Notes to Consolidated Financial Statements
NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Nature of Operations
– Orrstown Financial Services, Inc. (the “Company”) is a bank holding company (that has elected status as a financial holding company with the Board of Governors of the Federal Reserve System (the “FRB”)) whose primary activity consists of supervising its wholly-owned subsidiary, Orrstown Bank (the “Bank”). The Company operates through its office in Shippensburg, Pennsylvania. The Bank provides services through its network of
25
offices in Berks, Cumberland, Dauphin, Franklin, Lancaster, and Perry Counties of Pennsylvania and in Washington County, Maryland. The Bank engages in lending services for commercial, residential, commercial mortgages, construction, municipal, and various forms of consumer lending. Deposit services include checking, savings, time, and money market deposits. The Bank also provides investment and brokerage services through its Orrstown Financial Advisors division. The Company and the Bank are subject to the regulation of certain federal and state agencies and undergo periodic examinations by such regulatory authorities.
Basis of Presentation
– The unaudited condensed Consolidated Financial Statements of the Company and its subsidiary are presented for the three and
nine
months ended
September 30, 2016
and
2015
and have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) for interim financial information, the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. However, unaudited information reflects all adjustments (consisting solely of normal recurring adjustments) that are, in the opinion of management, considered necessary for a fair presentation of the financial position, results of operations and cash flows for the interim period. Information presented at
December 31, 2015
is condensed from audited year-end financial statements. These condensed Consolidated Financial Statements should be read in conjunction with the audited Consolidated Financial Statements and footnotes thereto, included in the Annual Report on Form 10-K for the year ended
December 31, 2015
. The Consolidated Financial Statements include the accounts of the Company and the Bank. Operating results for the three and
nine
months ended
September 30, 2016
are not necessarily indicative of the results that may be expected for the year ending
December 31, 2016
. All significant intercompany transactions and accounts have been eliminated.
Use of Estimates –
The preparation of financial statements in conformity with GAAP 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 actual results could differ.
Subsequent Events –
GAAP establishes standards for accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued. The subsequent events principle sets forth the period after the balance sheet date during which management of a reporting entity should evaluate events or transactions that may occur for potential recognition in the financial statements, identifies the circumstances under which an entity should recognize events or transactions occurring after the balance sheet date in its financial statements, and specifies the disclosures that should be made about events or transactions that occur after the balance sheet date.
Concentration of Credit Risk
– The Company generally grants commercial, residential, construction, municipal, and various forms of consumer lending to customers in its market area. Although the Company maintains a diversified loan portfolio, a significant portion of its customers’ ability to honor their contracts is dependent upon economic sectors for commercial real estate, including office space, retail strip centers, multi-family and hospitality, residential building operators, sales finance, sub-dividers and developers. Management evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if collateral is deemed necessary by the Company upon the extension of credit, is based on management’s credit evaluation of the customer. Collateral held varies, but generally includes real estate and equipment.
The types of securities the Company invests in are included in Note 2, “Securities Available for Sale” and the type of lending the Company engages in are included in Note 3, “Loans Receivable and Allowance for Loan Losses.”
Cash and Cash Equivalents –
For purposes of the consolidated statements of cash flows, cash and cash equivalents include cash, balances due from banks, federal funds sold and interest bearing deposits due on demand, all of which have original maturities of
90 days
or less. Net cash flows are reported for customer loan and deposit transactions, loans held for sale and redemption (purchases) of restricted investments in bank stocks, and short-term borrowings.
Restricted Investments in Bank Stocks –
Restricted investments in bank stocks, which represents required investments in the common stock of correspondent banks, are carried at cost as of
September 30, 2016
and
December 31, 2015
, and consists of common stock of the Federal Reserve Bank of Philadelphia (“Federal Reserve Bank”), Atlantic Community Bankers Bank and the Federal Home Loan Bank of Pittsburgh (“FHLB”).
Management evaluates the restricted investments in bank stocks for impairment in accordance with Accounting Standard Codification (ASC) Topic 942,
Accounting by Certain Entities (Including Entities with Trade Receivables) That Lend to or Finance the Activities of Others.
Management’s determination of whether these investments are impaired is based on their assessment of the ultimate recoverability of their cost rather than by recognizing temporary declines in value. The determination of whether a decline affects the ultimate recoverability of their cost is influenced by criteria such as (1) the significance of the decline in net assets of the correspondent bank as compared to the capital stock amount for the correspondent bank and the length of time this situation has persisted, (2) commitments by the correspondent bank to make payments required by law or regulation and the level of such payments in relation to the operating performance of the correspondent bank, and (3) the impact of legislative and regulatory changes on institutions and, accordingly, on the customer base of the correspondent bank.
Management believes
no
impairment charge is necessary related to the restricted investments in bank stocks as of
September 30, 2016
. However, security impairment analysis is completed quarterly and the determination that no impairment had occurred as of
September 30, 2016
is no assurance that impairment may not occur in the future.
Securities –
Certain debt securities that management has the positive intent and ability to hold to maturity are classified as “held to maturity” and recorded at amortized cost. “Trading” securities are recorded at fair value with changes in fair value included in earnings. As of
September 30, 2016
and
December 31, 2015
, the Company had
no
held to maturity or trading securities. Securities not classified as held to maturity or trading, including equity securities with readily determinable fair values, are classified as “available for sale” and recorded at fair value, with unrealized gains and losses excluded from earnings and reported in other comprehensive income. Purchase premiums and discounts are recognized in interest income using the interest method over the terms of the securities and approximate the level yield method. Gains and losses on the sale of securities are recorded on the trade date and are determined using the specific identification method.
Management evaluates securities for other-than-temporary impairment (“OTTI”) on at least a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. For securities in an unrealized loss position, management considers the extent and duration of the unrealized loss, and the financial condition and near-term prospects of the issuer. Management also assesses whether it intends to sell, or it is more likely than not that it will be required to sell, a security in an unrealized loss position before recovery of its amortized cost basis. If either of the criteria regarding intent or requirement to sell is met, the entire difference between amortized cost and fair value is recognized as impairment through earnings. For debt securities that do not meet the aforementioned criteria, the amount of impairment is split into
two
components as follows: 1) OTTI related to credit loss, which must be recognized in the income statement and 2) OTTI related to other factors, which is recognized in other comprehensive income. The credit loss is defined as the difference between the present value of the cash flows expected to be collected and the amortized cost basis. For equity securities, the entire amount of impairment is recognized through earnings.
The Company had
no
debt securities it deemed to be other than temporarily impaired at
September 30, 2016
or
December 31, 2015
.
The Company’s securities are exposed to various risks, such as interest rate risk, market risk, and credit risks. Due to the level of risk associated with certain investments and the level of uncertainty related to changes in the value of investments, it is at least reasonably possible that changes in risks in the near term would materially affect investment assets reported in the Consolidated Financial Statements.
Loans Held for Sale –
Loans originated and intended for sale in the secondary market are carried at the lower of aggregate cost or fair value (LOCM). Gains and losses on loan sales (sales proceeds minus carrying value) are recorded in non-interest income.
Loans –
The Company grants commercial, residential, commercial mortgage, construction, municipal, mortgage and various forms of consumer loans to its customers located principally in south-central Pennsylvania and northern Maryland. The ability of the Company’s debtors to honor their contracts is dependent largely upon the real estate and general economic conditions in this area.
Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off generally are reported at their outstanding unpaid principal balances adjusted for charge-offs, the allowance for loan losses, and any deferred fees or costs on originated loans. Interest income is accrued on the unpaid principal balance. Loan origination fees, net of certain direct origination costs, are deferred and amortized as a yield adjustment over the respective term of the loan.
For all classes of loans, the accrual of interest income on loans, including impaired loans, generally ceases when principal or interest is past due
90 days
or more or immediately if, in the opinion of management, full collection is unlikely. Interest will continue to accrue on loans past due
90 days
or more if the collateral is adequate to cover principal and interest, and the loan is
in the process of collection. Interest accrued, but not collected, as of the date of placement on nonaccrual status, is reversed and charged against current interest income, unless fully collateralized. Subsequent payments received are either applied to the outstanding principal balance or recorded as interest income, depending upon management’s assessment of the ultimate collectability of principal. Loans are returned to accrual status, for all loan classes, when all the principal and interest amounts contractually due are brought current, the loan has performed in accordance with the contractual terms of the note for a reasonable period of time, generally
six months
, and the ultimate collectability of the total contractual principal and interest is reasonably assured. Past due status is based on contractual terms of the loan.
Loans, the terms of which are modified, are classified as troubled debt restructurings ("TDRs") if a concession was granted in connection with the modification, for legal or economic reasons, related to the debtor’s financial difficulties. Concessions granted under a TDR typically involve a temporary deferral of scheduled loan payments, an extension of a loan’s stated maturity date, a temporary reduction in interest rates, or granting of an interest rate below market rates given the risk of the transaction. If a modification occurs while the loan is on accruing status, it will continue to accrue interest under the modified terms. Nonaccrual TDRs may be restored to accrual status if scheduled principal and interest payments, under the modified terms, are current for
six months
after modification, and the borrower continues to demonstrate its ability to meet the modified terms. TDRs are evaluated individually for impairment on a quarterly basis including monitoring of performance according to their modified terms.
Allowance for Loan Losses –
The allowance for loan losses is a valuation allowance for probable incurred credit losses. Loan losses are charged against the allowance when management believes the uncollectability of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance.
The allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectability of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.
See Note 3, “Loans Receivable and Allowance for Loan Losses,” for additional details.
Loan Commitments and Related Financial Instruments –
Financial instruments include off-balance sheet credit instruments, such as commitments to make loans and commercial letters of credit, issued to meet customer financing needs. The face amount for these items represents the exposure to loss, before considering customer collateral or ability to repay. Such financial instruments are recorded when they are funded.
Loans Serviced –
The Bank administers secondary market mortgage programs available through the FHLB and the Federal National Mortgage Association and offers residential mortgage products and services to customers. The Bank originates single-family residential mortgage loans for immediate sale in the secondary market, and retains the servicing of those loans sold to these investors. At
September 30, 2016
and
December 31, 2015
, the balance of loans serviced for others was
$326,461,000
and
$317,793,000
.
Transfers of Financial Assets –
Transfers of financial assets are accounted for as sales when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the Company, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and (3) the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity.
Cash Surrender Value of Life Insurance –
The Company has purchased life insurance policies on certain employees. Company owned life insurance is recorded at the amount that can be realized under the insurance contract at the balance sheet date, which is the cash surrender value adjusted for other charges or other amounts due that are probable at settlement.
Premises and Equipment –
Buildings, improvements, equipment, furniture and fixtures are carried at cost less accumulated depreciation and amortization. Land is carried at cost. Depreciation and amortization has been provided generally on the straight-line method and is computed over the estimated useful lives of the various assets as follows: buildings and improvements, including leasehold improvements –
10
to
40
years; and furniture and equipment –
3
to
15
years. Repairs and maintenance are charged to operations as incurred, while major additions and improvements are capitalized. Gain or loss on retirement or disposal of individual assets is recorded as income or expense in the period of retirement or disposal.
Intangible Assets –
Intangible assets represent purchased assets that lack physical substance but can be distinguished from goodwill because of contractual or other legal rights. The Company’s intangible assets have finite lives and are amortized, on a straight line basis, over their estimated lives, generally
10
years for deposit premiums and
15
years for customer lists.
Mortgage Servicing Rights –
The estimated fair value of mortgage servicing rights (MSRs) related to loans sold and serviced by the Company is recorded as an asset upon the sale of such loans. MSRs are amortized as a reduction to servicing income over the estimated lives of the underlying loans. MSRs are evaluated periodically for impairment, by comparing the carrying amount to estimated fair value. Fair value is determined periodically through a discounted cash flows valuation performed by a third party. Significant inputs to the valuation include expected servicing income, net of expense, the discount rate and the expected life of the underlying loans. To the extent the amortized cost of the MSRs exceeds their estimated fair values, a valuation allowance is established for such impairment through a charge against servicing income on the consolidated statement of income. If the Company determines, based on subsequent valuations, that impairment no longer exists or is reduced, the valuation allowance is reduced through a credit to earnings. The balance of mortgage servicing rights was
$2,671,000
and
$2,672,000
as of
September 30, 2016
and
December 31, 2015
, and is included in other assets.
Foreclosed Real Estate –
Real estate properties acquired through, or in lieu of, loan foreclosure are held for sale and are initially recorded at fair value less estimated costs to sell the underlying collateral. Capitalized costs include any costs that significantly improve the value of the properties. After foreclosure, valuations are periodically performed by management and the real estate is carried at the lower of carrying amount or fair value less estimated costs to sell. Foreclosed real estate totaled
$719,000
and
$710,000
as of
September 30, 2016
and
December 31, 2015
and is included in other assets.
Investments in Real Estate Partnerships –
The Company currently has a
99%
limited partner interest in several real estate partnerships in central Pennsylvania. These investments are affordable housing projects which entitle the Company to tax deductions and credits that expire through 2025. The Company accounts for its investments in affordable housing projects under the proportional amortization method when the criteria are met, which is limited to
one
investment entered into in 2015. Investments prior to 2015 did not meet the criteria, and are accounted for under the equity method of accounting. The recorded investment in these real estate partnerships, included in other assets in the balance sheet, totaled
$5,051,000
and
$5,450,000
as of
September 30, 2016
and
December 31, 2015
, of which
$2,045,000
and
$2,205,000
are accounted for under the proportional amortization method, respectively.
Losses accounted for under the equity method of
$83,000
and
$89,000
were recorded for the three months ended
September 30, 2016
and
2015
, and
$261,000
and
$273,000
for the
nine
months ended
September 30, 2016
and
2015
, and are included in other noninterest income. Losses on the investments accounted for under the proportional amortization method of
$52,000
for the three months ended
September 30, 2016
, and
$138,000
for the
nine
months ended
September 30, 2016
, net of federal income tax benefit, is netted against income tax expense. The Company recognized federal tax credits from the projects totaling
$184,000
and
$119,000
during the three months ended
September 30, 2016
and
2015
, and
$552,000
, and
$357,000
during the
nine
months ended
September 30, 2016
and
2015
, which is included in income tax expense.
Advertising
– The Company follows the policy of charging costs of advertising to expense as incurred. Advertising expense was
$238,000
and
$244,000
for the three months ended
September 30, 2016
and
2015
, and
$591,000
and
$500,000
for the
nine
months ended
September 30, 2016
and
2015
.
Securities Sold Under Agreements to Repurchase
(“Repurchase Agreements”)
–
The Company enters into agreements under which it sells securities subject to an obligation to repurchase the same or similar securities which are included in short-term borrowings. Under these Repurchase Agreements, the Company may transfer legal control over the assets but still retain effective control through an agreement that both entitles and obligates the Company to repurchase the assets. As a result, these Repurchase Agreements are accounted for as collateralized financing arrangements (i.e., secured borrowings) and not as a sale and subsequent repurchase of securities. The obligation to repurchase the securities is reflected as a liability in the Company’s consolidated balance sheet, while the securities underlying the Repurchase Agreements remain in the respective investment securities asset accounts. In other words, there is no offsetting or netting of the investment securities assets with the Repurchase Agreement liabilities. In addition, as the Company does not enter into reverse Repurchase Agreements, there is no such offsetting to be done with the Repurchase Agreements.
The right of setoff for a Repurchase Agreement resembles a secured borrowing, whereby the collateral would be used to settle the fair value of the Repurchase Agreement should the Company be in default (e.g., fails to make an interest payment to the counterparty). For the Repurchase Agreements, the collateral is held by the Company in a segregated custodial account under a third party agreement. Repurchase agreements are secured by U.S. Government Sponsored Enterprises mortgage-backed securities and mature overnight.
Stock Compensation Plans –
The Company has stock compensation plans that cover employees and non-employee directors. Stock compensation accounting guidance (Financial Accounting Standards Board ("FASB") ASC 718,
Compensation – Stock Compensation
) requires that the compensation cost relating to share-based payment transactions be recognized in financial statements. That cost is measured based on the grant date fair value of the stock award, including a Black-Scholes
model for stock options. Compensation cost for all stock awards is calculated and recognized over the employees’ service period, generally defined as the vesting period.
Income Taxes –
The Company accounts for income taxes in accordance with income tax accounting guidance (FASB ASC 740,
Income Taxes
). The income tax accounting guidance results in two components of income tax expense: current and deferred. Current income tax expense reflects taxes to be paid or refunded for the current period by applying the provisions of the enacted tax law to the taxable income or excess of deductions over revenues. The Company determines deferred income taxes using the liability (or balance sheet) method. Under this method, the net deferred tax asset or liability is based on the tax effects of the differences between the book and tax bases of assets and liabilities, and enacted changes in tax rates and laws are recognized in the period in which they occur.
Deferred income tax expense results from changes in deferred tax assets and liabilities between periods. Deferred tax assets are recognized if it is more likely than not, based on the technical merits, that the tax position will be realized or sustained upon examination. The term more likely than not means a likelihood of more than
50
percent; the terms examined and upon examination also include resolution of the related appeals or litigation processes, if any. A tax position that meets the more-likely-than-not recognition threshold is initially and subsequently measured as the largest amount of tax benefit that has a greater than 50 percent likelihood of being realized upon settlement with a taxing authority that has full knowledge of all relevant information. The determination of whether or not a tax position has met the more-likely-than-not recognition threshold considers the facts, circumstances, and information available at the reporting date and is subject to management’s judgment. Deferred tax assets are reduced by a valuation allowance if, based on the weight of evidence available, it is more likely than not that some portion or all of a deferred tax asset will not be realized. The Company recognizes interest and penalties, if any, on income taxes as a component of income tax expense.
Loss Contingencies –
Loss contingencies, including claims and legal actions arising in the ordinary course of business, are recorded as liabilities when the likelihood of loss is probable and an amount or range of loss can be reasonably estimated.
Treasury Stock –
Common stock shares repurchased are recorded as treasury stock at cost.
Earnings Per Share –
Basic earnings per share represent net income available to common stockholders divided by the weighted-average number of common shares outstanding during the period. Restricted stock awards are included in weighted average common shares outstanding as they are earned. Diluted earnings per share reflect the additional common shares that would have been outstanding if dilutive potential common shares had been issued. Potential common shares that may be issued by the Company relate solely to outstanding stock options and restricted stock awards.
Treasury shares are not deemed outstanding for earnings per share calculations.
Comprehensive Income –
Comprehensive income consists of net income and other comprehensive income. Other comprehensive income is limited to unrealized gains on securities available for sale for all years presented. The component of accumulated other comprehensive income, net of taxes, at
September 30, 2016
and
December 31, 2015
consisted of unrealized gains on securities available for sale and totaled
$5,136,000
and
$1,199,000
.
Fair Value of Financial Instruments –
Fair values of financial instruments are estimated using relevant market information and other assumptions, as more fully disclosed in Note 9. Fair value estimates involve uncertainties and matters of significant judgment. Changes in assumptions or in market conditions could significantly affect the estimates.
Segment Reporting
– The Company only operates in
one
significant segment – Community Banking. The Company’s non-banking activities are insignificant to the Consolidated Financial Statements.
Reclassification
– Certain amounts in the
2015
Consolidated Financial Statements have been reclassified to conform to the
2016
presentation. Reclassifications had no effect on prior year net income or shareholders' equity.
Recent Accounting Pronouncements
– In May 2014, the FASB issued ASU 2014-9,
Revenue from Contracts with Customers (Topic 606)
. ASU 2014-9, as amended, creates a new topic, Topic 606, to provide guidance on revenue recognition for entities that enter into contracts with customers to transfer goods or services or enter into contracts for the transfer of nonfinancial assets. The core principle of the guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. Additional disclosures are required to provide quantitative and qualitative information regarding the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. These amendments are effective for annual reporting periods beginning after December 15, 2017, including interim periods within that reporting period. Early application is permitted only as of annual reporting periods beginning after December 15, 2016,
including interim reporting periods within that period. The Company is evaluating the impact of this standard on its financial position and results of operations.
In January 2016, the FASB issued ASU No. 2016-01,
Financial Instruments-Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities.
The update provides updated accounting and reporting requirements for both public and non-public entities. The most significant provisions that will impact the Company are: 1) equity securities available for sale will be measured at fair value, with the changes in fair value recognized in the income statement;
2) the requirement to disclose the method(s) and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments at amortized cost on the balance sheet has been eliminated; 3) a provision to permit the utilization of the exit price notion when measuring the fair value of financial instruments for disclosure purposes; 4) a requirement for separate presentation of both financial assets and liabilities by measurement category and form of financial asset on the balance sheet or accompanying notes to the financial statements. The update will be effective for interim and annual periods beginning after December 15, 2017, using a cumulative-effect adjustment to the balance sheet as of the beginning of the year of adoption. Early adoption is not permitted. The Company is evaluating the impact of this standard on its financial position and results of operations.
In February 2016, the FASB issued ASU 2016-02,
Leases (Topic 842)
. The update provides updated accounting and reporting requirements, which, among other things, requires lessees to recognize the following for all leases (with the exception of short-term leases) at the commencement date: (1) A lease liability, which is a lessee‘s obligation to make lease payments arising from a lease, measured on a discounted basis; and (2) A right-of-use asset, which is an asset that represents the lessee’s right to use, or control the use of, a specified asset for the lease term. The amendments in this ASU are effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Early application is permitted upon issuance. Lessees must apply a modified retrospective transition approach for leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements. The modified retrospective approach would not require any transition accounting for leases that expired before the earliest comparative period presented. The Company anticipates that the impact on the balance sheet will result in an increase in assets and liabilities for its right of use assets and related lease liabilities for those leases that are outstanding at the date of adoption, however, it does not anticipate it will have a material impact on its results of operations. We are currently evaluating the other effects of adoption of this new standard on our financial position, including regulatory capital.
In March 2016, the FASB issued ASU 2016-09,
Compensation - Stock Compensation: Improvements to Employee Share-Based Payment Accounting (Topic 718).
The update will require recognition of the income tax effects of share-based awards in the income statement when the awards vest or are settled, eliminating the additional paid-in-capital pools. The guidance will be effective for interim and annual reporting periods beginning after December 15, 2016, with early adoption permitted. The Company does not anticipate this update will have a material impact on its financial position or results of operations.
In June 2016, the FASB issued ASU No. 2016-13,
Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments.
The amendments in this update replace the existing incurred loss impairment methodology in current GAAP with an expected loss impairment methodology, which considers a broader range of reasonable and supportable information to support credit loss estimates, including historical loss experience, current conditions and reasonable and foreseeable forecasts. ASU No. 2016-13 also requires enhanced and greater disclosure pertaining to significant estimates and judgments used in estimating credit losses, as well as the credit quality and underwriting standards of the Company’s financial instrument portfolio, including loans and securities. These amendments are effective for annual reporting periods beginning after December 15, 2019, including interim periods within that reporting period, with earlier adoption permitted as of one year earlier. The Company is currently evaluating the impact of the significance of this amendment, and the impact it will have on its financial position, results of operations, and regulatory capital ratios.
In August 2016, the FASB issued ASU 2016-15,
Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments
. The update makes eight targets changes to how cash receipts and cash payments are presented and classified in the consolidated statement of cash flows. This guidance will be effective for interim and annual reporting periods beginning after December 15, 2017, and will require adoption on a retrospective basis. The Company does not anticipate this update will have a material impact on its financial position or results of operations.
NOTE 2. SECURITIES AVAILABLE FOR SALE
At
September 30, 2016
and
December 31, 2015
, the investment securities portfolio was comprised exclusively of securities classified as “available for sale,” resulting in investment securities being carried at fair value. The amortized cost and fair values of investment securities available for sale at
September 30, 2016
and
December 31, 2015
were:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
(Dollars in thousands)
|
Amortized Cost
|
|
Gross Unrealized
Gains
|
|
Gross Unrealized
Losses
|
|
Fair Value
|
September 30, 2016
|
|
|
|
|
|
|
|
U.S. Government Agencies
|
$
|
41,748
|
|
|
$
|
203
|
|
|
$
|
82
|
|
|
$
|
41,869
|
|
States and political subdivisions
|
123,698
|
|
|
6,903
|
|
|
202
|
|
|
130,399
|
|
U.S. Government Sponsored Enterprises (GSE) residential mortgage-backed securities
|
121,489
|
|
|
2,392
|
|
|
0
|
|
|
123,881
|
|
GSE residential collateralized mortgage obligations (CMOs)
|
74,106
|
|
|
378
|
|
|
1,786
|
|
|
72,698
|
|
Private label CMOs
|
6,029
|
|
|
0
|
|
|
52
|
|
|
5,977
|
|
Total debt securities
|
367,070
|
|
|
9,876
|
|
|
2,122
|
|
|
374,824
|
|
Equity securities
|
50
|
|
|
28
|
|
|
0
|
|
|
78
|
|
Totals
|
$
|
367,120
|
|
|
$
|
9,904
|
|
|
$
|
2,122
|
|
|
$
|
374,902
|
|
December 31, 2015
|
|
|
|
|
|
|
|
U.S. Government Agencies
|
$
|
47,209
|
|
|
$
|
200
|
|
|
$
|
182
|
|
|
$
|
47,227
|
|
States and political subdivisions
|
124,421
|
|
|
2,483
|
|
|
943
|
|
|
125,961
|
|
GSE residential mortgage-backed securities
|
132,389
|
|
|
229
|
|
|
269
|
|
|
132,349
|
|
GSE residential CMOs
|
15,668
|
|
|
215
|
|
|
40
|
|
|
15,843
|
|
GSE commercial CMOs
|
63,598
|
|
|
735
|
|
|
563
|
|
|
63,770
|
|
Private label CMOs
|
8,944
|
|
|
0
|
|
|
43
|
|
|
8,901
|
|
Total debt securities
|
392,229
|
|
|
3,862
|
|
|
2,040
|
|
|
394,051
|
|
Equity securities
|
50
|
|
|
23
|
|
|
0
|
|
|
73
|
|
Totals
|
$
|
392,279
|
|
|
$
|
3,885
|
|
|
$
|
2,040
|
|
|
$
|
394,124
|
|
The following table shows gross unrealized losses and fair value of the Company’s available for sale securities that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that the individual securities have been in a continuous unrealized loss position at
September 30, 2016
and
December 31, 2015
:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Less Than 12 Months
|
|
12 Months or More
|
|
Total
|
(Dollars in thousands)
|
Fair Value
|
|
Unrealized
Losses
|
|
Fair Value
|
|
Unrealized
Losses
|
|
Fair Value
|
|
Unrealized
Losses
|
September 30, 2016
|
|
|
|
|
|
|
|
|
|
|
|
U.S. Government Agencies
|
$
|
5,875
|
|
|
$
|
12
|
|
|
$
|
14,233
|
|
|
$
|
70
|
|
|
$
|
20,108
|
|
|
$
|
82
|
|
States and political subdivisions
|
0
|
|
|
0
|
|
|
5,452
|
|
|
202
|
|
|
5,452
|
|
|
202
|
|
GSE residential collateralized mortgage obligations (CMOs)
|
63,107
|
|
|
1,779
|
|
|
712
|
|
|
7
|
|
|
63,819
|
|
|
1,786
|
|
Private label CMOs
|
5,976
|
|
|
52
|
|
|
0
|
|
|
0
|
|
|
5,976
|
|
|
52
|
|
Total temporarily impaired securities
|
$
|
74,958
|
|
|
$
|
1,843
|
|
|
$
|
20,397
|
|
|
$
|
279
|
|
|
$
|
95,355
|
|
|
$
|
2,122
|
|
December 31, 2015
|
|
|
|
|
|
|
|
|
|
|
|
U.S. Government Agencies
|
$
|
27,640
|
|
|
$
|
182
|
|
|
$
|
0
|
|
|
$
|
0
|
|
|
$
|
27,640
|
|
|
$
|
182
|
|
States and political subdivisions
|
30,252
|
|
|
373
|
|
|
14,139
|
|
|
570
|
|
|
44,391
|
|
|
943
|
|
GSE residential mortgage-backed securities
|
82,911
|
|
|
269
|
|
|
0
|
|
|
0
|
|
|
82,911
|
|
|
269
|
|
GSE residential CMOs
|
0
|
|
|
0
|
|
|
4,237
|
|
|
40
|
|
|
4,237
|
|
|
40
|
|
GSE commercial CMOs
|
33,606
|
|
|
563
|
|
|
0
|
|
|
0
|
|
|
33,606
|
|
|
563
|
|
Private label CMOs
|
8,901
|
|
|
43
|
|
|
0
|
|
|
0
|
|
|
8,901
|
|
|
43
|
|
Total temporarily impaired securities
|
$
|
183,310
|
|
|
$
|
1,430
|
|
|
$
|
18,376
|
|
|
$
|
610
|
|
|
$
|
201,686
|
|
|
$
|
2,040
|
|
The Company had
18
securities and
53
securities at
September 30, 2016
and
December 31, 2015
in which the amortized cost exceed their values, as discussed below.
U.S. Agencies and Government Sponsored Enterprises (GSE).
Fourteen
U.S. Agencies and GSE securities, including mortgage-backed securities and collateralized mortgage obligations, have amortized costs which exceed their fair values,
11
of which are in the less than 12 months category, and
three
had amortized costs which exceed their fair value for more than 12 months at
September 30, 2016
. At
December 31, 2015
, the Company had
29
U.S. Government Agencies and GSE securities, including mortgage-backed and collateralized mortgage obligations with unrealized losses of which
25
GSE securities have had amortized costs which exceeded their fair values for less than 12 months, and
four
have had amortized costs which exceed their fair values for more than 12 months. These unrealized losses have been caused by a rise in interest rates or widening of spreads from the time the securities were purchased. The contractual terms of those investments do not permit the issuer to settle the securities at a price less than the par value basis of the investments. Because the Company does not intend to sell the investments and it is not more likely than not that the Company will be required to sell the investments before recovery of their amortized cost basis, which may be maturity, the Company does not consider these investments to be other-than-temporarily impaired at
September 30, 2016
or at
December 31, 2015
.
State and Political Subdivisions.
One
state and political subdivision security had an amortized cost which exceeded its fair value in the more than 12 months category at
September 30, 2016
. At
December 31, 2015
,
21
state and political subdivision securities have an amortized cost which exceeded their fair value,
16
of which are in the less than 12 months category, and
five
are in the more than 12 months category. These unrealized losses have been caused by a rise in interest rates or a widening of spreads from the time the securities were purchased. Management considers the investment rating, the state of the issuer of the security and other credit support in determining whether the security is other-than-temporarily impaired. Because the Company did not intend to sell the investments and it is not more likely than not that the Company will be required to sell the investments before recovery of their amortized cost basis, which may be maturity, the Company does not consider these investments to be other-than-temporarily impaired at
September 30, 2016
or at
December 31, 2015
.
Private Label.
Three
private label collateralized mortgage obligations have unrealized losses,
all
of which were in the
less than 12 months
category at
September 30, 2016
. At
December 31, 2015
,
three
private label securities have an amortized cost which exceeded their fair value for less than 12 months. These unrealized losses have been caused by a rise in interest rates from the time the securities were purchased. Because the Company does not intend to sell the investments and it is not more likely than not that the Company will be required to sell the investments before recovery of their amortized cost basis, which
may be maturity, the Company does not consider these investments to be other-than-temporarily impaired at
September 30, 2016
or at
December 31, 2015
.
The amortized cost and fair values of securities available for sale at
September 30, 2016
by contractual maturity are shown below. Contractual maturities will differ from expected maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
|
|
|
|
|
|
|
|
|
|
Available for Sale
|
(Dollars in thousands)
|
Amortized Cost
|
|
Fair Value
|
|
|
|
|
Due in one year or less
|
$
|
0
|
|
|
$
|
0
|
|
Due after one year through five years
|
3,210
|
|
|
3,358
|
|
Due after five years through ten years
|
71,653
|
|
|
75,769
|
|
Due after ten years
|
90,583
|
|
|
93,141
|
|
Mortgage-backed securities and collateralized mortgage obligations
|
201,624
|
|
|
202,556
|
|
Total debt securities
|
367,070
|
|
|
374,824
|
|
Equity securities
|
50
|
|
|
78
|
|
|
$
|
367,120
|
|
|
$
|
374,902
|
|
Gross gains on the sales of securities were
$0
and
$29,000
for the three months ended
September 30, 2016
and
2015
. Gross gains on the sales of securities were
$1,468,000
and
$1,935,000
for the
nine
months ended
September 30, 2016
and
2015
. Gross losses on securities available for sale were
$48,000
and
$24,000
for the
nine
months ended
September 30, 2016
and
2015
.
Securities with a fair value of
$279,270,000
and
$250,397,000
at
September 30, 2016
and
December 31, 2015
were pledged to secure public funds and for other purposes as required or permitted by law.
NOTE 3. LOANS RECEIVABLE AND ALLOWANCE FOR LOAN LOSSES
The Company’s loan portfolio is broken down into segments to an appropriate level of disaggregation to allow management to monitor the performance by the borrower and to monitor the yield on the portfolio. Consistent with ASU 2010-20,
Disclosures about the Credit Quality of Financing Receivables and the Allowance for Loan Losses,
the segments were further broken down into classes, to allow for differing risk characteristics within a segment.
The risks associated with lending activities differ among the various loan classes, and are subject to the impact of changes in interest rates, market conditions for the collateral securing the loans, and general economic conditions. All of these factors may adversely impact the borrower’s ability to repay its loans, and impact the associated collateral.
The Company has various types of commercial real estate loans which have differing levels of credit risk associated with them. Owner-occupied commercial real estate loans are generally dependent upon the successful operation of the borrower’s business, with the cash flows generated from the business being the primary source of repayment of the loan. If the business suffers a downturn in sales or profitability, the borrower’s ability to repay the loan could be in jeopardy.
Non-owner occupied and multi-family commercial real estate loans and non-owner occupied residential loans present a different credit risk to the Company than owner-occupied commercial real estate loans, as the repayment of the loan is dependent upon the borrower’s ability to generate a sufficient level of occupancy to produce rental income that exceeds debt service requirements and operating expenses. Lower occupancy or lease rates may result in a reduction in cash flows, which hinders the ability of the borrower to meet debt service requirements, and may result in lower collateral values. The Company generally recognizes that greater risk is inherent in these credit relationships as compared to owner-occupied loans mentioned above.
Acquisition and development loans consist of 1-4 family residential construction and commercial and land development loans. The risk of loss on these loans is largely dependent on the Company’s ability to assess the property’s value at the completion of the project, which should exceed the property’s construction costs. During the construction phase, a number of factors could potentially negatively impact the collateral value, including cost overruns, delays in completing the project, competition, and real estate market conditions which may change based on the supply of similar properties in the area. In the
event the collateral value at the completion of the project is not sufficient to cover the outstanding loan balance, the Company must rely upon other repayment sources, including the guarantors of the project or other collateral securing the loan.
Commercial and industrial loans include advances to local and regional businesses for general commercial purposes and include permanent and short-term working capital, machinery and equipment financing, and may be either in the form of lines of credit or term loans. Although commercial and industrial loans may be unsecured for our highest-rated borrowers, the majority of these loans are secured by the borrower’s accounts receivable, inventory and machinery and equipment. In a significant number of these loans, the collateral also includes the business real estate or the business owner’s personal real estate or assets. Commercial and industrial loans present credit exposure to the Company, as they are more susceptible to risk of loss during a downturn in the economy, as borrowers may have greater difficulty in meeting their debt service requirements and the value of the collateral may decline. The Company attempts to mitigate this risk through its underwriting standards, including evaluating the credit worthiness of the borrower and, to the extent available, credit ratings on the business. Additionally, monitoring of the loans through annual renewals and meetings with the borrowers are typical. However, these procedures cannot eliminate the risk of loss associated with commercial and industrial lending.
Municipal loans consist of extensions of credit to municipalities and school districts within the Company’s market area. These loans generally present a lower risk than commercial and industrial loans, as they are generally secured by the municipality’s full taxing authority, by revenue obligations, or by its ability to raise assessments on its customers for a specific utility.
The Company originates loans to its retail customers, including fixed-rate and adjustable rate first lien mortgage loans with the underlying 1-4 family owner-occupied residential property securing the loan. The Company’s risk exposure is minimized in these types of loans through the evaluation of the credit worthiness of the borrower, including credit scores and debt-to-income ratios, and underwriting standards which limit the loan-to-value ratio to generally no more than
80%
upon loan origination, unless the borrower obtains private mortgage insurance.
Home equity loans, including term loans and lines of credit, present a slightly higher risk to the Company than 1-4 family first liens, as these loans can be first or second liens on 1-4 family owner-occupied residential property, but generally can have loan-to-value ratios of no greater than
90%
of the value of the real estate taken as collateral. The credit worthiness of the borrower is considered including credit scores and debt-to-income ratios, which generally cannot exceed
43%
.
Installment and other loans’ credit risk are mitigated through prudent underwriting standards, including the evaluation of the credit worthiness of the borrower through credit scores and debt-to-income ratios, and if secured, the collateral value of the assets. As these loans can be unsecured or secured by assets the value of which may depreciate quickly or may fluctuate, they typically present a greater risk to the Company than 1-4 family residential loans.
The loan portfolio, excluding residential loans held for sale, broken out by class, as of
September 30, 2016
and
December 31, 2015
was as follows:
|
|
|
|
|
|
|
|
|
(Dollars in thousands)
|
September 30, 2016
|
|
December 31, 2015
|
Commercial real estate:
|
|
|
|
Owner-occupied
|
$
|
111,437
|
|
|
$
|
103,578
|
|
Non-owner occupied
|
192,449
|
|
|
145,401
|
|
Multi-family
|
39,394
|
|
|
35,109
|
|
Non-owner occupied residential
|
56,759
|
|
|
54,175
|
|
Acquisition and development:
|
|
|
|
1-4 family residential construction
|
6,379
|
|
|
9,364
|
|
Commercial and land development
|
28,030
|
|
|
41,339
|
|
Commercial and industrial
|
87,492
|
|
|
73,625
|
|
Municipal
|
54,241
|
|
|
57,511
|
|
Residential mortgage:
|
|
|
|
First lien
|
134,498
|
|
|
126,022
|
|
Home equity - term
|
14,896
|
|
|
17,337
|
|
Home equity - lines of credit
|
114,274
|
|
|
110,731
|
|
Installment and other loans
|
7,212
|
|
|
7,521
|
|
|
$
|
847,061
|
|
|
$
|
781,713
|
|
In order to monitor ongoing risk associated with its loan portfolio and specific loans within the segments, management uses an internal grading system. The first several rating categories, representing the lowest risk to the Bank, are combined and given a “Pass” rating. Management generally follows regulatory definitions in assigning criticized ratings to loans, including special mention, substandard, doubtful or loss. The “Special Mention” category includes loans that have potential weaknesses that may, if not monitored or corrected, weaken the asset or inadequately protect the Bank’s position at some future date. These assets pose elevated risk, but their weakness does not yet justify a more severe, or classified rating. “Substandard” loans are classified as they have a well-defined weakness, or weaknesses that jeopardize liquidation of the debt. These loans are characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected. “Substandard” loans include loans that management has determined not to be impaired, as well as loans considered to be impaired. A “Doubtful” loan has a high probability of total or substantial loss, but because of specific pending events that may strengthen the asset, its classification of loss is deferred. “Loss” assets are considered uncollectible, as the underlying borrowers are often in bankruptcy, have suspended debt repayments, or have ceased business operations. Once a loan is classified as “Loss,” there is little prospect of collecting the loan’s principal or interest and it is generally written off.
The Bank has a loan review policy and program which is designed to identify and manage risk in the lending function. The Enterprise Risk Management (“ERM”) Committee, comprised of executive officers and loan department personnel, is charged with the oversight of overall credit quality and risk exposure of the Bank’s loan portfolio. This includes the monitoring of the lending activities of all Bank personnel with respect to underwriting and processing new loans and the timely follow-up and corrective action for loans showing signs of deterioration in quality. The loan review program provides the Bank with an independent review of the Bank’s loan portfolio on an ongoing basis. Generally, consumer and residential mortgage loans are included in the “Pass” categories unless a specific action, such as extended delinquencies, bankruptcy, repossession or death of the borrower occurs, which heightens awareness as to a possible credit event.
The following summarizes the Bank’s ratings based on its internal risk rating system as of
September 30, 2016
and
December 31, 2015
:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
(Dollars in thousands)
|
Pass
|
|
Special Mention
|
|
Non-Impaired Substandard
|
|
Impaired - Substandard
|
|
Doubtful
|
|
Total
|
September 30, 2016
|
|
|
|
|
|
|
|
|
|
|
|
Commercial real estate:
|
|
|
|
|
|
|
|
|
|
|
|
Owner-occupied
|
$
|
99,563
|
|
|
$
|
8,318
|
|
|
$
|
2,077
|
|
|
$
|
1,479
|
|
|
$
|
0
|
|
|
$
|
111,437
|
|
Non-owner occupied
|
168,158
|
|
|
12,261
|
|
|
5,127
|
|
|
6,253
|
|
|
650
|
|
|
192,449
|
|
Multi-family
|
37,108
|
|
|
1,284
|
|
|
795
|
|
|
207
|
|
|
0
|
|
|
39,394
|
|
Non-owner occupied residential
|
53,777
|
|
|
1,308
|
|
|
1,167
|
|
|
507
|
|
|
0
|
|
|
56,759
|
|
Acquisition and development:
|
|
|
|
|
|
|
|
|
|
|
|
1-4 family residential construction
|
5,859
|
|
|
364
|
|
|
156
|
|
|
0
|
|
|
0
|
|
|
6,379
|
|
Commercial and land development
|
27,371
|
|
|
11
|
|
|
646
|
|
|
2
|
|
|
0
|
|
|
28,030
|
|
Commercial and industrial
|
86,184
|
|
|
711
|
|
|
34
|
|
|
339
|
|
|
224
|
|
|
87,492
|
|
Municipal
|
54,241
|
|
|
0
|
|
|
0
|
|
|
0
|
|
|
0
|
|
|
54,241
|
|
Residential mortgage:
|
|
|
|
|
|
|
|
|
|
|
|
First lien
|
130,139
|
|
|
0
|
|
|
0
|
|
|
4,359
|
|
|
0
|
|
|
134,498
|
|
Home equity - term
|
14,802
|
|
|
0
|
|
|
0
|
|
|
94
|
|
|
0
|
|
|
14,896
|
|
Home equity - lines of credit
|
113,704
|
|
|
188
|
|
|
52
|
|
|
330
|
|
|
0
|
|
|
114,274
|
|
Installment and other loans
|
7,203
|
|
|
0
|
|
|
0
|
|
|
9
|
|
|
0
|
|
|
7,212
|
|
|
$
|
798,109
|
|
|
$
|
24,445
|
|
|
$
|
10,054
|
|
|
$
|
13,579
|
|
|
$
|
874
|
|
|
$
|
847,061
|
|
December 31, 2015
|
|
|
|
|
|
|
|
|
|
|
|
Commercial real estate:
|
|
|
|
|
|
|
|
|
|
|
|
Owner-occupied
|
$
|
96,715
|
|
|
$
|
1,124
|
|
|
$
|
3,630
|
|
|
$
|
2,109
|
|
|
$
|
0
|
|
|
$
|
103,578
|
|
Non-owner occupied
|
125,043
|
|
|
12,394
|
|
|
108
|
|
|
7,856
|
|
|
0
|
|
|
145,401
|
|
Multi-family
|
31,957
|
|
|
1,779
|
|
|
1,140
|
|
|
233
|
|
|
0
|
|
|
35,109
|
|
Non-owner occupied residential
|
50,601
|
|
|
1,305
|
|
|
1,374
|
|
|
895
|
|
|
0
|
|
|
54,175
|
|
Acquisition and development:
|
|
|
|
|
|
|
|
|
|
|
|
1-4 family residential construction
|
9,364
|
|
|
0
|
|
|
0
|
|
|
0
|
|
|
0
|
|
|
9,364
|
|
Commercial and land development
|
40,181
|
|
|
219
|
|
|
934
|
|
|
5
|
|
|
0
|
|
|
41,339
|
|
Commercial and industrial
|
70,967
|
|
|
1,380
|
|
|
544
|
|
|
734
|
|
|
0
|
|
|
73,625
|
|
Municipal
|
57,511
|
|
|
0
|
|
|
0
|
|
|
0
|
|
|
0
|
|
|
57,511
|
|
Residential mortgage:
|
|
|
|
|
|
|
|
|
|
|
|
First lien
|
121,214
|
|
|
0
|
|
|
0
|
|
|
4,808
|
|
|
0
|
|
|
126,022
|
|
Home equity - term
|
17,234
|
|
|
0
|
|
|
0
|
|
|
103
|
|
|
0
|
|
|
17,337
|
|
Home equity - lines of credit
|
109,731
|
|
|
230
|
|
|
180
|
|
|
590
|
|
|
0
|
|
|
110,731
|
|
Installment and other loans
|
7,504
|
|
|
0
|
|
|
0
|
|
|
17
|
|
|
0
|
|
|
7,521
|
|
|
$
|
738,022
|
|
|
$
|
18,431
|
|
|
$
|
7,910
|
|
|
$
|
17,350
|
|
|
$
|
0
|
|
|
$
|
781,713
|
|
Classified loans may also be evaluated for impairment. For commercial real estate, acquisition and development and commercial and industrial loans, a loan is considered impaired when, based on current information and events, it is probable that the Bank will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Generally, loans that are more than
90
days past due are deemed impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed to determine if the loan should be placed on nonaccrual status. Nonaccrual loans in the commercial and
commercial real estate portfolios and any TDRs are, by definition, deemed to be impaired. Impairment is measured on a loan-by-loan basis for commercial, construction and restructured loans by either the present value of the expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent. A loan is collateral dependent if the repayment of the loan is expected to be provided solely by the underlying collateral. For loans that are deemed to be impaired for extended periods of time, periodic updates on fair values are obtained, which may include updated appraisals. The updated fair values are incorporated into the impairment analysis as of the next reporting period.
Loan charge-offs, which may include partial charge-offs, are taken on an impaired loan that is collateral dependent if the loan’s carrying balance exceeds its collateral’s appraised value; the loan has been identified as uncollectible; and it is deemed to be a confirmed loss. Typically, impaired loans with a charge-off or partial charge-off will continue to be considered impaired, unless the note is split into
two
, and management expects the performing note to continue to perform and is adequately secured. The second, or non-performing note, would be charged-off. Generally, an impaired loan with a partial charge-off may continue to have an impairment reserve on it after the partial charge-off, if factors warrant.
As of
September 30, 2016
and
December 31, 2015
, nearly all of the Company’s impaired loans’ extent of impairment was measured based on the estimated fair value of the collateral securing the loan, except for TDRs. By definition, TDRs are considered impaired. All restructured loan impairments were determined based on discounted cash flows for those loans classified as TDRs and still accruing interest. For real estate loans, collateral generally consists of commercial real estate, but in the case of commercial and industrial loans, it would also consist of accounts receivable, inventory, equipment or other business assets. Commercial and industrial loans may also have real estate collateral.
According to policy, updated appraisals are generally required every
18 months
for classified loans in excess of
$250,000
. The “as is value” provided in the appraisal is often used as the fair value of the collateral in determining impairment, unless circumstances, such as subsequent improvements, approvals, or other circumstances dictate that another value provided by the appraiser is more appropriate.
Generally, impaired loans secured by real estate, other than performing TDRs, are measured at fair value using certified real estate appraisals that had been completed within the last
18 months
. Appraised values are further discounted for estimated costs to sell the property and other selling considerations to arrive at the property’s fair value. In those situations in which it is determined an updated appraisal is not required for loans individually evaluated for impairment, fair values are based on one or a combination of the following approaches. In those situations in which a combination of approaches is considered, the factor that carries the most consideration will be the one management believes is warranted. The approaches are as follows:
|
|
•
|
Original appraisal – if the original appraisal provides a strong loan-to-value ratio (generally
70%
or lower) and, after consideration of market conditions and knowledge of the property and area, it is determined by the Credit Administration staff that there has not been a significant deterioration in the collateral value, the original certified appraised value may be used. Discounts as deemed appropriate for selling costs are factored into the appraised value in arriving at fair value.
|
|
|
•
|
Discounted cash flows – in limited cases, discounted cash flows may be used on projects in which the collateral is liquidated to reduce the borrowings outstanding, and is used to validate collateral values derived from other approaches.
|
Collateral on certain impaired loans is not limited to real estate, and may consist of accounts receivable, inventory, equipment or other business assets. Estimated fair values are determined based on borrowers’ financial statements, inventory ledgers, accounts receivable agings or appraisals from individuals with knowledge in the business. Stated balances are generally discounted for the age of the financial information or the quality of the assets. In determining fair value, liquidation discounts are applied to this collateral based on existing loan evaluation policies.
The Company distinguishes Substandard loans on both an impaired and non-impaired basis, as it places less emphasis on a loan’s classification, and increased reliance on whether the loan was performing in accordance with the contractual terms. A “Substandard” classification does not automatically meet the definition of “impaired.” A "Substandard" loan is one that is inadequately protected by the current sound worth and paying capacity of the obligor or the collateral pledged, if any. Extensions of credit so classified have well-defined weaknesses which may jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected. Loss potential, while existing in the aggregate amount of substandard loans, does not have to exist in individual extensions of credit classified as "Substandard." As a result, the Company’s methodology includes an evaluation of certain accruing commercial real estate, acquisition and development and commercial and industrial loans rated “Substandard” to be collectively evaluated for impairment as opposed to evaluating these loans individually for impairment. Although we believe these loans have well defined weaknesses and meet the definition of “Substandard,” they are generally performing and management has concluded
that it is likely it will be able to collect the scheduled payments of principal and interest when due according to the contractual terms of the loan agreement.
Larger groups of smaller balance homogeneous loans are collectively evaluated for impairment. Generally, the Bank does not separately identify individual consumer and residential loans for impairment disclosures, unless such loans are the subject of a restructuring agreement due to financial difficulties of the borrower.
The following table summarizes impaired loans by class, segregated by those for which a specific allowance was required and those for which a specific allowance was not required as of
September 30, 2016
and
December 31, 2015
. The recorded investment in loans excludes accrued interest receivable due to insignificance. Related allowances established generally pertain to those loans in which loan forbearance agreements were in the process of being negotiated or updated appraisals were pending, and the partial charge-off will be recorded when final information is received.
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Impaired Loans with a Specific Allowance
|
|
Impaired Loans with No Specific Allowance
|
(Dollars in thousands)
|
Recorded
Investment
(Book Balance)
|
|
Unpaid Principal
Balance
(Legal Balance)
|
|
Related
Allowance
|
|
Recorded
Investment
(Book Balance)
|
|
Unpaid Principal
Balance
(Legal Balance)
|
September 30, 2016
|
|
|
|
|
|
|
|
|
|
Commercial real estate:
|
|
|
|
|
|
|
|
|
|
Owner-occupied
|
$
|
0
|
|
|
$
|
0
|
|
|
$
|
0
|
|
|
$
|
1,479
|
|
|
$
|
2,673
|
|
Non-owner occupied
|
6,095
|
|
|
6,428
|
|
|
650
|
|
|
808
|
|
|
1,405
|
|
Multi-family
|
0
|
|
|
0
|
|
|
0
|
|
|
207
|
|
|
372
|
|
Non-owner occupied residential
|
0
|
|
|
0
|
|
|
0
|
|
|
507
|
|
|
755
|
|
Acquisition and development:
|
|
|
|
|
|
|
|
|
|
Commercial and land development
|
0
|
|
|
0
|
|
|
0
|
|
|
2
|
|
|
17
|
|
Commercial and industrial
|
224
|
|
|
227
|
|
|
158
|
|
|
339
|
|
|
392
|
|
Residential mortgage:
|
|
|
|
|
|
|
|
|
|
First lien
|
781
|
|
|
781
|
|
|
64
|
|
|
3,578
|
|
|
4,261
|
|
Home equity - term
|
0
|
|
|
0
|
|
|
0
|
|
|
94
|
|
|
104
|
|
Home equity - lines of credit
|
0
|
|
|
0
|
|
|
0
|
|
|
330
|
|
|
432
|
|
Installment and other loans
|
2
|
|
|
3
|
|
|
2
|
|
|
7
|
|
|
34
|
|
|
$
|
7,102
|
|
|
$
|
7,439
|
|
|
$
|
874
|
|
|
$
|
7,351
|
|
|
$
|
10,445
|
|
December 31, 2015
|
|
|
|
|
|
|
|
|
|
Commercial real estate:
|
|
|
|
|
|
|
|
|
|
Owner-occupied
|
$
|
0
|
|
|
$
|
0
|
|
|
$
|
0
|
|
|
$
|
2,109
|
|
|
$
|
3,344
|
|
Non-owner occupied
|
0
|
|
|
0
|
|
|
0
|
|
|
7,856
|
|
|
8,600
|
|
Multi-family
|
0
|
|
|
0
|
|
|
0
|
|
|
233
|
|
|
385
|
|
Non-owner occupied residential
|
0
|
|
|
0
|
|
|
0
|
|
|
895
|
|
|
1,211
|
|
Acquisition and development:
|
|
|
|
|
|
|
|
|
|
Commercial and land development
|
0
|
|
|
0
|
|
|
0
|
|
|
5
|
|
|
19
|
|
Commercial and industrial
|
0
|
|
|
0
|
|
|
0
|
|
|
734
|
|
|
780
|
|
Residential mortgage:
|
|
|
|
|
|
|
|
|
|
First lien
|
1,952
|
|
|
1,984
|
|
|
271
|
|
|
2,856
|
|
|
3,369
|
|
Home equity - term
|
0
|
|
|
0
|
|
|
0
|
|
|
103
|
|
|
110
|
|
Home equity - lines of credit
|
22
|
|
|
23
|
|
|
10
|
|
|
568
|
|
|
688
|
|
Installment and other loans
|
8
|
|
|
9
|
|
|
8
|
|
|
9
|
|
|
35
|
|
|
$
|
1,982
|
|
|
$
|
2,016
|
|
|
$
|
289
|
|
|
$
|
15,368
|
|
|
$
|
18,541
|
|
The following tables summarize the average recorded investment in impaired loans and related interest income recognized on loans deemed impaired, generally on a cash basis, for the three and
nine
months ended
September 30, 2016
and
2015
:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended September 30,
|
|
2016
|
|
2015
|
(Dollars in thousands)
|
Average
Impaired
Balance
|
|
Interest
Income
Recognized
|
|
Average
Impaired
Balance
|
|
Interest
Income
Recognized
|
Commercial real estate:
|
|
|
|
|
|
|
|
Owner-occupied
|
$
|
1,650
|
|
|
$
|
0
|
|
|
$
|
2,336
|
|
|
$
|
0
|
|
Non-owner occupied
|
6,979
|
|
|
0
|
|
|
2,900
|
|
|
0
|
|
Multi-family
|
212
|
|
|
0
|
|
|
369
|
|
|
0
|
|
Non-owner occupied residential
|
525
|
|
|
0
|
|
|
866
|
|
|
0
|
|
Acquisition and development:
|
|
|
|
|
|
|
|
Commercial and land development
|
2
|
|
|
0
|
|
|
224
|
|
|
132
|
|
Commercial and industrial
|
494
|
|
|
0
|
|
|
797
|
|
|
0
|
|
Residential mortgage:
|
|
|
|
|
|
|
|
First lien
|
4,366
|
|
|
8
|
|
|
4,280
|
|
|
15
|
|
Home equity - term
|
95
|
|
|
0
|
|
|
174
|
|
|
0
|
|
Home equity - lines of credit
|
334
|
|
|
0
|
|
|
599
|
|
|
0
|
|
Installment and other loans
|
10
|
|
|
0
|
|
|
20
|
|
|
0
|
|
|
$
|
14,667
|
|
|
$
|
8
|
|
|
$
|
12,565
|
|
|
$
|
147
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Nine Months Ended September 30,
|
|
2016
|
|
2015
|
(Dollars in thousands)
|
Average
Impaired
Balance
|
|
Interest
Income
Recognized
|
|
Average
Impaired
Balance
|
|
Interest
Income
Recognized
|
Commercial real estate:
|
|
|
|
|
|
|
|
Owner-occupied
|
$
|
1,891
|
|
|
$
|
0
|
|
|
$
|
2,749
|
|
|
$
|
0
|
|
Non-owner occupied
|
7,334
|
|
|
0
|
|
|
2,120
|
|
|
0
|
|
Multi-family
|
221
|
|
|
0
|
|
|
452
|
|
|
0
|
|
Non-owner occupied residential
|
700
|
|
|
0
|
|
|
1,055
|
|
|
0
|
|
Acquisition and development:
|
|
|
|
|
|
|
|
Commercial and land development
|
3
|
|
|
0
|
|
|
313
|
|
|
137
|
|
Commercial and industrial
|
577
|
|
|
0
|
|
|
1,346
|
|
|
0
|
|
Residential mortgage:
|
|
|
|
|
|
|
|
First lien
|
4,587
|
|
|
25
|
|
|
4,771
|
|
|
33
|
|
Home equity - term
|
98
|
|
|
0
|
|
|
139
|
|
|
0
|
|
Home equity - lines of credit
|
474
|
|
|
0
|
|
|
562
|
|
|
0
|
|
Installment and other loans
|
14
|
|
|
0
|
|
|
23
|
|
|
0
|
|
|
$
|
15,899
|
|
|
$
|
25
|
|
|
$
|
13,530
|
|
|
$
|
170
|
|
The following table presents impaired loans that are TDRs, with the recorded investment as of
September 30, 2016
and
December 31, 2015
.
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
September 30, 2016
|
|
December 31, 2015
|
(Dollars in thousands)
|
Number of
Contracts
|
|
Recorded
Investment
|
|
Number of
Contracts
|
|
Recorded
Investment
|
Accruing:
|
|
|
|
|
|
|
|
Residential mortgage:
|
|
|
|
|
|
|
|
First lien
|
8
|
|
|
$
|
901
|
|
|
8
|
|
|
$
|
793
|
|
|
8
|
|
|
901
|
|
|
8
|
|
|
793
|
|
Nonaccruing:
|
|
|
|
|
|
|
|
Commercial real estate:
|
|
|
|
|
|
|
|
Non-owner occupied
|
1
|
|
|
6,095
|
|
|
0
|
|
|
0
|
|
Residential mortgage:
|
|
|
|
|
|
|
|
First lien
|
12
|
|
|
1,057
|
|
|
12
|
|
|
1,153
|
|
Installment and other loans
|
1
|
|
|
7
|
|
|
1
|
|
|
10
|
|
|
14
|
|
|
7,159
|
|
|
13
|
|
|
1,163
|
|
|
22
|
|
|
$
|
8,060
|
|
|
21
|
|
|
$
|
1,956
|
|
The loans presented above were considered TDRs as the result of the Company agreeing to below market interest rates for the risk of the transaction, allowing the loan to remain on interest-only status, or agreeing to a reduction in interest rates, in order to give the borrowers an opportunity to improve their cash flows. For TDRs in default of their original terms, impairment is generally determined on a collateral-dependent approach, except for accruing residential mortgage TDRs, which are generally on the discounted cash flow approach.
The following table presents the number of loans modified, and their pre-modification and post-modification investment balances for the three and
nine
months ended
September 30, 2016
and
2015
:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
2016
|
|
2015
|
(Dollars in thousands)
|
Number of
Contracts
|
|
Pre-
Modification
Recorded
Investment
|
|
Post
Modification
Recorded
Investment
|
|
Number of
Contracts
|
|
Pre-
Modification
Recorded
Investment
|
|
Post
Modification
Recorded
Investment
|
Three Months Ended September 30,
|
|
|
|
|
|
|
|
|
|
|
|
Commercial real estate:
|
|
|
|
|
|
|
|
|
|
|
|
Non-owner occupied
|
1
|
|
|
$
|
6,095
|
|
|
$
|
6,095
|
|
|
0
|
|
|
$
|
0
|
|
|
$
|
0
|
|
|
1
|
|
|
$
|
6,095
|
|
|
$
|
6,095
|
|
|
0
|
|
|
$
|
0
|
|
|
$
|
0
|
|
Nine Months Ended September 30,
|
|
|
|
|
|
|
|
|
|
|
|
Commercial real estate:
|
|
|
|
|
|
|
|
|
|
|
|
Non-owner occupied
|
1
|
|
|
$
|
6,095
|
|
|
$
|
6,095
|
|
|
0
|
|
|
$
|
0
|
|
|
$
|
0
|
|
Residential mortgage:
|
|
|
|
|
|
|
|
|
|
|
|
First lien
|
1
|
|
|
257
|
|
|
257
|
|
|
1
|
|
|
59
|
|
|
0
|
|
|
2
|
|
|
$
|
6,352
|
|
|
$
|
6,352
|
|
|
1
|
|
|
$
|
59
|
|
|
$
|
0
|
|
Certain loans modified during a period may no longer be outstanding at the end of the period if the loan was paid off.
The following table presents restructured loans, included in nonaccrual loans, that were modified as TDRs within the previous 12 months and for which there was a payment default during the three and
nine
months ended
September 30, 2016
and
2015
:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
2016
|
|
2015
|
(Dollars in thousands)
|
Number of
Contracts
|
|
Recorded
Investment
|
|
Number of
Contracts
|
|
Recorded
Investment
|
Three Months Ended September 30,
|
|
|
|
|
|
|
|
Residential mortgage:
|
|
|
|
|
|
|
|
First lien
|
0
|
|
|
$
|
0
|
|
|
0
|
|
|
$
|
0
|
|
|
0
|
|
|
$
|
0
|
|
|
0
|
|
|
$
|
0
|
|
Nine Months Ended September 30,
|
|
|
|
|
|
|
|
Residential mortgage:
|
|
|
|
|
|
|
|
First lien
|
0
|
|
|
$
|
0
|
|
|
4
|
|
|
$
|
308
|
|
|
0
|
|
|
$
|
0
|
|
|
4
|
|
|
$
|
308
|
|
No additional commitments have been made to borrowers whose loans are considered TDRs.
Management further monitors the performance and credit quality of the loan portfolio by analyzing the average length of time a portfolio is past due, by aggregating loans based on their delinquencies. The following table presents the classes of the loan portfolio summarized by aging categories of performing loans and nonaccrual loans as of
September 30, 2016
and
December 31, 2015
:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Days Past Due
|
|
|
|
|
|
|
(Dollars in thousands)
|
Current
|
|
30-59
|
|
60-89
|
|
90+
(still accruing)
|
|
Total
Past Due
|
|
Non-
Accrual
|
|
Total
Loans
|
September 30, 2016
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Commercial real estate:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Owner-occupied
|
$
|
109,958
|
|
|
$
|
0
|
|
|
$
|
0
|
|
|
$
|
0
|
|
|
$
|
0
|
|
|
$
|
1,479
|
|
|
$
|
111,437
|
|
Non-owner occupied
|
185,546
|
|
|
0
|
|
|
0
|
|
|
0
|
|
|
0
|
|
|
6,903
|
|
|
192,449
|
|
Multi-family
|
39,187
|
|
|
0
|
|
|
0
|
|
|
0
|
|
|
0
|
|
|
207
|
|
|
39,394
|
|
Non-owner occupied residential
|
56,252
|
|
|
0
|
|
|
0
|
|
|
0
|
|
|
0
|
|
|
507
|
|
|
56,759
|
|
Acquisition and development:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
1-4 family residential construction
|
6,379
|
|
|
0
|
|
|
0
|
|
|
0
|
|
|
0
|
|
|
0
|
|
|
6,379
|
|
Commercial and land development
|
28,028
|
|
|
0
|
|
|
0
|
|
|
0
|
|
|
0
|
|
|
2
|
|
|
28,030
|
|
Commercial and industrial
|
86,828
|
|
|
100
|
|
|
0
|
|
|
0
|
|
|
100
|
|
|
564
|
|
|
87,492
|
|
Municipal
|
54,241
|
|
|
0
|
|
|
0
|
|
|
0
|
|
|
0
|
|
|
0
|
|
|
54,241
|
|
Residential mortgage:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
First lien
|
130,243
|
|
|
345
|
|
|
453
|
|
|
0
|
|
|
798
|
|
|
3,457
|
|
|
134,498
|
|
Home equity - term
|
14,772
|
|
|
21
|
|
|
9
|
|
|
0
|
|
|
30
|
|
|
94
|
|
|
14,896
|
|
Home equity - lines of credit
|
113,448
|
|
|
382
|
|
|
75
|
|
|
39
|
|
|
496
|
|
|
330
|
|
|
114,274
|
|
Installment and other loans
|
7,187
|
|
|
7
|
|
|
9
|
|
|
0
|
|
|
16
|
|
|
9
|
|
|
7,212
|
|
|
$
|
832,069
|
|
|
$
|
855
|
|
|
$
|
546
|
|
|
$
|
39
|
|
|
$
|
1,440
|
|
|
$
|
13,552
|
|
|
$
|
847,061
|
|
December 31, 2015
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Commercial real estate:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Owner-occupied
|
$
|
101,395
|
|
|
$
|
74
|
|
|
$
|
0
|
|
|
$
|
0
|
|
|
$
|
74
|
|
|
$
|
2,109
|
|
|
$
|
103,578
|
|
Non-owner occupied
|
137,545
|
|
|
0
|
|
|
0
|
|
|
0
|
|
|
0
|
|
|
7,856
|
|
|
145,401
|
|
Multi-family
|
34,876
|
|
|
0
|
|
|
0
|
|
|
0
|
|
|
0
|
|
|
233
|
|
|
35,109
|
|
Non-owner occupied residential
|
53,280
|
|
|
0
|
|
|
0
|
|
|
0
|
|
|
0
|
|
|
895
|
|
|
54,175
|
|
Acquisition and development:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
1-4 family residential construction
|
9,364
|
|
|
0
|
|
|
0
|
|
|
0
|
|
|
0
|
|
|
0
|
|
|
9,364
|
|
Commercial and land development
|
41,236
|
|
|
0
|
|
|
98
|
|
|
0
|
|
|
98
|
|
|
5
|
|
|
41,339
|
|
Commercial and industrial
|
72,846
|
|
|
24
|
|
|
21
|
|
|
0
|
|
|
45
|
|
|
734
|
|
|
73,625
|
|
Municipal
|
57,511
|
|
|
0
|
|
|
0
|
|
|
0
|
|
|
0
|
|
|
0
|
|
|
57,511
|
|
Residential mortgage:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
First lien
|
120,119
|
|
|
1,844
|
|
|
44
|
|
|
0
|
|
|
1,888
|
|
|
4,015
|
|
|
126,022
|
|
Home equity - term
|
17,200
|
|
|
34
|
|
|
0
|
|
|
0
|
|
|
34
|
|
|
103
|
|
|
17,337
|
|
Home equity - lines of credit
|
109,740
|
|
|
286
|
|
|
91
|
|
|
24
|
|
|
401
|
|
|
590
|
|
|
110,731
|
|
Installment and other loans
|
7,488
|
|
|
16
|
|
|
0
|
|
|
0
|
|
|
16
|
|
|
17
|
|
|
7,521
|
|
|
$
|
762,600
|
|
|
$
|
2,278
|
|
|
$
|
254
|
|
|
$
|
24
|
|
|
$
|
2,556
|
|
|
$
|
16,557
|
|
|
$
|
781,713
|
|
The Company maintains the allowance for loan losses at a level believed to be adequate by management for probable incurred credit losses. The allowance is established and maintained through a provision for loan losses charged to earnings. Quarterly, management assesses the adequacy of the allowance for loan losses utilizing a defined methodology, which considers specific credit evaluation of impaired loans as discussed above, past loan loss historical experience, and qualitative factors. Management believes the approach properly addresses the requirements of ASC Subtopic 310-10-35 for loans individually identified as impaired, and ASC Subtopic 450-20 for loans collectively evaluated for impairment, and other bank regulatory guidance.
In connection with its quarterly evaluation of the adequacy of the allowance for loan losses, management continually reviews its methodology to determine if it continues to properly address the risk in the loan portfolio. For each loan class presented above, general allowances are provided for loans that are collectively evaluated for impairment, which are based on quantitative factors, principally historical loss trends for the respective loan class, adjusted for qualitative factors. In addition, an adjustment to the historical loss factors is made to account for delinquency and other potential risk not elsewhere defined within the Allowance for Loan and Lease Loss methodology.
Prior to December 31, 2015, the look back period for historical losses was 12 quarters, weighted one-half for the most recent four quarters, and one-quarter for each of the two previous four quarter periods in order to appropriately capture the loss history in the loan segment. Effective December 31, 2015, the Company extended the look back period to 16 quarters which will increase to 20 quarters through December 31, 2016. The extended period was on a prospective basis, more heavily weighted to the most recent four quarters. The look back period was extended as it was determined that a longer look back period is more consistent with the duration of an economic cycle. Management considers current economic, business, and real estate conditions, and the trends in historical charge-off percentages that resulted from applying partial charge-offs to impaired loans, and the impact of distressed loan sales during the year in determining the look back period.
In addition to the quantitative analysis, adjustments to the reserve requirements are allocated on loans collectively evaluated for impairment based on additional qualitative factors. As of
September 30, 2016
and
December 31, 2015
, the qualitative factors used by management to adjust the historical loss percentage to the allocation, which may range from a minus 150 basis points to a positive 150 basis points per factor, include:
Nature and Volume of Loans
– Loan growth in the current and subsequent quarters based on the Bank’s targeted growth and strategic plan, coupled with the types of loans booked based on risk management and credit culture, and the number of exceptions to loan policy, and supervisory loan to value exceptions, etc.
Concentrations of Credit and Changes within Credit Concentrations
– Factors considered include the composition of the Bank’s overall portfolio and management’s evaluation related to concentration risk management and the inherent risk associated with the concentrations identified.
Underwriting Standards and Recovery Practices
– Factors considered include changes to underwriting standards and perceived impact on anticipated losses, trends in the number of exceptions to loan policy; supervisory loan to value exceptions; and administration of loan recovery practices.
Delinquency Trends
– Factors considered include the delinquency percentages noted in the portfolio relative to economic conditions, severity of the delinquencies, and whether the ratios are trending upwards or downwards.
Classified Loans Trends
– Factors considered include the internal loan ratings of the portfolio, the severity of the ratings, and whether the loan segment’s ratings show a more favorable or less favorable trend, and underlying market conditions and their impact on the collateral values securing the loans.
Experience, Ability and Depth of Management/Lending staff
– Factors considered include the years of experience of senior and middle management and the lending staff and turnover of the staff, and instances of repeat criticisms of ratings.
Quality of Loan Review
– Factors include the years of experience of the loan review staff, in-house versus outsourced provider of review, turnover of staff and the perceived quality of their work in relation to other external information.
National and Local Economic Conditions
– Ratios and factors considered include trends in the consumer price index (CPI), unemployment rates, housing price index, housing statistics compared to the prior year, bankruptcy rates, regulatory and legal environment risks and competition
Activity in the allowance for loan losses for the three months ended September 30, 2016 and 2015 was as follows:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Commercial
|
|
Consumer
|
|
|
|
|
(Dollars in thousands)
|
Commercial
Real Estate
|
|
Acquisition
and
Development
|
|
Commercial
and
Industrial
|
|
Municipal
|
|
Total
|
|
Residential
Mortgage
|
|
Installment
and Other
|
|
Total
|
|
Unallocated
|
|
Total
|
September 30, 2016
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Balance, beginning of period
|
$
|
8,133
|
|
|
$
|
587
|
|
|
$
|
1,148
|
|
|
$
|
61
|
|
|
$
|
9,929
|
|
|
$
|
2,706
|
|
|
$
|
180
|
|
|
$
|
2,886
|
|
|
$
|
625
|
|
|
$
|
13,440
|
|
Provision for loan losses
|
215
|
|
|
89
|
|
|
76
|
|
|
(7
|
)
|
|
373
|
|
|
(119
|
)
|
|
(3
|
)
|
|
(122
|
)
|
|
(1
|
)
|
|
250
|
|
Charge-offs
|
0
|
|
|
0
|
|
|
0
|
|
|
0
|
|
|
0
|
|
|
(57
|
)
|
|
(47
|
)
|
|
(104
|
)
|
|
0
|
|
|
(104
|
)
|
Recoveries
|
124
|
|
|
0
|
|
|
2
|
|
|
0
|
|
|
126
|
|
|
96
|
|
|
42
|
|
|
138
|
|
|
0
|
|
|
264
|
|
Balance, end of period
|
$
|
8,472
|
|
|
$
|
676
|
|
|
$
|
1,226
|
|
|
$
|
54
|
|
|
$
|
10,428
|
|
|
$
|
2,626
|
|
|
$
|
172
|
|
|
$
|
2,798
|
|
|
$
|
624
|
|
|
$
|
13,850
|
|
September 30, 2015
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Balance, beginning of period
|
$
|
8,132
|
|
|
$
|
720
|
|
|
$
|
844
|
|
|
$
|
119
|
|
|
$
|
9,815
|
|
|
$
|
2,918
|
|
|
$
|
182
|
|
|
$
|
3,100
|
|
|
$
|
937
|
|
|
$
|
13,852
|
|
Provision for loan losses
|
9
|
|
|
(684
|
)
|
|
151
|
|
|
(2
|
)
|
|
(526
|
)
|
|
(54
|
)
|
|
8
|
|
|
(46
|
)
|
|
(31
|
)
|
|
(603
|
)
|
Charge-offs
|
(170
|
)
|
|
0
|
|
|
(27
|
)
|
|
0
|
|
|
(197
|
)
|
|
(222
|
)
|
|
(18
|
)
|
|
(240
|
)
|
|
0
|
|
|
(437
|
)
|
Recoveries
|
64
|
|
|
604
|
|
|
17
|
|
|
0
|
|
|
685
|
|
|
34
|
|
|
6
|
|
|
40
|
|
|
0
|
|
|
725
|
|
Balance, end of period
|
$
|
8,035
|
|
|
$
|
640
|
|
|
$
|
985
|
|
|
$
|
117
|
|
|
$
|
9,777
|
|
|
$
|
2,676
|
|
|
$
|
178
|
|
|
$
|
2,854
|
|
|
$
|
906
|
|
|
$
|
13,537
|
|
Activity in the allowance for loan losses for the
nine
months ended
September 30, 2016
and
2015
was as follows:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Commercial
|
|
Consumer
|
|
|
|
|
(Dollars in thousands)
|
Commercial
Real Estate
|
|
Acquisition
and
Development
|
|
Commercial
and
Industrial
|
|
Municipal
|
|
Total
|
|
Residential
Mortgage
|
|
Installment
and Other
|
|
Total
|
|
Unallocated
|
|
Total
|
September 30, 2016
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Balance, beginning of period
|
$
|
7,883
|
|
|
$
|
850
|
|
|
$
|
1,012
|
|
|
$
|
58
|
|
|
$
|
9,803
|
|
|
$
|
2,870
|
|
|
$
|
121
|
|
|
$
|
2,991
|
|
|
$
|
774
|
|
|
$
|
13,568
|
|
Provision for loan losses
|
236
|
|
|
(174
|
)
|
|
225
|
|
|
(4
|
)
|
|
283
|
|
|
(8
|
)
|
|
125
|
|
|
117
|
|
|
(150
|
)
|
|
250
|
|
Charge-offs
|
(26
|
)
|
|
0
|
|
|
(21
|
)
|
|
0
|
|
|
(47
|
)
|
|
(381
|
)
|
|
(159
|
)
|
|
(540
|
)
|
|
0
|
|
|
(587
|
)
|
Recoveries
|
379
|
|
|
0
|
|
|
10
|
|
|
0
|
|
|
389
|
|
|
145
|
|
|
85
|
|
|
230
|
|
|
0
|
|
|
619
|
|
Balance, end of period
|
$
|
8,472
|
|
|
$
|
676
|
|
|
$
|
1,226
|
|
|
$
|
54
|
|
|
$
|
10,428
|
|
|
$
|
2,626
|
|
|
$
|
172
|
|
|
$
|
2,798
|
|
|
$
|
624
|
|
|
$
|
13,850
|
|
September 30, 2015
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Balance, beginning of period
|
$
|
9,462
|
|
|
$
|
697
|
|
|
$
|
806
|
|
|
$
|
183
|
|
|
$
|
11,148
|
|
|
$
|
2,262
|
|
|
$
|
119
|
|
|
$
|
2,381
|
|
|
$
|
1,218
|
|
|
$
|
14,747
|
|
Provision for loan losses
|
(804
|
)
|
|
(639
|
)
|
|
202
|
|
|
(66
|
)
|
|
(1,307
|
)
|
|
919
|
|
|
97
|
|
|
1,016
|
|
|
(312
|
)
|
|
(603
|
)
|
Charge-offs
|
(711
|
)
|
|
(22
|
)
|
|
(77
|
)
|
|
0
|
|
|
(810
|
)
|
|
(574
|
)
|
|
(47
|
)
|
|
(621
|
)
|
|
0
|
|
|
(1,431
|
)
|
Recoveries
|
88
|
|
|
604
|
|
|
54
|
|
|
0
|
|
|
746
|
|
|
69
|
|
|
9
|
|
|
78
|
|
|
0
|
|
|
824
|
|
Balance, end of period
|
$
|
8,035
|
|
|
$
|
640
|
|
|
$
|
985
|
|
|
$
|
117
|
|
|
$
|
9,777
|
|
|
$
|
2,676
|
|
|
$
|
178
|
|
|
$
|
2,854
|
|
|
$
|
906
|
|
|
$
|
13,537
|
|
The following table summarizes the ending loan balances individually evaluated for impairment based upon loan segment, as well as the related allowance for loan losses allocation for each at
September 30, 2016
and
December 31, 2015
:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Commercial
|
|
Consumer
|
|
|
|
|
(Dollars in thousands)
|
Commercial
Real Estate
|
|
Acquisition
and
Development
|
|
Commercial
and
Industrial
|
|
Municipal
|
|
Total
|
|
Residential
Mortgage
|
|
Installment
and Other
|
|
Total
|
|
Unallocated
|
|
Total
|
September 30, 2016
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Loans allocated by:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Individually evaluated for impairment
|
$
|
9,096
|
|
|
$
|
2
|
|
|
$
|
563
|
|
|
$
|
0
|
|
|
$
|
9,661
|
|
|
$
|
4,783
|
|
|
$
|
9
|
|
|
$
|
4,792
|
|
|
$
|
0
|
|
|
$
|
14,453
|
|
Collectively evaluated for impairment
|
390,943
|
|
|
34,407
|
|
|
86,929
|
|
|
54,241
|
|
|
566,520
|
|
|
258,885
|
|
|
7,203
|
|
|
266,088
|
|
|
0
|
|
|
832,608
|
|
|
$
|
400,039
|
|
|
$
|
34,409
|
|
|
$
|
87,492
|
|
|
$
|
54,241
|
|
|
$
|
576,181
|
|
|
$
|
263,668
|
|
|
$
|
7,212
|
|
|
$
|
270,880
|
|
|
$
|
0
|
|
|
$
|
847,061
|
|
Allowance for loan losses allocated by:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Individually evaluated for impairment
|
$
|
650
|
|
|
$
|
0
|
|
|
$
|
158
|
|
|
$
|
0
|
|
|
$
|
808
|
|
|
$
|
64
|
|
|
$
|
2
|
|
|
$
|
66
|
|
|
$
|
0
|
|
|
$
|
874
|
|
Collectively evaluated for impairment
|
7,822
|
|
|
676
|
|
|
1,068
|
|
|
54
|
|
|
9,620
|
|
|
2,562
|
|
|
170
|
|
|
2,732
|
|
|
624
|
|
|
12,976
|
|
|
$
|
8,472
|
|
|
$
|
676
|
|
|
$
|
1,226
|
|
|
$
|
54
|
|
|
$
|
10,428
|
|
|
$
|
2,626
|
|
|
$
|
172
|
|
|
$
|
2,798
|
|
|
$
|
624
|
|
|
$
|
13,850
|
|
December 31, 2015
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Loans allocated by:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Individually evaluated for impairment
|
$
|
11,093
|
|
|
$
|
5
|
|
|
$
|
734
|
|
|
$
|
0
|
|
|
$
|
11,832
|
|
|
$
|
5,501
|
|
|
$
|
17
|
|
|
$
|
5,518
|
|
|
$
|
0
|
|
|
$
|
17,350
|
|
Collectively evaluated for impairment
|
327,170
|
|
|
50,698
|
|
|
72,891
|
|
|
57,511
|
|
|
508,270
|
|
|
248,589
|
|
|
7,504
|
|
|
256,093
|
|
|
0
|
|
|
764,363
|
|
|
$
|
338,263
|
|
|
$
|
50,703
|
|
|
$
|
73,625
|
|
|
$
|
57,511
|
|
|
$
|
520,102
|
|
|
$
|
254,090
|
|
|
$
|
7,521
|
|
|
$
|
261,611
|
|
|
$
|
0
|
|
|
$
|
781,713
|
|
Allowance for loan losses allocated by:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Individually evaluated for impairment
|
$
|
0
|
|
|
$
|
0
|
|
|
$
|
0
|
|
|
$
|
0
|
|
|
$
|
0
|
|
|
$
|
281
|
|
|
$
|
8
|
|
|
$
|
289
|
|
|
$
|
0
|
|
|
$
|
289
|
|
Collectively evaluated for impairment
|
7,883
|
|
|
850
|
|
|
1,012
|
|
|
58
|
|
|
9,803
|
|
|
2,589
|
|
|
113
|
|
|
2,702
|
|
|
774
|
|
|
13,279
|
|
|
$
|
7,883
|
|
|
$
|
850
|
|
|
$
|
1,012
|
|
|
$
|
58
|
|
|
$
|
9,803
|
|
|
$
|
2,870
|
|
|
$
|
121
|
|
|
$
|
2,991
|
|
|
$
|
774
|
|
|
$
|
13,568
|
|
NOTE 4. INCOME TAXES
The Company files income tax returns in the U.S. federal jurisdiction and the Commonwealth of Pennsylvania. The Bank also files an income tax return in the State of Maryland. The Company is no longer subject to U.S. federal, state or local income tax examination by tax authorities for years before
2013
.
The components of income tax expense for the three and
nine
months ended
September 30, 2016
and
2015
are summarized as follows:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three months ended September 30,
|
|
Nine months ended September 30,
|
(Dollars in thousands)
|
2016
|
|
2015
|
|
2016
|
|
2015
|
Current year provision (benefit):
|
|
|
|
|
|
|
|
Federal
|
$
|
1,066
|
|
|
$
|
(104
|
)
|
|
$
|
1,192
|
|
|
$
|
(63
|
)
|
State
|
8
|
|
|
(1
|
)
|
|
5
|
|
|
7
|
|
|
1,074
|
|
|
(105
|
)
|
|
1,197
|
|
|
(56
|
)
|
Deferred tax expense (benefit):
|
|
|
|
|
|
|
|
Federal
|
(948
|
)
|
|
561
|
|
|
(216
|
)
|
|
1,538
|
|
State
|
(1
|
)
|
|
6
|
|
|
10
|
|
|
16
|
|
|
(949
|
)
|
|
567
|
|
|
(206
|
)
|
|
1,554
|
|
Net income tax expense
|
$
|
125
|
|
|
$
|
462
|
|
|
$
|
991
|
|
|
$
|
1,498
|
|
The provision for income taxes includes
zero
and
$10,000
of applicable income tax expense related to net security gains for the three months ended
September 30, 2016
and
2015
. The provision for income taxes includes
$483,000
and
$669,000
of applicable income tax expense related to net securities gains for the
nine
months ended
September 30, 2016
and
2015
.
In the third quarter of 2016, the Company reassessed its estimated annual effective tax rate and changed the federal statutory rate from
35%
to
34%
, effective January 1, 2016, to reflect management's assessment that it will not be in the higher tax bracket. As a result, income tax expense reported for the first nine months was adjusted to reflect the change in tax rates and resulted in an increase in deferred income tax expense of
$176,000
, which was charged to the third quarter. This amount is comprised of
$235,000
of additional income tax for the six months ended June 30, 2016 and
$59,000
benefit for the three months ended September 30, 2016 from the application of the new rate to existing deferred balances.
The components of the net deferred tax asset, included in other assets, are as follows:
|
|
|
|
|
|
|
|
|
(Dollars in thousands)
|
September 30,
2016
|
|
December 31,
2015
|
Deferred tax assets:
|
|
|
|
Allowance for loan losses
|
$
|
5,059
|
|
|
$
|
5,111
|
|
Deferred compensation
|
532
|
|
|
547
|
|
Retirement plans and salary continuation
|
1,904
|
|
|
1,824
|
|
Share-based compensation
|
521
|
|
|
343
|
|
Off balance sheet reserves
|
301
|
|
|
218
|
|
Nonaccrual loan interest
|
415
|
|
|
246
|
|
Goodwill
|
99
|
|
|
124
|
|
Bonus accrual
|
127
|
|
|
359
|
|
Low income housing credit carryforward
|
1,900
|
|
|
1,652
|
|
Alternative minimum tax credit carryforward
|
3,648
|
|
|
2,195
|
|
Charitable contribution carryforward
|
50
|
|
|
211
|
|
Net operating loss carryforward
|
2,591
|
|
|
4,431
|
|
Other
|
420
|
|
|
182
|
|
Total deferred tax assets
|
17,567
|
|
|
17,443
|
|
Deferred tax liabilities:
|
|
|
|
Depreciation
|
719
|
|
|
815
|
|
Net unrealized gains on securities available for sale
|
2,646
|
|
|
646
|
|
Mortgage servicing rights
|
704
|
|
|
669
|
|
Purchase accounting adjustments
|
320
|
|
|
352
|
|
Other
|
192
|
|
|
181
|
|
Total deferred tax liabilities
|
4,581
|
|
|
2,663
|
|
Net deferred tax asset
|
$
|
12,986
|
|
|
$
|
14,780
|
|
The provision for income taxes differs from that computed by applying statutory rates to income before income taxes primarily due to the effects of tax-exempt income, non-deductible expenses and tax credits.
As of
September 30, 2016
, the Company had charitable contribution, low-income housing, and net operating loss carryforwards that expire through
2019
,
2036
and
2032
, respectively.
In assessing whether or not some or all of our deferred tax asset is more likely than not to be realized in the future, management considers all positive and negative evidence, including projected future taxable income, tax planning strategies and recent financial operating results. The ultimate realization of deferred tax assets is dependent upon existence, or generation, of taxable income in the periods when those temporary differences and net operating loss and credit carryforwards are deductible. Management considered projected future taxable income, length of time needed for carryforwards to reverse, available tax planning strategies, and other factors in making its assessment that it was more likely than not the net deferred tax assets would be realized, and that no valuation allowance was required at
September 30, 2016
or
December 31, 2015
.
NOTE 5. SHARE-BASED COMPENSATION PLANS
The Company maintains share-based compensation plans, the purpose of which are to provide officers, employees, and non-employee members of the Board of Directors of the Company and the Bank, with additional incentive to further the success of the Company. In May 2011, the shareholders of the Company approved the 2011 Orrstown Financial Services, Inc. Incentive Stock Plan (the “Plan”). Under the Plan,
381,920
shares of the common stock of the Company were reserved to be issued. As of
September 30, 2016
,
132,945
shares were available to be issued under the Plan.
Incentive awards under the Plan may consist of grants of incentive stock options, nonqualified stock options, stock appreciation rights, restricted stock, deferred stock units and performance shares. All employees of the Company and its present or future subsidiaries, and members of the Board of Directors of the Company or any subsidiary of the Company, are eligible to participate in the Plan. The Plan allows for the Compensation Committee of the Board of Directors to determine the type of incentive to be awarded, its term, manner of exercise, vesting of awards and restrictions on shares. Generally, awards are nonqualified under the IRS code, unless the awards are deemed to be incentive awards to employees, at the Compensation Committee’s discretion.
A roll forward of the Company’s nonvested restricted shares for the
nine
months ended
September 30, 2016
is presented below:
|
|
|
|
|
|
|
|
|
Shares
|
|
Weighted Average Grant Date Fair Value
|
|
|
|
|
Nonvested shares, beginning of year
|
197,381
|
|
|
$
|
16.17
|
|
Granted
|
50,045
|
|
|
18.12
|
|
Forfeited
|
(3,583
|
)
|
|
16.91
|
|
Vested
|
(12,500
|
)
|
|
15.97
|
|
Nonvested shares, at period end
|
231,343
|
|
|
$
|
16.59
|
|
For the three months ended
September 30, 2016
and
2015
,
$266,000
and
$229,000
was recognized as expense on the restricted stock awards, with tax benefits recorded of
$85,000
and
$80,000
for the respective periods.
For the
nine
months ended
September 30, 2016
and
2015
,
$762,000
and
$525,000
was recognized as expense on the restricted stock awards, with tax benefits recorded of
$259,000
and
$184,000
for the respective periods.
As of
September 30, 2016
and
December 31, 2015
, the unrecognized compensation expense related to the stock awards were
$2,321,000
and
$2,293,000
. The unrecognized compensation expense at
September 30, 2016
is expected to be recognized over a weighted-average period of
2.6 years
.
The intrinsic value of restricted share awards that vested during the period totaled
$237,000
for the
nine
months ended
September 30, 2016
.
A roll forward of the Company’s outstanding stock options for the
nine
months ended
September 30, 2016
is presented below:
|
|
|
|
|
|
|
|
|
Shares
|
|
Weighted Average Exercise Price
|
|
|
|
|
Outstanding at beginning of year
|
101,460
|
|
|
$
|
28.72
|
|
Forfeited
|
(2,725
|
)
|
|
25.78
|
|
Expired
|
(18,265
|
)
|
|
35.11
|
|
Options outstanding and exercisable, at period end
|
80,470
|
|
|
$
|
27.36
|
|
The exercise price of each option equals the market price of the Company’s stock on the date of grant and an option’s maximum term is
ten years
. All options are fully vested upon issuance. Information pertaining to options outstanding and exercisable at
September 30, 2016
is as follows:
|
|
|
|
|
|
|
|
|
|
|
Range of Exercise Prices
|
|
Number Outstanding
|
|
Weighted Average Remaining Contractual Life (Years)
|
|
Weighted Average Exercise Price
|
|
|
|
|
|
|
|
$21.14 - $24.99
|
|
35,099
|
|
|
3.66
|
|
$
|
21.47
|
|
$25.00 - $29.99
|
|
2,792
|
|
|
3.50
|
|
25.76
|
|
$30.00 - $34.99
|
|
35,231
|
|
|
1.18
|
|
31.34
|
|
$35.00 - $37.59
|
|
7,348
|
|
|
2.81
|
|
37.08
|
|
$21.14 - $37.59
|
|
80,470
|
|
|
2.49
|
|
$
|
27.36
|
|
The options outstanding and exercisable had
no
intrinsic value at
September 30, 2016
and
December 31, 2015
as each exercise price exceeded the market value.
The Company also maintains an employee stock purchase plan, in order to provide employees of the Company and its subsidiaries an opportunity to purchase stock of the Company. Under the employee stock purchase plan, eligible employees may purchase shares in an amount that does not exceed
10%
of their annual salary, up to the IRS limit, at the lower of
95%
of the fair market value of the shares on the semi-annual offering date, or related purchase date. The Company reserved
350,000
shares of its common stock, after making adjustments for stock dividends and a stock split, to be issued under the employee stock purchase plan. As of
September 30, 2016
,
186,004
shares were available to be issued under the employee stock purchase plan. Employees purchased
3,873
and
3,341
shares at a weighted average price of
$16.68
and
$15.91
for the three months ended
September 30, 2016
and
2015
. For the
nine
months ended
September 30, 2016
and
2015
, employees purchased
6,334
and
6,305
shares at a weighted average price of
$16.64
and
$15.83
. Compensation expense recognized on the employee stock purchase plan totaled
$14,000
and
$5,000
for the three months ended
September 30, 2016
and
2015
. For the
nine
months ended
September 30, 2016
and
2015
, compensation expense recognized on the employee stock purchase plan totaled
$17,000
and
$8,000
.
The Company uses a combination of issuing new shares or treasury shares to meet stock compensation exercises depending on market conditions.
NOTE 6. SHAREHOLDERS’ EQUITY AND REGULATORY CAPITAL
On January 19, 2016, the Company filed a shelf registration statement on Form S-3 with the Securities and Exchange Commission (the "Commission") that provides for up to an aggregate of
$100,000,000
, through the sale of common stock, preferred stock, warrants, debt securities, and units. To date, the Company has not issued any securities under this shelf registration.
The Company (on a consolidated basis) and the Bank are subject to various regulatory capital requirements administered by the federal and state banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s
and Bank’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific guidelines that involve quantitative measures of assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Although applicable to the Bank, prompt corrective action provisions are not applicable to bank holding companies, including financial holding companies.
Quantitative measures established by regulators to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios (as set forth in the following table) of total and Tier 1 capital (as defined in regulations) to risk-weighted assets (as defined), common equity Tier 1 capital (as defined) to risk weighted assets, and of Tier 1 capital (as defined) to average assets (as defined). Management believes, as of
September 30, 2016
and
December 31, 2015
, the Company and the Bank meet all capital adequacy requirements to which they are subject.
Effective January 1, 2015, the Company and Bank became subject to final rules establishing a new comprehensive capital framework for U.S. banking organizations, including community banks (the "Basel III Capital Rules"), which substantially revised the risk-based capital requirements in comparison to the previously existing U.S. risk-based capital rules. The Basel III Capital Rules, among other things, (i) introduced a new capital measure called “Common Equity Tier 1” (“CET1”), (ii) increased the minimum requirements for Tier 1 Capital ratio as well as the minimum levels to be considered well capitalized under prompt corrective action; (iii) and introduced the "capital conservation buffer”, designed to absorb losses during periods of economic stress. Institutions with a ratio of CET1 to risk-weighted assets above the minimum but below the conservation buffer are subject to constraints on dividends, equity repurchases and discretionary bonuses to executive officers based on the amount of the shortfall. The implementation of the capital conservation buffer began on January 1, 2016 at the 0.625% level and will be phased in over a four-year period (increasing by that amount on each subsequent January 1, until it reaches 2.5% on January 1, 2019).
As of
September 30, 2016
, the most recent notification from the Federal Deposit Insurance Corporation categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, an institution must maintain minimum total risk-based, Tier 1 risk-based, Common Equity Tier 1, and Tier 1 leverage ratios as set forth in the following table. There are no conditions or events since the notification that management believes have changed the Bank’s category.
The Company and the Bank’s actual capital ratios as of
September 30, 2016
and
December 31, 2015
, are also presented in the table.
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Actual
|
|
Minimum Capital
Requirement
|
|
Minimum to Be Well
Capitalized Under Prompt
Corrective Action Provisions
|
(Dollars in thousands)
|
Amount
|
|
Ratio
|
|
Amount
|
|
Ratio
|
|
Amount
|
|
Ratio
|
September 30, 2016
|
|
|
|
|
|
|
|
|
|
|
|
Total capital to risk weighted assets
|
|
|
|
|
|
|
|
|
|
|
|
Orrstown Financial Services, Inc.
|
$
|
138,574
|
|
|
14.9
|
%
|
|
$
|
74,381
|
|
|
8.0
|
%
|
|
n/a
|
|
|
n/a
|
|
Orrstown Bank
|
124,299
|
|
|
13.4
|
%
|
|
74,322
|
|
|
8.0
|
%
|
|
$
|
92,902
|
|
|
10.0
|
%
|
Tier 1 capital to risk weighted assets
|
|
|
|
|
|
|
|
|
|
|
|
Orrstown Financial Services, Inc.
|
126,876
|
|
|
13.7
|
%
|
|
55,786
|
|
|
6.0
|
%
|
|
n/a
|
|
|
n/a
|
|
Orrstown Bank
|
112,610
|
|
|
12.1
|
%
|
|
55,741
|
|
|
6.0
|
%
|
|
74,322
|
|
|
8.0
|
%
|
CET1 to risk weighted assets
|
|
|
|
|
|
|
|
|
|
|
|
Orrstown Financial Services, Inc.
|
126,876
|
|
|
13.7
|
%
|
|
41,839
|
|
|
4.5
|
%
|
|
n/a
|
|
|
n/a
|
|
Orrstown Bank
|
112,610
|
|
|
12.1
|
%
|
|
41,806
|
|
|
4.5
|
%
|
|
60,386
|
|
|
6.5
|
%
|
Tier 1 capital to average assets
|
|
|
|
|
|
|
|
|
|
|
|
Orrstown Financial Services, Inc.
|
126,876
|
|
|
9.6
|
%
|
|
52,847
|
|
|
4.0
|
%
|
|
n/a
|
|
|
n/a
|
|
Orrstown Bank
|
112,610
|
|
|
8.5
|
%
|
|
52,851
|
|
|
4.0
|
%
|
|
66,064
|
|
|
5.0
|
%
|
December 31, 2015
|
|
|
|
|
|
|
|
|
|
|
|
Total capital to risk weighted assets
|
|
|
|
|
|
|
|
|
|
|
|
Orrstown Financial Services, Inc.
|
$
|
134,562
|
|
|
15.8
|
%
|
|
$
|
68,078
|
|
|
8.0
|
%
|
|
n/a
|
|
|
n/a
|
|
Orrstown Bank
|
118,671
|
|
|
14.0
|
%
|
|
68,027
|
|
|
8.0
|
%
|
|
$
|
85,034
|
|
|
10.0
|
%
|
Tier 1 capital to risk weighted assets
|
|
|
|
|
|
|
|
|
|
|
|
Orrstown Financial Services, Inc.
|
123,825
|
|
|
14.6
|
%
|
|
51,058
|
|
|
6.0
|
%
|
|
n/a
|
|
|
n/a
|
|
Orrstown Bank
|
107,942
|
|
|
12.7
|
%
|
|
51,021
|
|
|
6.0
|
%
|
|
68,027
|
|
|
8.0
|
%
|
CET1 to risk weighted assets
|
|
|
|
|
|
|
|
|
|
|
|
Orrstown Financial Services, Inc.
|
123,825
|
|
|
14.6
|
%
|
|
38,294
|
|
|
4.5
|
%
|
|
n/a
|
|
|
n/a
|
|
Orrstown Bank
|
107,942
|
|
|
12.7
|
%
|
|
38,265
|
|
|
4.5
|
%
|
|
55,272
|
|
|
6.5
|
%
|
Tier 1 capital to average assets
|
|
|
|
|
|
|
|
|
|
|
|
Orrstown Financial Services, Inc.
|
123,825
|
|
|
9.8
|
%
|
|
50,684
|
|
|
4.0
|
%
|
|
n/a
|
|
|
n/a
|
|
Orrstown Bank
|
107,942
|
|
|
8.5
|
%
|
|
50,695
|
|
|
4.0
|
%
|
|
63,368
|
|
|
5.0
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
On September 14, 2015, the Board of Directors of the Company authorized a stock repurchase program under which the Company may repurchase up to
5%
of the Company's outstanding shares of common stock, or approximately
416,000
shares, in the open market, in accordance with all applicable securities laws and regulations, including Rule 10b-18 of the Securities Exchange Act of 1934, as amended. The extent to which the Company repurchases its shares, and the timing of such repurchases, will depend upon a variety of factors, including market conditions, regulatory requirements and other corporate considerations, as determined by management. Purchases may be made from time to time on open market or privately negotiated transactions. The repurchase program may be suspended or discontinued at any time. As of
September 30, 2016
,
82,725
shares had been repurchased under the program at a total cost of
$1,438,000
, or
$17.38
per share.
NOTE 7. EARNINGS PER SHARE
Earnings per share for the three and
nine
months ended
September 30, 2016
and
2015
were as follows:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended September 30,
|
|
Nine Months Ended September 30,
|
(Dollars in thousands, except per share data)
|
2016
|
|
2015
|
|
2016
|
|
2015
|
|
|
|
|
|
|
|
|
Net income
|
$
|
1,442
|
|
|
$
|
2,461
|
|
|
$
|
4,700
|
|
|
$
|
6,425
|
|
Weighted average shares outstanding (basic)
|
8,056
|
|
|
8,119
|
|
|
8,060
|
|
|
8,115
|
|
Impact of common stock equivalents
|
93
|
|
|
38
|
|
|
82
|
|
|
28
|
|
Weighted average shares outstanding (diluted)
|
8,149
|
|
|
8,157
|
|
|
8,142
|
|
|
8,143
|
|
Per share information:
|
|
|
|
|
|
|
|
Basic earnings per share
|
$
|
0.18
|
|
|
$
|
0.30
|
|
|
$
|
0.58
|
|
|
$
|
0.79
|
|
Diluted earnings per share
|
0.18
|
|
|
0.30
|
|
|
0.58
|
|
|
0.79
|
|
Stock options amounting to
81,000
and
102,000
shares of common stock were not considered in computing diluted earnings per share for the three months ended
September 30, 2016
and
2015
as their exercise would have been antidilutive as the exercise price exceeded the average market value. Stock options amounting to
93,000
and
112,000
shares of common stock were not considered in computing diluted earnings per share for the
nine
months ended
September 30, 2016
and
2015
as their exercise would have been antidilutive as the exercise price exceeded the average market value.
NOTE 8. FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK
The Company is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financial needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheets. The contract amounts of those instruments reflect the extent of involvement the Company has in particular classes of financial instruments.
The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit and financial guarantees written is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments.
|
|
|
|
|
|
|
|
|
|
Contract or Notional Amount
|
(Dollars in thousands)
|
September 30, 2016
|
|
December 31, 2015
|
Commitments to fund:
|
|
|
|
Revolving, open ended home equity loans
|
$
|
122,959
|
|
|
$
|
110,473
|
|
1-4 family residential construction loans
|
10,624
|
|
|
6,153
|
|
Commercial real estate, construction and land development loans
|
44,765
|
|
|
14,174
|
|
Commercial, industrial and other loans
|
122,136
|
|
|
84,480
|
|
Standby letters of credit
|
7,865
|
|
|
6,510
|
|
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer’s credit-worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based on management’s credit evaluation of the customer. Collateral held varies but may include accounts receivable, inventory, equipment, residential real estate, and income-producing commercial properties.
Standby letters of credit and financial guarantees written are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loans to customers. The Company holds collateral supporting those commitments when deemed necessary by management. The current amount of liability, as of
September 30, 2016
and
December 31, 2015
, for guarantees under standby letters of credit issued was not material.
The Company currently maintains a reserve in other liabilities totaling
$862,000
and
$472,000
at
September 30, 2016
and
December 31, 2015
for off-balance sheet credit exposures that currently are not funded, based on historical loss experience of the related loan class. For the three months ended
September 30, 2016
and
2015
,
$91,000
and
$(45,000)
was expensed (recovered) through noninterest expense for this exposure and for the
nine
months ended
September 30, 2016
and
2015
, the amount expensed (recovered) was
$390,000
and
$(30,000)
.
The Company has sold loans to the Federal Home Loan Bank of Chicago as part of its Mortgage Partnership Finance Program (“MPF Program”). Under the terms of the MPF Program, there is limited recourse back to the Company for loans that do not perform in accordance with the terms of the loan agreement. Each loan that is sold under the program is “credit enhanced” such that the individual loan’s rating is raised to “AA,” as determined by the Federal Home Loan Bank of Chicago. The sum of total loans sold under the MPF Program with limited recourse was
$38,538,000
and
$44,124,000
at
September 30, 2016
and
December 31, 2015
, with limited recourse back to the Company on these loans of
$8,199,000
and
$8,230,000
at these dates. Many of the loans sold under the MPF Program have primary mortgage insurance, which reduces the Company’s overall exposure. The Company is in the process of foreclosing on loans sold under the MPF Program or recovering amounts previously charged off, with a resulting net charge (recovery) of
$0
and
$(32,000)
for the three months ended
September 30, 2016
and
2015
, and of
$(112,000)
and
$127,000
for the
nine
months ended
September 30, 2016
and
2015
. These amounts, charged to other expenses represent an estimate of the Company’s loss under its recourse exposure.
NOTE 9. FAIR VALUE DISCLOSURES
The Company meets the requirements for disclosure of fair value information about financial instruments, whether or not recognized in the balance sheet. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate settlement of the instruments. Certain financial instruments and all non-financial instruments are excluded from disclosure requirements. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Company.
Fair value measurements under GAAP describes a framework for measuring fair value and requires disclosures about fair value measurements by establishing a three-level hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to valuation techniques that employ unobservable inputs (Level 3). If the inputs used to measure the assets or liabilities fall within different levels of the hierarchy, the classification is based on the lowest level input that is significant to the fair value measurement of the asset or liability. Classification of assets and liabilities within the hierarchy considers the markets in which the assets and liabilities are traded and the reliability and transparency of the assumptions used to determine fair value.
The three levels are defined as follows: Level 1 – inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets. Level 2 – inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar instruments in markets that are not active or by model-based techniques in which all significant inputs are observable in the market for the asset or liability, for substantially the full term of the financial instrument. Level 3 – the valuation methodology is derived from model-based techniques in which at least one significant input is unobservable to the fair value measurement and based on the Company’s own assumptions about market participants’ assumptions.
Following is a description of the valuation methodologies used for instruments measured on a recurring basis at estimated fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy:
Securities
Where quoted prices are available in an active market, securities are classified within Level 1 of the valuation hierarchy. Level 1 securities would include highly liquid government bonds, mortgage products and exchange traded equities. If quoted market prices are not available, securities are classified within Level 2 and fair values are estimated by using pricing models, quoted prices of securities with similar characteristics or discounted cash flow. Level 2 securities would include U.S. agency securities, mortgage-backed agency securities, obligations of states and political subdivisions and certain corporate, asset backed and other securities. In certain cases where there is limited activity or less transparency around inputs to the valuation, securities are classified within Level 3 of the valuation hierarchy. All of the Company’s securities are classified as available for sale.
The Company had
no
fair value liabilities measured on a recurring basis at
September 30, 2016
and
December 31, 2015
. A summary of assets at
September 30, 2016
and
December 31, 2015
, measured at estimated fair value on a recurring basis was as follows:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
(Dollars in Thousands)
|
Level 1
|
|
Level 2
|
|
Level 3
|
|
Total Fair
Value
Measurements
|
September 30, 2016
|
|
|
|
|
|
|
|
Securities available for sale:
|
|
|
|
|
|
|
|
U.S. Government Agencies
|
$
|
0
|
|
|
$
|
41,869
|
|
|
$
|
0
|
|
|
$
|
41,869
|
|
States and political subdivisions
|
0
|
|
|
130,399
|
|
|
0
|
|
|
130,399
|
|
U.S. Government Sponsored enterprises (GSE) residential mortgage-backed securities
|
0
|
|
|
123,881
|
|
|
0
|
|
|
123,881
|
|
GSE residential collateralized mortgage obligations (CMOs)
|
0
|
|
|
72,698
|
|
|
0
|
|
|
72,698
|
|
Private label CMOs
|
0
|
|
|
5,977
|
|
|
0
|
|
|
5,977
|
|
Total debt securities
|
0
|
|
|
374,824
|
|
|
0
|
|
|
374,824
|
|
Equity securities
|
0
|
|
|
78
|
|
|
0
|
|
|
78
|
|
Total securities
|
$
|
0
|
|
|
$
|
374,902
|
|
|
$
|
0
|
|
|
$
|
374,902
|
|
|
|
|
|
|
|
|
|
December 31, 2015
|
|
|
|
|
|
|
|
Securities available for sale:
|
|
|
|
|
|
|
|
U.S. Government Agencies
|
$
|
0
|
|
|
$
|
47,227
|
|
|
$
|
0
|
|
|
$
|
47,227
|
|
States and political subdivisions
|
0
|
|
|
125,961
|
|
|
0
|
|
|
125,961
|
|
GSE residential mortgage-backed securities
|
0
|
|
|
132,349
|
|
|
0
|
|
|
132,349
|
|
GSE residential collateralized mortgage obligations (CMOs)
|
0
|
|
|
15,843
|
|
|
0
|
|
|
15,843
|
|
GSE commercial CMOs
|
0
|
|
|
63,770
|
|
|
0
|
|
|
63,770
|
|
Private label CMOs
|
0
|
|
|
8,901
|
|
|
0
|
|
|
8,901
|
|
Total debt securities
|
0
|
|
|
394,051
|
|
|
0
|
|
|
394,051
|
|
Equity securities
|
0
|
|
|
73
|
|
|
0
|
|
|
73
|
|
Total securities
|
$
|
0
|
|
|
$
|
394,124
|
|
|
$
|
0
|
|
|
$
|
394,124
|
|
Certain financial assets are measured at fair value on a nonrecurring basis in accordance with GAAP. Adjustments to the fair value of these assets usually result from the application of lower-of-cost-or-market accounting or write-downs of individual assets.
The following describes the valuation techniques used by the Company to measure certain financial assets recorded at fair value on a nonrecurring basis in the financial statements:
Impaired Loans
The measurement of loss associated with impaired loans can be based on either the observable market price of the loan or the fair value of the collateral, or discounted cash flows based on a market rate of interest for performing TDRs. For collateral dependent loans, fair value is measured based on the value of the collateral securing the loan, less estimated costs to sell. Collateral may be in the form of real estate or business assets including equipment, inventory, and accounts receivable. The value of the real estate collateral is determined utilizing an income or market valuation approach based on an appraisal conducted by an independent, licensed appraiser outside of the Company using observable market data (Level 2). However, if the collateral is a house or building in the process of construction, or if management adjusts the appraisal value, then the fair value is considered Level 3. The value of business equipment is based upon an outside appraisal, if deemed significant, or the net book value on the applicable business’ financial statements if not considered significant using observable market data. Likewise, values for inventory and accounts receivable collateral are based on financial statement balances or aging reports (Level 3). Impaired loans with an allocation to the allowance for loan losses are measured at fair value on a nonrecurring basis. Any fair value adjustments are recorded in the period incurred as provision for loan losses on the consolidated statements of income. Specific allocations to the allowance for loan losses or partial charge-offs were
$2,695,000
and
$2,246,000
at
September 30, 2016
and
December 31, 2015
. Changes in the fair value of impaired loans for those still held at
September 30,
considered in the determination as to the provision for loan losses, totaled
$684,000
and
$75,000
for the three months ended
September 30, 2016
and
2015
, and
$815,000
and
$766,000
for the
nine
months ended
September 30, 2016
and
2015
.
Foreclosed Real Estate
Other real estate property acquired through foreclosure is initially recorded at the fair value of the property at the transfer date less estimated selling cost. Subsequently, other real estate owned is carried at the lower of its carrying value or the fair value less estimated selling cost. Fair value is usually determined based upon an independent third-party appraisal of the property or occasionally upon a recent sales offer. Specific charges to value the real estate owned at the lower of cost or fair value on properties held at
September 30, 2016
and
December 31, 2015
were
$204,000
and
$129,000
. Changes in the fair value of foreclosed real estate for those still held at
September 30,
charged to real estate expenses, totaled
$42,000
and
$21,000
for the three months ended
September 30, 2016
and
2015
, and totaled
$109,000
and
$21,000
for the
nine
months ended
September 30, 2016
and
2015
.
Mortgage Servicing Rights
The fair value of mortgage servicing rights is estimated to be equal to its carrying value, unless the quarterly valuation model calculates the present value of the estimated net servicing income is less than its carrying value, in which case a lower of cost or fair value charge is taken. As of September 30, 2016 and December 31, 2015, a
$139,000
and
$0
lower of cost or fair value reserve existed on the mortgage servicing right portfolio. For the three and nine months ended September 30, 2016, impairment charges of
$128,000
and
$139,000
were recorded.
The following table presents additional qualitative information about assets measured on a nonrecurring basis and for which the Company has utilized Level 3 inputs to determine fair value:
|
|
|
|
|
|
|
|
|
|
|
(Dollars in thousands)
|
Fair Value
Estimate
|
|
Valuation
Techniques
|
|
Unobservable Input
|
|
Range
|
September 30, 2016
|
|
|
|
|
|
|
|
Impaired loans
|
$
|
9,841
|
|
|
Appraisal of
collateral
|
|
Management adjustments on appraisals for property type and recent activity
|
|
0% - 68% discount
|
|
|
|
|
|
Management adjustments for liquidation expenses
|
|
0% - 41% discount
|
Foreclosed real estate
|
149
|
|
|
Appraisal of
collateral
|
|
Management adjustments on appraisals for property type and recent activity
|
|
15% - 100% discount
|
|
|
|
|
|
Management adjustments for liquidation expenses
|
|
3% - 6% discount
|
Mortgage servicing rights
|
2,532
|
|
|
Discounted cash flows
|
|
Weighted average CPR
|
|
12.80%
|
|
|
|
|
|
Discount rate
|
|
9.55%
|
December 31, 2015
|
|
|
|
|
|
|
|
Impaired loans
|
$
|
4,757
|
|
|
Appraisal of
collateral
|
|
Management adjustments on appraisals for property type and recent activity
|
|
0% - 70% discount
|
|
|
|
|
|
Management adjustments for liquidation expenses
|
|
6% - 44% discount
|
Foreclosed real estate
|
175
|
|
|
Appraisal of
collateral
|
|
Management adjustments on appraisals for property type and recent activity
|
|
10% - 20% discount
|
|
|
|
|
|
Management adjustments for liquidation expenses
|
|
5% - 6% discount
|
A summary of assets at
September 30, 2016
and
December 31, 2015
, measured at estimated fair value on a nonrecurring basis was as follows:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
(Dollars in thousands)
|
Level 1
|
|
Level 2
|
|
Level 3
|
|
Total
Fair Value
Measurements
|
September 30, 2016
|
|
|
|
|
|
|
|
Impaired Loans
|
|
|
|
|
|
|
|
Commercial real estate:
|
|
|
|
|
|
|
|
Owner-occupied
|
$
|
0
|
|
|
$
|
0
|
|
|
$
|
823
|
|
|
$
|
823
|
|
Non-owner occupied
|
0
|
|
|
0
|
|
|
6,181
|
|
|
6,181
|
|
Multi-family
|
0
|
|
|
0
|
|
|
207
|
|
|
207
|
|
Non-owner occupied residential
|
0
|
|
|
0
|
|
|
425
|
|
|
425
|
|
Acquisition and development:
|
|
|
|
|
|
|
|
Commercial and land development
|
0
|
|
|
0
|
|
|
2
|
|
|
2
|
|
Commercial and industrial
|
0
|
|
|
0
|
|
|
66
|
|
|
66
|
|
Residential mortgage:
|
|
|
|
|
|
|
|
First lien
|
0
|
|
|
0
|
|
|
1,980
|
|
|
1,980
|
|
Home equity - lines of credit
|
0
|
|
|
0
|
|
|
150
|
|
|
150
|
|
Installment and other loans
|
0
|
|
|
0
|
|
|
7
|
|
|
7
|
|
Impaired loans, net
|
$
|
0
|
|
|
$
|
0
|
|
|
$
|
9,841
|
|
|
$
|
9,841
|
|
|
|
|
|
|
|
|
|
Foreclosed real estate
|
|
|
|
|
|
|
|
Residential
|
$
|
0
|
|
|
$
|
0
|
|
|
$
|
127
|
|
|
$
|
127
|
|
Commercial and land development
|
0
|
|
|
0
|
|
|
22
|
|
|
22
|
|
Total foreclosed real estate
|
$
|
0
|
|
|
$
|
0
|
|
|
$
|
149
|
|
|
$
|
149
|
|
|
|
|
|
|
|
|
|
Mortgage servicing rights
|
$
|
0
|
|
|
$
|
2,532
|
|
|
$
|
0
|
|
|
$
|
2,532
|
|
|
|
|
|
|
|
|
|
December 31, 2015
|
|
|
|
|
|
|
|
Impaired Loans
|
|
|
|
|
|
|
|
Commercial real estate:
|
|
|
|
|
|
|
|
Owner-occupied
|
$
|
0
|
|
|
$
|
0
|
|
|
$
|
881
|
|
|
$
|
881
|
|
Non-owner occupied
|
0
|
|
|
0
|
|
|
736
|
|
|
736
|
|
Multi-family
|
0
|
|
|
0
|
|
|
233
|
|
|
233
|
|
Non-owner occupied residential
|
0
|
|
|
0
|
|
|
570
|
|
|
570
|
|
Acquisition and development:
|
|
|
|
|
|
|
|
Commercial and land development
|
0
|
|
|
0
|
|
|
5
|
|
|
5
|
|
Residential mortgage:
|
|
|
|
|
|
|
|
First lien
|
0
|
|
|
0
|
|
|
2,094
|
|
|
2,094
|
|
Home equity - lines of credit
|
0
|
|
|
0
|
|
|
229
|
|
|
229
|
|
Installment and other loans
|
0
|
|
|
0
|
|
|
9
|
|
|
9
|
|
Impaired loans, net
|
$
|
0
|
|
|
$
|
0
|
|
|
$
|
4,757
|
|
|
$
|
4,757
|
|
|
|
|
|
|
|
|
|
Foreclosed real estate
|
|
|
|
|
|
|
|
Residential
|
$
|
0
|
|
|
$
|
0
|
|
|
$
|
101
|
|
|
$
|
101
|
|
Commercial and land development
|
0
|
|
|
0
|
|
|
74
|
|
|
74
|
|
Total foreclosed real estate
|
$
|
0
|
|
|
$
|
0
|
|
|
$
|
175
|
|
|
$
|
175
|
|
Fair values of financial instruments
In addition to those disclosed above, the following methods and assumptions were used by the Company in estimating fair values of financial instruments as disclosed herein:
Cash and Due from Banks and Interest Bearing Deposits with Banks
The carrying amounts of cash and due from banks and interest bearing deposits with banks approximate their fair value.
Loans Held for Sale
Loans held for sale are carried at the lower of cost or fair value. These loans typically consist of one-to-four family residential loans originated for sale in the secondary market. Fair value is based on the price secondary markets are currently offering for similar loans using observable market data which is not materially different than cost due to the short duration between origination and sale.
Loans Receivable
For variable-rate loans that reprice frequently and have no significant change in credit risk, fair values are based on carrying values. Fair values for fixed rate loans are estimated using discounted cash flow analyses, using interest rates currently being offered in the market for loans with similar terms to borrowers of similar credit quality.
Restricted Investment in Bank Stock
These investments are carried at cost. The Company is required to maintain minimum investment balances in these stocks, which are not actively traded and therefore have no readily determinable market value.
Deposits
The fair values disclosed for demand deposits are, by definition, equal to the amount payable on demand at the reporting date (that is, their carrying amounts). The carrying amounts of variable-rate, fixed-term money market accounts and certificates of deposit approximate their fair values at the reporting date. Fair values for fixed-rate certificates of deposits and IRAs are estimated using a discounted cash flow calculation that applies interest rates currently being offered in the market to a schedule of aggregated expected maturities on time deposits.
Short-Term Borrowings
The carrying amounts of federal funds purchased, borrowings under Repurchase Agreements, and other short-term borrowings maturing within
90 days
approximate their fair values. Fair values of other short-term borrowings are estimated using discounted cash flow analysis based on the Company’s current borrowing rates for similar types of borrowing arrangements.
Long-Term Debt
The fair value of the Company’s fixed rate long-term borrowings is estimated using a discounted cash flow analysis based on the Company’s current incremental borrowing rate for similar types of borrowing arrangements. The carrying amounts of variable-rate long-term borrowings approximate their fair values at the reporting date.
Accrued Interest
The carrying amounts of accrued interest receivable and payable approximate their fair values.
Off-Balance-Sheet Instruments
The Company generally does not charge commitment fees. Fees for standby letters of credit and other off-balance-sheet instruments are not significant.
The estimated fair values of the Company’s financial instruments were as follows at
September 30, 2016
and
December 31, 2015
:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
(Dollars in thousands)
|
Carrying
Amount
|
|
Fair Value
|
|
Level 1
|
|
Level 2
|
|
Level 3
|
September 30, 2016
|
|
|
|
|
|
|
|
|
|
Financial Assets
|
|
|
|
|
|
|
|
|
|
Cash and due from banks
|
$
|
17,787
|
|
|
$
|
17,787
|
|
|
$
|
17,787
|
|
|
$
|
0
|
|
|
$
|
0
|
|
Interest bearing deposits with banks
|
19,854
|
|
|
19,854
|
|
|
19,854
|
|
|
0
|
|
|
0
|
|
Restricted investments in bank stocks
|
6,615
|
|
|
n/a
|
|
|
n/a
|
|
|
n/a
|
|
|
n/a
|
|
Securities available for sale
|
374,902
|
|
|
374,902
|
|
|
0
|
|
|
374,902
|
|
|
0
|
|
Loans held for sale
|
3,956
|
|
|
4,066
|
|
|
0
|
|
|
4,066
|
|
|
0
|
|
Loans, net of allowance for loan losses
|
833,211
|
|
|
847,597
|
|
|
0
|
|
|
0
|
|
|
847,597
|
|
Accrued interest receivable
|
3,690
|
|
|
3,690
|
|
|
0
|
|
|
1,869
|
|
|
1,821
|
|
Financial Liabilities
|
|
|
|
|
|
|
|
|
|
Deposits
|
1,133,332
|
|
|
1,140,146
|
|
|
0
|
|
|
1,140,146
|
|
|
0
|
|
Short-term borrowings
|
42,852
|
|
|
42,852
|
|
|
0
|
|
|
42,852
|
|
|
0
|
|
Long-term debt
|
24,247
|
|
|
25,162
|
|
|
0
|
|
|
25,162
|
|
|
0
|
|
Accrued interest payable
|
350
|
|
|
350
|
|
|
0
|
|
|
350
|
|
|
0
|
|
Off-balance sheet instruments
|
0
|
|
|
0
|
|
|
0
|
|
|
0
|
|
|
0
|
|
December 31, 2015
|
|
|
|
|
|
|
|
|
|
Financial Assets
|
|
|
|
|
|
|
|
|
|
Cash and due from banks
|
$
|
11,412
|
|
|
$
|
11,412
|
|
|
$
|
11,412
|
|
|
$
|
0
|
|
|
$
|
0
|
|
Interest bearing deposits with banks
|
16,928
|
|
|
16,928
|
|
|
16,928
|
|
|
0
|
|
|
0
|
|
Restricted investments in bank stocks
|
8,720
|
|
|
n/a
|
|
|
n/a
|
|
|
n/a
|
|
|
n/a
|
|
Securities available for sale
|
394,124
|
|
|
394,124
|
|
|
0
|
|
|
394,124
|
|
|
0
|
|
Loans held for sale
|
5,917
|
|
|
6,045
|
|
|
0
|
|
|
6,045
|
|
|
0
|
|
Loans, net of allowance for loan losses
|
768,145
|
|
|
776,067
|
|
|
0
|
|
|
0
|
|
|
776,067
|
|
Accrued interest receivable
|
3,845
|
|
|
3,845
|
|
|
0
|
|
|
2,257
|
|
|
1,588
|
|
Financial Liabilities
|
|
|
|
|
|
|
|
|
|
Deposits
|
1,032,167
|
|
|
1,032,265
|
|
|
0
|
|
|
1,032,265
|
|
|
0
|
|
Short-term borrowings
|
89,156
|
|
|
89,156
|
|
|
0
|
|
|
89,156
|
|
|
0
|
|
Long-term debt
|
24,495
|
|
|
25,357
|
|
|
0
|
|
|
25,357
|
|
|
0
|
|
Accrued interest payable
|
366
|
|
|
366
|
|
|
0
|
|
|
366
|
|
|
0
|
|
Off-balance sheet instruments
|
0
|
|
|
0
|
|
|
0
|
|
|
0
|
|
|
0
|
|
NOTE 10. CONTINGENCIES
The nature of the Company’s business generates a certain amount of litigation involving matters arising out of the ordinary course of business. Except as described below, in the opinion of management, there are
no
legal proceedings that might have a material effect on the results of operations, liquidity, or the financial position of the Company at this time.
The Company, the Bank and certain current and former directors and executive officers (collectively, “Orrstown Defendants”) are defendants in a putative class action filed by Southeastern Pennsylvania Transportation Authority (“SEPTA”) on May 25, 2012, in the United States District Court for the Middle District of Pennsylvania. In a later amended complaint, the list of defendants was expanded to include the Company’s then independent registered public accounting firm and the underwriters of the Company’s March 2010 public offering of common stock. The complaint, as amended, alleges among other things that (i) in connection with the Company’s Registration Statement on Form S-3 dated February 23, 2010 and its Prospectus Supplement dated March 23, 2010, and (ii) during the purported class period of March 15, 2010 through April 5, 2012, the Company issued materially false and misleading statements regarding the Company’s lending practices and financial results, including misleading statements concerning the stringent nature of the Bank’s credit practices and underwriting standards, the quality of its loan portfolio, and the intended use of the proceeds from the Company’s March 2010 public offering of common stock. The complaint asserts claims under Sections 11, 12(a) and 15 of the Securities Act of 1933, Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder, and seeks class certification, unspecified money damages, interest, costs, fees and equitable or injunctive relief.
On June 22, 2015, the Court dismissed without prejudice SEPTA’s amended complaint against all defendants, finding that SEPTA failed to state a claim under either the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended. The Court ordered that, within
30
days, SEPTA either seek leave to amend its amended complaint, accompanied by the proposed amendment, or file a notice of its intention to stand on the amended complaint.
On July 22, 2015, SEPTA filed a motion for leave to amend under Local Rule 15.1, as allowed by the Court’s ruling on June 22, 2015. Many of the allegations of the proposed second amended complaint are essentially the same or similar to the allegations of the dismissed amended complaint. The proposed second amended complaint also alleges that the Orrstown Defendants did not publicly disclose certain alleged failures of internal controls over loan underwriting, risk management, and financial reporting during the period 2009 to 2012, in violation of the federal securities laws. On February 8, 2016, the Court granted SEPTA’s motion for leave to amend and SEPTA filed its second amended complaint that same day.
On February 25, 2016, the Court issued a scheduling Order directing: all defendants to file any motions to dismiss by March 18, 2016; SEPTA to file an omnibus opposition to defendants’ motions to dismiss by April 8, 2016; and all defendants to file reply briefs in support of their motions to dismiss by April 22, 2016. Defendants timely filed their motions to dismiss the second amended complaint and the parties filed their briefs in accordance with the Court-ordered schedule. The February 25, 2016 Order stays all discovery and other deadlines in the case (including the filing of SEPTA’s motion for class certification) pending the outcome of the motions to dismiss.
The allegations of SEPTA’s proposed second amended complaint disclosed the existence of a confidential, non-public, fact-finding inquiry regarding the Company being conducted by the Commission. On September 27, 2016, the Company entered into a settlement agreement with the Commission resolving the investigation of accounting and related matters at the Company for the periods ended June 30, 2010, to December 31, 2011. As part of the settlement of the Commission’s administrative proceedings and pursuant to the cease-and-desist order, without admitting or denying the Commission’s findings, the Company, its Chief Executive Officer, its former Chief Financial Officer, its former Executive Vice President and Chief Credit Officer and its Chief Accounting Officer, agreed to pay civil money penalties to the Commission. The Company agreed to pay a civil money penalty of
$1,000,000
. The Company had previously established a reserve for that amount which was expensed in the second fiscal quarter of 2016.
On September 27, 2016, the Orrstown Defendants filed with the Court a Notice of Subsequent Event in Further Support of their Motion to Dismiss the Second Amended Complaint, regarding the settlement with the Commission. The Notice attached a copy of the Commission’s cease-and-desist order and briefly described what the Company believes are the most salient terms of the neither-admit-nor-deny settlement. On September 29, 2016, SEPTA filed a Response to the Notice, in which SEPTA argued that the settlement with the Commission did not support dismissal of the second amended complaint.
The Company believes that the allegations of SEPTA’s second amended complaint are without merit and intends to vigorously defend itself against those claims. Given that the SEPTA litigation is still in the pleading stage, it is not possible at this time to estimate reasonably possible losses, or even a range of reasonably possible losses, in connection with the litigation.