UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C.   20549
 
FORM 10-Q
(Mark One)
 
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.
 
For the quarterly period ended March 31, 2014
 
OR
 
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.
 
Commission File Number 0-18832
 
First Financial Service Corporation
(Exact Name of Registrant as specified in its charter)
 
Kentucky
61-1168311
(State or other jurisdiction
  (IRS Employer Identification No.)
of incorporation or organization)
 
 
2323 Ring Road
(270) 765-2131
Elizabethtown, Kentucky 42701
(Registrant's telephone number,
(Address of principal executive offices)
including area code)
(Zip Code)
 
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes x   No ¨
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x   No ¨
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  
 
Large Accelerated Filer ¨
Accelerated Filer ¨
Non-Accelerated Filer ¨
Smaller Reporting Company x
 
Indicate by a check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).   Yes ¨   No x
 
Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.
 
Class
 
Outstanding as of May 12, 2014
Common Stock
 
5,139,358 shares
 
 
 

FIRST FINANCIAL SERVICE CORPORATION

FORM 10-Q
TABLE OF CONTENTS
 
PART I FINANCIAL INFORMATION
 
 
 
 
Preliminary Note Regarding Forward-Looking Statements
 
 
 
 
Item 1.
Consolidated Financial Statements and Notes to Consolidated Financial Statements
 
 
 
 
Item 2.
Management's Discussion and Analysis of Financial Condition and Results of Operations
 
 
 
 
Item 3.
Quantitative and Qualitative Disclosures about Market Risk
 
 
 
 
Item 4.
Controls and Procedures
 
 
 
 
PART II – OTHER INFORMATION
 
 
 
 
Item 1.
Legal Proceedings
 
 
 
 
Item 1A.
Risk Factors
 
 
 
 
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
 
 
 
 
Item 3.
Defaults upon Senior Securities
 
 
 
 
Item 4.
Mine Safety Disclosures
 
 
 
 
Item 5.
Other Information
 
 
 
 
Item 6.
Exhibits
 
 
 
 

SIGNATURES

 

 
 
2

 

PRELIMINARY NOTE REGARDING

FORWARD-LOOKING STATEMENTS

 
Statements in this report that are not statements of historical fact are forward-looking statements. First Financial Service Corporation (also referred to as “FFKY,” the “Corporation,” “we” or “us”) may make forward-looking statements in future filings with the Securities and Exchange Commission (“SEC”), in press releases, and in oral and written statements made by or with the approval of the Corporation.   Forward-looking statements include, but are not limited to: (1) projections of revenues, income or loss, earnings or loss per share, capital structure and other financial items; (2) plans and objectives of the Corporation or its management or Board of Directors; (3) statements regarding future events, actions or economic performance; and (4) statements of assumptions underlying such statements.   Words such as “estimate,” “strategy,” “believes,” “anticipates,” “expects,” “intends,” “plans,” “targeted,” and similar expressions are intended to identify forward-looking statements, but are not the exclusive means of identifying such statements.
 
Various risks and uncertainties may cause actual results to differ materially from those indicated by our forward-looking statements.   In addition to those risks described under “Item 1A Risk Factors,” of this report and our Annual Report on Form 10-K, the following factors could cause such differences: changes in general economic conditions and economic conditions in Kentucky and the markets we serve, any of which may affect, among other things, our level of non-performing assets, charge-offs, and provision for loan loss expense; changes in interest rates that may reduce interest margins and impact funding sources; changes in market rates and prices which may adversely impact the value of financial products including securities, loans and deposits; changes in tax laws, rules and regulations; various monetary and fiscal policies and regulations, including those determined by the Federal Reserve Board, the Federal Deposit Insurance Corporation (“FDIC”) and the Kentucky Department of Financial Institutions (“KDFI”); competition with other local and regional commercial banks, savings banks, credit unions and other non-bank financial institutions; our ability to grow core businesses; our ability to develop and introduce new banking-related products, services and enhancements and gain market acceptance of such products; and management’s ability to manage these and other risks.  
 
Our forward-looking statements speak only as of the date on which they are made, and we undertake no obligation to update any forward-looking statement to reflect events or circumstances occurring after the date of any such statement.
 
 
3

 
Item 1.
 
FIRST FINANCIAL SERVICE CORPORATION
Consolidated Balance Sheets
(Unaudited)
 
 
 
March 31,
 
December 31,
 
(Dollars in thousands, except per share data)
 
2014
 
2013
 
 
 
 
 
 
 
 
 
ASSETS:
 
 
 
 
 
 
 
Cash and due from banks
 
$
12,911
 
$
13,476
 
Interest bearing deposits
 
 
67,875
 
 
52,512
 
Total cash and cash equivalents
 
 
80,786
 
 
65,988
 
 
 
 
 
 
 
 
 
Securities available-for-sale
 
 
240,826
 
 
269,282
 
Loans held for sale
 
 
687
 
 
470
 
 
 
 
 
 
 
 
 
Loans, net of unearned fees
 
 
459,157
 
 
466,862
 
Allowance for loan losses
 
 
(9,608)
 
 
(9,576)
 
Net loans
 
 
449,549
 
 
457,286
 
 
 
 
 
 
 
 
 
Federal Home Loan Bank stock
 
 
4,080
 
 
4,430
 
Cash surrender value of life insurance
 
 
10,518
 
 
10,428
 
Premises and equipment, net
 
 
23,491
 
 
23,773
 
Real estate owned:
 
 
 
 
 
 
 
Acquired through foreclosure, net of valuation allowance of
    $581 Mar (2014) and $581 Dec (2013)
 
 
12,260
 
 
11,657
 
Bank lots
 
 
1,446
 
 
1,469
 
Other repossessed assets
 
 
32
 
 
37
 
Accrued interest receivable
 
 
1,912
 
 
2,224
 
Accrued income taxes
 
 
2,907
 
 
2,907
 
Low-income housing investments
 
 
6,905
 
 
6,965
 
Other assets
 
 
1,500
 
 
1,701
 
 
 
 
 
 
 
 
 
TOTAL ASSETS
 
$
836,899
 
$
858,617
 
 
 
 
 
 
 
 
 
LIABILITIES AND STOCKHOLDERS' EQUITY
 
 
 
 
 
 
 
LIABILITIES:
 
 
 
 
 
 
 
Deposits:
 
 
 
 
 
 
 
Non-interest bearing
 
$
88,871
 
$
78,480
 
Interest bearing
 
 
670,401
 
 
705,007
 
Total deposits
 
 
759,272
 
 
783,487
 
 
 
 
 
 
 
 
 
Advances from Federal Home Loan Bank
 
 
12,354
 
 
12,389
 
Subordinated debentures
 
 
18,000
 
 
18,000
 
Accrued interest payable
 
 
4,821
 
 
4,485
 
Accrued senior preferred dividend
 
 
3,919
 
 
3,469
 
Accounts payable and other liabilities
 
 
3,486
 
 
3,968
 
 
 
 
 
 
 
 
 
TOTAL LIABILITIES
 
 
801,852
 
 
825,798
 
 
 
 
 
 
 
 
 
Commitments and contingent liabilities
 
 
-
 
 
-
 
 
 
 
 
 
 
 
 
STOCKHOLDERS' EQUITY:
 
 
 
 
 
 
 
Serial preferred stock, $1 par value per share; authorized 5,000,000 shares; issued and
    outstanding, 20,000 shares with a liquidation preference of $23.9 million Mar
    (2014), and $23.5 million Dec (2013)
 
 
20,000
 
 
19,997
 
Common stock, $1 par value per share; authorized 35,000,000 shares; issued and
    outstanding, 4,878,960 shares Mar (2014), and 4,870,887 shares Dec (2013)
 
 
4,879
 
 
4,871
 
Additional paid-in capital
 
 
36,376
 
 
36,230
 
Accumulated deficit
 
 
(18,265)
 
 
(17,711)
 
Accumulated other comprehensive loss
 
 
(7,943)
 
 
(10,568)
 
 
 
 
 
 
 
 
 
TOTAL STOCKHOLDERS' EQUITY
 
 
35,047
 
 
32,819
 
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY
 
$
836,899
 
$
858,617
 
 
See notes to the unuaudited consolidated financial statements.
 
 
4

 
FIRST FINANCIAL SERVICE CORPORATION
  Consolidated Statements of Operations
(Unaudited)
 
 
 
 
Three Months Ended
 
(Amounts in thousands, except per share data)
 
 
March 31,
 
 
 
 
2014
 
 
2013
 
 
 
 
 
 
 
 
 
Loans, including fees
 
$
5,753
 
$
6,818
 
Taxable securities
 
 
1,461
 
 
1,657
 
Tax exempt securities
 
 
32
 
 
65
 
Total interest income
 
 
7,246
 
 
8,540
 
 
 
 
 
 
 
 
 
Interest Expense:
 
 
 
 
 
 
 
Deposits
 
 
1,273
 
 
2,136
 
Federal Home Loan Bank advances
 
 
136
 
 
132
 
Subordinated debentures
 
 
341
 
 
341
 
Total interest expense
 
 
1,750
 
 
2,609
 
 
 
 
 
 
 
 
 
Net interest income
 
 
5,496
 
 
5,931
 
Provision for loan losses
 
 
-
 
 
(1,037)
 
Net interest income after provision for loan losses
 
 
5,496
 
 
6,968
 
 
 
 
 
 
 
 
 
Non-interest Income:
 
 
 
 
 
 
 
Customer service fees on deposit accounts
 
 
1,250
 
 
1,191
 
Gain on sale of mortgage loans
 
 
59
 
 
427
 
Gain on sale of investments
 
 
148
 
 
509
 
Loss on sale of investments
 
 
(211)
 
 
(282)
 
Loss on sale and write downs on real estate acquired through foreclosure
 
 
(5)
 
 
(1,060)
 
Gain on sale on real estate acquired through foreclosure
 
 
29
 
 
57
 
Other income
 
 
523
 
 
612
 
Total non-interest income
 
 
1,793
 
 
1,454
 
 
 
 
 
 
 
 
 
Non-interest Expense:
 
 
 
 
 
 
 
Employee compensation and benefits
 
 
3,541
 
 
3,793
 
Office occupancy expense and equipment
 
 
693
 
 
708
 
Outside services and data processing
 
 
976
 
 
863
 
Bank franchise tax
 
 
315
 
 
315
 
FDIC insurance premiums
 
 
466
 
 
689
 
Real estate acquired through foreclosure expense
 
 
86
 
 
294
 
Loan expense
 
 
185
 
 
222
 
Other expense
 
 
1,216
 
 
1,416
 
Total non-interest expense
 
 
7,478
 
 
8,300
 
 
 
 
 
 
 
 
 
Income (loss) before income taxes
 
 
(189)
 
 
122
 
Income tax expense (benefit)
 
 
(88)
 
 
-
 
Net Income (Loss)
 
 
(101)
 
 
122
 
Less:
 
 
 
 
 
 
 
Dividends on preferred stock
 
 
(450)
 
 
(250)
 
Accretion on preferred stock
 
 
(3)
 
 
(14)
 
Net income (loss) attributable to common shareholders
 
$
(554)
 
$
(142)
 
 
 
 
 
 
 
 
 
Shares applicable to basic income (loss) per common share
 
 
4,876,942
 
 
4,786,250
 
Basic income (loss) per common share
 
$
(0.11)
 
$
(0.03)
 
 
 
 
 
 
 
 
 
Shares applicable to diluted income (loss)per common share
 
 
4,876,942
 
 
4,786,250
 
Diluted income (loss) per common share
 
$
(0.11)
 
$
(0.03)
 
 
 
 
 
 
 
 
 
Cash dividends declared per common share
 
$
-
 
$
-
 
 
See notes to the unuaudited consolidated financial statements.
 
 
5

 
FIRST FINANCIAL SERVICE CORPORATION
Consolidated Statements of Comprehensive Income/(Loss)
(Unaudited)
 
 
 
Three Months Ended
 
 
 
March 31,
 
(Dollars in thousands)
 
2014
 
2013
 
Net Income/(Loss)
 
$
(101)
 
$
122
 
Other comprehensive income (loss):
 
 
 
 
 
 
 
Change in unrealized gain (loss) on securities available-for-sale
 
 
2,650
 
 
(950)
 
securities available-for-sale losses (gains)
 
 
63
 
 
(227)
 
Net unrealized gain (loss) recognized in comprehensive income
 
 
2,713
 
 
(1,177)
 
Tax effect
 
 
(88)
 
 
-
 
Total other comphrehensive income (loss)
 
 
2,625
 
 
(1,177)
 
 
 
 
 
 
 
 
 
Comprehensive Income/(Loss)
 
$
2,524
 
$
(1,055)
 
 
See notes to the unaudited consolidated financial statements.
 
 
6

 
FIRST FINANCIAL SERVICE CORPORATION
Consolidated Statements of Changes in Stockholders' Equity
Three Months Ended March 31, 2014
(Dollars In Thousands, Except Per Share Amounts)
(Unaudited)
 
 
 
Shares
 
Amount
 
Additional
Paid-in
 
Accumulated
 
Accumulated
Other
Comprehensive
Income (Loss),
 
 
 
 
 
 
Preferred 
 
Common
 
Preferred
 
Common
 
Capital
 
Deficit
 
Net of Tax
 
Total
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance, January 1, 2014
 
20,000
 
4,870,887
 
$
19,997
 
$
4,871
 
$
36,230
 
$
(17,711)
 
$
(10,568)
 
$
32,819
 
Net loss
 
-
 
-
 
 
-
 
 
-
 
 
-
 
 
(101)
 
 
-
 
 
(101)
 
Stock issued for stock options
    exercised and employee benefit plans
 
-
 
4,756
 
 
-
 
 
5
 
 
17
 
 
-
 
 
-
 
 
22
 
Issuance of restricted shares
 
-
 
3,317
 
 
-
 
 
3
 
 
(3)
 
 
-
 
 
-
 
 
-
 
Stock-based compensation expense
 
-
 
-
 
 
-
 
 
 
 
 
132
 
 
-
 
 
-
 
 
132
 
Total other comprehensive income (loss)
 
-
 
-
 
 
-
 
 
-
 
 
-
 
 
-
 
 
2,625
 
 
2,625
 
Dividends on preferred stock
 
-
 
-
 
 
-
 
 
-
 
 
-
 
 
(450)
 
 
-
 
 
(450)
 
Accretion of preferred stock discount
 
-
 
-
 
 
3
 
 
-
 
 
-
 
 
(3)
 
 
-
 
 
-
 
Balance, March 31, 2014
 
20,000
 
4,878,960
 
$
20,000
 
$
4,879
 
$
36,376
 
$
(18,265)
 
$
(7,943)
 
$
35,047
 
 
See notes to the unaudited consolidated financial statements.
 
 
7

 
FIRST FINANCIAL SERVICE CORPORATION
Consolidated Statements of Cash Flows
(Dollars In Thousands)
(Unaudited)
 
 
 
Three Months Ended
 
 
 
March 31,
 
 
 
2014
 
2013
 
Operating Activities:
 
 
 
 
 
 
 
Net income/(loss)
 
$
(101)
 
$
122
 
Adjustments to reconcile net income/(loss) to net cash provided by operating activities:
 
 
 
 
 
 
 
Provision for loan losses
 
 
-
 
 
(1,037)
 
Depreciation on premises and equipment
 
 
335
 
 
403
 
Change in real estate acquired through foreclosure valuation allowance
 
 
-
 
 
472
 
Loss on low-income housing investments
 
 
60
 
 
119
 
Net amortization (accretion) available-for-sale
 
 
101
 
 
1,014
 
Loss on sale of investments available-for-sale
 
 
211
 
 
282
 
Gain on sale of investments available-for-sale
 
 
(148)
 
 
(509)
 
Gain on sale of mortgage loans
 
 
(59)
 
 
(427)
 
Gain on sale of real estate acquired through foreclosure
 
 
(29)
 
 
(57)
 
Loss on sale of real estate acquired through foreclosure
 
 
2
 
 
477
 
Write-downs on real estate acquired through foreclosure
 
 
3
 
 
583
 
Origination of loans held for sale
 
 
(4,980)
 
 
(22,706)
 
Proceeds on sale of loans held for sale
 
 
4,822
 
 
25,530
 
Stock-based compensation expense
 
 
132
 
 
102
 
Changes in:
 
 
 
 
 
 
 
Cash surrender value of life insurance
 
 
(90)
 
 
(93)
 
Interest receivable
 
 
312
 
 
230
 
Other assets
 
 
283
 
 
(1,352)
 
Interest payable
 
 
336
 
 
340
 
Accounts payable and other liabilities
 
 
(571)
 
 
912
 
Net cash from operating activities
 
 
619
 
 
4,405
 
 
 
 
 
 
 
 
 
Investing Activities:
 
 
 
 
 
 
 
Sales of securities available-for-sale
 
 
36,126
 
 
75,536
 
Purchases of securities available-for-sale
 
 
(10,392)
 
 
(59,412)
 
Maturities of securities available-for-sale
 
 
5,272
 
 
12,003
 
Net change in loans
 
 
6,733
 
 
17,112
 
Redemption of Federal Home Loan Bank stock
 
 
350
 
 
375
 
Investment in low-income housing projects
 
 
-
 
 
(24)
 
Net purchases of premises and equipment
 
 
(30)
 
 
(193)
 
Proceeds from sales of real estate acquired through foreclosure
 
 
348
 
 
2,905
 
Net cash from investing activities
 
 
38,407
 
 
48,302
 
 
 
 
 
 
 
 
 
Financing Activities
 
 
 
 
 
 
 
Net change in deposits
 
 
(24,215)
 
 
(67,413)
 
Repayments to Federal Home Loan Bank
 
 
(35)
 
 
(35)
 
Issuance of common stock for employee benefit plans and exercise of stock options
 
 
22
 
 
29
 
Net cash from financing activities
 
 
(24,228)
 
 
(67,419)
 
 
 
 
 
 
 
 
 
Increase (decrease) in cash and cash equivalents
 
 
14,798
 
 
(14,712)
 
Cash and cash equivalents, beginning of period
 
 
65,988
 
 
63,103
 
Cash and cash equivalents, end of period
 
$
80,786
 
$
48,391
 
 
 
 
 
 
 
 
 
Supplemental noncash disclosures:
 
 
 
 
 
 
 
Transfers from loans to real estate acquired through foreclosure and repossessed assets
 
$
1,004
 
$
1,392
 
Loans to facilitate sales of real estate owned and repossessed assets
 
$
-
 
$
15
 
Dividends accrued not paid on preferred stock
 
$
450
 
$
250
 
 
See notes to the unaudited consolidated financial statements.
 
 
8

 
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
1.
BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
 
Basis of Presentation – The accompanying unaudited consolidated financial statements include the accounts of First Financial Service Corporation (the “Corporation”) and its wholly owned subsidiary, First Federal Savings Bank (the “Bank”). First Federal Savings Bank has two wholly owned subsidiaries, First Service Corporation of Elizabethtown and Heritage Properties, LLC. Unless the text clearly suggests otherwise, references to "us," "we," or "our" include First Financial Service Corporation and its wholly owned subsidiary, collectively referred to as the “Company”. All significant intercompany transactions and balances have been eliminated in consolidation.
 
The accompanying unaudited consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the quarter ended March 31, 2014 are not necessarily indicative of the results that may occur for the year ending December 31, 2014. For further information, refer to the consolidated financial statements and footnotes thereto included in the Corporation’s annual report on Form 10-K for the period ended December 31, 2013.
 
Reclassifications Some items in the prior year financial statements were reclassified to conform to the current presentation. Reclassifications had no effect on prior year operations or stockholders’   equity.
 
Adoption of New Accounting Standards – Effective January 2014, we adopted, ASU No. 2013-11, Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists (ASU 2013-11).   Current GAAP does not include explicit guidance on the financial statement presentation of an unrecognized tax benefit when a net operating loss carryforward, a similar tax loss, or a tax credit carryforward exists. The adoption of ASU 2013-11 requires an unrecognized tax benefit, or a portion of an unrecognized tax benefit to be presented in the financial statements as a reduction to a deferred tax asset for a net operating loss carryforward, a similar tax loss, or a tax credit carryforward, unless an exception applies.  This standard was effective for public entities for annual and interim reporting periods beginning after December 15, 2013. The adoption of this update did not have a material impact on the consolidated financial statements.
 
Recently Issued Accounting Pronouncement – In January 2014, the Financial Accounting Standards Board issued Accounting Standards Update No. 2014-01, Accounting for Investments in Qualified Affordable Housing Projects (ASU 2014-01). ASU 2014-01 permits reporting entities to make an accounting policy election to account for investments in qualified affordable housing projects using the proportional amortization method if certain conditions are met. Under the proportional amortization method, an entity amortizes the initial cost of the investment in proportion to the tax credits and other tax benefits received and recognizes the net investment performance in the income statement as a component of income tax expense. This new guidance also requires new disclosures for all investors in these projects. ASU 2014-01 is effective for interim and annual reporting periods beginning after December 15, 2014. Upon adoption, the guidance must be applied retrospectively to all periods presented. However, entities that use the effective yield method to account for investments in these projects before adoption may continue to do so for these pre-existing investments. The adoption of ASU 2014-01 is not expected to have a material impact on the consolidated financial statements.
 
 
9

 
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
2.
REGULATORY MATTERS
 
Since January 2011, the Bank has operated under Consent Orders with the Federal Deposit Insurance Corporation (“FDIC”) and the Kentucky Department of Financial Institutions (“KDFI”). The initial Consent Order required the Bank to achieve a total capital to risk-weighted assets ratio of 12 % and a Tier 1 capital to average total assets ratio of 9 %. It also prohibited the Bank from declaring dividends without the prior written approval of the FDIC and KDFI and has required the Bank to develop and implement plans to reduce its level of non-performing assets and concentrations of credit in commercial real estate loans, maintain adequate reserves for loan and lease losses, implement procedures to ensure compliance with applicable laws, and take certain other actions. When the Bank entered into a new Consent Order with the FDIC and KDFI in March 2012, it agreed that should it be unable to reach the required capital levels by June 30, 2012, and if directed in writing by the FDIC, then within 30 days the Bank would develop, adopt and implement a written plan to sell or merge itself into another federally insured financial institution. To date, the Bank has not received such a written direction. The latest Consent Order also includes the same substantive provisions as the initial Consent Order and requires the Bank to continue to adhere to the plans implemented in response to the initial Consent Order.
 
Copies of the Consent Orders are included as exhibits to our Form 8 - K filed on January 27, 2011 and our 2011 Annual Report on Form 10-K filed March 30, 2012.
 
In April 2011, the Corporation entered into a formal agreement with the Federal Reserve Bank of St. Louis, which requires the Corporation to obtain regulatory approval before declaring any dividends and to take steps to ensure the Bank complies with the Consent Order. We also may not redeem shares or obtain additional borrowings without prior approval.
 
The Consent Order and the formal agreement will remain in effect until modified or terminated by the FDIC, KDFI and Federal Reserve Bank of St. Louis.
 
At March 31, 2014, the Bank’s Tier 1 capital ratio was 8.15 % and the total risk-based capital ratio was 14.13 % compared to the minimum 9.00 % and 12.00 % capital ratios required by the Consent Order. Our comparable ratios at December 31, 2013 were 7.96 % and 13.48 %, respectively. For the sixth consecutive quarter, we have achieved and maintained the required total risk-based capital ratio. Our Tier 1 capital ratio also improved, but has yet to reach the Consent Order minimum. We continue to evaluate strategies to achieve and maintain the Tier 1 capital ratio as well as to comply with all of the other terms of the Consent Order.
 
The Bank is currently designated as a "troubled institution,” which status prohibits the Bank from accepting, renewing or rolling over brokered deposits and restricts the amount of interest the Bank may pay on deposits. Brokered deposits were $24.0 million at March 31, 2014, decreasing by $3.3 million from $27.3 million at December 31, 2013.
 
Bank regulatory agencies have discretion when an institution does not meet the terms of a regulatory order. The agencies may initiate changes in management, issue mandatory directives, impose monetary penalties or refrain from formal sanctions, depending on individual circumstances. Any material failure to comply with our regulatory orders would likely result in more stringent enforcement actions by the bank regulatory agencies, which could damage our reputation and have a material adverse effect on our business.
 
On April 21, 2014, we entered into an Agreement and Plan of Share Exchange (the “Agreement”) with Community Bank Shares of Indiana, Inc. (“CBIN”), whereby CBIN will acquire all of the outstanding shares of our common stock pursuant to a statutory share exchange (the “Share Exchange”).    It is anticipated that immediately following the Share Exchange, the Corporation will merge into CBIN and the Bank will merge into Your Community Bank, an Indiana chartered commercial bank and wholly owned subsidiary of CBIN (with Your Community Bank as the surviving bank).
 
The consummation of the Share Exchange is subject to various customary conditions, including receipt of the requisite regulatory approvals and the approval by the shareholders of the Corporation and of CBIN. The parties anticipate completing the Share Exchange in the late third or fourth quarter of 2014.
   
Our plans for 2014 include the following:
 
 
·        Continuing to work towards the completion of the merger and Share Exchange with Community Bank Shares of Indiana.
·
Continuing to address all requirements of our Consent Order and formal agreement.
·
Continuing to serve our community banking customers and operate the Corporation and the Bank in a safe and sound manner. We have worked diligently to maintain the strength of our retail and deposit franchise.
·
Continuing to reduce expenses and improve our ability to operate in a profitable manner.
·
Continuing to reduce our lending concentration in commercial real estate through expected maturities and repayments.
·
Accelerating our efforts to dispose of problem assets.
·
Continuing to reduce our inventory of other real estate owned properties.
 
 
10

 
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
3.
SECURITIES
 
The amortized cost basis and fair values of securities are as follows:
 
 
 
 
 
Gross
 
Gross
 
 
 
(Dollars in thousands)
 
Amortized
 
Unrealized
 
Unrealized
 
 
 
 
 
Cost
 
Gains
 
Losses
 
Fair Value
 
Securities available-for-sale:
 
 
 
 
 
 
 
 
 
 
 
 
 
March 31, 2014:
 
 
 
 
 
 
 
 
 
 
 
 
 
Government-sponsored
    collateralized mortgage obligations
 
$
102,756
 
$
230
 
$
(2,649)
 
$
100,337
 
Government-sponsored
    mortgage-backed residential
 
 
77,417
 
 
13
 
 
(2,902)
 
 
74,528
 
Corporate bonds
 
 
30,251
 
 
310
 
 
(173)
 
 
30,388
 
Asset backed-collateralized loan
    obligations
 
 
20,739
 
 
3
 
 
(453)
 
 
20,289
 
State and municipal
 
 
10,868
 
 
336
 
 
(3)
 
 
11,201
 
Commercial mortgage backed
 
 
4,092
 
 
-
 
 
(9)
 
 
4,083
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total
 
$
246,123
 
$
892
 
$
(6,189)
 
$
240,826
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Securities available-for-sale:
 
 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2013:
 
 
 
 
 
 
 
 
 
 
 
 
 
Government-sponsored
    collateralized mortgage obligations
 
$
104,390
 
$
86
 
$
(3,660)
 
$
100,816
 
Government-sponsored
    mortgage-backed residential
 
 
78,204
 
 
4
 
 
(3,884)
 
 
74,324
 
Corporate bonds
 
 
43,818
 
 
208
 
 
(328)
 
 
43,698
 
Asset backed-collateralized loan
    obligations
 
 
35,113
 
 
-
 
 
(635)
 
 
34,478
 
State and municipal
 
 
11,670
 
 
264
 
 
(11)
 
 
11,923
 
Commercial mortgage backed
 
 
4,097
 
 
-
 
 
(54)
 
 
4,043
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total
 
$
277,292
 
$
562
 
$
(8,572)
 
$
269,282
 
 
The amortized cost and fair value of securities at March 31, 2014, by contractual maturity, are shown below. Securities not due at a single maturity date, primarily mortgage-backed securities, are shown separately.
 
 
 
Available for Sale
 
 
 
Amortized
 
Fair
 
(Dollars in thousands)
 
Cost
 
Value
 
 
 
 
 
 
 
 
 
Due in one year or less
 
$
3,055
 
$
3,055
 
Due after one year through five years
 
 
26,910
 
 
27,118
 
Due after five years through ten years
 
 
4,733
 
 
4,700
 
Due after ten years
 
 
6,421
 
 
6,716
 
Investment securities with no single maturity date:
 
 
 
 
 
 
 
Government-sponsored collateralized mortgage
    obligations
 
 
102,756
 
 
100,337
 
Government-sponsored mortgage-backed
    residential
 
 
77,417
 
 
74,528
 
Asset backed-collateralized loan obligations
 
 
20,739
 
 
20,289
 
Commercial mortgage backed
 
 
4,092
 
 
4,083
 
 
 
$
246,123
 
$
240,826
 
 
 
11

 
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
3.
SECURITIES – (Continued)
 
The following schedule shows the proceeds from sales of available-for-sale securities and the gross realized gains and losses on those sales:
 
 
 
Three Months Ended
 
 
 
March 31,
 
 
 
2014
 
2013
 
 
 
(Dollars in thousands)
 
 
 
 
 
 
 
 
 
Proceeds from sales
 
$
36,126
 
$
75,536
 
Gross realized gains
 
 
148
 
 
509
 
Gross realized losses
 
 
211
 
 
282
 
 
Investment securities pledged to secure public deposits and Federal Home Loan Bank (FHLB) advances had an amortized cost of $ 175.4 million and fair value of $ 170.4 million at March 31, 2014 and a $ 193.0 million amortized cost and fair value of $ 185.8 million at December 31, 2013.
 
Securities with unrealized losses at March 31, 2014 and December 31, 2013 aggregated by major security type and length of time in a continuous unrealized loss position are as follows:
 
 
 
 
Less than 12 Months
 
12 Months or More
 
 
Total
 
March 31, 2014
 
 
Fair
 
 
Unrealized
 
 
Fair
 
 
Unrealized
 
 
Fair
 
 
Unrealized
 
Description of Securities
 
 
Value
 
 
Loss
 
 
Value
 
 
Loss
 
 
Value
 
 
Loss
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Government-sponsored collateralized
    mortgage obligations
 
$
51,722
 
$
(1,007)
 
$
23,848
 
$
(1,642)
 
$
75,570
 
$
(2,649)
 
Government-sponsored mortgage-backed
    residential
 
 
47,853
 
 
(1,599)
 
 
25,559
 
 
(1,303)
 
 
73,412
 
 
(2,902)
 
Corporate bonds
 
 
6,824
 
 
(93)
 
 
2,924
 
 
(80)
 
 
9,748
 
 
(173)
 
Asset backed-collateralized loan obligations
 
 
19,439
 
 
(453)
 
 
-
 
 
-
 
 
19,439
 
 
(453)
 
State and municipal
 
 
826
 
 
(3)
 
 
-
 
 
-
 
 
826
 
 
(3)
 
Commercial mortgage backed
 
 
4,083
 
 
(9)
 
 
-
 
 
-
 
 
4,083
 
 
(9)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total temporarily impaired
 
$
130,747
 
$
(3,164)
 
$
52,331
 
$
(3,025)
 
$
183,078
 
$
(6,189)
 
 
 
 
Less than 12 Months
 
12 Months or More
 
Total
 
December 31, 2013
 
Fair
 
Unrealized
 
Fair
Unrealized
 
Fair
 
Unrealized
 
Description of Securities
 
Value
 
Loss
 
Value
Loss
 
Value
 
Loss
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Government-sponsored collateralized
    mortgage obligations
 
$
59,168
 
$
(2,119)
 
$
20,560
 
$
(1,541)
 
$
79,728
 
$
(3,660)
 
Government-sponsored mortgage-backed
    residential
 
 
59,971
 
 
(2,864)
 
 
13,215
 
 
(1,020)
 
 
73,186
 
 
(3,884)
 
Corporate bonds
 
 
17,578
 
 
(328)
 
 
-
 
 
-
 
 
17,578
 
 
(328)
 
Asset backed-collateralized loan obligations
 
 
34,478
 
 
(635)
 
 
-
 
 
-
 
 
34,478
 
 
(635)
 
State and municipal
 
 
1,865
 
 
(11)
 
 
-
 
 
-
 
 
1,865
 
 
(11)
 
Commercial mortgage backed
 
 
4,043
 
 
(54)
 
 
-
 
 
-
 
 
4,043
 
 
(54)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total temporarily impaired
 
$
177,103
 
$
(6,011)
 
$
33,775
 
$
(2,561)
 
$
210,878
 
$
(8,572)
 
 
We evaluate investment securities with significant declines in fair value on at least a quarterly basis, and more frequently when economic or market concerns warrant such evaluation, to determine whether they should be considered other-than-temporarily impaired under current accounting guidance, which generally provides that if a security is in an unrealized loss position, whether due to general market conditions or industry or issuer-specific factors, the holder of the securities must assess whether the impairment is other-than-temporary.
 
In conducting this assessment, the Bank evaluates a number of factors including, but not limited to:
 
The length of time and the extent to which fair value has been less than the amortized cost basis;
The Bank’s intent to hold until maturity or sell the debt security prior to maturity;
 
 
12

 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
3.
SECURITIES – (Continued)
 
An analysis of whether it is more likely than not that the Bank will be required to sell the debt security before its anticipated recovery;
Adverse conditions specifically related to the security, an industry, or a geographic area;
The historical and implied volatility of the fair value of the security;
The payment structure of the security and the likelihood of the issuer being able to make payments;
Failure of the issuer to make scheduled interest or principal payments;
Any rating changes by a rating agency; and
Recoveries or additional decline in fair value subsequent to the balance sheet date.
 
Accounting guidance requires entities to split other than temporary impairment charges between credit losses (i.e., the loss based on the entity’s estimate of the decrease in cash flows, including those that result from expected voluntary prepayments), which are charged to earnings, and the remainder of the impairment charge (non-credit component) to accumulated other comprehensive income. This requirement pertains to both debt securities held to maturity and debt securities available for sale.
 
The unrealized losses on our investment securities were a result of changes in interest rates for fixed-rate securities where the interest rate received is less than the current rate available for new offerings of similar securities. Mortgage backed securities held in our investment portfolio were issued by U.S. government-sponsored entities and agencies, primarily Freddie Mac (“FHLMC”) and Fannie Mae (“FNMA”), institutions that the government has affirmed its commitment to support. Because the decline in market value on our investment securities is attributable to changes in interest rates and not credit quality, and because we do not intend to sell and it is more likely than not that we will not be required to sell these investments until recovery of fair value, which may be maturity, we do not consider these investments to be other-than-temporarily impaired at March 31, 2014.
 
At March 31, 2014, we own five collateralized loan obligation (“CLO”) securities subject to the Volcker Rule, with an amortized cost of $ 20.7 million and an unrealized loss of $ 453,000 . Absent changes to the Volcker Rule, we would be required to dispose of these securities before July 2015. We believe the unrealized loss reflected results not from credit risk but from interest rate changes and to the uncertainty created by the Volcker Rule. In the first quarter of 2014, we sold four of our CLOs to confirm their marketability and evaluate our assessment about their market values.   These four securities had an unrealized loss of $233,000 at December 31, 2013. We recorded a loss of $ 91,000 on these sales. We do not currently intend to sell additional CLOs.
 
 
13

 
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
4.             LOANS
Loans are summarized as follows:
 
 
 
March 31,
 
December 31,
 
(Dollars in thousands)
 
2014
 
2013
 
 
 
 
 
 
 
 
 
Commercial Real Estate:
 
 
 
 
 
 
 
Other
 
$
252,623
 
$
257,901
 
Land Development
 
 
19,204
 
 
20,476
 
Building Lots
 
 
1,515
 
 
1,559
 
Residential mortgage
 
 
99,887
 
 
99,344
 
Consumer and home equity
 
 
51,526
 
 
54,010
 
Commercial
 
 
21,695
 
 
20,621
 
Indirect consumer
 
 
12,817
 
 
13,041
 
 
 
 
459,267
 
 
466,952
 
Less:
 
 
 
 
 
 
 
Net deferred loan origination fees
 
 
(110)
 
 
(90)
 
Allowance for loan losses
 
 
(9,608)
 
 
(9,576)
 
 
 
 
(9,718)
 
 
(9,666)
 
 
 
 
 
 
 
 
 
Net Loans
 
$
449,549
 
$
457,286
 
 
The following tables present the activity in the allowance for loan losses by portfolio segment for the three months ending March 31, 2014 and 2013:
 
March 31, 2014
 
 
 
 
Commercial
 
Residential
 
Consumer &
 
Indirect
 
 
 
 
 
 
Commercial
 
Real Estate
 
Mortgage
 
Home Equity
 
Consumer
 
Total
 
(Dollars in thousands)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Allowance for loan losses:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Beginning Balance
 
$
540
 
$
8,358
 
$
292
 
$
309
 
$
77
 
$
9,576
 
Provision for loan losses
 
 
-
 
 
-
 
 
-
 
 
-
 
 
-
 
 
-
 
Charge-offs
 
 
-
 
 
(34)
 
 
(4)
 
 
(8)
 
 
(34)
 
 
(80)
 
Recoveries
 
 
9
 
 
54
 
 
3
 
 
16
 
 
30
 
 
112
 
Total ending allowance balance
 
$
549
 
$
8,378
 
$
291
 
$
317
 
$
73
 
$
9,608
 
 
March 31, 2013
 
 
 
 
Commercial
 
Residential
 
Consumer &
 
Indirect
 
 
 
 
 
 
Commercial
 
Real Estate
 
Mortgage
 
Home Equity
 
Consumer
 
Total
 
(Dollars in thousands)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Allowance for loan losses:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Beginning Balance
 
$
1,236
 
$
14,815
 
$
501
 
$
442
 
$
271
 
$
17,265
 
Provision for loan losses
 
 
(262)
 
 
(614)
 
 
(130)
 
 
37
 
 
(68)
 
 
(1,037)
 
Charge-offs
 
 
(94)
 
 
(391)
 
 
-
 
 
(47)
 
 
(16)
 
 
(548)
 
Recoveries
 
 
34
 
 
56
 
 
-
 
 
6
 
 
36
 
 
132
 
Total ending allowance balance
 
$
914
 
$
13,866
 
$
371
 
$
438
 
$
223
 
$
15,812
 
 
 
14

 
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
4.             LOANS – (Continued)
 
We did not implement any significant changes to our allowance related accounting policies or methodology during the current period.
 
The following table presents the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment and based on the impairment method as of March 31, 2014 and 2013 and December 31, 2013:
 
March 31, 2014
 
 
 
 
Commercial
 
Residential
 
Consumer &
 
Indirect
 
 
 
 
 
 
Commercial
 
Real Estate
 
Mortgage
 
Home Equity
 
Consumer
 
Total
 
(Dollars in thousands)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Allowance for loan losses:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Ending allowance balance attributable to loans:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Individually evaluated for impairment
 
$
144
 
$
2,730
 
$
3
 
$
32
 
$
-
 
$
2,909
 
Collectively evaluated for impairment
 
 
405
 
 
5,648
 
 
288
 
 
285
 
 
73
 
 
6,699
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total ending allowance balance
 
$
549
 
$
8,378
 
$
291
 
$
317
 
$
73
 
$
9,608
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Loans:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Loans individually evaluated for impairment
 
$
799
 
$
32,631
 
$
3,051
 
$
470
 
$
-
 
$
36,951
 
Loans collectively evaluated for impairment
 
 
20,896
 
 
240,711
 
 
96,836
 
 
51,056
 
 
12,817
 
 
422,316
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total ending loans balance
 
$
21,695
 
$
273,342
 
$
99,887
 
$
51,526
 
$
12,817
 
$
459,267
 
 
December 31, 2013
 
 
 
 
Commercial
 
Residential
 
 
Consumer &
 
Indirect
 
 
 
 
 
 
Commercial
 
Real Estate
 
 
Mortgage
 
Home Equity
 
Consumer
 
Total
 
(Dollars in thousands)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Allowance for loan losses:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Ending allowance balance attributable to loans:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Individually evaluated for impairment
 
$
148
 
$
2,603
 
$
3
 
$
32
 
$
-
 
$
2,786
 
Collectively evaluated for impairment
 
 
392
 
 
5,755
 
 
289
 
 
277
 
 
77
 
 
6,790
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total ending allowance balance
 
$
540
 
$
8,358
 
$
292
 
$
309
 
$
77
 
$
9,576
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Loans:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Loans individually evaluated for impairment
 
$
803
 
$
32,911
 
$
3,051
 
$
546
 
$
-
 
$
37,311
 
Loans collectively evaluated for impairment
 
 
19,818
 
 
247,025
 
 
96,293
 
 
53,464
 
 
13,041
 
 
429,641
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total ending loans balance
 
$
20,621
 
$
279,936
 
$
99,344
 
$
54,010
 
$
13,041
 
$
466,952
 
 
March 31, 2013
 
 
 
 
Commercial
 
Residential
 
Consumer &
 
Indirect
 
 
 
 
 
 
Commercial
 
Real Estate
 
Mortgage
 
Home Equity
 
Consumer
 
Total
 
(Dollars in thousands)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Allowance for loan losses:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Ending allowance balance attributable to loans:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Individually evaluated for impairment
 
$
192
 
$
6,439
 
$
55
 
$
91
 
$
-
 
$
6,777
 
Collectively evaluated for impairment
 
 
722
 
 
7,427
 
 
316
 
 
347
 
 
223
 
 
9,035
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total ending allowance balance
 
$
914
 
$
13,866
 
$
371
 
$
438
 
$
223
 
$
15,812
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Loans:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Loans individually evaluated for impairment
 
$
865
 
$
36,495
 
$
3,703
 
$
775
 
$
-
 
$
41,838
 
Loans collectively evaluated for impairment
 
 
16,165
 
 
274,186
 
 
105,513
 
 
54,495
 
 
13,813
 
 
464,172
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total ending loans balance
 
$
17,030
 
$
310,681
 
$
109,216
 
$
55,270
 
$
13,813
 
$
506,010
 
 
 
15

 
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
4.
LOANS – (Continued)
 
The following tables’ present loans individually evaluated for impairment by class of loans as of March 31, 2014 and 2013 and December 31, 2013. The difference between the unpaid principal balance and recorded investment represents partial write downs/charge offs taken on individual impaired credits. The recorded investment and average recorded investment in loans excludes accrued interest receivable and loan origination fees.
 
March 31, 2014
 
Unpaid
 
 
 
Allowance for
 
Average
 
Interest
 
Cash Basis
 
 
 
Principal
 
Recorded
 
Loan Losses
 
Recorded
 
Income
 
Interest
 
(Dollars in thousands)
 
Balance
 
Investment
 
Allocated
 
Investment
 
Recognized
 
Recognized
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
With no related allowance recorded:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial
 
$
681
 
$
477
 
$
-
 
$
476
 
$
3
 
$
3
 
Commercial Real Estate:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Land Development
 
 
1,439
 
 
1,439
 
 
-
 
 
1,714
 
 
21
 
 
21
 
Building Lots
 
 
477
 
 
212
 
 
-
 
 
212
 
 
-
 
 
-
 
Other
 
 
22,551
 
 
21,262
 
 
-
 
 
21,563
 
 
203
 
 
203
 
Residential Mortgage
 
 
3,099
 
 
2,992
 
 
-
 
 
2,992
 
 
19
 
 
19
 
Consumer and Home Equity
 
 
428
 
 
402
 
 
-
 
 
440
 
 
3
 
 
3
 
Indirect Consumer
 
 
-
 
 
-
 
 
-
 
 
-
 
 
-
 
 
-
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
With an allowance recorded:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial
 
 
322
 
 
322
 
 
144
 
 
325
 
 
2
 
 
2
 
Commercial Real Estate:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Land Development
 
 
2,206
 
 
2,206
 
 
1,581
 
 
2,206
 
 
26
 
 
26
 
Building Lots
 
 
-
 
 
-
 
 
-
 
 
-
 
 
-
 
 
-
 
Other
 
 
9,707
 
 
7,512
 
 
1,149
 
 
7,076
 
 
67
 
 
67
 
Residential Mortgage
 
 
59
 
 
59
 
 
3
 
 
59
 
 
-
 
 
-
 
Consumer and Home Equity
 
 
68
 
 
68
 
 
32
 
 
68
 
 
1
 
 
1
 
Indirect Consumer
 
 
-
 
 
-
 
 
-
 
 
-
 
 
-
 
 
-
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total
 
$
41,037
 
$
36,951
 
$
2,909
 
$
37,131
 
$
345
 
$
345
 
 
December 31, 2013
 
Unpaid
 
 
 
Allowance for
 
Average
 
Interest
 
Cash Basis
 
 
 
Principal
 
Recorded
 
Loan Losses
 
Recorded
 
Income
 
Interest
 
(Dollars in thousands)
 
Balance
 
Investment
 
Allocated
 
Investment
 
Recognized
 
Recognized
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
With no related allowance recorded:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial
 
$
679
 
$
475
 
$
-
 
$
747
 
$
21
 
$
21
 
Commercial Real Estate:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Land Development
 
 
2,014
 
 
1,989
 
 
-
 
 
2,898
 
 
139
 
 
139
 
Building Lots
 
 
477
 
 
212
 
 
-
 
 
212
 
 
-
 
 
-
 
Other
 
 
25,441
 
 
21,864
 
 
-
 
 
17,934
 
 
754
 
 
754
 
Residential Mortgage
 
 
3,119
 
 
2,992
 
 
-
 
 
2,368
 
 
63
 
 
63
 
Consumer and Home Equity
 
 
478
 
 
478
 
 
-
 
 
330
 
 
10
 
 
10
 
Indirect Consumer
 
 
-
 
 
-
 
 
-
 
 
-
 
 
-
 
 
-
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
With an allowance recorded:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial
 
 
328
 
 
328
 
 
148
 
 
314
 
 
9
 
 
9
 
Commercial Real Estate:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Land Development
 
 
2,206
 
 
2,206
 
 
1,581
 
 
2,538
 
 
121
 
 
121
 
Building Lots
 
 
-
 
 
-
 
 
-
 
 
-
 
 
-
 
 
-
 
Other
 
 
6,640
 
 
6,640
 
 
1,022
 
 
16,512
 
 
694
 
 
694
 
Residential Mortgage
 
 
59
 
 
59
 
 
3
 
 
312
 
 
8
 
 
8
 
Consumer and Home Equity
 
 
68
 
 
68
 
 
32
 
 
229
 
 
7
 
 
7
 
Indirect Consumer
 
 
-
 
 
-
 
 
-
 
 
-
 
 
-
 
 
-
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total
 
$
41,509
 
$
37,311
 
$
2,786
 
$
44,394
 
$
1,826
 
$
1,826
 
 
 
16

 
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
4.
LOANS – (Continued)
 
March 31, 2013
 
Unpaid
 
 
 
Allowance for
 
Average
 
Interest
 
Cash Basis
 
 
 
Principal
 
Recorded
 
Loan Losses
 
Recorded
 
Income
 
Interest
 
(Dollars in thousands)
 
Balance
 
Investment
 
Allocated
 
Investment
 
Recognized
 
Recognized
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
With no related allowance recorded:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial
 
$
878
 
$
672
 
$
-
 
$
630
 
$
4
 
$
4
 
Commercial Real Estate:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Land Development
 
 
3,868
 
 
3,120
 
 
-
 
 
3,997
 
 
49
 
 
49
 
Building Lots
 
 
477
 
 
212
 
 
-
 
 
212
 
 
-
 
 
-
 
Other
 
 
11,425
 
 
10,189
 
 
-
 
 
13,345
 
 
132
 
 
132
 
Residential Mortgage
 
 
3,382
 
 
3,382
 
 
-
 
 
1,691
 
 
9
 
 
9
 
Consumer and Home Equity
 
 
419
 
 
419
 
 
-
 
 
210
 
 
2
 
 
2
 
Indirect Consumer
 
 
-
 
 
-
 
 
-
 
 
-
 
 
-
 
 
-
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
With an allowance recorded:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial
 
 
193
 
 
193
 
 
192
 
 
338
 
 
2
 
 
2
 
Commercial Real Estate:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Land Development
 
 
2,674
 
 
2,674
 
 
899
 
 
2,674
 
 
32
 
 
32
 
Building Lots
 
 
-
 
 
-
 
 
-
 
 
-
 
 
-
 
 
-
 
Other
 
 
22,395
 
 
20,301
 
 
5,540
 
 
19,778
 
 
202
 
 
202
 
Residential Mortgage
 
 
321
 
 
321
 
 
55
 
 
267
 
 
1
 
 
1
 
Consumer and Home Equity
 
 
355
 
 
355
 
 
91
 
 
272
 
 
2
 
 
2
 
Indirect Consumer
 
 
-
 
 
-
 
 
-
 
 
-
 
 
-
 
 
-
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total
 
$
46,387
 
$
41,838
 
$
6,777
 
$
43,414
 
$
435
 
$
435
 
 
The following tables present the recorded investment in restructured, nonaccrual and loans past due over 90 days still on accrual by class of loans as of March 31, 2014 and December 31, 2013.
 
 
 
 
 
 
 
Restructured
 
 
 
 
 
 
 
 
 
 
 
Loans Past Due
 
Loans Past Due
 
 
 
March 31, 2014
 
 
 
 
 
Over 90 Days
 
Over 90 Days
 
Non-Accrual
 
 
 
Restructured on
 
Restructured on
 
Still
 
Still
 
Excluding
 
(Dollars in thousands)
 
Non-Accrual Status
 
Accrual Status
 
Accruing
 
Accruing
 
Restructured
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial
 
$
-
 
$
168
 
$
-
 
$
-
 
$
368
 
Commercial Real Estate:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Land Development
 
 
-
 
 
1,439
 
 
-
 
 
-
 
 
-
 
Building Lots
 
 
-
 
 
-
 
 
-
 
 
-
 
 
212
 
Other
 
 
978
 
 
21,272
 
 
-
 
 
-
 
 
5,945
 
Residential Mortgage
 
 
192
 
 
107
 
 
-
 
 
-
 
 
994
 
Consumer and Home Equity
 
 
-
 
 
72
 
 
-
 
 
-
 
 
161
 
Indirect Consumer
 
 
-
 
 
-
 
 
-
 
 
-
 
 
8
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total
 
$
1,170
 
$
23,058
 
$
-
 
$
-
 
$
7,688
 
 
 
 
 
 
 
 
Restructured
 
 
 
 
 
 
 
 
 
 
 
Loans Past Due
 
Loans Past Due
 
 
 
December 31, 2013
 
 
 
 
 
Over 90 Days
 
Over 90 Days
 
Non-Accrual
 
 
 
Restructured on
 
Restructured on
 
Still
 
Still
 
Excluding
 
(Dollars in thousands)
 
Non-Accrual Status
 
Accrual Status
 
Accruing
 
Accruing
 
Restructured
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial
 
$
-
 
$
178
 
$
-
 
$
-
 
$
421
 
Commercial Real Estate:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Land Development
 
 
-
 
 
1,687
 
 
-
 
 
-
 
 
302
 
Building Lots
 
 
-
 
 
-
 
 
-
 
 
-
 
 
212
 
Other
 
 
986
 
 
17,025
 
 
4,780
 
 
2,226
 
 
6,443
 
Residential Mortgage
 
 
301
 
 
-
 
 
-
 
 
-
 
 
1,532
 
Consumer and Home Equity
 
 
23
 
 
73
 
 
-
 
 
-
 
 
156
 
Indirect Consumer
 
 
-
 
 
-
 
 
-
 
 
-
 
 
30
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total
 
$
1,310
 
$
18,963
 
$
4,780
 
$
2,226
 
$
9,096
 
 
 
17

 
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
4.
LOANS – (Continued)
 
The following tables present the aging of the unpaid principal in past due loans as of March 31, 2014 and December 31, 2013 by class of loans:
 
March 31, 2014
 
30-59
 
60-89
 
Greater than
 
 
 
 
 
 
 
 
 
Days
 
Days
 
90 Days
 
Total
 
Loans Not
 
 
 
(Dollars in thousands)
 
Past Due
 
Past Due
 
Past Due
 
Past Due
 
Past Due
 
Total
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial
 
$
9
 
$
-
 
$
368
 
$
377
 
$
21,318
 
$
21,695
 
Commercial Real Estate:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Land Development
 
 
-
 
 
-
 
 
2,206
 
 
2,206
 
 
16,998
 
 
19,204
 
Building Lots
 
 
-
 
 
-
 
 
212
 
 
212
 
 
1,303
 
 
1,515
 
Other
 
 
4,072
 
 
4,937
 
 
4,714
 
 
13,723
 
 
238,900
 
 
252,623
 
Residential Mortgage
 
 
385
 
 
983
 
 
795
 
 
2,163
 
 
97,724
 
 
99,887
 
Consumer and Home Equity
 
 
395
 
 
37
 
 
98
 
 
530
 
 
50,996
 
 
51,526
 
Indirect Consumer
 
 
123
 
 
26
 
 
6
 
 
155
 
 
12,662
 
 
12,817
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total
 
$
4,984
 
$
5,983
 
$
8,399
 
$
19,366
 
$
439,901
 
$
459,267
 
 
December 31, 2013
 
30-59
 
60-89
 
Greater than
 
 
 
 
 
 
 
 
 
Days
 
Days
 
90 Days
 
Total
 
Loans Not
 
 
 
(Dollars in thousands)
 
Past Due
 
Past Due
 
Past Due
 
Past Due
 
Past Due
 
Total
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial
 
$
-
 
$
-
 
$
421
 
$
421
 
$
20,200
 
$
20,621
 
Commercial Real Estate:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Land Development
 
 
-
 
 
-
 
 
2,508
 
 
2,508
 
 
17,968
 
 
20,476
 
Building Lots
 
 
-
 
 
-
 
 
212
 
 
212
 
 
1,347
 
 
1,559
 
Other
 
 
5,250
 
 
6,213
 
 
11,236
 
 
22,699
 
 
235,202
 
 
257,901
 
Residential Mortgage
 
 
1,446
 
 
511
 
 
1,053
 
 
3,010
 
 
96,334
 
 
99,344
 
Consumer and Home Equity
 
 
430
 
 
23
 
 
117
 
 
570
 
 
53,440
 
 
54,010
 
Indirect Consumer
 
 
211
 
 
55
 
 
22
 
 
288
 
 
12,753
 
 
13,041
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total
 
$
7,337
 
$
6,802
 
$
15,569
 
$
29,708
 
$
437,244
 
$
466,952
 
 
Troubled Debt Restructurings:
 
We have allocated $ 1.0 million and $ 1.1 million of specific reserves to customers whose loan terms have been modified in troubled debt restructurings as of March 31, 2014 and December 31, 2013. We are not committed to lend additional funds to debtors whose loans have been modified in a troubled debt restructuring. Specific reserves are generally assessed prior to loans being modified as a TDR, as most of these loans migrate from our internal watch list and have been specifically reserved for as part of our normal reserving methodology.
 
During the period ending March 31, 2014, no new loans were modified as troubled debt restructurings. Prior to the 2014 period, the terms of certain loans were modified as troubled debt restructurings and the modification of the terms of such loans included one or a combination of the following: a reduction of the stated interest rate of the loan; an extension of the maturity date at a stated rate of interest lower than the current market rate for new debt with similar risk; or a permanent reduction of the recorded investment in the loan.
 
Modifications involving a reduction of the stated interest rate of the loan were for periods ranging from six months to one year. Modifications involving an extension of the maturity date were for periods ranging from three to six months.
 
 
18

 
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
4.
LOANS – (Continued)
 
The following table presents loans by class modified as troubled debt restructurings that occurred during the periods ending March 31, 2014 and 2013:
 
 
 
Three Months Ended
 
Three Months Ended
 
 
 
March 31, 2014
 
March 31, 2013
 
 
 
 
 
Pre-Modification
 
Post-Modification
 
 
 
Pre-Modification
 
Post-Modification
 
 
 
 
 
Outstanding
 
Outstanding
 
 
 
Outstanding
 
Outstanding
 
 
 
Number
 
Recorded
 
Recorded
 
Number
 
Recorded
 
Recorded
 
(Dollars in thousands)
 
of Loans
 
Investment
 
Investment
 
of Loans
 
Investment
 
Investment
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Troubled Debt Restructurings:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial
 
-
 
$
-
 
$
-
 
-
 
$
-
 
$
-
 
Commercial Real Estate:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Land Development
 
-
 
 
-
 
 
-
 
-
 
 
-
 
 
-
 
Building Lots
 
-
 
 
-
 
 
-
 
-
 
 
-
 
 
-
 
Other
 
-
 
 
-
 
 
-
 
3
 
 
2,154
 
 
2,154
 
Real Estate Construction
 
-
 
 
-
 
 
-
 
-
 
 
-
 
 
-
 
Residential Mortgage
 
-
 
 
-
 
 
-
 
-
 
 
-
 
 
-
 
Consumer and Home Equity
 
-
 
 
-
 
 
-
 
1
 
 
24
 
 
24
 
Indirect Consumer
 
-
 
 
-
 
 
-
 
-
 
 
-
 
 
-
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total
 
-
 
$
-
 
$
-
 
4
 
$
2,178
 
$
2,178
 
 
The troubled debt restructurings described above increased the allowance for loan losses allocated to troubled debt restructurings by $ 0 and $ 63,000 for the three months ended March 31, 2014 and 2013. Typically, these loans had allocated allowance prior to their formal modification. There were no charge-offs recorded on the troubled debt restructurings described above for the 2014 and 2013 periods.
 
The following table presents loans by class modified as troubled debt restructurings for which there was a payment default within twelve months following the modification during the periods ending March 31, 2014 and 2013:
 
 
 
Three Months Ended
 
Three Months Ended
 
 
 
March 31, 2014
 
March 31, 2013
 
 
 
Number
 
Recorded
 
Number
 
Recorded
 
(Dollars in thousands)
 
of Loans
 
Investment
 
of Loans
 
Investment
 
 
 
 
 
 
 
 
 
 
 
 
 
Troubled Debt Restructurings:
 
 
 
 
 
 
 
 
 
 
 
Commercial
 
-
 
$
-
 
-
 
$
-
 
Commercial Real Estate:
 
 
 
 
 
 
 
 
 
 
 
Land Development
 
-
 
 
-
 
-
 
 
-
 
Building Lots
 
-
 
 
-
 
-
 
 
-
 
Other
 
-
 
 
-
 
-
 
 
-
 
Real Estate Construction
 
-
 
 
-
 
-
 
 
-
 
Residential Mortgage
 
-
 
 
-
 
-
 
 
-
 
Consumer and Home Equity
 
-
 
 
-
 
-
 
 
-
 
Indirect Consumer
 
-
 
 
-
 
-
 
 
-
 
 
 
 
 
 
 
 
 
 
 
 
 
Total
 
-
 
$
-
 
-
 
$
-
 
 
For disclosure purposes, a loan is considered to be in payment default once it is 90 days contractually past due under the modified terms.
 
We did not have any troubled debt restructurings for which there was a payment default within twelve months following the modification during the periods ending March 31, 2014 and 2013.
 
 
19

 
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
4.             LOANS – (Continued)
 
Credit Quality Indicators:
 
We categorize loans into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. We analyze loans individually by classifying the loans as to credit risk. This analysis includes commercial and commercial real estate loans. We also evaluate credit quality on residential mortgage, consumer and home equity and indirect consumer loans based on the aging status and payment activity of the loan. This analysis is performed on a monthly basis. We use the following definitions for risk ratings:
 
Criticized: Loans classified as criticized have a potential weakness that deserves management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or in our credit position at some future date.
 
Substandard: Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.
 
Doubtful: Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.
 
Loss: Loans classified as loss are considered non-collectible and their continuance as bankable assets is not warranted.
 
Loans not meeting the criteria above that are analyzed individually as part of the above described process are considered to be pass rated loans. Loans listed as not rated are included in groups of homogeneous loans. For our residential mortgage, consumer and home equity, and indirect consumer homogeneous loans, we also evaluate credit quality based on the aging status of the loan, which was previously presented, and by payment activity.
 
 
20

 
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
4.              LOANS – (Continued)
 
As of March 31, 2014and December 31, 2013, and based on the most recent analysis performed, the risk category of loans by class of loans is as follows:
 
March 31, 2014
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
(Dollars in thousands)
 
Not Rated
 
Pass
 
Criticized
 
Substandard
 
Doubtful
 
Loss
 
Total
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial
 
$
-
 
$
20,429
 
$
466
 
$
800
 
$
-
 
$
-
 
$
21,695
 
Commercial Real Estate:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Land Development
 
 
-
 
 
14,762
 
 
2,236
 
 
2,206
 
 
-
 
 
-
 
 
19,204
 
Building Lots
 
 
-
 
 
882
 
 
421
 
 
212
 
 
-
 
 
-
 
 
1,515
 
Other
 
 
-
 
 
210,788
 
 
14,352
 
 
27,483
 
 
-
 
 
-
 
 
252,623
 
Residential Mortgage
 
 
95,753
 
 
-
 
 
1,035
 
 
3,099
 
 
-
 
 
-
 
 
99,887
 
Consumer and Home Equity
 
 
50,903
 
 
-
 
 
104
 
 
519
 
 
-
 
 
-
 
 
51,526
 
Indirect Consumer
 
 
12,783
 
 
-
 
 
-
 
 
34
 
 
-
 
 
-
 
 
12,817
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total
 
$
159,439
 
$
246,861
 
$
18,614
 
$
34,353
 
$
-
 
$
-
 
$
459,267
 
 
December 31, 2013
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
(Dollars in thousands)
 
Not Rated
 
Pass
 
Criticized
 
 
Substandard
 
Doubtful
 
Loss
 
Total
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial
 
$
-
 
$
19,289
 
$
470
 
$
862
 
$
-
 
$
-
 
$
20,621
 
Commercial Real Estate:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Land Development
 
 
-
 
 
15,484
 
 
2,484
 
 
2,508
 
 
-
 
 
-
 
 
20,476
 
Building Lots
 
 
-
 
 
906
 
 
441
 
 
212
 
 
-
 
 
-
 
 
1,559
 
Other
 
 
-
 
 
213,719
 
 
13,920
 
 
30,262
 
 
-
 
 
-
 
 
257,901
 
Residential Mortgage
 
 
95,351
 
 
-
 
 
942
 
 
3,051
 
 
-
 
 
-
 
 
99,344
 
Consumer and Home Equity
 
 
53,407
 
 
-
 
 
72
 
 
531
 
 
-
 
 
-
 
 
54,010
 
Indirect Consumer
 
 
12,988
 
 
-
 
 
-
 
 
53
 
 
-
 
 
-
 
 
13,041
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total
 
$
161,746
 
$
249,398
 
$
18,329
 
$
37,479
 
$
-
 
$
-
 
$
466,952
 
 
The following table presents the unpaid principal balance in residential mortgage, consumer and home equity and indirect consumer loans based on payment activity as of March 31, 2014 and December 31, 2013:
 
March 31, 2014
 
 
Residential
 
 
Consumer &
 
 
Indirect
 
(Dollars in thousands)
 
 
Mortgage
 
 
Home Equity
 
 
Consumer
 
 
 
 
 
 
 
 
 
 
 
 
Performing
 
$
98,701
 
$
51,365
 
$
12,809
 
Restructured on non-accrual
 
 
192
 
 
-
 
 
-
 
Non-accrual
 
 
994
 
 
161
 
 
8
 
 
 
 
 
 
 
 
 
 
 
 
Total
 
$
99,887
 
$
51,526
 
$
12,817
 
 
December 31, 2013
 
 
Residential
 
 
Consumer &
 
 
Indirect
 
(Dollars in thousands)
 
 
Mortgage
 
 
Home Equity
 
 
Consumer
 
 
 
 
 
 
 
 
 
 
 
 
Performing
 
$
97,511
 
$
53,831
 
$
13,011
 
Restructured on non-accrual
 
 
301
 
 
23
 
 
-
 
Non-accrual
 
 
1,532
 
 
156
 
 
30
 
 
 
 
 
 
 
 
 
 
 
 
Total
 
$
99,344
 
$
54,010
 
$
13,041
 
 
 
21

 
  NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
5.              REAL ESTATE ACQUIRED THROUGH FORECLOSURE
 
                A summary of the real estate acquired through foreclosure activity is as follows:
 
 
 
March 31,
 
December 31,
 
(Dollars in thousands)
 
2014
 
2013
 
 
 
 
 
 
 
 
 
Beginning balance, January 1,
 
$
11,657
 
$
22,286
 
Additions
 
 
954
 
 
8,713
 
Net proceeds from sale of properties
 
 
(348)
 
 
(17,076)
 
Writedowns
 
 
(3)
 
 
(2,185)
 
Change in valuation allowance
 
 
-
 
 
(81)
 
Ending balance
 
$
12,260
 
$
11,657
 
 
A summary of the real estate acquired through foreclosure valuation allowance activity is as follows:
 
 
 
March 31,
 
December 31,
 
(Dollars in thousands)
 
2014
 
2013
 
 
 
 
 
 
 
 
 
Beginning balance
 
$
581
 
$
500
 
Provision
 
 
-
 
 
427
 
Writedowns and loss on sale
 
 
-
 
 
(346)
 
Ending balance
 
$
581
 
$
581
 
 
Real estate acquired through foreclosure expense which consists primarily of property management expenses was $ 86,000 and $ 294,000 for the periods ended March 31, 2014 and 2013, respectively.

6.              INCOME TAXES
 
The calculation for the income tax provision or benefit generally does not consider the tax effects of changes in other comprehensive income, or OCI, which is a component of stockholders’ equity on the balance sheet.  However, an exception is provided in certain circumstances, such as when there is a full valuation allowance against net deferred tax assets, there is a loss from continuing operations and income in other components of the financial statements.  In such a case, pre-tax income from other categories, such as changes in OCI, must be considered in determining a tax benefit to be allocated to the loss from continuing operations.  For the quarter ended March 31, 2014 and March 31, 2013, this resulted in $ 88,000 and $ 0 of income tax benefit allocated to continuing operations.
 
A valuation allowance related to deferred tax assets is required when it is considered more likely than not that all or part of the benefit related to such assets will not be realized. In assessing the need for a full valuation allowance, we considered various factors including our five year cumulative loss position, the level of our non-performing assets, our inability to meet our forecasted levels of assets and operating results in 2013, 2012 and 2011 and our non-compliance with the capital requirements of our Consent Order. These factors represent the most significant negative evidence that we considered in concluding that a valuation allowance was necessary at March 31, 2014 and December 31, 2013.
 
 
22

 
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
7.
EARNINGS (LOSS) PER SHARE
 
The reconciliation of the numerators and denominators of the basic and diluted EPS is as follows:
 
 
 
Three Months Ended
 
(Amounts in thousands,
 
March 31,
 
except per share data)
 
2014
 
2013
 
 
 
 
 
 
 
 
 
Basic:
 
 
 
 
 
 
 
Net income/(loss)
 
$
(101)
 
$
122
 
Less:
 
 
 
 
 
 
 
Preferred stock dividends
 
 
(450)
 
 
(250)
 
Accretion on preferred stock discount
 
 
(3)
 
 
(14)
 
Net income (loss) available to common shareholders
 
$
(554)
 
$
(142)
 
Weighted average common shares
 
 
4,877
 
 
4,786
 
 
 
 
 
 
 
 
 
Diluted:
 
 
 
 
 
 
 
Weighted average common shares
 
 
4,877
 
 
4,786
 
Dilutive effect of stock options,warrants and restricted share awards
 
 
-
 
 
-
 
Weighted average common and incremental shares
 
 
4,877
 
 
4,786
 
 
 
 
 
 
 
 
 
Earnings (Loss) Per Common Share:
 
 
 
 
 
 
 
Basic
 
$
(0.11)
 
$
(0.03)
 
Diluted
 
$
(0.11)
 
$
(0.03)
 
 
Since the Corporation is reporting a net loss available to common shareholders for all periods presented, no stock options, warrants or restricted share awards were evaluated for dilutive purposes.

8.
STOCK BASED COMPENSATION PLAN
 
Our 2006 Stock Option and Incentive Compensation Plan, which is stockholder approved, authorizes us to grant restricted stock and incentive or non-qualified stock options to key employees and directors for a total of 763,935 shares of our common stock. We believe that the ability to award stock options and other forms of stock-based incentive compensation can assist us in attracting and retaining key employees. Stock-based incentive compensation is also a means to align the interests of key employees with those of our stockholders by providing awards intended to reward recipients for our long-term growth. Options to purchase shares generally vest over periods of one to five years and expire ten years after the date of grant. We issue new shares of common stock upon the exercise of stock options. If options or awards granted under the 2006 Plan expire or terminate for any reason without having been exercised in full or released from restriction, the corresponding shares shall again be available for option or award for the purposes of the Plan. At March 31, 2014, options and restricted stock available for future grant under the 2006 Plan totaled 113,330 .
 
Stock Options – The fair value of each option award is estimated on the date of grant using the Black-Scholes option valuation model that uses various weighted-average assumptions. The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant. The expected volatility is based on the fluctuation in the price of a share of stock over the period for which the option is being valued and the expected life of the options granted represents the period of time the options are expected to be outstanding.
 
 
23

 
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
8.
STOCK BASED COMPENSATION PLAN – (Continued)
 
The weighted-average assumptions for options granted during the quarter ended March 31, 2014 and the resulting estimated weighted average fair value per share is presented below.
 
 
 
March 31,
 
 
 
2014
 
Assumptions:
 
 
 
 
Risk-free interest rate
 
 
2.86
%
Expected dividend yield
 
 
-
%
Expected life (years)
 
 
10
 
Expected common stock market price volatility
 
 
64
%
Estimated fair value per share
 
$
3.57
 
 
A summary of option activity under the 2006 Plan for the period ended March 31, 2014 is presented below:
 
 
 
 
 
 
 
Weighted
 
 
 
 
 
 
 
 
Weighted
 
Average
 
 
 
 
 
 
Number
 
Average
 
Remaining
 
 
Aggregate
 
 
 
of
 
Exercise
 
Contractual
 
 
Intrinsic
 
 
 
Options
 
Price
 
Term
 
 
Value
 
 
 
 
 
 
 
 
 
 
(Dollars In Thousands)
 
Outstanding, beginning of period
 
376,300
 
$
3.13
 
 
 
 
 
 
Granted during period
 
5,000
 
 
4.90
 
 
 
 
 
 
Forfeited during period
 
(2,000)
 
 
1.83
 
 
 
 
 
 
Exercised during period
 
(500)
 
 
1.53
 
 
 
 
 
 
Outstanding, end of period
 
378,800
 
$
3.16
 
7.9
 
$
367
 
 
 
 
 
 
 
 
 
 
 
 
 
Eligible for exercise at period end
 
131,720
 
$
3.87
 
7.4
 
$
115
 
 
The total intrinsic value of options exercised during 2014 was $ 2,000 . The total cash received from options exercised during 2014 was $ 1,000 . There were no options exercised, modified or cash settled during the 2013 quarter. There was no tax benefit recognized from the option exercises as they are considered incentive stock options. Management expects all outstanding unvested options will vest.
 
Compensation cost related to options granted under the 2006 Plan that was charged against earnings for the periods ended March 31, 2014 and 2013 was $ 47,000 and $ 38,000 . As of March 31, 2014 there was $ 396,000 of total unrecognized compensation cost related to non-vested share-based compensation arrangements granted under the 2006 Plan. That cost is expected to be recognized over a weighted-average period of 3.3 years.
 
Restricted Stock – On January 2, 2014, we granted 63,300 shares of restricted common stock at the current market price of $ 4.91 . The restricted stock will vest over a five year period and will become fully vested on January 2, 2019, provided that the recipients have continued to perform substantial services for the Bank through that date. Any dividends declared on the restricted stock prior to vesting will be retained and paid only on the date of vesting. The transfer restrictions will expire upon the occurrence of a change of control event or upon the recipient’s death or disability.
 
Our 2012 Non-Employee Director Equity Compensation Program (the “Director Program”) enables us to compensate non-employee directors for their service with stock awards. We currently do not pay cash compensation to non-employee directors pursuant to agreements with bank regulatory agencies. The board has reserved 200,000 of the shares authorized for issuance under our shareholder approved 2006 Stock Option and Incentive Compensation Plan for stock awards under the Director Program.
 
 
24

 
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
8.
STOCK BASED COMPENSATION PLAN – (Continued)
 
The Director Program provides that each non-employee director elected or continuing in office on the date of each annual meeting of the Corporation’s shareholders will automatically receive an award of restricted stock on that date having a value of $ 30 ,000, based on the closing sale price per share of the Corporation’s common stock on the award date, rounded up to the next whole number. Accordingly, on May 15, 2013, the Company’s eight non-employee directors each received an award of 9,934 restricted shares, or 79,472 shares in total, that vest at the close of business on the day immediately preceding the date of the 2014 annual meeting of the Corporation’s shareholders, provided that the recipient has continued to serve as a member of the Board as of the date of vesting. The recipient may not transfer, pledge or dispose of the restricted stock until the close of business on the day immediately preceding the first anniversary of the award date. The transfer restrictions will also expire upon the occurrence of a Change of Control, as defined in the Plan, or upon the recipient’s death or disability. If a director ceases to serve as a member of the board for any reason, that director will automatically forfeit any unvested shares subject to an award. Any dividends declared on the restricted stock prior to vesting will be retained and paid only on the date the transfer restrictions expire.
 
A summary of changes in our non-vested restricted shares for the quarter ended March 31, 2014 is presented below:
 
 
 
 
 
Weighted
 
 
 
 
 
Average
 
 
 
Non-vested
 
Grant Date
 
 
 
Shares
 
Fair Value
 
 
 
 
 
 
 
 
Outstanding, beginning of period
 
63,497
 
$
3.81
 
Granted during period
 
63,300
 
 
4.91
 
Vested during period
 
(29,778)
 
 
3.60
 
Outstanding, end of period
 
97,019
 
$
4.59
 
 
Compensation cost related to restricted stock granted under the 2006 Plan that was charged against earnings for the periods ended March 31, 2014 and 2013 was $ 96,000 and $ 63,000 , respectively. As of March 31, 2014 there was $ 432,000 of total unrecognized compensation cost related to non-vested shares granted under the Plan. That cost is expected to be recognized over the remaining vesting period of 4.1 years.
 
 
25

 
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
9.             FAIR VALUE
 
U.S. GAAP defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date and establishes a fair value hierarchy that prioritizes the use of inputs used in valuation methodologies into the following three levels:
 
Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets. A quoted price in an active market provides the most reliable evidence of fair value and shall be used to measure fair value whenever available.
 
Level 2: Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.
 
Level 3: Significant unobservable inputs that reflect a reporting entity’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.
 
We used the following methods and significant assumptions to estimate the fair value.
 
Available-for-sale securities: The fair values of some corporate bonds are determined by obtaining quoted prices on nationally recognized securities exchanges (Level 1 inputs). For securities where quoted prices are not available, fair values are calculated on market prices of similar securities or determined by a matrix pricing, which is a mathematical technique widely used in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted securities (Level 2 inputs).
 
Impaired Loans: At the time a loan is considered impaired, it is valued at the lower of cost or fair value. Impaired loans carried at fair value generally receive specific allocations of the allowance for loan losses. For collateral dependent loans, fair value is commonly based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value. Non-real estate collateral may be valued using an appraisal, net book value per the borrower’s financial statements, or aging reports, adjusted or discounted based on management’s historical knowledge, changes in market conditions from the time of the valuation, and management’s expertise and knowledge of the client and client’s business, resulting in a Level 3 fair value classification. Once a loan is considered impaired, it is evaluated by a member of the Credit Department on at least a quarterly basis for additional impairment and adjusted accordingly.
 
Other Real Estate Owned: Assets acquired through or instead of loan foreclosure and bank lots held for sale are initially recorded at fair value less costs to sell when acquired, establishing a new cost basis. These assets are subsequently accounted for at lower of cost or fair value less estimated costs to sell. Fair value is commonly based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value.
 
Appraisals for both collateral-dependent impaired loans and other real estate owned are performed by certified general appraisers (for commercial properties) or certified residential appraisers (for residential properties) whose qualifications and licenses have been reviewed and verified by us. Once received, a member of the Credit Department reviews the assumptions and approaches utilized in the appraisal as well as the overall resulting fair value in comparison with via independent data sources such as recent market data or industry-wide statistics.
 
 
26

   
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
9.             FAIR VALUE - (Continued)
 
Assets and Liabilities Measured at Fair Value on a Recurring Basis
 
Assets measured at fair value on a recurring basis are summarized below: There were no transfers between Level 1 and Level 2 during the periods presented.
 
 
 
 
 
Quoted Prices in
 
 
 
 
 
 
 
 
 
 
 
 
Active Markets for
 
Significant Other
 
Significant
 
 
 
March 31,
 
Identical Assets
 
Observable Inputs
 
Unobservable Inputs
 
(Dollars in thousands)
 
2014
 
(Level 1)
 
(Level 2)
 
(Level 3)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Assets:
 
 
 
 
 
 
 
 
 
 
 
 
 
Government-sponsored
    collateralized mortgage
    obligations
 
$
100,337
 
$
-
 
$
100,337
 
$
-
 
Government-sponsored
    mortgage-backed  residential
 
 
74,528
 
 
-
 
 
74,528
 
 
-
 
Corporate bonds
 
 
30,388
 
 
7,725
 
 
22,663
 
 
-
 
Asset backed-collateralized
    loan obligations
 
 
20,289
 
 
-
 
 
20,289
 
 
-
 
State and municipal
 
 
11,201
 
 
-
 
 
11,201
 
 
-
 
Commercial mortgage backed
 
 
4,083
 
 
-
 
 
4,083
 
 
-
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total
 
$
240,826
 
$
7,725
 
$
233,101
 
$
-
 
 
 
 
 
 
 
Quoted Prices in
 
 
 
 
 
 
 
 
 
 
 
 
Active Markets for
 
Significant Other
 
Significant
 
 
 
December 31,
 
Identical Assets
 
Observable Inputs
 
Unobservable Inputs
 
(Dollars in thousands)
 
2013
 
(Level 1)
 
(Level 2)
 
(Level 3)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Assets:
 
 
 
 
 
 
 
 
 
 
 
 
 
Government-sponsored
    collateralized mortgage
    obligations
 
$
100,816
 
$
-
 
$
100,816
 
$
-
 
Government-sponsored
    mortgage-backed residential
 
 
74,324
 
 
-
 
 
74,324
 
 
-
 
Corporate bonds
 
 
43,698
 
 
10,768
 
 
32,930
 
 
-
 
Asset backed-collateralized
    loan obligations
 
 
34,478
 
 
-
 
 
34,478
 
 
-
 
State and municipal
 
 
11,923
 
 
-
 
 
11,923
 
 
-
 
Commercial mortgage backed
 
 
4,043
 
 
-
 
 
4,043
 
 
-
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total
 
$
269,282
 
$
10,768
 
$
258,514
 
$
-
 
 
We conduct a review of fair value hierarchy classifications on a quarterly basis. Reclassification of certain financial instruments may occur when input observability changes.
 
 
27

   
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
9.             FAIR VALUE - (Continued)
 
Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis
 
Assets measured at fair value on a nonrecurring basis are summarized below:
 
 
 
 
 
 
Quoted Prices in
 
 
 
 
 
 
 
 
 
 
 
 
Active Markets for
 
Significant Other
 
Significant
 
 
 
March 31,
 
Identical Assets
 
Observable Inputs
 
Unobservable Inputs
 
(Dollars in thousands)
 
2014
 
(Level 1)
 
(Level 2)
 
(Level 3)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Assets:
 
 
 
 
 
 
 
 
 
 
 
 
 
Impaired loans:
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial Real Estate:
 
 
 
 
 
 
 
 
 
 
 
 
 
Land Development
 
$
625
 
$
-
 
$
-
 
$
625
 
Other
 
 
6,363
 
 
-
 
 
-
 
 
6,363
 
Residential Mortgage
 
 
56
 
 
-
 
 
-
 
 
56
 
Consumer and Home Equity
 
 
36
 
 
-
 
 
-
 
 
36
 
Real estate acquired through foreclosure:
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial Real Estate:
 
 
 
 
 
 
 
 
 
 
 
 
 
Land Development
 
 
947
 
 
-
 
 
-
 
 
947
 
Other
 
 
2,500
 
 
-
 
 
-
 
 
2,500
 
Residential Mortgage
 
 
631
 
 
-
 
 
-
 
 
631
 
Other real estate owned:
 
 
 
 
 
 
 
 
 
 
 
 
 
Bank Lots
 
 
769
 
 
-
 
 
-
 
 
769
 
 
 
 
 
 
 
Quoted Prices in
 
 
 
 
 
 
 
 
 
 
 
 
Active Markets for
 
Significant Other
 
Significant
 
 
 
December 31,
 
Identical Assets
 
Observable Inputs
 
Unobservable Inputs
 
(Dollars in thousands)
 
2013
 
(Level 1)
 
(Level 2)
 
(Level 3)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Assets:
 
 
 
 
 
 
 
 
 
 
 
 
 
Impaired loans:
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial Real Estate:
 
 
 
 
 
 
 
 
 
 
 
 
 
Land Development
 
$
625
 
$
-
 
$
-
 
$
625
 
Other
 
 
5,618
 
 
-
 
 
-
 
 
5,618
 
Residential Mortgage
 
 
56
 
 
-
 
 
-
 
 
56
 
Consumer and Home Equity
 
 
36
 
 
-
 
 
-
 
 
36
 
Real estate acquired through foreclosure:
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial Real Estate:
 
 
 
 
 
 
 
 
 
 
 
 
 
Land Development
 
 
947
 
 
-
 
 
-
 
 
947
 
Other
 
 
2,667
 
 
-
 
 
-
 
 
2,667
 
Residential Mortgage
 
 
634
 
 
-
 
 
-
 
 
634
 
Other real estate owned:
 
 
 
 
 
 
 
 
 
 
 
 
 
Bank Lots
 
 
792
 
 
-
 
 
-
 
 
792
 
 
Impaired loans, which are measured for impairment using the fair value of the collateral for collateral dependent loans, had a carrying amount of $ 9.8 million and $ 23.8 million, with a valuation allowance of $ 2.7 million and $ 6.8 million, resulting in an additional provision for loan losses of $ 124,000 and a reversal of provision for loan losses of $ 1.2 million for the periods ended March 31 2014 and 2013, respectively.
 
 
28

 
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
9.             FAIR VALUE - (Continued)
 
Values for collateral dependent loans are generally based on appraisals obtained from licensed real estate appraisers and in certain circumstances consideration of offers obtained to purchase properties prior to foreclosure. Appraisals for commercial real estate generally use three methods to derive value: cost, sales or market comparison and income approach. The cost method bases value on the estimated cost to replace the current property after considering adjustments for depreciation. Values of the market comparison approach evaluate the sales price of similar properties in the same market area. The income approach considers net operating income generated by the property and an investors required return. The final value is a reconciliation of these three approaches and takes into consideration any other factors management deems relevant to arrive at a representative fair value.
 
Real estate owned acquired through foreclosure is recorded at fair value less estimated selling costs at the date of foreclosure. Fair value is based on the appraised market value of the property. Many of the appraisals utilize an income approach, such as the discounted cash flow method, to estimate future income and profits or cash flows.  Appraisals may also utilize a single valuation approach or a combination of approaches including a market comparison approach, where prices and other relevant information generated by market transactions involving identical or comparable properties are used to determine fair value.  The fair value may be subsequently reduced if the estimated fair value declines below the original appraised value. Fair value adjustments of $ 3,000 and $ 1.1 million were made to real estate owned during the periods ended March 31, 2014 and 2013 respectively.
 
The following table presents quantitative information about level 3 fair value measurements for financial instruments measured at fair value on a non-recurring basis at March 31, 2014.
 
(Dollars in thousands)
 
Fair
 
Valuation
 
Unobservable
 
Range (Weighted
 
 
 
Value
 
Technique(s)
 
Input(s)
 
Average)
 
 
 
 
 
 
 
 
 
 
 
Impaired loans:
 
 
 
 
 
 
 
 
 
Commercial Real Estate:
 
 
 
 
 
 
 
 
 
Land Development
 
625
 
Sales comparison approach
 
Adjustment for differences
    between comparable sales
 
3.10%-18.00% (15.98%)
 
 
 
 
 
 
 
 
 
 
 
Other
 
6,363
 
Income approach
 
Discount or capitalization rate
 
8.50%-9.00% (8.86%)
 
 
 
 
 
 
 
 
 
 
 
Residential Mortgage
 
56
 
Sales comparison approach
 
Adjustment for differences
    between comparable sales
 
3.00% (1)
 
 
 
 
 
 
 
 
 
 
 
Consumer and Home Equity
 
36
 
Sales comparison approach
 
Adjustment for differences
    between comparable sales
 
2.10%-2.25% (2.20%)
 
 
 
 
 
 
 
 
 
 
 
Real estate acquired through fore closure:
 
 
 
 
 
 
 
 
 
Commercial Real Estate:
 
 
 
 
 
 
 
 
 
Land Development
 
919
 
Income approach
 
Discount or capitalization rate
 
7.40%-29.00% (21.33%)
 
 
 
28
 
Sales comparison approach
 
Adjustment for differences
    between comparable sales
 
0.00% (1)
 
 
 
 
 
 
 
 
 
 
 
Other
 
1,625
 
Income approach
 
Discount or capitalization rate
 
9.40%-10.00% (9.80%)
 
 
 
875
 
Sales comparison approach
 
Adjustment for differences
    between comparable sales
 
20.00%-25.00% (20.73%)
 
 
 
 
 
 
 
 
 
 
 
Residential Mortgage
 
631
 
Sales comparison approach
 
Adjustment for differences
    between comparable sales
 
0.00%-13.00% (2.09%)
 
 
 
 
 
 
 
 
 
 
 
Real estate owned:
 
 
 
 
 
 
 
 
 
Bank Lots
 
769
 
Sales comparison approach
 
Adjustment for differences
    between comparable sales
 
10.00% (1)
 
 

(1) Unobservable inputs with a single discount listed include only one property.
   
 
29

 
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
9.              FAIR VALUE - (Continued)
 
Fair Value of Financial Instruments
 
The estimated fair value of financial instruments, not previously presented, is as follows:
 
 
 
 
 
March 31, 2014
 
(Dollars in thousands)
 
Carrying
 
Fair Value Measurements
 
 
 
Value
 
Total
 
Level 1
 
Level 2
 
Level 3
 
Financial assets:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Cash and due from banks
 
$
80,786
 
$
80,786
 
$
6,150
 
$
74,636
 
$
-
 
Mortgage loans held for sale
 
 
687
 
 
695
 
 
-
 
 
695
 
 
-
 
Loans, net
 
 
442,291
 
 
453,592
 
 
-
 
 
-
 
 
453,592
 
Accrued interest receivable
 
 
1,912
 
 
1,912
 
 
-
 
 
901
 
 
1,011
 
FHLB stock
 
 
4,080
 
 
N/A
 
 
N/A
 
 
N/A
 
 
N/A
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Financial liabilities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Deposits
 
 
759,272
 
 
763,194
 
 
-
 
 
763,194
 
 
-
 
Advances from Federal Home Loan Bank
 
 
12,354
 
 
13,229
 
 
-
 
 
13,229
 
 
-
 
Subordinated debentures
 
 
18,000
 
 
13,267
 
 
-
 
 
-
 
 
13,267
 
Accrued interest payable
 
 
4,821
 
 
4,821
 
 
-
 
 
4,821
 
 
-
 
 
 
 
 
 
December 31, 2013
 
 
 
Carrying
 
Fair Value Measurements
 
(Dollars in thousands)
 
Value
 
Total
 
Level 1
 
Level 2
 
Level 3
 
Financial assets:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Cash and due from banks
 
$
65,988
 
$
65,988
 
$
6,596
 
$
59,392
 
$
-
 
Mortgage loans held for sale
 
 
470
 
 
478
 
 
-
 
 
478
 
 
-
 
Loans, net
 
 
450,771
 
 
453,592
 
 
-
 
 
-
 
 
453,592
 
Accrued interest receivable
 
 
2,224
 
 
2,224
 
 
-
 
 
1,136
 
 
1,088
 
FHLB stock
 
 
4,430
 
 
N/A
 
 
N/A
 
 
N/A
 
 
N/A
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Financial liabilities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Deposits
 
 
783,487
 
 
788,230
 
 
-
 
 
788,230
 
 
-
 
Advances from Federal Home Loan Bank
 
 
12,389
 
 
13,315
 
 
-
 
 
13,315
 
 
-
 
Subordinated debentures
 
 
18,000
 
 
13,038
 
 
-
 
 
-
 
 
13,038
 
Accrued interest payable
 
 
4,485
 
 
4,485
 
 
-
 
 
4,485
 
 
-
 
 
The methods and assumptions, not previously presented, used to estimate fair values are described below:
 
(a) Cash and due from banks
 
The carrying amount of cash on hand approximates fair value and is classified as a Level 1. The carrying amount of cash due from bank accounts is classified as a Level 2.
 
(b) Mortgage loans held for sale
 
The fair value of mortgage loans held for sale is estimated based upon the binding contracts and quotes from third party investors resulting in a Level 2 classification.
 
(c) Loans, net
 
Fair values of loans are estimated as follows: For variable rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values resulting in a Level 3 classification. Fair values for other loans are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality resulting in a Level 3 classification. Impaired loans are valued at the lower of cost or fair value as described previously. The methods utilized to estimate the fair value of loans do not necessarily represent an exit price.
   
 
30

 
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
6.             FAIR VALUE - (Continued)
 
  (d) FHLB Stock
 
It is not practical to determine the fair value of FHLB stock due to restrictions placed on its transferability.   
 
  (e) Deposits
 
The carrying amounts of variable rate interest bearing deposits approximate their fair values at the reporting date resulting in a Level 2 classification.   Fair values for fixed rate interest bearing deposits are estimated using a discounted cash flows calculation that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits resulting in a Level 2 classification.
 
(f) Advances from Federal Home Loan Bank
 
The fair value of the FHLB advances is obtained from the FHLB and is calculated by discounting contractual cash flow using an estimated interest rate based on the current rates available to us for debt of similar remaining maturities and collateral terms resulting in a Level 2 classification.
 
(g) Subordinated debentures
 
The fair value for subordinated debentures is calculated using discounted cash flow analyses based on the current borrowing rates for similar types of borrowing arrangements resulting in a Level 3 classification.
 
(h) Accrued interest receivable/payable
 
The carrying amounts of accrued interest approximate fair value resulting in a Level 2 or Level 3 classification based on the level of the asset or liability with which the accrual is associated.
 
  (i) Off-balance Sheet Instruments
 
Fair values for off-balance sheet, credit-related financial instruments are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standing. The fair value of commitments is not material.
 
 
31

 
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
10.
SUBORDINATED DEBENTURES
 
On October 29, 2010, we exercised our right to defer regularly scheduled interest payments on both issues of junior subordinated notes relating to outstanding trust preferred securities.   Together, the junior subordinated notes had an outstanding principal amount of $ 18 million.   We have the right to defer payments of interest for up to 20 consecutive quarterly periods without default or penalty.   After such period, we must pay all deferred interest and resume quarterly interest payments or we will be in default. During the deferral period, the statutory trusts, which are wholly owned subsidiaries of First Financial Service Corporation formed to issue the trust preferred securities, will likewise suspend the declaration and payment of dividends on the trust preferred securities.   The regular scheduled interest payments will continue to be accrued for payment in the future and reported as an expense for financial statement purposes. As of March 31, 2014, we have deferred a total of fourteen quarterly payments and these accrued but unpaid interest payments totaled $ 4.8 million.

11.           PREFERRED STOCK
 
On January 9, 2009, we issued $ 20  million of cumulative perpetual preferred shares, with a liquidation preference of $ 1,000 per share (the “Senior Preferred Shares”) to the United States Treasury under its Capital Purchase Program (“CPP”). The Senior Preferred Shares constitute Tier 1 capital and rank senior to our common shares. The Senior Preferred Shares paid cumulative dividends quarterly at a rate of 5 % per year for the first five years and then reset to 9 % per year on January 9, 2014. The Senior Preferred Shares may be redeemed at any time, subject to prior approval from bank regulatory agencies. We also have the ability to defer dividend payments at any time, at our option.
 
Under the terms of our CPP stock purchase agreement, we also issued the Treasury a warrant to purchase an amount of our common stock equal to 15 % of the aggregate amount of the Senior Preferred Shares, or $ 3 million.   The warrant entitles Treasury to purchase 215,983 common shares at a purchase price of $ 13.89 per share.   The initial exercise price for the warrant and the number of shares subject to the warrant were determined by reference to the market price of our common stock calculated on a 20-day trailing average as of December 8, 2008, the date Treasury approved our application.   The warrant has a term of 10  years and is potentially dilutive to earnings per share.
 
Effective with the fourth quarter of 2010, we suspended payment of regular quarterly cash dividends on our Senior Preferred Shares.   The dividends will continue to be accrued for payment in the future and reported as a preferred dividend requirement that is deducted from income attributable to common shareholders for financial statement purposes.   As of March 31, 2014, we have deferred a total of fourteen quarterly payments and these accrued but unpaid dividends totaled $ 3.9 million.
 
Participation in the CPP requires a participating institution to comply with a number of restrictions and provisions, including standards for executive compensation and corporate governance that apply only as long as the Senior Preferred Shares are held by Treasury and limitations on share repurchases and the declaration and payment of dividends on common shares. The standard terms of the CPP require that a participating financial institution limit the payment of dividends to the most recent quarterly amount prior to October 14, 2008, which is $ 0.19 per share in our case. This dividend limitation will remain in effect until the preferred shares are retired though subject to the Consent Order discussed in Note 2.
 
On April 29, 2013, Treasury sold our Senior Preferred Shares to six funds in an auction.  Following the sale, the full $ 20 million stated value of our Senior Preferred Shares remains outstanding and our obligation to pay deferred and future dividends, at the current 9 % annual rate, continues until our Senior Preferred Shares are fully retired.
 
 
32

 
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
12.           STOCKHOLDERS’ EQUITY
 
(a)
Regulatory Capital Requirements – The Corporation and the Bank are subject to regulatory capital    requirements administered by federal banking agencies.   Capital adequacy guidelines and, additionally for banks, prompt corrective action regulations involve quantitative measures of assets, liabilities, and certain off-balance-sheet items calculated under regulatory accounting practices.   Capital amounts and classifications are also subject to qualitative judgments by regulators.   Failure to meet capital requirements can result in regulatory action.  
 
Prompt corrective action regulations provide five classifications: well capitalized, adequately capitalized,     undercapitalized, significantly undercapitalized, and critically undercapitalized, although these terms are not used to represent overall financial condition.   If adequately capitalized, regulatory approval is required to accept brokered deposits.   If undercapitalized, capital distributions are limited, as is asset growth and expansion, and capital restoration plans are required.  
 
Quantitative measures established by regulation to ensure capital adequacy require the Corporation and the Bank to maintain minimum amounts and ratios (set forth in the following table) of Total and Tier 1 capital (as defined in the regulations) to risk weighted assets (as defined) and of Tier 1 capital (as defined) to average assets (as defined).  
 
As a result of the Consent Order the Bank entered into with the FDIC and KDFI described in greater detail in Note 2, the Bank is categorized as a "troubled institution" by bank regulators, which by definition does not permit the Bank to be considered "well-capitalized".
 
On March 9, 2012, the Bank entered into a new Consent Order with the FDIC and KDFI. The 2012 Consent Order requires the Bank to achieve the same minimum capital ratios mandated by the January 2011 Consent Order, which are set forth below.   See Note 2 for additional information.
 
                    Our actual and required capital amounts and ratios are presented below.
 
(Dollars in thousands)
 
 
 
 
 
 
 
 
For Capital
 
 
 
Required by
 
 
 
 
Actual
 
 
 
Adequacy Purposes
 
 
 
Consent Order
 
As of March 31, 2014:
 
Amount
 
Ratio
 
 
Amount
 
Ratio
 
 
Amount
 
Ratio
 
Total risk-based capital (to risk- weighted assets)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Consolidated
 
$
67,747
 
12.60
%
 
$
43,022
 
8.00
%
 
$
64,533
 
12.00
%
Bank
 
 
76,176
 
14.13
 
 
 
43,119
 
8.00
 
 
 
64,678
 
12.00
 
Tier I capital (to risk-weighted assets)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Consolidated
 
 
57,319
 
10.66
 
 
 
21,511
 
4.00
 
 
 
N/A
 
N/A
 
Bank
 
 
69,403
 
12.88
 
 
 
21,559
 
4.00
 
 
 
N/A
 
N/A
 
Tier I capital (to average assets)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Consolidated
 
 
57,319
 
6.72
 
 
 
34,115
 
4.00
 
 
 
76,759
 
9.00
 
Bank
 
 
69,403
 
8.15
 
 
 
34,079
 
4.00
 
 
 
76,678
 
9.00
 
 
(Dollars in thousands)
 
 
 
 
 
 
 
 
For Capital
 
 
 
Required by
 
 
 
 
Actual
 
 
 
Adequacy Purposes
 
 
 
Consent Order
 
As of December 31, 2013:
 
Amount
 
Ratio
 
 
Amount
 
Ratio
 
 
Amount
 
Ratio
 
Total risk-based capital (to risk- weighted assets)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Consolidated
 
$
68,477
 
12.13
%
 
$
45,174
 
8.00
%
 
$
67,761
 
12.00
%
Bank
 
 
76,147
 
13.48
 
 
 
45,177
 
8.00
 
 
 
67,765
 
12.00
 
Tier I capital (to risk-weighted assets)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Consolidated
 
 
58,036
 
10.28
 
 
 
22,587
 
4.00
 
 
 
N/A
 
N/A
 
Bank
 
 
69,057
 
12.23
 
 
 
22,588
 
4.00
 
 
 
N/A
 
N/A
 
Tier I capital (to average assets)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Consolidated
 
 
58,036
 
6.68
 
 
 
34,737
 
4.00
 
 
 
78,158
 
9.00
 
Bank
 
 
69,057
 
7.96
 
 
 
34,706
 
4.00
 
 
 
78,088
 
9.00
 
 
 
33

 
13.
CHANGES IN AND RECLASSIFICATIONS FROM ACCUMULATED OTHER    COMPREHENSIVE INCOME
                                                                                                          
             Changes in accumulated other comprehensive income by component consists of the following:
 
 
 
Quarter Ended March 31,
 
 
 
Unrealized Gains and Losses on
 
 
 
Available-for-Sale Securities (1)
 
 
 
2014
 
2013
 
 
 
(Dollars in thousands)
 
 
 
 
 
 
 
 
 
Beginning balance
 
$
(10,568)
 
$
1,270
 
Other comprehensive income (loss) before reclassification
 
 
2,562
 
 
(950)
 
Amounts reclassified from accumulated other comprehensive income
 
 
63
 
 
(227)
 
Net other comprehensive income (loss)
 
 
2,625
 
 
(1,177)
 
Ending balance
 
$
(7,943)
 
$
93
 
 
(1) All amounts are net of tax.
 
  Reclassifications out of accumulated other comprehensive income consists of the following:
 
 
Three months ended March 31, 2014
(Dollars in thousands)
 
 
 
Amount
 
 
 
Details about
 
Reclassified From
 
Affected Line Item
 
Accumulated Other
 
Accumulated Other
 
in the
 
Comprehensive
 
Comprehensive
 
Consolidated
 
Income Components
 
Income
 
Statement of Operations
 
 
 
 
 
 
 
 
Unrealized gains and losses on
    available-for-sale securities
 
$
148
 
Gain on sale of investments
 
 
 
 
(211)
 
Loss on sale of investments
 
 
 
 
(63)
 
Total before tax
 
 
 
 
-
 
Income taxes/(benefits)
 
Total amount reclassified
 
$
(63)
 
Net income (loss)
 
 
Three months ended March 31, 2013
(Dollars in thousands)
 
 
 
Amount
 
 
 
Details about
 
Reclassified From
 
Affected Line Item
 
Accumulated Other
 
Accumulated Other
 
in the
 
Comprehensive
 
Comprehensive
 
Consolidated
 
Income Components
 
Income
 
Statement of Operations
 
 
 
 
 
 
 
 
Unrealized gains and losses on
    available-for-sale securities
 
$
509
 
Gain on sale of investments
 
 
 
 
(282)
 
Loss on sale of investments
 
 
 
 
227
 
Total before tax
 
 
 
 
-
 
Income taxes/(benefits)
 
Total amount reclassified
 
$
227
 
Net income (loss)
 
 
 
34

 
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
14.
SUBSEQUENT EVENT
 
On April 21, 2014, First Financial Service Corporation entered into an Agreement and Plan of Share Exchange (the “Agreement”) with Community Bank Shares of Indiana, Inc. (“CBIN”), whereby CBIN will acquire all of the outstanding shares of the Corporation’s common stock pursuant to a statutory share exchange (the “Share Exchange”). It is anticipated that immediately following the Share Exchange, the Corporation will merge into CBIN and the Bank will merge into Your Community Bank, an Indiana chartered commercial bank and wholly owned subsidiary of CBIN (with Your Community Bank as the surviving bank).
 
Subject to the terms and conditions of the Agreement, when the Share Exchange takes effect (the “Effective Time”), each issued and outstanding share of the Corporation’s common stock (other than shares for which dissenters’ rights are exercised) will be canceled and converted into the right to receive 0.153 shares of CBIN’s common stock (the “Exchange Ratio”), plus cash in lieu of any fractional share. Further, all options to purchase the Corporation’s common stock that are outstanding and exercisable immediately prior to the Effective Time will be canceled and converted into the right to receive a cash payment as provided in the Agreement.
 
The Exchange Ratio may be adjusted, as provided in the Agreement, if, as of the date ten business days prior to the Effective Time, (a) the Corporation’s consolidated net book value is less than $13,000,000 , or (b) the Bank has failed since the date of the Agreement to gain more than $3,000,000 (through payoffs, paydowns or certain collateral enhancements) with respect to sixteen specifically identified special assets.
 
The Agreement provides certain termination rights for both the Corporation and CBIN. If the Agreement is terminated by CBIN, because the Corporation enters into an agreement for a superior business combination, then the Corporation would be obligated to pay to CBIN a termination fee of $ 1,500,000 . If the Agreement is terminated by the Corporation, because CBIN fails to meet certain regulatory capital requirements, then CBIN would be obligated to pay the Corporation a termination fee of $ 500,000 .
 
The consummation of the Share Exchange is subject to various conditions, including (i) receipt of the requisite approval of the shareholders of the Corporation and of CBIN, (ii) receipt of regulatory approvals, (iii) absence of any law or order prohibiting the closing, and (iv) effectiveness of the registration statement to be filed by CBIN with the SEC to register the shares of CBIN common stock to be issued to Corporation shareholders in the Share Exchange. In addition, each party’s obligation to consummate the Share Exchange is subject to certain other customary conditions, including the accuracy of the representations and warranties of the other party and compliance of the other party with its covenants in all material respects. The parties anticipate completing the Share Exchange in the late third or fourth quarter of 2014.
 
 
35

 
Item 2.   

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 
GENERAL
 
We operate 17 full-service banking centers in six contiguous counties in central Kentucky along the Interstate 65 corridor and within the Louisville metropolitan area.   Our markets range from Louisville in Jefferson County, Kentucky approximately 40 miles north of our headquarters in Elizabethtown, Kentucky to Hart County, Kentucky, approximately 30 miles south of Elizabethtown.   Our markets are supported by a diversified industry base and have a regional population of over 1 million.   We operate in Hardin, Nelson, Hart, Bullitt, Meade and Jefferson counties in Kentucky.   We control in the aggregate 19% of the deposit market share in our central Kentucky markets outside of Louisville.  
 
We serve the needs and cater to the economic strengths of the local communities in which we operate, and we strive to provide a high level of personal and professional customer service. We offer a variety of financial services to our retail and commercial banking customers. These services include personal and corporate banking services and personal investment financial counseling services.
 
Through our personal investment financial counseling services, we offer a wide variety of non-insured investments including mutual funds, equity investments, and fixed and variable annuities. We invest in the wholesale capital markets to manage a portfolio of securities and use various forms of wholesale funding. The security portfolio contains a variety of instruments, including callable debentures, taxable and non-taxable debentures, fixed and adjustable rate mortgage backed securities, collateralized mortgage obligations and corporate securities.
 
Our results of operations depend primarily on net interest income, which is the difference between interest income from interest-earning assets and interest expense on interest-bearing liabilities. Our operations are also affected by non-interest income, such as service charges, loan fees, gains and losses from the sale of mortgage loans and revenue earned from bank owned life insurance. Our principal operating expenses, aside from interest expense, consist of compensation and employee benefits, occupancy costs, data processing expense, FDIC insurance premiums, costs associated with other real estate and provisions for loan losses.
 
The discussion and analysis section covers material changes in the financial condition since December 31, 2013 and material changes in the results of operations for the three month period ended March 31, 2014 as compared to 2013.   It should be read in conjunction with "Management’s Discussion and Analysis of Financial Condition and Results of Operations" included in our Annual Report on Form 10-K for the period ended December 31, 2013.
 
RECENT DEVELOPMENT
 
On April 21, 2014, we entered into an Agreement and Plan of Share Exchange (the “Agreement”) with Community Bank Shares of Indiana, Inc. (“CBIN”), whereby CBIN will acquire all of the outstanding shares of our common stock pursuant to a statutory share exchange (the “Share Exchange”).    It is anticipated that immediately following the Share Exchange, First Financial Service Corporation will merge into CBIN, and our subsidiary bank, First Federal Savings Bank (the “Bank”) will merge into Your Community Bank, CBIN’s subsidiary bank (with Your Community Bank as the surviving bank).
 
Headquartered in New Albany, Indiana, CBIN had total assets of $846.7 million as of March 31, 2014.   CBIN’s two wholly owned subsidiary banks, Your Community Bank and The Scott County State Bank, operate 24 banking offices in southern Indiana and central Kentucky, including the metro Louisville market. Its stock trades on the NASDAQ Global Select Market under the symbol “CBIN.”
 
Subject to the terms and conditions of the Agreement, when the Share Exchange takes effect (the “Effective Time”), each issued and outstanding share of FFKY common stock (other than shares for which dissenters’ rights are exercised) will be canceled and converted into the right to receive 0.153 shares of CBIN’s common stock (the “Exchange Ratio”), plus cash in lieu of any fractional share. Further, all options to purchase FFKY common stock that are outstanding and exercisable immediately prior to the Effective Time will be canceled and converted into the right to receive a cash payment as provided in the Agreement.
 
The Exchange Ratio may be adjusted, as provided in the Agreement, if, as of the date ten business days prior to the Effective Time, (a) our consolidated net book value is less than $13,000,000, or (b) the Bank has failed since the date of the Agreement to gain more than $3,000,000 (through payoffs, paydowns or certain collateral enhancements) with respect to sixteen specifically identified special assets.
 
 
36

 
The Agreement provides certain termination rights for both the Corporation and CBIN.   If the Agreement is terminated by CBIN, because the Corporation enters into an agreement for a superior business combination, then the Corporation would be obligated to pay to CBIN a termination fee of $1,500,000. If the Agreement is terminated by the Corporation, because CBIN fails to meet certain regulatory capital requirements, then CBIN would be obligated to pay the Corporation a termination fee of $500,000.
 
The consummation of the Share Exchange is subject to various customary conditions, including receipt of the requisite regulatory approvals and the approval by the shareholders of the Corporation and of CBIN. The parties anticipate completing the Share Exchange in the late third or fourth quarter of 2014.
 
OVERVIEW
 
Net loss attributable to common shareholders for the quarter ended March 31, 2014 was $554,000 or $0.11 per diluted common share compared to a net loss attributable to common shareholders of $142,000 or $0.03 per diluted common share for the same period in 2013.  
 
While still elevated, the level of non-performing assets is now at manageable levels not seen since the second quarter of 2009.   Compared to December 31, 2013, non-performing loans declined $8.6 million or 49%, non-performing assets declined $8.0 million or 26%, and classified and criticized assets declined $2.8 million or 5%. We sold seven OREO properties totaling $348,000 during the 2014 period.   Non-performing assets were $22.6 million or 2.70% of total assets at March 31, 2014 compared to $30.6 million or 3.56% of total assets at December 31, 2013.   The decrease in non-performing assets is mainly attributable to a $7.0 million decrease in loans past due 90 days still on accrual.   Four commercial real estate relationships totaling $10.0 million make up 44% of the total non-performing assets.   The relationships range in value from $931,000 to $6.2 million and have an aggregate specific reserve for $1.6 million.
 
The lower values on appraisals and reviews of OREO properties resulted in $3,000 in total write downs on OREO for the first quarter of 2014 compared to $583,000 in total write downs recorded during 2013.   We believe that we have written down OREO values to levels that will facilitate their liquidation, as indicated by recent sales.
 
As economic conditions improved and collateral values stabilized in 2013 and 2014, our provision for loan losses during this period has been much lower than in previous periods. The allowance for loan losses to total loans was 2.09% at March 31, 2014 while net charge-offs to average loans totaled (0.03%) for 2014 compared to 0.32% for 2013due to recoveries in 2014.   Non-performing loans were $8.9 million or 1.93% of total loans at March 31, 2014 compared to $17.4 million, or 3.73% of total loans for December 31, 2013.   The allowance for loan losses to non-performing loans, which excludes restructured loans on accrual status, was 108% at March 31, 2014 compared to 77% at March 31, 2013.  
 
The net interest margin improved to 2.83% for the quarter ended March 31, 2014 compared to 2.66% for the 2013 quarter.   The main driver to the improvement in the net interest margin for 2014 compared to 2013 is the intentional decrease of $131.6 million in average certificates of deposits that resulted in a reduction of $728,000 in related interest expense during the period.   We continue to anticipate modest improvement to the net interest margin over the next several quarters, as we continue to focus on restructuring the balance sheet to decrease our cost of funds, improve interest income, and reduce our interest rate risk exposure.   However, the balance sheet restructuring may be impacted by the acceleration of loan repayments.   Low interest rates, coupled with a competitive lending environment, continue to prove to be challenging.
 
REGULATORY MATTERS
 
Since January 2011, the Bank has operated under Consent Orders with the FDIC and KDFI. In the most recent Consent Order, the Bank agreed to achieve and maintain a Tier 1 capital ratio of 9.0% and a total risk-based capital ratio of 12.0% by June 30, 2012.   The Bank also agreed that if it should be unable to reach the required capital levels by that date, and if directed in writing by the FDIC, then within 30 days the Bank would develop, adopt and implement a written plan to sell or merge itself into another federally insured financial institution.   To date the Bank has not received such a written direction.   The Consent Order also prohibits the Bank from declaring dividends without the prior written approval of the FDIC and KDFI and requires the Bank to develop and implement plans to reduce its level of non-performing assets and concentrations of credit in commercial real estate loans, maintain adequate reserves for loan and lease losses, implement procedures to ensure compliance with applicable laws, and take certain other actions. A copy of the most recent Consent Order is included as Exhibit 10.8 to our 2011 Annual Report on Form 10-K filed March 30, 2012.  
 
 
37

 
At March 31, 2014, the Bank’s Tier 1 capital ratio was 8.15% and the total risk-based capital ratio was 14.13%, compared to the minimum 9.00% and 12.00% capital ratios required by the Consent Order. Our comparable ratios at December 31, 2013 were 7.96% and 13.48%, respectively.   For the sixth consecutive quarter, we have achieved and maintained the required total risk-based capital ratio. Our Tier 1 capital ratio has also steadily improved, but has yet to reach the Consent Order minimum. We continue to explore strategies to achieve and maintain the Tier 1 capital ratio as well as to comply with all of the other terms of the Consent Order.
 
Our plans for 2014 include the following:
 
· Continuing to work towards the completion of the merger and Share Exchange with Community Bank Shares of Indiana.
· Continuing to address all requirements of our Consent Order and formal agreement.
· Continuing to serve our community banking customers and operate the Corporation and the Bank in a safe and sound manner. We have worked diligently to maintain the strength of our retail and deposit franchise.
· Continuing to reduce expenses and improve our ability to operate in a profitable manner.
· Continuing to reduce our lending concentration in commercial real estate through expected maturities and repayments.  
· Accelerating our efforts to dispose of problem assets.  
· Continuing to reduce our inventory of other real estate owned properties.  
 
While our concerns about economic conditions in our market continue, we are working towards our long-range objectives including building additional core customer relationships, maintaining sufficient liquidity and capital levels, improving shareholder value, remediating our problem assets and building upon the sustained success of our retail franchise.  
 

CRITICAL ACCOUNTING POLICIES

 
Our accounting and reporting policies comply with U.S. generally accepted accounting principles and conform to general practices within the banking industry.   The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires us to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes.   These estimates, assumptions, and judgments are based on information available as of the date of the financial statements. Accordingly, as this information changes, the financial statements could change as our estimates, assumptions, and judgments change.   Certain policies inherently rely more heavily on the use of estimates, assumptions, and judgments and as such have a greater possibility of producing results that could be materially different than originally reported.   We consider our critical accounting policies to include the following:
 
Allowance for Loan Losses We maintain an allowance we believe to be sufficient to absorb probable incurred credit losses existing in the loan portfolio. Management, which is comprised of senior officers and certain accounting and credit associates, evaluates the allowance for loan losses on a monthly basis.  We estimate the amount of the allowance using past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of the underlying collateral, and current economic conditions.  While we estimate the allowance for loan losses based in part on historical losses within each loan category, estimates for losses within the commercial real estate portfolio depend more on credit analysis and recent payment performance. Allocations of the allowance may be made for specific loans or loan categories, but the entire allowance is available for any loan that, in management’s judgment, should be charged off. 
 
The allowance consists of specific and general components.   The specific component relates to loans that are individually classified as impaired.   The general component covers non-impaired loans and is based on historical loss experience for certain categories adjusted for current factors. Allowance estimates are developed with actual loss experience adjusted for current economic conditions.   Allowance estimates are considered a prudent measurement of the risk in the loan portfolio and are applied to individual loans based on loan type.
 
Based on our calculation, an allowance of $9.6 million or 2.09% of total loans was our estimate of probable incurred losses within the loan portfolio as of March 31, 2014.   We did not record any provision for loan losses on the income statement for the 2014 period.   If the mix and amount of future charge off percentages differ significantly from those assumed by management in making its determination, the allowance for loan losses and provision for loan losses on the income statement could materially increase.
 
Impairment of Investment Securities We review all unrealized losses on our investment securities to determine whether the losses are other-than-temporary.   We evaluate our investment securities on at least a quarterly basis, and more frequently when economic or market conditions warrant, to determine whether a decline in their value below amortized cost is other-than-temporary.   We evaluate a number of factors including, but not limited to: valuation estimates provided by investment brokers; how much fair value has declined below amortized cost; how long the decline in fair value has existed; the financial condition of the issuer; significant rating agency changes on the issuer; and management’s assessment that we do not intend to sell or will not be required to sell the security for a period of time sufficient to allow for any anticipated recovery in fair value.
 
 
38

 
At March 31, 2014, we own five collateralized loan obligation (“CLO”) securities subject to the Volcker Rule, with an amortized cost of $20.7 million and an unrealized loss of $453,000.   Absent changes to the Volcker Rule, we would be required to dispose of these securities before July 2015.   We believe the unrealized loss reflected results not from credit risk but from interest rate changes and to the uncertainty created by the Volcker Rule.   In the first quarter of 2014, we sold four of our CLOs to confirm their marketability and evaluate our assessment about their market values.   These four securities had an unrealized loss of $233,000 at December 31, 2013.   We recorded a loss of $91,000 on these sales.   We do not currently intend to sell additional CLOs.
 
The term “other-than-temporary” is not intended to indicate that the decline is permanent, but indicates that the possibility for a near-term recovery of value is not necessarily favorable, or that there is a lack of evidence to support a realizable value equal to or greater than the carrying value of the investment.   Once a decline in value is determined to be other-than-temporary, the cost basis of the security is written down to fair value and a charge to earnings is recognized for the credit component and the non-credit component is recorded to other comprehensive income.
 
Real Estate Owned The estimation of fair value is significant to real estate owned-acquired through foreclosure.   These assets are recorded at fair value less estimated selling costs at the date of foreclosure.   Fair value is based on the appraised market value of the property based on sales of similar assets when available.   The value may be subsequently reduced if the estimated fair value declines below the value recorded at the time of foreclosure.   Appraisals are performed at least annually, if not more frequently.   Typically, appraised values are discounted for the projected sale below appraised value in addition to the selling cost.   With certain appraised values where management believes a solid liquidation value has been established, the appraisal has been discounted only by the selling cost.   We have dedicated a team of associates and management focused on the continued resolution and work out of other real estate owned (“OREO”) .   Appropriate policies, committees and procedures have been put in place to ensure the proper accounting treatment and risk management of this area.
 
Income Taxes The provision for income taxes is based on income/(loss) as reported in the financial statements.   Deferred income tax assets and liabilities are computed for differences between the financial statement and tax basis of assets and liabilities that will result in taxable or deductible amounts in the future.   The deferred tax assets and liabilities are computed based on enacted tax laws and rates applicable to the periods in which the differences are expected to affect taxable income.   An assessment is made as to whether it is more likely than not that deferred tax assets will be realized.   A valuation allowance is established when necessary to reduce deferred tax assets to an amount more likely than not expected to be realized.   Income tax expense is the tax payable or refundable for the period plus or minus the change during the period in deferred tax assets and liabilities.   Tax credits are recorded as a reduction to the tax provision in the period for which the credits may be utilized.
 
A full valuation allowance related to deferred tax assets is required when it is considered more likely than not that all or part of the benefit related to such assets will not be realized.   In assessing the need for a full valuation allowance, we considered various factors including our five year cumulative loss position, the level of our non-performing assets, our inability to meet our forecasted levels of assets and full year operating results in 2013, 2012 and 2011 and our non-compliance with the capital requirements of our Consent Order.   Based on this assessment, we concluded that a valuation allowance was necessary at March 31, 2014 and December 31, 2013.
 
RESULTS OF OPERATIONS
 
Net loss attributable to common shareholders for the quarter ended March 31, 2014 was $554,000 or $0.11 per diluted common share compared to a net loss attributable to common shareholders of $142,000 or $0.03 per diluted common share for the same period in 2013.   Factors contributing to the net loss for 2014 included the following
 
· declining net interest income mainly driven by a decline of $1.1 million in loan interest income as a result of a decline of $57.8 million in average loan balances combined with the continuing low interest rate environment;
· although we did not record provision for loans loss expense in the 2014 quarter, in 2013 we recorded a $1.0 million reversal of provision expense due to the improvement in specific reserves allocated to several relationships based upon improved credit quality and the decline in the size of the loan portfolio;
· a decrease in net gains of $290,000 on the sale of securities available for sale, and
· a decline of $229,000 in securities interest income mainly due to the continued low interest rate environment.
 
 
39

 
These factors were partially offset by the following:
 
· a $1.1 million decrease in write downs and sale losses on OREO;
· a decline of $863,000 in deposit interest expense mainly as a result of an intentional decrease of $131.6 million in average certificates of deposits and other time deposits balances combined with a decline of 23 basis points in the cost of these deposits, and   
· a $245,000 decrease in real estate acquired through foreclosure expense and loan expense, the result of lower loan workout and loan portfolio management expenses as our level of non-performing assets has decreased.
 
Net loss attributable to common shareholders was also increased by dividends accrued on preferred shares.   Our book value per common share decreased from $4.85 at March 31, 2013 to $3.08 at March 31, 2014 largely as a result of unrealized losses on available-for-sale securities driven by increased market rates, compared to unrealized gains in 2013.  
 
Net Interest Income – The largest component of our net income is our net interest income.   Net interest income is the difference between interest income, principally from loans and investment securities, and interest expense, principally on customer deposits and borrowings. Changes in net interest income result from changes in volume, net interest spread and net interest margin. Volume refers to the average dollar levels of interest-earning assets and interest-bearing liabilities. Net interest spread refers to the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities. Net interest margin refers to net interest income divided by average interest-earning assets and is influenced by the level and relative mix of interest-earning assets and interest-bearing liabilities.
 
The majority of our assets are interest-earning and our liabilities are interest-bearing.  Accordingly, changes in interest rates may impact our net interest margin. The Federal Open Markets Committee (“FOMC”) uses the federal funds rate, which is the interest rate used by banks to lend to each other, to influence interest rates and the national economy. Changes in the federal funds rate have a direct correlation to changes in the prime rate, the underlying index for most of the variable-rate loans we issue.  The FOMC has held the target federal funds rate at a range of 0-25 basis points since December 2008.  As we are asset sensitive, continued low rates will negatively impact our earnings and net interest margin.
 
The large decline in the volume of interest-earning assets and the change in the mix of interest-earning assets reduced net interest income by $435,000 for 2014 compared to the prior year period.   Average interest earning assets decreased $115.8 million for 2014 compared to 2013 primarily driven by a decrease in average loans.   The decrease in average loans was due to loan principal payments, payoffs, charge-offs and the conversion of nonperforming loans to OREO properties.   In addition, due to the higher regulatory capital ratios required by our consent order, we elected not to replace much of this loan run-off consistent with our efforts to reduce our level of assets and risk-weighted assets. The average loan yield was 5.03% for 2014 compared to an average loan yield of 5.30% for 2013.  
 
Average interest-bearing liabilities decreased $121.3 million for the 2014 period compared to 2013 driven by a decrease in average certificates of deposit.   The decrease in average deposits was due an intentional decrease in certificates of deposit as we focus on restructuring the balance sheet to decrease our cost of funds and improve net interest income.
 
The tax equivalent yield on earning assets averaged 3.73% for 2014 compared to 3.82% for 2013.   The decline in the yields on interest-earning assets were more than offset by a decrease in our cost of funds, which averaged 0.98% for 2014 compared to an average cost of funds of 1.25% for 2013.   Net interest margin as a percent of average earning assets increased 17 basis points to 2.83% for the quarter ended March 31, 2014, compared to 2.66% for 2013.    We anticipate being able to continue taking advantage of the continued low interest rate environment to reduce our cost of funds, as term deposits re-price at more favorable terms.
 
 
40

 
AVERAGE BALANCE SHEET
 
The following table provides information relating to our average balance sheet and reflects the average yield on assets and average cost of liabilities for the indicated periods.   Yields and costs for the periods presented are derived by dividing income or expense by the average balances of assets or liabilities, respectively.
 
 
 
Quarter Ended March 31,
 
 
 
2014
 
2013
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Average
 
 
 
 
Average
 
Average
 
 
 
 
Average
 
(Dollars in thousands)
 
Balance
 
Interest
 
Yield/Cost (5)
 
Balance
 
Interest
 
Yield/Cost (5)
 
ASSETS
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Interest earning assets:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
U.S. Treasury and agencies
 
$
-
 
$
-
 
0.00
%
$
7,643
 
$
28
 
1.49
%
Mortgage-backed securities
 
 
213,793
 
 
1,026
 
1.95
%
 
288,384
 
 
1,210
 
1.70
%
State and political subdivision securities (1)
 
 
11,504
 
 
153
 
5.39
%
 
14,656
 
 
173
 
4.79
%
Corporate bonds
 
 
38,131
 
 
292
 
3.11
%
 
42,493
 
 
274
 
2.62
%
Loans (2) (3) (4)
 
 
464,308
 
 
5,753
 
5.03
%
 
522,106
 
 
6,818
 
5.30
%
FHLB stock
 
 
4,297
 
 
45
 
4.25
%
 
4,680
 
 
51
 
4.42
%
Interest bearing deposits
 
 
62,513
 
 
29
 
0.19
%
 
30,420
 
 
18
 
0.24
%
Total interest earning assets
 
 
794,546
 
 
7,298
 
3.73
%
 
910,382
 
 
8,572
 
3.82
%
Less: Allowance for loan losses
 
 
(9,855)
 
 
 
 
 
 
 
(17,018)
 
 
 
 
 
 
Non-interest earning assets
 
 
68,657
 
 
 
 
 
 
 
83,722
 
 
 
 
 
 
Total assets
 
$
853,348
 
 
 
 
 
 
$
977,086
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
LIABILITIES AND STOCKHOLDERS' EQUITY
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Interest bearing liabilities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Savings accounts
 
$
95,323
 
$
34
 
0.14
%
$
86,772
 
$
55
 
0.26
%
NOW and money market accounts
 
 
280,598
 
 
88
 
0.13
%
 
278,665
 
 
202
 
0.29
%
Certificates of deposit and other time deposits
 
 
316,578
 
 
1,151
 
1.47
%
 
448,187
 
 
1,879
 
1.70
%
FHLB advances
 
 
12,367
 
 
136
 
4.46
%
 
12,573
 
 
132
 
4.26
%
Subordinated debentures
 
 
18,000
 
 
341
 
7.68
%
 
18,000
 
 
341
 
7.68
%
Total interest bearing liabilities
 
 
722,866
 
 
1,750
 
0.98
%
 
844,197
 
 
2,609
 
1.25
%
Non-interest bearing liabilities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Non-interest bearing deposits
 
 
82,642
 
 
 
 
 
 
 
78,551
 
 
 
 
 
 
Other liabilities
 
 
12,592
 
 
 
 
 
 
 
10,395
 
 
 
 
 
 
Total liabilities
 
 
818,100
 
 
 
 
 
 
 
933,143
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Stockholders' equity
 
 
35,248
 
 
 
 
 
 
 
43,943
 
 
 
 
 
 
Total liabilities and stockholders' equity
 
$
853,348
 
 
 
 
 
 
$
977,086
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net interest income
 
 
 
 
$
5,548
 
 
 
 
 
 
$
5,963
 
 
 
Net interest spread
 
 
 
 
 
 
 
2.75
%
 
 
 
 
 
 
2.57
%
Net interest margin
 
 
 
 
 
 
 
2.83
%
 
 
 
 
 
 
2.66
%
 

(1)
Taxable equivalent yields are calculated assuming a 34% federal income tax rate.
(2) Includes loan fees, immaterial in amount, in both interest income and the calculation of yield on loans.
(3) Calculations include non-accruing loans in the average loan amounts outstanding.
(4) Includes loans held for sale.
(5) Annualized
 
 
41

 
RATE/VOLUME ANALYSIS
 
The table below shows changes in interest income and interest expense for the periods indicated.   For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to (1) changes in rate (changes in rate multiplied by old volume); (2) changes in volume (change in volume multiplied by old rate); and (3) changes in rate-volume (change in rate multiplied by change in volume).   Changes in rate-volume are proportionately allocated between rate and volume variance.
 
 
 
Three Months Ended
 
 
 
March 31,
 
 
 
2014 vs. 2013
 
 
 
Increase (decrease)
 
 
 
Due to change in
 
(Dollars in thousands)
 
 
 
 
 
 
 
Net
 
 
 
Rate
 
Volume
 
Change
 
 
 
 
 
 
 
 
 
 
 
 
Interest income:
 
 
 
 
 
 
 
 
 
 
U.S. Treasury and agencies
 
$
(21)
 
$
(7)
 
$
(28)
 
Mortgage-backed securities
 
 
158
 
 
(342)
 
 
(184)
 
State and political subdivision
 
 
 
 
 
 
 
 
 
 
securities
 
 
20
 
 
(40)
 
 
(20)
 
Corporate bonds
 
 
48
 
 
(30)
 
 
18
 
Loans
 
 
(337)
 
 
(728)
 
 
(1,065)
 
FHLB stock
 
 
(2)
 
 
(4)
 
 
(6)
 
Interest bearing deposits
 
 
(5)
 
 
16
 
 
11
 
 
 
 
 
 
 
 
 
 
 
 
Total interest earning assets
 
 
(139)
 
 
(1,135)
 
 
(1,274)
 
 
 
 
 
 
 
 
 
 
 
 
Interest expense:
 
 
 
 
 
 
 
 
 
 
Savings accounts
 
 
(26)
 
 
5
 
 
(21)
 
NOW and money market accounts
 
 
(115)
 
 
1
 
 
(114)
 
Certificates of deposit and other
 
 
 
 
 
 
 
 
 
 
time deposits
 
 
(227)
 
 
(501)
 
 
(728)
 
FHLB advances
 
 
6
 
 
(2)
 
 
4
 
Subordinated debentures
 
 
-
 
 
-
 
 
-
 
 
 
 
 
 
 
 
 
 
 
 
Total interest bearing liabilities
 
 
(362)
 
 
(497)
 
 
(859)
 
 
 
 
 
 
 
 
 
 
 
 
Net change in net interest income
 
$
223
 
$
(638)
 
$
(415)
 
 
NON-INTEREST INCOME AND NON-INTEREST EXPENSE
 
The following tables compare the components of non-interest income and expenses for the periods ended March 31, 2014 and 2013.   The tables show the dollar and percentage change from 2013 to 2014.   Below each table is a discussion of significant changes and trends.
 
 
 
Three Months Ended
 
 
 
March 31,
 
(Dollars in thousands)
 
2014
 
2013
 
Change
 
%
 
Non-interest income
 
 
 
 
 
 
 
 
 
 
 
 
Customer service fees on deposit accounts
 
$
1,250
 
$
1,191
 
$
59
 
5.0
%
Gain on sale of mortgage loans
 
 
59
 
 
427
 
 
(368)
 
-86.2
%
Gain on sale of investments
 
 
148
 
 
509
 
 
(361)
 
-70.9
%
Loss on sale of investments
 
 
(211)
 
 
(282)
 
 
71
 
-25.2
%
Loss on sale and write downs of real estate acquired through foreclosure
 
 
(5)
 
 
(1,060)
 
 
1,055
 
-99.5
%
Gain on sale on real estate acquired through foreclosure
 
 
29
 
 
57
 
 
(28)
 
-49.1
%
Other income
 
 
523
 
 
612
 
 
(89)
 
-14.5
%
 
 
$
1,793
 
$
1,454
 
$
339
 
23.3
%
 
 
42

 
We originate qualified Veterans Affairs (VA), Kentucky Housing Corporation (KHC), Rural Housing Corporation (RHC) and conventional secondary market loans and sell them into the secondary market with servicing rights released.   Gain on sale of mortgage loans decreased for 2014 due to a decrease in the volume and the yield earned on loans refinanced, originated and sold compared to 2013.
 
We invest in various types of liquid assets, including United States Treasury obligations, securities of various federal agencies, obligations of states and political subdivisions, corporate bonds, mutual funds, stocks and others.   During 2014 we recorded a net loss on the sale of debt investment securities of $63,000 compared to a net gain on sale of debt investment securities of $227,000 for the 2013 period .
 
Reducing non-interest income for 2014 was $5,000 in losses on the sale and write down of real estate owned properties. Offsetting the losses and write downs were recorded gains of $29,000 on the sale of seven real estate owned properties.
 
The decrease in other income for the 2014 period was the result of decreases in income received on real estate owned properties due to the sale of these properties.
 
 
 
Three Months Ended
 
 
 
March 31,
 
(Dollars in thousands)
 
2014
 
2013
 
Change
 
%
 
Non-interest expenses
 
 
 
 
 
 
 
 
 
 
 
 
Employee compensation and benefits
 
$
3,541
 
$
3,793
 
$
(252)
 
-6.6
%
Office occupancy expense and equipment
 
 
693
 
 
708
 
 
(15)
 
-2.1
%
Outside services and data processing
 
 
976
 
 
863
 
 
113
 
13.1
%
Bank franchise tax
 
 
315
 
 
315
 
 
-
 
0
%
FDIC insurance premiums
 
 
466
 
 
689
 
 
(223)
 
-32.4
%
Real estate acquired through foreclosure expense
 
 
86
 
 
294
 
 
(208)
 
-70.7
%
Loan expense
 
 
185
 
 
222
 
 
(37)
 
-16.7
%
Other expense
 
 
1,216
 
 
1,416
 
 
(200)
 
-14.1
%
 
 
$
7,478
 
$
8,300
 
$
(822)
 
-9.9
%
 
Outside services and data processing expense increased for 2014 primarily due to incurred costs related to a new credit builder checking product.
 
FDIC insurance premiums are based on the FDIC’s assessment base and rate structure. The assessment base is defined as the average consolidated total assets less average Tier I Capital.   As a result of the decrease in total deposits for 2014, FDIC insurance premiums have been reduced.
 
Real estate acquired through foreclosure expense and loan expense decreased due to a reduction in loan workout and loan portfolio management expenses as a result of fewer non-performing assets.
 
The decrease in other expense for the 2014 period relates to decreases in the amortization of our low income housing tax investments and decreases in marketing related expenses.
 
Income Taxes
 
The provision for income taxes includes federal and state income taxes and in 2014 and 2013 reflects a full valuation allowance against all of our deferred tax assets. An income tax benefit of $88,000 and $0 was recorded for the quarter ended March 31, 2014 and 2013 respectively.   Our March 31, 2014 tax benefit is entirely due to gains in other comprehensive income that are presented in current operations in accordance with applicable accounting standards.   Historically, the fluctuations in effective tax rates reflect the effect of permanent differences in the inclusion or deductibility of certain income and expenses, respectively, for income tax purposes.
 
A valuation allowance related to deferred tax assets is required when it is considered more likely than not that all or part of the benefit related to such assets will not be realized.   In assessing the need for a valuation allowance, we considered all positive and negative evidence including our five year cumulative loss position, the level of our non-performing assets, our inability to meet our forecasted levels of assets and operating results in 2013, 2012 and 2011 and the degree of our compliance with the capital requirements of our Consent Order.   Based on this assessment, we concluded that a valuation allowance was necessary at March 31, 2014 and December 31, 2013.   Our future effective income tax rate will fluctuate based on the mix of taxable and tax free investments we make and, to a greater extent, the impact of changes in the required amount of valuation allowance recorded against our net deferred tax assets and our overall level of taxable income.
 
 
43

 
Recording a valuation allowance does not have any impact on our liquidity, nor does it preclude us from using the tax losses, tax credits or other timing differences in the future.   To the extent that we generate taxable income in a given quarter, the valuation allowance may be reduced to fully or partially offset the corresponding income tax expense.   Any remaining deferred tax asset valuation allowance may be reversed through income tax expense once we can demonstrate a sustainable return to profitability and conclude that it is more likely than not the deferred tax asset will be utilized prior to expiration.  
 
ANALYSIS OF FINANCIAL CONDITION
 
Total assets at March 31, 2014 decreased $21.7 million compared to total assets at December 31, 2013.   The decrease was primarily attributable to a decline of $28.5 million in available-for-sale securities and a decline of $7.7 million in total loans offset by an increase in cash and cash equivalents of $14.8 million. Total deposits decreased $24.2 million due to an intentional reduction in certificates of deposit as we focus on restructuring the balance sheet to decrease our cost of funds and improve net interest income.
 
Loans
 
Total loans decreased $7.7 million to $459.3 million at March 31, 2014 compared to $466.9 million at December 31, 2013. Our commercial real estate portfolio decreased $6.6 million to $273.3 million at March 31, 2014.   The decline in the total loan portfolio is primarily the result of pay-offs, charge-offs, and loans being transferred to real estate acquired through foreclosure for commercial real estate loans, which together exceeded the volume of new loans originated.   The decline in the loan portfolio was also due, in part, to our ongoing efforts to resolve problem loans.   In a ddition, we have elected not to replace much of this loan run-off in order to reduce asset size and increase our regulatory capital ratios in light of the higher regulatory capital requirements imposed by our Consent Order.
 
 
 
March 31,
 
December 31,
 
(Dollars in thousands)
 
2014
 
2013
 
 
 
 
 
 
 
 
 
Commercial Real Estate:
 
 
 
 
 
 
 
Other
 
$
252,623
 
$
257,901
 
Land Development
 
 
19,204
 
 
20,476
 
Building Lots
 
 
1,515
 
 
1,559
 
Residential mortgage
 
 
99,887
 
 
99,344
 
Consumer and home equity
 
 
51,526
 
 
54,010
 
Commercial
 
 
21,695
 
 
20,621
 
Indirect consumer
 
 
12,817
 
 
13,041
 
 
 
 
459,267
 
 
466,952
 
Less:
 
 
 
 
 
 
 
Net deferred loan origination fees
 
 
(110)
 
 
(90)
 
Allowance for loan losses
 
 
(9,608)
 
 
(9,576)
 
 
 
 
(9,718)
 
 
(9,666)
 
 
 
 
 
 
 
 
 
Net Loans
 
$
449,549
 
$
457,286
 
 
Allowance and Provision for Loan Losses
 
Our financial performance depends on the quality of the loans we originate and management’s ability to assess the degree of risk in existing loans when it determines the allowance for loan losses.   An increase in loan charge-offs or non-performing loans or an inadequate allowance for loan losses could reduce net interest income, net income and capital, and limit the range of products and services we can offer.
 
Management, which is comprised of senior officers and certain accounting and credit associates, evaluates the allowance for loan losses monthly to maintain a level it believes to be sufficient to absorb probable incurred credit losses existing in the loan portfolio.   Periodic provisions to the allowance are made as needed.   The size of the allowance is determined by applying loss estimates to graded loans by categories, as described below.   When appropriate, a specific reserve will be established for individual impaired loans based upon the risk classification and the estimated potential for loss.   In accordance with our credit management processes, we obtain new appraisals on properties securing our non-performing commercial and commercial real estate loans and use those appraisals to determine specific reserves within the allowance for loan losses.   The Loan Appraisal Committee determines when appraisals must be obtained and reviews appraisals once received.   The Loan Appraisal Committee also reviews all non-accrual and restructured loan relationships.   As we receive new appraisals on properties securing non-performing loans, we recognize charge-offs and adjust specific reserves as appropriate.   In addition, management, which is comprised of senior officers and certain accounting and credit associates, analyzes such factors as changes in lending policies and procedures; real estate market conditions; underwriting standards; collection; charge-off and recovery history; changes in national and local economic business conditions and developments; changes in the characteristics of the portfolio; ability and depth of lending management and staff; changes in the trend of the volume and severity of past due, non-accrual and classified loans; troubled debt restructuring and other loan modifications; and results of regulatory examinations.  
 
 
44

 
Declines in collateral values, including commercial real estate, may impact our ability to collect on certain loans when borrowers are dependent on the values of the real estate as a source of cash flow.   While we anticipate that challenges will continue in the foreseeable future as we manage the overall level of our credit quality, we believe that credit quality and real estate values appear to be stabilizing as compared to the period before 2012.   As a result of the relative stabilization in real estate values during 2013 and 2014, our provision for loan losses decreased.   
 
As discussed in the Regulatory Matters to this section, we have entered into a Consent Order with bank regulatory agencies.   In addition to increasing capital ratios, we agreed to maintain adequate reserves for loan losses, develop and implement plans to reduce the level of non-performing assets and concentrations of credit in commercial real estate loans, implement revised credit risk management practices and credit administration policies and procedures, and report our progress to the regulators.
 
The following table analyzes our loan loss experience for the periods indicated.
 
 
 
Three Months Ended
 
 
 
March 31,
 
(Dollars in thousands)
 
2014
 
 
2013
 
 
 
 
 
 
 
 
 
 
Balance at beginning of period
 
$
9,576
 
 
$
17,265
 
 
 
 
 
 
 
 
 
 
Loans charged-off:
 
 
 
 
 
 
 
 
Residential mortgage
 
 
4
 
 
 
-
 
Consumer & home equity
 
 
42
 
 
 
63
 
Commercial & commercial real estate
 
 
34
 
 
 
485
 
Total charge-offs
 
 
80
 
 
 
548
 
Recoveries:
 
 
 
 
 
 
 
 
Residential mortgage
 
 
3
 
 
 
-
 
Consumer & home equity
 
 
46
 
 
 
42
 
Commercial & commercial real estate
 
 
63
 
 
 
90
 
Total recoveries
 
 
112
 
 
 
132
 
 
 
 
 
 
 
 
 
 
Net loans charged-off
 
 
(32)
 
 
 
416
 
 
 
 
 
 
 
 
 
 
Provision for loan losses
 
 
-
 
 
 
(1,037)
 
 
 
 
 
 
 
 
 
 
Balance at end of period
 
$
9,608
 
 
$
15,812
 
 
 
 
 
 
 
 
 
 
Allowance for loan losses to total loans
 
 
2.09
%
 
 
3.13
%
Annualized net charge-offs to average loans
    outstanding
 
 
(0.03)
%
 
 
0.32
%
Allowance for loan losses to total
    non-performing loans
 
 
108
%
 
 
77
%
 
We did not record provision for loan loss expense in the 2014 quarter.   However, in the prior year quarter, we recorded a $1.0 million reversal of provision expense due to a decline in the size of our loan portfolio, a lower level of classified loans compared to 2012, declining historical loss rates, and a reduction in the specific reserves allocated to several relationships based upon improved credit quality.  
 
The allowance for loan losses was $9.6 million at March 31, 2014, a decrease of $6.2 million compared to 2013. The decrease was driven by net charge-offs of $4.2 million taken during 2013, including specific reserves of $3.6 million charged off on our collateral dependent loans.   The allowance for loan losses as a percent of total loans was 2.09% for March 31, 2014 compared to 3.13% at March 31, 2013.   Specific reserves allocated to substandard loans made up 30% of the total allowance for loan loss at March 31, 2014 compared to 43% at March 31, 2013.   Net charge-offs for the 2014 period included $0 in partial charge-offs compared to partial charge-offs of $375,000 for the 2013 period.  
 
 
45

 
Allowance for loan losses to total non-performing loans increased to 108% at March 31, 2014 from 77% at March 31, 2013.   The increase in the coverage ratio for 2014 was driven by a significant decline in non-performing loans which more than offsets the decline in the allowance balance.   The allowance for loan loss for loans evaluated individually for impairment as a percentage of loans evaluated individually for impairment declined from 16.2% at March 31, 2013 to 8.5% at March 31, 2014, as specific reserves were charged off related to loans evaluated individually for impairment and deemed collateral dependent during the period.   Once charged down to net realizable value, our impairment analysis for these individually evaluated collateral-dependent loans indicated that no additional reserves were required.
 
Federal regulations require banks to classify their own assets on a regular basis.   The regulations provide for three categories of classified loans — substandard, doubtful and loss.   In addition, we also classify loans as criticized.   Loans classified as criticized have a potential weakness that deserves management’s close attention.
 
The following table provides information with respect to criticized and classified loans for the periods indicated:
 
 
 
March 31,
 
December 31,
 
September 30,
 
June 30,
 
March 31,
 
(Dollars in thousands)
 
2014
 
2013
 
2013
 
2013
 
2013
 
Criticized Loans:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total Criticized
 
$
18,614
 
$
18,329
 
$
22,456
 
$
27,892
 
$
27,068
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Classified Loans:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Substandard
 
$
34,353
 
$
37,479
 
$
45,798
 
$
41,256
 
$
42,043
 
Doubtful
 
 
-
 
 
-
 
 
-
 
 
-
 
 
-
 
Loss
 
 
-
 
 
-
 
 
-
 
 
-
 
 
-
 
Total Classified
 
$
34,353
 
$
37,479
 
$
45,798
 
$
41,256
 
$
42,043
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total Criticized and Classified
 
$
52,967
 
$
55,808
 
$
68,254
 
$
69,148
 
$
69,111
 
 
Total criticized and classified loans declined by $2.8 million or 5% from December 31, 2013 and by $16.1 million or 23% from March 31, 2013.   Approximately $29.9 million or 87% of the total classified loans at March 31, 2014 were related to commercial real estate loans in our market area.   Classified consumer loans totaled $553,000, classified mortgage loans totaled $3.1 million and classified commercial loans totaled $800,000.   Our decision to not record any provision for loan losses during 2014 resulted from the application of a consistent allowance methodology that is driven by risk ratings and historical loss trends adjusted for qualitative factors.   For more information on collection efforts, evaluation of collateral and how loss amounts are estimated, see “Non-Performing Assets,” below.
 
Although we may allocate a portion of the allowance to specific loans or loan categories, the entire allowance is available for charge-offs.   We develop our allowance estimates based on actual loss experience adjusted for current economic conditions.   Allowance estimates represent a prudent measurement of the risk in the loan portfolio, which we apply to individual loans based on loan type.   If economic conditions continue to put stress on our borrowers, this may require higher provisions for loan losses in future periods.   We have allocated additional resources to address credit quality and facilitate the structure and processes to diversify and strengthen our lending function.   Credit quality will continue to be a primary focus in 2014 and going forward.
 
Non-Performing Assets
 
Non-performing assets consist of certain non-accruing restructured loans for which the interest rate or other terms have been renegotiated, loans past due 90 days or more still on accrual, loans on which interest is no longer accrued, real estate acquired through foreclosure, and repossessed assets.   Three bank lots originally acquired for expansion but now held for sale are also classified as non-performing assets. Loans, including impaired loans, are placed on non-accrual status when they become past due 90 days or more as to principal or interest, unless they are adequately secured and in the process of collection.   Loans are considered impaired when we no longer anticipate full principal or interest will be paid in accordance with the contractual loan terms.   Impaired loans are carried at the present value of estimated future cash flows discounted at the loan’s effective interest rate, or at the fair value of the collateral less cost to sell if the loan is collateral dependent.
 
Non-accrual loans that have been restructured remain on non-accrual status until we determine the future collection of principal and interest is reasonably assured, which will require that the borrower demonstrate a period of performance in accordance to the restructured terms of six months or more. Accruing loans that have been restructured are evaluated for non-accrual status based on a current evaluation of the borrower’s financial condition and ability and willingness to service the modified debt.
 
 
46

 
We review our loans on a regular basis and implement normal collection procedures when a borrower fails to make a required payment on a loan.   If the delinquency on a mortgage loan exceeds 90 days and is not cured through normal collection procedures, or an acceptable arrangement is not worked out with the borrower, we institute measures to remedy the default, including commencing a foreclosure action.   We generally charge off consumer loans when management deems a loan uncollectible and any available collateral has been liquidated.   We handle commercial business and real estate loan delinquencies on an individual basis.   These loans are placed on non-accrual status upon becoming contractually past due 90 days or more as to principal and interest or where substantial doubt about full repayment of principal and interest is evident.  
 
We recognize interest income on loans on the accrual basis except for those loans in a non-accrual of income status. We discontinue accruing interest on impaired loans when management believes, after consideration of economic and business conditions and collection efforts, that the borrowers’ financial condition is such that collection of interest is doubtful, typically after the loan becomes 90 days delinquent.   When interest accrual is discontinued, existing accrued interest is reversed and interest income is subsequently recognized only to the extent we receive cash payments and are assured of repayment of all outstanding principal.
 
We require appraisals and perform evaluations on impaired assets upon initial identification.  Thereafter, we obtain appraisals or perform market value evaluations on impaired assets at least annually.  Recognizing the volatility of certain assets, we assess the transaction and market conditions to determine if updated appraisals are needed more frequently than annually.   Additionally, we evaluate the collateral condition and value in the event of foreclosure.  
 
We classify real estate acquired as a result of foreclosure or by deed in lieu of foreclosure as real estate owned until such time as it is sold. We classify new and used automobile, motorcycle and all-terrain vehicles acquired as a result of foreclosure as repossessed assets until they are sold. When such property is acquired we record it at fair value less estimated selling costs.   We charge any write-down of the property at the time of acquisition to the allowance for loan losses.   Subsequent gains and losses are included in non-interest income and non-interest expense.
 
Real estate owned acquired through foreclosure is recorded at fair value less estimated selling costs at the date of foreclosure.   Fair value is based on the appraised market value of the property based on sales of similar assets.   The value may be subsequently reduced if the estimated fair value declines below the original appraised value. We monitor market information and the age of appraisals on existing real estate owned properties and obtain new appraisals as circumstances warrant.   Real estate acquired through foreclosure was $12.3 million, an increase of $603,000 from December 31, 2013 and a decrease of $7.4 million from March 31, 2013.   We believe that our level of real estate acquired through foreclosure has stabilized, as the inflow of properties has slowed down substantially compared to 2013, 2012 and 2011. All properties held in OREO are listed for sale with various independent real estate agents.
 
A summary of the real estate acquired through foreclosure activity is as follows:
 
 
 
March 31,
 
December 31,
 
(Dollars in thousands)
 
2014
 
2013
 
 
 
 
 
 
 
 
 
Beginning balance, January 1,
 
$
11,657
 
$
22,286
 
Additions
 
 
954
 
 
8,713
 
Net proceeds from sale of properties
 
 
(348)
 
 
(17,076)
 
Writedowns
 
 
(3)
 
 
(2,185)
 
Change in valuation allowance
 
 
-
 
 
(81)
 
Ending balance
 
$
12,260
 
$
11,657
 
 
 
47

 
The following table provides information with respect to non-performing assets for the periods indicated.
 
 
 
March 31,
 
 
December 31,
 
 
September 30,
 
 
June 30,
 
 
March 31,
 
(Dollars in thousands)
 
2014
 
 
2013
 
 
2013
 
 
2013
 
 
2013
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Restructured on non-accrual status
 
$
1,170
 
 
$
1,310
 
 
$
7,927
 
 
$
8,639
 
 
$
9,099
 
Restructured past due 90 days still on accrual
 
 
-
 
 
 
4,780
 
 
 
4,837
 
 
 
-
 
 
 
-
 
Past due 90 days still on accrual
 
 
-
 
 
 
2,226
 
 
 
2,238
 
 
 
-
 
 
 
1,950
 
Loans on non-accrual status
 
 
7,688
 
 
 
9,096
 
 
 
6,511
 
 
 
9,215
 
 
 
9,596
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total non-performing loans
 
 
8,858
 
 
 
17,412
 
 
 
21,513
 
 
 
17,854
 
 
 
20,645
 
Real estate acquired through foreclosure
 
 
12,260
 
 
 
11,657
 
 
 
8,859
 
 
 
14,169
 
 
 
19,705
 
Real estate owned-bank lots
 
 
1,446
 
 
 
1,469
 
 
 
-
 
 
 
-
 
 
 
-
 
Other repossessed assets
 
 
32
 
 
 
37
 
 
 
16
 
 
 
37
 
 
 
32
 
Total non-performing assets
 
$
22,596
 
 
$
30,575
 
 
$
30,388
 
 
$
32,060
 
 
$
40,382
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Interest income that would have been earned on
    non-performing loans
 
$
446
 
 
$
902
 
 
$
1,127
 
 
$
946
 
 
$
1,094
 
Interest income recognized on non-performing
    loans
 
 
-
 
 
 
246
 
 
 
38
 
 
 
-
 
 
 
16
 
Ratios: Non-performing loans to total loans
 
 
1.93
%
 
 
3.73
%
 
 
4.52
%
 
 
3.64
%
 
 
4.08
%
Non-performing assets to total loans
 
 
4.92
%
 
 
6.55
%
 
 
6.38
%
 
 
6.54
%
 
 
7.98
%
 
Non-performing loans declined by $8.6 million to $8.9 million at March 31, 2014 compared to December 31, 2013.   The change in non-accrual loans was due to the transfer of a non-accrual relationship totaling $725,000 to real estate acquired through foreclosure.   Two commercial real estate relationships, one totaling $2.2 million and the other totaling $4.8 million were transferred from 90 days past due and still on accrual to accrual status as both relationships are performing as to the payment of principal and interest.  
 
Restructured l oans on nonaccrual status will be placed back on accrual status if we determine that the future collection of principal and interest is reasonably assured, which requires that the borrower demonstrate a period of performance of at least six months in accordance to the restructured terms.   All non-performing loans are considered impaired.
 
The following table provides information with respect to restructured loans for the periods indicated.
 
 
 
March 31,
 
December 31,
 
(Dollar in thousands)
 
2014
 
2013
 
 
 
 
 
 
 
 
 
Restructured loans on non-accrual
 
$
1,170
 
$
1,310
 
Restructured past due 90 days still on accrual
 
 
-
 
 
4,780
 
Restructured loans on accrual
 
 
23,058
 
 
18,963
 
 
 
 
 
 
 
 
 
Total restructured loans
 
$
24,228
 
$
25,053
 
 
Restructured loans on accrual increased during 2014 due to the reclassification of a commercial real estate relationship totaling $4.7 million from past due 90 days still on accrual status.   This was offset by the pay-off of a commercial real estate relationship totaling $358,000.  
 
The terms of our restructured loans have been renegotiated to reduce the rate of interest or extend the term, thus reducing the amount of cash flow required from the borrower to service the loans. We anticipate that our level of restructured loans will remain elevated as we identify borrowers in financial difficulty and work with them to modify to more affordable terms.   We have worked with customers when feasible to establish “A” and “B” note structures.   The “B” note is charged-off on our books but remains an outstanding balance for the customer.   These typically carry a very nominal or low rate of interest.   The “A” note is a note structured on a proper basis meeting internal policy standards for a performing loan.   After six months of performance, the “A” note restructured loan is eligible to be placed back on an accrual basis as a performing troubled debt restructured loan.
 
 
48

 
Investment Securities
 
Interest on securities provides us our largest source of interest income after interest on loans, constituting 20.6% of the total interest income for the quarter ended March 31, 2014.   The securities portfolio serves as a source of liquidity and earnings, and contributes to the management of interest rate risk.   We have the authority to invest in various types of liquid assets, including short-term United States Treasury obligations and securities of various federal agencies, obligations of states and political subdivisions, corporate bonds, certificates of deposit at insured savings institutions and banks, bankers' acceptances, and federal funds.   We may also invest a portion of our assets in certain commercial paper, collateralized loan obligations and corporate debt securities.   We are also authorized to invest in mutual funds and stocks whose assets conform to the investments that we are authorized to make directly. The investment portfolio decreased by $28.5 million primarily due to sales of corporate bonds and four of our CLOs, which sales were offset by the purchases of higher yielding investments.   Recent purchases have been high cash flow instruments with short average lives in order to decrease the volatility of the investment portfolio as well as to provide cash flow and limit interest rate risk.
 
We evaluate investment securities with significant declines in fair value on a quarterly basis to determine whether they should be considered other-than-temporarily impaired under current accounting guidance, which generally provides that if a security is in an unrealized loss position, whether due to general market conditions or industry or issuer-specific factors, the holder of the securities must assess whether the impairment is other-than-temporary. We consider the length of time and the extent to which the fair value has been less than cost, the financial condition and near-term prospects of the issuer, and whether management has the intent to sell the debt security or whether it is more likely than not that we will be required to sell the debt security before its anticipated recovery.   In analyzing an issuer’s financial condition, we may consider whether the securities are issued by the federal government or its agencies, whether downgrades by bond rating agencies have occurred, and the results of reviews of the issuer’s financial condition.  
 
The unrealized losses on our investment securities were a result of changes in interest rates for fixed-rate securities where the interest rate received is less than the current rate available for new offerings of similar securities.   Because the decline in market value is attributable to changes in interest rates and not credit quality, and because we do not intend to sell and it is more likely than not that we will not be required to sell these investments until recovery of fair value, which may be maturity, we did not consider these investments to be other-than-temporarily impaired at March 31, 2014.   See Note 3 – Securities for more information.
 
At March 31, 2014, we own five collateralized loan obligation (“CLO”) securities subject to the Volcker Rule, with an amortized cost of $20.7 million and an unrealized loss of $453,000.   Absent changes to the Volcker Rule, we would be required to dispose of these securities before July 2015.   We believe the unrealized loss reflected results not from credit risk but from interest rate changes and to the uncertainty created by the Volcker Rule.   In the first quarter of 2014, we sold four of our CLOs to confirm their marketability and evaluate our assessment about their market values.   These four securities had an unrealized loss of $233,000 at December 31, 2013.   We recorded a loss of $91,000 on these sales.   We do not currently intend to sell additional CLOs.
 
Deposits
 
We rely primarily on providing excellent customer service and on our long-standing relationships with customers to attract and retain deposits. Market interest rates and rates on deposit products offered by competing financial institutions can significantly affect our ability to attract and retain deposits.   We attract both short-term and long-term deposits from the general public by offering a wide range of deposit accounts and interest rates. In recent years market conditions have caused us to rely increasingly on short-term certificate accounts and other deposit alternatives that are more responsive to market interest rates.   We use forecasts based on interest rate risk simulations to assist management in monitoring our use of certificates of deposit and other deposit products as funding sources and the impact of the use of those products on interest income and net interest margin in various rate environments.  
 
Historically, we have utilized certificates of deposit placed by deposit brokers and deposits obtained through the CDARs program to support our asset growth. The CDARS system enables certificates of deposit that would exceed the current $250,000 FDIC coverage limit on deposits in a single financial institution to be redistributed to other financial institutions within the CDARS network in increments under the current coverage limit.   However, due to the Bank’s designation a s a “troubled institution,” we can no longer accept, renew or roll over brokered deposits (including deposits obtained through the CDARs program) without prior regulatory approval.   
 
 
49

 
Total deposits decreased $24.2 million since December 31, 2013.   Public funds decreased $16.4 million while retail and commercial deposits decreased $7.8 million.   We have public funds deposits from school boards, water districts and municipalities within our markets.   These deposits are larger than individual retail depositors.   However, we do not have a deposit relationship that we believe is significant enough to cause a negative impact on our liquidity position.   Brokered deposits were $24.0 million at March 31, 2014, decreasing by $3.3 million from $27.3 million at December 31, 2013.  
 
The following table shows the amount of our brokered deposits by time remaining until maturity.
 
 
 
 
(Dollars in  thousands)
 
 
 
 
 
 
2014
 
$
5,362
 
2015
 
 
3,249
 
2016
 
 
1,187
 
2017
 
 
-
 
2018
 
 
4,609
 
2019
 
 
9,636
 
 
 
$
24,043
 
 
We are currently a member of Qwickrate, which is a premier non-brokered market place that we use as an additional low cost funding source.   Qwickrate deposits totaled $18.2 million at both March 31, 2014 and December 31, 2013.   We do not anticipate a negative impact as a result of not being able to renew our current $24.0 million of brokered deposits due to additional funding sources such as Qwickrate, decreased loan generation, continued loan pay downs, and our highly liquid and mostly short-term investment portfolio.
 
We have deployed additional resources to try to reduce our cost of funds in this low rate environment.   The Consent Order resulted in the Bank being categorized as a "troubled institution" by bank regulators, which limits the interest rate the Bank can pay on interest bearing deposits.     Unless the Bank is granted a waiver because it resides in a market that the FDIC determines is a high rate market, the Bank is limited to paying deposit interest rates .75% above the average rates computed by the FDIC.   The Bank has elected not to pursue such a waiver and to adhere to the average rates computed by the FDIC plus the .75% rate cap.
 
The following table breaks down our deposits.
 
 
 
March 31,
 
December 31,
 
 
 
2014
 
2013
 
 
 
(In Thousands)
 
 
 
 
 
 
 
 
 
Non-interest bearing
 
$
88,871
 
$
78,480
 
NOW demand
 
 
177,965
 
 
192,514
 
Savings
 
 
99,138
 
 
90,176
 
Money market
 
 
92,290
 
 
94,367
 
Certificates of deposit
 
 
301,008
 
 
327,950
 
 
 
$
759,272
 
$
783,487
 
 
Advances from Federal Home Loan Bank
 
Deposits are the primary source of funds for our lending and investment activities and for our general business purposes.   We can also use advances (borrowings) from the Federal Home Loan Bank (FHLB) to compensate for reductions in deposits or deposit inflows at less than projected levels.   At March 31, 2014, outstanding FHLB advances totaled $12.4 million, and we had sufficient collateral available to borrow approximately $19.0 million in additional advances. Advances from the FHLB are secured by our stock in the FHLB, certain securities and substantially all of our first mortgage loans on an individual basis.  
 
Subordinated Debentures
 
Two trust subsidiaries of First Financial Service Corporation have together issued a total of $18 million trust preferred securities. The subsidiaries loaned the sales proceeds from these issuances to us in exchange for junior subordinated deferrable interest debentures. We are not considered the primary beneficiary of these trusts, which are variable interest entities. Therefore the trusts are not consolidated in our financial statements. Rather, the subordinated debentures we have issued to them are shown as a liability.   Our investment in the common stock of the trusts was $310,000.
 
 
50

 
The subordinated debentures are considered as Tier 1 capital or Tier 2 capital for the Corporation under current regulatory guidelines. Capital received from the proceeds of the sale of trust preferred securities cannot constitute more than 25% of the total core capital of the Corporation.   The amount of subordinated debentures in excess of the 25% limitation constitutes Tier 2 capital for the Corporation.   We have the option to defer interest payments on the subordinated debentures from time to time for a period not to exceed five consecutive years.  
 
In 2008, one such trust subsidiary issued $8.0 million in trust preferred securities and loaned the sales proceeds to us, which we used to finance the purchase of banking operations in Indiana that we later sold. The subordinated debentures we issued to the trust mature on June 24, 2038, can be called at par in whole or in part on or after June 24, 2018, and pay a fixed rate of 8% for thirty years.  
 
In 2007, the other trust subsidiary issued 30 year cumulative trust preferred securities totaling $10 million at a 10-year fixed rate of 6.69% adjusting quarterly thereafter at LIBOR plus 160 basis points.   These securities mature on March 22, 2037, and can be called at par in whole or in part on or after March 15, 2017.  
 
On October 29, 2010, we exercised our right to defer regularly scheduled interest payments on both issues of junior subordinated notes relating to outstanding trust preferred securities.   We have the right to defer payments of interest for up to 20 consecutive quarterly periods without default or penalty.   Thereafter, we must pay all deferred interest or we will be in default. During the deferral period, the subsidiary trusts likewise suspended payment of dividends on their trust preferred securities.   The regular scheduled interest payments will continue to be accrued for payment in the future and reported as an expense for financial statement purposes. As of March 31, 2014, we have deferred a total of fourteen quarterly payments and these accrued but unpaid interest payments totaled $4.8 million.
 
LIQUIDITY
 
Liquidity refers to our ability to generate adequate amounts of cash to meet financial obligations to our customers and shareholders in order to fund loans, respond to deposit outflows and to cover operating expenses. Maintaining a level of liquid funds through asset/liability management seeks to ensure that these needs are met at a reasonable cost.   Liquidity is essential to compensate for fluctuations in the balance sheet and provide funds for growth and normal operating expenditures.   Our investment and funds management policy identifies the primary sources of liquidity, establishes procedures for monitoring and measuring liquidity, and establishes minimum liquidity requirements in compliance with regulatory guidance. Management continually monitors the Bank’s liquidity position with oversight from the Asset Liability Committee.
 
Our banking centers provide access to retail deposit markets.   If large certificate depositors shift to our competitors or other markets in response to interest rate changes, we have the ability to replenish those deposits through alternative funding sources. In addition to maintaining a stable core deposit base, we maintain adequate liquidity primarily through the use of investment securities.   Traditionally, we have also borrowed from the FHLB to supplement our funding requirements.   At March 31, 2014, we had sufficient collateral available to borrow approximately $19.0 million through additional advances from the FHLB.   We believe that we have adequate funding sources through unpledged investment securities, repayments of loan principal, investment securities pay-downs and maturities and potential asset sales to meet our foreseeable liquidity requirements.
 
At the holding company level, the Corporation uses cash to pay dividends to stockholders, repurchase common stock, make selected investments and acquisitions, and service debt. The main sources of funding for the Corporation include dividends from the Bank, borrowings and access to the capital markets.  
 
The primary source of funding for the Corporation has been dividends and returns of investment from the Bank. Kentucky banking laws limit the amount of dividends that the Bank can pay to the Corporation without prior approval of the KDFI.   Under these laws, the amount of dividends that may be paid in any calendar year is limited to current year’s net income, as defined in the laws, combined with the retained net income of the preceding two years, less any dividends declared during those periods.   Our Consent Order requires us to obtain the consent of the Regional Director of the FDIC and the Commissioner of the KDFI to declare and pay cash dividends to the Corporation.  
 
The Corporation has also entered into a formal agreement with the Federal Reserve to obtain regulatory approval before declaring any dividends on our common or preferred stock.   We will not be able to pay cash dividends on our common stock in the future until we first pay all unpaid dividends on our Senior Preferred Shares and all deferred distributions on our trust preferred securities.   We may not redeem shares or obtain additional borrowings without prior approval.   Because of these limitations, consolidated cash flows as presented in the consolidated statements of cash flows may not represent cash immediately available to the Corporation.   During 2013, the Bank did not declare or pay any dividends to the Corporation.   Cash held by the Corporation at March 31, 2014 was $106,000 compared to cash of $147,000 at December 31, 2013.
 
 
51

 
CAPITAL
 
Stockholders’ equity increased $2.2 million for the period ended March 31, 2014, primarily due to a decrease in unrealized losses on securities available-for-sale during the period.   Our average stockholders’ equity to average assets ratio decreased to 4.13% at March 31, 2014 compared to 4.50% for the 2013 quarter.
 
On January 9, 2009, we sold $20 million of cumulative perpetual preferred shares, with a liquidation preference of $1,000 per share (the “Senior Preferred Shares”) to the U.S. Treasury (“Treasury”) under the terms of its Capital Purchase Program.   The Senior Preferred Shares constitute Tier 1 capital and rank senior to our common shares.   The Senior Preferred Shares paid cumulative dividends at a rate of 5% per year for the first five years and reset to a rate of 9% per year on January 9, 2014.
 
Under the terms of our CPP stock purchase agreement, we also issued Treasury a warrant to purchase an amount of our common stock equal to 15% of the aggregate amount of the Senior Preferred Shares, or $3 million.   The warrant entitles Treasury to purchase 215,983 common shares at a purchase price of $13.89 per share.   The initial exercise price for the warrant and the number of shares subject to the warrant were determined by reference to the market price of our common stock calculated on a 20-day trailing average as of December 8, 2008, the date Treasury approved our application.   The warrant has a term of 10 years and is potentially dilutive to earnings per share.
 
Effective with the fourth quarter of 2010, we suspended payment of regular quarterly cash dividends on our Senior Preferred Shares.   The dividends are cumulative and will continue to be accrued for payment in the future and reported as a preferred dividend requirement that is deducted from income to common shareholders for financial statement purposes.
 
On April 29, 2013, Treasury sold our Senior Preferred Shares to six funds in an auction.  Following the sale, the full $20 million stated value of our Senior Preferred Shares remains outstanding and our obligation to pay deferred and future dividends, currently at an annual rate of 9%, continues until our Senior Preferred Shares are fully retired.
 
During the first quarter of 2014, we did not purchase any shares of our common stock.   Like our agreement with the Federal Reserve, the terms of our Senior Preferred Shares do not allow us to repurchase shares of our common stock without prior written consent until the Senior Preferred Shares are fully retired.  
 
Each of the federal bank regulatory agencies has established minimum leverage capital requirements for banks. Banks must maintain a minimum ratio of Tier 1 capital to adjusted average quarterly assets ranging from 3% to 5%, subject to federal bank regulatory evaluation of an organization’s overall safety and soundness.  
 
The following table shows the ratios of Tier 1 capital, total capital to risk-adjusted assets and the leverage ratios for the Corporation and the Bank as of March 31, 2014.
 
Capital Adequacy Ratios as of
March 31, 2014
 
 
 
Regulatory
 
Ratio Required
 
 
 
 
 
Risk-Based Capital Ratios
 
Minimums
 
by Consent Order
 
The Bank
 
The Corporation
 
Tier 1 capital
 
4.00
%
N/A
 
12.88
%
10.66
%
Total risk-based capital
 
8.00
%
12.00
%
14.13
%
12.60
%
Tier 1 leverage ratio
 
4.00
%
9.00
%
8.15
%
6.72
%
 
In its 2012 Consent Order, the Bank agreed to achieve and maintain a Tier 1 capital ratio of 9.0% and a total risk-based capital ratio of 12.0% by June 30, 2012.   At March 31, 2014, the Bank’s Tier 1 capital ratio was 8.15% and the total risk-based capital ratio was 14.13% compared to 7.96% and 13.48% at December 31, 2013.   We are continuing our efforts to meet and maintain the required regulatory capital levels and all of the other consent order issues for the Bank.
 
The terms of the 2012 Consent Order and the actions we have taken to attain the capital ratios and meet the other requirements of the Order are described in greater detail under Regulatory Matters, above.
 
  
52

 
Item 3.   QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
 
Asset/Liability Management and Market Risk
 
To minimize the volatility of net interest income and exposure to economic loss that may result from fluctuating interest rates, we manage our exposure to adverse changes in interest rates through asset and liability management activities within guidelines established by our Asset Liability Committee (“ALCO”).   Comprised of senior management representatives, the ALCO has the responsibility for approving and ensuring compliance with asset/liability management policies.   Interest rate risk is the exposure to adverse changes in the net interest income as a result of market fluctuations in interest rates.   The ALCO, on an ongoing basis, monitors interest rate and liquidity risk in order to implement appropriate funding and balance sheet strategies.   Management considers interest rate risk to be our most significant market risk.
 
We utilize an earnings simulation model to analyze net interest income sensitivity.   We then evaluate potential changes in market interest rates and their subsequent effects on net interest income.   The model projects the effect of instantaneous movements in interest rates of both 100 and 200 basis points.   We also incorporate assumptions based on the historical behavior of our deposit rates and balances in relation to changes in interest rates into the model.   These assumptions are inherently uncertain and, as a result, the model cannot precisely measure future net interest income or precisely predict the impact of fluctuations in market interest rates on net interest income.   Actual results will differ from the model’s simulated results due to timing, magnitude and frequency of interest rate changes as well as changes in market conditions and the application and timing of various management strategies.
 
Our interest sensitivity profile was asset sensitive at March 31, 2014 and December 31, 2013.   Given a sustained 100 basis point increase in interest rates, our base net interest income would increase by an estimated 5.28% at March 31, 2014 compared to an increase of 3.89% at December 31, 2013.  
 
We did not run a model simulation for declining interest rates as of March 31, 2014 and December 31, 2013, because the Federal Open Market Committee effectively lowered the Fed Funds Target Rate between 0.00% to 0.25% in December 2008 and therefore, no further short-term rate reductions can occur.
 
Our interest sensitivity at any point in time will be affected by a number of factors.   These factors include the mix of interest sensitive assets and liabilities, their relative pricing schedules, market interest rates, deposit growth, loan growth, decay rates and prepayment speed assumptions.  
 
We use various asset/liability strategies to manage the re-pricing characteristics of our assets and liabilities designed to ensure that exposure to interest rate fluctuations is limited within our guidelines of acceptable levels of risk-taking.   As demonstrated by the March 31, 2014 and December 31, 2013 sensitivity tables, our balance sheet has an asset sensitive position. This means that our earning assets, which consist of loans and investment securities, will change in price at a faster rate than our deposits and borrowings.   Therefore, if short term interest rates increase, our net interest income will increase.   Likewise, if short term interest rates decrease, our net interest income will decrease.
 
 
53

 
Our sensitivity to interest rate changes is presented based on data as of March 31, 2014 and December 31, 2013 annualized to a one year period.
 
 
 
March 31, 2014
 
 
 
Increase in Rates
 
 
 
 
 
 
100
 
 
200
 
(Dollars in thousands)
 
Base
 
Basis Points
 
 
Basis Points
 
 
 
 
 
 
 
 
 
 
 
 
 
Projected interest income
 
$
26,312
 
$
30,213
 
 
$
34,215
 
Projected interest expense
 
 
5,270
 
 
8,059
 
 
 
10,848
 
 
 
 
 
 
 
 
 
 
 
 
 
Net interest income
 
$
21,042
 
$
22,154
 
 
$
23,367
 
Change from base
 
 
 
 
$
1,112
 
 
$
2,325
 
% Change from base
 
 
 
 
 
5.28
%
 
 
11.05
%
 
 
 
December 31, 2013
 
 
 
Increase in Rates
 
 
 
 
 
 
100
 
 
200
 
(Dollars in thousands)
 
Base
 
Basis Points
 
 
Basis Points
 
 
 
 
 
 
 
 
 
 
 
 
 
Projected interest income
 
$
27,800
 
$
31,688
 
 
$
35,783
 
Projected interest expense
 
 
5,364
 
 
8,378
 
 
 
11,392
 
 
 
 
 
 
 
 
 
 
 
 
 
Net interest income
 
$
22,436
 
$
23,310
 
 
$
24,391
 
Change from base
 
 
 
 
$
874
 
 
$
1,955
 
% Change from base
 
 
 
 
 
3.89
%
 
 
8.71
%
 
 
54

 
Item 4.   CONTROLS AND PROCEDURES
Management is responsible for establishing and maintaining effective disclosure controls and procedures, as defined under Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934. As of March 31, 2014, an evaluation was performed under the supervision and with the participation of management, including the Principal Executive Officer and Principal Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures.   Based on that evaluation, management and the Risk Management Committee of our Board of Directors concluded that disclosure controls and procedures were effective as of the end of the period covered by this report.
 
Management is responsible for establishing and maintaining adequate internal controls over financial reporting that are designed to produce reliable financial statements in accordance with U.S. generally accepted accounting principles.   Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements.   Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
 
There were no other changes in our internal control over financial reporting that occurred during the quarter ended March 31, 2014 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
 
Part II - OTHER INFORMATION
 
Item 1.          Legal Proceedings
 
In the normal course of operations, we may become defendants in various legal proceedings. Litigation is subject to inherent uncertainties and unfavorable rulings could occur.   Currently, there are no material pending legal proceedings to which we are a party, or to which any of our property is subject.
 
On February 11, 2013, seven plaintiffs filed a lawsuit against the Bank and two co-defendants in federal district court in Louisville, Kentucky. On the defendant parties’ motion, plaintiffs’ complaint was dismissed on November 19, 2013.   On November 22, 2013, the same plaintiffs filed a complaint in Kentucky state courts in an action styled William P. Miller, et al. v. First Federal Savings Bank of Elizabethtown, Inc. , et. al. , Civil Action No. 13-CI-1955.   Plaintiffs invested in two companies organized by one of the co-defendants, which companies purchased commercial property in Addison, Illinois. Plaintiffs also guaranteed loans made by the Bank to the two companies to finance the purchase of this same property, in the principal amount of $3,125,622.74. Plaintiffs allege that the Bank and the co-defendants violated Kentucky’s statutes; committed common law fraud, negligence, and negligence per se; and breached fiduciary duties. Plaintiffs seek to rescind the lending documents and recover damages, including punitive damages.   The Bank filed a counterclaim, cross-claim and third-party complaint to enforce the guaranty contracts against all guarantors. Thereafter, all the defendant parties filed motions to dismiss, which are pending.   In addition, simultaneously with the earlier federal court action, the Bank filed its own foreclosure lawsuit in the Illinois state courts to enforce its lending documents against the borrower and to sell the subject real estate collateral.   First Federal Savings Bank v. Addent, LLC, et. al. , No. 2013-CH-000570 (Illinois Circuit Court, DuPage County).   On January 6, 2014, the Illinois court entered judgment in the Bank’s favor.   The Bank intends to vigorously defend its interests in the Kentucky lawsuit and to collect from the guarantors, and to pursue to conclusion the Illinois foreclosure action in order to sell the collateral real estate.
 
Item 1A.      Risk Factors
 
There have been no material changes from the risk factors as previously disclosed in our Annual Report on Form 10-K for the year ended December 31, 2013.
 
Item 2.        Unregistered Sales of Securities and Use of Proceeds
 
We did not repurchase any shares of our common stock during the quarter ended March 31, 2014.
 
Item 3.         Defaults Upon Senior Securities
 
Not Applicable
 
 
55

 
Item 4.         Mine Safety Disclosures
 
Not Applicable
Item 5.       Other Information
None
 
Item 6.       Exhibits:
 
31.1
Certification of Principal Executive Officer Pursuant to Section 302 of Sarbanes-Oxley Act
 
 
31.2
Certification of Principal Financial Officer Pursuant to Section 302 of Sarbanes-Oxley Act
 
 
32
Certification of Principal Executive Officer and Principal Financial Officer Pursuant to 18 U.S.C. Section      1350 (As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002)
 
 
101
The following financial information from the Quarterly Report of First Financial Service Corporation on Form 10-Q for the quarter ended March 31, 2014, formatted in XBRL: (i) Consolidated Balance Sheets as of March 31, 2014 and December 31, 2013, (ii) Consolidated Statements of Operations for the three months ended March 31, 2014 and 2013, (iii) Consolidated Statements of Comprehensive Income/(Loss) for the three months ended March 31, 2014 and 2013, (iv) Consolidated Statements of Changes in Stockholders’ Equity for the three months ended March 31, 2014, (v) Consolidated Statements of Cash Flows for the three months ended March 31, 2014 and 2013, and (vi) Notes to the Unaudited Consolidated Financial Statements.
 
 
56

 
FIRST FINANCIAL SERVICE CORPORATION
 

SIGNATURES

 
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
 
Date:   May 15, 2014
By:
/s/ Gregory S. Schreacke
 
Gregory S. Schreacke
 
 
President
 
 
Principal Executive Officer
 
 
Duly Authorized Representative
Date:   May 15, 2014
 
 
 
By:
/s/ Frank Perez
 
 
Frank Perez
 
 
Chief Financial Officer
 
 
Principal Financial Officer
 
 
57

 

INDEX TO EXHIBITS

 
Exhibit No.
 
Description
31.1
 
Certification of Principal Executive Officer Pursuant to Section 302 of Sarbanes-Oxley Act.
 
 
 
31.2
 
Certification of Principal Financial Officer Pursuant to Section 302 of Sarbanes-Oxley Act.
 
 
 
32
 
Certification of Principal Executive Officer and Principal Financial Officer Pursuant to 18 U.S.C. Section 1350 and Section 906 of the Sarbanes-Oxley Act of 2002.
 
 
 
101
 
The following financial information from the Quarterly Report of First Financial Service Corporation on Form 10-Q for the quarter ended March 31, 2014, formatted in XBRL: (i) Consolidated Balance Sheets as of March 31, 2014 and December 31, 2013, (ii) Consolidated Statements of Operations for the three months ended March 31, 2014 and 2013, (iii) Consolidated Statements of Comprehensive Income/(Loss) for the three months ended March 31, 2014 and 2013, (iv) Consolidated Statements of Changes in Stockholders’ Equity for the three months ended March 31, 2014, (v) Consolidated Statements of Cash Flows for the three months ended March 31, 2014 and 2013, and (vi) Notes to the Unaudited Consolidated Financial Statements.
 
 
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