The following table presents the adjustment to convert net interest income to net interest income on a fully taxable equivalent basis for the three- and six-month periods ended June 30, 2007 and 2006.
Net interest income is the primary source of operating income for QNB. Net interest income is interest income, dividends, and fees on earning assets, less interest expense incurred on funding sources. Earning assets primarily include loans, investment securities and Federal funds sold. Sources used to fund these assets include deposits and borrowed funds. Net interest income is affected by changes in interest rates, the volume and mix of earning assets and interest-bearing liabilities, and the amount of earning assets funded by non-interest bearing deposits.
For purposes of this discussion, interest income and the average yield earned on loans and investment securities are adjusted to a tax-equivalent basis as detailed in the tables that appear on pages 18 and 19. This adjustment to interest income is made for analysis purposes only. Interest income is increased by the amount of savings of federal income taxes, which QNB realizes by investing in certain tax-exempt state and municipal securities and by making loans to certain tax-exempt organizations. In this way, the ultimate economic impact of earnings from various assets can be more easily compared.
The net interest rate spread is the difference between average rates received on earning assets and average rates paid on interest-bearing liabilities, while the net interest rate margin, which includes interest-free sources of funds, is net interest income expressed as a percentage of average interest-earning assets.
Net interest income increased 10.5% to $4,452,000 for the quarter ended June 30, 2007 as compared to $4,030,000 for the quarter ended June 30, 2006. On a tax-equivalent basis, net interest income increased by 9.5%, from $4,385,000 for the three months ended June 30, 2006 to $4,802,000 for the same period ended June 30, 2007. When comparing the second quarters of 2007 and 2006, the net interest margin improved by 22 basis points. The net interest margin increased to 3.40% for the second quarter of 2007 from 3.18% for the second quarter of 2006. The second quarter net interest margin also represents a 29 basis point improvement from the 3.11% recorded in the first quarter of 2007. The increase in both net interest income and the net interest margin reflect the benefits of the balance sheet restructuring transactions as well as the shift in earning assets from investment securities to higher yielding commercial loans.
Average earning assets increased 2.5%, with average loans increasing 13.9% when comparing the second quarter of 2007 to the same period in 2006. Average investment securities decreased 14.4% when comparing these same periods.
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
NET INTEREST INCOME (Continued)
The yield on earning assets on a tax-equivalent basis increased from 5.94% for the second quarter of 2006 to 6.49% for the second quarter of 2007. Interest income on investment securities decreased $78,000 when comparing the two quarters as a result of the reduction in balances. However, the average yield on the portfolio increased from 5.00% for the second quarter of 2006 to 5.67% for the second quarter of 2007. This increased yield reflects the benefits from the April transaction as well as other purchase and sale transactions since June of 2006, in which lower yielding securities were sold and the proceeds reinvested in higher yielding securities. QNB purchased very few securities in the normal course of business over the past year because of the strong growth in loans.
Interest income on loans increased $1,021,000 when comparing the two quarters, with increased balances being the greatest contributor. The yield on loans increased 31 basis points, to 6.91%, when comparing the second quarter of 2007 to the second quarter of 2006. Significant factors limiting the increase in the portfolio yield was the shape of the yield curve over the past year as well as the strong competition for loans. The yield curve has been relatively flat or inverted, with short-term rates being higher than mid and longer-term rates for most of the past year. In addition, customers have preferred to lock in fixed-rate or adjustable-rate loans with fixed-rate terms for three to ten years over higher yielding floating-rate loans. Most of the increase in loan income was in commercial loans. Income on commercial real estate loans increased $514,000 with average balances increasing 16.7% and contributing $389,000 of the increase in income. The yield on commercial real estate loans increased 30 basis points, to 6.84%, for the second quarter of 2007. Interest on commercial and industrial loans increased $266,000 with the majority of the increase related to the 26.5% increase in average balances. The average yield on these loans increased 16 basis points, to 7.33%. Growth in the indirect lease financing portfolio also contributed to the increase in total loan income. The yield on indirect leases was 9.73% for the second quarter of 2007, compared with 9.28% for same period in 2006. An increase in prepayment income and late charges contributed to the higher yield.
Residential mortgage and home equity loan activity has slowed over the past twelve months as the real estate market has softened. The average balance of residential mortgages declined 3.1% when comparing the two quarters while the average yield was 5.88% for both periods. Average home equity loans increased 4.0%, to $69,340,000, while the yield on the home equity portfolio increased 21 basis points to 6.52%. The demand for home equity loans has diminished as home values have stabilized or fallen and homeowners have already borrowed against the equity in their homes. The increase in market interest rates has also slowed the activity in residential real estate lending.
For the most part, earning assets are funded by deposits, which increased when comparing the two quarters. Average deposits increased $32,422,000, or 7.0%, with the growth occurring in higher cost time deposits, which increased $36,395,000, or 17.7%.
While total interest income on a tax-equivalent basis increased $977,000 when comparing the second quarter of 2007 to the second quarter of 2006, total interest expense increased $560,000. The rate paid on interest-bearing liabilities increased from 3.16% for the second quarter of 2006 to 3.56% for the second quarter of 2007, with the rate paid on interest-bearing deposits increasing from 2.81% to 3.46% during this same period. The increase in interest expense and the average rate paid on deposits was primarily the result of an increase in average balances and rates paid on time deposits. Interest expense and the rate paid on time deposits increased the most as these accounts were more reactive to the changes in market interest rates and competition. Interest expense on time deposits increased $870,000, while the average rate paid on time deposits increased from 3.70% to 4.58% when comparing the two periods.
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
NET INTEREST INCOME (Continued)
Like fixed-rate loans and investment securities, time deposits reprice over time and, therefore, have less of an immediate impact on costs in either a rising or falling rate environment. Unlike loans and investment securities, the maturity and repricing characteristics of time deposits tend to be shorter. With interest rates increasing over the past two years, customers have opted for shorter maturity time deposits. Approximately 68.5% of time deposits at June 30, 2007 will reprice or mature over the next 12 months.
As mentioned previously, the competition for deposits, and especially time deposits, led to significantly higher rates paid on these products. Like other financial institutions, QNB, as a result of consumer demand and the need to retain deposits, offered relatively short maturity time deposits at attractive rates. Most consumers are looking for short maturity time deposits in anticipation of short-term rates continuing to increase. It was and still is very common to see time deposit promotions with maturities less than one year at yields above 5.00%. Given the short-term nature of QNB’s time deposit portfolio and the current rates being offered, it is likely that both the average rate paid and total interest expense on time deposits will continue to increase in 2007.
Partially offsetting the increase in interest expense on deposits was a reduction in interest expense on long-term debt. As a result of the balance sheet restructuring as well as the maturity of $5,000,000 of floating rate FHLB borrowings, the average balance of long-term debt decreased from $55,000,000 for the second quarter of 2006 to $29,395,000 for the second quarter of 2007, while the average rate paid decreased from 5.62% to 5.08% when comparing the same periods, resulting in a reduction of interest expense of $397,000.
For the six-month period ended June 30, 2007, net interest income increased $535,000, or 6.7%, to $8,551,000. On a tax-equivalent basis net interest income increased $496,000, or 5.7%. Average earning assets increased $24,681,000, or 4.5%, while the net interest margin increased 4 basis points. The net interest margin on a tax-equivalent basis was 3.26% for the six-month period ended June 30, 2007 compared with 3.22% for the same period in 2006.
Total interest income on a tax-equivalent basis increased $2,056,000, from $15,990,000 to $18,046,000, when comparing the six-month periods ended June 30, 2006 to June 30, 2007. The increase in interest income was fairly evenly split between the impact of increases in interest rates and the increase in volumes. Approximately $976,000 of the increase in interest income was related to volume, while $1,080,000 was due to higher rates. Similar to the analysis for the second quarter, the restructuring transaction, the growth in commercial loans and the shift in the mix of earning assets from investment securities to loans resulted in the increase in interest income. Average loans increased 13.7% to $357,797,000, while average investment securities decreased 8.5%, to $206,946,000. The yield on earning assets increased from 5.88% to 6.35% for the six-month periods. The yield on loans increased from 6.55% to 6.89% during this time, while the yield on investments increased from 4.95% to 5.40% when comparing the six-month periods.
Total interest expense increased $1,560,000, from $7,239,000 for the six-month period ended June 30, 2006 to $8,799,000, for the six-month period ended June 30, 2007. Approximately $1,313,000 of the increase in interest expense was a result of higher interest rates. Interest expense on time deposits increased $1,644,000 with average balances increasing $31,039,000 or 14.9% and contributing $555,000 to the increase in interest expense. The average rate paid on time deposits increased 92 basis points to 4.51%, resulting in an additional $1,089,000 in interest expense.
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
NET INTEREST INCOME (Continued)
Interest expense on demand accounts increased $125,000 with the rate paid on these accounts increasing 27 basis points. The higher rate paid on interest bearing demand accounts relates to the higher rate paid on municipal and school district deposits, most of which are indexed to the Federal funds rate. The average Federal funds rate increased 59 basis points when comparing the six month periods.
Interest expense on money market accounts increased $148,000, and the rate paid increased from 2.71% to 3.07% when comparing the first six months of 2006 to the same period in 2007. Average money market balances increased $3,929,000 when comparing the two periods. During 2006, the primary money market product offered was the Treasury Select product which was indexed to a percentage of the 91-day Treasury bill rate based on balances in the account. The rate on this product increased as short-term interest rates increased. In addition, in response to competition, QNB promoted a 4.00% minimum rate on this product for new accounts with balances over $10,000 or for existing accounts with additional deposits of $5,000. This 4.00% promotional rate was offered for most of 2006 and was above the calculated rate under the terms of this product. In 2007, the Treasury Select money market account was changed to the Select money market account and the rate on this product is no longer indexed to the 91-day Treasury bill but is determined by QNB. However, because of the continued strong competition for these deposits, QNB has maintained a rate close to 4.00% for balances over $75,000.
Interest expense on short-term borrowings increased $81,000 both as a result of increases in rates paid and averages balances. The average rate paid increased from 3.26% for the first half of 2006 to 3.57% for the first half of 2007, while average balances increased $2,940,000, to $22,046,000. Repurchase agreements (a sweep product for commercial customers) increased $4,416,000 on average when comparing the two periods, while Federal funds purchased decreased $1,600,000 during the same period.
As a result of the payoff of the FHLB advances and the use of the lower costing repurchase agreements, interest expense on long-term debt decreased $430,000 when comparing the six-month periods. The average outstanding balance decreased from $55,000,000 to $40,591,000 while the average rate paid decreased from 5.58% to 5.43%. The impact from this transaction will continue to benefit net interest income growth on a year-to-date basis for the remainder of 2007.
PROVISION FOR LOAN LOSSES
The provision for loan losses represents management's determination of the amount necessary to be charged to operations to maintain the allowance for loan losses at a level that represents management’s best estimate of the known and inherent losses in the existing loan portfolio. Actual loan losses, net of recoveries, serve to reduce the allowance.
The determination of an appropriate level of the allowance for loan losses is based upon an analysis of the risk inherent in QNB's loan portfolio. Management uses various tools to assess the adequacy of the allowance for loan losses. One tool is a model recommended by the Office of the Comptroller of the Currency. This model considers a number of relevant factors including: historical loan loss experience, the assigned risk rating of the credit, current and projected credit-worthiness of the borrower, current value of the underlying collateral, levels of and trends in delinquencies and non-accrual loans, trends in volume and terms of loans, concentrations of credit, and national and local economic trends and conditions. This model is supplemented with another analysis that also incorporates QNB’s portfolio exposure to borrowers with large dollar concentration. Other tools include ratio analysis and peer group analysis.
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
PROVISION FOR LOAN LOSSES (Continued)
QNB’s management determined that a $150,000 and $45,000 provision for loan losses was necessary for the three-month periods ended June 30, 2007 and 2006, respectively. A $225,000 and $45,000 provision for loan losses was recorded for the six-month periods ended June 30, 2007 and 2006, respectively. The need for a provision was determined by the analysis described above and resulted in an allowance for loan losses that management believes is adequate in relation to the estimate of known and inherent losses in the portfolio. The higher provision reflects the inherent risk related to loan growth, combined with an increase in nonperforming loans and charge-offs.
QNB had a net recovery of $1,000 during the second quarter of 2007 and net charge-offs of $2,000 during the second quarter of 2006. For the six-month periods ended June 30, 2007 and 2006 QNB had net charge-offs of $82,000 and $22,000, respectively. The net charge-offs during the first half of 2007 related primarily to loans in the indirect lease financing portfolio. The asset quality of the commercial loan portfolio remains strong.
Non-performing assets (non-accruing loans, loans past due 90 days or more, other real estate owned and other repossessed assets) amounted to .15% and .02% of total assets at June 30, 2007 and 2006, respectively. These levels compare to .08% at December 31, 2006. Non-accrual loans were $645,000 and $416,000 at June 30, 2007 and December 31, 2006, respectively. There were no non-accrual loans at June 30, 2006. Loans past due 90 days or more and still accruing were $242,000 and $124,000, at June 30, 2007 and 2006, respectively. The increase in nonperforming loans since December 31, 2006, relates primarily to one loan for the purpose of commercial real estate investment which was placed on non-accrual status in the second quarter of 2007. QNB expects to collect all interest and principal on this loan.
QNB did not have any other real estate owned as of June 30, 2007, December 31, 2006 or June 30, 2006. Repossessed assets consisting of equipment, automobiles and motorcycles were $43,000 and $41,000 at June 30, 2007 and December 31, 2006, respectively. There were no repossessed assets as of June 30, 2006.
There were no restructured loans as of June 30, 2007, December 31, 2006 or June 30, 2006, respectively, as defined in FASB Statement No. 15, Accounting by Debtors and Creditors for Troubled Debt Restructurings, that have not already been included in loans past due 90 days or more or non-accrual loans.
The allowance for loan losses was $2,872,000 and $2,729,000 at June 30, 2007 and December 31, 2006, respectively. The ratio of the allowance to total loans was .76% and .79% at the respective period end dates. The decrease in the ratio was a result of the strong growth in the loan portfolio. The ratio, at .76% was at a level below peers but a ratio that QNB believed was adequate based on its analysis.
A loan is considered impaired, based on current information and events, if it is probable that QNB will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. The measurement of impaired loans is generally based on the present value of expected future cash flows discounted at the historical effective interest rate, except that all collateral-dependent loans are measured for impairment based on the fair value of the collateral. At June 30, 2007 and December 31, 2006, the recorded investment in loans for which impairment had been recognized in accordance with FASB Statement No. 114, Accounting by Creditors for Impairment of a Loan—an amendment of FASB Statements No. 5 and 15, totaled $633,000 and $403,000, respectively. The loans identified as impaired were collateral-dependent, with no valuation allowance necessary. There were no loans considered impaired at June 30, 2006.
Management, in determining the allowance for loan losses makes significant estimates and assumptions. Consideration is given to a variety of factors in establishing these estimates, including current economic conditions, diversification of the loan portfolio, delinquency statistics, results of loan reviews, borrowers’ perceived financial and managerial strengths, the adequacy of underlying collateral if collateral dependent, or the present value of future cash flows.
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
PROVISION FOR LOAN LOSSES (Continued)
Since the allowance for loan losses is dependent, to a great extent, on conditions that may be beyond QNB’s control, it is at least reasonably possible that management’s estimates of the allowance for loan losses and actual results could differ in the near term. In addition, various regulatory agencies, as an integral part of their examination process, periodically review QNB’s allowance for losses on loans. Such agencies may require QNB to recognize changes to the allowance based on their judgments about information available to them at the time of their examination.
NON-INTEREST INCOME
QNB, through its core banking business, generates various fees and service charges. Total non-interest income includes service charges on deposit accounts, ATM and check card income, income on bank-owned life insurance, mortgage servicing fees, trading account gains and losses and gains and losses on the sale of investment securities and residential mortgage loans.
Total non-interest income was $936,000 for the second quarter of 2007, a decrease of $15,000, or 1.6%, from the second quarter of 2006. For the six-month period ended June 30, 2007 total non-interest income was a loss of $732,000. Excluding the other-than-temporary impairment charge of $2,758,000, total non-interest income was $2,026,000, a $133,000, or 6.2%, decline from the $2,159,000 reported for the first half of 2006. A decline in realized gains on the sale of investment securities was the primary reason for the decline in non-interest income in both the three and six month periods.
Fees for services to customers are primarily comprised of service charges on deposit accounts. These fees increased $3,000, or .7%, to $467,000, when comparing the two quarters but declined $13,000, or 1.4%, to $891,000, when comparing the six-month periods. Overdraft income increased $4,000 for the three-month period, but declined $7,000 for the six-month period. These variances are a result of volume fluctuations as the item charge has remained the same. In addition, for the six-month period, fees on business checking accounts declined $4,000. This decline reflects the impact of a higher earnings credit rate for the first half of 2007 as compared to the first half of 2006. The higher earnings credit rate is a result of the increases in short-term interest rates. This credit is applied against balances to offset service charges incurred.
ATM and debit card income is primarily comprised of income on debit cards and ATM surcharge income for the use of QNB ATM machines by non-QNB customers. ATM and debit card income was $218,000 for the second quarter of 2007, an increase of $23,000, or 11.8%, from the amount recorded during the second quarter of 2006. Income from ATM and debit cards was $407,000 and $379,000 for the six months ended June 30, 2007 and 2006, respectively, an increase of 7.4%. Debit card income increased $20,000, or 14.0%, to $161,000, for the three-month period and $22,000, or 8.0%, to $295,000, for the six-month period. The increase in debit card income was a result of the increased reliance on the card as a means of paying for goods and services by both consumer and business cardholders. In addition, an increase in PIN-based transactions resulted in additional interchange income of $4,000 and $9,000, respectively, when comparing the respective three and six-month periods. Partially offsetting these positive variances was a reduction in ATM surcharge income of $1,000 and $2,000, respectively, for the three and six-month periods. The proliferation of ATM machines, as well as the ability to get cash back during a PIN-based transaction, has likely contributed to the decline in the number of transactions by non-QNB customers at QNB’s ATM machines.
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
NON-INTEREST INCOME (Continued)
Income on bank-owned life insurance represents the earnings on life insurance policies in which the Bank is the beneficiary. The earnings on these policies were $61,000 and $62,000 for the three months ended June 30, 2007 and 2006, respectively. For the six-month period, earnings on these policies increased $2,000, to $125,000. The insurance carriers reset the rates on these policies annually taking into consideration the interest rate environment as well as mortality costs. The existing policies have rate floors which minimize how low the earnings rate can go. Some of these policies are currently at their floor.
When QNB sells its residential mortgages in the secondary market, it retains servicing rights. A normal servicing fee is retained on all mortgage loans sold and serviced. QNB recognizes its rights to service financial assets that are retained in a transfer of assets in the form of a servicing asset. The servicing asset is amortized in proportion to and over the period of net servicing income or loss. Servicing assets are assessed for impairment based on their fair value. Mortgage servicing fees were $25,000 for both three-month periods ended June 30, 2007 and 2006. For the six-month periods ended June 30, 2007 and 2006 mortgage servicing fees were $50,000 and $48,000, respectively. There was no valuation allowance necessary in any of the periods. Amortization expense for the three-month periods ended June 30, 2007 and 2006 was $18,000 and $22,000, respectively. For the respective six-month periods amortization expense was $37,000 and $47,000. The higher amortization expense in 2006 was a result of early payoffs of mortgage loans through refinancing. As mortgage interest rates have increased and the residential mortgage market has softened refinancing activity as well as origination activity has slowed dramatically. The slowdown in mortgage activity has also had a negative impact on the average balance of mortgages sold and serviced as well as the fee income generated from these loans. The average balance of mortgages serviced for others was $68,990,000 for the second quarter of 2007 compared to $74,041,000 for the second quarter of 2006, a decrease of 6.8%. The average balance of mortgages serviced was approximately $69,858,000 for the six-month period ended June 30, 2007, compared to $75,124,000 for the first six months of 2006, a decrease of 7.0%. The timing of mortgage payments and delinquencies also impacts the amount of servicing fees recorded.
The fixed income securities portfolio represents a significant portion of QNB’s earning assets and is also a primary tool in liquidity and asset/liability management. QNB actively manages its fixed income portfolio in an effort to take advantage of changes in the shape of the yield curve, changes in spread relationships in different sectors and for liquidity purposes, as needed. Management continually reviews strategies that will result in an increase in the yield or improvement in the structure of the investment portfolio.
Net securities gains were $29,000 and $60,000 for the three months ended June 30, 2007 and 2006, respectively. Included in the gains for the second quarter of 2007 were gains related to activity in the marketable equity securities portfolio of the Company of $50,000. All the gains recorded in the second quarter of 2006 were related to activity in this portfolio. In April 2007, when the previously impaired securities were sold, interest rates had increased since the end of March 2007 resulting in an additional loss of $21,000.
For the six-months ended June 30, 2007, QNB recorded a net loss on investment securities of $2,469,000. Excluding the impairment loss of $2,758,000, gains on the sale of investment securities were $289,000. This gain compares to $415,000 for the first six months of 2006. Included in the $289,000 of gains for 2007 were $260,000 of gains from the marketable equity portfolio. This gain compares to gains of $257,000 from this portfolio in 2006. Net gains on the sale of debt securities for the first six months of 2007 were $30,000. During the first quarter of 2007, QNB sold $11,680,000 of securities with an average yield of 5.46% to help fund loans with an average yield of 7.16%. This transaction also resulted in a $50,000 securities gain. Net gains on the sale of debt securities for the first six months of 2006 were $157,000. During the first quarter of 2006, QNB entered into several liquidity transactions through the sale of investment securities to fund the strong growth in loans.
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
NON-INTEREST INCOME (Continued)
In addition, in 2006 QNB sold its preferred stock holdings and recorded a gain of $451,000 on the carrying value of those issues that had previously been impaired and a $300,000 loss on one issue that was not impaired in 2005.
The net gain on the sale of residential mortgage loans was $7,000 and $11,000 for the quarters ended June 30, 2007 and 2006, respectively, and $28,000 and $24,000 for the respective six-month periods. Residential mortgage loans to be sold are identified at origination. The net gain on residential mortgage sales is directly related to the volume of mortgages sold and the timing of the sales relative to the interest rate environment. Included in the gains on the sale of residential mortgages for the three month periods were $5,000 and $9,000, respectively related to the recognition of mortgage servicing assets. These amounts were $17,000 and $16,000 for the six-months ended June 30, 2007 and 2006, respectively. Proceeds from the sale of mortgages were $716,000 and $1,200,000 for the second quarter of 2007 and 2006, respectively. For the six-month periods, proceeds from the sale of residential mortgage loans amounted to $2,253,000 and $2,140,000, respectively. These modest amounts again reflect the slowdown in the residential mortgage market that has occurred since the refinancing boom that took place when interest rates reached historically low levels.
Other operating income decreased $5,000, to $129,000, when comparing the second quarter of 2007 to the second quarter of 2006. Retail brokerage income contributed $15,000 to this decline. QNB changed its Raymond James relationship from an independent branch employing a branch manager to a third party revenue sharing arrangement. Partially offsetting this decline were $4,000 in fees collected for cashing checks for non-QNB customers. This fee was instituted in 2007. Also helping offset the lower retail brokerage fees were title insurance income and tax-exempt life insurance proceeds.
For the six-month period ended June 30, 2007, other operating income was $236,000, a $30,000 reduction from the amount reported for 2006. The reduction in retail brokerage income accounts when comparing the two periods was $33,000. In addition, losses on the sale of repossessed assets increased $13,000 when comparing the first six months of 2007 to the first six months of 2006. Partially offsetting these declines were $9,000 in fees collected for cashing checks for non-QNB customers and a $6,000 increase in merchant income.
NON-INTEREST EXPENSE
Non-interest expense is comprised of costs related to salaries and employee benefits, net occupancy, furniture and equipment, marketing, third party services and various other operating expenses. Total non-interest expense was $4,152,000 for the quarter ended June 30, 2007. Excluding the prepayment penalty on the FHLB borrowings total non-interest expense was $3,412,000, an increase of $130,000, or 4.0%, from levels reported in the second quarter of 2006. Total non-interest expense for the six months ended June 30, 2007, excluding the prepayment penalty discussed above, was $6,734,000, an increase of $216,000, or 3.3%, over 2006 levels.
Salaries and benefits is the largest component of non-interest expense. Salaries and benefits expense increased $56,000, or 3.1%, to $1,870,000 for the quarter ended June 30, 2007 compared to the same quarter in 2006. Salary expense increased $48,000, or 3.3%, during the period to $1,503,000, while benefits expense increased $8,000, or 2.2%, to $367,000. Included in salary expense for the second quarter of 2007 and 2006, respectively was $24,000 and $31,000 in stock option compensation expense. Excluding the impact of the stock option expense, salary expense increased 3.9% when comparing the three-month periods. Merit and promotional increases account for the increase in salary expense. The increase in benefits expense is a result of higher payroll taxes and retirement plan expense partially offset by a slight reduction in medical premiums. The increase in payroll taxes and retirement plan expense is primarily related to the increase in salary expense while the reduction in medical premiums reflects a reduction in the number of people insured as well as the shift by employees to lower cost plans.
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
NON-INTEREST EXPENSE (Continued)
For the six-month period ended June 30, 2007, salaries and benefits expense increased $109,000, to $3,728,000, compared to the same period in 2006. Salary expense increased by $103,000, or 3.6%, while benefits expense increased by $6,000, or .8%, when comparing the two periods. Payroll tax expense and retirement plan expense increased by $12,000 and $10,000, respectively, when comparing the six-month periods. These increases were offset by a $15,000 reduction in medical and dental premiums.
Net occupancy expense decreased $7,000 to $289,000, when comparing the second quarter of 2007 to the second quarter of 2006. For the six-month period, net occupancy expense increased $25,000, to $600,000. For the three and six-month periods building repair and maintenance costs declined $20,000 and $15,000, respectively. Offsetting these savings were increases in depreciation expense of $7,000 and $14,000, respectively, and increases in building rental cost of $4,000 and $19,000, respectively. In addition, for the six-month period utility costs increased $9,000. Some of the increase in depreciation and utilities costs related to the renovations and opening of the commercial loan center in June 2006. The increase in branch rent primarily related to higher common area maintenance charges at leased locations and an increase in rent at one location.
Furniture and equipment expense increased $7,000, or 2.7%, to $262,000, when comparing the three-month periods ended June 30, 2007 and 2006 and increased $31,000, or 6.4%, to $517,000, when comparing the six-month periods. An increase in equipment maintenance costs, both repairs and maintenance contracts, accounts for the increase when comparing the three-month periods and $19,000 of the total increase when comparing the six-month periods.
Marketing expense increased $23,000 to $167,000, for the quarter ended June 30, 2007 and $26,000 to $323,000, for the six-month period. Increases in advertising contributed $8,000 and $17,000, respectively, to the increases in marketing expense for the respective three and six-month periods. During these same periods public relations costs increased $14,000 and $25,000, respectively. QNB made a strategic decision to increase its visibility in the communities it serves, particularly to businesses, through the use of billboards, television advertising and promotional giveaways to increase both product and brand recognition.
Third party services are comprised of professional services, including legal, accounting and auditing and consulting services, as well as fees paid to outside vendors for support services of day-to-day operations. These support services include correspondent banking services, statement printing and mailing, investment security safekeeping and supply management services. Third party services expense was $205,000 for the second quarter of 2007 compared to $196,000 for the second quarter of 2006. This increase related to higher outsourced internal audit and external audit fees as well as the use of consultants for an ATM project and for employee recruitment.
Telephone, postage and supplies expense increased $4,000 for the quarter, to $140,000, but declined $10,000 for the six-month period, to $266,000. Supplies expense increased $4,000 when comparing the three-month periods, but declined $9,000 when comparing the six-month periods. The decrease in expense for the six-month period was a result of higher costs in the first quarter of 2006 for the production of ATM and debit cards and costs related to supplies for the loan center.
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
NON-INTEREST EXPENSE (Continued)
State tax expense represents the payment of the Pennsylvania shares tax, which is based on the equity of the Bank, Pennsylvania sales and use tax and the Pennsylvania capital stock tax. State tax expense was $122,000 for the second quarter of 2007, an increase of $8,000 and $245,000 for the six-month period, an increase of $18,000 compared to the same period in 2006. This increase was a result of a higher shares tax resulting from an increase in the Bank’s equity.
Other operating expense was $357,000 for the three months ended June 30, 2007. This represents a 9.2% increase from the $327,000 reported for the three months ended June 30, 2006. Losses related to fraudulent check card transactions increased $20,000 when comparing the two periods. In addition, fees paid to members of the Board of Directors for attending meetings increased $11,000. This increase relates to an increase in both the meeting fee as well as the number of meetings held.
INCOME TAXES
QNB utilizes an asset and liability approach for financial accounting and reporting of income taxes. As of June 30, 2007, QNB’s net deferred tax asset was $1,261,000. The primary components of deferred taxes are a deferred tax asset of $977,000 relating to the allowance for loan losses and a deferred tax asset of $313,000 resulting from the FASB No. 115 adjustment for available for sale securities. As of June 30, 2006, QNB’s net deferred tax asset was $2,450,000 comprised of deferred tax assets of $812,000 related to the allowance for loan losses and $1,798,000 as a result of the FASB No. 115 adjustment for available-for-sale securities.
The realizability of deferred tax assets is dependent upon a variety of factors including the generation of future taxable income, the existence of taxes paid and recoverable, the reversal of deferred tax liabilities and tax planning strategies. A valuation allowance of $124,000 existed as of June 30, 2006 to offset a portion of the tax benefits associated with certain impaired securities that management believed may not be realizable. During 2006, QNB was able to recognize tax benefits due to realized and unrealized capital gains which allowed for the reversal of the valuation allowance. Based upon these and other factors, management believes it is more likely than not that QNB will realize the benefits of these remaining deferred tax assets. The net deferred tax asset is included in other assets on the consolidated balance sheet.
Applicable income taxes and effective tax rates were $161,000, or 14.8%, for the three-month period ended June 30, 2007, and $352,000, or 21.3%, for the same period in 2006. For the six-month period ended June 30, 2007 applicable income taxes were a $352,000 benefit. For the same period in 2006 income taxes were $632,000 and the effective tax rate was 17.5%. The lower effective tax rate for the second quarter of 2007 and the tax benefit for the six-month period ended June 30, 2007 is a result of the restructuring transactions involving the sale of securities and the prepayment of FHLB advances. The low effective tax rate for the six months ended June 30, 2006 reflected the reversal of approximately $85,000 of the valuation allowance established in 2005.
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
FINANCIAL CONDITION ANALYSIS
The balance sheet analysis compares average balance sheet data for the six months ended June 30, 2007 and 2006, as well as the period ended balances as of June 30, 2007 and December 31, 2006.
Average earning assets for the six-month period ended June 30, 2007 increased $24,681,000, or 4.5%, to $572,783,000 from $548,102,000 for the six months ended June 30, 2006. Average loans increased $43,078,000, or 13.7%, while average investments decreased $19,235,000, or 8.5%. Average Federal funds sold increased $1,835,000 when comparing these same periods. The growth in average loans during the past year was funded primarily through an increase in deposits and proceeds from the sale or maturity of investment securities.
QNB’s primary business is accepting deposits and making loans to meet the credit needs of the communities it serves. Loans are the most significant component of earning assets and growth in loans to small businesses and residents of these communities has been a primary focus of QNB. QNB has been successful in achieving strong growth in total loans, while at the same time maintaining excellent asset quality. Inherent within the lending function is the evaluation and acceptance of credit risk and interest rate risk. QNB manages credit risk associated with its lending activities through portfolio diversification, underwriting policies and procedures and loan monitoring practices.
Total loans have increased 13.1% between June 30, 2006 and June 30, 2007 and 9.5% since December 31, 2006. This loan growth was achieved despite the extremely competitive environment for commercial loans and the slowdown in residential mortgage and home equity loan markets. A key financial ratio is the loan to deposit ratio. With the continued strong growth in loans this ratio improved to 74.8% at June 30, 2007 compared with 71.7% at December 31, 2006 and 71.9% at June 30, 2006.
Average total commercial loans increased $33,813,000 when comparing the first half of 2007 to the first half of 2006. Most of the 16.1% growth in average commercial loans was in loans secured by real estate, either commercial or residential properties, which increased $22,890,000. Of this increase $20,690,000, or 90.4%, were adjustable-rate loans. While adjustable, most of these loans have a fixed rate for a period of time, from one year to ten years, before the rate adjusts. Commercial and industrial loans represent commercial purpose loans that are either secured by collateral other than real estate or unsecured. Many of these loans are for operating lines of credit. Average commercial and industrial loans increased $8,750,000, or 17.2%, when comparing the six-month periods. Also contributing to the growth in total commercial loans was an increase in tax-exempt loans. QNB continues to be successful in competing for loans to schools and municipalities. Average tax-exempt loans increased $2,173,000, or 10.5%, when comparing the six-month periods.
Indirect lease financing receivables represent loans to small businesses that are collateralized by equipment. These loans are originated by a third party and purchased by QNB based on criteria specified by QNB. The criteria include minimum credit scores of the borrower, term of the lease, type and age of equipment financed and geographic area. The geographic area primarily represents states contiguous to Pennsylvania. QNB is not the lessor and does not service these loans. Average indirect lease financing loans increased $5,485,000 when comparing the six-month periods. QNB has experienced an increase in the amount of charge-offs and delinquency in these types of loans over the past year. As a result, QNB has slowed the acquisition of indirect lease financing receivables in 2007.
Average home equity loans increased $4,119,000, while average residential mortgage loans declined $115,000 when comparing the first half of 2007 to the first half of 2006. The 6.3% increase in average home equity loans represents a reduction in the double digit growth that was achieved over the past few years and, along with the lack of activity in the first lien residential mortgage market, reflects the softening that has occurred in the housing market.
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
FINANCIAL CONDITION ANALYSIS (Continued)
The mix of deposits continued to be impacted by the reaction of customers to changes in interest rates on various products and by rates paid by the competition. Interest rates on time deposits and money market accounts continued to show the greatest sensitivity. Most customers appear to be looking for the highest rate for the shortest term.
Total average deposits increased $27,428,000, or 6.0%, to $485,494,000, for the first half of 2007 compared to the first half of 2006. Consistent with customers looking for the highest rate for the shortest term, most of the growth achieved was in time deposits which, on average, increased $31,039,000 when comparing the two periods. Most of the growth in time deposits occurred over the last three quarters and in the maturity range of greater than 6 months through 15 months, which QNB promoted heavily in response to customers’ preferences and competitors offerings. Average time deposits over $100,000 contributed $11,947,000 to the total growth in average time deposits when comparing the six-month periods. Continuing to increase time deposits will be a challenge because of the strong rate competition. Matching or beating competitors’ rates could have a negative impact on the net interest margin.
Money market account balances increased $3,929,000, or 8.2%, on average. The increase in money market balances was primarily the result of a 4.00% money market promotion offered during most of 2006. This promotion was used to compete with the other local financial institutions and internet banks offering attractive rates on money market balances. QNB has maintained a 4.00% money market rate on accounts with balances over $75,000 during 2007.
Average savings accounts declined $4,069,000, or 8.1%, when comparing the six-month periods as customers migrated from lower paying savings accounts to higher paying money market accounts and short-term time deposits.
Average non-interest-bearing deposits declined $3,248,000, or 6.0%, when comparing the six-month periods. These deposits are primarily comprised of business checking accounts and are volatile, depending on the timing of deposits and withdrawals. In addition, business customers are migrating to sweep accounts that transfer excess balances not used to cover daily activity to interest bearing accounts. This migration will result in an increase in the cost of funds as the use of this product increases.
As a result of the maturity and payoff of the $55,000,000 of FHLB advances and their replacement with only $25,000,000 of repurchase agreements, the average outstanding balance of long-term debt decreased from $55,000,000 for the six-months ended June 30, 2006 to $40,591,000 for the six-months ended June 30, 2007.
Total assets at June 30, 2006 were $606,497,000, compared with $614,539,000 at December 31, 2006, a decrease of 1.3%. The April 2007 restructuring transaction had a significant impact on the composition of the balance sheet, as did the growth in loans and deposits. The composition of the asset side of the balance sheet shifted from year-end with total loans increasing $32,569,000 between December 31, 2006 and June 30, 2007. In contrast, total investment securities declined by $36,605,000 between these dates. The proceeds from the investment portfolio were used to fund loan growth as well as payoff $27,000,000 in long-term debt. As a result of repaying the FHLB advances, QNB’s equity investment in the FHLB, included in non-marketable equity securities, was reduced by $2,078,000 when comparing December 31, 2006 to June 30, 2007. Other assets increased $918,000 from December 2006 to June 2007 with most of the change resulting from a $728,000 increase in Federal income taxes receivable.
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
FINANCIAL CONDITION ANALYSIS (Continued)
On the liability side, offsetting the reduction in long-term debt was a $23,719,000, or 5.0%, increase in total deposits since year-end. Growth in time deposits and interest-bearing demand accounts contributed $12,409,000 and $8,909,000, respectively, of the increase in total deposits since year-end. Non-interest bearing demand accounts increased $1,462,000 between December 31, 2006 and June 30, 2007. As mentioned previously, non-interest bearing and interest-bearing demand accounts can be volatile depending on the timing of deposits and withdrawals. Short-term borrowings decreased $4,232,000 between December 31, 2006 and June 30, 2007, as business sweep accounts classified as repurchase agreements declined.
LIQUIDITY
Liquidity represents an institution’s ability to generate cash or otherwise obtain funds at reasonable rates to satisfy commitments to borrowers and demands of depositors. QNB manages its mix of cash, Federal funds sold and investment securities in order to match the volatility, seasonality, interest sensitivity and growth trends of its deposit funds. Liquidity is provided from asset sources through maturities and repayments of loans and investment securities. The portfolio of investment securities classified as available-for-sale and QNB’s policy of selling certain residential mortgage originations in the secondary market also provide sources of liquidity. Additional sources of liquidity are provided by the Bank’s membership in the Federal Home Loan Bank of Pittsburgh (FHLB) and two unsecured Federal funds lines granted by correspondent banks totaling $21,000,000. The Bank has a maximum borrowing capacity with the FHLB of approximately $255,277,000. At June 30, 2007, QNB had no outstanding borrowings under the FHLB credit facility.
Cash and due from banks, Federal funds sold, available-for-sale securities and loans held-for-sale totaled $205,487,000 and $244,091,000 at June 30, 2007 and December 31, 2006, respectively. The decrease in liquid sources is primarily the result of the reduction of the available-for-sale securities portfolio caused by the repayment of the FHLB borrowings and the growth in the loan portfolio. While reduced, these sources should be adequate to meet normal fluctuations in loan demand and deposit withdrawals. During the first half of 2006 and 2007, QNB used its Federal funds lines to help temporarily fund loan growth. Average Federal funds purchased were $708,000 for the first half of 2007. This level compared to $2,308,000 for the same period in 2006.
Approximately $112,753,000 and $75,793,000 of available-for-sale securities at June 30, 2007 and December 31, 2006, respectively, were pledged as collateral for repurchase agreements and deposits of public funds. In addition, under terms of its agreement with the FHLB, QNB maintains otherwise unencumbered qualifying assets (principally 1-4 family residential mortgage loans and U.S. Government and agency notes, bonds, and mortgage-backed securities) in the amount of at least as much as its advances from the FHLB. As mentioned above, QNB had no outstanding borrowings under the FHLB credit facility.
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
CAPITAL ADEQUACY
A strong capital position is fundamental to support continued growth and profitability and to serve the needs of depositors. QNB’s shareholders’ equity at June 30, 2007 was $49,805,000, or 8.21% of total assets, compared to shareholders’ equity of $50,410,000, or 8.20% of total assets, at December 31, 2006. Shareholders’ equity at June 30, 2007 and December 31, 2006 included negative adjustments of $608,000 and $815,000, respectively, related to unrealized holding losses, net of taxes, on investment securities available-for-sale. Without the FASB No. 115 available-for-sale adjustments, shareholders’ equity to total assets would have been 8.31% and 8.34% at June 30, 2007 and December 31, 2006, respectively.
Shareholders’ equity averaged $51,026,000 for the first six months of 2007 and $49,760,000 during all of 2006, an increase of 2.5%. The ratio of average total equity to average total assets increased to 8.47% for the first half of 2007 compared to 8.37% for all of 2006.
QNB is subject to various regulatory capital requirements as issued by Federal regulatory authorities. Regulatory capital is defined in terms of Tier I capital (shareholders’ equity excluding unrealized gains or losses on available-for-sale securities and disallowed intangible assets), Tier II capital, which includes the allowance for loan losses and a portion of the unrealized gains on equity securities, and total capital (Tier I plus Tier II). Risk-based capital ratios are expressed as a percentage of risk-weighted assets. Risk-weighted assets are determined by assigning various weights to all assets and off-balance sheet arrangements, such as letters of credit and loan commitments, based on associated risk. Regulators have also adopted minimum Tier I leverage ratio standards, which measure the ratio of Tier I capital to total quarterly average assets.
The minimum regulatory capital ratios are 4.00% for Tier I, 8.00% for the total risk-based capital and 4.00% for leverage. Under the requirements, QNB had a Tier I capital ratio of 12.20% and 13.15%, a total risk-based ratio of 12.94% and 13.91% and a leverage ratio of 8.44% and 8.42% at June 30, 2007 and December 31, 2006, respectively. The decline in the Tier I and total risk-based capital ratios were the result of the impact of the securities loss and prepayment penalty on net income and retained earnings as well as the increase in risk weighted assets, resulting principally from a shift in assets from investment securities to loans.
The Federal Deposit Insurance Corporation Improvement Act of 1991 established five capital level designations ranging from “well capitalized” to “critically undercapitalized.” At June 30, 2007 and December 31, 2006, QNB met the “well capitalized” criteria which requires minimum Tier I and total risk-based capital ratios of 6.00% and 10.00%, respectively, and a leverage ratio of 5.00%.
INTEREST RATE SENSITIVITY
Since the assets and liabilities of QNB have diverse repricing characteristics that influence net interest income, management analyzes interest sensitivity through the use of gap analysis and simulation models. Interest rate sensitivity management seeks to minimize the effect of interest rate changes on net interest margins and interest rate spreads and to provide growth in net interest income through periods of changing interest rates. QNB’s Asset/Liability Management Committee (ALCO) is responsible for managing interest rate risk and for evaluating the impact of changing interest rate conditions on net interest income.
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
INTEREST RATE SENSITIVITY (Continued)
Gap analysis measures the difference between volumes of rate-sensitive assets and liabilities and quantifies these repricing differences for various time intervals. Static gap analysis describes interest rate sensitivity at a point in time. However, it alone does not accurately measure the magnitude of changes in net interest income because changes in interest rates do not impact all categories of assets and liabilities equally or simultaneously. Interest rate sensitivity analysis also involves assumptions on certain categories of assets and deposits. For purposes of interest rate sensitivity analysis, assets and liabilities are stated at their contractual maturity, estimated likely call date, or earliest repricing opportunity. Mortgage-backed securities, CMOs and amortizing loans are scheduled based on their anticipated cash flow. Savings accounts, including passbook, statement savings, money market, and interest-bearing demand accounts do not have a stated maturity or repricing terms and can be withdrawn or repriced at any time. These characteristics may impact QNB’s margin if more expensive alternative sources of deposits are required to fund loans or deposit runoff. Management projects the repricing characteristics of these accounts based on historical performance and assumptions that it believes reflect their rate sensitivity.
A positive gap results when the amount of interest rate sensitive assets exceeds interest rate sensitive liabilities. A negative gap results when the amount of interest rate sensitive liabilities exceeds interest rate sensitive assets.
QNB primarily focuses on the management of the one-year interest rate sensitivity gap. At June 30, 2007, interest-earning assets scheduled to mature or likely to be called, repriced or repaid in one year were $191,093,000. Interest-sensitive liabilities scheduled to mature or reprice within one year were $313,160,000. The one-year cumulative gap, which reflects QNB’s interest sensitivity over a period of time, was a negative $122,067,000 at June 30, 2007. The cumulative one-year gap equals -20.90% of total rate sensitive assets. This gap position compares to a negative gap position of $109,544,000, or -18.44%, of total rate sensitive assets, at December 31, 2006.
The increase in the negative gap position in the one-year time frame was a result of changes in the repricing and maturity structure of both the assets and liabilities. On the asset side, the amount of assets maturing or repricing declined by $1,023,000 from December 31, 2006 to June 30, 2007. This decrease was primarily caused by the extension of the average life of the investment portfolio resulting from an increase in market interest rates since December 31, 2006 as well as a result of the bonds traded as part of the restructuring transaction. QNB sold mortgage-backed securities and CMO’s that had shorter average lives and that had significant prepayment risk in a declining interest rate environment. QNB purchased mortgage-backed securities and CMO’s with longer average lives than what was sold, but that did not prepay significantly if rates declined or also that did not extend significantly if rates increased. Partially offsetting this was some shortening of the maturity and repricing characteristics of the loan portfolio. On the liability side, the amount of liabilities maturing or repricing increased by $11,500,000 since December 31, 2007. An $11,466,000 increase in municipal interest-bearing demand deposits accounts for most of this change. At June 30, 2007, $167,887,000, or 68.5%, of total time deposits was scheduled to reprice or mature in the next twelve months. This level compares to $161,358,000, or 69.3%, of total time deposits at December 31, 2006.
QNB also uses a simulation model to assess the impact of changes in interest rates on net interest income. The model reflects management’s assumptions related to asset yields and rates paid on liabilities, deposit sensitivity, and the size, composition and maturity or repricing characteristics of the balance sheet. The assumptions are based on what management believes at that time to be the most likely interest rate environment. Management also evaluates the impact of higher and lower interest rates by simulating the impact on net interest income of changing rates. While management performs rate shocks of 100, 200 and 300 basis points, it believes, that given the level of interest rates at June 30, 2007, that it is unlikely that interest rates would decline by 300 basis points. The simulation results can be found in the chart on page 36.
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
INTEREST RATE SENSITIVITY (Continued)
The results from the simulation model are consistent with the results implied by the GAP model. The decline in net interest income in a rising rate environment is consistent with the gap analysis and reflects the fixed-rate nature of the investment and loan portfolio and the increased expense associated with higher costing deposits and short-term borrowings. Net interest income increases if rates were to decline by 100 or 200 basis points. However, the rate of increase in net interest income slows and is not as great as the rate of decline in interest income with rising rates reflecting the hypothetical interest rate floors on interest-bearing transaction accounts, regular money market accounts and savings accounts. Interest rates on these products do not have the ability to decline to the degree that rates on earning assets can.
Actual results may differ from simulated results due to various factors including time, magnitude and frequency of interest rate changes, the relationship or spread between various rates, loan pricing and deposit sensitivity, and asset/liability strategies.
Management believes that the assumptions utilized in evaluating the vulnerability of QNB’s net interest income to changes in interest rates approximate actual experience. However, the interest rate sensitivity of QNB’s assets and liabilities, as well as the estimated effect of changes in interest rates on net interest income, could vary substantially if different assumptions are used or actual experience differs from the experience on which the assumptions were based.
The nature of QNB’s current operation is such that it is not subject to foreign currency exchange or commodity price risk. At June 30, 2007, QNB did not have any hedging transactions in place such as interest rate swaps, caps or floors.
The table below summarizes estimated changes in net interest income over a twelve-month period, under alternative interest rate scenarios.
| Change in Interest Rates | | Net Interest Income | | Dollar Change | | % Change | |
| +300 Basis Points | | $ | 14,548 | | $ | (3,823 | ) | | (20.87 | )% |
| +200 Basis Points | | | 16,948 | | | (1,423 | ) | | (7.75 | ) |
| +100 Basis Points | | | 17,679 | | | (692 | ) | | (3.77 | ) |
| FLAT RATE | | | 18,371 | | | - | | | - | |
| -100 Basis Points | | | 18,800 | | | 429 | | | 2.34 | |
| -200 Basis Points | | | 18,995 | | | 624 | | | 3.40 | |
| -300 Basis Points | | | 18,587 | | | 216 | | | 1.18 | |
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK.
The information required in response to this item is set forth in Item 2, above.
ITEM 4. CONTROLS AND PROCEDURES
We maintain a system of controls and procedures designed to provide reasonable assurance as to the reliability of the consolidated financial statements and other disclosures included in this report, as well as to safeguard assets from unauthorized use or disposition. We evaluated the effectiveness of the design and operation of our disclosure controls and procedures under the supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective as of the end of the period covered by this report. No changes were made to our internal controls over financial reporting or other factors that have materially affected, or are reasonably likely to materially affect, these controls during the prior fiscal quarter covered by this report.
QNB CORP. AND SUBSIDIARY
PART II. OTHER INFORMATION
JUNE 30, 2007
Item 1 Legal Proceedings
None.
Item 1A. Risk Factors
There were no material changes to the Risk Factors described in Item 1A in QNB’s Annual Report on Form 10-K for the period ended December 31, 2006.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
None.
Item 3. Default Upon Senior Securities
None.
Item 4. Submission of Matters to Vote of Security Holders
The 2007 Annual Meeting (the Meeting) of the shareholders of QNB Corp. (the Registrant) was held on May 15, 2007. A Notice of the Meeting was mailed to shareholders of record as of April 2, 2007 on or about April 17, 2007, together with proxy solicitation materials prepared in accordance with Section 14(a) of the Securities Exchange Act of 1934, as amended, and the regulations promulgated thereunder.
The Meeting was held for the following purposes:
(1) To elect three (3) Directors
There was no solicitation in opposition to the nominees of the Board of Directors for election to the Board of Directors and all such nominees were elected. The number of votes cast for or withheld for each of the nominees for election to the Board of Directors was as follows:
| Nominee | | For | | Withhold |
| Charles M. Meredith, III | | 2,425,418 | | 107,428 |
| Gary S. Parzych | | 2,446,252 | | 86,594 |
| Bonnie L. Rankin | | 2,432,782 | | 100,064 |
The continuing directors of the Registrant are:
Thomas J. Bisko, Dennis Helf, G. Arden Link, Kenneth F. Brown, Anna Mae Papso, Henry L. Rosenberger, and Edgar L. Stauffer
Item 5. Other Information
None.
Item 6. Exhibits
| Exhibit 3(i) | | Articles of Incorporation of Registrant, as amended. (Incorporated by reference to Exhibit 3(i) of Registrants Form DEF 14-A filed with the Commission on April 15, 2005). |
| | | |
| Exhibit 3(ii) | | Bylaws of Registrant, as amended. (Incorporated by reference to Exhibit 3(ii) of Registrants Form 8-K filed with the Commission on January 23, 2006). |
| | | |
| Exhibit 11 | | Statement Re: Computation of Earnings Per Share. (Included in Part I, Item I, hereof.) |
| | | |
| Exhibit 31.1 | | Section 302 Certification of President and CEO |
| | | |
| Exhibit 31.2 | | Section 302 Certification of Chief Financial Officer |
| | | |
| Exhibit 32.1 | | Section 906 Certification of President and CEO |
| | | |
| Exhibit 32.2 | | Section 906 Certification of Chief Financial Officer |
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.
| | | QNB Corp. |
| | | |
| Date: August 9, 2007 | | By: |
| | | |
| | | /s/ Thomas J. Bisko |
| | | Thomas J. Bisko |
| | | President/CEO |
| | | |
| Date: August 9, 2007 | | By: |
| | | |
| | | /s/ Bret H. Krevolin |
| | | Bret H. Krevolin |
| | | Chief Financial Officer |
