XNAS:RBCAA Republic Bancorp, Inc. Class A Quarterly Report 10-Q Filing - 3/31/2012

Effective Date 3/31/2012

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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

o Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

Commission File Number: 0-24649
 
LOGO

REPUBLIC BANCORP, INC.
(Exact name of registrant as specified in its charter)

Kentucky
61-0862051
(State of other jurisdiction of incorporation or organization)
(I.R.S. Employer Identification No.)
   
601 West Market Street, Louisville, Kentucky
40202
(Address of principal executive offices)
(Zip Code)
(502) 584-3600
 (Registrant’s telephone number, including area code)

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.
þ  Yes   o 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 (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
þ  Yes   o No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer   o           Accelerated filer  þ            Non-accelerated filer  o              Smaller reporting company  o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
o Yes   þ No

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

The number of shares outstanding of the registrant’s Class A Common Stock and Class B Common Stock, as of April 30, 2012, was 18,659,319 and 2,298,803, respectively.
 
 
1

 
 
 
 
2

 
 
PART I – FINANCIAL INFORMATION


CONSOLIDATED BALANCE SHEETS (in thousands) (unaudited)


   
March 31,
   
December 31,
 
   
2012
   
2011
 
ASSETS
           
             
Cash and cash equivalents
  $ 186,504     $ 362,971  
Securities available for sale
    603,260       645,948  
Securities to be held to maturity (fair value of $27,378 in 2012 and $28,342 in 2011)
    27,038       28,074  
Mortgage loans held for sale
    4,459       4,392  
Loans to be repurchased by the FDIC, net of discount
    17,003       -  
Loans, net of allowance for loan losses of $23,732 and $24,063 (2012 and 2011)
    2,371,055       2,261,232  
Federal Home Loan Bank stock, at cost
    28,439       25,980  
Premises and equipment, net
    34,321       34,681  
Goodwill
    10,168       10,168  
Other assets and accrued interest receivable
    62,587       46,545  
                 
TOTAL ASSETS
  $ 3,344,834     $ 3,419,991  
                 
LIABILITIES
               
                 
Deposits
               
    Non interest-bearing
  $ 595,498     $ 408,483  
    Interest-bearing
    1,453,301       1,325,495  
Total deposits
    2,048,799       1,733,978  
                 
Securities sold under agreements to repurchase and other short-term borrowings
    225,719       230,231  
Federal Home Loan Bank advances
    413,593       934,630  
Subordinated note
    41,240       41,240  
Other liabilities and accrued interest payable
    81,990       27,545  
                 
Total liabilities
    2,811,341       2,967,624  
                 
STOCKHOLDERS' EQUITY
               
                 
Preferred stock, no par value
    -       -  
Class A Common Stock and Class B Common Stock, no par value
    4,949       4,947  
Additional paid in capital
    132,318       131,482  
Retained earnings
    391,007       311,799  
Accumulated other comprehensive income
    5,219       4,139  
                 
Total stockholders' equity
    533,493       452,367  
                 
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY
  $ 3,344,834     $ 3,419,991  

 
See accompanying footnotes to consolidated financial statements.
 
 
3

 
 
CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)
(in thousands, except per share data)1

   
Three Months Ended
 
   
March 31,
 
   
2012
   
2011
 
INTEREST INCOME:
           
             
Loans, including fees
  $ 75,292     $ 88,161  
Taxable investment securities
    3,267       3,592  
Federal Home Loan Bank stock and other
    1,028       870  
Total interest income
    79,587       92,623  
                 
INTEREST EXPENSE:
               
                 
Deposits
    1,539       2,938  
Securities sold under agreements to repurchase and  other short-term borrowings
    112       251  
Federal Home Loan Bank advances
    4,086       4,834  
Subordinated note
    630       629  
Total interest expense
    6,367       8,652  
                 
NET INTEREST INCOME
    73,220       83,971  
                 
Provision for loan losses
    11,170       18,082  
                 
NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES
    62,050       65,889  
                 
NON INTEREST INCOME:
               
                 
Service charges on deposit accounts
    3,303       3,424  
Electronic refund check fees
    71,749       81,062  
Mortgage banking income
    1,354       816  
Debit card interchange fee income
    1,556       1,484  
Bargain purchase gain
    27,899       -  
Gain on sale of securities available for sale
    56       -  
Total impairment losses on investment securities
    -       (279 )
Gain recognized in other comprehensive income
    -       -  
   Net impairment loss recognized in earnings
    -       (279 )
Other
    892       805  
Total non interest income
    106,809       87,312  
                 
NON INTEREST EXPENSES:
               
                 
Salaries and employee benefits
    16,971       17,239  
Occupancy and equipment, net
    6,074       6,297  
Communication and transportation
    2,661       2,509  
Marketing and development
    938       904  
FDIC insurance expense
    430       1,635  
Bank franchise tax expense
    1,931       1,565  
Data processing
    1,221       748  
Debit card interchange expense
    601       523  
Supplies
    949       894  
Other real estate owned expense
    605       481  
Charitable contributions
    2,678       5,298  
Legal expense
    368       1,360  
FHLB advance prepayment expense
    2,436       -  
Other
    3,290       3,365  
Total non interest expenses
    41,153       42,818  
                 
INCOME BEFORE INCOME TAX EXPENSE
    127,706       110,383  
INCOME TAX EXPENSE
    45,234       38,971  
NET INCOME
  $ 82,472     $ 71,412  
                 
BASIC EARNINGS PER SHARE:
               
Class A Common Stock
  $ 3.94     $ 3.41  
Class B Common Stock
    3.92       3.40  
                 
DILUTED EARNINGS PER SHARE:
               
Class A Common Stock
  $ 3.92     $ 3.40  
Class B Common Stock
    3.90       3.39  
 
 
See accompanying footnotes to consolidated financial statements.
 
 
4

 
 
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (UNAUDITED)
(in thousands, except per share data)


   
Three Months Ended
 
   
March 31,
 
   
2012
   
2011
 
             
Net income
  $ 82,472     $ 71,412  
                 
OTHER COMPREHENSIVE INCOME
               
                 
Unrealized gain (loss) on securities available for sale
    1,739       728  
Change in unrealized losses on securities available for sale for
               
    which a portion of an other-than-temporary impairment has
               
    been recognized in earnings
    (22 )     (255 )
Realized amount on securities sold
    -       -  
Reclassification adjustment for gains/losses realized in income
    (55 )     (278 )
Net unrealized gains
    1,662       195  
Tax effect
    (582 )     (68 )
Net of tax amount
    1,080       127  
                 
COMPREHENSIVE INCOME
  $ 83,552     $ 71,539  
 
 
See accompanying footnotes to consolidated financial statements.
 
 
5

 
 
CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY (UNAUDITED)
THREE MONTHS ENDED MARCH 31, 2012

   
Common Stock
               
Accumulated
       
   
Class A
   
Class B
         
Additional
         
Other
   
Total
 
   
Shares
   
Shares
         
Paid In
   
Retained
   
Comprehensive
   
Stockholders'
 
(in thousands, except per share data)
 
Outstanding
   
Outstanding
   
Amount
   
Capital
   
Earnings
   
Income
   
Equity
 
                                           
Balance, January 1, 2012
    18,652       2,300     $ 4,947     $ 131,482     $ 311,799     $ 4,139     $ 452,367  
                                                         
Net income
    -       -       -       -       82,472       -       82,472  
                                                         
Net change in accumulated other comprehensive
                                                       
   income
    -       -       -       -       -       1,080       1,080  
                                                         
Dividend declared Common Stock:
                                                       
         Class A ($0.154 per share)
    -       -       -       -       (2,874 )     -       (2,874 )
         Class B ($0.140 per share)
    -       -       -       -       (322 )     -       (322 )
                                                         
Stock options exercised, net of shares redeemed
    6       -       2       183       (68 )     -       117  
                                                         
Conversion of Class B Common Stock to Class A
                                                       
   Common Stock
    1       (1 )     -       -       -       -       -  
                                                         
Notes receivable on Common Stock, net of
                                                       
   cash payments
    -       -       -       197       -       -       197  
                                                         
Deferred director compensation expense -
                                                       
   Company Stock
    3       -       -       54       -       -       54  
                                                         
Stock based compensation expense
    -       -       -       402       -       -       402  
                                                         
Balance, March 31, 2012
    18,662       2,299     $ 4,949     $ 132,318     $ 391,007     $ 5,219     $ 533,493  
 
 
See accompanying footnotes to consolidated financial statements.
 
 
6

 
 
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
THREE MONTHS ENDED MARCH 31, 2012 AND 2011 (in thousands)

   
2012
   
2011
 
OPERATING ACTIVITIES:
           
Net income
  $ 82,472     $ 71,412  
Adjustments to reconcile net income to net cash provided
               
    by operating activities:
               
      Depreciation, amortization and accretion, net
    3,057       2,583  
      Provision for loan losses
    11,170       18,082  
      Net gain on sale of mortgage loans held for sale
    (1,688 )     (708 )
      Origination of mortgage loans held for sale
    (52,245 )     (26,255 )
      Proceeds from sale of mortgage loans held for sale
    53,866       40,810  
      Net realized impairment of mortgage servicing rights
    12       -  
      Net realized (gain) loss on sales, calls and impairment of securities
    (56 )     279  
      Net gain on sale of other real estate owned
    (137 )     (151 )
      Writedowns of other real estate owned
    226       186  
      Deferred director compensation expense - Company Stock
    54       51  
      Stock based compensation expense
    402       105  
      Bargain purchase gain on acquisition
    (27,899 )     -  
      Net change in other assets and liabilities:
               
         Accrued interest receivable
    (699 )     (269 )
         Accrued interest payable
    (168 )     (225 )
         Other assets
    7,832       967  
         Other liabilities
    42,143       51,516  
              Net cash provided by operating activities
    118,342       158,383  
                 
INVESTING ACTIVITIES:
               
Net cash proceeds received in FDIC-assisted transaction
    846,399       -  
Purchases of securities available for sale
    (2,688 )     (149,222 )
Proceeds from calls, maturities and paydowns of securities available for sale
    54,652       44,044  
Proceeds from calls, maturities and paydowns of securities to be held to maturity
    1,031       2,469  
Proceeds from sales of securities available for sale
    35,224       -  
Proceeds from sales of other real estate owned
    6,270       2,613  
Net change in loans
    (73,072 )     (20,771 )
Net purchases of premises and equipment
    (1,371 )     (1,063 )
              Net cash provided by/(used in) investing activities
    866,445       (121,930 )
                 
FINANCING ACTIVITIES:
               
Net change in deposits
    (632,628 )     (277,981 )
Net change in securities sold under agreements to repurchase and other short-term borrowings
    (4,512 )     (59,524 )
Payments on Federal Home Loan Bank advances
    (541,037 )     (55,040 )
Proceeds from Federal Home Loan Bank advances
    20,000       45,000  
Net proceeds from Common Stock options exercised
    117       -  
Cash dividends paid
    (3,194 )     (2,964 )
              Net cash used in financing activities
    (1,161,254 )     (350,509 )
                 
NET CHANGE IN CASH AND CASH EQUIVALENTS
    (176,467 )     (314,056 )
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD
    362,971       786,371  
CASH AND CASH EQUIVALENTS AT END OF PERIOD
  $ 186,504     $ 472,315  
                 
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
               
Cash paid during the period for:
               
    Interest
  $ 6,535     $ 8,877  
    Income taxes
    1,037       64  
                 
SUPPLEMENTAL NONCASH DISCLOSURES
               
Transfers from loans to real estate acquired in settlement of loans
  $ 8,722     $ 5,436  
Loans provided for sales of other real estate owned
    382       533  
 

See accompanying footnotes to consolidated financial statements.
 
 
7

 
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – MARCH 31, 2012 AND 2011 (UNAUDITED) AND DECEMBER 31, 2011


1.
BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation – The consolidated financial statements include the accounts of Republic Bancorp, Inc. (the “Parent Company”) and its wholly-owned subsidiaries: Republic Bank & Trust Company (“RB&T”) and Republic Bank (collectively referred together with RB&T as the “Bank”), Republic Funding Company and Republic Invest Co. Republic Invest Co. includes its subsidiary, Republic Capital LLC. The consolidated financial statements also include the wholly-owned subsidiaries of RB&T: Republic Financial Services, LLC, TRS RAL Funding, LLC and Republic Insurance Agency, LLC. Republic Bancorp Capital Trust (“RBCT”) is a Delaware statutory business trust that is a wholly-owned unconsolidated finance subsidiary of Republic Bancorp, Inc. All companies are collectively referred to as “Republic” or the “Company.” All significant intercompany balances and transactions are eliminated in consolidation.

The accompanying unaudited consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, the financial statements do not include all of the information and footnotes required by U.S. generally accepted accounting principles (“GAAP”) for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for fair presentation have been included. Operating results for the three months ended March 31, 2012 are not necessarily indicative of the results that may be expected for the year ending December 31, 2012. For further information, refer to the consolidated financial statements and footnotes thereto included in Republic’s Form 10-K for the year ended December 31, 2011.

As of March 31, 2012, the Company was divided into three distinct business operating segments: Traditional Banking, Mortgage Banking and Tax Refund Solutions.

Traditional Banking and Mortgage Banking (collectively “Core Banking”)

Republic operates 43 banking centers, primarily in the retail banking industry, and conducted its operations predominately in metropolitan Louisville, Kentucky; central Kentucky; northern Kentucky; southern Indiana; metropolitan Tampa, Florida; metropolitan Cincinnati, Ohio; metropolitan Nashville, Tennessee and through an Internet banking delivery channel.

Effective January 27, 2012, RB&T assumed substantially all of the deposits and certain other liabilities and acquired certain assets of Tennessee Commerce Bank (“TCB”), headquartered in Franklin (Nashville MSA), Tennessee from the FDIC, as receiver for TCB. This acquisition represents a single banking center located in the Nashville MSA and represents RB&T’s initial entrance into the Tennessee market.

Core Banking results of operations are primarily dependent upon net interest income, which represents the difference between the interest income and fees on interest-earning assets and the interest expense on interest-bearing liabilities. Principal interest-earning Core Banking assets represent investment securities and real estate mortgage, commercial and consumer loans. Interest-bearing liabilities primarily consist of interest-bearing deposit accounts, securities sold under agreements to repurchase, as well as short-term and long-term borrowing sources.

Other sources of Core Banking income include service charges on deposit accounts, debit card interchange fee income, title insurance commissions, fees charged to customers for trust services and revenue generated from Mortgage Banking activities. Mortgage Banking activities represent both the origination and sale of loans in the secondary market and the servicing of loans for others. Additionally, in June 2011, the Bank commenced business in its newly established warehouse lending division. Through this division, the Bank provides short-term, revolving credit facilities to mortgage bankers across the nation. These credit facilities are secured by single family residential real estate loans.

Core Banking operating expenses consist primarily of salaries and employee benefits, occupancy and equipment expenses, communication and transportation costs, marketing and development expenses, Federal Deposit Insurance Corporation (“FDIC”) insurance expense, and various general and administrative costs. Core Banking results of operations are significantly impacted by general economic and competitive conditions, particularly changes in market interest rates, government laws and policies and actions of regulatory agencies.
 
 
8

 

Tax Refund Solutions

Republic, through its Tax Refund Solutions (“TRS”) segment, is one of a limited number of financial institutions that facilitates the payment of federal and state tax refund products through third-party tax preparers located throughout the U.S., as well as tax-preparation software providers. TRS’s three primary tax-related products have historically included: Electronic Refund Checks (“ERCs” or “ARs”), Electronic Refund Deposits (“ERDs” or “ARDs”) and Refund Anticipation Loans (“RALs”). Substantially all of the business generated by TRS occurs in the first quarter of the year. TRS traditionally operates at a loss during the second half of the year, during which the segment incurs costs preparing for the following year’s first quarter tax season.

As previously disclosed, effective December 8, 2011, RB&T entered into an agreement with the FDIC resolving its differences regarding the TRS operating segment. RB&T’s resolution with the FDIC was in the form of a Stipulation Agreement and a Consent Order (collectively, the “Agreement”). As part of the Agreement, RB&T and the FDIC settled all matters set out in the FDIC’s Amended Notice of Charges dated May 3, 2011 and the lawsuit filed against the FDIC by RB&T. As part of this settlement, RB&T agreed to discontinue its offering the RAL product by April 30, 2012, subsequent to the first quarter 2012 tax season.

ERCs/ERDs are products whereby a tax refund is issued to the taxpayer after RB&T has received the refund from the federal or state government. There is no credit risk or borrowing cost for RB&T associated with these products because they are only delivered to the taxpayer upon receipt of the refund directly from the Internal Revenue Service (“IRS”). Fees earned on ERCs/ERDs are reported as non interest income under the line item “Electronic Refund Check fees.”

RALs were short-term consumer loans offered to taxpayers that were secured by the customer’s anticipated tax refund, which represented the source of repayment. Prior to 2011, RB&T historically underwrote the RAL application utilizing the Debt Indicator (the “DI”) from the IRS in combination with an automated underwriting model utilizing information contained in the taxpayer’s tax return. The DI, which indicated whether an individual taxpayer would have any portion of the refund offset for delinquent taxes or other debts, such as unpaid child support or federally funded student loans, had historically been a meaningful underwriting component. In August 2010, the IRS announced that it would no longer provide tax preparers and associated financial institutions with the DI beginning with the first quarter 2011 tax season. In response to loss of access to the DI in 2011, RB&T significantly reduced the maximum RAL amount for individual customers, raised the RAL offering price to its customers and modified its underwriting and application requirements resulting in fewer RALs approved.

If a consumer’s RAL application was approved, RB&T advanced $1,500 of the taxpayer’s refund. As part of the RAL application process, each taxpayer signed an agreement directing the applicable taxing authority to send the taxpayer’s refund directly to RB&T. The refund received from the IRS or state taxing authority, if applicable, was used by RB&T to pay off the RAL. Any amount due the taxpayer above the amount of the RAL was remitted to the taxpayer once the refund was received by RB&T. The funds advanced by RB&T were generally repaid by the applicable taxing authority within two weeks. The fees earned on RALs were reported as interest income under the line item “Loans, including fees.”

RB&T’s discontinuance of RALs beyond 2012 is expected to have a material adverse impact on net income in 2013 and beyond, as the RAL product accounted for approximately 32.3% and 35.8% of the TRS segment’s three months ended March 31, 2012 and 2011 net income. It is expected that TRS will continue to be a material contributor to the Company’s overall net income in 2013 and beyond. Actual TRS net income for 2012 and beyond will be impacted by a number of factors, including those factors disclosed from time to time in the Company’s filings with the SEC and set forth under Part I Item 1A “Risk Factors” of the Company’s 2011 Form 10-K.

For additional discussion regarding the Consent Order, see the Company’s Form 8-K filed with the SEC on December 9, 2011, including Exhibits 10.1 and 10.2.

For additional discussion regarding TRS, see the following sections:
          Part I Item 1 “Financial Statements:”
o          Footnote 4 “Loans and Allowance for Loan Losses”
o          Footnote 5 “Deposits”
o          Footnote 6 “Federal Home Loan Bank Advances”
o          Footnote 11 “Segment Information”
 
 
9

 
 
Recently Adopted Accounting Pronouncements:

In May, 2011, the FASB issued an amendment to achieve common fair value measurement and disclosure requirements between U.S. and International accounting principles. Overall, the guidance is consistent with existing U.S. accounting principles; however, there are some amendments that change a particular principle or requirement for measuring fair value or for disclosing information about fair value measurements. The amendments in this guidance are effective for interim and annual reporting periods beginning after December 15, 2011. The effect of adopting this standard did not have a material effect on the Company’s operating results or financial condition, but the additional disclosures are included in Footnote 7.

In June 2011, the FASB amended existing guidance and eliminated the option to present the components of other comprehensive income as part of the statement of changes in shareholder’s equity. The amendment requires that comprehensive income be presented in either a single continuous statement or in two separate consecutive statements. The amendments in this guidance are effective as of the beginning of a fiscal reporting year, and interim periods within that year, that begins after December 15, 2011. The adoption of this amendment changed the presentation of the statement of comprehensive income for the Company to one continuous statement. The adoption of this amendment had no impact on the consolidated financial statements as the prior presentation of comprehensive income was in compliance with this amendment.

Summary of New Significant Accounting Policies:

Purchased Credit Impaired Loans – Purchased credit impaired loans acquired in a business combination are recorded at estimated fair value on their purchase date with no carryover of the related allowance for loan losses. In determining the estimated fair value of these loans, management considers a number of factors including, the remaining life of the acquired loans, estimated prepayments, estimated future credit losses, estimated value of the underlying collateral, estimated holding periods and the net present value of the cash flows expected to be received. To the extent that any smaller dollar purchased credit impaired loan is not specifically reviewed, when evaluating the net present value of the future estimated cash flows, management applies a loss estimate to that loan based on the average expected loss rates for the loans that were individually reviewed in that loan portfolio, adjusted for other factors, as applicable.

As provided for under GAAP, management has up to twelve months following the date of the acquisition to finalize the fair values of acquired assets and assumed liabilities. Material events that occur during the measurement period will be analyzed to determine if the new information reflected facts and circumstances that existed as of the acquisition date that if known, would have affected the measurement of fair value of the amounts recognized as of the acquisition date. The measurement period ends as soon as the Company receives the information it was seeking about facts and circumstances that existed as of the acquisition date or learns more information is not obtainable. The measurement period is limited to one year from the acquisition date. Once management has finalized the fair values of acquired assets and assumed liabilities within this twelve month period, management considers such values to be the “Day One Fair Values.”

The non-accretable difference represents the difference between the contractually required payments and the cash flows expected to be collected in accordance with management’s determination of the Day One Fair Values. Subsequent decreases to the expected cash flows will generally result in a provision for loan losses. Subsequent increases in cash flows will result in a reversal of the provision for loan losses to the extent of prior charges with a corresponding adjustment to the accretable yield, which would have a positive impact on interest income.

The accretable difference on purchased credit impaired loans represents the difference between the expected cash flows and the net present value of expected cash flows. Such difference is accreted into earnings using the level-yield method over the expected cash flow periods of the loans. In determining the net present value of the expected cash flows, the Bank used discount rates depending on loan risk characteristics.

Management separately monitors the purchased credit impaired loan portfolio and on a quarterly basis reviews loans contained within this portfolio against the factors and assumptions used in determining the Day One Fair Values. In addition to its quarterly evaluation, a loan is typically reviewed (i) when it is modified or extended, (ii) when material information becomes available to the Bank that provides additional insight regarding the loan’s performance, the status of the borrower, or the quality or value of the underlying collateral, or (iii) in conjunction with the quarterly review of projected cash flows which include a substantial portion of each acquired loan portfolio.

Reclassifications and recasts – Certain amounts presented in prior periods have been reclassified to conform to the current period presentation. These reclassifications had no impact on prior years’ net income. Additionally, as discussed above and in Footnote 2 “Bank Acquisition,” the Company may make future adjustments to the acquired assets and assumed liabilities for its FDIC-assisted acquisition in the determination of Day One Fair Values. As a result, certain amounts reported in this filing may be recast in the future.
 
 
10

 

2.           BANK ACQUISITION

On January 27, 2012 (the “Acquisition Date”), RB&T assumed substantially all of the deposits and certain other liabilities and acquired certain assets of Tennessee Commerce Bank (“TCB”), headquartered in Franklin (Nashville MSA), Tennessee from the FDIC, as receiver for TCB, pursuant to the terms of a Purchase and Assumption Agreement — Whole Bank; All Deposits (the “P&A Agreement”), entered into among RB&T, the FDIC as receiver of TCB and the FDIC. On January 30, 2012, TCB’s sole location re-opened as a division of RB&T. No capital was raised to complete this transaction, as the Company has grown capital through the retention of earnings which the Company can use to take advantage of such acquisition opportunities.

RB&T has determined that the acquisition constitutes a business acquisition as defined by the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 805, Business Combinations. Accordingly, the assets acquired and liabilities assumed are presented at their estimated fair values as required. Fair values were determined based on the requirements of ASC Topic 820, Fair Value Measurements. In many cases, the determination of these fair values required management to make estimates about discount rates, future expected cash flows, market conditions and other future events that are highly subjective in nature and subject to change.

The assets acquired and liabilities assumed in the transaction are presented at estimated fair value on the Acquisition Date. These fair value estimates are considered preliminary, and are subject to change for up to one year after the closing date of the acquisition, as additional information relative to Acquisition Date fair values becomes available. Due to the compressed due diligence period of a FDIC acquisition, the measurement period analysis of information that may be reflective of conditions existing as of the acquisition date generally extends longer within the one year measurement period compared to non-assisted transactions. The difference is attributable to the fact that FDIC assisted transactions are marketed for 2-4 weeks with on-site due diligence limited to 2-3 days while traditional non-assisted transactions generally have a 3-6 month due diligence and regulatory approval period prior to the acquisition. RB&T and the FDIC are engaged in on-going discussions that may impact, to an immaterial degree, which assets and liabilities are ultimately acquired or assumed by RB&T and/or the purchase prices. In addition, the tax treatment of FDIC assisted acquisitions is complex and subject to interpretations that may result in future adjustments of deferred taxes as of the Acquisition Date. At the Acquisition Date, a deferred tax liability of approximately $10 million was recorded in other liabilities.

RB&T acquired approximately $221 million in gross assets from the FDIC as receiver for TCB. In addition, RB&T also recorded a receivable from the FDIC for approximately $785 million, which represented the net difference between the assets acquired and the liabilities assumed adjusted for the discount RB&T received for the transaction. The FDIC paid approximately $771 million of this receivable on January 30, 2012 with the remaining $14 million paid on February 15, 2012.
 
 
11

 

A summary of the net assets acquired from the FDIC and the estimated fair value adjustments as of January 27, 2012 follows:
 
(in thousands)
 
January 27, 2012
 
       
Assets acquired, at contractual amount
  $ 221,126  
Liabilities assumed, at contractual amount
    (948,701 )
Net liabilities assumed per the Purchase and Assumption Agreement
    (727,575 )
         
Contractual Discount
    (56,970 )
Net receivable from the FDIC
  $ (784,545 )
         
Fair value adjustments:
       
    Loans
  $ (22,666 )
    Discount for loans to be repurchased by the FDIC
    (2,797 )
    Other real estate owned
    (3,359 )
    Other assets and accrued interest receivable
    (60 )
    Core deposit intangible
    64  
    Deposits
    (54 )
    All other
    (199 )
Total fair value adjustments
    (29,071 )
         
Discount
    56,970  
Bargain purchase gain, pre-tax
  $ 27,899  
 
 
12

 
 
Assets acquired and liabilities assumed as of March 31, 2012 and January 27, 2012 follows:

           
January 27, 2012
 
                 
Fair
         
           
Contractual
   
Value
   
Fair
 
(in thousands)
 
March 31, 2012
   
Amount
   
Adjustments
   
Value
 
ASSETS
                           
                             
Cash and cash equivalents
  $ 93,990       $ 61,943       (89 )   $ 61,854    
Securities available for sale
    4,357         42,646       -       42,646    
Loans to be repurchased by the FDIC, net of discount
    17,003         19,800       (2,797 )     17,003    
Loans
    49,933         79,112       (22,666 )     56,446    
Federal Home Loan Bank stock, at cost
    2,459         2,491       -       2,491    
Other assets and accrued interest receivable
    1,333         945       (60 )     885    
Other real estate owned
    6,188         14,189       (3,359 )     10,830    
Core deposit intangible
    64         -       64       64    
Discount
    -         (56,970 )     56,970       -    
FDIC settlement receivable
    -         784,545       -       784,545    
TOTAL ASSETS ACQUIRED
  $ 175,327       $ 948,701     $ 28,063     $ 976,764    
                                     
LIABILITIES
                                   
                                     
Deposits
                                   
    Non interest-bearing
  $ 27,537       $ 19,754     $ -     $ 19,754    
    Interest-bearing
    111,717         927,641       54       927,695    
Total deposits
    139,254         947,395       54       947,449    
                                     
Accrued income taxes payable
    9,670         -       9,988       9,988    
Other liabilities and accrued interest payable
    9,085         1,306       110       1,416    
                                     
TOTAL LIABILITIES ASSUMED
  $ 158,009       $ 948,701     $ 10,152     $ 958,853    
                                     
EQUITY
                                   
                                     
Bargain purchase gain, net of taxes
    17,911         -       17,911       17,911    
Other operating loss, net of taxes
    (572 )       -       -       -    
Accumulated other comprehensive loss
    (21 )       -       -       -    
                                     
TOTAL LIABILITIES ASSUMED AND EQUITY
  $ 175,327       $ 948,701     $ 28,063     $ 976,764    
                                     
 
 
13

 
 
The following is a description of the methods used to determine the fair values of significant assets and liabilities at Acquisition Date presented above.

Cash and Due from Banks and Interest-bearing Deposits in Banks – RB&T acquired $62 million in cash and cash equivalents. The carrying amount of these assets, adjusted for any cash items deemed uncollectible by management, was determined to be a reasonable estimate of fair value based on their short-term nature.

Investment Securities – RB&T acquired $43 million in securities at fair value. The majority of the securities acquired were subsequently sold during the first quarter of 2012 with RB&T realizing a net gain on the corresponding sales of approximately $56,000. Investment securities were acquired at their fair values from the FDIC. The fair values provided by the FDIC were reviewed and considered reasonable based on RB&T’s understanding of the marketplace. Federal Home Loan Bank stock was acquired at cost. It is not practicable to determine its fair value given restrictions on its marketability.

Loans – RB&T purchased approximately $99 million in loans with a fair value of approximately $73 million. The loans acquired by RB&T consist of residential real estate, commercial real estate, real estate construction, commercial and consumer loans. Subsequent to the Acquisition Date, the FDIC agreed to repurchase approximately $20 million of TCB loans at a price of par less the original discount that RB&T received when it purchased the loans on the Acquisition Date of $3 million.

Fair values for loans were based on a discounted cash flow methodology that considered factors including the type of loan and related collateral, classification status, fixed or variable interest rate, term of loan and whether or not the loan was amortizing, and a discount rate reflecting current market rates for new originations of comparable loans adjusted for the risk inherent in the cash flow estimates.

Certain loans that were deemed to be collateral dependent were valued based on the fair value of the underlying collateral. These estimates were based on the most recently available real estate appraisals with certain adjustments made based on the type of property, age of appraisal, current status of the property and other related factors to estimate the current value of the collateral.

Information obtained subsequent to January 27, 2012 through April 11, 2012 was considered in forming estimates of cash flows and collateral values as of the Acquisition Date.

The composition of acquired loans at January 27, 2012 follows:
 
   
Contractual
   
Fair Value
   
Fair
 
(in thousands)
 
Amount
   
Adjustments
   
Value
 
                   
Residential real estate
  $ 23,217     $ (4,076 )   $ 19,141  
Commercial real estate
    18,122       (6,971 )     11,151  
Real estate construction
    14,877       (2,681 )     12,196  
Commercial
    13,224       (6,939 )     6,285  
Home equity
    6,220       (606 )     5,614  
Consumer:
                       
    Credit cards
    608       (22 )     586  
    Overdrafts
    672       (621 )     51  
    Other consumer
    2,172       (750 )     1,422  
Total loans
  $ 79,112     $ (22,666 )   $ 56,446  
 
 
14

 
 
Loans purchased in the TCB acquisition are accounted for using one of two following accounting standards:

 
ASC Topic 310-20 is used to value loans that have not demonstrated post origination credit quality deterioration and the acquirer expects to collect all contractually required payments from the borrower. For these loans, the difference between the fair value of the loan at acquisition and the amortized cost of the loan would be amortized or accreted into income using the interest method.

 
ASC Topic 310-30 is used to value loans with post origination credit quality deterioration. For these loans, it is probable the acquirer will be unable to collect all contractually required payments from the borrower. Under ASC 310-30, the expected cash flows that exceed the initial investment in the loan (fair value) represent the “accretable yield,” which is recognized as interest income on a level-yield basis over the expected cash flow periods of the loans.

The following table presents the purchased loans that are included within the scope of ASC Topic 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality as of January 27, 2012:

 (in thousands)
     
       
Contractually-required principal and interest payments
  $ 52,278  
Non-accretable difference
    (21,308 )
Accretable yield
    (425 )
   Fair value of loans
    30,545  
 
RB&T utilized information obtained subsequent to January 27, 2012 through April 11, 2012 to finalize its fair value estimate for the assets acquired and liabilities assumed in the TCB transaction as of the Acquisition Date.

Loans to be repurchased by the FDIC were valued at the contractual amount reduced by the applicable discount.

In addition to the loans acquired by RB&T as part of the Agreement, RB&T is required to service TCB loans retained by the FDIC. The balance of these loans totaled $740 million at March 31, 2012. RB&T shall service these loans on behalf of the FDIC for a period of one year from the Acquisition Date, unless they are sold or transferred at an earlier time by the FDIC. Also, as part of the Agreement, the FDIC will reimburse RB&T for servicing the loans based upon an agreed upon fee, which approximates the servicing costs. Since the FDIC is reimbursing RB&T for its approximate costs to service the loans, a servicing asset/liability was not recorded as of the Acquisition Date nor is one expected to be recorded in the future.

Core Deposit Intangible – In its assumption of the deposit liabilities, RB&T believed that the customer relationships associated with these deposits had intangible value, although this value was anticipated to be modest given the nature of the deposit accounts and the anticipated rapid account run-off since realized. RB&T recorded a core deposit intangible asset of $64,000. This intangible asset represents the value of the relationships that TCB had with their deposit customers. The fair value of this intangible asset was estimated based on a discounted cash flow methodology that gave appropriate consideration to type of deposit, deposit retention, cost of the deposit base, and net maintenance cost attributable to customer deposits.

OREO – RB&T acquired $14 million in OREO related to the TCB acquisition, which was reduced by a $3 million fair value adjustment as of the Acquisition Date. OREO is presented at fair value, which is the estimated value that management expects to receive when the property is sold, net of related costs to sell. These estimates were based on the most recently available real estate appraisals, with certain adjustments made based on the type of property, age of appraisal, current status of the property and other related factors to estimate the current value of the property. Information obtained subsequent to January 27, 2012 through April 11, 2012 was considered in forming the estimates of the fair value of the OREO acquired. Included in this information were actual sales of OREO properties totaling $4.6 million between the Acquisition Date and April 11, 2012, as well as OREO properties under contract to be sold as of April 11, 2012 totaling $3.7 million.

Deposits – RB&T assumed $947 million in deposits at estimated fair value. As permitted by the FDIC, RB&T had the option to re-price the acquired deposit portfolios within seven days of the Acquisition Date. In addition, depositors had the option to withdraw funds without penalty. RB&T chose to re-price all of the acquired interest-bearing deposits, including transaction, time and brokered deposits. This re-pricing triggered time and brokered deposit run-off in-line with management’s expectations. Through March 31, 2012, approximately 85% of the assumed interest bearing deposit account balances had exited RB&T, with no penalty on the applicable time and brokered deposits. At March 31, 2012, RB&T had $139 million of deposits remaining from the TCB acquisition. The fair values used for the demand and savings deposits that comprise the transaction accounts acquired, by definition, equal the amount payable on demand at the Acquisition Date. The fair values for time deposits are estimated using a discounted cash flow calculation that applies interest rates currently being offered to the interest rates embedded on such time deposits. Information obtained subsequent to January 27, 2012 through April 11, 2012, was considered in forming estimates of cash flows for the deposit liabilities assumed as of the Acquisition Date.
 
 
15

 
 
The composition of deposits assumed at fair value at January 27, 2012 follows:
 
   
Contractual
   
Fair Value
   
Fair
 
(in thousands)
 
Amount
   
Adjustments
   
Value
 
                   
Non Interest Bearing
  $ 19,754     $ -     $ 19,754  
Demand (NOW)
    3,190       -       3,190  
Money market accounts
    11,338       -       11,338  
Savings
    91,859       -       91,859  
Individual retirement accounts*
    33,063       -       33,063  
Certificates of deposit*
    369,251       14       369,265  
Brokered deposits*
    418,940       40       418,980  
                         
    Total deposits
  $ 947,395     $ 54     $ 947,449  
                         
_________________
                       
* - denotes a time deposit
                       
 
With regard to the TCB acquisition, RB&T expects to incur acquisition and integration costs of approximately $2.1 million, with $636,000 of this expense recognized during the quarter ended March 31, 2012. Included in the total amount is $728,000 for estimated short-term retention bonuses for certain former TCB employees and short-term incentive bonuses for existing RB&T employees related to a successful branch consolidation and core system conversion scheduled for July 2012. In addition, the total also includes $418,000 for estimated professional and consulting fees, as well as $945,000 for a long-term incentive program for RB&T employees based upon a 2-year profitability target for the overall TCB operation.

Management believes that RB&T will achieve on-going direct operating expenses for the one-location TCB franchise, in addition to the acquisition and integration costs just discussed, in a range of $60,000 to $70,000 per month subsequent to the branch consolidation and core system conversion scheduled for July 2012.
 
 
16

 
 
3.             INVESTMENT SECURITIES

Securities available for sale:

The gross amortized cost and fair value of securities available for sale and the related gross unrealized gains and losses recognized in accumulated other comprehensive income (loss) were as follows:
 
   
Gross
   
Gross
   
Gross
       
   
Amortized
   
Unrealized
   
Unrealized
   
Fair
 
March 31, 2012 (in thousands)
 
Cost
   
Gains
   
Losses
   
Value
 
                         
U.S. Treasury securities and
                       
    U.S. Government agencies
  $ 131,956     $ 838     $ -     $ 132,794  
Private label mortgage backed security
    5,818       -       (1,298 )     4,520  
Mortgage backed securities - residential
    271,082       7,051       (7 )     278,126  
Collateralized mortgage obligations
    186,374       1,843       (397 )     187,820  
Total securities available for sale
  $ 595,230     $ 9,732     $ (1,702 )   $ 603,260  
                                 
                                 
   
Gross
   
Gross
   
Gross
         
   
Amortized
   
Unrealized
   
Unrealized
   
Fair
 
December 31, 2011 (in thousands)
 
Cost
   
Gains
   
Losses
   
Value
 
                                 
U.S. Treasury securities and
                               
    U.S. Government agencies
  $ 152,085     $ 814     $ (225 )   $ 152,674  
Private label mortgage backed security
    5,818       -       (1,276 )     4,542  
Mortgage backed securities - residential
    287,013       6,343       (27 )     293,329  
Collateralized mortgage obligations
    194,663       1,281       (541 )     195,403  
Total securities available for sale
  $ 639,579     $ 8,438     $ (2,069 )   $ 645,948  
 
Mortgage backed Securities

At March 31, 2012, with the exception of the $4.5 million private label mortgage backed and other private label mortgage-related securities, all other mortgage backed securities held by the Bank were issued by U.S. government-sponsored entities and agencies, primarily Federal Home Loan Mortgage Corporation (“Freddie Mac” or “FHLMC”) and Fannie Mae (“FNMA”), institutions that the government has affirmed its commitment to support. At March 31, 2012 and December 31, 2011, there were gross unrealized losses of $404,000 and $568,000 related to available for sale and held to maturity mortgage backed securities other than the private label mortgage backed and other private label mortgage-related securities. Because the decline in fair value of these mortgage backed securities is attributable to changes in interest rates and illiquidity, and not credit quality, and because the Bank does not have the intent to sell these mortgage backed securities, and it is likely that it will not be required to sell the securities before their anticipated recovery, management does not consider these securities to be other-than-temporarily impaired.

As mentioned throughout this filing, the Bank’s mortgage backed securities portfolio includes private label mortgage backed and other private label mortgage-related securities with a fair value of $4.5 million that had gross unrealized losses of approximately $1.3 million at March 31, 2012 and $1.3 million at December 31, 2011. As of March 31, 2012, the Bank believes there is no further credit loss component of OTTI in addition to that which has already been recorded. Additionally, the Bank does not have the intent to sell these securities and it is likely that it will not be required to sell the securities before their anticipated recovery.
 
 
17

 
 
Securities to be held to maturity:

The carrying value, gross unrecognized gains and losses, and fair value of securities to be held to maturity were as follows:

         
Gross
   
Gross
       
   
Carrying
   
Unrecognized
   
Unrecognized
   
Fair
 
March 31, 2012 (in thousands)
 
Value
   
Gains
   
Losses
   
Value
 
                         
U.S. Treasury securities and
                       
    U.S. Government agencies
  $ 4,227     $ -     $ -     $ 4,227  
Mortgage backed securities - residential
    1,260       101       -       1,361  
Collateralized mortgage obligations
    21,551       239       -       21,790  
Total securities to be held to maturity
  $ 27,038     $ 340     $ -     $ 27,378  
                                 
                                 
           
Gross
   
Gross
         
   
Carrying
   
Unrecognized
   
Unrecognized
   
Fair
 
December 31, 2011 (in thousands)
 
Value
   
Gains
   
Losses
   
Value
 
                                 
U.S. Treasury securities and
                               
    U.S. Government agencies
  $ 4,233     $ 18     $ (10 )   $ 4,241  
Mortgage backed securities - residential
    1,376       101       -       1,477  
Collateralized mortgage obligations
    22,465       159       -       22,624  
Total securities to be held to maturity
  $ 28,074     $ 278     $ (10 )   $ 28,342  
 
During the three months ended March 31, 2012, the Bank recognized net securities gains in earnings for securities available for sale as follows:

 
The Bank sold six available for sale securities acquired in the TCB acquisition with an amortized cost of $35 million, resulting in a pre-tax gain of $53,000.
 
The Bank realized $3,000 in pre-tax gains related to unamortized discount accretion on $10 million of callable U.S. Government agencies that were called during the first quarter of 2012 before their maturity.

During the three months ended March 31, 2011, there were no sales or calls of securities available for sale. The tax provision related to the Bank’s realized gains totaled $20,000 and $0 for the three months ended March 31, 2012 and 2011, respectively.

The amortized cost and fair value of the investment securities portfolio by contractual maturity at March 31, 2012 follows. Expected maturities may differ from contractual maturities if borrowers have the right to call or prepay obligations with or without call or prepayment penalties. Securities not due at a single maturity date are detailed separately.
 
   
Securities
   
Securities
 
   
available for sale
   
held to maturity
 
   
Amortized
   
Fair
   
Carrying
   
Fair
 
March 31, 2012 (in thousands)
 
Cost
   
Value
   
Value
   
Value
 
                         
Due in one year or less
  $ -     $ -     $ 188     $ 188  
Due from one year to five years
    131,956       132,794       4,039       4,043  
Due from five years to ten years
    -       -       -       -  
Due beyond ten years
    -       -       -       -  
Private label mortgage backed security
    5,818       4,520       -       -  
Mortgage backed securities - residential
    271,082       278,126       1,260       1,361  
Collateralized mortgage obligations
    186,374       187,820       21,551       21,790  
Total securities
  $ 595,230     $ 603,260     $ 27,038     $ 27,382  
 
 
18

 
 
At March 31, 2012 and December 31, 2011, there were no holdings of securities of any one issuer, other than the U.S. Government and its agencies, in an amount greater than 10% of stockholders’ equity.

Market Loss Analysis

Securities with unrealized losses at March 31, 2012 and December 31, 2011, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, are as follows:
 
   
Less than 12 months
   
12 months or more
   
Total
 
March 31, 2012 (in thousands)
 
Fair Value
   
Unrealized Losses
   
Fair Value
   
Unrealized Losses
   
Fair Value
   
Unrealized Losses
 
                                     
U.S. Treasury securities and
                                   
    U.S. Government agencies
  $ -     $ -     $ -     $ -     $ -     $ -  
Private label mortgage backed security
    -       -       4,520       (1,298 )     4,520       (1,298 )
Mortgage backed securities - residential,
                                               
   including Collateralized mortgage obligations
    79,256       (185 )     8,368       (219 )     87,624       (404 )
                                                 
Total
  $ 79,256     $ (185 )   $ 12,888     $ (1,517 )   $ 92,144     $ (1,702 )
                                                 
   
Less than 12 months
   
12 months or more
   
Total
 
December 31, 2011 (in thousands)
 
Fair Value
   
Unrealized Losses
   
Fair Value
   
Unrealized Losses
   
Fair Value
   
Unrealized Losses
 
                                                 
U.S. Treasury securities and
                                               
    U.S. Government agencies
  $ 60,547     $ (235 )   $ -     $ -     $ 60,547     $ (235 )
Private label mortgage backed security
    -       -       4,542       (1,276 )     4,542       (1,276 )
Mortgage backed securities - residential,
                                               
   including Collateralized mortgage obligations
    136,775       (568 )     -       -       136,775       (568 )
                                                 
Total
  $ 197,322     $ (803 )   $ 4,542     $ (1,276 )   $ 201,864     $ (2,079 )
 
At March 31, 2012, the Bank’s security portfolio consisted of 155 securities, 19 of which were in an unrealized loss position. The majority of unrealized losses are related to the Bank’s mortgage backed securities, as discussed in this section of the filing.

Other-than-temporary impairment (“OTTI”)

Unrealized losses for all investment securities are reviewed to determine whether the losses are “other-than-temporary.” Investment securities are evaluated for OTTI on at least a quarterly basis and more frequently when economic or market conditions warrant such an evaluation to determine whether a decline in their value below amortized cost is other-than-temporary. In conducting this assessment, the Bank evaluates a number of factors including, but not limited to:

      The length of time and the extent to which fair value has been less than the amortized cost basis;
      The Bank’s intent to hold until maturity or sell the debt security prior to maturity;
      An analysis of whether it is more likely than not that the Bank will be required to sell the debt security before its anticipated recovery;
      Adverse conditions specifically related to the security, an industry, or a geographic area;
      The historical and implied volatility of the fair value of the security;
      The payment structure of the security and the likelihood of the issuer being able to make payments;
      Failure of the issuer to make scheduled interest or principal payments;
      Any rating changes by a rating agency; and
      Recoveries or additional decline in fair value subsequent to the balance sheet date.
 
 
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The term “other-than-temporary” is not intended to indicate that the decline is permanent, but indicates that the prospects for a near-term recovery of value are not necessarily favorable, or that there is a general lack of evidence to support a realizable value equal to or greater than the carrying value of the investment. Once a decline in value is determined to be other-than-temporary, the value of the security is reduced and a corresponding charge to earnings is recognized for the anticipated credit losses.

Nationally, residential real estate values have declined significantly since 2007. These declines in value, coupled with the reduced ability of certain homeowners to refinance or repay their residential real estate obligations, have led to elevated delinquencies and losses in residential real estate loans. Many of these loans have previously been securitized and sold to investors as private label mortgage backed and other private label mortgage-related securities. The Bank owns one private label mortgage backed security with a total carrying value of $5.8 million at March 31, 2012. This security is mostly backed by “Alternative A” first lien mortgage loans and is backed with an insurance “wrap” or guarantee with an average life currently estimated at four years. Due to current market conditions, this asset remain extremely illiquid, and as such, the Bank determined I to be a Level 3 security in accordance with FASB ASC topic 820, “Fair Value Measurements and Disclosures.” Based on this determination, the Bank utilized an income valuation model (present value model) approach, in determining the fair value of these securities. This approach is beneficial for positions that are not traded in active markets or are subject to transfer restrictions, and/or where valuations are adjusted to reflect illiquidity and/or non-transferability. Such adjustments are generally based on available market evidence. In the absence of such evidence, management’s best estimate is used. Management’s best estimate consists of both internal and external support for these investments. See Footnote 7, “Fair Value” for additional discussion.

Further deterioration in economic conditions could cause the Bank to record additional impairment charges related to credit losses of up to $5.8 million, which is the current gross amortized cost of the Bank’s one private label mortgage-related security.

Pledged Investment Securities

Investment securities pledged to secure public deposits, securities sold under agreements to repurchase and securities held for other purposes, as required or permitted by law are as follows:

(in thousands)
 
March 31, 2012
   
December 31, 2011
 
             
Carrying amount
  $ 518,037     $ 613,927  
Fair value
    526,109       620,922  
 
 
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4.           LOANS AND ALLOWANCE FOR LOAN LOSSES

The composition of the loan portfolio follows:
 
(in thousands)
 
March 31, 2012
   
December 31, 2011
 
             
Residential real estate:
           
      Owner occupied
  $ 1,069,601     $ 985,735  
      Non owner occupied
    90,973       99,161  
Commercial real estate
    650,735       639,966  
Commercial real estate - purchased whole loans
    33,073       32,741  
Real estate construction
    73,301       67,406  
Commercial
    125,960       119,117  
Warehouse lines of credit
    59,850       41,496  
Home equity
    267,591       280,235  
Consumer:
               
     Credit cards
    8,465       8,580  
     Overdrafts
    757       950  
     Other consumer
    14,481       9,908  
                 
Total loans
    2,394,787       2,285,295  
Less: Allowance for loan losses
    23,732       24,063  
                 
Total loans, net
  $ 2,371,055     $ 2,261,232  
 
As discussed under Footnote 2“Bank Acquisition,” the above loan balances at March 31, 2012, contain $50 million related to the TCB acquisition.

The composition of loans acquired in the TCB transaction outstanding at March 31, 2012 follows:
 
(in thousands)
 
March 31, 2012
 
       
Residential real estate
  $ 18,448  
Commercial real estate
    11,106  
Real estate construction
    8,037  
Commercial
    4,903  
Home equity
    5,400  
Consumer:
       
    Credit cards
    639  
    Overdrafts
    92  
    Other consumer
    1,308  
Total loans
  $ 49,933  
 
 
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Credit Quality Indicators

Bank procedures for assessing and maintaining credit gradings differs slightly depending on whether a new or renewed loan is being underwritten, or whether an existing loan is being re-evaluated for potential credit quality concerns. The latter usually occurs upon receipt of updated financial information, or other pertinent data, that would potentially cause a change in the loan grade. Specific Bank procedures follow:

 
For new and renewed commercial and commercial real estate loans, the Bank’s Credit Administration Department, which acts independently of the loan officer, assigns the credit quality grade to the loan. Loan grades for new commercial and commercial real estate loans with an aggregate credit exposure of $1.5 million or greater are validated by the Senior Loan Committee (“SLC”). Loan grades for renewed commercial and commercial real estate loans with an aggregate credit exposure of $2 million or greater, are also validated by the SLC.

 
The SLC is chaired by the Chief Operating Officer of Commercial Banking (“COO”) and includes the Bank’s Chief Commercial Credit Officer (“CCCO”) and is attended by the Bank’s Chief Risk Management Officer (“CRMO”).

 
Commercial loan officers are responsible for reviewing their loan portfolios and reporting any adverse material changes to the CCCO. When circumstances warrant a review and possible change in the credit quality grade, loan officers are required to notify the Bank’s Credit Administration Department.

 
The COO meets monthly with commercial loan officers to discuss the status of past due loans and possible classified loans. These meetings are also designed to give the loan officers an opportunity to identify an existing loan that should be downgraded.

 
Monthly, members of senior management along with managers of Commercial Lending, Commercial Credit Administration, Special Assets and Retail Collections attend a Special Asset Committee (“SAC”) meeting. The SAC reviews all commercial and commercial real estate past due, classified, and impaired loans in excess of $100,000 and discusses the relative trends and current status of these assets. In addition, the SAC reviews all retail residential real estate loans exceeding $750,000 and all home equity loans exceeding $100,000 that are 80-days or more past due or that are on non-accrual status. SAC also reviews the actions taken by management regarding foreclosure mitigation, loan extensions, troubled debt restructures and collateral repossessions. Based on the information reviewed in this meeting, the SAC approves all specific loan loss allocations to be recognized by the Bank within its Allowance for Loan Loss analysis.

On at least an annual basis, the Bank’s internal loan review department analyzes all aggregate lending relationships with outstanding balances greater than $1 million that are internally classified as “Special Mention,” “Substandard,” “Doubtful” or “Loss.” In addition, for all “Pass” rated loans, the Bank analyzes, on at least an annual basis, all aggregate lending relationships with outstanding balances exceeding $4 million.

The Bank categorizes loans into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, public information, and current economic trends. The Bank also considers the fair value of the underlying collateral and the strength and willingness of the guarantor(s). The Bank analyzes loans individually and based on this analysis, establishes a credit risk rating. The Bank uses the following definitions for risk ratings:

Risk Grade 1 – Excellent (Pass): Loans fully secured by liquid collateral, such as certificates of deposit, reputable bank letters of credit, or other cash equivalents; loans fully secured by publicly traded marketable securities where there is no impediment to liquidation; or loans to any publicly held company with a current long-term debt rating of A or better.

Risk Grade 2 – Good (Pass): Loans to businesses that have strong financial statements containing an unqualified opinion from a CPA firm and at least three consecutive years of profits; loans supported by unaudited financial statements containing strong balance sheets, five consecutive years of profits, a five-year satisfactory relationship with the Bank, and key balance sheet and income statement trends that are either stable or positive; loans that are guaranteed or otherwise backed by the full faith and credit of United States government or an agency thereof, such as the Small Business Administration; or loans to publicly held companies with current long-term debt ratings of Baa or better.
 
 
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Risk Grade 3 – Satisfactory (Pass): Loans supported by financial statements (audited or unaudited) that indicate average or slightly below average risk and having some deficiency or vulnerability to changing economic conditions; loans with some weakness but offsetting features of other support are readily available; loans that are meeting the terms of repayment, but which may be susceptible to deterioration if adverse factors are encountered.

Loans may be graded Satisfactory when there is no recent information on which to base a current risk evaluation and the following conditions apply:

 
At inception, the loan was properly underwritten, did not possess an unwarranted level of credit risk, and the loan met the above criteria for a risk grade of Excellent, Good, or Satisfactory;

 
At inception, the loan was secured with collateral possessing a loan value within Loan Policy guidelines to protect the Bank from loss.

 
The loan has exhibited two or more years of satisfactory repayment with a reasonable reduction of the principal balance.

 
During the period that the loan has been outstanding, there has been no evidence of any credit weakness. Some examples of weakness include slow payment, lack of cooperation by the borrower, breach of loan covenants, or the borrower is in an industry known to be experiencing problems. If any of these credit weaknesses is observed, a lower risk grade may be warranted.

Risk Grade 4 – Satisfactory/Monitored (Pass): Loans in this category are considered to be of acceptable credit quality, but contain greater credit risk than Satisfactory loans due to weak balance sheets, marginal earnings or cash flow, or other uncertainties. These loans warrant a higher than average level of monitoring to ensure that weaknesses do not advance. The level of risk in a Satisfactory/Monitored loan is within acceptable underwriting guidelines so long as the loan is given the proper level of management supervision.

Risk Grade 5 – Special Mention: Loans that possess some credit deficiency or potential weakness that deserves close attention. Such loans pose an unwarranted financial risk that, if not corrected, could weaken the loan by adversely impacting the future repayment ability of the borrower. The key distinctions of a Special Mention classification are that (1) it is indicative of an unwarranted level of risk and (2) credit weaknesses are not defined impairments to the primary source of repayment and are consider potential.

Risk Grade 6 – Substandard: One or more of the following characteristics may be exhibited in loans classified Substandard:

 
Loans that possess a defined credit weakness. The likelihood that a loan will be paid from the primary source of repayment is uncertain. Financial deterioration is under way and very close attention is warranted to ensure that the loan is collected without loss.

 
Loans are inadequately protected by the current net worth and paying capacity of the obligor.

 
The primary source of repayment is gone, and the Bank is forced to rely on a secondary source of repayment, such as collateral liquidation or guarantees.

 
Loans have a distinct possibility that the Bank will sustain some loss if deficiencies are not corrected.

 
Unusual courses of action are needed to maintain a high probability of repayment.