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RBPAA > SEC Filings for RBPAA > Form 10-K on 27-Mar-2013All Recent SEC Filings

Show all filings for ROYAL BANCSHARES OF PENNSYLVANIA INC | Request a Trial to NEW EDGAR Online Pro

Form 10-K for ROYAL BANCSHARES OF PENNSYLVANIA INC


27-Mar-2013

Annual Report


ITEM 7. MANAGEMENT'S DISCUSSIONS AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis of financial condition and results of operations should be read in conjunction with the Consolidated Financial Statements of the Company and the related Notes in Item 8 of this Report.

Critical Accounting Policies, Judgments and Estimates

The accounting and reporting policies of the Company conform to accounting principles generally accepted in the United States of America and general practices within the financial services industry. Critical accounting policies, judgments and estimates relate to allowance for loan and lease losses, loans held for sale, the valuation of other real estate owned, the valuation of deferred tax assets, other-than-temporary impairment losses on investment securities, net periodic pension costs and the pension benefit obligation. The policies which significantly affect the determination of the Company's financial position, results of operations and cash flows are summarized in "Note 1 - Summary of Significant Accounting Polices" to the Consolidated Financial Statements and are discussed in the section captioned "Recent Accounting Pronouncements" of Management's Discussion and Analysis of Financial Condition and Results of Operations, included in Items 7 and 8 of this Report, each of which is incorporated herein by reference.

Investment Securities

Management determines the appropriate classification of debt securities at the time of purchase and re-evaluates such designation as of each balance sheet date.

Investments in debt securities that the Company has the positive intent and ability to hold to maturity are classified as held to maturity securities and reported at amortized cost. Debt and equity securities that are bought and held principally for the purpose of selling them in the near term are classified as trading securities and reported at fair value, with unrealized holding gains and losses included in earnings. Debt and equity securities not classified as trading securities, nor as held to maturity securities are classified as available for sale securities and reported at fair value, with unrealized holding gains or losses, net of deferred income taxes, reported in the accumulated other comprehensive income component of shareholders' equity. The Company did not hold trading securities at December 31, 2012 and 2011. Discounts and premiums are accreted/amortized to income by use of the level-yield method. Gain or loss on sales of securities available for sale is based on the specific identification method.


The Company evaluates securities for other-than-temporary impairment ("OTTI") at least on a quarterly basis. The Company assesses whether OTTI is present when the fair value of a security is less than its amortized cost. All investment securities are evaluated for OTTI under FASB ASC Topic 320, "Investments-Debt & Equity Securities" ("ASC Topic 320"). The non-agency collateralized mortgage obligations that are rated below AA are evaluated under FASB ASC Topic 320 Subtopic 40, "Beneficial Interests in Securitized Financial Assets" under FASB ASC Topic 325, "Investments-Other".

Under ASC Topic 320, OTTI is considered to have occurred with respect to debt securities (1) if an entity intends to sell the security; (2) if it is more likely than not an entity will be required to sell the security before recovery of its amortized cost basis; or (3) the present value of the expected cash flows is not sufficient to recover the entire amortized cost basis. In addition, the amount of the OTTI recognized in earnings depends on whether an entity intends to sell or will more likely than not be required to sell the security. If an entity intends to sell the security or will be required to sell the security, the OTTI shall be recognized in earnings equal to the entire difference between the fair value and the amortized cost basis at the balance sheet date. If an entity does not intend to sell the security and it is not more likely than not that the entity will be required to sell the security before the recovery of its amortized cost basis, the OTTI shall be separated into two amounts, the credit-related loss and the noncredit-related loss. The credit-related loss is based on the present value of the expected cash flows and is recognized in earnings.

For more information on the fair value of the Company's investment securities and other financial instruments refer to "Note 3 - Investment Securities" and "Note 20 - Fair Values of Financial Instruments" to the Consolidated Financial Statements included in Item 8 of this Report.

Allowance for Loan and Lease Losses

The Company considers that the determination of the allowance for loan and lease losses ("allowance") involves a higher degree of judgment and complexity than its other significant accounting policies. The allowance is calculated with the objective of maintaining a reserve level believed by management to be sufficient to absorb estimated credit losses. Management's determination of the adequacy of the allowance is based on periodic evaluations of the loan portfolio and other relevant factors. However, this evaluation is inherently subjective as it requires material estimates, including, among others, expected default probabilities, loss given default, expected commitment usage, the amounts of timing of expected future cash flows on impaired loans, mortgages, and general amounts for historical loss experience. The process also considers economic conditions, uncertainties in estimating losses and inherent risks in the loan portfolio. All of these factors may be susceptible to significant change. To the extent actual outcomes differ from management estimates, additional provisions for loan and lease losses may be required that would adversely impact earnings in future periods. See "Note 1 - Summary of Significant Accounting Policies" to the Consolidated Financial Statements included in Item 8 of this report.

Deferred Tax Assets

The Company recognizes deferred tax assets and liabilities for the future tax effects of temporary differences, net operating loss carry forwards and tax credits. Deferred tax assets are subject to management's judgment based upon available evidence that future realization is more likely than not. If management determines that the Company may be unable to realize all or part of net deferred tax assets in the future, a direct charge to income tax expense may be required to reduce the recorded value of the net deferred tax asset to the expected realizable amount.

RECENT ACCOUNTING PRONOUNCEMENTS

See "Note 1 - Summary Of Significant Accounting Policies" to the Consolidated Financial Statements included in Item 8 of this Report.


Results of Operations

Financial Highlights and Business Results: The Company's results of operations depend primarily on net interest income, which is the difference between interest income on interest-earning assets and interest expense on interest-bearing liabilities. Interest-earning assets consist principally of loans and investment securities, while interest-bearing liabilities consist primarily of deposits and borrowings. Net income is also affected by the provision for loan and lease losses and the level of non-interest income as well as by non-interest expenses, including salary and employee benefits, occupancy expenses and other operating expenses.

Like many other financial institutions the Company's financial results were negatively impacted by the recession, but the effects on the Company were more pronounced than the effects on its competitors. The concentration of commercial real estate loans coupled with the introduction of additional lines of business resulted in a much higher level of non-performing loans and losses. The past losses were partially attributed to charge-offs and impairment of commercial, construction and land loans associated with real estate projects, many of which were participation loans outside the Company's primary market. Some of the participation loans were located in Florida, Nevada, North Carolina and other markets that were overbuilt during the construction boom within the United States from 2000-2007. The Company also launched new business initiatives such as mezzanine lending, real estate joint ventures, hard money lending and equity investments in real estate shortly before the housing bubble burst which contributed to the losses. Additionally, the Company experienced a high level of investment impairment associated with corporate bonds, common stocks, private label mortgage backed securities and real estate investment funds that experienced declines in value during the past few years. Also contributing to the losses were increased costs associated with the high level of non-performing assets, legal expenses related to credit quality issues and the DOJ tax lien investigation (for additional information please read Item 3 "Legal Proceedings" of this Form 10-K), and higher Federal Deposit Insurance Corporation ("FDIC") assessments resulting from the higher rates for deposit insurance due to the Orders to Cease and Desist (the "Orders") which were issued in 2009 and replaced in 2011 with an informal agreement, known as a memorandum of understanding ("MOU"). Finally, the establishment of a valuation allowance in 2008 and subsequent years that currently amounts to $39.6 million, has prevented the Company from utilizing tax credits on losses during the past four years.

While the Company's deleveraging strategy improved the risk profile of the Company by shedding higher risk assets and paying off higher cost brokered CDs, it has had a negative impact on income. The deleveraging has resulted in lower average loan balances and a higher proportion of lower yielding investment securities, which have negatively impacted net interest income, a principal source of income. While the Company still expects external headwinds and credit quality costs associated with non-performing assets to negatively affect financial results, over time their impact may decline as the overall level of non-performing assets declines.

After announcing the retirements of the Company's CEO and President during the second quarter of 2012, the Company's Board conducted an executive search for a candidate for the combined role of President and CEO. On December 18, 2012 the Company announced F. Kevin Tylus as President and CEO of Royal Bank. On February 20, 2013, the Company announced that Mr. Tylus was appointed President, CEO and a Class III member of the board of directors of the Company. Former CEO, Robert Tabas, remains as Chairman of the Board of Directors. The Company is focused on transitioning Royal Bank into a true community bank with the branches becoming selling centers and not just service centers. Traditional consumer products such as home equity loans and a new mobile banking application are part of our enhanced product offerings. The Company has developed a Profitability Improvement Program to generate steady revenue growth, expense management and gain operational efficiencies. During 2012, Royal Bank hired a new Chief Lending Officer ("CLO") who has significant experience in commercial and consumer lending with a larger bank within the Philadelphia market. Through the restructuring of the Lending and Credit departments during the last half of 2012, Royal Bank has been able to increase commitments to extend credit by $23.8 million from $20.7 million at December 31, 2011 to $44.5 million at December 31, 2012.

Net Loss: The Company recorded a net loss of $15.6 million in 2012, which represented an increase of $7.0 million from the loss recorded in 2011 of $8.6 million. The increase in net loss was primarily related to a $3.2 million reduction in net interest income, a $2.0 million DOJ fine related to the tax lien subsidiaries, a $1.3 million reduction in net gains on other real estate owned ("OREO"), a $1.2 million increase in OREO impairment charges, and a $1.7 million increase in impairment on LHFS. Net loan balances, including loans held for sale, amounted to $328.5 million at year end 2012, which amounted to a decline of $81.9 million from balance at the end of 2011 due to charge-offs and impairments, loan sales, pay-downs, pay offs and transfers to OREO. Partially offsetting these unfavorable changes were a $1.7 million decline in the provision for loan and lease losses and a $934,000 decline in FDIC and state assessments.


Net interest income, which amounted to $22.1 million in 2012, decreased by $3.2 million, or 12.7%, from the prior year's results of $25.3 million. The continued decline in loan balances negatively impacted net interest income during the past year. In addition, the accelerated amortization of premiums coupled with the reinvestment of cash flows from the investment portfolio into lower yielding government agency securities during the continued low interest rate environment has had a significant adverse impact on the yield earned on investment securities. Other income of $3.6 million in 2012 was $3.2 million below the result for 2011 mainly due to a $1.8 million decline in income from real estate joint ventures, a $1.3 million decline in net gains on OREO, a $752,000 decrease in net gains on the sales of AFS investment securities, a $563,000 increase in impairment on investment securities resulting primarily from write-downs of two private equity funds, and a $478,000 decline in income related to real estate owned via equity investments as a result of the substantial completion of the remaining project during 2011. Partially offsetting these declines year over year for 2012 was a $1.7 million increase in gains on the sales of loans and leases which was primarily related to the sale of one non-performing loan in the second quarter of 2012.

Total non-performing loans at December 31, 2012 were $23.0 million and were comprised of $21.4 million in loans held for investment ("LHFI") and $1.6 million in loans held for sale ("LHFS"), which amounted to an improvement of $28.3 million, or 55.2%, from the level at December 31, 2011 resulting from charge-offs and impairments, sales of loans, transfers to OREO and improved credit quality. Total non-performing loans at December 31, 2011 were $51.3 million and were comprised of $38.7 million in LHFI and $12.6 million in LHFS. Non-performing loans were $65.8 million at December 31, 2010 and were comprised of $43.2 million in LHFI and $22.6 million in LHFS. OREO at December 31, 2012, amounted to $13.4 million versus $21.0 million at year end 2011, which amounted to a decline of $7.6 million, or 36.1%. As a consequence of the housing market's slow recovery and the sluggish growth in the overall economy, the Company continued to experience a high level of non-performing assets despite the continued progress in reducing the level of those assets. Impaired and non-accrual loans and OREO assets are reviewed in the "Credit Quality" section of this report. Basic and diluted losses per common share were both $1.33 for 2012 compared to basic and diluted losses per common share of $0.80 in 2011.

The Company recorded a net loss of $8.6 million in 2011, which represented an improvement of $15.5 million, or 64.5%, from loss recorded in 2010 of $24.1 million. The improved results were primarily related to a reduction in the provision for loan and lease losses of $14.4 million and a decline of $8.7 million in total other expense. The favorable change in the provision resulted primarily from a decrease in the outstanding loan balances year over year as well as a decline in the level of non-performing loans. Loan balances, including loans held for sale, amounted to $410.4 million at year end 2011, which amounted to a decline of $94.9 million from balance at the end of 2010 due to charge-offs, loan sales, pay-downs, pay offs and transfers to OREO. Other expenses of $32.1 million resulted in a year over year decline of $8.7 million, or 21.3%, and was attributed to an overall reduction of expenses related to the sale of Royal Asian at year end 2010, which amounted to $3.8 million; a reduction of $1.9 million in OREO impairment charges; lower FDIC and state assessments of $1.1 million associated with reduced deposit balances, mainly brokered CDs and deposits of Royal Asian; and the absence of impairment on real estate joint ventures which was $1.6 million in 2010 and the VIE related to real estate owned via equity investments being deconsolidated in 2011. The impairment related to the VIE in 2010 was $2.6 million.

Partially offsetting these favorable changes year over year for 2011 were a decline in both net interest income and other income. Net interest income, which amounted to $25.3 million in 2011, decreased by $6.0 million, or 19.1%, from $31.3 million for 2010. The decline in loan balances negatively impacted net interest income during the past year. In addition, a reduction in the yields on loans and investments and a 2010 non-recurring adjustment amounting to $905,000 also contributed to the decline in net interest income. The non-recurring adjustment was related to previously reversed interest income on a participation loan from a previous year. The overall decline in net interest income was partially mitigated by the continued reduction in interest expense related to lower interest rates principally associated with the re-pricing of maturing retail CDs and the redemption of brokered deposits and FHLB advances. Other income of $6.8 million in 2011 was $947,000 below the result for 2010 mainly due to impairment on investment securities of $1.8 million, resulting primarily from a complete write-down of one trust preferred security in the amount of $1.7 million.


Net Interest Income and Margin: Net interest income is the Company's primary source of income. Its level is a function of the average balance of interest-earning assets, the average balance of interest-bearing liabilities, and the spread between the yield on assets and liabilities. In turn, these factors are influenced by the pricing and mix of the Company's interest-earning assets and funding sources. Additionally, net interest income is affected by market and economic conditions, which influence rates on loan and deposit growth.

The Company utilizes the effective yield interest method for recognizing interest income as required by ASC Subtopic 20, "Nonrefundable Fees and Other Costs" ("ASC Subtopic 20") under FASB ASC Topic 310, "Receivables" ("ASC Topic 310"). ASC Subtopic 20 also guides our accounting for nonrefundable fees and costs associated with lending activities such as discounts, premiums, and loan origination fees. In the case of loan restructurings, if the terms of the new loan resulting from a loan refinancing or restructuring other than a troubled debt restructuring are at least as favorable to the Company as the terms for comparable loans to other customers with similar collection risks who are not refinancing or restructuring a loan with the Company, the refinanced loan is accounted for as a new loan. This condition is met if the new loan's effective yield is at least equal to the effective yield for such loans. Any unamortized net fees or costs and any prepayment penalties from the original loan shall be recognized in interest income when the new loan is granted.

Net interest income amounted to $22.1 million in 2012 as compared to $25.3 million in 2011, which resulted in a decline of $3.2 million, or 12.7%. The decrease was attributed mainly to a year-over-year decline in average loan balances and a declining yield on the investment portfolio despite an increase in average investment securities. The decline was partially offset by a reduction in the average interest-bearing deposit and borrowing balances. Additionally the average rate paid on the interest-bearing deposits continued to decline, specifically maturing retail CDs. (See the "Average Balance" table included in this discussion.) Net interest income amounted to $25.3 million in 2011 as compared to $31.3 million in 2010, which resulted in a decline of $6.0 million, or 19.1%. The decrease was attributed mainly to a decline in interest-earning assets, both loans and investments, primarily attributable to the de-leveraging of the balance sheet, a decline in the yields of those interest-earning assets, again principally loans and investments, and a nonrecurring favorable adjustment of $905,000 for interest income in 2010. The decline was partially offset by a reduction of the average balances and the average rate paid on interest-bearing liabilities associated with the redemption of brokered CDs and lower rates paid on maturing retail CDs.

Interest income of $32.0 million in 2012 amounted to a reduction of $7.4 million, or 18.8%, from the level of $39.4 million in 2011. The decrease was primarily driven by a $90.6 million decline in average loan balances year-over-year and a 107 basis point decline in the yield on investments, which were partially offset by the increased yield on loans. Interest income for loans declined by $4.4 million, or 14.8%, and was mainly attributed to the reduction of average total loans. Average total loans for 2012 were $384.4 million compared to $475.0 million for 2011. The decline in loan balances during 2012 was attributed to minimal new loan growth, loan prepayments, loan pay downs including $24.0 million in higher yielding tax lien certificates, charge-offs, impairments and transfers to OREO through foreclosure proceedings. Average investment securities of $344.9 million in 2012 amounted to an increase of $24.5 million, or 7.6%, from the average in 2011. For 2012, interest income on investment securities amounted to $6.7 million and declined $2.9 million, or 30.8%, from 2011.

The decline in the yield on average interest-earning assets contributed to the decline in interest income year over year (4.25% in 2012 versus 4.76% in 2011). The 51 basis point reduction was primarily comprised of a decline of 107 basis points on investment securities which was partially offset by a 33 basis point increase in total loans. The yield on investment securities was 1.94% for 2012 compared to 3.01% for 2011. As a result of the historically sustained low interest rates, the yield on investment securities declined despite the increase in average balances. This decline in yield was due to the replacement of sold and called higher yielding investment securities and the reinvestment of increased payments received on cash flowing investment securities during 2012 with lower yielding government agency securities. In addition, accelerated amortization of premiums paid on investment securities within the MBS/CMO portfolio due to a higher level of prepayments also contributed to the declining yield on investments. The increase in loan yield reflected a reduced concentration of non-performing loans within the loan portfolio, a higher concentration of higher yielding leases coupled with minimal interest reversals on new non-performing loans, which were partially offset by a reduced concentration of higher yielding tax liens.


Interest income of $39.4 million in 2011 amounted to a reduction of $17.9 million, or 31.2%, from the level of $57.3 million in 2010. The decline was attributable to a lower yield on interest-earning assets year over year for loans and investment securities, and a lower level of average interest-earning assets again related to both loans and investment securities. The reduction in loan balances and investment securities was driven in part by the Company's strategic capital initiative of de-leveraging the balance sheet. Interest income for loans declined by $13.0 million, or 30.5%, and was mainly attributed to the reduction of average total loans but was also related to a decline in the yield on the loan portfolio. Average balance of total loans amounted to $475.0 million during 2011 versus $643.5 million during 2010, which amounted to a decline of $168.5 million, or 26.2%, year over year. The reduction was comprised of charge-offs, pay downs, payoffs, the sale of Royal Asian Bank ("RAB") at year end 2010 and transfers to OREO that was accompanied by minimal new loan growth. The sale of RAB accounted for almost 40% of the overall decline. The interest income on investment securities amounted to $9.6 million and declined $4.8 million, or 33.3%, resulting from a decline in average investment securities coupled with a decline in the yield on the investment securities. Average investment securities of $320.4 million in 2011 amounted to a decline of $61.4 million, or 16.1%, from the average in 2010.

The decline in the yield on average interest-earning assets contributed to the decline in interest income year over year (4.76% in 2011 versus 5.29% in 2010). The 53 basis point reduction was comprised of a decline of 78 basis points on investment securities and a 39 basis point decrease in total loans. The decline in the yield on investment securities was mainly related to the replacement of sold investment securities and principal payments and prepayments on government agency investment securities with comparable investment securities at lower interest rates. The yield decrease on average total loans primarily resulted from the $905,000 favorable adjustment to interest income in 2010 as previously mentioned, the lower yields on new loans recorded during the past year and a change in the composition of the loans within the portfolio during 2011. The loan composition change was related to a decrease in the percentage of tax liens, which have the highest yields within the loan portfolio. At year end 2011, the variable rate portfolio represented approximately 40% of total loans; however the Company has mitigated a portion of this negative impact through the utilization of rate floors in many of the commercial loan agreements that exceed the current prime rate.

At December 31, 2012, non-performing loans to total loans amounted to 6.7%, whereas the same ratio at December 31, 2011, amounted to 12.0%. The favorable change year over year was primarily associated with the $28.3 million decline in non-performing loans during 2012, which was partially offset by the decline in the loan portfolio during 2012. The total interest income lost as a result of non-performing loans during 2012 amounted to $3.1 million, which resulted in a decrease of $2.0 million from 2011.

For the full year ended December 31, 2012, interest expense amounted to $9.9 million, which resulted in a decline of $4.2 million, or 29.7%, from the level recorded in the previous year. The decline in interest expense during 2012 was primarily due to a $75.0 million, or 10.1%, decline in average interest-bearing liabilities relative to 2011 and a 42 basis point decline in the interest rates paid on interest-bearing liabilities year over year. During 2012, average interest-bearing deposits of $517.6 million decreased $46.9 million, or 8.3%, compared to 2011. The reduction was entirely associated with CDs, which was primarily due to the intentional runoff of brokered CDs and higher priced retail CDs, that was partially offset by an increase in money market deposits and savings accounts. Average time deposits amounted to $276.0 million during 2012, which resulted in a decline of $51.6 million, or 15.8%, from the level during 2011 for the reasons previously noted. Average money market deposits increased $3.6 million, or 2.0%, year over year. Average borrowings of $123.6 million in 2012 declined $28.1 million, or 18.5%, from the level in 2011 due to the redemption and pay down of FHLB advances. In March of 2012, a maturing FHLB advance of $30.0 million at a rate of 4.32% was partially replaced with a five-year FHLB advance of $15.0 million with a fixed rate of 1.39%, which improved funding costs.

Average rates paid on all major liability categories declined year over year due to the continued lower re-pricing of maturing retail certificates of deposit and the redemption of higher cost brokered CDs, the redemption of higher cost FHLB . . .

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