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CLDB > SEC Filings for CLDB > Form 10-Q on 13-Nov-2013All Recent SEC Filings

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

Form 10-Q for CORTLAND BANCORP INC


13-Nov-2013

Quarterly Report


ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

Financial Review

The following is management's discussion and analysis of the financial condition and results of operations of Cortland Bancorp (the Company). The discussion should be read in conjunction with the Consolidated Financial Statements and related notes and summary financial information included elsewhere in this quarterly report.

Note Regarding Forward-looking Statements

The Private Securities Litigation Reform Act of 1995 provides a "safe harbor" for forward-looking statements. In addition to historical information, certain information included in this discussion and other material filed or to be filed by the Company with the Securities and Exchange Commission (as well as information included in oral statements or other written statements made or to be made by the Company) may contain forward-looking statements that involve risks and uncertainties. The words "believes," "expects," "may," "will," "should," "projects," "contemplates," "anticipates," "forecasts," "intends," or similar terminology identify forward-looking statements. These statements reflect management's beliefs and assumptions, and are based on information currently available to management.

Economic circumstances, the Company's operations and actual results could differ significantly from those discussed in any forward-looking statements. Some of the factors that could cause or contribute to such differences are changes in the economy and interest rates either nationally or in the Company's market area, including the impact of the impairment of securities; political actions, including failure of the United States Congress to raise the federal debt ceiling or the imposition of changes in the federal budget; changes in customer preferences and consumer behavior; increased competitive pressures or changes in either the nature or composition of competitors; changes in the legal and regulatory environment; changes in factors influencing liquidity, such as expectations regarding the rate of inflation or deflation, currency exchange rates, and other factors influencing market volatility; changes in assumptions underlying the establishment of reserves for possible loan losses, reserves for repurchase of mortgage loans sold and other estimates; and risks associated with other global economic, political and financial factors.

While actual results may differ significantly from the results discussed in the forward-looking statements, the Company undertakes no obligation to update publicly any forward-looking statement for any reason, even if new information becomes available.

Analysis of Assets and Liabilities for the First Nine Months

Earning assets are comprised of investment securities, loans and deposits at financial institutions, including the Federal Reserve Bank. Earning assets were $495.1 million at September 30, 2013, a decrease of 3.6% from the September 30, 2012 balance of $513.4 million, and a decrease of 7.6% from the December 31, 2012 balance of $535.7 million. The decrease from December 31, 2012 was the net result of the following: an increase in deposits at the Federal Reserve of $1.9 million and a $4.9 million increase in deposits at other banks, a decrease in investment securities available for sale of $33.7 million offset by an increase in trading securities of $7.2 million, $20.7 million of 60-day loans redeemed during the first quarter of 2013 offset by a $13.5 million increase in the commercial real estate loan portfolio, and a $18.8 million decrease in loans held for sale. Total assets of $536.6 million at September 30, 2013 reflect a decrease of 3.2% from the prior year asset total of $554.5 million and a decrease of 7.8% from December 31, 2012 asset total of $582.2 million.

Total cash and cash equivalents decreased by $1.8 million from year-end and decreased by $15.1 million from the balance at September 30, 2012. The decrease from last year is mainly due to a decrease of $19.0 million in deposits at the Federal Reserve.

At September 30, 2013, the investment securities available for sale portfolio was $150.9 million compared to $184.6 million at December 31, 2012, a decrease of $33.7 million, or 18.3%. These securities decreased $24.1 million compared to September 30, 2012, or 13.8%. Investment securities represented 30.5% of earning assets at September 30, 2013, compared to 34.1% at September 30, 2012 and 34.5% at December 31, 2012. The decrease is partially due to aggregate sales of $28.7 million in securities, calls and paydowns of $33.9 million and purchases of $34.2 million in 2013. Securities sales of $16.5 million occurred near September 30, 2013 with reinvestment of the proceeds occurring in October. Immediately prior to this sale and subsequently in late October, investment securities available-for-sale were in excess of $160 million. As the Company manages its balance sheet for loan growth, asset mix, liquidity and current interest rates and interest rate forecasts, the investment portfolio is a primary source of liquidity. The investment securities available for sale portfolio represented 35.3% of each deposit dollar at September 30, 2013, down from 39.9% a year ago and level with 38.7% of year-end levels.


The investment securities available-for-sale portfolio had net unrealized losses of $5.8 million at September 30, 2013, an increase of $4.0 million compared to net unrealized losses of $1.8 million at September 30, 2012, and an increase of $3.2 million compared to net unrealized losses of $2.6 million at December 31, 2012. The third quarter rise in interest rates was the primary impetus for the valuation decline.

The Company's investment portfolio contains trust preferred securities, which have resulted in valuation charges against income of $171,000 in 2012 and none recorded in 2013. The Company continues to value these securities consistent with valuation techniques prescribed under accounting standards. The market for these securities and similar securities, which had been relatively active through 2003, became illiquid during the financial crisis of 2008 and is still currently not active. Since 2008, the Company has modeled and analyzed the cash flow characteristics and has concluded that a major portion of these devalued securities were not recoverable. In 2012, a portion of these securities were sold.

The Company has an investment in trading securities of $7.2 million at September 30, 2013, with none at December 31, 2012 or September 30, 2012. This modest allocation of the securities portfolio into obligations of state and political subdivisions and cash equivalent instruments is intended to diversify the earnings of the portfolio.

Loans held for sale decreased to $5.9 million at September 30, 2013 compared to $24.8 million at December 31, 2012 and $16.0 million at September 30, 2012. The variance is reflective of the recent decline in mortgage banking volume. The Company significantly curtailed its residential mortgage operations as of September 13th by exiting the wholesale arena and limiting residential mortgage lending operations to its retail banking footprint. See further discussion of this matter in the non-interest income and non-interest expense section.

Total loans at September 30, 2013 were $314.9 million compared to $293.2 million a year ago, a 7.4% increase, and $317.3 million at December 31, 2012, a 0.7% decrease. The Company continues its objective of shifting its asset mix into in-market commercial loans with the intent of improving net interest margin.

Total loans net of the allowance for losses increased by $21.4 million during the twelve month period from September 30, 2012 to September 30, 2013, and decreased by $2.5 million from December 31, 2012. Total gross loans as a percentage of earning assets stood at 63.6% as of September 30, 2013, 57.1% at September 30, 2012 and 59.2% as of December 31, 2012. The total loan-to-deposit ratio was 73.7% at September 30, 2013, 66.8% at September 30, 2012 and 66.5% at December 31, 2012. The decrease in loan balances from year-end was, as stated previously, due in part to 60-day term commercial loans for a total of $20.7 million that closed in December 2012 and were fully secured by segregated deposit accounts with the Bank. The loans matured in the first quarter of 2013. The decrease was offset in part by the increase in commercial real estate loans of $13.5 million. Exclusive of these 60-day term loans, the growth in loans from December 2012 to September 2013 was 6.2%.

At September 30, 2013, the loan loss allowance of $3.9 million represented approximately 1.25% of outstanding loans, and at September 30, 2012 the loan loss allowance of $3.6 million represented approximately 1.23% of outstanding loans. The loan loss allowance at December 31, 2012 of $3.8 million represented approximately 1.21% of outstanding loans, or 1.29% excluding the 60-day term loans to which none of the allowance is allocated.

During the first nine months, loan charge-offs were $655,000 in 2013 compared to $452,000 for the same period in 2012, while the recovery of previously charged-off loans amounted to $273,000 in 2013 and $111,000 in 2012. The net charge-offs represent 0.17% of average loans for 2013 and 0.16% for the same period in 2012. Charge-offs of specific problem loans, as well as for smaller balance homogeneous loans, are recorded periodically during the year. The number of loan accounts and the amount of charge-off associated with account balances vary from period to period as loans are deemed uncollectible by management.

Despite less than favorable economic conditions over the past several years, the Company has been able to grow its loan portfolio without experiencing any substantive deterioration in credit quality. Nonaccrual loans declined to $2.3 million at September 30, 2013, or 0.72%, of loans, versus $3.0 million, or 0.94%, of loans at December 31, 2012 and $3.8 million, or 1.3%, of loans at September 30, 2012. The Company's allowance for loan losses now covers 173% of nonaccrual loans at September 30, 2013 compared to 129% at December 31, 2012 and 96% at September 30, 2012.

Bank-owned life insurance had a cash surrender value of $15.0 million at September 30, 2013, $14.0 million at December 31, 2012 and $13.9 million at September 30, 2012. In the second quarter of 2013, the Company purchased $714,000 in bank-owned life insurance contributing to the majority of the increase.

Other assets increased to $14.0 million at September 30, 2013 from $11.2 million at December 31, 2012 and $12.6 million at September 30, 2012. Included in other assets in 2012 is a prepaid assessment paid to the FDIC in December of 2009. This prepayment was the estimate, based on projected assessment rates and assessment base, made by the FDIC of premiums due until December 31, 2012. On June 30, 2013, the unused portion of $1.1 million was returned to the Company. The balance was $1.2 million at


December 31, 2012 and $1.3 million at September 30, 2012. Other real estate decreased to $33,000 at September 30, 2013 compared to $145,000 at December 31, 2012 and $242,000 at September 30, 2012. Also included in other assets is deferred taxes of $5.6 million, $5.0 million and $2.8 million for the periods ended September 30, 2013, December 31, 2012 and September 30, 2012, respectively, Federal income tax receivable of $1.1 million, $1.9 million and $3.3 million for the periods ended September 30, 2013, December 31, 2012 and September 30, 2012, respectively, and securities sold to settle due from investment sales of $2.4 million and $291,000 for the periods ended September 30, 2013 and 2012, and none at December 31, 2012.

In 2013, a $1.9 million investment in a partnership fund is included in other assets with an offsetting $1.8 million in other liabilities, which is the commitment to fund this affordable housing investment. At September 30, 2012, the valuation gain related to the mortgage banking derivatives was a $1.7 million asset compared to $170,000 at September 30, 2013 and $531,000 at December 31, 2012.

Noninterest-bearing deposits measured $84.0 million at September 30, 2013 compared to $91.7 million at December 31, 2012 and $82.3 million at September 30, 2012. Interest-bearing deposits decreased $41.7 million to $343.5 million at September 30, 2013 from $385.2 million at December 31, 2012 and decreased $13.1 million from $356.6 million at September 30, 2012. The decrease in interest-bearing deposits from year end is due partly to segregated money market deposit accounts with the Bank which fully collateralized $20.7 million in 60-day term commercial loans that closed in December 2012. The loans matured and the deposits withdrew the first quarter of 2013. The remaining decrease is attributed to our customers' ultimate investment of, and payment of taxes on, the shale bonus funds awarded to them and deposited during the third and fourth quarters of 2012.

Federal Home Loan Bank advances and short-term borrowings stayed fairly consistent at $47.5 million at September 30, 2013 from $46.1 million at December 31, 2012 and increased from $41.7 million at September 30, 2012. Future maturities of long-term notes are expected to be paid off. Management continues to use short-term borrowings to bridge its current cash flow needs.

Other liabilities measured $7.3 million at September 30, 2013, $4.7 million at December 31, 2012 and $18.2 million at September 30, 2012. The increase at September 30, 2013 from December 31, 2012 is due to $1.8 million commitment to fund the affordable housing partnership fund previously described. The decrease from September 30, 2012 included $13.0 million in securities purchases traded in September 2012 but settled in October 2012.

The Company continued to maintain its capital levels in 2013. The Company's total shareholders' equity measured $50.6 million at September 30, 2012 and $49.5 million on December 31, 2012 to $49.1 million at September 30, 2013. The Company's capital continues to meet the requirements for the Company to be deemed well capitalized under all regulatory measures. The Company's total risk-based capital is $19.0 million in excess of the 10% threshold for the Company to be well-capitalized.

In October 2012, the Company announced the reinstatement of a cash dividend reflecting the growing confidence supported by stable core earnings, increasing loan production, and restored capital levels. Dividends of $.09 per share were paid to shareholders of record to date in 2013.

Capital Resources

Regulatory standards for measuring capital adequacy require banks and bank holding companies to maintain capital based on "risk-adjusted" assets so that categories of assets with potentially higher credit risk require more capital backing than assets with lower risk. In addition, banks and bank holding companies are required to maintain capital to support, on a risk-adjusted basis, certain off-balance sheet activities such as standby letters of credit and interest rate swaps.

The risk-based standards classify capital into two tiers. Tier 1 capital consists of common shareholders' equity, noncumulative and cumulative perpetual preferred stock, qualifying trust preferred securities and minority interests less intangibles, disallowed deferred tax assets and the unrealized market value adjustment of investment securities available-for-sale. Tier 2 capital consists of a limited amount of the allowance for loan and lease losses, perpetual preferred stock (not included in Tier 1), hybrid capital instruments, term subordinated debt, and intermediate-term preferred stock.

The FFIEC determines the risk weightings of direct credit substitutions that have been downgraded below investment grade. Included in the definition of a direct credit substitute are mezzanine and subordinated tranches of trust preferred securities and non-agency collateralized mortgage obligations. Following these guidelines results in an increase in total risk-weighted assets with an attendant decrease in the risk-based capital and Tier 1 risk-based capital ratios.

As a result of the decline in the value of the Bank's trust preferred securities, the regulatory capital levels of the Bank are lower than otherwise would be. As a result of investment downgrades by the rating agencies, all of the 12 trust preferred securities were rated as "highly speculative grade" debt securities. As a consequence, the Bank is required to maintain higher levels of regulatory risk-based


capital for these securities due to the greater perceived risk of default by the underlying bank and insurance company issuers. Specifically, regulatory guidance requires the Bank to apply a higher "risk weighting formula" for these securities to calculate its regulatory capital ratios. The result of that calculation increases the Bank's risk-weighted assets for these securities to $52.5 million, well above the $13.9 million in amortized cost of these securities as of September 30, 2013, thereby significantly diluting the risk-based capital ratios by approximately 1.49% for September 30, 2013 compared to 1.58% for December 31, 2012.

Regardless of the trust preferred securities risk weighting, the Company met all capital adequacy requirements to which it was subject as of September 30, 2013 and December 31, 2012, as supported by the data in the following table. As of those dates, the Company met the capital requirements to be deemed "well capitalized" under regulatory prompt corrective action provisions.

                    Actual Regulatory Capital                  Regulatory Capital Ratio
                          Ratios as of:                             Requirements:
              September 30,           December 31,            Well              Adequately
                   2013                   2012            Capitalized           Capitalized
Tier I
capital to
risk-weighted
assets                13.58  %                13.15 %             6.00 %                4.00 %
Total
risk-based
capital to
risk-weighted
assets                14.55  %                14.10 %            10.00 %                8.00 %
Tier I
capital to
average
assets                10.38  %                 9.63 %             5.00 %                4.00 %

Risk-based capital standards require a minimum ratio of 8.00% of qualifying total capital to risk-adjusted total assets with at least 4.00% constituting Tier 1 capital. Capital qualifying as Tier 2 capital is limited to 100.00% of Tier 1 capital. All banks and bank holding companies are also required to maintain a minimum leverage capital ratio (Tier 1 capital to total average assets) in the range of 3.00% to 4.00%, subject to regulatory guidelines.

The Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) requires banking regulatory agencies to revise risk-based capital standards to ensure that they adequately account for the following additional risks: interest rate, concentration of credit, and non-traditional activities. Accordingly, regulators will subjectively consider an institution's exposure to declines in the economic value of its capital due to changes in interest rates in evaluating capital adequacy. The following table illustrates the Company's components of risk weighted capital ratios and the excess over amounts considered well-capitalized at September 30, 2013 and December 31, 2012. Management considers these excesses to be adequate with regard to the risks inherent in the balance sheet.

                                               (Amounts in thousands)
                                        September 30,           December 31,
                                            2013                    2012
     Tier 1 Capital                    $        56,639         $       53,996
     Tier 2 Capital                              4,027                  3,909
     QUALIFYING CAPITAL                $        60,666         $       57,905
     Risk-Adjusted Total Assets (*)    $       416,961         $      410,773
     Tier 1 Risk- Based Capital Excess $        31,621         $       29,350
     Total Risk- Based Capital Excess           18,970                 16,828
     Total Leverage Capital Excess              29,366                 25,966

(*) Includes off-balance sheet exposures

Total assets for leverage capital purposes is calculated as average assets less disallowed deferred tax assets and the net unrealized market value adjustment of investment securities available-for-sale, averaged $545.5 million for the nine months ended September 30, 2013 and $560.6 million for the year ended December 31, 2012.

Regulations require that investments designated as available-for-sale are marked-to-market with corresponding entries to the deferred tax account and shareholders' equity. Regulatory agencies, however, exclude these adjustments in computing risk-based capital, as their inclusion would tend to increase the volatility of this important measure of capital adequacy.

In early September 2013, the regulatory bodies agreed on the provisions of Basel III which substantially revises the capital requirements for all banks, varying with the size of the institution. The new requirements are to be phased in over four years beginning in 2015. The Company is awaiting further clarification and interpretation of the rules before it can assess the future effect on capital.


Certain Non-GAAP Measures

Certain financial information has been determined by methods other than Generally Accepted Accounting Principles (GAAP). Specifically, certain financial measures are based on core earnings rather than net income. Core earnings exclude income, expense, gains and losses that either are not reflective of ongoing operations or that are not expected to reoccur with any regularity or reoccur with a high degree of uncertainty and volatility. Such information may be useful to both investors and management and can aid them in understanding the Company's current performance trends and financial condition. Core earnings are a supplemental tool for analysis and not a substitute for GAAP net income. Reconciliation from GAAP net income to the non-GAAP measure of core earnings is referenced as part of management's discussion and analysis of financial condition and results of operations.

Core earnings, which exclude the OTTI charge and certain other non-recurring items, decreased for the nine months ended September 30, 2013 as compared to the nine months ended September 30, 2012. Core earnings for the first nine months of 2013 were $2.6 million, or $0.56 per share, compared to $3.3 million, or $0.72 per share for the first nine months of 2012. Core earnings for the third quarter of 2013 were $794,000, or $0.18 per share, compared to $1.3 million, or $0.28 per share for the third quarter of 2012.

The following is the reconciliation between core earnings and earnings under
GAAP.

(Amounts in thousands, except per share amounts)

                                               THREE MONTHS ENDED                  NINE MONTHS ENDED
                                                  September 30,                      September 30,
                                           2013                2012             2013             2012
GAAP earnings                            $      617          $   1,266        $   2,246        $   3,377
Impairment losses on investment
securities (net of tax))                         -                  -                -               113
Investment gains not in the ordinary
course of business (net of tax)*                 -                  -                -               (20 )
Expenses related to reorganization-net
of tax                                           12                 -               143               -
Expenses related to curtailment of
mortgage banking activities (net of
tax)                                            165                 -               165               -
Net impact of historic tax credit
investment                                       -                  -                -              (190 )
Core earnings                            $      794          $   1,266        $   2,554        $   3,280
Core earnings per share                  $     0.18          $    0.28        $    0.56        $    0.72

* Gains in 2012 are due to the settlement on General Motors Corporation bonds.

Analysis of Net Interest Income - Nine months ended September 30, 2013 and 2012

Net interest income, the principal source of the Company's earnings, is the amount by which interest and fees generated by interest-earning assets, primarily loans and investment securities, exceeds the interest cost of deposits and borrowed funds. On a fully taxable equivalent basis, net interest income measured $12.9 million at September 30, 2013 and $13.1 million at September 30, 2012. During the recent reporting period the net interest margin registered 3.34% at September 30, 2013 and 3.62% at September 30, 2012.

The decrease in interest income, on a fully taxable equivalent basis, of $776,000 is the product of a 45 basis point decrease in interest rates earned offset somewhat by a 6.0% year-over-year increase in average earning assets. The decrease in interest expense of $491,000 was a product of a 19 basis point decrease in rates paid and a 3.4% increase in interest-bearing liabilities. The net result was a 2.2% decrease in net interest income on a fully taxable equivalent basis, and a 28 basis point decrease in the Company's net interest margin on a slightly larger asset base with a different mix.

On a fully taxable equivalent basis, income on investment securities available-for-sale decreased by $895,000, or 21.3%. The average invested balances in these securities decreased by $3.9 million, or 2.1%, from the levels of a year ago. The decrease in the average balance of investment securities was accompanied by a 60 basis point decrease in the tax equivalent yield of the portfolio. The Company will continue attempting to redeploy liquidity into loans. Any reinvestment into the securities portfolio will serve to decrease the yield due to the current low rate environment. The average balance of trading securities was $4.7 million with resulting income on a fully taxable equivalent basis of $146,000 during the first nine months of 2013, compared to none for the same period in 2012.

On a fully taxable equivalent basis, income on loans decreased by $33,000, or 0.3%, for the first nine months of 2013 compared to the same period in 2012. A $25.2 million increase in the average balance of the loan portfolio, or 8.6%, was accompanied by a 43 basis point decrease in the portfolio's tax equivalent yield. Likewise, new loan volume is at historic low interest rates, while strong competition for good credits also drives rates downward. The commercial loan portfolio housed the majority of the increase in balances.


Other interest income increased by $6,000, or 37.5%, from the same period a year ago. The average balance of interest-earning deposits increased by $3.2 million, or 43.3%. The yield did not change during the first nine months of 2013 compared to 2012. Management intends to remain fully invested, minimizing on-balance sheet liquidity.

As the Company is located in the heart of the Utica Shale geography, material deposit growth was experienced in the latter part of 2012 as a result of customers receiving signing bonuses for the lease of mineral rights. Nearly $40 million in new deposits has been attributed to these bonuses. In the first half of 2013, nearly half of these funds were withdrawn for customer utilization, ultimate market plays and presumably to pay taxes. Average interest-bearing . . .

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