UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

 

FORM 10-Q

 

For the Quarterly Period Ended:  March 31, 2016

OR

For the transition Period from                 To                

Commission File Number 000-49966

 

COMMUNITY FIRST, INC.

(Exact Name of Registrant as Specified in its Charter)

 

 

(931) 380-2265

(Registrant’s Telephone Number, Including Area Code)

None

(Former Name, Address and 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  o

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

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 definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act:

 

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock as of the latest practicable date.  Common stock outstanding (no par value): 3,297,595 shares of common stock, no par value per share, as of May 6, 2016.

 

 

 

 

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COMMUNITY FIRST, INC.

TABLE OF CONTENTS

 

 

 

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PART I. FINANCIAL INFORMATION

Community First, Inc.

Consolidated Balance Sheets

March 31, 2016 (Unaudited) and December 31, 2015

(amounts in thousands, except share and per share data)

 

 

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Community First, Inc.

Consolidated Balance Sheets

March 31, 2016 (Unaudited) and December 31, 2015

(Continued)

(amounts in thousands, except share and per share data)

 

 

See accompanying notes to unaudited consolidated financial statements.

 

 

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Community First, Inc.

Consolidated Statements of Operations and Comprehensive Income

Three Months Ended March 31, 2016 and 2015

(Unaudited)

 

 

See accompanying notes to unaudited consolidated financial statements.

 

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Community First, Inc.

Consolidated Statements of Operations and Comprehensive Income

Three Months Ended March 31, 2016 and 2015

(Unaudited, Continued)

 

 

See accompanying notes to unaudited consolidated financial statements.

 

 

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Community First, Inc.

Consolidated Statement of Changes in Shareholders’ Equity

Three Months Ended March 31, 2016

(Unaudited)

(amounts in thousands, except share and per share data)

 

 

See accompanying notes to unaudited consolidated financial statements.

 

 

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Community First, Inc.

Consolidated Statements of Cash Flows

Three Months Ended March 31, 2016 and 2015

(Unaudited)

 

 

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Community First, Inc.

Consolidated Statements of Cash Flows

Three Months Ended March 31, 2016 and 2015

(Unaudited, Continued)

 

 

See accompanying notes to unaudited consolidated financial statements.

 

 

 

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COMMUNITY FIRST, INC.

Notes to Consolidated Financial Statements

March 31, 2016

(Unaudited)

 

(amounts in thousands, except share and per share data)

NOTE 1 – ORGANIZATION AND BASIS OF PRESENTATION

The consolidated financial statements include Community First, Inc. and its wholly-owned subsidiary, Community First Bank & Trust.  Community First, Inc., together with the Bank, is referred to herein as the “Company.” The sole subsidiary of Community First Bank & Trust is Community First Properties, Inc. (“Properties”), which was originally established as a Real Estate Investment Trust (“REIT”) but which terminated its REIT election in the first quarter of 2012.   Community First Bank & Trust together with its subsidiary is referred to herein as the “Bank.”   Intercompany transactions and balances are eliminated in consolidation.

The Bank conducts substantially all of its banking activities in Maury, Williamson and Hickman Counties, in Tennessee.  Its primary deposit products are checking, savings, and term certificate accounts, and its primary lending products are residential mortgage, commercial, and installment loans.  Substantially all loans are secured by specific items of collateral including business assets, consumer assets, and commercial and residential real estate.  Commercial loans are expected to be repaid from cash flows from operations of businesses.  The significant loan concentrations that exceed 10% of total loans are as follows:  commercial real estate loans, 1-4 family residential loans, and construction loans.  The customers’ ability to repay their loans is dependent, on the real estate and general economic conditions in the Company’s market areas.  Other financial instruments, which potentially represent concentrations of credit risk, include deposit accounts in other financial institutions and federal funds sold.

The unaudited consolidated financial statements as of March 31, 2016 and for the three-month periods ended March 31, 2016 and 2015 have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim information and in accordance with the instructions to Form 10-Q and Article 10 of Regulation S-X as promulgated by the Securities and Exchange Commission (the “SEC”) and, in the opinion of management, include all adjustments, consisting of normal recurring adjustments, necessary to present fairly the information.  They do not include all the information and footnotes required by GAAP for complete financial statements.  Operating results for interim periods are not necessarily indicative of the results that may be expected for the entire year. For further information, refer to the 2015 consolidated audited financial statements and footnotes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2015, filed with the SEC on March 9, 2016 (File No. 000-49966) (the “2015 Form 10-K”).

Critical Accounting Policies:

The consolidated financial statements in this report are prepared in conformity with GAAP and with general practices in the banking industry. As such, we are required to make certain estimates, judgments, and assumptions that we believe are reasonable based upon the information available. These estimates and assumptions affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. A summary of our significant accounting policies is described in our 2015 Form 10-K. The significant accounting policies and estimates which we believe are the most critical to aid in fully understanding and evaluating our reported financial results include the following:

Allowance for Loan Losses:  Credit risk is inherent in the business of extending loans to borrowers.  This credit risk is addressed through a valuation allowance for probable incurred credit losses.  Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed.  Subsequent recoveries, if any, are credited to the allowance. Management estimates the allowance balance required using past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions, and other factors.  Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management’s judgment, should be charged off.

The allowance consists of specific and general components.  The specific component relates to loans that are individually classified as impaired.

A loan is identified as impaired when, based on current information and events, it is probable that the scheduled payments of principal or interest will not be collected when due according to the contractual terms of the loan agreement.  However, some loans are termed impaired because of doubt regarding collectability of interest and principal according to the contractual terms, even though such loans are both fully secured by collateral and current in their interest and principal payments.  Additionally, loans are considered troubled debt restructurings and classified as impaired if their terms have been modified resulting in a concession, and for which the borrower is experiencing financial difficulties.

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COMMUNITY FIRST, INC.

Notes to Consolidated Financial Statements

March 31, 2016

(Unaudited)

 

NOTE 1 – ORGANIZATION AND BASIS OF PRESENTATION (Continued)

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

All loans over $250 that are unlikely to be collected under existing terms are individually evaluated for impairment.  If a loan is impaired, a portion of the allowance is allocated so that the loan is reported net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral.  Large groups of smaller balance homogeneous loans, such as consumer and residential real estate loans, are collectively evaluated for impairment, and accordingly, they are not separately identified for impairment disclosures.

Troubled debt restructurings are separately identified for impairment disclosures and are measured at the present value of estimated future cash flows using the loan’s effective rate at inception.  If a troubled debt restructuring is considered to be a collateral dependent loan, the loan is reported, net, at the fair value of the collateral.  For troubled debt restructurings that subsequently default, the Company determines the amount of reserve in accordance with the accounting policy for the allowance for loan losses.

The general component of the allowance covers loans collectively evaluated for impairment and is based on historical loss experience adjusted for current factors.  The historical loss experience is determined by portfolio segment and is based on the actual loss history experienced by the Company over the most recent four years.  This actual loss experience is supplemented with other economic factors based on the risks present for each portfolio segment.  These economic factors include, but are not limited to, consideration of the following:  levels of and trends in delinquencies and impaired loans; levels of and trends in charge-offs and recoveries; trends in volume and terms of loans; effects of any changes in risk selection and underwriting standards; other changes in lending policies, procedures, and practices; experience, ability, and depth of lending management and other relevant staff; national and local economic trends and conditions; industry conditions; and effects of changes in credit concentrations. The following loan portfolio segments have been identified with a discussion of the risk characteristics of these portfolio segments:

Real Estate Construction loans consist of loans made for both residential and commercial construction and land development.  Residential real estate construction loans are loans secured by real estate to build 1-4 family dwellings.  These are loans made to borrowers obtaining loans in their personal name for the personal construction of their own dwellings or loans to builders for the purpose of constructing homes for resale.  These loans to builders can be for speculative homes for which there is no specific homeowner for which the home is being built, as well as loans to builders that have a pre-sale contract to another party.

Commercial Construction loans are loans extended to borrowers secured by and to build commercial structures such as churches, retail strip centers, industrial warehouses or office buildings.  Land development loans are granted to commercial borrowers to finance the improvement of real estate by adding infrastructure so that ensuing construction can take place.  Construction and land development loans are generally short term in maturity to match the expected completion of a particular project.  These loan types are generally more vulnerable to changes in economic conditions in that they project there will be a demand for the product.  They require monitoring to ensure the project is progressing in a timely manner within the expected budgeted amount.  This monitoring is accomplished via periodic physical inspections by an outside third party.

1-4 Family Residential loans consist of both open end and closed end loans secured by first or junior liens on 1-4 family improved residential dwellings.  Open end loans are home equity lines of credit that allow the borrower to use equity in the real estate to borrow and repay as the need arises.  First and junior lien residential real estate loans are closed end loans with a specific maturity that generally does not exceed seven years.  Economic conditions can affect the borrower’s ability to repay the loans, and the value of the real estate securing the loans can change over the life of the loan.

Commercial Real Estate loans consist of loans secured by farmland or by improved commercial property.  Farmland includes all land known to be used or usable for agricultural purposes, such as crop and livestock production, grazing, or pasture land.  Improved commercial property can be owner occupied or non-owner occupied property secured by commercial structures such as churches, retail strip centers, hotels, industrial warehouses or office buildings.  The repayment of these loans tends to depend upon the operation and management of a business or lease income from a business, and therefore adverse economic conditions can affect the borrower’s ability to repay.

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COMMUNITY FIRST, INC.

Notes to Consolidated Financial Statements

March 31, 2016

(Unaudited)

 

NOTE 1 – ORGANIZATION AND BASIS OF PRESENTATION (Continued)

Other Real Estate Secured loans consist of loans secured by five or more multi-family dwelling units.  These loans are typically exemplified by apartment buildings or complexes.  The ability to manage and rent units affects the income that usually provides repayment for this type of loan.

Commercial, Financial, and Agricultural loans consist of loans extended for the operation of a business or a farm.  They are not secured by real estate.  Commercial loans are used to provide working capital, acquire inventory, finance the carrying of receivables, purchase equipment or vehicles, or purchase other capital assets. Agricultural loans are typically for purposes such as planting crops, acquiring livestock, or purchasing farm equipment.  The repayment of these loans comes from the cash flow of a business or farm and is generated by sales of inventory or providing of services.  The collateral tends to depreciate over time and is difficult to monitor.  Frequent statements are required from the borrower pertaining to inventory levels or receivables aging.

Consumer loans consist largely of loans extended to individuals for purposes such as to purchase a vehicle or other consumer goods. These loans are not secured by real estate but are frequently collateralized by the consumer items being acquired with the loan proceeds.  This type of collateral tends to depreciate, and therefore the term of the loan is tailored to fit the expected value of the collateral as it depreciates, along with specific underwriting policies and guidelines.

Tax Exempt loans consist of loans that are extended to entities such as municipalities.  These loans tend to be dependent on the ability of the borrowing entity to continue to collect taxes to repay the indebtedness.

Other loans consist of those loans which are not elsewhere classified in these categories and are not secured by real estate.

 

 

NOTE 2 - SECURITIES AVAILABLE FOR SALE

The following table summarizes the amortized cost and fair value of the available for sale securities portfolio at March 31, 2016 and December 31, 2015 and the corresponding amounts of gross unrealized gains and losses recognized in accumulated other comprehensive income (loss), net of applicable income taxes:

 

 

The proceeds from sales of securities and the associated gains and losses are listed below:

 

 

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COMMUNITY FIRST, INC.

Notes to Consolidated Financial Statements

March 31, 2016

(Unaudited)

 

NOTE 2 - SECURITIES AVAILABLE FOR SALE (Continued)

The amortized cost and fair value of the securities portfolio are shown by contractual maturity. Expected maturities may differ from contractual maturities if borrowers have the right to call or prepay obligations with or without call or prepayment penalties.  Mortgage backed securities are presented separately due to varying maturity dates as a result of prepayments.

 

 

At March 31, 2016 and December 31, 2015, respectively, securities totaling $42,901 and $46,757 were pledged to secure public deposits.

The Company did not hold securities of any one issuer, other than U.S. Government sponsored entities, with a face amount greater than 10% of shareholders’ equity as of March 31, 2016 or December 31, 2015.

The following table summarizes securities with unrealized losses at March 31, 2016 and December 31, 2015 aggregated by major security type and length of time in a continuous unrealized loss position:

 

 

 

Other-Than-Temporary Impairment

Management evaluates securities for other-than-temporary impairment (“OTTI”) at least on a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. The securities portfolio is evaluated for OTTI by segregating the portfolio into two general segments – securities in a loss position for less than 12 months and securities in a loss position for 12 months or more – and applying the appropriate OTTI model.  Securities classified as available for sale are generally evaluated for OTTI under the provisions of ASC 320-10, Investments - Debt and Equity Securities. In determining OTTI, management considers many factors, including: (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, (3) whether the market decline was affected by macroeconomic conditions, and (4) whether the Company has the intent to sell the debt security or more likely than not will be required to sell the debt security before its anticipated recovery.  The assessment of whether an other-than-temporary decline exists involves a high degree of subjectivity and judgment and is based on the information available to management at a point in time.

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COMMUNITY FIRST, INC.

Notes to Consolidated Financial Statements

March 31, 2016

(Unaudited)

 

NOTE 2 - SECURITIES AVAILABLE FOR SALE (Continued)

When OTTI occurs, the amount of the OTTI recognized in earnings depends on whether an entity intends to sell the security or it is more likely than not it will be required to sell the security before recovery of its amortized cost basis, less any current-period credit loss. If an entity intends to sell or it is more likely than not it will be required to sell the security before recovery of its amortized cost basis, less any current-period credit loss, the OTTI shall be recognized in earnings equal to the entire difference between the investment’s amortized cost basis and its fair value at the balance sheet date. If an entity does not intend to sell the security and it is not more likely than not that the entity will be required to sell the security before recovery of its amortized cost basis less any current-period loss, the OTTI shall be separated into the amount representing the credit loss and the amount related to all other factors. The amount of the total OTTI related to the credit loss is determined based on the present value of cash flows expected to be collected and is recognized in earnings. The amount of the total OTTI related to other factors is recognized in other comprehensive income, net of applicable taxes. The previous amortized cost basis less the OTTI recognized in accumulated other comprehensive income becomes the new amortized cost basis of the investment.

As of March 31, 2016, the Company’s securities portfolio consisted of 73 securities, 17 of which were in an unrealized loss position. Because the decline in fair value is attributable to changes in interest rates and illiquidity, and not credit quality, and because the Company did not have at March 31, 2016 the intent to sell these securities and at that date it was likely that it would not be required to sell the securities before their anticipated recovery, the Company did not consider these securities to be other-than-temporarily impaired at March 31, 2016.

 

 

NOTE 3 - FAIR VALUE

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

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

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

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

The Company used the following methods and significant assumptions to estimate the fair value of each type of financial instrument:

U.S. Government Sponsored Entities and Mortgage-Backed Securities:  The Company uses an independent third party to value its U.S. government sponsored entities and mortgage-backed securities, which are obligations that are not backed by the full faith and credit of the United States government and consist of Government Sponsored Entities that either issue the securities or guarantee the collection of principal and interest payments thereon. The third party’s valuation approach uses relevant information generated by recently executed transactions that have occurred in the market place that involve similar assets, as well as using cash flow information when necessary. These inputs are observable, either directly or indirectly in the market place for similar assets. The Company considers these valuations to be Level 2 pricing; however, when the securities are added to the portfolio after the third party’s system-wide market value monthly update, the valuations are considered Level 3 pricing.

State and Municipal Securities:  The valuation of the Company’s state and municipal securities is supported by analysis prepared by an independent third party. The third party’s approach to determining fair value involves using recently executed transactions for similar securities and market quotations for similar securities. For these securities that are rated by the rating agencies and have recent trades, the Company considers these valuations to be Level 2 pricing. For these securities that are not rated by the rating agencies and for which trading volumes are thin, the valuations are considered Level 3 pricing.

Corporate Securities:  For corporate securities where quoted prices or market prices of similar securities are not available, fair values are calculated using discounted cash flows (Level 3) as determined by an independent third party. The significant unobservable inputs used in the valuation model include discount rates and yields or current spreads to the United States Department of the Treasury (the “U.S. Treasury”) rates.

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COMMUNITY FIRST, INC.

Notes to Consolidated Financial Statements

March 31, 2016

(Unaudited)

 

NOTE 3 - FAIR VALUE (Continued)

Loans Held for Sale: Generally, the fair value of loans held for sale is based on what secondary markets are currently offering for loans with similar characteristics or based on an agreed upon sales price with third party investors and typically result in a Level 2 classification of the inputs for determining fair value.  The Company has elected to carry mortgage loans held for sale at fair value on a recurring basis as permitted under the guidance in ASC 825.

Impaired Loans: The fair value of impaired loans with specific allocations of the allowance for loan losses is generally based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value.

Other Real Estate Owned: Real estate acquired through foreclosure on a loan or by surrender of the real estate in lieu of foreclosure is called “OREO”. OREO is initially recorded at the fair value of the property less estimated costs to sell, which establishes a new cost basis. OREO is subsequently accounted for at the lower of cost or fair value less estimated costs to sell. Fair value is commonly based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Valuation adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value. Valuation adjustments are also required when the listing price to sell an OREO property has had to be reduced below the current carrying value. If there is a decrease in the fair value of the property from the last valuation, the decrease in value is charged to noninterest expense. All income produced from, changes in fair values in, and gains and losses on OREOs is also included in noninterest expense. During the time the property is held, all related operating and maintenance costs are expensed as incurred.

Appraisals for both collateral dependent impaired loans and OREO are performed by certified general appraisers, certified residential appraisers or state licensed appraisers whose qualifications and licenses are annually reviewed and verified by the Bank. Once received, either Bank personnel or an independent review appraiser reviews the assumptions and approaches utilized in the appraisal, as well as the overall resulting fair value, and determines whether the appraisal is reasonable. Appraisals for collateral dependent impaired loans and OREO are updated annually. On an annual basis, the Company compares the actual selling costs of collateral that has been liquidated to the selling price to determine what additional adjustment should be made to the appraisal value to arrive at fair value. Beginning in the third quarter of 2010, the Company’s analysis indicated that a discount of 15% should be applied to properties with appraisals performed within 12 months.

Mortgage Banking Derivatives: Commitments to fund mortgage loans (interest rate locks) to be sold into the secondary market are accounted for as free standing derivatives. Fair values of these mortgage derivatives are estimated based on the anticipated gain from the sale of the underlying loan. Changes in the fair values of these derivatives are included in noninterest income as gain on sale of loans.

Assets and Liabilities Measured on a Recurring Basis

 

 

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COMMUNITY FIRST, INC.

Notes to Consolidated Financial Statements

March 31, 2016

(Unaudited)

 

NOTE 3 - FAIR VALUE (Continued)

 

 

There were no transfers among fair value pricing levels during the three months ended March 31, 2016 and 2015.

The following table summarizes the differences between the fair value and the principal balance for loans held for sale measured at fair value as of December 31, 2015:

 

 

The table below presents a reconciliation and income statement classification of gains and losses for all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the three-month periods ended March 31, 2016 and 2015:

 

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COMMUNITY FIRST, INC.

Notes to Consolidated Financial Statements

March 31, 2016

(Unaudited)

 

NOTE 3 - FAIR VALUE (Continued)

Assets and Liabilities Measured on a Non-Recurring Basis

Assets and liabilities measured at fair value on a non-recurring basis are summarized below:

 

 

 

Impaired loans, with specific allocations or partial charge offs based on the fair value of the underlying collateral for collateral dependent loans, had a recorded investment of $351 at March 31, 2016, with a valuation allowance of $68, resulting in no additional provision for loan losses for the three-month period ended March 31, 2016. No additional provision was recorded in the first three months of 2015 on impaired loans. Impaired loans, with specific allocations or partial charge offs based on the fair value of the underlying collateral for collateral dependent loans, had a recorded investment of $490, with a valuation allowance of $166, resulting in no additional provision for loan losses for the year ended December 31, 2015.

Other real estate owned, measured at the lower of carrying or fair value less costs to sell, had a net carrying amount of $4,736, which is made up of the outstanding balance of $6,087, net of a valuation allowance of $1,351 at March 31, 2016, resulting in a write-down of $187 charged to expense in the three months ended March 31, 2016, compared to no write-down charged to expense in the three months ended March 31, 2015. Net carrying amount was $6,320 at December 31, 2015, which was made up of the outstanding balance of $8,188, net of a valuation allowance of $1,868.

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COMMUNITY FIRST, INC.

Notes to Consolidated Financial Statements

March 31, 2016

(Unaudited)

 

NOTE 3 - FAIR VALUE (Continued)

The following table presents quantitative information about Level 3 fair value measurements for financial instruments at fair value on a non-recurring basis at March 31, 2016:

 

 

Carrying amount and estimated fair values of significant financial instruments at March 31, 2016 and December 31, 2015 were as follows:

 

 

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COMMUNITY FIRST, INC.

Notes to Consolidated Financial Statements

March 31, 2016

(Unaudited)

 

NOTE 3 - FAIR VALUE (Continued)

 

 

Carrying amount is the estimated fair value for cash and cash equivalents, demand deposits, short-term debt, and variable rate loans or deposits that reprice frequently and fully resulting in a Level 1 classification. The method for determining fair values of securities was discussed elsewhere in this footnote. Restricted equity securities do not have readily determinable fair values due to their restrictions on transferability, therefore cost basis is appropriate fair value. For fixed rate loans and variable rate loans with infrequent repricing or repricing limits, fair value is based on discounted cash flows using current market rates applied to the estimated life and credit risk resulting in a Level 3 classification. For fixed and variable rate deposits with infrequent repricing or repricing limits, fair value is based on discounted cash flows using current market rates applied to the estimated life and credit risk resulting in a Level 2 classification. Fair value for impaired loans is estimated using discounted cash flow analysis or underlying collateral values resulting in a Level 3 classification. Fair value of loans held for sale is based on market quotes resulting in a Level 2 classification. Fair value of subordinated debentures is based on discounted cash flows using current rates for similar financing resulting in a Level 3 classification. The fair value of off-balance-sheet items is not considered material.

 

 

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COMMUNITY FIRST, INC.

Notes to Consolidated Financial Statements

March 31, 2016

(Unaudited)

 

NOTE 4 - LOANS

Loans outstanding by category at March 31, 2016 and December 31, 2015 were as follows:

 

 

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COMMUNITY FIRST, INC.

Notes to Consolidated Financial Statements

March 31, 2016

(Unaudited)

 

NOTE 4 – LOANS (Continued)

The following tables present activity in allowance for loan losses and the outstanding loan balance by portfolio segment and are based on impairment methods as of March 31, 2016 and 2015. The balances for “recorded investment” in the following tables related to credit quality do not include approximately $814, $680 and $792 in accrued interest receivable at March 31, 2016, March 31, 2015 and December 31, 2015, respectively. Accrued interest receivable is a component of the Company’s recorded investment in loans.

 

 

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COMMUNITY FIRST, INC.

Notes to Consolidated Financial Statements

March 31, 2016

(Unaudited)

 

NOTE 4 – LOANS (Continued)

 

 

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COMMUNITY FIRST, INC.

Notes to Consolidated Financial Statements

March 31, 2016

(Unaudited)

 

NOTE 4 – LOANS (Continued)

Loans individually evaluated for impairment by class of loans as of and for the three months ended March 31, 2016:

 

 

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COMMUNITY FIRST, INC.

Notes to Consolidated Financial Statements

March 31, 2016

(Unaudited)

 

NOTE 4 – LOANS (Continued)

Loans individually evaluated for impairment by class of loans as of and for the three months ended March 31, 2015:

 

 

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COMMUNITY FIRST, INC.

Notes to Consolidated Financial Statements

March 31, 2016

(Unaudited)

 

NOTE 4 – LOANS (Continued)

Loans individually evaluated for impairment by class of loans as of and for the year ended December 31, 2015:

 

 

Troubled Debt Restructurings

The Company has $7,755 of loans with allocated specific reserves of $296 to customers whose loan terms have been modified in troubled debt restructurings as of March 31, 2016 compared to $7,932 with allocated specific reserves of $311 at December 31, 2015.  The Company lost $3 and $34 of interest income in the three months ended March 31, 2016 and 2015, respectively, that would have been recorded in interest income if the specific loans had not been restructured.  The Bank had no commitments to lend additional funds to loans classified as troubled debt restructurings at March 31, 2016 or December 31, 2015.

During the first three months of 2016, the terms of certain loans were modified as troubled debt restructurings. The modification of the terms of such loans included one or a combination of the following: a reduction of the stated interest rate of the loan; an extension of the maturity date at a stated rate of interest lower than the current market rate for new debt with similar risk; or granting of amortization terms for balloon notes that are longer than the Bank’s typical practice.

Modifications involving a reduction of the stated interest rate and extension of the maturity date of the loan were for periods ranging from six months to two years.

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COMMUNITY FIRST, INC.

Notes to Consolidated Financial Statements

March 31, 2016

(Unaudited)

 

NOTE 4 – LOANS (Continued)

Loans classified as troubled debt restructurings are included in impaired loans.

Changes in the Company’s restructured loans are set forth in the table below:

 

The following table presents loans by class modified as troubled debt restructurings that occurred during the first three months of 2016 and 2015:

 

 

Troubled debt restructurings described in the table above had an outstanding balance of $26 at March 31, 2016. There was no increase for the allowance for loan losses during the first three months of 2016.  Troubled debt restructurings still accruing interest totaled $7,356 and $6,729 at March 31, 2016 and December 31, 2015, respectively.

A loan is considered to be in payment default once it is more than 90 days contractually past due under the modified terms.  There were no troubled debt restructurings for which there was a payment default within twelve months following the modification during the first three months of 2016 or 2015.

In order to determine whether a borrower is experiencing financial difficulty, an evaluation is performed of the probability that the borrower will be in payment default on any of its debt in the foreseeable future without modification.  This evaluation is performed in accordance with the Company’s internal loan policy.  Nonperforming loans include both smaller balance homogeneous loans that are collectively evaluated for impairment and individually classified impaired loans.

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COMMUNITY FIRST, INC.

Notes to Consolidated Financial Statements

March 31, 2016

(Unaudited)

 

NOTE 4 – LOANS (Continued)

The following table presents the recorded investment in nonaccrual loans and loans past due over 90 days still accruing by class of loans as of March 31, 2016 and December 31, 2015:

 

 

The following table presents the aging of the recorded investment in past due loans, including nonaccrual loans as of March 31, 2016 and December 31, 2015 by class of loans:

 

 

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COMMUNITY FIRST, INC.

Notes to Consolidated Financial Statements

March 31, 2016

(Unaudited)

 

NOTE 4 – LOANS (Continued)

 

 

Credit Quality Indicators:

The Company categorizes loans into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors.  The Company analyzes loans individually by classifying the loans as to credit risk.  The Company assigns an initial credit risk rating on every loan.  All loan relationships with aggregate debt greater than $250 are reviewed at least annually or more frequently if performance of the loan or other factors warrants review.  Smaller balance loans are reviewed and evaluated based on changes in loan performance, such as becoming past due or upon notifying the Bank of a change in the borrower’s financial status.  This analysis is performed on a monthly basis.  The Company uses the following definitions for risk ratings:

Watch.  Loans characterized by borrowers who have marginal cash flow, marginal profitability, or have experienced operating losses and declining financial condition.  The borrower has satisfactorily handled debts with the Bank in the past, but in recent months has either been late, delinquent in making payments, or made sporadic payments.  While the Bank continues to be adequately secured, the borrower’s margins have decreased or are decreasing, despite the borrower’s continued satisfactory condition.  Other characteristics of borrowers in this class include inadequate credit information and weakness of financial statement and repayment capacity, but with collateral that appears to limit the Bank’s exposure.  This classification includes loans to established borrowers that are reasonably margined by collateral, but where potential for improvement in financial capacity is limited.

Special Mention.  Loans with potential weaknesses that deserve management’s close attention.  If left uncorrected, these potential weaknesses may result in deteriorating prospects for the repayment source or in the Bank’s credit position in the future.

Substandard.  Loans inadequately protected by the payment capacity of the borrower or the pledged collateral.

Doubtful.  Loans with the same characteristics as substandard loans with the added characteristic that the weaknesses make collection or liquidation in full highly questionable and improbable on the basis of currently existing facts, conditions, and values.   These are poor quality loans in which neither the collateral nor the financial condition of the borrower presently ensure collectability in full in a reasonable period of time or evidence of permanent impairment in the collateral securing the loan.

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COMMUNITY FIRST, INC.

Notes to Consolidated Financial Statements

March 31, 2016

(Unaudited)

 

NOTE 4 – LOANS (Continued)

Impaired loans are evaluated separately from other loans in the Bank’s portfolio.  Credit quality information related to impaired loans was presented above and is excluded from the tables below.

Loans not meeting the criteria above that are analyzed individually as part of the above described process are considered to be pass rated loans.  As of March 31, 2016 and December 31, 2015, and based on the most recent analysis performed, the risk categories of loans by class of loans are as follows:

 

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COMMUNITY FIRST, INC.

Notes to Consolidated Financial Statements

March 31, 2016

(Unaudited)

 

 NOTE 4 – LOANS (Continued)

 

 

 

NOTE 5 - INCOME PER SHARE

In accordance with ASC 260-10, Earnings Per Share, basic income per share available to common shareholders is computed by dividing net income available to common shareholders by the weighted average number of common shares outstanding during the period.  Diluted income per share available to common shareholders reflects the potential dilution that could occur if securities, stock options or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the income of the Company.  The factors used in the income per share computation follow:

 

 

At March 31, 2016 and 2015, respectively, stock options for 40,400 and 47,800 shares of common stock were not considered in computing diluted net income per share for the three-month periods ended March 31, 2016 and 2015 because they were antidilutive.

 

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COMMUNITY FIRST, INC.

Notes to Consolidated Financial Statements

March 31, 2016

(Unaudited)

 

 

NOTE 6 - INCOME TAXES

The Company recorded $481 of income tax expense during the first three months of 2016, which is an effective tax rate of 39.02%.  Due to economic conditions and losses recognized between 2008 and 2015, the Company established a valuation allowance against materially all of its deferred tax assets.  Due to improvements in the Company’s performance and overall condition, management determined during the fourth quarter of 2015 that it is more likely than not that the Company’s deferred tax asset can be realized through current and future taxable income.  The Company has approximately $51,517 in net operating losses for state tax purposes that begin to expire in 2020 and $23,685 for federal tax purposes that begin to expire in 2031 to be utilized by future earnings.

 

 

NOTE 7 – REGULATORY MATTERS

Bank holding companies with total consolidated assets in excess of $1 billion and banks are subject to regulatory capital requirements administered by state and federal banking agencies.  Capital adequacy guidelines and, additionally for banks, prompt corrective action regulations, involve quantitative measures of assets, liabilities, and certain off‑balance‑sheet items calculated under regulatory accounting practices.  Capital amounts and classifications are also subject to qualitative judgments by regulators.  Failure to meet minimum capital requirements can initiate regulatory actions that could have a direct material effect on the financial statements.

Prompt corrective action regulations classify banks into one of five capital categories depending on how well they meet their minimum capital requirements.  Although these terms are not used to represent the overall financial condition of a bank, the classifications are:  well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized.  If adequately capitalized or worse, or subject to a written agreement, consent order, or cease and desist order requiring higher minimum capital levels, regulatory approval would be required for the Bank to accept, renew or rollover brokered deposits.  If a bank is classified as undercapitalized or worse, its capital distributions are restricted, as is its asset growth and expansion, and capital restoration plans are required.  At March 31, 2016, the Bank’s and the Company’s capital ratios were above those levels necessary to be considered “well capitalized” under the regulatory framework for prompt corrective action. Because the Company’s total assets were less than $1,000,000 at March 31, 2016, the Company is not required to maintain certain capital levels.  

On February 29, 2016, the Company was notified by the Federal Reserve Bank of Atlanta that the written agreement the Company had entered into in the second quarter of 2012 (the “Written Agreement”) had been terminated as of February 29, 2016.

The Company’s principal source of funds for dividend and/or interest payments is dividends received from the Bank.  Banking regulations limit the amount of dividends that may be paid without prior approval of regulatory agencies.  Under these regulations, the amount of dividends that may be paid by the Bank in any calendar year is limited to the current year’s net income, combined with the retained net income of the preceding two years, subject to the capital requirements described above.  In addition, for so long as the Bank has negative retained earnings, as it did at March 31, 2016, the Bank must receive the prior approval of the FDIC before it may pay a dividend to the Company.  At March 31, 2016, with the approval of the FDIC, the Bank could dividend up to $10,916 to the Company, without the consent of the Commissioner of the Department.  The Company is also restricted in the types and amounts of dividends it can pay pursuant to the terms of the Company’s Fixed Rate Non-Cumulative Perpetual Preferred Stock, Series A (the “Series A Preferred Stock”).

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COMMUNITY FIRST, INC.

Notes to Consolidated Financial Statements

March 31, 2016

(Unaudited)

 

NOTE 7 – REGULATORY MATTERS (Continued)

Banks and bank holding companies with total assets in excess of $1,000,000 are subject to various regulatory capital requirements administered by State and Federal banking agencies.  The Company’s and the Bank’s capital amounts and ratios at March 31, 2016 and December 31, 2015, were as follows:

 

 

The Bank’s capital ratios at March 31, 2016 were above those levels necessary to be considered “well capitalized” under the regulatory framework for prompt corrective action.

Because the Company’s total assets were less than $1,000,000 at March 31, 2016, the Company is not required to meet certain capital level requirements.  Had the Company’s assets exceeded $1,000,000 at that date, the Company’s capital levels at March 31, 2016 would have been considered “well capitalized”.

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COMMUNITY FIRST, INC.

Notes to Consolidated Financial Statements

March 31, 2016

(Unaudited)

 

NOTE 7 – REGULATORY MATTERS (Continued)

In July 2013, the Federal banking regulators, in response to the statutory requirements of The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), adopted new regulations implementing the Basel Capital Adequacy Accord (“Basel III”) and the related minimum capital ratios. The new capital requirements which were effective January 1, 2015 and apply to banks and bank holding companies with total assets in excess of $1,000,000, include a new “Common Equity Tier 1 Ratio”, which has stricter rules as to what qualifies as Common Equity Tier 1 Capital.  A summary of the changes to the regulatory capital ratios are as follows:

 

 

The guidelines under Basel III also establish a 2.5% capital conservation buffer requirement that is phased in over three years beginning January 1, 2016. The buffer is related to risk weighted assets. The Basel III minimum requirements for capital adequacy after giving effect to the buffer are as follows:

 

 

As described above, because the Company’s total assets are less than $1,000,000, the Company will not be required to comply with these new capital guidelines required under Basel III until its total assets exceed $1,000,000.

In order to avoid limitations on capital distributions such as dividends and certain discretionary bonus payments to executive officers, a banking organization must maintain capital ratios above the minimum ratios including the buffer. The requirements of Basel III also place additional restrictions on the inclusion of deferred tax assets and capitalized mortgage servicing rights as a percentage of Tier 1 Capital. In addition, the risk weights assigned to certain assets such as past due loans and certain real estate loans have been increased. The requirements of Basel III allowed banks and bank holding companies with less than $250 billion in assets a one-time opportunity to opt-out of a requirement to include unrealized gains and losses in accumulated other comprehensive income in their capital calculation.  The Company and the Bank have opted out of this requirement.

 

 

NOTE 8 – PREFERRED STOCK RESTRUCTURE

On February 25, 2016 holders of the Company’s Series A Preferred Stock and the Company’s common stock, no par value per share (the “Common Stock”), approved a collection of amendments to the Company’s charter (the “Charter Amendments”) to modify the terms of the Series A Preferred Stock to, among other things, (i) cancel the amount of undeclared dividends in respect of the Series A Preferred Stock; (ii) reduce the liquidation preference on the Series A Preferred Stock to $650 per share plus the amount of any declared and unpaid dividends, without accumulation of any undeclared dividends; (iii) reduce the dividend rate payable on the Series A Preferred Stock from 9% per annum to 5% per annum; (iv) change the designation of the Series A Preferred Stock from “Cumulative” to “Non-Cumulative” and change the rights of the holders of the Series A Preferred Stock such that dividends or distributions on the Series A Preferred Stock will not accumulate unless declared by the Company’s board of directors and subsequently not paid; and (v) eliminate the restrictions on the Company’s ability to pay dividends or make distributions on, or repurchase, shares of its Common Stock or other junior stock or stock ranking in parity with the Series A Preferred Stock prior to paying accumulated but undeclared dividends or distributions on the Series A Preferred Stock.  The Charter Amendments were effective on February 26, 2016.  As a result of the Charter Amendments, the Company reversed $4,386 of accrued dividends on the Series A Preferred Stock that reduced the Company’s accumulated deficit by the same amount and $4,167 of face value that increased the Company’s additional paid-in capital, which is included in Common Stock, by the same amount.

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COMMUNITY FIRST, INC.

Notes to Consolidated Financial Statements

March 31, 2016

(Unaudited)

 

NOTE 9 – SUBSEQUENT EVENTS

On April 26, 2016, the Company entered into a Preferred Stock Conversion Agreement (the “Conversion Agreement”) that provides for the conversion of all of the issued and outstanding shares of the Company’s Series A Preferred Stock, having a liquidation preference of $650 per share, into shares of the Company’s Common Stock. Pursuant to the Conversion Agreement, each holder of shares of the Series A Preferred Stock, including the Company’s directors and executive officers that own such shares, will have each share of his or her Series A Preferred Stock converted into 136.84 shares of Common Stock (the “Conversion Shares”), representing an effective conversion price for each share of Common Stock of $4.75.  The total number of shares of Common Stock issued to any holder of the Series A Preferred Stock will be rounded down to the nearest whole number.  Under the terms of the Conversion Agreement, the Company is expected to issue an aggregate of 1,629,097 shares of Common Stock to the holders of the Series A Preferred Stock.  The issuance of the Conversion Shares was approved by the Company’s board of directors and separately by the members of the board of directors that do not own any shares of the Series A Preferred Stock.

The Conversion Agreement includes customary representations, warranties and covenants as well as customary indemnification and termination provisions.  The Conversion Agreement is also subject to the satisfaction of certain closing conditions, including, among other things, the obtaining of all governmental consents and approvals necessary to exchange the Series A Preferred Stock and issue the Conversion Shares, including approval by the Federal Reserve Bank of Atlanta of the acquisition of the Conversion Shares by Eslick E. Daniel, Robert E. Daniel and Ruskin A. Vest, Jr.  In addition, the Conversion Agreement also requires each holder of the Series A Preferred Stock, on behalf of itself and its affiliates, to release the Company from any and all claims against the Company related to such holder’s ownership of the Series A Preferred Stock.  

Pursuant to the Conversion Agreement, the Company has agreed to issue 1,629,097 shares of Common Stock. The shares of Common Stock to be issued pursuant to the Conversion Agreement are being issued in exchange for shares of the Series A Preferred Stock having an aggregate liquidation preference of $7,738,250 in a private placement exempt from registration under Section 4(2) of the Securities Act of 1933, as amended (the "Securities Act"), and Rule 506 of Regulation D promulgated under the Securities Act as the Company believes each holder of the Series A Preferred Stock is an “accredited investor” as that term is defined in Rule 501 of Regulation D, and the Company did not engage in general solicitation or advertising in connection with the offer and sale of the Conversion Shares.

On April 28, 2016, the Company filed a registration statement on Form S-1 (the “Registration Statement”), with the SEC relating to a proposed public offering of up to 250,000 shares of its Common Stock in connection with a rights offering (the “Rights Offering”). The Company’s board of directors has set the close of business on May 10, 2016 as the record date for the shareholders of the Company who shall be entitled to receive the rights distributed by the Company in the Rights Offering.  

 

 

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OVERVIEW

(amounts in thousands, except share and per share data)

The following discussion compares the financial condition of the Company at March 31, 2016 to December 31, 2015, and the results of operations for the three months ended March 31, 2016 to the three months ended March 31, 2015.  This discussion should be read in conjunction with the interim financial statements and footnotes included herein.

Certain of the statements made herein, including information incorporated herein by reference to other documents, are “forward-looking statements” within the meaning and subject to the protections of Section 27A of the Securities Act of 1933 and Section 21E of the Exchange Act.  Forward-looking statements include statements with respect to our beliefs, plans, objectives, goals, expectations, anticipations, assumptions, estimates, intentions, and future performance, and involve known and unknown risks, uncertainties and other factors, which may be beyond our control, and which may cause our actual results, performance or achievements to be materially different from future results, performance or achievements expressed or implied by such forward-looking statements.  All statements other than statements of historical fact are statements that could be forward-looking statements.  You can identify these forward-looking statements through our use of words such as “may,” “will,” “anticipate,” “assume,” “should,” “indicate,” “would,” “believe,” “contemplate,” “expect,” “estimate,” “continue,” “plan,” “point to,” “project,” “could,” “intend,” “target,” and other similar words and expressions of the future.

These forward-looking statements may not be realized due to a variety of factors, including, without limitation those described under Item 1A, “Risk Factors”, in our Annual Report on Form 10-K for the year ended December 31, 2015, filed with the SEC on March 9, 2016 (File No. 000-49966) (the “2015 Form 10-K”) and in other reports we file with the SEC from time to time, and the following:

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OVERVIEW (Continued)

All written or oral forward-looking statements that are made by or are attributable to us are expressly qualified in their entirety by this cautionary notice.  We have no obligation and do not undertake to update, revise or correct any of the forward-looking statements after the date of this report, or after the respective dates on which such statements otherwise are made.

FINANCIAL CONDITION

At March 31, 2016, total assets were $466,722 and total liabilities were $438,208.  Total assets decreased $3,168 or 0.7% compared to $469,940 at December 31, 2015.  Total liabilities decreased $8,767 or 2.0%, compared to $446,975 at December 31, 2015.  The decrease in assets was caused primarily by decreases in securities available for sale, cash and cash equivalents and other real estate owned offset in part by increases in net loans.  The decrease in liabilities was caused primarily by decreases in interest-bearing deposits and other liabilities offset in part by an increase in noninterest-bearing deposits.  Total shareholders’ equity increased 24.4%, or $5,599, to $28,564 at March 31, 2016 compared to $22,965 at December 31, 2015.  The increase in equity was primarily due to the forgiveness of Series A Preferred Stock accrued dividends combined with net income during the first three months of 2016.

Cash and Cash Equivalents

Cash and cash equivalents were $15,468 at March 31, 2016 compared to $19,387 at December 31, 2015.  This decrease was primarily due to the use of cash to fund loan growth.

Time Deposits in Other Financial Institutions

Time deposits in other financial institutions totaled $24,177 at March 31, 2016 compared to $24,305 at December 31, 2015.  Management has begun utilizing time deposits in other financial institutions in conjunction with the Bank’s securities portfolio in order to maximize yield and maintain a reasonable total duration for the Bank’s assets outside of the loan portfolio.   Original maturities of time deposits in other financial institutions range from ten months to five years.   Most of the CDs with maturities beyond three years are callable with minimal early withdrawal penalties.  All of the deposits are in FDIC or National Credit Union Administration insured institutions and the amount on deposit with each individual institution does not exceed the deposit insurance limit of $250.  As of March 31, 2016, time deposits in other financial institutions had a weighted average rate of 1.09% and a weighted average remaining life of 0.412 years. 

Loans

Total loans (excluding loans held for sale) at March 31, 2016 were $285,820, compared to $264,469 at December 31, 2015, an increase of $21,351 or 8.1%.  The increase in loans during the first three months of 2016 was primarily due to an increased demand for new loans.  The increase in loan demand was primarily due to an uptick in the economy in the Bank’s market areas.  The most significant increases in loans were in commercial real estate, 1-4 family residential, and real estate construction segments.  

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FINANCIAL CONDITION (Continued)

Loans in the portfolio at March 31, 2016 of approximately $56,260, or 19.7%, are at a variable rate of interest while $227,905, or 79.7%, are at a fixed rate, and $1,655, or 0.6%, are nonaccrual.  Within one year of March 31, 2016, $40,285, or 14.1%, of total loans are subject to repricing. As market rates dropped during the economic recession, management implemented rate floors for many variable rate loans in an effort to protect the Bank’s net interest margin.  As a result, when market rates begin to rise, loans at their floor will not reprice at higher rates until market rates rise above their contractual floor rates.  Only the loans noted above that have variable rates not at a floor rate will reprice with the first increase in market rates.  The existence of these rate floors may negatively impact our net interest margin when rates begin to rise, at least until rates rise above these floors.

On March 31, 2016, the Company’s loan to deposit ratio (including loans held for sale) was 69.3%, compared to 63.5% at December 31, 2015.  Management expects loan demand to modestly improve through the remainder of 2016, though foreclosure activity could result in some additional decreases in loan balances.  

Securities Available for Sale

Set forth below is a table showing the carrying amount and breakdown of the Company’s securities available for sale at March 31, 2016 and December 31, 2015:

 

 

The Company’s securities portfolio is used to, among other things, provide yield and for pledging purposes to secure public fund deposits.  As of March 31, 2016, the carrying value of securities decreased $18,198 to $100,626, compared to $118,824 at December 31, 2015.  Securities available for sale as a percentage of total assets was 21.6% at March 31, 2016, compared to 25.3% at December 31, 2015.  Net unrealized gain on securities available for sale was $396 at March 31, 2016, compared to a net unrealized loss of $418 at December 31, 2015. Changes in interest rates in the securities market caused this fluctuation in the net unrealized loss/gain.  Management is continually monitoring the credit quality of the Bank’s investments and believes that the unrealized losses that existed in the Bank’s portfolio at March 31, 2016 are temporary based on the bond ratings and anticipated recovery of bonds held.  At March 31, 2016, the Company did not have the intent to sell these securities and it is more likely than not that it will not be required to sell the securities before their anticipated recovery.

Other Real Estate Owned

At March 31, 2016, other real estate owned (“OREO”) totaled $5,684, a decrease of $2,144 from $7,828 at December 31, 2015.  This decrease is primarily due to the sale of properties during the first three quarters of 2016.  The balance of OREO is comprised of properties acquired through or in lieu of foreclosure on real estate loans, and loans made to facilitate the sale of OREO properties that are required to be reported as OREO (“FAS 66 Loans”). The balances recorded for each individual property are based on appraisals that are not more than twelve months old, discounted by 15%.  The 15% discount was adopted by the Company beginning in the third quarter of 2010 based on an analysis of actual recoveries of OREO balances, including selling costs.  Based on that analysis, the Company recorded a valuation allowance of $346 (recognized through OREO expense) in the third quarter of 2010.  In addition, the Company began applying the 15% discount in its determination of specific reserves for impaired loans that are collateral dependent.  As a result, the majority of the financial loss incurred by the Company as a result of the 15% discount has been recognized through loan charge-offs and the provision for loan losses at the time the property is transferred to OREO, with the foreclosed property being transferred into OREO at the discounted value. The Company annually updates its analysis regarding the 15% discount.  Should such updates indicate that a change in the 15% discount is warranted, the Company would implement the change accordingly and that change would be applied to all properties that are subsequently moved into OREO.  Additional write-downs of individual properties typically occur when the results of updated appraisals and further application of the 15% discount on the value reflected in the updated appraisal indicates that the value of the respective property has declined.  The Company obtains updated appraisals for OREO properties at least every twelve months.  These write-downs are recognized in the quarterly period in which the appraisal is accepted by the Company.

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FINANCIAL CONDITION (Continued)

The Company actively markets the properties within its OREO portfolio utilizing both Bank personnel and third parties (brokers, agents, etc.). All OREO properties are classified into one of four categories: rental properties, non-rental properties, auction properties, and land. Rental properties consist of any property that can be leased or rented in order to produce income for the Company while the Company is pursuing the sale of the property.  Non-rental properties consist of improved real estate that the Company’s management has concluded would not be attractive to a renter or that management believes will be most efficiently sold unoccupied. Auction properties are typically properties of lower value that the Company is willing to accept the risk of an auction in order to sell. These properties are typically auctioned off within six to twelve months of the property being transferred into OREO; however, circumstances related to a particular property may warrant holding the property for a longer period. Auction properties are typically auctioned off in absolute auctions with no minimum reserves. Land generally consists of unimproved raw land, though some properties may have some infrastructure work completed for housing development. Properties within the land category of OREO are typically held for longer periods of time than other OREO properties as the marketing of these properties, particularly large parcels, often extends for over six months.

The following table shows a breakdown of the OREO portfolio by category as of the end of the periods indicated:

 

 

The Company makes every effort to sell OREO as quickly as feasible while still recovering as much of the original investment as possible.  Management also considers the cost associated with holding individual properties in determining how aggressively it markets an individual property.  The Company’s OREO that is classified as rental properties generally consists of 1-4 family properties, though some are commercial real estate.  Rental income generated by this group has typically exceeded the holding costs of the respective properties.  The majority of the rental properties are listed for sale with real estate agents; however, properties in this group are not the primary focus of management’s marketing efforts given the income producing nature of the property.  The Company’s OREO that is classified as auction properties are marketed aggressively with dates set for auctions and most auction properties being allowed to sell without a reserve price.  The Company’s other OREO properties are being marketed, though there is no definite date as to when they may be expected to be sold.

The following table provides activity within the OREO portfolio in terms of individual parcels for the three-month periods ended on the dates indicated:

 

 

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FINANCIAL CONDITION (Continued)

The following table sets forth information related to the largest five OREO properties held by the Company as of March 31, 2016:

 

 

The following table sets forth information related to the largest five OREO properties held by the Company as of December 31, 2015:

 

 

Each of the OREO properties identified in the March 31, 2016 table above is listed with a real estate agent and is also listed as available for sale on the Bank’s website.  The two properties classified as unimproved land were, at the time the loans were made, intended to be developed.  The property carried at $1,828 is commercial property located in an area that remains significantly and negatively impacted by the downturn in the real estate market.  A portion of the property is currently under contract; however, there is a lengthy due diligence period and the sale of the property may not ultimately be consummated.  If so, the Company will continue to actively market the property.  The property carried at $799 is located in a residential area that was also negatively impacted by the downturn in the economy.  Although there are some positive indicators of improvements in the local market where the property is located, management believes it will likely require a significant amount of time to sell the property and will continue to market the property.  The single family residence property carried at $627 is currently an income producing rental property.  The Company is actively marketing the property; however, since the home is more high-end than the typical home in our market, we anticipate that it could take a significant amount of time to sell the property.  The commercial real estate property carried at $782 consists of income producing rental properties that are being managed by a third party property manager on behalf of the Company.  The Company continues to market these rental properties, but because of the income producing nature of the properties, it is likely that management will resist selling the properties in the near term for less than the current carrying value of the properties.  The commercial property carried at $361 is a commercial/industrial building in an area that was also negatively impacted by the downturn of the economy.  Due to the deteriorated condition of the property, limited demand, and potential environmental risk, management believes it will likely require a significant amount of itme to sell the property.

Deposits

The Company relies on the Bank’s deposit growth, as well as alternative funding sources such as other borrowed money, Federal Home Loan Bank (“FHLB”) advances, and federal funds purchased from correspondent banks, to fund its operations.

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FINANCIAL CONDITION (Continued)

The following table sets forth the composition of the deposits at March 31, 2016 and December 31, 2015.

 

 

The following table sets forth all time deposits greater than $100 broken down by remaining maturity at March 31, 2016:

 

 

Total deposits were $412,200 at March 31, 2016, compared to $416,714 at December 31, 2015, a decrease of $4,514.  The decrease was primarily due to decreases in interest-bearing demand deposits offset in part by increases in noninterest-bearing deposits.

Shareholders’ Equity

At March 31, 2016, shareholders’ equity totaled $28,564, an increase of $5,599, or 24.4%, from $22,965 at December 31, 2015.  The increase was primarily due to forgiveness of Series A Preferred Stock dividends and net income during the first three months of 2016.

On February 25, 2016, the Company’s shareholders approved amendments to the Company’s charter that would cancel the amount of the accumulated but undeclared dividends in respect to the Series A Preferred Stock and reduce the face value of the Series A Preferred Stock From $1,000 per share to $650 per share.  These changes resulted in $4,265 of dividends being reversed, which reduced the Company’s accumulated deficit.  The reduction in liquidation value transferred $4,167 of capital from Series A Preferred Stock to Common Stock.

At the request of the FRB, the Board of Directors of the Company, on January 18, 2011, adopted a board resolution (which was replaced by the Written Agreement that was terminated on February 29, 2016) agreeing that the Company would not, among other things, incur additional debt, pay dividends on any of its common stock or preferred stock, or redeem treasury stock without approval from the FRB.  The Company requested permission to make dividend payments on its preferred stock and interest payments on its subordinated debentures that were scheduled for the first quarter of 2011.  In the first quarter of 2011, the FRB granted the Company permission to pay the dividends on its preferred stock that were due on February 15, 2011, but denied the Company permission to make interest payments on its subordinated debentures.  As a result of the FRB’s decision, the Company was required to begin the deferral of interest payments on each of its three issuances of subordinated debentures during the first quarter of 2011.  The Company has the right to defer the payment of interest on the subordinated debentures at any time, for a period not to exceed 20 consecutive quarters.  During the period in which it is deferring the payment of interest on its subordinated debentures, the indentures governing the subordinated debentures provide that the Company cannot pay any dividends on its Common Stock or preferred stock.  Accordingly, the Company was required to suspend its dividend payments on its preferred stock beginning in the second quarter of 2011.  On February 29, 2016, the Company was notified by the FRB that the Written Agreement had been terminated as of that date.  The Company received permission from the FRB to pay all accrued but unpaid dividends on its subordinated debentures in the fourth quarter of 2015 and made these payments in December 2015.  The Company made all interest payments due on its subordinated debentures in the first quarter of 2016.

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RESULTS OF OPERATIONS

Net Income

The Company had net income of $750 for the three months ended March 31, 2016 compared to net income of $938 for the same period in 2015, a decrease in net income of $188. This decrease was primarily due to the Company beginning to recognize income tax in the first quarter of 2016, when no income tax was recognized in the comparable period in 2015.  Net income available to common shareholders was $5,015 for the first three months of 2016 compared to $523 for the same period in 2015.  This increase was primarily due to the forgiveness of $4,265 of Series A Preferred Stock accrued dividends.

Average Balance Sheets, Net Interest Income

Changes in Interest Income and Interest Expense

The following table shows the average daily balances of each principal category of our assets, liabilities and shareholders’ equity and an analysis of net interest income for the three-month periods ended March 31, 2016 and 2015. The table reflects how changes in the volume of interest earning assets and interest-bearing liabilities and changes in interest rates have affected our interest income, interest expense, and net interest income for the periods indicated.  Information is provided in each category with respect to changes attributable to (1) changes in volume (changes in volume multiplied by prior rate); (2) changes in rate (changes in rate multiplied by prior volume); and (3) changes in rate/volume (changes in rate multiplied by change in volume).  The changes attributable to the combined impact of volume and rate have all been allocated to the changes due to rate.

 

 

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RESULTS OF OPERATIONS (Continued)

Net Interest Income

Net interest income for the first three months of 2016 was $3,547, an increase of $255, or 7.7%, compared to $3,292 for the same period in 2015. The increase in net interest income is primarily due to an increase in income on taxable securities available for sale combined with an increase in income from loans.

Total interest income for the three months ended March 31, 2016 was $4,232, an increase of $247 from $3,985 for the same period in 2015. The increase in interest income was primarily due to an increase in income from taxable securities available for sale combined with an increase in income from loans.

Interest income on taxable securities increased $162 to $624 in the first three months of 2016 compared to $462 in the first three months of 2015. The increase was primarily due to an increase in the average rate earned on taxable securities combined with an increase in the average balance of taxable securities.

The average rate earned on gross loans in the first three months of 2016 was 5.18% compared to 5.40% for the same period in 2015. The increase in income from loans was due to an increase in the average balance of loans offset by a decrease in the average rate earned on loans.  The increase in the average balance of loans was due to increased loan demand that continued in the first quarter of 2016.  The decrease in the average rate earned on loans was due to significant interest recoveries received on loans paid off during the first three months of 2015 that were formerly on nonaccrual status.  

Total interest expense was $685 in the first three months of 2016, a decrease of $8 from $693 in the first three months of 2015. The decrease in interest expense was primarily due to a decrease in the rate paid on the Company’s subordinated debentures in the first three months of 2016 compared to the same period in 2016.  The decrease in the rate paid on the Company’s subordinated debentures is due primarily to the lack of compounding of interest since accrued expense on these debentures is now current.

Provisions for Loan Losses

In the first three months of 2016, the Bank reversed $578 of the allowance for loan loss as a result of improvements in asset quality and significant loan recoveries. In the first three months of 2015, the Bank reversed $457 of the allowance for loan loss. The ratio of allowance for loan losses to gross loans was 1.30% at March 31, 2016 compared to 1.62% at December 31, 2015.

Management’s determination of the appropriate level of the provision for loan losses and the adequacy of the allowance for loan losses is based, in part, on an evaluation of specific loans, as well as the consideration of historical loss experience, which management believes is representative of probable incurred loan losses. Other factors considered by management include the composition of the loan portfolio, economic conditions, results of regulatory examinations, reviews of updated real estate appraisals, and the creditworthiness of the Bank’s borrowers and other qualitative factors.

Nonperforming loans increased from $7,266 at December 31, 2015 to $8,892 at March 31, 2016. The increase in nonperforming loans was primarily due to increases in our nonaccrual loans. During the first three months of 2016, four large loans that had been on the Company’s watch list for a significant amount of time became classified as nonaccrual. Management does not believe this is indicative of the condition of the entire loan portfolio.  This increase in nonperforming loans was more than offset by the decrease in historical loss factors as the Bank recorded a net recovery in loans in 2015.  The ratio of the allowance to nonperforming loans was 41.68% at March 31, 2016, compared to 58.84% at December 31, 2015. The portion of the allowance attributable to impaired loans was $324 at March 31, 2016 compared to $340 at December 31, 2015. Total impaired loans totaled $7,789 at March 31, 2016 compared to $7,964 at December 31, 2015.

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RESULTS OF OPERATIONS (Continued)

The portion of the allowance attributable to historical and environmental factors has decreased since December 31, 2015. Management’s evaluation of the allowance for loan losses, in addition to specific loan allocations, is based on volume of non-impaired loans and changes in credit quality and environmental factors. The improvement in the portion of the allowance attributable to historical and environmental factors occurred during the first three months of 2016 due to improvement in credit quality and environmental factors.

Problem loans that are not impaired are categorized into risk categories based on relevant information about the ability of borrowers to service their debt, such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. The Company analyzes loans individually by classifying the loans as to credit risk. The Company uses the following definitions for risk ratings:

Watch. Loans characterized by borrowers who have marginal cash flow, marginal profitability, or have experienced operating losses and declining financial condition. The borrower has satisfactorily handled debts with the Bank in the past, but in recent months has either been late, delinquent in making payments, or made sporadic payments. While the Bank continues to be adequately secured, the borrower’s margins have decreased or are decreasing, despite the borrower’s continued satisfactory condition. Other characteristics of borrowers in this class include inadequate credit information, weakness of financial statement and repayment capacity, but with collateral that appears to limit the Bank’s exposure. This classification includes loans to established borrowers that are reasonably margined by collateral, but where potential for improvement in financial capacity is limited.

Special Mention. Loans with potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in deteriorating prospects for the repayment source or in the Bank’s credit position in the future.

Substandard. Loans inadequately protected by the payment capacity of the borrower or the pledged collateral.

Doubtful. Loans with the same characteristics as substandard loans with the added characteristic that the weaknesses make collection or liquidation in full highly questionable and improbable on the basis of currently existing facts, conditions, and values. These are poor quality loans in which neither the collateral nor the financial condition of the borrower presently ensure collectability in full in a reasonable period of time or evidence of permanent impairment in the collateral securing the loan.

Impaired loans are evaluated separately from other loans in the Bank’s portfolio. Credit quality information related to impaired loans was presented above and is excluded from the tables below.

Loans not meeting the criteria above that are analyzed individually as part of the above described process are considered to be pass rated loans. As of March 31, 2016 and December 31, 2015, based on the most recent analysis performed, the risk category of loans by segment of loans is as follows:

 

 

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RESULTS OF OPERATIONS (Continued)

 

 

The table below illustrates changes in the AFLL ratio (the ratio, expressed as a percentage, of the allowance for loan losses to total gross loans) over the past five quarters and the changes in related risk metrics over the same periods:

 

 

Interest income on loans is discontinued at the time the loan is 90 days delinquent unless the loan is well-secured and in process of collection. Past due status is based on the contractual terms of the loan. In all cases, loans are placed on nonaccrual or charged-off at an earlier date if collection of principal or interest is considered doubtful.

The following table presents information regarding loans included as nonaccrual and troubled debt restructurings and the gross income that would have been recorded in the three-month periods ended March 31, 2016 and 2015 if the loans had been current:

 

 

Noninterest Income

Total noninterest income for the first three months of 2016 was $664, an increase of $100, or 17.7% from $564 for the same period in 2015. The increase was due to an increase in gains on sale of securities available for sale and gain on sale of loans.

Gains on sale of securities available for sale for the first three months of 2016 was $37, an increase of $36, or 3,600%, from $1 for the same period in 2015. This was due to the Company choosing to sell securities to help fund loan growth during the first three months of 2016.

Gain on sale of loans for the first three months of 2016 was $35, an increase of $12, or 52.2%, from $23 for the same period in 2015. This was a result of an increase in mortgage banking activity during the first three months of 2015.

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RESULTS OF OPERATIONS (Continued)

The table below shows noninterest income for the three-month periods ended March 31, 2016 and 2015.

 

 

Noninterest Expense

Noninterest expense for the first three months of 2016 was $3,558, an increase of $183, or 5.4%, from $3,375 for the same period in 2015. The increase was primarily due to increases in salaries and employee benefits, director expense and ATM expense offset by decreases in regulatory and compliance expense, other real estate expense and insurance expense.

Salaries and employee benefits totaled $1,906 in the first three months of 2016, an increase of $173, or 10.0%, from $1,733 for the same period in 2015. This increase was primarily the result of a bonus paid to members of executive management combined with cost of living salary increases.

Director expense totaled $103 in the first three months of 2016, an increase of $49, or 90.7%, from $54 for the same period in 2015. This increase was primarily due to changes in the director fee schedule that became effective in the first quarter of 2016.

ATM expense totaled $203 in the first three months of 2016, an increase of $41, or 25.3%, from $162 for the same period in 2015. This increase was primarily the result of a change in interchange fees paid by the Bank that occurred in the later part of 2015.

Other real estate expense totaled $2 for the first three months of 2016, a decrease of $41, or 95.3%, from $43 for the same period in 2015. Other real estate expense decreased during the first three months of 2016 as a result of fewer properties being sold at a loss and fewer properties experiencing writedowns as a result of stabilization of real estate prices.

Regulatory and compliance expense totaled $96 in the first three months of 2016, a decrease of $76, or 44.2%, from $172 for the same period in 2015. The decrease was primarily due to a reduction in the Bank’s FDIC insurance expense premium as a result of the lifting of all regulatory orders.

Insurance expense totaled $54 in the first three months of 2016, a decrease of $28, or 34.1%, from $82 for the same period in 2015. The decrease was primarily due to a reduction in the Bank’s corporate insurance expense premium as a result of the lifting of all regulatory orders.

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RESULTS OF OPERATIONS (Continued)

The table below shows noninterest expense for the three-month periods ended March 31, 2016 and 2015:

 

 

Income Taxes

The effective income tax rate was 39.02% for the three months ended March 31, 2016 and 0.0% for the three months ended March 31, 2015.

Due to economic condition and losses recognized between 2008 and 2011, the Company established a valuation allowance against all of its deferred tax assets.  During the fourth quarter of 2015, the Company determined that it is more likely than not that the asset can be realized through current and future taxable income.  As a result, the Company was able to reinstate all of its unrecognized deferred tax assets in the fourth quarter of 2015.  The Company has approximately $51,517 in net operating losses for state tax purposes and $23,685 for federal tax purposes to be utilized by future earnings as of March 31, 2016.

The Company currently has no unrecognized tax benefits that, if recognized, would favorably affect the income tax rate in future periods.  The Company does not expect any unrecognized tax benefits to significantly increase or decrease during the remainder of 2016.  It is the Company’s policy to recognize any interest accrued related to unrecognized tax benefits in interest expense, with any penalties recognized as operating expenses.

As of March 31, 2016, the Company had federal and state income tax net operating loss (NOL) carryforwards of $23,685 and $51,517, which will expire at various dates from 2020 through 2032. Such NOL carryforwards expire as follows:

 

 

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LIQUIDITY AND CAPITAL RESOURCES

Liquidity refers to the Company’s ability to fund loan demand, meet deposit customers’ withdrawal needs and provide for operating expenses. As summarized in the Consolidated Statements of Cash Flows, the Bank’s main source of cash flow is from receiving deposits from its customers and, to a lesser extent, repayment of loan principal and interest income on loans and investments, FHLB advances, the possible sale or pledge of investment securities, and federal funds purchased.

The Bank’s primary uses of cash are lending to its borrowers and investing in securities and short-term interest-earning assets. During the first three months of 2016, loan growth has outpaced deposit growth, and management believes this trend will continue throughout the remainder of 2016. In addition to funding loan growth, management plans to continue to utilize excess liquidity to invest in securities available for sale and time deposits in other financial institutions.

As a result of improvements in the Bank’s and the Company’s financial condition, management sought approval from its regulators to allow the Bank to pay dividends to the Company in an amount sufficient to allow the Company to pay all accrued but unpaid interest payments on its subordinated debentures during the fourth quarter of 2015.  The Company received all of the required regulatory approvals and in December 2015 made interest payments totaling $5,444 to the holders of the subordinated debt.  The Company also made its scheduled interest payment on its subordinated debentures in the first quarter of 2016.  As of March 31, 2016, the Company was current on all interest payments due related to its subordinated debentures.  The Company has the right to defer the payment of interest on the subordinated debentures at any time, for a period not to exceed 20 consecutive quarters.  During the period in which it is deferring the payment of interest on its subordinated debentures, the indentures governing the subordinated debentures provide that the Company cannot pay any dividends on its Common Stock or preferred stock.  

Also during the fourth quarter of 2015, the Company and Bank received permission for the Bank to pay additional dividends to the Company sufficient to allow it to redeem certain holders of the Company’s Series A Preferred Stock and fully redeem the Company’s Fixed Rate Cumulative Perpetual Preferred Stock, Series B (the “Series B Preferred Stock”).  On December 23, 2015, the Company entered into redemption agreements with certain of the holders of the Series A Preferred Stock who collectively held 5,901 shares of the Series A Preferred Stock.  The Company agreed to pay $600 per share to redeem the shares.  The shares were redeemed on December 31, 2015.  Upon redemption, $2,360 of the Company’s equity that was attributable to the redeemed shares of Series A Preferred Stock was transferred to common equity as a result of the cash redemption amount being less than the face value of the redeemed shares.  Due to the restrictions on the Company’s ability to pay dividends, a total of $2,114 of dividends had been accrued as of the redemption date for the 5,901 shares that were redeemed.  Upon redemption, the accrued dividends were reversed, which reduced the amount of the Company’s accumulated deficit.

Also during the fourth quarter of 2015, the Company redeemed all of its Series B Preferred Stock for full face value and accrued dividends.  The Company paid a total of $1,374 for the redemption of the Series B Preferred Stock.

As a result of these redemptions, at December 31, 2015 the Company had accumulated $4,265 in deferred dividends on the 11,905 shares of the Series A Preferred Stock that were not redeemed.  As a result of the Charter Amendments approved by the Company’s shareholders in the first quarter of 2016 that modified the terms of the Series A Preferred Stock, these deferred dividends were reversed in the first quarter of 2016, resulting in a further reduction of a like amount to the Company’s accumulated deficit.  Under the terms of the Series A Preferred Stock, failure to pay dividends for six dividend periods triggers the holders’ right to elect two directors to an institution’s board.  Since the Company has deferred payments of dividends on the Series A Preferred Stock for more than six quarters, the holders of the Series A Preferred Stock have the right to elect up to two directors to the Company’s board of directors.

Additionally, because the Company had, until December 2015, deferred the payment of interest on its subordinated debentures, Properties was also prohibited from paying dividends on its issued and outstanding preferred stock and common stock until such time as the Company is current on the payment of interest on its subordinated debt.  On December 31, 2015, Properties paid $778 to the holders of its outstanding preferred stock inclusive of $562 paid to the Bank.  The payment was for accrued but unpaid dividends on the preferred stock and also fully redeemed the shares at face value.  Properties no longer has any shares of preferred stock outstanding.

As of March 31, 2016, the Company had total consolidated equity of $28,564.  The outstanding face value of the Company’s preferred stock was $7,738, resulting in equity attributable to common stock of $20,826.   As a result, the Company’s Tier 1 common equity ratio would have been reported as 2.24% as of March 31, 2016.    Unless the Company significantly changes its current capital structure, it is possible that we could be required to report this ratio at an unsatisfactory level if the Company were to become subject to the capital rules adopted implementing Basel III. 

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LIQUIDITY AND CAPITAL RESOURCES (Continued)

Following termination of the informal agreement the Bank had entered into with the FDIC and the Department, the Bank is no longer subject to restrictions from the Department on its ability to pay dividends to the Company (other than the restrictions under applicable Tennessee law limiting the amount of dividends a bank incorporated under the laws of the state of Tennessee may pay to its shareholders to the current year’s net income and any retained net income for the prior two years).  However, for so long as the Bank has negative retained earnings, as it did at March 31, 2016, the Bank must receive the prior approval of the FDIC before it may pay a dividend to the Company.  At March 31, 2016, with the prior approval of the FDIC, the Bank could dividend up to $10,916 to the Company, without the consent of the Commissioner of the Department.

In late 2010, the Basel Committee on Banking Supervision issued “Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems” (“Basel III”), a new capital framework for banks and bank holding companies. Basel III imposes a stricter definition of capital, with more focus on common equity for those banks to which it is applicable. In July 2013, the federal bank regulatory agencies, including the Federal Reserve and the FDIC, adopted final rules that revised their risk-based and leverage capital requirements and their method for calculating risk-weighted assets to make them consistent with the agreements that were reached by the Basel Committee on Banking Supervision in Basel III and certain provisions of the Dodd-Frank Act. The rules, which became effective January 1, 2015, apply to all depository institutions, top-tier bank holding companies with total consolidated assets of $1,000,000 or more, and top-tier savings and loan holding companies (“banking organizations”). Among other things, the rules establish a new common equity Tier 1 minimum capital requirement of 4.5%, a minimum Tier 1 risk-based capital requirement of 6% (up from 4%), a total risk-based capital requirement of 8% and a Tier 1 leverage capital requirement of 4%.  In addition, the new rules assign higher risk weightings (150%) to exposures that are more than 90 days past due or are on nonaccrual status.  In order to be considered “well-capitalized”, the Bank must maintain at least the following minimum capital ratios: common equity Tier 1 capital of 6.5%; tier 1 risked-based capital of 8% (up from 6%); total risk-based capital of 10%; and tier 1 leverage capital of 5%.  The rules limit a banking organization’s capital distributions and certain discretionary bonus payments as well as a banking organization’s ability to repurchase its own shares if the banking organization does not hold a “capital conservation buffer” consisting of an additional 2.5% of capital (when the buffer is fully phased in) in addition to the amount necessary to meet its minimum risk-based capital requirements. As a result, when fully phased in, the capital requirements, inclusive of the capital conservation buffer, would be a Tier 1 leverage ratio of 4%, a Tier 1 common risk-based equity capital ratio of 7%, a Tier 1 equity risk-based capital ratio of 8.5% and a total risk-based capital ratio of 10.5%.  Beginning on January 1, 2016, 0.625% of the capital conservation buffer had been phased in. Under the new rules Tier 1 capital generally consists of common stock (plus related surplus) and retained earnings, limited amounts of minority interest in the form of additional Tier 1 capital instruments and non-cumulative preferred stock and related surplus, subject to certain eligibility standards, less goodwill and other specified intangible assets and other regulatory deductions, cumulative preferred stock and trust preferred securities (including associated subordinated debentures) issued after May 19, 2010 will no longer qualify as Tier 1 capital, but such securities issued prior to May 19, 2010 (like our subordinated debentures) including, in the case of bank holding companies with less than $15,000,000 in total assets, trust preferred securities issued prior to that date will continue to count as Tier 1 capital subject to certain quantitative limitations.  Our Series A Preferred Stock qualified as Tier 1 capital at December 31, 2015 and continues to qualify as Tier 1 capital following the effectiveness of the Charter Amendments.  Common equity Tier 1 capital generally consists of common stock (plus related surplus) and retained earnings plus limited amounts of minority interest in the form of common stock, less goodwill and other specified intangible assets and other regulatory deductions.  The final rules allow banks and their holding companies with less than $250,000,000 in assets a one-time opportunity to opt-out of a requirement to include unrealized gains and losses in Accumulated Other Comprehensive Income.  We and the Bank have opted out.  Because the Company’s total consolidated assets are below $1,000,000, these capital rules are not applicable to the Company on a consolidated basis.  Should the Company’s total consolidated assets increase to more than $1,000,000, the Company would then be subject to these rules.

At March 31, 2016, the Company had unfunded loan commitments outstanding of $36,820 and unfunded letters of credit of $1,760. Because these commitments generally have fixed expiration dates and many will expire without being drawn upon, the total commitment level does not necessarily represent future cash requirements. If the Company needed to fund these outstanding commitments, it has the ability to liquidate federal funds sold or securities available for sale or on a short-term basis to borrow and purchase federal funds from other financial institutions. Additionally, the Company could sell participations in these or other loans to correspondent banks.

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LIQUIDITY AND CAPITAL RESOURCES (Continued)

At March 31, 2016 and December 31, 2015, the Bank’s and the Company’s risk-based capital ratios and the minimums to be considered “well-capitalized” under prompt corrective action guidelines and the ratios required by the Consent Order were as follows:

 

 

 

 

At its current capital ratios, the Bank is considered “well capitalized”. Because the Company’s total assets were less than $1,000,000 at March 31, 2016, it is not subject to capital requirements on a consolidated basis, but had it been, it would have been considered “well-capitalized” under applicable regulations. Despite improvements in our consolidated capital levels, a significant portion of our capital on a consolidated basis consists of preferred stock and subordinated debentures which require repayments.

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LIQUIDITY AND CAPITAL RESOURCES (Continued)

On April 26, 2016, the Company entered into a Preferred Stock Conversion Agreement (the “Conversion Agreement”) that provides for the conversion of all of the issued and outstanding shares of the Company’s Series A Preferred Stock, having a liquidation preference of $650 per share, into shares of the Company’s Common Stock.  Pursuant to the Conversion Agreement, each holder of shares of the Series A Preferred Stock, including the Company’s directors and executive officers that own such shares, will have each share of his or her Series A Preferred Stock converted into 136.84 shares of Common Stock (the “Conversion Shares”), representing an effective conversion price for each share of Common Stock of $4.75.  The total number of shares of Common Stock to be issued to any holder of the Series A Preferred Stock will be rounded down to the nearest whole number.  Under the terms of the Conversion Agreement, the Company is expected to issue an aggregate of 1,629,097 shares of Common Stock to the holders of the Series A Preferred Stock.  The issuance of the Conversion Shares was approved by the Company’s board of directors and separately by the members of the board of directors that do not own any shares of the Series A Preferred Stock.  Consummation of the transaction contemplated by the Conversion Agreement is subject to satisfaction of certain customary closing conditions, including receipt of all required governmental approvals, including those necessary to permit those holders of the Series A Preferred Stock that will own in excess of 10% of the Company’s outstanding Common Stock following the closing to acquire those shares.

On April 28, 2016, the Company filed a registration statement on Form S-1 with the SEC relating to a proposed public offering of up to 250,000 shares of its Common Stock pursuant to a rights offering (the “Rights Offering”).  The Company’s board of directors has set the close of business on May 10, 2016 as the record date for the shareholders of the Company who shall be entitled to receive the rights distributed by the Company in the Rights Offering.

Management continually monitors the Bank’s sources and uses of cash in order to plan for future liquidity needs. The Bank’s most potentially volatile funding liabilities are national market time deposits. The Bank reduced its reliance on these funding sources during 2015 and the first three months of 2016.  The Bank’s national market CDs was $4,463 at March 31, 2016 and $5,855 at December 31, 2015. Management is currently utilizing national market CDs to take advantage of the favorable rates in that sector of the deposit market.

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Management uses a gap simulation model that takes cash flows into consideration. These include mortgage-backed securities, loan prepayments, and expected calls on securities. Non-maturing balances such as money markets, savings, and negotiable order of withdrawal (“NOW”) accounts have no contractual or stated maturities. A challenge in the rate risk analysis is to determine the impact of the non-maturing balances on the net interest margin as the interest rates change. Because these balances do not “mature” it is difficult to know how they will reprice as rates change. It is possible to glean some understanding by reviewing our pricing history on these categories relative to interest rates. Using the interest rate history from the Asset Liability Management software database spanning up to 20 quarters of data, we can derive the relationship between interest rates changes and the offering rates themselves. The analysis uses the T-Bill rate as an indicator of rate changes. The gap analysis uses beta factors to spread balances to reflect repricing speed. In the gap analysis the model considers deposit rate movements to determine what percentage of interest-bearing deposits that is actually repriceable within a year. Our cumulative one year gap position at March 31, 2016, was 0.69% of total assets. Our policy states that our one-year cumulative gap should not exceed 15% of total assets.

At March 31, 2016, $132,718 of $463,974 of interest earning assets will reprice or mature within one year. Loans maturing or repricing within one year totaled $85,153, or 30.2% of total loans, including loans held for sale at March 31, 2016. As of March 31, 2016, we had $120,008 in time deposits maturing or repricing within one year.

Gap analysis only shows the dollar volume of assets and liabilities that mature or reprice. It does not provide information on how frequently they will reprice. To more accurately capture the Company’s interest rate risk, we measure the actual effects the repricing opportunities have on earnings through income simulation models such as rate shocks of economic value of equity and rate shock interest income simulations.

To truly evaluate the impact of rate change on income, we believe the rate shock simulation of interest income is the best technique because variables are changed for the various rate conditions. The interest income change in each category of earning assets and liabilities is calculated as rates move up and down. In addition, the prepayment speeds and repricing speeds are changed. Rate shock is a method for stress testing the net interest margin over the next four quarters under several rate change levels. These levels span four 100 basis point increments up and down from the current interest rate. Our policy guideline is that the maximum percentage change in net interest income cannot exceed plus or minus 15% on a 200 basis point interest rate change.

Although interest rates are currently very low, the Company believes a -200 basis point rate shock is an effective and realistic test since interest rates on many of the Company's loans still have the ability to decline 200 basis points. For those loans that have floors above the -200 basis point rate shock, the interest rate would be at the floor rate. All deposit account rates would likely fall to their floors under the -200 basis point rate shock as well. This simulation analysis assumes that NOW and savings accounts have a lower correlation to changes in market interest rates than do loans, securities, and time deposits.

 

 

 

Our economic value of equity simulation measures our long-term interest rate risk. The economic value is the difference between the market value of the assets and the liabilities and, technically, it is our liquidation.

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QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK (Continued)

The technique is to apply rate changes and compute the value. The slope of the change between shock levels is a measure of the volatility of value risk. The slope is called duration. The greater the slope, the greater the impact or rate change on our long-term performance. Our policy guideline is that the maximum percentage change on economic value of equity cannot exceed plus or minus 10% on 100 basis point change and 20% on 200 basis point change. The following illustrates our equity at risk in the economic value of equity model.

 

 

 

One of management’s objectives in managing our balance sheet for interest rate sensitivity is to reduce volatility in the net interest margin by matching, as closely as possible, the timing of the repricing of its interest rate sensitive assets with interest rate sensitive liabilities.

The Company, with the participation of its management, including the Company’s Chief Executive Officer and Chief Financial Officer, carried out an evaluation of the effectiveness of the design and operation of its disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this Report. Based on their evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that as of the end of the period covered by this report, the Company’s disclosure controls and procedures are effective to ensure that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms.

There were no changes in the Company’s internal control over financial reporting that occurred during the period covered by this quarterly report that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

 

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Not applicable.

There have been no material changes in our "Risk Factors" as previously disclosed in our Annual Report on Form 10-K for the year ended December 31, 2015.

Not applicable.

Not applicable.

Not applicable.

Not applicable.

 

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SIGNATURES

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

Community First, Inc.

(Registrant)

 

 

 

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