XNAS:HMNF HMN Financial Inc Quarterly Report 10-Q Filing - 3/31/2012

Effective Date 3/31/2012

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Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

 

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2012

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) FOR THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                      to                    

Commission File Number 0-24100

 

 

HMN FINANCIAL, INC.

(Exact name of Registrant as specified in its Charter)

 

 

 

Delaware   41-1777397

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification Number)

1016 Civic Center Drive N.W.,

Rochester, MN

  55901
(Address of principal executive offices)   (ZIP Code)

Registrant’s telephone number, including area code: (507) 535-1200

 

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities 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. (Check one):

 

Large accelerated filer   ¨    Accelerated filer   ¨
Non-accelerated filer   ¨  (Do not check if a smaller reporting company)    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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock as of the latest practicable date.

 

Class

   Outstanding at April 20, 2012
Common stock, $0.01 par value    4,423,589

 

 

 


Table of Contents

HMN FINANCIAL, INC.

CONTENTS

 

   

PART I – FINANCIAL INFORMATION

     Page   

Item 1:

  Financial Statements (unaudited)   
  Consolidated Balance Sheets at March 31, 2012 and December 31, 2011      3   
  Consolidated Statements of Comprehensive Income (Loss) for the Three Months Ended March 31, 2012 and 2011      4   
  Consolidated Statement of Stockholders’ Equity for the Three Month Period Ended March 31, 2012      5   
  Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2012 and 2011      6   
  Notes to Consolidated Financial Statements      7   

Item 2:

  Management’s Discussion and Analysis of Financial Condition and Results of Operations      26   

Item 3:

  Quantitative and Qualitative Disclosures about Market Risk (Included in Item 2 under Market Risk)      36   

Item 4:

  Controls and Procedures      39   

PART II – OTHER INFORMATION

  

Item 1:

  Legal Proceedings      40   

Item 1A:

  Risk Factors      42   

Item 2:

  Unregistered Sales of Equity Securities and Use of Proceeds      42   

Item 3:

  Defaults Upon Senior Securities      42   

Item 4:

  Mine Safety Disclosures      43   

Item 5:

  Other Information      43   

Item 6:

  Exhibits      43   

Signatures

     44   

 

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Table of Contents

PART I – FINANCIAL INFORMATION

Item 1 : Financial Statements

HMN FINANCIAL, INC. AND SUBSIDIARIES

Consolidated Balance Sheets

 

     March 31,     December 31,  

(Dollars in thousands)

   2012     2011  
     (unaudited)        

Assets

    

Cash and cash equivalents

   $ 45,977        67,840   

Securities available for sale:

    

Mortgage-backed and related securities (amortized cost $16,609 and $19,586)

     17,597        20,645   

Other marketable securities (amortized cost $70,699 and $105,700)

     70,358        105,469   
  

 

 

   

 

 

 
     87,955        126,114   
  

 

 

   

 

 

 

Loans held for sale

     3,279        3,709   

Loans receivable, net

     538,069        555,908   

Accrued interest receivable

     2,262        2,449   

Real estate, net

     13,595        16,616   

Federal Home Loan Bank stock, at cost

     4,172        4,222   

Mortgage servicing rights, net

     1,497        1,485   

Premises and equipment, net

     7,704        7,967   

Prepaid expenses and other assets

     1,899        2,262   

Assets held for sale

     0        1,583   

Deferred tax asset, net

     0        0   
  

 

 

   

 

 

 

Total assets

   $ 706,409        790,155   
  

 

 

   

 

 

 

Liabilities and Stockholders’ Equity

    

Deposits

   $ 568,237        620,128   

Deposits held for sale

     0        36,048   

Federal Home Loan Bank advances

     70,000        70,000   

Accrued interest payable

     562        780   

Customer escrows

     1,623        933   

Accrued expenses and other liabilities

     6,522        5,205   
  

 

 

   

 

 

 

Total liabilities

     646,944        733,094   
  

 

 

   

 

 

 

Commitments and contingencies

    

Stockholders’ equity:

    

Serial preferred stock ($.01 par value):

    

Authorized 500,000 shares; issued shares 26,000

     24,915        24,780   

Common stock ($.01 par value):

    

Authorized 11,000,000; issued shares 9,128,662

     91        91   

Additional paid-in capital

     52,193        53,462   

Retained earnings, subject to certain restrictions

     45,462        42,983   

Accumulated other comprehensive income, net of tax

     292        471   

Unearned employee stock ownership plan shares

     (3,142     (3,191

Treasury stock, at cost 4,705,073 and 4,740,711 shares

     (60,346     (61,535
  

 

 

   

 

 

 

Total stockholders’ equity

     59,465        57,061   
  

 

 

   

 

 

 

Total liabilities and stockholders’ equity

   $ 706,409        790,155   
  

 

 

   

 

 

 

See accompanying notes to consolidated financial statements.

 

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Table of Contents

HMN FINANCIAL, INC. AND SUBSIDIARIES

Consolidated Statements of Comprehensive Income (Loss)

(unaudited)

 

    

Three Months Ended

March 31,

 
(Dollars in thousands)    2012     2011  

Interest income:

    

Loans receivable

   $ 7,796        9,903   

Securities available for sale:

    

Mortgage-backed and related

     193        324   

Other marketable

     249        417   

Cash equivalents

     27        1   

Other

     10        69   
  

 

 

   

 

 

 

Total interest income

     8,275        10,714   
  

 

 

   

 

 

 

Interest expense:

    

Deposits

     1,217        1,940   

Federal Home Loan Bank advances and Federal Reserve borrowings

     845        1,329   
  

 

 

   

 

 

 

Total interest expense

     2,062        3,269   
  

 

 

   

 

 

 

Net interest income

     6,213        7,445   

Provision for loan losses

     (128     1,946   
  

 

 

   

 

 

 

Net interest income after provision for loan losses

     6,341        5,499   
  

 

 

   

 

 

 

Non-interest income:

    

Fees and service charges

     829        924   

Loan servicing fees

     232        250   

Gain on sales of loans

     909        495   

Gain on sale of branch office

     552        0   

Other

     184        117   
  

 

 

   

 

 

 

Total non-interest income

     2,706        1,786   
  

 

 

   

 

 

 

Non-interest expense:

    

Compensation and benefits

     3,413        3,560   

(Gain) loss on real estate owned

     (77     47   

Occupancy

     882        940   

Deposit insurance

     270        404   

Data processing

     337        253   

Other

     1,418        1,588   
  

 

 

   

 

 

 

Total non-interest expense

     6,243        6,792   
  

 

 

   

 

 

 

Income before income tax expense

     2,804        493   

Income tax expense

     0        76   
  

 

 

   

 

 

 

Net income

     2,804        417   

Preferred stock dividends and discount

     (461     (449
  

 

 

   

 

 

 

Net income (loss) available to common shareholders

     2,343        (32
  

 

 

   

 

 

 

Basic earnings (loss) per common share

   $ 0.60        (0.01
  

 

 

   

 

 

 

Diluted earnings (loss) per common share

   $ 0.58        (0.01
  

 

 

   

 

 

 

Other comprehensive loss, net of tax:

    

Unrealized holding losses arising during the period

   $ (179     (114
  

 

 

   

 

 

 

Other comprehensive loss, net of tax

     (179     (114
  

 

 

   

 

 

 

Comprehensive income (loss) attributable to common shareholders

   $ 2,164        (146
  

 

 

   

 

 

 

See accompanying notes to consolidated financial statements.

 

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HMN FINANCIAL, INC. AND SUBSIDIARIES

Consolidated Statement of Stockholders’ Equity

For the Three Month Period Ended March 31, 2012

(unaudited)

 

(Dollars in thousands)

   Preferred
Stock
     Common
Stock
     Additional
Paid-in
Capital
    Retained
Earnings
    Accumulated
Other
Comprehensive
Income
    Unearned
Employee
Stock
Ownership
Plan
Shares
    Treasury
Stock
    Total
Stock-
Holders’
Equity
 

Balance, December 31, 2011

   $ 24,780         91         53,462        42,983        471        (3,191     (61,535     57,061   

Net income

             2,804              2,804   

Other comprehensive loss

               (179         (179

Preferred stock discount amortization

     135            (135             0   

Stock compensation tax benefits

           2                2   

Unearned compensation restricted stock awards

           (1,199           1,199        0   

Restricted stock awards forfeited

           10              (10     0   

Amortization of restricted stock awards

           76                76   

Preferred stock dividends accrued

             (325           (325

Earned employee stock ownership plan shares

           (23         49          26   
  

 

 

    

 

 

    

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance, March 31, 2012

   $ 24,915         91         52,193        45,462        292        (3,142     (60,346     59,465   
  

 

 

    

 

 

    

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

See accompanying notes to consolidated financial statements.

 

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Table of Contents

HMN FINANCIAL, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows

(unaudited)

 

     Three Months Ended
March 31,
 

(Dollars in thousands)

   2012     2011  

Cash flows from operating activities:

    

Net income

   $ 2,804        417   

Adjustments to reconcile net income to cash provided by operating activities:

    

Provision for loan losses

     (128     1,946   

Depreciation

     291        327   

Amortization of premiums, net

     37        69   

Amortization of deferred loan fees

     (64     (236

Amortization of mortgage servicing rights, net

     175        98   

Capitalized mortgage servicing rights

     (187     (87

Deferred income tax expense

     0        76   

(Gain) loss on sales of real estate

     (77     47   

Gain on sales of loans

     (909     (495

Proceeds from sale of loans held for sale

     27,605        14,266   

Disbursements on loans held for sale

     (22,672     (9,812

Amortization of restricted stock awards

     76        79   

Amortization of unearned ESOP shares

     49        48   

Earned employee stock ownership shares priced below original cost

     (23     (19

Stock option compensation

     2        8   

Decrease in accrued interest receivable

     187        90   

Decrease in accrued interest payable

     (218     (175

Decrease in other assets

     377        153   

Decrease in other liabilities

     (745     (61

Other, net

     74        41   
  

 

 

   

 

 

 

Net cash provided by operating activities

     6,654        6,780   
  

 

 

   

 

 

 

Cash flows from investing activities:

    

Principal collected on securities available for sale

     2,979        3,756   

Proceeds collected on maturities of securities available for sale

     35,000        30,000   

Purchases of securities available for sale

     0        (40,032

Redemption of Federal Home Loan Bank stock

     50        333   

Proceeds from sales of real estate

     3,508        1,055   

Net decrease in loans receivable

     14,063        19,212   

Gain on sale of branch office

     (552     0   

Payment on sale of branch office

     (36,981     0   

Purchases of premises and equipment

     (25     0   
  

 

 

   

 

 

 

Net cash provided by investing activities

     18,042        14,324   
  

 

 

   

 

 

 

Cash flows from financing activities:

    

(Decrease) increase in deposits

     (47,250     4,787   

Repayment of borrowings

     0        (7,500

Increase in customer escrows

     691        604   
  

 

 

   

 

 

 

Net cash used by financing activities

     (46,559     (2,109
  

 

 

   

 

 

 

(Decrease) increase in cash and cash equivalents

     (21,863     18,995   

Cash and cash equivalents, beginning of period

     67,840        20,981   
  

 

 

   

 

 

 

Cash and cash equivalents, end of period

   $ 45,977        39,976   
  

 

 

   

 

 

 

Supplemental cash flow disclosures:

    

Cash paid for interest

   $ 2,280        3,443   

Cash paid for income taxes

     5        0   

Supplemental noncash flow disclosures:

    

Transfer of loans to real estate

     478        6,231   

Loans transferred to loans held for sale

     3,818        2,806   

See accompanying notes to consolidated financial statements.

 

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HMN FINANCIAL, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(unaudited)

March 31, 2012 and 2011

(1) HMN Financial, Inc.

HMN Financial, Inc. (HMN or the Company) is a stock savings bank holding company that owns 100 percent of Home Federal Savings Bank (the Bank). The Bank has a community banking philosophy and operates retail banking and loan production offices in Minnesota and Iowa. The Bank has one wholly owned subsidiary, Osterud Insurance Agency, Inc. (OIA), which offers financial planning products and services. HMN has another wholly owned subsidiary, Security Finance Corporation (SFC), which is currently not actively engaged in any activities.

The consolidated financial statements included herein are for HMN, SFC, the Bank and OIA. All significant intercompany accounts and transactions have been eliminated in consolidation.

(2) Basis of Preparation

The accompanying unaudited consolidated financial statements were prepared in accordance with instructions for Form 10-Q and therefore, do not include all disclosures necessary for a complete presentation of the consolidated balance sheets, consolidated statements of comprehensive income (loss), consolidated statement of stockholders’ equity and consolidated statements of cash flows in conformity with U.S. generally accepted accounting principles. However, all normal recurring adjustments which are, in the opinion of management, necessary for the fair presentation of the interim financial statements have been included. The results of operations for the three-month period ended March 31, 2012 is not necessarily indicative of the results which may be expected for the entire year.

(3) New Accounting Standards

In April 2011, the FASB issued ASU 2011-03, Transfers and Servicing (Topic 860), Reconsideration of Effective Control for Repurchase Agreements. This ASU prescribes when an entity may or may not recognize a sale upon the transfer of financial assets subject to repurchase agreements. That determination is based, in part, on whether the entity has maintained effective control over the transferred assets. The amendments in this ASU removed from the assessment of effective control (1) the criterion requiring the transferor to have the ability to repurchase or redeem the financial assets on substantially the agreed terms, even in the event of default by the transferee, and (2) the collateral maintenance implementation guidance related to that criterion. Other criteria applicable to the assessment of effective control are not changed by the amendments in this ASU. This ASU is effective for the first interim or annual period beginning on or after December 15, 2011 and should be applied prospectively to transactions or modification of existing transactions that occur on or after the effective date. The adoption of this ASU in the first quarter of 2012 did not have a material impact on the Company’s consolidated financial statements.

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 amendments in this ASU change the wording used to describe the requirements in U.S. GAAP for measuring fair value and for disclosing information about fair value measurements in order to improve consistency in wording between U.S. GAAP and IFRS. Also, the amendments in the ASU require that for each class of assets and liabilities not measured at fair value on the balance sheet but for which the fair value is disclosed, the Company shall disclose the fair value hierarchy for each asset and liability class. This ASU is effective for interim or annual period beginning on or after December 15, 2011. The adoption of this ASU in the first quarter of 2012 did not have a material impact on the Company’s consolidated financial statements other than to change the disclosures relating to fair value measurements.

In June 2011, the FASB issued ASU 2011-05, Comprehensive Income (Topic 220), Presentation of Comprehensive Income. Prior to this ASU, U.S. GAAP allowed reporting entities three alternatives for presenting other comprehensive income and its components in financial statements. The first two options were to present this information in a single continuous statement of comprehensive income or in two separate but consecutive statements.

 

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The third option, which was used by the Company, was to present the components of other comprehensive income as part of the statement of changes in stockholders’ equity. This ASU eliminates the third option and therefore the Company selected to present this information in a single continuous statement of comprehensive income. This ASU is effective for fiscal years, and interim periods beginning after December 15, 2011. The adoption of this ASU in the first quarter of 2012 did not have a material impact on the Company’s consolidated financial statements other than to change the presentation of other comprehensive income as discussed above.

In December 2011, the FASB issued ASU 2011-11, Balance Sheet (Topic 210). The objective of this ASU is to provide enhanced disclosures that will enable users of its financial statements to evaluate the effect or potential effect of rights of setoff associated with an entity’s financial position. This includes the effect or potential effect of rights of setoff associated with an entity’s recognized assets and recognized liabilities within the scope of this ASU. The amendments require enhanced disclosures by requiring improved information about financial instruments and derivative instruments that are either (1) offset in accordance with either Section 210-20-45 or Section 815-10-45 or (2) subject to an enforceable master netting arrangement or similar agreement, irrespective of whether they are offset in accordance with either Section 210-20-45 or Section 815-10-45. An entity is required to apply the amendments for annual reporting periods beginning on or after January 1, 2013, and interim periods with those annual periods. The adoption of this ASU in the first quarter of 2013 is not anticipated to have any impact on the Company’s consolidated financial statements as it currently has no outstanding rights of setoff.

In December 2011, the FASB issued ASU 2011-12, Comprehensive Income (Topic 220). The amendments in this ASU supersede certain pending paragraphs in ASU 2011-05, Comprehensive Income (Topic 220): Presentation of Comprehensive Income, to effectively defer only those changes in ASU 2011-05 that relate to the presentation of reclassification adjustments out of accumulated other comprehensive income. All other requirements in ASU 2011-05 are not affected by this ASU, including the requirement to report comprehensive income either in a single continuous financial statement or in two separate but consecutive financial statements. The amendments in this ASU will be temporary to allow the FASB time to redeliberate the presentation requirements for reclassifications out of accumulated other comprehensive income for annual and interim financial statements for public, private, and non-profit entities. The adoption of this ASU in the first quarter of 2012 did not have a material impact on the Company’s consolidated financial statements other than to change the presentation of other comprehensive income as discussed above.

(4) Derivative Instruments and Hedging Activities

The Company had commitments outstanding to extend credit to future borrowers that had not closed prior to the end of the quarter. The Company intends to sell these commitments, which are referred to as its mortgage pipeline. As commitments to originate or purchase loans enter the mortgage pipeline, the Company generally enters into commitments to sell the mortgage pipeline into the secondary market on a firm commitment or best efforts basis. The commitments to originate, purchase or sell loans on a firm commitment basis are derivatives and are recorded at fair market value. As a result of marking these derivatives to market for the period ended March 31, 2012, the Company recorded an increase in other assets of $14,000, an increase in other liabilities of $11,000 and a gain included in the gain on sales of loans of $3,000.

The current commitments to sell loans held for sale are derivatives that do not qualify for hedge accounting. As a result, these derivatives are marked to market and the related loans held for sale are recorded at the lower-of-cost-or-market. The Company recorded a decrease in other liabilities of $56,000 and a gain included in the gain on sales of loans of $56,000.

(5) Fair Value Measurements

ASC 820, Fair Value Measurements establishes a framework for measuring the fair value of assets and liabilities using a hierarchy system consisting of three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. These levels are:

 

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Level 1—Valuation is based upon quoted prices for identical instruments traded in active markets that the Company has the ability to access.

Level 2—Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which significant assumptions are observable in the market.

Level 3 – Valuation is generated from model-based techniques that use significant assumptions not observable in the market and are used only to the extent that observable inputs are not available. These unobservable assumptions reflect our own estimates of assumptions that market participants would use in pricing the asset or liability. Valuation techniques include use of option pricing models, discounted cash flow models and similar techniques.

The following table summarizes the assets of the Company for which fair values are determined on a recurring basis as of March 31, 2012 and December 31, 2011.

 

     Carrying value at March 31, 2012  

(Dollars in thousands)

   Total     Level 1      Level 2     Level 3  

Securities available for sale

   $ 87,955        360         87,595        0   

Mortgage loan commitments

     43        0         43        0   
  

 

 

   

 

 

    

 

 

   

 

 

 

Total

   $ 87,998        360         87,638        0   
  

 

 

   

 

 

    

 

 

   

 

 

 
     Carrying value at December 31, 2011  

(Dollars in thousands)

   Total     Level 1      Level 2     Level 3  

Securities available for sale

   $ 126,114        613         125,501        0   

Mortgage loan commitments

     (94     0         (94     0   
  

 

 

   

 

 

    

 

 

   

 

 

 

Total

   $ 126,020        613         125,407        0   
  

 

 

   

 

 

    

 

 

   

 

 

 

There were no transfers between Levels 1, 2, or 3 during the three months ended March 31, 2012.

The Company may also be required, from time to time, to measure certain other financial assets at fair value on a nonrecurring basis in accordance with generally accepted accounting principles. These adjustments to fair value usually result from the application of the lower-of-cost-or-market accounting or write-downs of individual assets. For assets measured at fair value on a nonrecurring basis that were still held at March 31, 2012 and December 31, 2011, the following table provides the level of valuation assumptions used to determine each adjustment and the carrying value of the related individual assets or portfolios at March 31, 2012 and December 31, 2011.

 

     Carrying value at March 31, 2012         

(Dollars in thousands)

   Total      Level 1      Level 2      Level 3      Three months ended
March 31, 2012
Total Gains (Losses)
 

Loans held for sale

   $ 3,279         0         3,279         0         16   

Mortgage servicing rights

     1,497         0         1,497         0         0   

Loans (1)

     47,999         0         47,999         0         (1,101

Real estate, net (2)

     13,595         0         13,595         0         (143
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 66,370         0         66,370         0         (1,228
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

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     Carrying value at December 31, 2011         

(Dollars in thousands)

   Total      Level 1      Level 2      Level 3      Year ended
December 31,  2011
Total Gains (Losses)
 

Loans held for sale

   $ 3,709         0         3,709         0         129   

Mortgage servicing rights

     1,485         0         1,485         0         0   

Loans (1)

     38,162         0         38,162         0         (4,167

Real estate, net (2)

     16,616         0         16,616         0         (2,690

Assets held for sale

     1,583         0         1,583         0         0   

Deposits held for sale

     36,048         0         36,048         0         0   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 97,603         0         97,603         0         (6,728
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

(1) Represents carrying value and related write-downs of loans for which adjustments are based on the appraised value of the collateral. The carrying value of loans fully charged-off is zero.
(2) Represents the fair value and related losses of foreclosed real estate and other collateral owned that were measured at fair value subsequent to their initial classification as foreclosed assets.

(6) Fair Value of Financial Instruments

Generally accepted accounting principles require interim reporting period disclosure about the fair value of financial instruments, including assets, liabilities and off-balance sheet items for which it is practicable to estimate fair value. The fair value hierarchy level for each asset and liability, as defined in note 5, have been included in the following table as of March 31, 2012 as required by the adoption of ASU 2011-04 in the first quarter of 2012. The fair value estimates are made based upon relevant market information, if available, and upon the characteristics of the financial instruments themselves. Because no market exists for a significant portion of the Company’s financial instruments, fair value estimates are based upon judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments and other factors. The estimated fair value of the Company’s financial instruments as of March 31, 2012 and December 31, 2011 are shown below.

 

     March 31, 2012      December 31, 2011  
                 Fair value hierarchy   

 

                    

(Dollars in thousands)

   Carrying
amount
    Estimated
fair value
    Level 1      Level 2     Level 3    Contract
amount
     Carrying
amount
    Estimated
fair value
    Contract
Amount
 

Financial assets:

                     

Cash and cash equivalents

   $ 45,977        45,977        45,977                 67,840        67,840     

Securities available for sale

     87,955        87,955        360         87,595              126,114        126,114     

Loans held for sale

     3,279        3,279           3,279              3,709        3,709     

Loans receivable, net

     538,069        546,984           546,984              555,908        566,266     

Federal Home Loan Bank stock

     4,172        4,172           4,172              4,222        4,222     

Accrued interest receivable

     2,262        2,262           2,262              2,449        2,449     

Assets held for sale

     0        0                   1,583        1,605     

Financial liabilities:

                     

Deposits

     568,237        568,237           568,237              620,128        620,128     

Deposits held for sale

     0        0                   36,048        36,048     

Federal Home Loan Bank advances

     70,000        73,840           73,840              70,000        74,433     

Accrued interest payable

     562        562           562              780        780     

Off-balance sheet financial instruments:

                     

Commitments to extend credit

     16        16           16           97,662         29        29        91,113   

Commitments to sell loans

     (49     (49        (49        7,932         (94     (94     7,263   

Cash and Cash Equivalents

The carrying amount of cash and cash equivalents approximates their fair value.

Securities Available for Sale

The fair values of securities were based upon quoted market prices for identical or similar instruments in active markets.

 

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Table of Contents

Loans Held for Sale

The fair values of loans held for sale were based upon quoted market prices for loans with similar interest rates and terms to maturity.

Loans Receivable

The fair values of loans receivable were estimated for groups of loans with similar characteristics. The fair value of the loan portfolio, with the exception of the adjustable rate portfolio, was calculated by discounting the scheduled cash flows through the estimated maturity using anticipated prepayment speeds and using discount rates that reflect the credit and interest rate risk inherent in each loan portfolio. The fair value of the adjustable loan portfolio was estimated by grouping the loans with similar characteristics and comparing the characteristics of each group to the prices quoted for similar types of loans in the secondary market. This method of estimating fair value does not incorporate the exit-price concept of fair value prescribed by ASC 820, Fair Value Measurements and Disclosures.

Federal Home Loan Bank Stock

The carrying amount of FHLB stock approximates its fair value.

Accrued Interest Receivable

The carrying amount of accrued interest receivable approximates its fair value since it is short-term in nature and does not present unanticipated credit concerns.

Deposits

The fair value of demand deposits, savings accounts and certain money market account deposits is the amount payable on demand at the reporting date. The fair value of fixed maturity certificates of deposit is estimated using the rates currently offered for deposits of similar remaining maturities. If the fair value of the fixed maturity certificates of deposit is calculated at less than the carrying amount, the carrying value of these deposits is reported as the fair value.

The fair value estimate for deposits does not include the benefit that results from the low cost funding provided by the Company’s existing deposits and long-term customer relationships compared to the cost of obtaining different sources of funding. This benefit is commonly referred to as the core deposit intangible.

Federal Home Loan Bank Advances

The fair values of advances with fixed maturities are estimated based on discounted cash flow analysis using as discount rates the interest rates charged by the FHLB for borrowings of similar remaining maturities.

Accrued Interest Payable

The carrying amount of accrued interest payable approximates its fair value since it is short-term in nature.

Commitments to Extend Credit

The fair values of commitments to extend credit are estimated using the fees normally charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counter parties.

Commitments to Sell Loans

The fair values of commitments to sell loans are estimated using the quoted market prices for loans with similar interest rates and terms to maturity.

(7) Other Comprehensive Loss

Other comprehensive loss is defined as the change in equity during a period from transactions and other events from nonowner sources. Comprehensive income (loss) is the total of net income and other comprehensive loss, which for the Company is comprised of unrealized losses on securities available for sale. The components of other comprehensive loss and the related tax effects were as follows:

 

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Table of Contents
      For the period ended March 31,  
      2012     2011  

(Dollars in thousands)

   Before tax     Tax effect      Net of tax     Before tax     Tax effect     Net of tax  

Securities available for sale:

             

Net unrealized losses arising during the period

   $ (179     0         (179     (190     (76     (114
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

Other comprehensive loss

   $ (179     0         (179     (190     (76     (114
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

(8) Securities Available For Sale

The following table shows the gross unrealized losses and fair value for the securities available for sale portfolio, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at March 31, 2012 and December 31, 2011.

 

     March 31, 2012  
     Less than twelve months      Twelve months or more     Total  

(Dollars in thousands)

   # of
Investments
     Fair
Value
     Unrealized
Losses
     # of
Investments
     Fair
Value
     Unrealized
Losses
    Fair
Value
     Unrealized
Losses
 

Other marketable securities:

                      

Corporate preferred stock

     0       $ 0         0         0       $ 175         (525   $ 175         (525
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

   

 

 

    

 

 

 

Total temporarily impaired securities

     0       $ 0         0         0       $ 175         (525   $ 175         (525
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

   

 

 

    

 

 

 
     December 31, 2011  
     Less than twelve months      Twelve months or more     Total  

(Dollars in thousands)

   # of
Investments
     Fair
Value
     Unrealized
Losses
     # of
Investments
     Fair
Value
     Unrealized
Losses
    Fair
Value
     Unrealized
Losses
 

Other marketable securities:

                      

Corporate preferred stock

     0       $ 0         0         1       $ 175         (525   $ 175         (525
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

   

 

 

    

 

 

 

Total temporarily impaired securities

     0       $ 0         0         1       $ 175         (525   $ 175         (525
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

   

 

 

    

 

 

 

We review our investment portfolio on a quarterly basis for indications of impairment. This review includes analyzing the length of time and the extent to which the fair value has been lower than the cost, the market liquidity for the investment, the financial condition and near-term prospects of the issuer, including any specific events which may influence the operations of the issuer, and our intent and ability to hold the investment for a period of time sufficient to recover the temporary loss.

The unrealized losses reported for corporate preferred stock at March 31, 2012 and December 31, 2011 related to a single trust preferred security that was issued by the holding company of a small community bank. Typical of most trust preferred issuances, the issuer has the ability to defer interest payments for up to five years with interest payable on the deferred balance. In October 2009, the issuer elected to defer its scheduled interest payments as allowed by the terms of the security agreement. The issuer’s subsidiary bank has incurred operating losses due to increased provisions for loan losses but still meets the regulatory requirements to be considered “adequately capitalized” based on its most recent regulatory filing. Based on a review of the issuer, it was determined that the trust preferred security was not other-than-temporarily impaired at March 31, 2012. The Company does not intend to sell the preferred stock and has the intent and ability to hold it for a period of time sufficient to recover the temporary loss. Management believes that the Company will receive all principal and interest payments contractually due on the security and that the decrease in the market value is primarily due to a lack of liquidity in the market for trust preferred securities and the deferral of interest by the issuer. Management will continue to monitor the credit risk of the issuer and may be required to recognize other-than-temporary impairment charges on this security in future periods.

 

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Table of Contents

A summary of securities available for sale at March 31, 2012 and December 31, 2011 is as follows:

 

(Dollars in thousands)

   Amortized cost      Gross unrealized
gains
     Gross unrealized
losses
    Fair value  

March 31, 2012:

          

Mortgage-backed securities:

          

FHLMC

   $ 9,612         528         0        10,140   

FNMA

     6,641         456         0        7,097   

Collateralized mortgage obligations:

          

FHLMC

     167         2         0        169   

FNMA

     189         2         0        191   
  

 

 

    

 

 

    

 

 

   

 

 

 
     16,609         988         0        17,597   
  

 

 

    

 

 

    

 

 

   

 

 

 

Other marketable securities:

          

U.S. Government agency obligations

     69,999         184         0        70,183   

Corporate preferred stock

     700         0         (525     175   
  

 

 

    

 

 

    

 

 

   

 

 

 
     70,699         184         (525     70,358   
  

 

 

    

 

 

    

 

 

   

 

 

 
   $ 87,308         1,172         (525     87,955   
  

 

 

    

 

 

    

 

 

   

 

 

 

(Dollars in thousands)

   Amortized cost      Gross unrealized
gains
     Gross unrealized
losses
    Fair value  

December 31, 2011:

          

Mortgage-backed securities:

          

FHLMC

   $ 11,310         553         0        11,863   

FNMA

     7,670         499         0        8,169   

Collateralized mortgage obligations:

          

FHLMC

     335         4         0        339   

FNMA

     271         3         0        274   
  

 

 

    

 

 

    

 

 

   

 

 

 
     19,586         1,059         0        20,645   
  

 

 

    

 

 

    

 

 

   

 

 

 

Other marketable securities:

          

U.S. Government agency obligations

     105,000         294         0        105,294   

Corporate preferred stock

     700         0         (525     175   
  

 

 

    

 

 

    

 

 

   

 

 

 
     105,700         294         (525     105,469   
  

 

 

    

 

 

    

 

 

   

 

 

 
   $ 125,286         1,353         (525     126,114   
  

 

 

    

 

 

    

 

 

   

 

 

 

The following table indicates amortized cost and estimated fair value of securities available for sale at March 31, 2012 based upon contractual maturity adjusted for scheduled repayments of principal and projected prepayments of principal based upon current economic conditions and interest rates.

 

(Dollars in thousands)

   Amortized
Cost
     Fair
Value
 

Due less than one year

   $ 33,528         34,071   

Due after one year through five years

     52,679         53,283   

Due after five years through ten years

     401         426   

Due after 10 years

     700         175   
  

 

 

    

 

 

 

Total

   $ 87,308         87,955   
  

 

 

    

 

 

 

The allocation of mortgage-backed securities and collateralized mortgage obligations in the table above is based upon the anticipated future cash flow of the securities using estimated mortgage prepayment speeds. The allocation of other marketable securities that have call features is based on the anticipated cash flows to the call date if it is anticipated that the security will be called, or to the maturity date if it is not anticipated to be called.

 

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Table of Contents

(9) Loans Receivable, Net

A summary of loans receivable at March 31, 2012 and December 31, 2011 is as follows:

 

(Dollars in thousands)

   March 31,
2012
     December 31,
2011
 

1-4 family

   $ 117,645         119,066   

Commercial real estate:

     

Residential developments

     53,929         52,746   

Alternative fuels

     15,884         18,882   

Other

     210,493         218,286   
  

 

 

    

 

 

 
     280,306         289,914   

Consumer

     59,187         62,161   

Commercial business:

     

Construction/development

     4,661         4,786   

Banking

     4,899         4,899   

Other

     93,293         99,574   
  

 

 

    

 

 

 
     102,853         109,259   
  

 

 

    

 

 

 

Total loans

     559,991         580,400   

Less:

     

Unamortized discounts

     79         93   

Net deferred loan fees

     419         511   

Allowance for loan losses

     21,424         23,888   
  

 

 

    

 

 

 

Total loans receivable, net

   $ 538,069         555,908   
  

 

 

    

 

 

 

(10) Allowance for Loan Losses and Credit Quality Information

The allowance for loan losses is summarized as follows:

 

(Dollars in thousands)

   1-4 Family      Commercial
Real Estate
    Consumer     Commercial
Business
    Total  

Balance, December 31, 2011

   $ 3,718         13,622        1,159        5,389        23,888   

Provision for losses

     30         (184     219        (193     (128

Charge-offs

     0         (2,630     (265     (8     (2,903

Recoveries

     0         241        9        317        567   
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

Balance, March 31, 2012

   $ 3,748         11,049        1,122        5,505        21,424   
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

Allocated to:

           

Specific reserves

   $ 1,000         3,882        429        2,200        7,511   

General reserves

     2,748         7,167        693        3,305        13,913   
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

Balance, March 31, 2012

   $ 3,748         11,049        1,122        5,505        21,424   
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

Allocated to:

           

Specific reserves

   $ 1,086         3,559        367        1,621        6,633   

General reserves

     2,632         10,063        792        3,768        17,255   
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

Balance, December 31, 2011

   $ 3,718         13,622        1,159        5,389        23,888   
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

Loans receivable at December 31, 2011:

           

Individually reviewed for impairment

   $ 6,241         30,495        1,205        6,855        44,796   

Collectively reviewed for impairment

     112,825         259,419        60,956        102,404        535,604   
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

Ending balance

   $ 119,066         289,914        62,161        109,259        580,400   
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

Loans receivable at March 31, 2012:

           

Individually reviewed for impairment

   $ 8,714         38,064        1,377        7,355        55,510   

Collectively reviewed for impairment

     108,931         242,242        57,810        95,498        504,481   
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

Ending balance

   $ 117,645         280,306        59,187        102,853        559,991   
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

 

14


Table of Contents
(Dollars in thousands)    1-4 Family     Commercial
Real Estate
    Consumer     Commercial
Business
    Total  

Balance, December 31, 2010

   $ 2,145        24,590        924        15,169        42,828   

Provision for losses

     756        539        147        504        1,946   

Charge-offs

     (403     (7,576     (52     (2,308     (10,339

Recoveries

     0        5        4        509        518   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance, March 31, 2011

   $ 2,498        17,558        1,023        13,874        34,953   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Allocated to:

          

Specific reserves

   $ 1,578        7,501        133        9,636        18,848   

General reserves

     920        10,057        890        4,238        16,105   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance, March 31, 2011

   $ 2,498        17,558        1,023        13,874        34,953   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Loans receivable at December 31, 2010:

          

Individually reviewed for impairment

   $ 6,729        45,077        299        26,855        78,960   

Collectively reviewed for impairment

     121,806        311,314        70,304        126,184        629,608   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Ending balance

   $ 128,535        356,391        70,603        153,039        708,568   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Loans receivable at March 31, 2011:

          

Individually reviewed for impairment

   $ 6,113        30,371        293        24,495        61,272   

Collectively reviewed for impairment

     121,509        296,735        67,655        123,452        609,351   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Ending balance

   $ 127,622        327,106        67,948        147,947        670,623   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

The following table summarizes the amount of classified and unclassified loans at March 31, 2012 and December 31, 2011:

 

     March 31, 2012  
     Classified      Unclassified         

(Dollars in thousands)

   Special
Mention
     Substandard      Doubtful      Loss      Total      Total      Total
Loans
 

1-4 family

   $ 2,344         19,320         809         0         22,473         95,172         117,645   

Commercial real estate:

                    

Residential developments

     689         37,628         309         0         38,626         15,303         53,929   

Alternative fuels

     0         0         0         0         0         15,884         15,884   

Other

     5,668         18,211         77         0         23,956         186,537         210,493   

Consumer

     0         1,023         152         202         1,377         57,810         59,187   

Commercial business:

                    

Construction/development

     0         2,678         0         0         2,678         1,983         4,661   

Banking

     0         4,899         0         0         4,899         0         4,899   

Other

     2,597         8,548         334         0         11,479         81,814         93,293   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 
   $ 11,298         92,307         1,681         202         105,488         454,503         559,991   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

15


Table of Contents
     December 31, 2011  
     Classified      Unclassified         

(Dollars in thousands)

   Special
Mention
     Substandard      Doubtful      Loss      Total      Total      Total
Loans
 

1-4 family

   $ 8,870         11,129         738         0         20,737         98,329         119,066   

Commercial real estate:

                    

Residential developments

     444         39,709         1,113         0         41,266         11,480         52,746   

Alternative fuels

     0         0         0         0         0         18,882         18,882   

Other

     5,789         19,607         0         0         25,396         192,880         218,286   

Consumer

     0         857         224         124         1,205         60,956         62,161   

Commercial business:

                    

Construction/development

     0         2,722         0         0         2,722         2,064         4,786   

Banking

     0         3,750         1,149         0         4,899         0         4,899   

Other

     3,203         8,056         0         0         11,259         88,315         99,574   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 
   $ 18,306         85,830         3,224         124         107,484         472,916         580,400   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Classified loans represent special mention, performing substandard and non-performing loans. Loans classified as substandard are loans that are generally inadequately protected by the current net worth and paying capacity of the obligor, or by the collateral pledged, if any. Loans classified as substandard have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected. Loans classified as doubtful have the weaknesses of those classified as substandard, with additional characteristics that make collection in full on the basis of currently existing facts, conditions and values questionable, and there is a high possibility of loss. A loan classified as loss is considered uncollectible and of such little value that continuance as an asset on the balance sheet is not warranted. Loans classified as substandard or doubtful require the Bank to perform an analysis of the individual loan and charge off any loans, or portion thereof, that are deemed uncollectible.

 

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Table of Contents

The aging of past due loans at March 31, 2012 and December 31, 2011 are summarized as follows:

 

(Dollars in thousands)

   30-59
Days
Past Due
     60-89
Days
Past Due
     90 Days
or More
Past Due
     Total
Past Due
     Current
Loans
     Total
Loans
     Loans 90 Days or
More Past Due
and Still Accruing
 

March 31, 2012

                 

1-4 family

   $ 1,848         249         998         3,095         114,550         117,645         0   

Commercial real estate:

                    

Residential developments

     0         51         3,872         3,923         50,006         53,929         0   

Alternative fuels

     0         0         0         0         15,884         15,884         0   

Other

     681         55         3,681         4,417         206,076         210,493         0   

Consumer

     300         1         432         733         58,454         59,187         0   

Commercial business:

                    

Construction/development

     275         0         0         275         4,386         4,661         0   

Banking

     0         0         1,149         1,149         3,750         4,899         0   

Other

     273         2,324         2,825         5,422         87,871         93,293         0   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 
   $ 3,377         2,680         12,957         19,014         540,977         559,991         0   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

December 31, 2011

                    

1-4 family

   $ 1,876         305         1,297         3,478         115,588         119,066         0   

Commercial real estate:

                    

Residential developments

     107         290         8,211         8,608         44,138         52,746         0   

Alternative fuels

     0         0         0         0         18,882         18,882         0   

Other

     350         79         5,184         5,613         212,673         218,286         0   

Consumer

     658         374         387         1,419         60,742         62,161         0   

Commercial business:

                    

Construction/development

     286         0         0         286         4,500         4,786         0   

Banking

     0         0         1,149         1,149         3,750         4,899         0   

Other

     351         112         2,877         3,340         96,234         99,574         0   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 
   $ 3,628         1,160         19,105         23,893         556,507         580,400         0   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

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Table of Contents

Impaired loans include loans that are non-performing (non-accruing) and loans that have been modified in a troubled debt restructuring (TDR). The following table summarizes impaired loans and related allowances as of March 31, 2012 and December 31, 2011:

 

     March 31, 2012      December 31, 2011  

(Dollars in thousands)

   Recorded
Investment
     Unpaid
Principal
Balance
     Related
Allowance
     Recorded
Investment
     Unpaid
Principal
Balance
     Related
Allowance
 

Loans with no related allowance recorded:

                 

1-4 family

   $ 4,167         4,488         0         2,651         2,972         0   

Commercial real estate:

                 

Residential developments

     12,633         17,233         0         6,900         9,855         0   

Alternative fuels

     0         0         0         0         0         0   

Other

     3,882         4,576         0         3,745         4,381         0   

Consumer

     360         360         0         489         489         0   

Commercial business:

                 

Construction/development

     221         2,192         0         340         2,311         0   

Banking

     1,149         3,248         0         1,149         3,248         0   

Other

     404         1,412         0         598         1,607         0   

Loans with an allowance recorded:

                 

1-4 family

     4,547         4,547         1,001         3,590         3,590         1,086   

Commercial real estate:

                 

Residential developments

     15,577         16,520         2,381         13,889         14,017         2,546   

Alternative fuels

     0         0         0         0         0         0   

Other

     5,972         8,282         1,500         5,961         8,272         1,013   

Consumer

     1,017         1,017         429         716         716         367   

Commercial business:

                 

Construction/development

     0         0         0         0         0         0   

Banking

     0         0         0         0         0         0   

Other

     5,581         7,959         2,200         4,768         7,145         1,621   

Total:

                 

1-4 family

     8,714         9,035         1,001         6,241         6,562         1,086   

Commercial real estate:

                 

Residential developments

     28,210         33,753         2,381         20,789         23,872         2,546   

Alternative fuels

     0         0         0         0         0         0   

Other

     9,854         12,858         1,500         9,706         12,653         1,013   

Consumer

     1,377         1,377         429         1,205         1,205         367   

Commercial business:

                 

Construction/development

     221         2,192         0         340         2,311         0   

Banking

     1,149         3,248         0         1,149         3,248         0   

Other

     5,985         9,371         2,200         5,366         8,752         1,621   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 
   $ 55,510         71,834         7,511         44,796         58,603         6,633   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

18


Table of Contents

The following table summarizes the average recorded investment and interest income recognized on impaired loans during the three months ended March 31, 2012 and 2011:

 

     March 31, 2012      March 31, 2011  

(Dollars in thousands)

   Average
Recorded
Investment
     Interest
Income
Recognized
     Average
Recorded
Investment
     Interest
Income
Recognized
 

Loans with no related allowance recorded:

           

1-4 family

   $ 3,409         27         1,152         20   

Commercial real estate:

           

Residential developments

     9,767         227         6,183         73   

Alternative fuels

     0         0         0         0   

Other

     3,814         10         387         4   

Consumer

     425         1         72         0   

Commercial business:

           

Construction/development

     281         0         223         2   

Banking

     1,149         0         0         0   

Other

     501         0         520         15   

Loans with an allowance recorded:

           

1-4 family

     4,069         23         5,269         41   

Commercial real estate:

           

Residential developments

     14,733         37         20,021         110   

Alternative fuels

     0         0         4,995         0   

Other

     5,967         4         6,139         14   

Consumer

     867         11         224         3   

Commercial business:

           

Construction/development

     0         0         4,397         3   

Banking

     0         0         8,223         0   

Other

     5,175         15         12,312         75   

Total:

           

1-4 family

     7,478         50         6,421         61   

Commercial real estate:

           

Residential developments

     24,500         264         26,204         183   

Alternative fuels

     0         0         4,995         0   

Other

     9,781         14         6,526         18   

Consumer

     1,292         12         296         3   

Commercial business:

           

Construction/development

     281         0         4,620         5   

Banking

     1,149         0         8,223         0   

Other

     5,676         15         12,832         90   
  

 

 

    

 

 

    

 

 

    

 

 

 
   $ 50,157         355         70,117         360   
  

 

 

    

 

 

    

 

 

    

 

 

 

At March 31, 2012 and December 31, 2011, non-accruing loans totaled $33.0 million and $34.0 million, respectively, for which the related allowance for loan losses was $5.9 million and $5.2 million, respectively. The increase in the related allowances is due primarily to two new non-accruing loans and increased reserves on one existing non-accruing loan. All of the interest income that was recognized for non-accruing loans was recognized using the cash basis method of income recognition. Non-accruing loans for which no specific allowance has been recorded, because management determined that the value of the collateral was sufficient to repay the loan, totaled $10.6 million and $14.8 million, respectively. Non-accrual loans also include certain loans that have had terms modified in a TDR.

 

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Table of Contents

The non-accrual loans at March 31, 2012 and December 31, 2011 are summarized as follows:

 

(Dollars in thousands)

   March 31,
2012
     December 31,
2011
 

1-4 family

   $ 5,240       $ 4,435   

Commercial real estate:

     

Residential developments

     12,696         13,412   

Alternative fuels

     0         0   

Other

     7,802         9,246   

Consumer

     737         699   

Commercial business:

     

Construction/development

     221         340   

Banking

     1,149         1,149   

Other

     5,169         4,712   
  

 

 

    

 

 

 
   $ 33,014       $ 33,993   
  

 

 

    

 

 

 

During the third quarter of 2011, the Company adopted Accounting Standards Update (ASU) 2011-02, A Creditor’s Determination of Whether a Restructuring is a Troubled Debt Restructuring (Topic 310), which modified guidance for identifying restructurings of receivables that constitute a TDR. At March 31, 2012 and December 31, 2011, there were loans included in loans receivable, net, with terms that had been modified in a TDR totaling $43.8 million and $29.2 million, respectively. For the loans that were restructured in the first quarter of 2012, $12.3 million were classified but performing and $4.0 million were non-performing at March 31, 2012.

The following table summarizes troubled debt restructurings at March 31, 2012 and December 31, 2011:

 

     March 31, 2012      December, 31, 2011  

(Dollars in thousands)

   Accruing      Non-
Accrual
     Total      Accruing      Non-
Accrual
     Total  

1-4 Family

   $ 3,474         3,385         6,859         1,806         1,999         3,805   

Consumer

     71         640         711         507         71         578   

Commercial real estate

     17,567         13,683         31,250         7,837         12,221         20,058   

Commercial business

     815         4,135         4,950         653         4,110         4,763   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 
     $21,927         21,843         43,770         10,803         18,401         29,204   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

There were no material commitments to lend additional funds to customers whose loans were restructured or classified as nonaccrual at March 31, 2012 or December 31, 2011.

TDR concessions can include reduction of interest rates, extension of maturity dates, forgiveness of principal and/or interest due, or acceptance of real estate or other assets in full or partial satisfaction of the debt. Loan modifications are not reported as TDR’s after 12 months if the loan was modified at a market rate of interest for comparable risk loans, and the loan is performing in accordance with the terms of the restructured agreement for the entire 12 month period. All loans classified as TDR’s are considered to be impaired.

When a loan is modified as a TDR, there may be a direct, material impact on the loans within the balance sheet, as principal balances may be partially forgiven. The financial effects of TDR’s are presented in the following table and represent the difference between the outstanding recorded balance pre-modification and post-modification, for the three month period ending March 31, 2012.

 

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Table of Contents
     Three Months Ended
March 31, 2012
 

(Dollars in thousands)

   Number of
Contracts
     Pre-
modification
Outstanding
Recorded
Investment
     Post-modification
Outstanding
Recorded
Investment
 

Troubled debt restructurings:

        

1-4 family

     27       $ 3,204         3,204   

Commercial real estate:

        

Residential developments

     7         11,479         9,823   

Alternative fuels

     0         0         0   

Other

     6         2,815         2,758   

Consumer

     8         268         268   

Commercial business:

        

Construction/development

     0         0         0   

Banking

     0         0         0   

Other

     2         244         244   
  

 

 

    

 

 

    

 

 

 

Total

     50       $ 18,010         16,297   
  

 

 

    

 

 

    

 

 

 

Loans that were restructured within the 12 months preceding March 31, 2012 and defaulted during the three months ended March 31, 2012 are presented in the table below.

 

     Three Months Ended
March 31, 2012
 

(Dollars in thousands)

   Number of
Contracts
     Outstanding Recorded
Investment
 

1-4 family

     1       $ 93   

Commercial real estate:

     

Residential developments

     0         0   

Alternative fuels

     0         0   

Other

     3         510   

Consumer

     0         0   

Commercial business:

     

Construction/development

     0         0   

Banking

     0         0   

Other

     3         2,777   
  

 

 

    

 

 

 

Total

     7       $ 3,380   
  

 

 

    

 

 

 

The Company considers a loan to have defaulted when it becomes 90 or more days past due under the modified terms, when it is placed in non-accrual status, when it becomes other real estate owned, or when it becomes non-compliant with some other material requirement of the modification agreement.

Loans that were non-accrual prior to modification remain on non-accrual for at least six months following modification. Non-accrual TDR loans that have performed according to the modified terms for six months may be returned to accruing status. Loans that were accruing prior to modification remain on accrual status after the modification as long as the loan continues to perform under the new terms.

TDR’s are reviewed for impairment following the same methodology as other impaired loans. For loans that are collateral dependent, the value of the collateral is reviewed and additional reserves may be added as needed. Loans that are not collateral dependent may have additional reserves established if deemed necessary. The allowance for loan losses on TDR’s was $4.1 million, or 19.2%, of the total $21.4 million in loan loss reserves at March 31, 2012 and $3.5 million, or 14.6%, of the total $23.9 million in loan loss reserves at December 31, 2011.

 

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Table of Contents

(11) Investment in Mortgage Servicing Rights

A summary of mortgage servicing activity is as follows:

 

(Dollars in thousands)

   Three months ended
March 31, 2012
    Twelve months ended
December 31, 2011
    Three months ended
March 31, 2011
 

Balance, beginning of period

   $ 1,485        1,586        1,586   

Originations

     187        461        87   

Amortization

     (175     (562     (98
  

 

 

   

 

 

   

 

 

 

Balance, end of period

     1,497        1,485        1,575   
  

 

 

   

 

 

   

 

 

 

Fair value of mortgage servicing rights

   $ 1,887        1,878        2,636   
  

 

 

   

 

 

   

 

 

 

All of the loans being serviced were single family loans under the FNMA mortgage-backed security program or the individual loan sale program. The following is a summary of the risk characteristics of the loans being serviced at March 31, 2012.

 

(Dollars in thousands)

   Loan
Principal
Balance
     Weighted
Average
Interest
Rate
    Weighted
Average
Remaining
Term
     Number
of Loans
 

Original term 30 year fixed rate

   $ 201,392         5.00     298         1,775   

Original term 15 year fixed rate

     100,925         4.24        132         1,377   

Adjustable rate

     415         3.38        297         8   
  

 

 

    

 

 

      

 

 

 

The gross carrying amount of mortgage servicing rights and the associated accumulated amortization at March 31, 2012 is presented in the following table. Amortization expense was $175,000 and $98,000 for the three months ended March 31, 2012 and 2011, respectively.

 

(Dollars in thousands)

   Gross
Carrying
Amount
     Accumulated
Amortization
    Unamortized
Mortgage
Servicing Rights
 

Mortgage servicing rights

   $ 2,135         (638     1,497   
  

 

 

    

 

 

   

 

 

 

Total

   $ 2,135         (638     1,497   
  

 

 

    

 

 

   

 

 

 

The following table indicates the estimated future amortization expense for amortized mortgage servicing rights:

 

(Dollars in thousands)

      

Year ending December 31,

  

2012

   $ 262   

2013

     336   

2014

     314   

2015

     276   

2016

     190   

Thereafter

     119   
  

 

 

 

Projections of amortization are based on existing asset balances and the existing interest rate environment as of March 31, 2012. The Company’s actual experience may be significantly different depending upon changes in mortgage interest rates and other market conditions.

 

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Table of Contents

(12) Earnings (Loss) per Common Share

The following table reconciles the weighted average shares outstanding and the earnings (loss) available to common shareholders used for basic and diluted earnings per share:

 

     Three months ended March 31,  
     2012      2011  

Weighted average number of common shares outstanding

     

used in basic earnings per common share calculation

     3,914,220         3,816,686   

Net dilutive effect of:

     

Restricted stock awards

     99,513         0   
  

 

 

    

 

 

 

Weighted average number of shares outstanding

     

adjusted for effect of dilutive securities

     4,013,733         3,816,686   
  

 

 

    

 

 

 

Income (loss) available to common shareholders

   $ 2,342,316         (31,818

Basic earnings (loss) per common share

   $ 0.60         (0.01

Diluted earnings (loss) per common share

   $ 0.58         (0.01
  

 

 

    

 

 

 

At March 31, 2012 and March 31, 2011, there were 0 and 125,647 common share equivalents outstanding that are not included in the calculation of diluted earnings per share as they are anti-dilutive.

(13) Regulatory Capital and Oversight

The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank’s assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. The Bank’s capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.

The Bank entered into a written Supervisory Agreement with its primary regulator, the OTS, effective February 22, 2011 that primarily relates to the Bank’s financial performance and credit quality issues. This agreement replaced the prior memorandum of understanding that the Bank entered into with the OTS on December 9, 2009. In accordance with the agreement, the Bank submitted a two year business plan in May of 2011 that the OCC (as defined below and as successor to the OTS) accepted with the expectation that the Bank would be in adherence with the OCC’s Notification of Establishment of Higher Minimum Capital Ratios, dated August 8, 2011, also known as an individual minimum capital requirement or IMCR, which required the Bank to establish and maintain a minimum core capital ratio of 8.50% by December 31, 2011, as discussed more fully below. As required by the Supervisory Agreement, the Bank submitted an updated two year capital plan in January of 2012 that the OCC may make comments upon, and require revisions to. The Bank must operate within the parameters of the final business plan and is required to monitor and submit periodic reports on its compliance with the plan. The Bank also submitted a problem asset reduction plan that the OCC has accepted. The Bank must operate within the parameters of the final problem asset plan and is required to monitor and submit periodic reports on its compliance with the plan. The Bank has also revised its loan modification policies and its program for identifying, monitoring and controlling risk associated with concentrations of credit, and improved the documentation relating to the allowance for loan and lease losses as required by the agreement. In addition, without the consent of the OCC, the Bank may not declare or pay any cash dividends, increase its total assets during any quarter in excess of the amount of the net interest credited on deposit liabilities during the prior quarter, enter into any new contractual arrangement or renew or extend any existing arrangement related to compensation or benefits with any directors or officer, make any golden parachute payments, or enter into any significant contracts with a third party service provider. The Bank believes it was in compliance with all requirements of its Supervisory Agreement at March 31, 2012.

The Company also entered into a written Supervisory Agreement with the OTS effective February 22, 2011. This agreement replaced the prior memorandum of understanding that the Company entered into with the OTS on December 9, 2009. As required by the Supervisory Agreement, the Company submitted an updated two year capital plan in January of 2012 that the Federal Reserve Board (as successor to the OTS) may make comments upon, and to which it may require revisions. The Company must operate within the parameters of the final capital plan and is required to monitor and submit periodic reports on its compliance with the plan. In addition, without the consent of

 

23


Table of Contents

the Federal Reserve Board, the Company may not incur or issue any debt, guarantee the debt of any entity, declare or pay any cash dividends or repurchase any of the Company’s capital stock, enter into any new contractual arrangement or renew or extend any existing arrangement related to compensation or benefits with any directors or officer, or make any golden parachute payments. The Company believes it was in compliance with all requirements of its Supervisory Agreement at March 31, 2012.

References to the OTS shall mean, with respect to the Company, beginning July 21, 2011, the Federal Reserve Board (FRB) and mean, with respect to the Bank, beginning July 21, 2011, the Office of the Comptroller of the Currency (OCC). On July 21, 2011, the OTS was integrated into the OCC and the primary banking regulator for the Company became the FRB.

Quantitative measures established by regulations to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the following table) of Tier I (Core) capital, and risk-based capital (as defined in the regulations) to total assets (as defined in the regulations).

On March 31, 2012, the Bank’s tangible assets were $706.0 million, its adjusted total assets were $705.7 million and its risk-weighted assets were $532.8 million. The following table presents the Bank’s capital amounts and ratios at March 31, 2012 for actual capital, required capital and excess capital including ratios required to qualify as a well capitalized institution under the Prompt Corrective Actions regulations.

 

     Actual     Required to be
Adequately
Capitalized
    Excess Capital     To Be Well Capitalized
Under Prompt Corrective
Action Provisions
 

(Dollars in thousands)

   Amount     Percent  of
Assets(1)
    Amount      Percent of
Assets (1)
    Amount      Percent  of
Assets(1)
    Amount      Percent  of
Assets(1)
 

Bank stockholder’s equity

   $ 60,300                    

Less:

                   

Net unrealized gains on certain securities

available for sale

     (292                 

Disallowed servicing and tax assets

     0                    
  

 

 

                  

Tier I or core capital

     60,008                    

Tier I capital to adjusted total assets

       8.50   $ 28,228         4.00   $ 31,780         4.50   $ 35,285         5.00

Tier I capital to risk-weighted assets

       11.26   $ 21,312         4.00   $ 38,696         7.26   $ 31,969         6.00

Plus:

                   

Allowable allowance for loan losses

     6,842                    
  

 

 

                  

Risk-based capital

   $ 66,850        $ 42,625         $ 24,225         $ 53,281      
  

 

 

                  

Risk-based capital to risk- weighted assets

       12.55        8.00        4.55        10.00

 

(1) Based upon the Bank’s adjusted total assets for the purpose of the tangible and core capital ratios and risk-weighted assets for the purpose of the risk-based capital ratio.

The OCC established an IMCR for the Bank. An IMCR requires a bank to establish and maintain levels of capital greater than those generally required for a bank to be classified as “well-capitalized.” Effective December 31, 2011, the Bank was required to establish, and subsequently maintain, core capital at least equal to 8.50% of adjusted total assets, which was in excess of the Bank’s 7.14% core capital to adjusted total assets ratio at December 31, 2011. In February 2012, the Bank received a Notice of Failure to Maintain Minimum Capital Ratios from the OCC arising out of its failure to establish and maintain its IMCR of 8.50% core capital to adjusted total assets at December 31, 2011. Pursuant to the notice, the OCC required the Bank to submit by April 30, 2012 a further written capital plan of how it intends to achieve and maintain its IMCR, and a contingency plan in the event the IMCR is not achieved through the Bank’s primary plan. Because of the improved financial results and the decrease in assets experienced during the first quarter of 2012, the Bank’s core capital ratio improved to 8.50% at March 31, 2012. In April 2012, the Bank submitted the required revised capital and contingency plan to the OCC which the OCC may make comments upon, and require revisions to.

 

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The Bank’s failure to comply with the terms of the IMCR at December 31, 2011 was, and its failure to continue to comply in the future can be, deemed an unsafe and unsound banking practice and could subject it to further limits on growth and such legal actions or sanctions as the OCC considers appropriate. There can be no assurance that the Bank will continue to maintain compliance with the IMCR in the future. Possible sanctions include among others (i) the imposition of one or more cease and desist orders requiring corrective action, which are enforceable directives that may address any aspect of the Company or Bank management, operations or capital, including requirements to change management, raise equity capital, dispose of assets or effect a change of control; (ii) civil money penalties; and (iii) downgrades in the capital adequacy status of the Company and the Bank. These regulatory actions may significantly restrict the ability of the Company and the Bank to take operating and strategic actions that may be in the best interests of stockholders or compel the Company and the Bank to take operating and strategic actions that are not potentially in the best interests of stockholders.

Management believes that, as of March 31, 2012, the Bank’s capital ratios were in excess of those quantitative capital ratio standards set forth under the prompt corrective action regulations described above. The failure of the Bank to satisfy the IMCR at any time does not by itself affect the Bank’s status as “well-capitalized” within the meaning of these prompt corrective action regulations. However, there can be no assurance that the Bank will continue to maintain such status in the future. The OCC has extensive discretion in its supervisory and enforcement activities, and can adjust the requirement to be “well-capitalized” in the future.

In order to improve its capital ratios and maintain compliance with its IMCR, the Bank is, among other things, working to improve its financial results, reduce non-performing assets, and decrease the asset size of the Bank. In March 2012, the Bank also sold substantially all of the assets and liabilities associated with its Toledo, Iowa branch. If capital conditions were to deteriorate, the Bank may also determine it to be necessary or prudent to dispose of other non-strategic assets. These actions may result in changes in the Bank’s assets, liabilities and earnings, some of which may be material, during the period in which the action is taken or is consummated or over a longer period of time. Further, the Company may need, or be required by supervising banking regulators, to raise additional capital of which there can be no assurance that, if raised, it would be on terms favorable to the Company. If the Company raises capital through the issuance of additional shares of common stock or other equity securities, it would dilute the ownership interests of existing stockholders and, given our current common stock trading price, would be expected to dilute the per share book value of the Company’s common stock and could result in a change of control of the Company and the Bank.

(14) Commitments and Contingencies

The Bank issued standby letters of credit which guarantee the performance of customers to third parties. The standby letters of credit issued and available at March 31, 2012 were approximately $1.9 million, expire over the next two years, and are collateralized primarily with commercial real estate mortgages. Since the conditions under which the Bank is required to fund the standby letters of credit may not materialize, the cash requirements are expected to be less than the total outstanding commitments.

(15) Business Segments

The Bank has been identified as a reportable operating segment in accordance with the provisions of ASC 280. SFC and HMN did not meet the quantitative thresholds for determining reportable segments and therefore are included in the “Other” category.

The Company evaluates performance and allocates resources based on the segment’s net income, return on average assets and equity. Each corporation is managed separately with its own officers and board of directors, some of whom may overlap between the corporations.

The following table sets forth certain information about the reconciliations of reported profit and assets for each of the Company’s reportable segments.

 

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(Dollars in thousands)

   Home Federal
Savings Bank
    Other      Eliminations     Consolidated
Total
 

At or for the quarter ended March 31, 2012:

         

Interest income—external customers

   $ 8,275        0         0        8,275   

Non-interest income—external customers

     2,706        0         0        2,706   

Intersegment interest income

     0        1         (1     0   

Intersegment non-interest income

     47        3,024         (3,071     0   

Interest expense

     2,063        0         (1     2,062   

Amortization of mortgage servicing rights, net

     175        0         0        175   

Other non-interest expense

     5,892        223         (47     6,068   

Income tax expense

     0        0         0        0   

Net income

     3,026        2,802         (3,024     2,804   

Total assets

     706,328        61,739         (61,658     706,409   

At or for the quarter ended March 31, 2011:

         

Interest income—external customers

   $ 10,714        0         0        10,714   

Non-interest income—external customers

     1,788        0         0        1,788   

Loss on limited partnerships

     (2     0         0        (2

Intersegment interest income

     0        1         (1     0   

Intersegment non-interest income

     43        688         (731     0   

Interest expense

     3,270        0         (1     3,269   

Amortization of mortgage servicing rights, net

     98        0         0        98   

Other non-interest expense

     6,463        274         (43     6,694   

Income tax expense

     76        0         0        76   

Net income

     690        415         (688     417   

Total assets

     878,686        70,563         (70,493     878,756   
  

 

 

   

 

 

    

 

 

   

 

 

 

 

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HMN FINANCIAL, INC.

 

Item 2: MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Forward-looking Information

This quarterly report and other reports filed by the Company with the Securities and Exchange Commission may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are often identified by such forward-looking terminology as “expect,” “intent,” “look,” “believe,” “anticipate,” “estimate,” “project,” “seek,” “may,” “will,” “would,” “could,” “should,” “trend,” “target,” and “goal” or similar statements or variations of such terms and include, but are not limited to, those relating to increasing our core deposit relationships, reducing non-performing assets, reducing expense and generating improved financial results; the adequacy and amount of available liquidity and capital resources to the Bank; the Company’s liquidity and capital requirements; our expectations for core capital and our strategies and potential strategies for improvement thereof; changes in the size of the Bank’s loan portfolio; the recovery of the valuation allowance on deferred tax assets; the amount and mix of the Bank’s non-performing assets and the appropriateness of the allowance therefor; future losses on non-performing assets; the amount of interest-earning assets; the amount and mix of brokered and other deposits (including the Company’s ability to renew brokered deposits); the availability of alternate funding sources; the payment of dividends; the future outlook for the Company; the amount of deposits that will be withdrawn from checking and money market accounts and how the withdrawn deposits will be replaced; the projected changes in net interest income based on rate shocks; the range that interest rates may fluctuate over the next twelve months; the net market risk of interest rate shocks; the future outlook for the issuer trust preferred securities held by the Bank; and the Bank’s compliance with regulatory standards generally (including the Bank’s status as “well-capitalized”), and supervisory agreements, individual minimum capital requirements or other supervisory directives or requirements to which the Company or the Bank are or may become expressly subject, specifically, and possible responses of the OCC and FRB and the Bank and the Company to any failure to comply with any such regulatory standard, agreement or requirement. A number of factors could cause actual results to differ materially from the Company’s assumptions and expectations. These include but are not limited to the adequacy and marketability of real estate and other collateral securing loans to borrowers; federal and state regulation and enforcement, including restrictions set forth in the supervisory agreements between each of the Company and Bank and the OCC and FRB; possible legislative and regulatory changes, including changes in the degree and manner of regulatory supervision, the ability of the Company and the Bank to establish and adhere to plans and policies relating to, among other things, capital, business, non-performing assets, loan modifications, documentation of loan loss allowance and concentrations of credit that are satisfactory to the OCC and FRB, as applicable, in accordance with the terms of the Company and Bank supervisory agreements and to otherwise manage the operations of the Company and the Bank to ensure compliance with other requirements set forth in the supervisory agreements; the ability of the Company and the Bank to obtain required consents from the OCC and FRB, as applicable, under the supervisory agreements or other directives; the ability of the Bank to comply with its individual minimum capital requirement and other applicable regulatory capital requirements; enforcement activity of the OCC and FRB in the event of our non-compliance with any applicable regulatory standard, agreement or requirement; adverse economic, business and competitive developments such as shrinking interest margins, reduced collateral values, deposit outflows, changes in credit or other risks posed by the Company’s loan and investment portfolios, changes in costs associated with alternate funding sources, including changes in collateral advance rates and policies of the Federal Home Loan Bank, technological, computer-related or operational difficulties, results of litigation, and reduced demand for financial services and loan products; changes in accounting policies and guidelines, or monetary and fiscal policies of the federal government or tax laws; international economic developments; the Company’s access to and adverse changes in securities markets; the market for credit related assets; or other significant uncertainties. Additional factors that may cause actual results to differ from the Company’s assumptions and expectations include those set forth in the Company’s most recent filing on Form 10-K with the Securities and Exchange Commission. All forward-looking statements are qualified by, and should be considered in conjunction with, such cautionary statements. For additional discussion of the risks and uncertainties applicable to the Company, see the “Risk Factors” sections of the Company’s Annual Report on Form 10-K for the year ended December 31, 2011 and Part II, Item 1A of this Quarterly Report on Form 10-Q.

 

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General

The earnings of the Company are primarily dependent on the Bank’s net interest income, which is the difference between interest earned on loans and investments, and the interest paid on interest-bearing liabilities such as deposits, Federal Home Loan Bank (FHLB) advances, and Federal Reserve Bank (FRB) borrowings. The difference between the average rate of interest earned on assets and the average rate paid on liabilities is the “interest rate spread”. Net interest income is produced when interest-earning assets equal or exceed interest-bearing liabilities and there is a positive interest rate spread. Net interest income and net interest rate spread are affected by changes in interest rates, the volume and mix of interest-earning assets and interest-bearing liabilities, and the level of non-performing assets. The Company’s net income is also affected by the generation of non-interest income, which consists primarily of gains or losses from the sale of securities, gains from the sale of loans, fees for servicing mortgage loans, and the generation of fees and service charges on deposit accounts. The Bank incurs expenses in addition to interest expense in the form of salaries and benefits, occupancy expenses, provisions for loan losses and amortization of mortgage servicing assets. The earnings of financial institutions, such as the Bank, are also significantly affected by prevailing economic and competitive conditions, particularly changes in interest rates, government monetary and fiscal policies, and regulations of various regulatory authorities. Lending activities are influenced by the demand for and supply of business credit, single family and commercial properties, competition among lenders, the level of interest rates and the availability of funds. Deposit flows and costs of deposits are influenced by prevailing market rates of interest on competing investments, account maturities and the levels of personal income and savings.

Beginning with the Company’s 2008 fiscal year, the Company’s commercial business and commercial real estate loan portfolios have required significant allowances and charge offs due primarily to decreases in the estimated value of the underlying collateral supporting the loans, as many of these loans were made to borrowers in or associated with the real estate industry. The decrease in the estimated collateral value is primarily the result of reduced demand for real estate, particularly as it relates to single-family and commercial land developments. More stringent lending standards implemented by the mortgage industry in recent years have made it more difficult for some borrowers with marginal credit to qualify for a mortgage. This decrease in available credit and the overall weakness in the economy over the past several years reduced the demand for single family homes and the values of existing properties and developments where the Company’s commercial loan portfolio has concentrations. Consequently, our level of non-performing assets and the related provision for loan losses increased significantly in the past several years, relative to periods before 2008. The increased levels of non-performing assets, related provisions for loan losses and write offs of or allowances against goodwill and deferred taxes arising from adverse results of operations, were the primary reasons for the net losses incurred by the Company in each of the years 2008 through 2011.

Critical Accounting Estimates

Critical accounting policies are those policies that the Company’s management believes are the most important to understanding the Company’s financial condition and operating results. These critical accounting policies often involve estimates and assumptions that could have a material impact on the Company’s financial statements. The Company has identified the following critical accounting policies that management believes involve the most difficult, subjective, and/or complex judgments that are inherently uncertain. Therefore, actual financial results could differ significantly depending upon the estimates, assumptions and other factors used.

Allowance for Loan Losses and Related Provision

The allowance for loan losses is based on periodic analysis of the loan portfolio. In this analysis, management considers factors including, but not limited to, specific occurrences of loan impairment, changes in the size of the portfolios, national and regional economic conditions such as unemployment data, loan portfolio composition, loan delinquencies, local economic growth rates, historical experience and observations made by the Company’s ongoing internal audit and regulatory exam processes. Loans are charged off to the extent they are deemed to be uncollectible.

 

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The Company has established separate processes to determine the appropriateness of the loan loss allowance for its homogeneous single-family and consumer loan portfolios and its non-homogeneous loan portfolios. The determination of the allowance on the homogeneous single-family and consumer loan portfolios is calculated on a pooled basis with individual determination of the allowance of all non-performing loans. The determination of the allowance for the non-homogeneous commercial, commercial real estate, and multi-family loan portfolios involves assigning standardized risk ratings and loss factors that are periodically reviewed. The loss factors are estimated based on the Company’s own loss experience and are assigned to all loans without identified credit weaknesses. For each non-performing loan, the Company also performs an individual analysis of impairment that is based on the expected cash flows or the value of the assets collateralizing the loans and establishes any necessary reserves or charges off all loans or portion thereof that are deemed uncollectable.

The appropriateness of the allowance for loan losses is dependent upon management’s estimates of variables affecting valuation, appraisals of collateral, evaluations of performance and status, and the amounts and timing of future cash flows expected to be received on impaired loans. Such estimates, appraisals, evaluations and cash flows may be subject to frequent adjustments due to changing economic prospects of borrowers or properties. The estimates are reviewed periodically and adjustments, if any, are recorded in the provision for loan losses in the periods in which the adjustments become known. Because of the size of some loans, changes in estimates can have a significant impact on the loan loss provision. The allowance is allocated to individual loan categories based upon the relative risk characteristics of the loan portfolios and the actual loss experience. The Company increases its allowance for loan losses by charging the provision for loan losses against income. The methodology for establishing the allowance for loan losses takes into consideration probable losses that have been identified in connection with specific loans as well as probable losses in the loan portfolio for which additional specific reserves are not required. Although management believes that based on current conditions the allowance for loan losses is maintained at an appropriate amount to provide for probable loan losses inherent in the portfolio as of the balance sheet date, future conditions may differ substantially from those anticipated in determining the allowance for loan losses and adjustments may be required in the future.

Income Taxes

Deferred tax assets and liabilities are recognized for the future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. 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. These calculations are based on many complex factors including estimates of the timing of reversals of temporary differences, the interpretation of federal and state income tax laws and a determination of the differences between the tax and the financial reporting basis of assets and liabilities. Actual results could differ significantly from the estimates and interpretations used in determining the current and deferred income tax liabilities.

The Company maintains significant net deferred tax assets for deductible temporary differences, the largest of which relates to the allowance for loan and real estate losses and net operating loss carry forwards. For income tax purposes, only net charge-offs are deductible, not the entire provision for loan losses. Under generally accepted accounting principles, a valuation allowance is required to be recognized if it is “more likely than not” that the deferred tax asset will not be realized. The determination of the realizability of the deferred tax assets is highly subjective and dependent upon management’s judgment and evaluation of both positive and negative evidence, including the forecasts of future income, tax planning strategies and assessments of the current and future economic and business conditions. The Company considers both positive and negative evidence regarding the ultimate realizability of deferred tax assets. Positive evidence includes the ability to implement tax planning strategies to accelerate taxable income recognition and the probability that taxable income will be generated in future periods. Negative evidence includes the Company’s cumulative loss in the prior three year period, current financial performance, and the general business and economic trends. In the second quarter of 2010, the Company recorded a valuation allowance against the entire deferred tax asset balance and the Company continued to maintain a valuation reserve against the entire deferred tax asset balance at March 31, 2012.

 

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This determination was based primarily upon the existence of a three year cumulative loss position that is primarily attributable to significant provisions for loan losses incurred during the last three years. The creation of the valuation allowance, although it increased tax expense and similarly reduced tangible book value, does not have an effect on the Company’s cash flows, and may be recoverable in subsequent periods if the Company were to realize certain sustained future taxable income. It is possible that future conditions may differ substantially from those anticipated in determining the need for a valuation allowance on deferred tax assets and adjustments may be required in the future.

Determining the ultimate settlement of any tax position requires significant estimates and judgments in arriving at the amount of tax benefits to be recognized in the financial statements. It is possible that the tax benefits realized upon the ultimate resolution of a tax position may result in tax benefits that are significantly different from those estimated.

RESULTS OF OPERATIONS FOR FIRST QUARTER ENDED MARCH 31, 2012 COMPARED TO FIRST QUARTER ENDED MARCH 31, 2011

Net Income

Net income was $2.8 million for the first quarter of 2012, an improvement of $2.4 million, compared to net income of $0.4 million for the first quarter of 2011. Net income available to common shareholders was $2.3 million for the first quarter of 2012, an improvement of $2.3 million, from the net loss available to common shareholders of $32,000 for the first quarter of 2011. Diluted earnings per common share for the first quarter of 2012 were $0.58, an improvement of $0.59 from the diluted loss per common share of $0.01 for the first quarter of 2011. The improvement in net income was due primarily to a $2.1 million decrease in the provision for loan losses between the periods, $0.6 million gain on the previously announced Toledo, Iowa branch sale, and $0.4 million increase in the gains recognized on the sales of loans between the periods. These increases in income were partially offset by a $1.2 million decrease in net interest income as a result of a decrease in interest-earning assets between the periods.

Net Interest Income

Net interest income was $6.2 million for the first quarter of 2012, a decrease of $1.2 million, or 16.5%, compared to $7.4 million for the first quarter of 2011. Interest income was $8.3 million for the first quarter of 2012, a decrease of $2.4 million, or 22.8%, from $10.7 million for the first quarter of 2011. Interest income decreased between the periods primarily because of a $125 million decrease in average interest-earning assets between the periods. Average interest-earning assets decreased between the periods primarily because of a decrease in the commercial loan portfolio, which occurred because of declining loan demand and the Company’s focus on improving credit quality, reducing loan concentrations, managing interest rate risk and improving capital ratios. The average yield earned on interest-earning assets was 4.70% for the first quarter of 2012, a decrease of 51 basis points from the 5.21% average yield for the first quarter of 2011.

Interest expense was $2.1 million for the first quarter of 2012, a decrease of $1.2 million, or 36.9%, compared to $3.3 million for the first quarter of 2011. Interest expense decreased primarily because of a $119 million decrease in the average interest-bearing liabilities between the periods. The decrease in average interest-bearing liabilities is primarily the result of a decrease in the outstanding borrowings and brokered certificates of deposits between the periods and a decrease in other deposits as a result of the Toledo branch sale that was completed in the first quarter of 2012. The decrease in borrowings and brokered deposits between the periods was the result of using the proceeds from loan principal payments to fund maturing borrowings and brokered deposits. Interest expense also decreased because of the lower interest rates paid on money market accounts and certificates of deposits. The decreased rates were the result of the low interest rate environment that continued to exist during the first quarter of 2012. The average interest rate paid on interest-bearing liabilities was 1.22% for the first quarter of 2012, a decrease of 44 basis points from the 1.66% average interest rate paid in the first quarter of 2011.

 

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Net interest margin (net interest income divided by average interest earning assets) for the first quarter of 2012 was 3.53%, a decrease of 9 basis points, compared to 3.62% for the first quarter of 2011. Net interest margin declined between the periods primarily because the yield on interest-earning assets decreased more than the rates paid on interest-bearing liabilities. The decrease in the yield earned on interest-earning assets is a result of the continued decline in market interest rates on loans and investments between the periods. The rates paid on deposit accounts reflected a smaller decrease because the entire change in market rate could not be reflected in the deposit rates due to the already low interest rates being paid on deposit accounts and also because some lower rate FHLB advances matured during the quarter which increased the effective rate on interest-bearing liabilities.

A summary of the Company’s net interest margin for the three month periods ended March 31, 2012 and 2011 is as follows:

 

      For the three month period ended  
      March 31, 2012     March 31, 2011  

(Dollars in thousands)

   Average
Outstanding
Balance
     Interest
Earned/
Paid
     Yield/
Rate
    Average
Outstanding
Balance
     Interest
Earned/
Paid
     Yield/
Rate
 

Interest-earning assets:

                

Securities available for sale

   $ 105,257         442         1.69   $ 149,928         741         2.00

Loans held for sale

     2,784         21         3.11        1,537         17         4.49   

Mortgage loans, net

     117,583         1,497         5.12        128,307         1,763         5.57   

Commercial loans, net

     367,760         5,425         5.93        453,694         7,095         6.34   

Consumer loans, net

     60,769         853         5.65        68,666         1,028         6.07   

Cash equivalents

     49,948         27         0.21        24,444         1         0.02   

Federal Home Loan Bank stock

     4,174         10         0.92        6,692         69         4.18