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ANNB > SEC Filings for ANNB > Form 10-Q on 14-Nov-2011All Recent SEC Filings

Show all filings for ANNAPOLIS BANCORP INC

Form 10-Q for ANNAPOLIS BANCORP INC


14-Nov-2011

Quarterly Report


Item 2 - Management's Discussion and Analysis of Financial Condition and Results of Operations

Critical Accounting Policies

The Company's consolidated financial statements are prepared in accordance with GAAP and follow general practices within the banking industry. Application of these principles requires management to make estimates, assumptions, and judgments that affect the amounts reported in the 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. Estimates, assumptions, and judgments are necessary when assets and liabilities are required to be recorded at fair value, when a decline in the value of an asset not carried on the financial statements at fair value warrants an impairment write-down or valuation reserve to be established, or when an asset or liability needs to be recorded contingent upon a future event. Carrying assets and liabilities at fair value inherently results in more financial statement volatility. The fair values and the information used to record valuation adjustments for certain assets and liabilities are based either on quoted market prices or are provided by other third-party sources, when available.

Significant accounting policies followed by the Company are presented in Note 1 to the Company's 2010 consolidated financial statements which can be found in the Company's Form 10-K and recent accounting provisions adopted have been presented herein in Note I. These policies, along with the disclosures presented in the other 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 management has identified the determination of the allowance for credit losses to be the accounting area that requires the most subjective or complex judgments, and as such could be most subject to revision as new information becomes available.

The allowance for credit losses represents management's estimate of probable credit losses inherent in the loan portfolio. Determining the amount of the allowance for credit losses is considered a critical accounting estimate because it 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 the consolidated balance sheet.


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Allowance for Credit Losses Methodology

The Bank's allowance for credit losses is established through a provision for loan losses based on management's evaluation of the risks inherent in its loan portfolio and the general economy. The allowance for credit losses is maintained at an amount management considers adequate to cover estimated losses in loans receivable which are deemed probable and estimable based on information currently known to management. The Bank estimates an acceptable allowance for credit loss with the objective of quantifying portfolio risk into a dollar figure of inherent losses, thereby translating the subjective risk value into an objective number. Emphasis is placed on independent external loan reviews and regular internal reviews. The determination of the allowance for loan losses is based on a combination of the higher of the Bank's historical loss experience or the peer group average historical loss experience and ten (10) qualitative factors for specific categories and types of loans. The combination of the loss experience factor and the total qualitative factors ("Total ALLL Factor") is expressed as a percentage of the portfolio for specific categories and types of loans to create the inherent loss index for each loan portfolio. Individual loans deemed impaired are separated from the respective loan portfolios and a specific reserve allocation is assigned based upon Bank management's best estimate as to the loss exposure for each loan. Each Total ALLL Factor is assigned a percentage weight and that total weight is applied to each loan category. The Total ALLL Factor is different for each loan type and for each risk assessment category within each loan type.

The Bank's historical loss experience is calculated by aggregating the actual loan losses by category for the previous eight quarters and converting that total into a percentage for each loan category.

Peer Group average loss experience is calculated by averaging the industry loss experience by loan category over the last three full years and the current year to date. (Based upon the current economic and industry conditions, Bank management has shortened the "look back" at peer group loss experience to include an annualized average of the last eight "rolling" quarters).

Qualitative factors include: levels and trends in delinquencies and non-accruals; trends in volumes and terms of loans; effects of any changes in lending policies; the experience, ability and depth of management; national and local economic trends and conditions; concentrations of credit; quality of the bank's loan review system; and, external factors, such as competition, legal and regulatory requirements.

The total allowance for credit losses changes as the percentage weight assigned to each Total ALLL Factor is increased or decreased due to its particular circumstance, as the various types and categories of loans change as a percentage of total loans and as the aggregate of specific allowances is adjusted due to an increase or decrease in impaired loans.

Management believes this approach effectively measures the risk associated with any particular loan or group of loans. The Bank's Board of Directors engages an independent loan review consultant to evaluate the adequacy of the Bank's allowance for credit losses. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Bank's allowance for credit losses. Such agencies may require the Bank to make additional provisions for estimated credit losses based upon judgments different from those of management. The Bank recorded a total provision for credit losses of $338,000 for the three month period ended September 30, 2011 and $622,000 for the same period in 2010. For the nine month periods ended September 30, 2011 and 2010 the Bank


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recorded provisions of $1.6 million and $1.2 million, respectively. The aggregate provision was based upon the results of quarterly evaluations using a combination of factors including the level of nonperforming loans, the Bank's growth in total gross loans and the Bank's net credit loss experience. Total gross loans, including loans held for sale, increased by $14.2 million for the nine months ended September 30, 2011. For the same period, the Bank recorded charge-offs of $1.2 million and recovered $284,000 on previously charged-off loans. As of September 30, 2011, the Bank's allowance for credit losses was $7.5 million or 2.56% of total loans and 111.22% of nonperforming loans as compared to $6.9 million, or 2.45% of total loans and 81.68% of nonperforming loans as of December 31, 2010.

The Bank continues to monitor and modify its allowance for credit losses as conditions dictate. While management believes that, based on information currently available, the Bank's allowance for credit losses is sufficient to cover losses inherent in its loan portfolio at this time, no assurances can be given that the Bank's level of allowance for credit losses will be sufficient to cover future loan losses incurred by the Bank or that future adjustments to the allowance for credit losses will not be necessary if economic and other conditions differ substantially from economic and other conditions at the time management determined the current level of the allowance for credit losses. Management may in the future increase the level of the allowance as its loan portfolio increases or as circumstances dictate.

Activity in the allowance for credit losses for the nine months ended September 30, 2011 and 2010 is shown below:

                                                                  For the Nine Months Ended
(dollars in thousands)                                                  September 30,
                                                                   2011                 2010
Total loans outstanding - at September 30(1)                   $     294,160          $ 279,743
Average loans outstanding year-to-date                               288,312            276,931

Allowance for credit losses at beginning of period             $       6,853          $   7,926

Provision charged to expense                                           1,574              1,221

Chargeoffs:
Commercial loans                                                         872              1,242
Real estate and construction loans                                       182                221
Consumer and other loans                                                 140                327

Total                                                                  1,194              1,790

Recoveries:
Commercial loans                                                          13                  3
Real estate and construction loans                                       254                  3
Consumer and other loans                                                  17                 31

Total                                                                    284                 37


Net chargeoffs                                                           910              1,753

Allowance for credit losses at end of period                   $       7,517          $   7,394


Allowance for credit losses as a percent of total loans                 2.56 %             2.64 %
Net chargeoffs (recoveries) as a percent of average loans               0.32 %             0.63 %

(1) Includes loans held for sale.

The Bank's nonperforming assets, which are comprised of loans delinquent 90 days or more, non-accrual loans, loans that are categorized as being a troubled debt restructuring, loans with repossessed collateral and repossessed assets totaled $8.0 million at September 30, 2011, compared to $10.1 million at December 31, 2010, a decrease in nonperforming assets of $2.1 million or 20.8% The percentage of nonperforming assets to total assets was 1.83% at September 30, 2011, compared to 2.35% at December 31, 2010. The decrease in


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nonperforming assets was principally attributable to sales, payoffs and pay-downs of nonperforming assets of $2.8 million, the charge-off of $1.2 million of loans previously classified as nonperforming, the return to performing of $285,000 of loans and additional write-downs taken on REO and repossessed assets of $113,000. Offsetting these decreases was the addition to nonperforming of net new totaling $1.8 million.

The $8.0 million in nonperforming assets at September 30, 2011 included $6.0 million in nonaccrual loans, $774,000 in accruing troubled debt restructuring and $1.2 million in foreclosed real estate. Of the $6.0 million in nonaccrual loans at September 30, 2011, $4.6 million were secured by real estate, $932,000 were commercial loans and $446,000 were consumer and other loans. At December 31, 2010, assets classified as nonperforming totaled $10.1 million and consisted of $8.4 million in nonaccrual loans and loans delinquent 90 days or more and $1.7 million in other assets. Included in the $8.4 million of nonaccrual and loans delinquent 90 days or more was $5.7 million of loans secured by real estate, $2.1 million of commercial and $630,000 of consumer and other loans.

Comparison of Financial Condition at September 30, 2011 and December 31, 2010

Total assets of $435.8 million at September 30, 2011 increased 0.9% or $3.7 million compared to $432.1 million at December 31, 2010. Loan demand improved in the first nine months of 2011, with $294.2 million of gross loans as of September 30, 2011, an increase of $14.2 million from $280.1 million at December 31, 2010. The increase resulted primarily from the origination, net of payments of approximately $18.3 million in real estate secured loans offset by charge-offs of $1.2 million and the net sale of $1.4 million of loans held for sale. Investment securities decreased $11.4 million or 11.8% compared to December 31, 2010 while federal funds sold as of September 30, 2011 increased $9.6 million or 80.4% from December 31, 2010.

Deposits of $340.1 million at September 30, 2011 decreased $830,000 or 0.2% from December 31, 2010 deposits of $340.9 million. Savings balances decreased $7.8 million in total, due in part to a $3.0 million transfer into a certificate of deposit. Certificate of deposit balances, however, excluding the $3.0 million transfer decreased $1.3 million due to higher rate certificates of deposit maturing and not being renewed. NOW account balances decreased $2.4 million. Noninterest bearing demand deposit balances increased $7.6 million to $53.1 million at September 30, 2011 from $45.5 million at December 31, 2010.

Comparison of Operating Results for the Nine Months Ended September 30, 2011 and 2010.

General. The Company recorded net income of $1.5 million for the nine months ended September 30, 2011; an increase of $148,000, compared to net income of $1.4 million for the nine months ended September 30, 2010. Net income available to common shareholders for the nine months ended September 30, 2011 was $1.1 million or $0.29 per basic and $0.26 per diluted common shares compared to net income available to common shareholders of $990,000 or $0.25 per basic and diluted shares for the nine months ended September 30, 2010. Net interest income increased by $726,000 or 6.4% for the nine months ended September 30, 2011 compared to the same period in 2010. The provision for credit losses increased $353,000 to $1.6 million for the nine months ended September 30, 2011 compared to $1.2 million for the nine month period ended September 30, 2010.


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Interest Income. Total interest income decreased $146,000 or 1.0% for the nine months ended September 30, 2011 compared to the same period in 2010 as a result of lower yields on investment securities. Interest income on investments decreased $1.0 million. The yield on the investment portfolio decreased to 2.98% from 3.78% on balances $16.2 million lower on average over the same period in 2010. Income on the loan portfolio increased $873,000 or 7.3% for the nine months ended September 30, 2011 to $12.8 million from $11.9 million for the nine months ended September 30, 2010 due to an increase in average loan balances of $11.4 million and the recognition of $180,000 as income, from a paid-off loan previously classified as nonaccrual. The yield on the loan portfolio increased to 5.94% for the nine months ended September 30, 2011 from 5.76% for the nine months ended September 30, 2010.

Interest Expense. Total interest expense decreased by $872,000 or 24.0% for the nine months ended September 30, 2011 compared to the nine months ended September 30, 2010. The decrease was due to reducing the yields on the Company's "Superior Savings" product and other interest bearing accounts. The Company's savings product had an average balance of $139.0 million for the nine months ended September 30, 2011 and a yield of 0.68% compared to an average balance of $141.4 million and a yield of 1.03% for the nine months ended September 30, 2010. Contributing to the decrease in interest expense were the lower yields on all other deposit products, primarily money market accounts and certificates of deposit and the lower yields on repurchase agreements. The average rate of interest paid on all interest bearing liabilities was 1.06% for the nine months ended September 30, 2011 compared to 1.36% for the nine months ended September 30, 2010. Interest expense on long-term borrowings and junior subordinated debentures was $974,000 for the nine months ended September 30, 2011 compared to $1.0 million for the nine months ended September 30, 2010, a decrease of $27,000. The decrease in expense was a result of average Federal Home Loan Bank advances decreasing to $35.0 million for the nine months ended September 30, 2011 compared to $36.4 million on average for the same period in 2010.

Net Interest Income. Net interest income increased by $726,000 or 6.4% for the nine months ended September 30, 2011 compared to the nine months ended September 30, 2010. The increase was primarily the result of the lower overall cost of deposits. The Company's cost of funds decreased to 0.93% for the nine months ended September 30, 2011 compared to 1.22% for the nine months ended September 30, 2010.

For the nine months ended September 30, 2011, the net interest margin increased to 3.94% compared to 3.65% for the nine months ended September 30, 2010. The increase in net interest margin was primarily the result of the decrease in the yield paid on interest bearing liabilities to 1.06% from 1.36%. The yield on earning assets increased to 4.84% for the nine months ended September 30, 2011 from 4.81% for the same period in 2010. Income of approximately $180,000 on a loan previously categorized as nonaccrual was recognized during the nine month period ended September 30, 2011 compared to income of $280,000 recognized on loans categorized as nonaccrual for the nine months ended September 30, 2010.

Provision for Credit Losses. The Bank recorded a provision for credit losses of $1.6 million for the nine months ended September 30, 2011 compared to $1.2 million for the same period in 2010. The provision was based on the composition and credit quality of the loan portfolio as of September 30, 2011 and reflected the qualitative factors used to calculate the


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allowance for credit losses relating to historical delinquencies and losses and to factors relating to local economic conditions. Total gross loans increased by $14.2 million for the nine month period ended September 30, 2011 compared to December 31, 2010. The Bank recorded net charge-offs on loans deemed uncollectible of $910,000 for the nine months ended September 30, 2011 compared to $1.8 million for the same period in 2010 that included the charge-off of one loan for $1.0 million.

Noninterest Income. Total noninterest income increased by $21,000 or 1.5% to $1.4 million for the nine months ended September 30, 2011. Noninterest income was also $1.4 million for the same period in 2010. The increase in noninterest income was due to higher transaction related fee income and increased income from mortgage banking activity. Offsetting the increase in noninterest income were losses recognized on the disposal of fixed assets related to the May 27, 2011 closure of the Bank's Market House branch.

Noninterest Expense. Total noninterest expense increased by $218,000 or 2.3% for the nine months ended September 30, 2011 compared to the same period in 2010. The increase in total noninterest expense during the first nine months of 2011 compared with the same period in 2010 primarily resulted from a partial write-down of $198,000, based on a new appraisal, of a property owned by the Bank, held for future expansion. Staffing increases resulted in additional costs of $73,000, while marketing expenses increased $46,000 due to advertising and image campaigns. Offsetting these expenses were a reduction in legal expense of $62,000 due to receiving reimbursement of $56,000 of legal costs from the payoff of criticized and classified loans. FDIC expense decreased $89,000 for the nine months ended September 30, 2011.

Income Tax Expense. The Company recorded income tax expense for the nine-month period ended September 30, 2011 of $782,000 compared to $754,000 for the nine months ended September 30, 2010. The Company's combined effective federal and state income tax rate was approximately 34.2% for the nine months ended September 30, 2011 versus 35.8% for the nine months ended September 30, 2010.

The table below sets forth certain information regarding changes in interest income and interest expense attributable to (1) changes in volume (change in volume multiplied by the old rate); (2) changes in rates (change in rate multiplied by the old volume); and (3) changes in rate/volume (change in rate multiplied by change in volume).


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Rate/Volume Analysis



(dollars in thousands)                                 Nine Months Ended September 30, 2011 vs. 2010
                                                                                Due to Change in
                                             Increase or                                               Rate/
                                              (Decrease)           Volume             Rate             Volume
Interest income on:
Loans                                        $        873         $     491         $     367         $     15
Investment securities                              (1,012 )            (459 )            (651 )             98
Interest bearing deposits in other banks              (10 )              (3 )              (8 )              1
Federal funds sold and other overnight
Investments                                             3                 1                 2                0

Total interest income                                (146 )              30              (290 )            114

Interest expense on:
NOW accounts                                           (3 )               4                (6 )             (1 )
Money market accounts                                 (68 )               0               (68 )              0
Savings accounts                                     (380 )             (18 )            (368 )              6
Certificates of deposit                              (376 )            (138 )            (268 )             30
Repurchase agreements                                 (18 )               6               (22 )             (2 )
Long-term borrowing                                   (25 )             (34 )               9                0
Junior subordinated debt                               (2 )               0                (2 )              0

Total interest expense                               (872 )            (180 )            (725 )             33


Net interest income                          $        726         $     210         $     435         $     81


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Consolidated Average Balances, Yields and Rates



(dollars in thousands)                                            Nine Month Periods Ended
                                                September 30, 2011                        September 30, 2010
                                        Average      Interest       Yield/        Average      Interest       Yield/
                                        Balance         (1)          Rate         Balance         (1)          Rate
Assets
Interest earning assets
Federal funds sold and other
overnight investments                  $  15,930     $      27         0.23 %    $  15,514     $      24         0.21 %
Interest bearing balances with banks      15,087            13         0.12 %       17,271            23         0.18 %
Investment securities (1)                 91,822         2,044         2.98 %      108,046         3,056         3.78 %
Loans (2)                                288,312        12,807         5.94 %      276,931        11,934         5.76 %

Total interest earning assets            411,151        14,891         4.84 %      417,762        15,037         4.81 %
Noninterest earning assets
Cash and due from banks                    7,582                                     2,451
Other assets                              15,211                                    15,401

Total Assets                           $ 433,944                                 $ 435,614


Liabilities and Stockholders' Equity
Interest bearing deposits
NOW accounts                           $  32,892     $      32         0.13 %    $  29,743     $      35         0.16 %
Money market accounts                     42,280           149         0.47 %       42,236           217         0.69 %
Savings accounts                         138,952           704         0.68 %      141,354         1,084         1.03 %
Certificates of deposit                   77,508           844         1.46 %       87,439         1,220         1.87 %
Repurchase agreements                     16,163            59         0.49 %       14,958            77         0.69 %
Long-term borrowings                      35,000           843         3.22 %       36,424           868         3.19 %
Junior subordinated debt                   5,000           131         3.50 %        5,000           133         3.56 %

Total interest bearing liabilities       347,795         2,762         1.06 %      357,154         3,634         1.36 %

Noninterest bearing Liabilities
Demand deposit accounts                   48,446                                    42,194
Other liabilities                          1,991                                     1,724
Stockholders' Equity                      35,712                                    34,542

Total Liabilities and Stockholders'
Equity                                 $ 433,944                                 $ 435,614


Interest rate spread                                                   3.78 %                                    3.45 %
Ratio of interest earning assets to
interest bearing liabilities                                         118.22 %                                  116.97 %
Net interest income and net interest
margin                                               $  12,129         3.94 %                  $  11,403         3.65 %

(1) No tax-equivalent adjustments are made, as the effect would not be material.

(2) Includes nonaccrual loans

Comparison of Operating Results for the Three Months Ended September 30, 2011 and 2010.

General. The Company recorded net income for the three months ended September 30, 2011 of $668,000, an increase of $369,000, compared to a net income of $299,000 for the three months ended September 30, 2010. Net income available to common shareholders was $545,000 or $0.14 per basic and diluted common share, compared to net income available to common shareholders of $176,000 or $0.04 per basic and diluted common share for the three months ended September 30, 2010. Net interest income improved to $4.1 million from $3.7 million, an increase of $439,000 or 11.9% for the three months ended September 30, 2011 compared to the same period in 2010. The Bank recorded $338,000 in provision for credit losses during the three months ended . . .

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