FIRST UNITED CORP/MD/ – 10-K – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
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This discussion and analysis should be read in conjunction with the Consolidated Financial Statements and notes thereto for the year endedDecember 31, 2011 , which are included in Item 8 of Part II of this annual report. Recent Developments
Effective onJanuary 1, 2012 , theInsurance Group sold substantially all of its assets, net of cash, to an unrelated third party (the "Acquirer") for$3.6 million . Prior to that date, theInsurance Group operated as a full service insurance agency with offices inMaryland andWest Virginia . As part of this sale, we agreed that we would not compete with the Acquirer for insurance business other than with respect to insurance related to our banking, trust, lending, consumer finance company, and/or securities sales businesses. We also agreed to not solicit the Acquirer's customers or any person who was a customer of theInsurance Group at any time within three years prior to the sale. These restrictions will terminate onJanuary 1, 2017 . As a result of these agreements, we anticipate that our insurance activities for the foreseeable future will be limited to the sale of credit-related insurance products and the sale, through our networking arrangements, of annuities. Also as part of the sale, we agreed, untilJanuary 1, 2013 , to refer insurance business to the Acquirer. To the extent permitted by law, we will be entitled to a referral fee, equal to 10% of the commission payable to the Acquirer, when our referrals result in the sale of an insurance policy of a type not previously sold to the customer by the Acquirer. Total revenues for 2011 were$2.4 million and pre-tax operating expenses, net of amortization expense and expenses related to the sale were$2.2 million . Management does not expect the sale of theInsurance Group's assets or the referral arrangement to have a material impact on our future financial condition or results of operations. Overview
First United Corporation is a financial holding company which, through the Bank and its non-bank subsidiaries, provides an array of financial products and services primarily to customers in fourWestern Maryland counties and fourNortheastern West Virginia counties. Its principal operating subsidiary is the Bank, which consists of a community banking network of 28 branch offices located throughout its market areas. Our primary sources of revenue are interest income earned from our loan and investment securities portfolios and fees earned from financial services provided to customers. Consolidated net income available to common shareholders was$2.0 million for the year endedDecember 31, 2011 , compared to a net loss attributable to common shareholders of$11.8 million for the same period of 2010. Basic and diluted net income per common share for the year endedDecember 31, 2011 were$.33 , compared to basic and diluted net loss per common share of$1.91 for the same period of 2010. The change in earnings, from a net loss for the year endedDecember 31, 2010 to net income for the year endedDecember 31, 2011 , resulted primarily from a$6.6 million reduction in provision for loan losses and a$3.8 million reduction in net losses from sales of securities and other real estate owned. In addition,$19,000 in non-cash other-than-temporary impairment ("OTTI") charges were realized for the year endedDecember 31, 2011 , compared to$8.4 million for the same period of 2010. During 2011, we also recognized a gain of$1.4 million from the sale of a portion of the indirect auto loan portfolio. The decreases in expenses and the gain on the sale of indirect auto loans were offset by a decrease of$7.4 million in income tax benefit and a decline in net interest income of$3.3 million . The decrease in net interest income was driven by an$11.7 million reduction in interest income on a fully tax-equivalent ("FTE") basis attributable to lower levels of loans, the sale of a portion of the indirect auto portfolio and the lower interest rate environment. The net interest margin for the year endedDecember 31, 2011 , on an FTE basis, increased to 2.96% from 2.71% for the year endedDecember 31, 2010 . The increase in the net interest margin was driven primarily by the strategic plan to reduce cash levels by paying off certain liabilities that matured during 2011 and to change the composition of our deposit mix, focusing on lower cost core deposits. The provision for loan losses was$9.2 million for the year endedDecember 31, 2011 , compared to$15.7 million for fiscal year 2010. The lower provision expense was primarily due to a leveling in the credit quality of our loan portfolio. Management continued to make specific allocations for impaired loans where it was determined that the collateral supporting the loans is not adequate to cover the loan balance, and management adjusted the qualitative factors affecting the allowance for loan losses (the "ALL") to reflect changes in the economic environment. [25]
Interest expense on our interest-bearing liabilities decreased$8.0 million during 2011 when compared to 2010 due primarily to a planned decrease of$260.1 million in average interest-bearing deposits and a$39.1 million decrease in average debt outstanding. Management used cash to repay wholesale deposits and FHLB advances. The decline in expense was also due to the low interest rate environment and our strategy to provide special pricing only to full relationship customers. Other operating income increased$14.7 million during 2011 when compared to 2010. This increase was primarily attributable to an$8.4 million decrease in non-cash credit-related OTTI charges, and a decrease of$6.1 million in net losses related to sales of securities, sales and write downs of other real estate owned and a gain recognized on the sale of a portion of the indirect auto loan portfolio. Operating expenses decreased$3.2 million during 2011 when compared to the same period of 2010. This decrease was due primarily to a$1.1 million decline in salaries and benefits related to a reduction in full-time equivalents through attrition and reduced pension expense and a decline of$1.7 million inFDIC premiums attributable to the repayment of brokered deposits. ComparingDecember 31, 2011 toDecember 31, 2010 , outstanding loans decreased by$38.6 million (3.8%), net of the sale of$32.5 million of the indirect auto portfolio. CRE loans decreased$12.4 million as a result of the payoff of several large loans, charge-offs of loan balances and ongoing scheduled principal payments. Commercial and industrial ("C&I") loans increased$8.7 million and residential mortgages declined$9.5 million . Acquisition and development loans decreased$14.0 million due to principal repayments and charge offs. The decrease in the residential mortgage portfolio was attributable to regularly scheduled principal payments on existing loans and management's decision to use secondary market outlets such as Fannie Mae for the majority of new, longer-term, fixed-rate residential loan originations. The consumer loan portfolio declined$43.9 million due primarily to the sale of$32.5 million of retail installment contracts in our indirect auto loan portfolio and$11.4 million of repayment activity in the indirect auto portfolio which exceeded new production due to special financing offered by the automotive manufacturers, credit unions and certain large regional banks. AtDecember 31, 2011 , approximately 64% of the commercial loan portfolio was collateralized by real estate, compared to approximately 71% atDecember 31, 2010 . Interest income on loans in 2011 decreased by$8.8 million (on an FTE basis) when compared to 2010 due to the decrease in interest rates and the decline the in loan balances during 2011. Interest income on the investment securities decreased by$2.7 million (on an FTE basis) due to reinvesting called securities at lower rates. (Additional information on the composition of interest income is available in Table 1 that appears on page 32). Total deposits decreased$273.9 million during 2011 when compared to deposits atDecember 31, 2010 . The decline in deposits was due to a strategic decision to use cash to repay wholesale deposits and FHLB advances. The repayment of approximately$161 million in wholesale deposits was offset by increases of$28.7 million in non-interest bearing deposits,$9.0 million in traditional savings accounts and$2.1 million in retail money market accounts. Time deposits less than$100,000 declined$62.3 million while time deposits greater than$100,000 decreased$196.9 million . The decrease was due to a$160.4 million decline in brokered certificates of deposit and CDARS® participation, and a decrease of$36.5 million in retail certificates of deposit.
Interest expense decreased
Other Operating Income/Other Operating Expense - Other operating income, exclusive of losses, decreased$.2 million during the year endedDecember 31, 2011 when compared to fiscal year 2010. Service charge income decreased$.7 million due primarily to a reduction in non-sufficient funds ("NSF") fees resulting from newly enacted regulation of overdraft fees. Debit card income increased$.5 million during 2011 when compared to 2010 due to increased consumer spending and higher customer awareness of our rewards program. Trust department income increased$.3 million during 2011 when compared to 2010 due to a slight increase in assets under management and the fees received on those accounts and increased fees collected on estate administration. Assets under management were approximately$595 million atDecember 31, 2011 , a 1% increase overDecember 31, 2010 . Net gains of$.6 million were reported through other income during 2011, compared to net losses of$14.4 million during 2010. There were$19,000 in losses during 2011 that were attributable to non-cash OTTI charges on the investment portfolio, down from the$8.4 million during fiscal year 2010. The reduced OTTI charges resulted from the improvement in the financial industry, the debt securities of which make up the primary collateral for the securities in our collateralized [26]
debt obligation ("CDO") portfolio. Net gains of
Other operating expenses decreased$3.2 million (7%) for the year endedDecember 31, 2011 when compared to the year endedDecember 31, 2010 . The decrease was primarily due to a$1.1 million decline in salaries and benefits, resulting primarily from a reduction of full-time equivalent employees through attrition and reduced pension expense, and a$1.7 million decline inFDIC premiums attributable to the repayment of brokered deposits. Dividends - During 2011,First United Corporation did not declare or pay any dividends on the shares of its common stock on account of the board of directors' decision inNovember 2010 to defer quarterly cash dividends on the Series A Preferred Stock. There were no dividends paid on the Series A Preferred Stock in 2011. In 2010,First United Corporation paid a total of$.8 million in cash dividends on the shares of common stock and a total of$1.1 million in cash dividends on the Series A Preferred Stock. Looking Forward - We will continue to face risks and challenges in the future, including, without limitation, changes in local economic conditions in our core geographic markets, potential yield compression on loan and deposit products from existing competitors and potential new entrants in our markets, fluctuations in interest rates, and changes to existing federal and state laws and regulations that apply to banks and financial holding companies. For a more complete discussion of these and other risk factors, see Item 1A of Part I
of this annual report.
Critical Accounting Policies and Estimates
This discussion and analysis of our financial condition and results of operations is based upon our Consolidated Financial Statements, which have been prepared in accordance with accounting principles generally accepted inthe United States of America . The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent liabilities. (See Note 1 to the Consolidated Financial Statements.) On an on-going basis, management evaluates estimates, including those related to loan losses and intangible assets. Management bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Management believes the following critical accounting policies affect our more significant judgments and estimates used in the preparation of the Consolidated Financial Statements.
Allowance for Loan Losses, or ALL
One of our most important accounting policies is that related to the monitoring of the loan portfolio. A variety of estimates impact the carrying value of the loan portfolio, including the calculation of the ALL, the valuation of underlying collateral, the timing of loan charge-offs and the placement of loans on non-accrual status. The allowance is established and maintained at a level that management believes is adequate to cover losses resulting from the inability of borrowers to make required payment on loans. Estimates for loan losses are arrived at by analyzing risks associated with specific loans and the loan portfolio, current and historical trends in delinquencies and charge-offs, and changes in the size and composition of the loan portfolio. The analysis also requires consideration of the economic climate and direction, changes in lending rates, political conditions, legislation impacting the banking industry and economic conditions specific toWestern Maryland andNortheastern West Virginia . Because the calculation of the ALL relies on management's estimates and judgments relating to inherently uncertain events, actual results may differ from management's estimates.
The ALL is also discussed below in Item 7 under the heading "Allowance for Loan Losses" and in Note 7 to the Consolidated Financial Statements.
Goodwill and Other Intangible Assets
Accounting Standards Codification ("ASC") Topic 350, Intangibles - Goodwill and Other, establishes standards for the amortization of acquired intangible assets and impairment assessment of goodwill. We have$1.6 million related to acquisitions of insurance "books of business" which are subject to amortization. The$12.9 million in recorded goodwill is primarily related to the acquisition ofHuntington National Bank branches that occurred in 2003 and the acquisition of insurance books of business in 2008 that are not subject to periodic amortization. [27] Goodwill arising from business combinations represents the value attributable to unidentifiable intangible elements in the business acquired. Goodwill is not amortized but is tested for impairment annually or more frequently if events or changes in circumstances indicate that the asset might be impaired. Impairment testing requires that the fair value of each ofFirst United Corporation's reporting units be compared to the carrying amount of its net assets, including goodwill. If the estimated current fair value of the reporting unit exceeds its carrying value, no additional testing is required and an impairment loss is not recorded. Otherwise, additional testing is performed, and to the extent such additional testing results in a conclusion that the carrying value of goodwill exceeds its implied fair value, an impairment loss is recognized. Our goodwill relates to the value inherent in the banking business, and that value is dependent upon our ability to provide quality, cost effective services in a highly competitive local market. This ability relies upon continuing investments in processing systems, the development of value-added service features and the ease of use of our services. As such, goodwill value is supported ultimately by revenue that is driven by the volume of business transacted. A decline in earnings as a result of a lack of growth or the inability to deliver cost effective services over sustained periods can lead to impairment of goodwill, which could adversely impact earnings in future periods. ASC Topic 350 requires an annual evaluation of goodwill for impairment. The determination of whether or not these assets are impaired involves significant judgments and estimates. Throughout 2011, consistent withFirst United Corporation's peer group, the shares ofFirst United Corporation common stock traded below its book value. AtDecember 31, 2011 ,First United Corporation's stock price was significantly below its tangible book value. Management believed that these circumstances could indicate the possibility of impairment. Accordingly, management consulted a third party valuation specialist to assist it with the determination of the fair value ofFirst United Corporation , considering both the market approach (guideline public company method) and the income approach (discounted future benefits method). Due to the illiquidity in the common stock and the adverse conditions surrounding the banking industry, reliance was placed on the income approach in determining the fair value ofFirst United Corporation . The income approach is a discounted cash flow analysis that is determined by adding (i) the present value, which is a representation of the current value of a sum that is to be received some time in the future, of the estimated net income, net of dividends paid out, thatFirst United Corporation could generate over the next five years and (ii) the present value of a terminal value, which is a representation of the current value of an entity at a specified time in the future. The terminal value was calculated using both a price to tangible book multiple method and a capitalization method and the more conservative of the two was utilized in the fair value calculation.
Significant assumptions used in the above methods include:
· Net income from
incorporating conservative growth and mix assumptions;
· A discount rate of 11.0% based on the most recent [third quarter of 2011] Cost
of Capital Report from
Banking Sector adjusted for a size and risk premium of 302 basis points;
· A price to tangible book multiple of 1.12, which was the median multiple of
commercial bank mergers and acquisitions during 2011 for selling banks and
holding companies with non-performing assets to average assets between 4.0% and
6.0%, as provided by
· A capitalization rate of 8.0% (discount rate of 11.0% adjusted for a
conservative growth rate of 3.0%).
The resulting fair value of the income approach resulted in the fair value ofFirst United Corporation exceeding the carrying value by 66%. Management stressed the assumptions used in the analysis to provide additional support for the derived value. This stress testing showed that (i) the discount rate could increase to 27% before the excess would be eliminated in the tangible multiple method, and (ii) the assumption of the tangible book multiple could decline to 0.41 and still result in a fair value in excess of book value. Based on the results of the evaluation, management concluded that the recorded value of goodwill atDecember 31, 2011 was not impaired. However, future changes in strategy and/or market conditions could significantly impact these judgments and require adjustments to recorded asset balances. Management will continue to evaluate goodwill for impairment on an annual basis and as events occur or
circumstances change. Accounting for Income TaxesFirst United Corporation accounts for income taxes by recording deferred income taxes that reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Management exercises significant judgment in the evaluation of the amount and [28]
timing of the recognition of the resulting tax assets and liabilities. The judgments and estimates required for the evaluation are updated based upon changes in business factors and the tax laws.
A valuation allowance is recognized to reduce any deferred tax assets that based upon available information, it is more-likely-than-not all, or any portion, of the deferred tax asset will not be realized. Assessing the need for, and amount of, a valuation allowance for deferred tax assets requires significant judgment and analysis of evidence regarding realization of the deferred tax assets. In most cases, the realization of deferred tax assets is dependent upon the recognition of deferred tax liabilities and generating a sufficient level of taxable income in future periods, which can be difficult to predict. Our largest deferred tax assets involve differences related to ALL and unrealized losses on investment securities. Given the nature of our deferred tax assets, management determined no valuation allowances were needed atDecember 31, 2011 orDecember 31, 2010 except for a state valuation allowance for certain state deferred tax assets associated with our Parent Company. Management expects thatFirst United Corporation's adherence to the required accounting guidance may result in increased volatility in quarterly and annual effective income tax rates because of changes in judgment or measurement including changes in actual and forecasted income before taxes, tax laws and regulations, and tax planning strategies.
Other-Than-Temporary Impairment of
Securities available-for-sale:Securities available-for-sale are stated at fair value, with the unrealized gains and losses, net of tax, reported in the accumulated other comprehensive income/(loss) component in shareholders' equity.
The amortized cost of debt securities classified as available-for-sale is adjusted for amortization of premiums to the first call date, if applicable, or to maturity, and for accretion of discounts to maturity, or in the case of mortgage-backed securities, over the estimated life of the security. Such amortization and accretion, plus interest and dividends, are included in interest income from investments. Gains and losses on the sale of securities are recorded using the specific identification method. Management systematically evaluates securities for impairment on a quarterly basis. Based upon application of accounting guidance for subsequent measurement in ASC Topic 320 (Section 320-10-35), management assesses whether (i) it has the intent to sell a security being evaluated and (ii) it is more likely than not that First United Corporationwill be required to sell the security prior to its anticipated recovery. If neither applies, then declines in the fair values of securities below their cost that are considered other-than-temporary declines are split into two components. The first is the loss attributable to declining credit quality. Credit losses are recognized in earnings as realized losses in the period in which the impairment determination is made. The second component consists of all other losses, which are recognized in other comprehensive loss. In estimating OTTI losses, management considers (a) the length of time and the extent to which the fair value has been less than cost, (b) adverse conditions specifically related to the security, an industry, or a geographic area, (c) the historic and implied volatility of the fair value of the security, (d) changes in the rating of the security by a rating agency, (e) recoveries or additional declines in fair value subsequent to the balance sheet date, (f) failure of the issuer of the security to make scheduled interest or principal payments, and (g) the payment structure of the debt security and the likelihood of the issuer being able to make payments that increase in the future. Management also monitors cash flow projections for securities that are considered beneficial interests under the guidance of ASC Subtopic 325-40, Investments - Other - Beneficial Interests in Securitized Financial Assets, (ASC Section 325-40-35). This process is described more fully in the section of the Consolidated Balance Sheet Review entitled "Investment Securities ". Fair Value of Investments We have determined the fair value of our investment securities in accordance with the requirements of ASC Topic 820, Fair Value Measurements and Disclosures, which defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements required under other accounting pronouncements. We measure the fair market values of our investments based on the fair value hierarchy established in Topic 820. The determination of fair value of investments and other assets is discussed further in Note 23 to the Consolidated Financial Statements. Pension Plan Assumptions Our pension plan costs are calculated using actuarial concepts, as discussed within the requirements of ASC Topic 715, Compensation - Retirement Benefits. Pension expense and the determination of our projected pension liability are based upon two critical assumptions: the discount rate and the expected return on plan assets. We evaluate each of these [29] critical assumptions annually. Other assumptions impact the determination of pension expense and the projected liability including the primary employee demographics, such as retirement patterns, employee turnover, mortality rates, and estimated employer compensation increases. These factors, along with the critical assumptions, are carefully reviewed by management each year in consultation with our pension plan consultants and actuaries. Further information about our pension plan assumptions, the plan's funded status, and other plan information is included in Note 17 to the Consolidated Financial Statements. Other than as discussed above, management does not believe that any material changes in our critical accounting policies have occurred sinceDecember 31, 2010 .
Adoption of New Accounting Standards and Effects of New Accounting Pronouncements
Note 1 to the Consolidated Financial Statements discusses new accounting pronouncements that, when adopted, could affect our future consolidated financial statements.
CONSOLIDATED STATEMENT OF INCOME REVIEW
Net Interest Income Net interest income is our largest source of operating revenue. Net interest income is the difference between the interest earned on interest-earning assets and the interest expense incurred on interest-bearing liabilities. For analytical and discussion purposes, net interest income is adjusted to an FTE basis to facilitate performance comparisons between taxable and tax-exempt assets by increasing tax-exempt income by an amount equal to the federal income taxes that would have been paid if this income were taxable at the statutorily applicable rate.
The table below summarizes net interest income (on a fully taxable equivalent basis) for the 2011 and 2010.
(Dollars in thousands) 2011 2010 Interest income $ 61,029 $ 72,730 Interest expense 21,206 29,164 Net interest income $ 39,823 $ 43,566 Net interest margin % 2.96 % 2.71 %
Net interest income on an FTE basis decreased$3.7 million during the year endedDecember 31, 2011 over the same period in 2010 due to an$11.7 million (16.1%) decrease in interest income, which was partially offset by an$8.0 million (27.3%) decrease in interest expense. The decrease in net interest income resulted primarily from a lower level of loans and the lower interest rate environment in 2011 when compared to 2010. Average interest-earning assets decreased by$264.7 million during 2011. The average yield on our average earning assets increased slightly to 4.54% atDecember 31, 2011 from 4.52% atDecember 31, 2010 . This increase was due primarily to our strategy to deploy excess liquidity, invested at lower rates, to repay brokered and wholesale funding at their stated maturities rather than renew. Interest expense decreased during 2011 when compared to 2010 due to an overall reduction in interest rates paid on time deposits, driven by our decision to provide special rates only to full relationship customers, as well as lower balances and the shorter duration of the portfolio. The overall decrease of$299.2 million in average interest-bearing liabilities in 2011 when compared to 2010 decreased the average rate paid from 1.89% atDecember 31, 2010 to 1.71% atDecember 31, 2011 . As shown below, the composition of total interest income between 2011 and 2010 reflects a slight shift toward interest and fees on loans from investment securities. [30] % of Total Interest Income 2011 2010 Interest and fees on loans 88 % 86 % Interest on investment securities 11 % 13 % Other 1 % 1 % Table 1 sets forth the average balances, net interest income and expense, and average yields and rates for our interest-earning assets and interest-bearing liabilities for 2011, 2010 and 2009. Table 2 sets forth an analysis of volume and rate changes in interest income and interest expense of our average interest-earning assets and average interest-bearing liabilities for 2011, 2010 and 2009. Table 2 distinguishes between the changes related to average outstanding balances (changes in volume created by holding the interest rate constant) and the changes related to average interest rates (changes in interest income or expense attributed to average rates created by holding the outstanding balance constant). [31] Distribution of Assets, Liabilities and Shareholders' Equity Interest Rates and Interest Differential - Tax Equivalent Basis Table 1 For the Years Ended December 31 2011 2010 2009 Average Average Average Average Average Average (Dollars in thousands) Balance Interest Yield/Rate Balance Interest Yield/Rate Balance Interest Yield/Rate Assets Loans $ 953,774 $ 52,343 5.49 % $ 1,074,080 $ 61,115 5.69 % $ 1,132,569 $ 68,271 6.03 %Investment Securities : Taxable 173,811 4,081 2.35 148,565 5,524 3.72 224,647 13,106 5.83 Non taxable 76,237 4,228 5.55 94,728 5,518 5.83 98,960 5,962 6.02 Total 250,048 8,309 3.32 243,293 11,042 4.54 323,607 19,068 5.89 Federal funds sold 109,287 265 .24 190,878 422 .22 48,979 96 .20 Interest-bearing deposits with other banks 19,922 15 .08 87,860 104 .12 34,389 28 .08 Other interest earning assets 11,797 97 .82 13,453 47 .35 13,819 15 .11 Total earning assets 1,344,828 61,029 4.54 % 1,609,564 72,730 4.52 % 1,553,363 87,478 5.63 % Allowance for loan losses (21,495 ) (22,530 ) (14,960 ) Non-earning assets 167,896 176,265 157,741 Total Assets $ 1,491,229 $ 1,763,299 $ 1,696,144 Liabilities and Shareholders' Equity Interest-bearing demand deposits $ 98,395 $ 134 .14 % $ 115,478 $ 387 .34 % $ 107,869 $ 195 .18 % Interest-bearing money markets 224,303 748 .33 286,639 2,418 .84 283,430 2,802 .99 Savings deposits 100,598 277 .28 83,734 566 .68 76,703 498 .65 Time deposits: Less than $100k 290,651 5,650 1.94 366,922 7,802 2.13 323,409 9,241 2.86 $100k or more 267,648 5,090 1.90 388,945 6,910 1.78 355,589 7,480 2.10 Short-term borrowings 41,780 236 .56 45,055 283 .63 44,473 318 .72 Long-term borrowings 217,112 9,071 4.18 252,889 10,798 4.27 274,718 11,570 4.21 Total interest-bearing liabilities 1,240,487 21,206 1.71 % 1,539,662 29,164 1.89 % 1,466,191 32,104 2.19 % Non-interest-bearing deposits 135,365 109,145 110,883 Other liabilities 17,662 13,507 16,240 Shareholders' Equity 97,715 100,985 102,830 Total Liabilities and Shareholders' Equity $ 1,491,229 $ 1,763,299 $ 1,696,144 Net interest income and spread $ 39,823 2.83 % $ 43,566 2.63 % $ 55,374 3.44 % Net interest margin 2.96 % 2.71 % 3.56 % Notes:
(1) The above table reflects the average rates earned or paid stated on an FTE
basis assuming a tax rate of 35% for 2011, 2010 and 2009. The FTE adjustments
for the years ended
(2) The average balances of non-accrual loans for the years ended December 31,
2011, 2010 and 2009, which were reported in the average loan balances for
these years, were
(3) Net interest margin is calculated as net interest income divided by average
earning assets.
(4) The average yields on investments are based on amortized cost.
[32] Interest Variance Analysis (1) Table 2 2011 Compared to 2010 2010 Compared to 2009
(In thousands and tax equivalent basis) Volume Rate Net Volume Rate Net Interest Income: Loans $ (6,605 ) $ (2,167 ) $ (8,772 ) $ (3,328 ) $ (3,828 ) $ (7,156 ) Taxable Investments 593 (2,036 ) (1,443 ) (2,829 ) (4,753 ) (7,582 ) Non-taxable Investments (1,026 ) (264 ) (1,290 ) (247 ) (197 ) (444 ) Federal funds sold (196 ) 39 (157 ) 313 13 326 Other interest earning assets (624 ) 586 (38 ) 247 (139 ) 108 Total interest income (7,858 ) (3,842 )
(11,700 ) (5,844 ) (8,904 ) (14,748 )
Interest Expense: Interest-bearing demand deposits (23 ) (230 ) (253 ) 26 166 192 Interest-bearing money markets (206 ) (1,465 ) (1,671 ) 27 (411 ) (384 ) Savings deposits 47 (336 ) (289 ) 47 21 68 Time deposits less than $100 (1,480 ) (672 ) (2,152 ) 925 (2,364 ) (1,439 ) Time deposits $100 or more (2,305 ) 485 (1,820 ) 593 (1,163 ) (570 ) Short-term borrowings (18 ) (29 ) (47 ) 4 (39 ) (35 ) Long-term borrowings (1,495 ) (232 ) (1,727 ) (932 ) 160 (772 ) Total interest expense (5,480 ) (2,479 ) (7,959 ) 690 (3,630 ) (2,940 ) Net interest income $ (2,378 ) $ (1,363 ) $ (3,741 ) $ (6,534 ) $ (5,274 ) $ (11,808 ) Note:
(1) The change in interest income/expense due to both volume and rate has been
allocated to volume and rate changes in proportion to the relationship of the
absolute dollar amounts of the change in each. Provision for Loan Losses The provision for loan losses was$9.2 million for the year endedDecember 31, 2011 , compared to$15.7 million for fiscal year 2010. The lower provision for loan losses resulted primarily from stabilization in our total rolling historical loss rates and qualitative factors utilized in the determination of the ALL and stabilization in the level of classified assets. Approximately$.6 million of the lower provision for 2011 was related to the sale of$32.5 million of our indirect auto portfolio in the second quarter 2011. Management strives to ensure that the ALL reflects a level commensurate with the risk inherent in
our loan portfolio. Other Operating Income
The following table shows the major components of other operating income for the past two years, exclusive of net gains/(losses), and the percentage changes during these years:
(Dollars in thousands) 2011 2010 %
Change
Service charges on deposit accounts
-19.8 %
Other service charge income 652 641
1.7 %
Debit card income 2,125 1,580
34.5 %
Trust department income 4,413 4,096
7.7 %
Insurance commissions 2,424 2,712
-10.6 %
Bank owned life insurance (BOLI) 1,030 1,019
1.1 %
Brokerage commissions 767 694
10.5 %
Other income 685 849
-19.3 %
Total other operating income
-1.6 % As the table above illustrates, other operating income decreased by$.2 million in 2011 when compared to 2010, exclusive of net losses. The decline in service charges on deposit accounts was due primarily to a reduction in NSF fees, increased charge-off overdrafts and the new overdraft regulation implemented inAugust 2010 as a result of the Dodd-Frank Act. The creation of theConsumer Protection Bureau and its proposed regulation of overdraft fees and interchange fees [33] could have a material and adverse impact on our future service charge income. At this time, management cannot predict whether and when this regulation will be finalized and, if so, the extent to which it will reduce service charge income. We also experienced decreases in other income such as fee income from our investments inMaryland andWest Virginia title companies.
Debit card income increased due to increased consumer spending and higher customer awareness of our rewards program. Insurance commissions decreased in 2011 when compared to 2010 due primarily to reduced premiums.
Trust department income increased during 2011 when compared to 2010 due to a slight increase in assets under management and the fees received on those account, and increased fees on estate administration. Assets under management were$595 million and$590 million for 2011 and 2010, respectively. Brokerage commissions also increased during 2011 by 10.5% when compared to 2010. Other Operating Expense
Other operating expense for 2011 decreased by
(Dollars in thousands) 2011 2010 %
Change
Salaries and employee benefits $ 20,225 $ 21,307 -5.1 % Other expenses 7,426 8,409 -11.7 % FDIC premiums 2,362 4,017 -41.2 % Equipment 3,015 3,197 -5.7 % Occupancy 2,804 2,977 -5.8 % Data processing 2,744 2,637 4.1 % Professional services 1,575 1,388
13.5 %
Other real estate owned expense 858 589 45.7 %
Miscellaneous loan fees 849 528
60.8 %
Total other operating expense
The$1.1 million decrease in salaries and employee benefits during 2011 when compared to 2010 resulted primarily from a reduction of full-time equivalent employees through attrition and reduced service costs in the pension plan. Professional services expenses increased by 13.5% due primarily to increases in legal and consulting expenses. Other expenses decreased by 11.7% due primarily to decreases in marketing, postage and contract labor expenses.FDIC premiums decreased 41.2% as a result of reduced balances in deposits and a change in the deposit mix. The reduction in equipment expense resulted from a decrease in depreciation. Other real estate owned expenses increased 45.7% due primarily to an increase in other real estate owned properties in 2011. Miscellaneous loan fees increased 60.8% from 2010 to 2011 due primarily to an increase in problem loans. Applicable Income Taxes
Due to improved operating results in 2011, we recognized a smaller net tax benefit of$.6 million in 2011, compared to a net tax benefit of$8.0 million in 2010. The decrease resulted primarily from the change in earnings, from a net loss in 2010 to net income for 2011. The net tax benefit in 2010 resulted primarily from the$8.4 million non-cash OTTI charges on our investment portfolio and the increased loan loss provision. See Note 16 to the Consolidated Financial Statements under the heading "Income Taxes" for a detailed analysis of our deferred tax assets and liabilities. A valuation allowance has been provided for the$1.4 million in state tax loss carry forwards included in deferred tax assets, which will expire commencing in 2030. We have concluded that no valuation allowance is necessary for our remaining federal and state net deferred tax assets atDecember 31, 2011 , as it is more likely than not that they will be realized based on the following:
· the expected reversal of all but
deferred tax liabilities at
substantially utilize the dollar for dollar impact against the deferred tax
assets atDecember 31, 2011 ; [34]
· for the remaining excess deferred tax assets that will not be utilized by the
reversal of deferred tax liabilities, our expected future income will be
sufficient to utilize the deferred tax assets as they reverse or before any net
operating loss, if created, would expire; and
· tax planning strategies that can provide both one-time increases to taxable
income of up to approximately
unfavorable permanent items.
We will need to generate future taxable income of approximately$75 million to fully utilize the net deferred tax assets in the years in which they are expected to reverse. Management estimates that we can fully utilize the deferred tax assets in approximately seven years based on the historical pre-tax income and forecasts of estimated future pre-tax income as adjusted for permanent
book to tax differences.
CONSOLIDATED BALANCE SHEET REVIEW
Overview
Our total assets were
The total interest-earning asset mix atDecember 31, 2011 shows a slight increase in the percentage of loans and investments and a decline in cash and cash equivalents as a percentage of total assets from 2010 to 2011. These changes resulted from the implementation of our strategy to use our excess liquidity to repay, rather than renew, brokered and wholesale funding obligations at their stated maturities during the year. The mix for each year is illustrated below: Year End Percentage of Total Assets 2011 2010 Cash and cash equivalents 5 % 18 % Net loans 66 % 58 % Investments 18 % 14 % The year-end total liability mix has remained consistent during the two-year period as illustrated below. Year End Percentage of Total Liabilities 2011 2010 Total deposits 79 % 81 % Total borrowings 19 % 18 % Loan Portfolio
The Bank is actively engaged in originating loans to customers primarily inAllegany County ,Frederick County ,Garrett County , andWashington County inMaryland , and inBerkeley County ,Hardy County ,Mineral County , andMonongalia County inWest Virginia ; and the surrounding regions ofWest Virginia andPennsylvania . We have policies and procedures designed to mitigate credit risk and to maintain the quality of our loan portfolio. These policies include underwriting standards for new credits as well as continuous monitoring and reporting policies for asset quality and the adequacy of the allowance for loan losses. These policies, coupled with ongoing training efforts, have provided effective checks and balances for the risk associated with the lending process. Lending authority is based on the type of the loan, and the experience of the lending officer. Commercial loans are collateralized primarily by real estate and, to a lesser extent, equipment and vehicles. Unsecured commercial loans represent an insignificant portion of total commercial loans. Residential mortgage loans are collateralized by the related property. Generally, a residential mortgage loan exceeding a specified internal loan-to-value ratio requires private mortgage insurance. Installment loans are typically collateralized, with loan-to-value ratios which are established based on the financial condition of the borrower. We will also make unsecured consumer loans to qualified borrowers meeting our underwriting standards. Additional information about our loans and underwriting policies can be [35]
found in Item 1 of Part I of this annual report under the heading "Banking Products and Services".
Table 3 sets forth the composition of our loan portfolio. Historically, our policy has been to make the majority of our loan commitments in our market areas. We had no foreign loans in our portfolio as of
Summary of Loan Portfolio Table 3 The following table presents the composition of our loan portfolio for the past five years: (In millions) 2011 2010 2009 2008 2007 Commercial real estate $ 336.2 $ 348.6 $ 326.8 $ 322.4 $ 232.1
Acquisition and development 142.9 156.9 231.7 227.0 231.0
Commercial and industrial 78.7 70.0 81.3
December 31, 2011 toDecember 31, 2010 , outstanding loans decreased by$38.6 million (3.8%), net of the sale of$32.5 million of the indirect auto portfolio. CRE loans decreased$12.4 million as a result of the payoff of several large loans, charge-offs of loan balances and ongoing scheduled principal payments. Commercial and industrial ("C&I") loans increased$8.7 million and residential mortgages declined$9.5 million . Acquisition and development loans decreased$14.0 million due primarily to principal repayments and charge offs. The decrease in the residential mortgage portfolio was attributable to regularly scheduled principal payments on existing loans and management's decision to use secondary market outlets such as Fannie Mae for the majority of new, longer-term, fixed-rate residential loan originations. The consumer portfolio declined$43.9 million due primarily to the sale of$32.5 million of retail installment contracts in our indirect auto loan portfolio and$11.4 million of repayment activity in the indirect auto portfolio exceeded new production due to special financing offered by the automotive manufacturers, credit unions and certain large regional banks. AtDecember 31, 2011 , approximately 64% of the commercial loan portfolio was collateralized by real estate, compared to approximately 71% atDecember 31, 2010 . AtDecember 31, 2011 , adjustable interest rate loans made up 63% of total loans, compared to 62% atDecember 31, 2010 . Fixed-interest rate loans made up 37% of the total loan portfolio atDecember 31, 2011 , compared to 38% of total loans atDecember 31, 2010 . Comparing loans atDecember 31, 2010 to loans atDecember 31, 2009 , our loan portfolio decreased$112.1 million (10%). CRE loans increased$21.8 million , as management focused on growing the small business loan portfolio and as certain acquisition and development ("A&D") loans, which decreased$74.8 million , were completed and transferred to permanent financing. The A&D category also declined due to charged-off balances, foreclosures, and working some troubled credits out of the Bank. Commercial and industrial loans declined$11.3 million and residential mortgage declined$16.5 million . The decrease in the residential mortgage portfolio was attributable to the increased amount of loan refinancing that were occurring as consumers sought long-term fixed rate loans. We do not retain these long-term fixed rate loans, but use secondary market and Fannie Mae outlets to satisfy these loan requests. The consumer portfolio declined$31.3 million as repayment activity in the indirect auto portfolio exceeded new production resulting from the continued slowdown in economic activity and management's decision not to compete with the special financing offered by
the automotive manufacturers. [36]
The following table sets forth the maturities, based upon contractual dates, for selected loan categories as of
Maturities of Loan Portfolio at December 31, 2011 Table 4 Maturing After One Maturing Within But Within After Five (In thousands) One Year Five Years Years Total Commercial Real Estate $ 48,244 $ 48,806 $ 239,184 $ 336,234 Acquisition and Development 53,750 25,437 63,684 142,871 Commercial and Industrial 23,460 23,422 31,815 78,697 Residential Mortgage 17,433 6,672 323,115 347,220 Consumer 6,787 22,974 3,911 33,672 Total Loans $ 149,674 $ 127,311 $ 661,709 $ 938,694 Classified by Sensitivity to Change in Interest Rates Fixed-Interest Rate Loans $ 69,059 $ 105,789 $ 176,439 $ 351,287 Adjustable-Interest Rate Loans 80,615 21,522
485,270 587,407 Total Loans $ 149,674 $ 127,311 $ 661,709 $ 938,694 Management monitors the performance and credit quality of the loan portfolio by analyzing the age of the portfolio as determined by the length of time a recorded payment is past due. A loan is considered to be past due when a payment has not been received for 30 days past its contractual due date. For all loan segments, the accrual of interest is discontinued when principal or interest is delinquent for 90 days or more unless the loan is well-secured and in the process of collection. All non-accrual loans are considered to be impaired. Interest payments received on non-accrual loans are applied as a reduction of the loan principal balance. Loans are returned to accrual status when all principal and interest amounts contractually due are brought current and future payments are reasonably assured. Our policy for recognizing interest income on impaired loans does not differ from our overall policy for interest recognition. [37]
Table 5 sets forth the amounts of non-accrual, past-due and restructured loans for the past five years:
Risk Elements of Loan Portfolio Table 5 At December 31, (In thousands) 2011 2010 2009 2008 2007 Non-accrual loans: Commercial real estate $ 10,069 $ 11,893 $ 4,046 $ 2,175 $ 382 Acquisition and development 14,938 16,269 37,244 16,520 4,977 Commercial and industrial 9,364 1,355 0 2,338 0 Residential mortgage 3,796 5,236 5,227 3,434 60 Consumer 21 152 67 86 24 Total non-accrual loans $ 38,188 $ 34,905 $ 46,584 $ 24,553 $ 5,443 Accruing Loans Past Due 90 days or more: Commercial real estate $ 0 $ 0 $ 0 $ 513 $ 166 Acquisition and development 128 128 0 430 975 Commercial and industrial 0 44 0 174 563 Residential mortgage 1,509 2,437 1,483 1,686 1,004 Consumer 142 183 287 673 552 Total accruing loans past due 90 days or more $ 1,779 $ 2,792 $ 1,770
Total non-accrual and accruing loans past due 90 days or more $ 39,967 $ 37,697 $ 48,354 $ 28,029 $ 8,703 Restructured Loans (TDRs): Performing $ 10,657 $ 5,506 $ 22,160 $ 349 $ 0 Non-accrual (included above) 7,385 9,593 13,321 119 0 Total TDRs $ 18,042 $ 15,099 $ 35,481 $ 468 $ 0 Other Real Estate Owned $ 16,676 $ 18,072 $ 7,591 $ 2,424 $ 825 Impaired loans without a valuation allowance $ 41,778 $ 42,890 $ 102,553 $ 66,816 $ 6,814 Impaired loans with a valuation allowance 20,048 19,713 28,677 16,519 176 Total impaired loans $ 61,826 $ 62,603 $ 131,230 $ 83,335 $ 6,990 Valuation allowance related to impaired loans $ 3,951 $ 4,366 $ 7,624 $ 4,759 $ 176 Non-Accrual Loans as a % of Applicable Portfolio 2011 2010 2009 2008 2007 Commercial real estate 3.0 % 3.4 % 1.2 % .7 % .2 % Acquisition and development 10.5 % 10.4 % 16.1 % 7.3 % 2.2 % Commercial and industrial 11.9 % 1.9 % 0 3.0 % 0 Residential mortgage 1.1 % 1.5 % 1.4 % .9 % .02 % Consumer .1 % .2 % .1 % .1 % .02 %
Interest income not recognized as a result of placing loans on non-accrual status was
Performing loans considered to be impaired (including performing troubled debt restructurings, or TDRs), as defined and identified by management, amounted to$23.6 million atDecember 31, 2011 and$27.7 million atDecember 31, 2010 . Loans are identified as impaired when, based on current information and events, management determines that we [38] will be unable to collect all amounts due according to contractual terms. These loans consist primarily of A&D loans and CRE loans. The fair values are generally determined based upon independent third party appraisals of the collateral or discounted cash flows based upon the expected proceeds. Specific allocations have been made where management believes there is insufficient collateral to repay the loan balance if liquidated and there is no secondary source of repayment available. The level of performing impaired loans (other than performing TDRs) decreased$9.2 million during the year endedDecember 31, 2011 . Two CRE loans totaling$1.3 million were removed from impaired status due to satisfactory payment performance. Three A&D loans, two CRE loans and one residential mortgage loan, totaling$3.8 million , that were previously deemed to be performing impaired loans were modified and classified as performing TDRs. One$2.3 million A&D loan that was previously deemed to be a performing impaired loan was transferred to non-performing, and net principal repayments totaling$1.8 million were received on other loans deemed to be performing impaired loans during the year. Management will continue to monitor all loans that have been removed from an impaired status and take appropriate steps to ensure that satisfactory performance is sustained. The following table presents the details of TDRs by loan class atDecember 31, 2011 andDecember 31, 2010 : December 31, 2011 December 31, 2010 Number of Recorded Number of Recorded (in thousands) Contracts Investment Contracts Investment Performing Commercial real estate Non owner-occupied 2 $ 287 0 $ 0 All other CRE 1 3,162 0 0 Acquisition and development
1-4 family residential construction 1 2,489
0 0 All other A&D 4 2,645 4 2,778 Commercial and industrial 1 693 1 717 Residential mortgage
Residential mortgage - term 5 1,381 7 2,011 Residential mortgage - home equity 0 0
0 0 Consumer 0 0 0 0 Total performing 14 $ 10,657 12 $ 5,506 Non-accrual Commercial real estate Non owner-occupied 1 $ 448 2 $ 1,630 All other CRE 0 0 0 0 Acquisition and development 1-4 family residential construction 0 0
0 0 All other A&D 7 6,719 5 6,361 Commercial and industrial 0 0 1 1,355 Residential mortgage
Residential mortgage - term 1 218 2 247 Residential mortgage - home equity 0 0
0 0 Consumer 0 0 0 0 Total non-accrual 9 7,385 10 9,593 Total TDRs 23 $ 18,042 22 $ 15,099 The level of TDRs increased$2.9 million during 2011, reflecting the addition of 10 loans totaling$9.2 million to performing TDRs and the addition of one loan totaling$.2 million to non-accrual TDRs. One performing TDR totaling$.3 million and two non-accrual TDRs totaling$.7 million were repaid during the year. Loans totaling$1.0 million that had been modified at market rates prior to 2011 were removed from performing TDRs in 2011 because the borrowers had made at least six consecutive payments and were current at the time of reclassification. During 2011, principal payments of [39]$.3 million and$2.4 million were received on performing TDRs and non-accrual TDRs, respectively. During 2011, there were partial charge-offs of$.2 million on two performing TDRs and full charge-offs of one$.5 million non-accrual C&I TDR and one$1.1 million non-accrual non-owner occupied CRE TDR. Two performing A&D TDRs totaling$2.3 million were transferred to non-accrual during 2011. AtDecember 31, 2011 , additional funds of up to$1.6 million were committed to be advanced in connection with TDRs. Interest income not recognized due to rate modifications of TDRs was$.1 million , and interest income recognized on all TDRs was$.4 million in 2011. Allowance for Loan Losses
The ALL is maintained to absorb losses from the loan portfolio. The ALL is based on management's continuing evaluation of the quality of the loan portfolio, assessment of current economic conditions, diversification and size of the portfolio, adequacy of collateral, past and anticipated loss experience, and the amount of non-performing loans. The ALL is also based on estimates, and actual losses will vary from current estimates. These estimates are reviewed quarterly, and as adjustments, either positive or negative, become necessary, a corresponding increase or decrease is made in the ALL. The methodology used to determine the adequacy of the ALL is consistent with prior years. An estimate for probable losses related to unfunded lending commitments, such as letters of credit and binding but unfunded loan commitments is also prepared. This estimate is computed in a manner similar to the methodology described above, adjusted for the probability of actually funding the commitment. The ALL decreased to$19.5 million atDecember 31, 2011 from$22.1 million atDecember 31, 2010 . The provision for loan losses for the year endedDecember 31, 2011 decreased to$9.2 million from$15.7 million for the year endedDecember 31, 2010 . Net charge-offs declined to$11.8 million atDecember 31, 2011 from$13.7 million atDecember 31, 2010 . Included in the net charge-offs for the year endedDecember 31, 2011 were partial charge-offs of$5.1 million for two large CRE loans and$1.5 million for one other A&D loan. The decrease in the provision for loan losses from 2010 to 2011 resulted from management's analysis of the adequacy of the loan loss reserve, declining loan balances, charge-offs and improving economic conditions as noted by the Federal Reserve. The sale of$32.5 million of the indirect auto portfolio, which released$.6 million in provision expense, was a contributing factor to the lower provision expense. The ratio of the ALL to loans outstanding as ofDecember 31, 2011 was 2.08%, compared to 2.19% as ofDecember 31, 2010 . The decrease was due to a focused effort by management to recognize potential problem loans, charge-off potentially uncollectible balances, and record specific allocations and adjust qualitative factors to reflect the current quality of the loan portfolio. The ratio of net charge-offs to average loans for the year endedDecember 31, 2011 totaled 1.24%, compared to 1.28% for the year endedDecember 31, 2010 . Relative toDecember 31, 2010 , all segments of loans, with the exception of CRE loans, showed improvement. The net charge-off ratio for CRE loans as ofDecember 31, 2011 was 2.02%, compared to .13% as ofDecember 31, 2010 as a result of the$5.1 million partial charge-offs described above. The net charge-off ratio for A&D loans as ofDecember 31, 2011 was 1.91%, compared to 4.46% as ofDecember 31, 2010 . The ratios for C&I loans were .99% and 2.23% forDecember 31, 2011 andDecember 31, 2010 , respectively. The ratios for residential mortgage loans were .32% and .44% forDecember 31, 2011 and 2010, respectively. The ratios for consumer loans were 1.17% and 1.34% forDecember 31, 2011 and 2010, respectively. Accruing loans past due 30 days or more declined to 2.86% of the loan portfolio atDecember 31, 2011 , compared to 3.62% atDecember 31, 2010 . The delinquency ratio in the consumer segment atDecember 31, 2011 was 6.45%, compared to 3.87% atDecember 31, 2010 , and was negatively impacted by the sale of$32.5 million of our indirect auto portfolio, although the 30 days or more past due loans declined by$.8 million . Other improvements in the levels of past-due loans were attributable to a combination of a slowly improving economy and vigorous collection efforts by the Bank. Non-accrual loans totaled$38.2 million as ofDecember 31, 2011 , compared to$34.9 million as ofDecember 31, 2010 . Non-accrual loans which have been subject to a partial charge-off totaled$13.4 million as ofDecember 31, 2011 , compared to$2.9 million as ofDecember 31, 2010 . Management believes that the ALL atDecember 31, 2011 is adequate to provide for probable losses inherent in our loan portfolio. Amounts that will be recorded for the provision for loan losses in future periods will depend upon trends in the loan balances, including the composition of the loan portfolio, changes in loan quality and loss experience trends, potential recoveries on previously charged-off loans and changes in other qualitative factors. Management also
applies [40]
interest rate risk, collateral value and debt service sensitivity analyses to the CRE loan portfolio and obtains new appraisals on specific loans under defined parameters to assist in the determination of the periodic provision
for loan losses.
The ALL increased to$22.1 million atDecember 31, 2010 from$20.1 million atDecember 31, 2009 . The provision for loan losses remained stable for the year endedDecember 31, 2010 at$15.7 million , compared to$15.6 million for fiscal year 2009. Net charge-offs increased to$13.7 million atDecember 31, 2010 from$9.8 million atDecember 31, 2009 . As part of our loan review process, management noted an increase in foreclosures and bankruptcies in the geographic areas in which we operate. Additionally, the current economic environment caused a decline in real estate sales. Consequently, we closely reviewed and applied sensitivity analyses to collateral values to more adequately measure potential future losses. Where necessary, we obtained new appraisals on collateral. Specific allocations of the ALL were provided in those instances where we believed that losses might occur. As ofDecember 31, 2010 , the balance of the ALL was equal to 2.19% of total loans.
Table 6 presents the activity in the allowance for loan losses by major loan category for the past five years.
Analysis of Activity in the Allowance for Loan Losses Table 6 For the Years Ended December 31, (In thousands) 2011 2010 2009 2008 2007 Balance, January 1 $ 22,138 $ 20,090 $ 14,347 $ 7,304 $ 6,530 Charge-offs: Commercial real estate (6,886 ) (543 ) (729 ) (109 ) (10 )
Acquisition and development (3,055 ) (9,770 ) (3,902 )
(838 ) (211 ) Commercial and industrial (840 ) (2,225 ) (2,246 ) (2,951 ) (152 ) Residential mortgage (1,664 ) (2,008 ) (1,495 ) (672 ) (213 ) Consumer (893 ) (1,791 ) (2,413 ) (2,025 ) (1,636 ) Total charge-offs (13,338 ) (16,337 ) (10,785 ) (6,595 ) (2,222 ) Recoveries: Commercial real estate 95 94 103 0 0
Acquisition and development 322 1,097 40 23 0 Commercial and industrial 57 538 201 33 45 Residential mortgage 550 391 80
120 14 Consumer 499 539 516 537 625 Total recoveries 1,523 2,659 940 713 684 Net credit losses (11,815 ) (13,678 ) (9,845 ) (5,882 ) (1,538 ) Provision for loan losses 9,157 15,726 15,588
12,925 2,312 Balance at end of period
Allowance for loan losses to loans outstanding (as %) 2.08 % 2.19 % 1.79 % 1.26 % 0.70 % Net charge-offs to average loans outstanding during the period, annualized (as %) 1.24 % 1.28 % 0.87 % 0.54 % 0.15 %
Table 7 presents management's allocation of the ALL by major loan category in comparison to that loan category's percentage of total loans. Changes in the allocation over time reflect changes in the composition of the loan portfolio risk profile and refinements to the methodology of determining the ALL. Specific allocations in any particular category may be reallocated in the future as needed to reflect current conditions. Accordingly, the entire ALL is considered available to absorb losses in any category. [41] Allocation of the Allowance for Loan Losses Table 7 For the Years Ended December 31, % of % of % of % of % of Total Total Total Total Total (In thousands) 2011 Loans 2010 Loans 2009 Loans 2008 Loans 2007 Loans Commercial real estate $ 6,218 36 % $ 8,658 35 % $ 5,351 29 % $ 3,289 28 % $ 1,568 22 % Acquisition and development 7,190 15 % 6,345 16 % 7,922 21 % 3,396 20 % 1,641 22 % Commercial and industrial 2,190 8 % 1,345 7 % 1,945 7 % 2,318 7 % 615 8 % Residential mortgage 3,430 37 % 4,211 35 % 3,061 33 % 3,437 34 % 1,830 34 % Consumer 452 4 % 1,579 7 % 1,811 10 % 1,907 11 % 1,650 14 % Total $ 19,480 100 % $ 22,138 100 % $ 20,090 100 % $ 14,347 100 % $ 7,304 100 %Investment Securities Investment securities classified as available-for-sale are held for an indefinite period of time and may be sold in response to changing market and interest rate conditions or for liquidity purposes as part of our overall asset/liability management strategy. Available-for-sale securities are reported at market value, with unrealized gains and losses excluded from earnings and reported as a separate component of other comprehensive income included in shareholders' equity, net of applicable income taxes. For additional information, see Notes 1 and 6 to the Consolidated Financial Statements.
The following table sets forth the composition of our available-for-sale securities portfolio, reported at fair value, by major category as of the indicated dates:
Table 8 At December 31, 2011 2010 2009 Amortized Fair Value FV As % of
Amortized Fair Value FV As % of Amortized Fair Value FV As % of (In thousands) Cost (FV) Total Cost (FV) Total Cost (FV) Total Securities Available-for-Sale: U.S. government agencies $ 25,490 $ 25,580 11 % $ 24,813 $ 24,850 11 % $ 68,487 $ 68,263 25 % Residential mortgage- backed agencies 129,019 130,402 53 % 98,109 99,613 43 % 59,640 62,573 23 % Collateralized mortgage obligations 10,843 10,778 4 % 763 662 1 % 40,809 33,197 12 % Obligations of states and political subdivisions 65,424 68,816 28 % 94,250 94,724 41 % 95,190 97,303 35 % Collateralized debt obligations 36,385 9,447 4 % 36,533 9,838 4 % 44,478 12,448 5 % Total $ 267,161 $ 245,023 100 % $ 254,468 $ 229,687 100 % $ 308,604 $ 273,784 100 % Total investment securities increased$15.3 million during 2011 when compared to the balance atDecember 31, 2010 . AtDecember 31, 2011 , the securities classified as available-for-sale included a net unrealized loss of$22.1 million , which represents the difference between the fair value and amortized cost of securities in the portfolio and is primarily attributable to the CDOs. As discussed in Note 23 to the Consolidated Financial Statements, we measure fair market values based on the fair value hierarchy established in ASC Topic 820, Fair Value Measurements and Disclosures. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). Level 3 prices or valuation techniques require inputs that are both significant to the valuation assumptions and are not readily observable in the market (i.e. supported with little or no market activity). These Level 3 instruments are valued based on both observable and unobservable inputs derived from the best available data, some of which is internally developed, and considers risk premiums that a market participant would require.
Approximately
[42] represents the entire CDO portfolio, which was valued using significant unobservable inputs, or Level 3 pricing. The$26.9 million in unrealized losses associated with this portfolio relates to 18 pooled trust preferred securities that comprise the CDO portfolio. Unrealized losses of$17.7 million represent non-credit related OTTI charges on 13 of the securities, while$9.2 million of unrealized losses relates to five securities which have no credit related OTTI. The unrealized losses on these securities are primarily attributable to continued depression in the marketability and liquidity associated with CDOs.
The following table provides a summary of the trust preferred securities in the CDO portfolio and the credit status of the securities as of
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The terms of the debentures underlying trust preferred securities allow the issuer of the debentures to defer interest payments for up to 20 quarters, and, in such case, the terms of the related trust preferred securities require their issuers to contemporaneously defer dividend payments. The issuers of the trust preferred securities in our investment portfolio have defaulted and/or deferred payments, ranging from 7.08% to 40.41% of the total collateral balances underlying the securities. The securities were designed to include structural features that provide investors with credit enhancement or support to provide default protection by subordinated tranches. These features include over-collateralization of the notes or subordination, excess interest or spread which will redirect funds in situations where collateral is insufficient, and a specified order of principal payments. There are securities in our portfolio that are under-collateralized, which does represent additional stress on our tranche. However, in these cases, the terms of the securities require excess interest to be redirected from subordinate tranches as credit support, which provides additional support to our investment. Management systematically evaluates securities for impairment on a quarterly basis. Based upon application of Topic 320 (ASC Section 320-10-35), management must assess whether (i) it has the intent to sell the security and (ii) it is more likely than not thatFirst United Corporation will be required to sell the security prior to its anticipated recovery. If neither applies, then declines in the fair value of securities below their cost that are considered other-than-temporary declines are split into two components. The first is the loss attributable to declining credit quality. Credit losses are recognized in earnings as realized losses in the period in which the impairment determination is made. The second component consists of all other losses. The other losses are recognized in other comprehensive income. In estimating OTTI charges, management considers (a) the length of time and the extent to which the fair value has been less than cost, (b) adverse conditions specifically related to the security, an industry, or a geographic area, (c) the historic and implied volatility of the security, (d) changes in the rating of a security by a rating agency, (e) recoveries or additional declines in fair value subsequent to the balance sheet date, (f) failure of the issuer of the security to make scheduled interest payments, and (g) the payment structure of the debt security and the likelihood of the issuer being able to make payments that increase in the future. Due to the duration and the significant market value decline in the pooled trust preferred securities held in our portfolio, we performed more extensive testing on these securities for purposes of evaluating whether or not an OTTI has occurred. [43] The market for these securities as ofDecember 31, 2011 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 these 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 CDOs have been issued since 2007. There are currently very few market participants who are willing to transact for these securities. The market values for these securities, or any securities other than those issued or guaranteed by the Treasury, are very depressed relative to historical levels. Therefore, in the current market, a low market price for a particular bond may only provide evidence of stress in the credit markets in general rather than being an indicator of credit problems with a particular issue. Given the conditions in the current debt markets and the absence of observable transactions in the secondary and new issue markets, management has determined that (i) the few observable transactions and market quotations that are available are not reliable for the purpose of obtaining fair value atDecember 31, 2011 , (ii) an income valuation approach technique (i.e. present value) that maximizes the use of relevant observable inputs and minimizes the use of observable inputs will be equally or more representative of fair value than a market approach, and (iii) the CDO segment is appropriately classified within Level 3 of the valuation hierarchy because management determined that significant adjustments were required to determine fair value at the measurement date. Management utilizes an independent third party to prepare both the evaluations of OTTI and the fair value determinations for our CDOportfolio. Management believes that there were no material differences in the impairment evaluations and pricing betweenDecember 31, 2010 andDecember 31, 2011 . The approach of the third party to determine fair value involved several steps, including detailed credit and structural evaluation of each piece of collateral in each bond, default, recovery and prepayment/amortization probabilities for each piece of collateral in the bond, and discounted cash flow modeling. The discount rate methodology used by the third party combines a baseline current market yield for comparable corporate and structured credit products with adjustments based on evaluations of the differences found in structure and risks associated with actual and projected credit performance of each CDO being valued. Currently, there is an active and liquid trading market only for stand-alone trust preferred securities. Therefore, adjustments to the baseline discount rate are also made to reflect the additional leverage found in structured instruments. Based upon a review of credit quality and the cash flow tests performed by the independent third party, management determined that one security had credit-related OTTI during 2011. As a result, we recorded$19,000 in credit-related non-cash OTTI charges on the CDO security in earnings for the year endedDecember 31, 2011 . Management does not intend to sell this security nor is it more likely than not that we will be required to sell the security prior to recovery. The risk-based capital regulations require banks to set aside additional capital for securities that are rated below investment grade. Securities rated one level below investment grade require a 200% risk weighting. Additional methods are applicable to securities rated more than one level below investment grade. Management believes that, as ofDecember 31, 2011 , we maintain sufficient capital and liquidity to cover the additional capital requirements of these securities and future operating expenses. Additionally, we do not anticipate any material commitments or expected outlays of capital in the near term. Table 9 sets forth the contractual or estimated maturities of the components of our securities portfolio as ofDecember 31, 2011 and the weighted average yields on a tax-equivalent basis. [44] Investment Security Maturities, Yields, and Fair Values atDecember 31, 2011 Table 9 1 Year 5 Years Over Total Within To 5 To 10 10 Fair (In thousands) 1 Year Years Years Years Value Securities Available-for-Sale: U.S. government agencies $ 1,716 $ 0 $ 23,864 $ 0 $ 25,580 Residential mortgage-backed agencies 0 80,036 18,935 31,431 130,402 Collateralized mortgage obligations 0 557 10,221 0 10,778 Obligations of states and political subdivisions 0 0 18,956 49,860 68,816 Collateralized debt obligations 0 0 0 9,447 9,447 Total $ 1,716 $ 80,593 $ 71,976 $ 90,738 $ 245,023 Percentage of total .70 % 32.89 % 29.26 % 37.15 % 100.00 % Weighted average yield 2.25 % 2.62 % 3.05 % 3.90 % 3.29 % The weighted average yield was calculated using historical cost balances and does not give effect to changes in fair value. AtDecember 31, 2011 , we did not hold any securities in the name of any one issuer exceeding 10% of shareholders' equity. Deposits Table10 sets forth the actual and average deposit balances by major category for 2011, 2010 and 2009: Deposit Balances Table 10 2011 2010 2009 Actual Average Average Actual Average Average Actual Average Average (In thousands) Balance Balance Yield Balance Balance Yield Balance Balance Yield Non-interest-bearing demand deposits $ 149,888 $ 135,365 0 $ 121,142 $ 109,145 0 $ 106,976 $ 110,883 0 Interest-bearing deposits: Demand 101,492 98,395 .14 % 100,472 115,478 .34 % 100,856 107,869 .18 % Money Market: Retail 219,488 216,390 .32 % 217,401 218,571 .67 % 227,520 222,512 .90 % Brokered 0 7,913 .87 % 55,545 68,068 1.03 % 74,800 60,918 .96 %
Savings deposits 102,561 100,598 .28 % 93,543 83,734 .68 % 76,504 76,703 .65 % Time deposits less than $100K 216,324 290,651 1.94 % 278,588 366,922 2.13 % 344,802 323,409 2.86 % Time deposits$100K or more: Retail 185,045 171,557 2.32 % 221,564 127,590 1.18 % 138,877 143,589 2.68 % Brokered/CDARS 52,986 96,091 1.01 % 213,391 261,355 2.38 % 233,831 212,000 1.01 % Total Deposits $ 1,027,784 $ 1,116,960 $ 1,301,646 $ 1,350,863 $ 1,304,166 $ 1,257,883 Total deposits decreased$273.9 million for the year endedDecember 31, 2011 when compared to deposits atDecember 31, 2010 . Non-interest bearing deposits increased$28.7 million . Traditional savings accounts increased$9.0 million due to continued growth in our Prime Saver product. Total money market accounts decreased$53.4 million due to the repayment of$55.5 million in brokered accounts. Time deposits less than$100,000 declined$62.3 million and time deposits greater than$100,000 decreased$196.9 million . The decrease in time deposits greater than$100,000 was primarily due to the repayment of$105.5 million in brokered certificates of deposit and$54.9 million of maturities in our CDARS®product. Although brokered deposits are at very low rates in the current environment, management made the decision to right-size the balance sheet by using cash to repay brokered deposits and to allow certificates of deposit for non-relationship customers to run off. The decline in deposits during 2011 was due to the strategic plan to reduce cash levels by paying off certain brokered deposits, FHLB advances and public money at their maturities. Also during 2011, our internal treasury team developed a strategy to increase our net interest margin by changing the mix of our deposit base and focusing on customers with full banking relationships. [45] The following table sets forth the maturities of time deposits of$100,000 or more: Maturity of Time Deposits of $100,000 or More Table 11 December (In thousands) 31, 2011 Maturities 3 Months or Less $ 39,238 3-6 Months 51,153 6-12 Months 40,015 Over 1 Year 107,625 Total $ 238,031 Borrowed Funds
The following shows the composition of our borrowings at
(In thousands) 2011 2010
2009
Securities sold under agreements to repurchase
$ 47,563 Total short-term borrowings $ 36,868 $ 39,139 $ 47,563 Long-term FHLB advances 160,314 196,370 227,423
Junior subordinated debentures 46,730 46,730
43,121 Total long-term borrowings 207,044 243,100 270,544 Total borrowings $ 243,912 $ 282,239 $ 318,107
Average balance (from Table 1) $ 258,892 $ 297,944
$ 319,191
The following is a summary of short-term borrowings at
(Dollars in thousands) 2011 2010
2009
Securities sold under agreements to repurchase: Outstanding at end of year $ 36,868 $ 39,139 $ 47,563 Weighted average interest rate at year end 0.64 % 0.72 % 0.66 % Maximum amount outstanding as of any month end $ 51,403 $ 49,940 $ 50,052 Average amount outstanding 41,728 41,434
43,887
Approximate weighted average rate during the year 0.56 % 0.68 %
0.71 %
Total borrowings decreased by$38.3 million , or 14%, in 2011 when compared to 2010, while the average balance of borrowings decreased by$39.1 million during the same period. This decrease in 2011 was due to the$2.3 million decline in short-term borrowings as our Treasury Management customers used their deposits during 2011 and our repayment of$36.1 million in long-term FHLB advances during the year.
Total borrowings decreased by$35.9 million or 11% in 2010 when compared to 2009, while the average balance of borrowings decreased by$21.2 million during the same period. This decrease in 2010 was due to the$8.4 million decline in short-term borrowings as our Treasury Management customers used their deposits during 2010 and our repayment of$30.0 million in long-term FHLB advances during the year. These decreases were offset by an increase of$3.6 million in TPS Debentures that were issued to Trust III inJanuary 2010 . Management will continue to closely monitor interest rates within the context of its overall asset-liability management process. See the discussion under the heading "Interest Rate Sensitivity" in this Item 7 for further information
on this topic. [46]
As ofDecember 31, 2011 , we had additional borrowing capacity with the FHLB totaling$10 million , an additional$26 million of unused lines of credit with various financial institutions,$9 million of an unused secured line of credit with theFederal Reserve Bank and approximately$154 million through wholesale money market funds. See Note 11 to the Consolidated Financial Statements for further details about our borrowings and additional borrowing capacity, which is incorporated herein by reference. Capital Resources The Bank andFirst United Corporation are subject to risk-based capital regulations, which were adopted and are monitored by federal banking regulators. These regulations are used to evaluate capital adequacy and require an analysis of an institution's asset risk profile and off-balance sheet exposures, such as unused loan commitments and stand-by letters of credit. The regulations require that a portion of total capital be Tier 1 capital, consisting of common shareholders' equity, the qualifying portion of trust issued preferred securities, and perpetual preferred stock, less goodwill and certain other deductions. The remaining capital, or Tier 2 capital, consists of subordinated debt, mandatory convertible debt, the remaining portion of trust issued preferred securities, grandfathered senior debt and the ALL, subject to certain limitations. Under the risk-based capital regulations, banking organizations are required to maintain a minimum 8% (10% for well capitalized banks) total risk-based capital ratio (total qualifying capital divided by risk-weighted assets), including a Tier 1 ratio of 4% (6% for well capitalized banks). The risk-based capital rules have been further supplemented by a leverage ratio, defined as Tier I capital divided by average assets, after certain adjustments. The minimum leverage ratio is 4% (5% for well capitalized banks) for banking organizations that do not anticipate significant growth and have well-diversified risk (including no undue interest rate risk exposure), excellent asset quality, high liquidity and good earnings. Other banking organizations not in this category are expected to have ratios of at least 4-5%, depending on their particular condition and growth plans. Regulators may require higher capital ratios when warranted by the particular circumstances or risk profile of a given banking organization. In the current regulatory environment, banking organizations must stay well capitalized in order to receive favorable regulatory treatment on acquisition and other expansion activities and favorable risk-based deposit insurance assessments. Our capital policy establishes guidelines meeting these regulatory requirements and takes into consideration current or anticipated risks as well as potential future growth opportunities. AtDecember 31, 2011 ,First United Corporation's total risk-based capital ratio was 13.05% and the Bank's total risk-based capital ratio was 13.38%, both of which were well above the regulatory minimum of 8%. The total risk-based capital ratios ofFirst United Corporation and the Bank for year-end 2010 were 11.57% and 11.53%, respectively. As ofDecember 31, 2011 , the most recent notification from the regulators categorizesFirst United Corporation and the Bank as "well capitalized" under the regulatory framework for prompt corrective action. See Note 4 of the Notes to Consolidated Financial Statements for additional information regarding regulatory capital ratios. Total shareholders' equity increased$1.1 million to$96.7 million atDecember 31, 2011 , from$95.6 million atDecember 31, 2010 , primarily due to an increase in retained earnings. The return on average equity (ROE) for 2011 increased
to 3.71% from (10.10%) for 2010.
InJanuary 2009 , pursuant to the Treasury's TARP CPP and in return for$30 million ,First United Corporation sold to the Treasury the shares of its Series A Preferred Stock and the Warrant to purchase 326,323 shares of its common stock for an exercise price of$13.79 per share. The proceeds from this transaction count as Tier 1 capital and the Warrant qualifies as tangible common equity. Information about the terms of these securities is provided in Note 13 to the Consolidated Financial Statements. The terms of the Series A Preferred Stock call for the payment, if declared by the board of directors ofFirst United Corporation , of a quarterly cash dividend onFebruary 15th ,May 15th ,August 15th and November 15thof each year. At the request of theReserve Bank ,First United Corporation deferred the payment of cash dividends on the Series A Preferred Stock beginning with the payment that was due onNovember 15, 2010 . As ofDecember 31, 2011 , this deferral election remained in effect and dividends of$.4 million per quarterly dividend period continue to accrue.First United Corporation will be required to pay all accrued and unpaid dividends if and when the board of directors declares and pays the next quarterly cash dividend. Management cannot predict whether or when the board of directors will resume quarterly cash dividends on the Series A Preferred Stock.First United Corporation's ability to make dividend payments in the future will depend primarily on our earnings in future periods. [47]
OnDecember 15, 2010 , also at the request of theReserve Bank , the board of directors ofFirst United Corporation elected to defer quarterly interest payments under the TPS Debentures beginning with the payment that was due inMarch 2011 . As ofDecember 31, 2011 , this deferral election remained in effect and cumulative deferred interest was approximately$2.2 million , which has been fully accrued and must be paid in full when the board of directors elects to terminate the deferral.First United Corporation's ability to resume quarterly interest payments will depend primarily on our earnings in future periods. Accordingly, no assurance can be given as to if or whenFirst United Corporation will resume the payment of interest under the TPS Debentures. In connection with, and as a result of, the aforementioned deferrals, the board of directors ofFirst United Corporation voted to suspend the declaration of quarterly cash dividends on the common stock until further notice. The payment of cash dividends on the common stock is at the discretion of the board of directors and is dependent on our earnings in future periods. In addition, cash dividends on the common stock may be paid only if all accrued and unpaid interest due under the TPS Debentures and all accrued and unpaid dividends due under the Series A Preferred Stock have been paid in full. There can be no assurance as to if or whenFirst United Corporation will resume the payment of cash dividends on the common stock. Liquidity Management
Liquidity is a financial institution's capability to meet customer demands for deposit withdrawals and pay its other obligations while funding all credit-worthy loans. The factors that determine the institution's liquidity are:
· Reliability and stability of core deposits;
· Cash flow structure and pledging status of investments; and
· Potential for unexpected loan demand.
We actively manage our liquidity position through weekly meetings of a sub-committee of executive management, known as the Treasury Sub-Committee, which looks forward 12 months at 30-day intervals. The measurement is based upon the projection of funds sold or purchased position, along with ratios and trends developed to measure dependence on purchased funds and core growth. Monthly reviews by management and quarterly reviews by the <org>Asset and Liability Committee under prescribed policies and procedures are designed to ensure that we will maintain adequate levels of available funds. It is our policy to manage our affairs so that liquidity needs are fully satisfied through normal Bank operations. That is, the Bank will manage its liquidity to minimize the need to make unplanned sales of assets or to borrow funds under emergency conditions. The Bank will use funding sources where the interest cost is relatively insensitive to market changes in the short run (periods of one year or less) to satisfy operating cash needs. The remaining normal funding will come from interest-sensitive liabilities, either deposits or borrowed funds. When the marginal cost of needed wholesale funding is lower than the cost of raising this funding in the retail markets, the Bank may supplement retail funding with external funding sources such as:
· Unsecured Fed Funds lines of credit with upstream correspondent banks (FTN
Financial, M&T Bank, Atlantic Central Banker's Bank, Community Banker's Bank);
· Secured advances with the FHLB of
one to four family residential mortgage portfolio, home equity lines of credit
portfolio, CRE loan portfolio, and various securities. Cash may also be pledged
as collateral;
· Secured line of credit with the Fed Discount Window for use in borrowing funds
up to 90 days, using municipal securities as collateral;
· Brokered deposits, including CDs and money market funds, provide a method to
generate deposits quickly. These deposits are strictly rate driven but often
provide the most cost effective means of funding growth; and
· One Way Buy CDARS® funding - a form of brokered deposits that has become a
viable supplement to brokered deposits obtained directly. During 2011, management implemented a strategic plan to utilize excess liquidity to repay brokered deposits, non-relationship certificates of deposit and wholesale FHLB advances at their stated maturities. Reduction in these liabilities, deemed to be volatile funding by regulatory definition, should not have an impact on our levels of liquidity. [48]
Management believes that we have adequate liquidity available to respond to current and anticipated liquidity demands and is unaware of any trends or demands, commitments, events or uncertainties that will materially affect our ability to maintain liquidity at satisfactory levels.
Market Risk and Interest Sensitivity
Our primary market risk is interest rate fluctuation. Interest rate risk results primarily from the traditional banking activities that we engage in, such as gathering deposits and extending loans. Many factors, including economic and financial conditions, movements in interest rates and consumer preferences affect the difference between the interest earned on our assets and the interest paid on our liabilities. Interest rate sensitivity refers to the degree that earnings will be impacted by changes in the prevailing level of interest rates. Interest rate risk arises from mismatches in the repricing or maturity characteristics between interest-bearing assets and liabilities. Management seeks to minimize fluctuating net interest margins, and to enhance consistent growth of net interest income through periods of changing interest rates. Management uses interest sensitivity gap analysis and simulation models to measure and manage these risks. The interest rate sensitivity gap analysis assigns each interest-earning asset and interest-bearing liability to a time frame reflecting its next repricing or maturity date. The differences between total interest-sensitive assets and liabilities at each time interval represent the interest sensitivity gap for that interval. A positive gap generally indicates that rising interest rates during a given interval will increase net interest income, as more assets than liabilities will reprice. A negative gap position would benefit us during a period of declining interest rates. Throughout 2010 and 2011, we shifted our focus from a shorter duration balance sheet to a more neutral to slightly asset sensitive position, as we anticipated a rising interest rate environment in the future. As ofDecember 31, 2011 , we were slightly asset sensitive.
Our interest rate risk management goals are:
· Ensure that the board of directors and senior management will provide effective
oversight and ensure that risks are adequately identified, measured, monitored
and controlled;
· Enable dynamic measurement and management of interest rate risk;
· Select strategies that optimize our ability to meet our long-range financial
goals while maintaining interest rate risk within policy limits established by
the Board of Directors;
· Use both income and market value oriented techniques to select strategies that
optimize the relationship between risk and return; and
· Establish interest rate risk exposure limits for fluctuation in net interest
income ("NII"), net income and economic value of equity. In order to manage interest sensitivity risk, management formulates guidelines regarding asset generation and pricing, funding sources and pricing, and off-balance sheet commitments. These guidelines are based on management's outlook regarding future interest rate movements, the state of the regional and national economy, and other financial and business risk factors. Management uses computer simulations to measure the effect on net interest income of various interest rate scenarios. Key assumptions used in the computer simulations include cash flows and maturities of interest rate sensitive assets and liabilities, changes in asset volumes and pricing, and management's capital plans. This modeling reflects interest rate changes and the related impact on net interest income over specified periods. We evaluate the effect of a change in interest rates of +/-100 basis points to +/-400 basis points on both NII and Net Portfolio Value ("NPV") / Economic Value of Equity ("EVE"). We concentrate on NII rather than net income as long as NII remains the significant contributor to net income. NII modeling allows management to view how changes in interest rates will affect the spread between the yield paid on assets and the cost of deposits and borrowed funds. Unlike traditional Gap modeling, NII modeling takes into account the different degree to which installments in the same repricing period will adjust to a change in interest rates. It also allows the use of different assumptions in a falling versus a rising rate environment. The period considered by the NII modeling is the next eight quarters. NPV / EVE modeling focuses on the change in the market value of equity. NPV / EVE is defined as the market value of assets less the market value of liabilities plus/minus the market value of any off-balance sheet positions. By effectively looking at the present value of all future cash flows on or off the balance sheet, NPV / EVE modeling takes a longer-term view of interest rate risk. This complements the shorter-term view of the NII modeling. [49] Measures of NII at risk produced by simulation analysis are indicators of an institution's short-term performance in alternative rate environments. These measures are typically based upon a relatively brief period, usually one year. They do not necessarily indicate the long-term prospects or economic value
of the institution.
Based on the simulation analysis performed at
(Dollars in thousands) 2011 2010 +400 basis point increase $ 2,548 $ 3,979 +300 basis point increase $ 2,300 $ 3,268 +200 basis point increase $ 1,937 $ 2,284 +100 basis point increase $ 1,182 $ 1,160 -100 basis point increase $ (984 ) $ (662 )
This estimate is based on assumptions that may be affected by unforeseeable changes in the general interest rate environment and any number of unforeseeable factors. Rates on different assets and liabilities within a single maturity category adjust to changes in interest rates to varying degrees and over varying periods of time. The relationships between lending rates and rates paid on purchased funds are not constant over time. Management can respond to current or anticipated market conditions by lengthening or shortening the Bank's sensitivity through loan repricings or changing its funding mix. The rate of growth in interest-free sources of funds will influence the level of interest-sensitive funding sources. In addition, the absolute level of interest rates will affect the volume of earning assets and funding sources. As a result of these limitations, the interest-sensitive gap is only one factor to be considered in estimating the net interest margin. Impact of Inflation - Our assets and liabilities are primarily monetary in nature, and as such, future changes in prices do not affect the obligations to pay or receive fixed and determinable amounts of money. During inflationary periods, monetary assets lose value in terms of purchasing power and monetary liabilities have corresponding purchasing power gains. The concept of purchasing power is not an adequate indicator of the impact of inflation on financial institutions because it does not incorporate changes in interest rates, which are an important determination ofFirst United Corporation's earnings.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The information called for by this item is incorporated herein by reference to Item 7 of Part II of this annual report under the heading "Interest Rate Sensitivity".
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