nbn20171231_10q.htm

Table of Contents

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 

FORM 10-Q

 

Quarterly report pursuant to Section 13 or 15 (d) of the Securities Exchange Act of 1934

 

For the quarterly period ended December 31, 2017

 

Commission File Number: 1-14588

 

 

Northeast Bancorp


(Exact name of registrant as specified in its charter)

 

Maine

 

01-0425066

(State or other jurisdiction of incorporation or organization)

 

(I.R.S. Employer Identification No.)

     

500 Canal Street, Lewiston, Maine

 

04240

(Address of Principal executive offices)

 

(Zip Code)

 

(207) 786-3245

Registrant's telephone number, including area code

 

 

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 (or for such shorter period that the registrant was required to file such reports), and (2) has been subjected to such filing requirements for the past 90 days. Yes No ___

 

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   No ___

 

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 definition of "accelerated filer”, “large accelerated filer" and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (check one): Large accelerated filer __ Accelerated filer Non-accelerated filer __ Smaller Reporting Company __ 

 

Indicate by check mark whether the registrant is a shell company (as defined by Rule 12b-2 of the Exchange Act). Yes_ No

 

Indicate by check mark whether the registrant is an emerging growth company as defined in Rule 405 of the Securities Act of 1933 (§230.405 of this chapter) or Rule 12b-2 of the Securities Exchange Act of 1934 (§240.12b-2 of this chapter).

 

Emerging growth company  ☐

 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.  ☐ 

 

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. As of February 2, 2018, the registrant had outstanding 8,008,634 shares of voting common stock, $1.00 par value per share and 918,639 shares of non-voting common stock, $1.00 par value per share.

 

1

 

Part I.

Financial Information

 
       

 

Item 1.

Financial Statements (Unaudited)

3

 

 

Consolidated Balance Sheets December 31, 2017 and June 30, 2017

3

 

 

 

 

 

 

Consolidated Statements of Income Three and Six Months Ended December 31, 2017 and 2016

4
       
   

Consolidated Statements of Comprehensive Income Three and Six Months Ended December 31, 2017 and 2016

5
       

 

 

Consolidated Statements of Changes in Shareholders' Equity Six Months Ended December 31, 2017 and 2016 

6

 

 

 

 

 

 

Consolidated Statements of Cash Flows Six Months Ended December 31, 2017 and 2017

7

 

 

 

 

 

 

Notes to Unaudited Consolidated Financial Statements

8

 

 

 

 

 

Item 2.

Management's Discussion and Analysis of Financial Condition and Results of Operations

28

 

 

 

 

 

Item 3.

Quantitative and Qualitative Disclosure about Market Risk

44

 

 

 

 

 

Item 4.

Controls and Procedures

45
       

Part II.

Other Information

 

 

 

 

 

 

Item 1.

Legal Proceedings

46

 

 

 

 

 

Item 1A.

Risk Factors

46

 

 

 

 

 

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

46

 

 

 

 

 

Item 3.

Defaults Upon Senior Securities

46

 

 

 

 

 

Item 4.

Mine Safety Disclosures

46

 

 

 

 

 

Item 5.

Other Information

46

 

 

 

 

 

Item 6.

Exhibits

46
       
   

Signatures

47

 

2

 

PART 1- FINANCIAL INFORMATION

Item 1. Financial Statements (Unaudited)

 

NORTHEAST BANCORP AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS

(Unaudited)

(In thousands, except share and per share data)

 

   

December 31, 2017

   

June 30, 2017

 

Assets

               

Cash and due from banks

  $ 2,515     $ 3,582  

Short-term investments

    125,708       159,701  

Total cash and cash equivalents

    128,223       163,283  
                 

Available-for-sale securities, at fair value

    92,339       96,693  
                 

Residential real estate loans held for sale

    5,515       4,508  

SBA loans held for sale

    818       191  

Total loans held for sale

    6,333       4,699  
                 

Loans

               

Commercial real estate

    493,954       498,004  

Commercial and industrial

    178,840       175,654  

Residential real estate

    97,593       101,168  

Consumer

    3,803       4,369  

Total loans

    774,190       779,195  

Less: Allowance for loan losses

    4,355       3,665  

Loans, net

    769,835       775,530  
                 

Premises and equipment, net

    7,061       6,937  

Real estate owned and other repossessed collateral, net

    910       826  

Federal Home Loan Bank stock, at cost

    1,758       1,938  

Intangible assets, net

    1,082       1,300  

Loan servicing rights, net

    3,005       2,846  

Bank-owned life insurance

    16,402       16,179  

Other assets

    7,498       6,643  

Total assets

  $ 1,034,446     $ 1,076,874  
                 

Liabilities and Shareholders' Equity

               

Deposits

               

Demand

  $ 71,054     $ 69,827  

Savings and interest checking

    107,750       108,417  

Money market

    352,237       374,569  

Time

    317,613       337,037  

Total deposits

    848,654       889,850  
                 

Federal Home Loan Bank advances

    15,000       20,011  

Subordinated debt

    23,790       23,620  

Capital lease obligation

    741       873  

Other liabilities

    16,258       19,723  

Total liabilities

    904,443       954,077  
                 

Commitments and contingencies

    -       -  
                 

Shareholders' equity

               

Preferred stock, $1.00 par value, 1,000,000 shares authorized; no shares issued and outstanding at December 31, 2017 and June 30, 2017

    -       -  

Voting common stock, $1.00 par value, 25,000,000 shares authorized; 8,017,334 and 7,840,460 shares issued and outstanding at December 31, 2017 and June 30, 2017, respectively

    8,017       7,841  

Non-voting common stock, $1.00 par value, 3,000,000 shares authorized; 921,939 and 991,194 shares issued and outstanding at December 31, 2017 and June 30, 2017, respectively

    922       991  

Additional paid-in capital

    76,805       77,455  

Retained earnings

    45,855       38,142  

Accumulated other comprehensive loss

    (1,596 )     (1,632 )

Total shareholders' equity

    130,003       122,797  

Total liabilities and shareholders' equity

  $ 1,034,446     $ 1,076,874  

 

The accompanying notes are an integral part of these unaudited consolidated financial statements.

 

3

 

NORTHEAST BANCORP AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF INCOME

(Unaudited)

(In thousands, except share and per share data)

 

   

Three Months Ended December 31,

   

Six Months Ended December 31,

 
   

2017

   

2016

   

2017

   

2016

 

Interest and dividend income:

                               

Interest and fees on loans

  $ 14,501     $ 13,913     $ 29,883     $ 25,716  

Interest on available-for-sale securities

    267       247       533       486  

Other interest and dividend income

    492       172       1,022       387  

Total interest and dividend income

    15,260       14,332       31,438       26,589  
                                 

Interest expense:

                               

Deposits

    2,129       1,798       4,305       3,553  

Federal Home Loan Bank advances

    148       220       319       475  

Subordinated debt

    517       468       1,025       927  

Obligation under capital lease agreements

    9       13       21       27  

Total interest expense

    2,803       2,499       5,670       4,982  

Net interest and dividend income before provision for loan losses

    12,457       11,833       25,768       21,607  

Provision for loan losses

    437       628       792       820  

Net interest and dividend income after provision for loan losses

    12,020       11,205       24,976       20,787  
                                 

Noninterest income:

                               

Fees for other services to customers

    475       481       1,002       889  

Gain on sales of residential loans held for sale

    255       337       545       878  

Gain on sales of SBA loans

    341       1,734       1,361       2,476  

Gain on sales of other loans

    21       -       21       -  

Gain (loss) on real estate owned, other repossessed collateral and premises and equipment, net

    11       3       11       (11 )

Bank-owned life insurance income

    111       114       223       228  

Other noninterest income

    14       21       23       38  

Total noninterest income

    1,228       2,690       3,186       4,498  
                                 

Noninterest expense:

                               

Salaries and employee benefits

    5,173       5,161       10,427       10,475  

Occupancy and equipment expense

    1,150       1,252       2,260       2,481  

Professional fees

    425       399       867       895  

Data processing fees

    624       410       1,227       832  

Marketing expense

    70       97       157       184  

Loan acquisition and collection expense

    368       547       733       774  

FDIC insurance premiums

    80       22       160       146  

Intangible asset amortization

    109       109       218       218  

Other noninterest expense

    564       959       1,228       1,577  

Total noninterest expense

    8,563       8,956       17,277       17,582  

Income before income tax expense

    4,685       4,939       10,885       7,703  

Income tax expense

    1,381       1,839       2,995       2,852  

Net income

  $ 3,304     $ 3,100     $ 7,890     $ 4,851  
                                 

Weighted-average shares outstanding:

                               

Basic

    8,924,495       8,831,235       8,883,003       8,968,690  

Diluted

    9,168,084       8,864,618       9,129,010       8,999,062  

Earnings per common share:

                               
                                 

Basic

  $ 0.37     $ 0.35     $ 0.89     $ 0.54  

Diluted

    0.36       0.35       0.86       0.54  
                                 

Cash dividends declared per common share

  $ 0.01     $ 0.01     $ 0.02     $ 0.02  

 

The accompanying notes are an integral part of these unaudited consolidated financial statements.

 

4

 

NORTHEAST BANCORP AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Unaudited)

(Dollars in thousands)

 

   

Three Months Ended December 31,

   

Six Months Ended December 31,

 
   

2017

   

2016

   

2017

   

2016

 

Net income

  $ 3,304     $ 3,100     $ 7,890     $ 4,851  

Other comprehensive income, before tax:

                               

Available-for-sale securities:

                               

Change in net unrealized loss on available-for-sale securities

    (297 )     (1,336 )     (175 )     (1,414 )

Derivatives and hedging activities:

                               

Change in accumulated gain on effective cash flow hedges

    160       1,486       181       1,633  

Reclassification adjustments included in interest expense

    26       8       49       14  

Total derivatives and hedging activities

    186       1,494       230       1,647  

Total other comprehensive (loss) income, before tax

    (111 )     158       55       233  

Income tax expense (benefit) related to other comprehensive (loss) income

    (43 )     62       19       92  

Other comprehensive (loss) income, net of tax

    (68 )     96       36       141  

Comprehensive income

  $ 3,236     $ 3,196     $ 7,926     $ 4,992  

 

The accompanying notes are an integral part of these unaudited consolidated financial statements.

 

5

 

NORTHEAST BANCORP AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

(Unaudited)

(In thousands, except share and per share data)

 

                                                                   

Accumulated

   

 

 
   

Preferred Stock

   

Voting Common Stock

   

Non-voting Common Stock

   

Additional

Paid-in

   

Retained

   

Other

Comprehensive

   

Total

Shareholders'

 
   

Shares

   

Amount

   

Shares

   

Amount

   

Shares

   

Amount

   

Capital

   

Earnings

   

Loss

   

Equity

 
                                                                                 

Balance at June 30, 2016

    -     $ -       8,089,790     $ 8,089       1,227,683     $ 1,228     $ 83,020     $ 26,160     $ (1,906 )   $ 116,591  

Net income

    -       -       -       -       -       -       -       4,851       -       4,851  

Other comprehensive loss, net of tax

    -       -       -       -       -       -       -       -       141       141  

Common stock repurchased

    -       -       (645,238 )     (645 )     -       -       (6,298 )     -       -       (6,943 )

Conversion of voting common stock to non-voting common stock

    -       -       (116,000 )     (116 )     116,000       116       -       -       -       -  

Dividends on common stock at $0.02 per share

    -       -       -       -       -       -       -       (181 )     -       (181 )

Stock-based compensation

    -       -       -       -       -       -       483       -       -       483  

Issuance of restricted common stock

    -       -       160,000       160       -       -       (160 )     -       -       -  

Cancellation and forfeiture of restricted common stock

    -       -       (1,000 )     (1 )     -       -       1       -       -       -  

Balance at December 31, 2016

    -     $ -       7,487,552     $ 7,487       1,343,683     $ 1,344     $ 77,046     $ 30,830     $ (1,765 )   $ 114,942  

Balance at June 30, 2017

    -       -       7,840,460     $ 7,841       991,194     $ 991     $ 77,455     $ 38,142     $ (1,632 )   $ 122,797  

Net income

    -       -       -       -       -       -       -       7,890       -       7,890  

Other comprehensive loss, net of tax

    -       -       -       -       -       -       -       -       36       36  

Conversion of non-voting common stock to voting common stock

    -       -       69,255       69       (69,255 )     (69 )     -       -       -       -  

Dividends on common stock at $0.02 per share

    -       -       -       -       -       -       -       (177 )     -       (177 )

Stock-based compensation

    -       -       -       -       -       -       485       -       -       485  

Issuance of restricted common stock

    -       -       12,000       12       -       -       (12 )     -       -       -  

Cancellation and forfeiture of restricted common stock

    -       -       (15,756 )     (16 )     -       -       (39 )     -       -       (55 )

Stock options exercised, net

    -       -       111,375       111       -       -       (1,084 )     -       -       (973 )

Balance at December 31, 2017

    -     $ -       8,017,334     $ 8,017       921,939     $ 922     $ 76,805     $ 45,855     $ (1,596 )   $ 130,003  

 

The accompanying notes are an integral part of these unaudited consolidated financial statements.

 

6

 

NORTHEAST BANCORP AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(Dollars in thousands)

 

   

Six Months Ended December 31,

 
   

2017

   

2016

 

Operating activities:

               

Net income

  $ 7,890     $ 4,851  
Adjustments to reconcile net income to net cash provided by operating activities:                

Provision for loan losses

    792       820  

(Gain) loss recognized on real estate owned, other repossessed collateral and premises and equipment, net

    (11 )     11  

Accretion of fair value adjustments on loans, net

    (4,830 )     (5,640 )

Accretion of fair value adjustments on deposits, net

    -       (2 )

Amortization (accretion) of fair value adjustments on borrowings, net

    104       (51 )

Amortization of subordinated debt issuance costs

    55       138  

Originations of loans held for sale

    (49,309 )     (66,778 )

Net proceeds from sales of loans held for sale

    50,946       71,100  

Gain on sales of residential loans held for sale, net

    (545 )     (878 )

Gain on sales of SBA and other loans held for sale, net

    (1,382 )     (2,476 )

Net increase in loan servicing rights

    (159 )     (577 )

Amortization of intangible assets

    218       218  

Bank-owned life insurance income

    (223 )     (228 )

Depreciation and amortization of premises and equipment

    636       769  

Stock-based compensation

    485       483  

Deferred income tax expense

    498       -  

Amortization of available-for-sale securities, net

    450       555  

Net changes in other assets and liabilities:

               

Other assets

    (1,376 )     595  

Other liabilities

    (3,231 )     702  

Net cash provided by operating activities

    1,008       3,612  

Investing activities:

               

Purchases of available-for-sale securities

    (9,222 )     (9,056 )

Proceeds from maturities and principal payments on available-for-sale securities

    12,951       17,126  

Loan purchases

    (38,453 )     (59,886 )

Loan originations, principal collections, and purchased loan paydowns, net

    45,540       (13,413 )

Purchases of premises and equipment

    (795 )     (229 )

Redemption of Federal Home Loan Bank stock

    180       470  

Proceeds from sales of real estate owned and other repossessed collateral

    1,264       523  

Net cash provided by (used in) investing activities

    11,465       (64,465 )

Financing activities:

               

Net change in deposits

    (41,196 )     39,141  

Repurchase of common stock

    -       (6,943 )

Dividends paid on common stock

    (177 )     (181 )

Repayment of Federal Home Loan Bank advances

    (5,000 )     (10,000 )

Repayment of capital lease obligation

    (132 )     (125 )

Repurchases for tax withholdings on restricted common stock

    (55 )     -  

Repurchases for tax withholdings on stock options

    (973 )     -  

Net cash (used in) provided by financing activities

    (47,533 )     21,892  

Net decrease in cash and cash equivalents

    (35,060 )     (38,961 )

Cash and cash equivalents, beginning of period

    163,283       151,157  

Cash and cash equivalents, end of period

  $ 128,223     $ 112,196  
                 

Supplemental schedule of noncash investing activities:

               

Transfers from loans to real estate owned and other repossessed collateral

  $ 1,302     $ 1,946  

 

The accompanying notes are an integral part of these unaudited consolidated financial statements.

 

7

 

NORTHEAST BANCORP AND SUBSIDIARY

Notes to Unaudited Consolidated Financial Statements

December 31, 2017

 

1. Basis of Presentation

 

The accompanying unaudited interim consolidated financial statements include the accounts of Northeast Bancorp (“Northeast” or the “Company”) and its wholly-owned subsidiary, Northeast Bank (the “Bank”).

 

These unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“US GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and notes required by GAAP for complete financial statements. In the opinion of management, the accompanying consolidated financial statements contain all adjustments (consisting principally of normal recurring accruals) considered necessary for a fair presentation of the Company's financial position, results of operations, and cash flows for the interim periods presented. These accompanying unaudited financial statements and notes should be read in conjunction with the audited consolidated financial statements and notes thereto for the fiscal year ended June 30, 2017 (“Fiscal 2017”) included in the Company's Annual Report on Form 10-K filed with the Securities and Exchange Commission.

 

2. Recent Accounting Pronouncements

 

In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2014-09, Revenue from Contracts with Customers (Topic 606) (“ASU 2014-09”). ASU 2014-09 implements a common revenue standard that clarifies the principles for recognizing revenue. The core principle of ASU 2014-09 is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. To achieve that core principle, an entity should apply the following steps: (i) identify the contract(s) with a customer, (ii) identify the performance obligations in the contract, (iii) determine the transaction price, (iv) allocate the transaction price to the performance obligations in the contract and (v) recognize revenue when (or as) the entity satisfies a performance obligation. ASU 2015-14, Revenue from Contracts with Customers (Topic 606) (“ASU 2015-14”) was issued in August 2015 which defers adoption to annual reporting periods beginning after December 15, 2017. The timing of the Company’s revenue recognition is not expected to materially change. The Company is currently performing an assessment of revenue streams and reviewing contracts potentially affected by the ASU to determine the impact of the new guidance. The Company’s largest portions of revenue, interest and fees on loans and gain on sales of loans, are specifically excluded from the scope of the guidance, and the Company currently recognizes the majority of the remaining revenue sources in a manner that management believes is consistent with the new guidance. Because of this, management believes that revenue recognized under the new guidance will generally approximate revenue recognized under current GAAP. These observations are subject to change as the evaluation is completed.

 

In January 2016, the FASB issued ASU 2016-01, Financial Instruments—Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities (“ASU 2016-01”). This guidance changes how entities account for equity investments that do not result in consolidation and are not accounted for under the equity method of accounting. Entities will be required to measure these investments at fair value at the end of each reporting period and recognize changes in fair value in net income. A practicability exception will be available for equity investments that do not have readily determinable fair values; however, the exception requires the Company to adjust the carrying amount for impairment and observable price changes in orderly transactions for the identical or a similar investment of the same issuer. This guidance also changes certain disclosure requirements and other aspects of current US GAAP. This guidance is effective for fiscal years beginning after December 15, 2017, including interim periods within the fiscal year. Early adoption is permitted for only one of the six amendments. The Company is currently evaluating the impact of the adoption of ASU 2016-01 on its consolidated financial statements.

 

In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842) (“ASU 2016-02”). The new guidance establishes the principles to report transparent and economically neutral information about the assets and liabilities that arise from leases. Entities will be required to recognize the lease assets and lease liabilities that arise from leases in the statement of financial position and to disclose qualitative and quantitative information about lease transactions, such as information about variable lease payments and options to renew and terminate leases. This guidance is effective for fiscal years beginning after December 15, 2018, including interim periods within the fiscal year. The Company is currently evaluating the impact of the adoption of ASU 2016-02 to determine the potential impact it will have on its consolidated financial statements. The Company’s assets and liabilities will increase based on the present value of the remaining lease payments for leases in place at the adoption date; however, this is not expected to be material to the Company’s results of operations.

 

In March 2016, the FASB issued ASU 2016-09, Compensation—Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting (“ASU 2016-09”). The new guidance simplified several aspects of the accounting for share-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities, and classification on the statement of cash flows. Entities are required to recognize the income tax effects of awards in the income statement when the awards vest or are settled. This guidance became effective for the Company for the fiscal year beginning July 1, 2017. For interim reporting purposes the excess tax benefits or deficiencies shall be recorded as discrete items in the period in which they occur. In addition to the excess tax benefit treatment, the amendment removed the assumed proceeds related to the excess tax benefit from the calculation of diluted shares.

 

8

 

Upon adoption, the most significant impact of this amendment resulted from the prospective application of current excess tax benefits and deficiencies being recognized in income tax expense, which would previously have been recognized in additional paid-in capital. In the six months ended December 31, 2017, this item reduced income tax expense and increased net income by approximately $1.1 million, representing an income tax benefit arising from individuals who exercised non-qualified stock options and restricted stock awards that vested during the period. For the year ended June 30, 2017, the Company recognized $27 thousand in additional paid-in-capital related to the excess tax benefit, which, if under the new ASU, would have been recognized as an income tax benefit in the income statement. These amounts, treated as discrete items in the period in which they occur, will vary from year to year as a function of the volume of share-based payments vested or exercised and the then fair market value of the Company's stock in comparison to the compensation cost recognized in the financial statements. In addition to the excess tax benefit treatment, the amendment removed the assumed proceeds related to the excess tax benefit from the calculation of diluted shares which increased diluted weighted average common shares outstanding by 40,966 shares to 9,089,936. This amendment is applied on a prospective basis, and no prior periods were adjusted. Additionally upon adoption, the Company made a policy election to record forfeitures as they occur rather than make use of an estimate. The other provisions did not have a material impact on the Company's consolidated financial statements upon adoption.

 

In June 2016, the FASB issued ASU 2016-13, Financial Instruments—Credit Losses (Topic 326) (“ASU 2016-13”). This guidance is intended to provide financial statement users with more decision-useful information about the expected credit losses on financial instruments and other commitments to extend credit held by a reporting entity at each reporting date. To achieve this objective, the amendments in this guidance replace the incurred loss impairment methodology in current US GAAP with a methodology that reflects expected credit losses and requires consideration of a broader range of reasonable and supportable information to inform credit loss estimates. This ASU will be effective for fiscal years beginning after December 15, 2019. Early adoption is available as of the fiscal year beginning after December 15, 2018. The Company is evaluating the provisions of the guidance, and will closely monitor developments and additional guidance to determine the potential impact on the Company’s consolidated financial statements. Management is in the process of identifying the methodologies and the additional data requirements necessary to implement the guidance and plans to engage an existing third-party service provider to assist in implementation.

  

In May 2017, the FASB issued ASU 2017-09, Compensation-Stock Compensation (Topic 718): Scope of Modification Accounting (“ASU 2017-09”) which amends the scope of modification accounting for share-based payment arrangements. This update provides guidance on the types of changes to the terms or conditions of share-based payment awards to which an entity would be required to apply modification accounting. Specifically, an entity would not apply modification accounting if the fair value, vesting conditions, and classification of the awards are the same immediately before and after the modification. This update is effective for public business entities for annual periods being after December 15, 2017, including interim periods within those annual periods. Early adoption is permitted including adopting in any interim period. This update should be applied prospectively to awards modified on or after the effective date. The adoption of this guidance is not expected to have a significant impact on the Company’s consolidated financial statements.

 

In August 2017, the FASB issued ASU 2017-12, Derivatives and Hedging (Topic 815) (“ASU 2017-12”). This guidance permits hedge accounting for risk components in hedging relationships involving nonfinancial risk and interest rate risk, and improves the financial reporting of hedging relationships to better portray the economic results of an entity’s risk management activities in its financial statements. The amendments in this guidance are effective for public business entities for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years. Early adoption is permitted, including adoption in an interim period. The adoption of this guidance is not expected to have a significant impact on the Company’s consolidated financial statements.

 

9

 

3. Available-for-Sale Securities

 

The following presents a summary of the amortized cost, gross unrealized holding gains and losses, and fair value of available-for-sale securities.

 

   

December 31, 2017

 
   

Amortized

   

Gross Unrealized

   

Gross Unrealized

   

Fair

 
   

Cost

   

Gains

    Losses    

Value

 
   

(Dollars in thousands)

 

U.S. Government agency securities

  $ 57,365     $ -     $ (273 )   $ 57,092  

Agency mortgage-backed securities

    29,306       -       (726 )     28,580  

Other investments measured at net asset value

    6,791       -       (124 )     6,667  
    $ 93,462     $ -     $ (1,123 )   $ 92,339  

 

   

June 30, 2017

 
   

Amortized

   

Gross Unrealized

   

Gross Unrealized

   

Fair

 
    Cost    

Gains

   

Losses

   

Value

 
   

(Dollars in thousands)

 

U.S. Government agency securities

  $ 57,401     $ -     $ (233 )   $ 57,168  

Agency mortgage-backed securities

    33,523       -       (620 )     32,903  

Other investments measured at net asset value

    6,717       -       (95 )     6,622  
    $ 97,641     $ -     $ (948 )   $ 96,693  

 

When securities are sold, the adjusted cost of the specific security sold is used to compute the gain or loss on sale. There were no securities sold during the three and six months ended December 31, 2017 or 2016. At December 30, 2017, no investment securities were pledged as collateral to secure outstanding borrowings.

 

The following summarizes the Company’s gross unrealized losses and fair values aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position.

 

   

December 31, 2017

 
   

Less than 12 Months

   

More than 12 Months

   

Total

 
   

Fair

   

Unrealized

   

Fair

   

Unrealized

   

Fair

   

Unrealized

 
   

Value

   

Losses

   

Value

   

Losses

   

Value

   

Losses

 
   

(Dollars in thousands)

 

U.S. Government agency securities

  $ 21,111     $ (86 )   $ 35,981     $ (187 )   $ 57,092     $ (273 )

Agency mortgage-backed securities

    1,627       (9 )     26,953       (717 )     28,580       (726 )

Other investments measured at net asset value

    -       -       5,142       (124 )     5,142       (124 )
    $ 22,738     $ (95 )   $ 68,076     $ (1,028 )   $ 90,814     $ (1,123 )

 

   

June 30, 2017

 
   

Less than 12 Months

   

More than 12 Months

   

Total

 
   

Fair

   

Unrealized

   

Fair

   

Unrealized

   

Fair

   

Unrealized

 
   

Value

   

Losses

   

Value

   

Losses

   

Value

   

Losses

 
   

(Dollars in thousands)

 

U.S. Government agency securities

  $ 57,168     $ (233 )   $ -     $ -     $ 57,168     $ (233 )

Agency mortgage-backed securities

    19,571       (298 )     13,332       (322 )     32,903       (620 )

Other investments measured at net asset value

    5,115       (95 )     -       -       5,115       (95 )
    $ 81,854     $ (626 )   $ 13,332     $ (322 )   $ 95,186     $ (948 )

 

There were no other-than-temporary impairment losses on securities during the three and six months ended December 31, 2017 or 2016.

 

At December 31, 2017, the Company had 31 securities in a continuous loss position for greater than twelve months. At December 31, 2017, all of the Company’s available-for-sale securities were issued or guaranteed by either government agencies or government-sponsored enterprises. The decline in fair value of the Company’s available-for-sale securities at December 31, 2017 is attributable to changes in interest rates.

 

In addition to considering current trends and economic conditions that may affect the quality of individual securities within the Company’s investment portfolio, management of the Company also considers the Company’s ability and intent to hold such securities to maturity or recovery of cost. At December 31, 2017, the Company does not intend to sell and it is not more likely than not that the Company will be required to sell the investment securities before recovery of its amortized cost. As such, management does not believe any of the Company’s available-for-sale securities are other-than-temporarily impaired at December 31, 2017.

 

The investments measured at net asset value include a fund that seeks to invest in securities either issued or guaranteed by the U.S. government or its agencies, as well as a fund that primarily invests in the federally guaranteed portion of SBA 7(a) loans that adjust quarterly or monthly and are indexed to the Prime Rate. The underlying composition of these funds is primarily government agencies, other investment-grade investments, or the guaranteed portion of SBA 7(a) loans, as applicable. As of December 31, 2017, the effective duration of the fund that seeks to invest in securities either issued or guaranteed by the U.S. government or its agencies is 4.66 years.

 

10

 

The amortized cost and fair values of available-for-sale debt securities by contractual maturity are shown below as of December 31, 2017. Actual maturities may differ from contractual maturities because borrowers may have the right to prepay obligations with or without prepayment penalties.

 

   

Amortized Cost

   

Fair Value

 
   

(Dollars in thousands)

 

Due within one year

  $ 39,168     $ 38,981  

Due after one year through five years

    18,197       18,111  

Due after five years through ten years

    -       -  

Due after ten years

    -       -  

Total U.S. Government agency securities

    57,365       57,092  

Agency mortgage-backed securities

    29,306       28,580  

Total debt securities

  $ 86,671     $ 85,672  

 

4. Loans, Allowance for Loan Losses and Credit Quality

 

Loans are carried at the principal amounts outstanding, or amortized acquired fair value in the case of acquired loans, adjusted by partial charge-offs and net of deferred loan costs or fees. Loan fees and certain direct origination costs are deferred and amortized into interest income over the expected term of the loan using the level-yield method. When a loan is paid off, the unamortized portion is recognized in interest income. Interest income is accrued based upon the daily principal amount outstanding, except for loans on nonaccrual status.

 

Loans purchased by the Company are accounted for under ASC 310-30, Receivables—Loans and Debt Securities Acquired with Deteriorated Credit Quality ("ASC 310-30"). At acquisition, the effective interest rate is determined based on the discount rate that equates the present value of the Company's estimate of cash flows with the purchase price of the loan. Prepayments are not assumed in determining a purchased loan's effective interest rate and income accretion. The application of ASC 310-30 limits the yield that may be accreted on the purchased loan, or the "accretable yield," to the excess of the Company's estimate, at acquisition, of the expected undiscounted principal, interest, and other cash flows over the Company's initial investment in the loan. The excess of contractually required payments receivable over the cash flows expected to be collected on the loan represents the purchased loan's "nonaccretable difference." Subsequent improvements in expected cash flows of loans with nonaccretable differences result in a prospective increase to the loan's effective yield through a reclassification of some, or all, of the nonaccretable difference to accretable yield. The effect of subsequent credit-related declines in expected cash flows of purchased loans are recorded through a specific allocation in the allowance for loan losses. 

 

Loans are generally placed on nonaccrual status when they are past due 90 days as to either principal or interest, or when in management's judgment the collectability of interest or principal of the loan has been significantly impaired. Loans accounted for under ASC 310-30 are placed on nonaccrual when it is not possible to reach a reasonable expectation of the timing and amount of cash flows to be collected on the loan. When a loan has been placed on nonaccrual status, previously accrued and uncollected interest is reversed against interest on loans. Interest on nonaccrual loans is accounted for on a cash-basis or using the cost-recovery method when collectability is doubtful. A loan is returned to accrual status when collectability of principal and interest is reasonably assured and the loan has performed for a reasonable period of time.

 

In cases where a borrower experiences financial difficulties and the Company makes certain concessionary modifications to contractual terms, the loan is classified as a troubled debt restructuring ("TDR"), and therefore by definition is an impaired loan. Concessionary modifications may include adjustments to interest rates, extensions of maturity, and other actions intended to minimize economic loss and avoid foreclosure or repossession of collateral. For loans accounted for under ASC 310-30, the Company evaluates whether it has granted a concession by comparing the restructured debt terms to the expected cash flows at acquisition plus any additional cash flows expected to be collected arising from changes in estimate after acquisition. As a result, if an ASC 310-30 loan is modified to be consistent with, or better than, the Company's expectations at acquisition, the modified loan would not qualify as a TDR. Nonaccrual loans that are restructured generally remain on nonaccrual status for a minimum period of six months to demonstrate that the borrower can meet the restructured terms. If the restructured loan is on accrual status prior to being modified, it is reviewed to determine if the modified loan should remain on accrual status. If the borrower's ability to meet the revised payment schedule is not reasonably assured, the loan is classified as a nonaccrual loan. With limited exceptions, loans classified as TDRs remain classified as such until the loan is paid off.

 

11

 

The composition of the Company’s loan portfolio is as follows on the dates indicated.

 

   

December 31, 2017

   

June 30, 2017

 
   

Originated

   

Purchased

   

Total

   

Originated

   

Purchased

   

Total

 
   

(Dollars in thousands)

 

Residential real estate

  $ 80,462     $ 4,723     $ 85,185     $ 83,759     $ 3,377     $ 87,136  

Home equity

    12,313       95       12,408       13,931       101       14,032  

Commercial real estate

    255,679       238,275       493,954       256,280       241,724       498,004  

Commercial and industrial

    177,756       1,084       178,840       174,468       1,186       175,654  

Consumer

    3,803       -       3,803       4,369       -       4,369  

Total loans

  $ 530,013     $ 244,177     $ 774,190     $ 532,807     $ 246,388     $ 779,195  

 

Total loans include net deferred loan origination costs of $212 thousand and $507 thousand as of December 31, 2017 and June 30, 2017, respectively.

 

Past Due and Nonaccrual Loans

 

The following is a summary of past due and nonaccrual loans:

 

   

December 31, 2017

 
   

Past Due

30-59

Days

   

Past Due

60-89

Days

   

Past Due

90 Days or

More-Still

Accruing

   

Past Due

90 Days or

More-

Nonaccrual

   

Total Past

Due

   

Total

Current

   

Total

Loans

   

Nonaccrual

Loans

 
   

(Dollars in thousands)

 

Originated portfolio:

                                                               

Residential real estate

  $ 1,472     $ 618     $ -     $ 2,108     $ 4,198     $ 76,264     $ 80,462     $ 3,783  

Home equity

    -       148       -       108       256       12,057       12,313       107  

Commercial real estate

    1,870       288       -       123       2,281       253,398       255,679       2,537  

Commercial and industrial

    1,004       36       -       -       1,040       176,716       177,756       2,555  

Consumer

    55       53       -       36       144       3659       3,803       147  

Total originated portfolio

    4,401       1,143       -       2,375       7,919       522,094       530,013       9,129  

Purchased portfolio:

                                                               

Residential real estate and home equity

    -       -       -       220       220       4,598       4,818       220  

Commercial and industrial

    217       -       -       -       217       867       1,084       292  

Commercial real estate

    10,918       5,971       -       4,712       21,601       216,674       238,275       8,450  

Total purchased portfolio

    11,135       5,971       -       4,932       22,038       222,139       244,177       8,962  

Total loans

  $ 15,536     $ 7,114     $ -     $ 7,307     $ 29,957     $ 744,233     $ 774,190     $ 18,091  

 

   

June 30, 2017

 
   

Past Due

30-59

Days

   

Past Due

60-89

Days

   

Past Due

90 Days or

More-Still

Accruing

   

Past Due

90 Days or

More-

Nonaccrual

   

Total Past

Due

   

Total

Current

   

Total

Loans

   

Nonaccrual

Loans

 
   

(Dollars in thousands)

 

Originated portfolio:

                                                               

Residential real estate

  $ 141     $ 574     $ -     $ 1,398     $ 2,113     $ 81,646     $ 83,759     $ 3,337  

Home equity

    49       -       -       58       107       13,824       13,931       58  

Commercial real estate

    2,266       -       -       124       2,390       253,890       256,280       413  

Commercial and industrial

    -       -       -       2,433       2,433       172,035       174,468       2,600  

Consumer

    69       50       -       32       151       4,218       4,369       103  

Total originated portfolio

    2,525       624       -       4,045       7,194       525,613       532,807       6,511  

Purchased portfolio:

                                                               

Residential real estate and home equity

    -       1,082       -       16       1,098       2,380       3,478       1,056  

Commercial and industrial

    -       -       -       -       -       1,186       1,186       32  

Commercial real estate

    173       1,997       -       2,922       5,092       236,632       241,724       6,364  

Total purchased portfolio

    173       3,079       -       2,938       6,190       240,198       246,388       7,452  

Total loans

  $ 2,698     $ 3,703     $ -     $ 6,983     $ 13,384     $ 765,811     $ 779,195     $ 13,963  

 

12

 

Allowance for Loan Losses and Impaired Loans

 

The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. For residential and consumer loans, a charge-off is recorded no later than the point at which a loan is 180 days past due if the loan balance exceeds the fair value of the collateral, less estimated costs to sell. For commercial loans, a charge-off is recorded on a case-by-case basis when all or a portion of the loan is deemed to be uncollectible. Subsequent recoveries, if any, are credited to the allowance.

 

The allowance for loan losses consists of general, specific, and unallocated reserves and reflects management’s estimate of probable loan losses inherent in the loan portfolio at the balance sheet date. Management uses a consistent and systematic process and methodology to evaluate the appropriateness of the allowance for loan losses on a quarterly basis. The calculation of the allowance for loan losses is segregated by portfolio segments, which include: residential real estate, commercial real estate, commercial and industrial, consumer, and purchased loans. Risk characteristics relevant to each portfolio segment are as follows:

 

Residential real estate: All loans in this segment are collateralized by residential real estate and repayment is primarily dependent on the credit quality, loan-to-value ratio and income of the individual borrower. The overall health of the economy, particularly unemployment rates and housing prices, has a significant effect on the credit quality in this segment. For purposes of the Company’s allowance for loan loss calculation, home equity loans and lines of credit are included in residential real estate.

 

Commercial real estate: Loans in this segment are primarily income-producing properties. For owner-occupied properties, the cash flows are derived from an operating business, and the underlying cash flows may be adversely affected by deterioration in the financial condition of the operating business. The underlying cash flows generated by non-owner occupied properties may be adversely affected by increased vacancy rates. Management periodically obtains rent rolls and operating statements, with which it monitors the cash flows of these loans. Adverse developments in either of these areas will have an adverse effect on the credit quality of this segment. For purposes of the allowance for loan losses, this segment also includes construction loans.

 

Commercial and industrial: Loans in this segment are made to businesses and are generally secured by the assets of the business. Repayment is expected from the cash flows of the business. This segment also includes loans to non-bank lenders, which are generally secured by a collateral assignment of the notes and mortgages on loans originated by the non-bank lenders. Weakness in national or regional economic conditions, and a corresponding weakness in consumer or business spending, will have an adverse effect on the credit quality of this segment.

 

Consumer: Loans in this segment are generally secured, and repayment is dependent on the credit quality of the individual borrower. Repayment of consumer loans is generally based on the earnings of individual borrowers, which may be adversely impacted by regional labor market conditions.

 

Purchased: Loans in this segment are typically secured by commercial real estate, multi-family residential real estate, or business assets and have been acquired by the Bank’s Loan Acquisition and Servicing Group (“LASG”). Loans acquired by the LASG are, with limited exceptions, performing loans at the date of purchase. Repayment of loans in this segment is largely dependent on cash flow from the successful operation of the property, in the case of non-owner occupied property, or operating business, in the case of owner-occupied property. Loan performance may be adversely affected by factors affecting the general economy or conditions specific to the real estate market, such as geographic location or property type. Loans in this segment are evaluated for impairment under ASC 310-30. The Company reviews expected cash flows from purchased loans on a quarterly basis. The effect of a decline in expected cash flows subsequent to the acquisition of the loan is recognized through a specific allocation in the allowance for loan losses.

 

The general component of the allowance for loan losses for originated loans is based on historical loss experience adjusted for qualitative factors stratified by loan segment. The Company does not weight periods used in that analysis to determine the average loss rate in each portfolio segment. This historical loss factor is adjusted for the following qualitative factors:

 

 

Levels and trends in delinquencies;

 

 

Trends in the volume and nature of loans;

 

 

Trends in credit terms and policies, including underwriting standards, procedures and practices, and the experience and ability of lending management and staff;

 

 

Trends in portfolio concentration;

 

 

National and local economic trends and conditions;

 

 

Effects of changes or trends in internal risk ratings; and

 

 

Other effects resulting from trends in the valuation of underlying collateral.

 

The allocated component of the allowance for loan losses relates to loans that are classified as impaired. Impairment is measured on a loan-by-loan basis by either the present value of expected future cash flows discounted at the loan’s effective interest rate or the fair value of the collateral if the loan is collateral dependent. An allowance is established when the discounted cash flows or collateral value of the impaired loan is lower than the carrying value of the loan.

 

13

 

For all portfolio segments, except loans accounted for under ASC 310-30, a loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. 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, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. For the purchased loan segment, a loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to realize cash flows as expected at acquisition. For loans accounted for under ASC 310-30 for which cash flows can reasonably be estimated, loan impairment is measured based on the decrease in expected cash flows from those estimated at acquisition, excluding changes due to changes in interest rate indices and other non-credit related factors, discounted at the loan’s effective rate assumed at acquisition. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting the scheduled principal and interest payments when due.

 

The following table sets forth activity in the Company’s allowance for loan losses.

 

   

Three Months Ended December 31, 2017

 
   

Residential

   

Commercial

   

Commercial

                                 
   

Real Estate

   

Real Estate

   

and Industrial

   

Consumer

   

Purchased

   

Unallocated

   

Total

 
   

(Dollars in thousands)

 

Beginning balance

  $ 513     $ 2,443     $ 727     $ 41     $ 310     $ -     $ 4,034  

Provision

    176       74       (42 )     19       210       -       437  

Recoveries

    1       -       5       25       -       -       31  

Charge-offs

    (112 )     -       -       (35 )     -       -       (147 )

Ending balance

  $ 578     $ 2,517     $ 690     $ 50     $ 520     $ -     $ 4,355  

 

   

Three Months Ended December 31, 2016

 
   

Residential

   

Commercial

   

Commercial

                                 
   

Real Estate

   

Real Estate

   

and Industrial

   

Consumer

   

Purchased

   

Unallocated

   

Total

 
   

(Dollars in thousands)

 

Beginning balance

  $ 541     $ 1,421     $ 318     $ 68     $ 158     $ -     $ 2,506  

Provision

    6       351       207       40       24       -       628  

Recoveries

    27       19       6       21       -       -       73  

Charge-offs

    -       (41 )     -       (59 )     -       -       (100 )

Ending balance

  $ 574     $ 1,750     $ 531     $ 70     $ 182     $ -     $ 3,107  

 

   

Six Months Ended December 31, 2017

 
   

Residential

   

Commercial

   

Commercial

                                 
   

Real Estate

   

Real Estate

   

and Industrial

   

Consumer

   

Purchased

   

Unallocated

   

Total

 
   

(Dollars in thousands)

 

Beginning balance

  $ 477     $ 2,312     $ 520     $ 53     $ 303     $ -     $ 3,665  

Provision

    217       205       147       6       217       -       792  

Recoveries

    8       -       23       31       -       -       62  

Charge-offs

    (124 )     -       -       (40 )     -       -       (164 )

Ending balance

  $ 578     $ 2,517     $ 690     $ 50     $ 520     $ -     $ 4,355  

 

   

Six Months Ended December 31, 2016

 
   

Residential

   

Commercial

   

Commercial

                                 
   

Real Estate

   

Real Estate

   

and Industrial

   

Consumer

   

Purchased

   

Unallocated

   

Total

 
   

(Dollars in thousands)

 

Beginning balance

  $ 663     $ 1,195     $ 297     $ 62     $ 133     $ -     $ 2,350  

Provision

    (93 )     577       224       63       49       -       820  

Recoveries

    29       19       11       32       -       -       91  

Charge-offs

    (25 )     (41 )     (1 )     (87 )     -       -       (154 )

Ending balance

  $ 574     $ 1,750     $ 531     $ 70     $ 182     $ -     $ 3,107  

 

14

 

The following table sets forth information regarding the allowance for loan losses by portfolio segment and impairment methodology.

 

   

December 31, 2017

 
   

Residential

   

Commercial

   

Commercial

                                 
   

Real Estate

   

Real Estate

   

and Industrial

   

Consumer

   

Purchased

   

Unallocated

   

Total

 
   

(Dollars in thousands)

 

Allowance for loan losses:

                                                       

Individually evaluated

  $ 307     $ 163     $ 144     $ 9     $ -     $ -     $ 623  

Collectively evaluated

    271       2,354       546       41       -       -       3,212  

ASC 310-30

    -       -       -       -       520       -       520  

Total

  $ 578     $ 2,517     $ 690     $ 50     $ 520     $ -     $ 4,355  

Loans:

                                                       

Individually evaluated

  $ 6,053     $ 3,867     $ 2,592     $ 315     $ -     $ -     $ 12,827  

Collectively evaluated

    86,722       251,812       175,164       3,488       -       -       517,186  

ASC 310-30

    -       -       -       -       244,177       -       244,177  

Total

  $ 92,775     $ 255,679     $ 177,756     $ 3,803     $ 244,177     $ -     $ 774,190  

 

   

June 30, 2017

 
   

Residential

   

Commercial

   

Commercial

                                 
   

Real Estate

   

Real Estate

   

and Industrial

   

Consumer

   

Purchased

   

Unallocated

   

Total

 
   

(Dollars in thousands)

 

Allowance for loan losses:

                                                       

Individually evaluated

  $ 252     $ 147     $ 149     $ 4     $ -     $ -     $ 552  

Collectively evaluated

    225       2,165       371       49       -       -       2,810  

ASC 310-30

    -       -       -       -       303       -       303  

Total

  $ 477     $ 2,312     $ 520     $ 53     $ 303     $ -     $ 3,665  

Loans:

                                                       

Individually evaluated

  $ 5,676     $ 1,759     $ 2,694     $ 296     $ -     $ -     $ 10,425  

Collectively evaluated

    92,014       254,521       171,774       4,073       -       -       522,382  

ASC 310-30

    -       -       -       -       246,388       -       246,388  

Total

  $ 97,690     $ 256,280     $ 174,468     $ 4,369     $ 246,388     $ -     $ 779,195  

 

The following table sets forth information regarding impaired loans. Loans accounted for under ASC 310-30 that have performed based on cash flow and accretable yield expectations determined at date of acquisition are not considered impaired assets and have been excluded from the tables below.

 

   

December 31, 2017

   

June 30, 2017

 
           

Unpaid

                   

Unpaid

         
   

Recorded

   

Principal

   

Related

   

Recorded

   

Principal

   

Related

 
   

Investment

   

Balance

   

Allowance

   

Investment

   

Balance

   

Allowance

 
   

(Dollars in thousands)

 

Impaired loans without a valuation allowance:

                                               

Originated:

                                               

Residential real estate

  $ 3,848     $ 3,840     $ -     $ 4,052     $ 4,084     $ -  

Consumer

    276       303       -       250       271       -  

Commercial real estate

    2,482       2,477       -       359       354       -  

Commercial and industrial

    1,758       1,758       -       1,870       1,870       -  

Purchased:

                                               

Residential real estate

    54       54       -       1,056       1,099       -  

Commercial real estate

    10,589       13,408       -       8,696       11,468       -  

Commercial and industrial

    24       57       -       32       65       -  

Total

    19,031       21,897       -       16,315       19,211       -  
                                                 

Impaired loans with a valuation allowance:

                                               

Originated:

                                               

Residential real estate

    2,205       2,186       307       1,624       1,595       252  

Consumer

    39       41       9       46       55       4  

Commercial real estate

    1,385       1,374       163       1,400       1,388       147  

Commercial and industrial

    834       834       144       824       824       149  

Purchased:

                                               

Residential real estate

    166       180       4       -       -       -  

Commercial real estate

    4,676       5,102       190       3,528       3,929       176  

Commercial and industrial

    362       421       321       94       108       55  

Total

    9,667       10,138       1,138       7,516       7,899       783  

Total impaired loans

  $ 28,698     $ 32,035     $ 1,138     $ 23,831     $ 27,110     $ 783  

 

15

 

The following tables set forth information regarding interest income recognized on impaired loans.

 

   

Three Months Ended December 31,

 
   

2017

   

2016

 
   

Average

   

Interest

   

Average

   

Interest

 
   

Recorded

   

Income

   

Recorded

   

Income

 
   

Investment

   

Recognized

   

Investment

   

Recognized

 
   

(Dollars in thousands)

 

Impaired loans without a valuation allowance:

                               

Originated:

                               

Residential real estate

  $ 3,992     $ 38     $ 3,730     $ 62  

Consumer

    285       7       200       8  

Commercial real estate

    2,454       1       466       15  

Commercial and industrial

    1,794       2       1,080       33  

Purchased:

                               

Residential real estate

    566       -       1,087       -  

Commercial real estate

    9,814       102       4,705       47  

Commercial and industrial

    26       -       32       -  

Total

    18,931       150       11,300       165  
                                 

Impaired loans with a valuation allowance:

                               

Originated:

                               

Residential real estate

    1,904       42       1,952       73  

Consumer

    32       1       93       2  

Commercial real estate

    1,388       27       1,115       31  

Commercial and industrial

    850       2       504       12  

Purchased:

                               

Residential real estate

    83       1       -       -  

Commercial real estate

    4,108       38       1,423       7  

Commercial and industrial

    228       3       28       2  

Total

    8,593       114       5,115       127  

Total impaired loans

  $ 27,524     $ 264     $ 16,415     $ 292  

 

   

Six Months Ended December 31,

 
   

2017

   

2016

 
   

Average

   

Interest

   

Average

   

Interest

 
   

Recorded

   

Income

   

Recorded

   

Income

 
   

Investment

   

Recognized

   

Investment

   

Recognized

 
   

(Dollars in thousands)

 

Impaired loans without a valuation allowance:

                               

Originated:

                               

Residential real estate

  $ 4,012     $ 74     $ 3,550     $ 111  

Consumer

    273       13       219       11  

Commercial real estate

    1,756       94       461       23  

Commercial and industrial

    1,819       39       725       36  

Purchased:

                               

Residential real estate

    729       -       1,100       3  

Commercial real estate

    9,441       182       4,661       99  

Commercial and industrial

    28       -       21       -  

Total

    18,058       402       10,737       283  
                                 

Impaired loans with a valuation allowance:

                               

Originated:

                               

Residential real estate

    1,811       63       1,917       89  

Consumer

    36       2       97       4  

Commercial real estate

    1,392       49       1,155       49  

Commercial and industrial

    841       6       336       12  

Purchased:

                               

Residential real estate

    55       1       -       -  

Commercial real estate

    3,915       65       1,443       24  

Commercial and industrial

    183       3       19       2  

Total

    8,233       189       4,967       180  

Total impaired loans

  $ 26,291     $ 591     $ 15,704     $ 463  

 

16

 

Credit Quality

 

The Company utilizes a ten-point internal loan rating system for commercial real estate, construction, commercial and industrial, and certain residential loans as follows:

 

Loans rated 1 – 6: Loans in these categories are considered “pass” rated loans. Loans in categories 1-5 are considered to have low to average risk. Loans rated 6 are considered marginally acceptable business credits and have more than average risk.

 

Loans rated 7: Loans in this category are considered “special mention.” These loans show signs of potential weakness and are being closely monitored by management.

 

Loans rated 8: Loans in this category are considered “substandard.” Loans classified as substandard are inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. Assets so classified have a well-defined weakness or weaknesses that jeopardize the orderly repayment of the debt.

 

Loans rated 9: Loans in this category are considered “doubtful.” Loans classified as doubtful have all the weaknesses inherent in one graded 8 with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions and values, highly questionable and improbable.

 

Loans rated 10: Loans in this category are considered “loss” and of such little value that their continuance as loans is not warranted.

 

On an annual basis, or more often if needed, the Company formally reviews the ratings of all loans subject to risk ratings. Annually, the Company engages an independent third-party to review a significant portion of loans within these segments. Management uses the results of these reviews as part of its annual review process. Risk ratings on purchased loans, with and without evidence of credit deterioration at acquisition, are determined relative to the Company’s recorded investment in that loan, which may be significantly lower than the loan’s unpaid principal balance. 

 

The following tables present the Company’s loans by risk rating.

 

   

December 31, 2017

 
   

Originated Portfolio

                 
   

Commercial

   

Commercial

           

Purchased

         
   

Real Estate

   

and Industrial

   

Residential(1)

   

Portfolio

   

Total

 
   

(Dollars in thousands)

 

Loans rated 1- 6

  $ 248,576     $ 174,482     $ 13,754     $ 231,544     $ 668,356  

Loans rated 7

    4,537       2,186       66       3,021       9,810  

Loans rated 8

    2,566       1,088       1,298       9,612       14,564  

Loans rated 9

    -       -       19       -       19  

Loans rated 10

    -       -       -       -       -  
    $ 255,679     $ 177,756     $ 15,137     $ 244,177     $ 692,749  

 

   

June 30, 2017

 
   

Originated Portfolio

                 
   

Commercial

   

Commercial

           

Purchased

         
   

Real Estate

   

and Industrial

   

Residential(1)

   

Portfolio

   

Total

 
   

(Dollars in thousands)

 

Loans rated 1- 6

  $ 253,041     $ 171,160     $ 10,039     $ 229,980     $ 664,220  

Loans rated 7

    2,686       2,483       71       9,622       14,862  

Loans rated 8

    554       825       803       6,786       8,968  

Loans rated 9

    -       -       19       -       19  

Loans rated 10

    -       -       -       -       -  
    $ 256,281     $ 174,468     $ 10,932     $ 246,388     $ 688,069  

 

 

(1)

Certain of the Company’s loans made for commercial purposes, but secured by residential collateral, are rated under the Company’s risk-rating system.

 

17

 

Troubled Debt Restructurings

 

The following table shows the Company’s post-modification balance of TDRs by type of modification.

 

   

Three Months Ended December 31,

   

Six Months Ended December 31,

 
   

2017

   

2016

   

2017

   

2016

 
   

Number of

   

Recorded

   

Number of

   

Recorded

   

Number of

   

Recorded

   

Number of

   

Recorded

 
   

Contracts

   

Investment

   

Contracts

   

Investment

   

Contracts

   

Investment

   

Contracts

   

Investment

 
   

(Dollars in thousands)

 

Extended maturity

    -     $ -       1     $ 154       1     $ 18       1     $ 154  

Adjusted interest rate

    1       15       2       135       1       15       3       144  

Rate and maturity

    3       2,263       -       -       3       2,263       1       334  

Principal deferment

    2       283       1       161       3       938       1       161  

Court ordered concession

    -       -       -       -       -       -       -       -  
      6     $ 2,561       4     $ 450       8     $ 3,234       6     $ 793  

 

The following table shows loans modified in a TDR and the change in the recorded investment subsequent to the modifications occurring.

 

   

Three Months Ended December 31,

 
   

2017

   

2016

 
           

Recorded

   

Recorded

           

Recorded

   

Recorded

 
   

Number of

   

Investment

   

Investment

   

Number of

   

Investment

   

Investment

 
   

Contracts

   

Pre-Modification

   

Post-Modification

   

Contracts

   

Pre-Modification

   

Post-Modification

 
   

(Dollars in thousands)

 

Originated portfolio:

                                               

Residential real estate

    2     $ 29     $ 30       3     $ 266     $ 289  

Home equity

    -       -       -       -       -       -  

Commercial real estate

    2       2,079       2,140       -       -       -  

Commercial and industrial

    -       -       -       1       91       161  

Consumer

    -       -       -       -       -       -  

Total originated portfolio

    4       2,108       2,170       4       357       450  

Purchased portfolio:

                                               

Residential real estate

    -       -       -       -       -       -  

Commercial real estate

    1       123       123       -       -       -  

Commercial and industrial

    1       268       268       -       -       -  

Total purchased portfolio

    2       391       391       -       -       -  

Total

    6     $ 2,499     $ 2,561       4     $ 357     $ 450  

 

   

Six Months Ended December 31,

 
   

2017

   

2016

 
           

Recorded

   

Recorded

           

Recorded

   

Recorded

 
   

Number of

   

Investment

   

Investment

   

Number of

   

Investment

   

Investment

 
   

Contracts

   

Pre-Modification

   

Post-Modification

   

Contracts

   

Pre-Modification

   

Post-Modification

 
   

(Dollars in thousands)

 

Originated portfolio:

                                               

Residential real estate

    3     $ 47     $ 48       4     $ 275     $ 298  

Home equity

    -       -       -       -       -       -  

Commercial real estate

    2       2,079       2,140       -       -       -  

Commercial and industrial

    1       655       655       1       91       161  

Consumer

    -       -       -       -       -       -  

Total originated portfolio

    6       2,781       2,843       5       366       459  

Purchased portfolio:

                                               

Residential real estate

    -       -       -       -       -       -  

Commercial real estate

    1       123       123       -       -       -  

Commercial and industrial

    1       268       268       1       334       334  

Total purchased portfolio

    2       391       391       1       334       334  

Total

    8     $ 3,172     $ 3,234       6     $ 700     $ 793  

 

The Company considers TDRs past due 90 days or more to be in payment default. No loans modified in a TDR in the last twelve months defaulted during the three and six months ended December 31, 2017. As of December 31, 2016 and 2017, there were no further commitments to lend to borrowers associated with loans modified in a TDR.

 

18

 

ASC 310-30 Loans

 

The following tables present a summary of loans accounted for under ASC 310-30 that were acquired by the Company during the period indicated.

 

   

Three Months Ended December 31, 2017

   

Three Months Ended December 31, 2016

 
   

(Dollars in thousands)

 

Contractually required payments receivable

  $ 49,408     $ 68,466  

Nonaccretable difference

    (1,667 )     (977 )

Cash flows expected to be collected

    47,741       67,489  

Accretable yield

    (12,939 )     (21,456 )

Fair value of loans acquired

  $ 34,802     $ 46,033  

 

   

Six Months Ended

December 31, 2017

   

Six Months Ended

December 31, 2016

 
   

(Dollars in thousands)

 

Contractually required payments receivable

  $ 55,320     $ 94,720  

Nonaccretable difference

    (1,824 )     (3,494 )

Cash flows expected to be collected

    53,496       91,226  

Accretable yield

    (15,043 )     (31,340 )

Fair value of loans acquired

  $ 38,453     $ 59,886  

 

Certain loans accounted for under ASC 310-30 that were acquired by the Company are not accounted for using the income recognition model because the Company cannot reasonably estimate cash flows expected to be collected. These loans when acquired are placed on nonaccrual. The carrying amounts of such loans are as follows.

 

   

As of and for the Three Months Ended

December 31, 2017

   

As of and for the Six

Months Ended

December 31, 2017

 
   

(Dollars in thousands)

 

Loans acquired during the period

  $ 5     $ 5  

Loans at end of period

    6,901       6,901  

 

The following tables summarize the activity in the accretable yield for loans accounted for under ASC 310-30.

 

   

Three Months Ended

December 31, 2017

   

Three Months Ended

December 31, 2016

 
   

(Dollars in thousands)

 

Beginning balance

  $ 122,923     $ 124,023  

Acquisitions

    12,939       21,456  

Accretion

    (4,244 )     (4,656 )

Reclassifications from non-accretable difference to accretable yield

    1,095       973  

Disposals and other changes

    (7,810 )     (13,373 )

Ending balance

  $ 124,903     $ 128,423  

 

   

Six Months Ended

December 31, 2017

   

Six Months Ended

December 31, 2016

 
   

(Dollars in thousands)

 

Beginning balance

  $ 131,197     $ 124,151  

Acquisitions

    15,043       31,340  

Accretion

    (8,669 )     (9,308 )

Reclassifications from non-accretable difference to accretable yield

    4,523       1,131  

Disposals and other changes

    (17,191 )     (18,891 )

Ending balance

  $ 124,903     $ 128,423  

 

The following table provides information related to the unpaid principal balance and carrying amounts of ASC 310-30 loans.

 

   

December 31, 2017

   

June 30, 2017

 
   

(Dollars in thousands)

 

Unpaid principal balance

  $ 266,374     $ 271,709  

Carrying amount

    236,047       239,583  

 

19

 

5. Transfers and Servicing of Financial Assets

 

The Company sells loans in the secondary market and for certain loans, retains the servicing responsibility. Consideration for the sale includes the cash received as well as the related servicing rights asset. The Company receives fees for the services provided.

 

Capitalized servicing rights as of December 31, 2017 totaled $3.0 million, compared to $2.8 million as of June 30, 2017, and are classified as loan servicing rights, net, on the consolidated balance sheets.

 

Mortgage loans sold in the quarter ended December 31, 2017 totaled $17.6 million, compared to $17.7 million in the quarter ended December 31, 2016. Mortgage loans sold in the six months ended December 31, 2017 totaled $36.7 million, compared to $42.7 million in the six months ended December 31, 2016. Mortgage loans serviced for others totaled $9.3 million at December 31, 2017 and $10.7 million at June 30, 2017. Additionally, the Company was servicing commercial loans participated out to various other institutions amounting to $29.3 million and $25.2 million at December 31, 2017 and June 30, 2017, respectively.

 

SBA loans sold during the quarter ended December 31, 2017 totaled $3.4 million, compared to $17.5 million in the quarter ended December 31, 2016. SBA loans sold in the six months ended December 31, 2017 totaled $12.5 million, compared to $24.8 million in the six months ended December 31, 2016. SBA loans serviced for others totaled $146.8 million at December 31, 2017 and $144.4 million at June 30, 2017.

 

Mortgage and SBA loans serviced for others are accounted for as sales and therefore are not included on the accompanying consolidated balance sheets. The risks inherent in mortgage servicing assets and SBA servicing assets relate primarily to changes in prepayments that result from shifts in interest rates.

 

Contractually specified servicing fees were $234 thousand and $248 thousand for the quarters ended December 31, 2017 and 2016, respectively, and were included as a component of loan-related fees within noninterest income. Contractually specified servicing fees were $497 thousand and $408 thousand for the six months ended December 31, 2017 and 2016, respectively.  

 

The significant assumptions used in the valuation of the servicing rights included a range of discount rates from 9.6% to 15.8% and a weighted average prepayment speed assumption of 8.8%.

 

6. Earnings Per Share (EPS)

 

EPS is computed by dividing net income allocated to common shareholders by the weighted average common shares outstanding (including participating securities). The Company’s only participating securities are unvested restricted stock awards that contain non-forfeitable rights to dividends. The following table shows the weighted average number of shares outstanding for the periods indicated. Shares issuable relative to stock options granted have been reflected as an increase in the shares outstanding used to calculate diluted EPS, after applying the treasury stock method. The number of shares outstanding for basic and diluted EPS is presented as follows:

 

   

Three months Ended December 31,

   

Six months Ended December 31,

 
   

2017

   

2016

   

2017

   

2016

 
   

(In thousands, except share and per share data)

 
                                 

Net income

  $ 3,304     $ 3,100     $ 7,890     $ 4,851  
                                 

Weighted average shares used in calculation of basic EPS

    8,924,495       8,831,235       8,883,003       8,968,690  

Incremental shares from assumed exercise of dilutive securities

    243,589       33,383       246,007       30,372  

Weighted average shares used in calculation of diluted EPS

    9,168,084       8,864,618       9,129,010       8,999,062  
                                 

Basic earnings per common share

  $ 0.37     $ 0.35     $ 0.89     $ 0.54  

Diluted earnings per common share

  $ 0.36     $ 0.35     $ 0.86     $ 0.54  

 

For the three and six months ended December 31, 2017 and 2016, the following stock options were excluded from the calculation of diluted EPS due to the exercise price of these options exceeding the average market price of the Company’s common stock for the period. These options, which were not dilutive at that date, may potentially dilute EPS in the future.

 

   

Three Months Ended December 31,

   

Six Months Ended December 31,

 
   

2017

   

2016

   

2017

   

2016

 

Stock options

    -       714,545       -       714,545  

 

20

 

7. Derivatives and Hedging Activities

 

The Company has stand-alone derivative financial instruments in the form of interest rate caps that derive their value from a fee paid and are adjusted to fair value based on index and strike rate, and swap agreements that derive their value from the underlying interest rate. These transactions involve both credit and market risk. The notional amounts are amounts on which calculations, payments and the value of the derivative are based. Notional amounts do not represent direct credit exposures. Direct credit exposure arises in the event of nonperformance by the counterparties to these agreements, and is limited to the net difference between the calculated amounts to be received and paid, if any. Such differences, which represent the fair value of the derivative instruments, are reflected on the Company's balance sheet as derivative assets and derivative liabilities. The Company controls the credit risk of its financial contracts through credit approvals, limits and monitoring procedures, and does not expect any counterparties to fail to meet their obligations.

 

The Company currently holds derivative instruments that contain credit-risk related features that are in a net liability position, which may require that collateral be assigned to dealer banks. At December 31, 2017, the Company had posted cash collateral totaling $1.7 million with dealer banks related to derivative instruments in a net liability position.

 

The Company does not offset fair value amounts recognized for derivative instruments. The Company does not net the amount recognized for the right to reclaim cash collateral against the obligation to return cash collateral arising from derivative instruments executed with the same counterparty under a master netting arrangement.

 

Risk Management Policies—Derivative Instruments

 

The Company evaluates the effectiveness of entering into any derivative instrument agreement by measuring the cost of such an agreement in relation to the reduction in net income volatility within an assumed range of interest rates.

 

Interest Rate Risk Management—Cash Flow Hedging Instruments

 

The Company uses variable rate debt as a source of funds for use in the Company's lending and investment activities and other general business purposes. These debt obligations expose the Company to variability in interest payments due to changes in interest rates. If interest rates increase, interest expense increases. Conversely, if interest rates decrease, interest expense decreases. Management believes it is prudent to limit the variability of a portion of its interest payments and, therefore, generally hedges a portion of its variable-rate interest payments.

 

Information pertaining to outstanding interest rate caps and swap agreements used to hedge variable rate debt is as follows.

 

December 31, 2017

 

Notional Amount

 

Inception

Date

 

Termination

Date

 

Index

 

Receive

Rate

   

Pay Rate

   

Strike

Rate

   

Unrealized Loss

   

Fair

Value

 

Balance Sheet

Location

 

(Dollars in thousands)

 

Interest rate swaps:

                                                   
$ 5,000  

July 2013

 

July 2033

 

3 Mo. LIBOR

    1.69 %     3.38 %     n/a     $ (619 )   $ (619 )

Other Liabilities

 
  5,000  

July 2013

 

July 2028

 

3 Mo. LIBOR

    1.69 %     3.23 %     n/a       (409 )     (409 )

Other Liabilities

 
  5,000  

July 2013

 

July 2023

 

3 Mo. LIBOR

    1.69 %     2.77 %     n/a       (144 )     (144 )

Other Liabilities

 

Interest rate caps:

                                                   
  6,000  

October 2014

 

September 2019

 

3 Mo. LIBOR

    n/a       n/a       2.50 %     (116 )     4  

Other Assets

 
  10,000  

March 2015

 

February 2020

 

3 Mo. LIBOR

    n/a       n/a       2.50 %     (165 )     13  

Other Assets

 
$ 31,000                                       $ (1,453 )   $ (1,155 )    

 

June 30, 2017

 

Notional Amount

 

Inception

Date

 

Termination

Date

 

Index

 

Receive

Rate

   

Pay

Rate

   

Strike

Rate

   

Unrealized

Loss

   

Fair

Value

 

Balance Sheet

Location

 

(Dollars in thousands)

 

Interest rate swaps:

                                                   
$ 5,000  

July 2013

 

July 2033

 

3 Mo. LIBOR

    1.30 %     3.38 %     n/a     $ (666 )   $ (666 )

Other Liabilities

 
  5,000  

July 2013

 

July 2028

 

3 Mo. LIBOR

    1.30 %     3.23 %     n/a       (471 )     (471 )

Other Liabilities

 
  5,000  

July 2013

 

July 2023

 

3 Mo. LIBOR

    1.30 %     2.77 %     n/a       (218 )     (218 )

Other Liabilities

 

Interest rate caps:

                                                   
  6,000  

October 2014

 

September 2019

 

3 Mo. LIBOR

    n/a       n/a       2.50 %     (142 )     4  

Other Assets

 
  10,000  

March 2015

 

February 2020

 

3 Mo. LIBOR

    n/a       n/a       2.50 %     (186 )     14  

Other Assets

 
$ 31,000                                       $ (1,683 )   $ (1,337 )    

 

During the three and six months ended December 31, 2017 and 2016, no interest rate cap or swap agreements were terminated prior to maturity. Changes in the fair value of interest rate caps and swaps designated as hedging instruments of the variability of cash flows associated with variable rate debt are reported in other comprehensive income. These amounts subsequently are reclassified into interest expense as a yield adjustment in the same period in which the related interest on the debt affects earnings. Risk management results for the three and six months ended December 31, 2017 and 2016 related to the balance sheet hedging of variable rate debt indicates that the hedges were effective.

 

21

 

8. Other Comprehensive Income

 

The components of other comprehensive income are as follows:

 

   

Three Months Ended December 31,

 
   

2017

   

2016

 
   

Pre-tax

   

Tax Expense

   

After-tax

   

Pre-tax

   

Tax Expense

   

After-tax

 
   

Amount

   

(Benefit)

   

Amount

   

Amount

   

(Benefit)

   

Amount

 
   

(Dollars in thousands)

 

Change in net unrealized loss on available-for-sale securities

  $ (297 )   $ (113 )   $ (184 )   $ (1,336 )   $ (507 )   $ (829 )
                                                 

Change in accumulated loss on effective cash flow hedges

    160       60       100       1,486       566       920  

Reclassification adjustment for losses included in net income

    26       10       16       8       3       5  

Total derivatives and hedging activities

    186       70       116       1,494       569       925  

Total other comprehensive (loss) income

  $ (111 )   $ (43 )   $ (68 )   $ 158     $ 62     $ 96  

 

   

Six Months Ended December 31,

 
   

2017

   

2016

 
   

Pre-tax

   

Tax Expense

   

After-tax

   

Pre-tax

   

Tax Expense

   

After-tax

 
   

Amount

   

(Benefit)

   

Amount

   

Amount

   

(Benefit)

   

Amount

 
   

(Dollars in thousands)

 

Change in net unrealized gain or loss on available-for-sale securities

  $ (175 )   $ (68 )   $ (107 )   $ (1,414 )   $ (537 )   $ (877 )
                                                 

Change in accumulated loss on effective cash flow hedges

    181       68       113       1,633       624       1,009  

Reclassification adjustment for losses included in net income

    49       19       30       14       5       9  

Total derivatives and hedging activities

    230       87       143       1,647       629       1,018  

Total other comprehensive income

  $ 55     $ 19     $ 36     $ 233     $ 92     $ 141  


Accumulated other comprehensive loss is comprised of the following:

 

   

December 31, 2017

   

June 30, 2017

 
   

(Dollars in thousands)

 

Unrealized loss on available-for-sale securities

  $ (1,123 )   $ (948 )

Tax effect

    428       360  

After tax amount

    (695 )     (588 )

Unrealized loss on cash flow hedges

    (1,453 )     (1,683 )

Tax effect

    552       639  

After tax amount

    (901 )     (1,044 )

Accumulated other comprehensive loss

  $ (1,596 )   $ (1,632 )

 

9. Commitments and Contingencies

 

Commitments

 

The Company is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers and to reduce its own exposure to fluctuations in interest rates. These financial instruments include commitments to extend credit, standby letters of credit, and commitments to fund investments. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized on the consolidated balance sheets. The contract amounts of those instruments reflect the extent of involvement the Company has in particular classes of financial instruments.

 

The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments.

 

Financial instruments with contract amounts which represent credit risk are as follows:

 

   

December 31, 2017

   

June 30, 2017

 
   

(Dollars in thousands)

 

Commitments to grant loans

  $ 40,537     $ 15,244  

Unfunded commitments under lines of credit

    33,757       31,858  

Standby letters of credit

    3,460       3,400  

Commitment to fund investments

    -       1,000  

 

22

 

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 or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer’s credit worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based on management’s credit evaluation of the counter party. Collateral held varies but may include accounts receivable, inventory, property, plant and equipment, and income-producing commercial properties. The Company has recorded an allowance for possible losses on commitments and unfunded loans totaling $79 thousand and $39 thousand recorded in other liabilities at December 31, 2017 and June 30, 2017, respectively.

 

As of December 31, 2017, the Company does not have a commitment to fund investments.

 

Contingencies

 

The Company and its subsidiary are parties to litigation and claims arising in the normal course of business. Management believes that the liabilities, if any, arising from such litigation and claims will not be material to the Company’s consolidated financial position or results of operations.

 

10.

Stock-Based Compensation

 

In March 2016, the FASB issued ASU 2016-09. The new guidance simplifies several aspects of the accounting for share-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities, and classification on the statement of cash flows. Entities are now required to recognize the income tax effects of awards in the income statement when the awards vest or are settled.

 

The Company adopted ASU 2016-09 in the first quarter of fiscal 2018. Upon adoption, the most significant impact of this amendment resulted from the prospective application of current excess tax benefits and deficiencies being recognized in income tax expense, which previously would have been recognized in additional paid-in capital.

 

In addition to the excess tax benefit treatment, the amendment removed the assumed proceeds related to the excess tax benefit from the calculation of diluted shares. Additionally, dividends paid to employees for nonvested equity shares are also recognized through income tax expense.

 

For the six months ended December 31, 2017, in totality, the adoption of ASU 2016-09 reduced the Company's income tax expense by $1.1 million. The excess tax benefit under the new guidance is treated as a discrete item in the period in which it occurs, and will vary from quarter to quarter as a function of the volume of restricted stock that vests, the volume of options that are exercised and the market price of the Company's stock in comparison to the compensation cost recognized in the consolidated financial statements.

 

Upon adoption, the Company made a policy election to record forfeitures as they occur rather than make use of an estimate. The other provisions did not have a material impact on the Company's consolidated financial statements upon adoption.

 

11.

Income Taxes

 

On December 22, 2017, President Donald Trump signed into law the "Tax Cuts and Jobs Act", which among other items reduces the federal corporate tax rate to 21% from the previous federal corporate tax rate of 35%. The change in federal tax rate resulted in a $762 thousand decrease in federal income tax expense during the quarter ended December 31, 2017. Of this total, $328 thousand was related to the decrease in the federal corporate income tax rate for the three months ended December 31, 2017 and $434 thousand was related to income tax expense previously recorded in the three months ended September 30, 2017, to arrive at the required blended federal corporate income tax rate of 28.0% for fiscal 2018.

 

The change in the federal corporate tax rate also required the Company to revalue its deferred tax assets at the new federal rate. The Company performed an analysis to determine the impact of the revaluation of the deferred tax asset, which included a forecast of the expected deferred tax asset as of June 30, 2018. The result was a write-down of the deferred tax asset of $498 thousand, which increased federal income tax expense in the quarter ended December 31, 2017.

 

Included in the deferred tax asset was the revaluation of the tax on the available-for-sale securities, interest rate swaps and interest rate caps. Currently, the effect of the revaluation is an adjustment to the income tax provision and would remain in accumulated other comprehensive income (“AOCI”) until the investments either mature or are sold or the interest rate swaps and caps mature or are terminated. The FASB is currently contemplating whether this “stranded” AOCI should be reclassified to retained earnings. Pending a ruling by the FASB on the financial reporting effects of the Tax Cuts and Jobs Act, the Company left the “stranded” AOCI in AOCI, and, if required, will reclassify the amount when the final ruling is announced. The effect would be a reclassification of $283 thousand from AOCI to retained earnings, with no net effect on shareholders' equity.

 

23

 

12. Fair Value Measurements

 

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction (that is, not a forced liquidation or distressed sale) between market participants at the measurement date under current market conditions. The Company uses prices and inputs that are current as of the measurement date, including during periods of market dislocation. In periods of market dislocation, the observability of prices and inputs may be reduced for many instruments. This condition could cause an instrument to be reclassified from one level to another. When market assumptions are not readily available, the Company’s own assumptions are set to reflect those that market participants would use in pricing the asset or liability at the measurement date. If there has been a significant decrease in the volume and level of activity for the asset or liability, regardless of the valuation technique(s) used, the objective of a fair value measurement remains the same.

 

ASC 820 defines fair value and establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). The three levels of the fair value hierarchy under ASC 820 are described below:

 

Level 1 — Inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date.

 

Level 2 — Valuations based on significant observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.

 

Level 3 — Prices or valuations that require inputs that are both significant to the fair value measurement and unobservable.

 

To the extent that valuation is based on models or inputs that are less observable or unobservable in the market, the determination of fair value requires more judgment. Accordingly, the degree of judgment exercised by the Company in determining fair value is greatest for instruments categorized in Level 3. A financial instrument’s level within the fair value hierarchy is based on the lowest level of any input that is significant to the fair value measurement.

 

Valuation techniques - There have been no changes in the valuation techniques used during the current period.

 

Transfers - There were no transfers of assets and liabilities measured at fair value on a recurring or nonrecurring basis during the current period.

 

Assets and Liabilities Measured at Fair Value on a Recurring Basis:

 

Available-for-sale securities - Where quoted prices are available in an active market, securities are classified within Level 1 of the valuation hierarchy. Examples of such instruments include publicly-traded common and preferred stocks. If quoted prices are not available, then fair values are estimated by using pricing models ( i.e., matrix pricing) and market interest rates and credit assumptions or quoted prices of securities with similar characteristics and are classified within Level 2 of the valuation hierarchy. Examples of such instruments include government agency and government sponsored enterprise mortgage-backed securities, as well as certain preferred and trust preferred stocks. Level 3 securities are securities for which significant unobservable inputs are utilized.

 

Certain investments are measured at fair value using the net asset value per share as a practical expedient. These investments include a fund that seeks to invest in securities either issued or guaranteed by the U.S. government or its agencies, as well as a fund that primarily invests in the federally guaranteed portion of SBA 7(a) loans. The Company’s investment in securities either issued or guaranteed by the U.S. government or its agencies can be redeemed daily at the closing net asset value per share. The Company’s investment in SBA 7(a) loans can be redeemed quarterly with sixty days’ notice. In accordance with ASU 2015-07, these investments have not been included in the fair value hierarchy.

 

Derivative financial instruments - The valuation of the Company’s interest rate swaps and caps are determined using widely accepted valuation techniques including discounted cash flow analyses on the expected cash flows of derivatives. These analyses reflect the contractual terms of the derivatives, including the period to maturity, and use observable market-based inputs, including forward interest rate curves and implied volatilities. Unobservable inputs, such as credit valuation adjustments are insignificant to the overall valuation of the Company’s derivative financial instruments. Accordingly, the Company has determined that its interest rate derivatives fall within Level 2 of the fair value hierarchy.

 

The fair value of derivative loan commitments and forward loan sale agreements are estimated using the anticipated market price based on pricing indications provided from syndicate banks. These commitments and agreements are categorized as Level 2. The fair value of such instruments was nominal at each date presented.

 

24

 

Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis:

 

Collateral dependent impaired loans - Valuations of impaired loans measured at fair value are determined by a review of collateral values. Certain inputs used in appraisals are not always observable, and therefore impaired loans are generally categorized as Level 3 within the fair value hierarchy.

 

Real estate owned and other repossessed collateral - The fair values of real estate owned and other repossessed collateral are estimated based upon appraised values less estimated costs to sell. Certain inputs used in appraisals are not always observable, and therefore may be categorized as Level 3 within the fair value hierarchy. When inputs used in appraisals are primarily observable, they are classified as Level 2.

 

Loan servicing rights - The fair value of the servicing rights is based on a valuation model that calculates the present value of estimated future net servicing income. Adjustments are only recorded when the discounted cash flows derived from the valuation model are less than the carrying value of the asset. Certain inputs are not observable, and therefore loan servicing rights are generally categorized as Level 3 within the fair value hierarchy.

 

Fair Value of other Financial Instruments:

 

Cash and cash equivalents - The fair value of cash, due from banks, interest bearing deposits and Federal Home Loan Bank of Boston (“FHLBB”) overnight deposits approximates their relative book values, as these financial instruments have short maturities.

 

FHLBB stock - The carrying value of FHLBB stock approximates fair value based on redemption provisions of the FHLBB.

 

Loans - Fair values are estimated for portfolios of loans with similar financial characteristics. The fair value of performing loans is calculated by discounting scheduled cash flows through the estimated maturity using estimated market discount rates that reflect the credit and interest rate risk inherent in the loan. The estimates of maturity are based on the Company’s historical experience with repayments for each loan classification, modified, as required, by an estimate of the effect of current economic conditions, lending conditions and the effects of estimated prepayments.

 

Loans held for sale - The fair value of loans held-for-sale is estimated based on bid quotations received from loan dealers.

 

Interest receivable - The fair value of this financial instrument approximates the book value as this financial instrument has a short maturity. It is the Company’s policy to stop accruing interest on loans past due by more than 90 days. Therefore, this financial instrument has been adjusted for estimated credit losses.

 

Deposits - The fair value of deposits with no stated maturity, such as noninterest-bearing demand deposits, savings, NOW accounts and money market accounts, is equal to the amount payable on demand. The fair values of time deposits are based on the discounted value of contractual cash flows. The discount rate is estimated using the rates currently offered for deposits of similar remaining maturities. The fair value estimates do not include the benefit that results from the low-cost funding provided by the deposit liabilities compared to the cost of borrowing funds in the market. If that value were considered, the fair value of the Company’s net assets could increase.

 

FHLBB advances, capital lease obligations and subordinated debentures - The fair value of the Company’s borrowings with the FHLBB is estimated by discounting the cash flows through maturity or the next re-pricing date based on current rates available to the Company for borrowings with similar maturities. The fair value of the Company’s capital lease obligations and subordinated debentures are estimated by discounting the cash flows through maturity based on current rates available to the Company for borrowings with similar maturities.

 

Off-Balance Sheet Credit-Related Instruments - Fair values for off-balance-sheet, credit-related financial instruments are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standing. The fair value of such instruments was nominal at each date presented.

 

25

 

Assets and liabilities measured at fair value on a recurring basis are summarized below. 

 

   

December 31, 2017

 
   

Total

   

Level 1

   

Level 2

   

Level 3

 

 

 

(Dollars in thousands)

 
Assets                                

Available-for-sale securities:

                               

U.S. Government agency securities

  $ 57,092     $ -     $ 57,092     $ -  

Agency mortgage-backed securities

    28,580       -       28,580       -  

Other investments measured at net asset value(1)

    6,667       -       -       -  

Other assets – interest rate caps

    17       -       17       -  

Liabilities

                               

Other liabilities – interest rate swaps

  $ 1,172     $ -     $ 1,172     $ -  

 

   

June 30, 2017

 
   

Total

   

Level 1

   

Level 2

   

Level 3

 

 

 

(Dollars in thousands)

 
Assets                                

Available-for-sale securities:

                               

U.S. Government agency securities

  $ 57,168     $ -     $ 57,168     $ -  

Agency mortgage-backed securities

    32,903       -       32,903       -  

Other investments measured at net asset value(1)

    6,622       -       -       -  

Other assets – interest rate caps

    18       -       18       -  

Liabilities

                               

Other liabilities – interest rate swap

  $ 1,355     $ -     $ 1,355     $ -  

 

 

(1)

In accordance with ASU 820-10, certain investments that are measured at fair value using the net asset value per share (or its equivalent) as a practical expedient have not been classified in the fair value hierarchy. The fair value amount presented in the table are intended to permit reconciliation of the fair value amount to the consolidated financial statements.

 

Assets measured at fair value on a nonrecurring basis are summarized below.

 

   

December 31, 2017

 
   

Total

   

Level 1

   

Level 2

   

Level 3

 
   

(Dollars in thousands)

 

Collateral dependent impaired loans

  $ 2,217     $ -     $ -     $ 2,217  

Real estate owned and other repossessed collateral

    910       -       -       910  

Loan servicing rights

    3,005       -       -       3,005  

 

   

June 30, 2017

 
   

Total

   

Level 1

   

Level 2

   

Level 3

 
   

(Dollars in thousands)

 

Collateral dependent impaired loans

  $ 1,011     $ -     $ -     $ 1,011  

Real estate owned and other repossessed collateral

    826       -       -       826  

Loan servicing rights

    2,846       -       -       2,846  

 

The table below presents quantitative information about significant unobservable inputs (Level 3) for assets measured at fair value on a nonrecurring basis at the dates indicated.

 

   

Fair Value

   
   

December 31,

2017

   

June 30,
2017

 

Valuation Technique

   

(Dollars in thousands)

   

Collateral dependent impaired loans

  $ 2,217     $ 1,011  

Appraisal of collateral(1)

Real estate owned and other repossessed collateral

    910       826  

Appraisal of collateral(1)

Loan servicing rights

    3,005       2,846  

Discounted cash flow(2)

 

(1) Fair value is generally determined through independent appraisals of the underlying collateral. The Company may also use another available source of collateral assessment to determine a reasonable estimate of the fair value of the collateral. Appraisals may be adjusted by management for qualitative factors such as economic factors and estimated liquidation expenses. The range of these possible adjustments was 5% to 81%.

(2) Fair value is determined using a discounted cash flow model. The unobservable inputs include anticipated rate of loan prepayments and discount rates. The range of prepayment assumptions used was 4.2% to 11.4%. For discount rates, the range was 9.6% to 15.8%.

 

26

 

The table below summarizes the total gains (losses) on assets measured at fair value on a non-recurring basis for the three and six months ended December 31, 2017 and 2016.

 

   

Three months Ended December 31,

   

Six months Ended December 31,

 
   

2017

   

2016

   

2017

   

2016

 
   

(In thousands)

 
                                 

Collateral dependent impaired loans

  $ (328 )   $ (273 )   $ (351 )   $ (363 )

Real estate owned and other repossessed collateral

    45       83       45       70  

Loan servicing rights

    110       (220 )     110       (220 )

Total

  $ (173 )   $ (410 )   $ (196 )   $ (513 )

 

The following table presents the estimated fair value of the Company's financial instruments.

 

   

Carrying

   

Fair Value Measurements at December 31, 2017

 
   

Amount

   

Total

   

Level 1

   

Level 2

   

Level 3

 
   

(Dollars in thousands)

 

Financial assets:

                                       

Cash and cash equivalents

  $ 128,223     $ 128,223     $ 128,223     $ -     $ -  

Available-for-sale securities

    85,672       85,672       -       85,672       -  

Other investments measured at net asset value(1)

    6,667       6,667       -       -       -  

Federal Home Loan Bank stock

    1,758       1,758       -       1,758       -  

Loans held for sale

    6,333       6,333       -       6,333       -  

Loans, net

    769,835       773,755       -       -       773,755  

Accrued interest receivable

    2,245       2,245       -       2,245       -  

Interest rate caps

    17       17       -       17       -  
                                         

Financial liabilities:

                                       

Deposits

    848,654       848,766       -       848,766       -  

Federal Home Loan Bank advances

    15,000       15,000       -       15,000       -  

Capital lease obligation

    741       768       -       768       -  

Subordinated debentures

    23,790       25,291       -       -       25,291  

Interest rate swaps

    1,172       1,172       -       1,172       -  

 

   

Carrying

   

Fair Value Measurements at June 30, 2017

 
   

Amount

   

Total

   

Level 1

   

Level 2

   

Level 3

 
   

(Dollars in thousands)

 

Financial assets:

                                       

Cash and cash equivalents

  $ 163,283     $ 163,283     $ 163,283     $ -     $ -  

Available-for-sale securities

    90,071       90,071       -       90,071       -  

Other investments measured at net asset value(1)

    6,622       6,622       -       -       -  

Federal Home Loan Bank stock

    1,938       1,938       -       1,938       -  

Loans held for sale

    4,699       4,699       -       4,699       -  

Loans, net

    775,530       776,579       -       -       776,579  

Accrued interest receivable

    2,111       2,111       -       2,111       -  

Interest rate caps

    18       18       -       18       -  
                                         

Financial liabilities:

                                       

Deposits

    889,850       889,877       -       889,877       -  

Federal Home Loan Bank advances

    20,011       20,057       -       20,057       -  

Capital lease obligation

    873       918       -       918       -  

Subordinated debentures

    23,620       25,677       -       -       25,677  

Interest rate swaps

    1,355       1,355       -       1,355       -  

 

 

(1)

In accordance with ASU 820-10, certain investments that are measured at fair value using the net asset value per share (or its equivalent) as a practical expedienthave not been classified in the fair value hierarchy. The fair value amount presented in the table are intended to permit reconciliation of the fair value amount to the consolidated financial statements.

 

27

 

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

 

The following discussion should be read in conjunction with the consolidated financial statements, notes and tables included in Northeast Bancorp’s Annual Report on Form 10-K for the fiscal year ended June 30, 2017, filed with the Securities and Exchange Commission.

 

A Note about Forward Looking Statements

 

This report contains certain “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended and Section 21E of the Securities Exchange Act of 1934, as amended, such as statements relating to Northeast Bancorp’s financial condition, prospective results of operations, future performance or expectations, plans, objectives, prospects, loan loss allowance adequacy, simulation of changes in interest rates, capital spending and finance sources and revenue sources. These statements relate to expectations concerning matters that are not historical facts. Accordingly, statements that are based on management’s projections, estimates, assumptions, and judgments constitute forward-looking statements. These forward-looking statements, which are based on various assumptions (some of which are beyond the Company’s control), may be identified by reference to a future period or periods, or by the use of forward-looking terminology such as “believe”, “expect”, “estimate”, “anticipate”, “continue”, “plan”, “approximately”, “intend”, “objective”, “goal”, “project”, or other similar terms or variations on those terms, or the future or conditional verbs such as “will”, “may”, “should”, “could”, and “would”. Although the Company believes that these forward-looking statements are based on reasonable estimates and assumptions, they are not guarantees of future performance and are subject to known and unknown risks, uncertainties, contingencies, and other factors. Accordingly, the Company cannot give you any assurance that its expectations will, in fact, occur or that its estimates or assumptions will be correct. The Company cautions you that actual results could differ materially from those expressed or implied by such forward-looking statements as a result of, among other factors, changes in interest rates and real estate values; competitive pressures from other financial institutions; weakness in general economic conditions on a national basis or in the local markets in which the Company operates, including changes which adversely affect borrowers’ ability to service and repay the Company’s loans; changes in loan defaults and charge-off rates; changes in the value of securities and other assets, adequacy of loan loss reserves, or deposit levels necessitating increased borrowing to fund loans and investments; changes in government regulation; operational risks including, but not limited to, cybersecurity breaches, fraud and natural disasters; the risk that the Company may not be successful in the implementation of its business strategy; the risk that intangibles recorded in the Company’s financial statements will become impaired; changes in assumptions used in making such forward-looking statements; and the other risks and uncertainties detailed in the Company’s Annual Report on Form 10-K for the fiscal year ended June 30, 2017 as updated in the Company’s Quarterly Reports on Form 10-Q and other filings submitted to the Securities and Exchange Commission. These forward-looking statements speak only as of the date of this report and the Company does not undertake any obligation to update or revise any of these forward-looking statements to reflect events or circumstances occurring after the date of this report or to reflect the occurrence of unanticipated events.

 

Description of Business and Strategy

 

Business Overview

Northeast Bancorp (“we,” “our,” “us,” “Northeast” or the “Company”), incorporated under Maine law in 1987, is a bank holding company registered with the Board of Governors of the Federal Reserve System (the “Federal Reserve”). As a bank holding company registered under the Bank Holding Company Act of 1956, as amended (the “BHCA”), the Company is subject to regulation and supervision by the Federal Reserve. The Company’s primary subsidiary and principal asset is its wholly-owned banking subsidiary, Northeast Bank (the “Bank” or “Northeast Bank”), a Maine state-chartered bank originally organized in 1872. As a Federal Deposit Insurance Corporation (“FDIC”) insured Maine-chartered bank, the Bank is subject to regulation and supervision by the Maine Bureau of Financial Institutions (the “Bureau”) and the FDIC.

 

On December 29, 2010, the merger of the Company and FHB Formation LLC, a Delaware limited liability company (“FHB”), was consummated. As a result of the merger, the surviving company received a capital contribution of $16.2 million (in addition to the approximately $13.1 million in cash consideration paid to former shareholders), and the former members of FHB collectively acquired approximately 60% of the Company’s outstanding common stock. The Company applied the acquisition method of accounting, as described in Accounting Standards Codification (“ASC”) 805, Business Combinations (“ASC 805”) to the merger, which represents an acquisition by FHB of Northeast, with Northeast as the surviving company. 

 

28

 

In connection with the transaction, as part of the regulatory approval process, the Company and the Bank made certain commitments to the Federal Reserve, the most significant of which are (i) to maintain a Tier 1 leverage ratio of at least 10%, (ii) to maintain a total risk-based capital ratio of at least 15%, (iii) to limit purchased loans to 40% of total loans, (iv) to fund 100% of the Company’s loans with core deposits (defined as non-maturity deposits and non-brokered insured time deposits), and (v) to hold commercial real estate loans (including owner-occupied commercial real estate) to within 300% of total risk-based capital. On June 28, 2013, the Federal Reserve approved the amendment to exclude owner-occupied commercial real estate loans from the commitment to hold commercial real estate loans to within 300% of total risk-based capital. All other commitments made to the Federal Reserve in connection with the merger remain unchanged. The Company and the Bank are currently in compliance with all commitments to the Federal Reserve. The Company’s compliance ratios at December 31, 2017 follow:

 

Condition

 

Ratios as of December 31, 2017

 

(i) Tier 1 leverage capital ratio

    13.41 %

(ii) Total capital ratio

    20.30 %

(iii) Ratio of purchased loans to total loans, including loans held for sale

    31.28 %

(iv) Ratio of loans to core deposits (1)

    91.46 %

(v) Ratio of non-owner occupied commercial real estate loans to total capital (2)

    187.92 %

 

(1) Core deposits include all non-maturity deposits and non-brokered insured time deposits.

(2) For purposes of calculating this ratio, commercial real estate includes all non-owner occupied commercial real estate loans defined as such by regulatory guidance, including all land development and construction loans.

 

As of December 31, 2017, the Company, on a consolidated basis, had total assets of $1.0 billion, total deposits of $848.7 million, and shareholders’ equity of $130.0 million. The Company gathers retail deposits through its banking offices in Maine and the Bank's online affinity deposit program, ableBanking; originates loans through the Bank’s Community Banking Division; originates Small Business Administration (“SBA”) and United States Department of Agriculture (“USDA”) loans through the Bank’s national SBA group (“SBA Division”); and purchases and originates commercial loans through the Bank’s Loan Acquisition and Servicing Group (“LASG”). The Community Banking Division, with ten full-service branches and two loan production offices, operates from the Bank’s headquarters in Lewiston, Maine. LASG, ableBanking, and the SBA Division operate from the Company's offices in Boston, Massachusetts.

 

Unless the context otherwise requires, references herein to the Company include the Company and its subsidiary on a consolidated basis.

 

Strategy

 

The Company's goal is to prudently grow its franchise, while maintaining sound operations and risk management, by means of the following strategies:

 

Continuing to grow the LASG’s national originated and purchased loan business. We purchase commercial real estate loans nationally, at prices that on average have produced yields significantly higher than those available on our originated loan portfolio. We also originate loans nationally, taking advantage of our core expertise in underwriting and servicing national credits.

 

Growing our national SBA origination business. We originate loans on a national basis to small businesses, primarily through the SBA 7(a) program, which provides the partial guarantee of the SBA.

 

Continuing our community banking tradition. With a history that dates to 1872, our Community Banking Division maintains its focus on sales and service, with the goal of attracting and retaining deposits, and serving the lending needs of retail and commercial customers within our core markets.

 

Generating deposits to fund our business. We offer a full line of deposit products through our ten-branch network located in the Community Banking Division’s market. ableBanking is a direct savings platform providing an additional channel to raise core deposits to fund our asset strategy.

 

Critical Accounting Policies

 

Critical accounting policies are those that involve significant judgments and assessments by management, and which could potentially result in materially different results under different assumptions and conditions. The reader is encouraged to review each of the policies included in Form 10-K for the year ended June 30, 2017 to gain a better understanding of how Northeast’s financial performance is measured and reported. There has been no material change in critical accounting policies during the three and six months ended December 31, 2017.

 

Overview

 

Net income totaled $3.3 million for the quarter ended December 31, 2017, an increase of $204 thousand, or 6.6%, from net income of $3.1 million for the quarter ended December 31, 2016.

 

Net interest and dividend income before provision for loan losses increased by $624 thousand for the quarter ended December 31, 2017, compared to the quarter ended December 31, 2016. The increase is primarily due to higher average balances in the total loan portfolio. This increase was partially offset by higher funding costs and higher average deposit balances.

 

Noninterest income decreased by $1.5 million for the quarter ended December 31, 2017, compared to the quarter ended December 31, 2016, principally due to the following:

 

A decrease in gain on sale of SBA loans of $1.4 million, due to a lower amount of SBA loans sold in the quarter; and

 

A decrease in gain on sale of residential loans held for sale of $82 thousand, due to lower volume of residential loans sold in the quarter.

 

29

 

Noninterest expense decreased by $393 thousand for the quarter ended December 31, 2017, compared to the quarter ended December 31, 2016, primarily due to the following:

 

A decrease in other noninterest expense of $395 thousand, primarily due to a $330 thousand decrease in expense related to the quarterly valuation of SBA servicing rights; and

 

A decrease in loan expense of $179 thousand, largely driven by lower expense related to loan acquisition and refinance activity.

 

The decreases in noninterest expense were partially offset by an increase in data processing fees of $214 thousand, primarily due to increased costs associated with outsourcing of data processing.

 

Income tax expense decreased by $458 thousand for the quarter ended December 31, 2017, compared to the quarter ended December 31, 2016, primarily due to the following:

 

A decrease in the federal corporate income tax rate as a result of the Tax Cuts and Jobs Act signed into law on December 22, 2017, which resulted in a $762 thousand decrease in federal income tax expense. Of this total, $328 thousand was related to the decrease in the federal corporate income tax rate for the three months ended December 31, 2017 and $434 thousand was related to income tax expense previously recorded in the three months ended September 30, 2017, to arrive at the required blended federal corporate income tax rate of 28.0% for fiscal year 2018; and

 

A decrease in income tax expense as a result of a $279 thousand income tax benefit arising from the treatment of stock options exercised or vested restricted stock awards under ASU 2016-09, Compensation—Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting, whereby the tax effects of exercised options or vested awards are treated as a discrete item in the reporting period in which they occur.

 

The decreases in income tax expense were partially offset by the impact of revaluing the deferred tax asset as a result of the change in the federal corporate income tax rate as well as the recording of current year changes in the deferred tax asset, which resulted in an increase in income tax expense of $498 thousand.

 

Financial Condition

 

Overview

 

As of December 31, 2017, total assets were $1.0 billion, a decrease of $42.4 million, or 3.9%, from total assets of $1.1 billion as of June 30, 2017. The principal components of the change in the balance sheet follow:

 

The following table highlights the changes in the loan portfolio for the three and six months ended December 31, 2017:

 

   

Loan Portfolio Changes

 
   

Three Months Ended December 31, 2017

 
   

December 31, 2017 Balance

   

September 30, 2017 Balance

   

 

Change ($)

   

 

Change (%)

 
   

(Dollars in thousands)

 

LASG Purchased

  $ 244,177     $ 230,014     $ 14,163       6.16 %

LASG Originated

    346,874       340,756       6,118       1.80 %

SBA

    49,109       47,870       1,239       2.59 %

Community Banking

    134,030       140,944       (6,914 )     -4.91 %

Total

  $ 774,190     $ 759,584     $ 14,606       1.92 %

 

   

Six Months Ended December 31, 2017

 
   

December 31, 2017 Balance

   

June 30, 2017

Balance

   

 

Change ($)

   

 

Change (%)

 
   

(Dollars in thousands)

 

LASG Purchased

  $ 244,177     $ 246,388     $ (2,211 )     -0.90 %

LASG Originated

    346,874       330,515       16,359       4.95 %

SBA

    49,109       52,965       (3,856 )     -7.28 %

Community Banking

    134,030       149,327       (15,297 )     -10.24 %

Total

  $ 774,190     $ 779,195     $ (5,005 )     -0.64 %

 

Loans generated by the LASG for the quarter ended December 31, 2017 totaled $79.1 million, which consisted of $34.8 million of purchased loans, at an average price of 91.1% of unpaid principal balance, and $44.3 million of originated loans. The SBA Division closed and funded $4.5 million of new loans during the quarter ended December 31, 2017. In addition, the Company sold $3.4 million of the guaranteed portion of SBA loans in the secondary market, of which $1.6 million were originated in the current quarter and $1.8 million were originated in prior quarters. Residential loan production sold in the secondary market totaled $17.6 million for the quarter.

 

30

 

As noted above in the “Business Overview” section, the Company made certain commitments to the Federal Reserve in connection with the merger of FHB with and into the Company in December 2010. The Company’s loan purchase and commercial real estate loan availability under these conditions follow.

 

Basis for

Regulatory Condition

 

Condition

 

Availability at

December 31, 2017

 
       

(Dollars in millions)

 

Total Loans

 

Purchased loans may not exceed 40% of total loans

  $ 113.4  

Regulatory Capital

 

Non-owner occupied commercial real estate loans may not exceed 300% of total capital

    177.4  

 

An overview of the Bank’s LASG portfolio follows:

 

   

LASG Portfolio

 
   

Three Months Ended December 31,

 
   

2017

   

2016

 
   

Purchased

   

Originated

   

Secured Loans to

Broker-Dealers

   

Total LASG

   

Purchased

   

Originated

   

Secured Loans to Broker-Dealers

   

Total LASG

 
   

(Dollars in thousands)

 

Loans purchased or originated during the period:

                                                               

Unpaid principal balance

  $ 38,205     $ 44,285     $ -     $ 82,490     $ 51,112     $ 45,647     $ -       96,759  

Net investment basis

    34,802       44,285       -       79,087       46,033       45,647       -       91,680  

Loan returns during the period:

                                                               

Yield

    11.00 %     6.49 %     0.00 %     8.31 %     13.01 %     5.89 %     0.99 %     8.76 %

Total Return (2)

    11.00 %     6.49 %     0.00 %     8.31 %     13.01 %     5.89 %     0.99 %     8.76 %

 

   

Six Months Ended December 31,

 
   

2017

   

2016

 
   

Purchased

   

Originated

   

Secured Loans to

Broker-Dealers

   

Total LASG

   

Purchased (1)

   

Originated

   

Secured Loans to Broker-Dealers

   

Total LASG

 
   

(Dollars in thousands)

 

Loans purchased or originated during the period:

                                                               

Unpaid principal balance

  $ 42,523     $ 85,064     $ -     $ 127,587     $ 67,903     $ 88,025     $ -     $ 155,928  

Net investment basis

    38,453       85,064       -       123,517       59,886       88,025       -       147,911  

Loan returns during the period:

                                                               

Yield

    11.65 %     6.42 %     0.00 %     8.58 %     11.71 %     5.88 %     0.74 %     8.19 %

Total Return (2)

    11.65 %     6.42 %     0.00 %     8.58 %     11.73 %     5.88 %     0.74 %     8.19 %
                                                                 

Total loans as of period end:

                                                               

Unpaid principal balance

  $ 276,440     $ 346,874     $ -     $ 623,314     $ 288,455     $ 231,278     $ 48,000     $ 567,733  

Net investment basis

    244,177       346,874       -       591,051       255,048       231,278       48,000       534,326  

 

(1) Purchased loan balances include loans held for sale of $975 thousand.

(2) The total return on purchased loans represents scheduled accretion, accelerated accretion, gains on asset sales, and other noninterest income recorded during the period divided by the average invested balance, which includes loans held for sale, on an annualized basis. The total return does not include the effect of purchased loan charge-offs or recoveries in the quarter.

 

Assets

 

Cash and Due from Banks, Short-Term Investments and Available-for-Sale Securities

 

Cash and cash equivalents were $128.2 million as of December 31, 2017, a decrease of $35.1 million, or 21.5%, from $163.3 million at June 30, 2017. The decrease is primarily due to the decrease in deposits, offset by the decrease in loans in the period.

 

Available-for-sale securities totaled $92.3 million as of December 31, 2017, compared to $96.7 million as of June 30, 2017, representing a decrease of $4.4 million, or 4.5%, primarily due to principal payments on mortgage-backed securities. Included in available-for-sale securities are securities issued by government agencies and government-sponsored enterprises, as well as an investment of approximately $5.0 million in a CRA qualified fund that seeks to invest in securities either issued or guaranteed by the U.S. government or its agencies, as well as an investment of approximately $1.5 million in a CRA qualified fund that primarily invests in the federally guaranteed portion of SBA 7(a) loans. At December 31, 2017, no securities were pledged for outstanding borrowings.

 

31

 

Loans

 

The Company’s loan portfolio (excluding loans held-for-sale) by lending division follows:

 

   

December 31, 2017

 

 

 

 

 

Community Banking Division

   

LASG

   

SBA Division

   

Total

   

Percent of Total

 
   

(Dollars in thousands)

 

Originated loans:

                                       

Residential real estate

  $ 73,035     $ 7,298     $ 129     $ 80,462       10.39 %

Home equity

    12,313       -       -       12,313       1.59 %

Commercial real estate: non-owner occupied

    20,673       102,172       16,881       139,726       18.05 %

Commercial real estate: owner occupied

    12,776       78,218       24,959       115,953       14.98 %

Commercial and industrial

    11,430       159,186       7,140       177,756       22.96 %

Consumer

    3,803       -       -       3,803       0.49 %

Subtotal

    134,030       346,874       49,109       530,013       68.46 %

Purchased loans:

                                       

Residential real estate

    -       4,723       -       4,723       0.61 %

Home equity

    -       95       -       95       0.01 %

Commercial real estate: non-owner occupied

    -       134,486       -       134,486       17.37 %

Commercial real estate: owner occupied

    -       103,789       -       103,789       13.41 %

Commercial and industrial

    -       1,084       -       1,084       0.14 %

Subtotal

    -       244,177       -       244,177       31.54 %

Total

  $ 134,030     $ 591,051     $ 49,109     $ 774,190       100.00 %

 

   

 

June 30, 2017

 

 

 

 

 

Community Banking Division

   

LASG

   

SBA Division

   

Total

   

Percent of Total

 
   

(Dollars in thousands)

 

Originated loans:

                                       

Residential real estate

  $ 81,538     $ 2,092     $ 129     $ 83,759       10.75 %

Home equity

    13,931       -       -       13,931       1.79 %

Commercial real estate: non-owner occupied

    23,638       90,154       23,720       137,512       17.65 %

Commercial real estate: owner occupied

    13,502       83,446       21,820       118,768       15.24 %

Commercial and industrial

    12,349       154,823       7,296       174,468       22.39 %

Consumer

    4,369       -       -       4,369       0.56 %

Subtotal

    149,327       330,515       52,965       532,807       68.38 %

Purchased loans:

                                       

Residential real estate

    -       3,478       -       3,478       0.45 %

Commercial real estate: non-owner occupied

    -       134,970       -       134,970       17.32 %

Commercial real estate: owner occupied

    -       106,754       -       106,754       13.70 %

Commercial and industrial

    -       1,186       -       1,186       0.15 %

Subtotal

    -       246,388       -       246,388       31.62 %

Total

  $ 149,327     $ 576,903     $ 52,965     $ 779,195       100.00 %

 

Classification of Assets

 

Loans are classified as nonperforming when 90 or more days past due, unless a loan is well-secured and in the process of collection. Loans less than 90 days past due, for which collection of principal or interest is considered doubtful, also may be designated as nonperforming. In both situations, accrual of interest ceases. The Company typically maintains such loans as nonperforming until the respective borrowers have demonstrated a sustained period of payment performance.

 

In cases where a borrower experiences financial difficulties and the Company makes certain concessionary modifications, the loan is classified as a troubled debt restructuring (“TDR”). Concessionary modifications may include adjustments to interest rates, extensions of maturity, or other actions intended to minimize economic loss and avoid foreclosure or repossession of collateral. Nonaccrual loans that are restructured generally remain on nonaccrual status for a minimum period of six months to demonstrate that the borrower can meet the restructured terms. If the restructured loan is on accrual status prior to being modified, it is reviewed to determine if the modified loan should remain on accrual status. If the borrower’s ability to meet the revised payment schedule is not reasonably assured, the loan is classified as a nonaccrual loan. With limited exceptions, loans classified as TDRs remain classified as such until the loan is paid off.

 

Other nonperforming assets include other real estate owned (“OREO”) and other personal property securing loans repossessed by the Bank. The real estate and personal property collateral for commercial and consumer loans is recorded at fair value less estimated costs to sell upon repossession. Revenues and expenses are recognized in the period when received or incurred on OREO and in-substance foreclosures. Gains and losses on disposition are recognized in noninterest income.

 

32

 

The following table details the Company's nonperforming assets and other credit quality indicators as of December 31, 2017 and June 30, 2017. Management believes that, based on their carrying amounts, nonperforming assets are well secured based on the estimated fair value of underlying collateral.

 

   

Nonperforming Assets at December 31, 2017

 
   

Originated

   

Purchased

   

Total

 
   

(Dollars in thousands)

 

Loans:

                       

Residential real estate

  $ 3,783     $ 220     $ 4,003  

Home equity

    107       -       107  

Commercial real estate

    2,537       8,450       10,987  

Commercial and industrial

    2,555       292       2,847  

Consumer

    147       -       147  

Subtotal

    9,129       8,962       18,091  

Real estate owned and other repossessed collateral

    88       822       910  

Total

  $ 9,217     $ 9,784     $ 19,001  
                         

Ratio of nonperforming loans to total loans

              2.34 %

Ratio of nonperforming assets to total assets

              1.84 %

Ratio of loans past due to total loans

              3.87 %

Nonperforming loans that are current

            $ 7,686  

Commercial loans risk rated substandard or worse

    $ 13,046  

Troubled debt restructurings:

                 

On accrual status

                  $ 9,759  

On nonaccrual status

                  $ 8,022  

 

   

Nonperforming Assets at June 30, 2017

 
   

Originated

   

Purchased

   

Total

 
   

(Dollars in thousands)

 

Loans:

                       

Residential real estate

  $ 3,337     $ 1,056     $ 4,393  

Home equity

    58       -       58  

Commercial real estate

    413       6,364       6,777  

Commercial and industrial

    2,600       32       2,632  

Consumer

    103       -       103  

Subtotal

    6,511       7,452       13,963  

Real estate owned and other repossessed collateral

    4       822       826  

Total

  $ 6,515     $ 8,274     $ 14,789  
                         

Ratio of nonperforming loans to total loans

              1.79 %

Ratio of nonperforming assets to total assets

      1.37 %

Ratio of loans past due to total loans

              1.72 %

Nonperforming loans that are current

            $ 4,321  

Commercial loans risk rated substandard or worse

    $ 7,109  

Troubled debt restructurings:

                 

On accrual status

                  $ 9,702  

Nonaccrual status

                  $ 5,383  

 

As of December 31, 2017, nonperforming assets totaled $19.0 million, or 1.84% of total assets, as compared to $14.8 million, or 1.37% of total assets, as of June 30, 2017. The increase was attributed to an increase in loans purchased that were delinquent at purchase, as well as one LASG originated relationship, which became nonperforming in the six months ended December 31, 2017.

 

Allowance for Loan Losses

 

In connection with the application of the acquisition method of accounting for the merger on December 29, 2010, the allowance for loan losses was reduced to zero when the loan portfolio was marked to its then current fair value. Since that date, the Company has provided for an allowance for loan losses as new loans are originated or in the event that credit exposure in the pre-merger loan portfolio or other acquired loans exceeds the exposure estimated when initial fair values were determined.

 

The Company’s allowance for loan losses was $4.4 million as of December 31, 2017, compared to $3.7 million as of June 30, 2017. The increase in the period is primarily the result of the effect of changes in the qualitative factors, as well as the increase in specific reserve on one loan relationship.

 

The following table details ratios related to the allowance for loan losses for the periods indicated.

 

 

December 31, 2017

 

June 30, 2017

 

December 31, 2016

Allowance for loan losses to nonperforming loans

24.07%

 

26.25%

 

30.47%

Allowance for loan losses to total loans

0.56%

 

0.47%

 

0.41%

Last twelve months of net-charge offs to average loans

0.04%

 

0.04%

 

0.06%

 

33

 

While management believes that it uses the best information available to make its determinations with respect to the allowance, there can be no assurance that the Company will not have to increase its provision for loan losses in the future as a result of changing economic conditions, adverse markets for real estate or other factors.

 

Other Assets

 

Premises and equipment, net, increased by $124 thousand, or 1.8%, to $7.1 million at December 31, 2017, compared to $6.9 million at June 30, 2017. The increase was primarily due to fixed assets purchased during the period, offset by depreciation and amortization.

 

Intangible assets totaled $1.1 million and $1.3 million at December 31, 2017 and June 30, 2017, respectively. The $218 thousand decrease was the result of core deposit intangible asset amortization during the period.

 

Loan servicing rights totaled $3.0 million and $2.8 million at December 31, 2017 and June 30, 2017, respectively. The $159 thousand increase was the result of SBA loans sold during the quarter and the revaluation of the servicing rights performed on a quarterly basis, offset by amortization.

 

The cash surrender value of the Company’s bank-owned life insurance (“BOLI”) assets increased $223 thousand, or 1.4% to $16.4 million at December 31, 2017, compared to $16.2 million at June 30, 2017. Increases in cash surrender value are recognized in noninterest income and are not subject to income taxes. Borrowing on, or surrendering a policy, may subject the Company to income tax expense on the increase in cash surrender value. For these reasons, management considers BOLI an illiquid asset. BOLI represented 10.4% of the Company’s regulatory total capital at December 31, 2017.

 

Deposits, FHLBB Advances, Subordinated Debt, Liquidity, Capital, and Stock Repurchases

 

Deposits

 

The Company’s principal source of funding is its core deposit accounts. At December 31, 2017, non-maturity accounts, and non-brokered insured time deposits represented 100% of total deposits.

 

Total deposits decreased $41.2 million to $848.7 million as of December 31, 2017 from $889.9 million as of June 30, 2017. The decrease was attributable primarily to a decrease in money market accounts of $22.3 million, or 6.0% and a decrease in time deposits of $19.4 million, or 5.8%.

 

The composition of total deposits at December 31, 2017 and June 30, 2017 is as follows:

 

   

December 31, 2017

   

June 30, 2017

 
   

Amount

   

Percent of Total

   

Amount

   

Percent of Total

 
   

(Dollars in thousands)

 

Demand deposits

  $ 71,054       8.37 %   $ 69,827       7.84 %

NOW accounts

    71,420       8.42 %     71,247       8.01 %

Regular and other savings

    36,330       4.28 %     37,170       4.18 %

Money market deposits

    352,237       41.51 %     374,569       42.09 %

Total non-certificate accounts

    531,041       62.57 %     552,814       62.12 %

Term certificates of $250 thousand or less

    317,613       37.43 %     337,037       37.88 %

Term certificates greater than $250 thousand

    -       0.00 %     -       0.00 %

Total certificate accounts

    317,613       37.43 %     337,037       37.88 %

Total deposits

  $ 848,654       100.00 %   $ 889,850       100.00 %

 

FHLBB Advances

 

Advances from the Federal Home Loan Bank of Boston (“FHLBB”) were $15.0 million at December 31, 2017, compared to $20.0 million at June 30, 2017. As of December 31, 2017, the Company had pledged certain residential real estate loans and commercial real estate loans to secure outstanding advances and provide additional borrowing capacity. As of December 31, 2017, no securities were pledged for outstanding borrowings.

 

Subordinated Debt

 

On June 29, 2016, the Company entered into a Subordinated Note Purchase Agreement with certain institutional accredited investors pursuant to which the Company issued subordinated notes equal to $15.05 million in aggregate principal amount with an interest rate of 6.75% fixed-to-floating maturing in 2026 (“subordinated notes”). The subordinated notes, net of issuance costs, totaled $14.7 million at December 31, 2017, compared to $14.6 million at June 30, 2017.

 

34

 

The Company had junior subordinated debentures issued to affiliated trusts totaling $9.1 million and $9.0 million at December 31, 2017 and June 30, 2017, respectively. The unpaid principal balance of the junior subordinated debentures totaled $16.5 million at both December 31, 2017 and June 30, 2017.

 

Liquidity

 

The following table is a summary of unused borrowing capacity of the Company at December 31, 2017, in addition to traditional retail deposit products:

 

   

As of December 31, 2017

   
   

(Dollars in thousands)

   

Brokered time deposits

  $ 258,612  

Subject to policy limitation of 25% of total assets

Federal Home Loan Bank of Boston

    48,692  

Unused advance capacity subject to eligible and qualified collateral

Federal Discount Window Borrower-in-Custody

    1,263  

Unused credit line subject to the pledge of loans

Other available lines

    17,500    

Total unused borrowing capacity

  $ 326,067    

 

Retail deposits and other core deposit sources including deposit listing services are used by the Bank to manage its overall liquidity position. While we currently do not seek wholesale funding such as FHLBB advances and brokered deposits, the ability to raise them remains an important part of our liquidity contingency planning. While we closely monitor and forecast our liquidity position, it is affected by asset growth, deposit withdrawals and meeting other contractual obligations and commitments. The accuracy of our forecast assumptions may increase or decrease our overall available liquidity. To utilize the FHLBB advance capacity, the purchase of additional capital stock of the FHLBB may be required.

 

At December 31, 2017, the Company had $399.4 million of immediately accessible liquidity, defined as cash that the Bank reasonably believes could be raised within seven days through collateralized borrowings, brokered deposits or security sales. This position represented 38.6% of total assets. The Company also had $128.2 million of cash and cash equivalents at December 31, 2017.

 

Management believes that there are adequate funding sources to meet its liquidity needs for the foreseeable future. Primary funding sources are the repayment of principal and interest on loans, the renewal of time deposits, the potential for growth in the deposit base, and the credit availability from the FHLBB. Management does not believe that the terms and conditions that will be present at the renewal of these funding sources will significantly impact the Company’s operations, due to its management of the maturities of its assets and liabilities.

 

Capital

 

The unpaid principal balance and carrying amount of junior subordinated debentures totaled $16.5 million and $9.1 million, respectively, as of December 31, 2017. The unpaid principal balance and carrying amount of subordinated debt totaled $15.1 million and $14.7 million, respectively, as of December 31, 2017. The junior subordinated debt represents qualifying Tier 1 capital for the Company, up to a maximum of 25% of total Tier 1 capital, and the and subordinated debt represents qualifying Tier II capital for the Company. At December 31, 2017, the carrying amounts of the junior subordinated debt, net of the Company’s $496 thousand investment in the affiliated trusts, qualified as Tier 1 capital, and the subordinated debt qualified as Tier II capital.

 

At December 31, 2017, shareholders’ equity was $130.0 million, an increase of $7.2 million, or 5.9% from June 30, 2017. Book value per outstanding common share was $14.54 at December 31, 2017 and $13.90 at June 30, 2017. Tier 1 capital to total average assets of the Company was 13.4% as of December 31, 2017 and 12.8% at June 30, 2017.

 

Under the capital rules, risk-based capital ratios are calculated by dividing Tier 1 and total capital, respectively, by risk-weighted assets. Assets and off-balance sheet credit equivalents are assigned to one of several risk-weight categories, based primarily on relative risk. The rules require banks and bank holding companies to maintain a minimum common equity Tier 1 capital ratio of 4.5%, a minimum Tier 1 capital ratio of 6%, a total capital ratio of 8% and a leverage ratio of 4%. Additionally, subject to a transition schedule, the capital rules require a bank holding company to establish a capital conservation buffer of Tier 1 capital in an amount above the minimum risk-based capital requirements for "adequately capitalized" institutions equal to 2.5% of total risk weighted assets, or face restrictions on the ability to pay dividends, pay discretionary bonuses, and to engage in share repurchases.

 

A bank holding company, such as the Company, is considered "well capitalized" if the bank holding company (i) has a total capital ratio of at least 10%, (ii) has a Tier 1 risk-based capital ratio of at least 6%, and (iii) is not subject to any written agreement order, capital directive or prompt corrective action directive to meet and maintain a specific capital level for any capital measure. In addition, the FDIC has amended its prompt corrective action rules to reflect the revisions made by the revised capital rules described above. Under the FDIC's revised rules, which became effective January 1, 2015, an insured state nonmember bank is considered "well capitalized" if it (i) has a total capital ratio of 10.0% or greater; (ii) a Tier 1 risk-based capital ratio of 8.0% or greater; (iii) a common Tier 1 equity ratio of 6.5% or greater, (iv) a leverage capital ratio of 5.0% or greater; and (iv) is not subject to any written agreement, order, capital directive, or prompt corrective action directive to meet and maintain a specific capital level for any capital measure.

 

35

 

The Company and the Bank are considered "well capitalized" under all regulatory definitions. The Company's and the Bank's regulatory capital ratios are set forth below.

 

   

 

 

 

 

Actual

   

 

 

 

Minimum Capital

Requirements

   

 

Minimum To Be Well

Capitalized Under

Prompt Corrective

Action Provisions

   

Minimum

Capital Ratio

with Capital Conservation

Buffer

 
   

Amount

   

Ratio

   

Amount

   

Ratio

   

Amount

   

Ratio

   

Ratio

 
                                                         

December 31, 2017:

 

(Dollars in thousands)

 

Common equity tier 1 capital to risk weighted assets:

                                                       

Company

  $ 130,581       16.74 %   $ 35,101    

>4.5%

    $ N/A       N/A       7.0 %

Bank

    146,794       18.77 %     35,191    

>4.5%

      50,832    

>6.5%

      7.0 %
                                                         

Total capital to risk weighted assets:

                                                       

Company

    158,309       20.30 %     62,401    

>8.0%

      N/A       N/A       10.5 %

Bank

    151,228       19.34 %     62,562    

>8.0%

      78,203    

>10.0%

      10.5 %
                                                         

Tier 1 capital to risk weighted assets:

                                                       

Company

    139,211       17.85 %     46,801    

>6.0%

      N/A       N/A       8.5 %

Bank

    146,794       18.77 %     46,922    

>6.0%

      62,562    

>8.0%

      8.5 %
                                                         

Tier 1 capital to average assets:

                                                       

Company

    139,211       13.41 %     41,510    

>4.0%

      N/A       N/A       4.0 %

Bank

    146,794       14.14 %     41,524    

>4.0%

      51,904    

>5.0%

      4.0 %
                                                         

June 30, 2017:

                                                       

Common equity tier 1 capital to risk weighted assets:

                                                       

Company

  $ 123,442       16.00 %   $ 34,714    

>4.5%

    $ N/A       N/A       7.0 %

Bank

    138,744       17.98 %     34,727    

>4.5%

      50,162    

>6.5%

      7.0 %
                                                         

Total capital to risk weighted assets:

                                                       

Company

    150,269       19.48 %     61,715    

>8.0%

      N/A       N/A       10.5 %

Bank

    142,447       18.46 %     61,737    

>8.0%

      77,172    

>10.0%

      10.5 %
                                                         

Tier 1 capital to risk weighted assets:

                                                       

Company

    131,958       17.11 %     46,286    

>6.0%

      N/A       N/A       8.5 %

Bank

    138,744       17.98 %     46,303    

>6.0%

      61,737    

>8.0%

      8.5 %
                                                         

Tier 1 capital to average assets:

                                                       

Company

    131,958       12.81 %     41,215    

>4.0%

      N/A       N/A       4.0 %

Bank

    138,744       13.46 %     41,238    

>4.0%

      51,547    

>5.0%

      4.0 %

 

In addition to the minimum regulatory capital required for capital adequacy purposes included in the table above, the Company is required to maintain a capital conservation buffer, in the form of common equity, in order to avoid restrictions on capital distributions and discretionary bonuses. The required amount of the capital conservation buffer was 1.875% on January 1, 2018 and will increase by 0.625% until it reaches 2.5% on January 1, 2019.

 

The Bank may not declare or pay a cash dividend on, or repurchase, any of its capital stock from the Company if the effect thereof would cause the capital of the Bank to be reduced below the capital requirements imposed by the regulatory authorities or if such amount exceeds the otherwise allowable amount under FRB rules.

 

In connection with the merger, as part of the regulatory approval process, the Company and the Bank made certain commitments to the Federal Reserve, the most significant of which are (i) to maintain a Tier 1 leverage ratio of at least 10%, (ii) to maintain a total capital ratio of at least 15%, (iii) to limit purchased loans to 40% of total loans, (iv) to fund 100% of the Company's loans with core deposits (defined as non-maturity deposits and non-brokered insured time deposits), and (v) to hold non-owner occupied commercial real estate loans to within 300% of total capital. The Company and the Bank are currently in compliance with all commitments to the Federal Reserve.

 

Stock Repurchases

 

On October 21, 2016, the Board of Directors voted to amend the existing stock repurchase program to authorize the Company to purchase an additional 500,000 shares of its common stock, representing 5.7% of the Company’s outstanding common shares. Under the existing program, implemented in April 2014, the Company has purchased 1,970,000 shares through October 25, 2016 and no shares remained available for repurchase under the program on that date, prior to the 500,000 share increase in the repurchase plan. The amended stock repurchase program will expire on October 21, 2018.

 

36

 

Off-Balance Sheet Financial Instruments

 

The Company is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit, unused lines of credit, standby letters of credit, and commitments to fund investments. These instruments involve, to varying degrees, elements of credit and interest-rate risk in excess of the amounts recognized in the condensed consolidated balance sheet. The contract or notional amounts of these instruments reflect the extent of the Company’s involvement in particular classes of financial instruments. 

 

See Part I. Item I. “Notes to Unaudited Consolidated Financial Statements – Note 9: Commitments and Contingencies” for further discussion.

 

37

 

Results of Operations

 

General

 

Net income totaled $3.3 million for the quarter ended December 31, 2017, an increase of $204 thousand from $3.1 million for the quarter ended December 31, 2016.

 

The following table details the “Total Return” on purchased loans. When compared to the three months ended December 31, 2016, transactional income decreased by $1.0 million. The total return on purchased loans for the three months ended December 31, 2017 was 11.0%. The decrease over the prior comparable period was primarily due to lower accelerated accretion in the three months ended December 31, 2017. When compared to the six months ended December 31, 2016, transactional income increased by $432 thousand. This increase over the prior comparable period was primarily due to higher loan fees in the six months ended December 31, 2017. The following table details the total return on purchased loans:

 

   

Total Return on Purchased Loans

 
   

Three Months Ended December 31,

 
   

2017

   

2016

 
   

Income

   

Return (1)

   

Income

   

Return (1)

 
   

(Dollars in thousands)

 

Regularly scheduled interest and accretion

  $ 4,466       7.71 %   $ 4,716       8.01 %

Transactional income:

                               

Gain on loan sales

    -       0.00 %     -       0.00 %

Gain on sale of real estate owned

    -       0.00 %     -       0.00 %

Other noninterest income

    -       0.00 %     -       0.00 %

Accelerated accretion and loan fees

    1,903       3.29 %     2,943       5.00 %

Total transactional income

    1,903       3.29 %     2,943       5.00 %

Total

  $ 6,369       11.00 %   $ 7,659       13.01 %

 

   

Total Return on Purchased Loans

 
   

Six Months Ended December 31,

 
   

2017

   

2016

 
   

Income

   

Return (1)

   

Income

   

Return (1)

 
   

(Dollars in thousands)

 

Regularly scheduled interest and accretion

  $ 9,079       7.67 %   $ 9,470       8.07 %

Transactional income:

                               

Gain on loan sales

    -       0.00 %     -       0.00 %

Gain on sale of real estate owned

    -       0.00 %     19       0.02 %

Other noninterest income

    -       0.00 %     -       0.00 %

Accelerated accretion and loan fees

    4,721       3.98 %     4,270       3.64 %

Total transactional income

    4,721       3.98 %     4,289       3.66 %

Total

  $ 13,800       11.65 %   $ 13,759       11.73 %

 

 

(1)

The total return on purchased loans represents scheduled accretion, accelerated accretion, gains on asset sales, gains on real estate owned and other noninterest income recorded during the period divided by the average invested balance, which includes loans held for sale, on an annualized basis. The total return does not include the effect of purchased loan charge-offs or recoveries in the quarter. Total return is considered a non-GAAP financial measure.

 

Net Interest Income

 

Three Months Ended December 31, 2017 and 2016

 

Net interest and dividend income before provision for loan losses increased by $624 thousand for the quarter ended December 31, 2017, compared to the quarter ended December 31, 2016. The increase is primarily due to higher average balances in the total loan portfolio. This increase was partially offset by higher funding costs and higher average deposit balances.

 

   

Interest Income and Yield on Loans

 
   

Three Months Ended December 31,

 
   

2017

   

2016

 
   

Average

   

Interest

           

Average

   

Interest

         
   

Balance (1)

   

Income

   

Yield

   

Balance (1)

   

Income

   

Yield

 
   

(Dollars in thousands)

 

Community Banking

  $ 141,486     $ 1,753       4.92 %   $ 203,963     $ 2,350       4.57 %

SBA

    49,457       814       6.53 %     41,038       574       5.55 %

LASG:

                                               

Originated

    340,240       5,565       6.49 %     216,353       3,210       5.89 %

Purchased

    229,732       6,369       11.00 %     233,502       7,659       13.01 %

Secured Loans to Broker-Dealers

    -       -       0.00 %     48,000       120       0.99 %

Total LASG

    569,972       11,934       8.31 %     497,855       10,989       8.76 %

Total

  $ 760,915     $ 14,501       7.56 %   $ 742,856     $ 13,913       7.43 %

 

 

(1)

Includes loans held for sale.

 

38

 

The Company’s interest rate spread decreased by 4 basis points and net interest margin decreased by 1 basis point for the quarter ended December 31, 2017 compared to the quarter ended December 31, 2016. The decrease was principally due to higher deposit rates and average deposit balances.

 

The following sets forth the average balance sheets, interest income and interest expense, and average yields and costs for the three months ended December 31, 2017 and 2016.

 

   

Three Months Ended December 31,

 
   

2017

   

2016

 
           

Interest

   

Average

           

Interest

   

Average

 
   

Average

   

Income/

   

Yield/

   

Average

   

Income/

   

Yield/

 
   

Balance

   

Expense

   

Rate

   

Balance

   

Expense

   

Rate

 

Assets:

                                               

Interest-earning assets:

                                               

Investment securities

  $ 93,945     $ 267       1.13 %   $ 92,750     $ 247       1.06 %

Loans (1) (2) (3)

    760,915       14,501       7.56 %     742,856       13,931       7.44 %

Federal Home Loan Bank stock

    1,860       21       4.48 %     2,398       23       3.81 %

Short-term investments (4)

    145,305       471       1.29 %     114,276       149       0.52 %

Total interest-earning assets

    1,002,025       15,260       6.04 %     952,280       14,350       5.98 %

Cash and due from banks

    2,731                       2,764                  

Other non-interest earning assets

    33,164                       35,213                  

Total assets

  $ 1,037,920                     $ 990,257                  
                                                 

Liabilities & Shareholders' Equity:

                                               

Interest-bearing liabilities:

                                               

NOW accounts

  $ 70,287     $ 52       0.29 %   $ 71,795     $ 52       0.29 %

Money market accounts

    367,265       1,030       1.11 %     312,911       753       0.95 %

Savings accounts

    36,872       12       0.13 %     35,206       12       0.14 %

Time deposits

    303,246       1,035       1.35 %     317,318       981       1.23 %

Total interest-bearing deposits

    777,670       2,129       1.09 %     737,230       1,798       0.97 %

Federal Home Loan Bank advances

    17,719       148       3.31 %     27,099       220       3.22 %

Subordinated debt

    23,745       517       8.64 %     23,430       468       7.92 %

Capital lease obligations

    764       9       4.67 %     1,024       13       5.04 %

Total interest-bearing liabilities

    819,898       2,803       1.36 %     788,783       2,499       1.26 %
                                                 

Non-interest bearing liabilities:

                                               

Demand deposits and escrow accounts

    83,855                       80,538                  

Other liabilities

    5,676                       8,299                  

Total liabilities

    909,429                       877,620                  

Shareholders' equity

    128,491                       112,637                  

Total liabilities and shareholders' equity

  $ 1,037,920                     $ 990,257                  
                                                 

Net interest income (5)

          $ 12,457                     $ 11,851          
                                                 

Interest rate spread

                    4.68 %                     4.72 %

Net interest margin (6)

                    4.93 %                     4.94 %
                                                 

 

(1) Interest income and yield are stated on a fully tax-equivalent basis using the statutory tax rate.

 

(2) Includes loans held for sale.

 

(3) Nonaccrual loans are included in the computation of average, but unpaid interest has not been included for purposes of determining interest income.

 

(4) Short term investments include FHLB overnight deposits and other interest-bearing deposits.

(5) Includes tax exempt interest income of $18 thousand for the three months ended December 31, 2016.

 

(6) Net interest margin is calculated as net interest income divided by total interest-earning assets.

 

 

39

 

The following table presents the extent to which changes in volume and interest rates of interest earning assets and interest bearing liabilities have affected the Company’s interest income and interest expense during the periods indicated. Information is provided in each category with respect to (i) changes attributable to changes in volume (changes in volume multiplied by prior period rate), (ii) changes attributable to changes in rates (changes in rates multiplied by prior period volume) and (iii) change attributable to a combination of changes in rate and volume (change in rates multiplied by the changes in volume). Changes attributable to the combined impact of volume and rate have been allocated proportionately to the changes due to volume and the changes due to rate.

 

 

   

Three Months Ended December 31, 2017 compared to 2016

 
   

Change Due to Volume

   

Change Due to Rate

   

Total Change

 
   

(Dollars in thousands)

 

Interest earning assets:

                       

Investment securities

  $ 3     $ 17     $ 20  

Loans

    342       228       570  

Federal Home Loan Bank stock

    (6 )     4       (2 )

Short-term investments

    50       272       322  

Total interest-earning assets

    389       521       910  
                         

Interest-bearing liabilities:

                       

Interest-bearing deposits

    91       240       331  

Federal Home Loan Bank advances

    (78 )     6       (72 )

Subordinated debt

    6       43       49  

Capital lease obligations

    (3 )     (1 )     (4 )

Total interest-bearing liabilities

    16       288       304  

Total change in net interest income

  $ 373     $ 233     $ 606  

 

Six Months Ended December 31, 2017 and 2016

 

Net interest and dividend income before provision for the six months ended December 31, 2017 and 2016 was $25.8 million and $21.6 million, respectively. The increase of $4.2 million was largely attributable to higher loan volume and interest income in the originated loan portfolio, as well as an increase in transactional income. The following table summarizes interest income and related yields recognized on the Company’s loans for the six months ended December 31, 2017 and 2016.

 

   

Six Months Ended December 31,

 
   

2017

   

2016

 
   

Average

   

Interest

           

Average

   

Interest

         
   

Balance (1)

   

Income

   

Yield

   

Balance (1)

   

Income

   

Yield

 
   

(Dollars in thousands)

 

Community Banking

  $ 145,832     $ 3,496       4.76 %   $ 204,864     $ 4,754       4.60 %

SBA

    51,499       1,756       6.76 %     36,093       1,093       6.01 %

LASG:

                                               

Originated

    334,507       10,831       6.42 %     200,731       5,949       5.88 %

Purchased

    234,928       13,800       11.65 %     232,751       13,740       11.71 %

Secured Loans to Broker-Dealers

    -       -       0.00 %     48,000       180       0.74 %

Total LASG

    569,435       24,631       8.58 %     481,482       19,869       8.19 %

Total

  $ 766,766     $ 29,883       7.73 %   $ 722,439     $ 25,716       7.06 %

 

 

(1)

Includes loans held for sale.

 

40

 

The Company’s interest rate spread and net interest margin increased by 50 basis points and 52 basis points, respectively, for the six months ended December 31, 2017 compared to the six months ended December 31, 2016. The increase was primarily due to the increase in yield on loans from higher average balances and transactional income, offset partially by higher deposit rates and average deposit balances.

 

   

Six Months Ended December 31,

 
   

2017

   

2016

 
           

Interest

   

Average

           

Interest

   

Average

 
   

Average

   

Income/

   

Yield/

   

Average

   

Income/

   

Yield/

 
   

Balance

   

Expense

   

Rate

   

Balance

   

Expense

   

Rate

 

Assets:

                                               

Interest-earning assets:

                                               

Investment securities

  $ 94,886     $ 533       1.11 %   $ 93,825     $ 486       1.03 %

Loans (1) (2) (3)

    766,766       29,893       7.73 %     722,439       25,752       7.07 %

Federal Home Loan Bank stock

    1,899       41       4.28 %     2,403       46       3.80 %

Short-term investments (4)

    152,830       981       1.27 %     134,334       341       0.50 %

Total interest-earning assets

    1,016,381       31,448       6.14 %     953,001       26,625       5.54 %

Cash and due from banks

    2,933                       2,852                  

Other non-interest earning assets

    32,025                       33,012                  

Total assets

  $ 1,051,339                     $ 988,865                  
                                                 

Liabilities & Shareholders' Equity:

                                               

Interest-bearing liabilities:

                                               

NOW accounts

  $ 69,931     $ 102       0.29 %   $ 71,323     $ 103       0.29 %

Money market accounts

    377,449       2,127       1.12 %     302,323       1,435       0.94 %

Savings accounts

    36,953       25       0.13 %     35,488       25       0.14 %

Time deposits

    307,865       2,051       1.32 %     326,794       1,990       1.21 %

Total interest-bearing deposits

    792,198       4,305       1.08 %     735,928       3,553       0.96 %

Federal Home Loan Bank advances

    18,863       319       3.35 %     28,580       475       3.30 %

Subordinated debt

    23,703       1,025       8.58 %     23,395       927       7.86 %

Capital lease obligations

    797       21       5.23 %     1,056       27       5.07 %

Total interest-bearing liabilities

    835,561       5,670       1.35 %     788,959       4,982       1.25 %
                                                 

Non-interest bearing liabilities:

                                               

Demand deposits and escrow accounts

    82,210                       78,104                  

Other liabilities

    7,071                       8,255                  

Total liabilities

    924,842                       875,318                  

Shareholders' equity

    126,497                       113,547                  

Total liabilities and shareholders' equity

  $ 1,051,339                     $ 988,865                  
                                                 

Net interest income (5)

          $ 25,778                     $ 21,643          
                                                 

Interest rate spread

                    4.79 %                     4.29 %

Net interest margin (6)

                    5.03 %                     4.51 %

 

(1)  Interest income and yield are stated on a fully tax-equivalent basis using the statutory tax rate.

(2)  Includes loans held for sale.

(3)  Nonaccrual loans are included in the computation of average, but unpaid interest has not been included for purposes of determining interest income.

(4)  Short term investments include FHLB overnight deposits and other interest-bearing deposits.

(5)  Includes tax exempt interest income of $10 thousand and $36 thousand for the six months ended December 31, 2017 and December 31, 2016, respectively.

(6)  Net interest margin is calculated as net interest income divided by total interest-earning assets.

 

41

 

The following table presents the extent to which changes in volume and interest rates of interest earning assets and interest bearing liabilities have affected the Company’s interest income and interest expense during the periods indicated. Information is provided in each category with respect to (i) changes attributable to changes in volume (changes in volume multiplied by prior period rate), (ii) changes attributable to changes in rates (changes in rates multiplied by prior period volume) and (iii) changes attributable to a combination of changes in rate and volume (change in rates multiplied by the changes in volume). Changes attributable to the combined impact of volume and rate have been allocated proportionately to the changes due to volume and the changes due to rate

 

   

Six Months Ended December 31, 2017 compared to 2016

 
   

Change Due to Volume

   

Change Due to Rate

   

Total Change

 
   

(Dollars in thousands)

 

Interest earning assets:

                       

Investment securities

  $ 6     $ 41     $ 47  

Loans

    1,637       2,504       4,141  

Federal Home Loan Bank stock

    (11 )     6       (5 )

Short-term investments

    53       587       640  

Total interest-earning assets

    1,685       3,138       4,823  
                         

Interest-bearing liabilities:

                       

Interest-bearing deposits

    260       492       752  

Federal Home Loan Bank advances

    (164 )     8       (156 )

Subordinated debt

    12       86       98  

Capital lease obligations

    (7 )     1       (6 )

Total interest-bearing liabilities

    101       587       688  

Total change in net interest income

  $ 1,584     $ 2,551     $ 4,135  

 

Provision for Loan Losses

 

Quarterly, the Company determines the amount of the allowance for loan losses that is appropriate to provide for losses inherent in the Company’s loan portfolios, with the provision for loan losses determined by the net change in the allowance for loan losses. For loans accounted for under ASC 310-30, a provision for loan loss is recorded when estimates of future cash flows are lower than had been previously expected. See Part I. Item I. “Notes to Unaudited Consolidated Financial Statements — Note 4: Loans, Allowance for Loan Losses and Credit Quality” for further discussion.

 

The provision for loan losses for periods subsequent to the merger with FHB reflects the impact of adjusting loans to their then fair values, as well as the elimination of the allowance for loan losses in accordance with the acquisition method of accounting. Subsequent to the merger, the provision for loan losses has been recorded based on estimates of inherent losses in newly originated loans and for incremental reserves required for pre-merger loans based on estimates of deteriorated credit quality post-merger.

 

Three Months Ended December 31, 2017 and 2016

 

The provision for loan losses for the quarter ended December 31, 2017 and 2016 was $437 thousand and $628 thousand, respectively. The decrease in the Company’s loan loss provision was primarily due to the effect of changes in the qualitative factors, as well as updates to the specific reserve on impaired loans.

 

Six Months Ended December 31, 2017 and 2016

 

The provision for loan losses for the six months ended December 31, 2017 and 2016 was $792 thousand and $820 thousand, respectively. The decrease in the Company’s loan loss provision was due to the effect of changes in the qualitative factors.

 

Noninterest Income

 

Three Months Ended December 31, 2017 and 2016

 

Noninterest income decreased by $1.5 million for the quarter ended December 31, 2017, compared to the quarter ended December 31, 2016, principally due to the following:

 

A decrease in gain on sale of SBA loans of $1.4 million, due to a lower amount of SBA loans sold in the quarter; and

 

A decrease in gain on sale of residential loans held for sale of $82 thousand, due to lower volume of residential loans sold in the quarter.

 

42

 

Six Months Ended December 31, 2017 and 2016

 

Noninterest income decreased by $1.3 million for the six months ended December 31, 2017, compared to the six months ended December 31, 2016, principally due to the following:

 

A decrease in gain on sale of SBA loans of $1.1 million, due to a lower amount of SBA loans sold in the six month period; and

 

A decrease in gain on sale of residential loans held for sale of $333 thousand, due to lower volume of residential loans sold in the six month period.

 

Noninterest Expense

 

Three Months Ended December 31, 2017 and 2016

 

Noninterest expense decreased by $393 thousand for the quarter ended December 31, 2017, compared to the quarter ended December 31, 2016, primarily due to the following:

 

A decrease in other noninterest expense of $395 thousand, primarily due to a $330 thousand decrease in expense related to the quarterly valuation of SBA servicing rights; and

 

A decrease in loan expense of $179 thousand, largely driven by lower expense related to loan acquisition and refinance activity.

 

The decreases in noninterest expense were partially offset by an increase in data processing fees of $214 thousand, primarily due to increased cost associated with outsourcing of data processing.

 

Six Months Ended December 31, 2017 and 2016

 

Noninterest expense decreased by $305 thousand for the six months ended December 31, 2017, compared to the six months ended December 31, 2016, principally due to the following:

 

A decrease in other noninterest expense of $349 thousand, primarily due to a $330 thousand decrease in expense related to the valuation of SBA servicing rights; and

 

 

A decrease in occupancy and equipment expense of $221 thousand, primarily due to a decrease in IT-related equipment expense and computer equipment depreciation expense.

 

 

The decreases in noninterest expense were partially offset by an increase in data processing fees of $395 thousand, primarily due to the increased cost associated with outsourcing of data processing.

 

Income Taxes

 

Three Months Ended December 31, 2017 and 2016

 

The Company’s income tax expense was $1.4 million, or an effective tax rate of 29.5% for the quarter ended December 31, 2017, compared to income tax expense of $1.8 million, or an effective tax rate of 37.2% for the quarter ended December 31, 2016. Overall, tax expense decreased by $458 thousand for the quarter, primarily due to the following:

 

A decrease in the federal corporate income tax rate as a result of the Tax Cuts and Jobs Act signed into law on December 22, 2017, which resulted in a $762 thousand decrease in federal income tax expense. Of this total, $328 thousand was related to the decrease in the federal corporate income tax rate for the three months ended December 31, 2017 and $434 thousand was related to income tax expense previously recorded in the three months ended September 30, 2017, to arrive at the required blended federal corporate income tax rate of 28.0% for fiscal year 2018; and

 

A decrease in income tax expense as a result of a $279 thousand income tax benefit arising from the treatment of stock options exercised or vested restricted stock awards under ASU 2016-09, Compensation—Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting, whereby the tax effects of exercised options or vested awards are treated as a discrete item in the reporting period in which they occur.

 

The decreases in income tax expense were partially offset by the impact of revaluing the deferred tax asset as a result of the change in the federal corporate income tax rate as well as the recording of current year changes in the deferred tax asset, which resulted in an increase in income tax expense of $498 thousand.

 

Six Months Ended December 31, 2017 and 2016

 

The Company’s income tax expense was $3.0 million, or an effective tax rate of 27.5% for the six months ended December 31, 2017, compared to income tax expense of $2.9 million, or an effective tax rate of 37.0% for the six months ended December 31, 2016. Overall, income tax expense increased by $143 thousand for the six months, primarily due to the following:

 

An increase in income before income tax offset by a decrease in the federal corporate income tax rate as a result of the Tax Cuts and Jobs Act signed into law on December 22, 2017, which resulted in a blended federal corporate income tax rate of 28.0% for the six months ended December 31, 2017;

 

An increase in income tax expense of $498 thousand due to the revaluing of the deferred tax asset as a result of the change in the federal corporate income tax rate; and,

 

A decrease in income tax expense as a result of a $1.1 million income tax benefit arising from the treatment of stock options exercised or vested restricted stock awards under ASU 2016-09, Compensation—Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting, whereby the tax effects of exercised options or vested awards are treated as a discrete item in the reporting period in which they occur. See Part I. Item I. “Notes to Unaudited Consolidated Financial Statements — Note 10: Stock-Based Compensation” for further discussion.

 

43

 

Item 3. Quantitative and Qualitative Disclosure about Market Risk

 

Market Risk

 

Market risk is the risk of loss due to adverse changes in market prices and rates, and typically encompasses exposures such as sensitivity to changes in market interest rates, foreign currency exchange rates, and commodity prices. The Company has no exposure to foreign currency exchange or commodity price movements. Because net interest income is our primary source of revenue, interest rate risk is a significant market risk to which the Company is exposed.

 

Interest Rate Risk

 

Interest rate risk can be defined as the exposure of future net interest income to adverse movements in interest rates. Net interest income is affected by changes in interest rates as well as by fluctuations in the level, mix and duration of the Company's assets and liabilities. Over and above the influence that interest rates have on net interest income, changes in rates also affect the volume of lending activity, the ability of borrowers to repay loans, the volume of loan prepayments, the flow and mix of deposits, and the market value of the Company's assets and liabilities.

 

Asset/Liability Management

 

The Company's management has established an Asset Liability Management Committee ("ALCO"), which is responsible for managing the Company's interest rate risk in accordance with policies and limits approved by the Board of Directors. With regard to management of market risk, the ALCO is charged with managing the Company's mix of assets and funding sources to produce results that are consistent with the Company's liquidity, capital adequacy, growth, and profitability goals.

 

Exposure to interest rate risk is managed by Northeast through periodic evaluations of the current interest rate risk inherent in its rate-sensitive assets and liabilities, coupled with determinations of the level of risk considered appropriate given the Company's capital and liquidity requirements, business strategy, and performance objectives. Through such management, Northeast seeks to mitigate the potential volatility in its net interest income due to changes in interest rates in a manner consistent with the risk appetite established by the Board of Directors.

 

The ALCO's primary tool for measuring, evaluating, and managing interest rate risk is income simulation analysis. Income simulation analysis measures the interest rate risk inherent in the Company's balance sheet at a given point in time by showing the effect of interest rate shifts on net interest income over defined time horizons. These simulations take into account the specific repricing, maturity, prepayment and call options of financial instruments that vary under different interest rate scenarios. The ALCO reviews simulation results to determine whether the exposure to a decline in net interest income remains within established tolerance levels over the simulation horizons and to develop appropriate strategies to manage this exposure. The Company considers a variety of specified rate scenarios, including instantaneous rate shocks, against static (or flat) rates when measuring interest rate risk, and evaluates results over two consecutive twelve-month periods. All changes are measured in comparison to the projected net interest income that would result from an "unchanged" scenario, where interest rates remain stable over the measured time horizon(s).

 

While the ALCO reviews simulation assumptions to ensure they are reasonable, and back-tests simulation results on a periodic basis as a monitoring tool, income simulation analysis may not always prove to be an accurate indicator of the Company's interest rate risk or future earnings. There are inherent shortcomings in income simulation, given the number and variety of assumptions that must be made to perform it. For example, the projected level of future market interest rates and the shape of future interest rate yield curves have a major impact on income simulation results. Many assumptions concerning the repricing of financial instruments, the degree to which non-maturity deposits react to changes in market rates, and the expected prepayment rates on loans, mortgage-backed securities, and callable debt securities are also inherently uncertain. In addition, as income simulation analysis assumes that the Company's balance sheet will remain static over the simulation horizon, the results do not reflect the Company's expectations for future balance sheet growth, nor changes in business strategy that the Company could implement in response to rate shifts to mitigate its loss exposures. As such, although the analysis described above provides an indication of the Company's sensitivity to interest rate changes at a point in time, these estimates are not intended to and do not provide a precise forecast of the effect of changes in market interest rates on the Company's net interest income and will differ from actual results.

 

Measuring Interest Rate Risk

 

The Company can be subject to margin compression depending on the economic environment and the shape of the yield curve.  Under the Company's current balance sheet position, the Company's margin generally performs slightly better over time in a rising rate environment, while it generally decreases in a declining rate environment and when the yield curve is flattening or inverted.

 

Under a flattening yield curve scenario, margin compression occurs as the spread between the cost of funding and the yield on interest earning assets narrows.  Under this scenario the degree of margin compression is highly dependent on the Company's ability to fund asset growth through lower cost deposits.  However, if the curve is flattening, while short-term rates are rising, the adverse impact on margin may be somewhat delayed, as increases in the Prime Rate will initially result in the Company's asset yields re-pricing more quickly than funding costs.

 

44

 

Under an inverted yield curve situation, shorter-term rates exceed longer-term rates, and the impact on margin is similar but more adverse than the flat curve scenario.  Again, however, the extent of the impact on margin is highly dependent on the Company's balance sheet mix.

 

In a declining rate environment, margin compression will eventually occur as the yield on interest earning assets decreases more rapidly than decreases in funding costs.  The primary causes would be the impact of interest rate decreases (including decreases in the Prime Rate) on adjustable rate loans and the fact that decreases in deposit rates may be limited or lag decreases in the Prime Rate.

 

There have been no material changes in the results of the Company's net interest income sensitivity analysis as reported in the Company's 2017 Annual Report on Form 10-K.  At December 31, 2017, management continues to consider the Company's primary interest rate risk exposure to be margin compression that may result from changes in interest rates and/or changes in the mix of the Company's balance sheet components.  This would include the mix of fixed versus variable rate loans and investments on the asset side, and higher cost versus lower cost deposits and overnight borrowings versus term borrowings and certificates of deposit on the liability side.

 

Item 4. Controls and Procedures

 

The Company maintains controls and procedures designed to ensure that information required to be disclosed in the reports the Company files or submits under the Securities Exchange Act of 1934 (“Exchange Act”) is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission, and that such information is accumulated and communicated to the Company’s management, including the Chief Executive Officer and Chief Financial Officer (the Company’s principal executive officer and principal financial officer, respectively), as appropriate to allow for timely decisions regarding timely disclosure. In designing and evaluating disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management is required to apply its judgment in evaluating the cost/benefit relationship of possible controls and procedures.

 

The Company’s management, with the participation of the Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of its disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this Quarterly Report on Form 10-Q.

 

Based on this evaluation of the Company’s disclosure controls and procedures, the Chief Executive Officer and Chief Financial Officer have concluded that these disclosure controls and procedures were effective as of December 31, 2017.

 

There were no changes in the Company’s internal controls over financial reporting (as defined in Rule 13a-15(f) of the Exchange Act) that occurred during the quarter ended December 31, 2017 that have materially affected, or is reasonably likely to materially affect, the Company’s internal controls over financial reporting.

 

45

 

PART II – OTHER INFORMATION

 

Item 1.

Legal Proceedings

 

None.

 

 

Item 1A.

Risk Factors

 

There have been no material changes to the risk factors disclosed in Item 1A of the Company’s 2017 Annual Report on Form 10-K.

   

 Item 2.

 Unregistered Sales of Equity Securities and Use of Proceeds

 

There were no purchases made by the Company of its common stock during the three and six months ended December 31, 2017.

   

Item 3.

 

 

 

Item 4.

 

 

 

Item 5.

 

 

 

Item 6.

Defaults Upon Senior Securities

 

None.

 

Mine Safety Disclosures

 

Not applicable.

 

Other Information

 

None.

 

Exhibits

 

 

Exhibits No.

Description

 

31.1

Certification of the Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (Rule 13a-14(a)). *

 

31.2

Certification of the Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (Rule 13a-14(a)). *

 

32.1

Certificate of the Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (Rule 13a-14(b)). **

 

32.2

Certificate of the Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (Rule 13a-14(b)). **

 

101

The following materials from Northeast Bancorp’s Quarterly Report on Form 10-Q for the quarter ended December 31, 2017 formatted in XBRL: (i) Consolidated Balance Sheets at December 31, 2017 and June 30, 2017; (ii) Consolidated Statements of Income for the three and six months ended December 31, 2017 and 2016; (iii) Consolidated Statements of Comprehensive Income for the three and six months ended December 31, 2017 and 2016; (iv) Consolidated Statements of Changes in Shareholders’ Equity for the six months ended December 31, 2017 and 2016; (v) Consolidated Statements of Cash Flows for the six months ended December 31, 2017 and 2016; and (v) Notes to Unaudited Consolidated Financial Statements. *

 

* Filed herewith

** Furnished herewith

 

46

 

SIGNATURES

 

Pursuant to the requirements of the Securities Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

Date: February 9, 2018

 

NORTHEAST BANCORP

     

 

By:

/s/ Richard Wayne

 

 

  Richard Wayne

 

 

  President and Chief Executive Officer

 

 

 

 

By:

/s/ Jean-Pierre Lapointe

 

 

  Jean-Pierre Lapointe

 

 

  Chief Financial Officer and Treasurer 

 

 

47

 

NORTHEAST BANCORP

Index to Exhibits

 

Exhibits

No.

Description

 

31.1

Certification of the Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (Rule 13a-14(a)). *

 

31.2

Certification of the Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (Rule 13a-14(a)). *

 

32.1

Certificate of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (Rule 13a-14(b)). **

 

32.2

Certificate of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (Rule 13a-14(b)). **

 

101

The following materials from Northeast Bancorp’s Quarterly Report on Form 10-Q for the quarter ended December 31 2017 formatted in XBRL: (i) Consolidated Balance Sheets at December 31, 2017 and June 30, 2017; (ii) Consolidated Statements of Income for the three and six months ended December 31, 2017 and 2016; (iii) Consolidated Statements of Comprehensive Income for the three and six months ended December 31, 2017 and 2016; (iv) Consolidated Statements of Changes in Shareholders’ Equity for the six months ended December 31, 2017 and 2016; (v) Consolidated Statements of Cash Flows for the six months ended December 31, 2017 and 2016; and (v) Notes to Unaudited Consolidated Financial Statements. *

 

* Filed herewith

** Furnished herewith

 

 48