XNAS:FBMI Firstbank Corp Michigan Quarterly Report 10-Q Filing - 6/30/2012

Effective Date 6/30/2012

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 U.S. SECURITIES AND EXCHANGE COMMISSION
Washington, D.C.  20549

FORM 10-Q
[X]
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES AND EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2012

[   ]
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from          to            .

Commission file number:  000-14209
 
FIRSTBANK CORPORATION
(Exact name of registrant as specified in its charter)
 
Michigan   38-2633910
(State of Incorporation)
 
(I.R.S. Employer Identification No.)
     
311 Woodworth Avenue
   
Alma, Michigan
  48801
(Address of principal executive offices)   (Zip Code)
 
Registrant’s telephone number, including area code:  (989) 463-3131

Indicate by check mark whether the registrant (1) has filed all reports to be filed by Section 13 or 15(d) of the Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days.     Yes  X      No___

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
Yes   X      No___

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer”, “accelerated filer”, and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer ___  Accelerated filer ___ Non-accelerated filer ­­­___ Smaller reporting company _X__
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).     Yes           No X  

Common stock outstanding at July 31, 2012: 7,946,081 shares.
 
 
 

 
 
INDEX      
       
PART I.
FINANCIAL INFORMATION
   
       
Item 1.
Financial Statements (UNAUDITED)
Page 3
       
Item 2.
Management's Discussion and Analysis of Financial Condition and Results of Operations
Page 23
       
Item 3.
Quantitative and Qualitative Disclosures about Market Risk
Page 29
       
Item 4.
Controls and Procedures
 
Page 29
       
       
PART II.
OTHER INFORMATION
   
       
Item 5.
Other Information
 
Page 30
       
Item 6.
Exhibits
 
Page 30
       
       
SIGNATURES
   
Page 31
 
 
2

 
 
FIRSTBANK CORPORATION
              CONSOLIDATED BALANCE SHEETS
           AS OF JUNE 30, 2012 AND DECEMBER 31, 2011
(Dollars in thousands)
UNAUDITED  
                                                                                                                                                                               
   
June 30,
2012
   
December 31,
2011
 
ASSETS
           
Cash and due from banks
  $ 29,340     $ 40,151  
Short term investments
    61,832       35,665  
Total Cash and cash equivalents
    91,172       75,816  
                 
FDIC insured bank time certificates of deposit
    2,927       4,432  
Trading account securities
    7       2  
Securities available for sale
    326,673       342,184  
Federal Home Loan Bank stock
    7,266       7,266  
Loans held for sale
    3,857       349  
Loans, net of allowance for loan losses of $21,522 at June 30, 2012 and $21,019 at December 31, 2011
    966,508       962,890  
Premises and equipment, net
    24,978       25,087  
Goodwill
    35,513       35,513  
Core deposit and other intangibles
    1,177       1,448  
Other real estate owned
    3,741       5,251  
Accrued interest receivable and other assets
    21,919       25,061  
                 
TOTAL ASSETS
  $ 1,485,738     $ 1,485,299  
                 
                 
LIABILITIES AND SHAREHOLDERS’ EQUITY
               
LIABILITIES
               
Deposits:
               
Non-interest bearing accounts
  $ 217,824     $ 214,904  
Interest bearing accounts:
               
Demand
    330,582       340,942  
Savings
    258,607       241,603  
Time
    404,833       423,093  
Total Deposits
    1,211,846       1,220,542  
                 
Securities sold under agreements to repurchase and overnight borrowings
    45,746       46,784  
Federal Home Loan Bank advances
    24,334       19,457  
Subordinated Debentures
    36,084       36,084  
Accrued interest and other liabilities
    22,585       7,055  
Total Liabilities
    1,340,595       1,329,922  
                 
                 
SHAREHOLDERS’ EQUITY
               
Preferred stock; no par value, 300,000 shares authorized, 17,000 issued
    16,901       32,792  
Common stock; 20,000,000 shares authorized, 7,945,647 shares issued and outstanding ( 7,892,486 at December 31, 2011 )
    117,087       115,734  
Retained earnings
    7,397       3,955  
Accumulated other comprehensive income
    3,758       2,896  
Total Shareholders’ Equity
    145,143       155,377  
                 
TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY
  $ 1,485,738     $ 1,485,299  

See notes to consolidated financial statements.
 
 
3

 
 
FIRSTBANK CORPORATION
CONSOLIDATED STATEMENTS OF INCOME
JUNE 30, 2012 AND 2011
(Dollars in thousands except per share data)
UNAUDITED
                                                                                           
    Three Months Ended  June 30,  
    2012      2011  
Interest Income:
           
Interest and fees on loans
  $ 14,493     $ 15,571  
Securities
               
Taxable
    1,183       1,319  
Exempt from Federal Income Tax
    290       280  
Short term investments
    54       45  
Total Interest Income
    16,020       17,215  
Interest Expense:
               
Deposits
    1,718       2,945  
FHLB advances and other borrowing
    191       227  
Subordinated Debt
    272       302  
Total Interest Expense
    2,181       3,474  
Net Interest Income
    13,839       13,741  
Provision for loan losses
    2,494       4,256  
Net Interest Income after provision for loan losses
    11,345       9,485  
Non-interest Income:
               
Service charges on deposit accounts
    1,060       1,182  
Gain on sale of mortgage loans
    1,460       413  
Mortgage servicing, net of amortization
    15       76  
Gain/(loss) on trading account securities
    5       2  
Gain/(loss) on securities
    27       (2 )
Other
    462       340  
Total Non-interest Income
    3,029       2,011  
Non-interest Expense:
               
Salaries and employee benefits
    5,468       5,170  
Occupancy and equipment
    1,284       1,284  
FDIC insurance premium
    325       499  
Amortization of intangibles
    126       185  
Outside professional services
    300       318  
Advertising and promotions
    355       380  
Other real estate owned costs
    380       797  
Other
    2,794       2,177  
Total Non-interest Expense
    11,032       10,810  
                 
Income before federal income taxes
    3,342       686  
Federal income taxes
    938       58  
NET INCOME
  $ 2,404     $ 628  
                 
Preferred stock dividends and accretion of discount on preferred stock
    420       420  
NET INCOME AVAILABLE TO COMMON SHAREHOLDERS
  $ 1,984     $ 208  
                 
COMPREHENSIVE INCOME
               
Net Income
  $ 2,404     $ 628  
Change in unrealized gain on securities, net of tax and reclassification effects
    475       1,700  
TOTAL COMPREHENSIVE INCOME
  $ 2,879     $ 2,328  
                 
Basic Earnings Per Share
  $ 0.25     $ 0.03  
Diluted Earnings Per Share
  $ 0.25     $ 0.03  
Dividends Per Share
  $ 0.01     $ 0.01  

See notes to consolidated financial statements.
 
 
4

 
 
FIRSTBANK CORPORATION
CONSOLIDATED STATEMENTS OF INCOME
JUNE 30, 2012 AND 2011
(Dollars in thousands except per share data)
UNAUDITED
                             
    Six Months Ended  June 30,  
    2012      2011  
Interest Income:
           
Interest and fees on loans
  $ 29,061     $ 31,217  
Securities
               
Taxable
    2,404       2,330  
Exempt from Federal Income Tax
    573       573  
Short term investments
    108       84  
Total Interest Income
    32,146       34,204  
Interest Expense:
               
Deposits
    3,610       5,994  
FHLB advances and other borrowing
    382       508  
Subordinated Debt
    548       669  
Total Interest Expense
    4,540       7,171  
Net Interest Income
    27,606       27,033  
Provision for loan losses
    4,988       7,267  
Net Interest Income after provision for loan losses
    22,618       19,766  
Non-interest Income:
               
Service charges on deposit accounts
    2,118       2,274  
Gain on sale of mortgage loans
    3,155       981  
Mortgage servicing, net of amortization
    (79 )     104  
Gain/(loss) on trading account securities
    6       8  
Gain/(loss) on securities
    40       (10 )
Other
    1,003       699  
Total Non-interest Income
    6,243       4,056  
Non-interest Expense:
               
Salaries and employee benefits
    11,138       10,440  
Occupancy and equipment
    2,645       2,708  
FDIC insurance premium
    699       1,042  
Amortization of intangibles
    271       370  
Outside professional services
    603       580  
Advertising and promotions
    719       644  
Other real estate owned costs
    797       1,378  
Other
    5,207       4,410  
Total Non-interest Expense
    22,079       21,572  
                 
Income before federal income taxes
    6,782       2,250  
Federal income taxes
    1,961       407  
NET INCOME
  $ 4,821     $ 1,843  
                 
Preferred stock dividends and accretion of discount on preferred stock
    840       840  
NET INCOME AVAILABLE TO COMMON SHAREHOLDERS
  $ 3,981     $ 1,003  
                 
COMPREHENSIVE INCOME
               
Net Income
  $ 4,821     $ 1,843  
Change in unrealized gain on securities, net of tax and reclassification effects
    862       2,010  
TOTAL COMPREHENSIVE INCOME
  $ 5,683     $ 3,853  
                 
Basic Earnings Per Share
  $ 0.50     $ 0.13  
Diluted Earnings Per Share
  $ 0.50     $ 0.13  
Dividends Per Share
  $ 0.07     $ 0.02  

See notes to consolidated financial statements.
 
 
5

 
 
FIRSTBANK CORPORATION
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
FOR THE PERIODS ENDED DECEMBER 31, 2011 AND JUNE 30, 2012
(In Thousands of Dollars, Except for Share and per Share Data)
 
     
  Common
Stock
     
Preferred
 
     
Retained
Earnings/
 (Accumulated Deficit)
    Accumulated
Other
Comprehensive
Income (Loss)
     Total  
Balances at December 31, 2010
  $ 115,224     $ 32,763     $ 295     $ 146     $ 148,428  
Net income for 2011
                    5,623               5,623  
Cash dividends on common stock - $0.04 per share
                    (313 )             (313 )
Accrued dividends on preferred stock and accretion of discount on preferred stock
            29       (1,679 )             (1,650 )
Amortization of stock warrants
    (29 )             29               0  
Issuance of 11,610 shares of common stock through the dividend reinvestment plan
    62                               62  
Issuance of 34,803 shares of common stock from supplemental shareholder investments
    197                               197  
Issuance of 42,379 shares of common stock
    162                               162  
Stock option and restricted stock expense
    118                               118  
Net change in unrealized gain/(loss) on securities available for sale, net of tax of $1,417
                            2,750       2,750  
Balances at December 31, 2011
  $ 115,734     $ 32,792     $ 3,955     $ 2,896     $ 155,377  
                                         
                                         
Year to date net income June 30, 2012
                    4,821               4,821  
Cash dividends on common stock - $0.07 per share
                    (554 )             (554 )
Accrued dividends on preferred stock and accretion of discount on preferred stock
            15       (840 )             (825 )
Redemption of 16,000 shares of preferred stock
    850       (15,906 )                     (15,056 )
Amortization of stock warrants
    (15 )             15               0  
Issuance of 13,765 shares of common stock through the dividend reinvestment plan
    109                               109  
Issuance of 1,601 shares of common stock from supplemental shareholder investments
    13                               13  
Issuance of 37,795 shares of common stock
    351                               351  
Stock option and restricted stock expense
    45                               45  
Net change in unrealized gain/(loss) on securities available for sale, net of tax of $444
                            862       862  
Balances at June 30, 2012
  $ 117,087     $ 16,901     $ 7,397     $ 3,758     $ 145,143  

See notes to consolidated financial statements.
 
 
6

 
 
FIRSTBANK CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOW
                FOR THE  SIX MONTHS ENDED
               JUNE 30, 2012 AND 2011
                (Dollars in thousands)
                UNAUDITED
 
   
Six months ended June 31,
 
   
2012
   
2011
 
OPERATING ACTIVITIES
           
Net income
  $ 4,821     $ 1,843  
Adjustments to reconcile net income to net cash provided by operating activities:
               
Provision for loan losses
    4,988       7,267  
Depreciation of premises and equipment
    961       1,064  
Net amortization of security premiums/discounts
    1,913       1,784  
Gain on trading account securities
    (6 )     (8 )
(Gain)/Loss on securities transactions
    (40 )     10  
Amortization and impairment of intangibles
    271       370  
Stock option and stock grant compensation expense
    45       67  
Gain on sale of mortgage loans
    (3,155 )     (981 )
Proceeds from sales of mortgage loans
    96,921       30,104  
Loans originated for sale
    (97,274 )     (28,202 )
Deferred federal income tax expense/(benefit)
    (1,492 )     1,035  
Decrease in accrued interest receivable and other assets
    3,984       1,530  
Increase/(decrease) in accrued interest payable and other liabilities
    15,530       (582 )
NET CASH PROVIDED BY OPERATING ACTIVITIES
    27,467       15,301  
                 
INVESTING ACTIVITIES
               
Proceeds from sale of securities available for sale
    2,745       280  
Proceeds from maturities of CD’s
    1,485       937  
Proceeds from maturities and calls of securities available for sale
    63,841       73,067  
Purchases of securities available for sale
    (51,622 )     (101,970 )
Proceeds from sale of fixed assets
    4       20  
Net (increase)/decrease in portfolio loans
    (9,957 )     14,442  
Proceeds from sale of other real estate owned
    3,068       2,601  
Net purchases of premises and equipment
    (856 )     (1,210 )
NET CASH PROVIDED BY/(USED IN) INVESTING ACTIVITIES
    8,708       (11,833 )
                 
FINANCING ACTIVITIES
               
Net (decrease)/increase in deposits
    (8,696 )     34,537  
(Decrease)/increase in securities sold under agreements to repurchase and other short term borrowings     (1,038     4,976  
Repayment of Federal Home Loan Bank borrowings
    (3,123 )     (19,115 )
Proceeds from Federal Home Loan Bank borrowings
    8,000       0  
Repurchase of preferred stock
    (15,056 )     0  
Cash proceeds from issuance of common stock, net
    473       295  
Cash dividends-preferred stock
    (825 )     (825 )
Cash dividends-common stock
    (554 )     (156 )
NET CASH PROVIDED/(USED IN) BY FINANCING ACTIVITIES
    (20,819 )     19,712  
                 
INCREASE IN CASH AND CASH EQUIVALENTS
    15,356       23,180  
Cash and cash equivalents at beginning of period
    75,816       73,538  
CASH AND CASH EQUIVALENTS AT END OF PERIOD
  $ 91,172     $ 96,718  
                 
Supplemental Disclosure
               
Interest Paid
  $ 4,683     $ 7,405  
Income Taxes Paid
  $ 2,200     $ 975  
Non cash transfers of loans to Other Real Estate Owned
  $ 1,937     $ 3,845  

See notes to consolidated financial statements.
 
 
7

 

FIRSTBANK CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2012
UNAUDITED

NOTE 1- FINANCIAL STATEMENTS

The accompanying unaudited financial information presented is for Firstbank Corporation (“Corporation”) and its wholly owned subsidiaries:  Firstbank - Alma, Firstbank (Mt. Pleasant), Firstbank - West Branch (including its wholly owned subsidiary; 1st Title, Inc., and its 46% ownership in 1st Investors Title, LLC, Keystone Community Bank, Firstbank – West Michigan and its wholly owned subsidiary Accord Financial Services, Inc., collectively the “Banks”, FBMI Risk Management Services, Inc., a company that provides insurance coverage to only affiliates of Firstbank Corporation, and Austin Mortgage Company, a company that holds certain performing and non-performing residential mortgage loans originated prior to the acquisition of ICNB Financial Corporation, and beginning in the second quarter of 2009 certain non-performing loans transferred from affiliate banks. All of the subsidiaries listed above are fully owned except 1st Investors Title, LLC, in which we have a 46% minority interest. The consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three and six month periods ended June 30, 2012, are not necessarily indicative of the results that may be expected for the year ending December 31, 2012. The balance sheet at December 31, 2011, has been derived from the audited financial statements at that date. For further information, refer to the consolidated financial statements and footnotes thereto included in the Corporation’s annual report on Form 10-K for the year ended December 31, 2011.
 
Effect of Newly Issued but not yet Effective Accounting Standards
In May 2011, the FASB issued ASU 2011.04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs (the ASU). The ASU primarily clarifies existing fair value measurement guidance and is intended to align U.S. GAAP and IFRS.  Additionally, the guidance requires several new disclosures.
 
NOTE 2 - INVESTMENTS

The following table presents information about our investment portfolio, showing the gross unrealized gains and losses within each segment of the portfolio. Unrealized gains and losses are included in other comprehensive income. Unrealized losses have been analyzed and determined to be temporary in nature. The unrealized losses are related to changes in the interest rate environment compared with rates at the time the securities were purchased.

 
(Dollars in Thousands)
 
Amortized
Cost
   
Unrealized
 Gains
   
Unrealized
Losses
   
Carrying 
Value
 
June 30, 2012
                       
Securities available for sale
                       
U.S. governmental agency
  $ 117,782     $ 1,347     $ 0     $ 119,129  
States and political subdivisions
    81,060       1,679       (30 )     82,709  
Mortgage backed securities
    65,957       1,735       (1 )     67,691  
Collateralized mortgage obligations
    54,572       933       (18 )     55,487  
Equity and other securities
    1,591       66       0       1,657  
Total securities available for sale
  $ 320,962     $ 5,760     $ (49 )   $ 326,673  
                                 
December 31, 2011
                               
Securities available for sale
                               
U.S. governmental agency
  $ 132,534     $ 1,325     $ (25 )   $ 133,834  
States and political subdivisions
    76,574       1,238       (23 )     77,789  
Mortgage backed securities
    70,059       1,080       (87 )     71,052  
Collateralized mortgage obligations
    57,006       854       (15 )     57,845  
Equity and other securities
    1,606       58       0       1,664  
Total securities available for sale
  $ 337,779     $ 4,555     $ (150 )   $ 342,184  
 
 
8

 
 
Securities with unrealized losses at June 30, 2012 and December 31, 2011 not recognized in income are as follows:

(In Thousands of Dollars)
 
Less than 12 Months
   
12 Months or More
   
Total
 
 
Description of Securities
 
Fair
Value
   
Unrealized
 Loss
   
Fair
Value
   
Unrealized
Loss
   
Fair
 Value
   
Unrealized
 Loss
 
June 30, 2012
                                   
US governmental agency
  $ 0     $ 0     $ 0     $ 0     $ 0     $ 0  
States and political subdivisions
    3,902       (25 )     587       (5 )     4,489       (30 )
Mortgage backed securities
    627       (1 )     0       0       627       (1 )
Collateralized mortgage obligations
    2,416       (7 )     3,512       (11 )     5,928       (18 )
Total temporarily impaired
  $ 6,945     $ (33 )   $ 4,099     $ (16 )   $ 11,044     $ (49 )
                                                 
December 31, 2011
                                               
US governmental agencies
  $ 17,974     $ (25 )   $ 0     $ 0     $ 17,974     $ (25 )
States and political subdivisions
    5,987       (23 )     0       0       5,987       (23 )
Mortgage backed securities
    18,091       (87 )     0       0       18,091       (87 )
Collateralized mortgage obligations
    5,703       (11 )     887       (4 )     6,590       (15 )
Total temporarily impaired
  $ 47,755     $ (146 )   $ 887     $ (4 )   $ 48,642     $ (150 )

Unrealized losses on securities shown in the previous tables have not been recognized into income because management has the intent and ability to hold these securities for the foreseeable future. The decline in market value is due to changes in interest rates for debt securities and considered normal market fluctuations for equity securities. Management has also reviewed the issuers’ bond ratings, noting they are of high credit quality.

Trading account securities are marked to market with the change in value reported on the income statement. Gains and losses on available for sale securities are recognized if the security is either deemed to be other than temporarily impaired, or the security is sold. The following table shows gross gains and losses on investment securities for the six months ended June 30 of 2012 and 2011.

   
As of June 30,
 
(In Thousands of Dollars)
 
2012
   
2011
 
Trading Account Securities Gains/Losses
  $ 6     $ 8  
                 
Available for Sale Securities
               
Gross realized gains
    40       19  
Gross realized losses
    0       (29 )
Net realized gains (losses)
  $ 40     $ (10 )

The carrying value of securities at June 30, 2012, by stated maturity, is shown below. Actual maturities may differ from stated maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties.
 
(In Thousands of Dollars)
 
Carrying
Value
 
Due in one year or less
  $ 29,276  
Due after one year through five years
    152,035  
Due after five years through ten years
    68,406  
Due after ten years
    75,299  
Total debt securities
    325,016  
         
Equity securities
    1,657  
Total securities
  $ 326,673  

At June 30, 2012 and 2011, securities with carrying values approximating $45,746,000 and $46,304,000, respectively, were pledged to secure public trust deposits, securities sold under agreements to repurchase, and for such other purposes as required or permitted by law.

Federal Home Loan Bank stock is carried at cost, which approximates fair value.
 
 
9

 
 
NOTE 3 - LOANS

The following information provides a description of how loan grades are determined for our Commercial and Industrial and Commercial Real Estate Segments. In general, for Commercial and Industrial, and Commercial Real Estate Segments, the probability of loss increases with each rate change from the Grade 1 Excellent down through the Grade 9 Doubtful classes. For Consumer and Residential Mortgage segments, the probability of loss increases as loans move down from current to greater than 60 days past due, nonaccrual.

Grade 1 Excellent – Characteristics of loans in this category include: the loan is generally secured by cash or readily marketable securities; the borrower provides annual audited financials with interim financials reviewed quarterly; the loan has no delinquencies over ten days in the past year; the company’s management is considered to have a high degree of integrity; management of the company has over 15 years of experience; lines of credit have not and are not expected to be utilized; financial statements demonstrate consistently strong profits; and the company has little competition and excellent growth prospects.

Grade 2 Quality – Characteristics of loans in this category include: high net worth borrowers with excellent cash flow and a high degree of liquidity; the borrower generally has annual audited financial statements; there has been one or fewer delinquencies over ten days in the past year; the company’s management is considered to have a high degree of integrity; the company’s management has over ten years of experience; lines of credit have had nominal use over the preceding 12 months; financial statements demonstrate consistent profitability; and the company is in an excellent competitive position.

Grade 3 Good – Loans in this category are very strong, but may lack some of the net worth and/or cash flow characteristics of the previous rating. Characteristics of loans in this category include: annual reviewed financial statements and compiled quarterly financial statements, there has only been one or fewer delinquencies over 15 days in the past year, the company’s management has solid integrity, the company’s management is capable and has over five years of experience, lines of credit have regular usage with no balance in the last 60 days, financial statements demonstrate consistent but nominal profits, and the company has good a solid market share.

Grade 4 Acceptable – Characteristics of loans in this category include: annual compiled financial statements with quarterly information available or CPA prepared tax returns, there are only two or fewer delinquencies over 15 days of which only one is over 30 days in the past year, the company’s management has average business experience of over three years, lines of credit have regular use but have no current balance or a significant reduction in balance in the last 30 days, the company has been profitable in two of the preceding three years, and the company is competitive in its market and is maintaining its market share.

Loans graded as one through four are considered as Pass loans and are shown as one class of loans in our credit quality table.

Grade 5 Watch - This rating is used for loans which have shown some sign of weakness, but have not degraded to the point of requiring an impairment review. Characteristics of loans in this rating include: annual management prepared financial statements; delinquencies not exceeding three times over 30 days or one time over 60 days in the past year; weakening financial statements but profitable in two of the last three years; and a declining market share in a competitive market. These loans merit monitoring by management to assure that if circumstances deteriorate further actions are taken to protect the bank’s position.

Grade 6 Special Mention - This rating is used for loans which are included on a watch list and have degraded to a point where additional supervision is required; however, the bank remains confident in the full collection of all principal and interest. These loans are reviewed for impairment on a quarterly basis. Characteristics of loans in this rating may include: repeat delinquency; longer term negative trends in financial results; continuing deterioration of cash flows; concerns regarding the liquidity of guarantors; and other negative business trends.

Grade 7 Substandard - This rating is for loans for which a lender is actively working with the borrower to resolve issues and the full repayment of the loan is questionable. The loan is inadequately protected by current sound worth of the borrower, paying capacity of the guarantor, or pledged collateral. Loans in this grade have well defined weaknesses that jeopardize the full collectability of the loan and a distinct possibility of loss exits.  These loans are reviewed for impairment on a quarterly basis. Characteristics of loans in this rating may include: persistent delinquency; poor financial results of the business; negative cash flow; and the ability of guarantor(s) to provide support for the loan is questionable.
 
 
10

 
 
Grade 8 Impaired Nonaccrual - This rating is for loans which are considered impaired and classified as nonaccrual. Loans in this grade have all the weaknesses of those classified as substandard grade 7 above, with the added characteristic that, based upon currently known facts, the weaknesses make collection of all principal and interest due according to contractual terms unlikely. These loans are reviewed for impairment on a quarterly basis. Loans in this grade may be assigned an allocated reserve in the loan loss allowance analysis if a determination is made that the future cash flows or the value of the collateral do not support the current carrying value of the loan.

Grade 9 Doubtful Nonaccrual- This rating is for loans which are considered impaired and are classified as nonaccrual. Loans in this grade have all the weaknesses of those classified as impaired nonaccrual grade 8 above, with the added characteristic that the weaknesses make full collection through payment or liquidation of the collateral, based on currently known facts, highly questionable or improbable. These loans are reviewed for impairment on a quarterly basis. Loans in this grade may be assigned an allocated reserve in the loan loss allowance analysis if a determination is made that the future cash flows or the value of the collateral do not support the current carrying value of the loan.

Restructured Loans
Impaired Restructured and Accruing - Loans where the borrower is experiencing financial difficulty and the bank has granted a concession to the borrower. A concession may be: a reduction in the contractual interest rate below current market rates for loans of similar quality, a lengthening of the accrual time frame beyond normal market terms, a forgiveness of a portion of the outstanding principal, or acceptance of collateral in lieu of payment for a portion of the loan balance. If the loan is in accrual status at the time of the restructuring, the borrower has the ability to make the payments under the restructured terms, and the restructuring does not forgive principal, the loan remains on an accrual status under the new terms. However, if there is a forgiveness of debt or partial charge off, the loan will generally be graded as impaired nonaccrual (Grade 8) with any accrued interest reversed against interest income. If a loan is in nonaccrual status at the time of a restructuring, it will remain in nonaccrual status (Grade 8) at the time of restructuring. All non-accruing restructured loans remain in nonaccrual status until the borrower has demonstrated the ability to make the payments under the restructured terms by making a minimum of six months of payments. If the borrower makes the six months of payments without becoming past due 30 days or more, the loan may be returned to accrual status. The determination of the need for an allowance for loan loss adjustment is based on a factor relating to historical losses multiplied by the balance of the loan for residential mortgages, or a collateral impairment review for commercial loans, and a net present value adjustment relating to a change in interest rate and other terms, if applicable.

Impaired Restructured and Accruing loans are graded seven or better based on the above definitions. If  a restructured loan is graded as eight or nine, it is reported as Impaired Nonaccrual or Doubtful Nonaccrual, respectively.

For commercial loans graded eight and nine and consumer and residential mortgage loans reported in nonaccrual, interest income is generally not recognized until the loan improves and is returned to accrual status. In some cases, if the loan is well secured and the borrower’s ability to support the loan payments has improved, such as in the case of a restructured nonaccrual loan, interest income may be recognized on a cash basis while the loan is in nonaccrual status.

For Consumer and Residential Mortgage Loan Segments, loans are classified by risk based on current delinquency and nonaccrual status. These segments of loans will contain a separate class for restructured loans, if they exist.

The following credit quality indicators provide a system for distribution of our loan portfolio in a manner consistent with the previously described loan grading system and for use in the determination of our loan loss allowance. This presentation differs somewhat by loan category from classification of loans presented elsewhere in our regulatory reports and within this report. These variations primarily relate to how real estate loans are analyzed internally to determine the adequacy of the loan loss allowance, versus how we are required to report real estate loans for regulatory purposes.
 
 
11

 
 
Credit Quality Indicators:

Loans at period end were as follows:
     
(In Thousands of Dollars)
 
June 30,
2012
   
December 31,
2011
 
Commercial & Industrial
           
Pass loans
  $ 135,250     $ 122,812  
Watch loans
    13,824       19,542  
Special mention loans
    6,226       7,878  
Substandard loans
    2,587       2,928  
Impaired restructured and accruing loans
    3,058       3,562  
Impaired nonaccrual loans
    1,452       1,771  
Doubtful nonaccrual loans
    0       0  
Total Commercial & Industrial
    162,397       158,493  
                 
Commercial Real Estate
               
Pass loans
  $ 374,765     $ 373,320  
Watch loans
    57,624       56,571  
Special mention loans
    19,922       21,155  
Substandard loans
    7,044       5,686  
Impaired restructured and accruing loans
    10,985       10,652  
Impaired nonaccrual loans
    10,490       15,336  
Doubtful nonaccrual loans
    695       0  
Total Commercial Real Estate
    481,525       482,720  
                 
First lien residential mortgage loans
               
Performing loans
  $ 202,711     $ 199,117  
Loans > 60 days past due
    1,511       2,203  
Impaired restructured and accruing loans
    4,836       4,425  
Nonaccrual loans
    4,674       5,374  
Total First lien residential mortgage loans
    213,732       211,119  
                 
Junior lien residential mortgage loans
               
Performing loans
  $ 61,780     $ 66,169  
Loans > 60 days past due
    116       328  
Impaired restructured and accruing loans
    224       278  
Nonaccrual loans
    227       278  
Total Junior lien residential mortgage loans
    62,347       67,053  
                 
Consumer Loans
               
Performing loans
  $ 67,400     $ 64,075  
Loans > 60 days past due
    113       239  
Impaired restructured and accruing loans
    176       0  
Nonaccrual loans
    340       210  
Total Consumer Loans
    68,029       64,524  
                 
Total Loans
  $ 988,030     $ 983,909  

Allowance for Loan Losses

The allowance for loan losses is determined based on management’s estimate of probable losses incurred within the loan portfolio as of the balance sheet date. We determine the amount of the allowance for loan losses based on periodic evaluation of the loan portfolios and other relevant factors. This evaluation is inherently subjective and requires material estimates, which are subject to change. Factors that are considered in the evaluation of individual, and pools of loans, include: historical loss experience; likelihood of default; liquidation value of a loan’s underlying collateral; timing and amounts of expected future cash flows; and our exposure to loss in the event of default. We further estimate the impact of qualitative factors that may cause future losses to differ from historical experience. Such factors include: changes in credit quality, macro economic impacts on our customers, and changes in underwriting standards.

Our historical loss experience is determined based on actual losses incurred over the previous twelve quarters. We utilize a method of averaging these losses whereby we place a heavier emphasis on more recent experience. Our model provides a 50% weighting on the most recent four quarters, 30% weighting on the middle four quarters, and 20% weighting on the oldest four quarters.
 
 
12

 

The loan portfolio is segmented into five loan types: commercial and industrial loans; commercial real estate loans; consumer loans; residential mortgages – first liens; and residential mortgage – junior liens. These segments are further grouped by credit quality classifications.

The segments comprising commercial and industrial loans and commercial real estate loans are classified based on the loan grading system described above. We group loans rated as one through four together into one class of Pass loans. Commercial and industrial and commercial real estate loans graded as Pass and Watch are assigned a unique pooled loss rate based on historical losses incurred over the prior three years as described above. We adjust the calculated historical loss rate up or down based on current developments, that in management’s judgment are not reflected in the historical losses of the company. The current outstanding balance for each of these classes of loans is then multiplied by the adjusted historical loss rate to determine the amount of allowance for loan losses to reserve on that pool of loans.

Loans graded special mention use a shorter 12 month loss history to determine the loss rate. Losses over the preceding 12 month period are divided by the average balance outstanding of substandard and impaired loans to determine a historical loss rate. That calculated historical loss rate is multiplied by a probability factor to determine a loss rate to be applied to this class of loans. The probability factor is determined from an analysis of the migration of special mention loans to more severe risk classes over the preceding 12 month period.

Loans graded as substandard use the shorter 12 month loss history to determine the loss rate. Losses over the preceding 12 month period are divided by the average balance outstanding of substandard and impaired loans to determine a historical loss rate. The calculated historical loss rate, without adjustment for migration, is then multiplied times the outstanding balance of substandard loans to determine the amount of allowance for loan losses to provide for this class of loans.

Loans graded as impaired nonaccrual, impaired doubtful, and impaired restructured and accruing are individually analyzed for loan losses. An allocated reserve is established within the allowance for loan losses for the difference between the carrying value of the loan and its determined collectable value. To determine the collectable value of the loan, the present value of expected cash flows, the collateral value, or some combination of the two is used. The allocated reserve is established as the difference between the carrying value of the loan and the collectable value.

For consumer and residential loan segments, loans that are current, or less than 60 days past due are assigned a unique historical loss rate as described above for commercial Pass and Watch loans. For loans that are more than 60 days past due including nonaccrual loans, a loss rate is determined based on charge offs within the last 12 months, divided by the sum of the average balance of loans 60 days or more past due and nonaccrual loans. These loss rates are multiplied by the outstanding balances in each unique loan segment at the end of the reporting period to determine the amount of allowance for loan loss.

For restructured loans where the bank has granted a rate concession, an additional amount is added to the loan loss reserve that represents the difference in the present value of the cash flows between the original terms and the new terms of the modified loan, using the original interest rate of the loan as a discount rate. Any change in the present value of the loan due to passage of time is reflected as an adjustment to provision for loan loss expense.

After each of the steps outlined above is completed, the results are aggregated and compared with the existing balance of the allowance for loan losses. If the aggregation is greater than the balance, the allowance for loan losses is increased through a charge to earnings on the provision for loan losses line. If the resulting aggregation is below the current balance of the allowance for loan losses, management will determine, based upon the number, potential impact, and uncertainty of the estimates contained within the process whether the unallocated reserve is excessive. If in management’s judgment the unallocated reserve exceeds a level deemed prudent given the inherent uncertainty of these issues, a reversal of the provision for loan losses may be recorded.
 
 
13

 
 
Allowance for credit losses for the three and six months ended June 30 were:

(In Thousands of Dollars)
                                         
 
Three months ending
June 30, 2012
 
Commercial
and Industrial
   
Commercial
Real Estate
   
First Lien Residential Mortgages
   
Junior Lien Residential Mortgages
   
Consumer
Loans
   
 
Unallocated
   
 
Total
 
Allowance for Credit Losses:
                                         
Beginning balance
  $ 2,369     $ 11,767     $ 5,563     $ 532     $ 945     $ 44     $ 21,220  
Provision for loan losses
    317       720       581       100       (66 )     842       2,494  
Loans charged off
    (297 )     (1,308 )     (572 )     (109 )     (136 )     0       (2,422 )
Recoveries
    15       36       71       0       108       0       230  
Ending balance
  $ 2,404     $ 11,215     $ 5,643     $ 523     $ 851     $ 886     $ 21,522  
                                                         
Three months ending
June 30, 2011
                                                       
Allowance for Credit Losses:
                                                       
Beginning balance
  $ 2,762     $ 12,637     $ 4,022     $ 548     $ 1,078     $ 300     $ 21,347  
Provision for loan losses
    89       1,792       1,917       (212 )     394       276       4,256  
Loans charged off
    (129 )     (2,872 )     (1,303 )     218       (336 )     0       (4,422 )
Recoveries
    10       39       36       0       61        0       146  
Ending balance
  $ 2,732     $ 11,596     $ 4,672     $ 554     $ 1,197     $ 576     $ 21,327  
                                                         
                                                         
 
 
 
Six months ending
June 30, 2012
 
Commercial
 and Industrial
   
Commercial
 Real Estate
   
First Lien Residential Mortgages
   
Junior Lien Residential Mortgages
   
Consumer
 Loans
   
 
Unallocated
   
 
Total
 
Allowance for Credit Losses:
                                         
Beginning balance
  $ 2,485     $ 11,534     $ 5,393     $ 505     $ 931     $ 171     $ 21,019  
Provision for loan losses
    320       2,246       1,288       321       98       715       4,988  
Loans charged off
    (426 )     (2,649 )     (1,155 )     (303 )     (384 )     0       (4,917 )
Recoveries
    25       84       117       0       206       0       432  
Ending balance
  $ 2,404     $ 11,215     $ 5,643     $ 523     $ 851     $ 886     $ 21,522  
                                                         
Six months ending
June 30, 2011
                                                       
Allowance for Credit Losses:
                                                       
Beginning balance
  $ 3,024     $ 12,375     $ 3,960     $ 774     $ 1,162     $ 136     $ 21,431  
Provision for loan losses
    475       3,605       2,436       (107 )     418       440       7,267  
Loans charged off
    (889 )     (4,427 )     (1,764 )     (113 )     (518 )     0       (7,710 )
Recoveries
    122       43       40       0       134        0       339  
Ending balance
  $ 2,732     $ 11,596     $ 4,672     $ 554     $ 1,197     $ 576     $ 21,327  
                                                         
 
 
14

 
 
Recorded investment in financing receivables at period end were:
 
(In Thousands of Dollars)               First Lien        Junior Lien                    
June 30, 2012
 
Commercial and Industrial
   
Commercial Real Estate
   
Residential Mortgages
   
Residential Mortgages
   
Consumer Loans
   
 
Unallocated
   
 
Total
 
Ending balance: individually evaluated for impairment
  $ 169     $ 2,963     $ 0     $ 0     $ 0     $ 0     $ 3,132  
                                                         
Ending balance: collectively evaluated for impairment
  $ 2,235     $ 8,252     $ 5,643     $ 523     $ 851     $ 886     $ 18,390  
                                                         
Financing Receivables:
                                                       
Ending balance
  $ 162,397     $ 481,525     $ 213,732     $ 62,347     $ 68,029     $ 0     $ 988,030  
                                                         
Ending balance: individually evaluated for impairment
  $ 4,510     $ 22,170     $ 0     $ 0     $ 0     $ 0     $ 26,680  
                                                         
Ending balance: collectively evaluated for impairment
  $ 157,887     $ 459,355     $ 213,732     $ 62,347     $ 68,029     $ 0     $ 961,350  
                                                         
June 30, 2011
                                                       
Ending balance: individually evaluated for impairment
  $ 659     $ 3,318     $ 0     $ 0     $ 0     $ 0     $ 3,977  
                                                         
Ending balance: collectively evaluated for impairment
  $ 2,073     $ 8,278     $ 4,672     $ 554     $ 1,197     $ 576     $ 17,370  
                                                         
Financing Receivables:
                                                       
Ending balance
  $ 163,010     $ 491,893     $ 201,675     $ 72,807     $ 76,577     $ 0     $ 1,005,962  
                                                         
Ending balance: individually evaluated for impairment
  $ 1,129     $ 7,128     $ 0     $ 0     $ 0     $ 0     $ 8,257  
                                                         
Ending balance: collectively evaluated for impairment
  $ 161,881     $ 484,765     $ 201,675     $ 72,807     $ 76,577     $ 0     $ 997,705  

Age Analysis of Past Due Loans excluding nonaccrual loans:
 
(In thousands of dollars)
 
 
 
At June 30, 2012
 
 
30-59 Days
Past Due
   
 
 
60-89 Days
 Past Due
   
 
90 Days or
More Past Due
   
 
 
Total
Past Due
   
 
 
 
Current
   
 
Total
 Financing Receivables
   
Recorded Investment >
 90 days and accruing
 
Commercial and Industrial
  $ 622     $ 223     $ 8     $ 853     $ 160,092     $ 162,397     $ 8  
Commercial Real Estate
    562       437       177       1,176       469,164       481,525       177  
Residential Mortgages 1st Liens
    698       1,154       356       2,208       206,850       213,732       365  
Residential Mortgages Junior Liens
    192       100       17       309       61,811       62,347       17  
Consumer
    469       113       0       582       67,107       68,029       0  
Total
  $ 2,543     $ 2,027     $ 558     $ 5,128     $ 965,024     $ 988,030     $ 567  
 
At December 31, 2011
                                                       
Commercial and Industrial
  $ 1,039     $ 94     $ 0     $ 1,133     $ 155,589     $ 158,493     $ 0  
Commercial Real Estate
    4,313       500       0       4,813       462,571       482,720       0  
Residential Mortgage 1st Liens
    973       1,875       328       3,176       202,847       211,119       336  
Residential Mortgage Junior Liens
    561       255       73       889       65,886       67,053       73  
Consumer
    848       221       18       1,087       63,227       64,524       18  
Total
  $ 7,734     $ 2,945     $ 419     $ 11,098     $ 950,120     $ 983,909     $ 427  

Note: Recorded investment includeds principle outstandanding plus deferred fees and accrued interest.
 
 
15

 

Impaired loans were as follows:

(In Thousands of Dollars)
         
June 30, 2012
 
Recorded
Investment
   
Unpaid
Principal
Balance
   
Related
Allowance
 
Period end loans with no allocated allowance for loan losses
                 
Commercial and Industrial
  $ 3,659     $ 3,658       0  
Commercial Real Estate
    8,314       8,312       0  
Residential Mortgages 1st Liens
    9,510       9,510       0  
Residential Mortgages Junior Liens
    450       450       0  
Consumer
    516       516       0  
Total
  $ 22,449     $ 22,446     $ 0  
                         
Period end loans with allocated allowance for loan losses
                       
Commercial and Industrial
  $ 439     $ 618     $ 180  
Commercial Real Estate
    11,134       14,084       2,952  
Residential Mortgages 1st Liens
    0       0       0  
Residential Mortgages Junior Liens
    0       0       0  
Consumer
    0       0       0  
Total
  $ 11,573     $ 14,702     $ 3,132  
                         
Total
                       
Commercial and Industrial
  $ 4,098     $ 4,276     $ 180  
Commercial Real Estate
    19,448       22,396       2,952  
Residential Mortgages 1st Liens
    9,510       9,510       0  
Residential Mortgages Junior Liens
    450       450       0  
Consumer
    516       516       0  
Total
  $ 34,022     $ 37,148     $ 3,132  
                         
December 31, 2011
                       
Period end loans with no allocated allowance for loan losses
                       
Commercial and Industrial
  $ 4,358     $ 5,846       0  
Commercial Real Estate
    11,940       16,987       0  
Residential Mortgages 1st Liens
    10,079       11,120       0  
Residential Mortgages Junior Liens
    278       331       0  
Consumer
    210       249       0  
Total
  $ 26,865     $ 34,533     $ 0  
                         
Period end loans with allocated allowance for loan losses
                       
Commercial and Industrial
  $ 720     $ 998     $ 253  
Commercial Real Estate
    10,423       15,225       3,622  
Residential Mortgages 1st Liens
    0       0       0  
Residential Mortgages Junior Liens
    0       0       0  
Consumer
    0       0       0  
Total
  $ 11,143     $ 16,223     $ 3,875  
                         
Total
                       
Commercial and Industrial
  $ 5,078     $ 6,844     $ 253  
Commercial Real Estate
    22,363       32,212       3,622  
Residential Mortgages 1st Liens
    10,079       11,120       0  
Residential Mortgages Junior Liens
    278       331       0  
Consumer
    210       249       0  
Total
  $ 38,008     $ 50,756     $ 3,875  

Note: Recorded investment includes principle outstanding plus deferred fee and accrued interest, net of related allowance for loan losses.
 
 
16

 
 
Average recorded investment and income recognized on impaired loans were as follows:

   
Three months ended
June 30, 2012
   
Three months ended
June 30, 2011
 
(In Thousands of Dollars)
 
Average
Recorded Investment
   
Interest Income Recognized
   
Average
Recorded Investment
   
Interest Income Recognized
 
Period end loans with no allocated allowance for loan losses
                       
Commercial and Industrial
  $ 3,582     $ 62       972     $ 0  
Commercial Real Estate
    9,854       217       11,716       11  
Residential Mortgages 1st Liens
    9,762       116       8,868       15  
Residential Mortgages Junior Liens
    530       4       451       0  
Consumer
    501       5       190       2  
Total
  $ 24,229     $ 404     $ 22,196     $ 28  
                                 
Period end loans with allocated allowance for loan losses
                               
Commercial and Industrial
  $ 348     $ 0     $ 836     $ 0  
Commercial Real Estate
    10,662       40       8,623       0  
Residential Mortgages 1st Liens
    0       0       0       0  
Residential Mortgages Junior Liens
    0       0       0       0  
Consumer
    0       0       0       0  
Total
  $ 11,010     $ 40     $ 9,459     $ 0  
                                 
Total
                               
Commercial and Industrial
  $ 3,930     $ 62     $ 1,808     $ 0  
Commercial Real Estate
    20,516       257       20,339       11  
Residential Mortgages 1st Liens
    9,762       116       8,868       15  
Residential Mortgages Junior Liens
    530       4       451       0  
Consumer
    501       5       190       2  
Total
  $ 35,239