XOTC:FMCB Farmers & Merchants Bancorp Quarterly Report 10-Q Filing - 6/30/2012

Effective Date 6/30/2012

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 UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C.  20549

FORM 10-Q
 
x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2012

or

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934.
For the transition period from ________ to ________

Commission File Number:  000-26099

FARMERS & MERCHANTS BANCORP
(Exact name of registrant as specified in its charter)

Delaware
 
94-3327828
(State or other jurisdiction of incorporation or organization)
 
(I.R.S.  Employer Identification No.)
     
111 W. Pine Street, Lodi, California
 
95240
(Address of principal Executive offices)
 
(Zip Code)

Registrant's telephone number, including area code (209) 367-2300

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes x  No 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 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 (Check one):
 
Large accelerated filer  o
Accelerated filer  x
Non-accelerated filer  o
 Smaller Reporting Company o
 
(Do not check if a smaller reporting company)
 
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o   No x
 
Number of shares of common stock of the registrant:  Par value $0.01, authorized 7,500,000 shares; issued and outstanding 778,939 as of July 31, 2012.
 


 
 

 
 
FARMERS & MERCHANTS BANCORP

FORM 10-Q
 
PART I. - FINANCIAL INFORMATION
Page
     
Item 1 - 
Financial Statements
 
       
 
4
     
 
5
     
 
6
     
 
7
     
 
8
     
 
9
     
Item 2 - 
33
     
Item 3 - 
54
     
Item 4 - 
57
     
PART II. - OTHER INFORMATION
 
     
Item 1 - 
58
     
Item 1A - 
58
     
Item 2 - 
58
     
Item 3 - 
58
     
Item 4 - 
58
     
Item 5 - 
58
     
Item 6 - 
59
     
 
59
 
 
 
59
   
31(a) Certification of the Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
 
   
31(b) Certification of the Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
 
   
32 Certifications of the Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 
PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

FARMERS & MERCHANTS BANCORP
(in thousands)
 
June 30,
   
December 31,
   
June 30,
 
   
2012
   
2011
   
2011
 
Assets
 
(Unaudited)
         
(Unaudited)
 
Cash and Cash Equivalents:
                 
Cash and Due From Banks
  $ 39,673     $ 45,112     $ 48,604  
Interest Bearing Deposits with Banks
    1,096       56,548       8,100  
Total Cash and Cash Equivalents
    40,769       101,660       56,704  
                         
Investment Securities:
                       
Available-for-Sale
    501,892       479,820       423,915  
Held-to-Maturity
    70,195       63,092       63,584  
Total Investment Securities
    572,087       542,912       487,499  
                         
Loans
    1,203,994       1,163,078       1,191,801  
Less: Allowance for Loan Losses
    33,098       33,017       32,942  
Loans, Net
    1,170,896       1,130,061       1,158,859  
                         
Premises and Equipment, Net
    23,361       24,058       24,620  
Bank Owned Life Insurance
    48,330       47,418       46,494  
Interest Receivable and Other Assets
    71,844       73,575       72,528  
Total Assets
  $ 1,927,287     $ 1,919,684     $ 1,846,704  
                         
Liabilities
                       
Deposits:
                       
Demand
  $ 360,290     $ 389,639     $ 324,371  
Interest Bearing Transaction
    223,343       220,736       196,946  
Savings and Money Market
    542,922       498,011       494,716  
Time
    505,670       517,811       548,094  
Total Deposits
    1,632,225       1,626,197       1,564,127  
                         
Securities Sold Under Agreement to Repurchase
    -       60,000       60,000  
Federal Home Loan Bank Advances
    50,998       530       561  
Subordinated Debentures
    10,310       10,310       10,310  
Interest Payable and Other Liabilities
    34,979       33,301       30,602  
Total Liabilities
    1,728,512       1,730,338       1,665,600  
                         
Shareholders' Equity
                       
Preferred Stock
    -       -       -  
Common Stock
    8       8       8  
Additional Paid-In Capital
    75,410       75,590       75,590  
Retained Earnings
    115,838       109,081       101,907  
Accumulated Other Comprehensive Income, Net
    7,519       4,667       3,599  
Total Shareholders' Equity
    198,775       189,346       181,104  
Total Liabilities & Shareholders' Equity
  $ 1,927,287     $ 1,919,684     $ 1,846,704  
The accompanying notes are an integral part of these unaudited consolidated financial statements
 

FARMERS & MERCHANTS BANCORP
(in thousands except per share data)
 
Three Months
   
Six Months
 
   
Ended June 30,
   
Ended June 30,
 
   
2012
   
2011
   
2012
   
2011
 
Interest Income
                       
Interest and Fees on Loans
  $ 16,303     $ 17,490     $ 32,778     $ 34,997  
Interest on Deposits with Banks
    15       5       68       39  
Interest on Investment Securities:
                               
Taxable
    2,835       2,399       5,643       4,741  
Exempt from Federal Tax
    660       641       1,290       1,289  
Total Interest Income
    19,813       20,535       39,779       41,066  
                                 
Interest Expense
                               
Deposits
    975       1,396       2,032       2,942  
Borrowed Funds
    493       545       1,036       1,083  
Subordinated Debentures
    87       82       175       163  
Total Interest Expense
    1,555       2,023       3,243       4,188  
                                 
Net Interest Income
    18,258       18,512       36,536       36,878  
Provision for Loan Losses
    280       3,925       500       4,450  
Net Interest Income After Provision for Loan Losses
    17,978       14,587       36,036       32,428  
                                 
Non-Interest Income
                               
Service Charges on Deposit Accounts
    1,201       1,365       2,414       2,740  
Increase in Cash Surrender Value of Life Insurance
    456       459       912       910  
Debit Card and ATM Fees
    742       708       1,465       1,374  
Net (Loss) Gain on Deferred Compensation Investments
    (312 )     (15 )     619       390  
Other
    724       478       1,324       915  
Total Non-Interest Income
    2,811       2,995       6,734       6,329  
                                 
Non-Interest Expense
                               
Salaries and Employee Benefits
    8,021       7,463       15,942       14,705  
Net (Loss) Gain on Deferred Compensation Investments
    (312 )     (15 )     619       390  
Occupancy
    628       613       1,269       1,246  
Equipment
    878       711       1,596       1,425  
ORE Holding Costs
    78       367       93       892  
FDIC Insurance
    243       516       485       990  
Other
    3,135       1,578       4,789       3,021  
Total Non-Interest Expense
    12,671       11,233       24,793       22,669  
                                 
Income Before Income Taxes
    8,118       6,349       17,977       16,088  
Provision for Income Taxes
    2,956       2,194       6,625       5,807  
Net Income
  $ 5,162     $ 4,155     $ 11,352     $ 10,281  
Basic Earnings Per Common Share
  $ 6.63     $ 5.33     $ 14.57     $ 13.19  
The accompanying notes are an integral part of these unaudited consolidated financial statements
 

FARMERS & MERCHANTS BANCORP
(in thousands)
 
Three Months
   
Six Months
 
   
Ended June 30,
   
Ended June 30,
 
   
2012
   
2011
   
2012
   
2011
 
Net Income
  $ 5,162     $ 4,155     $ 11,352     $ 10,281  
                                 
Other Comprehensive Income
                               
Increase in Net Unrealized Gains on Available-for-Sale Securities
    3,538       4,663       4,921       3,427  
Deferred Tax Expense
    (1,488 )     (1,961 )     (2,069 )     (1,441 )
Change in Net Unrealized Gains on Available-for-Sale Securities, Net of Tax
    2,050       2,702       2,852       1,986  
                                 
Total Other Comprehensive Income
    2,050       2,702       2,852       1,986  
                                 
Comprehensive Income
  $ 7,212     $ 6,857     $ 14,204     $ 12,267  
The accompanying notes are an integral part of these unaudited consolidated financial statements
 
 
FARMERS & MERCHANTS BANCORP
(in thousands except share data)
                         
Accumulated
       
   
Common
         
Additional
         
Other
   
Total
 
   
Shares
   
Common
   
Paid-In
   
Retained
   
Comprehensive
   
Shareholders'
 
   
Outstanding
   
Stock
   
Capital
   
Earnings
   
Income, Net
   
Equity
 
Balance, January 1, 2011
    779,424     $ 8     $ 75,590     $ 96,030     $ 1,613     $ 173,241  
Net Income
            -       -       10,281       -       10,281  
Cash Dividends Declared on Common Stock ($5.65 per share)
            -       -       (4,404 )     -       (4,404 )
Change in Net Unrealized Gain on Securities Available for Sale, Net of Tax
    -       -       -       -       1,986       1,986  
Balance, June 30, 2011
    779,424     $ 8     $ 75,590     $ 101,907     $ 3,599     $ 181,104  
                                                 
Balance, January 1, 2012
    779,424     $ 8     $ 75,590     $ 109,081     $ 4,667     $ 189,346  
Net Income
            -       -       11,352       -       11,352  
Cash Dividends Declared on Common Stock ($5.90 per share)
            -       -       (4,595 )     -       (4,595 )
Repurchase of Stock
    (485 )     -       (180 )     -       -       (180 )
Change in Net Unrealized Gain on Securities Available for Sale, Net of Tax
    -       -       -       -       2,852       2,852  
Balance, June 30, 2012
    778,939     $ 8     $ 75,410     $ 115,838     $ 7,519     $ 198,775  
The accompanying notes are an integral part of these unaudited consolidated financial statements
 
 
FARMERS & MERCHANTS BANCORP
 
     
(in thousands)
 
Six Months Ended
 
   
June 30,
   
June 30,
 
   
2012
   
2011
 
Operating Activities:
           
Net Income
  $ 11,352     $ 10,281  
Adjustments to Reconcile Net Income to Net Cash Provided by Operating Activities:
               
Provision for Loan Losses
    500       4,450  
Depreciation and Amortization
    876       896  
Net Amortization of Investment Security Discounts & Premium
    1,721       373  
Net Gain on Sale of Property & Equipment
    -       (5 )
Net Change in Operating Assets & Liabilities:
               
Net Increase in Interest Receivable and Other Assets
    (1,221 )     (341 )
Net Increase (Decrease) in Interest Payable and Other Liabilities
    1,678       (244 )
Net Cash Provided by Operating Activities
    14,906       15,410  
Investing Activities:
               
Purchase of Investment Securities Available-for-Sale
    (106,797 )     (67,514 )
Proceeds from Sold, Matured, or Called Securities Available-for-sale
    87,911       74,485  
Purchase of Investment Securities Held-to-Maturity
    (10,359 )     (720 )
Proceeds from Matured or Called Securities Held-to-Maturity
    3,241       2,058  
Net Loans Paid, Originated or Acquired
    (41,559 )     (19,627 )
Principal Collected on Loans Previously Charged Off
    224       59  
Additions to Premises and Equipment
    (179 )     (1,317 )
Proceeds from Disposition of Property & Equipment
    -       20  
Net Cash Used by Investing Activities
    (67,518 )     (12,556 )
Financing Activities:
               
Net Increase (Decrease) in Deposits
    6,028       (2,376 )
Net Decrease in Securities Sold Under Agreement to Repurchase
    (60,000 )     -  
Net Change in Other Borrowings
    50,468       (30 )
Stock Repurchases
    (180 )     -  
Cash Dividends
    (4,595 )     (4,404 )
Net Cash Used in Financing Activities
    (8,279 )     (6,810 )
Decrease in Cash and Cash Equivalents
    (60,891 )     (3,956 )
Cash and Cash Equivalents at Beginning of Period
    101,660       60,660  
Cash and Cash Equivalents at End of Period
  $ 40,769     $ 56,704  
The accompanying notes are an integral part of these unaudited consolidated financial statements
 

FARMERS & MERCHANTS BANCORP

1. Significant Accounting Policies

Farmers & Merchants Bancorp (the “Company”) was organized March 10, 1999. Primary operations are related to traditional banking activities through its subsidiary Farmers & Merchants Bank of Central California (the “Bank”) which was established in 1916. The Bank’s wholly owned subsidiaries include Farmers & Merchants Investment Corporation and Farmers/Merchants Corp. Farmers & Merchants Investment Corporation has been dormant since 1991. Farmers/Merchants Corp. acts as trustee on deeds of trust originated by the Bank.

The Company’s other subsidiaries include F & M Bancorp, Inc. and FMCB Statutory Trust I. F & M Bancorp, Inc. was created in March 2002 to protect the name F & M Bank. During 2002 the Company completed a fictitious name filing in California to begin using the streamlined name “F & M Bank” as part of a larger effort to enhance the Company’s image and build brand name recognition. In December 2003 the Company formed a wholly owned subsidiary, FMCB Statutory Trust I. FMCB Statutory Trust I is a non-consolidated subsidiary per generally accepted accounting principles (GAAP) and was formed for the sole purpose of issuing Trust Preferred Securities.

The accounting and reporting policies of the Company conform to accounting principles generally accepted in the United States of America and prevailing practice within the banking industry. The following is a summary of the significant accounting and reporting policies used in preparing the consolidated financial statements.

Basis of Presentation
The accompanying consolidated financial statements and notes thereto have been prepared in accordance with accounting principles generally accepted in the United States of America for financial information.

These statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”) for interim reporting on Form 10-Q. Accordingly, certain disclosures normally presented in the notes to the annual consolidated financial statements prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) have been omitted. The Company believes that the disclosures are adequate to make the information not misleading. These interim financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011. The results of operations for the six-month period ended June 30, 2012 may not necessarily be indicative of future operating results.

The accompanying consolidated financial statements include the accounts of the Company and the Company’s wholly owned subsidiaries, F & M Bancorp, Inc. and the Bank, along with the Bank’s wholly owned subsidiaries, Farmers & Merchants Investment Corporation and Farmers/Merchants Corp. Significant inter-company transactions have been eliminated in consolidation.

The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions. These estimates and assumptions affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates.

Certain amounts in the prior years' financial statements and related footnote disclosures have been reclassified to conform to the current-year presentation. These reclassifications had no effect on previously reported net income or total shareholders’ equity. In the opinion of management, the accompanying consolidated financial statements reflect all adjustments (consisting only of normal recurring adjustments), which are necessary for a fair presentation of financial results for the periods presented.

 
Cash and Cash Equivalents
For purposes of the Consolidated Statements of Cash Flows, the Company has defined cash and cash equivalents as those amounts included in the balance sheet captions Cash and Due from Banks, Interest Bearing Deposits with Banks, Federal Funds Sold and Securities Purchased Under Agreements to Resell. Generally, these transactions are for one-day periods. For these instruments, the carrying amount is a reasonable estimate of fair value.

Investment Securities
Investment securities are classified at the time of purchase as held-to-maturity if it is management’s intent and the Company has the ability to hold the securities until maturity. These securities are carried at cost, adjusted for amortization of premium and accretion of discount using a level yield of interest over the estimated remaining period until maturity. Losses, reflecting a decline in value judged by the Company to be other than temporary, are recognized in the period in which they occur.

Securities are classified as available-for-sale if it is management’s intent, at the time of purchase, to hold the securities for an indefinite period of time and/or to use the securities as part of the Company’s asset/liability management strategy. These securities are reported at fair value with aggregate unrealized gains or losses excluded from income and included as a separate component of shareholders’ equity, net of related income taxes. Fair values are based on quoted market prices or broker/dealer price quotations on a specific identification basis. Gains or losses on the sale of these securities are computed using the specific identification method.

Trading securities, if any, are acquired for short-term appreciation and are recorded in a trading portfolio and are carried at fair value, with unrealized gains and losses recorded in non-interest income.

Management evaluates securities for other-than-temporary impairment (“OTTI”) on at least a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation.  For securities in an unrealized loss position, management considers the extent and duration of the unrealized loss, and the financial condition and near-term prospects of the issuer. Management also assesses whether it intends to sell, or it is more likely than not that it will be required to sell, a security in an unrealized loss position before recovery of its amortized cost basis. If either of the criteria regarding intent or requirement to sell is met, the entire difference between amortized cost and fair value is recognized as impairment through earnings.  For debt securities that do not meet the aforementioned criteria, the amount of impairment is split into two components as follows: (1) OTTI related to credit loss, which must be recognized in the income statement; and (2) OTTI related to other factors, which is recognized in other comprehensive income.  The credit loss is defined as the difference between the present value of the cash flows expected to be collected and the amortized cost basis. For equity securities, the entire amount of impairment is recognized through earnings.

In order to determine OTTI for purchased beneficial interests that, on the purchase date, were not highly rated, the Company compares the present value of the remaining cash flows as estimated at the preceding evaluation date to the current expected remaining cash flows. OTTI is deemed to have occurred if there has been an adverse change in the remaining expected future cash flows.

Loans
Loans are reported at the principal amount outstanding net of unearned discounts and deferred loan fees and costs. Interest income on loans is accrued daily on the outstanding balances using the simple interest method. Loan origination fees are deferred and recognized over the contractual life of the loan as an adjustment to the yield. Loans are placed on non-accrual status when the collection of principal or interest is in doubt or when they become past due for 90 days or more unless they are both well-secured and in the process of collection. For this purpose a loan is considered well-secured if it is collateralized by property having a net realizable value in excess of the amount of the loan or is guaranteed by a financially capable party. When a loan is placed on non-accrual status, the accrued and unpaid interest receivable is reversed and charged against current income; thereafter, interest income is recognized only as it is collected in cash. Additionally, cash would be applied to principal if all principal was not expected to be collected. Loans placed on non-accrual status are returned to accrual status when the loans are paid current as to principal and interest and future payments are expected to be made in accordance with the contractual terms of the loan.

 
A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due, including principal and interest, according to the contractual terms of the original agreement. Impaired loans are either: (1) non-accrual loans; or (2) restructured loans that are still accruing interest. Loans determined to be impaired are individually evaluated for impairment. When a loan is impaired, the Company measures impairment based on the present value of expected future cash flows discounted at the loan's effective interest rate, except that as a practical expedient, it may measure impairment based on a loan's observable market price, or the fair value of the collateral if the loan is collateral dependent. A loan is collateral dependent if the repayment of the loan is expected to be provided solely by the underlying collateral.

A restructuring of a loan constitutes a troubled debt restructuring (TDR) if the Company for economic or legal reasons related to the debtor's financial difficulties grants a concession to the debtor that it would not otherwise consider. Restructured loans typically present an elevated level of credit risk as the borrowers are not able to perform according to the original contractual terms. Loans that are reported as TDRs are considered impaired and measured for impairment as described above.

Generally, the Company will not restructure loans for customers unless: (1) the existing loan is brought current as to principal and interest payments; and (2) the restructured loan can be underwritten to reasonable underwriting standards. If these standards are not met other actions will be pursued (e.g., foreclosure) to collect outstanding loan amounts. After restructure a determination is made whether the loan will be kept on accrual status based upon the underwriting of the restructured credit.

Allowance for Loan Losses
The allowance for loan losses is an estimate of probable incurred credit losses inherent in the Company's loan portfolio as of the balance sheet date. The allowance is established through a provision for loan losses which is charged to expense. Additions to the allowance are expected to maintain the adequacy of the total allowance after credit losses and loan growth. Credit exposures determined to be uncollectible are charged against the allowance. Cash received on previously charged off amounts is recorded as a recovery to the allowance. The overall allowance consists of two primary components, specific reserves related to impaired loans and general reserves for inherent losses related to loans that are collectively evaluated for impairment.

The determination of the general reserve for loans that are collectively evaluated for impairment is based on estimates made by management, to include, but not limited to, consideration of historical losses by portfolio segment, internal asset classifications, and qualitative factors to include economic trends in the Company's service areas, industry experience and trends, geographic concentrations, estimated collateral values, the Company's underwriting policies, the character of the loan portfolio, and probable losses inherent in the portfolio taken as a whole.

The Company maintains a separate allowance for each portfolio segment (loan type). These portfolio segments include: (1) commercial real estate; (2) agricultural real estate; (3) real estate construction (including land and development loans); (4) residential 1st mortgages; (5) home equity lines and loans; (6) agricultural; (7) commercial; and (8) consumer and other. The allowance for loan losses attributable to each portfolio segment, which includes both impaired loans and loans that are collectively evaluated for impairment is combined to determine the Company's overall allowance, which is included on the consolidated balance sheet.

The Company assigns a risk rating to all loans and periodically performs detailed reviews of all such loans over a certain threshold to identify credit risks and to assess the overall collectability of the portfolio. A credit grade is established at inception for smaller balance loans, such as consumer and residential real estate, and then updated only when the loan becomes contractually delinquent or when the borrower requests a modification. During these internal reviews, management monitors and analyzes the financial condition of borrowers and guarantors, trends in the industries in which borrowers operate and the fair values of collateral securing these loans. These credit quality indicators are used to assign a risk rating to each individual loan. These risk ratings are also subject to examination by independent specialists engaged by the Company. The risk ratings can be grouped into five major categories, defined as follows:

 
Pass – A pass loan is a strong credit with no existing or known potential weaknesses deserving of management's close attention.
 
Special Mention – A special mention loan has potential weaknesses that deserve management's close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or in the Company's credit position at some future date. Special Mention loans are not adversely classified and do not expose the Company to sufficient risk to warrant adverse classification.

Substandard – A substandard loan is not adequately protected by the current financial condition and paying capacity of the borrower or the value of the collateral pledged, if any. Loans classified as substandard have a well defined weakness or weaknesses that jeopardize the liquidation of the debt. Well defined weaknesses include a project's lack of marketability, inadequate cash flow or collateral support, failure to complete construction on time or the project's failure to fulfill economic expectations. They are characterized by the distinct possibility that the Company will sustain some loss if the deficiencies are not corrected.

Doubtful – Loans classified doubtful have all the weaknesses inherent in those classified as substandard with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently known facts, conditions and values, highly questionable or improbable.

Loss – Loans classified as loss are considered uncollectible. Once a loan becomes delinquent and repayment becomes questionable, the Company will address collateral shortfalls with the borrower and attempt to obtain additional collateral. If this is not forthcoming and payment in full is unlikely, the Company will estimate its probable loss and immediately charge-off some or all of the balance.

The general reserve component of the allowance for loan losses also consists of reserve factors that are based on management's assessment of the following for each portfolio segment: (1) inherent credit risk; (2) historical losses; and (3) other qualitative factors. These reserve factors are inherently subjective and are driven by the repayment risk associated with each portfolio segment described below:

Real Estate Construction – Real Estate Construction loans including land loans generally possess a higher inherent risk of loss than other real estate portfolio segments. A major risk arises from the necessity to complete projects within specified cost and time lines. Trends in the construction industry significantly impact the credit quality of these loans, as demand drives construction activity. In addition, trends in real estate values significantly impact the credit quality of these loans, as property values determine the economic viability of construction projects.

Commercial Real Estate – Commercial real estate mortgage loans generally possess a higher inherent risk of loss than other real estate portfolio segments, except land and construction loans. Adverse economic developments or an overbuilt market impact commercial real estate projects and may result in troubled loans. Trends in vacancy rates of commercial properties impact the credit quality of these loans. High vacancy rates reduce operating revenues and the ability for properties to produce sufficient cash flow to service debt obligations.

Commercial – Commercial loans generally possess a lower inherent risk of loss than real estate portfolio segments because these loans are generally underwritten to existing cash flows of operating businesses. Debt coverage is provided by business cash flows and economic trends influenced by unemployment rates and other key economic indicators are closely correlated to the credit quality of these loans.

Agricultural Real Estate and Agricultural – Loans secured by crop production, livestock and related real estate are vulnerable to two risk factors that are largely outside the control of Company and borrowers: commodity prices and weather conditions.

Residential 1st Mortgages and Home Equity Lines and Loans – The degree of risk in residential real estate lending depends primarily on the loan amount in relation to collateral value, the interest rate and the borrower's ability to repay in an orderly fashion. These loans generally possess a lower inherent risk of loss than other real estate portfolio segments, although this is not always true as evidenced over the past several years. Economic trends determined by unemployment rates and other key economic indicators are closely correlated to the credit quality of these loans. Weak economic trends indicate that the borrowers' capacity to repay their obligations may be deteriorating.

 
Consumer & Other – A consumer installment loan portfolio is usually comprised of a large number of small loans scheduled to be amortized over a specific period. Most installment loans are made for consumer purchases. Economic trends determined by unemployment rates and other key economic indicators are closely correlated to the credit quality of these loans. Weak economic trends indicate that the borrowers' capacity to repay their obligations may be deteriorating.

At least quarterly, the Board of Directors and management review the adequacy of the allowance, including consideration of the relative risks in the portfolio, current economic conditions and other factors. If the Board of Directors and management determine that changes are warranted based on those reviews, the allowance is adjusted. In addition, the Company's and Bank's regulators, including the FRB, DFI and FDIC, as an integral part of their examination process, review the adequacy of the allowance. These regulatory agencies may require additions to the allowance based on their judgment about information available at the time of their examinations.

Allowance for Credit Losses on Off Balance Sheet Credit Exposures
The Company also maintains a separate allowance for off balance sheet commitments. Management estimates anticipated losses using historical data and utilization assumptions. The allowance for off balance sheet commitments is included in Interest Payable and Other Liabilities on the Company’s Consolidated Balance Sheet.

Premises and Equipment
Premises, equipment, and leasehold improvements are stated at cost, less accumulated depreciation and amortization. Depreciation is computed principally by the straight line method over the estimated useful lives of the assets. Estimated useful lives of buildings range from 30 to 40 years, and for furniture and equipment from 3 to 7 years. Leasehold improvements are amortized over the lesser of the terms of the respective leases, or their useful lives, which are generally 5 to 10 years. Remodeling and capital improvements are capitalized while maintenance and repairs are charged directly to occupancy expense.

Other Real Estate
Other real estate, which is included in other assets, is expected to be sold and is comprised of properties no longer utilized for business operations and property acquired through foreclosure in satisfaction of indebtedness. These properties are recorded at fair value less estimated selling costs upon acquisition. Revised estimates to the fair value less cost to sell are reported as adjustments to the carrying amount of the asset, provided that such adjusted value is not in excess of the carrying amount at acquisition. Initial losses on properties acquired through full or partial satisfaction of debt are treated as credit losses and charged to the allowance for loan losses at the time of acquisition. Subsequent declines in value from the recorded amounts, routine holding costs, and gains or losses upon disposition, if any, are included in non-interest income or expense as incurred.

Income Taxes
The Company uses the liability method of accounting for income taxes. This method results in the recognition of deferred tax assets and liabilities that are reflected at currently enacted income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settled. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes. The deferred provision for income taxes is the result of the net change in the deferred tax asset and deferred tax liability balances during the year. This amount, combined with the current taxes payable or refundable, results in the income tax expense for the current year.

The Company follows the standards set forth in the “Income Taxes” topic of the FASB Accounting Standards Codification (“ASC”), which clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements. This standard prescribes a recognition threshold and measurement standard for the financial statement recognition and measurement of an income tax position taken or expected to be taken in a tax return. It also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition.

 
When tax returns are filed, it is highly certain that some positions taken would be sustained upon examination by the taxing authorities, while others are subject to uncertainty about the merits of the position taken or the amount of the position that would be ultimately sustained. The benefit of a tax position is recognized in the financial statements in the period during which, based on all available evidence, management believes it is more likely than not that the position will be sustained upon examination, including the resolution of appeals or litigation processes, if any. Tax positions taken are not offset or aggregated with other positions. Tax positions that meet the more-likely-than-not recognition threshold are measured as the largest amount of tax benefit that is more than 50 percent likely of being realized upon settlement with the applicable taxing authority. The portion of the benefits associated with tax positions taken that exceeds the amount measured as described above is reflected as a liability for unrecognized tax benefits in the accompanying balance sheet along with any associated interest and penalties that would be payable to the taxing authorities upon examination.

Interest expense and penalties associated with unrecognized tax benefits, if any, are included in the provision for income taxes in the Consolidated Statements of Income.

Dividends and Basic Earnings Per Common Share
The Company’s common stock is not traded on any exchange. The shares are primarily held by local residents and are not actively traded. Basic earnings per common share amounts are computed by dividing net income by the weighted average number of common shares outstanding for the period. There are no common stock equivalent shares. Therefore, there is no presentation of diluted basic earnings per common share. See Note 6.

Segment Reporting
The “Segment Reporting” topic of the FASB ASC requires that public companies report certain information about operating segments. It also requires that public companies report certain information about their products and services, the geographic areas in which they operate, and their major customers. The Company is a holding company for a community bank, which offers a wide array of products and services to its customers. Pursuant to its banking strategy, emphasis is placed on building relationships with its customers, as opposed to building specific lines of business. As a result, the Company is not organized around discernible lines of business and prefers to work as an integrated unit to customize solutions for its customers, with business line emphasis and product offerings changing over time as needs and demands change. Therefore, the Company only reports one segment.

Derivative Instruments and Hedging Activities
The “Derivatives and Hedging” topic of the FASB ASC establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. All derivatives, whether designated in hedging relationships or not, are required to be recorded on the balance sheet at fair value. Changes in the fair value of those derivatives are accounted for depending on the intended use of the derivative and the resulting designation under specified criteria. If the derivative is designated as a fair value hedge, the changes in the fair value of the derivative and of the hedged item attributable to the hedged risk are recognized in earnings. If the derivative is designated as a cash flow hedge, designed to minimize interest rate risk, the effective portions of the change in the fair value of the derivative are recorded in other comprehensive income (loss), net of related income taxes. Ineffective portions of changes in the fair value of cash flow hedges are recognized in earnings.

From time to time, the Company utilizes derivative financial instruments such as interest rate caps, floors, swaps, and collars. These instruments are purchased and/or sold to reduce the Company’s exposure to changing interest rates. The Company marks to market the value of its derivative financial instruments and reflects gain or loss in earnings in the period of change or in other comprehensive income (loss). The Company was not utilizing any derivative instruments as of or for the period ended June 30, 2012, December 31, 2011 or June 30, 2011.

Comprehensive Income
The “Comprehensive Income” topic of the FASB ASC establishes standards for the reporting and display of comprehensive income and its components in the financial statements. Other comprehensive income (loss) refers to revenues, expenses, gains, and losses that generally accepted accounting principles recognize as changes in value to an enterprise but are excluded from net income. For the Company, comprehensive income includes net income and changes in fair value of its available-for-sale investment securities.

 
Loss Contingencies
Loss contingencies, including claims and legal actions arising in the ordinary course of business, are recorded as liabilities when the likelihood of loss is probable and an amount or range of loss can be reasonably estimated.  Management does not believe there now are such matters that will have a material effect on the financial statements.

2. Investment Securities

The amortized cost, fair values, and unrealized gains and losses of the securities available-for-sale are as follows (in thousands):
   
Amortized
   
Gross Unrealized
   
Fair/Book
 
June 30, 2012
 
Cost
   
Gains
   
Losses
   
Value
 
Government Agency & Government-Sponsored Entities
  $ 56,764     $ 314     $ -     $ 57,078  
Obligations of States and Political Subdivisions
    5,724       -       -     $ 5,724  
Mortgage Backed Securities (1)
    414,990       12,647       -       427,637  
Corporate Bonds
    8,983       29       17       8,995  
Other
    2,458       -       -       2,458  
Total
  $ 488,919     $ 12,990     $ 17     $ 501,892  
 
   
Amortized
   
Gross Unrealized
   
Fair/Book
 
December 31, 2011
 
Cost
   
Gains
   
Losses
   
Value
 
Government Agency & Government-Sponsored Entities
  $ 82,195     $ 413     $ 13     $ 82,595  
Obligations of States and Political Subdivisions
    5,782       -       -       5,782  
Mortgage Backed Securities (1)
    383,380       7,792       139       391,033  
Other
    410       -       -       410  
Total
  $ 471,767     $ 8,205     $ 152     $ 479,820  
 
   
Amortized
   
Gross Unrealized
   
Fair/Book
 
June 30, 2011
 
Cost
   
Gains
   
Losses
   
Value
 
Securities of U.S. Government Agencies
  $ 217,724     $ 496     $ 384     $ 217,836  
Obligations of States and Political Subdivisions
    5,620       -       -       5,620  
Mortgage Backed Securities (1)
    194,051       6,782       684       200,149  
Other
    310       -       -       310  
Total
  $ 417,705     $ 7,278     $ 1,068     $ 423,915  

The book values, estimated fair values and unrealized gains and losses of investments classified as held-to-maturity are as follows (in thousands):
 
   
Book
   
Gross Unrealized
   
Fair
 
June 30, 2012
 
Value
   
Gains
   
Losses
   
Value
 
Obligations of States and Political Subdivisions
  $ 67,159     $ 2,498     $ 51     $ 69,606  
Mortgage Backed Securities (1)
    806       25       -       831  
Other
    2,230       -       -       2,230  
Total
  $ 70,195     $ 2,523     $ 51     $ 72,667  
 
   
Book
   
Gross Unrealized
   
Fair
 
December 31, 2011
 
Value
   
Gains
   
Losses
   
Value
 
Obligations of States and Political Subdivisions
  $ 59,640     $ 2,736     $ -     $ 62,376  
Mortgage Backed Securities (1)
    1,205       46       -       1,251  
Other
    2,247       -       -       2,247  
Total
  $ 63,092     $ 2,782     $ -     $ 65,874  
 
                                 
   
Book
   
Gross Unrealized
   
Fair
 
June 30, 2011
 
Value
   
Gains
   
Losses
   
Value
 
Obligations of States and Political Subdivisions
  $ 59,648     $ 1,964     $ 7     $ 61,605  
Mortgage Backed Securities (1)
    1,673       72       -       1,745  
Other
    2,263       -       -       2,263  
Total
  $ 63,584     $ 2,036     $ 7     $ 65,613  

(1)
All Mortgage Backed Securities consist of securities collateralized by residential real estate and were issued by an agency or government sponsored entity of the U.S. government.


Fair values are based on quoted market prices or dealer quotes. If a quoted market price or dealer quote is not available, fair value is estimated using quoted market prices for similar securities.

The amortized carrying amount of investment securities at June 30, 2012 by contractual maturity are shown in the following tables (in thousands):

         
After 1
   
After 5
         
Total
 
Securities Available-for-Sale
 
Within
   
but
   
but
   
Over
   
Fair
 
June 30, 2012
 
1 Year
   
Within 5
   
Within 10
   
10 years
   
Value
 
Government Agency & Government-Sponsored Entities
  $ 10,031     $ 45,845     $ 1,202     $ -     $ 57,078  
Obligations of States and Political Subdivisions
    -       -       221       5,503       5,724  
Mortgage Backed Securities
    -       -       128,831       298,806       427,637  
Corporate Bonds
    596       8,399       -       -       8,995  
Other
    2,458       -       -       -       2,458  
Total
  $ 13,085     $ 54,244     $ 130,254     $ 304,309     $ 501,892  

         
After 1
   
After 5
         
Total
 
Securities Held-to-Maturity
 
Within
   
but
   
but
   
Over
   
Book
 
June 30, 2012
 
1 Year
   
Within 5
   
Within 10
   
10 years
   
Value
 
Obligations of States and Political Subdivisions
  $ 1,025     $ 9,928     $ 40,648     $ 15,558     $ 67,159  
Mortgage Backed Securities
    -       806       -       -       806  
Other
    -       5       2,225       -       2,230  
Total
  $ 1,025     $ 10,739     $ 42,873     $ 15,558     $ 70,195  

Expected maturities of mortgage-backed securities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

The following tables show those investments with gross unrealized losses and their market value aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at the dates indicated (in thousands):

   
Less Than 12 Months
   
12 Months or More
   
Total
 
   
Fair
   
Unrealized
   
Fair
   
Unrealized
   
Fair
   
Unrealized
 
June 30, 2012
 
Value
   
Loss
   
Value
   
Loss
   
Value
   
Loss
 
Obligations of States and Political Subdivisions
  $ 4,774     $ 51     $ -     $ -     $ 4,774     $ 51  
Corporate Bonds
    3,405       17       -       -       3,405       17  
Total
  $ 8,179     $ 68     $ -     $ -     $ 8,179     $ 68  
 
   
Less Than 12 Months
   
12 Months or More
   
Total
 
   
Fair
   
Unrealized
   
Fair
   
Unrealized
   
Fair
   
Unrealized
 
December 31, 2011
 
Value
   
Loss
   
Value
   
Loss
   
Value
   
Loss
 
Government Agency & Government-Sponsored Entities
  $ 4,987     $ 13     $ -     $ -     $ 4,987     $ 13  
Mortgage Backed Securities
    85,090       139       -       -       85,090       139  
Total
  $ 90,077     $ 152     $ -     $ -     $ 90,077     $ 152  
 
   
Less Than 12 Months
   
12 Months or More
   
Total
 
   
Fair
   
Unrealized
   
Fair
   
Unrealized
   
Fair
   
Unrealized
 
June 30, 2011
 
Value
   
Loss
   
Value
   
Loss
   
Value
   
Loss
 
Government Agency & Government-Sponsored Entities
  $ 86,806     $ 384     $ -     $ -     $ 86,806     $ 384  
Obligations of States and Political Subdivisions
    1,494       7       -       -       1,494       7  
Mortgage Backed Securities
    49,976       684       -       -       49,976       684  
Total
  $ 138,276     $ 1,075     $ -     $ -     $ 138,276     $ 1,075  


As of June 30, 2012, the Company held 329 investment securities of which 27 were in a loss position for less than twelve months.  No securities were in a loss position for twelve months or more.  Management periodically evaluates each investment security for other-than-temporary impairment relying primarily on industry analyst reports and observations of market conditions and interest rate fluctuations. Management believes it will be able to collect all amounts due according to the contractual terms of the underlying investment securities.

Securities of U.S. Government Agency and Government Sponsored Entities
The unrealized losses on the Company's investments in securities of government agency and government sponsored entities were $0, $13,000, and $384,000 at June 30, 2012, December 31, 2011, and June 30, 2011, respectively. Management believes that any unrealized losses were caused by interest rate fluctuations. Repayment of these investments is guaranteed by an agency or government sponsored entity of the U.S. government. Accordingly, it is expected that the securities would not be settled at a price less than the amortized cost of the Company's investment. Because the decline in market value is attributable to changes in interest rates and not credit quality, and because the Company did not intend to sell the securities and it was more likely than not that the Company would not have to sell the securities before recovery of their cost basis, the Company did not consider these investments to be other-than-temporarily impaired at December 31, 2011 and June 30, 2011.
 
Mortgage Backed Securities
The unrealized losses on the Company's investments in mortgage backed securities were $0, $139,000, and $684,000 at June 30, 2012, December 31, 2011, and June 30, 2011, respectively. The unrealized losses on the Company's investment in mortgage backed securities were caused by interest rate fluctuations. The contractual cash flows of these investments are guaranteed by an agency or government sponsored entity of the U.S. government. Accordingly, it is expected that the securities would not be settled at a price less than the amortized cost of the Company's investment. Because the decline in market value is attributable to changes in interest rates and not credit quality, and because the Company did not intend to sell the securities and it was more likely than not that the Company would not have to sell the securities before recovery of their cost basis, the Company did not consider these investments to be other-than-temporarily impaired at December 31, 2011 and June 30, 2011.

Obligations of States and Political Subdivisions
The continuing financial problems being experienced by certain municipalities, along with the financial stresses exhibited by some of the large monoline bond insurers have increased the overall risk associated with bank-qualified municipal bonds. As of June 30, 2012, over ninety-three percent of the Company’s bank-qualified municipal bond portfolio is rated at either the issue or issuer level, and all of these ratings are “investment grade.” The Company monitors the status of the approximately seven percent of the portfolio that is not rated and at the current time does not believe any of them to be exhibiting financial problems that could result in a loss in any individual security.

The unrealized losses on the Company's investments in obligations of states and political subdivisions were $51,000, $0, and $7,000 at June 30, 2012, December 31, 2011, and June 30, 2011, respectively. Management believed that any unrealized losses on the Company’s investment in obligations of states and political subdivisions were caused by interest rate fluctuations. Because the Company did not intend to sell the securities and it was more likely than not that the Company would not have to sell the securities before recovery of their cost basis, the Company did not consider these investments to be other-than-temporarily impaired at June 30, 2012 and June 30, 2011.

Corporate Bonds
The unrealized losses on the Company's investments in corporate bonds were $17,000 at June 30, 2012. The unrealized losses on the Company's investment in corporate bonds were caused by interest rate fluctuations. Accordingly, it is expected that the securities would not be settled at a price less than the amortized cost of the Company's investment. Because the decline in market value is attributable to changes in interest rates and not credit quality, and because the Company did not intend to sell the securities and it was more likely than not that the Company would not have to sell the securities before recovery of their cost basis, the Company did not consider these investments to be other-than-temporarily impaired at June 30, 2012.


Proceeds from calls of securities for the periods shown were as follows:

                   
(in thousands)
 
Proceeds
   
Gains
   
Losses
 
June 30, 2012
  $ 26,530     $ -     $ -  
December 31, 2011
    201,135       94       -  
June 30, 2011
    55,000       -       -  
 
Pledged Securities
As of June 30, 2012, securities carried at $314.9 million were pledged to secure public deposits, FHLB borrowings, and other government agency deposits as required by law. This amount at December 31, 2011, was $373.2 million.


3. Allowance for Loan Losses

The following tables show the allocation of the allowance for loan losses by portfolio segment and by impairment methodology at the dates indicated (in thousands):

June 30, 2012
 
Commercial
 Real Estate
   
Agricultural
 Real Estate
   
Real Estate
 Construction
   
Residential 1st
 Mortgages
   
Home Equity
Lines & Loans
   
Agricultural
   
Commercial
   
Consumer
 & Other
   
Unallocated
   
Total
 
                                                             
Year-To-Date Allowance for Loan Losses:
                                                           
Beginning Balance- January 1, 2012
  $ 5,823     $ 2,583     $ 1,933     $ 1,251     $ 3,746     $ 8,127     $ 8,733     $ 207     $ 614     $ 33,017  
Charge-Offs
    -       -       -       (1 )     (116 )     (240 )     (198 )     (88 )     -       (643 )
Recoveries
    -       89       -       -       10       61       32       32       -       224  
Provision
    (1,446 )     (39 )     (33 )     201       (126 )     (114 )     971       (11 )     1,097       500  
Ending Balance- June 30, 2012
  $ 4,377     $ 2,633     $ 1,900     $ 1,451     $ 3,514     $ 7,834     $ 9,538     $ 140     $ 1,711     $ 33,098  
                                                                                 
Second Quarter Allowance for Loan Losses:
                                                                               
Beginning Balance- April 1, 2012
  $ 4,443     $ 2,775     $ 2,201     $ 1,295     $ 3,552     $ 8,757     $ 8,637     $ 162     $ 1,120     $ 32,942  
Charge-Offs
    -       -       -       (1 )     (47 )     (240 )     -       (24 )     -       (312 )
Recoveries
    -       89       -       -       2       59       24       14       -       188  
Provision
    (66 )     (231 )     (301 )     157       7       (742 )     877       (12 )     591       280  
Ending Balance- June 30, 2012
  $ 4,377     $ 2,633     $ 1,900     $ 1,451     $ 3,514     $ 7,834     $ 9,538     $ 140     $ 1,711     $ 33,098  
Ending Balance Individually Evaluated for Impairment
    -       -       -       51       60       586       197       21       -       915  
Ending Balance Collectively Evaluated for Impairment
    4,377       2,633       1,900       1,400       3,454       7,248       9,341       119       1,711       32,183  
Loans:
                                                                               
Ending Balance
  $ 324,795     $ 285,630     $ 36,033     $ 123,053     $ 46,284     $ 210,780     $ 171,621     $ 5,798     $ -     $ 1,203,994  
Ending Balance Individually Evaluated for Impairment
    299       1,512       -       495       826       874       363       21       -       4,390  
Ending Balance Collectively Evaluated for Impairment
    324,496       284,118       36,033       122,558       45,458       209,906       171,258       5,777       -       1,199,604  
 
December 31, 2011
 
Commercial
 Real Estate
   
Agricultural
 Real Estate
   
Real Estate
 Construction
   
Residential 1st
 Mortgages
   
Home Equity
 Lines & Loans
   
Agricultural
   
Commercial
   
Consumer
 & Other
   
Unallocated
   
Total
 
                                                                                 
Year-To-Date Allowance for Loan Losses:
                                                                               
Beginning Balance- January 1, 2011
  $ 7,631     $ 1,539     $ 2,160     $ 1,164     $ 3,724     $ 6,733     $ 9,084     $ 216     $ 10     $ 32,261  
Charge-Offs
    (25 )     (384 )     -       (449 )     (751 )     (3,559 )     (788 )     (190 )     -       (6,146 )
Recoveries
    -       18       -       4       13       10       21       61       -       127  
Provision
    (1,783 )     1,410       (227 )     532       760       4,943       416       120       604       6,775  
Ending Balance- December 31, 2011
  $ 5,823     $ 2,583     $ 1,933     $ 1,251     $ 3,746     $ 8,127     $ 8,733     $ 207     $ 614     $ 33,017  
Ending Balance Individually Evaluated for Impairment
    686       -       -       -       80       793       54       23       -       1,636  
Ending Balance Collectively Evaluated for Impairment
    5,137       2,583       1,933       1,251       3,666       7,334       8,679       184       614       31,381  
Loans:
                                                                               
Ending Balance
  $ 305,704     $ 280,139     $ 29,607     $ 107,421     $ 50,956     $ 217,227     $ 165,089     $ 6,935     $ -     $ 1,163,078  
Ending Balance Individually Evaluated for Impairment
    4,562       954       -       1,194       576       1,337       292       23       -       8,938  
Ending Balance Collectively Evaluated for Impairment
    301,142       279,185       29,607       106,227       50,380       215,890       164,797       6,912       -       1,154,140  
 
June 30, 2011
 
Commercial
 Real Estate
   
Agricultural
 Real Estate
   
Real Estate
 Construction
   
Residential 1st
 Mortgages
   
Home Equity
 Lines & Loans
   
Agricultural
   
Commercial
   
Consumer
 & Other
   
Unallocated
   
Total
 
                                                                                 
Year-To-Date Allowance for Loan Losses: