Form 10-Q
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

 

    x     Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.

For the quarterly period ended September 30, 2012

or

 

    ¨     Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.

For the transition period from          to         

Commission File Number: 0-18415

 

 

Isabella Bank Corporation

(Exact name of registrant as specified in its charter)

 

 

 

Michigan   38-2830092

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

identification No.)

 

401 N. Main St, Mt. Pleasant, MI   48858
(Address of principal executive offices)   (Zip code)

(989) 772-9471

(Registrant’s telephone number, including area code)

N/A

(Former name, former address and former fiscal year, if changed since last report)

 

 

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.     x  Yes    ¨  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 (Section 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).    x  Yes    ¨  No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “accelerated filer”, “large accelerated filer”, and “smaller reporting company”, in Rule 12b-2 of the Exchange Act (Check One).

 

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

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    ¨  Yes    x   No

APPLICABLE ONLY TO CORPORATE ISSUERS:

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

Common Stock no par value, 7,620,399 as of October 19, 2012

 

 

 


Table of Contents

ISABELLA BANK CORPORATION

QUARTERLY REPORT ON FORM 10-Q

Table of Contents

 

PART I

        3   

Item 1

  

Interim Condensed Consolidated Financial Statements (Unaudited)

     3   

Item 2

  

Management’s Discussion and Analysis of Financial Condition and Results of Operations

     40   

Item 3

  

Quantitative and Qualitative Disclosures about Market Risk

     61   

Item 4

  

Controls and Procedures

     61   

PART II

        62   

Item 1

  

Legal Proceedings

     62   

Item 1A

  

Risk Factors

     62   

Item 2

  

Unregistered Sales of Equity Securities and Use of Proceeds

     62   

Item 6

  

Exhibits

     63   

SIGNATURES

     64   

 

2


Table of Contents

PART I – FINANCIAL INFORMATION

Item 1 – Interim Condensed Consolidated Financial Statements (Unaudited)

INTERIM CONDENSED CONSOLIDATED BALANCE SHEETS

(Dollars in thousands)

 

     September 30      December 31  
     2012      2011  

ASSETS

     

Cash and cash equivalents

     

Cash and demand deposits due from banks

   $ 19,202       $ 24,514   

Interest bearing balances due from banks

     5,462         4,076   
  

 

 

    

 

 

 

Total cash and cash equivalents

     24,664         28,590   

Certificates of deposit held in other financial institutions

     5,675         8,924   

Trading securities

     1,788         4,710   

Available-for-sale securities (amortized cost of $452,536 in 2012 and $414,614 in 2011)

     467,414         425,120   

Mortgage loans available-for-sale

     2,820         3,205   

Loans

     

Agricultural

     83,439         74,645   

Commercial

     369,366         365,714   

Consumer

     33,515         31,572   

Residential real estate

     280,431         278,360   
  

 

 

    

 

 

 

Total loans

     766,751         750,291   

Less allowance for loan losses

     12,062         12,375   
  

 

 

    

 

 

 

Net loans

     754,689         737,916   

Premises and equipment

     25,471         24,626   

Corporate owned life insurance

     22,594         22,075   

Accrued interest receivable

     6,565         5,848   

Equity securities without readily determinable fair values

     17,830         17,189   

Goodwill and other intangible assets

     46,592         46,792   

Other assets

     13,036         12,930   
  

 

 

    

 

 

 

TOTAL ASSETS

   $ 1,389,138       $ 1,337,925   
  

 

 

    

 

 

 

LIABILITIES AND SHAREHOLDERS’ EQUITY

     

Deposits

     

Noninterest bearing

   $ 126,362       $ 119,072   

NOW accounts

     174,350         163,653   

Certificates of deposit under $100 and other savings

     453,348         440,123   

Certificates of deposit over $100

     235,431         235,316   
  

 

 

    

 

 

 

Total deposits

     989,491         958,164   

Borrowed funds ($0 in 2012 and $5,242 in 2011 at fair value)

     226,580         216,136   

Accrued interest payable and other liabilities

     8,920         8,842   
  

 

 

    

 

 

 

Total liabilities

     1,224,991         1,183,142   
  

 

 

    

 

 

 

Shareholders’ equity

     

Common stock — no par value 15,000,000 shares authorized; issued and outstanding 7,611,350 shares (including 25,644 shares held in the Rabbi Trust) in 2012 and 7,589,226 shares (including 16,585 shares held in the Rabbi Trust) in 2011

     134,973         134,734   

Shares to be issued for deferred compensation obligations

     4,925         4,524   

Retained earnings

     18,178         13,036   

Accumulated other comprehensive income

     6,071         2,489   
  

 

 

    

 

 

 

Total shareholders’ equity

     164,147         154,783   
  

 

 

    

 

 

 

TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY

   $ 1,389,138       $ 1,337,925   
  

 

 

    

 

 

 

See notes to interim condensed consolidated financial statements.

 

3


Table of Contents

INTERIM CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

(Dollars in thousands except per share data)

 

     Common
Stock Shares
Outstanding
    Common Stock     Shares to be
Issued for
Deferred
Compensation
Obligations
    Retained
Earnings
    Accumulated
Other
Comprehensive
(Loss) Income
    Totals  

Balance, January 1, 2011

     7,550,074      $ 133,592      $ 4,682      $ 8,596      $ (1,709   $ 145,161   

Comprehensive income

     —          —          —          7,499        6,608        14,107   

Issuance of common stock

     90,049        1,891        —          —          —          1,891   

Common stock issued for deferred compensation obligations

     14,842        266        (254     —          —          12   

Share based payment awards under equity compensation plan

     —          —          486        —          —          486   

Common stock purchased for deferred compensation obligations

     —          (356     —          —          —          (356

Common stock repurchased pursuant to publicly announced repurchase plan

     (76,708     (1,391     —          —          —          (1,391

Cash dividends ($0.57 per share)

     —          —          —          (4,331     —          (4,331
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance, September 30, 2011

     7,578,257      $ 134,002      $ 4,914      $ 11,764      $ 4,899      $ 155,579   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance, January 1, 2012

     7,589,226        134,734        4,524        13,036        2,489      $ 154,783   

Comprehensive income

     —          —          —          9,695        3,582        13,277   

Issuance of common stock

     85,227        2,025        —          —          —          2,025   

Common stock transferred from the Rabbi Trust to satisfy deferred compensation obligations

     —          95        (95     —          —          —     

Share based payment awards under equity compensation plan

     —          —          496        —          —          496   

Common stock purchased for deferred compensation obligations

     —          (361     —          —          —          (361

Common stock repurchased pursuant to publicly announced repurchase plan

     (63,103     (1,520     —          —          —          (1,520

Cash dividends ($0.60 per share)

     —          —          —          (4,553     —          (4,553
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance, September 30, 2012

     7,611,350      $ 134,973      $ 4,925      $ 18,178      $ 6,071      $ 164,147   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

See notes to interim condensed consolidated financial statements.

 

4


Table of Contents

INTERIM CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(Dollars in thousands except per share data)

 

     Three Months Ended     Nine Months Ended  
     September 30     September 30  
     2012     2011     2012     2011  

Interest income

        

Loans, including fees

   $ 10,918      $ 11,365      $ 32,707      $ 34,190   

Investment securities

        

Taxable

     1,878        1,800        5,755        5,149   

Nontaxable

     1,232        1,201        3,652        3,569   

Trading account securities

     15        45        79        143   

Federal funds sold and other

     121        121        363        388   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total interest income

     14,164        14,532        42,556        43,439   

Interest expense

        

Deposits

     2,203        2,725        7,083        8,286   

Borrowings

     1,036        1,345        3,289        3,938   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total interest expense

     3,239        4,070        10,372        12,224   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net interest income

     10,925        10,462        32,184        31,215   

Provision for loan losses

     200        963        1,100        2,383   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net interest income after provision for loan losses

     10,725        9,499        31,084        28,832   
  

 

 

   

 

 

   

 

 

   

 

 

 

Noninterest income

        

Service charges and fees

     1,543        1,341        4,800        4,434   

Gain on sale of mortgage loans

     422        111        1,080        293   

Net loss on trading securities

     (9     (24     (41     (51

Net gain on borrowings measured at fair value

     —          42        33        159   

Gain on sale of available-for-sale investment securities

     116        —          1,119        —     

Other

     687        389        1,853        950   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total noninterest income

     2,759        1,859        8,844        5,785   
  

 

 

   

 

 

   

 

 

   

 

 

 

Noninterest expenses

        

Compensation and benefits

     5,130        4,814        15,663        14,565   

Occupancy

     649        633        1,889        1,892   

Furniture and equipment

     1,113        1,151        3,373        3,384   

Other

     2,236        1,915        6,682        6,038   
  

 

 

   

 

 

   

 

 

   

 

 

 

Available-for-sale impairment loss

        

Total other-than-temporary impairment loss

     —          —          486        —     

Portion of loss reported in other comprehensive income

     —          —          (204     —     
  

 

 

   

 

 

   

 

 

   

 

 

 

Net available-for-sale impairment loss

     —          —          282        —     
  

 

 

   

 

 

   

 

 

   

 

 

 

Total noninterest expenses

     9,128        8,513        27,889        25,879   
  

 

 

   

 

 

   

 

 

   

 

 

 

Income before federal income tax expense

     4,356        2,845        12,039        8,738   

Federal income tax expense

     899        334        2,344        1,239   
  

 

 

   

 

 

   

 

 

   

 

 

 

NET INCOME

   $ 3,457      $ 2,511      $ 9,695      $ 7,499   
  

 

 

   

 

 

   

 

 

   

 

 

 

Earnings per share

        

Basic

   $ 0.45      $ 0.33      $ 1.28      $ 0.99   
  

 

 

   

 

 

   

 

 

   

 

 

 

Diluted

   $ 0.44      $ 0.32      $ 1.24      $ 0.97   
  

 

 

   

 

 

   

 

 

   

 

 

 

Cash dividends per basic share

   $ 0.20      $ 0.19      $ 0.60      $ 0.57   
  

 

 

   

 

 

   

 

 

   

 

 

 

See notes to interim condensed consolidated financial statements.

 

5


Table of Contents

INTERIM CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Dollars in thousands)

 

     Three Months Ended     Nine Months Ended  
     September 30     September 30  
     2012     2011     2012     2011  

Net income

   $  3,457      $ 2,511      $ 9,695      $ 7,499   
  

 

 

   

 

 

   

 

 

   

 

 

 

Unrealized holding gains on available-for-sale securities:

        

Unrealized holding gains arising during the period

     2,990        4,721        5,209        10,050   

Reclassification adjustment for net realized gains included in net income

     (116     —          (1,119     —     

Reclassification adjustment for impairment loss included in net income

     —          —          282        —     
  

 

 

   

 

 

   

 

 

   

 

 

 

Net unrealized gains

     2,874        4,721        4,372        10,050   

Tax effect

     (763     (1,835     (790     (3,442
  

 

 

   

 

 

   

 

 

   

 

 

 

Other comprehensive income, net of tax

     2,111        2,886        3,582        6,608   
  

 

 

   

 

 

   

 

 

   

 

 

 

COMPREHENSIVE INCOME

   $ 5,568      $ 5,397      $ 13,277      $ 14,107   
  

 

 

   

 

 

   

 

 

   

 

 

 

See notes to interim condensed consolidated financial statements.

 

6


Table of Contents

INTERIM CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in thousands)

 

     Nine Months Ended
September 30
 
     2012     2011  

OPERATING ACTIVITIES

    

Net income

   $ 9,695      $ 7,499   

Reconciliation of net income to net cash provided by operations:

    

Provision for loan losses

     1,100        2,383   

Impairment of foreclosed assets

     17        45   

Depreciation

     1,802        1,909   

Amortization and impairment of originated mortgage servicing rights

     582        606   

Amortization of acquisition intangibles

     200        229   

Net amortization of available-for-sale securities

     1,683        1,117   

Available-for-sale security impairment loss

     282        —     

Gain on sale of available-for-sale securities

     (1,119     —     

Net unrealized losses on trading securities

     41        51   

Net gain on sale of mortgage loans

     (1,080     (293

Net unrealized gains on borrowings measured at fair value

     (33     (159

Increase in cash value of corporate owned life insurance

     (519     (428

Share-based payment awards under equity compensation plan

     496        486   

Origination of loans held for sale

     (69,503     (31,225

Proceeds from loan sales

     70,968        29,724   

Net changes in operating assets and liabilities which provided (used) cash:

    

Trading securities

     2,881        900   

Accrued interest receivable

     (717     (1,067

Other assets

     (1,994     423   

Accrued interest payable and other liabilities

     78        792   
  

 

 

   

 

 

 

Net cash provided by operating activities

     14,860        12,992   
  

 

 

   

 

 

 

INVESTING ACTIVITIES

    

Net change in certificates of deposit held in other financial institutions

     3,249        6,159   

Activity in available-for-sale securities

    

Sales

     40,677        3,000   

Maturities and calls

     58,598        49,117   

Purchases

     (138,043     (128,339

Loan principal originations, net

     (19,461     (18,923

Proceeds from sales of foreclosed assets

     1,446        1,625   

Purchases of premises and equipment

     (2,647     (1,576

Purchases of corporate owned life insurance

     —          (4,000
  

 

 

   

 

 

 

Net cash used in investing activities

     (56,181     (92,937
  

 

 

   

 

 

 

 

7


Table of Contents

INTERIM CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (continued)

(Dollars in thousands)

 

     Nine Months Ended
September 30
 
     2012     2011  

FINANCING ACTIVITIES

    

Acceptances and withdrawals of deposits, net

     31,327        65,102   

Increase in other borrowed funds

     10,477        22,130   

Cash dividends paid on common stock

     (4,553     (4,331

Proceeds from issuance of common stock

     2,025        1,637   

Common stock repurchased

     (1,520     (1,125

Common stock purchased for deferred compensation obligations

     (361     (356
  

 

 

   

 

 

 

Net cash provided by financing activities

     37,395        83,057   
  

 

 

   

 

 

 

(DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS

     (3,926     3,112   

Cash and cash equivalents at beginning of period

     28,590        18,109   
  

 

 

   

 

 

 

CASH AND CASH EQUIVALENTS AT END OF PERIOD

   $ 24,664      $ 21,221   
  

 

 

   

 

 

 

SUPPLEMENTAL CASH FLOWS INFORMATION:

    

Interest paid

   $ 10,526      $ 12,292   

Federal income taxes paid

     1,467        672   

SUPPLEMENTAL NONCASH INFORMATION:

    

Transfers of loans to foreclosed assets

   $ 1,588      $ 1,681   

Common stock issued for deferred compensation obligations

     —          254   

Common stock repurchased from the Rabbi Trust

     —          (266

See notes to interim condensed consolidated financial statements.

 

8


Table of Contents

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands except per share amounts)

NOTE 1 - BASIS OF PRESENTATION

As used in these Notes as well as in the Management’s Discussion and Analysis of Financial Condition and Results of Operations, references to “Isabella,” “we,” “our,” “us,” and similar terms refer to the consolidated entity consisting of Isabella Bank Corporation and its subsidiaries. Isabella Bank Corporation refers solely to the parent holding company, and Isabella Bank refers to Isabella Bank Corporation’s subsidiary, Isabella Bank.

The acronyms and abbreviations identified below are used in the Notes to the Interim Condensed Consolidated Financial Statements as well as in the Management’s Discussion and Analysis of Financial Condition and Results of Operations. You may find it helpful to refer back to this page as you read this report.

 

AFS: Available-for-sale    IFRS: International Financial Reporting Standards
ALLL: Allowance for loan and lease losses    IRR: Interest Rate Risk
ASC: FASB Accounting Standards Codification    JOBS Act: Jumpstart our Business Startups Act
ASU: FASB Accounting Standards Update    LIBOR: London Interbank Offered Rate
ATM: Automated Teller Machine    Moody’s: Moody’s Investors Service, Inc
Directors Plan: Isabella Bank Corporation and Related    N/A: Not applicable
Companies Deferred Compensation Plan for Directors    N/M: Not meaningful
Dodd-Frank Act: Dodd-Frank Wall Street Reform and    OCI: Other comprehensive income (loss)
Consumer Protection Act of 2010    OMSR: Originated mortgage servicing rights
FASB: Financial Accounting Standards Board    OREO: Other real estate owned
FDIC: Federal Deposit Insurance Corporation    OTTI: Other-than-temporary impairment
FFIEC: Federal Financial Institutions Examination Council    PBO: Projected Benefit Obligation
FRB: Board of Governors of the Federal    Rabbi Trust: A trust established to fund
Reserve System    the Directors Plan
FHLB: Federal Home Loan Bank    SEC: U.S. Securities & Exchange Commission
Freddie Mac: Federal Home Loan Mortgage Corporation    SOX: Sarbanes-Oxley Act of 2002
FTE: Fully taxable equivalent    TDR: Troubled debt restructuring
GAAP: U.S. generally accepted accounting principles    XBRL: eXtensible Business Reporting Language

The accompanying unaudited interim condensed consolidated financial statements have been prepared in accordance with GAAP for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. In our opinion, all adjustments considered necessary for a fair presentation have been included. Operating results for the three and nine month periods ended September 30, 2012 are not necessarily indicative of the results that may be expected for the year ending December 31, 2012. For further information, refer to the consolidated financial statements and footnotes thereto included in our annual report for the year ended December 31, 2011.

The accounting policies are materially the same as those discussed in Note 1 to the Consolidated Financial Statements included in our annual report for the year ended December 31, 2011.

 

9


Table of Contents

NOTE 2 - COMPUTATION OF EARNINGS PER SHARE

Basic earnings per share represents income available to common shareholders divided by the weighted average number of common shares outstanding during the period. Diluted earnings per share reflects additional common shares that would have been outstanding if dilutive potential common shares had been issued, as well as any adjustments to income that would result from the assumed issuance. Potential common shares that may be issued relate solely to outstanding shares in the Directors Plan.

Earnings per common share have been computed based on the following:

 

     Three Months Ended
September 30
     Nine Months Ended
September 30
 
     2012      2011      2012      2011  

Average number of common shares outstanding for basic calculation

     7,600,443         7,577,388         7,595,806         7,568,551   

Average potential effect of shares in the Directors Plan (1)

     206,233         197,937         203,250         195,360   
  

 

 

    

 

 

    

 

 

    

 

 

 

Average number of common shares outstanding used to calculate diluted earnings per common share

     7,806,676         7,775,325         7,799,056         7,763,911   
  

 

 

    

 

 

    

 

 

    

 

 

 

Net income

   $ 3,457       $ 2,511       $ 9,695       $ 7,499   
  

 

 

    

 

 

    

 

 

    

 

 

 

Earnings per share

           

Basic

   $ 0.45       $ 0.33       $ 1.28       $ 0.99   
  

 

 

    

 

 

    

 

 

    

 

 

 

Diluted

   $ 0.44       $ 0.32       $ 1.24       $ 0.97   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

(1) Exclusive of shares held in the Rabbi Trust

NOTE 3 – ACCOUNTING STANDARDS UPDATES

Recently Adopted Accounting Standards Updates

ASU No. 2011-03: “Reconsideration of Effective Control for Repurchase Agreements”

In April 2011, ASU No. 2011-03 amended ASC Topic 310, “Transfers and Servicing” to eliminate from the assessment of effective control, the criteria calling for the transferor to have the ability to repurchase or redeem the financial assets on substantially the agreed upon terms, even in the event of the transferee’s default. The assessment of effective control should instead focus on the transferor’s contractual rights and obligations. The new authoritative guidance was effective for interim and annual periods beginning on or after December 15, 2011 and did not impact our consolidated financial statements.

ASU No. 2011-04: “Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS”

In May 2011, ASU No. 2011-04 amended ASC Topic 820, “Fair Value Measurement” to align fair value measurements and disclosures in GAAP and IFRS. The ASU changes the wording used to describe the requirements in GAAP for measuring fair value and disclosures about fair value.

The ASU clarifies the application of existing fair value measurements and disclosure requirements related to:

 

   

The application of highest and best use and valuation premise concepts.

 

   

Measuring the fair value of an instrument classified in a reporting entity’s stockholders’ equity.

 

   

Disclosure about fair value measurements within Level 3 of the fair value hierarchy.

The ASU also changes particular principles or requirements for measuring fair value and disclosing information measuring fair value and disclosures related to:

 

   

Measuring the fair value of financial instruments that are managed within a portfolio.

 

   

Application of premiums and discounts in a fair value measurement.

 

10


Table of Contents

The new authoritative guidance was effective for interim and annual periods beginning on or after December 15, 2011 and did not have a financial impact but increased the level of disclosures related to fair value measurements in our interim condensed consolidated financial statements in 2012.

ASU No. 2011-05: “Presentation of Comprehensive Income”

In June 2011, ASU No. 2011-05 amended ASC Topic 220, “Comprehensive Income” to improve the comparability, consistency, and transparency of financial reporting and to increase the prominence of items reported in other comprehensive income. In addition, to increase the prominence of items reported in other comprehensive income, and to facilitate the convergence of GAAP and IFRS, the FASB eliminated the option to present components of other comprehensive income as part of the statement of changes in shareholders’ equity.

The new authoritative guidance was effective for interim and annual periods beginning on or after December 15, 2011 and did not have an impact on our consolidated financial statements as we have historically elected to present a separate statement of comprehensive income.

Pending Accounting Standards Updates

ASU No. 2012-02: “Intangibles—Goodwill and Other (Topic 350): Testing Indefinite-Lived Intangible Assets for Impairment”

In August, ASU No. 2012-02 amended ASC Topic 350, “Goodwill and Other” to simplify the testing of intangible assets with indefinite lives. This update will allow for a qualitative assessment of intangible assets with indefinite lives to determine whether or not it is necessary to perform the impairment test described in ASC Topic 350. The new authoritative guidance is effective for fiscal years beginning after September 15, 2012 and is not expected to have any impact on our consolidated financial statements.

NOTE 4 – TRADING SECURITIES

Trading securities, at fair value, consist of the following investments at:

 

     September 30      December 31  
     2012      2011  

States and political subdivisions

   $ 1,788       $ 4,710   

Included in the net trading losses of $41 during the first nine months of 2012 were $13 of net unrealized trading losses on securities that were held in our trading portfolio as of September 30, 2012. Included in the net trading losses of $51 during the first nine months of 2011 were $45 of net unrealized trading losses on securities that were held in the trading portfolio as of September 30, 2011.

 

11


Table of Contents

NOTE 5 – AVAILABLE-FOR-SALE SECURITIES

The amortized cost and fair value of AFS securities, with gross unrealized gains and losses, are as follows at:

 

     September 30, 2012  
            Gross      Gross         
     Amortized      Unrealized      Unrealized      Fair  
     Cost      Gains      Losses      Value  

Government sponsored enterprises

   $ 1,925       $ 32       $ —         $ 1,957   

States and political subdivisions

     176,576         9,394         490         185,480   

Auction rate money market preferred

     3,200         —           429         2,771   

Preferred stocks

     6,800         56         496         6,360   

Mortgage-backed securities

     138,086         4,142         —           142,228   

Collateralized mortgage obligations

     125,949         2,773         104         128,618   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 452,536       $ 16,397       $ 1,519       $ 467,414   
  

 

 

    

 

 

    

 

 

    

 

 

 
     December 31, 2011  
            Gross      Gross         
     Amortized      Unrealized      Unrealized      Fair  
     Cost      Gains      Losses      Value  

Government sponsored enterprises

   $ 395       $ 2       $ —         $ 397   

States and political subdivisions

     166,832         8,157         51         174,938   

Auction rate money market preferred

     3,200         —           1,151         2,049   

Preferred stocks

     6,800         —           1,767         5,033   

Mortgage-backed securities

     140,842         2,807         47         143,602   

Collateralized mortgage obligations

     96,545         2,556         —           99,101   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 414,614       $ 13,522       $ 3,016       $ 425,120   
  

 

 

    

 

 

    

 

 

    

 

 

 

The amortized cost and fair value of AFS securities by contractual maturity at September 30, 2012 are as follows:

 

     Maturing      Securities
With
Variable
Monthly
Payments

or
Continual
Call Dates
        
     Due in
One Year
or Less
     After One
Year But
Within
Five Years
     After Five
Years But
Within
Ten Years
     After Ten
Years
        Total  

Government sponsored enterprises

   $ —         $ —         $ 72       $ 1,853       $ —         $ 1,925   

States and political subdivisions

     7,300         37,147         82,543         49,586         —           176,576   

Auction rate money market preferred

     —           —           —           —           3,200         3,200   

Preferred stocks

     —           —           —           —           6,800         6,800   

Mortgage-backed securities

     —           —           —           —           138,086         138,086   

Collateralized mortgage obligations

     —           —           —           —           125,949         125,949   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total amortized cost

   $ 7,300       $ 37,147       $ 82,615       $ 51,439       $ 274,035       $ 452,536   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Fair value

   $ 7,302       $ 38,237       $ 88,912       $ 52,986       $ 279,977       $ 467,414   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Expected maturities for government sponsored enterprises and states and political subdivisions may differ from contractual maturities because issuers may have the right to call or prepay obligations.

 

12


Table of Contents

As auction rate money market preferred and preferred stocks have continual call dates, they are not reported by a specific maturity group. Because of their variable monthly payments, mortgage-backed securities and collateralized mortgage obligations are not reported by a specific maturity group.

A summary of the activity related to sales of AFS securities was as follows for the nine month period ended September 30, 2012:

 

Proceeds from sales of securities

   $ 40,677   
  

 

 

 

Gross realized gains

   $ 1,119   
  

 

 

 

Applicable income tax expense

   $ 380   
  

 

 

 

There were no sales of AFS securities in the first nine months of 2011. The cost basis used to determine the realized gains or losses of securities sold was the amortized cost of the individual investment security as of the trade date.

Information pertaining to AFS securities with gross unrealized losses at September 30, 2012 and December 31, 2011 aggregated by investment category and length of time that individual securities have been in a continuous loss position, follows:

 

     September 30, 2012  
     Less Than Twelve
Months
     Over Twelve Months         
     Gross
Unrealized
Losses
     Fair
Value
     Gross
Unrealized
Losses
     Fair
Value
     Total
Unrealized
Losses
 

States and political subdivisions

   $ 1       $ 315       $ 489       $ 2,410       $ 490   

Auction rate money market preferred

     —           —           429         2,771         429   

Preferred stocks

     —           —           496         3,303         496   

Mortgage-backed securities

     —           —           —           —           —     

Collateralized mortgage obligations

     104         15,001         —           —           104   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 105       $ 15,316       $ 1,414       $ 8,484       $ 1,519   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Number of securities in an unrealized loss position:

        4            6         10   
     

 

 

       

 

 

    

 

 

 
     December 31, 2011  
     Less Than Twelve Months      Over Twelve Months         
     Gross
Unrealized
Losses
     Fair
Value
     Gross
Unrealized
Losses
     Fair
Value
     Total
Unrealized
Losses
 

States and political subdivisions

   $ 51       $ 1,410       $ —         $ —         $ 51   

Auction rate money market preferred

     —           —           1,151         2,049         1,151   

Preferred stocks

     —           —           1,767         5,033         1,767   

Mortgage-backed securities

     47         24,291         —           —           47   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 98       $ 25,701       $ 2,918       $ 7,082       $ 3,016   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Number of securities in an unrealized loss position:

        6            6         12   
     

 

 

       

 

 

    

 

 

 

As of September 30, 2012 and December 31, 2011, we conducted an analysis to determine whether any securities currently in an unrealized loss position should be other-than-temporarily impaired. Such analyses considered, among other factors, the following criteria:

 

   

Has the value of the investment declined more than what is deemed to be reasonable based on a risk and maturity adjusted discount rate?

 

   

Is the issuer’s investment credit rating below investment grade?

 

13


Table of Contents
   

Is it probable that the issuer will be unable to pay the amount when due?

 

   

Is it more likely than not that we will have to sell the security before recovery of its cost basis?

 

   

Has the duration of the investment been extended?

As of September 30, 2012, we held an auction rate money market preferred security and preferred stocks which continued to be in an unrealized loss position as a result of the securities’ interest rates, as they are currently lower than the offering rates of securities with similar characteristics. We determined that any declines in the fair value of these securities are the result of changes in interest rates and not risks related to the underlying credit quality of the security. Additionally, none of the issuers of these securities are deemed to be below investment grade, we do not intend to sell the securities in an unrealized loss position, and it is unlikely than that we will have to sell the securities before recovery of their cost basis.

During the three month period ended March 31, 2012, we had one state issued student loan auction rate AFS investment security (which is included in states and political subdivisions) that was downgraded by Moody’s from A3 to Caa3. As a result of this downgrade, we engaged the services of an independent investment valuation firm to estimate the amount of credit losses (if any) related to this particular issue as of March 31, 2012. The evaluation calculated a range of estimated credit losses utilizing two different bifurcation methods: 1) Estimated Cash Flow Method and 2) Credit Yield Analysis Method. The two methods were then weighted, with a higher weighting applied to the Estimated Cash Flow Method, to determine the estimated credit related impairment. As a result of this analysis we, recognized an OTTI of $282 in earnings in the first quarter of 2012.

A summary of key valuation assumptions used in the aforementioned analysis as of March 31, 2012, follows:

 

     Discounted
Cash Flow Method

Ratings

  

Fitch

   Not Rated

Moody’s

   Caa3

S&P

   A

Seniority

   Senior

Discount rate

   LIBOR + 6.35%
   Credit Yield
   Analysis Method
  

 

Credit discount rate

   LIBOR + 4.00%

Average observed discounts based on closed transactions

   14.00%

To test for additional impairment of this security during the three months ended September 30, 2012, we obtained another investment valuation (from the same firm engaged to perform the initial valuation as of March 31, 2012) as of September 30, 2012. Based on the results of this valuation, no additional OTTI was indicated as of September 30, 2012.

A rollforward of credit related impairment recognized in earnings on available-for-sale securities in the three and nine months ended September 30, 2012 was as follows:

 

     Three Months      Nine Months  
     Ended      Ended  
     September 30, 2012      September 30, 2012  

Balance at beginning of period

   $ 282       $ —     

Additions to credit losses for which no previous OTTI was recognized

     —           282   
  

 

 

    

 

 

 

September 30, 2012

   $ 282       $ 282   
  

 

 

    

 

 

 

 

14


Table of Contents

There were no credit losses recognized in earnings on available-for-sale securities during 2011.

Based on our analysis using the above criteria, the fact that we have asserted that we do not have the intent to sell these securities in an unrealized loss position, and it is unlikely that we will have to sell the securities before recovery of their cost basis, we do not believe that the values of any other securities are other-than-temporarily impaired as of September 30, 2012 or December 31, 2011.

NOTE 6 – LOANS AND ALLOWANCE FOR LOAN LOSSES

We grant commercial, agricultural, residential real estate, and consumer loans to customers situated primarily in Clare, Gratiot, Isabella, Mecosta, Midland, Montcalm, and Saginaw counties in Michigan. The ability of the borrowers to honor their repayment obligations is often dependent upon the real estate, agricultural, light manufacturing, retail, gaming and tourism, higher education, and general economic conditions of this region. Substantially all of the consumer and residential real estate loans are secured by various items of property, while commercial loans are secured primarily by real estate, business assets, and personal guarantees; a portion of loans are unsecured.

Loans that we have the intent and ability to hold in our portfolio are reported at their outstanding principal balance adjusted for any charge-offs, the ALLL, and any deferred fees or costs. Interest income on loans is accrued over the term of the loan based on the principal amount outstanding. Loan origination fees and certain direct loan origination costs are capitalized and recognized as a component of interest income over the term of the loan using the level yield method.

The accrual of interest on commercial, agricultural, and residential real estate loans is typically discontinued at the time the loan is 90 days or more past due unless the credit is well-secured and in the process of collection. Consumer loans are typically charged off no later than 180 days past due. Past due status is based on contractual terms of the loan. In all cases, loans are placed on nonaccrual or charged off at an earlier date if collection of principal or interest is considered doubtful.

For loans that are placed on nonaccrual status or charged off, all interest accrued in the current calendar year, but not collected, is reversed against interest income while interest accrued in prior calendar years, but not collected, is charged against the allowance for loan losses. The interest on these loans is accounted for on the cash basis, until qualifying for return to accrual status. Loans are typically returned to accrual status after six months of continuous performance. For impaired loans not classified as nonaccrual, interest income continues to be accrued over the term of the loan based on the principal amount outstanding.

Commercial and agricultural loans include loans for commercial real estate, commercial operating loans, farmland and agricultural production, and state and political subdivisions. Repayment of these loans is often dependent upon the successful operation and management of a business; thus, these loans generally involve greater risk than other types of lending. We minimize our risk by limiting the amount of loans to any one borrower to $12,500. Borrowers with credit needs of more than $12,500 are serviced through the use of loan participations with other commercial banks. Commercial and agricultural real estate loans generally require loan-to-value limits of less than 80%. Depending upon the type of loan, past credit history, and current operating results, we may require the borrower to pledge accounts receivable, inventory, and property and equipment. Personal guarantees are generally required from the owners of closely held corporations, partnerships, and sole proprietorships. In addition, we require annual financial statements, prepare cash flow analyses, and review credit reports as deemed necessary.

We offer adjustable rate mortgages, fixed rate balloon mortgages, construction loans, and fixed rate mortgage loans which typically have amortization periods up to a maximum of 30 years. Fixed rate loans with an amortization of greater than 15 years are generally sold upon origination to Freddie Mac. Fixed rate residential real estate loans with an amortization of 15 years or less may be held in our portfolio, held for future sale, or sold upon origination. We consider the direction of interest rates, the sensitivity of our balance sheet to changes in interest rates, and overall loan demand to determine whether or not to sell these loans to Freddie Mac.

 

15


Table of Contents

Our lending policies generally limit the maximum loan-to-value ratio on residential real estate loans to 95% of the lower of the appraised value of the property or the purchase price, with the condition that private mortgage insurance is required on loans with loan to value ratios in excess of 80%. Substantially all loans upon origination have a loan to value ratio of less than 80%. Underwriting criteria for residential real estate loans include: evaluation of the borrower’s ability to make monthly payments, the value of the property securing the loan, ensuring the payment of principal, interest, taxes, and hazard insurance does not exceed 28% of a borrower’s gross income, all debt servicing does not exceed 36% of income, acceptable credit reports, verification of employment, income, and financial information. Appraisals are performed by independent appraisers and reviewed internally. All mortgage loan requests are reviewed by our mortgage loan committee or through a secondary market automated underwriting system; loans in excess of $400 require the approval of our Internal Loan Committee, the Board of Directors’ Loan Committee, or the Board of Directors.

Consumer loans include automobile loans, secured and unsecured personal loans, and overdraft protection related loans. Loans are amortized generally for a period of up to 6 years. The underwriting emphasis is on a borrower’s perceived intent and ability to pay rather than collateral value. No consumer loans are sold to the secondary market.

The ALLL is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the ALLL when we believe the uncollectibility of the loan balance is confirmed. Subsequent recoveries, if any, are credited to the ALLL.

The ALLL is evaluated on a regular basis and is based upon a periodic review of the collectibility of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral, and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.

The primary factors behind the determination of the level of the ALLL are specific allocations for impaired loans, historical loss percentages, as well as unallocated components. Specific allocations for impaired loans are primarily determined based on the difference between the net realizable value of the loan’s underlying collateral or the net present value of the projected payment stream and our recorded investment. Historical loss allocations were calculated at the loan class and segment levels based on a migration analysis of the loan portfolio over the preceding four years. An unallocated component is maintained to cover uncertainties that we believe affect our estimate of probable losses based on qualitative factors. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.

A summary of changes in the ALLL and the recorded investment in loans by segments follows:

 

     Allowance for Loan Losses
Three Months Ended September 30, 2012
 
     Commercial     Agricultural      Residential
Real Estate
    Consumer     Unallocated     Total  

Allowance for loan losses

             

July 1, 2012

   $ 6,008      $ 433       $ 3,669      $ 667      $ 1,541      $ 12,318   

Loans charged off

     (271     —           (213     (127     —          (611

Recoveries

     40        —           34        81        —          155   

Provision for loan losses

     1,132        6         (356     91        (673     200   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

September 30, 2012

   $ 6,909      $ 439       $ 3,134      $ 712      $ 868      $ 12,062   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

 

16


Table of Contents
     Allowance for Loan Losses
Nine Months Ended September 30, 2012
 
     Commercial     Agricultural     Residential
Real Estate
    Consumer     Unallocated     Total  

Allowance for loan losses

            

January 1, 2012

   $ 6,284      $ 1,003      $ 2,980      $ 633      $ 1,475      $ 12,375   

Loans charged off

     (957     —          (566     (364     —          (1,887

Recoveries

     168        —          95        211        —          474   

Provision for loan losses

     1,414        (564     625        232        (607     1,100   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

September 30, 2012

   $ 6,909      $ 439      $ 3,134      $ 712      $ 868      $ 12,062   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

     Allowance for Loan Losses and Recorded Investment in Loans
As of September 30, 2012
 
     Commercial      Agricultural      Residential
Real Estate
     Consumer      Unallocated      Total  

Allowance for loan losses

                 

Individually evaluated for impairment

   $ 2,915       $ —         $ 1,354       $ —         $ —         $ 4,269   

Collectively evaluated for impairment

     3,994         439         1,780         712         868         7,793   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 6,909       $ 439       $ 3,134       $ 712       $ 868       $ 12,062   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Loans

                 

Individually evaluated for impairment

   $ 16,593       $ 2,281       $ 8,429       $ 79          $ 27,382   

Collectively evaluated for impairment

     352,773         81,158         272,002         33,436            739,369   
  

 

 

    

 

 

    

 

 

    

 

 

       

 

 

 

Total

   $ 369,366       $ 83,439       $ 280,431       $ 33,515          $ 766,751   
  

 

 

    

 

 

    

 

 

    

 

 

       

 

 

 

 

     Allowance for Loan Losses
Three Months Ended September 30, 2011
 
     Commercial     Agricultural     Residential
Real Estate
    Consumer     Unallocated      Total  

Allowance for loan losses

             

July 1, 2011

   $ 6,738      $ 764      $ 2,885      $ 660      $ 1,331       $ 12,378   

Loans charged off

     (215     —          (857     (98     —           (1,170

Recoveries

     75        1        39        87        —           202   

Provision for loan losses

     116        (331     1,148        (3     33         963   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

    

 

 

 

September 30, 2011

   $ 6,714      $ 434      $ 3,215      $ 646      $ 1,364       $ 12,373   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

    

 

 

 

 

17


Table of Contents
     Allowance for Loan Losses
Nine Months Ended September 30, 2011
 
     Commercial     Agricultural     Residential
Real Estate
    Consumer     Unallocated     Total  

Allowance for loan losses

            

January 1, 2011

   $ 6,048      $ 1,033      $ 3,198      $ 605      $ 1,489      $ 12,373   

Loans charged off

     (1,084     (1     (1,735     (382     —          (3,202

Recoveries

     421        1        142        255        —          819   

Provision for loan losses

     1,329        (599     1,610        168        (125     2,383   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

September 30, 2011

   $ 6,714      $ 434      $ 3,215      $ 646      $ 1,364      $ 12,373   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

     Allowance for Loan Losses and Recorded Investment in Loans
As of December 31, 2011
 
     Commercial      Agricultural      Residential
Real Estate
     Consumer      Unallocated      Total  

Allowance for loan losses

                 

Individually evaluated for impairment

   $ 2,152       $ 822       $ 1,146       $ —         $ —         $ 4,120   

Collectively evaluated for impairment

     4,132         181         1,834         633         1,475         8,255   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 6,284       $ 1,003       $ 2,980       $ 633       $ 1,475       $ 12,375   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Loans

                 

Individually evaluated for impairment

   $ 14,097       $ 3,384       $ 7,664       $ 105          $ 25,250   

Collectively evaluated for impairment

     351,617         71,261         270,696         31,467            725,041   
  

 

 

    

 

 

    

 

 

    

 

 

       

 

 

 

Total

   $ 365,714       $ 74,645       $ 278,360       $ 31,572          $ 750,291   
  

 

 

    

 

 

    

 

 

    

 

 

       

 

 

 

The following table displays the credit quality indicators for commercial and agricultural credit exposures based on internally assigned credit ratings as of:

 

     September 30, 2012  
     Commercial      Agricultural  
     Real Estate      Other      Total      Real Estate      Other      Total  

Rating

                 

2 - High quality

   $ 25,824       $ 16,871       $ 42,695       $ 2,591       $ 2,196       $ 4,787   

3 - High satisfactory

     82,108         26,977         109,085         16,293         9,615         25,908   

4 - Low satisfactory

     126,649         47,965         174,614         25,073         20,704         45,777   

5 - Special mention

     13,224         2,271         15,495         961         2,751         3,712   

6 - Substandard

     19,124         2,404         21,528         1,631         1,363         2,994   

7 - Vulnerable

     2,783         2,358         5,141         —           —           —     

8 - Doubtful

     785         23         808         —           261         261   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 270,497       $ 98,869       $ 369,366       $ 46,549       $ 36,890       $ 83,439   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

18


Table of Contents
     December 31, 2011  
     Commercial      Agricultural  
     Real Estate      Other      Total      Real Estate      Other      Total  

Rating

                 

2 - High quality

   $ 11,113       $ 11,013       $ 22,126       $ 3,583       $ 1,390       $ 4,973   

3 - High satisfactory

     90,064         29,972         120,036         11,154         5,186         16,340   

4 - Low satisfactory

     118,611         57,572         176,183         24,253         15,750         40,003   

5 - Special mention

     15,482         4,200         19,682         3,863         2,907         6,770   

6 - Substandard

     19,017         4,819         23,836         1,640         4,314         5,954   

7 - Vulnerable

     187         —           187         —           —           —     

8 - Doubtful

     3,621         43         3,664         190         415         605   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 258,095       $ 107,619       $ 365,714       $ 44,683       $ 29,962       $ 74,645   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Internally assigned risk ratings are reviewed, at a minimum, when loans are renewed or when management has knowledge of improvements or deterioration of the credit quality of individual credits. Descriptions of the internally assigned risk ratings for commercial and agricultural loans are as follows:

 

1. EXCELLENT – Substantially Risk Free

Credit has strong financial condition and solid earnings history, characterized by:

 

   

High liquidity, strong cash flow, low leverage.

 

   

Unquestioned ability to meet all obligations when due.

 

   

Experienced management, with management succession in place.

 

   

Secured by cash.

 

2. HIGH QUALITY – Limited Risk

Credit with sound financial condition and has a positive trend in earnings supplemented by:

 

   

Favorable liquidity and leverage ratios.

 

   

Ability to meet all obligations when due.

 

   

Management with successful track record.

 

   

Steady and satisfactory earnings history.

 

   

If loan is secured, collateral is of high quality and readily marketable.

 

   

Access to alternative financing.

 

   

Well defined primary and secondary source of repayment.

 

   

If supported by guaranty, the financial strength and liquidity of the guarantor(s) are clearly evident.

 

3. HIGH SATISFACTORY – Reasonable Risk

Credit with satisfactory financial condition and further characterized by:

 

   

Working capital adequate to support operations.

 

   

Cash flow sufficient to pay debts as scheduled.

 

   

Management experience and depth appear favorable.

 

   

Loan performing according to terms.

 

   

If loan is secured, collateral is acceptable and loan is fully protected.

 

19


Table of Contents
4. LOW SATISFACTORY – Acceptable Risk

Credit with bankable risks, although some signs of weaknesses are shown:

 

   

Would include most start-up businesses.

 

   

Occasional instances of trade slowness or repayment delinquency – may have been 10-30 days slow within the past year.

 

   

Management’s abilities are apparent, yet unproven.

 

   

Weakness in primary source of repayment with adequate secondary source of repayment.

 

   

Loan structure generally in accordance with policy.

 

   

If secured, loan collateral coverage is marginal.

 

   

Adequate cash flow to service debt, but coverage is low.

To be classified as less than satisfactory, only one of the following criteria must be met.

 

5. SPECIAL MENTION – Criticized

Credit constitutes an undue and unwarranted credit risk but not to the point of justifying a classification of substandard. The credit risk may be relatively minor yet constitute an unwarranted risk in light of the circumstances surrounding a specific loan:

 

   

Downward trend in sales, profit levels, and margins.

 

   

Impaired working capital position.

 

   

Cash flow is strained in order to meet debt repayment.

 

   

Loan delinquency (30-60 days) and overdrafts may occur.

 

   

Shrinking equity cushion.

 

   

Diminishing primary source of repayment and questionable secondary source.

 

   

Management abilities are questionable.

 

   

Weak industry conditions.

 

   

Litigation pending against the borrower.

 

   

Collateral or guaranty offers limited protection.

 

   

Negative debt service coverage, however the credit is well collateralized and payments are current.

 

6. SUBSTANDARD – Classified

Credit where the borrower’s current net worth, paying capacity, and value of the collateral pledged is inadequate. There is a distinct possibility that we will implement collection procedures if the loan deficiencies are not corrected. In addition, the following characteristics may apply:

 

   

Sustained losses have severely eroded the equity and cash flow.

 

   

Deteriorating liquidity.

 

   

Serious management problems or internal fraud.

 

   

Original repayment terms liberalized.

 

   

Likelihood of bankruptcy.

 

   

Inability to access other funding sources.

 

   

Reliance on secondary source of repayment.

 

   

Litigation filed against borrower.

 

   

Collateral provides little or no value.

 

   

Requires excessive attention of the loan officer.

 

   

Borrower is uncooperative with loan officer.

 

20


Table of Contents
7. VULNERABLE – Classified

Credit is considered “Substandard” and warrants placing on nonaccrual. Risk of loss is being evaluated and exit strategy options are under review. Other characteristics that may apply:

 

   

Insufficient cash flow to service debt.

 

   

Minimal or no payments being received.

 

   

Limited options available to avoid the collection process.

 

   

Transition status, expect action will take place to collect loan without immediate progress being made.

 

8. DOUBTFUL – Workout

Credit has all the weaknesses inherent in a “Substandard” loan with the added characteristic that collection and/or liquidation is pending. The possibility of a loss is extremely high, but its classification as a loss is deferred until liquidation procedures are completed, or reasonably estimable. Other characteristics that may apply:

 

   

Normal operations are severely diminished or have ceased.

 

   

Seriously impaired cash flow.

 

   

Original repayment terms materially altered.

 

   

Secondary source of repayment is inadequate.

 

   

Survivability as a “going concern” is impossible.

 

   

Collection process has begun.

 

   

Bankruptcy petition has been filed.

 

   

Judgments have been filed.

 

   

Portion of the loan balance has been charged-off.

 

9. LOSS – Charge off

Credits are considered uncollectible and of such little value that their continuance as bankable assets is not warranted. This classification is for charged off loans but does not mean that the asset has absolutely no recovery or salvage value. These loans are further characterized by:

 

   

Liquidation or reorganization under bankruptcy, with poor prospects of collection.

 

   

Fraudulently overstated assets and/or earnings.

 

   

Collateral has marginal or no value.

 

   

Debtor cannot be located.

 

   

Over 120 days delinquent.

 

21


Table of Contents

Our primary credit quality indicators for residential real estate and consumer loans is the individual loan’s past due aging. The following tables summarize the past due and current loans as of:

 

     September 30, 2012  
     Accruing Interest
and Past Due:
           

Total

Past Due

               
     30-89
Days
     90 Days
or More
     Nonaccrual      and
Nonaccrual
     Current      Total  

Commercial

                 

Commercial real estate

   $ 4,100       $ 86       $ 2,939       $ 7,125       $ 263,372       $ 270,497   

Commercial other

     680         114         2,369         3,163         95,706         98,869   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total commercial

     4,780         200         5,308         10,288         359,078         369,366   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Agricultural

                 

Agricultural real estate

     36         91         —           127         46,422         46,549   

Agricultural other

     328         —           261         589         36,301         36,890   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total agricultural

     364         91         261         716         82,723         83,439   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Residential real estate

                 

Senior liens

     2,824         177         1,239         4,240         218,895         223,135   

Junior liens

     184         —           32         216         17,233         17,449   

Home equity lines of credit

     238         —           185         423         39,424         39,847   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total residential real estate

     3,246         177         1,456         4,879         275,552         280,431   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Consumer

                 

Secured

     220         —           —           220         27,938         28,158   

Unsecured

     64         —           —           64         5,293         5,357   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total consumer

     284         —           —           284         33,231         33,515   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 8,674       $ 468       $ 7,025       $ 16,167       $ 750,584       $ 766,751   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

     December 31, 2011  
     Accruing Interest
and Past Due:
           

Total

Past Due

               
     30-89
Days
     90 Days
or More
     Nonaccrual      and
Nonaccrual
     Current      Total  

Commercial

                 

Commercial real estate

   $ 1,721       $ 364       $ 4,176       $ 6,261       $ 251,834       $ 258,095   

Commercial other

     426         3         25         454         107,165         107,619   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total commercial

     2,147         367         4,201         6,715         358,999         365,714   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Agricultural

                 

Agricultural real estate

     —           99         189         288         44,395         44,683   

Agricultural other

     2         —           415         417         29,545         29,962   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total agricultural

     2         99         604         705         73,940         74,645   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Residential real estate

                 

Senior liens

     3,004         124         1,292         4,420         213,181         217,601   

Junior liens

     235         40         94         369         20,877         21,246   

Home equity lines of credit

     185         125         198         508         39,005         39,513   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total residential real estate

     3,424         289         1,584         5,297         273,063         278,360   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Consumer

                 

Secured

     158         5         —           163         26,011         26,174   

Unsecured

     23         —           —           23         5,375         5,398   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total consumer

     181         5         —           186         31,386         31,572   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 5,754       $ 760       $ 6,389       $ 12,903       $ 737,388       $ 750,291   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

22


Table of Contents

Impaired Loans

Loans may be classified as impaired if they meet one or more of the following criteria:

 

  1. There has been a chargeoff of its principal balance (in whole or in part);

 

  2. The loan has been classified as a Troubled Debt Restructuring (TDR); or

 

  3. The loan is in nonaccrual status.

Impairment is measured on a loan by loan basis for commercial, commercial real estate, agricultural, or agricultural real estate loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral, less cost to sell, if the loan is collateral dependent. Large groups of smaller balance homogeneous loans are collectively evaluated for impairment.

Interest income is recognized on impaired loans in nonaccrual status on the cash basis, but only after all principal has been collected. For impaired loans not in nonaccrual status, interest income is recognized daily as earned according to the terms of the loan agreement.

The following is a summary of information pertaining to impaired loans as of and for the periods ended:

 

     September 30, 2012      December 31, 2011  
     Outstanding
Balance
     Unpaid
Principal
Balance
     Valuation
Allowance
     Outstanding
Balance
     Unpaid
Principal
Balance
     Valuation
Allowance
 

Impaired loans with a valuation allowance

                 

Commercial real estate

   $ 6,392       $ 6,673       $ 2,259       $ 5,014       $ 5,142       $ 1,881   

Commercial other

     3,047         3,047         656         734         734         271   

Agricultural other

     —           —           —           2,689         2,689         822   

Residential real estate senior liens

     8,089         9,237         1,326         7,271         8,827         1,111   

Residential real estate junior liens

     152         198         28         195         260         35   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total impaired loans with a valuation allowance

   $ 17,680       $ 19,155       $ 4,269       $ 15,903       $ 17,652       $ 4,120   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Impaired loans without a valuation allowance

                 

Commercial real estate

   $ 5,356       $ 6,128          $ 7,984       $ 10,570      

Commercial other

     1,798         1,908            365         460      

Agricultural real estate

     —           —              190         190      

Agricultural other

     2,281         2,401            505         625      

Residential real estate senior liens

     3         65            —           —        

Home equity lines of credit

     185         485            198         498      

Consumer secured

     79         88            105         114      
  

 

 

    

 

 

       

 

 

    

 

 

    

Total impaired loans without a valuation allowance

   $ 9,702       $ 11,075          $ 9,347       $ 12,457      
  

 

 

    

 

 

       

 

 

    

 

 

    

Impaired loans

                 

Commercial

   $ 16,593       $ 17,756       $ 2,915       $ 14,097       $ 16,906       $ 2,152   

Agricultural

     2,281         2,401         —           3,384         3,504         822   

Residential real estate

     8,429         9,985         1,354         7,664         9,585         1,146   

Consumer

     79         88         —           105         114         —     
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total impaired loans

   $ 27,382       $ 30,230       $ 4,269       $ 25,250       $ 30,109       $ 4,120   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

23


Table of Contents
     Three Months Ended
September 30, 2012
     Nine Months Ended
September 30, 2012
 
     Average
Outstanding
Balance
     Interest
Income
Recognized
     Average
Outstanding
Balance
     Interest
Income
Recognized
 

Impaired loans with a valuation allowance

           

Commercial real estate

   $ 6,260       $ 106       $ 6,197       $ 287   

Commercial other

     1,996         67         1,183         95   

Agricultural other

     1,023         —           1,878         73   

Residential real estate senior liens

     7,992         86         7,802         261   

Residential real estate junior liens

     158         3         174         7   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total impaired loans with a valuation allowance

   $ 17,429       $ 262       $ 17,234       $ 723   
  

 

 

    

 

 

    

 

 

    

 

 

 

Impaired loans without a valuation allowance

           

Commercial real estate

   $ 5,651       $ 72       $ 6,749       $ 251   

Commercial other

     2,026         15         1,860         80   

Agricultural real estate

     179         —           214         —     

Agricultural other

     1,417         34         869         41   

Residential real estate senior liens

     2         2         1         2   

Home equity lines of credit

     188         6         194         14   

Consumer secured

     81         2         90         5   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total impaired loans without a valuation allowance

   $ 9,544       $ 131       $ 9,977       $ 393   
  

 

 

    

 

 

    

 

 

    

 

 

 

Impaired loans

           

Commercial

   $ 15,933       $ 260       $ 15,989       $ 713   

Agricultural

     2,619         34         2,961         114   

Residential real estate

     8,340         97         8,171         284   

Consumer

     81         2         90         5   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total impaired loans

   $ 26,973       $ 393       $ 27,211       $ 1,116   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

24


Table of Contents
     Three Months Ended
September 30, 2011
    Nine Months Ended
September 30, 2011
 
     Average
Outstanding
Balance
     Interest
Income
Recognized
    Average
Outstanding
Balance
     Interest
Income
Recognized
 

Impaired loans with a valuation allowance

          

Commercial real estate

   $ 4,770       $ 130      $ 4,402       $ 250   

Commercial other

     586         16        577         16   

Agricultural real estate

     58         3        58         3   

Agricultural other

     720         (38     1,140         4   

Residential real estate senior liens

     6,174         115        5,621         221   

Residential real estate junior liens

     179         1        165         5   
  

 

 

    

 

 

   

 

 

    

 

 

 

Total impaired loans with a valuation allowance

   $ 12,487       $ 227      $ 11,963       $ 499   
  

 

 

    

 

 

   

 

 

    

 

 

 

Impaired loans without a valuation allowance

          

Commercial real estate

   $ 5,743       $ 124      $ 3,878       $ 219   

Commercial other

     1,941         37        1,076         124   

Agricultural real estate

     207         2        112         1   

Agricultural other

     2,411         112        1,770         151   

Residential real estate senior liens

     —           1        201         1   

Home equity lines of credit

     100         10        100         10   

Consumer secured

     50         2        61         5   
  

 

 

    

 

 

   

 

 

    

 

 

 

Total impaired loans without a valuation allowance

   $ 10,452       $ 288      $ 7,198       $ 511   
  

 

 

    

 

 

   

 

 

    

 

 

 

Impaired loans

          

Commercial

   $ 13,040       $ 307      $ 9,933       $ 609   

Agricultural

     3,396         79        3,080         159   

Residential real estate

     6,453         127        6,087         237   

Consumer

     50         2        61         5   
  

 

 

    

 

 

   

 

 

    

 

 

 

Total impaired loans

   $ 22,939       $ 515      $ 19,161       $ 1,010   
  

 

 

    

 

 

   

 

 

    

 

 

 

Impaired loans, which include TDR’s, had $173 and $68 of unfunded commitments under lines of credit as of September 30, 2012 and 2011, respectively.

 

25


Table of Contents

Troubled Debt Restructurings

Loan modifications are considered to be TDR’s when a concession has been granted to a borrower who is experiencing financial difficulties.

Typical concessions granted include, but are not limited to:

 

  1. Agreeing to interest rates below prevailing market rates for debt with similar risk characteristics.

 

  2. Extending the amortization period beyond typical lending guidelines for debt with similar risk characteristics.

 

  3. Forbearance of principal.

 

  4. Forbearance of accrued interest.

To determine if a borrower is experiencing financial difficulties, we consider if:

 

  1. The borrower is currently in default on any of their debt.

 

  2. The borrower will likely default on any of their debt if the concession is not granted.

 

  3. The borrower’s cash flow is insufficient to service all of their debt if the concession is not granted.

 

  4. The borrower has declared, or is in the process of declaring, bankruptcy.

 

  5. The borrower is unlikely to continue as a going concern (if the entity is a business).

The following is a summary of information pertaining to TDR’s for the three and nine month periods ended September 30, 2012:

 

     Loans Restructured in the Three Month
Period ended September 30, 2012
     Loans Restructured in the Nine Month
Period ended September 30, 2012
 
     Number
of
Loans
     Pre-
Modification
Recorded
Investment
     Post-
Modification
Recorded
Investment
     Number
of
Loans
     Pre-
Modification
Recorded
Investment
     Post-
Modification
Recorded
Investment
 

Commercial other

     1       $ 178       $ 178         27       $ 5,069       $ 5,069   

Agricultural other

     —           —           —           6         561         561   

Residential real estate senior liens

     —           —           —           12         1,405         1,405   

Residential real estate junior liens

     1         22         22         1         22         22   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

     2       $ 200       $ 200         46       $ 7,057       $ 7,057   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

26


Table of Contents
     Loans Restructured in the Three Month
Period ended September 30, 2011
     Loans Restructured in the Nine Month
Period ended September 30, 2011
 
     Number
of
Loans
     Pre-
Modification
Recorded
Investment
     Post-
Modification
Recorded
Investment
     Number
of
Loans
     Pre-
Modification
Recorded
Investment
     Post-
Modification
Recorded
Investment
 

Commercial

                 

Commercial real estate

     1       $ 408       $ 408         1       $ 408       $ 408   

Commercial other

     21         4,069         3,737         42         12,143         11,700   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total commercial

     22         4,477         4,145         43         12,551         12,108   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Agricultural other

     3         143         143         11         1,481         1,481   

Residential real estate senior liens

     3         165         165         23         2,454         2,424   

Consumer secured

     3         34         34         5         50         50   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

     31       $ 4,819       $ 4,487         82       $ 16,536       $ 16,063   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

     Loans Restructured in the Three Month
Period Ended September 30, 2012
     Loans Restructured in the Nine Month
Period Ended September 30, 2012
 
     Below Market
Interest Rate
     Below Market
Interest Rate
and
Extension of
Amortization Period
     Below Market
Interest Rate
     Below Market
Interest Rate
and
Extension of
Amortization Period
 
     Number
of
Loans
     Pre-
Modification
Recorded
Investment
     Number
of
Loans
     Pre-
Modification
Recorded
Investment
     Number
of
Loans
     Pre-
Modification
Recorded
Investment
     Number
of
Loans
     Pre-
Modification
Recorded
Investment
 

Commercial other

     1       $ 178         —         $ —           25       $ 4,924         2       $ 145   

Agricultural other

     —           —           —           —           6         561         —           —     

Residential real estate senior liens

     —           —           —           —           4         324         8         1,081   

Residential real estate junior liens

     —           —           1         22         —           —           1         22   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

     1       $ 178         1       $ 22         35       $ 5,809         11       $ 1,248   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

27


Table of Contents
     Loans Restructured in the Three Month
Period Ended September 30, 2011
 
     Below Market
Interest Rate
     Extension of
Amortization Period
     Below Market
Interest Rate
and
Extension of
Amortization Period
 
     Number
of
Loans
     Pre-
Modification
Recorded
Investment
     Number
of
Loans
     Pre-
Modification
Recorded
Investment
     Number
of
Loans
     Pre-
Modification
Recorded
Investment
 

Commercial

                 

Commercial real estate

     1       $ 408         —         $ —           —         $ —     

Commercial other

     21         4,069         —           —           —           —     
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total commercial

     22         4,477         —           —           —           —     
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Agricultural other

     3         143         —           —           —           —     

Residential real estate senior liens

     1         85         1         7         1         73   

Consumer secured

     3         34         —           —           —           —     
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

     29       $ 4,739         1       $ 7         1       $ 73   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

     Loans Restructured in the Nine Month
Period Ended September 30, 2012
 
     Below Market
Interest Rate
     Extension of
Amortization Period
     Below Market
Interest Rate
and
Extension of
Amortization Period
 
     Number
of
Loans
     Pre-
Modification
Recorded
Investment
     Number
of
Loans
     Pre-
Modification
Recorded
Investment
     Number
of
Loans
     Pre-
Modification
Recorded
Investment
 

Commercial

                 

Commercial real estate

     1       $ 408         —         $ —           —         $ —     

Commercial other

     38         9,500         3         913         1         1,730   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total commercial

     39         9,908         3         913         1         1,730   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Agricultural other

     11         1,481         —           —           —           —     

Residential real estate senior liens

     18         2,083         2         57         3         314   

Consumer secured

     5         50         —           —           —           —     
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

     73       $ 13,522         5       $ 970         4       $ 2,044   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

We did not restructure any loans through the forbearance of principal or accrued interest in the three or nine month periods ended September 30, 2012 or 2011.

Based on our historical loss experience, losses associated with TDR’s are not significantly different than other impaired loans within the same loan segment. As such, TDR’s, including TDR’s that have been modified in the past 12 months that subsequently defaulted, are analyzed in the same manner as other impaired loans within their respective loan segment.

 

28


Table of Contents

Following is a summary of loans that defaulted in the three and nine month periods ended September 30, 2012, which were modified within 12 months prior to the default date:

 

     Three Months Ended September 30, 2012      Nine Months Ended September 30, 2012  
     Number
of
Loans
     Pre-
Default
Recorded
Investment
     Charge Off
Recorded
Upon Default
     Post-
Default
Recorded
Investment
     Number
of
Loans
     Pre-
Default
Recorded
Investment
     Charge Off
Recorded
Upon Default
     Post-
Default
Recorded
Investment
 

Commercial other

     2       $ 50       $ 25       $ 25         3       $ 132       $ 66       $ 66   

Residential real estate senior liens

     —           —           —           —           1         47         43         4   

Consumer secured

     1         8         8         —           1         8         8         —     
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

     3       $ 58       $ 33       $ 25         5       $ 187       $ 117       $ 70   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

We had no loans that defaulted during the first nine months of 2011, which were modified within 12 months prior to the default date.

The following is a summary of TDR loan balances as of:

 

     September 30
2012
     December 31
2011
 

Troubled debt restructurings

   $ 21,061       $ 18,756   

NOTE 7 – EQUITY SECURITIES WITHOUT READILY DETERMINABLE FAIR VALUES

Included in equity securities without readily determinable fair values are restricted securities, which are carried at cost, and investments in nonconsolidated entities accounted for under the equity method of accounting.

Equity securities without readily determinable fair values consist of the following as of:

 

     September 30
2012
     December 31
2011
 

Federal Home Loan Bank Stock

   $ 7,700       $ 7,380   

Investment in Corporate Settlement Solutions

     6,932         6,611   

Federal Reserve Bank Stock

     1,879         1,879   

Investment in Valley Financial Corporation

     1,000         1,000   

Other

     319         319   
  

 

 

    

 

 

 

Total

   $ 17,830       $ 17,189   
  

 

 

    

 

 

 

NOTE 8 – BORROWED FUNDS

Borrowed funds consist of the following obligations as of:

 

     September 30, 2012     December 31, 2011  
     Amount      Rate     Amount      Rate  

Federal Home Loan Bank advances

   $ 152,000         2.15   $ 142,242         3.16

Securities sold under agreements to repurchase without stated maturity dates

     57,927         0.20     57,198         0.25

Securities sold under agreements to repurchase with stated maturity dates

     16,653         3.51     16,696         3.51
  

 

 

    

 

 

   

 

 

    

 

 

 

Total

   $ 226,580         1.75   $ 216,136         2.42
  

 

 

    

 

 

   

 

 

    

 

 

 

The FHLB advances are collateralized by a blanket lien on all qualified 1-4 family residential real estate loans and certain mortgage-backed securities and collateralized mortgage obligations. Advances are also secured by our holdings of FHLB stock. We had the ability to borrow up to an additional $117,035 based on assets currently pledged as collateral as of September 30, 2012. During the first quarter of 2012, we reduced funding costs by modifying the terms of $60,000 of FHLB advances.

 

29


Table of Contents

The following table lists the maturity and weighted average interest rates of FHLB advances as of:

 

     September 30
2012
    December 31
2011
 
     Amount      Rate     Amount      Rate  

Fixed rate advances due 2012

   $ —           —        $ 17,000         2.97

One year putable fixed rate advances due 2012

     5,000         3.48     15,000         4.10

Variable rate advances due 2012

     5,000         0.50     —           —     

Fixed rate advances due 2013

     —           —          5,242         4.14

One year putable fixed rate advances due 2013

     —           —          5,000         3.15

Fixed rate advances due 2014

     —           —          25,000         3.16

Fixed rate advances due 2015

     42,000         1.12     45,000         3.30

Fixed rate advances due 2016

     10,000         2.15     10,000         2.15

Fixed rate advances due 2017

     40,000         2.15     20,000         2.56

Fixed rate advances due 2018

     20,000         2.86     —           —     

Fixed rate advances due 2019

     20,000         3.73     —           —     

Fixed rate advances due 2020

     10,000         1.98     —           —     
  

 

 

    

 

 

   

 

 

    

 

 

 

Total

   $ 152,000         2.15   $ 142,242         3.16
  

 

 

    

 

 

   

 

 

    

 

 

 

Securities sold under agreements to repurchase are classified as secured borrowings. Securities sold under agreements to repurchase without stated maturity dates generally mature within one to four days from the transaction date. Securities sold under agreements to repurchase are reflected at the amount of cash received in connection with the transaction. The securities underlying the agreements have a carrying value and a fair value of $112,873 and $99,869 at September 30, 2012 and December 31, 2011, respectively. Such securities remain under our control. We may be required to provide additional collateral based on the fair value of underlying securities.

The following table provides a summary of short term borrowings for the three and nine month periods ended September 30:

 

     Three Months Ended September 30  
     2012     2011  
     Maximum
Month-End
Balance
     Quarter
to Date
Average
Balance
     Weighted
Average
Interest Rate
During the
Period
    Maximum
Month-End
Balance
     Quarter
to Date
Average
Balance
     Weighted
Average
Interest Rate
During the
Period
 

Securities sold under agreements to repurchase without stated maturity dates

   $ 58,471       $ 57,983         0.20   $ 49,583       $ 47,871         0.25

Federal funds purchased

     15,000         5,848         0.46     18,300         2,563         0.46

 

30


Table of Contents
     Nine Months Ended September 30  
     2012     2011  
     Maximum
Month-End
Balance
     YTD
Average
Balance
     Weighted
Average
Interest Rate
During the
Period
    Maximum
Month-End
Balance
     YTD
Average
Balance
     Weighted
Average
Interest Rate
During the
Period
 

Securities sold under agreements to repurchase without stated maturity dates

   $ 58,584       $ 55,721         0.20   $ 49,583       $ 42,515         0.25

Federal funds purchased

     17,900         4,327         0.41     18,300         2,776         0.51

We had pledged certificates of deposit held in other financial institutions, trading securities, available-for-sale securities, and 1-4 family residential real estate loans in the following amounts at:

 

     September 30
2012
     December 31
2011
 

Pledged to secure borrowed funds

   $ 308,797       $ 292,092   

Pledged to secure repurchase agreements

     112,873         99,869   

Pledged for public deposits and for other purposes necessary or required by law

     23,480         26,761   
  

 

 

    

 

 

 

Total

   $ 445,150       $ 418,722   
  

 

 

    

 

 

 

We had no investment securities that are restricted to be pledged for specific purposes.

NOTE 9 – OTHER NONINTEREST EXPENSES

A summary of expenses included in other noninterest expenses are as follows for the three and nine month periods ended:

 

     Three Months Ended
September  30
     Nine Months Ended
September 30
 
     2012      2011      2012      2011  

Marketing and donations

   $ 610       $ 228       $ 1,639       $ 978   

FDIC insurance premiums

     218         209         646         874   

Directors fees

     235         203         654         620   

Audit fees

     179         195         509         518   

Education and travel

     112         102         378         306   

Printing and supplies

     91         108         310         297   

Postage and freight

     105         103         300         299   

Foreclosed asset and collection

     21         143         100         420   

Consulting fees

     92         63         350         163   

Amortization of deposit premium

     67         77         200         229   

Legal fees

     50         82         193         198   

Other Losses

     80         23         217         34   

All other

     376         379         1,186         1,102   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 2,236       $ 1,915       $ 6,682       $ 6,038   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

31


Table of Contents

NOTE 10 – FEDERAL INCOME TAXES

The reconciliation of the provision for federal income taxes and the amount computed at the federal statutory tax rate of 34% of income before federal income tax expense is as follows for the three and nine month periods ended September 30:

 

     Three Months Ended
September  30
    Nine Months Ended
September 30
 
     2012     2011     2012     2011  

Income taxes at 34% statutory rate

   $ 1,481      $ 967      $ 4,093      $ 2,971   

Effect of nontaxable income

        

Interest income on tax exempt municipal bonds

     (391     (389     (1,170     (1,157

Earnings on corporate owned life insurance

     (58     (48     (176     (146

Other

     (147     (204     (439     (460
  

 

 

   

 

 

   

 

 

   

 

 

 

Total effect of nontaxable income

     (596     (641     (1,785     (1,763

Effect of nondeductible expenses

     14        8        36        31   
  

 

 

   

 

 

   

 

 

   

 

 

 

Federal income tax expense

   $ 899      $ 334      $ 2,344      $ 1,239   
  

 

 

   

 

 

   

 

 

   

 

 

 

Included in OCI for the three and nine month periods ended September 30, 2012 and 2011 are changes in unrealized holding gains, related to auction rate money market preferred and preferred stocks. For federal income tax purposes, these securities are considered equity investments. As such, no deferred federal income taxes related to unrealized holding gains or losses are expected or recorded.

A summary of OCI follows for the three and nine month periods ended September 30:

 

     Three Months Ended  
     September 30, 2012     September 30, 2011  
     Auction
Rate
Money
Market
Preferreds
and
Preferred
Stocks
     All
Other
AFS
Securities
    Total     Auction
Rate
Money
Market
Preferreds
and
Preferred
Stocks
    All
Other
AFS
Securities
    Total  

Unrealized gains (losses) arising during the period

   $ 630       $ 2,360      $ 2,990      $ (675   $ 5,396      $ 4,721   

Reclassification adjustment for net realized gains included in net income

     —           (116     (116     —          —          —     
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net unrealized gains

     630         2,244        2,874        (675     5,396        4,721   

Tax effect

     —           (763     (763     —          (1,835     (1,835
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Other comprehensive income (loss), net of tax

   $ 630       $ 1,481      $ 2,111      $ (675   $ 3,561      $ 2,886   
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

32


Table of Contents
     Nine Months Ended  
     September 30, 2012     September 30, 2011  
     Auction
Rate
Money
Market
Preferreds
and
Preferred
Stocks
     All
Other
AFS
Securities
    Total     Auction
Rate
Money
Market
Preferreds
and
Preferred
Stocks
    All
Other
AFS
Securities
    Total  

Unrealized gains arising during the period

   $ 2,049       $ 3,160      $ 5,209      $ (72   $ 10,122      $ 10,050   

Reclassification adjustment for net realized gains included in net income

     —           (1,119     (1,119     —          —          —     

Reclassification adjustment for impairment loss included in net income

     —           282        282        —          —          —     
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net unrealized gains

     2,049         2,323        4,372        (72     10,122        10,050   

Tax effect

     —           (790     (790     —          (3,442     (3,442
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Other comprehensive income, net of tax

   $ 2,049       $ 1,533      $ 3,582      $ (72   $ 6,680      $ 6,608   
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

NOTE 11 – DEFINED BENEFIT PENSION PLAN

We maintain a noncontributory defined benefit pension plan, which was curtailed effective March 1, 2007. As a result of the curtailment, future salary increases are no longer considered and plan benefits are based on years of service and the employees’ five highest consecutive years of compensation out of the last ten years of service through March 1, 2007. We contributed $709 to the pension plan during the nine month period ended September 30, 2012 and contributed $140 to the plan in the nine month period ended September 30, 2011. We anticipate contributing $41 to the plan in the fourth quarter of 2012.

Following are the components of net periodic benefit cost for the three and nine month periods ended September 30:

 

     Three Months Ended
September 30
    Nine Months Ended
September 30
 
     2012     2011     2012     2011  

Interest cost on PBO

   $ 118      $ 126      $ 353      $ 380   

Expected return on plan assets

     (127     (131     (381     (392

Amortization of unrecognized actuarial net loss

     73        38        219        115   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net periodic benefit cost

   $ 64      $ 33      $ 191      $ 103   
  

 

 

   

 

 

   

 

 

   

 

 

 

NOTE 12 – FAIR VALUE

Following is a description of the valuation methodologies, key inputs, and an indication of the level of the fair value hierarchy in which the assets or liabilities are classified.

Cash and demand deposits due from banks: The carrying amounts of cash and short term investments, including Federal funds sold, approximate fair values. As such, we classify cash and demand deposits due from banks as Level 1.

Certificates of deposit held in other financial institutions: Interest bearing balances held in unaffiliated financial institutions include certificates of deposit and other short term interest bearing balances that mature within 3 years. Fair value is determined using prices for similar assets with similar characteristics. As such, we classify certificates of deposits held in other financial institutions as Level 2.

Investment securities: Investment securities are recorded at fair value on a recurring basis. Level 1 fair value measurement is based upon quoted prices for identical instruments. Level 2 fair value measurement is based upon quoted prices for similar instruments. If quoted prices are not available, fair values are measured using independent pricing models or other model based valuation techniques

 

33


Table of Contents

such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss and liquidity assumptions. The values for Level 1 and Level 2 investment securities are generally obtained from an independent third party. On a quarterly basis, we compare the values provided to alternative pricing sources.

Due to the limited trading activity of certain auction rate money market preferred securities and preferred stocks, we measured these securities using Level 3 inputs as of September 30, 2012. As the markets for these securities normalized and established regular trading patterns, we measured preferred stocks utilizing Level 1 inputs and an auction rate money market preferred security utilizing Level 2 inputs as of December 31, 2011 and continued to measure at these levels as of September 30, 2012.

The table below represents the activity in auction rate money market preferred available-for-sale investment securities measured with Level 3 inputs on a recurring basis for the:

 

     Three Months
Ended
September 30, 2011
    Nine Months Ended
September 30, 2011
 

Level 3 inputs at beginning of period

   $ 2,834      $ 2,865   

Net unrealized losses

     (371     (402
  

 

 

   

 

 

 

Level 3 inputs—September 30

   $ 2,463      $ 2,463   
  

 

 

   

 

 

 

The table below represents the activity in preferred stock available-for-sale investment securities measured with Level 3 inputs on a recurring basis for the:

 

     Three Months
Ended
September 30, 2011
    Nine Months Ended
September 30, 2011
 

Level 3 inputs at beginning of period

   $ 7,570      $ 6,936   

Net unrealized (losses) gains

     (304     330   
  

 

 

   

 

 

 

Level 3 inputs—September 30

   $ 7,266      $ 7,266   
  

 

 

   

 

 

 

We had no financial instruments measured with Level 3 inputs on a recurring basis during 2012.

Mortgage loans available-for-sale: Mortgage loans available-for-sale are carried at the lower of cost or fair value. The fair value of mortgage loans available-for-sale are based on what price secondary markets are currently offering for portfolios with similar characteristics. As such, we classify loans subjected to nonrecurring fair value adjustments as Level 2.

Loans: For variable rate loans with no significant change in credit risk, fair values are based on carrying values. Fair values for fixed rate loans are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. The resulting amounts are adjusted to estimate the effect of changes in the credit quality of borrowers since the loans were originated.

We do not record loans at fair value on a recurring basis. However, from time to time, loans are classified as impaired and a specific allowance for loan losses may be established. Loans for which it is probable that payment of interest and principal will be significantly different than the contractual terms of the original loan agreement are considered impaired. Once a loan is identified as impaired, we measure the estimated impairment. The fair value of impaired loans is estimated using one of several methods, including collateral value, market value of similar debt, enterprise value, liquidation value, or discounted cash flows. Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans.

We review the net realizable values of the underlying collateral for collateral dependent impaired loans on at least a quarterly basis for all loan types. To determine the collateral value, management utilizes independent appraisals, broker price opinions, or internal evaluations. These valuations are reviewed to determine whether an additional discount should be applied given the age of market

 

34


Table of Contents

information that may have been considered as well as other factors such as costs to carry and sell an asset if it is determined that the collateral will be liquidated in connection with the ultimate settlement of the loan. We use these valuations to determine if any charge offs or specific reserves are necessary. We may obtain new valuations in certain circumstances, including when there has been significant deterioration in the condition of the collateral, if the foreclosure process has begun, or if the existing valuation is deemed to be outdated.

Impaired loans where an allowance is established based on the net realizable value of collateral require classification in the fair value hierarchy. When the fair value of the collateral is based on an observable market price or a current appraisal value, we record the loan as nonrecurring Level 2. When a current appraised value is not available or we determine the fair value of collateral is further impaired below the appraised value, the impaired loan is classified as nonrecurring Level 3.

The table below lists the quantitative information about impaired loans measured utilizing Level 3 fair value measurements as of September 30, 2012:

 

Valuation Techniques

   Fair
Value
    

Unobservable Input

   Range
      Duration of cash flows    17 - 120 Months

Discounted cash flow

   $ 6,889      

Reduction in interest rate

from original loan terms

   2.13% - 3.38%
           

Discount applied to

collateral appraisal:

    
      Real Estate    20% -30%
      Equipment    50%

Discounted appraisal value

   $ 16,224       Livestock    50%
      Cash crop inventory    50%
      Other inventory    75%
      Accounts receivable    75%

Accrued interest: The carrying amounts of accrued interest approximate fair value. As such, we classify accrued interest as Level 1.

Goodwill and other intangible assets: Acquisition intangibles and goodwill are evaluated for potential impairment on at least an annual basis. Goodwill is typically qualitatively evaluated to determine if it is more likely than not that the carrying balance is impaired. If it is determined that the carrying balance of goodwill is more likely than not to be impaired, we perform a cash flow valuation to determine the extent of the potential impairment. Acquisition intangibles are tested for impairment with a cash flow valuation. This valuation method requires a significant degree of judgment. In the event the projected undiscounted net operating cash flows for these intangible assets are less than the carrying value, the asset is recorded at fair value as determined by the valuation model. If the testing resulted in impairment, we would classify goodwill and other acquisition intangibles subjected to nonrecurring fair value adjustments as Level 3. During 2012 and 2011 there were no impairments recorded on goodwill and other acquisition intangibles.

Equity securities without readily determinable fair values: We have investments in equity securities without readily determinable fair values as well as investments in joint ventures. The assets are individually reviewed for impairment on an annual basis, or more frequently if an indication of impairment exists, by comparing the carrying value to the estimated fair value. The lack of an independent source to validate fair value estimates, including the impact of future capital calls and transfer restrictions, is an inherent limitation in the valuation process. We classify nonmarketable equity securities and investments in joint ventures subjected to nonrecurring fair value adjustments as Level 3. During 2012 and 2011, there were no impairments recorded on equity securities without readily determinable fair values.

Foreclosed assets: Upon transfer from the loan portfolio, foreclosed assets are adjusted to and subsequently carried at the lower of carrying value or fair value less costs to sell. Net realizable value is based upon independent market prices, appraised values of the collateral, or management’s estimation of the value of the collateral and as such, we classify foreclosed assets as a nonrecurring Level 2. When the net realizable value of the collateral is further impaired below the appraised value but there is no observable market price, we record the foreclosed asset as nonrecurring Level 3.

 

35


Table of Contents

Originated mortgage servicing rights: OMSR is subject to impairment testing. A valuation model, which utilizes a discounted cash flow analysis using interest rates and prepayment speed assumptions currently quoted for comparable instruments and a discount rate determined by management, is used for impairment testing. If the valuation model reflects a value less than the carrying value, originated mortgage servicing rights are adjusted to fair value through a valuation allowance as determined by the model. As such, we classify loan servicing rights subject to nonrecurring fair value adjustments as Level 2.

Deposits: The fair value of demand, savings, and money market deposits are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amounts), and are classified as Level 1. Fair values for variable rate certificates of deposit approximate their recorded carrying value. Fair values for fixed rate certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits. As such, certificates of deposit are classified as Level 2.

Borrowed funds: The carrying amounts of federal funds purchased, borrowings under overnight repurchase agreements, and other short-term borrowings maturing within ninety days approximate their fair values. The fair values of other borrowed funds are estimated using discounted cash flow analyses based on current incremental borrowing arrangements.

We elected to measure a portion of borrowed funds at fair value as of December 31, 2011. These borrowings were recorded at fair value on a recurring basis, with the fair value measurement estimated using discounted cash flow analysis based on current incremental borrowing rates for similar types of borrowing arrangements. Changes in the fair value of these borrowings are included in noninterest income. As such, other borrowed funds are classified as Level 2.

The activity in borrowings which the Corporation had elected to carry at fair value was as follows:

 

     Three Months Ended
September 30
    Nine Months Ended
September 30
 
     2012      2011     2012     2011  

Borrowings carried at fair value—beginning of year

   $ —         $ 5,306      $ 5,242      $ 10,423   

Paydowns and maturities

     —           —          (5,209     (5,000

Net unrealized change in fair value

     —           (42     (33     (159
  

 

 

    

 

 

   

 

 

   

 

 

 

Borrowings carried at fair value—September 30

   $ —         $ 5,264      $ —        $ 5,264   
  

 

 

    

 

 

   

 

 

   

 

 

 

Unpaid principal balance—September 30

   $ —         $ 5,000      $ —        $ 5,000   
  

 

 

    

 

 

   

 

 

   

 

 

 

Commitments to extend credit, standby letters of credit and undisbursed loans: Fair values for off balance sheet lending commitments are based on fees currently charged to enter into similar agreements, taking into consideration the remaining terms of the agreements and the counterparties’ credit standings. As we do not charge fees for lending commitments outstanding, as it is not practicable to estimate the fair value of these instruments.

The preceding methods described may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values. Furthermore, although we believe our valuation methods are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different fair value measurement.

Estimated Fair Values of Financial Instruments Not Recorded at Fair Value in their Entirety on a Recurring Basis

Disclosure of the estimated fair values of financial instruments, which differ from carrying values, often requires the use of estimates. In cases where quoted market values in an active market are not available, we use present value techniques and other valuation methods to estimate the fair values of our financial instruments. These valuation methods require considerable judgment and the resulting estimates of fair value can be significantly affected by the assumptions made and methods used.

 

36


Table of Contents

The carrying amount and estimated fair value of financial instruments not recorded at fair value in their entirety on a recurring basis on our consolidated balance sheets are as follows as of:

 

     September 30, 2012  
     Carrying
Value
    Estimated
Fair Value
    (Level 1)      (Level 2)     (Level 3)  

ASSETS

           

Cash and demand deposits due from banks

   $ 24,664      $ 24,664      $ 24,664       $ —        $ —     

Certicates of deposit held in other financial institutions

     5,675        5,691        —           5,691        —     

Mortgage loans available-for-sale

     2,820        2,856        —           2,856        —     

Total loans

     766,751        780,793        —           753,411        27,382   

Less allowance for loan losses

     (12,062     (12,062     —           (7,793     (4,269
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

Net loans

     754,689        768,731        —           745,618        23,113   
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

Accrued interest receivable

     6,565        6,565        6,565         —          —     

Equity securities without readily determinable fair values (1)

     17,830        17,830        —           —          —     

Originated mortgage servicing rights

     2,290        2,290        —           2,290        —     

LIABILITIES

           

Deposits without stated maturities

     522,642        522,642        522,642         —          —     

Deposits with stated maturities

     466,849        475,526        —           475,526        —     

Borrowed funds

     226,580        234,229        —           234,229        —     

Accrued interest payable

     813        813        813         —          —     

 

     December 31, 2011  
     Carrying
Value
    Estimated
Fair Value
    (Level 1)      (Level 2)     (Level 3)  

ASSETS

           

Cash and demand deposits due from banks

   $ 28,590      $ 28,590      $ 28,590       $ -      $ -   

Certicates of deposit held in other financial institutions

     8,924        8,977        -         8,977        -   

Mortgage loans available-for-sale

     3,205        3,252        —           3,252        —     

Total loans

     750,291        769,177        —           743,927        25,250   

Less allowance for loan losses

     (12,375     (12,375     —           (8,255     (4,120
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

Net loans

     737,916        756,802        —           735,672        21,130   
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

Accrued interest receivable

     5,848        5,848        5,848         —          —     

Equity securities without readily determinable fair values (1)

     17,189        17,189        —           —          —     

Originated mortgage servicing rights

     2,374        2,374        —           2,374        —     

LIABILITIES

           

Deposits without stated maturities

     476,627        476,627        476,627         —          —     

Deposits with stated maturities

     481,537        499,644        —           499,644        —     

Borrowed funds

     210,894        222,538        —           222,538        —     

Accrued interest payable

     967        967        967         —          —     

 

(1) Due to the characteristics of equity securities without readily determinable fair values, they are not disclosed under a specific fair value hierarchy.

 

37


Table of Contents

Financial Instruments Recorded at Fair Value

The table below presents the recorded amount of assets and liabilities measured at fair value on:

 

     September 30, 2012     December 31, 2011  

Description

   Total      (Level 1)     (Level 2)     (Level 3)     Total      (Level 1)     (Level 2)     (Level 3)  

Recurring items

                  

Trading securities

                  

States and political subdivisions

     1,788         —          1,788        —          4,710         —          4,710        —     

Available-for-sale investment securities

                  

Government sponsored enterprises

     1,957         —          1,957        —          397         —          397        —     

States and political subdivisions

     185,480         —          185,480        —          174,938         —          174,938        —     

Auction rate money market preferred

     2,771         —          2,771        —          2,049         —          2,049        —     

Preferred stocks

     6,360         6,360        —          —          5,033         5,033        —          —     

Mortgage-backed securities

     142,228         —          142,228        —          143,602         —          143,602        —     

Collateralized mortgage obligations

     128,618         —          128,618        —          99,101         —          99,101        —     
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Total available-for-sale investment securities

     467,414         6,360        461,054        —          425,120         5,033        420,087        —     

Borrowed funds

     —           —          —          —          5,242         —          5,242        —     

Nonrecurring items

                  

Impaired loans (net of the allowance for loan losses)

     23,113         —          —          23,113        21,130         —          —          21,130   

Originated mortgage servicing rights

     2,290         —          2,290        —          2,374         —          2,374        —     

Foreclosed assets

     2,001         —          2,001        —          1,876         —          1,876        —     
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 
     496,606         6,360        467,133        23,113        460,452         5,033        434,289        21,130   
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Percent of assets and liabilities measured at fair value

        1.28     94.07     4.65        1.09     94.32     4.59
     

 

 

   

 

 

   

 

 

      

 

 

   

 

 

   

 

 

 

The changes in fair value of assets and liabilities recorded at fair value through earnings on a recurring basis and changes in assets and liabilities recorded at fair value on a nonrecurring basis, for which an impairment, or reduction of an impairment, was recognized in the three and nine month periods ended September 30, 2012 and 2011, are summarized as follows:

 

     Three Months Ended September 30  
     2012     2011  

Description

   Trading Gains
and (Losses)
    Other Gains
and (Losses)
    Total     Trading Gains
and (Losses)
    Other Gains
and (Losses)
    Total  

Recurring Items

            

Trading securities

     (9     —          (9     (24     —          (24

Borrowed funds

     —          —          —          —          42        42   

Nonrecurring Items

            

Foreclosed assets

     —          —          —          —          (10     (10

Originated mortgage servicing rights

     —          (98     (98     —          (296     (296
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total

     (9     (98     (107     (24     (264     (288
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

38


Table of Contents
     Nine Months Ended September 30  
     2012     2011  

Description

   Trading
Losses
    Other Gains
and (Losses)
    Total     Trading
Losses
    Other Gains
and (Losses)
    Total  
            

Recurring items

            

Trading securities

     (41     —          (41     (51     —          (51

Borrowed funds

     —          33        33        —          159        159   

Nonrecurring items

            

Foreclosed assets

     —          (17     (17     —          (45     (45

Originated mortgage servicing rights

     —          (56     (56     —          (314     (314
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total

     (41     (40     (81     (51     (200     (251
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

NOTE 13 – OPERATING SEGMENTS

Our reportable segments are based on legal entities that account for at least 10% of net operating results. The operations of Isabella Bank as of September 30, 2012 and 2011 and each of the three and nine month periods then ended, represented 90% or more of our consolidated total assets and operating results. As such, no additional segment reporting is presented.

 

39


Table of Contents

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

ISABELLA BANK CORPORATION FINANCIAL REVIEW

(All dollars in thousands, except per share data)

This section reviews the financial condition and results of operations of Isabella Bank Corporation and its subsidiaries for the three and nine month periods ended September 30, 2012 and 2011. This analysis should be read in conjunction with our 2011 annual report and with the unaudited interim condensed consolidated financial statements and notes, beginning on page 3 of this report. A comprehensive list of acronyms and abbreviations used throughout this discussion is included in “Note 1—Basis of Presentation” of our interim condensed consolidated financial statements.

Executive Summary

Despite the challenges of the current economic environment and increased regulatory compliance costs, we are pleased to report our highest quarterly earnings ever and we anticipate that the year ending December 31, 2012 will be our strongest year. There continues to be slight improvements in the local, regional, and national economies, but a large degree of economic uncertainty remains. Our continued success throughout these challenging times is a direct result of our unwavering focus on community banking principles, prudent underwriting standards, and long term sustainable growth. This focus has enabled us to continue to meet the needs of the communities we serve which translates into increased shareholder value.

As we continue to look to build upon our continued success and our desire to expand into complementary markets, we are excited about the prospects of our new Freeland, Michigan office which was opened in October 2012. The new location will complement our existing office locations, increase our brand awareness in the Freeland area, and provide additional shareholder value for years to come.

Recent Legislation

The Health Care and Education Act of 2010, the Patient Protection and Affordable Care Act, the Dodd-Frank Act, and the JOBS Act, have already and are expected to continue to have a significant impact on the Corporation’s operating results in future periods. While the legislation has been passed for these acts, much of the regulations have yet to be written. As such, the extent of the potential impact on our operations has yet to be determined. Of these three acts, the Dodd-Frank Act has had, and is likely to have, the most significant impact. This particular Act made sweeping changes in the regulation of financial institutions aimed at strengthening the operation of the financial services sector. As a result of the implementation of some of the provisions, we have had increases in compensation costs and this trend is expected to continue.

In June 2012, the FFIEC proposed new capital requirements for all financial institutions. In general, the proposal adds a new capital standard of equity capital to assets and increases the minimum capital ratios to be considered well capitalized. While these proposals are not yet final, they could significantly impact our capital requirements, which could impact our ability to pay dividends.

 

40


Table of Contents

RESULTS OF OPERATIONS

Selected Financial Data

The following table outlines the results of operations and provides certain performance measures for:

 

     Three Months Ended
September 30
    Nine Months Ended
September 30
 
     2012     2011     2012     2011  

INCOME STATEMENT DATA

        

Interest income

   $ 14,164      $ 14,532      $ 42,556      $ 43,439   

Interest expense

     3,239        4,070        10,372        12,224   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net interest income

     10,925        10,462        32,184        31,215   

Provision for loan losses

     200        963        1,100        2,383   

Noninterest income

     2,759        1,859        8,844        5,785   

Noninterest expenses

     9,128        8,513        27,889        25,879   

Federal income tax expense

     899        334        2,344        1,239   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net Income

   $ 3,457      $ 2,511      $ 9,695      $ 7,499   
  

 

 

   

 

 

   

 

 

   

 

 

 

PER SHARE

        

Basic earnings

   $ 0.45      $ 0.33      $ 1.28      $ 0.99   

Diluted earnings

     0.44        0.32        1.24        0.97   

Dividends

     0.20        0.19        0.60        0.57   

Market value*

     22.50        18.75        22.50        18.75   

Tangible book value*

     14.65        13.70        14.65        13.70   

BALANCE SHEET DATA

        

At end of period

        

Loans

   $ 766,751      $ 750,163      $ 766,751      $ 750,163   

Total assets

     1,389,138        1,324,093        1,389,138        1,324,093   

Deposits

     989,491        942,441        989,491        942,441   

Shareholders’ equity

     164,147        155,579        164,147        155,579   

Average balance

        

Loans

   $ 761,069      $ 746,856      $ 751,071      $ 741,308   

Total assets

     1,391,955        1,299,179        1,372,433        1,272,848   

Deposits

     988,136        932,508        979,934        920,290   

Shareholders’ equity

     152,537        146,514        154,428        146,271   

PERFORMANCE RATIOS

        

Return on average total assets (annualized)

     0.99     0.77     0.94     0.79

Return on average shareholders’ equity (annualized)

     9.07     6.86     8.37     6.84

Return on average tangible equity (annualized)

     12.56     9.97     11.96     10.08

Net interest margin yield (FTE annualized)

     3.73     3.85     3.72     3.90

Loan to deposit*

     77.49     79.60     77.49     79.60

Nonperforming loans to total loans*

     0.98     0.81     0.98     0.81

Nonperforming assets to total assets*

     0.68     0.61     0.68     0.61

ALLL to nonperforming loans*

     160.98     199.24     160.98     199.24

CAPITAL RATIOS

        

Shareholders’ equity to assets*

     11.82     11.75     11.82     11.75

Tier 1 capital to average assets*

     8.27     8.10     8.27     8.10

Tier 1 risk-based capital*

     13.35     12.43     13.35     12.43

Total risk-based capital*

     14.60     13.68     14.60     13.68

 

* At end of period

 

41


Table of Contents

Net Interest Income

Net interest income is our primary source of income. Interest income includes loan fees of $846 and $2,302 for the three and nine month periods ended September 30, 2012, respectively, as compared to $534 and $1,755 during the same periods in 2011. For analytical purposes, net interest income is adjusted to an FTE basis by adding the income tax savings from interest on tax exempt loans and securities, thus making year to year comparisons more meaningful.

AVERAGE BALANCES, INTEREST RATE, AND NET INTEREST INCOME

The following schedules present the daily average amount outstanding for each major category of interest earning assets, nonearning assets, interest bearing liabilities, and noninterest bearing liabilities. This schedule also presents an analysis of interest income and interest expense for the periods indicated. All interest income is reported on a FTE basis using a 34% tax rate. Nonaccruing loans, for the purpose of the following computations, are included in the average loan amounts outstanding. FRB and FHLB restricted equity holdings are included in accrued income and other assets.

The following table displays the results for the three month periods ended September 30:

 

     2012     2011  
     Average
Balance
    Tax
Equivalent
Interest
     Average
Yield /
Rate
    Average
Balance
    Tax
Equivalent
Interest
     Average
Yield /
Rate
 

INTEREST EARNING ASSETS

              

Loans

   $ 761,069      $ 10,918         5.74   $ 746,856      $ 11,365         6.09

Taxable investment securities

     316,639        1,878         2.37     243,123        1,800         2.96

Nontaxable investment securities

     149,390        2,006         5.37     135,433        1,961         5.79

Trading account securities

     1,862        23         4.94     4,905        68         5.55

Other

     26,367        121         1.84     38,412        121         1.26
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

 

Total earning assets

     1,255,327        14,946         4.76     1,168,729        15,315         5.24

NONEARNING ASSETS

              

Allowance for loan losses

     (12,484          (12,496     

Cash and demand deposits due from banks

     19,483             20,459        

Premises and equipment

     25,290             24,361        

Accrued income and other assets

     104,339             98,126        
  

 

 

        

 

 

      

Total assets

   $ 1,391,955           $ 1,299,179        
  

 

 

        

 

 

      

INTEREST BEARING LIABILITIES

              

Interest bearing demand deposits

   $ 172,931        52         0.12   $ 155,385        49         0.13

Savings deposits

     218,028        110         0.20     192,457        117         0.24

Time deposits

     472,873        2,041         1.73     469,791        2,559         2.18

Borrowed funds

     232,231        1,036         1.78     202,451        1,345         2.66
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

 

Total interest bearing liabilities

     1,096,063        3,239         1.18     1,020,084        4,070         1.60

NONINTEREST BEARING LIABILITIES

              

Demand deposits

     124,304             114,875        

Other

     19,051             17,706        

Shareholders’ equity

     152,537             146,514        
  

 

 

        

 

 

      

Total liabilities and shareholders’ equity

   $ 1,391,955           $ 1,299,179        
  

 

 

        

 

 

      

Net interest income (FTE)

     $ 11,707           $ 11,245      
    

 

 

        

 

 

    
       

 

 

        

 

 

 

Net yield on interest earning assets (FTE)

          3.73          3.85
       

 

 

        

 

 

 

 

42


Table of Contents

The following table displays the results for the nine month periods ended September 30:

 

     2012     2011  
     Average
Balance
    Tax
Equivalent
Interest
     Average
Yield /
Rate
    Average
Balance
    Tax
Equivalent
Interest
     Average
Yield /
Rate
 

INTEREST EARNING ASSETS

              

Loans

   $ 751,071      $ 32,707         5.81   $ 741,308      $ 34,190         6.15

Taxable investment securities

     306,006        5,755         2.51     226,104        5,149         3.04

Nontaxable investment securities

     144,170        5,956         5.51     134,948        5,830         5.76

Trading account securities

     2,925        120         5.47     5,174        217         5.59

Other

     33,619        363         1.44     38,407        388         1.35
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

 

Total earning assets

     1,237,791        44,901         4.84     1,145,941        45,774         5.33

NONEARNING ASSETS

              

Allowance for loan losses

     (12,559          (12,544     

Cash and demand deposits due from banks

     19,455             20,111        

Premises and equipment

     25,079             24,335        

Accrued income and other assets

     102,667             95,005        
  

 

 

        

 

 

      

Total assets

   $ 1,372,433           $ 1,272,848        
  

 

 

        

 

 

      

INTEREST BEARING LIABILITIES

              

Interest bearing demand deposits

   $ 171,079        156         0.12   $ 152,436        142         0.12

Savings deposits

     212,040        341         0.21     192,820        363         0.25

Time deposits

     476,186        6,586         1.84     463,950        7,781         2.24

Borrowed funds

     223,668        3,289         1.96     193,021        3,938         2.72
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

 

Total interest bearing liabilities

     1,082,973        10,372         1.28     1,002,227        12,224         1.63

NONINTEREST BEARING LIABILITIES

              

Demand deposits

     120,629             111,084        

Other

     14,403             13,266        

Shareholders’ equity

     154,428             146,271        
  

 

 

        

 

 

      

Total liabilities and shareholders’ equity

   $ 1,372,433           $ 1,272,848        
  

 

 

        

 

 

      

Net interest income (FTE)

     $ 34,529           $ 33,550      
    

 

 

        

 

 

    
       

 

 

        

 

 

 

Net yield on interest earning assets (FTE)

          3.72          3.90
       

 

 

        

 

 

 

 

43


Table of Contents

VOLUME AND RATE VARIANCE ANALYSIS

The following table sets forth the effect of volume and rate changes on interest income and expense for the periods indicated. For the purpose of this table, changes in interest due to volume and rate were determined as follows:

Volume Variance—change in volume multiplied by the previous year’s rate.

Rate Variance—change in the FTE rate multiplied by the previous year’s volume.

The change in interest due to both volume and rate has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the change in each.

 

     Three Months Ended
September 30, 2012 Compared to
September 30, 2011
Increase (Decrease) Due to
    Nine Months Ended
September 30, 2012 Compared to
September 30, 2011
Increase (Decrease) Due to:
 
     Volume     Rate     Net     Volume     Rate     Net  

CHANGES IN INTEREST INCOME

            

Loans

   $ 213      $ (660   $ (447   $ 446      $ (1,929   $ (1,483

Taxable investment securities

     479        (401     78        1,607        (1,001     606   

Nontaxable investment securities

     193        (148     45        388        (265     123   

Trading account securities

     (38     (7     (45     (92     (5     (97

Other

     (45     45        —          (51     26        (25
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total changes in interest income

     802        (1,171     (369     2,298        (3,174     (876

CHANGES IN INTEREST EXPENSE

            

Interest bearing demand deposits

     5        (2     3        17        (3     14   

Savings deposits

     14        (21     (7     34        (56     (22

Time deposits

     17        (535     (518     201        (1,396     (1,195

Borrowed funds

     178        (487     (309     562        (1,211     (649
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total changes in interest expense

     214        (1,045     (831     814        (2,666     (1,852
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net change in interest margin (FTE)

   $ 588      $ (126   $ 462      $ 1,484      $ (508   $ 976   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Our net yield on interest earning assets has leveled off in spite of the persistent low interest rate environment and soft loan demand. This is a direct result of our restructuring of $60,000 of FHLB advances in the first quarter of 2012, which is anticipated to reduce interest expense by approximately $450 for 2012.

Given that the historically low interest rate environment is expected to continue for the foreseeable future, the net yield on interest earning assets is likely to decline in future periods. This anticipated decline will be driven by continued reduction in rates earned on loans without a corresponding decline in funding rates. Any additional interest income will be contingent upon increases in volume, which will increase the speed of the rate reductions on interest earning assets.

 

44


Table of Contents

Allowance for Loan Losses

The viability of any financial institution is ultimately determined by its management of credit risk. Loans outstanding represent our single largest concentration of risk. The ALLL is our estimation of probable losses inherent in the existing loan portfolio. We allocate the ALLL throughout the loan portfolio based on our assessment of the underlying risks associated with each loan segment. Our assessments include allocations based on specific impairment allocations, historical losses, internally assigned credit ratings, and past due and nonaccrual balances. A portion of the ALLL is not allocated to any one loan segment, but is instead a reflection of other qualitative risks within the loan portfolio.

The following tables summarize our charge off and recovery activity for the:

 

     Three Months Ended
September 30
    Nine Months Ended
September 30
 
     2012     2011     2012     2011  

Allowance for loan losses at beginning of period

   $ 12,318      $ 12,378      $ 12,375      $ 12,373   

Loans charged off

        

Commercial and agricultural

     271        215        957        1,085   

Residential real estate

     213        857        566        1,735   

Consumer

     127        98        364        382   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total loans charged off

     611        1,170        1,887        3,202   
  

 

 

   

 

 

   

 

 

   

 

 

 

Recoveries

        

Commercial and agricultural

     40        76        168        422   

Residential real estate

     34        39        95        142   

Consumer

     81        87        211        255   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total recoveries

     155        202        474        819   

Provision for loan losses

     200        963        1,100        2,383   
  

 

 

   

 

 

   

 

 

   

 

 

 

Allowance for loan losses at end of period

   $ 12,062      $ 12,373      $ 12,062      $ 12,373   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net loans charged off

   $ 456      $ 968      $ 1,413      $ 2,383   

Average loans outstanding

     761,069        746,856        751,071        741,308   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net loans charged off to average loans outstanding

     0.06     0.13     0.19     0.32
  

 

 

   

 

 

   

 

 

   

 

 

 

Total amount of loans outstanding at end of period

   $ 766,751      $ 750,163      $ 766,751      $ 750,163   
  

 

 

   

 

 

   

 

 

   

 

 

 

Allowance for loan losses as a % of loans at end of period

     1.57     1.65     1.57     1.65
  

 

 

   

 

 

   

 

 

   

 

 

 

As shown in the preceding table, the level of net chargeoffs continues to decline. This trend has allowed us to reduce our provision, which has led to a decline in the ALLL in both amount and as a percentage of loans. For further discussion on the allocation of the ALLL, see “Note 6—Loans and Allowance for Loan Losses” to our interim condensed consolidated financial statements.

 

45


Table of Contents

Loans Past Due and Loans in Nonaccrual Status

Increases in past due and nonaccrual loans can have a significant impact on the allowance for loan losses. To determine the potential impact, and corresponding estimated losses, we analyze our historical loss trends on loans past due 30-89 days, 90 days or more, and nonaccrual loans. Loans past due and in nonaccrual status have increased over prior periods. Part of the increase in accruing loans past due 30-89 days from year end was related to one loan that had a balance of $1,302 as of September 30, 2012. This loan was also past due 30-89 days as of June 30, 2012. We will continue to closely monitor this loan for indicators of additional deterioration. The increase in nonaccrual loans was primarily the result of the addition of one loan in the three month period ended September 30, 2012 (for further discussion see nonperforming assets below).

A summary of loans past due and in nonaccrual status, including the composition of the ending balance of nonaccrual loans by type, is included in “Note 6—Loans and Allowance for Loan Losses” of our interim condensed consolidated financial statements.

Troubled Debt Restructurings

We have taken a proactive approach to avoid foreclosures on borrowers who are willing to work with us in modifying their loans, thus making them more affordable. While this approach has allowed certain borrowers to develop a payment structure that will allow them to continue making payments in lieu of foreclosure, it has contributed to a significant increase in the level of loans classified as TDR. The implementation of ASU No. 2011-02 “A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring” has also contributed to the increased level of TDR’s. The modifications have been extremely successful for us and our customers as very few of the modified loans have resulted in foreclosures. Troubled debt restructurings that have been placed in nonaccrual status may be placed back on accrual status after six months of continued performance.

The following table summarizes our troubled debt restructurings component of impaired loans as of:

 

     September 30, 2012      December 31, 2011         
     Accruing
Interest
     Nonaccrual      Total      Accruing
Interest
     Nonaccrual      Total      Total
Change
 

Current

   $ 17,637       $ 1,551       $ 19,188       $ 16,125       $ 514       $ 16,639       $ 2,549   

Past due 30-89 days

     594         1,017         1,611         1,614         429         2,043         (432

Past due 90 days or more

     30         232         262         —           74         74         188   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total troubled debt restructurings

   $ 18,261       $ 2,800       $ 21,061       $ 17,739       $ 1,017       $ 18,756       $ 2,305   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Additional disclosures about TDR’s are included in “Note 6—Loans and Allowance for Loan Losses” of our interim condensed consolidated financial statements.

 

46


Table of Contents

Nonperforming Assets

The following table summarizes our nonperforming assets as of:

 

     September 30
2012
    December 31
2011
 

Nonaccrual loans

   $ 7,025      $ 6,389   

Accruing loans past due 90 days or more

     468        760   
  

 

 

   

 

 

 

Total nonperforming loans

     7,493        7,149   

OREO

     1,986        1,867   

Repossessed assets

     15        9   
  

 

 

   

 

 

 

Total nonperforming assets

   $ 9,494      $ 9,025   
  

 

 

   

 

 

 

Nonperforming loans as a % of total loans

     0.98     0.95
  

 

 

   

 

 

 

Nonperforming assets as a % of total assets

     0.68     0.67
  

 

 

   

 

 

 

Loans are placed in nonaccrual status when the foreclosure process has begun, generally after a loan is 90 days past due, unless they are well secured and in the process of collection. Upon transferring the loans to nonaccrual status, an evaluation to determine the net realizable value of the underlying collateral is performed. This evaluation is used to help determine if any charge offs are necessary. Loans may be placed back on accrual status after six months of continued performance.

Included in the nonaccrual loan balances above were credits currently classified as troubled debt restructurings as of:

 

     September 30
2012
     December 31
2011
 

Commercial and agricultural

   $ 2,608       $ 520   

Residential real estate

     192         497   
  

 

 

    

 

 

 

Total

     $2,800         $1,017   
  

 

 

    

 

 

 

The following table lists individually significant commercial and agricultural loan relationships in nonaccrual status as of September 30, 2012 and December 31, 2011. To be classified as individually significant, the recorded investment in nonaccrual loans to each borrower must have exceeded $1,000 as of the end of either period.

 

     September 30, 2012      December 31, 2011  
     Outstanding
Balance
     Specific
Allocation
     Outstanding
Balance
     Specific
Allocation
 

Borrower 1

   $ 1,096       $ 175       $ —         $ —     

Borrower 2

     997         A         1,014         A   

Borrower 3

     —           —           1,900         B   

Borrower 4

     2,107         390         —           —     

Other not individually significant

     1,369            1,891      
  

 

 

       

 

 

    

Total

   $ 5,569          $ 4,805      
  

 

 

       

 

 

    

 

A -

  No specific allocation as the net realizable value of the loan’s underlying collateral value exceeded the loan’s carrying balance.

B -

  No specific allocation established for this loan as it was charged down to reflect the current market value of the real estate. This loan was subsequently transferred to OREO and sold in the second quarter of 2012.

There were no other individually significant credits included in nonaccrual loans as of September 30, 2012 or December 31, 2011.

Additional disclosures about nonaccrual loans are included in “Note 6—Loans and Allowance for Loan Losses” of our interim condensed consolidated financial statements.

 

47


Table of Contents

We continue to devote considerable attention to identifying impaired loans and adjusting the net carrying value of these loans to their current net realizable values through the establishment of a specific reserve or the recording of a chargeoff. We believe that all loans deemed to be impaired have been recognized.

We believe that the level of the ALLL is appropriate as of September 30, 2012 and we will continue to closely monitor overall credit quality and our policies and procedures related to the analysis of the ALLL to ensure that the allowance for loan losses remains appropriate.

NONINTEREST INCOME AND EXPENSES

Noninterest Income

Noninterest income consists of service charges and fee income, gains from the sale of mortgage loans, gains and losses on trading securities and borrowings measured at fair value, gains from the sale of investment securities, and other. Significant account balances are highlighted in the accompanying tables with additional descriptions of significant fluctuations:

 

     Three Months Ended September 30  
           Change  
     2012     2011     $     %  

Service charges and fees

        

NSF and overdraft fees

   $ 628      $ 653      $ (25     -3.8

ATM and debit card fees

     473        455        18        4.0

Trust fees

     279        253        26        10.3

Freddie Mac servicing fee

     185        188        (3     -1.6

Service charges on deposit accounts

     80        84        (4     -4.8

Net originated mortgage servicing rights loss

     (135     (325     190        N/M   

All other

     33        33        —          0.0
  

 

 

   

 

 

   

 

 

   

 

 

 

Total service charges and fees

     1,543        1,341        202        15.1

Gain on sale of mortgage loans

     422        111        311        280.2

Net loss on trading securities

     (9     (24     15        N/M   

Net gain on borrowings measured at fair value

     —          42        (42     -100.0

Gain on sale of available-for-sale investment securities

     116        —          116        N/M   

Other

        

Earnings on corporate owned life insurance policies

     171        141        30        21.3

Brokerage and advisory fees

     143        122        21        17.2

Income from investment in Corporate Settlement Solutions

     198        3        195        N/M   

Gain on sale of OREO

     75        32        43        134.4

All other

     100        91        9        9.9
  

 

 

   

 

 

   

 

 

   

 

 

 

Total other

     687        389        298        76.6
  

 

 

   

 

 

   

 

 

   

 

 

 

Total noninterest income

   $ 2,759      $ 1,859      $ 900        48.4
  

 

 

   

 

 

   

 

 

   

 

 

 

 

48


Table of Contents
     Nine Months Ended September 30  
           Change  
     2012     2011     $     %  

Service charges and fees

        

NSF and overdraft fees

   $ 1,783      $ 1,875      $ (92     -4.9

ATM and debit card fees

     1,407        1,299        108        8.3

Trust fees

     795        741        54        7.3

Freddie Mac servicing fee

     563        544        19        3.5

Service charges on deposit accounts

     238        242        (4     -1.7

Net originated mortgage servicing rights loss

     (85     (375     290        N/M   

All other

     99        108        (9     -8.3
  

 

 

   

 

 

   

 

 

   

 

 

 

Total service charges and fees

     4,800        4,434        366        8.3

Gain on sale of mortgage loans

     1,080        293        787        268.6

Net loss on trading securities

     (41     (51     10        N/M   

Net gain on borrowings measured at fair value

     33        159        (126     -79.2

Gain on sale of available-for-sale investment securities

     1,119        —          1,119        N/M   

Other

        

Earnings on corporate owned life insurance policies

     519        428        91        21.3

Brokerage and advisory fees

     410        405        5        1.2

Income (Loss) from investment in Corporate Settlement Solutions

     397        (281     678        N/M   

Gain on sale of OREO

     206        73        133        182.2

All other

     321        325        (4     -1.2
  

 

 

   

 

 

   

 

 

   

 

 

 

Total other

     1,853        950        903        95.1
  

 

 

   

 

 

   

 

 

   

 

 

 

Total noninterest income

   $ 8,844      $ 5,785      $ 3,059        52.9
  

 

 

   

 

 

   

 

 

   

 

 

 

Significant changes in noninterest income are detailed below:

 

   

We continuously analyze various fees related to deposit accounts including service charges and NSF and overdraft fees. Based on these analyses, we make any necessary adjustments to ensure that our fee structure is within the range of our competitors, while at the same time making sure that the fees remain fair to deposit customers. NSF and overdraft fees represent the largest single component of service charges and fees. While we have experienced significant increases in deposit accounts, NSF and overdraft fees have declined. This decline has been the result of reduced overdraft activity by our customers as well as changes in banking regulations. We expect this downward trend to continue into the foreseeable future.

 

   

As customers have continued to increase their dependence on ATM and debit cards, we have seen a corresponding increase in fees. We do not anticipate significant changes to our ATM and debit fee structure; however, we do expect that these fees will continue to increase as the usage of debit cards increases.

 

   

In recent periods, we have invested considerable efforts to increase our market share in trust and brokerage and advisory services. These efforts have translated into increases in revenues and we expect this trend to continue in future periods.

 

49


Table of Contents
   

The recent decline in offering rates on residential real estate loans has led to a significant increase in the level of refinancing activity. This increase in activity has resulted in substantial increases in the gain on sale of mortgage loans, while contributing to fluctuations in the value of our OMSR portfolio. This increased refinancing activity has also contributed to the increase in income from Corporate Settlement. We anticipate this trend to continue for the remainder of 2012.

 

   

Fluctuations in the gains and losses related to trading securities and borrowings measured at fair value are caused by interest rate variances. As we do not anticipate any significant changes to interest rates in the foreseeable future, and therefore we do not anticipate any large fluctuations in future periods.

 

   

We are continually analyzing our available-for-sale investment portfolio for potential sale opportunities that will improve our long term profitability. During the first quarter of 2012, we identified several pools of mortgage-backed securities with significant unrealized gains. As the interest rates of the underlying mortgages were significantly higher than the current offering rates for similar mortgages, we elected to realize these gains through the sales of such securities as the investments would have likely been paid off in the near term through refinancing activity. In the third quarter of 2012, we elected to sell some additional mortgage-backed securities as their current prepayment characteristics had resulted in less than acceptable yields. We do not anticipate any further significant investment sales during the remainder of 2012.

 

   

Earnings on corporate owned life insurance policies have increased from 2011 as a result of the purchase of an additional $4,000 in policies in the third quarter of 2011. Earnings are expected to approximate current levels for the remainder of 2012.

 

   

As market conditions have improved, we have been able to sell some of our OREO properties at gains. As property values and the facts and circumstances surrounding each property vary, this amount will fluctuate from period to period. We do not anticipate any assets currently included in OREO generating significant gains or losses in future periods.

 

   

The fluctuation in all other income is spread throughout various categories, none of which are individually significant. We do not anticipate any significant fluctuations from current levels for the remainder of 2012.

 

50


Table of Contents

Noninterest Expenses

Noninterest expenses include compensation and benefits, occupancy, furniture and equipment, available-for-sale security impairment loss, and other expenses. Significant account balances are highlighted in the accompanying tables with additional descriptions of significant fluctuations:

 

     Three Months Ended September 30  
            Change  
     2012      2011      $     %  

Compensation and benefits

          

Compensation

   $ 3,810       $ 3,567       $ 243        6.8

Benefits

     1,320         1,247         73        5.9
  

 

 

    

 

 

    

 

 

   

 

 

 

Total compensation and benefits

     5,130         4,814         316        6.6
  

 

 

    

 

 

    

 

 

   

 

 

 

Occupancy

          

Outside services

     147         147         —          0.0

Depreciation

     156         153         3        2.0

Property taxes

     129         121         8        6.6

Utilities

     125         122         3        2.5

Building repairs

     70         70         —          0.0

All other

     22         20         2        10.0
  

 

 

    

 

 

    

 

 

   

 

 

 

Total occupancy

     649         633         16        2.5
  

 

 

    

 

 

    

 

 

   

 

 

 

Furniture and equipment

          

Computer / service contracts

     455         504         (49     -9.7

Depreciation

     451         474         (23     -4.9

ATM and debit card fees

     177         161         16        9.9

All other

     30         12         18        150.0
  

 

 

    

 

 

    

 

 

   

 

 

 

Total furniture and equipment

     1,113         1,151         (38     -3.3
  

 

 

    

 

 

    

 

 

   

 

 

 

Other

          

Marketing and donations

     610         228         382        167.5

FDIC insurance premiums

     218         209         9        4.3

Directors fees

     235         203         32        15.8

Audit fees

     179         195         (16     -8.2

Education and travel

     112         102         10        9.8

Printing and supplies

     91         108         (17     -15.7

Postage and freight

     105         103         2        1.9

Foreclosed asset and collection

     21         143         (122     -85.3

Consulting fees

     92         63         29        46.0

Amortization of deposit premium

     67         77         (10     -13.0

Legal fees

     50         82         (32     -39.0

Other losses

     80         23         57        N/M   

All other

     376         379         (3     -0.8
  

 

 

    

 

 

    

 

 

   

 

 

 

Total other

     2,236         1,915         321        16.8
  

 

 

    

 

 

    

 

 

   

 

 

 

Total noninterest expenses

   $ 9,128       $ 8,513       $ 615        7.2
  

 

 

    

 

 

    

 

 

   

 

 

 

 

51


Table of Contents
     Nine Months Ended September 30  
            Change  
     2012      2011      $     %  

Compensation and benefits

          

Compensation

   $ 11,458       $ 10,636       $ 822        7.7

Benefits

     4,205         3,929         276        7.0
  

 

 

    

 

 

    

 

 

   

 

 

 

Total compensation and benefits

     15,663         14,565         1,098        7.5
  

 

 

    

 

 

    

 

 

   

 

 

 

Occupancy

          

Outside services

     447         454         (7     -1.5

Depreciation

     465         451         14        3.1

Property taxes

     388         379         9        2.4

Utilities

     349         355         (6     -1.7

Building repairs

     177         189         (12     -6.3

All other

     63         64         (1     -1.6
  

 

 

    

 

 

    

 

 

   

 

 

 

Total occupancy

     1,889         1,892         (3     -0.2
  

 

 

    

 

 

    

 

 

   

 

 

 

Furniture and equipment

          

Computer / service contracts

     1,469         1,429         40        2.8

Depreciation

     1,337         1,458         (121     -8.3

ATM and debit card fees

     507         457         50        10.9

All other

     60         40         20        50.0
  

 

 

    

 

 

    

 

 

   

 

 

 

Total furniture and equipment

     3,373         3,384         (11     -0.3
  

 

 

    

 

 

    

 

 

   

 

 

 

Available-for-sale security impairment loss

     282         —           282        N/M   

Other

          

Marketing and donations

     1,639         978         661        67.6

FDIC insurance premiums

     646         874         (228     -26.1

Directors fees

     654         620         34        5.5

Audit fees

     509         518         (9     -1.7

Education and travel

     378         306         72        23.5

Printing and supplies

     310         297         13        4.4

Postage and freight

     300         299         1        0.3

Foreclosed asset and collection

     100         420         (320     -76.2

Consulting fees

     350         163         187        114.7

Amortization of deposit premium

     200         229         (29     -12.7

Legal fees

     193         198         (5     -2.5

Other losses

     217         34         183        N/M   

All other

     1,186         1,102         84        7.6
  

 

 

    

 

 

    

 

 

   

 

 

 

Total other

     6,682         6,038         644        10.7
  

 

 

    

 

 

    

 

 

   

 

 

 

Total noninterest expenses

   $ 27,889       $ 25,879       $ 2,010        7.8
  

 

 

    

 

 

    

 

 

   

 

 

 

 

52


Table of Contents

Significant changes in noninterest expenses are detailed below:

 

   

The increase in compensation, and corresponding increases in employee benefits, is due to annual merit increases and our continued growth as well as additional staff additions to help comply with the Dodd Frank Act and other recently passed regulations.

 

   

As noted above, our customers have continued to increase their dependence on ATM and debit cards. This increased usage has resulted in a corresponding increase in fees that we pay to various service providers. We expect that these fees will continue to increase as the usage of debit cards increases.

 

   

We have long been a strong supporter of the various communities, schools, and charities in the markets we serve. In the 1996, we established a foundation that is generally funded from non-recurring revenue sources. The foundation allows us to make long term to organizations that benefit our communities. Donation expenses related to the foundation were $850 and $250 for the nine months ended September 30, 2012 and 2011, respectively.

 

   

FDIC insurance premiums declined in the third quarter of 2011 due to a change in the premium calculation. Since that time, premiums have increased as we have continued to grow our balance sheet. There are no significant changes to the premium calculation expected for the remainder of 2012.

 

   

The increase in consulting fees is primarily related to consulting services employed to review the FHLB advance restructure (see “Volume and Rate Variance Analysis”, above). They also increased due to the engagement of consultants to review our loan prepayment and deposit decay assumptions as well as to review various information technology projects. Consulting fees are anticipated to approximate current levels for the remainder of 2012.

 

   

As a result of decreases in foreclosure and repossession activity, we have seen significant declines in foreclosed asset and collection expenses. These expenses have also declined as we have been able to recover expenses through our collection efforts. These collection efforts have actually led to a net negative expense for the current quarter as we have been able to recover expenses incurred in previous periods. Foreclosed asset and collection expenses are expected to decline for the remainder of 2012.

 

   

During the first quarter of 2012, we recorded a credit impairment on an AFS investment security through earnings due to a bond being downgraded by Moody’s to Caa3. We will continue to monitor the investment portfolio throughout the year for other potential other-than-temporary impairments. For further discussion, see “Note 5—Available-For-Sale Securities” to the interim condensed consolidated financial statements.

 

   

Other losses have increased significantly in 2012 primarily as a result of losses incurred related to a fraudulent wire transfer as well as losses related to repurchase of a loan that was previously sold to a third party. We do not anticipate any significant other losses in the remainder of 2012.

 

   

The fluctuations in all other expenses are spread throughout various categories, none of which are individually significant.

 

53


Table of Contents

ANALYSIS OF CHANGES IN FINANCIAL CONDITION

 

     September 30
2012
    December 31
2011
    $ Change     % Change
(unannualized)
 

ASSETS

        

Cash and cash equivalents

   $ 24,664      $ 28,590      $ (3,926     -13.73

Certificates of deposit held in other financial institutions

     5,675        8,924        (3,249     -36.41

Trading securities

     1,788        4,710        (2,922     -62.04

Available-for-sale securities

     467,414        425,120        42,294        9.95

Mortgage loans available-for-sale

     2,820        3,205        (385     -12.01

Loans

     766,751        750,291        16,460        2.19

Allowance for loan losses

     (12,062     (12,375     313        N/M   

Premises and equipment

     25,471        24,626        845        3.43

Corporate owned life insurance

     22,594        22,075        519        2.35

Accrued interest receivable

     6,565        5,848        717        12.26

Equity securities without readily determinable fair values

     17,830        17,189        641        3.73

Goodwill and other intangible assets

     46,592        46,792        (200     -0.43

Other assets

     13,036        12,930        106        0.82
  

 

 

   

 

 

   

 

 

   

 

 

 

TOTAL ASSETS

   $ 1,389,138      $ 1,337,925      $ 51,213        3.83
  

 

 

   

 

 

   

 

 

   

 

 

 

LIABILITIES AND SHAREHOLDERS’ EQUITY

        

Liabilities

        

Deposits

   $ 989,491      $ 958,164      $ 31,327        3.27

Borrowed funds

     226,580        216,136        10,444        4.83

Accrued interest payable and other liabilities

     8,920        8,842        78        0.88
  

 

 

   

 

 

   

 

 

   

 

 

 

Total liabilities

     1,224,991        1,183,142        41,849        3.54

Shareholders’ equity

     164,147        154,783        9,364        6.05
  

 

 

   

 

 

   

 

 

   

 

 

 

TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY

   $ 1,389,138      $ 1,337,925      $ 51,213        3.83
  

 

 

   

 

 

   

 

 

   

 

 

 

As shown above, we were able to grow our balance sheet since December 31, 2011. The growth in deposits was supplemented by an increase in borrowed funds. As loan growth continues to be relatively soft, the additional funding provided by the growth in loans and deposits were deployed into available-for-sale investment securities to generate additional net interest income. We anticipate that loan growth will continue to be a challenge and that deposit growth will approximate current levels over the remainder of the year.

The following table outlines the changes in the loan portfolio:

 

     September 30
2012
     December 31
2011
     $ Change      % Change
(unannualized)
 

Agricultural

   $ 83,439       $ 74,645       $ 8,794         11.78

Commercial

     369,366         365,714         3,652         1.00

Consumer

     33,515         31,572         1,943         6.15

Residential real estate

     280,431         278,360         2,071         0.74
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 766,751       $ 750,291       $ 16,460         2.19
  

 

 

    

 

 

    

 

 

    

 

 

 

 

54


Table of Contents

The following table outlines the changes in the deposit portfolio:

 

     September 30
2012
     December 31
2011
     $ Change     % Change
(unannualized)
 

Noninterest bearing demand deposits

   $ 126,362       $ 119,072       $ 7,290        6.12

Interest bearing demand deposits

     174,350         163,653         10,697        6.54

Savings deposits

     221,930         193,902         28,028        14.45

Certificates of deposit

     374,445         395,777         (21,332     -5.39

Brokered certificates of deposit

     59,871         54,326         5,545        10.21

Internet certificates of deposit

     32,533         31,434         1,099        3.50
  

 

 

    

 

 

    

 

 

   

 

 

 

Total

   $ 989,491       $ 958,164       $ 31,327        3.27
  

 

 

    

 

 

    

 

 

   

 

 

 

Borrowed funds consist of the following obligations as of:

 

     September 30, 2012     December 31, 2011  
     Amount      Rate     Amount      Rate  

Federal Home Loan Bank advances

   $ 152,000         2.15   $ 142,242         3.16

Securities sold under agreements to repurchase without stated maturity dates

     57,927         0.20     57,198         0.25

Securities sold under agreements to repurchase with stated maturity dates

     16,653         3.51     16,696         3.51
  

 

 

    

 

 

   

 

 

    

 

 

 

Total

   $ 226,580         1.75   $ 216,136         2.42
  

 

 

    

 

 

   

 

 

    

 

 

 

The FHLB advances are collateralized by a blanket lien on all qualified 1-4 family residential real estate loans and certain mortgage-backed securities and collateralized mortgage obligations. Advances are also secured by FHLB stock. We had the ability to borrow up to an additional $117,035 based on assets currently pledged as collateral as of September 30, 2012. During the first quarter of 2012, we reduced funding costs by modifying the terms of $60,000 of FHLB advances. This modification strategy extended the duration of our interest bearing liabilities and will reduce interest expense by approximately $450 for 2012.

The following table lists the maturity and weighted average interest rates of FHLB advances as of:

 

     September 30
2012
    December 31
2011
 
     Amount      Rate     Amount      Rate  

Fixed rate advances due 2012

   $ —           —        $ 17,000         2.97

One year putable fixed rate advances due 2012

     5,000         3.48     15,000         4.10

Variable rate advances due 2012

     5,000         0.50     —           —     

Fixed rate advances due 2013

     —           —          5,242         4.14

One year putable fixed rate advances due 2013

     —           —          5,000         3.15

Fixed rate advances due 2014

     —           —          25,000         3.16

Fixed rate advances due 2015

     42,000         1.12     45,000         3.30

Fixed rate advances due 2016

     10,000         2.15     10,000         2.15

Fixed rate advances due 2017

     40,000         2.15     20,000         2.56

Fixed rate advances due 2018

     20,000         2.86     —           —     

Fixed rate advances due 2019

     20,000         3.73     —           —     

Fixed rate advances due 2020

     10,000         1.98     —           —     
  

 

 

    

 

 

   

 

 

    

 

 

 

Total

   $ 152,000         2.15   $ 142,242         3.16
  

 

 

    

 

 

   

 

 

    

 

 

 

 

55


Table of Contents

Capital

Capital consists solely of common stock, retained earnings, and accumulated other comprehensive income. We are currently authorized to raise capital through dividend reinvestment, employee and director stock purchases, and shareholder stock purchases. Pursuant to theses authorizations, we issued 85,227 shares or $2,025 of common stock during the first nine months of 2012, as compared to 89,898 shares or $1,633 of common stock during the same period in 2011. We also offer the Directors Plan which allows participants to purchase stock units, in lieu of cash payments. Pursuant to this plan, we increased shareholders’ equity by $496 and $486 during the nine month periods ended September 30, 2012 and 2011, respectively.

We have approved a publicly announced common stock repurchase plan. During the first nine months of 2012 and 2011, pursuant to this plan, we repurchased 63,103 shares of common stock at an average price of $24.09 and 76,708 shares of common stock at an average price of $18.13, respectively. As of September 30, 2012, we were authorized to repurchase up to an additional 105,893 shares of common stock.

There are no significant regulatory constraints placed on our capital. The FRB’s current recommended minimum primary capital to assets requirement is 6.0%. Our primary capital to adjusted average assets, which consists of shareholders’ equity plus the allowance for loan losses less acquisition intangibles, was 8.27% as of September 30, 2012.

The FRB has established a minimum risk based capital standard. Under this standard, a framework has been established that assigns risk weights to each category of on and off balance sheet items to arrive at risk adjusted total assets. Regulatory capital is divided by the risk adjusted assets with the resulting ratio compared to the minimum standard to determine whether a corporation has adequate capital. The minimum standard is 8%, of which at least 4% must consist of equity capital net of goodwill. The following table sets forth the percentages required under the Risk Based Capital guidelines and our values as of:

 

     September 30
2012
    December 31
2011
    Required  

Equity Capital

     13.35     12.92     4.00

Secondary Capital

     1.25     1.25     4.00
  

 

 

   

 

 

   

 

 

 

Total Capital

     14.60     14.17     8.00
  

 

 

   

 

 

   

 

 

 

Secondary capital includes only the allowance for loan losses. The percentage for the secondary capital under the required column is the maximum amount allowed from all sources.

The FRB and FDIC also prescribe minimum capital requirements for Isabella Bank. At September 30, 2012, the Bank exceeded these minimum capital requirements. Recently passed legislation will likely increase the required level of capital for banks. This increase in capital levels may have an adverse impact on our ability to grow and pay dividends.

Liquidity

Liquidity is monitored regularly by our Market Risk Committee, which consists of members of senior management. The committee reviews projected cash flows, key ratios, and liquidity available from both primary and secondary sources.

Our primary sources of liquidity are cash and demand deposits due from banks, certificates of deposit held in other financial institutions, trading securities, and available-for-sale securities. These categories totaled $499,541 or 36.0% of assets as of September 30, 2012 as compared to $467,344 or 34.9% as of December 31, 2011. Liquidity is important for financial institutions because of their need to meet loan funding commitments, depositor withdrawal requests, and various other commitments including expansion of operations, investment opportunities, and payment of cash dividends. Liquidity varies on a daily basis as a result of customer activity.

Our primary source of funds is deposit accounts. We also have the ability to borrow from the FHLB, the FRB, and through various correspondent banks as federal funds purchased. These funding methods typically carry a higher interest rate than traditional market deposit accounts. Some borrowed funds, including FHLB Advances, FRB Discount Window Advances, and repurchase agreements, require us to pledge assets, typically in the form of certificates of deposits held in other financial institutions, investment securities, or loans as collateral. We had the ability to borrow up to an additional $117,035 based on the assets currently pledged as collateral.

 

56


Table of Contents

The following table summarizes our sources and uses of cash for the nine month periods ended September 30:

 

     2012     2011     $ Variance  

Net cash provided by operating activities

   $ 14,860      $ 12,992      $ 1,868   

Net cash used in investing activities

     (56,181     (92,937     36,756   

Net cash provided by financing activities

     37,395        83,057        (45,662
  

 

 

   

 

 

   

 

 

 

(Decrease) increase in cash and cash equivalents

     (3,926     3,112        (7,038

Cash and cash equivalents January 1

     28,590        18,109        10,481   
  

 

 

   

 

 

   

 

 

 

Cash and cash equivalents September 30

   $ 24,664      $ 21,221      $ 3,443   
  

 

 

   

 

 

   

 

 

 

Market Risk

Our primary market risks are interest rate risk and liquidity risk. We have no significant foreign exchange risk and do not utilize interest rate swaps or derivatives, except for interest rate locks and forward loan commitments, in the management of IRR. Any changes in foreign exchange rates or commodity prices would have an insignificant impact on our interest income and cash flows.

IRR is the exposure of our net interest income to changes in interest rates. IRR results from the difference in the maturity or repricing frequency of a financial institution’s interest earning assets and its interest bearing liabilities. IRR is the fundamental method in which financial institutions earn income and create shareholder value. Excessive exposure to IRR could pose a significant risk to our earnings and capital.

The FRB, our primary Federal regulator, has adopted a policy requiring us to effectively manage the various risks that can have a material impact on our safety and soundness. The risks include credit, interest rate, liquidity, operational, and reputational. We have policies, procedures and internal controls for measuring and managing these risks. Specifically, the IRR policy and procedures include defining acceptable types and terms of investments and funding sources, liquidity requirements, limits on investments in long term assets, limiting the mismatch in repricing opportunity of assets and liabilities, and the frequency of measuring and reporting to our Board of Directors.

The primary technique to measure interest rate risk is simulation analysis. Simulation analysis forecasts the effects on the balance sheet structure and net interest income under a variety of scenarios that incorporate changes in interest rates, the shape of yield curves, interest rate relationships, and loan prepayments. These forecasts are compared against net interest income projected in a stable interest rate environment. While many assets and liabilities reprice either at maturity or in accordance with their contractual terms, several balance sheet components demonstrate characteristics that require an evaluation to more accurately reflect their repricing behavior. Key assumptions in the simulation analysis include prepayments on loans, probable calls of investment securities, changes in market conditions, loan volumes and loan pricing, deposit sensitivity and customer preferences. These assumptions are inherently uncertain as they are subject to fluctuation and revision in a dynamic environment. As a result, the simulation analysis cannot precisely forecast the impact of rising and falling interest rates on net interest income. Actual results will differ from simulated results due to many other factors, including changes in balance sheet components, interest rate changes, changes in market conditions, and management strategies.

Our interest rate sensitivity is estimated by first forecasting the next twelve months of net interest income under an assumed environment of a constant balance sheet and constant market interest rates (base case). We then compare the results of various simulation analyses to the base case. At September 30, 2012, we projected the change in net interest income during the next twelve months assuming market interest rates were to immediately decrease by 100 basis points and increase by 100, 200, 300, and 400 basis points in a parallel fashion over the entire yield curve during the same time period. We did not project scenarios showing decreases in interest rates beyond 100 basis points as this is considered extremely unlikely given prevailing interest rate levels. These projections were based on our assets and liabilities remaining static over the next twelve months, while factoring in probable calls and prepayments of certain investment securities and real estate residential and consumer loans. While it is extremely unlikely that interest rates would immediately increase at these levels, we feel that these extreme scenarios help us identify potential gaps and mismatches in the repricing characteristics of assets and liabilities. We regularly monitor our forecasted net interest income sensitivity to ensure that it remains within established limits.

 

57


Table of Contents

The following table summarizes our interest rate sensitivity as of:

 

     September 30, 2012  

Immediate basis point change assumption (short-term rates)

     -100        0         100        200        300        400   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

Percent change in net income vs. constant rates

     -1.45     —           0.28     -1.79     -2.54     -3.72
     September 30, 2011  

Immediate basis point change assumption (short-term rates)

     -100        0         100        200        300        400   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

Percent change in net income vs. constant rates

     -2.22     —           1.09     0.26     -1.88     N/A   

A 400 basis point increase was not applicable as of September 30, 2011 as we were not utilizing this scenario as part of our interest rate sensitivity analysis at that time.

The secondary method to measure interest rate risk is gap analysis. Gap analysis measures the cash flows and/or the earliest repricing of our interest bearing assets and liabilities. This analysis is useful for measuring trends in the repricing characteristics of the balance sheet. Significant assumptions are required in this process because of the imbedded repricing options contained in assets and liabilities. A substantial portion of our assets are invested in loans and investment securities with issuer call options. Residential real estate and consumer loans have imbedded options that allow the borrower to repay the balance prior to maturity without penalty, while commercial and agricultural loans have prepayment penalties. The amount of prepayments is dependent upon many factors, including the interest rate of a given loan in comparison to the current interest rate for residential real estate loans, the level of sales of used homes, and the overall availability of credit in the market place. Generally, a decrease in interest rates will result in an increase in cash flows from these assets. A significant portion of our securities are callable or have prepayment options. The call and prepayment options are more likely to be exercised in a period of decreasing interest rates. Investment securities, other than those that are callable, do not have any significant embedded options. Savings and NOW accounts may generally be withdrawn on request without prior notice. The timing of cash flows from these deposits is estimated based on historical experience. Time deposits have penalties that discourage early withdrawals.

The following tables provide information about assets and liabilities that are sensitive to changes in interest rates as of September 30, 2012 and December 31, 2011. The principal amounts of assets and time deposits maturing were calculated based on the contractual maturity dates. Savings and NOW accounts are based on management’s estimate of their future cash flows. During the third quarter of 2012, we engaged the services of a third party to analyze our historical loan prepayment speeds and non-contractual deposit decay rates. These analyses were prompted by the Office of Thrift Supervision’s discontinuation of publishing its various benchmarks for various loan prepayment speeds and deposit decay rates, which we had previously used for certain loan and deposit accounts (including as of December 31, 2011). As a result of implementing the results of these analyses, the estimated lives of our non-contractual deposit accounts significantly increased, which in turn significantly impacted the corresponding estimated cash flows for these accounts in the following table. We have reviewed the results of the analyses in detail and feel that it reasonably reflects the prepayment speeds and decay rates of our loan and deposit portfolios.

 

58


Table of Contents
(dollars in thousands)    September 30, 2012  
     2013     2014     2015     2016     2017     Thereafter     Total     Fair Value  

Rate sensitive assets

                

Other interest bearing assets

   $ 9,572      $ 1,325      $ 240      $ —        $ —        $ —        $ 11,137      $ 11,153   

Average interest rates

     0.82     1.14     1.25     —          —          —          0.87  

Trading securities

   $ 1,050      $ 738      $ —        $ —        $ —        $ —        $ 1,788      $ 1,788   

Average interest rates

     2.64     2.81     —          —          —          —          2.71  

Fixed interest rate securities

   $ 124,653      $ 66,580      $ 53,645      $ 38,084      $ 37,954      $ 146,498      $ 467,414      $ 467,414   

Average interest rates

     2.46     2.46     2.67     2.75     3.06     2.65     2.62  

Fixed interest rate loans (1)

   $ 139,585      $ 95,994      $ 88,688      $ 88,337      $ 104,694      $ 77,042      $ 594,340      $ 608,382   

Average interest rates

     5.93     5.67     5.77     5.35     4.70     4.78     5.41  

Variable interest rate loans (1)

   $ 69,647      $ 26,793      $ 29,299      $ 14,862      $ 21,910      $ 9,900      $ 172,411      $ 172,411   

Average interest rates

     4.70     3.89     3.71     3.71     3.38     3.99     4.11  

Rate sensitive liabilities

                

Borrowed funds

   $ 68,448      $ 5,225      $ 32,907      $ 30,000      $ 40,000      $ 50,000      $ 226,580      $ 234,229   

Average interest rates

     0.44     4.43     1.13     2.19     2.15     3.03     1.74  

Savings and NOW accounts

   $ 34,756      $ 31,593      $ 28,396      $ 25,549      $ 23,013      $ 252,973      $ 396,280      $ 396,280   

Average interest rates

     0.18     0.18     0.17     0.17     0.17     0.16     0.17  

Fixed interest rate time deposits

   $ 215,522      $ 67,291      $ 67,215      $ 51,449      $ 44,352      $ 19,867      $ 465,696      $ 474,373   

Average interest rates

     1.24     1.94     2.10     2.21     1.87     1.62     1.65  

Variable interest rate time deposits

   $ 784      $ 369      $ —        $ —        $ —        $ —        $ 1,153      $ 1,153   

Average interest rates

     0.46     0.45     —          —          —          —          0.46  
     December 31, 2011  
     2012     2013     2014     2015     2016     Thereafter     Total     Fair Value  

Rate sensitive assets

                

Other interest bearing assets

   $ 8,775      $ 4,125      $ 100      $ —        $ —        $ —        $ 13,000      $ 13,053   

Average interest rates

     1.18     1.33     0.35     —          —          —          1.22  

Trading securities

   $ 3,156      $ 1,031      $ 523      $ —        $ —        $ —        $ 4,710      $ 4,710   

Average interest rates

     3.34     2.48     2.49     —          —          —          3.06  

Fixed interest rate securities

   $ 104,559      $ 61,421      $ 48,659      $ 37,777      $ 35,108      $ 137,596      $ 425,120      $ 425,120   

Average interest rates

     2.98     2.84     2.91     2.93     3.21     3.01     2.98  

Fixed interest rate loans (1)

   $ 141,867      $ 140,390      $ 90,852      $ 75,690      $ 76,985      $ 61,854      $ 587,638      $ 606,524   

Average interest rates

     6.24     6.08     5.94     5.99     5.40     5.15     5.90  

Variable interest rate loans (1)

   $ 70,783      $ 25,267      $ 20,803      $ 18,853      $ 11,631      $ 15,316      $ 162,653      $ 162,653   

Average interest rates

     5.87     3.97     4.05     3.68     4.00     3.98     4.78  

Rate sensitive liabilities

                

Borrowed funds

   $ 89,869      $ 15,000      $ 25,869      $ 45,398      $ 20,000      $ 20,000      $ 216,136      $ 227,780   

Average interest rates

     1.42     3.93     3.13     3.30     2.67     2.56     2.41  

Savings and NOW accounts

   $ 120,850      $ 78,313      $ 51,291      $ 34,006      $ 22,803      $ 50,292      $ 357,555      $ 357,555   

Average interest rates

     0.20     0.19     0.18     0.17     0.15     0.15     0.18  

Fixed interest rate time deposits

   $ 264,147      $ 62,883      $ 46,802      $ 55,493      $ 43,601      $ 7,052      $ 479,978      $ 498,085   

Average interest rates

     1.61     2.67     2.33     2.56     2.41     1.48     2.00  

Variable interest rate time deposits

   $ 1,152      $ 407      $ —        $ —        $ —        $ —        $ 1,559      $ 1,559   

Average interest rates

     0.67     0.69     —          —          —          —          0.68  

 

(1) The fair value reported is exclusive of the allocation of the allowance for loan losses.

We do not believe that there has been a material change in the nature or categories of our primary market risk exposure, or the particular markets that present the primary risk of loss. As of the date of this report, we do not know of or expect there to be any material change in the general nature of our primary market risk exposure in the near term. The methods by which we manage primary market risk exposure, as described in our Annual Report on Form 10-K for the year ended December 31, 2011, have not changed materially during 2012. As of the date of this report, we do not expect to make material changes in those methods in the near term. We may change those methods in the future to adapt to changes in circumstances or to implement new techniques.

 

59


Table of Contents

FINANCIAL INSTRUMENTS WITH OFF BALANCE SHEET ARRANGEMENTS

We are party to credit related financial instruments with off-balance-sheet risk. These financial instruments are entered into in the normal course of business to meet the financing needs of our customers. These financial instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amounts recognized in the consolidated balance sheets. The contract or notional amounts of these instruments reflect the extent of involvement we have in a particular class of financial instrument.

The following table summarizes our credit related financial instruments with off-balance-sheet risk as of:

 

     September 30
2012
     December 31
2011
 

Unfunded commitments under lines of credit

   $ 109,593       $ 102,822   

Commercial and standby letters of credit

     4,033         4,461   

Commitments to grant loans

     23,377         21,806   

Unfunded commitments under lines of credit are commitments for possible future extensions of credit to existing customers. These commitments may expire without being drawn upon. Therefore, the total commitment amounts do not necessarily represent future cash requirements.

Commercial and standby letters of credit are conditional commitments issued to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support private borrowing arrangements, including commercial paper, bond financing, and similar transactions. These commitments to extend credit and letters of credit generally mature within one year. The credit risk involved in these transactions is essentially the same as that involved in extending loans to customers. We evaluate each customer’s credit worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary upon the extension of credit, is based on a credit evaluation of the borrower. While we consider standby letters of credit to be guarantees, the amount of the liability related to such guarantees on the commitment date is not significant and a liability related to such guarantees is not recorded on the consolidated balance sheets.

Commitments to grant loans are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. The amount of collateral obtained, if it is deemed necessary, is based on management’s credit evaluation of the customer. Commitments to grant loans include loans committed to be sold to the secondary market.

Our exposure to credit-related loss in the event of nonperformance by the counter parties to the financial instruments for commitments to extend credit and standby letters of credit could be up to the contractual notional amount of those instruments. We use the same credit policies as we do for extending loans to customers. No significant losses are anticipated as a result of these commitments.

Forward Looking Statements

This report contains certain forward looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. We intend such forward looking statements to be covered by the safe harbor provisions for forward looking statements contained in the Private Securities Litigation Reform Act of 1995, and is included in this statement for purposes of these safe harbor provisions. Forward looking statements, which are based on certain assumptions and describe future plans, strategies and expectations, are generally identifiable by use of the words “believe,” “expect,” “intend,” “anticipate,” “estimate,” “project,” or similar expressions. Our ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Factors which could have a material adverse effect on the operations and future prospects include, but are not limited to, changes in: interest rates, general economic conditions, monetary and fiscal policies of the U.S. Government, including policies of the U.S. Treasury and the FRB, the quality or composition of the loan or investment portfolios, demand for loan products, fluctuation in the value of collateral securing our loan portfolio, deposit flows, competition, demand for financial services in our market area, and accounting principles, policies and guidelines. These risks and uncertainties should be considered in evaluating forward looking statements and undue reliance should not be placed on such statements. Further information concerning Isabella Bank Corporation and its business, including additional factors that could materially affect our financial results, is included in our filings with the SEC.

 

60


Table of Contents

Item 3 – Quantitative and Qualitative Disclosures about Market Risk

The information presented in the “Market Risk” section of the Management’s Discussion and Analysis of Financial Condition and Results of Operations is incorporated herein by reference.

Item 4 – Controls and Procedures

DISCLOSURE CONTROLS AND PROCEDURES

We carried out an evaluation, under the supervision and with the participation of the Principal Executive Officer and Principal Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15(d)-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”)) as of September 30, 2012, pursuant to Exchange Act Rule 13a-15. Based upon that evaluation, the Principal Executive Officer and Principal Financial Officer concluded that our disclosure controls and procedures as of September 30, 2012, were effective to ensure that information required to be disclosed in reports that we file or submit under the Exchange Act are recorded, processed, summarized and reported within the time periods specified in SEC rules and forms.

CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING

During the most recent fiscal quarter, no change occurred in our internal control over financial reporting that materially affected, or is likely to materially effect, our internal control over financial reporting.

 

61


Table of Contents

PART II – OTHER INFORMATION

Item 1 – Legal Proceedings

We are not involved in any material legal proceedings. We are involved in ordinary, routine litigation incidental to our business; however, no such routine proceedings are expected to result in any material adverse effect on operations, earnings, or financial condition.

Item 1A – Risk Factors

There have been no material changes to the risk factors disclosed in Item 1A in our Annual Report on Form 10-K for the year ended December 31, 2011.

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

 

(A) None

 

(B) None

 

(C) Repurchases of Common Stock

We have adopted and announced a common stock repurchase plan. The plan was last amended on April 26, 2012, to allow for the repurchase of an additional 150,000 shares of common stock. These authorizations do not have expiration dates. As shares are repurchased under this plan, they are retired and revert back to the status of authorized, but unissued shares.

The following table provides information for the three month period ended September 30, 2012, with respect to this plan:

 

                   Total Number of
Shares  Purchased
as Part of Publicly
Announced Plan
or Program
     Maximum Number  of
Shares That May Yet Be
Purchased Under the
Plans or Programs
 
                   
   Shares Repurchased        
            Average Price
Per Share
       
     Number           

Balance, June 30, 2012

              127,415   

July 1 - 31, 2012

     5,691       $ 24.60         5,691         121,724   

August 1 - 31, 2012

     9,821         24.34         9,821         111,903   

September 1 - 30, 2012

     6,010         23.46         6,010         105,893   
  

 

 

    

 

 

    

 

 

    

 

 

 

Balance, September 30, 2012

     21,522       $ 24.16         21,522         105,893   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

62


Table of Contents

Item 6 – Exhibits

 

  (a) Exhibits

 

  31(a)   Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 by the Principal Executive Officer
  31(b)   Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 by the Principal Financial Officer
  32   Section 1350 Certification of Principal Executive Officer and Principal Financial Officer
101.1*   101.INS (XBRL Instance Document)
  101.SCH (XBRL Taxonomy Extension Schema Document)
  101.CAL (XBRL Calculation Linkbase Document)
  101.LAB (XBRL Taxonomy Label Linkbase Document)
  101.DEF (XBRL Taxonomy Linkbase Document)
  101.PRE (XBRL Taxonomy Presentation Linkbase Document)

 

In accordance with Rule 406T of Regulations S-T, the XBRL related information shall not be deemed to be “filed” for purposes of Section 18 of the Exchange Act, or otherwise subject to the liability of that section, and shall not be part of any registration statement or other document filed under the Securities Act or the Exchange Act, except as shall be expressly set forth by specific reference in such filing.

 

63


Table of Contents

SIGNATURES

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

 

Isabella Bank Corporation

Date: October 29, 2012

     

/s/ Richard J. Barz

      Richard J. Barz
      Chief Executive Officer
      (Principal Executive Officer)

Date: October 29, 2012

     

/s/ Dennis P. Angner

      Dennis P. Angner
      President, Chief Financial Officer
      (Principal Financial Officer, Principal Accounting Officer)

 

64