# Potomac Bancshares Inc: Form 10-Q for the period ended Jun 30, 2011

- Company: [Potomac Bancshares Inc](/companies/ptbs.md) (CIK 925173)
- Form: 10-Q
- Filed: 2011-08-15
- Accepted by EDGAR: Aug 15, 2011, 13:11 ET
- Period: 2011-06-30
- Accession: 0001206774-11-001867
- Inline XBRL: no
- Main document: https://www.sec.gov/Archives/edgar/data/925173/000120677411001867/potomac_10q.htm
- All documents and exhibits: https://www.sec.gov/Archives/edgar/data/925173/000120677411001867/

## Management's discussion and analysis

As filed, 21,035 characters.

CRITICAL ACCOUNTING POLICIES General The company’s financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). The financial information contained within our statements is, to a significant extent, financial information that is based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability. We use historical loss factors as one factor in determining the inherent loss that may be present in our loan portfolio. Actual losses could differ significantly from the historical factors that we use. In addition, GAAP itself may change from one previously acceptable method to another method. Although the economics of our transactions would be the same, the timing of events that would impact our transactions could change. Allowance for Loan Losses The allowance for loan losses is an estimate of the losses that may be sustained in our loan portfolio. The allowance is based on two basic principles of accounting: (1) losses be accrued when they are probable of occurring and are capable of estimation and (2) losses be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance.

The allowance consists of specific, general and unallocated components. The specific component relates to loans that are classified as loss, doubtful or substandard. For such loans that are also classified as impaired, an allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan. The general component covers non-classified loans and is based on historical loss experience adjusted for qualitative factors. An unallocated component is maintained to cover uncertainties that could affect management’s estimate of probable losses. The unallocated component of the allowance reflects that margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio. FINANCIAL OVERVIEW The second quarter of 2011 has been what one might call “more of the same.” The local economy has remained relatively unchanged. The housing market and unemployment continue to be a drag on the local economy. Management has counteracted the reductions in loan income by increasing the investment portfolio and reducing expenses wherever possible. We continue to pursue potential loan candidates and are vigilantly marketing our current inventory of foreclosed properties. It is management’s opinion that one of the key elements to improving our situation and that of the local economy is to reduce this housing inventory currently owned by financial institutions. As these inventories are liquidated, the real estate market should begin to rebound to a more “normal” market. We expect this economic growth to be slow and do not expect the real estate market to return to the level experienced during the first seven years of this century. Total assets have increased $3.2 million or 1.1% from the December 31, 2010 total of $297.6 million to $300.8 million at June, 2011. Though this change is relatively small, the movement within the assets is more significant. Net loans have decreased approximately $8.2 million from the December 31, 2010 total of $214.2 million to $206 million at June 30, 2011 due to minimal loan demand, the pay down of existing loans, loan charge-offs and the transfer of loans to OREO. Other real estate, net of valuation allowance, has increased $938 thousand. With the decrease in loans, excess funds of $13 million have been invested in securities in order to get more yield than if invested in Federal funds or leaving funds in the Federal Reserve account. Total deposits have increased $1.3 million or .5% at June 30, 2011 compared to December 31, 2010. Interest-bearing deposits have increased .6% during the first half of 2011, with non-interest bearing deposits remaining flat. The June 30, 2011 annualized return on average assets is .28% compared to .59% at December 31, 2010. At June 30, 2011 the annualized return on average equity is 3.15% compared to 6.70% at December 31, 2010. The recent debate in Congress regarding the national debt ceiling, federal budget deficit concerns and overall weakness in the economy recently resulted in a downgrade of U.S. government securities by Standard and Poor’s, one of the three major credit rating agencies. This downgrade and the possible future downgrade by one or both of the other two major ratings agencies could create uncertainty in the U.S. and global financial markets. These actions could cause other events which, directly or indirectly, may adversely affect the company’s operations, earnings and financial condition.

The following table is an analysis of the company’s allowance for loan losses with amounts shown in thousands. Management monitors the loan portfolio on a continual basis with procedures that allow for problem loans and potentially problem loans to be highlighted and watched. Written reports are prepared on a monthly basis for all loans including commercial loans graded below a certain level and are reported to the Board of Directors on a monthly basis. Based on experience, these loan policies and the bank’s grading and review system, management believes the loan loss allowance is adequate.

| Balance at beginning of period Charge-offs: | June 30, 2011 $5 012 | December 31, 2010 $5 718 | June 30, 2010 $5 718 |
| --- | ---: | ---: | ---: |
| Commercial, financial and agricultural | 12 | 313 | - - |
| Real estate – construction | 581 | 775 | 406 |
| Real estate – mortgage | 922 | 1 245 | 487 |
| Consumer | 76 | 293 | 141 |
| Total charge-offs | 1 591 | 2 626 | 1 034 |
| Recoveries: |  |  |  |
| Commercial, financial and agricultural | 11 | 25 | - - |
| Real estate – construction | 5 | - - | - - |
| Real estate – mortgage | 12 | 95 | 8 |
| Consumer | 65 | 201 | 114 |
| Total recoveries | 93 | 321 | 122 |
| Net charge-offs | 1 498 | 2 305 | 912 |
| Provision charged to operations | 599 | 1 599 | 771 |
| Balance at end of period | $4 113 | $5 012 | $5 577 |
| Ratio of net charge-offs (annualized) during the period |  |  |  |
| to average loans outstanding during the period | 1.40% | 1.01% | .80% |

As a result of the regular loan reviews by management, the allowance for loan losses decreased when comparing data as of June 30, 2011 to June 30, 2010. Many of the loans foreclosed upon or currently in nonaccrual status are related to the real estate industry. In comparing data for the loan loss reserve for the June 30, 2011 quarter end to December 31, 2010 information, the reserve has decreased. The decrease in the allowance for loan losses is partially due to loans with specific reserves being charged off. Management continues to review these assets on a regular basis. Loans are placed on nonaccrual status when principal or interest is delinquent for 90 days or more. Interest income generally is not recognized on specific impaired loans unless the likelihood of further loss is remote. Interest income on other nonaccrual loans is recognized only to the extent of interest payments received. The majority of the current nonaccrual loans as shown in the chart below are in the process of collection. Following is a table showing the risk elements in the loan portfolio with amounts in thousands.

| Nonperforming Assets Nonaccrual loans Troubled debt restructures (1) Foreclosed properties Total nonperforming assets Performing troubled debt restructures (2) Loans past due 90 days accruing interest | June 30, 2011 $4 299 - - 7 501 $11 800 $2 976 $- - | December 31, 2010 $2 233 - - 6 563 $8 796 $- - $- - | June 30, 2010 $3 094 - - 6 647 $9 741 $- - $- - |
| --- | ---: | ---: | ---: |
| Allowance for loan losses to period end loans | 1.96% | 2.29% | 2.46% |
| Nonperforming assets to period end loans and |  |  |  |
| foreclosed properties, net | 5.42% | 3.90% | 4.17% |
| Performing troubled debt restructures to period end loans | 1.42% | - -% | - -% |

(1) Currently there are no TDR’s in non-performing assets.

(2) Performing troubled debt restructures are restructured loans that are performing in accordance with the modified terms of the loan agreement.

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At June 30, 2011, other potential problem loans total $2.1 million. Loans are viewed as potential problem loans according to the ability of such borrowers to comply with current repayment terms. These loans include loans to customers currently in bankruptcy proceedings but continuing to make payments as agreed and customer loans that show potential weakness if corrective action is not taken. These loans are subject to constant management attention, and their status is reviewed on a regular basis.

The details of the income statements for the three month and six month periods ended June 30, 2011 and 2010 are highlighted below.

- Year to date net income in 2011 is 50% less than the 2010 net income. Quarterly income is 60.5% below the June quarter 2010 and 32.7% below the March 2011 quarter. The loan portfolio has decreased as the result of foreclosures and normal run off. Decline in property values have further affected the net income as other real estate write downs have been charged against income. In addition there were net gains on sale of other real estate in 2010 compared to net losses in 2011.
- At June 30, 2011, year to date total interest and dividend income is down 10% compared to June 30, 2010. A comparison of quarterly interest and dividend income provides a reduction of 11.3%. In each scenario the reasons for the decrease in income is the same. Loan yields are down slightly over the past year and the loan portfolio has decreased. As of June 30 there are also $4.3 million loans on nonaccrual status. The reduction in income is created by the decrease in loans and some decrease in rates. As of June 30, 2011 loans are down 7.4% compared to June 30, 2010.
- At June 30, 2011, year to date interest expense was 22.4% below 2010 expense for the same time period. The quarterly results were similar. Interest expense decreases 25.9% and 15.2% when compared to the June 2010 and March 2011 quarters, respectively. The decrease in expense is primarily due to a reduction in interest rates.
- Net interest margin at June 30, 2011 is 3.41%, down from the December 31, 2010 figure of 3.56% and June 30, 2010 figure of 3.53%. During the first six months of 2011, the overall average rate on loans dropped from 5.70% at December 31, 2010 to 5.55% at June 30, 2011. The overall rate on loans during the first six months of 2010 was 5.73%. During this same period the overall average rate being paid on deposits decreased to 1.40% from 1.68% at December 31, 2010 and 1.77% at June 30, 2010.

Noninterest income decreased 7.9% for the six months ended June 30, 2011 compared to June 30, 2010. Noninterest income decreased 6.0% for the three months ended June 30, 2011 compared to the three months ended June 30, 2010 and increased 8.4% when compared to the three months ended March 31, 2011. Some significant income items are listed here.

- At June 30, 2011 there is an overall loss on sale of OREO compared to an overall gain at June 30, 2010. This results in a decrease of 149.3% in the gain or loss on sale of OREO account.
- Visa and Mastercard fees have increased 12.2%. The increase is due to an overall increase in consumer spending and the likelihood that consumers continue to get more comfortable with using credit/debit cards versus cash.

Year to date total noninterest expense increased about 11.7% for the six months ended June 30, 2011 compared to the same period in 2010. The quarterly results were increases of 23% and 19.9% over the June 2010 and March 2011 quarters, respectively. Some details are listed below.

- Other professional fees have increased 38.2 % on a year to date comparison. The increase over the three months ended June 30, 2010 is 39.1%. The increase over the three months ended March 31, 2011 is 113.3%. The primary reasons include a payment to our vendor for SEC filings and design fees related to materials produced for the subsidiary bank’s 140th anniversary celebration. Both of these expense items were incurred during the June 30, 2011 quarter.
- ATM and check card expenses have increased 13.3% in the first six months of 2011 compared to the same time period in 2010. The increase jumps to 15.5% when compared to each of the quarters ended June 30, 2010 and March 31, 2011. The increase is due to the purchase of card stock (which generally occurs on a bi-annual basis) as well as an increase in the number of cards being reissued because of fraud, damage or loss by the customer.
- The additional write down of other real estate has increased by $267 thousand over the same period in 2010. This is the result of falling property values.
- Other operating expenses have increased 17.5% at June 30, 2011 compared to June 30, 2010. The significant contributing factors are outlined below.

Trust investing outsourcing has increased 27.4%. The increase is attributed to an increase in the value of assets and some increase in numbers of accounts being managed by our vendor.

Fees related to the maintenance of the Smart Checking product have increased 69.3%. The difference is partially due to some timing issues related to payments in early 2010 as well as to increases in the customer base for the Smart Checking product which increased overall costs.

Postage has increased 17%. The primary reason for the increase is an increase in the postage costs charged by the outsourcing vendor over that which we were paying for processing the mailings internally.

Miscellaneous real estate expense has increased 74%. The increase is due to several reasons. The bank has had a large volume of appraisals prepared to assess the adequacy of collateral values as compared to loan amounts. The bank has also had expenses for properties in process of foreclosure. When these properties are foreclosed, these costs are reclassified to foreclosed property expense.

LIQUIDITY

Liquidity is a measure of the Bank’s ability to respond to sudden changes in funding needs or funding sources. Examples of sudden changes could involve a sudden increase in loan demand, a funding need, or it might involve a large decrease in deposited funds, a funding source. The role of cash management is to manage assets and liabilities so that the Bank can respond to such fluctuations in sources and uses of cash. Management spends much of its time assessing our liquidity position.

Management is informed of the liquidity information via reports and committee discussion. The president is provided a weekly “dashboard” report of our liquidity information. The Asset/Liability Committee reviews and discusses our liquidity position on a quarterly basis. The committee has set a benchmark minimum liquidity ratio of 15%. Management has recently worked on a strategy to free up some pledged assets for liquidity purposes.

Public funds are required to have collateral pledged against their balances above the FDIC insurance limits. Generally the bank has pledged securities or obtained letters of credit from the Federal Home Loan Bank of Pittsburgh to cover public funds. Two additional strategies to cover these funds are now being used. In the case of public funds in the form of CDs, the bank is utilizing the CDARS network to insure their funds. We are also using the Insured Cash Sweep (ICS) product to secure public funds. Both of the programs provide complete coverage through FDIC insurance. Most importantly, the securities that had been pledged against the public funds can be used as a source of cash if the need would arise. The securities are effectively converted from a non liquid asset to a liquid asset.

Liquid assets of the company include cash and due from banks, securities purchased under agreements to resell, federal funds sold, securities available for sale, and loans and investments maturing within one year. The company’s statement of cash flows details this liquidity since January 1, 2011.

*Operating Activities.* The company’s net income usually provides cash from the bank’s operating activities. The net income figure is adjusted for certain noncash transactions such as depreciation expense that reduces net income but does not require a cash outlay. During 2011, the net income as adjusted has provided cash of $1.8 million. Interest income earned on loans and investment securities is the company’s major income source.

*Investing Activities.* Customer core deposits and company noncore funding provide the funds used to invest in loans and investment securities. In addition, the principal portion of loan payments, loan payoffs and maturity of investment securities provide cash flow. Purchases of bank premises and equipment are an investing activity. We have taken advantage of our noncore funding capabilities since deposit growth is not always sufficient. The net amount of cash used in investing activities in 2011 is $6.4 million.

*Financing Activities.* Customer core deposits and company noncore funding provide the financing for the investing activities as stated above. If the company has an excess of funds on any given day, the bank will sell these funds to make additional interest income to fund activities. Likewise, if the company has a shortage of funds on any given day it will purchase funds and pay interest for the use of these funds. Financing activities also include payment of dividends to shareholders, purchase of shares of the company’s common stock for the treasury and repayment of any noncore funding. The net amount of cash provided by financing activities in 2011 is $2.4 million.

At June 30, 2011, cash and due from banks, interest-bearing deposits in financial institutions, securities purchased under agreements to resell, federal funds sold and loans and securities maturing within one year were $38.1 million.

Noncore funding capabilities, including borrowing, provide additional liquidity. The subsidiary bank maintains a federal funds line with one financial institution and is a member of the Federal Home Loan Bank of Pittsburgh. In March 2010, the subsidiary bank modified a $3 million borrowing amortizing over three years from the Federal Home Loan Bank. In July 2009 the subsidiary bank secured a credit line with the Federal Reserve discount window. At June 30, 2011, the subsidiary bank has total credit available through these institutions of approximately $28.4 million.

ANALYSIS OF CAPITAL

The adequacy of the company’s capital is reviewed by management on an ongoing basis in terms of the size, composition, and quality of the company’s asset and liability levels, and consistency with regulatory requirements and industry standards. Management seeks to maintain a capital structure that will assure an adequate level of capital to support anticipated asset growth and absorb potential losses.

The Federal Reserve, the Comptroller of the Currency and the Federal Deposit Insurance Corporation have adopted capital guidelines to supplement the existing definitions of capital for regulatory purposes and to establish minimum capital standards. Specifically, the guidelines categorize assets and off-balance sheet items into four risk-weighted categories. The minimum ratio of qualifying total capital to risk-weighted assets is 8.0%, of which at least 4.0% must be tier 1 capital, composed of common equity, retained earnings and a limited amount of perpetual preferred stock, less certain goodwill items.

The Tier 1 capital to average assets ratio (leverage capital ratio) is 9.02% at June 30, 2011 compared to 9.36% at December 31, 2010. The Tier 1 capital to total risk weighted assets ratio is 12.59% at June 30, 2011 compared to 12.97% at December 31, 2010. The total capital to risk weighted assets ratio is 13.85% at June 30, 2011 compared to 14.24% at December 31, 2010. All capital ratios are within the regulatory guidelines.

|  | June 30, 2011 Actual Amount | Ratio | Minimum Capital Requirement Amount | Ratio |
| --- | --- | ---: | --- | ---: |
| Total capital to risk weighted assets | $30 268 | 13.85% | $17 483 | 8.00% |
| Tier 1 capital to risk weighted assets | $27 520 | 12.59% | $8 741 | 4.00% |
| Tier 1 capital to average assets | $27 520 | 9.02% | $12 202 | 4.00% |
|  | December 31, 2010 |  |  |  |
|  | Actual |  | Minimum Capital Requirement |  |
|  | Amount | Ratio | Amount | Ratio |
| Total capital to risk weighted assets | $30 798 | 14.24% | $17 306 | 8.00% |
| Tier 1 capital to risk weighted assets | $28 065 | 12.97% | $8 653 | 4.00% |
| Tier 1 capital to average assets | $28 065 | 9.36% | $11 992 | 4.00% |

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## Controls and procedures

As filed, 1,024 characters.

Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we have evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of the date of this quarterly report. Based on that evaluation, our principal executive officer and principal financial officer have concluded that these controls and procedures are effective. There were no significant changes in our internal controls or in other factors that could significantly affect these controls subsequent to the date of their evaluation.

Disclosure controls and procedures are our controls and other procedures that are designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosure.

Filed Aug 15, 2011.
Source: SEC EDGAR, the filing index for accession 0001206774-11-001867. Last ingested by Listed: Oct 24, 2026, 15:00 ET. No prices; not investment advice.