News Column

PEOPLES FINANCIAL CORP /MS/ - 10-Q - : Management's Discussion and Analysis of Financial Condition and Results of Operations

August 13, 2014

GENERAL

The Company is a one-bank holding company headquartered in Biloxi, Mississippi. It has two operating subsidiaries, PFC Service Corp., an inactive company, and The Peoples Bank, Biloxi, Mississippi (the "Bank"). The Bank provides a full range of banking, financial and trust services to state, county and local government entities and individuals and small and commercial businesses operating in those portions of Mississippi, Louisiana and Alabama which are within a fifty mile radius of the Waveland, Wiggins and Gautier branches, the Bank's three most outlying locations (the "trade area"). The following presents Management's discussion and analysis of the consolidated financial condition and results of operations of Peoples Financial Corporation and Subsidiaries. These comments should be considered in combination with the Consolidated Financial Statements and Notes to Consolidated Financial Statements included in this report on Form 10-Q and the Consolidated Financial Statements, Notes to Consolidated Financial Statements and Management's Discussion and Analysis included in the Company's Form 10-K for the year ended December 31, 2013. Forward-Looking Information Congress passed the Private Securities Litigation Act of 1995 in an effort to encourage corporations to provide information about a company's anticipated future financial performance. This act provides a safe harbor for such disclosure which protects the companies from unwarranted litigation if actual results are different from management expectations. This report contains forward-looking statements and reflects industry conditions, company performance and financial results. These forward-looking statements are subject to a number of factors and uncertainties which could cause the Company's actual results and experience to differ from the anticipated results and expectations expressed in such forward-looking statements. Such factors and uncertainties include, but are not limited to: changes in interest rates and market prices, changes in local economic and business conditions, increased competition for deposits and loans, a deviation in actual experience from the underlying assumptions used to determine and establish the allowance for loan losses, changes in the availability of funds resulting from reduced liquidity, changes in government regulations and acts of terrorism, weather or other events beyond the Company's control. New Accounting Pronouncements In April 2014, the Financial Accounting Standards Board issued Accounting Standards Update ("ASU") No. 2014-06, Technical Corrections and Improvements Related to Glossary Terms. This ASU added, deleted, corrected and modified terms in the Master Glossary of the Codification and was effective upon issuance. The adoption of this ASU did not have a material effect on the Company's financial position, results of operations or cash flows. 28



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Critical Accounting Policies

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America ("GAAP") requires Management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. The Company evaluates these estimates and assumptions on an on-going basis using historical experience and other factors, including the current economic environment. We adjust such estimates and assumptions when facts and circumstances dictate. Certain critical accounting policies affect the more significant estimates and assumptions used in the preparation of the consolidated financial statements.



Allowance for loan losses:

The Company's most critical accounting policy relates to its allowance for loan losses ("ALL"), which reflects the estimated losses resulting from the inability of its borrowers to make loan payments. The ALL is established and maintained at an amount sufficient to cover the estimated loss associated with the loan portfolio of the Company as of the date of the financial statements. Credit losses arise not only from credit risk, but also from other risks inherent in the lending process including, but not limited to, collateral risk, operation risk, concentration risk and economic risk. As such, all related risks of lending are considered when assessing the adequacy of the ALL. On a quarterly basis, Management estimates the probable level of losses to determine whether the allowance is adequate to absorb reasonably foreseeable, anticipated losses in the existing portfolio based on our past loan loss experience, known and inherent risk in the portfolio, adverse situations that may affect the borrowers' ability to repay and the estimated value of any underlying collateral and current economic conditions. Management believes that the ALL is adequate and appropriate for all periods presented in these financial statements. If there was a deterioration of any of the factors considered by Management in evaluating the ALL, the estimate of loss would be updated, and additional provisions for loan losses may be required. The analysis divides the portfolio into two segments: a pool analysis of loans based upon a five year average loss history which is updated on a quarterly basis and which may be adjusted by qualitative factors by loan type and a specific reserve analysis for those loans considered impaired under GAAP. All credit relationships with an outstanding balance of $100,000 or greater that are included in Management's loan watch list are individually reviewed for impairment. All losses are charged to the ALL when the loss actually occurs or when a determination is made that a loss is likely to occur; recoveries are credited to the ALL at the time of receipt.



Other Real Estate:

Other real estate ("ORE") includes real estate acquired through foreclosure. Each other real estate property is carried at fair value, less estimated costs to sell. Fair value is principally based on appraisals performed by third-party valuation specialists. If Management determines that the fair value of a property has decreased subsequent to foreclosure, the Company records a write down which is included in noninterest expense. 29



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Employee Benefit Plans:

Employee benefit plan liabilities and pension costs are determined utilizing actuarially determined present value calculations. The valuation of the benefit obligation and net periodic expense is considered critical, as it requires Management and its actuaries to make estimates regarding the amount and timing of expected cash outflows including assumptions about mortality, expected service periods and the rate of compensation increases.



Income Taxes:

GAAP requires the asset and liability approach for financial accounting and reporting for deferred income taxes. We use the asset and liability method of accounting for deferred income taxes and provide deferred income taxes for all significant income tax temporary differences. As part of the process of preparing our consolidated financial statements, the Company is required to estimate our income taxes in each of the jurisdictions in which we operate. This process involves estimating our actual current tax exposure together with assessing temporary differences resulting from differing treatment of items, such as the provision for loan losses, for tax and financial reporting purposes. These differences result in deferred tax assets and liabilities that are included in our consolidated statement of condition. We must also assess the likelihood that our deferred tax assets will be recovered from future taxable income, and to the extent we believe that recovery is not likely, we must establish a valuation allowance. Significant management judgment is required in determining our provision for income taxes, our deferred tax assets and liabilities and any valuation allowance recorded against our net deferred tax assets. To the extent the Company establishes a valuation allowance or adjusts this allowance in a period, we must include an expense within the tax provisions in the consolidated statement of income.



OVERVIEW

The Company is a community bank serving the financial and trust needs of its customers in its trade area of south Mississippi, southeast Louisiana and southwest Alabama. Maintaining a strong core deposit base and providing commercial and real estate lending in our trade area are the traditional focuses of the Company. Growth has largely been achieved through de novo branching activity, and it is expected that these strategies will continue to be emphasized in the future. Net income for the second quarter of 2014 was $335,000 compared with a net loss of $1,147,000 for the second quarter of 2013 and net income for the first half of 2014 was $914,000 as compared with a net loss of $541,000 for the first half of 2013. The improved net earnings was directly related to lower provisions for the allowance for loan losses in 2014. The provision for the allowance for loan losses was $537,000 and $1,074,000 for the second quarter and first half of 2014, respectively, compared with $3,538,000 and $4,077,000, respectively, for the second quarter and first half of 2013. Managing the net interest margin in the Company's highly competitive market and in context of larger economic conditions has been very challenging and will continue to be so for the foreseeable future. The yield on average loans has increased as nonaccrual loans have decreased significantly in 2014 as compared with 2013. The Company extended durations on its investments during 2013 in order to increase yield, which can be seen from the improved yield on average available for sale securities. 30 -------------------------------------------------------------------------------- Monitoring asset quality, estimating potential losses in our loan portfolio and addressing non-performing loans continue to be emphasized during these difficult economic times, as the local and national economy continues to negatively impact collateral values and borrowers' ability to repay their loans. There has been improvement in nonaccrual loans in recent quarters, and the Company is working diligently to continue that trend. The Company's nonaccrual loans totaled $24,908,000 and $26,171,000 at June 30, 2014 and December 31, 2013, respectively. Most of these loans are collateral-dependent, and the Company has rigorously evaluated the value of its collateral to determine potential losses. Non-interest income decreased $131,000 and $35,000 for the three and six months ended June 30, 2014 as compared with 2013 results. Service charges on deposit accounts increased $110,000 for the three months ended June 30, 2014 as compared with 2013, and increased $188,000 for the six months ended June 30, 2014 as compared with 2013. Results for the three and six months ended June 30, 2013 included gains on sales of securities of $255,000, while there were no sales in 2014. Non-interest expense increased $827,000 and $1,166,000 for the three and six months ended June 30, 2014 as compared with 2013 results. This increase for the three months ended June 30, 2014 was the result of increases in salaries and employee benefits of $352,000, equipment rentals, depreciation and maintenance of $95,000, FDIC assessments of $111,000, and ATM expenses of $147,000 as compared with 2013. These increases for the six months ended June 30, 2014 were the result of increases in salaries and employee benefits of $424,000, equipment rentals, depreciation and maintenance of $131,000, FDIC assessments of $95,000, and ATM expenses of $224,000 as compared with 2013.



Total assets at June 30, 2014 decreased $23,104,000 as compared with December 31, 2013. Loans decreased $13,830,000 at June 30, 2014 as compared with December 31, 2013, as principal payments, maturities, charge-offs and foreclosures on existing loans exceeded new loans.

RESULTS OF OPERATIONS

Net Interest Income

Net interest income, the amount by which interest income on loans, investments and other interest earning assets exceeds interest expense on deposits and other borrowed funds, is the single largest component of the Company's income. Management's objective is to provide the largest possible amount of income while balancing interest rate, credit, liquidity and capital risk. Changes in the volume and mix of interest earning assets and interest-bearing liabilities combined with changes in market rates of interest directly affect net interest income. 31



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Quarter Ended June 30, 2014 as Compared with Quarter Ended June 30, 2013

The Company's average interest earning assets decreased approximately $88,688,000, or 12%, from approximately $746,996,000 for the second quarter of 2013 to approximately $658,308,000 for the second quarter of 2014. Average loans decreased as loan demand has been weak in the Company's trade area and the volume of maturities and pay-offs, particularly in the gaming portfolio, have been significant. Federal funds sold also decreased based on the liquidity position of the bank subsidiary. The average yield on earning assets increased by 43 basis points, from 3.18% for the second quarter of 2013 to 3.61% for the second quarter of 2014. The yield on average loans increased from 4.24% in 2013 to 4.57% in 2014 as a result of the reduction in nonaccrual loans. Average nonaccrual loans decreased from approximately $49,668,000 in 2013 to approximately $25,447,000 in 2014. The yield on average taxable available for sale securities increased from 1.61% for the second quarter of 2013 to 2.01% for the second quarter of 2014 as a result of the Company's strategy of extending the duration of new investments. Future security purchases may be of shorter duration in anticipation of rising rates in the future. Average interest bearing liabilities decreased approximately $73,628,000, or 13%, from approximately $588,106,000 for the second quarter of 2013 to approximately $514,478,000 for the second quarter of 2014. Average time deposits decreased primarily as $11,500,000 in brokered deposits matured in August of 2013. Average federal funds purchased and securities sold under agreements to repurchase, which only included non-deposit accounts, decreased $76,021,000 as these customers reallocate their balances periodically. Average borrowings from the Federal Home Loan Bank increased $52,418,000 due to the liquidity needs of the bank subsidiary. The average rate paid on interest bearing liabilities for the second quarter of 2013 and the second quarter of 2014 was the same. The Company believes that it is unlikely that its cost of funds can be materially reduced further; however, any opportunity to do so will be considered. The Company's net interest margin on a tax-equivalent basis, which is net interest income as a percentage of average earning assets, was 3.40% for the quarter ended June 30, 2014, up 43 basis points from 2.97% for the quarter ended June 30, 2013.



Six Months Ended June 30, 2014 as Compared with Six Months Ended June 30, 2013

The Company's average interest earning assets decreased approximately $92,382,000, or 12%, from approximately $756,359,000 for the first half of 2013 to approximately $663,977,000 for the first half of 2014. Average loans decreased as loan demand has been weak in the Company's trade area and the volume of maturities and pay-offs, particularly in the gaming portfolio, have been significant. Federal funds sold also decreased based on the liquidity position of the bank subsidiary. The average yield on earning assets increased by 44 basis points, from 3.17% for the first half of 2013 to 3.61% for the first half of 2014, with the biggest impact to the yield on taxable available for sale securities. The yield on average loans increased from 4.22% for the first half of 2013 to 4.57% 32 -------------------------------------------------------------------------------- for the first half of 2014 as a result of the reduction in nonaccrual loans. Average nonaccrual loans decreased from approximately $51,780,000 in 2013 to approximately $25,540,000 in 2014. The yield on average taxable available for sale securities increased from 1.64% for the first half of 2013 to 2.01% for the first half of 2014 as a result of the Company's strategy of extending the duration of new investments. Future security purchases may be of shorter duration in anticipation of rising rates in the future. Average interest bearing liabilities decreased approximately $80,753,000, or 13%, from approximately $603,625,000 for the first half of 2013 to approximately $522,872,000 for the first half of 2014. Average time deposits decreased primarily as $24,000,000 in brokered deposits matured during 2013. Average federal funds purchased and securities sold under agreements to repurchase, which only included non-deposit accounts, decreased $61,375,000 as these customers reallocate their balances periodically. Average borrowings from the Federal Home Loan Bank increased $42,477,000 due to the liquidity needs of the bank subsidiary. The average rate paid on interest bearing liabilities decreased 3 basis points, from .27% for the first half of 2013 to .24% for the first half of 2014. The Company believes that it is unlikely that its cost of funds can be materially reduced further; however, any opportunity to do so will be considered. The Company's net interest margin on a tax-equivalent basis, which is net interest income as a percentage of average earning assets, was 3.42% for the six months ended June 30, 2014, up 46 basis points from 2.96% for the six months ended June 30, 2013.



The tables on the following pages analyze the changes in tax-equivalent net interest income for the quarters ended June 30, 2014 and 2013 and the six months ended June 30, 2014 and 2013.

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Analysis of Average Balances, Interest Earned/Paid and Yield (In Thousands) Three Months Ended June 30, 2014 Three Months Ended June 30, 2013 Average Balance Interest Earned/Paid Rate Average Balance Interest Earned/Paid Rate Loans (2)(3) $ 364,713 $ 4,165 4.57 % $ 409,527 $ 4,339 4.24 % Federal funds sold 4,135 3 0.29 % 41,747 31 0.30 % HTM: Non taxable (1) 12,665 111 3.51 % 9,368 85 3.63 % AFS: Taxable 238,348 1,197 2.01 % 247,670 996 1.61 % Non taxable (1) 34,495 468 5.43 % 37,383 493 5.28 % Other 3,952 3 0.30 % 1,301 3 0.92 % Total $ 658,308 $ 5,947 3.61 % $ 746,996 $ 5,947 3.18 % Savings & interest-bearing DDA $ 239,772 $ 46 0.08 % $ 252,948 $ 50 0.08 % Time deposits 93,106 228 0.98 % 129,955 265 0.82 % Federal funds purchased 121,352 22 0.07 % 197,373 43 0.09 % FHLB advances 60,248 56 0.37 % 7,830 40 2.04 % Total $ 514,478 $ 352 0.27 % $ 588,106 $ 398 0.27 % Net tax-equivalent spread 3.34 % 2.91 % Net tax-equivalent margin on earning assets 3.40 % 2.97 %



(1) All interest earned is reported on a taxable equivalent basis using a tax

rate of 34% in 2014 and 2013.

(2) Loan fees of $128 and $97 for 2014 and 2013, respectively, are included in

these figures.

(3) Includes nonaccrual loans.

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Analysis of Average Balances, Interest Earned/Paid and Yield (In Thousands) Six Months Ended June 30, 2014 Six Months Ended



June 30, 2013

Average Balance Interest Earned/Paid Rate Average Balance Interest Earned/Paid Rate Loans (2)(3) $ 368,217 $ 8,417 4.57 % $ 416,291 $ 8,778 4.22 % Federal funds sold 5,651 7 0.25 % 48,675 64 0.26 % HTM: Non taxable (1) 12,461 218 3.50 % 8,713 162 3.72 % AFS: Taxable 238,986 2,405 2.01 % 243,546 2,000 1.64 % Non taxable (1) 34,813 940 5.40 % 37,489 983 5.24 % Other 3,849 4 0.21 % 1,645 6 0.73 % Total $ 663,977 $ 11,991 3.61 % $ 756,359 $ 11,993 3.17 % Savings & interest-bearing DDA $ 235,906 $ 88 0.07 % $ 261,564 $ 97 0.07 % Time deposits 96,412 395 0.82 % 132,609 538 0.81 % Federal funds purchased 140,221 49 0.07 % 201,596 89 0.09 % FHLB advances 50,333 106 0.42 % 7,856 81 2.06 % Total $ 522,872 $ 638 0.24 % $ 603,625 $ 805 0.27 % Net tax-equivalent spread 3.37 % 2.90 % Net tax-equivalent margin on earning assets 3.42 % 2.96 %



(1) All interest earned is reported on a taxable equivalent basis using a tax

rate of 34% in 2014 and 2013.

(2) Loan fees of $256 and $246 for 2014 and 2013, respectively, are included in

these figures.

(3) Includes nonaccrual loans.

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Analysis of Changes in Interest Income and Interest Expense (In Thousands) For the Quarter Ended June 30, 2014 compared with June 30, 2013 Volume Rate Rate/Volume Total Interest earned on: Loans $ (475 )$ 336 $ (35 ) $ (174 ) Federal funds sold (28 ) (1 ) 1 (28 )



Held to maturity securities:

Non taxable 30 (3 )



(1 ) 26

Available for sale securities:

Taxable (37 ) 248 (10 ) 201 Non taxable (38 ) 14 (1 ) (25 ) Other 6 (2 ) (4 ) Total $ (542 )$ 592 $ (50 ) $ Interest paid on:



Savings & interest-bearing DDA $ (3 )$ (2 ) $

1 $ (4 ) Time deposits (75 ) 53 (15 ) (37 ) Federal funds purchased (17 ) (7 ) 3 (21 ) FHLB advances 268 (33 ) (219 ) 16 Total $ 173$ 11$ (230 )$ (46 ) 36



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Analysis of Changes in Interest Income and Interest Expense (In Thousands) For the Six Months Ended June 30, 2014 compared with June 30, 2013 Volume Rate Rate/Volume Total Interest earned on: Loans $ (1,014 )$ 737 $ (84 ) $ (361 ) Federal funds sold (57 ) (4 ) 4 (57 ) Held to maturity securities: Non taxable 70 (10 ) (4 ) 56 Available for sale securities: Taxable (37 ) 451 (9 ) 405 Non taxable (70 ) 29 (2 ) (43 ) Other 8 (4 ) (6 ) (2 ) Total $ (1,100 )$ 1,199$ (101 )$ (2 ) Interest paid on: Savings & interest-bearing DDA $ (10 )$ 1 $ $ (9 ) Time deposits (147 ) 5 (1 ) (143 ) Federal funds purchased (27 ) (18 ) 5 (40 ) FHLB advances 438 (64 ) (349 ) 25 Total $ 254$ (76 )$ (345 )$ (167 )



Provision for Loan Losses

In the normal course of business, the Company assumes risk in extending credit to its customers. This credit risk is managed through compliance with the loan policy, which is approved by the Board of Directors. The policy establishes guidelines relating to underwriting standards, including but not limited to financial analysis, collateral valuation, lending limits, pricing considerations and loan grading. The Company's Loan Review and Special Assets Departments play key roles in monitoring the loan portfolio and managing problem loans. New loans and, on a periodic basis, existing loans are reviewed to evaluate compliance with the loan policy. Loan customers in concentrated industries such as gaming and hotel/motel, as well as the exposure for out of area; residential and land development; construction and commercial real estate loans; and their direct and indirect impact on its operations are evaluated on a monthly basis. Loan delinquencies and deposit overdrafts are closely monitored in order to identify developing problems as early as possible. Lenders experienced in workout scenarios consult with loan officers and customers to address non-performing loans. A watch list of credits which pose a potential loss to the Company is prepared based on the loan grading system. This list forms the foundation of the Company's allowance for loan loss computation. 37 -------------------------------------------------------------------------------- Management relies on its guidelines and existing methodology to monitor the performance of its loan portfolio and identify and estimate potential losses based on the best available information. The potential effect resulting from the economic downturn on a national and local level, the decline in real estate values and actual losses incurred by the Company were key factors in our analysis. Much of the Company's loan portfolio is collateral-dependent, requiring careful consideration of changes in the value of the collateral. The Company's on-going, systematic evaluation resulted in the Company recording a provision for loan losses of $537,000 and $3,538,000 for the second quarters of 2014 and 2013, respectively, and $1,074,000 and $4,077,000 for the first half of 2014 and 2013, respectively. The allowance for loan losses as a percentage of loans was 2.61% and 2.38% at June 30, 2014 and December 31, 2013, respectively. The Company's analysis includes evaluating the current values of collateral securing all nonaccrual loans. Even though nonaccrual loans were $24,908,000 and $26,171,000 at June 30, 2014 and December 31, 2013, respectively, specific reserves of only $562,000 and $1,280,000, respectively, have been allocated to these loans as collateral values appear sufficient to cover loan losses or the loan balances have been charged down to their realizable value. The Company believes that its allowance for loan losses is appropriate as of June 30, 2014. The allowance for loan losses is an estimate, and as such, events may occur in the future which may affect its accuracy. The Company anticipates that it is possible that additional information will be gathered in future quarters which may require an adjustment to the allowance for loan losses. Management will continue to closely monitor its portfolio and take such action as it deems appropriate to accurately report its financial condition and results of operations.



Non-interest income

Quarter Ended June 30, 2014 as Compared with Quarter Ended June 30, 2013

Non-interest income decreased $131,000 for the second quarter of 2014 as compared with the second quarter of 2013. Trust department income and fees and service charges on deposit accounts increased in 2014 as compared with 2013. During the second quarter of 2013, the Company realized gains from sales and calls of securities while there were no sales or calls in 2014.



Trust department income and fees increased $21,000 in 2014 as compared with 2013 as a result of the increase in market value, on which fees are based, of personal trust accounts.

Service charges on deposit accounts increased by $110,000 during the second quarter of 2014 as compared with the second quarter of 2013. Fees from service charges increased $36,000 as a result of the Company increasing per account and per transaction fees during the third quarter of 2013 and ATM fee income increased $66,000 as the Company added three new off-site ATMs and per transaction fees increased. 38



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Six Months Ended June 30, 2014 as Compared with Six Months Ended June 30, 2013

Non-interest income decreased $35,000 for the first half of 2014 as compared with the first half of 2013. Trust department income and fees and service charges on deposit accounts increased in 2014 as compared with 2013. During the first half of 2013, the Company realized gains from sales and calls of securities while there were no sales or calls in 2014.



Trust department income and fees increased $23,000 in 2014 as compared with 2013 as a result of the increase in market value, on which fees are based, of personal trust accounts.

Service charges on deposit accounts increased by $188,000 during the first half of 2014 as compared with the first half of 2013. Fees from service charges increased $63,000 as a result of the Company increasing per account and per transaction fees during the third quarter of 2013. NSF fee income decreased $28,000. While NSF fee fluctuations are difficult to predict or analyze, it appears that customers may change their overdraft activity based on general economic conditions. ATM fee income increased $142,000 as the Company added three new off-site ATMs and per transaction fees increased.

Non-interest expense

Quarter Ended June 30, 2014 as Compared with Quarter Ended June 30, 2013

Total non-interest expense increased $827,000 for the second quarter of 2014 as compared with the second quarter of 2013. Salaries and employee benefits increased $352,000; equipment rentals, depreciation and maintenance increased $95,000; FDIC assessments increased $111,000; data processing expenses increased $55,000 and ATM expense increased $147,000 for the second quarter of 2014 as compared with the second quarter of 2013. The increase in salaries and employee benefits was primarily the result of an increase in salaries and increase in costs relating to the deferred compensation plans. Salaries increased $77,000 in the second quarter of 2014 as compared with the second quarter of 2013 due to merit raises. Costs associated with the Company's deferred compensation plans increased $260,000 as a result of a change in the discount rate utilized to compute the related liabilities.



The increase in equipment rentals, depreciation and maintenance expense was primarily the result of servicing costs associated with bank-wide hardware and software conversions during 2014.

FDIC assessment costs in 2013 included a refund of prepaid assessments which results in 2013 expense being lower than 2014 expense.

Data processing costs increased in 2014 as compared with 2013 as result of additional costs associated with bank-wide hardware and software conversions.

ATM expenses increased in 2014 as a result of increased ATM activity in the current year.

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Six Months Ended June 30, 2014 as Compared with Six Months Ended June 30, 2013

Total non-interest expense increased $1,166,000 for the first half of 2014 as compared with the first half of 2013. Salaries and employee benefits increased $424,000; equipment rentals, depreciation and maintenance increased $131,000; FDIC assessments increased $95,000; data processing expenses increased $56,000 and ATM expense increased $224,000 for the first half of 2014 as compared with the first half of 2013. The increase in salaries and employee benefits was primarily the result of an increase in salaries and increase in costs relating to the deferred compensation plans. Salaries increased $134,000 in the first half of 2014 as compared with the first half of 2013 due to merit raises. Costs associated with the Company's deferred compensation plans increased $250,000 as a result of a change in the discount rate utilized to compute the related liabilities.



The increase in equipment rentals, depreciation and maintenance expense was primarily the result of servicing costs associated with bank-wide hardware and software conversions during 2014.

FDIC assessment costs in 2013 included a refund of prepaid assessments which results in 2013 expense being lower than 2014 expense.

Data processing costs increased in 2014 as compared with 2013 as result of additional costs associated with bank-wide hardware and software conversions.

ATM expenses increased in 2014 as a result of increased ATM activity in the current year.

Income Taxes (Benefit)

Income taxes have been impacted by non-taxable income and federal tax credits during the quarters and six months ended June 30, 2014 and 2013, as follows (in thousands except rate): Quarters Ended June 30, 2014 2013 Tax Rate Tax Rate Taxes at statutory rate $ 34 34 $ (676 ) (34 ) Increase (decrease) resulting from: Tax-exempt interest income (130 ) (130 ) (61 ) (3 ) Income from BOLI (43 ) (43 ) (41 ) (2 ) Federal tax credits (74 ) (74 ) (74 ) (4 ) Other (22 ) (22 ) 10 1 Total income taxes (benefit) $ (235 ) (235 ) $ (842 ) (42 ) 40

-------------------------------------------------------------------------------- Six Months Ended June 30, 2014 2013 Tax Rate Tax Rate Taxes at statutory rate $ 201 34 $ (466 ) (34 ) Increase (decrease) resulting from: Tax-exempt interest income (260 ) (44 ) (146 ) (11 ) Income from BOLI (83 ) (14 ) (82 ) (6 ) Federal tax credits (148 ) (25 ) (148 ) (11 ) Other (34 ) (6 ) 11 1 Total income taxes (benefit) $ (324 ) (55 ) $ (831 ) (61 ) FINANCIAL CONDITION



Cash and due from banks decreased $4,274,000 at June 30, 2014, compared with December 31, 2013 in the management of the bank subsidiary's liquidity position.

Loans decreased $13,830,000 at June 30, 2014 compared with December 31, 2013, as principal payments, maturities, charge-offs and foreclosures on existing loans exceeded new loans. Other real estate ("ORE") decreased $706,000 at June 30, 2014 as compared with December 31, 2013. Loans totaling $194,000 were transferred into ORE while $650,000 was sold for a loss of $76,000 and writedowns of ORE to fair value were $174,000 during the first six months of 2014. Other assets decreased $2,183,000 at June 30, 2014 as compared with December 31, 2013 as deferred tax assets decreased $2,350,000 primarily as the increase in fair value of available for sale securities reduced an unrealized loss and other prepaid assets and receivables increased $371,000. Total deposits decreased $4,715,000 at June 30, 2014, as compared with December 31, 2013. Typically, significant increases or decreases in total deposits and/or significant fluctuations among the different types of deposits from quarter to quarter are anticipated by Management as customers in the casino industry and county and municipal entities reallocate their resources periodically.



Federal funds purchased and securities sold under agreements to repurchase decreased $22,269,000 at June 30, 2014 as compared with December 31, 2013 as several county and municipal entities reallocated their balances from a non-deposit account during the first half of 2014.

Employee and director benefit plans liabilities increased $648,000 at June 30, 2014 as compared with December 31, 2013 due to deferred compensation benefits earned by officers and directors during 2014. 41



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SHAREHOLDERS' EQUITY AND CAPITAL ADEQUACY

Strength, security and stability have been the hallmark of the Company since its founding in 1985 and of its bank subsidiary since its founding in 1896. A strong capital foundation is fundamental to the continuing prosperity of the Company and the security of its customers and shareholders. The Company and the Bank are subject to regulatory capital adequacy requirements imposed by the federal banking agencies. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, specific capital guidelines that involve quantitative measures of the bank subsidiary's assets and certain off-balance sheet items, adjusted for credit risk, as calculated under regulatory accounting practices must be met. The risk-based capital standards currently in effect are designed to make regulatory capital requirements more sensitive to differences in risk profiles among bank holding companies and banks and to account for off-balance sheet exposure. Quantitative measures established by regulation to ensure capital adequacy require the Company and Bank to maintain minimum amounts and ratios of Total and Tier 1 capital to risk-weighted assets, and Tier 1 capital to average assets. As of June 30, 2014, the most recent notification from the Federal Deposit Insurance Corporation categorized the bank subsidiary as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, the bank subsidiary must have a Total risk-based capital ratio of 10.00% or greater, a Tier 1 risk-based capital ratio of 6.00% or greater and a Leverage capital ratio of 5.00% or greater. There are no conditions or events since that notification that Management believes have changed the bank subsidiary's category. The actual capital amounts and ratios and required minimum capital amounts and ratios for the Company as of June 30, 2014 and December 31, 2013, are as follows (in thousands): Actual For Capital Adequacy Purposes Amount Ratio Amount Ratio



June 30, 2014: Total Capital (to Risk Weighted Assets) $ 111,330 23.69 % $ 37,600

8.00 %



Tier 1 Capital (to Risk Weighted Assets) 105,411 22.43 %

18,800 4.00 % Tier 1 Capital (to Average Assets) 105,411 14.19 % 29,711 4.00 %



December 31, 2013: Total Capital (to Risk Weighted Assets) $ 111,141 22.79 % $ 39,022

8.00 %



Tier 1 Capital (to Risk Weighted Assets) 105,009 21.54 %

19,511 4.00 % Tier 1 Capital (to Average Assets) 105,009 13.48 % 31,170 4.00 % 42

-------------------------------------------------------------------------------- The actual capital amounts and ratios and required minimum capital amounts and ratios for the Bank as of June 30, 2014 and December 31, 2013, are as follows (in thousands): For Capital Adequacy Acutal Purposes To Be Well Capitalized Amount Ratio Amount Ratio Amount Ratio



June 30, 2014: Total Capital (to Risk Weighted Assets) $ 107,602 22.93 % $ 37,548 8.00 % $ 46,935 10.00 % Tier 1 Capital (to Risk Weighted Assets) 101,691 21.67 % 18,774 4.00 % 28,161

6.00 % Tier 1 Capital (to Average Assets) 101,691 13.71 % 29,677 4.00 % 37,097 5.00 %



December 31, 2013: Total Capital (to Risk Weighted Assets) $ 106,870 21.94 % $ 38,968 8.00 % $ 48,711 10.00 % Tier 1 Capital (to Risk Weighted Assets) 100,746 20.69 % 19,484 4.00 % 29,227

6.00 % Tier 1 Capital (to Average Assets) 100,746 13.02 % 30,958 4.00 % 38,697 5.00 % In addition to monitoring its risk-based capital ratios, the Company also determines the primary capital ratio on a quarterly basis. This ratio was 14.88% at June 30, 2014, which is well above the regulatory minimum of 6.00%. Management continues to emphasize the importance of maintaining the appropriate capital levels of the Company and has established the goal of maintaining its primary capital ratio at 8.00%, which is the minimum requirement for classification as being "well-capitalized" by the banking regulatory authorities.



LIQUIDITY

Liquidity represents the Company's ability to adequately provide funds to satisfy demands from depositors, borrowers and other commitments by either converting assets to cash or accessing new or existing sources of funds. Management monitors these funds requirements in such a manner as to satisfy these demands and provide the maximum earnings on its earning assets. The Company manages and monitors its liquidity position through a number of methods, including through the computation of liquidity risk targets and the preparation of various analyses of its funding sources and utilization of those sources on a monthly basis. The Company also uses proforma liquidity projections which are updated on a monthly basis in the management of its liquidity needs and also conducts periodic contingency testing on its liquidity plan. Deposits, payments of principal and interest on loans, proceeds from maturities of investment securities and earnings on investment securities are the principal sources of funds for the Company. Borrowings from the FHLB, federal funds sold and federal funds purchased are utilized by the Company to manage its daily liquidity position. The Company has also been approved to participate in the Federal Reserve Bank's Discount Window Primary Credit Program, which it intends to use only as a contingency. 43



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REGULATORY MATTERS

During 2009, Management identified opportunities for improving risk management, addressing asset quality concerns, managing concentrations of credit risk and ensuring sufficient liquidity at the Bank as a result of its own investigation as well as examinations performed by certain bank regulatory agencies. In concert with the regulators, the Company and the Bank identified specific corrective steps and actions to enhance its risk management, asset quality and liquidity policies, controls and procedures. The Company and the Bank may not declare or pay any cash dividends without the prior written approval of their regulators.


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Source: Edgar Glimpses


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