Form 10-K
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

FORM 10-K

 

x Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the fiscal year ended December 31, 2011

or

 

¨ Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the transition period from             to            

Commission File Number 0-14492

 

 

FARMERS & MERCHANTS BANCORP, INC.

 

OHIO   34-1469491

(State or other jurisdiction of

incorporation or organization)

 

(IRS Employer

Identification No.)

 

307 North Defiance Street

Archbold, Ohio

 

43502

 
(Address of principal Executive offices)   (Zip Code)

Registrant’s telephone number, including area code (419) 446-2501

Securities registered pursuant to Section 12(b) of the Act:

Title of each class

 

Name of each exchange on which registered

None   None

Securities registered pursuant to Section 12(g) of the Act:

Common shares without par value

(Title of class)

 

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  ¨    No  x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.    Yes  ¨    No  x

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or Section 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 Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) 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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.    Yes  ¨    No  x

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

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

As of June 30, 2011, the aggregate market value of the registrant’s common stock held by non-affiliates of the registrant was $83,117,871.75

As of February 24, 2012, the Registrant had 5,200,000 shares of common stock issued of which 4,682,622 shares are outstanding.

 

 

DOCUMENTS INCORPORATED BY REFERENCE

Part III of Form 10-K – Portions of the definitive Proxy Statement for the 2011 Annual Meeting of Shareholders of Farmers & Merchants Bancorp, Inc.

 

 

 


Table of Contents

FARMERS & MERCHANTS BANCORP, INC.

TABLE OF CONTENTS

 

Form 10-K Items

       PAGE  

Item 1.

  Business      1-9   

Item 1a.

  Risk Factors      9-12   

Item 1b.

  Unresolved Staff Comments      12   

Item 2.

  Properties      12-13   

Item 3.

  Legal Proceedings      13   

Item 4.

  Mine Safety Disclosures      13   

Item 5.

  Market for Registrant’s Common Equity and Related Stockholder Matters      13-15   

Item 6.

  Selected Financial Data      16   

Item 7.

  Management Discussion and Analysis of Financial Condition and Results of Operations      17-39   

Item 7a.

  Quantitative and Qualitative Disclosures About Market Risk      39-40   

Item 8.

  Financial Statements and Supplementary Data      40-77   

Item 9.

  Changes In and Disagreements on Accounting and Financial Disclosure      78   

Item 9a.

  Controls and Procedures      79   

Item 9b.

  Other Information      79   

Item 10.

  Directors and Executive Officers of the Registrant      80-81   

Item 11.

  Executive Compensation      82   

Item 12.

  Security Ownership of Certain Beneficial Owners and Management      82   

Item 13.

  Certain Relationships and Related Transactions      82   

Item 14.

  Principal Accountant Fees and Services      82   

Item 15.

  Exhibits, Financial Schedules and Reports on Form 8-K      83-84   

Signatures & Certifications

     85   

Total Pages:

     86   

Statements contained in this portion of the Company’s annual report may be forward-looking statements, as that term is defined in the Private Securities Litigation Reform Act of 1995. Forward-looking statements may be identified by the use of such words as “intend,” “believe,” “expect,” “anticipate,” “should,” “planned,” “estimated,” and “potential.” Such forward-looking statements are based on current expectations, but may differ materially from those currently anticipated due to a number of factors, which include, but are not limited to, factors discussed in documents filed by the Company with the Securities and Exchange Commission from time to time. Other factors which could have a material adverse effect on the operations of the Company and its subsidiaries which include, but are not limited to, changes in interest rates, general economic conditions, legislative and regulatory changes, monetary and fiscal policies of the U.S. Government, including policies of the U.S. Treasury and the Federal Reserve Board, the quality and composition of the loan or investment portfolios, demand for loan products, deposit flows, competition, demand for financial services in the Bank’s market area, changes in relevant accounting principles and guidelines and other factors over which management has no control. The forward-looking statements are made as of the date of this report, and the Company assumes no obligation to update the forward-looking statements or to update the reasons why actual results could differ from those projected in the forward-looking statements.


Table of Contents

PART 1.

ITEM 1. BUSINESS

General

Farmers & Merchants Bancorp, Inc. (Company) is a bank holding company incorporated under the laws of Ohio in 1985. Our primary subsidiary, The Farmers & Merchants State Bank (Bank) is a community bank operating in Northwest Ohio since 1897. We report our financial condition and net income on a consolidated basis and we report only one segment.

Our executive offices are located at 307 North Defiance Street, Archbold, Ohio 43502, and our telephone number is (419) 446-2501.

For a discussion of the general development of the Company’s business throughout 2011, please see the portion of Management’s Discussion and Analysis of Financial Condition and Results of Operations captioned “2011 in Review”.

Nature of Activities

The Bank’s primary service area, Northwest Ohio and Northeast Indiana, continued to experience high but declining unemployment. After reaching a high of 11% unemployment for Ohio in March, 2010, the unemployment rate decreased in each of the ensuing months and closed the 2011 year at 8.1% for Ohio and 9% for Indiana. The agricultural industry continued its strong performance in 2011. Automotive showed improvement with car dealers in our marketing area ending with more profitable numbers than in recent years. Overall, business profits are improving, however borrowing activity remains sluggish. 1-4 family residential and construction remain weak. The consumer confidence increased from an average of 45% in 2009 to 53% in 2010 and December, 2011 topped 64.5%.

The Farmers & Merchants State Bank engages in general commercial banking business. Their activities include commercial, agricultural and residential mortgage, consumer and credit card lending activities. Because the Bank’s offices are located in Northwest Ohio and Northeast Indiana, a substantial amount of the loan portfolio is comprised of loans made to customers in the farming industry for such things as farm land, farm equipment, livestock and operating loans for seed, fertilizer, and feed. Other types of lending activities include loans for home improvements, and loans for such items as autos, trucks, recreational vehicles, motorcycles, etc.

The Bank also provides checking account services, as well as savings and time deposit services such as certificates of deposits. In addition ATM’s (automated teller machines) are provided at most branch locations along with other independent locations such as major employers and hospitals in the market area. The Bank has custodial services for IRA’s (Individual Retirement Accounts) and HSA’s (Health Savings Accounts). The Bank provides on-line banking access for consumer and business customers. For consumers, this includes bill-pay and on-line statement opportunities. For business customers, it provides the option of electronic transaction origination such as wire and ACH file transmittal. In addition the Bank offers remote deposit capture or electronic deposit processing.

The Bank’s underwriting policies, exercised through established procedures, facilitate operating in a safe and sound manner in accordance with supervisory and regulatory guidance. Within this sphere of safety and soundness, the Bank’s practice has been not to promote innovative, unproven credit products which may not be in the best interest of the Bank or its customers. The Bank does offer a hybrid loan. Hybrid loans are loans that start as a fixed rate

 

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mortgage but after a set number of years automatically adjust to an adjustable rate mortgage. The Bank offers a three year fixed rate mortgage after which the interest rate will adjust annually. The majority of the Bank’s adjustable rate mortgages are of this type. In order to offer longer term fixed rate mortgages, the Bank does participate in the Freddie Mac, Farmer Mac and Small Business Lending programs. The Bank also retains the servicing on these partially or 100% sold loans. In order for the customer to participate in these programs they must meet the requirements established by these agencies.

The Bank does not have a program to fund sub-prime loans. Sub-prime loans are characterized as a lending program or strategy that target borrowers who pose a significantly higher risk of default than traditional retail banking customers.

Following are the characteristics and underwriting criteria for each major type of loan the Bank offers:

Commercial Real Estate: Construction, purchase, and refinance of business purpose real estate. Risks include loan amount in relation to construction delays and overruns, vacancies, collateral value subject to market value fluctuations, interest rate, market demands, borrower’s ability to repay in orderly fashion, and others. The Bank does employ stress testing on higher balance loans to mitigate risk by ensuring the customer’s ability to repay in a changing rate environment before granting loan approval.

Agricultural Real Estate: Purchase of farm real estate or for permanent improvements to the farm real estate. Cash flow from the farm operation is the repayment source and is therefore subject to the financial success of the farm operation.

Consumer Real Estate: Purchase, refinance, or equity financing of one to four family owner occupied dwelling. Success in repayment is subject to borrower’s income, debt level, character in fulfilling payment obligations, employment, and others.

Commercial/Industrial: Loans to proprietorships, partnerships, or corporations to provide temporary working capital and seasonal loans as well as long term loans for capital asset acquisition. Risks include adequacy of cash flow, reasonableness of profit projections, financial leverage, economic trends, management ability, and others. The Bank does employ stress testing on higher balance loans to mitigate risk by ensuring the customer’s ability to repay in a changing rate environment before granting loan approval.

Agricultural: Loans for the production and housing of crops, fruits, vegetables, and livestock or to fund the purchase or re-finance of capital assets such as machinery and equipment, and livestock. The production of crops and livestock is especially vulnerable to commodity prices and weather. The vulnerability to commodity prices is offset by the farmer’s ability to hedge their position by the using future contracts. The risk related to weather is often mitigated by requiring federal crop insurance.

Consumer: Funding for individual and family purposes. Success in repayment is subject to borrower’s income, debt level, character in fulfilling payment obligations, employment, and others.

Industrial Development Bonds: Funds for public improvements in the Bank’s service area. Repayment ability is based on the continuance of the taxation revenue as the source of repayment.

All loan requests are reviewed as to credit worthiness and are subject to the Bank’s underwriting guidelines as to secured versus unsecured credit. Secured loans are in turn subject to loan to value (LTV) requirements based on collateral types as set forth in the Bank’s Loan Policy. In addition, credit scores of principal borrowers are reviewed and an approved exception from an additional officer is required should a credit score not meet the Bank’s Loan Policy guidelines.

Consumer Loans:

Maximum loan to value (LTV) for cars, trucks and light trucks vary from 90% to 110% depending on whether direct or indirect. Loans above 100% are generally due to additional charges for extended warranties and/or insurance coverage periods of lost wages or death.

Boats, campers, motorcycles, RV’s and Motor Coaches range from 80%-90% based on age of vehicle.

 

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1st or 2nd mortgages on 1-4 family homes range from 75%-90% with “in-house” first real estate mortgages requiring private mortgage insurance on those exceeding 80% LTV.

Raw land LTV maximum ranges from 65%-75% depending on whether or not the property has been improved.

Commercial/Agriculture:

Real Estate:

Maximum LTVs range from 70%-80% depending on type.

Accounts Receivable:

Up 80% LTV

Inventory:

Agriculture:

Livestock and grain up to 80% LTV, crops (insured) up to 75% and Warehouse Receipts up to 87%

Commercial:

Maximum LTV of 50% on raw and finished goods

Used vehicles, new recreational vehicles and manufactured homes not to exceed (NTE) 80% LTV

Equipment:

New not to exceed 80% of invoice, used NTE 50% of listed book or 75% of appraised value

Restaurant equipment up to 35% of market value

Heavy trucks, titled trailers and NTE 75% LTV and aircraft up to 75% of appraised value

We also provide checking account services, as well as savings and time deposit services such as certificates of deposits. In addition, ATM’s (automated teller machines) are also provided at our Ohio offices in Archbold, Wauseon, Stryker, West Unity, Bryan, Delta, Napoleon, Montpelier, Swanton, Defiance, and Perrysburg, along with ones at our Auburn and Angola, Indiana offices. Two ATM’s are located at Sauder Woodworking Co., Inc., a major employer in Archbold. Additional locations in Ohio are at Northwest State Community College, Archbold; Community Hospitals of Williams County, Bryan; Fairlawn Haven Wyse Commons, Archbold; R&H Restaurant, Fayette; Delta Eagles, Bryan Eagles; Sauder Village, Archbold; Fulton County Health Center, Wauseon; downtown Defiance; and a mobile trailer ATM. In Indiana, four additional ATM’s are located at St. Joe; at Kaiser’s Supermarket and Therma-Tru in Butler; and at DeKalb Memorial Hospital in Auburn.

F&M Investment Services, the brokerage department of the Bank, opened for business in April, 1999. Securities are offered through Raymond James Financial Services, Inc.

The Company is a bank holding company within the meaning of the Bank Holding Company Act of 1956. Our subsidiary bank is in turn regulated and examined by the Ohio Division of Financial Institutions, and the Federal Deposit Insurance Corporation. The activities of our bank subsidiary are also subject to other federal and state laws and regulations.

The Bank’s primary market includes communities located in the Ohio counties of Defiance, Fulton, Henry, Williams, and Wood. The commercial banking business in this market is highly competitive, with approximately 17 other depository institutions currently doing business in the Bank’s primary market. In our banking activities, we compete directly with other commercial banks, credit unions, farm credit services, and savings and loan institutions in each of our operating localities. In a number of our locations, we compete against entities which are much larger than us. The primary factors in competing for loans and deposits are the rates charged as well as location and quality of the services provided. On December 31, 2007, the Bank acquired the Knisely Bank of Indiana, expanding its market with the addition of offices in Butler and Auburn, Indiana, both located in DeKalb County. An additional office was opened in the summer of 2008 in Angola, Indiana, located in Steuben County. On July 9, 2010 the Bank purchased a branch office in Hicksville, Ohio shortening the distance between our Ohio and Indiana office.

At December 31, 2011, we had 261 full time equivalent employees. The employees are not represented by a collective bargaining unit. We provide our employees with a comprehensive benefit program, some of which are contributory. We consider our employee relations to be excellent.

 

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Supervision and Regulation

General

The Company is a corporation organized under the laws of the State of Ohio. The business in which the Company and its subsidiary are engaged is subject to extensive supervision, regulation and examination by various bank regulatory authorities. The supervision, regulation and examination to which the Company and its subsidiary are subject are intended primarily for the protection of depositors and the deposit insurance funds that insure the deposits of banks, rather than for the protection of shareholders.

Several of the more significant regulatory provisions applicable to banks and bank holding companies to which the Company and its subsidiary are subject are discussed below, along with certain regulatory matters concerning the Company and its subsidiary. To the extent that the following information describes statutory or regulatory provisions, it is qualified in its entirety by reference to the particular statutory provisions. Any change in applicable law or regulation may have a material effect on the business and prospects of the Company and its subsidiary.

Regulatory Agencies

The Company is a registered bank holding company and is subject to inspection, examination and supervision by the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”) pursuant to the Bank Holding Company Act of 1956, as amended.

The Bank is an Ohio chartered commercial bank. It is subject to regulation and examination by both the Ohio Division of Financial Institutions (ODFI) and the Federal Deposit Insurance Corporation (FDIC).

Holding Company Activities

As a bank holding company incorporated and doing business within the State of Ohio, the Company is subject to regulation and supervision under the Bank Holding Act of 1956, as amended (the “Act”). The Company is required to file with the Federal Reserve Board on quarterly basis information pursuant to the Act. The Federal Reserve Board may conduct examinations or inspections of the Company and its subsidiary.

The Company is required to obtain prior approval from the Federal Reserve Board for the acquisition of more than five percent of the voting shares or substantially all of the assets of any bank or bank holding company. In addition, the Company is generally prohibited by the Act from acquiring direct or indirect ownership or control of more than five percent of the voting shares of any company which is not a bank or bank holding company and from engaging directly or indirectly in activities other than those of banking, managing or controlling banks or furnishing services to its subsidiaries. The Company may, however, subject to the prior approval of the Federal Reserve Board, engage in, or acquire shares of companies engaged in activities which are deemed by the Federal Reserve Board by order or by regulation to be so closely related to banking or managing and controlling a bank as to be a proper activity.

On November 12, 1999, the Gramm-Leach-Bliley Act (the “GLB Act”) was enacted into law. The GLB Act made sweeping changes with respect to the permissible financial services which various types of financial institutions may now provide. The Glass-Steagall Act, which had generally prevented banks from affiliation with securities and insurance firms, was repealed. Pursuant to the GLB Act, bank holding companies may elect to become a “financial holding company,” provided that all of the depository institution subsidiaries of the bank holding company are “well capitalized” and “well managed” under applicable regulatory standards.

Under the GLB Act, a bank holding company that has elected to become a financial holding company may affiliate with securities firms and insurance companies and engage in other activities that are financial in nature. Activities that are “financial in nature” include securities underwriting, dealing and market-making, sponsoring mutual funds and investment companies, insurance underwriting and agency, merchant banking, and activities that the Federal Reserve Board has determined to be closely related to banking. No Federal Reserve Board approval is required for the Company to acquire a company, other than a bank holding company, bank or savings association, engaged in activities

 

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that are financial in nature or incidental to activities that are financial in nature, as determined by the Federal Reserve Board. Prior Federal Reserve Board approval is required before the Company may acquire the beneficial ownership or control of more than 5% of the voting shares, or substantially all of the assets, of a bank holding company, bank or savings association. If any subsidiary bank of the Company ceases to be “well capitalized” or “well managed” under applicable regulatory standards, the Federal Reserve Board may, among other actions, order the Company to divest the subsidiary bank. Alternatively, the Company may elect to conform its activities to those permissible for a bank holding company that is not also a financial holding company. If any subsidiary bank of the Company receives a rating under the Community Reinvestment Act of 1977 of less than satisfactory, the Company will be prohibited from engaging in new activities or acquiring companies other than bank holding companies, banks or savings associations. The Company has not elected to become a financial holding company and has no current intention of making such an election.

Affiliate Transactions

Various governmental requirements, including Sections 23A and 23B of the Federal Reserve Act, limit borrowings by holding companies and non-bank subsidiaries from affiliated insured depository institutions, and also limit various other transactions between holding companies and their non-bank subsidiaries, on the one hand, and their affiliated insured depository institutions on the other. Section 23A of the Federal Reserve Act also generally requires that an insured depository institution’s loan to its non-bank affiliates be secured, and Section 23B of the Federal Reserve Act generally requires that an insured depository institution’s transactions with its non-bank affiliates be on arms-length terms.

Interstate Banking and Branching

Under the Riegle-Neal Interstate Banking and Branching Efficiency Act (“Riegle-Neal”), subject to certain concentration limits and other requirements, adequately capitalized bank holding companies such as the Company are permitted to acquire banks and bank holding companies located in any state. Any bank that is a subsidiary of a bank holding company is permitted to receive deposits, renew time deposits, close loans, service loans and receive loan payments as an agent for any other bank subsidiary of that bank holding company. Banks are permitted to acquire branch offices outside their home states by merging with out-of-state banks, purchasing branches in other states and establishing de novo branch offices in other states. The ability of banks to acquire branch offices is contingent, however, on the host state having adopted legislation “opting in” to those provisions of Riegle-Neal. In addition, the ability of a bank to merge with a bank located in another state is contingent on the host state not having adopted legislation “opting out” of that provision of Riegle-Neal. The Company could from time to time use Riegle-Neal to acquire banks in additional states.

Control Acquisitions

The Change in Bank Control Act prohibits a person or group of persons from acquiring “control” of a bank holding company, unless the Federal Reserve Board has been notified and has not objected to the transaction. Under the rebuttable presumption established by the Federal Reserve Board, the acquisition of 10% or more of a class of voting stock of a bank holding company with a class of securities registered under Section 12 of the Exchange Act, such as the Company, would, under the circumstances set forth in the presumption, constitute acquisition of control of the bank holding company. In addition, a company is required to obtain the approval of the Federal Reserve Board under the Bank Holding Company Act before acquiring 25% (5% in the case of an acquirer that is a bank holding company) or more of any class of outstanding voting stock of a bank holding company, or otherwise obtaining control or a “controlling influence” over that bank holding company.

Liability for Banking Subsidiaries

Under the current Federal Reserve Board policy, a bank holding company is expected to act as a source of financial and managerial strength to each of its subsidiary banks and to maintain resources adequate to support each subsidiary bank. This support may be required at times when the bank holding company may not have the resources to provide it. In the event of a bank holding company’s bankruptcy, any commitment by the bank holding company to a U.S. federal bank

 

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regulatory agency to maintain the capital of a subsidiary bank would be assumed by the bankruptcy trustee and entitled to priority of payment. Any depository institution insured by the FDIC can be held liable for any loss incurred, or reasonably expected to be incurred, by the FDIC in connection with (1) the “default” of a commonly controlled FDIC-insured depository institution; or (2) any assistance provided by the FDIC to both a commonly controlled FDIC-insured depository institution “in danger of default.” The Company’s subsidiary bank is an FDIC-insured depository institution. If a default occurred with respect to the Bank, any capital loans to the Bank from its parent holding company would be subordinate in right of payment to payment of the Bank’s depositors and certain of its other obligations.

Regulatory Capital Requirements

The Company is required by the various regulatory authorities to maintain certain capital levels. Bank holding companies are required to maintain minimum levels of capital in accordance with Federal Reserve Board capital adequacy guidelines. If capital falls below minimum guideline levels, a bank holding company, among other things, may be denied approval to acquire or establish additional banks or non-bank businesses. The required capital levels and the Company’s capital position at December 31, 2010 and December 31, 2011 are summarized in the table included in Note 14 to the consolidated financial statements.

FDICIA

The Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”), and the regulations promulgated under FDICIA, among other things, established five capital categories for insured depository institutions-well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized-and requires U.S. federal bank regulatory agencies to implement systems for “prompt corrective action” for insured depository institutions that do not meet minimum capital requirements based on these categories. Unless a bank is well capitalized, it is subject to restrictions on its ability to offer brokered deposits and on certain other aspects of its operations. An undercapitalized bank must develop a capital restoration plan and its parent bank holding company must guarantee the bank’s compliance with the plan up to the lesser of 5% of the banks or thrift’s assets at the time it became undercapitalized and the amount needed to comply with the plan. As of December 31, 2011 the Company’s banking subsidiary was well capitalized pursuant to these prompt corrective action guidelines.

Dividend Restrictions

The ability of the Company to obtain funds for the payment of dividends and for other cash requirements will be largely dependent on the amount of dividends which may be declared by its banking subsidiary. Various U.S. federal statutory provisions limit the amount of dividends the Company’s banking subsidiary can pay to the Company without regulatory approval. Dividend payments by the Bank are limited to its retained earnings during the current year and its prior two years. See Note 15 to the consolidated financial statements for the actual amount.

Deposit Insurance Assessments

The deposits of the Company’s banking subsidiary are insured up to the regulatory limits set by the FDIC. Prior to April 1, 2011, deposits were subject to deposit insurance assessments based on the Federal Deposit Insurance Reform Act of 2005 which was effective on April 21, 2006. The FDIC maintains the Deposit Insurance Fund (“DIF”) by assessing depository institutions an insurance premium (assessment). The amount assessed to each institution was based on statutory factors that included the balance of insured deposits, as well as the degree of risk the institution posed to the DIF. The FDIC assessed higher rates to those institutions that posed greater risks to the insurance fund.

In order to recapitalize and restore the DIF, the FDIC initially established a Restoration Plan in October 2008 to return the DIF to the statutorily mandated minimum reserve ratio of 1.15 percent within five years. Since 2008 and due to the extraordinary circumstances facing the banking industry, the FDIC imposed an emergency special assessment in 2009 and continued to make further amendments to it Restoration Plan by extending the restoration period for the DIF, increasing the premium assessments, and changing how regular deposit insurance premiums are assessed.

 

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The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank Act”) revised the statutory authorities governing the FDIC’s management of the DIF. Key requirement from the Dodd-Frank Act resulted in the FDIC’s adoption of new rules in February 2011 regarding Assessments, Dividends, Assessment Base, and Large Bank Pricing. The new rules implemented the following changes: (1) redefined the definition of an institution’s deposit insurance assessment base from one based on domestic deposits to one based on assets now defined as “average consolidated total assets minus average tangible equity”; (2) changed the assessment rate adjustments to better account for risk based on an institution’s funding sources; (3) revised the deposit insurance assessment rate schedule in light of the new assessment base and assessment rate adjustments; (4) implemented Dodd-Frank Act dividend provisions; (5) revised the large insured depository institution assessment system to better differentiate for risk and to take into account losses the FDIC may incur from large institution failures; and (6) provided technical and other changes to the FDIC’s assessment rules. Though deposit insurance assessments maintain a risk-based approach, the FDIC imposed a more extensive risk-based assessment system on large insured depository institutions with at least $10 billion in total assets since they are more complex in nature and could pose greater risk. The rules became effective April 1, 2011 implementing the revised assessment rate schedule for the quarter beginning April 1, 2011. The revised assessment rate schedule was used to calculate the June 30, 2011 assessments which were due September 30, 2011 and subsequent quarterly assessments thereafter.

Due to the changes to the assessment base and assessment rates, as well as the DIF restoration time frame, the impact on the Company’s future deposit insurance assessments has been and should continue to be favorable.

The Emergency Economic Stabilization Act of 2008 provided a temporary increase in deposit insurance coverage from $100,000 to $250,000 per depositor. This legislation was effective immediately upon the President’s signature on October 3, 2008. The basic deposit insurance limit was set to return to $100,000 on January 1, 2010; however, on May 20, 2009 the temporary increase was extended through December 31, 2013.

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank Act”) permanently raised the standard maximum deposit insurance coverage amount to $250,000 and made the increase retroactive to January 1, 2008. This was effective immediately upon the President’s signature on July 21, 2010. The FDIC deposit insurance coverage limit applies per depositor, per insurance depository institution for each account ownership category.

The FDIC Board of Directors issued a final rule on November 9, 2010 implementing a provision of the Dodd-Frank Act which temporarily provided for separate deposit insurance coverage for noninterest-bearing transaction accounts. Funds held in noninterest-bearing transaction accounts are fully insured, without limit, and the temporary unlimited coverage is separate from, and in addition to, the deposit insurance coverage provided to depositors with respect to other accounts held at an insured depository institution. This temporary deposit insurance coverage became effective on December 31, 2010 and will terminate on December 31, 2012. A noninterest-bearing transaction account is a deposit account in which (1) interest is neither accrued nor paid, (2) depositors are permitted to make an unlimited number of transfers and withdrawals, and (3) the insured depository institution does not reserve the right to require advance notice of an intended withdrawal. As of January 1, 2013, noninterest-bearing transaction accounts will then be insured under the FDIC’s general deposit insurance coverage rules. The Dodd-Frank Act provision did not include low-interest NOW (Negotiable Order of Withdrawal) Accounts or Interest on Lawyer Trust Accounts (“IOLTAs”) within the definition of noninterest-bearing transaction accounts. On December 29, 2010, the FDIC Board of Directors issued a final rule amending the Federal Deposit Insurance Act (FDI Act) to include IOLTAs within the definition of a noninterest-bearing transaction account thereby providing such accounts with temporary, unlimited deposit insurance coverage.

Depositor Preference Statute

In the “liquidation or other resolution” of an institution by any receiver, U.S. federal legislation provides that deposits and certain claims for administrative expenses and employee compensation against the insured depository institution would be afforded a priority over general unsecured claims against that institution, including federal funds and letters of credit.

 

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Government Monetary Policy

The earnings of the Company are affected primarily by general economic conditions and to a lesser extent by the fiscal and monetary policies of the federal government and its agencies, particularly the Federal Reserve. Its policies influence, to some degree, the volume of bank loans and deposits, and interest rates charged and paid thereon, and thus have an effect on the earnings of the Company’s subsidiary Bank.

Capital Purchase Program

In response to the financial crisis affecting the banking system and financial markets, the Emergency Economic Stabilization Act of 2008 (the “EESA”) was signed into law on October 3, 2008 creating the Troubled Assets Relief Program (“TARP”). As part of TARP, the U.S. Treasury established the Capital Purchase Program to provide up to $700 billion of funding to eligible financial institutions through the purchase of capital stock and other financial institutions for the purpose of stabilizing and providing liquidity to the United States financial markets. The Company did not participate in the TARP Capital Purchase Program. In connection with the EESA, there have been numerous actions by the Federal Reserve Board, the United States Congress, the U.S. Treasury, the FDIC, the SEC and others to further the economic and banking industry stabilization efforts under the EESA. It remains unclear at this time what further legislative and regulatory measures will be implemented under the EESA that affect the Company.

Additional Regulation

The Bank is also subject to federal regulation as to such matters as required reserves, limitation as to the nature and amount of its loans and investments, regulatory approval of any merger or consolidation, issuance or retirement of their own securities, limitations upon the payment of dividends and other aspects of banking operations. In addition, the activities and operations of the Bank are subject to a number of additional detailed, complex and sometimes overlapping laws and regulations. These include state usury and consumer credit laws, state laws relating to fiduciaries, the federal Truth-in-Lending Act and Regulation Z, the federal Equal Credit Opportunity Act and Regulation B, the Fair Credit Reporting Act, the federal Home Mortgage Disclosure Act and Regulation C, the federal Electronic Funds Transfer Act and Regulation E, the federal Truth in Lending Act and Regulation Z, the federal Truth in Savings Act and Regulation DD, the Bank Secrecy Act, the federal Community Reinvestment Act, HUD’s Real Estate Settlement Act (RESPA) regulations, anti-discrimination laws and legislation, and antitrust laws.

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank Act”) signed by the President on July 21, 2010 posed a significant impact on financial regulations. Certain provisions such as the permanent increase in deposit insurance coverage had an immediate effective date. Provisions regarding rules for interchanges fees on electronic debit transactions must be effective by October 1, 2011. Other provisions which, though intended to provide regulatory relief to community banks, may require time and further analysis to evaluate the actual consequences. Implementation of the Dodd-Frank Act provisions, which are conservatively estimated at more than 5,000 pages of new or expanded regulations for banks, will result in new rulemaking by the federal regulatory agencies over the next several years. Fully implementing the new and expanded regulation will involve ensuring compliance with extensive new disclosure and reporting requirements. The Dodd-Frank Act created an independent regulatory body, the Bureau of Consumer Financial Protection (“Bureau”), with authority and responsibility to set rules and regulations for most consumer protection laws applicable to all banks – large and small - adds another regulator to scrutinize and police financial activities. Transfer to the Bureau of all consumer financial protection functions for designated laws by the other federal agencies was completed on July 21, 2011. The Bureau has responsibility for mortgage reform and enforcement, as well as broad new powers over consumer financial activities which could impact what consumer financial services would be available and how they are provided. The following consumer protection laws are the designated laws that will fall under the Bureau’s rulemaking authority: the Alternative Mortgage Transactions Parity Act of 1928, the Consumer Leasing Act of 1976, the Electronic Fund Transfer Act, the Equal Credit Opportunity Act, the Fair Credit Billing Act, the Fair Credit Reporting Act subject to certain exclusions, the Fair Debt Collection Practices Act, the Home Owners Protection Act, certain privacy provisions of the Gramm-Leach-Bliley Act, the Home Mortgage Disclosure Act (HMDA), the Home Ownership and Equity Protection Act of 1994, the Real Estate Settlement Procedures Act (RESPA), the S.A.F.E. Mortgage Licensing Act of 2008 (SAFE Act), and the Truth in Lending Act.

 

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The Bureau has issued a Notice regarding the Streamlining of Inherited Regulations. Suggestions from the public are requested regarding the streamlining of regulations inherited from the other Federal agencies due to the transfer of authority. The notice also sought suggestions for practical measures that would make complying with the regulations easier. In addition to the Notice of Streamlining of Inherited Regulations, the Bureau is currently republishing the regulations implementing the consumer financial protection laws. Issuance of Interim Final Rules for each regulation with a request for public comment provide for technical and conforming changes to reflect the transfer of authority and certain other non-substantive changes to the regulations made by the Dodd-Frank Act. Currently the Bureau is testing prototypes designs for a combined initial mortgage loan disclosure and a combined closing mortgage loan disclosure. This involves combining two key federal disclosures into a single mortgage disclosure form that is intended to be easy for the consumer to understand and will also make compliance easier. The public is invited to review and comment on what works. The Bureau has also issued a prototype of a shorter, simpler credit card agreement for public comment and review. The intent is to help consumers better understand their credit card agreements. The Bureau’s website (www.consumerfinance.gov) serves as a resource for submission of credit card complaints and mortgage complaints. Review and revision of current financial regulations in conjunction with added new financial service regulations will heighten the regulatory compliance burden and increase litigation risk for the banking industry.

Future Legislation

Changes to the laws and regulations, both at the federal and state levels, can affect the operating environment of the Company and its subsidiary in substantial and unpredictable ways. The Company cannot accurately predict whether those changes in laws and regulations will occur, and, if those changes occur, the ultimate effect they would have upon the financial condition or results of operations of the Company or its subsidiary.

Available Information

The Company maintains an Internet web site at the following internet address: www.fm-bank.com. The Company files reports with the Securities and Exchange Commission (SEC). Copies of all filings made with the SEC may be read and copied at the SEC’s Public Reference Room, 450 Fifth Street, Washington, DC, 20549. You may obtain information about the SEC’s Public Reference Room by calling (800/SEC-0330). Because the Company makes its filing with the SEC electronically, you may access such reports at the SEC’s website, www.sec.gov. The Company makes available, free of charge through its internet address, copies of its annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and any amendments to these reports as soon as reasonable practicable after such materials have been filed with or furnished to the SEC. Copies of these documents may also be obtained, either in electronic or paper form, by contacting Barbara J. Britenriker, Chief Financial Officer of the Company at (419) 446-2501.

Please see the Consolidated Financial Statements provided under Part II, Item 8 of this Form 10-K for information regarding the Company’s revenues from external customers, profits, and total assets for and as of, respectively, the fiscal year ended December  31, 2011.

ITEM 1a. RISK FACTORS

Significant Competition from an Array of Financial Service Providers

Our ability to achieve strong financial performance and a satisfactory return on investment to shareholders will depend in part on our ability to expand our available financial services. In addition to the challenge of attracting and retaining customers for traditional banking services, our competitors now include securities dealers, brokers, mortgage bankers, investment advisors and finance and insurance companies who seek to offer one-stop financial services to their customers that may include services that banks have not been able or allowed to offer to their customers in the past. The increasingly competitive environment is a result primarily of changes in regulation, changes in technology and product delivery systems and the accelerating pace of consolidation among financial services providers. If we fail to adequately address each of the competitive pressures in the banking industry, our financial condition and results of operations could be adversely affected.

 

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Credit Risk

The risk of nonpayment of loans is inherent in commercial banking. Such nonpayment could have an adverse effect on the Company’s earnings and our overall financial condition as well as the value of our common stock. Management attempts to reduce the Bank’s credit exposure by carefully monitoring the concentration of its loans within specific industries and through the loan approval process. However, there can be no assurance that such monitoring and procedures will totally mitigate the risks. Credit losses can cause insolvency and failure of a financial institution and, in such event, its shareholders could lose their entire investment. For more information on the exposure of the Company and the Bank to credit risk, see the section under Part II, Item 7 of this Form 10-K captioned “Loan Portfolio.”

Susceptibility to Changes in Regulation

Any changes to state and federal banking laws and regulations may negatively impact our ability to expand services and to increase the value of our business. We are subject to extensive state and federal regulation, supervision, and legislation that govern almost all aspects of our operations. These laws may change from time to time and are primarily intended for the protection of consumers, depositors and the deposit insurance funds. In addition, the Company’s earnings are affected by the monetary policies of the Board of Governors of the Federal Reserve. These policies, which include regulating the national supply of bank reserves and bank credit, can have a major effect upon the source and cost of funds and the rates of return earned on loans and investments. The Federal Reserve influences the size and distribution of bank reserves through its open market operations and changes in cash reserve requirements against member bank deposits. The Gramm-Leach-Bliley Act regarding financial modernization that became effective in November, 1999 removed many of the barriers to the integration of the banking, securities and insurance industries and is likely to increase the competitive pressures upon the Bank. We cannot predict what effect such Act and any presently contemplated or future changes in the laws or regulations or their interpretations would have on us, but such changes could be materially adverse to our financial performance. For more information on this subject, see the section under Part I, Item 1 of this Form 10-K captioned “Supervision and Regulation.”

Interest Rate Risk

Changes in interest rates affect our operating performance and financial condition in diverse ways. Our profitability depends in substantial part on our “net interest spread,” which is the difference between the rates we receive on loans and investments and the rates we pay for deposits and other sources of funds. Our net interest spread will depend on many factors that are partly or entirely outside our control, including competition, federal economic, monetary and fiscal policies, and economic conditions generally. Historically, net interest spreads for other financial institutions have widened and narrowed in response to these and other factors, which are often collectively referred to as “interest rate risk.” Over the last few years, the Bank, along with most other financial institutions, has experienced a “margin squeeze” as drastic interest rate decreases have made it difficult to maintain a more favorable net interest spread. During 2011, the Bank’s margin and spread tightened slightly as the rate environment remained low and flat. Maturities of higher rate deposits aided the decrease in cost of funds.

The Bank manages interest rate risk within an overall asset/liability framework. The principal objectives of asset/liability management are to manage sensitivity of net interest spreads and net income to potential changes in interest rates. Funding positions are kept within predetermined limits designed to ensure that risk-taking is not excessive and that liquidity is properly managed. In the event that our asset/liabilities management strategies are unsuccessful, our profitability may be adversely affected. For more information regarding the Company’s exposure to interest rate risk, see Part II, Item 7A of this Form 10-K.

Attraction and Retention of Key Personnel

Our success depends upon the continued service of our senior management team and upon our ability to attract and retain qualified financial services personnel. Competition for qualified employees is intense. In our experience, it can take a significant period of time to identify and hire personnel with the combination of skills and attributes required in carrying out our strategy. If we lose the services of our key personnel, or are unable to attract additional qualified personnel, our business, financial condition, results of operations and cash flows could be materially adversely affected.

 

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A key component of employee retention is providing a fair compensation base combined with the opportunity for additional compensation for above average performance. In this regard, the Company and the Bank use two incentive programs. The Company uses a stock award program to recognize and incent officers of the Bank. Under the long-term incentive compensation plan, restricted stock awards may be granted to officers. The amount of shares to be granted each year is determined by the Board Compensation Committee and may vary each year in its amount of shares and the number of recipients. The Compensation Committee determines the number of shares to be awarded overall and to the Chief Executive Officer (“CEO”). The CEO then makes recommendations to the committee as to the recipients of the remaining shares. The full Board of Directors approves the action of the Committee. Since the plan’s inception in 2005, all granted stock awards have utilized a three year cliff vesting feature. This is viewed as a retention aid as the awards may be forfeited should an officer leave employment during the vesting period.

A second incentive program of the Bank is based on cash compensation of which almost all employees participate (excluding commission based employees and other employees paid for specific higher paid positions, such as peak time.) A discussion of executive officer pay is incorporated within the proxy and as such, this discussion will pertain to all other employees. Non-officer employees are paid a cash incentive based on the projected overall performance of the Bank in terms of Return of Average Assets (“ROA”). The Compensation Committee determines the target performance levels on which the percentage of pay will be based. The Committee takes into account the five and ten year trend of ROA along with budget forecasted for the next year and the Bank’s past year performance. The Committee also considers the predicted banking environment under which the Bank will be operating. Non-officers receive incentive pay in December of the same year based on the year-to-date base compensation through the last pay received in November.

Officers, other than executive, receive incentive pay based on additional criterion. The officers are rewarded based on overall ROA of the Bank along with individual pre-established goals. Officers, therefore, have incentive pay at risk for individual performance. The individualized goals are recommended by each officer’s supervisor and are approved by an incentive committee of the Bank. The goals are designed to improve the performance of the Bank while also limiting the risk of a short-term performance focus. For example, a lending officer may be given two goals of which one is to grow loans within specific targets and another is tied to a specific level of past dues and charge-offs. The second goal limits the ability to be rewarded for growth at all costs along with the specific target levels within the growth goal itself. Officers in a support department may be given goals which create efficiencies, ensure compliance with procedures, or generate new fee or product opportunities. An average of four goals were given to each officer in 2011. Officers are paid cash incentives based on the year end ROA of the Bank and receive it within the first quarter of the following year. Should the ROA be forecasted to be positive but below the base target set by the Board, the officers are paid an incentive under the same basis and timing as non-officers disclosed above.

The percentages of base pay on which the incentive is calculated graduates higher as does the responsibility level of the employee and their ability to impact the financial performance of the Bank. These percentages are recommended by management to the Compensation Committee and Board for approval. The cash incentive plan along with its targets and goals are subject to modification at the Compensation Committee and Board’s discretion throughout each year.

Dividend Payout Restrictions

We currently pay a quarterly dividend on our common shares. However, there is no assurance that we will be able to pay dividends in the future. Dividends are subject to determination and declaration by our board of directors, which takes into account many factors. The declaration of dividends by us on our common stock is subject to the discretion of our board and to applicable state and federal regulatory limitations. The Company’s ability to pay dividends on its common stock depends on its receipt of dividends from the Bank. The Bank is subject to restrictions and limitations in the amount and timing of the dividends it may pay to the Company.

 

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Anti-Takeover Provisions

Provisions of our Articles of Incorporation and Ohio law could have the effect of discouraging takeover attempts which certain stockholders might deem to be in their interest. These anti-takeover provisions may make us a less attractive target for a takeover bid or merger, potentially depriving shareholders of an opportunity to sell their shares of common stock at a premium over prevailing market prices as a result of a takeover bid or merger.

Operational Risks

We are subject to certain operational risks, including, but not limited to, data processing system failures and errors, customer or employee fraud and catastrophic failures resulting from terrorist acts or natural disasters. We maintain a system of internal controls to mitigate against such occurrences and maintain insurance coverage for such risks that are insurable, but should such an event occur that is not prevented or detected by our internal controls, uninsured or in excess of applicable insurance limits, it could have a significant adverse impact on our business, financial condition or results of operations.

Limited Trading Market

Our common stock is not listed on any exchange or The NASDAQ Stock Market. Our stock is currently quoted in the over-the-counter markets.

ITEM 1b. UNRESOLVED STAFF COMMENTS

None.

ITEM 2. PROPERTIES

Our principal office is located in Archbold, Ohio.

The Bank operates from the facilities at 307 North Defiance Street. In addition, the Bank owns the property from 200 to 208 Ditto Street, Archbold, Ohio, which it uses for Bank parking and a community mini-park area. The Bank owns real estate at two locations, 207 Ditto Street and 209 Ditto Street in Archbold, Ohio upon which the bank built a commercial building to be used for storage, and a parking lot for company vehicles and employee parking. The Bank also owns real estate across from the main facilities to provide for parking.

The Bank occupies an Operations Center at 622 Clydes Way in Archbold, Ohio to accommodate our growth over the years. The bank owns a parking lot in downtown Montpelier which had been provided for customer use. The bank owns a property at 204 Washington Street, St Joe, Indiana at which an ATM is located.

The Bank owns all of its office locations, with the exception of Angola, Indiana. The Angola office location is leased. Current locations of retail banking services are:

 

Office

  

Location

Archbold, Ohio    1313 S Defiance Street
Wauseon, Ohio   

1130 N Shoop Avenue

119 N Fulton Street

Stryker, Ohio    300 S Defiance Street
West Unity, Ohio    200 W Jackson Street
Bryan, Ohio   

929 E High Street

1000 S Main Street

Delta, Ohio    101 Main Street
Montpelier, Ohio    1150 E Main Street
Napoleon, Ohio    2255 Scott Street
Swanton, Ohio    7 Turtle Creek Circle
Defiance, Ohio    1175 Hotel Drive
Perrysburg, Ohio    7001 Lighthouse Way
Butler, Indiana    200 S Broadway
Auburn, Indiana    403 Erie Pass
Angola, Indiana    2310 N Wayne Street
Hicksville, Ohio    100 N. Main Street

 

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All but one of the above locations have drive-up service facilities and an ATM.

ITEM 3. LEGAL PROCEEDINGS

There are no material pending legal proceedings, other than ordinary routine proceedings incidental to the business of the Bank or the Company, to which we are a party or of which any of our properties are the subject.

ITEM 4. Mine Safety Disclosures

None.

PART II.

ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

Our common stock is not listed on the NASDAQ stock market or any other stock exchange. While there is no established public trading market for our common stock, our shares are currently dually-quoted by various market makers on the Pink Sheets and the Over the Counter Bulletin Board, which are both over-the-counter quotation services for participant broker-dealers.

There are market makers that set a price for our stock; however, private sales continue to occur. The high and low sale prices were from sales of which we have been made aware by researching daily on Bloomberg.com. The high and low sale prices known to our management are as follows:

 

Stock Prices 2011

 

Quarter

   Low      High  

1st

   $ 17.65       $ 19.00   

2nd

     17.45         18.75   

3rd

     17.25         18.74   

4th

     17.11         17.96   

 

Stock Prices 2010

 

Quarter

   Low      High  

1st

   $ 16.00       $ 19.00   

2nd

     17.00         20.00   

3rd

     17.95         19.45   

4th

     16.95         18.75   

 

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The Company utilizes Registrar and Transfer Company as its transfer agent.

As of January 27, 2012 there were 2,040 record holders of our common stock.

Below is a line-graph presentation comparing the cumulative total shareholder returns for the Corporation, an index for NASDAQ Stock Market (U.S. Companies) comprised of all domestic common shares traded on the NASDAQ National Market System and the NASDAQ Bank Index for the five-year period ended December 31, 2011. The chart compares the value of $100 invested in the Corporation and each of the indices and assumes investment on December 31, 2006 with all dividends reinvested.

The Board of Directors recognizes that the market price of stock is influenced by many factors, only one of which is performance. The stock price performance shown on the graph is not necessarily indicative of future performance.

 

LOGO

I. Year 2006 as the Base

 

      2006      2007      2008      2009      2010      2011  

FMSB

     100.00         93.26         95.18         81.96         92.72         94.15   

NASDAQ - COMPOSITE

     100.00         110.63         66.60         96.61         114.00         113.13   

NASDAQ-BANK INDEX

     100.00         80.38         63.34         52.94         60.35         54.04   

Dividends are declared and paid quarterly. Per share dividends declared for the years ended 2011 and 2010 are as follows:

 

      1st Quarter      2nd Quarter      3rd Quarter      4th Quarter      Total  

2011

     0.19         0.19         0.19         0.19         0.76   

2010

     0.18         0.18         0.18         0.19         0.73   

The ability of the Company to pay dividends is limited by the dividend that the Company receives from the Bank. The Bank may pay as dividends to the Company its retained earnings during the current year and its prior two years. Currently, such limitation on the payment of dividends from the Bank to the Company does not materially restrict the Company’s ability to pay dividends to its shareholders.

Dividends declared during 2011 were $0.76 per share totaling $3.56 million, 4.11% higher than 2010 declared dividends of $0.73 per share. During 2011, the Company purchased 16,779 shares and awarded 11,000 shares to 56 employees and 778 shares were forfeited under its long term incentive plan. At year end, 2011, the Company held 483,663 shares in Treasury stock and 29,715 in unearned stock awards.

 

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Dividends declared during 2010 were $0.73 per share totaling $3.44 million, 1.39% higher than 2009 declared dividends of $0.72 per share. During 2010, the Company purchased 48,130 shares and awarded 10,150 restricted shares to 53 employees under its long term incentive plan. 1,575 shares were forfeited during 2010. At year end 2010, the Company held 477,106 shares in Treasury stock and 28,925 in unearned stock awards.

The Company continues to have a strong capital base and to maintain regulatory capital ratios that are significantly above the defined regulatory capital ratios. On January 20, 2012, the Company announced the authorization by its Board of Directors for the Company’s repurchase, either on the open market, or in privately negotiated transactions, of up to 200,000 shares of its outstanding common stock commencing January 20, 2012 and ending December 31, 2012.

 

Primary Ratio

     10.80

Tier I Leverage Ratio

     10.25

Risk Based Capital Tier I

     15.66

Total Risk Based Capital

     16.54

Stockholders’ Equity/Total Assets

     11.39

ISSUER PURCHASES OF EQUITY SECURITIES

 

Period

   Total Number
of Shares
Purchased
     Average Price
Paid per Share
     Total Number of
Shares Purchased
as Part of  Publicly
Announced
Programs
     Remaining Share
Repurchase
Authorization
 

10/1/2011 to 10/31/2011

     —           —           —           188,221   

11/1/2011 to 11/30/2011

     5,000       $ 17.96         5,000         183,221   

12/1/2011 to 12/31/2011

     0         0         0         183,221   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total (I)

     5,000       $ 17.96         5,000         183,221   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

(1) The Company purchased shares in the market pursuant to stock repurchase program publicly announced on January 21, 2011. On that date, the Board of Directors authorized the repurchase of 200,000 common shares between January 21, 2011 and December 31, 2011. 5,000 shares were repurchased in the fourth quarter. In total for 2011, 16,779 shares were repurchased.

Reclassification

Certain amounts in the 2010 and 2009 consolidated financial statements have been reclassified to conform with the 2011 presentation.

 

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ITEM 6. SELECTED FINANCIAL DATA

SUMMARY OF SELECTED CONSOLIDATED FINANCIAL DATA

Summary of Consolidated Statement of Income - UNAUDITED

 

     (In Thousands, except share data)  
     2011     2010     2009     2008     2007  

Summary of Income:

          

Interest income

   $ 36,660      $ 39,893      $ 41,114      $ 43,824      $ 45,424   

Interest expense

     8,156        10,863        13,220        18,101        21,722   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net Interest Income

     28,504        29,030        27,894        25,723        23,702   

Provision for loan loss

     1,715        5,325        3,558        1,787        871   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net interest income after provision for loan loss

     26,789        23,705        24,336        23,936        22,831   

Other income (expense), net

     (15,382     (14,342     (15,256     (14,763     (12,269
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income before income taxes

     11,407        9,363        9,080        9,173        10,562   

Income taxes

     2,893        2,382        2,475        2,450        2,828   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income

   $ 8,514      $ 6,981      $ 6,605      $ 6,723      $ 7,734   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Per Share of Common Stock:

          

Earnings per common share outstanding *

          

Net income

   $ 1.82      $ 1.48      $ 1.39      $ 1.39      $ 1.52   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Dividends

   $ 0.76      $ 0.73      $ 0.72      $ 0.68      $ 0.64   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Weighted average number of shares outstanding

     4,689,021        4,721,235        4,741,392        4,846,310        5,097,636   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

* Based on weighted average number of shares outstanding

Summary of Consolidated Balance Sheet - UNAUDITED

 

     (In Thousands)  
     2011     2010     2009     2008     2007  

Total assets

   $ 922,993      $ 906,363      $ 853,860      $ 805,729      $ 803,974   

Loans

     501,124        521,883        563,911        562,336        523,474   

Total Deposits

     739,382        724,513        676,444        615,732        634,593   

Stockholders’ equity

     105,091        94,403        93,584        90,547        89,375   

Key Ratios

          

Return on average equity

     8.56     7.38     7.19     7.51     8.71

Return on average assets

     0.93     0.80     0.80     0.84     1.06

Loans to deposits

     67.78     72.03     83.36     91.33     82.49

Capital to assets

     11.39     10.42     10.96     11.24     11.12

Dividend payout

     41.85     49.33     51.66     48.77     42.00

 

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

Critical Accounting Policy and Estimates

The Company’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America, and the Company follows general practices within the financial services industry in which it operates. At times the application of these principles requires Management to make assumptions, estimates and judgments that affect the amounts reported in the financial statements and accompanying notes. These assumptions, estimates and judgments are based on information available as of the date of the financial statements. As this information changes, the financial statements could reflect different assumptions, estimates and judgments. Certain policies inherently have a greater reliance on assumptions, estimates and judgments and as such have a greater possibility of producing results that could be materially different than originally reported. Examples of critical assumptions, estimates and judgments are when assets and liabilities are required to be recorded at fair value, when a decline in the value of an asset not required to be recorded at fair value warrants an impairment write-down or valuation reserve to be established, or when an asset or liability must be recorded contingent upon a future event.

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

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

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

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

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

The Company’s mortgage servicing rights relating to loans serviced for others represent an asset of the Company. This asset is initially capitalized and included in other assets on the Company’s consolidated balance sheet. The mortgage servicing rights are then amortized against noninterest income in proportion to, and over the period of, the estimated future net servicing income of the underlying mortgage servicing rights. There are a number of factors, however, that can affect the ultimate value of the mortgage servicing rights to the Company, including the estimated

 

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

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

2011 in Review

In many areas, the Company was able to return to “pre-recession” or 2007 levels during 2011. Overall profitability was the highest since 2007while asset quality continued its improvement that had begun in 2010. Unemployment remained high in the markets we serve, though improvement began the second half of 2010 and continued throughout 2011. The low interest rate environment continued to place pressure on the Company’s net interest margin. The economic outlook appears to favor economic recovery as some companies in the area announced probable expansion of their workforce in 2012. The local trucking industry volume has increased which serves as a leading indicator of increased spending.

Profitability was boosted in 2011 by the collection of two large nonaccrual loans. Both relationships were agricultural based. One collection occurred in the first quarter with the process taking three years to complete. The second relationship was placed on non-accrual in the second quarter with all funds collected in the fourth quarter. All legal fees associated with the collection process were also reimbursed to the Company. Nonaccruals decreased $3.7 million in 2011, ending the year with a $2.1 million balance. Further discussion of the impact of these collections is included in net interest income section along with the noninterest expense section.

The improvement in asset quality also correlates to a $20.8 million decrease in the net loan balances when comparing December 31, 2011 to the same date in 2010. This smaller balance in loans in turn explains a somewhat hidden cost – a decline in the interest income from loans for 2011 as compared to 2010. This is discussed in greater detail in the net interest income section.

Offsetting the lower interest income in the loan portfolio was the $504 thousand gain on sale of investments and a decrease in noninterest expense during 2011. The changes made to the FDIC assessment calculation for the second half were favorable to the Bank and contributed to the decrease in noninterest expense.

The Company is proud of the strides that were achieved in improving asset quality while increasing 2011’s net income over 2010. Earnings per share were significantly higher than the previous two years, $.34 higher than 2010 and $.43 higher than 2009. The Company is well positioned to face the challenges of 2012.

 

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Material Changes in Results of Operations

The discussion now turns to more financial based results and trends as a result of 2011 operations. In comparing line items of the consolidated statement of income for years ended 2009 through 2011, it is easily seen where the Company has been spending its time and the impact of the recession. Decreasing interest income and expense are obvious large factors on the profitability of the Company for 2011; however, that discussion can be found in the net interest income section. This discussion will focus on the significant noninterest items that impacted the operations of the Company.

The Company had concerns with the cost of regulation and possible loss of revenue from new regulations stemming from Dodd-Frank. One area of revenue impact was in overdraft fees. Updated Regulation E guidelines were implemented on August 15, 2010 and the Bank ended 2010 with a lower revenue stream by $22 thousand than 2009. This occurred even with the addition of the Hicksville office in July of 2010. 2011 also ended the year $20.8 thousand lower than in 2010 even though every office recorded an increase in the number of checking accounts and balances at yearend were $23 million higher than yearend 2010. Accounting for $2.4 million in noninterest income, this represents 71% of the line item service charges and fees on the income statement. The Bank has made this an area of focus for 2012 as this revenue stream remains under intense regulator review.

While the Bank did experience a heightened level of debit card fraud during the second quarter of 2011, overall, revenue improved $239 thousand from ATM/debit card usage as compared to 2010. This preceded an increase of $232 thousand in 2010 over 2009. The Bank receives interchange revenue from each “swipe” of the card. Both increases are attributed to the growth and popularity of the Bank’s Reward checking product which migrated to KASASA in 2010. One of the criteria for the payment of high interest on the account is utilizing the debit card at least twelve times per statement cycle. The Bank’s Reward & KASASA Checking customers averaged 29 and 25 transactions per statement during 2011 and 2010 respectively, surpassing the 9 transactions average of our Free Checking customers. The additional revenue from debit card usage offsets the interest expense, creating a win-win situation for the customers and the Bank. In 2011, this revenue stream was at risk to be reduced by the Federal Reserve regulating the interchange fee. The establishment of a tiered pricing for banks under $10 billion has helped to protect the profitability though the concern remains as to how long this tiered pricing will remain in effect. All of the KASASA products have a debit card usage qualification; however, interest income is not the customer benefit for all accounts. As an alternative to receiving interest on their deposits, customers may choose to receive credit towards iTunes downloads or donate earnings to charity.

The largest factor for 2011’s $1.4 million decline from 2010 in noninterest income was the loss on sale of other assets owned or OREO, an acronym for Other Real Estate Owned. OREO is the last piece in the funneling out of loan collection issues. While past due and watch list loans are the first to improve, OREO usually is the last. The loss consists of the loss recognized from sales and also from write-downs to the carrying value when appraisals or other factors necessitate it. 78% of the overall decrease in noninterest income is due to the losses on OREO. The correlating carrying value on the balance sheet as of December 31, 2011 is $896 thousand less than the same date in 2010.

With the secondary mortgage activity lower in 2011, the mortgage servicing rights income and gain on sale of loans at $807 thousand was $588 thousand lower than 2010. Long term rates are lower than a year ago; however the refinancing and new purchases activity has also decreased. Whether consumers are unable to refinance due to lower home values, increased cost of fees to do so, or failure to meet the qualifications, the activity has not equaled prior years. 2010 was $1.4 million; $381 thousand lower than 2009’s $1.78 million. Lower rates have not provided the level of stimulus it was hoped to.

The last item to discuss in the noninterest income section is the gain on sale of securities. 2010 had the highest income at $956 thousand with $504 and $230 thousand recorded in 2011 and 2009, respectively. The Company has been able to take advantage of the slope of the yield curve with higher short term rates in the portfolio garnering a premium in the market. Yield was not negatively impacted as duration was increased to preserve the interest income. This opportunity does not always present itself and the Company has utilized it to bolster earnings in 2010 and 2011.

Switching to the expense side, overall, non-interest expense decreased 1.4% in 2011 as compared to 2010 and 2.4% in comparing 2010 to 2009. The largest factor behind the higher 2009 level was FDIC assessment, which was broken out as its own line item on the statement of income due to its significance. The success of many cost cutting strategies is evident in the trend of decreasing noninterest expense from 2009 through 2011.

 

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The largest fluctuation between 2011 and 2010 in noninterest expense, aside from provision expense, was the summation line of salaries and wages on the income statement. Salaries and wages increased $439 thousand in 2011 over 2010; they increased $172 thousand in 2010 over 2009. Three main components flow into salaries and wages: base salary, deferred costs from loans and incentive pay. Base salaries decreased during 2011and 2010 even with the addition of the Hicksville office in July of 2010. Lower loan activity and a continuing decrease in “lobby” traffic allowed the Company to decrease the workforce through attrition. The deferred costs component actually decreased by $202 thousand in 2011 and $318 thousand in 2010 which in effect increases salary expense. Incentive pay increased $264 thousand in 2011 and $192 thousand in 2010. (For further discussion on incentive pay, see note 11 of the consolidated financial statements).

Mentioned previously was the mortgage refinancing activity of the last two years. A correlating expense to that activity is the amortization of mortgage servicing rights. The income was discussed previously; the amortization is the offset to the income recognized. These remain large line items on both the income and expense classification in the income statement. Income is recorded when the mortgage loan is first sold with servicing retained and is therefore recognized within one year. The amortization, however, is calculated over the life of the loan and accelerated when paid off early. An increase in this expense can be driven by two activities: an increase in the number of sold loans and/or by the acceleration of the expense from payoff and refinance activity. The best picture of the bottom line impact is achieved by netting the income with the expense each year. 2009 had net income of $225 thousand, 2010 had net income of only $1 thousand and 2011 had a net expense of $107 thousand. Of course, the value (or income) of the mortgage servicing right when sold also impacts the net position. The reason for 2009’s larger net position is due to the increase in the number of loans being serviced; thereby new rights are being established without having been offset by accelerated expense. This is evidenced by the year end number of loans and balances being up significantly. In 2010, the income barely offset the amortization expense. With the much slower activity in 2011, the amortization expense was higher than the new rights being capitalized. As of December 2011, there were 3,632 loans serviced with outstanding balance of $274.1 million for 2010 there were 3,647 loans serviced with outstanding balances of $275.7 million, there were 3,571 loans serviced with outstanding balances of $267.8 million for 2009. Returning to the expense only portion, expense for 2011 was $185 thousand lower than 2010 and 2010 was $250 thousand lower than 2009.

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

 

     (In Thousands)  
     2011     2010  

Beginning Year

   $ 2,178      $ 2,177   

Capitalized Additions

     391        684   

Amortization

     (498     (683

Valuation Allowance

     —          —     
  

 

 

   

 

 

 

End of Year

   $ 2,071      $ 2,178   
  

 

 

   

 

 

 

An increase in the incentive pay for the past two years is reflective of the Company outperforming its budget and performing better than the peer average. Employee benefits decreased for the third year in a row for 2011 by $74 thousand as compared to 2010 and a $109 thousand decrease in 2010 as compared to 2009. The Bank is partially self-insured and fluctuations to costs are therefore caused by fluctuations in claims made by employees along with the cost of insurance premiums. Employee’s group insurance costs were lower in 2011 than 2010 by $161 thousand and were down $134 for 2010 over 2009. In 2009, the Bank offered a traditional medical plan along with a Health Savings Account (HSA) option. Both options were available in 2009 and the decision was made to implement the HSA plan only bank-wide for 2010. A high profit-sharing contribution to the Bank’s employees 401K along with the match contribution increased this expense by $149.3 thousand in 2011 over 2010. 2010’s 401K expenses were $29 thousand lower than 2009. The profit-sharing percentage were 4.5% for 2011 and 3% for both 2010 and 2009.

 

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Occupancy expense increased by $45 thousand in 2011 as compared to 2010. In 2010 it increased $343 thousand over 2009. The largest expense increase in 2011 occupancy was utilities, which was driven by the additional office added in July 2010.

Data processing expense increased by only $25 thousand in 2011. A positive reduction in data processing expense of $183 thousand occurred in 2010. The larger reduction in 2010 was mainly due to the reduction of costs as the Bank switched its core service provider in February. The Company continues to investigate ways to reduce this expense. The pricing on many services, however, is based on number of accounts and the Bank fully expects those to increase with the KASASA additions and an improving economy.

The largest cost decrease of $3.6 million to the Bank in 2011 was the Provision for Loan Losses and it was the largest increase in 2010. A tough economic environment existed for most businesses in our primary market area during 2007 through 2010. In 2010, the provision expense was $1.8 million higher than 2009 and $3.5 million over 2008. Gross charge-offs were $6.4 million for 2010 and $3.3 million for 2009, as compared to 2011’s $2.7 million. Recoveries were $351, $795, and $242 thousand for 2011, 2010, and 2009, respectively. 2009 had a net charge-off position of $3.0 million and 2011 had a net charge-off position of $2.3 million. For all three years, activity was mainly commercial and commercial real estate driven. Further analysis by loan type is presented in the discussion of the allowance for credit losses.

Net Interest Income

The primary source of the Company’s traditional banking revenue is net interest income. Net interest income is the difference between interest income on interest earning assets, such as loans and securities, and interest expense on liabilities used to fund those assets, such as interest bearing deposits and other borrowings. Net interest income is affected by changes in both interest rates and the amount and composition of earning assets and liabilities. The change in net interest income is most often measured as a result of two statistics – interest spread and net interest margin. The difference between the yields on earning assets and the rates paid for interest bearing liabilities supporting those funds represents the interest spread. Because noninterest bearing sources of funds such as demand deposits and stockholders’ equity also support earning assets, the net interest margin exceeds the interest spread.

Overall, we continue to see compression in the net interest margin and spread with the risk remaining fairly constant. The net interest margin decreased by 21 basis points and the net interest spread decreased by 17 basis points in comparing 2011 to 2010, with both sides of the equation having lower yields. Major improvement occurred in the decrease of nonaccrual and watch list loans in 2011. Nonaccruals had increased during the first part of 2010 and decreased due to charge-off and payoff during the second half, specifically the fourth quarter. In first quarter of 2011, the Bank collected $640 thousand of nonaccured interest from a large agricultural loan that took multiple years to collect. During the fourth quarter 2011, the Bank again collected on a large agricultural loan that was in nonaccrual though the collection period was all in 2011. This was why the loan yield only decreased 4 basis points from 2010. Sustained improvement in the margin will be helped as a large portion of the nonaccruals have been removed from the books. Short term rates remained flat throughout the year and long term rates lowered during the fourth quarter and have since increased in the first two months of 2012.

Earnings assets increased during the year in actual and average balance. The interest collected on the earning assets decreased; the yield decreasing for 2011 as compared to 2010 and 2009 in all portfolios. The largest decrease in yield occurred in the taxable investment securities and was due to the large amount of calls on government sponsored agencies and the yield on new purchases as the growth in the portfolio was over $78.7 million in average. It was not unusual for a called security to be replaced with a new security with a yield lower by 100 basis points or more. Overall, this portfolio’s yield was 87 basis points lower in 2011 than in 2010, preceded by a 121 basis points drop in 2010 as compared to 2009.

Loans which have the highest earning asset yield decreased in average by $46.6 million when comparing 2011 average to 2010 average balance. The overall change in yield in the loan portfolio for 2011 was due mainly to the change in balance rather than to the change in rate though the collection of nonaccrual interest mentioned earlier inflated the rate factor. Given that the loan portfolio represented only 59% of the earning assets in 2011 as compared to 67% in 2010, it

 

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stands to reason that the overall asset yield decreased in 2011 as compared to 2010. Coupling this with the growth in earning assets being invested in securities and Federal Funds Sold and interest bearing bank balances, the overall yield on earning assets decreased 58 basis points as compared to 2010 and 110 basis points lower than 2009.

While the loan portfolio size had remained fairly constant in 2011, the yield, or income, generated had decreased for the third straight year. This was due to the low interest rate environment, with the lending prime rate within 22 basis points of the Company’s net interest spread at that time. Spread is the difference between what the Company earns on its assets and pays on its liabilities. It is on this spread that the Company must fund its operations and generate profit. When the asset yield decreases so must the cost of funds to maintain profitability. It becomes increasingly challenging as the asset yield gets closer to the prime lending rate, or the break-even point, of operations. To mitigate the low rate environment, the Bank placed rate floors on most variable loans during 2009, which were typically 125 basis points over the current prime rate. This protected the Bank during a flat rate environment. The challenge will come when rates start to rise and the Bank will be affected by the index spreads also placed on the loans. The Bank worked to increase the spread on loans during 2010 and 2011 to minimize the impact of an increased prime rate not directly correlating to an increased yield on loans.

Looking at the other side of the balance sheet and the interest cost of funds, a decrease in the cost is apparent for 2011 as compared to both 2010 and 2009. Fortunately, the cost of funds decreased at a faster rate than the asset yield in 2009 and the net interest margin and spread improved over 2008. Unfortunately, in 2010 and 2011, the asset yield decreased both years more than the cost of funds and the net interest margin and spread decreased as compared to 2009.

The impact of the change in the portfolio mix was a factor in the liabilities as it was in the assets. All portfolios decreased in cost of funds in comparing 2011 to 2010. The growth in balances was related to the growth in the new KASASA product offerings which rewarded customers by paying a higher interest rate for deposits which was offset by noninterest related Bank earnings and savings. By participating in the KASASA Saver product, a customer may have earned as much as 135 basis points more than the Bank’s basic savings account. Even with the increased interest cost to the Bank for offering these products, the Bank was still able to decrease its cost of funds by 9 basis points. Time deposits and other borrowed money both decreased. The Bank borrowed funds from the Federal Home Loan Bank in the first quarter of 2010, to lock in lower rates to replace maturities coming due in the second through fourth quarter of the year. The Bank did not borrow any additional funds in 2011, and the cost of those funds was again lower in 2011 since the associated expense of the matured advances was gone for a full year. The Bank paid off $13.2 million of FHLB borrowings during 2011. The average balance was lower by $12.1 million.

The following tables present net interest income, interest spread and net interest margin for the three years 2009 through 2011, comparing average outstanding balances of earning assets and interest bearing liabilities with the associated interest income and expense. The table also shows their corresponding average rates of interest earned and paid. The tax-exempt asset yields have been tax affected to reflect a marginal corporate tax rate of 34%. Average outstanding loan balances include non-performing loans and mortgage loans held for sale. Average outstanding security balances are computed based on carrying values including unrealized gains and losses on available-for-sale securities.

The percentage of interest earning assets to total assets increased in 2011 over 2010 and decreased slightly in 2010 over 2009 and remained above 90% at a respectable 93.9% and 90.73% for 2011 and 2010, respectively.

As stated previously, the decreased yield on the assets was outpaced by the decreased cost of funds in 2009. Not true for 2010 and 2011 where the reverse happened. While the average balance on interest bearing liabilities increased, the costs on those funds were significantly lower. The average cost for 2011 was 1.12% compared to 2010’s 1.53% and 2009’s 2.00%. The balances in noninterest bearing liabilities also increased during the last three years.

The largest fluctuation in the cost of funds was in the shorter term liabilities, savings deposits. The cost on savings decreased 9 basis points while on time deposits the cost decreased 42 basis points. The Bank has focused on increasing its core deposit base to lessen the dependency on higher cost time deposits. The Bank has also attempted to increase the duration of the time deposits; however, customers have maintained a short-term, twelve month focus.

 

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The yield on Tax-Exempt investments securities shown in the following charts were computed on a tax equivalent basis. The yield on Loans has been tax adjusted for the portion of tax-exempt IDB loans included in the total. Total Interest Earning Assets is therefore also reflecting a tax equivalent yield in both line items, also with the Net Interest Spread and Margin. The adjustments were based on a 34% tax rate.

[Remainder of this page intentionally left blank.]

 

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Table of Contents
     2011  
     (In Thousands)  
     Average
Balance
     Interest/
Dividends
     Yield/Rate  
ASSETS         

Interest Earning Assets:

        

Loans (1)

   $ 504,058       $ 29,840         5.96

Taxable investment securities

     255,627         4,793         1.87

Tax-exempt investment securities

     61,366         1,956         4.83

Federal funds sold & interest bearing deposits

     35,436         71         0.20
  

 

 

    

 

 

    

Total Interest Earning Assets

     856,487       $ 36,660         4.42
     

 

 

    

 

 

 

Non-Interest Earning Assets:

        

Cash and cash equivalents

     15,218         

Other assets

     40,648         
  

 

 

       

Total Assets

   $ 912,353         
  

 

 

       

LIABILITIES AND SHAREHOLDERS’ EQUITY

        

Interest Bearing Liabilities:

        

Savings deposits

   $ 349,816       $ 2,201         0.63

Other time deposits

     301,394         4,778         1.59

Other borrowed money

     25,465         883         3.47

Federal funds purchased and securities sold under agreement to repurchase

     51,576         294         0.57
  

 

 

    

 

 

    

Total Interest Bearing Liabilities

     728,251       $ 8,156         1.12
     

 

 

    

 

 

 

Non-Interest Bearing Liabilities:

        

Non-interest bearing demand deposits

     73,996         

Other

     10,678         
  

 

 

       

Total Liabilities

     812,925         
  

 

 

       

Shareholders’ Equity

     99,428         
  

 

 

       

Total Liabilities and Shareholders’ Equity

   $ 912,353         
  

 

 

       

Interest/Dividend income/yield

      $ 36,660         4.42

Interest Expense / yield

      $ 8,156         1.12
     

 

 

    

 

 

 

Net Interest Spread

      $ 28,504         3.30
     

 

 

    

 

 

 

Net Interest Margin

           3.47
        

 

 

 

 

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Table of Contents
     2010  
     (In Thousands)  
     Average
Balance
     Interest/
Dividends
     Yield/Rate  
ASSETS         

Interest Earning Assets:

        

Loans (1)

   $ 550,698       $ 32,860         6.00

Taxable investment securities

     176,885         4,847         2.74

Tax-exempt investment securities

     59,537         2,091         5.32

Federal funds sold & interest bearing deposits

     35,195         95         0.27
  

 

 

    

 

 

    

Total Interest Earning Assets

     822,315       $ 39,893         5.00
     

 

 

    

 

 

 

Non-Interest Earning Assets:

        

Cash and cash equivalents

     14,046         

Other assets

     42,096         
  

 

 

       

Total Assets

   $ 878,457         
  

 

 

       

LIABILITIES AND SHAREHOLDERS’ EQUITY

        

Interest Bearing Liabilities:

        

Savings deposits

   $ 305,426       $ 2,190         0.72

Other time deposits

     321,018         6,936         2.16

Other borrowed money

     37,517         1,459         3.89

Federal funds purchased and securities sold under agreement to repurchase

     46,530         278         0.60
  

 

 

    

 

 

    

Total Interest Bearing Liabilities

     710,491       $ 10,863         1.53
     

 

 

    

 

 

 

Non-Interest Bearing Liabilities:

        

Non-interest bearing demand deposits

     63,108         

Other

     10,207         
  

 

 

       

Total Liabilities

     783,806         
  

 

 

       

Shareholders’ Equity

     94,651         
  

 

 

       

Total Liabilities and Shareholders’ Equity

   $ 878,457         
  

 

 

       

Interest/Dividend income/yield

      $ 39,893         5.00

Interest Expense / yield

      $ 10,863         1.53
     

 

 

    

 

 

 

Net Interest Spread

      $ 29,030         3.47
     

 

 

    

 

 

 

Net Interest Margin

           3.68
        

 

 

 

 

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Table of Contents
     2009  
     (In Thousands)  
     Average
Balance
     Interest/
Dividends
     Yield/Rate  
ASSETS         

Interest Earning Assets:

        

Loans (1)

   $ 558,869       $ 33,585         6.04

Taxable investment securities

     146,872         5,798         3.95

Tax-exempt investment securities

     46,736         1,686         5.47

Federal funds sold & interest bearing deposits

     11,937         45         0.38
  

 

 

    

 

 

    

Total Interest Earning Assets

     764,414       $ 41,114         5.52
     

 

 

    

 

 

 

Non-Interest Earning Assets:

        

Cash and cash equivalents

     19,209         

Other assets

     39,007         
  

 

 

       

Total Assets

   $ 822,630         
  

 

 

       

LIABILITIES AND SHAREHOLDERS’ EQUITY

        

Interest Bearing Liabilities:

        

Savings deposits

   $ 257,345       $ 1,755         0.68

Other time deposits

     317,619         9,252         2.91

Other borrowed money

     38,498         1,727         4.49

Federal funds purchased and securities sold under agreement to repurchase

     45,920         486         1.06
  

 

 

    

 

 

    

Total Interest Bearing Liabilities

     659,382       $ 13,220         2.00
     

 

 

    

 

 

 

Non-Interest Bearing Liabilities:

        

Non-interest bearing demand deposits

     57,630         

Other

     13,778         
  

 

 

       

Total Liabilities

     730,790         
  

 

 

       

Shareholders’ Equity

     91,840         
  

 

 

       

Total Liabilities and Shareholders’ Equity

   $ 822,630         
  

 

 

       

Interest/Dividend income/yield

      $ 41,114         5.52

Interest Expense / yield

      $ 13,220         2.00
     

 

 

    

 

 

 

Net Interest Spread

      $ 27,894         3.52
     

 

 

    

 

 

 

Net Interest Margin

           3.79
        

 

 

 

 

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The following tables show changes in interest income, interest expense and net interest resulting from changes in volume and rate variances for major categories of earnings assets and interest bearing liabilities.

 

00000,,, 00000,,, 00000,,,
     2011 vs 2010
(In Thousands)
 
     Net     Due to change in  
     Change     Volume     Rate  

Interest Earning Assets:

      

Loans

   $ (3,020   $ (2,799   $ (221

Taxable investment securities

     (54     2,158        (2,212

Tax-exempt investment securities

     (135     97        (232

Federal funds sold & interest bearing deposits

     (24     1        (25
  

 

 

   

 

 

   

 

 

 

Total Interest Earning Assets

   $ (3,233   $ (543   $ (2,690
  

 

 

   

 

 

   

 

 

 

Interest Bearing Liabilities:

      

Savings deposits

   $ 11      $ 318      $ (307

Other time deposits

     (2,158     (424     (1,734

Other borrowed money

     (576     (469     (107

Federal funds purchased and securities sold under agreement to repurchase

     16        30        (14
  

 

 

   

 

 

   

 

 

 

Total Interest Bearing Liabilities

   $ (2,707   $ (545   $ (2,162
  

 

 

   

 

 

   

 

 

 

 

00000,,, 00000,,, 00000,,,
     2010 vs 2009
(In Thousands)
 
     Net     Due to change in  
     Change     Volume     Rate  

Interest Earning Assets:

      

Loans

   $ (725   $ (494   $ (231

Taxable investment securities

     (951     1,185        (2,136

Tax-exempt investment securities

     405        700        (295

Federal funds sold & interest bearing deposits

     50        88        (38
  

 

 

   

 

 

   

 

 

 

Total Interest Earning Assets

   $ (1,221   $ 1,479      $ (2,700
  

 

 

   

 

 

   

 

 

 

Interest Bearing Liabilities:

      

Savings deposits

   $ 435      $ 328      $ 107   

Other time deposits

     (2,316     99        (2,415

Other borrowed money

     (268     (44     (224

Federal funds purchased and securities sold under agreement to repurchase

     (208     6        (214
  

 

 

   

 

 

   

 

 

 

Total Interest Bearing Liabilities

   $ (2,357   $ 389      $ (2,746
  

 

 

   

 

 

   

 

 

 

As mentioned in the discussion earlier, in reviewing the 2011 to 2010 and the 2010 to 2009 comparison, an impact in change due to volume is evident; however the largest impact was due to rate. The strategy during 2010, 2011 and beyond is to extend the maturities of time deposit “specials” to over 24 months to prepare for rising rates. The other strategy employed during 2010 and 2011 was to increase core deposits by offering innovative products focused on customer needs: higher interest rates. In exchange for a high interest-bearing checking account, customers were asked to utilize services that benefited both the Bank and themselves. Smaller time deposit rate shoppers had an option to perhaps change their behavior of banking or those deposits were allowed to run off. The new core deposit products were indeed embraced by our customers and have helped to attain the deposit portfolio mix the Bank was after.

 

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Table of Contents

Allowance for Credit Losses

The Company segregates its Allowance for Loan and Lease Losses (ALLL) into two reserves: The ALLL and the Allowance for Unfunded Loan Commitments and Letters of Credit (AULC). When combined, these reserves constitute the total Allowance for Credit Losses (ACL).

The Bank’s ALLL methodology captures trends in leading, current, and lagging indicators which will directly affect the Bank’s allocation amount. Trends in such leading indicators as delinquency, unemployment changes in the Bank’s service area, experience and ability of staff, regulatory trends, and credit concentrations are referenced. A current indicator such as the total watch list loan amount to Capital, and a lagging indicator such as the charge off amount are referenced as well. A matrix is formed by loan type from these indicators that is responsive in making ALLL adjustments.

Special Mention loan balances decreased 4.5% or $486 thousand as of yearend 2011 compared to same date 2010. Substandard and Doubtful loan balances decreased 38.5% or $7 million comparing the same dates as above. In response to this significant improvement, the Bank decreased its ALLL to outstanding loan coverage percentage to 1.01% as of December 31, 2011. The Bank experienced a 7% decrease in Special Mention loan balances as of December 31, 2010 as compared to December 31, 2009. The Bank also experienced a 23% decrease or $6.7 million decrease in Substandard and Doubtful loan balances as of December 31, 2010 as compared to 2009. In spite of this decrease, the Bank’s ALLL to outstanding loans coverage percentage increased to 1.08% as of December 31, 2010. The Bank’s ALLL to outstanding loans coverage percentage was 1.05% as of December 31, 2009.

The above indicators are reviewed quarterly. Some of the indicators are quantifiable and as such will automatically adjust the ALLL once calculated. These indicators include the ratio of past due loans to total loans, loans past due greater than 30 days, and watch list to capital ratios with the watch list made up of loans graded 5,6 or 7 on a 1 to 7 scale, 1 being the best rating. Other indicators use more subjective data to the extent possible to evaluate the potential for inherent losses in the Bank’s loan portfolio. For example, the economic indicator uses the unemployment statistics from the communities in our market area to help determine whether the ALLL should be adjusted. At the end of 2010 and 2011, a slight improvement was noted in unemployment figures and several local firms were calling a small number of employees back from layoff and planning some expansion. The current recalls do not begin to approximate the number of positions lost.

All aggregate commercial and agricultural credits include real estate loans of $250,000 and over are reviewed annually by both credit committees and internal loan review to look for early signs of deterioration.

To establish the specific reserve allocation in the instance of real estate, a discount to the market value is established to account for liquidation expenses. The discounting percentage used for real estate mirrors the discounting of real estate as provided for in the Bank’s Loan Policy. However, unique or unusual circumstances may be present which will affect the real estate value and, when appropriately identified, can adjust the discounting percentage at the discretion of management.

The ACL decreased $638 thousand during 2011, preceded by a $375 thousand decrease during 2010. With the decrease in loan balances, the percentage of ACL to the total loan portfolio actually increased from 1.09% as of December 31, 2009 to 1.12% as of December 31, 2010. As of December 31, 2011, the percentage of ACL to the total loan portfolio decreased to 1.03% due to the improvement in troubled loan totals and a past due 30+ days percentage of .67%. This is the lowest since yearend 2006.

Please see Note 4 in the consolidated financial statement for additional tables regarding the composition of the ACL.

 

28


Table of Contents

Federal Income Taxes

Effective tax rates were 25.36%, 25.44%, and 27.26%, for 2011, 2010, and 2009, respectively. The effect of tax-exempt interest from holding tax-exempt securities and Industrial Development Bonds (IDBs) was $689, $744, and $629 thousand for 2011, 2010, and 2009, respectively.

Financial Condition

Average earning assets increased $34.2 million during 2011 over 2010 and were higher by $92.1 million as compared to 2009. The main cause of fluctuation was the Hicksville acquisition and the repositioning of the balance sheet. Average interest bearing liabilities increased $17.8 million over 2010 and $68.9 million from 2009. The increase in 2010 over 2009 was due to the success of the KASASA Checking product to attract funds into the savings deposit bucket and an increase in Health Savings Accounts.

Securities

The investment portfolio is primarily used to provide overall liquidity for the Bank. It is also used to provide required collateral for pledging to the Bank’s Ohio public depositors for amounts on deposit over the FDIC coverage limits. It may also be used to pledge for additional borrowings from third parties. Investments are made with the above criteria in mind while still seeking a fair market rate of return, and looking for maturities that fall within the projected overall strategy of the Bank. The possible need to fund growth is also a consideration.

All of the Bank’s security portfolio is categorized as available for sale, with the exception of stock, and as such is recorded at market value.

Security balances as of December 31 are summarized below:

 

     (In Thousands)  
     2011      2010      2009  

U.S. Treasury

   $ 26,691       $ 32,278       $ 5,219   

U.S. Government agency

     177,797         165,704         104,676   

Mortgage-backed securities

     55,413         24,531         36,848   

State and local governments

     67,618         64,804         60,538   
  

 

 

    

 

 

    

 

 

 
   $ 327,519       $ 287,317       $ 207,281   
  

 

 

    

 

 

    

 

 

 

The following table sets forth the maturities of investment securities as of December 31, 2011 and the weighted average yields of such securities calculated on the basis of cost and effective yields weighted for the scheduled maturity of each security. Tax-equivalent adjustments, using a thirty-four percent rate have been made in yields on obligations of state and political subdivisions. Stocks of domestic corporations have not been included.

 

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Table of Contents

Securities (Continued)

 

00000 00000 00000 00000
     Maturities  
     (Amounts in Thousands)  
     Within One Year     After One Year
Within Five Years
 
     Amount      Yield     Amount      Yield  

U.S. Treasury

   $ —           0.00   $ 26,691         1.22

U.S. Government agency

     10,111         1.23     147,744         1.46

Mortgage-backed securities

     —           0.00     429         4.44

State and local governments

     6,631         3.13     17,611         2.21

Taxable state and local governments

     —           0.00     2,640         3.14

 

$26,6910 $26,6910 $26,6910 $26,6910
     Maturities  
     (Amounts in Thousands)  
     After Five Years               
     Within Ten Years     After Ten Years  
     Amount      Yield     Amount      Yield  

U.S. Treasury

   $ —           0.00   $ —           0.00

U.S. Government agency

     19,942         1.47     —           0.00

Mortgage-backed securities

     23,655         2.97     31,329         3.00

State and local governments

     27,240         3.32     11,230         4.48

Taxable state and local governments

     384         3.12     1,882         5.38

As of December 31, 2011 the Bank did not hold a large block of any one investment security, except for U.S. Government agencies. The Bank also holds stock in the Federal Home Loan Bank of Cincinnati at a cost of $4.2 million. This is required in order to obtain Federal Home Loan Bank Loans. The Bank also acquired stock in the Federal Home Loan Bank of Indianapolis at a cost of $231.4 thousand and Banker’s Bancorp, Inc at a cost of $50.8 thousand through its acquisition of Knisely Bank. There were no borrowings at the time of acquisition associated with Federal Home Loan Bank of Indianapolis. The Bank had requested Federal Home Loan Bank of Indianapolis to buy back its stock when the acquisition of Knisely was completed in January 2008. A five year waiting period was imposed and the stock will be redeemed in full by January 3, 2013. An early redemption of 42,000 shares occurred in 2010 with another 41,000 shares redeemed in 2011. These decreased the holdings to a value of $148.4 thousand. The value of the stock in Banker’s Bancorp, Inc was written down to zero at the end of 2009 as the institution was taken over by its regulators. The Bank also owns stock of Farmer Mac with a carrying value of $37.4 thousand which is required to participate loans in the program.

Loan Portfolio

The Bank’s various loan portfolios are subject to varying levels of credit risk. Management mitigates these risks through portfolio diversification and through standardization of lending policies and procedures.

Risks are mitigated through an adherence to Loan Policy with any exception being recorded and approved by Senior Management or committees comprised of Senior Management. Loan Policy defines parameters to essential underwriting guidelines such as loan-to-value ratio, cash flow and debt-to-income ratio, loan requirements and covenants, financial information tracking, collection practice and others. Limitation to any one borrower is defined by the Bank’s legal lending limits and is stated in policy. On a broader basis, the Bank restricts total aggregate funding in comparison to Bank capital to any one business or agricultural sector by an approved sector percentage to capital limitation.

 

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Table of Contents

The following table shows the Bank’s loan portfolio by category of loan as of December 31st of each year, including loans held for sale:

 

     (In Thousands)  

Loans:

   2011      2010      2009      2008      2007  

Commercial real estate

   $ 201,158       $ 194,268       $ 214,849       $ 226,761       $ 181,340   

Agricultural real estate

     31,993         33,650         41,045         48,607         45,518   

Consumer real estate

     81,585         86,036         98,599         89,773         102,660   

Commercial and industrial

     114,497         117,344         120,543         112,526         104,188   

Agricultural

     52,598         65,400         59,813         56,322         58,809   

Consumer

     23,375         29,008         32,581         26,469         27,796   

Industrial Development Bonds

     1,196         1,965         2,552         7,572         9,289   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 
   $ 506,402       $ 527,671       $ 569,982       $ 568,030       $ 529,600   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

The following table shows the maturity of loans as of December 31, 2011:

 

     (In Thousands)         
            After One                
     Within      Year Within      After         
     One Year      Five Years      Five Years      Total  

Commercial Real Estate

   $ 17,857       $ 126,255       $ 57,046       $ 201,158   

Agricultural Real Estate

     3,234         10,401         18,358       $ 31,993   

Consumer Real Estate

     6,715         15,058         59,812       $ 81,585   

Commercial and industrial

     69,453         41,053         3,991       $ 114,497   

Agricultural

     35,314         14,833         2,451       $ 52,598   

Consumer

     5,703         15,677         1,995       $ 23,375   

Industrial Development Bonds

     25         279         892       $ 1,196   
  

 

 

    

 

 

    

 

 

    

 

 

 
   $ 138,301       $ 223,556       $ 144,545       $ 506,402   
  

 

 

    

 

 

    

 

 

    

 

 

 

The following table presents the total of loans due after one year which has either 1) predetermined interest rates (fixed) or 2) floating or adjustable interest rates (variable):

 

     (In Thousands)  
     Fixed      Variable         
     Rate      Rate      Total  

Commercial Real Estate

   $ 96,384       $ 86,915       $ 183,299   

Agricultural Real Estate

     19,874         8,861       $ 28,735   

Consumer Real Estate

     68,799         6,365       $ 75,164   

Commercial and industrial loans

     36,294         8,841       $ 45,135   

Agricultural

     16,998         348       $ 17,346   

Consumer, Master Card and Overdrafts

     17,673         3,630       $ 21,303   

Industrial Development Bonds

     1,171         —         $ 1,171   

The following table summarizes the Company’s nonaccrual and past due loans as of December 31 for each of the last five years:

 

     (In Thousands)  
     2011      2010      2009      2008      2007  

Non-accrual loans

   $ 2,131       $ 5,844       $ 14,054       $ 13,575       $ 4,918   

Accruing loans past due 90 days or more

     —           48         69         2,524         —     
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 2,131       $ 5,892       $ 14,123       $ 16,099       $ 4,918   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

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Table of Contents

Although loans may be classified as non-performing, some pay on a regular basis, and many continue to pay interest irregularly or at less than original contractual rates. Interest income that would have been recorded under the original terms of these loans was $101.6 thousand for 2011, $910 thousand for 2010, and $2.0 million for 2009. Any collections of interest on nonaccrual loans are included in interest income when collected unless it is on an impaired loan with a specific allocation. A collection of interest on an impaired loan with a specific allocation is applied to the loan balance to decrease the allocation needed. Total interest collections amounted to $1.2 million for 2011, $41 thousand for 2010, and $290 thousand for 2009. None of the interest collected in 2011 was applied to reduce a specific allocation. $3 thousand of interest collected in 2010 was applied to reduce the specific allocation, and $6 thousand of interest collected in 2009 was applied to reduce the specific allocations.

Loans are placed on nonaccrual status in the event that the loan is in past due status for more than 90 days or payment in full of principal and interest is not expected. The loss of interest due to the high balances in nonaccruals as of 2009 and 2010 significantly impacted the yield on loans. The collection of interest on nonaccrual loans helped the yield in 2011. December 31, 2011 had nonaccrual loan balances of $2.1 million compared to $5.8 and $14.1 million nonaccrual loan balances as of yearend 2010 and 2009, respectively. All of the balances of nonaccrual loans for the three years were secured.

As of December 31, 2011 the Bank had $22.7 million of loans which it considers to be potential problem loans in that the borrowers are experiencing financial difficulties compared to December 31, 2010 when the Bank had $27.4 million of these loans. These loans are subject to constant management attention and are reviewed at least monthly.

The amount of the potential problem loans was considered in management’s review of the loan loss reserve required at December 31, 2011 and 2010.

In extending credit to families, businesses and governments, banks accept a measure of risk against which an allowance for possible loan loss is established by way of expense charges to earnings. This expense, used to enlarge a bank’s allowance for loan losses, is determined by management based on a detailed monthly review of the risk factors affecting the loan portfolio, including general economic conditions, changes in the portfolio mix, past due loan-loss experience and the financial condition of the bank’s borrowers.

As of December 31, 2011, the Bank had loans outstanding to individuals and firms engaged in the various fields of agriculture in the amount of $52.6 million with an additional $32.0 million in agricultural real estate loans. The ratio of this segment of loans to the total loan portfolio is not considered unusual for a bank engaged in and servicing rural communities.

Loan modifications granted are typically for seasonality issues where cash flow is decreased. The time period involved is generally quite short in relation to the loan term. For example, a typical modification may consist of interest only payments for 90 days. We consider this treatment of interest only payments for a short time as an insignificant delay in payment. Consequently, we do not consider these occurrences as “troubled debt restructurings”. Interest rate modification to reflect a decrease in market interest rates or maintain a relationship with the debtor, where the debtor is not experiencing financial difficulty and can obtain funding from other sources, is not considered a troubled debt restructuring. As of December 31, 2011, the Bank had $3.4 million of its impaired loans that were classified as troubled debt restructurings. The Bank had almost $3.5 million classified as such as of December 31, 2010. The Bank is occasionally ordered by the courts to give terms to a borrower that are better than what the Bank would like for the risk associated with that credit but not below or beyond rates and terms available for better credits in our market. Therefore, the Bank has not done any modifications that it would classify as “troubled debt restructurings” under those circumstances.

Updated appraisals are required on all collateral dependent loans once they are deemed impaired. The Bank may also require an updated appraisal of a watch list loan which the Bank monitors under their loan policy. On a quarterly basis, Bank management reviews properties supporting asset dependent loans to consider market events that may indicate a change in value has occurred.

 

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Table of Contents

To determine observable market price, collateral asset values securing an impaired loan are periodically evaluated. Maximum time of re-evaluation is every 12 months for chattels and titled vehicles and every two years for real estate. In this process, third party evaluations are obtained and heavily relied upon. Until such time that updated appraisals are received, the Bank may discount the existing collateral value used.

Performing non-watch list customers secured in whole or in part by real estate do not require an updated appraisal unless the loan is rewritten and additional funds advanced. Watch List customers secured in whole or in part by real estate require updated appraisals every two years. All loans are subject to loan to values as found in Loan Policy no matter what their grade. Our watch list is reviewed on a quarterly basis by management and any questions to value are addressed at that time.

The majority of the Bank’s loans are made in the market by lenders that live and work in the market. Thus, their evaluation of the independent valuation is also valuable and serves as a double check.

On extremely rare occasions, the Bank will make adjustments to the recorded values of collateral securing commercial real estate loans without acquiring an updated appraisal for the subject property. The Bank has no formalized policy for determining when collateral value adjustments between regularly scheduled appraisals are necessary, nor does it use any specific methodology for applying such adjustments. However, on a quarterly basis as part of its normal operations, the Bank’s senior management and the Loan Review Committee will meet to review all commercial credits either deemed to be impaired or on the Bank’s Watch List. In addition to analyzing the recent performance of these loans, management and the Loan Review Committee will also consider any general market conditions that might warrant adjustments to the value of particular real estate collateralizing commercial loans. In addition, management conducts annual reviews of all commercial loans exceeding certain outstanding balance thresholds. In each of these situations, any information available to management regarding market conditions impacting a specific property or other relevant factors is considered, and lenders familiar with a particular commercial real estate loan and the underlying collateral may be present to provide their opinion on such factors. If the available information leads management to conclude a valuation adjustment is warranted, such an adjustment may be applied on the basis of the information available. If management concludes that an adjustment is warranted but lacks the specific information needed to reasonably quantify the adjustment, management will order a new appraisal on the subject property even though one may not be required under the Bank’s general policies for updating appraisal.

Note 4 of the Consolidated Financial Statements may also be reviewed for additional tables dealing with the Bank’s loans and ALLL.

ALLL is evaluated based on an assessment of the losses inherent in the loan portfolio. This assessment results in an allowance consisting of two components, allocated and unallocated.

Management considers several different risk assessments in determining ALLL. The allocated component of ALLL reflects expected losses resulting from an analysis of individual loans, developed through specific credit allocations for individual loans and historical loss experience for each loan category. For those loans where the internal credit rating is at or below a predetermined classification and management can reasonably estimate the loss that will be sustained based upon collateral, the borrowers operating activity and economic conditions in which the borrower operates, a specific allocation is made. For those borrowers that are not currently behind in their payment, but for which management believes based on economic conditions and operating activities of the borrower, the possibility exists for future collection problems, a reserve is established. The amount of reserve allocated to each loan portfolio is based on past loss experiences and the different levels of risk within each loan portfolio. The historical loan loss portion is determined using a historical loss analysis by loan category.

The unallocated portion of the reserve for loan losses is determined based on management’s assessment of general economic conditions as well as specific economic factors in the Bank’s marketing area. This assessment inherently involves a higher degree of uncertainty. It represents estimated inherent but undetected losses within the portfolio that are probable due to uncertainties in economic conditions, delays in obtaining information, including unfavorable information about a borrower’s financial condition and other current risk factors that may not have yet manifested themselves in the Bank’s historical loss factors used to determine the allocated component of the allowance.

 

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Table of Contents

Actual charge-off of loan balances is based upon periodic evaluations of the loan portfolio by management. These evaluations consider several factors, including, but not limited to, general economic conditions, financial condition of the borrower, and collateral.

As presented below, charge-offs decreased to $2.7 million for 2011 preceded by an increase to $6.4 million for 2010. The provision also decreased in 2011 and increased for 2010. 2011 had provision expense of $1.7 million compared to 2010 expense of $5.3 million and 2009 had $3.6 million in provision expense. The Commercial and Industrial portfolio had the largest net charge-off position in 2009 thru 2011. The ratio of net charge offs to average loans outstanding is evidence of the recognition of troubled loans and the write down of collateral values. The improvement in asset quality during the periods shown is reflected in the increased percentage of the allowance for loan loss to nonperforming loans.

With the charge-offs going higher in 2009, it became prudent to increase the ALLL for 2009. The increase provides for the high level of nonaccrual and watch list loans and recognizes the extended time period with which it has taken to achieve resolution and/or collection of these loans. The ALLL for 2010 and 2011 decreased due to the improvement in the asset quality as the balances in impaired loans and nonaccruals were drastically reduced over the same time periods. A smaller portion of the allowance was needed to fund the impaired loans as collateral remained sufficient to cover the outstanding amounts in most cases.

[Remainder of this page intentionally left blank.]

 

34


Table of Contents

The following table presents a reconciliation of the allowance for credit losses:

 

     (In Thousands)  
     2011     2010     2009  

Loans

   $ 506,215      $ 527,589      $ 569,982   
  

 

 

   

 

 

   

 

 

 

Daily average of outstanding loans

   $ 504,058      $ 550,698      $ 558,869   
  

 

 

   

 

 

   

 

 

 

Allowance for Loan Losses-Jan 1

     5,706      $ 6,008      $ 5,496   

Loans Charged off:

      

Commercial Real Estate

     360        1,147        —     

Ag Real Estate

     —          —          —     

Consumer Real Estate

     423        507        452   

Commercial and Industrial

     1,500        4,188        2,235   

Agricultural

     24        136        230   

Consumer & other loans

     374        444        371   
  

 

 

   

 

 

   

 

 

 
   $ 2,681      $ 6,422      $ 3,288   
  

 

 

   

 

 

   

 

 

 

Loan Recoveries:

      

Commercial Real Estate

     32        52        —     

Ag Real Estate

     —          —          —     

Consumer Real Estate

     61        55        11   

Commercial and Industrial

     19        515        72   

Agricultural

     67        17        6   

Consumer & other loans

     172        156        153   
  

 

 

   

 

 

   

 

 

 
   $ 351      $ 795      $ 242   
  

 

 

   

 

 

   

 

 

 

Net Charge Offs

   $ 2,330      $ 5,627      $ 3,046   

Provision for loan loss

   $ 1,715      $ 5,325      $ 3,558   

Acquisition provision for loan loss

     —          —          —     
  

 

 

   

 

 

   

 

 

 

Allowance for Loan & Lease Losses - Dec 31

   $ 5,091      $ 5,706      $ 6,008   

Allowance for Unfunded Loan Commitments & Letters of Credit Dec 31

   $ 130      $ 153      $ 227   
  

 

 

   

 

 

   

 

 

 

Total Allowance for Credit Losses - Dec 31

   $ 5,221      $ 5,859      $ 6,235   
  

 

 

   

 

 

   

 

 

 

Ratio of net charge-offs to average Loans outstanding

     0.46     1.02     0.55
  

 

 

   

 

 

   

 

 

 

Ratio of the Allowance for Loan Loss to Nonperforming Loans

     238.90     97.63     42.75
  

 

 

   

 

 

   

 

 

 

 

* Nonperforming loans are defined as all loans on nonaccrual, plus any loans past due 90 days not on nonaccrual.

 

35


Table of Contents

Allocation of ALLL per Loan Category in terms of dollars and percentage of loans in each category to total loans is as follows:

 

     (In Thousands)  
     2011             2010             2009             2008             2007         
     Amount             Amount             Amount             Amount             Amount         
     (000’s)      %      (000’s)      %      (000’s)      %      (000’s)      %      (000’s)      %  

Balance at End of Period Applicable To:

                             

Commercial Real Estate

   $ 2,088         39.74       $ 1,868         36.82       $ 1,810         39.99       $ 1,810         39.92       $ 1,358         34.24   

Ag Real Estate

     140         6.32         122         6.38         120         7.20         130         8.56         117         8.59   

Consumer Real Estate

     261         16.12         258         16.31         439         15.01         386         15.80         381         19.38   

Commercial and Industrial

     1,947         22.62         2,354         22.24         2,494         21.15         2,278         19.81         1,859         19.67   

Agricultural

     266         10.39         327         12.40         647         10.49         413         9.92         1,676         11.10   

Consumer, Overdrafts and other loans

     315         4.58         380         5.48         479         5.72         479         5.99         531         7.00   

Unallocated

     74         0.24         397         0.37         19         0.45         —              —        
  

 

 

       

 

 

       

 

 

       

 

 

       

 

 

    

Allowance for Loan & Lease Losses

   $ 5,091         100.00       $ 5,706         100.00       $ 6,008         100.00         5,496         100.00         5,922         100.00   

Off Balance Sheet Commitments

     130          $ 153          $ 227            226            156      
  

 

 

       

 

 

       

 

 

       

 

 

       

 

 

    

Total Allowance for Credit Losses

   $ 5,222          $ 5,859          $ 6,235          $ 5,722          $ 6,078      
  

 

 

       

 

 

       

 

 

       

 

 

       

 

 

    

Deposits

The amount of outstanding time certificates of deposits and other time deposits in amounts of $100,000 or more by maturity as of December 31, 2011 are as follows:

 

     (In Thousands)  
     Under
Three Months
     Over Three
Months
Less than
Six Months
     Over Six
Months Less
Than One
Year
     Over
One
Year
 

Time Deposits

   $ 22,332       $ 15,991       $ 23,606       $ 65,971   

The following table presents the average amount of and average rate paid on each deposit category:

 

     (In Thousands)  
     Non-Interest
DDAs
    Interest
DDAs
    Savings
Accounts
    Time
Accounts
 

December 31, 2011:

        

Average balance

   $ 70,547      $ 185,463      $ 164,352      $ 301,394   

Average rate

     0.00     0.81     0.43     1.59

December 31, 2010:

        

Average balance

   $ 60,489      $ 167,382      $ 138,044      $ 321,018   

Average rate

     0.00     0.96     0.42     2.16

December 31, 2009:

        

Average balance

   $ 55,793      $ 145,259      $ 112,086      $ 317,619   

Average rate

     0.00     1.02     0.24     2.91

 

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Table of Contents

Liquidity

Liquidity remains high and the Bank has access to $42 million of unsecured borrowings through correspondent banks and $132.8 million of unpledged securities which may be sold or used as collateral. An additional $23.5 million is also available from the Federal Home Loan Bank based on current collateral pledging with up to $124 million available provided adequate collateral is pledged.

Maintaining sufficient funds to meet depositor and borrower needs on a daily basis continues to be among our management’s top priorities. This is accomplished not only by the immediately liquid resources of cash, due from banks and federal funds sold, but also by the Bank’s available for sale securities portfolio. The average aggregate balance of these assets was $356 million for 2011, compared to $274 million for 2010, and $216 million for 2009. This represented 39.0 percent, 31.3 percent, and 26.3 percent of total average assets, respectively. Of the almost $328 million of debt securities in the company’s portfolio as of December 31, 2011, $39 million or 11.6 percent of the portfolio is expected to receive payments or mature in 2012. The availability of the funds may be reduced by the need to utilize securities for pledging purposes on public deposits. This liquidity provides the opportunity to fund loan growth without having to aggressively price deposits.

Historically, the primary source of liquidity has been core deposits that include noninterest bearing and interest bearing demand deposits, savings, money market accounts and time deposits of individuals. Core deposits increased as of year end balances in 2011, in all categories. Overall deposits increased an average of $34.6 million during 2011 compared to 2010’s increase over 2009 of $53.2 million in average deposits. These represent changes of 5.0 percent and 8.3 percent in average total deposits, respectively. The Bank also utilized Federal Funds purchased at times during 2010 and 2011. The average balance for 2011 was $96 thousand.

Again, historically, the primary use of new funds is placing the funds back into the community through loans for the acquisition of new homes, consumer products and for business development. The use of new funds for loans is measured by the loan to deposit ratio. The Company’s average loan to deposit ratio for 2011 was 68.24 percent, 2010 was 78.13 percent and 2009 was 85.95 percent. The lower ratios in 2011 and 2010 were due to the success of the deposit gathering function, the residential mortgage loans being sold in the secondary market and the lack of loan demand. The Company’s goal is for this ratio to be higher with loan growth being the driver; however, this was and may be difficult to achieve in 2012 with borrowers taking a conservative approach to increasing their liabilities.

Short-term debt such as federal funds purchased and securities sold under agreement to repurchase also provides the Company with liquidity. Short-term debt for both federal funds purchased and securities sold under agreement to repurchase amounted to $52.4 million at the end of 2011 compared to $51.2 million at the end of 2010 and to $43.3 million at the end of 2009. Though no federal funds were purchased at year end, the Bank does have arrangements with correspondent Banks that can be utilized when necessary. Following is a table showing the daily securities sold under agreement to repurchase activity for 2011, 2010, and 2009. These accounts are used to provide a sweep product to the Bank’s commercial customers. The decrease in balances during 2009 was due to business’ discontinuing the sweep as the cost of fees were higher than the interest benefit on lower balance accounts. Balances have increased in 2010 and 2011 as business’ build cash reserves and desiring to keep availability.

 

     Daily Securities Sold Under Agreement to Repurchase  
     Amount Outstanding
at End of Period
(000’S)
     Weighted Average Rate
End of Period
   

Maximum Amount
Borrowings Outstanding
Month End

(000’s)

     Approximate Average
Outstanding in Period
(000’s)
     Approximate Weighted
Average Interest Rate
For the Period
 

2011

   $ 38,209         0.15   $ 42,154       $ 36,910         0.30

2010

   $ 37,191         0.36   $ 37,501       $ 34,046         0.36

2009

   $ 33,457         0.42   $ 40,530       $ 37,696         0.48

Other borrowings are also a source of funds. Other borrowings consist of loans from the Federal Home Loan Bank of Cincinnati. These funds are then used to provide fixed rate mortgage loans secured by homes in our community.

 

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Table of Contents

Borrowings from this source decreased by $13.2 million to $16.7 million at December 31, 2011. This compares to decreased borrowings during 2010 of $4.3 million to $29.9 million at December 31, 2010 and increased borrowings during 2009 of $11.4 million to $34.2 million to end at December 31, 2009. The decreased borrowings were payoffs of matured notes in 2010 and 2011. Sufficient funds were available to fund growth so new advances were not needed.

Asset/Liability Management

The primary functions of asset/liability management are to assure adequate liquidity and maintain an appropriate balance between interest earning assets and interest bearing liabilities. It involves the management of the balance sheet mix, maturities, re-pricing characteristics and pricing components to provide an adequate and stable net interest margin with an acceptable level of risk. Interest rate sensitivity management seeks to avoid fluctuating net interest margins and to enhance consistent growth of net interest income through periods of changing interest rates.

Changes in net income, other than those related to volume arise when interest rates on assets re-price in a time frame or interest rate environment that is different from that of the re-pricing period for liabilities. Changes in net interest income also arise from changes in the mix of interest-earning assets and interest-bearing liabilities.

Historically, the Bank has maintained liquidity through cash flows generated in the normal course of business, loan repayments, maturing earning assets, the acquisition of new deposits, and borrowings. The Bank’s asset and liability management program is designed to maximize net interest income over the long term while taking into consideration both credit and interest rate risk. Interest rate sensitivity varies with different types of interest-earning assets and interest-bearing liabilities. Overnight federal funds on which rates change daily and loans that are tied to the market rate differ considerably from long-term investment securities and fixed rate loans. Similarly, time deposits over $100,000 and money market certificates are much more interest rate sensitive than passbook savings accounts. The Bank utilizes shock analysis to examine the amount of exposure an instant rate change of 100, 200, and 300 basis points in both increasing and decreasing directions would have on the financials. Acceptable ranges of earnings and equity at risk are established and decisions are made to maintain those levels based on the shock results.

Impact of Inflation and Changing Prices

The consolidated financial statements and notes thereto presented herein have been prepared in accordance with generally accepted accounting principles, which require the measurement of financial position and operating results in terms of historical dollars without considering the changes in the relative purchasing power of money over time due to inflation. The impact of inflation is reflected in the increased cost of the Company’s operations. Unlike most industrial companies, nearly all the assets and liabilities of the Company are monetary in nature. As a result, interest rates have a greater impact on the Company’s performance than do the effects of general levels of inflation. Interest rates do not necessarily move in the same direction or to the same extent as the prices of goods and service.

Contractual Obligations

Contractual Obligations of the Company totaled $361.6 million as of December 31, 2011. Time deposits represent contractual agreements for certificates of deposits held by its customers. Long term debt represents the borrowings with the Federal Home Loan Bank and is further defined in Note 4 and 9 of the Consolidated Financial Statements.

 

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Table of Contents

Contractual Obligations (Continued)

 

     Payment Due by Period (In Thousands)  

Contractual Obligations

   Total      Less than
1 year
     1-3
Years
     3-5
Years
     More than
5 years
 

Securities sold under agreement to repurchase

   $ 52,440       $ 52,440       $ —         $ —         $ —     

Time Deposits

     291,626         142,601         118,995         28,806         1,224   

Dividends Payable

     890         890         —           —           —     

Long Term Debt

     16,662         5,062         11,600         —           —     
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 361,618       $ 200,993       $ 130,595       $ 28,806       $ 1,224   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Capital Resources

Stockholders’ equity was $105.1 million as of December 31, 2011 compared to $94.4 million at December 31, 2010. Dividends declared during 2011 were $0.76 per share totaling $3.57 million and 2010 were $0.73 per share totaling $3.44 million. During 2010, the Company purchased 48,130 shares and awarded 10,150 restricted shares to 53 employees. For a summary of activity as it relates to the Company’s restricted stock awards, please refer to Note 11: Employee Benefit Plans in the consolidated financial statements. At yearend 2011, the Company held 483,663 shares in Treasury stock and 29,715 shares in unearned stock awards as compared to 2010, the Company held 477,106 shares in Treasury stock and 28,925 in unearned stock awards. On January 20, 2012 the Company announced the authorization by its Board of Directors for the Company’s repurchase, either on the open market, or in privately negotiated transactions, of up to 200,000 shares of its outstanding common stock commencing January 20, 2012 and ending December 31, 2012.

The Company continues to have a strong capital base and to maintain regulatory capital ratios that are significantly above the defined regulatory capital ratios.

At December 31, 2011, The Farmers & Merchants State Bank and Farmers & Merchants Bancorp, Inc had total risk-based capital ratios of 14.37% and 16.54%, respectively. Core capital to risk-based asset ratios of 12.99% and 15.66% are well in excess of regulatory guidelines. The Bank’s leverage ratio of 8.48% is also substantially in excess of regulatory guidelines as is the Company’s at 10.25%. For further discussion and analysis of regulatory capital requirements, refer to Note 14 of the Audited Financial Statements.

The Company’s subsidiaries are restricted by regulations from making dividend distributions in excess of certain prescribed amounts.

ITEM 7a. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Market Risk

Market risk is the exposure to loss resulting from changes in interest rates and equity prices. The primary market risk to which we are subject is interest rate risk. The majority of our interest rate risk arises from the instruments, positions and transactions entered into for purposes other than trading such as loans, available for sale securities, interest bearing deposits, short term borrowings and long term borrowings. Interest rate risk occurs when interest bearing assets and liabilities re-price at different times as market interest rates change. For example, if fixed rate assets are funded with variable rate debt, the spread between asset and liability rates will decline or turn negative if rates increase.

Interest rate risk is managed within an overall asset/liability framework. The principal objectives of asset/liability management are to manage sensitivity of net interest spreads and net income to potential changes in interest rates. Funding positions are kept within predetermined limits designed to ensure that risk-taking is not excessive and that liquidity is properly managed. In the event that our asset/liabilities management strategies are unsuccessful, our profitability may be adversely affected. The Company employs a sensitivity analysis utilizing interest rate shocks to help in this analysis.

 

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Table of Contents

The shocks presented below assume an immediate change of rate in the percentages and directions shown:

 

Interest Rate Shock on
Net Interest Margin
              Interest Rate Shock on
Net Interest Income
 

Net Interest
Margin (Ratio)

    % Change
to Flat Rate
    Rate
Direction
  Rate
changes by
    Cumulative
Total ($000)
    % Change
to Flat Rate
 
  2.53     -21.72   Rising     3.00     22,177        -22.80
  2.76     -14.49   Rising     2.00     24,353        -15.22
  2.99     -7.44   Rising     1.00     26,478        -7.82
  3.23     0.00   Flat     0        28,725        0.00
  3.25     0.49   Falling     -1.00     28,880        0.54
  3.11     -3.71   Falling     -2.00     27,628        -3.82
  2.91     -9.89   Falling     -3.00     25,776        -10.27

The shock chart currently shows a tightening in net interest margin over the next twelve months in a rising rate environment. It shows expansion of net interest margin should rates fall 1% then tightening should they fall lower. Both directional changes are well within risk exposure guidelines. The effect of the rate shocks may be mitigated to the extent that not all lines of business are directly tied to an external index.

ITEM 8. FINANCIAL STATEMENTS

Index To Consolidated Financial Statements

 

Report of Independent Registered Public Accounting Firm

     41   

Consolidated Balance Sheet at December 31, 2011 and 2010

     43   

Consolidated Statements of Income for the years ended December 31, 2011, 2010 and 2009

     44   

Consolidated Statements of Changes in Shareholders’ Equity for the years ended December  31, 2011, 2010 and 2009

     45   

Consolidated Statements of Cash Flow for the years ended December 31, 2011, 2010 and 2009

     46   

Notes to Consolidated Financial Statements

     47   

 

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Table of Contents

LOGO

Report of Independent Registered Public Accounting Firm

To the Board of Directors and Stockholders

Farmers & Merchants Bancorp, Inc.

We have audited the accompanying balance sheets of Farmers & Merchants Bancorp, Inc as of December 31, 2011 and 2010, and the related statements of income, comprehensive income, stockholders’ equity and cash flows for each of the years in the three-year period ended December 31, 2011. We also have audited the Company’s internal control over financial reporting as of December 31, 2011, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying financial statements. Our responsibility is to express an opinion on these financial statements and an opinion on the company’s internal control over financial reporting based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

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Table of Contents

In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Farmers & Merchants Bancorp, Inc as of December 31, 2011 and 2010, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2011 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, Farmers & Merchants Bancorp, Inc maintained, in all material respects, effective internal control over financial reporting as of December 31, 2011, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

 

/s/ Plante & Moran, PLLC

Plante & Moran, PLLC

Auburn Hills, MI

February 24, 2012

 

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Table of Contents

Farmers & Merchants Bancorp, Inc and Subsidiary

Consolidated Balance Sheet

December 31, 2011 and 2010

(000’s Omitted, Except Per Share Data)

 

     2011     2010  
Assets     

Assets

    

Cash and due from banks (Note 1)

   $ 31,609      $ 28,987   

Federal Funds Sold

     11,534        14,392   
  

 

 

   

 

 

 

Total cash and cash equivalents

     43,143        43,379   

Securities - available for sale (Note 3)

     327,519        287,317   

Other Securities, at cost (Note 3)

     4,365        4,406   

Loans, net (Note 4)

     501,124        521,883   

Premises and equipment (Note 5)

     16,984        17,202   

Goodwill

     4,074        4,074   

Mortgage Servicing Rights (Note 6)

     2,071        2,178   

Other Real Estate Owned

     3,572        4,468   

Other assets (Note 2)

     20,141        21,456   
  

 

 

   

 

 

 

Total Assets

   $ 922,993      $ 906,363   
  

 

 

   

 

 

 
Liabilities and Stockholders’ Equity     

Liabilities

    

Deposits

    

Noninterest-bearing

   $ 84,567      $ 70,554   

Interest-bearing

    

NOW accounts

     193,137        176,897   

Savings

     170,052        159,698   

Time (Note 7)

     291,626        317,364   
  

 

 

   

 

 

 

Total deposits

     739,382        724,513   

Securities sold under agreement to repurchase (Note 8)

     52,440        51,241   

FHLB Advances (Note 9)

     16,662        29,874   

Dividend payable

     890        894   

Accrued expenses and other liabilities (Note 10)

     8,528        5,438   
  

 

 

   

 

 

 

Total liabilities

     817,902        811,960   
  

 

 

   

 

 

 

Stockholders’ Equity (Note 14 and 15)

    

Common stock - No par value - 6,500,000 shares authorized; 5,200,000 shares issued & outstanding

     12,677        12,677   

Treasury Stock - 483,663 shares 2011, 477,106 shares 2010

     (9,898     (9,799

Unearned Stock Awards - 29,715 shares 2011, 28,925 shares 2010

     (564     (580

Retained earnings

     96,495        91,567   

Accumulated other comprehensive income

     6,381        538   
  

 

 

   

 

 

 

Total stockholders’ equity

     105,091        94,403   
  

 

 

   

 

 

 

Total Liabilities and Stockholders’ Equity

   $ 922,993      $ 906,363   
  

 

 

   

 

 

 

See Notes to Consolidated Financial Statements

 

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Table of Contents

Farmers & Merchants Bancorp, Inc and Subsidiary

Consolidated Statement of Income

Years Ended December 31, 2011, 2010 and 2009

(000’s Omitted, Except Per Share Data)

 

     2011     2010     2009  

Interest Income

      

Loans, including fees

   $ 29,840      $ 32,860      $ 33,585   

Debt securities:

      

U.S. Treasury and government agency

     4,457        4,583        5,496   

Municipalities

     2,107        2,167        1,788   

Dividends

     185        188        200   

Federal funds sold

     19        26        19   

Other

     52        69        26   
  

 

 

   

 

 

   

 

 

 

Total interest income

     36,660        39,893        41,114   

Interest Expense

      

Deposits

     6,980        9,126        11,007   

Federal funds purchased and securities sold under agreements to repurchase

     293        278        486   

Borrowed funds

     883        1,459        1,727   
  

 

 

   

 

 

   

 

 

 

Total interest expense

     8,156        10,863        13,220   
  

 

 

   

 

 

   

 

 

 

Net Interest Income - Before provision for loan losses

     28,504        29,030        27,894   

Provision for Loan Losses (Note 4)

     1,715        5,325        3,558   
  

 

 

   

 

 

   

 

 

 

Net Interest Income After Provision

      

For Loan Losses

     26,789        23,705        24,336   

Noninterest Income

      

Customer service fees

     3,313        2,487        3,276   

Other service charges and fees

     3,385        3,464        2,611   

Net gain (loss) on sale of other assets owned

     (1,169     (109     (70

Net gain on sale of loans

     807        1,395        1,776   

Net gain on sale of securities (Note 3)

     504        956        230   
  

 

 

   

 

 

   

 

 

 

Total noninterest income

     6,840        8,193        7,823   

Noninterest Expenses

      

Salaries and Wages

     9,212        8,773        8,601   

Employee benefits (Note 11)

     2,835        2,909        3,018   

Net occupancy expense

     1,501        1,456        1,113   

Furniture and equipment

     1,379        1,504        1,504   

Data processing

     978        953        1,136   

Franchise taxes

     892        863        914   

FDIC Assessment

     762        1,053        1,306   

Mortgage servicing rights amortization (Note 6)

     498        683        933   

Other general and administrative

     4,165        4,341        4,554   
  

 

 

   

 

 

   

 

 

 

Total other operating expenses

     22,222        22,535        23,079   
  

 

 

   

 

 

   

 

 

 

Income Before Income Taxes

     11,407        9,363        9,080   

Income Taxes (Note 10)

     2,893        2,382        2,475   
  

 

 

   

 

 

   

 

 

 

Net Income

   $ 8,514      $ 6,981      $ 6,605   
  

 

 

   

 

 

   

 

 

 

Earnings Per Share - Basic and Diluted

   $ 1.82      $ 1.48      $ 1.39   
  

 

 

   

 

 

   

 

 

 

Weighted Average Shares Outstanding

     4,689,021        4,721,235        4,741,392   
  

 

 

   

 

 

   

 

 

 

See Notes to Consolidated Financial Statements

 

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Table of Contents

Farmers & Merchants Bancorp, Inc. and Subsidiary

Consolidated Statement of Changes in Shareholders Equity

For the Years Ended December 31, 2011, 2010 and 2009

(000’s Omitted, Except per Share Data)

 

     Shares of
Common
Stock
    Common
Stock
     Treasury
Stock
    Unearned
Stock
Awards
    Retained
Earnings
    Accumulated
Other
Comprehensive
Income (Loss)
    Total
Stockholders’
Equity
 

Balance - January 01, 2009

     4,781,706      $ 12,677       $ (8,727   $ (503   $ 84,864      $ 2,236      $ 90,547   

Comprehensive income (Note 1):

               

Net income

              6,605          6,605   

Change in net unrealized gain on securities sale, net of reclassification adjustment and tax

                278        278   
               

 

 

 

Total comprehensive income

                  6,883   

Purchase of Treasury Stock

     (28,907        (555           (555

Shares issued for vested stock awards

            123            123   

Grant of Restricted Stock Awards-10,000 shares (Net of Forfeiture - 350)

     9,650           200        (193     (8       (1

Cash dividends declared - $0.72 per share

              (3,413       (3,413
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance - December 31, 2009

     4,762,449      $ 12,677       $ (9,082   $ (573   $ 88,048      $ 2,514      $ 93,584   

Comprehensive income (Note 1):

               

Net income

              6,981          6,981   

Change in net unrealized gain on securities sale, net of reclassification adjustment and tax

                (1,976     (1,976
               

 

 

 

Total comprehensive income

                  5,005   

Purchase of Treasury Stock

     (48,130        (894           (894

Shares issued for vested stock awards

            151            151   

Grant of Restricted Stock Awards-10,150 shares (Net of Forfeiture - 1,575)

     8,575           177        (158     (18       1   

Cash dividends declared - $0.73 per share

              (3,444       (3,444
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance - December 31, 2010

     4,722,894      $ 12,677       $ (9,799   $ (580   $ 91,567      $ 538      $ 94,403   

Comprehensive income (Note 1):

               

Net income

              8,514          8,514   

Change in net unrealized gain on securities sale, net of reclassification adjustment and tax

                5,843        5,843   
               

 

 

 

Total comprehensive income

                  14,357   

Purchase of Treasury Stock

     (16,779        (310           (310

Shares issued for vested stock awards

            202            202   

Grant of Restricted Stock Awards-11,000 shares (Net of Forfeiture - 778)

     10,222           211        (186     (23       2   

Cash dividends declared - $0.76 per share

              (3,563       (3,563
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance - December 31, 2011

     4,716,337      $ 12,677       $ (9,898   $ (564   $ 96,495      $ 6,381      $ 105,091   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

See notes to Consolidated Financial Statements

 

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Table of Contents

Farmers & Merchants Bancorp, Inc and Subsidiary

Consolidated Statement of Cash Flows

Years Ended December 31, 2011, 2010 and 2009

(000’s Omitted)

 

     2011     2010     2009  

Cash Flows from Operating Activities

      

Net income

   $ 8,514      $ 6,981      $ 6,605   

Adjustments to reconcile net income to net cash from operating activities:

      

Depreciation

     1,135        1,147        1,171   

Amortization of servicing rights

     498        683        933   

Amortization of Core Deposit Intangible

     312        235        157   

Provision for loan loss

     1,715        5,325        3,558   

Gain on sale of loans held for sale

     (807     (1,392     (1,203

Originations of loans held for sale

     (52,853     (83,705     (118,491

Proceeds from sale of loans held for sale

     53,631        82,315        118,284   

Accretion and amortization of securities

     2,902        1,595        809   

Deferred income tax expense (benefit)

     (165     210        142   

Loss on sale of other assets

     1,153        109        75   

Gain on sales of securities

     (504     (956     (230

Change in other assets and other liabilities, net

     1,628        (1,112     (6,026
  

 

 

   

 

 

   

 

 

 

Net cash provided by operating activities

     17,159        11,435        5,784   

Cash Flows from Investing Activities

      

Activity in securities:

      

Sales

     30,376        55,700        16,333   

Maturities, prepayments and calls

     53,661        104,602        78,292   

Purchases

     (117,744     (244,812     (124,354

Loan and lease originations and principal collections, net

     18,266        38,094        (3,723

Proceeds from sales of assets

     14        716        494   

Additions to premises and equipment

     (947     (2,294     (412

Net cash paid for acquisition

     —          (1,141     —     
  

 

 

   

 

 

   

 

 

 

Net cash used in investing activities

     (16,374     (49,135     (33,370

Cash Flows from Financing Activities

      

Net increase (decrease) in deposits

     14,869        48,069        60,712   

Net change in federal funds purchased and securities sold under agreements to repurchase

     1,199        7,984        (4,957

Proceeds from issuance of long-term debt

     —          9,000        —     

Repayment of long-term debt

     (13,212     (13,326     (11,436

Purchase of Treasury Stock

     (310     (894     (555

Cash dividends paid on common stock

     (3,567     (3,402     (3,417
  

 

 

   

 

 

   

 

 

 

Net cash provided by (used) financing activities

     (1,021     47,431        40,347   
  

 

 

   

 

 

   

 

 

 

Net Increase (Decrease) in Cash and Cash Equivalents

     (236     9,731        12,761   

Cash and Cash Equivalents - Beginning of Year

     43,379        33,648        20,887   
  

 

 

   

 

 

   

 

 

 

Cash and Cash Equivalents - End of Year

   $ 43,143      $ 43,379      $ 33,648   
  

 

 

   

 

 

   

 

 

 

Supplemental Information

      

Cash paid during the year for:

      

Interest

   $ 8,285      $ 11,244      $ 13,275   
  

 

 

   

 

 

   

 

 

 

Income taxes

   $ 1,850      $ 1,875      $ 2,725   
  

 

 

   

 

 

   

 

 

 

Noncash investing activities:

      

Transfer of loans to other real estate owned

   $ 2,236      $ 3,867      $ 1,588   
  

 

 

   

 

 

   

 

 

 

See Notes to Consolidated Financial Statements

 

46


Table of Contents

Farmers & Merchants Bancorp, Inc and Subsidiary

Notes to Consolidated Financial Statements

December 31, 2011, 2010, and 2009

Note 1 - Summary of Significant Accounting Policies

Nature of Operations

The Farmers & Merchants Bancorp, Inc. (the Company) through its bank subsidiary, The Farmers & Merchants State Bank (the Bank) provides a variety of financial services to individuals and small businesses through its offices in Northwest Ohio and Northeast Indiana.

Consolidation Policy

The consolidated financial statements include the accounts of Farmers & Merchants Bancorp, Inc. and its wholly-owned subsidiary, The Farmers & Merchants State Bank (the Bank), a commercial banking institution. All significant inter-company balances and transactions have been eliminated.

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses and the valuation of mortgage servicing rights, goodwill, available for sale investment securities, other real estate owned and impaired loans. Actual results could differ from those estimates.

The determination of the adequacy of the allowance for loan losses is based on estimates that are particularly susceptible to significant changes in the economic environment and market conditions. In connection with the determination of the estimated losses on loans, management obtains independent appraisals for significant collateral.

The Bank’s loans are generally secured by specific items of collateral including real property, consumer assets, and business assets. Although the Bank has a diversified loan portfolio, a substantial portion of its debtors’ ability to honor their contracts is dependent on local economic conditions in the agricultural industry.

While management uses available information to recognize losses on loans, further reductions in the carrying amounts of loans may be necessary based on changes in local economic conditions. In addition regulatory agencies, as an integral part of their examination process, periodically review the estimated losses on loans. Such agencies may require the Bank to recognize additional losses based on their judgments about information available to them at the time of their examination. Because of these factors, it is reasonably possible that the estimated losses on loans may change materially in the near term. However, the amount of the change that is reasonably possible cannot be estimated.

Cash and Cash Equivalents

For purposes of the consolidated statement of cash flows, the Company considers all highly liquid debt instruments purchased with an original maturity of three months or less to be cash equivalents. This includes cash on hand, amounts due from banks, and federal funds sold. Generally, federal funds are purchased and sold for one day periods.

Restrictions on Cash and Amounts Due from Banks

The Bank is required to maintain average balances on hand with the Federal Reserve Bank. The aggregate reserve was $4.2 million for December 31, 2011 and it was $3.3 million for December 31, 2010.

The Company and its subsidiary maintain cash balances with high quality credit institutions. At times such balances may be in excess of the federally insured limits.

 

47


Table of Contents

Farmers & Merchants Bancorp, Inc and Subsidiary

Notes to Consolidated Financial Statements

December 31, 2011, 2010, and 2009

 

Note 1 - Summary of Significant Accounting Policies (Continued)

 

Securities

Debt securities are classified as available-for-sale. Securities available-for-sale are carried at fair value with unrealized gains and losses reported in other comprehensive income. Realized gains and losses on securities available for sale are included in other income (expense) and, when applicable, are reported as a reclassification adjustment, net of tax, in other comprehensive income. Gains and losses on sales of securities are determined on the specific-identification method.

Declines in the fair value of securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses. In estimating other-than-temporary impairment losses, management considers (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. The related write-downs are included in earnings as realized losses.

Other Securities

Other Securities consists of Federal Home Loan Bank of Cincinnati and Indianapolis stock and Farmer Mac stock. These stocks are carried at cost and are held to enable the Bank to conduct business with the entities. The Federal Home Loan Banks sell and purchase their stock at par; therefore cost approximates market value. The Federal Home Loan Bank of Cincinnati stock is held as collateral security for all indebtedness of the Bank to the Federal Home Loan Bank.

Loans

Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off are reported at the amount of unpaid principal, reduced by unearned discounts and deferred loan fees and costs, as well as, by the allowance for loan losses. Interest income is accrued on a daily basis based on the principal outstanding.

Generally, a loan is classified as nonaccrual and the accrual of interest income is generally discontinued when a loan becomes ninety days past due as to principal or interest and these loans are placed on a “cash basis” for purposes of income recognition. Management may elect to continue the accrual of interest when the estimated net realizable value of collateral is sufficient to cover the principal and accrued interest, and the loan is in the process of collection. When a loan is placed on nonaccrual status, all previously accrued and unpaid interest receivable is charged against income.

Loan origination and commitment fees and certain direct loan origination costs are deferred and amortized as a net adjustment to the related loan’s yield. The Bank is generally amortizing these costs over the contractual life of such loans.

Allowance for Loan Losses

The allowance for loan losses is established through a provision for loan losses charged to income. Loans deemed to be uncollectable and changes in the allowance relating to loans are charged against the allowance for loan losses, and subsequent recoveries, if any, are credited to the allowance.

The allowance for loan losses is evaluated on a regular basis by management and is based on management’s periodic review of the collectability of the loans in light of historical experiences, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral, and prevailing economic conditions. This evaluation is inherently subjective, as it requires estimates that are subject to revision as more information becomes available.

The allowance consists of specific, general and unallocated components. The specific component relates to loans that are classified as doubtful, substandard or special mention. For such loans that are also classified as impaired, an allowance is established when the discounted cash flows (or collateral value or observable market

 

48


Table of Contents

Farmers & Merchants Bancorp, Inc and Subsidiary

Notes to Consolidated Financial Statements

December 31, 2011, 2010, and 2009

 

Note 1 - Summary of Significant Accounting Policies (Continued)

 

price) of the impaired loan is lower than the carrying value of that loan. The general component covers non-classified loans and is based on historical loss experience adjusted for qualitative factors. The unallocated component is maintained to cover uncertainties that could affect management’s estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.

A loan is considered impaired when, based on current information and events, it is probable that the Bank will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan by loan basis for commercial and agricultural loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent.

At 120 days delinquent, secured consumer loans are charged down to the value of the collateral, if repossession of the collateral is assured and/or in the process of repossession. Consumer mortgage loan deficiencies are charged down upon the sale of the collateral or sooner upon the recognition of collateral deficiency.

For the majority of the Bank’s impaired loans, the Bank will apply the observable market price methodology. However, the Bank may also utilize a measurement incorporating the present value of expected future cash flows discounted at the loan’s effective rate of interest. To determine observable market price, collateral asset values securing an impaired loan are periodically evaluated. Maximum time of re-evaluation is every 12 months for chattels and titled vehicles and every two years for real estate. In this process, third party evaluations are obtained and heavily relied upon. Until such time that updated appraisals are received, the Bank may discount the collateral value used.

Large groups of homogeneous loans are collectively evaluated for impairment. Accordingly, the Bank does not separately identify individual consumer loans for impairment disclosures.

For more information regarding the actual composition and classification of loans involved in the establishment of the allowance for loan loss, please see Note 4 provided here with the notes to consolidated financial statements.

Loans Held for Sale

Loans originated and intended for sale in the secondary market are carried at the lower of cost or estimated fair value in the aggregate. Net unrealized losses, if any, are recognized in a valuation allowance by charges to income.

Servicing Assets

Servicing assets are recognized as separate assets when rights are acquired through purchase or through sale of financial assets. Capitalized servicing rights are reported in other assets and are amortized into noninterest expense in proportion to, and over the period of, the estimated future net servicing income of the underlying financial assets. Servicing assets are evaluated for impairment based upon the fair value of the rights as compared to amortized cost. Impairment is determined by stratifying rights by predominant characteristics, such as interest rates and terms. Fair value is determined using prices for similar assets with similar characteristics, when available, or based upon discounted cash flows using market based assumptions. Impairment is recognized through a valuation allowance for an individual stratum, to the extent that fair value is less than the capitalized amount for the stratum. Fees received for servicing loans owned by investors are based on a percentage of the outstanding monthly principal balance of such loans and are included in operating income as loan payments are received. Costs of servicing loans are charged to expense as incurred.

 

49


Table of Contents

Farmers & Merchants Bancorp, Inc and Subsidiary

Notes to Consolidated Financial Statements

December 31, 2011, 2010, and 2009

 

Note 1 - Summary of Significant Accounting Policies (Continued)

 

Goodwill and other Intangible Assets

Goodwill results from business acquisitions and represents the excess of the purchase price over the fair value of acquired tangible assets and liabilities and identifiable intangible assets. Goodwill is assessed at least annually with the assistance of an independent third party for impairment and any such impairment is recognized in the period identified. No impairment has been recognized from the goodwill established from the Bank’s acquisition which occurred on December 31, 2007.

Other intangible assets consist of core deposit intangible assets arising from business acquisitions. They are initially measured at fair value and then are amortized on a straight line method over their estimated useful lives.

Off Balance Sheet Instruments

In the ordinary course of business, the Bank has entered into commitments to extend credit, including commitments under credit card arrangements, commercial letters of credit and standby letters of credit. Such financial instruments are recorded when they are funded.

Foreclosed Real Estate

Foreclosed real estate held for sale is carried at the lower of fair value minus estimated costs to sell, or cost. Costs of holding foreclosed real estate are charged to expense in the current period, except for significant property improvements, which are capitalized. Valuations are periodically performed by management and an allowance is established by a charge to non-interest expense if the carrying value exceeds the fair value minus estimated costs to sell. Foreclosed real estate is classified as other real estate owned. The net income from operations of foreclosed real estate held for sale is reported in non-interest income. At December 31, the Bank’s holding of other real estate owned totaled approximately $3.6 and $4.5 million for 2011 and 2010 respectively.

Bank Premises and Equipment

Land is carried at cost. Bank premises and equipment are stated at cost less accumulated depreciation. Depreciation is based on the estimated useful lives of the various properties and is computed using straight line and accelerated methods. Costs for maintenance and repairs are charged to operations as incurred. Gains and losses on dispositions are included in current operations.

Federal Income Tax

Deferred income tax assets and liabilities are determined using the liability (or balance sheet) method. Under this method, the net deferred tax asset or liability is determined based on the tax effects of the various temporary differences between the book and tax bases of the various balance sheet assets and liabilities and gives current recognition to changes in tax rates and laws.

Earnings Per Share

Basic earnings per share represent income available to common stockholders divided by the weighted-average number of common shares outstanding during the period. Basic and dilutive earnings per share are the same as the restricted stock grants are primarily anti-dilutive. As of December 31, the Company held 29,715, 28,925 and 27,772 shares of anti-dilutive restricted stock awards for 2011, 2010 and 2009 respectively.

Comprehensive Income

Accounting principles generally require that recognized revenue, expenses, gains and losses be included in net income. Certain changes in assets and liabilities, such as unrealized gains and losses on available-for-sale securities, are reported as a separate component of the equity section of the balance sheet. Such items, along with net income, are components of comprehensive income.

 

50


Table of Contents

Farmers & Merchants Bancorp, Inc and Subsidiary

Notes to Consolidated Financial Statements

December 31, 2011, 2010, and 2009

 

Note 1 - Summary of Significant Accounting Policies (Continued)

 

The components of other comprehensive income and related tax effects are as follows:

 

     (In Thousands)  
     2011     2010     2009  

Net unrealized gain (loss) on available-for-sale securities

   $ 9,357      $ (2,037   $ 701   

Reclassification adjustment for gain on sale of available-for-sale securities

     (504     (956     (281
  

 

 

   

 

 

   

 

 

 

Net unrealized gains (losses)

     8,853        (2,993     420   

Tax effect

     3,010        (1,017     142   
  

 

 

   

 

 

   

 

 

 

Other comprehensive income (loss)

   $ 5,843      $ (1,976   $ 278   
  

 

 

   

 

 

   

 

 

 

Other securities, not classified as available for sale, had a realized loss of $51 thousand for 2009. This amount is not included in the above table.

Reclassification

Certain amounts in the 2010 and 2009 consolidated financial statements have been reclassified to conform with the 2011 presentation.

Recent Accounting Pronouncements

Troubled Debt Restructurings – In April 2011, The FASB issued ASU 2011-02 “A Creditor’s Determination of Whether a Restructuring is a Troubled Debt Restructuring”, which provides additional guidance to help creditors in determining whether a creditor has granted a concession and whether a debtor is experiencing financial difficulties for purposes of determining whether a restructuring constitutes a troubled debt restructuring. The amendments in this update were effective for the Company for the year ended December 31, 2011. The adoption of this standard did not have any additional impact to the Bank’s troubled debt restructuring classification totals.

Fair Value – In May 2011, the FASB issued ASU 2011-04 “Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS”. The standard clarifies existing fair value measurement and disclosure requirements and changes existing principles and disclosure guidance. Clarifications were made to the relevancy of the highest and best use valuation concept, measurement of an instrument classified in an entity’s shareholder’s equity and disclosure of quantitative information about the unobservable inputs for level 3 fair value measurements. Changes to existing principles and disclosures included measurement of financial instruments managed within a portfolio, the application of premiums and discounts in fair value measurement, and additional disclosures related to fair value measurements. The updated guidance and requirements are effective for financial statements issued for the first interim or annual period beginning after December 15, 2011, and should be applied prospectively. The adoption of this standard is not expected to have a material effect on the Company’s financial statement.

Comprehensive Income – In June 2011, the FASB issued ASU 2011-05 “Presentation of Comprehensive Income”. This standard requires an entity to present the total of comprehensive income, the components of net income and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but continuous statements. This standard eliminates the option to present the components of other comprehensive income as part of the statement of equity. This standard is effective for fiscal years and interim periods with those years beginning after December 15, 2011. The implementation of this standard will only change the presentation of comprehensive income; it will not have an impact on the Company’s financial position or results of operations. In December 2011, the FASB issued ASU 2011-12.This standard defers the requirement to present reclassification adjustments for each component of OCI to both net income and OCI on the face of the financial statements.

 

51


Table of Contents

Farmers & Merchants Bancorp, Inc and Subsidiary

Notes to Consolidated Financial Statements

December 31, 2011, 2010, and 2009

 

Goodwill – In September 2011, the FASB issued ASU 2011-08, “Testing Goodwill for Impairment”. This standard gives an entity the option to assess qualitative factors to determine if goodwill is impaired. If the qualitative assessment indicates no impairment, a quantitative goodwill impairment test is not required. The standard is effective for fiscal years beginning after December 15, 2011, and early adoption is permitted. The adoption of this standard is not expected to have a material effect on the Company’s financial statements. The Company utilizes the services of an independent third party to assess if any impairment exists on its goodwill.

Note 2 - Business Combination & Asset Purchase

On July 9, 2010 the Bank completed its purchase of a branch office in Hicksville, Ohio from First Place Bank. Deposits of approximately $28 million and loans of $14 million were included in the purchase. The new office is located within the Bank’s current market area, shortening the distance between offices in the Ohio and Indiana market area. The following table summarizes the estimated values of the assets acquired and the liabilities assumed:

 

($ in Thousands)       

Cash

   $ 114   

Loans, Net of Discount

     13,792   

Accrued Interest on Loans

     64   

Premises and Equipment

     1,803   

Core Deposit Intangible Asset

     1,087   

Other Assets

     11   
  

 

 

 

Total Assets Acquired

   $ 16,871   
  

 

 

 

Deposits

   $ 27,749   

Accrued Interest on Deposits

     13   

Other Liabilities

     10   
  

 

 

 

Total Liabilities Assumed

   $ 27,772   
  

 

 

 

Net Liabilities Assumed

   $ (10,901
  

 

 

 

In connection with a December 31, 2007 Knisely acquisition, the Company recognized a core deposit intangible asset of $1.1 million, which is being amortized on a straight line basis over 7 years, which represents the estimated remaining economic useful life of the deposits.

The Company also recognized core deposit intangible assets of $1.09 million with the purchase of the Hicksville office. These are being amortized over an estimated remaining economic useful life of the deposits of 7 years on a straight line basis.

The estimated amortization expense for the years ended December 31, 2011, 2010 and 2009 was $312, $235 and $157 thousand, respectively.

 

52


Table of Contents

Farmers & Merchants Bancorp, Inc and Subsidiary

Notes to Consolidated Financial Statements

December 31, 2011, 2010, and 2009

 

Note 2 - Business Combination & Asset Purchase (Continued)

 

Amortization expense of the core deposit intangible assets remaining is as follows:

 

     (In Thousands)  
     Knisley      Hicksville      Total  

2012

   $ 157       $ 156       $ 313   

2013

     157         156         313   

2014

     157         156         313   

2015

     —           155         155   

2016

     —           155         155   

Thereafter

     —           77         77   
  

 

 

    

 

 

    

 

 

 

Total

   $ 471       $ 855       $ 1,326   
  

 

 

    

 

 

    

 

 

 

Note 3 - Securities

The amortized cost and fair value of securities, with gross unrealized gains and losses, follows:

 

$327,519 $327,519 $327,519 $327,519
     (In Thousands)  
     2011  
     Amortized
Cost
     Gross
Unrealized
Gains
     Gross
Unrealized
Losses
    Estimated
Market
Value
 

Available-for-Sale:

          

U.S. Treasury

   $ 26,050       $ 641       $ —        $ 26,691   

U.S. Government agency

     174,545         3,270         (18     177,797   

Mortgage-backed securities

     54,113         1,318         (18     55,413   

State and local governments

     63,143         4,476         (1     67,618   
  

 

 

    

 

 

    

 

 

   

 

 

 

Total available-for-sale securities

   $ 317,851       $ 9,705       $ (37   $ 327,519   
  

 

 

    

 

 

    

 

 

   

 

 

 

 

$327,519 $327,519 $327,519 $327,519
     (In Thousands)  
     2010  
     Amortized
Cost
     Gross
Unrealized
Gains
     Gross
Unrealized
Losses
    Estimated
Market
Value
 

Available-for-Sale:

          

U.S. Treasury

   $ 32,698       $ —         $ (420   $ 32,278   

U.S. Government agency

     166,000         1,308         (1,604     165,704   

Mortgage-backed securities

     23,282         1,249         —          24,531   

State and local governments

     64,522         792         (510     64,804   
  

 

 

    

 

 

    

 

 

   

 

 

 

Total available-for-sale securities

   $ 286,502       $ 3,349       $ (2,534   $ 287,317   
  

 

 

    

 

 

    

 

 

   

 

 

 

Investment securities will at times depreciate to an unrealized loss position. The Bank utilizes the following criteria to assess whether impairment is other than temporary. No one item by itself will necessarily signal that a security should be recognized as an other than temporary impairment.

 

  1. The fair value of the security has significantly declined from book value.

 

  2. A downgrade has occurred that lowered the credit rating to below investment grade (below Baa3 by Moody and BBB – by Standard and Poors.)

 

  3. Dividends have been reduced or eliminated or scheduled interest payments have not been made.

 

  4. The underwater security has longer than 10 years to maturity and the loss position had existed for more than 3 years.

 

  5. Management does not possess both the intent and ability to hold the security for a period of time sufficient to allow for any anticipated recovery in fair value.

 

53


Table of Contents

Farmers & Merchants Bancorp, Inc and Subsidiary

Notes to Consolidated Financial Statements

December 31, 2011, 2010, and 2009

 

Note 3 - Securities (Continued)

 

If the impairment is judged to be other than temporary, the cost basis of the individual security shall be written down to fair value, thereby establishing a new cost basis. The new cost basis shall not be changed for subsequent recoveries in fair value. The amount of the write down shall be included in current earnings as a realized loss. The recovery in fair value, if any, shall be recognized in earnings when the security is sold. The table below is presented by category of security and length of time in a continuous loss position. The Bank currently does not hold any securities with other than temporary impairment.

Information pertaining to securities with gross unrealized losses at December 31, 2011 and 2010, aggregated by investment category and length of time that individual securities have been in a continuous loss position follows:

 

0000000000 0000000000 0000000000 0000000000
     2011  
     (In Thousands)
Less Than Twelve Months
     (In Thousands)
Twelve Months & Over
 
     Gross
Unrealized
Losses
    Fair
Value
     Gross
Unrealized
Losses
     Fair
Value
 

U.S. Government agency

   $ (18   $ 12,192       $ —         $ —     

Mortgage-backed securities

     (18     —           —           —     

State and local governments

     (1     652         —           —     
  

 

 

   

 

 

    

 

 

    

 

 

 

Total available-for-sales securities

   $ (37   $ 12,844       $ —         $ —     
  

 

 

   

 

 

    

 

 

    

 

 

 

 

0000000000 0000000000 0000000000 0000000000
     2010  
     (In Thousands)
Less Than Twelve Months
     (In Thousands)
Twelve Months & Over
 
     Gross
Unrealized
Losses
    Fair
Value
     Gross
Unrealized
Losses
    Fair
Value
 

U.S. Treasury

   $ (420   $ 32,278       $ —        $ —     

U.S. Government agency

     (1,604     88,026         —          —     

Mortgage-backed securities

     —          —           —          —     

State and local governments

     (411     20,386         (99