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

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.

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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 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, 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 environmental factors such as economic, concentration, and growth trends. 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 quarter ended September 30, 2011 has produced little, if any, clarity to the economic outlook. 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 reducing expenses wherever possible, and continuing to reduce interest expense on deposits. There have been no significant adverse effects on deposit balances.

Management continues to pursue potential loan relationships and is 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. We expect economic growth to be slow and do not expect the real estate market to return to pre-recession levels.

The net loss for the quarter of $1.8 million and a net loss year to date of $1.3 million are primarily due to two charges posted in this quarter. First, we reduced the value of our foreclosed property assets by some $1.85 million upon obtaining updated appraisals on foreclosed property carried on our balance sheet. We evaluate these assets on an ongoing basis especially in a “declining real estate market” which our area continues to experience. About two thirds of the write-down involves residential lot developments foreclosed upon and charged down in 2009. These properties have continued to lose value due to very weak demand by consumers for new housing and little demand from builders for lots. A surplus of foreclosed properties on the market continues to keep prices low, so until new and existing housing values reach some sort of price equilibrium, there will be little demand for both lots and new construction.

A second charge of $2.1 million involves additions to our loan loss reserve as businesses and consumers continue to struggle because of the sluggish economy. In conjunction with our ongoing loan review process, an analysis of both primary and secondary sources of repayment including an assessment of the current value of collateral is performed. Again, most of the collateral that secures our loans is real estate and those values are down significantly.

Total assets have decreased $3.9 million or 1.3% from the December 31, 2010 total of $297.6 million to $293.7 million at September 30, 2011. Net loans have decreased approximately $12.1 million from the December 31, 2010 total of $214.2 million to $202.1 million at September 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 decreased $412 thousand. With the decrease in loans, excess funds have been invested in securities, and overnight funds at the Federal Reserve.

Total deposits have increased $275 thousand or .1% at September 30, 2011 compared to December 31, 2010. Interest-bearing deposits have decreased 1.2% during the first three quarters of 2011, with non-interest bearing deposits increasing 11.3%.

The Tier 1 capital to average assets ratio (leverage capital ratio) is 8.42% at September 30, 2011 compared to 9.36% at December 31, 2010. This capital ratio is within the regulatory guidelines for “well capitalized”.

The 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 for management review and are reported to the Board of Directors on a quarterly basis. In addition, a subcommittee of the board of directors meets monthly to review all classified assets. Based on experience, these loan policies and the bank’s grading and review system, management believes the loan loss allowance is adequate.

As a result of the regular loan reviews by management, the allowance for loan losses increased when comparing data as of September 30, 2011 to September 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 September 30, 2011 quarter end to December 31, 2010 information, the reserve has increased in relation to a continued weak economy. 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 and in the process of collection. Interest income generally is recognized on specific impaired loans unless the likelihood of further loss is expected. Interest income on other non-accrual loans is recognized only to the extent of interest payments received. The majority of the current non-accrual 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.

(1) Currently there is 1 TDR in non-performing assets with a balance of $50K.

(2) Within this amount are two TDR’s with balances totaling $155k and both are 30 or more days past due.

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

• Year to date net loss in 2011 is $1.37 million compared to net income of $1.39 million in 2010. Quarterly net loss is $1.8 million in 2011 compared to net income of $528 thousand for the same quarter of 2010. 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.
• The primary driver of both the year to date loss and quarterly loss are attributable to increases in the loan loss provision and write downs of OREO property. The year to date provision for loan loss has increased $1.7 million over the same period in 2010. The quarterly provision increased $1.9 million over the same quarter in 2010. Likewise, the write down of OREO property had a year to date increase of $2.1 million and a quarterly increase of $1.8 million. Both of these figures represent comparisons to the same time period in 2010.
• At September 30, 2011, year to date total interest and dividend income is down 9.5% compared to September 30, 2010. A comparison of quarterly interest and dividend income provides a reduction of 8.6%. In each scenario the reasons for the decrease in income are the same. Loan yields are down slightly over the past year and the loan portfolio has decreased. As of September 30 there are also $2.8 million in loans on nonaccrual status. As of September 30, 2011 loans are down 5.4% compared to December 31, 2010.
• At September 30, 2011, year to date interest expense was 26.7% below 2010 expense for the same time period. The quarterly results show a 36.2% drop in interest expense as compared to the same quarter in 2010. The decrease in expense is primarily due to a reduction in interest rates on deposit accounts as part of a planned strategy.
• Net interest margin at September 30, 2011 is 3.54%. This is down from the net interest margin of 3.56% for the same period in 2010. During the first nine months of 2011, the overall average rate on loans dropped to 5.56% at September 30, 2011 compared to 5.71% for the same period in 2010. During this same period the overall average rate being paid on deposits decreased to 1.29% from 1.72% at September 30, 2010.

Noninterest income increased 2.5% for the nine months ended September 30, 2011 compared to September 30, 2010 and increased 3.13% for the three months ended September 30, 2011 compared to the three months ended September 30, 2010. Some significant income items are listed here.

• Visa and Mastercard fees have increased 13.2% on a year to date basis compared to the same period in 2010. 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.
• Quarterly comparisons show a 13.1% increase in income from fiduciary activities and a 15.1% increase in fees from Visa and Mastercard. These results are in comparison to the quarter ended September 30, 2010.

Year to date total noninterest expense increased about 40.4% for the nine months ended September 30, 2011 compared to the same period in 2010. The quarterly result was an increase of 86.5% over the September 2010 quarter. Excluding write downs and losses from sales of other real estate, noninterest expense was up 4.6% and 1.1% for the nine and three month periods, respectively. Some details of the remaining accounts are listed below.

• Furniture and equipment expense increased 10.2% over September 30, 2010. The quarterly comparisons show an increase of 54.3% over the September 2010 quarter. The primary reason for the increase is maintenance expense related to our core banking software.
• Advertising and public relations expense increased 13.2% compared to the same period in 2010. The expense is 20.5% greater than the September 2010 quarter.
• Accounting, audit and compliance fees are up 29.8% over September 30, 2010. These same fees show an increase of 41.7% as compared to the September 30, 2010 quarter. The increase is due to auditing services provided by an outside vendor to help assess our loan portfolio.
• ATM and check card expenses have increased 15% in the first nine months of 2011 compared to the same time period in 2010. The increase jumps to 18% when compared to the quarter ended September 30, 2010. 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.
• Postage expense has increased 15.1% over September 30, 2010. The quarterly results show increases of 13.2% over the quarter ended September 30, 2010. The increase is primarily related to postage costs related to promotional materials and customer notifications. In the third quarter we expensed the postage costs for the shipment of the 140th anniversary calendars and mailings to notify customers of our privacy policy and changes in our fees on deposit accounts. Two of these three items are one time expenses not in the normal course of business.
• 2011 year to date other operating expenses have increased 13.5% compared to the same period in 2010. The significant contributing factors include trust investing outsource, other professional fees, other taxes, training and study, and credit reports and investigation.

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 implemented 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 loss as adjusted has provided cash of $3.1 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 provided by investing activities in 2011 is $4.8 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 used in financing activities in 2011 is $2.8 million.

At September 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 $41.5 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 September 30, 2011, the subsidiary bank has total credit available through these institutions of approximately $35.7 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. All capital ratios are within the regulatory guidelines for a “well capitalized institution” as noted below.

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.