposits with banks   1,312    3,133 
Securities available for sale (AFS), at fair value   38,989    41,939 
Securities held to maturity (HTM), at amortized cost   93,941    84,506 
Federal Home Loan Bank (FHLB) and Federal Reserve Bank (FRB) stock - at cost   6,677    6,434 
Loans receivable - net of allowance for loan losses of $8,375 and $8,481   889,870    862,409 
Premises and equipment, net   19,675    20,586 
Premises and equipment held for sale   2,000    - 
Other real estate owned (OREO)   6,431    5,883 
Accrued interest receivable   3,127    3,036 
Investment in bank owned life insurance   27,637    27,021 
Other assets   9,547    9,691 
Total Assets  $1,111,976   $1,082,878 
           
Liabilities and Stockholders' Equity          
Liabilities          
Deposits          
Non-interest-bearing deposits  $123,637   $122,195 
Interest-bearing deposits   758,642    747,189 
Total deposits   882,279    869,384 
Short-term borrowings   14,000    2,000 
Long-term debt   70,631    74,672 
Guaranteed preferred beneficial interest in junior subordinated debentures (TRUPs)   12,000    12,000 
Subordinated notes - 6.25%   23,000    - 
Accrued expenses and other liabilities   10,007    8,263 
Total Liabilities   1,011,917    966,319 
           
Stockholders' Equity          
Preferred Stock, Senior Non-Cumulative Perpetual, Series C - par value $1,000; authorized and issued 20,000 at December 31, 2014 and none at September 30, 2015   -    20,000 
Common stock - par value $.01; authorized - 15,000,000 shares; issued 4,709,945 and 4,702,715 shares, respectively   47    47 
Additional paid in capital   46,755    46,416 
Retained earnings   53,817    50,936 
Accumulated other comprehensive loss   (70)   (378)
Unearned ESOP shares   (490)   (462)
Total Stockholders' Equity   100,059    116,559 
Total Liabilities and Stockholders' Equity  $1,111,976   $1,082,878 

 

See notes to Consolidated Financial Statements

 

1 

 

 

CONSOLIDATED STATEMENTS OF INCOME (Unaudited)

 

   Three Months Ended September 30,   Nine Months Ended September 30, 
(dollars in thousands, except per share amounts )  2015   2014   2015   2014 
Interest and Dividend Income                    
Loans, including fees  $10,336   $10,114   $30,886   $29,382 
Taxable interest and dividends on investment securities   661    550    1,768    1,705 
Interest on deposits with banks   5    3    11    9 
Total Interest and Dividend Income   11,002    10,667    32,665    31,096 
                     
Interest Expense                    
Deposits   1,068    1,135    3,098    3,502 
Short-term borrowings   5    3    26    10 
Long-term debt   845    525    2,361    1,576 
Total Interest Expense   1,918    1,663    5,485    5,088 
                     
Net Interest Income   9,084    9,004    27,180    26,008 
Provision for loan losses   501    385    1,071    1,151 
Net Interest Income After Provision For Loan Losses   8,583    8,619    26,109    24,857 
                     
Noninterest Income                    
Loan appraisal, credit, and miscellaneous charges   61    143    209    335 
Gain on sale of asset   -    -    19    7 
Net (losses) gains on sale of OREO   (2)   56    (20)   60 
Net (losses) gains on sale of investment securities   -    -    (1)   24 
Loss on premises and equipment held for sale   (426)   -    (426)   - 
Income from bank owned life insurance   206    160    616    463 
Service charges   627    555    1,889    1,631 
Gain on sale of loans held for sale   -    204    104    348 
Total Noninterest Income   466    1,118    2,390    2,868 
                     
Noninterest Expense                    
Salary and employee benefits   4,185    3,939    12,218    11,960 
Occupancy expense   599    568    1,834    1,787 
Advertising   164    157    450    480 
Data processing expense   475    475    1,500    1,127 
Professional fees   353    249    920    767 
Depreciation of premises and equipment   210    181    615    548 
Telephone communications   56    41    141    132 
Office supplies   38    12    108    166 
FDIC Insurance   197    204    585    542 
OREO valuation allowance and expenses   129    38    682    332 
Other   625    621    1,809    1,742 
Total Noninterest Expense   7,031    6,485    20,862    19,583 
                     
Income before income taxes   2,018    3,252    7,637    8,142 
Income tax expense   735    1,363    2,822    3,197 
Net Income  $1,283   $1,889   $4,815   $4,945 
Preferred stock dividends   -    50    23    150 
Net Income Available to Common Stockholders  $1,283   $1,839   $4,792   $4,795 
                     
Earnings Per Common Share                    
Basic  $0.28   $0.40   $1.03   $1.03 
Diluted  $0.27   $0.39   $1.02   $1.03 
Cash dividends paid per common share  $0.10   $0.10   $0.30   $0.30 

 

See notes to Consolidated Financial Statements

 

2 

 

 

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited)

 

   Three Months Ended September 30,   Nine Months Ended September 30, 
(dollars in thousands)  2015   2014   2015   2014 
                 
Net Income  $1,283   $1,889   $4,815   $4,945 
Net unrealized holding gains (losses) arising during period, net of tax expense (benefit) of $151 and $(23); $201 and $64, respectively   230    152    308    319 
Reclassification adjustment for gains included in net income, net of tax expense (benefit) of $0 and $0; $0 and $(3), respectively   -    -    -    (5)
Comprehensive Income  $1,513   $2,041   $5,123   $5,259 

 

See notes to Consolidated Financial Statements

 

3 

 

 

CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

 

   Nine Months Ended Septemeber 30, 
(dollars in thousands)  2015   2014 
         
Cash Flows from Operating Activities          
Net income  $4,815   $4,945 
Adjustments to reconcile net income to net cash provided by operating activities          
Provision for loan losses   1,071    1,151 
Depreciation and amortization   1,055    954 
Loss on premises and equipment held for sale   426    - 
Loans originated for sale   (4,192)   (9,648)
Proceeds from sale of loans originated for sale   4,296    9,936 
Gain on sale of loans held for sale   (104)   (348)
Net loss (gains) on the sale of OREO   20    (60)
Losses (gains) on sales of HTM investment securities   1    (16)
Gains on sales of AFS investment securities   -    (8)
Gain on sale of asset   (19)   (7)
Net amortization of premium/discount on investment securities   157    245 
Increase in OREO valuation allowance   447    234 
Increase in cash surrender of bank owned life insurance   (617)   (463)
Increase in deferred income tax benefit   (571)   (378)
Increase in accrued interest receivable   (91)   (77)
Stock based compensation   182    147 
Decrease (increase) in deferred loan fees   (4)   166 
Increase (decrease) in accrued expenses and other liabilities   1,745    (113)
Decrease in other assets   641    2,470 
Net Cash Provided by Operating Activities   9,258    9,130 
           
Cash Flows from Investing Activities          
Purchase of AFS investment securities   (2,062)   (3,229)
Proceeds from redemption or principal payments of AFS investment securities   5,409    6,307 
Purchase of HTM investment securities   (23,647)   (4,580)
Proceeds from maturities or principal payments of HTM investment securities   14,099    10,840 
Net increase of FHLB and FRB stock   (243)   (843)
Purchase of bank owned life insurance policies   -    (7,000)
Loans originated or acquired   (180,539)   (188,276)
Principal collected on loans   150,067    147,577 
Purchase of premises and equipment   (2,585)   (1,807)
Proceeds from sale of OREO   930    1,878 
Proceeds from sale of HTM investment securities   66    3,179 
Proceeds from sale of AFS investment securities   -    2,056 
Proceeds from disposal of asset   34    20 
           
Net Cash Used in Investing Activities   (38,471)   (33,878)

 

4 

 

 

CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

(continued)

 

   Nine Months Ended Septemeber 30, 
(dollars in thousands)  2015   2014 
         
Cash Flows from Financing Activities          
Net increase in deposits  $12,895   $8,525 
Proceeds from long-term debt   -    5,000 
Payments of long-term debt   (4,041)   (790)
Net increase in short term borrowings   12,000    2,000 
Exercise of stock options   -    106 
Proceeds from subordinated notes   23,000    - 
Redemption of Small Business Lending Fund Preferred Stock   (20,000)   - 
Dividends paid   (1,456)   (1,545)
Net change in unearned ESOP shares   (28)   - 
Repurchase of common stock   (448)   - 
Net Cash Provided by Financing Activities   21,922    13,296 
Decrease in Cash and Cash Equivalents  $(7,291)  $(11,452)
           
Cash and Cash Equivalents - January 1   21,373    24,519 
Cash and Cash Equivalents - September 30  $14,082   $13,067 
           
Supplemental Disclosures of Cash Flow Information          
Cash paid during the period for          
Interest  $5,276   $5,066 
Income taxes  $2,518   $2,659 
           
Supplemental Schedule of Non-Cash Operating Activities          
Issuance of common stock for payment of compensation  $216   $182 
Transfer from loans to OREO  $1,947   $1,590 
Transfer from premises and equipment to premises and equipment held for sale  $2,000   $- 

 

See notes to Consolidated Financial Statements

 

5 

 

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

 

NOTE 1 – BASIS OF PRESENTATION

The consolidated financial statements of The Community Financial Corporation (the “Company”) and its wholly owned subsidiary, Community Bank of the Chesapeake (the “Bank”), and the Bank’s wholly owned subsidiary, Community Mortgage Corporation of Tri-County, included herein are unaudited.

 

The consolidated financial statements reflect all adjustments consisting only of normal recurring accruals that, in the opinion of management, are necessary to present fairly the Company’s financial condition, results of operations, and cash flows for the periods presented. Certain information and note disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission. The Company believes that the disclosures are adequate to make the information presented not misleading. The balances as of December 31, 2014 have been derived from audited financial statements. There have been no significant changes to the Company’s accounting policies as disclosed in the 2014 Annual Report. The results of operations for the three and nine months ended September 30, 2015 are not necessarily indicative of the results of operations to be expected for the remainder of the year or any other period. Certain previously reported amounts have been restated to conform to the 2015 presentation.

 

These consolidated financial statements should be read in conjunction with the consolidated financial statements and notes included in the Company’s 2014 Annual Report.

 

NOTE 2 – NATURE OF BUSINESS

The Company provides a variety of financial services to individuals and businesses through its offices in Southern Maryland and Fredericksburg, Virginia. Its primary deposit products are demand, savings and time deposits, and its primary lending products are commercial and residential mortgage loans, commercial loans, construction and land development loans, home equity and second mortgages and commercial equipment loans.

 

The Bank conducts business through its main office in Waldorf, Maryland, and eleven branch offices in Waldorf, Bryans Road, Dunkirk, Leonardtown, La Plata, Charlotte Hall, Prince Frederick, Lusby, California, Maryland; and King George and Fredericksburg, Virginia. The Company maintains five loan production offices (“LPOs”) in Annapolis, La Plata, Prince Frederick and Leonardtown, Maryland; and Fredericksburg, Virginia. The Leonardtown and Fredericksburg LPOs are co-located with branches. The Company opened its branch in Fredericksburg, Virginia in July 2014 and its LPO in Annapolis, Maryland in October 2014.

 

The Company agreed to sell its King George, Virginia branch building and equipment to a credit union. The transaction is expected to close in the first quarter of 2016, pending regulatory approval. The third quarter 2015 operating results reflect the financial impact of the transaction. See Note 16 for additional information.

 

NOTE 3 – INCOME TAXES

The Company files a consolidated federal income tax return with its subsidiaries. Deferred tax assets and liabilities are determined using the liability (or balance sheet) method. Under this method, the net deferred tax asset or liability is determined based on the tax effects of the temporary differences between the book and tax bases of the various balance sheet assets and liabilities and gives current recognition to changes in tax rates and laws and when it is considered more likely than not that deferred tax assets will be realized. It is the Company’s policy to recognize accrued interest and penalties related to unrecognized tax benefits as a component of tax expense. The Company’s income tax returns for the past three years are subject to examinations by tax authorities, and may change upon examination.

 

6 

 

 

NOTE 4 - ACCUMULATED OTHER COMPREHENSIVE GAIN (LOSS)

The following tables present the components of comprehensive gain (loss) for the three and nine months ended September 30, 2015 and 2014. The Company’s comprehensive gain (loss) was solely related to securities for the three and nine months ended September 30, 2015 and 2014.

  

  

Three Months Ended

September 30, 2015

  

Three Months Ended

September 30, 2014

 
(dollars in thousands)  Before Tax   Tax Effect   Net of Tax   Before Tax   Tax Effect   Net of Tax 
Net unrealized holding gains (losses) arising during period  $381   $151   $230   $129   $(23)  $152 
Reclassification adjustments   -    -    -    -    -    - 
Other comprehensive gain (loss)  $381   $151   $230   $129   $(23)  $152 

 

  

Nine Months Ended

September 30, 2015

  

Nine Months Ended

Septemeber 30, 2014

 
(dollars in thousands)  Before Tax   Tax Effect   Net of Tax   Before Tax   Tax Effect   Net of Tax 
                         
Net unrealized holding gains  arising during period  $509   $201   $308   $383   $64   $319 
Reclassification adjustments   -    -    -    (8)   (3)   (5)
Other comprehensive gain  $509   $201   $308   $375   $61   $314 

 

The following table presents the changes in each component of accumulated other comprehensive loss, net of tax, for the three and nine months ended September 30, 2015 and 2014.

 

   Three Months
Ended
September 30,
2015
   Three Months
Ended
September 30,
2014
   Nine Months
Ended
September 30,
2015
   Nine Months
Ended
September 30,
2014
 
(dollars in thousands)  Net Unrealized
Gains And Losses
   Net Unrealized
Gains And Losses
   Net Unrealized
Gains And Losses
   Net Unrealized
Gains And Losses
 
                 
Beginning of period  $(300)  $(895)  $(378)  $(1,057)
Other comprehensive gain (loss) before reclassifications   230    152    308    319 
Amounts reclassified from accumulated other comprehensive income   -    -    -    (5)
Net other comprehensive gain (loss)   230    152    308    314 
End of period  $(70)  $(743)  $(70)  $(743)

 

NOTE 5 - EARNINGS PER SHARE (“EPS”)

Basic earnings per common share represent income available to common shareholders, divided by the weighted average number of common shares outstanding during the period. Diluted earnings per share reflect additional common shares that would have been outstanding if dilutive potential common shares had been issued. Potential common shares that may be issued by the Company relate to outstanding stock options and are determined using the treasury stock method. At both September 30, 2015 and 2014, there were 87,436 options, which were excluded from the calculation as their effect would be anti-dilutive, because the exercise price of the options were greater than the average market price of the common shares. The Company has not granted any stock options since 2007 and all options outstanding at September 30, 2015 were anti-dilutive. Unvested restricted stock is excluded from the calculation of basic earnings per share. At September 30, 2015 there were 37,048 unvested shares of restricted stock. Basic and diluted earnings per share have been computed based on weighted-average common and common equivalent shares outstanding as follows:

 

7 

 

 

   Three Months Ended   Nine Months Ended 
   September 30,   September 30, 
(dollars in thousands)  2015   2014   2015   2014 
Net Income  $1,283   $1,889   $4,815   $4,945 
Less: dividends paid and accrued on preferred stock   -    (50)   (23)   (150)
Net income available to common shareholders  $1,283   $1,839   $4,792   $4,795 
                     
Average number of common shares outstanding   4,646,702    4,652,481    4,651,383    4,648,843 
Dilutive effect of common stock equivalents   37,048    17,303    37,048    16,604 
Average number of shares used to calculate diluted EPS   4,683,750    4,669,784    4,688,431    4,665,447 

 

NOTE 6 - STOCK-BASED COMPENSATION

The Company has stock-based incentive arrangements to attract and retain key personnel. In May 4, 2015, the 2015 Equity Compensation Plan (the “Plan”) was approved by shareholders, which authorizes the issuance of restricted stock, stock appreciation rights, stock units and stock options to the Board of Directors and key employees. Compensation expense for service-based awards is recognized over the vesting period. Performance-based awards are recognized based on a vesting schedule, if applicable, and the probability of achieving goals specified at the time of the grant.

 

Stock-based compensation expense totaled $61,000 and $182,000 for the three and nine months ended September 30, 2015, respectively, and $810 and $147,000 for the three and nine months ended September 30, 2014, respectively. Stock-based compensation expense consisted of the vesting of grants of restricted stock. In addition, in 2014 stock-based compensation expense included the vesting of restricted stock units.

 

All outstanding options were fully vested and the Company has not granted any stock options since 2007. The fair value of the Company’s outstanding employee stock options is estimated on the date of grant using the Black-Scholes option pricing model. The Company estimates expected market price volatility and expected term of the options based on historical data and other factors.

 

The exercise price for options granted is set at the discretion of the committee administering the Plan, but is not less than the market value of the shares as of the date of grant. An option’s maximum term is 10 years and the options vest at the discretion of the committee.

 

The following tables below summarize outstanding and exercisable options at September 30, 2015 and December 31, 2014.

 

       Weighted       Weighted-Average 
       Average   Aggregate   Contractual Life 
       Exercise   Intrinsic   Remaining In 
(dollars in thousands, except per share amounts)  Shares   Price   Value   Years 
                 
Outstanding at January 1, 2015   87,436   $23.60   $-      
Exercised   -    -    -      
Forfeited   -    -           
                     
Outstanding at September 30, 2015   87,436   $23.60   $80    - 
                     
Exercisable at September 30, 2015   87,436   $23.60   $80    - 

 

8 

 

 

       Weighted      

Weighted-

Average

 
       Average   Aggregate   Contractual Life 
       Exercise   Intrinsic   Remaining In 
(dollars in thousands, except per share amounts)  Shares   Price   Value   Years 
                 
Outstanding at January 1, 2014   159,517   $20.12   $347      
Exercised   (45,163)   15.89    207      
Forfeited   (26,918)   15.89           
Outstanding at December 31, 2014   87,436   $23.60   $-    - 
                     
Exercisable at December 31, 2014   87,436   $23.60   $-    - 

 

Options outstanding are all currently exercisable and are summarized as follows:

 

Shares Outstanding   Weighted Average  Weighted Average 
September 30, 2015   Remaining Contractual Life  Exercise Price 
 66,225   1 years  $22.29 
 21,211   2 years   27.70 
 87,436      $23.60 

 

The aggregate intrinsic value of outstanding stock options and exercisable stock options was $80,000 at September 30, 2015 and $0 at December 31, 2014. All options outstanding at December 31, 2014 were anti-dilutive and the intrinsic value was $0. Aggregate intrinsic value represents the difference between the Company’s closing stock price on the last trading day of the period, which was $23.50 and $20.07 per share at September 30, 2015 and December 31, 2014, respectively, and the exercise price multiplied by the number of in the money options outstanding.

 

The Company granted restricted stock and stock units in accordance with the Plan. The vesting period for granted restricted stock is between three and five years. As of September 30, 2015, unrecognized stock compensation expense was $769,000. The following tables summarize the unvested restricted stock awards and units outstanding at September 30, 2015 and December 31, 2014, respectively. There were no outstanding stock units at September 30, 2015 and December 31, 2014, respectively.

 

   Restricted Stock 
   Number of Shares  

Weighted

Average Grant

Date Fair Value

 
         
Nonvested at January 1, 2015   29,472   $20.83 
Granted   28,040    18.63 
Vested   (20,464)   19.62 
           
Nonvested at September 30, 2015   37,048   $19.83 

 

   Restricted Stock   Restricted Stock Units 
  

Number of

Shares

   Weighted
Average Grant
Date Fair Value
   Number of Units   Fair Value 
                 
Nonvested at January 1, 2014   16,832   $17.86    4,210   $20.71 
Granted   33,460    21.35    -    - 
Vested   (20,820)   19.26    (4,210)   20.28 
                     
Nonvested at December 31, 2014   29,472   $20.83    -   $- 

 

9 

 

 

NOTE 7 - GUARANTEED PREFERRED BENEFICIAL INTEREST IN JUNIOR SUBORDINATED DEBENTURES (“TRUPs”)

On June 15, 2005, Tri-County Capital Trust II (“Capital Trust II”), a Delaware business trust formed, funded and wholly owned by the Company, issued $5.0 million of variable-rate capital securities in a private pooled transaction. The variable rate is based on the 90-day LIBOR rate plus 1.70%. The Trust used the proceeds from this issuance, along with the $155,000 for Capital Trust II’s common securities, to purchase $5.2 million of the Company’s junior subordinated debentures. The interest rate on the debentures and the trust preferred securities is variable and adjusts quarterly. These capital securities qualify as Tier I capital and are presented in the Consolidated Balance Sheets as “Guaranteed Preferred Beneficial Interests in Junior Subordinated Debentures.” Both the capital securities of Capital Trust II and the junior subordinated debentures are scheduled to mature on June 15, 2035, unless called by the Company.

 

On July 22, 2004, Tri-County Capital Trust I (“Capital Trust I”), a Delaware business trust formed, funded and wholly owned by the Company, issued $7.0 million of variable-rate capital securities in a private pooled transaction. The variable rate is based on the 90-day LIBOR rate plus 2.60%. The Trust used the proceeds from this issuance, along with the Company’s $217,000 capital contribution for Capital Trust I’s common securities, to purchase $7.2 million of the Company’s junior subordinated debentures. The interest rate on the debentures and the trust preferred securities is variable and adjusts quarterly. These debentures qualify as Tier I capital and are presented in the Consolidated Balance Sheets as “Guaranteed Preferred Beneficial Interests in Junior Subordinated Debentures.” Both the capital securities of Capital Trust I and the junior subordinated debentures are scheduled to mature on July 22, 2034, unless called by the Company.

 

NOTE 8 – SUBORDINATED NOTES

On February 6, 2015 the Company issued $23.0 million of unsecured 6.25% fixed to floating rate subordinated notes due February 15, 2025 (“subordinated notes”). On February 13, 2015, the Company used proceeds of the offering to redeem all $20 million of the Company’s outstanding preferred stock issued under the Small Business Lending Fund (“SBLF”) program. The subordinated notes qualify as Tier 2 regulatory capital and replaced SBLF Tier 1 capital. The subordinated notes are not listed on any securities exchange or included in any automated dealer quotation system and there is no market for the notes. The notes are unsecured obligations and are subordinated in right of payment to all existing and future senior debt, whether secured or unsecured. The notes are not guaranteed obligations of any of the Company’s subsidiaries.

 

Interest will accrue at a fixed per annum rate of 6.25% from and including the issue date to but excluding February 15, 2020. From and including February 15, 2020 to but excluding the maturity date interest will accrue at a floating rate equal to the three-month LIBOR plus 479 basis points. Interest is payable on the notes on February 15 and August 15 of each year, commencing August 15, 2015, through February 15, 2020, and thereafter February 15, May 15, August 15 and November 15 of each year through the maturity date or earlier redemption date.

 

The subordinated notes may be redeemed in whole or in part on February 15, 2020 or on any scheduled interest payment date thereafter and upon the occurrence of certain special events. The redemption price is equal to 100% of the principal amount of the subordinated notes to be redeemed plus accrued and unpaid interest to the date of redemption. Any partial redemption will be made pro rata among all holders of the subordinated notes. The subordinated notes are not subject to repayment at the option of the holders. The subordinated notes may be redeemed at any time, if (1) a change or prospective change in law occurs that could prevent the Company from deducting interest payable on the notes for U.S. federal income tax purposes, (2) a subsequent event occurs that precludes the notes from being recognized as Tier 2 Capital for regulatory capital purposes, or (3) the Company is required to register as an investment company under the Investment Company Act of 1940, as amended.

 

10 

 

 

NOTE 9 - OTHER REAL ESTATE OWNED (“OREO”)

OREO assets are presented net of valuation allowances. The Company considers OREO as classified assets for regulatory and financial reporting. An analysis of OREO activity follows.

 

   Nine Months Ended September 30,  

Year Ended

December 31,

 
(dollars in thousands)  2015   2014   2014 
Balance at beginning of year  $5,883   $6,797   $6,797 
Additions of underlying property   1,946    1,590    2,742 
Disposals of underlying property   (951)   (1,819)   (2,422)
Transfers of OREO to loans   -    -    (1,000)
Valuation allowance   (447)   (234)   (234)
Balance at end of period  $6,431   $6,334   $5,883 

 

During the nine months ended September 30, 2015, additions of $1.9 million consisted of $784,000 for residential properties, $372,000 for residential lots and $790,000 for commercial buildings. During the nine months ended September 30, 2014, additions of $1.6 million consisted of residential properties totaling $631,000, residential lots of $319,000 and a commercial building of $640,000. The Company disposed of residential properties and finished residential lots at a loss of $20,000 for the nine months ended September 30, 2015 compared to gains on disposals of $60,000 for the nine months ended September 30, 2014. Additions to the valuation allowances of $447,000 and $234,000 were taken to adjust properties to current appraised values for the nine months ended September 30, 2015 and 2014, respectively. OREO carrying amounts reflect management’s estimate of the realizable value of these properties incorporating current appraised values, local real estate market conditions and related costs.

 

Expenses applicable to OREO assets include the following.

 

   Three Months Ended September 30,   Nine Months Ended September 30, 
(dollars in thousands)  2015   2014   2015   2014 
Valuation allowance  $73   $-   $447   $234 
Operating expenses   56    38    235    98 
   $129   $38   $682   $332 

 

11 

 

 

NOTE 10 – SECURITIES

 

   September 30, 2015 
   Amortized   Gross Unrealized   Gross Unrealized   Estimated 
(dollars in thousands)  Cost   Gains   Losses   Fair Value 
Securities available for sale (AFS)                    
Asset-backed securities issued by GSEs                    
Residential Mortgage Backed Securities ("MBS")  $23   $4   $-   $27 
Residential Collateralized Mortgage Obligations ("CMOs")   32,782    114    384    32,512 
Callable GSE Agency Bonds   1,994    4    -    1,998 
Corporate equity securities   37    3    -    40 
Bond mutual funds   4,266    146    -    4,412 
Total securities available for sale  $39,102   $271   $384   $38,989 
                     
Securities held to maturity (HTM)                    
Asset-backed securities issued by GSEs                    
Residential MBS  $22,078   $706   $32   $22,752 
Residential CMOs   69,922    503    347    70,078 
Asset-backed securities issued by Others:                    
Residential CMOs   1,191    -    106    1,085 
Total debt securities held to maturity   93,191    1,209    485    93,915 
                     
U.S. government obligations   750    -    -    750 
Total securities held to maturity  $93,941   $1,209   $485   $94,665 

 

   December 31, 2014 
   Amortized   Gross Unrealized   Gross Unrealized   Estimated 
(dollars in thousands)  Cost   Gains   Losses   Fair Value 
Securities available for sale (AFS)                    
Asset-backed securities issued by GSEs                    
Residential MBS  $33   $4   $-   $37 
Residential CMOs   38,294    77    830    37,541 
Corporate equity securities   37    3    -    40 
Bond mutual funds   4,199    122    -    4,321 
Total securities available for sale  $42,563   $206   $830   $41,939 
                     
Securities held to maturity (HTM)                    
Asset-backed securities issued by GSEs                    
Residential MBS  $19,501   $767   $45   $20,223 
Residential CMOs   62,683    379    580    62,482 
Asset-backed securities issued by Others:                    
Residential CMOs   1,472    -    112    1,360 
Total debt securities held to maturity   83,656    1,146    737    84,065 
                     
U.S. government obligations   850    -    -    850 
Total securities held to maturity  $84,506   $1,146   $737   $84,915 

 

At September 30, 2015, certain asset-backed securities with an amortized cost of $39.5 million were pledged to secure certain deposits. At September 30, 2015, asset-backed securities with an amortized cost of $2.0 million were pledged as collateral for advances from the Federal Home Loan Bank (“FHLB”) of Atlanta.

 

12 

 

 

At September 30, 2015, 99% of the asset-backed securities and agency bond portfolio was rated AAA by Standard & Poor’s or the equivalent credit rating from another major rating agency. AFS asset-backed securities and agency bonds issued by government sponsored entities (“GSEs”) had an average life of 3.91 years and an average duration of 3.65 years and are guaranteed by their issuer as to credit risk. HTM asset-backed securities issued by GSEs had an average life of 4.12 years and an average duration of 3.86 years and are guaranteed by their issuer as to credit risk.

 

At December 31, 2014, 99% of the asset-backed securities portfolio was rated AAA by Standard & Poor’s or the equivalent credit rating from another major rating agency. AFS asset-backed securities issued by GSEs had an average life of 3.66 years and average duration of 3.41 years and are guaranteed by their issuer as to credit risk. HTM asset-backed securities issued by GSEs had an average life of 3.40 years and average duration of 3.21 years and are guaranteed by their issuer as to credit risk.

 

We believe that AFS securities with unrealized losses will either recover in market value or be paid off as agreed. The Company intends to, and has the ability to, hold these securities until recovery of the market value which may be at maturity. We believe that the losses are the result of general perceptions of safety and creditworthiness of the entire sector and a general disruption of orderly markets in the asset class.

 

Management has the ability and intent to hold the HTM securities with unrealized losses until they mature, at which time the Company will receive full value for the securities. Because our intention is not to sell the investments and it is not more likely than not that we will be required to sell the investments before recovery of their amortized cost basis, which may be maturity, management considers the unrealized losses in the held-to-maturity portfolio to be temporary.

 

No charges related to other-than-temporary impairment were made during the nine months ended September 30, 2015 and 2014.

 

During the nine months ended September 30, 2015, the Company sold one HTM security with a carrying value of $68,000 and recognized a loss of $1,000. During the nine months ended September 30, 2014, the Company recognized net gains on the sale of securities of $24,000. The Company sold five AFS securities with a carrying value of $2.1 million and ten HTM securities with aggregate carrying values of $3.2 million, recognizing gains of $8,000 and $16,000, respectively. The sale of HTM securities were permitted under ASC 320 “Investments - Debt and Equity Securities.” ASC 320 permits the sale of HTM securities for certain changes in circumstances. Securities were disposed of using the safe harbor rule that allows for the sale of HTM securities that have principal payments paid down to less than 15% of original purchased par. ASC 320 10-25-15 indicates that a sale of a debt security after a substantial portion of the principal has been collected is equivalent to holding the security to maturity. In addition, HTM securities were disposed of under ASC 320-10-25-6 due to a significant deterioration in the issues’ creditworthiness and the increase in regulatory risk weights mandated for risk-based capital purposes.

 

AFS Securities

Gross unrealized losses and estimated fair value by length of time that the individual AFS securities have been in a continuous unrealized loss position at September 30, 2015 were as follows:

 

September 30, 2015  Less Than 12   More Than 12         
   Months   Months   Total 
(dollars in thousands)  Fair Value  

Unrealized

Loss

   Fair Value  

Unrealized

Loss

   Fair Value  

Unrealized

Losses

 
Asset-backed securities issued by GSEs  $-   $-   $18,435   $384   $18,435   $384 

 

At September 30, 2015, the AFS investment portfolio had an estimated fair value of $39.0 million, of which $18.4 million of the securities had some unrealized losses from their amortized cost. The securities with unrealized losses were CMOs issued by GSEs.

 

AFS securities issued by GSEs are guaranteed by the issuer. Total unrealized losses on the asset-backed securities issued by GSEs were $384,000 of the portfolio amortized cost of $32.8 million. AFS asset-backed securities issued by GSEs with unrealized losses had an average life of 4.24 years and an average duration of 3.91 years. We believe that the securities will either recover in market value or be paid off as agreed.

 

13 

 

 

Gross unrealized losses and estimated fair value by length of time that the individual AFS securities have been in a continuous unrealized loss position at December 31, 2014 were as follows:

 

December 31, 2014  Less Than 12   More Than 12         
   Months   Months   Total 
(dollars in thousands)  Fair Value  

Unrealized

Loss

   Fair Value  

Unrealized

Loss

   Fair Value  

Unrealized

Losses

 
Asset-backed securities  issued by GSEs  $294   $-   $26,856   $830   $27,150   $830 

 

At December 31, 2014, the AFS investment portfolio had an estimated fair value of $41.9 million, of which $27.2 million of the securities had some unrealized losses from their amortized cost. The securities with unrealized losses were CMOs issued by GSEs.

 

AFS securities issued by GSEs are guaranteed by the issuer. Total unrealized losses on the asset-backed securities issued by GSEs were $830,000 of the portfolio amortized cost of $38.3 million. AFS asset-backed securities issued by GSEs with unrealized losses had an average life of 3.77 years and an average duration of 3.46 years. We believe that the securities will either recover in market value or be paid off as agreed.

 

HTM Securities

Gross unrealized losses and estimated fair value by length of time that the individual HTM securities have been in a continuous unrealized loss position at September 30, 2015 were as follows:

 

September 30, 2015  Less Than 12   More Than 12         
   Months   Months   Total 
(dollars in thousands)  Fair Value  

Unrealized

Loss

   Fair Value  

Unrealized

Loss

   Fair Value  

Unrealized

Losses

 
Asset-backed securities issued by GSEs   7,474    31    17,287    348    24,761    379 
Asset-backed securities issued by other   -    -    1,084    106    1,084    106 
   $7,474   $31   $18,371   $454   $25,845   $485 

 

At September 30, 2015, the HTM investment portfolio had an estimated fair value of $94.7 million, of which $25.8 million of the securities had some unrealized losses from their amortized cost. Of these securities, $24.7 million were asset-backed securities issued by GSEs and the remaining $1.1 million were asset-backed securities issued by others.

 

HTM securities issued by GSEs are guaranteed by the issuer. Total unrealized losses on the asset-backed securities issued by GSEs were $379,000 of the portfolio amortized cost of $92.0 million. HTM asset-backed securities issued by GSEs with unrealized losses had an average life of 3.81 years and an average duration of 3.55 years. We believe that the securities will either recover in market value or be paid off as agreed. The Company intends to, and has the ability to, hold these securities to maturity.

 

HTM asset-backed securities issued by others are collateralized mortgage obligation securities. All of the securities have credit support tranches that absorb losses prior to the tranches that the Company owns. The Company reviews credit support positions on its securities regularly. Total unrealized losses on the asset-backed securities issued by others were $106,000 of the portfolio amortized cost of $1.2 million. HTM asset-backed securities issued by others with unrealized losses have an average life of 3.89 years and an average duration of 3.18 years.

 

14 

 

 

Gross unrealized losses and estimated fair value by length of time that the individual HTM securities have been in a continuous unrealized loss position at December 31, 2014 were as follows:

 

December 31, 2014  Less Than 12   More Than 12         
   Months   Months   Total 
(dollars in thousands)  Fair Value  

Unrealized

Loss

   Fair Value  

Unrealized

Loss

   Fair Value  

Unrealized

Losses

 
Asset-backed securities issued by GSEs  $14,508   $85   $21,091   $540   $35,599   $625 
Asset-backed securities  issued by other   -    -    1,291    112    1,291    112 
   $14,508   $85   $22,382   $652   $36,890   $737 

 

At December 31, 2014, the HTM investment portfolio had an estimated fair value of $84.9 million, of which $36.9 million of the securities had some unrealized losses from their amortized cost. Of these securities, $35.6 million were asset-backed securities issued by GSEs and the remaining $1.3 million were asset-backed securities issued by others.

 

HTM securities issued by GSEs are guaranteed by the issuer. Total unrealized losses on the asset-backed securities issued by GSEs were $625,000 of the portfolio amortized cost of $82.2 million. HTM asset-backed securities issued by GSEs with unrealized losses had an average life of 3.23 years and an average duration of 3.01 years. We believe that the securities will either recover in market value or be paid off as agreed. The Company intends to, and has the ability to, hold these securities to maturity.

 

HTM asset-backed securities issued by others are collateralized mortgage obligation securities. All of the securities have credit support tranches that absorb losses prior to the tranches that the Company owns. The Company reviews credit support positions on its securities regularly. Total unrealized losses on the asset-backed securities issued by others were $112,000 of the portfolio amortized cost of $1.5 million. HTM asset-backed securities issued by others with unrealized losses have an average life of 4.27 years and an average duration of 3.62 years.

 

Credit Quality of Asset-Backed Securities and Agency Bonds

The tables below present the Standard & Poor’s (“S&P”) or equivalent credit rating from other major rating agencies for AFS and HTM asset-backed securities and agency bonds issued by GSEs and others at September 30, 2015 and December 31, 2014 by carrying value. The Company considers noninvestment grade securities rated BB+ or lower as classified assets for regulatory and financial reporting. GSE asset-backed securities and GSE agency bonds with S&P AA+ ratings were treated as AAA based on regulatory guidance.

 

September 30, 2015  December 31, 2014
Credit Rating  Amount   Credit Rating  Amount 
(dollars in thousands)
AAA  $126,537   AAA  $119,762 
BBB   -   BBB   68 
BB   577   BB   695 
CCC+   614   CCC+   709 
Total  $127,728   Total  $121,234 

 

15 

 

 

NOTE 11 – LOANS

Loans consist of the following:

 

(dollars in thousands)  September 30, 2015   December 31, 2014 
         
Commercial real estate  $619,612   $561,080 
Residential first mortgages   140,462    152,837 
Construction and land development   38,132    36,370 
Home equity and second mortgages   21,230    21,452 
Commercial loans   51,884    73,625 
Consumer loans   403    613 
Commercial equipment   27,765    26,152 
    899,488    872,129 
Less:          
Deferred loan fees   1,243    1,239 
Allowance for loan losses   8,375    8,481 
    9,618    9,720 
           
   $889,870   $862,409 

 

At September 30, 2015, the Bank’s allowance for loan losses totaled $8.4 million, or 0.93% of loan balances, as compared to $8.5 million, or 0.97% of loan balances, at December 31, 2014. Management’s determination of the adequacy of the allowance is based on a periodic evaluation of the portfolio with consideration given to the overall loss experience, current economic conditions, size, growth and composition of the loan portfolio, financial condition of the borrowers and other relevant factors that, in management’s judgment, warrant recognition in providing an adequate allowance.

 

Risk Characteristics of Portfolio Segments

The Company manages its credit products and exposure to credit losses (credit risk) by the following specific portfolio segments (classes), which are levels at which the Company develops and documents its allowance for loan loss methodology. These segments are:

 

Commercial Real Estate (“CRE”)

Commercial and other real estate projects include office buildings, retail locations, churches, other special purpose buildings and commercial construction. Commercial construction balances were 5.6% and 4.4% of the CRE portfolio at September 30, 2015 and December 31, 2014, respectively. The Bank offers both fixed-rate and adjustable-rate loans under these product lines. The primary security on a commercial real estate loan is the real property and the leases that produce income for the real property. Loans secured by commercial real estate are generally limited to 80% of the lower of the appraised value or sales price at origination and have an initial contractual loan payment period ranging from three to 20 years.

 

Loans secured by commercial real estate are larger and involve greater risks than one-to four-family residential mortgage loans. Because payments on loans secured by such properties are often dependent on the successful operation or management of the properties, repayment of such loans may be subject to a greater extent to adverse conditions in the real estate market or the economy.

 

Residential First Mortgages

Residential first mortgage loans are generally long-term loans, amortized on a monthly basis, with principal and interest due each month. The contractual loan payment period for residential loans typically ranges from ten to 30 years. The Bank’s experience indicates that real estate loans remain outstanding for significantly shorter time periods than their contractual terms. Borrowers may refinance or prepay loans at their option, without penalty. The Bank’s residential portfolio has both fixed-rate and adjustable-rate residential first mortgages.

 

The annual and lifetime limitations on interest rate adjustments may limit the increases in interest rates on these loans. There are also credit risks resulting from potential increased costs to the borrower as a result of repricing of adjustable-rate mortgage loans. During periods of rising interest rates, the risk of default on adjustable-rate mortgage loans may increase due to the upward adjustment of interest cost to the borrower. The Bank’s adjustable rate residential first mortgage portfolio was $22.8 million or 2.5% of total gross loans of $899.5 million at September 30, 2015.

 

16 

 

 

Construction and Land Development

The Bank offers loans for the construction of one-to-four family dwellings. Generally, these loans are secured by the real estate under construction as well as by guarantees of the principals involved. In addition, the Bank offers loans to acquire and develop land, as well as loans on undeveloped, subdivided lots for home building by individuals.

 

A decline in demand for new housing might adversely affect the ability of borrowers to repay these loans. Construction and land development loans are inherently riskier than providing financing on owner-occupied real estate. The Bank’s risk of loss is affected by the accuracy of the initial estimate of the market value of the completed project as well as the accuracy of the cost estimates made to complete the project. In addition, the volatility of the real estate market has made it increasingly difficult to ensure that the valuation of land associated with these loans is accurate. During the construction phase, a number of factors could result in delays and cost overruns. If the estimate of construction costs proves to be inaccurate, the Bank may be required to advance funds beyond the amount originally committed to permit completion of the development. If the estimate of value proves to be inaccurate, a project’s value might be insufficient to assure full repayment. As a result of these factors, construction lending often involves the disbursement of substantial funds with repayment dependent, in part, on the success of the project rather than the ability of the borrower or guarantor to repay principal and interest. If the Bank forecloses on a project, there can be no assurance that the Bank will be able to recover all of the unpaid balance of, and accrued interest on, the loan as well as related foreclosure and holding costs.

 

Home Equity and Second Mortgage Loans

The Bank maintains a portfolio of home equity and second mortgage loans. These products contain a higher risk of default than residential first mortgages as in the event of foreclosure, the first mortgage would need to be paid off prior to collection of the second mortgage. This risk has been heightened as the market value of residential property has declined.

 

Commercial Loans

The Bank offers commercial loans to its business customers. The Bank offers a variety of commercial loan products including term loans and lines of credit. Such loans are generally made for terms of five years or less. The Bank offers both fixed-rate and adjustable-rate loans under these product lines. When making commercial business loans, the Bank considers the financial condition of the borrower, the borrower’s payment history of both corporate and personal debt, the projected cash flows of the business, the viability of the industry in which the consumer operates, the value of the collateral, and the borrower’s ability to service the debt from income. These loans are primarily secured by equipment, real property, accounts receivable, or other security as determined by the Bank.

 

Commercial loans are made on the basis of the borrower’s ability to make repayment from the cash flows of the borrower’s business. As a result, the availability of funds for the repayment of commercial loans may depend substantially on the success of the business itself.

 

Consumer Loans

Consumer loans consist of loans secured by automobiles, boats, recreational vehicles and trucks. The Bank also makes home improvement loans and offers both secured and unsecured personal lines of credit. Consumer loans entail greater risk from other loan types due to being secured by rapidly depreciating assets or the reliance on the borrower’s continuing financial stability.

 

Commercial Equipment Loans

These loans consist primarily of fixed-rate, short-term loans collateralized by a commercial customer’s equipment. When making commercial equipment loans, the Bank considers the same factors it considers when underwriting a commercial business loan. Commercial loans are of higher risk and typically are made on the basis of the borrower’s ability to make repayment from the cash flows of the borrower’s business. As a result, the availability of funds for the repayment of commercial loans may depend substantially on the success of the business itself. In the case of business failure, collateral would need to be liquidated to provide repayment for the loan. In many cases, the highly specialized nature of collateral equipment would make full recovery from the sale of collateral problematic.

 

17 

 

 

Non-accrual and Past Due Loans

Non-accrual loans as of September 30, 2015 and December 31, 2014 were as follows:

 

   September 30, 2015   December 31, 2014 
(dollars in thousands)  Total
Non-accrual Loans
   Total Number
of Loans
   Total
Non-accrual Loans
   Total Number
of Loans
 
                 
Commercial real estate  $7,047    14   $3,824    11 
Residential first mortgages   1,551    6    533    2 
Construction and land development   3,555    2    3,634    2 
Home equity and second mortgages   362    5    399    6 
Commercial loans   1,516    8    1,587    6 
Commercial equipment   385    5    286    4 
   $14,416    40   $10,263    31 

 

Non-accrual loans (90 days or greater delinquent and non-accrual only loans) increased $4.2 million from $10.3 million or 1.18% of total loans at December 31, 2014 to $14.4 million or 1.60% of total loans at September 30, 2015. Non-accrual only loans are loans classified as non-accrual due to customer operating results or payment history. In accordance with the Company’s policy, interest income is recognized on a cash basis for these loans.

 

The Bank had 40 non-accrual loans at September 30, 2015 compared to 31 non-accrual loans at December 31, 2014. Non-accrual loans at September 30, 2015 included $11.1 million, or 77% of non-accrual loans, attributed to 18 loans representing five customer relationships classified as substandard. Non-accrual loans at December 31, 2014 included $8.8 million, or 86% of nonperforming loans, attributed to 16 loans representing six customer relationships classified as substandard. Of these loans at September 30, 2015 and December 31, 2014, four loans totaling $3.8 million and $3.9 million, respectively, represented a stalled residential development project. During the second quarter of 2014, the Bank deferred the collection of principal and interest to enable the project to use available funds to build units and complete the project. The stalled development project loans are considered both troubled debt restructures (“TDRs”) and non-accrual loans. At September 30, 2015, the Bank had an additional two TDR loans totaling $1.3 million that are greater than 90 days delinquent. At December 31, 2014, the Bank had one additional TDR loan totaling $1.0 million that was greater than 90 days delinquent. These loans are classified solely as non-accrual loans for the calculation of financial ratios.

 

Non-accrual loans on which the recognition of interest has been discontinued, which did not have a specific allowance for impairment, amounted to $13.0 million and $9.3 million at September 30, 2015 and December 31, 2014, respectively. Interest due but not recognized on these balances at September 30, 2015 and December 31, 2014 was $924,000 and $781,000, respectively. Non-accrual loans with a specific allowance for impairment on which the recognition of interest has been discontinued amounted to $1.4 million and $1.0 million at September 30, 2015 and December 31, 2014, respectively. Interest due but not recognized on these balances at September 30, 2015 and December 31, 2014 was $155,000 and $64,000, respectively.

 

An analysis of past due loans as of September 30, 2015 and December 31, 2014 was as follows:

 

   September 30, 2015 
(dollars in thousands)  Current   31-60
Days
   61-89
Days
   90 or Greater
Days
   Total
Past Due
   Total
Loan
Receivables
 
Commercial real estate  $612,230   $-   $1,261   $6,121   $7,382   $619,612 
Residential first mortgages   138,769    -    142    1,551    1,693    140,462 
Construction and land dev.   34,577    -    -    3,555    3,555    38,132 
Home equity and second mtg.   20,764    66    38    362    466    21,230 
Commercial loans   49,916    214    238    1,516    1,968    51,884 
Consumer loans   402    1    -    -    1    403 
Commercial equipment   27,365    15    -    385    400    27,765 
Total  $884,023   $296   $1,679   $13,490   $15,465   $899,488 

 

18 

 

 

   December 31, 2014 
(dollars in thousands)  Current   31-60
Days
   61-89
Days
   90 or Greater
Days
   Total
Past Due
   Total
Loan
Receivables
 
Commercial real estate  $556,584   $-   $672   $3,824   $4,496   $561,080 
Residential first mortgages   151,375    133    796    533    1,462    152,837 
Construction and land dev.   32,736    -    -    3,634    3,634    36,370 
Home equity and second mtg.   20,939    90    24    399    513    21,452 
Commercial loans   71,952    86    -    1,587    1,673    73,625 
Consumer loans   612    1    -    -    1    613 
Commercial equipment   25,848    17    1    286    304    26,152 
Total  $860,046   $327   $1,493   $10,263   $12,083   $872,129 

 

There were no loans greater than 90 days still accruing interest at September 30, 2015 and at December 31, 2014.

 

Impaired Loans and Troubled Debt Restructures (“TDRs”)

Impaired loans, including TDRs, at September 30, 2015 and 2014 and at December 31, 2014 were as follows:

 

   September 30, 2015 
(dollars in
thousands)
  Unpaid
Contractual
Principal
Balance
   Recorded
Investment
With No
Allowance
   Recorded
Investment
With
Allowance
   Total
Recorded
Investment
   Related
Allowance
  

Quarter
Average

Recorded

Investment

  

Quarter
Interest

Income

Recognized

  

YTD
Average

Recorded

Investment

  

YTD
Interest

Income

Recognized

 
                                     
Commercial real estate  $29,228   $26,218   $2,980   $29,198   $390   $29,307   $247   $29,223   $767 
Residential first mortgages   4,371    3,688    683    4,371    121    4,386    36    4,407    119 
Construction and land dev.   4,329    3,637    691    4,328    471    4,329    4    4,299    10 
Home equity and second mtg.   529    470    -    470    -    475    2    481    9 
Commercial loans   4,233    3,708    282    3,990    232    4,311    38    4,500    124 
Commercial equipment   596    364    146    510    146    512    2    516    8 
Total  $43,286   $38,085   $4,782   $42,867   $1,360   $43,320   $329   $43,426   $1,037 

 

19 

 

 

   December 31, 2014 
(dollars in thousands)  Unpaid
Contractual
Principal
Balance
   Recorded
Investment
With No
Allowance
   Recorded
Investment
With
Allowance
   Total
Recorded
Investment
   Related
Allowance
   Average
Recorded
Investment
   Interest
Income
Recognized
 
                             
Commercial real estate  $31,812   $28,907   $2,622   $31,529   $97   $31,672   $1,258 
Residential first mortgages   3,407    2,526    881    3,407    76    3,426    155 
Construction and land dev.   6,402    6,102    -    6,102    -    6,474    133 
Home equity and second mtg.   708    649    -    649    -    630    19 
Commercial loans   7,587    7,030    406    7,436    155    7,196    252 
Consumer loans   -    -    -    -    -    -    - 
Commercial equipment   605    373    213    586    123    623    23 
Total  $50,521   $45,587   $4,122   $49,709   $451   $50,021   $1,840 

 

   September 30, 2014 
(dollars in
thousands)
  Unpaid
Contractual
Principal
Balance
  

Recorded

Investment

With No

Allowance

  

Recorded

Investment

With

Allowance

   Total
Recorded
Investment
   Related
Allowance
  

Quarter
Average

Recorded

Investment

  

Quarter
Interest Income

Recognized

   YTD
Average
Recorded
Investment
   YTD
Interest
Income
Recognized
 
                                     
Commercial real estate  $22,946   $18,350   $4,568   $22,918   $372   $22,979   $327   $23,002   $719 
Residential first mortgages   3,130    2,614    516    3,130    75    3,069    40    3,130    108 
Construction and land dev.   7,631    3,377    4,254    7,631    81    7,427    41    7,591    123 
Home equity and second mtg.   548    475    73    548    59    556    5    485    8 
Commercial loans   7,318    6,912    406    7,318    95    7,238    61    7,282    188 
Consumer loans   -    -    -    -    -    -    -    -    - 
Commercial equipment   542    357    166    523    89    526    7    536    16 
Total  $42,115   $32,085   $9,983   $42,068   $771   $41,795   $481   $42,026   $1,162 

 

TDRs, included in the impaired loan schedules above, as of September 30, 2015 and December 31, 2014 were as follows:

 

   September 30, 2015   December 31, 2014 
(dollars in thousands)  Dollars   Number
of Loans
   Dollars   Number
of Loans
 
                 
Commercial real estate  $12,594    14   $10,438    9 
Residential first mortgages   889    3    906    3 
Construction and land development   4,329    4    4,376    4 
Commercial loans   586    7    2,262    6 
Commercial equipment   125    2    154    2 
Total TDRs  $18,523    30   $18,136    24 
Less: TDRs included in non-accrual loans   (5,116)   (7)   (4,887)   (5)
Total accrual TDR loans  $13,407    23   $13,249    19 

 

20 

 

 

At September 30, 2015, the Bank had 23 accruing TDRs totaling $13.4 million compared to 19 accruing TDRs totaling $13.2 million as of December 31, 2014. The Bank added seven and 15 TDRs totaling $2.3 million and $12.0 million during the nine months ended September 30, 2015 and the year ended December 31, 2014, respectively. Two TDRs totaling $1.6 million were disposed of during the second quarter of 2015 due to a payoff and refinancing by another lender. The Bank had specific reserves of $1.1 million on nine TDRs totaling $3.9 million at September 30, 2015 and $251,000 on five TDRs totaling $2.5 million at December 31, 2014.

 

At September 30, 2015 and December 31, 2014, four loans totaling $3.8 million and $3.9 million, respectively, represented a stalled residential development project. During the second quarter of 2014, the Bank deferred the collection of principal and interest to enable the project to use available funds to build units and complete the project. The stalled development project loans are considered both TDRs and non-accrual loans. Additionally, at September 30, 2015, the Bank had two TDR loans totaling $1.3 million that are greater than 90 days delinquent. At December 31, 2014, the Bank had one additional TDR loan totaling $1.0 million that was greater than 90 days delinquent. These loans are classified solely as non-accrual loans for the calculation of financial ratios.

 

Interest income in the amount of $385,000 and $563,000 was recognized on TDR loans for the nine months ended September 30, 2015 and the year ended December 31, 2014, respectively.

 

Allowance for Loan Losses

The following tables detail activity in the allowance for loan losses at and for the three and nine months ended September 30, 2015 and 2014, respectively, and for the year ended December 31, 2014 and loan receivable balances at September 30, 2015 and 2014, respectively, and at December 31, 2014. An allocation of the allowance to one category of loans does not prevent the Company’s ability to utilize the allowance to absorb losses in a different category. The loan receivables are disaggregated on the basis of the Company’s impairment methodology.

 

(dollars in thousands)  Commercial
Real Estate
   Residential
First
Mortgage
   Construction
and Land
Development
   Home
Equity and
Second Mtg.
   Commercial
Loans
   Consumer
Loans
   Commercial
Equipment
   Total 
At and For the Three Months Ended September 30, 2015                     
                                         
Allowance for loan losses:                                        
Balance at July 1,  $3,859   $885   $1,205   $206   $1,366   $2   $1,234   $8,757 
Charge-offs   (17)   -    -    -    (138)   -    (743)   (898)
Recoveries   5    -    -    -    4    -    6    15 
Provisions   (252)   (152)   402    (46)   25    -    524    501 
Balance at September 30,  $3,595   $733   $1,607   $160   $1,257   $2   $1,021   $8,375 
                                         
At and For the Nine Months Ended September 30, 2015                     
                                         
Allowance for loan losses:                                        
Balance at January 1,  $4,076   $1,092   $1,071   $173   $1,677   $3   $389   $8,481 
Charge-offs   (63)   (30)   -    -    (353)   -    (797)   (1,243)
Recoveries   12    1    32    -    11    -    10    66 
Provisions   (430)   (330)   504    (13)   (78)   (1)   1,419    1,071 
Balance at September 30,  $3,595   $733   $1,607   $160   $1,257   $2   $1,021   $8,375 
Ending balance: individually
evaluated for impairment
  $390   $121   $471   $-   $232   $-   $146   $1,360 
Ending balance: collectively
evaluated for impairment
  $3,205   $612   $1,136   $160   $1,025   $2   $875   $7,015 
Loan receivables:                                        
Ending balance  $619,612   $140,462   $38,132   $21,230   $51,884   $403   $27,765   $899,488 
Ending balance: individually
evaluated for impairment
  $29,198   $4,371   $4,328   $470   $3,990   $-   $510   $42,867 
Ending balance: collectively
evaluated for impairment
  $590,414   $136,091   $33,804   $20,760   $47,894   $403   $27,255   $856,621 

 

 

21 

 

  

(dollars in thousands)  Commercial
Real Estate
   Residential
First
Mortgage
   Construction
and Land
 Development
   Home
Equity and
Second Mtg.
   Commercial
Loans
   Consumer
 Loans
   Commercial
Equipment
   Total 
                                 
At and For the Year Ended December 31, 2014                     
Allowance for loan losses:                                        
Balance at January 1,  $3,525   $1,401   $584   $249   $1,916   $10   $453   $8,138 
Charge-offs   (350)   (94)   (992)   (59)   (1,134)   (3)   (10)   (2,642)
Recoveries   11    186    84    10    5    11    25    332 
Provisions   890    (401)   1,395    (27)   890    (15)   (79)   2,653 
Balance at December 31,  $4,076   $1,092   $1,071   $173   $1,677   $3   $389   $8,481 
Ending balance: individually
evaluated for impairment
  $97   $76   $-   $-   $155   $-   $123   $451 
Ending balance: collectively
evaluated for impairment
  $3,979   $1,016   $1,071   $173   $1,522   $3   $266   $8,030 
Loan receivables:                                        
Ending balance  $561,080   $152,837   $36,370   $21,452   $73,625   $613   $26,152   $872,129 
Ending balance: individually
evaluated for impairment
  $31,529   $3,407   $6,102   $649   $7,436   $-   $586   $49,709 
Ending balance: collectively
evaluated for impairment
  $529,551   $149,430   $30,268   $20,803   $66,189   $613   $25,566   $822,420 

 

(dollars in thousands)  Commercial
Real Estate
   Residential
First
Mortgage
   Construction
and Land
Development
   Home
Equity and
Second Mtg.
   Commercial
Loans
   Consumer
 Loans
   Commercial
Equipment
   Total 
At and For the Three Months Ended September 30, 2014                     
                                         
Allowance for loan losses:                                        
Balance at July 1,  $3,977   $1,090   $573   $283   $1,735   $4   $388   $8,050 
Charge-offs   -    -    -    -    (175)   (3)   -    (178)
Recoveries   1    1    -    10    1    1    2    16 
Provisions   586    (12)   72    (1)   (226)   1    (35)   385 
Balance at September 30,  $4,564   $1,079   $645   $292   $1,335   $3   $355   $8,273 
                                         
At and For the Nine Months Ended September 30, 2014                     
                                         
Allowance for loan losses:                                        
Balance at January 1,  $3,525   $1,401   $584   $249   $1,916   $10   $453   $8,138 
Charge-offs   (49)   (94)   -    -    (930)   (3)   -    (1,076)
Recoveries   9    1    -    10    4    11    25    60 
Provisions   1,079    (229)   61    33    345    (15)   (123)   1,151 
Balance at September 30,  $4,564   $1,079   $645   $292   $1,335   $3   $355   $8,273 
Ending balance: individually
evaluated for impairment
  $372   $75   $81   $59   $95   $-   $89   $771 
Ending balance: collectively
evaluated for impairment
  $4,192   $1,004   $564   $233   $1,240   $3   $266   $7,502 
Loan receivables:                                        
Ending balance  $545,663   $155,234   $33,986   $21,330   $63,681   $661   $25,836   $846,391 
Ending balance: individually
evaluated for impairment
  $22,918   $3,130   $7,631   $548   $7,318   $-   $523   $42,068 
Ending balance: collectively
evaluated for impairment
  $522,745   $152,104   $26,355   $20,782   $56,363   $661   $25,313   $804,323 

 

22 

 

  

Credit Quality Indicators

Credit quality indicators as of September 30, 2015 and December 31, 2014 were as follows:

                         
Credit Risk Profile by Internally Assigned Grade

 

   Commercial Real Estate   Construction and Land Dev. 
(dollars in thousands)  9/30/2015   12/31/2014   9/30/2015   12/31/2014 
                 
Unrated  $69,285   $74,955   $5,511   $3,108 
Pass   522,140    451,256    28,292    27,160 
Special mention   1,893    4,383    -    - 
Substandard   26,294    30,486    4,329    6,102 
Doubtful   -    -    -    - 
Loss   -    -    -    - 
Total  $619,612   $561,080   $38,132   $36,370 

 

   Commercial Loans   Commercial Equipment 
(dollars in thousands)  9/30/2015   12/31/2014   9/30/2015   12/31/2014 
                 
Unrated  $10,871   $12,296   $9,766   $7,173 
Pass   37,033    53,844    17,750    18,517 
Special mention   -    49    -    - 
Substandard   3,980    7,436    103    462 
Doubtful   -    -    146    - 
Loss   -    -    -    - 
Total  $51,884   $73,625   $27,765   $26,152 

 

Credit Risk Profile Based on Payment Activity

  

   Residential First Mortgages   Home Equity and Second Mtg.   Consumer Loans 
(dollars in thousands)  9/30/2015   12/31/2014   9/30/2015   12/31/2014   9/30/2015   12/31/2014 
                         
Performing  $138,911   $152,304   $20,868   $21,053   $403   $613 
Nonperforming   1,551    533    362    399    -    - 
Total  $140,462   $152,837   $21,230   $21,452   $403   $613 

 

Summary of  Total Classified Loans            

 

(dollars in thousands)  9/30/2015   12/31/2014 
By Internally Assigned Grade  $34,851   $44,486 
By Payment Activity   1,500    2,249 
Total Classified  $36,351   $46,735 

 

A risk grading scale is used to assign grades to commercial real estate, construction and land development, commercial loans and commercial equipment loans. Loans are graded at inception, annually thereafter when financial statements are received and at other times when there is an indication that a credit may have weakened or improved. Only commercial loan relationships with an aggregate exposure to the Bank of $750,000 or greater are subject to being risk rated.

 

23 

 

  

Home equity and second mortgages and consumer loans are evaluated for creditworthiness in underwriting and are monitored based on borrower payment history. Residential first mortgages are evaluated for creditworthiness during credit due diligence before being purchased. Residential first mortgages, home equity and second mortgages and consumer loans are classified as unrated unless they are part of a larger commercial relationship that requires grading or are troubled debt restructures or nonperforming loans with an Other Assets Especially Mentioned (“OAEM”) or higher risk rating due to a delinquent payment history.

 

Management regularly reviews credit quality indicators as part of its individual loan reviews and on a monthly and quarterly basis. The overall quality of the Bank’s loan portfolio is assessed using the Bank’s risk grading scale, the level and trends of net charge-offs, nonperforming loans and delinquencies, the performance of troubled debt restructured loans and the general economic conditions in the Company’s geographical market. This review process is assisted by frequent internal reporting of loan production, loan quality, concentrations of credit, loan delinquencies and nonperforming and potential problem loans. Credit quality indicators and allowance factors are adjusted based on management’s judgment during the monthly and quarterly review process. Loans subject to risk ratings are graded on a scale of one to ten. The Company considers loans classified substandard, doubtful and loss as classified assets for regulatory and financial reporting.

 

Ratings 1 thru 6 - Pass

Ratings 1 thru 6 have asset risks ranging from excellent low risk to adequate. The specific rating assigned considers customer history of earnings, cash flows, liquidity, leverage, capitalization, consistency of debt service coverage, the nature and extent of customer relationship and other relevant specific business factors such as the stability of the industry or market area, changes to management, litigation or unexpected events that could have an impact on risks.

 

Rating 7 - OAEM (Other Assets Especially Mentioned) – Special Mention

These credits, while protected by the financial strength of the borrowers, guarantors or collateral, have reduced quality due to economic conditions, less than adequate earnings performance or other factors which require the lending officer to direct more than normal attention to the credit. Financing alternatives may be limited and/or command higher risk interest rates. OAEM loans are the first adversely classified assets on our watch list. These relationships will be reviewed at least quarterly.

 

Rating 8 - Substandard

Substandard assets are assets that are inadequately protected by the sound worth or paying capacity of the borrower or of the collateral pledged. These assets have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the possibility that the Bank will sustain some loss if the deficiencies are not corrected. Loss potential, while existing in the aggregate amount of substandard assets, does not have to exist in individual assets classified substandard. The loans may have a delinquent history or combination of weak collateral, weak guarantor strength or operating losses. When a loan is assigned to this category the Bank may estimate a specific reserve in the loan loss allowance analysis. These assets listed may include assets with histories of repossessions or some that are non-performing bankruptcies. These relationships will be reviewed at least quarterly.

  

Rating 9 - Doubtful

Doubtful assets have many of the same characteristics of Substandard with the exception that the Bank has determined that loss is not only possible but is probable and the risk is close to certain that loss will occur. When a loan is assigned to this category the Bank will identify the probable loss and the loan will receive a specific reserve in the loan loss allowance analysis. These relationships will be reviewed at least quarterly.

 

Rating 10 – Loss

Once an asset is identified as a definite loss to the Bank, it will receive the classification of “loss”. There may be some future potential recovery; however it is more practical to write off the loan at the time of classification. Losses will be taken in the period in which they are determined to be uncollectable.

 

NOTE 12 - REGULATORY CAPITAL

On January 1, 2015, the Company and Bank became subject to the new Basel III Capital Rules with full compliance with all of the final rule's requirements phased in over a multi-year schedule, to be fully phased-in by January 1, 2019. In July 2013, the Company’s primary federal regulator, the Federal Reserve, published final rules (the “Basel III Capital Rules”) establishing a new comprehensive capital framework for U.S. banking organizations. The rules implement the Basel Committee’s December 2010 framework known as “Basel III” for strengthening international capital standards as well as certain provisions of the Dodd-Frank Act. The Basel III Capital Rules substantially revise the risk-based capital requirements applicable to bank holding companies and depository institutions compared to the previous U.S. risk-based capital rules. The Basel III Capital Rules define the components of capital and address other issues affecting the numerator in banking institutions’ regulatory capital ratios. The Basel III Capital Rules also address risk weights and other issues affecting the denominator in banking institutions’ regulatory capital ratios and replace the existing risk-weighting approach with a more risk-sensitive approach. The Basel III Capital Rules also implement the requirements of Section 939A of the Dodd-Frank Act to remove references to credit ratings from the federal banking agencies’ rules.

 

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The rules include a new common equity Tier 1 capital to risk-weighted assets minimum ratio of 4.5%, raise the minimum ratio of Tier 1 capital to risk-weighted assets from 4.0% to 6.0%, require a minimum ratio (“Min. Ratio”) of Total Capital to risk-weighted assets of 8.0%, and require a minimum Tier 1 leverage ratio of 4.0%. A new capital conservation buffer (“CCB”) is also established above the regulatory minimum capital requirements. This capital conservation buffer will be phased-in beginning January 1, 2016 at 0.625% of risk-weighted assets and increase each subsequent year by an additional 0.625% until reaching its final level of 2.5% on January 1, 2019. Strict eligibility criteria for regulatory capital instruments were also implemented under the final rules. The final rules also revise the definition and calculation of Tier 1 capital, Total Capital, and risk-weighted assets.

 

As of September 30, 2015, the Company and Bank were well-capitalized under the regulatory framework for prompt corrective action under the new Basel III Capital Rules. Management believes, as of September 30, 2015 and December 31, 2014, that the Company and the Bank met all capital adequacy requirements to which they were subject. The Company’s and the Bank’s actual regulatory capital amounts and ratios are presented in the following table.

  

Regulatory Capital and Ratios      The Company   The Bank 
(dollars in thousands)      September 30, 2015   December 31, 2014   September 30, 2015   December 31, 2014 
                     
Common Equity       $100,059   $96,559   $132,193   $126,838 
Preferred Stock -SBLF        -    20,000    -    - 
Total Stockholders' Equity        100,059    116,559    132,193    126,838 
AOCI Losses (Gains)        70    378    70    378 
Common Equity Tier 1 Capital        100,129    116,937    132,263    127,216 
TRUPs        12,000    12,000    -    - 
Tier 1 Capital        112,129    128,937    132,263    127,216 
Allowable Reserve for Credit Losses and Other Tier 2 Adjustments        8,375    8,537    8,375    8,537 
Subordinated Notes        23,000    -    -    - 
Tier 2 Capital       $143,504   $137,474   $140,638   $135,753 
                          
Risk-Weighted Assets ("RWA")       $968,390   $903,931   $965,595   $902,136 
                          
Average Assets ("AA")       $1,106,081   $1,053,424   $1,103,381   $1,051,627 
    2019 Regulatory
 Min. Ratio + CCB (1)
             
Common Tier 1 Capital to RWA (2)   7.00%   10.34%   12.94%   13.70%   14.10%
Tier 1 Capital to RWA   8.50    11.58    14.26    13.70    14.10 
Tier 2 Capital to RWA   10.50    14.82    15.21    14.56    15.05 
Tier 1 Capital to AA (Leverage)   n/a    10.14    12.24    11.99    12.10 

 

 (1) These are the fully phased-in ratios as of January 1, 2019 that include the minimum capital ratio ("Min. Ratio") + the capital conservation buffer ("CCB"). The phase-in period is more fully described in the footnote above.  
   
 (2) The Common Tier 1 ratio became effective for regulatory reporting purposes when the Company and the Bank became subject to the new Basel III Capital Rules during the three months ended March 31, 2015.  

 

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NOTE 13 - FAIR VALUE MEASUREMENTS

The Company adopted FASB ASC Topic 820, “Fair Value Measurements” and FASB ASC Topic 825, “The Fair Value Option for Financial Assets and Financial Liabilities”, which provides a framework for measuring and disclosing fair value under generally accepted accounting principles. FASB ASC Topic 820 requires disclosures about the fair value of assets and liabilities recognized in the balance sheet in periods subsequent to initial recognition, whether the measurements are made on a recurring basis (for example, available for sale investment securities) or on a nonrecurring basis (for example, impaired loans).

 

FASB ASC Topic 820 defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. FASB ASC Topic 820 also establishes a fair value hierarchy, which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.

 

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

 

Under FASB ASC Topic 820, the Company groups assets and liabilities at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine the fair value. These hierarchy levels are:

 

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

 

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

 

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

 

Transfers between levels of the fair value hierarchy are recognized on the actual date of the event or circumstances that caused the transfer, which generally coincides with the Company’s monthly or quarterly valuation process.

  

There were no transfers between levels of the fair value hierarchy and the Company had no Level 3 fair value assets or liabilities for the nine months ended September 30, 2015 and the year ended December 31, 2014, respectively.

 

Following is a description of valuation methodologies used for assets and liabilities recorded at fair value:

 

Securities Available for Sale

Investment securities available for sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted prices, if available. If quoted prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions. Level 1 securities include those traded on an active exchange, such as the New York Stock Exchange, Treasury securities that are traded by dealers or brokers in active over-the-counter markets and money market funds. Level 2 securities include mortgage-backed securities issued by GSEs, municipal bonds and corporate debt securities. Securities classified as Level 3 include asset-backed securities in less liquid markets.

 

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Loans Receivable

The Company does not record loans at fair value on a recurring basis, however, from time to time, a loan is considered impaired and an allowance for loan loss is established. Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan are considered impaired. Management estimates the fair value of impaired loans using one of several methods, including the collateral value, market value of similar debt, enterprise value, liquidation value and discounted cash flows. Impaired loans not requiring a specific allowance represent loans for which the fair value of expected repayments or collateral exceed the recorded investment in such loans. At September 30, 2015 and December 31, 2014, substantially all of the impaired loans were evaluated based upon the fair value of the collateral. In accordance with FASB ASC 820, impaired loans where an allowance is established based on the fair value of collateral (loans with impairment) require classification in the fair value hierarchy. When the fair value of the collateral is based on an observable market price or a current appraised value, the Company records the loan as nonrecurring Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company records the loan as nonrecurring Level 3.

 

Premises and equipment held for sale

Premises and equipment are adjusted to fair value upon transfer of the assets to held for sale. Subsequently, premises and equipment held for sale are carried at the lower of carrying value or fair value. Fair value is based upon independent market prices, appraised value of the collateral or management’s estimation of the value of the collateral. When the fair value of the collateral is based on an observable market price (e.g., contracted sales price) or a current appraised value, the Company records the assets as nonrecurring Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company records the asset at nonrecurring Level 3.

 

Other Real Estate Owned

OREO is adjusted to fair value upon transfer of the loans to foreclosed assets. Subsequently, OREO is carried at the lower of carrying value or fair value. Fair value is based upon independent market prices, appraised value of the collateral or management’s estimation of the value of the collateral. When the fair value of the collateral is based on an observable market price or a current appraised value, the Company records the foreclosed asset as nonrecurring Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company records the foreclosed asset at nonrecurring Level 3.

 

Assets and Liabilities Recorded at Fair Value on a Recurring Basis

The tables below present the recorded amount of assets as of September 30, 2015 and December 31, 2014 measured at fair value on a recurring basis.

 

(dollars in thousands)  September 30, 2015 
Description of Asset  Fair  Value   Level 1   Level 2   Level 3 
Available for sale securities                    
Asset-backed securities issued by GSEs                    
CMOs  $32,512   $-   $32,512   $- 
MBS   27    -    27    - 
     Callable GSE Agency Bonds   1,998    -    1,998    - 
Corporate equity securities   40    -    40    - 
Bond mutual funds   4,412    -    4,412    - 
Total available for sale securities  $38,989   $-   $38,989   $- 

  

(dollars in thousands)  December 31, 2014 
Description of Asset  Fair Value   Level 1   Level 2   Level 3 
Available for sale securities                    
Asset-backed securities issued by GSEs                    
CMOs  $37,541   $-   $37,541   $- 
MBS   37    -    37    - 
Corporate equity securities   40    -    40    - 
Bond mutual funds   4,321    -    4,321    - 
Total available for sale securities  $41,939   $-   $41,939   $- 

 

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Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis

The Company may be required from time to time to measure certain assets at fair value on a nonrecurring basis in accordance with U.S. GAAP. These include assets that are measured at the lower of cost or market that were recognized at fair value below cost at the end of the period. Assets measured at fair value on a nonrecurring basis as of September 30, 2015 and December 31, 2014 are included in the tables below.

 

(dollars in thousands)  September 30, 2015 
Description of Asset  Fair Value   Level 1   Level 2   Level 3 
Loans with impairment                    
Commercial real estate  $2,590   $-   $2,590   $- 
Residential first mortgages   562    -    562    - 
Construction and land development   220    -    220    - 
Commercial loans   50    -    50    - 
Total loans with impairment  $3,422   $-   $3,422   $- 
Premises and equipment held for sale  $2,000        $2,000      
Other real estate owned  $6,431   $-   $6,431   $- 

 

(dollars in thousands)  December 31, 2014 
Description of Asset  Fair Value   Level 1   Level 2   Level 3 
Loans with impairment                    
Commercial real estate  $2,524   $-   $2,524   $- 
Residential first mortgage   805    -    805    - 
Commercial loans   251    -    251    - 
Commercial equipment   90    -    90    - 
Total loans with impairment  $3,670   $-   $3,670   $- 
Other real estate owned  $5,883   $-   $5,883   $- 

 

Loans with impairment had unpaid principal balances of $4.8 million and $4.1 million at September 30, 2015 and December 31, 2014, respectively, and include impaired loans with a specific allowance.

 

NOTE 14 - FAIR VALUE OF FINANCIAL INSTRUMENTS

The estimated fair value amounts have been determined by the Company using available market information and appropriate valuation methodologies. However, considerable judgment is required to interpret market data to develop the estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amounts the Company could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts. Therefore, any aggregate unrealized gains or losses should not be interpreted as a forecast of future earnings or cash flows. Furthermore, the fair values disclosed should not be interpreted as the aggregate current value of the Company.

 

Valuation Methodology

Investment securities - Fair values are based on quoted market prices or dealer quotes. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities.

 

FHLB and FRB stock - Fair values are at cost, which is the carrying value of the securities.

 

Investment in bank owned life insurance (“BOLI”) – Fair values are at cash surrender value.

 

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Loans receivable - For conforming residential first-mortgage loans, the market price for loans with similar coupons and maturities was used. For nonconforming loans with maturities similar to conforming loans, the coupon was adjusted for credit risk. Loans that did not have quoted market prices were priced using the discounted cash flow method. The discount rate used was the rate currently offered on similar products. Loans priced using the discounted cash flow method included residential construction loans, commercial real estate loans and consumer loans. The estimated fair value of loans held for sale is based on the terms of the related sale commitments.

 

Savings, NOW and money market deposits - The fair value of checking accounts, saving accounts and money market accounts were the amount payable on demand at the reporting date.

 

Time certificates - The fair value was determined using the discounted cash flow method. The discount rate was equal to the rate currently offered on similar products.

 

Long-term debt and short-term borrowings - These were valued using the discounted cash flow method. The discount rate was equal to the rate currently offered on similar borrowings.

 

Guaranteed preferred beneficial interest in junior subordinated securities (“TRUPs”) - These were valued using discounted cash flows. The discount rate was equal to the rate currently offered on similar borrowings.

 

Subordinated notes - These were valued using discounted cash flows. The discount rate was equal to the rate currently offered on similar borrowings.

 

Off-balance sheet instruments - The Company charges fees for commitments to extend credit. Interest rates on loans for which these commitments are extended are normally committed for periods of less than one month. Fees charged on standby letters of credit and other financial guarantees are deemed to be immaterial and these guarantees are expected to be settled at face amount or expire unused. It is impractical to assign any fair value to these commitments.

 

The Company’s estimated fair values of financial instruments are presented in the following tables.

 

September 30, 2015          Fair Value Measurements 
Description of Asset (dollars in thousands)  Carrying
Amount
   Fair Value   Level 1   Level 2   Level 3 
Assets                         
Investment securities - AFS  $38,989   $38,989   $-   $38,989   $- 
Investment securities - HTM   93,941    94,665    750    93,915    - 
FHLB and FRB Stock   6,677    6,677    -    6,677    - 
Loans Receivable   889,870    894,160    -    894,160    - 
Investment in BOLI   27,637    27,637    -    27,637    - 
                          
Liabilities                         
   Savings, NOW and money market accounts  $518,361   $518,361   $-   $518,361   $- 
Time deposits   363,918    364,806    -    364,806    - 
Long-term debt   70,631    71,389    -    71,389    - 
Short term borrowings   14,000    13,999    -    13,999    - 
TRUPs   12,000    8,200    -    8,200    - 
Subordinated notes   23,000    23,000    -    23,000    - 

 

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December 31, 2014          Fair Value Measurements 

 Description of Asset 
(dollars in thousands)
  Carrying
Amount
   Fair Value   Level 1   Level 2   Level 3 
Assets                         
Investment securities - AFS  $41,939   $41,939   $-   $41,939   $- 
Investment securities - HTM   84,506    84,915    850    84,065    - 
FHLB and FRB Stock   6,434    6,434    -    6,434    - 
Loans Receivable   862,409    861,427    -    861,427    - 
Investment in BOLI   27,021    27,021    -    27,021    - 
Liabilities                         
   Savings, NOW and money market accounts  $483,973   $483,973   $-   $483,973   $- 
Time deposits   385,411    386,510    -    386,510    - 
Long-term debt   74,672    77,919    -    77,919    - 
Short term borrowings   2,000    2,000    -    2,000    - 
TRUPs   12,000    7,400    -    7,400    - 

 

At September 30, 2015, the Company had outstanding loan commitments and standby letters of credit of $22.7 million and $18.8 million, respectively. Based on the short-term lives of these instruments, the Company does not believe that the fair value of these instruments differs significantly from their carrying values.

 

The fair value estimates presented herein are based on pertinent information available to management as of September 30, 2015 and December 31, 2014, respectively. Although management is not aware of any factors that would significantly affect the estimated fair value amounts, such amounts have not been comprehensively revalued for purposes of these financial statements since that date and, therefore, current estimates of fair value may differ significantly from the amount presented herein.

 

NOTE 15 – NEW ACCOUNTING STANDARDS

Financial Accounting Standards Board (“FASB”) Accounting Standards Update (“ASU”) No. 2014-04 - Receivables - Troubled Debt Restructurings by Creditors (Subtopic 310-40) - Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure. The amendments clarify that an in substance repossession or foreclosure occurs, and a creditor is considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan, upon either (1) the creditor obtaining legal title to the residential real estate property upon completion of a foreclosure or (2) the borrower conveying all interest in the residential real estate to the creditor to satisfy that loan through completion of a deed in lieu of foreclosure or through a similar legal agreement. The amendments require interim and annual disclosure of both (1) the amount of foreclosed residential real estate property held by the creditor and (2) the recorded investment in consumer mortgage loans collateralized by residential real estate that are in the process of foreclosure according to local requirements of the applicable jurisdiction. ASU 2014-04 is effective for interim and annual periods beginning after December 15, 2014. The adoption of ASU 2014-04 did not have a material impact on the Company’s consolidated financial statements.

 

ASU 2014-09 - Revenue from Contracts with Customers (Topic 606). ASU 2014-09 states that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. This update affects entities that enter into contracts with customers to transfer goods or services or enter into contracts for the transfer of nonfinancial assets, unless those contracts are within the scope of other standards. ASU 2014-09 is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2017. Early adoption is permitted, but not before the original effective date of December 15, 2016. The adoption of this guidance is not expected to have a material impact on the Company’s consolidated financial statements.

 

ASU 2014-11 - Transfers and Servicing (Topic 860) - Repurchase-to-Maturity Transactions, Repurchase Financings, and Disclosures. ASU 2014-11 requires that repurchase-to-maturity transactions be accounted for as secured borrowings consistent with the accounting for other repurchase agreements. In addition, ASU 2014-11 requires separate accounting for repurchase financings, which entails the transfer of a financial asset executed contemporaneously with a repurchase agreement from the same counterparty. ASU 2014-11 requires entities to disclose certain information about transfers accounted for as sales in transactions that are economically similar to repurchase agreements. In addition, ASU 2014-11 requires disclosures related to collateral, remaining contractual term and of the potential risks associated with repurchase agreements, securities lending transactions and repurchase-to-maturity transactions. ASU 2014-11 was effective for the Company on January 1, 2015 and did not have a material impact on the Company’s consolidated financial statements.

 

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ASU 2015-05 - Customer’s Accounting for Fees Paid in a Cloud Computing Arrangement. ASU 2015-05 provides guidance to customers about whether a cloud computing arrangement includes a software license. If a cloud computing arrangement includes a software license, the customer should account for the software license element of the arrangement consistent with the acquisition of other software licenses. If a cloud computing arrangement does not include a software license, the customer should account for the arrangement as a service contract. The new guidance does not change the accounting for a customer’s accounting for service contracts. ASU No. 2015-05 is effective for interim and annual reporting periods beginning after December 15, 2015. The Company is currently evaluating the provisions of ASU No. 2015-05 to determine the potential impact the new standard will have on the Company's Consolidated Financial Statements.

 

NOTE 16 – HELD FOR SALE PREMISES AND EQUIPMENT

The Company agreed to sell its King George, Virginia branch building and equipment to a credit union. The required conditions were met during the three months ended September 30, 2015 to classify the asset as held for sale (“HFS”) under FASB 360-10-45-9 which addresses accounting and reporting for long-lived assets to be disposed of by sale. FASB ASC 360-10-35-43 states that a long-lived asset classified as HFS should be measured at the lower of carrying amount or fair value less cost to sell. Based on the contracted sales price, the Company recorded an impairment of $426,000 for the three months ended for the three months ended September 30, 2015. The transaction is expected to close in the first quarter of 2016, pending regulatory approval.

 

Item 2 - Management's Discussion and Analysis of Financial Condition and Results of Operations

FORWARD-LOOKING STATEMENTS

 

This report contains forward-looking statements that are based on assumptions and may describe future plans, strategies and expectations of The Community Financial Corporation (the “Company”) and Community Bank of the Chesapeake (the “Bank”). These forward-looking statements are generally identified by use of the words “believe,” “expect,” “intend,” “anticipate,” “estimate,” “project” or similar expressions.

 

The Company and the Bank’s ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Factors that could have a material adverse effect on the operations of the Company and its subsidiaries include, but are not limited to, changes in interest rates, national and regional economic conditions, legislative and regulatory changes, monetary and fiscal policies of the U.S. government, including policies of the U.S. Treasury and the Federal Reserve Board, the quality and composition of the loan and investment portfolios, demand for loan products, deposit flows, competition, demand for financial services in the Company and the Bank’s market area, changes in real estate market values in the Company and the Bank’s market area and changes in relevant accounting principles and guidelines. Additional factors that may affect our results are discussed in Part I of the Company’s Annual Report on Form 10-K for the year ended December 31, 2014 (the “Form 10-K”) that we filed with the Securities and Exchange Commission. These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements. Except as required by applicable law or regulation, the Company does not undertake, and specifically disclaims any obligation, to release publicly the result of any revisions that may be made to any forward-looking statements to reflect events or circumstances after the date of the statements or to reflect the occurrence of anticipated or unanticipated events.

 

Critical Accounting Policies

Critical accounting policies are defined as those that involve significant judgments and uncertainties and could potentially result in materially different results under different assumptions and conditions. The Company considers its determination of the allowance for loan losses, the determination of other-than-temporarily impaired securities, the valuation of foreclosed real estate and the valuation of deferred tax assets to be critical accounting policies.

 

The Company’s Consolidated Financial Statements are prepared in accordance with accounting principles generally accepted in the United States of America and the general practices of the United States banking industry. Application of these principles requires management to make estimates, assumptions and judgments that affect the amounts reported in the financial statements and accompanying notes. These estimates, assumptions and judgments are based on information available as of the date of the financial statements. Accordingly, as this information changes, the financial statements could reflect different estimates, assumptions and judgments. Certain policies inherently have a greater reliance on the use of estimates, assumptions and judgments and, as such, have a greater possibility of producing results that could be materially different than originally reported.

 

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Estimates, assumptions and judgments are necessary when assets and liabilities are required to be recorded at fair value, when a decline in the value of an asset not carried on the financial statements at fair value warrants an impairment write-down or valuation reserve to be established or when an asset or liability needs to be recorded contingent upon a future event. Carrying assets and liabilities at fair value inherently results in more financial statement volatility. The fair values and the information used to record valuation adjustments for certain assets and liabilities are based either on quoted market prices or are provided by other third-party sources, when available. When these sources are not available, management makes estimates based upon what it considers to be the best available information.

 

Allowance for Loan Losses

The allowance for loan loss balance is an estimate based upon management’s evaluation of the loan portfolio. The allowance is comprised of a specific and a general component. The specific component consists of management’s evaluation of certain classified and non-accrual loans and their underlying collateral. Management assesses the ability of the borrower to repay the loan based upon all information available. Loans are examined to determine a specific allowance based upon the borrower’s payment history, economic conditions specific to the loan or borrower and other factors that would impact the borrower’s ability to repay the loan on its contractual basis. Depending on the assessment of the borrower’s ability to pay and the type, condition and value of collateral, management will establish an allowance amount specific to the loan.

 

Management uses a risk scale to assign grades to commercial real estate, construction and land development, commercial loans and commercial equipment loans. Commercial loan relationships with an aggregate exposure to the Bank of $750,000 or greater are risk rated. Residential first mortgages, home equity and second mortgages and consumer loans are monitored on an ongoing basis based on borrower payment history. Consumer loans and residential real estate loans are classified as unrated unless they are part of a larger commercial relationship that requires grading or are troubled debt restructures or nonperforming loans with an Other Assets Especially Mentioned or higher risk rating due to a delinquent payment history.

 

The Company’s commercial loan portfolio is periodically reviewed by regulators and independent consultants engaged by management.

 

In establishing the general component of the allowance, management analyzes non-impaired loans in the portfolio including changes in the amount and type of loans. This analysis reviews trends by portfolio segment in charge-offs, delinquency, classified loans, loan concentrations and the rate of portfolio segment growth. Qualitative factors also include an assessment of the current regulatory environment, the quality of credit administration and loan portfolio management and national and local economic trends. Based upon this analysis a loss factor is applied to each loan category and the Bank adjusts the loan loss allowance by increasing or decreasing the provision for loan losses.

 

Management has significant discretion in making the judgments inherent in the determination of the allowance for loan losses, including the valuation of collateral, assessing a borrower’s prospects of repayment and in establishing loss factors on the general component of the allowance. Changes in loss factors have a direct impact on the amount of the provision and on net income. Errors in management’s assessment of the global factors and their impact on the portfolio could result in the allowance not being adequate to cover losses in the portfolio, and may result in additional provisions. An increase or decrease in the allowance could result in a charge or credit to income before income taxes that materially impacts earnings. For additional information regarding the allowance for loan losses, refer to Notes 1 and 6 of the Consolidated Financial Statements as presented in the Company’s Form 10-K for the year ended December 31, 2014 and the discussion under the caption “Provision for Loan Losses” below.

 

Other-Than-Temporary-Impairment (“OTTI”)

Debt securities are evaluated quarterly to determine whether a decline in their value is other-than-temporary. The term “other-than-temporary” is not necessarily intended to indicate a permanent decline in value. It means that the prospects for near-term recovery of value are not necessarily favorable, or that there is a lack of evidence to support fair values equal to, or greater than, the carrying value of the investment. Accounting guidance indicates that the amount of other-than-temporary impairment that is recognized through earnings for debt securities is determined by comparing the present value of the expected cash flows to the amortized cost of the security. The discount rate used to determine the credit loss is the expected book yield on the security.

 

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For additional information regarding the evaluation of OTTI, refer to Notes 1 and 5 of the Consolidated Financial Statements as presented in the Company’s Form 10-K for the year ended December 31, 2014.

 

Other Real Estate Owned (“OREO”)

The Company maintains a valuation allowance on its other real estate owned. As with the allowance for loan losses, the valuation allowance on OREO is based on FASB ASC 450 “Contingencies,” as well as the accounting guidance on impairment of long-lived assets. These statements require that the Company establish a valuation allowance when it has determined that the carrying amount of a foreclosed asset exceeds its fair value. Fair value of a foreclosed asset is measured by the cash flows expected to be realized from its subsequent disposition. These cash flows are reduced for the costs of selling or otherwise disposing of the asset.

 

In estimating the cash flows from the sale of OREO, management must make significant assumptions regarding the timing and amount of cash flows. For example, in cases where the real estate acquired is undeveloped land, management must gather the best available evidence regarding the market value of the property, including appraisals, cost estimates of development and broker opinions. Due to the highly subjective nature of this evidence, as well as the limited market, long time periods involved and substantial risks, cash flow estimates are highly subjective and subject to change. Errors regarding any aspect of the costs or proceeds of developing, selling or otherwise disposing of foreclosed real estate could result in the allowance being inadequate to reduce carrying costs to fair value and may require an additional provision for valuation allowances.

 

For additional information regarding OREO, refer to Notes 1 and 8 of the Consolidated Financial Statements as presented in the Company’s Form 10-K for the year ended December 31, 2014.

 

Deferred Tax Assets

The Company accounts for income taxes in accordance with FASB ASC 740, “Income Taxes,” which requires that deferred tax assets and liabilities be recognized using enacted tax rates for the effect of temporary differences between the book and tax bases of recorded assets and liabilities. FASB ASC 740 requires that deferred tax assets be reduced by a valuation allowance if it is more likely than not that some portion or the entire deferred tax asset will not be realized.

 

The Company periodically evaluates the ability of the Company to realize the value of its deferred tax assets.  If the Company were to determine that it was not more likely than not that the Company would realize the full amount of the deferred tax assets, it would establish a valuation allowance to reduce the carrying value of the deferred tax asset to the amount it believes would be realized. The factors used to assess the likelihood of realization are the Company’s forecast of future taxable income and available tax-planning strategies that could be implemented to realize the net deferred tax assets.

 

Failure to achieve forecasted taxable income might affect the ultimate realization of the net deferred tax assets.  Factors that may affect the Company’s ability to achieve sufficient forecasted taxable income include, but are not limited to, the following: increased competition, a decline in net interest margin, a loss of market share, decreased demand for financial services and national and regional economic conditions. 

 

The Company’s provision for income taxes and the determination of the resulting deferred tax assets and liabilities involve a significant amount of management judgment and are based on the best information available at the time. The Company operates within federal and state taxing jurisdictions and is subject to audit in these jurisdictions. 

 

For additional information regarding the deferred tax assets, refer to Note 12 in the Consolidated Financial Statements as presented in the Company’s Form 10-K for the year ended December 31, 2014.

 

OVERVIEW

Community Bank of the Chesapeake (the “Bank”) is headquartered in Southern Maryland with branches located in Maryland and Virginia. The Bank is a wholly owned subsidiary of The Community Financial Corporation. The Bank conducts business through its main office in Waldorf, Maryland, and 11 branch offices in Waldorf, Bryans Road, Dunkirk, Leonardtown, La Plata, Charlotte Hall, Prince Frederick, Lusby and California, Maryland; and King George and Fredericksburg, Virginia. The Company opened the branch in Fredericksburg, Virginia in July 2014. The Company plans to open a second full-service branch in downtown Fredericksburg in early 2016. In addition, the Company maintains five commercial loan production offices (“LPOs”) in La Plata, Prince Frederick, Leonardtown and Annapolis, Maryland; and Fredericksburg, Virginia. The Leonardtown and Fredericksburg LPOs are co-located with branches.

 

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The Bank opened its LPO in Fredericksburg, Virginia during August 2013. The Fredericksburg Virginia area market is comparable in size to our legacy Southern Maryland footprint. During the second quarter of 2014, we continued to execute the Bank’s growth strategy and added seasoned lenders and support staff to expand into the city of Annapolis and surrounding Anne Arundel County. We opened the Annapolis LPO in October 2014. We are optimistic that our returns on these investments will continue to increase shareholder value.

 

The Bank has increased assets through loan production. The Bank believes that its ability to offer fast, flexible, local decision-making will continue to attract significant new business relationships. The Bank focuses its business generation efforts on targeting small and medium sized commercial businesses with revenues between $5.0 million and $35.0 million as well as local municipal agencies and not-for-profits. The Bank’s marketing is also directed towards increasing its balances of transaction deposit accounts. The Bank believes that increases in these account types will lessen the Bank’s dependence on higher-cost funding, such as certificates of deposit and borrowings. Although management believes that this strategy will increase financial performance over time, increasing the balances of certain products, such as commercial lending and transaction accounts, may also increase the Bank’s noninterest expense. The Bank recognizes that certain lending and deposit products increase the possibility of losses from credit and other risks.

 

Third quarter 2015 results reflect the Company’s agreement to sell its King George, Virginia branch building and equipment to InFirst Federal Credit Union. The transaction is expected to close in the first quarter of 2016, pending regulatory approval. The Company will transfer the $9.0 million in deposits to its La Plata, Maryland or Fredericksburg, Virginia branches. Employees will be offered open positions with the Bank. The third quarter 2015 operating results reflect a one-time $426,000 pre-tax provision for the loss on the transaction with a $0.05 impact to earnings per share. The elimination of the current direct annual operating costs of the King George branch will have an immediate positive impact on earnings per share in 2016 with the earned back estimated to be less than 10 months.

 

On February 6, 2015, the Company issued $23.0 million of unsecured 6.25% fixed to floating rate subordinated notes due 2025. On February 13, 2015, the Company used proceeds of the offering to redeem all $20 million of the Company’s outstanding preferred stock issued under the Small Business Lending Fund (“SBLF”) program. The subordinated notes qualify as Tier 2 regulatory capital and replaced SBLF Tier 1 capital. The balance of the net proceeds will be used for general corporate purposes, including, but not limited to, contributing capital to the Bank, supporting organic growth, possible acquisitions of branches or other financial institutions should attractive acquisition opportunities arise and the payment of dividends.

 

The Company has analyzed the costs and benefits regarding continuing its residential mortgage origination operations in the current regulatory environment.  Due to rapidly increasing compliance costs and risks associated with the origination of residential mortgages, the Bank discontinued originating residential loans in April 2015. The third party sources will allow the Company to maintain a well-diversified residential portfolio while addressing the credit needs in the communities we serve. The run off of the residential portfolio, which was $12.4 million for the nine months ended September 30, 2015, is not expected to continue as the Company has established third party residential loan sources and expects to fund more loans in its residential whole loan portfolio during the fourth quarter.

 

Economy

The U.S. economy grew slowly throughout 2013 and 2014. The impact of slower economic growth on the Southern Maryland economy has been moderated by the presence of federal government agencies and defense facilities, but the ongoing possibility of large cuts to the defense budget has hampered economic expansion. The Bank’s market expansion has enabled the Company to grow the loan portfolio in the present environment. Even through the difficult economic environment, the Bank’s capital levels and asset quality have remained strong.

 

34 

 

 

For additional information regarding the local economy and its impact on the Company’s business refer to the Business Section in the Company’s Form 10-K for the year ended December 31, 2014 under the caption “Market Area” (Part I. Item 1. Business Section – Market Area).

 

Selected Financial Information and Ratios 
   (Unaudited) 
   Three Months Ended September 30,   Nine Months Ended September 30, 
   2015   2014   2015   2014 
KEY OPERATING RATIOS                    
Return on average assets   0.46%   0.73%   0.59%   0.65%
Return on average common equity   5.09    7.78    6.42    6.85 
Return on average total equity   5.09    6.59    6.26    5.82 
Average total equity to
average total assets
   9.12    11.04    9.46    11.12 
Interest rate spread   3.41    3.61    3.48    3.52 
Net interest margin   3.55    3.74    3.60    3.66 
Cost of funds   0.77    0.73    0.75    0.76 
Cost of deposits   0.48    0.55    0.48    0.58 
Cost of debt   3.06    2.33    2.77    - 
Efficiency ratio   73.62    64.07    70.55    67.82 
Non-interest expense to
average assets
   2.55    2.50    2.56    2.56 
Avg. int-earning assets to
avg. int-bearing liabilities
   117.61    118.91    117.46    118.61 
Net charge-offs to average loans   0.40    0.08    0.18    0.17 
COMMON SHARE DATA                    
Basic net income per common share  $0.28   $0.40   $1.03   $1.03 
Diluted net income per common share   0.27    0.39    1.02    1.03 
Cash dividends paid per common share   0.10    0.10    0.10    0.10 
Weighted average common shares outstanding:                    
        Basic   4,646,702    4,652,481    4,651,383    4,648,843 
        Diluted   4,683,750    4,669,784    4,688,431    4,665,447 

 

35 

 

 

Selected Financial Information and Ratios (continued)
                 
   (Unaudited)             
(dollars in thousands, except per share amounts)  September 30, 2015   December 31, 2014   $ Change   % Change 
ASSET QUALITY                    
Total assets  $1,111,976   $1,082,878   $29,098    2.7%
Gross loans   899,488    872,129    27,359    3.1 
Classified Assets   43,973    54,022    (10,049)   (18.6)
Allowance for loan losses   8,375    8,481    (106)   (1.2)
Past due loans (PDLs) (31 to 89 days)   1,975    1,820    155    8.5 
Nonperforming loans (NPLs) (>=90 days)   13,490    10,263    3,227    31.4 
Non-accrual loans (a)   14,416    10,263    4,153    40.5 
Accruing troubled debt restructures (TDRs) (b)   13,407    13,249    158    1.2 
Other real estate owned (OREO)   6,431    5,883    548    9.3 
ASSET QUALITY RATIOS                    
Classified assets to total assets   3.95%   4.99%          
Classified assets to risk-based capital   30.64    39.30           
Allowance for loan losses to total loans   0.93    0.97           
Allowance for loan losses to nonperforming loans   62.08    82.64           
Past due loans (PDLs) to total loans   0.22    0.21           
Nonperforming loans (NPLs) to total loans   1.50    1.18           
Loan delinquency (PDLs + NPLs) to total loans   1.72    1.39           
Non-accrual loans to total loans   1.60    1.18           
Non-accrual loans and TDRs to total loans   3.09    2.70           
Non-accrual loans and OREO to total assets   1.87    1.49           
Non-accrual loans, OREO and TDRs
to total assets
   3.08    2.71           
COMMON SHARE DATA                    
Book value per common share  $21.24   $20.53           
Common shares outstanding at end of period   4,709,945    4,702,715           
OTHER DATA                    
Number of:                    
Full-time equivalent employees   174    172           
Branches   12    12           
Loan Production Offices   5    5           
REGULATORY CAPITAL RATIOS                    
Tier 1 capital to average assets   10.14%   12.24%          
Tier 1 common capital to risk-weighted assets   10.34    n/a           
Tier 1 capital to risk-weighted assets   11.58    14.26           
Total risk-based capital to risk-weighted assets   14.82    15.21           

  

 

(a)  Non-accrual loans include all loans that are 90 days or more delinquent and loans that are non-accrual due to the operating results or cash flows of a customer. Non-accrual loans can include loans that are current with all loan payments. Interest and principal are recognized on a cash-basis in accordance with the Bank's policy if the loans are not impaired or there is no impairment.

 

(b)  At September 30, 2015 and December 31, 2014, the Bank had total TDRs of $18.5 million and $18.1 million, respectively, with three and two TDR relationships totaling $5.1 million and $4.9 million, respectively, in non-accrual status.  One TDR customer relationship of $3.8 million dollars has terms that defer the payment of principal and interest for a period of time. These loans will be classified as non-accrual loans during the entire concession period. These loans are classified as non-accrual loans for the calculation of financial ratios.

 

36 

 

 

COMPARISON OF RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2015 AND 2014

 

Earnings Summary

Consolidated net income available to common shareholders for the three months ended September 30, 2015 decreased $556,000, or 30.2%, to $1.3 million, or $0.27 per common share (diluted), compared to $1.8 million, or $0.39 per common share (diluted), for the three months ended September 30, 2014. Third quarter 2015 earnings were primarily impacted compared to the prior year due to a decision to sell the branch building and equipment in King George, Virginia, increased interest expense from the refinancing of SBLF with subordinated debt at 6.25% during the first quarter of 2015, and a reduction in gains on loans held for sale. The Bank stopped originating residential mortgages in April 2015. In addition, yields on the loan portfolio have declined due to the lower interest environment. Our commercial real estate loan portfolio yields have been impacted as loans have reset at current low interest rates and the competition for loan volume has increased in our local market.

 

The decrease in net income available to common shareholders for the three months ended September 30, 2015 compared to the same period in 2014 was attributable to decreased noninterest income of $652,000, increased provision for loan losses of $116,000 and increased noninterest expense of $546,000. These decreases to net income were partially offset by increased net interest income of $80,000, decreased income tax expense of $628,000 and decreased preferred stock dividends of $50,000.

 

The Company agreed to sell its King George, Virginia branch building and equipment to InFirst Federal Credit Union. The transaction is expected to close in the first quarter of 2016, pending regulatory approval. The Company will transfer the $9.0 million in deposits to its La Plata, Maryland or Fredericksburg, Virginia branches. Employees will be offered open positions with the Bank. The third quarter 2015 operating results reflect a one-time $426,000 pre-tax loss on the transaction with a $0.05 impact to earnings per share. The elimination of the current direct annual operating costs of the King George branch will have an immediate positive impact on earnings per share in 2016 with the earned back estimated to be less than 10 months.

 

The Company’s return on average assets was 0.46% for the three months ended September 30, 2015 compared to 0.73% for the three months ended September 30, 2014. The Company’s return on average common stockholders' equity was 5.09% compared to 7.78% for the same comparative period.

 

Net Interest Income

The primary component of the Company’s net income is its net interest income, which is the difference between income earned on assets and interest paid on the deposits and borrowings used to fund them. Net interest income is affected by the difference between the yields earned on the Company’s interest-earning assets and the rates paid on interest-bearing liabilities, as well as the relative amounts of such assets and liabilities. Net interest income, divided by average interest-earning assets, represents the Company’s net interest margin.

 

Net interest income increased to $9.1 million for the three months ended September 30, 2015 compared to $9.0 million for the three months ended September 30, 2014. The net interest margin was 3.55% for the three months ended September 30, 2015, a 19 basis point decrease from 3.74% for the three months ended September 30, 2014. The decrease in net interest margin was largely the result of additional interest expense related to the subordinated debt issued during the first quarter of 2015 and a spike in net interest margin during the third quarter of 2014 due to the return of several loans from nonaccrual to performing status, which resulted in an increase in interest income of $118,000. Net interest margin declined six basis points from 3.66% for the nine months ended September 30, 2014 to 3.60% for the nine months ended September 30, 2015. Net interest margin at 3.55% for the three months ended September 30, 2015 decreased five basis points from 3.60% for the three months ended June 30, 2015. Net interest income was positively impacted from the increase in the average balance of loans and the continued decrease in the cost of deposits compared to the same period of 2014.

 

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The following table shows the components of net interest income and the dollar and percentage changes for the periods presented.

  

   Three Months Ended September 30,         
(dollars in thousands )  2015   2014   $ Change   % Change 
Interest and Dividend Income                    
   Loans, including fees  $10,336   $10,114   $222    2.2%
   Taxable interest and dividends on investment securities   661    550    111    20.2%
   Interest on deposits with banks   5    3    2    66.7%
Total Interest and Dividend Income   11,002    10,667    335    3.1%
                     
Interest Expenses                    
   Deposits   1,068    1,135    (67)   (5.9)%
   Short-term borrowings   5    3    2    66.7%
   Long-term debt   845    525    320    61.0%
Total Interest Expenses   1,918    1,663    255    15.3%
                     
Net Interest Income (NII)  $9,084   $9,004   $80    0.9%

 

Interest and dividend income increased by $335,000 to $11.0 million for the three months ended September 30, 2015 compared to $10.7 million for the three months ended September 30, 2014, primarily due to increased income from the growth in the average balance of loans and investments and increased investment yields. Interest and dividend income on loans increased $553,000 due to growth of $47.0 million in the average balance of loans from $832.7 million for the three months ended September 30, 2014 to $879.7 million for the three months ended September 30, 2015. Interest and dividend income on investments increased $113,000 during the third quarter of 2015 compared to the same period in the prior year as average interest-earning investment balances increased $13.9 million and average yields increased from 1.69% to 1.84%. Average loan yields declined 16 basis points from 4.86% for the three months ended September 30, 2014 to 4.70% for the three months ended September 30, 2015, which resulted in a decrease in interest and dividend income of $331,000.

 

Interest expense increased $255,000 to $1.9 million for the three months ended September 30, 2015 compared to the three months ended September 30, 2014, due primarily to an increase in interest expense related to the subordinated notes issued during the first quarter of 2015. During the three months ended September 30, 2015, interest expense increased $360,000 due to the subordinated note issuance, and $36,000 due to increased average balances of interest-bearing transaction deposit accounts compared to the same quarter of 2014. Additionally, interest expense increased $33,000 on money market accounts, as rates increased modestly from 0.26% to 0.30% for the third quarter of 2015. The average rate paid on debt, which includes long-term debt, trust preferred junior subordinated debentures (“TRUPS”), subordinated notes, and short-term borrowings, increased from 2.33% for the three months ended September 30, 2014 to 3.06% for the comparable period in 2015. The increases to interest expense were partially offset by reductions of $45,000 due to lower average balances of long-term debt and time deposits and $129,000 due to decreases in rates paid on time deposits and debt.

 

The issuance of subordinated debt was the primary reason the average cost of total interest-bearing liabilities increased six basis points from 0.82% for the third quarter of 2014 to 0.88% for the third quarter of 2015. However, the Company continued to make significant progress in reducing overall deposit costs, which decreased seven basis points from 0.55% for the three months ended September 30, 2014 to 0.48% for the three months ended September 30, 2015. Average transaction deposits, which include savings, money market, interest-bearing demand and non-interest bearing demand accounts, for the three months ended September 30, 2015 increased $71.1 million or 16.4% to $503.5 million compared to $432.4 million for the comparable period in 2014. The increase in average transaction deposits included growth in average noninterest bearing demand deposits of $19.8 million from $103.4 million for the three months ended September 30, 2014 to $123.2 million for the three months ended September 30, 2015. Average transaction accounts as a percentage of average total deposits increased from 52.5% for the three months ended September 30, 2014 to 57.0% for the three months ended September 30, 2015. The Company is less dependent on time deposits for funding. In the current year, the progress in continuing to add transaction deposits has mitigated some of the impact of the increased interest expense associated with the subordinated notes issued.

 

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The following table presents information on average balances and rates for deposits.

 

   For the Three Months Ended September 30, 
   2015   2014 
   Average   Average   Average   Average 
(dollars in thousands)  Balance   Rate   Balance   Rate 
Savings  $45,697    0.10%  $40,736    0.10%
Interest-bearing demand and money market accounts   334,691    0.30%   288,280    0.26%
Certificates of deposit   379,867    0.84%   390,975    0.96%
Total interest-bearing deposits   760,255    0.56%   719,991    0.63%
Noninterest-bearing demand deposits   123,118         103,405      
   $883,373    0.48%  $823,396    0.55%

 

The following table sets forth certain information regarding changes in interest income and interest expense of the Bank for the periods indicated. For each category of interest-earning asset and interest-bearing liability, information is provided on changes attributable to (1) changes in volume (changes in volume multiplied by old rate); and (2) changes in rate (changes in rate multiplied by old volume). Changes in rate-volume (changes in rate multiplied by the change in volume) have been allocated to changes due to volume.

  

   Three Months Ended September 30, 2015 
   compared to Three Months Ended 
   September 30, 2014 
       Due to     
dollars in thousands  Volume   Rate   Total 
             
Interest income:               
Loan portfolio (1)  $553   $(331)  $222 
Investment securities, federal funds sold and interest bearing deposits   64    49    113 
Total interest-earning assets  $617   $(282)  $335 
                
Interest-bearing liabilities:               
Savings   1    -    1 
Interest-bearing demand and money market accounts   35    33    68 
Certificates of deposit   (23)   (114)   (137)
Long-term debt   (23)   (18)   (41)
Short-term debt   1    1    2 
Subordinated notes   360    -    360 
Guaranteed preferred beneficial interest in junior subordinated debentures   -    2    2 
Total interest-bearing liabilities  $351   $(96)  $255 
Net change in net interest income  $266   $(186)  $80 

 

(1) Average balance includes non-accrual loans                    

 

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The following table presents information on the average balances of the Company’s interest-earning assets and interest-bearing liabilities and interest earned or paid thereon for the three months ended September 30, 2015 and 2014, respectively. There are no tax equivalency adjustments.

 

   For the Three Months Ended September 30, 
       2015           2014     
           Average           Average 
   Average       Yield/   Average       Yield/ 
dollars in thousands  Balance   Interest   Cost   Balance   Interest   Cost 
Assets                              
Interest-earning assets:                              
Loan portfolio (1)  $879,702   $10,336    4.70%  $832,674   $10,114    4.86%
Investment securities, federal funds sold and interest-bearing deposits   145,145    666    1.84%   131,162    553    1.69%
Total Interest-Earning Assets   1,024,847    11,002    4.29%   963,836    10,667    4.43%
Cash and cash equivalents   12,108              14,284           
Other assets   67,352              59,497           
Total Assets  $1,104,307      &n