Edgar Filing: AUBURN NATIONAL BANCORPORATION, INC

10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

x	Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.

For the quarterly period ended September 30, 2014

[ ]

Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.

For the transition period to

Commission File Number: 0-26486

Auburn National Bancorporation, Inc.

(Exact Name of Registrant as Specified in Its Charter)

Delaware

63-0885779

(State or other jurisdiction of

incorporation or organization)

(I.R.S. Employer

Identification No.)

100 N. Gay Street

Auburn, Alabama 36830

(334) 821-9200

(Address and telephone number of principal executive offices)

(Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes x No ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes x No ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):


Large Accelerated filer ¨	Accelerated filer ¨	Non-accelerated filer ¨	Smaller reporting company x
	(Do not check if a smaller reporting company)

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ¨ No x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.


Class		Outstanding at October 31, 2014
Common Stock, $0.01 par value per share		3,643,328 shares

AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARIES

INDEX


	PAGE
PART I. FINANCIAL INFORMATION

Item 1 Financial Statements

Consolidated Balance Sheets (Unaudited) as of September 30, 2014 and December 31, 2013		3

Consolidated Statements of Earnings (Unaudited) for the quarter and nine months ended September 30, 2014 and 2013		4

Consolidated Statements of Comprehensive Income (Unaudited) for the quarter and nine months ended September 30, 2014 and 2013		5

Consolidated Statements of Stockholders’ Equity (Unaudited) for the nine months ended September 30, 2014 and 2013		6

Consolidated Statements of Cash Flows (Unaudited) for the nine months ended September 30, 2014 and 2013		7

Notes to Consolidated Financial Statements (Unaudited)		8

Item 2 Management’s Discussion and Analysis of Financial Condition and Results of Operations		30

Table 1 – Explanation of Non-GAAP Financial Measures		48

Table 2 – Selected Quarterly Financial Data		49

Table 3 – Selected Financial Data		50

Table 4 – Average Balances and Net Interest Income Analysis – for the quarter ended September 30, 2014 and 2013		51

Table 5 – Average Balances and Net Interest Income Analysis – for the nine months ended September 30, 2014 and 2013		52

Table 6 – Loan Portfolio Composition		53

Table 7 – Allowance for Loan Losses and Nonperforming Assets		54

Table 8 – Allocation of Allowance for Loan Losses		55

Table 9 – CDs and Other Time Deposits of $100,000 or more		56

Item 3 Quantitative and Qualitative Disclosures About Market Risk		57

Item 4 Controls and Procedures		57

PART II. OTHER INFORMATION

Item 1 Legal Proceedings		57

Item 1A Risk Factors		57

Item 2 Unregistered Sales of Equity Securities and Use of Proceeds		57

Item 3 Defaults Upon Senior Securities		57

Item 4 Mine Safety Disclosures		57

Item 5 Other Information		57

Item 6 Exhibits		58

PART 1. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARIES

Consolidated Balance Sheets

(Unaudited)


(Dollars in thousands, except share data)	September 30, 2014			December 31, 2013

Assets:
Cash and due from banks	$	13,118		$	13,437
Federal funds sold		57,970			26,965
Interest bearing bank deposits		12,178			13,820

Cash and cash equivalents		83,266			54,222

Securities available-for-sale		264,827			271,219
Loans held for sale		3,521			2,296
Loans, net of unearned income		394,602			383,339
Allowance for loan losses		(4,754	)		(5,268)

Loans, net		389,848			378,071

Premises and equipment, net		10,175			10,442
Bank-owned life insurance		17,878			17,503
Other real estate owned		1,215			3,884
Other assets		10,406			13,706

Total assets	$	781,136		$	751,343

Liabilities:
Deposits:
Noninterest-bearing	$	127,472		$	125,740
Interest-bearing		553,291			543,104

Total deposits		680,763			668,844
Federal funds purchased and securities sold under agreements to repurchase		4,334			3,363
Long-term debt		12,217			12,217
Accrued expenses and other liabilities		10,629			2,434

Total liabilities		707,943			686,858

Stockholders’ equity:
Preferred stock of $.01 par value; authorized 200,000 shares; no issued shares		—			—
Common stock of $.01 par value; authorized 8,500,000 shares; issued 3,957,135 shares		39			39
Additional paid-in capital		3,763			3,759
Retained earnings		75,080			71,879
Accumulated other comprehensive income (loss), net		950			(4,552)
Less treasury stock, at cost - 313,807 shares and 314,017 shares at September 30, 2014 and December 31, 2013, respectively		(6,639)			(6,640)

Total stockholders’ equity		73,193			64,485

Total liabilities and stockholders’ equity	$	781,136		$	751,343

See accompanying notes to consolidated financial statements

AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARIES

Consolidated Statements of Earnings

(Unaudited)


	Quarter ended September 30,					Nine months ended September 30,

(In thousands, except share and per share data)	2014			2013		2014			2013

Interest income:
Loans, including fees	$	4,953		$	5,104	$	14,509		$	15,656
Securities:
Taxable		1,171			1,030		3,561			2,803
Tax-exempt		622			683		1,856			2,133
Federal funds sold and interest bearing bank deposits		33			39		105			99

Total interest income		6,779			6,856		20,031			20,691

Interest expense:
Deposits		1,221			1,344		3,733			4,097
Short-term borrowings		5			3		14			10
Long-term debt		105			239		313			941

Total interest expense		1,331			1,586		4,060			5,048

Net interest income		5,448			5,270		15,971			15,643
Provision for loan losses		300			—		(100)			400

Net interest income after provision for loan losses		5,148			5,270		16,071			15,243

Noninterest income:
Service charges on deposit accounts		228			224		660			707
Mortgage lending		534			750		1,268			2,397
Bank-owned life insurance		124			93		375			289
Other		366			365		1,081			1,086
Securities (losses) gains, net:
Realized (losses) gains, net		(235)			—		(197)			679
Total other-than-temporary impairments		—			—		(333)			—

Total securities (losses) gains, net		(235	)		—		(530	)		679

Total noninterest income		1,017			1,432		2,854			5,158

Noninterest expense:
Salaries and benefits		2,199			2,139		6,701			6,503
Net occupancy and equipment		346			346		1,039			1,010
Professional fees		204			197		635			582
FDIC and other regulatory assessments		125			130		399			467
Other real estate owned, net		(237)			68		(181)			111
Prepayment penalties on long-term debt		—			541		—			2,012
Other		947			853		2,731			2,539

Total noninterest expense		3,584			4,274		11,324			13,224

Earnings before income taxes		2,581			2,428		7,601			7,177
Income tax expense		709			636		2,049			1,789

Net earnings	$	1,872		$	1,792	$	5,552		$	5,388

Net earnings per share:
Basic and diluted	$	0.51		$	0.49	$	1.52		$	1.48

Weighted average shares outstanding:
Basic and diluted		3,643,328			3,643,028		3,643,262			3,642,967

See accompanying notes to consolidated financial statements

AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARIES

Consolidated Statements of Comprehensive Income

(Unaudited)


	Quarter ended September 30,				Nine months ended September 30,

(Dollars in thousands)	2014		2013		2014		2013

Net earnings	$	1,872	$	1,792	$	5,552	$	5,388

Other comprehensive (loss) income, net of tax:
Unrealized net holding (loss) gain on securities		(335)		(433)		5,167		(7,010)
Reclassification adjustment for net loss (gain) on securities recognized in net earnings		149		—		335		(428)

Other comprehensive (loss) income		(186)		(433)		5,502		(7,438)

Comprehensive income (loss)	$	1,686	$	1,359	$	11,054	$	(2,050)

See accompanying notes to consolidated financial statements

AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARIES

Consolidated Statements of Stockholders’ Equity

(Unaudited)


									Accumulated
					Additional				other
	Common Stock				paid-in		Retained		comprehensive		Treasury
(Dollars in thousands, except share data)	Shares		Amount		capital		earnings		(loss) income		stock		Total

Balance, December 31, 2012		3,957,135	$	39	$	3,756	$	67,821	$	5,174	$	(6,641)	$	70,149
Net earnings		—		—		—		5,388		—		—		5,388
Other comprehensive loss		—		—		—		—		(7,438)		—		(7,438)
Cash dividends paid ($0.63 per share)		—		—		—		(2,294)		—		—		(2,294)
Sale of treasury stock (155 shares)		—		—		2		—		—		—		2

Balance, September 30, 2013		3,957,135	$	39	$	3,758	$	70,915	$	(2,264)	$	(6,641)	$	65,807


Balance, December 31, 2013		3,957,135	$	39	$	3,759	$	71,879	$	(4,552)	$	(6,640)	$	64,485
Net earnings		—		—		—		5,552		—		—		5,552
Other comprehensive income		—		—		—		—		5,502		—		5,502
Cash dividends paid ($0.645 per share)		—		—		—		(2,351)		—		—		(2,351)
Sale of treasury stock (210 shares)		—		—		4		—		—		1		5

Balance, September 30, 2014		3,957,135	$	39	$	3,763	$	75,080	$	950	$	(6,639)	$	73,193

See accompanying notes to consolidated financial statements

AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows

(Unaudited)


	Nine months ended September 30,
(In thousands)	2014		2013

Cash flows from operating activities:
Net earnings	$	5,552	$	5,388
Adjustments to reconcile net earnings to net cash provided by operating activities:
Provision for loan losses		(100)		400
Depreciation and amortization		557		639
Premium amortization and discount accretion, net		1,150		1,620
Net loss (gain) on securities available-for-sale		530		(679)
Net gain on sale of loans held for sale		(880)		(1,693)
Increase (decrease) in MSR valuation allowance		31		(373)
Net (gain) loss on other real estate owned		(204)		13
Loss on prepayment of long-term debt		—		2,012
Loans originated for sale		(44,185)		(80,169)
Proceeds from sale of loans		43,469		81,689
Increase in cash surrender value of bank owned life insurance		(375)		(289)
Net (increase) decrease in other assets		(82)		2,392
Net increase in accrued expenses and other liabilities		8,200		455

Net cash provided by operating activities		13,663		11,405


Cash flows from investing activities:
Proceeds from sales of securities available-for-sale		37,132		38,614
Proceeds from maturities of securities available-for-sale		47,241		48,588
Purchase of securities available-for-sale		(70,943)		(99,923)
(Increase) decrease in loans, net		(12,126)		14,033
Net purchases of premises and equipment		(19)		(516)
Decrease in FHLB stock		235		1,153
Proceeds from sale of other real estate owned		3,322		2,599

Net cash provided by investing activities		4,842		4,548


Cash flows from financing activities:
Net increase in noninterest-bearing deposits		1,732		951
Net increase in interest-bearing deposits		10,187		12,653
Net increase in federal funds purchased and securities sold under agreements to repurchase		971		54
Repayments or retirement of long-term debt		—		(27,012)
Dividends paid		(2,351)		(2,294)

Net cash provided by (used in) financing activities		10,539		(15,648)

Net change in cash and cash equivalents		29,044		305
Cash and cash equivalents at beginning of period		54,222		61,949

Cash and cash equivalents at end of period	$	83,266	$	62,254



Supplemental disclosures of cash flow information:
Cash paid during the period for:
Interest	$	4,125	$	5,228
Income taxes		963		258
Supplemental disclosure of non-cash transactions:
Real estate acquired through foreclosure		449		2,278

See accompanying notes to consolidated financial statements

AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Unaudited)

NOTE 1: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

General

Auburn National Bancorporation, Inc. (the “Company”) provides a full range of banking services to individual and corporate customers in Lee County, Alabama and surrounding counties through its wholly owned subsidiary, AuburnBank (the “Bank”). The Company does not have any segments other than banking that are considered material.

Basis of Presentation and Use of Estimates

The unaudited consolidated financial statements in this report have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) for interim financial information. Accordingly, these financial statements do not include all of the information and footnotes required by U.S. GAAP for complete financial statements. The unaudited consolidated financial statements include, in the opinion of management, all adjustments necessary to present a fair statement of the financial position and the results of operations for all periods presented. All such adjustments are of a normal recurring nature. The results of operations in the interim statements are not necessarily indicative of the results of operations that the Company and its subsidiaries may achieve for future interim periods or the entire year. For further information, refer to the consolidated financial statements and footnotes included in the Company’s annual report on Form 10-K for the year ended December 31, 2013.

The unaudited consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. Auburn National Bancorporation Capital Trust I is an affiliate of the Company and was included in these unaudited consolidated financial statements pursuant to the equity method of accounting. Significant intercompany transactions and accounts are eliminated in consolidation.

The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities as of the balance sheet date and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term include other-than-temporary impairment on investment securities, the determination of the allowance for loan losses, fair value of financial instruments, and the valuation of deferred tax assets and other real estate owned.

Reclassifications

Certain amounts reported in prior periods have been reclassified to conform to the current-period presentation. These reclassifications had no impact on the Company’s previously reported net earnings or total stockholders’ equity.

Subsequent Events

The Company has evaluated the effects of events and transactions through the date of this filing that have occurred subsequent to September 30, 2014. The Company does not believe there were any material subsequent events during this period that would have required further recognition or disclosure in the unaudited consolidated financial statements included in this report.

Accounting Developments

In the first quarter of 2014, the Company adopted new guidance related to the following Accounting Standards Update (“Update” or “ASU”):

•

ASU 2013-11, Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists.

Information about this pronouncement is described in more detail below.

ASU 2013-11, Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists, is expected to eliminate diversity in practice as it provides guidance on financial statement presentation of an unrecognized tax benefit when a net operating loss (NOL) carryforward, a similar tax loss, or a tax credit carryforward exists. The changes were effective for the Company during the first quarter of 2014. Adoption of this ASU had no impact on the financial statements of the Company.

NOTE 2: BASIC AND DILUTED EARNINGS PER SHARE

Basic net earnings per share is computed by dividing net earnings by the weighted average common shares outstanding for the respective period. Diluted net earnings per share reflect the potential dilution that could occur upon exercise of securities or other rights for, or convertible into, shares of the Company’s common stock. At September 30, 2014 and 2013, respectively, the Company had no such securities or rights issued or outstanding, and therefore, no dilutive effect to consider for the diluted earnings per share calculation.

The basic and diluted earnings per share computations for the respective periods are presented below.


	Quarter ended September 30,				Nine months ended September 30,
(In thousands, except share and per share data)	2014		2013		2014		2013

Basic and diluted:
Net earnings	$	1,872	$	1,792	$	5,552	$	5,388
Weighted average common shares outstanding		3,643,328		3,643,028		3,643,262		3,642,967

Earnings per share	$	0.51	$	0.49	$	1.52	$	1.48

NOTE 3: VARIABLE INTEREST ENTITIES

Generally, a variable interest entity (“VIE”) is a corporation, partnership, trust or other legal structure that does not have equity investors with substantive or proportional voting rights or has equity investors that do not provide sufficient financial resources for the entity to support its activities.

At September 30, 2014, the Company did not have any consolidated VIEs to disclose but did have one nonconsolidated VIE, discussed below.

Trust Preferred Securities

The Company owns the common stock of a subsidiary business trust, Auburn National Bancorporation Capital Trust I, which issued mandatorily redeemable preferred capital securities (“trust preferred securities”) in the aggregate of approximately $7.0 million at the time of issuance. This trust meets the definition of a VIE of which the Company is not the primary beneficiary; the trust’s only assets are junior subordinated debentures issued by the Company, which were acquired by the trust using the proceeds from the issuance of the trust preferred securities and common stock. The junior subordinated debentures of approximately $7.2 million are included in long-term debt and the Company’s equity interest of $0.2 million in the business trust is included in other assets. Interest expense on the junior subordinated debentures is included in interest expense on long-term debt.

The following table summarizes VIEs that are not consolidated by the Company as of September 30, 2014.


(Dollars in thousands)	Maximum Loss Exposure		Liability Recognized		Classification

Type:
Trust preferred issuances		N/A		$ 7,217	Long-term debt

NOTE 4: SECURITIES

At September 30, 2014 and December 31, 2013, respectively, all securities within the scope of ASC 320, Investments – Debt and Equity Securities, were classified as available-for-sale. The fair value and amortized cost for securities available-for-sale by contractual maturity at September 30, 2014 and December 31, 2013, respectively, are presented below.


	1 year		1 to 5		5 to 10		After 10		Fair		Gross Unrealized				Amortized
(Dollars in thousands)	or less		years		years		years		Value		Gains		Losses		Cost

September 30, 2014
Agency obligations (a)	$	—		25,753		19,682		14,068		59,503		146		1,373	$	60,730
Agency RMBS (a)		—		—		6,958		132,226		139,184		1,064		1,545		139,665
State and political subdivisions		—		507		16,197		49,436		66,140		3,217		5		62,928

Total available-for-sale	$	—		26,260		42,837		195,730		264,827		4,427		2,923	$	263,323

December 31, 2013
Agency obligations (a)	$	—		—		23,247		21,275		44,522		—		4,557	$	49,079
Agency RMBS (a)		—		—		8,306		154,052		162,358		976		4,733		166,115
State and political subdivisions		—		1,735		21,366		41,238		64,339		1,560		459		63,238

Total available-for-sale	$	—		1,735		52,919		216,565		271,219		2,536		9,749	$	278,432

(a)	Includes securities issued by U.S. government agencies or government sponsored entities.

Securities with aggregate fair values of $119.7 million and $120.5 million at September 30, 2014 and December 31, 2013, respectively, were pledged to secure public deposits, securities sold under agreements to repurchase, Federal Home Loan Bank (“FHLB”) advances, and for other purposes required or permitted by law.

Included in other assets are cost-method investments. The carrying amounts of cost-method investments were $1.6 million and $1.8 million at September 30, 2014 and December 31, 2013, respectively. Cost-method investments primarily include non-marketable equity investments, such as FHLB of Atlanta stock and Federal Reserve Bank (“FRB”) stock.

Gross Unrealized Losses and Fair Value

The fair values and gross unrealized losses on securities at September 30, 2014 and December 31, 2013, respectively, segregated by those securities that have been in an unrealized loss position for less than 12 months and 12 months or longer, are presented below.


	Less than 12 Months				12 Months or Longer				Total
(Dollars in thousands)	Fair Value		Unrealized Losses		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses

September 30, 2014:
Agency obligations	$	17,494		28		23,609		1,345	$	41,103		1,373
Agency RMBS		25,730		62		52,358		1,483		78,088		1,545
State and political subdivisions		670		4		769		1		1,439		5

Total	$	43,894		94		76,736		2,829	$	120,630		2,923

December 31, 2013:
Agency obligations	$	35,933		3,182		8,590		1,376	$	44,523		4,558
Agency RMBS		109,774		4,393		7,683		339		117,457		4,732
State and political subdivisions		9,575		459		—		—		9,575		459

Total	$	155,282		8,034		16,273		1,715	$	171,555		9,749

For the securities in the previous table, the Company does not have the intent to sell and has determined it is not more likely than not that the Company will be required to sell the security before recovery of the amortized cost basis, which may be maturity. On a quarterly basis, the Company assesses each security for credit impairment. For debt securities, the Company evaluates, where necessary, whether credit impairment exists by comparing the present value of the expected cash flows to the securities’ amortized cost basis. For cost-method investments, the Company evaluates whether an event or change in circumstances has occurred during the reporting period that may have a significant adverse effect on the fair value of the investment.

In determining whether a loss is temporary, the Company considers all relevant information including:

•

the length of time and the extent to which the fair value has been less than the amortized cost basis;

•

adverse conditions specifically related to the security, an industry, or a geographic area (for example, changes in the financial condition of the issuer of the security, or in the case of an asset-backed debt security, in the financial condition of the underlying loan obligors, including changes in technology or the discontinuance of a segment of the business that may affect the future earnings potential of the issuer or underlying loan obligors of the security or changes in the quality of the credit enhancement);

•

the historical and implied volatility of the fair value of the security;

•

the payment structure of the debt security and the likelihood of the issuer being able to make payments that increase in the future;

•

failure of the issuer of the security to make scheduled interest or principal payments;

•

any changes to the rating of the security by a rating agency; and

•

recoveries or additional declines in fair value subsequent to the balance sheet date.

Agency obligations

The unrealized losses associated with agency obligations were primarily driven by changes in interest rates and not due to the credit quality of the securities. These securities were issued by U.S. government agencies or government-sponsored entities and did not have any credit losses given the explicit government guarantee or other government support.

Agency RMBS

The unrealized losses associated with agency residential mortgage-backed securities (“RMBS”) were primarily driven by changes in interest rates and not due to the credit quality of the securities. These securities were issued by U.S. government agencies or government-sponsored entities and did not have any credit losses given the explicit government guarantee or other government support.

Securities of U.S. states and political subdivisions

The unrealized losses associated with securities of U.S. states and political subdivisions were primarily driven by changes in interest rates and were not due to the credit quality of the securities. Some of these securities are guaranteed by a bond insurer, but management did not rely on the guarantee in making its investment decision. These securities will continue to be monitored as part of the Company’s quarterly impairment analysis, but are expected to perform even if the rating agencies reduce the credit rating of the bond insurers. As a result, the Company expects to recover the entire amortized cost basis of these securities.

Cost-method investments

At September 30, 2014, cost-method investments with an aggregate cost of $1.6 million were not evaluated for impairment because the Company did not identify any events or changes in circumstances that may have a significant adverse effect on the fair value of these cost-method investments.

The carrying values of the Company’s investment securities could decline in the future if the financial condition of an issuer deteriorates and the Company determines it is probable that it will not recover the entire amortized cost basis for the security. As a result, there is a risk that other-than-temporary impairment charges may occur in the future.

Other-Than-Temporarily Impaired Securities

The following table presents a roll-forward of the credit loss component of the amortized cost of debt securities that the Company has written down for other-than-temporary impairment and has recognized the credit component of the loss in earnings (referred to as “credit-impaired” debt securities). Other-than-temporary impairments recognized in earnings for credit-impaired debt securities are presented as additions in two components based upon whether the current period is the first time the debt security was credit-impaired (initial credit impairment) or is not the first time the debt security was credit-impaired (subsequent credit impairments). The credit loss component is reduced if the Company sells, intends to sell, or believes it will be required to sell previously credit-impaired debt securities. Additionally, the credit loss component is reduced if the Company receives cash flows in excess of what it expected to receive over the remaining life of the credit-impaired debt security, the security matures or the security is fully written-down and deemed worthless. Changes in the credit loss component of credit-impaired debt securities for the respective periods are presented below.


	Quarter ended September 30,				Nine months ended September 30,
(Dollars in thousands)	2014		2013		2014		2013

Balance, beginning of period Reductions:	$	—	$	757	$	—	$	1,257
Securities fully written down and deemed worthless		—		—		—		500

Balance, end of period	$	—	$	757	$	—	$	757

Other-Than-Temporary Impairment

The following table presents details of the other-than-temporary impairment related to securities.


	Quarter ended September 30,				Nine months ended September 30,
(Dollars in thousands)	2014		2013		2014		2013

Other-than-temporary impairment charges
Debt securities:
Agency RMBS	$	—	$	—	$	333	$	—

Total debt securities		—		—		333		—

Total other-than-temporary impairment charges	$	—	$	—	$	333	$	—

Other-than-temporary impairment on debt securities:
Recorded as part of gross realized losses:
Securities with intent to sell		—		—		333		—

Total other-than-temporary impairment on debt securities	$	—	$	—	$	333	$	—

Realized Gains and Losses

The following table presents the gross realized gains and losses on sales and other-than-temporary impairment charges related to securities.


	Quarter ended September 30,				Nine months ended September 30,
(Dollars in thousands)	2014		2013		2014		2013

Gross realized gains	$	429	$	—	$	467	$	685
Gross realized losses		(664)		—		(664)		(6)
Other-than-temporary impairment charges		—		—		(333)		—

Realized (losses) gains, net	$	(235)	$	—	$	(530)	$	679

NOTE 5: LOANS AND ALLOWANCE FOR LOAN LOSSES


	September 30,		December 31,
(In thousands)	2014		2013
Commercial and industrial	$	52,868	$	57,780
Construction and land development		34,189		36,479
Commercial real estate:
Owner occupied		51,836		56,102
Other		138,241		118,818

Total commercial real estate		190,077		174,920
Residential real estate:
Consumer mortgage		63,863		57,871
Investment property		42,692		43,835

Total residential real estate		106,555		101,706
Consumer installment		11,535		12,893

Total loans		395,224		383,778
Less: unearned income		(622)		(439)

Loans, net of unearned income	$	394,602	$	383,339

Loans secured by real estate were approximately 83.7% of the Company’s total loan portfolio at September 30, 2014. At September 30, 2014, the Company’s geographic loan distribution was concentrated primarily in Lee County, Alabama and surrounding areas.

In accordance with ASC 310, a portfolio segment is defined as the level at which an entity develops and documents a systematic method for determining its allowance for loan losses. As part of the Company’s quarterly assessment of the allowance, the loan portfolio is disaggregated into the following portfolio segments: commercial and industrial, construction and land development, commercial real estate, residential real estate and consumer installment. Where appropriate, the Company’s loan portfolio segments are further disaggregated into classes. A class is generally determined based on the initial measurement attribute, risk characteristics of the loan, and an entity’s method for monitoring and determining credit risk.

The following describe the risk characteristics relevant to each of the portfolio segments and classes.

Commercial and industrial (“C&I”) — includes loans to finance business operations, equipment purchases, or other needs for small and medium-sized commercial customers. Also included in this category are loans to finance agricultural production. Generally the primary source of repayment is the cash flow from business operations and activities of the borrower.

Construction and land development (“C&D”) — includes both loans and credit lines for the purpose of purchasing, carrying and developing land into commercial developments or residential subdivisions. Also included are loans and lines for construction of residential, multi-family and commercial buildings. Generally the primary source of repayment is dependent upon the sale or refinance of the real estate collateral.

Commercial real estate (“CRE”) — includes loans disaggregated into two classes: (1) owner occupied and (2) other.

Owner occupied – includes loans secured by business facilities to finance business operations, equipment and owner-occupied facilities primarily for small and medium-sized commercial customers. Generally the primary source of repayment is the cash flow from business operations and activities of the borrower, who owns the property.

Other – primarily includes loans to finance income-producing commercial and multi-family properties that are not owner occupied. Loans in this class include loans for neighborhood retail centers, hotels, medical and professional offices, single retail stores, industrial buildings, warehouses and apartments leased generally to local businesses and residents. Generally the primary source of repayment is dependent upon income generated from the real estate collateral. The underwriting of these loans takes into consideration the occupancy and rental rates, as well as the financial health of the borrower.

Residential real estate (“RRE”) — includes loans disaggregated into two classes: (1) consumer mortgage and (2) investment property.

Consumer mortgage – primarily includes first or second lien mortgages and home equity lines of credit to consumers that are secured by a primary residence or second home. These loans are underwritten in accordance with the Bank’s general loan policies and procedures which require, among other things, proper documentation of each borrower’s financial condition, satisfactory credit history and property value.

Investment property – primarily includes loans to finance income-producing 1-4 family residential properties. Generally the primary source of repayment is dependent upon income generated from leasing the property securing the loan. The underwriting of these loans takes into consideration the rental rates and property value, as well as the financial health of the borrower.

Consumer installment — includes loans to individuals both secured by personal property and unsecured. Loans include personal lines of credit, automobile loans, and other retail loans. These loans are underwritten in accordance with the Bank’s general loan policies and procedures which require, among other things, proper documentation of each borrower’s financial condition, satisfactory credit history, and if applicable, property value.

The following is a summary of current, accruing past due and nonaccrual loans by portfolio segment and class as of September 30, 2014, and December 31, 2013.


			Accruing		Accruing		Total
			30-89 Days		Greater than		Accruing		Non-		Total
(In thousands)	Current		Past Due		90 days		Loans		Accrual		Loans

September 30, 2014:
Commercial and industrial	$	52,567		245		—		52,812		56	$	52,868
Construction and land development		33,384		190		—		33,574		615		34,189
Commercial real estate:
Owner occupied		51,361		203		—		51,564		272		51,836
Other		138,031		—		—		138,031		210		138,241
Total commercial real estate		189,392		203		—		189,595		482		190,077
Residential real estate:
Consumer mortgage		63,537		12		25		63,574		289		63,863
Investment property		42,188		209		51		42,448		244		42,692
Total residential real estate		105,725		221		76		106,022		533		106,555
Consumer installment		11,472		59		—		11,531		4		11,535
Total	$	392,540		918		76		393,534		1,690	$	395,224


December 31, 2013:
Commercial and industrial	$	57,558		167		—		57,725		55	$	57,780
Construction and land development		34,883		14		—		34,897		1,582		36,479
Commercial real estate:
Owner occupied		54,214		861		—		55,075		1,027		56,102
Other		118,389		—		—		118,389		429		118,818
Total commercial real estate		172,603		861		—		173,464		1,456		174,920
Residential real estate:
Consumer mortgage		56,191		745		69		57,005		866		57,871
Investment property		42,935		598		—		43,533		302		43,835
Total residential real estate		99,126		1,343		69		100,538		1,168		101,706
Consumer installment		12,789		100		4		12,893		—		12,893
Total	$	376,959		2,485		73		379,517		4,261	$	383,778

Allowance for Loan Losses

The Company assesses the adequacy of its allowance for loan losses prior to the end of each calendar quarter. The level of the allowance is based upon management’s evaluation of the loan portfolio, past loan loss experience, current asset quality trends, known and inherent risks in the portfolio, adverse situations that may affect a borrower’s ability to repay (including the timing of future payment), the estimated value of any underlying collateral, composition of the loan portfolio, economic conditions, industry and peer bank loan loss rates and other pertinent factors, including regulatory recommendations. This evaluation is inherently subjective as it requires material estimates including the amounts and timing of future cash flows expected to be received on impaired loans that may be susceptible to significant change. Loans are charged off, in whole or in part, when management believes that the full collectability of the loan is unlikely. A loan may be partially charged-off after a “confirming event” has occurred which serves to validate that full repayment pursuant to the terms of the loan is unlikely.

The Company deems loans impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. Collection of all amounts due according to the contractual terms means that both the interest and principal payments of a loan will be collected as scheduled in the loan agreement.

An impairment allowance is recognized if the fair value of the loan is less than the recorded investment in the loan. The impairment is recognized through the allowance. Loans that are impaired are recorded at the present value of expected future cash flows discounted at the loan’s effective interest rate, or if the loan is collateral dependent, impairment measurement is based on the fair value of the collateral, less estimated disposal costs.

The level of allowance maintained is believed by management to be adequate to absorb probable losses inherent in the portfolio at the balance sheet date. The allowance is increased by provisions charged to expense and decreased by charge-offs, net of recoveries of amounts previously charged-off.

In assessing the adequacy of the allowance, the Company also considers the results of its ongoing internal and independent loan review processes. The Company’s loan review process assists in determining whether there are loans in the portfolio whose credit quality has weakened over time and evaluating the risk characteristics of the entire loan portfolio. The Company’s loan review process includes the judgment of management, the input from our independent loan reviewers, and reviews that may have been conducted by bank regulatory agencies as part of their examination process. The Company incorporates loan review results in the determination of whether or not it is probable that it will be able to collect all amounts due according to the contractual terms of a loan.

As part of the Company’s quarterly assessment of the allowance, management divides the loan portfolio into five segments: commercial and industrial, construction and land development, commercial real estate, residential real estate, and consumer installment loans. The Company analyzes each segment and estimates an allowance allocation for each loan segment.

The allocation of the allowance for loan losses begins with a process of estimating the probable losses inherent for these types of loans. The estimates for these loans are established by category and based on the Company’s internal system of credit risk ratings and historical loss data. The estimated loan loss allocation rate for the Company’s internal system of credit risk grades is based on its experience with similarly graded loans. For loan segments where the Company believes it does not have sufficient historical loss data, the Company may make adjustments based, in part, on loss rates of peer bank groups. At September 30, 2014 and December 31, 2013, and for the periods then ended, the Company adjusted its historical loss rates for the commercial real estate portfolio segment based, in part, on loss rates of peer bank groups.

The estimated loan loss allocation for all five loan portfolio segments is then adjusted for management’s estimate of probable losses for several “qualitative and environmental” factors. The allocation for qualitative and environmental factors is particularly subjective and does not lend itself to exact mathematical calculation. This amount represents estimated probable inherent credit losses which exist, but have not yet been identified, as of the balance sheet date, and are based upon quarterly trend assessments in delinquent and nonaccrual loans, credit concentration changes, prevailing economic conditions, changes in lending personnel experience, changes in lending policies or procedures and other influencing factors. These qualitative and environmental factors are considered for each of the five loan segments and the allowance allocation, as determined by the processes noted above, is increased or decreased based on the incremental assessment of these factors.

The Company regularly re-evaluates its practices in determining the allowance for loan losses. During 2014 and 2013, the Company implemented certain refinements to its allowance for loan losses methodology, specifically the way that historical loss factors are calculated. Beginning with the quarter ended June 30, 2014, the Company calculated average losses for all loan segments using a rolling 20 quarter historical period in order to better capture the effects of the most

recent economic cycle on the Company’s loan loss experience. Beginning with the quarter ended June 30, 2013, the Company calculated average losses for all loan segments using a rolling 8 quarter historical period (except for the commercial real estate loan segment, which used a 6 quarter historical period) and continued this methodology through March 31, 2014. Prior to June 30, 2013, the Company calculated average losses for all loan segments using a rolling 6 quarter historical period.

If the Company continued to calculate average losses for all loan segments other than commercial real estate using a rolling 8 quarter historical period and for the commercial real estate segment using a rolling 6 quarter historical period, the Company’s calculated allowance for loan loss allocation would have decreased by approximately $1.0 million at June 30, 2014. Other than the changes discussed above, the Company has not made any changes to its calculation of historical loss periods that would impact the calculation of the allowance for loan losses or provision for loan losses for the periods included in the accompanying consolidated balance sheets and statements of earnings.

The following table details the changes in the allowance for loan losses by portfolio segment for the respective periods.


	September 30, 2014
(In thousands)	Commercial and industrial		Construction and land development		Commercial real estate		Residential real estate		Consumer installment		Total
Quarter ended:
Beginning balance	$	639		907		1,913		1,095		174	$	4,728
Charge-offs		—		—		—		(287)		(39)		(326)
Recoveries		35		1		—		13		3		52

Net recoveries (charge-offs)		35		1		—		(274)		(36)		(274)
Provision for loan losses		(5)		(13)		22		262		34		300

Ending balance	$	669		895		1,935		1,083		172	$	4,754

Nine months ended:
Beginning balance	$	386		366		3,186		1,114		216	$	5,268
Charge-offs		(46)		(236)		—		(358)		(83)		(723)
Recoveries		71		4		118		103		13		309

Net recoveries (charge-offs)		25		(232)		118		(255)		(70)		(414)
Provision for loan losses		258		761		(1,369)		224		26		(100)

Ending balance	$	669		895		1,935		1,083		172	$	4,754


	September 30, 2013
(In thousands)	Commercial and industrial		Construction and land development		Commercial real estate		Residential real estate		Consumer installment		Total
Quarter ended:
Beginning balance	$	675		1,454		3,111		1,125		92		6,457
Charge-offs		(177)		—		(144)		(103)		(137)	$	(561)
Recoveries		23		1		—		21		5	$	50

Net (charge-offs) recoveries		(154)		1		(144)		(82)		(132)		(511)
Provision for loan losses		25		(266)		137		(61)		165	$	—

Ending balance	$	546		1,189		3,104		982		125	$	5,946

Nine months ended:
Beginning balance	$	812		1,545		3,137		1,126		103	$	6,723
Charge-offs		(245)		(39)		(262)		(558)		(199)		(1,303)
Recoveries		40		5		4		62		15		126

Net charge-offs		(205)		(34)		(258)		(496)		(184)		(1,177)
Provision for loan losses		(61)		(322)		225		352		206		400

Ending balance	$	546		1,189		3,104		982		125	$	5,946

The following table presents an analysis of the allowance for loan losses and recorded investment in loans by portfolio segment and impairment methodology as of September 30, 2014 and 2013.


	Collectively evaluated (1)				Individually evaluated (2)				Total
(In thousands)	Allowance for loan losses		Recorded investment in loans		Allowance for loan losses		Recorded investment in loans		Allowance for loan losses		Recorded investment in loans
September 30, 2014:
Commercial and industrial	$	669		52,785		—		83		669		52,868
Construction and land development		895		33,574		—		615		895		34,189
Commercial real estate		1,733		188,150		202		1,927		1,935		190,077
Residential real estate		1,083		105,672		—		883		1,083		106,555
Consumer installment		172		11,535		—		—		172		11,535

Total	$	4,552		391,716		202		3,508		4,754		395,224

September 30, 2013:
Commercial and industrial	$	546		58,630		—		136		546		58,766
Construction and land development		1,090		35,469		99		1,593		1,189		37,062
Commercial real estate		2,919		167,564		185		2,956		3,104		170,520
Residential real estate		982		101,576		—		989		982		102,565
Consumer installment		125		12,170		—		—		125		12,170

Total	$	5,662		375,409		284		5,674		5,946		381,083

(1)	Represents loans collectively evaluated for impairment in accordance with ASC 450-20, Loss Contingencies (formerly FAS 5), and pursuant to amendments by ASU 2010-20 regarding allowance for unimpaired loans.

(2)	Represents loans individually evaluated for impairment in accordance with ASC 310-30, Receivables (formerly FAS 114), and pursuant to amendments by ASU 2010-20 regarding allowance for impaired loans.

Credit Quality Indicators

The credit quality of the loan portfolio is summarized no less frequently than quarterly using categories similar to the standard asset classification system used by the federal banking agencies. The following table presents credit quality indicators for the loan portfolio segments and classes. These categories are utilized to develop the associated allowance for loan losses using historical losses adjusted for qualitative and environmental factors and are defined as follows:

Pass—loans which are well protected by the current net worth and paying capacity of the obligor (or guarantors, if any) or by the fair value, less cost to acquire and sell, of any underlying collateral.

Special Mention—loans with potential weakness that may, if not reversed or corrected, weaken the credit or inadequately protect the Company’s position at some future date. These loans are not adversely classified and do not expose an institution to sufficient risk to warrant an adverse classification.

Substandard Accruing—loans that exhibit a well-defined weakness which presently jeopardizes debt repayment, even though they are currently performing. These loans are characterized by the distinct possibility that the Company may incur a loss in the future if these weaknesses are not corrected

Nonaccrual—includes loans where management has determined that full payment of principal and interest is not expected.


(In thousands)	Pass		Special Mention		Substandard Accruing		Nonaccrual		Total loans
September 30, 2014:
Commercial and industrial	$	48,075		4,308		429		56	$	52,868
Construction and land development		32,524		483		567		615		34,189
Commercial real estate:
Owner occupied		50,185		1,149		230		272		51,836
Other		137,285		89		657		210		138,241
Total commercial real estate		187,470		1,238		887		482		190,077
Residential real estate:
Consumer mortgage		55,804		3,085		4,685		289		63,863
Investment property		40,359		876		1,213		244		42,692
Total residential real estate		96,163		3,961		5,898		533		106,555
Consumer installment		11,398		17		116		4		11,535
Total	$	375,630		10,007		7,897		1,690	$	395,224

December 31, 2013:
Commercial and industrial	$	53,060		4,183		482		55	$	57,780
Construction and land development		33,616		180		1,101		1,582		36,479
Commercial real estate:
Owner occupied		53,430		770		875		1,027		56,102
Other		117,490		91		808		429		118,818
Total commercial real estate		170,920		861		1,683		1,456		174,920
Residential real estate:
Consumer mortgage		50,392		1,137		5,476		866		57,871
Investment property		40,517		1,310		1,706		302		43,835
Total residential real estate		90,909		2,447		7,182		1,168		101,706
Consumer installment		12,713		34		146		—		12,893
Total	$	361,218		7,705		10,594		4,261	$	383,778

Impaired loans

The following tables present details related to the Company’s impaired loans. Loans which have been fully charged-off do not appear in the following table. The related allowance generally represents the following components which correspond to impaired loans:

•

Individually evaluated impaired loans equal to or greater than $500,000 secured by real estate (nonaccrual construction and land development, commercial real estate, and residential real estate loans).

•

Individually evaluated impaired loans equal to or greater than $250,000 not secured by real estate (nonaccrual commercial and industrial and consumer installment loans).

The following tables set forth certain information regarding the Company’s impaired loans that were individually evaluated for impairment at September 30, 2014 and December 31, 2013.


		September 30, 2014
(In thousands)		Unpaid principal balance (1)		Charge-offs and payments applied (2)		Recorded investment (3)			Related allowance

With no allowance recorded:
Commercial and industrial	$		83		—		83
Construction and land development			2,829		(2,214)		615
Commercial real estate:
Owner occupied			336		(64)		272
Other			300		(91)		209

Total commercial real estate			636		(155)		481
Residential real estate:
Consumer mortgages			939		(216)		723
Investment property			204		(44)		160

Total residential real estate			1,143		(260)		883

Total	$		4,691		(2,629)		2,062	$

With allowance recorded:
Commercial real estate:
Owner occupied			854		—		854			110
Other			592		—		592			92

Total commercial real estate			1,446		—		1,446			202

Total	$		1,446		—		1,446	$		202


Total impaired loans	$		6,137		(2,629)		3,508	$		202

(1)	Unpaid principal balance represents the contractual obligation due from the customer.

(2)	Charge-offs and payments applied represents cumulative charge-offs taken, as well as interest payments that have been applied against the outstanding principal balance subsequent to the loans being placed on nonaccrual status.

(3)	Recorded investment represents the unpaid principal balance less charge-offs and payments applied; it is shown before any related allowance for loan losses.


		December 31, 2013
(In thousands)		Unpaid principal balance (1)		Charge-offs and payments applied (2)		Recorded investment (3)			Related allowance

With no allowance recorded:
Commercial and industrial	$		124		—		124
Construction and land development			2,879		(1,682)		1,197
Commercial real estate:
Owner occupied			1,217		(190)		1,027
Other			518		(89)		429

Total commercial real estate			1,735		(279)		1,456
Residential real estate:
Consumer mortgages			952		(198)		754
Investment property			207		(35)		172

Total residential real estate			1,159		(233)		926

Total	$		5,897		(2,194)		3,703

With allowance recorded:
Construction and land development			452		(67)		385			88
Commercial real estate:
Owner occupied			875		—		875			110
Other			602		—		602			62

Total commercial real estate			1,477		—		1,477			172

Total	$		1,929		(67)		1,862	$		260

Total impaired loans	$		7,826		(2,261)		5,565	$		260

(1)	Unpaid principal balance represents the contractual obligation due from the customer.

(2)	Charge-offs and payments applied represents cumulative charge-offs taken, as well as interest payments that have been applied against the outstanding principal balance subsequent to the loans being placed on nonaccrual status.

(3)	Recorded investment represents the unpaid principal balance less charge-offs and payments applied; it is shown before any related allowance for loan losses.

The following table provides the average recorded investment in impaired loans and the amount of interest income recognized on impaired loans after impairment by portfolio segment and class during the respective periods.


		Quarter ended September 30, 2014				Nine months ended September 30, 2014
(In thousands)		Average recorded investment		Total interest income recognized		Average recorded investment		Total interest income recognized

Impaired loans:
Commercial and industrial	$		88		2		105		6
Construction and land development			730		—		1,159		—
Commercial real estate:
Owner occupied			1,129		9		1,367		31
Other			801		4		935		20

Total commercial real estate			1,930		13		2,302		51
Residential real estate:
Consumer mortgages			716		5		752		5
Investment property			162		—		166		—

Total residential real estate			878		5		918		5

Total	$		3,626		20		4,484		62


		Quarter ended September 30, 2013				Nine months ended September 30, 2013
		Average		Total interest		Average		Total interest
		recorded		income		recorded		income
(In thousands)		investment		recognized		investment		recognized

Impaired loans:
Commercial and industrial	$		139		2		152		7
Construction and land development			1,596		—		1,608		—
Commercial real estate:
Owner occupied			1,927		13		1,993		42
Other			832		4		1,581		4

Total commercial real estate			2,759		17		3,574		46
Residential real estate:
Consumer mortgages			776		—		801		—
Investment property			231		—		323		—

Total residential real estate			1,007		—		1,124		—

Total	$		5,501		19		6,458		53

Troubled Debt Restructurings

Impaired loans also include troubled debt restructurings (“TDRs”). In the normal course of business, management may grant concessions to borrowers that are experiencing financial difficulty. A concession may include, but is not limited to, delays in required payments of principal and interest for a specified period, reduction of the stated interest rate of the loan, reduction of accrued interest, extension of the maturity date or reduction of the face amount or maturity amount of the debt. A concession has been granted when, as a result of the restructuring, the Bank does not expect to collect all amounts due, including interest at the original stated rate. A concession may have also been granted if the debtor is not able to access funds elsewhere at a market rate for debt with similar risk characteristics as the restructured debt. In making the determination of whether a loan modification is a TDR, the Company considers the individual facts and circumstances surrounding each modification. As part of the credit approval process, the restructured loans are evaluated for adequate collateral protection in determining the appropriate accrual status at the time of restructure.

Similar to other impaired loans, TDRs are measured for impairment based on the present value of expected payments using the loan’s original effective interest rate as the discount rate, or the fair value of the collateral, less selling costs if the loan is collateral dependent. If the recorded investment in the loan exceeds the measure of fair value, impairment is recognized by establishing a valuation allowance as part of the allowance for loan losses or a charge-off to the allowance for loan losses. In periods subsequent to the modification, all TDRs are individually evaluated for possible impairment.

The following is a summary of accruing and nonaccrual TDRs, which are included in impaired loan totals, and the related allowance for loan losses, by portfolio segment and class as of September 30, 2014, and December 31, 2013.


		TDRs
(In thousands)		Accruing		Nonaccrual		Total			Related Allowance

September 30, 2014
Commercial and industrial	$		83		—		83	$		—
Construction and land development			—		615		615			—
Commercial real estate:
Owner occupied			854		272		1,126			110
Other			592		209		801			92

Total commercial real estate			1,446		481		1,927			202
Residential real estate:
Consumer mortgages			723		—		723			—
Investment property			—		160		160			—

Total residential real estate			723		160		883			—

Total	$		2,252		1,256		3,508	$		202

December 31, 2013
Commercial and industrial	$		124		—		124	$		—
Construction and land development			—		1,582		1,582			88
Commercial real estate:
Owner occupied			875		285		1,160			110
Other			602		429		1,031			62

Total commercial real estate			1,477		714		2,191			172
Residential real estate:
Consumer mortgages			—		754		754			—
Investment property			—		172		172			—

Total residential real estate			—		926		926			—

Total	$		1,601		3,222		4,823	$		260

At September 30, 2014, there were no significant outstanding commitments to advance additional funds to customers whose loans had been restructured.

The following table summarizes loans modified in a TDR during the respective periods both before and after their modification.


	Quarter ended September 30,						Nine months ended September 30,
			Pre-		Post -				Pre-		Post -
			modification		modification				modification		modification
	Number		outstanding		outstanding		Number		outstanding		outstanding
	of		recorded		recorded		of		recorded		recorded
(Dollars in thousands)	contracts		investment		investment		contracts		investment		investment


2014:
Commercial real estate:
Other		1	$	590		592		1	$	590		592

Total commercial real estate		1		590		592		1		590		592
Residential real estate:
Consumer mortgages		1		712		712		1		712		712

Total residential real estate		1		712		712		1		712		712

Total		2	$	1,302		1,304		2	$	1,302		1,304

2013:
Commercial real estate:
Owner occupied		1	$	882		882		1	$	882		882
Other		1		606		610		2		1,037		1,041

Total commercial real estate		2		1,488		1,492		3		1,919		1,923
Residential real estate:
Consumer mortgages		1		678		674		2		808		804

Total residential real estate		1		678		674		2		808		804

Total		3	$	2,166		2,166		5	$	2,727		2,727

The majority of the loans modified in a TDR during the quarter and nine months ended September 30, 2014 and 2013, respectively, included permitting delays in required payments of principal and/or interest or where the only concession granted by the Company was that the interest rate at renewal was considered to be less than a market rate.

The following table summarizes the recorded investment in loans modified in a TDR within the previous 12 months for which there was a payment default (defined as 90 days or more past due) during the respective periods.


	Quarter ended September 30,				Nine months Ended September 30,
(Dollars in thousands)	Number of Contracts		Recorded investment⁽¹⁾		Number of Contracts		Recorded investment⁽¹⁾
2014:
Commerical real estate:
Owner occupied		1	$	272		1	$	272

Total commercial real estate		1		272		1		272

Total		1	$	272		1	$	272


2013:
Construction and land development		—	$	—		1	$	1,197
Commerical real estate:
Other		1		426		1		426

Total commercial real estate		1		426		1		426

Total		1	$	426		2	$	1,623

(1)	Amount as of applicable month end during the respective period for which there was a payment default.

NOTE 6: MORTGAGE SERVICING RIGHTS, NET

Mortgage servicing rights (“MSRs”) are recognized based on the fair value of the servicing rights on the date the corresponding mortgage loans are sold. An estimate of the fair value of the Company’s MSRs is determined using assumptions that market participants would use in estimating future net servicing income, including estimates of prepayment speeds, discount rate, default rates, cost to service, escrow account earnings, contractual servicing fee income, ancillary income, and late fees. Subsequent to the date of transfer, the Company has elected to measure its MSRs under the amortization method. Under the amortization method, MSRs are amortized in proportion to, and over the period of, estimated net servicing income.

The Company has recorded MSRs related to loans sold without recourse to Fannie Mae. The Company generally sells conforming, fixed-rate, closed-end, residential mortgages to Fannie Mae. MSRs are included in other assets on the accompanying consolidated balance sheets.

The Company evaluates MSRs for impairment on a quarterly basis. Impairment is determined by stratifying MSRs into groupings based on predominant risk characteristics, such as interest rate and loan type. If, by individual stratum, the carrying amount of the MSRs exceeds fair value, a valuation allowance is established. The valuation allowance is adjusted as the fair value changes. Changes in the valuation allowance are recognized in earnings as a component of mortgage lending income.

The following table details the changes in amortized MSRs and the related valuation allowance for the respective periods.


		Quarter ended September 30,					Nine months ended September 30,
(Dollars in thousands)		2014		2013			2014		2013

MSRs, net:
Beginning balance	$		2,346	$	1,979	$		2,350	$	1,526
Additions, net			168		215			371		693
Amortization expense			(89)		(78)			(253)		(304)
Decrease (increase) in valuation allowance			12		172			(31)		373

Ending balance	$		2,437	$	2,288	$		2,437	$	2,288


Valuation allowance included in MSRs, net:
Beginning of period	$		43	$	185	$		—	$	386
End of period			31		13			31		13


Fair value of amortized MSRs:
Beginning of period	$		3,228	$	2,453	$		3,452	$	1,526
End of period			3,314		3,167			3,314		3,167

NOTE 7: DERIVATIVE INSTRUMENTS

Financial derivatives are reported at fair value in other assets or other liabilities on the accompanying Consolidated Balance Sheets. The accounting for changes in the fair value of a derivative depends on whether it has been designated and qualifies as part of a hedging relationship. For derivatives not designated as part of a hedging relationship, the gain or loss is recognized in current earnings within other noninterest income on the accompanying consolidated statements of earnings. From time to time, the Company may enter into interest rate swaps (“swaps”) to facilitate customer transactions and meet their financing needs. Upon entering into these swaps, the Company enters into offsetting positions in order to minimize the risk to the Company. These swaps qualify as derivatives, but are not designated as hedging instruments. At September 30, 2014 and December 31, 2013, the Company had no derivative contracts to assist in managing its own interest rate sensitivity.

Interest rate swap agreements involve the risk of dealing with counterparties and their ability to meet contractual terms. When the fair value of a derivative instrument is positive, this generally indicates that the counterparty or customer owes the Company, and results in credit risk to the Company. When the fair value of a derivative instrument is negative, the Company owes the customer or counterparty and therefore, has no credit risk.

A summary of the Company’s interest rate swap agreements at September 30, 2014 and December 31, 2013 is presented below.


			Other Assets		Other Liabilities
(Dollars in thousands)	Notional		Estimated Fair Value		Estimated Fair Value

September 30, 2014:
Pay fixed / receive variable	$	4,754		—		669
Pay variable / receive fixed		4,754		669		—

Total interest rate swap agreements	$	9,508		669		669

December 31, 2013:
Pay fixed / receive variable	$	5,017		—		844
Pay variable / receive fixed		5,017		844		—

Total interest rate swap agreements	$	10,034		844		844

NOTE 8: FAIR VALUE

Fair Value Hierarchy

“Fair value” is defined by ASC 820, Fair Value Measurements and Disclosures, as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction occurring in the principal market (or most advantageous market in the absence of a principal market) for an asset or liability at the measurement date. GAAP establishes a fair value hierarchy for valuation inputs that gives the highest priority to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The fair value hierarchy is as follows:

Level 1—inputs to the valuation methodology are quoted prices, unadjusted, for identical assets or liabilities in active markets.

Level 2—inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, or inputs that are observable for the asset or liability, either directly or indirectly.

Level 3—inputs to the valuation methodology are unobservable and reflect the Company’s own assumptions about the inputs market participants would use in pricing the asset or liability.

Level changes in fair value measurements

Transfers between levels of the fair value hierarchy are generally recognized at the end of the reporting period. The Company monitors the valuation techniques utilized for each category of financial assets and liabilities to ascertain when transfers between levels have been affected. The nature of the Company’s financial assets and liabilities generally is such that transfers in and out of any level are expected to be infrequent. For the nine months ended September 30, 2014, there were no transfers between levels and no changes in valuation techniques for the Company’s financial assets and liabilities.

Assets and liabilities measured at fair value on a recurring basis

Securities available-for-sale

Fair values of securities available for sale were primarily measured using Level 2 inputs. For these securities, the Company obtains pricing from third party pricing services. These third party pricing services consider observable data that may include broker/dealer quotes, market spreads, cash flows, market consensus prepayment speeds, benchmark yields, reported trades for similar securities, market consensus prepayment speeds, credit information and the securities’ terms and conditions. On a quarterly basis, management reviews the pricing received from the third party pricing services for reasonableness given current market conditions. As part of its review, management may obtain non-binding third party broker quotes to validate the fair value measurements. In addition, management will periodically submit pricing provided by the third party pricing services to another independent valuation firm on a sample basis. This independent valuation firm will compare the price provided by the third party pricing service with its own price and will review the significant assumptions and valuation methodologies used with management.

Interest rate swap agreements

The carrying amount of interest rate swap agreements was included in other assets and accrued expenses and other liabilities on the accompanying consolidated balance sheets. The fair value measurements for our interest rate swap agreements were based on information obtained from a third party bank. This information is periodically tested by the Company and validated against other third party valuations. If needed, other third party market participants may be utilized to corroborate the fair value measurements for our interest rate swap agreements. The Company classified these derivative assets and liabilities within Level 2 of the valuation hierarchy. These swaps qualify as derivatives, but are not designated as hedging instruments.

The following table presents the balances of the assets and liabilities measured at fair value on a recurring basis as of September 30, 2014 and December 31, 2013, respectively, by caption, on the accompanying consolidated balance sheets by ASC 820 valuation hierarchy (as described above).


			Quoted Prices in		Significant
			Active Markets		Other		Significant
			for		Observable		Unobservable
			Identical Assets		Inputs		Inputs
(Dollars in thousands)	Amount		(Level 1)		(Level 2)		(Level 3)
September 30, 2014:
Securities available-for-sale:
Agency obligations	$	59,503		—		59,503		—
Agency RMBS		139,184		—		139,184		—
State and political subdivisions		66,140		—		66,140		—

Total securities available-for-sale		264,827		—		264,827		—
Other assets ⁽¹⁾		669		—		669		—

Total assets at fair value	$	265,496		—		265,496		—


Other liabilities⁽¹⁾	$	669		—		669		—

Total liabilities at fair value	$	669		—		669		—

December 31, 2013:
Securities available-for-sale:
Agency obligations	$	44,522		—		44,522		—
Agency RMBS		162,358		—		162,358		—
State and political subdivisions		64,339		—		64,339		—

Total securities available-for-sale		271,219		—		271,219		—
Other assets ⁽¹⁾		844		—		844		—

Total assets at fair value	$	272,063		—		272,063		—


Other liabilities⁽¹⁾	$	844		—		844		—

Total liabilities at fair value	$	844		—		844		—

⁽¹⁾	Represents the fair value of interest rate swap agreements.

Assets and liabilities measured at fair value on a nonrecurring basis

Loans held for sale

Loans held for sale are carried at the lower of cost or fair value. Fair values of loans held for sale are determined using quoted market secondary market prices for similar loans. Loans held for sale are classified within Level 2 of the fair value hierarchy.

Impaired Loans

Loans considered impaired under ASC 310-10-35, Receivables, are loans for which, based on current information and events, it is probable that the Company will be unable to collect all principal and interest payments due in accordance with the contractual terms of the loan agreement. Impaired loans can be measured based on the present value of expected payments using the loan’s original effective rate as the discount rate, the loan’s observable market price, or the fair value of the collateral less selling costs if the loan is collateral dependent.

The fair value of impaired loans were primarily measured based on the value of the collateral securing these loans. Impaired loans are classified within Level 3 of the fair value hierarchy. Collateral may be real estate and/or business assets including equipment, inventory, and/or accounts receivable. The Company determines the value of the collateral based on independent appraisals performed by qualified licensed appraisers. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Appraised values are discounted for costs to sell and may be discounted further based on management’s historical knowledge, changes in market conditions from the date of the most recent appraisal, and/or management’s expertise and knowledge of the customer and the customer’s business. Such discounts by management are subjective and are typically significant unobservable inputs for determining fair value. Impaired loans are reviewed and evaluated on at least a quarterly basis for additional impairment and adjusted accordingly, based on the same factors discussed above.

Other real estate owned

Other real estate owned, consisting of properties obtained through foreclosure or in satisfaction of loans, are initially recorded at the lower of the loan’s carrying amount or the fair value less costs to sell upon transfer of the loans to other real estate. Subsequently, other real estate is carried at the lower of carrying value or fair value less costs to sell. Fair values are generally based on third party appraisals of the property and are classified within Level 3 of the fair value hierarchy. The appraisals are sometimes further discounted based on management’s historical knowledge, and/or changes in market conditions from the date of the most recent appraisal, and/or management’s expertise and knowledge of the customer and the customer’s business. Such discounts are typically significant unobservable inputs for determining fair value. In cases where the carrying amount exceeds the fair value, less costs to sell, a loss is recognized in noninterest expense.

Mortgage servicing rights, net

Mortgage servicing rights, net, included in other assets on the accompanying consolidated balance sheets, are carried at the lower of cost or estimated fair value. MSRs do not trade in an active market with readily observable prices. To determine the fair value of MSRs, the Company engages an independent third party. The independent third party’s valuation model calculates the present value of estimated future net servicing income using assumptions that market participants would use in estimating future net servicing income, including estimates of prepayment speeds, discount rate, default rates, cost to service, escrow account earnings, contractual servicing fee income, ancillary income, and late fees. Periodically, the Company will review broker surveys and other market research to validate significant assumptions used in the model. The significant unobservable inputs include prepayment speeds or the constant prepayment rate (“CPR”) and the weighted average discount rate. Because the valuation of MSRs requires the use of significant unobservable inputs, all of the Company’s MSRs are classified within Level 3 of the valuation hierarchy.

The following table presents the balances of the assets and liabilities measured at fair value on a nonrecurring basis as of September 30, 2014 and December 31, 2013, respectively, by caption, on the accompanying consolidated balance sheets and by FASB ASC 820 valuation hierarchy (as described above):


			Quoted Prices in
			Active Markets		Other		Significant
			for		Observable		Unobservable
	Carrying		Identical Assets		Inputs		Inputs
(Dollars in thousands)	Amount		(Level 1)		(Level 2)		(Level 3)
September 30, 2014:
Loans held for sale	$	3,521		—		3,521		—
Loans, net⁽¹⁾		3,306		—		—		3,306
Other real estate owned		1,215		—		—		1,215
Other assets ⁽²⁾		2,437		—		—		2,437
Total assets at fair value	$	10,479		—		3,521		6,958

December 31, 2013:
Loans held for sale	$	2,296		—		2,296		—
Loans, net⁽¹⁾		5,305		—		—		5,305
Other real estate owned		3,884		—		—		3,884
Other assets ⁽²⁾		2,350		—		—		2,350
Total assets at fair value	$	13,835		—		2,296		11,539

⁽¹⁾	Loans considered impaired under ASC 310-10-35, Receivables. This amount reflects the recorded investment in impaired loans, net of any related allowance for loan losses.

⁽²⁾	Represents MSRs, net, carried at lower of cost or estimated fair value.

Quantitative Disclosures for Level 3 Fair Value Measurements

The following is a reconciliation of the beginning and ending balances of recurring fair value measurements for trust preferred securities recognized in the accompanying consolidated balance sheets using Level 3 inputs:


	Nine months ended September 30,
(Dollars in thousands)	2014		2013
Beginning balance	$	—	$	652
Total realized and unrealized gains and (losses):
Included in other comprehensive income		—		90

Ending balance	$	—	$	742

At September 30, 2014, the Company had no Level 3 assets measured at fair value on a recurring basis. For Level 3 assets measured at fair value on a non-recurring basis at September 30, 2014, the significant unobservable inputs used in the fair value measurements are presented below.

Weighted

Carrying

Average

(Dollars in thousands)

Amount

Valuation Technique

Significant Unobservable Input

of Input

Nonrecurring:

Impaired loans

3,306

Appraisal

Appraisal discounts (%)

16.2%

Other real estate owned

1,215

Appraisal

Appraisal discounts (%)

16.3%

Mortgage servicing rights, net

2,437

Discounted cash flow

Prepayment speed or CPR (%)

9.4%

Discount rate (%)

10.0%

Fair Value of Financial Instruments

ASC 825, Financial Instruments, requires disclosure of fair value information about financial instruments, whether or not recognized on the face of the balance sheet, for which it is practicable to estimate that value. The assumptions used in the estimation of the fair value of the Company’s financial instruments are explained below. Where quoted market prices are not available, fair values are based on estimates using discounted cash flow analyses. Discounted cash flows can be significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. The following fair value estimates cannot be substantiated by comparison to independent markets and should not be considered representative of the liquidation value of the Company’s financial instruments, but rather are a good–faith estimate of the fair value of financial instruments held by the Company. ASC 825 excludes certain financial instruments and all nonfinancial instruments from its disclosure requirements.

The following methods and assumptions were used by the Company in estimating the fair value of its financial instruments:

Loans, net

Fair values for loans were calculated using discounted cash flows. The discount rates reflected current rates at which similar loans would be made for the same remaining maturities. This method of estimating fair value does not incorporate the exit-price concept of fair value prescribed by ASC 820 and generally produces a higher value than an exit-price approach. Expected future cash flows were projected based on contractual cash flows, adjusted for estimated prepayments.

Loans held for sale

Fair values of loans held for sale are determined using quoted market secondary market prices for similar loans.

Time Deposits

Fair values for time deposits were estimated using discounted cash flows. The discount rates were based on rates currently offered for deposits with similar remaining maturities.

Long-term debt

The fair value of the Company’s fixed rate long-term debt is estimated using discounted cash flows based on estimated current market rates for similar types of borrowing arrangements. The carrying amount of the Company’s variable rate long-term debt approximates its fair value.

The carrying value, related estimated fair value, and placement in the fair value hierarchy of the Company’s financial instruments at September 30, 2014 and December 31, 2013 are presented below. This table excludes financial instruments for which the carrying amount approximates fair value. Financial assets for which fair value approximates carrying value included cash and cash equivalents. Financial liabilities for which fair value approximates carrying value included noninterest-bearing demand, interest-bearing demand, and savings deposits due to these products having no stated maturity. In addition, financial liabilities for which fair value approximates carrying value included overnight borrowings such as federal funds purchased and securities sold under agreements to repurchase.


					Fair Value Hierarchy
(Dollars in thousands)	Carrying amount		Estimated fair value		Level 1 inputs		Level 2 inputs		Level 3 inputs
September 30, 2014:
Financial Assets:
Loans, net (1)	$	389,848	$	398,087	$	—	$	—	$	398,087
Loans held for sale		3,521		3,587		—		3,587		—
Financial Liabilities:
Time Deposits	$	253,871	$	256,024	$	—	$	256,024	$	—
Long-term debt		12,217		12,545		—		12,545		—
December 31, 2013:
Financial Assets:
Loans, net (1)	$	378,071	$	387,180	$	—	$	—	$	387,180
Loans held for sale		2,296		2,310		—		2,310		—
Financial Liabilities:
Time Deposits	$	261,199	$	263,985	$	—	$	263,985	$	—
Long-term debt		12,217		12,569		—		12,569		—

(1)	Represents loans, net of unearned income and the allowance for loan losses.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

General

The following discussion and analysis is designed to provide a better understanding of various factors related to the results of operations and financial condition of Auburn National Bancorporation, Inc. (the “Company”) and its wholly owned subsidiary, AuburnBank (the “Bank”). This discussion is intended to supplement and highlight information contained in the accompanying unaudited condensed consolidated financial statements and related notes for the quarters and nine months ended September 30, 2014 and 2013, as well as the information contained in our annual report on Form 10-K for the year ended December 31, 2013 and our quarterly reports on Form 10-Q for the quarters ended March 31, 2014 and June 30, 2014.

Special Notice Regarding Forward-Looking Statements

Certain of the statements made in this discussion and analysis and elsewhere, including information incorporated herein by reference to other documents, are “forward-looking statements” within the meaning of, and subject to, the protections of Section 27A of the Securities Act of 1933, as amended, (the “Securities Act”) and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”).

Forward-looking statements include statements with respect to our beliefs, plans, objectives, goals, expectations, anticipations, assumptions, estimates, intentions and future performance, and involve known and unknown risks, uncertainties and other factors, which may be beyond our control, and which may cause the actual results, performance, achievements, or financial condition of the Company to be materially different from future results, performance, achievements, or financial condition expressed or implied by such forward-looking statements. You should not expect us to update any forward-looking statements.

All statements other than statements of historical fact are statements that could be forward-looking statements. You can identify these forward-looking statements through our use of words such as “may,” “will,” “anticipate,” “assume,” “should,” “indicate,” “would,” “believe,” “contemplate,” “expect,” “estimate,” “continue,” “plan,” “point to,” “project,” “could,” “intend,” “target” and other similar words and expressions of the future. These forward-looking statements may not be realized due to a variety of factors, including, without limitation:

•

the effects of future economic, business and market conditions and changes, domestic and foreign, including seasonality;

•

governmental monetary and fiscal policies;

•

legislative and regulatory changes, including changes in banking, securities and tax laws, regulations and rules and their application by our regulators, including capital and liquidity requirements, and changes in the scope and cost of FDIC insurance;

•

changes in accounting policies, rules and practices;

•

the risks of changes in interest rates on the levels, composition and costs of deposits, loan demand, and the values and liquidity of loan collateral, securities, and interest sensitive assets and liabilities, and the risks and uncertainty of the amounts realizable and the timing of dispositions of assets by the FDIC where we may have a participation or other interest;

•

changes in borrower credit risks and payment behaviors;

•

changes in the availability and cost of credit and capital in the financial markets, and the types of instruments that may be included as capital for regulatory purposes;

•

changes in the prices, values and sales volumes of residential and commercial real estate;

•

the effects of competition from a wide variety of local, regional, national and other providers of financial, investment and insurance services;

•

the failure of assumptions and estimates underlying the establishment of allowances for possible loan and other asset impairments, losses and other estimates;

•

changes in technology or products that may be more difficult, costly, or less effective than anticipated;

•

the effects of war or other conflicts, acts of terrorism or other catastrophic events that may affect general economic conditions;

•

the failure of assumptions and estimates, as well as differences in, and changes to, economic, market and credit conditions, including changes in borrowers’ credit risks and payment behaviors from those used in our loan portfolio stress tests and other evaluations;

•

the risks that our deferred tax assets could be reduced if estimates of future taxable income from our operations and tax planning strategies are less than currently estimated, and sales of our capital stock could trigger a reduction in the amount of net operating loss carry-forwards that we may be able to utilize for income tax purposes; and

•

the other factors and information in this report and other filings that we make with the SEC under the Exchange Act, including our annual report on Form 10-K for the year ended December 31, 2013 and subsequent quarterly and current reports. See Part II, Item 1A, “RISK FACTORS”.

All written or oral forward-looking statements that are made by or attributable to us are expressly qualified in their entirety by this cautionary notice. We have no obligation and do not undertake to update, revise or correct any of the forward-looking statements after the date of this report, or after the respective dates on which such statements otherwise are made.

Business

The Company was incorporated in 1990 under the laws of the State of Delaware and became a bank holding company after it acquired its Alabama predecessor, which was a bank holding company established in 1984. The Bank, the Company’s principal subsidiary, is an Alabama state-chartered bank that is a member of the Federal Reserve System and has operated continuously since 1907. Both the Company and the Bank are headquartered in Auburn, Alabama. The Bank conducts its business primarily in East Alabama, including Lee County and surrounding areas. The Bank operates full-service branches in Auburn, Opelika, Valley, Hurtsboro, and Notasulga, Alabama. In-store branches are located in the Kroger and Wal-Mart SuperCenter stores in both Auburn and Opelika. The Bank also operates commercial loan production offices in Montgomery and Phenix City, Alabama.

Summary of Results of Operations


	Quarter ended September 30,				Nine months ended September 30,
(Dollars in thousands, except per share amounts)	2014		2013		2014		2013
Net interest income (a)	$	5,769	$	5,621	$	16,928	$	16,741

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