June 4, 2014, the Company and Old National Bancorp ("Old National") jointly announced the signing of a definitive agreement on June 3, 2014(the "Merger Agreement") pursuant to which the Company will be merged with and into Old National (the "Merger"). Simultaneously with the Merger, the Bank will merge with and into Old National Bank, a national banking association and wholly-owned subsidiary of Old National. Under the terms of the Merger Agreement, which was approved by the boards of directors of both companies, Company shareholders will receive 2.269 shares of Old National common stock and $10.63in cash (fixed) for each share of Company common stock. As provided in the Merger Agreement, the exchange ratio is subject to certain adjustments, calculated prior to closing, in the event shareholders' equity of the Company is below a specified amount. When the Merger becomes effective, each outstanding option to purchase Company common stock will fully vest (if unvested) and be converted into the right to receive in cash an amount equal to the positive difference, if any, of $10.63plus the Merger exchange ratio (as may be adjusted as described above) multiplied by the Average ONB Closing Price (as defined in the Merger Agreement) less the option exercise price, subject to the consent of option holders. As previously disclosed, two employees will terminate their employment agreements on or before the closing of the Merger and will receive the change of control payments to which they are entitled under their existing employment agreements. In addition, the Company has agreed to pay Old National a termination fee of $3,000,000upon termination of the Merger Agreement if (1) the Company's Board of Directors fails to recommend the Merger to its shareholders, makes an adverse recommendation or enters into or announces a competing acquisition proposal, or fails to publicly reaffirm its recommendation of the Merger upon Old National's request; (2) the Company's shareholders vote against the Merger or a quorum is not convened, and 12 months later the Company is acquired by a third party; or (3) the Merger Agreement is terminated because the Merger is not consummated by March 31, 2015, and prior to that date the Company receives an acquisition proposal that closes within 12 months after termination of the Merger Agreement. The transaction is expected to close in the fourth quarter of 2014. It remains subject to approval by the Company's shareholders at a special meeting called and to be held on September 3, 2014, and approval by federal regulatory authorities as well as the satisfaction of other customary closing conditions provided in the Merger Agreement.
LSB Financial Corp., an Indianacorporation ("LSB Financial" or the "Company"), is the holding company of Lafayette Savings Bank, FSB("Lafayette Savings" or the "Bank"). LSB Financialhas no separate operations and its business consists only of the business of Lafayette Savings. References in this Annual Report to "we," "us" and "our" refer to LSB Financialand/or Lafayette Savings as the context requires. Lafayette Savings is an independent, community-oriented financial institution. The Bank has been in business for 145 years and differs from many of our competitors by having a local board and local decision-making in all areas of business. In general, our business consists of attracting or 28 -------------------------------------------------------------------------------- acquiring deposits and lending that money out primarily as real estate loans to construct and purchase single-family residential properties, multi-family and commercial properties and to fund land development projects. We also make a limited number of commercial business and consumer loans. We have an experienced and committed staff and enjoy a good reputation for serving the people of the community, for understanding their financial needs and for finding a way to meet those needs. We contribute time and money to improve the quality of life in our market area and many of our employees volunteer for local non-profit agencies. We believe this sets us apart from the other 22 banks and credit unions that compete with us. We also believe that operating independently under the same name for over 145 years is a benefit to us - especially as local offices of large banks often have less local authority as their companies strive to consolidate. Focusing time and resources on acquiring customers who may be feeling disenfranchised by their no-longer-local or very large bank has proved to be a successful strategy. Tippecanoe Countyand the eight surrounding counties comprise Lafayette Savings' primary market area. Lafayette is the county seat of Tippecanoe Countyand West Lafayetteis the home of Purdue University. There are three things that set Greater Lafayetteapart from other urban areas of the country - the presence of a world class university, Purdue University; a government sector due to the presence of the county seat; and the mix of heavy industry and high-tech innovative start-up companies tied to Purdue University. In addition, Greater Lafayetteis a regional health care center serving nine counties and has a large campus of Ivy Tech Community College. Tippecanoe Countytypically shows better growth and lower unemployment rates than Indianaor the national economy because of the diverse employment base. The Tippecanoe Countyunemployment rate peaked at 10.6% in July 2009and at June 30, 2014was at 6.2% compared to 5.9% for Indianaand 6.1% nationally. Because of the high percentage of jobs in education, the unemployment rate in the county consistently shows an increase in unemployment during the summer months, averaging about a 1.7% increase in the unemployment rate. The local housing market has remained fairly stable for the last several years with no price bubble and no resulting price swings. As of the most recent first quarter results provided by the Federal Housing Finance Agency, the five year percent change in house prices for the Lafayette Metropolitan Statistical Area ("MSA") was a 1.44% decrease with the one-year change a 1.04% decrease. For the third quarter of 2013, housing prices in the MSA increased 0.67%. The 172 single family building permits issued in the first five months of 2014 in Tippecanoe Countywere just slightly over the five-year average of 170. There were 457 new home starts in 2013. The area's diversity did not make us immune to the ongoing effects of the recession; however, growth continues, although still not at the same rate as before the recession. Current signs of recovery, based on a report from Greater Lafayette Commerce, include increasing manufacturing employment, a continuing commitment to new facilities and renovations at Purdue University, and signs of renewed activity in residential development projects. Capital investments announced and/or made in 2013 totaled over $1 billioncompared to $605 millionin 2012. Purdue, the area's largest employer, had enrollment of almost 39,000 in the fall 2013 semester. Subaru, the area's largest industrial employer and producer of the Subaru Legacy, Outback and Tribeca, recently announced addition of more production capacity for a new model to be built there. They expect to hire 900 additional employees by 2016. Wabash National, the area's second largest industrial employer, continues to secure contracts to maintain its production level. Nanshan America began operating its new aluminum extrusion plant in Lafayettein 2012 and expects to employ 200 people. Alcoa will be adding a 115,000 square foot aluminum lithium plant to begin production in 2014 and employ 75 people. While the developments noted above lead us to believe the most serious 29 -------------------------------------------------------------------------------- problems are behind us as increased hiring and new industry moving to town have continued, we expect the recovery to be long term. In addition GE Aviationhas started work on a $100 millionjet engine plant in Lafayettethat will employ 200 people. We have seen progress in our problem loans as more borrowers who had fallen behind on their loan payments are qualifying for troubled debt restructures, or have resumed payments or, less often, we have acquired control of their properties. The majority of our delinquent loans are secured by real estate and we believe we have sufficient reserves to cover incurred losses. The challenge is to get delinquent borrowers back on a workable payment schedule or if that is not feasible, to get control of their properties through an overburdened court system. In 2013, we acquired one property through foreclosure and sold two OREO properties. In the first half of 2014, we took four properties into OREO and have sold two. The funds we use to make loans come primarily from deposits from customers in our market area, from brokered deposits and from Federal Home Loan Bank("FHLB") advances. In addition, we maintain an investment portfolio of available-for-sale securities to provide liquidity as needed. Our preference is to rely on local deposits unless the cost is not competitive, but if the need is immediate we will acquire pre-payable FHLB advances which are immediately available for member banks within their borrowing tolerance and can then be replaced with local or brokered deposits as they become available. We will also consider purchasing fixed term FHLB advances or brokered deposits as needed. We generally prefer brokered deposits over FHLB advances when the cost of raising money locally is not competitive. The brokered deposits are available with a range of terms, there is no collateral requirement and the money is predictable as it cannot be withdrawn early except in the case of the death of a depositor and there is no option to have the money rollover at maturity. Deposits in the first six months have remained fairly flat, decreasing by only $110,000, or 0.03%, from $314.6 millionto $314.5 million. Our reliance on brokered funds as a percentage of total deposits decreased slightly in 2014 from 4.35% of deposits to 3.80%, from $13.7 millionto $11.6 million. While we always welcome local deposits, the cost and convenience of brokered funds make them a useful alternative. We will also continue to rely on FHLB advances to provide immediate liquidity and help manage interest rate risk. Our primary source of income is net interest income, which is the difference between the interest income earned on our loan and investment portfolios and the interest expense incurred on deposits and borrowings. Our net interest income depends on the balance of our loan and investment portfolios and the size of our net interest margin - the difference between the income generated from loans and the cost of funding. Our net interest income also depends on the shape of the yield curve. The Federal Reserve has held short-term rates at almost zero for the last four years while long-term rates have stayed in the 3.0% range. Because deposits are generally tied to shorter-term market rates and loans are generally tied to longer-term rates this would typically be viewed as a positive step. We expect that the interest rate margins which began to decline late in 2013 will continue to do so as deposits are already at very low levels but because of the relatively weak demand for loans, those rates continue to fall. Our expectation for 2014 is that deposit rates will remain at these low levels as the Federal Reserve continues to focus on strengthening the economy. Overall loan rates are expected to remain low. Rate changes can typically be expected to have an impact on interest income. Because the Federal Reserve has stated it intends to keep rates low, we expect to see little change in the money supply or market rates in 2014. Low rates generally increase borrower preference for fixed rate products which we typically sell on the secondary market. Some existing adjustable rate loans can be expected to reprice to lower rates which could be expected to have a negative impact on our interest income, although many of our loans have already reached their interest rate floors. While we would 30 -------------------------------------------------------------------------------- expect to sell the majority of our fixed rate loans on the secondary market, we expect to book some higher quality loans to replace runoff in the portfolio. Although new loans put on the books during these times will be at comparatively low rates we expect they will provide a return above any other opportunities for investment. Our primary expense is interest on deposits and FHLB advances which are used to fund loan growth. We offer customers in our market area time deposits for terms ranging from three months to 66 months, checking accounts and savings accounts. We also purchase brokered deposits and FHLB advances as needed to provide funding or improve our interest rate risk position. Generally when interest rates are low, depositors will choose shorter-term products and conversely when rates are high, depositors will choose longer-term products. We consider expected changes in interest rates when structuring our interest-earning assets and our interest-bearing liabilities. When rates are expected to increase we try to book shorter-term assets that will reprice relatively quickly to higher rates over time, and book longer-term liabilities that will remain for a longer time at lower rates. Conversely, when rates are expected to fall, we would like our balance sheet to be structured such that loans will reprice more slowly to lower rates and deposits will reprice more quickly. We currently offer a three-year and a five-year certificate of deposit that allows depositors one opportunity to have their rate adjusted to the market rate at a future date to encourage them to choose longer-term deposit products. However, since we are not able to predict market interest rate fluctuations, our asset/liability management strategy may not prevent interest rate changes from having an adverse effect on our results of operations and financial condition.
Our results of operations may also be affected by general and local competitive conditions, particularly those with respect to changes in market rates, government policies and actions of regulatory authorities.
Possible Implications of Current Events
Significant external factors impact our results of operations including the general economic environment, changes in the level of market interest rates, government policies, actions by regulatory authorities and competition. Our cost of funds is influenced by interest rates on competing investments and general market rates of interest. Lending activities are influenced by the demand for real estate loans and other types of loans, which are in turn affected by the interest rates at which such loans are made, general economic conditions affecting loan demand and the availability of funds for lending activities. Management continues to assess the impact on the Company of the uncertain economic and regulatory environment affecting the country at large and the financial services industry in particular. The level of turmoil in the financial services industry, and the resulting actions of legislators and regulators, have presented additional risks and challenges for the Company, as described below: Extensive financial system reform, including implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act"), has imposed and will continue to impose new requirements on us. On
July 21, 2010, President Obamasigned into law the Dodd-Frank Act, which significantly changed the regulation of financial institutions and the financial services industry. Many of its provisions went into effect on July 21, 2011, the one-year anniversary. The Dodd-Frank Act includes provisions affecting large and small financial institutions alike, including several provisions that profoundly affect how community banks, thrifts, and small bank and thrift holding companies, such as LSB Financial, are regulated. Among other things, these provisions abolished the OTSand transferred its functions to the other federal banking agencies, relaxed rules regarding interstate branching, allowed financial institutions to pay interest on business checking accounts, changed the scope of federal deposit insurance coverage, imposed new capital requirements 31
on bank and thrift holding companies, and imposed limits on debit card interchange fees charged by large banks (commonly known as the Durbin Amendment).
The Dodd-Frank Act created a new, independent federal agency called the
Consumer Financial Protection Bureau("CFPB"), which was granted broad rulemaking, supervisory and enforcement powers under various federal consumer financial protection laws, including the Equal Credit Opportunity Act, Truth in Lending Act, Real Estate Settlement Procedures Act, Fair Credit Reporting Act, Fair Debt Collection Act, the Consumer Financial Privacy provisions of the Gramm-Leach-Bliley Act, and certain other statutes. In July 2011, many of the consumer financial protection functions formerly assigned to the federal banking and other designated agencies transferred to the CFBP. The CFBP has a large budget and staff, and has the authority to implement regulations under federal consumer protection laws and enforce those laws against financial institutions. The CFPBwill have examination and primary enforcement authority with respect to depository institutions with $10 billionor more in assets. Smaller institutions will be subject to rules promulgated by the CFPBbut will continue to be examined and supervised by the federal banking regulators for consumer compliance purposes. The CFPBwill have authority to prevent unfair, deceptive or abusive practice in connection with the offering of consumer financial products. Additionally, this bureau is authorized to collect fines and provide consumer restitution in the event of violations, engage in consumer financial education, track consumer complaints, request data, and promote the availability of financial services to underserved consumers and communities. Moreover, the Dodd-Frank Act authorizes the CFPBto establish certain minimum standards for the origination of residential mortgages including a determination of the borrower's ability to repay. In addition, the Dodd-Frank Act will allow borrowers to raise certain defenses to foreclosure if they receive any loan other than a "qualified mortgage" as defined by the CFPBThe CFPBhas indicated that mortgage lending is an area of supervisory focus and that it will concentrate its examination and rulemaking efforts on the variety of mortgage-related topics required under the Dodd-Frank Act, including minimum standards for the origination of residential mortgages. The CFPBhas published several final regulations impacting the mortgage industry, including rules related to ability-to-repay, mortgage servicing, escrow accounts, and mortgage loan originator compensation. The ability-to-repay rule makes lenders liable if they fail to assess ability to repay under a prescribed test, but also creates a safe harbor for so called "qualified mortgages." Failure to comply with the ability-to-repay rule may result in possible CFPBenforcement action and special statutory damages plus actual, class action, and attorneys' fees damages, all of which a borrower may claim in defense of a foreclosure action at any time. LSB Financial'smanagement is currently assessing the impact of these requirements on its mortgage lending business. The Dodd-Frank Act contains numerous other provisions affecting financial institutions of all types, many of which may have an impact on the operating environment of the Company in substantial and unpredictable ways. Consequently, the Dodd-Frank Act is expected to increase our cost of doing business, it may limit or expand our permissible activities, and it may affect the competitive balance within our industry and market areas. The nature and extent of future legislative and regulatory changes affecting financial institutions, including as a result of the Dodd-Frank Act and the CFPB, is unpredictable at this time. The Company's management continues to actively monitor the implementation of the Dodd-Frank Act and the regulations promulgated thereunder and assess its probable impact on the business, financial condition, and results of operations of the Company. However, the ultimate effect of the Dodd-Frank Act and the CFPBon the financial services industry in general, and the Company in particular, remains uncertain. Mortgage reform and anti-predatory lending regulations have been evolving. Title XIV of the Dodd-Frank Act, the Mortgage Reform and Anti-Predatory Lending Act, includes a series of 32
-------------------------------------------------------------------------------- amendments to the Truth In Lending Act with respect to mortgage loan origination standards affecting, among other things, originator compensation, minimum repayment standards and pre-payments. With respect to mortgage loan originator compensation, except in limited circumstances, an originator is prohibited from receiving compensation that varies based on the terms of the loan (other than the principal amount). The amendments to the Truth In Lending Act also prohibit a creditor from making a residential mortgage loan unless it determines, based on verified and documented information of the consumer's financial resources, that the consumer has a reasonable ability to repay the loan. The amendments also prohibit certain pre-payment penalties and require creditors offering a consumer a mortgage loan with pre-payment penalty to offer the consumer the option of a mortgage loan without such a penalty. In addition, the Dodd-Frank Act expands the definition of a "high-cost mortgage" under the Truth In Lending Act, and imposes new requirements on high-cost mortgages and new disclosure, reporting and notice requirements for residential mortgage loans, as well as new requirements with respect to escrows and appraisal practices. New capital rules have been approved that will affect the Company and the Bank as they are phased in from 2015 to 2019. On
July 2, 2013, the Federal Reserve approved final rules that substantially amend the regulatory risk-based capital rules applicable to the Company and the Bank. The FDICand the OCC subsequently approved these rules. The final rules implement the "Basel III" regulatory capital reforms and changes required by the Dodd-Frank Act. "Basel III" refers to two consultative documents released by the Basel Committee on Banking Supervisionin December 2009, the rules text released in December 2010, and loss absorbency rules issued in January 2011, which include significant changes to bank capital, leverage and liquidity requirements. The final rules include new risk-based capital and leverage ratios, which will be phased in from 2015 to 2019, and will refine the definition of what constitutes "capital" for purposes of calculating those ratios. The new minimum capital level requirements applicable to the Company and the Bank under the final rules are: (i) a new common equity Tier 1 capital ratio of 4.5%; (ii) a Tier 1 capital ratio of 6% (increased from 4%); (iii) a total capital ratio of 8% (unchanged from current rules); and (iv) a Tier 1 leverage ratio of 4% for all institutions. The rules also establish a "capital conservation buffer" above the new regulatory minimum capital requirements, which must consist entirely of common equity Tier 1 capital. The capital conservation buffer requirement will be phased in over four years beginning on January 1, 2016, as follows: the maximum buffer will be 0.625% of risk-weighted assets for 2016, 1.25% for 2017, 1.875% for 2018, and 2.5% for 2019 and thereafter. This will result in the following minimum ratios beginning in 2019: (i) a common equity Tier 1 capital ratio of 7.0%, (ii) a Tier 1 capital ratio of 8.5%, and (iii) a total capital ratio of 10.5%. Under the final rules, institutions are subject to limitations on paying dividends, engaging in share repurchases, and paying discretionary bonuses if its capital level falls below the buffer amount. These limitations would establish a maximum percentage of eligible retained income that could be utilized for such actions. Basel III provided discretion for regulators to impose an additional buffer, the "countercyclical buffer," of up to 2.5% of common equity Tier 1 capital to take into account the macro-financial environment and periods of excessive credit growth. However, the final rules permit the countercyclical buffer to be applied only to "advanced approach banks" (i.e., banks with $250 billionor more in total assets or $10 billionor more in total foreign exposures), which currently excludes the Company and the Bank. The final rules also implement revisions and clarifications consistent with Basel III regarding the various components of Tier 1 capital, including common equity, unrealized gains and losses, as well as certain instruments that will no longer qualify as Tier 1 capital, some of which would be phased out over time. 33 -------------------------------------------------------------------------------- The final rules also contain revisions to the prompt corrective action framework, which is designed to place restrictions on insured depository institutions, including the Bank, if their capital levels begin to show signs of weakness. These revisions take effect January 1, 2015. Under the prompt corrective action requirements, which are designed to complement the capital conservation buffer, insured depository institutions will be required to meet the following increased capital level requirements in order to qualify as "well capitalized": (i) a new common equity Tier 1 capital ratio of 6.5%; (ii) a Tier 1 capital ratio of 8% (increased from 6%); (iii) a total capital ratio of 10% (unchanged from current rules); and (iv) a Tier 1 leverage ratio of 5% (increased from 4%). The final rules set forth certain changes for the calculation of risk-weighted assets, which we will be required to utilize beginning January 1, 2015. The standardized approach final rule utilizes an increased number of credit risk exposure categories and risk weights, and also addresses: (i) an alternative standard of creditworthiness consistent with Section 939A of the Dodd-Frank Act; (ii) revisions to recognition of credit risk mitigation; (iii) rules for risk weighting of equity exposures and past due loans; (iv) revised capital treatment for derivatives and repo-style transactions; and (v) disclosure requirements for top-tier banking organizations with $50 billionor more in total assets that are not subject to the "advance approach rules" that apply to banks with greater than $250 billionin consolidated assets. Based on our current capital composition and levels, we believe that we would be in compliance with the requirements as set forth in the final rules if they were presently in effect. The current economic environment poses challenges for us and could adversely affect our financial condition and results of operations. We continue to operate in a challenging and uncertain economic environment, including generally uncertain national conditions and local conditions in our markets. Overall economic growth continues to be slow and national and regional unemployment rates remain at elevated levels. The risks associated with our business remain acute in periods of slow economic growth and high unemployment. Moreover, many financial institutions continue to be affected by an uncertain real estate market. While we continue to take steps to decrease and limit our exposure to problem loans, and while our local economy has remained somewhat insulated from the most severe effects of the current economic environment, we nonetheless retain direct exposure to the residential and commercial real estate markets and we are affected by these events. Our loan portfolio includes commercial real estate loans, residential mortgage loans, and construction and land development loans. Declines in real estate values, home sales volumes and financial stress on borrowers as a result of the uncertain economic environment, including job losses, could have an adverse effect on our borrowers or their customers, which could adversely affect our financial condition and results of operations. In addition, the current level of low economic growth on a national scale, the occurrence of another national recession or a deterioration in local economic conditions in our markets could drive losses beyond that which is provided for in our allowance for loan losses and result in the following other consequences: increases in loan delinquencies, problem assets and foreclosures may increase; demand for our products and services may decline; deposits may decrease, which would adversely impact our liquidity position; and collateral for our loans, especially real estate, may decline in value, in turn reducing customers' borrowing power, and reducing the value of assets and collateral associated with our existing loans. Difficult market conditions have adversely affected our industry. We are particularly exposed to downturns in the U.S. housing market. Dramatic declines in the housing market over the past five years, with falling home prices and increasing foreclosures, unemployment and under-employment, 34 -------------------------------------------------------------------------------- have negatively impacted the credit performance of mortgage and construction loans and securities and resulted in significant write-downs of asset values by financial institutions, including government-sponsored entities, major commercial and investment banks, and regional financial institutions. Reflecting concern about the stability of the financial markets generally and the strength of counterparties, many lenders and institutional investors have continued to observe tight lending standards, including with respect to other financial institutions, although there have been signs that lending is increasing. These market conditions have led to an increased level of commercial and consumer delinquencies, lack of consumer confidence, and increased market volatility. A worsening of these conditions would likely exacerbate the adverse effects of these difficult market conditions on the Company and others in the financial institutions industry. In particular, the Company may face the following risks in connection with these events:
• We are experiencing, and expect to continue experiencing increased regulation
of our industry, particularly as a result of the Dodd-Frank Act and the
Compliance with such regulation is expected to increase our costs and may
limit our ability to pursue business opportunities.
• Our ability to assess the creditworthiness of our customers may be impaired if
the models and approach we use to select, manage and underwrite our customers
become less predictive of future behaviors.
• The process we use to estimate losses inherent in our credit exposure requires
difficult, subjective and complex judgments, including forecasts of economic
conditions and how these economic predictions might impair the ability of our
borrowers to repay their loans, which may no longer be capable of accurate
estimation which may, in turn, impact the reliability of the process.
• Our ability to borrow from other financial institutions on favorable terms or
at all could be adversely affected by disruptions in the capital markets or
other events, including actions by rating agencies and deteriorating investor
• Competition in our industry could intensify as a result of the increasing
consolidation of financial services companies in connection with current
• We may be required to pay higher deposit insurance premiums because market
developments have significantly depleted the insurance fund of the Federal
insured deposits. Future reduction in liquidity in the banking system could pose challenges for us.
The Federal Reserve Bankhas been injecting vast amounts of liquidity into the banking system to compensate for weaknesses in short-term borrowing markets and other capital markets. However, the Federal Reserve has recently announced that it will begin cutting back and reducing its bond-buying program during 2014. A reduction in the Federal Reserve's activities or capacity could reduce liquidity in the markets, thereby increasing funding costs to the Company or reducing the availability of funds to the Company to finance its existing operations.
Changes in insurance premiums could adversely affect our financial condition and results of operations. The
35 -------------------------------------------------------------------------------- control of failed banks and ensures payment of deposits up to insured limits using the resources of the
Deposit Insurance Fund. The FDICcharges us premiums to maintain the Deposit Insurance Fund. The FDIChas set the designated reserve ratio for the Deposit Insurance Fundat 2.0% of insured deposits. The Bank is also subject to assessment for the Financing Corporation("FICO") to service the interest on its bond obligations. The amount assessed is in addition to the amount paid for deposit insurance. These assessments will continue until the FICO bonds are repaid between 2017 and 2019. Future increases in deposit insurance premiums or changes in risk classification would increase the Bank's costs.
FDIChas authority to increase insurance assessments. A significant increase in insurance premiums would likely have an adverse effect on the operating expenses and results of operations of the Bank. Management cannot predict what insurance assessment rates will be in the future. Concentrations of real estate loans could subject the Company to increased risks in the event of a real estate recession or natural disaster. A significant portion of the Company's loan portfolio is secured by real estate. The real estate collateral in each case provides an alternate source of repayment in the event of default by the borrower and may deteriorate in value during the time the credit is extended. While property values in the Midwest show signs of stabilizing, a further weakening of the real estate market in our primary market area could result in an increase in the number of borrowers unable to refinance or who may default on their loans and a reduction in the value of the collateral securing their loans, which in turn could have an adverse effect on our profitability and asset quality. If we are required to liquidate the collateral securing a loan to satisfy the debt during a period of reduced real estate values, our earnings and capital could be adversely affected. Significant natural disasters can also negatively affect the value of real estate that secures our loans or interrupt our business operations, also negatively impacting our operating results or financial condition. Credit risk could adversely affect our operating results or financial condition. One of the greatest risks facing lenders is credit risk - that is, the risk of losing principal and interest due to a borrower's failure to perform according to the terms of a loan agreement. During the recession, the banking industry experienced an increase in problem assets and credit losses, resulting from weakened national economic trends and a decline in housing values. Although improving, economic recovery has been slow. While management attempts to provide an allowance for loan losses at a level adequate to cover probable incurred losses based on loan portfolio growth, past loss experience, general economic conditions, information about specific borrower situations, and other factors, future adjustments to reserves may become necessary, and net income could be significantly affected, if circumstances differ substantially from assumptions used with respect to such factors. Interest rate risk could adversely affect our operating results or financial condition. The Company's earnings depend to a great extent upon the level of net interest income, which is the difference between interest income earned on loans and investments and the interest expense paid on deposits and other borrowings. Interest rate risk is the risk that the earnings and capital will be adversely affected by changes in interest rates. While the Company attempts to adjust its asset/liability mix in order to limit the magnitude of interest rate risk, interest rate risk management is not an exact science. Rather, it involves estimates as to how changes in the general level of interest rates will 36 -------------------------------------------------------------------------------- impact the yields earned on assets and the rates paid on liabilities. Moreover, rate changes can vary depending upon the level of rates and competitive factors. From time to time, maturities of assets and liabilities are not balanced, and a rapid increase or decrease in interest rates could have an adverse effect on net interest margins and results of operations of the Company. Volatility in interest rates can also result in disintermediation, which is the flow of funds away from financial institutions into direct investments, such as U.S. Governmentand corporate securities and other investment vehicles, including mutual funds, which, because of the absence of federal insurance premiums and reserve requirements, generally pay higher rates of return than financial institutions.
Critical Accounting Policies
Generally accepted accounting principles are complex and require management to apply significant judgments to various accounting, reporting and disclosure matters. Management of
LSB Financialmust use assumptions and estimates to apply these principles where actual measurement is not possible or practical. For a complete discussion of LSB Financial'ssignificant accounting policies, see Note 1 to the Consolidated Financial Statements as of December 31, 2013, included in the Company's Annual Report on Form 10-K for the year ended December 31, 2013. Certain policies are considered critical because they are highly dependent upon subjective or complex judgments, assumptions and estimates. Changes in such estimates may have a significant impact on the financial statements. Management has reviewed the application of these policies with the Audit Committee of LSB Financial'sBoard of Directors. These policies include the following: Allowance for Loan Losses. The allowance for loan losses represents management's estimate of probable losses inherent in Lafayette Savings' loan portfolios. In determining the appropriate amount of the allowance for loan losses, management makes numerous assumptions, estimates and assessments. The strategy also emphasizes diversification on an industry and customer level, regular credit quality reviews and quarterly management reviews of large credit exposures and loans experiencing deterioration of credit quality. Lafayette Savings' allowance consists of three components: probable losses estimated from individual reviews of specific loans, probable losses estimated from historical loss rates, and probable losses resulting from economic or other deterioration above and beyond what is reflected in the first two components of the allowance. All loans that are rated substandard and impaired, or are troubled debt restructures, are subject to individual review. Where appropriate, reserves are allocated to individual loans based on management's estimate of the borrower's ability to repay the loan given the availability of collateral, other sources of cash flow and legal options available to the Bank. Included in the review of individual loans are those that are impaired as provided in FASB ASC 310-10. Any allowances for impaired loans are determined by the fair value of the underlying collateral based on the discounted appraised value. Allowances for loans that are not collateral dependent are determined by the present value of expected future cash flows discounted at the loan's effective interest rate. Historical loss rates are applied to all loans not included in the ASC310-10 calculation. Historical loss rates for commercial and consumer loans may be adjusted for significant qualitative factors that, in management's judgment, reflect the impact of any current conditions on loss recognition. Factors which management considers in the analysis include the effects of the national and local economies, trends in the nature and volume of loans (delinquencies, charge-offs and non-accrual 37
-------------------------------------------------------------------------------- loans), changes in mix, asset quality trends, risk management and loan administration, changes in the internal lending policies and credit standards, collection practices and examination results from bank regulatory agencies and the Bank's internal loan review.
Allowances on individual loans and historical loss rates are reviewed quarterly and adjusted as necessary based on changing borrower and/or collateral conditions and actual collection and charge-off experience.
Lafayette Savings' primary market area for lending is
Tippecanoe County, Indianaand to a lesser extent the eight surrounding counties. When evaluating the adequacy of the allowance, consideration is given to this regional geographic concentration and the closely associated effect of changing economic conditions on Lafayette Savings' customers. Mortgage Servicing Rights. Mortgage servicing rights ("MSRs") associated with loans originated and sold, where servicing is retained, are capitalized and included in other intangible assets in the consolidated balance sheet. The value of the capitalized servicing rights represents the present value of the future servicing fees arising from the right to service loans in the portfolio. Critical accounting policies for MSRs relate to the initial valuation and subsequent impairment tests. The methodology used to determine the valuation of MSRs requires the development and use of a number of estimates, including anticipated principal amortization and prepayments of that principal balance. Events that may significantly affect the estimates used are changes in interest rates, mortgage loan prepayment speeds and the payment performance of the underlying loans. The carrying value of the MSRs is periodically reviewed for impairment based on a determination of fair value. For purposes of measuring impairment, the servicing rights are compared to a valuation prepared based on a discounted cash flow methodology, utilizing current prepayment speeds and discount rates. Impairment, if any, is recognized through a valuation allowance and is recorded as amortization of intangible assets. Accounting for Foreclosed Assets. Assets acquired through, or in lieu of, loan foreclosure are held for sale and are initially recorded at fair value less cost to sell at the date of foreclosure, establishing a new cost basis. Subsequent to foreclosure, valuations are periodically performed by management and the assets are carried at the lower of carrying amount or fair value less cost to sell. Revenue and expenses from operations and changes in the valuation allowance are included in net income or expense from foreclosed assets. 38 -------------------------------------------------------------------------------- Financial Condition SELECTED FINANCIAL CONDITION DATA (Dollars in thousands) June 30, December 31, $ % 2014 2013 Difference Difference (Unaudited) Total assets $ 368,688 $ 367,5811,107 0.30 % Loans receivable, including loans held for sale, net 254,240 255,360 (1,120 ) (0.44 ) 1-4 family residential mortgage loans 97,498 98,719 (1,221 ) (1.24 ) Home equity lines of credit 16,060 16,050 10 0.06 Other real estate loans net of undisbursed portion of loans 138,545 137,213 1,332 0.97 Commercial business loans 10,290 11,461 (1,171 ) (10.22 ) Consumer loans 1,260 1,160 100 8.62 Loans sold (for six months and year, respectively) 12,009 45,272 (33,263 ) (73.47 ) Non-performing loans over 90 days past due 521 1,384 (863 ) (62.36 ) Loans less than 90 days past due, not accruing 810 1,188 (378 ) (31.82 ) Other real estate owned 117 18 99 550.00 Non-performing assets 1,448 2,590 (1,142 ) (44.09 ) Cash and due from banks 16,735 21,961 (5,226 ) (23.80 ) Available-for-sale securities 64,326 62,705 1,621 2.59 Short-term investments 8,311 2,237 6,074 271.5 Interest-bearing time deposits 1,247 1,743 (496 ) (28.46 ) Deposits 314,510 314,620 (110 ) (0.03 ) Core deposits 193,993 185,106 8,887 4.80 Time accounts 120,517 129,514 (8,997 ) (6.95 ) Brokered deposits 11,556 13,690 (2,134 ) (15.59 ) FHLB advances 10,000 10,000 --- --- Shareholders' equity (net) 41,610 40,727 883 2.17
Comparison of Financial Condition at
Our total assets increased
$1.1 million, or 0.30%, during the six months from December 31, 2013to June 30, 2014. Primary components of this increase were a $1.1 millionincrease in securities and interest-bearing time deposits, an $848,000net increase in cash and cash equivalents, and a $254,000increase in fixed and other assets. These were offset by a $1.1 milliondecrease in net loans receivable including loans held for sale. The increase in securities and cash were primarily due to the investment of loan run-off in interest-earning securities. The decrease in loans was due to slow loan demand combined with continuing competition for existing loans. We also opened a new branch this quarter to replace a leased facility. Non-performing assets, which include non-accruing loans and foreclosed assets, decreased from $2.6 millionat December 31, 2013to $1.4 millionat June 30, 2014. Changes in non-performing loans at June 30, 2014compared to December 31, 2013were primarily due to the Bank agreeing to short sales on $777,000, upgrading loans of $676,000, taking $142,000into OREO and charging off 39 -------------------------------------------------------------------------------- $36,000, offset by the addition of $437,000of loans to non-accrual status due to concerns about the full collectability of principal and interest. In addition, we received principal payments of $48,000. Non-accruing loans at June 30, 2014were comprised of $1.2 million, or 92.66%, of one- to four-family residential real estate loans; $58,000, or 4.33%, of multi-family residential real estate loans and $40,000, or 3.01%, of non-real estate loans. Non-performing assets at June 30, 2014also included $117,000of foreclosed property compared to $18,000at December 31, 2013with the addition of three non-owner occupied residential properties. At June 30, 2014, our allowance for loan losses equaled 2.34% of total loans compared to 2.43% at December 31, 2013. The allowance for loan losses at June 30, 2014totaled 420.44% of non-performing assets compared to 245.13% at December 31, 2013, and 457.40% of non-performing loans at June 30, 2014compared to 246.81% at December 31, 2013. Our non-performing assets equaled 0.39% of total assets at June 30, 2014compared to 0.70% at December 31, 2013. When a loan is added to our classified loan list, an impairment analysis is completed to determine expected losses upon final disposition of the property. An adjustment to loan loss reserves is made at that time for any anticipated losses. This analysis is updated quarterly thereafter. It may take up to two years to move a foreclosed property through the system to the point where we can obtain title to the property and dispose of it. We attempt to acquire properties through deeds in lieu of foreclosure if there are no other liens on the properties. We acquired four properties in the first quarter of 2014 through a sheriff's sale and none in the second quarter. Although we believe we use the best information available to determine the adequacy of our allowance for loan losses, future adjustments to the allowance may be necessary, and net income could be significantly affected if circumstances and/or economic conditions cause substantial changes in the estimates we use in making the determinations about the levels of the allowance for losses. Additionally, various regulatory agencies, as an integral part of their examination process, periodically review our allowance for loan losses. These agencies may require the recognition of additions to the allowance based upon their judgments of information available at the time of their examination. Shareholders' equity increased from $40.7 millionat December 31, 2013to $41.6 millionat June 30, 2014, an increase of $883,000, or 2.17%, primarily as a result of net income of $778,000. Shareholders' equity to total assets was 11.29% at June 30, 2014compared to 11.08% at December 31, 2013. Dividends to common shareholders for the six-month period ended June 30, 2014were $.18per share. As required by the Federal Reserve, the Company's Board of Directors adopted resolutions confirming the Company's commitment to continue to obtain written approval from the Federal Reserve prior to declaring dividends, increasing debt or redeeming Company common stock. 40
Average Balances, Interest Rates and Yields
The following table presents, for the periods indicated, the total dollar amount of interest income earned on average interest-earning assets and the resulting yields on such assets, as well as the interest expense paid on average interest-bearing liabilities, and the rates paid on such liabilities. No tax equivalent adjustments were made. All average balances are monthly average balances. Non-accruing loans have been included in the table as loans carrying a zero yield. Deposits at the Federal Reserve are included in interest-earning assets and not in cash accounts. Three months ended Three months ended June 30, June 30, 2014 2013 Average Interest Average Interest Outstanding Earned/ Yield/ Outstanding Earned/ Yield/ Balance Paid Rate Balance Paid Rate (Unaudited; Dollars in thousands) Interest-Earning Assets: Loans receivable(1)
$ 253,641 $ 2,8974.57 % $ 270,939 $ 3,2615.18 % Other investments 87,542 296 1.36 70,986 201 1.13 Total interest-earning assets 341,183 3,193 3.74 341,925 3,462 4.05 Interest-Bearing Liabilities Savings deposits 32,342 5 0.06 31,759 5 0.06 Demand and NOW deposits 155,943 71 0.18 141,527 71 0.20 Time deposits 121,369 347 1.14 137,988 461 1.34 Borrowings 10,000 59 2.36 10,000 59 2.36 Total interest-bearing liabilities 319,654 482 0.60 321,274 596 0.74 Net interest income $ 2,711 $ 2,866Net interest rate spread 3.14 % 3.31 % Net earning assets $ 21,529 $ 20,651Net yield on average interest-earning assets 3.18 % 3.35 % Average interest-earning assets to average interest-bearing liabilities 1.07 x 1.06 x _________________
(1) Calculated net of deferred loan fees, loan discounts, loans in process and loss reserves.
Six months ended Six months ended June 30, June 30, 2014 2013 Average Interest Average Interest Outstanding Earned/ Yield/ Outstanding Earned/ Yield/ Balance Paid Rate Balance Paid Rate (Dollars in
Interest-Earning Assets: Loans receivable(1)
$ 254,861 $ 5,8364.58 % $ 274,411 $ 6,7384.91 % Other investments 86,272 601 1.39 67,859 366 1.08 Total interest-earning assets 341,133 6,437 3.77 342,270 7,104 4.15 Interest-Bearing Liabilities Savings deposits $ 31,3519 0.06 $ 30,9199 0.06 Demand and NOW deposits 155,890 144 0.18 138,707 148 0.21 Time deposits 122,326 706 1.15 139,908 949 1.36 Borrowings 10,000 118 2.36 11,667 138 2.37 Total interest-bearing liabilities 319,567 977 0.61 321,201 1,244 0.77 Net interest income $ 5,460 $ 5,860Net interest rate spread 3.16 % 3.38 % Net earning assets $ 21,566 $ 21,069Net yield on average interest-earning assets 3.20 % 3.42 % Average interest-earning assets to average interest-bearing liabilities 1.07 x 1.07 x 41
Results of Operations
Comparison of Operating Results for the Six Months and the Quarter ended
General. Net income for the six months ended
June 30, 2014was $778,000, a decrease of $539,000, or 40.93%, from the six months ended June 30, 2013. The decrease was primarily due to a $541,000, or 23.76%, decrease in non-interest income, a $400,000, or 6.83%, decrease in net interest income and a $266,000, or 4.89%, increase in non-interest expenses, partially offset by a $525,000, or 84.00%, decrease in the provision for loan losses and a $143,000, or 19.07%, decrease in taxes. Net income for the three months ended June 30, 2014was $258,000, a decrease of $406,000, or 61.14%, from the three months ended June 30, 2013. The decrease was primarily due to a $213,000, or 18.39%, decrease in non-interest income, a $203,000, or 7.33%, increase in non-interest expenses and a $155,000, or 5.41%, decrease in net interest income, partially offset by a $125,000, or 55.56%, decrease in the provision for loan losses, and a $40,000, or 10.96%, decrease in taxes. Net Interest Income. Net interest income for the six months ended June 30, 2014decreased $400,000, or 6.83%, over the same period in 2013. This decrease was primarily due to a 22 basis point decline in our net interest rate spread as the average yield on interest-earning assets decreased by 38 basis points while the yield on interest-earning liabilities decreased by only 16 basis points. Interest-earning assets decreased by $1.1 millionas the average balance of investment securities increased $18.4 millionoffset by a $19.6 milliondecrease in average loans receivable. The investment securities were purchased using excess cash balances and loan paydowns. Our net interest margin (net interest income divided by average interest-earning assets) decreased from 3.42% to 3.20%. Interest income on loans decreased $902,000, or 13.39%, for the six months ended June 30, 2014compared to the same six months in 2013 because the average balance of loans held in our portfolio decreased by $19.6 millionfrom $274.4 millionfor the six month period in 2013 to $254.9 millionin 2014. The average yield on loans decreased by 33 basis points from 4.91% to 4.58% over the same period. Interest earned on other investments and FHLB stock increased by $235,000, or 64.21%, for the six months ended June 30, 2014compared to the same period in 2013. This was primarily the result of an $18.4 millionincrease in the average balance of investments and FHLB stock from $67.9 millionto $86.3 millionover the same periods. The average yield increased from 1.08% to 1.39% over the comparable periods, an increase helped by our success in deploying cash items into higher earning investments. Interest expense for the six months ended June 30, 2014decreased $267,000, or 21.46%, compared to the same period in 2013 consisting of a $247,000decrease in interest paid on deposits and a $20,000decrease in interest on FHLB advances. The lower deposit costs were primarily due to a decrease in the average rate paid on deposits from 0.71% for the first six months of 2013 to 0.55% for the first six months of 2014. Average deposits were virtually unchanged during this period while we saw a $17.5 milliondecrease in the average balance of higher rate time deposits offset by a $17.1 millionincrease in the average balance of 42
-------------------------------------------------------------------------------- comparatively lower rate demand deposit accounts. The increase in demand deposit accounts was largely due to depositors opting for fund availability over higher rates, which could enable them to move their money into higher earning accounts when rates start to rise. The decrease in FHLB advance expense was primarily due to a decrease in the average balance of advances from
$11.7 millionfor the first six months of 2013 to $10.0 millionfor the first six months of 2014 as we paid off a maturing advance since slow loan demand reduced our need for additional funds. The average rate on advances decreased from 2.37% to 2.36%. Net interest income for the three months ended June 30, 2014decreased $155,000, or 5.41%, over the same period in 2013. This decrease was primarily due to a 17 basis point decline in our net interest rate spread as the average yield on interest-earning assets decreased by 31 basis points while the yield on interest-earning liabilities decreased by only 14 basis points. Interest-earning assets decreased by $742,000as the average balance of investment securities increased $16.6 millionoffset by a $17.3 milliondecrease in average loans receivable. The investment securities were purchased using excess cash balances and loan paydowns. Our net interest margin (net interest income divided by average interest-earning assets) decreased from 3.35% to 3.18%. Interest income on loans decreased $364,000, or 11.16%, for the three months ended June 30, 2014compared to the same three months in 2013 because the average balance of loans held in our portfolio decreased by $17.3 millionfrom $270.9 millionfrom the three month period in 2013 to $253.6 millionin 2014. The average yield on loans fell from 5.18% to 4.57% over this period. Interest earned on other investments and FHLB stock increased by $95,000, or 47.26%, for the three months ended June 30, 2014compared to the same period in 2013. This was primarily the result of a $16.6 millionincrease in average investment securities and a 23 basis point increase in the average yield on the investments and FHLB stock from 1.13% to 1.36% over the comparable periods. The increase in rate was primarily due to the movement of cash into earning assets. Interest expense for the three months ended June 30, 2014decreased $114,000, or 19.13%, compared to the same period in 2013 consisting entirely of a decrease in interest paid on deposit accounts with the average rate on certificates of deposit falling from 1.34% for the three month period in 2013 to 1.14% for the same period in 2014 and by a $16.6 milliondecrease in the average balance of certificate accounts which were moved to lower rate transaction and savings accounts which increased by $14.60 million. The increase in these balances was largely due to depositors opting for fund availability over higher rates until they feel more confident about the economic situation and preserving the option to move their money into higher earning accounts when rates start to rise. 43 -------------------------------------------------------------------------------- Provision for Loan Losses. The evaluation of the level of loan loss reserves is an ongoing process that includes closely monitoring loan delinquencies. The following chart shows delinquent loans as well as a breakdown of non-performing assets. June 30, 2014 December 31, 2013 June 30, 2013 (Dollars in thousands)
Loans delinquent 30-59 days $ 185 $ 483 $ 118 Loans delinquent 60-89 days 679 388 719 Total delinquencies under 90 days $ 864 $ 871 $ 837 Non-accruing loans $ 1,331 $ 2,572 $ 3,804 OREO 117 18 162 Total non-performing assets $ 1,448 $ 2,590 $ 3,966 Loans are included in the delinquent 30-59 days category when they become one month past due. Loans are included in the delinquent 60-89 days category when they become two months past due. Loans that are less than 90 days delinquent but are non-accruing are included in the non-accruing loan category but not in the delinquencies under 90 days. The accrual of interest income is generally discontinued when a loan becomes 90 days past due. Loans 90 days past due but not yet three payments past due will continue to accrue interest as long as it has been determined that the loan is well secured and in the process of collection. Troubled debt restructurings that were non-performing at the time of their restructure are considered non-accruing loans until sufficient time has passed for them to establish a pattern of compliance with the terms of the restructure. Changes in non-performing loans at
June 30, 2014compared to December 31, 2013were primarily due to the Bank agreeing to short sales on $777,000, upgrading loans of $676,000, taking $142,000into OREO and charging off $36,000, offset by the addition of $437,000of loans to non-accrual status due to concerns about the full collectability of principal and interest. In addition, we received principal payments of $48,000. We establish our provision for loan losses based on a systematic analysis of risk factors in the loan portfolio. The analysis includes consideration of concentrations of credit, past loss experience, current economic conditions, the amount and composition of the loan portfolio, estimated fair value of the underlying collateral, delinquencies and other relevant factors. From time to time, we also use the services of a consultant to assist in the evaluation of our growing commercial real estate loan portfolio. On at least a quarterly basis, a formal analysis of the adequacy of the allowance is prepared and reviewed by management and the Board of Directors. This analysis serves as a point-in-time assessment of the level of the allowance and serves as a basis for provisions for loan losses. More specifically, our analysis of the loan portfolio will begin at the time the loan is originated, at which time each loan is assigned a risk rating. If the loan is a commercial credit, the borrower will also be assigned a similar rating. Loans that continue to perform as agreed will be included in one of the non-classified loan categories. Portions of the allowance are allocated to loan portfolios in the various risk grades, based upon a variety of factors, including historical loss experience, trends in the type and volume of the loan portfolios, trends in delinquent and non-performing loans, and economic trends affecting our market. Loans no longer performing as 44 -------------------------------------------------------------------------------- agreed are assigned a higher risk rating, eventually resulting in their being regarded as classified loans. A collateral re-evaluation is completed on all classified loans. This process results in the allocation of specific amounts of the allowance to individual problem loans, generally based on an analysis of the collateral securing those loans. These components are added together and compared to the balance of our allowance at the evaluation date. At June 30, 2014, our largest areas of concern were loans on one- to four-family non-owner occupied rental properties and to a lesser extent on loans on one- to four-family owner-occupied properties, loans on non-campus multi-family properties and commercial non-real estate loans. Loans totaling $991,000on one- to four-family rental properties, $242,000on one- to four-family owner-occupied properties, $58,000on a multi-family property and $40,000on commercial non-real estate loans were past due more than 30 days at June 30, 2014. There has been some improvement in the local economy and we are seeing enough improvement in our one- to four-family rental property market to warrant restructuring a number of those relationships. However, we are working to decrease our concentrations in that sector, especially in non-campus housing. We recorded a $100,000provision for loan losses for the six months ended June 30, 2014as a result of our analyses of our current loan portfolios, compared to $625,000during the same period in 2013. The main reason for the decrease was the improvement in non-accruing and delinquent loans during the period. During the first six months of 2014, the net cost of taking properties into OREO and charging off losses was $556,000. We had recoveries of $196,000. We expect to obtain possession of more properties in 2014 that are currently in the process of foreclosure. The final disposition of these properties may result in a loss. The $6.1 millionallowance for loan losses was considered appropriate to cover probable incurred losses based on our evaluation and our loan mix. Our ratio of allowance for loan losses to non-performing assets increased from 245.13% at December 31, 2013to 420.44% at June 30, 2014. Non-performing assets to total assets decreased from 0.70% at December 31, 2013to 0.39% at June 30, 2014. Our loan portfolio contains no option ARM products, interest-only loans, or loans with initial teaser rates. While we occasionally make loans with credit scores in the subprime range, these loans are only made if there are sufficient mitigating factors, not as part of a subprime mortgage plan. We occasionally make mortgages that exceed high loan-to-value regulatory guidelines for property type. We currently have $9.0 millionof mortgage loans that are other than one- to four-family loans that qualify as high loan-to-value. We typically make these loans only to well-qualified borrowers. None of these loans is delinquent more than 30 days. We also have $5.0 millionof one- to four-family loans which either alone or combined with a second mortgage exceed high loan-to-value guidelines. None of these loans was delinquent more than 30 days. Our total high loan-to-value loans at June 30, 2014were at 33% of capital, well under regulatory guidelines of 100% of capital. We have $16.1 millionin home equity lines of credit, one of which was delinquent more than 30 days at June 30, 2014. 45
-------------------------------------------------------------------------------- An analysis of the allowance for loan losses for the three months ended
June 30, 2014and 2013 follows: Three months ended June 30, 2014 2013 (Dollars in thousands) Balance at March 31 $ 6,394 $ 6,062Loans charged off (460 ) (10 ) Recoveries 54 69 Provision 100 225 Balance at June 30 $ 6,088 $ 6,346At June 30, 2014, non-performing assets, consisting of non-accruing loans and other real estate owned, totaled $1.4 millioncompared to $2.6 millionat December 31, 2013. In addition to our non-performing assets, we identified $19.8 millionin other loans of concern where information about possible credit problems of borrowers causes management to have doubts as to the ability of the borrowers to comply with present repayment terms and may result in disclosure of such loans as non-performing assets in the future. The vast majority of these loans, as well as our non-performing assets, are well collateralized. Delinquent loans have remained under $1 millionfor the last 12 months. At June 30, 2014, we believe that our allowance for loan losses was appropriate to absorb probable incurred losses inherent in our loan portfolio. Our allowance for losses equaled 2.34% of net loans receivable and 457.40% of non-performing loans at June 30, 2014compared to 2.43% and 246.81% at December 31, 2013, respectively. Our non-performing assets equaled 0.39% of total assets at June 30, 2014compared to 0.70% at December 31, 2013. Non-Interest Income. Non-interest income for the six months ended June 30, 2014decreased by $541,000, or 23.76%, compared to the same period in 2013. This was primarily due to a $441,000decrease in the gain on sale of mortgage loans due to a $17.8 milliondecrease in loans sold from $29.9 millionin the first six months of 2013 to $12.0 millionin the first six months of 2014, a $114,000decrease in the fees from the sale of non-bank investment products through our Money Concepts program due to less sales activity, partially offset by $26,000increase in mortgage loan servicing fees due to a decrease in the cost of servicing problem loans, and a $7,000decrease in service charges and fee income primarily due to a lower volume of customer overdrafts. Non-interest income for the second quarter of 2014 decreased by $213,000, or 18.39%, compared to the same period in 2013 due primarily to a $200,000decrease in the gain on the sale of mortgage loans due to a $9.5 milliondecrease in loans sold, and a $12,000decrease in other income due to a decrease in fees from the sale of non-bank investment products as noted above. Non-Interest Expense. Non-interest expense for the six months ended June 30, 2014increased $266,000, or 4.89%, compared to the same period in 2013 due primarily to a $327,000increase in other expenses due to costs involved with the merger, a $78,000increase in occupancy costs due to first quarter winter maintenance related expenses and higher utility charges due to the unusually harsh weather and second quarter expenses related to our new branch, and a $15,000increase in computer costs due to an increase in the new products and services offered by the bank to its customers. These were offset by a $102,000decrease in 46
-------------------------------------------------------------------------------- salaries and employee benefits resulting from lower commission earned by loan originators caused by less loan origination activity and a
$51,000decrease in advertising costs due to a decision to reduce ongoing product marketing and focus marketing dollars on keeping customers aware of changes related to the merger with Old National Bankas they occur. Non-interest expense for the three months ended June 30, 2014increased $203,000, or 7.33%, compared to the same period in 2013 due primarily to a $296,000increase in other expenses due to costs involved with the merger, offset by a $71,000decrease in salaries and employee benefits resulting from lower commission earned by loan originators caused by less loan origination activity and a $16,000decrease in advertising costs due to a decision to reduce ongoing product marketing and focus marketing dollars on keeping customers aware of changes related to the merger with Old National Bankas they occur, and an $8,000decrease in occupancy costs due to an adjustment to personal property tax expenses. Income Tax Expense. Our income tax provision decreased by $144,000for the six months ended June 30, 2014compared to the six months ended June 30, 2013and decreased by $40,000for the three months ended June 30, 2014compared to the three months ended June 30, 2013due primarily to decreased pre-tax income.
Our primary sources of funds are deposits, repayment and prepayment of loans, interest earned on or maturation of investment securities and short-term investments, borrowings and funds provided from operations. While maturities and the scheduled amortization of loans, investments and mortgage-backed securities are a predictable source of funds, deposit flows and mortgage prepayments are greatly influenced by general market interest rates, economic conditions and competition. We monitor our cash flow carefully and strive to minimize the level of cash held in low-rate overnight accounts or in cash on hand. We also carefully track the scheduled delivery of loans committed for sale to be added to our cash flow calculations. Liquidity management is both a daily and long-term function for our senior management. We adjust our investment strategy, within the limits established by the investment policy, based upon assessments of expected loan demand, expected cash flows, FHLB advance opportunities, market yields and objectives of our asset/liability management program. Base levels of liquidity have generally been invested in interest-earning overnight and time deposits with the Federal Home Loan Bank of
Indianapolisand more recently at the Federal Reserve since they have started to pay interest on deposits in excess of reserve requirements and because of increasing wire transfer requests due to a change in funding methods now required by title companies. Funds for which a demand is not foreseen in the near future are invested in investment and other securities for the purpose of yield enhancement and asset/liability management. Our current internal policy for liquidity is 5% of total assets. Our liquidity ratio at June 30, 2014was 22.34% as a percentage of total assets compared to 22.16% at December 31, 2013.
We anticipate that we will have sufficient funds available to meet current funding commitments. At
47 -------------------------------------------------------------------------------- current construction projects in the amount of
$3.4 million. Certificates of deposit which will mature in one year or less totaled $78.3 millionat June 30, 2014. Included in that number are $3.9 millionof brokered deposits. Based on our experience, certificates of deposit held by local depositors have been a relatively stable source of long-term funds as such certificates are generally renewed upon maturity since we have established long-term banking relationships with our customers. Therefore, we believe a significant portion of such deposits will remain with us, although this cannot be assured. Brokered deposits can be expected not to renew at maturity and will have to be replaced with other funding upon maturity. We have $3.0 millionin FHLB advances maturing in the next twelve months. Capital Resources Shareholders' equity totaled $41.6 millionat June 30, 2014compared to $40.7 millionat December 31, 2013, an increase of $883,000or 2.17%, due primarily to net income of $778,000. Shareholders' equity to total assets was 11.29% at June 30, 2014compared to 11.08% at December 31, 2013. Federal insured savings institutions are required to maintain a minimum level of regulatory capital. If the requirement is not met, regulatory authorities may take legal or administrative actions, including restrictions on growth or operations or, in extreme cases, seizure. As of June 30, 2014and December 31, 2013, Lafayette Savings was categorized as well capitalized. Our actual and required capital amounts and ratios at June 30, 2014and December 31, 2013are presented below: To Be Well Capitalized Under Prompt Actual For Capital
Adequacy Purposes Corrective Action Provisions
Amount Ratio Amount Ratio Amount Ratio As of
June 30, 2014Total risk-based capital (to risk-weighted assets) $ 44,46017.8 % $ 19,9578.0 % $ 24,94610.0 % Tier I capital (to risk-weighted assets) 41,305 16.6 9,978 4.0 14,968 6.0 Tier I capital (to adjusted total assets) 41,305 11.2 11,064 3.0 18,440 5.0 As of December 31, 2013 Total risk-based capital (to risk-weighted assets) $ 43,60417.4 % $ 20,0548.0 % $ 25,06710.0 % Tier I capital (to risk-weighted assets) 40,431 16.1 10,027 4.0 15,040 6.0 Tier I capital (to adjusted total assets) 40,431 11.0 11,048 3.0 18,413 5.0 48
Disclosure Regarding Forward-Looking Statements
This document, including information included or incorporated by reference, contains, and future filings by
LSB Financialon Form 10-K, Form 10-Q and Form 8-K and future oral and written statements by LSB Financialand our management may contain, forward-looking statements about LSB Financialand its subsidiaries which we believe are within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements include, without limitation, statements with respect to anticipated future operating and financial performance, growth opportunities, interest rates, cost savings and funding advantages expected or anticipated to be realized by management. Words such as may, could, should, would, believe, anticipate, estimate, expect, intend, plan and similar expressions are intended to identify forward-looking statements. Forward-looking statements by LSB Financialand its management are based on beliefs, plans, objectives, goals, expectations, anticipations, estimates and intentions of management and are not guarantees of future performance. We disclaim any obligation to update or revise any forward-looking statements based on the occurrence of future events, the receipt of new information or otherwise. The important factors we discuss below and elsewhere in this document, as well as other factors discussed under the caption Management's Discussion and Analysis of Financial Condition and Results of Operations in this document and identified in our filings with the SECand those presented elsewhere by our management from time to time, could cause actual results to differ materially from those indicated by the forward-looking statements made in this document.
The following factors, many of which are subject to change based on various other factors beyond our control, could cause our financial performance to differ materially from the plans, objectives, expectations, estimates and intentions expressed in such forward-looking statements:
· the strength of
local economies in which we conduct our operations;
· the effects of, and changes in, trade, monetary and fiscal policies and laws,
including interest rate policies of the
Federal Reserve Board;
· financial market, monetary and interest rate fluctuations, particularly the
relative relationship of short-term interest rates to long-term interest
rates; · the timely development of and acceptance of new products and services of Lafayette Savings and the perceived overall value of these products and services by users, including the features, pricing and quality compared to competitors' products and services;
· the willingness of users to substitute competitors' products and services for
our products and services;
· the impact of changes in financial services laws and regulations (including
laws concerning taxes, accounting standards, banking, securities and insurance); · the impact of technological changes; 49
· acquisitions; · changes in consumer spending and saving habits; and · our success at managing the risks involved in the foregoing.