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PNBK > SEC Filings for PNBK > Form 10-K on 22-Mar-2013All Recent SEC Filings

Show all filings for PATRIOT NATIONAL BANCORP INC | Request a Trial to NEW EDGAR Online Pro



Annual Report

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operation

Critical Accounting Policies

Bancorp's significant accounting policies are described in Note 1 to the Consolidated Financial Statements included in this 2012 Annual Report on Form 10-K. The preparation of financial statements in accordance with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and to disclose contingent assets and liabilities. Actual results could differ from those estimates. Management has identified accounting for the allowance for loan losses, the analysis and valuation of its investment securities, and the valuation of deferred tax assets, as Bancorp's most critical accounting policies and estimates in that they are important to the portrayal of Bancorp's financial condition and results. They require management's most subjective and complex judgment as a result of the need to make estimates about the effect of matters that are inherently uncertain.

Allowance for Loan Losses

The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance.

The allowance for loan losses is evaluated on a regular basis by management and is based upon management's periodic review of the collectability of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower's ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.

The allowance consists of allocated and general components. The allocated component relates to loans that are considered impaired. For such impaired loans, an allowance is established when the discounted cash flows (or collateral value if the loan is collateral dependent or observable market price) of the impaired loan is lower than the carrying value of that loan. The general component covers all other loans, segregated generally by loan type, and is based on historical loss experience with adjustments for qualitative factors which are made after an assessment of internal or external influences on credit quality that are not fully reflected in the historical loss data. In addition, a risk rating system is utilized to evaluate the general component of the allowance for loan losses. Under this system, management assigns risk ratings between one and eleven. Risk ratings are assigned based upon the recommendations of the credit analyst and the originating loan officer and confirmed by the Loan Committee at the initiation of the transactions and are reviewed and changed, when necessary, during the life of the loan. Loans assigned a risk rating of six or above are monitored more closely by the credit administration officers and the Loan Committee.

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The Company provides for loan losses based on the consistent application of our documented allowance for loan loss methodology. Loan losses are charged to the allowance for loans losses and recoveries are credited to it. Additions to the allowance for loan losses are provided by charges against income based on various factors which, in our judgment, deserve current recognition in estimating probable losses. Loan losses are charged-off in the period the loans, or portion thereof, are deemed uncollectible. Generally, the Company will record a loan charge-off (including a partial charge-off) to reduce a loan to the estimated fair value of the underlying collateral, less cost to sell, for collateral dependent loans. The Company regularly reviews the loan portfolio and makes adjustments for loan losses in order to maintain the allowance for loan losses in accordance with U.S. generally accepted accounting principles. The allowance for loan losses consists primarily of the following two components:

(1) Allowances are established for impaired loans (generally defined by the Company as non-accrual loans, troubled debt restructured loans and loans that were previously classified as troubled debt restructurings but have been upgraded). The amount of impairment provided for as an allowance is represented by the deficiency, if any, between the present value of expected future cash flows discounted at the original loan's effective interest rate or the underlying collateral value, less estimated costs to sell, if the loan is collateral dependent, and the carrying value of the loan. Impaired loans that have no impairment losses are not considered for general valuation allowances described below.

(2) General allowances are established for loan losses on a portfolio basis for loans that do not meet the definition of impaired. The portfolio is grouped into similar risk characteristics, primarily loan type, loan-to-value, if collateral dependent, and internal risk ratings. Management applies an estimated loss rate to each loan group. The loss rates applied are based on the Company's cumulative prior two year loss experience adjusted, as appropriate, for the environmental factors discussed below. This evaluation is inherently subjective, as it requires material estimates that may be susceptible to significant revisions based upon changes in economic and real estate market conditions. Actual loan losses may be more or less than the allowance for loan losses management has established, which could have an effect on the Company's financial results.

The adjustments to the Company's loss experience are based on Management's evaluation of several environmental factors, including:

Changes in local, regional, national and international economic and business conditions and developments that affect the collectability of the portfolio, including the condition of various market segments;

Changes in the nature and volume of the portfolio and in the terms of the loans;

Changes in the experience, ability, and depth of lending management and other relevant staff;

Changes in the volume and severity of past due loans, the volume of nonaccrual loans, and the volume and severity of adversely classified or graded loans;

Changes in the quality of the loan review system;

Changes in the value of the underlying collateral for collateral-dependent loans;

The existence and effect of any concentrations of credit, and changes in the level of such concentrations; and

The effect of other external factors such as competition and legal and regulatory requirements on the level of estimated credit losses in the existing portfolio.

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In underwriting a loan secured by real property, we require an appraisal of the property by an independent licensed appraiser approved by the Company's Board of Directors. All appraisals are reviewed by qualified parties independent from the firm preparing the appraisals. The appraisal is subject to review by an independent third party hired by the Company. Management reviews and inspects properties before disbursement of funds during the term of a construction loan. Generally, management obtains updated appraisals when a loan is deemed impaired and if a construction loan, within 120 days prior to the scheduled maturity date. These appraisals may be more limited than those prepared for the underwriting of a new loan.

Management evaluates the allowance for loan losses based on the combined total of the impaired and general components. Generally, when the loan portfolio increases, absent other factors, the allowance for loan loss methodology results in a higher dollar amount of estimated probable losses. Conversely, when the loan portfolio decreases, absent other factors, the allowance for loan loss methodology results in a lower dollar amount of estimated probable losses.

Each quarter management evaluates the allowance for loan losses and adjust the allowance as appropriate through a provision for loan losses. While the Company uses the best information available to make evaluations, future adjustments to the allowance may be necessary if conditions differ substantially from the information used in making the evaluations. In addition, as an integral part of their examination process, the Office of the Comptroller of the Currency will periodically review the allowance for loan losses. The OCC may require the Company to adjust the allowance based on their analysis of information available to them at the time of their examination.

Fair Value Measurements

Bancorp uses fair value measurements to record fair value adjustments to certain assets and to determine fair value disclosures. Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value is best determined based upon quoted market prices. However, in certain instances, there are no quoted market prices for certain assets or liabilities. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Accordingly, the fair value estimates may not be realized in an immediate settlement of the asset or liability. Fair value measurements focus on exit prices in an orderly transaction (that is, not a forced liquidation or distressed sale) between market participants at the measurement date under current market conditions. If there has been a significant decrease in the volume and level of activity for the asset or liability, a change in valuation technique or the use of multiple valuation techniques may be appropriate. In such instances, determining the price at which willing market participants would transact at the measurement date under current market conditions depends on the facts and circumstances and requires the use of significant judgment.

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The Company's fair value measurements are classified into a fair value hierarchy based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. The three categories within the hierarchy are as follows:

Level 1 Inputs-Unadjusted quoted prices in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date.

Level 2 Inputs-Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. These might include quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, inputs other than quoted prices that are observable for the asset or liability (such as interest rates, volatilities, prepayment speeds, credit risks, etc.) or inputs that are derived principally from or corroborated by market data by correlation or other means.

Level 3 Inputs-Unobservable inputs for determining the fair values of assets or liabilities that reflect an entity's own assumptions about the assumptions that market participants would use in pricing the assets or liabilities.

The asset's or liability's fair value measurement level within the fair value hierarchy is based on the lower level of any input that is significant to the fair value measurement. Valuation techniques used need to maximize the use of observable inputs and minimize the use of unobservable inputs.

Bancorp performs a quarterly analysis of those securities that are in an unrealized loss position to determine if those losses qualify as other-than-temporary impairments. This analysis considers the following criteria in its determination: the ability of the issuer to meet its obligations, the impairment due to a deterioration in credit, management's plans and ability to maintain its investment in the security, the length of time and the amount by which the security has been in a loss position, the interest rate environment, the general economic environment and prospects or projections for improvement or deterioration.

Management has made the determination that none of the Bank's investment securities are other-than-temporarily impaired at December 31, 2012, and no impairment charges were recorded during the year ended December 31, 2012.

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Income taxes

The Company recognizes income taxes under the asset and liability method. Under this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, and loss carry forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized.

The Company recognizes a benefit from its tax positions only if it is more-likely-than-not that the tax position will be sustained on examination by taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position are measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement with a taxing authority that has full knowledge of all relevant information.

The periods subject to examination for the Company's Federal returns are the tax years 2007 through 2012. The periods subject to examination for the Company's significant state return, which is Connecticut, are the tax years 2008 through 2012. The Company believes that its income tax filing positions and deductions will be sustained upon examination and does not anticipate any adjustments that will result in a material change in its financial statements. As a result, no reserve for uncertain income tax positions has been recorded.

The Company's policy for recording interest and penalties related to uncertain tax positions is to record such items as part of its provision for federal and state income taxes.

Recent Economic Developments

There have been significant and historical disruptions in the financial system during the past few years and many lenders and financial institutions have reduced or ceased to provide funding to borrowers, including other lending institutions. The availability of credit, confidence in the entire financial sector, and volatility in financial markets has been adversely affected. The Federal Reserve Bank has been providing vast amounts of liquidity into the banking system to compensate for weaknesses in short-term borrowing markets and other capital markets.

The Federal Deposit Insurance Corporation (FDIC) insures deposits at FDIC-insured financial institutions up to certain limits. The FDIC charges insured financial institutions premiums to maintain the Deposit Insurance Fund. Based on the Bank's current capital classification, a higher level of FDIC insurance premiums is assessed.

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Patriot National Bank participated in the FDIC Transaction Account Guarantee Program which guaranteed full coverage on certain noninterest-bearing deposit transaction accounts, such as business accounts, until the expiration date of the program on December 31, 2010. Effective December 31, 2010 through December 31, 2012, the Board of Directors of the FDIC implemented a new final rule under section 343 of the Dodd-Frank Wall Street Reform and Consumer Protection Act that provides temporary unlimited coverage to depositors with noninterest-bearing transaction accounts, in addition to, and separate from, the coverage of at least $250,000 available under the FDIC's general rules. The term "noninterest-bearing transaction account" includes a traditional checking account or demand deposit account on which the Bank pays no interest. It also includes Interest on Lawyer Trust Accounts ("IOLTAs"). It does not include other accounts, such as Traditional checking or demand deposit accounts that may earn interest, NOW accounts or money market deposit accounts. The extended program was not renewed on December 31, 2012. Bancorp did not participate in the Debt Guarantee portion of the TLGP.


During a period of slow economic improvement, Bancorp reported a net loss of $536,000 ($0.01 loss per share) for 2012 compared to a net loss of $15.5 million ($0.40 loss per share) for 2011. This is primarily due to the improvement in the credit quality of the loan portfolio resulting in a reduction of $2.4 million to the provision for loan losses, compared to a $7.5 million provision in 2011, which included a $6.0 million adjustment to the provision due to the bulk sale of $66.8 million of non-performing assets in the first quarter of 2011. In addition, restructuring charges and asset disposals recorded in 2012 were $939,000 compared to $3.0 million recorded in the second quarter of 2011. Primarily as a result of restructuring charges incurred in 2011, salaries and benefits and occupancy and equipment expense were $2.3 million lower in 2012. Total assets ended the year at $617.9 million, which represents a decrease of $47.9 million from 2011. Management strategically planned for a continuation of a reduction in assets in 2012, as part of the Company's ongoing turnaround plan to reduce exposures in certain loan concentrations and to maintain regulatory capital ratios.

Net interest income for the year ended December 31, 2012 decreased $2.0 million, or 10%, to $17.8 million as compared to $19.8 million for the year ended December 31, 2011. This is the result of a reduced level of average earning assets, continued high levels of liquidity and the overall lower interest rate environment.

Total assets decreased 7% during the year as the loan portfolio decreased $42.4 million from $501.2 million at December 31, 2011 to $458.8 million at December 31, 2012. The available-for-sale securities portfolio decreased $24.8 million, or 37%, to $41.7 million at December 31, 2012 as compared to $66.5 million at December 31, 2011. Total deposits decreased $47.6 million from $544.9 million at December 31, 2011 to $497.3 million at December 31, 2012. This is reflective of management's pricing strategy to lower the cost of funds and reduce the reliance on higher cost funding products. FHLB advances are unchanged from December 31, 2011. Shareholders' equity decreased $982,000 from $50.5 million at December 31, 2011 as compared to $49.6 million at December 31, 2012. This is primarily the result of the net loss of $536,000 and the $752,000 reduction of accumulated other comprehensive income, partially offset by equity award grants of $306,000.

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Bancorp's total assets decreased $47.9 million, or 7%, from $665.8 million at December 31, 2011 to $617.9 million at December 31, 2012 as the Bank reduced its concentration of residential loans by $69.1 million primarily through loan sales. Construction loans continued to pay off and overall balances were reduced by $12.5 million or 56%. Commercial real estate loans increased $31.8 million. Interest bearing deposits increased $17.1 million compared to December 31, 2011, as the Bank chose to maintain higher levels of short-term liquidity during this record low interest rate environment, rather than locking in longer term investments at narrow spreads.


The following table is a summary of Bancorp's investment portfolio at fair value
at December 31 for the years shown.

                                                  2012               2011               2010
U. S. Government Agency bonds                 $  7,526,170       $  5,037,085       $         -
U. S. Government Agency mortgage-backed
securities                                      25,706,891         50,049,429         37,471,878
Corporate bonds                                  8,486,259         11,383,458                 -
Auction Rate preferred equity securities                -                  -           3,092,822
Federal Reserve Bank stock                       1,730,200          1,707,000          1,192,000
Federal Home Loan Bank stock                     4,343,800          4,508,300          4,508,300
Other investments                                3,500,000          3,500,000          3,500,000

Total Investments                             $ 51,293,320       $ 76,185,272       $ 49,765,000

Total investments decreased $24.9 million, or 33%, primarily due to sales of $47.0 million of government agency mortgage-backed securities and bonds and corporate bonds of $3.3 million. In addition, there were principal payments of $7.8 million on the government agency mortgage-backed securities. These were partially offset with purchases of government agency mortgage-backed securities and bonds of $33.5 million.

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The following table presents the maturity distribution of available-for-sale investment securities at December 31, 2012 and the weighted average yield of the amortized cost of such securities. The weighted average yields were calculated on the amortized cost and effective yields to maturity of each security. Actual maturities of mortgage-backed securities may differ from contractual maturities because the mortgages underlying the securities may be repaid without any penalties. As mortgage-backed securities are not due at a single maturity date, they are included in the "No maturity" category in the following maturity summary.

                                                            Over one        Over five                                                            Weighted
                                            One year        through          through          Over ten                                           Average
                                            or less        five years       ten years          years        No maturity          Total            Yield
U. S. Government Agency bonds              $       -      $         -      $  7,500,000      $       -      $         -       $  7,500,000            1.83 %
U. S. Government Agency mortgage-backed
securities                                         -                -                -               -        25,837,100        25,837,100            2.15 %
Corporate bonds                                    -                -         9,000,000              -                -          9,000,000            4.78 %

Total                                      $       -      $         -      $ 16,500,000      $       -      $ 25,837,100      $ 42,337,100            2.65 %

Weighted average yield                             -                -              3.44 %            -              2.15 %            2.65 %

The following table presents a summary of investments for any issuer that exceeds 10% of shareholders' equity at December 31, 2012:

                                                       Amortized Cost         Fair Value
Available for sale securities:
U. S. Government Agency mortgage-backed
securities and bonds                                  $     33,337,100       $ 33,233,061

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The following table is a summary of Bancorp's loan portfolio at December 31 for
each of the years shown:

                                     2012               2011               2010               2009               2008
Real Estate
Commercial                       $ 247,495,321      $ 215,659,837      $ 228,842,489      $ 230,225,306      $ 262,570,339
Residential                        119,033,025        188,108,855        187,058,318        195,571,225        170,449,780
Construction                         4,997,991         12,306,922         63,889,083        154,457,082        257,117,081
Construction to permanent            4,851,768         10,012,022         10,331,043         15,989,976         35,625,992
Commercial                          36,428,751         31,810,735         14,573,790         19,298,505         33,860,527
Consumer home equity                49,180,908         49,694,546         42,884,962         44,309,265         45,022,128
Consumer and overdrafts              2,162,718          2,164,972          1,932,763          1,155,059            993,707

Total loans                        464,150,482        509,757,889        549,512,448        661,006,418        805,639,554
Premiums on purchased loans            219,649            231,125            242,426            131,993            158,072
Net deferred costs (fees)              439,041            622,955            150,440           (138,350 )         (981,869 )
Allowance for loan losses           (6,015,636 )       (9,384,672 )      (15,374,101 )      (15,794,118 )      (16,247,070 )

Loans, net                       $ 458,793,536      $ 501,227,297      $ 534,531,213      $ 645,205,943      $ 788,568,687

Bancorp's net loan portfolio decreased $42.4 million, or 8%, to $458.8 million at December 31, 2012 from $501.2 million at December 31, 2011. The decline in the loan portfolio was primarily the result of sales of residential real estate loans and loan payoffs. Significant decreases in the portfolio include a $69.0 million decrease in residential loans, a $7.3 million decrease in construction loans, and a $5.2 million decrease in construction to permanent loans. These were partially offset with a $31.8 million increase in commercial real estate loans and a $4.6 million increase in commercial loans. The allowance for loan losses also decreased by $3.4 million. The decline in the loan portfolio in 2012 primarily reflects management's decision to reduce a growing concentration in lower yielding residential real estate loans.

At December 31, 2012, the net loan to deposit ratio was 92% and the net loan to asset ratio was 74%. Excluding the deposits held for sale at December 31, 2012, the net loan to deposit ratio was 97%. At December 31, 2011, the net loan to deposit ratio was 92%, and the net loan to asset ratio was 75%.

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Maturities and Sensitivities of Loans to Changes in Interest Rates

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