UNITED STATES SECURITIES AND EXCHANGE COMMISSION

 

Washington, D.C. 20549

 

FORM 10-Q

 

(Mark One)

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

 

For the quarterly period ended     June 30, 2017   

OR

 

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

 

For the transition period from ______________________________ to ________________________________

 

 

ENB Financial Corp

(Exact name of registrant as specified in its charter)

 

Pennsylvania	000-53297	51-0661129
(State or Other Jurisdiction of Incorporation)	(Commission File Number)	(IRS Employer Identification No)
31 E. Main St., Ephrata, PA	17522-0457
(Address of principal executive offices)	(Zip Code)

 

Registrant’s telephone number, including area code            (717) 733-4181           

 

Former name, former address, and former fiscal year, if changed since last report      Not Applicable     

 

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

Yes x            No o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Date File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files.)

Yes x           No o

 

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

	Large accelerated filer	o	Accelerated filer	o
	Non-accelerated filer	o	(Do not check if a smaller reporting company)
			Smaller reporting company	x
			Emerging growth company	o

 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.

 

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

Yes o           No x

 

APPLICABLE ONLY TO CORPORATE ISSUERS:

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date. As of August 5, 2017, the registrant had 2,848,203 shares of $0.20 (par) Common Stock outstanding.

 

ENB FINANCIAL CORP

INDEX TO FORM 10-Q

June 30, 2017

 

 

Part I – FINANCIAL INFORMATION
	Item 1.	Financial Statements
		Consolidated Balance Sheets at June 30, 2017 and 2016 and December 31, 2016 (Unaudited)	3
		Consolidated Statements of Income for the Three and Six Months Ended June 30, 2017 and 2016 (Unaudited)	4
		Consolidated Statements of Comprehensive Income for the Three and Six Months Ended June 30, 2017 and 2016 (Unaudited)	5
		Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2017 and 2016 (Unaudited)	6
		Notes to the Unaudited Consolidated Interim Financial Statements	7-31
	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	32-68
	Item 3.	Quantitative and Qualitative Disclosures about Market Risk	69-74
	Item 4.	Controls and Procedures	75
Part II – OTHER INFORMATION			76
	Item 1.	Legal Proceedings	76
	Item 1A.	Risk Factors	76
	Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	76
	Item 3.	Defaults Upon Senior Securities	76
	Item 4.	Mine Safety Disclosures	76
	Item 5.	Other Information	76
	Item 6.	Exhibits	77
SIGNATURE PAGE			78
EXHIBIT INDEX			79

 

 

Part I - Financial Information

Item 1. Financial Statements

 

CONSOLIDATED BALANCE SHEETS (UNAUDITED)

(DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)

 

		June 30,				December 31,				June 30,
		2017				2016				2016
		$				$				$
ASSETS
Cash and due from banks			17,759				19,852				14,400
Interest-bearing deposits in other banks			38,704				25,780				36,416
Total cash and cash equivalents			56,463				45,632				50,816
Securities available for sale (at fair value)			316,788				308,111				287,210
Loans held for sale			3,819				2,552				2,577
Loans (net of unearned income)			578,111				571,567				547,990
Less: Allowance for loan losses			7,802				7,562				7,247
Net loans			570,309				564,005				540,743
Premises and equipment			23,904				22,568				22,225
Regulatory stock			5,487				5,372				4,715
Bank owned life insurance			25,007				24,687				24,266
Other assets			10,023				11,326				7,355
Total assets			1,011,800				984,253				939,907
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Deposits:
Noninterest-bearing			295,900				280,543				254,158
Interest-bearing			545,068				536,948				515,701
Total deposits			840,968				817,491				769,859
Short-term borrowings			4,157				8,329				7,243
Long-term debt			64,904				61,257				61,537
Other liabilities			1,604				2,237				1,757
Total liabilities			911,633				889,314				840,396
Stockholders' equity:
Common stock, par value $0.20;
Shares:  Authorized 12,000,000
Issued 2,869,557 and Outstanding  2,853,203
(Issued 2,869,557 and Outstanding 2,850,382 as of 12/31/16)
(Issued 2,869,557 and Outstanding  2,855,183 as of 6/30/16)			574				574				574
Capital surplus			4,414				4,403				4,398
Retained earnings			97,578				95,475				93,046
Accumulated other comprehensive income (loss) net of tax			(1,852	)			(4,885	)			1,956
Less: Treasury stock cost on 16,354 shares (19,175 shares
as of 12/31/16 and 14,374 shares as of 6/30/16)			(547	)			(628	)			(463	)
Total stockholders' equity			100,167				94,939				99,511
Total liabilities and stockholders' equity			1,011,800				984,253				939,907

 

See Notes to the Unaudited Consolidated Interim Financial Statements  

CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)

(DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)

                   

		Three Months ended June 30,								Six Months ended June 30,
		2017				2016				2017				2016
		$				$				$				$
Interest and dividend income:
Interest and fees on loans			5,984				5,556				11,816				10,995
Interest on securities available for sale
Taxable			933				(326	)			1,820				148
Tax-exempt			1,110				956				2,231				1,822
Interest on deposits at other banks			92				30				146				56
Dividend income			94				78				182				159
Total interest and dividend income			8,213				6,294				16,195				13,180
Interest expense:
Interest on deposits			482				513				949				1,059
Interest on borrowings			249				244				484				509
Total interest expense			731				757				1,433				1,568
Net interest income			7,482				5,537				14,762				11,612
Provision for loan losses			120				50				210				—
Net interest income after provision for loan losses			7,362				5,487				14,552				11,612
Other income:
Trust and investment services income			426				373				908				760
Service fees			684				577				1,246				1,055
Commissions			584				544				1,131				1,059
Gains on securities transactions, net			107				938				247				1,666
Gains on sale of mortgages			437				397				792				552
Earnings on bank-owned life insurance			171				200				344				394
Other income			103				58				256				252
Total other income			2,512				3,087				4,924				5,738
Operating expenses:
Salaries and employee benefits			4,811				4,040				9,530				8,011
Occupancy			605				515				1,204				1,029
Equipment			297				272				579				535
Advertising & marketing			160				166				396				302
Computer software & data processing			549				454				1,079				874
Shares tax			215				227				430				453
Professional services			495				450				884				828
Other expense			583				588				1,131				1,162
Total operating expenses			7,715				6,712				15,233				13,194
Income before income taxes			2,159				1,862				4,243				4,156
Provision for federal income taxes			287				218				544				600
Net income			1,872				1,644				3,699				3,556
Earnings per share of common stock			0.66				0.58				1.30				1.25
Cash dividends paid per share			0.28				0.27				0.56				0.54
Weighted average shares outstanding			2,850,377				2,851,652				2,850,532				2,850,803

 

See Notes to the Unaudited Consolidated Interim Financial Statements  

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (UNAUDITED)

(DOLLARS IN THOUSANDS)

 

		Three Months ended June 30,								Six Months ended June 30,
		2017				2016				2017				2016
		$				$				$				$
Net income			1,872				1,644				3,699				3,556
Other comprehensive income, net of tax:
Unrealized gains arising during the period			4,208				3,420				4,842				5,012
Income tax effect			(1,430	)			(1,163	)			(1,646	)			(1,704	)
			2,778				2,257				3,196				3,308
Gains recognized in earnings			(107	)			(938	)			(247	)			(1,666	)
Income tax effect			36				319				84				566
			(71	)			(619	)			(163	)			(1,100	)
Other comprehensive income, net of tax			2,707				1,638				3,033				2,208
Comprehensive Income			4,579				3,282				6,732				5,764

 

See Notes to the Unaudited Consolidated Interim Financial Statements  

CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

(DOLLARS IN THOUSANDS)

		Six Months Ended June 30,
		2017				2016
		$				$
Cash flows from operating activities:
Net income			3,699				3,556
Adjustments to reconcile net income to net cash
provided by operating activities:
Net amortization of securities premiums and discounts and loan fees			1,989				4,096
Decrease (increase) in interest receivable			117				(5	)
Decrease in interest payable			(1	)			(47	)
Provision for loan losses			210				—
Gains on securities transactions, net			(247	)			(1,666	)
Gains on sale of mortgages			(792	)			(552	)
Loans originated for sale			(15,755	)			(19,099	)
Proceeds from sales of loans			15,280				18,200
Earnings on bank-owned life insurance			(344	)			(394	)
Depreciation of premises and equipment and amortization of software			808				799
Net increase (decrease) in deferred income tax			(29	)			116
Other assets and other liabilities, net			(1,017	)			(976	)
Net cash provided by operating activities			3,918				4,028
Cash flows from investing activities:
Securities available for sale:
Proceeds from maturities, calls, and repayments			9,704				32,425
Proceeds from sales			40,085				103,504
Purchases			(55,390	)			(132,625	)
Purchase of regulatory bank stock			(1,590	)			(1,135	)
Redemptions of regulatory bank stock			1,475				734
Purchase of bank-owned life insurance			—				(3	)
Net increase in loans			(6,737	)			(27,714	)
Purchases of premises and equipment, net			(2,024	)			(1,235	)
Purchase of computer software			(58	)			(282	)
Net cash used for investing activities			(14,535	)			(26,331	)
Cash flows from financing activities:
Net increase in demand, NOW, and savings accounts			29,905				44,738
Net decrease in time deposits			(6,428	)			(14,941	)
Net decrease in short-term borrowings			(4,172	)			(1,493	)
Proceeds from long-term debt			11,147				11,943
Repayments of long-term debt			(7,500	)			(10,000	)
Dividends paid			(1,596	)			(1,539	)
Proceeds from sale of treasury stock			270				249
Treasury stock purchased			(178	)			(65	)
Net cash provided by financing activities			21,448				28,892
Increase in cash and cash equivalents			10,831				6,589
Cash and cash equivalents at beginning of period			45,632				44,227
Cash and cash equivalents at end of period			56,463				50,816
Supplemental disclosures of cash flow information:
Interest paid			1,434				1,615
Income taxes paid			1,100				975
Supplemental disclosure of non-cash investing and financing activities:
Fair value adjustments for securities available for sale			(4,595	)			(3,346	)

 

See Notes to the Unaudited Consolidated Interim Financial Statements        

 

1.       Basis of Presentation

 

The accompanying unaudited consolidated interim financial statements have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information and to general practices within the banking industry. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all significant adjustments considered necessary for fair presentation have been included. Certain items previously reported have been reclassified to conform to the current period’s reporting format. Such reclassifications did not affect net income or stockholders’ equity.

 

ENB Financial Corp (“the Corporation”) is the bank holding company for its wholly-owned subsidiary Ephrata National Bank (the “Bank”). This Form 10-Q, for the second quarter of 2017, is reporting on the results of operations and financial condition of ENB Financial Corp.

 

Operating results for the three and six months ended June 30, 2017, are not necessarily indicative of the results that may be expected for the year ended December 31, 2017. For further information, refer to the consolidated financial statements and footnotes thereto included in ENB Financial Corp’s Annual Report on Form 10-K for the year ended December 31, 2016.

 

 

2.       Securities Available for Sale

 

The amortized cost, gross unrealized gains and losses, and fair value of securities held at June 30, 2017,

and December 31, 2016, are as follows:        

 

						Gross				Gross
(DOLLARS IN THOUSANDS)		Amortized				Unrealized				Unrealized				Fair
		Cost				Gains				Losses				Value
		$				$				$				$
June 30, 2017
U.S. government agencies			29,113				6				(430	)			28,689
U.S. agency mortgage-backed securities			53,912				50				(626	)			53,336
U.S. agency collateralized mortgage obligations			51,322				218				(427	)			51,113
Corporate bonds			54,453				70				(296	)			54,227
Obligations of states and political subdivisions			125,262				727				(2,140	)			123,849
Total debt securities			314,062				1,071				(3,919	)			311,214
Marketable equity securities			5,532				42				—				5,574
Total securities available for sale			319,594				1,113				(3,919	)			316,788
December 31, 2016
U.S. government agencies			33,124				—				(863	)			32,261
U.S. agency mortgage-backed securities			56,826				22				(979	)			55,869
U.S. agency collateralized mortgage obligations			38,737				41				(842	)			37,936
Corporate bonds			52,928				8				(845	)			52,091
Obligations of states and political subdivisions			128,428				346				(4,344	)			124,430
Total debt securities			310,043				417				(7,873	)			302,587
Marketable equity securities			5,469				55				—				5,524
Total securities available for sale			315,512				472				(7,873	)			308,111

The amortized cost and fair value of debt securities available for sale at June 30, 2017, by contractual maturity, are shown below. Actual maturities may differ from contractual maturities due to certain call or prepayment provisions.

 

CONTRACTUAL MATURITY OF DEBT SECURITIES

(DOLLARS IN THOUSANDS)      

		Amortized
		Cost				Fair Value
		$				$
Due in one year or less			16,297				16,201
Due after one year through five years			111,257				110,731
Due after five years through ten years			62,498				61,752
Due after ten years			124,010				122,530
Total debt securities			314,062				311,214

 

Securities available for sale with a par value of $65,958,000 and $63,726,000 at June 30, 2017, and December 31, 2016, respectively, were pledged or restricted for public funds, borrowings, or other purposes as required by law. The fair value of these pledged securities was $68,448,000 at June 30, 2017, and $65,770,000 at December 31, 2016.

 

Proceeds from active sales of securities available for sale, along with the associated gross realized gains and gross realized losses, are shown below. Realized gains and losses are computed on the basis of specific identification.

 

PROCEEDS FROM SALES OF SECURITIES AVAILABLE FOR SALE

(DOLLARS IN THOUSANDS)

 

		Three Months Ended June 30,								Six Months Ended June 30,
		2017				2016				2017				2016
		$				$				$				$
Proceeds from sales			26,398				55,404				40,085				103,504
Gross realized gains			216				987				388				1,717
Gross realized losses			109				49				141				51

 

Management evaluates all of the Corporation’s securities for other than temporary impairment (OTTI) on a periodic basis. No securities in the portfolio had other-than-temporary impairment recorded in the first six months of 2017 or 2016.

 

Information pertaining to securities with gross unrealized losses at June 30, 2017, and December 31, 2016, aggregated by investment category and length of time that individual securities have been in a continuous loss position follows:

 

TEMPORARY IMPAIRMENTS OF SECURITIES

(DOLLARS IN THOUSANDS)    

		Less than 12 months								More than 12 months								Total
						Gross								Gross								Gross
		Fair				Unrealized				Fair				Unrealized				Fair				Unrealized
		Value				Losses				Value				Losses				Value				Losses
		$				$				$				$				$				$
As of June 30, 2017
U.S. government agencies			26,683				(430	)			—				—				26,683				(430	)
U.S. agency mortgage-backed securities			40,068				(501	)			3,451				(125	)			43,519				(626	)
U.S. agency collateralized mortgage obligations			17,187				(332	)			4,882				(95	)			22,069				(427	)
Corporate bonds			35,985				(291	)			2,010				(5	)			37,995				(296	)
Obligations of states & political subdivisions			67,422				(1,720	)			12,564				(420	)			79,986				(2,140	)
Total debt securities			187,345				(3,274	)			22,907				(645	)			210,252				(3,919	)
Marketable equity securities			—				—				—				—				—				—
Total temporarily impaired securities			187,345				(3,274	)			22,907				(645	)			210,252				(3,919	)
As of December 31, 2016
U.S. government agencies			32,261				(863	)			—				—				32,261				(863	)
U.S. agency mortgage-backed securities			47,418				(856	)			3,989				(123	)			51,407				(979	)
U.S. agency collateralized mortgage obligations			33,206				(842	)			—				—				33,206				(842	)
Corporate bonds			45,335				(830	)			2,002				(15	)			47,337				(845	)
Obligations of states & political subdivisions			101,229				(4,063	)			8,041				(281	)			109,270				(4,344	)
Total debt securities			259,449				(7,454	)			14,032				(419	)			273,481				(7,873	)
Marketable equity securities			—				—				—				—				—				—
Total temporarily impaired securities			259,449				(7,454	)			14,032				(419	)			273,481				(7,873	)

  

In the debt security portfolio there were 153 positions that were carrying unrealized losses as of June 30, 2017. There were no instruments considered to be other-than-temporarily impaired at June 30, 2017.

 

The Corporation evaluates both equity and fixed maturity positions for other-than-temporary impairment at least on a quarterly basis, and more frequently when economic and market concerns warrant such evaluation. U.S. generally accepted accounting principles provide for the bifurcation of OTTI into two categories: (a) the amount of the total OTTI related to a decrease in cash flows expected to be collected from the debt security (the credit loss), which is recognized in earnings, and (b) the amount of total OTTI related to all other factors, which is recognized, net of taxes, as a component of accumulated other comprehensive income.

 

As part of management’s normal monthly securities review, instruments are examined for known or expected calls that would impact the value of the bonds by causing accelerated amortization. If a security was purchased at a high premium, or dollar price above par, the remaining premium has to be amortized on a straight line basis to the known call date. Calls can occur in a majority of the securities the Corporation purchases but they are dependent on the structure of the instrument, and can also be dependent on certain conditions. The Corporation experienced a clean-up call on a Ginnie Mae U.S. agency mortgage-backed security in the fourth quarter of 2016, which required $385,000 of remaining premium to be amortized. Subsequent to this event, all other high coupon and/or high premium U.S. agency mortgage-backed securities and collateralized mortgage obligations were reviewed to determine if there was any other current material exposure to clean-up call provisions. No other securities were identified with impending clean-up calls.

 

On March 15, 2016, management was made aware of a regulatory call provision on a CoBank bond held by the Corporation. CoBank is a sub-U.S. agency and cooperative of the Farm Credit Association (FCA), a U.S. government sponsored enterprise (GSE). The bond is classified as a corporate bond for disclosure purposes. The regulatory call was not anticipated and the high coupon bond was purchased at a high premium. The call required accelerated amortization to the April 15, 2016 call date, resulting in an additional $479,000 of amortization through June 30, 2016. This regulatory call specifically involved the CoBank issue maturing on April 16, 2018.

 

On April 26, 2016, management became aware of an AgriBank bond call. AgriBank is another cooperative of the FCA. The Corporation owned $6.4 million par of the AgriBank issue maturing on July 15, 2019, with a book value of $6.6 million as of June 30, 2016. AgriBank went public with this call, stating they intended to call the bonds on July 15, 2016. As a result of this par call notice, management accelerated the amortization of the remaining premium on the AgriBank bond, beginning in April and running until the call date of July 15, 2016. As of June 30, 2016, $1,040,000 of accelerated amortization was recorded on this bond with remaining accelerated amortization of $162,000 to be recorded in July of 2016. After July 15, 2016, the Corporation no longer held any sub-U.S. Agency debt of FCA or any other U.S. GSE.

 

In both the CoBank and AgriBank matters investors, including the Corporation, have contested the ability of both CoBank and AgriBank to conduct these regulatory calls. Presently, the Corporation is listed on a complaint filed in the Southern District of New York against CoBank by over 30 previous holders of CoBank bonds. The complaint has gone through initial mediation phases and is in the discovery stage now with the matter proceeding toward trial. Management anticipates going through a similar process with AgriBank, however that litigation is taking the form of a class action lawsuit with a plaintiff seeking to represent the class. The Corporation, as a member of the class, is waiting for the court to issue a ruling on AgriBank’s motion to dismiss. In both litigation efforts management is contesting the process that was undertaken to exercise these regulatory calls. Management cannot make any prediction or draw any conclusion as to the outcome of any negotiations and/or litigation in connection with these matters.

 

3.        Loans and Allowance for Loan Losses

 

The following table presents the Corporation’s loan portfolio by category of loans as of June 30, 2017, and December 31, 2016:

 

LOAN PORTFOLIO

(DOLLARS IN THOUSANDS)        

		June 30,				December 31,
		2017				2016
		$				$
Commercial real estate
Commercial mortgages			86,519				86,434
Agriculture mortgages			154,383				163,753
Construction			18,895				24,880
Total commercial real estate			259,797				275,067
Consumer real estate (a)
1-4 family residential mortgages			166,810				150,253
Home equity loans			11,052				10,391
Home equity lines of credit			57,141				53,127
Total consumer real estate			235,003				213,771
Commercial and industrial
Commercial and industrial			42,309				42,471
Tax-free loans			16,764				13,091
Agriculture loans			18,066				21,630
Total commercial and industrial			77,139				77,192
Consumer			5,068				4,537
Gross loans prior to deferred fees			577,007				570,567
Less:
Deferred loan costs, net			1,104				1,000
Allowance for loan losses			(7,802	)			(7,562	)
Total net loans			570,309				564,005

 

(a)	Real estate loans serviced for others, which are not included in the Consolidated Balance Sheets, totaled $80,123,000 and $66,767,000 as of June 30, 2017, and December 31, 2016, respectively.

 

 

The Corporation grades commercial credits differently than consumer credits. The following tables represent all of the Corporation’s commercial credit exposures by internally assigned grades as of June 30, 2017 and December 31, 2016. The grading analysis estimates the capability of the borrower to repay the contractual obligations under the loan agreements as scheduled. The Corporation's internal commercial credit risk grading system is based on experiences with similarly graded loans.

 

The Corporation's internally assigned grades for commercial credits are as follows:

 

·

Pass – loans which are protected by the current net worth and paying capacity of the obligor or by the value of the underlying collateral.

 

·

Special Mention – loans where a potential weakness or risk exists, which could cause a more serious problem if not corrected.

 

·

Substandard – loans that have a well-defined weakness based on objective evidence and characterized by the distinct possibility that the Corporation will sustain some loss if the deficiencies are not corrected.

 

·

Doubtful – loans classified as doubtful have all the weaknesses inherent in a substandard asset.  In addition, these weaknesses make collection or liquidation in full highly questionable and improbable, based on existing circumstances.

 

·

Loss – loans classified as a loss are considered uncollectible, or of such value that continuance as an asset is not warranted.

 

COMMERCIAL CREDIT EXPOSURE

CREDIT RISK PROFILE BY INTERNALLY ASSIGNED GRADE

(DOLLARS IN THOUSANDS)

 

June 30, 2017		Commercial Mortgages				Agriculture Mortgages				Construction				Commercial and Industrial				Tax-free Loans				Agriculture Loans				Total
		$				$				$				$				$				$				$
Grade:
Pass			80,649				143,219				17,895				35,984				16,764				16,884				311,395
Special Mention			377				3,766				—				679				—				79				4,901
Substandard			5,493				7,398				1,000				5,646				—				1,103				20,640
Doubtful			—				—				—				—				—				—				—
Loss			—				—				—				—				—				—				—
Total			86,519				154,383				18,895				42,309				16,764				18,066				336,936

 

December 31, 2016		Commercial Mortgages				Agriculture Mortgages				Construction				Commercial and Industrial				Tax-free Loans				Agriculture Loans				Total
		$				$				$				$				$				$				$
Grade:
Pass			78,367				155,820				23,880				36,887				13,091				20,245				328,290
Special Mention			4,860				5,360				—				1,955				—				653				12,828
Substandard			3,207				2,573				1,000				3,629				—				732				11,141
Doubtful			—				—				—				—				—				—				—
Loss			—				—				—				—				—				—				—
Total			86,434				163,753				24,880				42,471				13,091				21,630				352,259

 

For consumer loans, the Corporation evaluates credit quality based on whether the loan is considered performing or non-performing. Non-performing loans consist of those loans greater than 90 days delinquent and nonaccrual loans. The following tables present the balances of consumer loans by classes of the loan portfolio based on payment performance as of June 30, 2017 and December 31, 2016:

 

CONSUMER CREDIT EXPOSURE

CREDIT RISK PROFILE BY PAYMENT PERFORMANCE

(DOLLARS IN THOUSANDS)    

 

June 30, 2017		1-4 Family Residential Mortgages				Home Equity Loans				Home Equity Lines of Credit				Consumer				Total
Payment performance:		$				$				$				$				$
Performing			166,422				11,052				57,141				5,068				239,683
Non-performing			388				—				—				—				388
Total			166,810				11,052				57,141				5,068				240,071

 

December 31, 2016		1-4 Family Residential Mortgages				Home Equity Loans				Home Equity Lines of Credit				Consumer				Total
Payment performance:		$				$				$				$				$
Performing			149,873				10,388				53,127				4,536				217,924
Non-performing			380				3				—				1				384
Total			150,253				10,391				53,127				4,537				218,308

 

The following tables present an age analysis of the Corporation’s past due loans, segregated by loan portfolio class, as of June 30, 2017 and December 31, 2016:

 

AGING OF LOANS RECEIVABLE

(DOLLARS IN THOUSANDS)  

 

																										Loans
										Greater																Receivable >
		30-59 Days				60-89 Days				than 90				Total Past								Total Loans				90 Days and
June 30, 2017		Past Due				Past Due				Days				Due				Current				Receivable				Accruing
		$				$				$				$				$				$				$
Commercial real estate
Commercial mortgages			392				—				418				810				85,709				86,519				—
Agriculture mortgages			—				—				—				—				154,383				154,383				—
Construction			—				—				—				—				18,895				18,895				—
Consumer real estate
1-4 family residential mortgages			505				279				388				1,172				165,638				166,810				388
Home equity loans			39				5				—				44				11,008				11,052				—
Home equity lines of credit			30				—				—				30				57,111				57,141				—
Commercial and industrial
Commercial and industrial			—				204				96				300				42,009				42,309				21
Tax-free loans			—				—				—				—				16,764				16,764				—
Agriculture loans			—				—				—				—				18,066				18,066				—
Consumer			9				2				—				11				5,057				5,068				—
Total			975				490				902				2,367				574,640				577,007				409

 

 

																										Loans
										Greater																Receivable >
		30-59 Days				60-89 Days				than 90				Total Past								Total Loans				90 Days and
December 31, 2016		Past Due				Past Due				Days				Due				Current				Receivable				Accruing
		$				$				$				$				$				$				$
Commercial real estate
Commercial mortgages			—				419				417				836				85,598				86,434				—
Agriculture mortgages			165				—				—				165				163,588				163,753				—
Construction			—				—				—				—				24,880				24,880				—
Consumer real estate
1-4 family residential mortgages			565				662				380				1,607				148,646				150,253				380
Home equity loans			178				—				3				181				10,210				10,391				3
Home equity lines of credit			—				—				—				—				53,127				53,127				—
Commercial and industrial
Commercial and industrial			266				—				75				341				42,130				42,471				—
Tax-free loans			—				—				—				—				13,091				13,091				—
Agriculture loans			—				—				—				—				21,630				21,630				—
Consumer			16				4				1				21				4,516				4,537				1
Total			1,190				1,085				876				3,151				567,416				570,567				384

 

The following table presents nonaccrual loans by classes of the loan portfolio as of June 30, 2017 and December 31, 2016:

 

NONACCRUAL LOANS BY LOAN CLASS

(DOLLARS IN THOUSANDS)  

 

		June 30,				December 31,
		2017				2016
		$				$
Commercial real estate
Commercial mortgages			578				646
Agriculture mortgages			—				—
Construction			—				—
Consumer real estate
1-4 family residential mortgages			—				—
Home equity loans			—				—
Home equity lines of credit			—				—
Commercial and industrial
Commercial and industrial			75				75
Tax-free loans			—				—
Agriculture loans			—				—
Consumer			—				—
Total			653				721

 

As of June 30, 2017 and December 31, 2016, all of the Corporation’s commercial loans on nonaccrual status were also considered impaired. Information with respect to impaired loans for the three and six months ended June 30, 2017 and June 30, 2016, is as follows:

 

IMPAIRED LOANS

(DOLLARS IN THOUSANDS)  

 

		Three months ended June 30,								Six months ended June 30,
		2017				2016				2017				2016
		$				$				$				$
Average recorded balance of impaired loans			2,060				1,605				2,103				1,640
Interest income recognized on impaired loans			19				14				32				28

 

Interest income on impaired loans would have increased by approximately $4,000 and $11,000 for the three and six months ended June 30, 2017, compared to $3,000 and $7,000 for the three and six months ended June 30, 2016, had these loans performed in accordance with their original terms.

 

During the six months ended June 30, 2017 there was one loan modification made causing a loan to be considered a troubled debt restructuring (TDR). A TDR is a loan where management has granted a concession to the borrower from the original terms. A concession is generally defined as more favorable payment or credit terms granted to a borrower in an effort to improve the likelihood of the lender collecting principal in its entirety. Concessions usually are in the form of interest only for a period of time, or a lower interest rate offered in an effort to enable the borrower to continue to make normally scheduled payments. The loan classified as a TDR during the second quarter of 2017 was an agricultural loan with a principal balance at June 30, 2017, of $281,000. The concession granted to the borrower was an interest-only period initially running for three months to March 31, 2017. However, in April 2017, that deferral period was extended for an additional three months, causing management to classify the loan as a TDR. The concession period ended June 30, 2017. Subsequent to June 30, 2017, but prior to the filing of this report, the borrower resumed normal principal and interest payments as of July 2017. There were no loans classified as a TDR during the six months ended June 30, 2016.

 

The following tables summarize information in regards to impaired loans by loan portfolio class as of June 30, 2017, December 31, 2016, and June 30, 2016:

 

IMPAIRED LOAN ANALYSIS

(DOLLARS IN THOUSANDS)  

 

June 30, 2017		Recorded Investment				Unpaid Principal Balance				Related Allowance				Average Recorded Investment				Interest Income Recognized
		$				$				$				$				$
With no related allowance recorded:
Commercial real estate
Commercial mortgages			578				675				—				677				4
Agriculture mortgages			1,211				1,211				—				1,229				26
Construction			—				—				—				—				—
Total commercial real estate			1,789				1,886				—				1,906				30
Commercial and industrial
Commercial and industrial			75				75				—				75				—
Tax-free loans			—				—				—				—				—
Agriculture loans			281				281				—				122				2
Total commercial and industrial			356				356				—				197				2
Total with no related allowance			2,145				2,242				—				2,103				32
With an allowance recorded:
Commercial real estate
Commercial mortgages			—				—				—				—				—
Agriculture mortgages			—				—				—				—				—
Construction			—				—				—				—				—
Total commercial real estate			—				—				—				—				—
Commercial and industrial
Commercial and industrial			—				—				—				—				—
Tax-free loans			—				—				—				—				—
Agriculture loans			—				—				—				—				—
Total commercial and industrial			—				—				—				—				—
Total with a related allowance			—				—				—				—				—
Total by loan class:
Commercial real estate
Commercial mortgages			578				675				—				677				4
Agriculture mortgages			1,211				1,211				—				1,229				26
Construction			—				—				—				—				—
Total commercial real estate			1,789				1,886				—				1,906				30
Commercial and industrial
Commercial and industrial			75				75				—				75				—
Tax-free loans			—				—				—				—				—
Agriculture loans			281				281				—				122				2
Total commercial and industrial			356				356				—				197				2
Total			2,145				2,242				—				2,103				32

 

IMPAIRED LOAN ANALYSIS
(DOLLARS IN THOUSANDS)
December 31, 2016		Recorded Investment				Unpaid Principal Balance				Related Allowance				Average Recorded Investment				Interest Income Recognized
		$				$				$				$				$
With no related allowance recorded:
Commercial real estate
Commercial mortgages			646				743				—				768				2
Agriculture mortgages			1,248				1,248				—				1,285				55
Construction			—				—				—				—				—
Total commercial real estate			1,894				1,991				—				2,053				57
Commercial and industrial
Commercial and industrial			75				75				—				76				—
Tax-free loans			—				—				—				—				—
Agriculture loans			—				—				—				—				—
Total commercial and industrial			75				75				—				76				—
Total with no related allowance			1,969				2,066				—				2,129				57
With an allowance recorded:
Commercial real estate
Commercial mortgages			—				—				—				—				—
Agriculture mortgages			—				—				—				—				—
Construction			—				—				—				—				—
Total commercial real estate			—				—				—				—				—
Commercial and industrial
Commercial and industrial			—				—				—				—				—
Tax-free loans			—				—				—				—				—
Agriculture loans			—				—				—				—				—
Total commercial and industrial			—				—				—				—				—
Total with a related allowance			—				—				—				—				—
Total by loan class:
Commercial real estate
Commercial mortgages			646				743				—				768				2
Agriculture mortgages			1,248				1,248				—				1,285				55
Construction			—				—				—				—				—
Total commercial real estate			1,894				1,991				—				2,053				57
Commercial and industrial
Commercial and industrial			75				75				—				76				—
Tax-free loans			—				—				—				—				—
Agriculture loans			—				—				—				—				—
Total commercial and industrial			75				75				—				76				—
Total			1,969				2,066				—				2,129				57

 

IMPAIRED LOAN ANALYSIS
(DOLLARS IN THOUSANDS)
June 30, 2016		Recorded Investment				Unpaid Principal Balance				Related Allowance				Average Recorded Investment				Interest Income Recognized
		$				$				$				$				$
With no related allowance recorded:
Commercial real estate
Commercial mortgages			773				870				—				341				—
Agriculture mortgages			1,285				1,285				—				1,299				28
Construction			—				—				—				—				—
Total commercial real estate			2,058				2,155				—				1,640				28
Commercial and industrial
Commercial and industrial			75				75				—				—				—
Tax-free loans			—				—				—				—				—
Agriculture loans			—				—				—				—				—
Total commercial and industrial			75				75				—				—				—
Total with no related allowance			2,133				2,230				—				1,640				28
With an allowance recorded:
Commercial real estate
Commercial mortgages			—				—				—				—				—
Agriculture mortgages			—				—				—				—				—
Construction			—				—				—				—				—
Total commercial real estate			—				—				—				—				—
Commercial and industrial
Commercial and industrial			—				—				—				—				—
Tax-free loans			—				—				—				—				—
Agriculture loans			—				—				—				—				—
Total commercial and industrial			—				—				—				—				—
Total with a related allowance			—				—				—				—				—
Total by loan class:
Commercial real estate
Commercial mortgages			773				870				—				341				—
Agriculture mortgages			1,285				1,285				—				1,299				28
Construction			—				—				—				—				—
Total commercial real estate			2,058				2,155				—				1,640				28
Commercial and industrial
Commercial and industrial			75				75				—				—				—
Tax-free loans			—				—				—				—				—
Agriculture loans			—				—				—				—				—
Total commercial and industrial			75				75				—				—				—
Total			2,133				2,230				—				1,640				28

 

The following table details activity in the allowance for loan losses by portfolio segment for the six months ended June 30, 2017:

 

ALLOWANCE FOR CREDIT LOSSES

(DOLLARS IN THOUSANDS)

 

		Commercial Real Estate				Consumer Real Estate				Commercial and Industrial				Consumer				Unallocated				Total
		$				$				$				$				$				$
Allowance for credit losses:
Beginning balance - December 31, 2016			3,795				1,652				1,552				82				481				7,562
Charge-offs			—				—				(7	)			(4	)			—				(11	)
Recoveries			—				20				9				2				—				31
Provision			(275	)			163				95				3				104				90
Balance - March 31, 2017			3,520				1,835				1,649				83				585				7,672
Charge-offs			—				—				—				(3	)			—				(3	)
Recoveries			—				—				10				3				—				13
Provision			208				83				(42	)			36				(165	)			120
Ending Balance - June 30, 2017			3,728				1,918				1,617				119				420				7,802

 

During the six months ended June 30, 2017, provision expenses were recorded for the consumer real estate, commercial and industrial, and consumer loan segments, with a credit provision recorded in the commercial real estate loan category. The decrease in the amount of allowance for loan losses allocated to commercial real estate was primarily due to a material drop in commercial real estate loans over the first six months of 2017. As of December 31, 2016, 50.2% of the Corporation’s allowance for loan losses was allocated to commercial real estate loans, which consisted of 48.2% of all loans. As of June 30, 2017, 47.8 % of the allowance was allocated to commercial real estate loans which consisted of 45.0% of total loans.

 

Delinquency rates among the Corporation’s loan pools remain very low. Additionally, there have been no charge-offs for four of our loan pools over the past three years. However, classified loans experienced a large increase in the first six months of 2017. The Corporation’s classified loans were relatively low and stable throughout 2016 but in the first quarter of 2017 increased by $7.4 million, from $14.2 million to $21.6 million. Two large loan relationships, one consisting of business loans and mortgages, and the other agriculture mortgages were classified as substandard in the first quarter. In the second quarter of 2017, classified loans increased another $4.0 million, to $25.6 million. This increase was primarily caused by four loan customers being classified as substandard, two being commercial and two agricultural-related. Management believes that classified loans may continue to increase in the remainder of 2017 but at a significantly slower pace. Currently, the agricultural lending sector remains under stress due to weak milk and egg prices impacting farmers. Outside of the commercial loan relationships noted above, the health of the Corporation’s commercial real estate and commercial and industrial borrowers is generally stable with no material trends related to certain types of industries. Commercial borrowers that have exposure to agriculture are subject to more financial stress in the current environment. As a result of weaker milk and egg prices, the qualitative factors for both agricultural dairy and non-dairy agriculture were increased in the second quarter of 2017. The significant increases in classified loans along with slightly higher qualitative factors, caused management to record provision expense of $210,000 through June 30, 2017 despite the continuation of very low levels of delinquencies and charge-offs.

 

The following table details activity in the allowance for loan losses by portfolio segment for the six months ended June 30, 2016:

 

ALLOWANCE FOR CREDIT LOSSES

(DOLLARS IN THOUSANDS)

 

		Commercial Real Estate				Consumer Real Estate				Commercial and Industrial				Consumer				Unallocated				Total
		$				$				$				$				$				$
Allowance for credit losses:
Beginning balance - December 31, 2015			3,831				1,403				1,314				62				468				7,078
Charge-offs			—				—				(4	)			(12	)			—				(16	)
Recoveries			—				10				16				2				—				28
Provision			(303	)			(45	)			47				15				236				(50	)
Balance - March 31, 2016			3,528				1,368				1,373				67				704				7,040
Charge-offs			—				—				—				(2	)			—				(2	)
Recoveries			—				—				159				—				—				159
Provision			255				105				(271	)			6				(45	)			50
Ending Balance - June 30, 2016			3,783				1,473				1,261				71				659				7,247

 

During the six months ended June 30, 2016, small provision expenses were recorded for the consumer real estate and consumer loan segments with credit provisions recorded in all other loan categories. Delinquency rates among most loan pools were very low, while charge-offs were very light with only $18,000 of charge-offs in the first six months of 2016. Changes in qualitative factors were unchanged for five loan pools, while they increased for three pools and declined for one. For purposes of evaluating the qualitative factors the Corporation’s four primary loan types above are broken down into nine (9) more detailed loan types. A large recovery in June supported no provision expense for the six months ended June 30, 2016, as recoveries are added to the Corporation’s ALLL balance. 

 

The following tables present the balance in the allowance for credit losses and the recorded investment in loans receivable by portfolio segment based on impairment method as of June 30, 2017 and December 31, 2016:

 

ALLOWANCE FOR CREDIT LOSSES AND RECORDED INVESTMENT IN LOANS RECEIVABLE

(DOLLARS IN THOUSANDS)  

 

As of June 30, 2017:		Commercial Real Estate				Consumer Real Estate				Commercial and Industrial				Consumer				Unallocated				Total
		$				$				$				$				$				$
Allowance for credit losses:
Ending balance: individually evaluated
for impairment			—				—				—				—				—				—
Ending balance: collectively evaluated
for impairment			3,728				1,918				1,617				119				420				7,802
Loans receivable:
Ending balance			259,797				235,003				77,139				5,068								577,007
Ending balance: individually evaluated
for impairment			1,789				—				356				—								2,145
Ending balance: collectively evaluated
for impairment			258,008				235,003				76,783				5,068								574,862

 

As of December 31, 2016:		Commercial Real Estate				Consumer Real Estate				Commercial and Industrial				Consumer				Unallocated				Total
		$				$				$				$				$				$
Allowance for credit losses:
Ending balance: individually evaluated
for impairment			—				—				—				—				—				—
Ending balance: collectively evaluated
for impairment			3,795				1,652				1,552				82				481				7,562
Loans receivable:
Ending balance			275,067				213,771				77,192				4,537								570,567
Ending balance: individually evaluated
for impairment			1,894				—				75				—								1,969
Ending balance: collectively evaluated
for impairment			273,173				213,771				77,117				4,537								568,598

 

4. Fair Value Presentation

 

U.S. generally accepted accounting principles establish a hierarchal disclosure framework associated with the level of observable pricing utilized in measuring assets and liabilities at fair value. The three broad levels defined by the hierarchy are as follows:

 

Level I:

Quoted prices are available in active markets for identical assets or liabilities as of the reported date.

 

Level II:

Pricing inputs are other than the quoted prices in active markets, which are either directly or indirectly observable as of the reported date. The nature of these assets and liabilities includes items for which quoted prices are available but traded less frequently and items that are fair-valued using other financial instruments, the parameters of which can be directly observed.

 

Level III:

Assets and liabilities that have little to no observable pricing as of the reported date. These items do not have two-way markets and are measured using management’s best estimate of fair value, where the inputs into the determination of fair value require significant management judgment or estimation.

 

The following tables present the assets reported on the consolidated balance sheets at their fair value as of June 30, 2017, and December 31, 2016, by level within the fair value hierarchy. As required by U.S. generally accepted accounting principles, financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement.

 

Fair Value Measurements:

 

ASSETS MEASURED ON A RECURRING BASIS

(DOLLARS IN THOUSANDS)

		June 30, 2017
		Level I				Level II				Level III				Total
		$				$				$				$
U.S. government agencies			—				28,689				—				28,689
U.S. agency mortgage-backed securities			—				53,336				—				53,336
U.S. agency collateralized mortgage obligations			—				51,113				—				51,113
Corporate bonds			—				54,227				—				54,227
Obligations of states & political subdivisions			—				123,849				—				123,849
Marketable equity securities			5,574				—				—				5,574
Total securities			5,574				311,214				—				316,788

 

On June 30, 2017, the Corporation held no securities valued using level III inputs. All of the Corporation’s debt instruments were valued using level II inputs, where quoted prices are available and observable, but not necessarily quotes on identical securities traded in active markets on a daily basis. The Corporation’s CRA fund investments and bank stocks are fair valued utilizing level I inputs because the funds have their own quoted prices in an active market. As of June 30, 2017, the CRA fund investments had a $5,250,000 book and fair market value and the bank stock portfolio had a book value of $282,000, and fair market value of $324,000.

 

Fair Value Measurements:

ASSETS MEASURED ON A RECURRING BASIS

(DOLLARS IN THOUSANDS)    

		December 31, 2016
		Level I				Level II				Level III				Total
		$				$				$				$
U.S. government agencies			—				32,261				—				32,261
U.S. agency mortgage-backed securities			—				55,869				—				55,869
U.S. agency collateralized mortgage obligations			—				37,936				—				37,936
Corporate bonds			—				52,091				—				52,091
Obligations of states & political subdivisions			—				124,430				—				124,430
Marketable equity securities			5,524				—				—				5,524
Total securities			5,524				302,587				—				308,111

 

On December 31, 2016, the Corporation held no securities valued using level III inputs. All of the Corporation’s debt instruments were valued using level II inputs, where quoted prices are available and observable but not necessarily quotes on identical securities traded in active markets on a daily basis. As of December 31, 2016, the Corporation’s CRA fund investments had a book and fair market value of $5,250,000 and the bank stock portfolio had a book value of $219,000 and a market value of $274,000 utilizing level I pricing.

 

Financial instruments are considered level III when their values are determined using pricing models, discounted cash flow methodologies, or similar techniques, and at least one significant model assumption or input is unobservable. In addition to these unobservable inputs, the valuation models for level III financial instruments typically also rely on a number of inputs that are readily observable either directly or indirectly. Level III financial instruments also include those for which the determination of fair value requires significant management judgment or estimation. There were no level III securities as of June 30, 2017 or December 31, 2016.

 

The following tables present the assets measured on a nonrecurring basis on the Consolidated Balance Sheets at their fair value as of June 30, 2017 and December 31, 2016, by level within the fair value hierarchy:

 

ASSETS MEASURED ON A NONRECURRING BASIS

(Dollars in Thousands)

		June 30, 2017
		Level I $				Level II $				Level III $				Total $
Assets:
Impaired Loans			—				—				2,145				2,145
Total			—				—				2,145				2,145

 

 

		December 31, 2016
		Level I $				Level II $				Level III $				Total $
Assets:
Impaired Loans			—				—				1,969				1,969
Total			—				—				1,969				1,969

 

The Corporation had a total of $2,145,000 of impaired loans as of June 30, 2017, with no specific allocation against these loans and $1,969,000 of impaired loans as of December 31, 2016, with no specific allocation against these loans. The value of impaired loans is generally determined through independent appraisals of the underlying collateral. The Corporation had no OREO (Other Real Estate Owned) assets as of December 31, 2016 and June 30, 2017.

 

The following table presents additional quantitative information about assets measured at fair value on a nonrecurring basis for which the Corporation has utilized level III inputs to determine fair value:

 

QUANTITATIVE INFORMATION ABOUT LEVEL III FAIR VALUE MEASUREMENTS

(DOLLARS IN THOUSANDS)      

	June 30, 2017
	Fair Value	Valuation	Unobservable	Range
	Estimate	Techniques	Input	(Weighted Avg)
Impaired loans	2,145	Appraisal of	Appraisal	-20% (-20%)
		collateral (1)	adjustments (2)
			Liquidation	-10% (-10%)
			expenses (2)

 

	December 31, 2016
	Fair Value	Valuation	Unobservable	Range
	Estimate	Techniques	Input	(Weighted Avg)
Impaired loans	1,969	Appraisal of	Appraisal	-20% (-20%)
		collateral (1)	adjustments (2)
			Liquidation	-10% (-10%)
			expenses (2)

 

(1) Fair value is generally determined through independent appraisals of the underlying collateral, which generally include various level III inputs which are not identifiable.

(2) Appraisals may be adjusted by management for qualitative factors such as economic conditions and estimated liquidation expenses.  The range and weighted average of liquidation expenses and other appraisal adjustments are presented as a percent of the appraisal.  

Interim Disclosures about Fair Value of Financial Instruments

 

The following methods and assumptions were used to estimate the fair value of each class of financial instrument:

 

Cash and Cash Equivalents

For these short-term instruments, the carrying amount is a reasonable estimate of fair value.

 

Securities Available for Sale

Management utilizes quoted market pricing for the fair value of the Corporation's securities that are available for sale, if available. If a quoted market rate is not available, fair value is estimated using quoted market prices for similar securities.

 

Regulatory Stock

Regulatory stock is valued at a stable dollar price, which is the price used to purchase or liquidate shares; therefore, the carrying amount is a reasonable estimate of fair value.

 

Loans Held for Sale

Loans held for sale are individual loans for which the Corporation has a firm sales commitment; therefore, the carrying value is a reasonable estimate of the fair value.

 

Loans

The fair value of fixed and variable rate loans is estimated by discounting back the scheduled future cash flows of the particular loan product, using the market interest rates of comparable loan products in the Corporation’s greater market area, with the same general structure, comparable credit ratings, and for the same remaining maturities.

 

Accrued Interest Receivable

The carrying amount of accrued interest receivable is a reasonable estimate of fair value.

 

Bank Owned Life Insurance

Fair value is equal to the cash surrender value of the life insurance policies.

 

Deposits

The fair value of non-interest bearing demand deposit accounts and interest bearing demand, savings, and money market deposit accounts is based on the amount payable on demand at the reporting date. The fair value of fixed-maturity time deposits is estimated by discounting back the expected cash flows of the time deposit using market interest rates from the Corporation’s greater market area currently offered for similar time deposits with similar remaining maturities.

 

Borrowings

The carrying amount of short-term borrowing is a reasonable estimate of fair value. The fair value of long-term borrowing is estimated by comparing the rate currently offered for the same type of borrowing instrument with a matching remaining term.

 

Accrued Interest Payable

The carrying amount of accrued interest payable is a reasonable estimate of fair value.

 

Firm Commitments to Extend Credit, Lines of Credit, and Open Letters of Credit

These financial instruments are generally not subject to sale and estimated fair values are not readily available. The carrying value, represented by the net deferred fee arising from the unrecognized commitment or letter of credit, and the fair value, determined by discounting the remaining contractual fee over the term of the commitment, using fees currently charged to enter into similar agreements with similar credit risk, is not considered material for disclosure purposes. The contractual amounts of unfunded commitments are presented in Note 6.

 

Fair Value of Financial Instruments

 

The carrying amounts and estimated fair values of the Corporation's financial instruments at June 30, 2017 and December 31, 2016, are summarized as follows:

 

FAIR VALUE OF FINANCIAL INSTRUMENTS

(DOLLARS IN THOUSANDS)

 

		June 30, 2017
										Quoted Prices in
										Active Markets				Significant Other				Significant
										for Identical				Observable				Unobservable
		Carrying								Assets				Inputs				Inputs
		Amount				Fair Value				(Level 1)				(Level II)				(Level III)
		$				$				$				$				$
Financial Assets:
Cash and cash equivalents			56,463				56,463				56,463				—				—
Securities available for sale			316,788				316,788				5,574				311,214				—
Regulatory stock			5,487				5,487				5,487				—				—
Loans held for sale			3,819				3,819				3,819				—				—
Loans, net of allowance			570,309				574,457				—				—				574,457
Accrued interest receivable			3,633				3,633				3,633				—				—
Bank owned life insurance			25,007				25,007				25,007				—				—
Financial Liabilities:
Demand deposits			295,900				295,900				295,900				—				—
Interest-bearing demand deposits			17,668				17,668				17,668				—				—
NOW accounts			82,249				82,249				82,249				—				—
Money market deposit accounts			99,387				99,387				99,387				—				—
Savings accounts			190,588				190,588				190,588				—				—
Time deposits			155,176				156,122				—				—				156,122
Total deposits			840,968				841,914				685,792				—				156,122
Short-term borrowings			4,157				4,157				4,157				—				—
Long-term debt			64,904				65,021				—				—				65,021
Accrued interest payable			383				383				383				—				—

FAIR VALUE OF FINANCIAL INSTRUMENTS

(DOLLARS IN THOUSANDS)

 

		December 31, 2016
										Quoted Prices in
										Active Markets				Significant Other				Significant
										for Identical				Observable				Unobservable
		Carrying								Assets				Inputs				Inputs
		Amount				Fair Value				(Level 1)				(Level II)				(Level III)
		$				$				$				$				$
Financial Assets:
Cash and cash equivalents			45,632				45,632				45,632				—				—
Securities available for sale			308,111				308,111				5,524				302,587				—
Regulatory stock			5,372				5,372				5,372				—				—
Loans held for sale			2,552				2,552				2,552				—				—
Loans, net of allowance			564,005				563,418				—				—				563,418
Accrued interest receivable			3,750				3,750				3,750				—				—
Bank owned life insurance			24,687				24,687				24,687				—				—
Financial Liabilities:
Demand deposits			280,543				280,543				280,543				—				—
Interest-bearing demand deposits			20,108				20,108				20,108				—				—
NOW accounts			85,540				85,540				85,540				—				—
Money market deposit accounts			93,943				93,943				93,943				—				—
Savings accounts			175,753				175,753				175,753				—				—
Time deposits			161,604				163,464				—				—				163,464
Total deposits			817,491				819,351				655,887				—				163,464
Short-term borrowings			8,329				8,329				8,329				—				—
Long-term debt			61,257				61,372				—				—				61,372
Accrued interest payable			384				384				384				—				—

 

 

6.       Commitments and Contingent Liabilities

 

In order to meet the financing needs of its customers in the normal course of business, the Corporation makes various commitments that are not reflected in the accompanying consolidated financial statements. These commitments include firm commitments to extend credit, unused lines of credit, and open letters of credit. As of June 30, 2017, firm loan commitments were $46.4 million, unused lines of credit were $206.8 million, and open letters of credit were $10.6 million. The total of these commitments was $263.8 million, which represents the Corporation’s exposure to credit loss in the event of nonperformance by its customers with respect to these financial instruments. The actual credit losses that may arise from these commitments are expected to compare favorably with the Corporation’s loan loss experience on its loan portfolio taken as a whole. The Corporation uses the same credit policies in making commitments and conditional obligations as it does for balance sheet financial instruments.

 

7. Accumulated Other Comprehensive Income (Loss)

 

The activity in accumulated other comprehensive income (loss) for the three and six months ended June 30, 2017 and 2016 is as follows:

 

ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS) (1) (2)

(DOLLARS IN THOUSANDS)  

 

		Unrealized
		Gains (Losses)
		on Securities
		Available-for-Sale
		$
Balance at December 31, 2016			(4,885	)
Other comprehensive income before reclassifications			418
Amount reclassified from accumulated other comprehensive income			(92	)
Period change			326
Balance at March 31, 2017			(4,559	)
Other comprehensive loss before reclassifications			2,778
Amount reclassified from accumulated other comprehensive loss			(71	)
Period change			2,707
Balance at June 30, 2017			(1,852	)
Balance at December 31, 2015			(252	)
Other comprehensive income before reclassifications			1,050
Amount reclassified from accumulated other comprehensive income			(480	)
Period change			570
Balance at March 31, 2016			318
Other comprehensive income before reclassifications			2,257
Amount reclassified from accumulated other comprehensive income			(619	)
Period change			1,638
Balance at June 30, 2016			1,956

 

(1) All amounts are net of tax.  Related income tax expense or benefit is calculated using a Federal income tax rate of 34%.

(2) Amounts in parentheses indicate debits.        

DETAILS ABOUT ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS) COMPONENTS (1)

(DOLLARS IN THOUSANDS)

 

		Amount Reclassified from
		Accumulated Other Comprehensive
		Income (Loss)
		For the Three Months
		Ended June 30,
		2017				2016				Affected Line Item in the
		$				$				Consolidated Statements of Income
Securities available-for-sale:
Net securities gains reclassified into earnings			107				938			Gains on securities transactions, net
Related income tax expense			(36	)			(319	)		Provision for federal income taxes
Net effect on accumulated other comprehensive
income for the period			71				619

 

(1) Amounts in parentheses indicate debits.

       

 

DETAILS ABOUT ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS) COMPONENTS (1)

(DOLLARS IN THOUSANDS)      

 

		Amount Reclassified from
		Accumulated Other Comprehensive
		Income (Loss)
		For the Six Months
		Ended June 30,
		2017				2016				Affected Line Item in the
		$				$				Consolidated Statements of Income
Securities available-for-sale:
Net securities gains reclassified into earnings			247				1,666			Gains on securities transactions, net
Related income tax expense			(84	)			(566	)		Provision for federal income taxes
Net effect on accumulated other comprehensive
income for the period			163				1,100

 

(1) Amounts in parentheses indicate debits.      

 

 

8. Recently Issued Accounting Standards

 

In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers (a new revenue recognition standard). The Update’s core principle is that a company will recognize revenue to depict the transfer of 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. In addition, this Update specifies the accounting for certain costs to obtain or fulfill a contract with a customer and expands disclosure requirements for revenue recognition. This Update is effective for annual reporting periods beginning after December 15, 2016, including interim periods within that reporting period. The Corporation is evaluating the effect of adopting this new accounting Update.

 

In January 2016, the FASB issued ASU 2016-01, Financial Instruments – Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities. This Update applies to all entities that hold financial assets or owe financial liabilities and is intended to provide more useful information on the recognition, measurement, presentation, and disclosure of financial instruments. Among other things, this Update (a) requires equity investments (except those accounted for under the equity method of accounting or those that result in consolidation of the investee) to be measured at fair value with changes in fair value recognized in net income; (b) simplifies the impairment assessment of equity investments without readily determinable fair values by requiring a qualitative assessment to identify impairment; (c) eliminates the requirement to disclose the fair value of financial instruments measured at amortized cost for entities that are not public business entities; (d) eliminates the requirement for public business entities to disclose the method(s) and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost on the balance sheet; (e) requires public business entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes; (f) requires an entity to present separately in other comprehensive income the portion of the total change in the fair value of a liability resulting from a change in the instrument-specific credit risk when the entity has elected to measure the liability at fair value in accordance with the fair value option for financial instruments; (g) requires separate presentation of financial assets and financial liabilities by measurement category and form of financial asset (that is, securities or loans and receivables) on the balance sheet or the accompanying notes to the financial statements; and (h) clarifies that an entity should evaluate the need for a valuation allowance on a deferred tax asset related to available-for-sale securities in combination with the entity’s other deferred tax assets. For public business entities, the amendments in this Update are effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. For all other entities, including not-for-profit entities and employee benefit plans within the scope of Topics 960 through 965 on plan accounting, the amendments in this Update are effective for fiscal years beginning after December 15, 2018, and interim periods within fiscal years beginning after December 15, 2019. All entities that are not public business entities may adopt the amendments in this Update earlier as of the fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The Corporation is currently evaluating the impact the adoption of the standard will have on the Corporation’s financial position or results of operations.

 

In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842). The standard requires lessees to recognize the assets and liabilities that arise from leases on the balance sheet.  A lessee should recognize in the statement of financial position a liability to make lease payments (the lease liability) and a right-of-use asset representing its right to use the underlying asset for the lease term.  A short-term lease is defined as one in which (a) the lease term is 12 months or less and (b) there is not an option to purchase the underlying asset that the lessee is reasonably certain to exercise. For short-term leases, lessees may elect to recognize lease payments over the lease term on a straight-line basis. For public business entities, the amendments in this Update are effective for fiscal years beginning after December 15, 2018, and interim periods within those years. For all other entities, the amendments in this Update are effective for fiscal years beginning after December 15, 2019, and for interim periods within fiscal years beginning after December 15, 2020. The amendments should be applied at the beginning of the earliest period presented using a modified retrospective approach with earlier application permitted as of the beginning of an interim or annual reporting period. The Corporation is currently assessing the practical expedients it may elect at adoption, but does not anticipate the amendments will have a significant impact on the financial statements. Based on the Corporation’s preliminary analysis of its current portfolio, the impact to the Corporation’s balance sheet is estimated to result in less than a one percent increase in assets and liabilities. This Update is not expected to have a significant impact on the Corporation’s financial statements.

 

In March 2016, the FASB issued ASU 2016-08, Revenue from Contracts with Customers (Topic 606). The amendments in this Update affect entities with transactions included within the scope of Topic 606, which includes entities that enter into contracts with customers to transfer goods or services (that are an output of the entity’s ordinary activities) in exchange for consideration. The amendments in this Update do not change the core principle of the guidance in Topic 606; they simply clarify the implementation guidance on principal versus agent considerations. The amendments in this Update are intended to improve the operability and understandability of the implementation guidance on principal versus agent considerations. The amendments in this Update affect the guidance in ASU 2014-09, Revenue from Contracts with Customers (Topic 606), which is not yet effective. The effective date and transition requirements for the amendments in this Update are the same as the effective date and transition requirements of Update 2014-09. ASU No. 2015-14, Revenue from Contracts with Customers (Topic 606): Deferral of the Effective Date, defers the effective date of Update 2014-09 by one year. The Corporation is currently evaluating the impact the adoption of the standard will have on the Corporation’s financial position or results of operations.

 

In April 2016, the FASB issued ASU 2016-10, Revenue from Contracts with Customers (Topic 606). The amendments in this Update affect entities with transactions included within the scope of Topic 606, which includes entities that enter into contracts with customers to transfer goods or services in exchange for consideration. The amendments in this Update do not change the core principle for revenue recognition in Topic 606. Instead, the amendments provide (1) more detailed guidance in a few areas and (2) additional implementation guidance and examples based on feedback the FASB received from its stakeholders. The amendments are expected to reduce the degree of judgment necessary to comply with Topic 606, which the FASB expects will reduce the potential for diversity arising in practice and reduce the cost and complexity of applying the guidance. The amendments in this Update affect the guidance in ASU 2014-09, Revenue from Contracts with Customers (Topic 606), which is not yet effective. The effective date and transition requirements for the amendments in this Update are the same as the effective date and transition requirements in Topic 606 (and any other Topic amended by Update 2014-09). ASU 2015-14, Revenue from Contracts with Customers (Topic 606): Deferral of the Effective Date, defers the effective date of Update 2014-09 by one year. The Company is currently evaluating the impact the adoption of the standard will have on the Corporation’s financial position or results of operations.

 

In June 2016, the FASB issued ASU 2016-13, Financial Instruments-Credit Losses: Measurement of Credit Losses on Financial Instruments (“ASU 2016-13”), which changes the impairment model for most financial assets. This ASU is intended to improve financial reporting by requiring timelier recording of credit losses on loans and other financial instruments held by financial institutions and other organizations. The underlying premise of the ASU is that financial assets measured at amortized cost should be presented at the net amount expected to be collected, through an allowance for credit losses that is deducted from the amortized cost basis. The allowance for credit losses should reflect management’s current estimate of credit losses that are expected to occur over the remaining life of a financial asset. The income statement will be effected for the measurement of credit losses for newly recognized financial assets, as well as the expected increases or decreases of expected credit losses that have taken place during the period. ASU 2016-13 is effective for annual and interim periods beginning after December 15, 2019, and early adoption is permitted for annual and interim periods beginning after December 15, 2018. With certain exceptions, transition to the new requirements will be through a cumulative effect adjustment to opening retained earnings as of the beginning of the first reporting period in which the guidance is adopted. We expect to recognize a one-time cumulative effect adjustment to the allowance for loan losses as of the beginning of the first reporting period in which the new standard is effective, but cannot yet determine the magnitude of any such one-time adjustment or the overall impact of the new guidance on the consolidated financial statements.

 

In March 2017, the FASB issued ASU 2017-08, Receivables – Nonrefundable Fees and Other Costs (Subtopic 310-20). The amendments in this Update shorten the amortization period for certain callable debt securities held at a premium. Specifically, the amendments require the premium to be amortized to the earliest call date. The amendments do not require an accounting change for securities held at a discount; the discount continues to be amortized to maturity. For public business entities, the amendments in this Update are effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. For all other entities, the amendments are effective for fiscal years beginning after December 15, 2019, and interim periods within fiscal years beginning after December 15, 2020. Early adoption is permitted, including adoption in an interim period. If an entity early adopts the amendments in an interim period, any adjustments should be reflected as of the beginning of the fiscal year that includes that interim period. An entity should apply the amendments in this Update on a modified retrospective basis through a cumulative-effect adjustment directly to retained earnings as of the beginning of the period of adoption. Additionally, in the period of adoption, an entity should provide disclosures about a change in accounting principle. The Corporation is currently evaluating the impact the adoption of the standard will have on the Corporation’s financial position or results of operations.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

The following discussion and analysis represents management’s view of the financial condition and results of operations of the Corporation. This discussion and analysis should be read in conjunction with the consolidated financial statements and other financial schedules included in this quarterly report, and in conjunction with the 2016 Annual Report to Shareholders of the Corporation. The financial condition and results of operations presented are not indicative of future performance.

 

Forward-Looking Statements

 

The U.S. Private Securities Litigation Reform Act of 1995 provides safe harbor in regards to the inclusion of forward-looking statements in this document and documents incorporated by reference. Forward-looking statements pertain to possible or assumed future results that are made using current information. These forward-looking statements are generally identified when terms such as: “believe,” “estimate,” “anticipate,” “expect,” “project,” “forecast,” and other similar wordings are used. The readers of this report should take into consideration that these forward-looking statements represent management’s expectations as to future forecasts of financial performance, or the likelihood that certain events will or will not occur. Due to the very nature of estimates or predications, these forward-looking statements should not be construed to be indicative of actual future results. Additionally, management may change estimates of future performance, or the likelihood of future events, as additional information is obtained. This document may also address targets, guidelines, or strategic goals that management is striving to reach but may not be indicative of actual results.

 

Readers should note that many factors affect this forward-looking information, some of which are discussed elsewhere in this document and in the documents that are incorporated by reference into this document. These factors include, but are not limited to, the following:

 

·

National and local economic conditions

·

Effects of slow economic conditions or prolonged economic weakness, specifically the effect on loan customers to repay loans

·

Health of the housing market

·

Real estate valuations and its impact on the loan portfolio

·

Interest rate and monetary policies of the Federal Reserve Board

·

Volatility of the securities markets including the valuation of securities

·

Future actions or inactions of the United States government, including a failure to increase the government debt limit or a prolonged shutdown of the federal government

·

Political changes and their impact on new laws and regulations

·

Competitive forces

·

Impact of mergers and acquisition activity in the local market and the effects thereof

·

Potential impact from continually evolving cybersecurity and other technological risks and attacks, including additional costs, reputational damage, regulatory penalties, and financial losses

·

Changes in customer behavior impacting deposit levels and loan demand

·

Changes in accounting principles, policies, or guidelines as may be adopted by the regulatory agencies, as well as the Public Company Accounting Oversight Board, the Financial Accounting Standards Board, and other accounting standards setters

·

Ineffective business strategy due to current or future market and competitive conditions

·

Management’s ability to manage credit risk, liquidity risk, interest rate risk, and fair value risk

·

Operation, legal, and reputation risk

·

Results of the regulatory examination and supervision process

·

The impact of new laws and regulations, including the impact of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 and the regulations issued thereunder

·

Possible impacts of the capital and liquidity requirements of the Basel III standards and other regulatory pronouncements, regulations and rules

·

Disruptions due to flooding, severe weather, or other natural disasters

·

The risk that our analyses of these risks and forces could be incorrect and/or that the strategies developed to address them could be unsuccessful

 

Readers should be aware if any of the above factors change significantly, the statements regarding future performance could also change materially. The safe harbor provision provides that the Corporation is not required to publicly update or revise forward-looking statements to reflect events or circumstances that arise after the date of this report. Readers should review any changes in risk factors in documents filed by the Corporation periodically with the Securities and Exchange Commission, including Item 1A of Part II of this Quarterly Report on Form 10-Q, Annual Reports on Form 10-K, and Current Reports on Form 8-K.

 

Results of Operations

 

Overview

The Corporation recorded net income of $1,872,000 and $3,699,000 for the three and six-month periods ended June 30, 2017, a 13.9% and 4.0% increase respectively, from the $1,644,000 and $3,556,000 earned during the same periods in 2016. The earnings per share, basic and diluted, were $0.66 and $1.30 for the three and six months ended June 30, 2017, compared to $0.58 and $1.25 for the same periods in 2016.

 

The primary reason for the increase in earnings was an increase in the Corporation’s net interest income (NII). The Corporation’s net interest income (NII) increased by $1,945,000, or 35.1%, and $3,150,000, or 27.1%, for the three and six months ended June 30, 2017, compared to the same periods in 2016. The increase in NII primarily resulted from an increase in interest on securities and dividend income of $1,413,000, or 224.3%, and $2,081,000, or 105.6%, for the three and six-month periods ended June 30, 2017, caused by $1,519,000 of non-recurring amortization on U.S. sub-agency bonds recorded in the first six months of 2016, with no similar amount in 2017. The Corporation’s NII also benefited from a $428,000, or 7.7%, and $821,000, or 7.5% increase in interest and fees on loans, as well as a decrease in interest expense on deposits and borrowings of $26,000, or 3.4%, and $135,000, or 8.6%, for the three and six-month periods ended June 30, 2017, compared to 2016.

 

The Corporation recorded $120,000 of provision expense in the second quarter of 2017, compared to $50,000 for the second quarter of 2016, and provision expense of $210,000 for the six months ended June 30, 2017, compared to no provision expense for the year-to-date period in 2016, representing a $210,000 decrease in income in 2017 compared to 2016. The gains from the sale of securities were $107,000 and $247,000 for the three and six months ended June 30, 2017, compared to $938,000 and $1,666,000 for the same periods in 2016, representing decreases of $831,000, or 88.6%, and $1,419,000, or 85.2%, respectively. Market interest rates were lower in 2016, making it more conducive to achieving gains from the sale of securities. The gain on the sale of mortgages increased by $40,000, or 10.1%, and $240,000, or 43.5%, for the three and six-month periods ended June 30, 2017, compared to the prior year’s periods. Both mortgage production and margins made on sold mortgages were higher in the first six months of 2017 compared to 2016. Total operating expenses increased $1,003,000, or 14.9%, and $2,039,000, or 15.5%, for the three and six months ended June 30, 2017, compared to the same periods in 2016.

 

The financial services industry uses two primary performance measurements to gauge performance: return on average assets (ROA) and return on average equity (ROE). ROA measures how efficiently a bank generates income based on the amount of assets or size of a company. ROE measures the efficiency of a company in generating income based on the amount of equity or capital utilized. The latter measurement typically receives more attention from shareholders. The ROA and ROE increased for the three months ended June 30, 2017, compared to the same period in the prior year due primarily to higher earnings. ROA for the six-month period in 2017 decreased compared to the prior year due to a faster asset growth rate that outpaced the increase in earnings. However, ROE increased for the six-month period as equity did not increase at a rapid pace allowing the growth in earnings to positively impact ROE.

 

Key Ratios		Three Months Ended								Six Months Ended
		June 30,								June 30,
		2017				2016				2017				2016
Return on Average Assets			0.75%				0.71%				0.75%				0.78%
Return on Average Equity			7.69%				6.79%				7.75%				7.40%

 

The results of the Corporation’s operations are best explained by addressing, in further detail, the five major sections of the income statement, which are as follows:

 

·

Net interest income

·

Provision for loan losses

·

Other income

·

Operating expenses

·

Provision for income taxes

 

The following discussion analyzes each of these five components.

 

Net Interest Income

 

Net interest income (NII) represents the largest portion of the Corporation’s operating income. In the first six months of 2017, NII generated 75.0% of the Corporation’s gross revenue stream, which consists of net interest income and non-interest income, compared to 66.9% in the first six months of 2016. The overall performance of the Corporation is highly dependent on the changes in net interest income since it comprises such a significant portion of operating income. Without the impact of the accelerated amortization on the U.S. Sub-Agency bonds, the Corporation’s NII would have accounted for 69.6% of the gross revenue stream for the first six months of 2016.

 

The following table shows a summary analysis of net interest income on a fully taxable equivalent (FTE) basis. For analytical purposes and throughout this discussion, yields, rates, and measurements such as NII, net interest spread, and net yield on interest earning assets are presented on an FTE basis. The FTE net interest income shown in both tables below will exceed the NII reported on the consolidated statements of income, which is not shown on an FTE basis. The amount of FTE adjustment totaled $604,000 and $1,211,000 for the three and six months ended June 30, 2017, compared to $535,000 and $1,046,000 for the same periods in 2016.

 

NET INTEREST INCOME
(DOLLARS IN THOUSANDS)
		Three Months Ended								Six Months Ended
		June 30,								June 30,
		2017				2016				2017				2016
		$				$				$				$
Total interest income			8,213				6,294				16,195				13,180
Total interest expense			731				757				1,433				1,568
Net interest income			7,482				5,537				14,762				11,612
Tax equivalent adjustment			604				535				1,211				1,046
Net interest income (fully taxable equivalent)			8,086				6,072				15,973				12,658

 

 

NII is the difference between interest income earned on assets and interest expense incurred on liabilities. Accordingly, two factors affect net interest income:

 

·

The rates earned on interest earning assets and paid on interest bearing liabilities

·

The average balance of interest earning assets and interest bearing liabilities

 

The Federal funds rate, the Prime rate, the shape of the U.S. Treasury curve, and other wholesale funding curves, all affect NII. The Federal Reserve controls the Federal funds rate, which is one of a number of tools available to the Federal Reserve to conduct monetary policy. The Federal funds rate, and guidance on when the rate might be changed, is often the focal point of discussion regarding the direction of interest rates. Until December 16, 2015, the Federal funds rate had not changed since December 16, 2008. On December 16, 2015, the Federal funds rate was increased 25 basis points to 0.50%, from 0.25%. On December 14, 2016, the Federal funds rate was increased 25 basis points to 0.75%. On March 15, 2017 and June 14, 2017, the Federal funds rate was again increased 25 basis points so the rate at June 30, 2017 was 1.25%. Prior to December of 2015, the period of seven years with extremely low and unchanged overnight rates was the lowest and longest in U.S. history. The impact has been a lower net interest margin to the Corporation and generally across the financial industry. The increase in December of 2015 and 2016, as well as the increases in March and June of 2017 resulted in higher short-term U.S. Treasury rates, but the long-term rates initially decreased, resulting in a flattening of the yield curve. Long-term rates like the ten-year U.S. Treasury were 194 basis points under the 4.25% Prime rate as of June 30, 2017. It appears that the general conditions of a flatter yield curve with low long-term U.S. Treasury rates, significantly below the Prime rate, will continue for 2017. Management anticipates the next 0.25% Federal Reserve rate increase could occur in the fourth quarter of 2017. It remains to be seen whether mid and long-term U.S. Treasury rates will also increase to the same degree that the Federal Reserve will move the overnight Federal funds rate. If they do not, the yield curve would further flatten making it harder for the Corporation to increase asset yield.

 

The Prime rate is generally used by commercial banks to extend variable rate loans to business and commercial customers. For many years, the Prime rate has been set at 300 basis points, or 3.00% higher, than the Federal funds rate and typically moves when the Federal funds rate changes. As such, the Prime rate increased from 3.25% to 3.50% on December 16, 2015, from 3.50% to 3.75% on December 14, 2016, from 3.75% to 4.00% on March 15, 2017, and from 4.00% to 4.25% on June 14, 2017. The Corporation’s Prime-based loans, including home equity lines of credit and some variable rate commercial loans reprice a day after the Federal Reserve rate movement.

 

As a result of the December 2015 Federal Reserve rate increase the Corporation’s NII on a tax equivalent basis began to increase in 2016 with the Corporation’s margin increasing to 3.12% for the year, compared to 3.07% in 2015. The December 2016 Federal Reserve rate increase again came too late in the year to significantly impact the 2016 margin but did have a positive impact to the margin in 2017. The Corporation’s NII for the first six months of 2017 increased substantially over the same period in 2016, by $3,150,000, or 27.1%, with the margin increasing to 3.44%. However, there was non-recurring security amortization of $1,519,000 recorded in the first half of 2016, which had a negative impact on NII. Without this impact, NII would have increased by $1,631,000, or 12.4% in 2017 compared to 2016. Management’s asset liability sensitivity measurements continue to show a benefit to both margin and NII given further Federal Reserve rate increases. Actual results over the past six quarters have confirmed the asset sensitivity of the Corporation’s balance sheet. Management expects that any additional Federal Reserve rate increases in 2017 would further improve both margin and NII.

 

The extended extremely low Federal funds rate has enabled management to reduce the cost of funds on overnight borrowings and allowed lower interest rates paid on deposits, reducing the Corporation’s interest expense. It was only after the third 25-basis point Fed rate increase in March of 2017 that the Corporation raised some deposit rates minimally. While the low Prime rate reduced the yield on the Corporation’s loans for many years, the rate increases through June of 2017 did act to boost interest income and help improve the Corporation’s margin. With a higher Prime rate and elevated Treasury rates, higher asset yields should be possible throughout the remainder of 2017. Due to the increasing number of variable rate loans in the Corporation’s loan portfolio, the 25 basis point increase in the Prime rate at the end of 2015, 2016, and in March and June of 2017 did cause higher NII in the month of December 2015, and for the entire year of 2016. The full impact of all of these increases will be experienced in the third quarter of 2017. Additionally, with potentially one more Fed rate increase in 2017, the Corporation should see even more benefit due to the near immediate repricing of the Prime-based variable loans.

 

Security yields fluctuate more rapidly than loan yields based primarily on the changes to the U.S. Treasury rates and yield curve. During 2016, management did generally direct a large portion of the security sale proceeds into loan growth resulting in higher overall asset yields. With higher Treasury rates in the first half of 2017 compared to the first half of 2016, security reinvestment has been occurring at slightly higher yields and amortization has slowed resulting in higher yields. The Corporation’s loan yield has begun to increase as the variable rate portion of the loan portfolio is repricing higher with each Federal Reserve rate movement. The vast majority of the Corporation’s commercial Prime-based loans are priced at the Prime rate, currently at 4.25%. The pricing for the most typical five-year fixed rate commercial loans is currently very similar to the Prime rate. Previously, any increases in variable rate loans acted to bring down overall loan yield. Now with the rates being very similar it is much more beneficial to the Corporation to grow the variable rate loans in a period of rising rates. An element of the Corporation’s Prime-based commercial loans is priced above the Prime rate based on the level of credit risk of the borrower. Management does price a portion of consumer variable rate loans above the Prime rate, which also helps to improve loan yield. Both commercial and consumer Prime-based pricing continues to be driven largely by local competition.

 

Mid-term and long-term interest rates on average were higher in 2017 compared to 2016. The average rate of the 10-year U.S. Treasury was 2.35% in the first six months of 2017 compared to 1.83% in the first six months of 2016, and it stood at 2.31% on June 30, 2017, compared to 1.49% at June 30, 2016. The slope of the yield curve has been compressed throughout most of 2016 and through the first half of 2017, but with the Fed rate increase in March and June of 2017, there was slightly more slope between the short end and long end of the curve compared to the prior year. There was a difference of 106 basis points between overnight rates and the 10-year U.S. Treasury as of June 30, 2017, compared to 49 basis points as of June 30, 2016. The slope of the yield curve has fluctuated many times in the past two years with the 10-year U.S. Treasury yield as high as 2.60% in 2016 and 2.62% in 2017, and as low as 1.37% in 2016 and 2.14% in 2017. Although the yield curve is still relatively flat, the slightly higher slope in the curve allowed for security reinvestment during the first half of 2017 at slightly higher rates but management was not able to increase loan rates to improve yield. The non-recurring sub-agency amortization of $1,519,000 for the year-to-date period ended June 30, 2016, negatively affected security yield resulting in artificially low yields during 2016 and higher yields during 2017. With higher long-term rates in 2017 and the likelihood of further Fed rate increases, the Corporation’s asset yield is projected to increase throughout 2017.

 

While it is becoming increasingly difficult to achieve savings on the Corporation’s overall cost of funds, management was able to selectively reprice time deposits and borrowings to lower levels during the six months ended June 30, 2017, resulting in savings on these instruments. Generally, it was longer-term CDs repricing at lower rates that helped to achieve interest expense savings on deposits. It is anticipated that interest rates on interest bearing core deposits will need to be increased during the remainder of 2017 if the Federal Reserve does act to raise interest rates again. Management selectively repriced some CD rates higher after the March Fed increase. Borrowing costs, and the wholesale borrowing curves that they are based on, generally follow the direction and slope of the U.S. Treasury curve. However, these curves can be quicker to rise and slower to fall as the providers of these funds seek to protect themselves from rate movements. The Corporation was able to refinance some borrowings at lower rates in 2016 but it will be difficult to do this going forward as rates are higher now and most borrowings are already at lower interest rates relative to their term.

 

Management currently anticipates that the overnight interest rate and Prime rate will remain at the current levels until the fourth quarter of 2017 with the possibility of one more 0.25% rate increase by year-end. It is likely that mid and long-term U.S. Treasury rates will increase throughout the remainder of 2017 in anticipation of an additional Federal Reserve rate movement. This would allow management to achieve higher earnings on assets if the opportunity for higher yielding securities and the ability to price new loans at higher market rates occurred. However, it is also possible that even after a Federal Reserve rate increase the yield curve could flatten, making it more difficult for management to lend out or reinvest at higher interest rates out further on the yield curve. Additionally, Federal Reserve rate increases would continue to affect the repricing of the Corporation’s liabilities. Management would expect to have to increase deposit rates further to remain competitive in the market and maturing borrowings would likely begin to reprice to higher rates.

 

The following table provides an analysis of year-to-date changes in net interest income by distinguishing what changes were a result of average balance increases or decreases and what changes were a result of interest rate increases or decreases.

 

RATE/VOLUME ANALYSIS OF CHANGES IN NET INTEREST INCOME

(TAXABLE EQUIVALENT BASIS, DOLLARS IN THOUSANDS)

 

Six Months Ended June 30,

Six Months Ended June 30,

2017 vs. 2016