The following discussion and analysis is intended to assist in understanding and evaluating the changes in the financial condition and earnings performance of the Company and its subsidiaries for the three month periods ended
March 31, 2014and 2013. This discussion and analysis should be read in conjunction with the Company's consolidated financial statements and notes thereto for the year ended December 31, 2013, included in the Company's Form 10-K for the year ended December 31, 2013. FORWARD-LOOKING STATEMENTS From time to time, Royal Bancshares of Pennsylvania, Inc.(the "Company") may include forward-looking statements relating to such matters as anticipated financial performance, business prospects, technological developments, new products, research and development activities and similar matters in this and other filings with the Securities and Exchange Commission. The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements. When we use words such as "believes," "expects," "anticipates" or similar expressions, we are making forward-looking statements. In order to comply with the terms of the safe harbor, the Company notes that a variety of factors could cause the Company's actual results and experience to differ materially from the anticipated results or other expectations expressed in the Company's forward-looking statements. The risks and uncertainties that may affect the operations, performance development and results of the Company's business include the following: general economic conditions, including their impact on capital expenditures; interest rate fluctuations; business conditions in the banking industry; the regulatory environment: the nature, extent, and timing of governmental actions and reforms, including the rules of participation for the Troubled Asset Relief Program voluntary Capital Purchase Plan under the Emergency Economic Stabilization Act of 2008, which may be changed unilaterally and retroactively by legislative or regulatory actions; rapidly changing technology and evolving banking industry standards; competitive factors, including increased competition with community, regional and national financial institutions; new service and product offerings by competitors and price pressures and similar items. All forward-looking statements contained in this report are based on information available as of the date of this report. These statements speak only as of the date of this report, even if subsequently made available by the Company on its website, or otherwise. The Company expressly disclaims any obligation to update any forward-looking statement to reflect future statements to reflect future events or developments.
CRITICAL ACCOUNTING POLICIES, JUDGMENTS AND ESTIMATES
The accounting and reporting policies of the Company conform to accounting principles generally accepted in
the United States of Americaand general practices within the financial services industry. Applications of the principles in the Company's preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States of Americarequires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and the accompanying notes. These estimates and assumptions are based on information available as of the date of the consolidated financial statements; therefore, actual results could differ from those estimates. Note 1 to the Company's Consolidated Financial Statements (included in Item 8 of the Form 10-K for the year ended December 31, 2013) lists significant accounting policies used in the development and presentation of the Company's consolidated financial statements. The following discussion and analysis, the significant accounting policies, and other financial statement disclosures identify and address key variables and other quantitative and qualitative factors that are necessary for an understanding and evaluation of the Company and its results of operations. We completed an internal review of this financial information. This review requires substantive judgment and estimation. As disclosed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2013, we have identified other-than-temporary impairment on investment securities, accounting for allowance for loan and lease losses, valuation allowance of deferred tax assets, loans held for sale, the valuation of other real estate owned, net periodic pension costs and the pension benefit obligation as among the most critical accounting policies and estimates. These critical accounting policies and estimates are important to the presentation of the Company's financial condition and results of operations, and they require difficult, subjective or complex judgments as a result of the need to make estimates. - 41 -
Financial Highlights and Business Results
June 29, 1995, pursuant to the plan of reorganization approved by the shareholders of Royal Bank America, formerly Royal Bank of Pennsylvania(" Royal Bank"), all of the outstanding shares of common stock of Royal Bankwere acquired by Royal Bancsharesand were exchanged on a one-for-one basis for common stock of Royal Bancshares. The principal activities of the Company are supervising Royal Bank, which engages in a general banking business principally in Montgomery, Chester, Bucks, Philadelphiaand Berkscounties in Pennsylvaniaand in central and southern New Jerseyand Delaware. The Company also has a wholly owned non-bank subsidiary, Royal Investments of Delaware, Inc., which is engaged in investment activities. The Company's results of operations depend primarily on net interest income, which is the difference between interest income earned on interest-earning assets and interest expense paid on interest-bearing liabilities. Interest-earning assets consist principally of loans and investment securities, while interest-bearing liabilities consist primarily of deposits and borrowings. Refer to the "Net Interest Income and Net Interest Margin" section in Management's Discussion and Analysis of Financial Condition and Results of Operation below for additional information on interest yield and cost. Royal Bankprincipally generates commercial real estate loans primarily secured by first mortgage liens, construction loans for commercial real estate projects and residential home development, land development loans, tax liens and leases. At March 312014, commercial real estate loans, commercial and industrial loans, construction and land development loans, and leases comprised 42%, 19%, 13%, and 12%, respectively, of the total loan portfolio. Construction loans and land development loans can have more risk associated with them, especially when a weakened economy, such as we have experienced the past few years, adversely impacts the commercial rental or home sales market. Net income is also affected by the provision for loan and lease losses and the level of non-interest income as well as by non-interest expenses, including salary and benefits, occupancy expenses and other operating expenses. From 2008 through 2012, the Company recorded significant impairment charges on non-accrual loans, OREO and investment securities, which had weighed heavily on earnings and was the largest contributing factor to the Company's losses in those years. Also contributing to the losses were increased costs associated with the historically high level of non-performing assets and legal expenses related to credit quality issues and the tax lien subsidiaries. Finally, the establishment of a valuation allowance in 2008 and subsequent years that currently amounts to $37.2 million, has prevented the Company from utilizing tax credits from losses during the past five years. Management successfully executed the Company's strategic plan which included improving the overall level of credit quality, maintaining reduced credit risk within the investment portfolio, cutting the overall level of expenses, and returning to profitability. While the Company's past deleveraging strategy improved the risk profile of the Company by shedding higher risk assets and paying off higher cost brokered CDs, it has had a negative impact on income. The deleveraging has resulted in lower average loan balances and a higher proportion of lower yielding investment securities, which have negatively impacted net interest income, a principal source of income. While credit quality costs associated with non-performing assets negatively affect financial results, their impact has diminished as the overall level of non-performing assets declined. The financial results for the first quarter of 2014 illustrate the further progress of the Company's current multi-faceted strategic plan with the goal of consistent profitability. A key strategy in 2014 is to refresh Royal Bank'sretail products and branch network. During the first quarter of 2014, the Company reorganized the retail division to better serve existing customers, develop the retail sales teams, and attain new customer relationships. Royal Bankheld a successful 50th anniversary campaign, offering a Kindle to new customers who met certain deposit account opening criteria. The Company relocated the Villanovaand Phoenixville branches and is in the process of relocating two additional branches to more convenient, high-traffic locations within similar markets. Additionally, customers now have access to 55,000 ATMs nationwide from a new arrangement. During the most recent quarter, five highly experienced industry veterans joined the Company. These included two commercial relationship managers, two retails sales managers and the head of sales and product training. Their collective experience spans community and regional banks. The hiring of these individuals was funded through the rightsizing of the organization and is fully integrated into the Company's budget. Overall positive financial results have benefited from our rebranding and the ability to attract and retain commercial and consumer customers. - 42 -
Consolidated Net Income
Net income for the first quarter of 2014 amounted to
$1.5 millionand basic and diluted earnings per share of $0.06compared to $118,000and basic and diluted loss per share of ( $0.03) for the comparable period in 2013. The $1.4 millionimprovement for the three months ended March 31, 2014as compared to the three months ended March 31, 2013was mainly related to the following items:
· Net interest income grew
· Salaries and benefits declined
· Credit for loan and lease losses improved
· Credit related expenses decreased
· Gains on sales of loans and leases increased
Partially offsetting these positive items was a
$676,000reduction in gains on the sale of Company owned real estate, and increases of $71,000and $60,000in advertising and marketing and occupancy and equipment expenses, respectively.
Total interest income of
$7.1 millionfor the first quarter of 2014 grew $399,000, or 5.9%, from the comparable quarter of 2013. The improvement was primarily driven by an increase of $638,000quarter versus quarter in interest income on investment securities. Average interest-earning assets amounted to $690.7 millionin the first quarter of 2014, which resulted in a decline of $18.1 million, or 2.6%, from the level of $708.8 millionin the first quarter of 2013. The decrease in average interest-earning assets was mainly related to a $22.6 milliondrop in average investment securities to $318.2 millionfor the quarter ended March 31, 2014. Average cash equivalents declined $9.1 millionquarter over quarter. While average loan balances increased $13.6 millionto $366.2 millionfor the first quarter of 2014, the associated interest income declined $237,000and was directly related to the tax lien portfolio. Interest income related to tax liens fell $433,000quarter over quarter due to an $11.5 million, or 46.0% decline in average balances. Interest income on the remaining loan portfolio increased $196,000. For the first quarter of 2014, the yield on average interest-earning assets of 4.20% amounted to an enhancement of 34 basis points from the yield of 3.86% for the prior year's first quarter. Driving the improvement in yield quarter over quarter was an increase of 92 basis points in the average yield on investments (2.45% versus 1.53%) which contributed $685,000to interest income. Contributing to the increase in average yield on average interest-earning assets were non-recurring loan fees of approximately $130,000. However the average yield on loans declined 49 basis points (5.79% versus 6.28%). The investment yield in the first quarter of 2013 was negatively impacted by the accelerated amortization of premiums due to prepayments of government agency mortgage-backed ("MBS") and collateralized mortgage obligation ("CMO") securities. The decrease in loan yields reflects the decline in higher yielding tax liens quarter versus quarter which adversely effected interest income by $433,000.
Total interest expense of
$1.6 millionin the first quarter of 2014 declined $355,000, or 17.9%, from the comparable quarter of 2013. The reduction in interest expense was primarily associated with a decline in the average interest rates paid on average interest-bearing liabilities as well as lower average balances of such liabilities. For the first quarter of 2014, average interest-bearing liabilities of $594.9 milliondecreased $22.8 million, or 3.7%, from $617.7 millionfor the comparable period in 2013. For the three months ended March 31, 2014, average certificates of deposit and average borrowings amounted to $236.6 millionand $130.2 million, respectively, and reflected declines of $8.7 million, or 3.5%, and $3.8 million, or 2.8%, respectively, from the comparable quarter of 2013. These declines in average balances combined with interest rate reductions resulted in interest expense decreases of $165,000and $195,000for average CDs and borrowings, respectively. - 43 - -------------------------------------------------------------------------------- The average interest rate paid on average total interest-bearing liabilities during the first quarter of 2014 amounted to 1.11%, which represented an improvement of 19 basis points from the average interest rate paid during the comparable quarter of 2013. During the first quarter of 2014 the average interest rate paid on average interest-bearing deposits was 0.80% which resulted in a decline of 10 basis points from the level of 0.90% during the comparable quarter of 2013. Quarter versus quarter lower average interest rates were paid on CDs (1.26% in 2014 versus 1.49% in 2013), while NOW and money market rates slightly increased 2 basis points (0.32% in 2014 versus 0.30% in 2013). The decline in average interest rates paid on CDs was attributed to lower rates on new accounts and the continued run off of maturing retail CDs. The average interest rate paid for borrowings during the first quarter of 2014 was 2.22%, which amounted to a reduction of 52 basis points from the average rate paid of 2.74% during the first quarter of 2013.
Net Interest Income and Margin
Net interest income for the quarter ended
March 31, 2014amounted to $5.5 millionresulting in an increase of $754,000, or 15.8%, from the comparable quarter of 2013. The improvement in net interest income was primarily attributed to an increase in the average yield on investment securities and a net reduction in the average rates paid on average interest-bearing liabilities quarter versus quarter. The increase in the average yield on investment securities was due to higher yields on new purchases. Additionally, the prepayments on government agency MBS and CMO investment securities declined, which had a positive effect on the amortization of premiums. The decrease in average CD and borrowing balances combined with their respective interest rate reductions contributed $358,000to the total decline in interest expense. The net interest margin for the first quarter of 2014 was 3.24%, which grew 51 basis points from 2.73% for the comparable quarter of 2013. Quarter over quarter, the contribution from the 92 basis point improvement in the average yield on investment securities (2.45% versus 1.53%) was partially offset by the 49 basis point reduction in the average yield on loans and leases (5.79% versus 6.28%). The average yield on interest-earning assets for the first quarter of 2014 was 4.20% compared to 3.86% for the same period in 2013. Contributing to the increase in average yield on average interest-earning assets were non-recurring loan fees of approximately $130,000. Funding costs improved from an average interest rate paid of 1.30% for the first quarter of 2013 to 1.11% for the first quarter of 2014. The Company continued to redeem and re-price maturing retail CDs which led to a 23 basis point reduction in average interest rates paid quarter over quarter (1.26% in 2014 versus 1.49% in 2013). Additionally the average rates paid on borrowings declined 52 basis points (2.22% in 2014 versus 2.74% in 2013). - 44 - -------------------------------------------------------------------------------- The following table represents the average daily balances of assets, liabilities and shareholders' equity and the respective interest-earning assets and interest-bearing liabilities, as well as average rates for the periods indicated. The loans outstanding include non-accruing loans. The yields are presented on an annualized basis. For the three months ended
For the three months ended
March 31, 2014 March 31, 2013 (In thousands, except Average Balance Average Balance percentages) Interest Yield Interest Yield
Cash equivalents $ 6,393
318,171 1,922 2.45 % 340,806 1,284 1.53 % Loans 366,166 5,224 5.79 % 352,541 5,461 6.28 % Total interest earning assets 690,730 7,151 4.20 % 708,855 6,752 3.86 % Non-earning assets 42,625 48,790 Total average assets
$ 733,355 $ 757,645Interest-bearing deposits NOW and money markets $ 210,233167 0.32 % $ 220,813162 0.30 % Savings 17,874 9 0.20 % 17,581 9 0.21 % Time deposits 236,598 737 1.26 % 245,267 902 1.49 % Total interest bearing deposits 464,705 913 0.80 % 483,661 1,073 0.90 % Borrowings 130,245 712 2.22 % 134,064 907 2.74 % Total interest bearing liabilities 594,950 1,625 1.11 % 617,725 1,980 1.30 % Non-interest bearing deposits 63,913 58,373 Other liabilities 23,750 27,757 Shareholders' equity 50,742 53,790 Total average liabilities and equity $ 733,355 $ 757,645Net interest margin $ 5,5263.24 % $ 4,7722.73 %
Rate Volume Analysis
The following table sets forth a rate/volume analysis, which segregates in detail the major factors contributing to the change in net interest income for the three month period ended
- 45 - --------------------------------------------------------------------------------
For the three months ended March 31, 2014 vs. 2013 Increase (decrease) (In thousands) Volume Rate Total Interest income Interest-bearing deposits
$ (7 ) $ 5 $ (2 )Total short term earning assets (7 ) 5 (2 ) Investments securities (47 ) 685 638 Loans Commercial demand loans (85 ) 60 (25 ) Commercial real estate 129 (116 ) 13 Residential real estate 197 (80 ) 117 Leases 89 79 168 Tax certificates (318 ) (115 ) (433 ) Consumer (7 ) (2 ) (9 ) Loan fees (68 ) - (68 ) Total loans (63 ) (174 ) (237 ) Total (decrease) increase in interest income (117 ) 516 399 Interest expense Deposits NOW and money market $ (8 ) $ 13 $ 5Savings - - - Time deposits (30 ) (135 ) (165 ) Total deposits (38 ) (122 ) (160 ) Borrowings (26 ) (165 ) (191 ) Trust preferred - (4 ) (4 ) Total decrease in interest expense (64 )
(291 ) (355 ) Total (decrease) increase in net interest income
Credit Risk Management The Company's loan and lease portfolio (the "credit portfolio") is subject to varying degrees of credit risk. The Company maintains an allowance for loan and lease losses (the "allowance") to absorb losses in the loan and lease portfolio. The allowance is based on the review and evaluation of the loan and lease portfolio, along with ongoing, quarterly assessments of the probable losses inherent in that portfolio. The allowance represents an estimation made pursuant to FASB ASC Topic 450, "Contingencies" ("ASC Topic 450") or FASB ASC Topic 310, "Receivables" ("ASC Topic 310"). The adequacy of the allowance is determined through evaluation of the credit portfolio, and involves consideration of a number of factors, as outlined below, to establish a prudent level. Determination of the allowance is inherently subjective and requires significant estimates, including estimated losses on pools of homogeneous loans and leases based on historical loss experience and consideration of current economic trends, which may be susceptible to significant change. Loans and leases deemed uncollectible are charged against the allowance, while recoveries are credited to the allowance. Management adjusts the level of the allowance through the provision for loan and lease losses, which is recorded as a current period expense. The Company's systematic methodology for assessing the appropriateness of the allowance includes: (1) general reserves reflecting historical loss rates by loan type, (2) specific reserves for risk-rated credits based on probable losses on an individual or portfolio basis and (3) qualitative reserves based upon current economic conditions and other risk factors. - 46 - -------------------------------------------------------------------------------- The loan portfolio is stratified into loan segments that have similar risk characteristics. The general allowance is based upon historical loss rates using a weighted three-year rolling average of the historical loss experienced within each loan segment. The qualitative factors used to adjust the historical loss experience address various risk characteristics of the Company's loan and lease portfolio include evaluating: (1) trends in delinquencies and other non-performing loans, (2) changes in the risk profile related to large loans in the portfolio, (3) changes in the growth trends of categories of loans comprising the loan and lease portfolio, (4) concentrations of loans and leases to specific industry segments, and (5) changes in economic conditions on both a local and national level, (6) quality of loan review and board oversight, (7) changes in lending policies and procedures, and (8) changes in lending staff. Each factor is assigned a value to reflect improving, stable or declining conditions based on management's best judgment using relevant information available at the time of the evaluation. Adjustments to the factors are supported through documentation of changes in conditions in a report accompanying the allowance calculation. The specific reserves are determined utilizing standards required under ASC Topic 310. A loan is considered impaired when it is probable that interest and principal will not be collected according to the contractual terms of the loan agreement. Non-accrual loans and loans restructured under a troubled debt restructuring are evaluated for impairment on an individual basis considering all known relevant factors that may affect loan collectability such as the borrower's overall financial condition, resources and payment record, support available from financial guarantors and the sufficiency of current collateral values (current appraisals or rent rolls for income producing properties), and risks inherent in different kinds of lending (such as source of repayment, quality of borrower and concentration of credit quality). Non-accrual loans that experience insignificant payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower's prior payment record and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan by loan basis for commercial and industrial loans, commercial real estate loans and construction loans by either the present value of expected future cash flows discounted at the loan's effective interest rate or the fair value of the collateral if the loan is collateral dependent. The estimated fair values of substantially all of the Company's impaired loans are measured based on the estimated fair value of the loan's collateral. The Company obtains third-party appraisals on the fair value of real estate collateral. Appraised values are discounted to arrive at the estimated selling price of the collateral, which is considered to be the estimated fair value. The discounts also include estimated costs to sell the property. For commercial and industrial loans secured by non-real estate collateral, such as accounts receivable, inventory and equipment, estimated fair values are determined based on the borrower's financial statements, inventory reports, accounts receivable aging or equipment appraisals or invoices. Indications of value from these sources are generally discounted based on the age of the financial information or the quality of the assets. Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Once a loan is determined to be impaired it will be deducted from the portfolio and the net remaining balance will be used in the general and qualitative analysis. A specific reserve is established for an impaired loan if its carrying value exceeds its estimated fair value. The amount of the allowance is reviewed and approved by the Chief Financial Officer ("CFO"), Chief Administrative and Risk Officer ("CARO"), Chief Lending Officer ("CLO"), and Chief Credit Officer ("CCO") on at least a quarterly basis. Management believes that the allowance at
March 31, 2014is adequate. However, its determination requires significant judgment, and estimates of probable losses inherent in the credit portfolio can vary significantly from the amounts actually observed. While management uses available information to recognize probable losses, future changes to the allowance may be necessary based on changes in the credits comprising the portfolio and changes in the financial condition of borrowers, such as may result from changes in economic conditions. In addition, regulatory agencies, as an integral part of their examination process, periodically review the credit portfolio and the allowance. Such review may result in additional provisions based on their judgment of information available at the time of each examination. - 47 - -------------------------------------------------------------------------------- Due to the continuing improvement in the credit quality of the loan portfolio and the decline in non-accrual loan balances, the Company recorded a credit to the allowance of $639,000in the first quarter of 2014 compared to a credit of $251,000in the comparable quarter of 2013. The allowance decreased $1.8 millionfrom $13.7 millionat December 31, 2013to $11.9 millionat March 31, 2014. The decline in the allowance was directly related to the charge-off of specific reserves and a reduction of approximately $7.0 millionin classified loans. Impaired loans decreased $1.6 millionduring the first quarter of 2014. The allowance was 3.31% of total loans and leases held for investment at March 31, 2014compared to 3.73% at December 31, 2013.
Changes in the allowance were as follows:
For the three months ended March 31, (In thousands) 2014 2013 Balance at period beginning
$ 13,671 $ 17,261Charge-offs Commercial real estate (350 ) (835 ) Construction and land development - (820 ) Commercial and industrial (452 ) (173 ) Leases (118 ) (147 ) Tax certificates (265 ) (10 ) Total charge-offs (1,185 ) (1,985 ) Recoveries Commercial real estate - 104 Construction and land development - 95 Commercial and industrial 4 4 Residential real estate 2 151 Leases 13 - Tax certificates - 10 Total recoveries 19 364 Net charge-offs (1,166 ) (1,621 ) (Credit) provision for loan and lease losses (639 ) (251 ) Balance at period end $ 11,866 $ 15,389
An analysis of the allowance by loan type is set forth below:
March 31, 2014 December 31, 2013 Percent of Percent of outstanding outstanding loans in each loans in each Allowance category to Allowance category to (In thousands, except percentages) amount total loans amount total loans Commercial real estate
$ 4,92841.8 % $ 5,49840.5 % Construction and land development 2,263 12.8 % 2,316 12.3 % Commercial and industrial 1,862 19.1 % 3,006 21.7 % Multi-family 401 3.3 % 402 3.2 % Residential real estate 490 7.4 % 473 7.0 % Leases 1,357 12.2 % 1,223 11.6 % Tax certificates 387 3.1 % 555 3.5 % Consumer 17 0.3 % 15 0.2 % Unallocated 161 - 183 - Total allowance $ 11,866100.0 % $ 13,671100.0 % - 48 -
The following table presents the principal amounts of non-accrual loans and other real estate owned: March 31, December 31, (Amounts in thousands) 2014 2013 Non-accrual loans (1)
$ 9,345 $ 10,157Other real estate owned 9,368 9,617 Total nonperforming assets $ 18,713 $ 19,774Nonperforming assets to total assets 2.55 % 2.70 % Total non-accural loans to total loans 2.61 % 2.76 % ALLL to non-accrual loans 126.98 % 134.60 % ALLL to total LHFI 3.31 % 3.73 %
(1) Generally, a loan is placed on non-accruing status when it has been delinquent for a period of 90 days or more.
The composition of non-accrual loans is as follows:
March 31, 2014 December 31, 2013 Loan Specific Loan Specific (In thousands) balance reserves balance reserves Non-accrual loans Commercial real estate
$ 1,580$ - $ 2,325 $ 331Construction and land development 2,318 - 2,650 - Commercial & industrial 2,937 - 3,629 452 Residential real estate 746 22 632 19 Leases 627 116 467 60 Tax certificates 1,137 - 454 24 Total non-accrual loans $ 9,345 $ 138 $ 10,157 $ 886
Non-accrual loan activity for the first quarter of 2014 is set forth below:
1st Quarter Actvity Balance at Payments January 1, and other Transfer to Balance at (In thousands) 2014 Additions decreases Charge-offs* OREO March 31, 2014
Non-accrual loans Construction and land development
$ 2,650$ - $ (332 )$ - $ - $ 2,318 Commercial real estate 2,325 - (395 ) (350 ) - 1,580 Commercial & industrial 3,629 99 (339 ) (452 ) - 2,937 Residential real estate 632 114 - - - 746 Leases 467 278 - (118 ) - 627 Tax certificates 454 1,620 - (265 ) (672 ) 1,137 Total non-accrual loans $ 10,157 $ 2,111 $ (1,066 ) $ (1,185 ) $ (672 )$ 9,345
*Charge-offs on LHFI were recorded in the allowance.
- 49 - -------------------------------------------------------------------------------- Total non-accrual loans at
March 31, 2014were $9.3 millioncompared to $10.2 millionat December 31, 2013. The slight decrease of $812,000was the result of $1.2 millionin charge-offs related to specific reserves, $1.0 millionreduction in existing non-accrual loan balances through payments and payoffs, and $672,000in transfers to OREO, which were partially offset by additions of $2.1 million. The tax certificate portfolio accounted for the majority of the new non-accrual activity and transfers to OREO. If interest had been accrued, such income would have been approximately $275,000for the three months ended March 31, 2014. The Company had no loans past due 90 days or more on which it has continued to accrue interest during the quarter. Typically, loans are restored to accrual status when the loan is brought current, has performed in accordance with the contractual terms for a reasonable period of time (generally six months) and the ultimate collectibility of the total contractual principal and interest is no longer in doubt.
The Company identifies a loan as impaired when it is probable that interest and principal will not be collected according to the contractual terms of the loan agreement. Impaired loans include troubled debt restructurings ("TDRs"). The Company does not accrue interest income on impaired non-accrual loans. Excess proceeds received over the principal amounts due on impaired non-accrual loans are recognized as income on a cash basis. The Company recognizes interest income under the accrual basis when the principal payments on the loans become current and the collateral on the loan is sufficient to cover the outstanding obligation to the Company. If these factors do not exist, the Company does not recognize income. The following is a summary of information pertaining to impaired loans and leases: March 31, December 31, (In thousands) 2014 2013
Impaired loans with a valuation allowance
Total impaired loans and leases
Valuation allowance related to impaired loans
$ 138$ 886 For the three months ended March 31, (In thousands) 2014 2013 Average investment in impaired loans $ 17,767 $ 28,534Interest income recognized on impaired loans and leases $ 101 $ 161Interest income recognized on a cash basis on impaired loans and leases $ - $ 27
Troubled Debt Restructurings
A loan modification is deemed a TDR when two conditions are met: 1) the borrower is experiencing financial difficulty and 2) concessions are made by the Company that would not otherwise be considered for a borrower or collateral with similar credit risk characteristics. All loans classified as TDRs are considered to be impaired. TDRs are returned to an accrual status when the loan is brought current, has performed in accordance with the contractual restructured terms for a reasonable period of time (generally six months) and the ultimate collectibility of the total contractual restructured principal and interest is no longer in doubt. At
March 312014, the Company had twelve TDRs, with a total carrying value of $10.3 million. At the time of the modifications, four of the loans were already classified as impaired non-accrual loans. At December 31, 2013, the Company had twelve TDRs with a total carrying value of $12.1 million. The Company's policy for TDRs is to recognize income on currently performing restructured loans under the accrual method. - 50 -
Other Real Estate Owned
OREO slightly declined
$249,000from $9.6 millionat December 31, 2013to $9.4 millionat March 31, 2014. During the past year there was a shift in OREO composition from real estate acquired through, or in lieu of foreclosure in settlement of loans to real estate acquired through foreclosure related to tax liens. Set forth below is a table which details the changes in OREO from December 31, 2013to March 31, 2014. For the three months ended March 31, 2014 (In thousands) Loans Tax Liens Total Beginning balance $ 1,725 $ 7,892 $ 9,617Net proceeds from sales (55 ) (820 ) (875 ) Net (losses) gains on sales (14 ) 143 129 Assets acquired on non-accrual loans - 672 672 Impairment charge (74 ) (101 ) (175 ) Ending balance $ 1,582 $ 7,786 $ 9,368At March 31, 2014, OREO was comprised of $769,000in land, $521,000in commercial real estate, $7.8 millionin tax liens, and residential real estate with a fair value of $292,000. During the first quarter of 2014, the Company sold two condominiums related to a construction project in Minneapolis, Minnesotain which the Company is a participant. The Company received its pro rata share of net proceeds in the amount of $55,000and recorded a net loss of $14,000. As a result of these two sales and new agreements of sale the Company recorded an impairment charge of $74,000on the remaining condominium units. As shown in the table above the composition of the OREO assets has evolved to properties acquired through the tax lien portfolio. During the first quarter of 2014, the Company transferred $672,000to OREO which represents eight properties. During the same period the Company sold thirteen of the tax lien properties, received proceeds of $820,000, and recorded net gains of $143,000as a result of these sales. Additionally, the Company recorded impairment charges of $101,000in the first quarter of 2014 related to the tax lien properties. At December 31, 2013, OREO assets acquired through the tax lien portfolio were $7.9 millionand were comprised of 59 properties.
Credit Classification Process
The Company uses a nine point risk rating classification system commonly used in the financial services industry. The first four risk rating classifications are rated Pass. The riskier classifications include Pass-Watch, Special Mention, Substandard, Doubtful and Loss. During the underwriting process, the CCO assigns each loan with an initial risk rating, which is approved by the appropriate loan committee. From time to time, and at the general direction of any of the various loan committees, the ratings may be changed based on the findings of that committee. Items considered in assigning ratings include the financial strength of the borrower and/or guarantors, the type of collateral, the collateral lien position, the type of loan and loan structure, any potential risk inherent in the specific loan type, higher than normal monitoring of the loan or any other factor deemed appropriate by any of the various committees for changing the rating of the loan. Any such change in rating is reflected in the minutes of that committee. The loan review function is outsourced to a third party vendor which examines credit quality and portfolio management. The loan review vendor applies the Company's loan rating system to specific credits and reviews approximately 50% of the total commercial loan portfolio. Emphasis is on the larger new and seasoned loan relationships and includes criticized and classified loans. Additionally, the loan review vendor ensures that all critical industry segments are adequately represented in their review. The loan review vendor will also review loans specifically requested by management. Upon completion of a loan review, a copy of any review receiving an adverse classification by the reviewer is presented to the
Classified, Charge-off and Impairment Committee("CCIC") for discussion. The CCO is the primary bank officer dealing with the third party vendor during the reviews. - 51 - -------------------------------------------------------------------------------- Loans on the Company's Special Assets Committee list are also subject to loan review even though they are receiving the daily attention of an assigned officer and monthly attention of the Special Assets Committee. A watch list is maintained and reviewed at each meeting of CCIC. CCIC was formed to formalize the process and documentation required to classify, remove from classification, impair or charge-off a loan. The CCIC, which is comprised of the CEO, CARO, CFO, CCO, and CLO meet as required and provide regular updated reports to the Board of Directors. Loans are added to the watch list, even though the loans may be current or less than 30 days delinquent if they exhibit elements of substandard creditworthiness. The watch list contains a statement for each loan as to why it merits special attention, and this list is distributed to the Board of Directors on a monthly basis. Loans may be removed from the watch list if the CCIC determines that exception items have been resolved or creditworthiness has improved. Additionally, if loans become serious collection matters and are listed on the Company's monthly delinquent loan or Special Assets Committee lists, they may be removed from the watch list. Minutes outlining the CCIC's findings and recommendations are issued after each meeting for follow-up by individual loan officers.
Potential Problem Loans
Potential problem loans are loans not currently classified as non-performing loans, but for which management has doubts as to the borrowers' ability to comply with present repayment terms. The loans are usually delinquent more than 30 days but less than 90 days and include non-impaired substandard loans. Potential problem loans amounted to approximately
$9.3 millionand $9.1 millionat March 31, 2014and December 31, 2013. Included in potential problem loans is one relationship with a carrying value of $4.1 million. While the loan relationship was not delinquent at March 31, 2014or December 31, 2013, management is concerned about the credit and has been monitoring it closely.
Non-interest income for the first quarter of 2014 was
$772,000compared to $1.4 millionfor the comparable quarter of 2013 resulting in a decrease of $636,000. During the first quarter of 2013, the Company recorded $676,000in gains on the sale of premises and equipment related to the sale of two Company owned properties. There were no such gains in the 2014 period. Additionally, gains on the sale of AFS investment securities declined $45,000( $0in 2014 versus $45,000in 2013) and net gains on the sale of OREO declined $33,000( $129,000in 2014 versus $162,000in 2013). Gains on the sales of loans and leases increased $121,000from $16,000for the three months ended March 31, 2013to $137,000for the same period in 2014. Non-interest Expense Non-interest expense decreased $818,000from $6.1 millionfor the first quarter of 2013 to $5.3 millionfor the first quarter of 2014. The improvement was primarily related to a decline of $409,000, or 14.7%, in salaries and benefits ( $2.4 millionin 2014 versus $2.8 millionin 2013) due to a 22% reduction in the workforce. Quarter versus quarter as asset credit quality continued to improve, impairment on LHFS fell $100,000( $0in 2014 versus $100,000in 2013), loan collection expenses decreased $97,000( $39,000in 2014 versus $136,000in 2013) and OREO expenses and impairment declined $83,000( $286,000in 2014 versus $369,000in 2013). Professional and legal fees declined $57,000( $603,000in 2014 versus $660,000in 2013) and the Company did not record restructuring charges in 2014 ( $0in 2014 versus $87,000in 2013). The 2013 restructuring charges were related to the reduction in work force of twelve employees which occurred during the first quarter of 2013. Partially offsetting these declines was an increase of $71,000in marketing and advertising ( $116,000in 2014 versus $45,000in 2013) for promotion of the Company's new and enhanced products and services. Additionally, the harsh winter conditions in our markets impacted occupancy and equipment expenses, which increased $60,000( $630,000in 2014 versus $570,000in 2013).
Income Tax Expense
Total income tax expense for the first quarter of 2014 and the comparable quarter of 2013 was
$0. The Company did not record a tax expense during the first quarter of 2014 despite net income of $1.5 millionand the first quarter of 2013 despite net income of $118,000due to the inability to utilize the net operating loss carryforward from prior years. - 52 -
The Company concluded at
March 31, 2014and December 31, 2013that it was more likely than not that the Company would not generate sufficient future taxable income to realize all of the deferred tax assets. Management's conclusion was based on consideration of the relative weight of the available evidence and the uncertainty of future market conditions on results of operations. As a result the Company has recorded a cumulative non-cash charge of $37.2 millionin the consolidated statement of operations that began in the period ended December 31, 2008related to the establishment of a valuation allowance for the deferred tax asset for the portion of the future tax benefit that more likely than not will not be utilized in the future. The effective tax rate for the first quarters of both 2014 and 2013 was 0%.