| · | Comparison of the estimated current book value to that of updated listed sales prices on our real estate owned and that of similar properties (not owned by the Company). |
WaterStone Bank also establishes valuation allowances based on an evaluation of the various risk components that are inherent in the credit portfolio (general component). The risk components that are evaluated include past loan loss experience; the level of non-performing and classified assets; current economic conditions; volume, growth, and composition of the loan portfolio; adverse situations that may affect the borrower's ability to repay; the estimated value of any underlying collateral; regulatory guidance; and other relevant factors. The allowance is increased by provisions charged to earnings and recoveries of previously charged-off loans and reduced by charge-offs. Charge-offs approximate the amount by which the outstanding principal balance exceeds the estimated net realizable value of the underlying collateral. The adequacy of the allowance for loan losses is reviewed and approved quarterly by the WaterStone Bank board of directors. The allowance reflects management's best estimate of the amount needed to provide for the probable loss on impaired loans and other inherent losses in the loan portfolio, and is based on a risk model developed and implemented by management and approved by the WaterStone Bank board of directors.
Actual results could differ from this estimate, and future additions to the allowance may be necessary based on unforeseen changes in loan quality and economic conditions. More specifically, if our future charge-off experience increases substantially from our past experience; or if the value of underlying loan collateral, in our case real estate, declines in value by a substantial amount; or if unemployment in our primary market area increases significantly; our allowance for loan losses may be inadequate and we will incur higher provisions for loan losses and lower net income in the future.
In addition, state and federal regulators periodically review the WaterStone Bank allowance for loan losses. Such regulators have the authority to require WaterStone Bank to recognize additions to the allowance at the time of their examination.
Income Taxes. The Company and its subsidiaries file consolidated federal and combined and separate entity state income tax returns. The provision for income taxes is based upon income in the consolidated financial statements, rather than amounts reported on the income tax return. Deferred tax assets and liabilities 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 as well as for net operating loss carry forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized as income or expense in the period that includes the enactment date.
Under generally accepted accounting principles, a valuation allowance is required to be recognized if it is "more likely than not" that a deferred tax asset will not be realized. The determination of the realizability of the deferred tax assets is highly subjective and dependent upon judgment concerning management's evaluation of both positive and negative evidence, the forecasts of future income, applicable tax planning strategies, and assessments of current and future economic and business conditions. Examples of positive evidence may include the existence of taxes paid in available carry-back years as well as the probability that taxable income will be generated in future periods. Examples of negative evidence may include cumulative losses in a current year and prior two years and general business and economic trends. At both June 30, 2012 and December 31, 2011, the Company determined a valuation allowance continued to be necessary, largely based on the negative evidence represented by a cumulative loss in the most recent three-year period caused by the significant loan loss provisions recorded during those three years. In addition, general uncertainty regarding the economy and the housing market has increased the potential volatility and uncertainty of projected earnings. Management is required to re-evaluate the deferred tax asset and the related valuation allowance quarterly.
Positions taken in the Company's tax returns are subject to challenge by the taxing authorities upon examination. The benefit of uncertain tax positions are initially recognized in the financial statements only when it is more likely than not the position will be sustained upon examination by the tax authorities. Such tax positions are both initially and subsequently measured as the largest amount of tax benefit that has a greater than 50% likelihood of being realized upon settlement with the tax authority, assuming full knowledge of the position and all relevant facts. Interest and penalties on income tax uncertainties are classified within income tax expense in the income statement.
Management believes the Company's tax policies and practices are critical because the determination of the tax provision and current and deferred tax assets and liabilities have a material impact on our net income and the carrying value of our assets. We have no plans to change the tax recognition methodology in the future without hard evidence of sustainable earnings trends which are reliant on net interest income, mortgage banking income and significantly reduced credit losses. If the estimated valuation allowance against our deferred asset is adjusted it will affect our future net income.
Fair Value Measurements. The Company determines the fair value of its assets and liabilities in accordance with ASC 820. ASC 820 establishes a standard framework for measuring and disclosing fair value under GAAP. A number of valuation techniques are used to determine the fair value of assets and liabilities in the Company's financial statements. The valuation techniques include quoted market prices for investment securities, appraisals of real estate from independent licensed appraisers and other valuation techniques. Fair value measurements for assets and liabilities where limited or no observable market data exists are based primarily upon estimates, and are often calculated based on the economic and competitive environment, the characteristics of the asset or liability and other factors. Therefore, the valuation results cannot be determined with precision and may not be realized in an actual sale or immediate settlement of the asset or liability. Additionally, there are inherent weaknesses in any calculation technique, and changes in the underlying assumptions used, including discount rates and estimates of future cash flows, could significantly affect the results of current or future values. Significant changes in the aggregate fair value of assets and liabilities required to be measured at fair value or for impairment are recognized in the income statement under the framework established by GAAP.
Comparison of Operating Results for the Six Months Ended June 30, 2012 and 2011
General - Net income for the six months ended June 30, 2012 totaled $8.4 million, or $0.27 for both basic and diluted income per share, compared to a net loss of $2.1 million, or $0.07 for both basic and diluted loss per share, for the six months ended June 30, 2011. The six months ended June 30, 2012 generated an annualized return on average assets of 0.99% and an annualized return on average equity of 9.59%, compared to an annualized loss on average assets of 0.24% and an annualized loss on average equity of 2.51% for the comparable period in 2011. The results of operations for the six months ended June 30, 2012 as compared to the six months ended June 30, 2011 reflect a $7.2 million increase in the pre-tax results of operations from our mortgage banking operations, a $5.1 million decrease in the provision for loan losses, a $408,000 decrease in expense related to real estate owned, partially offset by a $2.6 million decrease in net interest income and an $807,000 increase in income taxes. The provision for loan losses totaled $5.1 million during the six months ended June 30, 2012, compared to $10.2 million for the six months ended June 30, 2011. Loan charge-off activity and specific loan loss reserves are discussed in additional detail in the Asset Quality section.
Segment Review - As described in Note 14 of the notes to consolidated financial statements, the Company's primary reportable segment is community banking. Community banking consists of lending and deposit gathering (as well as other banking-related products and services) to consumers and businesses and the support to deliver, fund, and manage such banking services. The Company's mortgage banking segment provides residential mortgage products for the purpose of sale on the secondary market. As such, it is a transaction based business. Transaction volume can vary significantly from period to period based upon changes in market interest rates and other economic and political factors.
Mortgage banking segment assets (which consist predominantly of loans held for sale) increased $37.2 million, or 37.1%, to $137.4 million as of June 30, 2012 compared to $100.2 million as of December 31, 2011. Additional details are provided in the "Loans Held for Sale" section. Mortgage banking segment revenues increased $21.1 million, or 133.9%, to $36.8 million for the six months ended June 30, 2012 compared to $15.7 million during the six months ended June 30, 2011. The $21.1 million increase in mortgage banking revenues was attributable to both an increase in loan origination volume, as well as increased margins. Loans originated for sale on the secondary market totaled $767.1 million during the six months ended June 30, 2012, which represents a $363.8 million, or 90.2%, increase in originations from the six months ended June 30, 2011, which totaled $403.3 million. In addition to the increase in revenues resulting from the increase in origination volume, mortgage banking revenues increased due to an increase in average sales margin. The increase in average sales margin was driven by an increase in pricing on all products in all geographic markets. The major components of mortgage banking revenues include fees and premiums associated with the sale of residential loans held for sale, which are discussed in section "Mortgage Banking Income." The major expenses for the mortgage banking segment are compensation, payroll taxes and other employee benefits, as well as occupancy, office furniture and equipment and other expenses, which are covered generally in the consolidated discussion in section "Noninterest Expense."
Average Balance Sheets, Interest and Yields/Costs
The following tables set forth average balance sheets, average yields and costs, and certain other information for the periods indicated. No tax-equivalent yield adjustments were made, as the effect thereof was not material. Non-accrual loans were included in the computation of average balances. The yields set forth below include the effect of deferred fees, discounts and premiums that are amortized or accreted to interest income or expense.
| | Six Months Ended June 30, | |
| | | 2012 | | | 2011 | |
| | Average Balance | | | Interest | | | Yield/Cost | | | Average Balance | | | Interest | | | Yield/Cost | |
| | (Dollars in Thousands) | |
| Assets | | | | | | | | | | | | | | | | | | |
| Interest-earning assets: | | | | | | | | | | | | | | | | | | |
Loans receivable, net(1) | | $ | 1,284,612 | | | | 32,892 | | | | 5.13 | % | | $ | 1,319,131 | | | | 36,506 | | | | 5.58 | % |
Mortgage related securities(2) | | | 121,915 | | | | 1,784 | | | | 2.93 | | | | 100,402 | | | | 2,048 | | | | 4.11 | |
Debt securities, (2)(6) federal funds sold and short-term investments | | | 196,728 | | | | 1,255 | | | | 1.28 | | | | 239,758 | | | | 1,664 | | | | 1.40 | |
| Total interest-earning assets | | | 1,603,255 | | | | 35,931 | | | | 4.49 | | | | 1,659,291 | | | | 40,218 | | | | 4.89 | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Noninterest-earning assets | | | 96,856 | | | | | | | | | | | | 104,078 | | | | | | | | | |
| Total assets | | $ | 1,700,111 | | | | | | | | | | | $ | 1,763,369 | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Liabilities and equity | | | | | | | | | | | | | | | | | | | | | | | | |
| Interest-bearing liabilities: | | | | | | | | | | | | | | | | | | | | | | | | |
| Demand accounts | | $ | 30,445 | | | | 13 | | | | 0.09 | | | $ | 37,416 | | | | 14 | | | | 0.08 | |
| Money market and savings accounts | | | 117,419 | | | | 163 | | | | 0.28 | | | | 115,374 | | | | 185 | | | | 0.32 | |
| Time deposits | | | 857,086 | | | | 5,690 | | | | 1.33 | | | | 950,021 | | | | 7,777 | | | | 1.65 | |
| Total interest-bearing deposits | | | 1,004,950 | | | | 5,866 | | | | 1.17 | | | | 1,102,811 | | | | 7,976 | | | | 1.46 | |
| Borrowings | | | 464,855 | | | | 9,010 | | | | 3.89 | | | | 442,252 | | | | 8,601 | | | | 3.92 | |
| Total interest-bearing liabilities | | | 1,469,805 | | | | 14,876 | | | | 2.03 | | | | 1,545,063 | | | | 16,577 | | | | 2.16 | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Noninterest-bearing liabilities | | | | | | | | | | | | | | | | | | | | | | | | |
| Non interest-bearing deposits | | | 39,411 | | | | | | | | | | | | 28,964 | | | | | | | | | |
| Other noninterest-bearing liabilities | | | 15,447 | | | | | | | | | | | | 18,622 | | | | | | | | | |
| Total noninterest-bearing liabilities | | | 54,858 | | | | | | | | | | | | 47,586 | | | | | | | | | |
| Total liabilities | | | 1,524,663 | | | | | | | | | | | | 1,592,649 | | | | | | | | | |
| Equity | | | 175,448 | | | | | | | | | | | | 170,720 | | | | | | | | | |
| Total liabilities and equity | | $ | 1,700,111 | | | | | | | | | | | $ | 1,763,369 | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Net interest income | | | | | | $ | 21,055 | | | | | | | | | | | $ | 23,641 | | | | | |
Net interest rate spread (3) | | | | | | | | | | | 2.46 | % | | | | | | | | | | | 2.73 | % |
Net interest-earning assets (4) | | $ | 133,450 | | | | | | | | | | | $ | 114,228 | | | | | | | | | |
Net interest margin (5) | | | | | | | | | | | 2.63 | % | | | | | | | | | | | 2.87 | % |
| Average interest-earning assets to average interest-bearing liabilities | | | | | | | | | | | 109.08 | % | | | | | | | | | | | 107.39 | % |
__________
(1) Interest income includes net deferred loan fee amortization income of $296,000 and $337,000 for the six months ended June 30, 2012 and 2011, respectively.
(2) Average balance of mortgage related and debt securities are based on amortized historical cost.
(3) Net interest rate spread represents the difference between the yield on average interest-earning assets and the cost of
average interest-bearing liabilities.
(4) Net interest-earning assets represent total interest-earning assets less total interest-bearing liabilities.
(5) Net interest margin represents net interest income divided by average total interest-earning assets.
(6) Interest income from tax exempt securities is not significant to total interest income, therefore, interest yield on interest earning assets are not stated on a
tax equivalent basis. The average balance of tax exempt securities totaled $19.3 million and $27.0 million for the six months ended June 30, 2012 and 2011, respectively.
Rate/Volume Analysis
The following table sets forth the effects of changing rates and volumes on our net interest income for the periods indicated. The rate column shows the effects attributable to changes in rate (changes in rate multiplied by prior volume). The volume column shows the effects attributable to changes in volume (changes in volume multiplied by prior rate). The net column represents the sum of the prior columns. For purposes of this table, changes attributable to changes in both rate and volume that cannot be segregated have been allocated proportionately based on the changes due to rate and the changes due to volume.
| | Six Months Ended June 30, | |
| | 2012 versus 2011 | |
| | Increase (Decrease) due to | |
| | Volume | | | Rate | | | Net | |
| | (In Thousands) | |
| Interest income: | | | | | | | | | |
Loans receivable(1) (2) | | $ | (892 | ) | | | (2,722 | ) | | | (3,614 | ) |
Mortgage related securities(3) | | | 393 | | | | (657 | ) | | | (264 | ) |
Other earning assets(3) | | | (277 | ) | | | (132 | ) | | | (409 | ) |
| Total interest-earning assets | | | (776 | ) | | | (3,511 | ) | | | (4,287 | ) |
| | | | | | | | | | | | | |
| Interest expense: | | | | | | | | | | | | |
| Demand accounts | | | (3 | ) | | | 2 | | | | (1 | ) |
| Money market and savings accounts | | | 3 | | | | (25 | ) | | | (22 | ) |
| Time deposits | | | (701 | ) | | | (1,386 | ) | | | (2,087 | ) |
| Total interest-bearing deposits | | | (701 | ) | | | (1,409 | ) | | | (2,110 | ) |
| Borrowings | | | 480 | | | | (71 | ) | | | 409 | |
| Total interest-bearing liabilities | | | (221 | ) | | | (1,480 | ) | | | (1,701 | ) |
| Net change in net interest income | | $ | (555 | ) | | | (2,031 | ) | | | (2,586 | ) |
______________
(1) Interest income includes net deferred loan fee amortization income of $296,000 and $337,000 for the six months ended June 30, 2012 and 2011, respectively.
(2) Non-accrual loans have been included in average loans receivable balance.
(3) Includes available for sale securities. Average balance of available for sale securities is based on amortized historical cost.
Total Interest Income - Total interest income decreased $4.3 million, or 10.7%, to $35.9 million during the six months ended June 30, 2012 from $40.2 million during the six months ended June 30, 2011.
Interest income on loans decreased $3.6 million, or 9.9%, to $32.9 million during the six months ended June 30, 2012 from $36.5 million during the six months ended June 30, 2011. The decrease in interest income was primarily due to a 45 basis point decrease in the average yield on loans to 5.13% for the six-month period ended June 30, 2012 from 5.58% for the comparable period in 2011. The decrease in interest income on loans also reflects $34.5 million, or 2.6%, decrease in the average balance of loans outstanding to $1.28 billion during the six months ended June 30, 2012 from $1.32 billion during the comparable period in 2011.
Interest income from mortgage-related securities decreased $264,000, or 12.9%, to $1.8 million during the six months ended June 30, 2012 from $2.0 million during the six months ended June 30, 2011. The decrease in interest income was due to a 118 basis point decrease in the average yield on mortgage-related securities to 2.93% for the six months ended June 30, 2012 from 4.11% for the comparable period in 2011. The decrease in average yield resulted from a general turnover of the investment security portfolio. During the six months ended June 30, 2012, the investment portfolio was decreased by $44.9 million maturities of debt securities, $16.2 million in principal repayments in mortgage related securities and $11.9 million in sales of municipal securities. The proceeds from maturities, principal repayments and sales were reinvested at a lower average rate which is reflective of the current interest rate environment. The decrease in interest income from mortgage-related securities due to a decrease in average yield was partially offset by a $21.5 million, or 21.4%, increase in the average balance of mortgage-related securities to $121.9 million for the six months ended June 30, 2012 from $100.4 million during the comparable period in 2011.
Interest income from other interest earning assets (comprised of debt securities, federal funds sold and short-term investments) decreased $409,000, or 24.6%, to $1.3 million for the six months ended June 30, 2012 compared to $1.7 million for the six months ended June 30, 2011. Interest income decreased due to a decrease of $43.0 million, or 17.9%, in the average balance of other earning assets to $196.7 million during the six months ended June 30, 2012 from $240.0 million during the comparable period in 2011. The decrease in interest income from other earning assets also reflects a 12 basis point decline in the average yield on other earning assets to 1.28% for the six months ended June 30, 2012 from 1.40% for the comparable period in 2011.
Total Interest Expense - Total interest expense decreased by $1.7 million, or 10.3%, to $14.9 million during the six months ended June 30, 2012 from $16.6 million during the six months ended June 30, 2011. This decrease was the result of both a decrease in the average cost of funds as well as a decrease in the average balance of interest bearing deposits and borrowings. The average cost of funds decreased 13 basis points to 2.03% for the six months ended June 30, 2012 from 2.16% for the six months ended June 30, 2011. Total average interest bearing deposits and borrowings outstanding decreased $75.3 million, or 4.9%, to $1.47 billion for the six months ended June 30, 2012 compared to an average balance of $1.55 billion for the six months ended June 30, 2011.
Interest expense on deposits decreased $2.1 million, or 26.4%, to $5.9 million during the six months ended June 30, 2012 from $8.0 million during the comparable period in 2011. The decrease in interest expense on deposits was primarily due to a decrease in the cost of average deposits of 29 basis points to 1.17% for the six months ended June 30, 2012 compared to 1.46% for the comparable period during 2011. The decrease in the cost of deposits reflects the low interest rate environment due to the Federal Reserve's low short term interest rate policy. These rates are typically used by financial institutions in pricing deposit products. The decrease in interest expense attributable to the decrease in the cost of deposits was compounded by a decrease of $97.9 million, or 8.9%, in the average balance of interest-bearing deposits to $1.0 billion during the six months ended June 30, 2012 from $1.1 billion during the comparable period in 2011. The decrease in average interest-bearing deposits was exclusively the result of a decrease in time deposits, which carry a higher cost than demand, money market or savings accounts. The decrease in time deposits was consistent with the Bank's liquidity needs and funding obligations.
Interest expense on borrowings increased $409,000, or 4.8%, to $9.0 million during the six months ended June 30, 2012 from $8.6 million during the comparable period in 2011. The increase primarily resulted from a $22.6 million, or 5.1%, increase in average borrowings outstanding to $464.9 million during the six months ended June 30, 2012 from $442.3 million during the comparable period in 2011. The increased use of borrowings as a funding source during the six months ended June 30, 2012 reflects an increased use of external lines of credit within our mortgage banking segment to fund loan originations to be sold on the secondary market. The average cost of borrowings decreased 3 basis points to 3.89% during the six months ended June 30, 2012 compared to 3.92% during the six months ended June 30, 2011.
Net Interest Income - Net interest income decreased by $2.6 million, or 10.9%, to $21.1 million during the six months ended June 30, 2012 as compared to $23.6 million during the comparable period in 2011. The decrease in net interest income resulted primarily from a 27 basis point decrease in our interest rate spread to 2.46% during the six months ended June 30, 2012 from to 2.73% during the six months ended June 30, 2011. The 27 basis point decrease in the interest rate spread resulted from a 40 basis point decrease in the average yield on interest earning assets, which was partially offset by a 13 basis point decrease in the average cost of interest bearing liabilities.
Provision for Loan Losses - Our provision for loan losses decreased $5.1 million, or 49.8%, to $5.1 million during the six months ended June 30, 2012, from $10.2 million during the six months ended June 30, 2011. The decrease in the provision for loan losses resulted from a decrease in loans exhibiting risk characteristics that require estimated loan loss provisions in excess of our historical average experience rates when compared to the same period of the prior year. While the provision for loan losses has decreased from the prior year, it remains at historical high levels. These levels remain high due to continued general economic stress resulting in reduced levels of income earned by many of our borrowers combined with loan collateral values, primarily real estate, that remain at levels below those estimated at the time the loans were originally made. These factors result in higher levels of actual loss experience which when applied to the portfolio in general require higher loan loss provisions. The provision for the six months ended June 30, 2012 reflected $4.9 million of net loan charge-offs, as well as continued weakness in local real estate markets which required an overall increase to the allowance for loan losses. See the "Asset Quality" section for an analysis of charge-offs, nonperforming assets, specific reserves and additional provisions.
Noninterest Income - Total noninterest income increased $21.3 million, or 125.4%, to $38.3 million during the six months ended June 30, 2012 from $17.0 million during the comparable period in 2011. The increase resulted from an increase in mortgage banking income. Mortgage banking income increased $21.3 million, or 137.7%, to $36.7 million for the six months ended June 30, 2012, compared to $15.4 million during the comparable period in 2011. The $21.3 million increase in mortgage banking income was the result of an increase in origination and sales volumes as well as an increase in average sales margins. The increase in average sales margin reflects an increase in pricing and fees on all products in all geographic markets.
Despite the increase in pricing, overall loan origination volumes increased significantly compared to the prior year which reflects the continued strong demand for fixed-rate loans due in large part to historically low interest rates on these products. Loans originated for sale on the secondary market totaled $767.1 million during the six months ended June 30, 2012, which represents a $363.8 million, or 90.2%, increase in originations from the six months ended June 30, 2011, which totaled $403.3 million.
Our overall margin can be affected by the mix of both loan type (conventional loans versus governmental) and loan purpose (purchase versus refinance). During the six months ended June 30, 2012, the growth in loan origination volume resulted in a shift towards lower yielding conventional loans and loans made for the purpose of a refinancing, however, margins increased for all loan types and loan purpose, compared to the six months ended June 30, 2011. Loans originated for the purpose of a residential property purchase, which generally yields a higher margin than loans originated for the purpose of a refinance, comprised 60% of total originations during the six months ended June 30, 2012, compared to 67% during the six months ended June 30, 2011. The mix of loan type also changed slightly with conventional loans and governmental loans comprising 65% and 35% of all loan originations, respectively during the six months ended June 30, 2012. During the six months ended June 30, 2011 conventional loans and governmental loans comprised 58% and 42% of all loan originations, respectively.
Noninterest Expense - Total noninterest expense increased $12.4 million, or 37.3%, to $45.8 million during the six months ended June 30, 2012 from $33.3 million during the comparable period in 2011. The increase was primarily attributable to increased compensation expense and other noninterest expense.
Compensation, payroll taxes and other employee benefit expense increased $8.3 million, or 47.9%, to $25.6 million during the six months ended June 30, 2012 compared to $17.3 million during the comparable period in 2011. Due primarily to an increase in loan origination activity, total compensation, payroll taxes and other employee benefits at our mortgage banking subsidiary increased $9.0 million, or 83.1%, to $19.8 million for the six months ended June 30, 2012 compared to $10.8 million during the comparable period in 2010. The increase in compensation at our mortgage banking subsidiary correlates to the increase in mortgage banking income due to the commission based compensation structure in place for our mortgage banking loan officers. The increase in total compensation, payroll taxes and other benefits at our mortgage banking subsidiary was partially offset by a decrease in compensation, payroll taxes and other employee benefits at our banking segment. Due to a decrease in stock based compensation, health care related expense and a reduction in staffing, compensation, payroll taxes and other employee benefits at our banking segment decreased $701,000 to $6.2 million for the six months ended June 30, 2012 compared to $6.9 million during the comparable period in 2011.
Real estate owned expense decreased $408,000, or 8.7%, to $4.3 million during the six months ended June 30, 2012 from $4.7 million during the comparable period in 2011. Real estate owned expense includes the net operating and carrying costs related to the properties. In addition, it includes net gain or loss recognized upon the sale of a foreclosed property, as well as write-downs recognized to maintain the properties at the lower of cost or estimated fair value. The decrease in real estate owned expense results from a decrease in net property management expense and an increase in net gains on the sales of properties, partially offset by an increase in write-downs of asset values. During the six months ended June 30, 2012, net operating expense, which includes but is not limited to property taxes, maintenance and management fees, net of rental income decreased $1.5 million, or 48.4%, to $1.6 million from $3.1 million during the comparable period in 2011. The decrease in net operating expense compared to the prior period resulted from a decrease in the number and average balance of properties owned. The average balance of real estate owned totaled $54.9 million for the six months ended June 30, 2012 compared to $61.1 million for the six months ended June 30, 2011. Net losses recognized on the sale or write-down of real estate owned totaled $2.7 million during the six months ended June 30, 2012, compared to $1.6 million during the comparable period in 2011.
Other noninterest expense increased $3.7 million or 110.4%, to $7.0 million during the six months ended June 30, 2012 from $3.3 million during the comparable period in 2011. The increase resulted from an increase in operational costs related to the expansion of our mortgage banking operations of $3.7 million to $6.2 million for the six months ended June 30, 2012, compared to $2.5 million during the comparable period in 2011.
Income Taxes - During the six months ended June 30, 2012 the Company recorded income tax expense of $71,000. This includes state income tax expense of $255,000 related to various states in which our mortgage banking subsidiary does business and to which our state net operating loss carryforwards do not apply. State tax expense is partially offset by a federal benefit of $184,000 from a prior year over estimate of liability related to an IRS audit of the company's federal income tax returns for the years 2005 through 2009.
During the six months ended June 30, 2011, the Company recorded a net income tax benefit of $736,000 which relates to the intraperiod tax allocation between other comprehensive income and loss from continuing operations, and represents an out-of-period adjustment for an error that originated beginning in 2008 that was corrected during the six months ended June 30, 2011 period. The correction of the error was not material to the six months ended June 30, 2011. The impact of this error to all prior periods was not deemed to be material.
Comparison of Operating Results for the Three Months Ended June 30, 2012 and 2011
General - Net income for the three months ended June 30, 2012 totaled $6.2 million, or $0.20 for both basic and diluted income per share, compared to a net loss of $584,000, or $0.02 for both basic and diluted loss per share, for the three months ended June 30, 2011. The three months ended June 30, 2012 generated an annualized return on average assets of 1.45% and an annualized return on average equity of 14.12%, compared to an annualized loss on average assets of 0.13% and an annualized loss on average equity of 1.37% for the comparable period in 2011. The results of operations for the three months ended June 30, 2012 as compared to the three months ended June 30, 2011 reflect a $4.8 million increase in the pre-tax results of operations from our mortgage banking operations, a $3.9 million decrease in the provision for loan losses, partially offset by a $1.1 million decrease in net interest income and a $816,000 increase in income taxes. The provision for loan losses totaled $1.4 million during the three months ended June 30, 2012, compared to $5.3 million for the three months ended June 30, 2011. Loan charge-off activity and specific loan loss reserves are discussed in additional detail in the "Asset Quality" section.
Segment Review - As described in Note 14 of the notes to consolidated financial statements, the Company's primary reportable segment is community banking. Community banking consists of lending and deposit gathering (as well as other banking-related products and services) to consumers and businesses and the support to deliver, fund, and manage such banking services. The Company's mortgage banking segment provides residential mortgage products for the purpose of sale on the secondary market.
Mortgage banking segment assets (which consist predominantly of loans held for sale) increased $37.2 million, or 37.1%, to $137.4 million as of June 30, 2012 compared to $100.2 million as of December 31, 2011. Additional details are provided in the "Loans Held for Sale" section. Mortgage banking revenues increased $13.1 million, or 137.2%, to $22.6 million for the three months ended June 30, 2012 compared to $9.5 million during the three months ended June 30, 2011. The $13.1 million increase in mortgage banking revenues was attributable to both an increase in loan origination volume, as well as increased margins. Loans originated for sale on the secondary market totaled $440.2 million during the three months ended June 30, 2012, which represents a $219.9 million, or 99.8%, increase in originations from the three months ended June 30, 2011, which totaled $220.3 million. In addition to the increase in revenues resulting from the increase in origination volume, mortgage banking revenues increased due to an increase in average sales margin. The increase in average sales margin was driven by an increase in pricing on all products in all geographic markets. The major components of mortgage banking revenues include fees and premiums associated with the sale of residential loans held for sale, which are discussed in section "Mortgage Banking Income." The major expenses for the mortgage banking segment are compensation, payroll taxes and other employee benefits, as well as occupancy, office furniture and equipment and other expenses, which are covered generally in the consolidated discussion in section "Noninterest Expense."
Average Balance Sheets, Interest and Yields/Costs
The following tables set forth average balance sheets, average yields and costs, and certain other information for the periods indicated. No tax-equivalent yield adjustments were made, as the effect thereof was not material. Non-accrual loans were included in the computation of average balances. The yields set forth below include the effect of deferred fees, discounts and premiums that are amortized or accreted to interest income or expense.
| | Three Months Ended June 30, | |
| | | 2012 | | | 2011 | |
| | Average Balance | | | Interest | | | Yield/Cost | | | Average Balance | | | Interest | | | Yield/Cost | |
| | (Dollars in Thousands) | |
| Assets | | | | | | | | | | | | | | | | | | |
| Interest-earning assets: | | | | | | | | | | | | | | | | | | |
Loans receivable, net(1) | | $ | 1,275,192 | | | | 16,319 | | | | 5.13 | % | | $ | 1,297,046 | | | | 18,040 | | | | 5.58 | % |
Mortgage related securities(2) | | | 140,792 | | | | 921 | | | | 2.62 | | | | 97,587 | | | | 1,012 | | | | 4.16 | |
Debt securities,(2)(6) federal funds sold and short-term investments | | | 195,179 | | | | 548 | | | | 1.13 | | | | 252,300 | | | | 829 | | | | 1.32 | |
| Total interest-earning assets | | | 1,611,163 | | | | 17,788 | | | | 4.43 | | | | 1,646,933 | | | | 19,881 | | | | 4.84 | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Noninterest-earning assets | | | 96,858 | | | | | | | | | | | | 102,554 | | | | | | | | | |
| Total assets | | $ | 1,708,021 | | | | | | | | | | | $ | 1,749,487 | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Liabilities and equity | | | | | | | | | | | | | | | | | | | | | | | | |
| Interest-bearing liabilities: | | | | | | | | | | | | | | | | | | | | | | | | |
| Demand accounts | | $ | 40,258 | | | | 6 | | | | 0.06 | | | $ | 38,443 | | | | 8 | | | | 0.08 | |
| Money market and savings accounts | | | 124,151 | | | | 77 | | | | 0.25 | | | | 119,467 | | | | 90 | | | | 0.30 | |
| Time deposits | | | 844,806 | | | | 2,580 | | | | 1.23 | | | | 935,653 | | | | 3,779 | | | | 1.62 | |
| Total interest-bearing deposits | | | 1,009,215 | | | | 2,663 | | | | 1.06 | | | | 1,093,563 | | | | 3,877 | | | | 1.42 | |
| Borrowings | | | 472,052 | | | | 4,497 | | | | 3.82 | | | | 437,886 | | | | 4,290 | | | | 3.93 | |
| Total interest-bearing liabilities | | | 1,481,267 | | | | 7,160 | | | | 1.94 | | | | 1,531,449 | | | | 8,167 | | | | 2.14 | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Noninterest-bearing liabilities | | | | | | | | | | | | | | | | | | | | | | | | |
| Non interest-bearing deposits | | | 32,697 | | | | | | | | | | | | 28,714 | | | | | | | | | |
| Other noninterest-bearing liabilities | | | 18,520 | | | | | | | | | | | | 18,161 | | | | | | | | | |
| Total noninterest-bearing liabilities | | | 51,217 | | | | | | | | | | | | 46,875 | | | | | | | | | |
| Total liabilities | | | 1,532,484 | | | | | | | | | | | | 1,578,324 | | | | | | | | | |
| Equity | | | 175,537 | | | | | | | | | | | | 171,163 | | | | | | | | | |
| Total liabilities and equity | | $ | 1,708,021 | | | | | | | | | | | $ | 1,749,487 | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Net interest income | | | | | | $ | 10,628 | | | | | | | | | | | $ | 11,714 | | | | | |
Net interest rate spread (3) | | | | | | | | | | | 2.49 | % | | | | | | | | | | | 2.70 | % |
Net interest-earning assets (4) | | $ | 129,896 | | | | | | | | | | | $ | 115,484 | | | | | | | | | |
Net interest margin (5) | | | | | | | | | | | 2.65 | % | | | | | | | | | | | 2.85 | % |
| Average interest-earning assets to average interest-bearing liabilities | | | | | | | | | | | 108.77 | % | | | | | | | | | | | 107.54 | % |
(1) Interest income includes net deferred loan fee amortization income of $146,000 and $117,000 for the three months ended June 30, 2012 and 2011, respectively.
(2) Average balance of mortgage related and debt securities are based on amortized historical cost.
(3) Net interest rate spread represents the difference between the yield on average interest-earning assets and the cost of
average interest-bearing liabilities.
(4) Net interest-earning assets represent total interest-earning assets less total interest-bearing liabilities.
(5) Net interest margin represents net interest income divided by average total interest-earning assets.
(6) Interest income from tax exempt securities is not significant to total interest income, therefore, interest yield on interest earning assets are not stated on a tax equivalent basis. The average balance of
tax exempt securities totaled $13.7 million and $27.9 million for the three months ended June 30, 2012 and 2011, respectively.
-- 53 --
Rate/Volume Analysis
The following table sets forth the effects of changing rates and volumes on our net interest income for the periods indicated. The rate column shows the effects attributable to changes in rate (changes in rate multiplied by prior volume). The volume column shows the effects attributable to changes in volume (changes in volume multiplied by prior rate). The net column represents the sum of the prior columns. For purposes of this table, changes attributable to changes in both rate and volume that cannot be segregated have been allocated proportionately based on the changes due to rate and the changes due to volume.
| | Three Months Ended June 30, | |
| | 2012 versus 2011 | |
| | Increase (Decrease) due to | |
| | Volume | | | Rate | | | Net | |
| | (In Thousands) | |
| Interest income: | | | | | | | | | |
Loans receivable(1) (2) | | $ | (300 | ) | | | (1,421 | ) | | | (1,721 | ) |
Mortgage related securities(3) | | | 359 | | | | (450 | ) | | | (91 | ) |
Other earning assets(3) | | | (171 | ) | | | (110 | ) | | | (281 | ) |
| Total interest-earning assets | | | (112 | ) | | | (1,981 | ) | | | (2,093 | ) |
| | | | | | | | | | | | | |
| Interest expense: | | | | | | | | | | | | |
| Demand accounts | | | - | | | | (2 | ) | | | (2 | ) |
| Money market and savings accounts | | | 3 | | | | (16 | ) | | | (13 | ) |
| Time deposits | | | (341 | ) | | | (858 | ) | | | (1,199 | ) |
| Total interest-bearing deposits | | | (338 | ) | | | (876 | ) | | | (1,214 | ) |
| Borrowings | | | 328 | | | | (121 | ) | | | 207 | |
| Total interest-bearing liabilities | | | (10 | ) | | | (997 | ) | | | (1,007 | ) |
| Net change in net interest income | | $ | (102 | ) | | | (984 | ) | | | (1,086 | ) |
______________
| (1) | Interest income includes net deferred loan fee amortization income of $146,000 and $117,000 for the three months ended June 30, 2012 and 2011, respectively. |
(2) Non-accrual loans have been included in average loans receivable balance.
(3) Includes available for sale securities. Average balance of available for sale securities is based on amortized historical cost.
Total Interest Income - Total interest income decreased $2.1 million, or 10.5%, to $17.8 million during the three months ended June 30, 2012 from $19.9 million during the three months ended June 30, 2011.
Interest income on loans decreased $1.7 million, or 9.5%, to $16.3 million during the three months ended June 30, 2012 from $18.0 million during the three months ended June 30, 2011. The decrease in interest income was primarily due to a 45 basis point decrease in the average yield on loans to 5.13% for the three-month period ended June 30, 2012 from 5.58% for the comparable period in 2011. The decrease in interest income on loans also reflects $21.9 million, or 1.7%, decrease in the average balance of loans outstanding to $1.28 billion during the three months ended June 30, 2012 from $1.30 billion during the comparable period in 2011.
Interest income from mortgage-related securities decreased $91,000, or 9.0%, to $921,000 during the three months ended June 30, 2012 from $1.0 million during the three months ended June 30, 2011. The decrease in interest income was due to a 154 basis point decrease in the average yield on mortgage-related securities to 2.62% for the three months ended June 30, 2012 from 4.16% for the comparable period in 2011. The decrease in average yield resulted from a general turnover of the investment security portfolio. During the six months ended June 30, 2012, the investment portfolio was decreased by $19.8 million maturities of debt securities and $8.8 million in principal repayments in mortgage related securities. The proceeds from maturities and principal repayments were reinvested at a lower average rate which is reflective of the current interest rate environment. The decrease in interest income from mortgage-related securities due to a decrease in average yield was partially offset by a $43.2 million, or 44.3%, increase in the average balance of mortgage-related securities to $140.8 million for the three months ended June 30, 2012 from $97.6 million during the comparable period in 2011.
Interest income from other interest earning assets (comprised of debt securities, federal funds sold and short-term investments) decreased $281,000, or 33.9%, to $548,000 for the three months ended June 30, 2012 compared to $829,000 for the three months ended June 30, 2011. Interest income decreased due to a decrease of $57.1 million, or 22.6%, in the average balance of other earning assets to $195.2 million during the three months ended June 30, 2012 from $252.3 million during the comparable period in 2011. The decrease in interest income from other earning assets also reflects a 19 basis point decline in the average yield on other earning assets to 1.13% for the three months ended June 30, 2012 from 1.32% for the comparable period in 2011.
Total Interest Expense - Total interest expense decreased by $1.0 million, or 12.3%, to $7.2 million during the three months ended June 30, 2012 from $8.2 million during the three months ended June 30, 2011. This decrease was the result of both a decrease in the average cost of funds as well as a decrease in the average balance of interest bearing deposits and borrowings. The average cost of funds decreased 20 basis points to 1.94% for the three months ended June 30, 2012 from 2.14% for the three months ended June 30, 2011. Total average interest bearing deposits and borrowings outstanding decreased $50.2 million, or 3.3%, to $1.48 billion for the three months ended June 30, 2012 compared to an average balance of $1.53 billion for the three months ended June 30, 2011.
Interest expense on deposits decreased $1.2 million, or 31.3%, to $2.7 million during the three months ended June 30, 2012 from $3.9 million during the comparable period in 2011. The decrease in interest expense on deposits was primarily due to a decrease in the cost of average deposits of 36 basis points to 1.06% for the three months ended June 30, 2012 compared to 1.42% for the comparable period during 2011. The decrease in the cost of deposits reflects the low interest rate environment due to the Federal Reserve's low short term interest rate policy. These rates are typically used by financial institutions in pricing deposit products. The decrease in interest expense attributable to the decrease in the cost of deposits was compounded by a decrease of $84.3 million, or 7.7%, in the average balance of interest bearing deposits to $1.0 billion during the three months ended June 30, 2012 from $1.1 billion during the comparable period in 2011. The decrease in average interest-bearing deposits was exclusively the result of a decrease in time deposits, which carry a higher cost than demand, money market or savings accounts. The decrease in time deposits was consistent with the Bank's liquidity needs and funding obligations.
Interest expense on borrowings increased $207,000, or 4.8%, to $4.5 million during the three months ended June 30, 2012 from $4.3 million during the comparable period in 2011. The increase primarily resulted from a $34.2 million, or 7.8%, increase in average borrowings outstanding to $472.1 million during the three months ended June 30, 2012 from $437.9 million during the comparable period in 2011. The increased use of borrowings as a funding source during the three months ended June 30, 2012 reflects an increased use of external lines of credit within our mortgage banking segment to fund loan originations to be sold on the secondary market. The increase in interest expense on borrowings due to an increase in average balance was partially offset by an 11 basis point decrease in the average cost of borrowings to 3.82% during the three months ended June 30, 2012 compared to 3.93% during the three months ended June 30, 2011.
Net Interest Income - Net interest income decreased by $1.1 million, or 9.3%, to $10.6 million during the three months ended June 30, 2012 as compared to $11.7 million during the comparable period in 2011. The decrease in net interest income resulted primarily from a 21 basis point decrease in our interest rate spread to 2.49% during the three months ended June 30, 2012 from 2.70% during the three months ended June 30, 2011. The 21 basis point decrease in the interest rate spread resulted from a 41 basis point decrease in the average yield on interest earning assets, which was partially offset by a 20 basis point decrease in the average cost of interest bearing liabilities.
Provision for Loan Losses - Our provision for loan losses decreased $3.9 million, or 73.0%, to $1.4 million during the three months ended June 30, 2012, from $5.3 million during the three months ended June 30, 2011. The decrease in the provision for loan losses resulted from a decrease in loans exhibiting risk characteristics that require estimated loan loss provisions in excess of our historical average experience rates when compared to the same period of the prior year. See the "Asset Quality" section for an analysis of charge-offs, nonperforming assets, specific reserves and additional provisions.
Noninterest Income - Total noninterest income increased $13.1 million, or 128.5%, to $23.3 million during the three months ended June 30, 2012 from $10.2 million during the comparable period in 2011. The increase resulted primarily from an increase in mortgage banking income.
Mortgage banking income increased $13.2 million, or 142.6%, to $22.5 million for the three months ended June 30, 2012, compared to $9.3 million during the comparable period in 2011. The $13.2 million increase in mortgage banking income was the result of an increase in origination and sales volumes as well as an increase in average sales margins. The increase in average sales margin reflects an increase in pricing and fees on all products in all geographic markets.
Despite the increase in pricing, overall loan origination volumes increased significantly compared to the prior year which reflects the continued strong demand for fixed-rate loans due in large part to historically low interest rates on these products. Loans originated for sale on the secondary market totaled $440.2 million during the three months ended June 30, 2012, which represents a $219.9 million, or 99.8%, increase in originations from the three months ended June 30, 2011, which totaled $220.3 million.
Our overall margin can be affected by the mix of both loan type (conventional loans versus governmental) and loan purpose (purchase versus refinance). During the three months ended June 30, 2012, the growth in loan origination volume resulted in a shift towards lower yielding conventional loans and loans made for the purpose of a refinancing, however, margins increased for all loan types and loan purpose, compared to the three months ended June 30, 2011. Loans originated for the purpose of a residential property purchase, which generally yields a higher margin than loans originated for the purpose of a refinance, comprised 64% of total originations during the three months ended June 30, 2012, compared to 78% during the three months ended June 30, 2011. The mix of loan type also changed slightly with conventional loans and governmental loans comprising 65% and 35% of all loan originations, respectively during the three months ended June 30, 2012. During the three months ended June 30, 2011 conventional loans and governmental loans comprised 54% and 46% of all loan originations, respectively.
Noninterest Expense - Total noninterest expense increased $8.3 million, or 46.0%, to $26.2 million during the three months ended June 30, 2012 from $18.0 million during the comparable period in 2011. The increase was primarily attributable to increased compensation and other noninterest expense.
Compensation, payroll taxes and other employee benefit expense increased $5.6 million, or 59.3%, to $15.0 million during the three months ended June 30, 2012 compared to $9.4 million during the comparable period in 2011. Due primarily to an increase in loan origination activity, total compensation, payroll taxes and other benefits at our mortgage banking subsidiary increased $5.7 million, or 87.4%, to $12.1 million for the three months ended June 30, 2012 compared to $6.4 million during the comparable period in 2010. The increase in compensation at our mortgage banking subsidiary correlates to the increase in mortgage banking income due to the commission based compensation structure in place for our mortgage banking loan officers. The increase in total compensation, payroll taxes and other benefits at our mortgage banking subsidiary was partially offset by a decrease in compensation, payroll taxes and other employee benefits at our banking segment.
Real estate owned expense decreased $48,000, or 1.7%, to $2.8 million during the three months ended June 30, 2012 from $2.9 million during the comparable period in 2011. Real estate owned expense includes the net operating and carrying costs related to the properties. In addition, it includes net gain or loss recognized upon the sale of a foreclosed property, as well as write-downs recognized to maintain the properties at the lower of cost or estimated fair value. The decrease in real estate owned expense results from a decrease in net property management expense and an increase in gains on the sales of properties partially offset by an increase in write-downs of asset values. During the three months ended June 30, 2012, net operating expense, which includes but is not limited to property taxes, maintenance and management fees, net of rental income decreased $860000, or 56.1%, to $674,000 from $1.5 million during the comparable period in 2011. The decrease in net operating expense compared to the prior period resulted from a decrease in average balance of properties owned. The average balance of real estate owned totaled $53.3 million for the three months ended June 30, 2012 compared to $61.4 million for the three months ended June 30, 2011. Net losses recognized on the sale or write-down of real estate owned totaled $2.2 million during the three months ended June 30, 2012, compared to $1.4 million during the comparable period in 2011.
Other noninterest expense increased $2.2 million or 130.2%, to $3.9 million during the three months ended June 30, 2012 from $1.7 million during the comparable period in 2011. The increase resulted from an increase in operational costs related to the expansion of our mortgage banking operations of $2.1 million, or 151.1%, to $3.4 million for the three months ended June 30, 2012, compared to $1.4 million during the comparable period in 2011. Increases in other noninterest expenses due to the expansion of our mortgage banking operations were partially offset by a decrease in expense within our community banking segment.
Income Taxes - During the three months ended June 30, 2012 the Company recorded income tax expense of $41,000. This includes state income tax expense of $225,000 related to various states in which our mortgage banking subsidiary does business and to which our state net operating loss carryforwards do not apply. State tax expense is partially offset by a federal benefit of $184,000 from a prior year over estimate of liability related to an IRS audit of the company's federal income tax returns for the years 2005 through 2009.
During the three months ended June 30, 2011, the Company recorded a net income tax benefit of $775,000 which primarily relates to the intraperiod tax allocation between other comprehensive income and loss from continuing operations, and represents an out-of-period adjustment for an error that originated beginning in 2008 that was corrected during the six months ended June 30, 2011 period. The correction of the error was not material to the six months ended June 30, 2011. The impact of this error to all prior periods was not deemed to be material.
Comparison of Financial Condition at June 30, 2012 and December 31, 2011
Total Assets - Total assets decreased by $31.7 million, or 1.8%, to $1.68 billion at June 30, 2012 from $1.71 billion at December 31, 2011. The decrease in total assets reflects decreases in loans receivable of $49.5 million, cash and cash equivalents of $15.5 million, real estate owned of $8.9 million and securities held to maturity of $2.6 million. Funds received from the repayment of loans held in portfolio and from short-term borrowings and escrow deposits were combined with cash and used to reduce deposits by $65.1 million, increase loans held for sale by $34.2 million, reduce other liabilities by $7.5 million and increase securities available for sale by $6.7 million during the six months ended June 30, 2012.
Cash and Cash Equivalents - Cash and cash equivalents decreased by $15.5 million, or 19.3%, to $64.9 million at June 30, 2012 from $80.4 million at December 31, 2011. The decrease in cash and cash equivalents is not reflective of an overall change in strategy with respect to cash management. The overall level of cash and cash equivalents continues to reflect the Company's plan to maintain higher than usual liquidity given the current economic environment and relatively low rates of return available on securities and other investments.
Securities Available for Sale - Securities available for sale increased by $6.7 million, or 3.3%, to $213.2 million at June 30, 2012 from $206.5 million at December 31, 2011. This increase reflects a $56.4 million increase in mortgage backed securities and a $5.5 million increase in government sponsored enterprise issued collateralized mortgage obligations, partially offset by a $42.3 million decrease in government sponsored enterprise bonds and a $14.1 million decrease in municipal securities. During the six months ended June 30, 2012, the proceeds from maturities and calls of government sponsored enterprise securities and from the sale of municipal securities were reinvested in mortgage related securities deemed to provide a better risk-adjusted return. The Company sold $11.6 million in short-term municipal securities at a gain of $241,000 in order to capture the related value of the tax-exempt feature of the securities not otherwise realized due to the Company's taxable loss position. As of June 30, 2012, the Company holds two available for sale private label issue collateralized mortgage obligations with a total fair value of $18.1 million and an amortized cost of $18.4 million that were determined to be other than temporarily impaired. The $371,000 unrealized loss (before taxes) is included in other comprehensive income. During the six months ended June 30, 2012, $4,000 was recognized as additional other than temporary impairment with respect to one of the private label issue collateralized mortgage obligations which was charged against earnings. As of June 30, 2012, the Company also holds two municipal securities with a total fair value and amortized cost of $215,000 that were determined to be other than temporarily impaired. During the six months ended June 30, 2012, $100,000 was recognized as additional other than temporary impairment with respect to these municipal securities which was charged against earnings.
Loans Receivable - Loans receivable held for investment decreased $49.5 million, or 4.1%, to $1.17 billion at June 30, 2012 from $1.22 billion at December 31, 2011. The 2012 decrease in total loans receivable was primarily attributable to a $23.0 million decrease in one- to four-family loans and a $21.5 million decrease in over four-family loans. The decrease in one- to four-family loans reflects a decline in loan demand for variable-rate real estate mortgage loans as borrowers continue to prefer long-term fixed-rate products that the Company does not generally retain in its portfolio. As a result of the low interest rate environment with respect to long-term fixed-rate real estate mortgage products, the Company continued to experience a shift in the composition of loan originations during 2012 and 2011 from one- to four-family residential variable-rate loans to residential real estate loans collateralized by over four-family properties and commercial real estate, as these categories of borrowers displayed relatively stable levels of demand for our existing products. During the six months ended June 30, 2012, $11.0 million in loans were transferred to real estate owned and $4.9 million were charged-off, net of recoveries.
The following table shows loan origination, principal repayment activity, transfers to real estate owned, charge-offs and sales during the periods indicated.
| | As of or for the | | | As of or for the | |
| | Six Months Ended June 30, | | | Year Ended | |
| | | | 2012 | | | | 2011 | | | December 31, 2011 | |
| | (In Thousands) | |
| Total gross loans receivable and held for sale at beginning of period | | $ | 1,304,947 | | | $ | 1,443,824 | | | | 1,443,824 | |
| Real estate loans originated for investment: | | | | | | | | | | | | |
| Residential | | | | | | | | | | | | |
| One- to four-family | | | 10,352 | | | | 5,668 | | | | 13,651 | |
| Over four-family | | | 22,930 | | | | 21,658 | | | | 60,367 | |
| Home equity | | | 1,915 | | | | 2,069 | | | | 4,328 | |
| Construction and land | | | 238 | | | | 12,448 | | | | 3,487 | |
| Commercial real estate | | | 10,900 | | | | 2,810 | | | | 25,398 | |
| Total real estate loans originated for investment | | | 46,335 | | | | 44,653 | | | | 107,231 | |
| Consumer | | | 35 | | | | - | | | | - | |
| Commerical business loans originated for investment | | | 3,013 | | | | 6,744 | | | | 9,366 | |
| Total loans originated for investment | | | 49,383 | | | | 51,397 | | | | 116,597 | |
| | | | | | | | | | | | | |
| Principal repayments | | | (82,992 | ) | | | (90,955 | ) | | | (200,544 | ) |
| Transfers to real estate owned | | | (11,002 | ) | | | (16,167 | ) | | | (28,259 | ) |
| Loan principal charged-off, net of recoveries | | | (4,872 | ) | | | (5,195 | ) | | | (18,821 | ) |
| Net activity in loans held for investment | | | (49,483 | ) | | | (60,920 | ) | | | (131,027 | ) |
| | | | | | | | | | | | | |
| Loans originated for sale | | | 767,092 | | | | 403,309 | | | | 1,027,346 | |
| Loans sold | | | (732,886 | ) | | | (447,556 | ) | | | (1,035,196 | ) |
| Net activity in loans held for sale | | | 34,206 | | | | (44,247 | ) | | | (7,850 | ) |
| Total gross loans receivable and held for sale at end of period | | $ | 1,289,670 | | | $ | 1,338,657 | | | | 1,304,947 | |
Allowance for Loan Losses - The allowance for loan losses increased $228,000, or 0.7%, to $32.7 million at June 30, 2012 from $32.4 million at December 31, 2011. The $228,000 increase in the allowance for loan losses during the six months ended June 30, 2012 is attributable to a $3.5 million increase in specific loan loss reserves related to impaired loans, partially offset by a $3.3 million decrease in the general valuation allowance. The $3.5 million increase in specific loan loss reserves was primarily the result of an increase in the coverage rate with respect to performing collateral based specific impairment reviews with respect to impaired loans. This increase in specific reviews and subsequent specific reserves resulted in a corresponding decrease in general reserves. Along with this shift from general to specific reserves, the decrease in general valuation allowance resulted primarily from a decrease the overall balance of loans outstanding. As of June 30, 2012, the allowance for loan losses to total loans receivable was 2.80% and was equal to 38.53% of non-performing loans, compared to 2.67% and 41.46%, respectively, at December 31, 2011. The overall $228,000 increase in the allowance for loan losses during the six months ended June 30, 2012 was primarily the result of increases in the allowance for loan losses related to the over four-family and commercial real estate categories. The increase in allowance for loan losses related to these categories resulted from an increase in commercial real estate loans classified as impaired and a decrease in collateral values related to over four-family loans previously classified as impaired. Increases in the allowance for loan losses related to the over four-family and commercial real estate categories were partially offset by a decrease in allowance for loan losses related to the one- to four- family category which was a direct result of a decrease in one- to four-family loans identified as impaired. Weakness in the residential real estate market has continued for the past four years and the risk of loss on loans secured by residential real estate remains at an elevated level. That portion of the allowance for loan losses attributable to mortgage loans secured by residential real estate remained relatively unchanged at 85.2% of the total allowance for loan losses at June 30, 2012 and 85.5% December 31, 2011.
Real Estate Owned - Total real estate owned decreased $8.9 million, or 15.6%, to $47.8 million at June 30, 2012 from $56.7 million at December 31, 2011. During the six months ended June 30, 2012, $11.0 million was transferred from loans to real estate owned upon completion of foreclosure. Declines in property values evidenced by updated appraisals, responses to list prices on properties held for sale and/or deterioration in the condition of properties resulted in write downs totaling $3.4 million during the six months ended June 30, 2012. During the same period, sales of real estate owned totaled $16.2 million.
Prepaid Expenses and Other Assets - Prepaid expenses and other assets increased by $4.9 million or 58.9%, to $13.3 million at June 30, 2012 from $8.4 million at December 31, 2011. The increase is primarily due to a decrease in deferred income tax valuation allowances and an increase in mortgage banking derivative assets and other receivables due from third parties related to the origination of loans held for sale as well as an increase in the mortgage servicing rights intangible asset that relates to an increase in loans sold on a servicing retained basis.
Deposits - Total deposits decreased $65.1 million, or 6.2%, to $986.2 million at June 30, 2012 from $1.05 billion at December 31, 2011. The reduction in deposits reflects management's decision to accept a certain level of deposit run-off during a period of diminished loan demand. Total time deposits decreased $84.3 million, or 9.6%, to $794.5 million at June 30, 2012 from $878.7 million at December 31, 2011. The decrease in time deposits was partially offset by an increase in money market and demand deposits. Total money market and savings deposits increased $10.8 million, or 10.4%, to $114.9 million at June 30, 2012 from $104.1 million at December 31, 2011. Total demand deposits increased $8.4 million, or 12.2%, to $76.8 million at June 30, 2012 from $68.5 million at December 31, 2011.
Borrowings - Total borrowings increased $17.9 million, or 3.9%, to $479.0 million at June 30, 2012 from $461.1 million at December 31, 2011. The increase in borrowings relates entirely to an increase in the use of bank lines of credit to finance loans held for sale. The balance of these lines of credit increased by $17.9 million, to $45.0 million at June 30, 2012, from $27.1 million at December 31, 2011.
Advance Payments by Borrowers for Taxes - Advance payments by borrowers for taxes increased $13.6 million to $14.5 million at June 30, 2012 from $942,000 at December 31, 2011. The increase was the result of payments received from borrowers for their real estate taxes and is seasonally normal, as balances increase during the course of the calendar year until real estate tax obligations are paid out in the fourth quarter.
Other Liabilities - Other liabilities decreased $7.5 million, or 22.5%, to $25.7 million at June 30, 2012 from $33.1 million at December 31, 2011. The decrease resulted primarily from a $10.7 million seasonal decrease in outstanding escrow checks. The Company receives payments from borrowers for their real estate taxes during the course of the calendar year until real estate tax obligations are paid out in the fourth quarter. These amounts remain classified as other liabilities until settled. The decrease related to escrow checks was partially offset by an increase in amounts due to third parties related to the origination of loans held for sale.
Shareholders' Equity - Shareholders' equity increased by $9.4 million, or 5.7%, to $175.8 million at June 30, 2012 from $166.4 million at December 31, 2011. The increase in stockholders' equity was primarily due to an $8.4 million increase in retained earnings reflecting net income for the six months ended June 30, 2012. In addition to the increase in retained earnings, shareholders' equity was positively impacted by a $841,000 increase in accumulated other comprehensive income and a $427,000 decrease in unearned ESOP shares.
ASSET QUALITY
NONPERFORMING ASSETS
The following table summarizes nonperforming loans and assets:
| | At June 30, | | | At December 31, | |
| | | | 2012 | | | | 2011 | |
| | (Dollars in Thousands) | |
| Non-accrual loans: | | | | | | | | |
| Residential | | | | | | | | |
| One- to four-family | | $ | 48,575 | | | | 55,609 | |
| Over four-family | | | 24,739 | | | | 13,680 | |
| Home equity | | | 2,004 | | | | 1,334 | |
| Construction and land | | | 5,826 | | | | 6,946 | |
| Commercial real estate | | | 3,581 | | | | 514 | |
| Consumer | | | 27 | | | | - | |
| Commercial | | | - | | | | 135 | |
| Total non-accrual loans | | | 84,752 | | | | 78,218 | |
| Real estate owned | | | | | | | | |
| One- to four-family | | | 21,637 | | | | 27,449 | |
| Over four-family | | | 13,742 | | | | 16,231 | |
| Construction and land | | | 8,793 | | | | 8,796 | |
| Commercial real estate | | | 3,643 | | | | 4,194 | |
| Total real estate owned | | | 47,815 | | | | 56,670 | |
| Total nonperforming assets | | $ | 132,567 | | | | 134,888 | |
| | | | | | | | | |
| Total non-accrual loans to total loans, net | | | 7.26 | % | | | 6.43 | % |
| Total non-accrual loans and performing troubled debt restructurings to total loans receivable restructurings to total loans receivable | | | 9.77 | % | | | 8.45 | % |
| Total non-accrual loans to total assets | | | 5.05 | % | | | 4.57 | % |
| Total nonperforming assets to total assets | | | 7.89 | % | | | 7.88 | % |
All loans that exceed 90 days past due with respect to principal and interest are recognized as non-accrual. Troubled debt restructurings which are nonaccrual either due to being past due greater than 90 days or which have not yet performed under the modified terms for a reasonable period of time, are included in the table above. In addition, loans which are past due less than 90 days are evaluated to determine the likelihood of collectability given other credit risk factors such as early stage delinquency, the nature of the collateral or the results of a borrower review. When the collection of all contractual principal and interest is determined to be unlikely, the loan is moved to non-accrual status and an updated appraisal of the underlying collateral is ordered. This process generally takes place between contractual past due dates 60 to 90 days. Upon determining the updated estimated value of the collateral, a loan loss provision is recorded to establish a specific reserve to the extent that the outstanding principal balance exceeds the updated estimated net realizable value of the collateral. When a loan is determined to be uncollectible, typically coinciding with the initiation of foreclosure action, the specific reserve is reviewed for adequacy, adjusted if necessary, and charged-off.
Total non-accrual loans increased by $6.5 million, or 8.4%, to $84.8 million as of June 30, 2012 compared to $78.2 million as of December 31, 2011. The ratio of non-accrual loans to total loans receivable was 7.26% at June 30, 2012 compared to 6.43% at December 31, 2011. The $6.5 million net increase in non-accrual loans during the six months ended June 30, 2012 was primarily attributable to one $12.2 million lending relationship that went on to non-accrual status during the period. During the six months ended June 30, 2012, a total of $31.3 million in loans were placed on non-accrual status. Offsetting the addition of loans added to non-accrual status were $11.0 million in transfers to real estate owned (net of charge-offs), $8.0 million in loans that were returned to accrual status, $3.4 million in charge-offs and $1.4 million in principal repayments.
Of the $84.8 million in total non-accrual loans as of June 30, 2012, $75.9 million in loans have been specifically reviewed to assess whether a specific valuation allowance is necessary. A specific valuation allowance is established for an amount equal to the impairment when the carrying value of the loan exceeds the present value of expected future cash flows, discounted at the loan's original effective interest rate or the fair value of the underlying collateral with an adjustment made for costs to dispose of the asset. Based upon these specific reviews, a total of $7.4 million in partial charge-offs have been recorded with respect to these loans as of June 30, 2012. Partially charged-off loans measured for impairment based upon net realizable collateral value are maintained in a "non-performing" status and are disclosed as impaired loans. In addition, specific reserves totaling $10.9 million have been recorded as of June 30, 2012. The remaining $8.9 million of non-accrual loans were reviewed on an aggregate basis and $2.1 million in general valuation allowance was deemed necessary as of June 30, 2012. The $2.1 million in general valuation allowance is based upon a migration analysis performed with respect to similar non-accrual loans in prior periods.
There were no accruing loans past due 90 days or more during the six months ended June 30, 2012 and 2011.
TROUBLED DEBT RESTRUCTURINGS
The following table summarizes troubled debt restructurings:
| | At June 30, | | | At December 31, | |
| | | | 2012 | | | | 2011 | |
| | (In Thousands) | |
| Troubled debt restructurings | | | | | | | | |
| Substandard | | $ | 39,796 | | | | 47,220 | |
| Watch | | | 14,729 | | | | 8,192 | |
| Total troubled debt restructurings | | $ | 54,525 | | | | 55,412 | |
All troubled debt restructurings are considered to be impaired and are risk rated as either substandard or watch and are included in the internal risk rating tables disclosed in Note 3 in the notes to the financial statements. Specific reserves have been established to the extent that these collateral-based impairment analyses indicate that a collateral shortfall exists.
LOAN DELINQUENCY
The following table summarizes loan delinquency in total dollars and as a percentage of the total loan portfolio:
| | At June 30, | | | At December 31, | |
| | | | 2012 | | | | 2011 | |
| | (Dollars in Thousands) | |
| | | | | | | | | |
| Loans past due less than 90 days | | $ | 20,917 | | | | 36,798 | |
| Loans past due 90 days or more | | | 63,464 | | | | 56,612 | |
| Total loans past due | | $ | 84,381 | | | | 93,410 | |
| | | | | | | | | |
| Total loans past due to total loans receivable | | | 7.23 | % | | | 7.68 | % |
Loans past due decreased by $9.0 million, or 9.7%, to $84.4 million at June 30, 2012 from $93.4 million at December 31, 2011. Loans past due 90 days or more increased by $6.9 million, or 12.1%, during the six months ended June 30, 2012 while loans past due less than 90 days decreased by $15.9 million, or 43.2%. The $6.9 million increase in loans past due 90 days or more was primarily attributable to a $9.9 million increase in loans collateralized by over four-family residential real estate. This increase relates to one borrower relationship that was past due less than 90 days as of December 31, 2011. Within the category of loans past due less than 90 days, only the category of loans collateralized by commercial real estate experienced an increase in overall delinquent balance when compared to December 31, 2011. All other loan categories experienced declines in total loan balance past due less than 90 days.
REAL ESTATE OWNED
Total real estate owned decreased by $8.9 million, or 15.6%, to $47.8 million at June 30, 2012, compared to $56.7 million at December 31, 2011. During the six months ended June 30, 2012, $11.0 million was transferred from loans to real estate owned upon completion of foreclosure. Declines in property values evidenced by updated appraisals, responses to list prices on properties held for sale and/or deterioration in the condition of properties resulted in write-downs totaling $3.4 million during the six months ended June 30, 2012. During the same period, sales of real estate owned totaled $16.2 million. New appraisals received on real estate owned and collateral dependent impaired loans are based upon an "as is value" assumption. During the period of time in which we are awaiting receipt of an updated appraisal, loans evaluated for impairment based upon collateral value are measured by the following:
• Confirming that the physical condition of the real estate has not significantly changed since the last valuation date;
• Applying an updated adjustment factor (as described previously) to an existing appraisal;
• Comparing the estimated current value of the collateral to that of updated sales values experienced on similar collateral;
• Comparing the estimated current value of the collateral to that of updated values seen on current appraisals of similar collateral; and
• Comparing the estimated current value to that of updated listed sales prices on our real estate owned and that of similar properties (not owned by the Company).
We held 283 properties as real estate owned as of June 30, 2012, compared to 323 properties at December 31, 2011. Of the $47.8 million in real estate owned properties as of June 30, 2012, $39.0 million consist of one- to four-family, over four-family and commercial real estate properties. Of all real estate owned, these property types present the greatest opportunity to offset operating expenses through the generation of rental income. Of the $39.0 million in one- to four-family, over four-family and commercial real estate properties, $20.4 million, or 52.2%, represent properties that are generating rental revenue. Virtually all habitable real estate owned is managed with the intent of attracting a lessee to generate revenue. Foreclosed properties are recorded at the lower of carrying value or fair value with charge-offs, if any, charged to the allowance for loan losses upon transfer to real estate owned. The fair value is primarily based upon updated appraisals in addition to an analysis of current real estate market conditions.
A summary of the allowance for loan losses is shown below:
ALLOWANCE FOR LOAN LOSSES
| | At or for the Six Months | |
| | Ended June 30, | |
| | | | 2012 | | | | 2011 | |
| | (Dollars in Thousands) | |
| | | | | | | | | |
| Balance at beginning of period | | $ | 32,430 | | | | 29,175 | |
| Provision for loan losses | | | 5,100 | | | | 10,156 | |
| Charge-offs: | | | | | | | | |
| Mortgage | | | | | | | | |
| One- to four-family | | | 4,133 | | | | 2,901 | |
| Over four-family | | | 612 | | | | 1,591 | |
| Home Equity | | | 158 | | | | 350 | |
| Commercial real estate | | | 43 | | | | 177 | |
| Construction and land | | | 192 | | | | 159 | |
| Consumer | | | - | | | | 7 | |
| Commercial | | | 59 | | | | 313 | |
| Total charge-offs | | | 5,197 | | | | 5,498 | |
| Recoveries: | | | | | | | | |
| Mortgage | | | | | | | | |
| One- to four-family | | | 252 | | | | 126 | |
| Over four-family | | | 11 | | | | 12 | |
| Home Equity | | | 22 | | | | 4 | |
| Construction and land | | | 15 | | | | - | |
| Consumer | | | - | | | | 1 | |
| Commercial | | | 25 | | | | 10 | |
| Total recoveries | | | 325 | | | | 153 | |
| Net charge-offs | | | 4,872 | | | | 5,345 | |
| Allowance at end of period | | $ | 32,658 | | | $ | 33,986 | |
| | | | | | | | | |
| Ratios: | | | | | | | | |
| Allowance for loan losses to non-accrual loans at end of period | | | 38.53 | % | | | 42.29 | % |
| Allowance for loan losses to loans receivable at end of period | | | 2.80 | % | | | 2.73 | % |
| Net charge-offs to average loans outstanding (annualized) | | | 0.76 | % | | | 0.82 | % |
| Current year provision for loan losses to net charge-offs | | | 104.68 | % | | | 189.99 | % |
| Net charge-offs (annualized) to beginning of the year allowance | | | 15.02 | % | | | 36.95 | % |
_______________
At June 30, 2012, the allowance for loan losses was $32.7 million, compared to $32.4 million at December 31, 2011. As of June 30, 2012, the allowance for loan losses represented 2.80% of total loans receivable and was equal to 38.53% of non-performing loans, compared to 2.67% and 41.46%, respectively, at December 31, 2011. The $228,000 increase in the allowance for loan losses during the six months ended June 30, 2012 is attributable to a $3.5 million increase in specific loan loss reserves related to impaired loans, partially offset by a $3.3 million decrease in the general valuation allowance. The $3.5 million increase in specific loan loss reserves and was primarily the result of an increase in the coverage rate with respect to performing collateral based specific impairment reviews with respect to impaired loans. This increase in specific reviews and subsequent specific reserves resulted in a corresponding decrease in general reserves. Along with this shift from general to specific reserves, the decrease in general valuation allowance resulted primarily from a decrease the overall balance of loans outstanding.
Net charge-offs totaled $4.9 million, or an annualized 0.76% of average loans for the six months ended June 30, 2012, compared to $5.3 million, or an annualized 0.82% of average loans for the six months ended June 30, 2011. Of the $4.9 million in net charge-offs during the six months ended June 30, 2012, $3.9 million related to loans secured by one- to four-family residential loans. Weakness in the residential real estate market has continued for the past three years and the risk of loss on loans secured by residential real estate remains at an elevated level.
The loan loss provision of $5.1 million for the six months ended June 30, 2012 reflects the Company's conclusion as to the need for the ending allowance to be $32.7 million following the net charge-offs recorded during the period and a review of the Bank's loan portfolio and general economic conditions.
Our underwriting policies and procedures emphasize the fact that credit decisions must rely on both the credit quality of the borrower and the estimated value of the underlying collateral. Credit quality is assured only when the estimated value of the collateral is objectively determined and is not subject to significant fluctuation. The quantified deterioration of the credit quality of our loan portfolio as described above is the direct result of borrowers who were not financially strong enough to make regular interest and principal payments or maintain their properties when the economic environment no longer allowed them the option of converting estimated real estate value increases into short-term cash flow.
The allowance for loan losses has been determined in accordance with GAAP. We are responsible for the timely and periodic determination of the amount of the allowance required. Future provisions for loan losses will continue to be based upon our assessment of the overall loan portfolio and the underlying collateral, trends in nonperforming loans, current economic conditions and other relevant factors. To the best of management's knowledge, all probable losses have been provided for in the allowance for loan losses.
The establishment of the amount of the loan loss allowance inherently involves judgments by management as to the adequacy of the allowance, which ultimately may or may not be correct. Higher than anticipated rates of loan default would likely result in a need to increase provisions in future years. See "Critical Accounting Policies" above for a discussion on the use of judgment in determining the amount of the allowance for loan losses.
Impact of Inflation and Changing Prices
The financial statements and accompanying notes of the Company have been prepared in accordance with GAAP. GAAP generally requires the measurement of financial position and operating results in terms of historical dollars without consideration for changes in the relative purchasing power of money over time due to inflation. The impact of inflation is reflected in the increased cost of our operations. Unlike industrial companies, our assets and liabilities are primarily monetary in nature. As a result, changes in market interest rates have a greater impact on performance than do the effects of inflation.
Liquidity and Capital Resources
We maintain liquid assets at levels we consider adequate to meet our liquidity needs. Our liquidity ratio averaged 5.1% and 6.6% for the six months ended June 30, 2012 and 2011, respectively. The liquidity ratio is equal to average daily cash and cash equivalents for the period divided by average total assets. We adjust our liquidity levels to fund loan commitments, repay our borrowings, fund deposit outflows and pay real estate taxes on mortgage loans. We also adjust liquidity as appropriate to meet asset and liability management objectives. The operational adequacy of our liquidity position at any point in time is dependent upon the judgment of the senior management as supported by the Asset/Liability Committee. Liquidity is monitored on a daily, weekly and monthly basis using a variety of measurement tools and indicators.
Our primary sources of liquidity are deposits, amortization and repayment of loans, sales of loans held for sale, maturities of investment securities and other short-term investments, and earnings and funds provided from operations. While scheduled principal repayments on loans are a relatively predictable source of funds, deposit flows and loan repayments are greatly influenced by market interest rates, economic conditions, and rates offered by our competitors. We set the interest rates on our deposits to maintain a desired level of total deposits. In addition, we invest excess funds in short-term, interest-earning assets, which provide liquidity to meet lending requirements. Additional sources of liquidity used for the purpose of managing long- and short-term cash flows include advances from the FHLBC.
A portion of our liquidity consists of cash and cash equivalents, which are a product of our operating, investing and financing activities. At June 30, 2012 and 2011, respectively, $64.9 million and $95.5 million of our assets were invested in cash and cash equivalents. At June 30, 2012 cash and cash equivalents are comprised of the following: $50.4 million in cash held at the Federal Reserve Bank and other depository institutions and $14.5 million in federal funds sold and short-term investments. Our primary sources of cash are principal repayments on loans, proceeds from the calls and maturities of debt and mortgage-related securities, increases in deposit accounts, federal funds purchased and advances from the FHLBC.
During the six months ended June 30, 2012, the collection of principal payments on loans, net of loan originations provided cash flow of $33.6 million, compared to $38.9 million for the six months ended June 30, 2011. The decrease in loans receivable is reflective of the general decline in loan demand for variable-rate residential real estate mortgage loans combined with the Company's tightened underwriting standards given the current economic environment. The decrease in the loan portfolio during the six months ended June 30, 2012 was primarily attributable to a $23.0 million decrease in one- to four-family loans and a $21.5 million decrease in over four-family loans. The decrease in one- to four-family loans reflects a decline in loan demand for variable-rate real estate mortgage loans as borrowers continue to prefer long-term fixed-rate products that the Company does not generally retain in its portfolio.
Deposit flows are generally affected by the level of interest rates, the interest rates and products offered by local competitors, and other factors. Deposits decreased by $65.1 million for the six months ended June 30, 2012. The decrease in deposits was driven by a $84.3 million decrease in time deposits, partially offset by a $10.8 million increase in money market and savings deposits and an $8.4 million increase in demand deposits. As a result of the consent order issued by state and federal regulators effective December 18, 2009, the Bank is prohibited from accepting or renewing brokered deposits and all other deposit rates are capped by the FDIC.
Liquidity management is both a daily and longer-term function of business management. If we require funds beyond our ability to generate them internally, borrowing agreements exist with the FHLBC which provide an additional source of funds. At June 30, 2012, we had $350.0 million in advances from the FHLBC with contractual maturity dates in 2016, 2017 or 2018. All advances are callable quarterly until maturity. As an additional source of funds, we also enter into repurchase agreements. At June 30, 2012, we had $84.0 million in repurchase agreements. The repurchase agreements mature at various times in 2017, however, all are callable quarterly until maturity.
At June 30, 2012, we had outstanding commitments to originate loans of $22.7 million. In addition, at June 30, 2012 we had unfunded commitments under construction loans of $5.6 million, unfunded commitments under business lines of credit of $10.4 million and unfunded commitments under home equity lines of credit and standby letters of credit of $19.5 million. At June 30, 2012 certificates of deposit scheduled to mature in one year or less totaled $561.3 million. Based on prior experience, management believes that, subject to the Bank's funding needs, a significant portion of such deposits will remain with us, although there can be no assurance that this will be the case. In the event a significant portion of our deposits is not retained by us, we will have to utilize other funding sources, such as FHLBC advances, in order to maintain our level of assets. However, we cannot assure that such borrowings would be available on attractive terms, or at all, if and when needed. Alternatively, we could reduce our level of liquid assets, such as our cash and cash equivalents and securities available-for-sale in order to meet funding needs. In addition, the cost of such deposits may be significantly higher if market interest rates are higher or there is an increased amount of competition for deposits in our market area at the time of renewal.
Contractual Obligations, Commitments, Contingent Liabilities, and Off-balance Sheet Arrangements
The following tables present information indicating various contractual obligations and commitments of the Company as of June 30, 2012 and the respective maturity dates.
| Contractual Obligations | |
| | | | | | | | More than | | | More than | | | | |
| | | | | | | | One Year | | | Three Years | | | Over | |
| | | | | One Year | | | Through | | | Through | | | Five | |
| | Total | | | or Less | | | Three Years | | | Five Years | | | Years | |
| | (In Thousands) | |
Deposits without a stated maturity (4) | | $ | 191,727 | | | | 191,727 | | | | - | | | | - | | | | - | |
Certificates of deposit (4) | | | 794,471 | | | | 561,276 | | | | 209,773 | | | | 23,422 | | | | - | |
Bank lines of credit (4) | | | 45,031 | | | | 45,031 | | | | - | | | | - | | | | - | |
Federal Home Loan Bank advances (1) | | | 350,000 | | | | - | | | | - | | | | 245,000 | | | | 105,000 | |
Repurchase agreements (2)(4) | | | 84,000 | | | | - | | | | - | | | | 24,000 | | | | 60,000 | |
Operating leases (3) | | | 3,348 | | | | 1,589 | | | | 1,458 | | | | 301 | | | | - | |
| Salary continuation agreements | | | 850 | | | | 170 | | | | 340 | | | | 340 | | | | - | |
| | $ | 1,469,427 | | | | 799,793 | | | | 211,571 | | | | 293,063 | | | | 165,000 | |
_____________
(1) Secured under a blanket security agreement on qualifying assets, principally, mortgage loans. Excludes interest which will accrue on the advances. All Federal Home Loan Bank advances with maturities exceeding
one year are callable on a quarterly basis.
(2) The repurchase agreements are callable on a quarterly basis until maturity.
(3) Represents non-cancelable operating leases for offices and equipment.
(4) Excludes interest.
The following table details the amounts and expected maturities of significant off-balance sheet commitments as of June 30, 2012.
| Other Commitments | |
| | | | | | | | | More than | | | More than | | | | |
| | | | | | | | | One Year | | | Three Years | | | Over | |
| | | | | | One Year | | | Through | | | Through | | | Five | |
| | Total | | | or Less | | | Three Years | | | Five Years | | | Years | |
| | (In Thousands) | |
Real estate loan commitments (1) | | $ | 22,713 | | | | 22,713 | | | | - | | | | - | | | | - | |
Unused portion of home equity lines of credit (2) | | | 18,582 | | | | 18,582 | | | | - | | | | - | | | | - | |
Unused portion of construction loans (3) | | | 5,550 | | | | 5,550 | | | | - | | | | - | | | | - | |
| Unused portion of business lines of credit | | | 10,395 | | | | 10,395 | | | | - | | | | - | | | | - | |
| Standby letters of credit | | | 922 | | | | 922 | | | | - | | | | - | | | | - | |
| Total Other Commitments | | $ | 58,162 | | | | 58,162 | | | | - | | | | - | | | | - | |
______________
General: Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract and generally have fixed expiration dates or other termination clauses.
(1) Commitments for loans are extended to customers for up to 90 days after which they expire.
(2) Unused portions of home equity loans are available to the borrower for up to 10 years.
(3) Unused portions of construction loans are available to the borrower for up to 1 year.
Item 3.
Quantitative and Qualitative Disclosures about Market Risk
Management of Market Risk
General.The majority of our assets and liabilities are monetary in nature. Consequently, our most significant form of market risk is interest rate risk. Our assets, consisting primarily of mortgage loans, have longer maturities than our liabilities, consisting primarily of deposits. As a result, a principal part of our business strategy is to manage interest rate risk and reduce the exposure of our net interest income to changes in market interest rates. Accordingly, WaterStone Bank's board of directors has established an Asset/Liability Committee which is responsible for evaluating the interest rate risk inherent in our assets and liabilities, for determining the level of risk that is appropriate given our business strategy, operating environment, capital, liquidity and performance objectives, and for managing this risk consistent with the guidelines approved by the board of directors. Management monitors the level of interest rate risk on a regular basis and the Asset/Liability Committee meets at least weekly to review our asset/liability policies and interest rate risk position, which are evaluated quarterly.
We have sought to manage our interest rate risk in order to minimize the exposure of our earnings and capital to changes in interest rates. We have implemented the following strategies to manage our interest rate risk: (i) emphasizing variable rate loans including variable rate one- to four-family, and commercial real estate loans as well as three to five year commercial real estate balloon loans; (ii) reducing and shortening the expected average life of the investment portfolio; and (iii) whenever possible, lengthening the term structure of our deposit base and our borrowings from the FHLBC. These measures should reduce the volatility of our net interest income in different interest rate environments.
Income Simulation. Simulation analysis is an estimate of our interest rate risk exposure at a particular point in time. At least quarterly we review the potential effect changes in interest rates may have on the repayment or repricing of rate sensitive assets and funding requirements of rate sensitive liabilities. Our most recent simulation uses projected repricing of assets and liabilities at June 30, 2012 on the basis of contractual maturities, anticipated repayments and scheduled rate adjustments. Prepayment rate assumptions may have a significant impact on interest income simulation results. Because of the large percentage of loans and mortgage-backed securities we hold, rising or falling interest rates may have a significant impact on the actual prepayment speeds of our fixed-rate mortgage related assets that may in turn affect our interest rate sensitivity position. When interest rates rise, prepayment speeds slow and the average expected lives of our fixed-rate assets would tend to lengthen more than the expected average lives of our liabilities and therefore would most likely have a negative impact on net interest income and earnings. This effect is offset by the impact that variable-rate assets have on net interest income as interest rates rise and fall.
| | Percentage Increase (Decrease) in Estimated Annual Net Interest Income Over 12 Months | |
| 300 basis point gradual rise in rates | | | (4.38) | |
| 200 basis point gradual rise in rates | | | (4.99) | |
| 100 bassis point gradual rise in rates | | | (5.57) | |
| Unchanged rate scenario | | | (6.06) | |
| 100 bassis point gradual decline in rates | | | (7.54) | |
| 200 bassis point gradual decline in rates | | | (11.43) | |
| 300 bassis point gradual decline in rates | | | (13.48) | |
WaterStone Bank's Asset/Liability policy limits projected changes in net average annual interest income to a maximum decline of 20% for various levels of interest rate changes measured over a 12-month period when compared to the flat rate scenario. In addition, projected changes in the economic value of equity are limited to a maximum decline of 10% to 80% for interest rate movements of 100 to 300 basis points when compared to the flat rate scenario. These limits are re-evaluated on a periodic basis and may be modified, as appropriate. Because our balance sheet is asset sensitive, net interest income is projected to decline as interest rates fall. At June 30, 2012, a 100 basis point gradual increase in interest rates had the effect of decreasing forecast net interest income by 5.57% while a 100 basis point decrease in rates had the effect of decreasing net interest income by 7.54%. At June 30, 2012, a 100 basis point gradual increase in interest rates had the effect of decreasing the economic value of equity by 3.33% while a 100 basis point decrease in rates had the effect of decreasing the economic value of equity by 2.70%. While we believe the assumptions used are reasonable, there can be no assurance that assumed prepayment rates will approximate actual future mortgage-backed security and loan repayment activity.
Item 4.
Controls and Procedures
Disclosure Controls and Procedures : Company management, with the participation of the Company's Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company's disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the "Exchange Act")) as of the end of the period covered by this report. Based on such evaluation, the Company's Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, the Company's disclosure controls and procedures are effective in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act.
Internal Control Over Financial Reporting : There have been no changes in the Company's internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fiscal quarter to which this report relates that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting.
PART II. OTHER INFORMATION
Item 1.
Legal Proceedings
We are not involved in any pending legal proceedings as a defendant other than routine legal proceedings occurring in the ordinary course of business. At June 30, 2012, we believe that any liability arising from the resolution of any pending legal proceedings will not be material to our financial condition or results of operations.
In addition to the "Risk Factors" in Item 1A of the Company's annual report on Form 10-K for the year ended December 31, 2011, we set forth the following additional risk factors.
A Significant Portion of our Liabilities are Time Deposits
If interest rates rise, our cost of funds could significantly increase, adversely affecting our ability to generate a profit. At June 30, 2012, time deposits totaled $794.5 million, comprising 80.6% of our total deposits. If market rates begin to rise our costs of funds may significantly increase or we may experience significant deposit outflows. Either of which will adversely affect our ability to operate profitably.
(a) Exhibits: See Exhibit Index, which follows the signature page hereof.
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.
| WATERSTONE FINANCIAL, INC. (Registrant) | | | |
| Date: August 3, 2012 | | | | |
| /s/ Douglas S. Gordon | | | |
| Douglas S. Gordon | | | |
| Chief Executive Officer | | | |
| Date: August 3, 2012 | | | | |
| /s/ Richard C. Larson | | | |
| Richard C. Larson | | | |
| Chief Financial Officer | | | |
EXHIBIT INDEX
WATERSTONE FINANCIAL, INC.
Form 10-Q for Quarter Ended June 30, 2012
| Exhibit No. | | Description | | Filed Herewith | |
| 31.1 | | Sarbanes-Oxley Act Section 302 Certification signed by the Chief Executive Officer of Waterstone Financial, Inc. | | X | |
| 31.2 | | Sarbanes-Oxley Act Section 302 Certification signed by the Chief Financial Officer of Waterstone Financial, Inc. | | X | |
| 32.1 | | Certification pursuant to 18 U.S. C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 signed by the Chief Executive Officer of Waterstone Financial, Inc. | | X | |
| 32.2 | | Certification pursuant to 18 U.S. C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 signed by the Chief Financial Officer of Waterstone Financial, Inc. | | X | |
