PINX:PFLC Pacific Financial Corp 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

(Mark One)

xQUARTERLY 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) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from ____________ to ____________

 

Commission File Number 000-29829

 

PACIFIC FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

 

  Washington
(State or other jurisdiction of
incorporation or organization)

91-1815009
(IRS Employer Identification No.)

 

 

 

1101 S. Boone Street
Aberdeen, Washington 98520-5244
(360) 533-8870
(Address, including zip code, and telephone number,
including area code, of Registrant's principal executive offices)

 

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 website, if any, every Interactive Data File required to be submitted and posted to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes x No ¨

 

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

 

¨ Large Accelerated Filer ¨ Accelerated Filer ¨ Non-accelerated Filer x Smaller Reporting Company

 

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

 

The number of shares of the issuer's common stock, par value $1.00 per share, outstanding as of April 30, 2012, was 10,121,853 shares.

 

 
 

 

TABLE OF CONTENTS

 

PART I FINANCIAL INFORMATION 3
     
ITEM 1. FINANCIAL STATEMENTS (UNAUDITED) 3
     
  CONDENSED CONSOLIDATED BALANCE SHEETS  
  MARCH 31, 2012 AND DECEMBER 31, 2011 3
     
  CONDENSED CONSOLIDATED STATEMENTS OF INCOME  
  THREE MONTHS ENDED MARCH 31, 2012 AND 2011 4
     
  CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE  
  INCOME THREE MONTHS ENDED MARCH 31, 2012 AND 2011 5
     
  CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS  
  THREE MONTHS ENDED MARCH 31, 2012 AND 2011 6
     
  CONDENSED CONSOLIDATED STATEMENTS OF SHAREHOLDERS'  
  EQUITY THREE MONTHS ENDED MARCH 31, 2012 AND 2011 8
     
  NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS 9
     
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL  
  CONDITION AND RESULTS OF OPERATIONS 28
     
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 40
     
ITEM 4. CONTROLS AND PROCEDURES 41
     
PART II OTHER INFORMATION 41
     
ITEM 1. LEGAL PROCEEDINGS 41
     
ITEM 1A. RISK FACTORS 41
     
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS 41
     
ITEM 3. DEFAULTS UPON SENIOR SECURITIES 41
     
ITEM 4. MINE SAFETY DISCLOSURES 41
     
ITEM 5. OTHER INFORMATION 41
     
ITEM 6. EXHIBITS 42
     
  SIGNATURES 42

  

 
 

 

PART I – FINANCIAL INFORMATION

 

ITEM 1 – FINANCIAL STATEMENTS

 

PACIFIC FINANCIAL CORPORATION

Condensed Consolidated Balance Sheets

March 31, 2012 and December 31, 2011

(Dollars in thousands) (Unaudited)

 

   March 31, 2012   December 31, 2011 
Assets          
Cash and due from banks  $11,905   $12,607 
Interest bearing deposits in banks   39,341    28,525 
Investment securities available-for-sale (amortized cost of  $48,935 and $47,015)   49,515    47,652 
Investment securities held-to-maturity (fair value of $7,075  and $7,118)   6,997    7,025 
Federal Home Loan Bank stock, at cost   3,182    3,182 
Loans held for sale   11,581    14,541 
           
Loans   468,102    474,893 
Allowance for credit losses   10,863    11,127 
Loans, net   457,239    463,766 
           
Premises and equipment   14,754    14,884 
Other real estate owned   7,956    7,725 
Accrued interest receivable   2,407    2,156 
Cash surrender value of life insurance   17,406    17,275 
Goodwill   11,282    11,282 
Other intangible assets   1,268    1,268 
Other assets   9,842    9,366 
           
Total assets  $644,675   $641,254 
           
Liabilities and Shareholders' Equity          
Deposits:          
Demand, non-interest bearing  $98,286   $108,899 
Savings and interest-bearing demand   302,835    286,642 
Time, interest-bearing   149,298    152,509 
Total deposits   550,419    548,050 
           
Accrued interest payable   1,548    1,490 
Secured borrowings   727    741 
Short-term borrowings   3,000     
Long-term borrowings   7,500    10,500 
Junior subordinated debentures   13,403    13,403 
Other liabilities   3,794    3,800 
Total liabilities   580,391    577,984 
           
Commitments and Contingencies (Note 7)        
           
Shareholders' Equity          
Common Stock (par value $1); 25,000,000 shares authorized; 10,121,853 shares issued and outstanding at March 31, 2012 and December 31, 2011   10,122    10,122 
Additional paid-in capital   41,346    41,342 
Retained earnings   13,069    12,051 
Accumulated other comprehensive income (loss)   (253)   (245)
Total shareholders' equity   64,284    63,270 
           
Total liabilities and shareholders' equity  $644,675   $641,254 

 

See notes to condensed consolidated financial statements.

 

3
 

 

PACIFIC FINANCIAL CORPORATION

Condensed Consolidated Statements of Income

Three months ended March 31, 2012 and 2011

(Dollars in thousands, except per share data) (Unaudited)

 

   Three Months Ended
 March 31,
 
   2012   2011 
Interest and dividend income          
Loans  $6,546   $6,825 
Investment securities and FHLB dividends   470    516 
Deposits with banks and federal funds sold   18    24 
Total interest and dividend income   7,034    7,365 
           
Interest Expense          
Deposits   825    1,365 
Other borrowings   159    315 
Total interest expense   984    1,680 
           
Net Interest Income   6,050    5,685 
Provision for credit losses   100    500 
Net interest income after provision for credit losses   5,950    5,185 
           
Non-interest Income          
Service charges on deposits   413    414 
Net gain on sales of other real estate owned   172    3 
Gain on sales of loans   799    553 
Gain on sales of investments available-for-sale, net   10    110 
Net other-than-temporary impairment losses ( net of $192 and $429, respectively, recognized in other comprehensive income before taxes)   (70)   (193)
Earnings on bank owned life insurance   131    130 
Other operating income   393    316 
Total non-interest income   1,848    1,333 
           
Non-interest Expense          
Salaries and employee benefits   3,758    3,428 
Occupancy and equipment   613    644 
Other real estate owned write-downs   107    116 
Other real estate owned operating costs   122    92 
Professional services   157    175 
FDIC and State assessments   194    313 
Data processing   343    282 
Other   1,305    1,092 
Total non-interest expense   6,599    6,142 
           
Income before income taxes   1,199    376 
Income taxes (benefit)   181    (56)
           
Net Income  $1,018   $432 
           
Earnings per common share:          
Basic  $0.10   $0.04 
Diluted   0.10    0.04 
Weighted Average shares outstanding:          
Basic   10,121,853    10,121,853 
Diluted   10,121,861    10,121,853 

 

See notes to condensed consolidated financial statements.

  

4
 

 

PACIFIC FINANCIAL CORPORATION

Condensed Consolidated Statements of Comprehensive Income

Three months ended March 31, 2012 and 2011

(Dollars in thousands, except per share data) (Unaudited)

 

   Three Months Ended
 March 31,
 
   2012   2011 
         
Net income  $1,018   $432 
           
Other comprehensive income (loss), net of tax:          
Net unrealized gains (losses) on investment securities   (37)   258 
Defined benefit plans   29    23 
           
Other Comprehensive Income (Loss)   (8)   281 
           
Comprehensive Income  $1,010   $713 

 

See notes to condensed consolidated financial statements.

 

5
 

 

PACIFIC FINANCIAL CORPORATION

Condensed Consolidated Statements of Cash Flows

Three months ended March 31, 2012 and 2011

(Dollars in thousands)

(Unaudited)

 

   2012   2011 
OPERATING ACTIVITIES          
Net income  $1,018   $432 
Adjustments to reconcile net income to net cash provided by operating activities:          
Provision for credit losses   100    500 
Depreciation and amortization   498    407 
Origination of loans held for sale   (46,131)   (30,461)
Proceeds of loans held for sale   49,890    35,632 
Gain on sales of loans   (799)   (553)
Gain on sale of investments available-for-sale   (10)   (110)
Net OTTI losses recognized in earnings   70    193 
Net gain on sale of other real estate owned   (172)   (3)
Increase in accrued interest receivable   (251)   (208)
Increase in accrued interest payable   58    45 
Other real estate owned write-downs   107    116 
Additions to other real estate owned   (104)   (50)
Other, net   (718)   2,192 
Net cash provided by operating activities   3,556    8,132 
           
INVESTING ACTIVITIES          
Net (increase) decrease in interest bearing balances with banks   (10,816)   13,843 
Purchase of securities available-for-sale   (5,729)   (8,265)
Proceeds from maturities of investments held-to-maturity   27    30 
Proceeds from sales of securities available-for-sale   2,443    3,119 
Proceeds from maturities of securities available-for-sale   1,126    1,620 
Net (increase) decrease in loans   4,944    (5,540)
Proceeds from sales of other real estate owned   1,544    200 
Purchase of premises and equipment   (152)   (240)
Net cash provided by (used in) investing activities   (6,613)   4,767 
           
FINANCING ACTIVITIES          
Net increase (decrease) in deposits   2,369    (6,739)
Net decrease in secured borrowings   (14)   (145)
Net cash provided by (used in) financing activities   2,355    (6,884)
           
Net increase (decrease) in cash and due from banks   (702)   6,015 
           
Cash and due from Banks          
Beginning of period   12,607    7,428 
           
End of period  $11,905   $13,443 
           
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION          
Cash payments for:          
Interest  $926   $1,635 
Income taxes   916     

 

(continued)

  

6
 

 

SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING AND FINANCING ACTIVITIES          
Change in fair value of securities available-for-sale, net of tax  $(37)  $258 
Other real estate owned acquired in settlement of loans   (1,772)   (966)
Financed sale of other real estate owned   166    619 
Reclass of long-term borrowings to short-term borrowings   3,000     

 

 

See notes to condensed consolidated financial statements.

 

7
 

 

PACIFIC FINANCIAL CORPORATION

Condensed Consolidated Statements of Shareholders' Equity

Three months ended March 31, 2012 and 2011

(Dollars in thousands)

(Unaudited)

 

   Shares of
Common
Stock
   Common
Stock
   Additional
Paid-in
Capital
   Retained
Earnings
   Accumulated
Other
Comprehensive
Loss
   Total 
                         
Balance January 1, 2011   10,121,853   $10,122   $41,316   $9,233   $(902)  $59,769 
                               
Other comprehensive income:                              
Net income                  432         432 
Unrealized holding gain on securities less reclassification adjustment for net gains included in net income                       258    258 
Amortization of unrecognized prior service costs and net (gains)/losses                       23    23 
Comprehensive income                            713 
                               
Stock compensation expense             6              6 
                               
Balance March 31, 2011   10,121,853   $10,122   $41,322   $9,665   $(621)  $60,488 
                               
Balance January 1, 2012   10,121,853   $10,122   $41,342   $12,051   $(245)  $63,270 
                               
Other comprehensive income:                              
Net income                  1,018         1,018 
Unrealized holding gain on securities less reclassification adjustment for net gains included in net income                       (37)   (37)
Amortization of unrecognized prior service costs and net (gains)/losses                       29    29 
Comprehensive income                            1,010 
                               
Stock compensation expense             4              4 
                               
Balance March 31, 2012   10,121,853   $10,122   $41,346    13,069   $(253)  $64,284 

 

See notes to condensed consolidated financial statements.

  

8
 

 

PACIFIC FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

(Dollars in thousands, except per share amounts)

 

Note 1 – Basis of Presentation

 

The accompanying unaudited condensed consolidated financial statements have been prepared by Pacific Financial Corporation ("Pacific" or the "Company") in accordance with accounting principles generally accepted in the United States of America ("GAAP") for interim financial information and with instructions to Form 10-Q. Accordingly, these financial statements do not include all of the information and footnotes required by GAAP for complete financial statements. In the opinion of management, adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three months ended March 31, 2012, are not necessarily indicative of the results anticipated for the year ending December 31, 2012. Certain information and footnote disclosures included in the Company's consolidated financial statements for the year ended December 31, 2011, have been condensed or omitted from this report. Accordingly, these statements should be read in conjunction with the financial statements and notes thereto included in the Company's Annual Report on Form 10-K for the year ended December 31, 2011.

 

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates.

 

Note 2 – Earnings per Share

 

The following table illustrates the computation of basic and diluted earnings per share.

 

   Three Months Ended
March 31,
 
   2012   2011 
Basic:          
Net income  $1,018   $432 
Weighted average shares outstanding   10,121,853    10,121,853 
Basic earnings per share  $0.10   $0.04 
           

Diluted:

          
Net income  $1,018   $432 
Weighted average shares outstanding   10,121,853    10,121,853 
Effect of dilutive stock options   8     
Weighted average shares outstanding assuming dilution   10,121,861    10,121,853 
Diluted earnings per share  $0.10   $0.04 

 

As of March 31, 2012 and 2011, there were 524,107 and 616,608 shares, respectively, subject to outstanding options and 699,642 and 699,642 shares, respectively, subject to outstanding warrants with exercise prices in excess of the current market value. All of these shares are not included in the table above, as exercise of these options and warrants would not be dilutive to shareholders. Additionally, as of March 31, 2012, there were 7,274 shares subject to outstanding restricted stock units, which shares are also not included because of the current market value price is above the share price on the date the award was granted.

 

9
 

 

Note 3 – Investment Securities

 

Investment securities consist principally of short and intermediate term debt instruments issued by the U.S. Treasury, other U.S. government agencies, state and local government units, and other corporations, and mortgage backed securities (“MBS”).

 

Securities Held-to-Maturity  Amortized
Cost
   Unrealized
Gains
   Unrealized
Losses
   Fair
Value
 
                 
March 31, 2012                    
State and municipal securities  $6,727   $55   $   $6,782 
Agency MBS   270    23        293 
Total  $6,997   $78   $   $7,075 
                     
December 31, 2011                    
State and municipal securities  $6,732   $68   $   $6,800 
Agency MBS   293    25        318 
Total  $7,025   $93   $   $7,118 

 

Securities Available-for-Sale  Amortized
Cost
   Unrealized
Gains
   Unrealized
Losses
   Fair
Value
 
                 
March 31, 2012                    
U.S. Government securities  $72   $10   $   $82 
State and municipal securities   22,518    1,195    22    23,691 
Agency MBS   16,691    234    42    16,883 
Non-agency MBS   6,370    22    838    5,554 
Corporate bonds   3,284    38    17    3,305 
Total  $48,935   $1,499   $919   $49,515 
                     
December 31, 2011                    
U.S. Government securities  $73   $11   $   $84 
State and municipal securities   21,398    1,462    1    22,859 
Agency MBS   16,709    255    49    16,915 
Non-agency MBS   6,825    25    968    5,882 
Corporate bonds   2,010        98    1,912 
Total  $47,015   $1,753   $1,116   $47,652 

  

10
 

 

Unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in continuous unrealized loss position, as of March 31, 2012 and December 31, 2011 are summarized as follows:

 

   Less than 12 Months   12 months or More   Total 
Available-for-Sale  Fair
Value
   Gross
Unrealized
Losses
   Fair
Value
   Gross
Unrealized
Losses
   Fair
Value
   Gross
Unrealized
Losses
 
                         
March 31, 2012                              
State and municipal securities  $1,137   $22   $   $   $1,137   $22 
Agency MBS   6,325    42            6,325    42 
Non-agency MBS   604    53    3,925    785    4,529    838 
Corporate bonds   1,991    17            1,991    17 
Total  $10,057   $134   $3,925   $785   $13,982   $919 
                               
December 31, 2011                              
U.S. Government securities  $   $   $   $   $   $ 
State and municipal securities   77    1            77    1 
Agency MBS   4,985    49            4,985    49 
Non-agency MBS   590    90    4,223    878    4,813    968 
Corporate bonds   1,912    98            1,912    98 
Total  $7,564   $238   $4,223   $878   $11,787   $1,116 

 

At March 31, 2012, there were 20 investment securities in an unrealized loss position, of which six were in a continuous loss position for 12 months or more. The unrealized losses on these securities were caused by changes in interest rates, widening pricing spreads and market illiquidity, leading to a decline in the fair value subsequent to their purchase. The Company has evaluated the securities shown above and anticipates full recovery of amortized cost with respect to these securities at maturity or sooner in the event of a more favorable market environment. Based on management’s evaluation, and because the Company does not have the intent to sell these securities and it is not more likely than not that it will have to sell the securities before recovery of cost basis, the Company does not consider these investments to be other-than-temporarily impaired at March 31, 2012, except as described below with respect to one non-agency MBS.

 

For non-agency MBS the Company estimates expected future cash flows of the underlying collateral, together with any credit enhancements. The expected future cash flows of the underlying collateral are determined using the remaining contractual cash flows adjusted for future expected credit losses (which considers current delinquencies, future expected default rates and collateral value by vintage) and prepayments. The expected cash flows of the security are then discounted to arrive at a present value amount. For the three months ended March 31, 2012, one non-agency MBS was determined to be other-than-temporarily-impaired resulting in the Company recording $192 in impairments not related to credit losses through other comprehensive income and $70 in impairments related to credit losses through earnings.

 

Gross gains realized on sales of securities were $16 and $110 and gross losses realized were $6 and $0 during the three months ended March 31, 2012 and 2011, respectively.

 

The Company did not engage in originating subprime mortgage loans and it does not believe that it has material exposure to subprime mortgage loans or subprime mortgage backed securities. Additionally, the Company does not have any investment in, or exposure to, collateralized debt obligations, structured investment vehicles or Euro zone sovereign debt.

   

11
 

 

Note 4 – Loans

 

Loans and Leases

 

Loans (including loans held for sale) at March 31, 2012 and December 31, 2011 are as follows:

 

   March 31,
2012
   December 31,
2011
 
         
Commercial and industrial  $93,404   $90,731 
Residential real estate:          
Residential 1-4 family   87,783    90,552 
Multi-family   8,909    7,682 
Commercial real estate:          
Construction and land development   46,410    47,156 
Commercial real estate – owner occupied   113,667    118,469 
Commercial real estate – non owner occupied   97,152    103,005 
Farmland   24,221    23,752 
Installment   8,855    8,928 
Less unearned income   (718)   (841)
           
Total Loans  $479,683   $489,434 

 

Allowance for Credit Losses

 

Changes in the allowance for credit losses and recorded investment in loans as of, and for the three months ended March 31, 2012 are as follows:

 

   Commercial   Commercial
Real Estate
(“CRE”)
   Residential
Real Estate
   Consumer   Unallocated   2012
Total
 
                         
Allowance for Credit Losses:                              
Beginning balance  $1,012   $6,803   $1,046   $642   $1,624   $11,127 
Charge-offs   (57)   (245)   (71)   (23)       (396)
Recoveries   23    8        1        32 
Provision (release) for credit losses   (42)   (227)   (117)   17    469    100 
                               
Ending balance  $936   $6,339   $858   $637   $2,093   $10,863 
                               
Ending balance: individually evaluated for impairment       1,782    11            1,793 
                               
Ending balance: collectively evaluated for impairment   936    4,557    847    637    2,093    9,070 
                               
Loans:                              
Ending balance: individually evaluated for impairment  $698   $9,990   $1,102   $   $   $11,790 
                               
Ending balance: collectively evaluated for impairment   92,706    271,460    84,009    8,855        457,030 
                               
Loans held for sale           11,581            11,581 
                               
Ending balance  $93,404   $281,450   $96,692   $8,855   $   $480,401 
Less unearned income                            (718)
                               
Ending balance total loans                           $479,683 

  

12
 

 

Changes in the allowance for credit losses and recorded investment in loans as of, and for the year ended December 31, 2011 are as follows:

 

   Commercial   Commercial
Real Estate
(“CRE”)
   Residential
Real Estate
   Consumer   Unallocated   2011
Total
 
                         
Allowance for Credit Losses:                              
Beginning balance  $816   $5,385   $1,754   $690   $1,972   $10,617 
Charge-offs   (161)   (2,005)   (665)   (93)       (2,924)
Recoveries   69    750    107    8        934 
Provision (release) for credit losses   288    2,673    (150)   37    (348)   2,500 
                               
Ending balance  $1,012   $6,803   $1,046   $642   $1,624   $11,127 
                               
Ending balance: individually evaluated for impairment       1,987    45            2,032 
                               
Ending balance: collectively evaluated for impairment   1,012    4,816    1,001    642    1,624    9,095 
                               
Loans:                              
Ending balance: individually evaluated for impairment  $529   $13,076   $827   $   $   $14,432 
                               
Ending balance: collectively evaluated for impairment   90,202    279,306    82,866    8,928        461,302 
                               
Loans held for sale           14,541            14,541 
                               
Ending balance  $90,731   $292,382   $98,234   $8,928   $   $490,275 
Less unearned income                            (841)
                               
Ending balance total loans                           $489,434 

  

Credit Quality Indicators

 

Federal regulations require that the Bank periodically evaluate the risks inherent in its loan portfolios. In addition, the Washington Division of Banks and the Federal Deposit Insurance Corporation (“FDIC”) have authority to identify problem loans and, if appropriate, require them to be reclassified. There are three classifications for problem loans: Substandard, Doubtful, and Loss. These terms are used as follows:

 

·“Substandard” loans have one or more defined weaknesses and are characterized by the distinct possibility some loss will be sustained if the deficiencies are not corrected.

 

·“Doubtful” loans have the weaknesses of loans classified as "Substandard," with additional characteristics that suggest the weaknesses make collection or recovery in full after liquidation of collateral questionable on the basis of currently existing facts, conditions, and values. There is a high possibility of loss in loans classified as "Doubtful."

 

·“Loss” loans are considered uncollectible and of such little value that continued classification of the credit as a loan is not warranted. If a loan or a portion thereof is classified as "Loss," it must be charged-off; meaning the amount of the loss is charged against the allowance for credit losses, thereby reducing that reserve.

 

The Bank also classifies some loans as “Pass” or Other Loans Especially Mentioned (“OLEM”). Within the Pass classification certain loans are “Watch” rated because they have elements of risk that require more monitoring than other performing loans. Pass grade loans include a range of loans from very high credit quality to acceptable credit quality. These borrowers generally have strong to acceptable capital levels and consistent earnings and debt service capacity. Loans with higher grades within the Pass category may include borrowers who are experiencing unusual operating difficulties, but have acceptable payment performance to date. Overall, loans with a Pass grade show no immediate loss exposure. Loans classified as OLEM continue to perform but have shown deterioration in credit quality and require close monitoring.

  

13
 

 

Loans by credit quality risk rating at March 31, 2012 are as follows:

 

   Pass   Other Loans
Especially
Mentioned
   Substandard   Doubtful   Total 
                     
Commercial  $87,998   $1,048   $4,322   $36   $93,404 
                          
Real estate:                         
Construction and development   38,566    855    6,989        46,410 
Residential 1-4 family   82,290    1,284    4,209        87,783 
Multi-family   8,909                8,909 
CRE – owner occupied   106,655    1,784    5,228        113,667 
CRE – non owner occupied   76,266    9,783    11,103        97,152 
Farmland   23,022    110    1,089        24,221 
Total real estate   335,708    13,816    28,618        378,142 
                          
Consumer   8,423    7    418    7    8,855 
                          
Subtotal  $432,129   $14,871   $33,358   $43   $480,401 
Less unearned income                       (718)
                          
Total loans                      $479,683 

 

Loans by credit quality risk rating at December 31, 2011 are as follows:

 

   Pass   Other Loans
Especially
Mentioned
   Substandard   Doubtful   Total 
                     
Commercial  $83,920   $2,232   $4,579    $—   $90,731 
                          
Real estate:                         
Construction and development   37,804    1,394    7,958        47,156 
Residential 1-4 family   86,239    741    3,572        90,552 
Multi-family   7,682                7,682 
CRE – owner occupied   111,028    1,856    5,585        118,469 
CRE – non owner occupied   77,414    13,877    11,714        103,005 
Farmland   22,543    110    1,099        23,752 
Total real estate   342,710    17,978    29,928        382,950 
                          
Consumer   8,804    53    63    8    8,928 
                          
Subtotal  $435,434   $20,263   $34,570   $8   $490,275 
Less unearned income                       (841)
                          
Total loans                      $489,434 

 

14
 

 

Impaired Loans

 

Following is a summary of information pertaining to impaired loans at March 31, 2012:

 

   Recorded
Investment
   Unpaid
Principal
Balance
   Related
Allowance
   3 Month
Average
Recorded
Investment
   3 Months
Interest
Income
Recognized
 
With no related allowance recorded:                         
Commercial  $698   $698   $   $614   $9 
Residential real estate   917    1,000        723    2 
Commercial real estate:                         
CRE – owner occupied   314    413        472    1 
CRE – non-owner occupied   2,922    3,015        2,917     
Construction and development   3,127    5,151        4,231    24 
                          
With an allowance recorded:                         
Residential real estate   185    194    11    242     
Commercial real estate:                         
CRE – non-owner occupied   3,627    3,997    1,782    3,627     
Construction and development               287     
                          
Total:                         
Commercial   698    698        614    9 
Residential real estate   1,102    1,194    11    965    2 
Commercial real estate:                         
CRE – owner occupied   314    413        472    1 
CRE – non-owner occupied   6,549    7,012    1,782    6,544     
Construction and development   3,127    5,151        4,518    24 

 

Following is a summary of information pertaining to impaired loans at December 31, 2011:

 

   Recorded
Investment
   Unpaid
Principal
Balance
   Related
Allowance
   Average
Recorded
Investment
   Interest
Income
Recognized
 
With no related allowance recorded:                         
Commercial  $530   $556   $   $355   $15 
Residential real estate   528    620        1,314    16 
Commercial real estate:                         
CRE – owner occupied   629    719        971    7 
CRE – non-owner occupied   2,912    2,912        3,181    21 
Construction and development   5,335    7,501        5,868    188 
                          
With an allowance recorded:                         
Commercial               202    5 
Residential real estate   298    298    45    74     
Commercial real estate:                         
CRE - non-owner occupied   3,627    3,997    1,782    725     
Construction and development   573    573    205    716    3 
                          
Total:                         
Commercial   530    556        557    20 
Residential real estate   826    918    45    1,388    16 
Commercial real estate:                         
CRE – owner occupied   629    719        971    7 
CRE – non-owner occupied   6,539    6,909    1,782    3,906    21 
Construction and development   5,908    8,074    205    6,584    191 

  

15
 

 

Aging Analysis

 

The following table provides an age analysis of past due loans at March 31, 2012.

 

   Current   30-59
Days
Past Due
   60-89
Days
Past Due
   Greater
Than 90
Days Past
Due and
Still
Accruing
   Total
Past
Due
   Non-
accrual
Loans
   Total
Loans
 
                                    
Commercial  $91,866   $716   $   $122   $838   $700   $93,404 
                                    
Real estate:                                   
Construction & development   42,714    115    155        270    3,426    46,410 
Residential 1-4 family   85,464    1,368        148    1,516    803    87,783 
Multi-family   8,909                        8,909 
CRE owner occupied   109,188    3,735    430        4,165    314    113,667 
CRE non-owner occupied   90,603                    6,549    97,152 
Farmland   24,221                        24,221 
Total real estate   361,099    5,218    585    148    5,951    11,092    378,142 
                                    
Consumer   8,847    1    7        8        8,855 
                                    
Less unearned income   (718)                       (718)
                                    
Total  $461,094   $5,935   $592   $270   $6,797   $11,792   $479,683 

 

The following table provides an age analysis of past due loans at December 31, 2011.

 

   Current   30-59
Days
Past Due
   60-89
Days
Past Due
   Greater
Than 90
Days Past
Due and
Still
Accruing
   Total
Past
Due
   Non-
accrual
Loans
   Total
Loans
 
                             
Commercial  $89,981   $220   $   $   $220   $530   $90,731 
                                    
Real estate:                                   
Construction & development   41,570    76            76    5,510    47,156 
Residential 1-4 family   88,661    880    184    299    1,363    528    90,552 
Multi-family   7,682                        7,682 
CRE owner occupied   116,979    508    353        861    629    118,469 
CRE non-owner occupied   96,332    134            134    6,539    103,005 
Farmland   23,752                        23,752 
Total real estate   374,976    1,598    537    299    2,434    13,206    390,616 
                                    
Consumer   8,869    59            59        8,928 
                                    
Less unearned income   (841)                       (841)
                                    
Total  $472,985   $1,877   $537   $299   $2,713   $13,736   $489,434 

  

16
 

 

Modifications

 

A modification of a loan constitutes a troubled debt restructuring (“TDR”) when a borrower is experiencing financial difficulty and the modification constitutes a concession.  There are various types of concessions when modifying a loan, however, forgiveness of principal is rarely granted by the Company.  Commercial and industrial loans modified in a TDR may involve term extensions, below market interest rates and/or interest-only payments wherein the delay in the repayment of principal is determined to be significant when all elements of the loan and circumstances are considered.  Additional collateral, a co-borrower, or a guarantor is often required.  Commercial mortgage and construction loans modified in a TDR often involve reducing the interest rate for the remaining term of the loan, extending the maturity date at an interest rate lower than the current market rate for new debt with similar risk, or substituting or adding a new borrower or guarantor.  Construction loans modified in a TDR may also involve extending the interest-only payment period.  Residential mortgage loans modified in a TDR are primarily comprised of loans where monthly payments are lowered to accommodate the borrowers’ financial needs. Land loans are typically structured as interest-only monthly payments with a balloon payment due at maturity.  Land loans modified in a TDR typically involve extending the balloon payment by one to three years, and providing an interest rate concession. Home equity modifications are made infrequently and are uniquely designed to meet the specific needs of each borrower. 

 

Loans modified in a TDR are typically already on non-accrual status and partial charge-offs have in some cases already been taken against the outstanding loan balance.  As a result, loans modified in a TDR for the Company may have the financial effect of increasing the specific allowance associated with the loan.  An allowance for impaired loans that have been modified in a TDR is measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s observable market price, or the estimated fair value of the collateral, less any selling costs, if the loan is collateral dependent.  The Company’s practice is to re-appraise collateral dependent loans semi-annually. During the three months ended March 31, 2012, there was no impact on the allowance from TDRs during the period, as the loans classified as TDRs during the period did not have a specific reserve and were already considered impaired loans at the time of modification.

 

The Company closely monitors the performance of modified loans for delinquency, as delinquency is considered an early indicator of possible future default. If loans modified in a TDR subsequently default, the Company evaluates the loan for possible further impairment. The allowance may be increased, adjustments may be made in the allocation of the allowance, or partial charge-offs may be taken to further write-down the carrying value of the loan.

 

The following tables present TDRs as of March 31, 2012 all of which were modified due to financial stress of the borrower.

 

   Current TDRs   Subsequently Defaulted TDRs 
   Number
of
Contracts
   Pre-TDR
Outstanding
Recorded
Investment
   Post-TDR
Outstanding
Recorded
Investment
   Number
of
Contracts
   Pre-TDR
Outstanding
Recorded
Investment
   Post-TDR
Outstanding
Recorded
Investment
 
                               
Commercial   1   $335   $331                
Residential real estate   2    264    262       $   $ 
CRE owner occupied   1    59    57             
CRE non-owner occupied   1    2,180    2,180             
Construction & development   3    2,972    1,846    2    2,561    2,465 
                               
Ending balance (1)   8   $5,810   $4,676    2   $2,561   $2,465 

 

17
 

 

(1)The period end balances are inclusive of all partial pay downs and charge-offs since the modification date. Loans modified in a TDR that were fully paid down, fully charged-off, or foreclosed upon by period end are not reported.

  

The construction and development loan TDRs that subsequently defaulted were modified by extending the maturity date. Both loans were on non-accrual status prior to and after the TDR. The subsequent default reported above occurred during the last twelve months and were subsequently transferred to other real estate owned during the three months ended March 31, 2012. There were no other loans modified as a TDR within the previous 12 months that subsequently defaulted during the three months ended March 31, 2012.

 

Loans classified as TDRs are considered impaired loans. The Company had no commitments to lend additional funds for loans classified as troubled debt restructured at March 31, 2012.

 

Note 5 – Other Comprehensive Income (Loss)

 

The following table presents the components of other comprehensive income (loss) for the three months ended March 31, 2012 and 2011.

 

   Before Tax   Tax Effect   Net of Tax 
Three months Ended March 31, 2012               
                
Net unrealized losses on investment securities:               
Net unrealized losses arising during the period  $(117)  $(40)  $(77)
Less: reclassification adjustment for net gains realized in net income   60    20    40 
Net unrealized losses on investment securities   (57)   (20)   (37)
                
Defined Benefit Plans:               
Amortization of unrecognized prior service costs and net actuarial gains/losses   44    15    29 
                
Other Comprehensive Loss  $(12)  $(4)  $(8)
                
Three months Ended March 31, 2011               
                
Net unrealized gains on investment securities:               
Net unrealized gains arising during the period  $474   $161   $313 
Less: reclassification adjustment for net gains realized in net income   83    28    55 
Net unrealized gains on investment securities   391    133    258 
                
Defined Benefit Plans:               
Amortization of unrecognized prior service costs and net actuarial gains/losses   35    12    23 
                
Other Comprehensive Income  $426   $145   $281 

  

18
 

 

Note 6 – Stock Based Compensation

 

Stock Options

 

The Company’s 2000 Stock Incentive Plan provided for incentive and non-qualified stock options and other types of stock based awards to key personnel. Under the plan, the Company was authorized to issue up to 1,100,000 shares; however the plan expired January 1, 2011. On April 27, 2011, the shareholders of the Company approved the 2011 Equity Incentive Plan, pursuant to which the Company is authorized to issue up to 900,000 shares of common stock in connection with awards under the plan.

 

The fair value of stock options granted is determined using the Black-Scholes option pricing model based on the following assumptions. Expected volatility is based on historical volatility of the Company’s common stock. The expected term of stock options granted is based on the simplified method, which is the simple average between contractual term and vesting period. The risk-free rate is based on the expected term of stock options and the applicable U.S. Treasury yield in effect at the time of grant. There were no options granted during the three months ended March 31, 2012 and 2011.

 

A summary of stock option activity under the stock option plans as of March 31, 2012 and 2011, and changes during the three months then ended are presented below:

 

   Shares   Weighted
Average
Exercise Price
   Weighted
Average
Remaining
Contractual
Term ( Years)
   Aggregate
Intrinsic
Value
 
March 31, 2012                    
                     
Outstanding beginning of period   586,448   $11.32           
Granted                  
Exercised                  
Forfeited   (10,050)   11.30           
Expired   (47,291)   10.57           
                     
Outstanding end of period   529,107   $11.39    4.7   $ 
                     
Exercisable end of period   358,177   $13.23    3.3   $ 
                     
March 31, 2011                    
                     
Outstanding beginning of period   818,612   $11.07           
Granted                  
Exercised                  
Forfeited   (24,225)   10.00           
Expired   (177,779)   10.10           
                     
Outstanding end of period   616,608   $11.40    5.2   $ 
                     
Exercisable end of period   413,933   $12.87    3.8   $ 

  

19
 

 

A summary of the status of the Company’s non-vested options as of March 31, 2012 and 2011 and changes during the three months then ended are presented below:

 

   2012   2011 
   Shares   Weighted
Average Fair
Value
   Shares   Weighted
Average Fair
Value
 
                 
Non-vested beginning of period   174,740   $0.37    218,885   $0.51 
Granted                
Vested                
Forfeited   (3,810)   0.29    (16,210)   0.46 
                     
Non-vested end of period   170,930   $0.38    202,675   $0.51 

 

The Company accounts for stock based compensation in accordance with GAAP, which requires measurement of compensation cost for all stock-based awards based on grant date fair value and recognition of compensation cost over the service period of each award. Stock-based compensation expense during the three months ended March 31, 2012 and 2011 was $4 and $6 ($3 and $4 net of tax), respectively. Future compensation expense for unvested awards outstanding as of March 31, 2012 is estimated to be $28 recognized over a weighted average period of 1.7 years. There were no options exercised during the three months ended March 31, 2012 and 2011.

 

Restricted Stock Units

 

On March 16, 2012, the Company granted restricted stock units (“RSU”) to certain employees receiving awards under the Company’s Annual Incentive Compensation Plan. Recipients of RSUs will be issued a specified number of shares of the Company’s common stock upon the lapse of applicable restrictions. Restrictions require the employee to continue in employment for a period of three years from the date the RSU is awarded.

 

The following table summarizes RSU activity during 2012. There was no RSU activity prior to 2012.

 

   Shares   Weighted average
grant price
   Weighted average
remaining contractual
terms (in years)
 
             
Outstanding, January 1, 2012      $     
Granted   7,274    4.15    3.0 
                
Outstanding, March 31, 2012   7,274   $4.15    3.0 

 

For the three months ended March 31, 2012, the Company did not recognize any compensation expense related to RSUs as the RSUs were granted at the end of the quarter. As of March 31, 2012, there was $30 of total unrecognized compensation expense related to non-vested RSUs.

  

20
 

 

Note 7 – Commitments and Contingencies

 

The Bank is party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit, and involve, to varying degrees, elements of credit risk in excess of the amount recognized on the consolidated balance sheets.

 

The Bank’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of those instruments. The Bank uses the same credit policies in making commitments and conditional obligations as they do for on-balance-sheet instruments. A summary of the Bank’s off-balance sheet commitments at March 31, 2012 and December 31, 2011 is as follows:

 

   March 31,   December 31, 
   2012   2011 
         
Commitments to extend credit  $86,090   $91,596 
Standby letters of credit   1,356    1,310 

 

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Many of the commitments expire without being drawn upon; therefore total commitment amounts do not necessarily represent future cash requirements. The Bank evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary upon extension of credit, is based on management’s credit evaluation of the customer. Collateral held varies, but may include accounts receivable, inventory, property and equipment, residential real estate, and income-producing commercial properties.

 

Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers.

 

In connection with certain loans held for sale, the Bank typically makes representations and warranties that the underlying loans conform to specified guidelines. If the underlying loans do not conform to the specifications, the Bank may have an obligation to repurchase the loans or indemnify the purchaser against loss. The Bank believes that the potential for loss under these arrangements is remote. Accordingly, no contingent liability is recorded in the condensed consolidated financial statements.

 

The Company is currently not party to any material pending litigation. However, because of the nature of its activities, the Company may be subject to or threatened with legal actions in the ordinary course of business. In the opinion of management, liabilities arising from these claims, if any, will not have a material effect on the results of operations or financial condition of the Company.

 

Note 8 – Recent Accounting Pronouncements

 

In May 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2011-04, “Fair Value Measurement (Topic 820) – Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs.”  This ASU is the result of joint efforts by the FASB and International Accounting Standards Board to develop a single, converged fair value framework on how (not when) to measure fair value and what disclosures to provide about fair value measurements.  The ASU is largely consistent with existing fair value measurement principles in U.S. GAAP (Topic 820), with many of the amendments made to eliminate unnecessary wording differences between U.S. GAAP and International Financial Reporting Standards.  The amendments are effective for interim and annual periods beginning after December 15, 2011 with prospective application required.  The Company adopted the provisions of ASU No. 2011-04 effective January 1, 2012. The fair value measurement provisions had no impact on the Company’s consolidated financial statements. See Note 9 for the enhanced disclosures required by ASU No. 2011-04.

  

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In June 2011, FASB issued ASU No. 2011-05, “Comprehensive Income (Topic 220): Presentation of Comprehensive Income”. This ASU will require companies to present the components of net income and other comprehensive income either as one continuous statement or as two consecutive statements. It eliminates the option to present components of other comprehensive income as part of the statement of changes in stockholders' equity. The standard does not change the items which must be reported in other comprehensive income, how such items are measured or when they must be reclassified to net income. This standard is effective for interim and annual periods beginning after December 15, 2011. The FASB subsequently deferred the effective date of certain provisions of this standard pertaining to the reclassification of items out of accumulated other comprehensive income. A Consolidated Statement of Comprehensive Income has been included part of the Company’s unaudited financial statements, for the periods ended March 31, 2012 and 2011. The adoption of ASU No. 2011-05 had no impact on the Company’s financial condition, results of operations or cash flows.

 

Note 9 – Fair Value Measurements

 

Fair Value Hierarchy

 

The Company uses an established hierarchy for measuring fair value that is intended to maximize the use of observable inputs and minimize the use of unobservable inputs. This hierarchy uses three levels of inputs to measure the fair value of assets and liabilities as follows:

 

Level 1 – Valuations based on quoted prices in active exchange markets for identical assets or liabilities; also includes certain corporate debt securities actively traded in over-the-counter markets.

 

Level 2 – Valuations of assets and liabilities traded in less active dealer or broker markets. Valuations include quoted prices for similar assets and liabilities traded in the same market; quoted prices for identical or similar instruments in markets that are not active; and model–derived valuations whose inputs are observable or whose significant value drivers are observable. Valuations may be obtained from, or corroborated by, third-party pricing services. This category generally includes certain U.S. Government, agency and non-agency securities, state and municipal securities, mortgage-backed securities, corporate securities, and residential mortgage loans held for sale.

 

Level 3 – Valuation based on unobservable inputs supported by little or no market activity for financial instruments whose value is determined using pricing models, discounted cash flow methodologies, yield curves and similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation. Level 3 valuations incorporate certain assumptions and projections in determining the fair value assigned to such assets or liabilities, but in all cases are corroborated by external data, which may include third-party pricing services.

 

Investments Securities available-for-sale

 

The Company uses an independent pricing service to assist management in determining fair values of investment securities available-for-sale. This service provides pricing information by utilizing evaluated pricing models supported with market data information. Standard inputs include benchmark yields, reported trades, broker/dealer quotes, credit ratings, bids and offers, relative credit information and reference data from market research publications. Investments securities that are deemed to have been trading in illiquid or inactive markets may require the use of significant unobservable inputs.

  

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The pricing service provides quoted market prices when available. Quoted prices are not always available due to bond market inactivity. For securities where quoted prices or market prices of similar securities are not available, fair values are calculated using discounted cash flows. Discounted cash flows are calculated using spread to swap and LIBOR curves that are updated to incorporate loss severities, volatility, credit spread and optionality. Additionally, the pricing service may obtain a broker quote when sufficient information is not available to produce a valuation. Valuations and broker quotes are non-binding and do not represent quotes on which one may execute the disposition of the assets.

 

The Company generally obtains one value from its primary external third-party pricing service. The Company’s third-party pricing service has established processes for us to submit inquiries regarding quoted prices. The Company’s third-party pricing service will review the inputs to the evaluation in light of any new market data presented by us. The Company’s third-party pricing service may then affirm the original quoted price or may update the evaluation on a going forward basis.

 

On a quarterly basis, management reviews the pricing information received from the third party-pricing service through a combination of procedures that include an evaluation of methodologies used by the pricing service, analytical reviews and performance analysis of the prices against statistics and trends and maintenance of an investment watch list. Based on this review, management determines whether the current placement of the security in the fair value hierarchy is appropriate or whether transfers may be warranted. As necessary, the Company compares prices received from the pricing service to discounted cash flow models or through performing independent valuations of inputs and assumptions similar to those used by the pricing service in order to ensure prices represent a reasonable estimate of fair value. Although the Company does identify differences from time to time as a result of these validation procedures, the Company did not make any significant adjustments as of March 31, 2012 or December 31, 2011.

 

The following table presents the balances of assets measured at fair value on a recurring basis at March 31, 2012 and December 31, 2011.

 

March 31, 2012  Readily Available
Market Inputs
Level 1
   Observable
Market Inputs
Level 2
   Significant
Unobservable
Inputs
 Level 3
   Total 
                 
Securities available-for-sale                    
U.S. Government securities  $   $82   $   $82 
State and municipal securities   83    22,530    1,078    23,691 
Agency MBS       16,883        16,883 
Non-agency MBS       5,554        5,554 
Corporate bonds   1,314    1,991        3,305 
                     
Total  $1,397   $47,040   $1,078   $49,515 

  

23
 

 

December 31, 2011  Readily Available
Market Inputs
Level 1
   Observable
Market Inputs
Level 2
   Significant
Unobservable
Inputs
Level 3
   Total 
                 
Securities available-for-sale                    
U.S. Government securities  $   $84   $   $84 
State and municipal securities       21,719    1,140    22,859 
Agency MBS       16,915        16,915 
Non-agency MBS       5,882        5,882 
Corporate bonds   918    994        1,912 
                     
Total  $918   $45,594   $1,140   $47,652 

 

As of March 31, 2012 and December 31, 2011 the Company had two investments classified as Level 3 investments which consist of local non-rated municipal bonds for which the Company is the sole owner of the entire bond issue. The valuation of these securities is supported by analysis prepared by an independent third party. Their approach to determining fair value involves using recently executed transactions for similar securities and market quotations for similar securities. As these securities are not rated by the rating agencies and there is no trading volume, Management determined that these securities should be classified as Level 3 inputs. Additionally, these securities are considered sensitive to changes in credit given the unobserved assumed credit ratings.

 

The following table presents a reconciliation of assets that are measured at fair value on a recurring basis using significant unobservable inputs (Level 3) during the three months ended March 31, 2012 and 2011, respectively. There were no transfers of assets in to or out of Level 3 for the three months ended March 31, 2012.

 

   Three months ended
March 31,
 
   2012   2011 
         
Balance beginning of period  $1,140   $1,157 
Included in other comprehensive income (loss)   (62)   (5)
           
Balance end of period  $1,078   $1,152 

 

Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis

 

Certain assets and liabilities are measured at fair value on a nonrecurring basis after initial recognition such as loans measured for impairment and other real estate owned (“OREO”). The following methods were used to estimate the fair value of each such class of financial instrument:

 

Loans held for sale – Loans held for sale are carried at the lower of cost or fair value. Loans held for sale are measured at fair value based on a discounted cash flow calculation using interest rates currently available on similar loans. The fair value was determined based on an aggregated loan basis. When a loan is sold, the gain is recognized in the consolidated statement of income as the proceeds less the book value of the loan including unamortized fees and capitalized direct costs.

  

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Impaired loans – A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due (both interest and principal) according to the contractual terms of the loan agreement. Impaired loans are classified as Level 3 in the fair value hierarchy and are measured based on the present value of expected future cash flows or by the net realizable value of the collateral if the loan is collateral dependent. In determining the net realizable value of the underlying collateral, we primarily rely on third party appraisals by qualified licensed appraisers, less costs to sell. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach.

 

Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available and include consideration for variations in location, size, and income production capacity of the property. Additionally, the appraisals are periodically further adjusted by the Company in consideration of charges that may be incurred in the event of foreclosure and are based on management’s historical knowledge, changes in business factors and changes in market conditions. Such discounts are typically significant, and may range from 10% to 25% resulting in a Level 3 classification. There were no additional adjustments made by the Company to impaired loans measured at fair value at March 31, 2012.

 

Impaired loans are reviewed and evaluated quarterly for additional impairment and adjusted accordingly, based on the same factors identified above. Because of the high degree of judgment required in estimating the fair value of collateral underlying impaired loans and because of the relationship between fair value and general economic conditions, we consider the fair value of impaired loans to be highly sensitive to changes in market conditions.

 

Other real estate owned – OREO is initially recorded at the lower of the carrying amount of the loan or fair value of the property less estimated costs to sell. This amount becomes the property’s new basis. Management considers third party appraisals in determining the fair value of particular properties. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach.

 

Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available and include consideration for variations in location, size, and income production capacity of the property. Additionally, the appraisals are periodically further adjusted by the Company in consideration of charges that may be incurred in the event of foreclosure and are based on management’s historical knowledge, changes in business factors and changes in market conditions. Such discounts are typically significant, and may range from 10% to 25% resulting in a Level 3 classification.

 

Any write-downs based on the property fair value less estimated costs to sell at the date of acquisition are charged to the allowance for credit losses. Management periodically reviews OREO to ensure the property is carried at the lower of its new basis or fair value, net of estimated costs to sell. Any additional write-downs based on re-evaluation of the property fair value are charged to non-interest expense. Because of the high degree of judgment required in estimating the fair value of OREO and because of the relationship between fair value and general economic conditions, we consider the fair value of OREO to be highly sensitive to changes in market conditions.

  

25
 

 

The following table presents the Company’s assets that were held at the end of each period that were accounted for at fair value on a nonrecurring basis at March 31, 2012 and December 31, 2011.

 

   Readily Available
Market Inputs
Level 1
   Observable
Market Inputs
Level 2
   Significant
Unobservable
Inputs
Level 3
   Total 
March 31, 2012                    
Impaired loans  $   $   $620   $620 
OREO  $   $   $961   $961 
                     
December 31, 2011                    
Impaired loans  $   $   $7,183   $7,183 
OREO  $   $   $6,455   $6,455 

 

Other real estate owned with a pre-foreclosure loan balance of $1,862 was acquired during the three months ended March 31, 2012. Upon foreclosure, certain of these assets were written down $90 to their fair value, less estimated costs to sell, which was charged to the allowance for credit losses during the period.

 

The following table presents quantitative information about Level 3 inputs for financial instruments measured at fair value on a nonrecurring basis at March 31, 2012:

 

   

Fair

Value

 

Valuation

Technique

 

Significant

Unobservable

Inputs

 

Range (Weighted

Average)

 
                   
OREO – construction and land development   $ 503   Appraised value - Sales comparison approach   Adjustment for market conditions   0-10% (5%)  
                     
OREO – commercial real estate   $ 458   Appraised value - Sales comparison approach   Adjustment for market conditions   0-10% (9%)  

 

Fair Value of Financial Instruments

 

The following methods and assumptions were used by the Company in estimating the fair values of financial instruments disclosed in these consolidated financial statements:

 

Cash and due from banks, Interest bearing deposits in banks, and Federal funds sold

The carrying amounts of cash, interest bearing deposits at other financial institutions, and federal funds sold approximate their fair value.

 

Investment Securities Available-for-Sale and Held-to-Maturity

The fair value of all investment securities are based upon the assumptions market participants would use in pricing the security. Such assumptions include observable and unobservable inputs such as quoted market prices, dealer quotes and analysis of discounted cash flows.

 

26
 

 

Loans, net and Loans held for sale

The fair value of loans is estimated based on comparable market statistics for loans with similar credit ratings. An additional liquidity discount is also incorporated to more closely align the fair value with observed market prices. Fair values of loans held for sale are based on a discounted cash flow calculation using interest rates currently available on similar loans. The fair value was based on an aggregate loan basis.

 

Deposits

The fair value of deposits with no stated maturity date is included at the amount payable on demand. Fair values for fixed rate certificates of deposit are estimated using a discounted cash flow calculation based on interest rates currently offered on similar certificates.

 

Secured borrowings

For variable rate secured borrowings that reprice frequently and have no significant change in credit risk, fair values are based on carrying values.

 

Short-term borrowings

The fair values of the Company’s short-term borrowings are estimated using discounted cash flow analysis based on the Company’s incremental borrowing rates for similar types of borrowing arrangements.

 

Long-term borrowings

The fair values of the Company’s long-term borrowings is estimated using discounted cash flow analysis based on the Company’s incremental borrowing rates for similar types of borrowing arrangements.

 

Junior subordinated debentures

The fair value of the junior subordinated debentures and trust preferred securities is estimated using discounted cash flow analysis based on interest rates currently available for junior subordinated debentures.

 

Off-Balance-Sheet Instruments

The fair value of commitments to extend credit and standby letters of credit was estimated using the rates currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the customers. Since the majority of the Company’s off-balance-sheet instruments consist of non-fee producing, variable-rate commitments, the Company has determined they do not have a material fair value.

  

27
 

 

The estimated fair value of the Company’s financial instruments at March 31, 2012 and December 31, 2011 are as follows:

 

March 31, 2012  Carrying
Amount
   Level 1   Level 2   Level 3   Total
Fair Value
 
                     
Financial Assets                         
Cash and cash equivalents  $51,246   $51,246   $   $   $51,246 
Securities available-for sale   49,515    1,397    47,040    1,078    49,515 
Securities held-to-maturity   6,997        7,075        7,075 
Loans held for sale   11,581        11,581        11,581 
Loans, net   457,239            414,674    414,674 
                          
Financial Liabilities                         
Deposits  $550,419   $   $551,978   $   $551,978 
Short-term borrowings   3,000        3,066        3,066 
Long-term borrowings   7,500        7,780        7,780 
Secured borrowings   727        727        727 
Junior subordinated debentures   13,403            6,788    6,788 

 

December 31, 2011  Carrying
Amount
   Level 1   Level 2   Level 3   Total
Fair Value
 
                     
Financial Assets                         
Cash and cash equivalents  $41,132   $41,132   $   $   $41,132 
Securities available-for sale   47,652    918    45,594    1,140    47,652 
Securities held-to-maturity   7,025        7,118        7,118 
Loans held for sale   14,541        14,808        14,808 
Loans, net   463,766            419,059    419,059 
                          
Financial Liabilities                         
Deposits  $548,050   $   $549,472   $   $549,472 
Short-term borrowings                    
Long-term borrowings   10,500        10,867        10,867 
Secured borrowings   741        741        741 
Junior subordinated debentures   13,403            6,691    6,691 

  

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ITEM 2 – MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

A Warning About Forward-Looking Information

 

This document contains forward-looking statements that are subject to risks and uncertainties. These statements are based on the present beliefs and assumptions of our management, and on information currently available to them. Forward-looking statements include the information concerning our possible future results of operations set forth under "Management's Discussion and Analysis of Financial Condition and Results of Operations" and statements preceded by, followed by or that include the words "believes," "expects," "anticipates," "intends," "plans," "estimates" or similar expressions.

 

Any forward-looking statements in this document are subject to the risks of our business, including risk factors described in our Annual Report on Form 10-K for the year ended December 31, 2011 (the “2011 10-K”), as well as risks relating to, among other things, the following:

 

1.          changing laws, regulations, standards, and government programs that may limit our revenue sources, significantly increase our costs, including compliance and insurance costs, limit our opportunities to generate noninterest income, and place additional burdens on our limited management resources;

 

2.          poor economic or business conditions, nationally and in the regions in which we do business, that have resulted in, and may continue to result in, among other things, a deterioration in credit quality and/or reduced demand for credit and other banking services, and additional workout and other real estate owned (“OREO”) expenses;

 

3.          decreases in real estate and other asset prices, whether or not due to economic conditions, that may reduce the value of the assets that serve as collateral for many of our loans;

 

4          competitive pressures among depository and other financial institutions that may impede our ability to attract and retain depositors, borrowers and other customers, maintain and improve our net interest income and margin and non-interest income, such as fee income, and/or retain our key employees; and

 

5.          a lack of liquidity in the market for our common stock that may make it difficult or impossible for you to liquidate your investment in our stock or lead to distortions in the market price of our stock.

 

Our management believes the forward-looking statements in this report are reasonable; however, you should not place undue reliance on them. Forward-looking statements are not guarantees of performance. They involve risks, uncertainties and assumptions. Many of the factors that will determine our future results and share value are beyond our ability to control or predict. We undertake no obligation to update forward-looking statements.

 

29
 

 

Overview

 

The Company is a bank holding company headquartered in Aberdeen, Washington. The Company's wholly-owned subsidiary, The Bank of the Pacific (the “Bank”), is a state chartered bank, also located in Washington. The Company has two wholly-owned subsidiary trusts known as PFC Statutory Trust I and II (the “Trusts”) that were formed December 2005 and May 2006, respectively, in connection with the issuance of trust preferred securities. The Company was incorporated in the state of Washington on February 12, 1997, pursuant to a holding company reorganization of the Bank.

 

The Company conducts its banking business through the Bank, which operates 16 branches located in communities in Grays Harbor, Pacific, Whatcom, Skagit and Wahkiakum counties in the state of Washington and one in Clatsop County, Oregon. During the current quarter, the Company opened a loan production office in Burlington, Washington.

 

The Bank provides loan and deposit services to customers who are predominantly small and middle-market businesses and middle-income individuals.

 

Critical Accounting Policies

 

Critical accounting policies are discussed in the 2011 10-K under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operation – Critical Accounting Policies.” There have been no material changes in our critical accounting policies from the 2011 10-K.

 

Recent Accounting Pronouncements

 

Please see Note 8 of the Company's Notes to Condensed Consolidated Financial Statements above for a discussion of recent accounting pronouncements and the likely effect on the Company.

 

Financial Summary

 

The following are significant trends reflected in the Company’s results of operations for the three months ended March 31, 2012 and financial condition as of that date:

 

·Net income for the three months ended March 31, 2012 was $1,018,000, an increase of $586,000 compared to the same period of the prior year, and represents the ninth consecutive quarter of profitability.

 

·Return on average assets and return on average equity were 0.64% and 6.35%, respectively, for the three months ended March 31, 2012, compared to 0.27% and 2.89%, respectively, for the same period in 2011.

 

·Net interest income of $6,050,000 for the three months ended March 31, 2012 increased $365,000 compared to the same period of the prior year. The increase is primarily the result of decreased funding costs. Net interest margin improved to 4.24% for the three months ended March 31, 2012, compared to 3.95% in the same period one year ago.

 

·The Bank’s tier 1 leverage ratio was 10.67% and total risk-based capital ratio was 15.55% at March 31, 2012, a slight increase from 10.35% and 15.05%, respectively, at year-end.

 

30
 

 

·Total assets were $644,675,000 at March 31, 2012, an increase of $3,421,000, or 0.53%, over year-end 2011. Increases in investments and interest bearing deposits with banks were the primary contributors to overall asset growth, which were partially offset by a decrease in loans. Total loans, including loans held for sale, of $479,683,000 at March 31, 2012, decreased $9,751,000, or 1.99%, compared to year-end 2011.

 

·Non-performing assets (“NPAs”) totaled $20,018,000 at March 31, 2012, which represents 3.11% of total assets, and is a decrease from $21,760,000 at December 31, 2011. The decrease is largely due to a decline in non-performing loans from $14,035,000 at year-end 2011 to $12,062,000 as of March 31, 2012. The largest reduction was in the construction and land development non-performing loan category which decreased by $2,084,000, or 37.85%, due to pay-offs. NPAs continue to be concentrated in construction and land development loans and commercial real estate loans, which represented $10,289,000, or 51.40%, of NPAs.

 

·Provision for credit losses was $100,000 for the three months ended March 31, 2012 compared to $500,000 for the same period one year ago. The allowance for credit losses decreased to 2.26% of total loans (including loans held for sale) compared to 2.27% at year-end 2011.

 

·Total deposits of $550,419,000 at March 31, 2012 increased $2,369,000, or 0.43%, for the three months ended March 31, 2012, compared to December 31, 2011, primarily in commercial interest bearing demand and money market accounts, which were partially offset by decreases in non-interest bearing demand and certificates of deposit accounts. Additionally, funding costs for deposits decreased to 0.75% for the current quarter, compared to 1.20% for the same period a year ago.

 

·The Company’s liquidity ratio of approximately 43% at March 31, 2012 remains strong and translates into over $278 million in available funding to meet loan and deposit needs.

 

Results of Operations

 

Net income. For the three months ended March 31, 2012, net income was $1,018,000, compared to $432,000 for the same period in 2011. The increase in net income in the current quarter was primarily related to increases in net interest income and gain on sale of loans and other real estate owned coupled with decreases in provision for credit losses and FDIC assessments, which were partially offset by an increase in salaries and benefits and data processing expenses.

 

Net interest income. Net interest income for the three months ended March 31, 2012 increased $365,000 or 6.42% compared to the same period in 2011. See the table below and the accompanying discussion for further information on interest income and expense. The net interest margin (net interest income divided by average earning assets and adjusted for tax on tax-exempt securities and loans) increased to 4.24% for the three months ended March 31, 2012 from 3.95% for the same period of the prior year. The increase in the current three month period is due to a decrease in the average cost of funds to 0.85% at March 31, 2012 from 1.37% one year ago, that was only partially offset by a decline in the Company’s average yield earned on assets from 5.26% to 5.08%.

 

31
 

 

The following tables set forth information with regard to average balances of interest earning assets and interest bearing liabilities and the resultant yields or cost, net interest income, and the net interest margin on a tax equivalent basis. Loans held for sale and non-accrual loans are included in total loans.

 

Three Months Ended March 31,

 

    2012    2011 
       Interest         Interest    
  Average   Income   Avg   Average   Income   Avg 
(dollars in thousands)  Balance   (Expense)   Rate   Balance   (Expense)   Rate 
Interest Earning Assets                              
Loans (1)  $480,227   $6,622*   5.52%  $480,063   $6,900*   5.75%
Taxable securities   30,084    230    3.06    29,693    280    3.77 
Tax-exempt securities   25,440    365*   5.74    23,027    358*   6.22 
Federal Home Loan Bank Stock   3,183            3,183         
Interest earning balances with banks   31,272    18    0.23    39,539    24    0.24 
                               
Total interest earning assets  $570,206   $7,235    5.08%  $575,505   $7,562    5.26%
                               
Cash and due from banks   9,744             9,565           
Bank premises and equipment (net)   14,851             15,167            
Other real estate owned   8,116             6,770            
Other assets   41,885             41,814            
Allowance for credit losses   (11,094)           (10,870)          
                               
Total assets  $633,708           637,951           
                               
Interest Bearing Liabilities                              
Savings and interest bearing demand  $289,885   $(322)   0.44%  $263,132   $(443)   0.67%
Time deposits   150,558    (503)   1.34    191,244    (922)   1.93 
Total deposits   440,443    (825)   0.75    454,376    (1,365)   1.20 
                               
Short-term borrowings   1,780    (13)   2.92    10,500    (100)   3.81 
Long-term borrowings   8,720    (62)   2.84    10,500    (89)   3.39 
Secured borrowings   734    (8)   4.36    921    (13)   5.65 
Junior subordinated debentures   13,403    (76)   2.27    13,403    (113)   3.37 
Total borrowings   24,637    (159)   2.58    35,324    (315)   3.57 
                               
Total interest-bearing liabilities  $465,080   $(984)   0.85%  $489,700   $(1,680)   1.37%
                               
Demand deposits   99,223             83,562           
Other liabilities   5,315             4,905           
Shareholders’ equity   64,090             59,784           
                               
Total liabilities and shareholders’ equity  $633,708           $637,951           
                               
Net interest income    $6,251*            $5,882*     
Net interest spread         4.39%             4.09%
Net interest margin         4.24%          3.95%
Tax equivalent adjustment    $200*            $197*     

 

* Tax equivalent basis – 34% tax rate used

 

(1) Interest income on loans includes loan fees of $138 and $166 in 2012 and 2011, respectively.

 

Interest and dividend income on a tax equivalent basis for the three months ended March 31, 2012 decreased $327,000, or 4.32%, compared to the same period in 2011. The decrease was primarily due to the decline in income earned on our loan portfolio as a result of the continued low interest rate environment. Loans averaged $480,227,000 with an average yield of 5.52% for the three months ended March 31, 2012, compared to average loans of $480,063,000 with an average yield of 5.75% for the same period in 2011. Interest and dividend income on investment securities on a tax equivalent basis for the three months ended March 31, 2012 decreased $43,000, or 6.74%, compared to the same period in 2011. The decrease was attributable to the reduction in rates earned on adjustable rate mortgage-backed securities and the maturity and sale of higher yielding securities that cannot be replaced in the current low rate environment.

 

32
 

 

Average interest earning balances with banks for the three months ended March 31, 2012 were $31,272,000 with an average yield of 0.23% compared to $39,539,000 with an average yield of 0.24% for the same period in 2011.

 

Interest expense for the three months ended March 31, 2012 decreased $696,000, or 41.43%, compared to the same period in 2011. The decrease is primarily attributable to a decrease in rates paid on deposits and junior subordinated debentures. Average interest-bearing deposit balances for the three months ended March 31, 2012 and 2011 were $440,443,000 and $454,376,000, respectively, with an average cost of 0.75% and 1.20%, respectively.

 

Average borrowings for the three months ended March 31, 2012 were $24,637,000 with an average cost of 2.58% compared to $35,324,000 with an average cost of 3.57% for the same period in 2011. The decrease in average borrowing balances outstanding is primarily due to the maturity of $10,500,000 in FHLB advances in the later part of 2011. The pay down in borrowings was funded by growth in lower cost demand, money market and savings deposits, further improving net interest margin.

 

Provision and allowance for credit losses. The allowance for credit losses reflects management's current estimate of the amount required to absorb probable losses on loans in its loan portfolio based on factors present as of the end of the period.  Loans deemed uncollectible are charged against, and reduce the allowance.

 

Periodic provisions for credit losses are charged to current expense to replenish the allowance for credit losses in order to maintain the allowance at a level management considers adequate. The amount of provision is based on an analysis of various factors including historical loss experience based on volumes and types of loans, volumes and trends in delinquencies and non-accrual loans, trends in portfolio volume, results of internal and independent external credit reviews, and anticipated economic conditions. Estimated loss factors used in the allowance for credit loss analysis are established based in part on historic charge-off data by loan category and economic conditions. During the three months ended March 31, 2012, there were no changes to the loss factors used in the allowance for credit losses. For additional information, please see the discussion under the heading “Critical Accounting Policies” in Item 7 of our 2011 10-K.

 

During the three months ended March 31, 2012, provision for credit losses totaled $100,000 compared to $500,000 for the same periods in 2011. The decrease in provision for credit losses in the current three-month period is due to improving credit quality as evidenced by decreases in non-performing loans and non-performing assets and a decrease in loans classified substandard and especially mentioned (OLEM). Non-performing loans decreased from $14,035,000 at December 31, 2011, to $12,062,000 at March 31, 2012. Loans classified as substandard decreased $1,212,000 from year-end 2011 to $33,358,000 at the close of the quarter, while OLEM decreased by $5,393,000 to $14,870,000.

 

For the three months ended March 31, 2012, net charge-offs were $364,000 compared to $343,000 for the same periods in 2011. Net charge-offs for the twelve months ended December 31, 2011 were $1,990,000. The ratio of net charge-offs to average loans outstanding for the three months ended March 31, 2012 and 2011 was 0.07% and 0.07%, respectively.

 

33
 

 

At March 31, 2012, the allowance for credit losses was $10,863,000 compared to $11,127,000 at December 31, 2011, and $10,774,000 at March 31, 2011. The decrease compared to year-end 2011 is due to continued improvement in credit quality and a decline in non-performing loans as discussed above. The ratio of the allowance for credit losses to total loans outstanding (including loans held for sale) was 2.26%, 2.34% and 2.26%, at March 31, 2012, December 31, 2011 and March 31, 2011, respectively. While the allowance for credit losses as a percentage of total loans has come down, it still remains elevated compared to historical standards and is reflective of management’s review of qualitative factors including the continued uncertainty in the economy, pervasive high unemployment rates in our geographic markets, and deterioration in real estate values, albeit at a slower pace than in the last three years.

 

The Company’s loan portfolio includes a significant portion of government guaranteed loans which are fully guaranteed by the United States Government. Government guaranteed loans were $52,899,000, $52,928,000, and $52,836,000 at March 31, 2012, December 31, 2011 and March 31, 2011, respectively. The ratio of allowance for credit losses to total loans outstanding excluding the government guaranteed loans was 2.55%, 2.64%, and 2.55%, respectively.

 

There is no precise method of predicting specific credit losses or amounts that ultimately may be charged off. The determination that a loan may become uncollectible, in whole or in part, is a matter of significant management judgment. Similarly, the adequacy of the allowance for credit losses is a matter of judgment that requires consideration of many factors, including (a) economic conditions and the effect on particular industries and specific borrowers; (b) a review of borrowers' financial data, together with industry data, the competitive situation, the borrowers' management capabilities and other factors; (c) a continuing evaluation of the loan portfolio, including monitoring by lending officers and staff credit personnel of all loans which are identified as being of less than acceptable quality; (d) an in-depth review, at a minimum of quarterly or more frequently as considered necessary, of all loans judged to present a possibility of loss (if, as a result of such quarterly analysis, the loan is judged to be not fully collectible, the carrying value of the loan is reduced to that portion considered collectible); and (e) an evaluation of the underlying collateral for secured lending, including the use of independent appraisals of real estate properties securing loans. An analysis of the adequacy of the allowance is conducted by management quarterly and is reviewed by the board of directors. Based on this analysis and applicable accounting standards, management considers the allowance for credit losses to be adequate at March 31, 2012.

 

Non-performing assets and other real estate owned. Non-performing assets totaled $20,018,000 at March 31, 2012. This represents 3.11% of total assets, compared to $21,760,000, or 3.39%, at December 31, 2011, and $17,506,000, or 2.74%, at March 31, 2011. Construction and land development loans and commercial real estate loans are the primary components of non-performing assets, representing $10,289,000, or 51.39%, of non-performing assets.

 

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The following table presents information related to the Company’s non-performing assets:

 

SUMMARY OF NON-PERFORMING ASSETS
(in thousands)
  March 31, 
2012
   December 31,
2011
   March 31,
 2011
 
             
Accruing loans past due 90 days or more  $270   $299   $85 
Non-accrual loans:               
Construction, land development and other land loans   3,426    5,510    6,765 
Residential real estate 1-4 family   803    528    1,734 
Commercial real estate   6,863    7,168    1,642 
Farmland            
Commercial and industrial   700    530    616 
                
Total non-accrual loans (1)   11,792    13,736    10,757 
                
Total non-performing loans   12,062    14,035    10,842 
                
OREO   7,956    7,725    6,664 
                
Total Non-Performing Assets (2)  $20,018   $21,760   $17,506 
                
Troubled debt restructured loans on accrual status  $   $398   $ 
Allowance for credit losses  $10,863   $11,127   $10,774 
Allowance for credit losses to non-performing loans   90.06%   79.28%   99.37%
Allowance for credit losses to non-performing assets   54.27%   51.14%   61.54%
Non-performing loans to total loans (3)   2.57%   2.96%   2.30%
Non-performing assets to total assets   3.11%   3.39%   2.74%

 

(1)   Includes $4,676,000, $8,132,000 and $2,931,000 in non-accrual troubled debt restructured loans (“TDRs”) as of March 31, 2012, December 31, 2011 and March 31, 2011, respectively, which are also considered impaired loans.

(2)   Does not include TDRs on accrual status.

(3)   Excludes loans held for sale.

 

Non-performing loans decreased $1,973,000, or 14.1%, from the balance at December 31, 2011 due to a decrease in non-accrual construction, land development and other land loans. The level of non-performing assets is still considered elevated by historical standards and reflects the continued weakness in the real estate market and economy. The Company continues to aggressively monitor and identify non-performing assets and take action based upon available information. In addition to the increase in non-performing loans, OREO increased slightly by $231,000, or 2.99%, from the balance at December 31, 2011. While OREO balances increased, there was significant OREO activity during the current quarter, including the sale of six properties totaling $1,710,000, which resulted in gain on sale of $172,000 recognized in earnings, which was offset by new transfers, or improvements, to OREO of $1,876,000 during the quarter.

 

Currently, it is our practice to obtain new appraisals on non-performing collateral dependent loans and/or OREO semi-annually. Based upon the appraisal review for non-performing loans, the Company will record the loan at the lower of carrying value or fair value of collateral (less estimated costs to sell) by recording a charge-off to the allowance for credit losses or by designating a specific reserve per accounting principles generally accepted in the United States. Generally, the Company will record the charge-off rather than designate a specific reserve.  As a result, the carrying amount of non-performing loans will not exceed the estimated value of the underlying collateral.   During the three months ended March 31, 2012 and 2011, as a result of these appraisals and other factors, the Company recorded OREO write-downs of $107,000 and $116,000, respectively, and net charge-offs of $364,000 and $343,000, respectively.

 

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OREO at March 31, 2012 totaled $7,956,000 and consists of properties as follows: thirteen land or land development properties totaling $3,823,000, three residential construction properties totaling $887,000, eight commercial real estate properties totaling $2,312,000, and three single family residences collectively valued at $934,000. The balances are recorded at the lower of the original carrying amount of the loan or estimated net realizable value of the real estate less selling costs.

 

A troubled debt restructuring (“TDR”) is a loan for which the terms have been modified in order to grant a concession to a borrower that is experiencing financial difficulty. Troubled debt restructurings are considered impaired loans and reported as such. For more information regarding TDRs, see Note 4-“Loans” of the condensed consolidated financial statements. The Company had troubled debt restructures totaling $4,676,000 and $8,132,000 at March 31, 2012 and December 31, 2011, respectively, all of which were on non-accrual status at March 31, 2012. TDRs totaling $398,000 as of December 31, 2011 were accruing interest. TDRs as of March 31, 2011 were all on non-accrual status. The decrease in the current period is largely due to the transfer of $2,465,000 in previously restructured construction and land loans to other real estate owned.

 

Non-interest income and expense. Non-interest income for the three months ended March 31, 2012 increased by $515,000, or 38.63%, compared to the same period in 2011. The increase was the result of an increase in gain on sale of OREO of $169,000 and gain on sale of loans of $246,000. Gain on sales of loans, the largest component of non-interest income, totaled $799,000 for the three months ended March 31, 2012 compared to $553,000 for the same period in 2011. The increase for the three month period is due to increased mortgage refinancing activity compared to 2011. Originations of loans held for sale were $46,131,000 for the three months ended March 31, 2012, compared to $30,461,000 for the same period in 2011.

 

Service charges on deposits for the three months ended March 31, 2012 were relatively unchanged at $413,000 compared to $414,000, for the same periods in 2011.

 

The Bank recorded net gains on sale of securities available-for-sale of $10,000 during the three months ended March 31, 2012, compared to $110,000 for the same periods in the prior year, which was more than offset by a decline in other-than-temporary-impairment (“OTTI”) losses. For the three months ended March 31, 2012 one non-agency mortgage-backed security was determined to be other-than-temporarily-impaired resulting in the Company recording $70,000 in impairment charges related to credit losses through earnings compared to $193,000 for the same period a year ago. As of March 31, 2012, an additional $192,000 in impairments not related to credit losses have been recorded through other comprehensive income. There were no additional OTTI securities at March 31, 2012 or December 31, 2011.

 

Total non-interest expense for the three months ended March 31, 2012 increased $457,000, or 7.44% compared to the same period in 2011. The increase was mostly related to increases in salary and employee benefit costs and data processing expenses, which were partially offset by reductions in FDIC assessments and occupancy and equipment expenses. Salaries and employee benefits for the three months ended March 31, 2012 and 2011 were $3,758,000 and $3,428,000, respectively. The increase is mostly related to annual performance and merit increases, as well as an increase in health insurance premiums. Full time equivalent employees at March 31, 2012 were 221 compared to 223 at March 31, 2011.

 

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Income taxes. The federal income tax expense (benefit) for the three months ended March 31, 2012 was $181,000 as compared to ($56,000) for the three months ended March 31, 2011. The effective tax rate for the three months ended March 31, 2012 was 15.1%. The effective tax rate differs from the statutory rate of 34.4% due to tax exempt income representing an increasing share of income as investments in municipal securities and loans, income earned on BOLI, and tax credits received on investments in low income housing partnerships remained at historical levels, while other earnings declined.

 

Financial Condition

 

Assets. Total assets were $644,675,000 at March 31, 2012, an increase of $3,421,000, or 0.53%, over year-end 2011. Increases in interest bearing deposits with banks and investments were the primary contributors to overall asset growth, which were partially offset by a decrease in loans.

 

Investments. The investment portfolio provides the Company with an income alternative to loans. The Company’s investment portfolio at March 31, 2012 was $56,512,000 compared to $54,677,000 at the end of 2011, an increase of $1,835,000, or 3.36%, due to investments in municipal and corporate bond securities as an alternative to cash. For additional information on investments, see Note 3 of the Notes to Condensed Consolidated Financial Statements contained in "Item 1, Financial Statements."

 

Loans. Total loans, including loans held for sale, decreased $9,751,000, or 2.00%, to $479,683,000 at March 31, 2012, compared to $489,434,000 at December 31, 2011. The decrease in loans was primarily due to a decline of $10,655,000 in commercial real estate loans which was largely a result of continued loan payoffs prior to maturity, which the Company believes are reflective of the current low interest rate environment and economic conditions. This decline, together with smaller declines in residential loans, offset a modest increase in commercial and industrial loans. Loan detail by category, including loans held for sale, as of March 31, 2012 and December 31, 2011 follows (in thousands):

 

  March 31,
2012
   December 31,
2011
 
         
Commercial and industrial  $93,404   $90,731 
Residential al estate:          
Residential 1-4 family   87,783    90,552 
Multi-family   8,909    7,682 
Commercial real estate:          
Construction and land development   46,410    47,156 
Commercial real estate – owner occupied   113,667    118,469 
Commercial real estate – non owner occupied   97,152    103,005 
Farmland   24,221    23,752 
Installment   8,855    8,928 
Less unearned income   (718)   (841)
Total Loans   479,683    489,434 
Allowance for credit losses   (10,863)   (11,127)
           
Net Loans  $468,820   $478,307 

 

Interest and fees earned on our loan portfolio is our primary source of revenue. Gross loans represented 74% of total assets as of March 31, 2012, compared to 76% at December 31, 2011. The majority of the Company’s loan portfolio is comprised of commercial and industrial loans and real estate loans. The commercial and industrial loans are a diverse group of loans to small, medium, and larger businesses for purposes ranging from working capital needs to term financing of equipment.

 

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The commercial real estate loan category constitutes 44% of our loan portfolio and generally consists of a wide cross-section of retail, small office, warehouse, and industrial type properties. Loan to value ratios for the Company’s commercial real estate loans at origination generally do not exceed 75% and debt service ratios are generally 125% or better. While we have significant balances within this lending category, we believe that our lending policies and underwriting standards are sufficient to reduce risk even in a downturn in the commercial real estate market. Additionally, this is a sector in which we have significant long-term management experience. It is our strategic plan to seek growth in commercial and small business loans where available and owner occupied commercial real estate loans.

 

We remain aggressive in managing our construction loan and land development portfolios. While these segments have historically played a significant role in our loan portfolio, balances have declined over the last three years. Construction and land development loans represented 9.7% and 9.6% of our loan portfolio at March 31, 2012 and at December 31, 2011, respectively. We believe this segment will remain challenged through 2012, although to a lesser extent than the previous three years.

 

The Bank is not engaging in new land acquisition and development financing. Limited residential speculative construction financing is being provided for a select group of borrowers that is designed to facilitate exit from the related loans. It was the Company’s strategic objective to reduce concentrations in land and residential construction and total commercial real estate below the regulatory guidelines of 100% and 300% of risk based capital, respectively, which was completed in the first quarter of 2010. As of March 31, 2012, concentration in commercial real estate as a percentage of risk based capital stood at 210% and concentration in land and residential construction as a percentage of risk-based capital was 44%.

 

Deposits. Total deposits were $550,419,000 at March 31, 2012, an increase of $2,369,000, or 0.43%, compared to December 31, 2011. Deposit detail by category as of March 31, 2012 and December 31, 2011 follows (in thousands):

 

  March 31,
2012
   December 31,
2011
 
         
Demand, non-interest bearing  $98,286   $108,899 
Interest bearing demand   132,133    122,160 
Money market   103,775    99,031 
Savings   66,927    65,451 
Time, interest bearing   149,298    152,509 
           
Total deposits  $550,419   $548,050 

 

Non-interest bearing demand deposits decreased $10,613,000, or 9.75%, which is consistent with the cyclical pattern of our commercial customers which draw on cash reserves during the winter months. Interest bearing demand, money market and savings accounts all increased as of March 31, 2012 compared to year-end 2011 largely in public and Indian nation deposits. In total, non-maturity deposits (total deposits less time deposits) increased $5,580,000, or 1.41%.

 

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Time deposits decreased $3,211,000, or 2.11%, due to our commitment to maintain a disciplined pricing strategy, focusing on enhancing long-term customer relationships rather than on rate sensitive customers. As a result, the percentage of time certificates of deposit to total deposits decreased to 27.1% at March 31, 2012, from 27.8% at December 31, 2011, which favorably impacted net interest margin.

 

It is our strategic goal to grow core deposits through the quality and breadth of our branch network, increased brand awareness, superior sales practices and competitive rates. In the long-term we anticipate continued growth in our core deposits through both the addition of new customers and our current client base. In addition, management’s strategy for funding asset growth as opportunities arise may include use of brokered and other wholesale deposits on an as-needed basis.

 

Liquidity. We believe adequate liquidity continues to be available to accommodate fluctuations in deposit levels, fund operations, provide for customer credit needs, and meet obligations and commitments on a timely basis. The Bank’s primary sources of funds are customer deposits, maturities of investment securities, loan sales, loan repayments, net income, and other borrowings which are used to make loans, acquire investment securities and other assets, and fund continuing operations. While maturities and scheduled amortization of loans are a predictable source of funds, deposit flows and prepayments are greatly influenced by the level of interest rates, economic conditions, and competition. In addition to customer deposits, when necessary, liquidity can be increased by taking advances from credit available to the Bank.

 

The Bank’s liquidity position at March 31, 2012, includes $51.2 million in cash and interest bearing deposits with banks and $59.5 million in investments classified as available-for-sale. We generally maintain sufficient cash and short-term investments to meet short-term liquidity needs. In addition, the Bank maintains credit facilities with correspondent banks totaling $16,000,000, of which none was used as of March 31, 2012. The Bank also has a credit line with the Federal Home Loan Bank (“FHLB”) of Seattle for up to 20% of assets, of which $10,500,000 was used at March 31, 2012. Based on current pledged collateral, the Bank had $112.5 million of available borrowing capacity on its line at the FHLB, although each advance is subject to prior consent. The Bank also has a borrowing facility of $50.9 million at the Federal Reserve Bank subject to pledged collateral, of which none was used at March 31, 2012. Borrowings may be used on a short-term basis to compensate for reductions in deposits, but are generally not considered a long-term solution to liquidity needs.

 

The holding company relies on dividends from the Bank, proceeds from the exercise of stock options, and proceeds from the issuance of shares of common stock for its funds, which are used for various corporate purposes. Dividends from the Bank are the holding company's most important source of funds, and are subject to regulatory restrictions and the capital needs of the Bank, which are always primary. Sales of trust preferred securities (“TRUPs”) have historically also been a source of liquidity for the holding company and capital for both the holding company and the Bank; however, we have not issued TRUPs since 2006 and do not anticipate TRUPs will be a source of liquidity in 2012 or beyond. The Company and the Bank are subject to certain restrictions on the payment of dividends without prior regulatory approval.

 

At March 31, 2012, two wholly-owned subsidiary grantor trusts established by the Company had issued and outstanding $13,403,000 of trust preferred securities. During 2009, the Company elected to exercise the right to defer interest payments on trust preferred debentures. Under the terms of the indenture, the Company has the right to defer interest payments for up to twenty consecutive quarterly periods without going into default. During the period of deferral, the principal balance and unpaid interest will continue to bear interest as set forth in the indenture. In addition, the Company will not be permitted to pay any dividends or distributions on, or redeem or make a liquidation payment with respect to, any of the Company’s common stock during the deferral period. As of March 31, 2012, deferred interest totaled $1,327,000 and is included in accrued interest payable on the balance sheet.

 

39
 

 

For additional information regarding trust preferred securities, see the 2011 10-K under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity”.

 

Capital. The Federal Reserve and the FDIC have established minimum guidelines that mandate risk-based capital requirements for bank holding companies and member banks. Under the guidelines, risk percentages are assigned to various categories of assets and off-balance sheet items to calculate a risk-adjusted capital ratio. Regulatory minimum risk-based capital guidelines under the Federal Reserve require Tier 1 capital to risk-weighted assets of 4% and total capital to risk-weighted assets of 8% to be considered adequately capitalized. To qualify as well capitalized under the FDIC guidelines, banks must have a Tier 1 leverage ratio of 5%, a Tier 1 risk-based capital ratio of 6%, and a Total risk-based capital ratio of 10%. Failure to qualify as well capitalized can negatively impact a bank’s ability to expand and to engage in certain activities.

 

The capital ratios for the Company and the Bank at March 31, 2012 and December 31, 2011, were as follows:

 

    Company   Bank    Requirements  
  March
31, 2012
   December 31,
2011
   March
31, 2012
   December
31, 2011
   Adequately
Capitalized
   Well
Capitalized
 
Tier 1 leverage ratio   10.47%   10.18%   10.67%   10.35%   4%   5%
Tier 1 risk-based capital ratio   14.03%   13.56%   14.29%   13.79%   4%   6%
Total risk-based capital ratio   15.29%   14.82%   15.55%   15.05%   8%   10%

 

Total shareholders' equity was $64,284,000 at March 31, 2012, an increase of $1,014,000, or 1.60%, compared to December 31, 2011.

 

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

Interest rate, credit, and operations risks are the most significant market risks that affect the Company's performance. The Company relies on loan review, prudent loan underwriting standards, and an adequate allowance for possible credit losses to mitigate credit risk.

 

An asset/liability management simulation model is used to measure interest rate risk. The model produces regulatory oriented measurements of interest rate risk exposure. The model quantifies interest rate risk by simulating forecasted net interest income over a 12-month time period under various interest rate scenarios, as well as monitoring the change in the present value of equity under the same rate scenarios. The present value of equity is defined as the difference between the market value of assets less current liabilities. By measuring the change in the present value of equity under various rate scenarios, management is able to identify interest rate risk that may not be evident from changes in forecasted net interest income.

 

The Company is currently asset sensitive, meaning that interest earning assets mature or re-price more quickly than interest-bearing liabilities in a given period. Therefore, a significant increase in market rates of interest could improve net interest income. Conversely, a decreasing rate environment may adversely affect net interest income.

 

It should be noted that the simulation model does not take into account future management actions that could be undertaken should actual market rates change during the year. Also, the simulation model results are not exact measures of the Company's actual interest rate risk. They are only indicators of rate risk exposure based on assumptions produced in a simplified modeling environment designed to heighten sensitivity to changes in interest rates. The rate risk exposure results of the simulation model typically are greater than the Company's actual rate risk. That is due to the modeling environment, which generally depicts a worst-case situation. Management has assessed the results of the simulation reports as of March 31, 2012 and believes that there has been no material change since December 31, 2011.

40
 

 

ITEM 4. CONTROLS AND PROCEDURES

 

The Company's disclosure controls and procedures are designed to ensure that information the Company must disclose in its reports filed or submitted under the Securities Exchange Act of 1934 ("Exchange Act") is recorded, processed, summarized, and reported on a timely basis. Our management has evaluated, with the participation and under the supervision of our chief executive officer (“CEO”) and chief financial officer (“CFO”), the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Exchange Act) as of the end of the period covered by this report. Based on this evaluation, our CEO and CFO have concluded that, as of such date, the Company's disclosure controls and procedures are effective in ensuring that information relating to the Company, including its consolidated subsidiaries, required to be disclosed in reports that it files under the Exchange Act is (1) recorded, processed, summarized, and reported within the time periods specified in the SEC's rules and forms, and (2) accumulated and communicated to our management, including our CEO and CFO, as appropriate to allow timely decisions regarding required disclosures.

No change in the Company's internal control over financial reporting occurred during our last fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting.

 

PART II – OTHER INFORMATION

 

ITEM 1.          LEGAL PROCEEDINGS

 

Not applicable.

 

ITEM 1A.          RISK FACTORS

 

There has been no material change from the risk factors previously reported in the 2011 10-K.

 

ITEM 2.          UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

 

None.

 

ITEM 3.          DEFAULTS UPON SENIOR SECURITIES

 

None.

 

ITEM 4.          MINE SAFETY DISCLOSURES

 

None.

 

ITEM 5.          OTHER INFORMATION

 

None.

 

41
 

 

ITEM 6.          EXHIBITS

 

See Exhibit Index immediately following signatures below.

 

SIGNATURES

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

  PACIFIC FINANCIAL CORPORATION
     
DATED:  May 14, 2012 By: /s/ Dennis A. Long
    Dennis A. Long
    Chief Executive Officer
     
  By: /s/ Denise Portmann
    Denise Portmann
    Chief Financial Officer

 

42
 

 

EXHIBIT INDEX

 

EXHIBIT NO.   EXHIBIT
     
31.1   Certification of CEO under Rule 13a – 14(a) of the Exchange Act.
31.2   Certification of CFO under Rule 13a – 14(a) of the Exchange Act.
32   Certification of CEO and CFO under 18 U.S.C. Section 1350.
101.   INS XBRL Instance Document *
101.   SCH XBRL Taxonomy Extension Schema Document *
101.   CAL XBRL Taxonomy Extension Calculation Linkbase Document *
101.   DEF XBRL Taxonomy Extension Definition Linkbase Document *
101.   LAB XBRL Taxonomy Extension Label Linkbase Document *
101.   PRE XBRL Taxonomy Extension Presentation Linkbase Document *

 

 

* Pursuant to Rule 406T of Regulation S-T, these interactive data files are deemed not filed or part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933, as amended, or Section 18 of the Securities Exchange Act of 1934, as amended and otherwise are not subject to liability under those sections.

 

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PINX:PFLC Pacific Financial Corp Quarterly Report 10-Q Filling

Pacific Financial Corp PINX:PFLC Stock - Get Quarterly Report SEC Filing of Pacific Financial Corp PINX:PFLC stocks, including company profile, shares outstanding, strategy, business segments, operations, officers, consolidated financial statements, financial notes and ownership information.

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PINX:PFLC Pacific Financial Corp Quarterly Report 10-Q Filing - 3/31/2012
Name |  Ticker |  Star Rating |  Market Cap |  Stock Type |  Sector |  Industry Star Rating |  Investment Style |  Total Assets |  Category |  Top Holdings |  Top Sectors |  Symbol |  Title Star Rating |  Category |  Total Assets |  Top Holdings |  Top Sectors |  Symbol |  Name Title |  Date |  Author |  Collection |  Interest |  Popularity Topic |  Sector |  Key Indicators |  User Interest |  Market Cap |  Industry Name |  Ticker |  Star Rating |  Market Cap |  Stock Type |  Sector |  Industry Star Rating |  Investment Style |  Total Assets |  Category |  Top Holdings |  Top Sectors |  Symbol / Ticker |  Title Star Rating |  Category |  Total Assets |  Symbol / Ticker |  Name Title |  Date |  Author |  Collection |  Popularity |  Interest Title |  Date |  Company |  Symbol |  Interest |  Popularity Title |  Date |  Company |  Symbol |  Interest |  Popularity

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