Potomac Bancshares Inc: Form 10-Q for the period ended Mar 31, 2012

CRITICAL ACCOUNTING POLICIES

General

The company’s financial statements are prepared in accordance with U. S. generally accepted accounting principles. 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, U. S. generally accepted accounting principles 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 margin value of collateral and the loan balance. The allowance consists of specific and general components. The specific component relates to loans (other than consumer and residential mortgage loans) that are classified as 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 environmental factors such as economic, concentration and growth trends. The bank uses a twelve month rolling average period for use in calculating the historical loss factor. FINANCIAL OVERVIEW The first quarter of 2012 has provided positive results with net income of $320 thousand, up almost 25% over the same period in 2011. The bank has produced two consecutive quarters of income despite the challenging economic environment. There has been significant positive movement in the unemployment rate in our local market over the past twelve months. We are seeing loan growth in the residential real estate portfolio. In addition to those items outside management control, the actions taken in the past year are creating improvement in economic performance. Interest expense as a result of decreases in deposit rates, are a significant reason for our ability to produce a profit. Management has aggressively marketed our inventory of other real estate. However, the inventory is still higher than what we would prefer. Management is hopeful that sales of other real estate will continue at a moderate pace. Total assets have increased $10.9 million or 3.8% from the December 31, 2011 total of $287.4 million to $298.3 million at March 31, 2012. Net loans have decreased approximately $1.9 million from the December 31, 2011 total of $202.8 million to $200.9 million at March 31, 2012 due to 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 $389 thousand. With the decrease in loans and increase in deposits excess funds have been invested in securities, and overnight funds at the Federal Reserve. Total deposits have increased $11.9 million or 4.7% at March 31, 2012 compared to December 31, 2011. Interest-bearing deposits have increased 2.6% during the first quarter of 2012, with non-interest bearing deposits increasing 16.9%. Other liabilities have decreased approximately $2 million dollars. The decrease is primarily due to a $2 million contribution to the pension plan. The Tier 1 capital to average assets ratio (leverage capital ratio) is 8.70% at March 31, 2012 compared to 8.56% at December 31, 2011. This capital ratio is within the regulatory guidelines for “well capitalized”.

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.

Loans are placed on nonaccrual status when the loan officer or collections officer who is supervising a particular loan determines that it is no longer prudent for a loan to continue to accrue interest, the loan is to be placed on nonaccrual status.

Generally it is the policy of this bank to stop accruing interest when principal or interest is greater than 90 days past due based upon the loan’s contractual terms, unless the loan is well secured and in the process of collection. Furthermore, should the bank become aware of events which have occurred or are expected to occur which causes doubt as to the full collectability of principal or interest in the future, even though the loan is currently less than 90 days past due, the loan is considered for nonaccrual status.

In order to justify the continuation of the accrual of interest on a loan which is greater than 90 days past due, the loan must be well secured and in the process of collection. 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 are 7 TDR’s in non-performing assets with a balance of $3.4 million.

(2) Within this amount is 1 TDR with a balance totaling $35 thousand 30 or more days past due.

The details of the income statements for the three month period ended March 31, 2012 and 2011 are highlighted below.

• Year to date net income in 2012 is $320 thousand compared to net income of $257 thousand in 2011. The loan portfolio has decreased as the result of foreclosures and normal run off. Deposits have increased slightly. However, the increase in volume has been offset by significant decreases in rates paid on deposit accounts. Decline in property values have further affected the net income as other real estate write downs have been charged against income. In addition net losses on the sale of other real estate doubled in the first quarter of 2012 compared to net losses in the same period in 2011.
• Interest income has decreased to $2.9 million at March 31, 2012 from $3.2 million at March 31, 2011. The reduction is primarily due to a decrease of approximately $240 thousand in the loan portfolio. This coupled with historically low interest rates has created the slight reduction in interest income.
• Total interest expense has decreased 50.4% in 2012 compared to 2011. Interest on deposits has decreased 49.7% during the first quarter of 2012 when compared with the first quarter of 2011.
• Provision for loan loss has decreased 27% when compared to the March 31, 2011 quarter.
• Net interest margin at March 31, 2012 is 3.80%. This is an increase from the net interest margin of 3.56% at December 31, 2011 and 3.44% at March 31, 2011. During the first three months of 2012, the overall average rate on loans decreased to 5.36% at March 31, 2012 compared to 5.53% at December 31, 2011 and 5.64% for the quarter ending March 31, 2011. The overall average rate being paid on deposits decreased to .83% from 1.21% at December 31, 2011 and from 1.53% at March 31, 2011.

Noninterest income increased 6.5% for the three months ended March 31, 2012 compared to March 31, 2011 and decreased 18% for the three months ended March 31, 2012 compared to the three months ended December 31, 2011. Some significant income items are listed here.

• Trust income increased 11.3% when compared to the March 31, 2011 quarter and increased 13.36% when compared to the December 31, 2011 quarter. The increase, in both cases, are due to new customer volume as rates have remained relatively steady.
• Visa and MasterCard fees have increased 13.8% on a year to date basis compared to the same period in 2011. 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.
• The primary cause of the decrease in non-interest income compared to the December quarter was the termination of an other post-retirement benefit plan in the fourth quarter of 2011.

Year to date total noninterest expense increased about 8.27% for the three months ended March 31, 2012 compared to the same period in 2011. The quarterly result was an increase of 4% over the December 31, 2011 quarter. Excluding expenses and losses related to foreclosed properties non-interest expense increased by 1.04% when compared to the March 31, 2011 quarter, and decreased 1.82% when compared to the December 31, 2011 quarter. Some details of the remaining accounts are listed below.

• Equipment expense increased 21% over the March 31, 2011 quarter. The increase is a combination of increases in expenses related to our banking software and the expense of new computers purchased.
• Computer services and online banking expense increased 52.2% over the first quarter 2011 results. The increase is due to increases in costs related to the bank’s core software and additional online banking expenses related to new resources provided to customers.
• Loss on sale of other real estate increased 100% in the first quarter of 2012 as compared to the first quarter of 2011. The increase is primarily due to the housing market slump lowering values in our market area coupled with a moderate amount of foreclosed properties remaining in the market.
• The FDIC assessment expense has decreased 36% from the March 31, 2011 quarterly total. The decrease is due to the change in the base rate of the calculation. The rate is now calculated on average assets as opposed to total deposits.
• Other professional fees have increased 45.2% over the March 2011 quarter. The primary reason for the increase is one time professional fees related to the design of new materials explaining the changes in the deposit accounts and fees related to updating materials for the bank’s new “tag line”.
• Foreclosed property expense has increased 14.5% in 2012 compared to 2011. The increase in expense is due to new inventory being added to other real estate and ongoing costs of existing inventory not yet sold.
• Write down of other real estate has increased significantly during the first quarter of 2012 compared to both the December 31, 2011 and March 31, 2011 quarters. The increase is due to the continual drop in property values. The write downs were executed based on new appraisals.
• ATM and check card expenses have increased 31% in the first three months of 2012 compared to the same time period in 2011. The increase is due to a significant increase in the number of transactions as well as a slight increase in per transaction fees.

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%.

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, 2012.

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 2012, the net income as adjusted has used cash of $1.2 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 2012 is $4.0 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 2012 is $12.5 million.

At March 31, 2012, 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 $47.2 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 July 2009 the subsidiary bank secured a credit line with the Federal Reserve discount window. At March 31, 2012, the subsidiary bank has total credit available through these institutions of approximately $89.2 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.

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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.