QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
| ITEM 2. | MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS |
QNB Corp. (herein referred to as QNB or the Company) is a bank holding company headquartered in Quakertown, Pennsylvania. The Company, through its wholly-owned subsidiary, QNB Bank (the Bank), has been serving the residents and businesses of upper Bucks, northern Montgomery and southern Lehigh counties in Pennsylvania since 1877. The Bank is a locally managed community bank that provides a full range of commercial and retail banking and retail brokerage services.
Tabular information presented throughout management’s discussion and analysis, other than share and per share data, is presented in thousands of dollars.
FORWARD-LOOKING STATEMENTS
In addition to historical information, this document contains forward-looking statements. Forward-looking statements are typically identified by words or phrases such as “believe,” “expect,” “anticipate,” “intend,” “estimate,” “project” and variations of such words and similar expressions, or future or conditional verbs such as “will,” “would,” “should,” “could,” “may” or similar expressions. The U.S. Private Securities Litigation Reform Act of 1995 provides safe harbor in regard to the inclusion of forward-looking statements in this document and documents incorporated by reference.
Shareholders should note that many factors, some of which are discussed elsewhere in this document and in the documents that are incorporated by reference, and including the risk factors identified in Item 1A of QNB’s 2011 Form 10-K, could affect the future financial results of the Company and its subsidiary and could cause those results to differ materially from those expressed in the forward-looking statements contained or incorporated by reference in this document. These factors include, but are not limited, to the following:
| · | Volatility in interest rates and shape of the yield curve; |
| · | Operating, legal and regulatory risks; |
| · | Economic, political and competitive forces affecting the Company’s line of business; |
| · | The risk that the Federal Deposit Insurance Corporation (FDIC) could levy additional insurance assessments on all insured institutions in order to replenish the Deposit Insurance Fund based on the level of bank failures in the future; and |
| · | The risk that the analysis of these risks and forces could be incorrect, and/or that the strategies developed to address them could be unsuccessful. |
QNB cautions that these forward-looking statements are subject to numerous assumptions, risks and uncertainties, all of which change over time, and QNB assumes no duty to update forward-looking statements. Management cautions readers not to place undue reliance on any forward-looking statements. These statements speak only as of the date of this report on Form 10-Q, even if subsequently made available by QNB on its website or otherwise, and they advise readers that various factors, including those described above, could affect QNB’s financial performance and could cause actual results or circumstances for future periods to differ materially from those anticipated or projected. Except as required by law, QNB does not undertake, and specifically disclaims any obligation, to publicly release any revisions to any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements.
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The discussion and analysis of the financial condition and results of operations are based on the consolidated financial statements of QNB, which are prepared in accordance with U.S. generally accepted accounting principles (GAAP) and predominant practices within the banking industry. The preparation of these consolidated financial statements requires QNB to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. QNB evaluates estimates on an on-going basis, including those related to the determination of the allowance for loan losses, the determination of the valuation of other real estate owned and foreclosed assets, other-than-temporary impairments on investment securities, the determination of impairment of restricted bank stock, the valuation of deferred tax assets, stock-based compensation and income taxes. QNB bases its estimates on historical experience and various other factors and assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
Other-Than-Temporary Investment Security Impairment
Securities are evaluated periodically to determine whether a decline in their value is other-than-temporary. Management utilizes criteria such as the magnitude and duration of the decline, in addition to the reasons underlying the decline, to determine whether the loss in value is other-than-temporary. The term “other-than-temporary” is not intended to indicate that the decline is permanent, but indicates that the prospect for a near-term recovery of value is not necessarily favorable, or that there is a lack of evidence to support a realizable value equal to or greater than the carrying value of the investment. For equity securities, once a decline in value is determined to be other-than-temporary, the value of the equity security is reduced and a corresponding charge to earnings is recognized.
The Company follows accounting guidance related to the recognition and presentation of other-than-temporary impairment that specifies (a) if a company does not have the intent to sell a debt security prior to recovery and (b) it is more likely than not that it will not have to sell the debt security prior to recovery, the security would not be considered other-than-temporarily impaired unless there is a credit loss. When an entity does not intend to sell the security, and it is more likely than not, the entity will not have to sell the security before recovery of its cost basis, it will recognize the credit component of an other-than-temporary impairment of a debt security in earnings and the remaining portion in other comprehensive income. For held-to-maturity debt securities, the amount of an other-than-temporary impairment recorded in other comprehensive income for the noncredit portion of a previous other-than-temporary impairment is amortized prospectively over the remaining life of the security on the basis of the timing of future estimated cash flows of the security.
There were no credit-related other-than-temporary impairment charges in the first quarter of 2012 or 2011.
Impairment of Restricted Investment in Bank Stocks
Restricted bank stock is comprised of restricted stock of the Federal Home Loan Bank of Pittsburgh (FHLB) and the Atlantic Central Bankers Bank. Federal law requires a member institution of the FHLB to hold stock of its district bank according to a predetermined formula. These restricted securities are carried at cost.
In December 2008, the FHLB of Pittsburgh notified member banks that it was suspending dividend payments and the repurchase of capital stock to preserve capital. Management’s determination of whether these investments are impaired is based on their assessment of the ultimate recoverability of their cost rather than by recognizing temporary declines in value. The determination of whether a decline affects the ultimate recoverability of their cost is influenced by criteria such as (1) the significance of the decline in net assets of the FHLB as compared to the capital stock amount for the FHLB and the length of time this situation has persisted, (2) commitments by the FHLB to make payments required by law or regulation and the level of such payments in relation to the operating performance of the FHLB, and (3) the impact of legislative and regulatory changes on institutions and, accordingly, on the customer base of the FHLB.
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
CRITICAL ACCOUNTING POLICIES AND ESTIMATES (Continued)
Impairment of Restricted Investment in Bank Stocks (Continued)
On October 28, 2010, the FHLB announced their decision to institute a limited excess capital stock repurchase. These capital stock repurchases continued on a quarterly basis during 2011 and the first quarter of 2012. In addition on February 22, 2012 the FHLB announced its decision to pay an annual dividend of 0.10%. Further repurchases or excess capital stock or cash dividends will be evaluated quarterly by the FHLB. Management believes no impairment charge is necessary related to the restricted stock balance as of March 31, 2012.
Allowance for Loan Losses
QNB considers that the determination of the allowance for loan losses involves a higher degree of judgment and complexity than its other significant accounting policies. The allowance for loan losses is calculated with the objective of maintaining a level believed by management to be sufficient to absorb probable known and inherent losses in the outstanding loan portfolio. The allowance is reduced by actual credit losses and is increased by the provision for loan losses and recoveries of previous losses. The provisions for loan losses are charged to earnings to bring the total allowance for loan losses to a level considered necessary by management.
The allowance for loan losses is based on management’s continual review and evaluation of the loan portfolio. The level of the allowance is determined by assigning specific reserves to individually identified problem credits and general reserves to all other loans. The portion of the allowance that is allocated to impaired loans is determined by estimating the inherent loss on each credit after giving consideration to the value of underlying collateral. The general reserves are based on the composition and risk characteristics of the loan portfolio, including the nature of the loan portfolio, credit concentration trends, delinquency and loss experience, as well as other qualitative factors such as current economic trends.
Management emphasizes loan quality and close monitoring of potential problem credits. Credit risk identification and review processes are utilized in order to assess and monitor the degree of risk in the loan portfolio. QNB’s lending and credit administration staff are charged with reviewing the loan portfolio and identifying changes in the economy or in a borrower’s circumstances which may affect the ability to repay debt or the value of pledged collateral. A loan classification and review system exists that identifies those loans with a higher than normal risk of uncollectibility. Each commercial loan is assigned a grade based upon an assessment of the borrower’s financial capacity to service the debt and the presence and value of collateral for the loan. An independent loan review group tests risk assessments and evaluates the adequacy of the allowance for loan losses. Management meets monthly to review the credit quality of the loan portfolio and quarterly to review the allowance for loan losses.
In addition, various regulatory agencies, as an integral part of their examination process, periodically review QNB’s allowance for loan losses. Such agencies may require QNB to recognize additions to the allowance based on their judgments about information available to them at the time of their examination.
Management believes that it uses the best information available to make determinations about the adequacy of the allowance and that it has established its existing allowance for loan losses in accordance with GAAP. If circumstances differ substantially from the assumptions used in making determinations, future adjustments to the allowance for loan losses may be necessary and results of operations could be affected. Because future events affecting borrowers and collateral cannot be predicted with certainty, increases to the allowance may be necessary should the quality of any loans deteriorate as a result of the factors discussed above.
Foreclosed Assets
Assets acquired through, or in lieu of, loan foreclosure are held-for-sale and are 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. Revenue and expenses and changes in the valuation allowance are included in net expenses from foreclosed assets.
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
CRITICAL ACCOUNTING POLICIES AND ESTIMATES (Continued)
Stock-Based Compensation
QNB sponsors stock-based compensation plans, administered by a board committee, under which both qualified and non-qualified stock options may be granted periodically to certain employees. QNB accounts for all awards granted under stock-based compensation plans in accordance with ASC 718, Compensation-Stock Compensation. 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. QNB estimates the fair value of stock options on the date of the grant using the Black-Scholes option pricing model. The model requires the use of numerous assumptions, many of which are highly subjective in nature.
Income Taxes
QNB accounts for income taxes under the asset/liability method in accordance with income tax accounting guidance, ASC 740, Income Taxes. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, as well as operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance is established against deferred tax assets when, in the judgment of management, it is more likely than not that such deferred tax assets will not become available. Because the judgment about the level of future taxable income is dependent to a great extent on matters that may, at least in part, be beyond QNB’s control, it is at least reasonably possible that management’s judgment about the need for a valuation allowance for deferred tax assets could change in the near term.
RESULTS OF OPERATIONS - OVERVIEW
QNB reported net income for the first quarter of 2012 of $2,471,000, or $0.77 per share on a diluted basis. This represents an 11.8% increase compared to net income of $2,211,000, or $0.70 per share on a diluted basis, for the same period in 2011.
The results for the first quarter of 2012 represent a record quarter for QNB and reflect an increase in non-interest income of $626,000 and a lower provision for credit losses of $350,000. These positive variances were partially offset by a $151,000 reduction in net interest income and a $431,000 increase in non-interest expense.
Net income expressed as an annualized rate of return on average assets and average shareholders’ equity was 1.15% and 14.71%, respectively, for the quarter ended March 31, 2012 compared with 1.11% and 14.72%, respectively, for the quarter ended March 31, 2011.
Net Interest Income and Net Interest Margin
Net interest income for the quarter ended March 31, 2012 totaled $6,806,000, a slight decrease of $151,000, or 2.2%, over the same period in 2011. When comparing the two quarters, strong growth in deposits and the investment of these deposits into the securities portfolio was offset by a reduction in the net interest margin resulting in lower net interest income. Average earning assets grew by $57,001,000, or 7.3%, when comparing the first quarter of 2012 to the same period in 2011, with average investment securities increasing $49,423,000, or 17.0%. On the funding side, average deposits increased $57,071,000, or 8.2%, with average transaction accounts increasing $71,088,000, or 17.9%. The growth in transaction accounts was broad based across all product lines and all customer types with the largest increases centered in QNB's Online eSavings product and the deposits of several local school districts and municipalities. Offsetting a portion of this growth was a decline in average time deposits of $14,017,000 when comparing the first quarter 2012 with the same period in 2011.
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
RESULTS OF OPERATIONS – OVERVIEW (Continued)
The net interest margin for the first quarter of 2012 was 3.53% compared to 3.89% for the first quarter of 2011 and 3.53% for the fourth quarter of 2011. The historically low interest rate environment of the past few years when combined with the growth in earning assets occurring in the investment portfolio, which generally earn a lower yield than loans, contributed to a decline in the net interest margin. During the beginning of this interest rate cycle, funding costs declined at a faster pace and to a greater degree than rates on earning assets resulting in an increasing net interest margin. However, since the second quarter of 2011 this trend has reversed as funding costs have approached bottom while yields on earning assets continue to reprice lower resulting in a lower net interest margin.
The average rate earned on earning assets declined 59 basis points from 5.00% for the first quarter of 2011 to 4.41% for the first quarter of 2012. When comparing the change in the yield on earning assets between the two first quarter periods, loans and investment securities declined from 5.85% and 3.75%, respectively, for the first quarter of 2011 to 5.37% and 3.20%, respectively, for the first quarter of 2012, a decline of 48 basis points and 55 basis points, respectively.
In comparison, the cost of interest-bearing liabilities declined 27 basis points from 1.27% to 1.00% over the same time periods. The interest rate paid on interest-bearing deposits declined by 26 basis points to 0.91% for the first quarter of 2012 compared to the first quarter of 2011. Time deposits was the greatest contributor with the average rate paid on time deposits declining 32 basis points from 1.73% for the first quarter of 2011 to 1.41% for the first quarter of 2012. The rates paid on the various transaction account types; interest-bearing demand, municipal, money market and savings declined between 12 basis points and 18 basis points when comparing the two quarters. The cost of interest-bearing liabilities should decline in the second quarter of 2012 as $15,000,000 of long-term debt at a rate of 4.75% matured in April and was repaid.
Asset Quality, Provision for Loan Loss and Allowance for Loan Loss
QNB closely monitors the quality of its loan portfolio and as a result of a reduction in non-performing loans, lower amounts of loan charge-offs and a reduction in outstanding balances, QNB was able to reduce its provision for loan losses while increasing the balance of the allowance for loan losses and coverage of the allowance for loan losses to total loans and nonperforming loans.
QNB recorded a provision for loan losses of $300,000 in the first quarter of 2012 compared with $650,000 in the first quarter of 2011 and $950,000 in the fourth quarter of 2011. Net loan charge-offs were $85,000, or 0.07% annualized of total average loans, for the first quarter of 2012, compared with $413,000, or 0.35% annualized of total average loans, for the first quarter of 2011 and $576,000, or 0.48% annualized of total average loans, for the fourth quarter of 2011.
QNB's allowance for loan losses of $9,456,000 represents 1.97% of total loans at March 31, 2012 compared to an allowance for loan losses of $9,241,000, or 1.88% of total loans, at December 31, 2011 and $9,192,000, or 1.92% of total loans, at March 31, 2011.
Asset quality continues to slowly improve. Total non-performing assets were $23,234,000 at March 31, 2012 compared with $24,145,000 as of December 31, 2011 and $14,721,000 as of March 31, 2011. Included in this classification are non-performing loans, other real estate owned (OREO) and repossessed assets, and non-performing pooled trust preferred securities. Total non-performing loans, which represent loans on non-accrual status, loans past due more than 90 days and still accruing interest and restructured loans were $19,903,000, or 4.15% of total loans, at March 31, 2012 compared with $21,390,000, or 4.36% of total loans, at December 31, 2011 and $13,012,000, or 2.72% of total loans, at March 31, 2011. The increase in non-performing assets during 2011 was primarily the result of several large commercial loan relationships that showed signs of financial difficulty and collateral values that were below the carrying value of the loan. These loans were placed on non-accrual status because it is possible that all principal and interest payments will not be received as expected. Loans on non-accrual status were $17,064,000 at March 31, 2012 compared with $18,597,000 at December 31, 2011 and $10,589,000 at March 31, 2011. In cases where there is a collateral shortfall on non-accrual loans, specific impairment reserves have been established based on updated collateral values even if the borrower continues to pay in accordance with the terms of the agreement. Of the total amount of non-accrual loans at March 31, 2012, $10,242,000, or 60% of the loans classified as non-accrual, are current or past due less than 30 days at March 31, 2012.
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
RESULTS OF OPERATIONS – OVERVIEW (Continued)
QNB had OREO and other repossessed assets of $1,277,000 as of March 31, 2012 compared with $826,000 at December 31, 2011 and $0 at March 31, 2011. Non-performing pooled trust preferred securities are carried at fair value which was $2,054,000, $1,929,000, and $1,709,000 at March 31, 2012, December 31, 2011 and March 31, 2011, respectively. The increase in the balance of non-performing pooled trust preferred securities reflects an improvement in the fair value of these securities and not the purchase of additional securities.
Non-Interest Income
Total non-interest income was $1,566,000 for the first quarter of 2012, an increase of $626,000 compared with the same period in 2011. Net gains on the sale of investment securities and residential mortgage loans account for $620,000 of this total increase. QNB recorded $389,000 of net gains on the sale of investment securities during the first quarter of 2012 compared to net losses of $43,000 recognized in the first quarter of 2011. Included in the first quarter of 2012 securities gains were $386,000 recorded on the sale of equity securities. With the outstanding performance of the U.S. equity markets in the first quarter of 2012, QNB elected to sell some equity holdings and recognize gains. In the first quarter of 2011, QNB recorded gains of $126,000 on the sale of equity securities and net losses of $169,000 on the sale of lower yielding mortgage-backed and Agency securities.
As a result of historically low mortgage rates the amount of residential mortgage refinancing activity has increased significantly as has the amount of gains recorded on the sale of these mortgages. QNB recorded gains of $227,000 on the sale of mortgages during the first quarter of 2012 compared with $39,000 in the first quarter of 2011.
Non-Interest Expense
Total non-interest expense was $4,851,000 for the first quarter of 2012, an increase of $431,000, or 9.8% compared to $4,420,000 for the first quarter of 2011. Salaries and benefits expense contributed the largest portion of the total increase in non-interest expense increasing $239,000, or 10.0%. A seven person increase in the number of full-time equivalent employees, including the addition of a Chief Information and Technology Officer during the third quarter of 2011, along with promotional and merit increases contributed to the $175,000 increase in salary expense. Payroll related taxes increased $26,000, medical and dental benefit premiums and claims increased $21,000 and retirement plan expense increased $18,000 when comparing the two quarters.
Net occupancy and furniture and fixtures expense increased $54,000, or 7.7%, with the majority of the increase in depreciation expense, common area maintenance adjustments on a couple of leased properties and equipment maintenance costs.
Also contributing to the increase in non-interest expense was a $91,000, or 36.6%, increase in third party services and a $67,000 increase in expenses related to the maintenance of other real estate owned. The increase in third party services relates primarily to ongoing costs associated with the new online and mobile banking system introduced in the third quarter of 2011 and the outsourcing of email services to a third party provider during the second quarter of 2011. Marketing expense increased $26,000, or 14.9%, as a result of an increase in public relations and donations costs.
Partially offsetting these higher costs were reductions in FDIC insurance expense of $82,000, or 31.4%. The decrease in FDIC premium expense was a result of a reduction in the rate charged and a change in the method of calculating the basis of the premium effective as of April 1, 2011.
These items noted in the foregoing overview, as well as others, will be discussed and analyzed more thoroughly in the next sections.
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Average Balances, Rate, and Interest Income and Expense Summary (Tax-Equivalent Basis) | | | | | | | |
| | | | | | | | | | | | | | | | | | | |
| | | Three Months Ended | |
| | | March 31, 2012 | | | March 31, 2011 | |
| | | Average | | | Average | | | | | | Average | | | Average | | | | |
| | | Balance | | | Rate | | | Interest | | | Balance | | | Rate | | | Interest | |
| Assets | | | | | | | | | | | | | | | | | | |
| Federal funds sold | | $ | - | | | | 0.00 | % | | $ | - | | | $ | - | | | | 0.00 | % | | $ | - | |
| Investment securities: | | | | | | | | | | | | | | | | | | | | | | | | |
| U.S. Government agencies | | | 65,586 | | | | 1.85 | % | | | 303 | | | | 60,748 | | | | 2.13 | % | | | 323 | |
| State and municipal | | | 76,480 | | | | 5.58 | % | | | 1,067 | | | | 67,224 | | | | 5.94 | % | | | 999 | |
| Mortgage-backed and CMOs | | | 188,500 | | | | 2.73 | % | | | 1,287 | | | | 155,217 | | | | 3.51 | % | | | 1,360 | |
| Other debt securities | | | 6,095 | | | | 1.78 | % | | | 27 | | | | 4,089 | | | | 1.16 | % | | | 12 | |
| Equities | | | 3,285 | | | | 4.18 | % | | | 34 | | | | 3,245 | | | | 3.34 | % | | | 27 | |
| Total investment securities | | | 339,946 | | | | 3.20 | % | | | 2,718 | | | | 290,523 | | | | 3.75 | % | | | 2,721 | |
| Loans: | | | | | | | | | | | | | | | | | | | | | | | | |
| Commercial real estate | | | 256,720 | | | | 5.43 | % | | | 3,465 | | | | 262,295 | | | | 5.99 | % | | | 3,877 | |
| Residential real estate | | | 27,154 | | | | 5.07 | % | | | 344 | | | | 23,398 | | | | 5.57 | % | | | 326 | |
| Home equity loans | | | 51,836 | | | | 4.60 | % | | | 593 | | | | 56,903 | | | | 4.83 | % | | | 678 | |
| Commercial and industrial | | | 97,275 | | | | 4.98 | % | | | 1,205 | | | | 85,766 | | | | 5.31 | % | | | 1,123 | |
| Indirect lease financing | | | 12,156 | | | | 9.23 | % | | | 281 | | | | 13,660 | | | | 8.84 | % | | | 302 | |
| Consumer loans | | | 2,308 | | | | 14.15 | % | | | 81 | | | | 2,643 | | | | 13.56 | % | | | 88 | |
| Tax-exempt loans | | | 34,835 | | | | 5.42 | % | | | 469 | | | | 32,034 | | | | 6.15 | % | | | 485 | |
| Total loans, net of unearned income* | | | 482,284 | | | | 5.37 | % | | | 6,438 | | | | 476,699 | | | | 5.85 | % | | | 6,879 | |
| Other earning assets | | | 13,921 | | | | 0.26 | % | | | 9 | | | | 11,928 | | | | 0.24 | % | | | 7 | |
| Total earning assets | | | 836,151 | | | | 4.41 | % | | | 9,165 | | | | 779,150 | | | | 5.00 | % | | | 9,607 | |
| Cash and due from banks | | | 10,634 | | | | | | | | | | | | 9,616 | | | | | | | | | |
| Allowance for loan losses | | | (9,344 | ) | | | | | | | | | | | (8,892 | ) | | | | | | | | |
| Other assets | | | 28,451 | | | | | | | | | | | | 26,415 | | | | | | | | | |
| Total assets | | $ | 865,892 | | | | | | | | | | | $ | 806,289 | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Liabilities and Shareholders' Equity | | | | | | | | | | | | | | | | | | | | | | | | |
| Interest-bearing deposits: | | | | | | | | | | | | | | | | | | | | | | | | |
| Interest-bearing demand | | $ | 95,830 | | | | 0.34 | % | | | 80 | | | $ | 87,361 | | | | 0.52 | % | | | 113 | |
| Municipals | | | 54,343 | | | | 0.64 | % | | | 87 | | | | 39,858 | | | | 0.78 | % | | | 77 | |
| Money market | | | 78,134 | | | | 0.36 | % | | | 71 | | | | 73,584 | | | | 0.52 | % | | | 94 | |
| Savings | | | 177,031 | | | | 0.72 | % | | | 315 | | | | 136,697 | | | | 0.84 | % | | | 282 | |
| Time | | | 184,068 | | | | 1.38 | % | | | 629 | | | | 199,842 | | | | 1.70 | % | | | 836 | |
| Time of $100,000 or more | | | 101,226 | | | | 1.49 | % | | | 374 | | | | 99,469 | | | | 1.79 | % | | | 440 | |
| Total interest-bearing deposits | | | 690,632 | | | | 0.91 | % | | | 1,556 | | | | 636,811 | | | | 1.17 | % | | | 1,842 | |
| Short-term borrowings | | | 20,899 | | | | 0.52 | % | | | 27 | | | | 25,085 | | | | 0.89 | % | | | 55 | |
| Long-term debt | | | 20,297 | | | | 4.75 | % | | | 244 | | | | 20,307 | | | | 4.75 | % | | | 241 | |
| Total interest-bearing liabilities | | | 731,828 | | | | 1.00 | % | | | 1,827 | | | | 682,203 | | | | 1.27 | % | | | 2,138 | |
| Non-interest-bearing deposits | | | 63,316 | | | | | | | | | | | | 60,066 | | | | | | | | | |
| Other liabilities | | | 3,158 | | | | | | | | | | | | 3,124 | | | | | | | | | |
| Shareholders' equity | | | 67,590 | | | | | | | | | | | | 60,896 | | | | | | | | | |
| Total liabilities and | | | | | | | | | | | | | | | | | | | | | | | | |
| shareholders' equity | | $ | 865,892 | | | | | | | | | | | $ | 806,289 | | | | | | | | | |
| Net interest rate spread | | | | | | | 3.41 | % | | | | | | | | | | | 3.73 | % | | | | |
| Margin/net interest income | | | | | | | 3.53 | % | | $ | 7,338 | | | | | | | | 3.89 | % | | $ | 7,469 | |
Tax-exempt securities and loans were adjusted to a tax-equivalent basis and are based on the marginal Federal corporate tax rate of 34 percent.
Non-accrual loans and investment securities are included in earning assets.
* Includes loans held-for-sale
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Rate/Volume Analysis. The following table shows the fully taxable equivalent effect of changes in volumes and rates on interest income and interest expense. Changes in net interest income that could not be specifically identified as either a rate or volume change were allocated to changes in volume.
| | | Three Months Ended | |
| | | March 31, 2012 compared | |
| | | to March 31, 2011 | |
| | | | | | | | | | |
| | | Total | | | Due to change in: | |
| | | Change | | | Volume | | | Rate | |
| Interest income: | | | | | | | | | |
| Federal funds sold | | $ | - | | | $ | - | | | $ | - | |
| Investment securities: | | | | | | | | | | | | |
| U.S. Government agencies | | | (20 | ) | | | 27 | | | | (47 | ) |
| State and municipal | | | 68 | | | | 137 | | | | (69 | ) |
| Mortgage-backed and CMOs | | | (73 | ) | | | 291 | | | | (364 | ) |
| Other debt securities | | | 15 | | | | 6 | | | | 9 | |
| Equities | | | 7 | | | | - | | | | 7 | |
| Loans: | | | | | | | | | | | | |
| Commercial real estate | | | (412 | ) | | | (51 | ) | | | (361 | ) |
| Residential real estate | | | 18 | | | | 52 | | | | (34 | ) |
| Home equity loans | | | (85 | ) | | | (55 | ) | | | (30 | ) |
| Commercial and industrial | | | 82 | | | | 161 | | | | (79 | ) |
| Indirect lease financing | | | (21 | ) | | | (33 | ) | | | 12 | |
| Consumer loans | | | (7 | ) | | | (10 | ) | | | 3 | |
| Tax-exempt loans | | | (16 | ) | | | 47 | | | | (63 | ) |
| Other earning assets | | | 2 | | | | 1 | | | | 1 | |
| Total interest income | | | (442 | ) | | | 573 | | | | (1,015 | ) |
| Interest expense: | | | | | | | | | | | | |
| Interest-bearing demand | | | (33 | ) | | | 12 | | | | (45 | ) |
| Municipals | | | 10 | | | | 29 | | | | (19 | ) |
| Money market | | | (23 | ) | | | 7 | | | | (30 | ) |
| Savings | | | 33 | | | | 86 | | | | (53 | ) |
| Time | | | (207 | ) | | | (60 | ) | | | (147 | ) |
| Time of $100,000 or more | | | (66 | ) | | | 11 | | | | (77 | ) |
| Short-term borrowings | | | (28 | ) | | | (9 | ) | | | (19 | ) |
| Long-term debt | | | 3 | | | | 3 | | | | - | |
| Total interest expense | | | (311 | ) | | | 79 | | | | (390 | ) |
| Net interest income | | $ | (131 | ) | | $ | 494 | | | $ | (625 | ) |
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
NET INTEREST INCOME
The following table presents the adjustment to convert net interest income to net interest income on a fully taxable-equivalent basis for the three-month periods ended March 31, 2012 and 2011.
| Three months ended March 31, | | 2012 | | | 2011 | |
| Total interest income | | $ | 8,633 | | | $ | 9,095 | |
| Total interest expense | | | 1,827 | | | | 2,138 | |
| Net interest income | | | 6,806 | | | | 6,957 | |
| Tax-equivalent adjustment | | | 532 | | | | 512 | |
| Net interest income (fully taxable-equivalent) | | $ | 7,338 | | | $ | 7,469 | |
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 for funding sources. Earning assets primarily include loans, investment securities, interest bearing balances at the Federal Reserve Bank (Fed) 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 above. 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. The Investment and Asset/Liability Management Committees work to manage and maximize the net interest margin for the Company.
Net interest income decreased $151,000, or 2.2%, to $6,806,000 for the quarter ended March 31, 2012 as compared to the quarter ended March 31, 2011. On a tax-equivalent basis, net interest income decreased $131,000, or 1.8%, from $7,469,000 for the three months ended March 31, 2011 to $7,338,000 for the same period ended March 31, 2012.
When comparing the two quarters, strong growth in deposits and the investment of these deposits into the securities portfolio was offset by a reduction in the net interest margin resulting in lower net interest income. Average earning assets grew by $57,001,000, or 7.3%, when comparing the first quarter of 2012 to the same period in 2011, with average investment securities increasing $49,423,000, or 17.0%, and average loans increasing $5,585,000, or 1.2%. On the funding side, average deposits increased $57,071,000, or 8.2%, with average transaction accounts increasing $71,088,000, or 17.9%. The growth in transaction accounts was broad based across all product lines and all customer types with the largest increases centered in QNB's Online eSavings product and the deposits of several local school districts and municipalities. Offsetting a portion of this growth was a decline in average time deposits of $14,017,000 when comparing the first quarter 2012 with the same period in 2011.
With the growth in earning assets occurring in the investment portfolio, the mix of earning assets changed which contributed to a decline in the net interest margin, as investment securities generally earn a lower yield than loans. In addition, while the economy has shown signs of improvement, issues in the residential and commercial real estate markets persist as do high levels of unemployment. During the third quarter of 2011, the Federal Reserve Open Market Committee announced that they were likely to leave the Federal funds rate at exceptionally low levels through mid-2013 (subsequently extended to 2014) and that they would purchase longer-term Treasury securities in an effort to further reduce longer-term interest rates. These actions combined with events in Europe had the impact of lowering Treasury interest rates and flattening the yield curve as longer-term rates declined more than short-term rates. A low level of interest rates has been
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
NET INTEREST INCOME (continued)
in place since 2008 and has resulted in lower yields earned on both loans and investment securities as well as lower rates paid on deposits and borrowed funds. During the beginning of this interest rate cycle, funding costs declined at a faster pace and to a greater degree than rates on earning assets resulting in an increasing net interest margin. However, since the second quarter of 2011 this trend has reversed as funding costs have approached bottom while yields on earning assets continue to reprice lower resulting in a lower net interest margin.
As a result of these historically low interest rates, over the past year, a significant amount of higher yielding bonds with call features were called and prepayments on mortgage-related securities increased, with these proceeds being reinvested in lower yielding investment securities. In addition, new loans are being originated at significantly lower rates, variable rate loans are repricing lower and many customers with fixed rates are requesting that their rates be modified lower. The net interest margin for the first quarter of 2012 was 3.53% compared to 3.89% for the first quarter of 2011 and 3.53% for the fourth quarter of 2011. Also negatively impacting both the yield on earning assets and the net interest margin was an increase in nonaccrual loans from $10,589,000 at March 31, 2011 to $17,064,000 at March 31, 2012.
The Rate-Volume Analysis tables, as presented on a tax-equivalent basis, highlight the impact of changing rates and volumes on interest income and interest expense. Total interest income on a tax-equivalent basis decreased $442,000, or 4.6% to $9,165,000 for the first quarter of 2012, while total interest expense decreased $311,000, or 14.5%, to $1,827,000. Volume growth in earning assets contributed an additional $573,000 of interest income but was offset by a decline in interest income of $1,015,000 resulting from lower interest rates. With regard to interest expense, lower funding costs resulted in a decline in interest expense of $390,000 which was partially offset by a $79,000 increase in interest expense resulting from growth in balances of interest-bearing deposits.
The yield on earning assets on a tax-equivalent basis decreased 59 basis points from 5.00% for the first quarter of 2011 to 4.41% for the first quarter of 2012 and also declined by two basis points from the 4.43% reported for the fourth quarter of 2011. In comparison, the rate paid on interest-bearing liabilities decreased 27 basis points from 1.27% for the first quarter of 2011 to 1.00% for the first quarter of 2012 and decreased three basis points when compared to 1.03% reported in the fourth quarter of 2011.
Interest income on investment securities decreased $3,000 when comparing the two quarters as the increase in average balances offset the 55 basis point decline in the average yield of the portfolio. The average yield on the investment portfolio was 3.20% for the first quarter of 2012 compared with 3.75% for the first quarter of 2011. As noted previously, the decline in the yield on the investment portfolio is primarily the result of the extended period of low interest rates which has resulted in an increase in cash flow from the investment portfolio as prepayments speeds on mortgage-backed securities and CMOs ramped-up as did the amount of calls of agency and municipal securities. The actions by the Federal Open Market Committee noted above have resulted in a further increase in prepay speeds and calls. The reinvestment of these funds was in securities that had lower yields than what they replaced. The growth in the investment portfolio was primarily in high-quality U.S. Government agency and agency issued mortgage-backed and CMO securities as well as in tax-exempt state and municipal bonds.
Income on Government agency securities decreased $20,000, as the 8.0% growth in average balances was offset a 28 basis point decline in the yield from 2.13% for the first quarter of 2011 to 1.85% for the same period in 2012. Most of the bonds in the agency portfolio have call features ranging from three months to three years, many of which were exercised as a result of the low interest rate environment. The proceeds from these called bonds as well as liquidity from deposit growth were reinvested in securities with significantly lower yields.
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
NET INTEREST INCOME (continued)
Interest income on tax-exempt municipal securities increased $68,000 with higher balances accounting for $137,000 of additional income. Average balances of tax-exempt municipal securities increased $9,256,000, or 13.8%, to $76,480,000 for the first quarter of 2012. As a result of credit concerns in the municipal market arising from issues with the insurance companies that insure the bonds and concerns over the general health of state and municipal governments because of declining revenues and budget issues resulting from economic conditions, municipal bond yields declined but not to the same degree as yields on other types of securities. As a result QNB expanded its purchase of municipal bonds, primarily general obligation bonds of issuers with strong underlying credit ratings. The yield on the state and municipal portfolio decreased 36 basis points from 5.94% for the first quarter of 2011 to 5.58% for the first quarter of 2012. This decline in yield reduced interest income by $69,000 when comparing the two quarters.
Interest income on mortgage-backed securities and CMOs decreased $73,000 with an increase in average balances offsetting in part the significant impact of lower rates. Average balances increased $33,283,000, or 21.4%, to $188,500,000 when comparing the two periods and contributed $291,000 in additional income. The yield on the mortgage-backed and CMO portfolio decreased 78 basis points from 3.51% for the first quarter of 2011 to 2.73% for the first quarter of 2012, resulting in a $364,000 reduction in interest income. This portfolio was expanded because it provides higher yields relative to agency bonds and also provides monthly cash flow which can be used for liquidity purposes or can be reinvested when interest rates eventually increase. With the historically low interest rate environment mortgage refinancing activity over the past two years was significant resulting in an increase in prepayments on these securities. Since most of these securities were purchased at a premium, prepayments result in a shorter amortization period of this premium and therefore a reduction in income.
Income on loans decreased $441,000 to $6,438,000 when comparing the first quarters of 2012 and 2011 with the decline in the portfolio yield being the reason. The yield on the loan portfolio decreased 48 basis points to 5.37% when comparing the same periods, resulting in a reduction in interest income of $552,000. When comparing the two quarters average balances increased 1.1% resulting in an additional $111,000 in interest income. Prior to the third quarter of 2011, QNB was able to minimize the decline in the portfolio yield by implementing interest rate floors on some variable rate commercial loans and home equity lines of credit and by maintaining its pricing structure. However, since the third quarter of 2011, as a result of the decline in market rates and an increase in competition for quality loans, QNB lowered the rates offered on new loans and reduced rates on some existing loans.
The largest category of the loan portfolio is commercial real estate loans. This category of loans includes commercial purpose loans secured by either commercial properties such as office buildings, factories, warehouses, medical facilities and retail establishments, or residential real estate, usually the residence of the business owner. The category also includes construction and land development loans. Income on commercial real estate loans decreased $412,000 and was impacted by both the decline in yield and a decrease in average balances. The yield on commercial real estate loans was 5.43% for the first quarter of 2012, a decrease of 56 basis points from the 5.99% reported for the first quarter of 2011. Average balances decreased $5,575,000, or 2.1%, to $256,720,000, for the three months ended March 31, 2012 compared with the same quarter in 2011.
Income on commercial and industrial loans, the second largest category, increased $82,000 with the positive impact from the growth in balances being partially offset by the decline in the yield. Average commercial and industrial loans increased $11,509,000, or 13.4%, to $97,275,000 for the first quarter of 2012, contributing an additional $161,000 in interest income. The average yield on these loans decreased 33 basis points to 4.98% resulting in a decrease in income of $79,000. Many of the loans in this category are indexed to the prime interest rate and have floors. Since the prime rate did not change over the past year the yield on this portfolio did not decline to the same degree as some other categories.
Income on home equity loans declined by $85,000 when comparing the first quarter of 2012 and 2011. During this same time period average home equity loans decreased $5,067,000, or 8.9%, to $51,836,000, while the yield on the home equity portfolio decreased 23 basis points to 4.60%. The demand for home equity loans has declined as home values have fallen preventing some homeowners from having equity in their homes to borrow against while others have taken advantage of the low interest rates on mortgages and refinanced their home equity loans into a new mortgage.
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
NET INTEREST INCOME (continued)
Given the low yields on alternative investment securities management decided to retain some 15 year mortgages to borrowers with high credit scores and low loan to value ratios. As a result, average residential mortgage loans secured by first lien 1-4 family residential mortgages increased by $3,756,000, or 16.1%, to $27,154,000 for the first quarter of 2012. During this same period the average yield on the portfolio declined by 50 basis points to 5.07% for the first quarter of 2012. The net result was an additional $18,000 in interest income.
For the most part, earning assets are funded by deposits, which increased on average by $57,071,000, or 8.2%, to $753,948,000, when comparing the first quarters of 2012 and 2011. While total income on earning assets on a tax-equivalent basis decreased $442,000 when comparing the first quarter of 2012 to the first quarter of 2011, total interest expense declined $311,000. Interest expense on total deposits decreased $286,000 while interest expense on borrowed funds decreased $25,000 when comparing the two quarters. The rate paid on interest-bearing liabilities decreased 27 basis points from 1.27% for the first quarter of 2011 to 1.00% for the first quarter of 2012. During this same period, the rate paid on interest-bearing deposits decreased 26 basis points from 1.17% to 0.91%.
The growth in deposits when comparing the first quarter of 2012 with the first quarter of 2011 was not centered in time deposits but in accounts with greater liquidity, such as interest-bearing demand, interest-bearing municipal accounts, and savings deposits. Average interest-bearing demand accounts increased $8,469,000, or 9.7%, to $95,830,000 for the first quarter of 2012 compared to the first quarter of 2011; however, interest expense on interest-bearing demand accounts decreased $33,000 to $80,000 for the first quarter of 2012 as the average rate paid decreased from 0.52% for the first quarter of 2011 to 0.34% for the first quarter of 2012. The reduction in the cost of funds reflects the exceptionally low interest rate environment over the past year and the historic lows reached by Treasury rates. Included in this category is QNB-Rewards checking, a high-rate checking account product. The decrease in interest expense and the average rate paid on interest-bearing demand accounts is primarily the result of a reduction in the rate paid on QNB-Rewards checking. The rate paid on this account for the first quarter of 2011 was 2.05% on balances up to $25,000 and 0.75% for balances over $25,000 compared to 1.25% on balances up to $25,000 and 0.50% for balances over $25,000 during the first quarter of 2012. In order to receive the high rate a customer must receive an electronic statement, have one direct deposit or other ACH transaction and have at least 12 check card purchase transactions post and clear per statement cycle. For the first quarter of 2012, the average balance in this product was $28,998,000 and the related interest expense was $72,000 for an average yield of 0.99%. In comparison, the average balance of the QNB-Rewards accounts for the first quarter of 2011 was $27,658,000 with a related interest expense of $105,000 and an average rate paid of 1.54%. Even with the reduction in the rates paid on the QNB-Rewards product, the yield of 1.25% for the first $25,000 and 0.50% on balances over $25,000, assuming qualifications are met, is still an attractive rate relative to competitors’ offerings as well as other QNB products. This product also generates fee income through the use of the check card. The average balance of other interest-bearing demand accounts included in this category increased from $59,703,000 for the first quarter of 2011 to $66,832,000 for the first quarter of 2012. The average rate paid on these balances was 0.05% for both three month periods.
Interest expense on municipal interest-bearing demand accounts increased $10,000 to $87,000 for the first quarter of 2012. The increase in interest expense was the result of a substantial increase in average balances offsetting a decline in the rate paid. The average balance of municipal interest-bearing demand accounts increased $14,485,000, or 36.3%, while the average interest rate paid on these accounts decreased from 0.78% for the first quarter of 2011 to 0.64% for the first quarter of 2012. Most of these accounts are tied directly to the Federal funds rate with most having rate floors between 0.25% and 0.75%. QNB was successful in increasing their relationships with several of these customers over the past year, accounting for the increase in balances.
Average money market accounts increased $4,550,000, or 6.2%, to $78,134,000 for the first quarter of 2012 compared with the same period in 2011. When comparing these same periods interest expense on money market accounts decreased $23,000 to $71,000 and the average interest rate paid declined 16 basis points to 0.36% for the first quarter of 2012. The decline in interest expense and the rate paid is a function of the overall decline in market rates.
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
NET INTEREST INCOME (continued)
During the second quarter of 2009 QNB introduced an online eSavings account to compete with other online savings accounts. This product was introduced at a yield of 1.85% and has been extremely successful having grown to $136,359,000 at March 31, 2012. As market rates declined, the eSavings yield was also reduced and was 0.90% at March 31, 2012. The average yield paid on these accounts was 0.93% for the first quarter of 2012 compared with a yield of 1.22% for the first quarter of 2011. The average balance of this product was $127,642,000 for the first quarter of 2012 compared to $85,480,000 for the first quarter of 2011 and contributed to the $40,334,000, or 29.5%, increase in total average savings accounts when comparing the two quarters. Traditional statement savings accounts, passbook savings and club accounts are also included in the savings category; however, experienced little change when comparing the first quarter 2012 average to the same 2011 quarter. The average rate paid on total savings accounts decreased 12 basis points from 0.84% for the first quarter of 2011 to 0.72% for the first quarter of 2012 while interest expense increased 11.7% from $282,000 to $315,000 over the same period.
The repricing of time deposits at lower rates has had the greatest impact on total interest expense when comparing the two quarters. Total interest expense on time deposits decreased $273,000, or 21.4%, to $1,003,000 for the first quarter of 2012. Average total time deposits decreased by $14,017,000, or 4.7%, to $285,294,000 for the first quarter of 2012. Similar to 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, however, the maturity and repricing characteristics of time deposits tend to be shorter. Over the course of 2011 and the first three months of 2012 a significant amount of time deposits have repriced lower as rates have declined. The average rate paid on time deposits decreased from 1.73% to 1.41% when comparing the first quarter of 2011 to the same period in 2012.
Approximately $134,847,000, or 47.3%, of time deposits at March 31, 2012 will reprice or mature over the next 12 months. The average rate paid on these time deposits is approximately 0.94%. Given the short-term nature of QNB’s time deposit portfolio and the current rates being offered, it is likely that the average rate paid on time deposits may continue to decline slightly in the near term as higher costing time deposits are repriced lower. However, given the short-term nature of these deposits interest expense could increase if short-term time deposit rates were to increase suddenly.
Short-term borrowings are primarily comprised of sweep accounts structured as repurchase agreements with our commercial customers. Interest expense on short-term borrowings decreased from $55,000 for the first quarter of 2011 to $27,000 for the first quarter of 2012. When comparing these same periods average balances decreased from $25,085,000 to $20,899,000 while the average rate paid declined from 0.89% to 0.52%.
QNB had approximately $20,300,000 of average long-term debt at an average rate of 4.75% for both the first quarter of 2012 and 2011. In April 2012, $15,000,000 of debt at a rate of 4.75% matured and was repaid. This will result in a reduction of interest expense going forward.
To continue to attract and retain deposits, QNB plans to be competitive with respect to rates and to continue to deliver products with terms and features that appeal to customers. The QNB Rewards checking and online eSavings accounts are examples of such products.
PROVISION FOR LOAN LOSSES AND ALLOWANCE FOR LOAN LOSSES
The provision for loan losses represents management's determination of the amount necessary to be charged to operations to bring the allowance for loan losses to a level that represents management’s best estimate of the known and inherent losses in the existing loan portfolio. Management believes that it uses the best information available to make determinations about the adequacy of the allowance and that it has established its existing allowance for loan losses in accordance with U.S. generally accepted accounting principles (GAAP). The determination of an appropriate level for the allowance for loan losses is based upon an analysis of the risks inherent in QNB’s loan portfolio. Management, in determining the allowance for loan losses, makes significant estimates and assumptions. 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
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
PROVISION FOR LOAN LOSSES AND ALLOWANCE FOR LOAN LOSSES (continued)
management’s estimates of the allowance for loan losses and actual results could differ. 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. Actual loan losses, net of recoveries, serve to reduce the allowance.
Management closely monitors the quality of its loan portfolio and performs a quarterly analysis of the appropriateness of the allowance for loan losses. This analysis considers a number of relevant factors including: specific impairment reserves, historical loan loss experience, general economic conditions, levels of and trends in delinquent and non-performing loans, levels of classified loans, trends in the growth rate of loans and concentrations of credit.
Economic conditions over the past few years have contributed to high rates of unemployment and a softening of the residential and commercial real estate markets. These factors have had a negative impact on both consumers and small businesses and have contributed to higher than historical levels of net charge-offs and increases in specific reserves and in non-performing, impaired and classified loans. These factors when combined with the inherent risk related to the significant growth in the loan portfolio prior to 2011 and continued concerns related to economic conditions have resulted in elevated levels of the provision for loan losses and the allowance for loan losses. Since December 31, 2008, the start of the financial crisis, QNB has increased its allowance for loan losses from $3,836,000, or 0.95% of total loans, to $9,456,000, or 1.97% of total loans at March 31, 2012. Over the past year the allowance for loan losses has been relatively stable representing $9,241,000, or 1.89% of total loans at December 31, 2011, and $9,192,000, or 1.92% of total loans at March 31, 2011. The allowance for loan losses at March 31, 2012 is at a level that QNB management believes is adequate as of that date based on its analysis of known and inherent losses in the portfolio.
QNB recorded a provision for loan losses of $300,000 in the first quarter of 2012. This compares to provisions of $650,000 for the quarter ended March 31, 2011 and $950,000 for the quarter ended December 31, 2011. Net loan charge-offs were $85,000, or 0.07% (annualized) of average total loans for the first quarter of 2012 compared with $413,000, or 0.35% (annualized) of average total loans for the first quarter of 2011 and $576,000, or 0.48% (annualized) of average total loans for the fourth quarter of 2011. Two borrowers account for approximately $411,000 of the first quarter 2011 charge-offs. Of this amount $391,000 was specifically reserved for as of December 31, 2010.
As referenced in the following table, the levels of non-performing loans peaked at September 30, 2011 at $21,956,000 and have started to decline over the past two quarters. At March 31, 2012, non-performing loans totaled $19,903,000, as compared to $21,390,000 at December 31, 2011 and $13,012,000 at March 31, 2011. Non-performing loans have risen from 2.72% of total loans at March 31, 2011 to 4.15% at March 31, 2012. The largest increase in non-performing loans from March 31, 2011 took place between the second and third quarter of 2011. It was primarily the result of several large commercial loan relationships that had signs of financial difficulty and tight collateral values. These loans were placed on non-accrual status because it is possible that all principal and interest payments will not be received as expected. Loans on non-accrual status were $17,064,000 at March 31, 2012 compared with $18,597,000 at December 31, 2011 and $10,589,000 at March 31, 2011. In cases where there is a collateral shortfall on non-accrual loans, specific impairment reserves have been established based on the updated collateral values even if the borrower continues to pay in accordance with the terms of the agreement. Of the total amount of non-accrual loans at March 31, 2012, $10,242,000, or 60.0%, were current or past due less than 30 days at quarter end.
Delinquent loans are considered performing loans and exclude non-accrual loans, restructured loans and loans 90 days or more past due and still accruing interest (all of which are considered non-performing loans). Total delinquent loans at March 31, 2012, December 31, 2011 and March 31, 2011 represent 0.49%, 0.58% and 0.65% of total loans, respectively.
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
PROVISION FOR LOAN LOSSES AND ALLOWANCE FOR LOAN LOSSES (continued)
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. Factors considered by management in determining impairment include payment status, collateral value and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and shortfalls on a case-by-case basis, taking into consideration all the circumstances surrounding the loan and the borrower, including length of the delay, the reasons for the delay, the borrower’s prior payment record and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan by loan basis for commercial loans and indirect lease financing loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate or the fair value of the collateral, if the loan is collateral dependent. At March 31, 2012 and December 31, 2011, the recorded investment in loans for which impairment has been identified totaled $34,153,000 and $30,368,000 of which $27,459,000 and $21,822,000, respectively, required no specific allowance for loan loss. The recorded investment in impaired loans requiring an allowance for loan losses was $6,694,000 and $8,546,000 at March 31, 2012 and December 31, 2011, respectively. At March 31, 2012 and December 31, 2011, the related allowance for loan losses associated with these loans was $2,552,000 and $2,065,000, respectively. Most of the loans that have been identified as impaired are collateral-dependent. See Note 8 to the Notes to Consolidated Financial Statements for additional detail of impaired loans.
The following table shows detailed information and ratios pertaining to the Company’s loan and asset quality:
| | | March 31, | | | December 31, | | | March 31, | |
| | | 2012 | | | 2011 | | | 2011 | |
| Non-accrual loans | | $ | 17,064 | | | $ | 18,597 | | | $ | 10,589 | |
| Loans past due 90 days or more and still accruing interest | | | 171 | | | | 380 | | | | 36 | |
| Restructured loans (not included above) | | | 2,668 | | | | 2,413 | | | | 2,387 | |
| Total non-performing loans | | | 19,903 | | | | 21,390 | | | | 13,012 | |
| Other real estate owned and repossessed assets | | | 1,277 | | | | 826 | | | | - | |
| Non-accrual investment securities | | | 2,054 | | | | 1,929 | | | | 1,709 | |
| Total non-performing assets | | $ | 23,234 | | | $ | 24,145 | | | $ | 14,721 | |
| | | | | | | | | | | | | |
| Total loans (excluding loans held-for-sale): | | | | | | | | | | | | |
| Average total loans (YTD) | | $ | 481,353 | | | $ | 476,612 | | | $ | 476,277 | |
| Total loans | | | 479,474 | | | | 489,936 | | | | 478,394 | |
| | | | | | | | | | | | | |
| Allowance for loan losses | | | 9,456 | | | | 9,241 | | | | 9,192 | |
| | | | | | | | | | | | | |
| Allowance for loan losses to: | | | | | | | | | | | | |
| Non-performing loans | | | 47.51 | % | | | 43.20 | % | | | 70.64 | % |
| Total loans | | | 1.97 | % | | | 1.89 | % | | | 1.92 | % |
| Average total loans | | | 1.96 | % | | | 1.94 | % | | | 1.93 | % |
| | | | | | | | | | | | | |
| Non-performing loans to total loans | | | 4.15 | % | | | 4.36 | % | | | 2.72 | % |
| Non-performing assets to total assets | | | 2.63 | % | | | 2.78 | % | | | 1.80 | % |
| | | | | | | | | | | | | |
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
PROVISION FOR LOAN LOSSES AND ALLOWANCE FOR LOAN LOSSES (continued)
An analysis of loan charge-offs for the three months ended March 31, 2012 compared to 2011 is as follows:
| Three months ended March 31, | | 2012 | | | 2011 | |
| Net charge-offs | | $ | 85 | | | $ | 413 | |
| | | | | | | | | |
| Net charge-offs (annualized) to: | | | | | | | | |
| Total loans | | | 0.07 | % | | | 0.35 | % |
| Average total loans | | | 0.07 | % | | | 0.35 | % |
| Allowance for loan losses | | | 3.60 | % | | | 18.26 | % |
NON-INTEREST INCOME
| Non-Interest Income Comparison | | | | | | | | | | | | |
| | | | | | | | | Change from | |
| | | | | | prior year | |
| Three months ended March 31, | | 2012 | | | 2011 | | | Amount | | | Percent | |
| Fees for services to customers | | $ | 339 | | | $ | 327 | | | $ | 12 | | | | 3.7 | % |
| ATM and debit card | | | 364 | | | | 328 | | | | 36 | | | | 11.0 | % |
| Bank-owned life insurance | | | 78 | | | | 110 | | | | (32 | ) | | | -29.1 | % |
| Merchant income | | | 85 | | | | 62 | | | | 23 | | | | 37.1 | % |
| Net gain (loss) on investment securities | | | 389 | | | | (43 | ) | | | 432 | | | | 1004.7 | % |
| Net gain on sale of loans | | | 227 | | | | 39 | | | | 188 | | | | 482.1 | % |
| Other | | | 84 | | | | 117 | | | | (33 | ) | | | -28.2 | % |
| Total | | $ | 1,566 | | | $ | 940 | | | $ | 626 | | | | 66.6 | % |
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, merchant income and gains and losses on the sale of investment securities and residential mortgage loans. Total non-interest income for the first quarter of 2012 was $1,566,000, an increase of $626,000, compared to $940,000 for the first quarter of 2011.
Fees for services to customers were $339,000 for the first quarter of 2012, a $12,000, or 3.7%, increase from the same period in 2011. Overdraft income, representing approximately 64% of total fees for services to customers during the first quarter of 2012, declined slightly by $5,000. The decline in overdraft income was more than offset by increase in service charges on checking accounts, internet banking fees and other miscellaneous fees.
ATM and debit card income is primarily comprised of transaction income on debit cards and ATM cards and ATM surcharge income for the use of QNB’s ATM machines by non-QNB customers. ATM and debit card income was $364,000 for the first quarter of 2012, an increase of $36,000, or 11.0%, from the amount recorded during the first quarter of 2011. Debit card income increased $18,000, or 8.3% to $234,000, while ATM interchange income increased $17,000, or 18.5% to $112,000. The increase in debit and ATM card income was a result of the continuing increased reliance on the card as a means of paying for goods and services by both consumers and business cardholders. The higher rate of increase in ATM PIN-based transactions is a function of some merchants recommending lower costing PIN based transactions over higher costing signature debit transactions as well as an increase in the amount QNB receives per transaction. Helping to contribute to the growth is the QNB Rewards checking product, a high-yield checking account which requires, among other terms, the posting of a minimum of twelve debit card purchase transactions per statement cycle to receive the high
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
NON-INTEREST INCOME (continued)
interest rate. The passage of the Dodd-Frank Act could have negative implications on the amount of interchange income earned by QNB in the future. The impact at this time is unknown.
Income on bank-owned life insurance (BOLI) represents the earnings and death benefits on life insurance policies in which the Bank is the beneficiary. Income on these policies was $78,000 and $110,000 in the first quarter of 2012 and 2011, respectively. Included in total BOLI income for the first quarter of 2011 was a death benefit payment of $31,000 on a life insurance policy in which the Bank was the beneficiary. 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.
Merchant income represents fees charged to merchants for the bank’s handling of credit card or charge sales. Merchant income was $85,000 for the first quarter of 2012, an increase of $23,000, or 37.1%, from the amount reported in the same period in 2011. The increase in merchant income is primarily a result of an increase in the number of merchant’s using QNB services.
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 and changes in spread relationships in different sectors and for liquidity purposes. Management continually reviews strategies that will result in an increase in the yield or improvement in the structure of the investment portfolio, including monitoring credit and concentration risk in the portfolio.
Net investment securities gains were $389,000 for the quarter ended March 31, 2012 compared with net losses recognized of $43,000 for the comparable quarter in 2011. Included in the first quarter of 2012 securities gains were $386,000 recorded on the sale of equity securities. With the outstanding performance of the U.S. equity markets in the first quarter of 2012, QNB elected to sell some equity holdings and recognize gains. In the first quarter of 2011, QNB recorded gains of $126,000 on the sale of equity securities and net losses of $169,000 on the sale of lower yielding mortgage-backed and Agency securities. There were no credit-related OTTI charges during the first quarter of 2012 or 2011.
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. Residential mortgage loans to be sold are identified at origination. The net gain on the sale of residential mortgage loans was $227,000 and $39,000 for the quarters ended March 31, 2012 and 2011, respectively. This $188,000 increase in the net gain on sale of loans was a result of an increase in the amount of residential mortgage refinancing activity and the amount of gains recorded on the sale of these mortgages. Contributor to the increase in the gain per loan was the interest rate environment at the time of sale. In 2012, interest rates were declining during most of the first quarter resulting in larger gains being recorded per sale while during most of the first quarter of 2011 interest rates were rising, decreasing the per sale gain. Proceeds from the sale of residential mortgages were $5,491,000 and $2,711,000 for the first quarters of 2012 and 2011, respectively.
The $33,000 decrease in other non-interest income when comparing the two quarters is primarily the result of a decrease in mortgage servicing income and letter of credit fees. Mortgage servicing income declined $14,000, or 49%, when comparing the three months ended March 31, 2012 with the same period in 2011. 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 obligation 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. On a quarterly basis, servicing assets are assessed for impairment based on their fair value. The timing of mortgage payments and delinquencies also impacts the amount of servicing fees recorded. As a result of the significant decline in mortgage interest rates and the resulting increase in refinancing activity, prepayment speeds increased. This had the impact of reducing the income on mortgage servicing as the related servicing asset must be written off when a loan is paid in full. Letter of credit fees declined by $13,000 when comparing the first quarter of 2012 to the same quarter in 2011. The reduction is primarily related to a large letter of credit to a commercial customer that expired during the fourth quarter of 2011.
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
NON-INTEREST EXPENSE
| Non-Interest Expense Comparison | | | | | | | | | | | | |
| | | | | | | | | Change from | |
| | | | | | prior year | |
| Three months ended March 31, | | 2012 | | | 2011 | | | Amount | | | Percent | |
| Salaries and employee benefits | | $ | 2,626 | | | $ | 2,387 | | | $ | 239 | | | | 10.0 | % |
| Net occupancy | | | 424 | | | | 397 | | | | 27 | | | | 6.8 | % |
| Furniture and equipment | | | 330 | | | | 303 | | | | 27 | | | | 8.9 | % |
| Marketing | | | 201 | | | | 175 | | | | 26 | | | | 14.9 | % |
| Third-party services | | | 339 | | | | 248 | | | | 91 | | | | 36.7 | % |
| Telephone, postage and supplies | | | 150 | | | | 148 | | | | 2 | | | | 1.4 | % |
| State taxes | | | 160 | | | | 150 | | | | 10 | | | | 6.7 | % |
| FDIC insurance premiums | | | 180 | | | | 262 | | | | (82 | ) | | | -31.3 | % |
| Other | | | 441 | | | | 350 | | | | 91 | | | | 26.0 | % |
| Total | | $ | 4,851 | | | $ | 4,420 | | | $ | 431 | | | | 9.8 | % |
Non-interest expense is comprised of costs related to salaries and employee benefits, net occupancy, furniture and equipment, marketing, third party services, FDIC insurance premiums, regulatory assessments and taxes and various other operating expenses. Total non-interest expense was $4,851,000 for the first quarter of 2012, an increase of $431,000, or 9.8%, compared to the first quarter of 2011. QNB’s overhead efficiency ratio, which represents the percentage of each dollar of revenue that is used for non-interest expense, is calculated by taking non-interest expense divided by net operating revenue on a tax-equivalent basis. QNB’s efficiency ratios were 54.5% and 52.6% for the three months ended March 31, 2012 and 2011, respectively, and compare favorably with Pennsylvania commercial banks with assets between $500 million and $1 billion which had an average efficiency ratio of 65.2% for the fourth quarter of 2011, the most recent period available.
Salaries and benefits is the largest component of non-interest expense. QNB monitors, through the use of various surveys, the competitive salary and benefit information in its markets and makes adjustments when appropriate. Salaries and benefits expense for the first quarter of 2012 were $2,626,000, an increase of $239,000, or 10.0%, over the $2,387,000 reported in the first quarter of 2011. Salary expense increased $175,000, or 9.4%, during the period to $2,035,000. A seven person increase in the number of full-time equivalent employees, including the addition of a Chief Information & Technology Officer during the third quarter of 2011, along with promotion and merit increases contributed to the increase in salary expense. Comparing the two quarters, benefits expense increased $64,000, or 12.1%, to $591,000. Payroll related taxes increased $26,000, medical and dental benefit premiums and claims increased $21,000 and retirement plan expense increased $18,000 when comparing the two quarters.
Net occupancy expense increased $27,000, or 6.8%, to $424,000 for the first quarter of 2012 while furniture and equipment expense increased $27,000, or 8.9%, to $330,000 for the same period. Most of the increase in net occupancy expense relates to higher ongoing common area maintenance costs and adjustments for the permanent Wescosville branch, opened in October 2010. The increase in furniture and equipment expense relates to higher depreciation on furniture and equipment, amortization of computer software and equipment maintenance costs, which all increased when comparing the first quarter of 2012 to the first quarter of 2011.
Marketing expense increased $26,000, or 14.9%, to $201,000 for the quarter ended March 31, 2012. Increases in charitable contributions and public relations costs account for most of the increase in marketing expense. QNB contributes to many not-for-profit organizations and clubs and sponsors many local events in the communities it serves.
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
NON-INTEREST EXPENSE (continued)
Third party services are comprised of professional services, including legal, accounting, 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 increased $91,000, or 36.7%, to $339,000 for the three months ended March 31, 2012 when compared to the same period in 2011. The largest portion of the increase related to third party IT services for ongoing costs associated with the new online and mobile banking system introduced in the third quarter of 2011 and the outsourcing of email services to a third party provider during the second quarter of 2011.
State tax expense represents the accrual 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 $160,000 for the first quarter of 2012, an increase of $10,000 compared to the same period in 2011. The Bank’s Pennsylvania Shares Tax was $158,000 for the first quarter of 2012, an increase of $10,000 resulting from an increase in the Bank’s equity. The Corporation’s capital stock tax was unchanged at $2,000.
FDIC insurance premium expense decreased $82,000, or 31.3%, to $180,000, when comparing the first quarter of 2012 to 2011. Beginning April 1, 2011, the FDIC changed the method used to calculate insurance premiums. Prior to this date deposits were used as the base for calculating the premium while going forward assets less tangible equity are used as the base. In addition, the rate was reduced by approximately seven basis points for institutions classified as Risk Category 1.
Other non-interest expense increased $91,000, or 26.0%, to $441,000 for the first quarter of 2012. The majority of the increase, $69,000, relates to expenses associated with other real estate owned. These expenses include taxes, insurance and maintenance costs related to the properties held by the Bank.
INCOME TAXES
QNB utilizes an asset and liability approach for financial accounting and reporting of income taxes. As of March 31, 2012, QNB’s net deferred tax asset was $1,172,000. The primary components of deferred taxes are a deferred tax asset of $3,215,000 relating to the allowance for loan losses, a deferred tax asset of $134,000 generated by OTTI charges on equity securities and a deferred tax asset of $435,000 related to OTTI charges on trust preferred securities. Partially offsetting these deferred tax assets was a deferred tax liability of $2,304,000 resulting from unrealized gains on available-for-sale securities. As of March 31, 2011, QNB’s net deferred tax asset was $2,653,000. The primary components of deferred taxes at March 31, 2011 are a deferred tax asset of $3,125,000 relating to the allowance for loan losses, a deferred tax asset of $188,000 generated by OTTI charges on equity securities and a deferred tax asset of $435,000 related to OTTI charges on trust preferred securities. Partially offsetting these deferred tax assets was a deferred tax liability of $764,000 resulting from unrealized gains on 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. 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 the effective tax rate were $750,000, or 23.3%, for the three-month period ended March 31, 2012. Applicable income taxes and the effective tax rate were $616,000, or 21.8%, for the three-month period ended March 31, 2011. The higher effective tax rate for 2012 is predominantly a result of tax-exempt income from loans and securities comprising a lower proportion of pre-tax income.
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
FINANCIAL CONDITION ANALYSIS
The following balance sheet analysis compares average balance sheet data for the three months ended March 31, 2012 and 2011, as well as the period ended balances as of March 31, 2012 and December 31, 2011.
Average earning assets for the three-month period ended March 31, 2012 increased $57,001,000, or 7.3%, to $836,151,000 from $779,150,000 for the three months ended March 31, 2011. The mix of earning assets has changed somewhat when comparing the two periods. Average loans increased $5,585,000, or 1.2%, while average investment securities increased $49,423,000, or 17.0%. Average loans represented 57.7% of earning assets for the first three months of 2012, while average investment securities represented 40.7% of earning assets for the same period. This compares to 61.2% and 37.3%, respectively, for the first three months of 2011. Average other earning assets increased $1,993,000, or 16.7%, when comparing these same periods. Given the slow-down in loan growth and the relatively low yield of 0.25% on interest-bearing deposits at the Federal Reserve Bank, the decision was made to try and stay as fully invested as possible, while still retaining adequate liquidity.
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. 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 increased 0.2% between March 31, 2011 and March 31, 2012 but decreased 2.1% since December 31, 2011. Loan growth which had been strong for 2009 and most of 2010, slowed significantly beginning in the fourth quarter of 2010. Businesses appear to be holding off investing in new equipment or any other type of financing and are paying down their lines with excess cash. Despite the lack of demand QNB is committed to make credit available to its customers.
Average total commercial loans increased $8,735,000 when comparing the first three months of 2012 to the first three months of 2011. Most of the 2.3% growth in average commercial loans was in commercial and industrial loans, which increased $11,509,000, or 13.4%, to $97,275,000. 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 loans secured by real estate, either commercial or residential properties decreased $5,575,000, or 2.1%, when comparing the average balances for the three month periods while average tax-exempt loans to state and municipal organizations increased $2,801,000, or 8.7%, over the same time period.
Average home equity loans continue to decline with average balances decreasing from $56,903,000 for the first quarter of 2011 to $51,836,000 for the first three months of 2012. With the decline in mortgage interest rates that took place, customers have paid down their home equity loans when they refinance their first mortgage. The other impact of the low interest rate environment is movement from fixed rate home equity loans to floating rate lines tied to the prime rate.
Total investment securities were $350,955,000 at March 31, 2012 and $348,091,000 at December 31, 2011. The composition of the portfolio is little changed since December 31, 2011.
Collateralized debt obligations (CDO) are securities derived from the packaging of various assets with many backed by subprime mortgages. These instruments are complex and difficult to value. QNB did a review of its mortgage related securities and concluded that it has minimal exposure to subprime mortgages within its U.S. government sponsored agency (GNMA, FHLMC and FNMA) mortgage-backed and CMO investment portfolios. QNB does not own any non-agency mortgage security or CDO backed by subprime mortgages.
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
FINANCIAL CONDITION ANALYSIS (continued)
QNB does own CDOs in the form of pooled trust preferred securities. These securities are comprised mainly of securities issued by banks or bank holding companies, and to a lesser degree, insurance companies. QNB owns the mezzanine tranches of these securities. These securities are structured so that the senior and mezzanine tranches are protected from defaults by over-collateralization and cash flow default protection provided by subordinated tranches. QNB holds eight of these securities with an amortized cost of $3,640,000 and a fair value of $2,054,000 at March 31, 2012. There was no credit-related other-than-temporary impairment charge in the first quarter of 2012 or 2011. It is possible that future calculations could require recording additional other-than-temporary impairment charges through earnings. For additional detail on these securities see Note 7 Investment Securities and Note 9 Fair Value Measurements and Disclosures.
For the most part, earning assets are funded by deposits. Total average deposits increased $57,071,000, or 8.2%, to $753,948,000 for the first three months of 2012 compared to the first three months of 2011. Customers are continuing to look for the safety of FDIC insured deposits and the stability of a strong local community bank as opposed to the volatility of the equity markets and the uncertainty of the larger regional and national banks.
Most of the increase in average deposits was in savings accounts which increased $40,334,000, or 29.5%, to $177,031,000 for the first quarter of 2012. The growth in savings accounts is largely due to the success of QNB’s newest deposit product, Online eSavings. Average non-interest bearing demand accounts increased $3,250,000, or 5.4%, when comparing the three month periods with growth in personal accounts being the primary contributor. Average interest-bearing demand and municipal accounts increased $8,469,000, or 9.7%, and $14,485,000, or 36.3%, respectively, when comparing the first three months of 2012 and 2011. Business accounts are the primary factor behind the growth of the interest-bearing demand accounts while the growth in relationships with a couple of school districts contributed to the increase in municipal balances. Total average time deposits decreased $14,017,000, or 4.7%, when comparing the two quarters as customers were looking for the liquidity of transaction accounts including the eSavings product.
Total assets at March 31, 2012 were $882,940,000 compared with $868,804,000 at December 31, 2011, an increase of $14,136,000, or 1.6%. Interest-bearing deposits in banks increased $21,202,000 when comparing December 31, 2011 to March 31, 2012. This increase was planned to have adequate cash on hand to pay off $15,000,000 of long-term debt at maturity in April 2012. Total loans decreased $10,462,000, or 2.1%, to $479,474,000 at March 31, 2012. As discussed previously the demand for loans by businesses and consumers has slowed dramatically.
On the liability side, total deposits increased by $14,056,000, or 1.9%, since year-end. Similar to prior periods, the growth was centered in lower-cost core deposits, including savings accounts which increased $17,540,000, or 10.5%, to $185,173,000. The increase in savings accounts was almost entirely in the Online eSavings product whose balances increased from $117,871,000 at December 31, 2011 to $136,359,000 at March 31, 2012. The rate on this account was reduced from 1.00% to 0.90% on February 1, 2012. Money market accounts decreased $4,324,000, or 5.4%, from $79,856,000 at December 31, 2011 to $75,532,000 at March 31, 2012. The decrease was in business accounts which decreased by $6,023,000. These deposits can be volatile depending on the timing of deposits and withdrawals. Time deposits increased only $265,000, or 0.1%, from $285,024,000 at December 31, 2011 to $285,289,000 at March 31, 2012 as customers continue to look for liquidity in anticipation of rising interest rates.
Short-term borrowings declined $1,672,000 from $24,021,000 at December 31, 2011 to $22,349,000 at March 31, 2012. The majority of these balances are commercial sweep accounts which are also volatile based on businesses receipt and disbursement of funds.
Long-term debt was $20,295,000 at March 31, 2012. In April 2012, at maturity, $15,000,000 of repurchase agreements at a weighted average rate of 4.75% will be repaid.
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
LIQUIDITY
Liquidity represents an institution’s ability to generate cash or otherwise obtain funds at reasonable rates to satisfy demand for loans and deposit withdrawals. QNB attempts to manage its mix of cash and interest-bearing balances, Federal funds sold and investment securities in an attempt to match the volatility, seasonality, interest sensitivity and growth trends of its loans and deposits. The Company manages its liquidity risk by measuring and monitoring its liquidity sources and estimated funding needs. 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. Core deposits and cash management repurchase agreements have historically been the most significant funding source for QNB. These deposits and repurchase agreements are generated from a base of consumers, businesses and public funds primarily located in the Company’s market area.
Additional sources of liquidity are provided by the Bank’s membership in the FHLB. At March 31, 2012, the Bank had a maximum borrowing capacity with the FHLB of approximately $182,419,000. The maximum borrowing capacity changes as a function of qualifying collateral assets. QNB has no outstanding borrowings with the FHLB at March 31, 2012. In addition, the Bank maintains two unsecured Federal funds lines with two correspondent banks totaling $18,000,000. At March 31, 2012, there were no outstanding borrowings under these lines. Future availability under these lines is subject to the policies of the granting banks and may be withdrawn. As part of its contingency funding plan QNB successfully tested its ability to borrow from these sources during the third quarter of 2011.
Total cash and cash equivalents, available-for-sale investment securities and loans held-for-sale totaled $383,355,000 and $359,581,000 at March 31, 2012 and December 31, 2011, respectively. The increase in liquid sources is primarily the result of a $21,202,000 increase in interest-bearing cash at the Federal Reserve Bank as of March 31, 2012. This source of liquidity was primarily funded from an increase in total deposits and a reduction in total loans. The sources and level of liquidity maintained should be adequate to meet normal fluctuations in loan demand or deposit withdrawals. With the current low interest rate environment, it is anticipated that the investment portfolio will continue to provide significant liquidity as agency and municipal bonds are called and as cash flow on mortgage-backed and CMO securities continues to be steady. In the event that interest rates would increase the cash flow available from the investment portfolio could decrease.
Approximately $135,391,000 and $158,189,000 of available-for-sale securities at March 31, 2012 and December 31, 2011, respectively, were pledged as collateral for repurchase agreements and deposits of public funds.
As an additional source of liquidity, QNB is a member of the Certificate of Deposit Account Registry Service (CDARS) program offered by the Promontory Interfinancial Network, LLC. CDARS is a funding and liquidity management tool used by banks to access funds and manage their balance sheet. It enables financial institutions to provide customers with full FDIC insurance on time deposits over $250,000 that are placed in the program. During the third quarter of 2011, QNB began offering Insured Cash Sweep (ICS), a product similar to CDARS, but one that provides liquidity like a money market or savings account.
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 March 31, 2012 was $72,542,000, or 8.22% of total assets, compared to shareholders' equity of $70,841,000, or 8.15% of total assets, at December 31, 2011. Shareholders’ equity at March 31, 2012 and December 31, 2011 included a positive adjustment of $4,473,000 and $4,665,000, respectively, related to unrealized holding gains, net of taxes, on investment securities available-for-sale. Without these adjustments, shareholders' equity to total assets would have been 7.75% and 7.66% at March 31, 2012 and December 31, 2011, respectively.
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
CAPITAL ADEQUACY (continued)
Average shareholders' equity and average total assets were $67,590,000 and $865,892,000 for the first three months of 2012, an increase of 6.5% and 3.0%, respectively, from the averages for the year ended December 31, 2011. The ratio of average total equity to average total assets was 7.81% for the first three months of 2012 compared to 7.55% for all of 2011.
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 debt securities and disallowed intangible assets), Tier II capital, which includes the allowable portion of the allowance for loan losses which is limited to 1.25% of risk-weighted assets 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 following table sets forth consolidated information for QNB Corp.:
| Capital Analysis | | March 31, 2012 | | | December 31, 2011 | |
| Tier I | | | | | | |
| Shareholder's equity | | $ | 72,542 | | | $ | 70,841 | |
| Net unrealized securities gains | | | (4,473 | ) | | | (4,665 | ) |
| Total Tier I risk-based capital | | $ | 68,069 | | | $ | 66,176 | |
| | | | | | | | | |
| Tier II | | | | | | | | |
| Allowable portion: Allowance for loan losses | | $ | 7,226 | | | $ | 7,270 | |
| Unrealized gains on equity securities | | | 218 | | | | 248 | |
| Total risk-based capital | | $ | 75,513 | | | $ | 73,694 | |
| Risk-weighted assets | | $ | 575,883 | | | $ | 579,633 | |
| Average assets | | $ | 865,892 | | | $ | 870,133 | |
| | | | | | | | | |
| | | | | | | | | |
| Capital Ratios | | March 31, 2012 | | | December 31, 2011 | |
| Tier I capital/risk-weighted assets | | | 11.82 | % | | | 11.42 | % |
| Total risk-based capital/risk-weighted assets | | | 13.11 | % | | | 12.71 | % |
| Tier I capital/average assets (leverage ratio) | | | 7.86 | % | | | 7.61 | % |
The minimum regulatory capital ratios are 4.00% for Tier I, 8.00% for the total risk-based capital and 4.00% for leverage. All capital ratios have improved from December 31, 2011 as the Tier I and total risk based capital levels have increased while the risk-weighted assets and quarterly average assets have declined since year end.
During the first quarter of 2010, QNB began offering a Dividend Reinvestment and Stock Purchase Plan (the “Plan”) to provide participants a convenient and economical method for investing cash dividends paid on the Company’s common stock in additional shares at a discount. The Plan also allows participants to make additional cash purchases of stock at a discount. Stock purchases under the Plan contributed $196,000 to capital during first three months of 2012.
The Board of Directors has authorized the repurchase of up to 100,000 shares of its common stock in open market or privately negotiated transactions. The repurchase authorization does not bear a termination date. As of March 31, 2012, 57,883 shares were repurchased under this authorization at an average price of $16.97 and a total cost of $982,000. There were no shares repurchased under the plan since the first quarter of 2009.
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
CAPITAL ADEQUACY (continued)
Continuing to impact risk-weighted assets is the $26,230,000 of risk-weighted assets due to mezzanine tranches of pooled trust preferred securities that were downgraded below investment grade during the first quarter of 2009. Although the amortized cost of these securities was only $3,640,000 at March 31, 2012, regulatory guidance required an additional $26,230,000 to be included in risk-weighted assets. The Bank utilized the method as outlined in the Call Report Instructions for an available-for-sale bond that has not triggered the Low Level Exposure (LLE) rule. The mezzanine tranches of CDOs that utilized this method of risk-weighting are five out of eight pooled trust preferred securities (PreTSLs) held by the Bank as of March 31, 2012. The other three pooled trust preferred securities have only one tranche remaining so the treatment noted above does not apply.
The Federal Deposit Insurance Corporation Improvement Act of 1991 established five capital level designations ranging from "well capitalized" to "critically undercapitalized." At March 31, 2012 and December 31, 2011, management believes that the Company and the Bank met all capital adequacy requirements to which they are subject and have 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%.
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 control over financial reporting during the fiscal quarter covered by this report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
QNB CORP. AND SUBSIDIARY
PART II. OTHER INFORMATION
MARCH 31, 2012
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, 2011.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
| Period | | Total Number of Shares Purchased | | | Average Price Paid per Share | | | Total Number of Shares Purchased as Part of Publicly Announced Plan | | | Maximum Number of Shares that may yet be Purchased Under the Plan | |
| | | | | | | | | | | | | |
| January 1, 2012 through January 31, 2012 | | | - | | | | - | | | | - | | | | 42,117 | |
| February 1, 2012 through February 29, 2012 | | | - | | | | - | | | | - | | | | 42,117 | |
| March 1, 2012 through March 31, 2012 | | | - | | | | - | | | | - | | | | 42,117 | |
| Total | | | - | | | | - | | | | - | | | | 42,117 | |
| (1) Transactions are reported as of settlement dates. |
| (2) QNB’s current stock repurchase plan was approved by its Board of Directors and announced on January 24, 2008 and subsequently increased on February 9, 2009. |
| (3) The total number of shares approved for repurchase under QNB’s current stock repurchase plan is 100,000. |
| (4) QNB’s current stock repurchase plan has no expiration date. |
| (5) QNB has no stock repurchase plan that it has determined to terminate or under which it does not intend to make further purchases. |
Item 3. Default Upon Senior Securities
None.
Item 4. Mine Safety Disclosures
None.
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 Chief Executive Officer |
| | | |
| Exhibit 31.2 | | Section 302 Certification of Chief Financial Officer |
| | | |
| Exhibit 32.1 | | Section 906 Certification of Chief Executive Officer |
| | | |
| Exhibit 32.2 | | Section 906 Certification of Chief Financial Officer |
| | | |
| The following Exhibits are being furnished* as part of this report: |
| | | |
| | |
| 101.INS | | XBRL Instance Document.* |
| 101.SCH | | XBRL Taxonomy Extension Schema Document.* |
| 101.CAL | | XBRL Taxonomy Extension Calculation Linkbase Document.* |
| 101.LAB | | XBRL Taxonomy Extension Label Linkbase Document.* |
| 101.PRE | | XBRL Taxonomy Extension Presentation Linkbase Document.* |
| 101.DEF | | XBRL Taxonomy Extension Definitions Linkbase Document.* |
| | | |
| | * | These interactive data files are being furnished as part of this Quarterly Report, and, in accordance with Rule 402 of Regulation S-T, shall not be deemed filed for purposes of Section 11 or 12 of the Securities Act of 1933, as amended, or Section 18 of the Securities Exchange Act of 1934, as amended, or otherwise subject to liability under those sections. |
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: May 14, 2012 | By: | /s/ Thomas J. Bisko | |
| | | Thomas J. Bisko | |
| | | Chief Executive Officer | |
| | | | |
Date: May 14, 2012 | By: | /s/ Bret H. Krevolin | |
| | | Bret H. Krevolin | |
| | | Chief Financial Officer | |
| | | | |
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