XOTC:FNHM FNBH Bancorp Inc Quarterly Report 10-Q Filing - 6/30/2012

Effective Date 6/30/2012

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

Form 10-Q

 

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

For the quarterly period ended June 30, 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 0-25752

 

FNBH BANCORP, INC.

(Exact name of registrant as specified in its charter)

 

MICHIGAN   38-2869722
(State or other jurisdiction of incorporation or organization)   (I.R.S. Employer Identification No.)

 

101 East Grand River, Howell, Michigan 48843

(Address of principal executive offices) (Zip Code)

 

Registrant’s telephone number, including area code: (517) 546-3150

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).   Yes ¨ No ¨

 

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

Large accelerated filer ¨ Accelerated filer ¨ Non-accelerated filer ¨ Smaller reporting company x

 

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

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: 454,327 shares of the Corporation’s Common Stock (no par value) were outstanding as of August 14, 2012.

 

 
 

 

TABLE OF CONTENTS

 

      Page
      Number
       
Part I  Financial Information (unaudited)    
Item 1.  Financial Statements:    
  Consolidated Balance Sheets as of June 30, 2012 and December 31, 2011   1
  Consolidated Statements of Operations for the three and six months ended June 30, 2012 and 2011   2
  Consolidated Statements of Comprehensive Income (Loss) for the three and six months ended June 30, 2012 and 2011   3
  Consolidated Statements of Shareholders’ Equity for the three and six months ended June 30, 2012 and 2011   4
  Consolidated Statements of Cash Flows for the six months ended June 30, 2012 and 2011   5
  Notes to Interim Consolidated Financial Statements   6
       
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations   22
Item 3. Quantitative and Qualitative Disclosures about Market Risk   35
Item 4. Controls and Procedures   35
       
Part II. Other Information    
Item 1A  Risk Factors    36
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds   36
Item 6. Exhibits   37
       
Signatures   38

 

 
 

 

Discussions and statements in this report that are not statements of historical fact, including, without limitation, statements that include terms such as “will,” “may,” “should,” “believe,” “expect,” “forecast,” “anticipate,” “estimate,” “project,” “intend,” “likely,” “optimistic” and “plan,” and statements about future or projected financial and operating results, plans, projections, objectives, expectations, and intentions and other statements that are not historical facts, are forward-looking statements. Forward-looking statements include, but are not limited to, descriptions of plans and objectives for future operations, products or services; projections of our future revenue, earnings or other measures of economic performance; forecasts of credit losses and other asset quality trends; predictions as to our Bank’s ability to achieve or maintain certain regulatory capital standards; our expectation that we will have or be able to maintain sufficient cash to meet expected obligations during 2012; and descriptions of steps we may take to improve our capital position. These forward-looking statements express our current expectations, forecasts of future events, or long-term goals and, by their nature, are subject to assumptions, risks, and uncertainties. Although we believe that the expectations, forecasts, and goals reflected in these forward-looking statements are reasonable, actual results could differ materially for a variety of reasons, including, among others:

 

·our ability to successfully raise new equity capital and/or our ability to implement our capital restoration and recovery plan;
·our ability to continue as a going concern in light of the uncertainty regarding the extent and timing of possible future regulatory enforcement action against the Bank;
·the failure of assumptions underlying the establishment of and provisions made to our allowance for loan losses;
·our ability to comply with the various requirements imposed by the Consent Order against the Bank;
·the timing and pace of an economic recovery in Michigan and the United States in general, including regional and local real estate markets;
·the ability of our Bank to attain and maintain certain regulatory capital standards;
·limitations on our ability to access and rely on wholesale funding sources;
·the continued services of our management team, particularly as we work through our asset quality issues and the implementation of our capital restoration plan; and
·implementation of the recently enacted Dodd-Frank Wall Street Reform and Consumer Protection Act or other new legislation, which may have significant effects on us and the financial services industry

 

This list provides examples of factors that could affect the results described by forward-looking statements contained in this report, but the list is not intended to be all inclusive. The risk factors disclosed in Part I – Item A of our Annual Report on Form 10-K for the year ended December 31, 2011, as updated by any new or modified risk factors disclosed in Part II – Item 1A of any subsequently filed Quarterly Report on Form 10-Q, include all known risk our management believes could materially affect the results described by forward-looking statements in this report. However, those risks may not be the only risks we face. Our results of operations, cash flows, financial position, and prospects could also be materially and adversely affected by additional factors that are not presently known to us, that we currently consider to be immaterial, or that develop after the date of this report. We cannot assure you that our future results will meet expectations. While we believe the forward-looking statements in this report are reasonable, you should not place undue reliance on any forward-looking statement. In addition, these statements speak only as of the date made. We do not undertake, and expressly disclaim, any obligation to update or alter any statements, whether as a result of new information, future events, or otherwise, except as required by applicable law.

 

 
 

 

Part I - Financial Information

Item 1. Financial Statements

 

FNBH BANCORP INC. AND SUBSIDIARIES

Consolidated Balance Sheets

(Unaudited)

 

   June 30,   December 31, 
   2012   2011 
   (in thousands, except share amounts) 
Assets          
Cash and due from banks  $26,512   $50,020 
Short term investments   197    197 
Total cash and cash equivalents   26,709    50,217 
           
Investment securities:          
Investment securities available for sale, at fair value   70,969    32,325 
FHLBI and FRB stock, at cost   779    779 
Total investment securities   71,748    33,104 
           
Loans held for investment:          
Commercial   164,640    179,381 
Consumer   13,871    14,674 
Real estate mortgage   13,968    14,789 
Total loans held for investment   192,479    208,844 
Less allowance for loan losses   (12,162)   (12,690)
Net loans held for investment   180,317    196,154 
Premises and equipment, net   7,375    7,494 
Other real estate owned, held for sale   3,331    3,026 
Accrued interest and other assets   2,083    2,085 
Total assets  $291,563   $292,080 
           
Liabilities and Shareholders' Equity          
Liabilities          
Deposits:          
Demand (non-interest bearing)  $87,924   $83,506 
NOW   28,878    27,723 
Savings and money market   77,828    77,291 
Time deposits   87,186    91,756 
Brokered certificates of deposit   1,118    3,376 
Total deposits   282,934    283,652 
Other borrowings   125    60 
Accrued interest, taxes, and other liabilities   1,867    1,758 
Total liabilities   284,926    285,470 
           
Shareholders' Equity          
Preferred stock, no par value.  Authorized 30,000 shares; no shares issued and outstanding   -    - 
Common stock, no par value.  Authorized 11,000,000 shares at June 30, 2012 and 7,000,000 shares at December 31, 2011; 454,327 shares issued and outstanding at June 30, 2012 and 453,533 shares issued and outstanding at December 31, 2011   7,200    7,082 
Retained deficit   (868)   (825)
Deferred directors' compensation   461    577 
Accumulated other comprehensive loss   (156)   (224)
Total shareholders' equity   6,637    6,610 
Total liabilities and shareholders' equity  $291,563   $292,080 

 

See notes to interim consolidated financial statements (unaudited)

 

1
 

 

FNBH BANCORP, INC. AND SUBSIDIARIES

Consolidated Statements of Operations

Three and Six Months Ended June 30, 2012 and 2011

(Unaudited)

 

   Three months ended   Six months ended 
   June 30,   June 30, 
   2012   2011   2012   2011 
   (in thousands, except per share amounts) 
Interest and dividend income:                    
Interest and fees on loans  $2,504   $2,939   $5,191   $5,904 
Interest and dividends on investment securities:                    
U.S. Treasury, agency securities and CMOs   281    275    488    469 
Obligations of states and political subdivisions   12    68    26    131 
Other securities   6    7    12    12 
Interest on short term investments   1    1    1    1 
Total interest and dividend income   2,804    3,290    5,718    6,517 
Interest expense   276    400    584    851 
Net interest income   2,528    2,890    5,134    5,666 
Provision for loan losses   450    3,800    900    4,600 
Net interest income (deficiency) after provision for loan losses   2,078    (910)   4,234    1,066 
Noninterest income:                    
Service charges and other fee income   689    672    1,382    1,299 
Trust income   46    49    91    103 
Other   (3)   1    (3)   32 
Total noninterest income   732    722    1,470    1,434 
Noninterest expense:                    
Salaries and employee benefits   1,233    1,170    2,475    2,382 
Net occupancy expense   172    209    403    480 
Equipment expense   82    102    175    180 
Professional and service fees   456    403    846    753 
Loan collection and foreclosed property expenses   168    111    287    264 
Computer service fees   112    109    225    222 
Computer software amortization expense   5    59    62    119 
FDIC assessment fees   252    258    503    584 
Insurance   148    136    294    283 
Printing and supplies   57    51    92    80 
Director fees   20    20    40    39 
Net loss on sale/writedown of OREO and repossessions   13    17    19    43 
Other   181    168    326    295 
Total noninterest expense   2,899    2,813    5,747    5,724 
Loss before federal income taxes   (89)   (3,001)   (43)   (3,224)
Federal income tax expense (benefit)   -    (78)   -    (78)
Net loss  $(89)  $(2,923)  $(43)  $(3,146)
                     
Per share statistics:                    
Basic and diluted EPS  $(0.19)  $(6.39)  $(0.09)  $(6.88)
Basic and diluted average shares outstanding   457,413    457,311    457,408    457,295 

 

See notes to interim consolidated financial statements (unaudited)

 

2
 

 

FNBH BANCORP, INC. AND SUBSIDIARIES

Consolidated Statements of Comprehensive Income (Loss)

Three and Six Months Ended June 30, 2012 and 2011

(Unaudited)

 

   Three Months Ended   Six Months Ended 
   June 30,   June 30, 
   2012   2011   2012   2011 
   (in thousands) 
Net loss  $(89)  $(2,923)  $(43)  $(3,146)
Other comprehensive income (loss), net of tax:                    
Net change in unrealized gains (losses) on securities available for sale during the period   107    330    71    408 
Less:  reclassification adjustment for gain (loss) recognized in earnings, net of tax   (3)   -    (3)   - 
Comprehensive income (loss)  $15   $(2,593)  $25   $(2,738)

 

See notes to interim consolidated financial statements (unaudited)

 

3
 

 

FNBH BANCORP, INC. AND SUBSIDIARIES

Consolidated Statements of Shareholders' Equity

Six Months Ended June 30, 2012 and 2011

(Unaudited)

 

   Common
Stock
   Retained
Earnings
(Deficit)
   Deferred
Directors'
Compensation
   Accumulated
Other
Comprehensive
Income (Loss)
   Total 
   (in thousands) 
Balances at January 1, 2011  $6,935   $2,748   $708   $(257)  $10,134 
Earned portion of long term incentive plan   6                   6 
Issued 878 shares for deferred directors' fees   131         (131)        - 
Net loss        (3,146)             (3,146)
Other comprehensive income                  408    408 
Balances at June 30, 2011  $7,072   $(398)  $577   $151   $7,402 
                          
Balances at January 1, 2012  $7,082   $(825)  $577   $(224)  $6,610 
Earned portion of long term incentive plan   2                   2 
Issued 774 shares for deferred directors' fees   116         (116)        - 
Net loss        (43)             (43)
Other comprehensive income                  68    68 
Balances at June 30, 2012  $7,200   $(868)  $461   $(156)  $6,637 

 

See notes to interim consolidated financial statements (unaudited)

 

4
 

 

FNBH BANCORP, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows

(Unaudited)

 

   Six  months ended June 30, 
   2012   2011 
   (in thousands) 
Cash flows from operating activities:          
Net loss  $(43)  $(3,146)
Adjustments to reconcile net loss to net cash from operating activities:          
Provision for loan losses   900    4,600 
Depreciation and amortization   258    345 
Deferred income tax (benefit) expense   -    (78)
Net amortization on investment securities   326    166 
Loss on sale of available for sale securities   3    - 
Earned portion of long term incentive plan   2    6 
Loss on disposal of premises and equipment   -    2 
Net loss on the sale/writedown of OREO and repossessions   19    43 
(Increase) decrease in accrued interest income and other assets   (12)   508 
Increase in accrued interest, taxes, and other liabilities   109    72 
Net cash from operating activities   1,562    2,518 
Cash flows from investing activities          
Purchases of available for sale securities   (50,733)   (16,085)
Proceeds from sales of available for sale securities   247    - 
Proceeds from maturities and calls of available for sale securities   6,990    250 
Proceeds from mortgage-backed securities paydowns - available for sale   4,591    2,392 
Proceeds from repurchase of FHLBI stock   -    122 
Net decrease in loans   14,318    9,093 
Proceeds from sale of OREO and repossessions   295    1,387 
Capital expenditures   (125)   (209)
Net cash used for investing activities   (24,417)   (3,050)
Cash flows from financing activites:          
Net decrease in deposits   (718)   (12,152)
Proceeds from borrowings   65    - 
Net cash used for financing activities   (653)   (12,152)
Net change in cash and cash equivalents   (23,508)   (12,684)
Cash and cash equivalents at beginning of period   50,217    40,572 
Cash and cash equivalents at end of period  $26,709   $27,888 
           
Supplemental disclosures:          
Interest paid  $609   $893 
Loans transferred to other real estate   619    1,055 
Loans charged off   2,365    6,054 

 

See notes to interim consolidated financial statements (unaudited)

 

5
 

 

Notes to Consolidated Financial Statements (unaudited)

 

1. Basis of Presentation

The accompanying unaudited 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 Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, these financial statements do not include all of the information and footnotes required by US GAAP for complete financial statements. In the opinion of management of FNBH Bancorp, Inc. (the Corporation), all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation were included. The results of operations for the three and six month period ended June 30, 2012 are not necessarily indicative of the results to be expected for the year ending December 31, 2012. For further information, refer to the consolidated financial statements and footnotes thereto included in the 2011 Annual Report contained in the Corporation’s report on Form 10-K filing. Certain reclassifications have been made to prior period financial statements to conform to the current period presentation.

 

The consolidated financial statements included in this Form 10-Q have been prepared assuming our wholly-owned subsidiary bank, First National Bank in Howell (the Bank), continues to operate in the normal course of business for the foreseeable future, and do not include any adjustments to recorded assets or liabilities should we be unable to continue as a going concern.

 

2. Financial Condition and Management’s Plan

In light of the Bank’s recent losses, insufficient capital position at June 30, 2012 and noncompliance with a regulatory capital directive stipulated under a Consent Order (as described in “Management’s Discussion and Analysis of Financial Condition and Results of Operations”), management believes that it is reasonable to anticipate continued and elevated regulatory oversight of the Bank. In addition, any continued weaknesses in the Michigan economy and local real estate market will likely continue to negatively impact the Bank’s near-term performance and profitability. In response to these difficult market conditions and regulatory standing, management has embarked on various initiatives to mitigate the impact of the economic and regulatory challenges facing the Bank. However, even if successful, implementation of all components of management’s plan is not expected to ensure profitable results in 2012 and may not be successful in maintaining the Bank or the Corporation as a going concern. Management’s recovery plan is detailed in Note 2 of the consolidated financial statements included in the 2011 Annual Report within the Corporation’s Form 10-K filing.

 

Integral to management’s plan is the restoration of the Bank’s capital to a level sufficient to comply with the Office of the Comptroller of the Currency’s (“OCC”) capital directive and provide sufficient capital resources and liquidity to meet commitments and business needs. To date, the Bank has not raised the capital necessary to satisfy requirements of the Consent Order. Management and the Board of Directors continue to work to try to raise the additional equity believed necessary to sufficiently recapitalize the Bank. Management and the Board of Directors are committed to pursuing all potential alternatives and sources of capital to restore the Bank’s capital levels. Such alternatives include raising capital from existing shareholders, individuals, institutional capital market investors and private equity funds and the identification of suitors for a sale or merger transaction.

 

On May 8, 2012, the Corporation accepted subscription commitments from accredited investors pursuant to which the Corporation agreed to sell, subject to the satisfaction of certain conditions, securities denominated as "Units" solely to accredited investors (the "Capital Raise"). Each Unit was offered for a price of $1,500 and consists of 715 shares of the Corporation's common stock and $1,000 principal amount of 10% subordinated debentures to be issued by the Corporation. Some, but not all, of these subscription commitments have been funded into escrow pending the closing of the Capital Raise.

 

The closing of the Capital Raise is subject to material conditions, including a condition regarding the existence and/or terms of any formal regulatory enforcement action against the Bank, and compliance by one or more investors with federal law applicable to the acquisition of "control" of a bank holding company. The satisfaction or waiver of these conditions is largely out of the control of the Corporation. If the conditions to the closing of the Capital Raise are not satisfied or waived, the closing will not occur. If the closing occurs as a result of the waiver of such conditions, there can be no assurances that the Bank will not continue to be subject to regulatory enforcement action, including the Consent Order, following the closing of the Capital Raise. In light of the existence of these conditions, a reader of this Quarterly Report should not make a decision regarding whether to invest in the Corporation based on an assumption that the Capital Raise will close.

 

If the Capital Raise closes, the Corporation intends to contribute substantially all of the proceeds from the Capital Raise (less commissions and other offering expenses and less an amount to be retained by FNBH to pay future expected holding company expenses) to the Bank in order to improve the Bank's capital levels. See also the “Capital” section within “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in this Form 10-Q.

 

While the Company is hopeful that its ongoing efforts to raise additional capital will be successful, there are significant hurdles that remain in order for the Company to raise the amount of capital necessary for the Bank to comply with the requirements of the Consent Order. The Company makes no assurances that its plan or related efforts will improve the Bank’s financial condition and further deterioration of the Bank’s capital position is possible. The current economic environment in southeast Michigan and local real estate market conditions will continue to impose significant challenges on the Bank and are expected to adversely impact financial results. Any further declines in the Bank’s capital levels may likely result in more regulatory oversight or enforcement action by either the OCC or the Federal Deposit Insurance Corporation (the “FDIC”).

 

6
 

 

3. Securities

Securities available for sale consist of the following:

 

       Unrealized     
   Amortized Cost   Gains   Losses   Fair Value 
   (in thousands) 
June 30, 2012                    
Obligations of state and political subdivisions  $1,035   $38   $-   $1,073 
U.S. agency   3,000    17    -    3,017 
Mortgage-backed/CMO   67,041    244    (551)   66,734 
Preferred stock(1)   49    96    -    145 
Total  $71,125   $395   $(551)  $70,969 
                     
December 31, 2011                    
Obligations of state and political subdivisions  $1,284   $27   $-   $1,311 
U.S. agency   6,990    20    (2)   7,008 
Mortgage-backed/CMO   24,226    144    (473)   23,897 
Preferred stock(1)   49    60    -    109 
Total  $32,549   $251   $(475)  $32,325 

 

(1)Represents preferred stocks issued by Freddie Mac and Fannie Mae

 

Securities are reviewed quarterly for possible other-than-temporary impairment (OTTI) based on guidance included in ASC Topic 320, Investments – Debt and Equity Instruments. This guidance requires an entity to assess whether it intends to sell, or whether it is more likely than not that it will be required to sell, a security in an unrealized loss position before the recovery of the security’s amortized cost basis. If either of these criteria is met, the entire difference between the amortized cost and fair value is recognized in earnings. For securities that do not meet the aforementioned criteria, the amount of impairment recognized in earnings is limited to the amount related to credit losses, while impairment related to other factors is recognized in other comprehensive income.

 

Management’s review of the securities portfolio for the existence of OTTI considers various qualitative and quantitative factors regarding each investment category, including if the securities were U.S. Government issued, the credit rating of the securities, credit outlook, payment status and financial condition, the length of time a security has been in a loss position, the size of the loss position and other meaningful information.

 

At June 30, 2012 and December 31, 2011, the Corporation had one non-agency mortgage-backed security which has been impaired for more than twelve months. A summary of the par value, book value, carrying value (fair value) and unrealized loss for the security is presented below:

 

   June 30, 2012   December 31, 2011 
   Amount   % of Par   Amount   % of Par 
   (dollars in thousands) 
Par value  $2,612    100.00%  $2,791    100.00%
Book value   2,321    88.87%   2,500    89.61%
Carrying value   1,977    75.70%   2,064    73.95%
Unrealized loss   344    13.17%   437    15.66%

 

The Corporation makes a quarterly assessment of the OTTI on the non-agency mortgage-backed security primarily based on a quarterly cash flow analysis performed by an independent third-party specialist. The evaluation includes a comparison of the present value of expected cash flows to previous estimates to determine whether adverse changes in cash flows resulted during the period. The analysis considers attributes of the security, such as its super tranche position, and specific loan level collateral underlying the security. Certain key attributes of the underlying loans supporting the security included the following:

 

   June 30,   December 31, 
   2012   2011 
Weighted average remaining credit score (based on original FICO)   739    741 
Primary location of underlying loans:          
California   70%   70%
Florida   3%   3%
Other   27%   27%
Delinquency status of underlying loans:          
Past due 30-59 days   2.34%   2.29%
Past due 60-89 days   0.82%   1.69%
Past due 90 days or more   10.48%   9.45%
In process of foreclosure   7.70%   8.24%
Held as other real estate owned   1.90%   1.65%

 

The specialist calculates an estimate of the fair value of the security’s cash flows using an INTEX valuation model, subject to certain assumptions regarding collateral related cash flows such as expected prepayment rates, default rates, loss severity estimates, and discount rates as key valuation inputs. Certain key assumptions (unobservable inputs) used to estimate the fair value of the security include:

 

7
 

 

   June 30,
2012
   December 31,
2011
 
         
Voluntary repayment rate (CRR)   10.17%   10.30%
Default rates:          
Within next 12 months   10.02%   10.47%
Decreasing to (by month 37)   3.71%   4.29%
Decreasing to (by month 215)   0.00%   0.00%
Loss severity rates:          
Initial loss upon default (Year 1)   49.48%   49.94%
Per annum decrease (Years 2 - 11)   2.50%   2.50%
Floor (Year 12)   23.00%   23.00%
Discount rate (1):   10.00%   11.00%
Remaining credit support provided by other collateral pools of underlying loans within the security:   2.90%   4.79%

 

(1) Intended to reflect estimated uncertainity and liquidity premiums, after adjustment for estimated credit loss cash flows

 

The prepayment assumptions used with the model consider borrowers’ incentive to prepay based on market interest rates and borrowers’ ability to prepay based on underlying assumptions for borrowers’ ability to qualify for a new loan based on their credit and appraised property value, by location. As such, prepayment speeds decrease as credit quality and home prices deteriorate, reflecting a diminished ability to refinance.

 

In addition, collateral cash flow assumptions utilize a valuation technique under a “Liquidation Scenario” whereby loans are evaluated by delinquency and are assigned probability of default and loss factors deemed appropriate in the current economic environment. The liquidation scenarios assume that all loans 60 or more days past due migrate to default, are liquidated, and losses are realized over a period of between six and twenty four months based in part upon initial loan to value ratios and estimated changes in both historical and future property values since origination as obtained from financial data resources.

 

At June 30, 2012, based on a present value at a prospective yield of future cash flows for the investment as provided by the specialist and after management’s evaluation of the reasonableness of the specialist’s underlying assumptions regarding Level 2 and Level 3 inputs, the Corporation concluded that the security’s expected cash flows continue to support the amortized cost of the security and no additional other-than-temporary impairment had been incurred. Accordingly, the unrealized (non-credit) loss on the security was determined to approximate $344,000 using the valuation methodology and applicable inputs and assumptions described above.

 

The following is a summary of the gross unrealized losses and fair value of securities by length of time that individual securities have been in a continuous loss position:

 

   Less than 12 months   12 months or more   Total 
   Unrealized       Unrealized       Unrealized     
   Losses   Fair Value   Losses   Fair Value   Losses   Fair Value 
   (in thousands) 
June 30, 2012                        
Mortgage-backed/CMO  $(207)  $34,455   $(344)  $1,977   $(551)  $36,432 
                               
December 31, 2011                              
U.S agency  $(2)  $1,998   $-   $-   $(2)  $1,998 
Mortgage-backed/CMO   (36)   6,890    (437)   2,064    (473)   8,954 
Total  $(38)  $8,888   $(437)  $2,064   $(475)  $10,952 

 

The amortized cost and fair value of securities available for sale, by contractual maturity, follow. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

 

   June 30, 2012   December 31, 2011 
   Amortized Cost   Fair Value   Amortized Cost   Fair Value 
   (in thousands) 
Maturing within one year  $-   $-   $-   $- 
Maturing after one year but within five years   -    -    4,990    4,996 
Maturing after five years but within ten years   3,305    3,332    2,305    2,327 
Maturing after ten years   779    903    1,028    1,105 
   $4,084   $4,235   $8,323   $8,428 
Mortgage-backed/CMO   67,041    66,734    24,226    23,897 
Total  $71,125   $70,969   $32,549   $32,325 

 

Securities, with an amortized cost of approximately $60.1 million at June 30, 2012 were pledged to secure public deposits and for other purposes required or permitted by law, including approximately $49.7 million of securities pledged as collateral at the Federal Home Loan Bank of Indianapolis (FHLBI) to support potential liquidity needs of the Bank. At December 31, 2011, the amortized cost of pledged securities approximated $30.0 million, including $24.2 million of securities pledged as collateral at the FHLBI for contingent liquidity needs of the Bank.

 

8
 

 

The Bank owns stock in both the Federal Home Loan Bank of Indianapolis (FHLBI) and the Federal Reserve Bank (FRB), both of which are recorded at cost. The Bank is required to hold stock in the FHLBI equal to 5% of the institution’s borrowing capacity with the FHLBI. The Bank’s investment in FHLBI stock amounted to $735,000 at June 30, 2012 and December 31, 2011, respectively. The Bank’s investment in FRB stock, which totaled $44,000 at June 30, 2012 and December 31, 2011, is a requirement for the Bank’s membership in the Federal Reserve System. These securities can only be resold to, or redeemed by, the issuer.

 

4. Loans

The following is the recorded investment in portfolio loans:

 

   June 30,   December 31, 
   2012   2011 
   (in thousands) 
Commercial  $12,895   $13,590 
Commercial real estate:          
Construction, land development, and other land   11,694    13,918 
Owner occupied   53,806    61,555 
Nonowner occupied   78,298    80,984 
Consumer real estate:          
Commercial purpose   8,130    9,080 
Mortgage - Residential   15,170    15,056 
Home equity and home equity  lines of credit   8,347    9,865 
Consumer and Other   4,316    4,992 
Subtotal   192,656    209,040 
Unearned income   (177)   (196)
Total Loans  $192,479   $208,844 

 

Included in the consumer real estate loans above are residential first mortgages reported as “real estate mortgages” on the consolidated balance sheet. In addition, a portion of these consumer real estate loans include commercial purpose loans where the borrower has pledged a 1-4 family residential property as collateral. Loans also include the reclassification of demand deposit overdrafts, which amounted to $80,000 at June 30, 2012 and $99,000 at December 31, 2011, respectively.

 

Loans serviced for others, including commercial participations sold, are not reported as assets of the Bank and approximated $3.7 million at June 30, 2012 and $4.0 million at December 31, 2011.

 

5. Allowance for Loan Losses and Credit Quality of Loans

The Corporation separates its loan portfolio into segments to perform the calculation and analysis of the allowance for loan losses. The four segments analyzed are Commercial, Commercial Real Estate, Consumer Real Estate, and Consumer and Other. The Commercial segment includes loans to finance commercial and industrial businesses that are not secured by real estate. The Commercial Real Estate segment includes: i) construction real estate loans to finance construction and land development and/or loans secured by vacant land and ii) commercial real estate loans secured by non-farm, non-residential real estate which are further classified as either owner occupied or non-owner occupied based on the underlying collateral type. The Consumer Real Estate segment includes (commercial and non-commercial purpose) loans that are secured by 1 – 4 family residential real estate properties, including first mortgages on residential properties and home equity loans and lines of credit that are secured by first or second liens on residential properties. The Consumer and Other segment includes all loans not included in any other segment. These are primarily loans to consumers for household, family, and other personal expenditures, such as autos, boats, and recreational vehicles.

 

Activity in the allowance for loan losses by portfolio segment for the three months ended June 30 follows:

 

9
 

 

       Commercial   Consumer   Consumer     
   Commercial   Real Estate   Real Estate   and Other   Total 
   (in thousands) 
2012                         
Allowance for loan losses:                         
Beginning balance  $565   $8,560   $2,645   $232   $12,002 
Charge offs   (24)   (590)   (145)   (38)   (797)
Recoveries   85    314    92    16    507 
Provision   48    1,042    (521)   (119)   450 
Ending balance  $674   $9,326   $2,071   $91   $12,162 
                          
2011                         
Allowance for loan losses:                         
Beginning balance  $1,144   $10,363   $2,044   $183   $13,734 
Charge offs   (1)   (3,669)   (1,002)   (53)   (4,725)
Recoveries   89    21    93    42    245 
Provision   (261)   3,116    973    (28)   3,800 
Ending balance  $971   $9,831   $2,108   $144   $13,054 

 

Activity in the allowance for loan losses by portfolio segment for the six months ended June 30 follows:

 

       Commercial   Consumer   Consumer     
   Commercial   Real Estate   Real Estate   and Other   Total 
   (in thousands) 
2012                         
Allowance for loan losses:                         
Beginning balance  $636   $9,113   $2,680   $261   $12,690 
Charge offs   (241)   (1,695)   (362)   (67)   (2,365)
Recoveries   113    680    103    41    937 
Provision   166    1,228    (350)   (144)   900 
Ending balance  $674   $9,326   $2,071   $91   $12,162 
                          
2011                         
Allowance for loan losses:                         
Beginning balance  $1,049   $10,555   $2,213   $153   $13,970 
Charge offs   (225)   (4,221)   (1,508)   (100)   (6,054)
Recoveries   123    227    118    70    538 
Provision   24    3,270    1,285    21    4,600 
Ending balance  $971   $9,831   $2,108   $144   $13,054 

 

10
 

 

The following presents the balance in allowance for loan losses and loan balances by portfolio segment based on impairment method:

 

       Commercial   Consumer   Consumer     
   Commercial   Real Estate   Real Estate   and Other   Total 
   (in thousands) 
June 30, 2012                         
Allowance for loan losses:                         
Individually evaluated for impairment  $47   $2,642   $321   $-   $3,010 
Collectively evaluated for impairment   627    6,684    1,750    91    9,152 
Total allowance for loan losses  $674   $9,326   $2,071   $91   $12,162 
                          
Loan balances:                         
Individually evaluated for impairment  $682   $25,927   $2,940   $-   $29,549 
Collectively evaluated for impairment   12,213    117,872    28,707    4,316    163,108 
Total loans  $12,895   $143,799   $31,647   $4,316   $192,657 
                          
December 31, 2011                         
Allowance for loan losses:                         
Individually evaluated for impairment  $174   $2,278   $432   $-   $2,884 
Collectively evaluated for impairment   462    6,835    2,248    261    9,806 
Total allowance for loan losses  $636   $9,113   $2,680   $261   $12,690 
                          
Loan balances:                         
Individually evaluated for impairment  $766   $21,483   $2,871   $-   $25,120 
Collectively evaluated for impairment   12,824    134,974    31,130    4,992    183,920 
Total loans  $13,590   $156,457   $34,001   $4,992   $209,040 

 

Management’s on-going monitoring of the credit quality of the portfolio relies on an extensive credit risk monitoring process that considers several factors including: current economic conditions affecting the Bank’s customers, the payment performance of individual loans and pools of homogenous loans, portfolio seasoning, changes in collateral values, and detailed reviews of specific relationships.

 

Our internal loan grading system assigns a risk grade to all commercial loans. This grading system is similar to those employed by banking regulators. Grades 1 through 5 are considered “pass” credits and grade 6 are considered “watch” credits and are subject to greater scrutiny. Those loans graded 7 and higher are considered substandard and are individually evaluated for impairment if reported as nonaccrual and are greater than $100,000 or part of an aggregate relationship exceeding $100,000. All commercial loans are graded at inception and reviewed, and if appropriate, re-graded at various intervals thereafter. Additionally, our commercial loan portfolio and assigned risk grades are periodically subjected to review by external loan reviewers and banking regulators. Certain of the key factors considered in assigning loan grades include: cash flows, operating performance, financial condition, collateral, industry condition, management, and the strength, liquidity and willingness of guarantors’ support.

 

11
 

 

A description of the general characteristics of each risk grade follows:

 

·RATING 1 (Satisfactory – Minimal Risk) - Loans in this category are to persons or entities of unquestioned financial strength, a highly liquid financial position, with collateral that is liquid and well margined. These borrowers have performed without question on past obligations, and the Bank expects their performance to continue. Internally generated cash flow covers current maturities on long-term debt by a substantial margin.

 

·RATING 2 (Satisfactory – Modest Risk) – These loans to persons or entities with strong financial condition and above-average liquidity who have previously satisfactorily handled their obligations with the Bank. Collateral securing the Bank’s debt is margined in accordance with policy guidelines. Internally-generated cash flow covers current maturities on long-term debt more than adequately.

 

·RATING 3 (Satisfactory - Average) – These are loans with average cash flow and ratios compared to peers. Usually RMA comparisons show where companies fall in the performance spectrum. Companies have consistent performance for 3 or more years.

 

·RATING 4 (Satisfactory – Acceptable Risk) – Loans to persons or entities with an average financial condition, adequate collateral margins, adequate cash flow to service long-term debt, and net worth comprised mainly of fixed assets are included in this category. These entities are minimally profitable now, with projections indicating continued profitability into the foreseeable future. Overall, these loans are basically sound.

 

·RATING 5 (Satisfactory - Acceptable – Monitor) - These loans are characterized by borrowers who have marginal, but adequate cash flow, marginal profitability, but currently have been meeting the obligations of their loan structure. However, adverse changes in the borrower’s circumstances and/ or current economic conditions are more likely to impair their capacity for repayment. The borrower has in the past satisfactorily handled debts with the Bank, but may be experiencing some minor delinquency in making payments, or other signs of temporary cash flow issues. Borrower may be experiencing declining margins or other negative financial trends, despite the borrower’s continued satisfactory condition and positive cash flow. Other characteristics of borrowers in this class include inadequate credit information, weakness of financial statement, or declining but positive repayment capacity. This classification includes loans to new or established borrowers with satisfactory loan structure, but where near term economic or business issues appears to remain stable and the near term projections would limit the ability for an improvement in the financial trends of the borrower.

 

·RATING 6 (Special Mention - OAEM) - Loans in this class have potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the asset or in the Bank’s credit position at some future date. These potential weaknesses may result in a deterioration of the repayment of the loan and increase the credit risk. Special mention assets are not adversely classified and do not expose the Bank to sufficient risk to warrant adverse classification. Special mention credits may include a borrower that pays the Bank on a timely basis (occasional 30 day delinquent) and may be experiencing temporary cash flow deficiencies.

 

·RATING 7 (Substandard) – A substandard loan is inadequately protected by the current sound worth and paying capacity of the borrower or of the collateral pledged, if any. Loans so classified must have a well-defined weakness, or weaknesses, that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected. Loss potential, while existing in the aggregate amount of substandard loans, does not have to exist in individual loans. Substandard credits may include a borrower that pays consistently past due, has significant cash flow shortages and may have a collateral shortfall that requires a specific reserve.

 

·RATING 8 (Doubtful) - This risk rating class has all of the weaknesses inherent in the substandard rating but with the added characteristic that the weaknesses make collection in full or liquidation, on the basis of currently known existing facts, condition, and values, highly questionable and improbable. These are poor quality loans in which neither the collateral, if any, nor the financial condition of the borrower presently ensure collectability in full within a reasonable period of time; in fact, there is permanent impairment in the collateral securing the Bank’s loan. These loans are in a work-out status, must be non-accrual status and have a defined work-out strategy.

 

This is a transitional risk rating class while collateral value and other factors are assessed. Loans will remain in this class for the assessment period, but in no event for more than 1 year. If there is no improvement in the Bank’s position during that time, a charge-off will be taken to best reflect known asset collateral value. If the loan goes into a “Deeds in Redemption” status before 1 year, any shortfall will be recognized immediately.

 

The assessment of compensating factors may result in a rating plus or minus one grade from those listed above. These factors include, but are not limited to collateral, guarantors, environmental conditions, history, plan/projection reasonableness, quality of information, and payment delinquency.

 

The internal loan grading system is applied to the residential real estate portion of our consumer loan portfolio upon certain triggering events (e.g., delinquency, bankruptcy, restructuring, etc.). However, large groups of smaller balance homogeneous loans, such as consumer and residential real estate loans are collectively evaluated for impairment and they are not separately identified for impairment disclosures. The primary risk element for the residential real estate portion of consumer loans is the timeliness of borrowers’ scheduled payments. We rely primarily on our internal reporting system to monitor past due loans and have internal policies and procedures to pursue collection and protect our collateral interests in order to mitigate losses.

 

Our monitoring of credit quality is further denoted by classification of loans as nonperforming, which reflects loans where the accrual of interest has been discontinued and loans that are past due 90 days or more and still accruing interest. In addition, nonperforming loans include troubled debt restructured loans (as discussed below) that are on nonaccrual status or past due 90 days or more. Troubled debt restructured loans that are accruing interest and not past due 90 days or more are excluded from nonperforming loans.

 

12
 

 

The following presents the recorded investment in loans by risk grade and a summary of nonperforming loans by class of loan:

 

    Not Rated    1    2    3    4    5    6    7    Total    Nonperforming 
    (in thousands) 
June 30, 2012                                                  
Commercial  $215   $689   $36   $1,163   $3,395   $4,336   $2,133   $928   $12,895   $330 
Commercial Real Estate:                                                  
Construction, land development, and other land   -    -    -    -    542    4,719    896    5,537    11,694    5,396 
Ownner occupied   47    -    -    2,468    17,257    22,361    4,388    7,285    53,806    4,418 
Nonowner occupied   -    -    479    521    18,665    30,396    16,698    11,539    78,298    6,321 
Consumer real estate:                                                  
Commercial Purpose   94    -    -    291    1,287    2,973    345    3,140    8,130    2,385 
Mortgage - Residential   12,484    -    -    -    -    -    -    2,686    15,170    1,831 
Home equity and home equity lines of credit   7,878    -    -    -    -    -    -    469    8,347    398 
Consumer and Other   4,143    -    -    -    6    10    -    157    4,316    34 
Total  $24,861   $689   $515   $4,443   $41,152   $64,795   $24,460   $31,741   $192,656   $21,113 
                                                   
December 31, 2011                                                  
Commercial  $33   $649   $243   $2,207   $3,875   $4,495   $760   $1,328   $13,590   $549 
Commercial Real Estate:                                                  
Construction, land development, and other land   89    -    -    -    534    5,863    255    7,177    13,918    6,710 
Ownner occupied   51    -    507    3,426    18,212    27,325    4,189    7,845    61,555    5,714 
Nonowner occupied   -    -    -    809    25,322    36,135    6,832    11,886    80,984    5,153 
Consumer real estate:                                                  
Commercial Purpose   -    -    -    309    1,719    3,027    796    3,229    9,080    2,643 
Mortgage - Residential   12,639    -    -    -    -    -    -    2,417    15,056    1,587 
Home equity and home equity lines of credit   9,201    -    -    -    -    -    -    664    9,865    571 
Consumer and Other   4,164    -    -    431    121    117    -    159    4,992    44 
Total  $26,177   $649   $750   $7,182   $49,783   $76,962   $12,832   $34,705   $209,040   $22,971 

 

13
 

 

Loans are considered past due when contractually required principal or interest has not been received. The amount classified as past due is the entire principal balance outstanding of the loan, not just the amount of payments that are past due.

An aging analysis of the recorded investment in past due loans, segregated by class of loans follows:

 

                           90+ Days 
   Loans Past Due       Total   Past Due 
   30-59 Days   60-89 Days   90+ Days   Total   Current   Loans   and Accruing 
   (in thousands) 
June 30, 2012                                   
Commercial  $109   $169   $213   $491   $12,404   $12,895   $86 
Commercial real estate:                                   
Construction, land development, and other land   352    -    2,637    2,989    8,705    11,694      
Owner occupied   790    922    1,257    2,969    50,837    53,806    - 
Nonowner occupied   -    75    2,425    2,500    75,798    78,298    - 
Consumer real estate:                                   
Commercial purpose   69    59    309    437    7,693    8,130    - 
Mortgage - Residential   361    306    149    816    14,354    15,170    - 
Home equity and home equity  lines of credit   74    88    -    162    8,185    8,347      
Consumer and Other   54    15    25    94    4,222    4,316    - 
Total  $1,809   $1,634   $7,015   $10,458   $182,198   $192,656   $86 
                                    
December 31, 2011                                   
Commercial  $86   $-   $137   $223   $13,367   $13,590   $9 
Commercial real estate:                                   
Construction, land development, and other land   114    49    4,072    4,235    9,683    13,918    - 
Owner occupied   106    -    1,277    1,383    60,172    61,555    - 
Nonowner occupied   -    162    630    792    80,192    80,984    - 
Consumer real estate:                                   
Commercial purpose   214    -    456    670    8,410    9,080    - 
Mortgage - Residential   419    -    81    500    14,556    15,056    - 
Home equity and home equity  lines of credit   218    79    13    310    9,555    9,865    - 
Consumer and Other   50    2    3    55    4,937    4,992    - 
Total  $1,207   $292   $6,669   $8,168   $200,872   $209,040   $9 

 

Loans are placed on nonaccrual when, in the opinion of management, the collection of additional interest is doubtful. Loans are generally placed on nonaccrual upon becoming ninety days past due. However, loans may be placed on nonaccrual regardless of whether or not they are past due. All cash received on nonaccrual loans is applied to the principal balance. Loans are considered for return to accrual status on an individual basis when all principal and interest amounts contractually due are brought current and future payments are reasonably assured.

 

The following is a summary of the recorded investment in nonaccrual loans, by class of loan:

 

   June 30,   December 31, 
   2012   2011 
   (in thousands) 
Commercial  $244   $540 
Commercial real estate:          
Construction, land development, and other land   5,396    6,710 
Owner occupied   4,418    5,714 
Nonowner occupied   6,321    5,153 
Consumer real estate:          
Commercial purpose   2,385    2,643 
Mortgage - Residential   1,831    1,587 
Home equity and home equity lines of credit   398    571 
Consumer and Other   34    44 
Total  $21,027   $22,962 

 

14
 

 

The following presents information pertaining to impaired loans and related valuation allowance allocations by class of loan:

 

   June 30, 2012   December 31, 2011 
   Recorded
Investment
   Unpaid
Principal
Balance
   Valuation
Allowance
   Recorded
Investment
   Unpaid
Principal
Balance
   Valuation
Allowance
 
   (in thousands) 
Wiith an allowance recorded:                              
Commercial  $597   $666   $47   $322   $369   $174 
Commercial real estate:                              
Construction, land development, and other land   3,718    6,024    551    3,241    6,665    730 
Owner occupied   4,922    6,122    733    3,351    4,540    865 
Nonowner occupied   7,905    9,406    1,358    5,609    8,098    683 
Consumer real estate:                              
Commercial purpose   1,253    1,543    321    2,075    3,288    432 
Mortgage - Residential   -    -    -    -    -    - 
Home equity and home equity lines of credit   -    -    -    -    -    - 
Consumer and Other   -    -    -    -    -    - 
Total   18,395    23,761    3,010    14,598    22,960    2,884 
                               
With no allowance recorded:                              
Commercial   85    667    -    444    903    - 
Commercial real estate:                              
Construction, land development, and other land   2,686    3,569    -    3,363    4,656    - 
Owner occupied   2,931    3,714    -    3,467    4,560    - 
Nonowner occupied   3,765    5,433    -    2,452    2,747    - 
Consumer real estate:                              
Commercial purpose   1,687    2,946    -    796    1,039    - 
Mortgage - Residential   -    -    -    -    -    - 
Home equity and home equity  lines of credit   -    -    -    -    -    - 
Consumer and Other   -    -    -    -    -    - 
Total   11,154    16,329    -    10,522    13,905    - 
                               
Total:                              
Commercial   682    1,333    47    766    1,272    174 
Commercial real estate:                              
Construction, land development, and other land   6,404    9,593    551    6,604    11,321    730 
Owner occupied   7,853    9,836    733    6,818    9,100    865 
Nonowner occupied   11,670    14,839    1,358    8,061    10,845    683 
Consumer real estate:                              
Commercial purpose   2,940    4,489    321    2,871    4,327    432 
Mortgage - Residential   -    -    -    -    -    - 
Home equity and home equity lines of credit   -    -    -    -    -    - 
Consumer and Other   -    -    -    -    -    - 
Total Impaired Loans  $29,549   $40,090   $3,010   $25,120   $36,865   $2,884 

 

15
 

 

The following presents information pertaining to the recorded investment in impaired loans:

 

   Three Months Ended   Six Months Ended   Three Months Ended   Six Months Ended 
   June 30, 2012   June 30, 2012   June 30, 2011   June 30, 2011 
   Average
Outstanding
Balance
   Interest
Income
Recognized
   Average
Outstanding
Balance
   Interest
Income
Recognized
   Average
Outstanding
Balance
   Interest
Income
Recognized
   Average
Outstanding
Balance
   Interest
Income
Recognized
 
   (in thousands) 
Commercial  $712   $7   $728   $13   $1,044   $25   $1,127   $25 
Commercial real estate:                                        
Construction, land development, and other land   6,562    16    6,170    21    9,306    -    8,643    - 
Owner occupied   8,029    63    7,171    84    6,415    5    6,473    7 
Nonowner occupied   12,092    70    10,725    103    11,277    28    11,318    54 
Consumer real estate:                                        
Commercial purpose   3,051    12    2,972    15    2,916    38    2,506    39 
Mortgage - Residential   -    -    -    -    -    -    -    - 
Home equity and home equity  lines of credit   -    -    -    -    -    -    -    - 
Consumer and Other   -    -    -    -    -    -    -    - 
Total  $30,446   $168   $27,766   $236   $30,958   $96   $30,067   $125 

 

For loans where impairment is measured based on the present value of expected future cash flows, subsequent changes in present value and related allowance adjustments resulting from the passage of time are accounted for within the provision for loan losses rather than interest income.

 

Troubled Debt Restructurings

The Corporation may agree to modify the terms of a loan to improve its ability to collect amounts due. The modified terms are intended to enable customers to mitigate the risk of foreclosure by creating a payment structure that provides for continued loan payment requirements based on their current cash flow ability. Modifications, including renewals where concessions are made by the Bank and result from the debtor’s financial difficulties are considered troubled debt restructurings (TDRs).

 

Loan modifications are considered TDRs when the modification includes terms outside of normal lending practices (i.e., concessions) to a borrower who is experiencing financial difficulties.

 

Typical concessions granted include, but are not limited to:

 

1.Agreeing to interest rates below prevailing market rates for debt with similar risk characteristics
2.Extending the amortization period beyond typical lending guidelines for debt with similar risk characteristics
3.Forbearance of principal
4.Forbearance of accrued interest

 

To determine if a borrower is experiencing financial difficulties, the Corporation considers if:

 

1.The borrower is currently in default on any other of their debt
2.It is likely that the borrower would default on any of their debt if the concession was not granted
3.The borrower’s cash flow was sufficient to service all of their debt if the concession was not granted
4.The borrower has declared, or is in the process of declaring bankruptcy
5.The borrower is a going concern (if the entity is a business)

 

16
 

 

The following summarizes troubled debt restructurings:

 

   June 30, 2012   December 31, 2011 
   Outstanding Recorded
Investment
   Outstanding Recorded
Investment
 
   Accruing   Nonaccrual   Total   Accruing   Nonaccrual   Total 
   (in thousands) 
Commercial  $515   $168   $683   $239   $299   $538 
Commercial real estate:                              
Construction, land development,  and other land   1,161    3,089    4,250    20    4,564    4,584 
Owner occupied   3,503    2,704    6,207    1,104    3,307    4,411 
Nonowner occupied   5,350    3,346    8,696    2,361    2,498    4,859 
Consumer real estate:                              
Commercial purpose   652    1,636    2,288    228    2,025    2,253 
Mortgage - Residential   344    941    1,285    351    770    1,121 
Home equity and home equity  lines of credit   52    209    261    -    213    213 
Consumer and Other   -    90    90    89    11    100 
Total  $11,577   $12,183   $23,760   $4,392   $13,687   $18,079 

 

Troubled debt restructured loans may qualify for return to accrual status if the borrower complies with the revised terms and conditions and has demonstrated sustained payment performance consistent with the modified terms for a minimum of six consecutive payment cycles after the restructuring date. In addition, the collection of future payments must be reasonably assured.

 

The following presents information regarding existing loans that were restructured, resulting in the loan being classified as a troubled debt restructuring:

 

   Loans Restructured in the Three Months 
Ended June 30, 2012
   Loans Restructured in the Six Months Ended
June 30, 2012
 
       Pre-Modification   Post-
Modification
       Pre-Modification   Post-
Modification
 
   Number   Recorded   Recorded   Number   Recorded   Recorded 
   of Loans   Investment   Investment   of Loans   Investment   Investment 
   (dollars in thousands) 
Commercial   -   $-   $-    -   $-   $- 
Commercial real estate:                              
Construction, land development, and other land   -    -    -    -    -    - 
Owner occupied   -    -    -    -    -    - 
Nonowner occupied   1    262    262    3    873    873 
Consumer real estate:                              
Commercial purpose   2    431    431    2    431    431 
Mortgage - Residential   -    -    -    1    207    207 
Home equity and home equity  lines of credit   -    -    -    1    53    53 
Consumer and Other   -    -    -    -    -    - 
Total   3   $693   $693    7   $1,564   $1,564 

 

Three commercial loans and two commercial real estate loans with an aggregate recorded investment of $917,000 that were modified as TDRs in the last twelve months defaulted during the three and six months ended June 30, 2012. A loan is considered to be in payment default generally once it is 90 days contractually past due under the modified terms.

 

17
 

 

The following summarizes the nature of concessions granted by the Corporation to borrowers experiencing financial difficulties which resulted in troubled debt restructurings:

 

   Non-Market Interest Rate   Extension of Amortization
Period
   Non-Market Interest Rate
and Extension of
Amortization Period
 
       Pre-Modification       Pre-
Modification
       Pre-
Modification
 
   Number   Recorded   Number   Recorded   Number   Recorded 
   of Loans   Investment   of Loans   Investment   of Loans   Investment 
   (dollars in thousands) 
Three months ended June 30, 2012                              
Commercial   -   $-    -   $-    -   $- 
Commercial real estate:                              
Construction, land development, and other land   -    -    -    -    -    - 
Owner occupied   -    -    -    -    -    - 
Nonowner occupied   1    262    -    -    -    - 
Consumer real estate:                              
Commercial purpose   2    431    -    -    -    - 
Mortgage - Residential   -    -    -    -    -    - 
Home equity and home equity lines of credit   -    -    -    -    -    - 
Consumer and Other   -    -    -    -    -    - 
Total   3   $693    -   $-    -   $- 
                               
Six months ended June 30, 2012                              
Commercial   -   $-    -   $-    -   $- 
Commercial real estate:                              
Construction, land development, and other land   -    -    -    -    -    - 
Owner occupied   -    -    -    -    -    - 
Nonowner occupied   2    405    -    -    1    468 
Consumer real estate:                              
Commercial purpose   2    431    -    -    -    - 
Mortgage - Residential   1    207    -    -    -    - 
Home equity and home equity lines of credit   1    53    -    -    -    - 
Consumer and Other   -    -    -    -    -    - 
Total   6   $1,096    -   $-    1   $468 

 

During the three and six month periods ended June 30, 2012, non-market interest rate restructurings included pre-modification recorded investments of approximately $692,000 and $888,000, respectively, related to performing loans that were renewed at either their existing contractual rates or non-market interest rates.

 

6. Fair Value Measurements

The Corporation measures fair values based on ASC Topic 820, Fair Value Measurements and Disclosures. ASC Topic 820 defines fair value and establishes a consistent framework for measuring and expands disclosure requirements for fair value measurements. Fair value represents the estimated price that would be received from selling an asset or paid to transfer a liability, otherwise known as an “exit price”. The three levels of inputs that may be used to measure fair value are as follows:

 

Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.

 

Level 2: Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in markets that are not active; or other inputs that are observable or can be derived from or corroborated by observable market data by correlation or other means.

 

Level 3: Significant unobservable inputs that reflect a reporting entity’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.

 

The following is a description of the Corporation’s valuation methodologies used to measure and disclose the fair values of its financial assets and liabilities on a recurring basis:

 

Securities available for sale. Securities available for sale are recorded at fair value on a recurring basis. Fair value measurement is based on quoted prices, if available (Level 1). If quoted prices are not available, fair values are measured using independent pricing models such as matrix pricing models (Level 2). Matrix pricing is a mathematical technique widely used in the financial industry to value debt securities without relying on quoted market prices for specific securities but rather by relying on securities’ relationships to other benchmark quoted prices. Level 2 securities include U.S. government and agency securities, other U.S. government and agency mortgage-backed securities, municipal bonds and preferred stock securities. Level 3 securities include private collateralized mortgage obligations. The fair value measurement of our only Level 3 security, a non-agency mortgage-backed security, and details regarding significant unobservable inputs and assumptions used in estimating its fair value, is detailed in Note 3, Investment Securities.

 

18
 

 

Fair value of assets measured on a recurring basis:

 

       Quoted Prices in
Active Markets for
Identical Assets
   Significant Other
Observable
Inputs
   Significant
Unobservable Inputs
 
   Total   (Level 1)   (Level 2)   (Level 3) 
   (in thousands) 
June 30, 2012                    
Obligations of state and political subdivisions  $1,073   $-   $1,073   $- 
U.S. agency securities   3,017    -    3,017    - 
Mortgage-backed/CMO securities   66,734    -    64,757    1,977 
Preferred stock securities   145    -    145    - 
Total investment securities available for sale  $70,969   $-   $68,992   $1,977 
                     
December 31, 2011                    
Obligations of state and political subdivisions   1,311   $-   $1,311   $- 
U.S. agency securities   7,008    -    7,008    - 
Mortgage-backed/CMO securities   23,897    -    21,833    2,064 
Preferred stock securities   109    -    109    - 
Total investment securities available for sale  $32,325   $-   $30,261   $2,064 

 

The reconciliation for the asset classified by the Corporation measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the six months ended June 30, 2012 is as follows:

 

   (in thousands) 
Fair value of non-agency mortgage-backed security, beginning of period (1)  $2,064 
Total gains (losses) realized/unrealized:     
Included in earnings (2)   - 
Included in other comprehensive income (loss) (2)   93 
Purchases, issuances, and other settlements   (180)
Transfers into Level 3   - 
Fair value of non-agency mortgage-backed security, June 30, 2012  $1,977 
      
Total amount of losses for the period included in earnings attributable to the change in unrealized losses relating to assets still held at June 30, 2012  $- 

 

(1)Non-agency mortgage-backed security classified as available for sale is valued using internal valuation models and pricing information from third parties.
(2)Realized gain (losses), including unrealized losses deemed other-than-temporary, are reported in noninterest income. Unrealized gains (losses) are reported in accumulated other comprehensive income (loss).

 

The following is a description of the Corporation’s valuation methodologies used to measure and disclose the fair values of its financial assets and liabilities on a nonrecurring basis:

 

Loans. The Corporation does not record loans at fair value on a recurring basis. However, from time to time, the Corporation records nonrecurring fair value adjustments to impaired loans. These loans are reported in the nonrecurring table below at initial recognition of impairment and on an ongoing basis until recovery or charge off. A loan is considered impaired when it is probable that all of the principal and interest due under the original terms of the loan may not be collected. Impairment is typically measured based on the fair value of the underlying collateral which is determined, where possible, using observable market prices derived from appraisals or broker price opinions, which are considered to be Level 2. When a current appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Corporation records the impaired loan as nonrecurring Level 3. Fair value may also be measured using the present value of expected future cash flows discounted at the loan’s effective interest rate. Since certain assumptions and unobservable inputs are currently used in both techniques, impaired loans are recorded as Level 3 in the fair value hierarchy.

 

Other real estate owned. Real estate acquired through foreclosure or deed-in-lieu is adjusted to fair value less costs to sell upon transfer of the loan to other real estate owned, usually based on an appraisal of the property. Subsequently, other real estate owned is carried at the lower of carrying value or fair value less costs to sell. A valuation based on a current appraisal or by a broker’s opinion is considered a Level 2 fair value. If management determines the fair value of the property is further impaired below the appraised value and there is no observable market price, the Corporation records the property as nonrecurring Level 3.

 

19
 

 

Fair value on a nonrecurring basis is as follows:

 

       Quoted Prices in
Active Markets
for Identical
Assets
   Significant
Other
Observable
Inputs
   Significant
Unobservable
Inputs
 
   Total   (Level 1)   (Level 2)   (Level 3) 
   (in thousands) 
June 30, 2012                    
Impaired loans (1)  $26,539    -    -    26,539 
Other real estate owned   3,331    -    -    3,331 
                     
December 31, 2011                    
Impaired loans (1)  $22,236   $-   $-   $22,236 
Other real estate owned   3,026    -    -    3,026 

 

(1)Represents carrying value and related write-downs and specific reserves on loans for which fair value is measured using either the appraised value of the underlying collateral or the present value of expected future cash flows discounted at the loan’s effective interest rate, and other unobservable inputs.

 

7. Fair Value of Financial Instruments

Fair value disclosures require fair-value information about financial instruments for which it is practicable to estimate that value. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. In that regard, the derived fair-value estimates cannot be substantiated by comparison to independent markets and, in many cases, cannot be realized in immediate settlement of the instrument.

 

Fair-value methods and assumptions for the Corporation’s financial instruments are as follows:

 

Cash and cash equivalents – The carrying amounts reported in the consolidated balance sheet for cash and due from banks and short term investments reasonably approximate those assets’ fair values.

 

Investment securities – Fair values for investment securities are determined as discussed above.

 

FHLBI and FRB stock – The carrying amount is the estimated fair value of FHLBI and FRB stock. Due to restrictions placed on transferability, these equity securities are not readily marketable and are recorded at cost (par value) and evaluated for impairment based on the ultimate recoverability of the par value.

 

Loans – For variable-rate loans that reprice frequently, fair values are generally based on carrying values, adjusted for credit risk. The fair value of fixed-rate loans is estimated by discounting future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities.

 

Loans are not recorded at fair value on a recurring basis. As noted above, from time to time, we record nonrecurring fair value adjustments to collateral dependent loans to reflect partial write-downs or specific reserves that are based on an observable market price or a current estimate of collateral value. These loans are reported in the nonrecurring table above at initial recognition of impairment and on an ongoing basis until recovery or charge off.

 

Accrued interest income – The carrying amount of accrued interest income is a reasonable estimate of fair value.

 

Deposit liabilities – The fair value of deposits with no stated maturity, such as demand deposit, NOW, savings, and money market accounts, is equal to the amount payable on demand. The fair value of certificates of deposit is estimated using rates currently offered for wholesale funds with similar remaining maturities.

 

Other borrowings – The carrying amount of other borrowings is a reasonable estimate of fair value.

 

Accrued interest expense – The carrying amount of accrued interest payable is a reasonable estimate of fair value.

 

Off-balance-sheet instruments – The fair value of commitments to extend credit is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. For fixed-rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates. The fair value of commitments to extend credit, including letters of credit, is estimated to approximate their aggregate book balance and is not considered material and therefore not included in the following table.

 

20
 

 

The carrying amount, estimated fair value and level within the fair value hierarchy of the Corporation’s financial instruments are as follows:

 

   Level in   June 30, 2012   December 31, 2011  
   Fair Value
Hierarchy
   Carrying
Value 
   Fair
Value
   Carrying
Value 
   Fair
Value 
 
   (in thousands) 
Financial assets:                         
Cash and due from banks   Level 1   $26,512   $26,512   $50,020   $50,020 
Short term investments   Level 2    197    197    197    197 
Investment securities   Level 2    68,992    68,992    30,261    30,261 
Non-agency mortgage-backed security   Level 3    1,977    1,977    2,064    2,063 
FHLBI and FRB stock   Level 2    779    779    779    779 
Loans, net (a)   Level 3    180,317    181,504    196,154    197,088 
Accrued interest income   Level 2    742    742    739    739 
                          
Financial liabilities:                         
Deposits   Level 2   $282,934   $283,211   $283,652   $284,547 
Other borrowings   Level 2    125    125    60    60 
Accrued interest expense   Level 2    112    112    136    136 

 

(a) Included $26.5 million and $22.2 million of impaired loans recorded at fair value on a nonrecurring basis at June 30, 2012 and December 31, 2011, respectively.

 

Limitations

Fair-value estimates are made at a specific point in time based on relevant market information and information about the financial instrument. These estimates do not reflect any premium or discounts that could result from offering for sale at one time the Corporation’s entire holdings of a particular financial instrument. Because no market exists for a significant portion of the Corporation’s financial instruments, fair-value estimates are based on judgments regarding future loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment, and, therefore, cannot be determined with precision. Changes in assumptions could significantly affect the estimates.

 

8. Earnings per Common Share

Basic earnings per common share is based on the weighted average number of common shares and participating securities outstanding during the period. Diluted earnings per share is the same as basic earnings per share because any additional potential common shares issuable are included in the basic earnings per share calculation. The Corporation follows guidance included in ASC Topic 260, Earnings Per Share, related to determining whether instruments granted in a share-based payment transaction are participating securities. This guidance requires that unvested stock awards which contain non-forfeitable rights to dividends or dividend equivalents, whether paid or unpaid (referred to as “participating securities”), be included in the number of shares outstanding for both basic and diluted earnings per share calculations. Our unvested restricted stock under the Long-Term Incentive Plan is considered a participating security. In the event of a net loss, the participating securities are excluded from the calculation of both basic and diluted earnings per share, as the impact would be anti-dilutive.

 

   Second Quarter   Year to Date 
   2012   2011(1)   2012   2011(1) 
   (dollars in thousands, except per share amounts) 
                 
Weighted average shares outstanding   457,413    457,311    457,408    457,295 
Weighted average unvested restricted stock outstanding   -    -    -    - 
Weighted average basic and diluted shares outstanding   457,413    457,311    457,408    457,295 
                     
Net loss available to common shareholders  $(89)  $(2,923)  $(43)  $(3,146)
Basic and diluted net loss per share  $(0.19)  $(6.39)  $(0.09)  $(6.88)

 

(1) Number of shares is adjusted to reflect the 1-for-7 reverse stock split effective October 3, 2011.

 

9. Long Term Incentive Plan

Under the Long Term Incentive Plan (the “LTIP”), the Corporation had the authority to grant stock options and restricted stock as compensation to key employees. Such authority expired April 22, 2008. The Corporation did not award any stock options under the LTIP. The restricted shares granted under the LTIP have a five-year vesting period. The awards were recorded at fair value on the grant date and are amortized into salary expense over the vesting period.

 

21
 

 

A summary of the activity under the LTIP for the six months ended June 30, 2012 and 2011 is presented below:

 

   2012   2011 
       Weighted-Average
Grant Date
       Weighted-Average
Grant Date
 
Restricted Stock Awards (1)  Shares   Fair Value   Shares (1)   Fair Value 
Outstanding at January 1,   40   $98.88    173   $112.20 
Granted   -    -    -    - 
Vested   (18)   108.37    (50)   127.71 
Forfeited   -    -    -    - 
Outstanding at June 30,   22   $91.00    123   $105.95 

 

(1) Number of shares are adjusted to reflect the 1-for-7 reverse stock split effective October 3, 2011.

 

The total fair value of the awards vested during the three months ended June 30, 2012 and 2011 was $1,000 and $2,000, respectively. Awards vested during the six months ended June 30, 2012 and 2011 had a total fair value of $2,000 and $6,000, respectively. As of June 30, 2012, there was $2,000 of total unrecognized compensation cost related to nonvested stock awards under the LTIP. That cost is expected to be recognized over a weighted-average period of less than one year.

 

10. Income Taxes

The provision for income taxes represents federal income tax expense calculated using estimated annualized rates on taxable income or loss generated during the respective periods adjusted, as necessary, to avoid recording tax benefits during loss periods in excess of amounts expected to be realized.

 

The Corporation recorded a valuation allowance against the tax benefit related to the respective pre-tax losses incurred during the three and six month periods ended June 30, 2012 and 2011 due to the uncertainty of future taxable income necessary to realize the recorded net deferred tax asset. In the second quarter of 2011, the Corporation recorded a federal income tax benefit to reduce its deferred tax valuation allowance established on previously recorded deferred tax assets. The decrease in the recorded valuation allowance resulted from an increase in the deferred tax liability related to appreciation in the available for sale investment portfolio.

 

10. Shareholders’ Equity

On May 24, 2012, at the Corporation’s annual shareholder meeting, the shareholders approved an increase in the number of authorized shares of common stock from 7 million shares to 11 million shares. The additional shares are required to close the planned Capital Raise (see Note 2) and to provide additional shares for future issuance should further capital needs arise.

 

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

The Corporation, a Michigan business corporation, is a one bank holding company which owns all of the outstanding capital stock of First National Bank in Howell (the Bank) and all of the outstanding stock of HB Realty Co., a subsidiary. The following is a discussion of the Corporation’s results of operations for the three and six months ended June 30, 2012 and 2011, and the Corporation’s financial condition, focusing on its liquidity and capital resources.

 

The Bank is currently “significantly undercapitalized” by regulatory standards. On September 24, 2009, the Bank became subject to the terms of a Consent Order agreement with the Office of the Comptroller of the Currency (“OCC”). The Consent Order requires management and the board of directors to take certain actions to improve the financial condition of the Bank, including achieving and maintaining minimum leverage and total risk-based capital ratios of at least 8.5% and 11%, respectively, by January 22, 2010. To date, the Bank has failed to meet these required minimum ratios and is currently out of compliance with these required minimum capital ratios as well as other requirements of the Consent Order.

 

On May 8, 2012, the Corporation accepted subscription commitments from accredited investors pursuant to which the Corporation agreed to sell, subject to the satisfaction of certain conditions, securities denominated as "Units" solely to accredited investors (the "Capital Raise"). Each Unit was offered for a price of $1,500 and consists of 715 shares of the Corporation's common stock and $1,000 principal amount of 10% subordinated debentures to be issued by the Corporation. Some, but not all, of these subscription commitments have been funded into escrow pending the closing of the Capital Raise.

 

The closing of the Capital Raise is subject to material conditions, including a condition regarding the existence and/or terms of any formal regulatory enforcement action against the Bank, and compliance by one or more investors with federal law applicable to the acquisition of "control" of a bank holding company. The satisfaction or waiver of these conditions is largely out of the control of the Corporation. If the conditions to the closing of the Capital Raise are not satisfied or waived, the closing will not occur. If the closing occurs as a result of the waiver of such conditions, there can be no assurances that the Bank will not continue to be subject to regulatory enforcement action, including the Consent Order, following the closing of the Capital Raise. In light of the existence of these conditions, a reader of this Quarterly Report should not make a decision regarding whether to invest in the Corporation based on an assumption that the Capital Raise will close.

 

If the Capital Raise closes, the Corporation intends to contribute substantially all of the proceeds from the Capital Raise (less commissions and other offering expenses and less an amount to be retained by the Corporation to pay future expected holding company expenses) to the Bank in order to improve the Bank's capital levels.

 

22
 

 

In light of the uncertainty of completing the Capital Raise due to material conditions beyond our control and the Bank’s noncompliance with the Consent Order, recent losses and deficient capital position, management believes it is reasonable to anticipate that further regulatory oversight or enforcement action may be taken by the OCC. See also the “Capital” and “Regulatory Enforcement Action” sections of this Management’s Discussion and Analysis for further details.

 

The success of the Corporation depends to a great extent upon the economic conditions in Livingston County and the surrounding area. The Corporation has in general experienced a slowing economy in Michigan since 2007. In particular, Michigan’s unemployment rate at June 2012, although improved from 2011 and 2010 levels, remains above the national average and among the worst for all states. Unlike larger banks that are more geographically diversified, we provide banking services to customers primarily in Livingston County. Our loan portfolio, the ability of the borrowers to repay these loans, and the value of the collateral securing these loans is impacted by local economic conditions. The continued economic difficulties in Michigan have had and may continue to have adverse consequences as described below in “Loans and Asset Quality”.

 

Dramatic declines in commercial real estate values in recent years, with elevated levels of foreclosures and unemployment have resulted in and may continue to result in significant write-downs of asset values by us and other financial institutions. These write-downs have caused many financial institutions to seek additional capital, to merge with larger and stronger institutions and, in some cases, to fail. Additionally, capital and credit markets have continued to experience elevated levels of volatility and disruption in recent years. This market turmoil and tightening of credit have led to a lack of general consumer confidence and reduction in business activity.

 

Due to the conditions and events discussed above and elsewhere in this Form 10-Q, there is significant uncertainty regarding the impact of potential future regulatory action against the Bank. The extent of such regulatory action may threaten the Bank’s ability to continue operating as a going concern. Even if we do not become subject to more stringent regulatory requirements or restrictions, our current capital deficiencies and elevated levels of nonperforming assets may make it difficult to continue as a going concern. (At June 30, 2012, our nonperforming assets exceed the sum of the Bank’s capital and allowance for loan losses by approximately 30%). As described elsewhere in this Form 10-Q, we have established our allowance for loan losses at a level we currently believe, based on data available to us, is sufficient to absorb expected losses in our loan portfolio. However, this process involves a very significant degree of judgment, is based on numerous different assumptions that are difficult to make and, by its nature, is inherently uncertain. Moreover, the performance of our existing portfolio is, in many respects, dependent on external factors such as our borrowers’ ability to repay their loan obligations and the value of collateral securing those obligations, which in turn depend on macro and micro economic conditions including the pace of economic recovery in Southeast Michigan. If our loan portfolio performs worse that we currently expect, we may not have sufficient capital to absorb all of the losses, which could render us insolvent. Notwithstanding the above, the consolidated financial statements included in this Form 10-Q have been prepared assuming the Bank continues to operate in the normal course of business for the foreseeable future, and do not include any adjustments to recorded assets or liabilities should we be unable to continue as a going concern.

 

As fully described in Note 2, “Regulatory Matters and Going Concern”, of the consolidated financial statements included in the 2011 Annual Report within the Corporation’s Form 10-K filing, management has undertaken various initiatives identified in its recovery plan to address the current challenges facing the Bank. The successful implementation of the various actions being undertaken by management will be difficult in the current economic environment. Even if such actions are successfully implemented, such strategy may not be sufficient to increase the Bank's capital levels to satisfactory levels, return the Bank to profitability, or otherwise avoid further regulatory oversight or enforcement action. Any further declines in the Bank’s capital levels may result in more severe regulatory oversight or enforcement action by either the OCC or FDIC, including the possibility of regulatory receivership.

 

It is against this backdrop that we discuss our financial condition and results of operations for the three and six months ended June 30, 2012 as compared to same three and six month periods in 2011.

 

Earnings

 

   Second Quarter   Year to Date 
   2012   2011   2012   2011 
   (dollars in thousands, except per share amounts) 
                 
Net loss  $(89)  $(2,923)  $(43)  $(3,146)
Basic and diluted net loss per share(1)  $(0.19)  $(6.39)  $(0.09)  $(6.88)

 

(1) Number of shares are adjusted to reflect the 1-for-7 reverse stock split effective October 3, 2011.

 

Net loss for the three months ended June 30, 2012 decreased by $2.8 million compared to the same period last year. In the second quarter of 2012, the provision for loan losses decreased by $3.3 million, noninterest income increased by $10,000, and noninterest expense increased by $86,000.

 

Net loss for the six months ended June 30, 2012 decreased by $3.1 million compared to the same period last year. For the six months ended June 30, 2012, the provision for loan losses decreased by $3.7 million, noninterest income increased by $36,000, and noninterest expense increased by $23,000.

 

Net Interest Income

 

   Second Quarter   Year to Date 
   2012   2011   2012   2011 
   (in thousands) 
                 
Interest and dividend income  $2,804   $3,290   $5,718   $6,517 
Interest expense   276    400    584    851 
Net interest income  $2,528   $2,890   $5,134   $5,666 

 

23
 

 

Interest Yields and Costs

The following shows an analysis of net interest margin for the three and six months ended June 30:

 

   For the three months ended June 30, 
   2012   2011 
   Average
Balance
   Interest   Rate   Average
Balance
   Interest   Rate 
   (dollars in thousands) 
Assets:                              
Interest earning assets:                              
Short term investments  $197   $0.10    0.23%  $196   $0.10    0.27%
Securites: Taxable   62,520    287.5    1.84%   36,335    282.1    3.11%
Tax-exempt(1)   1,215    18.9    6.20%   6,060    97.3    6.42%
Commercial loans (2)(3)   170,242    2,203.0    5.12%   197,725    2,573.1    5.15%
Consumer loans (2)(3)   14,152    177.6    5.05%   15,657    207.3    5.31%
Real estate loans (2)(3)   14,125    131.2    3.71%   15,514    168.4    4.34%
Total earnings and total interest income   262,451    2,818.3    4.26%   271,487    3,328.3    4.86%
Cash and due from banks   24,170              21,753           
All other assets   12,410              13,202           
Allowance for loan losses   (12,059)             (13,605)          
Total Assets  $286,972             $292,837           
Liabilities and Shareholders' Equity:                              
Interest bearing liabilities:                              
NOW  $29,036   $1.3    0.02%  $28,617   $1.7    0.02%
Savings   42,355    2.4    0.02%   42,090    9.9    0.09%
MMDA   35,586    40.0    0.45%   33,542    50.6    0.60%
Time   89,538    232.3    1.04%   99,822    337.4    1.36%
Total interest bearing liabilities and total interest expense   196,515    276.0    0.57%   204,071    399.6    0.79%
Non-interest bearing deposits   81,582              76,368           
All other liabilities   2,021              2,093           
Shareholders' Equity   6,854              10,305           
Total Liabilities and Shareholders' Equity  $286,972             $292,837           
Interest spread             3.69%             4.07%
Net interest income - FTE       $2,542.3             $2,928.7      
Net interest margin             3.84%             4.27%

 

(1)Average yields in the above table have been adjusted to a tax-equivalent basis using a 34% tax rate.
(2)Includes average non-accrual loans of approximately $21.7 million and $30.5 million for the three months ended June 30, 2012 and 2011.
(3)Interest on loans includes origination fees totaling $18,000 in 2012 and $19,000 in 2011.

 

24
 

 

   For the six months ended June 30, 
   2012   2011 
   Average
Balance
   Interest   Rate   Average
Balance
   Interest   Rate 
   (dollars in thousands) 
Assets:                               
Interest earning assets:                              
Short term investments  $197   $0.20    0.23%  $196   $0.3    0.36%
Securites:   Taxable   50,887    500.2    1.97%   30,844    481.2    3.12%
Tax-exempt(1)   1,250    39.0    6.24%   6,181    191.7    6.20%
Commercial loans (2)(3)   174,499    4,571.5    5.18%   199,715    5,152.8    5.13%
Consumer loans (2)(3)   14,290    360.5    5.07%   15,908    426.6    5.41%
Real estate loans (2)(3)   14,388    274.5    3.81%   15,780    342.8    4.34%
Total earnings and total interest income   255,511    5,745.9    4.46%   268,624    6,595.4    4.89%
Cash and due from banks   32,320              28,733           
All other assets   12,326              13,509           
Allowance for loan losses   (12,460)             (13,851)          
Total Assets  $287,697             $297,015           
Liabilities and Shareholders' Equity:                              
Interest bearing liabilities:                              
NOW  $28,608   $3.0    0.02%  $29,021   $4.2    0.03%
Savings   41,550    4.9    0.02%   41,129    22.8    0.11%
MMDA   36,006    88.7    0.50%   35,196    109.1    0.63%
Time   91,055    487.4    1.08%   101,676    714.5    1.42%
Total interest bearing liabilities and total interest expense   197,219    584.0    0.60%   207,022    850.6    0.83%
Non-interest bearing deposits   81,705              77,638           
All other liabilities   1,998              2,110           
Shareholders' Equity   6,775              10,245           
Total Liabilities and Shareholders' Equity  $287,697             $297,015           
Interest spread             3.86%             4.06%
Net interest income - FTE       $5,161.9             $5,744.8      
Net interest margin             4.00%             4.25%

 

(1)Average yields in the above table have been adjusted to a tax-equivalent basis using a 34% tax rate.
(2)Includes average non-accrual loans of approximately $22.4 million and $30.6 million for the six months ended June 30, 2012 and 2011.
(3)Interest on loans includes origination fees totaling $32,000 in 2012 and $46,000 in 2011.

 

Interest Earning Assets/Interest Income

On a tax equivalent basis, interest income decreased $510,000 (15.3%) in the second quarter of 2012 compared to the second quarter of 2011. This was due to a decrease in average earning assets of $9.0 million (3.3%) combined with a decrease in the yield on average earning assets of 60 basis points.

 

The average balance of securities increased $21.3 million (50.3%) in the second quarter of 2012 compared to the same period in 2011. This increase was due to $25.4 million of security purchases made in the second quarter of 2012 in our continued effort to gradually invest a portion of the Bank’s excess on-balance liquidity into interest earning assets. The yield on average security balances decreased 166 basis points in the second quarter compared to 2011 due to sales of higher yielding securities in December 2011 coupled with comparatively lower yields on new securities acquired during 2012.

 

Loan average balances decreased $30.4 million (13.3%) in the second quarter of 2012 compared to the same period last year and the average yield decreased 9 basis points. The largest decline in terms of average balances was in commercial loans, the majority of our loan portfolio, which decreased $27.5 million (13.9%) in the second quarter of 2012 compared to 2011 while the average yield decreased 3 basis points. Commercial loans have continued to decrease due to receipt of scheduled payments, negotiated pay-downs and settlements collected on problem loans, pay-offs received from borrowers, pay-offs from borrowers’ refinancing with other financial institutions, charge offs and limited new loan originations. It is expected that continued efforts to manage the Bank’s regulatory capital levels (i.e., shrinking the Bank’s size) will further decrease both average loan balances and net interest income in future periods. In addition, the renewal of maturing loans in the current lower rate environment will continue to exert downward pressure on average loan portfolio yields.

 

Loan yields in 2012 continue to be negatively impacted by the elevated level of nonperforming loans. Management expects the average balance of nonperforming loans to continue to decrease but remain elevated in 2012, adversely impacting net interest income. Moreover, competitive pressures and the weakened local economy have had, and are expected to continue to have, a negative impact on commercial loan balances and yields.

 

For the first six months of the year, tax equivalent interest income decreased $850,000 (12.9%) compared to the same period of 2011. This was due to a decrease in average earning assets of $13.1 million (4.9%) combined with a decrease in the yield on average earning assets of 43 basis points.

 

25
 

 

The average balance of securities increased $15.1 million (40.8%) for the first six months of 2012 compared to 2011. As noted above, this increase was due to the gradual investment of a portion of the Corporation’s excess on-balance sheet liquidity into earning assets. The yield on average security balances decreased 150 basis points for the first six months of 2012 compared to 2011 due to the recent purchases of lower yielding securities in the current rate environment.

 

Loan average balances decreased $28.2 million (12.2%) in the first six months of 2012 compared to 2011 and the average yield decreased 2 basis points. The largest decline in terms of average balances was in commercial loans, which decreased $25.2 million (12.6%) combined with an increase in yield of 5 basis points in the first six months of 2012 compared to 2011. Average balances decreased primarily due to receipt of scheduled payments, charge-offs, and limited new loan originations.

 

Interest Bearing Liabilities/Interest Expense

Interest expense on deposits for the second quarter of 2012 decreased $124,000 (30.9%) compared to the second quarter of 2011. This was the result of lower interest rates paid on deposits of 22 basis points combined with lower average deposit balances of $7.6 million (3.7%).

 

Interest expense on deposits for the first six months of 2012 decreased $267,000 (31.3%) compared to 2011. This was the result of lower interest rates paid on deposits of 23 basis points combined with lower average deposit balances of $9.8 million (4.7%).

 

Liquidity

Liquidity is managed to ensure stable, reliable and cost-effective sources of funds to satisfy demand for credit, deposit withdrawals and investment opportunities. Liquidity risk is the risk of the Corporation being unable to meet current and future financial obligations in a timely manner. To manage liquidity risk the Corporation relies primarily on a large, stable core deposit base and excess on-balance sheet cash positions. Additionally, the Corporation has access to certain wholesale funding sources (as discussed below) to manage unexpected liquidity needs.

 

The Corporation identifies, measures and monitors its liquidity profile. The profile is evaluated daily, weekly and monthly by analyzing the composition of all funding sources, reviewing projected liquidity commitments and identifying sources and uses of funds. A contingency funding plan is also prepared that details the potential erosion of funds in the event of systemic financial market crisis or institution-specific stress. In addition, the overall management of the Corporation’s liquidity position is integrated into retail deposit pricing policies to ensure a stable core deposit base.

 

Asset liquidity for financial institutions typically consists of cash and cash equivalents, certificates of deposit and investment securities available for sale. These categories totaled $98 million at June 30, 2012 or about 33.5% of total assets. This compares to $82 million or about 28.3% of total assets at year-end 2011. Liquidity is important for financial institutions because of the need to meet loan funding commitments and depositor withdrawal requests. Liquidity can vary significantly on a daily basis based on customer activity.

 

Of the Corporation’s liquid assets at June 30, 2012, investment securities with a fair value of approximately $60 million were pledged for borrowing availability on a line of credit from the Federal Home Loan Bank of Indianapolis (“FHLBI”), to secure public deposits or for other purposes as required or permitted by law.

 

Deposits are the principal source of funds for the Bank. Management monitors rates at other financial institutions in the area to ascertain that its rates are competitive in the market. Management also attempts to offer a wide variety of products to meet the needs of its customers. The makeup of the Bank’s “Large Certificates”, which are generally considered to be more volatile and sensitive to changes in rates, consist principally of local depositors known to the Bank. The Bank had Large Certificates totaling approximately $32.8 million at June 30, 2012 and $34.7 million at December 31, 2011, respectively. The Bank had $1.1 million of brokered deposits at June 30, 2012. Due to the Bank’s capital classification as “significantly undercapitalized” at June 30, 2012, these brokered deposits may not be renewed or additional brokered deposits issued without prior approval of the Federal Deposit Insurance Corporation (“FDIC”). See “Capital” section of this Management’s Discussion and Analysis for further details.

 

It is Bank management’s intention to handle unexpected liquidity needs through its cash and cash equivalents, FHLBI borrowings, or Federal Reserve discount borrowings. At June 30, 2012, the Bank had a $48 million line of credit available at the FHLBI for which the Bank has pledged investment securities and certain commercial and consumer loans secured by residential real estate as collateral. The Bank also had a $9.6 million line of credit available at the Federal Reserve for which the Bank has pledged certain commercial loans as collateral. At June 30, 2012, the Bank had no borrowings outstanding against these lines of credit.

 

Although the Bank has established these lines of credit, because of its “significantly undercapitalized” regulatory status, any borrowing requests are subject to review (i.e., for purpose and repayment ability) and approval by the FHLBI and Federal Reserve, respectively. Consequently, full borrowing availability under these existing lines may be restricted at the respective lender’s discretion and terms may be limited or restricted. However, in the event the Bank would need additional funding and be unable to access either line of credit facility, management could act to remove the pledge of investment securities presently securing a portion of the FHLBI line of credit, thereby allowing such securities to be sold to provide further liquidity. If necessary, the Bank could also satisfy unexpected liquidity needs through liquidation of unpledged securities.

 

Interest Rate Risk

Interest rate risk is the potential for economic losses due to future rate changes and can be reflected as a loss of future net interest income and/or a loss of current market values. The Corporation’s Asset/Liability Management Committee’s (ALCO) objective is to measure the effect on net interest income and to adjust the balance sheet to minimize the inherent risk while at the same time maximizing income. Tools used by management include the standard GAP report which reflects the repricing schedule for various asset and liability categories and an interest rate shock simulation report. The Bank has no market risk sensitive instruments held for trading purposes. However, 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 including commitments to extend credit and letters of credit. A commitment or letter of credit is not recorded as an asset until the instrument is exercised.

 

26
 

 

The table below shows the scheduled maturity and repricing of the Corporation’s interest sensitive assets and liabilities as of June 30, 2012:

 

   0-3   4-12   1-5   5+     
   Months   Months   Years   Years   Total 
   (dollars in thousands) 
Assets:                         
Loans  $82,611   $49,298   $59,897   $673   $192,479 
Securities   9,276    17,360    43,250    1,862    71,748 
Short term investments   197    -    -    -    197 
Total rate sensitive assets  $92,084   $66,658   $103,147   $2,535   $264,424 
                          
Liabilities:                         
NOW, Savings & MMDA  $35,282   $-   $-   $71,424   $106,706 
Time Deposits   19,860    42,045    26,373    26    88,304 
Total rate sensitive liabilities  $55,142   $42,045   $26,373   $71,450   $195,010 
                          
Rate sensitivity GAP and ratios:                         
GAP for period  $36,942   $24,613   $76,774   $(68,915)     
Cumulative GAP   36,942    61,555    138,329    69,414      
                          
Cumulative rate sensitive ratio   1.67    1.63    2.12    1.36      
December 31, 2011 rate sensitive ratio   1.59    1.43    1.80    1.21      

 

The preceding table sets forth the time periods in which earning assets and interest bearing liabilities will mature or may re-price in accordance with their contractual terms. The entire balance of savings including MMDA and NOW are not categorized as 0-3 months, although they are variable rate products. Some of these balances are core deposits and are not considered rate sensitive. Allocations are made to time periods based on the Bank’s historical experience and management’s analysis of industry trends.

 

In the GAP table above, the short term (one year and less) cumulative interest rate sensitivity is 163% asset sensitive as of June 30, 2012.

 

Because of the Bank’s asset sensitive position, if market interest rates increase, this positive GAP position indicates that the interest margin would be positively affected. However, GAP analysis is limited and may not provide an accurate indication of the impact of general interest rate movements on the net interest margin since repricing of various categories of assets and liabilities is subject to the Bank’s needs, competitive pressures, and the needs of the Bank’s customers. In addition, various assets and liabilities indicated as repricing within the same period may in fact reprice at different times within the period and at different rate indices. Due to these inherent limitations in the GAP analysis, the Corporation also utilizes simulation modeling, which measures the impact of upward and downward movements of interest rates on interest margin. This modeling indicates that a 100 basis point gradual decrease in interest rates would decrease net interest income by approximately 1.8% in the first year, while a 200 basis point increase in interest rates would increase net interest income by approximately 5.4% in the first year. This is influenced by the assumptions regarding how quickly and to what extent liabilities will reprice with an increase in interest rates.

 

Loans

   Second Quarter   Year to Date 
   2012   2011   2012   2011 
   (in thousands) 
                     
Provision for loan losses  $450   $3,800   $900   $4,600 

 

The provision for loan losses for the second quarter of 2012 was $450,000 compared to $3.8 million for the second quarter of 2011. Provision expense of $900,000 was recorded for the six months ended June 30, 2012 compared to $4.6 million during the same period of 2011. In general, the reduced 2012 provision expense reflects decreasing trends in the levels of existing and newly identified nonperforming loans, gradual stabilization in real estate values for certain problem credits, and continued shrinkage in the overall loan portfolio relative to conditions faced by the Bank one year ago. Although reduced from 2011, the 2012 provision expense remains elevated due to continued economic stress in the Bank’s market area and the Bank’s significant and recent historical loan loss experience.

 

Loan charge offs for the six months ended June 30, 2012 totaled $2.4 million compared to $6.1 million recognized during the same prior year period. The 2012 charge offs included approximately $539,000 of protective advances paid by the Bank to protect its interest in collateral scheduled for tax sale. Specific reserves were established by the Bank in 2011 as estimates of potential loss related to these protective advances (i.e., unpaid taxes). The remaining 2012 charge offs related primarily to collateral liquidation shortfalls on existing impaired loans and management’s determination of certain borrowers’ inability to support future cash flow projections. Despite the continued need for charge offs related to collateral deficiencies on impaired loans, the general rate of decline in real estate values has slowed and may portend a decrease in future charge offs as the Bank’s higher risk commercial real estate portfolio continues to shrink.

 

In recent quarters we have generally experienced a net improvement in our overall asset quality which is largely attributable to the stabilization of certain underlying collateral values resulting in lower reserves on some of our substandard impaired loans. However, during the second quarter of 2012, management’s monitoring and assessment of potential weaknesses in certain pass credits (Grade 5) resulted in the loans’ migration to special mention (Grade 6). These downgrades required a slight increase in general reserves due to higher loss allocation factors used in our allowance for loan loss analysis. The resulting increase in general reserves was partially offset by improvement in our rolling 12 quarter loss history and the impact of lower outstanding loan balances at June 30, 2012. Management considered these factors in conjunction with its quarterly analysis of the loan portfolio to identify and quantify the level of credit risk to estimate losses to determine the recorded provision expense of $900,000 for the first six months of 2012 and the level of the allowance for loan losses of $12.2 million at June 30, 2012.

 

27
 

 

Loans and Asset Quality

The following table reflects the composition of the commercial and consumer loans in the Consolidated Financial Statements. Included in the residential first mortgage totals below are the “real estate mortgage” loans listed in the Consolidated Financial Statements and other loans to customers who pledge their homes as collateral for their borrowings. A portion of the loans listed in residential first mortgages represent commercial loans where the borrower has pledged a 1-4 family residential property as collateral. In the majority of the loans to commercial customers, the Bank is relying on the borrower’s cash flow to service the loans.

 

The following table shows the balance and percentage composition of loans as of:

 

   June 30, 2012   December 31, 2011 
   Balances   Percent   Balances   Percent 
   (dollars in thousands) 
Secured by real estate:                    
Residential first mortgage  $21,266    11.0%  $21,755    10.4%
Residential home equity/other junior liens   10,381    5.4%   12,246    5.9%
Construction, land development and other land loans   11,694    6.1%   13,918    6.7%
Commercial (nonfarm, nonresidential)   132,104    68.6%   142,539    68.2%
Commercial   12,895    6.7%   13,590    6.5%
Consumer and Other   4,316    2.2%   4,992    2.3%
Total gross loans   192,656    100.0%   209,040    100.0%
Net unearned fees   (177)        (196)     
Total loans  $192,479        $208,844      

 

The loan portfolio decreased $16.4 million (7.8%) in the first six months of 2012. The largest decline was in loans secured by nonresidential properties (owner occupied and nonowner occupied) which decreased $10.4 million (7.3%). Loans secured by consumer real estate decreased $2.4 million (6.9%), construction, land development and other land loans decreased $2.2 million (16.0%), and commercial loans decreased $695,000 (5.1%).

 

The decrease in nearly all portfolio segments was primarily attributable to receipt of scheduled payments from borrowers, special pay-downs and negotiated settlements collected on problem loans, and pay-offs received directly from borrowers or via borrowers’ refinancing with other financial institutions. Additionally, loan balances decreased by approximately $1.8 million of charge offs (net of $539,000 for protective advances as discussed above) and $619,000 of loans transferred to other real estate.

 

The future size of the loan portfolio is dependent on a number of economic, competitive, and regulatory factors faced by the Bank. In light of the economic and regulatory challenges currently impacting the Bank, we anticipate continued and managed shrinkage of the loan portfolio during the remainder of 2012. Further declines in loans, restrictions on the Bank’s ability to make new loans or competition that leads to lower relative pricing on new loans could adversely impact our operating results.

 

Nonperforming assets consist of loans accounted for on a nonaccrual basis, loans contractually past due 90 days or more as to interest or principal payments (but not included in nonaccrual loans), and other real estate which has been acquired through foreclosure and is actively managed through the time of disposition to minimize loss. In addition, nonperforming loans include troubled debt restructured loans (“TDRs”) that are on nonaccrual status or past due 90 days or more. At June 30, 2012, December 31, 2011 and June 30, 2011, there were approximately $12.2 million, $13.7 million and $14.0 million of TDRs included in nonperforming loans. TDRs that are not past due 90 days or more are excluded from nonperforming loan totals.

 

The aggregate amount of nonperforming loans and other nonperforming assets are presented below:

 

   June 30,   December 31,   June 30, 
   2012   2011   2011 
   (dollars in thousands) 
             
Nonaccrual loans  $21,027   $22,962   $29,266 
90 days or more past due and still accruing   86    9    - 
Total nonperforming loans   21,113    22,971    29,266 
Other real estate owned   3,331    3,026    3,919 
Total nonperforming assets  $24,444   $25,997   $33,185 
                
Nonperforming loans as a percent of total loans   10.97%   11.00%   13.29%
Allowance for loan losses as a percent of nonperforming loans   57.61%   55.25%   44.60%
Nonperforming assets as a percent of total loans and other real estate   12.48%   12.27%   14.80%

 

Nonperforming loans at June 30, 2012 decreased $1.9 million from December 31, 2011 and $8.1 million from June 30, 2011. The decrease from December 31, 2011 results from the combination of approximately $1.5 million of charge offs recognized primarily on collateral dependent loans, the upgrade of approximately $300,000 of loans now demonstrating both improved cash flows and established payment history following the culmination of successful work-outs and/or restructurings, the transfer of approximately $607,000 of loans to other real estate owned, and approximately $3.2 million of continued payments received from borrowers, which in aggregate, exceeded approximately $3.7 million of newly identified nonperforming loans which were comprised principally of commercial real estate loans. Management continues to focus on reducing the level of nonperforming assets and making improvements in asset quality.

 

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As of June 30, 2012, approximately $12.1 million (57.4%) of nonperforming loans are making scheduled payments on their loans. Management closely monitors each of these loans to identify opportunities where workout efforts or restructuring may improve borrowers’ credit risk profiles to facilitate a return to accrual status for credits with sustained repayment histories. All nonperforming loans are reviewed regularly for collectability and uncollectible balances are promptly charged off.

 

Management regularly evaluates the condition of problem credits and when reduced cash flows coupled with collateral shortfalls are evident, the loans are placed on nonaccrual. In addition, loans are generally placed on nonaccrual when principal or interest is past due ninety days or more. If management believes there is significant risk of not collecting full principal and interest, we may elect to place the loan on nonaccrual even if the borrower is current. Based on the existing level of problem loans, we anticipate that other real estate owned may increase as the Bank manages through the problem loan portfolio and borrowers continue to face financial difficulties and tight credit markets.

 

Other real estate owned (“OREO”) is comprised primarily of commercial real estate properties totaling $3.3 million at June 30, 2012 and $3.0 million at December 31, 2011. Nonperforming loans move into OREO as the foreclosure process is completed and any redemption period expires and from the receipt of deeds in lieu of foreclosure.

 

At June 30, 2012, impaired loans totaled approximately $29.5 million, of which $18.4 million were assigned specific reserves of $3.0 million. Impaired loans without specific reserve allocations totaled $11.1 million, indicating that the loans are well collateralized at this time. A loan is considered impaired when it is probable that that all or part of amounts due according to the contractual terms of the loan agreement will not be collected on a timely basis or the loan has been restructured and is classified as a troubled debt restructuring (“TDR”). Impairment is measured by comparing the Bank’s recorded investment in the loan to the present value of expected future cash flows at the loan’s effective interest rate, the fair value of the collateral, or the loan’s observable market price.

 

Of the impaired loans reported at June 30, 2012, $18.4 million are on nonaccrual status, based on management’s assessment using criteria discussed above. All cash received on nonaccrual loans is applied to principal balance. Loans are considered for return to accrual status on an individual basis when all principal and interest amounts contractually due are brought current and future payments are reasonable assured. Interest income is recognized on TDRs pursuant to the criteria noted below.

 

The following table summarizes the troubled debt restructuring component of impaired loans at:

 

   June 30, 2012   December 31, 2011 
   Accruing           Accruing         
   Interest   Nonaccrual   Total   Interest   Nonaccrual   Total 
   (in thousands) 
                         
Current  $11,491   $8,999   $20,490   $4,392   $11,059   $15,451 
Past due 30-89 days   -    523    523    -    376    376 
Past due 90 days or more   86    2,661    2,747    -    2,252    2,252 
Total troubled debt restructurings  $11,577   $12,183   $23,760   $4,392   $13,687   $18,079 

 

Troubled debt restructured loans accrue interest if the borrower complies with the revised terms and conditions and has demonstrated sustained payment performance consistent with the modified terms for a minimum of six consecutive payment cycles after the restructuring date and if collection of future payments is reasonably assured.

 

Allowance for Loan Losses

The allowance for loan losses at June 30, 2012 was $12.2 million a decrease of $528,000 from December 31, 2011. The allowance for loan losses represented 6.32% and 6.08% of gross loans at June 30, 2012 and December 31, 2011 and provided a coverage ratio to nonperforming loans of 57.6% and 55.2% at each respective period-end.

 

Management estimates the required allowance balance based on past loan loss experience, the nature and volume of the portfolio segments and concentrations, information about specific borrower situations, estimated collateral values, economic conditions and trends, and other factors. Allocations of the allowance are made for specific loans, but the entire allowance is available for any loan that, in management’s judgment, should be charged off. Management continually analyzes portfolio risk to refine the process of effective risk identification and measurement for determination of what it believes is an adequate allowance for loan losses. When all of these factors were considered, management determined that the $900,000 provision for the six months of 2012 and the $12.2 million allowance as of June 30, 2012 were appropriate.

 

Given the significant portion of our loans that are secured by real estate, our portfolio continues to be sensitive to the weakened economic conditions in Southeast Michigan and the Bank’s market area, and is especially impacted by depressed real estate values. In response, each quarter our portfolio management practices continue to analyze and quantify risk within all segments of our portfolio to ensure effective problem loan identification procedures. Our practice is to obtain updated appraisals on criticized loans secured by real estate and apply appropriate discounting practices based on perceived declines in market value.

 

Although updated appraisals received during more recent quarters indicated that property values for collateral on our impaired loans continue to be depressed, the appraisals did not reflect the extent of value erosion relative to that experienced in prior quarters. However, at present, the weak Michigan economy and elevated unemployment levels continue to delay signs of economic recovery in our market area. Consequently, we have continued to allocate reserves for these risks and uncertainties, resulting in reserves above normal levels.

 

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If the economy continues to weaken and/or real estate values decline further, nonperforming loans may increase in subsequent quarters. Due to the uncertainty of future economic conditions and the decline in real estate values, the provision for loan losses for the balance of 2012 may continue to be impacted by the Bank’s concentration in real estate secured loans. While we have considered these factors when determining the level of reserves, it is difficult to accurately predict future economic events, especially in the current environment.

 

The allowance consists of specific and general components. The specific component relates to loans that are classified as nonaccrual or to loans where borrowers are experiencing financial difficulty. For such loans that are also classified as impaired, an allowance is established when the collateral value, less costs to sell, (or discounted cash flows or observable market price) of the impaired loan is lower than the carrying value of that loan. The general component covers non-classified loans and is based on historical loss experience, adjusted for qualitative factors used to reflect changes in the portfolio’s collectability not captured by historical loss data.

 

The methodology for measuring the appropriate level of allowance and related provision for loan losses relies on several key elements, which include specific allowances for loans considered impaired, general allowances for non-impaired commercial loans based on our internal loan grading system, and general allocations based on historical trends for homogeneous loan groups with similar risk characteristics.

 

The general allowance allocated to non-impaired commercial loans was based on the internal risk grade of such loans and their assigned portfolio segment, as primarily determined based on underlying collateral; and, if real estate secured, the type of real estate. Each portfolio segment within the Pass (Grade 0-5), Special Mention (Grade 6) and Substandard – Not Impaired below $100,000 (Grade 7) risk grade is assigned a loss allocation factor. The higher a risk grade, the greater the assigned loss allocation percentage. Accordingly, changes in the risk grades of loans affect the amount of the allowance allocation.

 

Our loss factors are determined based on our actual loss history and adjusted for significant qualitative factors that, in management’s judgment, affect the collectability of the portfolio at the analysis date. We use a rolling 12 quarter net charge off history as the base for our computation which is weighted to give emphasis to more recent quarters and may be adjusted for extraordinary current trends.

 

Groups of homogeneous noncommercial loans, such as residential real estate loans, home equity and home equity lines of credit, and consumer loans receive allowance allocations based on loan type, using the same 12 quarter net charge off history described above. All loss allocations for homogenous pools of loans are adjusted for consideration of general economic and business conditions, credit quality and delinquency trends, collateral values, and recent loss experience for these similar pools of loans.

 

Although management evaluates the adequacy of the allowance for loan losses based on information known at a given point in time, as facts and circumstances change, the provision and resulting allowance may also change. While we believe that our allowance for loan loss analysis has identified all probable losses inherent in the portfolio at June 30, 2012, there can be no assurance that all losses have been identified or that the amount of the allowance is sufficient.

 

Noninterest Income

Noninterest income for the three and six month periods ended June 30, 2012 increased $10,000 (1.4%) and $36,000 (2.5%), respectively, from the same periods in 2011. The components of noninterest income are shown in the table below:

 

   Second Quarter   Year to Date 
   2012   2011   2012   2011 
   (in thousands) 
                 
Service charges and fees on deposits  $378   $383   $753   $738 
Other fees   311    289    629    561 
Trust income   46    49    91    103 
Gain on sale of loans   -    -    -    31 
Loss on sale of securities   (3)   -    (3)   - 
Miscellaneous   -    1    -    1 
Total  $732   $722   $1,470   $1,434 

 

Relative to the same prior year period, service charges and fees on deposit accounts decreased for the three month period ended June 30, 2012 as a result of declines in consumer NSF fee income. Other fees increased for the three month period ended June 30, 2012 due to higher fees earned on ATM transactions and increased volumes providing greater (inter-change) fee income. Trust income decreased due to continued run-off in customer accounts and balances and limited new business opportunities. During the second quarter of 2012, the Corporation sold one municipal bond which resulted is a loss.

 

For the six month period ended June 30, 2012 compared to the same 2011 period, the increase in both service charges on deposits and other fees correlates, in part, with our restructuring of the Bank’s suite of deposit products in late 2011, to provide more competitive services to our customers while creating greater potential for the Bank to realize additional fee income based on customer account utilization and activity levels. The increase in service charges and fees on deposits primarily relates to adjustments applied to our customers’ recurring usage of the Bank’s overdraft protection service which resulted in higher NSF fee income. Other fees increased due to check printing fees charged to a greater number of customers, increased fees earned on ATM transactions and increased network volumes providing greater (inter-change) fee income. In 2011, the Corporation recognized gains on the sale of two government guaranteed SBA loans.

 

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Noninterest Expense

For the three and six months ended June 30, 2012, noninterest expense increased over the same prior year periods. However, as noted below, the primary increases in noninterest expense resulted directly from management’s continued efforts to remediate asset quality, recapitalize the Corporation and to generate revenue enhancements via targeted marketing efforts. Management continues to focus on initiatives to better control and reduce noninterest expense in this challenging economic environment.

 

   Second Quarter   Year to Date 
   2012   2011   2012   2011 
   (in thousands) 
                 
Salaries and employee benefits  $1,233   $1,170   $2,475   $2,382 
Occupany expense   172    209    403    480 
Equipment expense   82    102    175    180 
Professional and service fees   456    403    846    753 
Loan collection and foreclosed property expense   168    111    287    264 
Computer service fees   112    109    225    222 
Computer software amortization expense   5    59    62    119 
FDIC assessment fees   252    258    503    584 
Insurance expense   148    136    294    283 
Printing and supplies   57    51    92    80 
Director fees   20    20    40    39 
Net loss on sale/writedown of OREO and repossessions   13    17    19    43 
Other expenses   181    168    326    295 
Total  $2,899   $2,813   $5,747   $5,724 

 

The most significant component of our noninterest expense is salaries and employee benefits. The 2012 increase in salaries and employee benefits primarily resulted from the hiring of a marketing director and a chief credit officer in the second and fourth quarter of 2011, respectively. Partially offsetting these salary increases, the Bank received a credit in the first quarter of 2012 to adjust previously estimated group medical insurance premiums, effective to the contract renewal date in December 2011.

 

Occupancy expense decreased primarily due to the warmer weather experienced in the first quarter of 2012, which lowered snow removal expense and utility costs. Equipment expense decreased in 2012 due to elevated vehicle repair expenses incurred during the same prior year periods.

 

Professional and service fees increased primarily due to elevated consulting expenses incurred in our efforts to recapitalize the Corporation, including a special loan review engagement performed for investor due diligence purposes and tax research related to preservation of the Corporation’s net operating loss carry forward.

 

Loan collection and foreclosed property expenses include collection costs related to nonperforming and delinquent loans, including costs incurred to protect the Bank’s interest in collateral securing problem loans prior to taking title to the property, appraisal expenses and carrying costs related to other real estate. These expenses increased due to higher appraisal expense and expenses paid to a third-party to operate an ORE (hotel) property.

 

Computer software amortization expense decreased as a result of our core system software becoming fully amortized in the second quarter of 2012.

 

FDIC assessments decreased as a result of changes in the assessment base implemented by the FDIC beginning April 1, 2011 and the Bank’s reduced asset size relative to same prior year periods.

 

Other expenses increased primarily due to the timing of when certain community contributions were expensed in 2012 compared to 2011 and due to losses incurred for fraudulent debit card activity in 2012.

 

Federal Income Tax Expense (Benefit)

Due to the uncertainty of generating future taxable income necessary to realize the recorded net deferred tax asset, the Corporation has recorded a valuation allowance against the tax benefit related to its cumulative pre-tax losses, including the pre-tax loss incurred during the three and six month periods ended June 30, 2012 and 2011, respectively. In the second quarter of 2011, the Corporation recorded a federal income tax benefit to reduce its valuation allowance established on previously recorded deferred tax assets. The tax benefit resulted from adjustment of the deferred tax liability related to appreciation in the available for sale investment portfolio.

 

Capital

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

 

The Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) required that the federal regulatory agencies adopt regulations defining five capital tiers for banks:

 

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    Total   Tier 1    
    Risk-Based   Risk-Based    
    Capital Ratio   Capital Ratio   Leverage Ratio
Well capitalized   10% or above   6% or above   5% or above
Adequately capitalized   8% or above   4% or above   4% or above
Undercapitalized   Less than 8%   Less than 4%   Less than 4%
Significantly undercapitalized   Less than 6%   Less than 3%   Less than 3%
Critically undercapitalized   -   -   A ratio of tangible equity to
            total assets of 2% or less

 

Quantitative measures established by regulation to ensure capital adequacy require the Corporation and the Bank to maintain minimum amounts and ratios of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined), and Tier 1 capital (as defined) to average assets (as defined). The Corporation’s and the Bank’s actual capital amounts and ratios are presented in the following table:

 

           Minimum for   To be Well Capitalized 
           Capital Adequacy   Under Prompt Corrective 
   Actual   Purposes   Action Provision 
As of June 30, 2012  Amount   Ratio   Amount   Ratio   Amount   Ratio 
   (dollars in thousands) 
Total Capital (to risk weighted assets)                              
Bank  $9,876    4.60%  $17,185    8.00%  $21,482    10.00%
FNBH Bancorp   9,599    4.47%   17,185    8.00%   N/A    N/A 
                               
Tier 1 Capital (to risk weighted assets)                              
Bank   7,070    3.29%   8,593    4.00%   12,889    6.00%
FNBH Bancorp   6,793    3.16%   8,593    4.00%   N/A    N/A 
                               
Tier 1 Capital (to average assets)                              
Bank   7,070    2.46%   11,479    4.00%   14,349    5.00%
FNBH Bancorp   6,793    2.37%   11,479    4.00%   N/A    N/A 
                               
As of December 31, 2011   Amount    Ratio    Amount    Ratio    Amount    Ratio 
Total Capital (to risk weighted assets)                              
Bank  $9,987    4.49%  $17,811    8.00%  $22,264    10.00%
FNBH Bancorp   9,742    4.38%   17,811    8.00%   N/A    N/A 
                               
Tier 1 Capital (to risk weighted assets)                              
Bank   7,078    3.18%   8,906    4.00%   13,358    6.00%
FNBH Bancorp   6,833    3.07%   8,906    4.00%   N/A    N/A 
                               
Tier 1 Capital (to average assets)                              
Bank   7,078    2.44%   11,606    4.00%   14,507    5.00%
FNBH Bancorp   6,833    2.36%   11,606    4.00%   N/A    N/A 

 

The OCC has established the following minimum capital standards for national banks: a leverage requirement consisting of a minimum ratio of Tier 1 capital to total average assets of 3% for the most highly-rated banks, with minimum requirements of 4% to 5% for all others, and a risk-based capital requirement consisting of a minimum ratio of total capital to total risk-weighted assets of 8%, at least one-half of which must be Tier 1 capital. Tier 1 capital consists principally of shareholders’ equity. These capital requirements are minimum requirements. Higher capital levels will be required if warranted by the particular circumstances or risk profiles of individual institutions. Federal law provides the federal banking regulators with broad power to take prompt corrective action to resolve the problems of undercapitalized institutions.

 

On September 24, 2009, the Bank consented to the issuance of a Consent Order (the “Consent Order”) with the OCC. Pursuant to the Consent Order, the Bank was required to achieve and maintain total capital equal to 11% of risk weighted assets and Tier 1 capital equal to at least 8.5% of adjusted total assets by January 22, 2010. At June 30, 2012 and through the current date, the Bank’s capital ratios are and continue to be significantly below the increased minimum requirements imposed by the OCC. In addition and as a result of noncompliance with certain terms of the Consent Order, the Bank is categorized as “significantly undercapitalized” for Prompt Corrective Action purposes, as described in Note 2 of the 2011 Annual Report contained in the Corporation’s report on Form 10-K filing. The Prompt Corrective Action provisions impose certain restrictions on institutions that are undercapitalized. The restrictions become increasingly more severe as an institution’s capital category declines from undercapitalized to significantly undercapitalized to critically undercapitalized.

 

As described within earlier portions of this Form 10-Q filing, the Corporation accepted subscription commitments from accredited investors on May 8, 2012. The closing of such transaction (the “Capital Raise”) is subject to material conditions, including a condition regarding the existence and/or terms of any formal regulatory enforcement action against the Bank, and compliance by one or more investors with federal law applicable to the acquisition of "control" of a bank holding company. The satisfaction or waiver of these conditions is largely out of the control of the Corporation. If the conditions to the closing of such transaction are not satisfied or waived, the closing will not occur. (In light of the existence of these conditions, a reader of this Quarterly Report should not make a decision regarding whether to invest in the Corporation based on an assumption that the Capital Raise will close.) If the closing occurs as a result of the waiver of such conditions, there can be no assurances that the Bank will not continue to be subject to regulatory enforcement action, including the Consent Order, following the closing of such transaction. In light of the Bank’s recent losses and deficient capital position at June 30, 2012, it is reasonable to anticipate further regulatory enforcement action by either the OCC or FDIC, particularly if the Corporation is unsuccessful in closing the Capital Raise or otherwise raising additional capital.

 

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Even if we do not become subject to more stringent regulatory requirements or restrictions, our current capital deficiencies and elevated levels of nonperforming assets may make it very difficult to continue as a going concern. As described elsewhere in this Form 10-Q, we have established our allowance for loan losses at a level we currently believe, based on the data available to us, is sufficient to absorb expected losses in our loan portfolio. However, this process involves a very significant degree of judgment, is based on numerous different assumptions that are difficult to make and, by its nature, is inherently uncertain. Moreover, the performance of our existing loan portfolio is, in many respects, dependent on external factors such as our borrowers' ability to repay their loan obligations and the value of collateral securing those obligations, which in turn depend on macro and micro economic conditions including the pace of economic recovery in Southeast Michigan. If our loan portfolio performs worse than we currently expect, we may not have sufficient capital to absorb all of the losses, which could render us insolvent.

 

If the Corporation is unable to successfully close the Capital Raise transaction described above, the Corporation’s alternatives for additional capital will be limited. The ongoing liquidity concerns in the broader market and the loss of confidence in financial institutions will likely serve to increase our cost of funding and further limit our access to capital. We may not be able to raise the necessary capital on favorable terms, or at all. While the Company is hopeful that its ongoing efforts to raise additional capital will be successful, there are significant hurdles that remain in order for the Company to raise the amount of capital necessary for the Bank to comply with the requirements of the Consent Order. An inability to raise capital would likely have a materially adverse effect on our business, financial condition and results of operations. Management’s future plans in response to the Bank’s “significantly undercapitalized” regulatory classification and the need to raise additional capital pursuant to the Consent Order are described more fully in Note 2 of the 2011 Annual Report contained in the Corporation’s report on Form 10-K filing.

 

The Corporation’s ability to pay dividends is subject to various regulatory and state law requirements. Due to the Bank’s financial condition, the Bank cannot pay a dividend to the Corporation without the prior approval of the OCC. The Corporation suspended, indefinitely, the payment of dividends in the third quarter of 2008 due to the Bank’s inability to pay dividends to the holding company and insufficient cash at the holding company to pay the dividends.

 

Pursuant to the results of recent examinations of the Corporation by the Federal Reserve, the Corporation is considered a troubled institution due to the critically deficient condition of its subsidiary Bank. As such, the Federal Reserve has required the Corporation to take action to support the Bank, which principally involves a capital infusion sufficient to satisfy minimum capital ratios imposed on the Bank. In addition, the Corporation must receive prior approval from the Federal Reserve before the payment of dividends, issuance of debt, or redemption of stock. Additional restrictions imposed on the Corporation by the Federal Reserve relate to changes in the composition of board members, the employment of senior executive officers or changes in the responsibilities of senior executive officers, and limitations on indemnification and severance payments.

 

As a result of the Bank's current inability to pay dividends to the Corporation, the Corporation has an insufficient level of resources and cash flows to meet operational liquidity needs. The Bank is prohibited from paying expenses on behalf of the Corporation. To resolve the Corporation's illiquidity and the deficient capital levels at the Corporation and the Bank, the Corporation's board of directors has provided certain interim funding to the Corporation. Depending on the extent of the future cash needs of the holding company, the timing and success of the Capital Raise transaction described above, and the directors' willingness and ability to continue funding holding company expenses (through loans), the Corporation may be required to attempt to borrow funds from other sources to pay its expenses. Such additional borrowings may be at a price and on terms that are unfavorable to the Corporation. The holding company incurred pre-tax expenses totaling approximately $71,000 and $76,000, for the six month periods ended June 30, 2012 and 2011, respectively.

 

Regulatory Enforcement Action

As discussed above, the Bank is subject to a Consent Order issued by the OCC on September 24, 2009 that requires the Bank to raise capital in order to achieve certain minimum capital ratios. See "Capital" above for more information regarding these capital requirements, the Bank's current failure to meet the capital requirements of the Consent Order, and the status of the pending Capital Raise transaction.

 

In addition to the minimum capital ratios, the Consent Order imposes several other requirements on the Bank. The Bank has taken a number of actions to address such other requirements (many of which were underway well before the Consent Order was issued), including:

 

·the Board of Directors of the Bank appointed a Compliance Committee to ensure the Bank's compliance with the Consent Order and periodically report on such compliance efforts to the OCC;

 

·the Bank adopted a written strategic plan that intended, among other things, to address many of the requirements set forth in Consent Order, and the Bank has taken ongoing actions to monitor the Bank's performance relative to the strategic plan;

 

·the Bank enhanced its liquidity risk management program via improved procedures for cash flow forecasting, monitoring and reporting, development of a contingency funding plan and increased its borrowing availability under lines of credit secured by certain pledged loans and investments;

 

·the Bank has implemented numerous policies and procedures intended to improve asset quality levels within the loan portfolio, including: identifying, monitoring, and reporting of problem loans via application of a comprehensive risk grade assessment system; development of specific workout strategies on all significant impaired loans; attempted restructuring of certain problem credits to mitigate the extent of potential future loss by the Bank; and, overall improvements to underwriting policies and credit structuring practices;

 

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·the Bank engaged an independent third-party loan review specialist to assess the Bank's ability to effectively assign appropriate risk grades and identify problem loans;

 

·the Bank engaged an independent third-party to validate the Bank's allowance for loan loss methodology to ensure it conforms with regulatory guidance and accounting principles generally accepted in the United States of America, including an evaluation of the key assumptions used in the loan loss analysis;

 

·the Bank enhanced its policies and procedures for obtaining and reviewing appraisals on property securing loans made by the Bank;

 

·the Bank implemented a practice of developing a written action plan for each parcel of other real estate owned;

 

·the Bank has taken ongoing actions in an effort to reduce the Bank's concentration in commercial real estate (CRE) loans and construction and development (C&D) loans;

 

·the Bank has taken ongoing actions to improve many aspects of its credit and loan policies and programs; and

 

·the Bank enhanced its program designed to maintain an adequate allowance for loan and lease losses (ALLL).

 

While the Bank believes it has made significant progress in its efforts to comply with all requirements of the Consent Order other than the minimum capital requirements, the OCC continues to cite deficiencies and noncompliance with respect to each of the requirements of the Consent Order. As such, additional, ongoing actions by the Bank are required in order to be in compliance with the Consent Order as ultimately determined by the OCC. While the OCC could take further and immediate regulatory enforcement action against the Bank if the OCC believes the Bank is not in compliance with any requirement of the Consent Order, the Bank currently believes its failure to meet the minimum capital requirements established by the Consent Order is the primary risk factor in determining the likelihood and extent of any further, more severe regulatory enforcement action (such as receivership of the Bank).

 

Recent Developments

On September 22, 2011, at a special shareholder meeting, the shareholders of the Company approved a 1-for-7 reverse stock split of the Corporation's outstanding shares of common stock. This reverse stock split was implemented on October 3, 2011.  The primary purpose of the reverse stock split was to increase the number of the Corporation’s authorized common stock available for future issuance.  Please refer to the proxy statement the Corporation filed with the Securities and Exchange Commission (SEC) on August 10, 2011 for more details regarding the reverse stock split.

 

In addition, on May 24, 2012, at the Corporation’s annual shareholder meeting, the shareholders approved an increase in the number of authorized shares of common stock from 7 million shares to 11 million shares. The additional shares are required to close the planned Capital Raise and to provide additional shares for future issuance should further capital needs arise.

 

The Corporation's efforts to raise capital (as described in "Capital" above) may trigger an ownership change of the Corporation that would negatively affect the Corporation's ability to utilize its net operating loss carry forwards and other deferred tax assets in the future. If such an ownership change were to occur, the Corporation may incur higher than anticipated tax expense, which would reduce future net income. The Corporation structured the Capital Raise transaction described above in a manner to avoid such an ownership change, but there can be no assurances that we will successfully close such transaction due to material conditions beyond our control and, even if such transaction is closed, there is no guarantee that we will successfully avoid such an ownership change or otherwise realize value from our deferred tax assets. If we are unsuccessful in closing such transaction, we may not be able to raise capital without causing such an ownership change. In addition, on October 14, 2011, the Corporation entered into a Tax Benefits Preservation Plan as a further protection against an ownership change that would adversely affect the Corporation's future ability to use its deferred tax assets. The plan adopted by the Corporation is similar to tax benefit preservation plans adopted by other public companies with significant tax attributes that may be subject to limitations under the federal tax laws regarding a change in their ownership. In accordance with the plan, shares held by any person who acquires, without the approval of the Corporation's Board of Directors and excluding certain investors specified in the plan, beneficial ownership of 4.9% or more of the Corporation's outstanding common stock could be subject to significant dilution. There is no guarantee, however, that the plan will prevent the occurrence of an ownership change for purposes of the federal tax laws. Please refer to the Current Report on Form 8-K filed by the Corporation with the SEC on October 18, 2011 and the Registration Statement on Form 8-A filed on October 14, 2011 for more information regarding this plan.

 

Critical Accounting Policies

The Corporation maintains critical accounting policies for the valuation of investment securities, the allowance for loan losses, and income taxes. Refer to Notes 1c, 3, 1e, and 1k of the December 31, 2011 Consolidated Financial Statements as included in Form 10-K for additional information on critical accounting policies.

 

Contractual Obligations

The Bank had outstanding irrevocable standby letters of credit, which carry a maximum potential commitment of approximately $66,000 at June 30, 2012 and $132,000 at December 31, 2011, respectively. These letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. The majority of these letters of credit are short-term guarantees of one year or less, although some have maturities which extend as long as two years. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loans to customers. The Bank primarily holds real estate as collateral supporting those commitments for which collateral is deemed necessary. The extent of collateral held on those commitments at March 31, 2012 and December 31, 2011, where there is collateral, was in excess of the committed amount. A letter of credit is not recorded on the balance sheet unless a customer fails to perform.

 

34
 

 

New Accounting Standards

The FASB has issued ASU 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs. This ASU represents the converged guidance of the FASB and the IASB (the Boards) on fair value measurement. The collective efforts of the Boards and their staffs, reflected in ASU 2011-04, have resulted in common requirements for measuring fair value and for disclosing information about fair value measurements, including a consistent meaning of the term “fair value.” The Boards have concluded the common requirements will result in greater comparability of fair value measurements presented and disclosed in financial statement prepared in accordance with U.S. GAAP and IFRSs. The amendments to the Codification in this ASU are to be applied prospectively. For public entities, the amendments are effective during interim and annual periods beginning after December 15, 2011. Early adoption by public entities was not permitted. Disclosure of the fair value levels of our financial assets and liabilities was added to Note 3 and 7 upon adoption of this standard in the first quarter of 2012.

 

The FASB has issued ASU 2011-05, Comprehensive Income (Topic 220); Presentation of Comprehensive Income. This ASU amends accounting standards to allow an entity the option to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. In both choices, an entity is required to present each component of net income along with total net income, each component of other comprehensive income along with a total for other comprehensive income, and a total amount for comprehensive income. ASU 2011-05 eliminates the option to present the components of other comprehensive income as part of the statement of changes in shareholders’ equity. The amendments in the ASU do not change the items that must be reported in other comprehensive income or when an item of other comprehensive income must be reclassified to net income. ASU 2011-05 should be applied retrospectively effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. Presentation of comprehensive income in a separate statement was added upon adoption of this standard in the first quarter of 2012.

 

Recent Legislative Developments

In July 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act was signed into law.  Uncertainty remains as to the ultimate impact of the new law, which could have a material adverse impact either on the financial services industry as a whole or on the Corporation’s and Bank’s business, results of operations and financial condition. This new federal law contains a number of provisions that could affect the Corporation and the Bank. For example, the law:

 

·Makes national banks (such as the Bank) and their subsidiaries subject to a number of state laws that were previously preempted by federal laws;

 

·Imposes new restrictions on how mortgage brokers and loan originators may be compensated;

 

·Establishes a new federal consumer protection agency that will have broad authority to develop and implement rules regarding most consumer financial products;

 

·Creates new rules affecting corporate governance and executive compensation at all publicly traded companies (such as the Corporation);

 

·Broadens the base for FDIC insurance assessments and makes other changes to federal deposit insurance, including permanently increasing FDIC deposit insurance coverage to $250,000; and

 

·Allows depository institutions to pay interest on business checking accounts

 

Many of these provisions are not yet effective and are subject to implementation by various regulatory agencies. As a result, the actual impact this new law will have on the Bank's business is not yet known. However, this law and any other changes to laws applicable to the financial industry may impact the profitability of the Bank's business activities or change certain of its business practices and may expose the Corporation and the Bank to additional costs, including increased compliance costs, and require the investment of significant management attention and resources. As a result, this law may negatively affect the business and future financial performance of the Corporation and the Bank.

 

On April 5, 2012, the Jumpstart Our Business Startups Act (JOBS Act) was signed into law. The JOBS Act is intended to stimulate economic growth by helping smaller and emerging growth companies access the U.S. capital markets. It amends various provisions of, and adds new sections to, the Securities Act of 1933 and the Securities Exchange Act of 1934, as well as provisions of the Sarbanes-Oxley Act of 2002. The SEC has been directed to issue rules implementing certain JOBS Act amendments. For bank holding companies, the JOBS Act increases the statutory threshold for deregistration under the Securities Exchange Act of 1934 from 300 shareholders to 1,200 shareholders of record. We are currently evaluating the effects that the JOBS Act and the regulations adopted pursuant to the JOBS Act will have on the Corporation.

 

In December 2010, the Basel Committee on Banking Supervision, an international forum for cooperation on banking supervisory matters, announced the "Basel III" capital rules, which set new capital requirements for banking organizations. In June 2012, the Federal Reserve requested comment on three proposed rules that, taken together, would establish an integrated regulatory capital framework implementing the Basel III regulatory capital reforms in the U.S. As proposed, the U.S. implementation of Basel III would lead to significantly higher capital requirements and more restrictive leverage and liquidity ratios than those currently in place. Once adopted, these new capital requirements would be phased in over time, which is expected to occur between 2013 and 2019. The U.S. implementation of these standards could have an adverse impact on our financial position and future earnings due to, among other things, the increased minimum Tier 1 capital ratio requirements that will be implemented. However, the ultimate impact of the U.S. implementation of the new capital and liquidity standards on the Corporation and the Bank is still being reviewed. In addition, important questions remain as to how the numerous capital and liquidity mandates of the Dodd-Frank Act will be integrated with the requirements of Basel III.

 

Item 3. Quantitative and Qualitative Disclosures About Market Risk

 

There has been no material change in the market risk faced by the Corporation since December 31, 2011. For information regarding our risk factors, refer to the FNBH Bancorp, Inc. Form 10-K for the year ended December 31, 2011.

 

Item 4. Controls and Procedures

 

(a)Evaluation of Disclosure Controls and Procedures.

With the participation of management, the Corporation’s Chief Executive Officer and Chief Financial Officer completed an evaluation of the effectiveness of the Corporation’s disclosure controls and procedures (as defined in Exchange Act Rules 13a – 15(e) and 15d – 15(e)) for the period ended June 30, 2012. Based on that evaluation and the identification of a material weakness in the Corporation’s internal control over financial reporting in January 2012 (see below) the Chief Executive Officer and Chief Financial Officer have concluded that the Corporation’s disclosure controls were not effective at June 30, 2012 to ensure that information required to be disclosed in its reports that the Corporation files or submits to the Securities and Exchange Commission under the Exchange Act is recorded, processed, summarized and reported on a timely basis.

 

In light of the existing material weakness, in preparing the Corporation’s interim consolidated financial statements included in this report, the Corporation performed a thorough review of the determination of completeness and accuracy of the allowance for loan losses and the provision for loan losses, as well as the timeliness of charge offs on impaired loans and identification of other real estate owned to ensure that the Corporation’s interim consolidated financial statements included in this report have been prepared in accordance with U.S. GAAP. The Corporation’s Chief Executive Officer and Chief Financial Officer have certified that, based on their knowledge, the Corporation’s interim consolidated financial statements included in this report fairly present in all material respects the Corporation’s financial condition, results of operations and cash flows for the periods presented in this report.

 

35
 

 

For complete information regarding management’s identification of a material weakness in January 2012, the determination that a material weakness existed at December 31, 2011, and management’s plan to remediate the material weakness, refer to Item 9A. Controls and Procedures of the FNBH Bancorp, Inc. Form 10-K for the year ended December 31, 2011.

 

Management began to execute remediation plans during the first quarter of 2012. These remedial actions are expected to strengthen the Corporation’s internal control over financial reporting and will, over time, address the material weakness identified in January 2012. Because some of these remedial actions will take place on a quarterly basis, their successful implementation will continue to be evaluated before management is able to conclude that the related material weakness has been remediated. The Corporation cannot provide any assurance that these remediation efforts will be successful or that the Corporation’s internal control over financial reporting will be effective as a result of these efforts.

 

(b)Changes in Internal Control Over Financial Reporting.

During the quarter ended June 30, 2012 there were no changes in the Corporation’s internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

PART II - OTHER INFORMATION

 

Item 1A. Risk Factors

 

There have been no material changes to the risk factors disclosed in Item 1A. Risk Factors of the Corporation's Annual Report on Form 10-K for the year ended December 31, 2011.

 

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

 

Other than as previously reported in our current Report on Form 8-K filed on May 11, 2012, there were no sales or repurchases of stock by the Corporation for the three months ended June 30, 2012.

 

36
 

 

Item 6. Exhibits

 

The following exhibits (listed by number corresponding to the Exhibit Table as Item 601 in Regulation S-K) are filed with this report:

 

10.1 Form of Subscription Agreement, dated May 8, 2012, between the Corporation and certain accredited investors.
   
31.1 Certificate of the Chief Executive Officer of FNBH Bancorp, Inc. pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
   
31.2 Certificate of the Chief Financial Officer of FNBH Bancorp, Inc. pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
   
32.1 Certificate of the Chief Executive Officer of FNBH Bancorp, Inc. pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. 1350).
   
32.2 Certificate of the Chief Financial Officer of FNBH Bancorp, Inc. pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. 1350).

 

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SIGNATURES

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this Quarterly Report on Form 10-Q for the quarter ended June 30, 2012 to be signed on its behalf by the undersigned hereunto duly authorized.

 

  FNBH BANCORP, INC.
   
   /s/Ronald L. Long
  Ronald L. Long
  President and Chief Executive Officer
   
  /s/Mark J. Huber
  Mark J. Huber
  Chief Financial Officer

 

Date:  August 14, 2012

 

38

 

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