News Column

DCB FINANCIAL CORP - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

August 14, 2014

Introduction

DCB Financial Corp (the "Company" or "DCB") is a financial holding company formed under the laws of the State of Ohio. The Company is the parent of The Delaware County Bank & Trust Company (the "Bank"), DCB Title Services LLC and DCB Insurance Services, Inc. The Bank is a state-chartered commercial bank, which conducts business from its main offices at 110 Riverbend Avenue in Lewis Center, Ohio, and through its 13 branch offices located in Delaware County, Ohio and surrounding communities. The Bank provides customary retail and commercial banking services to its customers, including checking and savings accounts, time deposits, IRAs, safe deposit facilities, personal loans, commercial loans, commercial leases, real estate mortgage loans, night depository facilities and trust and personalized wealth management services. The Bank also provides cash management, bond registrar and payment services. The Bank operates a wholly-owned subsidiary, ORECO, Inc., which is engaged in the ownership and disposition of the Bank's foreclosed real estate. Forward-Looking Statements Certain statements in this report constitute "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995, such as statements relating to the financial condition and prospects, lending risks, plans for future business development and marketing activities, capital spending and financing sources, capital structure, the effects of regulation and competition, and the prospective business of both the Company and the Bank. Where used in this report, the words "anticipate," "believe," "estimate," "expect," "intend," and similar words and expressions, related to the Company or the Bank or their respective management, identify forward-looking statements. Such forward-looking statements reflect the current views of the Company and are based on information currently available to the management of the Company and the Bank and upon current expectations, estimates, and projections about the Company and its industry, management's belief with respect thereto, and certain assumptions made by management. These forward-looking statements are not guarantees of future performance and are subject to risks, uncertainties, and other factors that could cause actual results to differ materially from those expressed or implied by such forward-looking statements. Potential risks and uncertainties include, but are not limited to: (i) significant increases in competitive pressure in the banking and financial services industries; (ii) changes in the interest rate environment which could reduce anticipated or actual margins; (iii) changes in political conditions or the legislative or regulatory environment; (iv) general economic conditions, either nationally or regionally (especially in central Ohio), becoming less favorable than expected resulting in, among other things, a deterioration in credit quality of assets; (v) changes occurring in business conditions and inflation; (vi) changes in technology; (vii) changes in monetary and tax policies; (viii) changes in the securities markets; and (ix) other risks and uncertainties detailed from time to time in the filings of the Company with the Securities and Exchange Commission. The Company does not undertake, and specifically disclaims any obligation, to publicly revise any forward-looking statements to reflect events or circumstances after the date of such statements or to reflect the occurrence of anticipated or unanticipated events. 29.



Overview of the second quarter of 2014

Total assets were $500.5 million and total deposits were $436.1 million at June

30, 2014, compared with $502.4 million and $449.4 million (including deposits

held-for-sale) at December 31, 2013, respectively.



Net income was $37,000 for the three months ended June 30, 2014, compared with

$156,000 for the same period in 2013. For the six months ended June 30, 2014,

net income was $156,000 compared with $298,000 for the first half of 2013.

Net income per diluted share was $0.01 and $0.02 for the three months ending

June 30, 2014 and 2013, respectively. Net income per diluted share was $0.02

for the six months ending June 30, 2014 compared with $0.04 per share for the

same period in 2013.



The net interest margin was 3.51% in the second quarter of 2014 compared with

3.29% in the year-ago quarter and 3.50% in the first quarter of 2014.



Non-recurring gains and losses in the second quarter of 2014 aggregated

$118,000 of net losses, compared to net non-recurring gains, negative provision

for loan losses and income tax benefit aggregating $631,000 in the year-ago

quarter. There was no loan loss provision or income tax benefit in the second

quarter of 2014.



Non-recurring gains and losses in the first half of 2014 aggregated $63,000 of

net losses, compared to net non-recurring gains, negative provision for loan

losses and income tax benefit aggregating $1.4 million in the prior year. There

was no loan loss provision or income tax benefit in the first half of 2014.

Total non-performing assets (including TDR's) were $15.3 million or 3.06% of

total assets at June 30, 2014, compared to $17.7 million or 3.59% at March 31,

2014 and $21.9 million or 4.36% at December 31, 2013.



Total non-performing assets (excluding TDR's) were $6.0 million or 1.20% of

total assets at June 30, 2014, compared to $5.2 million or 1.05% at March 31,

2014 and $9.1 million or 1.81% at December 31, 2013.



Non-interest income was 21.9% and 22.1%, respectively, of total revenue in the

three and six months ended June 30, 2014, compared to 24.5% and 24.9%,

respectively, in the year-ago periods.

Our efficiency ratio was 96.6% and 109.5%, respectively, in the three and six

months ended June 30, 2014, compared to 97.6% and 110.9%, respectively, in the

year-ago periods.



Comparison of Results of Operations

General

Net income was $37,000 or $0.01 per diluted share for the three months ended June 30, 2014, compared to net income of $156,000 or $0.02 per diluted share for the same period in 2013. Non-recurring gains and losses in the second quarter of 2014 aggregated $118,000 of net losses, compared to net non-recurring gains, negative provision for loan losses, and income tax benefit of $631,000 in the year-ago quarter. There was no loan loss provision in the second quarter of 2014. Net income was $156,000 or $0.02 per diluted share for the six months ended June 30, 2014, compared to net income of $298,000 or $0.04 per diluted share for the same period in 2013. Non-recurring gains and losses in the first half of 2014 aggregated $63,000 of net losses, compared to net non-recurring gains, negative provision for loan losses, and income tax benefit of $1.4 million in the prior year. There was no loan loss provision in the first half of 2014. 30. Net Interest Income

Net interest income totaled $4.0 million in the three months ended June 30, 2014, compared with $3.8 million in the year-ago quarter and $4.0 million in the first quarter of 2014. Average interest-earning assets decreased $3.3 million in the second quarter compared to the year-ago quarter, and were $12.9 million lower than the first quarter of 2014, due primarily to the effect on average assets, net of organic loan growth over the last four quarters, of the sale of the Company's Marysville branch in the first quarter of 2014, and to payoffs of two large commercial relationships totaling $5.7 million late in the first quarter of 2014. The net interest margin increased 22 basis points in the second quarter compared with the year-ago quarter and was 1 basis point higher than the first quarter of 2014. The net interest margin was 3.51% in the second quarter of 2014, compared with 3.29% in the year-ago quarter and 3.50% in the first quarter of 2014. The earning assets yield increased 2 basis points in the second quarter of 2014 compared with the year-ago quarter, due largely to growth in our loan portfolio which was funded primarily from cash on deposit with the Federal Reserve and cash flows from our securities portfolio. The cost of interest-bearing liabilities decreased 19 basis points over the same period as a result of maturing time accounts which either were renewed at lower rates or were transferred into our interest-bearing demand and money market accounts, which earn interest at lower rates than time accounts. Also, we restructured advances from the Federal Home Loan Bank in November, 2013 which contributed to a 176 basis point decrease in the cost of borrowings in the second quarter compared to the year-ago quarter.

Average interest-earning assets were $453.4 million in the second quarter, compared with $456.7 million in the year-ago quarter and $466.4 million in the first quarter of 2014. The average balance of loans increased by $27.9 million, while average balance of interest earning cash and cash equivalents decreased $22.7 million and average investments decreased $8.5 million when compared with the year-ago quarter, as we used our excess liquidity position to fund organic loan growth. Total average loans were 78.7% of total average interest-earning assets in the second quarter of 2014, compared with 72.0% in the year-ago quarter and 77.1% in the first quarter of 2014. The average balance of time deposits declined $43.3 million in the second quarter compared with the year-ago quarter, while average balances in lower-costing interest-bearing demand, savings and money market accounts increased $21.2 million, and the average balance of non-interest-bearing demand accounts increased $15.7 million over that same period.

Net interest income totaled $8.0 million in the first half 2014, which was an increase of $585,000 or 7.9% compared with $7.4 million in the year-ago period. The net interest margin was 3.48% for the six months ended June 30, 2014, compared with 3.29% in the year-ago period. The earning asset yield was unchanged in the first half of 2014 compared with the year-ago period, and the cost of interest-bearing liabilities decreased 21 basis points over the same period. Average interest-earning assets were $460.4 million in the first half of 2014, which was an increase of $6.2 million or 1.4% from the first half of 2013. Total average loans were 77.8% of total interest-earning assets in the six months ended June 30, 2014, compared with 70.5% in the first half of 2013. The average balance in time deposits decreased $45.7 million in the first half of 2014 compared with the year-ago period, while the average balances in lower-costing interest-bearing demand, savings and money market accounts increased $28.1 million, and the average balance of non-interest-bearing demand accounts increased $16.7 million. 31.

The following table presents certain information from the Company's average balance sheet and reflects the average yield on interest-earning assets and the average cost of interest-bearing liabilities (dollars in thousands). Such yields and costs are derived by dividing income or expense by the average balance of interest-earning assets or interest-bearing liabilities. Average balances are derived from daily balances. Interest on tax-exempt securities is reported on a historical basis without tax-equivalent adjustment. Average loan balances include non-accruing loans and loans held for sale. Loan income includes cash received on non-accruing loans. Three months ending June 30, 2014 2013 Outstanding Earned/ Yield/ Outstanding Earned/ Yield/ balance paid rate balance paid rate Interest-earning assets: Federal funds sold and other short term $ 13,566$ 9 0.28 % $ 36,271$ 21 0.24 % Taxable securities 78,587 490 2.50 86,884 442 2.04 Tax-exempt securities 4,603 44 3.84 4,804 47 3.92 Loans 356,678 3,719 4.15 328,769 3,735 4.56 Total interest-earning assets 453,434 4,262 3.75



456,728 4,245 3.73

Non-interest-earning assets 40,778

48,182 Total assets $ 494,212$ 504,910 Interest-bearing liabilities: Interest-bearing demand and money market deposits $ 206,925$ 139 0.27 % $ 188,114$ 123 0.26 % Savings deposits 42,720 16 0.15 40,344 15 0.15 Certificates of deposit 81,415 108 0.53

124,760 284 0.91 Total deposits 331,060 263 0.32 353,218 422 0.48 Borrowed funds 4,894 36 2.94 6,145 72 4.70 Total interest-bearing liabilities 335,954 299 0.36 359,363 494 0.55 Non-interest-bearing liabilities 112,529 96,349 Total liabilities 448,483 455,712 Shareholders' equity 45,729 49,198 Total liabilities and shareholders' equity $ 494,212$ 504,910 Net interest income; interest rate spread $ 3,963 3.39 % $ 3,751 3.18 % Net interest margin (net interest income as a percent of average interest-earning assets) 3.51 % 3.29 % Average interest-earning assets to average interest-bearing liabilities 135 % 127 % 32. Six months ending June 30, 2014 2013 Outstanding Earned/ Yield/ Outstanding Earned/ Yield/ balance paid rate balance paid rate Interest-earning assets: Federal funds sold and other short term $ 17,635$ 23 0.26 % $ 42,163$ 50 0.24 % Taxable securities 79,827 998 2.56 87,366 962 2.22 Tax-exempt securities 4,707 90 3.87 4,599 93 4.08 Loans 358,252 7,456 4.17 320,086 7,286 4.59 Total interest-earning assets 460,421 8,567 3.73



454,214 8,391 3.73

Non-interest-earning assets 40,828

50,581 Total assets $ 501,249$ 504,795 Interest-bearing liabilities: Interest-bearing demand and money market deposits $ 209,007$ 275 0.27 % $ 184,887$ 236 0.26 % Savings deposits 43,118 31 0.14 39,153 29 0.15 Certificates of deposit 83,797 237 0.57

129,522 608 0.95 Total deposits 335,922 543 0.36 353,562 873 0.50 Borrowed funds 5,086 72 2.85 6,584 151 4.62 Total interest-bearing liabilities 341,008 615 0.36



360,146 1,024 0.57

Non-interest-bearing liabilities 115,068 95,850 Total liabilities 456,076 455,996 Shareholders' equity 45,173 48,799 Total liabilities and shareholders' equity $ 501,249$ 504,795 Net interest income; interest rate spread $ 7,952 3.37 % $ 7,367 3.16 % Net interest margin (net interest income as a percent of average interest-earning assets) 3.48 % 3.29 % Average interest-earning assets to average interest-bearing liabilities 135 %

126 % 33.



Asset Quality and Allowance for Loan Losses

Delinquent loans (including non-accrual) totaled $5.7 million or 1.58% of total loans at June 30, 2014, compared to $4.6 million or 1.29% of total loans at March 31, 2014 and $8.1 million or 2.24% at the end of 2013. Nonaccrual loans totaled $4.6 million or 1.29% of total loans at June 30, 2014, compared to $3.6 million or 1.02%of total loans at March 31, 2014 and $6.9 million or 1.90% of total loans at December 31, 2013. Delinquent loans June 30, 2014 March 31, 2014



December 31, 2013

$ %(1) $ %(1) $ %(1) (Dollars in thousands) 30 days past due $ 1,022 0.29 % $ 834 0.23

% $ 945 0.26 % 60 days past due 18 0.00 % 132 0.04 % 290 0.08 % 90 days past due and still accruing - - - - - -

Non-accrual 4,620 1.29 % 3,607 1.02 % 6,904 1.90 % Total $ 5,660 1.58 % $ 4,573 1.29 % $ 8,139 2.24 %



(1) As a percentage of total loans, excluding deferred costs

Non-performing assets were $15.3 million or 3.06% of total assets at June 30, 2014, compared with $17.7 million or 3.59% of total assets at March 31, 2014 and $21.9 million or 4.36% of total assets at December 31, 2013. Troubled debt restructurings ("TDR's") which are performing in accordance with the restructured terms and accruing interest, but are included in non-performing assets, were $9.3 million at June 30, 2014, compared to $12.6 million at March 31, 2014 and $12.8 million at December 31, 2013.



The following table represents information concerning the aggregate amount of non-performing assets (includes loans held for sale):

Non-performing assets June 30, 2014 March 31, 2014 December 31, 2013 (Dollars in thousands) Non-accruing loans: Residential real estate loans and home equity $ 425 $ 511 $ 352 Commercial real estate 2,779 1,647 1,850 Commercial and industrial 1,354 1,449 4,702 Consumer loans and credit cards 62 - - Total non-accruing loans 4,620 3,607 6,904 Accruing loans delinquent 90 days or more - - - Total non-performing loans (excluding TDR's) 4,620 3,607 6,904 Collateralized debt obligations - - 976 Other real estate and repossessed assets 1,406 1,563 1,219 Total non-performing assets (excluding TDR's) $ 6,026 $ 5,170 $ 9,099 Troubled debt restructurings(1) $ 9,297 $ 12,569 $ 12,788 Total non-performing loans (including TDR's) $ 13,917$ 16,176 $ 19,692 Total non-performing assets (including TDR's) $ 15,323$ 17,739 $ 21,887



(1) TDR's that are in compliance with their modified terms and accruing interest.

34. Much of the improvement in asset quality in the first half of 2014 has resulted from the execution of previously disclosed strategies developed in the fourth quarter of 2013 to accelerate the disposition of certain troubled assets, in particular two commercial relationships which totaled $5.7 million at the end of 2013. As of June 30, 2014, a total of $4.7 million of cash has been collected on these relationships. One of the relationships, with a carrying amount of $2.7 million at the end of 2013, was paid off for the full carrying amount in the first quarter. A second relationship with an outstanding balance of $3.0 million and an allowance allocation of $1.5 million at the end of 2013 has been paid down by $2.0 million in the first half of 2014, of which $554,000 was received in the second quarter. The Company recorded a partial charge-off on this second relationship of $750,000 in the first quarter, using the specific loan loss allocation established for this relationship in the fourth quarter of 2013. As a result of the $554,000 that was collected on this relationship in the second quarter, an identical amount of allowance for loan losses allocated to this relationship at the end of 2013 has been freed up and incorporated into the general and qualitative components of the allowance for loan losses, as of June 30, 2014. The Company maintains a 100% reserve allocation against the remaining balance of $197,000 at the end of the second quarter (net of the partial chargeoff), due to uncertainty as to the collectability of the remaining balance. The Company has retained legal counsel in anticipation of exploring claims to be made against the third-party purchaser of certain of the borrower's assets which, the Company maintains, were and remain subject to a perfected first lien position of the Company. Certain troubled loans totaling $418,000 and classified as held-for-sale at the end of 2013 were sold during the second quarter of 2014 for $395,000. Writedowns and losses on loans held-for-sale totaled $114,000 in the second quarter, with $23,000 realized upon sales of loans and $91,000 from writedowns on remaining loans held-for-sale at the end of the second quarter. Net charge-offs were $777,000 or 0.87% (annualized) of average loans in the second quarter, compared to net charge-offs of $15,000 in the year-ago quarter. Net charge-offs were $2.1 million or 1.15% (annualized) of average loans in the first half of 2014, compared to net recoveries of $511,000 in the year-ago period. Three relationships comprised nearly all of the charge-offs in the first half of 2014, which were charged against specific allowance allocations established in the fourth quarter of 2013. There was no provision for loan losses recorded in the first half of 2014, as the $3.3 million loan loss provision recorded in the fourth quarter of 2013 included specific allocations for the three large relationships charged-off in the first half of 2014. Negative provisions for loan losses of $240,000 and $890,000 were recorded in the quarter and six months ended June 30, 2013 as the result of the net recoveries and other credit quality indicators in those periods. The provision for loan losses as a percentage of net charge-offs was not meaningful for first half of 2014 and 2013. On a linked-quarters basis, the provision for loan losses as a percentage of net charge-offs was 97.2% for the four calendar quarters ending June 30, 2014. The allowance for loan losses was $4.6 million at June 30, 2014, compared with $5.3 million at March 31, 2014 and $6.7 million at December 31, 2013. The ratio of the allowance for loan losses to total loans was 1.28% at June 30, 2014, compared with 1.51% at March 31, 2014 and 1.85% at December 31, 2013. The ratio of the allowance for loan losses to non-performing loans (including TDR's) was 33.9% at June 30, 2014, compared with 33.0% at March 30, 2014 and 34.1% at December 31, 2013. The ratio of the allowance for loan losses to non-accrual loans was 109% at June 30, 2014, compared with 148% at March 30, 2014 and 97% at December 31, 2013. 35. We assess a number of quantitative and qualitative factors at the individual portfolio level in determining the adequacy of the allowance for loan losses and the required provision expense each quarter. In addition, we analyze certain broader, non-portfolio specific factors in assessing the adequacy of the allowance for credit losses, such as the allowance as a percentage of total loans and leases, the allowance as a percentage of non-performing loans and leases and the provision expense as a percentage of net charge-offs. This portion of the allowance has been considered "unallocated," which means it is not based on either quantitative or qualitative factors. At June 30, 2014, $258,000 or 5.7% of the allowance for credit losses was considered to be "unallocated," compared to $173,000 or 3.2% at March 31, 2014. There was no unallocated amount at December 31, 2013. The amount of unallocated allowance to the total allowance has trended upward in the first half of 2014 as the result of improvement in recent quarters in our asset quality metrics, including the amounts of and changes in: i) classified loans; ii) past due and nonaccrual loans; iii) troubled debt restructurings, and; iv) specific allowance allocations for impaired loans. The following table summarizes changes in the allowance for loan losses arising from loans charged off, recoveries on loans previously charged off and additions to the allowance, which have been charged to expense (in thousands). Three months ended Six months ended Allowance for loan losses June 30, June 30, 2014 2013 2014 2013 (Dollars in thousands) Allowance for loan losses, beginning of period $ 5,345$ 6,758$ 6,724$ 6,882 Loans charged-off (846 ) (187 ) (2,258 ) (434 ) Recoveries of loans previously charged-off 69 172 199 945 Net loans charged-off (777 ) (15 ) (2,059 ) 511 Allowance related to loans transferred to held-for-sale - - (97 ) - Provision for loan losses - (240 ) - (890 ) Allowance for loan losses, end of period $ 4,568$ 6,503$ 4,568$ 6,503 36. Non-interest Income



The following table sets forth certain information on non-interest income for the years indicated (dollars in thousands):

Three months ended June 30, Six months ended June 30, % % 2014 2013 $ Change Change 2014 2013 $ Change Change Service charges $ 489$ 573$ (84 ) (14.7 )%



$ 1,000$ 1,121$ (121 ) (10.8 )% Wealth management income

378 355 23 6.5 671 671 - - Treasury management fees 59 64 (5 ) (7.8 ) 115 126 (11 ) (8.7 ) BOLI income 164 165 (1 ) (0.6 ) 402 405 (3 ) (0.7 ) Writedowns and losses on loans held for sale (114 ) - (114 ) (100.0 ) (357 ) - (357 ) (100.0 ) Gain on sale of REO (4 ) 2 (6 ) (300.0 ) (4 ) 86 (90 ) (104.7 ) Gain (loss) on sale of securities - 135 (135 ) (100.0 ) (140 ) 135 (275 ) (203.7 ) Gain on sale of branch - - - - 438 - 438 100.0 Other 24 57 (33 ) (57.9 ) 62 115 (53 ) (46.1 ) Total non-interest income $ 996$ 1,351$ (355 ) (26.3 )% $ 2,187$ 2,659$ (472 ) (17.8 )%

Non-interest income was $996,000 in the second quarter of 2014, compared to $1.4 million in the second quarter of 2013 and $1.2 million in the first quarter of 2014. Non-recurring gains, writedowns and losses accounted for much of the changes in non-interest income in the second quarter compared to the year-ago quarter and to the first quarter of 2014. Nonrecurring writedowns and losses, net of nonrecurring gains were $118,000 in the second quarter of 2014 (writedowns and losses on loans held-for-sale and loss on sale of REO), compared to net nonrecurring gains of $137,000 in the year-ago quarter (gains on sales of securities and REO) and net non-recurring gains $53,000 in the first quarter of 2014 (gain on sale of branch, writedowns of loans held-for-sale and loss on sale of securities available-for-sale).



Non-interest income (net of nonrecurring income, gains and losses and gains/losses on the sales of securities) accounted for 21.9% of total revenue in the second quarter of 2014, compared with 24.5% in the year-ago quarter and 22.2% in the first quarter of 2014.

Noninterest income was $2.2 million in the first half of 2014, compared to $2.7 million in the first half of 2013. Nonrecurring writedowns and losses, net of nonrecurring gains were $63,000 in the first half of 2014, compared to net nonrecurring gains of $221,000 in the year-ago period.



Non-interest income accounted for 21.9% of total revenue in the first half of 2014, compared with 24.9% in prior year.

37. Non-interest Expense



The following table sets forth certain information on non-interest expenses for the years indicated (dollars in thousands):

Three months ended June 30, Six months ended June 30, % $ % 2014 2013 $ Change Change 2014 2013 Change Change Salaries and benefits $ 2,712$ 2,864$ (152 ) (5.3 )% $ 5,490$ 5,836$ (346 ) (5.9 )% Occupancy and equipment 837 800 37 4.6 1,641 1,593 48 3.0 Professional services 197 491 (294 ) (59.9 ) 617 947 (330 ) 34.8 Advertising 77 66 11 16.7 158 173 (15 ) (8.7 ) Office supplies, postage and courier 89 94 (5 ) 5.3 184 199 (15 ) (7.5 ) FDIC insurance premium 172 101 71 70.3 340 254 86 33.9 State franchise taxes 67 133 (66 ) (49.6 ) 132 344 (212 ) (61.6 ) Other 771 891 (120 ) (13.5 ) 1,421 1,550 (129 ) (8.3 ) Total non-interest expenses $ 4,922$ 5,440$ (518 ) (9.5 )% $ 9,983$ 10,896$ (913 ) (8.4 )% Non-interest expenses were $4.9 million for the second quarter of 2014, compared with $5.4 million in the year-ago quarter and $5.1 million for the first quarter of 2014. The decrease from the year-ago quarter is primarily attributable to a $294,000 decrease in professional services, a $152,000 decrease in salaries and benefits, a $120,000 decrease in other non-interest expenses, and a $66,000 decrease in state franchise taxes. The decrease in professional services is due primarily to the substantial improvement in our asset quality which has reduced the need for outside professional services related to the workout of classified assets. The decrease in salaries and benefits is attributable to a decline in incentive compensation expense as loan originations during the quarter are down from the year-ago quarter, and to the elimination of $47,000 of salaries expense attributable to the Company's former Marysville branch. The decrease in state franchise taxes is the result of a change in the tax law which changed how the tax is calculated in the current year.



The Company's efficiency ratio was 96.6% in the second quarter of 2014, compared with 109.5% in the year-ago quarter, and 98.5% in the first quarter of 2014.

Non-interest expenses were $10.0 million in the first half of 2014, which was a decrease of $913,000 or 8.4% compared to the first half of 2013 as salaries and benefits expense decreased $346,000, franchise taxes decreased $122,000, and professional services decreased $330,000 for the same reasons discussed above.



The Company's efficiency ratio was 97.6% for the first half of 2014, compared to 110.9% in the prior year.

Income Taxes The Company had net deferred tax assets totaling $11.0 million and $11.6 million with valuation allowances of $11.3 million and $11.2 million, respectively, at June 30, 2014 and December 31, 2013. Included in net deferred tax assets are gross deferred tax assets of $12.0 million and $11.7 million at June 30, 2014 and December 31, 2013, respectively. Deferred tax liabilities at June 30, 2014 were comprised entirely of the tax liability generated by the unrealized gains on securities available-for-sale. 38.



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

Total assets were $500.5 million at June 30, 2014, which was a decrease of $1.9 million from $502.4 million at December 31, 2013. Assets sold in connection with the sale of the Company's Marysville branch in the first quarter totaled $18.7 million and included cash of $12.5 million, loans of $4.8 million and fixed assets of $1.4 million. Deposits attributable to the branch totaling $19.4 million were assumed by the buyer.



Securities

Investment securities totaled $80.7 million at June 30, 2014, compared with $79.9 million at December 31, 2013. Our portfolio is comprised primarily of investment grade securities. The breakdown of the securities portfolio at June 30, 2014 was 48.4% government-sponsored entity guaranteed mortgage-backed securities, 27.2% municipal securities, 17.4% obligations of U.S. government-sponsored corporations and 7.0% corporate bonds. Mortgage-backed securities, which totaled $39.1 million at June 30, 2014, are comprised primarily of pass-through securities backed by conventional residential mortgages and guaranteed by Fannie-Mae, Freddie-Mac or Ginnie Mae, which in turn are backed by the U.S. government.



Loans

The following table sets forth the composition of our loan portfolio, including loans held-for-sale at the dates indicated (dollars in thousands):

June 30, 2014 March 31, 2014 December 31, 2013 Amount Percent Amount Percent Amount Percent Loan portfolio composition Commercial and industrial $ 104,959 29.4 % $ 110,886 31.3 % $ 122,901 33.8 % Commercial real estate 104,387 29.2 % 105,077 29.7 % 106,901 29.4 % Real estate and home equity 114,038 31.9 % 105,573

29.8 % 98,622 27.1 % Consumer and credit card 34,102 9.5 % 32,759 9.2 % 35,265 9.7 % Total loans $ 357,486 100.0 % $ 354,295 100.0 % 363,689 100.0 % Net deferred loan costs 182 164 165 Allowance for loan losses (4,568 ) (5,345 ) (6,724 ) Net loans $ 353,100$ 349,114$ 357,130 Total loans, including loans held for sale, increased $3.3 million in the second quarter, and were $357.7 million at June 30, 2014, compared with $354.4 million at March 31, 2014. Residential mortgages and consumer loans increased at annualized rates of 32.1% and 16.4%, respectively, in the second quarter primarily as the result of business development initiatives including ongoing engagement with and calling on local real estate agencies and a successful cross-selling program to existing customers. Commercial and industrial loans decreased $5.9 million in the second quarter, through a combination of weakness in demand, normal amortization, prepayments and chargeoffs.



Deposits

Deposits totaled $436.1 million at June 30, 2014, which was a slight decrease from $439.8 million at the end of the first quarter. Time accounts decreased $7.1 million in the second quarter, which was partially offset by increases in savings, demand and money market accounts aggregating $3.4 million. Consistent with the financial sector generally, the very low interest rate environment continues to influence the Company's deposit composition, as customer preference for non-maturity savings, demand and money market accounts outweighs that of time accounts. 39. Liquidity Liquidity is the ability of the Company to fund customers' needs for borrowing and deposit withdrawals. The purpose of liquidity management is to assure sufficient cash flow to meet all of the financial commitments and to capitalize on opportunities for business expansion. This ability depends on the financial strength, asset quality and types of deposit and investment instruments offered by the Company to its customers. The Company's principal sources of funds are deposits, loan and security repayments, maturities of securities, sales of securities available for sale and other funds provided by operations. The Bank also has the ability to borrow from the FHLB. While scheduled loan repayments and maturing investments are relatively predictable, deposit flows and early loan and mortgage-backed security prepayments are more influenced by interest rates, general economic conditions, and competition. The Company maintains investments in liquid assets based upon management's assessment of (1) need for funds, (2) expected deposit flows, (3) yields available on short-term liquid assets and (4) objectives of the asset/liability management program. Cash and cash equivalents totaled $28.8 million at June 30, 2014, compared to $25.4 million at December 31, 2013. Cash and equivalents represented 5.8% of total assets at June 30, 2014 and 5.0% of total assets at December 31, 2013. The Company has the ability to borrow funds from the FHLB and the Federal Reserve Bank should the Company need to supplement its future liquidity. Management believes the Company's liquidity position is adequate based on its current level of cash, cash equivalents, core deposits, the stability of its other funding sources, and the support provided by its capital base. Capital Resources Stockholders' equity was $46.8 million at June 30, 2014, compared with $46.4 million at March 31, 2014, and $45.3 million at December 31, 2013. The increase since December is primarily the result of the difference between the unrealized loss of $940,000 on one collateralized debt obligation ("CDO") at December 31, 2013, and the actual loss recognized upon the sale of that security in the first quarter of $140,000. Sharply higher demand for these types of securities in the first quarter of 2014 contributed to the increase in the value of the CDO during that quarter. The remaining increase in stockholder's equity is due primarily to an increase in unrealized gains on securities available-for-sale and to net income in the first half of 2014.



The Bank's Tier 1 leverage ratio was 8.97% and its total risk-based capital ratio was 14.02% at the end of the second quarter, both of which comfortably exceeded the regulatory thresholds required to be classified as a "well-capitalized" institution, which are 5.0% and 10.0%, respectively.

The Company and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly discretionary actions by regulators that, if undertaken, could have a direct material effect on our financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of our assets, liabilities, and certain off balance-sheet items as calculated under regulatory accounting practices. Our capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Quantitative measures established by regulation to ensure capital adequacy require the Company and its subsidiary bank to maintain minimum amounts and ratios (set forth in the following tables) of total and Tier 1 Capital (as defined in the regulations) to risk-weighted assets (as defined) and of Tier 1 Capital (as defined) to average assets (as defined). 40.



The following table compares our actual capital amounts and ratios with those needed to qualify for the "well-capitalized" category, which is the highest capital category as defined in the regulations, dollars in thousands:

To Be Well-Capitalized Under Prompt For Capital Adequacy Corrective Action Actual Purposes Provisions Amount Ratio Amount Ratio Amount Ratio As of June 30, 2014 Total risk-based capital Consolidated $ 50,600 14.36 % $ 28,196 > 8.00 % N/A N/A Bank $ 49,416 14.02 % $ 28,196 > 8.00 % $ 35,245 >10.00 % Tier 1 capital Consolidated $ 46,192 13.11 % $ 14,098 > 4.00 % N/A N/A Bank $ 45,008 12.77 % $ 14,098 > 4.00 % $ 21,147 > 6.00 % Leverage Consolidated $ 46,192 9.20 % $ 20,076 > 4.00 % N/A N/A Bank $ 45,008 8.97 % $ 20,076 > 4.00 % $ 25,095 > 5.00 % As of December 31, 2013 Total risk-based capital Consolidated $ 50,644 13.82 % $ 29,321 > 8.00 % N/A N/A Bank $ 49,473 13.50 % $ 29,321 > 8.00 % $ 36,651 >10.00 % Tier 1 capital Consolidated $ 46,036 12.56 % $ 14,661 > 4.00 % N/A N/A Bank $ 44,865 12.24 % $ 14,661 > 4.00 % $ 21,992 > 6.00 % Leverage Consolidated $ 46,036 9.00 % $ 20,456 > 4.00 % N/A N/A Bank $ 44,865 8.77 % $ 20,456 > 4.00 % $ 25,570 > 5.00 %


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Source: Edgar Glimpses


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