News Column

COLONIAL FINANCIAL SERVICES, INC. - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

August 14, 2014

Forward-Looking Statements

This report contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, including statements about anticipated operating and financial performance, such as loan originations, operating efficiencies, loan sales, charge-offs and loan loss provision, growth opportunities, regulatory compliance, interest rates and deposit growth. Words such as "may," "could," "should," "would," "will," "will likely result," "believe," "expect," "plan," "will continue," "is anticipated," "estimate," "intend," "project," and similar expressions are intended to identify these forward-looking statements. We wish to caution readers not to place undue reliance on any such forward-looking statements, each of which speaks only as of the date made. Such statements are subject to certain risks and uncertainties that could cause actual results to differ materially from historical earnings than those presently anticipated or projected.

Our ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Factors which could have a material adverse effect on our operations include, but are not limited to, changes in interest rates, national and regional economic conditions, legislative and regulatory changes, monetary and fiscal policies of the U. S. Government, including policies of the U. S. Treasury and the Federal Reserve Board, the quality and composition of our loan or investment portfolios, demand for our loan products, deposit flows, competitive products and pricing, demand for financial services in our market area, changes in real estate values in our area, and changes in relevant accounting principles and guidelines. Additional factors that could affect our results may be discussed in our Form 10-K for the year ended December 31, 2013 under Part I, Item 1A-"Risk Factors" and in other reports filed with the Securities and Exchange Commission.

Critical Accounting Policies

Critical accounting policies are those that involve significant judgments and assumptions by management and that have, or could have, a material impact on our income or the carrying value of our assets. Our critical accounting policies are those related to our allowance for loan losses, the evaluation of other-than-temporary impairment of investments securities, the valuation of and our ability to realize deferred tax assets and the measurement of fair value.

Allowance for Loan Losses. The allowance for loan losses is calculated with the objective of maintaining an allowance sufficient to absorb estimated probable loan losses inherent in the loan portfolio. Management's determination of the adequacy of the allowance is based on periodic evaluations of the loan portfolio and other relevant factors. However, this evaluation is inherently subjective, as it requires an estimate of the loss for each risk rating and for each impaired loan, an estimate of the amounts and timing of expected future cash flows, and an estimate of the value of collateral.

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We have established a systematic method of periodically reviewing the credit quality of the loan portfolio in order to establish the allowance for loan losses. The allowance for loan losses is based on our current judgments about the credit quality of individual loans and segments of the loan portfolio. The allowance for loan losses is established through a provision for loan losses based on our evaluation of the losses inherent in the loan portfolio, and considers all known internal and external factors that affect loan collectability as of the reporting date.

The allowance for loan losses consists of specific, general and unallocated components. Specific allocations are made for loans that are determined to be impaired. Impairment is measured by determining the present value of expected future cash flows or, for collateral-dependent loans, the fair value of the collateral adjusted for market conditions and selling expenses. The fair value of impaired collateral dependent loans is estimated using an appraisal of the collateral less estimated liquidation expenses or discounted cash flows for non-collateral dependent loans. Those impaired loans not requiring a write-down represent loans for which the fair value of the collateral or expected repayments exceeds the recorded investment in such loans. Impaired loans are charged off to the estimated fair value.

The allowance for losses on loans is determined by segregating the loans by loan category and assigning allowance percentages based on our historical loss experience, delinquency trends and management's evaluation of the collectability of the loan portfolio. The allowance is adjusted for significant factors that, in management's judgment, affect the collectability of the portfolio as of the evaluation date. These significant factors may include changes in our lending policies and procedures, changes in current general economic conditions and business conditions affecting our primary lending areas, credit quality trends, collateral values, loan volumes and concentrations, seasoning of the loan portfolio, loss experience, and duration of the current business cycle. The applied loss factors are re-evaluated each reporting period to ensure their relevance in the current economic environment.

The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio. Future provisions for loan losses may include an unallocated component as we re-evaluate our estimates including, but not limited to changes in economic conditions in our market area, declines in local property values and concentrations of risk. Included in our estimate and evaluation is an analysis of our mortgage loans, both current and delinquent, that may have private mortgage insurance.

Management believes this is a critical accounting policy because this evaluation involves a high degree of complexity and requires us to make subjective judgments that often require assumptions or estimates about various matters. Historically, we believe our estimates and assumptions have proven to be relatively accurate. Nevertheless, because a small number of non-performing loans could result in net charge-offs significantly in excess of the estimated losses inherent in our loan portfolio, additional provisions to the allowance for loan losses may be required that would adversely impact earnings for future periods. In addition, the OCC and the Board of Governors of the Federal Reserve System, as an integral part of their examination processes, periodically review our allowance for loan losses. They may require the recognition of adjustments to the allowance for loan losses based on their judgment of information available to them at the time of their examinations. To the extent that actual outcomes differ from management's estimates, additional provisions to the allowance for loan losses may be required that would adversely impact earnings in future periods.

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Other-Than-Temporary Impairment. Investment securities are evaluated on at least a quarterly basis, to determine whether a decline in their value is other-than-temporary. In estimating other-than-temporary impairment losses, management considers (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) whether or not we intend to sell or expect that it is more likely than not that we will be required to sell the investment security prior to an anticipated recovery in fair value. Once a decline in value for a debt security is determined to be other than temporary, the other-than-temporary impairment is separated into (a) the amount of total other-than-temporary impairment related to a decrease in cash flows expected to be collected from the debt security (the credit loss) and (b) the amount of other-than-temporary impairment related to all other factors. The amount of the total other-than-temporary impairment related to credit loss is recognized in earnings. The amount of other-than-temporary impairment related to other factors is recognized in other comprehensive income (loss). For equity securities, the full amount of the other-than-temporary impairment is recognized in earnings.

Valuation of Deferred Tax Assets. In evaluating our ability to realize deferred tax assets, management considers all positive and negative information, including our past operating results and our forecast of future taxable income. In determining future taxable income, management utilizes a budget process that makes business assumptions and the implementation of feasible and prudent tax planning strategies. These assumptions require us to make judgments about our future taxable income and are consistent with the plans and estimates we use to manage our business. Any reduction in estimated future taxable income may require us to record a valuation allowance against our deferred tax assets which would result in additional income tax expense in the period.

Fair Value Measurements. The fair value of a financial instrument is defined as the amount at which the instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. We estimate the fair value of financial instruments using a variety of valuation methods. Where financial instruments are actively traded and have quoted market prices, quoted market prices are used for fair value. When the financial instruments are not actively traded, other observable market inputs, such as quoted prices of securities with similar characteristics, may be used, if available, to determine fair value. When observable market prices do not exist, we estimate fair value. Other factors such as model assumptions and market dislocations can affect estimates of fair value. Differences in the fair value and carrying value of certain financial instruments (including changes in the differences between the fair value and the carrying value from period to period), such as loans, securities held to maturity, deposits and borrowings do not affect our reported financial condition or results of operations, as such financial instruments are carried at cost.

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Comparison of Financial Condition at June 30, 2014 and December 31, 2013

Total assets decreased $32.5 million, or 5.6%, to $550.7 million at June 30, 2014, from $583.2 million at December 31, 2013. The decrease was mainly the result of decreases in cash and amounts due from banks, investment securities held-to-maturity, and net loans receivable offset by an increase in investment securities available-for-sale.

Net loans receivable decreased $8.5 million, or 3.1%, to $267.7 million at June 30, 2014 from $276.2 million at December 31, 2013. One- to four-family residential real estate loans increased $3.5 million to $153.2 million at June 30, 2014 from $149.7 at December 31, 2013. Commercial real estate loans decreased $11.9 million to $67.7 million at June 30, 2014 from $79.6 million at December 31, 2013. Construction and land loans increased $1.3 million to $10.0 million at June 30, 2014 from $8.7 million at December 31, 2013. Home equity loans and lines of credit decreased $1.0 million to $25.4 million at June 30, 2014 from $26.4 million at December 31, 2013. Commercial loans decreased by $4.5 million to $12.8 million at June 30, 2014 from $17.3 million at December 31, 2013. Included in the net loans receivable are nonaccrual loans which decreased to $12.6 million at June 30, 2014 from $13.6 million at December 31, 2013.

Real estate owned decreased to $3.2 million at June 30, 2014 from $3.3 million at December 31, 2013. We currently hold through the foreclosure process or deed-in-lieu of foreclosure 16 properties, seven of which are residential one- to four-family properties, three of which are nonresidential properties and six of which are construction and land loans. The activity in the real estate owned category includes three previously disclosed possible shovel-ready branch locations in the amount of $2.4 million that were moved from the office property and equipment category in June 2012.

Securities available-for-sale increased $11.4 million, or 5.0%, to $238.5 million at June 30, 2014 from $227.1 at December 31, 2013. This increase was the result of purchases in the amount of $62.9 million and transfers from the held-to-maturity portfolio in the amount of $10.0 million and a market value increase of $4.8 million offset by calls, maturities and sales in the amount of $58.0 million and $8.1 million in principal amortization. Securities held-to-maturity decreased by $17.3 million as the held-to-maturity portfolio was transferred to the available-for-sale portfolio.

Deposits decreased $46.4 million, or 8.9%, to $475.6 million at June 30, 2014 from $522.0 million at December 31, 2013. NOW accounts decreased $10.9 million, or 7.1%, to $141.4 million at June 30, 2014 from $152.3 million at December 31, 2013. Savings accounts decreased $25.0 million to $86.2 million at June 30, 2014 from $111.2 million at December 31, 2013. Super NOW accounts decreased by $5.5 million to $38.2 million at June 30, 2014 from $43.7 million at December 31, 2013. Non-interest bearing demand accounts increased by $7.6 million to $50.3 million at June 30, 2014 from $42.7 million at December 31, 2013. Certificates of deposit decreased by $4.9 million to $103.4 million at June 30, 2014 from $108.2 million at December 31, 2013. We did not aggressively price our certificates of deposit upon maturity, but some certificate of deposit customers remained with us by opening other types of deposit accounts.

Federal Home Loan Bank borrowings totaled $9.8 million at June 30, 2014. There were no Federal Home Loan Bank borrowings outstanding at December 31, 2013.

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Total stockholders' equity increased $3.9 million to $63.1 million at June 30, 2014 from $59.2 million at December 31, 2013. This increase was mainly attributable to net income of $586,000 and an increase in the market value of available for sale securities of $3.2 million.

Comparison of Operating Results for the Three Months Ended June 30, 2014 and June 30, 2013

General. We experienced net income of $553,000 for the three months ended June 30, 2014 compared to a net loss of $980,000 for the three months ended June 30, 2013. The principal reasons for the increase in net income were a decrease in the provision for loan losses in the amount of $2.7 million and a decrease in total non-interest expense of $615,000, offset by a decrease in net interest income of $341,000, a decrease in non-interest income of $486,000 and an increase in income tax expense of $922,000.

Interest Income. Interest income decreased $718,000 to $3.9 million for the three months ended June 30, 2014 from $4.6 million for the three months ended June 30, 2013. The decrease in interest income resulted from a decrease of $372,000 in interest income on loans and a decrease of $346,000 in interest income on securities.

Interest income on loans decreased $372,000 to $3.0 million for the three months ended June 30, 2014 from $3.4 million for the three months ended June 30, 2013. This decrease was caused by a decrease in the average yield on loans to 4.48% for the three months ended June 30, 2014 from 4.58% for the three months ended June 30, 2013 along with a decrease in the average balance of loans of $26.5 million to $269.5 million for the three months ended June 30, 2014 from $296.0 million for the three months ended June 30, 2013.

Interest income on securities decreased by $346,000 to $862,000 for the three months ended June 30, 2014 from $1.2 million for the three months ended June 30, 2013. The decrease in interest income on securities was due to a decrease in the average balance of taxable and tax-exempt securities to $235.5 million for the three months ended June 30, 2014 from $292.2 million for the three months ended June 30, 2013 along with a decrease in the average yield of 19 basis points to 1.46% from 1.65% for the three months ended June 30, 2014 and 2013. The yields on tax-exempt securities are not tax-affected.

Interest Expense. Interest expense decreased $377,000 to $668,000 for the three months ended June 30, 2014 from $1.1 million for the three months ended June 30, 2013.

Interest expense on interest-bearing deposits decreased by $367,000 to $666,000 for the three months ended June 30, 2014 from $1.1 million for the three months ended June 30, 2013. The decrease in interest expense on interest-bearing deposits was due to a decrease in the average rate paid on interest-bearing deposits to 0.60% for the three months ended June 30, 2014 from 0.82% for the three months ended June 30, 2013, and a decrease in the average balance of interest-bearing deposits to $442.6 million for the three months ended June 30, 2014 from $506.7 million for the three months ended June 30, 2013. We experienced decreases in the average cost across all categories of interest-bearing deposits for the three months ended June 30, 2014, reflecting lower market rates.

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Interest expense on borrowings decreased $10,000 to $2,000 for the three months ended June 30, 2014 from $12,000 for the three months ended June 30, 2013. This decrease was primarily due to a $10.2 million decrease in the average balance of borrowings to $2.5 million for the three months ended June 30, 2014 from $12.7 million for the three months ended June 30, 2013 offset by an increase in the average rate paid on borrowings to 0.38% for the three months ended June 30, 2014 from 0.37% for the three months ended June 30, 2013.

Provision for Loan Losses. We establish provisions for loan losses, which are charged to operations in order to maintain the allowance for loan losses at a level we consider necessary to absorb probable credit losses inherent in the loan portfolio. In determining the level of the allowance for loan losses, we consider past and current loss experience, evaluation of real estate collateral, current economic conditions, volume and type of lending, adverse situations that may affect a borrower's ability to repay a loan and the levels of nonperforming and other classified loans. The amount of the allowance is based on estimates and the ultimate losses may vary from such estimates as more information becomes available or later events change. We assess the allowance for loan losses on a quarterly basis and make provisions for loan losses in order to maintain the allowance.

In March 2013, in an effort to enhance the allowance for loan loss methodology, the Bank instituted a migration analysis process in determining the allowance. Migration analysis uses loan level attributes to track the movement of loans through the various loan classifications in order to estimate the percentage of losses likely to be incurred in a financial institution's current portfolio. The purpose of migration analysis is to determine what rate of loss an institution has incurred on similarly criticized or past due loans. This purpose is the same as that of historical loss rate analysis, but it is more granular and therefore can give a truer reflection of the losses inherent in the current portfolio.

During the three months ended June 30, 2014, the Company charged off $1.2 million in loans, which included $91,000 on one- to four-family real estate loans, $26,000 on commercial real estate loans, $82,000 on home equity and lines of credit, and $990,000 on commercial loans. As part of the Bank's loan collection process, we re-appraise loans that are 90 days delinquent or impaired. The reasons for the charge-offs in the three months ended June 30, 2014 were the cash flow analysis that we completed on non-collateral based impaired loans and the reduced appraisals that we received on collateral-based impaired loans we were monitoring. The charge-offs during this quarter are included in our risk-weighted historical loss rates based on the nature, type and industry sector of the loan. The historical loan rates are then incorporated in calculating the general component of our allowance for loan loss by loan category.

During the three months ended June 30, 2013, the Company charged off $2.2 million in loans, which included $159,000 on one- to four-family real estate loans, $947,000 on commercial real estate loans, $57,000 on home equity and lines of credit, $1.0 million on commercial loans, and $3,000 on consumer loans. As part of the Bank's loan collection process, we re-appraise loans that are delinquent or impaired. The reason for the charge-offs in the three months ended June 30, 2013 were partially due to the reduced appraisals that we received on the impaired loans we were monitoring. The charge-offs during this quarter are included in our risk-weighted historical loss rates based on the nature, type and industry sector of the loan. The historical loan rates are then incorporated in calculating the general component of our allowance for loan loss by loan category.

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Based on our evaluation of the above factors, we did not record a provision for loan losses for the three months ended June 30, 2014 and we recorded a provision for loan losses of $2.7 million for the three months ended June 30, 2013. The allowance for loan losses was $5.1 million, or 1.85% of total loans, at June 30, 2014, compared to $4.6 million, or 1.54% of total loans, at June 30, 2013. Our balance of loans we evaluated individually for impairment was $20.7 million at June 30, 2014 and $25.3 million at December 31, 2013. At June 30, 2014, December 31, 2013 and June 30, 2013, we maintained unallocated allowances for loan losses of $1.8 million, $750,000 and $1.5 million respectively. The main reason for the increase in the unallocated portion of the allowance for loan losses is the amount of recoveries we received on loans that were previously charged off against earnings. The unallocated portion of the allowance is deemed to be appropriate as it reflects an uncertainty that remains in the loan portfolio, as well as a Company-specific, industry-wide reluctance and a regulatory reluctance to reduce allowances at this time. The Company believes that the amount of provision in 2014 and the resulting allowance at June 30, 2014, are appropriate given the continuing level of risk in the loan portfolio, including the overall level of non-performing loans.

To the best of our knowledge, we have recorded all losses that are both probable and reasonable to estimate at June 30, 2014 and 2013. However, future changes in the factors described above, including, but not limited to, actual loss experience with respect to our loan portfolio (including residential and commercial real estate loans) could result in material increases in our provisions for loan losses.

Non-interest Income. Non-interest income was $900,000 for the three months ended June 30, 2014 and $1.4 million for the three months ended June 30, 2013. For the three months ended June 30, 2014, there was a net gain on the sale and call of investment securities in the amount of $492,000 compared to a net gain of $1.0 million for the three months ended June 30, 2013. For the three months ended June 30, 2014, there were $47.8 million in available-for-sale securities sold and for the three months ended June 30, 2013, there were $25.1 million in available-for-sale securities sold. Fees and service charges on deposit accounts increased by $42,000 to $295,000 for the three months ended June 30, 2014 from $253,000 for the three months ended June 30, 2013. Earnings on bank owned life insurance totaled $106,000 for the three months ended June 30, 2014 and $111,000 for the three months ended June 30, 2013.

Non-interest Expense. Non-interest expense decreased $615,000 to $3.2 million for the three months ended June 30, 2014 from $3.9 million for the three months ended June 30, 2013. Compensation and benefits expense decreased by $199,000 to $1.4 million for the three months ended June 30, 2014 compared to $1.6 million for the three months ended June 30, 2013. The decrease in compensation and benefit expense was due to the elimination of director fees for the three months ended June 30, 2014 as the director's suspended payment of their fees. The decline was also due to reduced employee hours as branch staffing was matched to customer activity for the three months ended June 30, 2014, as compared to the three months ended June 30, 2013, and reduced ESOP and stock-based compensation expense. Occupancy and equipment expense increased $9,000 to $389,000 for the three months ended June 30, 2014 from $380,000 for the three months ended June 30, 2013. Federal deposit insurance premiums decreased $17,000 to $175,000 for the three months ended June 30, 2014 from $192,000 for the three months ended June 30, 2013. The decrease in federal deposit insurance premiums was due to reduced deposit balances. Data processing fees increased by $21,000 to $269,000 for the three months ended June 30, 2014 from $248,000 for the three months ended June 30, 2013. Professional fees decreased $113,000 due to decreased costs associated with loan collection, regulatory consulting and strategic planning services. Net real estate owned expense decreased $247,000 to $300,000 for the three months ended June 30, 2014 from $547,000 for the three months ended June 30, 2013. This decrease was due to reduced write-downs on REO properties and reduced REO expenses offset by a loss in the amount of $71,000 on real estate owned sold for the three months ended June 30, 2014 compared to a gain in the amount of $21,000 on real estate owned sold for the three months ended June 30, 2013.

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Income Tax Expense/Benefit. We recorded income tax expense of $326,000 for the three months ended June 30, 2014, compared to an income tax benefit of $596,000 for the three months ended June 30, 2013. The effective tax rates for the three months ended June 30, 2014 and 2013 were 37.0% and (37.8%), respectively.

Comparison of Operating Results for the Six Months Ended June 30, 2014 and June 30, 2013

General. We experienced net income of $586,000 for the six months ended June 30, 2014 compared to a net loss of $483,000 for the six months ended June 30, 2013. The principal reasons for the increase in net income were a decrease in the provision for loan losses in the amount of $2.1 million and a decrease in total non-interest expense of $744,000 offset by a decrease in net interest income of $553,000, a decrease in total non-interest income of $603,000 and an increase in income tax expense of $680,000.

Interest Income. Interest income decreased $1.3 million to $8.0 million for the six months ended June 30, 2014 from $9.3 million for the six months ended June 30, 2013. The decrease in interest income resulted from a decrease of $871,000 in interest income on loans and a decrease of $450,000 in interest income on securities.

Interest income on loans decreased $871,000 to $6.1 million for the six months ended June 30, 2014 from $7.0 million for the six months ended June 30, 2013. The average balance of loans decreased $24.2 million to $271.8 million for the six months ended June 30, 2014 from $296.0 million for the six months ended June 30, 2013 along with a decrease in the average yield to 4.49% for the six months ended June 30, 2014 from 4.72% for the six months ended June 30, 2013.

Interest income on securities decreased by $450,000 to $1.9 million for the six months ended June 30, 2014 from $2.3 million for the six months ended June 30, 2013. The decrease in interest income on securities was due to a decrease in the average yield on taxable and tax-exempt securities of 10 basis points to 1.57% for the six months ended June 30, 2014 from 1.67% for the six months ended June 30, 2013 along with a decrease in the average balance of taxable and tax-exempt securities to $239.5 million for the six months ended June 30, 2014 from $279.9 million for the six months ended June 30, 2013. The yields on tax-exempt securities are not tax-affected.

Interest Expense. Interest expense decreased $768,000 to $1.4 million for the six months ended June 30, 2014 from $2.1 million for the six months ended June 30, 2013.

Interest expense on interest-bearing deposits decreased by $764,000 to $1.3 million for the six months ended June 30, 2014 from $2.1 million for the six months ended June 30, 2013. The decrease in interest expense on interest-bearing deposits was due to a decrease in the average rate paid on interest-bearing deposits to 0.60% for the six months ended June 30, 2014 from 0.83% for the six months ended June 30, 2013 along with a decrease in the average balance of interest-bearing deposits to $447.5 million for the six months ended June 30, 2014 from $511.1 million for the six months ended June 30, 2013. We experienced decreases in the average balances of savings accounts and certificates of deposit and increases in NOW and Super-NOW and money market accounts. We experienced decreases in the average cost across all categories of interest-bearing deposits for the six months ended June 30, 2014 compared to the six months ended June 30, 2013.

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Interest expense on borrowings decreased $4,000 to $8,000 for the six months ended June 30, 2014 from $12,000 for the six months ended June 30, 2013. This decrease was primarily due to a $2.3 million decrease in the average balance of borrowings to $4.3 million for the six months ended June 30, 2014 from $6.5 million for the six months ended June 30, 2013, offset by an increase in the average rate paid on borrowings to 0.38% for the six months ended June 30, 2014 from .37% for the six months ended June 30, 2013.

Provision for Loan Losses. We establish provisions for loan losses, which are charged to operations in order to maintain the allowance for loan losses at a level we consider necessary to absorb probable credit losses inherent in the loan portfolio. In determining the level of the allowance for loan losses, we consider past and current loss experience, evaluation of real estate collateral, current economic conditions, volume and type of lending, adverse situations that may affect a borrower's ability to repay a loan and the levels of nonperforming and other classified loans. The amount of the allowance is based on estimates and the ultimate losses may vary from such estimates as more information becomes available or later events change. We assess the allowance for loan losses on a quarterly basis and make provisions for loan losses in order to maintain the allowance.

In March 2013, in an effort to enhance the allowance for loan loss methodology, the Bank instituted a migration analysis process in determining the allowance. Migration analysis uses loan level attributes to track the movement of loans through the various loan classifications in order to estimate the percentage of losses likely to be incurred in a financial institution's current portfolio. The purpose of migration analysis is to determine what rate of loss an institution has incurred on similarly criticized or past due loans. This purpose is the same as that of historical loss rate analysis, but it is more granular and therefore can give a truer reflection of the losses inherent in the current portfolio.

During the six months ended June 30, 2014, the Company charged off $2.8 million in loans, which included $191,000 on one- to four-family loans, $145,000 on commercial real estate loans, $76,000 on construction and land loans, $100,000 on home equity and lines of credit and $2.3 million on commercial loans. As part of the Bank's loan collection process, we re-appraise loans that are delinquent or impaired. The reasons for the charge-offs in the six months ended June 30, 2014 were the cash flow analysis that we completed on non-collateral based impaired loans and the reduced appraisals that we received on collateral-based impaired loans we were monitoring. The charge-offs during this period are included in our risk-weighted historical loss rates based on the nature, type and industry sector of the loan. The historical loan rates are then incorporated in calculating the general component of our allowance for loan loss by loan category.

During the six months ended June 30, 2013, the Company charged off $2.3 million in loans, which included $159,000 on one- to four-family loans, $947,000 on commercial real estate loans, $37,000 on construction and land loans, $150,000 on home equity and lines of credit, $1.0 million on commercial loans, and $7,000 on consumer loans. As part of the Bank's loan collection process, we re-appraise loans that are delinquent or impaired. The reason for the charge-offs in the six months ended June 30, 2013 were the reduced appraisals that we received on impaired loans we were monitoring. The charge-offs during this period are included in our risk-weighted historical loss rates based on the nature, type and industry sector of the loan. The historical loan rates are then incorporated in calculating the general component of our allowance for loan loss by loan category.

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Based on our evaluation of the above factors, we recorded a provision for loan losses of $548,000 for the six months ended June 30, 2014 and a provision for loan losses of $2.7 million for the six months ended June 30, 2013. The allowance for loan losses was $5.1 million, or 1.85% of total loans, at June 30, 2014, compared to $4.6 million, or 1.54% of total loans, at June 30, 2013. Our balance of loans we evaluated individually for impairment was $20.7 million at June 30, 2014 and $25.3 million at December 31, 2013. At June 30, 2014, December 31, 2013 and June 30, 2013, we maintained unallocated allowances for loan losses of $1.8 million, $750,000 and $1.5 million respectively. The main reason for the increase in the unallocated portion of the allowance for loan losses is the amount of recoveries we received on loans that were previously charged off against earnings. The unallocated portion of the allowance is deemed to be appropriate as it reflects an uncertainty that remains in the loan portfolio, as well as a Company-specific, industry-wide reluctance and a regulatory reluctance to reduce allowances at this time. The Company believes that the amount of provision in 2014 and the resulting allowance at June 30, 2014, are appropriate given the continuing level of risk in the loan portfolio, including the overall level of non-performing loans.

To the best of our knowledge, we have recorded all losses that are both probable and reasonable to estimate at June 30, 2014 and 2013. However, future changes in the factors described above, including, but not limited to, actual loss experience with respect to our loan portfolio (including residential and commercial real estate loans) could result in material increases in our provisions for loan losses.

Non-interest Income. Non-interest income was $1.3 million for the six months ended June 30, 2014 and $1.9 million for the six months ended June 30, 2013. Fees and service charges on deposit accounts decreased by $34,000 to $567,000 for the six months ended June 30, 2014 from $601,000 for the six months ended June 30, 2013. For the six months ended June 30, 2014, there was a net gain on the sale and call of investment securities in the amount of $496,000 compared to a net gain of $1.1 million for the six months ended June 30, 2013. Earnings on bank owned life insurance totaled $211,000 for the six months ended June 30, 2014 and $218,000 for the six months ended June 30, 2013.

Non-interest Expense. Non-interest expense decreased $744,000 to $6.5 million for the six months ended June 30, 2014 from $7.3 million for the six months ended June 30, 2013. Compensation and benefits expense decreased by $489,000 to $2.9 million for the six months ended June 30, 2014 from $3.4 million for the six months ended June 30, 2013. The decrease in compensation and benefit expense was due to the elimination of director fees for the six months ended June 30, 2014 as the director's suspended payment of their fees. The decline was also due to reduced employee hours as branch staffing was matched to customer activity for the six months ended June 30, 2014, as compared to the six months ended June 30, 2013, and reduced ESOP and stock-based compensation expense. Occupancy and equipment expense increased $58,000 to $844,000 for the six months ended June 30, 2014 from $786,000 for the six months ended June 30, 2013. Federal deposit insurance premiums increased $40,000 to $363,000 for the six months ended June 30, 2014 from $323,000 for the six months ended June 30, 2013 due to increased premiums. Data processing fees increased by $31,000 to $516,000 for the six months ended June 30, 2014 from $485,000 for the six months ended June 30, 2013. This increase was due to costs associated with item processing. Professional fees increased $12,000 to $651,000 for the six months ended June 30, 2014 from $639,000 for the six months ended June 30, 2013. Net real estate owned expense decreased $210,000 to $550,000 for the six months ended June 30, 2014 from $760,000 for the six months ended June 30, 2013 due to reduced allowances for REO properties and reduced REO expenses.

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Income Tax Benefit. We recorded an income tax expense of $263,000 for the six months ended June 30, 2014, compared to an income tax benefit of $417,000 for the six months ended June 30, 2013. The effective tax rates are 31.0% and (46.3%), respectively.

Liquidity and Capital Resources

Liquidity is the ability to meet current and future financial obligations of a short-term nature. Our primary sources of funds consist of deposit inflows, loan repayments and maturities and sales of securities. While maturities and scheduled amortization of loans and securities are predictable sources of funds, deposit flows and mortgage prepayments are greatly influenced by general interest rates, economic conditions and competition.

We regularly adjust our investments in liquid assets based upon our assessment of expected loan demand, expected deposit flows, yields available on interest-earning deposits and securities, and the objectives of our asset/liability management program. Excess liquid assets are invested generally in interest-earning deposits and short- and intermediate-term securities.

Our most liquid assets are cash and cash equivalents. The levels of these assets are dependent on our operating, financing, lending and investing activities during any given period. At June 30, 2014, cash and cash equivalents totaled $7.0 million. Securities classified as available-for-sale, which provide additional sources of liquidity, totaled $238.5 million at June 30, 2014. In addition, at June 30, 2014, we had the ability to borrow a total of $165.2 million from the Federal Home Loan Bank of New York (30% of our assets at that date). On that date, there were $9.8 million in Federal Home Loan Bank advances outstanding.

At June 30, 2014, loan commitments outstanding totaled $10.0 million. In addition to commitments to originate loans, we had $21.2 million in unadvanced funds to borrowers. Total certificates of deposit due within one year of June 30, 2014 totaled $53.8 million. Total certificates of deposit due within one year of June 30, 2014 represent 11.3% of total deposits. If these deposits do not remain with us, we will be required to seek other sources of funds, including other certificates of deposit and Federal Home Loan Bank advances. Depending on market conditions, we may be required to pay higher rates on such deposits or other borrowings than we currently pay on the certificates of deposit due on or before June 30, 2015. We have the ability to attract and retain deposits by adjusting the interest rates offered.

We have no material commitments or demands that are likely to affect our liquidity other than set forth above. In the event loan demand were to increase at a pace greater than expected, or any unforeseen demand or commitment were to occur, we could access our borrowing capacity with the Federal Home Loan Bank of New York or increase deposit rates to attract additional deposits.

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Our primary investing activities are the origination of loans and the purchase of securities. For the six months ended June 30, 2014, we originated $28.4 million of loans and purchased $62.9 million of securities. For the six months ended June 30, 2013, we originated $30.1 million of loans and purchased $112.0 million of securities.

Financing activities consist primarily of activity in deposit accounts and Federal Home Loan Bank advances. We experienced a net decrease of $46.5 million and a net decrease of $26.5 million in total deposits for the six months ended June 30, 2014 and 2013, respectively. Deposit flows are affected by the overall level of interest rates, the interest rates and products offered by us and our local competitors and other factors. We generally manage the pricing of our deposits to be competitive in our local markets.

There were $9.8 million in Federal Home Loan Bank short-term borrowings outstanding at June 30, 2014. Federal Home Loan Bank advances have primarily been used to fund loan demand and purchase securities.

Colonial Bank, FSB is subject to various regulatory capital requirements administered by the Office of Comptroller of the Currency, including a risk-based capital measure. The risk-based capital guidelines include both a definition of capital and a framework for calculating risk-weighted assets by assigning balance sheet assets and off-balance sheet items to broad risk categories. Please see Note 11, Regulatory Matters and Capital Requirements, for minimal capital requirements imposed on the Bank by the Office of Comptroller of the Currency.

In July 2013, the Office of the Comptroller of the Currency and the other federal bank regulatory agencies issued a final rule that will revise their leverage and risk-based capital requirements and the method for calculating risk-weighted assets to make them consistent with agreements that were reached by the Basel Committee on Banking Supervision and certain provisions of the Dodd-Frank Act. Among other things, the rule establishes a new common equity Tier 1 minimum capital requirement (4.5% of risk-weighted assets), increases the minimum Tier 1 capital to risk-based assets requirement (from 4% to 6% of risk-weighted assets) and assigns a higher risk weight (150%) to exposures that are more than 90 days past due or are on nonaccrual status and to certain commercial real estate facilities that finance the acquisition, development or construction of real property. The final rule also requires unrealized gains and losses on certain "available-for-sale" securities holdings to be included for purposes of calculating regulatory capital requirements unless a one-time opt-in or opt-out is exercised. The rule limits a banking organization's capital distributions and certain discretionary bonus payments if the banking organization does not hold a "capital conservation buffer" consisting of 2.5% of common equity Tier 1 capital to risk-weighted assets in addition to the amount necessary to meet its minimum risk-based capital requirements.

The final rule becomes effective for Colonial Bank FSB on January 1, 2015. The capital conservation buffer requirement will be phased in beginning January 1, 2016 and ending January 1, 2019, when the full capital conservation buffer requirement will be effective. The final rule also implements consolidated capital requirements for savings and loan holding companies, such as Colonial Financial Services, Inc., effective January 1, 2015.

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Source: Edgar Glimpses


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