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FMAO > SEC Filings for FMAO > Form 10-K on 26-Feb-2014All Recent SEC Filings

Show all filings for FARMERS & MERCHANTS BANCORP INC

Form 10-K for FARMERS & MERCHANTS BANCORP INC


26-Feb-2014

Annual Report


ITEM 7. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Critical Accounting Policy and Estimates

The Company's consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America, and the Company follows general practices within the financial services industry in which it operates. At times the application of these principles requires management to make assumptions, estimates and judgments that affect the amounts reported in the financial statements and accompanying notes. These assumptions, estimates and judgments are based on information available as of the date of the financial statements. As this information changes, the financial statements could reflect different assumptions, estimates and judgments. Certain policies inherently have a greater reliance on assumptions, estimates and judgments and as such have a greater


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possibility of producing results that could be materially different than originally reported. Examples of critical assumptions, estimates and judgments are when assets and liabilities are required to be recorded at fair value, when a decline in the value of an asset not required to be recorded at fair value warrants an impairment write-down or valuation reserve to be established, or when an asset or liability must be recorded contingent upon a future event.

All significant accounting policies followed by the Company are presented in Note 1 to the consolidated financial statements. These policies, along with the disclosures presented in the notes to the consolidated financial statements and in the management discussion and analysis of financial condition and results of operations, provide information on how significant assets and liabilities are valued and how those values are determined for the financial statements. Based on the valuation techniques used and the sensitivity of financial statement amounts to assumptions, estimates and judgments underlying those amounts, management has identified the determination of the Allowance for Loan and Lease Losses (ALLL) and the valuation of its Mortgage Servicing Rights (MSR) and Other Real Estate Owned (ORE) as the accounting areas that requires the most subjective or complex judgments, and as such could be the most subject to revision as new information becomes available.

Assets acquired through, or in lieu of, loan foreclosure are held for sale and are initially recorded at the lower of fair value or the loan carrying amount at the date of foreclosure. Subsequent to foreclosure, valuations are periodically performed by management and the assets are carried at the lower of carrying amount or fair value less cost to sell.

The ALLL represents management's estimate of credit losses inherent in the Bank's loan portfolio at the report date. The estimate is a composite of a variety of factors including experience, collateral value, and the general economy. ALLL includes a specific portion, a formula driven portion, and a general nonspecific portion. The collection and ultimate recovery of the book value of the collateral, in most cases, is beyond our control.

The Company is also required to estimate the value of its MSR. The Company recognizes as separate assets rights to service fixed rate single-family mortgage loans that it has sold without recourse but services for others for a fee. Mortgage servicing assets are initially recorded at cost, based upon pricing multiples as determined by the purchaser, when the loans are sold. Mortgage servicing assets are carried at the lower of the initial carrying value, adjusted for amortization, or estimated fair value. Amortization is determined in proportion to and over the period of estimated net servicing income using the level yield method. For purposes of determining impairment, the mortgage servicing assets are stratified into like groups based on loan type, term, new versus seasoned and interest rate. The valuation is completed by an independent third party.

The expected and actual rates of mortgage loan prepayments are the most significant factors driving the potential for the impairment of the value of mortgage servicing assets. Increases in mortgage loan prepayments reduce estimated future net servicing cash flows because the life of the underlying loan is reduced.

The Company's mortgage servicing rights relating to loans serviced for others represent an asset of the Company. This asset is initially capitalized and included in other assets on the Company's consolidated balance sheet. The mortgage servicing rights are then amortized against noninterest income in proportion to, and over the period of, the estimated future net servicing income of the underlying mortgage servicing rights. There are a number of factors, however, that can affect the ultimate value of the mortgage servicing rights to the Company, including the estimated prepayment speed of the loan and the discount rate used to present value the servicing right. For example, if the mortgage loan is prepaid, the Company will receive fewer servicing fees, meaning that the present value of the mortgage servicing rights is less than the carrying value of those rights on the Company's balance sheet. Therefore, in an attempt to reflect an accurate expected value to the Company of the mortgage servicing rights, the Company receives a valuation of its mortgage servicing rights from an independent third party. The independent third party's valuation of the mortgage servicing rights is based on relevant characteristics of the Company's loan servicing portfolio, such as loan terms, interest rates and recent national prepayment experience, as well as current national market interest rate levels, market forecasts and other economic conditions. Management, with the advice from its third party valuation firm, review the assumptions related to prepayment speeds, discount rates, and capitalized mortgage servicing income on a quarterly basis. Changes are reflected in the following quarter's analysis related to the mortgage servicing asset. In addition, based upon the independent third party's valuation of the Company's mortgage servicing rights, management then establishes a valuation allowance by each strata, if necessary, to quantify the likely impairment of the value of the mortgage servicing rights to the Company. The estimates of prepayment speeds and discount rates are inherently uncertain, and different estimates could have a material impact on the Company's net income and results of operations. The valuation allowance is evaluated and adjusted quarterly by management to reflect changes in the fair value of the underlying mortgage servicing rights based on market conditions. The accuracy of these estimates and assumptions by management and its third party can be directly tied back to the fact that management has not been required to record a valuation allowance through its income statement based upon the valuation of each stratum of serving rights.


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For more information regarding the estimates and calculations used to establish the ALLL and the value of Mortgage Servicing Rights, please see Note 1 to the consolidated financial statements provided herewith.

2013 in Review

Lower losses on sales of Other Assets owned coupled with lower cost of funds aided in the profitability performance of 2013. Holdings of Other Real Estate Owned "ORE" decreased through 2013 with a significant decrease in the last half of the year within a development property. Losses also decreased as previous write downs were realized in prior years. The loss on sale of Other Assets was $144 thousand for 2013 and $634 thousand in 2012. These were significantly both lower than 2011's loss of almost $1.2 million. The Bank continued to grow core deposits and decreased other borrowings and time deposits while also improving the cost of funds.

Loan growth occurred in the fourth quarter both from the acquisition of the Custar branch completed December 2013 and mainly through relationships developed in the Bank's newer markets. Due to the timing of the growth, 2013 was not as greatly impacted as 2014 will be. The net interest margin tightened slightly for the year though a slight improvement occurred in the four quarter.

2012's performance was bolstered by the gains on sales from real estate loans. Due to the low rate environment, the Company's customers were able to refinance their loans and lower their payments and/or reduce the term of the loan. This activity occurred in both the home loan and agricultural real estate markets. It accounts for a significant portion of the improvement in the noninterest income segment of the income statement. The net interest margin continued to tighten through the year as evidenced by the lower net interest income on the income statement. Negative loan growth was a contributing factor along with loss on yield from investments due to maturities and calls and lower reinvestment rate opportunities.

Charge-off activity in 2013 was higher than 2012 which was significantly lower than 2011. Asset quality improved and a record low of the ratio of past due loans to total loans was achieved in December 2013. Therefore, provision expense of $858 thousand for 2013 was only slightly higher than the $738 thousand recorded for 2012. In 2011, the Bank recorded $1.7 million in provision expense.

All rates remain low and are expected to remain low throughout 2014. This has enabled the Company to continue to sell investment securities and recognize a gain without compromising the yield. The transactions have modestly extended the duration of the investment portfolio. For 2013, the recognized gain was $775 thousand, which was lower than 2012's $852 thousand while higher than 2011's $504 thousand. Most of the securities sold were agencies maturing in a shorter time period than the securities that were purchased to replace them. The Bank was able to continue to capitalize on the steepness of the yield curve and the unrealized markets gain position the last three years. Sales in the fourth quarter of 2013 were used to fund loan growth. The market value of the security portfolio has reversed as evidenced by the large negative comprehensive income reported on the income statement. There is not much additional opportunity to sell investment securities for a gain at this time.

Overall, the increased profitability of 2013 and 2012 resulted primarily from the improvement in noninterest income. Noninterest income of 2013 was up 56.3% over 2011 and 2012 was 60.3% higher than 2011. Net income was down 8.0% compared to 2012 and was up 5.8% compared to 2011. The Company has done an exceptional job of recognizing opportunities to provide services and products that the low rate environment made possible. A commitment to improve asset quality over the years also benefited the Company during 2012 and 2013. These opportunities are further discussed in the Material Changes in Results of Operations. The Company remains strong, stable and well capitalized and has the capacity to continue to cover the increased costs of doing business in a tough economy while seeking good loans to improve profitability. The Company continues to look for new opportunities to generate and protect revenue and provide additional channels through which to serve our customers and maintain our high level of customer satisfaction.


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Material Changes in Results of Operations

Non-Interest Income

The discussion now turns to more financial based results and trends as a result of 2013 operations. In comparing line items of the consolidated statement of income for years ended 2011 through 2013, it is easy to see where the Company has been spending its time and the impact of the recession. Decreasing interest income and expense are obviously large factors relating to the profitability of the Company for 2013 and 2012; which is discussed in the section captioned Net Interest Income. This section will focus on the significant noninterest items that impacted the operations of the Company.

The Company has concerns with the increased costs associated with regulatory compliance, and possible loss of revenue from new regulations stemming from Dodd-Frank Act. History has proven the concern is justified. One area of revenue impacted was in overdraft fees. Updated Regulation E guidelines were implemented on August 15, 2010 and the Bank ended 2010 with a lower revenue stream by $22 thousand than 2009. This occurred even with the addition of the Hicksville office in July of 2010. 2011 also ended the year $20.8 thousand lower in overdraft fees than in 2010 even though every office recorded an increase in the number of checking accounts, and balances at year-end were $23 million higher than year-end 2010. At year-end 2012 and 2013, the number of checking accounts again increased along with the balances; however average collected overdraft fees per account decreased as compared to 2011. In the last two years, checking balances have increased $47.9 million and the number of checking accounts increased by 3,138, while average revenue per account continued to decline. Overdraft fees in 2013 accounted for $2.7 million in noninterest income. This represents 71.5% of the line item service charges and fees on the income statement. The Bank has made this an area of focus for 2014 as this revenue stream remains under intense regulator review.

2013 revenue improved $308 and $888 thousand from ATM/debit card usage as compared to 2012 and 2011, respectively. The Bank receives interchange revenue from each "swipe" of the card. Both increases are attributed to the growth and popularity of the Bank's KASASA checking product. One of the criteria for the payment of high interest on the account is utilizing the debit card at least twelve times per statement cycle. The Bank's KASASA checking customers averaged 31, 30 and 29 transactions per statement during 2013, 2012 and 2011 respectively, surpassing the 10 to 11 transactions average of our Free Checking customers. The additional revenue from debit card usage offsets the interest expense, creating a win-win situation for the customers and the Bank. In 2011, this revenue stream was at risk of being reduced by the Federal Reserve regulation of the interchange fee. The establishment of a tiered pricing for banks under $10 billion has helped to protect the profitability from such fees, although the concern remains as to how long this tiered pricing will remain in effect. All of the Bank KASASA products have a debit card usage qualification; however, interest income is not the customer benefit for all accounts. As an alternative to receiving interest on their deposits, customers may choose to receive credit towards iTunes downloads or donate earnings to charity. While this revenue stream continues to improve with more depositors using electronic methods for purchasing, the expense of fraud has offset much of the revenue gain. Further discussion can be found in the non-interest expense section regarding the net effect of debit card activity.

As discussed last year in the "2012 In Review", the largest positive impact on the income statement was derived from sales activity; including net loss on sale of other assets owned, net gain on sale of loans, and net gain on sale of securities. During 2012, the net gain on sale of loans, which is derived from sales of real estate loans into the secondary market, was the most significant factor for this category, and was $1.2 million higher than 2011. The gain on residential real estate loans accounted for $1.3 million and $725 thousand was derived from gain on sales of agricultural real estate. Both of these programs are offered to our customers to enable them to have a fixed rate loan and the Bank limiting its interest rate risk exposure. Of these loan types, the Bank sells 100% of the residential loans and 90% of the agricultural loans into the secondary market. In 2011, $387.6 and $28.4 thousand were the gains recorded for the sales of residential and agricultural real estate, respectively. 2013 activity did not reach the same high levels as 2012, though it did exceed 2011. Gains of $865 and $258 thousand were recorded for residential and agricultural real estate respectively for 2013. In conjunction with these sales, the Bank maintains servicing and those income amounts also increased during 2013 and 2012 and are included in the customer service fees line item. As the amount of loan balances being serviced increased so did the corresponding income. However, new sales in 2012 catapulted this income higher than 2013 or 2011. 2013 recognized servicing income of $1.1 million compared to 2012's recognized servicing income of $1.2 million which was $309.9 thousand higher than 2011.


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While net loss on sale of other assets owned, mainly OREO property, does not represent income for the years presented, the decrease in the amount of the loss for 2013 and 2012, as compared to 2011, does contribute to improved profitability. The loss of $634 thousand for 2012 and $1.2 million for 2011stems not only from sales but also from write-downs in the carrying value of those properties still held on the Bank's balance sheet. The number of properties decreased and the carrying value declined in 2013 to $2.1 million and 2012 to $2.3 million from $3.6 million in 2011.

The last line item in the noninterest income section as was discussed previously is the net gain on sale of investments. The Bank has taken advantage of this opportunity the last three years and expects to continue as long as the rates remain low and the yield curve is favorable to the transaction. The Bank will not increase short-term gain at the sacrifice of long-term profitability. Some of the $91 million in proceeds realized on the sale of securities in 2013 were used to fund loan growth. This is a source of funds that will continue to be analyzed for use in the coming year. Gains of $775 thousand were recorded for 2013 as compared to $852 and $504 thousand for 2012 and 2011 respectively.

Overall, noninterest income decreased $268 thousand in 2013 following a year where it had increased $4.2 million. Some of the additional revenue may not be easily duplicated as it is dependent on economic and market conditions to provide the opportunity. However, the increased revenue amounts from deposit and loan services should continue to provide improved profitability in the future. Gains on sales should also continue in the near term though when it will change is unknown at this time.

Moving to the expense side, overall, non-interest expense increased 2.1% in 2013 as compared to 2012 and was lower than the 6.0% increase of 2012 as in compared to 2011. The largest factor behind the higher 2012 level was the impact of employee benefit payments on the income statement. Employee benefits increased $453 thousand in 2012 over 2011; they decreased $69 thousand in 2013 compared to 2012. Three main components flow into employee benefits: payroll taxes, group health insurance, and pension expense. The Bank is partially self-insured and fluctuations in its costs are therefore caused by fluctuations in claims made by employees, along with the cost of insurance premiums. Employee's group insurance costs were higher in 2012 than 2011 by $314.1 thousand and continued to increase during 2013 to equal $1.7 million, which was $38.5 thousand higher than 2012. 2014 is predicted to increase again due to an increased cost of providing insurance coverage stemming from the implementation of the Affordable Care Act. The Bank offers a Health Savings Account (HSA) option. The Bank makes a contribution to the employees HSA along with a limited matching contribution to employee contributions. 2013's 401K expenses were $153.9 thousand lower than 2012 as the profit sharing percentage was lower at 4.5%. A higher profit-sharing contribution to the employees' 401K along with the matching contribution increased this expense by $88.5 thousand in 2012 over 2011. The profit-sharing percentages were 5% for 2012 and 4.5% for 2011. (For further discussion on incentive pay, see note 11 of the consolidated financial statements.)

Mentioned previously was the mortgage refinancing activity of the last three years. A correlating expense to that activity is the amortization of mortgage servicing rights. The income was discussed previously; the amortization is the expense that offsets the income recognized. These remain large line items on both the income and expense classification in the income statement. Income is recorded when the mortgage loan is first sold with servicing retained and is therefore recognized within one year. The amortization, however, is calculated over the life of the loan and accelerated as loans are paid off early. An increase in this expense can be driven by two activities: an increase in the number of sold loans and/or by the acceleration of the expense from payoff and refinance activity. The best picture of the bottom line impact is achieved by netting the income with the expense each year. 2013 had net income of only $2 thousand, 2011 had a net expense of $107 thousand and 2012 had net expense of $8 thousand. Of course, the value (or income) of the mortgage servicing right when sold also impacts the net position. With the much slower activity in 2011, the amortization expense was higher than the new rights being capitalized. While gain on sale of these loans was high in 2012, the net position was an expense indicating the activity was mainly refinance. 2013 had new loan activity and lower refinance activity making the additions and amortization almost equal. The number of loans and balances also indicates this as the levels have remained fairly constant. As of December 2013, there were 3,684 loans serviced with balances of $282.1 million. As of December 2012, there were 3,674 loans serviced with balances of $280.4 million. As of December 2011, there were 3,632 loans serviced with outstanding balance of $273.1 million. Amortization expense for 2013 was $426 thousand. Amortization expense for 2012 was $270 thousand higher than 2011 at $769 thousand.


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The impact of mortgage servicing rights to both noninterest income and expense is shown in the following table:

                                               (In Thousands)
                                             2013         2012
                    Beginning Year          $ 2,063      $ 2,071
                    Capitalized Additions       429          761
                    Amortization               (426 )       (769 )
                    Valuation Allowance          -            -

                    End of Year             $ 2,066      $ 2,063

Salaries and wages increased in 2013 with the addition of two offices and base wages increasing 4.46% or $408 thousand over 2012. Incentive pay was lower by $110.1 thousand as the Bank's performance was not up to the level of 2012, even though the number of employees receiving an incentive was higher.

Salaries and wages decreased $173 thousand in 2012 as compared to 2011. Base salary, incentive, compensation deferred costs from loans and restricted stock awards are compiled in this line item. One similarity between 2012 and 2011 is the increase in the incentive pay for those two years and is reflective of the Company outperforming its budget and performing better than the peer average. Deferred costs from loans, which is an offset to salary expense, was lower than 2012 by $181.5 thousand and 2012 was larger by $474 thousand than 2011. Again, 2012 is reflective of large refinancing activity of which 2013 experienced lower levels.

Occupancy expense decreased by $168 thousand in 2013 as compared to 2012. Although real estate taxes and building depreciation were higher, these were offset by lower insurance and utilities costs. Occupancy expense decreased by $82 thousand in 2012 as compared to 2011. The largest expense increase in 2012 occupancy expense was real estate taxes. The biggest factor driving the decrease in occupancy expense for both 2013 and 2012 was the increased rental income from the Bank's investment services. $217 thousand more was collected in 2013 as compared to 2012 and 2012 collected $80 thousand more than 2011.

Data processing expense increased $93 thousand during 2013 and by $141 thousand in 2012. The Company continues to investigate ways to reduce this expense. The pricing on many services, however, is based on number of accounts and the Bank fully expects those to increase with the addition of the Waterville and Custar offices and overall Bank growth.

The FDIC assessment decreased in 2012 as new regulation changed the method of calculation in the summer of 2011. 2012 represented the first full year under the new method. As can be seen, the change to calculations based on asset size rather than deposits has been very beneficial to F&M. 2013 was higher than 2012 as the Bank grew in size by $19.3 million over 2012.

The last line item in the noninterest expense is "other general and administrative". While it is higher by $449 thousand in 2013 following a large increase of $944 thousand in 2012 over 2011's $4.2 million, the fluctuation is not isolated to a single source. The primary factors impacting this fluctuation in 2013 are increases in both ATM expense and in legal and loan collection expenses. 2011 included a reimbursement of over $300 thousand in costs with the collection of one relationship that took three years to complete. The increased expense of $376.3 thousand relating to ATM and debit cards in 2013 over 2012 is caused by many factors. First, 2012 was lower due to incentive credits received by the Bank for switching providers and these credits were depleted early in 2013. Increased usage corresponds to increases in both revenue and cost. Finally, fraud increases cost as new cards have to be issued to limit the risk exposure. The fraud losses themselves are not recognized in this breakout, however the cost of replacement cards is. The Bank is not currently deploying chip technology within its cards; however the Bank is aware the adoption of embedded chips will increase this expense in the coming years.

Provision for loan losses is the last non-interest line item to discuss. The provision expense increased $120 thousand for 2013. The slight increase was needed to offset the loan growth in the fourth quarter and the net charge-off activity of 2013. Continued improvement in asset quality kept the provision expense lower than the growth alone would have warranted. The provision expense for 2012 was lower than for 2011 by $977 thousand. Net charge-offs of $888 and $605 thousand for 2013 and 2012, respectively, were considerably lower than the $1.7 million recorded for 2011. Commercial and Industrial loans had the largest charge-off activity in 2013 and 2011 while 2012 was impacted with higher levels in the consumer portfolios. Further analysis by loan type is presented in the discussion of the allowance for credit losses.


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Net Interest Income

The primary source of the Company's traditional banking revenue is net interest income. Net interest income is the difference between interest income on interest earning assets, such as loans and securities, and interest expense on liabilities used to fund those assets, such as interest bearing deposits and other borrowings. Net interest income is affected by changes in both interest rates and the amount and composition of earning assets and liabilities. The change in net interest income is most often measured as a result of two statistics - interest spread and net interest margin. The difference between the yields on earning assets and the rates paid for interest bearing liabilities . . .

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