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

August 13, 2014

Results of Operations

Net income for the second quarter of 2014 was $1.3 million, or $.39 per share, compared to net income of $1.1 million, or $.33 per share, for the second quarter of 2013. The increase in net income is due primarily to a $1.2 million lower loan loss provision and an increase of $488,000 in interest income on securities in the second quarter of 2014 compared to the same period last year. This lower provision was partially offset by gains on security sales of $817,000 and a gain on extinguishment of long-term debt of approximately $300,000 in the second quarter of 2013, and a reduction of $379,000 in interest income on loans compared to the same quarter in 2013. Net income for the first six months of 2014 was $2.4 million, or $.71 per share, compared to $2.2 million, or $.63 per share, for the same period in 2013. For the six months of 2014, a lower provision of $1.0 million was offset by the above mentioned gains and a decrease of $733,000 in interest income on loans; however, interest income on securities was $581,000 higher and non-interest expenses were down approximately $300,000 for the first six months of 2014 compared to the same period in 2013.



Net Interest Income

Net interest income was $5.3 million for the second quarter of 2014, compared to $5.1 million for the second quarter of 2013. Net interest margin increased to 3.51% for the second quarter of 2014, compared to 3.34% for the same quarter last year. Net interest income for the first half of 2014 was $10.6 million, compared to $10.5 million for the first half of 2013. Net interest income has increased primarily due to increased investment in long term tax-exempt municipal securities and slower prepayments on mortgage-related securities. As a result, interest income on securities increased $488,000 and $581,000 for the three and six months ended June 30, 2014 compared to the same periods last year. Loan interest income was down $379,000 and $733,000 for the three and six months ended June 30, 2014 compared to the same periods in 2013. The decreases were due primarily to lower average loan balances and continued repricing of new and variable rate loans to lower rates. This lower loan interest income was partially offset by lower interest expense of $116,000 and $259,000 for the second quarter and first six months of 2014 compared to the same periods in 2013 due to continued runoff of higher priced time deposits.



Provision for Loan Losses

The provision for loan losses for the second quarter and first six months of 2014 was $135,000 and $410,000, compared to $1.3 million and $1.4 million for the same periods last year. During the second quarter of 2013, the provision for loan losses increased approximately $1.2 million to add specific loan reserves for one commercial loan that was subsequently charged-off. Net charge-offs were $431,000 in the second quarter of 2014, compared to $167,000 in the second quarter of 2013. Year to date net charge-offs for 2014 were $748,000, compared to $397,000 for the first six months of 2013. Despite the increase in charge-offs, asset quality improved during the first six months of 2014. Non-performing loans declined to $3.2 million at June 30, 2014, from $5.8 million and $9.1 million at December 31, 2013 and June 30, 2013 respectively, due primarily to the resolution of problem loans. Other real estate owned also decreased to $1.6 million at June 30, 2014 from $1.9 million at June 30, 2013.



Non-interest Income

Total non-interest income was $2.1 million for the second quarter of 2014, compared to $3.3 million for the second quarter of 2013. During the second quarter of 2013, the Company realized a gain of $300,000 on the extinguishment of $1.0 million in trust preferred debt and approximately $817,000 in securities sale gains. There were no such gains during the second quarter or first six months of 2014. As a result, non-interest income for the first six months of 2014 was $4.0 million, compared to $5.2 million for the same period last year. In addition, total NSF fees for the first half of 2014 have declined $152,000, or 13%, when compared to the first six months of 2013.



Non-interest Expense

Total non-interest expense was $5.6 million for each of the second quarter of 2014 and 2013. Non-interest expense for the first six months of 2014 was $11.2 million, compared to $11.5 million for the same period last year. The expense decrease is primarily due to a $164,000 decrease in net costs associated with the operation of other real estate and a decrease of approximately $171,000 in state taxes due to Ohio's new financial institution tax replacing Ohio's bank franchise tax. 29



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Income Taxes

The provision for income taxes for the second quarter of 2014 was $337,000, or 20.1% effective rate, compared to $336,000, or 22.8% effective rate, for the second quarter of 2013. The provision for income taxes for the first half of 2014 was $588,000, or 19.5% effective rate, compared to $618,000, or 22.3% effective rate, for the first half of 2013. The decrease in the effective tax rate compared to the second half of 2013 is primarily due to an increase in tax-exempt securities interest during the first half of 2014.



Financial Condition

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

June 30, December 31, 2014 Change 2014 2013 Amount Percent Total assets $ 652,196$ 638,312$ 13,884 2.2 Interest-bearing deposits 40,148 41,901 (1,753 ) (4.2 ) Federal funds sold 452 443 9 2.0 Loans, net * 386,808 395,443 (8,635 ) (2.2 ) Securities 163,039 138,098 24,941 18.1 Demand deposits 120,056 115,206 4,850 4.2 Savings, NOW, MMDA deposits 352,116 339,260 12,856 3.8 CD's $100 and over 16,645 18,328 (1,683 ) (9.2 ) Other time deposits 71,960 78,006 (6,046 ) (7.8 ) Total deposits 560,777 550,800 9,977 1.8 Long-term borrowings 14,310 14,310 0 0 Stockholders' equity 70,937 68,035 2,902 4.3



* Excludes loans held for sale

At June 30, 2014, total assets were $652.2 million, an increase of $13.9 million from December 31, 2013 primarily due to an increase in securities. Loans have decreased $8.6 million from December 31, 2013. The decline was primarily due to the seasonal decline in the agriculture portfolio, which has decreased approximately $7.1 million from December 31, 2013. Securities increased $24.9 million in the first half of 2014 with purchases of $13.9 million in long-term tax-exempt municipal securities and the remaining growth in short-term mortgage-related securities. Total deposit liabilities increased $10.0 million from December 31, 2013. The Company has experienced an increase in transaction, savings and money market accounts of approximately $17.7 million during the first half of 2014 primarily due to 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 $7.7 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 June 30, 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): June 30, December 31, June 30, 2014 2013 2013



Loans accounted for on non-accrual basis $ 3,171$ 5,734

$ 9,006

Accruing loans which are past due 90 days 16 32 74 Other real estate owned 1,601 1,224 1,894 Total non-performing assets $ 4,788 $ $6,990$ 10,974 30

-------------------------------------------------------------------------------- Table of Contents Troubled debt restructurings, accruing $ 5,427$ 2,694$ 1,200 Ratios: Allowance to total loans .95 % 1.01 % 1.42 % Net charge-offs to average loans (annualized) .44 % .82 % .20 % Non-performing assets to total loans and other real estate owned 1.23 %



1.74 % 2.66 %

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 decreased to $281,000 at June 30, 2014, compared to $526,000 at December 31, 2013 due to charge-offs of approximately $350,000 on two commercial real estate properties. General reserves decreased to $3.4 million at June 30, 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 June 30, 2014, there was $2.3 million in small business relationships on non-accrual. In addition, approximately $752,000 of nonaccrual loans were acquired from American National Bank and are covered under the FDIC loss share agreement. Nonaccrual residential real estate loans totaled $781,000, with the largest balance being $153,000. Non-accrual agricultural loans totaled $53,000, consumer loans totaled $2,000, and home equity credit loans totaled $61,000.



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 June 30, 2014 was 69.6%, compared to 72.5% at December 31, 2013 and 71.6% at June 30, 2013. Loans to total assets were 59.9% at June 30, 2014, compared to 62.6% at December 31, 2013 and 62.2% at June 30, 2013. At June 30, 2014, the Company had $40.1 million in interest-earning deposits. The Company has $163.0 million in available-for-sale securities that are readily marketable. Approximately 49.2% 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 97.1% 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. 31



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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 June 30, 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 June 30, 2014Total Risk-Based Capital (to Risk-Weighted Assets) Consolidated $ 79,271 19.29 % $ 32,874 8.0 % $ 41,092 10.0 % Bank 74,058 18.04 32,848 8.0 41,060 10.0 Tier I Capital (to Risk-Weighted Assets) Consolidated 75,556 18.39 16,437 4.0 24,655 6.0 Bank 70,343 17.13 16,424 4.0 24,636 6.0 Tier I Capital (to Average Assets) Consolidated 75,556 11.56 26,152 4.0 N/A N/A Bank 70,343 10.77 26,124 4.0 32,655 5.0 As of December 31, 2013Total Risk-Based Capital (to Risk-Weighted Assets) Consolidated $ 79,041 19.10 % $ 33,107 8.0 % 41,384 10.0 % 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 24,830 6.0 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

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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. 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. 33



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