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NB&T FINANCIAL GROUP INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

May 14, 2014

Results of Operations

Net income for the first quarter of 2014 was $1.1 million, or $.32 per share, compared to net income of $1.0 million, or $.30 per share, for the first quarter of 2013. Net income increased primarily due to a $283,000 reduction in operating costs, offset by a $135,000 increase in the provision for loan losses and continued margin compression.



Net Interest Income

Net interest income was $5.2 million for the first quarter of 2014, compared to $5.4 million for the first quarter of 2013. Net interest margin decreased to 3.48% for the first quarter of 2014, compared to 3.50% for the same quarter last year. The net interest margin decreased primarily due to continued repricing of new and variable-rate loans to lower rates. The decrease in loan yield was partially offset by the recovery of $186,000 in non-accrued interest due to the resolution of one commercial real estate loan and an increase in investment yields due to increased investment in longer term tax-exempt municipals and slower prepayments on mortgage related securities.



Provision for Loan Losses

The provision for loan losses for the first quarter of 2014 was $275,000, compared to $140,000 in the same quarter last year. Net charge-offs were $318,000 in the first quarter of 2014, compared to $230,000 in the first quarter of 2013. Despite the increase in charge-offs, asset quality improved during the quarter. Non-performing loans declined to $4.7 million at March 31, 2014, compared to $5.8 million and $10.4 million at December 31, 2013 and March 31, 2013 respectively, due primarily to the resolution of problem loans. Other real estate owned also decreased to $1.0 million at March 31, 2014 from $1.2 million and $1.9 million at December 31, 2013 and March 31, 2013, respectively.



Non-interest Income

Total non-interest income was $2.0 million for the first quarter of 2014, compared to $2.0 million for the first quarter of 2013. In the first quarter of 2014, the Company experienced an $81,000 decline in NSF fees due to higher deposit balances, which lowered the number of NSF items, partially offset by a $68,000 increase in trust income compared to same quarter last year.



Non-interest Expense

Total non-interest expense was $5.6 million for the first quarter of 2014, compared to $5.9 million for the first quarter of 2013. The expense decrease is primarily due to a $201,000 decrease in net costs associated with the operation of other real estate and a decrease of approximately $79,000 in state taxes due to Ohio's new financial institution tax replacing Ohio's bank franchise tax.



Income Taxes

The provision for income taxes for the first quarter of 2014 was $251,000, or 18.8% effective rate, compared to $282,000, or 21.7% effective rate, for the first quarter of 2013. The decrease in the effective tax rate compared to the first quarter of 2013 is primarily due to an increase in tax-exempt securities interest during the first quarter of 2014. 28



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Financial Condition

The changes that have occurred in the Company's financial condition during 2014 are as follows (in thousands):

March 31, December 31, 2014 Change 2014 2013 Amount Percent Total assets $ 660,964$ 638,312$ 22,652 3.5 Interest-bearing deposits 58,276 41,901 16,375 39.1 Federal funds sold 447 443 4 0.9 Loans, net * 385,857 395,443 (9,586 ) (2.4 ) Securities 154,848 138,098 16,750 12.1 Demand deposits 123,922 115,206 8,716 7.6 Savings, NOW, MMDA deposits 357,445 339,260 18,185 5.4 CD's $100 and over 16,913 18,328 (1,415 ) (7.7 ) Other time deposits 73,847 78,006 (4,160 ) (5.3 ) Total deposits 572,127 550,800 21,327 3.9 Long-term borrowings 14,310 14,310 0 0 Stockholders' equity 69,443 68,035 1,408 2.1



* Excludes loans held for sale

At March 31, 2014, total assets were $661.0 million, an increase of $22.7 million from December 31, 2013 primarily due to an increase in interest-bearing deposits. Loans have decreased $9.6 million from December 31, 2013. The decline was primarily due to the seasonal decline in the agriculture portfolio, which has decreased approximately $10.4 million from December 31, 2013. Securities increased $16.8 million in the first quarter of 2014 with purchases of $8.7 million in longer-term tax-exempt municipal securities and the remaining growth in shorter-term mortgage-related securities. Total deposit liabilities increased $21.3 million from December 31, 2013. The Company has experienced an increase in transaction, savings and money market accounts of approximately $26.9 million during the first quarter of 2014 due to seasonal public funds, as well as the decision by depositors to keep their funds in more liquid deposits that offer comparable rates to shorter-term certificates of deposit. As a result, the increase in transaction accounts was partially offset by a decline in time deposits of approximately $5.6 million. The Company continues to allow higher-priced deposits to leave based on its liquidity position and lower-rate reinvestment alternatives.



Allowance for Loan Losses

The Company's loan loss experience for the periods ended March 31, 2014 and 2013 is outlined in Note 4 of the financial statements. The following table sets forth selected information regarding the Company's loan quality at the dates indicated (in thousands): March 31, December 31, March 31, 2014 2013 2013



Loans accounted for on non-accrual basis $ 4,640$ 5,734$ 9,097 Accruing loans which are past due 90 days

19 32 1,285 Other real estate owned 1,050 1,224 1,868 Total non-performing assets $ 5,709 $ $6,990$ 12,250 Troubled debt restructurings, accruing $ 2,696$ 2,694$ 2,762 Ratios: Allowance to total loans 1.03 % 1.01 % 1.15 % Net charge-offs to average loans (annualized) .33 % .82 % .23 % Non-performing assets to total loans and other real estate owned 1.46 % 1.74 % 2.96 % 29



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The allowance is maintained to absorb losses in the portfolio. Management's determination of the adequacy of the allowance is based on reviews of specific loans, loan loss experience, general economic conditions and other pertinent factors. If, as a result of charge-offs or increases in risk characteristics of the loan portfolio, the allowance is below the level considered by management to be adequate to absorb possible loan losses, the provision for loan losses is increased. Loans deemed not collectible are charged off and deducted from the allowance. Recoveries on loans previously charged off are added to the allowance. The Company allocates the allowance for loan losses to specifically classified loans and non-classified loans generally based on the one- and three-year net charge-off history. In assessing the adequacy of the allowance for loan losses, the Company considers three principal factors: (1) the one- and three-year rolling average charge-off percentage applied to the current outstanding balance by portfolio type; (2) specific allocations applied to individual loans estimated by management to have a potential loss; and (3) estimated losses attributable to loan risk ratings and current unemployment rates. Specific reserves increased to $623,000 at March 31, 2014, compared to $526,000 at December 31, 2013 due to a decrease in the fair market value of two commercial real estate properties. General reserves decreased to $3.4 million at March 31, 2014, compared to $3.5 million at December 31, 2013. This decrease is due to a decline in the thirty-six month historical loan loss rate and the lower Ohio unemployment rate. As of March 31, 2014, there was $3.5 million in small business relationships on non-accrual. Approximately $944,000 of this amount consisted of one relationship, all secured by commercial real estate or business assets. In addition, approximately $726,000 of nonaccrual loans were acquired from American National Bank and are covered under the FDIC loss share agreement. Nonaccrual residential real estate loans totaled $895,000, with the largest balance being $156,000. Non-accrual agricultural loans totaled $63,000, consumer loans totaled $23,000, and home equity credit loans totaled $110,000.



Liquidity and Capital Resources

Effective liquidity management ensures that the cash flow requirements of depositors and borrowers, as well as Company cash needs, are met. The Company manages liquidity on both the asset and liability sides of the balance sheet. The loan-to-deposit ratio at March 31, 2014 was 68.1%, compared to 72.5% at December 31, 2013 and 70.6% at March 31, 2013. Loans to total assets were 59.0% at March 31, 2014, compared to 62.6% at December 31, 2013 and 60.5% at March 31, 2013. At March 31, 2014, the Company had $58.3 million in interest-earning deposits. The Company has $154.8 million in available-for-sale securities that are readily marketable. Approximately 53.7% of the available-for-sale portfolio is pledged to secure public deposits, short-term and long-term borrowings and for other purposes as required by law. The balance of the available-for-sale securities could be sold if necessary for liquidity purposes. Also, a stable deposit base, consisting of 97.0% core deposits, makes the Company less susceptible to large fluctuations in funding needs. The Company has the ability to borrow short-term funds from two correspondent banks and the Federal Reserve Bank. The Company also has both short- and long-term borrowing available through the Federal Home Loan Bank (FHLB). The Company has the ability to obtain deposits in the brokered certificate of deposit market to help provide liquidity. 30



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The Federal Reserve Board has adopted risk-based capital guidelines that assign risk weightings to assets and off-balance sheet items and also define and set minimum capital requirements (risk-based capital ratios). At March 31, 2014 and December 31, 2013, the Company had the following risk-based capital ratios, which are well above the regulatory minimum requirements (dollar amounts in thousands): Required Required For Capital Adequacy To Be Well Capitalized Actual Purposes (1) Amount Ratio Amount Ratio Amount Ratio As of March 31, 2014Total Risk-Based Capital (to Risk-Weighted Assets) Consolidated $ 79,182 19.36 % $ 32,714 8.0 % $ 40,892 10.0 % Bank 72,916 17.85 32,686 8.0 40,858 10.0 Tier I Capital (to Risk-Weighted Assets) Consolidated 75,172 18.38 16,357 4.0 24,535 6.0 Bank 68,906 16.86 16,343 4.0 24,515 6.0 Tier I Capital (to Average Assets) Consolidated 75,172 11.44 26,284 4.0 N/A N/A Bank 68,906 10.46 26,349 4.0 32,937 5.0 As of December 31, 2013Total Risk-Based Capital (to Risk-Weighted Assets) Consolidated $ 79,041 19.10 % $ 33,107 8.0 % N/A N/A Bank 71,729 17.35 33,080 8.0 $ 41,349 10.0 % Tier I Capital (to Risk-Weighted Assets) Consolidated 74,988 18.12 16,553 4.0 N/A N/A Bank 67,676 16.37 16,540 4.0 24,810 6.0 Tier I Capital (to Average Assets) Consolidated 74,988 11.56 25,952 4.0 N/A N/A Bank 67,676 10.41 25,992 4.0 32,490 5.0



(1) The amounts and percentages set forth for the Bank are established by the

prompt corrective action regulations of the Office of the Comptroller of the

Currency. The amounts and percentages set forth for the Company are

established by the Federal Reserve Board. The Bank Holding Company Act

requires the Company to be well capitalized in order to remain a financial

holding company.

CRITICAL ACCOUNTING POLICIES

The accounting and reporting policies of the Company are in accordance with accounting principles generally accepted in the United States and conform to general practices within the banking industry. The Company's significant accounting policies are described in detail in the notes to the Company's consolidated financial statements for the year ended December 31, 2013. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions. The financial position and results of operations can be affected by these estimates and assumptions and are integral to the understanding of reported results. Critical accounting policies are those policies that management believes are the most important to the portrayal of the Company's financial condition and results, and they require management to make estimates that are difficult, subjective, or complex. 31



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Allowance for Loan Losses - The allowance for loan losses provides coverage for probable losses inherent in the Company's loan portfolio. Management evaluates the adequacy of the allowance for loan losses each quarter based on changes, if any, in underwriting activities, the loan portfolio composition (including product mix and geographic, industry or customer-specific concentrations), trends in loan performance, regulatory guidance and economic factors. This evaluation is inherently subjective, as it requires the use of significant management estimates. Many factors can affect management's estimates of specific and expected losses, including volatility of default probabilities, collateral values, rating migrations, loss severity and economic and political conditions. The allowance is increased through provisions charged to operating earnings and reduced by net charge-offs. The Company determines the amount of the allowance based on relative risk characteristics of the loan portfolio. The allowance recorded for commercial loans is based on reviews of individual credit relationships and historical loss experience. The allowance recorded for homogeneous consumer loans is based on an analysis of loan mix, risk characteristics of the portfolio, and historical losses, adjusted for current trends, for each homogeneous category or group of loans. The allowance for loan losses relating to impaired loans is based on the loan's observable market price, the collateral for certain collateral-dependent loans, or the discounted cash flows using the loan's effective interest rate. Regardless of the extent of the Company's analysis of customer performance, portfolio trends or risk management processes, certain inherent but undetected losses are probable within the loan portfolio. This is due to several factors, including inherent delays in obtaining information regarding a customer's financial condition or changes in their unique business conditions, the judgmental nature of individual loan evaluations, collateral assessments and the interpretation of economic trends. Volatility of economic or customer-specific conditions affecting the identification and estimation of losses for larger non-homogeneous credits and the sensitivity of assumptions utilized to establish allowances for homogenous groups of loans are among other factors. The Company estimates a range of inherent losses related to the existence of these exposures. The estimates are based upon the Company's evaluation of risk associated with the commercial and consumer allowance levels and the estimated impact of the current economic environment. Fair Value of Securities - The Company uses the Fair Value Measurements prescribed under the FASB Accounting Standards Codification to value its securities. The ASC defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The ASC also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value: Level 1 Quoted prices in active markets for identical assets or liabilities Level 2 Observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be



corroborated by

observable market data for substantially the full term of the assets or liabilities



Level 3 Unobservable inputs that are supported by little or no market activity

and that are significant to the fair value of the assets or liabilities The fair value of available-for-sale securities are determined by various valuation methodologies. Level 2 securities include U.S. Government agency securities, mortgage-backed securities, and obligations of political and state subdivisions. Level 2 inputs do not include quoted prices for individual securities in active markets; however, they do include inputs that are either directly or indirectly observable for the individual security being valued. Such observable inputs include interest rates and yield curves at commonly quoted intervals, volatilities, prepayment speeds, credit risks and default rates. Also included are inputs derived principally from or corroborated by observable market data by correlation or other means. Goodwill and Other Intangibles - The Company records all assets and liabilities acquired in purchase acquisitions, including goodwill and other intangibles, at fair value as required by the "Intangibles - Goodwill & Other" topic of the FASB Accounting Standards Codification. Goodwill is subject, at a minimum, to annual tests for impairment. Testing includes evaluating the current market price of the stock versus book value, the current economic value of equity versus current book value, and recent market sales of financial institutions. Based on the review of all three factors, management has concluded goodwill is not impaired. Other intangible assets are amortized over their estimated useful lives using straight-line and accelerated methods, and are subject to impairment if events or circumstances indicate a possible inability to realize the carrying amount. The initial goodwill and other intangibles recorded and subsequent impairment analysis requires management to make subjective judgments concerning estimates of how the acquired asset will perform in the future. Events and factors that may significantly affect the estimates include, among others, customer attrition, changes in revenue growth trends, specific industry conditions and changes in competition. 32



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