# Fidelity D & D Bancorp Inc: Form 10-Q for the period ended Mar 31, 2011

- Company: [Fidelity D & D Bancorp Inc](/companies/fdbc.md) (CIK 1098151)
- Form: 10-Q
- Filed: 2011-05-11
- Accepted by EDGAR: May 11, 2011, 12:32 ET
- Period: 2011-03-31
- Accession: 0001144204-11-027981
- Inline XBRL: no
- Main document: https://www.sec.gov/Archives/edgar/data/1098151/000114420411027981/v221793_10q.htm
- All documents and exhibits: https://www.sec.gov/Archives/edgar/data/1098151/000114420411027981/

## Management's discussion and analysis

As filed, 59,447 characters.

The following is management's discussion and analysis of the significant changes in the consolidated financial condition of the Company as of March 31, 2011 compared to December 31, 2010 and a comparison of the results of operations for the three-months ended March 31, 2011 and 2010. Current performance may not be indicative of future results. This discussion should be read in conjunction with the Company’s 2010 Annual Report filed on Form 10-K.

### Forward-looking statements

Certain of the matters discussed in this Quarterly Report on Form 10-Q may constitute forward-looking statements for purposes of the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended, and as such may involve known and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements of the Company to be materially different from future results, performance or achievements expressed or implied by such forward-looking statements. The words “expect,” “anticipate,” “intend,” “plan,” “believe,” “estimate,” and similar expressions are intended to identify such forward-looking statements.

The Company’s actual results may differ materially from the results anticipated in these forward-looking statements due to a variety of factors, including, without limitation:

- the effects of economic deterioration on current customers, specifically the effect of the economy on loan customers’ ability to repay loans;
- the costs and effects of litigation and of unexpected or adverse outcomes in such litigation;
- the impact of new laws and regulations, including the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 and the regulations promulgated there under;
- governmental monetary and fiscal policies, as well as legislative and regulatory changes;
- the effect of changes in accounting policies and practices, as may be adopted by the regulatory agencies, as well as the Financial Accounting Standards Board and other accounting standard setters;
- the risks of changes in interest rates on the level and composition of deposits, loan demand, and the values of loan collateral, securities and interest rate protection agreements, as well as interest rate risks;
- the effects of competition from other commercial banks, thrifts, mortgage banking firms, consumer finance companies, credit unions, securities brokerage firms, insurance companies, money market and other mutual funds and other financial institutions operating in the Company’s market area and elsewhere, including institutions operating locally, regionally, nationally and internationally, together with such competitors offering banking products and services by mail, telephone, computer and the internet;
- technological changes;
- acquisitions and integration of acquired businesses;
- the failure of assumptions underlying the establishment of reserves for loan losses and estimations of values of collateral and various financial assets and liabilities;
- volatilities in the securities markets;
- deteriorating economic conditions;
- disruption of credit and equity markets; and
- acts of war or terrorism.

The Company cautions readers not to place undue reliance on forward-looking statements, which reflect analyses only as of the date of this document. We have no obligation to update any forward-looking statements to reflect events or circumstances after the date of this document.

Readers should review the risk factors described in other documents that we file or furnish, from time to time, with the Securities and Exchange Commission, including Annual Reports to Shareholders, Annual Reports filed on Form 10-K and other current reports filed or furnished on Form 8-K.

### General

The Company’s results of operations depend primarily on net interest income. Net interest income is the difference between interest income and interest expense. Interest income is generated from yields on interest-earning assets, which consist principally of loans and investment securities. Interest expense is incurred from rates paid on interest-bearing liabilities, which consist of deposits and borrowings. Net interest income is determined by the Company’s interest rate spread (the difference between the yields earned on its interest-earning assets and the rates paid on its interest-bearing liabilities) and the relative amounts of interest-earning assets and interest-bearing liabilities. Interest rate spread is significantly impacted by: changes in interest rates and market yield curves and their related impact on cash flows; the composition and characteristics of interest-earning assets and interest-bearing liabilities; differences in the maturity and re-pricing characteristics of assets compared to the maturity and re-pricing characteristics of the liabilities that fund them and by the competition in the marketplace.

The Company’s profitability is also affected by the level of its non-interest income and expenses and by the provisions for loan losses income taxes. Non-interest income consists mostly of service charges on the Company’s loan and deposit products, trust and asset management service fees, increases in the cash surrender value of the bank owned life insurance, net gains or losses from sales of loans, securities and foreclosed assets held-for-sale and from credit-related other-than-temporary impairment (OTTI) charges on investment securities. Non-interest expense consists of compensation and related employee benefit expenses, occupancy, equipment, data processing, advertising, marketing, FDIC insurance premiums, professional fees, supplies and other operating overhead.

The Company’s profitability is significantly affected by general economic and competitive conditions, changes in market interest rates, government policies and actions of regulatory authorities. The Company’s loan portfolio is comprised principally of commercial and commercial real estate loans. The properties underlying the Company’s mortgages are concentrated in Northeastern Pennsylvania. Credit risk, which represents the possibility of the Company not recovering amounts due from its borrowers, is significantly related to local economic conditions in the areas where the properties are located as well as the Company’s underwriting standards. Economic conditions affect the market value of the underlying collateral as well as the levels of adequate cash flow and revenue generation from income-producing commercial properties.

### Comparison of the results of operations

### Three months ended March 31, 2011 and 2010

### Overview

Net income for the first quarter of 2011 was $1,227,000, or $0.56 per diluted share, compared to net income of $556,000, or $0.26 per diluted share, recorded in the same quarter of 2010. The improvement in net income was due to: a $615,000, or 12%, net decrease in operating expenses, a $267,000 combined increase in net interest and non-interest income and a $100,000, or 17%, lower provision for loan losses. These items were partially offset by a higher provision for income taxes.

Return on average assets (ROA) and return on average shareholders’ equity (ROE) were 0.86% and 10.41%, respectively, for the three months ended March 31, 2011 compared to 0.38% and 4.85%, respectively, for the three months ended March 31, 2010. The improvements in both ROA and ROE are attributable to higher net income recorded in the current year period.

#### Net interest income and interest sensitive assets / liabilities

Net interest income improved marginally from $5,159,000 in the first quarter of 2010 to $5,234,000 in the first quarter of 2011. The $75,000 improvement was caused by a larger decline in interest expense than interest income. Compared to the first quarter of 2010, interest expense declined $566,000, or 30%, in the first quarter of 2011. The decrease consisted of lower rates paid on interest-bearing deposits and lower balances of borrowings. The lower rate environment caused deposits to price 34 basis points below the deposit pricing that was in effect in the year-ago quarter. The lower rates were the primary cause of interest expense on deposits to decline by $372,000, or 26%, in the first quarter of 2011 compared to the first quarter of 2010. The lower interest expense from borrowings was due principally from the payoff of $20,500,000 in short- and long-term FHLB advances in 2010. The effect of the lower average balances of borrowings was the principal cause of interest expense on borrowings to decline $193,000, or 41%, in the first quarter of 2011 compared to the first quarter of 2010.

Interest income declined $491,000, or 7%, due primarily to a 95 basis point decrease in yields from the investment portfolio, as well as an $11,900,000 decrease in average balances of interest-earning assets, mostly from the risk management practice to strategically reduce the average balance of the commercial loan portfolio. The decline in yield in the investment portfolio was caused by the defaults in preferred term securities and their related migration to non-accrual status and lower yields from mortgage-backed and government agency securities.

The Company’s tax-equivalent margin and spread improved to 4.05% and 3.78%, respectively, for the three months ended March 31, 2011 from 3.91% and 3.63% during the same period of 2010. The improvement in spread is from a more rapid decline in rates paid on interest-costing liabilities compared to the decline in yields from interest-earning assets. The improved margin is from both the aforementioned improvement in spread, higher net interest income and a reduction in the volume of interest-earning assets.

The Company’s Asset Liability Management (ALM) team will, if and when deemed necessary, adjust interest rates on deposits and repurchase agreements and implement strengthening strategic initiatives to minimize the impact this prolonged low interest rate environment may have on the Company’s interest margin performance.

The table that follows sets forth a comparison of average balances and their corresponding fully tax-equivalent (FTE) interest income and expense and annualized tax-equivalent yield and cost for the periods indicated (dollars in thousands):

| Assets Interest-earning assets: | Three months ended: March 31, 2011 Average balance | Interest | Yield / rate | March 31, 2010 Average balance | Interest | Yield / rate |
| --- | ---: | ---: | ---: | ---: | ---: | ---: |
| Loans and leases | $419,208 | $6,001 | 5.80% | $437,200 | $6,302 | 5.85% |
| Investments | 97,458 | 741 | 3.08 | 92,932 | 924 | 4.03 |
| Federal funds sold | 81 | 0 | 0.25 | 12,884 | 7 | 0.22 |
| Interest-bearing deposits | 27,880 | 17 | 0.25 | 13,458 | 8 | 0.25 |
| Total interest-earning assets | 544,627 | 6,759 | 5.03 | 556,474 | 7,241 | 5.28 |
| Non-interest-earning assets | 37,044 |  |  | 31,888 |  |  |
| Total assets | $581,671 |  |  | $588,362 |  |  |
| **Liabilities and shareholders' equity** |  |  |  |  |  |  |
| Interest-bearing liabilities: |  |  |  |  |  |  |
| Other interest-bearing deposits | $252,283 | $297 | 0.48% | $257,210 | $506 | 0.78% |
| Certificates of deposit | 139,878 | 745 | 2.16 | 146,384 | 908 | 2.46 |
| Borrowed funds | 21,748 | 256 | 4.77 | 42,042 | 423 | 4.08 |
| Repurchase agreements | 14,787 | 19 | 0.52 | 18,012 | 45 | 1.01 |
| Total interest-bearing liabilities | 428,696 | 1,317 | 1.25 | 463,648 | 1,882 | 1.65 |
| Non-interest-bearing deposits | 101,942 |  |  | 74,808 |  |  |
| Other non-interest-bearing liabilities | 3,257 |  |  | 3,380 |  |  |
| Shareholders' equity | 47,776 |  |  | 46,526 |  |  |
| Total liabilities and shareholders' equity | $581,671 |  |  | $588,362 |  |  |
| Net interest income/interest rate spread |  | $5,442 | 3.78% |  | $5,359 | 3.63% |
| Net interest margin |  |  | 4.05% |  |  | 3.91% |

In the preceding table, interest income was adjusted to a tax-equivalent basis, using the corporate federal tax rate of 34%, to recognize the income from tax-exempt interest-earning assets as if the interest was taxable. This treatment allows a uniform comparison between yields on interest-earning assets. Loans include loans HFS and non-accrual loans but exclude the allowance for loan losses. Securities include non-accrual securities. Average balances are based on amortized cost and do not reflect net unrealized gains or losses. Net interest margin is calculated by dividing net interest income by total average interest-earning assets.

#### Provision for loan losses

The provision for loan losses represents the necessary amount to charge against current earnings, the purpose of which is to increase the allowance for loan losses to a level that represents management’s best estimate of known and inherent losses in the Company’s loan portfolio. Loans determined to be uncollectible are charged off against the allowance for loan losses. The required amount of the provision for loan losses, based upon the adequate level of the allowance for loan losses, is subject to ongoing analysis of the loan portfolio. The Company’s Special Assets Committee meets periodically to review problem loans. The committee is comprised of management, including the senior loan officer, the chief risk officer, loan officers, loan workout officers and collection personnel. The committee reports quarterly to the Credit Administration Committee of the Board of Directors.

Management continuously reviews the risks inherent in the loan portfolio. Specific factors used to evaluate the adequacy of the loan loss provision during the formal process include:

- specific loans that could have loss potential;
- levels of and trends in delinquencies and non-accrual loans;
- levels of and trends in charge-offs and recoveries;
- trends in volume and terms of loans;
- changes in risk selection and underwriting standards;
- changes in lending policies, procedures and practices;
- experience, ability and depth of lending management;
- national and local economic trends and conditions; and
- changes in credit concentrations.

The provision for loan losses was $475,000 for the three months ending March 31, 2011 and was $575,000 for the three month period ending March 31, 2010. The $475,000 provision for the current quarter was recorded to provide increased allocations for an increase in commercial loans which were risk rated substandard. For a further discussion on the risk rating categories of loans, see the caption “Credit Quality Indicators” located within note 4, “Loans” of the consolidated financial statements. For a further discussion on non-performing loans, see “Non-performing assets” under the caption “Comparison of financial condition at March 31, 2011 and December 31, 2010”, below.

The allowance for loan losses was $8,224,000 at March 31, 2011 compared to $7,898,000 at December 31, 2010. For a further discussion on the allowance for loan losses, see “Allowance for loan losses” under the caption “Comparison of financial condition at March 31, 2011 and December 31, 2010” below.

#### Other income

In the first quarter of 2011, the Company recorded non-interest income of $1,338,000 compared to $1,146,000 recorded in the first quarter of 2010 - an increase of $192,000, or 17%. The improvement in non-interest income was from increased gains recognized from mortgage banking services and from the recognition of a $90,000 gain from the sale of a Small Business Administration commercial loan. During the three months ended March 31, 2011, the Company sold $8,670,000 of residential mortgage loans at gains of $155,000 compared to $7,964,000 of sold mortgage loans at gains of $99,000 during the first quarter of 2010. The higher level of mortgage gains was due to a slightly more favorable pricing in 2011 compared to 2010. Further contributing to the improvement in non-interest income were increased fees from trust and financial services activities. A decrease in commercial lending late charges was the principal cause of loan fee income to decrease by $25,000, or 18%, during the three months ended March 31, 2011 compared to the three months ended March 31, 2010.

#### Other operating expenses

Total operating expense declined $615,000, or 12%, from $5,105,000 for the first three months of 2010 to $4,490,000 recorded during the first three months of 2011. Salary and employee benefits decreased $544,000, or 20%, in the first quarter of 2011 compared to the same quarter of 2010. The 2010 figure included a one-time severance and voluntary termination payout caused by the planned, structured reorganization of the Company. The average full-time equivalent (FTE) number of employees for the three months ended March 31, 2011 was 156 compared to 178 average FTEs in the first quarter of 2010. Loan collection and other real estate expenses decreased $113,000, or 74% in the current year quarter compared to the same quarter in 2010. In 2010, the Company incurred higher collection expenses in order to resolve more problematic loans. In the 2010 quarter, the Company incurred higher ORE related expenses for property maintenance and also incurred higher selling costs in anticipation and upon the sale of a commercial ORE property. The maintenance costs and selling costs incurred in the 2011 quarter were related to the upkeep of residential properties and the sale of one residential ORE property where selling costs are typically less than on commercial properties. The $81,000, or 9%, increase in premises and equipment was the result of higher utility costs, expenses associated with facilities maintenance from the region’s prolonged severe weather conditions and increased amortization of leasehold improvements from 2010 branch upgrade expenditures. Professional fess decreased $86,000, or 25%, during the current year’s quarter compared to the 2010 quarter. Services provided by the Company’s legal, audit and professional consulting services were not as extensive in the first quarter of 2011 compared to the 2010 quarter. A higher insurable deposit base upon which the FDIC premium is determined has resulted in an increase in the FDIC insurance premium of $35,000, or 18%.

#### Provision for income taxes

The effective tax rates for the three months ended March 31, 2011 and 2010 were 23.6% and 11.1%, respectively. The higher effective tax rate in 2011 was due to the higher 2011 pretax earnings level which was more that 2.5 times the 2010 amount coupled with a relatively stable amount of net non-taxable items.

### Comparison of financial condition at

### March 31, 2011 and December 31, 2010

#### Overview

Consolidated assets increased $34,624,000 to $596,297,000 or 6%, as of March 31, 2011 from $561,673,000 at December 31, 2010. The increase was from $30,753,000 growth in deposits and a $1,529,000 increase in shareholders’ equity.

#### Investment securities

At the time of purchase, management classifies investment securities into one of three categories: trading, available-for-sale (AFS) or held-to-maturity (HTM). To date, management has not purchased any securities for trading purposes. Most of the securities the Company purchases are classified as AFS even though there is no immediate intent to sell them. The AFS designation affords management the flexibility to sell securities and position the balance sheet in response to capital levels, liquidity needs or changes in market conditions. Securities AFS are carried at fair value in the consolidated balance sheet with an adjustment to shareholders’ equity, net of tax, presented under the caption “Accumulated other comprehensive income (loss).” Securities designated as HTM are carried at amortized cost and represent debt securities that the Company has the ability and intent to hold until maturity.

As of March 31, 2011, the carrying value of investment securities amounted to $90,882,000, or 15% of total assets, compared to $83,431,000, or 15% of total assets, at December 31, 2010. At March 31, 2011, approximately 46% of the carrying value of the investment portfolio was comprised of U.S. Government Sponsored Enterprise residential mortgage-backed securities (MBS – GSE residential or mortgage-backed securities) that amortize and provide monthly cash flow.

As of March 31, 2011, investment securities were comprised of HTM and AFS securities with carrying values of $467,000 and $90,415,000, respectively. The AFS debt securities were recorded with a net unrealized loss in the amount of $5,225,000 and equity securities were recorded with an unrealized gain of $160,000, compared to $5,937,000 and $154,000, respectively as of December 31, 2010, a net improvement of $718,000.

The Company’s investment policy is designed to complement its lending activity. During the three months ended March 31, 2011, the carrying value of total investments increased $7,451,000. The Company uses cash flow generated from mortgage-backed securities pay downs, bond calls, as well as excess cash to invest, re-invest and advantageously diversify the securities portfolio in response to market conditions, interest rate environments, the performance of other interest-earning assets, interest rate risk, credit risk and anticipated liquidity needs.

A comparison of investment securities at March 31, 2011 and December 31, 2010 is as follows (dollars in thousands):

|  | March 31, 2011 Amount% |  | December 31, 2010 Amount% |  |
| --- | ---: | ---: | ---: | ---: |
| MBS - GSE residential | $41,516 | 45.7 | $41,043 | 49.2 |
| State & municipal subdivisions | 26,236 | 28.9 | 24,171 | 29.0 |
| Agency - GSE | 21,260 | 23.4 | 16,288 | 19.5 |
| Pooled trust preferred securities | 1,388 | 1.5 | 1,453 | 1.7 |
| Equity securities - financial services | 482 | 0.5 | 476 | 0.6 |
| Total investments | $90,882 | 100.0 | $83,431 | 100.0 |

Quarterly, management performs a review of the investment portfolio to determine the cause of declines in the fair value of each security. The Company uses inputs provided by independent third parties to determine the fair value of its investment securities portfolio. Inputs provided by the third party are reviewed and corroborated by management. Evaluations of the causes of the unrealized losses are performed to determine whether impairment is temporary or other-than-temporary. Considerations such as the Company’s intent and ability to hold the securities to maturity, recoverability of the invested amounts over the intended holding period, the length of time and the severity in pricing decline below cost, the interest rate environment, the receipt of amounts contractually due and whether or not there is an active market for the security, for example, are applied, along with the financial condition of the issuer for management to make a realistic judgment of the probability that the Company will be unable to collect all amounts (principal and interest) due in determining whether a security is other than temporarily impaired. If a decline in value is deemed to be other-than-temporary, the amortized cost of the security is reduced by the credit impairment amount and a corresponding charge to earnings is recognized. If at the time of sale, call or maturity the proceeds exceed the security’s amortized cost, the impairment charge may be fully or partially recovered.

The Company owns 13 tranches of pooled trust preferred securities (PreTSLs). The market for these securities and other issues of PreTSLs at March 31, 2011 remained inactive. The inactivity was evidenced first by a significant widening of the bid-ask spread in the brokered markets in which PreTSLs trade, then by a significant decrease in the volume of trades relative to historical levels and the lack of a new-issue market since 2007. There are currently very few market participants who are willing and/or able to transact for these securities. Given the conditions in the debt markets and in the absence of observable transactions in the secondary and a new-issue market, management has made the following observations and has determined:

- The few observable transactions and market quotations that were available were not reliable for purposes of determining fair value at March 31, 2011;
- An income valuation approach (present value technique) that maximizes the use of relevant observable market inputs and minimizes the use of unobservable inputs are equally or more representative of fair value than the market approach valuation technique; and
- The 13 PreTSLs are classified within “Level 3” (as defined in current accounting guidance and explained in Note 7, “Fair Measurements” of the consolidated financial statements) of the fair value hierarchy because significant adjustments are required to determine fair value at the measurement date. The Company engages an independent third party that is a structured products specialist firm, to analyze the PreTSL portfolio. The approach and results were reviewed and corroborated by management. The approach to determine OTTI involves the following:
- Data about the transaction structure, as defined in the offering documents and the underlying collateral, were collected;
- The credit worthiness of each collateral is determined by reviewing the obligor and estimating the credit risk existing or inherent for such obligor;
- Using the credit risk estimates and making assumptions about default correlation, simulate 10,000 Monte Carlo scenarios (a class of computational algorithms that rely on repeated random sampling to compute their results) with respect to default timing for each security;
- Project tranche cash flows over 10,000 Monte Carlo scenarios; determine the percentage of the total scenarios that result in a loss to the tranche. If the number of scenarios resulting in a loss exceeded 50%, OTTI is presumed to exist;
- Utilize several high-level financial factors to construct an appropriate discount rate for each tranche within each transaction. Factors include the portfolio’s weighted average credit rating, the average life of the collateral pool, the Bloomberg US Bank Benchmark discount rate, an appropriate spread differential to account for the rating assumed by the Bloomberg US Bank Benchmark and the actual average rating of the collateral pool. Lastly, credit loss already assumed under Monte Carlo simulation is subtracted from the discount rate construction in the previous step to avoid double-counting of credit risk;
- With an appropriate discount rate for each tranche, an appropriate book price is determined;
- With a projected discount rate, an estimated cash flow test was performed on each issue to compare the present value of the currently estimated cash flows as of March 31, 2011 to the amount projected as of the last measurement date, December 31, 2010;
- If the results of the cash flow tests resulted in a significant adverse change in projected cash flows, credit-related OTTI is present.

Based on the technique described, the Company determined that as of March 31, 2011, the amortized cost of one PreTSL – XXIV had declined $75,000 in total during the first three months of 2011 and since the present value of the security’s expected cash flows were insufficient to recover the entire amortized cost, the securities are deemed to have experienced credit-related OTTI in the amount of $75,000 which was charged to current earnings as a component of other income in the consolidated statement of income for the three months ended March 31, 2011. Future analyses could yield results that may indicate further impairment has occurred and would therefore require additional write-downs and corresponding OTTI charges to current earnings. For more information about OTTI charges, please see Note 3, “Investment securities” of the consolidated financial statements.

#### Federal Home Loan Bank Stock

In order to gain access to the low-cost products and services offered by the FHLB, investment in FHLB stock is required for membership in the organization and is carried at cost since there is no market value available. The amount the Company is required to invest is dependent upon the relative size of outstanding borrowings the Company has with the FHLB. Excess stock is typically repurchased from the Company at par if the level of borrowings declines to a predetermined level. In addition, the Company normally earns a return or dividend on the amount invested.

In December 2008, to preserve capital, the FHLB declared a suspension on the redemption of its stock and ceased payment of quarterly dividends until such time it becomes prudent to reinstate either or both. During the fourth quarter of 2010 and again in the first quarter of 2011, the FHLB announced a partial lifting and limited repurchase of the stock redemption provision of the suspension. As a result, the Company was able to redeem $239,000 of its FHLB stock in the fourth quarter of 2010 and an additional $227,000 in the first quarter of 2011. The dividend suspension remains in effect. Future redemptions and dividend payments will be predicated on the financial performance and health of the FHLB. Based on the financial results of the FHLB for the three months ended March 31, 2011 and for the year-ended December 31, 2010, management believes that the suspension of both the dividend payments and excess capital stock repurchase is temporary in nature. Management further believes that the FHLB will continue to be a primary source of wholesale liquidity for both short- and long-term funding and has concluded that its investment in FHLB stock is not other than temporarily impaired. There can be no assurance, however, that future negative changes to the financial condition of the FHLB may not require the Company to recognize an impairment charge with respect to such holdings. The Company will continue to monitor the financial condition of the FHLB and assess its future ability to resume normal dividend payments and stock redemption activities.

#### Loans held-for-sale (HFS)

Upon origination, certain residential mortgages are classified as HFS. In the event of market rate increases, fixed-rate loans and loans not immediately scheduled to re-price would no longer produce yields consistent with the current market. In a declining interest rate environment, the Company would be exposed to prepayment risk and, as rates on adjustable-rate loans decrease, interest income would be negatively affected. Consideration is given to the Company’s current liquidity position and projected future liquidity needs. To better manage prepayment and interest rate risk, loans that meet these conditions may be classified as HFS. The carrying value of loans HFS is at the lower of cost or estimated fair value. If the fair values of these loans fall below their original cost, the difference is written down and charged to current earnings. Subsequent appreciation in the portfolio is credited to current earnings but only to the extent of previous write-downs.

As of March 31, 2011, Loans HFS amounted to $310,000 with a corresponding fair value of $315,000, compared to $213,000 and $217,000, respectively, at December 31, 2010. During the three months ended March 31, 2011, residential mortgage loans with principal balances of $8,670,000 were sold into the secondary market with net gains of approximately $155,000 recognized, compared to $7,964,000 and $99,000, respectively, during the quarter ended March 31, 2010.

#### Loans

The Company originates commercial and industrial (commercial), commercial real estate (CRE), residential mortgages, consumer, home equity and construction loans. The relative volume of originations is dependent upon customer demand, current interest rates and the perception and duration of future interest levels. As part of the overall strategy to serve the business community in which it operates, the Company is focused on developing and implementing products and services to the broad spectrum of businesses that operate in its marketplace. The Company’s goals center on building relationships by providing credit and cash management products and services, continuing to diversify its loan portfolio and utilizing loan participations to reduce risk in larger credit transactions. A loan participation is a tool that allows a community bank to meet the needs of its local customer base. Certain customers, from time-to-time, may require funding that is out of the lending limit of a local community bank. In such circumstances, it allows a bank to originate the loan, and subsequently sell a portion, or portions, of that loan to other financial institutions, thereby mitigating the risk the Company will take on with one loan. These sold portions of the loan are referred to as loan participations.

The policies, procedures and credit risk of the Company are reflective of the current economy. The risks associated with interest rates are being managed by utilizing floating versus long-term fixed rates and exploring programs where the Company can match its cost of funds.

### Commercial and industrial

Commercial and industrial lending increased $5,580,000, or 7%, to $90,709,000 during the first quarter of 2011. While the majority of this portfolio remained unchanged, with originations replacing scheduled run-off, the Company saw an increase in municipal tax anticipation loans. Tax anticipation loan activity provides the Company an opportunity to establish deposit and trust relationships in addition to provide for the funding needs of the local municipal and school district communities.

### Commercial real estate

Commercial real estate lending declined $898,000, or 1%, from $169,194,000 at December 31, 2010 to $168,296,000 as of March 31, 2011. There were several factors contributing to this overall decrease, including loan demand, continued utilization of participations, adhering to strict pricing requirements and underwriting considerations that are reflective of the current economy.

### Residential real estate

Residential real estate was essentially unchanged since December 31, 2010. During 2011, the Company may begin to originate, for portfolio, fixed-rate 10- and 15-year residential mortgages that in the recent past were typically sold into the secondary market. The loans will be originated to conform to standard underwriting industry guidelines. By doing so, the Company will bolster its net interest margin performance, enhance capital through an extended earnings stream, limit exposure to credit risk and, because of the relatively shorter duration, minimize interest rate risk. This strategy will be managed as to not take on excessive credit and or interest rate risk.

### Consumer loans

Consumer loans declined $1,030,000, or 1%, during the first quarter of 2011. Though a modest decline, the Company’s intention for 2011 is to expand this segment and grow the portfolio, while maintaining asset quality.

The composition of the loan portfolio at March 31, 2011 and December 31, 2010, is summarized as follows (dollars in thousands):

|  | March 31, 2011 Amount% |  | December 31, 2010 Amount% |  | Variance% |  |
| --- | ---: | ---: | ---: | ---: | ---: | ---: |
| Commercial and industrial | $90,709 | 21.6 | $85,129 | 20.5 | $5,580 | 6.6 |
| Commercial real estate: |  |  |  |  |  |  |
| Non-owner occupied | 85,270 | 20.3 | 87,355 | 21.0 | (2,085) | (2.4) |
| Owner occupied | 69,472 | 16.6 | 69,338 | 16.7 | 134 | 0.2 |
| Construction | 13,554 | 3.2 | 12,501 | 3.0 | 1,053 | 8.4 |
| Consumer: |  |  |  |  |  |  |
| Home equity installment | 38,578 | 9.2 | 40,089 | 9.6 | (1,511) | (3.8) |
| Home equity line of credit | 30,063 | 7.2 | 29,185 | 7.0 | 878 | 3.0 |
| Auto | 11,089 | 2.7 | 10,734 | 2.6 | 355 | 3.3 |
| Other | 6,413 | 1.5 | 7,165 | 1.7 | (752) | (10.5) |
| Residential: |  |  |  |  |  |  |
| Real estate | 70,252 | 16.7 | 68,160 | 16.4 | 2,092 | 3.1 |
| Construction | 4,097 | 1.0 | 6,145 | 1.5 | (2,048) | (33.3) |
| Total | 419,497 | 100.0 | 415,801 | 100.0 | $3,696 | 0.9 |
| Allowance for loan losses | 8,224 |  | 7,898 |  | $326 |  |
| Loans, net | $411,273 |  | $407,903 |  | $3,370 |  |

#### Allowance for loan losses

Management continually evaluates the credit quality of the Company’s loan portfolio and performs a formal review of the adequacy of the allowance for loan losses (the allowance) on a quarterly basis. The allowance reflects management’s best estimate of the amount of credit losses in the loan portfolio. Management’s judgment is based on the evaluation of individual loans, past experience, the assessment of current economic conditions and other relevant factors including the amounts and timing of cash flows expected to be received on impaired loans. Those estimates may be susceptible to significant change. The provision for loan losses represents the amount necessary to maintain an appropriate allowance. Loan losses are charged directly against the allowance when loans are deemed to be uncollectible. Recoveries from previously charged-off loans are added to the allowance when received.

Management applies two primary components during the loan review process to determine proper allowance levels. The two components are a specific loan loss allocation for loans that are deemed impaired and a general loan loss allocation for those loans not specifically allocated. The methodology to analyze the adequacy of the allowance for loan losses is as follows:

- identification of specific impaired loans by loan category;
- calculation of specific allowances where required for the impaired loans based on collateral and other objective and quantifiable evidence;
- determination of homogenous pools by loan category and eliminating the impaired loans;
- application of historical loss percentages (two-year average) to pools to determine the allowance allocation;
- application of qualitative factor adjustment percentages to historical losses for trends or changes in the loan portfolio, and/or current economic conditions.

Allocation of the allowance for different categories of loans is based on the methodology as explained above. A key element of the methodology to determine the allowance is the Company’s credit risk evaluation process, which includes credit risk grading of individual commercial loans. Commercial loans are assigned credit risk grades based on the Company’s assessment of conditions that affect the borrower’s ability to meet its contractual obligations under the loan agreement. That process includes reviewing borrowers’ current financial information, historical payment experience, credit documentation, public information and other information specific to each individual borrower. Upon review, the commercial loan credit risk grade is revised or reaffirmed. The credit risk grades may be changed at any time management feels an upgrade or downgrade may be warranted. The credit risk grades for the commercial loan portfolio are taken into account in the reserve methodology and loss factors are applied based upon the credit risk grades. The loss factors applied are based upon the Company’s historical experience as well as what management believes to be best practices and within common industry standards. Historical experience reveals there is a direct correlation between the credit risk grades and loan charge-offs. The changes in allocations in the commercial loan portfolio from period-to-period are based upon the credit risk grading system and from periodic reviews of the loan portfolio.

Each quarter, management performs an assessment of the allowance and the provision for loan losses. The Company’s Special Assets Committee meets quarterly and the applicable lenders discuss each relationship under review and reach a consensus on the appropriate estimated loss amount based on current accounting guidelines. The Special Assets Committee’s focus is on ensuring the pertinent facts are considered and the reserve amounts pursuant to the accounting principles are reasonable. The assessment process includes the review of all loans on a non-accruing basis as well as a review of certain loans to which the lenders or the Company’s Credit Administration function have assigned a criticized or classified risk rating.

Total charge-offs net of recoveries for the three months ending March 31, 2011, were $149,000, compared to $397,000 in the first three months of 2010. The reduced level of charge-offs recorded in the current year is primarily attributable to lower charge-offs incurred on commercial loans. Recoveries of $4,000 were recorded on commercial and industrial loans at March 31, 2011 compared to commercial and industrial loan net charge-offs of $142,000 for the three months ending March 31, 2010. Consumer loan net charge-offs of $62,000 were recorded during the three months ending March 31, 2011 versus $55,000 at the March 31, 2010 like period end. There were no commercial real estate loan net charge-offs during the three month period ending March 31, 2011 versus $200,000 of net charge-offs at March 31, 2010. Residential real estate loan net charge-offs totaled $91,000 for the three month period ending March 31, 2011. There were no residential real estate charge-offs in the same period of 2010. For a discussion on the provision for loan losses, see the “Provision for loan losses,” located in the results of operations section of management’s discussion and analysis contained herein.

The allowance for loan losses was $8,224,000 at March 31, 2011 and $7,898,000 at December 31, 2010. Management believes that the current balance in the allowance for loan losses of $8,224,000 is sufficient to withstand the identified potential credit quality issues that may arise and others unidentified but inherent to the portfolio as of this time. Potential problem loans are those where there is known information that leads management to believe repayment of principal and/or interest is in jeopardy and the loans are currently neither on non-accrual status nor past due 90 days or more. Given continuing pressure on property values and the generally uncertain economic backdrop, there could be additional instances which become identified in future periods that may require additional charge-offs and/or increases to the allowance. The ratio of allowance for loan losses to total loans was 1.96% at March 31, 2011 compared to 1.90% at December 31, 2010.

The following tables set forth the activity in the allowance for loan losses and certain key ratios for the period indicated:

|  | As of and for the three months ended March 31, 2011 | As of and for the twelve months ended December 31, 2010 | As of and for the three months ended March 31, 2010 |
| --- | ---: | ---: | ---: |
| Balance at beginning of period | $7,897,822 | $7,573,603 | $7,573,603 |
| Provision charged to operations | 475,000 | 2,085,000 | 575,000 |
| Charge-offs: |  |  |  |
| Commercial and industrial | - | 451,979 | 144,690 |
| Commercial real estate | - | 892,426 | 200,000 |
| Consumer | 67,429 | 462,816 | 76,483 |
| Residential | 98,835 | 1,812 | - |
| Total | 166,264 | 1,809,033 | 421,173 |
| Recoveries: |  |  |  |
| Commercial and industrial | 3,850 | 3,839 | 2,849 |
| Commercial real estate | 246 | 2,799 | - |
| Consumer | 5,845 | 39,904 | 21,310 |
| Residential | 7,479 | 1,710 | - |
| Total | 17,420 | 48,252 | 24,159 |
| Net charge-offs | 148,844 | 1,760,781 | 397,014 |
| Balance at end of period | $8,223,978 | $7,897,822 | $7,751,589 |
| Total loans, end of period | $419,806,900 | $416,014,151 | $434,257,867 |

| Net charge-offs to (annualized): | As of and for the three months ended March 31, 2011 |  | As of and for the twelve months ended December 31, 2010 |  | As of and for the three months ended March 31, 2010 |  |
| --- | ---: | --- | ---: | --- | ---: | --- |
| Average loans | 0.14% |  | 0.41% |  | 0.36% |  |
| Allowance for loan losses | 7.24% |  | 22.29% |  | 20.49% |  |
| Provision for loan losses | 0.31 | x | 0.84 | x | 0.69 | x |
| Allowance for loan losses to: |  |  |  |  |  |  |
| Total loans | 1.96% |  | 1.90% |  | 1.79% |  |
| Non-accrual loans | 0.87 | x | 0.79 | x | 0.70 | x |
| Non-performing loans | 0.82 | x | 0.77 | x | 0.68 | x |
| Net charge-offs (annualized) | 13.81 | x | 4.48 | x | 4.88 | x |
| Loans 30-89 days past due and still accruing | $3,952,990 |  | $2,611,162 |  | $6,770,142 |  |
| Loans 90 days past due and accruing | $547,735 |  | $288,618 |  | $255,290 |  |
| Non-accrual loans | $9,463,218 |  | $9,968,675 |  | $11,099,264 |  |
| Allowance for loan losses to loans 90 |  |  |  |  |  |  |
| days or more past due and accruing | 15.01 | x | 27.36 | x | 30.36 | x |

#### Non-performing assets

The Company defines non-performing assets as accruing loans past due 90 days or more, non-accrual loans, restructured loans, other real estate owned (ORE), non-accrual securities and repossessed assets. As of March 31, 2011, non-performing assets represented 2.37% of total assets basically unchanged from 2.38% at December 31, 2010.

In the review of loans for both delinquency and collateral sufficiency, management concluded that there were a number of loans that lacked the ability to repay in accordance with contractual terms. The decision to place loans on a non-accrual status is made on an individual basis after considering factors pertaining to each specific loan. The commercial loans are placed on non-accrual status when management has determined that payment of all contractual principal and interest is in doubt or the loan is past due 90 days or more as to principal and interest, unless well-secured and in the process of collection. Consumer loans secured by real estate are placed on non-accrual status at 120 days past due as to principal and interest, and unsecured consumer loans are charged-off when the loan is 90 days or more past due as to principal and interest. Uncollected interest income accrued on all non-accrual loans is reversed and charged to interest income.

The majority of the non-performing assets for the period were comprised of non-accruing commercial business loans, non-accruing real estate loans, troubled debt restructurings, non-accrual securities and ORE. Most of the loans are collateralized, thereby mitigating the Company’s potential for loss. During the first three months of 2011, $932,000 of corporate bonds consisting of pooled trust preferred securities were on non-accrual status, compared to $1,910,000 during the first three months of 2010. For a further discussion on the Company’s securities portfolio, see Note 3, “Investments Securities”, within the notes to the consolidated financial statements and the section entitled “Investments”, contained within this management discussion and analysis section.

Non-performing loans declined slightly from $10,257,000 on December 31, 2010 to $10,011,000 on March 31, 2011. At December 31, 2010, the over 90 day past due portion was comprised of eight loans ranging from $1,600 to $111,000, and the non-accrual loan portion numbered 65 loans ranging from $2,900 to $1,800,000. At March 31, 2011, there were three loans ranging from $99,000 to $210,000 in the over 90 days past due category, and 64 loans ranging from $2,900 to $1,750,000 in the non-accrual category. The reduction of $246,000 in non-performing loans from December 31, 2010 to March 31, 2011 resulted mainly from non-accrual mortgage loans which were either repaid or returned to accruing (performing) status.

The Company, on a regular basis, reviews changes to loans to determine if they meet the definition of a troubled debt restructuring (TDR). TDR loans arise when a borrower experiences financial difficulty and the Company grants a concession that it would not otherwise make in order to maximize the Company’s recovery. TDR loans aggregated $3,820,000 at March 31, 2011 which consisted of $2,068,000 of accruing commercial real estate loans and $1,752,000 of non-accrual commercial real estate loans. The non-accruing TDRs of $1,752,000 are included in the non-accrual loan totals. At December 31, 2010 TDRs aggregated $783,000 all of which were accruing loans. The TDR amount increased by $3,037,000 during the quarter. One loan relationship aggregating $1,752,000 which had been on non-accrual was restructured. It will remain on non-accrual status until specific performance has been demonstrated. A second, unrelated loan in the amount of $1,784,000 was restructured and classified as a TDR due to concessions granted, however, this loan had been and continues to be paid current and remains on an accruing status. A third loan of approximately $500,000 which had been in TDR at December 31, 2010 was subsequently removed based upon performance.

If applicable, a TDR loan classified as non-accrual would require a minimum of six months of payments before consideration for a return to accrual status. Concessions made to borrowers typically involve an extension of the loan’s maturity date or a change in the loan’s amortization period. The Company believes its concessions have been successful as the borrowers are generally current with respect to the restructured terms. The Company has not reduced interest rates, forgiven principal or entered into any forbearance or other actions with respect to these loans. If loans characterized as a TDR perform according to the restructured terms for a satisfactory period of time, the TDR designation may be removed in a new calendar year if the loan yields a market rate of interest.

ORE at March 31, 2011 was $1,132,000 and consisted of four properties. At March 31, 2011, the non-accrual loans aggregated $9,463,000 as compared to $9,969,000 at December 31, 2010. The net reduction in the level of non-accrual loans during the quarter ended March 31, 2011 occurred as follows: additions to the non-accrual loan component of the non-performing assets totaling $1,032,000 were made during the first three months of the year. These were offset by reductions or payoffs of $659,000, charge-offs of $126,000, and $753,000 of loans that returned to performing status. Loans past due 90 days or more and accruing were $548,000 at March 31, 2011 and $289,000, at December 31, 2010. Non-accrual securities were $932,000 at March 31, 2011 and $1,091,000 at December 31, 2010. The ratio of non-performing loans to total loans declined to 2.38% at March 31, 2011 from 2.47% at December 31, 2010.

The following table sets forth non-performing assets data as of the period indicated:

| Loans past due 90 days or more | March 31, 2011 | December 31, 2010 | March 31, 2010 |
| --- | ---: | ---: | ---: |
| and accruing | $547,735 | $288,618 | $255,290 |
| Non-accrual loans | 9,463,218 | 9,968,675 | 11,099,264 |
| Total non-performing loans | 10,010,953 | 10,257,293 | 11,354,554 |
| Troubled debt restructurings | 2,067,595 | 782,688 | - |
| Other real estate owned | 1,131,595 | 1,260,895 | 337,397 |
| Non-accrual securities | 932,521 | 1,091,311 | 1,910,243 |
| Total non-performing assets | $14,142,664 | $13,392,187 | $13,602,194 |
| Total loans including HFS | $419,806,900 | $416,014,151 | $434,257,867 |
| Total assets | $596,296,512 | $561,673,152 | $595,288,575 |
| Non-accrual loans to total loans | 2.25% | 2.40% | 2.56% |
| Non-performing loans to total loans | 2.38% | 2.47% | 2.61% |
| Non-performing assets to total assets | 2.37% | 2.38% | 2.28% |

The composition of non-performing loans as of March 31, 2011 is as follows (dollars in thousands):

|  | Gross loan balances | Past due 90 days or more and still accruing | Non- accrual loans | Total non- performing loans | % of gross loans |
| --- | ---: | ---: | ---: | ---: | ---: |
| Commercial and industrial | $90,709 | $210 | $165 | $375 | 0.41% |
| Commercial real estate: |  |  |  |  |  |
| Non-owner occupied | 85,270 | 228 | 1,970 | 2,199 | 2.58% |
| Owner occupied | 69,472 | - | 2,765 | 2,765 | 3.98% |
| Construction | 13,554 | - | - | - | - |
| Consumer: |  |  |  |  |  |
| Home equity installment | 38,578 | 110 | 705 | 815 | 2.11% |
| Home equity line of credit | 30,063 | - | 490 | 490 | 1.63% |
| Auto | 11,089 | - | - | - | - |
| Other | 6,413 | - | - | - | - |
| Residential: |  |  |  |  |  |
| Real estate | 70,252 | - | 3,274 | 3,274 | 4.66% |
| Construction | 4,097 | - | 94 | 94 | 2.30% |
| Loans held for sale | 310 | - | - | - | - |
| Total | $419,807 | $548 | $9,463 | $10,012 | 2.38% |

#### Foreclosed assets held-for-sale

Foreclosed assets held-for-sale, consisting of ORE, was $1,132,000 at March 31, 2011 consisted of four properties which are listed for sale with local realtors. The $129,000 decline in ORE from the December 31, 2010 balance of $1,261,000 is mainly the result of the sale of a residential property.

#### Deposits

The Bank is a community-based commercial financial institution, member FDIC, which offers a variety of deposit products with varying ranges of interest rates and terms. Deposit products include savings, clubs, interest-bearing checking (NOW), money market, non-interest-bearing checking (DDAs) and certificates of deposit accounts. Certificates of deposit accounts, or CDs, are deposits with stated maturities which can range from seven days to ten years. The flow of deposits is significantly influenced by general economic conditions, changes in prevailing interest rates, pricing and competition. To determine deposit product offering interest rates, the Company considers local competition, spreads to earning-asset yields, liquidity position and rates charged for alternative sources of funding such as borrowings and FHLB advances. Like all banks, the Company competes for deposits. When setting interest rates, the deposit-gathering strategies also include consideration of the Company’s balance sheet structure and cost effectiveness that are mindful of the current and forecasted economic climate.

Compared to December 31, 2010 total deposits grew $30,752,000, or 6%, during the three months ended March 31, 2011. The growth in total deposits was due to increases in DDA, savings and money market accounts of $27,503,000, or 32%, $9,012,000, or 9% and $2,719,000, or 3%, respectively, partially offset by lower CD and NOW balances. Generally, deposits are obtained from consumers and businesses within the communities that surround the Company’s 11 branch offices and all deposits are insured by the FDIC up to the full extent permitted by law. The large increase in DDA accounts was primarily due to an influx of municipal tax collections. These deposits are seasonal in nature, and are not permanent. In an effort to grow and retain core deposits, the Company introduces innovative options to its variety of deposit products. The Company has successfully focused on providing exemplary customer service and introducing highly innovative deposit-gathering techniques. This approach has strengthened the Company’s low-cost funding base. The continued low interest rate environment has resulted in a wide-spread preference for customers to place their money in non-maturing interest-bearing accounts rather than to renew maturing CDs. When the market rates do rise, the Company will focus on and promote CD gathering strategies that will strive to increase time deposits while maintaining its low-costing core deposit foundation.

The following table represents the components of deposits as of the date indicated (dollars in thousands):

|  | March 31, 2011 Amount% |  | December 31, 2010 Amount% |  |
| --- | ---: | ---: | ---: | ---: |
| Money market | $82,329 | 16.0 | $79,610 | 16.5 |
| NOW | 65,738 | 12.8 | 67,572 | 14.0 |
| Savings and club | 114,847 | 22.4 | 105,835 | 21.9 |
| Certificates of deposit | 137,003 | 26.7 | 143,651 | 29.8 |
| Total interest-bearing | 399,917 | 77.9 | 396,668 | 82.2 |
| Non-interest-bearing | 113,283 | 22.1 | 85,780 | 17.8 |
| Total deposits | $513,200 | 100.0 | $482,448 | 100.0 |

The Company uses the Certificate of Deposit Account Registry Service (CDARS) reciprocal program to obtain FDIC insurance protection for customers who have large deposits that at times may exceed the FDIC maximum amount of $250,000. In the CDARS program, deposits with varying terms and interest rates, originated in the Company’s own markets, are exchanged for deposits of other financial institutions that are members in the CDARS network. By placing these deposits in other participating institutions, the deposits of our customers are fully insured by the FDIC. In return for deposits placed with network institutions, the Company receives from network institutions deposits that are approximately equal in amount and contain similar terms as those placed for our customers. Deposits the Company receives, or reciprocal deposits, from other institutions are considered brokered deposits by regulatory definitions. As of March 31, 2011 CDARS represented $11,889,000, or 2%, of total deposits, compared to $11,876,000, or 2%, of total deposits at December 31, 2010.

Excluding CDARS, certificates of deposit accounts of $100,000 or more amounted to $47,778,000 and $51,340,000 at March 31, 2011 and December 31, 2010, respectively. Certificates of deposit of $250,000 or more amounted to $18,333,000 and $19,120,000 as of March 31, 2011 and December 31, 2010.

Including CDARS, approximately 37% and 38% of the CDs are scheduled to mature in 2011 and 2012, respectively. Renewing CDs may re-price to lower or higher market rates depending on the direction of interest rate movements, the shape of the yield curve, competition, the rate profile of the maturing accounts and depositor preference for alternative products. In this current low interest rate environment, a widespread preference has been for customers with maturing CDs to hold their deposits in readily available transaction products such as savings accounts. When interest rates begin to rise, the Company expects CDs to grow to more normal levels.

#### Borrowings

Borrowings are used as a complement to deposit generation as an alternative funding source whereby the Bank will borrow under customer repurchase agreements in the local market, advances from the Federal Home Loan Bank of Pittsburgh (FHLB) and other correspondent banks for asset growth and liquidity needs.

Repurchase agreements are non-insured interest-bearing liabilities that have a perfected security interest in qualified investments of the Company. The FDIC Depositor Protection Act of 2009 requires banks to provide a perfected security interest to the purchasers of uninsured repurchase agreements. Repurchase agreements are offered through a sweep product. A sweep account is designed to ensure that on a daily basis, an attached DDA is adequately funded and excess funds are transferred, or swept, into an interest-bearing overnight repurchase agreement account. Due to the constant flow of funds in to and out of the sweep product, their balances tend to be somewhat volatile, similar to a DDA. Customer liquidity is the typical cause for variances in repurchase agreements, which for the first three months of 2011 increased $2,900,000, or 38%, from December 31, 2010.

The components of borrowings as of March 31, 2011 and December 31, 2010 are as follows (dollars in thousands):

|  | March 31, 2011 Amount% |  | December 31, 2010 Amount% |  |
| --- | ---: | ---: | ---: | ---: |
| Repurchase agreements | $10,406 | 32.3 | $7,548 | 25.5 |
| Demand note, U.S. Treasury | 725 | 2.3 | 1,000 | 3.4 |
| FHLB advances: |  |  |  |  |
| Long-term | 21,000 | 65.4 | 21,000 | 71.1 |
| Total borrowings | $32,131 | 100.0 | $29,548 | 100.0 |

## Market risk

As filed, 24,367 characters.

#### Management of interest rate risk and market risk analysis.

In January 2010, the Federal Financial Institutions Examination Council (FFIEC) released an Advisory on Interest Rate Risk Management (IRR Advisory) to remind institutions of the supervisory expectations regarding sound practices for managing interest rate risk. While some degree of interest rate risk is inherent in the business of banking, the FFIEC expects financial institutions to have sound risk management practices in place to measure monitor and control interest rate risk exposures, and interest rate risk management should be an integral component of an institution’s risk management infrastructure. The FFIEC expects all institutions to manage their interest rate risk exposures using processes and systems commensurate with the balance sheet complexity, business model, risk profile, scope of operations, earnings and capital levels. The IRR Advisory reiterates the importance of effective corporate governance, policies and procedures, risk measuring and monitoring systems, stress testing, and internal controls related to the interest rate risk exposures of institutions.

The IRR Advisory encourages institutions to use a variety of techniques to measure interest rate risk exposure including: gap analysis, income measurement and valuation measurement for assessing the impact of changes in market rates and simulation modeling to measure interest rate risk exposure. The IRR Advisory also reminds institutions that stress testing, which includes both scenario and sensitivity analysis, is an integral component of interest rate risk management. Institutions should regularly assess interest rate risk exposures beyond typical industry conventions and towards the given economic climate including changes in rates of a magnitude that is greater than the general practice of up and down 200 basis points and different scenarios to reflect changes in slopes of the yield curve.

The adequacy and effectiveness of an institution’s interest rate risk management process and the level of its exposures are critical factors in the regulatory evaluation of an institution’s sensitivity to changes in interest rates and capital adequacy. Management believes the Company’s interest rate risk measurement framework is sound and provides an effective means to measure, monitor, analyze, indentify and control interest rate risk in the balance sheet.

The Company is subject to the interest rate risks inherent in its lending, investing and financing activities. Fluctuations of interest rates will impact interest income and interest expense along with affecting market values of all interest-earning assets and interest-bearing liabilities, except for those assets or liabilities with a short term remaining to maturity. Interest rate risk management is an integral part of the asset/liability management process. The Company has instituted certain procedures and policy guidelines to manage the interest rate risk position. Those internal policies enable the Company to react to changes in market rates to protect net interest income from significant fluctuations. The primary objective in managing interest rate risk is to minimize the adverse impact of changes in interest rates on net interest income along with creating an asset/liability structure that maximizes earnings.

*Asset/Liability Management.* One major objective of the Company when managing the rate sensitivity of its assets and liabilities is to stabilize net interest income. The management of and authority to assume interest rate risk is the responsibility of the Company’s Asset/Liability Committee (ALCO), which is comprised of senior management and members of the board of directors. ALCO meets quarterly to monitor the relationship of interest-sensitive assets to interest- sensitive liabilities. The process to review interest rate risk is a regular part of managing the Company. Consistent policies and practices of measuring and reporting interest rate risk exposure, particularly regarding the treatment of non-contractual assets and liabilities, are in effect. In addition, there is an annual process to review the interest rate risk policy with the board of directors which includes limits on the impact to earnings from shifts in interest rates.

*Interest Rate Risk Measurement.* Interest rate risk is monitored through the use of three complementary measures: static gap analysis, earnings at risk simulation and economic value at risk simulation. While each of the interest rate risk measurements has limitations, taken together they represent a reasonably comprehensive view of the magnitude of interest rate risk in the Company and the distribution of risk along the yield curve, the level of risk through time and the amount of exposure to changes in certain interest rate relationships.

*Static Gap.* The ratio between assets and liabilities re-pricing in specific time intervals is referred to as an interest rate sensitivity gap. Interest rate sensitivity gaps can be managed to take advantage of the slope of the yield curve as well as forecasted changes in the level of interest rate changes.

To manage this interest rate sensitivity gap position, an asset/liability model commonly known as cumulative gap analysis is used to monitor the difference in the volume of the Company’s interest-sensitive assets and liabilities that mature or re-price within given time intervals. A positive gap (asset sensitive) indicates that more assets will mature or re-price during a given period compared to liabilities, while a negative gap (liability sensitive) has the opposite effect. The Company employs computerized net interest income simulation modeling to assist in quantifying interest rate risk exposure. This process measures and quantifies the impact on net interest income through varying interest rate changes and balance sheet compositions. The use of this model assists the ALCO to gauge the effects of the interest rate changes on interest-sensitive assets and liabilities in order to determine what impact these rate changes will have upon the net interest spread. As of March 31, 2011, the Bank maintained a one-year cumulative gap of positive $101.3 million, or 17.0%, of total assets. The effect of this positive gap position provided a mismatch of assets and liabilities which may expose the Bank to interest rate risk during periods of falling interest rates. Conversely, in an increasing interest rate environment, net interest income could be positively impacted because more assets than liabilities would re-price upward during the one-year period.

Certain shortcomings are inherent in the method of analysis discussed above and presented in the next table. Although certain assets and liabilities may have similar maturities or periods of re-pricing, they may react in different degrees to changes in market interest rates. The interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types of assets and liabilities may lag behind changes in market interest rates. Certain assets, such as adjustable-rate mortgages, have features which restrict changes in interest rates on a short-term basis and over the life of the asset. In the event of a change in interest rates, prepayment and early withdrawal levels may deviate significantly from those assumed in calculating the table. The ability of many borrowers to service their adjustable-rate debt may decrease in the event of an interest rate increase.

The following table illustrates the Company’s interest sensitivity gap position at March 31, 2011 (dollars in thousands):

|  | Three months or less | More than three months to twelve months | More than one year to three years | More than three years | Total |
| --- | ---: | ---: | ---: | ---: | ---: |
| Cash and cash equivalents | $37,762 | $- | $- | $9,681 | $47,443 |
| Investment securities (1)(2) | 5,776 | 12,648 | 23,846 | 52,927 | 95,197 |
| Loans (2) | 129,006 | 77,495 | 107,301 | 97,781 | 411,583 |
| Fixed and other assets | - | 9,502 | - | 32,572 | 42,074 |
| Total assets | $172,544 | $99,645 | $131,147 | $192,961 | $596,297 |
| Total cumulative assets | $172,544 | $272,189 | $403,336 | $596,297 |  |
| Non-interest bearing transaction deposits (3) | $- | $11,328 | $31,153 | $70,802 | $113,283 |
| Interest-bearing transaction deposits (3) | 71,312 | - | 72,542 | 119,062 | 262,916 |
| Time deposits | 17,529 | 59,598 | 45,020 | 14,854 | 137,001 |
| Repurchase agreements | 10,406 | - | - | - | 10,406 |
| Short-term borrowings | 725 | - | - | - | 725 |
| Long-term debt | - | - | 5,000 | 16,000 | 21,000 |
| Other liabilities | - | - | - | 2,663 | 2,663 |
| Total liabilities | $99,972 | $70,926 | $153,715 | $223,381 | $547,994 |
| Total cumulative liabilities | $99,972 | $170,898 | $324,613 | $547,994 |  |
| Interest sensitivity gap | $72,572 | $28,719 | $(22,568) | $(30,420) |  |
| Cumulative gap | $72,572 | $101,291 | $78,723 | $48,303 |  |
| Cumulative gap to total assets | 12.2% | 17.0% | 13.2% | 8.1% |  |

(1) Includes FHLB stock and the net unrealized gains/losses on securities AFS.

(2) Investments and loans are included in the earlier of the period in which interest rates were next scheduled to adjust or the period in which they are due. In addition, loans are included in the periods in which they are scheduled to be repaid based on scheduled amortization. For amortizing loans and MBS – GSE residential, annual prepayment rates are assumed reflecting historical experience as well as management’s knowledge and experience of its loan products.

(3) The Bank’s demand and savings accounts are generally subject to immediate withdrawal. However, management considers a certain amount of such accounts to be core accounts having significantly longer effective maturities based on the retention experiences of such deposits in changing interest rate environments. The effective maturities presented are the recommended maturity distribution limits for non-maturing deposits based on historical deposit studies.

*Earnings at Risk and Economic Value at Risk Simulations.* The Company recognizes that more sophisticated tools exist for measuring the interest rate risk in the balance sheet that extend beyond static re-pricing gap analysis. Although it will continue to measure its re-pricing gap position, the Company utilizes additional modeling for identifying and measuring the interest rate risk in the overall balance sheet. The ALCO is responsible for focusing on “earnings at risk” and “economic value at risk”, and how both relate to the risk-based capital position when analyzing the interest rate risk.

*Earnings at Risk.* Earnings at risk simulation measures the change in net interest income and net income should interest rates rise and fall. The simulation recognizes that not all assets and liabilities re-price one-for-one with market rates (e.g., savings rate). The ALCO looks at “earnings at risk” to determine income changes from a base case scenario under an increase and decrease of 200 basis points in interest rate simulation models.

*Economic Value at Risk.* Earnings at risk simulation measures the short-term risk in the balance sheet. Economic value (or portfolio equity) at risk measures the long-term risk by finding the net present value of the future cash flows from the Company’s existing assets and liabilities. The ALCO examines this ratio quarterly utilizing an increase and decrease of 200 basis points in interest rate simulation models. The ALCO recognizes that, in some instances, this ratio may contradict the “earnings at risk” ratio.

The following table illustrates the simulated impact of 200 basis points upward or downward movement in interest rates on net interest income, net income and the change in the economic value (portfolio equity). This analysis assumes that interest-earning asset and interest-bearing liability levels at March 31, 2011 remain constant. The impact of the rate movements was developed by simulating the effect of rates changing over a twelve-month period from the March 31, 2011 levels:

| Earnings at risk: Percent change in: | Rates +200 | Rates -200 |
| --- | ---: | ---: |
| Net interest income | 5.3% | (2.6 ) % |
| Net income | 14.7 | (7.3) |
| Economic value at risk: |  |  |
| Percent change in: |  |  |
| Economic value of equity | (24.4) | (5.8) |
| Economic value of equity |  |  |
| as a percent of book assets | (1.9) | (0.5) |

Economic value has the most meaning when viewed within the context of risk-based capital. Therefore, the economic value may normally change beyond the Company's policy guideline for a short period of time as long as the risk-based capital ratio (after adjusting for the excess equity exposure) is greater than 10%. As of March 31, 2011, the Company’s risk-based capital ratio was 12.1%.

The table below summarizes estimated changes in net interest income over a twelve-month period beginning April 1, 2011, under alternate interest rate scenarios using the income simulation model described above (dollars in thousands):

| Change in interest rates | Net interest income | $% variance | variance |
| --- | ---: | ---: | ---: |
| +200 basis points | $22,861 | $1,149 | 5.3% |
| +100 basis points | 22,114 | 402 | 1.9 |
| Flat rate | 21,712 | - | - |
| -100 basis points | 21,779 | 67 | 0.3 |
| -200 basis points | 21,153 | (559) | (2.6) |

Simulation models require assumptions about certain categories of assets and liabilities. The models schedule existing assets and liabilities by their contractual maturity, estimated likely call date or earliest re-pricing opportunity. MBS – GSE residential securities and amortizing loans are scheduled based on their anticipated cash flow including estimated prepayments. For investment securities, the Bank uses a third-party service to provide cash flow estimates in the various rate environments. Savings, money market and NOW accounts do not have a stated maturity or re-pricing term and can be withdrawn or re-priced at any time. This may impact the margin if more expensive alternative sources of deposits are required to fund loans or deposit runoff. Management projects the re-pricing characteristics of these accounts based on historical performance and assumptions that it believes reflect their rate sensitivity. The model reinvests all maturities, repayments and prepayments for each type of asset or liability into the same product for a new like term at current product interest rates. As a result, the mix of interest-earning assets and interest bearing-liabilities is held constant.

#### Liquidity

Liquidity management ensures that adequate funds will be available to meet customers’ needs for borrowings, deposit withdrawals and maturities and normal operating expenses of the Company. Current sources of liquidity are cash and cash equivalents, asset maturities and pay-downs within one year, loans HFS and investments AFS, growth of core deposits, growth of repurchase agreements, increases of other borrowed funds from correspondent banks and issuance of capital stock. Although regularly scheduled investment and loan payments are a dependable source of daily funds, the sales of loans HFS and investments AFS, deposit activity and investment and loan prepayments are significantly influenced by general economic conditions and the interest rate environment. During low and declining interest rate environments, prepayments from interest-sensitive assets tend to accelerate and provide significant liquidity which can be used to invest in other interest-earning assets but at lower market rates. Conversely, during periods of high and rising interest rates, prepayments from interest-sensitive assets tend to decelerate causing cash flow from mortgage loans and the MBS–GSE residential securities portfolio to decrease. Rising interest rates may also cause deposit inflow to accelerate at higher market interest rates. The Company closely monitors activity in the capital markets and takes appropriate action to ensure that the liquidity levels are adequate for funding, investing and operating activities.

The Company’s contingency funding plan (CFP) sets a framework for handling liquidity issues in the event circumstances arise which the Company deems to be less than normal. To accomplish this, the Company established guidelines for identifying, measuring, monitoring and managing the resolution of potentially serious liquidity crises. The Company’s CFP outlines required monitoring tools, acceptable alternative funding sources and required actions during various liquidity scenarios. Thus, the Company has implemented a proactive means for the measurement and resolution for dealing with potentially significant adverse liquidity issues. At least quarterly, the CFP monitoring tools, current liquidity position and monthly projected liquidity sources and uses are presented and reviewed by the Company’s ALCO. As of March 31, 2011, the Company has not experienced any adverse liquidity issues that would give rise to its inability to raise liquidity in an emergency situation.

For the three months ended March 31, 2011, the Company generated $24.5 million of cash. The Company’s operations provided $4.2 million mostly from the net proceeds from mortgage banking services and lower net operating expenses. The $33.6 million of growth in deposits and repurchase agreements as well as cash inflow from investments helped fund $17.6 million of new security investments and net growth in commercial and industrial loans. The excess cash will be used to grow the residential loan and investment portfolios and provide for the unpredictable seasonal and sporadic deposit cash flow from the Company’s municipal customers.

The Company is a party to financial instruments with off-balance sheet risk in the normal course of business in order to meet the financing needs of its customers and in connection with the overall interest rate management strategy. These instruments involve, to a varying degree, elements of credit, interest rate and liquidity risk. In accordance with GAAP, these instruments are not recorded in the consolidated financial statements. Such instruments primarily include lending commitments and lease obligations.

Lending commitments include commitments to originate loans and commitments to fund unused lines of credit. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established by contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since some of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.

In addition to lending commitments, the Company has contractual obligations related to operating lease commitments, certificates of deposit, FHLB advances and repurchase agreements. Operating lease commitments are obligations under various non-cancelable operating leases on buildings and land used for office space and other bank purposes. The Company’s position with respect to lending commitments and significant contractual obligations, both on a short- and long-term basis has not changed materially from December 31, 2010.

As of March 31, 2011, the Company maintained $47.4 million in cash and cash equivalents, $90.7 million in securities AFS and loans HFS and had approximately $222.1 million available to borrow from the FHLB, the Discount Window of the Federal Reserve Bank, correspondent banks and CDARS. The combined total of $360.2 represented 60% of total assets as of March 31, 2011. Management believes this level of liquidity to be strong and adequate to support current operations.

#### Capital

During the three months ended March 31, 2011, total shareholders' equity increased $1,529,000, or 3%. The improvement was caused by: net income of $1,227,000; a $474,000 (net of a $3,000 non-credit-related OTTI gain) after tax improvement in the market value of the AFS securities portfolio; $67,000 in proceeds from employees enrolled in the Company’s Employee Stock Purchase Plan; partially offset by $263,000 of dividends paid to shareholders, net of dividends reinvested and optional cash payments received from participants in the Company’s Dividend Reinvestment Plan.

As of March 31, 2011, the Company reported a net unrealized loss of $3,344,000, net of tax, from the securities AFS, an improvement compared to the net unrealized loss of $3,817,000 as of December 31, 2010. The condition of the economy, though improving, continues to assert uncertainty in the financial and capital markets and has had a sizable and prolonged negative impact on the fair value estimates on the securities in banks’ investment portfolios. Management maintains these changes are due mainly to liquidity problems in the financial markets and to a lesser extent the deterioration in the creditworthiness of the issuers.

The Company (on a consolidated basis) and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possible additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s and the Bank’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk-weightings and other factors. Prompt corrective action provisions are not applicable to bank holding companies.

Under these guidelines, assets and certain off-balance sheet items are assigned to broad risk categories, each with appropriate weights. The resulting capital ratios represent capital as a percentage of total risk-weighted assets and certain off-balance sheet items. The appropriate risk-weighting, pursuant to regulatory guidelines, required a gross-up in the risk-weighting of securities that were rated below investment grade, thereby significantly inflating the total risk-weighted assets. This requirement had an adverse impact on the total capital and Tier I capital ratios in 2011 and 2010. The regulatory guidelines require all banks and bank holding companies to maintain a minimum ratio of total risk-based capital to total risk-weighted assets (Total Risk Adjusted Capital) of 8%, including Tier I capital to total risk-weighted assets (Tier I Capital) of 4% and Tier I capital to average total assets (Leverage Ratio) of at least 4%. As of March 31, 2011, the Company and the Bank met all capital adequacy requirements to which it was subject.

The Company continues to closely monitor and evaluate alternatives to enhance its capital ratios as the regulatory and economic environments change. The following table depicts the capital amounts and ratios of the Company and the Bank as of March 31, 2011:

| Total capital (to risk-weighted assets) | Actual amount | Ratio |  | For capital adequacy purposes Amount |  | Ratio |  | To be well capitalized under prompt corrective action provisions Amount |  | Ratio |
| --- | ---: | ---: | --- | ---: | --- | ---: | --- | ---: | --- | ---: |
| Consolidated | $54,509,388 | 12.1% | ≥ | $36,069,556 | ≥ | 8.0% |  | N/A |  | N/A |
| Bank | $54,130,664 | 12.0% | ≥ | $36,059,748 | ≥ | 8.0% | ≥ | $45,074,685 | ≥ | 10.0% |
| Tier I capital |  |  |  |  |  |  |  |  |  |  |
| (to risk-weighted assets) |  |  |  |  |  |  |  |  |  |  |
| Consolidated | $48,768,534 | 10.8% | ≥ | $18,034,778 | ≥ | 4.0% |  | N/A |  | N/A |
| Bank | $48,463,312 | 10.8% | ≥ | $18,029,874 | ≥ | 4.0% | ≥ | $27,044,811 | ≥ | 6.0% |
| Tier I capital |  |  |  |  |  |  |  |  |  |  |
| (to average assets) |  |  |  |  |  |  |  |  |  |  |
| Consolidated | $48,768,534 | 8.4% | ≥ | $23,260,311 | ≥ | 4.0% |  | N/A |  | N/A |
| Bank | $48,463,312 | 8.4% | ≥ | $23,242,306 | ≥ | 4.0% | ≥ | $29,052,882 | ≥ | 5.0% |

## Controls and procedures

As filed, 1,065 characters.

As of the end of the period covered by this Quarterly Report on Form 10-Q, an evaluation was carried out by the Company’s management, with the participation of its President and Chief Executive Officer and Chief Financial Officer, of the effectiveness of the Company’s disclosure controls and procedures, as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934. Based on such evaluation, the President and Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are designed to ensure that information required to be disclosed in the reports the Company files or furnishes under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and regulations, and are effective. The Company made no changes in its internal controls over financial reporting or in other factors that materially affected, or are reasonably likely to materially affect, these controls during the last fiscal quarter ended March 31, 2011.

## Risk factors

As filed, 206 characters.

Management of the Company does not believe there have been any material changes in risk factors that were disclosed in the 2010 Form 10-K filed with the Securities and Exchange Commission on March 29, 2011.

Filed May 11, 2011.
Source: SEC EDGAR, the filing index for accession 0001144204-11-027981. Last ingested by Listed: Nov 6, 2026, 18:40 ET. No prices; not investment advice.