Document
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10 – Q

[X]         QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2016
or
[  ]         TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934  For the transition period from ___________ to __________.

Commission File Number 0-16587 
sfglogousethisonea07.jpg

Summit Financial Group, Inc.
(Exact name of registrant as specified in its charter)
West Virginia
55-0672148
(State or other jurisdiction of
(IRS Employer
incorporation or organization)
Identification No.)
300 North Main Street
 
Moorefield, West Virginia
26836
(Address of principal executive offices)
(Zip Code)
(304) 530-1000
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Sections 13 or 15(d) of the Securities and Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes þ
No o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
Yes þ
No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definition of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer o               Accelerated filer þ
Non-accelerated filer o                  Smaller reporting company o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes o
No þ

Indicate the number of shares outstanding of each of the issuer’s classes of Common Stock as of the latest practicable date.

Common Stock, $2.50 par value
10,704,441 shares outstanding as of November 1, 2016



Table of Contents


 
 
 
Page
PART  I.
FINANCIAL INFORMATION
 
 
 
 
 
 
Item 1.
Financial Statements
 
 
 
 
 
 
 
Consolidated balance sheets
September 30, 2016 (unaudited), December 31, 2015,
and September 30, 2015 (unaudited)
 
 
 
 
 
 
Consolidated statements of income
for the three months and nine months ended
September 30, 2016 and 2015 (unaudited)
 
 
 
 
 
 
Consolidated statements of comprehensive
income for the three months and nine months ended
September 30, 2016 and 2015 (unaudited)
 
 
 
 
 
 
Consolidated statements of shareholders’ equity
for the nine months ended
September 30, 2016 and 2015 (unaudited)
 
 
 
 
 
 
Consolidated statements of cash flows
for the nine months ended
September 30, 2016 and 2015 (unaudited)
 
 
 
 
 
 
Notes to consolidated financial statements (unaudited)
 
 
 
 
 
Item 2.
Management's Discussion and Analysis of Financial Condition
and Results of Operations
 
 
 
 
 
Item 3.
Quantitative and Qualitative Disclosures about Market Risk
 
 
 
 
 
Item 4.
Controls and Procedures

2


Table of Contents


PART II.
OTHER INFORMATION
 
 
Item 1.
Legal Proceedings
 
 
 
 
 
Item 1A.
Risk Factors
 
 
 
 
 
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
None
 
 
 
 
 
Item 3.
Defaults upon Senior Securities
None
 
 
 
 
 
Item 4.
Mine Safety Disclosures
None
 
 
 
 
 
Item 5.
Other Information
None
 
 
 
 
 
Item 6.
Exhibits
 
 
 
 
SIGNATURES
 
 
 
 
 
EXHIBIT INDEX
 

3


Consolidated Balance Sheets (unaudited)




 
September 30,
2016
 
December 31,
2015
 
September 30,
2015
Dollars in thousands
(unaudited)
 
(*)
 
(unaudited)
ASSETS
 
 
 

 
 
Cash and due from banks
$
25,067

 
$
3,625

 
$
4,232

Interest bearing deposits with other banks
9,432

 
5,862

 
8,057

Cash and cash equivalents
34,499

 
9,487

 
12,289

Securities available for sale
262,102

 
280,792

 
272,127

Other investments
13,182

 
8,949

 
7,016

Loans held for sale, net

 
779

 
83

Loans, net
1,234,605

 
1,079,331

 
1,062,348

Property held for sale
24,767

 
25,567

 
29,713

Premises and equipment, net
21,802

 
21,572

 
20,457

Accrued interest receivable
5,470

 
5,544

 
5,295

Intangible assets
7,348

 
7,498

 
7,548

Cash surrender value of life insurance policies
38,504

 
37,732

 
37,481

Other assets
15,357

 
15,178

 
14,947

Total assets
$
1,657,636

 
$
1,492,429

 
$
1,469,304

 
 
 
 
 
 
LIABILITIES AND SHAREHOLDERS' EQUITY
 

 
 

 
 

Liabilities
 

 
 

 
 

Deposits
 

 
 

 
 

Non interest bearing
$
122,652

 
$
119,010

 
$
118,887

Interest bearing
1,034,132

 
947,699

 
953,204

Total deposits
1,156,784

 
1,066,709

 
1,072,091

Short-term borrowings
234,657

 
171,394

 
145,291

Long-term borrowings
74,146

 
75,581

 
76,059

Subordinated debentures owed to unconsolidated subsidiary trusts
19,589

 
19,589

 
19,589

Other liabilities
18,640

 
15,412

 
15,985

Total liabilities
1,503,816

 
1,348,685

 
1,329,015

 
 
 
 
 
 
Commitments and Contingencies


 


 


 
 
 
 
 
 
Shareholders' Equity
 

 
 

 
 

Preferred stock, $1.00 par value, authorized 250,000 shares

 

 

Common stock and related surplus, $2.50 par value; authorized 20,000,000 shares; issued: 10,857,801 shares 2016, 10,853,566 shares December 2015 and 10,844,912 shares September 2015; outstanding: 10,701,841 shares 2016, 10,671,744 shares December 2015 and 10,658,199 shares September 2015
46,114

 
45,741

 
45,612

Unallocated common stock held by Employee Stock Ownership Plan - 2016 - 155,960 shares, December 2015 - 181,822 shares and September 2015 - 186,713 shares
(1,684
)
 
(1,964
)
 
(2,017
)
Retained earnings
109,808

 
100,423

 
97,129

Accumulated other comprehensive income
(418
)
 
(456
)
 
(435
)
Total shareholders' equity
153,820

 
143,744

 
140,289

 
 
 
 
 
 
Total liabilities and shareholders' equity
$
1,657,636

 
$
1,492,429

 
$
1,469,304


(*) - December 31, 2015 financial information has been extracted from audited consolidated financial statements



See Notes to Consolidated Financial Statements

Table of Contents
4


Consolidated Statements of Income (unaudited)


 
 
For the Three Months Ended September 30,
 
For the Nine Months Ended September 30,
Dollars in thousands, except per share amounts
 
2016
 
2015
 
2016
 
2015
Interest income
 
 
 
 
 
 
 
 
Interest and fees on loans
 
 
 
 
 
 
 
 
Taxable
 
$
14,009

 
$
12,855

 
$
40,788

 
$
38,443

Tax-exempt
 
133

 
128

 
412

 
361

Interest and dividends on securities
 
 

 
 

 
 

 
 

Taxable
 
1,138

 
933

 
3,284

 
3,302

Tax-exempt
 
621

 
610

 
1,857

 
1,821

Interest on interest bearing deposits with other banks
 
5

 
5

 
13

 
6

Total interest income
 
15,906

 
14,531

 
46,354

 
43,933

Interest expense
 
 

 
 

 
 

 
 

Interest on deposits
 
2,209

 
2,106

 
6,533

 
6,251

Interest on short-term borrowings
 
675

 
130

 
1,334

 
369

Interest on long-term borrowings and subordinated debentures
 
985

 
990

 
2,937

 
3,030

Total interest expense
 
3,869

 
3,226

 
10,804

 
9,650

Net interest income
 
12,037

 
11,305

 
35,550

 
34,283

Provision for loan losses
 

 
250

 
500

 
1,000

Net interest income after provision for loan losses
 
12,037

 
11,055

 
35,050

 
33,283

Other income
 
 

 
 

 
 

 
 

Insurance commissions
 
1,016

 
983

 
3,030

 
3,191

Service fees related to deposit accounts
 
1,138

 
1,111

 
3,175

 
3,159

Realized securities gains
 
61

 
373

 
836

 
1,023

Bank owned life insurance income
 
258

 
259

 
772

 
782

Other
 
276

 
267

 
788

 
837

Total other income
 
2,749

 
2,993

 
8,601

 
8,992

Other expense
 
 

 
 

 
 

 
 

Salaries, commissions, and employee benefits
 
4,819

 
4,479

 
14,265

 
13,108

Net occupancy expense
 
525

 
496

 
1,576

 
1,483

Equipment expense
 
716

 
582

 
2,059

 
1,677

Professional fees
 
270

 
402

 
1,171

 
1,109

Amortization of intangibles
 
50

 
50

 
150

 
150

FDIC premiums
 
200

 
300

 
800

 
950

Merger expense
 
80

 

 
345

 

Foreclosed properties expense
 
100

 
168

 
317

 
534

(Gain) loss on sales of foreclosed properties
 
(169
)
 
35

 
(451
)
 
288

Write-downs of foreclosed properties
 
134

 
1,046

 
503

 
1,779

Other
 
1,694

 
1,314

 
4,675

 
4,060

Total other expense
 
8,419

 
8,872

 
25,410

 
25,138

Income before income taxes
 
6,367

 
5,176

 
18,241

 
17,137

Income tax expense
 
2,086

 
1,515

 
5,655

 
5,181

Net Income
 
$
4,281

 
$
3,661

 
$
12,586

 
$
11,956

 
 
 
 
 
 
 
 
 
Basic earnings per common share
 
$
0.40

 
$
0.34

 
$
1.18

 
$
1.19

Diluted earnings per common share
 
$
0.40

 
$
0.34

 
$
1.18

 
$
1.12








See Notes to Consolidated Financial Statements 

Table of Contents
5


Consolidated Statement of Comprehensive Income (unaudited)


 
For the Three Months Ended 
 September 30,
Dollars in thousands
2016
 
2015
Net income
$
4,281

 
$
3,661

Other comprehensive income (loss):
 

 
 

Net unrealized gain (loss) on cashflow hedge of:
2016 - $965, net of deferred taxes of $357; 2015 - ($2,033), net of deferred taxes of ($752)
608

 
(1,281
)
Net unrealized gain (loss) on available for sale debt securities of:
2016 - ($1,437), net of deferred taxes of ($532) and reclassification adjustment for net realized gains included in net income of $61; 2015 - $1,041, net of deferred taxes of $385 and reclassification adjustment for net realized gains included in net income of $373
(905
)
 
656

Total comprehensive income
$
3,984

 
$
3,036




 
For the Nine Months Ended 
 September 30,
Dollars in thousands
2016
 
2015
Net income
$
12,586

 
$
11,956

Other comprehensive income (loss):
 

 
 

Net unrealized loss on cashflow hedge of:
2016 - ($2,114), net of deferred taxes of ($782); 2015 - ($3,063), net of deferred taxes of ($1,133)
(1,332
)
 
(1,930
)
Net unrealized gain (loss) on available for sale debt securities of:
2016 - $2,175, net of deferred taxes of $805 and reclassification adjustment for net realized gains included in net income of $836; 2015 - ($916), net of deferred taxes of ($339) and reclassification adjustment for net realized gains included in net income of $1,023
1,370

 
(577
)
Total comprehensive income
$
12,624

 
$
9,449

























See Notes to Consolidated Financial Statements

Table of Contents
6


Consolidated Statements of Shareholders’ Equity (unaudited)


Dollars in thousands, except per share amounts
Series 2009
Preferred
Stock and
Related
Surplus
 
Series 2011
Preferred
Stock and
Related
Surplus
 
Common
Stock and
Related
Surplus
 
Unallocated Common Stock Held by ESOP
 
Retained
Earnings
 
Accumulated
Other
Compre-
hensive
Income
 
Total
Share-
holders'
Equity
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance, December 31, 2015
$

 
$

 
$
45,741

 
$
(1,964
)
 
$
100,423

 
$
(456
)
 
$
143,744

 
 
 
 
 
 
 
 
 
 
 
 
 
 
Nine Months Ended September 30, 2016
 

 
 

 
 

 
 
 
 

 
 

 
 

Comprehensive income:
 

 
 

 
 

 
 
 
 

 
 

 
 

Net income

 

 

 

 
12,586

 

 
12,586

Other comprehensive income

 

 

 

 

 
38

 
38

Total comprehensive income
 

 
 

 
 

 
 
 
 

 
 

 
12,624

Stock compensation expense

 

 
150

 

 

 

 
150

Unallocated ESOP shares committed to be released - 25,862 shares

 

 
148

 
280

 

 

 
428

Common stock issuances from reinvested dividends

 

 
75

 

 
(75
)
 

 

Common stock cash dividends declared ($0.30 per share)

 

 

 

 
(3,126
)
 

 
(3,126
)
Balance, September 30, 2016
$

 
$

 
$
46,114

 
$
(1,684
)
 
$
109,808

 
$
(418
)
 
$
153,820

 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance, December 31, 2014
$
3,419

 
$
5,764

 
$
32,670

 
$

 
$
87,719

 
$
2,072

 
$
131,644

 
 
 
 
 
 
 
 
 
 
 
 
 
 
Nine Months Ended September 30, 2015
 

 
 

 
 

 
 
 
 

 
 

 
 

Comprehensive income:
 

 
 

 
 

 
 
 
 

 
 

 
 

Net income

 

 

 

 
11,956

 

 
11,956

Other comprehensive loss

 

 

 

 

 
(2,507
)
 
(2,507
)
Total comprehensive income
 

 
 

 
 

 
 
 
 

 
 

 
9,449

Stock compensation expense

 

 
100

 

 

 

 
100

Conversion of Series 2009 Preferred Stock to common stock
(3,419
)
 

 
3,404

 

 

 

 
(15
)
Conversion of Series 2011 Preferred Stock to common stock

 
(5,764
)
 
5,748

 

 

 

 
(16
)
Issuance of 497,571 shares of common stock

 

 
4,747

 

 

 

 
4,747

Purchase of unallocated common stock of 208,333 held by ESOP

 

 

 
(2,250
)
 

 

 
(2,250
)
Unallocated ESOP shares committed to be released - 21,620 shares

 

 
23

 
233

 

 

 
256

Repurchase and retirement of 100,000 shares of common stock

 

 
(1,080
)
 

 

 

 
(1,080
)
Common stock cash dividends declared ($0.24 per share)

 

 

 

 
(2,546
)
 

 
(2,546
)
Balance, September 30, 2015
$

 
$

 
$
45,612

 
$
(2,017
)
 
$
97,129

 
$
(435
)
 
$
140,289














See Notes to Consolidated Financial Statements

Table of Contents
7


Consolidated Statements of Cash Flows (unaudited)


 
 
Nine Months Ended
Dollars in thousands
 
September 30,
2016
 
September 30,
2015
Cash Flows from Operating Activities
 
 
 
 
Net income
 
$
12,586

 
$
11,956

Adjustments to reconcile net earnings to net cash provided by operating activities:
 
 

 
 

Depreciation
 
884

 
790

Provision for loan losses
 
500

 
1,000

Stock compensation expense
 
150

 
101

Deferred income tax expense (benefit)
 
(235
)
 
97

Loans originated for sale
 
(7,068
)
 
(2,997
)
Proceeds from loans sold
 
7,847

 
3,441

Securities gains
 
(836
)
 
(1,023
)
(Gain) loss on disposal of assets
 
(480
)
 
290

Write-downs of foreclosed properties
 
503

 
1,779

Amortization of securities premiums (accretion of discounts), net
 
3,338

 
3,952

Amortization of intangibles, net
 
150

 
159

Decrease in accrued interest receivable
 
75

 
543

Increase in cash surrender value of bank owned life insurance
 
(772
)
 
(781
)
Increase in other assets
 
(762
)
 
(564
)
Increase in other liabilities
 
673

 
239

Net cash provided by operating activities
 
16,553

 
18,982

Cash Flows from Investing Activities
 
 

 
 

Proceeds from maturities and calls of securities available for sale
 
630

 
1,743

Proceeds from sales of securities available for sale
 
63,641

 
54,080

Principal payments received on securities available for sale
 
27,696

 
30,884

Purchases of securities available for sale
 
(73,595
)
 
(79,844
)
Purchases of other investments
 
(15,389
)
 
(6,528
)
Proceeds from sales & redemptions of other investments
 
10,942

 
5,695

Net loans made to customers
 
(156,744
)
 
(45,882
)
Purchases of premises and equipment
 
(1,199
)
 
(1,187
)
Proceeds from disposal of premises and equipment
 
43

 

Proceeds from sales of other repossessed assets & property held for sale
 
3,659

 
8,984

Net cash (used in) investing activities
 
(140,316
)
 
(32,055
)
Cash Flows from Financing Activities
 
 

 
 

Net increase in demand deposit, NOW and savings accounts
 
54,831

 
22,248

Net increase (decrease) in time deposits
 
35,244

 
(11,502
)
Net increase in short-term borrowings
 
63,263

 
21,658

Repayment of long-term borrowings
 
(1,435
)
 
(1,431
)
Repayment of subordinated debt
 

 
(16,800
)
Net proceeds from issuance of common stock
 

 
4,704

Retirement of common stock
 

 
(1,080
)
Purchase of unallocated common stock held by ESOP
 

 
(2,250
)
Dividends paid on common stock
 
(3,128
)
 
(2,504
)
Dividends paid on preferred stock
 

 
(191
)
Net cash provided by financing activities
 
148,775

 
12,852

Increase (decrease) in cash and cash equivalents
 
25,012

 
(221
)
Cash and cash equivalents:
 
 

 
 

Beginning
 
9,487

 
12,510

Ending
 
$
34,499

 
$
12,289

 
(Continued)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
See Notes to Consolidated Financial Statements
 
 
 
 

Table of Contents
8


Consolidated Statements of Cash Flows (unaudited) - continued


 
 
Nine Months Ended
Dollars in thousands
 
September 30,
2016
 
September 30,
2015
Supplemental Disclosures of Cash Flow Information
 
 
 
 
Cash payments for:
 
 
 
 
Interest
 
$
10,889

 
$
9,693

Income taxes
 
$
5,768

 
$
5,345

 
 
 
 
 
Supplemental Schedule of Noncash Investing and Financing Activities
 
 
 
 

Real property and other assets acquired in settlement of loans
 
$
2,053

 
$
2,404

























































See Notes to Consolidated Financial Statements

Table of Contents
9



NOTE 1.  BASIS OF PRESENTATION

We, Summit Financial Group, Inc. and subsidiaries, prepare our consolidated financial statements in accordance with accounting principles generally accepted in the United States of America for interim financial information and with instructions to Form 10-Q and Regulation S-X.  Accordingly, they do not include all the information and footnotes required by accounting principles generally accepted in the United States of America for annual year end financial statements.  In our opinion, all adjustments considered necessary for a fair presentation have been included and are of a normal recurring nature.

The presentation of financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period.  Actual results could differ materially from these estimates.

The results of operations for the quarter and nine months ended September 30, 2016 are not necessarily indicative of the results to be expected for the full year.  The consolidated financial statements and notes included herein should be read in conjunction with our 2015 audited financial statements and Annual Report on Form 10-K.  Certain accounts in the consolidated financial statements for December 31, 2015 and September 30, 2015, as previously presented, have been reclassified to conform to current year classifications.

NOTE 2.  SIGNIFICANT NEW AUTHORITATIVE ACCOUNTING GUIDANCE

ASU 2015-01, Income Statement - Extraordinary and Unusual Items (Subtopic 225-20) - Simplifying Income Statement Presentation by Eliminating the Concept of Extraordinary Items eliminates from U.S. GAAP the concept of extraordinary items, which, among other things, required an entity to segregate extraordinary items considered to be unusual and infrequent from the results of ordinary operations and show the item separately in the income statement, net of tax, after income from continuing operations. ASU 2015-01 was effective for us January 1, 2016, and did not have a significant impact on our financial statements.

ASU 2015-03, Interest-Imputation of Interest (Subtopic 835-30) - Simplifying the Presentation of Debt Issuance Costs specifies that debt issuance costs related to a recognized liability are to be reported in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts. The recognition and measurement guidance for debt issuance costs are not affected by the amendments in this ASU. ASU 2015-03 was effective for us January 1, 2016 and did not have a material impact on our financial statements.

The guidance of ASU No. 2015-03 did not address presentation or subsequent measurement of debt issuance costs related to line-of-credit arrangements. Given the absence of authoritative guidance for debt issuance costs related to line-of-credit arrangements within the update, in ASU 2015-15, Interest—Imputation of Interest (Subtopic 835-30) - Presentation and Subsequent Measurement of Debt Issuance Costs Associated with Line-of-Credit Arrangements (Amendments to SEC Paragraphs Pursuant to Staff Announcement at June 18, 2015 EITF Meeting), issued in August 2015, the SEC staff stated that they would not object to any entity deferring and presenting debt issuance costs as an asset and subsequently amortizing the deferred debt issuance costs ratably over the term of the line-of-credit arrangement, regardless of whether there are any outstanding borrowings on the line-of-credit arrangement.

ASU 2015-16, Business Combinations (Topic 805) – Simplifying the Accounting for Measurement-Period Adjustments requires that adjustments to provisional amounts that are identified during the measurement period of a business combination be recognized in the reporting period in which the adjustment amounts are determined. Furthermore, the income statement effects of such adjustments, if any, must be calculated as if the accounting had been completed at the acquisition date reflecting the portion of the amount recorded in current-period earnings that would have been recorded in previous reporting periods if the adjustment to the provisional amounts had been recognized as of the acquisition date. Under previous guidance, adjustments to provisional amounts identified during the measurement period are to be recognized retrospectively. ASU 2015-16 became effective for us on January 1, 2016 and did not have a significant impact on our financial statements.

ASU 2016-01, Financial Instruments – Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities, among other things, (i) requires equity investments, with certain exceptions, to be measured at fair value with changes in fair value recognized in net income, (ii) simplifies the impairment assessment of equity investments without readily determinable fair values by requiring a qualitative assessment to identify impairment, (iii) eliminates the requirement for public business entities to disclose the methods and significant assumptions used to estimate the fair value that is required to

Table of Contents
10


be disclosed for financial instruments measured at amortized cost on the balance sheet, (iv) requires public business entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes, (v) requires an entity to present separately in other comprehensive income the portion of the total change in the fair value of a liability resulting from a change in the instrument-specific credit risk when the entity has elected to measure the liability at fair value in accordance with the fair value option for financial instruments, (vi) requires separate presentation of financial assets and financial liabilities by measurement category and form of financial asset on the balance sheet or the accompanying notes to the financial statements and (viii) clarifies that an entity should evaluate the need for a valuation allowance on a deferred tax asset related to available-for-sale. ASU 2016-01 will be effective for us on January 1, 2018 and is not expected to have a significant impact on our financial statements.

ASU 2016-02, Leases (Topic 842) will, among other things, require lessees to recognize a lease liability, which is a lessee‘s obligation to make lease payments arising from a lease, measured on a discounted basis; and a right-of-use asset, which is an asset that represents the lessee’s right to use, or control the use of, a specified asset for the lease term. ASU 2016-02 does not significantly change lease accounting requirements applicable to lessors; however, certain changes were made to align, where necessary, lessor accounting with the lessee accounting model and ASC Topic 606, Revenue from Contracts with Customers. ASU 2016-02 will be effective for us on January 1, 2019 and will require transition using a modified retrospective approach for leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements. We are currently evaluating the potential impact of ASU 2016-02 on our financial statements.

ASU 2016-05, Derivatives and Hedging (Topic 815) Effect of Derivative Contract Novations on Existing Hedge Accounting Relationships, clarifies that a change in the counterparty to a derivative instrument that has been designated as the hedging instrument under ASC Topic 815 does not, in and of itself, require dedesignation of that hedging relationship provided that all other hedge accounting criteria continue to be met. ASU 2016-05 will be effective for us on January 1, 2017 and is not expected to have a significant impact on our financial statements.

ASU 2016-09, Compensation - Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting, requires that all excess tax benefits and tax deficiencies related to share-based payment awards be recognized as income tax expense or benefit in the income statement during the period in which they occur. Previously, such amounts were recorded in the pool of excess tax benefits included in additional paid-in capital, if such pool was available. Because excess tax benefits are no longer recognized in additional paid-in capital, the assumed proceeds from applying the treasury stock method when computing earnings per share should exclude the amount of excess tax benefits that would have previously been recognized in additional paid-in capital. Additionally, excess tax benefits should be classified along with other income tax cash flows as an operating activity rather than a financing activity, as was previously the case. ASU 2016-09 also provides that an entity can make an entity-wide accounting policy election to either estimate the number of awards that are expected to vest (current GAAP) or account for forfeitures when they occur. ASU 2016-09 changes the threshold to qualify for equity classification (rather than as a liability) to permit withholding up to the maximum statutory tax rates (rather than the minimum as was previously the case) in the applicable jurisdictions. ASU 2016-09 will be effective on January 1, 2017 and is not expected to have a significant impact on our financial statements.

ASU No. 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, requires the measurement of all expected credit losses for financial assets held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts and requires enhanced disclosures related to the significant estimates and judgments used in estimating credit losses, as well as the credit quality and underwriting standards of an organization’s portfolio. In addition, ASU 2016-13 amends the accounting for credit losses on available-for-sale debt securities and purchased financial assets with credit deterioration. ASU 2016-13 will be effective on January 1, 2020. We are currently evaluating the potential impact of ASU 2016-13 on our financial statements.

ASU 2016-15, Statement of Cash Flows (Topic 230) - Classification of Certain Cash Receipts and Cash Payments provides guidance related to certain cash flow issues in order to reduce the current and potential future diversity in practice. ASU 2016-15 will be effective for us on January 1, 2018 and is not expected to have a significant impact on our financial statements.

ASU 2016‑16, Intra-Entity Transfers of Assets Other Than Inventory requires an entity to recognize the income tax consequences of intra-entity transfers of assets other than inventory at the time that the transfer occurs. Current guidance does not require recognition of tax consequences until the asset is eventually sold to a third party. ASU 2016-16 is effective for fiscal years, and interim periods within, beginning after December 15, 2017, with early adoption permitted as of the first interim period presented in a year. We are evaluating the impact of the adoption of ASU 2016‑16 on January 1, 2018 to our consolidated financial statements.

11



NOTE 3.  FAIR VALUE MEASUREMENTS

ASC Topic 820 defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date.  ASC Topic 820 also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.  The standard describes three levels of inputs that may be used to measure fair value.

Level 1: Quoted prices (unadjusted) or identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.

Level 2: Significant other observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, and other inputs that are observable or can be corroborated by observable market data.

Level 3: Significant unobservable inputs that reflect a company’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.
        
Accordingly, securities available-for-sale are recorded at fair value on a recurring basis. Additionally, from time to time, we may be required to record other assets at fair value on a nonrecurring basis, such as loans held for sale, and impaired loans held for investment.  These nonrecurring fair value adjustments typically involve application of lower of cost or market accounting or write-downs of individual assets.

Following is a description of valuation methodologies used for assets and liabilities recorded at fair value.

Available-for-Sale Securities:  Investment securities available-for-sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted prices, if available.  If quoted prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions.  Level 1 securities include those traded on an active exchange, such as the New York Stock Exchange, U.S. Treasury securities that are traded by dealers or brokers in active over-the-counter markets and money market funds.  Level 2 securities include mortgage-backed securities issued by government sponsored entities, municipal bonds and corporate debt securities.

Derivative Financial Instruments:  Derivative financial instruments are recorded at fair value on a recurring basis. Fair value measurement is based on pricing models run by a third-party, utilizing observable market-based inputs.  All future floating cash flows are projected and both floating and fixed cash flows are discounted to the valuation date.  As a result, we classify interest rate swaps as Level 2.

Loans Held for Sale:  Loans held for sale are carried at the lower of cost or market value.  The fair value of loans held for sale is based on what secondary markets are currently offering for portfolios with similar characteristics.  As such, we classify loans subject to nonrecurring fair value adjustments as Level 2.

Loans:  We do not record loans at fair value on a recurring basis. However, from time to time, a loan is considered impaired and an allowance for loan loss is established.  Loans for which it is probable that payment of interest and principal will not be made in accordance with the original contractual terms of the loan agreement are considered impaired.  Once a loan is identified as individually impaired, management measures impairment in accordance with ASC Topic 310, Accounting by Creditors for Impairment of a Loan.  The fair value of impaired loans is estimated using one of several methods, including collateral value, liquidation value and discounted cash flows. Those impaired loans not requiring an allowance represent loans for which the discounted cash flows or collateral value exceeds the recorded investments in such loans. These loans are carried at recorded loan investment, and therefore are not included in the following tables of loans measured at fair value. Impaired loans internally graded as substandard, doubtful, or loss are evaluated using the fair value of collateral method.  All other impaired loans are measured for impairment using the discounted cash flows method. In accordance with ASC Topic 310, impaired loans where an allowance is established based on the fair value of collateral requires classification in the fair value hierarchy. When the fair value of the collateral is based on an observable market price or a current appraised value, we record the impaired loan as nonrecurring Level 2. When a current appraised value is not available and there is no observable market price, we record the impaired loan as nonrecurring Level 3.  


12


When impaired loans are deemed required to be included in the fair value hierarchy, management immediately begins the process of evaluating the estimated fair value of the underlying collateral to determine if a related specific allowance for loan losses or charge-off is necessary.  Current appraisals are ordered once a loan is deemed impaired if the existing appraisal is more than twelve months old, or more frequently if there is known deterioration in value. For recently identified impaired loans, a current appraisal may not be available at the financial statement date. Until the current appraisal is obtained, the original appraised value is discounted, as appropriate, to compensate for the estimated depreciation in the value of the loan’s underlying collateral since the date of the original appraisal.  Such discounts are generally estimated based upon management’s knowledge of sales of similar collateral within the applicable market area and its knowledge of other real estate market-related data as well as general economic trends.  When a new appraisal is received (which generally are received within 3 months of a loan being identified as impaired), management then re-evaluates the fair value of the collateral and adjusts any specific allocated allowance for loan losses, as appropriate.  In addition, management also assigns a discount of 7–10% for the estimated costs to sell the collateral.

Foreclosed properties:  Foreclosed properties consists of real estate acquired in foreclosure or other settlement of loans. Such assets are carried on the balance sheet at the lower of the investment in the real estate or its fair value less estimated selling costs.  The fair value of foreclosed properties is determined on a nonrecurring basis generally utilizing current appraisals performed by an independent, licensed appraiser applying an income or market value approach using observable market data (Level 2).  Updated appraisals of foreclosed properties are generally obtained if the existing appraisal is more than 18 months old or more frequently if there is a known deterioration in value.  However, if a current appraisal is not available, the original appraised value is discounted, as appropriate, to compensate for the estimated depreciation in the value of the real estate since the date of its original appraisal.  Such discounts are generally estimated based upon management’s knowledge of sales of similar property within the applicable market area and its knowledge of other real estate market-related data as well as general economic trends (Level 3).  Upon foreclosure, any fair value adjustment is charged against the allowance for loan losses.  Subsequent fair value adjustments are recorded in the period incurred and included in other noninterest expense in the consolidated statements of income.

Assets and Liabilities Recorded at Fair Value on a Recurring Basis

The table below presents the recorded amount of assets and liabilities measured at fair value on a recurring basis.
 
Balance at
 
Fair Value Measurements Using:
Dollars in thousands
September 30, 2016
 
Level 1
 
Level 2
 
Level 3
Available for sale securities
 
 
 
 
 
 
 
U.S. Government sponsored agencies
$
15,692

 
$

 
$
15,692

 
$

Mortgage backed securities:
 

 
 

 
 

 
 

Government sponsored agencies
135,205

 

 
135,205

 

Nongovernment sponsored entities
5,401

 

 
5,401

 

State and political subdivisions
250

 

 
250

 

Corporate debt securities
19,903

 

 
8,597

 
11,306

Other equity securities
77

 

 
77

 

Tax-exempt state and political subdivisions
85,574

 

 
85,574

 

Total available for sale securities
$
262,102

 
$

 
$
250,796

 
$
11,306

 
 
 
 
 
 
 
 
Derivative financial liabilities
 

 
 

 
 

 
 

Interest rate swaps
$
8,270

 
$

 
$
8,270

 
$


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13


 
Balance at
 
Fair Value Measurements Using:
Dollars in thousands
December 31, 2015
 
Level 1
 
Level 2
 
Level 3
Available for sale securities
 
 
 
 
 
 
 
U.S. Government sponsored agencies
$
21,475

 
$

 
$
21,475

 
$

Mortgage backed securities:
 

 
 

 
 

 
 

Government sponsored agencies
146,734

 

 
146,734

 

Nongovernment sponsored entities
7,885

 

 
7,885

 

State and political subdivisions
1,953

 

 
1,953

 

Corporate debt securities
14,226

 

 
8,367

 
5,859

Other equity securities
77

 

 
77

 

Tax-exempt state and political subdivisions
88,442

 

 
88,442

 

Total available for sale securities
$
280,792

 
$

 
$
274,933

 
$
5,859

 
 
 
 
 
 
 
 
Derivative financial liabilities
 

 
 

 
 

 
 

Interest rate swaps
$
5,072

 
$

 
$
5,072

 
$



Assets and Liabilities Recorded at Fair Value on a Nonrecurring Basis

We may be required, from time to time, to measure certain assets at fair value on a nonrecurring basis in accordance with U.S. generally accepted accounting principles.  These include assets that are measured at the lower of cost or market that were recognized at fair value below cost at the end of the period.  Assets measured at fair value on a nonrecurring basis are included in the table below.
 
Balance at
 
Fair Value Measurements Using:
Dollars in thousands
September 30, 2016
 
Level 1
 
Level 2
 
Level 3
Residential mortgage loans held for sale
$

 
$

 
$

 
$

 
 
 
 
 
 
 
 
Collateral-dependent impaired loans
 

 
 

 
 

 
 

Commercial
$

 
$

 
$

 
$

Commercial real estate

 

 

 

Construction and development
648

 

 
648

 

Residential real estate
130

 

 
130

 

Total collateral-dependent impaired loans
$
778

 
$

 
$
778

 
$

 
 
 
 
 
 
 
 
Foreclosed properties
 

 
 

 
 

 
 

Commercial real estate
$
976

 
$

 
$
976

 
$

Construction and development
19,933

 

 
19,933

 

Residential real estate
279

 

 
279

 

Total foreclosed properties
$
21,188

 
$

 
$
21,188

 
$



 
Balance at
 
Fair Value Measurements Using:
Dollars in thousands
December 31, 2015
 
Level 1
 
Level 2
 
Level 3
Residential mortgage loans held for sale
$
779

 
$

 
$
779

 
$

 
 
 
 
 
 
 
 
Collateral-dependent impaired loans
 

 
 

 
 

 
 

Commercial
$

 

 
$

 
$

Commercial real estate
627

 

 

 
627

Construction and development
1,054

 

 

 
1,054

Residential real estate
279

 

 
279

 

Total collateral-dependent impaired loans
$
1,960

 
$

 
$
279

 
$
1,681

 
 
 
 
 
 
 
 
Foreclosed properties
 

 
 

 
 

 
 

Commercial real estate
$
1,103

 
$

 
$
1,103

 
$

Construction and development
18,477

 

 
18,419

 
58

Residential real estate
314

 

 
314

 

Total foreclosed properties
$
19,894

 
$

 
$
19,836

 
$
58


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14



ASC Topic 825, Financial Instruments, requires disclosure of the fair value of financial assets and financial liabilities, including those financial assets and financial liabilities that are not measured and reported at fair value on a recurring basis or non-recurring basis.  The following summarizes the methods and significant assumptions we used in estimating our fair value disclosures for financial instruments.

Cash and cash equivalents:  The carrying values of cash and cash equivalents approximate their estimated fair value.

Interest bearing deposits with other banks:  The carrying values of interest bearing deposits with other banks approximate their estimated fair values.

Federal funds sold:  The carrying values of Federal funds sold approximate their estimated fair values.

Securities:  Estimated fair values of securities are based on quoted market prices, where available.  If quoted market prices are not available, estimated fair values are based on quoted market prices of comparable securities.
 
Loans held for sale:  The carrying values of loans held for sale approximate their estimated fair values.

Loans:  The estimated fair values for loans are computed based on scheduled future cash flows of principal and interest, discounted at interest rates currently offered for loans with similar terms to borrowers of similar credit quality.  No prepayments of principal are assumed.

Accrued interest receivable and payable:  The carrying values of accrued interest receivable and payable approximate their estimated fair values.

Deposits:  The estimated fair values of demand deposits (i.e. non-interest bearing checking, NOW, money market and savings accounts) and other variable rate deposits approximate their carrying values.  Fair values of fixed maturity deposits are estimated using a discounted cash flow methodology at rates currently offered for deposits with similar remaining maturities.  Any intangible value of long-term relationships with depositors is not considered in estimating the fair values disclosed.

Short-term borrowings:  The carrying values of short-term borrowings approximate their estimated fair values.

Long-term borrowings:  The fair values of long-term borrowings are estimated by discounting scheduled future payments of principal and interest at current rates available on borrowings with similar terms.

Subordinated debentures owed to unconsolidated subsidiary trusts:  The carrying values of subordinated debentures owed to unconsolidated subsidiary trusts approximate their estimated fair values.

Derivative financial instruments:  The fair value of the interest rate swaps is valued using independent pricing models.

Off-balance sheet instruments:  The fair values of commitments to extend credit and standby letters of credit are estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present credit standing of the counter parties.  The amounts of fees currently charged on commitments and standby letters of credit are deemed insignificant, and therefore, the estimated fair values and carrying values are not shown below.


Table of Contents
15


The carrying values and estimated fair values of our financial instruments are summarized below:
 
 
September 30, 2016
 
December 31, 2015
Dollars in thousands
 
Carrying
Value
 
Estimated
Fair
Value
 
Carrying
Value
 
Estimated
Fair
Value
Financial assets
 
 
 
 
 
 
 
 
Cash and cash equivalents
 
$
34,499

 
$
34,499

 
$
9,487

 
$
9,487

Securities available for sale
 
262,102

 
262,102

 
280,792

 
280,792

Other investments
 
13,182

 
13,182

 
8,949

 
8,949

Loans held for sale, net
 

 

 
779

 
779

Loans, net
 
1,234,605

 
1,251,189

 
1,079,331

 
1,084,955

Accrued interest receivable
 
5,470

 
5,470

 
5,544

 
5,544

 
 
$
1,549,858

 
$
1,566,442

 
$
1,384,882

 
$
1,390,506

Financial liabilities
 
 

 
 

 
 

 
 

Deposits
 
$
1,156,784

 
$
1,168,549

 
$
1,066,709

 
$
1,077,510

Short-term borrowings
 
234,657

 
234,657

 
171,394

 
171,394

Long-term borrowings
 
74,146

 
77,670

 
75,581

 
80,506

Subordinated debentures owed to unconsolidated subsidiary trusts
 
19,589

 
19,589

 
19,589

 
19,589

Accrued interest payable
 
741

 
741

 
826

 
826

Derivative financial liabilities
 
8,270

 
8,270

 
5,072

 
5,072

 
 
$
1,494,187

 
$
1,509,476

 
$
1,339,171

 
$
1,354,897


NOTE 4.  EARNINGS PER SHARE

The computations of basic and diluted earnings per share follow:
 
 
For the Three Months Ended September 30,
 
 
2016
 
2015
Dollars in thousands,
except per share amounts
 
Income
(Numerator)
 
Common
Shares
(Denominator)
 
Per
Share
 
Income
(Numerator)
 
Common
Shares
(Denominator)
 
Per
Share
Net income
 
$
4,281

 
 
 
 
 
$
3,661

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Basic EPS
 
$
4,281

 
10,692,423

 
$
0.40

 
$
3,661

 
10,703,526

 
$
0.34

 
 
 
 
 
 
 
 
 
 
 
 
 
Effect of dilutive securities:
 
 
 
 
 
 

 
 
 
 
 
 

Stock options
 
 
 
12,865

 
 

 
 
 
8,677

 
 

Stock appreciation rights
 
 
 
21,851

 
 
 
 
 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Diluted EPS
 
$
4,281

 
10,727,139

 
$
0.40

 
$
3,661

 
10,712,203

 
$
0.34



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16


 
 
For the Nine Months Ended September 30,
 
 
2016
 
2015
Dollars in thousands,
except per share amounts
 
Income
(Numerator)
 
Common
Shares
(Denominator)
 
Per
Share
 
Income
(Numerator)
 
Common
Shares
(Denominator)
 
Per
Share
Net income
 
$
12,586

 
 
 
 
 
$
11,956

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Basic EPS
 
$
12,586

 
10,682,129

 
$
1.18

 
$
11,956

 
10,069,374

 
$
1.19

 
 
 
 
 
 
 
 
 
 
 
 
 
Effect of dilutive securities:
 
 

 
 
 
 

 
 
 
 
 
 

Stock options
 
 
 
8,774

 
 

 
 
 
8,608

 
 

Stock appreciation rights
 
 
 
1,443

 
 
 
 
 

 
 
Series 2011 convertible
preferred stock
 

 

 
 

 

 
381,859

 
 

Series 2009 convertible
preferred stock
 

 

 
 

 

 
168,298

 
 

 
 
 
 
 
 
 
 
 
 
 
 
 
Diluted EPS
 
$
12,586

 
10,692,346

 
$
1.18

 
$
11,956

 
10,628,139

 
$
1.12


Stock option and stock appreciation right (SAR) grants and the convertible preferred shares are disregarded in this computation if they are determined to be anti-dilutive.  Our anti-dilutive stock options for the quarter and nine months ended September 30, 2016 were 33,600 shares and 57,000 shares respectively, and totaled 128,900 shares for both the quarter and nine months ended September 30, 2015. Our anti-dilutive SARs for both the three and nine months ended September 30, 2015 were 166,717.

NOTE 5.  SECURITIES

The amortized cost, unrealized gains, unrealized losses and estimated fair values of securities at September 30, 2016, December 31, 2015, and September 30, 2015 are summarized as follows:
 
September 30, 2016
 
Amortized
 
Unrealized
 
Estimated
Dollars in thousands
Cost
 
Gains
 
Losses
 
Fair Value
Available for Sale
 
 
 
 
 
 
 
Taxable debt securities
 
 
 
 
 
 
 
U.S. Government and agencies and corporations
$
14,818

 
$
921

 
$
47

 
$
15,692

Residential mortgage-backed securities:
 

 
 

 
 

 
 

Government-sponsored agencies
132,913

 
2,556

 
264

 
135,205

Nongovernment-sponsored entities
5,382

 
48

 
29

 
5,401

State and political subdivisions
 

 
 

 
 

 
 

Water and sewer revenues
250

 

 

 
250

Corporate debt securities
20,003

 
49

 
149

 
19,903

Total taxable debt securities
173,366

 
3,574

 
489

 
176,451

Tax-exempt debt securities
 

 
 

 
 

 
 

State and political subdivisions
 

 
 

 
 

 
 

General obligations
47,014

 
2,221

 
115

 
49,120

Water and sewer revenues
7,980

 
265

 
11

 
8,234

Lease revenues
7,392

 
321

 
38

 
7,675

Sales tax revenues
2,880

 
124

 

 
3,004

Other revenues
16,869

 
701

 
29

 
17,541

Total tax-exempt debt securities
82,135

 
3,632

 
193

 
85,574

Equity securities
77

 

 

 
77

Total available for sale securities
$
255,578

 
$
7,206

 
$
682

 
$
262,102


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17


 
December 31, 2015
 
Amortized
 
Unrealized
 
Estimated
Dollars in thousands
Cost
 
Gains
 
Losses
 
Fair Value
Available for Sale
 
 
 
 
 
 
 
Taxable debt securities
 
 
 
 
 
 
 
U.S. Government and agencies and corporations
$
20,461

 
$
1,063

 
$
49

 
$
21,475

Residential mortgage-backed securities:
 

 
 

 
 

 
 

Government-sponsored agencies
145,586

 
1,943

 
795

 
146,734

Nongovernment-sponsored entities
7,836

 
82

 
33

 
7,885

State and political subdivisions
 

 
 

 
 

 
 

Water and sewer revenues
250

 

 

 
250

Other revenues
1,729

 

 
26

 
1,703

Corporate debt securities
14,494

 

 
268

 
14,226

Total taxable debt securities
190,356

 
3,088

 
1,171

 
192,273

Tax-exempt debt securities
 

 
 

 
 

 
 

State and political subdivisions
 

 
 

 
 

 
 

General obligations
52,490

 
1,767

 
41

 
54,216

Water and sewer revenues
7,614

 
172

 

 
7,786

Lease revenues
8,671

 
187

 
1

 
8,857

Special tax revenues
4,532

 
72

 

 
4,604

Other revenues
12,703

 
290

 
14

 
12,979

Total tax-exempt debt securities
86,010

 
2,488

 
56

 
88,442

Equity securities
77

 

 

 
77

Total available for sale securities
$
276,443

 
$
5,576

 
$
1,227

 
$
280,792



 
September 30, 2015
 
Amortized
 
Unrealized
 
Estimated
Dollars in thousands
Cost
 
Gains
 
Losses
 
Fair Value
Available for Sale
 
 
 
 
 
 
 
Taxable debt securities:
 
 
 
 
 
 
 
U.S. Government and agencies and corporations
$
26,816

 
$
1,275

 
$
37

 
$
28,054

Residential mortgage-backed securities:
 

 
 

 
 

 
 

Government-sponsored agencies
141,116

 
2,854

 
406

 
143,564

Nongovernment-sponsored agencies
8,641

 
96

 
36

 
8,701

State and political subdivisions:


 


 


 


       Water and sewer revenues
500

 
1

 

 
501

       Lottery/casino revenues
1,214

 

 
29

 
1,185

       Other revenues
1,733

 
7

 

 
1,740

Corporate debt securities
10,796

 
17

 
144

 
10,669

Total taxable debt securities
190,816

 
4,250

 
652

 
194,414

Tax-exempt debt securities:
 

 
 

 
 

 
 

State and political subdivisions:


 


 


 


        General obligations
47,618

 
1,638

 
197

 
49,059

        Water and sewer revenues
8,954

 
94

 
9

 
9,039

        Lease revenues
3,982

 
34

 
9

 
4,007

        Special tax revenues
4,540

 
46

 
55

 
4,531

        Lottery/casino revenues
3,629

 
11

 
44

 
3,596

        Other revenues
7,223

 
185

 
4

 
7,404

Total tax-exempt debt securities
75,946

 
2,008

 
318

 
77,636

Equity securities
77

 

 

 
77

Total available for sale securities
$
266,839

 
$
6,258

 
$
970

 
$
272,127


The below information is relative to the five states where issuers with the highest volume of state and political subdivision securities held in our portfolio are located.  We own no such securities of any single issuer which we deem to be a concentration.

Table of Contents
18


 
September 30, 2016
 
Amortized
 
Unrealized
 
Estimated
Dollars in thousands
Cost
 
Gains
 
Losses
 
Fair Value
 
 
 
 
 
 
 
 
Michigan
14,237

 
462

 
31

 
14,668

Illinois
10,167

 
587

 
2

 
10,752

West Virginia
8,725

 
157

 
7

 
8,875

Texas
8,197

 
371

 
20

 
8,548

Indiana
5,852

 
252

 
39

 
6,065


Management performs pre-purchase and ongoing analysis to confirm that all investment securities meet applicable credit quality standards.  Prior to July 1, 2013, we principally used credit ratings from Nationally Recognized Statistical Rating Organizations (“NRSROs”) to support analyses of our portfolio of securities issued by state and political subdivisions, as we generally do not purchase securities that are rated below the six highest NRSRO rating categories.  Beginning July 1, 2013, in addition to considering a security’s NRSRO rating, we now also assess or confirm through an internal review of an issuer’s financial information and other applicable information that:  1) the issuer’s risk of default is low; 2) the characteristics of the issuer’s demographics and economic environment are satisfactory; and 3) the issuer’s budgetary position and stability of tax or other revenue sources are sound.

The maturities, amortized cost and estimated fair values of securities at September 30, 2016, are summarized as follows:
Dollars in thousands
 
Amortized
Cost
 
Estimated
Fair Value
Due in one year or less
 
$
53,078

 
$
54,009

Due from one to five years
 
86,572

 
88,289

Due from five to ten years
 
18,245

 
18,713

Due after ten years
 
97,606

 
101,014

Equity securities
 
77

 
77

 
 
$
255,578

 
$
262,102


The proceeds from sales, calls and maturities of available for sale securities, including principal payments received on mortgage-backed obligations, and the related gross gains and losses realized, for the nine months ended September 30, 2016 are as follows:
 
 
Proceeds from
 
Gross realized
Dollars in thousands
 
Sales
 
Calls and
Maturities
 
Principal
Payments
 
Gains
 
Losses
Securities available for sale
 
$
63,641

 
$
630

 
$
27,696

 
$
1,117

 
$
281


We held 48 available for sale securities having an unrealized loss at September 30, 2016.  We do not intend to sell these securities, and it is more likely than not that we will not be required to sell these securities before recovery of their amortized cost bases.  We believe that this decline in value is primarily attributable to the lack of market liquidity and to changes in market interest rates and not due to credit quality.  Accordingly, no other-than-temporary impairment charge to earnings is warranted at this time.


Table of Contents
19


Provided below is a summary of securities available for sale which were in an unrealized loss position at September 30, 2016 and December 31, 2015.

 
September 30, 2016
 
Less than 12 months
 
12 months or more
 
Total
Dollars in thousands
Estimated
Fair Value
 
Unrealized
Loss
 
Estimated
Fair Value
 
Unrealized
Loss
 
Estimated
Fair Value
 
Unrealized
Loss
Temporarily impaired securities
 
 
 
 
 
 
 
 
 
 
 
Taxable debt securities
 
 
 
 
 
 
 
 
 
 
 
U.S. Government agencies and corporations
$
855

 
$
(5
)
 
$
2,734

 
$
(42
)
 
$
3,589

 
$
(47
)
Residential mortgage-backed securities:
 

 
 

 
 

 
 

 
 

 
 

Government-sponsored agencies
22,900

 
(149
)
 
8,853

 
(115
)
 
31,753

 
(264
)
Nongovernment-sponsored entities

 

 
3,405

 
(29
)
 
3,405

 
(29
)
Corporate debt securities
1,701

 
(49
)
 
5,952

 
(100
)
 
7,653

 
(149
)
Tax-exempt debt securities
 

 
 

 
 

 
 

 
 

 
 

State and political subdivisions:
 

 
 

 
 

 
 

 
 

 
 

General obligations
8,399

 
(115
)
 

 

 
8,399

 
(115
)
Water and sewer revenues
824

 
(11
)
 

 

 
824

 
(11
)
Lease revenues
1,104

 
(38
)
 

 

 
1,104

 
(38
)
Other revenues
2,396

 
(29
)
 

 

 
2,396

 
(29
)
Total temporarily impaired securities
38,179

 
(396
)
 
20,944

 
(286
)
 
59,123

 
(682
)
Total other-than-temporarily
 

 
 

 
 

 
 

 
 

 
 

impaired securities

 

 

 

 

 

Total
$
38,179

 
$
(396
)
 
$
20,944

 
$
(286
)
 
$
59,123

 
$
(682
)


 
December 31, 2015
 
Less than 12 months
 
12 months or more
 
Total
Dollars in thousands
Estimated
Fair Value
 
Unrealized
Loss
 
Estimated
Fair Value
 
Unrealized
Loss
 
Estimated
Fair Value
 
Unrealized
Loss
Temporarily impaired securities
 
 
 
 
 
 
 
 
 
 
 
Taxable debt securities
 
 
 
 
 
 
 
 
 
 
 
U.S. Government agencies and corporations
$
2,104

 
$
(2
)
 
$
3,151

 
$
(47
)
 
$
5,255

 
$
(49
)
Residential mortgage-backed securities:
 

 
 

 
 

 
 

 
 

 
 

Government-sponsored agencies
52,970

 
(569
)
 
8,672

 
(226
)
 
61,642

 
(795
)
Nongovernment-sponsored entities
2,298

 

 
2,819

 
(33
)
 
5,117

 
(33
)
State and political subdivisions:
 

 
 

 
 

 
 

 
 

 
 

Other revenues
1,702

 
(26
)
 

 

 
1,702

 
(26
)
Corporate debt securities
8,367

 
(268
)
 

 

 
8,367

 
(268
)
Tax-exempt debt securities
 

 
 

 
 

 
 

 
 

 
 

State and political subdivisions:
 

 
 

 
 

 
 

 
 

 
 

General obligations
5,977

 
(41
)
 

 

 
5,977

 
(41
)
Lease revenues
576

 
(1
)
 

 

 
576

 
(1
)
Other revenues
1,218

 
(14
)
 

 

 
1,218

 
(14
)
Total temporarily impaired securities
75,212

 
(921
)
 
14,642

 
(306
)
 
89,854

 
(1,227
)
Total other-than-temporarily
 

 
 

 
 

 
 

 
 

 
 

impaired securities

 

 

 

 

 

Total
$
75,212

 
$
(921
)
 
$
14,642

 
$
(306
)
 
$
89,854

 
$
(1,227
)





Table of Contents
20


NOTE 6.  LOANS

Loans are generally stated at the amount of unpaid principal, reduced by unearned discount and allowance for loan losses. Interest on loans is accrued daily on the outstanding balances.  Loan origination fees and certain direct loan origination costs are deferred and amortized as adjustments of the related loan yield over its contractual life. We categorize residential real estate loans in excess of $600,000 as jumbo loans.

Generally, loans are placed on nonaccrual status when principal or interest is greater than 90 days past due based upon the loan's contractual terms.  Interest is accrued daily on impaired loans unless the loan is placed on nonaccrual status.  Impaired loans are placed on nonaccrual status when the payments of principal and interest are in default for a period of 90 days, unless the loan is both well-secured and in the process of collection.  Interest on nonaccrual loans is recognized primarily using the cost-recovery method.  Loans may be returned to accrual status when repayment is reasonably assured and there has been demonstrated performance under the terms of the loan or, if applicable, the terms of the restructured loans.

Commercial-related loans or portions thereof (which are risk-rated) are charged off to the allowance for loan losses when the loss has been confirmed.  This determination is made on a case by case basis considering many factors, including the prioritization of our claim in bankruptcy, expectations of the workout/restructuring of the loan and valuation of the borrower’s equity.  We deem a loss confirmed when a loan or a portion of a loan is classified “loss” in accordance with bank regulatory classification guidelines, which state, “Assets classified loss are considered uncollectible and of such little value that their continuance as bankable assets is not warranted”.
 
Consumer-related loans are generally charged off to the allowance for loan losses upon reaching specified stages of delinquency, in accordance with the Federal Financial Institutions Examination Council policy.  For example, credit card loans are charged off by the end of the month in which the account becomes 180 days past due or within 60 days from receiving notification about a specified event (e.g., bankruptcy of the borrower), which ever is earlier.  Residential mortgage loans are generally charged off to net realizable value no later than when the account becomes 180 days past due.  Other consumer loans, if collateralized, are generally charged off to net realizable value at 120 days past due.

Loans are summarized as follows:
Dollars in thousands
 
September 30,
2016
 
December 31,
2015
 
September 30,
2015
Commercial
 
$
110,466

 
$
97,201

 
$
89,250

Commercial real estate
 
 

 
 

 
 

Owner-occupied
 
192,254

 
203,555

 
199,068

Non-owner occupied
 
367,196

 
337,294

 
336,550

Construction and development
 
 

 
 

 
 

Land and land development
 
65,430

 
65,500

 
66,164

Construction
 
11,276

 
9,970

 
8,419

Residential real estate
 
 

 
 

 
 

Non-jumbo
 
228,777

 
221,750

 
222,739

Jumbo
 
57,276

 
50,313

 
46,092

Home equity
 
75,161

 
74,300

 
73,652

Mortgage warehouse lines
 
108,983

 

 

Consumer
 
19,756

 
19,251

 
19,124

Other
 
9,649

 
11,669

 
12,518

Total loans, net of unearned fees
 
1,246,224

 
1,090,803

 
1,073,576

Less allowance for loan losses
 
11,619

 
11,472

 
11,228

Loans, net
 
$
1,234,605

 
$
1,079,331

 
$
1,062,348


Table of Contents
21



The following table presents the contractual aging of the recorded investment in past due loans by class as of September 30, 2016 and 2015 and December 31, 2015.
 
At September 30, 2016
 
Past Due
 
 
 
> 90 days and Accruing
Dollars in thousands
30-59 days
 
60-89 days
 
> 90 days
 
Total
 
Current
 
Commercial
$
301

 
$
138

 
$
602

 
$
1,041

 
$
109,425

 
$

Commercial real estate
 

 
 

 
 

 
 

 
 

 
 

Owner-occupied
251

 

 
505

 
756

 
191,498

 

Non-owner occupied
311

 
78

 

 
389

 
366,807

 

Construction and development
 

 
 

 
 

 
 

 
 

 
 

Land and land development
238

 

 
3,731

 
3,969

 
61,461

 

Construction

 

 

 

 
11,276

 

Residential mortgage
 

 
 

 
 

 
 

 
 

 
 

Non-jumbo
1,932

 
1,488

 
2,762

 
6,182

 
222,595

 

Jumbo

 

 

 

 
57,276

 

Home equity

 
136

 
318

 
454

 
74,707

 

Mortgage warehouse lines

 

 

 

 
108,983

 

Consumer
135

 
44

 
148

 
327

 
19,429

 
21

Other

 

 

 

 
9,649

 

Total
$
3,168

 
$
1,884

 
$
8,066

 
$
13,118

 
$
1,233,106

 
$
21

 
 
At December 31, 2015
 
Past Due
 
 
 
> 90 days and Accruing
Dollars in thousands
30-59 days
 
60-89 days
 
> 90 days
 
Total
 
Current
 
Commercial
$
345

 
$
26

 
$
632

 
$
1,003

 
$
96,198

 
$

Commercial real estate
 

 
 

 
 

 
 

 
 

 
 

Owner-occupied
158

 
386

 
437

 
981

 
202,574

 

Non-owner occupied
1

 

 
856

 
857

 
336,437

 

Construction and development
 
 
 

 
 

 
 

 
 

 
 

Land and land development
1,182

 
194

 
4,547

 
5,923

 
59,577

 

Construction

 

 

 

 
9,970

 

Residential mortgage
 

 
 

 
 

 
 

 
 

 
 

Non-jumbo
2,276

 
2,647

 
1,591

 
6,514

 
215,236

 

Jumbo

 

 

 

 
50,313

 

Home equity
374

 
172

 
100

 
646

 
73,654

 

Consumer
155

 
41

 
92

 
288

 
18,963

 
9

Other

 

 

 

 
11,669

 

Total
$
4,491

 
$
3,466

 
$
8,255

 
$
16,212

 
$
1,074,591

 
$
9



Table of Contents
22


 
At September 30, 2015
 
Past Due
 
 
 
> 90 days and Accruing
Dollars in thousands
30-59 days
 
60-89 days
 
> 90 days
 
Total
 
Current
 
Commercial
$
42

 
$
41

 
$
623

 
$
706

 
$
88,544

 
$

Commercial real estate
 

 
 

 
 

 
 

 
 

 
 

Owner-occupied
961

 

 
436

 
1,397

 
197,671

 

Non-owner occupied
309

 
657

 
188

 
1,154

 
335,396

 

Construction and development
 

 
 

 
 

 
 

 
 

 
 

Land and land development
39

 

 
4,538

 
4,577

 
61,587

 

Construction

 

 

 

 
8,419

 

Residential mortgage
 

 
 

 
 

 
 

 
 

 
 

Non-jumbo
3,239

 
1,108

 
2,065

 
6,412

 
216,327

 

Jumbo

 

 

 

 
46,092

 

Home equity
165

 
209

 
27

 
401

 
73,251

 

Consumer
169

 
77

 
42

 
288

 
18,836

 
8

Other

 

 

 

 
12,518

 

Total
$
4,924

 
$
2,092

 
$
7,919

 
$
14,935

 
$
1,058,641

 
$
8


Nonaccrual loans:  The following table presents the nonaccrual loans included in the net balance of loans at September 30, 2016, December 31, 2015 and September 30, 2015.
 
 
September 30,
 
December 31,
Dollars in thousands
 
2016
 
2015
 
2015
Commercial
 
$
846

 
$
884

 
$
853

Commercial real estate
 
 

 
 

 
 

Owner-occupied
 
505

 
437

 
437

Non-owner occupied
 
4,362

 
4,858

 
5,518

Construction and development
 
 

 
 

 
 

Land & land development
 
4,360

 
5,346

 
5,623

Construction
 

 

 

Residential mortgage
 
 

 
 

 
 

Non-jumbo
 
3,680

 
3,689

 
2,987

Jumbo
 

 

 

Home equity
 
494

 
191

 
258

Mortgage warehouse lines
 

 

 

Consumer
 
148

 
44

 
83

Total
 
$
14,395

 
$
15,449

 
$
15,759

 
Impaired loans:  Impaired loans include the following:

Loans which we risk-rate (consisting of loan relationships having aggregate balances in excess of $2.5 million, or loans exceeding $500,000 and exhibiting credit weakness) through our normal loan review procedures and which, based on current information and events, it is probable that we will be unable to collect all amounts due in accordance with the original contractual terms of the loan agreement.   Risk-rated loans with insignificant delays or insignificant short falls in the amount of payments expected to be collected are not considered to be impaired.

Loans that have been modified in a troubled debt restructuring.

Both commercial and consumer loans are deemed impaired upon being contractually modified in a troubled debt restructuring. Troubled debt restructurings typically result from our loss mitigation activities and occur when we grant a concession to a borrower who is experiencing financial difficulty in order to minimize our economic loss and to avoid foreclosure or repossession of collateral.  Once restructured in a troubled debt restructuring, a loan is generally considered impaired until its maturity, regardless of whether the borrower performs under the modified terms.  Although such a loan may be returned to accrual status if the criteria set forth in our accounting policy are met, the loan would continue to be evaluated for an asset-specific allowance for loan losses and we would continue to report the loan in the impaired loan table below.

The table below sets forth information about our impaired loans.

Table of Contents
23



Method Used to Measure Impairment of Impaired Loans
 
 
Dollars in thousands
 
 
 
 
 
 
 
 
September 30,
 
December 31,
 
Method used to measure impairment
Loan Category
2016
 
2015
 
2015
 
Commercial
$
650

 
$
41

 
$
41

 
Fair value of collateral
 
159

 
269

 
201

 
Discounted cash flow
Commercial real estate
 

 
 

 
 
 
 
Owner-occupied
318

 
795

 
783

 
Fair value of collateral
 
7,095

 
7,646

 
7,616

 
Discounted cash flow
Non-owner occupied
4,596

 
5,924

 
5,728

 
Fair value of collateral
 
7,121

 
7,775

 
7,722

 
Discounted cash flow
Construction and development
 
 
 
 
 
 
 
Land & land development
5,191

 
10,047

 
6,597

 
Fair value of collateral
 
2,131

 
2,257

 
2,177

 
Discounted cash flow
Residential mortgage
 

 
 
 
 
 
 
Non-jumbo
1,732

 
1,730

 
1,753

 
Fair value of collateral
 
4,748

 
4,375

 
4,378

 
Discounted cash flow
Jumbo
3,682

 
3,792

 
3,869

 
Fair value of collateral
 
859

 
876

 
871

 
Discounted cash flow
Home equity
190

 
186

 
186

 
Fair value of collateral
 
523

 
523

 
523

 
Discounted cash flow
Consumer

 
2

 

 
Fair value of collateral
 
48

 
68

 
68

 
Discounted cash flow
Total
$
39,043

 
$
46,306

 
$
42,513

 
 


Table of Contents
24


The following tables present loans individually evaluated for impairment at September 30, 2016, December 31, 2015 and September 30, 2015.
 
September 30, 2016
Dollars in thousands
Recorded
Investment
 
Unpaid
Principal Balance
 
Related
Allowance
 
Average
Impaired
Balance
 
Interest Income
Recognized
while impaired
 
 
 
 
 
 
 
 
 
 
Without a related allowance
 
 
 
 
 
 
 
 
 
Commercial
$
791

 
$
790

 
$

 
$
400

 
$
9

Commercial real estate
 

 
 

 
 

 
 

 
 

Owner-occupied
4,914

 
4,914

 

 
4,932

 
188

Non-owner occupied
10,394

 
10,396

 

 
10,831

 
456

Construction and development
 

 
 

 
 

 
 

 
 

Land & land development
6,181

 
6,181

 

 
6,207

 
104

Construction

 

 

 

 

Residential real estate
 

 
 

 
 

 
 

 
 

Non-jumbo
3,852

 
3,861

 

 
3,732

 
170

Jumbo
3,683

 
3,682

 

 
3,711

 
176

Home equity
713

 
713

 

 
710

 
21

Mortgage warehouse lines

 

 

 

 

Consumer
48

 
48

 

 
52

 
5

Total without a related allowance
$
30,576

 
$
30,585

 
$

 
$
30,575

 
$
1,129

 
 
 
 
 
 
 
 
 
 
With a related allowance
 

 
 

 
 

 
 

 
 

Commercial
$
19

 
$
19

 
$
19

 
$
6

 
$

Commercial real estate
 

 
 

 
 

 
 

 
 

Owner-occupied
2,499

 
2,499

 
12

 
2,491

 
112

Non-owner occupied
1,321

 
1,321

 
132

 
1,332

 
43

Construction and development
 

 
 

 
 

 
 

 
 

Land & land development
1,140

 
1,141

 
492

 
1,155

 
58

Construction

 

 

 

 

Residential real estate
 
 
 
 
 
 
 
 
 
Non-jumbo
2,617

 
2,619

 
216

 
2,329

 
103

Jumbo
859

 
859

 
25

 
864

 
43

Home equity

 

 

 

 

Mortgage warehouse lines

 

 

 

 

Consumer

 

 

 

 

Total with a related allowance
$
8,455

 
$
8,458

 
$
896

 
$
8,177

 
$
359

 
 
 
 
 
 
 
 
 
 
Total
 

 
 

 
 

 
 

 
 

Commercial
$
27,259

 
$
27,261

 
$
655

 
$
27,354

 
$
970

Residential real estate
11,724

 
11,734

 
241

 
11,346

 
513

Consumer
48

 
48

 

 
52

 
5

Total
$
39,031

 
$
39,043

 
$
896

 
$
38,752

 
$
1,488







Table of Contents
25


 
December 31, 2015
Dollars in thousands
Recorded
Investment
 
Unpaid
Principal Balance
 
Related
Allowance
 
Average
Impaired
Balance
 
Interest Income
Recognized
while impaired
 
 
 
 
 
 
 
 
 
 
Without a related allowance
 
 
 
 
 
 
 
 
 
Commercial
$
242

 
$
242

 
$

 
$
319

 
$
17

Commercial real estate
 

 
 

 
 

 
 

 
 

Owner-occupied
5,401

 
5,402

 

 
5,438

 
191

Non-owner occupied
10,740

 
10,741

 

 
9,982

 
310

Construction and development
 
 
 

 
 

 
 

 
 

Land & land development
7,635

 
7,635

 

 
9,497

 
263

Construction

 

 

 

 

Residential real estate
 

 
 

 
 

 
 

 
 

Non-jumbo
3,590

 
3,600

 

 
3,316

 
160

Jumbo
3,871

 
3,869

 

 
4,412

 
181

Home equity
709

 
709

 

 
709

 
32

Consumer
68

 
68

 

 
72

 
6

Total without a related allowance
$
32,256

 
$
32,266

 
$

 
$
33,745

 
$
1,160

 
 
 
 
 
 
 
 
 
 
With a related allowance
 

 
 

 
 

 
 

 
 

Commercial
$

 
$

 
$

 
$

 
$

Commercial real estate
 

 
 

 
 

 
 

 
 

Owner-occupied
2,997

 
2,997

 
45

 
3,003

 
135

Non-owner occupied
2,709

 
2,709

 
386

 
2,728

 
72

Construction and development
 
 
 

 
 

 
 

 
 

Land & land development
1,139

 
1,139

 
85

 
1,154

 

Construction

 

 

 

 

Residential real estate
 

 
 

 
 

 
 

 
 

Non-jumbo
2,530

 
2,531

 
226

 
2,552

 
114

Jumbo
871

 
871

 
34

 
878

 
43

Home equity

 

 

 

 

Consumer

 

 

 

 

Total with a related allowance
$
10,246

 
$
10,247

 
$
776

 
$
10,315

 
$
364

 
 
 
 
 
 
 
 
 
 
Total
 

 
 

 
 

 
 

 
 

Commercial
$
30,863

 
$
30,865

 
$
516

 
$
32,121

 
$
988

Residential real estate
11,571

 
11,580

 
260

 
11,867

 
530

Consumer
68

 
68

 

 
72

 
6

Total
$
42,502

 
$
42,513

 
$
776

 
$
44,060

 
$
1,524





 

Table of Contents
26


 
September 30, 2015
Dollars in thousands
Recorded
Investment
 
Unpaid
Principal Balance
 
Related
Allowance
 
Average
Impaired
Balance
 
Interest Income
Recognized
while impaired
 
 
 
 
 
 
 
 
 
 
Without a related allowance
 
 
 
 
 
 
 
 
 
Commercial
$
310

 
$
310

 
$

 
$
345

 
$
63

Commercial real estate
 

 
 

 
 

 
 

 
 

Owner-occupied
5,420

 
5,421

 

 
5,450

 
586

Non-owner occupied
11,635

 
11,636

 

 
10,362

 
988

Construction and development
 
 
 

 
 

 
 

 
 

Land & land development
12,136

 
12,304

 

 
11,282

 
908

Construction

 

 

 

 

Residential real estate
 

 
 

 
 

 
 

 
 

Non-jumbo
3,399

 
3,408

 

 
3,930

 
462

Jumbo
3,794

 
3,792

 

 
3,820

 
554

Home equity
710

 
709

 

 
709

 
93

Consumer
70

 
70

 

 
75

 
21

Total without a related allowance
$
37,474

 
$
37,650

 
$

 
$
35,973

 
$
3,675

 
 
 
 
 
 
 
 
 
 
With a related allowance
 

 
 

 
 

 
 

 
 

Commercial
$

 
$

 
$

 
$

 
$

Commercial real estate
 

 
 

 
 

 
 

 
 

Owner-occupied
3,019

 
3,020

 
46

 
3,005

 
409

Non-owner occupied
2,063

 
2,063

 
190

 
2,074

 
244

Construction and development
 
 
 

 
 

 
 

 
 

Land & land development

 

 

 

 

Construction

 

 

 

 

Residential real estate
 

 
 

 
 

 
 

 
 

Non-jumbo
2,695

 
2,697

 
251

 
2,714

 
348

Jumbo
876

 
876

 
37

 
880

 
134

Home equity

 

 

 

 

Consumer

 

 

 

 

Total with a related allowance
$
8,653

 
$
8,656

 
$
524

 
$
8,673

 
$
1,135

 
 
 
 
 
 
 
 
 
 
Total
 

 
 

 
 

 
 

 
 

Commercial
$
34,583

 
$
34,754

 
$
236

 
$
32,518

 
$
3,198

Residential real estate
11,474

 
11,482

 
288

 
12,053

 
1,591

Consumer
70

 
70

 

 
75

 
21

Total
$
46,127

 
$
46,306

 
$
524

 
$
44,646

 
$
4,810


A modification of a loan is considered a troubled debt restructuring (“TDR”) when a borrower is experiencing financial difficulty and the modification constitutes a concession that we would not otherwise consider. This may include a transfer of real estate or other assets from the borrower, a modification of loan terms, or a combination of both.  A loan continues to be classified as a TDR for the life of the loan.  Included in impaired loans are TDRs of $29.2 million, of which $28.5 million were current with respect to restructured contractual payments at September 30, 2016, and $30.5 million, of which $28.9 million were current with respect to restructured contractual payments at December 31, 2015.  There were no commitments to lend additional funds under these restructurings at either balance sheet date.

The following table presents by class the TDRs that were restructured during the three and nine months ended September 30, 2016 and September 30, 2015 . Generally, the modifications were extensions of term, modifying the payment terms from principal and interest to interest only for an extended period, or reduction in interest rate.  All TDRs are evaluated individually for allowance for loan loss purposes.


Table of Contents
27


 
For the Three Months Ended 
 September 30, 2016
 
For the Three Months Ended 
 September 30, 2015
Dollars in thousands
Number of
Modifications
 
Pre-modification
Recorded
Investment
 
Post-modification
Recorded
Investment
 
Number of
Modifications
 
Pre-modification
Recorded
Investment
 
Post-modification
Recorded
Investment
Commercial

 
$

 
$

 

 
$

 
$

Commercial real estate
 
 
 
 
 
 
 
 
 
 
 
Owner-occupied

 

 

 

 

 

Non-owner occupied

 

 

 

 

 

Construction and development
 
 
 
 
 
 
 
 
 
 
 
Land & land development

 

 

 
1

 
1,182

 
1,182

Construction

 

 

 

 

 

Residential real estate
 
 
 
 
 
 
 
 
 
 
 
Non-jumbo
1

 
307

 
307

 

 

 

Jumbo

 

 

 

 

 

Home equity

 

 

 

 

 

Mortgage warehouse lines

 

 

 

 

 

Consumer

 

 

 

 

 

Total
1

 
$
307

 
$
307

 
1

 
$
1,182

 
$
1,182



 
For the Nine Months Ended 
 September 30, 2016
 
For the Nine Months Ended 
 September 30, 2015
Dollars in thousands
Number of
Modifications
 
Pre-modification
Recorded
Investment
 
Post-modification
Recorded
Investment
 
Number of
Modifications
 
Pre-modification
Recorded
Investment
 
Post-modification
Recorded
Investment
Commercial

 
$

 
$

 

 
$

 
$

Commercial real estate
 
 
 
 
 
 
 
 
 
 
 
Owner-occupied

 

 

 

 

 

Non-owner occupied

 

 

 

 

 

Construction and development
 
 
 
 
 
 
 
 
 
 
 
Land & land development

 

 

 
1

 
1,182

 
1,182

Construction

 

 

 

 

 

Residential real estate
 
 
 
 
 
 
 
 
 
 
 
Non-jumbo
4

 
702

 
702

 

 

 

Jumbo

 

 

 

 

 

Home equity

 

 

 

 

 

Mortgage warehouse lines

 

 

 

 

 

Consumer
1

 
2

 
2

 

 

 

Total
5

 
$
704

 
$
704

 
1

 
$
1,182

 
$
1,182




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28


The following table presents defaults during the stated period of TDRs that were restructured during the past twelve months.  For purposes of these tables, a default is considered as either the loan was past due 30 days or more at any time during the period, or the loan was fully or partially charged off during the period. 
 
For the Three Months Ended 
 September 30, 2016
 
For the Nine Months Ended 
 September 30, 2016
Dollars in thousands
Number
of
Defaults
 
Recorded
Investment
at Default Date
 
Number
of
Defaults
 
Recorded
Investment
at Default Date
Commercial

 
$

 

 
$

Commercial real estate


 


 


 


Owner-occupied

 

 

 

Non-owner occupied

 

 

 

Construction and development

 


 


 


Land & land development

 

 

 

Construction

 

 

 

Residential real estate


 


 


 


Non-jumbo
3

 
452

 
3

 
452

Jumbo

 

 

 

Home equity

 

 

 

Mortgage warehouse lines

 

 

 

Consumer
1

 
2

 
1

 
2

Total
4

 
$
454

 
4

 
$
454


The following table details the activity regarding TDRs by loan type for the three months and nine months ended September 30, 2016, and the related allowance on TDRs.
For the Three Months Ended September 30, 2016
 
Construction & Land Development
 
 
 
Commercial Real Estate
 
Residential Real Estate
 
 
 
 
 
 
 
 
Dollars in thousands
Land &
Land
Develop-
ment
 
Construc-
tion
 
Commer-
cial
 
Owner
Occupied
 
Non-
Owner
Occupied
 
Non-
jumbo
 
Jumbo
 
Home
Equity
 
Mortgage Warehouse Lines
 
Con-
sumer
 
Other
 
Total
Troubled debt restructurings
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance July 1, 2016
$
3,956

 
$

 
$
198

 
$
9,118

 
$
6,001

 
$
5,457

 
$
4,575

 
$
523

 
$

 
$
54

 
$

 
$
29,882

Additions

 

 

 

 

 
303

 

 

 

 

 

 
303

Charge-offs

 

 

 
(2
)
 

 

 

 

 

 

 

 
(2
)
Net (paydowns) advances
(57
)
 

 
(7
)
 
(381
)
 
(504
)
 
(44
)
 
(34
)
 

 

 
(6
)
 

 
(1,033
)
Transfer into foreclosed properties

 

 

 

 

 

 

 

 

 

 

 

Refinance out of TDR status

 

 

 

 

 

 

 

 

 

 

 

Balance, September 30, 2016
$
3,899

 
$

 
$
191

 
$
8,735

 
$
5,497

 
$
5,716

 
$
4,541

 
$
523

 
$

 
$
48

 
$

 
$
29,150

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Allowance related to troubled debt restructurings
$
492

 
$

 
$

 
$
144

 
$

 
$
216

 
$
25

 
$

 
$

 
$

 
$

 
$
877



Table of Contents
29


For the Nine Months Ended September 30, 2016
 
Construction & Land Development
 
 
 
Commercial Real Estate
 
Residential Real Estate
 
 
 
 
 
 
 
 
Dollars in thousands
Land &
Land
Develop-
ment
 
Construc-
tion
 
Commer-
cial
 
Owner
Occupied
 
Non-
Owner
Occupied
 
Non-
jumbo
 
Jumbo
 
Home
Equity
 
Mortgage Warehouse Lines
 
Con-
sumer
 
Other
 
Total
Troubled debt restructurings
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance January 1, 2016
$
4,188

 
$

 
$
242

 
$
9,314

 
$
6,059

 
$
5,496

 
$
4,634

 
$
523

 
$

 
$
68

 
$

 
$
30,524

Additions

 

 

 

 

 
698

 

 

 

 
1

 

 
699

Charge-offs

 

 

 
(128
)
 

 
(52
)
 

 

 

 

 

 
(180
)
Net (paydowns) advances
(289
)
 

 
(51
)
 
(451
)
 
(562
)
 
(426
)
 
(93
)
 

 

 
(21
)
 

 
(1,893
)
Transfer into foreclosed properties

 

 

 

 

 

 

 

 

 

 

 

Refinance out of TDR status

 

 

 

 

 

 

 

 

 

 

 

Balance, September 30, 2016
$
3,899

 
$

 
$
191

 
$
8,735

 
$
5,497

 
$
5,716

 
$
4,541

 
$
523

 
$

 
$
48

 
$

 
$
29,150

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Allowance related to troubled debt restructurings
$
492

 
$

 
$

 
$
144

 
$

 
$
216

 
$
25

 
$

 
$

 
$

 
$

 
$
877


We categorize loans into risk categories based on relevant information about the ability of borrowers to service their debt such as current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. We analyze loans individually by classifying the loans as to credit risk.  We internally grade all commercial loans at the time of loan origination. In addition, we perform an annual loan review on all non-homogenous commercial loan relationships with an aggregate exposure of $2.5 million, at which time these loans are re-graded.

We use the following definitions for our risk grades:

Pass: Loans graded as Pass are loans to borrowers of acceptable credit quality and risk. They are higher quality loans that do not fit any of the other categories described below.

OLEM (Special Mention):  Commercial loans categorized as OLEM are potentially weak. The credit risk may be relatively minor yet represent a risk given certain specific circumstances. If the potential weaknesses are not monitored or mitigated, the asset may weaken or inadequately protect our position in the future.

Substandard:   Commercial loans categorized as Substandard are inadequately protected by the borrower’s ability to repay, equity, and/or the collateral pledged to secure the loan. These loans have identified weaknesses that could hinder normal repayment or collection of the debt. These loans are characterized by the distinct possibility that we will sustain some loss if the identified weaknesses are not mitigated.

Doubtful:  Commercial loans categorized as Doubtful have all the weaknesses inherent in those loans classified as Substandard, with the added elements that the full collection of the loan is improbable and the possibility of loss is high.

Loss:  Loans classified as loss are considered to be non-collectible and of such little value that their continuance as a bankable asset is not warranted. This does not mean that the loan has absolutely no recovery value, but rather it is neither practical nor desirable to defer writing off the loan, even though partial recovery may be obtained in the future.

The following table presents the recorded investment in construction and development, commercial, and commercial real estate loans which are generally evaluated based upon the internal risk ratings defined above.

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30


Loan Risk Profile by Internal Risk Rating
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Construction and Development
 
 
 
 
 
Commercial Real Estate
 
 
 
 
Land and Land Development
 
Construction
 
Commercial
 
Owner Occupied
 
Non-Owner Occupied
 
Mortgage Warehouse Lines
Dollars in thousands
9/30/2016
 
12/31/2015
 
9/30/2016
 
12/31/2015
 
9/30/2016
 
12/31/2015
 
9/30/2016
 
12/31/2015
 
9/30/2016
 
12/31/2015
 
9/30/2016
12/31/2015
Pass
$
58,169

 
$
57,155

 
$
11,276

 
$
9,970

 
$
108,563

 
$
95,174

 
$
190,854

 
$
202,226

 
$
361,531

 
$
329,861

 
$
108,983

$

OLEM (Special Mention)
1,737

 
1,598

 

 

 
1,142

 
1,295

 
576

 
546

 
958

 
1,602

 


Substandard
5,524

 
6,747

 

 

 
761

 
732

 
824

 
783

 
4,707

 
5,831

 


Doubtful

 

 

 

 

 

 

 

 

 

 


Loss

 

 

 

 

 

 

 

 

 

 


Total
$
65,430

 
$
65,500

 
$
11,276

 
$
9,970

 
$
110,466

 
$
97,201

 
$
192,254

 
$
203,555

 
$
367,196

 
$
337,294

 
$
108,983

$

 
The following table presents the recorded investment in consumer, residential real estate, and home equity loans, which are generally evaluated based on the aging status of the loans, which was previously presented, and payment activity.
 
Performing
 
Nonperforming
Dollars in thousands
9/30/2016
 
12/31/2015
 
9/30/2015
 
9/30/2016
 
12/31/2015
 
9/30/2015
Residential real estate
 
 
 
 
 
 
 
 
 
 
 
Non-jumbo
$
225,097

 
$
218,763

 
$
219,050

 
$
3,680

 
$
2,987

 
$
3,689

Jumbo
57,276

 
50,313

 
46,092

 

 

 

Home Equity
74,667

 
74,042

 
73,461

 
494

 
258

 
191

Consumer
19,574

 
19,149

 
19,071

 
182

 
102

 
53

Other
9,649

 
11,669

 
12,518

 

 

 

Total
$
386,263

 
$
373,936

 
$
370,192

 
$
4,356

 
$
3,347

 
$
3,933


Loan commitments:  ASC Topic 815, Derivatives and Hedging, requires that commitments to make mortgage loans should be accounted for as derivatives if the loans are to be held for sale, because the commitment represents a written option and accordingly is recorded at the fair value of the option liability.

NOTE 7.  ALLOWANCE FOR LOAN LOSSES

We maintain the allowance for loan losses at a level considered adequate to provide for estimated probable credit losses inherent in the loan portfolio.  The allowance is comprised of three distinct reserve components:  (1) specific reserves related to loans individually evaluated, (2) quantitative reserves related to loans collectively evaluated, and (3) qualitative reserves related to loans collectively evaluated.  A summary of the methodology we employ on a quarterly basis with respect to each of these components in order to evaluate the overall adequacy of our allowance for loan losses is as follows:

Specific Reserve for Loans Individually Evaluated

First, we identify loan relationships having aggregate balances in excess of $500,000 and that may also have credit weaknesses.  Such loan relationships are identified primarily through our analysis of internal loan evaluations, past due loan reports, and loans adversely classified by regulatory authorities.  Each loan so identified is then individually evaluated to determine whether it is impaired – that is, based on current information and events, it is probable that we will be unable to collect all amounts due in accordance with the contractual terms of the underlying loan agreement.  Substantially all of our impaired loans historically have been collateral dependent, meaning repayment of the loan is expected or is considered to be provided solely from the sale of the loan’s underlying collateral.  For such loans, we measure impairment based on the fair value of the loan’s collateral, which is generally determined utilizing current appraisals.  A specific reserve is established in an amount equal to the excess, if any, of the recorded investment in each impaired loan over the fair value of its underlying collateral, less estimated costs to sell. Our policy is to re-evaluate the fair value of collateral dependent loans at least every twelve months unless there is a known deterioration in the collateral’s value, in which case a new appraisal is obtained. Beginning in 2014, for purposes of loans that have been modified in a troubled debt restructuring and not internally graded as substandard, doubtful, or loss ("performing TDRs") we began measuring impairment using the discounted cash flows method. Under this method, a specific reserve is established in an amount equal to the excess, if any, of the recorded investment in each impaired loan over its discounted cash flows.

Quantitative Reserve for Loans Collectively Evaluated
 
Second, we stratify the loan portfolio into the following eleven loan pools:  land and land development, construction, commercial, commercial real estate -- owner-occupied, commercial real estate -- non-owner occupied, conventional residential mortgage, jumbo residential mortgage, home equity, mortgage warehouse lines, consumer, and other.  Quantitative reserves

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31


relative to each loan pool are established as follows:  for all loan segments detailed above an allocation equaling 100% of the respective pool’s average 12 month historical net loan charge-off rate (determined based upon the most recent twelve quarters) is applied to the aggregate recorded investment in the pool of loans.
 
Qualitative Reserve for Loans Collectively Evaluated
 
Third, we consider the necessity to adjust our average historical net loan charge-off rates relative to each of the above eleven loan pools for potential risks factors that could result in actual losses deviating from prior loss experience.  For example, if we observe a significant increase in delinquencies within the conventional mortgage loan pool above historical trends, an additional allocation to the average historical loan charge-off rate is applied.  Such qualitative risk factors considered are:  (1) levels of and trends in delinquencies and impaired loans, (2) levels of and trends in charge-offs and recoveries, (3)trends in volume and term of loans, (4) effects of any changes in risk selection and underwriting standards, and other changes in lending policies, procedures, and practice, (5) experience, ability, and depth of lending management and other relevant staff, (6) national and local economic trends and conditions, (7) industry conditions, and (8) effects of changes in credit concentrations.

An analysis of the allowance for loan losses for the nine month periods ended September 30, 2016 and 2015, and for the year ended December 31, 2015 is as follows:
 
 
Nine Months Ended 
 September 30,
 
Year Ended 
 December 31,
Dollars in thousands
 
2016
 
2015
 
2015
Balance, beginning of year
 
$
11,472

 
$
11,167

 
$
11,167

Losses:
 
 
 
 
 
 
Commercial
 
379

 
77

 
77

Commercial real estate
 
 
 
 
 
 
Owner occupied
 
179

 
559

 
559

Non-owner occupied
 
122

 
178

 
178

Construction and development
 
 
 
 
 
 
Land and land development
 
50

 
457

 
457

Construction
 

 

 

Residential real estate
 
 
 
 
 
 
Non-jumbo
 
119

 
316

 
417

Jumbo
 

 
206

 
208

Home equity
 
117

 
76

 
76

Mortgage warehouse lines
 

 

 

Consumer
 
61

 
62

 
69

Other
 
128

 
88

 
110

Total
 
1,155

 
2,019

 
2,151

Recoveries:
 
 

 
 

 
 

Commercial
 
69

 
6

 
10

Commercial real estate
 
 
 
 
 
 
Owner occupied
 
25

 
282

 
290

Non-owner occupied
 
13

 
6

 
13

Construction and development
 
 
 
 
 
 
Land and land development
 
514

 
454

 
456

Construction
 

 

 

Real estate - mortgage
 
 
 
 
 
 
Non-jumbo
 
58

 
90

 
107

Jumbo
 
6

 
96

 
96

Home equity
 
3

 
3

 
3

Mortgage warehouse lines
 

 

 

Consumer
 
55

 
88

 
105

Other
 
59

 
55

 
126

Total
 
802

 
1,080

 
1,206

Net losses
 
353


939


945

Provision for loan losses
 
500

 
1,000

 
1,250

Balance, end of period
 
$
11,619


$
11,228


$
11,472

 
 

Table of Contents
32


Activity in the allowance for loan losses by loan class during the first nine months of 2016 is as follows:
 
Construction & Land Development
 
 
 
Commercial Real Estate
 
Residential Real Estate
 
 
 
 
 
 
 
 
Dollars in thousands
Land &
Land
Develop-
ment
 
Construc-
tion
 
Commer-
cial
 
Owner
Occupied
 
Non-
Owner
Occupied
 
Non-
jumbo
 
Jumbo
 
Home
Equity
 
Mortgage Warehouse Lines
 
Con-
sumer
 
Other
 
Total
Allowance for loan losses
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Beginning balance
$
2,852

 
$
15

 
$
780

 
$
1,589

 
$
2,977

 
$
1,253

 
$
1,593

 
$
253

 
$

 
$
60

 
$
100

 
$
11,472

Charge-offs
50

 

 
379

 
179

 
122

 
119

 

 
117

 

 
61

 
128

 
1,155

Recoveries
514

 

 
69

 
25

 
13

 
58

 
6

 
3

 

 
55

 
59

 
802

Provision
(1,814
)
 
9

 
734

 
543

 
1,097

 
694

 
(1,157
)
 
267

 

 
37

 
90

 
500

Ending balance
$
1,502


$
24


$
1,204


$
1,978


$
3,965


$
1,886


$
442


$
406


$

 
$
91


$
121


$
11,619

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Allowance related to:
 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 
 
 

 
 

 
 

Loans individually
evaluated for impairment
$
493

 
$

 
$
19

 
$
12

 
$
132

 
$
216

 
$
25

 
$

 
$

 
$

 
$

 
$
897

Loans collectively
evaluated for impairment
1,009

 
24

 
1,185

 
1,966

 
3,833

 
1,670

 
417

 
406

 

 
91

 
121

 
10,722

Total
$
1,502

 
$
24

 
$
1,204

 
$
1,978

 
$
3,965

 
$
1,886

 
$
442

 
$
406

 
$

 
$
91

 
$
121

 
$
11,619

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Loans
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 
 
 

 
 

 
 

Loans individually
evaluated for impairment
$
7,322

 
$

 
$
809

 
$
7,413

 
$
11,717

 
$
6,480

 
$
4,541

 
$
713

 
$

 
$
48

 
$

 
$
39,043

Loans collectively
evaluated for impairment
58,108

 
11,276

 
109,657

 
184,841

 
355,479

 
222,297

 
52,735

 
74,448

 
108,983

 
19,708

 
9,649

 
1,207,181

Total
$
65,430

 
$
11,276

 
$
110,466

 
$
192,254

 
$
367,196

 
$
228,777

 
$
57,276

 
$
75,161

 
$
108,983

 
$
19,756

 
$
9,649

 
$
1,246,224


NOTE 8.  GOODWILL AND OTHER INTANGIBLE ASSETS

The following tables present our goodwill by reporting unit at September 30, 2016 and other intangible assets by reporting unit at September 30, 2016 and December 31, 2015.
 
 
Goodwill Activity
Dollars in thousands
 
Community Banking
 
Insurance Services
 
Total
Balance, January 1, 2016
 
$
1,488

 
$
4,710

 
$
6,198

Acquired goodwill, net
 

 

 

Balance, September 30, 2016
 
$
1,488

 
$
4,710

 
$
6,198

 
 
Other Intangible Assets
 
 
September 30, 2016
 
December 31, 2015
Dollars in thousands
 
Community
Banking
 
Insurance
Services
 
Total
 
Community
Banking
 
Insurances
Services
 
Total
Unidentifiable intangible assets
 
 
 
 
 
 
 
 
 
 
 
 
Gross carrying amount
 
$
2,268

 
$

 
$
2,268

 
$
2,268

 
$

 
$
2,268

Less: accumulated amortization
 
2,268

 

 
2,268

 
2,268

 

 
2,268

Net carrying amount
 
$

 
$

 
$

 
$

 
$

 
$

 
 
 
 
 
 
 
 
 
 
 
 
 
Identifiable intangible assets
 
 

 
 

 
 

 
 

 
 

 
 

Gross carrying amount
 
$

 
$
3,000

 
$
3,000

 
$

 
$
3,000

 
$
3,000

Less: accumulated amortization
 

 
1,850

 
1,850

 

 
1,700

 
1,700

Net carrying amount
 
$

 
$
1,150

 
$
1,150

 
$

 
$
1,300

 
$
1,300


We recorded amortization expense of approximately $150,000 for the nine months ended September 30, 2016 relative to our other intangible assets.  Annual amortization is expected to approximate $200,000 for each of the years ending 2016 through 2020.

Table of Contents
33



NOTE 9.  DEPOSITS

The following is a summary of interest bearing deposits by type as of September 30, 2016 and 2015 and December 31, 2015:
Dollars in thousands
 
September 30,
2016
 
December 31,
2015
 
September 30,
2015
Demand deposits, interest bearing
 
$
212,172

 
$
215,721

 
$
217,242

Savings deposits
 
321,563

 
266,825

 
259,185

Time deposits
 
500,397

 
465,153

 
476,777

Total
 
$
1,034,132

 
$
947,699

 
$
953,204


Included in time deposits are deposits acquired through a third party (“brokered deposits”) totaling $178.9 million, $126.5 million and $132.0 million at September 30, 2016, December 31, 2015, and September 30, 2015, respectively.

A summary of the scheduled maturities for all time deposits as of September 30, 2016 is as follows:
Dollars in thousands
 
Three month period ending December 31, 2016
$
68,598

Year ending December 31, 2017
200,514

Year ending December 31, 2018
85,847

Year ending December 31, 2019
50,217

Year ending December 31, 2020
41,697

Thereafter
53,524

Total
$
500,397


The following is a summary of the maturity distribution of all certificates of deposit in denominations of $100,000 or more as of September 30, 2016:
Dollars in thousands
Amount
 
Percent
Three months or less
$
49,747

 
12.8
%
Three through six months
42,758

 
11.0
%
Six through twelve months
85,427

 
22.0
%
Over twelve months
210,358

 
54.2
%
Total
$
388,290

 
100.00
%



NOTE 10.  BORROWED FUNDS

Short-term borrowings:    A summary of short-term borrowings is presented below:
 
Nine Months Ended September 30,
 
2016
 
2015
Dollars in thousands
Short-term
FHLB
Advances
 
Federal Funds
Purchased
and Lines
of Credit
 
Short-term
FHLB
Advances
 
Federal Funds
Purchased
and Lines
of Credit
Balance at September 30
$
231,200

 
$
3,457

 
$
141,850

 
$
3,441

Average balance outstanding for the period
177,239

 
3,455

 
144,073

 
5,104

Maximum balance outstanding at any month end during period
231,200

 
3,457

 
171,160

 
7,438

Weighted average interest rate for the period
0.54
%
 
0.50
%
 
0.42
%
 
0.25
%
Weighted average interest rate for balances
 

 
 

 
 

 
 

     outstanding at September 30
0.59
%
 
0.50
%
 
0.33
%
 
0.25
%


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34


 
Year Ended December 31, 2015
Dollars in thousands
Short-term
FHLB
Advances
 
Federal Funds
Purchased
and Lines
of Credit
 Balance at December 31
$
167,950

 
$
3,444

Average balance outstanding for the period
146,412

 
4,690

Maximum balance outstanding at any month end during period
171,160

 
7,438

Weighted average interest rate for the period
0.43
%
 
0.50
%
Weighted average interest rate for balances outstanding at December 31
0.35
%
 
0.26
%

Long-term borrowings:  Our long-term borrowings of $74.1 million, $75.6 million and $76.1 million at September 30, 2016, December 31, 2015, and September 30, 2015 respectively, consisted primarily of advances from the Federal Home Loan Bank (“FHLB”) and structured reverse repurchase agreements with two unaffiliated institutions. All FHLB advances are collateralized primarily by similar amounts of residential mortgage loans, certain commercial loans, mortgage backed securities and securities of U. S. Government agencies and corporations.
 
Balance at September 30,
 
Balance at 
 December 31,
Dollars in thousands
2016
 
2015
 
2015
Long-term FHLB advances
$
792

 
$
900

 
$
873

Long-term reverse repurchase agreements
72,000

 
72,000

 
72,000

Term loan
1,354

 
3,159

 
2,708

Total
$
74,146

 
$
76,059

 
$
75,581

 
The term loan at September 30, 2016 is secured by the common stock of our subsidiary bank and bears a variable interest rate of prime minus 50 basis points with a final maturity of 2017. Our long term FHLB borrowings and reverse repurchase agreements bear both fixed and variable rates and mature in varying amounts through the year 2026.

The average interest rate paid on long-term borrowings for the nine month period ended September 30, 2016 was 4.43% compared to 4.37% for the first nine months of 2015.

Subordinated debentures owed to unconsolidated subsidiary trusts:  We have three statutory business trusts that were formed for the purpose of issuing mandatorily redeemable securities (the “capital securities”) for which we are obligated to third party investors and investing the proceeds from the sale of the capital securities in our junior subordinated debentures (the “debentures”).  The debentures held by the trusts are their sole assets.  Our subordinated debentures totaled $19.6 million at September 30, 2016, December 31, 2015, and September 30, 2015.

In October 2002, we sponsored SFG Capital Trust I, in March 2004, we sponsored SFG Capital Trust II, and in December 2005, we sponsored SFG Capital Trust III, of which 100% of the common equity of each trust is owned by us.  SFG Capital Trust I issued $3.5 million in capital securities and $109,000 in common securities and invested the proceeds in $3.61 million of debentures. SFG Capital Trust II issued $7.5 million in capital securities and $232,000 in common securities and invested the proceeds in $7.73 million of debentures. SFG Capital Trust III issued $8.0 million in capital securities and $248,000 in common securities and invested the proceeds in $8.25 million of debentures.  Distributions on the capital securities issued by the trusts are payable quarterly at a variable interest rate equal to 3 month LIBOR plus 345basis points for SFG Capital Trust I, 3 month LIBOR plus 280basis points for SFG Capital Trust II, and 3 month LIBOR plus 145basis points for SFG Capital Trust III, and equals the interest rate earned on the debentures held by the trusts, and is recorded as interest expense by us.  The capital securities are subject to mandatory redemption in whole or in part, upon repayment of the debentures.  We have entered into agreements which, taken collectively, fully and unconditionally guarantee the capital securities subject to the terms of the guarantee.  The debentures of each Capital Trust are redeemable by us quarterly.

The capital securities held by SFG Capital Trust I, SFG Capital Trust II, and SFG Capital Trust III qualify as Tier 1 capital under Federal Reserve Board guidelines.  In accordance with these Guidelines, trust preferred securities generally are limited to 25% of Tier 1 capital elements, net of goodwill.  The amount of trust preferred securities and certain other elements in excess of the limit can be included in Tier 2 capital.
 
A summary of the maturities of all long-term borrowings and subordinated debentures for the next five years and thereafter is as follows:

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35


Dollars in thousands
 
 
Long-term
borrowings
 
Subordinated
debentures owed
to unconsolidated
subsidiary trusts
Year Ending December 31,
2016
 
$
27,476

 
$

 
2017
 
918

 

 
2018
 
45,017

 

 
2019
 
18

 

 
2020
 
19

 

 
Thereafter
 
698

 
19,589

 
 
 
$
74,146

 
$
19,589



NOTE 11.  SHARE-BASED COMPENSATION

The 2014 Long-Term Incentive Plan (“2014 LTIP”) was adopted by our shareholders in May 2014 to enhance the ability of the Company to attract and retain exceptionally qualified individuals to serve as key employees. The LTIP provides for the issuance of up to 500,000 shares of common stock, in the form of equity awards including stock options, restricted stock, restricted stock units, stock appreciation rights ("SARs"), performance units, other stock-based awards or any combination thereof,  to our key employees. 

Stock options awarded under the 2009 Officer Stock Option Plan and the 1998 Officer Stock Option Plan (collectively, the “Plans”) were not altered by the 2014 LTIP, and remain subject to the terms of the Plans.  However, under the terms of the 2014 LTIP, all shares of common stock remaining issuable under the Plans at the time the 2014 LTIP was adopted ceased to be available for future issuance.
 
Under the 2014 LTIP and the Plans, stock options and SARs have generally been granted with an exercise price equal to the fair value of Summit's common stock on the grant date. We periodically grant employee stock options to individual employees. During second quarter 2015, we granted 166,717 SARs that become exercisable ratably over five years (20% per year) and expire ten years after the grant date. There were no grants of stock options or SARs during the first nine months of 2016.

The fair value of our employee stock options and SARs granted under the Plans is estimated at the date of grant using the Black-Scholes option-pricing model. This model requires the input of highly subjective assumptions, changes to which can materially affect the fair value estimate. Additionally, there may be other factors that would otherwise have a significant effect on the value of employee stock options and SARs granted but are not considered by the model. Because our employee stock options and SARs have characteristics significantly different from those of traded options and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options and SARs at the time of grant. The assumptions used to value SARs issued during 2015 were a risk-free interest rate of 1.96%, an expected dividend yield of 2.75%, an expected common stock volatility of 61.84%, and an expected life of 10 years.

We recognize compensation expense based on the estimated number of stock awards expected to actually vest, exclusive of the awards expected to be forfeited.  During the first nine months of 2016 and 2015, our stock compensation expense and related deferred taxes were insignificant.

A summary of activity in our Plans during the first nine months of 2016 and 2015 is as follows:
 
For the Nine Months Ended September 30,
 
2016
 
2015
 
Options/SARs
 
Weighted-Average
Exercise Price
 
Options/SARs
 
Weighted-Average
Exercise Price
Outstanding, January 1
244,147

 
$
14.05

 
157,170

 
$
20.43

Granted

 

 
166,717

 
12.01

Exercised

 

 

 

Forfeited

 

 

 

Expired

 

 

 

Outstanding, September 30
244,147

 
$
14.05

 
323,887

 
$
16.10



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36



Other information regarding awards outstanding and exercisable at September 30, 2016 is as follows:
 
Options/SARs Outstanding
 
Options/SARs Exercisable
Range of
exercise price
# of
awards
 
WAEP
 
Wted. Avg.
Remaining
Contractual
Life (yrs)
 
Aggregate
Intrinsic
Value
(in thousands)
 
# of
awards
 
WAEP
 
Aggregate
Intrinsic
Value
(in thousands)
$2.54 - $6.00
7,750

 
$
3.75

 
4.43
 
$
119

 
7,750

 
$
3.75

 
$
119

6.01 - 10.00
12,680

 
8.71

 
1.90
 
133

 
12,680

 
8.71

 
133

10.01 - 17.50
166,717

 
12.01

 
8.57
 
1,192

 
33,343

 
12.01

 
238

17.51 - 20.00
23,400

 
17.80

 
1.26
 
32

 
23,400

 
17.80

 
32

20.01 - 25.93
33,600

 
25.93

 
1.69
 

 
33,600

 
25.93

 

 
244,147

 
14.05

 
 
 
$
1,476

 
110,773

 

 
$
522


NOTE 12.  COMMITMENTS AND CONTINGENCIES

Off-Balance Sheet Arrangements

We are a party to certain financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of our customers.  These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the statement of financial position.  The contract amounts of these instruments reflect the extent of involvement that we have in this class of financial instruments.

Many of our lending relationships contain both funded and unfunded elements.  The funded portion is reflected on our balance sheet.  The unfunded portion of these commitments is not recorded on our balance sheet until a draw is made under the loan facility.  Since many of the commitments to extend credit may expire without being drawn upon, the total commitment amounts do not necessarily represent future cash flow requirements.

A summary of the total unfunded, or off-balance sheet, credit extension commitments follows:
Dollars in thousands
 
September 30,
2016
Commitments to extend credit:
 
 
Revolving home equity and credit card lines
 
$
59,974

Construction loans
 
26,839

Other loans
 
102,185

Standby letters of credit
 
2,888

Total
 
$
191,886


Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract.  Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee.  We evaluate each customer's credit worthiness on a case-by-case basis.  The amount of collateral obtained, if we deem necessary upon extension of credit, is based on our credit evaluation.  Collateral held varies but may include accounts receivable, inventory, equipment or real estate.

Standby letters of credit are conditional commitments issued to guarantee the performance of a customer to a third party.  Standby letters of credit generally are contingent upon the failure of the customer to perform according to the terms of the underlying contract with the third party.

Our exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit is represented by the contractual amount of those instruments.  We use the same credit policies in making commitments and conditional obligations as we do for on-balance sheet instruments.

Legal Contingencies

On May 13, 2014, the ResCap Liquidating Trust (“ResCap”), as successor to Residential Funding Company, LLC f/k/a Residential Funding Corporation (“RFC”), filed a complaint against Summit Financial Mortgage, LLC (“Summit Mortgage”), a former

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37


residential mortgage subsidiary of Summit whose operations were discontinued in 2007, in the United States Bankruptcy Court for the Southern District of New York and subsequently amended its complaint on July 25, 2014. The Amended Complaint asserts the following three causes of action related to Summit Mortgage’s origination and subsequent sale of mortgage loans to Residential Funding Corporation:  1) Summit Mortgage breached its representations and warranties made in the contract governing the sale of the mortgage loans to RFC;  2) an indemnification claim against Summit Mortgage for damages paid by ResCap to settle claims in RFC’s bankruptcy proceeding which allegedly relate to mortgage loans Summit Mortgage sold to RFC; 3) a claim for damages against Summit Community Bank, Inc., former parent of Summit Mortgage, arising out of a guaranty in which the Bank guaranteed Summit Mortgage’s full performance under the contract governing the sale of mortgage loans to RFC. Summit has filed a motion to dismiss the case. Based upon the applicable statute of limitations, the Court granted our motion to dismiss the breach of contract claim with respect to loans Summit sold to RFC prior to March 14, 2006. The court otherwise denied our motion to dismiss on the grounds that the other arguments raised factual questions that could not be decided on a motion to dismiss. An estimate as to possible loss resulting from the Amended Complaint cannot be provided at this time because such an estimate cannot be made. Summit intends to defend these claims vigorously.
 
We are not a party to any other litigation except for matters that arise in the normal course of business.  While it is impossible to ascertain the ultimate resolution or range of financial liability with respect to these contingent matters, in the opinion of management, the outcome of these matters will not have a significant adverse effect on the consolidated financial statements.

NOTE 13.  REGULATORY MATTERS

We and our subsidiaries are subject to various regulatory capital requirements administered by the banking regulatory agencies.  Under capital adequacy guidelines and the regulatory framework for prompt corrective action, we and each of our subsidiaries must meet specific capital guidelines that involve quantitative measures of our and our subsidiaries’ assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices.  We and each of our subsidiaries’ capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.

Quantitative measures established by regulation to ensure capital adequacy require us and each of our subsidiaries to maintain minimum amounts and ratios of total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier I capital (as defined) to average assets (as defined).  We believe, as of September 30, 2016, that we and each of our subsidiaries met all capital adequacy requirements to which they were subject.

The most recent notifications from the banking regulatory agencies categorized us and each of our subsidiaries as well capitalized under the regulatory framework for prompt corrective action.  To be categorized as well capitalized, we and each of our subsidiaries must maintain minimum total risk-based, Tier I risk-based, and Tier I leverage ratios as set forth in the table below.
The Basel III Capital Rules became effective for us on January 1, 2015, with full compliance with all of the final rule's requirements phased in over a multi-year schedule, to be fully phased-in by January 1, 2019. As of September 30, 2016, our capital levels remained characterized as "well-capitalized" under the new rules. See the Capital Requirements section included in Part I Item 1 Business of our 2015 Annual Report on Form 10-K for further discussion of Basel III.

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The following table presents Summit's, as well as our subsidiary, Summit Community Bank's ("Summit Community"), actual and required minimum capital amounts and ratios as of September 30, 2016 and December 31, 2015 under the Basel III Capital Rules. The minimum required capital levels presented below reflect the minimum required capital levels (inclusive of the full capital conservation buffers) that will be effective as of January 1, 2019 when the Basel III Capital Rules have been fully phased-in. Capital levels required to be considered well capitalized are based upon prompt corrective action regulations, as amended to reflect the changes under the Basel III Capital Rules.
 
 
 Actual
 
Minimum Required Capital - Basel III Fully Phased-in
 
Minimum Required To Be Well Capitalized
Dollars in thousands
 
Amount
 
Ratio
 
Amount
 
Ratio
 
Amount
 
Ratio
As of September 30, 2016
 
 
 
 
 
 
 
 
 
 
 
 
CET1 (to risk weighted assets)
 
 
 
 
 
 
 
 
 
 
 
 
Summit
 
$
147,791

 
11.1
%
 
$
93,202

 
7.0
%
 
$
86,544

 
6.5
%
Summit Community
 
166,332

 
12.5
%
 
93,146

 
7.0
%
 
86,493

 
6.5
%
Tier I Capital (to risk weighted assets)
 
 

 
 

 
 

 
 

 
 

Summit
 
164,707

 
12.4
%
 
112,904

 
8.5
%
 
106,263

 
8.0
%
Summit Community
 
166,332

 
12.5
%
 
113,106

 
8.5
%
 
106,452

 
8.0
%
Total Capital (to risk weighted assets)
 
 
 
 
 
 
 
 
 
 
Summit
 
176,326

 
13.3
%
 
139,205

 
10.5
%
 
132,576

 
10.0
%
Summit Community
 
177,951

 
13.4
%
 
139,439

 
10.5
%
 
132,799

 
10.0
%
Tier I Capital (to average assets)
 
 

 
 

 
 

 
 

 
 

 
 

Summit
 
164,707

 
10.4
%
 
63,349

 
4.0
%
 
79,186

 
5.0
%
Summit Community
 
166,332

 
10.5
%
 
63,365

 
4.0
%
 
79,206

 
5.0
%

 
 
 Actual
 
Minimum Required Capital - Basel III Fully Phased-in
 
Minimum Required To Be Well Capitalized
Dollars in thousands
 
Amount
 
Ratio
 
Amount
 
Ratio
 
Amount
 
Ratio
As of December 31, 2015
 
 

 
 

 
 

 
 

CET1 (to risk weighted assets)
 
 
 
 
 
 
 
 
 
 
 
 
Summit
 
137,849

 
11.8
%
 
81,775

 
7.0
%
 
75,934

 
6.5
%
Summit Community
 
158,081

 
13.6
%
 
81,365

 
7.0
%
 
75,553

 
6.5
%
Tier I Capital (to risk weighted assets)
 
 

 
 

 
 

 
 

 
 

Summit
 
156,849

 
13.4
%
 
99,494

 
8.5
%
 
93,641

 
8.0
%
Summit Community
 
158,081

 
13.6
%
 
98,801

 
8.5
%
 
92,989

 
8.0
%
Total Capital (to risk weighted assets)
 
 

 
 

 
 

 
 

 
 

Summit
 
168,321

 
14.4
%
 
122,734

 
10.5
%
 
116,890

 
10.0
%
Summit Community
 
169,553

 
14.5
%
 
122,780

 
10.5
%
 
116,933

 
10.0
%
Tier I Capital (to average assets)
 
 

 
 

 
 

 
 

 
 

 
 

Summit
 
156,849

 
10.7
%
 
58,635

 
4.0
%
 
73,294

 
5.0
%
Summit Community
 
158,081

 
10.8
%
 
58,549

 
4.0
%
 
73,186

 
5.0
%


NOTE  14.  SEGMENT INFORMATION

We operate two business segments:  community banking and insurance & financial services.  These segments are primarily identified by the products or services offered.  The community banking segment consists of our full service banks which offer customers traditional banking products and services through various delivery channels.  The insurance & financial services segment includes three insurance agency offices that sell insurance products.  The accounting policies discussed throughout the notes to the consolidated financial statements apply to each of our business segments.


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39


Inter-segment revenue and expense consists of management fees allocated to the community banking and the insurance & financial services segments for all centralized functions that are performed by the parent, including overall direction in the areas of strategic planning, investment portfolio management, asset/liability management, financial reporting and other financial and administrative services.  Information for each of our segments is included below:
 
 
Nine Months Ended September 30, 2016
Dollars in thousands
 
Community
Banking
 
Insurance &
Financial
Services
 
Parent
 
Eliminations
 
Total
Net interest income (loss)
 
$
36,028

 
$

 
$
(478
)
 
$

 
$
35,550

Provision for loan losses
 
500

 

 

 

 
500

Net interest income (loss) after provision for loan losses
 
35,528




(478
)



35,050

Other income
 
5,240

 
3,361

 
1,166

 
(1,166
)
 
8,601

Other expenses
 
21,735

 
3,106

 
1,735

 
(1,166
)
 
25,410

Income (loss) before income taxes
 
19,033


255


(1,047
)



18,241

Income tax expense (benefit)
 
5,897

 
95

 
(337
)
 

 
5,655

Net income (loss)
 
$
13,136

 
$
160

 
$
(710
)
 
$


$
12,586

Inter-segment revenue (expense)
 
$
(1,081
)
 
$
(85
)
 
$
1,166

 
$

 
$

Average assets
 
$
1,565,099

 
$
5,951

 
$
172,840

 
$
(199,962
)
 
$
1,543,928


 
 
Nine Months Ended September 30, 2015
Dollars in thousands
 
Community
Banking
 
Insurance &
Financial
Services
 
Parent
 
Eliminations
 
Total
Net interest income (loss)
 
$
34,861

 
$

 
$
(578
)
 
$

 
$
34,283

Provision for loan losses
 
1,000

 

 

 

 
1,000

Net interest income (loss) after provision for loan losses
 
33,861

 

 
(578
)
 


33,283

Other income
 
5,371

 
3,621

 
850

 
(850
)
 
8,992

Other expenses
 
20,961

 
3,204

 
1,823

 
(850
)
 
25,138

Income (loss) before income taxes
 
18,271

 
417

 
(1,551
)
 


17,137

Income tax expense (benefit)
 
5,577

 
115

 
(511
)
 

 
5,181

Net income (loss)
 
$
12,694

 
$
302

 
$
(1,040
)
 
$


$
11,956

Inter-segment revenue (expense)
 
$
(785
)
 
$
(65
)
 
$
850

 
$

 
$

Average assets
 
$
1,493,759

 
$
5,932

 
$
167,973

 
$
(205,059
)
 
$
1,462,605



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40


 
 
Three Months Ended September 30, 2016
Dollars in thousands
 
Community
Banking
 
Insurance &
Financial
Services
 
Parent
 
Eliminations
 
Total
Net interest income (loss)
 
$
12,197

 
$

 
$
(160
)
 
$

 
$
12,037

Provision for loan losses
 

 

 

 

 

Net interest income (loss) after provision for loan losses
 
12,197

 

 
(160
)
 

 
12,037

Other income
 
1,622

 
1,127

 
389

 
(389
)
 
2,749

Other expenses
 
7,249

 
1,002

 
557

 
(389
)
 
8,419

Income (loss) before income taxes
 
6,570

 
125

 
(328
)
 

 
6,367

Income tax expense (benefit)
 
2,155

 
40

 
(109
)
 

 
2,086

Net income (loss)
 
$
4,415

 
$
85

 
$
(219
)
 
$

 
$
4,281

Inter-segment revenue (expense)
 
$
(361
)
 
$
(28
)
 
$
389

 
$

 
$

Average assets
 
$
1,609,343

 
$
6,005

 
$
175,581

 
$
(201,875
)
 
$
1,589,054


 
 
Three Months Ended September 30, 2015
Dollars in thousands
 
Community
Banking
 
Insurance &
Financial
Services
 
Parent
 
Eliminations
 
Total
Net interest income (loss)
 
$
11,468

 
$

 
$
(163
)
 
$

 
$
11,305

Provision for loan losses
 
250

 

 

 

 
250

Net interest income (loss) after provision for loan losses
 
11,218

 

 
(163
)
 

 
11,055

Other income
 
1,882

 
1,111

 
283

 
(283
)
 
2,993

Other expenses
 
7,515

 
1,045

 
595

 
(283
)
 
8,872

Income (loss) before income taxes
 
5,585

 
66

 
(475
)
 

 
5,176

Income tax expense (benefit)
 
1,639

 
15

 
(139
)
 

 
1,515

Net income (loss)
 
$
3,946

 
$
51

 
$
(336
)
 
$

 
$
3,661

Inter-segment revenue (expense)
 
$
(262
)
 
$
(21
)
 
$
283

 
$

 
$

Average assets
 
$
1,494,933

 
$
5,949

 
$
167,633

 
$
(201,522
)
 
$
1,466,993



NOTE  15.  DERIVATIVE FINANCIAL INSTRUMENTS

We use derivative instruments primarily to protect against the risk of adverse interest rate movements on the cash flows of certain liabilities and the fair values of certain assets.  Derivative instruments represent contracts between parties that usually require little or no initial net investment and result in one party delivering cash or another type of asset to the other party based upon a notional amount and an underlying as specified in the contract.  A notional amount represents the number of units of a specific item, such as currency units.  An underlying represents a variable, such as an interest rate or price index.  The amount of cash or other asset delivered from one party to the other is determined based upon the interaction of the notional amount of the contract with the underlying.  Derivatives can also be implicit in certain contracts and commitments.

As with any financial instrument, derivative instruments have inherent risks, primarily market and credit risk.  Market risk associated with changes in interest rates is managed by establishing and monitoring limits as to the degree of risk that may be undertaken as part of our overall market risk monitoring process.  Credit risk occurs when a counterparty to a derivative contract with an unrealized gain fails to perform according to the terms of the agreement.  Credit risk is managed by monitoring the size and maturity structure of the derivative portfolio, and applying uniform credit standards to all activities with credit risk.

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In accordance with ASC 815, Derivatives and Hedging, all derivative instruments are recorded on the balance sheet at fair value.  Changes in the fair value of derivatives are recorded each period in current earnings or other comprehensive income, depending on whether a derivative is designated as part of a hedge transaction and, if it is, depending on the type of hedge transaction.

Fair-value hedges – For transactions in which we are hedging changes in fair value of an asset, liability, or a firm commitment, changes in the fair value of the derivative instrument are generally offset in the income statement by changes in the hedged item’s fair value.

Cash-flow hedges – For transactions in which we are hedging the variability of cash flows related to a variable-rate asset, liability, or a forecasted transaction, changes in the fair value of the derivative instrument are reported in other comprehensive income. The gains and losses on the derivative instrument, which are reported in comprehensive income, are reclassified to    earnings in the periods in which earnings are impacted by the variability of cash flows of the hedged item.

The ineffective portion of all hedges is recognized in current period earnings.

Other derivative instruments – For risk management purposes that do not meet the hedge accounting criteria and, therefore, do not qualify for hedge accounting.  These derivative instruments are accounted for at fair value with changes in fair value recorded in the income statement.
 
We have entered into three forward-starting, pay-fixed/receive LIBOR interest rate swaps.  $40 million notional with an effective date of July 18, 2016, was designated as a cash flow hedge of $40 million of forecasted variable rate Federal Home Loan Bank advances.  Under the terms of this swap we will pay a fixed rate of 2.98% for a 3 year period.  $30 million notional with an effective date of April 18, 2016, was designated as a cash flow hedge of $30 million of forecasted variable rate Federal Home Loan Bank advances.  Under the terms of this swap we will pay a fixed rate of 2.89% for a 4.5 year period.   $40 million notional with an effective date of October 18, 2016,  was designated as a cash flow hedge of $40 million of forecasted variable rate Federal Home Loan Bank advances.  Under the terms of the swap we will pay a fixed rate of 2.84% for a 3 year period.

We have entered into two pay fixed/receive variable interest rate swaps to hedge fair value variability of two commercial fixed rate loans with the same principal, amortization, and maturity terms of the underlying loans, which are designated as fair value hedges. Under the terms of a $9.95 million original notional swap with an effective date of January 15, 2015, we will pay a fixed rate of 4.33% for a 10 year period. Under the terms of a $11.3 million original notional swap with an effective date of December 18, 2015, we will pay a fixed rate of 4.30% for a 10 year period.

A summary of our derivative financial instruments as of September 30, 2016 and December 31, 2015 follows:

 
September 30, 2016
 
 
 
Derivative Fair Value
 
Net Ineffective
Dollars in thousands
Notional
Amount
 
Asset
 
Liability
 
Hedge Gains/(Losses)
CASH FLOW HEDGES
 
 
 
 
 
 
 
Pay-fixed/receive-variable interest rate swaps
 
 
 
 
 
 
 
Short term borrowings
$
110,000

 
$

 
$
7,186

 
$

 
 
 
 
 
 
 
 
FAIR VALUE HEDGES
 
 
 
 
 
 
 
Pay-fixed/receive-variable interest rate swaps
 
 
 
 
 
 
 
Commercial real estate loans
$
20,639

 
$

 
$
1,084

 
$



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December 31, 2015
 
 
 
Derivative Fair Value
 
Net Ineffective
Dollars in thousands
Notional
Amount
 
Asset
 
Liability
 
Hedge Gains/(Losses)
CASH FLOW HEDGES
 
 
 
 
 
 
 
Pay-fixed/receive-variable interest rate swaps
 
 
 
 
 
 
Short term borrowings
$
110,000

 
$

 
$
5,071

 
$

 
 
 
 
 
 
 
 
FAIR VALUE HEDGES
 
 
 
 
 
 
 
Pay-fixed/receive-variable interest rate swaps
 
 
 
 
 
 
 
Commercial real estate loans
$
21,250

 
$
94

 
$
95

 
$


NOTE 16. EMPLOYEE STOCK OWNERSHIP PLAN ("ESOP")

On July 30, 2015, our ESOP purchased 225,000 shares of Summit Financial Group Inc. common stock in a privately negotiated transaction, at $10.80 per share for a total purchase price of $2,430,000. On July 21, 2015, our Board of Directors approved the company lending to our ESOP $2,250,000 to partially finance the purchase, and was used to purchase 208,333 unallocated shares.

In accordance with ASC 718, Compensation - Stock Compensation, this purchase of unallocated ESOP shares will be shown as a reduction of shareholders' equity, similar to a purchase of treasury stock. The loan receivable from the ESOP to the Company is not reported as an asset nor is the debt of the ESOP reported as a liability on the Company's Consolidated Balance Sheets. Cash dividends on allocated shares (those credited to ESOP participants' accounts) are recorded as a reduction of shareholders' equity and distributed directly to participants' accounts.  Cash dividends on unallocated shares (those held by the ESOP not yet credited to participants' accounts) are used to pay a portion of the ESOPs debt service requirements.  

Unallocated ESOP shares will be allocated to ESOP participants ratably as the ESOP's loan is repaid. When the shares are committed to be released and become available for allocation to plan participants, the then fair value of such shares will be charged to compensation expense.  Unallocated shares owned by the Company’s ESOP are not considered to be outstanding for the purpose of computing earnings per share.

The ESOP shares as of September 30 as are follows:

ESOP Shares
 
 
 
 
At September 30,
 
2016
 
2015
Allocated shares
406,371

 
363,347

Shares committed to be released
25,862

 
21,620

Unallocated shares
155,960

 
186,713

Total ESOP shares
588,193

 
571,680

 
 
 
 
Market value of unallocated shares (in thousands)
$
2,988

 
$
2,198


NOTE 17. ACQUISITIONS
On October 1, 2016, Summit Community Bank, Inc., a wholly-owned subsidiary of Summit, acquired Highland County Bankshares, Inc. ("HCB") and its subsidiary First and Citizens Bank, headquartered in Monterey, Virginia, for $21.8 million. HCB's assets and liabilities approximated $123 million and $107 million, respectively, at September 30, 2016.
The former First and Citizens offices will continue to operate under that name until close of business on Friday, December 2, 2016, and will commence operating under the name Summit Community Bank on Monday, December 5, 2016.
On June 1, 2016, we entered into a Definitive Merger Agreement between Summit Community Bank, Inc., a wholly-owned subsidiary of Summit, and First Century Bankshares, Inc. ("FCB"). Pursuant to the terms of the merger agreement, Summit Community Bank, Inc. will acquire all of the outstanding shares of common stock of FCB in exchange for cash in the amount of $22.50 per share or 1.2433 shares of Summit common stock. FCB shareholders will have a right to receive cash, Summit's common stock, or a combination of cash and Summit stock, subject to proration to result in approximately 35% cash and 65% stock consideration in the aggregate, subject to an adjustment if FCB’s adjusted shareholders’ equity as of the effective date of

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the merger deviates materially from the target determined by the parties. FCB's assets approximated $413 million at September 30, 2016.
We have received all regulatory approvals, and anticipate the acquisition will close early 2017, subject to customary closing conditions, including approval of FCB's shareholders. Following the consummation of the merger, FCB’s wholly-owned subsidiary First Century Bank will be consolidated with Summit Community Bank.


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Management's Discussion and Analysis of Financial Condition and Results of Operations

INTRODUCTION

The following discussion and analysis focuses on significant changes in our financial condition and results of operations of Summit Financial Group, Inc. (“Company” or “Summit”) and our operating segments, Summit Community Bank (“Summit Community”), and Summit Insurance Services, LLC for the periods indicated.  See Note 14 of the accompanying consolidated financial statements for our segment information.  This discussion and analysis should be read in conjunction with our 2015 audited financial statements and Annual Report on Form 10-K.

The Private Securities Litigation Act of 1995 indicates that the disclosure of forward-looking information is desirable for investors and encourages such disclosure by providing a safe harbor for forward-looking statements by us.  Our following discussion and analysis of financial condition and results of operations contains certain forward-looking statements that involve risk and uncertainty.  In order to comply with the terms of the safe harbor, we note that a variety of factors could cause our actual results and experience to differ materially from the anticipated results or other expectations expressed in those forward-looking statements.

OVERVIEW

Our primary source of income is net interest income from loans and deposits.  Business volumes tend to be influenced by the overall economic factors including market interest rates, business spending, and consumer confidence, as well as competitive conditions within the marketplace.

Interest earning assets increased by 6.46% for the first nine months in 2016 compared to the same period of 2015 while our net interest earnings on a tax equivalent basis increased 3.69%.  Our tax equivalent net interest margin decreased 10 basis points as our yield on interest earning assets declined 4 basis points while our cost of interest bearing funds increased 7 basis points.

BUSINESS SEGMENT RESULTS

We are organized and managed along two major business segments, as described in Note 14 of the accompanying consolidated financial statements.  The results of each business segment are intended to reflect each segment as if it were a stand alone business.  Net income by segment follows:
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
Dollars in thousands
 
2016
 
2015
 
2016
 
2015
Community banking
 
$
4,415

 
$
3,946

 
$
13,136

 
$
12,694

Insurance & financial services
 
85

 
51

 
160

 
302

Parent
 
(219
)
 
(336
)
 
(710
)
 
(1,040
)
Consolidated net income
 
$
4,281

 
$
3,661

 
$
12,586

 
$
11,956


CRITICAL ACCOUNTING POLICIES

Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America and follow general practices within the financial services industry.  Application of these principles requires us to make estimates, assumptions, and judgments that affect the amounts reported in our financial statements and accompanying notes.  These estimates, assumptions, and judgments are based on information available as of the date of the financial statements; accordingly, as this information changes, the financial statements could reflect different estimates, assumptions, and judgments.  Certain policies inherently have a greater reliance on the use of estimates, assumptions, and judgments and as such have a greater possibility of producing results that could be materially different than originally reported.

Our most significant accounting policies are presented in the notes to the consolidated financial statements of our 2015 Annual Report on Form 10-K.  These policies, along with the other disclosures presented in the financial statement notes and in this financial review, provide information on how significant assets and liabilities are valued in the financial statements and how those values are determined.

Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, assumptions, and estimates underlying those amounts, we have identified the determination of the allowance for loan losses, the valuation of goodwill, fair value measurements and deferred tax assets to be the accounting areas that require the most subjective or complex judgments, and as such could be most subject to revision as new information becomes available.

Allowance for Loan Losses:  The allowance for loan losses represents our estimate of probable credit losses inherent in the loan portfolio.  Determining the amount of the allowance for loan losses is considered a critical accounting estimate because it

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requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change.  The loan portfolio also represents the largest asset type on our consolidated balance sheet.  To the extent actual outcomes differ from our estimates, additional provisions for loan losses may be required that would negatively impact earnings in future periods.  Note 6 to the consolidated financial statements of our 2015 Annual Report on Form 10-K describes the methodology used to determine the allowance for loan losses and a discussion of the factors driving changes in the amount of the allowance for loan losses is included in the Asset Quality section of the financial review of the 2015 Annual Report on Form 10-K.

Goodwill:  Goodwill is subject to an analysis by reporting unit at least annually to determine whether write-downs of the recorded balances are necessary.  Initially, an assessment of qualitative factors (Step 0) is performed to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that the fair value of a reporting unit is less than its carrying amount.  If, after assessing the totality of events or circumstances, we determine it is not more likely than not that the fair value of a reporting unit is less than its carrying value, then performing the two-step impairment test is unnecessary.  However, if we conclude otherwise, then we are required to perform the first step (Step 1) of the two-step impairment test by calculating the fair value of the reporting unit and comparing the fair value with the carrying amount of the reporting unit.  If the fair value is less than the carrying value, an expense may be required on our books to write down the goodwill to the proper carrying value.  Step 2 of impairment testing, which is necessary only if the reporting unit does not pass Step 1, compares the implied fair value of the reporting unit goodwill with the carrying amount of the goodwill for the reporting unit.  The implied fair value of goodwill is determined in the same manner as goodwill that is recognized in a business combination.

Community Banking – During third quarter 2016, we performed the Step 0 assessment of our goodwill of our community banking reporting unit and determined that it was not more likely than not that the fair value was less than its carrying value.  In performing the qualitative Step 0 assessments, we considered certain events and circumstances  such as macroeconomic conditions, industry and market considerations, overall financial performance and cost factors when evaluating whether it is more likely than not that the fair value is less than its carrying amount. No indicators of impairment were noted as of September 30, 2016.
 
Insurance Services – During third quarter 2016, we performed the Step 0 assessment of our goodwill of our insurance services reporting unit.  We considered certain events and circumstances specific to the reporting unit, such as macroeconomic conditions, industry and market considerations, overall financial performance and cost factors when evaluating whether it is more likely than not that the fair value of our insurance services reporting unit is less than its carrying value and deemed it necessary to perform the further 2-step impairment test.  We performed an internal valuation utilizing the income approach to determine the fair value of our insurance services reporting unit.  This methodology consisted of discounting the expected future cash flows of this unit based upon a forecast of its operations considering long-term key business drivers such as anticipated commission revenue growth.  The long term growth rate used in determining the terminal value was estimated at 2.5%, and a discount rate of 10.0% was applied to the insurance services unit’s estimated future cash flows.  We did not fail this Step 1 test as of September 30, 2016, therefore Step 2 testing was not necessary.
 
We cannot assure you that future goodwill impairment tests will not result in a charge to earnings. See Note 9 of the consolidated financial statements of our Annual Report on Form 10-K for further discussion of our intangible assets, which include goodwill.

Fair Value Measurements:  ASC Topic 820 Fair Value Measurements and Disclosures provides a definition of fair value, establishes a framework for measuring fair value, and requires expanded disclosures about fair value measurements. Fair value is the price that could be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. Based on the observability of the inputs used in the valuation techniques, we classify our financial assets and liabilities measured and disclosed at fair value in accordance with the three-level hierarchy (e.g., Level 1, Level 2 and Level 3) established under ASC Topic 820. Fair value determination in accordance with this guidance requires that we make a number of significant judgments. In determining the fair value of financial instruments, we use market prices of the same or similar instruments whenever such prices are available. We do not use prices involving distressed sellers in determining fair value. If
observable market prices are unavailable or impracticable to obtain, then fair value is estimated using modeling techniques such as discounted cash flow analyses. These modeling techniques incorporate our assessments regarding assumptions that market participants would use in pricing the asset or the liability, including assumptions about the risks inherent in a particular valuation technique and the risk of nonperformance.
 

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Fair value is used on a recurring basis for certain assets and liabilities in which fair value is the primary basis of accounting. Additionally, fair value is used on a non-recurring basis to evaluate assets or liabilities for impairment or for disclosure purposes in accordance with ASC Topic 825 Financial Instruments.
 
Deferred Income Tax Assets:  At September 30, 2016, we had net deferred tax assets of $11.9 million. Based on our ability to offset the net deferred tax asset against taxable income in carryback years and expected future taxable income in carryforward years, there was no impairment of the deferred tax asset at September 30, 2016.  All available evidence, both positive and negative, was considered to determine whether, based on the weight of that evidence, impairment should be recognized. However, our forecast process includes judgmental and quantitative elements that may be subject to significant change. If our forecast of taxable income within the carryback/carryforward periods available under applicable law is not sufficient to cover the amount of net deferred tax assets, such assets may become impaired.

RESULTS OF OPERATIONS

Earnings Summary

Net income for the nine months ended September 30, 2016 increased to $12.6 million, or $1.18 per diluted share as compared to $12.0 million or $1.12 per diluted share for the same period of 2015. Net income for the quarter ended September 30, 2016 increased to $4.3 million, or $0.40 per diluted share, compared to $3.7 million, or $0.34 per diluted share for the same period of 2015. Earnings for the both the quarter and nine months ended September 30, 2016, compared to the same periods of 2015, were positively impacted by increased net interest income, increased gains on sales of foreclosed properties, and reduced write-downs of foreclosed properties while being negatively impacted by smaller gains realized on sales of securities, higher personnel costs and other noninterest expenses.  Included in earnings for the nine months ended September 30, 2016 was $836,000 in realized securities gains, $451,000 in gains on the sales of foreclosed properties, and $503,000 of charges resulting from the write-down of a portion of our foreclosed properties to fair value.  Returns on average equity and assets for the first nine months of 2016 were 11.29% and 1.09%, respectively, compared with 11.61% and 1.09% for the same period of 2015.

Net Interest Income

Net interest income is the principal component of our earnings and represents the difference between interest and fee income generated from earning assets and the interest expense paid on deposits and borrowed funds.  Fluctuations in interest rates as well as changes in the volume and mix of earning assets and interest bearing liabilities can materially impact net interest income.

Our net interest income on a fully tax-equivalent basis totaled $36.7 million for the nine months ended September 30, 2016, or $1,311,000 or 3.70% more than the $35.4 million for the same period of 2015.  Our tax-equivalent earnings on interest earning assets increased $2,466,000, while the cost of interest bearing liabilities also increased $1,155,000 (see Table II).

Average interest earning assets increased 6.5% from $1.35 billion during the first nine months of 2015 to $1.44 billion for the first nine months of 2016, while average interest bearing liabilities increased 5.1% from $1.19 billion at September 30, 2015 to $1.26 billion at September 30, 2016. The growth in interest earning assets outpaced the growth in interest bearing liabilities, and was funded primarily by reductions in property held for sale, growth in deposits, increased short term borrowings, and growth in equity.

Our consolidated net interest margin decreased to 3.40% for the nine months ended September 30, 2016, compared to 3.50% for the same period in 2015, as the yields on earning assets decreased 4 basis points, while the cost of our interest bearing funds increased by 7 basis points.

Assuming no significant change in market interest rates and excluding the impact of pending acquisitions, we anticipate modest growth in our net interest income to continue over the near term due to growth in the volume of interest earning assets, primarily loans, coupled with expected moderate improvement in net interest margin over the same period.  We continue to monitor the net interest margin through net interest income simulation to minimize the potential for any significant negative impact.  See the “Market Risk Management” section for further discussion of the impact changes in market interest rates could have on us.  Further analysis of our yields on interest earning assets and interest bearing liabilities are presented in Tables I and II below.

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Table I - Average Balance Sheet and Net Interest Income Analysis
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
September 30, 2016
 
September 30, 2015
Dollars in thousands
Average
Balance
 
Earnings/
Expense
 
Yield/
Rate
 
Average
Balance
 
Earnings/
Expense
 
Yield/
Rate
Interest earning assets
 
 
 
 
 
 
 
 
 
 
 
Loans, net of unearned fees (1)
 
 
 
 
 
 
 
 
 
 
 
Taxable
$
1,134,463

 
$
40,788

 
4.80
%
 
$
1,044,010

 
$
38,443

 
4.92
%
Tax-exempt (2)
14,890

 
624

 
5.60
%
 
12,801

 
547

 
5.71
%
Securities
 

 
 

 
 

 
 
 
 
 
 
Taxable
206,437

 
3,284

 
2.12
%
 
211,642

 
3,302

 
2.09
%
Tax-exempt (2)
76,155

 
2,814

 
4.94
%
 
75,685

 
2,759

 
4.87
%
Federal funds sold and interest bearing deposits with other banks
9,093

 
13

 
0.19
%
 
9,395

 
6

 
0.09
%
Total interest earning assets
1,441,038

 
47,523

 
4.41
%
 
1,353,533

 
45,057

 
4.45
%
Noninterest earning assets
 

 
 

 
 

 
 
 
 
 
 
Cash & due from banks
3,819

 
 

 
 

 
3,842

 
 
 
 
Premises and equipment
21,575

 
 

 
 

 
20,373

 
 
 
 
Property held for sale
24,365

 
 
 
 
 
33,840

 
 
 
 
Other assets
64,648

 
 

 
 

 
62,302

 
 
 
 
Allowance for loan losses
(11,517
)
 
 

 
 

 
(11,285
)
 
 
 
 
Total assets
$
1,543,928

 
 

 
 

 
$
1,462,605

 
 
 
 
Interest bearing liabilities
 

 
 

 
 

 
 
 
 
 
 
Interest bearing demand deposits
$
208,755

 
$
248

 
0.16
%
 
205,749

 
179

 
0.12
%
Savings deposits
296,458

 
1,663

 
0.75
%
 
252,701

 
1,307

 
0.69
%
Time deposits
474,691

 
4,622

 
1.30
%
 
485,939

 
4,765

 
1.31
%
Short-term borrowings
180,694

 
1,334

 
0.99
%
 
149,177

 
368

 
0.33
%
Long-term borrowings and capital trust securities
94,574

 
2,937

 
4.15
%
 
101,245

 
3,030

 
4.00
%
Total interest bearing liabilities
1,255,172

 
10,804

 
1.15
%
 
1,194,811

 
9,649

 
1.08
%
Noninterest bearing liabilities and shareholders' equity
 

 
 

 
 

 
 
 
 
 
 
Demand deposits
121,701

 
 

 
 

 
116,057

 
 
 
 
Other liabilities
18,423

 
 

 
 

 
14,371

 
 
 
 
Total liabilities
1,395,296

 
 

 
 

 
1,325,239

 
 
 
 
Shareholders' equity - preferred

 
 

 
 

 
2,388

 
 
 
 
Shareholders' equity - common
148,632

 
 

 
 

 
134,978

 
 
 
 
Total liabilities and shareholders' equity
$
1,543,928

 
 

 
 

 
$
1,462,605

 
 
 
 
Net interest earnings
 

 
$
36,719

 
 

 
 
 
$
35,408

 
 
Net yield on interest earning assets
 
 

 
3.40
%
 
 
 
 
 
3.50
%

(1)
- For purposes of this table, nonaccrual loans are included in average loan balances.
(2)
- Interest income on tax-exempt securities and loans has been adjusted assuming an effective tax rate of 34% for all periods presented. The tax equivalent adjustment resulted in an increase in interest income of $1,169,000 and $1,124,000 for the periods ended September 30, 2016 and 2015, respectively.


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Table II - Changes in Interest Margin Attributable to Rate and Volume
 
 
 
 
 
 
 
 
 
For the Nine Months Ended
 
 
September 30, 2016 versus September 30, 2015
 
 
Increase (Decrease) Due to Change in:
Dollars in thousands
 
Volume
 
Rate
 
Net
Interest earned on:
 
 
 
 
 
 
Loans
 
 
 
 
 
 
Taxable
 
$
3,302

 
$
(957
)
 
$
2,345

Tax-exempt
 
89

 
(12
)
 
77

Securities
 
 

 
 
 
 
Taxable
 
(81
)
 
63

 
(18
)
Tax-exempt
 
18

 
37

 
55

Federal funds sold and interest bearing deposits with other banks
 

 
7

 
7

Total interest earned on interest earning assets
 
3,328

 
(862
)
 
2,466

 
 
 
 
 
 
 
Interest paid on:
 
 

 
 
 
 
Interest bearing demand deposits
 
3

 
66

 
69

Savings deposits
 
240

 
116

 
356

Time deposits
 
(107
)
 
(36
)
 
(143
)
Short-term borrowings
 
93

 
873

 
966

Long-term borrowings and capital trust securities
 
(203
)
 
110

 
(93
)
Total interest paid on interest bearing liabilities
 
26

 
1,129

 
1,155

 
 
 
 
 
 
 
Net interest income
 
$
3,302

 
$
(1,991
)
 
$
1,311


Noninterest Income

Total noninterest income decreased to $8.6 million for the first nine months of 2016, compared to $9.0 million for the same period of 2015.  Further detail regarding noninterest income is reflected in the following table.
Table III - Noninterest Income
 
 
 
 
 
 
 
 
For the Quarter Ended September 30,
 
For the Nine Months Ended September 30,
Dollars in thousands
2016
 
2015
 
2016
 
2015
Insurance commissions
$
1,016

 
$
983

 
$
3,030

 
$
3,191

Service fees related to deposit accounts
1,138

 
1,111

 
3,175

 
3,159

Realized securities gains
61

 
373

 
836

 
1,023

Bank owned life insurance income
258

 
259

 
772

 
782

Other
276

 
267

 
788

 
837

Total
$
2,749

 
$
2,993

 
$
8,601

 
$
8,992


Noninterest Expense

Total noninterest expense increased 1.1% for the nine months ended September 30, 2016, as compared to the same period in 2015, with increased gains on sales of foreclosed properties and lower write-downs of foreclosed properties having the largest positive impacts and higher salaries, commissions, and employee benefits having the largest negative impact.  Table IV below shows the breakdown of the changes.

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Table IV - Noninterest Expense
 
 
 
 
 
 
 
 
 
 
 
 
 
 
For the Quarter Ended September 30,
 
For the Nine Months Ended September 30,
 
 
 
 
Change
 
 
 
 
 
Change
 
 
 
Dollars in thousands
2016
 
 $
 
%
 
2015
 
2016
 
 $
 
%
 
2015
 
Salaries, commissions, and employee benefits
$
4,819

 
$
340

 
7.6
 %
 
$
4,479

 
$
14,265

 
$
1,157

 
8.8
 %
 
$
13,108

 
Net occupancy expense
525

 
29

 
5.8
 %
 
496

 
1,576

 
93

 
6.3
 %
 
1,483

 
Equipment expense
716

 
134

 
23.0
 %
 
582

 
2,059

 
382

 
22.8
 %
 
1,677

 
Professional fees
270

 
(132
)
 
(32.8
)%
 
402

 
1,171

 
62

 
5.6
 %
 
1,109

 
Amortization of intangibles
50

 

 
 %
 
50

 
150

 

 
 %
 
150

 
FDIC premiums
200

 
(100
)
 
(33.3
)%
 
300

 
800

 
(150
)
 
(15.8
)%
 
950

 
Merger expense
80

 
80

 
n/a

 

 
345

 
345

 
n/a

 

 
Foreclosed properties expense
100

 
(68
)
 
(40.5
)%
 
168

 
317

 
(217
)
 
(40.6
)%
 
534

 
(Gain) loss on sales of foreclosed properties
(169
)
 
(204
)
 
(582.9
)%
 
35

 
(451
)
 
(739
)
 
(256.6
)%
 
288

 
Write-downs of foreclosed properties
134

 
(912
)
 
(87.2
)%
 
1,046

 
503

 
(1,276
)
 
(71.7
)%
 
1,779

 
Other
1,694

 
380

 
28.9
 %
 
1,314

 
4,675

 
615

 
15.1
 %
 
4,060

 
Total
$
8,419

 
$
(453
)
 
(5.1
)%
 
$
8,872

 
$
25,410

 
$
272

 
1.1
 %
 
$
25,138

 

Salaries, commissions, and employee benefits: These expenses are 8.8% higher in first nine months of 2016 compared to first nine months of 2015 due to an increase in number of employees, general merit raises, and increased incentive accruals based upon performance. In accordance with our policies, substantially all salary and wage merit raises are awarded at the beginning of the second quarter of each year.

Foreclosed properties expense: Management expects foreclosed properties expense to trend lower than in recent years due to lower levels of foreclosed properties.

Write-downs of foreclosed properties: Management anticipates write-downs of foreclosed properties to their fair values to trend lower in 2016 than in recent years.

Credit Experience

As a result of a historically slow economic recovery, our foreclosed properties portfolio remains elevated relative to our peers.   Prior elevated levels of nonperforming loans have returned to acceptable levels. Management expects net reductions in foreclosed properties to continue, although not as rapid as over the past two years.

For purposes of this discussion, we define nonperforming assets to include foreclosed properties, other repossessed assets, and nonperforming loans, which is comprised of loans 90 days or more past due and still accruing interest and nonaccrual loans. Performing TDRs are excluded from nonperforming loans.

The provision for loan losses represents charges to earnings necessary to maintain an adequate allowance for probable credit losses inherent in the loan portfolio. Our determination of the appropriate level of the allowance is based on an ongoing analysis of credit quality and loss potential in the loan portfolio, change in the composition and risk characteristics of the loan portfolio, and the anticipated influence of national and local economic conditions.  The adequacy of the allowance for loan losses is reviewed quarterly and adjustments are made as considered necessary.

We recorded $500,000 and $1,000,000 provisions for loan losses for the first nine months of 2016 and 2015, respectively.  These smaller provisions are a result of lower average loan losses experienced over the past twelve quarters. Lower losses cause our historical charge-off factor of the quantitative reserve calculation to decline, thus requiring fewer quantitative reserves.


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As illustrated in Table V below, our non-performing assets have decreased since year end 2015.
Table V - Summary of Non-Performing Assets
 
 
 
 
 
 
 
 
September 30,
 
December 31,
Dollars in thousands
 
2016
 
2015
 
2015
Accruing loans past due 90 days or more
 
$
21

 
$
8

 
$
9

Nonaccrual loans
 
 

 
 

 
 

Commercial
 
846

 
884

 
853

Commercial real estate
 
4,867

 
5,295

 
5,955

Commercial construction and development
 

 

 

Residential construction and development
 
4,360

 
5,346

 
5,623

Residential real estate
 
4,174

 
3,880

 
3,245

Consumer
 
148

 
44

 
83

Total nonaccrual loans
 
14,395

 
15,449

 
15,759

Foreclosed properties
 
 

 
 

 
 

Commercial
 

 

 

Commercial real estate
 
1,749

 
3,210

 
1,300

Commercial construction and development
 
8,664

 
9,328

 
8,717

Residential construction and development
 
13,741

 
14,965

 
14,069

Residential real estate
 
613

 
2,210

 
1,481

Total foreclosed properties
 
24,767

 
29,713

 
25,567

Repossessed assets
 
12

 

 
5

Total nonperforming assets
 
$
39,195

 
$
45,170

 
$
41,340

Total nonperforming loans as a percentage of total loans
 
1.16
%
 
1.44
%
 
1.45
%
Total nonperforming assets as a percentage of total assets
 
2.36
%
 
3.07
%
 
2.77
%
Allowance for loan losses as a percentage of nonperforming loans
 
80.60
%
 
72.64
%
 
72.75
%
Allowance for loan losses as a percentage of period end loans
 
0.93
%
 
1.05
%
 
1.05
%

The following table details the activity regarding our foreclosed properties for the three and nine months ended September 30, 2016 and 2015.
Table VI - Foreclosed Property Activity
 
 
 
 
 
 
 
For the Three Months Ended 
 September 30,
 
For the Nine Months Ended 
 September 30,
 
Dollars in thousands
2016
 
2015
 
2016
 
2015
 
Beginning balance
$
23,425

 
$
31,500

 
$
25,567

 
$
37,529

 
Acquisitions
1,880

 
1,691

 
2,014

 
2,404

 
Improvements

 
10

 
463

 
33

 
Disposals
(404
)
 
(2,442
)
 
(2,774
)
 
(8,474
)
 
Writedowns to fair value
(134
)
 
(1,046
)
 
(503
)
 
(1,779
)
 
Balance March 31
$
24,767

 
$
29,713

 
$
24,767

 
$
29,713

 
 
 
Refer to Note 6 of the accompanying consolidated financial statements for information regarding our past due loans, impaired loans, nonaccrual loans, and troubled debt restructurings and to Note 7 for a summary of the methodology we employ on a quarterly basis to evaluate the overall adequacy of our allowance for loan losses.

Relationship between Allowance for Loan Losses, Net Charge-offs and Nonperforming Loans

In analyzing the relationship between the allowance for loan losses, net loan charge-offs and nonperforming loans, it is helpful to understand the process of how loans are treated as they deteriorate over time. Reserves for loans are established at origination through the quantitative and qualitative reserve process discussed in the accompanying Note 7 to the financial statements.

Charge-offs, if necessary, are typically recognized in a period after the reserves were established. If the previously established reserves exceed that needed to satisfactorily resolve the problem credit, a reduction in the overall level of the reserve could be

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recognized. In summary, if loan quality deteriorates, the typical credit sequence is periods of reserve building, followed by periods of higher net charge-offs.

Consumer loans are generally charged off to the allowance for loan losses upon reaching specified stages of delinquency, in accordance with the Federal Financial Institutions Examination Council policy.  For example, credit card loans are charged off by the end of the month in which the account becomes 180 days past due or within 60 days from receiving notification about a specified event (e.g., bankruptcy of the borrower), whichever is earlier.  Residential mortgage loans are generally charged off to net realizable value no later than when the account becomes 180 days past due.  Other consumer loans, if collateralized, are generally charged off to net realizable value at 120 days past due.

Commercial-related loans (which are risk-rated) are charged off to the allowance for loan losses when the loss has been confirmed. This determination includes many factors, including the prioritization of our claim in bankruptcy, expectations of the workout/restructuring of the loan and valuation of the borrower’s equity.
 
Substantially all of our nonperforming loans are secured by real estate. The majority of these loans were underwritten in accordance with our loan-to-value policy guidelines which range from 70-85% at the time of origination. The fair values of the underlying collateral value or the discounted cash flows remain in excess of the recorded investment in many of our nonperforming loans, and therefore, no specific reserve allocation is required.

At September 30, 2016, December 31, 2015, and September 30, 2015, our allowance for loan losses totaled $11.6 million, or 0.93% of total loans, $11.5 million, or 1.05% of total loans and $11.2 million, or 1.05% of total loans, respectively, and is considered adequate to cover our estimate of probable credit losses inherent in our loan portfolio.

At September 30, 2016, December 31, 2015, and September 30, 2015, we had approximately $24.8 million, $25.6 million and $29.7 million, respectively, in other real estate owned which was obtained as the result of foreclosure proceedings.  Although foreclosed property is recorded at fair value less estimated costs to sell, the prices ultimately realized upon their sale may or may not result in us recognizing loss.

FINANCIAL CONDITION

Our total assets were $1.66 billion at September 30, 2016, compared to $1.49 billion at December 31, 2015, representing an 11.1% increase.  Table VIII below serves to illustrate significant changes in our financial position between December 31, 2015 and September 30, 2016.
Table VIII - Summary of Significant Changes in Financial Position
 
 
Balance
December 31,
 
Increase (Decrease)
 
Balance
September 30,
Dollars in thousands
 
2015
 
Amount
 
Percentage
 
2016
Assets
 
 
 
 
 
 
 
 
Securities available for sale
 
$
280,792

 
(18,690
)
 
(6.7
)%
 
$
262,102

Loans, net
 
1,079,331

 
155,274

 
14.4
 %
 
1,234,605

Liabilities
 
 

 
 

 
 

 
 

Deposits
 
$
1,066,709

 
90,075

 
8.4
 %
 
$
1,156,784

Short-term borrowings
 
171,394

 
63,263

 
36.9
 %
 
234,657

Long-term borrowings
 
75,581

 
(1,435
)
 
(1.9
)%
 
74,146


Net loans grew 14.4% during the first nine months of 2016 principally as a result of us entering into a participation arrangement with a regional bank to fund residential mortgage warehouse lines of medium- and large-sized mortgage originators located throughout the United States. The outstanding balance of these lines totaled $109.0 million at September 30, 2016. Our loan growth was funded primarily with deposits, short-term borrowings and a reduction of our securities portfolio.
 
Deposits increased approximately $90.1 million during the first nine months of 2016; checking deposits remained relatively unchanged, while savings deposits and time deposits increased approximately $54.7 million and $35.2 million, respectively.

Refer to Notes 5, 6, 9, and 10 of the notes to the accompanying consolidated financial statements for additional information with regard to changes in the composition of our securities, loans, deposits and borrowings between September 30, 2016 and December 31, 2015.



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LIQUIDITY AND CAPITAL RESOURCES

Liquidity reflects our ability to ensure the availability of adequate funds to meet loan commitments and deposit withdrawals, as well as provide for other transactional requirements.  Liquidity is provided primarily by funds invested in cash and due from banks (net of float and reserves), Federal funds sold, non-pledged securities, and available lines of credit with the Federal Home Loan Bank of Pittsburgh (“FHLB”) and Federal Reserve Bank of Richmond, which totaled approximately $530 million or 31.95% of total consolidated assets at September 30, 2016.

Our liquidity strategy is to fund loan growth with deposits and other borrowed funds while maintaining an adequate level of short- and medium-term investments to meet normal daily loan and deposit activity.  As a member of the FHLB, we have access to approximately $547 million.  As of September 30, 2016 and December 31, 2015, these advances totaled approximately $232 million and $169 million, respectively.  At September 30, 2016, we had additional borrowing capacity of $315 million through FHLB programs.  We have established a line with the Federal Reserve Bank to be used as a contingency liquidity vehicle.  The amount available on this line at September 30, 2016 was approximately $93 million, which is secured by a pledge of our consumer and commercial and industrial loan portfolios.  We have a $6 million unsecured line of credit with a correspondent bank.  Also, we classify all of our securities as available for sale to enable us to liquidate them if the need arises.
 
Liquidity risk represents the risk of loss due to the possibility that funds may not be available to satisfy current or future commitments based on external market issues, customer or creditor perception of financial strength, and events unrelated to Summit such as war, terrorism, or financial institution market specific issues.  The Asset/Liability Management Committee (“ALCO”), comprised of members of senior management and certain members of the Board of Directors, oversees our liquidity risk management process.   The ALCO develops and recommends policies and limits governing our liquidity to the Board of
Directors for approval with the objective of ensuring that we can obtain cost-effective funding to meet current and future obligations, as well as maintain sufficient levels of on-hand liquidity, under both normal and “stressed” circumstances.
 
We continuously monitor our liquidity position to ensure that day-to-day as well as anticipated funding needs are met.  We are not aware of any trends, commitments, events or uncertainties that have resulted in or are reasonably likely to result in a material change to our liquidity.

One of our continuous goals is maintenance of a strong capital position.  Through management of our capital resources, we seek to provide an attractive financial return to our shareholders while retaining sufficient capital to support future growth.  Shareholders’ equity at September 30, 2016 totaled $153.8 million compared to $143.7 million at December 31, 2015.

Refer to Note 13 of the notes to the accompanying consolidated financial statements for additional information regarding regulatory restrictions on our capital as well as our subsidiaries’ capital.

CONTRACTUAL CASH OBLIGATIONS

During our normal course of business, we incur contractual cash obligations.  The following table summarizes our contractual cash obligations at September 30, 2016.
Table IX - Contractual Cash Obligations
 
 
 
 
Dollars in thousands
 
Long
Term
Debt
 
Capital
Trust
Securities
 
Operating
Leases
2016
 
$
27,476

 
$

 
$
76

2017
 
918

 

 
250

2018
 
45,017

 

 
162

2019
 
18

 

 
136

2020
 
19

 

 
23

Thereafter
 
698

 
19,589

 

Total
 
$
74,146

 
$
19,589

 
$
647



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OFF-BALANCE SHEET ARRANGEMENTS

We are involved with some off-balance sheet arrangements that have or are reasonably likely to have an effect on our financial condition, liquidity, or capital.  These arrangements at September 30, 2016 are presented in the following table.
Table X - Off-Balance Sheet Arrangements
 
September 30,
Dollars in thousands
 
2016
Commitments to extend credit:
 
 
Revolving home equity and credit card lines
 
$
59,974

Construction loans
 
26,839

Other loans
 
102,185

Standby letters of credit
 
2,888

Total
 
$
191,886



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MARKET RISK MANAGEMENT

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.  Interest rate risk is our primary market risk and results from timing differences in the repricing of assets, liabilities and off-balance sheet instruments, changes in relationships between rate indices and the potential exercise of imbedded options.  The principal objective of asset/liability management is to minimize interest rate risk and our actions in this regard are taken under the guidance of our Asset/Liability Management Committee (“ALCO”), which is comprised of members of senior management and members of the Board of Directors.  The ALCO actively formulates the economic assumptions that we use in our financial planning and budgeting process and establishes policies which control and monitor our sources, uses and prices of funds.

Some amount of interest rate risk is inherent and appropriate to the banking business.  Our net income is affected by changes in the absolute level of interest rates.  Our interest rate risk position at present is slightly liability sensitive.  The nature of our lending and funding activities tends to drive our interest rate risk position to being liability sensitive.  That is, absent any changes in the volumes of our interest earning assets or interest bearing liabilities, liabilities are likely to reprice faster than assets, resulting in a decrease in net income in a rising rate environment.  Net income would increase in a falling interest rate environment.  Net income is also subject to changes in the shape of the yield curve.  In general, a flattening yield curve would result in a decline in our earnings due to the compression of earning asset yields and funding rates, while a steepening would result in increased earnings as margins widen.

Several techniques are available to monitor and control the level of interest rate risk.  We primarily use earnings simulations modeling to monitor interest rate risk.  The earnings simulation model forecasts the effects on net interest income under a variety of interest rate scenarios that incorporate changes in the absolute level of interest rates and changes in the shape of the yield curve.  Each increase or decrease in interest rates is assumed to gradually take place over the next 12 months, and then remain stable, except for the up 400 scenario, which assumes a gradual increase in rates over 24 months.  Assumptions used to project yields and rates for new loans and deposits are derived from historical analysis.  Securities portfolio maturities and prepayments are reinvested in like instruments.  Mortgage loan prepayment assumptions are developed from industry estimates of prepayment speeds.  Noncontractual deposit repricings are modeled on historical patterns.

The following table presents the estimated sensitivity of our net interest income to changes in interest rates, as measured by our earnings simulation model as of September 30, 2016.  The sensitivity is measured as a percentage change in net interest income given the stated changes in interest rates (gradual change over 12 months, stable thereafter for the down 100 and the up 200 scenarios, and gradual change over 24 months for the up 400 scenario) compared to net interest income with rates unchanged in the same period.  The estimated changes set forth below are dependent on the assumptions discussed above and are well within our ALCO policy limits shown below relative to reductions in net interest income over the ensuing twelve month period.
 
 
 
Estimated % Change in
Net Interest Income over:
Change in
 
 
0 - 12 Months
 
13 - 24 Months
Interest Rates
Policy

 
Actual

 
Actual

Down 100  basis points (1)
-7
 %
 
0.65
 %
 
1.90
 %
Up 200 basis points (1)
-10
 %
 
-2.58
 %
 
-1.21
 %
Up 400 basis points (2)
N/A

 
-1.91
 %
 
-4.17
 %
 
 
 
 
 
 
(1) assumes a parallel shift in the yield curve over 12 months
(2) assumes a parallel shift in the yield curve over 24 months



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CONTROLS AND PROCEDURES

Our management, including the Chief Executive Officer and Chief Financial Officer, has conducted as of September 30, 2016, an evaluation of the effectiveness of disclosure controls and procedures as defined in Exchange Act Rule 13a-15(e).  Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the disclosure controls and procedures as of September 30, 2016 were effective.  There were no changes in our internal control over financial reporting that occurred during the quarter ended September 30, 2016 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
 

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Part II. Other Information




Item 1.  Legal Proceedings

Refer to Note 12 of the Notes to the Consolidated Financial Statements in Part I, Item 1 for information regarding legal proceedings not reportable under this Item.

Item 1A.  Risk Factors

In addition to the other information set forth in this report, you should carefully consider the factors discussed in Part I, “Item 1A. Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2015.

Item 6. Exhibits

Exhibit 3.i
Amended and Restated Articles of Incorporation of Summit Financial Group, Inc.
 
 
Exhibit 3.ii
Articles of Amendment 2009
 
 
Exhibit 3.iii
Articles of Amendment 2011
 
 
Exhibit 3.iv
Amended and Restated By-Laws of Summit Financial Group, Inc.
 
 
Exhibit 11
Statement re: Computation of Earnings per Share – Information contained in Note 4 to the Consolidated Financial Statements on page 15 of this Quarterly Report is incorporated herein by reference.
 
 
Exhibit 31.1
Sarbanes-Oxley Act Section 302 Certification of Chief Executive Officer
 
 
Exhibit 31.2
Sarbanes-Oxley Act Section 302 Certification of Chief Financial Officer
 
 
Exhibit 32.1
Sarbanes-Oxley Act Section 906 Certification of Chief Executive Officer
 
 
Exhibit 32.2
Sarbanes-Oxley Act Section 906 Certification of Chief Financial Officer
 
 
Exhibit 101
Interactive Data File (XBRL)


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SIGNATURES


Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 
 
SUMMIT FINANCIAL GROUP, INC.
 
 
(registrant)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
By:
  /s/ H. Charles Maddy, III
 
 
 
H. Charles Maddy, III,
 
 
 
President and Chief Executive Officer
 
 
 
 
 
 
 
 
 
 
 
 
 
 
By:
/s/ Robert S. Tissue
 
 
 
Robert S. Tissue,
 
 
 
Senior Vice President and Chief Financial Officer
 
 
 
 
 
 
 
 
 
 
 
 
 
 
By:
/s/ Julie R. Markwood
 
 
 
Julie R. Markwood,
 
 
 
Vice President and Chief Accounting Officer
 
 
 
 
 
 
 
 
Date:
November 3, 2016
 
 




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EXHIBIT INDEX


Exhibit No.
Description
Page
Number
(3)
Articles of Incorporation and By-laws:
 
 
(i)  Amended and Restated Articles of Incorporation of Summit Financial Group, Inc.
(a)
 
(ii)  Articles of Amendment 2009
(b)
 
(iii)  Articles of Amendment 2011
(c)
 
(iv)  Amended and Restated By-laws of Summit Financial Group, Inc.
(d)
11
Statement re:  Computation of Earnings per Share
15
 
 
 
31.1
Sarbanes-Oxley Act Section 302 Certification of Chief Executive Officer
 
 
 
 
31.2
Sarbanes-Oxley Act Section 302 Certification of Chief Financial Officer
 
 
 
 
32.1*
Sarbanes-Oxley Act Section 906 Certification of Chief Executive Officer
 
 
 
 
32.2*
Sarbanes-Oxley Act Section 906 Certification of Chief Financial Officer
 
101**
Interactive data file (XBRL)
 

*Furnished, not filed.
** As provided in Rule 406T of Regulation S-T, this information is furnished and not filed for purposes of Sections 11 and 12 of the Securities Act of 1933 and Section 18 of the Securities Exchange Act of 1934.

(a)
Incorporated by reference to Exhibit 3.i of Summit Financial Group, Inc.’s filing on Form 10-Q dated March 31, 2006.
(b)
Incorporated by reference to Exhibit 3.1 of Summit Financial Group, Inc.’s filing on Form 8-K dated September 30, 2009.
(c)
Incorporated by reference to Exhibit 3.1 of Summit Financial Group, Inc.’s filing on Form 8-K dated November 3, 2011.
(d)
Incorporated by reference to Exhibit 3.2 of Summit Financial Group, Inc.’s filing on Form 10-Q dated June 30, 2006.


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