News Column

SUSSEX BANCORP - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

August 12, 2014

MANAGEMENT STRATEGY

We are a community-oriented financial institution serving northern New Jersey, northeastern Pennsylvania, New York City, New York and Orange County, New York. While offering traditional community bank loan and deposit products and services, we obtain non-interest income through our insurance brokerage operations and the sale of non-deposit products. We continue to focus on strengthening our core operating performance by improving our net interest income and margin by closely monitoring our yield on earning assets and adjusting the rates offered on deposit products. The economic downturn continues to impact our level of nonperforming assets. We have been focused on building for the future and strengthening our core operating results within a risk management framework.



CRITICAL ACCOUNTING POLICIES

Our consolidated financial statements are prepared in accordance with U.S. GAAP and practices within the banking industry. Application of these principles requires management to make estimates, assumptions, and judgments that affect the amounts reported in our consolidated financial statements and accompanying notes. These estimates, assumptions, and judgments are based on information available as of the date of the financial statements; accordingly, as this information changes, the financial statements could reflect different estimates, assumptions, and judgments. Actual results could differ from those estimates. Critical accounting estimates are necessary in the application of certain accounting policies and procedures, and are particularly susceptible to significant change. Critical accounting policies are defined as those that are reflective of significant judgments and uncertainties, and could potentially result in materially different results under different assumptions and conditions. There have been no material changes to our critical accounting policies during the six months ended June 30, 2014. For additional information on our critical accounting policies, please refer to Note 1 of the consolidated financial statements included in our 2013 Annual Report on Form 10-K. 24 --------------------------------------------------------------------------------



COMPARISION OF OPERATING RESULTS FOR THREE MONTHS ENDED JUNE 30, 2014 AND 2013

Overview - For the quarter ended June 30, 2014, we reported net income of $607 thousand, or $0.13 per basic and diluted share, as compared to net income of $134 thousand, or $0.04 per basic and diluted share, for the same period last year. The increase in net income for the quarter ended June 30, 2014 was largely due to a decrease in credit quality costs (provision for loan losses, loan collection costs and expenses and write-downs related to foreclosed real estate) of $683 thousand or 48.3%, and increases in net interest income of $367 thousand and gain on securities transactions of $65 thousand. Comparative Average Balances and Average Interest Rates - The following table presents, on a fully tax equivalent basis, a summary of our interest-earning assets and their average yields, and interest-bearing liabilities and their average costs for the three month periods ended June 30, 2014 and 2013: Three Months Ended June 30, (Dollars in thousands) 2014 2013 Average Average Average Average Earning Assets: Balance Interest Rate (2) Balance Interest Rate (2) Securities: Tax exempt (3) $ 33,764$ 384 4.56% $ 29,579$ 373 5.06% Taxable 62,775 214 1.37% 94,286 126 0.54% Total securities 96,539 598 2.48% 123,865 499 1.62% Total loans receivable (1) (4) 420,506 4,800 4.58% 363,996 4,485 4.94% Other interest-earning assets 7,368 4 0.22% 2,122 2 0.38%



Total earning assets 524,413 $ 5,402 4.13% $ 489,983$ 4,986 4.08%

Non-interest earning assets 37,675 39,409 Allowance for loan losses (5,653) (5,777) Total Assets $ 556,435 523,615 Sources of Funds: Interest bearing deposits: NOW $ 115,065$ 43 0.15% $ 108,523$ 35 0.13% Money market 11,146 4 0.14% 13,950 6 0.17% Savings 144,942 74 0.20% 155,156 83 0.21% Time 108,133 294 1.09% 98,482 329 1.34% Total interest bearing deposits 379,286 415 0.44% 376,111 453 0.48% Borrowed funds 49,244 361 2.94% 34,549 273 3.17% Junior subordinated debentures 12,887 52 1.62% 12,887 55 1.71% Total interest bearing liabilities 441,417 $ 828 0.75% $



423,547 $ 781 0.74%

Non-interest bearing liabilities: Demand deposits 63,239



58,411

Other liabilities 2,713



1,806

Total non-interest bearing liabilities 65,952



60,217

Stockholders' equity 49,066



39,851

Total Liabilities and Stockholders' Equity $ 556,435$ 523,615 Net Interest Income and Margin (5) 4,574 3.50% 4,205 3.44% Tax-equivalent basis adjustment (129) (127) Net Interest Income $ 4,445$ 4,078 (1) Includes loan fee income (2) Average rates on securities are calculated on amortized costs (3) Full taxable equivalent basis, using a 39% effective tax rate and adjusted for TEFRA (Tax and Equity Fiscal Responsibility Act) interest expense disallowance (4) Loans outstanding include non-accrual loans (5) Represents the difference between interest earned and interest paid, divided by average total interest-earning assets Net Interest Income - Net interest income is the difference between interest and fees on loans and other interest-earning assets and interest paid on interest-bearing liabilities. Net interest income is directly affected by changes in volume and mix of interest-earning assets and interest-bearing liabilities that support those assets, as well as changing interest rates when differences exist in repricing dates of assets and liabilities. 25

-------------------------------------------------------------------------------- Net interest income on a fully tax equivalent basis increased $369 thousand, or 8.8%, to $4.6 million for the second quarter of 2014 as compared to $4.2 million for same period in 2013. The increase in net interest income was largely due to a $34.4 million, or 7.0%, increase in average interest earning assets, principally loans receivable, which increased $56.5 million, or 15.5%, and was partially offset by a decrease in the average balance on the securities portfolio of $27.3 million, or 22.1%. The aforementioned increase also benefited from a 6 basis point increase in the net interest margin to 3.50% for the second quarter of 2014 as compared to the same period last year. The increase in the net interest margin was mostly due to an increase in the average rate received on interest earning assets, which increased 5 basis points to 4.13% for the second quarter of 2014 from 4.08% for the same period in 2013. Interest Income - Our total interest income, on a fully tax equivalent basis, increased $416 thousand, or 8.3%, to $5.4 million for the quarter ended June 30, 2014 as compared to the same period last year. The increase was due to higher earning asset yields, which increased 5 basis points to 4.13% for the quarter ended June 30, 2014, as compared to the same period in 2013. Our total interest income earned on loans receivable increased $315 thousand, or 7.0%, to $4.8 million for the second quarter of 2014 as compared to the same period in 2013. The increase was driven by an increase in average balance of loans receivable of $56.5 million, or 15.5%, for the three months ended June 30, 2014, as compared to same period last year. The increase in interest income earned on loans receivable was partly offset by a 36 basis point decline in average yields to 4.58% for the quarter ended June 30, 2014, as compared to the same period in 2013. Our total interest income earned on securities, on a fully tax equivalent basis, increased $99 thousand, to $598 thousand for the quarter ended June 30, 2014, from $499 thousand for the same period in 2013. This increase was largely due to an increase in the average rate earned on securities, which increased 86 basis points for the quarter ended June 30, 2014, as compared to the same period last year. Other interest-earning assets include federal funds sold and interest bearing deposits in other banks. Our interest earned on total other interest-earning assets increased $2 thousand for the second quarter of 2014 as compared to the same period in 2013 due to an increase in average balances. The average balances in other interest-earning assets increased $5.2 million to $7.4 million in the first quarter of 2014 from $2.1 million during the second quarter a year earlier. Interest Expense - Our interest expense for the three months ended June 30, 2014 increased $47 thousand, or 6.0%, to $828 thousand from $781 thousand for the same period in 2013. The improvement was principally due to higher average rates paid on total interest-bearing liabilities, which increased 1 basis points from 0.74% for the three months ended June 30, 2013 to 0.75% for the same period in 2014 combined with an increase in average balances in interest-bearing liabilities, which increased $17.9 million, or 4.2%, to $441.4 million for the second quarter of 2014 from $423.5 million for the same period in 2013. Our interest expense on deposits declined $38 thousand, or 8.4%, for the quarter ended June 30, 2014, as compared to the same period last year. The decline was largely attributed to lower rates on total interest bearing deposits, which decreased 4 basis points to 0.44% for the second quarter 2014 as compared to the same period in 2013. The decrease in rates on deposit products reflects management's asset/liability strategies and a lower market rate environment between the two periods. Provision for Loan Losses - Provision for loan losses decreased $300 thousand to $400 thousand for the second quarter of 2014, as compared to $700 thousand for the same period in 2013. The decrease in the provision for loan losses for the quarter ended June 30, 2014 was largely attributed to the resolution of problem loans. The provision for loan losses reflects management's judgment concerning the risks inherent in our existing loan portfolio and the size of the allowance necessary to absorb the risks, as well as the activity in the allowance during the periods. Management reviews the adequacy of its allowance on an ongoing basis and will provide additional provisions, as management may deem necessary. Non-Interest Income - We reported an increase in non-interest income of $95 thousand, or 7.0%, to $1.5 million for the second quarter of 2014 as compared to the same period last year. The increase in non-interest income was largely due to an increase in gains on securities transactions of $65 thousand and increases in insurance commissions and fees of $49 thousand, or 7.6%, which were partially offset by a decrease in investment brokerage fees of $17 thousand, or 31.5%. Non-Interest Expense - Our non-interest expenses increased $48 thousand, or 1.0%, to $4.7 million for the second quarter of 2014 as compared to the same period last year. The increase for the second quarter of 2014 as compared to the same period in 2013 was largely due to increases in salaries and employee benefits expense of $120 thousand, director fees of $118 thousand and data processing fees of $94 thousand, which were partially offset by decreases in expenses and write-downs related to foreclosed real estate of $436 thousand. The increase in director fees was principally related to a deferred compensation plan that is tied to the performance of our common stock. The increase in data processing fees was principally due to de-conversion charges related to a planned technology upgrade scheduled for the third quarter of 2014. 26 -------------------------------------------------------------------------------- Income Taxes - Our income tax expense, which includes both federal and state tax expenses, was $159 thousand for the three months ended June 30, 2014, compared to income tax benefit of $82 thousand for the three months ended June 30, 2013.



COMPARISION OF OPERATING RESULTS FOR SIX MONTHS ENDED JUNE 30, 2014 AND 2013

Overview - For the six months ended June 30, 2014, we reported net income of $1.3 million, or $0.28 per basic and diluted share, as compared to net income of $232 thousand, or $0.07 per basic and diluted share, for the same period last year. The increase in net income for the six months ended June 30, 2014 was largely due to a decrease in credit quality costs (provision for loan losses, loan collection costs and expenses and write-downs related to foreclosed real estate) of $1.7 million or 55.6%, and an increase in net interest income of $830 thousand, which were partially offset by a decrease in gain on securities transactions of $305 thousand Comparative Average Balances and Average Interest Rates - The following table presents, on a fully taxable equivalent basis, a summary of our interest-earning assets and their average yields, and interest-bearing liabilities and their average costs for the six month periods ended June 30, 2014 and 2013: Six Months Ended June 30, (Dollars in thousands) 2014 2013 Average Average Average Average Interest Earning Assets: Balance (1) Rate (2) Balance Interest (1) Rate (2) Securities: Tax exempt (3) $ 33,747$ 767 4.58% $ 30,881$ 766 5.00% Taxable 65,119 431 1.33% 96,824 280 0.58% Total securities 98,866 1,198 2.44% 127,705 1,046 1.65% Total loans receivable (4) 411,681 9,423 4.62% 356,778 8,761 4.95% Other interest-earning assets 6,399 7 0.22% 5,033 7 0.28% Total earning assets 516,946 $ 10,628 4.15% 489,516 $ 9,814 4.04% Non-interest earning assets 36,647 39,932 Allowance for loan losses (5,651) (5,541) Total Assets $ 547,942$ 523,907 Sources of Funds: Interest bearing deposits: NOW $ 115,361$ 82 0.14% $ 110,410$ 71 0.13% Money market 11,855 8 0.14% 14,424 15 0.21% Savings 145,509 149 0.21% 156,524 194 0.25% Time 103,557 566 1.10% 100,967 711 1.42% Total interest bearing deposits 376,282 805 0.43% 382,325 991 0.52% Borrowed funds 47,741 709 2.99% 30,597 535 3.53% Junior subordinated debentures 12,887 105 1.64% 12,887 109 1.71% Total interest bearing liabilities 436,910 $ 1,619 0.75%



425,809 $ 1,635 0.77%

Non-interest bearing liabilities: Demand deposits 60,405 54,158 Other liabilities 2,458 3,796 Total non-interest bearing liabilities 62,863 57,954 Stockholders' equity 48,169 40,144 Total Liabilities and Stockholders' Equity $ 547,942$ 523,907 Net Interest Income and Margin (5) $ 9,009 3.51% $ 8,179 3.37% Tax-equivalent basis adjustment (258) (258) Net Interest Income $ 8,751$ 7,921 (1) Includes loan fee income (2) Average rates on securities are calculated on amortized costs (3) Full taxable equivalent basis, using a 39% effective tax rate and adjusted for TEFRA (Tax and Equity Fiscal Responsibility Act) interest expense disallowance (4) Loans outstanding include non-accrual loans (5) Represents the difference between interest earned and interest paid, divided by average total interest-earning assets 27

-------------------------------------------------------------------------------- Net Interest Income - Net interest income is the difference between interest and fees on loans and other interest-earning assets and interest paid on interest-bearing liabilities. Net interest income is directly affected by changes in volume and mix of interest-earning assets and interest-bearing liabilities that support those assets, as well as changing interest rates when differences exist in repricing dates of assets and liabilities. Net interest income on a fully tax equivalent basis increased $830 thousand, or 10.1%, to $9.0 million for the first six months of 2014 as compared to $8.2 million for same period in 2013. The increase in net interest income was largely due to a $27.4 million, or 5.6%, increase in average interest earning assets, principally loans receivable, which increased $54.9 million, or 15.4%, and was partially offset by a decrease in the average balance on the securities portfolio of $28.8 million, or 22.6%. The aforementioned increase also benefited from a 14 basis point increase in the net interest margin to 3.51% for the first six months of 2014 as compared to the same period last year. The increase in the net interest margin was mostly due to an increase in the average rate received on interest earning assets, which increased 11 basis points to 4.15% for the first six months of 2014 from 4.04% for the same period in 2013. Interest Income - Our total interest income, on a fully tax equivalent basis, increased $814 thousand, or 8.3%, to $10.6 million for the six months ended June 30, 2014, as compared to the same period last year. The increase was due to higher earning asset yields, which increased 11 basis points to 4.15% for the six months ended June 30, 2014, as compared to the same period in 2013. Our total interest income earned on loans receivable increased $662 thousand, or 7.6%, to $9.4 million for the second quarter of 2014 as compared to the same period in 2013. The increase was driven by an increase in average balance of loans receivable of $54.9 million, or 15.4%, for the six months ended June 30, 2014, as compared to same period last year. The increase in interest income earned on loans receivable was partly offset by a 33 basis point decline in average yields to 4.62% for the six months ended June 30, 2014, as compared to the same period in 2013. Our total interest income earned on securities, on a fully tax equivalent basis, increased $152 thousand, to $1.2 million for the six months ended June 30, 2014, from $1.0 million for the same period in 2013. This increase was largely due to an increase in the average rate earned on securities, which increased 79 basis points for the six months ended June 30, 2014, as compared to the same period last year. Other interest-earning assets include federal funds sold and interest bearing deposits in other banks. Our interest earned on total other interest-earning assets remained flat for the first six months of 2014 as compared to the same period in 2013. The average balances in other interest-earning assets increased $1.4 million to $6.4 million in the first six months of 2014 from $5.0 million during the first six months a year earlier. Interest Expense - Our interest expense for the six months ended June 30, 2014 decreased $16 thousand, or 1.0%, to $1.6 million from $1.6 million for the same period in 2013. The improvement was principally due to lower average rates paid on total interest-bearing liabilities, which declined 2 basis points from 0.77% for the six months ended June 30, 2013 to 0.75% for the same period in 2014 partially offset by an increase in average balances in interest-bearing liabilities, which increased $11.1 million, or 2.6%, to $436.9 million for the first six months of 2014 from $425.8 million for the same period in 2013. Our interest expense on deposits declined $186 thousand, or 18.8%, for the six months ended June 30, 2014, as compared to the same period last year. The decline was largely attributed to lower rates on total interest bearing deposits, which decreased 9 basis points to 0.43% for the first six months of 2014 as compared to the same period in 2013. The decrease in rates on deposit products reflects management's asset/liability strategies and a lower market rate environment between the two periods. Provision for Loan Losses - Provision for loan losses decreased $989 thousand to $853 thousand for the first six months of 2014 as compared to $1.8 million for the same period in 2013. The decrease in the provision for loan losses for the six months ended June 30, 2014 was largely attributed to the resolution of problem loans. The provision for loan losses reflects management's judgment concerning the risks inherent in our existing loan portfolio and the size of the allowance necessary to absorb the risks, as well as the activity in the allowance during the periods. Management reviews the adequacy of its allowance on an ongoing basis and will provide additional provisions, as management may deem necessary. Non-Interest Income - We reported a decrease in non-interest income of $199 thousand, or 6.1%, to $3.0 million for the first six months of 2014 as compared to the same period last year. The decrease in non-interest income was largely due to a decrease in gains on securities transactions of $305 thousand, which was partially offset by increases in insurance commissions and fees of $180 thousand, or 12.1%. Non-Interest Expense - Our non-interest expenses decreased $62 thousand, or 0.7%, to $9.2 million for the first six months of 2014 as compared to the same period last year. The decrease for the first six months of 2014 as compared to the same period in 2013 was largely due to a decrease in expenses and write-downs related to foreclosed real estate of $747 thousand, which was partly offset by increases in salaries and employee benefits expense of $303 thousand, data 28

-------------------------------------------------------------------------------- processing fees of $145 thousand and occupancy of $109 thousand The increase in data processing fees was principally due to de-conversion charges related to a planned technology upgrade scheduled for the third quarter of 2014. Income Taxes - Our income tax expense, which includes both federal and state tax expenses, was $457 thousand for the six months ended June 30, 2014, compared to income tax benefit of $172 thousand for the six months ended June 30, 2013.



COMPARISION OF FINANCIAL CONDITION AT JUNE 30, 2014 TO DECEMBER 31, 2013

Total Assets - At June 30, 2014, the Company's total assets were $557.2 million, an increase of $23.3 million, or 4.4%, as compared to total assets of $533.9 million at December 31, 2013. The increase in total assets was largely driven by net growth in total loans of $35.9 million, or 9.2%, which was partially offset by declines in the securities portfolio of $9.4 million, or 9.7%, and in cash and cash equivalents of $2.1 million, or 16.1%.



Cash and Cash Equivalents - Our cash and cash equivalents decreased by $2.1 million to $11.1 million at June 30, 2014, or 2.0% of total assets, from $13.2 million, or 2.5%, of total assets, at December 31, 2013. The decrease was largely due to the investment of excess liquidity into loans.

Securities Portfolio - At June 30, 2014, the securities portfolio, which includes available for sale and held to maturity securities, was $87.3 million compared to $96.8 million at December 31, 2013. Available for sale securities were $81.3 million at June 30, 2014, compared to $90.7 million at December 31, 2013. The available for sale securities are held primarily for liquidity, interest rate risk management and profitability. Accordingly, our investment policy is to invest in securities with low credit risk, such as U.S. government agency obligations, state and political obligations and mortgage-backed securities. Held to maturity securities were $6.1 million at June 30, 2014 and December 31, 2013.



Net unrealized gains (losses) in the securities portfolio were $327 thousand and ($3.6) million at June 30, 2014 and December 31, 2013, respectively.

We conduct a regular assessment of our investment securities to determine whether any securities are other-than-temporarily impaired ("OTTI"). Further detail of the composition of the securities portfolio and discussion of the results of the most recent OTTI assessment are in Note 2 - Securities to our unaudited consolidated financial statements. Our securities in unrealized loss positions are mostly driven by changes in spreads and market interest rates. All of our debt and equity securities in an unrealized loss position have been evaluated for other-than-temporary impairment as of June 30, 2014 and we do not consider any security OTTI. We evaluated the prospects of the issuers in relation to the severity and the duration of the unrealized losses. In addition, we do not intend to sell, and it is more likely than not that we will not have to sell, any of our securities before recovery of their cost basis. Other investments totaled $3.0 million and $2.7 million at June 30, 2014 and December 31, 2013, respectively, and consisted primarily of FHLB stock. We also held $100 thousand in time deposits with other financial institutions at June 30, 2014 and December 31, 2013.



Loans - The loan portfolio comprises our largest class of earning assets.

Total loans receivable, net of unearned income, increased $35.9 million, or 9.2%, to $428.3 million at June 30, 2014, as compared to $392.4 million at December 31, 2013. The increase in loans was primarily in the commercial real estate portfolio, which increased $32.0 million, or 12.3%, to $292.6 million at June 30, 2014, as compared to $260.7 million at December 31, 2013 and in the commercial and industrial portfolio, which increased $4.0 million, or 26.2%, to $19.2 million at June 30, 2014, as compared to $15.2 million at December 31, 2013. The following table summarizes the composition of our gross loan portfolio by type: (Dollars in thousands) June 30, 2014 December 31, 2013 Commercial and industrial loans $ 19,189 $ 15,205 Construction 8,923 7,307 Commercial real estate 292,620 260,664 Residential real estate 106,471 107,992 Consumer and other 1,488 1,617 Total gross loans $ 428,691 $ 392,785 29

-------------------------------------------------------------------------------- Loan and Asset Quality - Our overall credit quality continued to improve through June 30, 2014, as our total problem assets, which is composed of foreclosed real estate, criticized assets and classified assets, declined $3.5 million, or 12.8%, to $23.5 million at June 30, 2014, from $27.1 million at December 31, 2013. Non-performing assets ("NPAs"), which include non-accrual loans, loans 90 days past due and still accruing, troubled debt restructured loans currently performing in accordance with renegotiated terms and foreclosed real estate, decreased $1.9 million, or 11.5%, to $14.7 million at June 30, 2014, as compared to $16.6 million at December 31, 2013. Non-accrual loans decreased $1.7 million, or 14.2%, to $10.2 million at June 30, 2014, as compared to $11.9 million at December 31, 2013. The top five non-accrual loan relationships total $6.4 million, or 63.1%, of total non-accrual loans and 43.9% of total NPAs at June 30, 2014. The remaining non-accrual loans have an average loan balance of $111 thousand. Loans past due 30 to 89 days decreased $698 thousand, or 19.0%, to $3.0 million at June 30, 2014, as compared to $3.7 million at December 31, 2013. We continue to actively market our foreclosed real estate properties, which decreased $72 thousand to $2.9 million at June 30, 2014, as compared to $2.9 million at December 31, 2013. The decrease was primarily due to the sale of foreclosed real estate properties for $683 thousand and write downs of $110 thousand, which were partially offset by additions of $715 thousand in new foreclosed real estate properties during 2014. At June 30, 2014, our foreclosed real estate properties had an average value of approximately $317 thousand per property. The allowance for loan losses increased $433 thousand, or 8.0% to $5.9 million, or 1.37% of total loans, at June 30, 2014, compared to $5.4 million, or 1.38% of total loans, at December 31, 2013. We recorded $853 thousand in provision for loan losses, which was partly offset by $420 thousand in net charge-offs for 2014. The allowance for loan losses as a percentage of non-accrual loans improved to 57.4% at June 30, 2014 from 45.6% at December 31, 2013. Management continues to monitor our asset quality and believes that the non-performing assets are adequately collateralized and anticipated material losses have been adequately reserved for in the allowance for loan losses. However, given the uncertainty of the current real estate market, additional provisions for losses may be deemed necessary in future periods. The following table provides information regarding risk elements in the loan portfolio at each of the periods presented: (Dollars in thousands) June 30, 2014 December 31, 2013 Non-accrual loans $ 10,200 $ 11,892 Non-accrual loans to total loans 2.38%



3.03%

Non-performing assets $ 14,665 $



16,569

Non-performing assets to total assets 2.63%



3.10%

Allowance for loan losses as a % of 57.39%



45.59%

non-accrual loans Allowance for loan losses to total loans 1.37% 1.38% A loan is considered impaired, in accordance with the impairment accounting guidance, when based on current information and events, it is probable that we will be unable to collect all amounts due from the borrower in accordance with the contractual terms of the loan. Total impaired loans at June 30, 2014 were $11.8 million and at December 31, 2013 were $13.5 million. Impaired loans measured at fair value on a non-recurring basis decreased to $3.6 million on June 30, 2014 from $5.5 million at December 31, 2013. The principal balances on loans measured at fair value were $4.2 million and $6.0 million, net of valuation allowance of $597 thousand at June 30, 2014 and $485 thousand at December 31, 2013. Impaired loans include loans modified in troubled debt restructurings where concessions have been granted to borrowers experiencing financial difficulties. These concessions could include a reduction in the interest rate on the loan, payment extensions, forgiveness of principal, forbearance or other actions intended to maximize collection. Not all impaired loans and restructured loans are on non-accrual, and therefore not all are considered non-performing loans. Restructured loans still accruing totaled $1.6 million at June 30, 2014 and December 31, 2013. We also continue to monitor our portfolio for potential problem loans. Potential problem loans are defined as loans which causes management to have serious concerns as to the ability of such borrowers to comply with the present loan repayment terms and which may cause the loan to be placed on non-accrual status. As of June 30, 2014, we had 8 loan relationships totaling $1.4 million that we deemed potential problem loans. Management is actively monitoring these loans. Further detail of the credit quality of the loan portfolio is included in Note 4 - Allowance for Loan Losses and Credit Quality of Financing Receivables to our unaudited consolidated financial statements. 30

-------------------------------------------------------------------------------- Allowance for Loan Losses - The allowance for loan losses consists of general, allocated and unallocated components. The allocated component relates to loans that are classified as impaired. For those loans that are classified as impaired, an allowance is established when the discounted cash flows, collateral value or observable market price of the impaired loan is lower than the carrying value of that loan. The general component covers non-impaired loans and is based on historical charge-off experience and expected losses derived from our internal risk rating process. The unallocated component covers the potential for other adjustments that may be made to the allowance for pools of loans after an assessment of internal or external influences on credit quality that are not fully reflected in the historical loss or risk rating data. Management regularly assesses the appropriateness and adequacy of the loan loss reserve in relation to credit exposure associated with individual borrowers, overall trends in the loan portfolio and other relevant factors, and believes the reserve is reasonable and adequate for each of the periods presented. At June 30, 2014, the total allowance for loan losses increased $433 thousand, or 8.0%, to $5.9 million, as compared to $5.4 million at December 31, 2013. The components of this increase were a provision for loan losses of $853 thousand and net charge-offs totaling $420 thousand in the first six months of 2014. The provision also reflects the continued weakness in current real estate values in our market area and reduced cash flows to support the repayment of loans. The allowance for loan losses as a percentage of total loans was 1.4% at June 30, 2014 and December 31, 2013.



The table below presents information regarding our provision and allowance for loan losses for the six months ended June 30, 2014 and 2013:

(Dollars in thousands) June 30, 2014 June 30, 2013 Balance, beginning of period $ 5,421$ 4,976 Provision 853 1,842 Charge-offs (466) (1,221) Recoveries 46 50 Balance, end of period $ 5,854$ 5,647 The table below presents details concerning the allocation of the allowance for loan losses to the various categories for each of the periods presented. The allocation is made for analytical purposes and it is not necessarily indicative of the categories in which future credit losses may occur. The total allowance is available to absorb losses from any category of loans. June 30, 2014 December 31, 2013 Percent of Percent of Loans In Each Loans In Each Category To Category To (Dollars in thousands) Amount Gross Loans Amount Gross Loans Commercial and industrial $ 257 4.5% $ 222 3.9% Construction 354 2.1% 308 1.9% Commercial real estate 3,750 68.3% 3,399 66.4% Residential real estate 837 24.8% 941 27.5% Consumer and other loans 13 0.3% 16 0.4% Unallocated 643 - 535 - Total $ 5,854 100.0% $ 5,421 100.0%



Bank-Owned Life Insurance (BOLI) - Our BOLI carrying value amounted to $12.1 million at June 30, 2014 and $11.9 million at December 31, 2013.

Goodwill and Other Intangibles - Goodwill represents the excess of the purchase price over the fair market value of net assets acquired. At June 30, 2014 and December 31, 2013, we had recorded goodwill totaling $2.8 million, primarily as a result of the acquisition of Tri-State in 2001. In accordance with U.S. GAAP, goodwill is not amortized, but evaluated at least annually for impairment. Any impairment of goodwill results in a charge to income. We periodically assess whether events and changes in circumstances indicate that the carrying amounts of goodwill and intangible assets may be impaired. The estimated fair value of the reporting segment exceeded its book value; therefore, no write-down of goodwill was required. The goodwill related to the insurance agency is not deductible for tax purposes.



Deposits - Our total deposits increased $14.0 million, or 3.3%, to $444.3 million at June 30, 2014, from $430.3 million at December 31, 2013. The increase in deposits was due to an increase in non-interest bearing deposits of $9.5 million,

31 -------------------------------------------------------------------------------- or 16.4%, and interest bearing deposits of $4.5 million, or 1.2%, for June 30, 2014, as compared to December 31, 2013. Our funding mix continues to improve as low cost deposits grow. Borrowings - Borrowings consist of short term and long term advances from the FHLB. The advances are secured under terms of a blanket collateral agreement by a pledge of qualifying mortgage loans. We had $46.0 million and $41.0 million in borrowings, at a weighted average interest rate of 3.09% at June 30, 2014 and 3.22% at December 31, 2013. The borrowings at June 30, 2014 consisted of $25.0 million of fixed rate advances, $10.0 million of advances with quarterly convertible puts that allow us to put the advance back to the FHLB quarterly after one year from issuance and $11.0 million of advances with quarterly convertible options that allow the FHLB to change the note rate to a then current market rate. Junior Subordinated Debentures - On June 28, 2007, Sussex Capital Trust II, a Delaware statutory business trust and wholly-owned subsidiary of the Company, issued $12.5 million of variable rate capital trust pass-through securities to investors. Sussex Capital Trust II purchased $12.9 million of variable rate junior subordinated deferrable interest debentures from us. The debentures are the sole asset of the Trust. The terms of the junior subordinated debentures are the same as the terms of the capital securities. We have also fully and unconditionally guaranteed the obligations of the Trust under the capital securities. The interest rate is based on the three-month LIBOR plus 144 basis points and adjusts quarterly. The rate at June 30, 2014, was 1.67%. The capital securities are currently redeemable by us at par in whole or in part. The capital securities must be redeemed upon final maturity of the subordinated debentures on September 15, 2037. The proceeds of these trust preferred securities, which have been contributed to the Bank, are included in the Bank's capital ratio calculations and treated as Tier I capital.



In accordance with FASB ASC 810, Consolidations, our wholly owned subsidiary, Sussex Capital Trust II, is not included in our consolidated financial statements.

Equity - Stockholders' equity, inclusive of accumulated other comprehensive income, net of income taxes, was $49.7 million, an increase of $3.3 million when compared to December 31, 2013. The increase was largely due to net income for the year and an increase in accumulated other comprehensive income relating to a reduction in the net unrealized losses on available for sale securities. At June 30, 2014, the leverage, Tier I risk-based capital and total risk-based capital ratios for the Bank were 10.31%, 13.60% and 14.85%, respectively, all in excess of the ratios required to be deemed "well-capitalized."



LIQUIDITY AND CAPITAL RESOURCES

A fundamental component of our business strategy is to manage liquidity to ensure the availability of sufficient resources to meet all financial obligations and to finance prospective business opportunities. Liquidity management is critical to our stability. Our liquidity position over any given period of time is a product of our operating, financing and investing activities. The extent of such activities is often shaped by such external factors as competition for deposits and loan demand.

Traditionally, financing for our loans and investments is derived primarily from deposits, along with interest and principal payments on loans and investments. At June 30, 2014, total deposits amounted to $444.3 million, an increase of $14.0 million, or 3.3%, from December 31, 2013. At June 30, 2014 and December 31, 2013, advances from FHLB and subordinated debentures totaled $58.9 million and $53.9 million, respectively, and represented 10.6% and 10.1% of total assets, respectively.



Loan production continued to be our principal investing activity. Net loans receivable at June 30, 2014, amounted to $422.5 million, an increase of $35.5 million, or 9.2%, compared to December 31, 2013.

Our most liquid assets are cash and due from banks and federal funds sold. At June 30, 2014, the total of such assets amounted to $11.1 million, or 2.0%, of total assets, compared to $13.2 million, or 2.5%, of total assets at December 31, 2013. Another significant liquidity source is our available for sale securities portfolio. At June 30, 2014, available for sale securities amounted to $81.3 million compared to $90.7 million at December 31, 2013. In addition to the aforementioned sources of liquidity, we have available various other sources of liquidity, including federal funds purchased from other banks and the Federal Reserve Bank discount window. The Bank also has the capacity to borrow an additional $5.4 million through its membership in the FHLB and $10.0 million at Atlantic Central Bankers Bank at June 30, 2014. Management believes that our sources of funds are sufficient to meet our present funding requirements. The Bank's regulators have implemented risk based guidelines that require banks to maintain Tier I capital as a percent of risk-adjusted assets of 4.0% and Tier II capital as a percentage of risk-adjusted assets of 8.0% at a minimum. At June 30, 2014, the Bank's Tier I and Tier II capital ratios were 13.60% and 14.85%, respectively. In addition to the risk- 32



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based guidelines, the Bank's regulators require that banks which meet the regulators' highest performance and operational standards maintain a minimum leverage ratio (Tier I capital as a percent of tangible assets) of 4.0%. As of June 30, 2014, the Bank had a leverage ratio of 10.31%. The Bank's risk based and leverage ratios are in excess of those required to be considered "well-capitalized" under FDIC regulations. The Board of Governors of the Federal Reserve System also imposes similar capital requirements on bank holding companies with consolidated assets of $500 million or more. Under Federal Reserve reporting requirements, a bank holding company that reaches $500 million or more in total consolidated assets as of June 30 of the preceding year must begin reporting its consolidated capital beginning in March of the following year. The Bank began reporting its consolidated capital in March 2013. We have no investment or financial relationship with any unconsolidated entities that are reasonably likely to have a material effect on liquidity or the availability of capital resources, except for the trust preferred securities of Sussex Capital Trust II. We are not aware of any known trends or any known demands, commitments, events or uncertainties, which would result in any material increase or decrease in liquidity. Management believes that any amounts actually drawn upon can be funded in the normal course of operations. Off-Balance Sheet Arrangements - Our consolidated financial statements do not reflect off-balance sheet arrangements that are made in the normal course of business. These off-balance sheet arrangements consist of unfunded loans and letters of credit made under the same standards as on-balance sheet instruments. These unused commitments, at June 30, 2014, totaled $66.2 million and consisted of $18.9 million in commitments to grant commercial real estate, construction and land development loans, $22.2 million in home equity lines of credit, $23.6 million in other unused commitments and $1.4 million in letters of credit. These instruments have fixed maturity dates, and because many of them will expire without being drawn upon, they do not generally present any significant liquidity risk to us. Management believes that any amounts actually drawn upon can be funded in the normal course of operations.


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Source: Edgar Glimpses


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