LNB Bancorp 10-Q 2009
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
For the quarterly period ended September 30, 2009
For the transition period from to
Commission file number: 0-13203
LNB Bancorp, Inc.
(Exact name of the registrant as specified on its charter)
(Registrants telephone number, including area code)
(Former name, former address and former fiscal year, if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months, and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of large accelerated filer, accelerated filer and smaller reporting company in Rule 12b-2 of the Exchange Act. (Check one):
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ
The number of common shares of the registrant outstanding on November 5, 2009 was 7,295,663.
LNB Bancorp, Inc.
Table of Contents
Part I FINANCIAL INFORMATION
Consolidated Balance Sheets
See accompanying notes to consolidated financial statements.
Consolidated Statements of Income (unaudited)
See accompanying notes to consolidated financial statements
Consolidated Statements of Shareholders Equity (unaudited)
See accompanying notes to consolidated financial statements
Consolidated Statements of Cash Flows (unaudited)
See accompanying notes to consolidated financial statements
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands except per share amounts)
(1) Summary of Significant Accounting Policies
Basis of Presentation
The consolidated financial statements include the accounts of LNB Bancorp, Inc. (the Corporation) and its wholly-owned subsidiary, The Lorain National Bank (the Bank). The consolidated financial statements also include the accounts of North Coast Community Development Corporation which is a wholly-owned subsidiary of the Bank. All intercompany transactions and balances have been eliminated in consolidation.
Use of Estimates
The Corporation prepares its financial statements in conformity with U.S. generally accepted accounting principles (GAAP). As such, GAAP requires the Corporations management (Management) to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and revenues and expenses during the reporting period. Actual results could differ from those estimates. Areas involving the use of Managements estimates and assumptions include the allowance for loan losses, the realization of deferred tax assets, fair values of certain securities, net periodic pension expense, and accrued pension costs recognized in the Corporations consolidated financial statements. Estimates that are more susceptible to change in the near term include the allowance for loan losses and the fair value of certain securities.
The Corporations activities are considered to be a single industry segment for financial reporting purposes. The Corporation is a bank holding company engaged in the business of commercial and retail banking, investment management and trust services, and banking centers located throughout Lorain, eastern Erie, western Cuyahoga, and Summit counties of Ohio. This market provides the source for substantially all of the Banks deposit, loan and trust activities. The majority of the Banks income is derived from a diverse base of commercial, mortgage and retail lending activities and investments.
Statement of Cash Flows
For purposes of reporting in the Consolidated Statements of Cash Flows, cash and cash equivalents include currency on hand, amounts due from banks, Federal funds sold, and securities purchased under resale agreements. Generally, Federal funds sold and securities purchased under resale agreements are for one day periods.
Securities that are bought and held for the sole purpose of being sold in the near term are deemed trading securities with any related unrealized gains and losses reported in earnings. The Corporation held trading securities as of September 30, 2009 and December 31, 2008. Securities that the Corporation has a positive intent and ability to hold to maturity are classified as held to maturity. As of September 30, 2009 and December 31, 2008, the Corporation did not hold any securities classified as held to maturity. Securities that are not classified as trading or held to maturity are classified as available for sale. Securities classified as available for sale are carried at their fair value with unrealized gains and losses, net of tax, included as a component of accumulated other comprehensive income, net of tax. A decline in the fair value of securities below cost, that is deemed other than temporary, is charged to earnings resulting in establishment of a new cost basis for the security. Interest and dividends on securities, including amortization of premiums and accretion of discounts using the effective interest method over the period to maturity or call, are included in interest income.
The Bank is a member of the Federal Home Loan Bank (FHLB) system. Members are required to own a certain amount of FHLB stock based on the level of borrowings and other factors, and may invest in additional amounts. The Bank is also a member of and owns stock in the Federal Reserve Bank of Cleveland. The Bank also owns stock in Bankers Bancshares Inc., an institution that provides correspondent banking services to community banks. Stock in these institutions is classified as restricted stock, is recorded at redemption value which approximates fair value, and is periodically evaluated for impairment based on ultimate recovery of par value. Both cash and stock dividends are reported as income.
Loans Held For Sale
Loans held for sale are carried at the lower of amortized cost or estimated fair value, determined on an aggregate basis for each type of loan. Net unrealized losses are recognized by charges to income. Gains and losses on loan sales (sales proceeds minus carrying value) are recorded in noninterest income.
Loans are reported at the principal amount outstanding, net of unearned income, premiums and discounts. Loans acquired through business combinations are valued at fair market value on or near the date of acquisition. The difference between the principal amount outstanding and the fair market valuation is amortized over the aggregate average life of each class of loan. Unearned income includes deferred fees, net of deferred direct incremental loan origination costs. Unearned income is amortized to interest income, over the contractual life of the loan, using the interest method. Deferred direct loan origination fees and costs are amortized to interest income, over the contractual life of the loan, using the interest method.
Loans are generally placed on nonaccrual status when they are 90 days past due for interest or principal or when the full and timely collection of interest or principal becomes uncertain. When a loan has been placed on nonaccrual status, the accrued and unpaid interest receivable is reversed against interest income. Generally, a loan is returned to accrual status when all delinquent interest and principal becomes current under the terms of the loan agreement and when the collectibility is no longer doubtful.
A loan is impaired when full payment under the original loan terms is not expected. Impairment is evaluated in total for smaller-balance loans of similar nature such as real estate mortgages and installment loans, and on an individual loan basis for commercial loans that are graded substandard or below. Factors considered by Management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis. If a loan is impaired, a portion of the allowance may be allocated so that the loan is reported, net, at the present value of estimated future cash flows using the loans existing rate or at the fair value of collateral if repayment is expected solely from the collateral.
Allowance for Loan Losses
The allowance for loan losses is Managements estimate of credit losses inherent in the loan portfolio at the balance sheet date. Managements determination of the allowance, and the resulting provision, is based on judgments and assumptions, including general economic conditions, loan portfolio composition, loan loss experience, Managements evaluation of credit risk relating to pools of loan and individual borrowers, sensitivity analysis and expected loss models, value of underlying collateral, and observations of internal loan review staff or banking regulators.
The provision for loan losses is determined based on Managements evaluation of the loan portfolio and the adequacy of the allowance for loan losses under current economic conditions and such other factors which, in Managements judgment, deserve current recognition.
Servicing assets are recognized as separate assets when rights are acquired through sale of financial assets. Capitalized servicing rights are reported in other assets and are amortized into noninterest income in proportion to, and over the period of, the estimated future net servicing income of the underlying financial assets. Servicing assets are evaluated for impairment based upon the fair value of the rights as compared to amortized cost. Impairment is determined by stratifying rights by predominant characteristics, such as interest rates and terms. Fair value is determined using prices for similar assets with similar characteristics, when available, or based upon discounted cash flows using market-based assumptions. Impairment is recognized through a valuation allowance for an individual stratum, to the extent that fair value is less than the capitalized amount for the stratum.
Bank Premises and Equipment
Bank premises and equipment are stated at cost less accumulated depreciation and amortization. Depreciation and amortization are computed generally on the straight-line method over the estimated useful lives of the assets. Upon the sale or other disposition of assets, the cost and related accumulated depreciation are retired and the resulting gain or loss is recognized. Maintenance and repairs are charged to expense as incurred, while renewals and improvements are capitalized. Software costs related to externally developed systems are capitalized at cost less accumulated amortization. Amortization is computed on the straight-line method over the estimated useful life.
Goodwill and Core Deposit Intangibles
Intangible assets arise from acquisitions and include goodwill and core deposit intangibles. Goodwill is the excess of purchase price over the fair value of identified net assets in acquisitions. Core deposit intangibles represent the value of depositor relationships purchased. Goodwill is tested at least annually for impairment. Core deposit intangible assets are amortized using the straight-line method over ten years and are subject to annual impairment testing.
Other Real Estate Owned
Other real estate owned (OREO) represent properties acquired through customer loan default. Real estate and other tangible assets acquired through foreclosure are carried as OREO on the Consolidated Balance Sheet at fair value, net of estimated costs to sell, not to exceed the cost of property acquired through foreclosure.
Split-Dollar Life Insurance
The Corporation recognizes a liability and related compensation costs for endorsement split-dollar life insurance policies that provide a benefit to certain employees extending to post-retirement periods. The liability is recognized based on the substantive agreement with the employee. This accounting became effective January 1, 2008 and was applied as a change in accounting principle through a $725 cumulative-effect adjustment to retained earnings as of January 1, 2008.
Investment and Trust Services Assets and Income
Property held by the Corporation in fiduciary or agency capacity for its customers is not included in the Corporations financial statements as such items are not assets of the Corporation. Income from the Investment and Trust Services Division is reported on an accrual basis.
The Corporation and its wholly-owned subsidiary file a consolidated Federal income tax return. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be removed or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance is recorded when necessary to reduce deferred tax assets to amounts which are deemed more likely than not to be realized.
Comprehensive income consists of net income and other comprehensive income. Other comprehensive income includes unrealized gains and losses on securities available for sale and changes in the unfunded status of the pension plan, which are also recognized as separate components of shareholders equity.
The Corporation is authorized to issue up to 1,000,000 shares of Voting Preferred Stock, no par value. As of September 30, 2009, 25,223 shares of the Corporations Fixed Rate Cumulative Perpetual Preferred Stock, Series B (Series B preferred stock) has been issued. No such stock had been issued as of September 30, 2008. The Board of Directors of the Corporation is authorized to provide for the issuance of one or more series of Voting Preferred Stock and establish the dividend rate, dividend dates, whether dividends are cumulative, liquidation prices, redemption rights and prices, sinking fund requirements, conversion rights, and restrictions on the issuance of any series of Voting Preferred Stock. The Voting Preferred Stock may be issued with conversion rights to common stock and may rank prior to the common stock in dividends, liquidation preferences, or both. The Corporation has authorized 750,000 Series A Voting Preferred Shares, none of which have been issued.
New Accounting Pronouncements
Management is not aware of any proposed or recent regulations or current recommendations by the Financial Accounting Standards Board or by regulatory authorities, which, if they were implemented, would have a material effect on the liquidity, capital resources, or operations of the Corporation.
We have evaluated subsequent events through November 6, 2009, the date of issuance of the unaudited condensed consolidated financial statements. During this period we did not have any material recognizable subsequent events.
(2) Earnings Per Share
Basic earnings per share are computed by dividing income available to common shareholders by the weighted average number of shares outstanding during the year. Diluted earnings per share is computed based on the weighted average number of shares outstanding plus the effects of dilutive stock options outstanding during the year. Basic and diluted earnings per share are calculated as follows:
Stock options for 201,000 common shares were not considered in computing diluted earnings per common share for the three and nine month periods ended September 30, 2009 and 2008, respectively, because they were antidilutive. Additionally, stock options for 2,500 common shares were not considered in computing diluted earnings per share for the three and nine month periods ended September 30, 2009 due to the net loss.
(3) Cash and Due from Banks
Federal Reserve Board regulations require the Bank to maintain reserve balances on deposits with the Federal Reserve Bank of Cleveland. The required ending reserve balance was $1,340 on September 30, 2009 and $1,309 on December 31, 2008.
(4) Goodwill and Intangible Assets
On May 10, 2007, LNB Bancorp, Inc. completed the acquisition of Morgan Bancorp, Inc., of Hudson, Ohio and its wholly-owned subsidiary, Morgan Bank, NA. Under the terms of the transaction, the Corporation acquired all of the outstanding stock of Morgan Bancorp, Inc. in a stock and cash merger transaction valued at $27,864. The acquisition was accounted for using the purchase method of accounting, and accordingly, the purchase price was allocated to the assets purchased and the liabilities assumed based upon the estimated fair values at the date of acquisition. The purchase accounting fair values are being amortized under various methods and over the lives of the corresponding assets and liabilities. Goodwill recorded for the acquisition amounted to $18,755. The Corporation recorded $1,367 in core deposit intangibles related to the acquisition of Morgan Bank, NA. These core deposit intangibles were amortized $34 for the three months ended September 30, 2009 and September 30, 2008 and $102 and $104 for the nine months ended September 30, 2009 and September 30, 2008, respectively.
The consolidated statements of income reflect the operating results of the Morgan Bank division of the Corporation since the effective date of the acquisition.
Core deposit intangibles are amortized over their estimated useful life of 10 years. A summary of core deposit intangible assets, including those from the Morgan Bancorp, Inc. acquisition, follows:
The Corporation assesses goodwill for impairment annually and more frequently in certain circumstances. Goodwill is assessed at a reporting unit level by applying a fair-value based test using discounted estimated future net cash flows. The goodwill analysis for impairment is being performed by an independent service provider as of September 30, 2009 and is currently in process.
The amortized cost, gross unrealized gains and losses and fair values of securities available for sale at September 30, 2009 and December 31, 2008 follows:
The cost, gross unrealized gains and losses and fair values of trading securities at September 30, 2009 and December 31, 2008 follows:
(6) Loans and Allowance for Loan Losses
Loan balances at September 30, 2009 and December 31, 2008 are summarized as follows:
Activity in the allowance for loan losses for the six-month periods ended September 30, 2009 and September 30, 2008 is summarized as follows:
Nonaccrual loans at September 30, 2009 were $42,018, as compared to $19,592 at December 31, 2008, and $17,932 at September 30, 2008.
(7) Stock Options and Stock Appreciation Rights
A broad-based equity incentive plan, the 2006 Stock Incentive Plan, was adopted by the Corporations shareholders on April 18, 2006. Options were granted under this Plan in 2007 and 2008. On May 14, 2009, the Corporation granted 2,500 options to its Chief Financial Officer at $5.34 per share, with the options expiring in 2019. The Corporation also has nonqualified stock option agreements outside of the 2006 Stock Incentive Plan. Grants under the nonqualified stock option agreements have been made from 2005 to 2007. On January 20, 2006, the Corporation issued an aggregate of 30,000 stock appreciation rights (SARs) under the Corporations Stock Appreciation Rights Plan to eight employees, 15,500 of which have expired due to employee terminations.
The expense recorded for the three months ending September 30, 2009 was $3 for SARs and $12 for stock options. For the nine months ending September 30, 2008 there was expense of $3 recorded for SARs and $69 for stock options. The number of options or SARs and the exercise prices for these nonqualified incentive options or SARs outstanding as of September 30, 2009 follows:
A summary of the status of stock options at September 30, 2009, and changes during the nine months then ended, is presented in the table below:
Deposit balances at September 30, 2009 and December 31, 2008 are summarized as follows:
The aggregate amount of certificates of deposit in denominations of $100,000 or more amounted to $115,581 and $153,677 at September 30, 2009 and December 31, 2008, respectively. Brokered time deposits totaling $0 and $12,483 at September 30, 2009 and December 31, 2008, respectively, are included in these totals.
The maturity distribution of certificates of deposit as of September 30, 2009 follows:
(9) Short-Term Borrowings
The Corporation has a line of credit for advances and discounts with the Federal Reserve Bank of Cleveland. The amount of this line of credit varies on a monthly basis. The line is equal to 50% of the balances of qualified home equity lines of credit that are pledged as collateral. At September 30, 2009, the Bank had pledged approximately $3,906 in qualifying home equity lines of credit, resulting in an available line of credit of approximately $1,953. No amounts were outstanding at September 30, 2009 or December 31, 2008.
Short-term borrowings include securities sold under repurchase agreements and Federal funds purchased from correspondent banks. The table below presents information for short-term borrowings for the periods ended September 30, 2009 and December 31, 2008.
(10) Federal Home Loan Bank Advances
Federal Home Loan Bank advances amounted to $43,005 and $53,357 at September 30, 2009 and December 31, 2008 respectively. All advances are bullet maturities with no call features. At September 30, 2009, collateral pledged for FHLB advances consisted of qualified real estate mortgage loans, home equity lines of credit and investment securities of $89,584, $108,335 and $14,381, respectively. The maximum borrowing capacity of the Bank at September 30, 2009 was $59,009 with unused collateral borrowing capacity of $15,954. The Bank maintains a $40,000 cash management line of credit (CMA) with the FHLB.
The following table presents the activity on this line of credit for the periods ended September 30, 2009 and December 31, 2008.
(11) Trust Preferred Securities
On May 9, 2007, the Corporation completed two private offerings of trust preferred securities through two separate Delaware statutory trusts sponsored by the Corporation. LNB Trust I (Trust I) sold $10.0 million of preferred securities and LNB Trust II (Trust II) sold $10.0 million of preferred securities (Trust I and Trust II are hereafter collectively referred to as the Trusts). The proceeds from the offering were used to fund the cash portion of the Morgan Bancorp, Inc. acquisition. The Corporation owns all of the common securities of each of the Trusts. The subordinated notes mature in 2037. Trust I bears a floating interest rate (current three-month LIBOR plus 148 basis points). Trust II bears a fixed rate of 6.64% through June 15, 2017, and then becomes a floating interest rate (current three-month LIBOR plus 148 basis points). Interest on the notes is payable quarterly.
The subordinated notes are redeemable in whole or in part, without penalty, at the Corporations option on or after June 15, 2012 and mature on June 15, 2037. The notes are junior in right of payment to the prior payment in full of all senior indebtedness of the Corporation, whether outstanding at May 9, 2007, the date of the Indenture for the trusts, or thereafter incurred. At September 30, 2009, the balance of the subordinated notes payable to Trust I and Trust II was $10,310 each. The interest rates in effect as of the last determination date in 2009 were 1.78% and 6.64% for Trust I and Trust II, respectively.
(12) Commitments, Credit Risk, and Contingencies
In the normal course of business, the Bank enters into commitments that involve off-balance sheet risk to meet the financing needs of its customers. These instruments are currently limited to commitments to extend credit and standby letters of credit. Commitments to extend credit involve elements of credit risk and interest rate risk in excess of the amount recognized in the consolidated balance sheets. The Banks exposure to credit loss in the event of nonperformance by the other party to the commitment is represented by the contractual amount of the commitment. The Bank uses the same credit policies in making commitments as it does for on-balance sheet instruments. Interest rate risk on commitments to extend credit results from the possibility that interest rates may have moved unfavorably from the position of the Bank since the time the commitment was made.
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates of 30 to 120 days or other termination clauses and may require payment of a fee. Since some of the commitments may expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.
The Bank evaluates each customers credit worthiness on a case-by-case basis. The amount of collateral obtained by the Bank upon extension of credit is based on Managements credit evaluation of the applicant. Collateral held is generally single-family residential real estate and commercial real estate. Substantially all of the obligations to extend credit are variable rate. Standby letters of credit are conditional commitments issued to guarantee the performance of a customer to a third party. Standby letters of credit generally are contingent upon the failure of the customer to perform according to the terms of the underlying contract with the third party.
A summary of the contractual amount of commitments at September 30, 2009 follows:
(13) Estimated Fair Value of Financial Instruments
The Corporation discloses estimated fair values for its financial instruments. Fair value estimates, methods and assumptions are set forth below for the Corporations financial instruments.
The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value:
Estimates of fair value are made at a specific point in time, based on relevant market information and information about the financial instrument. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore, cannot be determined with precision. Changes in assumptions could significantly affect the estimates.
Estimates of fair value are based on existing on-and-off balance sheet financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. For example, the Bank has a substantial Investment and Trust Services Division that contributes net fee income annually. The Investment and Trust Services Division is not considered a financial instrument and its value has not been incorporated into the fair value estimates. Other significant assets and liabilities that are not considered financial instruments include property, plant and equipment, goodwill and deferred tax liabilities. In addition, it is not practicable for the Corporation to estimate the tax ramifications related to the
realization of the unrealized gains and losses and they have not been reflected in any of the estimates of fair value. The impact of these tax ramifications can have a significant effect on estimates of fair value. The estimated fair values of the Corporations financial instruments at September 30, 2009 and December 31, 2008 are summarized as follows:
The following table presents information about the Corporations assets and liabilities measured at fair value on a recurring basis as of September 30, 2009, and the valuation techniques used by the Corporation to determine those fair values.
In general, fair values determined by Level 1 inputs use quoted prices in active markets for identical assets or liabilities that the Corporation has the ability to access. Fair values determined by Level 2 inputs use other inputs that are observable, either directly or indirectly. These Level 2 inputs include quoted prices for similar assets and liabilities in active markets, and other inputs such as interest rates and yield curves that are observable at commonly quoted intervals. Level 3 inputs are unobservable inputs, including inputs that are available in situations where there is little, if any, market activity for the related asset or liability.
In instances where inputs used to measure fair value fall into different levels in the above fair value hierarchy, fair value measurements in their entirety are categorized based on the lowest level input that is significant to the valuation. The Corporations assessment of the significance of particular inputs to these fair value measurements requires judgment and considers factors specific to each asset or liability.
The following information pertains to assets measured by fair value on a recurring basis (in thousands):
Gains of $315 were included under security gains in earnings for the nine month period ended September 30, 2009 for assets held and measured at fair value as of September 30, 2009.
The Corporation has assets that, under certain conditions, are subject to measurement at fair value on a non-recurring basis. At September 30, 2009, such assets consist primarily of impaired loans. The Corporation has estimated the fair values of these assets using Level 3 inputs, specifically discounted cash flow projections. During the quarter ended September 30, 2009, the impairment charges recorded to the income statement for impaired loans were not significant.
Impaired loans valued using Level 3 inputs consist of non-homogeneous loans that are considered impaired. Impaired loans valued using Level 3 inputs totaled $33,040 at September 30, 2009. The Corporation estimates the
fair value of the loans based on the present value of expected future cash flows using managements best estimate of key assumptions. These assumptions include future payment ability, timing of payment streams, and estimated realizable values of available collateral (typically based on outside appraisals).
ITEM 2. Managements Discussion and Analysis of Financial Condition and Results of Operations.
The Corporation is a bank holding company headquartered in Lorain, Ohio, deriving substantially all of its revenue from the Bank. The Corporation provides a range of products and services to commercial customers and the community, and currently operates 20 banking centers throughout Lorain, eastern Erie, western Cuyahoga and Summit counties in Ohio.
This Managements Discussion and Analysis (MD&A) section discusses the financial condition and results of operations of the Corporation for the three and nine months ended September 30, 2009. This MD&A should be read in conjunction with the financial information contained in the Corporations Form 10-K for the fiscal year ended December 31, 2008 and in the accompanying consolidated financial statements and notes contained in this Form 10-Q.
This Form 10-Q contains forward-looking statements within the meaning of the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. Terms such as will, should, plan, intend, expect, continue, believe, anticipate and seek, as well as similar comments, are forward-looking in nature. Actual results and events may differ materially from those expressed or anticipated as a result of risks and uncertainties which include but are not limited to:
Critical Accounting Policies and Estimates
The Corporations consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America. The Corporation follows general practices within the banking industry and application of these principles requires Management to make assumptions, estimates and judgments that affect the financial statements and accompanying notes. These assumptions, estimates and judgments are based on information available as of the date of the financial statements.
The most significant accounting policies followed by the Corporation are presented in Note 1 to the Consolidated Financial Statements contained within this Form 10-Q. These policies are fundamental to the understanding of results of operation and financial conditions.
The accounting policies considered by Management to be critical are as follows:
Allowance for Loan Losses
The allowance for loan losses is an amount that Management believes will be adequate to absorb probable credit losses inherent in the loan portfolio taking into consideration such factors as past loss experience, changes in the nature and volume of the portfolio, overall portfolio quality, loan concentrations, specific problem loans, and current economic conditions that affect the borrowers ability to pay. Determination of the allowance is subjective in nature. Loan losses are charged off against the allowance when Management believes that the full collectability of the loan is unlikely. Recoveries of amounts previously charged-off are credited to the allowance.
A loan is considered impaired when it is probable that not all principal and interest amounts will be collected according to the terms of the loan contract. Residential mortgage, installment and other consumer loans are evaluated collectively for impairment. Individual commercial loans exceeding size thresholds established by Management are evaluated for impairment. Impaired loans are written down by the establishment of a specific allowance where necessary. The fair value of all loans currently evaluated for impairment is collateral-dependent and therefore the fair value is determined by the fair value of the underlying collateral.
The Corporation maintains the allowance for loan losses at a level adequate to absorb Managements estimate of probable credit losses inherent in the loan portfolio. The allowance is comprised of a general allowance, a specific allowance for identified problem loans and an unallocated allowance.
The general allowance is determined by applying estimated loss factors to the credit exposures from outstanding loans. For commercial and commercial real estate loans, loss factors are applied based on internal risk grades of these loans. Many factors are considered when these grades are assigned to individual loans such as current and past delinquency, financial statements of the borrower, current net realizable value of collateral and the general economic environment and specific economic trends affecting the portfolio. For residential real estate, installment and other loans, loss factors are applied on a portfolio basis. Loss factors are based on the Corporations historical loss experience and are reviewed for appropriateness on a quarterly basis, along with other factors affecting the collectability of the loan portfolio.
Specific allowances are established for all classified loans when Management has determined that, due to identified significant conditions, it is probable that a loss has been incurred that exceeds the general allowance loss factor from these loans. The unallocated allowance recognizes the estimation risk associated with the allocated general and specific allowances and incorporates Managements evaluation of existing conditions that are not included in the allocated allowance determinations. These conditions are reviewed quarterly by Management and include general economic conditions, credit quality trends and internal loan review and regulatory examination findings.
Management believes that it uses the best information available to determine the adequacy of the allowance for loan losses. However, future adjustments to the allowance may be necessary and the results of operations could be significantly and adversely affected if circumstances differ substantially from the assumptions used in making the determinations.
The Corporation computes income tax expense (benefit) by applying the current statutory tax rates to net taxable income (loss) after consideration of permanent differences. Deferred tax assets and liabilities are recognized for the temporary differences between the tax basis and book basis of an asset or liability and will result in taxable or deductible amounts in future periods. Deferred tax assets are recorded only to the extent that the amount of net deductible temporary differences or carry forward attributes may be offset against taxable temporary differences reversing in future periods or utilized to the extent of managements estimate of future taxable income. A valuation allowance is provided for deferred tax assets to the extent that the value of net deductible temporary differences and carry forward attributes exceeds managements estimates of taxes payable on future taxable income.
New Accounting Pronouncements
Management is not aware of any proposed regulations or current recommendations by the Financial Accounting Standards Board or by regulatory authorities, which, if they were implemented, would have a material effect on the liquidity, capital resources, or operations of the Corporation.
Summary of Earnings (Dollars in thousands except per share data)
Net loss for the third quarter of 2009 was $4,376, and $2,543 for the nine months ended September 30, 2009. Net loss available to common shareholders for the third quarter of 2009 was $4,695, or $0.64 per diluted common share. Net loss available to common shareholders for the nine months ended September 30, 2009 was $3,480, or $0.48 per diluted common share. This compares to net income of $1,823, or $.25 per diluted share, for the third quarter of 2008 and net income of $2,135, or $.29 per diluted share, for the nine months ended September 30, 2008.
Third quarter earnings were significantly impacted by higher credit cost as the Corporation provided $11,067 for possible loan losses. The higher provision is a result of an increase in problem loans, including non-accrual and classified loans, and the decline in collateral values associated with these loans during the third quarter. The provision for the third quarter on a per share basis equaled $1.52 compared to $.06 for the same period one year ago. Net charge-offs for the quarter were $1,489 led largely by consumer loans given the weakness of the local economy. For the nine month period, the provision for loan losses equaled $15,360 or $2.11 per share in 2009 compared to $5,609 or $.77 per share in 2008. By comparison, the provision expense for the year ended December 31, 2007 was $2,225 or $.32 per share.
Net interest income on the fully tax-equivalent basis (FTE) for the quarter ended September 30, 2009 was $9,714 compared to $8,342 for the same period one year ago. The net interest margin improved from 3.28% in the third quarter of 2008 to 3.30% in 2009 as the cost of interest bearing liabilities fell from 2.70% in 2008 to 1.92% in 2009, a decline of 78 basis points and the yield on earning assets dropped from 5.71% in 2008 to 4.97% in 2009, or 74 basis points. Total loans averaged $818,877 for the third quarter of 2009 compared to $790,746 in 2008. Installment loans and home equity lines of credit continue to account for a significant portion of the growth, installments increased $12,358 and home equities $14,742, commercial loans for the same period increased $16,232. Mortgage loans decreased by $15,201 as the Corporation continues to sell new loan production to Freddie Mac rather than adding the loans to the loan portfolio. During the third quarter, $7,363 of mortgage loans were sold. Over the past year the Corporation has seen a strong continued growth in deposits, primarily time deposits, in both consumer and public funds, reducing its reliance on non-core funding alternatives.
Noninterest income ended the quarter at $3,124 compared to $3,158 for the third quarter of 2008. Fee income, which excludes the gain on the sale of assets, was up 4.3% year over year. Trust and brokerage fees improved in the third quarter, ending the quarter at $496 compared to $441 in the third quarter of 2008. Service charges on deposit accounts remain flat period over period as customers remain conservative in managing their accounts. Gain on the sale of loans was up $43 or 14.4% for the quarter and $321 or 50.0% for the nine month periods, primarily due to higher mortgage loan originations given the low interest rate environment and the increase in refinancing activity.
Total noninterest expense for the third quarter of 2009 was $8,737 compared to $8,498 for 2008. For the first nine months of 2008 and for the first nine months of 2009, total noninterest expense was $26,577 compared to $25,860 for the same period in 2008. FDIC assessments represent a significant increase year over year. Excluding the FDIC expense, both the quarter and year-to-date periods saw lower non-interest expenses compared to 2008. Salary and employee benefits were down 5.7% or $218 for the third quarter compared to 2008 and 2.9% or $337 year-to-date. The Corporation continues to be extremely diligent in addressing the noninterest expenses within its control. The
Corporations efficiency ratio for the third quarter of 2009 was 68.06% compared to 73.90% for the same period of 2008 and for the first nine months of 2009, was 71.38% compared to 76.40% for the first half of 2008.
Results of Operations
Net Interest Income
Net interest income is the difference between interest income earned on interest-earning assets and the interest expense paid on interest-bearing liabilities. Net interest income is the Corporations principal source of revenue, accounting for 75.41% of the Corporations revenues for the three months ended September 30, 2009. The amount of net interest income is affected by changes in the volume and mix of earning assets and interest-bearing liabilities, the level of rates earned or paid on those assets and liabilities and the amount of loan fees earned. The Corporation reviews net interest income on a fully taxable equivalent basis, which presents interest income with an adjustment for tax-exempt interest income on an equivalent pre-tax basis assuming a 34% statutory Federal tax rate. These rates may differ from the Corporations actual effective tax rate. The net interest margin is net interest income as a percentage of average earning assets.
Three Months Ended September 30, 2009 versus Three Months Ended September 30, 2008
Net interest income, before provision for loan losses, was $9,578 for the third quarter 2009 as compared to $8,229 during the same quarter 2008. Adjusting for tax-exempt income, net interest income, before provision for loan losses, for the third quarter 2009 and 2008 was $9,714 and $8,342, respectively. The net interest margin FTE, determined by dividing tax equivalent net interest income by average earning assets, was 3.30% for the three months ended September 30, 2009 compared to 3.28% for the three months ended September 30, 2008.
Average earning assets for the third quarter of 2009 were $1,169,229. This was an increase of $158,841 or 15.72% over the same quarter last year. The yield on average earning assets was 4.97% in the third quarter of 2009 as compared to 5.71% for the same period last year. The yield on average loans during the third quarter of 2009 was 5.60%. This was 44 basis points lower than that of the third quarter of 2008 at 6.04%. Interest income from securities was $3,083 (FTE) for the three months ended September 30, 2009, as compared to $2,447 during the third quarter of 2008. The yield on average securities was 4.21% and 4.80% for these periods, respectively. The cost of interest-bearing liabilities was 1.92% during the third quarter of 2009 as compared to 2.70% during the same period in 2008. The average cost of trust preferred securities was 4.31% for the third quarter of 2009, compared to 5.40% for the third quarter of 2008. One half of the securities were issued at a fixed rate of 6.64% and the other at LIBOR plus 1.48%.
Nine Months Ended September 30, 2009 versus Nine Months Ended September 30, 2008
Net interest income, before provision for loan losses, for the first nine months of 2009 was $27,610 as compared to $23,888 for the same period in 2008. Adjusting for tax-exempt income, net interest income, before provision for loan losses, for the first nine months of 2009 and 2008 was $28,006 and $24,202, respectively. The net interest margin FTE was 3.30% for the nine months ended September 30, 2009 compared to 3.24% for the nine months ended September 30, 2008.
Interest income FTE produced by earning assets during the first nine months of 2009 was $43,798. This compares to interest income from earning assets of $44,256 during the first nine months of 2008. Average earning assets increased $138,002, or 13.85%, to $1,134,258 for the first nine months of 2009 as compared to $996,256 for the first nine months of 2008. The yield on average earning assets was 5.16% for the first nine months of 2009 as compared to 5.93% for the same period last year, or a decrease of 77 basis points.
Interest income FTE from loans was $34,657 for the first nine months of 2009, and $36,583 for the first nine months of 2008. The yield on loans for the first nine months of 2009 and 2008 was 5.69% and 6.32%, respectively. Average loans increased $39,033, or 5.05%, over the same period of 2008. Average installment loans (primarily indirect auto loans) increased $17,497 and average commercial loans increased $13,310 when comparing the first nine months of 2009 to the first nine months of 2008.
Interest expense was $15,792 for the first nine months of 2009 compared to $20,054 for the first nine months of 2008. Average interest-bearing liabilities increased $98,721, or 11.06%, to $991,361 for the first nine months of 2009 as compared to $892,640 for the first nine months of 2008. Interest expense from deposits for the first nine months of the year was $13,829 in 2009 and $17,041 in 2008. Average interest-bearing deposits for the first nine months of 2009 increased $116,638 over the same period in 2008. The cost of deposits for the first nine months of 2009 decreased 87 basis points in comparison to the first nine months of 2008. During the nine month period ending
September 30, 2009, average brokered time deposits decreased $4,162 while average consumer time deposits increased $99,910 in comparison to the same period in 2008.
Table 1 displays the components of net interest income for the three and nine months ended September 30, 2009 and 2008. Rates are computed on a tax equivalent basis and nonaccrual loans are included in the average loan balances.
Table 1: Condensed Consolidated Average Balance Sheets
Interest, Rate, and Rate/ Volume differentials are stated on a Fully-Tax Equivalent (FTE) Basis.
Net interest income may also be analyzed by comparing the volume and rate components of interest income and interest expense. Table 2 is an analysis of the changes in interest income and expense between the quarters ended September 30, 2009 and September 30, 2008. The table is presented on a fully tax-equivalent basis.
Table 2: Rate/Volume Analysis of Net Interest Income (FTE)
Net interest income (FTE) for the third quarter 2009 and 2008 was $9,714 and $8,342, respectively. Interest income (FTE) for the third quarter of 2009 increased $161 in comparison to the same period in 2008. This increase is attributable to $1,150 decrease due to rate, offset by an increase of $1,311 due to volume. For the same period, interest expense decreased $1,211, with the decrease being attributable to a $1,850 decrease due to rate, offset by an increase due to volume of $639. Overall, while balance sheet growth contributed $672 to net interest income (FTE), the impact of rate, the difference between interest income and interest expense of $700, had a more significant contribution to the overall net interest income (FTE) increase of $1,372.
Net interest income (FTE) for the nine month period ended September 30, 2009 and 2008 was $28,006 and $24,202, respectively. Interest income (FTE) decreased $458 during the first nine months of 2009, with $4,093 of the decrease due to rate offset by an increase of $3,635 due to volume. For the same period, interest expense decreased $4,262, with an increase of $2,187 due to volume, offset by a decrease of $6,449 due to rate. Overall, net interest income (FTE) increased $3,804 driven largely by changes in rate of $2,356 and $1,448 due to volume.
Table 3: Details on Noninterest Income
Three Months Ended September 30, 2009 as compared to the Three Months Ended September 30, 2008
Noninterest income for the three months ended September 30, 2009 was $3,124, a decrease of $34, or 1.08%, over the same period 2008. Deposit service charges and fees from electronic banking increased $15, or 0.76%, as compared to the same period last year. This increase was primarily the result of a fee charged to business accounts during the third quarter of 2009 that was implemented to recapture a portion of the Corporations FDIC assessments. Total net gains recorded during the third quarter of 2009 decreased $147 over the third quarter of 2008. Of this decrease, $135 was attributable to the sale of securities. Sales of bank owned property resulted in a loss of $35 during the third quarter of 2009.
Nine Months Ended September 30, 2009 as compared to the Nine Months Ended September 30, 2008
Noninterest income for the nine months ended September 30, 2009 was $9,225 or a decrease of $421, or 4.36%, from the same period 2008. The prior period included two non-recurring items, $460 received in a partial redemption of stock issued by VISA and $216 received from the redemption of a bank owned life insurance policy. Excluding these non-recurring items, noninterest income increased 2.84% compared to the same period of 2008. Trust fees and service charges have been adversely affected by the current economic conditions. Trust fees decreased $155, or 9.93%, over the same period of last year and deposit service charges and fees from electronic banking decreased $149, or 2.66%, over the comparable period of last year.
The gain of $674 on securities during the first nine months of 2009 was a combination of a gain on sale of available-for-sale securities of $359 and an unrealized gain on trading securities of $315. The Corporation continues to assess its available-for-sale securities which are due to be called or to mature in the near term for potential sale to be replaced with purchases of mortgage-backed securities and some agency securities in order to implement a strategy to balance interest rate risk and profitability. Given the interest rate environment, the interest rates available on mortgage-backed securities have made these securities more attractive to holders than agency securities.
Table 4: Details on Noninterest Expense
Three Months Ended September 30, 2009 as compared to the Three Months Ended September 30, 2008
Noninterest expense increased $239, or 2.81%, for the third quarter of 2009 over the same period 2008. Contributing to the increase were higher costs for outside services, mainly attorney fees. FDIC assessments increased $566 compared to the same period of 2008 as a result of an increase in the assessment rate that took effect during the second quarter of 2009.
Nine Months Ended September 30, 2009 as compared to the Nine Months Ended September 30, 2008
Noninterest expense was $26,577 for the nine months ended September 30, 2009. This is an increase of $717 or 2.77%, as compared to $25,860 recorded for the nine months ended September 30, 2008. In addition to the special assessment imposed by the FDIC during the second quarter of $580, FDIC assessments increased $1,215 compared
to the same period of 2008. Offsetting this increase was a decline in other real estate owned expense of $629. During the second quarter of 2008, certain properties were revalued as a result of the decline in real estate market values. The valuation adjustments that were required were expensed directly to the income statement. The first nine months of 2009 included $199 of expense related to litigation involving a shareholder of the Corporation, the same shareholder that had also requested a special meeting in 2008. Included in noninterest expense during the first nine months of 2008 was $572 related to this special shareholder meeting. This affected outside services, marketing and public relations, and postage expenses.
The Corporation recognized a tax benefit of $2,726 during the third quarter of 2009 and income tax expense of $595 for the same period of 2008. Included in net income for the three months ended September 30, 2009 was $479 of nontaxable income, including $184 related to life insurance policies and $295 of tax-exempt investment and loan interest income.
An income tax benefit of $2,559 was recognized for the nine month period ended September 30, 2009 compared to a tax benefit of $70 for the nine month period ended September 30, 2008. Included in net income for the nine months ended September 30, 2009 was $1,312 of nontaxable income, including $453 related to life insurance policies and $859 of tax-exempt investment and loan interest income. After considering the tax-exempt income and relatively small nondeductible expenses, income subject to tax is significantly less than income before income tax expense.
The new market tax credit generated by North Coast Community Development Corporation, a wholly-owned subsidiary of the Bank, also had a significant impact on income tax expense and contributes to a lower effective tax rate for the Corporation.
Balance Sheet Analysis
The Corporations assets at September 30, 2009 were $1,181,179 as compared to $1,136,135 at December 31, 2008. This is an increase of $45,044, or 3.96%.
The composition of the Corporations securities portfolio at September 30, 2009 and December 31, 2008 is presented in Note 5 to the Consolidated Financial Statements contained within this Form 10-Q. The Corporation continues to employ the securities portfolio to manage interest rate risk and to manage its liquidity needs. Currently, the portfolio is comprised of 3.09% trading securities, 95.17% available for sale securities and 1.74% restricted stock. Available for sale securities are comprised of 20.18% U.S. Government agencies, 70.05% U.S. agency mortgage backed securities, and 9.77% municipal securities. At September 30, 2009 the available for sale securities had a net temporary unrealized gain of $8,202, representing 3.00% of the total amortized cost of the Banks available for sale securities. Trading securities held at fair value on September 30, 2009 were $8,865, and did not have any unrealized losses recorded against income.
The detail of loan balances are presented in Note 6 to the Consolidated Financial Statements contained within this Form 10-Q. Table 5 provides further detail by loan purpose.
Table 5: Details on Loan Balances
Total loans at September 30, 2009 were $813,600. This is an increase of $10,049 from December 31, 2008. At September 30, 2009, commercial loans represented 55.95% of total portfolio loans. Consumer loans, consisting of installment loans and home equity loans, comprised 33.95% of total portfolio loans. Consumer loans are made to borrowers on both secured and unsecured terms dependent on the maturity and nature of the loan. Real estate mortgages comprise 10.10% of total portfolio loans.
Loans held for sale, and not included in portfolio loans, were $1,707 at September 30, 2009. Mortgage loans held for sale represented 21.56% and installment loans represented 78.44% of loans held for sale. There were no commercial loans held for sale at September 30, 2009. Loans held for sale at December 31, 2008 were $3,580 and consisted of 1.59% mortgage loans and 98.41% installment loans. The Corporation retains the servicing rights on these loans.
Table 6: Deposits and Borrowings
Average deposits for the nine months ended September 30, 2009 were $988,443 compared to average deposits of $879,301 for the year ended December 31, 2008. Average consumer time deposits increased $86,498 over the nine month period between December 31, 2008 and September 30, 2009 despite aggressive reaction to rate cuts during the first quarter of 2009. Average brokered time deposits decreased during this same period as the Corporation has been less reliant on brokered time deposits over the last several months. Deposit accounts and the generation of deposit accounts continue to be the primary source of funds within our market area. The Corporation offers various deposit products to both retail and business customers. The Corporation also utilizes its business sweep accounts to generate funds as well as the brokered CD market to provide funding comparable to other national market borrowings, which include the Federal Home Loan Bank of Cincinnati and the Federal Reserve Bank of Cleveland.
Substantially all of the Banks deposits are insured up to applicable limits by the FDIC. Accordingly, the Bank is subject to deposit insurance premium assessments by the FDIC. Under current law, the FDIC is required to maintain the Deposit Insurance Fund (DIF) reserve ratio within the range of 1.15% to 1.50% of estimated insured deposits. Current law also requires the FDIC to implement a restoration plan when it determines that the DIF reserve ratio has fallen, or will fall within six months, below 1.15% of estimated insured deposits. On May 22, 2009 the FDIC imposed a 5 basis point special assessment on each insured depository institutions assets minus its Tier 1 capital as reported in the report of condition of June 30, 2009 and collected on September 30, 2009.
On September 29, 2009, the FDIC adopted a Notice of Proposed Rulemaking (NPR), which would require insured depository institutions to prepay their quarterly risk-based assessments for the fourth quarter of 2009, and for all of 2010, 2011, and 2012, on December 30, 2009, along with each institutions risk-based deposit insurance assessment for the third quarter of 2009. The FDIC will not refund or collect any additional prepaid assessments based upon changes in an institutions actual assessment rate or the actual decrease in or growth of deposits during these three years. However, any prepaid assessment that is not exhausted by December 30, 2014, would be returned to the institution at that time.
The Corporation utilizes both short-term and long-term borrowings to assist in the growth of earning assets. For the Corporation, short-term borrowings include federal funds purchased and repurchase agreements. As of September 30, 2009, the Corporation had $31,422 of short-term borrowings. There were no federal funds purchased at September 30, 2009, and repurchase agreements increased $8,494 over December 31, 2008. Long-term borrowings for the Corporation consist of Federal Home Loan Bank advances of $43,005 and junior subordinated debentures of $20,620. Federal Home Loan Bank advances were $53,357 at December 31, 2008. Maturities of long-term Federal Home Loan Bank advances are presented in Note 9 to the Consolidated Financial Statements contained within this Form 10-Q. During the second quarter of 2007, the Corporation completed a private offering of trust preferred securities, as described in Note 11 to the Consolidated Financial Statements contained within this Form 10-Q. The securities were issued in two $10 million tranches, one of which pays dividends at a fixed rate of 6.64% per annum and the other of which pays dividends at LIBOR plus 1.48% per annum.
The Corporation continues to maintain an appropriate capital position. Total shareholders equity was $104,998 at September 30, 2009. This is a decrease of 1.92% over December 31, 2008. Net loss decreased total shareholders equity by $2,543 for the nine months ended September 30, 2009. Factors increasing shareholders equity were a $2,807 increase in accumulated other comprehensive gain resulting from an increase in the fair value of available for sale securities, and a $69 increase for share-based payment arrangements, net of tax. Cash dividends payable to common shareholders in the amount of $1,386 and preferred shareholders in the amount of $1,020 decreased total shareholders equity in the first nine months of 2009.
The Corporation held 328,194 shares of common stock as treasury stock at September 30, 2009, at a cost of $6,092. The Corporation and the Bank continue to monitor growth of the balance sheet to stay within the guidelines established by applicable regulatory authorities. At September 30, 2009 and December 31, 2008, the Corporation and Bank maintained capital ratios consistent with current guidelines to be deemed well-capitalized under Federal banking regulations.
On July 28, 2005, the Corporation announced a share repurchase program of up to 5 percent, or about 332,000, of its common shares outstanding. Repurchased shares can be used for a number of corporate purposes, including the Corporations stock option and employee benefit plans. The share repurchase program provides that share repurchases are to be made primarily on the open market from time-to-time until the 5 percent maximum is repurchased or the earlier termination of the repurchase program by the Board of Directors, at the discretion of management based upon market, business, legal and other factors. However, the terms of the Corporations sale of $25.2 million of its series B preferred stock to the U.S. Treasury in December 2008 in conjunction with the TARP Capital Purchase Program include limitations on the Corporations ability to repurchase its common shares. For three years after the issuance or until the U.S. Treasury no longer holds any series B preferred stock, the Corporation will not be able to repurchase any of its common shares or preferred stock without, among other things, U.S. Treasury approval or the availability of certain limited exceptions, e.g., purchases in connection with the Corporations benefit plans. Furthermore, as long as the series B preferred stock issued to the U.S. Treasury is outstanding, repurchases or redemptions relating to certain equity securities, including the Corporations common shares, are prohibited until all accrued and unpaid dividends are paid on such preferred stock, subject to certain
limited exceptions. As of September 30, 2009, the Corporation had repurchased an aggregate of 202,500 shares under this program.
The Corporation elected on July 14, 2009 to terminate its status as a financial holding company. The Corporation will remain a bank holding company within the meaning of the Bank Holding Company Act of 1956, as amended. The Corporations Management does not believe that this election will have an adverse effect on the Corporations current operations as the Corporation does not currently engage in any activities that would require the Corporation to be registered as a financial holding company.
ITEM 3. Quantitative and Qualitative Disclosures About Market Risk.
Risk management is an essential aspect in operating a financial services company successfully and effectively. The most prominent risk exposures, for a financial services company, are credit, operational, interest rate, market, and liquidity risk. Credit risk involves the risk of uncollectible interest and principal balance on a loan when it is due. Fraud, legal and compliance issues, processing errors, technology and the related disaster recovery, and breaches in business continuation and internal controls are types of operational risks. Changes in interest rates affecting net interest income are considered interest rate risks. Market risk is the risk that a financial institutions earnings and capital or its ability to meet its business objectives are adversely affected by movements in market rates or prices. Such movements include fluctuations in interest rates, foreign exchange rates, equity prices that affect the changes in value of available-for-sale securities, credit spreads, and commodity prices. The inability to fund obligations due to investors, borrowers, or depositors is liquidity risk. For the Corporation, the dominant risks are market risk and credit risk.
Credit Risk Management
Uniform underwriting criteria, ongoing risk monitoring and review processes, and well-defined, centralized credit policies dictate the management of credit risk for the Corporation. As such, credit risk is managed through the Banks allowance for loan loss policy which requires the loan officer, lending officers, and the loan review committee to manage loan quality. The Corporations credit policies are reviewed and modified on an ongoing basis in order to remain suitable for the management of credit risks within the loan portfolio as conditions change. The Corporation uses a loan rating system to properly classify and assess the credit quality of individual commercial loan transactions. The loan rating system is used to determine the adequacy of the allowance for loan losses for regulatory reporting purposes and to assist in the determination of the frequency of review for credit exposures.
Nonperforming Assets, Delinquency and Potential Problem Loans
Total nonperforming assets consist of nonperforming loans, loans which have been restructured, and other foreclosed assets. As such, a loan is considered nonperforming if it is 90 days past due and/or in Managements estimation the collection of interest on the loan is doubtful. Nonperforming loans no longer accrue interest and are accounted for on a cash basis. The classification of restructured loans involves the deterioration of a borrowers financial ability leading to original terms being favorably modified or either principal or interest being forgiven. Nonperforming loans at September 30, 2009 were $42,018 as compared to $19,592 at December 31, 2008, an increase of $22,426. Of this total, commercial loans were $31,705 as compared to $14,209 at December 31, 2008. These commercial loans are primarily secured by real estate and, in some cases, by SBA guarantees, and have either been charged-down to their realizable value or a specific reserve has been established for any collateral short-fall. At September 30, 2009, construction and land development represented $6,944 of the total commercial loan nonperforming, with the remaining being commercial and industrial. All nonperforming loans are being actively managed.
Management also monitors delinquency and potential commercial problem loans. Bank-wide delinquency at September 30, 2009 was 5.99% of total loans as compared to 3.76% at December 31, 2008. Total 30-90 day delinquency was 0.82% of total loans at September 30, 2009 and 1.34% at December 31, 2008.
Other foreclosed assets were $1,071 as of September 30, 2009 compared to $1,108 at December 31, 2008. The $1,071 is comprised of $342 in 1-4 family residential properties and $729 in non-farm non-residential properties. This compares to $837 in 1-4 family residential properties with the remainder in non-farm non-residential properties as of December 31, 2008.
Table 7 sets forth nonperforming assets at September 30, 2009 and December 31, 2008.
Table 7: Nonperforming Assets
Provision and Allowance for Loan Losses
The allowance for loan losses is maintained by the Corporation at a level considered by Management to be adequate and appropriate to cover probable credit losses inherent in the Corporations loan portfolio. The amount of the provision for loan losses charged to operating expenses is the amount necessary, in the estimation of Management, to maintain the allowance for loan losses at an adequate level. Management determines the adequacy of the allowance based upon past experience, changes in portfolio size and mix, trends in delinquency, relative quality of the loan portfolio and the rate of loan growth, assessments of current and future economic conditions, and information about specific borrower situations, including their financial position and collateral values, and other factors, which are subject to change over time. While Managements periodic analysis of the allowance for loan losses may dictate portions of the allowance be allocated to specific problem loans, the entire amount is available for any loan charge-offs that may occur. Table 8 presents the detailed activity in the allowance for loan losses and related charge-off activity for the three and nine month periods ended September 30, 2009 and 2008.
Table 8: Analysis of Allowance for Loan Losses
The provision for loan losses for the quarter ended September 30, 2009 was $11,067 and for the nine month period ended September 30, 2009 was $15,360. The provision for the third quarter reflects a higher level of non-accrual loans which increased $8,885 during the quarter. Criticized loans also increased during the quarter, by $4,908. In addition, the collateral value of the properties securing these loans continued to decline and specific reserves were increased on a number of these loans as a result of new valuations received during the quarter.
The allowance for loan losses at September 30, 2009 was $22,556, or 2.77%, of outstanding loans, compared to $11,355, or 1.43%, of outstanding loans at September 30, 2008 and $11,652 or 1.45%, of outstanding loans at December 31, 2008. The allowance for loan losses was 53.68% and 65.09% of nonperforming loans at September 30, 2009 and September 30, 2008, respectively.
Net charge-offs for the three months ended September 30, 2009 were $1,489, as compared to $990 for the three months ended September 30, 2008. Net charge-offs for the nine months ended September 30, 2009 were $4,456, as compared to $2,074 for the nine months ended September 30, 2008. Annualized net charge-offs as a percent of average loans for the third quarter and first nine months of 2009 were 0.72% and 0.73% respectively, as compared to 0.50% and 0.36% respectively, for the same periods in 2008. The provision charged to expense was $11,067 for the three months ended September 30, 2009 and $471 for the same period 2008. The provision for loan losses for the three month and nine month periods ended September 30, 2009 was, in the opinion of Management, adequate when balancing the charge-off levels with the level of nonperforming loans, the level of potential problem loans and delinquency. The resulting allowance for loan losses is, in the opinion of Management, sufficient given its analysis of the information available about the portfolio at September 30, 2009. The Corporation continues to aggressively address potential problem loans, and underwriting standards continue to be adjusted in response to trends and asset review findings.
Market Risk Management
The Corporation manages market risk through its Asset/Liability Management Committee (ALCO) at the Bank level governed by policies set forth and established by the Board of Directors. This committee assesses interest rate risk exposure through two primary measures: rate sensitive assets divided by rate sensitive liabilities and earnings-at-risk simulation of net interest income over the one year planning cycle and the longer term strategic horizon in order to provide a stable and steadily increasing flow of net interest income.
The difference between a financial institutions interest rate sensitive assets and interest rate sensitive liabilities is referred to as the interest rate gap. An institution that has more interest rate sensitive assets than interest rate sensitive liabilities in a given period is said to be asset sensitive or has a positive gap. This means that if interest rates rise, a corporations net interest income may rise and if interest rates fall, its net interest income may decline. If interest sensitive liabilities exceed interest sensitive assets then the opposite impact on net interest income may occur. The usefulness of the gap measure is limited. It is important to know the gross dollars of assets and liabilities that may re-price in various time horizons, but without knowing the frequency and basis of the potential rate changes the predictive power of the gap measure is limited.
Two more useful tools in managing market risk are earnings-at-risk simulation and economic value of equity simulation. An earnings-at-risk analysis is a modeling approach that combines the repricing information from gap analysis, with forecasts of balance sheet growth and changes in future interest rates. The result of this simulation provides Management with a range of possible net interest margin outcomes. Trends that are identified in earnings-at-risk simulation can help identify product and pricing decisions that can be made currently to assure stable net interest income performance in the future. At September 30, 2009, a shock treatment of the balance sheet, in which a parallel shift in the yield curve occurs and all rates increase immediately, indicates that in a +200 basis point shock, net interest income would decrease $859 or 3.11%, and in a -200 basis point shock, net interest income would increase $953, or 3.45%. The reason for the lack of symmetry in these results is the implied floors in many of the Corporations core funding which limits their downward adjustment from current offering rates. This analysis is done to describe a best or worst case scenario. Factors such as non-parallel yield curve shifts, Management pricing changes, customer preferences and other factors are likely to produce different results.
The economic value of equity approach measures the change in the value of the Corporations equity as the value of assets and liabilities on the balance sheet change with interest rates. September 30, 2009, this analysis indicated that a +200 basis point change in rates would reduce the value of the Corporations equity by 10.31% while a -200 basis point change in rates would increase the value of the Corporations equity by 14.17%.
Liquidity Risk Management
Liquidity risk is the possibility of the Corporation being unable to meet current and future financial obligations in a timely manner. Liquidity is managed to ensure stable, reliable and cost-effective sources of funds to satisfy demand for credit, deposit withdrawals and investment opportunities. The Corporation relies on a large, stable core deposit base and a diversified base of wholesale funding sources to manage liquidity risk.
The Corporations primary source of liquidity is its core deposit base, raised though its retail branch system, along with unencumbered, or unpledged, investment securities. The Corporation also has available unused wholesale sources of liquidity, including advances from the Federal Home Loan Bank of Cincinnati, borrowings through the discount window at the Federal Reserve Bank of Cleveland and access to certificates of deposit issued through brokers. Liquidity is also provided by unencumbered, or unpledged, investment securities that totaled $48,626 at September 30, 2009.
ITEM 4. Controls and Procedures
The Corporations Management carried out an evaluation, under the supervision and with the participation of the Chief Executive Officer and the Chief Financial Officer, of the effectiveness of the design and operation of the Corporations disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) promulgated under the Securities Exchange Act of 1934) as of June 30, 2009, pursuant to the evaluation of these controls and procedures required by Rule 13a-15 of the Securities Exchange Act of 1934.
Based upon that evaluation, the Chief Executive Officer along with the Chief Financial Officer concluded that the Corporations disclosure controls and procedures as of September 30, 2009 were: (1) designed to ensure that material information relating to the Corporation and its subsidiaries is made known to the Chief Executive Officer and Chief Financial Officer by others within the entities, and (2) effective, in that they provide reasonable assurance that information required to be disclosed by the Corporation in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SECs rules and forms. No change in the Corporations internal control over financial reporting (as defined by 13a-15(f) and 15(d)-15(f) under the Exchange Act) occurred during the fiscal quarter ended September 30, 2009 that has materially affected, or is reasonably likely to materially affect, the Corporations internal control over financial reporting.
PART II OTHER INFORMATION
Item 1. Legal Proceedings
On April 18, 2008, the Corporation and Richard M. Osborne and certain other parties entered into a settlement agreement (the Settlement Agreement) to settle certain contested matters relating to the Corporations 2008 annual meeting of shareholders. Under the Settlement Agreement, among other things, Mr. Osborne agreed not to seek representation on the Corporations Board of Directors or to solicit proxies with respect to the voting of the Corporations common shares for a period of at least 18 months after April 18, 2008. In proxy materials filed with the Securities and Exchange Commission on March 20, 2009, Mr. Osborne indicated his intent to solicit proxies in favor of the election of two nominees for election as directors at the Annual Meeting. On March 24, 2009, the Corporation filed a complaint against Mr. Osborne for declaratory judgment and preliminary and permanent injunctive relief in the United States District Court for the Northern District of Ohio, Eastern Division, to restrain Mr. Osborne from (a) engaging in any solicitation of proxies or consents, (b) seeking to advise, encourage or influence any person or entity with respect to the voting of any voting securities of the Corporation, (c) initiating, proposing or otherwise soliciting shareholders of the Corporation for the approval of shareholder proposals, (d) entering into any discussions, negotiations, agreements, arrangements or understanding with any third party with respect to any of the foregoing and (e) disseminating his proposed proxy materials to shareholders of the Corporation. The Corporation also sought an order from the Court temporarily restraining Mr. Osborne from engaging in any of the foregoing activities. On March 28, 2009, the Court issued an order granting the Corporations motion for a temporary restraining order. On April 3, 2009, the Court issued an order granting the Corporations motion for a preliminary injunction restraining Mr. Osborne from engaging in any of the foregoing activities. On June 11, 2009, the Court held a case management conference. The Court set a discovery cut-off for December 11, 2009 and trial for March 1, 2010. The Corporation has served written discovery on Mr. Osborne.
In addition to the other information set forth in this report, you should carefully consider the risk factors disclosed in Item 1A of the Corporations Annual Report on Form 10-K for the fiscal year ended December 31, 2008.
The Corporations ability to pay dividends is subject to limitations.
Holders of the Corporations common shares are only entitled to receive such dividends as the Board of Directors may declare out of funds legally available for such payments. Furthermore, the Corporations common shareholders are subject to the prior dividend rights of holders of its preferred stock.
In September 2009, the Corporation reduced its quarterly dividend on its common shares to $0.01 per share and does not expect to increase the quarterly dividend above $0.01 for the foreseeable future. The Corporation could determine to eliminate its common shares dividend altogether. Furthermore, as long as the Series B Preferred Stock is outstanding, dividend payments and repurchases or redemptions relating to certain equity securities, including the Corporations common shares, are prohibited until all accrued and unpaid dividends are paid on such preferred stock, subject to certain limited exceptions. This could adversely affect the market price of the Corporations common shares. Also, the Corporation is a bank holding company and its ability to declare and pay dividends is dependent on certain federal regulatory considerations, including the guidelines of the Federal Reserve regarding capital adequacy and dividends.
In addition, terms of the Corporations outstanding trust preferred securities prohibit it from declaring or paying any dividends or distributions on its capital stock, including its common shares, if an event of default has occurred and is continuing under the applicable indenture or if the Corporation has given notice of its election to defer interest payments but the related deferral period has not yet commenced or a deferral period is continuing.
Additional capital may not be available to the Corporation if and when it is needed.
The Corporation and the Bank are subject to capital-based regulatory requirements. The ability of the Corporation and the Bank to meet capital requirements is dependent upon a number of factors, including results of operations, level of nonperforming assets, interest rate risk, future economic conditions, future changes in regulatory and accounting policies and capital requirements, and the ability to raise additional capital if and when it is needed. Certain circumstances, such as a reduction of capital due to losses from nonperforming assets or otherwise, could cause the Corporation or the Bank become unable to meet applicable regulatory capital requirements, which may materially and adversely affect the Corporations financial condition, liquidity and results of operations. In such an event, additional capital may be required to meet requirements. The Corporations ability to raise additional capital, if needed, will depend on conditions in the capital markets at that time which are outside its control, and on the Corporations financial performance. Accordingly, additional capital, if needed, may not be available on terms acceptable to the Corporation. Furthermore, if any such additional capital is raised through the offering of equity securities, it may dilute the holdings of the Corporations existing shareholders or reduce the market price of the Corporations common shares, or both.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.
Issuer Purchases of Equity Securities
On July 28, 2005, the Corporation announced a share repurchase program of up to 5 percent, or about 332,000, of its common shares outstanding. Repurchased shares can be used for a number of corporate purposes, including the Corporations stock option and employee benefit plans. The share repurchase program provides that share repurchases are to be made primarily on the open market from time-to-time until the 5 percent maximum is repurchased or the earlier termination of the repurchase program by the Board of Directors, at the discretion of management based upon market, business, legal and other factors. However, the terms of the Corporations sale of $25.2 million of its series B preferred stock to the U.S. Treasury in December 2008 in conjunction with the TARP Capital Purchase Program include limitations on the Corporations ability to repurchase its common shares. For three years after the issuance or until the U.S. Treasury no longer holds any series B preferred stock, the Corporation will not be able to repurchase any of its common shares or preferred stock without, among other things, U.S. Treasury approval or the availability of certain limited exceptions, e.g., purchases in connection with the Corporations benefit plans. Furthermore, as long as the series B preferred stock issued to the U.S. Treasury is outstanding, repurchases or redemptions relating to certain equity securities, including the Corporations common shares, are prohibited until all accrued and unpaid dividends are paid on such preferred stock, subject to certain limited exceptions. As of September 30, 2009, the Corporation had repurchased an aggregate of 202,500 shares under this program.
(a) The exhibits to this Form 10-Q are referenced in the Exhibit Index attached hereto.
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
LNB Bancorp, Inc.
Pursuant to Item 601 of Regulation S-K