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

Show all filings for CORTLAND BANCORP INC



Quarterly Report



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; changes in operations of CSB Mortgage Company (CSB) as a result of the activity in the residential real estate market; 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 Six Months

Earning assets are comprised of investment securities, loans and deposits at financial institutions, including the Federal Reserve Bank. Earning assets were $500.3 million at June 30, 2013, an increase of 2.9% from the June 30, 2012 balance of $486.2 million, and a decrease of 6.6% from the December 31, 2012 balance of $535.7 million. The decrease from December 31 was the net result of the following: an increase in deposits at the Federal Reserve of $1.8 million, a decrease in investment securities available for sale of $18.8 million offset by an increase in trading securities of $7.0 million, $20.7 million of 60-day loans redeemed during the first quarter of 2013, and a $10.3 million decrease in loans held for sale as a result of CSB Mortgage Company activity. Total assets of $537.8 million at June 30, 2013 reflect an increase of 2.9% from the one year ago asset total of $522.7 million and a decrease of 7.6% from December 31, 2012 asset total of $582.2 million.

Total cash and cash equivalents decreased by $9.4 million from year-end and increased by $1.1 million from the balance at June 30, 2012.

At June 30, 2013, the investment securities available for sale portfolio was $165.9 million compared to $184.6 million at December 31, 2012, a decrease of $18.8 million, or 10.2%. These securities decreased $11.4 million compared to June 30, 2012, or 6.4%. Investment securities represented 33.2% of earning assets at June 30, 2013, compared to 36.5% at June 30, 2012 and 34.5% at December 31, 2012. The decrease from one year ago is partially due to the sale of $3.5 million in trust preferred securities in September 2012. 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 38.5% of each deposit dollar at June 30, 2013, down from 42.8 % a year ago and level with 38.7% of year-end levels.

The investment securities available-for-sale portfolio had net unrealized losses of $5.5 million at June 30, 2013, an increase of $1.9 million compared to net unrealized losses of $3.6 million at June 30, 2012, and an increase of $2.9 million compared to net unrealized

losses of $2.6 million at December 31, 2012. The second 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 $13.7 million in 2009, $2.7 million in 2010, $202,000 in 2011, $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 $7.0 million at June 30, 2013, with none at December 31, 2012 or June 30, 2012. This modest allocation of the securities portfolio into a managed fund consisting of tax-free securities is intended to diversify the earnings of the portfolio.

Loans held for sale decreased to $14.5 million at June 30, 2013 compared to $24.8 million at December 31, 2012 and $14.9 million at June 30, 2012. The variance is reflective of the volume of mortgage banking activity, which most recently slowed with the increase in interest rates.

Total loans at June 30, 2013 were $301.9 million compared to $284.3 million a year ago, a 6.2% increase, and $317.3 million at December 31, 2012, a 4.8% 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 $16.8 million during the twelve month period from June 30, 2012 to June 30, 2013, and decreased by $15.7 million from December 31, 2012. Total gross loans as a percentage of earning assets stood at 60.3% as of June 30, 2013, 58.5% at June 30, 2012 and 59.2% as of December 31, 2012. The total loan-to-deposit ratio was 70.1% at June 30, 2013, 68.6% at June 30, 2012 and 66.5% at December 31, 2012. The decrease in loans 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. Exclusive of these 60-day term loans, the growth in loans from December 2012 to June 2013 was 1.8%.

At June 30, 2013, the loan loss allowance of $4.1 million represented approximately1.37% of outstanding loans, and at June 30, 2012 the loan loss allowance of $3.3 million represented approximately 1.17% 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 six months, loan charge-offs were $207,000 in 2013 compared to $382,000 for the same period in 2012, while the recovery of previously charged-off loans amounted to $177,000 in 2013 and $62,000 in 2012. The net charge-offs represent 0.02% of average loans for 2013 and 0.23% 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 $2.7 million at June 30, 2013, or 0.90%, of loans, versus $3.0 million, or 0.94%, of loans at December 31, 2012 and $5.2 million, or 1.52%, of loans at June 30, 2012. The Company's allowance for loan losses now covers 153% of nonaccrual loans at June 30, 2013 compared to 129% at December 31, 2012 and 64% at June 30, 2012.

Bank-owned life insurance had a cash surrender value of $14.9 million at June 30, 2013, $14.0 million at December 31, 2012 and $13.8 million at June 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 $12.8 million at June 30, 2013 from $11.2 million at December 31, 2012 and $12.2 million at June 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 June 30, 2012. Other real estate decreased to $87,000 at June 30, 2013 compared to $145,000 at December 31, 2012 and $316,000 at June 30, 2012. Also included in other assets is deferred taxes of $5.5 million, $5.0 million and $6.8 million for the periods ended June 30, 2013, December 31, 2012 and June 30, 2012, respectively, and Federal income tax receivable of $900,000, $1.9 million and $287,000 for the periods ended June 30, 2013, December 31, 2012 and June 30, 2012, respectively.

In 2013, a $2.0 million investment in a partnership fund is included in other assets with an offsetting $2.0 million in other liabilities, which is the commitment to fund this affordable housing investment. Also at June 30, 2013, the valuation gain related to the mortgage banking derivatives was a $1.4 million asset.

Noninterest-bearing deposits measured $84.1 million at June 30, 2013 compared to $91.7 million at December 31, 2012 and $74.4 million at June 30, 2012. Interest-bearing deposits decreased $38.3 million to $346.9 million at June 30, 2013 from $385.2 million at December 31, 2012 and increased $7.0 million from $339.9 million at June 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 the ultimate investment of, and payment of taxes on, the shale bonus funds deposited during the third and fourth quarters of 2012.

Federal Home Loan Bank advances and short-term borrowings stayed consistent at $45.7 million at June 30, 2013 from $46.1 million at December 31, 2012 and decreased from $50.6 million at June 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 $7.1 million at June 30, 2013, $4.7 million at December 31, 2012 and $4.5 million at June 30, 2012. The increase at June 30, 2013 is due to derivative valuations related to the mortgage banking operations and the $2.0 million commitment to fund the affordable housing partnership fund previously described.

The Company continued to maintain its capital levels in 2013. The Company's total shareholders' equity measured $48.1 million at June 30, 2012 and $49.5 million on December 31, 2012 to $48.9 million at June 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 $19.9 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. A dividend of $.06 per share was 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 $53.5 million, well above the $13.9 million in amortized cost of these securities as of June 30, 2013, thereby significantly diluting the risk-based capital ratios by approximately 1.59% for June 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 June 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:
                June 30,            December 31,            Well              Adequately
                  2013                  2012            Capitalized           Capitalized
Tier I capital
assets              13.81  %                13.15 %             6.00 %                4.00 %
capital to
assets              14.84  %                14.10 %            10.00 %                8.00 %
Tier I capital
to average
assets              10.29  %                 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 June 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)
                                           June 30,           December 31,
                                             2013                 2012
        Tier 1 Capital                    $   56,732         $       53,996
        Tier 2 Capital                         4,229                  3,909
        QUALIFYING CAPITAL                $   60,961         $       57,905
        Risk-Adjusted Total Assets (*)    $  410,657         $      410,773
        Tier 1 Risk- Based Capital Excess $   32,093         $       29,350
        Total Risk- Based Capital Excess      19,895                 16,828
        Total Leverage Capital Excess         29,178                 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, which averaged $551.0 million for the six months ended June 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 June 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 six months ended June 30, 2013 as compared to the six months ended June 30, 2012. Core earnings for the first six months of 2013 were $1.8 million, or $0.39 per share, compared to $2.0 million, or $0.45 per share for the first six months of 2012.

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

                                  (Amounts in thousands, except per share amounts)
                              THREE MONTHS ENDED                           SIX MONTHS ENDED
                                   June 30,                                    June 30,
                          2013                   2012                  2013                2012
GAAP earnings        $        799           $        952          $      1,629        $      2,111
Impairment losses
on investment
securities (net of
tax)                           -                      -                     -                  113
Investment gains
not in the
ordinary course of
business (net of
tax)*                          -                     (20   )                -                  (20  )
Expenses related
reorganization-net             84                     -                    131                  -
Net impact of
historic tax
credit investment              -                      -                     -                 (190  )
Core earnings        $        883           $        932          $      1,760        $      2,014
Core earnings per
share                $       0.20           $       0.21          $       0.39        $       0.45

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

Analysis of Net Interest Income - Six months ended June 30, 2013 and 2012

                                                                              (Amounts in thousands)
                                                        June 30, 2013                                         June 30, 2012
                                        Average                              Average          Average                              Average
                                        Balance           Interest             Rate           Balance           Interest             Rate
Interest-earning deposits and other
earning assets                         $   11,814         $      16               0.27 %     $    6,106         $      12               0.38 %
Investment securities(1)(2)(3)            182,057             2,245               2.47 %        186,134             2,984               3.21 %
Trading securities(1)(2)(3)                 3,518                62               3.56 %             -                 -                  -  %
Loans(1)(2)(3)                            321,406             8,002               5.00 %        287,338             7,916               5.52 %
Total interest-earning assets          $  518,795         $  10,325               3.99 %     $  479,578         $  10,912               4.55 %
Interest-bearing demand and money
market deposits                        $   93,397         $      93               0.20 %     $   80,460         $      65               0.16 %
Savings                                   120,280                44               0.08 %        101,593                51               0.10 %
Time                                      145,733               973               1.35 %        157,522             1,287               1.64 %
Total interest-bearing deposits           359,410             1,110               0.62 %        339,575             1,403               0.83 %
Other borrowings                           46,008               614               2.69 %         43,192               637               2.97 %
Subordinated debt                           5,155                45               1.77 %          5,155                51               1.94 %
Total interest-bearing liabilities     $  410,573         $   1,769               0.87 %     $  387,922         $   2,091               1.08 %
Net interest income                                       $   8,556                                             $   8,821
Net interest rate spread(4)                                                       3.12 %                                                3.47 %
Net interest margin(5)                                                            3.31 %                                                3.68 %

(1) Includes both taxable and tax exempt investment securities available-for-sale and loans and tax exempt trading securities.

(2) The amounts are presented on a fully taxable equivalent basis using the statutory tax rate of 34%, and have been adjusted to reflect the effect of disallowed interest expense related to carrying tax-exempt assets. The tax equivalent income adjustment for loans, investment securities available-for-sale and trading securities was $18,000, $303,000 and $21,000, respectively, for 2013 and $23,000, $357,000 and $0, respectively, for 2012.

(3) Average balance outstanding includes the average amount outstanding of all non-accrual investment securities and loans. Investment securities consist of average total principal adjusted for amortization of premium and accretion of discount and include both taxable and tax-exempt securities. Loans consist of average total loans, including loans held for sale, less average deferred fees and costs.

(4) Net interest rate spread represents the difference between the yield on earning assets and the rate paid on interest-bearing liabilities.

(5) Net interest margin is calculated by dividing the net interest income by total interest-earning assets.

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 $8.6 million at June 30, 2013 and $8.8 million at June 30, 2012. During the recent reporting period the net interest margin registered 3.31% at June 30, 2013 and 3.68% at June 30, 2012.

The decrease in interest income, on a fully taxable equivalent basis, of $587,000 is the product of a 56 basis point decrease in interest rates earned offset somewhat by a 8.2% year-over-year increase in average earning assets. The decrease in interest expense of $322,000 was a product of a 21 basis point decrease in rates paid and a 5.8% increase in interest-bearing liabilities. The net result was a 3.0% decrease in net interest income on a fully taxable . . .

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