UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

      

FORM 10-Q

      

(Mark One)

 

For the quarterly period ended September 30, 2013

or

 

For the transition from                       to                     

Commission file number: 0-13814

      

Cortland Bancorp

(Exact name of registrant as specified in its charter)

      

   

 

330- 637-8040

(Registrant’s telephone number, including area code)

N/A

(Former name, former address and former fiscal year, if changed since last report)

      

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    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  x    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 and large accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

   

 

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

APPLICABLE ONLY TO CORPORATE ISSUERS:

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

   

 

   

      

      

   

   

       

 

   

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CORTLAND BANCORP AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS (UNAUDITED)

(Amounts in thousands, except share data)

   

 

   

   

   

   

   

   

See accompanying notes to the unaudited consolidated financial statements of Cortland Bancorp and Subsidiaries

   

   

 

 2 

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CORTLAND BANCORP AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)

(Amounts in thousands, except share data)

   

 

   

   

See accompanying notes to the unaudited consolidated financial statements of Cortland Bancorp and Subsidiaries

   

   

 

 3 

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CORTLAND BANCORP AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (UNAUDITED)

(Amounts in thousands)

   

 

   

   

   

   

   

   

   

   

   

   

   

   

   

   

   

   

See accompanying notes to the unaudited consolidated financial statements of Cortland Bancorp and Subsidiaries

   

   

 

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CORTLAND BANCORP AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY (UNAUDITED)

(Amounts in thousands)

   

 

   

   

   

   

   

   

   

   

   

See accompanying notes to the unaudited consolidated financial statements of Cortland Bancorp and Subsidiaries

   

   

   

   

 

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CORTLAND BANCORP AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

(Amounts in thousands)

   

 

   

   

   

   

   

See accompanying notes to the unaudited consolidated financial statements of Cortland Bancorp and Subsidiaries

   

   

   

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

   

   

1.) Basis of Presentation:

The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States (U.S. 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 footnotes required by U.S. GAAP for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring items) considered necessary for a fair presentation have been included. Operating results for the three and nine months ended September 30, 2013 are not necessarily indicative of the results that may be expected for the year ending December 31, 2013. These interim unaudited consolidated financial statements should be read in conjunction with our annual audited financial statements as of December 31, 2012, included in our Form 10-K for the year ended December 31, 2012, filed with the United States Securities and Exchange Commission. The accompanying consolidated balance sheet at December 31, 2012, has been derived from the audited consolidated balance sheet but does not include all of the information and footnotes required by U.S. GAAP for complete financial statements.

   

2.) Reclassifications:

Certain items contained in the 2012 financial statements have been reclassified to conform to the presentation for 2013. Such reclassifications had no effect on the net results of operations or equity.

   

3.) Investment Securities:

Investments in debt and equity securities are classified as held-to-maturity, available-for-sale or trading. Securities classified as held-to-maturity are those that management has the positive intent and ability to hold to maturity. Securities classified as available-for-sale are those that could be sold for liquidity, investment management, or similar reasons, even though management has no present intentions to do so. Securities classified as trading are those that management has bought principally for the purpose of selling in the near term. The Company currently has no securities classified as held-to-maturity.

Available-for-sale securities are carried at fair value with unrealized gains and losses recorded as a separate component of shareholders’ equity, net of tax effects. Realized gains or losses on dispositions are based on net proceeds and the adjusted carrying amount of securities sold, using the specific identification method. Interest income includes amortization of purchase premium or discount and is amortized on the level-yield method without anticipating payments, except for both U.S. Government and private-label mortgage-backed and related securities where twelve months of historical prepayments are taken into consideration. Trading securities are carried at fair value with valuation adjustments included in other non-interest income.

Available-for-sale securities are evaluated periodically to determine whether a decline in value is other-than-temporary. Management utilizes criteria such as the magnitude and duration of the decline, along with the reasons underlying the decline, to determine whether the loss in value is other-than-temporary. The term “other-than-temporary” is not intended to indicate that the decline is permanent, but indicates that the prospect for a near-term recovery of value is not necessarily favorable and that there is a lack of evidence to support a realizable value equal to or greater than the carrying value of the investment. Unrealized losses on investments have not been recognized into income. However, once a decline in value is determined to be other-than-temporary, the credit related other-than-temporary impairment (OTTI) is recognized in earnings while the non-credit related OTTI on securities not expected to be sold is recognized in other comprehensive loss.

 

 7 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

   

The following table is a summary of investment securities available-for-sale: 

   

 

   

 

FHLB and FRB stock are carried at cost and the Company is required to hold such investments as a condition of membership in order to transact business with the FHLB and the FRB. While the FHLBs have been negatively impacted by the recent economic conditions, the FHLB of Cincinnati has reported profits for 2012 and year-to-date 2013, remains in compliance with regulatory capital and liquidity requirements, continues to pay dividends on stock and makes redemptions at par value. With consideration given to these factors, management concluded that the stock was not impaired at September 30, 2013 or December 31, 2012.

Trading securities of $7.2 million are an investment in obligations of states and political subdivisions and cash equivalent investments.

The amortized cost and fair value of debt securities at September 30, 2013, by contractual maturity, are shown below. Actual maturities will differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties.

   

 

 

 8 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

   

The table below sets forth the proceeds and gains or losses realized on securities sold or called for the periods presented:

   

 

Investment securities with a carrying value of approximately $96.2 million and $107.6 million were pledged to secure deposits and for other purposes at September 30, 2013 and December 31, 2012. The remaining securities provide an adequate level of liquidity.

 

 9 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

   

   

The following is a summary of the fair value of securities with unrealized losses and an aging of those unrealized losses at September 30, 2013:

   

 

The above table comprises 79 investment securities where the fair value is less than the related amortized cost.

The following is a summary of the fair value of securities with unrealized losses and an aging of those unrealized losses at December 31, 2012:

   

 

The above table comprises 46 investment securities where the fair value is less than the related amortized cost.

The trust preferred securities with an unrealized loss represent pools of trust preferred debt primarily issued by bank holding companies and insurance companies. The unrealized losses on the Company’s investment in U.S. Government-sponsored-mortgage-backed securities, U.S. Government-sponsored collateralized mortgage obligations, obligations of states and political subdivisions and U.S. Government agencies and corporations were caused by changes in market rates and related spreads, as well as reflecting current distressed conditions in the credit markets and the market’s on-going reassessment of appropriate liquidity and risk premiums. It is expected that the securities would not be settled at less than the amortized cost of the Company’s investment because the decline in fair value is attributable to changes in interest rates and relative spreads and not credit quality. Also, the Company does not intend to sell those investments and it is not more-likely-than-not that the Company will be required to sell the investments before recovery of its amortized cost basis less any current period credit loss. The Company does not consider these investments to be other-than-temporarily impaired at September 30, 2013.

Securities Deemed to be Other-Than-Temporarily Impaired

The Company reviews investment debt securities on an ongoing basis for the presence of other-than-temporary impairment (OTTI) with formal reviews performed quarterly.

For debt securities in an unrealized loss position, management assesses whether (a) it has the intent to sell the debt security or (b) it is more-likely-than-not that it will be required to sell the debt security before its anticipated recovery. If either of these conditions is met, an OTTI on the security must be recognized.

 

 10 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

   

In instances in which a determination is made that a credit loss (defined as the difference between the present value of the cash flows expected to be collected and the amortized cost basis) exists but the entity does not intend to sell the debt security and it is not more-likely-than-not that the entity will be required to sell the debt security before the anticipated recovery of its remaining amortized cost basis (i.e., the amortized cost basis less any current-period credit loss), the Company presents the amount of the OTTI recognized in the income statement.

In these instances, the impairment is separated into (a) the amount of the total impairment related to the credit loss, and (b) the amount of the total impairment related to all other factors. The amount of the total OTTI related to the credit loss is recognized in earnings. The amount of the total impairment related to all other factors is recognized in comprehensive income. The total other-than-temporary impairment is presented in the income statement with an offset for the amount of the total other-than-temporary impairment that is recognized in comprehensive income.

As more fully disclosed in Note 9, the Company assessed the impairment of certain securities currently in an illiquid market. Through the impairment assessment process, the Company determined that the investments discussed in the following table were other-than-temporarily impaired at September 30, 2013 and 2012. No investments were determined to be other-than-temporarily impaired in the quarters ended September 30, 2013 and 2012.

The Company records impairment credit losses in earnings (before tax) and non-credit impairment losses in other comprehensive income (before tax) as indicated in the following table:

   

 

The following provides a cumulative rollforward of credit losses recognized in earnings for trust preferred securities held for the three and nine months ended:

   

 

During the third quarter of 2012, the Company was able to sell 19 of the 22 bank collateralized positions. All of these securities exhibited evidence of significant deterioration in issuers’ creditworthiness. The 3 remaining bank collateralized positions, as well as the 9 positions collateralized by insurance companies, have historically not exhibited material other-than-temporary impairment, thus were excluded from sale considerations. The Company continues to have both the intent and ability to hold these securities until recovery of their cost basis.

At September 30, 2013, there was $1,029,700 of investment securities considered to be in non-accrual status. This balance is comprised of 2 of its 12 investments in trust preferred securities. As a result of the delay in the collection of interest payments, management placed these securities in non-accrual status. Current estimates indicate that the interest payment delays may exceed ten years. All other trust preferred securities remain in accrual status.

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

   

   

4.) Loans and Allowance for Loan Losses:

The Company, through the Bank, grants residential, consumer and commercial loans to customers located primarily in Northeastern Ohio and Western Pennsylvania.

The following represents the composition of the loan portfolio for the period ending:

   

 

Management has an established methodology to determine the adequacy of the allowance for loan losses that assesses the risks and losses inherent in the loan portfolio. For purposes of determining the allowance for loan losses, the Company has segmented loans in the portfolio by product type. Loans are segmented into the following pools: commercial loans, commercial real estate loans, residential real estate loans and consumer loans. The Company also sub-segments the consumer loan portfolio into the following two classes: other consumer loans and home equity loans. Historical loss percentages for each risk category are calculated and used as the basis for calculating allowance allocations. These historical loss percentages are calculated over multiple periods for all portfolio segments. Management evaluates these results and utilizes the most reflective period in the calculation. Certain qualitative factors are then added to the historical allocation percentage to get the adjusted factor.

These factors include, but are not limited to, the following:

   

 

The following factors are analyzed and applied to loans internally graded with higher credit risk in addition to the above factors for non-classified loans:

   

 

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

   

The following is an analysis of changes in the allowance for loan losses for the periods ended:

   

 

   

 

   

 

   

 

The total allowance reflects management’s estimate of loan losses inherent in the loan portfolio at the consolidated balance sheet date.

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

   

The following tables present a full breakdown by portfolio segment, the changes in the allowance for loan losses and the recorded investment in loans for the periods ended September 30, 2013 and December 31, 2012:

      

 

   

 

The following tables represent credit exposures by internally assigned grades for September 30, 2013 and December 31, 2012. The grading analysis estimates the capability of the borrower to repay the contractual obligations of the loan agreements as scheduled or at all. The Company’s internal credit risk grading system is based on experiences with similarly graded loans.

The Company’s internally assigned grades are as follows:

 

 

 

 

 

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

   

The following table is a summary of credit quality indicators by internally assigned grade as of September 30, 2013 and December 31, 2012:

   

 

   

 

The Company evaluates the classification of consumer, home equity and residential loans primarily on a pooled basis. If the Company becomes aware that adverse or distressed conditions exist that may affect a particular loan, the loan is downgraded following the above definitions of special mention and substandard.

The following table is a summary of consumer credit exposure as of September 30, 2013 and December 31, 2012:

   

 

   

 

Loans are considered to be nonperforming when they become 90 days past due or on nonaccrual status, though the Company may be receiving partial payments of interest and partial repayments of principal on such loans. When a loan is placed in non-accrual status, previously accrued but unpaid interest is deducted from interest income. Loans in foreclosure are considered nonperforming.

Troubled Debt Restructuring

Nonperforming loans also include certain loans that have been modified in trouble debt restructurings (TDRs) where economic concessions have been granted to borrowers who have experienced or are expected to experience financial difficulties. These concessions typically result from the Company’s loss mitigation activities and could include reductions in the interest rate, payment extensions, forgiveness of principal, forbearance or other actions. Certain TDRs are classified as nonperforming at the time of restructure and may only be returned to performing status after considering the borrower’s sustained repayment performance for a reasonable period, generally six months.

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

   

The following table shows the amounts of contractual interest income and interest income actually reflected in income on TDRs for the periods indicated.

   

 

The following table presents, by class, information related to loans modified in a TDR during the three and nine months ended September 30, 2013 and September 30, 2012 (1):

   

 

   

 

   

 

   

The two new commercial real estate loans had either the rate unchanged or blended with no rate impact. Both loans had loan term changes.  Two of the Commercial loans were to the same company,   The loans had loan term changes with no rate concessions made. The other commercial loan had multiple changes including rate change, shortened maturity and additional collateral.

   

During 2013, the Company removed one commercial real estate loan from TDR status. The previously reported TDR had a recorded investment of $1.1 million as of December 31, 2012. In 2013, the Company re-underwrote and re-modified the loan at terms that were considered to be at market for loans with comparable risk. Management expects the borrower to perform under the re-modified terms based on the cash flows of the borrower. Based on the terms of the of the re-modification, the loan no longer meets the criteria for a troubled debt restructuring and, as such, was removed from TDR status in 2013 and is no longer evaluated individually for impairment.

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

   

The following table is an aging analysis of the recorded investment of past due loans as of September 30, 2013 and December 31, 2012:

   

 

   

 

An impaired loan is a loan on which, based on current information and events, it is probable that a creditor will be unable to collect all amounts due (including both interest and principal) according to the contractual terms of the loan agreement. However, an insignificant delay or insignificant shortfall in amount of payments on a loan does not indicate that the loan is impaired.

When a loan is determined to be impaired, impairment should be measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate. However, as a practical expedient, the Company will measure impairment based on a loan’s observable market price, or the fair value of the collateral if the loan is collateral dependent.

The following are the criteria for selecting individual loans / relationships for impairment analysis. Non-homogenous loans which meet the criteria below are evaluated quarterly.

 

 

 

 

 

 

Any loan evaluated for impairment is excluded from the general pool of loans in the ALLL calculation regardless if a specific reserve was determined. If management determines that the value of the impaired loan is less than the recorded investment in the loan (net of previous charge-offs, deferred loan fees or costs and unamortized premium or discount), impairment is recognized through an allowance estimate or a charge-off to the allowance.

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

   

The following table presents the recorded investment and unpaid principal balances for impaired loans, excluding homogenous loans for which impaired analyses are not necessarily performed, with the associated allowance amount, if applicable, at September 30, 2013 and December 31, 2012. Also presented are the average recorded investments in the impaired balances and interest income recognized after impairment for the nine months ended September 30, 2013 and September 30, 2012.

   

 

   

 

   

 

   

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

   

   

 

The following table is a summary of classes of loans on non-accrual status as of September 30, 2013 and December 31, 2012:

   

 

As of September 30, 2013 and December 31, 2012, there were $1.9 million and $2.7 million, respectively, in loans that were neither classified as non-accrual nor considered impaired, but which can be considered potential problem loans.

   

5.) Legal Proceedings:

The Company is involved in legal actions arising in the ordinary course of business. In the opinion of management, the outcomes from these matters, either individually or in the aggregate, are not expected to have any material effect on the Company.

   

6.) Earnings Per Share and Capital Transactions:

The following table sets forth the computation of basic earnings per common share and diluted earnings per common share. Basic earnings per share is computed by dividing net income by the weighted average number of shares outstanding during the applicable period.

   

 

   

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

   

7.) Subordinated Debt:

In July 2007, a trust formed by the Company issued $5.0 million of floating rate trust preferred securities as part of a pooled offering of such securities due December 2037. The Company owns all $155,000 of the common securities issued by the trust. The securities bear interest at the 3-month LIBOR rate plus 1.45%. The rates at September 30, 2013 and December 31, 2012 were 1.70% and 1.76%, respectively. The Company issued subordinated debentures to the trust in exchange for the proceeds of the trust preferred offering. The debentures represent the sole assets of this trust. The Company may redeem the subordinated debentures, in whole or in part, at par.

The trust is not consolidated with the Company’s financial statements. Accordingly, the Company does not report the securities issued by the trust as liabilities, but instead reports as liabilities the subordinated debentures issued by the Company and held by the trust. The subordinated debentures qualify as Tier 1 capital for regulatory purposes in determining and evaluating the Company’s capital adequacy.

   

8.) Commitments:

Commitments to fund certain mortgage loans (interest rate locks) to be sold into the secondary market, forward contracts for the future sale of mortgage-backed securities and forward contracts for the future delivery of these mortgage loans are considered derivatives. It is the Company’s practice to enter into the forward contracts for the future sale of mortgage-backed securities when interest rate lock commitments are entered into in order to economically hedge the effect of changes in interest rates resulting from its commitments to fund the loans. These mortgage banking derivatives are not formally designated in hedge relationships. The Company reports the derivative assets and liabilities in other assets and other liabilities; associated income and expense is reported in mortgage banking gains.

Although residential mortgage loans originated and sold are without recourse as to performance, third parties to which the loans are sold can require repurchase of loans in the event noncompliance with the representations and warranties included in the sales agreements exists. These repurchases are typically those for which the borrower is in a nonperforming status, diminishing the prospects for future collection on the loan. The Company historically has not been required to repurchase any loans; however, provision is made for the contingent probability of this occurrence.

The following table is a summary of mortgage banking derivative commitments and the related balance sheet accounts:

   

 

The Bank 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, standby letters of credit and financial guarantees. Such instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized on the consolidated balance sheets. The contract or notional amounts for those instruments reflect the extent of involvement the Company has in particular classes of financial instruments.

In the event of nonperformance by the other party, the Company’s exposure to credit loss on these financial instruments is represented by the contract or notional amount of the instrument. The Company uses the same credit policies in making commitments and conditional obligations as it does for instruments recorded on the balance sheet. The amount and nature of collateral obtained, if any, is based on management’s credit evaluation.

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

   

The following table is a summary of such contractual commitments:

   

 

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. Generally these financial arrangements have fixed expiration dates or other termination clauses and may require payment of a fee. Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. 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 creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Bank upon extension of credit, is based on management’s credit evaluation of the counterparty. Collateral held varies but may include accounts receivable, inventory, property, plant and equipment and income-producing commercial properties.

The Company also offers limited overdraft protection as a non-contractual courtesy which is available to businesses as well as individually/jointly owned accounts in good standing for personal or household use. The Company reserves the right to discontinue this service without prior notice.

The following table is a summary of overdraft protection for the periods indicated:

   

 

   

   

9.) Fair Value of Assets and Liabilities:

Measurements

Accounting guidance affirms that the objective of fair value when the market for an asset is not active is the price that would be received to sell the asset in an orderly transaction, and clarifies and includes additional factors for determining whether there has been a significant decrease in market activity for an asset when the market for that asset is not active. ASC Topic 820 requires an entity to base its conclusion about whether a transaction was not orderly on the weight of the evidence.

The Company groups assets and liabilities recorded at fair value into three levels based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. A financial instrument’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement (with level 1 considered highest and level 3 considered lowest). A brief description of each level follows:

 

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

   

The following tables present the assets reported on the consolidated balance sheets at their fair value as of September 30, 2013 and December 31, 2012 by level within the fair value hierarchy. Financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement.

   

 

   

 

The following table presents the changes in the Level 3 fair value category for the three and nine months ended September 30, 2013 and 2012. The Company classifies financial instruments in Level 3 of the fair value hierarchy when there is reliance on at least one significant unobservable input to the valuation model. In addition to these unobservable inputs, the valuation models for Level 3 financial instruments typically also rely on a number of inputs that are readily observable either directly or indirectly.

   

 

The Company conducts OTTI analyses on a quarterly basis. The initial indication of other-than-temporary impairment for both debt and equity securities is a decline in the fair value below the amount recorded for an investment. A decline in value that is considered

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

   

to be other-than-temporary is recorded as a loss within non-interest income in the consolidated statements of income. In determining whether an impairment is other than temporary, the Company considers a number of factors, including, but not limited to, the length of time and extent to which the market value has been less than cost, recent events specific to the issuer, including investment downgrades by rating agencies and economic conditions of its industry, and a determination that the Company does not intend to sell those investments and it is not more-likely-than-not that the Company will be required to sell the investments before recovery of its amortized cost basis less any current period credit loss. Among the factors that are considered in determining the Company’s intent and ability is a review of its capital adequacy, interest rate risk position and liquidity.

The Company also considers the issuer’s financial condition, capital strength and near-term prospects. In addition, for debt securities the Company considers the cause of the price decline (general level of interest rates and industry- and issuer-specific factors), current ability to make future payments in a timely manner and the issuer’s ability to service debt, the assessment of a security’s ability to recover any decline in market value, the ability of the issuer to meet contractual obligations and the Company’s intent and ability to retain the security. All of the foregoing require considerable judgment.

Trust Preferred Securities

The Company evaluates current available information in estimating the future cash flows of securities and determines whether there have been favorable or adverse changes in estimated cash flows from the cash flows previously projected. The Company considers the structure and term of the pool and the financial condition of the underlying issuers. Specifically, the evaluation incorporates factors such as interest rates and appropriate risk premiums, the timing and amount of interest and principal payments and the allocation of payments to the various note classes. Current estimates of cash flows are based on the most recent trustee reports, announcements of deferrals or defaults, expected future default rates and other relevant market information.

The Company holds trust preferred securities that are backed by pooled trust preferred debt issued by banks, thrifts, insurance companies and real estate investment trusts. These securities were all rated investment grade at inception. Beginning during the second half of 2008 and into 2013, factors outside the Company’s control impacted the fair value of these securities and will likely continue to do so for the foreseeable future. These factors include, but are not limited to, the following: guidance on fair value accounting, issuer credit deterioration, issuer deferral and default rates, potential failure or government seizure of underlying financial institutions or insurance companies, ratings agency actions, or regulatory actions. As a result of changes in these and various other factors during 2009 and into 2013, Moody’s Investors Service, Fitch Ratings and Standards and Poor’s downgraded multiple trust preferred securities, including securities held by the Company. All of the trust preferred securities held by the Company are now considered to be below investment grade. The deteriorating economic, credit and financial conditions experienced in 2008 and through 2012 have resulted in illiquid and inactive financial markets and severely depressed prices for these securities. The Company analyzed the cash flow characteristics of the securities to determine which investments the Company does not consider to be OTTI at September 30, 2013. The Company does not intend to sell the securities and it is more-likely-than-not that the Company will not be required to sell the securities before recovery of its amortized cost basis. There was no adverse change in the cash flows. Although the Company did not identify additional OTTI in these investments at September 30, 2013, there is a risk that subsequent evaluations could result in recognition of OTTI charges in the future. The remaining securities had life-to-date impairment losses as presented below.

The following table details the breakdown of trust preferred securities for the periods indicated:

   

 

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

   

   

The following table details the 2 debt securities with other-than-temporary impairment, their credit ratings at September 30, 2013 and the related losses recognized in earnings:

   

 

The following table details the 2 debt securities with other-than-temporary impairment, their credit ratings at September 30, 2012 and the related losses recognized in earnings:

   

 

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

   

The following table provides additional information related to the Company’s trust preferred securities as of September 30, 2013 used to evaluate other-than-temporary impairments:

   

 

The following table provides additional information related to the Company’s trust preferred securities as of December 31, 2012 used to evaluate other-than-temporary impairments:

   

 

The market for these securities at September 30, 2013 and December 31, 2012 is not active and markets for similar securities are also not active. The inactivity was evidenced first by a significant widening of the bid-ask spread in the brokered markets in which trust preferred securities trade and then by a significant decrease in the volume of trades relative to historical levels. The new issue market is also inactive as no new trust preferred securities have been issued since 2007. There are currently very few market participants who are willing and/or able to transact for these securities. The pooled market value for these securities remains very depressed relative to historical levels. Although there has been marked improvement in the credit spread premium in the corporate bond space, no such improvement has been noted in the market for trust preferred securities.

 

 25 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

   

Given conditions in the debt markets today and the absence of observable transactions in the secondary and the new issue markets, the Company determined the following:

 

 

 

The Company enlisted the aid of an independent third party to perform the trust preferred security valuations. The approach to determining fair value involved the following process:

 

 

 

 

The effective discount rates on an overall basis generally range from 5.7% to 17.9% and are highly dependent upon the credit quality of the collateral, the relative position of the tranche in the capital structure of the trust preferred security and the prepayment assumptions.

With the passage of the Dodd-Frank Act, trust preferred securities issued by institutions with assets greater than $15.0 billion will no longer be included in Tier 1 capital after 2013. As a result, prepayment assumptions were adjusted to include early redemptions by all institutions meeting this criteria. As the vast majority of institutions in the trust preferred securities collateral base fall below this threshold, the revised assumption did not materially impact the valuation results.

The following tables present the assets measured on a nonrecurring basis on the consolidated balance sheets at their fair value as of September 30, 2013 and December 31, 2012, by level within the fair value hierarchy. Impaired loans that are collateral dependent are written down to fair value through the establishment of specific reserves. Techniques used to value the collateral that secure the impaired loans include: quoted market prices for identical assets, classified as Level 1 inputs; observable inputs employed by certified appraisers for similar assets, classified as Level 2 inputs. In cases where valuation techniques include inputs that are unobservable and are based on estimates and assumptions developed by management based on the best information available under each circumstance, the asset valuation is classified as Level 3 inputs.

   

 

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

   

   

 

Impaired loans: A loan is considered to be impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due (both interest and principal) according to the contractual terms of the loan agreement. Impaired loans are measured, as a practical expedient, at the loan’s observable market price or the fair market value of the collateral if the loan is collateral dependent.

Other real estate owned (OREO): Real estate acquired through foreclosure or deed-in-lieu of foreclosure is included in other assets. Such real estate is carried at fair value less estimated costs to sell. Any reduction from the carrying value of the related loan to fair value at the time of acquisition is charged to the allowance for loan losses. Any subsequent reduction in fair market value is reflected as a valuation allowance through a charge to income. Costs of significant property improvements are capitalized, whereas costs relating to holding and maintaining the property are charged to expense.

Financial Instruments

The Company disclosures fair value information about financial instruments, whether or not recognized in the consolidated balance sheets, for which it is practicable to estimate the value. In cases where quoted market prices are not available, fair values are based on estimates using present value or other estimation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows.

Such techniques and assumptions, as they apply to individual categories of the financial instruments, are as follows:

Cash and cash equivalents – The carrying amounts for cash and cash equivalents are a reasonable estimate of those assets’ fair value.

Investment securities – Fair values of securities are based on quoted market prices, where available. If quoted market prices are not available, fair values are based on quoted market prices of comparable securities. Prices on trust preferred securities were calculated using a discounted cash-flow technique. Cash flows were estimated based on credit and prepayment assumptions. The present value of the projected cash flows was calculated using a discount rate equal to the current yield used to accrete the beneficial interest.

Loans held for sale – Loans held for sale consist of residential mortgage loans originated for sale. Loans held for sale are recorded at fair value based on what the secondary markets are currently offering for loans with similar characteristics.

Loans, net of allowance for loan losses – Market quotations are generally not available for loan portfolios. The fair value is estimated by discounting future cash flows using current market inputs at which loans with similar terms and qualities would be made to borrowers of similar credit quality.

Bank-owned life insurance – The fair value is based upon the cash surrender value of the underlying policies and matches the book value.

Accrued interest receivable – The carrying amount is a reasonable estimate of these assets’ fair value.

Mortgage banking derivatives – The Company enters into derivative financial instruments in the form of interest rate locks with potential mortgage loan borrowers, and likewise enters into contracts for the future delivery of residential mortgage loans into the secondary markets. These derivative instruments are recognized as either assets or liabilities at fair value on a recurring basis in the consolidated balance sheets as indicated in the ensuing table. Commitments to deliver mortgage loans are valued at the commitment

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

   

price from the investor. Interest rate lock commitments are valued at best execution prices at September 30, 2013. Forward contracts to sell mortgage-backed securities are valued at trading levels as of September 30, 2013. Fair value adjustments relating to these mortgage banking derivatives are recorded in current year earnings as a component of mortgage banking gains.

Demand, savings and money market deposits – Demand, savings, and money market deposit accounts are valued at the amount payable on demand.

Time deposits – The fair value of certificates of deposit is based on the discounted value of contractual cash flows. The discount rates are estimated using market rates currently offered for similar instruments with similar remaining maturities.

FHLB advances – The fair value for fixed rate advances is estimated by discounting the future cash flows using rates at which advances would be made to borrowers with similar credit ratings and for the same remaining maturities. The fair value for the fixed rate advances that are convertible to quarterly LIBOR floating rate advances on or after certain specified dates at the option of the FHLB and the FHLB fixed rate advances that are putable on or after certain specified dates at the option of the FHLB are priced using the FHLB of Cincinnati’s model.

Short-term borrowings – Short-term borrowings generally have an original term to maturity of one year or less. Consequently, their carrying value is a reasonable estimate of fair value.

Subordinated debt – The floating issuances curves to maturity are averaged to obtain an index. The spread between BBB-rated bank debt and 25-year swap rates is determined to calculate the spread on outstanding trust preferred securities. The discount margin is then added to the index to arrive at a discount rate, which determines the present value of projected cash flows.

Accrued interest payable – The carrying amount is a reasonable estimate of these liabilities’ fair value. The fair value of unrecorded commitments at September 30, 2013 and December 31, 2012 is not material.

In addition, other assets and liabilities of the Company that are not defined as financial instruments are not included in the disclosures, such as property and equipment. Also, non-financial instruments typically not recognized in financial statements nevertheless may have value but are not included in the above disclosures. These include, among other items, the estimated earning power of core deposit accounts, the trained work force, customer goodwill and similar items. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Company.

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

   

The carrying amounts and estimated fair values of the Company’s financial instruments are as follows:

   

 

   

 

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

   

The following tables present quantitative information about the Level 3 significant unobservable inputs for assets and liabilities measured at fair value on a recurring and nonrecurring basis at September 30, 2013 and December 31, 2012:

   

 

 

   

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

   

   

 

 

   

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

   

10.) Accumulated Other Comprehensive Income:

   

The following table presents the changes in accumulated other comprehensive loss by component net of tax for the three and nine months ended September 30, 2013:

   

 

   

(a) All amounts are net of tax. Amounts in parentheses indicate debits.

   

The following table presents significant amounts reclassified out of each component of accumulated other comprehensive income for both the three and nine months ended September 30, 2013:

   

 

   

   

 

   

   

   

   

 

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CONSOLIDATED AVERAGE BALANCE SHEETS, YIELDS AND RATES (UNAUDITED)

 

 

 

 

 

   

   

   

 

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CONSOLIDATED AVERAGE BALANCE SHEETS, YIELDS AND RATES (UNAUDITED)

 

 

 

 

 

 

   

   

 

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SELECTED FINANCIAL DATA FOR THE QUARTER ENDED

(In thousands of dollars, except for ratios and per share amounts)

   

   

 

 

   

   

   

   

 

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

Financial Review

The following is management’s discussion and analysis of the financial condition and results of operations of Cortland Bancorp (the Company). The discussion should be read in conjunction with the Consolidated Financial Statements and related notes and summary financial information included elsewhere in this quarterly report.

Note Regarding Forward-looking Statements

The Private Securities Litigation Reform Act of 1995 provides a “safe harbor” for forward-looking statements. In addition to historical information, certain information included in this discussion and other material filed or to be filed by the Company with the Securities and Exchange Commission (as well as information included in oral statements or other written statements made or to be made by the Company) may contain forward-looking statements that involve risks and uncertainties. The words “believes,” “expects,” “may,” “will,” “should,” “projects,” “contemplates,” “anticipates,” “forecasts,” “intends,” or similar terminology identify forward-looking statements. These statements reflect management’s beliefs and assumptions, and are based on information currently available to management.

Economic circumstances, the Company’s operations and actual results could differ significantly from those discussed in any forward-looking statements. Some of the factors that could cause or contribute to such differences are changes in the economy and interest rates either nationally or in the Company’s market area, including the impact of the impairment of securities; political actions, including failure of the United States Congress to raise the federal debt ceiling or the imposition of changes in the federal budget; changes in customer preferences and consumer behavior; increased competitive pressures or changes in either the nature or composition of competitors; changes in the legal and regulatory environment; changes in factors influencing liquidity, such as expectations regarding the rate of inflation or deflation, currency exchange rates, and other factors influencing market volatility; changes in assumptions underlying the establishment of reserves for possible loan losses, reserves for repurchase of mortgage loans sold and other estimates; and risks associated with other global economic, political and financial factors.

While actual results may differ significantly from the results discussed in the forward-looking statements, the Company undertakes no obligation to update publicly any forward-looking statement for any reason, even if new information becomes available.

Analysis of Assets and Liabilities for the First Nine Months

Earning assets are comprised of investment securities, loans and deposits at financial institutions, including the Federal Reserve Bank. Earning assets were $495.1 million at September 30, 2013, a decrease of 3.6% from the September 30, 2012 balance of $513.4 million, and a decrease of 7.6% from the December 31, 2012 balance of $535.7 million. The decrease from December 31, 2012 was the net result of the following: an increase in deposits at the Federal Reserve of $1.9 million and a $4.9 million increase in deposits at other banks, a decrease in investment securities available for sale of $33.7 million offset by an increase in trading securities of $7.2 million, $20.7 million of 60-day loans redeemed during the first quarter of 2013 offset by a $13.5 million increase in the commercial real estate loan portfolio, and a $18.8 million decrease in loans held for sale. Total assets of $536.6 million at September 30, 2013 reflect a decrease of 3.2% from the prior year asset total of $554.5 million and a decrease of 7.8% from December 31, 2012 asset total of $582.2 million.

Total cash and cash equivalents decreased by $1.8 million from year-end and decreased by $15.1 million from the balance at September 30, 2012. The decrease from last year is mainly due to a decrease of $19.0 million in deposits at the Federal Reserve.

At September 30, 2013, the investment securities available for sale portfolio was $150.9 million compared to $184.6 million at December 31, 2012, a decrease of $33.7 million, or 18.3%. These securities decreased $24.1 million compared to September 30, 2012, or 13.8%. Investment securities represented 30.5% of earning assets at September 30, 2013, compared to 34.1% at September 30, 2012 and 34.5% at December 31, 2012. The decrease is partially due to aggregate sales of $28.7 million in securities, calls and paydowns of $33.9 million and purchases of $34.2 million in 2013. Securities sales of $16.5 million occurred near September 30, 2013 with reinvestment of the proceeds occurring in October. Immediately prior to this sale and subsequently in late October, investment securities available-for-sale were in excess of $160 million. As the Company manages its balance sheet for loan growth, asset mix, liquidity and current interest rates and interest rate forecasts, the investment portfolio is a primary source of liquidity. The investment securities available for sale portfolio represented 35.3% of each deposit dollar at September 30, 2013, down from 39.9% a year ago and level with 38.7% of year-end levels.

 

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The investment securities available-for-sale portfolio had net unrealized losses of $5.8 million at September 30, 2013, an increase of $4.0 million compared to net unrealized losses of $1.8 million at September 30, 2012, and an increase of $3.2 million compared to net unrealized losses of $2.6 million at December 31, 2012. The third quarter rise in interest rates was the primary impetus for the valuation decline.

The Company’s investment portfolio contains trust preferred securities, which have resulted in valuation charges against income of $171,000 in 2012 and none recorded in 2013. The Company continues to value these securities consistent with valuation techniques prescribed under accounting standards. The market for these securities and similar securities, which had been relatively active through 2003, became illiquid during the financial crisis of 2008 and is still currently not active. Since 2008, the Company has modeled and analyzed the cash flow characteristics and has concluded that a major portion of these devalued securities were not recoverable. In 2012, a portion of these securities were sold.

The Company has an investment in trading securities of $7.2 million at September 30, 2013, with none at December 31, 2012 or September 30, 2012. This modest allocation of the securities portfolio into obligations of state and political subdivisions and cash equivalent instruments is intended to diversify the earnings of the portfolio.

Loans held for sale decreased to $5.9 million at September 30, 2013 compared to $24.8 million at December 31, 2012 and $16.0 million at September 30, 2012. The variance is reflective of  the recent decline in mortgage banking volume. The Company significantly curtailed its residential mortgage operations as of September 13th by exiting the wholesale arena and limiting residential mortgage lending operations to its retail banking footprint. See further discussion of this matter in the non-interest income and non-interest expense section.

Total loans at September 30, 2013 were $314.9 million compared to $293.2 million a year ago, a 7.4% increase, and $317.3 million at December 31, 2012, a 0.7% decrease. The Company continues its objective of shifting its asset mix into in-market commercial loans with the intent of improving net interest margin.

Total loans net of the allowance for losses increased by $21.4 million during the twelve month period from September 30, 2012 to September 30, 2013, and decreased by $2.5 million from December 31, 2012. Total gross loans as a percentage of earning assets stood at 63.6% as of September 30, 2013, 57.1% at September 30, 2012 and 59.2% as of December 31, 2012. The total loan-to-deposit ratio was 73.7% at September 30, 2013, 66.8% at September 30, 2012 and 66.5% at December 31, 2012. The decrease in loan balances from year-end was, as stated previously, due in part to 60-day term commercial loans for a total of $20.7 million that closed in December 2012 and were fully secured by segregated deposit accounts with the Bank. The loans matured in the first quarter of 2013. The decrease was offset in part by the increase in commercial real estate loans of $13.5 million. Exclusive of these 60-day term loans, the growth in loans from December 2012 to September 2013 was 6.2%.

At September 30, 2013, the loan loss allowance of $3.9 million represented approximately 1.25% of outstanding loans, and at September 30, 2012 the loan loss allowance of $3.6 million represented approximately 1.23% of outstanding loans. The loan loss allowance at December 31, 2012 of $3.8 million represented approximately 1.21% of outstanding loans, or 1.29% excluding the 60-day term loans to which none of the allowance is allocated.

During the first nine months, loan charge-offs were $655,000 in 2013 compared to $452,000 for the same period in 2012, while the recovery of previously charged-off loans amounted to $273,000 in 2013 and $111,000 in 2012. The net charge-offs represent 0.17% of average loans for 2013 and 0.16% for the same period in 2012. Charge-offs of specific problem loans, as well as for smaller balance homogeneous loans, are recorded periodically during the year. The number of loan accounts and the amount of charge-off associated with account balances vary from period to period as loans are deemed uncollectible by management.

   

Despite less than favorable economic conditions over the past several years, the Company has been able to grow its loan portfolio without experiencing any substantive deterioration in credit quality.  Nonaccrual loans declined to $2.3 million at September 30, 2013, or 0.72%, of loans, versus $3.0 million, or 0.94%, of loans at December 31, 2012 and $3.8 million, or 1.3%, of loans at September 30, 2012. The Company’s allowance for loan losses now covers 173% of nonaccrual loans at September 30, 2013 compared to 129% at December 31, 2012 and 96% at September 30, 2012.

Bank-owned life insurance had a cash surrender value of $15.0 million at September 30, 2013, $14.0 million at December 31, 2012 and $13.9 million at September 30, 2012. In the second quarter of 2013, the Company purchased $714,000 in bank-owned life insurance contributing to the majority of the increase.

Other assets increased to $14.0 million at September 30, 2013 from $11.2 million at December 31, 2012 and $12.6 million at September 30, 2012. Included in other assets in 2012 is a prepaid assessment paid to the FDIC in December of 2009. This prepayment was the estimate, based on projected assessment rates and assessment base, made by the FDIC of premiums due until December 31, 2012. On June 30, 2013, the unused portion of $1.1 million was returned to the Company. The balance was $1.2 million at

 

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December 31, 2012 and $1.3 million at September 30, 2012. Other real estate decreased to $33,000 at September 30, 2013 compared to $145,000 at December 31, 2012 and $242,000 at September 30, 2012. Also included in other assets is deferred taxes of $5.6 million, $5.0 million and $2.8 million for the periods ended September 30, 2013, December 31, 2012 and September 30, 2012, respectively, Federal income tax receivable of $1.1 million, $1.9 million and $3.3 million for the periods ended September 30, 2013, December 31, 2012 and September 30, 2012, respectively, and securities sold to settle due from investment sales of $2.4 million and $291,000 for the periods ended September 30, 2013 and 2012, and none at December 31, 2012.

In 2013, a $1.9 million investment in a partnership fund is included in other assets with an offsetting $1.8 million in other liabilities, which is the commitment to fund this affordable housing investment. At September 30, 2012, the valuation gain related to the mortgage banking derivatives was a $1.7 million asset compared to $170,000 at September 30, 2013 and $531,000 at December 31, 2012.

Noninterest-bearing deposits measured $84.0 million at September 30, 2013 compared to $91.7 million at December 31, 2012 and $82.3 million at September 30, 2012. Interest-bearing deposits decreased $41.7 million to $343.5 million at September 30, 2013 from $385.2 million at December 31, 2012 and decreased $13.1 million from $356.6 million at September 30, 2012. The decrease in interest-bearing deposits from year end is due partly to segregated money market deposit accounts with the Bank which fully collateralized $20.7 million in 60-day term commercial loans that closed in December 2012. The loans matured and the deposits withdrew the first quarter of 2013. The remaining decrease is attributed to our customers’ ultimate investment of, and payment of taxes on, the shale bonus funds awarded to them and deposited during the third and fourth quarters of 2012.

Federal Home Loan Bank advances and short-term borrowings stayed fairly consistent at $47.5 million at September 30, 2013 from $46.1 million at December 31, 2012 and increased from $41.7 million at September 30, 2012. Future maturities of long-term notes are expected to be paid off. Management continues to use short-term borrowings to bridge its current cash flow needs.

Other liabilities measured $7.3 million at September 30, 2013, $4.7 million at December 31, 2012 and $18.2 million at September 30, 2012. The increase at September 30, 2013 from December 31, 2012 is due to $1.8 million commitment to fund the affordable housing partnership fund previously described. The decrease from September 30, 2012 included $13.0 million in securities purchases traded in September 2012 but settled in October 2012.

The Company continued to maintain its capital levels in 2013. The Company’s total shareholders’ equity measured $50.6 million at September 30, 2012 and $49.5 million on December 31, 2012 to $49.1 million at September 30, 2013. The Company’s capital continues to meet the requirements for the Company to be deemed well capitalized under all regulatory measures. The Company’s total risk-based capital is $19.0 million in excess of the 10% threshold for the Company to be well-capitalized.

In October 2012, the Company announced the reinstatement of a cash dividend reflecting the growing confidence supported by stable core earnings, increasing loan production, and restored capital levels. Dividends of $.09 per share were paid to shareholders of record to date in 2013.

Capital Resources

Regulatory standards for measuring capital adequacy require banks and bank holding companies to maintain capital based on “risk-adjusted” assets so that categories of assets with potentially higher credit risk require more capital backing than assets with lower risk. In addition, banks and bank holding companies are required to maintain capital to support, on a risk-adjusted basis, certain off-balance sheet activities such as standby letters of credit and interest rate swaps.

The risk-based standards classify capital into two tiers. Tier 1 capital consists of common shareholders’ equity, noncumulative and cumulative perpetual preferred stock, qualifying trust preferred securities and minority interests less intangibles, disallowed deferred tax assets and the unrealized market value adjustment of investment securities available-for-sale. Tier 2 capital consists of a limited amount of the allowance for loan and lease losses, perpetual preferred stock (not included in Tier 1), hybrid capital instruments, term subordinated debt, and intermediate-term preferred stock.

The FFIEC determines the risk weightings of direct credit substitutions that have been downgraded below investment grade. Included in the definition of a direct credit substitute are mezzanine and subordinated tranches of trust preferred securities and non-agency collateralized mortgage obligations. Following these guidelines results in an increase in total risk-weighted assets with an attendant decrease in the risk-based capital and Tier 1 risk-based capital ratios.

As a result of the decline in the value of the Bank’s trust preferred securities, the regulatory capital levels of the Bank are lower than otherwise would be. As a result of investment downgrades by the rating agencies, all of the 12 trust preferred securities were rated as “highly speculative grade” debt securities. As a consequence, the Bank is required to maintain higher levels of regulatory risk-based

 

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capital for these securities due to the greater perceived risk of default by the underlying bank and insurance company issuers. Specifically, regulatory guidance requires the Bank to apply a higher “risk weighting formula” for these securities to calculate its regulatory capital ratios. The result of that calculation increases the Bank’s risk-weighted assets for these securities to $52.5 million, well above the $13.9 million in amortized cost of these securities as of September 30, 2013, thereby significantly diluting the risk-based capital ratios by approximately 1.49% for September 30, 2013 compared to 1.58% for December 31, 2012.

Regardless of the trust preferred securities risk weighting, the Company met all capital adequacy requirements to which it was subject as of September 30, 2013 and December 31, 2012, as supported by the data in the following table. As of those dates, the Company met the capital requirements to be deemed “well capitalized” under regulatory prompt corrective action provisions.

   

 

Risk-based capital standards require a minimum ratio of 8.00% of qualifying total capital to risk-adjusted total assets with at least 4.00% constituting Tier 1 capital. Capital qualifying as Tier 2 capital is limited to 100.00% of Tier 1 capital. All banks and bank holding companies are also required to maintain a minimum leverage capital ratio (Tier 1 capital to total average assets) in the range of 3.00% to 4.00%, subject to regulatory guidelines.

The Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) requires banking regulatory agencies to revise risk-based capital standards to ensure that they adequately account for the following additional risks: interest rate, concentration of credit, and non-traditional activities. Accordingly, regulators will subjectively consider an institution’s exposure to declines in the economic value of its capital due to changes in interest rates in evaluating capital adequacy. The following table illustrates the Company’s components of risk weighted capital ratios and the excess over amounts considered well-capitalized at September 30, 2013 and December 31, 2012. Management considers these excesses to be adequate with regard to the risks inherent in the balance sheet.

   

 

 

Total assets for leverage capital purposes is calculated as average assets less disallowed deferred tax assets and the net unrealized market value adjustment of investment securities available-for-sale, averaged $545.5 million for the nine months ended September 30, 2013 and $560.6 million for the year ended December 31, 2012.

Regulations require that investments designated as available-for-sale are marked-to-market with corresponding entries to the deferred tax account and shareholders’ equity. Regulatory agencies, however, exclude these adjustments in computing risk-based capital, as their inclusion would tend to increase the volatility of this important measure of capital adequacy.

In early September 2013, the regulatory bodies agreed on the provisions of Basel III which substantially revises the capital requirements for all banks, varying with the size of the institution. The new requirements are to be phased in over four years beginning in 2015. The Company is awaiting further clarification and interpretation of the rules before it can assess the future effect on capital.

 

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Certain Non-GAAP Measures

Certain financial information has been determined by methods other than Generally Accepted Accounting Principles (GAAP). Specifically, certain financial measures are based on core earnings rather than net income. Core earnings exclude income, expense, gains and losses that either are not reflective of ongoing operations or that are not expected to reoccur with any regularity or reoccur with a high degree of uncertainty and volatility. Such information may be useful to both investors and management and can aid them in understanding the Company’s current performance trends and financial condition. Core earnings are a supplemental tool for analysis and not a substitute for GAAP net income. Reconciliation from GAAP net income to the non-GAAP measure of core earnings is referenced as part of management’s discussion and analysis of financial condition and results of operations.

Core earnings, which exclude the OTTI charge and certain other non-recurring items, decreased for the nine months ended September 30, 2013 as compared to the nine months ended September 30, 2012. Core earnings for the first nine months of 2013 were $2.6 million, or $0.56 per share, compared to $3.3 million, or $0.72 per share for the first nine months of 2012. Core earnings for the third quarter of 2013 were $794,000, or $0.18 per share, compared to $1.3 million, or $0.28 per share for the third quarter of 2012.

The following is the reconciliation between core earnings and earnings under GAAP.

   

 

   

 

   

* Gains in 2012 are due to the settlement on General Motors Corporation bonds.

Analysis of Net Interest Income – Nine months ended September 30, 2013 and 2012

Net interest income, the principal source of the Company’s earnings, is the amount by which interest and fees generated by interest-earning assets, primarily loans and investment securities, exceeds the interest cost of deposits and borrowed funds. On a fully taxable equivalent basis, net interest income measured $12.9 million at September 30, 2013 and $13.1 million at September 30, 2012. During the recent reporting period the net interest margin registered 3.34% at September 30, 2013 and 3.62% at September 30, 2012.

The decrease in interest income, on a fully taxable equivalent basis, of $776,000 is the product of a 45 basis point decrease in interest rates earned offset somewhat by a 6.0% year-over-year increase in average earning assets. The decrease in interest expense of $491,000 was a product of a 19 basis point decrease in rates paid and a 3.4% increase in interest-bearing liabilities. The net result was a 2.2% decrease in net interest income on a fully taxable equivalent basis, and a 28 basis point decrease in the Company’s net interest margin on a slightly larger asset base with a different mix.

On a fully taxable equivalent basis, income on investment securities available-for-sale decreased by $895,000, or 21.3%. The average invested balances in these securities decreased by $3.9 million, or 2.1%, from the levels of a year ago. The decrease in the average balance of investment securities was accompanied by a 60 basis point decrease in the tax equivalent yield of the portfolio. The Company will continue attempting to redeploy liquidity into loans. Any reinvestment into the securities portfolio will serve to decrease the yield due to the current low rate environment. The average balance of trading securities was $4.7 million with resulting income on a fully taxable equivalent basis of $146,000 during the first nine months of 2013, compared to none for the same period in 2012.

On a fully taxable equivalent basis, income on loans decreased by $33,000, or 0.3%, for the first nine months of 2013 compared to the same period in 2012. A $25.2 million increase in the average balance of the loan portfolio, or 8.6%, was accompanied by a 43 basis point decrease in the portfolio’s tax equivalent yield. Likewise, new loan volume is at historic low interest rates, while strong competition for good credits also drives rates downward. The commercial loan portfolio housed the majority of the increase in balances.

 

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Other interest income increased by $6,000, or 37.5%, from the same period a year ago. The average balance of interest-earning deposits increased by $3.2 million, or 43.3%. The yield did not change during the first nine months of 2013 compared to 2012. Management intends to remain fully invested, minimizing on-balance sheet liquidity.

As the Company is located in the heart of the Utica Shale geography, material deposit growth was experienced in the latter part of 2012 as a result of customers receiving signing bonuses for the lease of mineral rights. Nearly $40 million in new deposits has been attributed to these bonuses. In the first half of 2013, nearly half of these funds were withdrawn for customer utilization, ultimate market plays and presumably to pay taxes. Average interest-bearing demand deposits and money market accounts increased by $10.9 million, or 13.5%, for the nine months ended September 30, 2013 compared to the same period of 2012, while average savings balances increased by $16.0 million, or 15.6%. Total interest paid on interest-bearing demand deposits and money market accounts was $135,000, a $30,000 increase from last year. The average rate paid on these products increased by 3 basis points primarily the result of larger deposits in the higher yielding tiers of the money market accounts. Total interest paid on savings accounts was $65,000, a $13,000 decrease from last year. The average rate paid on savings accounts decreased by 3 basis points. The average balance of time deposit products decreased by $14.0 million, or 8.9%, as the average rate paid decreased by 27 basis points, from 1.60% to 1.33%. Interest expense decreased on time deposits by $455,000 from the prior year. Customers are opting for more liquid accounts versus time deposits in this low rate environment. As time deposits mature, the balances are reinvested at the lower current rates. After an extended period of declining average rates paid on deposits, the Company is experiencing a flattening on a linked quarter basis.

Average borrowings and subordinated debt increased by $335,000 while the average rate paid on borrowings decreased by 15 basis points. Management plans to pay down long-term borrowings at their respective maturity dates in the future using current liquidity and continues to utilize short-term borrowings to bridge liquidity gaps.

Impairment Analysis of Investment Securities

The Company owns 12 trust preferred securities totaling $14.5 million (par value) issued by banks, thrifts, insurance companies and real estate investment trusts. The market for these securities at September 30, 2013 is not fully active and markets for similar securities are also not completely active. Given conditions in the debt markets today and the absence of observable transactions in the secondary and new issue markets, the Company determined the few observable transactions and market quotations that are available are not reliable for purposes of determining fair value at September 30, 2013. It was decided that an income valuation approach technique (present value technique) that maximizes the use of relevant observable inputs and minimizes the use of unobservable inputs would be more representative of fair value than the market approach valuation technique used at measurement dates prior to 2008.

The Company enlisted the aid of an independent third party to perform the trust preferred securities valuations. The approach to determining fair value involved the following process:

 

 

 

 

The effective fair value discount rates on an overall basis generally range from 5.7% to 17.9% and are highly dependent upon the credit quality of the collateral, the relative position of the tranche in the capital structure of the trust preferred securities and the prepayment assumptions.

Based upon the results of the analysis, the Company currently believes that a weighted average price of approximately $0.69 per $1.00 of par value is representative of the fair value of the 12 trust preferred securities, with individual securities therein ranging from $0.34 to $0.95.

The Company considered all information available as of September 30, 2013 to estimate the impairment and resulting fair value of the trust preferred securities. These securities are supported by a number of banks and insurance companies located throughout the country. The FDIC has recently indicated that there are many financial institutions still considered troubled banks even after the numerous failures in the past three years. The Company recognized no credit related impairment in the first nine months of 2013 and $171,000 in the first nine months of 2012. If the conditions of the underlying banks in the trust preferred securities worsen, there may be additional impairment to recognize in 2013 or later.

 

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Analysis of Provision, Non-Interest Income, Non-Interest Expense and Federal Income Tax for the First Nine Months

During the first nine months of both 2012 and 2013, the amount charged to operations as a provision for loan loss was adjusted to account for charge-offs against the allowance, as well as an increase in loan balances recorded in the portfolio, expected losses on specific problem loans and several qualitative factors, including factors specific to the local economy and to industries operating in the local market. The Company has allocated a portion of the allowance for a number of specific problem loans through the first nine months of 2013, but has not experienced significant deterioration in any loan type, including the residential real estate portfolios or the commercial loan portfolio, and accordingly has not added any special provision for these loan types. For the nine months ended September 30, 2013, the provision for loan losses was $500,000, exceeding net charge-offs of $382,000, which included a charge-off of $407,000 to which a specific reserve was allocated prior to the charge-off. For the same period last year, the provision was $900,000, also exceeding net charge-offs of $341,000. Provision expense levels are in recognition of loan growth and a changing composition of the loan portfolio as the Company takes aim at managing its balance sheet with a commercially-oriented focus.

Total non-interest income, excluding investment gains and impairment losses, decreased by $79,000 from the same period a year ago. After impairment losses and gains on investment securities, non-interest income increased by $570,000 from the same period a year ago.

Mortgage banking gains were $1.4 million for both September 30, 2013 and 2012. As indicated in Note 8 to the Consolidated Financial Statements, the Company’s mortgage banking unit enters into various interest rate derivative contracts with the purpose of neutralizing the effect of interest rates on mortgage loan commitments. The gains and losses of all these activities are included in mortgage banking gains. Although mortgage banking gains for the nine months are equivalent to year-ago levels, the application volume driving the revenues has declined substantially over the past four months. The persistent rise in mortgage rates that began in May 2013 have caused the Company’s application volume to decline from $82.9 million and $94.2 million for the first and second quarters this year to $42.7 million in this third quarter. Application volume for the third quarter 2012 was $123.9 million. With the dramatic volume decrease and the prospects for any turnaround considered improbable in the near term, the Company curtailed portions of its mortgage banking activities. Originations from the wholesale channel and all out-of-market retail origination was closed down as of September 13, 2013. In addition to the origination channels, operational staff were also severed in order to right-size the business line with expected volume. These decisions in the aggregate are expected to contribute positively to net income prospectively.

   

Gains on securities called and net gains on the sale of available-for-sale investment securities increased by $478,000 from year ago levels. Consistent with the balance sheet strategy, the Company periodically reviews its investment portfolio to clean up odd-lot securities and to reduce interest rate risk.  Recent government programs, such as HARP, promote prepayment activities in mortgage backed securities, thus cutting short the intended investment performance.  Proactively removing the securities with higher prepayment risk allows the Company to reinvest into securities that produce consistent cash flows. Gains in the first half of 2012 were offset by impairment losses attributable to trust preferred securities primarily issued by bank holding companies. Losses of $171,000 were recognized in 2012 while none were recognized in 2013.

   

Fees for customer services decreased by $133,000, or 8.6%, driven by customer activities. Other sources of non-recurring non-interest income increased by $56,000 from the same period a year ago. This latter income category is subject to fluctuation due to the non-recurring nature of the items. Included in other non-interest income in 2013 is $122,000 in trading income, with none in 2012. Also included in other non-interest income is $116,000 in wealth management income in 2013. As a revenue diversification initiative, the Company continues to expand wealth management efforts.  Two advisors now sell non-deposit investment products to customers in the bank’s branch network through a third party provider.  As assets under management grow, fee income paid by the third party provider of non-deposit investment products will enhance non-interest income revenue.

Total non-interest expenses in the first nine months were $13.0 million in 2013 compared to $11.4 million in 2012, an increase of $1.6 million, or 14.2%.

During the first nine months of 2013, expenditures for salaries and employee benefits increased by $1.3 million, or 21.2%, from the similar period a year ago. Much of this increase is due to the additional personnel hired to operate the mortgage banking operation up to its curtailment in September 2013 and to manage the increasing lending volume generated though core bank lending operations. Also, approximately $217,000 in branch restructuring costs were incurred in 2013. Full time equivalent employment averaged 167 during the first nine months of 2013 and 159 during the first nine months of 2012. The addition of employees thoughout 2013 were related to the mortgage banking operation.

Included in non-interest expenses for the nine months ended September 30, 2012 quarter is the one-time investment of $444,000 in a Historic Tax Credit partnership which generated $634,000 in tax credits for 2012. The Company recorded no tax credit activity through the nine month period ended September 30, 2013 but expects modest recognition in 2014 and beyond. All other expense categories increased by 15.6%, or $731,000 in the aggregate. These expense categories are subject to fluctuation due to non-recurring

 

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items. The majority of these increases relate to the expenses incurred by the mortgage banking operation in the form of professional fees, third-party consulting fees and compliance-related costs and $229,000 of costs to exit the wholesale mortgage banking channel and reducing mortgage operations late in the third quarter of 2013.

The effective tax rate for the first nine months was 19.7% in 2013 and 8.6% in 2012, resulting in income tax expense of $551,000 in 2013 and 317,000 in 2012. A $483,000 historic tax credit and the $151,000 tax benefit on the partnership loss contributed to the lower effective tax rate in 2012.

The provision for income taxes differs from the amount of income tax determined applying the applicable U.S. statutory federal income tax rate (34%) to pre-tax income as a result of the following differences:

   

 

The majority of non-taxable income consists of interest on obligations of states and political subdivisions.

Analysis of Net Interest Income –Third quarter ended September 30, 2013 and 2012

Net interest income, the principal source of the Company’s earnings, is the amount by which interest and fees generated by interest-earning assets, primarily loans and investment securities, exceed the interest cost of deposits and borrowed funds.  On a fully taxable equivalent basis, net interest income measured $4.3 million at both September 30, 2013 and 2012. During the recent reporting period the net interest margin registered 3.42% at September 30, 2013 and 3.51% at September 30, 2012.

The decrease in interest income, on a fully taxable equivalent basis, of $189,000 is the product of a 24 basis point decrease in interest rates earned offset somewhat by a 1.9% year-over-year increase in average earning assets.  The decrease in interest expense of $169,000 was a product of a 16 basis point decrease in rates paid and a 1.3% decrease in interest-bearing liabilities. The net result was a 5.0% decrease in net interest income on a fully taxable equivalent basis, and a 9 basis point decrease in the Company’s net interest margin on a slightly larger asset base with a different mix.

On a fully taxable equivalent basis, income on investment securities available-for-sale decreased by $156,000, or 12.8%. The average invested balances in these securities decreased by $3.4 million, or 1.9%, from the levels of a year ago.  The decrease in the average balance of investment securities available-for-sale was accompanied by a 32 basis point decrease in the tax equivalent yield of the portfolio. The Company expects to continue redeployment of liquidity into loans. Any reinvestment into the securities portfolio will serve to decrease the yield due to the current low rate environment. The average balance of trading securities was $$7.0 million with resulting income on a fully taxable equivalent basis of $83,000 in the third quarter of 2013, compared to none for the same quarter in 2012.

On a fully taxable equivalent basis, income on loans decreased by $118,000, or 2.9%, for the third quarter of 2013 compared to the same period in 2012. A $7.6 million increase in the average balance of the loan portfolio, or 2.5%, was accompanied by a 28 basis point decrease in the portfolio’s tax equivalent yield. Likewise, new loan volume is at historic low interest rates, while strong competition for good credits also drives rates downward.

Other interest income increased by $2,000, or 50.0%, from the same period a year ago.  The average balance of interest earning deposits decreased by $1.8 million, or 18.9%. The yield increased by 11 basis points during the third quarter of 2013 compared to 2012. Management intends to minimize amounts held in deposits in order to increase yield on assets.

Average interest-bearing demand deposits and money market accounts increased by $7.0 million, or 8.6%, while average savings balances increased by $10.7 million, or 10.2%. Total interest paid on interest-bearing demand deposits and money market accounts was $42,000, a $3,000 increase from last year. The average rate paid on these products did not change from the third quarter of 2013 compared to 2012. Total interest paid on savings accounts was $22,000, a $5,000 decrease from last year. The average rate paid on

 

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savings accounts decreased by 3 basis points.  The average balance of time deposit products decreased by $18.3 million, or 11.8%, as the average rate paid decreased by 21 basis points, from 1.52% to 1.31%.  Interest expense decreased on time deposits by $143,000 from the prior year.  As time deposits mature, the balances are reinvested at the lower current rates. After an extended period of declining average rates paid on deposits, the Company is experiencing a flattening on a linked quarter basis.  

Average borrowings and subordinated debt decreased by $4.6 million while the average rate paid on borrowings increased by 5 basis points.  Management plans to pay down long-term borrowings at their respective maturity dates in the future using current liquidity.

Analysis of Provision, Non-Interest Income, Non-Interest Expense and Federal Income Tax for the Third Quarter

Loan charge-offs during the quarter were $448,000 in 2013, compared to $70,000 in 2012, while the recovery of previously charged-off loans amounted to $96,000 during the quarter of 2013, compared to $49,000 in the same period of 2012.  The Company’s provision for loan losses was $150,000 during the quarter of 2013 and $300,000 in the same quarter of 2012, commensurate with the growth rate of loans during each of the periods.  Included in the 2013 charge-off is one loan for $407,000 which had a specific reserve assigned to it for the total amount, therefore it had no impact on current earnings or provision. Charge-offs of specific problem loans, as well as for smaller balance homogeneous loans, are recorded periodically during the year.  The number of loan accounts and the amount of charge-offs associated with account balances vary from period to period as loans are deemed uncollectible by management.  The balance of the allowance for loan losses and provisions to the loan loss allowance are based on an assessment of both the risk of loss and the amount of loss on loans within the loan portfolio.  

Total non-interest income, excluding investment gains and impairment losses, decreased by $790,000 from the quarter ended September 30, 2012 compared to the same quarter of 2013. After impairment losses and gains on investment securities, non-interest income decreased by $429,000 from the same period a year ago. This resulted in a $908,000 decrease for the third quarter of 2013 compared to the same period in 2012.

Mortgage banking gains declined from $1.0 million in 2012 to $109,000 in 2013. This decline is driven by mortgage application volume which declined to $42.7 million in the third quarter, 2013 compared to $123.9 million for the similar period in 2012. As previously noted, the Company curtailed its retail mortgage operations and exited the wholesale arena. Non-interest income, excluding the previously noted mortgage banking revenues, in the third quarter increased by $479,000 over the same period last year, and by $572,000 on a nine month year-to-date basis, led primarily by securities gains.

Gains on securities called and net gains on the sale of available-for-sale investment securities increased by $361,000 from year ago levels as a result of the clean-up of odd-lot securities. Fees for other customer services decreased by $7,000. Other sources of non-recurring non-interest income increased by $125,000 from the same period a year ago. This latter income category is subject to fluctuation due to the non-recurring nature of the items. The increase is due partly to wealth management income of $51,000 and trading income of $172,000 in the third quarter of 2013 and none in the similar quarter of 2012. Also, the sale of other real estate sold produced a loss of $38,000 in the third quarter of 2013 versus a $13,000 gain in 2012.

Total non-interest expenses in the third quarter were $4.5 million in 2013, compared to $3.8 million in 2012, an increase of $661,000, or 17.2%.  Salaries and benefits increased in the third quarter of 2013 by $391,000, or 17.7%, from the similar period a year ago. This increase is due mainly to costs associated with the wholesale mortgage unit and exit costs of $20,000. All other expense categories increased by 16.5%, or $270,000 in the aggregate. These expense categories are subject to fluctuation due to non-recurring items.  The majority of the increase is due to increased costs associated with the exit of the wholesale mortgage unit of approximately $229,000.

Income before tax during the third quarter amounted to $729,000 in 2013 compared to $1.7 million in 2012.  The effective tax rate for the third quarter was 15.4% in 2013 and 25.0% in 2012, resulting in income tax expense of $112,000 and $422,000, respectively. Third quarter net income was $617,000 in 2013 compared to $1.3 million in 2012.  Income per share for the third quarter was $0.14 in 2013 and $0.28 in 2012.

Liquidity

The central role of the Company’s liquidity management is to (1) ensure sufficient liquid funds to meet the normal transaction requirements of its customers, (2) take advantage of market opportunities requiring flexibility and speed, and (3) provide a cushion against unforeseen liquidity needs.

Liquidity risk arises from the possibility that the Company may not be able to satisfy current or future financial commitments or may become unduly reliant on alternative funding sources. The objective of liquidity management is to ensure the Company has the ability to fund balance sheet growth and meet deposit and debt obligations in a timely and cost-effective manner. Management monitors liquidity through a regular review of asset and liability maturities, funding sources, and loan and deposit forecasts. The Company

 

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maintains strategic and contingency liquidity plans to ensure sufficient available funding to satisfy requirements for balance sheet growth, proper management of capital markets funding sources and addressing unexpected liquidity requirements.

Principal sources of liquidity available to the Company include assets considered relatively liquid, such as interest-bearing deposits in other banks, federal funds sold and, cash and due from banks, as well as cash flows from maturities and repayments of loans, investment securities and mortgage-backed securities.

In order to address the concern of FDIC insurance of larger depositors, the Bank is a member of the Certificate of Deposit Account Registry Service (CDARS^®) program and the Insured Cash Sweep (ICS) program. Through CDARS^®, the Bank’s customers can increase their FDIC insurance by up to $50.0 million through reciprocal certificate of deposit accounts and likewise through ICS, they can accomplish the same through money market savings accounts. This is accomplished by the Bank entering into reciprocal depository relationships with other member banks. The individual customer’s large deposit is broken into amounts below $250,000 and placed with other banks that are members of the network. The reciprocal member bank issues certificates of deposit or money market savings accounts in amounts that ensure that the entire deposit is eligible for FDIC insurance. At September 30, 2013, the Bank did not have any deposits in the CDARS^® program, but had $2.0 million of deposits in the ICS money market program. For regulatory purposes, CDARS^® and ICS are considered a brokered deposit even though reciprocal deposits are matched with funds from customers in the local market.

Along with its liquid assets, the Bank has other sources of liquidity available to it which help to ensure that adequate funds are available as needed. These other sources include, but are not limited to, the ability to obtain deposits through the adjustment of interest rates, the purchasing of federal funds, correspondent bank lines of credit and access to the Federal Reserve Discount Window. The Bank is also a member of the Federal Home Loan Bank of Cincinnati, which provides its largest source of liquidity. At September 30, 2013, the Bank had approximately $7.1 million available of collateral-based borrowing capacity at FHLB of Cincinnati, supplementing the $684,000 of availability with the Federal Reserve Discount window. Additionally, the FHLB has committed a $25.8 million cash management line, of which nothing has been disbursed, subject to posting additional collateral. The Bank, by policy, has access to approximately 5% of total deposits in brokered certificates of deposit that could be used as an additional source of liquidity. At September 30, 2013, there was a $3.0 million outstanding balance in brokered certificates of deposit. The Company was also granted a total of $8.5 million in unsecured, discretionary Federal Funds lines of credit with no funds drawn upon as of September 30, 2013. Unpledged securities of $41.9 million are also available for borrowing under repurchase agreements or as additional collateral for FHLB lines of credit or to sell to generate liquidity.

The Bank occasionally utilized short term borrowings under its FHLB cash management line to fund the needs of mortgage banking. Upon establishing a consistent inventory of loans held for sale, such loans may be used as additional collateral for FHLB borrowings.

The Company has other more limited sources of liquidity. In addition to its existing liquid assets, it can raise funds in the securities market through debt or equity offerings or it can receive dividends from its bank subsidiary. Generally, the Bank may pay dividends without prior approval as long as the dividend is not more than the total of the current calendar year-to-date earnings plus any earnings from the previous two years not already paid out in dividends, as long as the Bank remains well-capitalized after the dividend payment. The amount available for dividend at September 30, 2013 is $9.0 million. Future dividend payments by the Bank to the Company are based upon future earnings. The Company had cash of $271,000 at September 30, 2013 available to meet cash needs. It also held a $6.0 million note receivable, the cash flow from which approximates the debt service on the Junior Subordinated Debentures. Cash is generally used by the Company to pay quarterly interest payments on the debentures, pay dividends to common shareholders and to fund operating expenses.

Cash and cash equivalents decreased from $40.8 million at September 30, 2012 and $27.6 million at December 31, 2012 to $25.7 million at September 30, 2013, as the Company strives to be fully invested, minimizing on balance sheet liquidity.

 

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The following table details the cash flows from operating activities for the nine months ended:

   

 

Key variations stem from: 1) Amortization on investments measured $2.1 million at September 30, 2013 compared to $1.8 million at September 30, 2012, reflecting more securities purchased at a premium in this low rate environment. 2) Gains were recognized on the sale, call or maturity of investments of $538,000 compared to $60,000 in the same period of 2012 due in part to odd-lot security sales. 3) Impairment losses of $171,000 were recognized in 2012 with none being recognized in 2013. 4) In 2013, a refund of $933,000 was received from the IRS with a resulting decrease in federal income tax receivable. 5) Loans held for sale decreased by $18.8 million in 2013 compared to an increase of $15.1 million in 2012 due to the impact of interest rates on activity of mortgage banking and the exit from wholesale operations in September 2013. 6) Included in the $1.2 million change in FDIC assessment is a refund of $1.1 million. 7) A purchase of trading securities was made in 2013 for $7.0 million. Refer to the Consolidated Statements of Cash Flows for a summary of the sources and uses of cash for 2013 and 2012.

Critical Accounting Policies and Estimates

The discussion and analysis of the Company’s financial condition and results of operation are based upon the Consolidated Financial Statements, which have been prepared in accordance with U.S. Generally Accepted Accounting Principles (GAAP). The preparation of these consolidated financial statements requires management to make estimates and judgments that affect the reported amounts of assets and liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities at the date of the Company’s consolidated financial statements. Actual results may differ from these estimates under different assumptions or conditions.

Certain accounting policies involve significant judgments and assumptions by management which has a material impact on the carrying value of certain assets and liabilities; management considers such accounting policies to be critical accounting policies. The judgments and assumptions used by management are based on historical experience and other factors, which are believed to be reasonable under the circumstances.

Management believes the following are critical accounting policies that require the most significant judgments and estimates used in the preparation of the Company’s consolidated financial statements.

   

Accounting for the Allowance for Loan Losses

The determination of the allowance for loan losses and the resulting amount of the provision for loan losses charged to operations reflects management’s current judgment about the credit quality of the loan portfolio and takes into consideration changes in lending policies and procedures, changes in economic and business conditions, changes in the nature and volume of the portfolio and, in the terms of loans, changes in the experience, ability and depth of lending management, changes in the volume and severity of past due,

 

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non-accrual and adversely classified or graded loans, changes in the quality of the loan review system, changes in the value of underlying collateral for collateral-dependent loans, the existence and effect of any concentrations of credit and the effect of competition, legal and regulatory requirements and other external factors. The nature of the process by which we determine the appropriate allowance for loan losses requires the exercise of considerable judgment. While management utilizes its best judgment and information available, the ultimate adequacy of the allowance is dependent upon a variety of factors beyond our control, including the performance of the loan portfolio, the economy, changes in interest rates and the view of the regulatory authorities toward loan classifications. The allowance is increased by the provision for loan losses and decreased by charge-offs when management believes the uncollectibility of a loan is confirmed. Subsequent recoveries, if any, are credited to the allowance. A weakening of the economy or other factors that adversely affect asset quality could result in an increase in the number of delinquencies, bankruptcies or defaults and a higher level of non-performing assets, net charge offs, and provision for loan losses in future periods.

The Company’s allowance for loan losses methodology consists of three elements: specific valuation allowances based on probable losses on specific loans; valuation allowances based on historical loan loss experience for similar loans with similar characteristics and trends; and general valuation allowances based on general economic conditions and other qualitative risk factors both internal and external to the Company. These elements support the basis for determining allocations between the various loan categories and the overall adequacy of our allowance to provide for probable losses inherent in the loan portfolio.

With these methodologies, a general allowance is established for each loan type based on historical losses for each loan type in the portfolio. Additionally, management allocates a specific allowance for “Impaired Credits,” which is based on current information and events; it is probable the Company will not collect all amounts due according to the original contractual terms of the loan agreement. The level of the general allowance is established to provide coverage for management’s estimate of the credit risk in the loan portfolio by various loan segments not covered by the specific allowance. Additional information regarding allowance for credit losses can be found in the Notes to the Consolidated Financial Statements (Note 4) and elsewhere in this Management’s Discussion and Analysis.

Investment Securities and Impairment

The classification and accounting for investment securities is discussed in detail in Note 3 of the Consolidated Financial Statements. Investment securities must be classified as held-to-maturity, available-for-sale, or trading. The appropriate classification is based partially on our ability to hold the securities to maturity and largely on management’s intentions, if any, with respect to either holding or selling the securities. The classification of investment securities is significant since it directly impacts the accounting for unrealized gains and losses on securities. Unrealized gains and losses on trading securities, if any, flow directly through earnings during the periods in which they arise, whereas available-for-sale securities are recorded as a separate component of shareholders’ equity (accumulated other comprehensive income or loss) and do not affect earnings until realized. The fair values of our investment securities are generally determined by reference to quoted market prices and reliable independent sources. At each reporting date, the Company assesses whether there is an “other-than-temporary” impairment to the Company’s investment securities. Such impairment must be recognized in current earnings rather than in other comprehensive income (loss).

The Company reviews investment debt securities on an ongoing basis for the presence of other-than-temporary impairment (OTTI) with formal reviews performed quarterly. OTTI losses on individual investment securities were recognized during 2012 in accordance with FASB ASC topic 320, Investments – Debt and Equity Securities. The purpose of this ASC is to provide greater clarity to investors about the credit and noncredit component of an OTTI event and to communicate more effectively when an OTTI event has occurred. This ASC amends the OTTI guidance in GAAP for debt securities, improves the presentation and disclosure of OTTI on investment securities and changes the calculation of the OTTI recognized in earnings in the financial statements. This ASC does not amend existing recognition and measurement guidance related to OTTI of equity securities.

For debt securities, ASC topic 320 requires an entity to assess whether it has the intent to sell the debt security or it is more-likely-than-not that it will be required to sell the debt security before its anticipated recovery. If either of these conditions is met, an OTTI on the security must be recognized.

In instances in which a determination is made that a credit loss (defined as the difference between the present value of the cash flows expected to be collected and the amortized cost basis) exists but the entity does not intend to sell the debt security and it is not more-likely-than-not that the entity will be required to sell the debt security before the anticipated recovery of its remaining amortized cost basis (i.e., the amortized cost basis less any current-period credit loss), ASC topic 320 changes the presentation and amount of the OTTI recognized in the income statement.

In these instances, the impairment is separated into the amount of the total impairment related to the credit loss and the amount of the total impairment related to all other factors. The amount of the total other-than-temporary impairment related to the credit loss is recognized in earnings. The amount of the total impairment related to all other factors is recognized in other comprehensive income (loss). The total OTTI is presented in the income statement with an offset for the amount of the total OTTI that is recognized in other comprehensive income (loss). In determining the amount of impairment related to credit loss, the Company uses a third party

 

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discounted cash flow model, several inputs for which require estimation and judgment. Among these inputs are projected deferral and default rates and estimated recovery rates. Realization of events different than that projected could result in a large variance in the values of the securities.

Income Taxes

The provision for income taxes is based on income reported for financial statement purposes and differs from the amount of taxes currently payable, since certain income and expense items are reported for financial statement purposes in different periods than those for tax reporting purposes. Accrued taxes represent the net estimated amount due or to be received from taxing authorities. In estimating accrued taxes, the Company assesses the relative merits and risks of the appropriate tax treatment of transactions taking into account statutory, judicial and regulatory guidance in the context of the Company’s tax position.

The Company accounts for income taxes using the asset and liability approach, the objective of which is to establish deferred tax assets and liabilities for the temporary differences between the financial reporting basis and tax basis of our assets and liabilities at enacted tax rates expected to be in effect when such amounts are realized or settled. The Company conducts periodic assessments of deferred tax assets, including net operating loss carryforwards, to determine if it is more-likely-than-not that they will be realized. In making these assessments, the Company considers taxable income in prior periods, projected future taxable income, potential tax planning strategies and projected future reversals of deferred tax items. These assessments involve a certain degree of subjectivity which may change significantly depending on the related circumstances.

Authoritative Accounting Guidance

In December 2011, the FASB issued ASU 2011-11, Balance Sheet (Topic 210): Disclosures about Offsetting Assets and Liabilities. The amendments in this Update affect all entities that have financial instruments and derivative instruments that are either (1) offset in accordance with either Section 210-20-45 or Section 815-10-45 or (2) subject to an enforceable master netting arrangement or similar agreement. The requirements amend the disclosure requirements on offsetting in Section 210-20-50. This information will enable users of an entity’s financial statements to evaluate the effect or potential effect of netting arrangements on an entity’s financial position, including the effect or potential effect of rights of setoff associated with certain financial instruments and derivative instruments in the scope of this Update. An entity is required to apply the amendments for annual reporting periods beginning on or after January 1, 2013, and interim periods within those annual periods. An entity should provide the disclosures required by those amendments retrospectively for all comparative periods presented. This ASU did not have a material effect on the Company’s financial position or results of operations.

In January 2013, the FASB issued ASU 2013-01, Balance Sheet (Topic 210): Clarifying the Scope of Disclosures about Offsetting Assets and Liabilities. The amendments clarify that the scope of Update 2011-11 applies to derivatives accounted for in accordance with Topic 815, Derivatives and Hedging, including bifurcated embedded derivatives, repurchase agreements and reverse repurchase agreements, and securities borrowing and securities lending transactions that are either offset in accordance with Section 210-20-45 or Section 815-10-45 or subject to an enforceable master netting arrangement or similar agreement. An entity is required to apply the amendments for fiscal years beginning on or after January 1, 2013, and interim periods within those annual periods. An entity should provide the required disclosures retrospectively for all comparative periods presented. The effective date is the same as the effective date of Update 2011-11. This ASU did not have a material effect on the Company’s financial position or results of operations.

In February 2013, the FASB issued ASU 2013-02, Comprehensive Income (Topic 220): Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income. The amendments in this Update require an entity to report the effect of significant reclassifications out of accumulated other comprehensive income on the respective line items in net income if the amount being reclassified is required under U.S. generally accepted accounting principles (GAAP) to be reclassified in its entirety to net income. For other amounts that are not required under U.S. GAAP to be reclassified in their entirety to net income in the same reporting period, an entity is required to cross-reference other disclosures required under U.S. GAAP that provide additional detail about those amounts. For public entities, the amendments are effective prospectively for reporting periods beginning after December 15, 2012. For nonpublic entities, the amendments are effective prospectively for reporting periods beginning after December 15, 2013. Early adoption is permitted. This ASU did not have a material effect on the Company’s financial position or results of operations.

In July 2013, the FASB issued ASU 2013-10, Derivatives and Hedging (Topic 815): Inclusion of the Fed Funds Effective Swap Rate (or Overnight Index Swap Rate) as a Benchmark Interest Rate for Hedge Accounting Purposes. The amendments in this Update permit the Fed Funds Effective Swap Rate (OIS) to be used as a U.S. benchmark interest rate for hedge accounting purposes under Topic 815, in addition to UST and LIBOR. The amendments also remove the restriction on using different benchmark rates for similar hedges. The amendments are effective prospectively for qualifying new or redesignated hedging relationships entered into on or after July 17, 2013. This ASU did not have a material effect on the Company’s financial position or results of operations.  

   

 

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In July 2013, the FASB issued ASU 2013-11, Income Taxes (Topic 740): Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists. This Update applies to all entities that have unrecognized tax benefits when a net operating loss carryforward, a similar tax loss, or a tax credit carryforward exists at the reporting date. An unrecognized tax benefit, or a portion of an unrecognized tax benefit, should be presented in the financial statements as a reduction to a deferred tax asset for a net operating loss carryforward, a similar tax loss, or a tax credit carryforward, except as follows. To the extent a net operating loss carryforward, a similar tax loss, or a tax credit carryforward is not available at the reporting date under the tax law of the applicable jurisdiction to settle any additional income taxes that would result from the disallowance of a tax position or the tax law of the applicable jurisdiction does not require the entity to use, and the entity does not intend to use, the deferred tax asset for such purpose, the unrecognized tax benefit should be presented in the financial statements as a liability and should not be combined with deferred tax assets. The assessment of whether a deferred tax asset is available is based on the unrecognized tax benefit and deferred tax asset that exist at the reporting date and should be made presuming disallowance of the tax position at the reporting date. The amendments in this Update are effective for fiscal years, and interim periods within those years, beginning after December 15, 2013. For nonpublic entities, the amendments are effective for fiscal years, and interim periods within those years, beginning after December 15, 2014. Early adoption is permitted. The amendments should be applied prospectively to all unrecognized tax benefits that exist at the effective date. Retrospective application is permitted. This ASU did not have a material effect on the Company’s financial position or results of operations.

Available Information

The Company files an annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports with the Securities and Exchange Commission (SEC) pursuant to Section 13(a) or 15(d) of the Exchange Act of 1934 Amended (the Exchange Act). The Company’s website is www.cortland-banks.com. The Company makes available through its website, free of charge, the reports filed with the SEC, as soon as reasonably practicable after such material is electronically filed, or furnished to, the SEC. The SEC also maintains a website that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC at www.sec.gov. The public may read and copy any materials filed with the Commission at the SEC’s Public Reference Room at 100 F Street, NE, Washington, DC 20549, on official business days during the hours of 10:00 am to 3:00 pm. The public may obtain information on the operation of the Public Reference Room by calling the Commission at 1-800-SEC-0330.

   

   

   

 

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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

There have been no material changes in the quantitative and qualitative information about market risk from the information provided in the Company’s Form 10-K for the year ended December 31, 2012.

   

   

   

 

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ITEM 4. CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures. With the supervision and participation by management, including the Company’s principal executive officer and principal financial officer, the effectiveness of disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”)) has been evaluated as of the end of the period covered by this report. Based upon that evaluation, the Company’s principal executive officer and principal financial officer have concluded that these controls and procedures were effective.

Changes in Internal Control Over Financial Reporting. Our Chief Executive Officer and Chief Financial Officer have concluded that there have been no significant changes during the period covered by this report in the Company’s internal control over financial reporting (as defined in Rules 13a-13 and 15d-15 of the Exchange Act) that have materially affected, or are reasonably likely to materially affect, internal control over financial reporting.

   

   

 

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PART II—OTHER INFORMATION

Item 1. Legal Proceedings

See Note (5) of the financial statements.

Item 1A. Risk Factors

There have been no material changes in the risk factors disclosed by the Company in its Report on Form 10-K for the fiscal year ended December 31, 2012.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds—Not applicable

Company’s Common Stock—There were no repurchases of shares of the Company’s common stock during the nine months ended September 30, 2013.

Item 3. Defaults upon Senior Securities—Not applicable

Item 4. Mine Safety Disclosures—Not applicable

Item 5. Other Information—Not applicable

   

   

 

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CORTLAND BANCORP AND SUBSIDIARIES

INDEX TO EXHIBITS

Item 6. Exhibits—The following exhibits are filed or incorporated by reference as part of this report:

   

 

 

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CORTLAND BANCORP AND SUBSIDIARIES

SIGNATURES

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

CORTLAND BANCORP

(Registrant)

   

   

 

   

 

   

   

 

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