UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



FORM 10-Q



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



        For quarterly period ended March 31, 2020



☐    TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT



        For the transition period from _______________ to ________________



Commission file number 0-14237



First United Corporation

(Exact name of registrant as specified in its charter)





(800)  470-4356

(Registrant's telephone number, including area code)



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





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 periods that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes ☑   No ☐



Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted 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 such files).  Yes ☑   No ☐



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





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 standard 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 ☐   No ☑



Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: 6,966,898 shares of common stock, par value $.01 per share, as of April 30, 2020.



 

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INDEX TO QUARTERLY REPORT

FIRST UNITED CORPORATION 





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PART I.  FINANCIAL INFORMATION

Item 1.  Financial Statements



FIRST UNITED CORPORATION

Consolidated Statement of Financial Condition

(In thousands, except per share data)







See accompanying notes to the consolidated financial statements



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FIRST UNITED CORPORATION

Consolidated Statement of Operations

(In thousands, except per share data)



See accompanying notes to the consolidated financial statements



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FIRST UNITED CORPORATION

Consolidated Statement of Comprehensive (Loss)/Income

(In thousands)





See accompanying notes to the consolidated financial statements

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FIRST UNITED CORPORATION

Consolidated Statement of Changes in Shareholders’ Equity

(In thousands, except per share data)

















See accompanying notes to the consolidated financial statements

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FIRST UNITED CORPORATION

Consolidated Statement of Cash Flows

(In thousands)



See accompanying notes to the consolidated financial statements

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FIRST UNITED CORPORATION

NoteS to Consolidated Financial Statements (UNAUDITED)





Note 1 – Basis of Presentation



The accompanying unaudited consolidated financial statements of First United Corporation and its consolidated subsidiaries, including First United Bank & Trust (the “Bank”), have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) for interim financial information, as required by the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 270, Interim Reporting, and with the instructions to Form 10-Q and Rule 8-03 of Regulation S-X.  Accordingly, they do not include all the information and footnotes required for annual financial statements.  In the opinion of management, all adjustments considered necessary for a fair presentation, consisting of normal recurring items, have been included.  Operating results for the three-month period ended March 31, 2020 are not necessarily indicative of the results that may be expected for the full year or for any future interim period.  These consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in First United Corporation’s Annual Report on Form 10-K for the year ended December 31, 2019. 



As used in these notes, the terms “the Corporation” “we”, “us”, and “our” refer to First United Corporation and, unless the context clearly requires otherwise, its consolidated subsidiaries.



The Corporation has evaluated events and transactions occurring subsequent to the statement of financial condition date of March 31, 2020 for items that should potentially be recognized or disclosed in these financial statements.

 

Note 2 – Significant Event



On March 11, 2020, the World Health Organization declared a pandemic as a result of the global spread of the coronavirus, commonly referred to as COVID-19.  The spread of the disease quickly accelerated in the United States and to date, all 50 states have reported cases.  The U.S. and state governments reacted to the pandemic by issuing shelter at home orders and requiring that non-essential businesses be closed to prevent spread of the virus.  The health crisis quickly turned into a financial crisis resulting in guidance and mandates regarding foreclosures and repossessions and accounting and regulatory changes designed to encourage banks to work with customers suffering detrimental financial impact.



As a result of the pandemic effecting the states and local markets in which it operates, the Corporation successfully implemented its Business Continuity Plan with the goal of protecting the health, safety and financial well-being of its associates and customers.   As part of its plan to protect the financial well-being of its customers, the Corporation chose to participate and educate its customers on the government sponsored plans established to provide financial assistance to businesses.



The U.S. Government’s Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”) established the Small Business Administration (“SBA”) Paycheck Protection Program (“PPP”) which provides small businesses with resources to maintain payroll, hire back employees who may have been laid off, and to cover applicable overhead expenses.  We acted expeditiously to prepare our associates so they could guide our customers on the proper procedures necessary to enable them to take advantage of this program.  We developed an SBA PPP specific information site within our website that provided detailed information, links and materials for eligible customers to access.  Internally, we reallocated resources to review, process and enter customer applications, working tirelessly over extended hours to provide access to as many local business owners as possible.   We were able to fund 428 loan applications for approximately $111.0 million from the first tranche of PPP designated funds.  Congress allocated additional funding to the PPP on April 23, 2020.  Due to our advance preparation and software implementation, we were able to quickly gain approval for an additional 492 loan applications for approximately $29.0 million thru May 1, 2020.  In total, we have gained approval for over $140 million dollars to 920 small businesses.  Approximately 73% of the loans were under $100,000 in size and approximately 65% of the businesses receiving the loans employed less than 10 employees.  We will continue to provide access to the PPP and process applications, for as long as the PPP is open and funds are available, so that we can assist as many small business owners in our markets as possible.  These loans are 100% guaranteed by the SBA, have up to a two-year maturity, provide for a six-month deferral period, and have an interest rate of 1%.  These loans may be forgiven by the SBA if the borrower meets certain conditions, including by using at least 75% of the loan proceeds for payroll costs.  The SBA also established processing fees from 1% to 5%, depending on the loan amount.  We anticipate to receive approximately $3.5 million in fees. 



In April 2020, the Bank established eligibility to participate in the Paycheck Protection Program Liquidity Facility (“PPPLF”) which was established by Congress and administered by the Federal Reserve Bank.  This facility uses the SBA guaranteed PPP loans as collateral, offering 100% collateral coverage with no recourse to the Bank.   The majority of the PPP loan disbursements, which were all subsequent to quarter end, have been to internal, non-interest-bearing accounts awaiting use by borrowers.  As a result, we have not yet accessed the PPPLF, but are prepared to utilize the fund when management determines the timing is appropriate.



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The Corporation’s allowance for loan losses increased $2.5 million to $15.0 million at March 31, 2020 compared to $12.5 million at December 31, 2019.  The allowance for loan losses (the “ALL”) to total loans was 1.42% and 1.19% at March 31, 2020 and December 31, 2019, respectively.  This increase was driven by the increased provision expense which was adjusted for qualitative factors related to the economic uncertainty and increased unemployment rates related to the COVID-19 pandemic.



While the pandemic has had an impact on most industries, some have been more impacted than others.  The following chart includes data on our consumer and commercial loan portfolios, including a breakdown by industry, the percentage of the portfolio that has been modified through May 6, 2020 as a result of COVID-19 and the corresponding allowance for loan losses for each category as of March 31, 2020.  Modifications include either deferrals of principal and interest or interest only periods of three months.  Residential mortgage deferrals result in extensions of the maturity date of the loans and commercial modifications result in either an extension of the maturity payment or a balloon payment at maturity.







 





On March 16, 2020, in response to the COVID-19 outbreak, the Federal Reserve Board reduced the federal funds rate by 150 basis points to a target range of  0% to .25%, and the yields on 10-year and 30-year treasury notes have declined to historic lows.  As a result of this decline, the Corporation’s future net interest margin and spread may be reduced.



Note 3 – Earnings Per Common Share



Basic earnings per common share is derived by dividing net income available to common shareholders by the weighted-average number of common shares outstanding during the period and does not include the effect of any potentially dilutive common stock equivalents.  Diluted earnings per share is derived by dividing net income available to common shareholders by the weighted-average number of shares outstanding, adjusted for the dilutive effect of outstanding common stock equivalents, such as restricted stock units (“RSUs”).  At March 31, 2020, there were RSUs relating to 25,004 shares of common stock outstanding.  

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The following table sets forth the calculation of basic and diluted earnings per common share for the three-month periods ended March 31, 2020 and 2019:  









 

Note 4 – Net Gains



The following table summarizes the gain/(loss) activity for the three-month periods ended March 31, 2020 and 2019:









 

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Note 5 – Investments



The following table shows a comparison of amortized cost and fair values of investment securities at March 31, 2020 and December 31, 2019:







Proceeds from sales of available for sale securities and the realized gains and losses were as follows:





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The following table shows the Corporation’s investment securities with gross unrealized losses and fair values at March 31, 2020 and December 31, 2019, aggregated by investment category and the length of time that individual securities have been in a continuous unrealized loss position:







Management systematically evaluates securities for impairment on a quarterly basis.  Based upon application of accounting guidance for subsequent measurement in ASC Topic 320 (ASC Section 320-10-35), management assesses whether (a) the Corporation has the intent to sell a security being evaluated and (b) it is more likely than not that the Corporation will be required to sell the security prior to the anticipated recovery of any decline in fair value.  If neither applies, then any decline in the fair value below the security’s cost that is considered an other-than-temporary decline is split into two components.  The first component is the loss attributable to declining credit quality.  Credit losses are recognized in earnings as realized losses in the period in which the impairment determination is made.  The second component consists of all other losses, which are recognized in other comprehensive loss.  In estimating other than temporary impairment (“OTTI”) losses, management considers (1) the length of time and the extent to which the fair value has been less than cost, (2) adverse conditions specifically related to the security, an industry, or a geographic area, (3) the historic and implied volatility of the fair value of the security, (4) changes in the rating of the security by a rating agency, (5) recoveries or additional declines in fair value subsequent to the balance sheet date, (6) failure of the issuer of the security to make scheduled interest or principal payments, and (7) the payment structure of the debt security and the likelihood of the issuer being able to make payments that increase in the future.  Management also monitors cash flow projections for securities that are considered beneficial interests under the guidance of ASC Subtopic 325-40, Investments – Other – Beneficial Interests in Securitized Financial Assets, (ASC Section 325-40-35). 



Management believes that the valuation of certain securities is a critical accounting policy that requires significant estimates in preparation of the Corporation’s consolidated financial statements.  Management utilizes an independent third party to prepare both the impairment valuations and fair value determinations for the Corporation’s collateralized debt obligation (“CDO”) portfolio consisting of pooled trust preferred securities.  See Note 8 for a discussion of the methodology used by management to determine the fair values of these securities.  Based upon a review of credit quality and the cash flow tests performed by the independent third party, management determined that there were no securities that had credit-related non-cash OTTI charges during the first three months of 2020 or 2019. 



The Corporation does not believe that the investment securities that were in an unrealized loss position at March 31, 2020 represent other-than-temporary impairment.  The Corporation does not intend to sell nor is it anticipated that it would be required to sell any of its impaired investment securities at a loss. 

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The following tables present a cumulative roll-forward of the amount of non-cash OTTI charges related to credit losses which have been recognized in earnings for the trust preferred securities in the CDO portfolio held and not intended to be sold for the three-month periods ended March 31, 2020 and 2019:  





The amortized cost and estimated fair value of securities by contractual maturity at March 31, 2020 are shown in the following table.  Actual maturities may differ from contractual maturities because the issuers of the securities may have the right to call or prepay obligations with or without call or prepayment penalties.



 

Note 6  – Loans and Related Allowance for Loan Losses



The following table summarizes the primary segments of the loan portfolio at March 31, 2020 and December 31, 2019:







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The following table presents the classes of the loan portfolio summarized by the aggregate Pass and the criticized categories of Special Mention and Substandard within the internal risk rating system at March 31, 2020 and December 31, 2019:







The increase of $6.7 million in the substandard category from December 31, 2019 to March 31, 2020 was primarily due to one large relationship in the “ALL other CRE” and “Commercial and Industrial” categories.  This loan is current and well collateralized and is not considered impaired.  It was classified as substandard due to a reduction in cash flows and a slight deterioration in the borrower’s balance sheet. 





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The following table presents the classes of the loan portfolio summarized by the aging categories of performing loans and non-accrual loans at March 31, 2020 and December 31, 2019:





Non-accrual loans totaled $11.0 million at March 31, 2020, compared to $10.8 million at December 31, 2019.  The increase in non-accrual balances at March 31, 2020 was primarily related to one new CRE loan of $0.2 million.  Management continues to monitor the $8.0 million A&D participation loan that was added to non-accrual loans in the first quarter of 2019.  This loan is serviced by another lender and is now under a forbearance agreement.  Management established a specific allocation at the time the loan was placed into non-accrual and believes that the $2.1 million at March 31, 2020 is adequate based upon an appraisal obtained in the second quarter of 2019.  Discussions are currently underway for the sale of the property or notes.  The Request for Proposal process was delayed by COVID-19.



Non-accrual loans that have been subject to partial charge-offs totaled $0.1 million both at March 31, 2020 and December 31, 2019.  Loans secured by 1-4 family residential real estate properties in the process of foreclosure were $0.2 million and $0.1 million at March 31, 2020 and December 31, 2019, respectively.  All foreclosure and repossession activity have been temporarily suspended as a result of the COVID-19 pandemic and the federal and state guidance issued in response thereto.  As a percentage of the loan portfolio, accruing loans past due 30 days or more increased to 0.35%, compared to 0.33% at December 31, 2019 which offset the decrease in the 60-89 days past due.



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The following table summarizes the primary segments of the ALL at March 31, 2020 and December 31, 2019, segregated by the amount required for loans individually evaluated for impairment and the amount required for loans collectively evaluated for impairment: 









The evaluation of the need and amount of a specific allocation of the ALL and whether a loan can be removed from impairment status is made on a quarterly basis. 



The following table presents impaired loans by class, segregated by those for which a specific allowance was required and those for which a specific allowance was not required at March 31, 2020 and December 31, 2019:







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The following tables present the activity in the ALL for the three-month periods ended March 31, 2020 and 2019:







The ALL is based on estimates, and actual losses may vary from current estimates.   Management believes that the granularity of the homogeneous pools and the related historical loss ratios and other qualitative factors, as well as the consistency in the application of assumptions, result in an ALL that is representative of the risk found in the components of the portfolio at any given date.



The following table presents the average recorded investment in impaired loans by class and related interest income recognized for the periods indicated:







The Bank modifies loan terms in the normal course of business.  Among other reasons, modifications might be made in an effort to retain the loan relationship, to remain competitive in the current interest rate environment and/or to re-amortize or extend the loan’s term to better match the loan’s payment stream with the borrower’s cash flow.  A modified loan is considered to be a troubled debt restructuring (“TDR”) when the Bank has determined that the borrower is troubled (i.e., experiencing financial difficulties). The Bank evaluates the probability that the borrower will be in payment default on any of its debt obligations in the foreseeable future without modification. To make this determination, the Bank performs a global financial review of the borrower and loan guarantors to assess their current ability to meet their financial obligations.    



Section 4013 of the CARES Act allows financial institutions to suspend application of certain current TDRs accounting guidance under ASC 310-40 for loan modifications related to the COVID-19 pandemic made between March 1, 2020 and the earlier of December 31, 2020 or 60 days after the end of the COVID-19 national emergency, provided certain criteria are met. This relief can be applied to loan modifications for borrowers that were not more than 30 days past due as of December 31, 2019 and to loan modifications that defer or delay the payment of principal or interest, or change the interest rate on the loan. In April 2020, federal and state banking regulators issued the Interagency Statement on Loan Modifications and Reporting for Financial Institutions Working with Customers Affected by the Coronavirus to provide further interpretation of when a borrower is experiencing financial difficulty, specifically indicating that if the modification is either short-term (e.g., six months) or mandated by a federal or state government in response to the COVID-19 pandemic, the borrower is not experiencing financial difficulty under ASC 310-40. The Corporation continues to prudently work with borrowers negatively impacted by the COVID-19 pandemic while managing credit risks and recognizing appropriate

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allowance for credit losses on its loan portfolio.  See Note 2 to the financial statements included elsewhere in this report for additional information. 



There were 15 loans totaling $4.1 million and $4.2  million that were classified as TDRs at March 31, 2020 and December 31, 2019, respectively.  The following tables present the volume and recorded investment in TDR’s at the times they were modified, by class and type of modification that occurred during the periods indicated:





During the three months ended March 31, 2020, there were no new TDRs and no modifications on existing TDRs.  There were no payment defaults under TDRs.



During the three months ended March 31, 2019, there were no new TDRs but two existing TDRs that had reached their modification maturity dates were re-modified.  These re-modifications did not impact the ALL.  During the three months ended March 31, 2019, there were no payment defaults under TDRs.





 

Note 7 - Other Real Estate Owned, net



The following table presents the components of other real estate owned (“OREO”) at March 31, 2020 and December 31, 2019:







The following table presents the activity in the OREO valuation allowance for the three-month periods ended March 31, 2020 and 2019:







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The following table presents the components of OREO expenses, net, for the three-month periods ended March 31, 2020 and 2019:





 

Note 8 – Fair Value of Financial Instruments



Fair value is defined as the price to sell an asset or to transfer a liability in an orderly transaction between willing market participants as of the measurement date.  Fair value is best determined by values quoted through active trading markets.  Active trading markets are characterized by numerous transactions of similar financial instruments between willing buyers and willing sellers. Because no active trading market exists for various types of financial instruments, many of the fair values disclosed were derived using present value discounted cash flows or other valuation techniques described below.  As a result, the Corporation’s ability to actually realize these derived values cannot be assumed. 



The Corporation measures fair values based on the fair value hierarchy established in ASC Paragraph 820-10-35-37.  The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements).  The three levels of inputs that may be used to measure fair value under the hierarchy are as follows:



Level 1: Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets and liabilities.  This level is the most reliable source of valuation.



Level 2: Quoted prices that are not active, or inputs that are observable either directly or indirectly, for substantially the full term of the asset or liability.  Level 2 inputs include inputs other than quoted prices that are observable for the asset or liability (for example, interest rates and yield curves at commonly quoted intervals, volatilities, prepayment speeds, loss severities, credit risks, and default rates).  It also includes inputs that are derived principally from or corroborated by observable market data by correlation or other means (market-corroborated inputs).  Several sources are utilized for valuing these assets, including a contracted valuation service, Standard & Poor’s (“S&P”) evaluations and pricing services, and other valuation matrices. 



Level 3: Prices or valuation techniques that require inputs that are both significant to the valuation assumptions and not readily observable in the market (i.e. supported with little or no market activity).  Level 3 instruments are valued based on the best available data, some of which is internally developed, and consider risk premiums that a market participant would require.



The level established within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement.

 

Management believes that the Corporation’s valuation techniques are appropriate and consistent with the techniques used by other market participants.  However, the use of different methodologies and assumptions could result in a different estimate of fair values at the reporting date.  The valuation techniques used by the Corporation to measure, on a recurring and non-recurring basis, the fair value of assets as of March 31, 2020 are discussed in the paragraphs that follow. 



Investments – The fair value of investments is determined using a market approach.  As of March 31, 2020, the U.S. Government agencies, residential and commercial mortgage-backed securities, collateralized mortgage obligations, and state and political subdivisions bonds, excluding the TIF bonds, segments are classified as Level 2 within the valuation hierarchy.  Their fair values were determined based upon market-corroborated inputs and valuation matrices, which were obtained through third party data service providers or securities brokers through which the Corporation has historically transacted both purchases and sales of investment securities.  The TIF bonds are classified as Level 3 within the valuation hierarchy as they are not openly traded.



The CDO segment, which consists of pooled trust preferred securities issued by banks, thrifts and insurance companies, is classified as Level 3 within the valuation hierarchy.  At March 31, 2020, the Corporation owned nine trust preferred securities with an amortized cost of $18.4 million and a fair value of $12.4 million. As of March 31, 2020, the market for these securities is not active and the markets for similar securities are also not active.  The inactivity was evidenced first by a significant widening of the bid-ask spread in the brokered markets in which these securities trade and then by a significant decrease in the volume of trades relative to historical

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levels.  The new issue market is also inactive, as few CDOs have been issued since 2007.  There are currently very few market participants who are willing to effect transactions in these securities.  The market values for these securities or any securities other than those issued or guaranteed by the U.S. Department of the Treasury (the “Treasury”) are depressed relative to historical levels.  Therefore, in the current market, a low market price for a particular bond may only provide evidence of stress in the credit markets in general rather than being an indicator of credit problems with a particular issue.  Given the conditions in the current debt markets and the absence of observable transactions in the secondary and new issue markets, management has determined that (a) the few observable transactions and market quotations that are available are not reliable for the purpose of obtaining fair value at March 31, 2020, (b) an income valuation approach technique (i.e. present value) that maximizes the use of relevant observable inputs and minimizes the use of unobservable inputs will be equally or more representative of fair value than a market approach, and (c) the CDO segment is appropriately classified within Level 3 of the valuation hierarchy because management determined that significant adjustments were required to determine fair value at the measurement date.



Management utilizes on an independent third party to prepare both the evaluations of OTTI as well as the fair value determinations for its CDO portfolio. Management believes that the valuations are adequately reflected at March 31, 2020.



The approach used by the third party to determine fair value involved several steps, which included detailed credit and structural evaluation of each piece of collateral in each bond, projection of default, recovery and prepayment/amortization probabilities for each piece of collateral in the bond, and discounted cash flow modeling. The discount rate methodology used by the third party combines a baseline current market yield for comparable corporate and structured credit products with adjustments based on evaluations of the differences found in structure and risks associated with actual and projected credit performance of each CDO being valued.  Currently, the only active and liquid trading market that exists is for stand-alone trust preferred securities, with a limited market for highly-rated CDO securities that are more senior in the capital structure than the securities in the CDO portfolio.  Therefore, adjustments to the baseline discount rate are also made to reflect the additional leverage found in structured instruments.



Derivative financial instruments (Cash flow hedge) – The Corporation’s open derivative positions are interest rate swap agreements.  Those classified as Level 2 open derivative positions are valued using externally developed pricing models based on observable market inputs provided by a third party and validated by management.   The Corporation has considered counterparty credit risk in the valuation of its interest rate swap assets. 



Impaired loans – Loans included in the table below are those that are considered impaired with a specific allocation or with a partial charge-off.  Fair value consists of the loan balance less its valuation allowance and is generally determined based on independent third-party appraisals of the collateral or discounted cash flows based upon the expected proceeds.  These assets are included as Level 3 fair values based upon the lowest level of input that is significant to the fair value measurements. 



Other real estate owned – OREO included in the table below are considered impaired with specific write-downs.  Fair value of other real estate owned is based on independent third-party appraisals of the properties.  These values were determined based on the sales prices of similar properties in the approximate geographic area.  These assets are included as Level 3 fair values based upon the lowest level of input that is significant to the fair value measurements.  



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For Level 3 assets and liabilities measured at fair value on a recurring and non-recurring basis as of March 31, 2020 and December 31, 2019, the significant unobservable inputs used in the fair value measurements were as follows:







NOTE:

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For assets measured at fair value on a recurring and non-recurring basis, the fair value measurements by level within the fair value hierarchy used at March 31, 2020 and December 31, 2019 are as follows:











There were no transfers of assets between any of the fair value hierarchy for the three-month periods ended March 31, 2020 or 2019.

The following tables show a reconciliation of the beginning and ending balances for fair valued assets measured on a recurring basis using Level 3 significant unobservable inputs for the three-month periods ended March 31, 2020 and 2019:







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Gains/losses (realized and unrealized) included in earnings for the periods identified above are reported in the Consolidated Statement of Operations in Other Operating Income.  There were no gains or losses included in earnings attributable to the change in realized/unrealized gains or losses related to the assets for the three-month periods ended March 31, 2020 and 2019.



The disclosed fair values may vary significantly between institutions based on the estimates and assumptions used in the various valuation methodologies.  The derived fair values are subjective in nature and involve uncertainties and significant judgment. Therefore, they cannot be determined with precision. Changes in the assumptions could significantly impact the derived estimates of fair value.  Disclosure of non-financial assets such as buildings as well as certain financial instruments such as leases is not required.  Accordingly, the aggregate fair values presented do not represent the underlying value of the Corporation.



The following tables present fair value information about financial instruments, whether or not recognized in the Consolidated Statement of Financial Condition, for which it is practicable to estimate that value. The actual carrying amounts and estimated fair values of the Corporation’s financial instruments that are included in the Consolidated Statement of Financial Condition are as follows:









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Note 9 – Accumulated Other Comprehensive Loss



The following table presents the changes in each component of accumulated other comprehensive loss for the 12 months ended December 31, 2019 and the three months ended March 31, 2020:



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The following tables present the components of other comprehensive income/(loss) for the three-month periods ended

March 31, 2020 and 2019:







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The following table presents the details of amounts reclassified from accumulated other comprehensive loss for the three-month periods ended March 31, 2020 and 2019:





 

Note 10 – Borrowed Funds



The following is a summary of short-term borrowings with original maturities of less than one year:







At March 31, 2020, the repurchase agreements were secured by $50.7 million in investment securities issued by government related agencies.  A minimum of 102% of fair value is pledged against account balances.



At March 31, 2020, the long-term FHLB advances were secured by $228.2 million in loans.

 

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Note 11 – Employee Benefit Plans



The following tables present the components of the net periodic pension plan cost for First United Corporation’s noncontributory Defined Benefit Pension Plan (the “Pension Plan”) and the Bank’s Defined Benefit Supplemental Executive Retirement Plan (“Defined Benefit SERP”) for the periods indicated:









The service cost component of net periodic benefit cost is included in salaries and benefits and all other components of net periodic benefit cost are included in other operating expenses in the Consolidated Statement of Operations for the Corporation’s Pension and Defined Benefit SERP plans. 



The Pension Plan is a noncontributory defined benefit pension plan that covers our employees who were hired prior to the freeze and others who were grandfathered into the plan.  The benefits are based on years of service and the employees’ compensation during the last five years of employment.  At March 31, 2020, the market value of the pension plan assets declined approximately $7.0 million as a result of the decline in the rate environment related to the COVID-19 pandemic. 



Effective April 30, 2010, the Pension Plan was amended, resulting in a “soft freeze”, the effect of which prohibits new entrants into the plan and ceases crediting of additional years of service after that date.  Effective January 1, 2013, the Pension Plan was amended to unfreeze it for those employees for whom the sum of their (a) ages, at their closest birthday plus (b) years of service for vesting purposes equals 80 or greater.  The “soft freeze” continues to apply to all other plan participants.  Pension benefits for these participants are managed through discretionary contributions to the First United Corporation 401(k) Profit Sharing Plan (the “401(k) Plan”). 



The Bank established the Defined Benefit SERP in 2001 as an unfunded supplemental executive retirement plan.  The Defined Benefit SERP is available only to a select group of management or highly compensated employees to provide supplemental retirement benefits in excess of limits imposed on qualified plans by federal tax law.  Concurrent with the establishment of the Defined Benefit SERP, the Bank acquired Bank Owned Life Insurance (“BOLI”) policies on the senior management personnel and officers of the Bank.  The benefits resulting from the favorable tax treatment accorded the earnings on the BOLI policies are intended to provide a source of funds for the future payment of the Defined Benefit SERP benefits as well as other employee benefit costs. 



The benefit obligation activity for both the Pension Plan and Defined Benefit SERP was calculated using an actuarial measurement date of January 1. Plan assets and the benefit obligations were calculated using an actuarial measurement date of December 31.



The Corporation will assess the need for future annual contributions to the pension plan based upon its funded status and an evaluation of the future benefits to be provided thereunder.  A contribution of $1.0 million was made to the Pension Plan during the first three months of 2020.  The Corporation expects to fund the annual projected benefit payments for the Defined Benefit SERP from operations.



On January 9, 2015, First United Corporation and members of management who do not participate in the Defined Benefit SERP entered into participation agreements under the Deferred Compensation Plan, each styled as a Defined Contribution SERP Agreement (the “Contribution Agreement”).  Pursuant to each Contribution Agreement, First United Corporation agreed, for each Plan Year (as

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defined in the Deferred Compensation Plan) in which it determines that it has been Profitable (as defined in the Contribution Agreement), to make a discretionary contribution to the participant’s Employer Account in an amount equal to 15% of the participant’s base salary level for such Plan Year, with the first Plan Year being the year ending December 31, 2015.  The Contribution Agreement provides that the participant will become 100% vested in the amount maintained in his or her Employer Account upon the earliest to occur of the following events: (a) Normal Retirement (as defined in the Contribution Agreement); (b)  Separation from Service (as defined in the Contribution Agreement) following a Change of Control (as defined in the Deferred Compensation Plan) and subsequent Triggering Event (as defined in the Contribution Agreement); (c) Separation from Service due to a Disability (as defined in the Contribution Agreement); (d) with respect to a particular award of Employer Contribution Credits, the participant’s completion of two consecutive Years of Service (as defined in the Contribution Agreement) immediately following the Plan Year for which such award was made; or (e) death.  Notwithstanding the foregoing, however, a participant will lose entitlement to the amount maintained in his or her Employer Account in the event employment is terminated for Cause (as defined in the Contribution Agreement).  In addition, the Contribution Agreement conditions entitlement to the amounts held in the Employer Account on the participant (1) refraining from engaging in Competitive Employment (as defined in the Contribution Agreement) for three years following his or her Separation from Service, (2) refraining from injurious disclosure of confidential information concerning the Corporation, and (3) remaining available, at the First United Corporation’s reasonable request, to provide at least six hours of transition services per month for 12 months following his or her Separation from Service (except in the case of death or Disability), except that only item (2) will apply in the event of a Separation from Service following a Change of Control and subsequent Triggering Event. 



In January 2018, the Board approved discretionary contributions to four participants totaling $119,252.  The contributions vested on December 31, 2019.   In January 2019, the Board of Directors of First United Corporation approved discretionary contributions to four participants totaling $123,179.  The Corporation recorded $12,007 and $18,788 of related compensation expense for the first three months of 2020 and 2019, respectively, related to these contributions.  In January 2020, the Board approved discretionary contributions to four participants totaling $126,058. The Corporation recorded $15,757 of related compensation for the first quarter of 2020 related to these contributions.  Each of the above annual contributions has a two-year vesting period.

  

Note 12 - Equity Compensation Plan Information



At the 2018 Annual Meeting of Shareholders, First United Corporation’s shareholders approved the First United Corporation 2018 Equity Compensation Plan which authorizes the issuance of up to 325,000 shares of common stock to employees, directors and qualifying consultants pursuant to stock options, stock appreciation rights, stock awards, dividend equivalents, and other stock-based awards. 



The Corporation complies with the provisions of ASC Topic 718, Compensation-Stock Compensation, in measuring and disclosing stock compensation cost.   The measurement objective in ASC Paragraph 718-10-30-6 requires public companies to measure the cost of employee services received in exchange for an award of equity instruments based on the grant date fair value of the award.  The cost is recognized in expense over the period in which an employee is required to provide service in exchange for the award (the vesting period).



Stock-based awards were made to non-employee directors in May 2019 pursuant to First United Corporation’s director compensation policy.  Each director receives an annual retainer of 1,000 shares of First United Corporation common stock, plus $10,000 to be paid, at the director’s election, in cash or additional shares of common stock.  In 2019, a total of 14,641 fully-vested shares of common stock were issued to directors, which had a grant date fair market value of $18.30 per share.  Director stock compensation expense was $66,983 for the three months ended March 31, 2020 and $66,717 for the three months ended March 31, 2019. 



Restricted Stock Units



On March 26, 2020, pursuant to the recently-adopted Long-Term Incentive Plan (the "LTIP"), the Compensation Committee (the "Committee") of the Corporation granted restricted stock units ("RSUs") to the Corporation's principal executive officer, its principal financial officer, and certain of its other executive officers.  An RSU contemplates the issuance of shares of common stock of the Corporation if and when the RSU vests.



The RSUs granted to each of the foregoing officers consist of (a) a performance-vesting award for a three-year performance period ending December 31, 2021, (b) a performance-vesting award for a three-year performance period ending December 31, 2022, and (c) a time-vesting award that will vest ratably over a three-year period beginning on March 26, 2021. Under the performance-vesting RSUs, the officers will receive 50% of the target number of shares if at least one of the threshold performance levels is met, 100% of the target number of shares if at least one of the target performance levels is met, and 150% of the target number of shares if at least one of the maximum performance levels is met. Actual vesting amounts will be pro-rated between threshold and target levels and target and maximum levels to reward incremental improvement. For the performance period ending December 31, 2021, the RSUs' performance goal is based on earnings per share for the year ending December 31, 2021. For the performance period ending December 31, 2022, the RSUs' performance goals are based on earnings per share for the year ending December 31, 2022 and growth in tangible book value per

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share during the performance period. The threshold, target and maximum performance levels for these grants will be disclosed pursuant to Item 402 of Regulation S-K following the conclusion of the applicable performance period.



To receive any shares under a RSU, a grantee must be employed by the Corporation or one of its subsidiaries on the applicable vesting date, except that a grantee whose employment terminates prior to such vesting date due to death, disability or retirement will be entitled to a pro-rated portion of the shares subject to the RSUs, assuming that, in the case of performance-vesting RSUs, the performance goals had been met at their "target" levels.



In the first quarter of 2020, RSUs relating to 25,004 shares of common stock (target level) were granted, which had a grant date fair market value of $12.54 per share of common stock underlying each RSU.  Stock compensation expense was $31,242 for the first quarter of 2020.  Compensation expense related to unvested units was $282,282.

 

Note 13 – Derivative Financial Instruments



As a part of managing interest rate risk, the Bank entered into interest rate swap agreements to modify the re-pricing characteristics of certain interest-bearing liabilities. The Corporation has designated these interest rate swap agreements as cash flow hedges under the guidance of ASC Subtopic 815-30, Derivatives and Hedging – Cash Flow Hedges. Cash flow hedges have the effective portion of changes in the fair value of the derivative, net of taxes, recorded in net accumulated other comprehensive loss. 



In March 2016, the Corporation entered into four interest rate swap contracts totaling $30.0 million notional amount, hedging future cash flows associated with floating rate trust preferred debt.  These contracts include a three-year $5.0 million contract that matured on June 17, 2019, a five-year $5.0 million contract that matures on March 17, 2021, a seven-year $5.0 million contract that matures on March 17, 2023 and a 10-year $15.0 million contract that matures on March 17, 2026.



The fair value of the interest rate swap contracts was $(1.4) million and $(133) thousand at March 31, 2020 and December 31, 2019, respectively.



For the three months ended March 31, 2020, the Corporation recorded a decrease in the value of the derivatives of $1.3 million and the related deferred tax of $352 thousand in net accumulated other comprehensive loss to reflect the effective portion of cash flow hedges.  ASC Subtopic 815-30 requires the net accumulated other comprehensive loss to be reclassified to earnings if the hedge becomes ineffective or is terminated.  There was no hedge ineffectiveness recorded for the three months ended March 31, 2020.  The Corporation does not expect any losses relating to these hedges to be reclassified into earnings within the next 12 months.



Interest rate swap agreements are entered into with counterparties that meet established credit standards and the Corporation believes that the credit risk inherent in these contracts is not significant as of March 31, 2020.



The table below discloses the impact of derivative financial instruments on the Corporation’s Consolidated Financial Statements for the three-month periods ended March 31, 2020 and 2019.







Notes:

(a) Reported as interest expense

(b) Reported as other income

 

Note 14 – Assets and Liabilities Subject to Enforceable Master Netting Arrangements



Interest Rate Swap Agreements



The Corporation has entered into interest rate swap agreements to modify the re-pricing characteristics of certain interest-bearing liabilities as a part of managing interest rate risk.  The swap agreements have been designated as cash flow hedges, and accordingly, the fair value of the interest rate swap contracts is reported in Other Assets or Other Liabilities on the Consolidated Statement of Financial Condition.  The swap agreements were entered into with a third-party financial institution.  The Corporation is

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party to master netting arrangements with its financial institution counterparty; however, the Corporation does not offset assets and liabilities under these arrangements for financial statement presentation purposes.  The master netting arrangements provide for a single net settlement of all swap agreements, as well as collateral, in the event of default on, or termination of, any one contract.  Collateral, in the form of cash and investment securities, are pledged by the Corporation as the counterparty with net liability positions in accordance with contract thresholds.  See Note 13 to the Consolidated Financial Statements for more information.



Securities Sold Under Agreements to Repurchase (“Repurchase Agreements”)



The Bank enters into agreements under which it sells interests in U.S. securities to certain customers subject to an obligation to repurchase, and on the part of the customers to resell, such interests.  Under these arrangements, the Bank may transfer legal control over the assets but still retain effective control through an agreement that both entitles and obligates the Bank to repurchase the assets.  As a result, these repurchase agreements are accounted for as collateralized financing arrangements (i.e., secured borrowings) and not as a sale and subsequent repurchase of securities.  The obligation to repurchase the securities is reflected as a liability in the Consolidated Statement of Condition, while the securities underlying the repurchase agreements remain in the respective investment securities asset accounts.  There is no offsetting or netting of the investment securities assets with the repurchase agreement liabilities.  In addition, as the Bank does not enter into reverse repurchase agreements, there is no such offsetting to be done with the repurchase agreements.  The right of setoff for a repurchase agreement resembles a secured borrowing, whereby the collateral would be used to settle the fair value of the repurchase agreement should the Bank be in default (i.e. fails to repurchase the U.S. securities on the maturity date of the agreement).  The investment security collateral, maintained at 102% of the borrowing, is held by a third party financial institution in the counterparty’s custodial account.



The following table presents the assets and liabilities subject to an enforceable master netting arrangement or repurchase agreements at March 31, 2020 and December 31, 2019.  



 



Note 15 - Goodwill



Goodwill is not amortized but is tested for impairment annually or more frequently if events or changes in circumstances indicate that the asset might be impaired. The Corporation is considered the only reporting unit.  Impairment testing requires that the fair value of each of the Corporation’s reporting units be compared to the carrying amount of its net assets, including goodwill.  If the fair value of the reporting unit exceeds the carrying value, no additional testing is required, and an impairment loss is not recognized. Otherwise, an impairment loss is recognized to the extent the carrying value exceeds fair value but is limited to the amount of goodwill.  The annual impairment test was completed in December 2019 and no impairment was recognized.

 

The emergence of COVID-19 as a global pandemic during the first quarter of 2020 has resulted in significant deterioration in the economic environment which has impacted expected earnings and the price of the Corporation’s common stock.  These events are considered triggering events requiring interim testing and, accordingly, we performed an analysis to determine whether the Corporation’s fair value exceeds its carrying value in March 31, 2020.  Based on the analysis, fair value continues to exceed carrying value and, therefore, no impairment was recognized. In the event of a prolonged economic uncertainty or further deterioration in the economic outlook, continued assessments of our goodwill will likely be required in future periods.

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Note 16 – Adoption of New Accounting Standards and Effects of New Accounting Pronouncements



In June 2016, the FASB issued Accounting Standards Update (“ASU”) 2016-13, Financial Instruments- Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments.  ASU 2016-13 introduces an approach based on expected losses to estimate credit losses on certain types of financial instruments.  It also modifies the impairment model for available-for-sale debt securities and provides for a simplified accounting model for purchases financial assets with credit deterioration since their origination.  The new model referred to as current expected credit losses (“CECL”) model, will apply to: (a) financial assets subject to credit losses and measured at amortized cost; and (b) certain off-balance sheet credit exposures.  This includes loans, held to maturity debt securities, loan commitments, financial guarantees and net investments in leases as well as reinsurance and trade receivables.  The estimate of expected credit losses should consider historical information, current information, and supportable forecasts, including estimates of prepayments.  ASU 2016-13 was originally effective for SEC filers for annual periods beginning after December 15, 2019, and interim periods within those annual periods.  In November 2019, the FASB approved a delay of the required implementation date of ASU No. 2016-13 for smaller reporting companies, as defined by the SEC, including the Corporation, resulting in a required implementation date for the Corporation of January 1, 2023. 



In August 2018, the FASB issued ASU 2018-13, “Fair Value Measurement (Topic 820)” - Changes to the Disclosure Requirements for Fair Value Measurement. This ASU modifies the disclosure requirements on fair value measurements by requiring that Level 3 fair value disclosures include the range and weighted average of significant unobservable inputs used to develop those fair value measurements. For certain unobservable inputs, an entity may disclose other quantitative information in lieu of the weighted average if the entity determines that other quantitative information would be a more reasonable and rational method to reflect the distribution of unobservable inputs used to develop Level 3 fair value measurements. ASU 2018-13 became effective for the Corporation on January 1, 2020 and did not have a significant impact on its financial condition or results of operations.



In March 2020, the FASB issued ASU No. 2020-04, “Reference Rate Reform (Topic 848).”  The ASU provides optional expedients and exceptions for applying GAAP to contracts, hedging relationships, and other transactions affected by reference rate reform if certain criteria are met.  The amendment only applies to contracts, hedging relationships, and other transactions that reference LIBOR or another reference rate expected to be discontinued because of the reference rate reform.  The ASU is effective as of March 12, 2020 through December 31, 2022.  The Corporation is in the process of evaluating the impact of this standard but believes that its adoption will not have a material impact on the Corporation’s financial condition or results of operations.



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



INTRODUCTION



The following discussion and analysis is intended as a review of material changes in and significant factors affecting the financial condition and results of operations of First United Corporation and its consolidated subsidiaries for the periods indicated.  This discussion and analysis should be read in conjunction with the unaudited consolidated financial statements and the notes thereto contained in Item 1 of Part I of this report, as well as the audited consolidated financial statements and related notes included in First United Corporation’s Annual Report on Form 10-K for the year ended December 31, 2019.



Unless the context clearly suggests otherwise, references in this report to “us”, “we”, “our”, and “the Corporation” are to First United Corporation and its consolidated subsidiaries.



FORWARD-LOOKING STATEMENTS



This report contains forward-looking statements as defined by the Private Securities Litigation Reform Act of 1995.  Forward-looking statements do not represent historical facts, but are statements about management's beliefs, plans and objectives about the future, as well as its assumptions and judgments concerning such beliefs, plans and objectives.  These statements are evidenced by terms such as "anticipate," "estimate," "should," "expect," "believe," "intend," and similar expressions.  Although these statements reflect management's good faith beliefs and projections, they are not guarantees of future performance and they may not prove true.  The beliefs, plans and objectives on which forward-looking statements are based involve risks and uncertainties that could cause actual results to differ materially from those addressed in the forward-looking statements.  For a discussion of these risks and uncertainties, see the section of the periodic reports that First United Corporation files with the Securities and Exchange Commission entitled "Risk Factors", including the risk factor set forth in First United Corporation’s Annual Report on Form 10-K, as amended, for the year ended December 31, 2019 entitled, “The outbreak of the recent coronavirus (‘COVID-19’), or an outbreak of another highly infectious or contagious disease, could adversely affect the Corporation’s business, financial condition and results of operations.” and any updates thereto that might be contained in subsequent reports filed by First United Corporation.  The risks and uncertainties associated with the COVID-19 pandemic and its impact on the Corporation will depend on, among other things, the length of time that the pandemic continues; the duration of shelter-in-place orders and the potential imposition of further restrictions on travel in the future; the effect of the pandemic on the global, national, and local economies and on the businesses of our borrowers and their ability to make payments on their obligations; the remedial actions and stimulus measures adopted by federal, state, and local governments; and the inability of employees to work due to illness, quarantine, or government mandates.



FIRST UNITED CORPORATION



First United Corporation is a Maryland corporation chartered in 1985 and a bank holding company registered with the Board of Governors of the Federal Reserve System (the “FRB”) under the Bank Holding Company Act of 1956, as amended.   The Corporation’s primary business is serving as the parent company of First United Bank & Trust, a Maryland trust company (the “Bank”), First United Statutory Trust I (“Trust I”) and First United Statutory Trust II (“Trust II”), both Connecticut statutory business trusts. 

(Trust I and Trust II, the “Trusts”).  The Trusts were formed for the purpose of selling trust preferred securities that qualified as Tier 1 capital.  The Bank has two consumer finance company subsidiaries - OakFirst Loan Center, Inc., a West Virginia corporation, and OakFirst Loan Center, LLC, a Maryland limited liability company - and two subsidiaries that it uses to hold real estate acquired through foreclosure or by deed in lieu of foreclosure - First OREO Trust, a Maryland statutory trust, and FUBT OREO I, LLC, a Maryland limited liability company. 



At March 31, 2020, the Corporation’s total assets were $1.5 billion, net loans were $1.0 billion, and deposits were $1.2 billion.  Shareholders’ equity at March 31, 2020 was $118.5 million.



The Corporation maintains an Internet site at www.mybank.com on which it makes available, free of charge, its Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and all amendments to the foregoing as soon as reasonably practicable after these reports are electronically filed with, or furnished to, the SEC.

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ESTIMATES AND CRITICAL ACCOUNTING POLICIES



This discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America.  The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent liabilities.  (See Note 1 of the Notes to Consolidated Financial Statements included in Item 8 of Part II of First United Corporation’s Annual Report on Form 10-K for the year ended December 31, 2019). On an on-going basis, management evaluates estimates, including those related to loan losses and potential impairment of goodwill, other-than-temporary impairment (“OTTI”) of investment securities, income taxes, fair value of investments and pension plan assumptions.  Management bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.  Management believes the following critical accounting policies affect our more significant judgments and estimates used in the preparation of the consolidated financial statements.



Management does not believe that any material changes in our critical accounting policies have occurred since December 31, 2019.



Allowance for Loan Losses



One of our most important accounting policies is that related to the monitoring of the loan portfolio.  A variety of estimates impact the carrying value of the loan portfolio, including the calculation of the allowance for loan losses (the “ALL”), the valuation of underlying collateral, the timing of loan charge-offs and the placement of loans on non-accrual status. The ALL is established and maintained at a level that management believes is adequate to cover losses resulting from the inability of borrowers to make required payment on loans. Estimates for loan losses are arrived at by analyzing risks associated with specific loans and the loan portfolio, current and historical trends in delinquencies and charge-offs, and changes in the size and composition of the loan portfolio. The analysis also requires consideration of the economic climate and outlook, including the economic conditions specific to Western Maryland and Northeastern West Virginia, changes in lending rates, political conditions, and legislation impacting the banking industry.  Because the calculation of the ALL relies on management’s estimates and judgments relating to inherently uncertain events, actual results may differ from management’s estimates.



Goodwill



Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 350, Intangibles - Goodwill and Other, establishes standards for the amortization of acquired intangible assets and impairment assessment of goodwill.  The $11.0 million recorded as goodwill at March 31, 2020 is primarily related to the Bank’s 2003 acquisition of Huntington National Bank branches and is not subject to periodic amortization. 



Goodwill arising from business combinations represents the value attributable to unidentifiable intangible elements in the business acquired. Goodwill is not amortized but is tested for impairment annually or more frequently if events or changes in circumstances indicate that the asset might be impaired. Impairment testing requires that the fair value of each of the Corporation’s reporting units be compared to the carrying amount of its net assets, including goodwill.  If the estimated current fair value of the reporting unit exceeds the carrying value, no additional testing is required and an impairment loss is not recorded. Otherwise, additional testing is performed, and to the extent such additional testing results in a conclusion that the carrying value of goodwill exceeds its implied fair value, an impairment loss is recognized.



Our goodwill relates to value inherent in the banking business, and that value is dependent upon our ability to provide quality, cost effective services in a highly competitive local market.  This ability relies upon continuing investments in processing systems, the development of value-added service features and the ease of use of our services.  As such, goodwill value is ultimately supported by revenue that is driven by the volume of business transacted.  A decline in earnings as a result of a lack of growth or the inability to deliver cost effective services over sustained periods can lead to impairment of goodwill, which could adversely impact earnings in future periods.  ASC Topic 350 requires an annual evaluation of goodwill for impairment and a re-valuation at an interim period if there have been indications of impairment. The determination of whether or not these assets are impaired involves significant judgments and estimates. 



The emergence of COVID-19 as a global pandemic during the first quarter of 2020 has resulted in significant deterioration in the economic environment which has impacted expected earnings and the price of the Corporation’s common stock.  These events are considered triggering events requiring interim testing and, accordingly, we performed an analysis to determine whether the Corporation’s fair value exceeds its carrying value in March 31, 2020.  Based on the analysis, fair value continues to exceed carrying value and, therefore, no impairment was recognized. In the event of a prolonged economic uncertainty or further deterioration in the economic outlook, continued assessments of our goodwill will likely be required in future periods.

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Accounting for Income Taxes



We account for income taxes in accordance with ASC Topic 740, Income Taxes.  Under this guidance, deferred taxes are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases.  Deferred tax assets and liabilities are measured using enacted tax rates that will apply to taxable income in the years in which those temporary differences are expected to be recovered or settled.  Increases or decreases in the value of deferred tax assets and liabilities due to a change in tax rates are recognized as income or expense, respectively, in the period that includes the date on which the change becomes effective.



Management regularly reviews the carrying amount of the Corporation’s net deferred tax assets to determine if the establishment of a valuation allowance is necessary.  If management determines, based on the available evidence, that it is more likely than not that all or a portion of our net deferred tax assets will not be realized in future periods, then a deferred tax valuation allowance will be established.  Consideration is given to various positive and negative factors that could affect the realization of the deferred tax assets.  In evaluating this available evidence, management considers, among other things, historical performance, expectations of future earnings, the ability to carry back losses to recoup taxes previously paid, length of statutory carry forward periods, experience with utilization of operating loss and tax credit carry forwards not expiring, tax planning strategies and timing of reversals of temporary differences.  Significant judgment is required in assessing future earnings trends and the timing of reversals of temporary differences.  Management’s evaluation is based on current tax laws as well as management’s expectations of future performance.



Management expects that our adherence to the required accounting guidance may result in increased volatility in quarterly and annual effective income tax rates because of changes in judgment or measurement including changes in actual and forecasted income before taxes, tax laws and regulations, and tax planning strategies.



Other-Than-Temporary Impairment of Investment Securities



Management systematically evaluates securities for impairment on a quarterly basis.  Based upon application of accounting guidance for subsequent measurement in ASC Topic 320, Investments – Debt and Equity Securities (Section 320-10-35), management assesses whether (a) the Corporation has the intent to sell a security being evaluated and (b) it is more likely than not that the Corporation will be required to sell the security prior to the anticipated recovery of any decline in fair value.  If neither applies, then any decline in the fair value below the security’s cost that is considered an other-than-temporary decline is split into two components.  The first is the loss attributable to declining credit quality.  Credit losses are recognized in earnings as realized losses in the period in which the impairment determination is made.  The second component consists of all other losses, which are recognized in other comprehensive loss.  In estimating OTTI losses, management considers (1) the length of time and the extent to which the fair value has been less than cost, (2) adverse conditions specifically related to the security, an industry, or a geographic area, (3) the historic and implied volatility of the fair value of the security, (4) changes in the rating of the security by a rating agency, (5) recoveries or additional declines in fair value subsequent to the balance sheet date, (6) failure of the issuer of the security to make scheduled interest or principal payments, and (7) the payment structure of the debt security and the likelihood of the issuer being able to make payments that increase in the future.  Management also monitors cash flow projections for securities that are considered beneficial interests under the guidance of ASC Subtopic 325-40, Investments – Other – Beneficial Interests in Securitized Financial Assets, (ASC Section 325-40-35).  This process is described more fully in the Investment Securities section of the Consolidated Balance Sheet Review. 



Fair Value of Investments



We have determined the fair value of our investment securities in accordance with the requirements of ASC Topic 820, Fair Value Measurements and Disclosures, which defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements required under other accounting pronouncements.  The Corporation measures the fair market values of its investments based on the fair value hierarchy established in Topic 820.  The determination of fair value of investments and other assets is discussed further in Note 8 to the consolidated financial statements presented elsewhere in this report.



Pension Plan Assumptions



Our pension plan costs are calculated using actuarial concepts, as discussed within the requirements of ASC Topic 715, Compensation – Retirement Benefits.  Pension expense and the determination of our projected pension liability are based upon two critical assumptions: (a) the discount rate; and (b) the expected return on plan assets.  We evaluate each of these critical assumptions annually.  Other assumptions impact the determination of pension expense and the projected liability including the primary employee demographics, such as retirement patterns, employee turnover, mortality rates, and estimated employer compensation increases.  These factors, along with the critical assumptions, are carefully reviewed by management each year in consultation with our pension plan consultants and actuaries.  Further information about our pension plan assumptions, the plan’s funded status, and other plan information is included in Note 11 to the consolidated financial statements presented elsewhere in this report.    

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Response to COVID-19



Protecting the health, safety, protection and financial well-being of our associates and customers was and continues to be our goal as we quickly adapted to COVID-19. 



The following actions were implemented from our well-designed and tested Business Continuity Plan:























Paycheck Protection Program



The U.S. Government’s Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”) established the Small Business Administration (“SBA”) Paycheck Protection Program (“PPP”) which provides small businesses with resources to maintain payroll, hire back employees who may have been laid off, and to cover applicable overhead expenses.  We acted expeditiously to prepare our associates so they could guide our customers on the proper procedures necessary to enable them to take advantage of this program.  We developed an SBA PPP specific information site within our website that provided detailed information, links and materials for eligible customers to access.  Internally, we reallocated resources to review, process and data enter customer applications, working tirelessly over extended hours to provide access to as many local business owners as possible.   We were able to fund 428 loan applications for approximately $111.0 million from the first tranche of PPP designated funds.  Congress allocated additional funding to the program on April 23, 2020.  Due to our advance preparation and software implementation, we were able to quickly gain approval for an additional 492 loan applications for approximately $29.0 million thru May 1, 2020.  In total, we have gained approval for over $140 million dollars to 920 small business, protecting in excess of 16,000 jobs.  Approximately 73% of the loans were under $100,000 in size and approximately 65% of the businesses receiving the loans employed less than 10 employees.  We will continue to provide access to the PPP and process applications for as long as the PPP is open and funds are available so that we can assist as many small business owners in our markets as possible.    These loans are 100% guaranteed by the SBA, have up to a two year maturity, provide for a six-month deferral period, and have an interest rate of 1%.  These loans may be forgiven by the SBA if the borrower meets certain conditions, including by using at least 75% of the loan proceeds for payroll costs.  The SBA also established processing fees from 1% to 5%, depending on the loan amount.  We anticipate receiving approximately $3.5 million in fees.



In April 2020, the Bank established eligibility to participate in the Paycheck Protection Program Liquidity Facility (“PPPLF”) which was established by Congress and administered by the Federal Reserve Bank.  This facility uses the SBA guaranteed PPP loans as

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collateral, offering 100% collateral coverage with no recourse to the Bank. First United’s Board of Directors (the “Board”) and management feel it is prudent to maintain our existing liquidity facilities available for our contingency funding plan given the current economic conditions.   The majority of the PPP loan disbursements, which were all subsequent to quarter end, have been to internal, non-interest-bearing accounts awaiting use by borrowers.  As a result, we have not yet accessed the PPPLF, but are prepared to utilize the fund when management determines the timing is appropriate.



Liquidity Sources



Management has reviewed its Liquidity Contingency Funding Plan in preparation of funding needs as it relates to the COVID-19 pandemic.  As of March 31, 2020, the Corporation had approximately $115.0 million in unsecured lines of credit with its correspondent banks, $2.1 million with the Federal Reserve Discount Window, and approximately $158.2 million of secured borrowings with the Federal Home Loan Bank of Atlanta.  Additionally, the Corporation has access to the brokered certificates of deposit market.



As noted above, the Corporation is eligible to access the PPPLF when it is deemed appropriate.



Capital 



The Corporation’s and the Bank’s capital ratios are strong, and both institutions are considered to be well-capitalized by applicable regulatory measures. 

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SELECTED FINANCIAL DATA



The following table sets forth certain selected financial data for the three-month periods ended March 31, 2020 and 2019 and is qualified in its entirety by the detailed information and unaudited financial statements, including the notes thereto, included elsewhere in this quarterly report.







Note: (a) Annualized             



RESULTS OF OPERATIONS



Overview



Consolidated net income was $1.8 million for the quarter ended March 31, 2020, compared to $3.2 million for 2019.  Basic and diluted net income per share for the first three months of 2020 were both $.25, compared to basic and diluted net income per share of $.44 for the same period of 2019, a 43% decrease. The decrease in earnings was due to an increase in the provision for loan losses of $2.3 million and a $0.3 million increase in other operating expenses, offset by an increase in net interest income of $0.5 million, a decrease in income tax expense of $0.4 million, and a slight increase of $0.3 million in other operating income and gains.  The increase in provision expense for the first quarter of 2020 was due to the uncertainty of the economic environment related to the COVID-19 health crisis.  While we believe that our borrowers, both consumer and commercial, will be negatively impacted, the extent of this impact is unknown and very uncertain. Accordingly, we believe it was prudent to adjust qualitative factors to increase our first quarter provision expense to account for the rapidly declining economic conditions and the inherent effects on our loan portfolio. Of the $2.7 million expense for the quarter, $2.4 million is related to qualitative factor adjustments and $.3 million is related to loan growth.  The net interest margins, on a fully tax-equivalent (“FTE”) basis, were stable for the quarters ended March 31, 2020 and 2019 at 3.69% and 3.72%, respectively. 

 

The provision for loan losses was $2.7 million for the three-month period ended March 31, 2020 and $0.3 million for the three-month period ended March 31, 2019.  The increase in provision expense for the first quarter of 2020 was due to the uncertainty of the economic environment related to the COVID-19 health crisis.  Of the $2.7 million expense for the quarter, $2.4 million is related to qualitative factor adjustments and $0.3 million is related to loan growth.



Net interest income increased $0.5 million during the first three months of 2020 over the same period in 2019.  Comparing the three-months ended March 31, 2020 to the same period of 2019, the increase in interest income was due to a $0.7 million increase in interest and fees on loans.  The increase in interest and fees on loans was due primarily to an increase in average balances of $39.2 million related to the loan growth in the fourth quarter of 2019.  The rate earned on the loan portfolio increased slightly, by 2 basis points, despite the significant decline in the rate environment over the past year.  The average balance of the investment portfolio decreased by $9.2 million due primarily to calls in the portfolio.  Excess cash balances attributable to deposit growth were invested at the lower Fed Funds rate which negatively offset interest income for the quarter ended March 31, 2020.



Interest expense on our interest-bearing liabilities remained flat during the quarter ended March 31, 2020 when compared to 2019 due to continued rate reductions on our deposit products in response to the declining rate environment, particularly our money market products.  With approximately 75% of our deposit portfolio adjustable, we can respond quickly to declining rates. Average growth of $24.1 million in our non-interest bearing accounts offset the higher interest expense and allowed continued control of our cost of deposits.



Other operating income, including gains, increased $0.3 million for the quarter ended March 31, 2020 when compared to 2019.  The increase was attributable to the $0.1 million increase in Trust and brokerage income despite the significant decline in market values in the latter part of March.  Trust fees are directly impacted by changes in market value. At March 31, 2020, assets under management

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in the Trust Department totaled $821.4 million as compared to $864.8 million at March 31, 2019.  We believe market values will recover but anticipate trust department income may be reduced for the remainder of 2020.  Debit card income remained flat for the quarter ended March 31, 2020 when compared to the same period of 2019.  Service charge income increased $0.2 million for the quarter ended March 31, 2020 when compared to the same period of 2019, as we experienced growth in fee income on our new YouFirst deposit account package.



Other operating expenses increased slightly by $0.3 million for the quarter ended March 31, 2020 when compared to the same period of 2019.  Salaries and benefits decreased $0.3 million due primarily to the reduced headcount as a result of the voluntary separation program implemented in the fourth quarter of 2019 and reduced life and health insurance costs.  These reductions offset the annual merit increases awarded to our associates in April 2019.  FDIC premiums decreased $0.1 million due to a credit received on our quarterly assessments. Equipment, occupancy and technology expenses increased $0.2 million when compared to 2019.  Professional services increased $0.5 million as a result of increased legal and professional expenses.  Other miscellaneous expenses remained flat when compared to 2019 due to our continued focus on expense control.  Increased consulting, fraud expenses, Visa processing fees, and investor relations expense were offset by reductions in schools and seminars, dues and licenses, office supplies, contract labor, business related meals and other employee benefits expenses.



Net Interest Income



Net interest income is our largest source of operating revenue.  Net interest income is the difference between the interest that we earn on our interest-earning assets and the interest expense we incur on our interest-bearing liabilities.  For analytical and discussion purposes, net interest income is adjusted to a FTE basis to facilitate performance comparisons between taxable and tax-exempt assets by increasing tax-exempt income by an amount equal to the federal income taxes that would have been paid if this income were taxable at the statutorily applicable rate.  This is a non-GAAP disclosure and management believes it is not materially different than the corresponding GAAP disclosure.



The table below summarizes net interest income for the three months ended March 31, 2020 and 2019.







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The following table sets forth the average balances, net interest income and expense, and average yields and rates of our interest-earning assets and interest-bearing liabilities for the three-month periods ended March 31, 2020 and 2019:







Note: 



Net interest income, on a non-GAAP, FTE basis, increased $0.5 million (4.6%) during the quarter ended March 31, 2020 when compared to the quarter ended March 31, 2019 due to a $0.5 million (3.7%) increase in interest income.  Interest expense remained stable when comparing the first quarter of 2020 to the first quarter of 2019.  The net interest margin for the quarter ended March 31, 2020 was 3.69%, compared to 3.72% for the quarter ended March 31, 2019, declining only 3 basis points despite a 2.25% drop in the Fed Funds rates year over year.

 

Comparing the three-months ended March 31, 2020 to the same period of 2019, the increase in interest income was due to a $0.7 million increase in interest and fees on loans.  The increase in interest and fees on loans was due primarily to an increase in average balances of $39.2 million related to the loan growth in the fourth quarter of 2019.  The rate earned on the loan portfolio increased slightly, by 2 basis points, despite the significant decline in the rate environment over the past year.  The average balance of the investment portfolio decreased by $9.2 million due primarily to calls in the portfolio.  Excess cash balances attributable to deposit growth were invested at the lower Fed Funds rate which negatively offset interest income for the quarter ended March 31, 2020.

 

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Interest expense on our interest-bearing liabilities remained flat during the quarter ended March 31, 2020 when compared to 2019 due to continued rate reductions on our deposit products in response to the declining rate environment, particularly our money market products.  With approximately 75% of our deposit portfolio adjustable, we can respond quickly to declining rates. Average growth of $24.1 million in our non-interest bearing accounts offset the higher interest expense and allowed continued control of our cost of deposits.



The following table sets forth an analysis of volume and rate changes in interest income and interest expense for our average interest-earning assets and average interest-bearing liabilities for the three-month periods ended March 31, 2020 and 2019:







Note: 





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Provision for Loan Losses



The provision for loan losses was $2.7 million for the three-month period ended March 31, 2020 and $0.3 million for the three-month period ended March 31, 2019.  The increase in provision expense for the first quarter of 2020 was due to the uncertainty of the economic environment related to the COVID-19 health crisis.  While we believe that our borrowers, both consumer and commercial, will be negatively impacted by the COVID-19 pandemic, the extent of this impact is unknown and very uncertain. Accordingly, we believe it was prudent to adjust qualitative factors to increase our first quarter provision expense to account for the rapidly declining economic conditions and the inherent effects on our loan portfolio. Of the $2.7 million expense for the quarter, $2.4 million is related to qualitative factor adjustments and $0.3 million is related to loan growth.



Other Operating Income



The following table shows the major components of other operating income for the three-month periods ended March 31, 2020 and 2019, exclusive of net gains: 







Other Operating Expenses



The composition of other operating expenses for the three-month periods ended March 31, 2020 and 2019 is illustrated in the following table:







Provision for Income Taxes



In reporting interim financial information, income tax provisions should be determined under the procedures set forth in ASC Topic 740, Income Taxes (Section 740-270-30).  This guidance provides that at the end of each interim period, an entity should make its best estimate of the effective tax rate expected to be applicable for the full fiscal year.  The rate so determined should be used in providing for income taxes on a current year-to-date basis.  The effective tax rate should reflect anticipated investment tax credits, capital gains rates, and other available tax planning alternatives.  In arriving at this effective tax rate, however, no effect should be included for the tax related to significant, unusual or extraordinary items that will be separately reported or reported net of their related tax effect in reports for the interim period or for the fiscal year. 



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The effective income tax rate as a percentage of income for the quarter ended March 31, 2020 increased from 21.8% to 22.9% when compared to the same period of 2019, primarily due to the reduction in tax exempt income from the investment portfolio.



FINANCIAL CONDITION



Balance Sheet Overview



Total assets at March 31, 2020 remained stable at $1.4 billion, with an increase of $19.5 million from December 31, 2019.  During the quarter, cash and interest-bearing deposits in other banks increased $22.0 million, the investment portfolio decreased $3.1 million and gross loans increased $1.6 million.  The increase in cash was due to strong deposit growth, cash flow from calls on the investment portfolio, commercial loan payoffs early in the quarter as well as refinances of balances in our mortgage portfolio.   Other real estate owned (“OREO”) balances remained stable as there was minimal activity in this portfolio during the first quarter.  Other assets decreased by $0.9 million. Total liabilities increased $26.9 million.  This increase was attributable to the strong deposit growth of $30.4 million in the first quarter of 2020, offset by a decline in short-term borrowings of $9.3 million. The deposit growth during the first quarter was due to increased relationship balances for customers adding new funds to our insured products.  Our Treasury Management overnight investment sweep decreased $9.3 million as municipalities utilized their existing cash for working capital needs during these unprecedented times. Other liabilities increased $5.9 million due to the change in the market value of the pension plan assets.  Total shareholders’ equity decreased $7.4 million in the first quarter of 2020.  This decrease was due to the increase in accumulated other comprehensive loss related to a decline in the market values of our pension plan assets, the stock repurchase of $2.7 million, and the payment of dividends of $0.9 million in the first quarter of 2020.



Loan Portfolio



The following table presents the composition of our loan portfolio at the dates indicated:







Outstanding loans remained stable at $1.1 billion at March 31, 2020 when compared to December 31, 2019.  Commercial real estate (“CRE”) loans increased $2.2 million due to expansion of customer relationships as well as an increase in small business loans.  Acquisition and development (“A&D”) loans increased $3.4 million as new production offset amortization and payoffs.   Commercial and industrial (“C&I”) loans increased slightly by $1.2 million.  The growth in the commercial portfolios was offset by a decline in residential mortgage loans of $5.2 million as the customer preferred longer-term fixed rate loans were sold to Fannie Mae. Given the current low-rate interest environment, management prefers utilizing the secondary market at this time. The consumer loan portfolio remained stable during the first quarter.  We have not seen an increase in usage on lines of credits to date, but anticipate that these lines will be utilized for cash needs in these uncertain times related to the COVID-19 pandemic.



Commercial loan production for the first quarter of 2020 was approximately $35.0 million of new money, most of which was construction production that has not yet funded.  Amortization and payoffs were approximately $15.0 million in the first quarter.  Despite a decline in balances, the mortgage department had record production of approximately $23.0 million in the first quarter of 2020.  While both in-house and secondary market products are utilized, the longer-term fixed rate loans are primarily being sold to Fannie Mae. We continue to book first time homebuyer, adjustable rate and non-conforming jumbo mortgages to our portfolio. The mortgage pipeline remains strong at $32.0 million.  We anticipate reduced loan demand for the remainder of 2020, which may impact the net interest margin.

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Risk Elements of Loan Portfolio



The following table presents the risk elements of our loan portfolio at the dates indicated.  Management is not aware of any potential problem loans other than those listed in this table or discussed below.









Performing loans considered to be impaired (including performing troubled debt restructurings, or TDRs), as defined and identified by management, amounted to $4.3 million at March 31, 2020 and December 31, 2019.  Loans are identified as impaired when, based on current information and events, management determines that we will be unable to collect all amounts due according to contractual terms.  These loans consist primarily of A&D loans and CRE loans.  The fair values are generally determined based upon independent third-party appraisals of the collateral or discounted cash flows based upon the expected proceeds.  Specific allocations have been made where management believes there is insufficient collateral to repay the loan balance if liquidated and there is no secondary source of repayment available.



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The following table presents the details of impaired loans that are TDRs by class at March 31, 2020 and December 31, 2019:





The level of TDRs remained stable at $4.1 million at March 31, 2020 when compared to December 31, 2019, with a slight reduction due to payments made during the quarter.  There were no new TDRs during the first quarter of 2020.



Allowance and Provision for Loan Losses 



The ALL is maintained to absorb losses from the loan portfolio.  The ALL is based on management’s continuing evaluation of the quality of the loan portfolio, assessment of current economic conditions, diversification and size of the portfolio, adequacy of collateral, past and anticipated loss experience, and the amount of non-performing loans.



The ALL is also based on estimates, and actual losses will vary from current estimates.  These estimates are reviewed quarterly, and as adjustments, either positive or negative, become necessary, a corresponding increase or decrease is made in the ALL.  The methodology used to determine the adequacy of the ALL is consistent with prior years.  An estimate for probable losses related to unfunded lending commitments, such as letters of credit and binding but unfunded loan commitments is also prepared.  This estimate is computed in a manner similar to the methodology described above, adjusted for the probability of actually funding the commitment.



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The following table presents a summary of the activity in the ALL for the three months ended March 31:







The ALL was $15.0 million at March 31, 2020 compared to $12.5 million at December 31, 2019, an increase of 20% that primarily resulted from the adjustment to qualitative factors associated with the negative trend in economic outlook directly related to COVID-19.  The provision for loan losses was $2.7 million for the quarter ended March 31, 2020 and $0.3 million for the quarter ended March 31, 2019.  Net charge-offs of $0.2 million were recorded for the first three months of 2020, compared to net recoveries of $0.2 million for 2019. Absent the COVID-19 related factor adjustments attributable to $2.4 million in provision expense for the quarter, the provision expense would have been approximately $0.3 million. The ratio of the ALL to loans outstanding was 1.42% at March 31, 2020 and 1.15% at March 31, 2019. 



The ratio of net charge offs to average loans for the quarter ended March 31, 2020 was an annualized 0.07%, compared to net recoveries to average loans of 0.06% for the quarter ended March 31, 2019.  The CRE portfolio had an annualized net recovery rate of .08% as of March 31, 2020, compared to a net recovery rate of 0.04% as of March 31, 2019.  The A&D loans had an annualized net charge-off rate of 0.00% as of March 31, 2020, compared to a net charge-off rate of 0.06% as of March 31, 2019.  The C&I portfolio had net charge-offs to average loans of 0.28% as of March 31, 2020, compared to a net recovery rate of 0.18% as of March 31, 2019.  The residential mortgage ratios were a net charge-off rate of 0.07% as of March 31, 2020, compared to a net recovery rate of 0.09% as of March 31, 2019, and the consumer loan ratios were net charge-off rates of 0.95% and 0.08% as of March 31, 2020 and March 31, 2019, respectively.  Our special assets team continues to aggressively collect on charged-off loans.



Management believes that the ALL at March 31, 2020 is adequate to provide for probable losses inherent in our loan portfolio.  Amounts that will be recorded for the provision for loan losses in future periods will depend upon trends in the loan balances, including the composition of the loan portfolio, changes in loan quality and loss experience trends, potential recoveries on previously charged-off loans and changes in other qualitative factors.  Management also applies interest rate risk, collateral value and debt service sensitivity analyses to the Commercial real estate loan portfolio and obtains new appraisals on specific loans under defined parameters to assist in the determination of the periodic provision for loan losses.



Investment Securities



At March 31, 2020, the total amortized cost basis of the available-for-sale investment portfolio was $134.3 million, compared to a fair value of $130.8 million.  Unrealized gains and losses on securities available-for-sale are reflected in accumulated other comprehensive loss, a component of shareholders’ equity.  The amortized cost basis of the held to maturity portfolio was $91.4 million, compared to a fair value of $98.3 million. 



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The following table presents the composition of our securities portfolio at amortized cost and fair values at the dates indicated:







Total fair value of investment securities available-for-sale decreased by $0.5 million since December 31, 2019.  At March 31, 2020, the securities classified as available-for-sale included a net unrealized loss of $3.5 million, which represents the difference between the fair value and amortized cost of securities in the portfolio.



As discussed in Note 8 to the consolidated financial statements presented elsewhere in this report, the Corporation measures fair market values based on the fair value hierarchy established in ASC Topic 820, Fair Value Measurements and Disclosures. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). Level 3 prices or valuation techniques require inputs that are both significant to the valuation assumptions and are not readily observable in the market (i.e. supported with little or no market activity).  These Level 3 instruments are valued based on both observable and unobservable inputs derived from the best available data, some of which is internally developed, and considers risk premiums that a market participant would require. 



Approximately $118.4 million of the available-for-sale portfolio was valued using Level 2 pricing and had net unrealized gains of $2.5 million at March 31, 2020.  The remaining $12.4 million of the securities available-for-sale represents the entire CDO portfolio, which was valued using significant unobservable inputs (Level 3 assets).  The $6.1 million in net unrealized losses associated with this portfolio relates to 9 pooled trust preferred securities that comprise the CDO portfolio. Net unrealized losses of $4.5 million represent non-credit related OTTI charges on seven of the securities, while $1.6 million of unrealized losses relates to two securities which have had no credit related OTTI. 



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The following table provides a summary of the trust preferred securities in the CDO portfolio and the credit status of these securities as of March 31, 2020:





*Security has been deemed other-than-temporarily impaired and loss has been recognized in accordance with ASC Section 320-10-35.





The terms of the debentures underlying trust preferred securities allow the issuer of the debentures to defer interest payments for up to 20 quarters, and, in such case, the terms of the related trust preferred securities allow their issuers to defer dividend payments for up to 20 quarters.  Some of the issuers of the trust preferred securities in our investment portfolio have defaulted and/or deferred payments ranging from 5.48% to 14.83% of the total collateral balances underlying the securities.  The securities were designed to include structural features that provide investors with credit enhancement or support to provide default protection by subordinated tranches.  These features include over-collateralization of the notes or subordination, excess interest or spread which will redirect funds in situations where collateral is insufficient, and a specified order of principal payments.  There are securities in our portfolio that are under-collateralized, which does represent additional stress on our tranche.  However, in these cases, the terms of the securities require excess interest to be redirected from subordinate tranches as credit support, which provides additional support to our investment.



Management systematically evaluates securities for impairment on a quarterly basis.  Based upon application of ASC Topic 320 (Section 320-10-35), management must assess whether (a) the Corporation has the intent to sell the security and (b) it is more likely than not that the Corporation will be required to sell the security prior to its anticipated recovery.  If neither applies, then declines in the fair value of securities below their cost that are considered other-than-temporary declines are split into two components.  The first is the loss attributable to declining credit quality.  Credit losses are recognized in earnings as realized losses in the period in which the impairment determination is made.  The second component consists of all other losses.  The other losses are recognized in other comprehensive income.  In estimating OTTI charges, management considers (1) the length of time and the extent to which the fair value has been less than cost, (2) adverse conditions specifically related to the security, an industry, or a geographic area, (3) the historic and implied volatility of the security, (4) changes in the rating of a security by a rating agency, (5) recoveries or additional declines in fair value subsequent to the balance sheet date, (6) failure of the issuer of the security to make scheduled interest payments, and (7) the payment structure of the debt security and the likelihood of the issuer being able to make payments that increase in the future.  Due to the duration and the significant market value decline in the pooled trust preferred securities held in our portfolio, we performed more extensive testing on these securities for purposes of evaluating whether or not an OTTI has occurred. 



The market for these securities as of March 31, 2020 is not active and markets for similar securities are also not active.  The inactivity was evidenced first by a significant widening of the bid-ask spread in the brokered markets in which these securities trade and then by a significant decrease in the volume of trades relative to historical levels.  The new issue market is also inactive, as no new CDOs have been issued since 2007.  There are currently very few market participants who are willing to effect transactions in these securities.  The market values for these securities, or any securities other than those issued or guaranteed by the U.S. Department of the Treasury (the “Treasury”), are very depressed relative to historical levels.  Therefore, in the current market, a low market price for a particular bond may only provide evidence of stress in the credit markets in general rather than being an indicator of credit problems with a particular issue.  Given the conditions in the current debt markets and the absence of observable transactions in the secondary and new issue markets, management has determined that (a) the few observable transactions and market quotations that are available are not reliable for the purpose of obtaining fair value at March 31, 2020, (b) an income valuation approach technique (i.e. present value) that maximizes the use of relevant unobservable inputs and minimizes the use of observable inputs will be equally or more representative of fair value than a market approach, and (c) the CDO segment is appropriately classified within Level 3 of the valuation hierarchy because management determined that significant adjustments were required to determine fair value at the measurement date.

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Management utilizes on an independent third party to prepare both the evaluations of OTTI and the fair value determinations for the CDO portfolio.  Management does not believe that there were any material differences in the OTTI evaluations and pricing between December 31, 2019 and March 31, 2020.



The approach used by the third party to determine fair value involved several steps, which included detailed credit and structural evaluation of each piece of collateral in each bond, projection of default, recovery and prepayment/amortization probabilities for each piece of collateral in the bond, and discounted cash flow modeling. The discount rate methodology used by the third party combines a baseline current market yield for comparable corporate and structured credit products with adjustments based on evaluations of the differences found in structure and risks associated with actual and projected credit performance of each CDO being valued.  Currently, the only active and liquid trading market that exists is for stand-alone trust preferred securities, with a limited market for highly-rated CDO securities that are more senior in the capital structure than the securities in the CDO portfolio.  Therefore, adjustments to the baseline discount rate are also made to reflect the additional leverage found in structured instruments.



Based upon a review of credit quality and the cash flow tests performed by the independent third party, management determined that no securities had credit-related OTTI during the first three months of 2020.   Additionally, there has been no change in the performing collateral, no decline in the percentage of deferrals/defaults to original collateral, and increases in collateral support for each of the positions held by the Corporation.



Deposits



The following table presents the composition of our deposits at the dates indicated:





Total deposits at March 31, 2020 increased $30.4 million when compared to deposits at December 31, 2019.  During the first quarter of 2020, non-interest-bearing deposits increased $5.3 million. This growth was driven by both our retail and commercial markets. Traditional savings accounts increased $5.6 million, as our Prime Saver product continued to be the savings product of choice.  Total demand deposits increased by $2.3 million and total money market accounts increased by $22.6 million, due primarily to growth in our variable rate Value Money Market account introduced in late 2019.  Time deposits less than $100,000 decreased by $1.5 million and time deposits greater than $100,000 decreased by $3.9 million.  The decline in time deposits greater than $100,000 was primarily related to a local municipality utilizing a maturing certificate of deposit for cash needs during this unprecedented economic environment. 



Borrowed Funds



The following table presents the composition of our borrowings at the dates indicated:





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Total short-term borrowings decreased by $9.3 million during the first three months of 2020.  This decrease is due to the decline in our Treasury Management overnight investment sweep as municipalities utilized their existing cash for working capital needs during these unprecedented times.  Long-term borrowings remained constant during the first three months of 2020.



Liquidity Management



Liquidity is a financial institution’s capability to meet customer demands for deposit withdrawals while funding all credit-worthy loans.  The factors that determine the institution’s liquidity are:





We actively manage our liquidity position through regular meetings of a sub-committee of executive management, known as the Treasury Team, which looks forward 12 months at 30-day intervals.  The measurement is based upon the projection of funds sold or purchased position, along with ratios and trends developed to measure dependence on purchased funds and core growth.  Monthly reviews by management and quarterly reviews by the Asset and Liability Committee under prescribed policies and procedures are designed to ensure that we will maintain adequate levels of available funds.



It is our policy to manage our affairs so that liquidity needs are fully satisfied through normal Bank operations.  That is, the Bank will manage its liquidity to minimize the need to make unplanned sales of assets or to borrow funds under emergency conditions.  The Bank will use funding sources where the interest cost is relatively insensitive to market changes in the short run (periods of one year or less) to satisfy operating cash needs.  The remaining normal funding will come from interest-sensitive liabilities, either deposits or borrowed funds.  When the marginal cost of needed wholesale funding is lower than the cost of raising this funding in the retail markets, the Corporation may supplement retail funding with external funding sources such as:





Management believes that we have adequate liquidity available to respond to current and anticipated liquidity demands and is not aware of any trends or demands, commitments, events or uncertainties that are likely to materially affect our ability to maintain liquidity at satisfactory levels.  Please refer to the section of this Item 2 entitled “Response to COVID-19” for more details on our primary sources of liquidity.



Market Risk and Interest Sensitivity



Our primary market risk is interest rate fluctuation.  Interest rate risk results primarily from the traditional banking activities that we engage in, such as gathering deposits and extending loans.  Many factors, including economic and financial conditions, movements in interest rates and consumer preferences affect the difference between the interest earned on our assets and the interest paid on our liabilities.  Interest rate sensitivity refers to the degree that earnings will be impacted by changes in the prevailing level of interest rates.  Interest rate risk arises from mismatches in the repricing or maturity characteristics between interest-bearing assets and liabilities.  Management seeks to minimize fluctuating net interest margins, and to enhance consistent growth of net interest income through periods of changing interest rates.  Management uses interest sensitivity gap analysis and simulation models to measure and manage these risks.  The interest rate sensitivity gap analysis assigns each interest-earning asset and interest-bearing liability to a time frame reflecting its next repricing or maturity date.  The differences between total interest-sensitive assets and liabilities at each time interval represent the interest sensitivity gap for that interval.  A positive gap generally indicates that rising interest rates during a given interval will increase net interest income, as more assets than liabilities will reprice. A negative gap position would benefit us during a period of declining interest rates. 



At March 31, 2020, we were asset sensitive.



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Our interest rate risk management goals are:





In order to manage interest sensitivity risk, management formulates guidelines regarding asset generation and pricing, funding sources and pricing, and off-balance sheet commitments.  These guidelines are based on management’s outlook regarding future interest rate movements, the state of the regional and national economy, and other financial and business risk factors.  Management uses computer simulations to measure the effect on net interest income of various interest rate scenarios.  Key assumptions used in the computer simulations include cash flows and maturities of interest rate sensitive assets and liabilities, changes in asset volumes and pricing, and management’s capital plans.  This modeling reflects interest rate changes and the related impact on net interest income over specified periods. 



We evaluate the effect of a change in interest rates of +/-100 basis points to +/-400 basis points on both NII and Net Portfolio Value (“NPV”) / Economic Value of Equity (“EVE”).  We concentrate on NII rather than net income as long as NII remains the significant contributor to net income.



NII modeling allows management to view how changes in interest rates will affect the spread between the yield paid on assets and the cost of deposits and borrowed funds.  Unlike traditional Gap modeling, NII modeling takes into account the different degree to which installments in the same repricing period will adjust to a change in interest rates. It also allows the use of different assumptions in a falling versus a rising rate environment.  The period considered by the NII modeling is the next eight quarters.



NPV / EVE modeling focuses on the change in the market value of equity. NPV / EVE is defined as the market value of assets less the market value of liabilities plus/minus the market value of any off-balance sheet positions.  By effectively looking at the present value of all future cash flows on or off the balance sheet, NPV / EVE modeling takes a longer-term view of interest rate risk.  This complements the shorter-term view of the NII modeling.



Measures of NII at risk produced by simulation analysis are indicators of an institution’s short-term performance in alternative rate environments.  These measures are typically based upon a relatively brief period, usually one year.  They do not necessarily indicate the long-term prospects or economic value of the institution.



Based on the simulation analysis performed at March 31, 2020 and December 31, 2019, management estimated the following changes in net interest income, assuming the indicated rate changes:







This estimate is based on assumptions that may be affected by unforeseeable changes in the general interest rate environment and any number of unforeseeable factors.  Rates on different assets and liabilities within a single maturity category adjust to changes in interest rates to varying degrees and over varying periods of time.  The relationships between lending rates and rates paid on purchased funds are not constant over time.  Management can respond to current or anticipated market conditions by lengthening or shortening the Bank’s sensitivity through loan repricings or changing its funding mix.  The rate of growth in interest-free sources of funds will influence the level of interest-sensitive funding sources.  In addition, the absolute level of interest rates will affect the volume of earning assets and funding sources.  As a result of these limitations, the interest-sensitive gap is only one factor to be considered in estimating the net interest margin.



Management believes that no material changes in our market risks, our procedures used to evaluate and mitigate those risks, or our actual or simulated sensitivity positions have occurred since December 31, 2019.  Our NII simulation analysis as of December 31,

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2019 is included in Item 7 of Part II Item 7 of Part II of our Annual Report on Form 10-K for the year ended December 31, 2019 under the heading “Market Risk and Interest Sensitivity.



Impact of Inflation – Our assets and liabilities are primarily monetary in nature, and as such, future changes in prices do not affect the obligations to pay or receive fixed and determinable amounts of money.  During inflationary periods, monetary assets lose value in terms of purchasing power and monetary liabilities have corresponding purchasing power gains.  The concept of purchasing power is not an adequate indicator of the impact of inflation on financial institutions because it does not incorporate changes in our earnings.



Capital Resources



We require capital to fund loans, satisfy our obligations under the Bank’s letters of credit, meet the deposit withdrawal demands of the Bank’s customers, and satisfy our other monetary obligations.  To the extent that deposits are not adequate to fund our capital requirements, we can rely on the funding sources identified above under the heading “Liquidity Management”.  At March 31, 2020, the Bank had $115.0 million available through unsecured lines of credit with correspondent banks, $2.1 million available through a secured line of credit with the Fed Discount Window and approximately $158.2 million available through the FHLB.  Management is not aware of any demands, commitments, events or uncertainties that are likely to materially affect our ability to meet our future capital requirements.    



In addition to operational requirements, the Bank and the Corporation are subject to risk-based capital regulations, which were adopted and are monitored by federal banking regulators.  These regulations are used to evaluate capital adequacy and require an analysis of an institution’s asset risk profile and off-balance sheet exposures, such as unused loan commitments and stand-by letters of credit.   Based on capital ratios at March 31, 2020, both the Bank and First United Corporation are considered to be well-capitalized.





The following table presents our capital ratios as of the dates indicated:





Contractual Obligations, Commitments and Off-Balance Sheet Arrangements



Contractual Obligations



The Corporation enters into contractual obligations in the normal course of business.  Among these obligations are FHLB advances and junior subordinated debentures, operating lease agreements for banking and subsidiaries’ offices and for data processing and telecommunications equipment.  Comparing March 31, 2020 to December 31, 2019, short-term borrowings decreased $9.3 million, primarily due to the decline in our Treasury Management overnight investment sweep accounts as municipalities utilized their cash for working capital needs during these unprecedented times.



Commitments



Loan commitments are made to accommodate the financial needs of our customers.  Letters of credit commit us to make payments on behalf of customers when certain specified future events occur.  The credit risks inherent in loan commitments and letters of credit are essentially the same as those involved in extending loans to customers, and these arrangements are subject to our normal credit policies.  We are not a party to any other off-balance sheet arrangements. 

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Commitments to extend credit in the form of consumer, commercial and business at the dates indicated were as follows:







The increase of $25.9 million in commitments at March 31, 2020 compared to December 31, 2019 was due to increased demand for consumer and commercial construction early in the quarter.  Management will continue to monitor these balances as the COVID-19 pandemic has slowed the underlying projects and disbursements of funds.

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Item 3.  Quantitative and Qualitative Disclosures about Market Risk



The information required by this item is included in Item 2 of Part I of this report under the caption “Market Risk and Interest Sensitivity” and in Item 7 of Part II of First United Corporation’s Annual Report on Form 10-K for the year ended December 31, 2019 under the heading “Market Risk and Interest Sensitivity” both of which are incorporated in this Item 3 by reference.



Item 4.  Controls and Procedures



We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our reports filed under the Securities Exchange Act of 1934 with the SEC, such as this Quarterly Report, is recorded, processed, summarized and reported within the periods specified in those rules and forms, and that such information is accumulated and communicated to our management, including First United Corporation’s principal executive officer (“PEO”) and its principal financial officer (“PFO”), as appropriate, to allow for timely decisions regarding required disclosure.  A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met.  Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs.  These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake.  Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control.  The design of any system of controls is also based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. 



An evaluation of the effectiveness of these disclosure controls as of March 31, 2020 was carried out under the supervision and with the participation of management, including the PEO and the PFO.  Based on that evaluation, management, including the PEO and the PFO, has concluded that our disclosure controls and procedures are, in fact, effective at the reasonable assurance level. 



During the quarter ended March 31, 2020, there was no change in our internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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Part II.  OTHER INFORMATION



Item 1.  Legal Proceedings



None.



Item 1A.  Risk Factors



The risks and uncertainties to which our financial condition and operations are subject are discussed in detail in Item 1A of Part I of First United Corporation’s Annual Report on Form 10-K for the year ended December 31, 2019.  Management does not believe that any material changes in our risk factors have occurred since they were last disclosed.

 

Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds



The following table provides information about shares of common stock purchased by or on behalf of First United Corporation and its affiliates (as defined by Exchange Act Rule 10b-18) during the three-month period ended March 31, 2020:









   

Item 3.  Defaults upon Senior Securities



None. 



Item 4.  Mine Safety Disclosures



Not Applicable.



Item 5.  Other Information



None.



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Item 6.  Exhibits



The exhibits filed or furnished with this quarterly report are listed in the following Exhibit Index.







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SIGNATURES



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





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