XNAS:LSBK Lake Shore 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

(Mark One)

 

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

 

For the quarterly period ended June 30, 2012

 

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

 

Commission file number: 000-51821

 

LAKE SHORE BANCORP, INC.

(Exact name of registrant as specified in its charter)

 

United States   20-4729288
(State or other jurisdiction of incorporation or organization)   (I.R.S. Employer Identification Number)
     
31 East Fourth Street, Dunkirk, New York   14048
(Address of principal executive offices)   (Zip code)
     

 

   (716) 366-4070  
   (Registrant’s telephone number, including area code)  

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months, and (2) has been subject to such filing requirements for the past 90 days.

 

     Yes x  No o  

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

     Yes x  No o  

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 definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

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

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

 

     Yes o  No x  

 

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

 

Common stock ($0.01 par value) 5,939,132 shares outstanding as of August 1, 2012.

 

 

 
 

TABLE OF CONTENTS

             
ITEM   PART I   PAGE
             
1   FINANCIAL STATEMENTS      
    - Consolidated Statements of Financial Condition as of June 30, 2012 (Unaudited) and December 31, 2011    2
    - Consolidated Statements of Income for the Three and Six Months Ended June 30, 2012 and 2011 (Unaudited)    3
    - Consolidated Statements of Comprehensive Income for the Three and Six Months Ended June 30, 2012 and 2011 (Unaudited)    4
    - Consolidated Statements of Changes in Stockholders’ Equity for the Six Months Ended June 30, 2012 and 2011 (Unaudited)    5
    - Consolidated Statements of Cash Flows for the Six Months ended June 30, 2012 and 2011 (Unaudited)    6
    - Notes to Unaudited Consolidated Financial Statements   7
2   MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS    33
3   QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK    50
4   CONTROLS AND PROCEDURES   50
         
      PART II    
             
1A RISK FACTORS     51
2   UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS   51
6   EXHIBITS     52
             
SIGNATURES       53

1
 

 

Table of Contents 

 

PART I

 

Item 1. Financial Statements

LAKE SHORE BANCORP, INC. and SUBSIDIARY

Consolidated Statements of Financial Condition

       
   June 30,
2012
  December 31,
2011
    (Unaudited)   
   (Dollars in thousands, except per share data)
       
Assets          
           
Cash and due from banks  $7,714   $7,031 
Interest earning deposits   12,670    5,402 
Federal funds sold   9,016    11,271 
           
Cash and Cash Equivalents   29,400    23,704 
           
Securities available for sale   170,679    164,165 
Federal Home Loan Bank stock, at cost   2,116    2,219 
Loans receivable, net of allowance for loan losses 2012 $1,324; 2011 $1,366   266,190    275,068 
Premises and equipment, net   8,498    8,530 
Accrued interest receivable   1,801    1,919 
Bank owned life insurance   11,496    11,376 
Other assets   1,939    1,616 
           
Total Assets  $492,119   $488,597 
           
Liabilities and Stockholders’ Equity          
           
Liabilities          
Deposits:          
Interest bearing  $353,949   $352,369 
Non-interest bearing   30,830    27,429 
           
Total Deposits   384,779    379,798 
           
Short-term borrowings   14,320    6,910 
Long-term debt   17,150    27,230 
Advances from borrowers for taxes and insurance   2,967    3,148 
Other liabilities   7,192    7,564 
           
Total Liabilities   426,408    424,650 
           
Commitments and Contingencies        
           
Stockholders’ Equity          
Common stock, $0.01 par value per share, 25,000,000 shares authorized;
6,612,500 shares issued and 5,939,132 shares outstanding at June 30, 2012 and December 31, 2011
   66    66 
Additional paid-in capital   27,978    27,987 
Treasury stock, at cost (673,368 shares at June 30, 2012 and December 31, 2011)   (6,260)   (6,260)
Unearned shares held by ESOP   (2,004)   (2,046)
Unearned shares held by RRP   (580)   (606)
Retained earnings   41,376    39,770 
Accumulated other comprehensive income   5,135    5,036 
           
Total Stockholders’ Equity   65,711    63,947 
           
Total Liabilities and Stockholders’ Equity  $492,119   $488,597 

 

See notes to consolidated financial statements.

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Table of Contents 

  

LAKE SHORE BANCORP, INC. and SUBSIDIARY

CONSOLIDATED STATEMENTS OF INCOME

 

   Three Months Ended
June 30,
  Six Months Ended
June 30,
   2012  2011  2012  2011
   (Unaudited)
   (Dollars in thousands except per share data)
                     
Interest Income                    
Loans, including fees  $3,553   $3,580   $7,150   $7,085 
Investment securities, taxable   972    1,137    1,982    2,281 
Investment securities, tax-exempt   479    498    948    965 
Other   9    6    13    20 
Total Interest Income   5,013    5,221    10,093    10,351 
Interest Expense                    
Deposits   1,036    1,147    2,117    2,359 
Short-term borrowings   13    8    23    15 
Long-term debt   117    230    264    486 
Other   27    28    54    56 
Total Interest Expense   1,193    1,413    2,458    2,916 
                     
Net Interest Income   3,820    3,808    7,635    7,435 
                     
Provision for loan losses   85    265    50    285 
                     
Net Interest Income after Provision for Loan Losses   3,735    3,543    7,585    7,150 
                     
Non-interest income                    
Service charges and fees   429    427    848    848 
Earnings on bank owned life insurance   61    66    120    129 
                     
Total other-than-temporary impairment (“OTTI”) losses   (566)       (566)    
Portion of OTTI losses recognized in comprehensive income (before taxes)   509        509     
Net OTTI losses recognized in earnings   (57)       (57)    
                     
Gain on sale of securities available for sale       31        31 
Recovery on previously impaired investment securities               57 
Other   24    21    67    60 
Total Non-Interest Income   457    545    978    1,125 
                     
Non-interest Expenses                    
Salaries and employee benefits   1,539    1,391    3,076    2,938 
Occupancy and equipment   448    434    890    895 
Professional services   352    304    668    577 
Data processing   153    143    305    282 
Advertising   81    130    253    253 
FDIC Insurance   56    127    122    249 
Postage and Supplies   56    58    117    133 
Other   359    246    680    508 
Total Non-Interest Expenses   3,044    2,833    6,111    5,835 
                     
Income before Income Taxes   1,148    1,255    2,452    2,440 
                     
Income tax expense   253    268    550    503 
                     
Net Income  $895   $987   $1,902   $1,937 
Basic and diluted earnings per common share  $0.16   $0.17   $0.33   $0.34 
Dividends declared per share  $0.07   $0.07   $0.14   $0.14 

 

See notes to consolidated financial statements.  

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Table of Contents 

  

Lake Shore Bancorp Inc. and Subsidiary

Consolidated Statements of Comprehensive Income

             
   Three Months Ended  Six Months Ended
   June 30,  June 30,
   2012  2011  2012  2011
      (Unaudited)   
      (Dollars in thousands)   
             
Net Income  $895   $987   $1,902   $1,937 
Other Comprehensive Income, net of tax:                    
Unrealized holding gains on securities available for sale   562    1,623    64    2,407 
                     
Reclassification adjustments related to:                    
Recovery on previously impaired investment securities               (35)
Gains on sales of securities included in net income       (19)       (19)
Impairment charge for losses included in net income   35        35     
Total Other Comprehensive Income   597    1,604    99    2,353 
                     
Total Comprehensive Income  $1,492   $2,591   $2,001   $4,290 

 

See notes to consolidated financial statements.

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LAKE SHORE BANCORP, INC. and SUBSIDIARY

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

Six Months Ended June 30, 2012 and 2011 (unaudited)

 

   Common Stock  Additional Paid-in Capital  Treasury
Stock
  Unearned Shares Held by ESOP  Unearned Shares Held by RRP  Retained Earnings  Accumulated Other Comprehensive Income (Loss)  Total
   (Dollars in thousands, except share and per share data)
    
Balance – January 1, 2011  $66   $27,920   $(6,091)  $(2,132)  $(757)  $36,737   $(533)  $55,210 
                                         
Net income                       1,937        1,937 
Other comprehensive income, net of tax                           2,353    2,353 
ESOP shares earned (3,968 shares)       (2)       43                41 
Stock based compensation       53                        53 
RRP shares earned (5,599 shares)       (17)           76            59 
Purchase of treasury stock, at cost (17,950 shares)           (169)                   (169)
Cash dividends declared ($0.14 per share)                       (367)       (367)
Balance – June 30, 2011  $66   $27,954   $(6,260)  $(2,089)  $(681)  $38,307   $1,820   $59,117 
                                         
Balance – January 1, 2012  $66   $27,987   $(6,260)  $(2,046)  $(606)  $39,770   $5,036   $63,947 
Net income                       1,902        1,902 
Other comprehensive income, net of tax                           99    99 
ESOP shares earned (3,968 shares)       (3)       42                39 
Stock based compensation       5                        5 
RRP shares earned (1,966 shares)       (11)           26            15 
Cash dividends declared ($0.14 per share)                       (296)       (296)
Balance – June 30, 2012  $66   $27,978   $(6,260)  $(2,004)  $(580)  $41,376   $5,135   $65,711 

 

See notes to consolidated financial statements.

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Table of Contents 

  

LAKE SHORE BANCORP, INC. and SUBSIDIARY

CONSOLIDATED STATEMENTS of CASH FLOWS

 

   Six Months Ended
   June 30,
   2012  2011
   (Unaudited)
   (Dollars in thousands)
    
Cash Flows from Operating Activities          
Net Income  $1,902   $1,937 
Adjustments to reconcile net income to net cash provided by operating activities:          
Net amortization of investment securities   160    41 
Amortization of deferred loan costs   276    249 
Provision for loan losses   50    285 
Impairment of investment securities   57     
Recovery on previously impaired investment securities       (57)
Gain on sale of investment securities       (31)
Originations of loans held for sale   (156)   (253)
Proceeds from sales of loans held for sale   156    253 
Depreciation and amortization   326    332 
Increase in bank owned life insurance, net   (120)   (129)
ESOP shares committed to be released   39    41 
Stock based compensation expense   20    112 
Decrease (increase) in accrued interest receivable   118    (120)
Decrease in other assets   448    903 
Decrease in other liabilities   (434)   (84)
           
Net Cash Provided by Operating Activities   2,842    3,479 
           
Cash Flows from Investing Activities          
Activity in available for sale securities:          
Sales       4,673 
Maturities, prepayments and calls   15,884    11,588 
Purchases   (22,454)   (16,599)
Purchases of Federal Home Loan Bank Stock   (17)   (44)
Redemptions of Federal Home Loan Bank Stock   120    118 
Loan origination and principal collections, net   7,784    (9,273)
Additions to premises and equipment   (297)   (121)
           
Net Cash Provided by (Used in) Investing Activities   1,020    (9,658)
           
Cash Flows from Financing Activities          
Net increase in deposits   4,981    3,105 
Net decrease in advances from borrowers for taxes and insurance   (181)   (134)
Net increase in short-term borrowings   7,410    950 
Proceeds from issuance of long-term debt       3,000 
Repayment of long-term debt   (10,080)   (6,580)
Purchase of Treasury Stock       (169)
Cash dividends paid   (296)   (367)
           
Net Cash Provided by (Used In) Financing Activities   1,834    (195)
           
Net Increase (Decrease) in Cash and Cash Equivalents   5,696    (6,374)
           
Cash and Cash Equivalents – Beginning   23,704    33,514 
           
Cash and Cash Equivalents – Ending  $29,400   $27,140 
Supplementary Cash Flows Information          
Interest paid  $2,498   $2,954 
Income taxes paid  $706   $365 
Supplementary Schedule of Noncash Investing and Financing Activities          
Foreclosed real estate acquired in settlement of loans  $887   $71 

 

See notes to consolidated financial statements

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Table of Contents 

  

LAKE SHORE BANCORP, INC. and Subsidiary

Notes to Consolidated Financial Statements (unaudited)

 

NOTE 1 – NATURE OF OPERATIONS AND BASIS OF PRESENTATION

 

Lake Shore Bancorp, Inc. (the “Company”) was formed on April 3, 2006 to serve as the stock holding company for Lake Shore Savings Bank (“the Bank”) as part of the Bank’s conversion and reorganization from a New York-chartered mutual savings and loan association to the federal mutual holding form of organization.

 

The interim consolidated financial statements include the accounts of the Company and the Bank, its wholly owned subsidiary. All intercompany accounts and transactions of the consolidated subsidiary have been eliminated in consolidation.

 

The interim financial statements included herein as of June 30, 2012 and for the three and six months ended June 30, 2012 and 2011 have been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission, and therefore, do not include all information or footnotes necessary for a complete presentation of the consolidated statements of financial condition, results of operations and cash flows in conformity with accounting principles generally accepted in the United States of America (“GAAP”). The consolidated balance sheet at December 31, 2011 has been derived from the audited consolidated financial statements at that date, but does not include all of the information and footnotes required by GAAP for complete consolidated financial statements. The consolidated financial statements reflect all adjustments that are, in the opinion of management, necessary for a fair statement of such information and to make the financial statements not misleading. These interim consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the audited consolidated financial statements included in the Company’s Form 10-K for the year ended December 31, 2011. The consolidated results of operations for the three and six months ended June 30, 2012 are not necessarily indicative of the results for any subsequent period or the entire year ending December 31, 2012.

 

To prepare these consolidated financial statements in conformity with GAAP, management of the Company made a number of estimates and assumptions relating to the reporting of assets and liabilities and the reporting of revenue and expenses. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses, securities valuation estimates, evaluation of impairment of securities and income taxes.

 

The Company has evaluated events and transactions occurring subsequent to the balance sheet as of June 30, 2012 for items that should potentially be recognized or disclosed in these consolidated financial statements. The evaluation was conducted through the date these consolidated financial statements were issued.

 

NOTE 2 – NEW ACCOUNTING STANDARDS

There were no new accounting standards affecting the Company during the period that were not previously disclosed.

7
 

 

Table of Contents 

  

NOTE 3 – INVESTMENT SECURITIES

The amortized cost and fair value of securities are as follows:

    June 30, 2012
   Amortized
Cost
  Gross
Unrealized Gains
  Gross Unrealized
Losses
  Fair
Value
   (Dollars in Thousands)
                     
Securities Available for Sale:                    
                     
 U.S. Treasury bonds  $12,915   $2,421   $   $15,336 
 Municipal bonds   51,688    3,800    (27)   55,461 
 Mortgage-backed securities:                    
Collateralized mortgage obligations
-private label
   108    2        110 
Collateralized mortgage obligations
-government sponsored entities
   61,186    795    (50)   61,931 
Government National Mortgage
Association
   2,934    275        3,209 
Federal National Mortgage
Association
   21,593    1,127        22,720 
Federal Home Loan Mortgage
Corporation
   6,679    527        7,206 
Asset-backed securities
-private label
   5,020    491    (985)   4,526 
Asset-backed securities
-government sponsored entities
   159    15        174 
 Equity securities   22        (16)   6 
                     
   $162,304   $9,453   $(1,078)  $170,679 

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NOTE 3 – INVESTMENT SECURITIES (continued)

    December 31, 2011 
         Gross    Gross      
    Amortized    Unrealized    Unrealized    Fair 
    Cost    Gains    Losses    Value 
    (Dollars in Thousands) 
                     
SECURITIES AVAILABLE FOR SALE:                    
                     
U.S. Treasury bonds  $12,935   $2,143     $15,078 
Municipal bonds   49,561    4,115        53,676 
Mortgage-backed securities:                    
Collateralized mortgage obligations -private label   133       (4)   129 
Collateralized mortgage obligations -government sponsored entities   59,669    1,127    (25)   60,771 
Government National Mortgage Association   3,141    208        3,349 
Federal National Mortgage Association   19,612    958        20,570 
Federal Home Loan Mortgage Corporation   5,246    520        5,766 
Asset-backed securities -private label   5,459    378    (1,205)   4,632 
Asset-backed securities -government sponsored entities   173    16        189 
                   
Equity securities    22     —    (17)   5 
                     
   $155,951   $9,465  (1,251)  $164,165 

 

All of our collateralized mortgage obligations are backed by residential mortgages.

 

At June 30, 2012 and December 31, 2011, equity securities consisted of 22,368 shares of Federal Home Loan Mortgage Corporation (“FHLMC”) common stock.

At June 30, 2012, thirty-two municipal bonds with a cost of $10.0 million and fair value of $11.0 million were pledged under a collateral agreement with the Federal Reserve Bank of New York for liquidity borrowing. In addition, at June 30, 2012, eleven municipal bonds with a cost of $4.1 million and a fair value of $4.5 million were pledged as collateral for customer deposits in excess of the Federal Deposit Insurance Corporation (“FDIC”) insurance limits. At December 31, 2011, thirty-two municipal bonds with a cost of $10.0 million and fair value of $11.2 million were pledged under a collateral agreement with the Federal Reserve Bank of New York for liquidity borrowing. In addition, at December 31, 2011, eleven municipal bonds with a cost of $4.1 million and a fair value of $4.6 million were pledged as collateral for customer deposits in excess of the FDIC insurance limits.

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NOTE 3 – INVESTMENT SECURITIES (continued)

The following table sets forth the Company’s investment in securities available for sale with gross unrealized losses of less than twelve months and gross unrealized losses of twelve months or more and associated fair values as of the dates indicated: 

   Less than 12 Months  12 Months or More  Total
   Fair
Value
  Gross
Unrealized Losses
  Fair
Value
  Gross
Unrealized Losses
  Fair
Value
  Gross
Unrealized Losses
         (Dollars in thousands)      
                   
June 30, 2012                              
Municipal bonds  $1,529   $(27)  $   $   $1,529   $(27)
Mortgage-backed securities   12,188    (50)           12,188    (50)
Asset-backed securities – private label           3,724    (985)   3,724    (985)
Equity securities           6    (16)   6    (16)
   $13,717   $(77)  $3,730   $(1,001)  $17,447   $(1,078)
                               
December 31, 2011                              
Mortgage-backed securities  $6,982   $(29)  $   $   $6,982   $(29)
Asset-backed securities – private label           3,846    (1,205)   3,846    (1,205)
Equity securities           5    (17)   5    (17)
   $6,982   $(29)  $3,851   $(1,222)  $10,833   $(1,251)

 

The Company reviews investment securities on an ongoing basis for the presence of other-than-temporary impairment (“OTTI”) with formal reviews performed quarterly.

 

The Company determines whether the unrealized losses in accordance with FASB ASC Topic 320 “Investments - Debt and Equity Securities” are other-than-temporary, The evaluation is based upon factors such as the creditworthiness of the issuers/guarantors, the underlying collateral and the continuing performance of the securities.

 

Management also evaluates other facts and circumstances that may be indicative of an OTTI condition. This includes, but is not limited to, an evaluation of the type of security, length of time and extent to which fair value has been less than cost, and near-term prospects of the issuer. The Company uses the cash flow expected to be realized from the security, which includes assumptions about interest rates, timing and severity of defaults, estimates of potential recoveries, the cash flow distribution from the provisions in the applicable bond indenture and other factors, then applies a discounting rate equal to the effective yield of the security. If the present value of the expected cash flows is less than the amortized book value it is considered a credit loss. The fair value of the security is determined using the same expected cash flows; the discount rate is a rate the Company determines from open market and other sources as appropriate for the security. The difference between the fair value and the credit loss is recognized in other comprehensive income, net of taxes.

At June 30, 2012 the Company’s investment portfolio included twelve mortgage-backed securities and seven municipal bonds in the unrealized losses less than twelve months category. The mortgage-backed securities and municipal bonds were not evaluated further for OTTI as the unrealized losses on the individual securities were less than 20% of book value, which management deemed to be immaterial, and the credit ratings remained strong. The Company expects these securities to be repaid in full, with no losses realized. Management does not intend to sell these securities and it is more likely than not that it will not be required to sell these securities.

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NOTE 3 – INVESTMENT SECURITIES (continued)

 

At June 30, 2012, the Company had one equity security, and four private label asset-backed securities in the unrealized loss of twelve months or more category. The Company’s investment in equity securities is a requirement of its membership with the FHLMC. The equity security was not evaluated further for OTTI, despite the percentage of unrealized losses, due to immateriality.

One of the four private label asset-backed securities in this category was not evaluated further for OTTI, as the unrealized loss was less than 20% of book value. The temporary impairment was due to declines in fair value resulting from changes in interest rates and/or increased credit liquidity spreads since the security was purchased. The Company expects this security to be repaid in full, with no losses realized. Management does not intend to sell this security and it is more likely than not that it will not be required to sell this security.

Three of the four private label securities in this category were evaluated further for OTTI, as the unrealized loss was greater than 20% of book value for the individual security or the related credit ratings were below investment grade, or the Company’s analysis indicated a possible loss of principal. The following table provides additional information relating to these private label asset-backed securities as of June 30, 2012 (dollars in thousands):

                         Delinquent %           
                                   Foreclosure/      
                         Over    Over    OREO /      
     Book    Fair    Unrealized    Lowest    60    90    Bankruptcy    OREO 
Security    Value    Value    Gain/(Loss)    Rating    days    days    %    % 
                                          
1    $1,943   $1,434   $(509)   C    40.70%   39.80%   18.90%   2.00%
2    1,217    906    (311)   CCC    34.80%   32.90%   14.90%   1.50%
3    1,000    843    (157)   CCC    21.30%   20.00%   12.90%   0.60%
                                          
Total    4,160   $3,183   $(977)                         

 

The three private label asset-backed securities listed above were evaluated for OTTI under the guidance of FASB ASC Topic 320. The Company believes the unrealized losses on these three private label asset-backed securities occurred due to the current challenging economic environment, high unemployment rates, a continued decline in housing values in many areas of the country, and increased delinquency trends. It is possible that principal losses may be incurred on the tranches we hold in these specific securities. Management’s evaluation of the estimated discounted cash flows in comparison to the amortized book value reflected the need to record an initial OTTI charge against earnings of $57,000 for one of the securities noted above, as of June 30, 2012, as the calculation of the estimated discounted cash flows showed an additional principal loss. Management’s evaluation of the estimated discounted cash flows in comparison to the amortized book value for the remaining securities listed above did not reflect the need to record OTTI charges against earnings as of June 30, 2012. The estimated discounted cash flows for these remaining securities did not show an additional principal loss under various prepayment and default rate scenarios. Management concluded that it does not intend to sell these securities and that it is more likely than not it will not be required to sell these securities.

Management also completed an OTTI analysis for two private label asset-backed securities, which did not have unrealized losses as of June 30, 2012. However, an impairment charge had been taken on these securities during 2008. Management reviewed key credit metrics for these securities, including delinquency rates, cumulative default rates, prepayment speeds, foreclosure rates, loan-to-values and credit support levels. Management’s calculation of the estimated discounted cash flows did not show additional principal losses for these securities under various prepayment and default rate scenarios. As a result of the stress tests that were performed, management concluded that additional OTTI charges were not required as of June 30, 2012 on these securities. Management also concluded that it does not intend to sell the securities and that it is not likely it will be required to sell these securities.

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NOTE 3 – INVESTMENT SECURITIES (continued)

 

The unrealized losses shown in the above table, were recorded as a component of other comprehensive income, net of tax on the Company’s Consolidated Statements of Changes in Stockholders’ Equity.

 

The following table presents a summary of the credit related OTTI charges recognized as components of earnings:

 

   For the Six
Months Ended
June 30, 2012
  For the Year
Ended
December 31, 2011
   (Dollars in thousands)
    
Beginning balance  $1,084   $1,176 
Addition:          
Credit loss not previously recognized   57     
Reductions:          
Losses realized during the period on OTTI previously recognized   (20)   (35)
Receipt of cash flows on previously recorded OTTI       (57)
Ending balance  $1,121   $1,084 

 

Further deterioration in credit quality and/or a continuation of the current imbalances in liquidity that exist in the marketplace might adversely affect the fair values of the Company’s investment portfolio and may increase the potential that certain unrealized losses will be designated as other than temporary and that the Company may incur additional write-downs in future periods.

 

Scheduled contractual maturities of available for sale securities are as follows:

 

   Amortized
Cost
  Fair
Value
   (Dollars in Thousands)
       
June 30, 2012:          
       After five years through ten years  $19,426   $21,916 
       After ten years   45,177    48,881 
       Mortgage-backed securities   92,500    95,176 
       Asset-backed securities   5,179    4,700 
       Equity securities   22    6 
   $162,304   $170,679 

 

During the six months ended June 30, 2012, the Company did not sell any available for sale securities. The Company sold available for sale securities during the six months ended June 30, 2011, for total proceeds of $4.7 million, resulting in gross realized gains of $115,000 and gross realized losses of $84,000.

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NOTE 4 - ALLOWANCE FOR LOAN LOSSES

Management segregates the loan portfolio into loan types and analyzes the risk level for each loan type when determining its allowance for loan losses. The loan types are as follows:

 

Real Estate Loans:

  • One- to Four-Family – are loans secured by first lien collateral on residential real estate primarily held in the Western New York region. These loans can be affected by economic conditions and the value of underlying properties. Western New York has not been impacted as severely as other parts of the country by fluctuating real estate prices. Furthermore, the Company has conservative underwriting standards and does not have any sub-prime loans in its loan portfolio.
  • Home Equity - are loans or lines of credit secured by second lien collateral on owner-occupied residential real estate primarily held in the Western New York area. These loans can also be affected by economic conditions and the values of underlying properties.
  • Commercial Real Estate – are loans used to finance the purchase of real property, which generally consists of developed real estate that is held as first lien collateral for the loan. These loans are secured by real estate properties that are primarily held in the Western New York region. Commercial real estate lending involves additional risks compared with one- to four-family residential lending, because payments on loans secured by commercial real estate properties are often dependent on the successful operation or management of the properties, and/or the collateral value of the commercial real estate securing the loan, and repayment of such loans may be subject to adverse conditions in the real estate market or economic conditions to a greater extent than one- to four-family residential mortgage loans. Also, commercial real estate loans typically involve large loan balances to single borrowers or groups of related borrowers.
  • Construction – are loans to finance the construction of either one- to four-family owner occupied homes or commercial real estate. At the end of the construction period, the loan automatically converts to either a conventional or commercial mortgage, as applicable. Risk of loss on a construction loan depends largely upon the accuracy of the initial estimate of the value of the property at completion compared to the estimated cost of construction.

Other Loans:

  • Commercial – includes business installment loans, lines of credit, and other commercial loans. Most of our commercial loans have variable interest rates tied to the prime rate, and are for terms generally not in excess of 10 years. Whenever possible, we collateralize these loans with a lien on business assets and equipment and require the personal guarantees from principals of the borrower. Commercial loans generally involve a higher degree of credit risk because the collateral underlying the loans may be in the form of intangible assets and/or inventory subject to market obsolescence. Commercial loans can also involve relatively large loan balances to a single borrower or groups of related borrowers, with the repayment of such loans typically dependent on the successful operation of the commercial businesses and the income stream of the borrower. Such risks can be significantly affected by economic conditions.
  • Consumer – consist of loans secured by collateral such as an automobile or a deposit account, unsecured loans and lines of credit. Consumer loans tend to have a higher credit risk due to the loans being either unsecured or secured by rapidly depreciable assets. Furthermore, consumer loan payments are dependent on the borrower’s continuing financial stability, and therefore are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy.

The allowance for loan losses is a valuation account that reflects the Company’s evaluation of the losses inherent in its loan portfolio. In order to determine the adequacy of the allowance for loan losses, the Company estimates losses by loan type using historical loss factors, as well as other environmental factors, such as trends in loan volume and loan type, loan concentrations, changes in the experience, ability and depth of the Company’s lending management, and national and local economic conditions.

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NOTE 4 - ALLOWANCE FOR LOAN LOSSES (continued)

 

The Company also reviews all loans on which the collectability of principal may not be reasonably assured, by reviewing payment status, financial conditions and estimated value of loan collateral. These loans are assigned an internal loan grade, and the Company assigns the amount of loss components to these classified loans based on loan grade.

 

The following table summarizes the activity in the allowance for loan losses for the three and six months ended June 30, 2011 and 2012 and the distribution of the allowance for loan losses and loans receivable by loan portfolio class and impairment method as of June 30, 2012:

    Real Estate Loans    Other Loans           
    One-to                                    
    Four-    Home                               
    Family    Equity    Commercial    Construction    Commercial    Consumer    Unallocated    Total 
                   (Dollars in thousands)                
June 30, 2011                                        
                                         
Allowance for Loan Losses:                                        
Balance – April 1, 2011  $306   $90   $350   $   $177   $21   $   $944 
Charge-offs                       (5)       (5)
Recoveries                       2        2 
Provision   67        148        51    (1)       265 
Balance – June 30, 2011  $373   $90   $498   $   $228   $17   $   $1,206 
                                         
Balance – January 1, 2011  $407   $141   $278   $1   $104   $21   $1   $953 
Charge-offs       (29)               (10)       (39)
Recoveries   4                    3        7 
Provision   (38)   (22)   220    (1)   124    3    (1)   285 
Balance – June 30, 2011  $373   $90   $498   $   $228   $17   $   $1,206 

 

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NOTE 4 - ALLOWANCE FOR LOAN LOSSES (continued)

 

   Real Estate Loans  Other Loans            
   One- to                     
   Four-  Home                  
   Family  Equity  Commercial  Construction  Commercial  Consumer  Unallocated  Total
   (Dollars in thousands)
    
June 30, 2012                        
                         
Allowance for Loan Losses:                                        
Balance – April 1, 2012  $381   $66   $719   $   $146   $10   $3   $1,325 
Charge-offs   (94)                   (1)       (95)
Recoveries           8            1        9 
Provision   69    22    (40)   2    35    (2)   (1)   85 
Balance – June 30, 2012  $356   $88   $687   $2   $181   $8   $2   $1,324 
                                         
Balance – January 1, 2012  $441   $125   $522   $   $265   $13   $   $1,366 
Charge-offs   (100)               (1)   (1)       (102)
Recoveries   1        8            1        10 
Provision   14    (37)   157    2    (83)   (5)   2    50 
Balance – June 30, 2012  $356   $88   $687   $2   $181   $8   $2   $1,324 
Ending balance: individually evaluated for impairment  $   $   $8   $   $   $   $   $8 
Ending balance: collectively evaluated for impairment  $356   $88   $679   $2   $181   $8   $2   $1,316 
                                         
Gross Loans Receivable (1):                                        
                                         
Ending balance  $172,116   $30,439   $47,939   $682   $11,912   $1,743   $   $264,831 
Ending balance: individually evaluated for impairment  $   $   $130   $   $13   $   $   $143 
Ending balance: collectively evaluated for impairment  $172,116   $30,439   $47,809   $682   $11,899   $1,743   $   $264,688 

   

   (1)  Gross Loans Receivable does not include allowance for loan losses of $(1,324) or deferred loan costs of $2,683
                    

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NOTE 4 - ALLOWANCE FOR LOAN LOSSES (continued)

 

The following table summarizes the distribution of the allowance for loan losses and loans receivable by loan portfolio class and impairment method as of December 31, 2011:

 

   Real Estate Loans  Other Loans      
   One- to                     
   Four-  Home                  
   Family  Equity  Commercial  Construction  Commercial  Consumer  Unallocated  Total
            (Dollars in thousands)         
                         
December 31, 2011                                        
                                         
Allowance for Loan Losses:                                        
Balance – December 31, 2011  $441   $125   $522   $   $265   $13   $   $1,366 
Ending balance: individually evaluated for impairment  $   $   $8   $   $   $   $   $8 
Ending balance: collectively evaluated for impairment  $441   $125   $514   $   $265   $13   $   $1,358 
                                         
Gross Loans Receivable (1):                                        
Ending Balance  $182,922   $30,671   $44,776   $519   $12,911   $1,948   $   $273,747 
Ending balance: individually evaluated for impairment  $   $   $133   $   $   $   $   $133 
Ending balance:
collectively evaluated for impairment
  $182,922   $30,671   $44,643   $519   $12,911   $1,948   $   $273,614 

      (1) Gross Loans Receivable does not include allowance for loan losses of $(1,366) or deferred loan costs of $2,687.

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NOTE 4 - ALLOWANCE FOR LOAN LOSSES (continued)

 

Although the allocations noted above are by loan type, the allowance for loan losses is general in nature and is available to offset losses from any loan in the Company’s portfolio.

A loan is considered impaired when, based on current information and events, it is probable that the Company will not be able to collect the scheduled payments of principal and interest when due according to the contractual terms of the loan agreement. Factors considered in determining impairment include payment status, collateral value and the probability of collecting scheduled payments when due. Impairment is measured on a loan-by-loan basis for commercial real estate loans and commercial loans. Larger groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Company does not separately identify individual consumer, home equity, or one- to four-family loans for impairment disclosure, unless they are subject to a troubled debt restructuring.

 

The following is a summary of information pertaining to impaired loans for the periods indicated:

 

      Unpaid     Average  Interest
   Recorded  Principal  Related  Recorded  Income
   Investment  Balance  Allowance  Investment  Recognized
   (Dollars in thousands)
            For the six ended months
   At June 30, 2012  June 30, 2012
                
With no related allowance recorded:                         
Commercial real estate  $   $   $   $59   $ 
Commercial loans   13    13        13     
With an allowance recorded:                         
Commercial real estate   130    130    8    133    7 
Total  $143   $143   $8   $205   $7 
                          
                          
                   For the year ended 
    At December 31, 2011    December 31, 2011 
With no related allowance recorded:                         
Commercial real estate  $   $   $   $131   $14 
With an allowance recorded:                         
Commercial real estate   133    133    8    245    16 
Total  $133   $133   $8   $376   $30 

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NOTE 4 - ALLOWANCE FOR LOAN LOSSES (continued)

 

The following table provides an analysis of past due loans as of the dates indicated:

   30-59
Days
Past
Due
  60-
89
Days
Past
Due
  90 Days
or More
Past
Due
  Total
Past
Due
  Current
Due
 

 

Total Loans
Receivable

   (Dollars in thousands)
    
June 30, 2012:                            
Real Estate Loans:                            
         Residential, one- to four-family  $745   $412   $995   $2,152   $169,964    $ 172,116
         Home equity   94    26    228    348    30,091    30,439
         Commercial       255        255    47,684    47,939
         Construction                   682    682
Other Loans:                            
         Commercial   83    21    93    197    11,715    11,912
         Consumer   10        28    38    1,705    1,743
Total  $932   $714   $1,344   $2,990   $261,841    $ 264,831
                             
December 31, 2011:                            
Real Estate Loans:                            
         Residential, one- to four-family  $949   $608   $1,989   $3,546   $179,376    $ 182,922
         Home equity   403    51    157    611    30,060    30,671
         Commercial   890    39    228    1,157    43,619    44,776
         Construction                   519    519
Other Loans:                            
         Commercial   41    3    159    203    12,708    12,911
         Consumer   58    4    28    90    1,858    1,948
Total  $2,341   $705   $2,561   $5,607   $268,140   $ 273,747

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NOTE 4 - ALLOWANCE FOR LOAN LOSSES (continued)

 

The following table is a summary of nonaccrual loans and accruing loans delinquent 90 days or more by loan class for the dates indicated:

 

    At June 30,    At December 31, 
    2012    2011 
    (Dollars in thousands) 
           
Loans past due 90 days or more but still accruing:     
Real Estate Loans:          
Residential, one- to four-family  $13   $328 
Home equity   54    21 
Commercial        
Construction        
Other loans:          
Commercial       87 
Consumer   24    23 
Total  $91   $459 
           
Loans accounted for on a non-accrual basis:          
Real Estate Loans:          
Residential, one- to four-family  $1,461   $1,821 
Home equity   213    209 
Commercial   130    228 
Construction        
Other loans:          
Commercial   160    76 
Consumer   4    5 
Total  $1,968   $2,339 

 

The accrual of interest on loans is discontinued when, in management’s opinion, the borrower may be unable to meet payments as they become due. When interest accrual is discontinued, all unpaid accrued interest is reversed. Interest income is subsequently recognized only to the extent cash payments are received. If ultimate collection of principal is in doubt, all cash receipts on impaired loans are applied to reduce the principal balance. Interest income not recognized on non-accrual loans during the six month period ended June 30, 2012 and June 30, 2011 was $69,000 and $56,000 respectively.

 

The Company’s policies provide for the classification of loans as follows:

 

·Pass/Performing
·Watch/Special Mention – does not currently expose the Company to a sufficient degree of risk but does possess credit deficiencies or potential weaknesses deserving the Company’s close attention;

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NOTE 4 - ALLOWANCE FOR LOAN LOSSES (continued)

 

·Substandard – has one or more defined weaknesses and are characterized by the distinct possibility that the Company will sustain some loss if the deficiencies are not corrected;
·Doubtful – has all the weaknesses inherent in substandard loans with the additional characteristic that the weaknesses present make collection or liquidation in full on the basis of currently existing facts, conditions and values questionable, and there is a high possibility of loss; and
·Loss – loan is considered uncollectible and continuance as a loan of the Company is not warranted.

 

The Company’s Asset Classification Committee is responsible for monitoring risk ratings and making changes as deemed appropriate. Each commercial loan is individually assigned a loan classification. The Company’s consumer loans, including residential one- to four-family loans and home equity loans, are not individually classified. Instead the Company uses the delinquency status as the credit quality indicator for consumer loans. Unless the loan is well secured and in the process of collection, all consumer loans that are more than 90 days past due are classified.

 

The following table summarizes the internal loan grades applied to the Company’s loan portfolio as of June 30, 2012 and December 31, 2011:

 

  

Pass/

Performing

 

Special

Mention

  Substandard  Doubtful  Loss  Total
   (Dollars in thousands)
    
June 30, 2012                  
Real Estate Loans:                              
Residential, one- to four-family  $170,398   $   $1,718   $   $   $172,116 
Home Equity   30,163        181    95        30,439 
Commercial   43,756    3,977    76    130        47,939 
Construction   682                    682 
Other Loans:                              
Commercial   10,889    716    199    108        11,912 
Consumer   1,736        7            1,743 
Total  $257,624   $4,693   $2,181   $333   $   $264,831 
                               
December 31, 2011                              
Real Estate Loans:                              
Residential, one- to four-family  $180,606   $   $1,991   $265   $60   $182,922 
Home Equity   30,270        401            30,671 
Commercial   41,234    3,233    81    228        44,776 
Construction   519                    519 
Other Loans:                              
Commercial   11,252    1,313    241    105        12,911 
Consumer   1,940        8            1,948 
Total  $265,821   $4,546   $2,722   $598   $60   $273,747 

 

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NOTE 4 - ALLOWANCE FOR LOAN LOSSES (continued)

 

Troubled debt restructurings (“TDRs”) occur when we grant borrowers concessions that we would not otherwise grant but for economic or legal reasons pertaining to the borrower’s financial difficulties. A concession is made when the terms of the loan modification are more favorable than the terms the borrower would have received in the current market under similar financial difficulties. These concessions may include, but are not limited to, modifications of the terms of the debt, the transfer of assets or the issuance of an equity interest by the borrower to satisfy all or part of the debt, or the addition of borrower(s). The Company identifies loans for potential TDRs primarily through direct communication with the borrower and evaluation of the borrower’s financial statements, revenue projections, tax returns, and credit reports. Even if the borrower is not presently in default, management will consider the likelihood that cash flow shortages, adverse economic conditions, and negative trends may result in a payment default in the near future. Generally, we will not return a TDR to accrual status until the borrower has demonstrated the ability to make principal and interest payments under the restructured terms for at least six consecutive months.

 

For the six months ended June 30, 2012, 23 one- to four-family real estate loans with aggregate balances of $2.2 million were modified and not classified as TDRs. The modified loans are part of our standard loan products offered to qualified customers who receive a lower interest rate in order to maintain the customer lending relationship. In the second quarter of 2011, one home equity loan for $31,000 was modified and classified as a TDR. The TDR home equity loan was modified due to the borrower’s financial difficulties, in which case past due post petition payments and attorney fees were capitalized as part of the loan balance, increasing the balance to $34,000 from $31,000, and the loan term was extended by 8 years with no change in interest rate. This loan was classified as a substandard loan with no specific reserve established and was 240 days past due under the modified terms at June 30, 2012.

 

NOTE 5 – EARNINGS PER SHARE

 

Earnings per share was calculated for the three and six months ended June 30, 2012 and 2011, respectively. Basic earnings per share is based upon the weighted average number of common shares outstanding, exclusive of unearned shares held by the Employee Stock Ownership Plan of Lake Shore Bancorp, Inc. (the “ESOP”) and unearned shares held by the Recognition and Retention Plan (“RRP”). Diluted earnings per share is based upon the weighted average number of common shares outstanding and common share equivalents that would arise from the exercise of dilutive securities. Stock options and unvested restricted stock are regarded as potential common stock and are considered in the diluted earnings per share calculations to the extent they would be dilutive and computed using the treasury stock method.

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NOTE 5 – EARNINGS PER SHARE (continued)

 

The calculated basic and diluted earnings per share are as follows:

   Three Months Ended June 30, 2012   Three Months Ended June 30, 2011 
         
Numerator – net income  $895,000   $987,000 
Denominators:          
Basic weighted average shares outstanding   5,704,393    5,688,620 
Increase in weighted average shares outstanding due to (1):          
Stock options   4,746    4,650 
Unvested restricted stock awards   739    1,523 
Diluted weighted average shares outstanding   5,709,878    5,694,793 
Earnings per share:          
Basic  $0.16   $0.17 
Diluted  $0.16   $0.17 
         
   Six Months Ended   June 30, 2012   Six Months Ended June 30, 2011 
         
Numerator – net income  $1,902,000   $1,937,000 
Denominators:          
Basic weighted average shares outstanding   5,702,910    5,689,458 
Increase in weighted average shares outstanding due to (1):          
Stock options   4,336    4,277 
Unvested restricted stock awards   298    1,060 
Diluted weighted average shares outstanding   5,707,544    5,694,795 
Earnings per share:          
Basic  $0.33   $0.34 
Diluted  $0.33   $0.34 

   
(1)Stock options to purchase 206,643 shares under the Company’s 2006 Stock Option Plan (the “Stock Option Plan”) at $11.50 per share were outstanding during the six month period ended June 30, 2012 but were not included in the calculation of diluted earnings per share because to do so would have been anti-dilutive. Stock options to purchase 219,289 shares under the Stock Option Plan at $11.50 per share and restricted unvested shares of 3,690 under the RRP plan were outstanding during the six month period ended June 30, 2011, but were not included in the calculation of diluted earnings per share because to do so would have been anti-dilutive.

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NOTE 6– COMMITMENTS TO EXTEND CREDIT

 

The Company has commitments to extend credit with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. Such commitments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated statements of financial condition.

 

The Company’s exposure to credit loss is represented by the contractual amount of these commitments. The Company follows the same credit policies in making commitments as it does for on-balance sheet instruments.

 

The following commitments to extend credit were outstanding as of the dates specified:

 

   Contract Amount 
   June 30,   December 31, 
   2012   2011 
   (Dollars in thousands) 
         
Commitments to grant loans  $5,137   $3,984 
Unfunded commitments under lines of credit  $27,522   $26,304 

 

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses. The commitments for lines of credit may expire without being drawn upon. Therefore, the total commitment amounts do not necessarily represent future cash requirements. The amount of collateral obtained, if it is deemed necessary by the Company, is based on management’s credit evaluation of the customer. At June 30, 2012 and December 31, 2011, the Company’s fixed rate loan commitments totaled $3.9 million and $2.0 million, respectively. The range of interest rates on these fixed rate commitments was 2.96% to 10.00% at June 30, 2012.

 

NOTE 7– STOCK-BASED COMPENSATION

 

As of June 30, 2012, the Company had three stock-based compensation plans currently allocated, which are described below. The compensation cost that has been recorded under salary and benefits expense in the non-interest expense section of the consolidated statements of income for these plans was $30,000 and $50,000 for the three months ended June 30, 2012 and 2011, respectively. The compensation cost that has been recorded for the six months ended June 30, 2012 and June 30, 2011 was $59,000 and $153,000.

 

Stock Option Plan

 

The Company’s 2006 Stock Option Plan (the “Stock Option Plan”), which was approved by the Company’s shareholders, permits the grant of options to its employees and non-employee directors for up to 297,562 shares of common stock.

 

Both incentive stock options and non-qualified stock options may be granted under the Stock Option Plan. The exercise price of each stock option equals the market price of the Company’s common stock on the date of grant and an option’s maximum term is ten years. The stock options generally vest over a five year period.

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NOTE 7– STOCK-BASED COMPENSATION (continued)

 

A summary of the status of the Stock Option Plan as of June 30, 2012 and 2011 is presented below:

 

   June 30, 2012   June 30, 2011 
   Options   Exercise Price   Remaining Contractual Life  Options   Exercise Price   Remaining Contractual Life 
                        
Outstanding at beginning of year   236,809   $11.05       249,455   $11.07      
Granted                          
Forfeited               (12,646)   11.50      
Outstanding at end of period   236,809   $11.05       236,809   $11.05      
                             
Options exercisable at end of period   221,845   $11.26   4 years   186,046   $11.32    5 years 

 

 

At June 30, 2012, stock options outstanding had an intrinsic value of $70,000 and 60,753 options remained available for grant under the Stock Option Plan. Compensation expense amounted to $3,000 for the quarters ended June 30, 2012 and $17,000 for the quarter ended June 30, 2011. Compensation expense amounted to $5,000 for the six months ended June 30, 2012 and $53,000 for the six months ended June 30, 2011. At June 30, 2012, $18,000 of unrecognized compensation cost related to stock options is expected to be recognized over a period of 18 to 30 months.

 

Recognition and Retention Plan

 

The Company’s 2006 Recognition and Retention Plan (“RRP”), which was approved by the Company’s shareholders, permits the grant of restricted stock awards (“Awards”) to employees and non-employee directors for up to 119,025 shares of common stock.

 

Awards vest at a rate of 20% per year. As of June 30, 2012, there were 70,344 shares vested or distributed to eligible participants under the RRP. Compensation expense amounted to $8,000 for the quarter ended June 30, 2012 and $13,000 for the quarter ended June 30, 2011. Compensation expense amounted to $15,000 for the six months ended June 30, 2012 and $59,000 for the six months ended June 30, 2011. At June 30, 2012, $68,000 of unrecognized compensation cost related to the RRP is expected to be recognized over a period of 18 to 30 months.

 

A summary of the status of unvested shares under the RRP for the six months ended June 30, 2012 and 2011 is as follows:

 

   June 30,
2012
   Weighted Average Grant Price   June 30,
2011
   Weighted Average Grant Price 
                     
Unvested shares outstanding at beginning of year   14,304   $7.92    31,546   $9.43 
Granted                
Vested   (3,974)   7.93    (3,975)   7.93 
Forfeited           (5,950)   11.50 
Unvested shares outstanding at end of quarter   10,330   $7.92    21,621   $9.13 

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NOTE 7– STOCK-BASED COMPENSATION (continued)

 

Employee Stock Ownership Plan (“ESOP”)

 

The Company established the ESOP for the benefit of eligible employees of the Company and Bank. All Company and Bank employees meeting certain age and service requirements are eligible to participate in the ESOP. Participants’ benefits become fully vested after five years of service once the employee is eligible to participate in the ESOP. The Company utilized $2.6 million of the proceeds of its 2006 stock offering to extend a loan to the ESOP and the ESOP used such proceeds to purchase 238,050 shares of stock on the open market at an average price of $10.70 per share, plus commission expenses. As a result of the purchase of shares by the ESOP, total stockholders’ equity of the Company was reduced by $2.6 million. As of June 30, 2012, the balance of the loan to the ESOP was $2.0 million and the fair value of unallocated shares was $1.9 million. As of June 30, 2012, there were 51,578 allocated shares and 186,472 unallocated shares compared to 43,643 allocated shares and 194,407 unallocated shares at June 30, 2011. The ESOP compensation expense was $20,000 for the quarters ended June 30, 2012 and 2011 based on 1,984 shares earned in each of those quarters. The ESOP compensation expense was $39,000 for the six months ended June 30, 2012 and $41,000 for the six months ended June 30, 2011 based on 3,968 shares earned in each of those periods.

 

NOTE 8 – FAIR VALUE of Financial instruments

 

Management uses its best judgment in estimating the fair value of the Company’s financial instruments; however, there are inherent weaknesses in any estimation technique. Therefore, for substantially all financial instruments, the fair value estimates herein are not necessarily indicative of the amounts the Company could have realized in a sale transaction on the dates indicated. The estimated fair value amounts have been measured as of June 30, 2012 and December 31, 2011 and have not been re-evaluated or updated for purposes of these consolidated financial statements subsequent to those respective dates. The estimated fair values of these financial instruments subsequent to the respective reporting dates may be different than the amounts reported here.

 

The measurement of fair value under FASB ASC Topic 820, “Fair Value Measurements and Disclosures” establishes a fair value hierarchy that prioritizes the inputs to valuation methods used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities measurements (Level 1) and the lowest priority to unobservable input measurements (Level 3). The three levels of the fair value hierarchy under FASB ASC Topic 820 are as follows:

 

Level 1: Unadjusted quoted prices in active markets for identical assets or liabilities that the reporting entity can access at the measurement date.

 

Level 2: Inputs other than quoted prices included in Level 1 that are observable for the asset or liability either directly or indirectly.

 

Level 3: Unobservable inputs for determining the fair values of assets or liabilities that reflect an entity’s own assumptions about the assumptions that market participants would use in pricing the assets or liabilities.

 

An asset’s or liability’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement.

 

For assets measured at fair value on a recurring and nonrecurring basis, the fair value measurements by level within the fair value hierarchy used at June 30, 2012 and December 31, 2011 were as follows:

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NOTE 8– FAIR VALUE OF FINANCIAL INSTRUMENTS (CONTINUED)

   Fair Value Measurements at June 30, 2012
    
   June 30, 2012   Quoted Prices
in Active
Markets for
Identical
Assets
(Level 1)
  Significant Other Observable Inputs
(Level 2)
   Significant
Other Unobservable Inputs
(Level 3)
 
   (Dollars in thousands) 
     
Measured at fair value on a recurring basis:               
    Securities available for sale:                  
U.S. Treasury bonds  $15,336  $ 15,336  $   $ 
Municipal bonds   55,461      55,461     
Mortgage-backed securities:                  
Collateralized mortgage obligations - private label   110      110     
Collateralized mortgage obligations - government sponsored entities   61,931      61,931     
Government National Mortgage Association   3,209      3,209     
Federal National Mortgage Association   22,720      22,720     
Federal Home Loan Mortgage Corporation   7,206      7,206     
Asset-backed securities:                  
Private label   4,526      540    3,986 
Government sponsored entities   174      174     
Equity securities   6      6     
Total  $170,679  $ 15,336  $151,357   $3,986
Measured at fair value on a non-recurring basis:                  
      Foreclosed real estate  $559  $   $   $559 

 

Any transfers between levels would be recognized as of the actual date of event or change in circumstances that caused the transfer. There were no reclassifications between the Level 1 and Level 2 categories for the six months ended June 30, 2012.

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NOTE 8– FAIR VALUE OF FINANCIAL INSTRUMENTS (CONTINUED) 

    
   Fair Value Measurements at December 31, 2011
                
   December 31,
2011
   Quoted Prices in
Active Markets
for Identical Assets
(Level 1)
   Significant
Other
Observable
Inputs
(Level 2)
   Significant
Other
Unobservable Inputs
(Level 3)
                          
      (Dollars in thousands)    
                          
Measured at fair value on a recurring basis:                         
    Securities available for sale:                    
       U.S. Treasury bonds  $15,078   $15,078   $   $ 
       Municipal bonds   53,676        53,676     
       Mortgage-backed securities:                    
Collateralized mortgage obligations - private label   129        129     
Collateralized mortgage obligations - government sponsored entities   60,771        60,771     
Government National Mortgage Association   3,349        3,349     
Federal National Mortgage Association   20,570        20,570     
Federal Home Loan Mortgage Corporation   5,766        5,766     
Asset-backed securities:                    
Private label   4,632        696    3,936 
Government sponsored entities   189        189     
Equity securities   5        5     
Total  $164,16   $15,078   $145,151   $3,936 
Measured at fair value on a non-recurring basis:                    
Impaired loans   $ 125    $       $125 
Foreclosed real estate  315   $      $315 

 

Level 2 inputs for assets or liabilities measured at fair value on a recurring basis might include 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, inputs other than quoted prices that are observable for the asset or liability (such as interest rates, volatilities, prepayment speeds, credit risks, etc.) or inputs that are derived principally from or corroborated by market data by correlation or other means

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NOTE 8– FAIR VALUE OF FINANCIAL INSTRUMENTS (CONTINUED)

 

The following table presents a reconciliation of the securities available for sale measured at fair value on a recurring basis using significant unobservable inputs (Level 3), specifically, asset-backed securities -private label, for the six months ended June 30, 2012 and 2011

         
   2012   2011 
   (Dollars in thousands) 
         
Beginning Balance  $3,936   $4,278 
Total gains – realized/unrealized:          
Included in earnings        
Included in other comprehensive income   330    101 
Total losses – realized/unrealized:          
Included in earnings   (57)    
Included in other comprehensive income       (8)
Purchases, issuances and settlements        
Sales        
Principal Paydowns   (223)   (232)
Transfers to (out of) Level 3        
           
Ending Balance  $3,986   $4,139 

 

Both observable and unobservable inputs may be used to determine the fair value of assets and liabilities measured on a recurring basis that the Company has classified within the Level 3 category. As a result, any unrealized gains and losses for assets within the Level 3 category may include changes in fair value attributable to both observable (e.g., changes in market interest rates) and unobservable (e.g., changes in unobservable long-dated volatilities) inputs.

 

The following table presents additional quantitative information about the Level 3 inputs for the asset backed securities - private label category. The fair values for this category were developed using the discounted cash flow technique with the following unobservable input ranges as of June 30, 2012 (dollars in thousands) 

 

      Unobservable Inputs
 Security Category Fair Value 
Estimate
Loan Type/ 
Collateral
Credit
Ratings 
 Constant Prepayment Speed (CPR)  Probability of Default (Annual Default Rate) Loss Severity 
 Asset-backed  $3,986 Prime First and   CCC thru   1-7  5.0%-  70.0%-
 securities – Private    Second  D    10.5%  100.0% 
Label     Lien-Residential Real Estate        

 

Level 3 inputs are determined by internal management with inputs from its third party financial advisor on a quarterly basis. The significant unobservable inputs used in the fair value measurement of the reporting entity’s asset-backed, private label securities are prepayment rates, probability of default and loss severity in the event of default. Significant increases or decreases in any of those inputs in isolation would result in a significantly lower or higher fair value measurement. Generally, a change in the assumption used for the probability of default is accompanied by a directionally similar change in the assumption used for the loss severity and a directionally opposite change in the assumption used for prepayment rates.

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NOTE 8– FAIR VALUE OF FINANCIAL INSTRUMENTS (CONTINUED)

Fair value on impaired loans is based on either recent appraisals less estimated selling costs of related collateral or discounted cash flows based on current market conditions. As of June 30, 2012, impaired loans had a gross carrying amount of $13,000 without a specific allowance. As of December 31, 2011, impaired loans with a specific allowance had a gross carrying amount of $133,000 with a valuation allowance of $8,000. The use of independent appraisals, discounted cash flow models and management’s best judgment are significant inputs in arriving at the fair value of the underlying collateral and impaired loans are therefore classified within level 3 of the fair value hierarchy.

Foreclosed real estate consists of property acquired in settlement of loans which is carried at its fair value based on recent appraisals less estimated selling costs and which has been subsequently written down during the period. Fair value is based upon independent market prices or appraised value of the property. These assets are included in Level 3 fair value based upon the lowest level of input that is significant to the fair value measurement. The use of independent appraisals and management’s best judgment are significant inputs in arriving at the fair value of the underlying collateral and foreclosed real estate is therefore classified within level 3 of the fair value hierarchy.

The carrying amount and estimated fair value of the Company’s financial instruments, whether carried at cost or fair value, are as follows:

  

   Fair Value Measurements at June 30, 2012
    
         Quoted Prices      
         in Active  Significant  Significant
         Markets for  Other  Other
         Identical  Observable  Unobservable
   Carrying  Estimated  Assets  Inputs  Inputs
   Amount  Fair Value  (Level 1)  (Level 2)  (Level 3)
      (Dollars in thousands)   
          
Financial assets:                         
Cash and cash equivalents  $29,400   $29,400   $29,400     
Securities available for sale   170,679    170,679    15,336    151,357    3,986 
Federal Home Loan Bank stock   2,116    2,116    2,116         
Loans receivable   266,190    267,567            267,567 
Accrued interest receivable   1,801    1,801    1,801         
                          
Financial liabilities:                         
Deposits   384,779    390,866    171,829    219,037     
Short-term borrowings   14,320    14,320    14,320         
Long-term debt   17,150    17,638        17,638     
Accrued interest payable   40    40    40         
                         
Off-balance-sheet financial instruments                    

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NOTE 8– FAIR VALUE OF FINANCIAL INSTRUMENTS (CONTINUED)

  

 

 

Fair Value Measurements at

December 31, 2011

   Carrying Amount  Estimated
Fair Value
   (Dollars in thousands)
    
Financial assets:          
       Cash and cash equivalents  $23,704   $23,704 
       Securities available for sale   164,165    164,165 
       Federal Home Loan Bank stock   2,219    2,219 
       Loans receivable   275,068    278,647 
       Accrued interest receivable   1,919    1,919 
           
Financial liabilities:          
       Deposits   379,798    385,995 
       Short-term borrowings   6,910    6,910 
       Long-term debt   27,230    27,978 
       Accrued interest payable   80    80 
           
Off-balance-sheet financial instruments       
           

 

The following valuation techniques were used to measure the fair value of financial instruments in the above table:

 

Cash and cash equivalents (carried at cost)

 

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

 

Securities available for sale (carried at fair value)

 

The fair value of securities available for sale are determined by obtaining quoted market prices on nationally recognized securities exchanges (Level 1) or matrix pricing (Level 2), which is a mathematical technique used widely in the industry to value debt securities without relying exclusively on quoted market prices for the specific securities, but rather by relying on the securities’ relationship to other benchmark quoted prices. The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. treasury yield curve, live trading levels, trade execution date, market consensus prepayment speeds, credit information and the security’s terms and conditions, among other things. Level 2 securities which are fixed income instruments that are not quoted on an exchange, but are traded in active markets, are valued using prices obtained from our custodian, who use third party data service providers. Securities available for sale measured within the Level 3 category consist of private label asset-backed securities. The fair value measurement for these Level 3 securities is explained more fully earlier in this footnote.

 

Federal Home Loan Bank stock (carried at cost)

 

The carrying amount of Federal Home Loan Bank stock approximates fair value. 

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NOTE 8– FAIR VALUE OF FINANCIAL INSTRUMENTS (CONTINUED)

 

Loans Receivable (carried at cost)

 

The fair value of fixed-rate and variable rate performing loans is estimated using a discounted cash flow method. The discount rates take into account interest rates currently being offered to customers for loans with similar terms, the credit risk associated with the loan, estimated maturity and market factors including liquidity. The estimate of maturity is based on the Company’s contractual cash flows adjusted for prepayment estimates based on current economic and lending conditions. Fair value for significant nonperforming loans is based on carrying value which does not exceed recent external appraisals of any underlying collateral. Due to the significant judgment involved in evaluating credit quality, loans are classified within Level 3 of the fair value hierarchy.

 

Accrued Interest Receivable and Payable (carried at cost)

 

The carrying amount of accrued interest receivable and payable approximates fair value.

 

Deposits (carried at cost)

 

The fair value of deposits with no stated maturity, such as savings, money market and checking is the amount payable on demand at the reporting date and are classified within Level 1 of the fair value hierarchy. The fair value of time deposits is based on the discounted value of contractual cash flows at current rates of interest for similar deposits using market rates currently offered for deposits of similar remaining maturities. Due to the minimal amount of unobservable inputs involved in evaluating assumptions used for discounted cash flows of time deposits, these deposits are classified within Level 2 of the fair value hierarchy.

 

Borrowings (carried at cost)

 

The fair value of long-term debt was calculated by discounting scheduled cash flows at current market rates of interest for similar borrowings through maturity of each instrument. Due to the the minimal amount of unobservable inputs involved in evaluating assumptions used for discounted cash flows of long-term debt, they are classified within Level 2 of the fair value hierarchy. The carrying amount of short term borrowings approximates fair value of such liability.

 

Off-Balance Sheet Financial Instruments (disclosed at cost)

 

Fair values of the Company’s off-balance sheet financial instruments (lending commitments) are based on fees currently charged to enter into similar agreements, taking into account, the remaining terms of the agreements and the counterparties’ credit standing. Other than loan commitments, the Company does not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on its financial condition.

 

NOTE 9 – TREASURY STOCK

 

During the quarter and six months ended June 30, 2012, the Company made no repurchases of shares of common stock. As of June 30, 2012, there were 91,510 shares remaining to be repurchased under the existing stock repurchase program.

 

During the quarter ended June 30, 2011, the Company did not repurchase any common stock. During the six months ended June 30, 2011, the Company repurchased 17,950 shares of common stock at an average cost of $9.39 per share. Of these shares, 15,000 were repurchased pursuant to the Company’s publicly announced common stock repurchase programs. The remaining 2,950 shares were repurchased from the trustee of the Company’s unvested RRP stock, when two awardees sold vested shares. As of June 30, 2011, there were 91,510 shares remaining to be repurchased under the existing stock repurchase program.

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NOTE 10 – SUBSEQUENT EVENTS

 

On July 25, 2012, the Board of Directors declared a quarterly dividend of $0.07 per share on the Company’s common stock, payable on August 22, 2012 to shareholders of record as of August 6, 2012.

 

Lake Shore, MHC (the “MHC”) which holds 3,636,875 shares, or 61.2% of the Company’s total outstanding stock, will not waive receipt of the dividend payment as it has in past quarters because of the Federal Reserve Board’s recently implemented interim final regulation which requires the prior approval of a majority of the eligible votes of the MHC’s members (i.e., depositors) for the MHC to waive the receipt of dividends. Due to the significant time and expense that would be required to obtain the member vote required by the Federal Reserve Board’s regulation, the Board of Directors of the MHC has determined not to pursue such a vote at this time. Because the Federal Reserve Board has not yet finalized this regulation, the Company can make no assurances that it will continue to declare regular quarterly cash dividends or that its dividend policy will not change in the future. The Company’s Board of Directors will review the Federal Reserve Board’s final rule on mutual holding company dividend waivers when such rule becomes available, and will evaluate its impact on the payment of future quarterly dividends.

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

 

Forward-Looking Statements

 

This Quarterly Report on Form 10-Q contains certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements may be identified by words such as “believe,” “will,” “expect,” “project,” “may,” “could,” “anticipate,” “estimate,” “intend,” “plan,” “targets” and similar expressions. These statements are based upon our current beliefs and expectations and are subject to significant risks and uncertainties. Actual results may differ materially from those set forth in the forward-looking statements as a result of numerous factors.

 

The following factors, including the factors set forth in Part II, Item 1A of this and previous Quarterly Reports on Form 10-Q and in Part I, Item 1A of the Company’s Annual Report on Form 10-K for the year ended December 31, 2011, among others, could cause actual results to differ materially from the anticipated results or other expectations expressed in our forward-looking statements:

 

Ÿgeneral and local economic conditions;

 

Ÿchanges in interest rates, deposit flows, demand for mortgages and other loans, real estate values and competition;

 

Ÿthe ability of our customers to make loan payments;

 

Ÿour ability to continue to control costs and expenses;

 

Ÿchanges in accounting principles, policies or guidelines;

 

Ÿour success in managing the risks involved in our business;

 

Ÿinflation, and market and monetary fluctuations;

 

Ÿthe transfer of supervisory and enforcement authority over savings banks to the Office of the Comptroller of the Currency and savings and loan holding companies to the Federal Reserve Board;

 

Ÿchanges in legislation or regulation, including the implementation of the Dodd-Frank Act; and

 

Ÿother economic, competitive, governmental, regulatory and technological factors affecting our operations, pricing, products and services.

 

Any or all of our forward-looking statements in this Quarterly Report on Form 10-Q and in any other public statements we make may differ from actual outcomes. They can be affected by inaccurate assumptions we might make or known or unknown risks and uncertainties. Consequently, no forward-looking statements can be guaranteed. We undertake no obligation to publicly update any forward looking statement, whether as a result of new information, future events or otherwise.

 

Overview

 

The following discussion and analysis is presented to assist in the understanding and evaluation of our consolidated financial condition and results of operations. It is intended to complement the unaudited consolidated financial statements and notes thereto appearing elsewhere in this Form 10-Q and should be read in conjunction therewith. The detailed discussion focuses on our consolidated financial condition as of June 30, 2012 compared to the financial condition as of December 31, 2011 and the consolidated results of operations for the three and six months ended June 30, 2012 and 2011.

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Our results of operations depend primarily on our net interest income, which is the difference between the interest income we earn on loans and investments and the interest we pay on deposits and other interest-bearing liabilities. Net interest income is affected by the relative amounts of interest-earning assets and interest-bearing liabilities and the interest rates we earn or pay on these balances.

 

Our operations are also affected by non-interest income, such as service fees and gains and losses on the sales of securities and loans, our provision for loan losses and non-interest expenses, which include salaries and employee benefits, occupancy and equipment costs, professional fees, and other general and administrative expenses.

 

Financial institutions like us, in general, are significantly affected by economic conditions, competition and the monetary and fiscal policies of the federal government. Lending activities are influenced by the demand for and supply of housing, competition among lenders, interest rate conditions, and funds availability. Our operations and lending are principally concentrated in the Western New York area, and our operations and earnings are influenced by local economic conditions. Deposit balances and cost of funds are influenced by prevailing market rates on competing investments, customer preferences, and levels of personal income and savings in our primary market area.

 

Management Strategy

 

Our Reputation. With more than 120 years of service to our community, our primary management strategy has been to maintain our perceived image as one of the most respected and recognized community banks in Western New York. We strive to accomplish this goal by continuing to emphasize our high quality customer service and financial strength.

 

Branching. In April 2010, we opened our newest branch in Depew, New York. This is our fifth branch in Erie County, New York, and our tenth overall. This office had generated deposits of $26.5 million as of June 30, 2012. Our offices are located in Dunkirk, Fredonia, Jamestown, Lakewood, and Westfield in Chautauqua County, New York and in Depew, East Amherst, Hamburg, Kenmore, and Orchard Park in Erie County, New York. Saturation of the market in Chautauqua County led to our expansion plan in Erie County, which is a critical component of our future profitability and growth. An important strategic objective is to continue to evaluate the technology supporting our customer service. We are committed to making investments in technology, and we believe that it represents an efficient way to deploy a portion of our capital. To this end, the Company has developed a five year plan for the implementation of cost effective and efficient digital services to meet our customer’s technology needs, to focus on attracting new customers, and to improve our operational efficiencies. Although we remain committed to expanding our retail branch footprint whenever it makes strategic sense, we will be concentrating our near term efforts on developing “clicks” instead of “bricks.”

 

Our People. A large part of our success is related to customer service and customer satisfaction. Having employees who understand and value our clientele and their business is a key component to our success. We believe that our present staff is one of our competitive strengths, and thus the retention of such persons and our ability to continue to attract high quality personnel is a high priority.

 

Residential Mortgage and Other Lending. Historically, our lending portfolio has been composed predominantly of residential one- to four-family mortgage loans. At June 30, 2012 and December 31, 2011, we held $172.1 million and $182.9 million of residential one- to four-family mortgage loans, respectively, which constituted 65.0% and 66.8% of our total loan portfolio, at such respective dates. We originate commercial real estate loans to finance the purchase of real property, which generally consists of developed real estate. At June 30, 2012 and December 31, 2011, our commercial real estate loan portfolio consisted of loans totaling $47.9 million and $44.8 million respectively, or 18.1% and 16.4%, respectively, of total loans. In addition to commercial real estate loans, we also engage in small business commercial lending, including business installment loans, lines of credit, and other commercial loans. At June 30, 2012 and December 31, 2011, our commercial loan portfolio consisted of loans totaling $11.9 million and $12.9 million, respectively, or 4.5% and 4.7%, respectively, of total loans. Other loan products offered to our customers include home equity loans and lines of credit, construction loans and consumer loans, including automobile loans, overdraft lines of credit and share loans. We may sell one- to four-family residential loans in the future as part of our interest rate risk strategy and asset/liability management, if it is deemed appropriate. We typically retain servicing rights when we sell one- to four-family residential loans. One- to four-family residential mortgage loans will continue to be the dominant type of loan in our lending portfolio.

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Investment Strategy. Our investment policy is designed primarily to manage the interest rate sensitivity of our assets and liabilities, to generate a favorable return without incurring undue interest rate and credit risk, to complement our lending activities and to provide and maintain liquidity within established guidelines. We employ a third party financial advisor to assist us in managing our investment portfolio and developing balance sheet strategies.

 

At June 30, 2012 and December 31, 2011, we had $170.7 million and $164.2 million, respectively, invested in securities available for sale, the majority of which are agency mortgage-backed, agency collateralized mortgage obligations (“CMOs”) and municipal securities.

 

Asset-Liability Strategy. As stated above, our business consists primarily of originating one- to four-family residential mortgage loans and commercial real estate loans secured by property in our market area and investing in residential mortgage-backed securities, CMOs and municipal securities. Typically, one- to four-family residential mortgage loans involve a lower degree of risk and carry a lower yield than commercial real estate and commercial business loans. Our loans are primarily funded by time deposits and savings accounts. This has resulted in our being vulnerable to increases in interest rates, as our interest-bearing liabilities will mature or re-price more quickly than our interest-earning assets in a rising rate environment. Although we plan to continue to originate one- to four-family residential mortgage loans going forward, we have been and intend to continue to increase our focus on the origination of commercial real estate loans and commercial business loans, which generally provide higher returns and have shorter durations than one- to four-family residential mortgage loans. Furthermore, our strategy involves improving our funding mix by increasing our core deposits in order to help reduce and control our cost of funds. We value core deposits (savings, money market and demand accounts) because they represent longer-term customer relationships and lower cost of funds. As part of our strategy to expand our commercial loan portfolio, we expect to attract lower cost core deposits as part of these borrower relationships. We offer competitive rates on a variety of deposit products to meet the needs of our customers and we promote long term deposits, where possible, to meet asset-liability goals.

 

We are actively involved in managing our balance sheet through the direction of our asset-liability committee and the assistance of a third party advisor. Recent economic conditions have underscored the importance of a strong balance sheet. We strive to achieve this through managing our interest rate risk and maintaining strong capital levels, putting aside adequate loan loss reserves and keeping liquid assets on hand. Diversifying our asset mix not only improves net interest margin but also reduces the exposure of our net interest income and earnings to interest rate risk. We will continue to manage our interest rate risk by diversifying the type and maturity of our assets in our loan and investment portfolios and monitoring the maturities in our deposit portfolio and borrowing facilities.

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Critical Accounting Policies

 

It is management’s opinion that accounting estimates covering certain aspects of our business have more significance than others due to the relative importance of those areas to overall performance, or the level of subjectivity required in making such estimates. Management considers the accounting policy relating to the allowance for loan losses to be a critical accounting policy given the uncertainty in evaluating the level of the allowance for loan losses required for probable credit losses and the material effect that such judgments can have on the results of operations. Management’s quarterly evaluation of the adequacy of the allowance considers our historical loan loss experience, review of specific loans, current economic conditions, and such other factors considered appropriate to estimate loan losses. Management uses presently available information to estimate probable losses on loans; however, future additions to the allowance may be necessary based on changes in estimates, assumptions, or economic conditions. Significant factors that could give rise to changes in these estimates include, but are not limited to, changes in economic conditions in our local area, concentrations of risk and decline in local property values. Refer to Note 4 of the Notes to the Consolidated Financial Statements for more information on the allowance for loan losses.

 

In management’s opinion, the accounting policy relating to the valuation of investments is a critical accounting policy. The fair values of our investments are determined using public quotations, third party dealer quotes, pricing models, or discounted cash flows. Thus, the determination may require significant judgment or estimation, particularly when liquid markets do not exist for the item being valued. The use of different assumptions for these valuations could produce significantly different results which may have material positive or negative effects on the results of our operations. Refer to Note 8 of the Notes to the Consolidated Financial Statements for more information on fair value.

 

Management also considers the accounting policy relating to the impairment of investments to be a critical accounting policy due to the subjectivity and judgment involved and the material effect an impairment loss could have on the consolidated results of income. The credit portion of a decline in the fair value of investments below cost deemed to be other-than-temporary may be charged to earnings resulting in the establishment of a new cost basis for an asset. Management continually reviews the current value of its investments for evidence of OTTI. Refer to Note 3 of the Notes to the Consolidated Financial Statements for more information on OTTI.

 

These critical policies and their application are reviewed periodically by our Audit Committee and our Board of Directors. All accounting policies are important, and as such, we encourage the reader to review each of the policies included in the notes to our audited consolidated financial statements included in our Form 10-K for the year ended December 31, 2011 to better understand how our financial performance is reported.

 

Analysis of Net Interest Income

 

Net interest income represents the difference between the interest we earn on our interest-earning assets, such as mortgage loans and investment securities, and the expense we pay on interest-bearing liabilities, such as time deposits and borrowings. Net interest income depends on both the volume of our interest-earning assets and interest-bearing liabilities and the interest rates we earn or pay on them.

 

Average Balances, Interest and Average Yields. The following tables set forth certain information relating to our average balance sheets and reflects the average yield on interest-earning assets and average cost of interest-bearing liabilities, interest earned and interest paid for the periods indicated. Such yields and costs are derived by dividing income or expense by the average balance of interest-earning assets or interest-bearing liabilities, respectively, for the periods presented. Average balances are derived from daily balances over the periods indicated. The average balances for loans are net of allowance for loan losses, but include non-accrual loans. Interest income on securities does not include a tax equivalent adjustment for bank qualified municipals.

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   For the Three Months ended
June 30, 2012
  For the Three Months ended
June 30, 2011
   Average Balance  Interest Income/
Expense
  Yield/
Rate
  Average Balance  Interest Income/
Expense
  Yield/
Rate
   (Dollars in thousands)
    
Interest-earning assets:                              
Interest-earning deposits & federal funds sold  $24,114   $9    0.15%  $15,865   $6    0.15%
Securities   170,655    1,451    3.40%   166,548    1,635    3.93%
Loans   267,245    3,553    5.32%   269,198    3,580    5.32%
Total interest-earning assets   462,014    5,013    4.34%   451,611    5,221    4.62%
Other assets   30,415              30,740           
Total assets  $492,429             $482,351           
                               
Interest-bearing liabilities:                              
Demand and NOW accounts  $41,665   $13    0.12%  $40,491   $18    0.18%
Money market accounts   62,343    83    0.53%   50,592    70    0.55%
Savings accounts   35,812    14    0.16%   34,340    18    0.21%
Time deposits   214,708    926    1.73%   224,782    1,041    1.85%
Borrowed funds   32,062    130    1.62%   37,945    238    2.51%
Other interest-bearing liabilities   1,227    27    8.80%   1,270    28    8.82%
Total interest-bearing liabilities   387,817    1,193    1.23%   389,420    1,413    1.45%
Other non-interest bearing liabilities   39,128              34,398           
Stockholders’ equity   65,484              58,533           
Total liabilities and stockholders’ equity  $492,429             $482,351           
                               
Net interest income       $3,820             $3,808      
                               
Interest rate spread             3.11%             3.17%
                               
Net interest margin             3.31%             3.37%

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   For the Six Months ended
June 30, 2012
  For the Six Months ended
June 30, 2011
   Average Balance  Interest Income/
Expense
  Yield/
Rate
  Average Balance  Interest Income/
Expense
  Yield/
Rate
      (Dollars in thousands)
       
Interest-earning assets:                              
Interest-earning deposits & federal funds sold  $22,505   $13    0.12%  $20,194   $20    0.20%
Securities   168,921    2,930    3.47%   162,761    3,246    3.99%
Loans   269,475    7,150    5.31%   266,423    7,085    5.32%
Total interest-earning assets   460,901    10,093    4.38%   449,378    10,351    4.61%
Other assets   30,443              31,604           
Total assets  $491,344             $480,982           
                               
Interest-bearing liabilities:                              
Demand and NOW accounts  $41,056   $26    0.13%  $40,291   $35    0.17%
Money market accounts   61,439    165    0.54%   49,477    136    0.55%
Savings accounts   34,885    27    0.15%   33,547    35    0.21%
Time deposits   216,504    1,899    1.75%   227,648    2,153    1.89%
Borrowed funds   32,654    287    1.76%   38,524    501    2.60%
Other interest-bearing liabilities   1,233    54    8.76%   1,275    56    8.78%
Total interest-bearing liabilities   387,771    2,458    1.27%   390,762    2,916    1.49%
Other non-interest bearing liabilities   38,262              32,853           
Stockholders’ equity   65,311              57,367           
Total liabilities and stockholders’ equity  $491,344             $480,982           
                               
Net interest income       $7,635             $7,435      
                               
Interest rate spread             3.11%             3.12%
                               
Net interest margin             3.31%             3.31%
                               

 

Rate Volume Analysis. The following tables analyze the dollar amount of changes in interest income and interest expense for major components of interest-earning assets and interest-bearing liabilities. The tables show the amount of the change in interest income or expense caused by either changes in outstanding balances (volume) or changes in interest rates. The effect of a change in volume is measured by applying the average rate during the first period to the volume change between the two periods. The effect of changes in rate is measured by applying the change in rate between the two periods to the average volume during the first period. Changes attributable to both rate and volume, which cannot be segregated, have been allocated proportionately to the absolute value of the change due to volume and the change due to rate.

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   Three Months ended June 30, 2012
Compared to
Three Months ended June 30, 2011
   Rate  Volume  Net Change
   (Dollars in thousands)
    
Interest-earning assets:               
Interest-earning deposits and federal funds sold  $—     $3   $3 
Securities   (223)   39    (184)
Loans, including fees    (1)   (26)   (27)
                
Total interest-earning assets    (224)   16    (208)
                
Interest-bearing liabilities:               
Demand and NOW accounts   (6)   1    (5)
Money market accounts   (3)   16    13 
Savings accounts   (5)   1    (4)
Time deposits   (70)   (45)   (115)

Total deposits

   (84)   (27)   (111)
Other interest-bearing liabilities:               
     Borrowed funds and other   (75)   (34)   (109)
                
Total interest-bearing liabilities   (159)   (61)   (220)
                
Total change in net interest income  $(65)  $77   $12 
    
   Six Months ended June 30, 2012
Compared to
Six Months ended June 30, 2011
   Rate  Volume  Net Change
   (Dollars in thousands)
    
Interest-earning assets:               
Interest-earning deposits and federal funds sold  $(9)  $2   $(7)
Securities   (435)   119    (316)
Loans, including fees   (16)   81    65 
                
Total interest-earning assets    (460)   202    (258)
                
Interest-bearing liabilities:               
Demand and NOW accounts   (10)   1    (9)
Money market accounts   (3)   32    29 
Savings accounts   (9)   1    (8)
Time deposits   (152)   (102)   (254)

 

Total deposits

   (174)   (68)   (242)
Other interest-bearing liabilities:               
Borrowed funds and other   (146)   (70)   (216)
                
Total interest-bearing liabilities   (320)   (138)   (458)
                
Total change in net interest income  $(140)  $340   $200 

 

Our earnings may be adversely impacted by an increase in interest rates because the majority of our interest-earning assets are long-term, fixed rate mortgage-related assets that will not reprice as long-term interest rates increase. Conversely, a majority of our interest-bearing liabilities have much shorter contractual maturities and are expected to reprice. A significant portion of our deposits have no contractual maturities and are likely to reprice quickly as short-term interest rates increase. Therefore, in an increasing rate environment, our cost of funds is expected to increase more rapidly than the yields earned on our loan portfolio and securities portfolio. An increasing rate environment is expected to cause a decrease in our net interest rate spread and a decrease in our earnings. In order to mitigate this effect, the Bank's Asset-Liability Committee is continuing to review its options in relation to core deposit growth, implementation of new products, promotion of adjustable rate commercial loan products and use of derivatives.

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In a decreasing interest rate environment, our earnings may increase or decrease. If long-term interest-earning assets do not reprice and interest rates on short-term deposits begin to decrease, earnings may rise. In the current rate environment, rates on the investment portfolio have declined significantly but rates on deposit products and borrowed funds have also dropped, which has assisted in maintaining our interest rate spread. In the current extended low rate environment, the cost of funding is beginning to fall more slowly than the decline in asset yields, resulting in a flat or slight decrease to our net interest margin.

 

For the three months ended June 30, 2012, the average yields on our loan portfolio and investment portfolio were 5.32% and 3.40%, respectively, in comparison to 5.32% and 3.93%, respectively, for the three months ended June 30, 2011. Overall, the average yield on our interest earning assets decreased by 28 basis points to 4.34% for the three months ended June 30, 2012 in comparison to the three months ended June 30, 2011. For the three months ended June 30, 2012, the average rate that we were paying on interest-bearing liabilities decreased by 22 basis points to 1.23% in comparison to the same period in the prior year. This was partially due to an 89 basis point decrease in the average interest rate paid on our borrowings from 2.51% for the three months ended June 30, 2011 to 1.62% for the three month period ended June 30, 2012 and a 12 basis point decrease in the average rate paid on time deposits from 1.85% for the three month period ended June 30, 2011 to 1.73% for the three month period ended June 30, 2012. Our interest rate spread for the three months ended June 30, 2012 was 3.11%, which was a 6 basis point decrease in comparison to the three months ended June 30, 2011. Our net interest margin was 3.31% and 3.37% for the three months ended June 30, 2012 and 2011, respectively.

 

For the six months ended June 30, 2012, the average yields on our loan portfolio and investment portfolio were 5.31% and 3.47%, respectively, in comparison to 5.32% and 3.99%, respectively, for the six months ended June 30, 2011. Overall, the average yield on our interest earning assets decreased by 23 basis points to 4.38% for the six months ended June 30, 2012 in comparison to the six months ended June 30, 2011. For the six months ended June 30, 2012, the average rate that we were paying on interest-bearing liabilities decreased by 22 basis points to 1.27% in comparison to the same period in the prior year. This was partially due to an 84 basis point decrease in the average interest rate paid on our borrowings from 2.60% for the six months ended June 30, 2011 to 1.76% for the six month period ended June 30, 2012 and a 14 basis point decrease in the average rate paid on time deposits from 1.89% for the six month period ended June 30, 2011 to 1.75% for the six month period ended June 30, 2012. Our interest rate spread for the six months ended June 30, 2012 was 3.11%, which was a 1 basis point decrease in comparison to the six months ended June 30, 2011. Our net interest margin was 3.31% for the six months ended June 30, 2012 and 2011.

 

Comparison of Financial Condition at June 30, 2012 and December 31, 2011

 

Total assets at June 30, 2012 were $492.1 million, an increase of $3.5 million, or 0.1%, from $488.6 million at December 31, 2011. The increase in total assets was primarily due to a $5.7 million increase in cash and cash equivalents and a $6.5 million increase in securities available for sale, partially offset by an $8.9 million decrease in loans receivable, net.

 

Cash and cash equivalents increased by $5.7 million, or 24.0%, from $23.7 million at December 31, 2011 to $29.4 million at June 30, 2012. The increase was primarily attributed to a $5.0 million increase in total deposits since December 31, 2011, as well as the receipt of cash flow from prepayments on the loan and investment portfolios, which have not yet been re-deployed to fund new loans or purchase investment securities.

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Securities available for sale increased $6.5 million, or 4.0%, to $170.7 million at June 30, 2012 compared to $164.2 million at December 31, 2011. During the six month period ended June 30, 2012, the Company purchased $22.5 million of available for sale securities, including collateralized mortgage obligations, mortgage-backed securities and municipal bonds. The purchases were funded by the receipt of $15.9 million in paydowns on the investment portfolio, with the remainder being funded by deposit growth and paydowns received on the loan portfolio.

 

Loans receivable, net decreased during the six month period between June 30, 2012 and December 31, 2011 as shown in the table below:

 

   At June 30,   At December 31,   Change 
   2012   2011   $   % 
   (Dollars in thousands) 
     
Real Estate Loans:                    
Residential, one- to four-family  $172,116   $182,922   $(10,806)   (5.9)%
Home equity   30,439    30,671    (232)   (0.8)%
Commercial   47,939    44,776    3,163    7.1%
Construction   682    519    163    31.4%
Total Real Estate Loans   251,176    258,888    (7,712)   (3.0)%
Other Loans:                    
Commercial   11,912    12,911    (999)   (7.7)%
Consumer   1,743    1,948    (205)   (10.5)%
Total Gross Loans   264,831    273,747    (8,916)   (3.3)%
Allowance for loan losses   (1,324)   (1,366)   42    3.1%
Net deferred loan costs   2,683    2,687    (4)   (0.1)%
Loans receivable, net  $266,190   $275,068   $(8,878)   (3.2)%

 

The decrease in loans receivable, net was primarily due to a decrease in residential one- to four-family real estate loans and commercial loans, partially offset by an increase in commercial real estate loans. During 2012, we remain strategically focused on increasing our commercial real estate and commercial loan portfolios to diversify our asset mix, to take advantage of the opportunities available to serve small businesses in our market area, and to maintain an effective net interest margin. The decrease in residential, one- to four-family real estate loans was primarily due to a strategic decision made by the Company not to match lower rates offered by our competitors in an effort to avoid increased interest rate risk. The decrease in commercial loans is primarily due to an increase in loan payoffs as a result of the competitive interest rate environment in our market area. Management continues to look for high quality loans to add to its portfolio and will continue to emphasize loan originations to the extent that it is profitable and prudent.

 

The table below shows changes in deposit volumes by type of deposit between June 30, 2012 and December 31, 2011:

 

   At June 30,   At December 31,   Change 
   2012   2011      $       % 
    (Dollars in thousands)
     
Demand Deposits:               
Non-interest bearing  $30,830   $27,429   $3,401    12.4%
Interest bearing   41,946    40,649    1,297    3.2%
Money market   62,551    58,157    4,395    7.6%
Savings   36,502    33,676    2,826    8.4%
Time deposits   212,950    219,887    (6,937)   (3.2)%
Total Deposits  $384,779   $379,798   $4,981    1.3%
                     

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The growth in demand deposits, money market and savings accounts, was the result of the Company’s continued strategic focus on attracting commercial deposit relationships and growing core deposits among its retail customers. The decrease in time deposits was a result of the Company’s decision to not match higher interest rates being offered by competitors in our market area in an effort to maintain our net interest margin.

 

Our borrowings, consisting of advances from the Federal Home Loan Bank of New York (“FHLBNY”), decreased by $2.7 million, or 7.8%, from $34.1 million at December 31, 2011 to $31.5 million at June 30, 2012. Long-term debt decreased $10.1 million from $27.2 million at December 31, 2011 to $17.2 million at June 30, 2012. Short-term borrowings increased $7.4 million from $6.9 million at December 31, 2011 to $14.3 million at June 30, 2012. As long-term debt matured, the Company paid off $2.7 million of such debt in order to reduce interest expense, and the remaining proceeds were transferred into short-term borrowings to take advantage of lower interest rates.

 

Total stockholders’ equity increased $1.8 million, or 2.8%, from $63.9 million at December 31, 2011 to $65.7 million at June 30, 2012. The increase in total stockholders’ equity was primarily due to $1.9 million in net income during the six month period ended June 30, 2012, partially offset by $296,000 in cash dividends paid.

 

Comparison of Results of Operations for the Three Months Ended June 30, 2012 and 2011

 

General. Net income was $895,000 for the three month period ended June 30, 2012, or $0.16 per diluted share, a decrease of $92,000, or 9.3%, compared to net income of $987,000, or $0.17 per diluted share, for the three month period ended June 30, 2011. The decrease in net income during the three month period ended June 30, 2012 compared to the three month period ended June 30, 2011 was due to a $211,000 increase in non-interest expenses and an $88,000 decrease in non-interest income partially offset by a $180,000 decrease in the provision for loan losses.

 

Interest Income. Interest income decreased by $208,000, or 4.0%, to $5.0 million for the three month period ended June 30, 2012 compared to the three month period ended June 30, 2011. The decrease in interest income was primarily due to a $184,000 decline in investment interest income, or 11.3%, to $1.5 million for the three month period ended June 30, 2012 compared to $1.6 million for the same period in 2011 due to the decrease in the average yield on investment securities. The investment portfolio had an average balance of $170.7 million and an average yield of 3.40% for the three month period ended June 30, 2012 compared to an average balance of $166.5 million and an average yield of 3.93% for the three month period ended June 30, 2011. The average balance of the investment portfolio increased due to the re-investment of paydowns received on the loan and investment portfolios, as well as funds obtained through deposit growth, into the purchase of new available for sale securities. The average yield on the investment portfolio decreased as new securities were purchased at lower yields than the rates earned on securities which had paid off, as a result of the current low interest rate environment. Loan interest income decreased by $27,000, or 0.8%, for the three month period ended June 30, 2012 compared to the same period in 2011. The average yield on our loan portfolio remained constant at 5.32% for both periods, despite a $2.0 million decrease in the average loan balance. The decrease in the average balance of loans receivable was primarily due to a decrease in one- to four-family real estate loans, partially offset by an increase in commercial real estate loans. Other interest income increased $3,000, or 50.0%, for the three month period ended June 30, 2012 compared to the same period in 2011, due to an $8.2 million increase in the average balance of other interest-earning deposits and federal funds sold. The average yield on other interest-earning deposits and federal funds sold remained constant at 0.15% for both three month periods ended June 30, 2012 and 2011.

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Interest Expense. Interest expense decreased by $220,000, or 15.6%, from $1.4 million for the three months ended June 30, 2011 to $1.2 million for the three months ended June 30, 2012. The interest paid on deposits decreased by $111,000 to $1.0 million for the three month period ended June 30, 2012 when compared to the three month period ended June 30, 2011 due primarily to the decrease in the average rate paid on deposits. The average balance of deposits for the three month period ended June 30, 2012 was $354.5 million with an average rate of 1.17% compared to the average balance of deposits of $350.2 million and an average rate of 1.31% for the three month period ended June 30, 2011. The decrease in the average rate paid on deposits was due to the continued low interest rate environment in 2012. The increase in the average balance of deposits was primarily due to deposit growth in core deposit accounts partially offset by a decrease in time deposits. The interest expense related to advances from the FHLBNY decreased $108,000, or 45.4%, for the three month period ended June 30, 2012 when compared to the same three month period in June 2011. This decrease was due to a $5.9 million decrease in average FHLBNY advance balances and an 89 basis point decline in the average rate paid on FHLBNY advances when comparing the three month period ended June 30, 2012 with the same three month period in 2011. The decrease in the average advance balances was a result of the Company’s decision to utilize excess cash obtained through deposit growth and loan prepayments in 2011 and 2012 to pay down borrowings. The low interest rate environment caused the average rate paid on borrowings to decrease.

 

Provision for Loan Losses. Provision for loan losses during the three month period ended June 30, 2012 was $85,000, a decrease of $180,000, or 67.9%, in comparison to $265,000 for the three month period ended June 30, 2011. Nonperforming loans have remained steady at $2.1 million and $2.5 million at June 30, 2012 and 2011, respectively. Net charge-offs have also remained low with an annualized ratio of net charge-offs to average loans receivable of 0.07% and 0.02% as of June 30, 2012 and 2011, respectively.

 

During the three month period ended June 30, 2012, the Company recorded a $91,000 provision for loan losses as part of its review of certain environmental factors for residential real estate and home equity loans. Management concluded that an adjustment was considered necessary due to the lengthening of the foreclosure process in New York State based on changes in state law. The increased delay between when a bank begins the foreclosure process and obtains ownership of the collateral increases the Bank’s risk of loss due to additional expenses for past due taxes, property deterioration due to lack of property maintenance, and legal fees. Management did not take this change in foreclosure law into account when calculating the provision during prior periods. As such, historical loss factors used in prior periods were understated. This adjustment will increase the provision to more accurately reflect the losses inherent in the residential mortgage and home equity loan portfolios. During the quarter ended June 30, 2012, a $40,000 decrease in the provision was recorded for commercial real estate loans, due to an upgrade in the classification of certain loans as well as the payoff of one loan. This was offset by a $35,000 increase in the provision for commercial loans primarily related to the Company’s equipment loan portfolio due to the standard risks present by the inherent nature of these types of loans.

 

During the three month period ended June 30, 2011, the Company recorded a $199,000 provision for loan losses as part of its review of certain environmental factors for commercial real estate loans and commercial loans. Management concluded that an increased provision was needed for its commercial loan portfolio due to the increase in portfolio size and the standard risks presented by these types of loans. The remaining $66,000 in the provision for loan losses was attributed to changes in loan classifications for certain one- to four-family residential mortgage loans.

 

Refer to Note 4 of the Notes to the Consolidated Financial Statements (unaudited) for details on the provision for loan losses.

 

The majority of our loans are residential mortgage loans backed by first lien collateral on real estate held in the Western New York region. Western New York has not been impacted as severely as other parts of the country by fluctuating real estate market values. We do not hold any sub-prime loans in our loan portfolio.

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We establish provisions for loan losses, which are charged to operations, in order to maintain the allowance at a level management considers necessary to absorb probable incurred credit losses in the loan portfolio. The amount of allowance is based on estimates and the ultimate losses may vary from such estimates as more information becomes available or later events occur. Management assesses the allowance for loan losses on a quarterly basis and makes provisions for loan losses in order to maintain adequacy of the allowance.

 

Non-interest Income. Non-interest income decreased $88,000, or 16.2%, from $545,000 for the three months ended June 30, 2011 to $457,000 for the three months ended June 30, 2012. The decrease was primarily due to a non-cash, pre-tax impairment charge of $57,000 to write-down a single asset-backed security, compared with a $31,000 gain on sale of investments recorded during the quarter ended June 30, 2011. The impairment charge was attributable to a significant decline in the market value of a bond that is not expected to be recovered over its term. During the three month period ended June 30, 2011, we sold thirteen municipal bonds that were set to mature between 2018 and 2029 in order to reduce our concentration in municipal bonds and the average life of the investment portfolio.

 

Non-interest Expense. Non-interest expense increased by $211,000, or 7.4%, to $3.0 million for the quarter ended June 30, 2012 from $2.8 million for the quarter ended June 30, 2011. The increase was largely due to a $148,000, or 10.6%, increase in salaries and employee benefits primarily due to the addition of two new directors, annual salary increases and annual increases in health insurance premiums. The increase in salaries and employee benefits expense was also impacted by the decrease in deferred salary expense incurred to originate loans due to a decrease in loan originations during the three months ended June 30, 2012 when compared to the same period in 2011. The increase in salaries and employee benefits expense was partially offset by lower stock option expenses for awards that became fully vested at December 31, 2011. Other non-interest expenses increased by $113,000, or 45.9%, for the three month period ended June 30, 2012 compared to the same period in 2011, primarily due to an increase in expenses related to foreclosures, as well as an increase in donations and promotional expenses. Professional services increased $48,000, or 15.8%, for the three month period ended June 30, 2012 compared to the same three month period in 2011, primarily due to an increase in legal and consulting services. Occupancy and equipment expenses increased $14,000 for the three month period ended June 30, 2012 when compared to the same three month period in 2011 primarily due to increases in software maintenance costs, property taxes and maintenance and repairs of buildings and equipment. These increases were partially offset by a $71,000 decrease in FDIC insurance, or 55.9%, for the three month period ended June 30, 2012 compared to the same period in 2011, due to the new insurance premium calculation methodology that the FDIC enacted in accordance with the Dodd-Frank Act during 2011. Advertising expenses decreased by $49,000, or 37.7%, for the three month period ended June 30, 2012 compared to the same period in 2011, primarily due to the timing of expenses for the production of the 2012 advertising campaign.

 

Income Tax Expense. Income tax expense decreased by $15,000, or 5.6%, from $268,000 for the three month period ended June 30, 2011 to $253,000 for the three month period ended June 30, 2012. The decrease was primarily due to a decrease in income before income taxes during 2012 offset by an increase in the effective tax rate from 21.4% for the three months ended June 30, 2011 to 22.0% for the three months ended June 30, 2012. The increase in the effective tax rate was primarily due to a disproportionate decrease in tax exempt income when compared to the decrease in income before income taxes for 2012.

 

Comparison of Results of Operations for the Six Months Ended June 30, 2012 and 2011

 

General. Net income was $1.90 million for the six month period ended June 30, 2012, or $0.33 per diluted share, a decrease of $35,000, or 1.8%, compared to net income of $1.94 million, or $0.34 per diluted share, for the six month period ended June 30, 2011. The decrease in net income during the six month period ended June 30, 2012 compared to the six month period ended June 30, 2011 was due to a $276,000 increase in non-interest expenses, a $147,000 decrease in non-interest income and a $47,000 increase in income tax expense partially offset by a $200,000 increase in net interest income and a $235,000 decrease in provision for loan losses.

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Interest Income. Interest income decreased by $258,000, or 2.5%, to $10.1 million for the six month period ended June 30, 2012 compared to the six month period ended June 30, 2011. The decrease in interest income was primarily due to a decrease in investment interest income. Investment interest income decreased by $316,000, or 9.7%, to $2.9 million for the six month period ended June 30, 2012 compared to $3.2 million for the same period in 2011 due to the decrease in the average yield on investment securities. The investment portfolio had an average balance of $168.9 million and an average yield of 3.47% for the six month period ended June 30, 2012 compared to an average balance of $162.8 million and an average yield of 3.99% for the six month period ended June 30, 2011. The average balance of the investment portfolio increased primarily due to the re-investment of paydowns on the loan and investment portfolio, as well as funds obtained from deposit growth, into the purchase of new available for sale securities. The average yield on the investment portfolio decreased due to the yields on purchases of new securities being lower than yields on securities which had paid off, as a result of the current low interest rate environment. Loan interest income increased by $65,000, or 0.9%, to $7.2 million for the six month period ended June 30, 2012 compared to the same period in 2011, primarily due to a $3.1 million increase in the average balance of loans to $269.5 million. The average yield on the loan portfolio was 5.31% for the six month period ended June 30, 2012 and 5.32% for the six month period ended June 30, 2011. Other interest income decreased $7,000, or 35.0%, for the six month period ended June 30, 2012 to $13,000 in comparison to the same period in 2011, despite a $2.3 million increase in the average balance of other interest earning deposits and federal funds sold. The decrease in other interest income was primarily due to an 8 basis point decline in the average yield from 0.20% to 0.12% for the six month periods ended June 30, 2011 and 2012, respectively.

 

Interest Expense. Interest expense decreased by $458,000, or 15.7%, from $2.9 million for the six month period ended June 30, 2011 to $2.5 million for the six month period ended June 30, 2012. The interest paid on deposits decreased by $242,000 to $2.1 million for the six month period ended June 30, 2012 when compared to the same period in 2011 due primarily to the decrease in the average rate paid on deposits. The average balance of deposits for the six month period ended June 30, 2012 was $353.9 million with an average rate of 1.20% compared to the average balance of deposits of $351.0 million and an average rate of 1.34% for the six month period ended June 30, 2011. The decrease in the average rate paid on deposits was due to the continued low interest rate environment in 2012. The increase in the average balance of deposits was primarily due to deposit growth in our core deposit accounts partially offset by a decrease in time deposits. The interest expense related to advances from the FHLBNY decreased $214,000, or 42.7%, for the six month period ended June 30, 2012 when compared to the same six month period in June 2011. The decrease in interest expense on advances occurred due to a $5.9 million decrease in average balances and an 84 basis point decline in the average rate paid when comparing the six month period ended June 30, 2012 with the same six month period in 2011. The decrease in the average advance balances was a result of the Company’s decision to utilize excess cash obtained through deposit growth and loan prepayments in 2011 and 2012 to pay down borrowings. The low interest rate environment caused the average rate paid on borrowings to decrease.

 

Provision for Loan Losses. A net provision of $50,000 was recorded to the allowance for loan losses during the six month period ended June 30, 2012 compared to a provision of $285,000 to the allowance for loan losses during the six month period ended June 30, 2011. Our credit quality remains strong, as nonperforming loans have remained steady at $2.1 million and $2.5 million at June 30, 2012 and 2011, respectively, despite a $3.1 million increase in average loans outstanding for the six months ended June 30, 2012 when compared to the same period in 2011. Net charge-offs in 2012 were $92,000 for the six months ended June 30, 2012 compared to $32,000 for the six months ended June 30, 2011.

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During the six month period ended June 30, 2012, the Company recorded a $157,000 provision for loan losses on commercial real estate loans due to an increase in the loan balances and number of classified loans in this category. This provision was offset by an $83,000 reduction in the provision for loan losses on commercial loans due to a reduction in the loan portfolio balances for this loan type. The provision for loan losses was further reduced by a net $28,000 decrease on the residential real estate loans (including one- to four-family loans and home equity loans) and consumer loans due to declining loan balances in these categories. The decrease in provision for loan losses on residential real estate loans was partially offset by the lengthening of the foreclosure process in New York State based on changes in state law, as discussed earlier in this document.

 

Provision for loan losses during the six month period ended June 30, 2011 was $285,000. Upon review of the environmental factors relating to the commercial real estate loans and commercial loans during 2011, management determined that a $199,000 provision for loan losses was necessary due to the increase in portfolio size and the standard risks presented by the nature of these types of loans. During the six months ended June 30, 2011, management also recorded $145,000 in provision for loan losses for specific commercial real estate or commercial loans that had become classified loans or had been downgraded due to certain factors, such as delinquency. The provisions related to commercial loans were partially offset by a $60,000 reduction in the allowance for loan losses for one- to four-family real estate loans and home equity loans.

 

Refer to Note 4 of the Notes to the Consolidated Financial Statements (unaudited) for details on the provision for loan losses.

 

Non-interest Income. Non-interest income decreased $147,000, or 13.1%, from $1.1 million for the six month period ended June 30, 2011 to $978,000 for the six month period ended June 30, 2012. The decrease was primarily due to a non-cash, pre-tax impairment charge of $57,000 related to the Company’s write-down of one asset-backed security during the second quarter of 2012. The Company recognized an $31,000 gain on the sale of municipal bond securities and a $57,000 recovery on previously impaired asset-backed securities during the six months ended June 30, 2011.

 

Non-interest Expense. Non-interest expense increased by $276,000, or 4.7%, to $6.1 million for the six month period ended June 30, 2012 compared to the six month period ended June 30, 2011. Salaries and employee benefits increased $138,000, or 4.7%, for the six month period ended June 30, 2012 compared to the six month period ended June 30, 2011. The increase was primarily due to the addition of two new directors in 2012, salary increases, higher benefit expenses, and an unplanned accrual for a retirement benefit. The increase in salaries and employee benefits expense was also impacted by the decrease in deferred salary expense incurred to originate loans due to a decrease in loan originations during the six months ended June 30, 2012 when compared to the same period in 2011. The increase in salaries and employee benefits expense was partially offset by lower stock option expenses for awards that became fully vested at December 31, 2011. Other non-interest expenses increased by $172,000, or 33.9%, for the six month period ended June 30, 2012 compared to the same period in 2011, primarily due to a $123,000 increase in foreclosure expenses incurred during the first six months of 2012, as compared to the prior year period. Professional services increased $91,000, or 15.8%, for the six month period ended June 30, 2012 compared to the same six month period in 2011, primarily due to increased legal and consulting services. These increases were partially offset by a $127,000 decrease in FDIC insurance premiums, or 51.0%, for the six month period ended June 30, 2012 compared to the same period in 2011, due to the new insurance premium calculation methodology that the FDIC enacted in accordance with the Dodd-Frank act, which became effective in 2011.

 

Income Tax Expense. Income tax expense increased by $47,000, or 9.3%, from $503,000 for the six month period ended June 30, 2011 to $550,000 for the six month period ended June 30, 2012. The increase was primarily due to an increase in the effective tax rate from 20.6% for the six month period ended June 30, 2011 to 22.4% for the six month period ended June 30, 2012. The increase in the effective tax rate was primarily due to a disproportionate decrease in tax exempt income when compared to the decrease in income before income taxes for 2012.

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Loans Past Due and Non-performing Assets

 

We define non-performing loans as loans that are either non-accruing or accruing whose payments are 90 days or more past due. Non-performing assets, including non-performing loans and foreclosed real estate, totaled $3.0 million at June 30, 2012 and $3.1 million at December 31, 2011.

 

The following table presents information regarding our non-accrual loans, accruing loans delinquent 90 days or more, and foreclosed real estate as of the dates indicated.

 

   At
June 30,
2012
   At
December 31,
2011
 
   (Dollars in thousands) 
     
Loans past due 90 days or more but still accruing:          
Real estate loans:          
Residential, one- to four-family  $13   $328 
Home equity   54    21 
Commercial        
Construction        
Other loans:          
Commercial       87 
Consumer   24    23 
Total  $91   $459 
           
Loans accounted for on a nonaccrual basis:          
Real estate loans:          
Residential, one- to four-family  $1,461   $1,821 
Home equity(1)   213    209 
Commercial   130    228 
Construction        
Other loans:          
Commercial   160    76 
Consumer   4    5 
Total non-accrual loans   1,968    2,339 
Total nonperforming loans   2,059    2,798 
Foreclosed real estate   900    315 
Restructured loans        
Total nonperforming assets  $2,959   $3,113 
Ratios:          
           
Nonperforming loans as a percent of net loans:   0.77%   1.02%
           
Nonperforming assets as a percent of total assets:   0.60%   0.64%

 

(1)As of June 30, 2012 and December 31, 2011, one home equity loan for $31,000 was restructured and classified as a troubled debt restructuring, due to the borrower’s financial difficulties. The loan was placed on nonaccrual status and was classified as a substandard loan with no specific reserve established and was 240 days past due under the modified terms as of June 30, 2012.
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The following table sets forth activity in our allowance for loan losses and other ratios at or for the dates indicated:

 

   At or for the
Six Months ended
June 30, 2012
   At or for the
Six Months ended
June 30, 2011
 
   (Dollars in thousands) 
         
Balance at beginning of period:  $1,366   $953 
Provision for loan losses   50    285 
Charge-offs:          
   Real estate loans:          
       Residential, one- to four-family   100     
       Home equity       29 
       Commercial        
       Construction        
   Other loans:          
       Commercial   1     
       Consumer   1    10 
Total charge-offs   102    39 
Recoveries:          
   Real estate loans:          
       Residential, one- to four-family   1    4 
       Home equity        
       Commercial   8     
       Construction        
   Other loans:          
     Commercial        
     Consumer   1    3 
Total recoveries   10    7 
           
Net charge-offs   92    32 
           
Balance at end of period  $1,324   $1,206 
           
Average loans outstanding  $269,475   $266,423 
           
Allowance for loan losses as a percent of total loans   0.50%   0.44%
Allowance for loan losses as a percent of non-performing loans   64.30%   47.99%
           
Ratio of net charge-offs to average loans outstanding (1)   0.07%   0.02%
           

(1) Annualized

          

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Liquidity and Capital Resources

 

Liquidity describes our ability to meet the financial obligations that arise during the ordinary course of business. Liquidity is primarily needed to meet the lending and deposit withdrawal requirements of our customers and to fund current and planned expenditures. Our primary sources of funds consist of deposits, scheduled amortization and prepayments of loans and mortgage-backed and asset-backed securities, maturities and sales of other investments, interest earning deposits at other financial institutions and funds provided from operations. We have a written agreement with the Federal Home Loan Bank of New York, which allows us to borrow up to $125.0 million as of June 30, 2012, and is collateralized by a pledge of our mortgage loans. At June 30, 2012, we had outstanding advances under this agreement of $31.5 million. We have a written agreement with the Federal Reserve Bank discount window for overnight borrowings which is collateralized by a pledge of our securities, and allows us to borrow up to the value of the securities pledged, which was $10.0 million as of June 30, 2012. There were no balances outstanding with the Federal Reserve Bank at June 30, 2012. In 2011, we established a line of credit with M&T Bank for $7.0 million, of which $5.0 million is unsecured and the remaining $2.0 million will be secured by a pledge of our securities when a draw is made. There were no borrowings on this line as of June 30, 2012.

 

Historically, loan repayments and maturing investment securities were a relatively predictable source of funds. However, in light of the current economic environment, there are now more risks related to loan repayments and the valuation and maturity of investment securities. In addition, deposit flows, calls of investment securities, and prepayments of loans and mortgage-backed securities are strongly influenced by interest rates, general and local economic conditions, and competition in the marketplace. These factors and the current economic environment reduce the predictability of the timing of these sources of funds.

 

Our primary investing activities include the origination of loans and the purchase of investment securities. For the six months ended June 30, 2012, we originated loans of approximately $19.8 million in comparison to approximately $30.4 million of loans originated during the six months ended June 30, 2011. Purchases of investment securities totaled $22.5 million in the six months ended June 30, 2012 and $16.6 million in the six months ended June 30, 2011.

 

At June 30, 2012, we had loan commitments to borrowers of approximately $5.1 million and overdraft lines of protection and unused home equity lines of credit of approximately $27.5 million.

 

Total deposits were $385.0 million at June 30, 2012, as compared to $379.8 million at December 31, 2011. Time deposit accounts scheduled to mature within one year were $97.5 million at June 30, 2012. Based on our deposit retention experience, current pricing strategy, and competitive pricing policies, we anticipate that a significant portion of these time deposits will remain with us following their maturity.

 

In recent years, macro-economic conditions negatively impacted liquidity and credit quality across the financial markets as the U.S. economy experienced a recession. Although recent reports have indicated improvements in the macro-economic conditions, the recession has had far-reaching effects. However, our financial condition, credit quality and liquidity position remain strong.

 

We are committed to maintaining a strong liquidity position; therefore, we monitor our liquidity position on a daily basis. We anticipate that we will have sufficient funds to meet our current funding commitments. The marginal cost of new funding, however, whether from deposits or borrowings from the Federal Home Loan Bank, will be carefully considered as we monitor our liquidity needs. Therefore, in order to minimize our cost of funds, we may consider additional borrowings from the Federal Home Loan Bank in the future.

 

We do not anticipate any material capital expenditures during the remainder of 2012. We do not have any balloon or other payments due on any long-term obligations or any off-balance sheet items other than loan commitments as described in Note 6 in the Notes to our Consolidated Financial Statements and the commitments and unused lines of credit noted above.

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Off-Balance Sheet Arrangements

 

Other than loan commitments, we do not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, revenues or expenses, results of operations, liquidity, capital expenditures, or capital resources that is material to investors. Refer to Note 6 of the Notes to Consolidated Financial Statements for a summary of loan commitments outstanding as of June 30, 2012.

 

Item 3. Quantitative and Qualitative Disclosures about Market Risk.

 

Not applicable as the Company is a smaller reporting company.

 

Item 4. Controls and Procedures.

 

Disclosure Controls and Procedures

 

The Company’s management, with the participation of its Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of the Company’s disclosure controls and procedures (as defined in Rules 13(a)-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) as of the end of the period covered by this report. Based upon such evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, the Company’s disclosure controls and procedures were effective.

 

Changes in Internal Control over Financial Reporting

 

There have not been any changes in the Company’s internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934) during the quarter ended June 30, 2012 that have materially affected, or are reasonably likely to materially affect, internal control over financial reporting.

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PART II

 

Item 1A. Risk Factors

 

There have been no material changes in the Company’s risk factors from those disclosed in its annual report on Form 10-K.

 

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

 

The following table reports information regarding repurchases by the Company of its common stock in each month of the quarter ended June 30, 2012:

 

COMPANY PURCHASES OF EQUITY SECURITIES

 

 

 

 

 

 

 

Period

 

 

 

 

Total Number
of Shares
Purchased

 

 

 

 

 

Average Price
Paid per Share

Total Number
of Shares
Purchased as
Part of Publicly Announced
Plans or
Programs
Maximum
Number of
Shares that May
Yet be
Purchased
Under the Plans
or Programs (1)
April 1, 2012 
through April 30, 2012
- - - 91,510
May 1, 2012
through May 31, 2012
- - - 91,510
June 1, 2012
through June 30, 2012
- - - 91,510
  Total - - - 91,510

______________

(1)On November 17, 2010, our Board of Directors approved a new stock repurchase plan pursuant to which we can repurchase up to 116,510 shares of our outstanding common stock. This amount represented 5% of our outstanding stock not owned by the MHC as of November 23, 2010. The repurchase plan does not have an expiration date and superseded all of the prior stock repurchase programs.

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Item 6. Exhibits

 

3.1 Charter of Lake Shore Bancorp, Inc.1
3.2 Amended and Restated Bylaws of Lake Shore Bancorp, Inc.2
4.1 Form of Stock Certificate of Lake Shore Bancorp, Inc.3
10.1 Employment Agreement between Daniel P. Reininga and Lake Shore Bancorp, Inc.4
10.2 Employment Agreement between Daniel P. Reininga and Lake Shore Savings Bank
10.3 Amended and Restated Change of Control Agreement between Rachel A. Foley and Lake Shore Bancorp, Inc.5
10.4 2012 Lake Shore Savings Bank Supplemental Executive Retirement Plan6
31.1  Certification by the Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002*
31.2  Certification by the Chief Financial Officer Pursuant to Section 302 of the Sarbanes- Oxley Act of 2002* 
32.1  Certification by the Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002*
32.2 Certification by the Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002*

____________

* Filed herewith

1 Incorporated herein by reference to the Exhibits to the Registration Statement on Form S-1, filed with the Securities and Exchange Commission on November 4, 2005 (Registration No. 333-129439). 

2 Incorporated herein by reference to Exhibit 3.2 to Form 8-K, filed with the Securities and Exchange Commission on December 23, 2011. 

3 Incorporated herein by reference to the Exhibits to Amendment No. 2 to the Registration Statement on Form S-1/A, filed with the Securities and Exchange Commission on February 8, 2006 (Registration No. 333-129439). 

4 Incorporated herein by reference to Exhibits 10.1 and 10.2 to Form 8-K, filed with the Securities and Exchange Commission on February 3, 2011. 

5 Incorporated herein by reference to Exhibit 10.3 to Form 8-K, filed with the Securities and Exchange Commission on February 3, 2011. 

6 Incorporated herein by reference to Exhibit 10.1 to Form 8-K, filed with the Securities and Exchange Commission on June 29, 2012.

52
 

 

Table of Contents 

 

SIGNATURES

 

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

 

  LAKE SHORE BANCORP, INC.  
  (Registrant)  
       
  /s/ Daniel P. Reininga  
 August 14, 2012 By: Daniel P. Reininga  
    President and Chief Executive Officer  
    (Principal Executive Officer)  
       
  /s/ Rachel A. Foley  
  By: Rachel A. Foley  
 August 14, 2012   Chief Financial Officer  
    (Principal Financial and Accounting Officer)  
       

 

53

 


XNAS:LSBK Lake Shore Bancorp Inc Quarterly Report 10-Q Filling

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