News Column

FIRST FARMERS & MERCHANTS CORP - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations.

August 11, 2014

FORWARD-LOOKING STATEMENTS

Certain statements contained in this report may not be based on historical facts and are "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). These forward-looking statements may be identified by, among other things, the use of forward-looking terminology such as "could," "would," "expect," "believe," "intend," "may," "will," "can," or "should" or future or conditional verb tenses, and variations or negatives of such terms. These forward-looking statements include, without limitation, those relating to the Corporation's valuation methodologies, contributions to the Corporation's post-retirement benefit plan and returns on the plan's assets, characterization of accrual and non-accrual loans, concessions granted for troubled debt restructurings, impairment of securities, repayment of loans, loan portfolio concentrations, fair value of impaired loans, satisfaction of capital adequacy requirements, risk rating classifications of loans, calculation of our ALLL, adequacy of traditional sources of cash generated from operating activities to meet liquidity needs, the impact of various factors on net interest income, the realization of deferred income tax assets, and the impact of remediation efforts concerning internal control over financial reporting. We caution you not to place undue reliance on such forward-looking statements in this report because results could differ materially from those anticipated due to a variety of factors. These factors include, but are not limited to, conditions in the financial market, liquidity, the sufficiency of our ALLL, economic conditions in the communities in the State of Tennessee where the Corporation does business, the impact of government regulation and supervision, interest rate risk, including changes in monetary policy and fluctuating interest rates, the Corporation's ability to attract and retain key personnel, competition from other financial services providers, recent legislation and regulations impacting service fees, the Corporation's ability to pay dividends, the availability of additional capital on favorable terms, the Corporation's ability to adapt its products and services to evolving industry standards and consumer preferences, security breaches and other disruptions and other factors detailed from time to time in our filings with the Securities and Exchange ommission (the "SEC"). We undertake no obligation to update these forward-looking statements to reflect events or circumstances that occur after the date of this report.

EXECUTIVE OVERVIEW



At June 30, 2014, the consolidated total assets of the Corporation were $1,114,973, its consolidated gross loans were $618,687, its total deposits were $966,883 and its total shareholders' equity was $109,312. The Corporation's loan portfolio at June 30, 2014 reflected an increase of $11,921, or 2.0%, compared to December 31, 2013. Total deposits increased $9,546, or 1.0%, and shareholders' equity increased by 6.5% during the first six months of 2014.

Securities



Available-for-sale securities are an integral part of the asset/liability management process of the Corporation. Accordingly, they represent an important source of liquidity available to fund loans and accommodate asset reallocation strategies dictated by changes in the Corporation's operating and tax plans, shifting yield spread relationships and changes in configuration of the yield curve. At June 30, 2014, the Corporation's investment securities portfolio had $365,017 of available-for-sale securities, which are valued at fair market value, and $23,902 of held-to-maturity securities, which are valued at cost on the balance sheet. These compare to $329,714 of available-for-sale securities and $27,839 of held-to-maturity securities as of December 31, 2013.

Loans and Loan Losses



The loan portfolio is the largest component of earning assets for the Corporation and, consequently, provides the largest amount of revenue for the Corporation. The loan portfolio also contains the highest exposure to risk as a result of the possibility of unexpected deterioration in the credit quality of borrowers. When analyzing potential loans, management of the Corporation assesses both interest rate objectives and credit quality objectives in determining whether to make a given loan and the appropriate pricing for that loan. All loans are expected to be repaid from cash flow or proceeds from the sale of selected assets of the borrowers. Collateral requirements for the loan portfolio are based on credit evaluation of the borrowers. The goal of the Corporation is to diversify loans to avoid a concentration of credit in a specific industry, person, entity, product, service, or any area vulnerable to a tax law change or an economic event.

Loan volume increased in the second quarter of 2014, resulting in total loans increasing by $11,921, or 2.0% during the six-month period ended June 30, 2014 as compared to the six month period ended June 30, 2013. Commercial loans increased by $3,148, or 0.9%, in the second quarter, and the retail portfolio increased by $8,773, or 3.5%. At $618,687, total loans outstanding increased by $39,086, or 6.7%, at June 30, 2014 compared to December 31, 2013. Loan demand has shown an improvement during the six months ended June 30, 2014, especially in the construction and development portfolio.

All dollar amounts are reported in thousands except share and per share data. 31 --------------------------------------------------------------------------------



Loans identified with losses by management are promptly charged off. Furthermore, consumer loan accounts are charged off automatically based on regulatory requirements.

The ALLL is a reserve established through a provision for loan losses charged to expense, which represents management's best estimate of probable losses that have been incurred within the existing portfolio of loans. The allowance, in the judgment of management, is necessary to reserve for estimated loan losses and risks inherent in the loan portfolio. The Corporation's ALLL methodology includes allowance allocations calculated in accordance with ASC Topic 310 and ASC Topic 450. Accordingly, the methodology is based on historical loss experience by type of credit and internal risk grade, specific homogeneous risk pools and specific loss allocations, with adjustments for current events and conditions. The Corporation's process for determining the appropriate level of the ALLL is designed to account for credit deterioration as it occurs. The provision for loan losses reflects loan quality trends, including the levels of and trends related to non-accrual loans, past due loans, potential problem loans, classified and criticized loans and net charge-offs or recoveries, among other factors. The provision for loan losses also reflects the totality of actions taken on all loans for a particular period. In other words, the amount of the provision reflects not only the necessary increases in the ALLL related to newly identified criticized loans, but it also reflects actions taken related to other loans including, among other things, any necessary increases or decreases in required allowances for specific loans or loan pools. See Note 5 - Loans in the accompanying notes to consolidated financial statements included elsewhere in this report for further details regarding the Corporation's methodology for estimating the appropriate level of the ALLL.

Collectability. A formal process is in place to enhance control over the underwriting of loans and to monitor loan collectability. This process includes education and training of personnel about the Corporation's loan policies and procedures, assignment of credit analysts to support lenders, timely identification of loans with adverse characteristics, control of corrective actions and objective monitoring of loan reviews. The Corporation's Special Assets Department identifies and monitors assets that need special attention. At June 30, 2014, this process identified loans totaling $1,346 that were classified as other assets especially mentioned compared to loans totaling $4,898 at December 31, 2013. Loans totaling $11,016 were classified as substandard at June 30, 2014, compared to loans totaling $4,302 at December 31, 2013. Loans totaling $2,246 were classified as doubtful at June 30, 2014, compared to loans totaling $2,325 at December 31, 2013.

Loans having a recorded balance of $16,025 and $9,225 at June 30, 2014 and December 31, 2013, respectively, have been identified as impaired. Nonaccrual loans amounting to $10,468 and $5,396 at June 30, 2014 and December 31, 2013, respectively, were not accruing interest. The large increase in impaired and nonaccrual loans is primarily related to one commercial real estate credit with an outstanding balance of approximately $4.4 million in which events occurred to cause the loan to be downgraded during the first quarter, as management concluded the timing and amounts of future cash flows cannot be reasonably estimated. A specific reserve of approximately $1.1 million was applied to this loan. In the second quarter of 2014, there was another large commercial credit downgraded, adding approximately $3.5 million to impaired loans.

Deposits



The Corporation does not have any foreign offices and all deposits are serviced in its 18 domestic offices. The Corporation's average deposits increased 3.2% during the first six months of 2014 compared to an increase of 5.5% in the first six months of 2013. Average total noninterest-bearing deposits were 18.5% of total deposits at June 30, 2014, contributing to the Corporation's low cost of deposits, compared to 17.6% at December 31, 2013.

Regulatory Requirements for Capital

The Corporation and First Farmers and Merchants Bank, the Corporation's sole direct subsidiary (the "Bank"), are subject to federal regulatory capital adequacy standards. Failure to meet capital adequacy requirements could result in certain mandatory, and possibly additional discretionary, actions by regulators that could have a direct material adverse effect on the financial condition of the Corporation and the Bank. Federal regulations require the Corporation and the Bank to meet specific capital adequacy guidelines that involve quantitative measures of assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital classification is also subject to qualitative judgments by the regulators about components, risk weightings and other factors.

Under federal regulatory standards, to be "well-capitalized," the Corporation's and the Bank's Tier 1 Risk-Based Capital Ratio (ratio of Tier 1 Capital to risk-weighted assets) must be at least 6%, its Total Risk-Based Capital Ratio (ratio of total capital to risk-weighted assets) must be at least 10%, and its Tier 1 Leverage Capital Ratio (ratio of Tier 1 Capital to average assets) must be at least 5%. Equity capital (net of certain adjustments for intangible assets and investments in non-consolidated subsidiaries and certain classes of preferred stock) and other certain equity like instruments are considered Tier 1 Capital. Tier 2 Capital consists of core capital plus supplementary or temporary capital such as subordinated debt, some types of preferred stock, and a defined percentage of the ALLL.

All dollar amounts are reported in thousands except share and per share data.

32

--------------------------------------------------------------------------------



As of June 30, 2014, the Bank's Tier 1 Risk-Based Capital Ratio, Total Risk-Based Capital Ratio and Tier 1 Leverage Capital Ratios were 13.9%, 15.1%, and 9.0%, respectively, compared to 13.8%, 15.0%, and 9.1% at December 31, 2013. At June 30, 2014, the Corporation's Tier 1 Risk-Based Capital Ratio, Total Risk-Based Capital Ratio and Tier 1 Leverage Capital Ratios were 14.3%, 15.5% and 9.3%, respectively, compared to 14.1%, 15.3%, and 9.4% at December 31, 2013. Management believes, as of June 30, 2014, that the Corporation and the Bank each met all capital adequacy requirements to which they are subject.

LIQUIDITY AND CAPITAL RESOURCES

Most of the capital needs of the Corporation historically have been met with retained earnings.

The Corporation and the Bank are subject to Tennessee statutes and regulations that impose restrictions on the amount of dividends that may be declared. Furthermore, any dividend payments are subject to the continuing ability of the Corporation to maintain its compliance with minimum federal regulatory capital requirements and to retain its characterization under federal regulations as a "well-capitalized" institution. The Corporation's Board of Directors has adopted a liquidity policy that outlines specific liquidity target balances. Compliance with this policy is reviewed quarterly by the Corporation's Asset/Liability Committee and results are reported to the Corporation's Board of Directors.

The Corporation's formal asset and liability management process is used to manage interest rate risk and assist management in maintaining reasonable stability in the gross interest margin as a result of changes in the level of interest rates and/or the spread relationships among interest rates. The Corporation uses an earnings simulation model to evaluate the impact of different interest rate scenarios on the gross margin. Each quarter, the Corporation's Asset/Liability Committee monitors the relationship of rate sensitive earning assets to rate sensitive interest-bearing liabilities (interest rate sensitivity), which is the principal factor in determining the effect that fluctuating interest rates will have on future net interest income. Rate sensitive earning assets and interest bearing liabilities are financial instruments that can be re-priced to current market rates within a defined time period.

Management believes that the Corporation's traditional sources of cash generated from operating activities are adequate to meet the liquidity needs for normal ongoing operations; however, the Corporation also has access to additional liquidity, if necessary, through additional advances from the FHLB or the CMA with the FHLB. The borrowings from the FHLB have been used generally for investment strategies to enhance the Corporation's portfolio. At June 30, 2014, the Corporation had $40,000 borrowing capacity.

CRITICAL ACCOUNTING POLICIES

The accounting principles the Corporation follows and the methods of applying these principles conform with GAAP and with general practices within the banking industry. In connection with the application of those principles, the Corporation's management has made judgments and estimates that with respect to the determination of the ALLL and the recognition of deferred income tax assets, have been critical to the determination of the Corporation's financial position, results of operations and cash flows.

Allowance for Loan and Lease Losses

The Corporation's management assesses the adequacy of the ALLL prior to the end of each month and prepares a more formal review quarterly to assess the risk in the Corporation's loan portfolio. This assessment includes procedures to estimate the allowance and test the adequacy and appropriateness of the resulting balance. The ALLL represents calculated amounts for specifically identified credit exposure and exposures readily predictable by historical or comparative experience. Even though this calculation considers specific credits, the entire allowance is available to absorb any credit losses.

These calculated amounts are determined by assessing loans identified as not in compliance with loan agreements. These loans are generally in two different risk groups. One group is unique loans (commercial loans, including those loans considered impaired). The second group consists of pools of homogenous loans (generally retail and mortgage loans). The calculation for unique loans is based primarily on risk rating grades assigned to each of these loans as a result of the Corporation's loan management and review processes. Each risk-rating grade is assigned a loss ratio, which is determined based on the experience of management, discussions with banking regulators and the independent loan review process. The amount allocated for an impaired loan is based on estimated cash flows discounted at the loan's original effective interest rate or the underlying collateral value. Historical data, including actual loss experience on specific types of homogenous loans, is used to allocate amounts for loans or groups of loans

All dollar amounts are reported in thousands except share and per share data.

33

--------------------------------------------------------------------------------



meeting the specified criteria. Management has implemented procedures that give more detailed historical data by category of retail and consumer credit and performance characteristics to broaden the analysis and improve monitoring of potential credit risk.

Criteria considered and processes utilized in evaluating the adequacy of the ALLL are: ÿPortfolio quality trends;

Changes in the nature and volume of the portfolio; Present and prospective economic and business conditions, locally and nationally; Management review systems and board oversight, including external loan review processes; Changes in credit policy, credit administration, portfolio management and procedures; Changes in personnel, management and staff; and Existence and effect of any concentrations of credit.



In assessing the adequacy of the ALLL, the risk characteristics of the entire loan portfolio are evaluated. This process includes the judgment of the Corporation's management, input from independent loan reviews and reviews that may have been conducted by Corporation regulators as part of their usual examination process.

RESULTS OF OPERATIONS



Total interest income for the six months ended June 30, 2014 was $18,145 compared to $18,746 for the six months ended June 30, 2013. Interest and fees earned on loans and investments are the primary components of total interest income. Interest and fees earned on loans were $13,942, a decrease of $334 during the six months ended June 30, 2014 compared to the six months ended June 30, 2013. The lower interest rates for loans were the primary reason for the lower interest income. Interest earned on investment securities and other earning assets was $4,203, a decrease of $267, or 6.0%, during the six months ended June 30, 2014 compared to the six months ended June 30, 2013. The decrease in interest earned on investment securities was primarily the result of the call or maturity of several higher yielding municipal bonds in the second quarter of 2014.

Total interest expense in the six months ended June 30, 2014 was $1,243, a decrease of $342, or 21.6%, compared to the six months ended June 30, 2013. The lower interest rates for certificates of deposits and public funds during the second quarter of 2014 were the primary reasons for the lower expense. As a policy, budgeted financial goals are monitored on a quarterly basis by the Corporation's Asset/Liability Committee, which reviews the actual dollar change in net interest income for different interest rate movements. A negative dollar change in net interest income for a 12-month and 24-month period of less than 10.0% of net interest income given a 100 to 200 basis point shift in interest rates is considered an acceptable rate risk position. The rate risk analysis for the 24-month period beginning July 1, 2014 and ending June 30, 2016 showed a worst-case potential change to net interest income, in the very unlikely event of a negative 100 basis point shift in interest rates, of 9.5%, or a decrease in net interest income of $3,115 by the end of the period. In a more likely scenario, the rate risk analysis for the 24-month period beginning July 1, 2014 and ending June 30, 2016 showed a worst-case potential change to net interest income, in the event of a 200 basis point shift in interest rates, of 2.4%, or a decrease of $785 by the end of the period.

Net interest income of the Corporation on a fully taxable equivalent basis is influenced primarily by changes in:

(1) the volume and mix of earning assets and sources of funding; (2) market rates of interest; and (3) income tax rates.



The impact of some of these factors can be controlled by management policies and actions. External factors also can have a significant impact on changes in net interest income from one period to another. Some examples of such factors are:

(1) the strength of credit demands by customers; (2) Federal Reserve Board monetary policy; and



(3) fiscal and debt management policies of the federal government, including changes in tax laws.

The net interest margin, on a tax equivalent basis, at June 30, 2014, December, 31, 2013 and June 30, 2013, was 3.47%, 3.66% and 3.64%, respectively. The decline during the first six months of 2014 was in part caused by lower yield on earnings assets.

Overall, the Corporation has experienced continued declining charge-offs trends and improved credit quality ratios. As such, no additions were made to the provision for loan losses in the second quarter of 2014 and in the second quarter of 2013.

All dollar amounts are reported in thousands except share and per share data.

34

--------------------------------------------------------------------------------



Noninterest income was $5,742, a decrease of $207, or 3.5%, during the six months ended June 30, 2014 compared to the six months ended June 30, 2013. The gain on sales of securities for the six months ended June 30, 2014 and 2013 was $547 and $829, respectively, which accounted for the majority of the decrease in noninterest income over the six-month period.

Noninterest expense, excluding the provision for loan losses, was $16,123 in the six months ended June 30, 2014, decrease of $139, or .1%, as compared to noninterest expense for the six months ended June 30, 2013.

Net income for the six months ended June 30, 2014 was $4,859 compared to $5,441 for the six months ended June 30, 2013. The Corporation earned $0.97 per share for the six months ended in June 30, 2014, compared to $1.06 per share for the six months ended June 30, 2013. The decrease is mostly because of a decrease in noninterest income.

OFF-BALANCE SHEET ARRANGEMENTS

The Corporation is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and stand-by letters of credit. These instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the balance sheet. The contract or notional amounts of those instruments reflect the extent of involvement the Corporation has in those financial instruments. Loan commitments are agreements to lend to a customer as long as there is not a violation of any condition established in the loan commitment contract. Stand-by letters of credit are conditional commitments issued by the Corporation to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements, including commercial paper, bond financing and similar transactions. The credit risk involved in issuing letters of credit is essentially the same as that involved in making a loan.

The total outstanding balance of loan commitments and stand-by letters of credit in the normal course of business at June 30, 2014 were $138,664 and $7,646, respectively.

At June 30, 2014, the Corporation and the Bank did not have any off-balance sheet arrangements other than commitments to extend credit and stand-by letters of credit.


For more stories on investments and markets, please see HispanicBusiness' Finance Channel



Source: Edgar Glimpses


Story Tools






HispanicBusiness.com Facebook Linkedin Twitter RSS Feed Email Alerts & Newsletters