XNAS:BKYF Bank of Kentucky Financial Corp 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 quarterly period ended June 30, 2012

 

¨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: 001-34214

 

THE BANK OF KENTUCKY FINANCIAL CORPORATION
(Exact name of registrant as specified in its charter)

 

Kentucky   61-1256535
(State or other jurisdiction of   (I.R.S. Employer
incorporation or organization)   Identification Number)

 

111 Lookout Farm Drive, Crestview Hills, Kentucky  41017
(Address of principal executive offices) (Zip Code)

 

Registrant’s telephone number: (859) 371-2340

 

Indicate by checkmark whether the registrant (1) 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. Yesx No¨

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§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 ¨

 

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 “accelerated filer,” “large accelerated filer,” and “smaller reporting company,” in Rule 12b-2 of the Exchange Act (Check one):

Large accelerated filer ¨                          Accelerated filer x 

Non-accelerated filer ¨                            Smaller reporting company ¨

(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 ¨       No x

 

As of July 24, 2012, 7,465,841 shares of the registrant's Common Stock, no par value, were issued and outstanding.

 

 
 

 

The Bank of Kentucky Financial Corporation

 

INDEX

 

    PAGE 
Part I FINANCIAL INFORMATION
     
  Item 1 – Financial Statements 3
     
  Item 2 – Management’s Discussion and Analysis of   Financial Condition and Results of Operations 31
     
  Item 3 – Quantitative and Qualitative Disclosures About   Market Risk 48
     
  Item 4 – Controls and Procedures 48
     
Part II OTHER INFORMATION  
     
  Item 1 – Legal Proceedings 49
     
  Item 1A – Risk Factors 49
     
  Item 2 – Unregistered Sales of Equity Securities and Use of Proceeds 49
     
  Item 3 – Defaults Upon Senior Securities 49
     
  Item 4 – Mine Safety Disclosures 49
     
  Item 5 – Other Information 49
     
  Item 6 – Exhibits 49

 

2
 

 

PART I FINANCIAL INFORMATION

 

Item 1. Financial Statements

THE BANK OF KENTUCKY FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

(Dollars in thousands, except per share data - unaudited) 

  

June 30,

2012

  

December 31,

2011

 
Assets          
Cash and cash equivalents  $66,719   $135,964 
Interest-bearing deposits with banks   250    250 
Available-for-sale securities   321,322    322,512 
Held-to-maturity securities   54,882    48,975 
Loans held for sale   13,983    8,920 
Total loans   1,143,733    1,129,954 
Less:  Allowance for loan losses   18,346    18,288 
   Net loans   1,125,387    1,111,666 
Premises and equipment, net   22,923    22,827 
FHLB stock, at cost   5,099    5,099 
Goodwill   22,023    22,023 
Acquisition intangibles, net   2,833    3,228 
Cash surrender value of life insurance   33,232    32,850 
Accrued interest receivable and other assets   35,212    30,410 
Total assets  $1,703,865   $1,744,724 
           
Liabilities & Shareholders’ Equity          
Liabilities          
Deposits  $1,455,328   $1,498,821 
Short-term borrowings   24,373    29,300 
Notes payable   48,727    48,739 
Accrued interest payable and other liabilities   10,987    11,294 
Total liabilities   1,539,415    1,588,154 
           
Shareholders’ Equity          
Common stock, no par value, 15,000,000 shares authorized, 7,465,841(2012) and 7,432,995 (2011) shares issued   3,098    3,098 
Additional paid-in capital   34,873    34,121 
Retained earnings   122,742    116,038 
Accumulated other comprehensive income   3,737    3,313 
Total shareholders’ equity   164,450    156,570 
Total liabilities and shareholders’ equity  $1,703,865   $1,744,724 

 

See accompanying notes.

 

3
 

 

THE BANK OF KENTUCKY FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME

FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2012 AND 2011

(Dollars in thousands, except per share data - unaudited)

  

Three Months

Ended June 30

  

Six Months 

Ended June 30

 
  2012   2011   2012   2011 
INTEREST INCOME                     
Loans, including related fees  $13,791   $14,612   $27,592   $28,933 
Securities and other   1,870    1,811    3,757    3,489 
Total interest income   15,661    16,423    31,349    32,422 
                     
INTEREST EXPENSE                    
Deposits   1,348    2,142    2,914    4,539 
Borrowings   266    254    544    508 
Total interest expense   1,614    2,396    3,458    5,047 
                     
Net interest income   14,047    14,027    27,891    27,375 
Provision for loan losses   1,700    3,000    3,500    6,000 
Net interest income after provision for loan losses   12,347    11,027    24,391    21,375 
                     
NON-INTEREST INCOME                    
Service charges and fees   2,241    2,424    4,442    4,581 
Mortgage banking income   589    228    1,175    506 
Net securities gains (losses)   (4)   -    203    231 
Company owned life insurance earnings   290    279    610    542 
Bankcard transaction revenue   952    859    1,854    1,648 
Trust fee income   694    723    1,383    1,386 
Other   591    461    1,292    1,003 
Total non-interest income   5,353    4,974    10,959    9,897 
                     
NON-INTEREST EXPENSE                    
Salaries and benefits   5,724    5,045    11,175    9,799 
Occupancy and equipment   1,315    1,241    2,592    2,489 
Data processing   533    467    1,068    961 
Advertising   386    399    769    722 
Other   3,569    3,483    7,265    7,013 
Total non-interest expense   11,527    10,635    22,869    20,984 
                     
INCOME BEFORE INCOME TAXES   6,173    5,366    12,481    10,288 
Less: income taxes   1,749    1,572    3,542    2,982 
NET INCOME  $4,424   $3,794   $8,939   $7,306 
Preferred stock dividend and discount accretion   -    (259)   -    (516)
Net Income available to common shareholders  $4,424   $3,535   $8,939   $6,790 
Comprehensive Income  $4,933   $5,523   $9,363   $9,413 
Net income per common share:                    
Earnings per share, basic  $.59   $.48   $1.20   $.91 
Earnings per share, diluted  $.59   $.47   $1.19   $.91 

See accompanying notes.

 

4
 

 

THE BANK OF KENTUCKY FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

FOR THE THREE AND SIX MONTHS ENDED JUNE 30

(Dollars in thousands, except per share data -unaudited)

 

  Three Months   Six Months  
  Ended June 30    Ended June 30 
  

2012 

  

2011 

  

2012 

   2011 
Beginning balance  $159,474   $161,018   $156,570   $159,370 
Comprehensive income:                    
Net income   4,424    3,794    8,939    7,306 
Change in net unrealized gain(loss), net of tax   509    1,729    424    2,107 
Total comprehensive income   4,933    5,523    9,363    9,413 
                     
Cash dividends paid on common stock   -    -    (2,235)   (2,081)
Exercise of stock options (32,846 and 0 shares), including tax benefit   19    14    704    14 
Stock-based compensation expense   24    50    48    101 
Paid and accrued dividends on preferred stock   -    (212)   -    (424)
Balance as of  June 30  $164,450   $166,393   $164,450   $166,393 
Dividends per share  $-   $-   $0.30   $0.28 

 

See accompanying notes.

 

5
 

 

THE BANK OF KENTUCKY FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

FOR THE SIX MONTHS ENDED JUNE 30

(Dollars in thousands - unaudited)

 

   2012   2011 
         
Cash Flows from Operating Activities          
           
Net income  $8,939   $7,306 
Adjustments to reconcile net income to net cash From operating activities   (4,409)   22,192 
Net cash from operating activities   4,530    29,498 
           
Cash Flows from Investing Activities          
           
Net change in interest-bearing balances   -    (150)
Proceeds from paydowns and maturities of held-to-maturity securities   2,310    4,019 
Proceeds from paydowns and maturities of available-for-sale securities   104,002    95,626 
Purchases of held-to-maturity securities   (8,252)   (6,428)
Purchases of available-for-sale securities   (110,452)   (139,408)
Purchases of company owned life insurance   -    (6,500)
Net change in loans   (19,624)   (31,700)
Proceeds from the sale of other real estate   2,247    2,684 
Proceeds from the sale of securities   6,944    13,367 
Property and equipment expenditures   (987)   (235)
Net cash from investing activities   (23,812)   (68,725)
           
Cash Flows from Financing Activities          
           
Net change in deposits   (43,493)   (67,028)
Net change in short-term borrowings   (4,927)   (2,809)
Proceeds from exercise of stock options   704    14 
Cash dividends paid   (2,235)   (2,505)
Payments on note payable   (12)   (11)
Net cash from financing activities   (49,963)   (72,339)
           
Net change in cash and cash equivalents   (69,245)   (111,566)
Cash and cash equivalents at beginning of period   135,964    172,664 
Cash and cash equivalents at end of period  $66,719   $61,098 

 

See accompanying notes.

 

6
 

 

 

THE BANK OF KENTUCKY FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2012

(unaudited)

 

Note 1 - Basis of Presentation:

 

The condensed consolidated financial statements include the accounts of The Bank of Kentucky Financial Corporation (“BKFC” or the “Company”) and its wholly owned subsidiary, The Bank of Kentucky, Inc. (the “Bank”). All significant intercompany accounts and transactions have been eliminated.

 

Note 2 - General:

 

These financial statements were prepared in accordance with the instructions for Form 10-Q and Rule 10-01 of Regulation S-X and, therefore, do not include all of the disclosures necessary for a complete presentation of financial position, results of operations and cash flows in conformity with generally accepted accounting principles. Except for required accounting changes, these financial statements have been prepared on a basis consistent with the annual financial statements and include, in the opinion of management, all adjustments, consisting of only normal recurring adjustments, necessary for a fair presentation of the results of operations and financial position at the end of and for the periods presented. These financial statements and notes should be read in conjunction with the Company’s audited consolidated financial statements and notes thereto as set forth in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011.

 

The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions based on available information. These estimates and assumptions affect the amounts reported in the financial statements and the disclosures provided, and future results could differ. The allowance for loan losses and the fair values of financial instruments, in particular, are subject to change.

 

Note 3 - Earnings per Share:

 

Earnings per share are computed based upon the weighted average number of shares of common stock outstanding during the three and six month periods. Diluted earnings per share are computed assuming that average stock options and warrants outstanding are exercised and the proceeds, including the relevant tax benefit, are used entirely to reacquire shares at the average price for the period. For the three months ended June 30, 2012 and 2011, 262,874 and 326,682 options were not considered, as they were not dilutive, and for the six months ended June 30, 2012 and 2011, 273,555 and 399,160 options were not considered, as they were not dilutive. The following table presents the numbers of shares used to compute basic and diluted earnings per share for the indicated periods:

 

7
 

 

   Three Months
Ended
June 30
   Six Months
Ended
June 30
 
   2012   2011   2012   2011 
Weighted average shares outstanding   7,465,434    7,432,487    7,457,019    7,432,391 
Dilutive effects of assumed exercises of stock options and warrants   76,938    69,244    75,169    48,539 
Shares used to compute diluted earnings per share   7,542,372    7,501,731    7,532,188    7,480,930 

 

Note 4 – Stock-Based Compensation:

 

Options to buy stock are granted to directors, officers and employees under the Company’s stock option and incentive plan (the “Plan”), which provides for the issuance of up to 1,200,000 shares. The specific terms of each option agreement are determined by the Compensation Committee at the date of the grant. For current options outstanding, options granted to directors vest immediately and options granted to employees generally vest evenly over a five-year period.

 

The Company recorded stock option expense of $24,000 (net of taxes) and $51,000 (net of taxes) in the three and six months ended June 30, 2012, and $79,000 (net of taxes) and $157,000 (net of taxes) in the three and six months ended June 30, 2011.

 

Note 5 – Cash and Cash Equivalents:

 

Cash and cash equivalents include cash on hand, amounts due from banks, federal funds sold and investments in money market mutual funds. The Company reports net cash flows for customer loan and deposit transactions, interest-bearing balances with banks and short-term borrowings with maturities of 90 days or less.

 

Note 6 – Reclassification:

 

Certain prior period amounts have been reclassified to conform to the current period presentation. Such reclassifications have no effect on previously reported net income or shareholders’ equity.

 

Note 7 – New Accounting Pronouncements:

 

In May 2011, the Financial Accounting Standards Board (“FASB”) issued an amendment to achieve common fair value measurement and disclosure requirements between U.S. and International accounting principles. Overall, the guidance is consistent with existing U.S. accounting principles; however, there are some amendments that change a particular principle or requirement for measuring fair value or for disclosing information about fair value measurements. This update became effective for the Company for interim and annual reporting periods beginning after December 15, 2011 and did not have a material impact on the Company's consolidated financial position or results of operations.

 

8
 

 

In June 2011, the FASB amended existing guidance and eliminated the option to present the components of other comprehensive income as part of the statement of changes in shareholders’ equity. The amendment requires that comprehensive income be presented in either a single continuous statement or in two separate consecutive statements. This update became effective for the Company for interim and annual reporting periods beginning after December 15, 2011 and did not have a material impact on the Company's consolidated financial position or results of operations.

 

Note 8Securities:

 

The fair value of available-for-sale securities and the related gains and losses recognized in accumulated other comprehensive income (loss) was as follows (in thousands):

 

       Gross   Gross     
  Amortized   Unrealized   Unrealized   Fair 
Available-for-Sale   Cost   Gains   Losses   Value 
June 30, 2012                    
U.S. government, federal agencies and government sponsored enterprises  $135,012   $1,163   $(20)  $136,155 
U.S. government residential mortgage-backed   179,589    4,625    (107)   184,107 
Corporate   1,060    -    -    1,060 
   $315,661   $5,788   $(127)  $321,322 

 

       Gross   Gross     
   Amortized   Unrealized   Unrealized   Fair 
   Cost   Gains   Losses   Value 
December 31, 2011                    
U.S. government, federal agencies and government sponsored enterprises  $168,104   $1,368   $(12)  $169,460 
U.S. government residential mortgage-backed   148,329    3,727    (64)   151,992 
Corporate   1,060    -    -    1,060 
   $317,493   $5,095   $(76)  $322,512 

 

9
 

  

The carrying amount, unrecognized gains and losses, and fair value of securities held-to-maturity were as follows (in thousands):

 

       Gross   Gross     
  Amortized   Unrecognized   Unrecognized   Fair 
Held-to-Maturity   Cost   Gains   Losses   Value 
2012                    
Municipal and other obligations  $54,882   $1,921   $(57)  $56,746 
                     
2011                    
Municipal and other obligations  $48,975   $1,693   $(25)  $50,643 

 

The amortized cost and fair value of debt securities and carrying amount, if different, at June 30, 2012 by contractual maturity were as follows (in thousands), with securities not due at a single maturity date, primarily mortgage-backed securities, shown separately.

 

   Available-for-Sale   Held-to-Maturity 
   Amortized   Fair   Amortized   Fair 
   Cost   Value   Cost   Value 
Due in one year or less  $1,881   $1,894   $3,419   $3,440 
Due after one year through five years   65,648    66,294    27,251    28,215 
Due after five years through ten years   67,483    67,967    18,287    19,167 
Due after ten years   1,060    1,060    5,925    5,925 
U.S. Government agency mortgage-backed   179,589    184,107    -    - 
                     
   $315,661   $321,322   $54,882   $56,747 

 

Proceeds on the sale of $6,944,000 of available-for-sale securities resulted in gains of $203,000 for the first six months of 2012. No securities were sold with losses in the first six months of 2012. There was a $4,000 negative adjustment, recorded as of the settlement date, in the second quarter of 2012 with respect to the gain on sale of securities recorded in the first quarter of 2012. Proceeds on the sale of $13,367,000 of available-for-sale securities resulted in gains of $231,000 for the first six months of 2011, with no losses.

 

Management evaluates securities for other-than-temporary impairment (“OTTI”) at least on a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. Investment securities classified as available-for-sale or held-to-maturity are evaluated for OTTI under ASC 320, Accounting for Certain Investments in Debt and Equity Securities.

 

In determining OTTI, management considers many factors, including: (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, (3) whether the market decline was affected by macroeconomic conditions and (4) whether the entity has the intent to sell the debt security or more likely than not will be required to sell the debt security before its anticipated recovery. The assessment of whether an other-than temporary decline exists involves a high degree of subjectivity and judgment and is based on the information available to management at a point in time.

 

10
 

 

When OTTI occurs, the amount of the OTTI recognized in earnings depends on whether an entity intends to sell the security or more likely than not will be required to sell the security before recovery of its amortized cost basis less any current-period credit loss. If an entity intends to sell or more likely than not will be required to sell the security before recovery of its amortized cost basis less any current-period credit loss, the OTTI shall be recognized in earnings equal to the entire difference between the investment’s amortized cost basis and its fair value at the balance sheet date. Otherwise, the OTTI shall be separated into the amount representing the credit loss and the amount related to all other factors. The amount of the total OTTI related to the credit loss is determined based on the present value of cash flows expected to be collected and is recognized in earnings. The amount of the total OTTI related to other factors shall be recognized in other comprehensive income, net of applicable taxes. The previous amortized cost basis less the OTTI recognized in earnings shall become the new amortized cost basis of the investment.

 

As of June 30, 2012, the Bank’s security portfolio consisted of 226 securities, 17 of which were in an unrealized loss position of $184. There was no other-than-temporary-impairment of securities at June 30, 2012. Unrealized losses have not been recognized into income because the issuers’ bonds are of high credit quality (U.S. government agencies and government sponsored enterprises and “A” rated or better Kentucky municipalities), management does not have the intent to sell these securities and it is likely that it will not be required to sell the securities before their anticipated recovery.

 

Mortgage-backed Securities

 

At June 30, 2012, 100% of the mortgage-backed securities held by the Bank were issued by U.S. government sponsored entities and agencies, primarily Fannie Mae and Freddie Mac, institutions which the government has affirmed its commitment to support. Because a decline in market value would be attributable to changes in interest rates and illiquidity, and not credit quality, and because the Bank does not have the intent to sell these mortgage-backed securities and it is likely that it will not be required to sell the securities before their anticipated recovery, the Bank does not consider these securities to be other than temporarily impaired at June 30, 2012.

 

At June 30, 2012 and December 31, 2011, securities with a carrying value of $340,071 and $342,288 were pledged to secure public deposits and repurchase agreements.

 

Securities with unrealized losses at June 30, 2012 and December 31, 2011, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, were as follows (in thousands):

 

   Less than 12 Months   12 Months or More   Total 
   Fair   Unrealized   Fair   Unrealized   Fair   Unrealized 
Description of Securities  Value   Loss   Value   Loss   Value   Loss 
June 30, 2012                              
U.S. government, federal agencies and government sponsored enterprises  $14,193   $(20)  $-   $-   $14,193   $(20)
U.S. government residential mortgage-backed   23,532    (107)   -    -    23,532    (107)
Municipal & other obligations   3,559    (57)   -    -    3,559    (57)
                               
Total temporarily impaired  $41,284   $(184)  $-   $-   $41,284   $(184)
                               
December 31, 2011                              
U.S. government, federal agencies and government sponsored enterprises  $18,734   $(12)  $-   $-   $18,734   $(12)
U.S government residential mortgage-backed   36,707    (64)   -    -    36,707    (64)
Municipal & other obligations   3,225    (24)   388    (1)   3,613    (25)
Total temporarily impaired  $58,666   $(100)  $388   $(1)  $59,054   $(101)

 

11
 

 

Note 9 - Loans

 

Loan balances were as follows (in thousands):

   6/30/2012   12/31/2011 
Commercial  $181,932   $193,176 
Residential real estate   280,135    266,268 
Nonresidential real estate   539,748    523,485 
Construction   100,094    104,788 
Consumer   16,307    16,618 
Municipal obligations   27,014    27,066 
Gross loans   1,145,230    1,131,401 
Less:     Deferred loan origination fees and discount   (1,497)   (1,447)
             Allowance for loan losses   (18,346)   (18,288)
           
Net loans  $1,125,387   $1,111,666 

  

12
 

 

The following tables present the activity in the allowance for loan losses for the three months ending June 30, 2012 and the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment and based on impairment method as of June 30, 2012 and December 31, 2011 (in thousands):

 

           Non                 
       Residential   Residential           Municipal     
June 30, 2012  Commercial   Real estate   Real estate   Construction   Consumer   Obligations   Total 
Allowance for loan losses                                   
Beginning balance  $2,581   $2,916   $6,768   $5,694   $166   $237   $18,362 
Provision for loan losses   (406)   995    163    688    321    (61)   1,700 
Loans charged off   (16)   (148)   (269)   (1,219)   (156)   -    (1,808)
Recoveries   -    23    4    4    61    -    92 
                                    
Total ending allowance balance  $2,159   $3,786   $6,666   $5,167   $392   $176   $18,346 
                                    
Ending allowance balance attributable to loans                                   
Individually evaluated for impairment  $138   $870   $2,279   $4,229   $-   $-   $7,516 
Collectively evaluated for impairment   2,021    2,916    4,387    938    392    176    10,830 
                                    
Total ending allowance balance  $2,159   $3,786   $6,666   $5,167   $392   $176   $18,346 
                                    
Loans                                   
Loans individually evaluated for impairment  $865   $7,670   $19,913   $8,077   $-   $-   $36,525 
Loans collectively evaluated for impairment   181,067    272,465    519,835    92,017    16,307    27,014    1,108,705 
                                    
Total ending loans balance  $181,932   $280,135   $539,748   $100,094   $16,307   $27,014   $1,145,230 

 

13
 

 

The following tables present the activity in the allowance for loan losses for the six months ending June 30, 2012 and the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment and based on impairment method as of June 30, 2012 and December 31, 2011 (in thousands):

 

           Non                 
       Residential   Residential           Municipal     
June 30, 2012  Commercial   Real estate   Real estate   Construction   Consumer   Obligations   Total 
Allowance for loan losses                                   
Beginning balance  $3,207   $2,591   $7,614   $4,701   $162   $13   $18,288 
Provision for loan losses   (677)   1,687    220    1,706    401    163    3,500 
Loans charged off   (372)   (522)   (1,173)   (1,246)   (325)   -    (3,638)
Recoveries   1    30    5    6    154    -    196 
                                    
Total ending allowance balance  $2,159   $3,786   $6,666   $5,167   $392   $176   $18,346 
                                    
Ending allowance balance attributable to loans                                   
Individually evaluated for impairment  $138   $870   $2,279   $4,229   $-   $-   $7,516 
Collectively evaluated for impairment   2,021    2,916    4,387    938    392    176    10,830 
                                    
Total ending allowance balance  $2,159   $3,786   $6,666   $5,167   $392   $176   $18,346 
                                    
Loans                                   
Loans individually evaluated for impairment  $865   $7,670   $19,913   $8,077   $-   $-   $36,525 
Loans collectively evaluated for impairment   181,067    272,465    519,835    92,017    16,307    27,014    1,108,705 
                                    
Total ending loans balance  $181,932   $280,135   $539,748   $100,094   $16,307   $27,014   $1,145,230 

 

           Non                 
       Residential   Residential           Municipal     
June 30, 2011  Commercial   Real estate   Real estate   Construction   Consumer   Obligations   Total 
Allowance for loan losses                                   
Beginning balance  $3,440   $2,431   $8,126   $3,150   $166   $55   $17,368 
Provision for loan losses   1,387    396    1,138    2,844    253   (18)    6,000 
Loans charged off   (920)   (464)   (2,484)   (1,499)   (462)   -    (5,829)
Recoveries   24    40    2    1    210    -    277 
                                    
Total ending allowance balance  $3,931   $2,403   $6,782   $4,496   $167   $37   $17,816 

 

14
 

 

           Non                 
       Residential   Residential           Municipal     
December 31, 2011  Commercial   Real estate   Real estate   Construction   Consumer   Obligations   Total 
Ending allowance balance attributable to loans                                   
Individually evaluated for impairment  $224   $477   $2,994   $3,748   $-   $-   $7,443 
Collectively evaluated for impairment   2,983    2,114    4,620    953    162    13    10,845 
                                    
   $3,207   $2,591   $7,614   $4,701   $162   $13   $18,288 
Loans                                   
Loans individually evaluated for impairment  $917   $6,100   $20,390   $7,854   $-   $-   $35,261 
Loans collectively evaluated for impairment   192,259    260,168    503,095    96,934    16,618    27,066    1,096,140 
                                    
                                    
Total ending loans balance  $193,176   $266,268   $523,485   $104,788   $16,618   $27,066   $1,131,401 

  

15
 

 

The following table presents individually impaired loans by class of loans as of and for the three months ended June 30, 2012 (in thousands):

 

   Unpaid       Allowance for   Average   Interest     
   Principal   Recorded   Loan Losses   Recorded   Income   Interest 
   Balance   Investment   Allocated   Investment   Recognized   Received 
                         
With no related allowance recorded                              
Commercial  $349   $309   $-   $309   $-   $- 
                               
Residential real estate                              
Home equity lines of credit   50    50    -    50    -    - 
Multifamily properties   -    -    -    264    -    - 
Other   2,060    2,045    -    2,059    -    - 
                               
Nonresidential real estate                              
Owner occupied properties   188    188    -    574    -    - 
Non owner occupied properties   1,894    1,892    -    2,317    -    - 
                               
Construction   655    355    -    178    -    - 
                               
With an allowance recorded                              
Commercial   557    557    138    1,001    2    1 
                               
Residential real estate                              
Home equity lines of credit   137    137    137    137    -    - 
Multifamily properties   2,115    1,784    241    892    11    11 
Other   3,729    3,654    492    3,642    21    17 
                               
Nonresidential real estate                              
Owner occupied properties   9,009    9,008    1,124    9,037    78    77 
Non owner occupied properties   9,644    8,824    1,155    8,246    47    22 
                               
Construction   8,834    7,722    4,229    8,824    46    41 
                               
Total  $39,221   $36,525   $7,516   $37,530   $205   $169 

  

16
 

 

The following table presents individually impaired loans by class of loans as of and for the six months ended June 30, 2012 (in thousands):

 

   Unpaid       Allowance for   Average   Interest     
   Principal   Recorded   Loan Losses   Recorded   Income   Interest 
   Balance   Investment   Allocated   Investment   Recognized   Received 
                         
With no related allowance recorded                              
Commercial  $349   $309   $-   $309   $-   $- 
                               
Residential real estate                              
Home equity lines of credit   50    50    -    50    -    - 
Multifamily properties   -    -    -    398    -    - 
Other   2,060    2,045    -    1,973    -    - 
                               
Nonresidential real estate                              
Owner occupied properties   188    188    -    802    -    - 
Non owner occupied properties   1,894    1,892    -    2,373    -    - 
                               
Construction   655    355    -    169    -    - 
                               
With an allowance recorded                              
Commercial   557    557    138    1,013    3    1 
                               
Residential real estate                              
Home equity lines of credit   137    137    137    103    -    - 
Multifamily properties   2,115    1,784    241    446    11    11 
Other   3,729    3,654    492    3,681    45    40 
                               
Nonresidential real estate                              
Owner occupied properties   9,009    9,008    1,124    9,235    158    156 
Non owner occupied properties   9,644    8,824    1,155    7,884    109    72 
                               
Construction   8,834    7,722    4,229    8,778    118    110 
                               
Total  $39,221   $36,525   $7,516   $37,214   $444   $390 

  

17
 

 

The following table presents individually impaired loans by class of loans as of and for the six months ended June 30, 2011 (in thousands):

 

   Unpaid       Allowance for   Average   Interest     
   Principal   Recorded   Loan Losses   Recorded   Income   Interest 
   Balance   Investment   Allocated   Investment   Recognized   Received 
                         
With no related allowance recorded                              
Commercial  $722   $432   $-   $371   $-   $- 
                               
Residential real estate                              
Home equity lines of credit   -    -    -    -    -    - 
Multifamily properties   -    -    -    17    -    - 
Other   2,529    2,529    -    1,337    -    - 
                               
Nonresidential real estate                              
Owner occupied properties   341    218    -    143    -    - 
Non owner occupied properties   1,196    1,190    -    867    -    - 
                               
Construction   1,757    928    -    464    -    - 
                               
With an allowance recorded                              
Commercial   3,616    3,361    1,320    2,230    7    4 
                               
Residential real estate                              
Home equity lines of credit   -    -    -    -    -    - 
Multifamily properties   870    870    247    871    28    19 
Other   2,679    2,660    581    2,610    36    34 
                               
Nonresidential real estate                              
Owner occupied properties   897    897    178    1,503    1    1 
Non owner occupied properties   9,332    7,915    1,753    9,252    125    120 
                               
Construction   10,432    9,191    3,587    8,829    127    108 
                               
Total  $34,371   $30,191   $7,666   $28,494   $324   $286 

  

18
 

 

The following table presents loans individually evaluated for impairment by class of loans as of December 31, 2011 (in thousands):

 

   Unpaid       Allowance for 
   Principal   Recorded   Loan Losses 
   Balance   Investment   Allocated 
             
With no related allowance recorded               
Commercial  $350   $310   $- 
                
Residential real estate               
Home equity lines of credit   50    50    - 
Multifamily properties   538    538    - 
Other   1,703    1,703    - 
                
Nonresidential real estate               
Owner occupied properties   1,101    1,101    - 
Non owner occupied properties   2,122    2,116    - 
                
Construction   356    319    - 
                
With an allowance recorded               
Commercial   733    607    224 
                
Residential real estate               
Home equity lines of credit   -    -    - 
Multifamily properties   -    -    - 
Other   3,859    3,809    477 
                
Nonresidential real estate               
Owner occupied properties   10,771    9,798    1,477 
Non owner occupied properties   8,476    7,375    1,517 
                
Construction   8,267    7,535    3,748 
                
Total  $38,326   $35,261   $7,443 

 

19
 

 

The following table presents the aging of the recorded investment in past due loans by class of loans as of June 30, 2012 and December 31, 2011 (in thousands):

 

   Loans   Loans over             
   30-90 days   90 days       Loans not     
   past due   past due   Nonaccrual   past due   Total 
June 30, 2012                         
Commercial  $498   $-   $1,074   $180,360   $181,932 
Residential real estate                         
Home equity lines of credit   241    -    1,095    100,244    101,580 
Multifamily properties   -    -    448    42,908    43,356 
Other residential real estate   1,055    -    4,388    129,756    135,199 
                          
Nonresidential real estate                         
Owner occupied properties   1,747    -    1,653    263,562    266,962 
Non owner occupied properties   3,369    126    3,583    265,708    272,786 
Construction   78    -    3,798    96,218    100,094 
                          
Consumer                         
Credit card balances   20    68    -    6,239    6,327 
Other consumer   43    1    226    9,710    9,980 
                          
Municipal obligations   -    -    -    27,014    27,014 
                          
Total  $7,051   $195   $16,265   $1,121,719   $1,145,230 

 

   Loans   Loans over             
   30-90 days   90 days       Loans not     
   past due   past due   Nonaccrual   past due   Total 
December 31, 2011                         
Commercial  $692   $74   $1,175   $191,235   $193,176 
Residential real estate                         
Home equity lines of credit   1,094    -    910    92,676    94,680 
Multifamily properties   -    -    -    36,756    36,756 
Other residential real estate   5,854    112    4,415    124,451    134,832 
                          
Nonresidential real estate                         
Owner occupied properties   2,623    -    2,270    247,875    252,768 
Non owner occupied properties   3,942    -    4,358    262,417    270,717 
Construction   265    -    1,897    102,626    104,788 
                          
Consumer                         
Credit card balances   60    32    -    6,400    6,492 
Other consumer   37    1    626    9,462    10,126 
                          
Municipal obligations   -    -    -    27,066    27,066 
                          
Total  $14,567   $219   $15,651   $1,100,964   $1,131,401 

  

20
 

 

Troubled Debt Restructurings:

 

The Company has allocated $4,374,000 and $2,074,000 of specific reserves to customers whose loan terms have been modified in troubled debt restructurings as of June 30, 2012 and December 31, 2011, respectively. Troubled debt restructurings totaled $20,737,000 and $15,229,000 as of June 30, 2012 and December 31, 2011, respectively. The Company has not committed to lend additional amounts as of June 30, 2012 and December 31, 2011 to customers with outstanding loans that are classified as troubled debt restructurings.

 

Modifications involving a reduction of the stated interest rate of the loan were for periods up to three years. Modifications involving an extension of the maturity date were for periods ranging from eight months to twelve months.

 

The following table presents loans by class modified as troubled debt restructurings that occurred during the six months ending June 30, 2012:

 

       Pre-Modification   Post-Modification 
       Outstanding Recorded   Outstanding Recorded 
   Number of Loans   Investment   Investment 
Troubled Debt Restructurings:               
                
Commercial   3   $508,281   $467,796 
Residential real estate               
Home equity lines of credit   -    -    - 
Multifamily properties               
Other residential real estate   6    4,170,926    4,049,039 
Nonresidential real estate               
Owner occupied properties   3    8,137,536    7,857,519 
Non owner occupied properties   4    3,661,111    3,152,428 
Construction   6    5,463,376    5,210,624 
Consumer               
Credit card balances   -    -    - 
Other consumer   -    -    - 
                
Municipal obligations   -    -    - 
                
Total   22   $21,941,230   $20,737,406 

 

The troubled debt restructurings described above increased the allowance for loan losses by $681,727 and resulted in charge-offs of $1,112,147 during the second quarter ending June 30, 2012 and $1,262,147 for the six months ending June 30, 2012.

 

The following table presents loans by class modified as troubled debt restructurings for which there was a payment default within twelve months following the modification during the period ending June 30, 2012:

 

21
 

 

Troubled Debt Restructurings        
That Subsequently Defaulted:  Number of Loans   Recorded Investment 
           
Commercial   3   $467,796 
Residential real estate          
Home equity lines of credit          
Multifamily properties          
Other residential real estate   3    3,195,080 
Nonresidential real estate          
Owner occupied properties   1    7,647,784 
Non owner occupied properties   3    1,472,171 
Construction   2    3,168,504 
Consumer          
Credit card balances          
Other consumer          
Municipal obligations   -    - 
           
Total   12   $15,951,335 

 

A loan is considered to be in payment default once it is 30 days contractually past due under the modified terms.

 

The troubled debt restructurings that subsequently defaulted described above increased the allowance for loan losses by $411,322 and resulted in charge-offs of $1,112,147 during the second quarter ending June 30, 2012 and $1,262,147 for the six months ending June 30, 2012.

 

Credit Quality Indicators:

 

The Company categorizes loans into risk categories based on relevant information about the ability of borrowers to service their debt, including: current financial information, historical payment experience, credit documentation, public information and current economic trends, among other factors. The Company analyzes loans individually by classifying the loans as to credit risk. This analysis includes loans with an outstanding balance greater than $100,000 and non-homogeneous loans, such as commercial and commercial real estate loans. This analysis is performed on a quarterly basis. Loans with balances below $100,000 and homogenous loans, such as residential real estate and consumer loans, are analyzed for credit quality based on aging status, which was previously presented. The Company uses the following definitions for risk ratings:

 

Special Mention. Loans classified as special mention have a potential weakness that deserves management's close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or of the institution's credit position at some future date.

 

Substandard. Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.

 

22
 

 

Doubtful. Loans classified as 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 existing facts, conditions and values, highly questionable and improbable.

 

Based on the most recent analysis performed, the risk category of loans by class of loans is as follows (in thousands):

 

       Special                 
   Pass   Mention   Substandard   Doubtful   Not Rated(1)   Total 
June 30, 2012                              
Commercial  $161,292   $16,847   $3,793   $-   $-   $181,932 
Residential real estate                              
Home equity lines of credit   11,472    965    1,006    90    88,047    101,580 
Multifamily properties   41,471    101    1,784    -    -    43,356 
Other residential real estate   40,109    1,133    10,844    31    83,082    135,199 
                               
Nonresidential real estate                              
Owner occupied properties   232,488    16,713    17,761    -    -    266,962 
Non owner occupied properties   249,678    7,827    15,281    -    -    272,786 
Construction   85,966    3,383    10,745    -    -    100,094 
                               
Consumer                              
Credit card balances   -    -    -    2    6,325    6,327 
Other consumer   -    -    16    -    9,964    9,980 
Municipal obligations   27,014    -    -    -    -    27,014 
                               
Total  $849,490   $46,969   $61,230   $123   $187,418   $1,145,230 

 

(1) Not rated loans represent the homogenous pools risk category.

 

       Special                 
   Pass   Mention   Substandard   Doubtful   Not Rated(1)   Total 
December 31, 2011                              
Commercial  $170,394   $9,684   $13,098   $-   $-   $193,176 
Residential real estate                              
Home equity lines of credit   -    712    976    84    92,908    94,680 
Multifamily properties   36,115    103    538    -    -    36,756 
Other residential real estate   38,725    1,357    10,843    -    83,907    134,832 
                               
Nonresidential real estate                              
Owner occupied properties   221,941    7,754    23,073    -    -    252,768 
Non owner occupied properties   246,614    8,902    15,201    -    -    270,717 
Construction   90,297    3,398    11,093    -    -    104,788 
                               
Consumer                              
Credit card balances   -    -    -    -    6,492    6,492 
Other consumer   -    -    22    -    10,104    10,126 
Municipal obligations   27,066    -    -    -    -    27,066 
                               
Total  $831,152   $31,910   $74,844   $84   $193,411   $1,131,401 

 

(1) Not rated loans represent the homogenous pools risk category.

 

23
 

 

Note 10 –Fair Value:

Accounting guidance establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value:

 

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

 

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

 

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

 

Investment Securities: The fair values of securities available-for-sale are determined by matrix pricing, which is a mathematical technique widely used in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted securities (Level 2 inputs). One corporate security is valued using Level 3 inputs as there is no readily observable market activity. Management determines the value of this security based on expected cash flows, the credit quality of the security and current market interest rates.

 

Derivatives: The Bank’s derivative instruments consist of over-the-counter interest-rate swaps that trade in liquid markets. The fair value of the derivative instruments is primarily measured by obtaining pricing from broker-dealers recognized to be market participants. The pricing is derived from market observable inputs that can generally be verified and do not typically involve significant judgment by the Bank. This valuation method is classified as Level 2 in the fair value hierarchy.

 

Impaired Loans: At the time a loan is considered impaired, it is valued at the lower of cost or fair value. Impaired loans carried at fair value generally receive specific allocations of the allowance for loan losses. For collateral dependent loans, fair value is commonly based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value. Non-real estate collateral may be valued using an appraisal, net book value per the borrower’s financial statements or aging reports, adjusted or discounted based on management’s historical knowledge, changes in market conditions from the time of the valuation and management’s expertise and knowledge of the client and client’s business, resulting in a Level 3 fair value classification. Impaired loans are evaluated on a quarterly basis for additional impairment and adjusted accordingly.

 

24
 

 

Other Real Estate Owned: Assets acquired through or instead of loan foreclosure are initially recorded at fair value less costs to sell when acquired, establishing a new cost basis. These assets are subsequently accounted for at the lower of cost or fair value less estimated costs to sell. Fair value is commonly based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value.

 

Loans Held For Sale: Loans held for sale are carried at the lower of cost or fair value, which is evaluated on a pool-level basis. The fair value of loans held for sale is determined using quoted prices for similar assets, adjusted for specific attributes of that loan or other observable market data, such as outstanding commitments from third party investors (Level 2).

 

Assets and Liabilities Measured on a Recurring Basis

Assets and liabilities measured at fair value on a recurring basis are summarized below (in thousands):

 

       Fair Value Measurements at 
       June 30, 2012 Using: 
           Significant     
       Quoted Prices in   Other   Significant 
   Total   Active Markets for   Observable   Unobservable 
   June 30,   Identical Assets   Inputs   Inputs 
   2012   (Level 1)   (Level 2)   (Level 3) 
Assets                    
Investment securities available-for-sale                    
U.S. government sponsored entities and agencies  $136,155   $-   $136,155   $- 
U.S. government agency mortgage backed   184,107    -    184,107    - 
Corporate   1,060    -    -    1,060 
Derivatives   1,596    -    1,596    - 
Total  $322,918   $-   $321,858   $1,060 
                     
Liabilities                    
Derivatives  $1,596   $-   $1,596   $- 
Total  $1,596   $-   $1,596   $- 

 

       Fair Value Measurements at 
       December 31, 2011 Using: 
           Significant     
       Quoted Prices in   Other   Significant 
   Total   Active Markets for   Observable   Unobservable 
   December 31,   Identical Assets   Inputs   Inputs 
   2011   (Level 1)   (Level 2)   (Level 3) 
Assets                    
Investment securities available-for-sale                    
U.S. government sponsored entities and agencies  $169,460    -    169,460    - 
U.S. government agency mortgage backed   151,992    -    151,992    - 
Corporate   1,060    -    -    1,060 
Derivatives   1,349    -    1,349    - 
Total  $323,861    -    322,801    1,060 
                     
Liabilities                    
Derivatives  $1,349    -    1,349    - 
Total  $1,349    -    1,349    - 

 

25
 

 

There were no transfers between Level 1 and Level 2 during 2012 or 2011.

 

There were no gains or losses for assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the quarter ended June 30, 2012.

 

There were no changes in unrealized gains and losses recorded in earnings for the quarter ended June 30, 2012 for Level 3 assets and liabilities that are still held at June 30, 2012.

 

The table below presents a reconciliation of all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the period ended June 30 (in thousands):

 

   Corporate Securities 
   6/30/12   12/31/11 
         
Balance of recurring Level 3 assets at January 1  $1,060   $1,060 
Total gains or losses for the period:          
Included in earnings          
Included in other comprehensive income          
Purchases   -    - 
Sales   -    - 
Issuances   -    - 
Settlements   -    - 
Transfers into Level 3   -    - 
Transfers out of Level 3   -    - 
           
Balance of recurring Level 3 assets at December 31  $1,060   $1,060 

 

The following table presents quantitative information about recurring Level 3 fair value measurements at June 30, 2012 (in thousands):

 

      Valuation        
   Fair value   Technique(s)  Unobservable Input(s)  Value 
               
Corporate security  $1,060   Discounted cash flow  Probability of default   0%

 

The interest rate on this security is based on interest rates paid for securities with similar credit characteristics, but the probability of default is determined through a credit quality review rather than formal ratings or other observable inputs. The interest rate adjusts to reflect current market conditions of highly rated investments, if probability of default changed significantly, the interest rate would adjust accordingly and the fair value would be updated. Management reviews this interest rate and the security’s credit quality quarterly and a market value adjustment is made if necessary pursuant to this review.

 

26
 

 

Assets and Liabilities Measured on a Non-Recurring Basis

(Dollars in thousands)

Assets and liabilities measured at fair value on a non-recurring basis are summarized below:

 

       Fair Value Measurements at 
       June 30, 2012 Using: 
           Significant     
       Quoted Prices in   Other   Significant 
   Total   Active Markets for   Observable   Unobservable 
   June 30   Identical Assets   Inputs   Inputs 
   2012   (Level 1)   (Level 2)   (Level 3) 
Assets                    
Impaired loans:                    
Commercial  $419   $-   $75   $344 
Nonresidential real estate   -                
Owner occupied properties   7,884    -    605    7,279 
Non owner occupied properties   7,669    -    906    6,763 
Residential real estate                    
Home equity lines of credit   -    -    -    - 
Multifamily properties   1,543    -    -    1,543 
Other   3,162    -    2,672    490 
Construction   3,493    -    2,801    692 
Total  $24,170   $-   $7,059   $17,111 

 

       Fair Value Measurements at 
       December 31, 2011 Using: 
           Significant     
       Quoted Prices in   Other   Significant 
   Total   Active Markets for   Observable   Unobservable 
   December 31   Identical Assets   Inputs   Inputs 
   2011   (Level 1)   (Level 2)   (Level 3) 
Assets                    
Impaired loans                    
Commercial  $383   $-   $-   $383 
Nonresidential real estate   -                
Owner occupied properties   8,320    -    -    8,320 
Non owner occupied properties   5,858    -    375    5,483 
Residential real estate                    
Home equity lines of credit   -    -    -    - 
Multifamily properties   -    -    -    - 
Other   3,332    -    1,832    1,500 
Construction   3,787    -    214    3,573 
Total  $21,680   $-   $2,421   $19,259 

 

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Impaired loans, which are measured for impairment using the fair value of the collateral for collateral dependent loans, had a gross carrying amount of $31,686,000 with a valuation allowance of $7,516,000, resulting in an increase in provision for loan losses of $73,000 for the first half of 2012. As of December 31, 2011, impaired loans had a gross carrying amount of $29,124,000, with a valuation allowance of $7,443,000, resulting in an increase in provision for loan losses of $1,699,000.

 

Values for collateral dependent loans are generally based on appraisals obtained from licensed real estate appraisers and in certain circumstances consideration of offers obtained to purchase properties prior to foreclosure or other factors management deems relevant to arrive at a representative fair value.  Appraisals for commercial real estate generally use three methods to derive value: cost, sales or market comparison and income approach.  The cost method bases value on the cost to replace the current property.  The market comparison approach evaluates the sales price of similar properties in the same market area.  The income approach considers net operating income generated by the property and an investor’s required return.  The final fair value is based on a reconciliation of these three approaches. The loans classified as Level 2 had current and viable appraisals, while loans classified as Level 3 had older appraisals and required the use of other unobservable inputs with additional discounts ranging from 5% to10%.

 

The following table presents quantitative information about recurring Level 3 fair value measurements at June 30, 2012 (in thousands):

  Fair
Value
   Valuation Technique(s)   Unobservable Input(s)    Value 
Assets                    
Impaired Loans:                    
Commercial   344   Cost, sales, income approach   adjustments for comparable properties, market conditions    5-10% 
Nonresidential real estate                    
Owner occupied properties   7,279   Cost, sales, income approach   adjustments for comparable properties, market conditions    5-10% 
Non owner occupied properties   6,763   Cost, sales, income approach   adjustments for comparable properties, market conditions    5-10% 
Residential real estate                    
Home equity lines of credit                    
Multifamily properties   1,543   Cost, sales, income approach   adjustments for comparable properties, market conditions    5-10% 
Other   490   Cost, sales, income approach   adjustments for comparable properties, market conditions    5-10% 
Construction   692   Cost, sales, income approach   adjustments for comparable properties, market conditions    5-10% 
Total   17,111                

 

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The carrying amounts and estimated fair values of financial instruments at June 30, 2012 and December 31, 2011 are as follows (in thousands):

 

       Fair Value Measurements at 
       June 30, 2012 Using: 
   Carrying Value   Level 1   Level 2   Level 3   Total 
(Dollars in thousands)                    
Financial assets                         
Cash and cash equivalents  $66,719   $66,719   $    $    $66,719 
Interest-bearing deposits with Banks   250         250         250 
Securities available-for-sale   321,322         320,262    1,060    321,322 
Securities held-to-maturity   54,882         56,746         56,746 
Federal Home Loan Bank stock   5,099    N/A              N/A 
Loans held for sale   13,983         13,983         13,983 
Loans, net   1,125,387         1,111,953    17,111    1,129,064 
Accrued interest receivable   4,684         4,684         4,684 
Derivative assets   1,596         1,596         1,596 
Financial liabilities                         
Deposits  $(1,455,328)  $ (1,081,198)  $(374,130)  $     $(1,455,328)
Short-term borrowings   (24,373)        (24,373)        (24,373)
Notes payable   (48,727)        (21,497)   (22,355)   (43,852)
Accrued interest payable   (1,201)        (1,201)        (1,201)
Standby letters of credit   (180)        (180)        (180)
Derivative liabilities   (1,596)        (1,596)        (1,596)

 

       Fair Value Measurements at 
       December 31, 2011 Using: 
   Carrying Value   Level 1   Level 2   Level 3   Total 
(Dollars in thousands)                    
Financial assets                         
Cash and cash equivalents  $135,964   $135,964   $    $    $135,964 
Interest-bearing deposits with Banks   250         250         250 
Securities available-for-sale   322,512         321,452    1,060    322,512 
Securities held-to-maturity   48,975         50,643         50,643 
Federal Home Loan Bank stock   5,099    N/A              N/A 
Loans held for sale   8,920         8,920         8,920 
Loans, net   1,111,666         1,093,529    19,259    1,112,788 
Accrued interest receivable   4,887         4,887         4,887 
Derivative assets   1,349         1,349         1,349 
Financial liabilities                         
Deposits  $(1,498,821)  $ (1,092,434)  $(408,859)  $    $(1,501,293)
Short-term borrowings   (29,300)        (29,300)        (29,300)
Notes payable   (48,739)        (27,477)   (18,476)   (45,953)
Accrued interest payable   (1,582)        (1,582)        (1,582)
Standby letters of credit   (263)        (263)        (263)
Derivative liabilities   (1,349)        (1,349)        (1,349)

 

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The estimated fair value approximates carrying amounts for all items except those described below. The carrying amounts of cash and short-term instruments approximate fair values and are classified as either Level 1 or Level 2. Estimated fair value for both securities available-for-sale and held-to-maturity is as previously described for securities available-for-sale. It is not practicable to determine the fair value of Federal Home Loan Bank stock due to restrictions placed on its transferability. Fair values of loans, excluding loans held for sale, are estimated as set forth below:

 

For variable rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values resulting in a Level 2 classification. Fair values for other loans are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality resulting in a Level 2 classification. Impaired loans are valued at the lower of cost or fair value as described previously. The methods utilized to estimate the fair value of loans do not necessarily represent an exit price. The fair value of loans held for sale is estimated based upon binding contracts and quotes from third party investors resulting in a Level 2 classification. The fair values disclosed for demand deposits (e.g., interest and non-interest checking, passbook savings and certain types of money market accounts) are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amount) resulting in either a Level 1 or Level 2 classification. The carrying amounts of variable rate, fixed-term money market accounts and certificates of deposit approximate their fair values at the reporting date resulting in either a Level 2 or Level 3 classification. Fair values for fixed rate certificates of deposit are estimated using a discounted cash flows calculation that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits resulting in a Level 3 classification. The carrying amounts of federal funds purchased, borrowings under repurchase agreements and other short-term borrowings, generally maturing within ninety days, approximate their fair values resulting in a Level 2 classification. The fair values of the Company’s long-term borrowings are estimated using discounted cash flow analyses based on the current borrowing rates for similar types of borrowing arrangements resulting in a Level 2 classification. The fair values of the Company’s subordinated debentures are estimated using discounted cash flow analyses based on the current borrowing rates for similar types of borrowing arrangements resulting in a Level 3 classification. Fair values for off-balance sheet, credit-related financial instruments 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. The fair value of commitments is not material. Estimated fair value of standby letters of credit are based on their current unearned fee balance. Estimated fair value for commitments to make loans and unused lines of credit are considered nominal. Estimated fair value for derivatives is determined as previously described above.

 

30
 

 

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

 

The objective of this section is to help shareholders and potential investors understand our views on our results of operations and financial condition. You should read this discussion in conjunction with the consolidated financial statements and notes to the consolidated financial statements that appear elsewhere in this quarterly report on form 10-Q (this “Quarterly Report”). References to “we,” “us,” and “our” in this section refer to the Bank of Kentucky Financial Corporation (“BKFC”) and its subsidiaries, including The Bank of Kentucky, Inc. (“the Bank”), unless otherwise specified or unless the context otherwise requires.

 

FORWARD-LOOKING STATEMENTS

 

Certain statements contained in this quarterly report which are not statements of historical fact constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Examples of forward-looking statements include, but are not limited to, projections of revenues, income or loss, earnings or loss per share, the payment or non-payment of dividends, capital structure and other financial items; statements of plans and objectives of us or our management or Board of Directors; and statements of future economic performance and statements of assumptions underlying such statements. Words such as “believes,” “anticipates,” “intends” and other similar expressions are intended to identify forward-looking statements but are not the exclusive means of identifying such statements.

 

Forward-looking statements involve risks and uncertainties that may cause actual results to differ materially from those in such statements. Factors that could cause actual results to differ from those discussed in the forward-looking statements include, but are not limited to, the following:

 

·indications of an improving economy may prove to be premature;

 

·general economic or industry conditions could be less favorable than expected, resulting in a deterioration in credit quality, a change in the allowance for credit losses or a reduced demand for credit or fee-based products and services;

 

·changes or volatility in interest rates may adversely impact the value of securities, loans, deposits and other financial instruments and the interest rate sensitivity of our balance sheet as well as our liquidity;

 

·our ability to determine accurate values of certain assets and liabilities;

 

·the impact of turmoil in the financial markets and the effectiveness of governmental actions taken in response, and the effect of such governmental actions on us, our competitors and counterparties, financial markets generally and availability of credit specifically;

 

·changes in the extensive laws, regulations and policies governing financial services companies, including the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), and any regulations promulgated thereunder;

 

·the potential need to adapt to industry changes in information technology systems, on which the Bank is highly dependent, could present operational issues or require significant capital spending;

 

31
 

 

·competitive pressures could intensify and affect the Bank’s profitability, including as a result of continued industry consolidation, the increased availability of financial services from non-banks, technological developments or bank regulatory reform; and

 

·acquisitions may not produce revenue enhancements or cost savings at levels or within timeframes originally anticipated, or may result in unforeseen integration difficulties.

 

Any forward-looking statements made by us or on our behalf speak only as of the date they are made, and we do not undertake any obligation to update any forward-looking statement to reflect the impact of subsequent events or circumstances. Before making an investment decision, you should carefully consider all risks and uncertainties disclosed in our other public documents on file with the Securities and Exchange Commission (“SEC”), including those described in Item 1A of our Annual Report on Form 10-K, for the year ended December 31, 2011.

  

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

 

BKFC has prepared all of the consolidated financial information in this Quarterly Report in accordance with GAAP. In preparing the consolidated financial statements in accordance with generally accepted accounting principles, BKFC makes estimates and assumptions that affect the reported amount of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. There can be no assurances that actual results will not differ from those estimates.

 

We have identified the accounting policy related to the allowance for loan losses as critical to the understanding of BKFC’s results of operations, since the application of this policy requires significant management assumptions and estimates that could result in reporting materially different amounts if conditions or underlying circumstances were to change.

 

The Bank maintains an allowance to absorb probable, incurred loan losses inherent in the loan portfolio. The allowance for loan losses is maintained at a level the Bank considers to be adequate and is based upon ongoing quarterly assessments and evaluations of the collectability and historical loss experience of loans. Loan losses are charged and recoveries are credited to the allowance for loan losses. Provisions for loan losses are based on the Bank’s review of its historical loan loss experience and such factors that, in management’s judgment, deserve consideration under existing economic conditions in estimating probable loan losses. The Bank’s strategy for credit risk management includes a combination of well-defined credit policies, uniform underwriting criteria and ongoing risk monitoring and review processes for all commercial and consumer credit exposures. The credit risk management strategy also includes assessments of compliance with commercial and consumer policies, risk ratings and other important credit information. The strategy also emphasizes regular credit examinations and management reviews of loans exhibiting deterioration in credit quality. The Bank strives to identify potential problem loans early and promptly undertake the appropriate actions necessary to mitigate or eliminate the increasing risk identified in these loans.

 

32
 

 

The allowance for loan losses consists of two components, the specific reserve, pursuant to ASC 310, Accounting by Creditors for Impairment of a Loan, and the general reserve, pursuant to ASC 450-10, Accounting for Contingencies. A loan is considered impaired when, based upon current information and events, it is probable that the bank will be unable to collect all amounts due according to the contractual terms of the loan. The specific reserve component is an estimate of loss based upon an impairment review of larger loans that are considered impaired. The general reserve includes an estimate of commercial and consumer loans with similar characteristics. Depending on the set of facts with respect to a particular loan, the Bank utilizes one of the following methods for determining the proper impairment of a loan:

 

·the present value of expected future cash flows of a loan;
·the market price of the loan based upon readily available information for that type of loan; and
·the fair value of collateral.

 

The allowance established for impaired loans is generally based, for all collateral-dependent loans, on the fair market value of the collateral, less the estimated cost to liquidate. For non-collateral dependent loans (such as accruing troubled debt restructurings), the allowance is based on the present value of expected future cash flows discounted by the loan’s effective interest rate. A small portion of the Bank’s loans which are impaired under the ASC 310 process carry no specific reserve allocation. These loans were reviewed for impairment and are considered adequately collateralized with respect to their respective outstanding principal loan balances. The majority of these loans are loans which have had their respective impairment (or specific reserve) amounts charged off, or are loans related to other impaired loans which continue to have a specific reserve allocation. It is the Bank’s practice to maintain these impaired loans, as analyzed and provided for in the ASC 310 component of the allowance for loan losses, to avoid double counting of any estimated losses that may have been included in the ASC 450-10 component of the allowance for loan losses.

 

Generally, the Bank orders a new or updated appraisal on real estate properties which are subject to an impairment review. Upon completion of the impairment review, loan reserves are increased as warranted. Charge-offs, if necessary, are generally recognized in a period after the reserves were established. Adjustments to new or updated appraisal values are not typical, but in those cases when an adjustment is necessary, it is documented with supporting information and typically results in an adjustment to decrease the property’s value because of additional information obtained concerning the property after the appraisal or update has been received by the Bank. If a new or updated appraisal is not available at the time of a loan’s impairment review, the Bank typically applies a discount to the value of an old appraisal to reflect the property’s current estimated value if there is believed to be deterioration in either (i) the physical or economic aspects of the subject property or (ii) any market conditions. Updated valuations on 1 to 4 family residential properties with small to moderate values are generally accomplished by obtaining an Automated Valuation Model (“AVM”) or a Broker’s Price Opinion (“BPO”). Generally, an “as is” value is utilized in most of the Bank’s real estate based impairment analyses. However, under certain limited circumstances, an “as stabilized” valuation may be utilized, provided that the “as stabilized” value is tied to a well-justified action plan to bring the real estate project to a stabilized occupancy under a reasonable period of time.

 

If a partially charged-off loan has been restructured in a manner that is reasonably assured of repayment and performance according to prudently modified terms, and has sustained historical payment performance for a reasonable period of time prior to and/or after the restructuring, it may be returned to accrual status and classified as a TDR loan. However, if the above conditions can not be reasonably met, the loan remains on non-accrual status.

 

33
 

 

In addition, the Bank evaluates the collectability of both principal and interest when assessing the need for loans to be placed on non-accrual status. Non-accrual status denotes loans in which, in the opinion of management, the collection of additional interest is unlikely. A loan is generally placed on non-accrual status if: (i) it becomes 90 days or more past due (120 days past due for consumer loans) or (ii) for which payment in full of both principal and interest can not be reasonably expected.

 

Historical loss rates are applied to all other loans not subject to specific reserve allocations. The loss rates applied to loans are derived from analyzing a range of the loss experience sustained on loans according to their internal risk rating. These loss rates may be adjusted to account for environmental factors, if warranted. The general reserve also includes homogeneous loans, such as consumer installment, residential mortgage and home equity loans that are not individually risk graded. For these loans that are not individually risk graded, a range of historic loss experience of the portfolio is used to determine the appropriate allowance for the portfolios. Allocations for the allowance are established for each pool of loans based on the expected net charge-offs for one year.

 

In the second quarter of 2012 management developed a detailed approach to setting the environmental adjustments to the historic loss rates and discontinued the use of high and low range of reserve percentages. Management believes that this more detailed approach adds efficiencies and provides more precision to the allowance for loan losses estimations. Factors that management considers as part of this approach in setting the environmental adjustments include economic trends, loan policies, lender experience, loan growth, delinquency trend, non-performing asset trends, classified loan trends and credit concentrations.

 

Reserves on individual loans and historical loss rates are reviewed quarterly and adjusted as necessary based on changing borrower and/or collateral conditions, as well as actual collection and charge-off experience.

 

Charge-offs are recognized when it becomes evident that a loan or a portion of a loan is deemed uncollectible regardless of its delinquent status. The Bank generally charges off that portion of a loan that is determined to be unsupported by an obligor’s continued ability to repay the loan from income and/or assets, both pledged and unpledged as collateral.

  

OVERVIEW

 

Economic Overview

 

Despite positive economic news in the second quarter of 2012, the overall economic recovery remains muted after a very deep recession highlighted by high unemployment, depressed real estate values and high levels of problem assets in the banking industry. The second quarter of 2012 continued to show signs of positive growth as gross domestic product expanded at an anticipated rate of 1.8% from the previous quarter, which remains well below the historical normalized 3% growth rate. For the year, the U.S. economy is anticipated to grow at 2.1% over 2011’s output, which has been revised lower from the expected 2.3% growth at the end of the first quarter. The national unemployment rate fell during the second quarter by 0.10% to 8.17%. The economy also produced 225,000 non-farm jobs in the quarter, which was substantially lower than previous quarters. The expectation for the remaining six months of 2012 is that the U.S. economy will continue to experience muted growth. The major risks for the remainder of 2012 with respect to the overall economy will be the severity of the recession in Europe, and the impact of food and energy inflation on the consumers. Interest rates remain low as a result of the continuing actions by the Federal Reserve with respect to the target fed funds rate.

 

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2012 Second Quarter and Six Month Performance Overview

 

The results of the second quarter and first six months of 2012 reflect improving credit metrics and continued revenue growth which was offset by higher non-interest expense. In the second quarter of 2012 total loans increased $13,533,000 (1%) from the previous quarter, which was the highest quarterly organic loan growth experienced in the last three years. The second quarter and first six months of 2012 results also benefited from the elimination of the Company’s preferred stock dividends and related amortization expense as a result of the Company’s repurchase of the remaining $17 million of Fixed Rate Cumulative Perpetual Preferred Stock, Series A (the “Series A Preferred Stock”), previously issued to the U.S. Department of the Treasury (the “U.S. Treasury”) as part of the Troubled Asset Relief Program (“TARP”) Capital Purchase Program (“CPP”). The 26% increase in diluted earnings per share for the second quarter of 2012 as compared to the same period in 2011 was the result of a 43% reduction in the provision for loan losses, and a 2% growth in revenue, which was offset with an 8% increase in non-interest expense as compared to the same period in 2011. The reduction in the provision for loan losses was accompanied by lower levels of charged-off loans from both the previous year and on a sequential basis from the first quarter of 2012.

 

The following sections provide more detail on subjects presented in the overview. 

 

FINANCIAL CONDITION

 

Total assets at June 30, 2012 were $1,703,865,000 as compared to $1,744,724,000 at December 31, 2011, a decrease of $40,859,000 (2%). Cash and cash equivalents decreased $69,245,000 (51%) from $135,964,000 at December 31, 2011 to $66,719,000 at June 30, 2012. Loans outstanding increased $13,779,000 from $1,129,954,000 at December 31, 2011 to $1,143,733,000 at June 30, 2012.

 

As Table 1 illustrates, the increase in the loan portfolio in 2012 was the result of an increase in commercial real estate loans of $16,263,000 (3%) and residential real estate loans of $13,868,000 (5%) and was offset with a decrease in commercial loans of $11,244,000 (6%). Management expects a steady, although slow, increase in loan demand in 2012, mirroring the current economic conditions as discussed above. The Bank intends to continue to work to make loans that meet its longstanding prudent lending standards.

 

Contributing to the increase in other assets was a maturity of $5,000,000 in available-for-sale securities on June 30, 2012. These securities were classified as an accounts receivable as the proceeds had not been received by June 30, 2012.

 

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Deposits decreased $43,493,000 to $1,455,328,000 at June 30, 2012, compared to $1,498,821,000 at December 31, 2011. The largest decrease in deposits came from interest bearing transaction deposits which decreased $41,918,000, or 9% from December 31, 2011. The Bank’s interest bearing transaction accounts include public fund accounts which decreased $53,660,000 or 15% from the end of 2011. Public funds are deposits of local municipalities, schools and other public entities, and tend to be cyclical in nature with higher balances in the fourth quarter of the year as a result of property tax receipts. Also, an increase in non-interest bearing deposits of $24,692,000 or 9% was offset with a $31,430,000, or 9%, decrease in certificates of deposits (CDs). Management believes the decrease in certificates of deposits is a result of the low rate environment.

 

Table 1 Composition of the Bank’s loans and deposits at the dates indicated:

 

   June 30, 2012   December 31, 2011 
   Amount   %   Amount   % 
   (Dollars in thousands) 
Type of Loan:                
Commercial real estate loans  $539,748    47.1%  $523,485    46.3%
                     
One- to four-family residential real estate loans   280,136    24.5    266,268    23.5 
                     
Commercial loans   181,932    15.9    193,176    17.1 
Consumer loans   16,307    1.4    16,618    1.5 
                     
Construction and land development loans   100,094    8.7    104,788    9.2 
Municipal obligations   27,014    2.4    27,066    2.4 
Total loans  $1,145,231    100.0%  $1,131,401    100.0%
Less:                    
Deferred loan fees   1,498         1,447      
Allowance for loan losses   18,346         18,288      
Net loans  $1,125,387        $1,111,666      
                     
Type of Deposit:                    
Non-interest bearing deposits  $307,782    21.1%  $283,090    18.9%
Interest bearing transaction deposits   418,656    28.8    460,574    30.7 
Money market deposits   241,772    16.6    250,051    16.7 
Savings deposits   112,988    7.8    96,247    6.4 
Certificates of deposits   311,294    21.4    342,724    22.9 
Individual retirement accounts   62,836    4.3    66,135    4.4 
Total Deposits  $1,455,328    100.0%  $1,498,821    100.0%

  

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RESULTS OF OPERATIONS

 

GENERAL

 

Net income available to common shareholders for the six months ended June 30, 2012 increased from $6,790,000 ($.91 diluted earnings per share) in 2011 to $8,939,000 ($1.19 diluted earnings per share) in 2012, an increase of $2,149,000 (32%). Net income available to common shareholders for the quarter ended June 30, 2012 was $4,424,000 ($.59 diluted earnings per share) as compared to $3,535,000 ($.47 diluted earnings per share) during the same period of 2011, an increase of $889,000 (25%). The primary reason for the substantial increase in net income from the second quarter of 2011 as compared to the second quarter of 2012 was a $1,300,000 (43%) decrease in the provision for loan losses, which was reflective of improving credit metrics as compared to the second quarter of 2011. Additionally, total revenue increased by $399,000 (2%), which was offset by non-interest expense, which increased by $892,000 (8%) for the second quarter of 2012 as compared to the same period of 2011. As described above in the section entitled “Overview”, the second quarter 2012 results also reflect a decrease of $259,000 in Preferred Stock dividends and amortization resulting from the repurchase of the Company’s Series A Preferred Stock from the U.S. Treasury. The increase in revenue for the second quarter of 2012 as compared to the second quarter of 2011 included a $20,000 increase in net interest income and $379,000 (8%) increase in non-interest income. Contributing to the increase in non-interest income were gains on the sale of real estate loans, which increased $361,000 (158%) and bankcard transaction revenue which increased $93,000 (11%) from the second quarter of 2011, which were partially offset by a $183,000 (8%) decrease in service charges and fees in the same time period. Contributing to the increase in non-interest expense was a $679,000 (13%) increase in salaries and benefits expense. Contributing to the decrease in the provision for loan losses was lower net charge-offs and non-performing loans ratios in the second quarter of 2012 versus the same period in 2011.

 

NET INTEREST INCOME

 

Net interest income increased $20,000 in the second quarter of 2012 as compared to the same period in 2011, while the year to date total increased $516,000 (2%) from $27,375,000 in 2011 to $27,891,000 in 2012. As illustrated in Table 2, average earning assets increased $86,036,000 or 6% from the second quarter of 2011 to the second quarter of 2012, while average interest bearing liabilities only increased $52,922,000 or 4% in the same period. Table 4 shows that the net interest income on a fully tax equivalent basis was positively impacted by the volume additions to the balance sheet by $627,000, which was partially offset with a negative rate variance of $591,000. As further illustrated in Table 4, the favorable volume variance was driven by the increase in interest income attributable to securities of $308,000. Driving the increase in interest income from securities was a $55,868,000 or 17% increase in the average balance of securities outstanding from the second quarter of 2011 to the second quarter of 2012. As the negative rate variance in the second quarter of 2012 shows, if rates were to continue to fall in 2012, the effect on the Company is expected to be negative, as shown and explained below.

 

As illustrated in Table 2 below, the net interest margin of 3.65% for the second quarter of 2012 was 19 basis points lower than the 3.84% net interest margin for the second quarter of 2011. The cost of interest-bearing liabilities decreased 28 basis points from .79% for the second quarter of 2011 to .51% in the second quarter of 2012, while the yield on earning assets decreased 32 basis points from 4.48% for the second quarter of 2011 to 4.06% for the second quarter of 2012. Contributing to the decrease in the net interest margin from the second quarter of 2011 was the mix of earning assets. The average balance in securities, which yielded 2.10% in the second quarter of 2012, increased on average $55,868,000 (17%) from the second quarter of 2011, while the average balance in loans, which yielded 4.93% in the second quarter of 2012, increased by only $17,127,000 (2%) from the second quarter of 2011.

 

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The Company uses an earnings simulation model to estimate and evaluate the impact of changing interest rates on earnings. The model projects the effect of instantaneous movements in interest rates of both 100 and 200 basis points. By simulating the effects of movements in interest rates, the model can estimate the Company’s interest rate exposure. The results of the model are used by management to approximate the results of rate changes and do not indicate actual expected results. As shown below, the June 30, 2012 simulation analysis indicates that the Company is in a slightly liability interest rate sensitive position, with the net interest income negatively impacted by rising rates. As a result of the current historically low rate environment, the effects of a 100 basis point decrease in rates would also be negative to the net interest income. This is the result of a significant portion of the interest-bearing liabilities already having a cost below 1.00%.

 

 Net interest income estimates are summarized below.

 

   Net Interest Income Change 
Increase 200 bp   (1.92)%
Increase 100 bp   (1.30)
Decrease 100 bp   (2.78)

 

Table 2 & 3 below set forth certain information relating to the Bank’s average balance sheet information and reflects the average yield on interest-earning assets, on a tax equivalent basis, and the average cost of interest-bearing liabilities for the periods indicated. Such yields and costs are derived by dividing income or expense by the average monthly balance of interest-earning assets or interest-bearing liabilities, respectively, for the periods presented. Average balances are daily averages for the Bank and include non-accruing loans in the loan portfolio, net of the allowance for loan losses.

 

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Table 2- Average Balance Sheet Rates for Three Months Ended June 30, 2012 and 2011 (presented on a tax equivalent basis in thousands)

 

   Three Months ended June 30, 2012   Three Months ended June 30, 2011 
   Average
outstanding
balance
   Interest
earned/
paid
  
Yield/
rate
   Average
outstanding
balance
   Interest
earned/
paid
  
Yield/
rate
 
                 
Interest-earning assets:                              
Loans receivable (1)(2)  $1,136,894   $13,948    4.93%  $1,119,767   $14,770    5.29%
Securities (2)   375,245    1,961    2.10    319,377    1,881    2.36 
Other interest-earning assets   70,648    79    0.45    57,607    84    0.58 
                               
Total interest-earning assets   1,582,787    15,988    4.06    1,496,751    16,735    4.48 
                               
Non-interest-earning assets   147,788              137,239           
Total assets  $1,730,575             $1,633,990           
                               
Interest-bearing liabilities:                              
Transaction accounts   813,312    425    0.21    721,948    513    0.29 
Time deposits   381,387    923    0.97    423,038    1,629    1.54 
Borrowings   75,789    266    1.41    72,580    254    1.40 
Total interest-bearing liabilities   1,270,488    1,614    0.51    1,217,566    2,396    0.79 
                               
Non-interest-bearing liabilities   298,125              252,718           
                               
Total liabilities   1,568,613              1,470,284           
                               
Shareholders’ equity   161,962              163,706           
                               
Total liabilities and shareholders’ equity  $1,730,575             $1,633,990           
                               
Net interest income       $14,374             $14,339      
Interest rate spread             3.55%             3.69%
Net interest margin (net interest income as a percent of average interest-earning assets)             3.65%             3.84%
Effect of net free funds (earning assets funded by non- interest bearing liabilities)             0.10%             0.15%
Average interest-earning assets to interest-bearing liabilities   124.58%             122.93%          

 

 

(1)Includes non-accrual loans.
(2)Income presented on a tax equivalent basis using a 35.00% tax rate in 2012 and 2011, respectively. The tax equivalent adjustment was $327,000 and $312,000 in 2012 and 2011, respectively.

 

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Table 3- Average Balance Sheet Rates for Six Months Ended June 30, 2012 and 2011 (presented on a tax equivalent basis in thousands)

  

   Six Months ended June 30, 2012   Six Months ended June 30, 2011 
   Average
outstanding
balance
   Interest
earned/
paid
  
Yield/
rate
   Average
outstanding
balance
   Interest
earned/
paid
  
Yield/
rate
 
                 
Interest-earning assets:                              
Loans receivable (1)(2)  $1,135,131   $27,906    4.94%  $1,114,153   $29,234    5.29%
Securities (2)   374,636    3,921    2.10    310,901    3,573    2.32 
Other interest-earning assets   79,622    171    0.43    84,397    222    0.53 
                               
Total interest-earning assets   1,589,389    31,998    4.05    1,509,451    33,029    4.41 
                               
Non-interest-earning assets   148,483              133,063           
Total assets  $1,737,872             $1,642,514           
                               
Interest-bearing liabilities:                              
Transaction accounts   817,477    895    0.22    725,063    1,184    0.33 
Time deposits   392,243    2,019    1.04    431,155    3,355    1.57 
Borrowings   78,293    544    1.40    73,065    508    1.40 
Total interest-bearing liabilities   1,288,013    3,458    0.54    1,229,283    5,047    0.83 
                               
Non-interest-bearing liabilities   289,867              251,281           
                               
Total liabilities   1,577,880              1,480,564           
                               
Shareholders’ equity   159,992              161,950           
                               
Total liabilities and shareholders’ equity  $1,737,872             $1,642,514           
                               
Net interest income       $28,540             $27,982      
Interest rate spread             3.51%             3.58%
Net interest margin (net interest income as a percent of average interest-earning assets)             3.61%             3.74%
Effect of net free funds (earning assets funded by non-interest bearing liabilities)             0.10%             0.16%
Average interest-earning assets to interest-bearing liabilities   123.39%             122.79%          

 

 

(1)Includes non-accrual loans.
(2)Income presented on a tax equivalent basis using a 35.00% tax rate in 2012 and 2011, respectively. The tax equivalent adjustment was $649,000 and $607,000 in 2012 and 2011, respectively.

 

Table 4 below illustrates the extent to which changes in interest rates and changes in volume of interest-earning assets and interest-bearing liabilities have affected the Bank’s interest income and expense during the periods indicated. For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to (i) changes in volume (change in volume multiplied by prior year rate), (ii) changes in rate (change in rate multiplied by prior year volume) and (iii) total changes in rate and volume. The combined effects of changes in both volume and rate, which cannot be separately identified, have been allocated proportionately to the change due to volume and the change due to rate.

 

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Table 4-Volume/Rate Analysis (in thousands)

 

   Three months ended June 30, 2012
Compared to
Three months ended June 30, 2011
   Six months ended June 30, 2012
Compared to
Six months ended June 30, 2011
 
  

Increase (Decrease)

Due to

  

Increase (Decrease)

Due to

 
   Volume   Rate   Total   Volume   Rate   Total 
Interest income attributable to:                              
Loans receivable  $224   $(1,046)  $(822)  $547   $(1,875)  $(1,328)
                               
Securities   308    (228)   80    692    (344)   348 
Other interest-earning assets(1)   17    (22)   (5)   (12)   (39)   (51)
                               
Total interest-earning assets   549    (1,296)   (747)   1,227    (2,258)   (1,031)
                               
                               
Interest expense attributable to:                              
Transactions accounts   60    (148)   (88)   138    (427)   (289)
Time deposits   (148)   (558)   (706)   (284)   (1,052)   (1,336)
Borrowings   11    1    12    37    (1)   36 
                               
Total interest-bearing liabilities   (77)   (705)   (782)   (109)   (1,480)   (1,589)
                               
Increase (decrease) in net interest income  $626   $(591)  $35   $1,336   $(778)  $558 

______________________________

 

(1)Includes federal funds sold and interest-bearing deposits in other financial institutions.

 

PROVISION FOR LOAN LOSSES

 

Like many other financial institutions, the Bank has been significantly affected by the national economic downturn that began over four years ago. While the Bank has experienced an increase in defaults and foreclosures in this economic period, the levels of such activity have been significantly less than other regions in the country due, in part, to the fact that the Bank’s market in the northern Kentucky and greater Cincinnati area did not experience as dramatic a rise in real estate values over the last several years as other markets.

 

Although, the Bank is seeing the benefit of the current slow economic recovery, management believes that with the continuing economic uncertainty, high unemployment rates and low real estate values, the resulting pressure on earnings will remain above historical levels. This will include continuing higher than historic levels of charge-offs in the loan portfolio and, as a result, higher provisions for loan losses and a higher reserve for loan losses on the balance sheet. Higher provisions for loan losses will lead to lower earnings and slower capital growth. Management believes that loan growth experienced in the second quarter of 2012 is consistent with the slowly improving economic conditions, and management anticipates growing demand for loans in the coming quarters.

 

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As discussed above, the provision for loan losses for the second quarter of 2012 reflected slowly improving economic conditions. Although the credit metrics have deteriorated significantly since the beginning of the current economic downturn, there are signs of improvement which have allowed provision expense to decrease from its previous levels. The provision for loan losses was $1,700,000 for the second quarter of 2012, compared to $3,000,000 for the same period in 2011 while the year to date total in 2012 was $3,500,000 versus $6,000,000 in 2011. The decrease of $1,300,000 (43%) in the second quarter reflected a decrease in the non-performing loans and net charge-offs ratios in the second quarter of 2012 as compared to the same period in 2011. For the second quarter of 2012, net charge-offs were $1,716,000 or 0.61% of average loan balances compared to 2011 figures of $2,871,000 or 1.03% of average loan balances. As illustrated in Table 5 below, total non-accrual loans plus loans past due 90 days or more were $16,460,000 (1.44% of loans outstanding) at June 30, 2012, compared to $16,422,000 (1.46% of loans outstanding) at June 30, 2011. Management’s evaluation of the inherent risk in the loan portfolio considers both historic losses and information regarding specific borrowers. Management continues to monitor the non-performing relationships and has established appropriate reserves.

 

On a sequential quarterly basis, the provision for loan losses decreased $100,000 or 5% from the first quarter of 2012. Contributing to this decrease was lower non-performing loans, which decreased $999,000 or 6% from the end of the first quarter. Also as detailed below a $13,614,000 or 18% decrease in loans classified as substandard which was offset with a $15,059,000 or 47% increase in loans classified as special mention from December 31, 2011. Contributing to the decrease in the provision for loan losses as a result of the movement of loans from substandard to special mention is a result of a lower reserve ratio need for better rated loans.

 

The aggregate amounts of the Bank’s classified assets at June 30, 2012 and December 31, 2011 were as follows:

 

   6/30/12   12/31/11 
   (Dollars in thousands) 
Special mention (risk rating 6)  $46,969   $31,910 
Substandard (risk rating 7 & 8)   61,230    74,844 
Doubtful (risk rating 9)   123    84 
           
Total classified assets  $108,322   $106,838 

 

Non-performing assets, which include non-performing loans, other real estate owned (“OREO”) and repossessed assets, totaled $22,410,000 at June 30, 2012 versus $18,324,000 at June 30, 2011. This represents 1.32% of total assets at June 30, 2012 compared to 1.15% at June 30, 2011. The main increase in non-performing assets was in OREO balances which increased from $1,902,000 at June 30, 2011 to $5,950,000 at June 30, 2012. This increase was primarily the result of one commercial real estate relationship that added $3,475,000 in OREO in the fourth quarter of 2011. These properties are initially recorded at their fair value less estimated costs to sell with the difference between this value and the loan balance being recorded as a charge-off. On a sequential quarterly basis OREO balances decreased $378,000 or 6% as sales of existing properties outpaced new repossessed assets.

 

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Accruing Troubled Debt Restructurings (TDRs). In certain circumstances, the Bank may modify the terms of a loan to maximize the collection of amounts due. In cases where the borrower is experiencing financial difficulties or is expected to experience difficulties in the near-term, concessionary modification is granted to minimize or eliminate the economic loss and to avoid foreclosure or repossession of the collateral. Modifications may include interest rate reductions, extension of the maturity date or a reduction in the principal balance. Restructured loans accrue interest as long as the borrower complies with the revised terms. Total accruing TDRs were $15,388,000 at June 30, 2012 versus $7,022,000 at June 30, 2011. The Bank expects increases in TDRs as the Bank works with relationships that show signs of stress, in order to proactively manage and resolve problem loans.

 

Allowance for Loan Losses (“ALL”). The slight increase in the ALL was directionally consistent in the second quarter of 2012 with the change in the credit metrics and the continued uncertain economic conditions experienced since December 31, 2011. The ALL increased $58,000 from $18,288,000 at December 31, 2011 to $18,346,000 at June 30, 2012, which decreased the allowance for loan losses as a percentage of total loans from 1.62% at December 31, 2011 to 1.60% at June 30, 2012. The amount of the allowance allocated to impaired loans at the end of the first quarter of 2012, was $7,516,000, which was up $73,000 from $7,443,000 at December 31, 2011. The impairment process is described in the “Critical Accounting Policies and Estimates” section of this Quarterly Report. Contributing to both the increase in charge-offs and in the ALL during the current economic environment is the significant decrease in real estate values. Management believes the current level of the ALL is sufficient to absorb probable incurred losses in the loan portfolio. Management continues to monitor the loan portfolio closely and believes the provision for loan losses is directionally consistent with the changes in the probable losses inherent in the loan portfolio from the year end of 2011 to the second quarter of 2012. The Bank does not originate or purchase sub-prime loans for its portfolio. Management will continue to monitor and evaluate the effects of the current housing market conditions and any signs of further deterioration in credit quality on the Bank’s loan portfolio. Management believes the current economic strains will continue throughout 2012 and expects continuing higher than normal credit losses and provisioning expense in the foreseeable future.

 

Monitoring loan quality and maintaining an adequate allowance is an ongoing process overseen by senior management and the loan review function. On at least a quarterly basis, a formal analysis of the adequacy of the ALL is prepared and reviewed by management and the Company’s Board of Directors. This analysis serves as a point in time assessment of the level of the ALL and serves as a basis for provisions for loan losses. The loan quality monitoring process includes assigning loan grades and the use of a watch list to identify loans of concern.

 

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The following tables set forth an analysis of certain credit risk information for the periods indicated:

 

Table 5-Summary of Loan Loss Experience and Allowance for Loan Loss Analysis (in thousands)

 

   Three Months ended June 30,   Six Months ended June 30, 
   2012   2011   2012   2011 
Balance of allowance at beginning of period  $18,362   $17,688   $18,288   $17,368 
Recoveries of loans previously charged off:                    
Commercial loans   8    3    12    43 
Consumer loans   82    88    177    213 
Mortgage loans   2    0    7    21 
Total recoveries   92    91    196    277 
Loans charged off:                    
Commercial loans   1,532    2,641    2,684    4,931 
Consumer loans   261    303    563    645 
Mortgage loans   15    19    390    253 
Total charge-offs   1,808    2,963    3,637    5,829 
Net charge-offs   (1,716)   (2,872)   (3,442)   (5,552)
Provision for loan losses   1,700    3,000    3,500    6,000 
Balance of allowance at end of period  $18,346   $17,816   $18,346   $17,816 
Net charge-offs to average loans outstanding for period   0.61%   1.03%   0.61%   1.00%
Allowance at end of period to loans at end of period   1.60%   1.58%   1.60%   1.58%
Allowance to non-performing loans at end of period   111%   108%   111%   108%

 

44
 

 

Table 6 - Analysis of non-performing loans for the periods indicated (in thousands)

 

   June 30, 
  2012
   December31,
  2011
 
         
Loans accounted for on a non-accrual basis:          
Nonresidential real estate  $5,236   $6,628 
Residential real estate   5,483    5,325 
Construction   3,798    1,897 
Commercial   1,074    1,175 
Consumer and other   674    626 
Total   16,265    15,651 
Accruing loans which are contractually past due 90 days or more:          
Nonresidential real estate  $-   $- 
Residential real estate   126    112 
Construction   -    - 
Commercial   -    74 
Consumer and other loans   69    33 
Total   195    219 
Total non-performing loans  $16,460   $15,870 
Non-performing loans as a percentage of total loans   1.44%   1.40%
Accruing restructured loans (TDRs)  $15,388   $13,306 
Non-accruing restructured loans (TDRs)  $5,349   $1,923 
Other real estate owned  $5,950   $5,844 

 

NON-INTERES