Forward-Looking Statements
This report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). The Private Securities Litigation Reform Act of 1995 provides a “safe harbor” for forward looking statements. Such statements are not historical facts and include expressions about management’s confidence and strategies and management’s expectations about new and existing programs and products, relationships, opportunities, taxation, technology and market conditions. When used in this and in our future filings with the SEC in our press releases and in oral statements made with the approval of an authorized executive officer, the words or phrases “will,” “will likely result,” “could,” “anticipates,” “believes,” “continues,” “expects,” “plans,” “will continue,” “is anticipated,” “estimated,” “project” or “outlook” or similar expressions (including confirmations by one of our authorized executive officers of any such expressions made by a third party with respect to us) are intended to identify forward-looking statements. We wish to caution readers not to place undue reliance on any such forward-looking statements, each of which speaks only as of the date made, even if subsequently made available on our website or otherwise. Such statements are subject to certain risks and uncertainties that could cause actual results to differ materially from historical earnings and those presently anticipated or projected.
Factors that may cause actual results to differ from those results, expressed or implied, include, but are not limited to, those discussed under “Business”, “Risk Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in the 2011 Form 10-K, under this Item 2, and in our other filings with the SEC.
Although management has taken certain steps to mitigate any negative effect of these factors, significant unfavorable changes could severely impact the assumptions used and have an adverse effect on profitability. The Company undertakes no obligation to publicly revise any forward-looking statements to reflect anticipated or unanticipated events or circumstances occurring after the date of such statements.
This Report contains certain financial information determined by methods other than in accordance with generally accepted accounting policies in the United States (GAAP). These non-GAAP financial measures are “tangible book value per common share,” “return on average tangible assets,” “return on average tangible equity,” and “average tangible equity to average tangible assets.” This non-GAAP disclosure has limitations as an analytical tool and should not be considered in isolation or as a substitute for analysis of the Company’s results as reported under GAAP, nor is it necessarily comparable to non-GAAP performance measures that may be presented by other companies. Our management uses these non-GAAP measures in its analysis of our performance because it believes these measures are material and will be used as a measure of our performance by investors.
The following information should be read in conjunction with the consolidated financial statements and the related notes thereto included in the 2011 Form 10-K and in this Form 10-Q.
Critical Accounting Policies and Estimates
The following discussion is based upon our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). The preparation of these financial statements requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses.
Note 1 to our audited consolidated financial statements included in the 2011 Form 10-K contains a summary of the Company’s significant accounting policies. Management believes the following critical accounting policies encompass the more significant judgments and estimates used in the preparation of our consolidated financial statements.
Allowance for Loan Losses. Management believes our policy with respect to the methodology for the determination of the allowance for loan losses (“ALLL”) involves a high degree of complexity and requires management to make difficult and subjective judgments which often require assumptions or estimates about highly uncertain matters. Changes in these judgments, assumptions or estimates could materially impact the results of operations. This critical policy and its application are reviewed quarterly with our audit committee and Board of Directors.
Management is responsible for preparing and evaluating the ALLL on a quarterly basis in accordance with Bank policy, and the Interagency Policy Statement on the ALLL released by the Board of Governors of the Federal Reserve System on December 13, 2006 as well as GAAP. We believe that our allowance for loan losses is adequate to cover specifically identifiable loan losses, as well as estimated losses inherent in our portfolio for which certain losses are probable but not specifically identifiable. The allowance for loan losses is based upon management’s evaluation of the adequacy of the allowance account, including an assessment of known and inherent risks in the portfolio, giving consideration to the size and composition of the loan portfolio, actual loan loss experience, level of delinquencies, detailed analysis of individual loans for which full collectability may not be assured, the existence and estimated net realizable value of any underlying collateral and guarantees securing the loans, and current economic and market conditions. Although management utilizes the best information available, the level of the allowance for loan losses remains an estimate that is subject to significant judgment and short term change. Various regulatory agencies may require us and our banking subsidiaries to make additional provisions for loan losses based upon information available to them at the time of their examination. The majority of our loans are secured by real estate in New Jersey, primarily in Monmouth and Union counties. The Company has also expanded its lending efforts into Middlesex County. Accordingly, the collectability of a substantial portion of the carrying value of our loan portfolio is susceptible to changes in local market conditions and may be adversely affected should real estate values decline or the New Jersey and/or our local market areas experience economic shock.
Stock Based Compensation. Stock based compensation cost has been measured using the fair value of an award on the grant date and is recognized over the service period, which is usually the vesting period. The fair value of each option is amortized into compensation expense on a straight-line basis between the grant date for the option and each vesting date. The Company estimates the fair value of stock options on the date of grant using the Black-Scholes option pricing model. The model requires the use of numerous assumptions, many of which are highly subjective in nature.
Goodwill Impairment. Although goodwill is not subject to amortization, the Company must test the carrying value for impairment at least annually or more frequently if events or changes in circumstances indicate that the asset might be impaired. Impairment testing requires that the fair value of our reporting unit be compared to the carrying amount of its net assets, including goodwill. Our reporting unit was identified as our community bank operations. If the fair value of the reporting unit exceeds the book value, no write-down of recorded goodwill is necessary. If the fair value of a reporting unit is less than book value, an expense may be required on the Company’s books to write-down the related goodwill to the proper carrying value. Impairment testing for goodwill was completed at September 30, 2012 and no goodwill impairment was recorded.
Investment Securities Impairment Valuation. Securities are evaluated on at least a quarterly basis, and more frequently when market conditions warrant such an evaluation, to determine whether a decline in their value is other-than-temporary. The analysis of other-than-temporary impairment requires the use of various assumptions including, but not limited to, the length of time the investment’s book value has been greater than fair value, the severity of the investment’s decline and the credit deterioration of the issuer. For debt securities, management assesses whether (a) it has the intent to sell the security and (b) it is more likely than not that it will be required to sell the security prior to its anticipated recovery. These steps are done before assessing whether the entity will recover the cost basis of the investment.
In instances when a determination is made that an other-than-temporary impairment exists but the investor does not intend to sell the debt security and it is not more likely than not that it will be required to sell the debt security prior to its anticipated recovery, the other-than-temporary impairment is separated into (a) the amount of the total other-than-temporary impairment related to a decrease in cash flows expected to be collected from the debt security (the credit loss) and (b) the amount of the total other-than-temporary impairment related to all other factors. The amount of the total other-than-temporary impairment related to the credit loss is recognized in earnings. The amount of the total other-than-temporary impairment related to all other factors is recognized in other comprehensive income.
Other Real Estate Owned (“OREO”). OREO includes real estate acquired through foreclosure. Real estate owned is initially recorded at fair value less cost to sell at the date of foreclosure, establishing a new cost basis. Subsequent to foreclosure, valuations are periodically performed by management and the assets are carried at the lower of carrying amount or fair value less cost to sell. When a property is acquired, the excess of the loan balance over fair value is charged to the allowance for loan losses. Operating results from real estate owned including rental income, operating expenses, and gains and losses realized from the sales of real estate owned are recorded as incurred. OREO is periodically reviewed to ensure that the fair value of the property supports the carrying value.
Deferred Tax Assets and Liabilities. We recognize deferred tax assets and liabilities for future tax effects of temporary differences, net operating loss carry forwards and tax credits. Deferred tax assets are subject to management’s judgment based upon available evidence that future realization is more likely than not. If management determines that we may be unable to realize all or part of net deferred tax assets in the future, a direct charge to income tax expense may be required to reduce the recorded value of the net deferred tax asset to the expected realizable amount.
Overview
The Company reported net income to common shareholders of $1.2 million for the three months ended September 30, 2012, compared to $703,000, for the same period in 2011, an increase of $500,000, or 71.1%. Basic and diluted earnings per common share after preferred stock dividends and accretion were both $0.15 for the quarter ended September 30, 2012 compared to $0.09 for the same period in 2011. Net income to common shareholders for the third quarter of 2012 was positively impacted by a $69,000 refund from the U.S. Treasury for an overpayment of dividends paid on our preferred stock issued in connection with the Small Business Lending Fund (“SBLF”) established under the Small Business Jobs Act of 2010. These refunds relate to prior period dividend rate revisions. For the same period in 2011, net income to common shareholders was adversely impacted by a $301,000 remaining discount accretion resulting from the redemption of the preferred stock issued under the U.S. Treasury TARP Capital Purchase Plan. Excluding the effect of these items, net income to common shareholders for the three months ended September 30, 2012 would have amounted to $1.1 million compared to $1.0 million for the same period in 2011, an increase of $130,000 or 12.9%. The annualized return on average assets increased to 0.71% for the three months ended September 30, 2012 as compared to 0.65% for the same period in 2011. The annualized return on average shareholders’ equity increased to 5.47% for the three month period ended September 30, 2012 as compared to 5.23% for the three month period ended September 30, 2011.
The Company reported net income to common shareholders of $3.3 million for the nine months ended September 30, 2012, compared to $2.4 million, for the same period in 2011, an increase of $839,000, or 34.7%. Basic and diluted earnings per common share after preferred stock dividends and accretion were $0.41 and $0.40, respectively, for the nine months ended September 30, 2012 compared to $0.31 and $0.30, respectively, for the same period in 2011. Net income to common shareholders for the nine months ended September 30, 2012 was positively impacted by the $69,000 refund from the U.S. Treasury described above. These refunds relate to prior period dividend rate revisions. For the same period in 2011, net income to common shareholders was adversely impacted by the $301,000 remaining discount accretion described above. Excluding the effect of these items, net income to common shareholders for the nine months ended September 30, 2012 would have amounted to $3.2 million compared to $2.7 million for the same period in 2011, an increase of $469,000 or 17.2%. The annualized return on average assets increased to 0.69% for the nine months ended September 30, 2012 as compared to 0.62% for the same period in 2011. The annualized return on average shareholders’ equity increased to 5.35% for the nine month period ended September 30, 2012 as compared to 5.03% for the nine month period ended September 30, 2011. Tangible book value per common share rose to $7.58 at September 30, 2012 as compared to $7.04 at September 30, 2011, as disclosed in the Non-GAAP Financial Measures table.
Net interest income increased by $96,000, or 1.5%, for the quarter ended September 30, 2012 from the same period in 2011, primarily due to an increase in average interest earning assets partially offset by a contraction in our net interest margin. On a linked quarter basis, net interest income increased by $161,000, or 2.5%, from the second quarter of 2012 also due principally to an increase in our average interest earning assets. The Company reported a net interest margin of 4.09% for the quarter ended September 30, 2012, an increase of 1 basis point when compared to the 4.08% reported for the quarter ended June 30, 2012 and a decrease of 7 basis points when compared to the 4.16% for the quarter ended September 30, 2011. The decline from last year was primarily due to the low interest rate environment as well as the timing of a portion of loan growth, which occurred in the latter part of the quarter. In addition, $31,000 of interest and late fee reversals was recorded on loans, which were transferred into non-accrual status during the quarter ended September 30, 2012.
Net interest income increased by $226,000, or 1.2%, for the nine months ended September 30, 2012 compared to the same period in 2011, primarily resulting from a higher level of average interest earning assets. The Company reported a net interest margin of 4.12% for the nine months ended September 30, 2012, a decrease of 12 basis points compared to the 4.24% reported for the nine months ended September 30 30, 2011. The Company’s net interest income increased despite margin compression resulting from the maturities, prepayments or contractual repricing of loans and securities in this extended period of low interest rates.
The provision for loan losses for the three months ended September 30, 2012 was $330,000, compared to a provision for loan losses of $730,000 for the corresponding 2011 period. The provision for loan losses for the nine months ended September 30, 2012 was $950,000, as compared to a provision for loan losses of $1.9 million, for the corresponding 2011 period. The decrease in our provision was primarily due to lesser allowance requirements for certain identified impaired loans. The Company’s provision considers a number of factors, including our assessment of the current state of the economy, prolonged high levels of unemployment in our market, allowances related to impaired loans and loan growth. The provision for the comparable 2011 period considered the same factors.
Non-interest income for the quarter ended September 30, 2012 totaled $597,000, a decrease of $221,000, or 27.0%, compared to the same period in 2011. The decrease was primarily due to $324,000 of gains on the sale of securities in 2011 compared to no security sales in 2012. Additionally, a $32,000 credit loss recorded on a pooled trust preferred security was recorded during the third quarter 2012. These decreases were partially offset by an increase in fees generated by our residential mortgage department, higher bank-owned life insurance income resulting from increased purchases of such investments in the fourth quarter of 2011 along with an increase in service fees on deposit accounts. Non-interest income for the nine months ended September 30, 2012 totaled $1.9 million, an increase of $103,000, or 5.7%, compared to the same period in 2011. The increase was due primarily to an increase in fees generated by our residential mortgage department, increases in service fees on deposit accounts, higher bank-owned life insurance income resulting from increased purchases of such investments in the fourth quarter of 2011, as well as higher gains on the sale of SBA loans. These increases were partially offset by a decrease in the gains on the sale of securities available for sale, as well as an $80,000 credit loss on a pooled trust preferred security recorded during the nine month period September 30, 2012.
Non-interest expense for the quarter ended September 30, 2012 totaled $4.9 million, an increase of $80,000, or 1.7%, from the same period in 2011. This increase was primarily due to a $140,000 increase in salaries and benefits resulting from higher residential mortgage commissions, along with the hiring of additional key personnel as the Company continues to expand its lending division. These increases were partially offset by lower professional fees and occupancy and equipment expense. Non-interest expense for the nine months ended September 30, 2012 totaled $14.9 million, an increase of $507,000, or 3.5%, over the same period in 2011, due primarily to same year over year items discussed above.
Total assets at September 30, 2012 were $705.1 million, an increase of 4.5% from total assets of $674.6 million at December 31, 2011. Total loans at September 30, 2012 were $555.0 million, an increase of 4.7% compared to $530.1 million at December 31, 2011. Total deposits were $577.7 million at September 30, 2012, an increase of 4.3% from total deposits of $553.9 million at December 31, 2011. Core checking deposits at September 30, 2012 increased $17.5 million, or 11.8%, when compared to year-end 2011, resulting primarily from increased business and consumer activity, while savings accounts, inclusive of money market deposits, increased 5.5%. Conversely, higher cost time deposits decreased 8.6% over this same period.
The Company’s allowance for loan losses was $7.5 million at September 30, 2012 compared to $7.3 million at December 31, 2011. The allowance for loan losses as a percentage of total loans at September 30, 2012 was 1.35%, compared with 1.38% at December 31, 2011. Non-performing assets at September 30, 2012, as a percentage of total assets were 1.71%, down from 1.93% at December 31, 2011. Non-performing assets decreased to $12.0 million at September 30, 2012 as compared to $13.0 million at December 31, 2011.
RESULTS OF OPERATIONS
The Company’s principal source of revenue is net interest income, which is the difference between interest income on earning assets and interest expense on deposits and borrowings. Interest earning assets consist primarily of loans, investment securities and Federal funds sold. Sources to fund interest-earning assets consist primarily of deposits and borrowed funds. The Company’s net income is also affected by its provision for loan losses, other income and other expenses. Other income consists primarily of service charges, commissions and fees, earnings from investment in life insurance and gains on the sale of securities, while other expenses are primarily comprised of salaries and employee benefits, occupancy costs and other operating expenses.
The following table provides information on our performance ratios for the dates indicated.
| | | As of and for the Three months ended September 30, | | | | As of and for the Nine months ended September 30, | | |
| | | 2012 | | | | 2011 | | | | 2012 | | | | 2011 | | |
| Return on average assets | | | 0.71% | | | | | 0.65% | | | | | 0.69% | | | | | 0.62% | | |
| Return on average tangible assets (1) | | | 0.73% | | | | | 0.67% | | | | | 0.71% | | | | | 0.64% | | |
| Return on average shareholders' equity | | | 5.47% | | | | | 5.23% | | | | | 5.35% | | | | | 5.03% | | |
| Return on average tangible shareholders' equity (1) | | | 6.87% | | | | | 6.72% | | | | | 6.75% | | | | | 6.50% | | |
| Net interest margin | | | 4.09% | | | | | 4.16% | | | | | 4.12% | | | | | 4.24% | | |
| Average equity to average assets | | | 12.93% | | | | | 12.49% | | | | | 12.90% | | | | | 12.43% | | |
| Average tangible equity to average tangible assets (1) | | | 10.57% | | | | | 10.02% | | | | | 10.50% | | | | | 9.89% | | |
| (1) | The following table provides the reconciliation of non-GAAP financial measures for the dates indicated: |
| | | As of and for the Three months ended September 30, | | | As of and for the Nine months ended September 30, | |
| | | 2012 | | | 2011 | | | 2012 | | | 2011 | |
| | | | | | | | | | | | | |
| Net income available to common shareholders | | $ | 1,203 | | | $ | 703 | | | $ | 3,257 | | | $ | 2,418 | |
| Effect of U.S. Treasury preferred stock refund | | | (69 | ) | | | - | | | | (69 | ) | | | - | |
| Effect of accelerated portion of discount accretion | | | - | | | | 301 | | | | - | | | | 301 | |
| Net income available to common shareholders | | | | | | | | | | | | | | | | |
| excluding U.S. Treasury preferred stock | | | | | | | | | | | | | | | | |
| refund and accelerated discount accretion | | $ | 1,134 | | | $ | 1,004 | | | $ | 3,188 | | | $ | 2,719 | |
| | | | | | | | | | | | | | | | | |
| Diluted earnings per common share | | $ | 0.15 | | | $ | 0.09 | | | $ | 0.40 | | | $ | 0.30 | |
| Effect of U.S. Treasury preferred stock refund | | | (0.01 | ) | | | - | | | | (0.01 | ) | | | - | |
| Effect of accelerated portion of discount accretion | | | - | | | | 0.04 | | | | - | | | | 0.04 | |
| Diluted earnings per common share excluding | | | | | | | | | | | | | | | | |
| U.S. Treasury preferred stock refund and | | | | | | | | | | | | | | | | |
| and accelerated discount accretion | | $ | 0.14 | | | $ | 0.13 | | | $ | 0.39 | | | $ | 0.34 | |
| | | | | | | | | | | | | | | | | |
| Book value per common share | | $ | 9.89 | | | $ | 9.39 | | | $ | 9.89 | | | $ | 9.39 | |
| Effect of intangible assets | | | (2.31 | ) | | | (2.35 | ) | | | (2.31 | ) | | | (2.35 | ) |
| Tangible book value per common share | | $ | 7.58 | | | $ | 7.04 | | | $ | 7.58 | | | $ | 7.04 | |
| | | | | | | | | | | | | | | | | |
| Return on average assets | | | 0.71% | | | | 0.65% | | | | 0.69% | | | | 0.62% | |
| Effect of intangible assets | | | 0.02% | | | | 0.02% | | | | 0.02% | | | | 0.02% | |
| Return on average tangible assets | | | 0.73% | | | | 0.67% | | | | 0.71% | | | | 0.64% | |
| | | | | | | | | | | | | | | | | |
| Return on average equity | | | 5.47% | | | | 5.23% | | | | 5.35% | | | | 5.03% | |
| Effect of average intangible assets | | | 1.40% | | | | 1.49% | | | | 1.40% | | | | 1.47% | |
| Return on average tangible equity | | | 6.87% | | | | 6.72% | | | | 6.75% | | | | 6.50% | |
| | | | | | | | | | | | | | | | | |
| Average equity to average assets | | | 12.93% | | | | 12.49% | | | | 12.90% | | | | 12.43% | |
| Effect of intangible assets | | | (2.36% | ) | | | (2.47% | ) | | | (2.40% | ) | | | (2.54% | ) |
| Average tangible equity to average tangible assets | | | 10.57% | | | | 10.02% | | | | 10.50% | | | | 9.89% | |
This Report contains certain financial information determined by methods other than in accordance with generally accepted accounting policies in the United States (GAAP). These non-GAAP financial measures are “net income available to common shareholders excluding U.S. Treasury preferred stock refund and accelerated discount accretion,” ‘diluted earnings per common share excluding U.S. Treasury preferred stock refund and accelerated discount accretion,” “tangible book value per common share,” “return on average tangible assets,” “return on average tangible equity” and “average tangible equity to average tangible assets.” This non-GAAP disclosure has limitations as an analytical tool and should not be considered in isolation or as a substitute for analysis of the Company’s results as reported under GAAP, nor is it necessarily comparable to non-GAAP performance measures that may be presented by other companies. Our management uses these non-GAAP measures in its analysis of our performance because it believes these measures are material and will be used as a measure of our performance by investors.
On October 29, 2012, Hurricane Sandy made landfall in New Jersey and caused damage across large portions of the Mid-Atlantic, Northeastern, and Midwestern United States. While we experienced no substantial damage to any of our facilities, our operations remained closed until October 30, 2012, with limited operational capabilities through November 5, 2012. Additionally, many of our customers have been negatively impacted. As the aftermath of the storm is still affecting large portions of the region, we are currently unable to quantify the financial impact of the storm. However, it is not expected to be significant to the Company’s overall fourth-quarter 2012 financial results.
We anticipate that our earnings will remain challenged for the remainder of 2012 principally due to the sluggish economic conditions in the New Jersey commercial and real estate markets and the impact of Hurricane Sandy on the New Jersey markets that we serve. In addition, should a further general decline in economic conditions in New Jersey continue caused by the after effects of Hurricane Sandy or otherwise, the Company may suffer higher default rates on its loans, decreased value of assets it holds as collateral, and potentially lower loan originations due to heightened competition for lending relationships coupled with our higher credit standards and requirements.
Three months ended September 30, 2012 compared to September 30, 2011
Net Interest Income
Net interest income increased by $96,000, or 1.5%, for the three months ended September 30, 2012 compared to the corresponding period in 2011, primarily due to by an increase in average interest earning assets partially offset by a contraction in our net interest margin. Average interest earning assets totaled $642.9 million for the third quarter of 2012, an increase of $21.7 million, or 3.5%, from $621.2 million for the same period in 2011. The net interest spread and net interest margin decreased to 3.90% and 4.09%, respectively, for the three months ended September 30, 2012, from 3.95% and 4.16%, respectively, for the three months ended September 30, 2011, due primarily to lower interest rates on our interest earning assets. The decline for the quarter was primarily due to the prolonged low interest rate environment, which has continued to exert pressure on asset yields, as well as the timing of our loan closings, which occurred in the latter part of the quarter and thus resulted in funds remaining in a lower yielding cash position for most of the quarter rather than in higher yielding loans. Additionally, net interest income was impacted by $31,000 of interest and late fee reversals on loans transferred into non-accrual status.
Total interest income for the three months ended September 30, 2012 decreased by $80,000, or 1.0%. The decrease in interest income was primarily due to interest rate related decreases in interest income of $629,000, partially offset by volume related increases in interest income of $549,000 for the third quarter of 2012 as compared to the same prior year period.
Interest and fees on loans decreased $61,000, or 0.8%, to $7.3 million for the three months ended September 30, 2012 compared to $7.4 million for the corresponding period in 2011. Interest rate related decreases equaled $528,000, offset by a volume related increase of $467,000. The average balance of the loan portfolio for the three months ended September 30, 2012 increased by $32.8 million, or 6.3%, to $551.0 million from $518.2 million for the corresponding period in 2011. The average annualized yield on the loan portfolio was 5.29% for the quarter ended September 30, 2012 compared to 5.66% for the quarter ended September 30, 2011. Additionally, the average balance of non-accrual loans during the three month period amounted to $4.9 million and $6.2 million at September 30, 2012 and 2011, respectively, impacted the Company’s loan yield for both periods presented.
Interest income on Federal funds sold and interest bearing deposits was $15,000 for the three months ended September 30, 2012, representing a decrease of $16,000, or 51.6%, from $31,000 for the three months ended September 30, 2011. For the three months ended September 30, 2012 and 2011, the Bank held no Federal funds sold. During the second quarter 2011, in order to maximize earnings on excess liquidity and increase the safety of our funds, the Bank transferred its entire Fed funds sold balance to the Federal Reserve Bank of New York, which paid a higher return than our correspondent banks. For the three months ended September 30, 2012, interest bearing deposits had an average balance of $23.7 million as compared to an average balance of $48.3 million for the same period in 2011. This average balance decrease was primarily due to an increase in loan growth and investment purchases, partially offset by deposit growth. The average annualized yield was 0.25% for both periods.
Interest income on investment securities totaled $391,000 for the three months ended September 30, 2012 compared to $394,000 for the three months ended September 30, 2011, a decrease of $3,000, or 0.8%. The decrease in interest income on investment securities was primarily attributable to new purchases at lower interest rates which replaced maturities, calls, principal paydowns and sales of existing securities as well as reinvesting a portion of our cash liquidity position. For the three months ended September 30, 2012, investment securities had an average balance of $68.3 million with an average annualized yield of 2.29% compared to an average balance of $54.7 million with an average annualized yield of 2.88% for the three months ended September 30, 2011. This decline in yield was the result of the lower interest rate environment.
Interest expense on interest-bearing liabilities amounted to $1.1 million for the three months ended September 30, 2012 compared to $1.3 million for the corresponding period in 2011, a decrease of $176,000, or 13.5%. This decrease in interest expense was comprised of a $156,000 rate-related decrease primarily resulting from lower deposit rates as well as a $20,000 volume-related decrease.
The Bank continues to focus on developing core deposit relationships. Additionally, management continues to restructure the mix of interest-bearing liabilities portfolio by decreasing our funding dependence from high-cost time deposits to lower-cost core checking, money market and savings account deposit products. The average balance of interest-bearing liabilities increased to $505.8 million for the three months ended September 30, 2012 from $496.0 million for the same period last year, an increase of $9.8 million, or 2.0%. Average NOW accounts increased $4.6 million from $60.3 million with an average annualized yield of 0.43% during the third quarter of 2011, to $64.9 million with an average annualized yield of 0.40% during the third quarter of 2012. Average savings deposits increased by $20.9 million over this same period while the average annualized yield declined by 10 basis points. These average balance increases were partially offset by a decrease in our money market deposits of $2.9 million over this same period while the average annualized yield declined by 17 basis points as well as a decrease of $13.9 million in our average time deposit balances and a decrease of 19 basis points in the average annualized yield. During the third quarter of 2012, our average demand deposits totaled $97.4 million, an increase of $6.5 million, or 7.1%, over the same period last year. For the three months ended September 30, 2012, the average annualized cost for all interest-bearing liabilities was 0.89%, compared to 1.04% for the three months ended September 30, 2011, a decrease of 15 basis points.
Our strategies for increasing and retaining core relationship deposits, managing loan originations within our acceptable credit criteria and loan category concentrations, and our planned branch network growth have combined to meet our liquidity needs. The Company also offers agreements to repurchase securities, commonly known as repurchase agreements, to our customers as an alternative to other insured deposits. Average balances of repurchase agreements for the third quarter of 2012 were $17.9 million, with an average interest rate of 0.58%, compared to $16.9 million, with an average interest rate of 0.66%, for the third quarter of 2011.
The Company also utilizes FHLB term borrowings as an additional funding source. The average balance of such borrowings for the third quarter of 2012 and 2011 remained unchanged at $13.5 million, with an average interest rate of 3.20% and 3.20%, respectively.
The following tables reflect, for the periods presented, the components of our net interest income, setting forth (1) average assets, liabilities, and shareholders’ equity, (2) interest income earned on interest-earning assets and interest expenses paid on interest-bearing liabilities, (3) average yields earned on interest-earning assets and average rates paid on interest-bearing liabilities, (4) our net interest spread (i.e., the average yield on interest-earning assets less the average rate on interest-bearing liabilities), and (5) our margin on interest-earning assets. Yields on tax-exempt assets have not been calculated on a fully tax-exempt basis.
| | | Three Months Ended September 30, 2012 | | Three Months Ended September 30, 2011 |
| (dollars in thousands) | | Average Balance | | | Interest Income/ Expense | | | Average Rate | | Average Balance | | | Interest Income/ Expense | | | Average Rate |
| ASSETS | | | | | | | | | | | | | | | | | | |
| Interest Earning Assets: | | | | | | | | | | | | | | | | | | |
| Interest bearing deposits in banks | | $ | 23,705 | | | $ | 15 | | | | 0.25 | % | | $ | 48,335 | | | $ | 31 | | | | 0.25 | % |
| Federal funds sold | | | - | | | | - | | | | 0.00 | % | | | - | | | | - | | | | 0.00 | % |
| Investment securities | | | 68,261 | | | | 391 | | | | 2.29 | % | | | 54,713 | | | | 394 | | | | 2.88 | % |
| Loans, net of unearned fees (1) (2) | | | 550,976 | | | | 7,333 | | | | 5.29 | % | | | 518,214 | | | | 7,394 | | | | 5.66 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Total Interest Earning Assets | | | 642,942 | | | | 7,739 | | | | 4.79 | % | | | 621,262 | | | | 7,819 | | | | 4.99 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Non-Interest Earning Assets: | | | | | | | | | | | | | | | | | | | | | | | | |
| Allowance for loan losses | | | (7,364 | ) | | | | | | | | | | | (6,879 | ) | | | | | | | | |
| All other assets | | | 62,684 | | | | | | | | | | | | 61,550 | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Total Assets | | $ | 698,262 | | | | | | | | | | | $ | 675,933 | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| LIABILITIES & SHAREHOLDERS' EQUITY | | | | | | | | | | | | | | | | | | | | | | | | |
| Interest-Bearing Liabilities: | | | | | | | | | | | | | | | | | | | | | | | | |
| NOW deposits | | $ | 64,872 | | | | 66 | | | | 0.40 | % | | $ | 60,281 | | | | 66 | | | | 0.43 | % |
| Savings deposits | | | 220,761 | | | | 398 | | | | 0.72 | % | | | 199,846 | | | | 414 | | | | 0.82 | % |
| Money market deposits | | | 83,457 | | | | 75 | | | | 0.36 | % | | | 86,384 | | | | 115 | | | | 0.53 | % |
| Time deposits | | | 105,268 | | | | 452 | | | | 1.71 | % | | | 119,137 | | | | 570 | | | | 1.90 | % |
| Repurchase agreements | | | 17,940 | | | | 26 | | | | 0.58 | % | | | 16,852 | | | | 28 | | | | 0.66 | % |
| FHLB-term borrowings | | | 13,500 | | | | 109 | | | | 3.20 | % | | | 13,500 | | | | 109 | | | | 3.20 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Total Interest Bearing Liabilities | | | 505,798 | | | | 1,126 | | | | 0.89 | % | | | 496,000 | | | | 1,302 | | | | 1.04 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Non-Interest Bearing Liabilities: | | | | | | | | | | | | | | | | | | | | | | | | |
| Demand deposits | | | 97,368 | | | | | | | | | | | | 90,873 | | | | | | | | | |
| Other liabilities | | | 4,778 | | | | | | | | | | | | 4,618 | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Total Non-Interest Bearing Liabilities | | | 102,146 | | | | | | | | | | | | 95,491 | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Shareholders' Equity | | | 90,318 | | | | | | | | | | | | 84,442 | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Total Liabilities and Shareholders' Equity | | $ | 698,262 | | | | | | | | | | | $ | 675,933 | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| NET INTEREST INCOME | | | | | | $ | 6,613 | | | | | | | | | | | $ | 6,517 | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| NET INTEREST SPREAD (3) | | | | | | | | | | | 3.90 | % | | | | | | | | | | | 3.95 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| NET INTEREST MARGIN(4) | | | | | | | | | | | 4.09 | % | | | | | | | | | | | 4.16 | % |
| (1) | Included in interest income on loans are loan fees. |
| (2) | Includes non-performing loans. |
| (3) | The interest rate spread is the difference between the weighted average yield on average interest earning assets and the weighted average cost of average interest bearing liabilities. |
| (4) | The interest rate margin is calculated by dividing annualized net interest income by average interest earning assets. |
| | | Nine Months Ended September 30, 2012 | | Nine Months Ended September 30, 2011 |
| (dollars in thousands) | | Average Balance | | | Interest Income/ Expense | | | Average Rate | | Average Balance | | | Interest Income/ Expense | | | Average Rate |
| ASSETS | | | | | | | | | | | | | | | | | | |
| Interest Earning Assets: | | | | | | | | | | | | | | | | | | |
| Interest bearing deposits in banks | | $ | 29,997 | | | $ | 57 | | | | 0.25 | % | | $ | 37,140 | | | $ | 70 | | | | 0.25 | % |
| Federal funds sold | | | - | | | | - | | | | 0.00 | % | | | 4,205 | | | | 7 | | | | 0.22 | % |
| Investment securities | | | 64,277 | | | | 1,175 | | | | 2.44 | % | | | 50,539 | | | | 1,161 | | | | 3.06 | % |
| Loans, net of unearned fees (1) (2) | | | 540,085 | | | | 21,844 | | | | 5.40 | % | | | 518,413 | | | | 22,069 | | | | 5.69 | % |
| | | | | | | | | | | | | | | | | �� | | | | | | | | |
| Total Interest Earning Assets | | | 634,359 | | | | 23,076 | | | | 4.86 | % | | | 610,297 | | | | 23,307 | | | | 5.11 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Non-Interest Earning Assets: | | | | | | | | | | | | | | | | | | | | | | | | |
| Allowance for loan losses | | | (7,250 | ) | | | | | | | | | | | (6,550 | ) | | | | | | | | |
| All other assets | | | 63,450 | | | | | | | | | | | | 59,206 | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Total Assets | | $ | 690,559 | | | | | | | | | | | $ | 662,953 | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| LIABILITIES & SHAREHOLDERS' EQUITY | | | | | | | | | | | | | | | | | | | | | | | | |
| Interest-Bearing Liabilities: | | | | | | | | | | | | | | | | | | | | | | | | |
| NOW deposits | | $ | 64,193 | | | | 200 | | | | 0.42 | % | | $ | 56,477 | | | | 191 | | | | 0.45 | % |
| Savings deposits | | | 216,085 | | | | 1,217 | | | | 0.75 | % | | | 198,593 | | | | 1,309 | | | | 0.88 | % |
| Money market deposits | | | 83,276 | | | | 252 | | | | 0.40 | % | | | 88,733 | | | | 397 | | | | 0.60 | % |
| Time deposits | | | 107,625 | | | | 1,430 | | | | 1.77 | % | | | 116,476 | | | | 1,650 | | | | 1.89 | % |
| Repurchase agreements | | | 18,257 | | | | 81 | | | | 0.59 | % | | | 16,038 | | | | 91 | | | | 0.76 | % |
| FHLB-term borrowings | | | 13,500 | | | | 325 | | | | 3.22 | % | | | 13,500 | | | | 324 | | | | 3.21 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Total Interest Bearing Liabilities | | | 502,936 | | | | 3,505 | | | | 0.93 | % | | | 489,817 | | | | 3,962 | | | | 1.08 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Non-Interest Bearing Liabilities: | | | | | | | | | | | | | | | | | | | | | | | | |
| Demand deposits | | | 94,134 | | | | | | | | | | | | 86,292 | | | | | | | | | |
| Other liabilities | | | 4,422 | | | | | | | | | | | | 4,451 | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Total Non-Interest Bearing Liabilities | | | 98,556 | | | | | | | | | | | | 90,743 | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Shareholders' Equity | | | 89,067 | | | | | | | | | | | | 82,393 | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Total Liabilities and Shareholders' Equity | | $ | 690,559 | | | | | | | | | | | $ | 662,953 | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| NET INTEREST INCOME | | | | | | $ | 19,571 | | | | | | | | | | | $ | 19,345 | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| NET INTEREST SPREAD (3) | | | | | | | | | | | 3.93 | % | | | | | | | | | | | 4.03 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| NET INTEREST MARGIN(4) | | | | | | | | | | | 4.12 | % | | | | | | | | | | | 4.24 | % |
| (1) | Included in interest income on loans are loan fees. |
| (2) | Includes non-performing loans. |
| (3) | The interest rate spread is the difference between the weighted average yield on average interest earning assets and the weighted average cost of average interest bearing liabilities. |
| (4) | The interest rate margin is calculated by dividing annualized net interest income by average interest earning assets. |
Analysis of Changes in Net Interest Income
The following table sets forth for the periods indicated a summary of changes in interest earned and interest paid resulting from changes in volume and changes in rates:
| | | Three Months Ended September 30, 2012 | | | Nine Months Ended September 30, 2012 | |
| | | Compared to Three Months Ended | | | Compared to Nine Months Ended | |
| | | September 30, 2011 | | | September 30, 2011 | |
| | | Increase (decrease) due to change in | |
| | | Volume | | | Rate | | | Net | | | Volume | | | Rate | | | Net | |
| | | (in thousands) | | | (in thousands) | |
| Interest Earned On: | | | | | | | | | | | | | | | | | | |
| Interest bearing deposits in banks | | $ | (16 | ) | | $ | - | | | $ | (16 | ) | | $ | (13 | ) | | $ | - | | | $ | (13 | ) |
| Federal funds sold | | | - | | | | - | | | | - | | | | (7 | ) | | | - | | | | (7 | ) |
| Investment securities | | | 98 | | | | (101 | ) | | | (3 | ) | | | 210 | | | | (196 | ) | | | 14 | |
| Loans | | | 467 | | | | (528 | ) | | | (61 | ) | | | 926 | | | | (1,151 | ) | | | (225 | ) |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Total Interest Income | | | 549 | | | | (629 | ) | | | (80 | ) | | | 1,116 | | | | (1,347 | ) | | | (231 | ) |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Interest Paid On: | | | | | | | | | | | | | | | | | | | | | | | | |
| NOW deposits | | | 5 | | | | (5 | ) | | | - | | | | 26 | | | | (17 | ) | | | 9 | |
| Savings deposits | | | 43 | | | | (59 | ) | | | (16 | ) | | | 116 | | | | (208 | ) | | | (92 | ) |
| Money market deposits | | | (4 | ) | | | (36 | ) | | | (40 | ) | | | (25 | ) | | | (120 | ) | | | (145 | ) |
| Time deposits | | | (66 | ) | | | (52 | ) | | | (118 | ) | | | (126 | ) | | | (94 | ) | | | (220 | ) |
| Repurchase agreements | | | 2 | | | | (4 | ) | | | (2 | ) | | | 13 | | | | (23 | ) | | | (10 | ) |
| Long-term debt | | | - | | | | - | | | | - | | | | - | | | | 1 | | | | 1 | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Total Interest Expense | | | (20 | ) | | | (156 | ) | | | (176 | ) | | | 4 | | | | (461 | ) | | | (457 | ) |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Net Interest Income | | $ | 569 | | | $ | (473 | ) | | $ | 96 | | | $ | 1,112 | | | $ | (886 | ) | | $ | 226 | |
The change in interest due to both volume and rate has been allocated proportionally to both, based on their relative absolute values.
Provision for Loan Losses
The provision for loan losses for the three months ended September 30, 2012 decreased to $330,000, as compared to a provision for loan losses of $730,000 for the corresponding 2011 period. The decrease in our provision was primarily due to lesser allowance requirements for certain identified impaired loans partially offset by loan growth. The $330,000 provision for three months ended September 30, 2012 considered a number of factors, including our assessment of the current state of the economy, prolonged high levels of unemployment in our market, and allowances related to impaired loans and loan activity. The provision for the comparable 2011 period considered the same factors. The provision for loan losses is determined by an allocation process whereby an estimated allowance is allocated to the specific allowance for impaired loans and the general allowance for pools of loans. The allocation reflects management’s assessment of economic conditions, credit quality and other risk factors inherent in the loan portfolio. The allowance for loan losses totaled $7.5 million, or 1.35% of total loans at September 30, 2012, as compared to $7.3 million, or 1.32% at June 30, 2012 and $7.3 million, or 1.38% at December 31, 2011. The increase of $228,000 in the allowance for loan losses during the third quarter is primarily due to the additional provision of $330,000 recorded during the third quarter of 2012 and $27,000 in recoveries, partially offset by loan charge-offs of $129,000.
In management’s opinion, the allowance for loan losses, totaling $7.5 million at September 30, 2012, is adequate to cover losses inherent in the portfolio. In the current interest rate and credit quality environment, our prudent risk management philosophy has been to stay within our established credit culture. We anticipate continued loan volume during 2012 as we continue to target credit worthy customers that have become dissatisfied with their relationships with larger financial institutions. Management will continue to review the need for additions to its allowance for loan losses based upon its ongoing review of the loan portfolio, the level of delinquencies and general market and economic conditions.
Non-Interest Income
For the three months ended September 30, 2012, non-interest income amounted to $597,000 compared to $818,000 for the corresponding period in 2011. The decrease of $221,000, or 27.0%, was primarily due to $324,000 of gains on the sale of securities in 2011 compared to no sales in 2012. Additionally, a $32,000 credit loss on a pooled trust preferred security was recorded during the third quarter 2012. These decreases were partially offset by an increase of $91,000 in origination fees resulting from higher loan volume in our residential mortgage department, a $21,000 increase in bank-owned life insurance income resulting from increased purchases of such investments during the fourth quarter of 2011 and a $31,000 increase in service fees on deposit accounts.
Non-Interest Expenses
Non-interest expenses for the three months ended September 30, 2012 increased $80,000, or 1.7%, to $4.9 million compared to $4.8 million for the three months ended September 30, 2011. This increase was primarily due to a $140,000 increase in salaries and benefits resulting from higher residential commissions along with the hiring of additional key personnel as the Company continues to expand its lending division. Additionally, outside service fees expenses increased $32,000 while data processing expenses increased $29,000. These increases were partially offset by a decrease of $75,000, or 31.0% in professional fees due to lower activity and a decrease in occupancy and equipment expenses of $17,000, or 2.1% primarily due to lower depreciation on capitalized expenditures. Additionally, other real estate owned (“OREO”) expenses, OREO impairments and sales and loan workout expenses decreased $28,000. Amortization of intangible assets, which was the result of The Town Bank acquisition in 2006, amounted to $39,000 for the third quarter of 2012 compared to $47,000 for the corresponding period in 2011.
Income Taxes
The Company recorded income tax expense of $727,000 for the three months ended September 30, 2012 compared to $661,000 for the three months ended September 30, 2011. The effective tax rate for the three months ended September 30, 2012 and 2011 was 37.1% and 37.4%, respectively.
Nine months ended September 30, 2012 compared to September 30, 2011
Net Interest Income
Net interest income increased by $226,000, or 1.2%, to $19.6 million for the nine months ended September 30, 2012 compared to $19.4 million for the corresponding period in 2011, primarily as a result of lower deposit rates and a higher level of core checking deposits coupled with a $24.1 million, or 3.9% increase in our average interest earning assets. The net interest spread and net interest margin decreased to 3.93% and 4.12%, respectively, for the nine months ended September 30, 2012, from 4.03% and 4.24%, respectively, for the nine months ended September 30, 2011, due primarily to the prolonged low interest rate environment, which had continued to exert pressure on asset yields.
Total interest income for the nine months ended September 30, 2012 decreased by $231,000, or 1.0%. The decrease in interest income was primarily due to rate-related decreases in interest income of $1.3 million, partially offset by volume-related increases in interest income of $1.1 for the nine months ended September 30, 2012 as compared to the same prior year period.
Interest and fees on loans decreased $225,000, or 1.0%, to $21.8 million for the nine months ended September 30, 2012 compared to $22.1 million for the corresponding period in 2011. Rate-related decreases equaled $1.2 million, partially offset by a volume-related increase of $926,000. The average balance of the loan portfolio for the nine months ended September 30, 2012 increased by $21.7 million, or 4.2%, to $540.1 million from $518.4 million for the corresponding period in 2011. The average annualized yield on the loan portfolio was 5.40% for the nine months ended September 30, 2012 compared to 5.69% for the nine months ended September 30, 2011. Additionally, the average balance of non-accrual loans, which amounted to $5.1 million and $5.9 million at September 30, 2012 and 2011, respectively, impacted the Company’s loan yield for both periods presented.
Interest income on Federal funds sold and interest bearing deposits was $57,000 for the nine months ended September 30, 2012, representing a decrease of $20,000, or 26.0%, from $77,000 for the nine months ended September 30, 2011. For the nine months ended September 30, 2012, the Bank held no Federal funds sold. During the second quarter 2011, in order to maximize earnings on excess liquidity and increase the safety of our funds, the Bank transferred its entire Fed funds sold balance to the Federal Reserve Bank of New York, which paid a higher return than our correspondent banks. For the nine months ended September 30, 2012, interest bearing deposits had an average balance of $30.0 million as compared to an average balance of $37.1 million for the same period in 2011. This average balance decrease in interest bearing deposits and Federal funds sold was primarily due to an increase in loan growth and investment purchases, partially offset by deposit growth. The average annualized yield was 0.25% for both periods.
Interest income on investment securities increased $14,000, or 1.2%, to $1.2 million for the nine months ended September 30, 2012 compared to the nine months ended September 30, 2011. The increase in interest income on investment securities was primarily attributable to new purchases which replaced maturities, calls, principal paydowns and sales of existing securities as well as reinvesting a portion of our cash liquidity position. For the nine months ended September 30, 2012, investment securities had an average balance of $64.3 million with an average annualized yield of 2.44% compared to an average balance of $50.5 million with an average annualized yield of 3.06% for the nine months ended September 30, 2011. This decline in yield was the result of the lower interest rate environment.
Interest expense on interest-bearing liabilities amounted to $3.5 million for the nine months ended September 30, 2012 compared to $4.0 million for the corresponding period in 2011, a decrease of $457,000, or 11.5%. This decrease in interest expense was comprised of a $461,000 rate-related decrease primarily resulting from lower deposit rates, partially offset by $4,000 in volume-related increases.
The Bank continues to remain focused on developing core deposit relationships. Additionally, management continued to restructure the mix of interest-bearing liabilities portfolio by decreasing our funding dependence from high-cost time deposits to lower-cost core checking, money market and savings account deposit products. The average balance of interest-bearing liabilities increased to $502.9 million for the nine months ended September 30, 2012 from $489.8 million for the same period last year, an increase of $13.1 million, or 2.7%. Our average NOW accounts increased $7.7 million from $56.5 million with an average annualized yield of 0.45% during the nine months ended September 30, 2011, to $64.2 million with an average annualized yield of 0.42% during the same period in 2012. Our average savings deposits increased by $17.5 million over this same period while the average annualized yield declined by 13 basis points. These average balance increases were partially offset by a decrease in our money market deposits of $5.5 million over this same period while the average annualized yield declined by 20 basis points and our average certificates of deposit decreased by $8.9 million, or 7.6%, to $107.6 million with an average annualized yield of 1.77% for the nine months ended September 30, 2012 from $116.5 million with an average annualized yield of 1.89% for the same period in 2011. During the nine months ended September 30, 2012, our average demand deposits totaled $94.1 million, an increase of $7.8 million, or 9.1%, over the same period last year. For the nine months ended September 30, 2012, the average annualized cost for all interest-bearing liabilities was 0.93%, compared to 1.08% for the nine months ended September 30, 2011, a decrease of 15 basis points.
Our strategies for increasing and retaining core relationship deposits, managing loan originations within our acceptable credit criteria and loan category concentrations, and our planned branch network growth have combined to meet our liquidity needs. The Company also offers agreements to repurchase securities, commonly known as repurchase agreements, to our customers as an alternative to other insured deposits. Average balances of repurchase agreements for the nine months ended September 30, 2012 were $18.3 million, with an average interest rate of 0.59%, compared to $16.0 million, with an average interest rate of 0.76%, for the nine months ended September 30, 2011.
The Company also utilizes FHLB term borrowings as an additional funding source. The average balance of such borrowings for the nine months ended September 30, 2012 and 2011 remained unchanged at $13.5 million, with an average interest rate of 3.22% and 3.21%, respectively.
Provision for Loan Losses
The provision for loan losses for the nine months ended September 30, 2012 decreased to $950,000, compared to a provision for loan losses of $1.9 million for the corresponding 2011 period. The decrease in our provision was primarily due to lesser allowance requirements for certain identified impaired loans partially offset by loan growth. The $950,000 provision for nine months ended September 30, 2012 considered a number of factors, including our assessment of the current state of the economy, prolonged high levels of unemployment in our market, and allowances related to impaired loans and loan activity. The provision for the comparable 2011 period considered the same factors. The provision for loan losses is determined by an allocation process whereby an estimated allowance is allocated to the specific allowance for impaired loans and the general allowance for pools of loans. The allocation reflects management’s assessment of economic conditions, credit quality and other risk factors inherent in the loan portfolio.
Non-Interest Income
For the nine months ended September 30, 2012, non-interest income amounted to $1.9 million compared to $1.8 million for the corresponding period in 2011. The increase of $103,000, or 5.7%, was due primarily to an increase of $260,000 in origination fees resulting from higher loan volume in our residential mortgage department, an increase of $86,000 in the gain on the sale of SBA loans, a $69,000 increase in bank-owned life insurance income resulting from increased purchases of such investments during the fourth quarter of 2011 and an increase of $89,000 in service fees on deposit accounts and debit card fees. These increases were partially offset by a decrease of $324,000 in gains on the sale of securities as well as an $80,000 credit loss on a pooled trust preferred security recorded during the nine months ended September 30, 2012.
Non-Interest Expenses
Non-interest expenses for the nine months ended September 30, 2012 increased $507,000, or 3.5%, to $14.9 million compared to $14.4 million for the nine months ended June 30, 2011. This increase was primarily due to an increase of $511,000 related to OREO sales as the net loss on sales of OREO properties in 2012 amounted to $130,000 as compared to a net gain of $381,000 during the same period in 2011. Salaries and benefits increased $218,000 primarily resulting from higher residential mortgage commissions, along with the hiring of additional key personnel as the Company continues to expand its lending division. Loan workout expenses increased $116,000 primarily due to the recapture of previously paid expenses during the nine month period ended September 30, 2011. Additionally, outside service fees as well as advertising expense increased $85,000 and $40,000, respectively, due to increased activity. These increases were partially offset by a decrease in FDIC insurance and assessments of $122,000, or 22.9%, primarily due to the change in assessment calculation from a deposit based calculation to an asset based less Tier 1 capital calculation. Professional fees decreased $134,000, or 20.6% based on activity. Occupancy and equipment expenses declined by $102,000, or 4.2%, primarily due to lower depreciation on capitalized expenditures while insurance expenses declined by $38,000 due to lower renewal rates. Amortization of intangible assets, which was the result of The Town Bank acquisition in 2006, amounted to $125,000 for the nine months ended September 30, 2012 compared to $153,000 for the corresponding period in 2011.
Income Taxes
The Company recorded income tax expense of $2.1 million for the nine months ended September 30, 2012 compared to $1.8 million for the nine months ended September 30, 2011. The effective tax rate for the nine months ended September 30, 2012 and 2011 was 36.9% and 37.1%, respectively.
FINANCIAL CONDITION
Assets
At September 30, 2012, our total assets were $705.1 million, an increase of $30.5 million, or 4.5%, over total assets of $674.6 million at December 31, 2011. At September 30, 2012, our total loans were $555.0 million, an increase of $24.9 million, or 4.7%, from the $530.1 million reported at December 31, 2011. Investment securities, including restricted stock, were $66.8 million at September 30, 2012 as compared to $62.8 million at December 31, 2011, an increase of $4.0 million, or 6.4%. At September 30, 2012, cash and cash equivalents totaled $43.5 million compared to $38.0 million at December 31, 2011, an increase of $5.5 million, or 14.5%, as our liquidity position continues to remain strong at September 30, 2012. Goodwill totaled $18.1 million at both September 30, 2012 and December 31, 2011.
Liabilities
Total deposits increased $23.8 million, or 4.3%, to $577.7 million at September 30, 2012, from $553.9 million at December 31, 2011. Deposits are the Company’s primary source of funds. The deposit increase during the nine month period ending September 30, 2012 was primarily attributable to the Company’s strategic initiative to continue to grow market share through core deposit relationships. The Company anticipates continued loan demand increases during the remainder of 2012 and beyond and will depend on the expansion and maturation of our branch network as the primary funding source. As a secondary funding source, the Company intends to utilize borrowed funds at opportune times during changing rate cycles. The Company continues to experience change in the mix of the deposit products through its branch sales efforts, which are targeted to gain market penetration. In order to fund future loan demand, the Company intends to raise the most cost-efficient funding sources available within the market area.
Securities Portfolio
Investment securities, including restricted stock, totaled $66.8 million at September 30, 2012 compared to $62.8 million at December 31, 2011, an increase of $4.0 million, or 6.4%. During the nine months ended September 30, 2012, investment securities and restricted stock purchases amounted to $14.5 million, while repayments, calls and maturities amounted to $10.5 million. There were no sales of securities available for sale during the nine months ended September 30, 2012 and 2011.
The Company maintains an investment portfolio to fund increased loans and liquidity needs (resulting from decreased deposits or otherwise) and to provide an additional source of interest income. The portfolio is comprised of obligations of the U.S. Government agencies and U.S. Government-sponsored entities, municipal securities and a limited amount of corporate debt securities. All of our mortgage-backed investment securities are collateralized by pools of mortgage obligations that are guaranteed by privately managed, U.S. Government-sponsored enterprises (“GSE”), such as Fannie Mae, Freddie Mac and Government National Mortgage Association. Due to these GSE guarantees, these investment securities are susceptible to less risk of non-performance and default than other corporate securities which are collateralized by private pools of mortgages. At September 30, 2012, the Company maintained $22.0 million of GSE mortgage-backed securities in the investment portfolio and $17.5 million of collateralized residential mortgage obligations, all of which are current as to payment of principal and interest and were performing in accordance with the terms set forth in their respective prospectuses.
Included within the Company’s investment portfolio are trust preferred securities, which consists of four single issue securities and one pooled issue security. These securities have an amortized cost value of $3.0 million and a fair value of $2.2 million at September 30, 2012. The unrealized loss on these securities is related to general market conditions, the widening of interest rate spread and downgrades in credit ratings. The single issue securities are from large money center banks. The pooled instrument consists of securities issued by financial institutions and insurance companies, and we hold the mezzanine tranche of such security. Senior tranches generally are protected from defaults by over-collateralization and cash flow default protection provided by subordinated tranches, with senior tranches having the greatest protection and mezzanine tranches subordinated to the senior tranches. For the pooled trust preferred security, management reviewed expected cash flows and credit support and determined it was not probable that all principal and interest would be repaid. In this pooled trust preferred security, there are 28 out of 40 banks that are performing at September 30, 2012. The deferrals and defaults as a percentage of original collateral at September 30, 2012 was 31.7%. As the Company does not intend to sell this security and it is more likely than not that the Company will not be required to sell this security, the total other-than-temporary impairment on this security was $474,000 at September 30, 2012, of which $308,000 was determined to be a credit loss and charged to operations and $166,000 was determined to be non-credit related and included in the other comprehensive income component. There was $80,000 other-than-temporary charge to earnings recorded during the nine month period ended September 30, 2012 as compared to none for the same period in 2011.
Management evaluates all securities for other-than-temporary impairment at least on a quarterly basis, and more frequently when economic and market concerns warrant such evaluations. As of September 30, 2012, all of these securities are current with their scheduled interest payments, with the exception of the one pooled trust preferred security with an amortized cost basis of $192,000 at September 30, 2012, which has been remitting reduced amounts of interest as some individual participants of the pool have deferred interest payments. Future deterioration in the cash flow of these instruments or the credit quality of the financial institution issuers could result in future additional impairment charges.
The Company accounts for its investment securities as available for sale or held to maturity. Management determines the appropriate classification at the time of purchase. Based on an evaluation of the probability of the occurrence of future events, we determine if we have the ability and intent to hold the investment securities to maturity, in which case we classify them as held to maturity. All other investments are classified as available for sale.
Securities classified as available for sale must be reported at fair value, with unrealized gains and losses excluded from earnings and reported as a separate component of shareholders’ equity, net of taxes. Gains or losses on the sales of securities available for sale are recognized upon realization utilizing the specific identification method. The net effect of unrealized gains or losses, caused by marking our available for sale portfolio to fair value, could result in fluctuations in the level of shareholders’ equity and equity-related financial ratios as changes in market interest rates cause the fair value of fixed-rate securities to fluctuate.
Securities classified as held to maturity are carried at cost, adjusted for amortization of premium and accretion of discount over the terms of the maturity in a manner that approximates the interest method.
Loan Portfolio
The following table summarizes total loans outstanding, by loan category and amount as of September 30, 2012 and December 31, 2011.
| | | September 30, 2012 | | December 31, 2011 |
| | | Amount | | | Percent | | Amount | | | Percent |
| | | (in thousands, except for percentages) | |
| | | | | | | | | | | | | |
| Commercial and industrial | | $ | 134,390 | | | | 24.2% | | | $ | 136,869 | | | | 25.8% | |
| Real estate – construction | | | 72,878 | | | | 13.1% | | | | 51,180 | | | | 9.6% | |
| Real estate – commercial | | | 284,578 | | | | 51.3% | | | | 270,688 | | | | 51.1% | |
| Real estate – residential | | | 18,794 | | | | 3.4% | | | | 19,201 | | | | 3.6% | |
| Consumer | | | 44,986 | | | | 8.1% | | | | 52,853 | | | | 10.0% | |
| Unearned fees | | | (588 | ) | | | (0.1% | ) | | | (661 | ) | | | (0.1% | ) |
| Total loans | | $ | 555,038 | | | | 100.0% | | | $ | 530,130 | | | | 100.0% | |
For the nine months ended September 30, 2012, total loans increased by $24.9 million, or 4.7%, to a new high of $555.0 million from $530.1 million at December 31, 2011. While the overall economy has been restrictive and somewhat constrained by the fragile economic environment, our local economy seems to reflect some strengthening in certain sectors. However, we anticipate continued increased loan volume to be a major challenge for the remaining part of 2012 and into 2013, as we continue to target credit worthy customers. Adverse credit conditions have created a difficult environment for both borrowers and lenders. The low rate environment has created a higher than anticipated level of prepayments and payoffs by borrowers looking to deleverage portions of their business and personal debts.
Real estate commercial loans increased $13.9 million, or 5.1%, to $284.6 million at September 30, 2012 from $270.7 million at December 31, 2011. Real estate construction loans increased by $21.7 million, or 42.4%, to $72.9 million at September 30, 2012 from $51.2 million at December 31, 2011. This increase is primarily due to increased draws on existing commercial real estate construction loans as well as construction loans, which require initial draws on projects. These increases were partially offset by decreases in commercial and industrial loans, which decreased $2.5 million, or 1.8%, to $134.4 million at September 30, 2012 from $136.9 million at December 31, 2011, real estate residential loans decreased $407,000, or 2.1%, to $18.8 million at September 30, 2012 from $19.2 million at December 31, 2011 and consumer loans, which decreased $7.9 million, or 14.9%, to $45.0 million at September 30, 2012 from $52.9 million at December 31, 2011.
Other Real Estate Owned (“OREO”)
OREO represents real estate acquired as a result of foreclosure or by deed in lieu of foreclosure and are carried at the lower of cost or fair value less estimated selling costs. When a property is acquired, the excess of the loan balance over fair value, less selling costs, is charged to the allowance for loan losses. Operating results from real estate owned, including rental income, operating expenses, and gains and losses realized from the sales of real estate owned are recorded as incurred. At September 30, 2012, the Bank had $3.6 million in other real estate owned as compared to $7.8 million in other real estate owned at December 31, 2011.
The decrease of $4.2 million is primarily due to the sale of seven OREO properties with a carrying value of $4.4 million, for which the Company recorded a loss of $130,000 during the nine months ended September 30, 2012. Additionally, the Company recorded $360,000 in impairments on two existing OREO properties, primarily due to a decrease in collateral values which was supported by current appraisals. These decreases were partially offset by the addition of two OREO properties totaling $525,000 as well as $66,000 of capitalized construction costs. Our OREO balance at September 30, 2012 consists of six properties with the largest OREO property totaling $830,000. This property is a 14 acre parcel containing a single family residence along with a horse farm located in Somerset County. The remaining $2.7 million is comprised principally of real estate construction and residential real estate properties.
As of September 30, 2012, two OREO properties totaling $1.4 million are under contract for sale. One sale is for the aforementioned 14 acre single family residence and a horse farm in the amount of $850,000. The other contract is for the sale of the final lot in a eight lot subdivision located in Warren County in the amount of $585,000. The Company believes both closings will take place in the near future and we will incur minimal losses relating thereto.
Asset Quality
One of our key operating objectives has been, and continues to be, to maintain a high level of credit quality. We continually analyze our asset quality through a variety of strategies, we have been proactive in addressing problem and non-performing assets and management believes our allowance for loan losses are adequate to cover known and potential losses. These strategies, as well as our prudent maintenance of sound credit standards for new loan originations, have resulted in relatively low levels of non-performing loans. Our loan portfolio composition generally consists of loans secured by commercial real estate, development and construction of real estate projects in the Union and Monmouth County, New Jersey area. The Company has established a loan production office (“LPO”) in the Middlesex County area and has begun generating loans from this location as well. We continue to have lending success and growth in the medical markets through our Private Banking Department. Since the latter part of 2008, the financial and capital markets have been faced with significant disruptions and volatility. The weakened economy has contributed to an overall challenge in building loan volume and we continue to be faced with declines in real estate values, which tend to reduce the collateral coverage of our existing loans. Efficient and effective asset-management strategies reflect the type and quality of assets being originated.
We continue to note positive signs in asset quality trends as the number of troubled loans continued to decrease over the course of 2011 and through the third quarter of 2012. These disruptions have been exacerbated by the continued weakness in the real estate and housing markets as well as the prolonged high unemployment rate. We closely monitor local and regional real estate markets and other factors related to risks inherent in our loan portfolio. The improvement in our asset quality trends is reflective of the Company’s proactive efforts in identifying troubled credits early to correct problems, record charge-offs promptly based on current collateral values, and to maintain an adequate allowance for loan losses at all times.
At September 30, 2012, commercial and industrial loans accounted for 24.2% of total loans, real estate - construction loans accounted for 13.1% of total loans and real estate - commercial loans accounted for 51.3% of total loans. Real estate - residential accounted for 3.4% of total loans and consumer loans accounted for 8.1% of total loans. These percentages are well below our internal policy limits.
The Bank does not originate or purchase loans with payment options, negative amortization loans or sub-prime loans. We evaluate the classification of all our loans and the financial results of some of those loans may be adversely affected by changes in the prevailing economic conditions, either nationally or in our local Union, Middlesex and Monmouth County areas, including decreases in real estate values, adverse employment conditions, the monetary and fiscal policies of the federal and state government and other significant external events. For loans involved in a workout situation, a new or updated appraisal or evaluation, as appropriate, is ordered to address current project plans and market conditions that were considered in the development of the workout plan. The consideration include whether there has been material deterioration in the following factors: the performance of the project; conditions for the geographic market and property type; variances between actual conditions and original appraisal assumptions; changes in project specifications (e.g., changing a planned condominium project to an apartment building); loss of a significant lease or a take-out commitment; or increases in pre-sales fallout. A new appraisal may not be necessary in instances where an internal evaluation is used and appropriately updates the original appraisal assumptions to reflect current market conditions and provides an estimate of the collateral’s fair value for impairment analysis.
Non-Performing Assets
Non-performing assets include loans that are not accruing interest (non-accrual loans) as a result of principal or interest being in default for a period of 90 days or more, loans past due 90 days or more and still accruing and other real estate owned, which consists of real estate acquired as the result of a defaulted loan. A loan is placed on non-accrual status when collection of all principal or interest is considered unlikely or when principal or interest is past due for 90 days or more, unless the loan is well-secured and the repayment of the debt or restoration to a current status will occur in the near term, in which case, the loan will continue to accrue interest. Any unpaid interest previously accrued on those loans is reversed from income. Interest income on other non-accrual loans is recognized only to the extent of interest payments received. During 2011, the Bank adopted Financial Accounting Standards Board (“FASB”) – Receivables (Topic 310) guidance on determination of whether a restructuring is a troubled debt restructuring (“TDR”). The guidance was applicable to restructurings on or after January 1, 2011. A TDR is a loan in which the contractual terms have been modified resulting in the Bank granting a concession to a borrower who is experiencing financial difficulties in order for the Bank to have a greater opportunity of collecting the indebtedness from the borrower. Non-accruing TDRs are included in non-performing loans.
At September 30, 2012 the Company had $4.7 million in non-accrual loans as compared to $5.2 million at December 31, 2011. All of the non-performing loans are secured by real estate. At September 30, 2012, there were four loans totaling $3.7 million past due 90 days or more and still accruing. These loans are well secured and full collection is expected in the near term. Subsequent to September 30, 2012, two loans totaling $2.8 million were paid off and/or reinstated in full. The two remaining loans totaling $953,000 are anticipated to be cured within the near term. At December 31, 2011, the Company had no loans past due 90 days or more and still accruing.
The following table summarizes our non-performing assets as of September 30, 2012 and December 31, 2011.
| (dollars in thousands) | | September 30, 2012 | | | December 31, 2011 | |
| | | | | | | |
| Non-Performing Assets: | | | | | | |
| | | | | | | |
| Non-Accrual Loans: | | | | | | |
| Commercial and industrial | | $ | 1,647 | | | $ | 2,349 | |
| Real estate-construction | | | - | | | | 292 | |
| Real estate-commercial | | | 950 | | | | 145 | |
| Real estate – residential | | | 263 | | | | 263 | |
| Consumer | | | 1,829 | | | | 2,191 | |
| | | | | | | | | |
| Total Non-Accrual Loans | | | 4,689 | | | | 5,240 | |
| | | | | | | | | |
| Loans 90 days or more past due and still accruing | | | 3,744 | | | | - | |
| | | | | | | | | |
| Total Non-Performing Loans | | | 8,433 | | | | 5,240 | |
| | | | | | | | | |
| Other Real Estate Owned | | | 3,593 | | | | 7,765 | |
| | | | | | | | | |
| Total Non-Performing Assets | | $ | 12,026 | | | $ | 13,005 | |
| | | | | | | | | |
| Ratios: | | | | | | | | |
| | | | | | | | | |
| Non-Performing loans to total loans | | | 1.52 | % | | | 0.99 | % |
| | | | | | | | | |
| Non-Performing assets to total assets | | | 1.71 | % | | | 1.93 | % |
| | | | | | | | | |
| Troubled Debt Restructured Loans | | $ | 9,852 | | | $ | 7,579 | |
Total non-performing loans at September 30, 2012, increased by $3.2 million from December 31, 2011. Fourteen loans comprise the $8.4 million of non-performing loans at September 30, 2012 compared to twelve loans which comprised the $5.2 million at December 31, 2011. The increase of $3.2 million in non-performing loans is a direct result of several loans that reported 90 days or more past due at September 30, 2012, as discussed above. At September 30, 2012, the Company believes it has a manageable level of non-performing loans, many of which are in the final stages of loss mitigation or legal resolution.
At September 30, 2012, non-performing commercial and industrial loans decreased by $702,000 from December 31, 2011, due to the settlement payoff of one loan totaling $517,000 wherein the Company received full principal including fees. Additionally, there was a full charge-off of one loan totaling $113,000 and a partial charge-off on one loan totaling $280,000, both of which were previously reserved for, and the transfer of one loan to OREO totaling $335,000 which was subsequently sold during the second quarter 2012, in which the Company recorded a gain of $7,000. These decreases were partially offset by the addition of two loans totaling $543,000.
At September 30, 2012, non-performing real estate construction loans decreased by $292,000 from December 31, 2011. The loan reported as of December 31, 2011 was taken into OREO via Deed-in-Lieu of foreclosure during the second quarter of 2012.
At September 30, 2012, non-performing real-estate commercial loans increased by $805,000 from December 31, 2011, due to the addition of one loan which the Company has already initiated litigation. This loan is well secured and the Company believes it will take possession of the property in 2013.
At September 30, 2012, non-performing real estate residential loans remained unchanged at $263,000 from December 31, 2011.
At September 30, 2012, non-performing consumer loans decreased by $362,000 from December 31, 2011, due to the partial charge-off of $158,000 on one loan, which was previously reserved for and the pay-off including fees of two loans totaling $253,000. These decreases were partially offset by the addition of one loan totaling $49,000 during the three months ended September 30, 2012.
At September 30, 2012, the Company had two real-estate commercial loans totaling $3.1 million and two commercial and industrial loans totaling $647,000 that were 90 days or more past due and still accruing. This increase was the direct result of several loans that reported 90 days or more past due at September 30, 2012. Subsequent to September 30, 2012, two of these loans totaling $2.8 million were paid off and/or reinstated in full. The two remaining loans totaling $953,000 are anticipated to be cured within the near term.
At September 30, 2012, OREO balance decreased to $3.6 million as compared to $7.8 million at December 31, 2011. Our single largest OREO asset in the amount of $830,000, is a 14 acre parcel containing a single family residence along with a horse farm located in Somerset County. The Company has a contract for sale on this property in the amount of $850,000. The remaining $2.7 million is comprised principally of real estate construction and residential real estate properties. During the nine months ended September 30, 2012, there have been seven OREO sales totaling $4.3 million during the nine months ended September 30, 2012, in which the Company recorded a net loss in the amount of $130,000.
Loans whose terms are modified are classified as troubled debt restructurings if the Company grants such borrowers concessions and it is deemed that those borrowers are experiencing financial difficulty. Concessions granted under a troubled debt restructuring generally involve a temporary reduction in interest rate or an extension of a loan’s stated maturity date. Non-accrual troubled debt restructurings are restored to accrual status if principal and interest payments, under the modified terms, are current for six consecutive months after the modification. Loans classified as troubled debt restructurings are designated as impaired. Modifications involving troubled borrowers may include extension of maturity date, reduction in the stated interest rate, rescheduling of future cash flows.
The Company’s troubled debt restructured modifications are made on short terms (12 month terms) in order to aggressively monitor and track performance. The short-term modifications performances are monitored for continued payment performance for an additional period of time after the expiration of the concession. Balance reductions and annualized loss rates are also important metrics that are monitored. The main objective of the modification programs is to reduce the payment burden for the borrower and improve the net present value of the Company’s expected cash flows.
As of September 30, 2012, loans modified in a troubled debt restructuring totaled $9.9 million, including $4.3 million that are current, $2.0 million that are 30-59 days past due and $3.6 million that are 90 days or more past due. There were no troubled debt restructuring loans that are 60-89 days past due. The Company believes that all loans that are 90 days or more past due will be resolved and either brought current or paid in full during the fourth quarter of 2012.
Potential Problem Loans
Overall credit quality in the portfolio remains strong even though the economic weakness has impacted several potential problem loans. Potential problem loans consist of special mention and substandard loans that continue to accrue interest. At September 30, 2012, the Company had $44.1 million in loans that were risk rated as special mention or substandard. This is an increase of approximately $8.0 million from year ended December 31, 2011, which totaled $36.1 million. The change in risk rated loans was attributable to certain loan which were downgraded due to a variety of changing conditions, including general economic conditions and/or conditions applicable to the specific borrower. All loans which were downgraded during the nine month period ended September 30, 2012, are currently performing. It is believed that the remediation of a majority of these loans represented in the increase may warrant a risk rating upgrade at a point in the near future.
At September 30, 2012, other than the loans set forth above, the Company is not aware of any loans which present serious doubts as to the ability of its borrowers to comply with present loan repayment terms and which are expected to fall into one of the risk categories set forth in the description herein.
Allowance for Loan Losses
The following table summarizes our allowance for loan losses for the nine months ended September 30, 2012 and 2011 and for the year ended December 31, 2011.
| | | September 30, | | | December 31, | |
| | | 2012 | | | 2011 | | | 2011 | |
| | | (in thousands, except percentages) | |
| | | | | | | | | | |
| Balance at beginning of year | | $ | 7,310 | | | $ | 6,246 | | | $ | 6,246 | |
| Provision charged to expense | | | 950 | | | | 1,855 | | | | 2,205 | |
| Loans charged off, net | | | (774 | ) | | | (1,108 | ) | | | (1,141 | ) |
| Balance of allowance at end of period | | $ | 7,486 | | | $ | 6,993 | | | $ | 7,310 | |
| | | | | | | | | | | | | |
Ratio of net charge-offs to average loans outstanding (annualized) | | | 0.19 | % | | | 0.29 | % | | | 0.22 | % |
Balance of allowance as a percent of loans at period-end | | | 1.35 | % | | | 1.35 | % | | | 1.38 | % |
Ratio of allowance at period-end to non-performing loans | | | 88.77 | % | | | 110.20. | % | | | 139.50 | % |
At September 30, 2012 the Company’s allowance for loan losses was $7.5 million, compared to $7.3 million at December 31, 2011. Loss allowance as a percentage of total loans at September 30, 2012 was 1.35%, compared with 1.38% at December 31, 2011. The Company had total provisions to the allowance for loan losses for the nine month period ended September 30, 2012 in the amount of $950,000 as compared to $1.9 million for the comparable period in 2011. There was $774,000 in net charge-offs for the nine months ended September 30, 2012, compared to $1.1 million for the same period in 2011. During the nine month period ended September 30, 2012, the Company recorded gross charge-offs of $844,000, which represents five commercial and industrial loans totaling $552,000, one real estate construction loan totaling $60,000 and three consumer loans totaling $232,000. All loans which the Company charged-off or had a direct write-down had been previously identified and specific reserves were applied. Non-performing loans at September 30, 2012 are either well-collateralized or adequately reserved for in the allowance for loan losses.
Management maintains the allowance for credit losses at a level estimated to absorb probable loan losses of the loan portfolio. The allowance is based on ongoing evaluations of the probable estimated losses inherent in the loan portfolio. Our methodology for evaluating the appropriateness of the allowance includes segmentation of the loan portfolio into its various asset components, tracking the historical levels of criticized loans and delinquencies, and assessing the nature and trend of loan charge-offs. Additionally, the volume of non-performing loans, concentration risks by size, type, and geography, new products and markets, collateral adequacy, credit policies and procedures, staffing, underwriting consistency, and economic conditions are taken into consideration. Risks within the loan portfolio are analyzed on a continuous basis by the Bank’s senior management, outside independent loan review auditors, directors’ loan committee, and board of directors. A risk system, consisting of multiple grading categories, is utilized as an analytical tool to assess risk and set appropriate reserves. Although management attempts to maintain the allowance at a level deemed adequate to cover any losses, future additions to the allowance may be necessary based upon changes in market conditions, either generally or specific to our area, or changes in the circumstances of particular borrowers. In addition, various regulatory agencies periodically review our allowance for loan losses. These agencies may require the Company to take additional provisions based on their judgments about information available to them at the time of their examination.
Prudent risk management practices remain a high priority, especially during these times of inconsistent economic stability and high unemployment levels. Along with this conservative approach, we have further stressed our qualitative and quantitative allowance factors to primarily reflect the current state of the economy, the weak housing market and prolonged high levels of unemployment. We apply this process and methodology in a consistent manner and reassess and modify the estimation methods and assumptions on a regular basis.
Bank-Owned Life Insurance
In November of 2004, the Company invested in $3.5 million of bank-owned life insurance as a source of funding for additional life insurance benefits for officers and employee benefit expenses related to the Company’s non-qualified Supplemental Executive Retirement Plan (“SERP”) for certain executive officers implemented in 2004 that provides for payments upon retirement, death or disability. In 2009, 2010 and 2011, the Company purchased an additional $3.5 million, $1.0 million and $3.5 million, respectively, of bank-owned life insurance in order to provide additional life insurance benefits for additional officers upon death or disability and to provide a source of funding for future enhancements of the benefits under the SERP. Expenses related to the SERP were approximately $161,000 and $68,000 for the nine months ended September 30, 2012 and 2011, respectively. Bank-owned life insurance involves our purchase of life insurance on a selected group of officers. The Company is the owner and beneficiary of the policies. Increases in the cash surrender values of this investment are recorded in other income in the statement of operations. Income on bank-owned life insurance amounted to $347,000 and $278,000 for the nine months ended September 30, 2012 and 2011, respectively.
Premises and Equipment
Premises and equipment totaled approximately $2.4 million and $2.6 million at September 30, 2012 and December 31, 2011, respectively. The Company purchased premises and equipment amounting to $221,000 primarily to replace fully depreciated and un-repairable equipment, while depreciation expenses totaled $490,000 and $560,000 for the nine months ended September 30, 2012 and 2011, respectively.
Goodwill and Other Intangible Assets
Intangible assets totaled $18.4 million at September 30, 2012 and December 31, 2011. The Company’s intangible assets at September 30, 2012 were comprised of $18.1 million of goodwill and $306,000 of core deposit intangibles, net of accumulated amortization of $1.8 million. The Company performed its annual goodwill impairment analysis as of September 30, 2012. Based on the results of the step one goodwill impairment analysis, the Company concluded that there was no impairment on the current goodwill balance of $18.1 million. At December 31, 2011, the Company’s intangible assets were comprised of $18.1 million of goodwill and $431,000 of core deposit intangibles, net of accumulated amortization of $1.7 million.
Deposits
Deposits are the primary source of funds used by the Company in lending and for general corporate purposes. In addition to deposits, the Company may derive funds from principal repayments on loans, the sale of loans and securities designated as available for sale, maturing investment securities and borrowing from financial intermediaries. The level of deposit liabilities may vary significantly and is dependent upon prevailing interest rates, money market conditions, general economic conditions and competition. The Company’s deposits consist of checking, savings and money market accounts along with certificates of deposit and individual retirement accounts. Deposits are obtained from individuals, partnerships, corporations, unincorporated businesses and non-profit organizations throughout the Company’s market area. We attempt to control the flow of deposits primarily by pricing our deposit offerings to be competitive with other financial institutions in our market area, but not necessarily offering the highest rate.
At September 30, 2012, total deposits amounted to $577.7 million, reflecting an increase of $23.8 million, or 4.3%, from December 31, 2011. Core checking deposits increased $17.5 million, or 11.8%, while savings accounts, inclusive of money market deposits, increased $16.1 million, or 5.5%. Conversely, higher cost time deposits decreased $9.8 million, or 8.6%, over this same period. The Bank has continued to focus on building non-interest-bearing deposits, as this lowers the institution’s costs of funds. Additionally, our savings accounts and other interest-bearing deposit products, excluding high-cost certificates of deposit, provide an efficient and cost-effective source to fund our loan originations.
One of the primary strategies is the accumulation and retention of core deposits. Core deposits consist of all deposits, except certificates of deposit in excess of $100,000. Core deposits at September 30, 2012 accounted for 92.0% of total deposits compared to 90.5% at December 31, 2011. The balance in our certificates of deposit (“CDs”) over $100,000 at September 30, 2012 totaled $46.4 million as compared to $52.8 million at December 31, 2011. During the first quarter of 2011, the Company placed $5.0 million in brokered CDs. The term on these CDs ranged from 54 to 66 months with interest rates ranging from 2.15% to 2.25%. During the first quarter of 2012, $3.5 million in brokered CDs were called and $2.7 million of new brokered CDs were placed at substantially lower rates for similar terms. During the second quarter of 2012, $2.1 million of additional brokered CDs were placed at 1.75% for a term of 84 months. At September 30, 2012, the Company has $6.3 million in brokered CDs, with rates ranging from 1.32% to 2.15% with original terms ranging from 54 to 84 months. The Company found this strategy was able to provide a more cost-effective source of longer-term funding as the rates paid for these brokered CDs were lower than current fixed rate term advances at the FHLB of New York.
Borrowings
The Bank utilizes its account relationship with Atlantic Central Bankers Bank to borrow funds through its Federal funds borrowing line in an aggregate amount up to $10.0 million. The Bank also established a $7.0 million credit facility with another correspondent bank during the first quarter of 2011. These borrowings are priced on a daily basis. There were no outstanding borrowings under these lines at September 30, 2012 and December 31, 2011. The Bank also has a remaining borrowing capacity with the FHLB of approximately $41.6 million based on the current loan collateral pledged of $55.1 million at September 30, 2012. At September 30, 2012 and December 31, 2011, the Bank had no short-term borrowings outstanding under this line.
Long-term debt consisted of the following FHLB fixed rate advances at September 30, 2012 and at December 31, 2011:
| | Amount | | | Rate | | Original Term | Maturity |
| (dollars in thousands) |
| | | | | | | | |
| Convertible Note | $ 7,500 | | | 3.97% | | 10 years | November 2017 |
| Fixed Rate Note | 1,500 | | | 1.67% | | 4 years | August 2014 |
| Fixed Rate Note | 1,500 | | | 2.00% | | 5 years | August 2015 |
| Fixed Rate Note | 1,500 | | | 2.41% | | 6 years | August 2016 |
| Fixed Rate Note | 1,500 | | | 2.71% | | 7 years | August 2017 |
| | | | | | | | |
| | $ 13,500 | | | 3.18% | | | |
The $7.5 million convertible note contains an option which allows the FHLB to adjust the rate on the note in November 2012 to the then current market rate offered by the FHLB. The Company has the option to repay this advance, if converted, without penalty.
Repurchase Agreements
Securities sold under agreements to repurchase, which are classified as secured borrowings, generally mature within one to four days after the transaction date. Securities sold under agreements to repurchase are reflected as the amount of cash received in connection with the transaction. The Company may be required to provide additional collateral based on the fair value of the underlying securities. Securities sold under agreements to repurchase increased to $18.9 million at September 30, 2012 from $16.2 million at December 31, 2011, an increase of $2.7 million, or 16.7%.
Liquidity
Liquidity defines the Company’s ability to generate funds to support asset growth, meet deposit withdrawals, maintain reserve requirements and otherwise operate on an ongoing basis. An important component of the Company’s asset and liability management structure is the level of liquidity available to meet the needs of our customers and requirements of our creditors. The liquidity needs of the Bank are primarily met by cash on hand, Federal funds sold position, maturing investment securities and short-term borrowings on a temporary basis. The Bank invests the funds not needed to meet its cash requirements in overnight Federal funds sold and an interest bearing account with the Federal Reserve Bank of New York. With adequate deposit inflows coupled with the above-mentioned cash resources, management is maintaining short-term assets which we believe are sufficient to meet our liquidity needs.
At September 30, 2012, the Company had $43.5 million in cash and cash equivalents as compared to $38.0 million at December 31, 2011. Cash and cash equivalent balances consisted of no Federal funds sold at September 30, 2012 and December 31, 2011, and $31.6 million and $30.4 million at the Federal Reserve Bank of New York at September 30, 2012 and December 31, 2011, respectively. It was determined by management during 2010 to transfer most of the Bank’s investable funds out of the Federal funds sold position and into the interest bearing deposit account at the Federal Reserve Bank of New York due primarily to a higher rate of return, which averages approximately 10 basis points higher. During the second quarter of 2011, the remaining $7.0 million in Federal funds sold was transferred to the Federal Reserve Bank of New York primarily due to the above-mentioned reasons. Additionally, balances at the Federal Reserve Bank of New York provide the highest level of safety for our investable funds.
Off-Balance Sheet Arrangements
The Company’s financial statements do not reflect off-balance sheet arrangements that are made in the normal course of business. These off-balance sheet arrangements consist of unfunded loans and letters of credit made under the same standards as on-balance sheet instruments. These instruments have fixed maturity dates, and because many of them will expire without being drawn upon, they do not generally present any significant liquidity risk to the Company.
Management believes that any amounts actually drawn upon these commitments can be funded in the normal course of operations. The following table sets forth the Bank’s off-balance sheet arrangements as of September 30, 2012 and December 31, 2011:
| | | September 30, 2012 | | | December 31, 2011 | |
| | | (dollars in thousands) | |
| | | | | | | |
| Home equity lines of credit | | $ | 28,266 | | | $ | 27,524 | |
| Commitments to fund commercial real estate and construction loans | | | 64,858 | | | | 72,409 | |
| Commitments to fund commercial and industrial loans | | | 49,504 | | | | 56,272 | |
| Commercial and financial letters of credit | | | 3,860 | | | | 5,066 | |
| | | $ | 146,488 | | | $ | 161,271 | |
Capital
Shareholders’ equity increased by approximately $3.8 million, or 4.4%, to $90.9 million at September 30, 2012 compared to $87.1 million at December 31, 2011. Net income for the nine month period ended September 30, 2012 added $3.6 million to shareholders’ equity. Stock option compensation expense of $136,000, options exercised of $124,000 and net unrealized gains on securities available for sale, net of tax, of $241,000, all contributed to the increase. These increases were partially offset by decreases of $318,000 relating to the dividends on the preferred stock Series C.
The Company and the Bank are subject to various regulatory and capital requirements administered by the Federal banking agencies. Our federal banking regulators, the Board of Governors of the Federal Reserve System (which regulates bank holding companies) and the Federal Deposit Insurance Corporation (which regulates the Bank), have issued guidelines classifying and defining capital. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions that, if undertaken, could have a direct material effect on the Company’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and classification of the Company and the Bank is also subject to qualitative judgments by the regulators about components, risk weightings and other factors.
Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios, set forth in the following tables of Tier 1 Capital to Average Assets (Leverage Ratio), Tier 1 Capital to Risk Weighted Assets and Total Capital to Risk Weighted Assets. Management believes that, at September 30, 2012, the Company and the Bank met all capital adequacy requirements to which they are subject.
As of September 30, 2012, the Bank met all regulatory requirements for classification as well-capitalized under the regulatory framework for prompt corrective action. Management believes that there are no conditions or events that have changed the Bank’s categories.
The capital ratios of the Company and the Bank, at September 30, 2012 and December 31, 2011, are presented below.
| | | Tier I Capital to Average Assets Ratio (Leverage Ratio) | | Tier I Capital to Risk Weighted Assets Ratio | | Total Capital to Risk Weighted Assets Ratio |
| | | September 30, 2012 | | December 31, 2011 | | September 30, 2012 | | December 31, 2011 | | September 30, 2012 | | December 31, 2011 |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Community Partners | | | 10.59% | | | | 10.39% | | | | 12.03% | | | | 12.01% | | | | 13.28% | | | | 13.26% | |
| Two River | | | 10.57% | | | | 10.38% | | | | 12.01% | | | | 12.00% | | | | 13.26% | | | | 13.25% | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
“Adequately capitalized” institution (under Federal regulations) | | | 4.00% | | | | 4.00% | | | | 4.00% | | | | 4.00% | | | | 8.00% | | | | 8.00% | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
“Well capitalized” institution (under Federal regulations) | | | 5.00% | | | | 5.00% | | | | 6.00% | | | | 6.00% | | | | 10.00% | | | | 10.00% | |
On July 26, 2012, the Company filed a shelf Registration Statement on Form S-3 with the Securities and Exchange Commission (SEC). This Registration Statement was declared effective by the SEC on August 6, 2012. The filing of the Registration Statement does not require the Company to issue any securities. The Registration Statement will allow the Company the flexibility to offer and sell, from time to time, in one or more public offerings, up to a total aggregate of $30 million of its common stock, preferred stock, debt securities, or warrants, either separately or together. The debt securities, preferred stock and warrants may be convertible or exercisable or exchangeable for other debt or equity securities of the Company. We will provide the specific terms of the securities offered in one or more supplements to the prospectus contained in the Registration Statement.
We intend to use the net proceeds from the sale of the securities registered by this Registration Statement for general corporate purposes. General corporate purposes may include, among other purposes, contribution to the capital of the Bank to support its lending and investing activities; the repayment of our debt; redemption of our outstanding Series C Preferred Stock; to support or fund acquisitions of other institutions or branches, if opportunities for such transactions become available; and investments in activities that are permitted for bank holding companies. We may temporarily invest funds that we do not immediately need for these purposes in investment securities or use them to make payments on our borrowings. The applicable prospectus supplement will provide details on the use of proceeds of any specific offering.
Federal banking regulators have proposed revisions to the bank capital requirement standards known as Basel III. Basel III strengthens bank capital requirements and introduces new regulatory requirements on bank liquidity and bank leverage. Based on the Company’s current understanding of these proposed regulations, as of September 30, 2012, each of the Company and the Bank anticipates being classified as well-capitalized under the proposed regulation upon finalization and implementation of the Basel III requirements. However, there is still need for clarification of Basel III as well as interpretation and implementation by federal banking regulators, so the ultimate impact of Basel III on the Company is not completely known at this point. The comment period on the proposed rules under Basel III ended in October 2012; changes to the calculation resulting from the comment process could result in materially different capital ratios from the amounts estimated. On November 9, 2012, federal banking regulators provided guidance that they did not expect Basel III to become effective on January 1, 2013 and will take into account operational and other considerations when determining appropriate implementation dates and associated transition periods.
Not required.
The Company has established disclosure controls and procedures designed to ensure that information required to be disclosed in the reports that the Company files or submits under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in SEC rules and forms and is accumulated and communicated to management, including the principal executive officer and principal financial officer, to allow timely decisions regarding required disclosure.
The Company’s principal executive officer and principal financial officer, with the assistance of other members of the Company’s management, have evaluated the effectiveness of the design and operation of the Company’s disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this quarterly report. Based upon such evaluation, the Company’s principal executive officer and principal financial officer have concluded that the Company’s disclosure controls and procedures are effective as of the end of the period covered by this quarterly report.
The Company’s principal executive officer and principal financial officer have also concluded that there was no change in the Company’s internal control over financial reporting (as such term is defined in Rule 13a-15(f) under the Exchange Act) that occurred during the quarter ended September 30, 2012 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.
