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EX-32 - EXHIBIT 32 - SIERRA BANCORPv445200_ex32.htm
EX-31.2 - EXHIBIT 31.2 - SIERRA BANCORPv445200_ex31-2.htm
EX-31.1 - EXHIBIT 31.1 - SIERRA BANCORPv445200_ex31-1.htm

 

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES

EXCHANGE ACT OF 1934

 

FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2016

Commission file number: 000-33063

 

Sierra Bancorp

(Exact name of Registrant as specified in its charter)

 

California 33-0937517
(State of Incorporation) (IRS Employer Identification No)

 

86 North Main Street, Porterville, California 93257

(Address of principal executive offices)        (Zip Code)

 

(559) 782-4900

(Registrant’s telephone number, including area code)

 

Not Applicable

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

 

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days.

  Yes  þ No  ¨  

 

Indicate by check mark whether the Registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

  Yes  þ No  ¨  

 

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.

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

 

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

  Yes  ¨ No  þ  

 

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

 

Common stock, no par value, 13,884,794 shares outstanding as of July 29, 2016

 

 

 

 

FORM 10-Q

 

Table of Contents

 

  Page
Part I - Financial Information 1
Item 1. Financial Statements (Unaudited) 1
Consolidated Balance Sheets 1
Consolidated Statements of Income 2
Consolidated Statements of Comprehensive Income 3
Consolidated Statements of Cash Flows 4
Notes to Unaudited Consolidated Financial Statements 5
   
Item 2. Management’s Discussion & Analysis of Financial Condition & Results of Operations 32
Forward-Looking Statements 32
Critical Accounting Policies 32
Overview of the Results of Operations and Financial Condition 33
Earnings Performance 34
Net Interest Income and Net Interest Margin 34
Provision for Loan and Lease Losses 38
Non-interest Income and Non-Interest Expense 39
Provision for Income Taxes 41
Balance Sheet Analysis 42
Earning Assets 42
Investments 42
Loan and Lease Portfolio 43
Nonperforming Assets 45
Allowance for Loan and Lease Losses 46
Off-Balance Sheet Arrangements 48
Other Assets 48
Deposits and Interest-Bearing Liabilities 49
Deposits 49
Other Interest-Bearing Liabilities 50
Non-Interest Bearing Liabilities 50
Liquidity and Market Risk Management 50
Capital Resources 53
   
Item 3. Qualitative & Quantitative Disclosures about Market Risk 54
   
Item 4. Controls and Procedures 54
   
Part II - Other Information 55
Item 1. - Legal Proceedings 55
Item 1A. - Risk Factors 55
Item 2. - Unregistered Sales of Equity Securities and Use of Proceeds 55
Item 3. - Defaults upon Senior Securities 55
Item 4. - (Removed and Reserved) 55
Item 5. - Other Information 55
Item 6. - Exhibits 56
   
Signatures 57

 

 

 

 

PART I - FINANCIAL INFORMATION

Item 1 – Financial Statements

SIERRA BANCORP

CONSOLIDATED BALANCE SHEETS

(dollars in thousands)

 

   June 30, 2016   December 31, 2015 
   (unaudited)   (audited) 
ASSETS          
Cash and due from banks  $51,576   $46,627 
Interest-bearing deposits in banks   1,465    1,996 
Total cash & cash equivalents   53,041    48,623 
Securities available for sale   528,539    507,582 
Loans and leases:          
Gross loans and leases   1,155,262    1,132,856 
Allowance for loan and lease losses   (10,042)   (10,423)
Deferred loan and lease fees, net   2,651    2,169 
Net loans and leases   1,147,871    1,124,602 
Premises and equipment, net   22,449    21,990 
Foreclosed assets   2,897    3,193 
Company owned life insurance   43,829    44,140 
Goodwill   6,908    6,908 
Other intangible assets, net   1,170    930 
Other assets   36,584    38,569 
   $1,843,288   $1,796,537 
           
LIABILITIES AND SHAREHOLDERS' EQUITY          
Deposits:          
Non-interest bearing  $433,328   $432,251 
Interest bearing   1,052,746    1,032,377 
Total deposits   1,486,074    1,464,628 
Repurchase agreements   10,194    9,405 
Federal funds purchased   4,100    - 
Short-term borrowings   93,700    75,300 
Long-term borrowings   -    2,000 
Junior subordinated debentures   30,928    30,928 
Other liabilities   19,977    23,936 
Total Liabilities   1,644,973    1,606,197 
           
Commitments and contingent liabilities (Note 8)          
           
Shareholders' equity          
Common stock, no par value; 24,000,000 shares authorized; 13,285,568 and 13,254,088 shares issued and outstanding at June 30, 2016 and December 31, 2015, respectively   62,825    62,404 
Additional paid in capital   2,755    2,689 
Retained earnings   127,638    122,701 
Accumulated other comprehensive income   5,097    2,546 
Total shareholders' equity   198,315    190,340 
   $1,843,288   $1,796,537 

 

The accompanying notes are an integral part of these consolidated financial statements

 

 1 

 

SIERRA BANCORP

CONSOLIDATED STATEMENTS OF INCOME

(dollars in thousands, except per share data, unaudited)

 

   Three months ended June 30,   Six months ended June 30, 
   2016   2015   2016   2015 
Interest and dividend income                    
Loans and leases, including fees  $13,147   $12,880   $26,240   $25,200 
Taxable securities   2,052    2,003    4,199    4,251 
Tax-exempt securities   730    732    1,460    1,457 
Dividend income on securities   -    48    36    93 
Federal funds sold and other   5    6    32    18 
Total interest income   15,934    15,669    31,967    31,019 
Interest expense                    
Deposits   508    449    999    893 
Short-term borrowings   31    21    56    31 
Long-term borrowings   -    3    -    7 
Subordinated debentures   200    178    402    352 
Total interest expense   739    651    1,457    1,283 
Net Interest Income   15,195    15,018    30,510    29,736 
Provision for loan losses   -    -    -    - 
Net interest income after provision for loan losses   15,195    15,018    30,510    29,736 
Non-interest income                    
Service charges on deposits   2,478    2,278    4,848    4,269 
Net gains on sale of securities available-for-sale   146    307    122    323 
Other income   1,950    2,069    3,898    4,069 
Total non-interest income   4,574    4,654    8,868    8,661 
Other operating expense                    
Salaries and employee benefits   6,624    6,125    13,490    13,020 
Occupancy and equipment   1,866    1,666    3,617    3,326 
Other   5,225    4,960    10,087    9,865 
Total other operating expense   13,715    12,751    27,194    26,211 
Income before taxes   6,054    6,921    12,184    12,186 
Provision for income taxes   1,968    2,364    4,062    3,891 
Net income  $4,086   $4,557   $8,122   $8,295 
                     
PER SHARE DATA                    
Book value  $14.93   $13.88   $14.93   $13.88 
Cash dividends  $0.12   $0.10   $0.24   $0.20 
Earnings per share basic  $0.31   $0.34   $0.61   $0.61 
Earnings per share diluted  $0.31   $0.33   $0.61   $0.60 
Average shares outstanding, basic   13,280,443    13,560,091    13,272,903    13,619,050 
Average shares outstanding, diluted   13,393,448    13,686,206    13,388,664    13,745,467 
                     
Total shareholder equity (in thousands)  $198,315   $186,106   $198,315   $186,106 
Shares outstanding   13,285,568    13,404,812    13,285,568    13,404,812 
Dividends Paid  $1,593,395   $1,361,581   $3,184,711   $2,730,579 

 

The accompanying notes are an integral part of these consolidated financial statements

 

 2 

 

SIERRA BANCORP

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(dollars in thousands, unaudited)

 

   Three months ended June 30,   Six months ended June 30, 
   2016   2015   2016   2015 
                 
Net Income  $4,086   $4,557   $8,122   $8,295 
Other comprehensive income, before tax:                    
Unrealized gains on securities:                    
Unrealized holding (losses) gains arising during period   2,486    (2,805)   4,487    (2,509)
Less: reclassification adjustment for gains (1) included in net income   (146)   (307)   (122)   (323)
Other comprehensive (loss) income, before tax   2,340    (3,112)   4,365    (2,832)
Income tax expense (benefit) related to items of other comprehensive income (loss), net of tax   (984)   1,309    (1,814)   1,126 
Other comprehensive income (loss) gain   1,356    (1,803)   2,551    (1,706)
                     
Comprehensive Income  $5,442   $2,754   $10,673   $6,589 

 

(1) Amounts are included in net gains on investment securities available-for-sale on the Consolidated Statements of Income in non-interest revenue. Income tax expense associated with the reclassification adjustment for the three months ended June 30, 2016 and 2015 was $61 thousand and $129 thousand respectively. Income tax expense associated with the reclassification adjustment for the six months ended June 30, 2016 and 2015 was $51 thousand and $136 thousand respectively.

 

The accompanying notes are an integral part of these consolidated financial statements

 

 3 

 

SIERRA BANCORP

CONSOLIDATED STATEMENTS OF CASH FLOWS

(dollars in thousands, unaudited)

 

   Six months ended June 30, 
   2016   2015 
Cash flows from operating activities:          
Net income  $8,122   $8,295 
Adjustments to reconcile net income to net cash provided by operating activities:          
Gain on sales of securities   (122)   (323)
Gain on sales of loans   -    - 
Loss on disposal of fixed assets   2    55 
Loss (gain) on sale on foreclosed assets   1    (78)
Writedowns on foreclosed assets   262    173 
Share-based compensation expense   169    18 
Provision for loan losses   -    - 
Depreciation   1,209    1,119 
Net accretion on purchased loans   (70)   (526)
Net amortization on securities premiums and discounts   3,312    3,384 
Decrease in unearned net loan fees   482    247 
Decrease (increase) in cash surrender value of life insurance policies   311    (731)
Loss from sale of loans   -    - 
Decrease in interest receivable and other assets   67    246 
Increase in other liabilites   (3,959)   (640)
Deferred income tax provision   310    470 
Excess tax benefit from equity based compensation   85    40 
Net cash provided by operating activities   10,181    11,749 
           
Cash flows from investing activities:          
Maturities of securities available for sale   30    290 
Proceeds from sales/calls of securities available for sale   5,365    22,538 
Purchases of securities available for sale   (70,675)   (67,813)
Principal pay downs on securities available for sale   45,536    44,056 
Purchases of FHLB stock   (399)   (504)
Net increase in loans receivable, net   (24,377)   (103,829)
Purchases of premises and equipment, net   (1,901)   (1,672)
Proceeds from sale premises and equipment   231    55 
Proceeds from sales of foreclosed assets   729    981 
Net cash used in investing activities   (45,461)   (105,898)
           
Cash flows from financing activities:          
Increase in deposits   21,446    104,895 
Increase (decrease) in borrowed funds   16,400    (10,500)
Increase in Fed funds purchased   4,100    - 
Increase in repurchase agreements   789    4,021 
Cash dividends paid   (3,185)   (2,730)
Repurchases of common stock   -    (5,251)
Stock options exercised   233    349 
Excess tax benefit from equity based compensation   (85)   (40)
Net cash provided by financing activities   39,698    90,744 
           
 Increase (decrease) in cash and due from banks   4,418    (3,405)
           
Cash and cash equivalents          
Beginning of period   48,623    50,095 
End of period  $53,041   $46,690 

 

The accompanying notes are an integral part of these consolidated financial statements

 

 4 

 

Sierra Bancorp

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2016

 

Note 1 – The Business of Sierra Bancorp

 

Sierra Bancorp (the “Company”) is a California corporation headquartered in Porterville, California, and is a registered bank holding company under federal banking laws. The Company was formed to serve as the holding company for Bank of the Sierra (the “Bank”), and has been the Bank’s sole shareholder since August 2001. The Company exists primarily for the purpose of holding the stock of the Bank and of such other subsidiaries it may acquire or establish. As of June 30, 2016, the Company’s only other subsidiaries were Sierra Statutory Trust II and Sierra Capital Trust III, which were formed in March 2004 and June 2006, respectively, solely to facilitate the issuance of capital trust pass-through securities (“TRUPS”). Pursuant to the Financial Accounting Standards Board (“FASB”) standard on the consolidation of variable interest entities, these trusts are not reflected on a consolidated basis in the Company’s financial statements. References herein to the “Company” include Sierra Bancorp and its consolidated subsidiary, the Bank, unless the context indicates otherwise.

 

The Bank is a California state-chartered bank headquartered in Porterville, California. Bank of the Sierra was incorporated in September 1977, and opened for business in January 1978 as a one-branch bank with $1.5 million in capital and eleven employees. Our growth in the ensuing years has primarily been organic, but includes three whole-bank acquisitions: Sierra National Bank in the year 2000, Santa Clara Valley Bank in 2014, and Coast National Bank in July of 2016 (see Note 13 to the financial statements, Recent Developments, for details on the Coast acquisition). With our latest acquisition the Bank now operates 33 full-service branches and a loan production office, and offers a full range of retail and commercial banking services in California's South Central Valley and neighboring communities, the Central Coast, and select Southern California locations including Ventura County and the Santa Clarita Valley. Our most recent branching activity occurred in the second quarter of 2016, with the opening of a de novo branch in Sanger, California and the purchase of a competitor bank’s Porterville branch which was consolidated into our main office (see Note 13 to the financial statements, Recent Developments, for details on the branch acquisition). We have also received regulatory approvals for another branch in Bakersfield, California, which is under construction and should be ready to commence operations by the first quarter of 2017. In addition to our stand-alone offices the Bank has specialized lending units which include a real estate industries center, an agricultural credit center, and an SBA lending unit. We also have ATMs at all branch locations and offsite ATMs at six different non-branch locations. We were well over $1.8 billion in assets as of June 30, 2016, even without consideration of the assets gained via the Coast National Bank acquisition, and for the past several years have claimed the distinction of being the largest bank headquartered in the South San Joaquin Valley. The Bank’s deposit accounts are insured by the Federal Deposit Insurance Corporation (“FDIC”) up to maximum insurable amounts.

 

Note 2 – Basis of Presentation

 

The accompanying unaudited consolidated financial statements have been prepared in a condensed format, and therefore do not include all of the information and footnotes required by U.S. generally accepted accounting principles (“GAAP”) for complete financial statements. The information furnished in these interim statements reflects all adjustments that are, in the opinion of Management, necessary for a fair statement of the results for such period. Such adjustments can generally be considered as normal and recurring unless otherwise disclosed in this Form 10-Q. In preparing the accompanying financial statements, Management has taken subsequent events into consideration and recognized them where appropriate. The results of operations in the interim statements are not necessarily indicative of the results that may be expected for any other quarter, or for the full year. Certain amounts reported for 2015 have been reclassified to be consistent with the reporting for 2016. The interim financial information should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2015, as filed with the Securities and Exchange Commission.

 

 5 

 

Note 3 – Current Accounting Developments

 

In May 2014, the FASB issued Accounting Standards Update (“ASU”) 2014-09, Revenue from Contracts with Customers (Topic 606). This ASU is the result of a joint project initiated by the FASB and the International Accounting Standards Board (IASB) to clarify the principles for recognizing revenue, and to develop common revenue standards and disclosure requirements that would: (1) remove inconsistencies and weaknesses in revenue requirements; (2) provide a more robust framework for addressing revenue issues; (3) improve comparability of revenue recognition practices across entities, industries, jurisdictions, and capital markets; (4) provide more useful information to users of financial statements through improved disclosures; and (5) simplify the preparation of financial statements by reducing the number of requirements to which an entity must refer. The guidance affects any entity that either enters into contracts with customers to transfer goods or services or enters into contracts for the transfer of nonfinancial assets. The core principle is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The guidance provides steps to follow to achieve the core principle. An entity should disclose sufficient information to enable users of financial statements to understand the nature, amount, timing and uncertainty of revenue and cash flows arising from contracts with customers. Qualitative and quantitative information is required with regard to contracts with customers, significant judgments and changes in judgments, and assets recognized from the costs to obtain or fulfill a contract. This ASU is effective for annual reporting periods beginning after December 15, 2017, including interim periods therein, with early adoption permitted for reporting periods beginning after December 15, 2016. The Company does not expect to adopt this guidance early and is currently evaluating the potential effects of the guidance on its financial statements and disclosures.

 

In June 2014 the FASB issued ASU 2014-12, Compensation–Stock Compensation (Topic 718): Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved after the Requisite Service Period. These amendments to existing guidance require that a performance target be treated as a “performance condition” if it affects vesting and can be achieved after the requisite service period. To account for such awards, a reporting entity should apply existing guidance in Topic 718 as it relates to awards with performance conditions that affect vesting. The total amount of compensation cost recognized during and after the requisite service period should reflect the number of awards that are expected to vest, and should be adjusted to reflect those awards that ultimately vest. The requisite period ends when the employee can cease rendering service and still be eligible to vest in the award if the performance target is achieved. ASU 2014-12 is effective for annual periods and interim periods within those annual periods beginning after December 15, 2015. It was adopted by the Company for the first quarter of 2016, and because our stock compensation practices do not currently utilize performance-based criteria there was no impact upon our financial statements or operations upon adoption.

 

In April 2015 the FASB issued ASU 2015-03, Interest–Imputation of Interest (Subtopic 835-30): Simplifying the Presentation of Debt Issuance Costs, to simplify the presentation of debt issuance costs related to a recognized debt liability by reflecting those costs as a direct deduction from the carrying amount of debt liability, consistent with debt discounts. ASU 2015-15 was subsequently issued in August 2015 to clarify the SEC staff’s position on presenting and measuring debt issuance costs incurred in connection with line-of-credit arrangements. ASU 2015-03, as modified by ASU 2015-15, became effective for interim and annual periods beginning after December 15, 2015, and we adopted this guidance for the first quarter of 2016 without any material effect on our consolidated financial statements.

 

In January 2016 the FASB issued ASU 2016-01, Financial Instruments–Overall: Recognition and Measurement of Financial Assets and Financial Liabilities. This guidance primarily affects the accounting for equity securities with readily determinable fair values, by requiring that the changes in fair value for such securities will be reflected in earnings rather than in other comprehensive income. The accounting for other financial instruments such as loans, debt securities, and financial liabilities is largely unchanged. ASU 2016-01 also changes the presentation and disclosure requirements for financial instruments, including a requirement that public business entities use exit pricing when estimating fair values for financial instruments measured at amortized cost for disclosure purposes. ASU 2016-01 is generally effective for public business entities in fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. We are evaluating the potential effects of this guidance on our financial statements and disclosures, but do not currently expect it to have a material impact upon adoption.

 

In February 2016 the FASB issued ASU 2016-02, Leases (Topic 842). This new standard is being issued to increase the transparency and comparability around lease obligations. Previously unrecorded off-balance sheet obligations will now be brought more prominently to light by presenting lease liabilities on the face of the balance sheet, accompanied by enhanced qualitative and quantitative disclosures in the notes to the financial statements. ASU 2016-02 is generally effective for public business entities in fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. The Company is currently evaluating the potential impact of this guidance on its financial statements and disclosures.

 

 6 

 

In March 2016 the FASB issued ASU 2016-09, Compensation–Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting, as part of its simplification initiative. Currently, as they relate to share-based payments, tax benefits in excess of compensation costs (“windfalls”) are recorded in equity, and tax deficiencies (“shortfalls”) are recorded in equity to the extent of previous windfalls, and then to the income statement. ASU 2016-09 will reduce some of the administrative complexities by eliminating the need to track a windfall “pool,” but could increase the volatility of income tax expense. This change is required to be applied prospectively to all excess tax benefits and tax deficiencies resulting from settlements after the date of adoption. ASU 2016-09 also removes the requirement to delay recognition of a windfall tax benefit until it reduces current taxes payable. Under the new guidance, the benefit will be recorded when it arises, subject to normal valuation allowance considerations. This change is required to be applied on a modified retrospective basis, with a cumulative-effect adjustment to opening retained earnings. Furthermore, all tax-related cash flows resulting from share-based payments are to be reported as operating activities on the statement of cash flows, a change from the current requirement to present windfall tax benefits as an inflow from financing activities and an outflow from operating activities. However, cash paid by an employer when directly withholding shares for tax withholding purposes should be classified as a financing activity. Under the new guidance, entities are also permitted to make an accounting policy election for the impact of forfeitures on expense recognition for share-based payment awards. Forfeitures can be estimated in advance, as required today, or recognized as they occur. Estimates will still be required in certain circumstances, such as at the time of modification of an award or issuance of a replacement award in a business combination. If elected, the change to recognize forfeitures when they occur needs to be adopted using a modified retrospective approach, with a cumulative effect adjustment recorded to opening retained earnings. ASU 2016-09 is effective for public business entities for annual reporting periods beginning after December 15, 2016, and interim periods within that reporting period. Early adoption will be permitted in any interim or annual period, with any adjustments reflected as of the beginning of the fiscal year of adoption. We are currently evaluating the potential impact of this guidance on our financial statements and disclosures.

 

In June 2016 the FASB issued ASU 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, which eliminates the probable initial recognition threshold for credit losses in current U.S. GAAP, and instead requires an organization to record a current estimate of all expected credit losses over the contractual term for financial assets carried at amortized cost. This is commonly referred to as the current expected credit losses (“CECL”) methodology. Expected credit losses for financial assets held at the reporting date will be measured based on historical experience, current conditions, and reasonable and supportable forecasts. Another change from existing U.S. GAAP involves the treatment of purchased credit deteriorated assets, which are more broadly defined than purchased credit impaired assets in current accounting standards. When such assets are purchased, institutions will estimate and record an allowance for credit losses that is added to the purchase price rather than being reported as a credit loss expense. Furthermore, ASU 2016-13 updates the measurement of credit losses on available-for-sale debt securities, by mandating that institutions record credit losses on available-for-sale debt securities through an allowance for credit losses rather than the current practice of writing down securities for other-than-temporary impairment. ASU 2016-13 will also require the enhancement of financial statement disclosures regarding estimates used in calculating credit losses. ASU 2016-13 does not change the existing write-off principle in U.S. GAAP or current nonaccrual practices, nor does it change accounting requirements for loans held for sale or certain other financial assets which are measured at the lower of amortized cost or fair value. As a public business entity that is an SEC filer, ASU 2016-13 becomes effective for the Company on January 1, 2020, although early application is permitted for 2019. On the effective date, institutions will apply the new accounting standard as follows: for financial assets carried at amortized cost, a cumulative-effect adjustment will be recognized on the balance sheet for any change in the related allowance for loan and lease losses generated by the adoption of the new standard; financial assets classified as purchased credit impaired assets prior to the effective date will be reclassified as purchased credit deteriorated assets as of the effective date, and will be grossed up for the related allowance for expected credit losses created as of the effective date; and, debt securities on which other-than-temporary impairment had been recognized prior to the effective date will transition to the new guidance prospectively with no change in their amortized cost basis. We are currently evaluating the potential impact of this guidance on our financial statements and disclosures, and in general expect an increase in our allowance for loan and lease losses upon adoption.

 

Note 4 – Supplemental Disclosure of Cash Flow Information

 

During the six months ended June 30, 2016 and 2015, cash paid for interest due on interest-bearing liabilities was $1.423 million and $1.318 million, respectively. There was $2.500 million in cash paid for income taxes during the six months ended June 30, 2016, and $4.550 million in cash paid for income taxes for the six months ended June 30, 2015. Assets totaling $694,000 and $501,000 were acquired in settlement of loans for the six months ended June 30, 2016 and June 30, 2015, respectively. We received $729,000 in cash from the sale of foreclosed assets during the first six months of 2016 relative to $981,000 during the first six months of 2015, which represents sales proceeds less loans (if any) extended to finance such sales.

 

 7 

 

Note 5 – Share Based Compensation

 

The 2007 Stock Incentive Plan (the “2007 Plan”) was adopted by the Company in 2007. Our 1998 Stock Option Plan was concurrently terminated, although options to purchase 43,500 shares that were granted under that plan were still outstanding as of June 30, 2016 and remain unaffected by the plan’s termination. The 2007 Plan provides for the issuance of both “incentive” and “nonqualified” stock options to officers and employees, and of “nonqualified” stock options to non-employee directors of the Company. The 2007 Plan also provides for the issuance of restricted stock awards to these same classes of eligible participants, on such terms and conditions as are established at the discretion of the Board of Directors or the Compensation Committee, although no restricted stock awards have been issued by the Company. The total number of shares of the Company’s authorized but unissued stock reserved for issuance pursuant to awards under the 2007 Plan was initially 1,500,000 shares, although due to awards granted since the inception of the plan the number remaining available for grant had declined to 741,940 at June 30, 2016. No equity awards can be issued under the 2007 Plan after February 15, 2017, when the plan expires, but any award granted under the plan prior to February 15, 2017 had an original life of 10 years and thus may extend beyond that date. The dilutive impact of stock options outstanding is discussed below in Note 6, Earnings per Share.

 

Pursuant to FASB’s standards on stock compensation, the value of each stock option granted is reflected in our income statement as employee compensation or directors’ expense by amortizing the value over the vesting period for options with graded vesting, or by expensing it as of the grant date for immediately vested options. The Company is utilizing the Black-Scholes model to value stock options, and the “multiple option” approach is used to allocate the resulting valuation to actual expense. Under the multiple option approach an employee’s options for each vesting period are separately valued and amortized, which appears to be the preferred method for option grants with graded vesting. A pre-tax charge of $12,000 was reflected in the Company’s income statement during the second quarter of 2016 and $11,000 was charged during the second quarter of 2015, as expense related to stock options. For the first half, the charges totaled $169,000 in 2016 and $18,000 in 2015.

 

Note 6 – Earnings per Share

 

The computation of earnings per share, as presented in the Consolidated Statements of Income, is based on the weighted average number of shares outstanding during each period. There were 13,280,433 weighted average shares outstanding during the second quarter of 2016, and 13,560,091 during the second quarter of 2015. There were 13,272,903 weighted average shares outstanding during the first six months of 2016, and 13,619,050 during the first six months of 2015.

 

Diluted earnings per share include the effect of the potential issuance of common shares, which for the Company is limited to shares that would be issued on the exercise of “in-the-money” stock options. For the second quarter of 2016, calculations under the treasury stock method resulted in the equivalent of 113,015 shares being added to basic weighted average shares outstanding for purposes of determining diluted earnings per share, while a weighted average of 162,700 stock options were excluded from the calculation because they were underwater and thus anti-dilutive. For the second quarter of 2015 the equivalent of 126,115 shares were added in calculating diluted earnings per share while 169,300 anti-dilutive stock options were excluded. Likewise, for the first half of 2016 the equivalent of 115,761 shares were added to basic weighted average shares outstanding in calculating diluted earnings per share and a weighted average of 212,700 stock options that were anti-dilutive for the period were excluded, compared to the inclusion of the equivalent of 126,417 shares and exclusion of 171,700 anti-dilutive options in calculating diluted earnings per share for first half of 2015.

 

Note 7 – Comprehensive Income

 

As presented in the Consolidated Statements of Comprehensive Income, comprehensive income includes net income and other comprehensive income. The Company’s only source of other comprehensive income is unrealized gains and losses on available-for-sale investment securities. Gains or losses on investment securities that were realized and reflected in net income of the current period, which had previously been included in other comprehensive income as unrealized holding gains or losses in the period in which they arose, are considered to be reclassification adjustments that are excluded from other comprehensive income in the current period.

 

 8 

 

Note 8 – Financial Instruments with Off-Balance-Sheet Risk

 

The Company is a party to financial instruments with off-balance-sheet risk in the normal course of business. Those financial instruments currently consist of unused commitments to extend credit and standby letters of credit. They involve, to varying degrees, elements of risk in excess of the amount recognized in the balance sheet. The Company’s exposure to credit loss in the event of nonperformance by counterparties for commitments to extend credit and letters of credit is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments and issuing letters of credit as it does for originating loans included on the balance sheet. The following financial instruments represent off-balance-sheet credit risk (dollars in thousands):

 

   June 30, 2016   December 31, 2015 
Commitments to extend credit  $325,357   $354,890 
Standby letters of credit  $8,990   $16,654 

 

Commitments to extend credit consist primarily of the unused or unfunded portions of the following: home equity lines of credit; commercial real estate construction loans, where disbursements are made over the course of construction; commercial revolving lines of credit; mortgage warehouse lines of credit; unsecured personal lines of credit; and formalized (disclosed) deposit account overdraft lines. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many commitments are expected to expire without being drawn upon, the unused portions of committed amounts do not necessarily represent future cash requirements. Standby letters of credit are generally unsecured and are issued by the Company to guarantee the performance of a customer to a third party, and the credit risk involved in issuing letters of credit is essentially the same as the risk involved in extending loans to customers.

 

At June 30, 2016, the Company was also utilizing a letter of credit in the amount of $97 million issued by the Federal Home Loan Bank on the Company’s behalf as security for certain deposits and to facilitate certain credit arrangements with the Company’s customers. That letter of credit is backed by loans which are pledged to the FHLB by the Company.

 

Note 9 – Fair Value Disclosures and Reporting, the Fair Value Option and Fair Value Measurements

 

FASB’s standards on financial instruments, and on fair value measurements and disclosures, require all entities to disclose in their financial statement footnotes the estimated fair values of financial instruments for which it is practicable to estimate fair values. In addition to disclosure requirements, FASB’s standard on investments requires that our debt securities which are classified as available for sale and our equity securities that have readily determinable fair values be measured and reported at fair value in our statement of financial position. Certain impaired loans are also reported at fair value, as explained in greater detail below, and foreclosed assets are carried at the lower of cost or fair value. FASB’s standard on financial instruments permits companies to report certain other financial assets and liabilities at fair value, but we have not elected the fair value option for any of those financial instruments.

 

Fair value measurement and disclosure standards also establish a framework for measuring fair values. Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability, in an orderly transaction between market participants on the measurement date. Further, the standards establish a fair value hierarchy that encourages an entity to maximize the use of observable inputs and limit the use of unobservable inputs when measuring fair values. The standards describe three levels of inputs that may be used to measure fair values:

 

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

 

·Level 2: Significant observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, and 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 factors that market participants would likely consider in pricing an asset or liability.

 

 9 

 

Fair value estimates are made at a specific point in time based on relevant market data and information about the financial instruments. The estimates do not reflect any premium or discount that could result from offering the Company’s entire holdings of a particular financial instrument for sale at one time, nor do they attempt to estimate the value of anticipated future business related to the instruments. In addition, the tax ramifications related to realized gains and losses could have a significant effect on fair value estimates but have not been considered in those estimates. Because no active market exists for a significant portion of our financial instruments, fair value disclosures are based on judgments regarding current economic conditions, risk characteristics of various financial instruments and other factors. The estimates are subjective and involve uncertainties and matters of significant judgment, and therefore cannot be determined with precision. Changes in assumptions could significantly alter the fair values presented. The following methods and assumptions were used by the Company to estimate its financial instrument fair values disclosed at June 30, 2016 and December 31, 2015:

 

·Cash and cash equivalents and fed funds sold: The carrying amount is estimated to be fair value.

 

·Investment securities: Fair values are determined by obtaining quoted prices on nationally recognized securities exchanges or by matrix pricing, which is a mathematical technique used widely in the industry to value debt securities by relying on their relationship to other benchmark quoted securities when quoted prices for specific securities are not readily available.

 

·Loans and leases: For variable-rate loans and leases that re-price frequently with no significant change in credit risk or interest rate spread, fair values are based on carrying values. Fair values for other loans and leases are estimated by discounting projected cash flows at interest rates being offered at each reporting date for loans and leases with similar terms, to borrowers of comparable creditworthiness. The carrying amount of accrued interest receivable approximates its fair value.

 

·Loans held for sale: Since loans designated by the Company as available-for-sale are typically sold shortly after making the decision to sell them, realized gains or losses are usually recognized within the same period and fluctuations in fair values are not relevant for reporting purposes. If available-for-sale loans are on our books for an extended period of time, the fair value of those loans is determined using quoted secondary-market prices.

 

·Collateral-dependent impaired loans: Collateral-dependent impaired loans are carried at fair value when it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the original loan agreement and the loan has been written down to the fair value of its underlying collateral, net of expected disposition costs where applicable.

 

·Cash surrender value of life insurance policies: Fair values are based on net cash surrender values at each reporting date.

 

·Investments in, and capital commitments to, limited partnerships: The fair values of our limited partner investments in low-income housing tax credit funds and other limited partnership investments are estimated using quarterly indications of value provided by the general partners. The fair values of undisbursed capital commitments are assumed to be the same as their book values.

 

·Other investments: Certain investments for which no secondary market exists are carried at cost and the carrying amount for those investments typically approximates their estimated fair value, unless an impairment analysis indicates the need for adjustments.

 

·Deposits: Fair values for non-maturity deposits are equal to the amount payable on demand at the reporting date, which is the carrying amount. Fair values for fixed-rate certificates of deposit are estimated using a cash flow analysis, discounted at interest rates being offered at each reporting date by the Bank for certificates with similar remaining maturities. The carrying amount of accrued interest payable approximates its fair value.

 

·Short-term borrowings: Current carrying amounts are used as an approximation of fair values for federal funds purchased, overnight advances from the Federal Home Loan Bank (“FHLB”), borrowings under repurchase agreements, and other short-term borrowings maturing within ninety days of the reporting dates. Fair values of other short-term borrowings are estimated by discounting projected cash flows at the Company’s current incremental borrowing rates for similar types of borrowing arrangements.

 

·Long-term borrowings: Fair values are estimated using projected cash flows discounted at the Company’s current incremental borrowing rates for similar types of borrowing arrangements.

 

·Subordinated debentures: Fair values are determined based on the current market value for like instruments of a similar maturity and structure.

 

·Commitments to extend credit and letters of credit: If funded, the carrying amounts for currently unused commitments would provide an equivalent measure of fair values for the newly created financial assets at the funding date. However, because of the high degree of uncertainty with regard to whether or not those commitments will ultimately be funded, fair values for loan commitments and letters of credit in their current undisbursed state cannot reasonably be estimated, and only notional values are disclosed in the table below.

 

 10 

 

Estimated fair values for the Company’s financial instruments are as follows, as of the dates noted:

 

Fair Value of Financial Instruments

(dollars in thousands, unaudited)

 

   June 30, 2016 
       Estimated Fair Value 
  

Carrying

Amount

  

Quoted Prices in

Active Markets for

Identical Assets

(Level 1)

  

Significant

Observable
Inputs

(Level 2)

  

Significant

Unobservable
Inputs

(Level 3)

   Total 
Financial assets:                         
Cash and cash equivalents  $53,041   $53,041   $-   $-   $53,041 
Investment securities available for sale   528,539    1,127    527,412    -    528,539 
Loans and leases, net held for investment   1,145,888    -    1,172,194    -    1,172,194 
Collateral dependent impaired loans   1,983    -    1,983    -    1,983 
Loans held-for-sale   -    -    -    -    - 
Cash surrender value of life insurance policies   43,829    -    43,829    -    43,829 
Other investments   7,945    -    7,945    -    7,945 
Investment in limited partnership   8,568    -    8,568    -    8,568 
Accrued interest receivable   5,697    -    5,697    -    5,697 
                          
Financial liabilities:                         
Deposits:                         
Noninterest-bearing  $433,328   $433,328   $-   $-   $433,328 
Interest-bearing   1,052,746    -    929,491    -    929,491 
Fed funds purchased and repurchase agreements   14,294    -    14,294    -    14,294 
Short-term borrowings   93,700    -    93,700    -    93,700 
Long-term borrowings   -    -    -    -    - 
Subordinated debentures   30,928    -    8,847    -    8,847 
Limited partnership capital commitment   3,070    -    3,070    -    3,070 
Accrued interest payable   128    -    128    -    128 

 

   Notional Amount 
Off-balance-sheet financial instruments:     
Commitments to extend credit  $325,357 
Standby letters of credit   8,990 

 

   December 31, 2015 
       Estimated Fair Value 
  

Carrying

Amount

  

Quoted Prices in

Active Markets for

Identical Assets

(Level 1)

  

Significant

Observable
Inputs

(Level 2)

  

Significant

Unobservable
Inputs

(Level 3)

   Total 
Financial assets:                         
Cash and cash equivalents  $48,623   $48,623   $-   $-   $48,623 
Investment securities available for sale   507,582    1,296    506,286    -    507,582 
Loans and leases, net held for investment   1,120,773    -    1,136,386    -    1,136,386 
Collateral dependent impaired loans   3,829    -    3,829    -    3,829 
Cash surrender value of life insurance policies   44,140    -    44,140    -    44,140 
Other Investments   7,546    -    7,546    -    7,546 
Investment in limited partnership   6,217    -    6,217    -    6,217 
Accrued interest receivable   5,808    -    5,808    -    5,808 
                          
Financial liabilities:                         
Deposits:                         
   Noninterest-bearing  $432,251   $432,251   $-   $-   $432,251 
   Interest-bearing   1,032,377    -    1,032,547    -    1,032,547 
Fed funds purchased and repurchase agreements   9,405    -    9,405    -    9,405 
Short-term borrowings   75,300    -    75,300    -    75,300 
Long-term borrowings   2,000    -    2,001    -    2,001 
Subordinated debentures   30,928    -    7,383    -    7,383 
Limited partnership capital commitment   795    -    795    -    795 
Accrued interest payable   116    -    116    -    116 

 

   Notional Amount 
Off-balance-sheet financial instruments:     
Commitments to extend credit  $354,890 
Standby letters of credit   16,654 

 

 11 

 

For financial asset categories that were actually reported at fair value as of June 30, 2016 and December 31, 2015, the Company used the following methods and significant assumptions:

 

·Investment securities: Fair values are determined by obtaining quoted prices on nationally recognized securities exchanges or by matrix pricing, which is a mathematical technique used widely in the industry to value debt securities by relying on their relationship to other benchmark quoted securities.

 

·Collateral-dependent impaired loans: Collateral-dependent impaired loans are carried at fair value when it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the original loan agreement and the loan has been written down to the fair value of its underlying collateral, net of expected disposition costs where applicable.

 

·Foreclosed assets: Repossessed real estate (known as other real estate owned, or “OREO”) and other foreclosed assets are carried at the lower of cost or fair value. Fair value is the appraised value less expected selling costs for OREO and some other assets such as mobile homes, and fair values for any other foreclosed assets are represented by estimated sales proceeds as determined using reasonably available sources. Foreclosed assets for which appraisals can be feasibly obtained are periodically measured for impairment using updated appraisals. Fair values for other foreclosed assets are adjusted as necessary, subsequent to a periodic re-evaluation of expected cash flows and the timing of resolution. If impairment is determined to exist, the book value of a foreclosed asset is immediately written down to its estimated impaired value through the income statement, thus the carrying amount is equal to the fair value and there is no valuation allowance.

 

Assets reported at fair value on a recurring basis are summarized below:

 

Fair Value Measurements - Recurring

(dollars in thousands, unaudited)

 

   Fair Value Measurements at June 30, 2016, using     
   Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
   Significant
Observable
Inputs
(Level 2)
   Significant
Unobservable
Inputs
(Level 3)
   Total   Realized
Gain/(Loss)
 
Investment securities                         
US Government agencies  $-   $24,872   $-   $24,872   $- 
Mortgage-backed securities   -    394,614    -    394,614    - 
State and poltical subdivisions   -    107,926    -    107,926    - 
Other securities   1,127    -    -    1,127    - 
                          
Total available-for-sale securities  $1,127   $527,412   $-   $528,539   $- 

 

   Fair Value Measurements at December 31, 2015, using     
   Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
   Significant
Observable
Inputs
(Level 2)
   Significant
Unobservable
Inputs
(Level 3)
   Total   Realized
Gain/(Loss)
 
Investment securities                         
US Government agencies  $-   $29,042   $-   $29,042   $- 
Mortgage-backed securities   -    375,061    -    375,061    - 
State and poltical subdivisions   -    102,183    -    102,183    - 
Other securities   1,296    -    -    1,296    - 
                          
Total available-for-sale securities  $1,296   $506,286   $-   $507,582   $- 

 

 12 

 

Assets reported at fair value on a nonrecurring basis are summarized below:

 

Fair Value Measurements – Nonrecurring

(dollars in thousands, unaudited)

 

   Fair Value Measurements at June 30, 2016, using 
   Quoted Prices in Active
Markets for
Identical Assets (Level 1)
   Significant
Observable Inputs
(Level 2)
   Significant
Unobservable Inputs
(Level 3)
   Total 
Impaired loans                    
Real Estate:                    
1-4 family residential construction  $-   $-   $-   $- 
Other construction/land   -    75    -    75 
1-4 family - closed-end   -    -    -    - 
Equity lines   -    -    -    - 
Multi-family residential   -    -    -    - 
Commercial real estate - owner occupied   -    20    -    20 
Commercial real estate-non-owner occupied   -    1,845    -    1,845 
Farmland   -    -    -    - 
Total real estate   -    1,940    -    1,940 
Agriculture   -    -    -    - 
Commercial and industrial   -    -    -    - 
Consumer loans   -    43    -    43 
Total impaired loans   -    1,983    -    1,983 
Foreclosed assets  $-   $2,897   $-   $2,897 
Total assets measured on a norecurring basis  $-   $4,880   $-   $4,880 

 

   Fair Value Measurements at December 31, 2015, using 
   Quoted Prices in Active
Markets for
Identical Assets (Level 1)
   Significant
Observable Inputs
(Level 2)
   Significant
Unobservable Inputs
(Level 3)
   Total 
Impaired loans                    
Real Estate:                    
1-4 family residential construction  $-   $-   $-   $- 
Other construction/land   -    179    -    179 
1-4 family - closed-end   -    499    -    499 
Equity lines   -    30    -    30 
Multi-family residential   -    -    -    - 
Commercial real estate - owner occupied   -    26    -    26 
Commercial real estate-non-owner occupied   -    3,053    -    3,053 
Farmland   -    -         - 
Total real estate   -    3,787    -    3,787 
Agriculture   -    -         - 
Commercial and industrial   -    -         - 
Consumer loans   -    42         42 
Total impaired loans   -    3,829    -    3,829 
Foreclosed assets  $-   $3,193   $-   $3,193 
Total assets measured on a norecurring basis  $-   $7,022   $-   $7,022 

 

The table above includes collateral-dependent impaired loan balances for which a specific reserve has been established or on which a write-down has been taken. Information on the Company’s total impaired loan balances and specific loss reserves associated with those balances is included in Note 11 below, and in Management’s Discussion and Analysis of Financial Condition and Results of Operation in the “Nonperforming Assets” and “Allowance for Loan and Lease Losses” sections.

 

The unobservable inputs are based on Management’s best estimates of appropriate discounts in arriving at fair market value. Increases or decreases in any of those inputs could result in a significantly lower or higher fair value measurement. For example, an increase or decrease in actual loss rates would create a directionally opposite change in the fair value of unsecured impaired loans.

 

 13 

 

Note 10 – Investments

 

Investment Securities

 

Although the Company currently has the intent and the ability to hold the securities in its investment portfolio to maturity, the securities are all marketable and are classified as “available for sale” to allow maximum flexibility with regard to interest rate risk and liquidity management. Pursuant to FASB’s guidance on accounting for debt and equity securities, available for sale securities are carried on the Company’s financial statements at their estimated fair market values, with monthly tax-effected “mark-to-market” adjustments made vis-à-vis accumulated other comprehensive income in shareholders’ equity.

 

Amortized Cost And Estimated Fair Value

(dollars in thousands, unaudited):

The amortized cost and estimated fair value of investment securities available-for-sale are as follows

 

   June 30, 2016 
   Amortized
Cost
   Gross
Unrealized
Gains
   Gross
Unrealized
Losses
   Estimated Fair
Value
 
                 
US Government agencies  $24,466   $409   $(3)  $24,872 
Mortgage-backed securities   391,345    3,951    (682)   394,614 
State and poltical subdivisions   103,433    4,503    (10)   107,926 
Other securities   500    627    -    1,127 
Total investment securities  $519,744   $9,490   $(695)  $528,539 

 

   December 31, 2015 
   Amortized
Cost
   Gross
Unrealized
Gains
   Gross
Unrealized
Losses
   Estimated Fair
Value
 
                 
US Government agencies  $28,801   $303   $(62)  $29,042 
Mortgage-backed securities   374,683    2,440    (2,062)   375,061 
State and political subdivisons   99,093    3,146    (56)   102,183 
Other securities   575    721    -    1,296 
Total investment securities  $503,152   $6,610   $(2,180)  $507,582 

 

 14 

 

At June 30, 2016 and December 31, 2015, the Company had 90 securities and 175 securities, respectively, with unrealized losses. Management has evaluated those securities as of the respective dates, and does not believe that any of the unrealized losses are other than temporary. Gross unrealized losses on our investment securities as of the indicated dates are disclosed in the table below, categorized by investment type and by the duration of time that loss positions on individual securities have continuously existed (over or under twelve months).

 

Investment Portfolio - Unrealized Losses

(dollars in thousands, unaudited)

 

   June 30, 2016 
   Less than twelve months   Twelve months or more 
   Gross
Unrealized
       Gross
Unrealized
     
   Losses   Fair Value   Losses   Fair Value 
                 
US Government agencies  $(3)  $3,301   $-   $- 
Mortgage-backed securities   (323)   67,579    (359)   51,187 
State and political subdivisions   (10)   1,583    -    - 
Total  $(336)  $72,463   $(359)  $51,187 

 

   December 31, 2015 
   Less than twelve months   Twelve months or more 
   Gross
Unrealized
       Gross
Unrealized
     
   Losses   Fair Value   Losses   Fair Value 
                 
US Government agencies  $(62)  $10,329   $-   $- 
Mortgage-backed securities   (1,608)   187,734    (454)   35,511 
State and political subdivisions   (17)   3,409    (39)   3,847 
Total  $(1,687)  $201,472   $(493)  $39,358 

 

The table below summarizes the Company’s gross realized gains and losses as well as gross proceeds from the sales of securities, for the periods indicated:

 

Investment Portfolio - Realized Gains/(Losses)

(dollars in thousands, unaudited)

 

   Three months ended June 30,   Six months ended June 30, 
   2016   2015   2016   2015 
Proceeds from sales, calls and maturities of securities available for sale  $2,790   $2,963   $5,395   $22,828 
Gross gains on sales, calls and maturities of securities available for sale  $146   $307   $160   $522 
Gross losses on sales, calls and maturities  of securities available for sale   -    -    (38)   (199)
Net gains on sale of securities available for sale  $146   $307   $122   $323 

 

 15 

 

The amortized cost and estimated fair value of investment securities available-for-sale at June 30, 2016 and December 31, 2015 are shown below, grouped by the remaining time to contractual maturity dates. The expected life of investment securities may not be consistent with contractual maturity dates, since the issuers of the securities could have the right to call or prepay obligations with or without penalties.

 

Estimated Fair Value of Contractual Maturities

(dollars in thousands, unaudited)

 

   June 30, 2016 
   Amortized
Cost
   Fair Value 
         
Maturing within one year  $6,164   $6,370 
Maturing after one year through five years   250,424    253,919 
Maturing after five years through ten years   47,068    48,674 
Maturing after ten years   47,348    49,287 
           
Investment securities not due at a single maturity date:          
U.S Government agencies collateralized by mortgage obligations   168,240    169,162 
Other securities   500    1,127 
   $519,744   $528,539 

 

   December 31, 2015 
   Amortized
Cost
   Fair Value 
         
Maturing within one year  $3,657   $3,706 
Maturing after one year through five years   242,719    244,733 
Maturing after five years through ten years   50,144    51,308 
Maturing after ten years   50,413    51,671 
           
Investment securities not due at a single maturity date:          
U.S Government agencies collateralized by mortgage obligations   155,644    154,868 
Other securities   575    1,296 
   $503,152   $507,582 

 

At June 30, 2016, the Company’s investment portfolio included securities issued by 292 different government municipalities and agencies located within 27 states with a fair value of $107.9 million. The largest exposure to any single municipality or agency was a $934,000 (fair value) bond issued by the Thurston School District in Washington, to be repaid by property taxes.

 

The Company’s investments in bonds issued by states, municipalities and political subdivisions are evaluated in accordance with Supervision and Regulation Letter 12-15 issued by the Board of Governors of the Federal Reserve System, “Investing in Securities without Reliance on Nationally Recognized Statistical Rating Organization Ratings,” and other regulatory guidance. Credit ratings are considered in our analysis only as a guide to the historical default rate associated with similarly-rated bonds. There have been no significant differences in our internal analyses compared with the ratings assigned by the third party credit rating agencies.

 

 16 

 

The following table summarizes the amortized cost and fair values of general obligation and revenue bonds in the Company’s investment securities portfolio at the indicated dates, identifying the state in which the issuing municipality or agency operates for our largest geographic concentrations:

 

Revenue and General Obligation Bonds by Location

(dollars in thousands, unaudited)

 

   June 30, 2016   December 31, 2015 
   Amortized   Fair Market   Amortized   Fair Market 
General obligation bonds  Cost   Value   Cost   Value 
State of issuance                    
California  $23,250   $24,690   $20,473   $21,642 
Texas   17,656    18,326    16,575    16,954 
Illinois   10,234    10,545    9,997    10,191 
Ohio   9,059    9,305    7,610    7,748 
Washington   5,873    6,090    5,905    6,081 
Arizona   2,023    2,103    2,039    2,108 
Utah   951    1,013    953    990 
Other states   18,518    19,298    20,334    20,848 
Total General Obligation Bonds   87,564    91,370    83,886    86,562 
                     
Revenue bonds                    
State of issuance                    
Texas   4,969    5,153    3,732    3,863 
Utah   4,426    4,631    4,434    4,519 
Washington   1,306    1,387    1,791    1,827 
California   1,002    1,030    1,002    1,028 
Ohio   318    319    318    319 
Other states   3,848    4,036    3,930    4,065 
Total Revenue Bonds   15,869    16,556    15,207    15,621 
                     
Total Obligations of States and Political Subdivisions  $103,433   $107,926   $99,093   $102,183 

 

 17 

 

The revenue bonds in the Company’s investment securities portfolios were issued by government municipalities and agencies to fund public services such as utilities (water, sewer, and power), educational facilities, and general public and economic improvements. The primary sources of revenue for these bonds are delineated in the table below, which shows the amortized cost and fair market values for the largest revenue concentrations as of the indicated dates.

 

Revenue Bonds by Type

(dollars in thousands, unaudited)

 

   June 30, 2016   December 31, 2015 
   Amortized   Fair Market   Amortized   Fair Market 
Revenue bonds  Cost   Value   Cost   Value 
Revenue source:                    
Water  $4,402   $4,516   $3,942   $4,052 
College & University   2,706    2,876    2,975    3,103 
Sales Tax   2,256    2,373    2,630    2,663 
Lease   2,299    2,403    2,040    2,100 
Port, Airport & Marina   1,302    1,374    -    - 
Electric & Power   729    753    679    691 
Other sources   2,175    2,261    2,941    3,012 
Total Revenue Bonds  $15,869   $16,556   $15,207   $15,621 

 

Low-Income Housing Tax Credit (“LIHTC”) Fund Investments

 

The Company has the ability to invest in limited partnerships which own housing projects that qualify for federal and/or California state tax credits, by mandating a specified percentage of low-income tenants for each project. The tax credits flow through to investors, augmenting any returns that might be derived from an increase in property values. Because rent levels are lower than standard market rents and the projects are generally highly leveraged, each project also typically generates tax-deductible operating losses that are allocated to the limited partners.

 

The Company invested in seven LIHTC fund limited partnerships from 2001 through 2007, and in the second quarter of 2016 we committed $3 million to another such fund. Our investments to date have all been in California-focused funds which help the Company meet its obligations under the Community Reinvestment Act. We utilize the equity method of accounting for our LIHTC fund investments. Under the equity method, our balance sheet initially reflects an asset that represents the total cash expected to be invested over the life of the partnership. Any commitments or contingent commitments for future investment are reflected as a liability. The income statement treatment under the equity method reflects tax credits received by the Company “below the line” within the income tax provision, while fund operating results are included “above the line” in non-interest income. As noted above, operating results are typically losses that are netted against non-interest income.

 

As of June 30, 2016 our total LIHTC investment balance was $7.4 million, which includes $2.4 million in remaining commitments for additional capital contributions to the limited partnerships. There were $343,000 in tax credits derived from our LIHTC investments which were recognized during the six months ended June 30, 2016, and a pass-through operating loss of $519,000 associated with those investments was included in pre-tax income for the same time period. Our LIHTC investments are evaluated annually for potential impairment, and we have concluded that the carrying value of the investments is stated fairly and is not impaired.

 

 18 

 

 

Note 11 – Credit Quality and Nonperforming Assets

 

Credit Quality Classifications

 

The Company monitors the credit quality of loans on a continuous basis using the regulatory and accounting classifications of pass, special mention, substandard and impaired to characterize the associated credit risk. Balances classified as “loss” are immediately charged off. The Company conforms to the following definitions for risk classifications utilized:

 

·Pass: Larger non-homogeneous loans not meeting the risk rating definitions below, and smaller homogeneous loans that are not assessed on an individual basis.

 

·Special mention: Loans which have potential issues that deserve the close attention of Management. If left uncorrected, those potential weaknesses could eventually diminish the prospects for full repayment of principal and interest according to the contractual terms of the loan agreement, or could result in deterioration of the Company’s credit position at some future date.

 

·Substandard: Loans that have at least one clear and well-defined weakness that could jeopardize the ultimate recoverability of all principal and interest, such as a borrower displaying a highly leveraged position, unfavorable financial operating results and/or trends, uncertain repayment sources or a deteriorated financial condition.

 

·Impaired: A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. Impaired loans include all nonperforming loans, restructured troubled debt (“TDRs”), and certain other loans that are still being maintained on accrual status. A TDR may be nonperforming or performing, depending on its accrual status and the demonstrated ability of the borrower to comply with restructured terms (see “Troubled Debt Restructurings” section below for additional information on TDRs).

 

 19 

 

Credit quality classifications for the Company’s loan balances were as follows, as of the dates indicated:

 

Credit Quality Classifications

(dollars in thousands, unaudited)

 

   June 30, 2016 
   Pass   Special
Mention
   Substandard   Impaired   Total 
Real Estate:                         
1-4 family residential construction  $16,939   $-   $-   $-   $16,939 
Other construction/land   32,065    5,356    -    969    38,390 
1-4 family - closed end   127,637    774    935    6,112    135,458 
Equity lines   34,599    1,700    748    3,777    40,824 
Multi-family residential   31,017    -    -    417    31,434 
Commercial real estate - owner occupied   201,868    3,984    3,045    3,302    212,199 
Commercial real estate - non-owner occupied   164,128    5,378    167    5,103    174,776 
Farmland   129,053    560    2,484    43    132,140 
Total real estate   737,306    17,752    7,379    19,723    782,160 
                          
Agricultural   49,775    159    24    65    50,023 
Commercial and industrial   86,649    22,143    661    2,293    111,746 
Mortgage Warehouse   197,715    -    -    -    197,715 
Consumer loans   11,485    148    23    1,962    13,618 
Total gross loans and leases  $1,082,930   $40,202   $8,087   $24,043   $1,155,262 

 

   December 31, 2015 
   Pass   Special
Mention
   Substandard   Impaired   Total 
Real Estate:                         
1-4 family residential construction  $13,784   $1,157   $-   $-   $14,941 
Other construction/land   35,901    135    -    1,323    37,359 
1-4 family - closed end   127,972    2,498    387    6,499    137,356 
Equity lines   39,966    199    957    3,111    44,233 
Multi-family residential   26,178    -    -    1,044    27,222 
Commercial real estate - owner occupied   196,211    12,075    7,322    3,100    218,708 
Commercial real estate - non-owner occupied   155,223    4,505    170    5,209    165,107 
Farmland   130,285    1,563    724    610    133,182 
Total real estate   725,520    22,132    9,560    20,896    778,108 
                          
Agricultural   46,197    40    -    -    46,237 
Commercial and industrial   108,931    933    755    2,588    113,207 
Mortgage Warehouse   180,355    -    -    -    180,355 
Consumer loans   12,718    178    16    2,037    14,949 
Total gross loans and leases  $1,073,721   $23,283   $10,331   $25,521   $1,132,856 

 

 20 

 

Past Due and Nonperforming Assets

 

Nonperforming assets are comprised of loans for which the Company is no longer accruing interest, and foreclosed assets, including mobile homes and OREO. OREO consists of real properties acquired by foreclosure or similar means, which the Company is offering or will offer for sale. Nonperforming loans and leases result when reasonable doubt surfaces with regard to the ability of the Company to collect all principal and interest. At that point, we stop accruing interest on the loan or lease in question and reverse any previously-recognized interest to the extent that it is uncollected or associated with interest-reserve loans. Any asset for which principal or interest has been in default for 90 days or more is also placed on non-accrual status even if interest is still being received, unless the asset is both well secured and in the process of collection. An aging of the Company’s loan balances is presented in the following tables, by number of days past due as of the indicated dates:

 

Loan Portfolio Aging

(dollars in thousands, unaudited)

 

   June 30, 2016 
   30-59 Days Past
Due
   60-89 Days Past
Due
   90 Days Or More
Past Due(1)
   Total Past Due   Current   Total Financing
Receivables
   Non-Accrual
Loans(2)
 
Real Estate:                                   
1-4 family residential construction  $-   $-   $-   $-   $16,939   $16,939   $- 
Other construction/land   -    -    -    -    38,390    38,390    257 
1-4 family - closed end   75    -    -    75    135,383    135,458    446 
Equity lines   298    78    197    573    40,251    40,824    1,630 
Multi-family residential   -    -    -    -    31,434    31,434    - 
Commercial real estate - owner occupied   198    -    358    556    211,643    212,199    2,276 
Commercial real estate - non-owner occupied   -    -    -    -    174,776    174,776    235 
Farmland   -    43    -    43    132,097    132,140    43 
Total real estate   571    121    555    1,247    780,913    782,160    4,887 
                                    
Agricultural   -    -    64    64    49,959    50,023    65 
Commercial and industrial   32    1    112    145    111,601    111,746    529 
Mortgage warehouse lines   -    -    -    -    197,715    197,715    - 
Consumer   99    13    -    112    13,506    13,618    463 
Total gross loans and leases  $702   $135   $731   $1,568   $1,153,694   $1,155,262   $5,944 

 

(1) As of June 30, 2016 there were no loans over 90 days past due and still acrruing.

(2) Included in total financing receivables

 

   December 31, 2015 
   30-59 Days Past
Due
   60-89 Days Past
Due
   90 Days Or More
Past Due(1)
   Total Past Due   Current   Total Financing
Receivables
   Non-Accrual
Loans(2)
 
Real Estate:                                   
1-4 family residential construction  $612   $545   $-   $1,157   $13,784   $14,941   $- 
Other construction/land   18    129    63    210    37,149    37,359    457 
1-4 family - closed end   1,065    917    566    2,548    134,808    137,356    2,298 
Equity lines   199    247    484    930    43,303    44,233    1,770 
Multi-family residential   -    630    -    630    26,592    27,222    630 
Commercial real estate - owner occupied   232    129    260    621    218,087    218,708    2,325 
Commercial real estate - non-owner occupied   -    -    -    -    165,107    165,107    262 
Farmland   -    -    -    -    133,182    133,182    610 
Total real estate   2,126    2,597    1,373    6,096    772,012    778,108    8,352 
                                    
Agricultural   -    -    -    -    46,237    46,237    - 
Commercial and industrial   127    153    86    366    112,841    113,207    710 
Mortgage warehouse lines   -    -    -    -    180,355    180,355    - 
Consumer   98    9    45    152    14,797    14,949    572 
Total gross loans and leases  $2,351   $2,759   $1,504   $6,614   $1,126,242   $1,132,856   $9,634 

 

(1) As of December 31, 2015 there were no loans over 90 days past due and still accruing.

(2) Included in total financing receivables

 

 21 

 

Troubled Debt Restructurings

 

A loan that is modified for a borrower who is experiencing financial difficulty is classified as a troubled debt restructuring if the modification constitutes a concession. At June 30, 2016, the Company had a total of $17.2 million in TDRs, including $2.5 million in TDRs that were on non-accrual status. Generally, a non-accrual loan that has been modified as a TDR remains on non-accrual status for a period of at least six months to demonstrate the borrower’s ability to comply with the modified terms. However, performance prior to the modification, or significant events that coincide with the modification, could result in a loan’s return to accrual status after a shorter performance period or even at the time of loan modification. Regardless of the period of time that has elapsed, if the borrower’s ability to meet the revised payment schedule is uncertain then the loan will be kept on non-accrual status. Moreover, a TDR is generally considered to be in default when it appears that the customer will not likely be able to repay all principal and interest pursuant to restructured terms.

 

The Company may agree to different types of concessions when modifying a loan or lease. The tables below summarize TDRs which were modified during the noted periods, by type of concession:

 

Troubled Debt Restructurings, by Type of Loan Modification

(dollars in thousands, unaudited)

 

   Three months ended June 30, 2016 
   Rate
Modification
   Term
Modification
   Interest Only
Modification
   Rate & Term
Modification
   Total 
                     
Real estate:                         
Other construction/land  $-   $-   $-   $-   $- 
1-4 family - closed-end   -    -    547    259    806 
Equity lines   -    1,051    -    -    1,051 
Multi-family residential   -    -    -    132    132 
Commercial real estate - owner occupied   -    -    -    -    - 
Total real estate loans   -    1,051    547    391    1,989 
Commercial and industrial   -    -    -    -    - 
Consumer loans   -    -    -    10    10 
   $-   $1,051   $547   $401   $1,999 

 

   Three months ended June 30, 2015 
   Rate
Modification
   Term
Modification
   Interest Only
Modification
   Rate & Term
Modification
   Total 
                     
Real Estate:                         
Other construction/land  $-   $-   $-   $-   $- 
1-4 family - closed-end   -    -    -    226    226 
Equity lines   -    146    -    290    436 
Multi-family residential   -    418    -    -    418 
Commercial real estate - owner occupied   -    -    -    -    - 
Total real estate loans   -    564    -    516    1,080 
Commercial and industrial   -    25    -    -    25 
Consumer loans   -    -    -    -    - 
   $-   $589   $-   $516   $1,105 

 

 22 

 

Troubled Debt Restructurings, by Type of Loan Modification
(dollars in thousands, unaudited)  

 

   Six months ended June 30, 2016 
   Rate
Modification
   Term
Modification
   Interest Only
Modification
   Rate & Term
Modification
   Total 
                     
Real estate:                         
Other construction/land  $-   $17   $-   $-   $17 
1-4 family - closed-end   -    -    547    259    806 
Equity lines   -    1,280    -    -    1,280 
Multi-family residential   -    -         132    132 
Commercial real estate - owner occupied   -    -    -    266    266 
Total real estate loans   -    1,297    547    657    2,501 
Commercial and industrial   -    -    -    -    - 
Consumer loans   -    20    -    60    80 
   $-   $1,317   $547   $717   $2,581 

 

   Six months ended June 30, 2015 
   Rate
Modification
   Term
Modification
   Interest Only
Modification
   Rate & Term
Modification
   Total 
                     
Real Estate:                         
Other construction/land  $-   $111   $-   $-   $111 
1-4 family - closed-end   -    -    -    226    226 
Equity lines   -    351    -    290    641 
Multi-family residential   -    418    -    -    418 
Commercial real estate - owner occupied   -    -    -    -    - 
Total real estate loans   -    880    -    516    1,396 
Commercial and industrial   -    68    -    -    68 
Consumer loans   -    -    -    -    - 
   $-   $948   $-   $516   $1,464 

 

 23 

 

The following tables present, by class, additional details related to loans classified as TDRs during the referenced periods, including the recorded investment in the loan both before and after modification and balances that were modified during the period:

 

Troubled Debt Restructurings

(dollars in thousands, unaudited)

 

   Three months ended June 30, 2016 
       Pre-
Modification
   Post-
Modification
         
   Number of
Loans
   Outstanding
Recorded
Investment
   Outstanding
Recorded
Investment
   Reserve
Difference(¹)
   Reserve 
Real Estate:                         
Other Construction/Land   0   $-   $-   $-   $- 
1-4 family - closed-end   5    806    806    75    139 
Equity Lines   8    1,051    1,051    1    22 
Multi-family residential   1    132    132    -    7 
Commercial RE- owner occupied   0    -    -    -    - 
Total Real Estate Loans        1,989    1,989    76    168 
                          
Commercial and Industrial   0    -    -    -    - 
Consumer loans   1    10    10    -    1 
        $1,999   $1,999   $76   $169 

 

(1) This represents the change in the ALLL reserve for these credits measured as the difference between the specific post-modification impairment reserve and the pre-modification reserve calculated under our general allowance for loan loss methodology.

 

   Three months ended June 30, 2015 
       Pre-
Modification
   Post-
Modification
         
   Number of
Loans
   Outstanding
Recorded
Investment
   Outstanding
Recorded
Investment
   Reserve
Difference(¹)
   Reserve 
Real Estate:                         
Other Construction/Land   0   $-   $-   $-   $- 
1-4 family - closed-end   2    226    226    6    7 
Equity Lines   5    436    436    142    157 
Multi-family residential   1    418    418    -    1 
Commercial RE- owner occupied   0    -    -    -    - 
Total Real Estate Loans        1,080    1,080    148    165 
                          
Commercial and Industrial   1    25    25    -    11 
Consumer loans   0    -    -    -    - 
        $1,105   $1,105   $148   $176 

 

(1) This represents the change in the ALLL reserve for these credits measured as the difference between the specific post-modification impairment reserve and the pre-modification reserve calculated under our general allowance for loan loss methodology.

 

 24 

 

   Six months ended June 30, 2016 
       Pre-
Modification
   Post-
Modification
         
   Number of
Loans
   Outstanding
Recorded
Investment
   Outstanding
Recorded
Investment
   Reserve
Difference(¹)
   Reserve 
Real Estate:                         
Other Construction/Land   1   $17   $17   $-   $2 
1-4 family - closed-end   5    806    806    75    139 
Equity Lines   10    1,280    1,280    -    30 
Multi-family residential   1    132    132    -    7 
Commercial RE- owner occupied   1    266    266    -    4 
Total Real Estate Loans        2,501    2,501    75    182 
                          
Commercial and Industrial   0    -    -    -    - 
Consumer loans   3    80    80    -    6 
        $2,581   $2,581   $75   $188 

 

(1) This represents the change in the ALLL reserve for these credits measured as the difference between the specific post-modification impairment reserve and the pre-modification reserve calculated under our general allowance for loan loss methodology.

 

   Six months ended June 30, 2015 
       Pre-
Modification
   Post-
Modification
         
   Number of
Loans
   Outstanding
Recorded
Investment
   Outstanding
Recorded
Investment
   Reserve
Difference(¹)
   Reserve 
Real Estate:                         
Other Construction/Land   2   $111   $111   $4   $2 
1-4 family - closed-end   2    226    226    6    7 
Equity Lines   7    641    641    142    218 
Multi-family residential   1    418    418    -    1 
Commercial RE- owner occupied   0    -    -    -    - 
Total Real Estate Loans        1,396    1,396    152    228 
                          
Commercial and Industrial   3    68    68    (19)   23 
Consumer loans   0    -    -    -    - 
        $1,464   $1,464   $133   $251 

 

(1) This represents the change in the ALLL reserve for these credits measured as the difference between the specific post-modification impairment reserve and the pre-modification reserve calculated under our general allowance for loan loss methodology.

 

The company had no finance receivables modified as TDRs within the previous twelve months that defaulted or were charged off during the three month or six month periods ended June 30, 2016 and 2015 respectively.

 

Purchased Credit Impaired Loans

 

The Company may acquire loans which show evidence of credit deterioration since origination. These purchased credit impaired (“PCI”) loans are recorded at the amount paid, since there is no carryover of the seller’s allowance for loan losses. Potential losses on PCI loans subsequent to acquisition are recognized by an increase in the allowance for loan losses. PCI loans are accounted for individually or are aggregated into pools of loans based on common risk characteristics. The Company estimates the amount and timing of expected cash flows, and expected cash receipts in excess of the amount paid for the loan(s) are recorded as interest income over the remaining life of the loan or pool of loans (accretable yield). The excess of contractual principal and interest over expected cash flows is not recorded (nonaccretable difference). Expected cash flows are periodically re-evaluated throughout the life of the loan or pool of loans. If the present value of the expected cash flows is determined at any time to be less than the carrying amount, a reserve is recorded. If the present value of the expected cash flows is greater than the carrying amount, it is recognized as part of future interest income.

 

 25 

 

Our acquisition of Santa Clara Valley Bank in the fourth quarter of 2014 included a portfolio of loans, some of which have shown evidence of credit deterioration since origination and for which it was probable at acquisition that all contractually required payments would not be collected. The carrying amount and unpaid principal balance of those PCI loans was as follows, as of the dates indicated (dollars in thousands):

 

Purchased Credit Impaired Loans:

(dollars in thousands, unaudited)

 

   June 30, 2016 
   Unpaid Principal Balance   Carrying Value 
         
Real estate secured  $1,124   $171 
Commercial and industrial   19    - 
Consumer   -    - 
Total purchased credit impaired loans  $1,143   $171 

 

   December 31, 2015 
   Unpaid Principal Balance   Carrying Value 
         
Real estate secured  $1,158   $188 
Commercial and industrial   38    - 
Consumer   1    - 
Total purchased credit impaired loans  $1,197   $188 

 

An allowance for loan losses totaling $117,000 was allocated for PCI loans as of June 30, 2016, as compared to $121,000 at December 31, 2015. We also recorded approximately $70,000 in discount accretion on PCI loans during the six months ended June 30, 2016.

 

Note 12 – Allowance for Loan and Lease Losses

 

The Company’s allowance for loan and lease losses, a contra-asset, is established through a provision for loan and lease losses. The allowance is maintained at a level that is considered adequate to absorb probable losses on certain specifically identified loans, as well as probable incurred losses inherent in the remaining loan portfolio. Specifically identifiable and quantifiable losses are immediately charged off against the allowance; recoveries are generally recorded only when cash payments are received subsequent to the charge off. We employ a systematic methodology, consistent with FASB guidelines on loss contingencies and impaired loans, for determining the appropriate level of the allowance for loan and lease losses and adjusting it at least quarterly. Pursuant to that methodology, impaired loans and leases are individually analyzed and a criticized asset action plan is completed specifying the financial status of the borrower and, if applicable, the characteristics and condition of collateral and any associated liquidation plan. A specific loss allowance is created for each impaired loan, if necessary.

 

 26 

 

The following tables disclose the unpaid principal balance, recorded investment, average recorded investment, and interest income recognized for impaired loans on our books as of the dates indicated. Balances are shown by loan type, and are further broken out by those that required an allowance and those that did not, with the associated allowance disclosed for those that required such. Included in the valuation allowance for impaired loans shown in the tables below are specific reserves allocated to TDRs, totaling $1.619 million at June 30, 2016 and $1.486 million at December 31, 2015.

 

Impaired Loans

(dollars in thousands, unaudited)

   June 30, 2016 
   Unpaid
Principal
Balance(1)
   Recorded
Investment(2)
   Related
Allowance
   Average
Recorded
Investment
   Interest Income
Recognized(3)
 
With an allowance recorded                         
Real Estate:                         
Other construction/land  $558   $521   $42   $581   $15 
1-4 Family - closed-end   7,989    6,042    325    8,118    233 
Equity lines   3,337    3,284    164    3,426    32 
Multi-family residential   417    417    7    421    27 
Commercial real estate- owner occupied   1,375    1,352    537    1,431    125 
Commercial real estate- non-owner occupied   5,096    4,940    1,359    5,185    173 
Farmland   -    -    -    -    - 
Total real estate   18,772    16,556    2,434    19,162    605 
Agriculture   -    -    -    -    - 
Commercial and industrial   2,254    2,254    591    2,435    48 
Consumer loans   1,931    1,927    302    2,084    57 
    22,957    20,737    3,327    23,681    710 
With no related allowance recorded                         
Real estate:                         
Other construction/land   567    448    -    599    12 
1-4 family - closed-end   321    70    -    667    1 
Equity lines   522    493    -    537    - 
Multi-family residential   -    -    -    -    - 
Commercial real estate- owner occupied   2,036    1,950    -    2,340    - 
Commercial real estate- non-owner occupied   163    163    -    194    - 
Farmland   43    43    -    50    - 
Total real estate   3,652    3,167    -    4,387    13 
Agriculture   65    65    -    66    - 
Commercial and industrial   107    39    -    292    1 
Consumer loans   196    35    -    304    - 
    4,020    3,306    -    5,049    14 
Total  $26,977   $24,043   $3,327   $28,730   $724 

 

(1)Contractual principal balance due from customer.

(2)Principal balance on Company's books, less any direct charge offs, including interest applied to principal and unaccreted discount or premium.

(3)Interest income is recognized on performing balances on a regular accrual basis.

 

 27 

 

   December 31, 2015 
   Unpaid
Principal
Balance(1)
   Recorded
Investment(2)
   Related
Allowance
   Average
Recorded
Investment
   Interest Income
Recognized(3)
 
With an allowance recorded                         
Real estate:                         
Other construction/land  $919   $769   $83   $967   $42 
1-4 family - closed-end   8,085    6,137    290    6,157    255 
Equity lines   2,339    2,269    214    2,374    17 
Multifamily residential   414    414    1    417    5 
Commercial real estate- owner occupied   1,272    1,272    589    1,405    139 
Commercial real estate- non-owner occupied   3,350    3,350    1,712    3,390    164 
Farmland   -    -    -    -    - 
Total real estate   16,379    14,211    2,889    14,710    622 
Commercial and industrial   2,572    2,559    683    2,857    97 
Consumer loans   2,023    2,022    343    2,298    112 
    20,974    18,792    3,915    19,865    831 
With no related allowance recorded                         
Real estate:                         
Other construction/land   554    554    -    566    34 
1-4 family - closed-end   585    362    -    602    - 
Equity lines   843    842    -    840    - 
Multifamily residential   630    630    -    633    - 
Commercial real estate- owner occupied   1,828    1,828    -    2,251    - 
Commercial real estate- non-owner occupied   2,006    1,859    -    2,102    118 
Farmland   610    610    -    629    - 
Total real estate   7,056    6,685    -    7,623    152 
Commercial and industrial   45    29    -    77    - 
Consumer loans   160    15    -    256    - 
    7,261    6,729    -    7,956    152 
Total  $28,235   $25,521   $3,915   $27,821   $983 

 

(1)Contractual principal balance due from customer.

(2)Principal balance on Company's books, less any direct charge offs, including interest applied to principal and unaccreted discount or premium.

(3)Interest income is recognized on performing balances on a regular accrual basis.

 

The specific loss allowance for an impaired loan generally represents the difference between the book value of the loan and either the fair value of underlying collateral less estimated disposition costs, or the loan’s net present value as determined by a discounted cash flow analysis. The discounted cash flow approach is typically used to measure impairment on loans for which it is anticipated that repayment will be provided from cash flows other than those generated solely by the disposition or operation of underlying collateral. However, historical loss rates may be used to determine a specific loss allowance if they indicate a higher potential reserve need than the discounted cash flow analysis. Any change in impairment attributable to the passage of time is accommodated by adjusting the loss allowance accordingly.

 

 28 

 

For loans where repayment is expected to be provided by the disposition or operation of the underlying collateral, impairment is measured using the fair value of the collateral. If the collateral value, net of the expected costs of disposition where applicable, is less than the loan balance, then a specific loss reserve is established for the shortfall in collateral coverage. If the discounted collateral value is greater than or equal to the loan balance, no specific loss reserve is required. At the time a collateral-dependent loan is designated as nonperforming, a new appraisal is ordered and typically received within 30 to 60 days if a recent appraisal is not already available. We generally use external appraisals to determine the fair value of the underlying collateral for nonperforming real estate loans, although the Company’s licensed staff appraisers may update older appraisals based on current market conditions and property value trends. Until an updated appraisal is received, the Company uses the existing appraisal to determine the amount of the specific loss allowance that may be required. The specific loss allowance is adjusted, as necessary, once a new appraisal is received. Updated appraisals are generally ordered at least annually for collateral-dependent loans that remain impaired. Current appraisals were available or in process for 96% of the Company’s impaired real estate loan balances at June 30, 2016. Furthermore, the Company analyzes collateral-dependent loans on at least a quarterly basis, to determine if any portion of the recorded investment in such loans can be identified as uncollectible and would therefore constitute a confirmed loss. All amounts deemed to be uncollectible are promptly charged off against the Company’s allowance for loan and lease losses, with the loan then carried at the fair value of the collateral, as appraised, less estimated costs of disposition if applicable. Once a charge-off or write-down is recorded, it will not be restored to the loan balance on the Company’s accounting books.

 

Our methodology also provides for the establishment of a “general” allowance for probable incurred losses inherent in loans and leases that are not impaired. Unimpaired loan balances are segregated by credit quality, and are then evaluated in pools with common characteristics. At the present time, pools are based on the same segmentation of loan types presented in our regulatory filings. While this methodology utilizes historical loss data and other measurable information, the classification of loans and the establishment of the allowance for loan and lease losses are both to some extent based on Management’s judgment and experience. Our methodology incorporates a variety of risk considerations, both quantitative and qualitative, in establishing an allowance for loan and lease losses that Management believes is appropriate at each reporting date. Quantitative information includes our historical loss experience, delinquency and charge-off trends, and current collateral values. Qualitative factors include the general economic environment in our markets and, in particular, the condition of the agricultural industry and other key industries. Lending policies and procedures (including underwriting standards), the experience and abilities of lending staff, the quality of loan review, credit concentrations (by geography, loan type, industry and collateral type), the rate of loan portfolio growth, and changes in legal or regulatory requirements are additional factors that are considered. The total general reserve established for probable incurred losses on unimpaired loans was $6.715 million at June 30, 2016.

 

There were no material changes to the methodology used to determine our allowance for loan and lease losses during the three months ended June 30, 2016. We continue to consider the estimated impact of drought conditions and lower oil prices on credit quality, in evaluating the adequacy of our allowance. As we add new products and expand our geographic coverage, and as the economic environment changes, we expect to enhance our methodology to keep pace with the size and complexity of the loan and lease portfolio and respond to pressures created by external forces. We engage outside firms on a regular basis to assess our methodology and perform independent credit reviews of our loan and lease portfolio. In addition, the Company’s external auditors, the FDIC, and the California DBO review the allowance for loan and lease losses as an integral part of their audit and examination processes. Management believes that the current methodology is appropriate given our size and level of complexity.

 

 29 

 

The tables that follow detail the activity in the allowance for loan and lease losses for the periods noted:

 

Allowance for Credit Losses and Recorded Investment in Financing Receivables

(dollars in thousands, unaudited)

 

   Three months ended June 30, 2016 
   Real Estate   Agricultural
Production
   Commercial and
Industrial
   Consumer   Unallocated   Total 
                         
Allowance for credit losses:                              
Beginning Balance  $4,713   $567   $2,503   $1,119   $1,128   $10,030 
Charge-offs   (71)   -    (66)   (494)   -    (631)
Recoveries   336    2    39    266    -    643 
Provision   (496)   (153)   1,265    353    (969)   - 
                               
Ending Balance  $4,482   $416   $3,741   $1,244   $159   $10,042 

 

   Six months ended June 30, 2016 
   Real Estate   Agricultural
Production
   Commercial and
Industrial
   Consumer   Unallocated   Total 
                         
Allowance for credit losses:                              
Beginning Balance  $4,783   $722   $2,533   $1,263   $1,122   $10,423 
Charge-offs   (280)   -    (174)   (985)   -    (1,439)
Recoveries   397    4    160    497    -    1,058 
Provision   (418)   (310)   1,222    469    (963)   - 
                               
Ending Balance  $4,482   $416   $3,741   $1,244   $159   $10,042 
                               
Reserves:                              
Specific  $2,434   $-   $591   $302   $-   $3,327 
General   2,048    416    3,150    942    159    6,715 
                               
Ending Balance  $4,482   $416   $3,741   $1,244   $159   $10,042 
                               
Loans evaluated for impairment:                              
Individually  $19,723   $65   $2,293   $1,962   $-   $24,043 
Collectively   762,437    49,958    307,168    11,656    -    1,131,219 
                               
Ending Balance  $782,160   $50,023   $309,461   $13,618   $-   $1,155,262 

 

   Year ended December 31, 2015 
   Real Estate   Agricultural
Production
   Commercial and
Industrial
   Consumer   Unallocated   Total 
                         
Allowance for credit losses:                              
Beginning Balance  $6,243   $986   $1,944   $1,765   $310   $11,248 
Charge-offs   (706)   -    (395)   (1,739)   -    (2,840)
Recoveries   751    81    225    958    -    2,015 
Provision   (1,505)   (345)   759    279    812    - 
                               
Ending Balance  $4,783   $722   $2,533   $1,263   $1,122   $10,423 
                               
Reserves:                              
Specific  $2,889   $-   $683   $343   $-   $3,915 
General   1,894    722    1,850    920    1,122    6,508 
                               
Ending Balance  $4,783   $722   $2,533   $1,263   $1,122   $10,423 
                               
Loans evaluated for impairment:                              
Individually  $20,896   $-   $2,588   $2,037   $-   $25,521 
Collectively   757,212    46,237    290,974    12,912    -    1,107,335 
                               
Ending Balance  $778,108   $46,237   $293,562   $14,949   $-   $1,132,856 

 

 30 

 

Note 13 – Recent Developments

 

On May 13, 2016, the Company acquired certain loans and deposits from Citizens Business Bank concurrent with the closure of that bank’s Porterville branch. At the time of acquisition there were a total of $10 million in deposits and $1 million in loans, which we consolidated into our Porterville Main office.

 

In January 2016 the Company entered into a definitive agreement to acquire Coast Bancorp, the holding company for Coast National Bank. The transaction closed on July 8, 2016, subsequent to the receipt of requisite regulatory and shareholder approvals, and immediately following that acquisition, Coast National Bank was merged with and into Bank of the Sierra. Coast National Bank was a community bank with branch offices in San Luis Obispo, Paso Robles, and Arroyo Grande, and a loan production office in Atascadero, California. Shortly after transaction closing, the Atascadero location was converted into a full-service branch office. The transaction also involved Sierra Bancorp’s acquisition of 100% of the voting equity of Coast Bancorp Statutory Trust II and Sierra Bancorp’s assumption of $7 million in associated junior subordinated debentures. The aggregate consideration tendered by the Company in its acquisition of Coast Bancorp consisted of 599,242 shares of Sierra Bancorp common stock and $3.3 million in cash, and one-time acquisition costs are expected to add roughly $3.2 million to the Company’s pre-tax non-interest expense in 2016. At the merger date the Coast acquisition contributed approximately $95 million to the Company’s outstanding loan balances, $31 million to investments, and $129 million to total deposits. In accordance with GAAP, assets and liabilities will be reflected on the Company’s books at their estimated fair values and there was no carryover of the allowance for loan losses that had previously been recorded by Coast. The Company will also record a deferred income tax asset, goodwill, and a core deposit intangible in conjunction with the acquisition, although those amounts have not yet been definitively determined. Goodwill represents the excess of consideration transferred over the fair values of the identifiable net assets acquired. The core deposit intangible will be amortized on a straight line basis over eight years, commencing at the date of acquisition. Goodwill and core deposit intangibles are not deductible for income tax purposes.

 

 31 

 

PART I - FINANCIAL INFORMATION

 

ITEM 2

 

MANAGEMENT’S DISCUSSION AND

ANALYSIS OF FINANCIAL CONDITION

AND RESULTS OF OPERATIONS

 

FORWARD-LOOKING STATEMENTS

 

This Form 10-Q includes forward-looking statements that involve inherent risks and uncertainties. Words such as “expects”, “anticipates”, “believes”, “projects”, and “estimates” or variations of such words and similar expressions are intended to identify forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions that are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed, forecast in, or implied by such forward-looking statements.

 

A variety of factors could have a material adverse impact on the Company’s financial condition or results of operations, and should be considered when evaluating the Company’s potential future financial performance. They include, but are not limited to, the potential impact of extreme drought conditions on businesses and consumers located in the Company’s market areas; unfavorable economic conditions in the Company’s service areas; risks associated with fluctuations in interest rates; liquidity risks; increases in nonperforming assets and credit losses that could occur, particularly in times of weak economic conditions or rising interest rates; reductions in the market value of available-for-sale securities that could result if interest rates increase substantially or an issuer has real or perceived financial difficulties; the Company’s ability to attract and retain skilled employees; the Company’s ability to successfully deploy new technology; the success of acquisitions or branch expansion; and risks associated with the multitude of current and prospective laws and regulations to which the Company is and will be subject. Risk factors that could cause actual results to differ materially from results that might be implied by forward-looking statements include the risk factors disclosed in the Company’s Form 10-K for the fiscal year ended December 31, 2015.

 

CRITICAL ACCOUNTING POLICIES

 

The Company’s financial statements are prepared in accordance with accounting principles generally accepted in the United States. The financial information and disclosures contained within those statements are significantly impacted by Management’s estimates and judgments, which are based on historical experience and incorporate various assumptions that are believed to be reasonable under current circumstances. Actual results may differ from those estimates under divergent conditions.

 

Critical accounting policies are those that involve the most complex and subjective decisions and assessments, and have the greatest potential impact on the Company’s stated results of operations. In Management’s opinion, the Company’s critical accounting policies deal with the following areas: the establishment of the allowance for loan and lease losses, as explained in detail in Note 12 to the consolidated financial statements and in the “Provision for Loan and Lease Losses” and “Allowance for Loan and Lease Losses” sections of this discussion and analysis; the valuation of impaired loans and foreclosed assets, as discussed in Note 11 to the consolidated financial statements; income taxes and deferred tax assets and liabilities, especially with regard to the ability of the Company to recover deferred tax assets as discussed in the “Provision for Income Taxes” and “Other Assets” sections of this discussion and analysis; and goodwill and other intangible assets, which are evaluated annually for impairment and for which we have determined that no impairment exists, as discussed in the “Other Assets” section of this discussion and analysis. Critical accounting areas are evaluated on an ongoing basis to ensure that the Company’s financial statements incorporate our most recent expectations with regard to those areas.

 

 32 

 

OVERVIEW OF THE RESULTS OF OPERATIONS

AND FINANCIAL CONDITION

 

results of operations Summary

 

Second quarter 2016 compared to Second quarter 2015

 

Net income for the quarter ended June 30, 2016 was $4.086 million, representing a decline of $471,000, or 10%, relative to net income of $4.557 million for the quarter ended June 30, 2015. Basic and diluted earnings per share for the second quarter of 2016 were both $0.31, compared to $0.34 basic earnings per share and $0.33 diluted earnings per share for the second quarter of 2015. The Company’s annualized return on average equity was 8.38% and annualized return on average assets was 0.93% for the quarter ended June 30, 2016, compared to 9.67% and 1.07%, respectively, for the quarter ended June 30, 2015. The primary drivers behind the variance in net income are as follows:

 

·Net interest income was up by $177,000, or 1%, due to growth in average interest-earning assets totaling $45 million, or 3%, that was partially offset by the impact of a five basis point drop in our net interest margin. There was no loan loss provision recorded in either quarter.

 

·Total non-interest income fell by $80,000, or 2%, due to a drop in investment gains and the impact of the special dividend received on our Federal Home Loan Bank (“FHLB”) stock in the second quarter of 2015, partially offset by fees earned from increased activity on commercial deposit accounts, higher overdraft income, and rising debit card interchange income.

 

·Total non-interest expense reflects an increase of $964,000, or 8%, due to non-recurring acquisition costs totaling $128,000 that were recognized in the second quarter of 2016 as well as increases in personnel costs, occupancy expense, debit card processing costs, and foreclosed assets expense (including write-downs). Lower telecommunications expense helped offset some of the expense increases.

 

·The Company’s provision for income taxes was 33% of pre-tax income in the second quarter of 2016 relative to 34% in the second quarter of 2015. The tax provisioning rate fell in 2016 due to lower pre-tax income and a slightly higher level of tax credits.

 

First Half 2016 compared to First Half 2015

 

Net income for the first half of 2016 was $8.122 million, representing a decline of $173,000, or 2%, relative to net income of $8.295 million for the first half of 2015. Basic and diluted earnings per share for the first half of 2016 were both $0.61, compared to $0.61 basic earnings per share and $0.60 diluted earnings per share for the first half of 2015. The Company’s annualized return on average equity was 8.39% and annualized return on average assets was 0.93% for the six months ended June 30, 2016, compared to a return on equity of 8.87% and return on assets of 1.00% for the six months ended June 30, 2015. The primary drivers behind the variance in year-to-date net income are as follows:

 

·Net interest income increased $774,000, or 3%, due to the positive impact of a $75 million increase in average interest-earning assets that was partially offset by an 11 basis point drop in our net interest margin. There was no loan loss provision recorded in either period.

 

·Total non-interest income was up $207,000, or 2%, due to fees earned from increased activity on commercial deposit accounts, higher overdraft income, and higher debit card interchange income, offset in part by lower gains from the sale of investments and lower dividends on our FHLB stock.

 

·Total non-interest expense increased by $983,000, or 4%, due to non-recurring acquisition costs of $342,000 in the first half of 2016 relative to $101,000 in the first half of 2015, in addition to relatively large increases in personnel costs, occupancy expense, debit card processing costs, foreclosed assets expense, and legal/accounting costs. The expense increases were offset in part by a non-recurring reversal of certain director retirement plan accruals in the first quarter of 2016, and lower telecommunications costs.

 

·The Company’s provision for income taxes was 33% of pre-tax income for the first half of 2016, relative to 32% for the first half of 2015. Since pre-tax income was almost the same in the first half of 2016 as in the first half of 2015, the higher tax provisioning for the first half comparison is the result of a lower level of available tax credits and lower non-taxable BOLI income.

 

 33 

 

Financial Condition Summary

 

June 30, 2016 relative to December 31, 2015

 

The Company’s assets totaled $1.843 billion at June 30, 2016, relative to total assets of $1.797 billion at December 31, 2015. Total liabilities were $1.645 billion at June 30, 2016 compared to $1.606 billion at the end of 2015, and shareholders’ equity totaled $198 million at June 30, 2016 compared to $190 million at December 31, 2015. The following is a summary of key balance sheet changes during the first six months of 2016:

 

·The Company’s assets were up $47 million, or 3%, due primarily to higher loan, investment, and cash balances.

 

·Gross loans increased by $22 million, or 2%, as the result of a $17 million increase in mortgage warehouse loans stemming from higher line utilization, as well as increases in non-farm real estate loans and agricultural production loans. The remaining growth in net loan balances was facilitated by loan participations purchased during the period.

 

·Total nonperforming assets, including non-accrual loans and foreclosed assets, were reduced by $4 million, or 31%, during the first six months of 2016, including the return to accrual status of our single largest remaining nonperforming loan. The Company’s ratio of nonperforming assets to total loans plus foreclosed assets was 0.76% at June 30, 2016, compared to 1.13% at December 31, 2015.

 

·Deposit balances reflect net growth of $21 million, or 1%, due to growth in core non-maturity deposits that was partially offset by an $8 million reduction in time deposits.

 

·Junior subordinated debentures remain the same, but other borrowings were increased by $21 million during the first half of 2016 to support growth in loans and investments.

 

·Total capital reflects an increase of $8 million, or 4%, for the first six months of the year due to the rising level of retained earnings, the impact of stock options exercised, and an increase in accumulated other comprehensive income. There were no shares repurchased during the first half of 2016. Due to the growth in capital relative to a very minor increase in risk-weighted assets, our consolidated total risk-based capital ratio increased to 17.51% at June 30, 2016 from 17.01% at year-end 2015.

 

EARNINGS PERFORMANCE

 

The Company earns income from two primary sources. The first is net interest income, which is interest income generated by earning assets less interest expense on deposits and other borrowed money. The second is non-interest income, which primarily consists of customer service charges and fees but also comes from non-customer sources such as bank-owned life insurance. The majority of the Company’s non-interest expense is comprised of operating costs that facilitate offering a full range of banking services to our customers.

 

Net interest income AND NET INTEREST MARGIN

 

Net interest income increased by $177,000, or 1%, for the second quarter of 2016 relative to the second quarter of 2015, and by $774,000, or 3%, for the first half of 2016 compared to the first half of 2015. The level of net interest income we recognize in any given period depends on a combination of factors including the average volume and yield for interest-earning assets, the average volume and cost of interest-bearing liabilities, and the mix of products which comprise the Company’s earning assets, deposits, and other interest-bearing liabilities. Net interest income is also impacted by the reversal of interest for loans placed on non-accrual status during the reporting period, and the recovery of interest on loans that had been on non-accrual and were paid off, sold or returned to accrual status.

 

The following tables show average balances for significant balance sheet categories and the amount of interest income or interest expense associated with each category for the noted periods. The tables also display the calculated yields on each major component of the Company’s investment and loan portfolios, the average rates paid on each key segment of the Company’s interest-bearing liabilities, and our net interest margin for the noted periods.

 

 34 

 

Average Balances and Rates  For the three months ended   For the three months ended 
(dollars in thousands, except per share data)  Ended June 30, 2016   Ended June 30, 2015 
Assets  Average
Balance (1)
   Income/
Expense
   Average
Rate/Yield (2)(3)
   Average
Balance (1)
   Income/
Expense
   Average
Rate/Yield (2)(3)
 
Investments:                              
Federal funds sold/due from time  $4,830   $5    0.41%  $8,193   $6    0.29%
Taxable   417,881    2,052    1.94%   405,951    2,003    1.95%
Non-taxable   104,548    730    4.25%   99,092    732    4.50%
Equity   1,177    -    0.00%   2,005    48    9.47%
Total investments   528,436    2,787    2.38%   515,241    2,789    2.44%
                               
Loans and Leases:(4)                              
Real estate   776,172    9,703    5.03%   713,966    9,253    5.20%
Agricultural   47,184    520    4.43%   29,447    306    4.17%
Commercial   105,750    1,251    4.76%   107,245    1,218    4.56%
Consumer   14,152    270    7.67%   17,387    409    9.44%
Mortgage warehouse lines   137,937    1,353    3.95%   181,001    1,639    3.63%
Direct financing leases   1,592    21    5.31%   1,950    26    5.35%
Other   1,951    29    5.98%   1,962    29    5.93%
Total loans and leases   1,084,738    13,147    4.87%   1,052,958    12,880    4.91%
Total interest earning assets (5)   1,613,174    15,934    4.07%   1,568,199    15,669    4.11%
Other earning assets   7,853              7,397           
Non-earning assets   137,025              138,752           
Total assets  $1,758,052             $1,714,348           
                               
Liabilities and shareholders' equity                              
Interest bearing deposits:                              
Demand deposits  $146,686   $110    0.30%  $127,176   $94    0.30%
NOW   314,556    78    0.10%   293,263    87    0.12%
Savings accounts   202,011    56    0.11%   186,265    52    0.11%
Money market   97,971    16    0.07%   114,540    21    0.07%
CDAR's   2,074    -    0.00%   11,285    2    0.07%
Certificates of deposit<$100,000   73,913    57    0.31%   77,749    62    0.32%
Certificates of deposit>$100,000   222,547    191    0.35%   220,273    131    0.24%
Total interest bearing deposits   1,059,758    508    0.19%   1,030,551    449    0.17%
Borrowed Funds:                              
Federal funds purchased   1,399    3    0.86%   5    -    - 
Repurchase agreements   9,989    10    0.40%   8,544    9    0.42%
Short term borrowings   17,273    18    0.42%   27,689    12    0.17%
Long term borrowings   -    -    0.00%   2,000    3    0.60%
TRUPS   30,928    200    2.60%   30,928    178    2.31%
Total borrowed funds   59,589    231    1.56%   69,166    202    1.17%
Total interest bearing liabilities   1,119,347    739    0.27%   1,099,717    651    0.24%
Demand deposits - non-interest bearing   427,581              412,874           
Other liabilities   14,918              12,745           
Shareholders' equity   196,206              189,012           
Total liabilities and shareholders' equity  $1,758,052             $1,714,348           
                               
Interest income/interest earning assets             4.07%             4.11%
Interest expense/interest earning assets             0.18%             0.17%
Net interest income and margin(6)       $15,195    3.89%       $15,018    3.94%

 

(1) Average balances are obtained from the best available daily or monthly data and are net of deferred fees and related direct costs.

(2) Yields and net interest margin have been computed on a tax equivalent basis utilizing a 35% effective tax rate.

(3) Annualized

(4) Loan costs have been included in the calculation of interest income. Loan costs were approximately $109 thousand and $10 thousand for the quarters ended June 30, 2016 and 2015. Loans are gross of the allowance for possible loan losses.

(5) Non-accrual loans have been included in total loans for purposes of total earning assets.

(6) Net interest margin represents net interest income as a percentage of average interest-earning assets.

 

 35 

 

Average Balances and Rates  For the six months ended   For the six months ended 
(dollars in thousands, except per share data)  June 30, 2016   June 30, 2015 
Assets  Average
Balance (1)
   Income/
Expense
   Average
Rate/Yield (2)(3)
   Average
Balance (1)
   Income/
Expense
   Average
Rate/Yield (2)(3)
 
Investments:                              
Federal funds sold/Due from time  $12,389   $32    0.51%  $13,758   $18    0.26%
Taxable   413,424    4,199    2.01%   407,912    4,251    2.07%
Non-taxable   103,261    1,460    4.30%   98,648    1,457    4.52%
Equity   1,215    36    5.86%   2,118    93    8.73%
Total Investments   530,289    5,727    2.43%   522,436    5,819    2.51%
                               
Loans and Leases:(4)                              
Real Estate   775,248    19,492    5.06%   702,957    18,439    5.29%
Agricultural   46,504    1,022    4.42%   28,093    569    4.08%
Commercial   106,293    2,477    4.69%   108,015    2,539    4.74%
Consumer   14,486    672    9.33%   17,834    843    9.53%
Mortgage Warehouse Lines   127,502    2,471    3.90%   144,954    2,694    3.75%
Direct Financing Leases   1,605    42    5.26%   1,984    53    5.39%
Other   1,989    64    6.47%   2,149    63    5.91%
Total Loans and Leases   1,073,627    26,240    4.91%   1,005,986    25,200    5.05%
Total Interest Earning Assets (5)   1,603,916    31,967    4.11%   1,528,422    31,019    4.20%
Other Earning Assets   7,700              7,220           
Non-Earning Assets   135,831              138,073           
Total Assets  $1,747,447             $1,673,715           
                               
Liabilities and Shareholders' Equity                              
Interest Bearing Deposits:                              
Demand Deposits  $136,829   $205    0.30%  $117,956   $173    0.30%
NOW   311,085    166    0.11%   288,337    172    0.12%
Savings Accounts   199,463    109    0.11%   180,505    100    0.11%
Money Market   98,600    32    0.07%   114,733    42    0.07%
CDAR's   7,072    2    0.06%   11,284    4    0.07%
Certificates of Deposit<$100,000   74,246    114    0.31%   78,589    127    0.33%
Certificates of Deposit>$100,000   220,985    371    0.34%   213,093    264    0.25%
Brokered Deposits   -    -    0.00%   1,298    11    1.71%
Total Interest Bearing Deposits   1,048,280    999    0.19%   1,005,795    893    0.18%
Borrowed Funds:                              
Federal Funds Purchased   700    3    0.86%   3    -    - 
Repurchase Agreements   9,463    19    0.40%   7,688    15    0.39%
Short Term Borrowings   16,640    34    0.41%   18,008    16    0.18%
Long Term Borrowings   615    -    0.00%   3,017    7    0.47%
TRUPS   30,928    402    2.61%   30,928    352    2.30%
Total Borrowed Funds   58,346    458    1.58%   59,644    390    1.32%
Total Interest Bearing Liabilities   1,106,626    1,457    0.26%   1,065,439    1,283    0.24%
Demand deposits- non interest bearing   431,572              404,431           
Other liabilities   14,659              15,261           
Shareholders' equity   194,590              188,584           
Total liabilities and shareholders' equity  $1,747,447             $1,673,715           
                               
Interest Income/Interest Earning Assets             4.11%             4.20%
Interest Expense/Interest Earning Assets             0.19%             0.17%
Net Interest Income and Margin(6)       $30,510    3.92%       $29,736    4.03%

 

(1) Average balances are obtained from the best available daily or monthly data and are net of deferred fees and related direct costs.

(2) Yields and net interest margin have been computed on a tax equivalent basis utilizing a 35% effective tax rate.

(3) Annualized

(4) Loan costs have been included in the calculation of interest income. Loan costs were approximately $164 thousand and $360 thousand for the six months ended June 30, 2016 and 2015. Loans are gross of the allowance for possible loan losses.

(5) Non-accrual loans have been included in total loans for purposes of total earning assets.

(6) Net interest margin represents net interest income as a percentage of average interest-earning assets.

 

 36 

 

The Volume and Rate Variances table below sets forth the dollar difference for the comparative periods in interest earned or paid for each major category of interest-earning assets and interest-bearing liabilities, and the amount of such change attributable to fluctuations in average balances (volume) or differences in average interest rates. Volume variances are equal to the increase or decrease in average balances multiplied by prior period rates, and rate variances are equal to the change in rates multiplied by prior period average balances. Variances attributable to both rate and volume changes, calculated by multiplying the change in rates by the change in average balances, have been allocated to the rate variance.

 

Volume & Rate Variances  Three months ended June 30,   Six months ended June 30, 
(dollars in thousands)  2016 over 2015   2016 over 2015 
   Increase(decrease) due to   Increase(decrease) due to 
Assets:  Volume   Rate   Net   Volume   Rate   Net 
Investments:                              
Federal funds sold / Due from time  $(2)  $1   $(1)  $(2)  $16   $14 
Taxable   59    (10)   49    57    (109)   (52)
Non-taxable(1)   40    (42)   (2)   68    (65)   3 
Equity   (20)   (28)   (48)   (40)   (17)   (57)
Total Investments   77    (79)   (2)   83    (175)   (92)
Loans and Leases:                              
Real Estate   806    (356)   450    1,896    (843)   1,053 
Agricultural   184    30    214    373    80    453 
Commercial   (17)   50    33    (40)   (22)   (62)
Consumer   (76)   (63)   (139)   (158)   (13)   (171)
Mortgage Warehouse   (390)   104    (286)   (324)   101    (223)
Direct Financing Leases   (5)   -    (5)   (10)   (1)   (11)
Other   -    -    -    (5)   6    1 
Total Loans and Leases   502    (235)   267    1,732    (692)   1,040 
Total Interest Earning Assets  $579   $(314)  $265   $1,815   $(867)  $948 
Liabilities                              
Interest Bearing Deposits:                              
Demand Deposits  $14   $2   $16   $28   $4   $32 
NOW   6    (15)   (9)   14    (20)   (6)
Savings Accounts   4    -    4    11    (2)   9 
Money Market   (3)   (2)   (5)   (6)   (4)   (10)
CDAR's   (2)   -    (2)   (1)   (1)   (2)
Certificates of Deposit < $100,000   (3)   (2)   (5)   (7)   (6)   (13)
Certificates of Deposit > $100,000   1    59    60    10    97    107 
Brokered Deposits   -    -    -    (11)   -    (11)
Total Interest Bearing Deposits   17    42    59    38    68    106 
Borrowed Funds:                              
Federal Funds Purchased   -    3    3    -    3    3 
Repurchase Agreements   2    (1)   1    3    1    4 
Short Term Borrowings   (5)   11    6    (1)   19    18 
Long Term Borrowings   (3)   -    (3)   (6)   (1)   (7)
TRUPS   -    22    22    -    50    50 
Total Borrowed Funds   (6)   35    29    (4)   72    68 
Total Interest Bearing Liabilities   11    77    88    34    140    174 
Net Interest Margin/Income  $568   $(391)  $177   $1,781   $(1,007)  $774 

 

(1) Yields on tax exempt income have not been computed on a tax equivalent basis.

 

 37 

 

The volume variance calculated for the second quarter of 2016 relative to the second quarter of 2015 was a favorable $568,000, due to an increase of $45 million, or 3%, in the average balance of interest-earning assets resulting from growth in loans and investments. The rate variance for the second quarter comparison was an unfavorable $391,000, due to a drop of four basis points in our yield on earning assets relative to a three basis point increase in the cost of interest-bearing liabilities. Our yield on interest-earning assets is down because investment yields have dropped due to the reinvestment of portfolio cash flows in a historically low interest rate environment, and the weighted average yield on loans is lower due to the impact of continued competition on loan rates and a small drop in non-recurring interest income. Nonrecurring interest income, primarily in the form of interest recovered on non-accrual loans net of interest reversed on loans placed on non-accrual status, totaled $22,000 in the second quarter of 2016 relative to $45,000 in the second quarter of 2015. Our weighted average cost of interest-bearing liabilities increased slightly because of higher interest rates paid on trust-preferred securities (“TRUPS”) and large time deposits. The unfavorable rate variance was exacerbated by the allocation of the variance attributable to both rate and volume changes (as per the calculations noted above), and also by the volume differential between our interest-earning assets and interest-bearing liabilities. That differential averaged $468 million for the second quarter of 2015, the base period for the rate variance calculation, thus the decrease in our earning asset yield was applied to a much higher balance than rate changes for interest-bearing liabilities and had a greater impact on net interest income.

 

The Company’s net interest margin, which is tax-equivalent net interest income as a percentage of average interest-earning assets, was affected by the same factors discussed above relative to rate and volume variances. Our net interest margin was 3.89% in the second quarter of 2016, a drop of five basis points relative to the second quarter of 2015. The principal development affecting our net interest margin in the second quarter of 2016 was lower yields on loans and investments.

 

For net interest income in the first half of 2016 relative to the first half of 2015, a favorable variance of $1.781 million attributable to volume changes was partially offset by an unfavorable rate variance of $1.007 million. The volume variance for the half was due primarily to an increase of $75 million, or 5%, in average interest-earning assets, which was enhanced by strong growth in the average balance of loans relative to lower-yielding investments. As with the quarter, the negative rate variance for the half is the result of declining yields on earning assets relative to a slightly higher weighted average rate on interest-bearing liabilities. In addition to competitive pressures on loan rates, the year-to-date rate variance was impacted by nonrecurring interest income, with totaled only $65,000 for the first six months of 2016 but added $411,000 to interest income for the first six months of 2015. The unfavorable rate variance was also intensified by the allocation of variances attributable to both rate and volume changes, and the fact that the decrease in our yield on earning assets was applied to a much higher balance than the rate change for interest-bearing liabilities. The Company’s net interest margin for the first half of 2016 was 3.92%, a drop of 11 basis points relative to our net interest margin for the first half of 2015.

 

Provision for loan and LEASE losses

 

Credit risk is inherent in the business of making loans. The Company sets aside an allowance for loan and lease losses, a contra-asset account, through periodic charges to earnings which are reflected in the income statement as the provision for loan and lease losses. A loan loss provision has not been necessary thus far in 2016, nor was a provision recorded in 2015.

 

The Company’s loan loss provision has been sufficient to maintain our allowance for loan and lease losses at a level that, in Management’s judgment, is adequate to absorb probable loan losses related to specifically-identified impaired loans as well as probable incurred losses in the remaining loan portfolio. Specifically identifiable and quantifiable loan losses are immediately charged off against the allowance. The Company had $12,000 in net recoveries on charged off balances in the second quarter of 2016 relative to $169,000 in net loans charged off in the second quarter of 2015, and net charge-offs were $381,000 in the first six months of 2016 relative to $699,000 in the first six months of 2015. A loan loss provision has not been recorded in recent periods due to the following factors: we had net recoveries on charged off loans in the second quarter of 2016, which went back into the allowance for loan and lease losses; loan charge-offs for several preceding periods were primarily recorded against pre-established reserves, which alleviated what otherwise might have been a need for reserve replenishment; growth in our performing loan portfolio has been concentrated in loan types with low historical loss rates, thus having a positive impact on general reserves for performing loans; and, new loans booked since the great recession have been underwritten using tighter credit standards than was the case for many legacy loans. Partially offsetting these favorable factors in the second quarter of 2016 was the transfer of certain energy-related credits into a higher-risk credit quality classification, with elevated historical loss rates applied in calculating loss reserves.

 

 38 

 

 

The Company’s policies for monitoring the adequacy of the allowance and determining loan amounts that should be charged off, and other detailed information with regard to changes in the allowance, are discussed in note 12 to the consolidated financial statements and below under “Allowance for Loan and Lease Losses.” The process utilized to establish an appropriate allowance for loan and lease losses can result in a high degree of variability in the Company’s loan loss provision, and consequently in our net earnings.

 

NON-INTEREST INCOME and NON-INTEREST expense

 

The following table provides details on the Company’s non-interest income and non-interest expense for the three-month and six-month periods ended June 30, 2016 and 2015:

 

Non Interest Income/Expense

(dollars in thousands, unaudited)

   For the three months ended June 30,   For the six months ended June 30, 
   2016   % of Total   2015   % of Total   2016   % of Total   2015   % of Total 
NON-INTEREST INCOME:                                        
Service charges on deposit accounts  $2,478    54.18%  $2,278    48.95%  $4,848    54.66%  $4,269    49.29%
Other service charges, commissions & fees   1,783    38.98%   1,750    37.60%   3,593    40.52%   3,472    40.09%
Gains on securities   146    3.19%   307    6.60%   122    1.38%   323    3.73%
Bank owned life insurance   229    5.01%   231    4.96%   439    4.95%   588    6.79%
Other   (62)   -1.36%   88    1.89%   (134)   -1.51%   9    0.10%
Total non-interest income  $4,574    100.00%  $4,654    100.00%  $8,868    100.00%  $8,661    100.00%
As a % of average interest-earning assets (1)        1.14%        1.19%        1.12%        1.14%
                                         
OTHER OPERATING EXPENSE:                                        
Salaries and employee benefits  $6,624    48.28%  $6,125    48.04%  $13,490    49.61%  $13,020    49.67%
Occupancy costs                                        
Furniture & equipment   596    4.35%   504    3.95%   1,163    4.28%   1,011    3.86%
Premises   1,270    9.26%   1,162    9.11%   2,454    9.02%   2,315    8.83%
Advertising and marketing costs   695    5.07%   681    5.34%   1,184    4.35%   1,245    4.75%
Data processing costs   861    6.28%   858    6.73%   1,627    5.98%   1,697    6.47%
Deposit services costs   861    6.28%   759    5.95%   1,722    6.33%   1,549    5.91%
Loan services costs                                        
Loan processing   192    1.40%   227    1.78%   359    1.32%   484    1.85%
Foreclosed assets   319    2.33%   92    0.72%   450    1.65%   237    0.90%
Other operating costs                                        
Telephone & data communications   366    2.67%   510    4.00%   749    2.75%   979    3.74%
Postage & mail   226    1.65%   252    1.98%   453    1.67%   452    1.72%
Other   230    1.68%   212    1.66%   386    1.42%   379    1.45%
Professional services costs                                        
Legal & accounting   425    3.10%   376    2.95%   850    3.13%   709    2.70%
Acquistion Cost   128    0.93%   (11)   -0.09%   342    1.26%   101    0.39%
Other professional service   487    3.55%   508    3.98%   868    3.19%   943    3.60%
Stationery & supply costs   231    1.68%   325    2.55%   650    2.39%   661    2.52%
Sundry & tellers   204    1.49%   171    1.35%   447    1.65%   429    1.64%
Total non-interest expense  $13,715    100.00%  $12,751    100.00%  $27,194    100.00%  $26,211    100.00%
As a % of average interest-earning assets (1)        3.42%        3.26%        3.43%        3.46%
Efficiency Ratio (2)   68.10%        64.13%        67.51%        66.91%     

 

(1) Annualized

(2) Tax Equivalent

 

Total non-interest income declined by $80,000, or 2%, for the quarterly comparison, but increased by $207,000, or 2%, for the comparative year-to-date periods. Both the second quarter and the first six months of 2016 saw a higher level of customer activity that generated additional fee income, but experienced lower gains on the sale of investment securities and a drop in dividends on our FHLB stock. For the year-to-date comparison, income on bank-owned life insurance (“BOLI”) also declined. Total non-interest income was an annualized 1.14% of average interest-earning assets in the second quarter of 2016 relative to 1.19% in the second quarter of 2015, and was 1.12% for the first six months of 2016 relative to 1.14% for the first six months of 2015. The ratio fell slightly due primarily to a higher level of average interest-earning assets.

 

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Service charge income on deposits increased by $200,000, or 9%, for the quarterly comparison and by $579,000, or 14%, for the year-to-date comparison, due primarily to fees earned from increased activity on commercial accounts and higher overdraft income. Other service charges, commissions, and fees also increased by $33,000, or 2%, for the second quarter and $121,000, or 3%, for the first six months, largely as a result of higher debit card interchange income. Gains realized on the sale of investment securities totaled $146,000 in the second quarter of 2016 relative to $307,000 in the second quarter of 2015, for a decline of $161,000, or 52%. For the first half, investment gains totaled $122,000 in 2016 compared to $323,000 in 2015, representing a drop of $201,000, or 62%.

 

BOLI income was down only $2,000 in the second quarter of 2016 relative to the second quarter of 2015, but dropped by $149,000, or 25%, for the year-to-date comparison due to lower crediting rates, a drop in net cash surrender values, and fluctuations in income on BOLI associated with deferred compensation plans. The Company owns and derives income from two basic types of BOLI: “general account” and “separate account.” At June 30, 2016 the Company had $38.7 million invested in single-premium general account BOLI, down from $39.3 million at the end of 2015 due to certain policies that were paid out in the first quarter of 2016. General account BOLI generates income that is used to fund expenses associated with executive salary continuation plans, director retirement plans and other employee benefits. Interest credit rates on general account BOLI do not change frequently and the income is typically fairly consistent, but rate reductions have led to slightly lower income in recent periods. In addition to general account BOLI, at June 30, 2016 the Company had $5.1 million invested in separate account BOLI, which produces income that helps offset expense accruals for deferred compensation accounts the Company maintains for certain directors and senior officers. Those accounts have returns pegged to participant-directed investment allocations that can include equity, bond, or real estate indices, and are thus subject to gains or losses which often contribute to significant fluctuations in income (and associated expense accruals). There was a gain on separate account BOLI totaling $36,000 in the second quarter of 2016 relative to a loss of $15,000 in the second quarter of 2015, for an absolute difference of $51,000. For the first half, there was an $11,000 gain in 2016 compared to a gain of $109,000 in 2015, resulting in a decline in income of $98,000. As noted, gains and losses on separate account BOLI are related to expense accruals or reversals associated with participant gains and losses on deferred compensation balances, thus their impact on taxable income tends to be minimal.

 

The “Other” category under non-interest income reflects reductions of $150,000 for the quarter and $143,000 for the year-to-date period. This line item includes gains and losses on the disposition of assets other than OREO, rent on bank-owned property other than OREO, dividends on restricted stock, and other miscellaneous income. Pass-through expenses associated with our investments in low-income housing tax credit funds are netted against this category. The largest unfavorable impact on 2016 over 2015 variances in “Other” non-interest income was the result of a $245,000 special dividend received on our FHLB stock in the second quarter of 2015 and not repeated in 2016, although that reduction was partially offset by higher debit card interchange income and dividends received on other non-listed stock in 2016.

 

Total non-interest expense increased by $964,000, or 8%, in the second quarter of 2016 relative to the second quarter of 2015, and by $983,000, or 4%, for the first half of 2016 compared to the first half of 2015. As detailed below there were several significant fluctuations within non-interest expense, including items of a non-recurring nature. Because of the increase in total non-interest expense, it rose to an annualized 3.42% of average interest-earning assets in the second quarter of 2016 relative to 3.26% in the second quarter of 2015. However, due to a sizeable increase in the denominator, non-interest expense fell slightly as an annualized percentage of average interest earning assets for the six-month comparison despite the 4% increase in total expense.

 

The largest component of non-interest expense, salaries and employee benefits, increased by $499,000, or 8%, for the second quarter of 2016 over the second quarter of 2015, and by $470,000, or 4%, for the first six months of 2016 compared to the first six months of 2015. The higher level of salaries and benefits was the result of salary increases in the normal course of business, higher staffing levels as vacant positions were filled, and temporary salaries and overtime costs incurred in preparation for our recent acquisition (totaling roughly $80,000 for the quarter and $120,000 for the year-to-date period), partially offset by lower group health insurance costs. For the second quarter comparison, personnel expense was also adversely impacted by a $98,000 drop in the level of deferred salaries directly related to successful loan originations (which increases current period expense), as well as an increase of $55,000 in deferred compensation expense accruals associated with the aforementioned increase in separate account BOLI income. The first half comparison was impacted by a $50,000 increase in equity incentive compensation costs due to stock options issued to Company officers during the first quarter of 2016. Total salaries and benefits increased slightly as a percentage of total non-interest expense for the comparative quarters, but dropped slightly for the year-to-date comparison.

 

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Occupancy expense was up $200,000, or 12%, for the quarter, and $291,000, or 9%, for the first six months due primarily to rent escalations in the normal course of business, office renovations in recent periods, and our loan production off