|• FORM 10-Q • EXHIBIT 31.1 • EXHIBIT 31.2 • EXHIBIT 32 • XBRL INSTANCE DOCUMENT • XBRL TAXONOMY EXTENSION SCHEMA • XBRL TAXONOMY EXTENSION CALCULATION LINKBASE • XBRL TAXONOMY EXTENSION DEFINITION LINKBASE • XBRL TAXONOMY EXTENSION LABEL LINKBASE • XBRL TAXONOMY EXTENSION PRESENTATION LINKBASE|
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
For the quarterly period ended March 31, 2012
For the transition period from ______________ to _____________
Commission file number: 0-54447
NAUGATUCK VALLEY FINANCIAL CORPORATION
(Exact name of registrant as specified in its charter)
(Registrant’s telephone number, including area code)
(Former name, former address and former fiscal year, if changed since last report)
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 such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes x No ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act (Check one):
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes ¨ No x
As of May 8, 2012, there were 7,002,208 shares of the registrant’s common stock outstanding.
NAUGATUCK VALLEY FINANCIAL CORPORATION
Table of Contents
Part I - FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements (Unaudited)
Consolidated Statements of Financial Condition
(In thousands, except share data)
See accompanying notes to unaudited consolidated financial statements.
Consolidated Statements of Income and Comprehensive Income
(In thousands, except per share data)
(1) Earnings per share for the three months ended March 31, 2011 have been restated to reflect the effect of the Company's stock offering and concurrent second-step conversion effective June 29, 2011 at an exchange ratio of 0.9978.
See accompanying notes to unaudited consolidated financial statements.
Consolidated Statements of Changes in Stockholder’s Equity
Three months ended March 31, 2012
(Unaudited, in thousands, except share data)
See accompanying notes to unaudited consolidated financial statements.
Consolidated Statements of Cash Flows (In thousands)
See accompanying notes to unaudited consolidated financial statements.
Notes to Unaudited Consolidated Financial Statements
NOTE 1 – NATURE OF OPERATIONS
Effective June 29, 2011, Naugatuck Valley Financial Corporation (the “Company”) completed its public stock offering in connection with the conversion of Naugatuck Valley Mutual Holding Company (the “MHC”) from the mutual holding company to the stock holding company form of organization (the “Conversion”). As a result of the Conversion, the Company succeeded Naugatuck Valley Financial Corporation, a Federal corporation (the “Federal Corporation”), as the holding company for Naugatuck Valley Savings and Loan (the “Bank”) and the MHC ceased to exist. A total of 4,173,008 shares of Company common stock were sold in a subscription and community offering at $8.00 per share, including 250,380 shares purchased by the Naugatuck Valley Savings and Loan Employee Stock Ownership Plan (the “ESOP”). Additionally, shares totaling 2,829,358 were issued to the stockholders of the Federal Corporation (other than the MHC) in exchange for their shares of Federal Corporation common stock at an exchange ratio of 0.9978 share of Company common stock for each share of Federal Corporation common stock. Shares outstanding after the stock offering and the exchange totaled 7,002,366. Net proceeds from the reorganization and stock offering totaled $31.3 million, after deducting offering costs of $2.1 million. Net income per share and the weighted average shares outstanding for the three months ended March 31, 2011 have been restated to reflect the Conversion.
Originally organized in 1922, the Bank is a federally chartered stock savings bank which is headquartered in Naugatuck, Connecticut. The Bank provides a full range of personal banking services to individual and small business customers located primarily in the Naugatuck Valley and the immediate surrounding vicinity. It is subject to competition from other financial institutions throughout the region. The Bank is also subject to the regulations of various federal agencies and undergoes periodic examinations by those regulatory authorities.
The Bank owns Naugatuck Valley Mortgage Servicing Corporation, which qualifies and operates as a Connecticut passive investment company pursuant to legislation.
NOTE 2 - BASIS OF PRESENTATION
The accompanying consolidated interim financial statements are unaudited and include the accounts of the Company, the Bank, and the Bank’s wholly owned subsidiary, Naugatuck Valley Mortgage Servicing Corporation. The consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and with the instructions to SEC Form 10-Q. Accordingly, they do not include all the information and footnotes required by GAAP for complete financial statements. All significant intercompany accounts and transactions have been eliminated in consolidation. These consolidated financial statements reflect, in the opinion of management, all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of the Company’s financial position and the results of its operations and its cash flows at the dates and for the periods presented.
In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the statement of condition, and income and expenses for the interim period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near-term relate to the determination of the allowance for losses on loans, the valuation of real estate acquired in connection with foreclosure or in satisfaction of loans, deferred income taxes and the valuation of certain investment securities. While management uses available information to recognize losses and properly value these assets, future adjustments may be necessary based on changes in economic conditions both in Connecticut and nationally.
Management has evaluated subsequent events for potential recognition or disclosure in the financial statements. No subsequent events were identified that would have required a change to the financial statements or disclosure in the notes to the financial statements.
Operating results for the three months ended March 31, 2012 are not necessarily indicative of the results that may be expected for the year ending December 31, 2012.
These consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K/A for the year ended December 31, 2011.
Certain reclassifications have been made to prior period consolidated financial statements to conform to the March 31, 2012 consolidated financial statement presentation. These reclassifications only changed the reporting categories but did not affect the Company’s results of operations or financial position. Share and per share data for periods prior to the Conversion have been restated to reflect the effect of the Company’s stock offering and concurrent second-step conversion effective June 29, 2011 at an exchange ratio of 0.9978.
NOTE 3 - CRITICAL ACCOUNTING POLICIES
The Company considers accounting policies involving significant judgments and assumptions by management that have, or could have, a material impact on the carrying value of certain assets or on income to be critical accounting policies. The accounting policies related to loans and the allowance for loan losses are presented below. For a summary of all other significant accounting policies, please refer to Note 4, “Summary of Significant Accounting Policies”, contained in the Company’s Annual Report on Form 10-K/A for the year ended December 31, 2011.
Allowance for Loan Losses. Determining the amount of the allowance for loan losses necessarily involves a high degree of judgment. Although the Company believes that it uses the best information available to establish the allowance for loan losses, future additions to the allowance may be necessary based on estimates that are susceptible to change as a result of changes in economic conditions and other factors. Management reviews the level of the allowance on a quarterly basis, at a minimum, and establishes the provision for loan losses based on the composition of the loan portfolio, delinquency levels, loss experience, economic conditions, and other factors related to the collectability of the loan portfolio.
The Company engages an independent review of its commercial loan portfolio at least annually and adjusts its loan ratings based upon this review. In addition, the Company’s regulatory authorities, as an integral part of their examination process, periodically review the Company’s allowance for loan losses and may require the Company to recognize adjustments to the allowance based on its judgments about information available to it at the time of its examination.
Impaired Loans - Impaired loans consist of non-accrual loans and troubled debt restructurings (“TDRs”) in accordance with applicable authoritative accounting guidance. With the exception of loans that were restructured and still accruing interest, a loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect all contractual principal and interest due according to the terms of the loan agreement. Loans deemed to be impaired are classified as non-accrual.
Impairment is measured by estimating the value of the loan based on the present value of expected future cash flows discounted at the loan’s initial effective interest rate or the fair value of the underlying collateral less costs to sell, if repayment of the loan is considered collateral-dependent. All impaired loans are included in non-performing assets.
Non-accrual loans. Loans are automatically placed on non-accrual status when payment of principal or interest is more than 90 days delinquent. Loans are also placed on non-accrual status if collection of principal or interest in full is in doubt or if the loan has been restructured. When loans are placed on non-accrual status, unpaid accrued interest is fully reversed, and further income is recognized only to the extent received. The loan may be returned to accrual status if unpaid principal and interest are repaid so that the loan is less than 90 days delinquent.
Troubled Debt Restructurings. TDRs are loans for which the original contractual terms of the loans have been modified and both of the following conditions exist: (i) the restructuring constitutes a concession (including reduction of interest rates or extension of maturity dates) and (ii) the borrower is experiencing financial difficulties. Loans are not classified as TDRs when the modification is short-term or results in only an insignificant delay or shortfall in the payments to be received. The Company’s TDRs are determined on a case-by-case basis in connection with ongoing loan collection processes.
The Company does not accrue interest on any TDRs unless it believes collection of all principal and interest under the modified terms is reasonably assured. Generally, six consecutive months of payment performance by the borrower under the restructured terms is required before a TDR is returned to accrual status assuming the loan is restructured at market rates. However, the period could vary depending upon the individual facts and circumstances of the loan.
For a TDR to begin accruing interest, the borrower must demonstrate both some level of performance and the capacity to perform under the modified terms. A history of timely payments and adherence to financial covenants generally serve as sufficient evidence of the borrower’s performance. An evaluation of the borrower’s current creditworthiness is used to assess whether the borrower has the capacity to repay the loan under the modified terms. This evaluation includes an estimate of expected cash flows, evidence of strong financial position, and estimates of the value of collateral, if applicable. (See Note 6 for additional information on TDRs.)
NOTE 4 — Accounting Standards Updates
Recently Adopted Accounting Guidance
Clarification to Accounting for Troubled Debt Restructurings: In April 2011, the Financial Accounting Standards Board (“FASB”) issued guidance to clarify the accounting for TDRs. Given the recent economic downturn, many banks have seen an increase in the number of loan modifications. Diversity in practice exists in terms of identifying whether a loan modification qualifies as a TDR, such that the FASB was asked to provide guidance. This new guidance was developed to assist creditors in determining whether a loan modification meets the criteria to be considered a TDR, both for purposes of recording an impairment and for disclosure of TDRs. The amendment specifies that in evaluating whether a restructuring constitutes a TDR, a creditor must conclude that both of the following conditions exist: (i) the restructuring constitutes a concession and (ii) the borrower is experiencing financial difficulties. The Company adopted this guidance effective July 1, 2011, and applied this guidance to restructurings occurring on or after January 1, 2011. The new guidance did not impact the Company’s financial position, results of operations, or liquidity or the numbers of TDRs indentified.
Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and International Financial Reporting Standards (“IFRS”): In April 2011, the FASB issued guidance that clarifies the wording used to describe many of the requirements in GAAP for measuring fair value and for disclosing information about fair value measurements. The guidance does not extend the use of fair value accounting, but clarifies the wording on how it should be applied to be consistent with IFRS and expands certain disclosure requirements relating to Level 3 fair value measurements. For many of the requirements, the FASB does not intend for the amendments in this update to result in a change in application from current guidance. This guidance is to be applied prospectively for interim and annual periods beginning after December 15, 2011. Since the guidance only relates to disclosure, the adoption of this guidance is not expected to impact the Company’s financial condition, results of operations, or liquidity.
Statement of Comprehensive Income: In April 2011, the FASB issued accounting guidance requiring companies to include a statement of comprehensive income as part of its interim and annual financial statements. The new guidance gives companies the option to present net income and comprehensive income either in one continuous statement or in two separate, but consecutive statements. This approach represents a change from current GAAP, which allows companies to report OCI and its components in the statement of shareholder’s equity. The guidance also allows companies to present OCI either net of tax with details in the notes or shown gross of tax (with tax effects shown parenthetically). This guidance is effective for fiscal years beginning after December 15, 2011, but early adoption is permitted. Since the guidance only relates to disclosure, the adoption of this guidance did not impact the Company’s financial condition, results of operations, or liquidity.
Recently Issued Accounting Guidance
There were no additional accounting standards updates applicable to the Company issued by FASB during the first quarter ended March 31, 2012. Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies are not expected to have a material impact on the Company’s financial position, results of operations or cash flows.
NOTE 5 – INVESTMENT SECURITIES
At March 31, 2012, the composition of the investment portfolio was:
At December 31, 2011, the composition of the investment portfolio was:
The Company has identified other investment securities in which the fair value of the security is less than the cost of the security. This can be from an increase in interest rates since the time of purchase or from deterioration in the credit quality of the issuer. All investment securities which have unrealized losses have undergone an internal impairment review.
Management’s review for impairment generally entails identification and analysis of individual investments that have fair values less than amortized cost, including consideration of the length of time the investment has been in an unrealized loss position and the expected recovery period; discussion of evidential matter, including an evaluation of factors or triggers that could cause individual investments to qualify as having other-than-temporary impairment and those that would not support other-than-temporary impairment; and documentation of the results of these analyses. As a result of the reviews, management has determined that there are no other investment securities which have deteriorated in credit quality subsequent to purchase, and believes that these unrealized losses are temporary and are the result of changes in market interest rates and market conditions over the past several years.
The following is a summary of the fair values and related unrealized losses aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at March 31, 2012, and December 31, 2011.
NOTE 6 – LOANS RECEIVABLE
A summary of loans receivable at March 31, 2012 and December 31, 2011 is as follows:
Credit Quality of Financing Receivables and the Allowance for Loan Losses
Management segregates the loan portfolio into portfolio segments, which are defined as the levels at which the Company develops and documents a systematic method for determining its allowance for loan losses. The portfolio segments are segregated based on loan types and the underlying risk factors present in each loan type. Such risk factors are periodically reviewed by management and revised as deemed appropriate.
The Company’s loan portfolio is segregated into the following portfolio segments:
One-to Four-Family Owner Occupied Loans. This portfolio segment consists of the origination of first mortgage loans secured by one-to four-family owner occupied residential properties and residential construction loans to individuals to finance the construction of residential dwellings for personal use located in our market area. Although the Company has experienced an increase in foreclosures on its owner occupied loan portfolio over the past year, foreclosures are still at relatively low levels and believe this is due mainly to its conservative underwriting and lending policies which do not allow for risky loans such as “Option ARM,” “sub-prime” or “Alt-A” loans.
Commercial Real Estate and Multi-family Loans. This portfolio segment includes loans secured by commercial real estate, non-owner occupied one-to four-family and multi-family dwellings for property owners and businesses in our market area. Loans secured by commercial real estate generally have larger loan balances and more credit risk than owner occupied one-to four-family mortgage loans. The increased risk is the result of several factors, including the concentration of principal in a limited number of loans and borrowers, the impact of local and general economic conditions on the borrower’s ability to repay the loan, and the increased difficulty of evaluating and monitoring these types of loans.
Construction and Land Development Loans. This portfolio segment includes commercial construction loans for commercial development projects, including condominiums, apartment buildings, and single family subdivisions as well as office buildings, retail and other income producing properties and land loans, which are loans made with land as security. Construction and land development financing generally involves greater credit risk than long-term financing on improved, owner-occupied real estate. Risk of loss on a construction loan depends largely upon the accuracy of the initial estimate of the value of the property at completion of construction compared to the estimated cost (including interest) of construction and other assumptions. If the estimate of construction cost proves to be inaccurate, the Company may be required to advance additional funds beyond the amount originally committed in order to protect the value of the property. Moreover, if the estimated value of the completed project proves to be inaccurate, the borrower may hold a property with a value that is insufficient to assure full repayment. Construction loans also expose the Company to the risks that improvements will not be completed on time in accordance with specifications and projected costs and that repayment will depend on the successful operation or sale of the properties, which may cause some borrowers to be unable to continue with debt service which exposes the Company to greater risk of non-payment and loss. Additionally, economic factors such as the decline of property values may have an adverse effect on the ability of the borrower to sell the property.
Commercial Business Loans. This portfolio segment includes commercial business loans secured by real estate, assignments of corporate assets, and personal guarantees of the business owners. Commercial business loans generally have higher interest rates and shorter terms than other loans, but they also may involve higher average balances, increased difficulty of loan monitoring and a higher risk of default since their repayment generally depends on the successful operation of the borrower’s business.
Real Estate Secured Loans. This portfolio segment includes home equity loans and home equity lines of credit secured by owner occupied one-to four-family residential properties. Loans of this type are generally written at a maximum of 75% of the appraised value of the property and require that the Company has a second lien position on the property. These loans are written at a higher interest rate and a shorter term than mortgage loans. The Company has experienced a low level of foreclosure in this type of loan during recent periods. These loans can be affected by economic conditions and the values of the underlying properties.
Consumer Loans. This portfolio segment includes loans secured by passbook or certificate accounts, or automobiles, as well as unsecured personal loans and overdraft lines of credit. This type of loan may entail greater risk than do residential mortgage loans, particularly in the case of loans that are unsecured or secured by assets that depreciate rapidly.
Loans are generally carried at the amount of unpaid principal, less the allowance for loan losses and adjusted for deferred loan fees, which are amortized over the term of the loan using the interest method. Interest on loans is accrued based on the principal amounts outstanding. It is the Company’s policy to discontinue the accrual of interest when a loan is specifically determined to be impaired or when the principal or interest is delinquent for more than 90 days. When a loan is placed on nonaccrual status, all interest previously accrued but not collected is reversed against current period interest income.
The allowance for loan losses is established through a provision for loan losses. The Company maintains the allowance at a level believed, to the best of management’s knowledge, adequate to cover all known and inherent losses in the loan portfolio that are both probable and reasonable to estimate at each reporting date.
Management reviews the allowance for loan losses on at least a quarterly basis in order to identify those inherent losses and to assess the overall collection probability for the loan portfolio. The evaluation process by portfolio segment includes, among other things, an analysis of delinquency trends, non-performing loan trends, the level of charge-offs and recoveries, prior loss experience, total loans outstanding, the volume of loan originations, the type, size and geographic concentration of the loans, the value of collateral securing the loan, the borrower’s ability to repay and repayment performance, the number of loans requiring heightened management oversight, local economic conditions and industry experience.
The establishment of the allowance for loan losses is significantly affected by management’s judgment and uncertainties, and there is a likelihood that different amounts would be reported under different conditions or assumptions. The Office of the Comptroller of the Currency (“OCC”), as an integral part of its examination process, periodically reviews the allowance for loan losses and may require the Company to make additional provisions for estimated loan losses based upon judgments different from those of management.
The allowance generally consists of specific and general components. The specific component relates to loans that have been evaluated and determined to be impaired under ASC 310-10-35. For such impaired loans, when the discounted cash flows (or collateral value or observable market price if the loan is collateral dependent) of the impaired loan is lower than the carrying value of that loan, the Company will charge the difference to loss or establish an allowance if the loss is not confirmed. The general component covers non-classified loans and is based on historical loss experience adjusted for qualitative factors. Additional general reserves are placed on loans classified as either doubtful, substandard or special mention. Although for analytical purposes, certain reserves are attributed to loans that are impaired and general components are attributed to loans evaluated collectively. The allowance is available to cover all charge offs that arise from the loan portfolio.
The Company will continue to monitor and modify its allowance for loan losses as conditions dictate. No assurances can be given that the level of allowance for loan losses will cover all of the inherent losses in the loan portfolio or that future adjustments to the allowance for loan losses will not be necessary if economic and other conditions differ substantially from the economic and other conditions used by management to determine the current level of the allowance for loan losses.
The following tables set forth the balance of the allowance for loan losses at March 31, 2012 and December 31, 2011, by portfolio segment, disaggregated by impairment methodology, which is then further segregated by amounts evaluated for impairment collectively and individually. Also included is a summary of transactions in the allowance for loan losses for the three months ended March 31, 2012 and the year ended December 31, 2011. The allowance for loan losses allocated to each portfolio segment is not necessarily indicative of future losses in any particular portfolio segment and does not restrict the use of the allowance to absorb losses in other portfolio segments.
The Company’s policies provide for the classification of loans and other assets into the following categories: pass (1 - 4), bankable with care (5), special mention (6), substandard (7), doubtful (8) and loss (9). Consistent with regulatory guidelines, loans and other assets that are considered to be of lesser quality are classified as substandard, doubtful, or loss assets. An asset is considered substandard if it is inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Substandard assets include those assets characterized by the distinct possibility that we will sustain some loss if the deficiencies are not corrected. Assets classified as doubtful have all of the weaknesses inherent in those classified substandard with the added characteristic that the weaknesses present make collection or liquidation in full, on the basis of currently existing facts, conditions and values, highly questionable and improbable. Assets (or portions of assets) classified as loss are those considered uncollectible and of such little value that their continuance as assets without establishment of a specific valuation allowance or charge-off is not warranted. Assets that do not expose us to risk sufficient to warrant classification in one of the aforementioned categories, but which possess potential weaknesses that deserve close attention, are required to be designated as special mention.
When assets are classified as special mention, substandard or doubtful, the Company disaggregates these assets and allocates a portion of the related general loss allowances to such assets as the Company deems prudent. Determinations as to the classification of assets and the amount of loss allowances are subject to review by our principal federal regulator, the Office of the Comptroller of the Currency, which can require that we establish additional loss allowances. The Company regularly reviews its asset portfolio to determine whether any assets require classification in accordance with applicable regulations.
The following tables are a summary of the loan portfolio quality indicators by loan class as of March 31, 2012 and December 31, 2011:
When a loan is 15 days past due, the Company sends the borrower a late notice. The Company also contacts the borrower by phone if the delinquency is not corrected promptly after the notice has been sent. When the loan is 30 days past due, the Company mails the borrower a letter reminding the borrower of the delinquency, and attempt to contact the borrower personally to determine the reason for the delinquency in order to ensure that the borrower understands the terms of the loan and the importance of making payments on or before the due date. If necessary, subsequent delinquency notices are issued and the account will be monitored on a regular basis thereafter. By the 90th day of delinquency, the Company will send the borrower a final demand for payment and may recommend foreclosure. A summary report of all loans 30 days or more past due is provided to the board of directors of the Company each month, and more frequently to the Asset Quality Committee of the Board of Directors.
Loans are automatically placed on non-accrual status when payment of principal or interest is more than 90 days delinquent. Loans are also placed on non-accrual status if collection of principal or interest in full is in doubt or if the loan has been restructured. When loans are placed on non-accrual status, unpaid accrued interest is fully reversed, and further income is recognized only to the extent received. The loan may be returned to accrual status if unpaid principal and interest are repaid so that the loan is less than 90 days delinquent. Management works closely with the Asset Quality Committee of the Board of Directors in an effort to resolve nonperforming assets in a manner most advantageous to the Company.
The following tables set forth certain information with respect to our loan portfolio delinquencies by loan class and amount as of March 31, 2012 and December 31, 2011:
The following table is a summary of nonaccrual loans by loan class as of March 31, 2012 and December 31, 2011:
Nonperforming loans (defined as nonaccrual loans and TDRs) totaled $27.3 million at March 31, 2012 compared to $24.7 million at December 31, 2011 ($1.3 million of which at both dates is fully guaranteed by the U.S. Small Business Administration). The amount of income that was contractually due but not recognized on nonperforming loans totaled $108,000 for the quarter ended March 31, 2012, compared with $365,000 for the year ended December 31, 2011.
At March 31 2012, there were no loans 90 or more days past due and still accruing interest. At March 31, 2012, the Company had 88 loans on non-accrual status with foregone interest for the period since the loans were placed on non-accrual status in the amount of approximately $986,000. Included in these loans were 43 loans which were not 90 days past due, but were placed on non-accrual status as a result of a recent modification or the identification of a weakness on the loan.
The Company accounts for impaired loans under GAAP. An impaired loan generally is one for which it is probable, based on current information, that the lender will not collect all the amounts due under the contractual terms of the loan. Loans are individually evaluated for impairment. When the Company classifies a problem asset as impaired, it makes an allowance for that portion of the asset that is deemed uncollectible.
At March 31, 2012, the Company had $22.0 million of loans which were considered to be impaired, with a valuation allowance of $11,000, compared to $19.4 million of such loans at December 31, 2011 with a valuation allowance of $1.4 million. The increase is primarily due to the classification of the following as impaired during the period: two residential development loans, eight commercial real estate loans, four commercial loans secured by business assets, four residential mortgage loans and one home equity loan. The increases were partially offset by removing from impaired status, one residential mortgage loan and one home equity loan. Additionally, $1.1 million of specific reserves that were allowed under previous regulatory supervision, were charged off against the loan balances as required under current supervision.
The following tables are a summary of impaired loans by class of loans as of March 31, 2012 and December 31, 2011:
Loan modifications are generally performed at the request of the individual borrower and may include reduction in interest rates, changes in payments, and maturity date extensions. TDRs are loans for which the original contractual terms of the loans have been modified and both of the following conditions exist: (i) the restructuring constitutes a concession (including reduction of interest rates or extension of maturity dates) and (ii) the borrower is experiencing financial difficulties. Loans are not classified as TDRs when the modification is short-term or results in only an insignificant delay or shortfall in the payments to be received. The Company’s loan modifications are determined on a case-by-case basis in connection with ongoing loan collection processes.
The following table presents a summary of loans that were restructured during the three months ended March 31, 2012.
The specific reserve portion of the allowance for loan losses on TDRs is determined by discounting the restructured cash flows at the original effective rate of the loan before modification or is based on the underlying collateral value less costs to sell, if repayment of the loan is considered collateral-dependent. If the resulting amount is less than the recorded book value, the Company either establishes a valuation allowance (i.e. specific reserve) as a component of the allowance for loan losses, or charges off the impaired balance if it determines that such amount is a confirmed loss. This method is used consistently for all segments of the portfolio. The allowance for loan losses also includes an allowance based on a loss migration analysis for each loan category for loans that are not individually evaluated for specific impairment. All loans charged-off, including TDRs charged-off, are factored into this calculation by portfolio segment. During the three months ended March 31, 2012, the Company charged off $1.8 million of loans classified as TDRs, on which there were $733,000 of related specific reserves.
NOTE 7 - EARNINGS PER SHARE
Basic net income per common share is calculated by dividing the net income available to common stockholders by the weighted-average number of common shares outstanding during the period. Diluted net income per common share is computed in a manner similar to basic net income per common share except that the weighted-average number of common shares outstanding is increased to include the incremental common shares (as computed using the treasury stock method) that would have been outstanding if all potentially dilutive common stock equivalents were issued during the period. The Company's common stock equivalents are comprised of stock options and restricted stock awards. Anti-dilutive shares are common stock equivalents with weighted-average exercise prices in excess of the weighted-average market value for the periods presented. For the three months ended March 31, 2012, anti-dilutive options excluded from the calculations totaled 305,751 options (with an exercise price of $11.12) and 7,482 options (with an exercise price of $12.51). For the three months ended March 31, 2011, anti-dilutive options excluded from the calculations totaled 317,849 options (with an exercise price of $11.12) and 7,483 options (with an exercise price of $12.51). Unallocated common shares held by the ESOP are not included in the weighted-average number of common shares outstanding for purposes of calculating either basic or diluted net income per common share.
NOTE 8 - COMPREHENSIVE INCOME
Comprehensive income is net income adjusted for any changes in equity from non-owner sources that are not recorded in the income statement (such as changes in the net unrealized gain/loss on available-for-sale securities). The purpose of reporting comprehensive income is to provide a measure of all changes in equity that result from recognized transactions and other economic events of the period other than transactions with owners in their capacity as owners. The Company’s sole source of other comprehensive income is the net unrealized gain on its available-for-sale securities.
The Company has not recognized deferred taxes related to unrealized capital losses in other comprehensive income due to its current inability to use them.
NOTE 9 - EQUITY INCENTIVE PLAN
Under the Naugatuck Valley Financial Corporation 2005 Equity Incentive Plan (the “Incentive Plan”), the Company may grant up to 371,794 stock options and 148,717 shares of restricted stock to its employees, officers and directors for an aggregate amount of up to 520,511 shares of the Company’s common stock for issuance upon the grant or exercise of awards. Both incentive stock options and non-statutory stock options may be granted under the Incentive Plan.
The amounts and terms of the awards granted under the Incentive Plan are summarized in the following table.
To date, stock option awards have been granted with an exercise price equal to the higher of the market price of the Company’s stock at the date of grant or $11.12, which was the market price of the Company’s stock at the date stock option awards were initially granted under the Incentive Plan. All granted stock options and restricted stock awards vest at 20% per year beginning on the first anniversary of the date of grant.
Stock options and restricted stock awards are considered common stock equivalents for the purpose of computing earnings per share on a diluted basis.
The Company is recording share-based compensation expense related to outstanding stock option and restricted stock awards based upon the fair value at the date of grant over the vesting period of such awards on a straight-line basis. The fair value of each restricted stock allocation, based on the market price at the date of grant, is recorded to unearned stock awards. Compensation expenses related to unearned restricted shares are amortized to compensation, taxes and benefits expense over the vesting period of the restricted stock awards. The fair value of each stock option award is estimated on the date of grant using the Black-Scholes option pricing method as described below. The Company recorded share-based compensation expense of $1,083 for the three months ended March 31, 2012, compared to $5,751 for the three months ended March 31, 2011, in connection with the stock option and restricted stock awards. Additionally, during the three months ended March 31, 2012, the Company repurchased 84 shares of its stock that were surrendered for the purpose of satisfying withholding taxes on vested restricted stock awards.
The fair value of each stock option award is estimated on the date of grant using the Black-Scholes option pricing method which includes several assumptions such as volatility, expected dividends, expected term and risk-free rate for each stock option award. In determining the expected term of the option awards, the Company elected to follow the simplified method as permitted by the SEC Staff Accounting Bulletin 107. Under this method, the Company has estimated the expected term of the options as being equal to the average of the vesting term plus the original contractual term. The Company estimated its volatility using the historical volatility of other, similar companies during a period of time equal to the expected life of the options. The risk-free rate for the periods within the contractual life of the options is based upon the U.S. Treasury yield curve in effect at the time of grant. Assumptions used to determine the weighted-average fair value of stock options granted were as follows:
NOTE 10 - DIVIDENDS
On January 24, 2012, the Company's Board of Directors declared a cash dividend of $0.03 per outstanding common share, which was paid on March 1, 2012, to stockholders of record as of the close of business on February 10, 2012.
NOTE 11 – FAIR VALUE
The Company uses fair value to record adjustments to certain assets and liabilities and to prepare required disclosures. Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value is best determined using market quotes. However, in many instances, there are no quoted market prices available. In such instances, fair values are determined using various valuation techniques. Various assumptions and observable inputs must be relied upon in applying these techniques. Accordingly, the fair value estimates may not be realized in an immediate transfer of the respective asset or liability.
The following is a summary of the carrying value and estimated fair value of the Company’s significant financial instruments as of March 31, 2012 and December 31, 2011:
Fair Value Hierarchy
Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Current accounting guidance establishes a fair value hierarchy based on the transparency of inputs participants use to price an asset or liability. The fair value hierarchy prioritizes these inputs into the following three levels:
Categorization within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement. A description of the valuation methodologies used by the Company is presented below:
Cash and cash equivalents - The carrying amount of cash, due from banks, and interest-bearing deposits is used to approximate fair value, given the short timeframe to maturity and as such assets do not present unanticipated credit concerns.
Investment Securities - When quoted prices are available in an active market, the Company classifies securities within Level 1 of the valuation hierarchy. If quoted market prices are not available, the Company employs an independent pricing service who utilizes matrix pricing to calculate fair value. Such fair value measurements consider observable data such as dealer quotes, market spreads, cash flows, yield curves, live trading levels, trade execution data, market consensus prepayments speeds, credit information, and the respective terms and conditions for debt instruments. Level 2 securities include CMOs, mortgage backed securities and corporate bonds issued by GSEs.
When a market is illiquid or there is a lack of transparency around the inputs to valuation, the respective securities are classified as Level 3 and reliance is placed upon internally developed models and management judgment and evaluation for valuation. Auction-rate trust preferred securities (“ARPs”) are currently classified as Level 3.
Management uses an internally developed model to value ARPs. The valuation model is based on a discounted cash flow using the expected value of the collateral preferred shares, either at call dates or the maturity date of the trust, the credit rating of the issuer of each of the ARPs, the expected yield during the holding period and current rates for U.S. Treasury securities matching the expected remaining term of the trust. The expected value of the collateral preferred shares (either when called or upon maturity of the trust) is assumed to range between current market prices and par. Discount rates are implied from observable market inputs. The resulting discounted cash flows for each of the ARPs indicated little to no impairment in the fair value of the securities. On a quarterly basis, management reviews the trust preferred securities pricing generated from our internal model.
Loans Receivable - Loans held for sale are accounted for at the lower of cost or market. The fair value of loans held for sale are based on quoted market prices of similar or identical loans sold in conjunction with securitization transactions, adjusted as required for changes in loan characteristics. The Company employs an independent third party to provide fair value estimates for loans held for investment. Such estimates are calculated using discounted cash flow analysis, using market interest rates for comparable loans. The associated cash flows are adjusted for credit and other potential losses. Fair value for impaired loans is estimated using the net present value of the expected cash flows or the fair value of the underlying collateral if repayment is collateral dependent.
Accrued income receivable – The carrying amounts reported in the statement of financial condition approximate these assets’ fair value.
Mortgage-servicing rights – The Company sells residential mortgage loans with servicing rights retained. At the time of the sale, the Company determines the value of the retained servicing rights, which represents the present value of the differential between the contractual servicing fee and adequate compensation, defined as the fee a sub-servicer would require to assume the role of servicer, after considering the estimated effects of prepayments. If material, a portion of the gain on the sale of the loan is recognized as due to the value of the servicing rights, and a servicing asset is recorded.
The Company has engaged an independent third party to perform the servicing rights analysis on a quarterly basis. The cost basis of loan servicing rights is amortized on a level yield basis over the period of estimated net servicing revenue and such amortization is included in the consolidated statement of income as a reduction of loan servicing fee income. Servicing rights are evaluated for impairment by comparing their aggregate carrying amount to their fair value. The fair value of loan servicing rights is estimated using a present value cash flow model. The most important assumptions used in the valuation model are the anticipated rate of loan prepayments and discount rates. All assumptions are based on standards used by market participants. Impairment is recognized as an adjustment to loan and servicing income.
Foreclosed Property and Repossessed Assets - Foreclosed property and repossessed assets are recorded as held for sale initially at the lower of the loan balance or fair value of the collateral less estimated selling costs. For the three months ended March 31, 2012 and 2011, foreclosed properties and repossessed assets with a carrying value of $258,000 and $227,000, respectively, were transferred to foreclosed property and repossessed assets from loans. Prior to the transfer, the assets whose fair value less costs to sell was less than their carrying value, were written down to fair value through a charge to the allowance for loan losses. Subsequent to foreclosure, valuations are updated periodically, and the assets may be marked down further, reflecting a new cost basis. There was one subsequent valuation adjustment to a foreclosed property in the amount of $12,000 for the three months ended March 31, 2012. There were no subsequent valuation adjustments to foreclosed properties and repossessed assets for the three months ended March 31, 2010. Collateral dependent impaired loans and foreclosed real estate and repossessed assets are considered Level 3, as the fair value is based on an appraisal and the adjustment to comparable sales made by the appraiser are unobservable. Non collateral dependent loans are measured using a discounted cash flow technique and are also considered Level 3, as the inputs are the Bank’s own assumptions.
Deposit Liabilities - The fair values disclosed for demand deposits are by definition equal to the amount payable on demand at the reporting date which is also their carrying value. The carrying amounts of variable-rate, fixed term money market accounts and certificates of deposit approximate their fair values at the reporting date. Fair values for fixed rate certificates of deposit are estimated using a discounted cash flow calculation that applies market interest rates on comparable instruments to a schedule of aggregated expensed monthly maturities on time deposits.
Borrowed Funds - Carrying value is as an estimate of fair value for securities sold under agreements to repurchase and other short term debt that matures within 90 days. The fair values of other borrowings are estimated using discounted cash flow analyses based on current market rates adjusted, as appropriate, for associated credit and option risks.
Mortgagors’ escrow accounts – The carrying amounts reported in the statement of financial condition approximate the fair value of the mortgagors’ escrow accounts.
Under certain circumstances we make adjustment to fair value for our assets although they are not measured at fair value on an ongoing basis. These include assets that are measured at the lower of cost or market that were recognized at fair value (i.e., below cost) at the end of the period, as well as assets that are not measured at fair value on an ongoing basis but are subject to fair value adjustments in certain circumstances (e.g., when there is evidence of impairment).
Assets and liabilities measured at fair value on a recurring and non-recurring basis at March 31, 2012 are summarized below:
There were no significant transfers of assets between Levels 1, 2 or 3 of the fair value hierarchy during the three months ended March 31, 2012.
The following table shows a reconciliation of the beginning and ending balances for Level 3 assets measured at fair value on a recurring basis:
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
This discussion should be read in conjunction with the Company’s Consolidated Financial Statements for the year ended December 31, 2011 included in the Company’s Annual Report on Form 10-K/A.
This report contains forward-looking statements that are based on assumptions and may describe future plans, strategies and expectations of the Company. These forward-looking statements are generally identified by use of the words “believe”, “expect”, “intend”, “anticipate”, “estimate”, “project” or similar expressions. The Company’s ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Factors which could have a material adverse effect on the operations of the Company and its subsidiaries include, but are not limited to, changes in interest rates, national and regional economic conditions, legislative and regulatory changes, monetary and fiscal policies of the U.S. government, including policies of the U.S. Treasury and the Federal Reserve Board, the size, quality and composition of the loan or investment portfolios, demand for loan products, deposit flows, competition, demand for financial services in the Company’s market area, changes in real estate market values in the Company’s market area, and changes in relevant accounting principles and guidelines. Additional factors are discussed below under “Item 1A – Risk Factors” and in the Company’s Annual Report on Form 10-K/A for the year ended December 31, 2011. These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements. Except as required by applicable law or regulation, the Company does not undertake, and specifically disclaims any obligation, to release publicly the result of any revisions that may be made to any forward-looking statements to reflect events or circumstances after the date of the statements or to reflect the occurrence of anticipated or unanticipated events.
Comparison of Financial Condition at March 31, 2012 and December 31, 2011
Total assets were relatively flat, decreasing $102,000 from $572.2 million at December 31, 2011 to $572.1 million at March 31, 2012. Net loans receivable decreased by $14.3 million, or 3.1%, partially offset by an increase in cash and cash equivalents of $10.5 million. Decreases were experienced in all categories of loans in loans: one-to four-family loans decreased by $7.0 million, multi-family and commercial real estate loans decreased by $6.1 million, construction loans decreased by $1.4 million, and commercial business loans and consumer loans each decreased by $1.0 million. The decrease in one-to four-family loans is primarily related to the sale of new production 30 year fixed rate mortgages on the secondary market. Commercial real estate loans and commercial business loans decreased primarily due to normal amortization, combined with a few large pay offs and decreased demand for these types of products. The construction loan portfolio has decreased as homes are sold on existing projects and consumer loans have decreased as customers have been paying off second mortgages as they refinance into first mortgages.
Total liabilities were $490.5 million at March 31, 2012 compared to $489.9 million at December 31, 2011. Deposits at March 31, 2012 decreased $265,000, or 0.1%, from December 31, 2011. Between December 31, 2011 and March 31, 2012, core deposits (defined as all deposits other than certificates of deposit) increased $6.1 million while certificates of deposit decreased $6.4 million. Management attributes the increase in core deposits to management’s strategy to offer competitive short term rates and products, as well as depositor preference to maintain funds in short term accounts given the expectation for higher market interest rates. Advances from the Federal Home Loan Bank of Boston decreased by $2.9 million, from $64.3 million at December 31, 2011 to $61.4 million at March 31, 2012, while reverse repurchase agreements increased $5.7 million, from $6.5 million to $12.2 million over the same period.
Total stockholders’ equity was $81.6 million at March 31, 2012 compared to $82.3 million at December 31, 2011. The decrease in stockholders’ equity was primarily due to the net loss of $977,000 experienced for the three month period and dividends of $198,000 paid to shareholders, partially offset by a net decrease in the unrealized loss on available for sale securities of $495,000.
Comparison of Operating Results For the Three Months Ended March 31, 2012 and 2011
General. For the three months ended March 31, 2012, the Company recorded a net loss of $977,000 compared to net income of $396,000 for the three months ended March 31, 2011, a decrease of $1.4 million or 346.7%. The decrease was primarily due to increased loan loss provisions and a higher level of noninterest expense, including the previously announced deposit related charge relating to the underpayment of interest on certain certificate of deposit accounts. These increases were partially offset by higher levels of net interest income and noninterest income.
Net Interest Income. Net interest income for the quarter ended March 31, 2012 totaled $4.9 million compared to $4.4 million for the quarter ended March 31, 2011, an increase of $509,000 or 11.6%. The increase in net interest income was primarily due to a decrease in interest expense of $805,000, or 34.1%, in the three month period. The decrease was primarily due to a decrease in the average rates paid on interest bearing liabilities. The average rates paid on deposits and borrowings decreased by 57 basis points in the three month period. The rate decrease is mainly due to certificates of deposit renewing at lower rates or being transferred to savings accounts during the period. The average balances of interest bearing liabilities decreased by 4.7% for the three months ended March 31, 2012. The decrease in interest bearing liabilities is attributed primarily to a 23.4% decrease in the average balance of borrowings.
The decrease in interest expense was partially offset by a decrease in interest income. Interest income decreased by $296,000, or 4.4%, in the three month period. The decrease was primarily due to a decrease in the average rates earned on interest earning assets. The average rates earned on loans and investments decreased by 18 basis points in the three month period. The average balances of interest earning assets decreased by 0.8% for the three months ended March 31, 2012. The decrease in interest earning assets is attributed to a 2.3% decrease in the average balance of the loan portfolio, partially offset by a 13.7% increase in the average balance of the investment portfolio. The decrease is due primarily to the sale of new production of residential mortgages through the Bank’s secondary mortgage operation, combined with loan payoffs.
The following table summarizes changes in interest income and interest expense for the three months ended March 31, 2012 and 2011.
The following table summarizes average balances and average yields and costs for the three months ended March 31, 2012 and 2011.
Allowance for Loan Losses and Asset Quality. The allowance for loan losses is a valuation allowance for the probable losses inherent in the loan portfolio. We evaluate the need to establish allowances against losses on loans on a quarterly basis, or more often if warranted. When additional allowances are needed a provision for loan losses is charged against earnings. The recommendations for increases or decreases to the allowance are presented by management to the Board of Directors on a quarterly basis, or more often if warranted. The methodology for assessing the adequacy of the allowance for loan losses consists of the following process:
On a quarterly basis, or more often if warranted, management analyzes the loan portfolio. For individually evaluated loans that are considered impaired, an allowance will be established based on either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s observable market price, or for loans that are considered collateral dependant, the fair value of the collateral when a loss in not confirmed. A loan is considered impaired when, based on current information and events, it is probable that a creditor will be unable to collect all amounts due under the contractual term of the loan agreement.
All other loans, including loans that are individually evaluated but not considered impaired, are segregated into groups based on similar risk factors. Each of these groups is then evaluated based on several factors to estimate credit losses. Management will determine for each category of loans with similar risk characteristics the historical loss rate. Historical loss rates provide a reasonable starting point for the Bank’s analysis but analysis and trends in losses do not form a sufficient basis to determine the appropriate level of the loan loss allowance. Management also considers qualitative and environmental factors likely to cause losses. These factors include but are not limited to: changes in the amount and severity of past due, non-accrual and adversely classified loans; changes in local, regional, and national economic conditions that will affect the collectibility of the portfolio; changes in the nature and volume of loans in the portfolio; changes in concentrations of credit, lending area, industry concentrations, or types of borrowers; changes in lending policies, procedures, competition, management, portfolio mix, competition, pricing, loan to value trends, extension and modification requests; and loan quality trends. This analysis establishes factors that are applied to each of the segregated groups of loans to determine an acceptable level of loan loss allowance.
In addition, the Company engages an independent consultant to review the commercial loan portfolio and consider recommendations based on their review of specific credits in the portfolio for classifying and monitoring these loans.
Although the Company believes that it uses the best information available to establish the allowance for loan losses, future adjustments to the allowance for loan losses may be necessary and results of operations could be adversely affected if circumstances differ substantially from the assumptions used in making the determinations. In addition, because further events affecting borrowers and collateral cannot be predicted with certainty, there can be no assurance that the existing allowance for loan losses is adequate or that increases will not be necessary should the quality of any loans deteriorate as a result of the factors discussed above.
Furthermore, while the Company believes it has established the allowance for loan losses in conformity with GAAP, there can be no assurance that regulators, in reviewing the Company’s loan portfolio during their examination process, will not request the Company to increase our allowance for loan losses based on information available to them at the time of their examination and their judgment, which may differ from ours.
Any material increase in the allowance for loan losses may adversely affect the Company’s financial condition and results of operations.
The following table summarizes the activity in the allowance for loan losses and provision for loan losses for the three months ended March 31, 2012 and 2011.
The provision for loan losses was $2.0 million for the three months ended March 31, 2012, compared to $438,000 for the same period in 2011. The increased provision in the 2012 period is due to management’s estimate of possible losses in the loan portfolio, primarily due to increased non-performing loans, charge offs and continuing recessionary economic conditions. The balances of non-performing assets increased $2.0 million between December 31, 2011 and March 31, 2012, primarily as a result of higher balances of nonaccrual loans. The Bank continues its efforts to work with borrowers during these difficult economic times. Classified assets increased $9.6 million over the same period as several large loans were downgraded. Charge-offs were $2.8 million during the three months ended March 31, 2012, compared to $147,000 during the three months ended March 31, 2011. The charge-offs in the 2012 period were due to the write-down of $301,000 on nine one- to four-family loans, one of which was for a deed-in-lieu of foreclosure, the write-down of $101,000 on three home equity loans, one of which was to facilitate a short sale of the collateral property, the write down of six commercial real estate loans and six construction loans in the amounts of $960,000 and $573,000, respectively, and the charge off of nine commercial business loans totaling $876,000. Included in the charge-off amounts this quarter was the write off of $1.1 million of specific reserves that were allowed under previous regulatory supervision, but are now required to be charged directly against the loan balances.
The following table provides information with respect to the Company’s nonperforming assets at the dates indicated. The Company did not have any accruing loans past due 90 days or more at the dates presented.
The following table shows the aggregate amounts of the Company’s classified assets at the dates indicated.
The 15.5% increase in the level of classified assets from December 31, 2011 to March 31, 2012 was primarily in the commercial loan portfolio. Classified assets are primarily loans rated special mention or substandard in accordance with regulatory guidance. These assets warrant and receive increased management oversight and allowance for loan losses (both general allowances and, in certain cases, specific allowances) have been established to account for the increased credit risk of these assets. At March 31, 2012, $27.0 million of classified assets were nonperforming assets, compared to $24.3 million at December 31, 2011.
Noninterest Income. The following table summarizes noninterest income for the three months ended March 31, 2012 and 2011.
Noninterest income was $1.0 million for the quarter ended March 31, 2012 compared to $837,000 for the quarter ended March 31, 2011, an increase of 20.8%. The increase is primarily due to an increase in income generated by increased activity in the secondary mortgage market, combined with increases in fees for other services. These increases were partially offset by decreases in income from investment advisory services, fees for services related to deposit accounts and income from bank owned life insurance. Additionally, $147,000 is included in the three months ended March 31, 2011 representing a partial recovery with respect to Fannie Mae auction rate pass-through certificates on which an other-than-temporary impairment charge was recorded in the third quarter of 2008.
Noninterest Expense. The following table summarizes noninterest expense for the three months ended March 31, 2012 and 2011.
Noninterest expense was $5.5 million for the quarter ended March 31, 2012 compared to $4.3 million for the quarter ended March 31, 2011. The increase was primarily the result of increases in compensation costs, professional fees, loss on foreclosed real estate, director’s compensation, advertising, and office supplies, partially offset by decreases in computer processing, FDIC insurance and office occupancy over the 2011 period. Increases in compensation were due primarily to the expansion of our secondary mortgage operation, combined with additional staff hired to ensure regulatory compliance. Additionally, during the quarter ended March 31, 2012, the Bank accrued $800,000 in connection with the previously announced deposit-related charge related to the underpayment of interest on certain certificate of deposit accounts.
Income Taxes. Provision (benefit) for income taxes was ($541,000) for the quarter ended March 31, 2012 compared to $396,000 for the quarter ended March 31, 2011. The primary reason for the decrease was the net loss experienced before provision for income taxes.
Liquidity and Capital Resources
Liquidity is the ability to meet current and future short-term financial obligations. The Bank’s primary sources of funds consist of deposit inflows, loan repayments, maturities and sales of investment securities and advances from the Federal Home Loan Bank of Boston. While maturities and scheduled amortization of loans and securities are predictable sources of funds, deposit flows and mortgage prepayments are greatly influenced by general interest rates, economic conditions and competition.
Each quarter the Bank projects liquidity availability and demands on this liquidity for the next 90 days. The Bank regularly adjusts its investments in liquid assets based upon its assessment of (1) expected loan demand, (2) expected deposit flows, (3) yields available on interest-earning deposits and securities, and (4) the objectives of our asset/liability management program. Excess liquid assets are invested generally in federal funds and short- and intermediate-term U.S. Government agency obligations.
The Bank’s most liquid assets are cash and cash equivalents. The levels of these assets depend on our operating, financing, lending and investing activities during any given period. At March 31, 2012, cash and cash equivalents totaled $28.6 million, including federal funds of $5.9 million. Securities classified as available-for-sale, which provide additional sources of liquidity, totaled $28.2 million at March 31, 2012. At March 31, 2012, the Bank had the ability to borrow a total of $136.2 million from the Federal Home Loan Bank of Boston, of which $61.4 million in borrowings was outstanding, along with $12.2 million in repurchase agreements. At March 31, 2012, the Bank had arranged overnight lines of credit of $2.5 million with the Federal Home Loan Bank of Boston. The Bank had no overnight advances outstanding with the Federal Home Loan Bank of Boston as of that date. In addition, at March 31, 2012, the Bank had the ability to borrow $15 million from the Federal Reserve Bank Discount Window. The Bank had no advances outstanding on this line at March 31, 2012.
The following table summarizes the commitments and contingent liabilities as of the dates indicated:
Certificates of deposit due within one year of March 31, 2012 totaled $101.4 million, or 24.7% of total deposits. If these deposits do not remain with the Bank, it will be required to seek other sources of funds, including other certificates of deposit and its available lines of credit. Depending on market conditions, the Bank may be required to pay higher rates on such deposits or other borrowings than are currently paid on the certificates of deposit due on or before March 31, 2013. Based on past experience, however, the Bank believes that a significant portion of our certificates of deposit will remain with us. The Bank has the ability to attract and retain deposits by adjusting the interest rates offered.
Historically, the Company (on a consolidated basis) has remained highly liquid. The Company is not aware of any trends and/or demands, commitments, events or uncertainties that could result in a material decrease in liquidity. The Company expects that all of our liquidity needs, including the contractual commitments stated above and increases in loan demand, can be met by our currently available liquid assets and cash flows. In the event loan demand was to increase at a pace greater than expected, or any unforeseen demand or commitment were to occur, we could access our borrowing capacity with the Federal Home Loan Bank of Boston or the Federal Reserve Bank Discount Window. The Company expects that our currently available liquid assets and our ability to borrow from both the Federal Home Loan Bank of Boston and the Federal Reserve Bank would be sufficient to satisfy our liquidity needs without any material adverse effect on our liquidity.
The Bank’s primary investing activities are the origination of loans and the purchase of securities. For the three months ended March 31, 2012, the Bank originated $40.1 million of loans, including renewals, refinances and advances. These activities were funded primarily by the proceeds from sales and maturities of available-for-sale securities and held to maturity securities of $2.9 million, proceeds of from the sale of loans in the secondary market in the amount of $17.6 million, and loan payoffs combined with normal amortization.
Financing activities consist primarily of activity in deposit accounts and in Federal Home Loan Bank advances. The Bank experienced a net decrease in total deposits of $265,000 for the three months ended March 31, 2012. Deposit flows are affected by the overall level of interest rates, the interest rates and products offered by us and its local competitors and other factors. The Bank generally manages the pricing of deposits to be competitive and to increase core deposit relationships. Occasionally, the Bank offers promotional rates on certain deposit products in order to attract deposits. The Bank experienced a net decrease in Federal Home Loan Bank advances of $2.9 million, and an increase in repurchase agreements of $5.7 million for the three months ended March 31, 2012.
The Company is a separate legal entity from the Bank and must provide for its own liquidity. In addition to its operating expenses, the Company, on a stand-alone basis, is responsible for paying any dividends declared to its shareholders. The Company’s primary source of income is dividends received from the Bank. The amount of dividends that the Bank may declare and pay to the Company in any calendar year, without the receipt of prior approval from the OCC but with prior notice to the OCC, cannot exceed net income for that year to date plus retained net income (as defined) for the preceding two calendar years. On a stand-alone basis, the Company had liquid assets of $11.8 million at March 31, 2012.
The Company is not subject to separate regulatory capital requirements. At March 31, 2012, the Bank was subject to the regulatory capital requirements of the OCC, including a risk-based capital measure. The risk-based capital guidelines include both a definition of capital and a framework for calculating risk-weighted assets by assigning balance sheet assets and off-balance sheet items to broad risk categories. At March 31, 2012, the Bank exceeded all of its regulatory capital requirements, and was considered “well capitalized” under regulatory guidelines.
The following table is a summary of the Bank’s actual capital as computed under the standards established by the OCC at March 31, 2012.
Off-Balance Sheet Arrangements
In the normal course of operations, the Company engages in a variety of financial transactions that, in accordance with generally accepted accounting principles, are not recorded in our financial statements. These transactions involve, to varying degrees, elements of credit, interest rate, and liquidity risks. Such transactions are used primarily to manage customers’ requests for funding and take the form of loan commitments, unused lines of credit, amounts due on construction loans, amounts due on commercial loans, commercial letters of credit and commitments to sell loans.
For the three months ended March 31, 2012, the Company did not engage in any off-balance-sheet transactions reasonably likely to have a material effect on its financial condition, results of operations or cash flows.
Item 3. Quantitative and Qualitative Disclosures About Market Risk.
Qualitative Aspects of Market Risk. The Company’s most significant form of market risk is interest rate risk. The Company manages the interest rate sensitivity of our interest-bearing liabilities and interest-earning assets in an effort to minimize the adverse effects of changes in the interest rate environment. Deposit accounts typically react more quickly to changes in market interest rates than mortgage loans because of the shorter maturities of deposits. As a result, sharp increases in interest rates may adversely affect the Company’s earnings while decreases in interest rates may beneficially affect the Company’s earnings. To reduce the potential volatility of the Company’s earnings, the Company has sought to improve the match between assets and liability maturities (or rate adjustment periods), while maintaining an acceptable interest rate spread, by originating adjustable-rate mortgage loans for retention in our loan portfolio, variable-rate home equity lines and variable-rate commercial loans and by purchasing variable-rate investments and investments with expected maturities of less than 10 years. Generally, loans are sold without recourse and with servicing retained. The Company currently does not participate in hedging programs, interest rate swaps or other activities involving the use of off-balance sheet derivative financial instruments.
The Bank’s Asset/Liability Committee communicates, coordinates and controls all aspects of asset/liability management. The committee establishes and monitors the volume and mix of assets and funding sources with the objective of managing assets and funding sources.
Quantitative Aspects of Market Risk. The Company also uses a third party consultant to perform interest rate sensitivity and net interest income simulation analysis. The net interest income simulation measures the volatility of net interest income as a consequence of different interest rate conditions at a particular point in time. Using a range of assumptions, the simulations provide an estimate of the impact of changes in interest rates on net interest income. The various assumptions used in the model are reviewed on a quarterly basis by the asset/liability committee. Changes to these assumptions can significantly affect the results of the simulation.
The following table, which is based on information that we provided to our third party consultant as of March 31, 2012, presents an approximation of our exposure as a percentage of estimated net interest income for the next 12-month period using interest income simulation. The simulation uses projected repricing of assets and liabilities on the basis of contractual maturities, anticipated repayments and scheduled rate adjustments. Prepayment speeds can have a significant impact on the interest income simulation. When interest rates rise, prepayment speeds tend to slow down. When interest rates fall, prepayment speeds tend to increase. We believe that our assumptions included in the simulation are reasonable; however, there can be no guarantee that these prepayment rates will approximate actual future repayment activity. Our third party consultant also performs dynamic modeling. This type of modeling employs a further set of assumptions attempting to simulate scenarios that are more likely than an immediate and sustained shock of 100 to 300 basis points and include the business planning strategies. The changes in rates in the table below are assumed to occur immediately.
Item 4. Controls and Procedures.
The Company’s management, including the Company’s principal executive officer and principal financial officer, have evaluated the effectiveness of the Company’s “disclosure controls and procedures”, as such term is defined in Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended, (the “Exchange Act”). Based upon that evaluation, the principal executive officer and principal financial officer concluded that, as of the end of the period covered by this report, the Company’s disclosure controls and procedures were effective for the purpose of ensuring that the information required to be disclosed in the reports that the Company files or submits under the Exchange Act with the Securities and Exchange Commission (the “SEC”) (1) is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and (2) is accumulated and communicated to the Company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure.
There were no changes in the Company’s internal control over financial reporting during the three months ended March 31, 2012 that have materially affected, or are reasonable likely to materially affect, the Company’s internal control over financial reporting.
Part II - OTHER INFORMATION
Item 1. - Legal Proceedings.
The Company is not involved in any pending legal proceedings. The Bank is not involved in any pending legal proceedings other than routine legal proceedings occurring in the ordinary course of business. Such routine legal proceedings, in the aggregate, are believed by management to be immaterial to its financial condition and results of operations.
Item 1A. – Risk Factors.
In addition to the other information set forth in this report, you should carefully consider the factors discussed in Part I, “Item 1A. Risk Factors” in the Company’s Annual Report on Form 10-K/A for the year ended December 31, 2011, which could materially affect the Company’s business, financial condition or future results. The risks described in the Company’s Annual Report on Form 10-K/A are not the only risks that the Company faces. Additional risks and uncertainties not currently known to the Company or that the Company currently deems to be immaterial also may materially adversely affect our business, financial condition and/or operating results.
Item 2. – Unregistered Sales of Equity Securities and Use of Proceeds.
Item 3. – Defaults Upon Senior Securities. Not applicable
Item 4. – Mine Safety Disclosures. Not applicable
Item 5. – Other Information. Not applicable
Item 6. – Exhibits.
* Furnished, not filed.
(1) Incorporated by reference to Exhibit 3.1 to the Company’s Registration Statement on Form S-1, as amended, initially filed on June 11, 2010.
(2) Incorporated herein by reference to Exhibit 3.2 to the Company’s Registration Statement on Form S-1, as amended, initially filed on June 11, 2010.
(3) Incorporated herein by reference to Exhibit 4.0 to the Company’s Registration Statement on Form S-1, as amended, initially filed on June 11, 2010.
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.