News Column

FIRST KEYSTONE CORP - 10-Q - First Keystone Corporation Management's Discussion and Analysis of Financial Condition and Results of Operation

August 8, 2014

This quarterly report contains certain forward-looking statements, which are included pursuant to the "safeharbor" provisions of the Private Securities Litigation Reform Act of 1995, and reflect management's beliefs and expectations based on information currently available. These forward-looking statements are inherently subject to significant risks and uncertainties, including changes in general economic and financial market conditions, the Corporation's ability to effectively carry out its business plans and changes in regulatory or legislative requirements. Other factors that could cause or contribute to such differences are changes in competitive conditions, and pending or threatened litigation. Although management believes the expectations reflected in such forward-looking statements are reasonable, actual results may differ materially.

CRITICAL ACCOUNTING ESTIMATES

The Corporation has chosen accounting policies that it believes are appropriate to accurately and fairly report its operating results and financial position, and the Corporation applies those accounting policies in a consistent manner. The Significant Accounting Policies are summarized in Note 1 to the consolidated financial statements included in the 2013 Annual Report on Form 10-K. There have been no changes to the Critical Accounting Estimates since the Corporation filed its Annual Report on Form 10-K for the year ended December 31, 2013.

RESULTS OF OPERATIONS



Quarter ended June 30, 2014 compared to quarter ended June 30, 2013

First Keystone Corporation realized earnings for the three months ended June 30, 2014 of $2,756,000, a decrease of $1,116,000, or 28.8% from the three months ended June 30, 2013. The decrease in net income for the three months ended June 30, 2014 was primarily due to a decrease in non-interest income. While net interest income was higher, the provision for loan losses remained the same, non-interest income decreased significantly, and non-interest expense increased slightly as compared to the same period one year ago.

On a per share basis, for the three months ended June 30, 2014, net income was $0.50 versus $0.70 in the three months ended June 30, 2013. Cash dividends amounted to $0.26 per share for the three months ended June 30, 2014 and 2013.

NET INTEREST INCOME



The major source of operating income for the Corporation is net interest income, defined as interest income less interest expense. For the three months ended June 30, 2014, interest income amounted to $7,776,000, a decrease of $48,000 or 0.6% from the three months ended June 30, 2013, while interest expense amounted to $1,108,000 for the three months ended June 30, 2014, a decrease of $121,000, or 9.8% from the three months ended June 30, 2013. As a result, net interest income increased $73,000 or 1.1% for the three months ended June 30, 2014 to $6,668,000 from $6,595,000 for the same period in 2013.

The Corporation's net interest margin for the three months ended June 30, 2014 was 3.48% compared to 3.84% for the same period in 2013. The decrease in net interest margin was a result of the unprecedented continuing low interest rate environment.

PROVISION FOR LOAN LOSSES



The provision for loan losses for the three months ended June 30, 2014 and June 30, 2013 was $200,000. After the Corporation's analysis of the current loan portfolio, including historic losses, past-due trends, current economic conditions, and other relevant factors, the provision for loan losses remained consistent with the same period in the prior year. Net charge-offs for the three months ended June 30, 2014 and 2013 were $200,000 and $172,000, respectively. See Allowance for Loan Losses on page 36 for further discussion.

31 NON-INTEREST INCOME



Total non-interest income was $2,518,000 for the three months ended June 30, 2014, as compared to $3,765,000 for the same period in 2013, a decrease of $1,247,000, or 33.1%. Gains on sales of mortgage loans decreased $174,000 over the three months ended June 30, 2013 to $56,000. Mortgage originations fell as rates continued to rise slightly and fewer customers qualified for secondary market loans during the three months ended June 30, 2014. Net gains on sales of investment securities decreased $1,209,000 to $1,203,000 as compared to the three months ended June 30, 2013. The Bank has taken gains and losses in the portfolio to reduce market risk and protect from further changes in value in the face of increases in long-term interest rates.

Excluding net investment securities gains, non-interest income was $1,315,000 for the three months ended June 30, 2014, a decrease of $38,000, or 2.8% from the second quarter of 2013.

While Trust Department income and ATM and debit card fees both increased, they were not large enough to offset the $174,000 reduction in gains on sales of mortgage loans.

NON-INTEREST EXPENSE



Total non-interest expense was $5,439,000 for the quarter ended June 30, 2014, as compared to $5,323,000 for the quarter ended June 30, 2013. Non-interest expense increased $116,000, or 2.2%.

Expenses associated with employees (salaries and employee benefits) continue to be the largest category of non-interest expense. Salaries and benefits amounted to $2,825,000, or 51.9% of total non-interest expense for the three months ended June 30, 2014, as compared to 50.9% for the same three months of 2013. Net occupancy, furniture and equipment, and computer expense amounted to $872,000 for the quarter ended June 30, 2014, a decrease of $45,000, or 4.9%. All other non-interest expenses amounted to $1,742,000 for the three months ended June 30, 2014, an increase of $44,000, or 2.6% as compared to the same three months of 2013.

The overall increase in non-interest expense related primarily to expenses associated with our new Dallas and Shickshinny offices along with the opening of our new administrative facility in Berwick. In addition, the Corporation experienced increased costs related to data processing expenses. In the second quarter of 2014, the Bank began to incur data processing costs as a result of the planned outsourcing of its core processing system for data security, disaster recovery and system efficiency goals. Advertising expenses were also higher due to the rollout of the Bank's new suite of rewards checking products called Kasasa in the first quarter of 2014.

INCOME TAXES



Effective tax planning has helped produce favorable net income. Income tax expense amounted to $791,000 for the three months ended June 30, 2014, as compared to $965,000 for the three months ended June 30, 2013, a decrease of $174,000. The effective total income tax rate was 22.3% for the second quarter of 2014 as compared to 20.0% for the second quarter of 2013. The increase in the effective tax rate was due to the sales of tax-free municipal securities during the past year and the impact of the tax credits from the low-income housing partnerships. The Corporation looks to maximize its tax-exempt income derived from both tax-free loans and tax-free municipal securities.

Six months ended June 30, 2014 compared to six months ended June 30, 2013

First Keystone Corporation realized earnings for the six months ended June 30, 2014 of $5,054,000, a decrease of $1,344,000, or 21.0% from the six months ended June 30, 2013. The decrease in net income for the first six months of 2014 was due to several factors, including a decrease in non-interest income and an increase in non-interest expense, offset by a decrease in the provision for loan losses.

On a per share basis, for the six months ended June 30, 2014, net income was $0.91 versus $1.17 in the first six months of 2013. Cash dividends amounted to $0.52 per share in the first six months of 2014 and 2013.

Year-to-date net income annualized as of June 30, 2014, amounted to a return on average common equity of 10.03%, a return on tangible equity net of goodwill of 12.38% and a return on assets of 1.14%. For the six months ended June 30, 2013, these measures were 12.19%, 14.91%, and 1.57%, respectively, on an annualized basis.

32 NET INTEREST INCOME



For the six months ended June 30, 2014, interest income amounted to $15,409,000, a decrease of $259,000 or 1.7% from the same six month period in 2013, while interest expense amounted to $2,233,000 for the six months ended June 30, 2014, a decrease of $242,000, or 9.8% from the six months ended June 30, 2013. As a result, net interest income decreased $17,000 or 0.1% for the six months ended June 30, 2014 to $13,176,000 from $13,193,000 for the same period in 2013.

Our net interest margin for the six months ended June 30, 2014 was 3.46% compared to 3.91% for the six months ended June 30, 2013. The decrease in the net interest margin was a result of the unprecedented continuing low interest rate environment.

PROVISION FOR LOAN LOSSES



The provision for loan losses for the six months ended June 30, 2014 was $333,000 as compared to $600,000 for the six months ended June 30, 2013. The decrease in the provision for loan losses resulted from the Corporation's analysis of the current loan portfolio, including historic losses, past-due trends, current economic conditions, and other relevant factors. Net charge-offs for the six months ended June 30, 2014 and 2013 were $375,000 and $442,000, respectively. See Allowance for Loan Losses on page 36 for further discussion.

NON-INTEREST INCOME



Total non-interest income was $4,233,000 for the six months ended June 30, 2014, as compared to $5,217,000 for the six months ended June 30, 2013, a decrease of $984,000, or 18.9%. Gains on sales of mortgage loans decreased $360,000 over the first half of 2014 to $80,000. Mortgage originations fell as rates continued to rise slightly and fewer customers qualified for secondary market loans. Net gains on sales of investment securities decreased $880,000 to $1,800,000 as compared to the six months ended June 30, 2013. The Bank has taken gains and losses in the portfolio to reduce market risk and protect from further changes in value in the face of increases in long-term interest rates.

Excluding net investment securities gains, non-interest income was $2,433,000 for the first half of 2014, a decrease of $104,000, or 4.1% from the first half of 2013.

While Trust Department income, service charges and fees and ATM and debit card fees increased, they were not large enough to offset the $360,000 reduction in gains on sales of mortgage loans.

NON-INTEREST EXPENSE



Total non-interest expense was $10,691,000 for the six months ended June 30, 2014, as compared to $10,004,000 for the six months ended June 30, 2013. Non-interest expense increased $687,000, or 6.9%.

Expenses associated with employees (salaries and employee benefits) continue to be the largest category of non-interest expense. Salaries and benefits amounted to $5,642,000, or 52.8% of total non-interest expense for the six months ended June 30, 2014, as compared to 54.3% for the six months of 2013. Net occupancy, furniture and equipment, and computer expense amounted to $1,745,000 for the six months ended June 30, 2014, an increase of $106,000, or 6.5%. All other non-interest expenses amounted to $3,304,000 for the six months ended June 30, 2014, an increase of $367,000, or 12.5% as compared to the same six months ended June 30, 2013.

The overall increase in non-interest expense related primarily to expenses associated with our new Dallas and Shickshinny offices along with the opening of our new administrative facility in Berwick. In addition, the Corporation experienced increased costs related to data processing, collections and foreclosed real estate expenses. In the second quarter of 2014, the Bank began to incur data processing costs as a result of the planned outsourcing of its core processing system for data security, disaster recovery and system efficiency goals. Advertising expenses were also higher due to the rollout of the Bank's new suite of rewards checking products called Kasasa in the first quarter of 2014.

33 INCOME TAXES



Income tax expense amounted to $1,331,000 for the six months ended June 30, 2014, as compared to $1,408,000 for the six months ended June 30, 2013, a decrease of $77,000. The effective total income tax rate was 20.8% for the six months ended June 30, 2014 as compared to 18.0% for the six months ended June 30, 2013. The increase in the effective tax rate was due to the sales of tax-free municipal securities during the past year and the impact of the tax credits from the low-income housing partnerships.

FINANCIAL CONDITION SUMMARY



Total assets decreased to $892,763,000 as of June 30, 2014, a decrease of $8,751,000, or 1.0% from year-end 2013. As of June 30, 2014, total deposits amounted to $642,576,000, a decrease of 6.9% from year-end 2013.

Total loans increased by $16,656,000 or 3.7%. Loan demand appears to be increasing as the Bank has seen an increase in loan originations.

Total cash and cash equivalents decreased compared to year-end 2013 due to reductions in balances held at correspondent banks.

The Corporation continues to maintain and manage its asset growth. The Corporation's strong equity capital position provides an opportunity to further leverage its asset growth. Total borrowings increased in the first six months of 2014 by $35,152,000 to $143,814,000 from $108,662,000 as of December 31, 2013. Borrowings increased to support increased loan balances and replace decreased deposit balances.

SEGMENT REPORTING



Currently, management measures the performance and allocates the resources of the Corporation as a single segment.

EARNING ASSETS



Earning assets are defined as those assets that produce interest income. By maintaining a healthy asset utilization rate, i.e., the volume of earning assets as a percentage of total assets, the Corporation maximizes income. The earning asset ratio (average interest earning assets divided by average total assets) equaled 91.7% at June 30, 2014, compared to 91.5% at June 30, 2013. This indicates that the management of earning assets is a priority and non-earning assets, primarily cash and due from banks, fixed assets and other assets, are maintained at minimal levels. The primary earning assets are loans and investment securities.

Our primary earning asset, total loans, increased to $463,174,000 as of June 30, 2014, up $16,656,000, or 3.7% since year-end 2013. The loan portfolio continues to be diversified. Overall asset quality has remained consistent with non-performing assets decreasing slightly since year-end 2013. Total non-performing assets were $4,310,000 as of June 30, 2014, a decrease of $39,000, or 0.9% from $4,349,000 reported in non-performing assets as of December 31, 2013. Total allowance for loan losses to total non-performing assets was 150.3% as of June 30, 2014 and 149.9% at December 31, 2013.

In addition to loans, another primary earning asset is our overall investment portfolio, which decreased in size from December 31, 2013, to June 30, 2014. Available-for-sale securities amounted to $348,877,000 as of June 30, 2014, a decrease of $4,821,000 from year-end 2013. Interest-bearing deposits in other banks decreased as of June 30, 2014, to $1,000,000 from $22,366,000 at year-end 2013.

LOANS



Total loans increased to $463,174,000 as of June 30, 2014 as compared to $446,518,000 as of December 31, 2013. The table on page 15 provides data relating to the composition of the Corporation's loan portfolio on the dates indicated. Total loans increased by $16,656,000 or 3.7%.

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Increasing demand for borrowing by both individuals and businesses accounted for the 3.7% increase in the loan portfolio from December 31, 2013 to June 30, 2014. The Commercial and Industrial portfolio decreased $561,000 to $60,261,000 as of June 30, 2014 as compared to $60,822,000 as of December 31, 2013. The decrease in the Commercial and Industrial portfolio (which includes tax-free commercial and industrial loans) was attributed to weak loan demand, which was offset by loan payoffs, along with typical loan amortization. The Commercial Real Estate portfolio (which includes tax-free commercial real estate loans) increased $12,496,000 to $237,901,000 as of June 30, 2014, as compared to $225,405,000 at December 31, 2013. The increase was mainly attributed to new loan originations totaling $24,207,000, which were offset by loan payoffs of $6,992,000, combined with typical amortizations in the loan portfolio. The Residential Real Estate portfolio increased $4,884,000 to $159,559,000 as of June 30, 2014, as compared to $154,675,000 as of December 31, 2013. The increase was the result of new originations, and to a lesser extent, refinances held in the Bank's portfolio. The Corporation continued to originate and sell certain long-term fixed rate residential mortgage loans which conform to secondary market requirements. The Corporation derives ongoing income from the servicing of mortgages sold in the secondary market. The Corporation continues its efforts to lend to creditworthy borrowers despite the continued slow economic conditions.

Management believes that the loan portfolio is well diversified. The total commercial portfolio was $298,162,000 of which $237,901,000 or 51.4% of total loans is secured by commercial real estate.

The largest relationship is comprised of various real estate entities, with a related owner who began real estate investment and development activities in 1989. The relationship had outstanding loan balances and unused commitments of $12,354,000 at June 30, 2014. The individual owns a diverse mix of real estate entities which specialize in construction/development projects, leasing of commercial office space, and rental of multi-tenant residential units. This relationship is comprised of $4,744,000 in long term debt, two construction mortgages totaling $6,610,000, and a $1,000,000 line of credit. The relationship is well secured by first lien mortgages on income producing commercial and residential real estate, plus collateral pledge of cash accounts and marketable securities.

The second largest relationship is a manufacturing/fabrication company and its related entities. The company has a long history of successful operations dating back to 1980. The relationship had outstanding loan balances and unused commitments of $9,147,000 at June 30, 2014. The debt consists of approximately $6,652,000 in term debt secured by various real estate holdings, and approximately $2,495,000 in operating lines of credit secured by business assets and guaranties.

The third largest relationship at June 30, 2014 consists of $8,377,000 in a tax free loan and an unused commitment to a municipality founded in 1816 consisting of 35 square miles. According to township officials, the population has been increasing steadily since 2001 and is currently in excess of 11,000 people. In 2012, the township completed its $74,000,000 sewer expansion project. The Bank's loan is secured by project receivables and the full faith, credit, and taxing power of the township.

The fourth largest relationship is a real estate development company and its related entities, specializing in the design, construction, and management of multi-tenant residential housing. The company was established in the late 1980s with its primary market being the Corporation's immediate central market area. The relationship had outstanding loan balances and unused commitments of $8,238,000 at June 30, 2014. The debt consists of approximately $5,526,000 in term debt secured by various real estate holdings, and approximately $2,712,000 in lines of credit secured by various real estate holdings. The loans are secured primarily by income producing multi-tenant real estate.

The fifth largest relationship consists of a real estate development/holding company that was established in 2006 to construct a multi-tenant medical complex, as well as the medical-related entities that operate out of the complex. The relationship had outstanding loan balances and unused commitments of $8,120,000 at June 30, 2014. The debt is comprised of approximately $6,428,000 in term debt, as well as $1,692,000 in operating lines of credit. This relationship is well secured by business assets, undeveloped land, and commercial and residential real estate.

Each of the relationships is located within the Corporation's market area.

Each of the loans is paying as agreed and none of the loans are considered criticized or classified. The property securing each of the loans was appraised at the time the loan was originated. Appraisals are ordered independently of the loan approval process from appraisers on an approved list. All appraisals are reviewed internally for conformity with accepted standards of the Bank.

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All loan relationships in excess of $1,500,000 are reviewed internally and through an external loan review process on an annual basis. Such review is based upon analysis of current financial statements of the borrower, co-borrowers/guarantors, payment history, and economic conditions.

Overall, the portfolio risk profile as measured by loan grade is considered low risk, as $450,209,000 or 97.2% of total loans are graded Pass; $6,801,000 or 1.5% are graded Special Mention; $5,716,000 or 1.3% are graded Substandard; and $0 are graded Doubtful. The rating is intended to represent the best assessment of risk available at a given point in time, based upon a review of the borrower's financial statements, credit analysis, payment history with the Bank, credit history and lender knowledge of the borrower. See Note 4 - Loans and Allowance for Loan Losses for risk grading tables.

Overall, non-pass grades increased to $12,517,000 at June 30, 2014, as compared to $6,698,000 at December 31, 2013. Commercial and Industrial non-pass grades increased to $310,000 as of June 30, 2014 as compared to $86,000 as of December 31, 2013. Commercial Real Estate non-pass grades increased to $10,670,000 as of June 30, 2014 as compared to $5,499,000 as of December 31, 2013. The Residential Real Estate and Consumer loan non-pass grades increased to $1,537,000 as of June 30, 2014 as compared to $1,113,000 as of December 31, 2013.

The increase in Commercial Real Estate non-pass grade loans was mainly the result of the downgrade of nine loans. Eight of the downgraded loans totaling $638,000 are with a single individual for various multi-tenant housing projects. Unpaid real estate taxes and municipal liens have had a negative impact on the relationship. Despite the circumstances, the borrower continues to perform. One loan of $4,971,000 is with a real estate development company. The weak real estate market has hindered the process of the development plans and expected sales have not materialized. However, the borrower remains strong and continues to perform.

The Corporation continues to internally underwrite each of its loans to comply with prescribed policies and approval levels established by its Board of Directors. Total Loans (Dollars in thousands) June 30, December 31, 2014 2013 Commercial and Industrial $ 60,261$ 60,822 Commercial Real Estate 237,901 225,405 Residential Real Estate 159,559 154,675 Consumer 5,453 5,616 Total loans $ 463,174$ 446,518 ALLOWANCE FOR LOAN LOSSES



The allowance for loan losses constitutes the amount available to absorb losses within the loan portfolio. As of June 30, 2014, the allowance for loan losses was $6,477,000 as compared to $6,519,000 as of December 31, 2013. The allowance for loan losses is established through a provision for loan losses charged to expenses. Loans are charged against the allowance for possible loan losses when management believes that the collectability of the principal is unlikely. The risk characteristics of the loan portfolio are managed through the various control processes, including credit evaluations of individual borrowers, periodic reviews, and diversification by industry. Risk is further mitigated through the application of lending procedures such as the holding of adequate collateral and the establishment of contractual guarantees.

Management performs a quarterly analysis to determine the adequacy of the allowance for loan losses. The methodology in determining adequacy incorporates specific and general allocations together with a risk/loss analysis on various segments of the portfolio according to an internal loan review process. This assessment results in an allocated allowance. Management maintains its loan review and loan classification standards consistent with those of its regulatory supervisory authority.

Management considers, based upon its methodology, that the allowance for loan losses is adequate to cover foreseeable future losses. However, there can be no assurance that the allowance for loan losses will be adequate to cover significant losses, if any, that might be incurred in the future.

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The Analysis of Allowance for Loan Losses table contains an analysis of the allowance for loan losses indicating charge-offs and recoveries for the six month periods ended June 30, 2014 and 2013. For the first six months of 2014, net charge-offs as a percentage of average loans was 0.08% as compared to 0.10% for the six month period ended June 30, 2013. Net charge-offs amounted to $375,000 for the first six months of 2014 as compared to $442,000 for the first six months of 2013. The decrease in net charge-offs in the first six months of 2014 as compared to the first six months of 2013 related primarily to decreased losses in Commercial and Residential Real Estate loans. During the first six months of 2014, $411,000 in Commercial and Residential Real Estate loans were charged off as compared to $446,000 for the first six months of 2013.

For the first six months of 2014, the provision for loan losses was $333,000 as compared to $600,000 for the first six months of 2013. The provision, net of charge-offs and recoveries, increased the quarter end Allowance for Loan Losses to $6,477,000 of which 11.4% was attributed to the Commercial and Industrial component; 53.3% attributed to the Commercial Real Estate component; 25.0% attributed to the Residential Real Estate component (primarily residential mortgages); 0.8% attributed to the Consumer component; and 9.5% being the unallocated component (refer to the activity in Note 4 - Loans and Allowance for Loan Losses on page 16). The Corporation determined that the provision for loan losses made during the current quarter was sufficient to maintain the allowance for loan losses at a level necessary for the probable losses inherent in the loan portfolio as of June 30, 2014.

Analysis of Allowance for Loan Losses

(Dollars in thousands) June 30, June 30, 2014 2013 Balance at beginning of the six month period $ 6,519$ 5,772



Charge-offs:

Commercial and Industrial 7 - Real Estate - Commercial and Residential 411 446 Consumer 15 22 433 468



Recoveries:

Commercial and Industrial 21 19 Real Estate - Commercial and Residential 36 4 Consumer 1 3 58 26 Net charge-offs 375 442 Additions charged to operations 333 600 Balance at end of the six month period $ 6,477$ 5,930



Ratio of net charge-offs during the period to average loans outstanding during the period

0.08 % 0.10 % Allowance for loan losses to average loans outstanding during the period 1.42 % 1.38 %



It is the policy of management and the Corporation's Board of Directors to make a provision for both identified and unidentified losses inherent in its loan portfolio. A provision for loan losses is charged to operations based upon an evaluation of the potential losses in the loan portfolio. This evaluation takes into account such factors as portfolio concentrations, delinquency trends, trends of non-accrual and classified loans, economic conditions, and other relevant factors.

The loan review process, which is conducted quarterly, is an integral part of the Bank's evaluation of the loan portfolio. A detailed quarterly analysis to determine the adequacy of the Corporation's allowance for loan losses is reviewed by the Board of Directors.

With the Bank's manageable level of net charge-offs and the additions to the reserve from the provision out of operations, the allowance for loan losses as a percentage of average loans amounted to 1.42% at June 30, 2014 and 1.38% at June 30, 2013.

37 NON-PERFORMING ASSETS



The table on page 39 detail the Corporation's non-performing assets and impaired loans as of the dates indicated. Generally, a loan is classified as non-accrual and the accrual of interest on such a loan is discontinued when the contractual payment of principal or interest has become 90 days past due or management has serious doubts about further collectability of principal or interest, even though the loan currently is performing. A loan may remain on accrual status if it is in the process of collection and is either guaranteed or well secured. When a loan is placed on non-accrual status, unpaid interest credited to income in the current year is reversed and unpaid interest accrued in prior years is charged against current period income. A modification of a loan constitutes a troubled debt restructuring ("TDR") when a borrower is experiencing financial difficulty and the modification constitutes a concession that the Corporation would not otherwise consider. Modifications to loans classified as TDRs generally include reductions in contractual interest rates, principal deferments and extensions of maturity dates at a stated interest rate lower than the current market for a new loan with similar risk characteristics. While unusual, there may be instances of loan principal forgiveness. Foreclosed assets held for resale represent property acquired through foreclosure, or considered to be an in-substance foreclosure.

Total non-performing assets amounted to $4,310,000 as of June 30, 2014 as compared to $4,349,000 as of December 31, 2013. The economy, in particular, high unemployment, weak job markets, unsettled fuel prices, rising energy costs, and the continued slowness in the housing industry had a direct effect on the Corporation's non-performing assets. The Corporation is closely monitoring its Commercial Real Estate portfolio because of the current economic environment. In particular, vacancy rates are rising and rents and property values in some markets have fallen. Non-accrual loans totaled $4,010,000 as of June 30, 2014 as compared to $3,551,000 as of December 31, 2013. Foreclosed assets held for resale decreased to $237,000 as of June 30, 2014 from $480,000 as of December 31, 2013. Loans past-due 90 days or more and still accruing interest amounted to $63,000 as of June 30, 2014 as compared to $318,000 as of December 31, 2013. At June 30, 2014, Loans past-due 90 days or more and still accruing interest consisted of one Commercial Real Estate loan, which is deemed to be well secured by collateral and is in the process of collection. Non-performing assets to total loans was 0.9% as of June 30, 2014 compared to 1.0% at December 31, 2013. Non-performing assets to total assets was 0.5% as of June 30, 2014 and December 31, 2013. The allowance for loan losses to total non-performing assets was 150.3% as of June 30, 2014 as compared to 149.9% as of December 31, 2013. Additional detail can be found on page 39 in the Non-Performing Assets and Impaired Loans table and page 22 in the Financing Receivables on Non-Accrual Status table. Asset quality is a priority and the Corporation retains a full-time loan review officer to closely track and monitor overall loan quality, along with a full-time workout specialist to manage collection and liquidation efforts.

Impaired loans were $6,898,000 at June 30, 2014 and $5,974,000 at December 31, 2013. The largest impaired loan relationship at June 30, 2014 consisted of a purchased participation loan secured by commercial real estate. The Corporation's participation share of the loan was $1,413,000. The collateral evaluation at June 30, 2014 carried a value of $5,813,000, after considering estimated appraisal adjustments and cost to sell of 40% and considering the total participation outstanding note balance, resulting in the Corporation's specific allocation of $0. At June 30, 2014, the second largest impaired loan relationship was represented by one performing loan carrying a balance of $880,000 secured by commercial real estate. The collateral evaluation at June 30, 2014 carried a value of $1,012,000, after estimated appraisal adjustments and cost to sell of 56%, resulting in a specific allocation of $0. The third largest impaired loan relationship at June 30, 2014 was represented by three non-performing loans carrying a balance of $619,000 secured by residential real estate. The collateral evaluation at June 30, 2014 carried a value of $638,000 after estimated appraisal adjustments and cost to sell of 9%, resulting in a specific allocation of $0. The estimated appraisal adjustments and cost to sell percentages are determined based on the market area in which the real estate securing the loan is located, among other factors, and therefore, can differ from one loan to another. Of the $6,898,000 in impaired loans at June 30, 2014, none were located outside the Corporation's primary market area.

Loans categorized as TDRs carried an unpaid balance of $4,301,000 as of June 30, 2014 as compared to $3,961,000 as of December 31, 2013. The increase was attributable to deterioration in the respective borrowers' financial position, and in some cases a declining collateral value, along with the Bank's proactive monitoring of the loan portfolio resulting in the identification of additional loans classified as TDRs. Of the nineteen restructured loans at June 30, 2014, two loans are classified in the Commercial and Industrial portfolio, sixteen loans are classified in the Commercial Real Estate portfolio, and one loan is classified in the Consumer portfolio. At June 30, 2014, seven Commercial Real Estate loans classified as TDRs with a combined recorded investment of $970,000 were not in compliance with the terms of their restructure, compared to June 30, 2013 when three Commercial Real Estate loans classified as TDRs with a combined recorded investment of $304,000 were not in compliance with the terms of their restructure. The troubled debt restructurings at June 30, 2014 consisted of five term modifications beyond the original stated term, five interest rate modifications, and nine payment modifications. TDRs are separately identified for impairment disclosures, and if necessary, a specific allocation is established. As of June 30, 2014, no specific allocations were attributable to the TDRs.

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The Corporation's non-accrual loan valuation procedure for any loans greater than $250,000 requires an appraisal to be obtained and reviewed annually at year end. A quarterly collateral evaluation is performed which may include a site visit, property pictures and discussions with realtors and other similar business professionals to ascertain current values.

For non-accrual loans less than $250,000 upon classification and typically at year end, the Corporation completes a Certificate of Inspection, which includes the results of an onsite inspection, insured values, tax assessed values, recent sales comparisons and a review of the previous evaluations.

Improving loan quality is a priority. The Corporation actively works with borrowers to resolve credit problems and will continue its close monitoring efforts in 2014. Excluding the assets disclosed in the Non-Performing Assets and Impaired Loans tables below and the Troubled Debt Restructurings section in Note 4 - Loans and Allowance for Loan Losses, management is not aware of any information about borrowers' possible credit problems which cause serious doubt as to their ability to comply with present loan repayment terms.

Should the economic climate no longer continue to be stable or deteriorate further, borrowers may experience difficulty, and the level of impaired loans and non-performing assets, charge-offs and delinquencies could rise and possibly require additional increases in the Corporation's allowance for loan losses.

In addition, regulatory authorities, as an integral part of their examinations, periodically review the allowance for possible loan losses. They may require additions to allowances based upon their judgments about information available to them at the time of examination.

A concentration of credit exists when the total amount of loans to borrowers, who are engaged in similar activities that are similarly impacted by economic or other conditions, exceed 10% of total loans. As of June 30, 2014 and December 31, 2013, management is of the opinion that there were no loan concentrations exceeding 10% of total loans.

(Dollars in thousands) June 30, December 31, 2014 2013 Non-performing assets Non-accrual loans $ 4,010$ 3,551 Foreclosed assets held for resale 237 480 Loans past-due 90 days or more and still accruing interest 63 318 Total non-performing assets $ 4,310$ 4,349 Impaired loans Non-accrual loans $ 4,010$ 3,551 Accruing TDRs 2,888 2,423 Total impaired loans 6,898 5,974 Allocated allowance for loan losses (44 ) (140 ) Net investment in impaired loans $ 6,854$ 5,834 Impaired loans with a valuation allowance $ 133 $ 275 Impaired loans without a valuation allowance 6,765 5,699 Total impaired loans $ 6,898$ 5,974 Valuation allowance related to impaired loans $ 44 $ 140 Allocated valuation allowance as a percent of impaired loans 0.6 % 2.3 % Impaired loans to total loans 1.5 % 1.3 % Non-performing assets to total loans 0.9 % 1.0 % Non-performing assets to total assets 0.5 % 0.5 % Allowance for loan losses to impaired loans 93.9 % 109.1 % Allowance for loan losses to total non-performing assets 150.3 % 149.9 % 39



Real estate mortgages comprise 85.8% of the loan portfolio as of June 30, 2014, as compared to 85.1% as of December 31, 2013. Real estate mortgages consist of both residential and commercial real estate loans. The real estate loan portfolio is well diversified in terms of borrowers, collateral, interest rates, and maturities. Also, the residential real estate loan portfolio is largely comprised of fixed rate mortgages. The real estate loans are concentrated primarily in the Corporation's market area and are subject to risks associated with the local economy. The commercial real estate loans typically reprice approximately every three to five years and are also concentrated in the Corporation's market area. The Corporation's loss exposure on its impaired loans continues to be mitigated by collateral positions on these loans. The allocated allowance for loan losses associated with impaired loans is generally computed based upon the related collateral value of the loans. The collateral values are determined by recent appraisals, but are generally discounted by management based on historical dispositions, changes in market conditions since the last valuation and management's expertise and knowledge of the borrower and the borrower's business.

DEPOSITS AND OTHER BORROWED FUNDS

Consumer and commercial retail deposits are attracted primarily by the Bank's eighteen full service office locations, as well as its new eBranch that offers online account openings. The Bank offers a broad selection of deposit products and continually evaluates its interest rates and fees on deposit products. The Bank regularly reviews competing financial institutions interest rates, especially when establishing interest rates on certificates of deposit.

Total deposits decreased $47,499,000 to $642,576,000 as of June 30, 2014 as non-interest bearing deposits increased by $9,601,000 and interest bearing deposits decreased by $57,100,000 from year-end 2013. Total deposits decreased due to the withdrawal of funds by a municipal depositor through normal, seasonal use of funds. In addition, certain national market jumbo certificates of deposit matured and were not renewed. Total short-term and long-term borrowings increased to $143,814,000 as of June 30, 2014, from $108,662,000 at year-end 2013, an increase of $35,152,000, or 32.3%. Total borrowings increased due to fund growth in the loan portfolio and to replace the decrease in deposits.

Other liabilities decreased from $6,034,000 as of December 31, 2013 to $2,940,000 as of June 30, 2014. At December 31, 2013, the Corporation committed to purchase $2,945,000 in investment securities, which settled in January of 2014.

CAPITAL STRENGTH



Normal increases in capital are generated by net income, less dividends paid out. During the first six months of the year, net income less dividends paid increased capital by $2,180,000. Accumulated other comprehensive income (loss) derived from net unrealized gains (losses) on investment securities available-for-sale also impacts capital. At December 31, 2013, accumulated other comprehensive income (loss) was $(54,000). Accumulated other comprehensive income stood at $3,883,000 at June 30, 2014, an increase of $3,937,000. Fluctuations in interest rates have regularly impacted the gain/loss position in the Bank's investment portfolio, as well as its decision to sell securities at a gain or loss. In order to protect the Bank from market risk in the event of further interest rate increases, the Bank chose to sell a portion of its securities during the first half of 2014 at an overall net gain of $1,800,000. These fluctuations from net unrealized gains (losses) on investment securities available-for-sale do not affect regulatory capital.

The Corporation held 235,149 shares of common stock, as treasury stock, at June 30, 2014 and December 31, 2013. This had an effect of reducing our total stockholders' equity by $5,823,000 as of June 30, 2014 and December 31, 2013. Beginning in June 2012, the Corporation began issuing common stock for new shares purchased by participants in the Corporation's Dividend Reinvestment Program ("DRIP").

Total stockholders' equity was $103,027,000 as of June 30, 2014, and $96,351,000 as of December 31, 2013. Leverage ratio and risk based capital ratios remain very strong. As of June 30, 2014, our leverage ratio was 9.13% compared to 8.87% as of December 31, 2013. In addition, Tier I risk based capital and total risk based capital ratios as of June 30, 2014, were 14.35% and 15.60%, respectively. The same ratios as of December 31, 2013 were 13.68% and 14.92%, respectively.

LIQUIDITY



The Corporation's objective is to maintain adequate liquidity to meet funding needs at a reasonable cost and to provide contingency plans to meet unanticipated funding needs or a loss of funding sources, while minimizing interest rate risk. Adequate liquidity provides resources for credit needs of borrowers, for depositor withdrawals and for funding corporate operations.

40



Sources of liquidity are as follows:

Growth in the core deposit base;

Proceeds from sales or maturities of investment securities;

Payments received on loans and mortgage-backed securities;

Overnight correspondent bank borrowings on various credit lines; and,

Borrowing capacity available from the FHLB.

Managing liquidity remains an important segment of asset/liability management. The overall liquidity position of the Corporation is maintained by an active asset/liability management committee. The Corporation believes that its core deposits are stable even in periods of changing interest rates. Liquidity and funds management are governed by policies and are measured on a monthly basis. These measurements indicate that liquidity generally remains stable and exceeds the Corporation's minimum defined levels of adequacy. Other than the trends of continued competitive pressures and volatile interest rates, there are no known demands, commitments, events or uncertainties that will result in, or that are reasonably likely to result in, liquidity increasing or decreasing in any material way.

MARKET RISK



Market risk is the risk of loss arising from adverse changes in the fair value of financial instruments due to changes in interest rates, exchange rates and equity prices. The Corporation's market risk is composed primarily of interest rate risk. The Corporation's interest rate risk results from timing differences in the repricing of assets, liabilities, off-balance sheet instruments, and changes in relationships between rate indices and the potential exercise of explicit or embedded options.

Increases in the level of interest rates also may adversely affect the fair value of the Corporation's securities and other earning assets. Generally, the fair value of fixed-rate instruments fluctuates inversely with changes in interest rates. As a result, increases in interest rates could result in decreases in the fair value of the Corporation's interest-earning assets, which could adversely affect the Corporation's results of operations if sold, or, in the case of interest-earning assets classified as available-for-sale, the Corporation's stockholders' equity, if retained. Under FASB ASC 320-10, Investment Debt and Equity Securities, changes in the unrealized gains and losses, net of taxes, on securities classified as available-for-sale are reflected in the Corporation's stockholders' equity. The Corporation does not own any trading assets.

Asset/Liability Management



The principal objective of asset/liability management is to manage the sensitivity of the net interest margin to potential movements in interest rates and to enhance profitability through returns from managed levels of interest rate risk. The Corporation actively manages the interest rate sensitivity of its assets and liabilities. Several techniques are used for measuring interest rate sensitivity. Interest rate risk arises from the mismatches in the repricing of assets and liabilities within a given time period, referred to as a rate sensitivity gap. If more assets than liabilities mature or reprice within the time frame, the Corporation is asset sensitive. This position would contribute positively to net interest income in a rising rate environment. Conversely, if more liabilities mature or reprice, the Corporation is liability sensitive. This position would contribute positively to net interest income in a falling rate environment. The Corporation's cumulative gap at one year indicates the Corporation is liability sensitive.

Earnings at Risk



The Bank's Asset/Liability Committee ("ALCO") is responsible for reviewing the interest rate sensitivity position and establishing policies to monitor and limit exposure to interest rate risk. The guidelines established by ALCO are reviewed by the Corporation's Board of Directors. The Corporation recognizes that more sophisticated tools exist for measuring the interest rate risk in the balance sheet beyond interest rate sensitivity gap. Although the Corporation continues to measure its interest rate sensitivity gap, the Corporation utilizes additional modeling for interest rate risk in the overall balance sheet. Earnings at risk and economic values at risk are analyzed.

Earnings simulation modeling addresses earnings at risk and net present value estimation addresses economic value at risk. While each of these interest rate risk measurements has limitations, taken together they represent a reasonably comprehensive view of the magnitude of interest rate risk in the Corporation.

41 Earnings Simulation Modeling



The Corporation's net income is affected by changes in the level of interest rates. Net income is also subject to changes in the shape of the yield curve. For example, a flattening of the yield curve would result in a decline in earnings due to the compression of earning asset yields and increased liability rates, while a steepening would result in increased earnings as earning asset yields widen.

Earnings simulation modeling is the primary mechanism used in assessing the impact of changes in interest rates on net interest income. The model reflects management's assumptions related to asset yields and rates paid on liabilities, deposit sensitivity, size and composition of the balance sheet. The assumptions are based on what management believes at that time to be the most likely interest rate environment. Earnings at risk is the change in net interest income from a base case scenario under various scenarios of rate shock increases and decreases in the interest rate earnings simulation model.

The table below presents an analysis of the changes in net interest income and net present value of the balance sheet resulting from various increases or decreases in the level of interest rates, such as two percentage points (200 basis points) in the level of interest rates. The calculated estimates of change in net interest income and net present value of the balance sheet are compared to current limits approved by ALCO and the Board of Directors. The earnings simulation model projects net interest income would decrease 7.0%, 14.5% and 22.6% in the 100, 200 and 300 basis point increasing rate scenarios presented. In addition, the earnings simulation model projects net interest income would decrease 3.8% and 9.8% in the 100 and 200 basis point decreasing rate scenarios presented. All of these forecasts are within the Corporation's one year policy guidelines.

The analysis and model used to quantify the sensitivity of net interest income becomes less reliable in a decreasing rate scenario given the current unprecedented low interest rate environment with federal funds trading in the 0 - 25 basis point range. Results of the decreasing basis point declining scenarios are affected by the fact that many of the Corporation's interest-bearing liabilities are at rates below 1% and therefore cannot decline 100 or more basis points. However, the Corporation's interest-sensitive assets are able to decline by these amounts. For the six months ended June 30, 2014, the cost of interest-bearing liabilities averaged 0.64%, and the yield on average interest-earning assets, on a fully taxable equivalent basis, averaged 4.0%.

Net Present Value Estimation



The net present value measures economic value at risk and is used for helping to determine levels of risk at a point in time present in the balance sheet that might not be taken into account in the earnings simulation model. The net present value of the balance sheet is defined as the discounted present value of asset cash flows minus the discounted present value of liability cash flows. At June 30, 2014, the 100 and 200 basis point immediate decreases in rates are estimated to affect net present value with a decrease of 2.0% and 8.0%, respectively. Additionally, net present value is projected to decrease 7.0%, 17.0% and 28.7% in the 100, 200 and 300 basis point immediate increase scenarios, respectively. All scenarios presented are below the Corporation's policy limits, with an exception in the 300 basis point immediate increase scenario which exceeds the policy of -40.0% by 1.8%.

42



The computation of the effects of hypothetical interest rate changes are based on many assumptions. They should not be relied upon solely as being indicative of actual results, since the computations do not contemplate actions management could undertake in response to changes in interest rates.

Effect of Change in Interest Rates

Projected Change Effect on Net Interest Income 1-Year Net Income Simulation Projection +300 bp Shock vs. Stable Rate (22.6 )% +200 bp Shock vs. Stable Rate (14.5 )% +100 bp Shock vs. Stable Rate (7.0 )% Flat rate - -100 bp Shock vs. Stable Rate (3.8 )% -200 bp Shock vs. Stable Rate (9.8 )% Effect on Net Present Value of Balance Sheet Static Net Present Value Change +300 bp Shock vs. Stable Rate (28.7 )% +200 bp Shock vs. Stable Rate (17.0 )% +100 bp Shock vs. Stable Rate (7.0 )% Flat rate - -100 bp Shock vs. Stable Rate (3.0 )% -200 bp Shock vs. Stable Rate (8.0 )% 43


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Source: Edgar Glimpses


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