Item 1. Business.
On April 30, 2010 the stockholders of the Bank approved the formation of a bank holding company, Highlands Bancorp, Inc., under a Plan of Acquisition (the "Plan") whereby each outstanding share of the Bank’s common stock, $5 par value per share, was transferred and contributed to the holding company in exchange for one share of the holding company’s common stock, no par value per share. This exchange of shares was completed during the third quarter of 2010. Due to the reorganization, the Bank’s common stock surplus of $7,041,000 was transferred to common stock with no par value.
The only activity of Highlands Bancorp, Inc. is the ownership of Highlands State Bank (the “Bank”). The Company is subject to the supervision and regulation of the Board of Governors of the Federal Reserve System (the “FRB”) and New Jersey Department of Banking and Insurance (“NJDOBI”). The Bank is subject to supervision and regulation by the NJDOBI and the Federal Deposit Insurance Corporation (“FDIC”).
The Bank is a New Jersey state chartered bank which commenced operations on October 31, 2005. The Bank is a full service bank providing personal and business lending and deposit services. The Bank’s primary market is Sussex and Passaic Counties in New Jersey. HSB Mountain Lakes, LLC was formed as a subsidiary of the Bank in 2010 to hold certain real estate acquired in settlement of loans. HSB Chapel LLC, and HSB Village Way LLC were formed as subsidiaries of the Bank in 2011 also to hold real estate properties acquired in settlement of loans. The Bank’s principal office is located at 310 Route 94 in Vernon, NJ. We also operate two additional branch offices at 351 Sparta Ave, Sparta, New Jersey and at 650 Union Boulevard, Totowa, New Jersey. Our Sparta office was acquired as part of our merger with Noble Community Bank, which was consummated at the end of 2008. Our new Totowa branch office, which opened in the fourth quarter of 2011, replaced the Bank’s original Totowa branch which opened in 2009, designed to capitalize on the Passaic County contacts of our President and Chief Executive Officer, George E. Irwin. Mr. Irwin served as the President and Chief Executive Officer of Greater Community Bank of Totowa, New Jersey for over 18 years.
The Bank engages in the general business of commercial banking. The Bank offers traditional commercial banking services such as savings and checking accounts and provides commercial, consumer and mortgage loans. Bank deposits are insured by the FDIC up to applicable limits. The Bank provides a wide range of commercial banking products and services, including personal and business checking accounts and time deposits, money market accounts and regular savings accounts. The Bank does not presently have any trust powers and, therefore, does not offer any trust services.
The Bank structures its specific services and fees in a manner designed to attract the business of small and medium-sized businesses and the professional community, as well as that of individuals, in the Sussex and Passaic Counties, New Jersey area. The Bank engages in a wide range of lending activities and offers commercial, consumer, mortgage, construction and personal loans. All lending decisions are made on the basis of credit soundness. The Bank from time to time participates in multi-bank credit arrangements in order to take part in loans for amounts that are in excess of the Bank's legal lending limit. In commercial lending, the Bank offers loans for equipment and working capital needs, as well as for financing of commercial real estate. In consumer lending, the Bank offers personal, automobile, bridge, home equity and home improvement loans. The Bank also makes one-to-four-family residential real estate loans.
The Bank believes it offers competitive rates for its services, thereby enabling consumers and business entities in its service area to avail themselves of the Bank's credit and non-credit services.
Unless otherwise indicated, the terms “us”, “we”, and “our” refer to the Company on a consolidated basis.
Participation in the Capital Purchase Program
In October 2008, the United States Treasury Department (the “Treasury”) announced a voluntary Capital Purchase Program, a part of the Troubled Asset Relief Program (TARP), to encourage U.S. financial institutions to build capital to increase the flow of financing to U.S. businesses and consumers and to support the U.S. economy. Highlands applied to participate in this program prior to December 31, 2008 and received approval in January 2009.
On May 8, 2009, the Bank issued to the Treasury 3,091 shares of Series 2009A Preferred Stock and a warrant to purchase 155 shares of the Bank’s Series 2009B Preferred Stock for an aggregate purchase price of $3,091,000 in cash (“TARP funds”). The warrant was exercised as a cashless exercise on May 8, 2009 and 155 shares of Series 2009B Preferred Stock were issued. Both series of preferred stock qualified as Tier 1 capital. On December 22, 2009, the Bank consummated a second financing with the Treasury under the Capital Purchase Program for Small Banks pursuant to which the Bank issued to the Treasury an additional 2,359 shares of Series 2009A Preferred Stock for total proceeds of $2,359,000. The Series 2009A Preferred Stock paid non-cumulative dividends of 5% per annum for the first five years and 9% per annum thereafter. Series 2009B Preferred Stock paid non-cumulative dividends of 9% per annum.
Upon consummation of the holding company reorganization on August 31, 2010, the Company assumed all of the Bank’s obligations under the preferred stock, and issued to the Treasury shares of the Company’s preferred stock in exchange for the outstanding shares of Bank preferred stock.
Participation in the Small Business Lending Program
In 2011, the Company applied to participate in the Treasury’s Small Business Lending Program, and the Company was approved to participate in the program, a $30 billion fund established under the Small Business Jobs Act of 2010 that encourages lending to small businesses by providing capital to qualified community banks with assets less than $10 billion. On September 22, 2011, the Company entered into a Securities Purchase Agreement (the “Purchase Agreement”) with the Treasury, pursuant to which the Company issued and sold to the Treasury 6,853 shares of its Senior Non-Cumulative Perpetual Preferred Stock, Series C (the “Series C Preferred Stock”), having a liquidation preference of $1,000 per share (the “Liquidation Amount”), for proceeds of $6,853,000. The proceeds were used to redeem the Series 2009A and 2009B preferred stock previously issued to the Treasury under the Capital Purchase Program, and to further enhance the Bank’s business lending efforts.
The Series C Preferred Stock qualifies as Tier 1 capital. Non-cumulative dividends are payable quarterly on the Series C Preferred Stock, beginning January 1, 2012. The dividend rate is calculated as a percentage of the aggregate Liquidation Amount of the outstanding Series C Preferred Stock and is based on changes in the level of “Qualified Small Business Lending” or “QSBL” (as defined in the Purchase Agreement) by the Bank. Based upon the increase in the Bank’s level of QSBL over the baseline level calculated under the terms of the Purchase Agreement, the dividend rate for the initial dividend period, which is from the date of issuance through December 31, 2011, has been set at 1.65%. For the 2nd through 10th calendar quarters, the annual dividend rate may be adjusted to between 1% and 5%, to reflect the amount of change in the Banks’ level of QSBL. For the 11th calendar quarter through 4.5 years after issuance, the dividend rate will be fixed at between 1% and 7% based upon the increase in QSBL as compared to the baseline. After 4.5 years from issuance, the dividend rate will increase to 9%.
The Series C preferred shares are non-voting, other than class voting rights on matters that could adversely affect the shares. The preferred shares are redeemable at any time, with Treasury, Federal Reserve and FDIC approval. Apart from the Series C shares, no other shares of the Company’s preferred stock are currently outstanding.
Business Strategy
The Bank was founded by a group of local business persons and professionals on the premise that an essential component of a vibrant local economy is a strong community bank that focuses on serving the financial needs of the individuals, professionals and small- to medium sized businesses in its local communities. As big banks became more and more depersonalized, cut back on services offered to customers, and increased fees in the local markets they had penetrated, the group believed an opportunity arose to offer high quality banking and other financial services with personalized attention. The group was convinced that the communities were under served by these larger institutions, and would therefore welcome an institution that would provide timely and personalized services coupled with timely and direct access to decision makers.
The deposit services we offer include checking accounts, savings accounts and certificates of deposit for both personal and business use. As of December 31, 2011, the Company had total deposits of $141.0 million. We offer commercial, consumer and mortgage related products with particular emphasis on loans that are tailored to meet the needs of small- to medium sized businesses, professionals and individuals. These products include commercial and residential mortgage, term and working capital loans and home equity credit lines. As of December 31, 2011, the Company had total net loans of $131.3 million.
The Company believes that the current trend of consolidation among larger financial institutions results in personnel who are not intimately familiar with the needs of individuals and business in our service areas, a curtailment of services, and increased fees. Our business strategy is to continue to pursue additional business from those customers who, as a result of these trends, are underserved or undervalued by larger financial institutions. Even in these difficult times, we believe our marketplace remains one of the most desirable banking markets in the entire country. We further believe that by pursuing these undervalued customers, coupled with the application of sound business principals, we are building a strong customer foundation. Further, by providing a level of service that is customer oriented, including access to our decision makers, and by expanding our brand into local communities located in the densely populated and affluent northern New Jersey marketplace, the Company believes it can create value for its shareholders.
Lending Activities.
We engage in a variety of lending activities including commercial, construction, residential real estate and consumer transactions. Lending activities are focused on individuals, professionals and small- to medium-sized businesses by attracting customers with personal service and attractive pricing. We have not engaged in subprime lending.
In managing the growth of the loan portfolio, management has focused on: (1) the application of prudent underwriting criteria; (2) active involvement by senior management and the board of directors in the loan approval process; (3) active monitoring of loans to ensure that repayments are made in a timely manner and to identify potential problem loans; and (4) review of select aspects of the loan portfolio by independent consultants.
Commercial and Commercial Real Estate Loans. The commercial loan portfolio consists primarily of commercial loans to small and medium sized businesses and individuals for general business and real estate uses. Commercial and commercial real estate loans are generally secured by real estate and/or by the guarantees of the principals of the borrowers. Commercial loans that exceed our legal limits are participated with other commercial banks. At December 31, 2011, we had $93.6 million in commercial loans outstanding, representing 70.2% of the total loan portfolio.
Commercial loans are made on a line of credit and fixed basis to finance inventory, equipment or short-term working capital. These loans are generally made on a secured basis with the personal guarantees of the principal owners with occasional policy exceptions. Fixed rate loans generally have terms of one to five years.
Commercial real estate loans are made for the acquisition of new property or the refinancing of existing property. These loans are typically related to commercial businesses and secured by the underlying real estate used in the business or real property of the principals.
Construction Loans. Construction loans are generally made to builders, developers and consumers who wish to build their own homes or commercial structures. These loans are secured by the real estate being developed and are generally personally guaranteed by the principals of the borrowers. The duration of construction loans generally is limited to 12 to 18 months, although payments may be structured on a longer amortization basis. Construction loans generally carry a higher degree of risk than long-term financing of existing properties because repayment depends on the ultimate completion of the project and, on some occasions, the sale of the property. As of December 31, 2011, the Company had $6.5 million of real estate construction loans outstanding, representing 4.8% of the total loan portfolio.
Residential Real Estate and Home Equity Loans. We offer both home equity lines of credit and home equity loans. Risks associated with loans secured by residential properties are generally lower than commercial real estate and construction loans and include general economic risks, such as the strength of the job market, employment stability and the strength of the housing market. Since most loans are secured by a primary or secondary residence, the borrower’s continued employment is the greatest risk to repayment. As of December 31, 2011, the Company had $10.4 million in residential real estate loans outstanding representing 7.8% of the total loan portfolio, and $22.7 million in home equity loans outstanding, representing 17.0% of the total loan portfolio.
Consumer Loans. We offer a variety of loans to individuals for personal and household purposes. Consumer loans are generally considered to have greater risk than first or second mortgages on real estate because they may be unsecured, or, if they are secured, the value of the collateral may be difficult to assess and more likely to decrease in value than real estate. At December 31, 2011, the Company had $222 thousand in consumer loans outstanding, representing 0.2% of the total loan portfolio.
Competition
The Company operates in a highly competitive environment competing for deposits and loans with commercial banks, thrifts, credit unions and other financial institutions, many of which have greater financial resources. In addition, in November 1999, the Gramm-Leach-Bliley Financial Modernization Act of 1999 was passed into law. The Act permits insurance companies and securities firms, among others, to acquire financial institutions and has increased competition within the financial services industry. Certain competitors have significantly higher lending limits and provide services to their customers that we do not offer.
The Company believes that it is able to compete favorably with its competitors because it provides responsive personalized services through management's knowledge and awareness of its service area, customers and businesses.
Service Area
Primary market areas consist of Sussex County and Passaic County, each in New Jersey, although the extensive banking and business experience of our management attracts customers in the neighboring counties and throughout New Jersey.
Supervision and Regulation
Bank holding companies and banks are extensively regulated under both federal and state law. These laws and regulations are intended to protect depositors, not shareholders. To the extent that the following information describes statutory and regulatory provisions, it is qualified in its entirety by reference to the particular statutory and regulatory provisions. Any change in the applicable law or regulation may have a material effect on the business and prospects of the Company and the Bank.
Bank Holding Company Regulation
General
As a bank holding company registered under the Bank Holding Company Act, the Company is subject to the regulation and supervision applicable to bank holding companies by the Board of Governors of the Federal Reserve System. The Company is required to file with the Federal Reserve annual reports and other information regarding its business operations and those of its subsidiaries.
The Bank Holding Company Act requires, among other things, the prior approval of the Federal Reserve in any case where a bank holding company proposes to (i) acquire all or substantially all of the assets of any other bank, (ii) acquire direct or indirect ownership or control of more than 5% of the outstanding voting stock of any bank (unless it owns a majority of such company's voting shares) or (iii) merge or consolidate with any other bank holding company. The Federal Reserve will not approve any acquisition, merger, or consolidation that would have a substantially anti-competitive effect, unless the anti-competitive impact of the proposed transaction is clearly outweighed by a greater public interest in meeting the convenience and needs of the community to be served. The Federal Reserve also considers capital adequacy and other financial and managerial resources and future prospects of the companies and the banks concerned, together with the convenience and needs of the community to be served, when reviewing acquisitions or mergers.
The Bank Holding Company Act generally prohibits a bank holding company, with certain limited exceptions, from (i) acquiring or retaining direct or indirect ownership or control of more than 5% of the outstanding voting stock of any company which is not a bank or bank holding company, or (ii) engaging directly or indirectly in activities other than those of banking, managing or controlling banks, or performing services for its subsidiaries, unless such non-banking business is determined by the Federal Reserve to be so closely related to banking or managing or controlling banks as to be properly incident thereto.
The Bank Holding Company Act was substantially amended through the Gramm-Leach Bliley Financial Modernization Act of 1999 ("Financial Modernization Act"). The Financial Modernization Act permits bank holding companies and banks, which meet certain capital, management and Community Reinvestment Act standards to engage in a broader range of non-banking activities. In addition, bank holding companies that elect to become financial holding companies may engage in certain banking and non-banking activities without prior Federal Reserve approval. Finally, the Financial Modernization Act imposes certain new privacy requirements on all financial institutions and their treatment of consumer information. At this time, the Company has elected not to become a financial holding company, as it does not engage in any activities that are not permissible for banks.
There are a number of obligations and restrictions imposed on bank holding companies and their depository institution subsidiaries by law and regulatory policy that are designed to minimize potential loss to the depositors of such depository institutions and the FDIC insurance funds in the event the depository institution becomes in danger of default. Under provisions of the Bank Holding Company Act, a bank holding company is required to serve as a source of financial strength to its subsidiary depository institutions and to commit resources to support such institutions in circumstances where it might not do so absent such policy. The Federal Reserve also has the authority under the Bank Holding Company Act to require a bank holding company to terminate any activity or to relinquish control of a non-bank subsidiary upon the Federal Reserve's determination that such activity or control constitutes a serious risk to the financial soundness and stability of any bank subsidiary of the bank holding company.
Capital Adequacy Guidelines for Bank Holding Companies
The Federal Reserve has adopted risk-based capital guidelines for bank holding companies. The risk-based capital guidelines are designed to make regulatory capital requirements more sensitive to differences in risk profile among banks and bank holding companies to account for off-balance sheet exposure, and to minimize disincentives for holding liquid assets. Under these guidelines, assets and off-balance sheet items are assigned to broad risk categories, each with appropriate weights. The resulting capital ratios represent capital as a percentage of total risk-weighted assets and off-balance sheet items. These requirements apply on a consolidated basis to bank holding companies with consolidated assets of $500 million or more and to certain bank holding companies with less than $500 million in consolidated assets if they are engaged in substantial non-banking activities or meet certain other criteria. We do not meet these criteria, and so are not subject to a minimum consolidated capital requirement.
In addition to the risk-based capital guidelines, the Federal Reserve has adopted a minimum Tier I capital (leverage) ratio, under which a bank holding company must maintain a minimum level of Tier I capital to average total consolidated assets of at least 3% in the case of a bank holding company that has the highest regulatory examination rating and is not contemplating significant growth or expansion. All other bank holding companies are expected to maintain a leverage ratio of at least 100 to 200 basis points above the stated minimum. This minimum leverage requirement only applies to bank holding companies on a consolidated basis if the risk based capital requirements discussed above apply. We do not have a minimum consolidated capital requirement at the holding company level at this time.
Bank Regulation
As a commercial bank organized under the banking laws of the State of New Jersey, the Bank is subject to the regulation, supervision, and control of the New Jersey Department of Banking and Insurance. As an FDIC-insured institution, the Bank is subject to regulation, supervision and control of the FDIC, an agency of the federal government. The regulations of the FDIC and the New Jersey Department of Banking and Insurance impact virtually all of the Bank’s activities, including the minimum level of capital it must maintain, the ability to pay dividends and to expand through new branches or acquisitions, and various other matters. The following are highlights of certain of these regulations.
Insured Deposits. The Dodd-Frank Wall Street Reform and Consumer Protection Act adopted in July 2010 (the “Dodd-Frank Act”) has caused significant changes in the FDIC’s insurance of deposit accounts. Among other things, the Dodd-Frank Act permanently increased the FDIC deposit insurance limit to $250 thousand per depositor. In addition, the Dodd-Frank Act includes provisions replacing, by statute, the FDIC’s program to provide unlimited deposit insurance coverage for noninterest bearing transactional accounts. Institutions are not required to opt into this coverage, and can not opt out of the program. In addition, institutions are not required to pay an additional assessment for this additional coverage. Under the Dodd-Frank Act, this unlimited coverage for non-interest bearing transaction accounts will expire on January 1, 2013.
On February 7, 2011 the FDIC announced the approval of a revised assessment system mandated by the Dodd-Frank Act. The Dodd-Frank Act requires that the base on which deposit insurance assessments are charged be revised from one based on domestic deposits to one based on assets. The FDIC’s rule bases the assessment base on average total consolidated assets minus average tangible equity, instead of domestic deposits, and has lowered assessments for community banks with less than $10 billion in assets. The new rate schedule was effective during the second quarter of 2011 and has reduced the Company’s costs for Federal deposit insurance.
Capital Adequacy Guidelines. The FDIC has promulgated risk-based capital guidelines that are designed to make regulatory capital requirements more sensitive to differences in risk profile among banks, to account for off-balance sheet exposure, and to minimize disincentives for holding liquid assets. Under these guidelines, assets and off-balance sheet items are assigned to broad risk categories, each with appropriate weights. The resulting capital ratios represent capital as a percentage of total risk-weighted assets and off-balance sheet items.
Bank assets are given risk weights of 0%, 20%, 50% and 100%. In addition, certain off-balance sheet items are given similar credit conversion factors to convert them to asset equivalent amounts to which an appropriate risk-weight will apply. Those computations will result in the total risk-weighted assets. Most loans are assigned to the 100% risk category, except for those performing first mortgage loans fully secured by residential property, which carry a 50% risk weighting. Most investment securities (including general obligation claims of states or other political subdivisions of the United States) are assigned to the 20% category, except for municipal or state revenue bonds, which have a 50% risk-weighting, and direct obligations of the U.S. Treasury or obligations backed by the full faith and credit of the U.S. government, which have a 0% risk-weight. In converting off-balance sheet items, direct credit substitutes, including general guarantees and standby letters of credit backing financial obligations, are given a 100% risk weighting. Transaction-related contingencies such as bid bonds, standby letters of credit backing non-financial obligations and undrawn commitments (including credit lines with an initial maturity of more than one year), have a 50% risk weighting.
Short-term commercial letters of credit have a 20% risk weighting, and certain short-term unconditionally cancelable commitments have a 0% risk weighting.
In addition to the risk-based capital guidelines, the FDIC has adopted a minimum Tier 1 capital (leverage) ratio. The minimum required ratio of total capital to risk-weighted assets (including certain off-balance sheet activities, such as standby letters of credit) is 8%. At least half of the Bank’s total capital is required to be “Tier 1 Capital,” consisting of common stockholders’ equity and certain qualifying preferred or hybrid instruments less certain goodwill items and other intangible assets. The remainder (“Tier 2 Capital”) may consist of (a) the allowance for loan losses of up to 1.25% of risk-weighted assets, (b) excess of qualifying preferred stock, (c) hybrid capital instruments, (d) perpetual debt, (e) mandatory convertible securities, and (f) qualifying subordinated debt and intermediate-term preferred stock up to 50% of Tier 1 Capital. Total capital is the sum of Tier 1 Capital and Tier 2 Capital less reciprocal holdings of other banking organizations’ capital instruments, investments in unconsolidated subsidiaries and any other deductions as determined by the FDIC.
Dividends. The Bank may pay dividends as declared from time to time by the Board of Directors out of funds legally available, subject to certain restrictions. Under the New Jersey Banking Act of 1948, the Bank may not pay a cash dividend unless, following the payment, the Bank’s capital stock will be unimpaired and the Bank will have a surplus of no less than 50% of the Bank capital stock or, if not, the payment of the dividend will not reduce the surplus. In addition, the Bank cannot pay dividends in such amounts as would reduce the Bank’s capital below regulatory imposed minimums.
Community Reinvestment Act. The Community Reinvestment Act of 1977, as amended (the “CRA”), requires that banks meet the credit needs of all of their assessment area (as established for these purposes in accordance with applicable regulations based principally on the location of branch offices), including those of low income areas and borrowers. The CRA does not establish specific lending requirements or programs for financial institutions nor does it limit an institution’s discretion to develop the types of products and services that it believes are best suited to its particular community, consistent with the CRA. The CRA requires the FDIC to assess an institution’s record of meeting the credit needs of its community and to take such record into account in the evaluation of certain applications by such institution. The CRA requires public disclosure of an institution’s CRA rating and requires that a written evaluation of an institution’s performance utilizing a four-tiered descriptive rating system be undertaken. An institution’s CRA rating is considered in determining whether to grant charters, branches and other deposit facilities, relocations, mergers, consolidations and acquisitions. Performance less than satisfactory may be the basis for denying an application. The Bank is rated “Satisfactory” in CRA.
USA PATRIOT Act. Under the United and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism (USA PATRIOT) Act of 2001, financial institutions are subject to prohibitions against specified financial transactions and account relationships as well as enhanced due diligence and “know your customer” standards in their dealings with foreign financial institutions and foreign customers. The USA PATRIOT Act requires financial institutions to establish anti-money laundering programs meeting the minimum standards specified by the Act and implementing regulations. While the Bank does not expect to have any significant international banking relationships, and does not anticipate that the USA PATRIOT Act will have a material effect on its business or operations, the effect of the compliance burden imposed by the Act on the Bank cannot be predicted with certainty.
The Dodd-Frank Wall Street Reform and Consumer Protection Act. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 was signed into law on July 21, 2010. Generally, the Dodd-Frank Act is effective the day after it was signed into law, but different effective dates apply to specific sections of the law, many of which will not become effective until various Federal regulatory agencies have promulgated rules implementing the statutory provisions. Some uncertainty remains as to the ultimate impact of the Dodd-Frank Act, which could have a material adverse impact on the financial services industry by increasing compliance costs and reducing some sources of revenue. The Dodd-Frank Act, among other things:
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Directs the Federal Reserve to issue rules which limit debit-card interchange fees;
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Provides for an increase in the FDIC assessment for depository institutions with assets of $10 billion or more, increases in the minimum reserve ratio for the deposit insurance fund from 1.15% to 1.35% and changes the basis for determining FDIC premiums from deposits to assets;
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Permanently increases the deposit insurance coverage to $250 thousand and allows depository institutions to pay interest on checking accounts;
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Creates a new consumer financial protection bureau that will have rulemaking authority for a wide range of consumer protection laws that would apply to all banks and would have broad powers to supervise and enforce consumer protection laws directly for large institutions;
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Provides for new disclosure and other requirements relating to executive compensation and corporate governance;
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Changes standards for Federal preemption of state laws related to federally chartered institutions and their subsidiaries;
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Provides mortgage reform provisions regarding a customer’s ability to repay, restricting variable-rate lending by requiring the ability to repay to be determined for variable-rate loans by using the maximum rate that will apply during the first five years of a variable-rate loan term, and making more loans subject to provisions for higher cost loans, new disclosures, and certain other revisions; and
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Creates a financial stability oversight council that will recommend to the Federal Reserve increasingly strict rules for capital, leverage, liquidity, risk management and other requirements as companies grow in size and complexity.
Federal Securities Regulation. The Company is a reporting company under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and therefore is required to file current, quarterly and annual reports, as well as proxy statements and certain other materials, with the Securities and Exchange Commission (“SEC”). Compliance with these requirements increases our non-interest expense.
On July 30, 2002, the Sarbanes-Oxley Act, or “SOX” was enacted. SOX is not a banking law, but applies to all companies that are subject to the Exchange Act. The stated goals of SOX are to increase corporate responsibility, to provide for enhanced penalties for accounting and auditing improprieties at publicly traded companies and to protect investors by improving the accuracy and reliability of corporate disclosures pursuant to the securities laws. SOX is the most far reaching U.S. securities legislation enacted in some time.
SOX includes very specific additional disclosure requirements and new corporate governance rules and requires the SEC and securities exchanges to adopt extensive additional disclosure, corporate governance and other related rules, and mandates further studies of specific issues by the SEC. SOX represents significant federal involvement in matters traditionally left to state regulatory systems, such as the regulation of the accounting profession, and to state corporate law, such as the relationship between a board of directors and management and between a board of directors and its committees.
Complying with the requirements of SOX increases our compliance costs and could make it more difficult to attract and retain board members. This 10-K report does not include an attestation report of the Company’s registered public accounting firm regarding internal control over financial due to exemption provided under SEC regulations.
Anti-Terrorism Legislation - On October 26, 2001, a new anti-terrorism bill, the International Money Laundering Abatement and Anti-Terrorism Funding Act of 2001, was signed into law. This law restricts money laundering by terrorists in the United States and abroad. This act specifies new "know your customer" requirements that will obligate financial institutions to take actions to verify the identity of the account holders in connection with opening an account at any U.S. financial institution. Banking regulators will consider compliance with the act's money laundering provisions in making decisions regarding approval of acquisitions and mergers. In addition, sanctions for violations of the act can be imposed in an amount equal to twice the sum involved in the violating transaction, up to $1 million.
Employees
At December 31, 2011, we employed 38 full-time equivalent employees. None of these employees are covered by a collective bargaining agreement and we believe that our employee relations are good.
Item 1A.
Item 1A. Risk Factors.
Risks affecting Our Business:
Our nonperforming assets have substantially increased over the past several years, and this has, and will continue, to affect our results of operations.
At December 31, 2011, our total nonperforming assets increased to $10.1 million or 6.1% of our total assets, from $5.8 million or 3.5% of our total assets at December 31, 2010. Foreclosed real estate has increased $2.4 million to $3.2 million at year end 2011, compared to $799 thousand at year end 2010. This level of nonperforming assets reflects the continued general economic slowdown in our marketplace and its effect on our borrowers. The deterioration in credit quality has negatively impacted our results of operations, through additional provisions for loan losses and reduced interest income, and will continue to impact our performance until these assets are resolved. In addition, future increases in our nonperforming assets will further negatively affect our results of operations. We can give you no assurance that our nonperforming assets will not increase further.
The nationwide economic conditions may adversely affect our business by reducing real estate values in our trade area and stressing the ability of customers to repay their loans.
The New Jersey trade area, like the rest of the United States, has experienced economic contraction and continuing weak economic conditions. As a result, many companies have experienced reduced revenues and have laid off employees. These factors have stressed the ability of both commercial and consumer customers to repay their loans, and have, and may in the future, result in higher levels of nonaccrual loans. In addition, real estate values have declined in the trade area. Since the majority of our loans are secured by real estate, declines in the market value of real estate impact the value of the collateral securing our loans, and could lead to greater losses in the event of defaults on loans secured by real estate.
The potential impact of changes in monetary policy and interest rates may negatively affect our operations.
Operating results may be significantly affected (favorably or unfavorably) by market rates of interest that, in turn, are affected by prevailing economic conditions, by the fiscal and monetary policies of the United States govern­ment and by the policies of various regulatory agencies. Our earnings will depend primarily upon interest rate spread (i.e., the difference between income earned on loans and investments and the interest paid on deposits and borrowings). Like most financial institutions, we may be subject to the risk of fluctuations in interest rates, which, if signifi­cant, may have a material adverse effect on operations.
Earnings may not grow if we are unable to successfully attract core deposits and lending opportunities and exploit opportunities to generate fee-based income.
In the event that we are unable to execute our business strategy of continued growth in loans and deposits, earnings could be adversely impacted. The ability to continue to grow depends, in part, upon the ability to expand our market share, to successfully attract core deposits and identify loan and investment opportunities, as well as opportunities to generate fee-based income. The ability to manage growth successfully will also depend on whether we can continue to efficiently fund asset growth and maintain asset quality and cost controls, as well as on factors beyond our control such as economic conditions and interest rate trends.
There is no active and liquid public trading market for the Company’s stock.
Although there are sporadic quotations and trading in the Company’s common stock on the OTC Bulletin Board, there is no established, liquid market for its common stock. It is unlikely that an active or liquid trading market in the Company’s common stock will develop in the near term, and if such a market develops, there is no assurance that it will continue. In an inactive and/or illiquid market, shareholders wishing to sell their shares may have to find buyers through their own efforts. In addition, sales of large amounts of shares could adversely affect the prevailing market price.
Risks Related to the Company and the Banking Industry:
Changes in local economic conditions could adversely affect our loan portfolio.
Our success depends to a great extent upon the general economic conditions of the local markets that we serve. Unlike larger banks that are more geographically diversified, we provide banking and financial services primarily to customers in Sussex and Passaic Counties in the New Jersey market, so any decline in the economy of New Jersey could have an adverse impact the Company.
Loans, the ability of borrowers to repay these loans, and the value of collateral securing these loans are impacted by economic conditions. Financial results, the credit quality of the existing loan portfolio, and the ability to generate new loans with acceptable yield and credit characteristics may be adversely affected by changes in prevailing economic conditions, including declines in real estate values, changes in interest rates, adverse employment conditions and the monetary and fiscal policies of the federal government. We cannot assure you that positive trends or developments will continue or that negative trends or developments will not have a significant adverse effect on us.
The financial services industry is undergoing a period of great volatility and disruption
The Company is subject to interest rate risk and variations in interest rates may negatively affect its financial performance. In addition, dislocation and volatility in the credit markets may negatively affect the value of assets.
Beginning in mid 2007, there has been significant turmoil and volatility in global financial markets. Nationally, economic factors such as inflation or recession, a rise in unemployment, a weakened US dollar, and rising consumer costs persist. Recent market uncertainty regarding the financial sector has increased. In addition to the impact on the economy generally, changes in interest rates, in the shape of the yield curve, or in valuations in the debt or equity markets or disruptions in the liquidity or other functioning of financial markets, all of which have been seen recently, could directly impact the Company in one or more of the following ways:
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Net interest income, the difference between interest earned on our interest-earning assets and interest paid on interest-bearing liabilities, represents a significant portion of our earnings. Both increases and decreases in the interest rate environment may reduce profits. We expect that we will continue to realize income from the spread between the interest we earn on loans, securities and other interest-earning assets, and the interest we pay on deposits, borrowings and other interest-bearing liabilities. The net interest spread is affected by the differences between the maturity and repricing characteristics of our interest-earning assets and interest-bearing liabilities. Our interest-earning assets may not reprice as slowly or rapidly as our interest-bearing liabilities.
·
The market value of our securities portfolio may decline and result in other than temporary charges. The values of securities in the portfolio are affected by factors that impact the U.S. securities market in general as well as specific financial sector factors and entities. Further declines in these sectors may result in future other than temporary impairment charges.
·
Asset quality may deteriorate as borrowers become unable to repay their loans.
There is a risk that we may not be repaid in a timely manner, or at all, for loans we make.
The risk of non-payment (or deferred or delayed payment) of loans is inherent in commercial banking. Such non-payment, or delayed or deferred payment of loans, may have a material adverse effect on our earnings and overall financial condition. Additionally, in compliance with applicable banking laws and regulations, we maintain an allowance for loan losses created through charges against earnings. As of December 31, 2011, the allowance for loan losses was $2.1 million. Our marketing focus on small- to medium sized businesses may result in our assumption of certain lending risks that are different from or greater than those which would apply to loans made to larger companies. We seek to minimize our credit risk exposure through credit controls, which include evaluation of potential borrowers’ available collateral, liquidity and cash flow. However, there can be no assurance that such procedures will actually reduce loan losses.
Our allowance for loan losses may not be adequate to cover actual losses.
Like all financial institutions, we maintain an allowance for loan losses to provide for loan defaults and nonperformance. Our allowance for loan losses may not be adequate to cover actual losses, and future provisions for loan losses could materially and adversely affect the results of our operations. Although risks within the loan portfolio are analyzed on a continuous basis by management, we can provide you no assurance that our analysis will cause us to avoid future losses. The amount of future losses is susceptible to changes in economic, operating and other conditions, including changes in interest rates that may be beyond our control, and these losses may exceed current estimates. State and federal regulatory agencies, as an integral part of their examination process, review our loans and allowance for loan losses and have in the past required an increase in our allowance for loan losses. Although we believe that our allowance for loan losses is adequate to cover probable and reasonably estimated losses, we cannot assure you that we will not further increase the allowance for loan losses or that our regulators will not require us to increase this allowance. Either of these occurrences could adversely affect our earnings.
Competition from other financial institutions in originating loans and attracting deposits may adversely affect our profitability.
We face substantial competition in originating loans. This competition comes principally from other banks, savings institutions, mortgage banking companies, credit unions and other lenders. Many of our competitors enjoy advantages, including greater financial resources and higher lending limits, a wider geographic presence, more accessible branch office locations, the ability to offer a wider array of services or more favorable pricing alternatives, as well as lower origination and operating costs. This competition could reduce our net income by decreasing the number and size of loans that we originate and the interest rates we may charge on these loans.
In attracting deposits, we face substantial competition from other insured depository institutions such as banks, savings institutions and credit unions, as well as institutions offering uninsured investment alternatives, including money market funds. Many of our competitors enjoy advantages, including greater financial resources, more aggressive marketing campaigns and better brand recognition and more branch locations. These competitors may offer higher interest rates than we do, which could decrease the deposits that we attract or require us to increase our rates to retain existing deposits or attract new deposits. Increased deposit competition could adversely affect our ability to generate the funds necessary for lending operations that may increase our cost of funds.
We compete with non-bank providers of financial services, such as brokerage firms, consumer finance companies, insurance companies and governmental organizations that may offer more favorable terms. Some of our non-bank competitors are not subject to the same extensive regulations that govern our operations. As a result, such non-bank competitors may have advantages over us in providing certain products and services. This competition may reduce or limit our margins on banking services, reduce our market share and adversely affect our earnings and financial condition.
The banking business is subject to significant government regulations, which are designed for the protection of depositors and the public, but not our stockholders.
We are subject to extensive governmental supervision, regulation and control. These laws and regulations are subject to change, and may require substantial modifications to our operations or may cause us to incur substantial additional compliance costs. In addition, future legislation and government policy could adversely affect the commercial banking industry and our operations. Such governing laws can be anticipated to continue to be the subject of future modification. These laws and regulations are generally designed to protect depositors and the deposit insurance funds and to foster economic growth and not for the purpose of protecting stockholders. Our management cannot predict what effect any such future modifications will have on our operations.
For example, the recently adopted Dodd-Frank Act has and will result in substantial new compliance costs, and may restrict certain sources of revenue. The Dodd-Frank Act was signed into law on July 21, 2010. Generally, the Act is effective the day after it was signed into law, but different effective dates apply to specific sections of the law, many of which will not become effective until various Federal regulatory agencies have promulgated rules implementing the statutory provisions. Uncertainty remains as to the ultimate impact of the Dodd-Frank Act, which could have a material adverse impact either on the financial services industry as a whole, or on our business, results of operations and financial condition. The Dodd-Frank Act, among other things:
●
Directs the Federal Reserve to issue rules to limit debit-card interchange fees;
●
Provides for an increase in the FDIC assessment for depository institutions with assets of $10 billion or more, increases in the minimum reserve ratio for the deposit insurance fund from 1.15% to 1.35% and changes the basis for determining FDIC premiums from deposits to assets;
●
Permanently increases the deposit insurance coverage to $250 thousand and allows depository institutions to pay interest on checking accounts;
●
Creates a new consumer financial protection bureau that will have rulemaking authority for a wide range of consumer protection laws that would apply to all banks and would have broad powers to supervise and enforce consumer protection laws;
●
Provides for new disclosure and other requirements relating to executive compensation and corporate governance;
●
Changes standards for Federal pre-emption of state laws related to federally chartered institutions and their subsidiaries;
●
Provides mortgage reform provisions regarding a customer’s ability to repay, restricting variable-rate lending by requiring the ability to repay to be determined for variable-rate loans by using the maximum rate that will apply during the first five years of a variable-rate loan term, and making more loans subject to provisions for higher cost loans, new disclosures, and certain other revisions; and
●
Creates a financial stability oversight council that will recommend to the Federal Reserve increasingly strict rules for capital, leverage, liquidity, risk management and other requirements as companies grow in size and complexity.
We can give no assurance that future changes in laws and regulations or changes in their interpretation will not adversely affect our business.
We cannot predict how changes in technology will impact our business.
The financial services market, including banking services, is increasingly affected by advances in technology, including developments in:
■ telecommunications;
■ data processing;
■ automation;
■ internet-based banking;
■ telephone banking; and
■ debit cards and so-called “smart cards.”
Our ability to compete successfully in the future will depend, to a certain extent, on whether we can anticipate and respond to technological changes. We offer electronic banking services for our consumer and business customers via our website, www.highlandsstatebank.com, including internet banking and electronic bill payment. We also offer MasterCard Check Cards, ATM cards and automatic and ACH transfers. The successful operation and further development of these and other new technologies will likely require additional capital investments in the future. We cannot assure you that we will have sufficient resources or access to the necessary proprietary technology to remain competitive in the future.
Our information systems may experience an interruption or breach in security.
The Company relies heavily on communications and information systems to conduct its business. Any failure, interruption or breach in security of these systems could result in failures or disruptions in our customer-relationship management, general ledger, deposit, loan and other systems. While the Company has policies and procedures designed to prevent or limit the effect of the failure, interruption or security breach of its information systems, there can be no assurance that any such failures, interruptions or security breaches will not occur; or, if they do occur, that they will be adequately addressed. The occurrence of any failures, interruptions or security breaches of our information systems could damage the Company’s reputation, result in a loss of customer business, subject us to additional regulatory scrutiny or expose us to civil litigation and possible financial liability; any of which could have a material adverse affect on the Company’s financial condition and results of operations.
Item 1B.
Item 1B. Unresolved Staff Comments.
None.
Item 2.
Item 2. Properties.
We currently lease our main banking office at 310 Route 94 in Vernon, New Jersey and each of our two branch locations at 650 Union Boulevard in Totowa, New Jersey and 351 Sparta Ave in Sparta, New Jersey. These leases are as follows:
Item 3.
Item 3. Legal Proceedings.
From time to time, we are subject to legal proceedings and claims in the ordinary course of business. We are currently not aware of any such legal proceedings or claims that management believes will have, individually or in the aggregate, a material adverse effect on the business, financial condition, or operating results of the Company.
Item 4.
Item 4. Mine Safety Disclosures.
Not applicable.
PART II
Item 5.
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
Presently, there is no active and liquid trading market for the Company’s common stock. The stock is approved for quotation on the OTC Bulletin Board under the ticker symbol HSBK.OB. However, trading in the Company’s common stock on such market has been infrequent and in very limited volume. Broadridge Company acts as the transfer agent and registrar for the common stock of the Company.
The following table shows the high and low sale prices for the common stock traded on the OTC Bulletin Board from January 1, 2010 through December 31, 2011
There are five hundred and thirteen (513) record holders of the Company’s common stock.
The Company has not paid any dividends to date and has no plans to do so in the immediate future. The Company may, in the future pay dividends as declared from time to time by the Board of Directors out of funds legally available, subject to certain restrictions. For as long as ownership of the Bank remains the Company’s primary business, the Company’s ability to pay dividends will be dependent upon the Bank’s ability to pay dividends to the Company. Under the New Jersey Banking Act of 1948, the Bank may not pay a cash dividend unless, following the payment, the Bank’s capital stock will be unimpaired and the Bank will have a surplus of no less than 50% of the Bank’s capital stock or, if not, the payment of the dividend will not reduce the surplus. In addition, the Bank cannot pay dividends in such amounts as would reduce the Bank’s capital below regulatory imposed minimums. While the general terms and conditions of participation in the US Treasury’s SBLF program do not prohibit participating community banks from paying dividends to their shareholders, there are several conditions that may affect dividend payments. During participation in the SBLF program, any dividend or securities redemption must not result in more than a 10 percent decrease in the bank’s Tier I capital from a level existing immediately after the closing of the SBLF securities purchase agreement.
Equity Compensation Plans
Recent Sales of Unregistered Securities.
In connection with the holding company reorganization, the Registrant issued one share of its common stock for each share of the common stock of Highlands State Bank outstanding. The transaction was undertaken pursuant to the exemption from registration provided under Section 3(a) (12) of the Securities Act of 1933, as amended.
Item 6.
Item 6. Selected Financial Data
Not Applicable.
Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
This discussion and analysis provides an overview of the consolidated financial condition and results of operations of Highlands Bancorp, Inc. (the “Company”) as of December 31, 2011 and 2010 and for the years then ended. This discussion should be read in conjunction with the audited consolidated financial statements and the accompanying notes for the years ended December 31, 2011 and 2010 contained elsewhere herein. Current performance does not guarantee and may not be indicative of similar performance in the future. The Company completed the holding company reorganization, and its acquisition of the Bank, in the third quarter of 2010. This transaction was accounted for in a similar manner to the pooling-of-interests method of accounting. Accordingly, the financial information relating to periods prior to the reorganization are reported under the name of Highlands Bancorp, Inc.
Critical Accounting Policies
The financial statements included in this report have been prepared in conformity with accounting principles generally accepted in the United States of America. In preparing the financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the dates of the statements of financial condition and revenues and expenses for the periods then ended. Actual results could differ significantly from those estimates. Note 1 to the Company’s Consolidated Financial Statements for the year ended December 31, 2011 contains a summary of the Company’s significant accounting policies. Some of these policies are particularly sensitive, requiring significant judgments, estimates and assumptions to be made by management, most particularly in connection with determining the provision for loan losses and the appropriate level of the allowance for loan losses, the valuation of foreclosed assets, the determination of other-than-temporary impairment on securities and the valuation of deferred tax assets.
Allowance for Loan Losses. The allowance for loan losses is based upon management’s evaluation of the adequacy of the allowance, including an assessment of known and inherent risks in the portfolio, giving consideration to the size and composition of the loan portfolio, actual loan loss experience, level of delinquencies, detailed analysis of individual loans for which full collectability may not be assured, the existence and estimated net realizable value of any underlying collateral and guarantees securing the loans, and current economic and market conditions. Although management uses the best information available, the level of the allowance for loan losses remains an estimate which is subject to significant judgment and short-term change. Various regulatory agencies, as an integral part of their examination process, periodically review the allowance for loan losses. Such agencies may require us to make additional provisions for loan losses based upon information available to them at the time of their examination.
Foreclosed Assets. The Company’s valuation of foreclosed assets is based upon management’s review of the properties in the portfolio and the appraised values and disposal prospects of those properties. The purpose of management’s review is to identify and record impairment.
Investment Securities Impairment Valuation. Securities are evaluated on at least a quarterly basis, and more frequently when market conditions warrant such an evaluation, to determine whether a decline in their value is other-than-temporary. The analysis of other-than-temporary impairment requires the use of various assumptions including, but not limited to, the length of time the investment’s book value has been less than fair value, the severity of the investment’s decline and the credit deterioration of the issuer. For debt securities, management assesses whether (a) it has the intent to sell the security and (b) it is more likely than not that it will be required to sell the security prior to its anticipated recovery. These steps are done before assessing whether the entity will recover the cost basis of the investment.
In instances when a determination is made that an other-than-temporary impairment exists but the investor does not sell the debt security and it is not more likely than not that it will be required to sell the debt security prior to its anticipated recovery, the other-than-temporary impairment of debt securities is separated into (a) the amount of the total other-than-temporary impairment related to a decrease in cash flows expected to be collected from the debt security (credit loss) and (b) the amount of the total other-than-temporary impairment related to all other factors. The amount of the total other-than-temporary impairment related to the credit loss is recognized in earnings. The amount of the total other-than-temporary impairment related to all other factors is recognized in other comprehensive income.
Deferred Tax Assets and Liabilities. We recognize deferred tax assets and liabilities for future tax effects of temporary differences, net operating loss carry forwards and tax credits. Deferred tax assets are subject to management’s judgment based upon available evidence that future realization is more likely than not. If management determines that we may be unable to realize all or part of the net deferred tax assets in the future, a valuation allowance is recorded to reduce the recorded value of the net deferred tax asset to the expected realizable amount. For the year ended December 31, 2011, we recognized $480 thousand of deferred tax assets and the related income tax benefit. Prior to 2011 we did not recognize any deferred tax assets or the related income tax benefit due to the operating losses incurred since the commencement of operations.
Deferred income taxes are provided on the liability method whereby deferred tax assets are recognized for deductible temporary differences and deferred tax liabilities are recognized for taxable temporary differences. Temporary differences are the differences between the reported amounts of assets and liabilities and net operating loss carryforwards and their tax basis. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion of the deferred tax assets will not be realized. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment.
Forward-looking Statements
This discussion contains forward-looking statements within the meaning of the Securities Exchange Act of 1934, as amended, including statements of goals, intentions, and expectations as to future trends, plans, events or results of the Company’s operations and policies and regarding general economic conditions. These statements are based upon current and anticipated economic conditions, nationally and in our market, interest rates and interest rate policy, competitive factors and other conditions that, by their nature, are not susceptible to accurate forecast, and are subject to significant uncertainty.
Such forward-looking statements can be identified by the use of forward-looking terminology such as “believes”, “expects”, “may”, “intends”, “will”, “should”, “anticipates”, or the negative of any of the foregoing or other variations thereon or comparable terminology, or by discussion of strategy.
No assurance can be given that the future results covered by forward-looking statements will be achieved. Such statements are subject to risks, uncertainties, and other factors that could cause actual results to differ materially from future results expressed or implied by such forward-looking statements. Important factors that could impact the Company’s operating results include, but are not limited to, those listed under the heading “Risk Factors” in this Annual Report on Form 10-K filed with the SEC and the following (i) the effects of changing economic conditions in the Company's market areas and nationally, (ii) credit risks of commercial, real estate, consumer and other lending activities, (iii) significant changes in interest rates, (iv) changes in federal and state banking laws and regulations which could impact the Company’s operations, and (v) other external developments which could materially affect the Company’s business and operations.
OVERVIEW
The Company is the holding company for Highlands State Bank, a New Jersey state chartered commercial bank that commenced operations on October 31, 2005. The Bank’s principal office is located in Vernon, New Jersey and it operates two additional branches, one each in Sparta, New Jersey and Totowa, New Jersey.
The following table sets forth selected measures of the Company’s financial position or performance for the dates or periods indicated.
(1)
Total revenue equals net interest income plus non-interest income.
Like most financial institutions, the Company derives the majority of its income from interest it receives on its interest-earning assets, such as loans and investments. Our primary source of funds for making these loans and investments is deposits, on which we pay interest. Consequently, one of the key measures of our success is our amount of net interest income, or the difference between the income on our interest-earning assets and the expense on our interest-bearing liabilities, such as deposits and borrowings. Another key measure is the spread between the yield we earn on these interest-earning assets and the rate we pay on interest-bearing liabilities, which is called net interest spread.
There are risks inherent in all loans, and we maintain an allowance for loan losses to absorb probable losses on existing loans that may become uncollectible. This allowance is maintained by charging a provision for loan losses against operating earnings. A detailed discussion of this process, as well as several tables describing the allowance for loan losses, is provided below.
In addition to earning interest on loans and investments, we earn income through other sources, such as fees and other charges to customers. The various components of non-interest income, as well as non-interest expense, are described in the following discussion.
Results of Operations for the Years Ended December 31, 2011 and 2010
Income Statement Review
Our results of operations depend primarily on net interest income, which is the difference between the interest earned on interest-earning assets and the interest paid on funds borrowed to support those assets, primarily deposits. Net interest margin is the difference between the weighted average rate received on interest-earning assets and the weighted average rate paid on interest-bearing liabilities, as well as the average level of interest-earning assets as compared with that of interest-bearing liabilities. Net income is also affected by the amount of non-interest income and other non-interest expenses.
Summary
For the year ended December 31, 2011, the Company had total net income of $1.5 million, compared to a net income of $470 thousand in 2010. Net income available to common stockholders was $1.2 million or $.67 per diluted share for 2011 based on average shares outstanding of 1,788,262 compared to $153 thousand or $.09 per diluted share for the year ended December 31, 2010 during 2010 based on average shares outstanding of 1,788,262. The difference between net income and income available to common stockholders reflects dividend and accretion expense on the Company’s outstanding preferred stock. Preferred stock dividends and accretion of $342 thousand were recorded for the year ended December 31, 2011 compared to $317 thousand in 2010. These preferred stock dividends relate to the shares of preferred stock issued to the United States Treasury under its Capital Purchase Program and Small Business Lending Fund programs, as discussed in Note 9 to the financial statements contained in this report. The improvement in earnings for 2011 when compared to 2010 was the result improved net interest income after the provision for loan losses due to loan growth during the year, reductions made to deposit rates, lower borrowing costs, and a lower provision for loan losses. Non-interest income declined by $84 thousand due to lower gains from sales of available for sale investment securities, reduced loan fee and insufficient fund income, and a loss on the sale of an other real estate owned (“OREO”) property acquired through foreclosure. These declines in non-interest income were partially offset by increased other income which reflected higher OREO property rental income and merchant settlement credits during 2011. Non-interest expenses increased $113 thousand, reflecting higher employee salary and benefit costs of $188 thousand due to additions made to staff, higher occupancy and equipment costs of $67 thousand relating to the addition of the new Totowa branch location lease and the writeoff of the former Totowa branch lease, which were partially offset by lower depreciation charges, increased data processing costs associated with our growth, and higher miscellaneous costs which included increased expenses relating to loans, loan collection, and OREO charges. These increases in expense were partially offset by reduced deposit insurance premiums of $126 thousand due to lower assessment rates, and a decline in legal fees of $119 thousand resulting from legal fee insurance claim reimbursements received during the year.
During 2011 our net interest income increased by $521 thousand. The increase reflected a reallocation of our earning assets into higher yielding loans from deposits in other banks, and was further enhanced by a $260 thousand reduction in provision for loan losses during 2011. The yield on interest-earning assets increased to 4.73% for 2011, as compared to 4.57% for 2010 as a result of a $12.8 million increase in average loans receivable resulting in a larger portion of interest income generated by higher yielding assets. In addition, the cost of funds declined to 0.99% for 2011, as compared to 1.23% for 2010. During 2011 the cost of interest paying deposits decreased due to changes in rates paid on deposits, resulting in an increase in net interest spread of 40 basis points to 3.74% for 2011 compared to 3.34% for 2010. The net interest margin also increased 38 basis points to 3.98% for 2011 compared to 3.60% for 2010. The improvement in margin also reflects the increase in yield on our interest-earning assets and the decline in cost of funds for 2011.
Total average earning assets decreased $2.3 million to $159.9 million in 2011 compared to $162.2 million for 2010 as a result of declines in interest-bearing deposits with other banks and investment securities. Average total interest-bearing liabilities also decreased $6.1 million to $121.1 million in the current year compared to $127.2 million in the prior year, reflecting lower balances in money market and savings accounts, partially offset by increased time deposit balances obtained through both retail and wholesale channels. Slow economic conditions experienced during 2011 continue to be very challenging for all banks.
Preferred stock dividends and accretion of $342 thousand were recorded for the year ended December 31, 2011 compared to $317 thousand in 2010. These preferred stock dividends relate to the shares of preferred stock issued to the United States Treasury under its Capital Purchase Program, as discussed in Note 9 to the financial statements contained in this report. The results for 2011 also include a charge to retained earnings of $83,000 for the remaining unaccreted discount on preferred stock issued to the United States Treasury (“Treasury”) in 2009 under the Treasury’s Capital Purchase Program (“CPP”). The one-time write-off was the result of the Company redeeming the Treasury’s CPP preferred stock in order to participate in the Treasury’s Small Business Lending Fund (“SBLF”). As a result of the Company’s participation in the SBLF and its redemption of the CPP preferred stock, the Company expects to pay preferred stock dividends at a lower rate in future periods.
Net Interest Income
The Company’s primary source of revenue is net interest income. Net interest income is determined by the balances of interest-earning assets and interest-bearing liabilities and the interest rates earned and paid on these balances. The amount of net interest income recorded is affected by the rate and amount of growth of interest-earning assets and interest-bearing liabilities, the amount of interest-earning assets as compared to the amount of interest-bearing liabilities, and by changes in interest rates earned and interest rates paid on these assets and liabilities.
Net interest income for the year ended December 31, 2011 was $6.4 million compared to net interest income of $5.8 million for the year ended December 31, 2010. The improvement in net interest income for the year ended December 31, 2011 is a result of the change in the mix of earning assets towards higher yielding loans from lower yielding bank deposits, and from decreased interest expense associated with deposit rate reductions and reduced money market and savings deposits. Our net interest margin for the year ended December 31, 2011 increased 38 basis points to 3.98% from 3.60% for the year ended December 31, 2010.
Total interest income for the year ended December 31, 2011 increased $150 thousand to $7.6 million as compared to $7.4 million for the year ended December 31, 2010 as a result of growth in the loan portfolio. Average earning assets were $159.9 million for the year ended December 31, 2010 compared to $162.2 million for the year ended December 31, 2010. The $2.3 million decline in average earning assets in 2011 was primarily a result of declines in average deposits with other banks of $12.8 million, or 50.8%, and in average investment securities of $3.1 million, or 16.7%. The yield on average earning assets increased to 4.73% for 2011 as compared to 4.57% for 2010. This increase was primarily the result of our loan growth.
Total interest expense for the year ended December 31, 2011 decreased $371 thousand to $1.2 million as compared with $1.6 million for the year ended December 31, 2010. Average interest-bearing deposit account balances declined $3.8 million to $115.4 million for 2011, from $119.2 million for 2010, as a result of reductions in interest rates paid to depositors, a change in the mix of the deposit portfolio, and lower borrowing costs. Average interest-bearing liabilities were $121.1 million for the year ended December 31, 2011 compared to $127.2 million for the year ended December 31, 2010. The yield on average interest- bearing liabilities decreased to 0.99% for 2011 compared to 1.23% for 2010.
The following table sets forth certain information relating to our average assets and liabilities for the years ended December 31, 2011 and 2010, and reflects the average yield on assets and average cost of liabilities for the periods indicated. Such yields are derived by dividing income or expense by the average balance of assets or liabilities, respectively, for the periods shown. Average loans are stated net of deferred costs and include non-accrual loans. Securities available for sale are reflected in the following table at amortized cost.
Analysis of Changes in Net Interest Income
Net interest income also can be analyzed in terms of the impact of changing interest rates and changing volume. As shown in the table below, of the total increase in net interest income of $521 thousand in 2011 compared to 2010, volume-related factors accounted for $494 thousand of the increase in net interest income and rate- related factors accounted for $27 thousand. The increased volume of earning assets provided an additional $515 thousand in interest income due to loan growth, and increased deposits to fund that growth resulted in higher interest expense of $21 thousand when comparing 2011 to 2010. Changes related to lower yields on interest-earning assets had a negative impact of $365 thousand on net interest income while lower rates on interest-bearing liabilities reduced interest expense by $392 thousand for these same periods.
The following table sets forth the effect which varying levels of interest-earning assets, interest-bearing liabilities and the applicable rates have had on changes in net interest income for the periods presented. Changes due to both volume and rates have been allocated in proportion to the relationship of the dollar amount change in each.
Provision for Loan Losses
The allowance for loan losses is established through provisions for loan losses charged against income. Loans deemed to be uncollectible are charged against the allowance for loan losses, and subsequent recoveries, if any, are credited to the allowance.
The allowance for loan losses will be maintained at a level considered adequate to provide for losses that can be reasonably anticipated. Management’s periodic evaluation of the adequacy of the allowance is based on known and inherent risks in the portfolio, adverse situations that may affect the borrower’s ability to repay, the estimated value of any underlying collateral, composition of the loan portfolio, current economic conditions and other relevant factors. This evaluation is inherently subjective as it requires material estimates that may be susceptible to significant revisions as more information becomes available.
At the end of each quarter or more often, if necessary, management analyzes the collectability of loans and accordingly adjusts the loan loss allowance to an appropriate level. The allowance for loan losses covers estimated credit losses on individually evaluated loans that are determined to be impaired, as well as estimated credit losses inherent in the remainder of the loan portfolio. For a description of the process for determining the adequacy of the allowance for loan losses, see the “Allowance for Loan Losses” section below.
For the year ended December 31, 2011, management provided a provision for loan losses of $397 thousand, compared to a provision of $657 thousand for the year ended December 31, 2010. Non-accrual loans increased to $4.9 million at December 31, 2011 from $4.1 million at year end 2010. For 2011, loan charge-offs totaled $73 thousand, as compared to $441 thousand for 2010. The reduction in charge-offs led to the reduced provision in 2011. While charge-offs have declined, the overall local, regional and national economies have yet to show consistent improvement, and we may experience additional charge-offs in the future. Recoveries on previously charged off loans totaled $66 thousand for 2011, as compared to $39 thousand during 2010.
At December 31, 2011, the allowance for loan losses totaled $2.1 million representing 1.56% of total outstanding loans, as compared to $1.7 million or 1.38% of total outstanding loans at year end 2010. Based principally on economic conditions, asset quality, and loan-loss experience including that of comparable institutions in our market area, the allowance is believed to be adequate. We have not participated in any sub-prime lending activity.
Non-interest Income
Total non-interest income was $474 thousand for the twelve month period ended December 31, 2011 compared to $558 thousand for the same period in 2010. The decrease of $84 thousand is primarily due to reduced gains from the sales of available for sale securities of $76 thousand, lower loan fees of $26 thousand, and insufficient fund charges of $11 thousand, which were partially offset by higher debit card interchange fees of $20 thousand and loan late fees of $9 thousand. The current year also reflected an $11 thousand loss during the second quarter of 2011 on the sale of a foreclosed real estate property.
Non-interest Expenses
Non-interest expenses were $5.4 million in 2011 compared to $5.3 million in 2010. The following table sets forth information related to the various components of non-interest expenses for each period.
Non-interest expenses increased $113 thousand or 2.1% from $5.3 million for the year ended December 31, 2010 to $5.4 million for the same period ended December 31, 2011. The largest component of the increase was in employee salaries and benefits of $188 thousand, or 8.5%, due to increases in staff and the addition of two new loan officers during 2011, increased occupancy and equipment costs of $67 thousand, or 7.1%, as a result costs associated with our new Totowa branch office location, higher mainframe data processing costs of $47 thousand or 9.1% due to increased volume of accounts and enhanced network support services, and higher other expenses of $52 thousand or 8.0% reflecting loan and foreclosed asset costs. These increased charges for 2011 were partially offset by lower deposit insurance premiums of $126 thousand or 42.4% due to lower assessment rates, and reduced professional fee costs of $119 thousand or 21.1% as a result of legal fee claim reimbursements received during the year.
Provision for Income Taxes
Income tax expense on pre-tax income of $1.1 million for the year ended December 31, 2011 of $502 thousand was offset by the utilization of net operating loss carryforwards and the resultant reversal of the valuation allowance on deferred tax assets of $982 thousand for a net tax benefit of $480 thousand. Income tax expense on pre-tax income of $470 thousand for the year ended December 31, 2010 of $204 thousand was offset by the utilization of net operating loss carryforwards and the resultant reversal of the valuation allowance on deferred tax assets of $204 thousand.
Deferred income taxes are provided on the liability method whereby deferred tax assets are recognized for deductible temporary differences and deferred tax liabilities are recognized for taxable temporary differences. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion of the deferred tax assets will not be realized. To satisfy the “more likely than not” criteria required to reduce the valuation allowance, the Company would need to demonstrate that a consistent positive trend of profitability is sustainable. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment.
The Company has provided a $2,590,000 valuation allowance on the net deferred tax asset at December 31, 2011due to the uncertainty of the realization of the entire deferred tax asset. Due to projections of taxable income in 2012, management believes that it is more likely than not that the Company will realize the benefit of the $480,000 deferred tax asset recorded.
At December 31, 2011, the Company has available unused net operating loss carryforwards available for federal and state income tax purposes of approximately $6,100,000 and $2,800,000, respectively, which start to expire in 2025 for federal purposes and 2012 for state purposes.
Financial Condition
Balance Sheet Review
Overview
During 2011, assets increased $1.8 million or 1.1% from $164.2 million at December 31, 2010 to $166.0 million at December 31, 2011 due primarily to loan portfolio growth and increases in foreclosed real estate. The increases were partially offset by declines in interest-bearing deposits in other banks and securities available for sale. Total assets at December 31, 2011 primarily consisted of net loans outstanding of $131.3 million, time deposits in other banks of $9.3 million and investment securities available for sale of $15.3 million. At December 31, 2010 total assets consisted of net loans outstanding of $121.0 million, time deposits in other banks of $19.6 million and investment securities available for sale of $17.5 million. Foreclosed assets, or other real estate owned (“OREO”) totaled $3.2 million at December 31, 2011, increasing from $799 thousand at the end of 2010 and consisted of three commercial properties acquired during the year through loan default.
Total deposits at December 31, 2011, were $141.0 million compared to $136.4 million at December 31, 2010, an increase of $4.6 million or 3.4%. Deposits consisted principally of certificates of deposit, money market, savings, checking and interest-bearing checking accounts which at December 31, 2011 were $38.2 million, $34.6 million, $34.6 million, $27.3 million, and $6.4 million, respectively, compared to $26.2 million, $33.3 million, $43.8 million, $26.3 million, and $6.8 million at December 31, 2010, respectively. The mix of our deposit portfolio changed during 2011 as time deposit, money market and checking accounts increased by $12.0 million, $1.4 million, and $991 thousand, respectively, and savings and interest checking balances declined by $9.2 million and $470 thousand, respectively. Borrowings were $5.5 million at December 31, 2011 decreasing $5.5 million compared to $11.0 million at December 31, 2010 as excess funds from matured interest-bearing deposits in banks and investment securities not used to fund our loan growth were used to pay off borrowings during the year.
Time Deposits in Other Banks
Time deposits in other banks decreased $10.3 million from $19.6 million at December 31, 2010 to $9.3 million at December 31, 2011. The proceeds from the maturities of these short-term deposits were used to fund growth in the loan portfolio.
Investments
The securities portfolio is classified, in its entirety, as “available for sale.” Management believes that a portfolio classification of available for sale allows complete flexibility in the investment portfolio. Management intends to hold these securities for an indefinite amount of time, but not necessarily to maturity. Such securities are carried at fair value with unrealized gains or losses reported as a separate component of stockholders’ equity. The portfolio is structured to provide a return on investment while providing a consistent source of liquidity and meeting our risk standards. Investment securities consist primarily of U.S. agency securities, mortgage-backed securities issued by FHLMC or FNMA, and corporate debt securities. We did not hold any derivatives as of December 31, 2011 or December 31, 2010.
Total securities at December 31, 2011 were $15.3 million compared to securities of $17.5 million at December 31, 2010. The carrying value of the securities portfolio as of December 31, 2011 includes a net unrealized gain of $200 thousand, which is recorded as accumulated other comprehensive income in stockholders’ equity. This compares to a net unrealized gain of $258 thousand at December 31, 2010. No securities are deemed to be other than temporarily impaired as of December 31, 2011. The decline in the securities portfolio reflects proceeds of the portfolio used to fund growth in loans.
The following table sets forth information about the maturities and weighted yields on investment securities as of December 31, 2011.
The amortized cost and fair value of investments (all available for sale) as of each of the years ended December 31, 2011 and 2010 are shown in the following table:
Restricted investments in bank stocks
Restricted investments in bank stocks represent required investments in the common stock of correspondent banks. As of December 31, 2011 and December 31, 2010 the Company had an investment of $100 thousand in the common stock of Atlantic Central Bankers’ Bank, Camp Hill, Pennsylvania, which is carried at cost. In addition, we are also required to maintain an investment in the stock of the FHLB according to a predetermined formula as set forth in the FHLB’s Capital Plan. This required investment in FHLB stock fluctuates in proportion to our outstanding debt to the FHLB and is also carried at cost. As debt is repaid, stock held in excess of the minimum requirement is periodically adjusted and refunded. The Bank became a member of the FHLB in March 2008. At December 31, 2011, the investment in FHLB stock totaled $433 thousand compared to $690 thousand at December 31, 2010.
Loans
The loan portfolio comprises the largest component of the Company’s earning assets. All of the Company’s loans are to domestic borrowers. Total gross loans at December 31, 2011 increased $10.7 million to $133.4 million from $122.7 million at December 31, 2010. There were no loans classified as held for sale at December 31, 2011 or December 31, 2010. The ratio of loans, net of the allowance for loan losses, to deposits has increased from 88.73% at December 31, 2010 to 93.09% at December 31, 2011 due to faster loan growth than deposit balance growth. The loan portfolio at December 31, 2011 was comprised of commercial loans of $100.1 million, an increase of $16.4 million from December 31, 2010, and consumer loans of $33.3 million, a decrease of $5.7 million from December 31, 2010, before the allowance for loan losses. The Bank has not originated, nor does it intend to originate sub-prime mortgage loans.
The following table sets forth the classification of the loan portfolio for each of the years ended December 31, 2011 and 2010.
Commercial loans are made for the purpose of providing working capital, financing the purchase of equipment or inventory, and for other business purposes. Real estate loans consist of loans secured by commercial or residential real property and loans for the construction of commercial or residential property. Consumer loans are made for the purpose of financing the purchase of consumer goods, home improvements, and other personal needs, and are generally secured by the personal property purchased.
Commercial real estate loans typically involve large loan balances to single borrowers or groups of related borrowers. The payment experience of such loans is typically dependent upon the successful operation of the real estate project. These risks can be significantly affected by supply and demand conditions in the market for office and retail space and for apartments and, as such may be subject, to a greater extent, to adverse conditions in the economy. In dealing with these risk factors, the Company generally limits itself to a real estate market or to borrowers with which management has experience. We generally concentrate on originating commercial real estate loans secured by properties located within our market area. In addition, many of our commercial real estate loans are secured by owner-occupied property with personal guarantees for the debt.
The information in the following tables is based on the contractual maturities of individual loans, including loans that may be subject to renewal at their contractual maturity. Renewal of such loans is subject to review and credit approval, as well as modification of terms upon maturity. Actual repayments of loans may differ from the maturities reflected below because borrowers have the right to prepay obligations with or without prepayment penalties.
The following tables summarize the loan maturity distribution by type and related interest rate characteristics as of December 31, 2011.
Credit Risk and Loan Quality
Our written lending policies require specified underwriting, loan documentation and credit analysis standards to be met prior to funding for the majority of new loan balances. The Loan Committee is comprised of senior members of management who oversee the loan approval process to monitor that proper standards are maintained.
The accrual of interest on loans is discontinued when the contractual payment of principal or interest has become 90 days past due or management has serious doubts about further collectability of principal or interest, even though the loan is currently performing. A loan may remain on accrual status if it is in the process of collection and is either guaranteed or well secured. When a loan is placed on non-accrual status, unpaid interest credited to income in the current year is reversed and unpaid interest accrued in prior years is charged against the allowance for loan losses. Interest received on non-accrual loans is generally either applied against principal or reported as interest income, according to management’s judgment as to the collectability of principal. Generally, loans are restored to accrual status when the obligation is brought current, has performed in accordance with the contractual terms for a reasonable period of time, and the ultimate collectability of the total contractual principal and interest is no longer in doubt. During 2011, interest on non-accruing loans not recognized as interest income totaled $265 thousand compared to $388 thousand during 2010.
The allowance for loan losses increased $390 thousand to $2.1 million at December 31, 2011 from $1.7 million at December 31, 2010. At December 31, 2011 and December 31, 2010, the allowance for loan losses represented 1.56% and 1.38% respectively of total loans. Based upon current economic conditions, the composition of the loan portfolio, the perceived credit risk in the portfolio, the evaluation of non-performing loans and loan-loss experience of comparable institutions in our market area, management feels the allowance is adequate to absorb reasonably anticipated losses.
At December 31, 2011 the company had sixteen non-accrual loans totaling $4.9 million. There were two loans past due greater than 90 days and accruing of $959 thousand combined, and two troubled debt restructurings (“TDR”) loans of $1.1 million still accruing. The Company had three commercial properties with net realizable value of $3.2 million classified as foreclosed assets at December 31, 2011.
The balance of non-accrual loans at December 31, 2011 included two construction loans with an aggregate balance of $1.7 million. These two loans are part of a housing subdivision that have active sales contracts and in which the borrower is now constructing a pre-sold home. The Company expects the construction and sale of this home to be completed by May 2012. The Company remains in control of the disbursements and cash flow of this project.
At December 31, 2011 there were four commercial real estate non-accrual loans totaling $1.9 million. The four properties are moving toward foreclosure. One of the four properties has a contract of sale pending. It is expected that the other three properties will be foreclosed on this year, as these loans have been in the court system a protracted amount of time. $576 thousand of the commercial real estate non-accrual loans have a 90% guarantee from the USDA. Management believes these construction and commercial real estate loans are adequately collateralized by the property values.
The commercial non-accrual loan balance at December 31, 2011 consisted of four loans with a balance of $643 thousand. One of the four loans, with a balance of $131 thousand, has a 90% guarantee from the USDA. A second loan with a balance of $46 thousand is scheduled to be sold in early 2012.
Also at December 31, 2011 there were three home equity loans in non-accrual, with a balance of $310 thousand, and two non-accrual residential first mortgages with balances of $329 thousand combined. The two residential first mortgages are well secured, with one having an LTV of 23% and the other having mortgage insurance.
At December 31, 2011 the Company had two loans classified as TDR’s with combined balances of $1.1 million. They consist of one loan secured by commercial real estate and one secured by residential real estate. The two loans are current as of December 31, 2011. At restructure the principal balance of the commercial mortgage was $463 thousand. Owed interest, late fees and escrow arrears of $19 thousand were added to the then principal balance to make the restructured loan amount $482 thousand. The new structure reduced the borrower’s monthly payment approximately $2 thousand. The first two years are payments of interest only. The current balance is $482 thousand.
The residential loan was modified from a 25 year home equity to a 30 amortizing loan with a 3 year balloon by taking out a first mortgage with another institution of $64 thousand, adding the Bank’s then principal balance of $499 thousand and past due interest and late fees of $12 thousand for a restructured loan total of $575 thousand. The rate was reduced to 2.875% from 5.00%. The new structure moved the Bank into first position and reduced the borrower’s monthly payments allowing them to keep current. This is current with a balance of $572 thousand and with adequate collateral. The TDR loans have adequate impaired loan allowances.
At December 31, 2011 there were impaired loans in the amount of $5.8 million compared to $4.4 million at December 31, 2010. Impaired loans requiring a specific allowance for loan loss were $5.8 million at December 31, 2011 compared to $4.4 million at December 31, 2010. The allowance for loan losses on the impaired loans was $446 thousand and $176 thousand at December 31, 2011 and December 31, 2010, respectively. There were no partial charge-downs on impaired loans during 2011 and $796 thousand in partial charge-downs on impaired loans during 2010.
The following table summarizes loan delinquency and other non-performing assets at the dates indicated.
Potential Problem Loans (“Watch List”)
We maintain a list of performing loans where management has identified conditions which potentially could cause such loans to be downgraded into higher risk categories in future periods. Loans on the watch list are subject to heightened scrutiny and more frequent review by management. The balance of the watch list loans at December 31, 2011 totaled $1.1 million and consists of seven loans, compared to a total of $1.8 million at December 31, 2010. Two of these loans are commercial real estate loans totaling $854 thousand. Two of the seven loans are consumer loans totaling $205 thousand and the remaining three loans are commercial industrial loans totaling $47 thousand. Watch list loans identified represent a higher degree of risk of collectability. We continue to monitor all loans identified as “watch” to ensure timely payments and early detection of further potential problems.
Allowance for loan losses
The allowance for loan losses represents an amount that management believes will be adequate to absorb estimated probable credit losses on existing loans. The allowance for loan losses is established through provisions for loan losses charged against income. Loans deemed to be uncollectible are charged against the allowance for loan losses, and subsequent recoveries, if any, are credited to the allowance. The allowance for loan losses is maintained at a level considered adequate to provide for losses that can be reasonably anticipated. Management’s periodic evaluation of the adequacy of the allowance is based on known and inherent risks in the portfolio, adverse situations that may affect the borrower’s ability to repay, the estimated value of any underlying collateral, composition of the loan portfolio, current economic conditions and other relevant factors. This evaluation is inherently subjective as it requires material estimates that may be susceptible to significant revisions as more information becomes available.
The allowance consists of specific, general, and unallocated components. The specific component relates to loans that are classified as either 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 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. An 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 and 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 the 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 by either the present value of expected future cash flows discounted at the loan’s effective interest rate or the fair value of the collateral if the loan is collateral dependent.
As of December 31, 2011, the allowance for loan losses totaled $2.1 million, compared to $1.7 million at December 31, 2010. Based on the information available as of December 31, 2011, management believes that the allowance for loan losses is adequate.
The following table sets forth a summary of the changes in the allowance for loan losses for the periods indicated:
The following table sets forth the allocation of the allowance for loan losses by loan category as of December 31 at each of the periods presented. The specific allocations in any particular category may be reallocated in the future to reflect then current conditions. Accordingly, management considers the entire allowance to be available to absorb losses in any category.
Loan Concentrations
As of December 31, and 2011, there were no concentrations of loans exceeding 10% of total loans. Our loans consist primarily of credits to business and individual borrowers located in northern New Jersey.
Premises and Equipment
Premises and equipment, net of accumulated depreciation, increased $292 thousand from December 31, 2010 to December 31, 2011. This increase is primarily due to the addition of premises and equipment relating to our new Totowa branch location.
Deposits
Our primary source of funds for loans and investments is deposits. We attract deposits by offering competitive interest rates on all deposit products, and may at times supplement deposits raised in the local market with wholesale and brokered certificates of deposit. At December 31, 2011 we had $2.6 million of brokered deposits, and no brokered deposits at December 31, 2010. Total deposits at December 31, 2011 increased $4.6 million to $141.1million from $136.4 million at December 31, 2010, primarily due to growth in time deposit balances, partially offset by the migration and outflow of savings account balances in search of higher-yielding alternative deposits accounts as rates remain low during 2011. Time deposits increased by $12.0 million and savings deposits decreased by $9.2 million. Money market accounts and demand deposit balances also increased by $1.4 million, and $991 thousand, respectively.
The following table sets forth the average balance of deposits and the average rates paid on deposits for the years ended December 31, 2011 and 2010.
Core deposits, which exclude time deposits of $100,000 or more, provide a relatively stable funding source for our interest-earning assets. Core deposits totaled $114.8 million and $125.6 million as of December 31, 2011, and December 31, 2010, respectively.
The maturity distribution of time deposits of $100,000 or more as of December 31, 2011, is as follows:
Short-Term Borrowed Funds
Short-term borrowings generally consist of federal funds purchased, securities sold under repurchase agreements and other secured borrowings from correspondent banks.
The following table outlines various sources of borrowed funds at or for each of the years ended December 31, 2011 and 2010. The maximum balance represents the highest indebtedness for each category of short-term borrowed funds at any month ended during each of the periods shown.
As of December 31, 2011 and 2010, we had a borrowing facility with a correspondent bank totaling $5 million, of which $2.5 million is available on an unsecured basis. The remaining $2.5 million is a secured line of credit with security provided by a pledge of securities held in safekeeping.
Long-Term Debt
Long-term debt at December 31, 2011 consisted of FHLB advances totaling $5.0 million with a weighted average interest rate of 2.61% and a weighted average life of 14 months, as compared to FHLB advances totaling $5.0 million with a weighted average interest rate of 2.61% and a weighted average life of 26 months at December 31, 2010. The Bank became a member of FHLB in March 2008. The advances are collateralized by restricted investments in FHLB bank stock, U.S Government sponsored agency securities, and mortgage backed securities.
Capital Resources and Adequacy
Total stockholders’ equity was $18.5 million as of December 31, 2011, representing a net increase of $2.4 million from December 31, 2010. The increase in capital was a result of net income of $1.5 million and a net increase in preferred stock balance of $1.2 million as a result of the Company’s participation in the U.S. Treasury’s SBLF program, partially offset by preferred stock dividends of $239 thousand.
The Bank exceeds the minimum capital requirements established by regulatory agencies. Under the capital adequacy guidelines, capital is classified into two tiers. These guidelines require an institution to maintain a certain level of Tier 1 and Tier 2 capital to risk-weighted assets. Tier 1 capital consists of preferred stock and common shareholders’ equity, excluding the unrealized gain or loss on securities available for sale, minus certain intangible assets. Tier 2 capital also consists of certain hybrid instruments, the allowance for loan losses subject to certain limitations and qualifying subordinated debt. In determining the amount of risk-weighted assets, all assets, including certain off-balance sheet assets, are multiplied by a risk-weight factor of 0% to 100% based on the risks believed inherent in the type of asset.
Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets and of Tier 1 capital to average assets which is known as the Tier 1 leverage ratio.
Under the capital guidelines, the Bank must maintain a minimum total risk-based capital of 8%, with at least 4% being Tier 1 capital. In addition, the Bank must maintain a minimum Tier 1 leverage ratio of at least 4%. To be considered “well-capitalized,” the Bank must maintain total risk-based capital of at least 10%, Tier 1 risk based capital of at least 6%, and a leverage ratio of at least 5%.
The following table provides a comparison of the Bank’s risk based capital ratios and leverage ratios :
At December 31, 2011 and December 31, 2010, the Bank exceeded the minimum regulatory capital requirements necessary to be considered a “well capitalized” financial institution under applicable federal banking regulations.
The Federal Reserve, as the regulator of the Company, maintains similar requirements for all bank holding companies with consolidated assets in excess of $500 million, and for those bank holding companies directly engaged in certain activities. As we do not meet either of these criteria, we are not currently subject to these requirements.
Return on Average Equity and Assets
The following table shows the return on average assets (net income divided by total average assets), return on equity (net income divided by average equity), and the equity to assets ratio (average equity divided by total average assets) for each of the years ended December 31, 2011 and 2010.
Effect of Inflation and Changing Prices
The effect of relative purchasing power over time due to inflation has not been taken into effect in the Company’s consolidated financial statements. Rather, the statements have been prepared on a historical cost basis in accordance with accounting principles generally accepted in the United States of America.
Unlike most industrial companies, the assets and liabilities of financial institutions, such as the Company, are primarily monetary in nature. Therefore, the effect of changes in interest rates will have a more significant impact on its performance than will the effect of changing prices and inflation in general. In addition, interest rates may generally increase as the rate of inflation increases, although not necessarily in the same magnitude. The Company seeks to manage the relationships between interest-sensitive assets and liabilities in order to protect against wide rate fluctuations, including those resulting from inflation.
Liquidity
Liquidity represents the ability to meet the cash demands for funding of loans and to meet depositors’ requirements for use of their funds. Sources of liquidity are cash balances, due from banks, and federal funds sold. Cash and cash equivalents were $2.7 million at December 31, 2011, compared to $1.4 million at December 31, 2010.
The objective of liquidity management is to assure that sufficient sources of funds are available as needed and at a reasonable cost to meet ongoing and unexpected operational cash needs and commitments and to take advantage of income producing opportunities as they arise. Sufficient liquidity must be available to meet the cash requirements of depositors wanting to withdraw funds and of borrowers wanting their credit needs met. Additionally, liquidity is needed to insure the ability to act at those times when profitable new lending and/or investment opportunities arise. While the desired level of liquidity may vary depending upon a variety of factors, it is a primary goal to maintain strong liquidity in all economic environments through active balance sheet management.
Liquidity management is the ongoing process of monitoring and managing sources and uses of funds. The primary sources of funds are deposits, scheduled amortization of loan principal, maturities of investment securities and funds provided by operations. While scheduled loan payments and investment maturities are relatively predictable sources of funds, deposit flows and loan prepayments are far less predictable and are influenced by general interest rates, economic conditions and competition. Management measures and monitors our liquidity position on a frequent basis in order to better understand, predict and respond to balance sheet trends. The liquidity analysis encompasses a review of anticipated changes in loan balances, investments securities, core deposits and borrowed funds over a three month, six month and one year period.
As of December 31, 2011, FHLB advances outstanding were $5.0 million compared to $11.0 million at December 31, 2010.
As of December 31, 2011 and 2010, liquid assets, consisting of cash and due from banks, interest-bearing deposits of other banks, Federal funds sold and investment securities available for sale, totaled $18.0 million, and $18.9 million, respectively, representing 10.8% and 11.5 % of total assets, respectively.
Additional liquidity sources include principal and interest payments from the investment security and loan portfolios. Long-term liquidity needs may be met by selling securities available for sale, selling loans or raising additional capital. We maintain certain additional short-term borrowing facilities that can also be accessed for incremental funding. The Bank has a borrowing facility with a correspondent bank as discussed in Note 8 of the audited financial statements included in this filing totaling $5.0 million, with half of the credit available on an unsecured basis. The remaining half is a secured line of credit with security provided by a pledge of Bank investment assets. All secured facilities are available for short-term limited purpose usage. The Bank also has borrowing capacity with the Federal Home Loan Bank of New York in the amount of $7.7 million at December 31, 2011 which is collateralized by restricted investments in FHLB bank stock, U.S. Government sponsored agency securities, and mortgage backed securities. At December 31, 2011, the Bank had $15.3 million of available for sale securities. Securities with carrying values of approximately $8.5 million at December 31, 2011 were pledged as collateral to secure securities sold under agreements to repurchase, public deposits, and for other purposes required or permitted by law.
Contractual Obligations
The Company currently leases the Bank’s main banking office at 310 Route 94 in Vernon, New Jersey and each of its two branch locations at 650 Union Boulevard in Totowa, New Jersey and 351 Sparta Avenue in Sparta, New Jersey. These leases expire in 2016, 2021, and 2014 for each office, respectively.
Off-Balance Sheet Arrangements
The Company’s financial statements do not reflect various off-balance sheet arrangements that are made in the normal course of business, which may involve some liquidity risk. These off-balance sheet arrangements consist mainly of unfunded loans and lines of credit made under the same standards as on-balance sheet instruments. These unused commitments totaled $42.0 million at December 31, 2011. In addition, the Company also has letters of credit outstanding of $336 thousand at December 31, 2011. Because these instruments have fixed maturity dates, and because many of them will expire without being drawn upon, they do not generally present any significant liquidity risk. Management is of the opinion that liquidity is sufficient to meet its anticipated needs.
Interest Rate Sensitivity
The primary objective of asset liability management is to optimize net interest income over time while maintaining a balance sheet mix that is prudent with respect to liquidity, capital adequacy and interest rate risk. Interest rate risk addresses the potential adverse impact of interest rate movements on net interest income.
Market risk is the risk of loss from adverse changes in market prices and rates that principally arise from interest rate risk inherent in the Company’s lending, investing, deposit gathering, and borrowing activities. Other types of market risks, such as foreign currency exchange rate risk and commodity price risk, do not normally arise in the normal course of our business. Management actively monitors and manages interest rate risk exposure.
One tool used to monitor interest rate risk is the measurement of interest sensitivity “gap,” which is the positive or negative dollar difference between interest-earning assets and interest-bearing liabilities that are subject to interest rate repricing within a given period of time. Interest rate sensitivity can be managed by repricing assets or liabilities, selling securities available for sale, or replacing an asset or liability at maturity. Managing the amount of assets and liabilities repricing in this same time interval helps to hedge the risk and minimize the impact on net interest income of rising or falling interest rates. The Bank generally would benefit from increasing market rates of interest when it has an asset-sensitive gap position and generally would benefit from decreasing market rates of interest when it is liability-sensitive.
As of December 31, 2011, the Bank was liability sensitive over a one-year time frame. However, gap analysis is not a precise indicator of the interest sensitivity position. This analysis presents only a static view of the timing of maturities and repricing opportunities, without taking into consideration that changes in interest rates do not affect all assets and liabilities equally. For example, assumptions are made concerning the repricing characteristics of deposit products with no contractual maturities. Net interest income may be impacted by other significant factors in a given interest rate environment, including changes in the volume and mix of interest-earning assets and interest-bearing liabilities.
It is the responsibility of the board of directors and senior management to understand and control the interest rate risk exposures assumed by the Company. The board has delegated authority to the asset liability management committee (“ALCO”) for the development of ALCO policies and for the management of the asset liability management function. The ALCO committee is comprised of members of the Board and senior management and meets quarterly, or more frequently as needed. The ALCO committee has the responsibility for maintaining a level of interest rate risk exposures within board approved limits.
The following table sets forth information regarding interest rate sensitivity as of December 31, 2011, for each of the time intervals indicated. The information in the table may not be indicative of our interest rate sensitivity position at other points in time. In addition, management makes assumptions concerning the repricing characteristics of deposit products with no contractual maturities and the maturity distribution indicated in the table may differ from the contractual maturities of interest-earning assets due to consideration of prepayment speeds under various interest rate change scenarios in the application of interest rate sensitivity methods described above.
Based upon the interest rate gap shown in the table above, the Bank’s interest rate sensitivity is within Board approved guidelines.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk.
Not Applicable
Item 8.
Item 8. Financial Statements and Supplementary Data.
Reference is made to page for a list of financial statements and supplementary data required to be filed pursuant to this Item 8. The information required by the Item 8 is provided beginning on page hereof.
Item 9.
Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure.
Not Applicable
Item 9A.
Item 9A. Controls and Procedures.
(a) The Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Chief Executive Officer and principal financial officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures pursuant to Exchange Act Rule 13a-15. Based upon that evaluation, the Chief Executive Officer and principal financial officer concluded that, as of the end of the period covered by this report, the Company’s disclosure controls and procedures are effective in timely alerting them to material information relating to the Company (including its consolidated subsidiaries) required to be included in the Company’s periodic SEC filings.
(b) Management’s report on internal control over financial reporting
The management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s system of internal control over financial reporting was designed by or under the supervision of the Company’s chief executive officer and chief financial officer to provide reasonable assurance regarding the reliability of the preparation of the Company’s financial statements for external and regulatory reporting purposes, in accordance with U.S. generally accepted accounting principles. The Company’s management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2011, based on the criteria established in Internal Control-Integrated Framework issued by the COSO. Based on the assessment, management determined that, as of December 31, 2011, the Company’s internal control over financial reporting is effective. This 10-K report does not include an attestation report of the Company’s registered public accounting firm regarding internal control over financial due to exemption provided under SEC regulations.
The forgoing shall not deemed to be “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, or otherwise subject to the liabilities of that Section. In addition, this information shall not be deemed to be incorporated by reference into any of the Registrant’s filings with the Securities and Exchange Commission, except as shall be expressly set forth by specific reference in any such filing.
/s/ George E. Irwin
/s/ Eileen D. Piersa
George E. Irwin
Eileen D. Piersa
President and Chief Executive Officer
Senior Vice President and Chief Financial Officer
(c) Changes in internal controls:
There were not any significant changes in internal controls or in other factors that could significantly affect these controls subsequent to the date of their evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
Item 9B.
Item 9B. Other Information.
Not Applicable.
PART III
Item 10.
Item 10. Directors, Executive Officers and Corporate Governance.
Other than as set forth below, the information required by this Item is incorporated by reference from the Company’s Proxy Statement for the its 2012 Annual Meeting of Shareholders under the caption “Election of Directors,” and the information under the captions, “Compliance with Section 16(a) of the Securities Exchange Act of 1934,” and, "Governance of the Company,". It is expected that such Proxy Statement will be filed with the SEC no later than April 30, 2012.
The following table sets forth the names, ages, principal occupations, and business experience for all non-director executive officers of the Company. Unless otherwise indicated, principal occupations shown for each Director have extended for five or more years.
Term of
Office (1)
Name
Age
Positions During the Last 5 Years
Commenced
Eileen D. Piersa
Senior Vice President and Chief Financial Officer, and Treasurer
of the Bank (2005 - present). Senior Vice President, and
Chief Financial Officer, and Treasurer of the Bancorp
since its inception (2010 - present)
Patrick W. Smith
Executive Vice President and Senior Loan Officer of the Bank
since August 2008
(1) Under New Jersey law, executive officers serve at the pleasure of the Board of Directors, without a fixed term.
There are no family relationships between any director, or executive officer.
Section 16(a) Beneficial Ownership Reporting Compliance
The information required by this Item is incorporated by reference to the Company’s Proxy Statement for the its 2011
Annual Meeting of Shareholders under the caption “Compliance With Section 16(a) of the Securities Exchange Act of 1934”. It is expected that such Proxy Statement will be filed with the Securities Exchange Commission (“SEC”) no later than April 30, 2012.
Item 11.
Item 11. Executive Compensation.
The information required by this Item is incorporated by reference to the Company’s Proxy Statement for the its 2012 Annual Meeting of Shareholders under the caption “Executive Compensation”. It is expected that such Proxy Statement will be filed with the SEC no later than April 30, 2012.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.
The information required by this Item is incorporated by reference to the Company’s Proxy Statement for the its 2012 Annual Meeting of Shareholders under the caption “Security Ownership of Management”. It is expected that such Proxy Statement will be filed with the SEC no later than April 30, 2012.
Item 13.
Item 13. Certain Relationships and Related Transactions, and Director Independence.
The information required by this Item is incorporated by reference to the Company’s Proxy Statement for the its 2012 Annual Meeting of Shareholders under the caption “Interest of Management and Others in Certain Transactions; Review, Approval or Ratification of Transactions with Related Persons”. It is expected that such Proxy Statement will be filed with the SEC no later than April 30, 2012.
Item 14.
Item 14. Principal Accounting Fees and Services.
The information concerning principal accountant fees and services as well as related pre-approval policies under the caption “Principal Accounting Firm Fees” in the Proxy Statement for the Company’s 2012 Annual Meeting of Shareholders is incorporated by reference herein. It is expected that such Proxy Statement will be filed with the SEC no later than April 30, 2012.
PART IV
Item 15.
Item 15. Exhibits, Financial Statement Schedules.
(a)
Exhibits
3(i)
Articles of Incorporation (1)
3(ii)
By-laws (1)
4.1
Certificate of Amendment Designating the Senior Non-Cumulative Perpetual Preferred Stock, Series C, as filed with the Division of Revenue of the State of New Jersey on September 19, 2011.(2)
4.2
Certificate of Amendment to the Certificate of Amendment Designating the Senior Non-Cumulative Perpetual Preferred Stock, Series C, as filed with the Division of Revenue of the State of New Jersey on September 22, 2011.(2)
4.3 Form of Stock Certificate for Fixed Senior Non-Cumulative Perpetual Preferred Stock, Series C. (2)
10.1
The Highlands State Bank 2006 Nonstatutory Stock Option Plan dated March 9, 2006 (1)
10.2
The Highlands State Bank 2006 Incentive Stock Option Plan dated March 9, 2006 (1)
10.3
The Highlands State Bank 2006 Nonemployee Director’s Stock Option Plan dated March 9, 2006 (1)
10.4
Employment Agreement dated January 20, 2006 by and between the Bank and George E. Irwin, as amended by the Employment Agreement Amendment dated December 20, 2011 (1)(3)
10.5
Securities Purchase Agreement, dated September 22, 2011, between the Company and the Secretary of the Treasury, with respect to the issuance and sale of the Series C Preferred Stock. (2)
Subsidiary of the Registrant
Rule 13a-14(a)/15d-14(a) Certifications:
Exhibit 31.1 - Certification of George E. Irwin pursuant to SEC Rule 13a-14(a)
Exhibit 31.2 - Certification of Eileen D. Piersa pursuant to SEC Rule 13a-14(a)
Section 1350 Certifications :
Exhibit 32.1 - Certification of George E. Irwin Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
Exhibit 32.2 - Certification of Eileen D. Piersa pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
(1)
-
Incorporated by reference from the Registrants filing on Form 8-K12G3 filed with the SEC on September 7, 2010
(2)
-
Incorporated by reference to Exhibits 3.1, 3.2, 4.1 and 10.1 to the Registrant’s Current Report on Form 8-K filed with the SEC on September 26, 2011
(3)
-
Incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K filed with the SEC on December 22, 2011
The following Exhibits are being furnished* as part of this report:
No.
Description
101.INS
XBRL Instance Document.*
101.SCH
XBRL Taxonomy Extension Schema Document.*
101.CAL
XBRL Taxonomy Extension Calculation Linkbase Document.*
101.LAB
XBRL Taxonomy Extension Label Linkbase Document.*
101.PRE
XBRL Taxonomy Extension Presentation Linkbase Document.*
101.DEF
XBRL Taxonomy Extension Definitions Linkbase Document.*
* These interactive data files are being furnished as part of this Annual Report, and, in accordance with Rule 402 of Regulation S-T, shall not be deemed filed for purposes of Section 11 or 12 of the Securities Act of 1933, as amended, or Section 18 of the Securities Exchange Act of 1934, as amended, or otherwise subject to liability under those sections.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized in Vernon, State of New Jersey, on March 28, 2012.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated below on March 28, 2012.
Highlands Bancorp, Inc.
Consolidated Financial Statements
December 31, 2011 and 2010
Page
Report of Independent Registered Public Accounting Firm
Financial Statements
Consolidated Balance Sheets
Consolidated Statements of Income
Consolidated Statements of Stockholders' Equity
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Stockholders
Highlands Bancorp, Inc.
Vernon, New Jersey
We have audited the accompanying consolidated balance sheets of Highlands Bancorp, Inc. and subsidiary (the “Company”) as of December 31, 2011 and 2010, and the related consolidated statements of income, stockholders’ equity and cash flows for the years then ended. The Company’s management is responsible for these financial statements. Our responsibility is to express an opinion on these financial statements 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. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes 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, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Highlands Bancorp, Inc. and subsidiary as of December 31, 2011 and 2010, and the results of its operations and its cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States of America.
/s/ ParenteBeard LLC
Allentown, Pennsylvania
March 28, 2012
Highlands Bancorp, Inc.
Consolidated Balance Sheets
December 31, 2011 and 2010
Highlands Bancorp, Inc.
Consolidated Statements of Income
Years Ended December 31, 2011 and 2010
Highlands Bancorp, Inc.
Consolidated Statements of Stockholders’ Equity
Years Ended December 31, 2011 and 2010
(In Thousands)
Highlands Bancorp, Inc.
Consolidated Statements of Cash Flows
Years Ended December 31, 2011 and 2010
Highlands Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2011 and 2010
Note 1 - Summary of Significant Accounting Policies
Organization and Nature of Operations
The consolidated financial statements include the accounts of Highlands Bancorp, Inc. (the “Company”) and its wholly-owned subsidiary, Highlands State Bank (the “Bank” or “Highlands”) and the Bank’s wholly-owned subsidiaries, HSB Mountain Lakes, LLC and HSB Chapel LLC. All significant intercompany accounts and transactions have been eliminated in the consolidated financial statements.
On April 30, 2010 the stockholders of the Bank approved the formation of a bank holding company, Highlands Bancorp, Inc., under a Plan of Acquisition (the "Plan") whereby each outstanding share of the Bank’s common stock, $5 par value per share, was transferred and contributed to the holding company in exchange for one share of the holding company’s common stock, no par value per share. This exchange of shares was completed on August 31, 2010. The transaction was accounted for in a manner similar to the pooling-of-interests method of accounting. Accordingly, the financial information relating to periods prior to August 31, 2010 are reported under the name of Highlands Bancorp, Inc.
The only activity of Highlands Bancorp, Inc. is the ownership of Highlands State Bank. The Company is subject to the supervision and regulation of the Board of Governors of the Federal Reserve System (the “FRB”) and New Jersey Department of Banking and Insurance (“NJDOBI”). The Bank is subject to supervision and regulation by the NJDOBI and the Federal Deposit Insurance Corporation (“FDIC”).
Highlands State Bank (the “Bank” or “Highlands”) is a New Jersey state chartered bank which commenced operations on October 31, 2005. The Bank is a full service bank providing personal and business lending and deposit services. The area served by the Bank includes Sussex and Passaic Counties of New Jersey. HSB Mountain Lakes, LLC, and HSB Chapel LLC were formed in 2010 and 2011, respectively, to hold certain real estate properties acquired in settlement of loans.
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. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses, determination of other than temporary impairment of securities, the valuation of foreclosed assets and the valuation of deferred tax assets.
Significant Group Concentrations of Credit Risk
Most of the Company’s activities are with customers located within northern New Jersey. Note 2 discusses the types of securities that the Company invests in. Note 3 discusses the types of lending that the Company engages in. Although the Company has a diversified loan portfolio, its debtors’ ability to honor their contracts is influenced by the region’s economy. The Company does not have any significant concentrations to any one industry or customer.
Highlands Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2011 and 2010
Note 1 - Summary of Significant Accounting Policies (Continued)
Presentation of Cash Flows
For purposes of reporting cash flows, cash and cash equivalents include cash on hand, amounts due from banks, federal funds sold and short-term interest-bearing deposits in other banks all with original maturities within ninety days. Generally, federal funds are purchased or sold for one day periods.
Time Deposits in Other Banks
Interest- bearing time deposits in other banks mature within one year and are carried at cost. All time deposits are covered by FDIC insurance.
Securities
Securities classified as available for sale are those securities that the Company intends to hold for an indefinite period of time but not necessarily to maturity. Securities available for sale are carried at fair value. Any decision to sell a security classified as available for sale would be based on various factors, including significant movement in interest rates, changes in maturity mix of the Company’s assets and liabilities, liquidity needs, regulatory capital considerations and other similar factors. Unrealized gains and losses are reported as increases or decreases in other comprehensive income (loss). Realized gains or losses, determined on the basis of the cost of the specific securities sold, are included in earnings. Premiums and discounts are recognized in interest income using the interest method over the terms of the securities.
Securities classified as held to maturity are those debt securities the Company has both the intent and ability to hold to maturity regardless of changes in market conditions, liquidity needs or changes in general economic conditions. These securities are carried at cost, adjusted for the amortization of premium and accretion of discount, computed by the interest method over the terms of the securities. At December 31, 2011 and 2010, the Company held no securities classified as held to maturity.
Other-than-temporary impairment losses accounting guidance specifies that (a) if a company does not have the intent to sell a debt security prior to recovery and (b) it is more likely than not to it will not have to sell the debt security prior to recovery, the security would not be considered other-than-temporarily impaired unless there is a credit loss. When an entity does not intend to sell the security, and it is more likely than not, the entity will not have to sell the security before recovery of its cost basis, it will recognize the credit component of an other-than-temporary impairment of a debt security in earnings and the remaining portion in other comprehensive income.
The Company did not recognize any other-than-temporary impairment losses in the years ended December 31, 2011 or 2010.
Highlands Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2011 and 2010
Note 1 - Summary of Significant Accounting Policies (Continued)
Restricted Investment in Bank Stock
Restricted stock is comprised of stock of the Federal Home Loan Bank of New York (FHLB) in the amount of $433,300 and Atlantic Central Bankers Bank in the amount of $100,000. Federal law requires a member institution of the FHLB to hold stock according to a predetermined formula. All restricted stock is recorded at cost. The FHLB has notified member banks that it is reducing dividend rates and taking steps to improve liquidity. Management has evaluated the restricted stock for impairment and believes no impairment charge was necessary at December 31, 2011. The determination of whether a decline affects the ultimate recovery of their cost is influenced by criteria such as (1) the significance of the decline in net assets of the FHLB as compared to the capital stock amount for FHLB and the length of time this situation has persisted, (2) commitment by the FHLB to make payments required by law or regulation and the level of such payments in relation to the operating performance of the FHLB, and (3) the impact of legislative and regulatory changes on institutions and accordingly, on the customer base of the FHLB.
Loans Receivable
Loans receivable that management has the intent and ability to hold for the foreseeable future or until maturity or payoff are stated at their outstanding unpaid principal balances, net of an allowance for loan losses and any deferred fees or costs. Interest income is accrued on the unpaid principal balance. Loan origination fees, net of certain direct origination costs, are deferred and recognized as an adjustment of the yield (interest income) of the related loans. The Company is amortizing these amounts over the contractual life of the loan. Premiums and discounts on purchased loans are amortized as adjustments to interest income using the effective yield method.
The loans receivable portfolio is segmented into commercial and consumer loans. Commercial loans consist of the following classes: commercial real estate, commercial construction, and commercial. Consumer loans consist of the following classes: residential real estate loans, home equity loans and other consumer loans.
For all classes of loans receivable, the accrual of interest is discontinued when the contractual payment of principal or interest has become 90 days past due or management has serious doubts about further collectability of principal or interest, even though the loan is currently performing. A loan may remain on accrual status if it is in the process of collection and is either guaranteed or well secured. When a loan is placed on nonaccrual status, unpaid interest credited to income in the current year is reversed and unpaid interest accrued in prior years is charged against the allowance for loan losses. Interest received on nonaccrual loans, including impaired loans generally is either applied against principal or reported as interest income, according to management’s judgment as to the collectability of principal. Generally, loans are restored to accrual status when the obligation is brought current, has performed in accordance with the contractual terms for a reasonable period of time (generally six months) and the ultimate collectability of the total contractual principal and interest is no longer in doubt. The past due status of all classes of loans receivable is determined based on contractual due dates for loan payments.
Allowance for Loan Losses
The allowance for loan losses represents management’s estimate of losses inherent in the loan portfolio as of the balance sheet date and is recorded as a reduction to loans. The allowance for loan losses is increased by the provision for loan losses, and decreased by charge-offs, net of recoveries. Loans deemed to be uncollectible are charged against the allowance for loan losses, and subsequent recoveries, if any, are credited to the allowance. All, or part, of the principal balance of loans receivable are charged off to the allowance as soon as it is determined that the repayment of all, or part, of the principal balance is highly unlikely. Because all identified losses are immediately charged off, no portion of the allowance for loan losses is restricted to any individual loan or groups of loans, and the entire allowance is available to absorb any and all loan losses.
Highlands Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2011 and 2010
Note 1 - Summary of Significant Accounting Policies (Continued)
The allowance for loan losses is maintained at a level considered adequate to provide for losses that can be reasonably anticipated. Management performs a periodic evaluation of the adequacy of the allowance. The allowance is based on the Company’s past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower’s ability to repay, the estimated value of any underlying collateral, composition of the loan portfolio, current economic conditions and other relevant factors. This evaluation is inherently subjective as it requires material estimates that may be susceptible to significant 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 impaired. For loans that are classified as impaired, an allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan. The general component covers pools of loans by loan class including commercial loans not considered impaired, as well as smaller balance homogeneous loans, such as residential real estate, home equity and other consumer loans. These pools of loans are evaluated for loss exposure based upon historical loss rates for each of these categories of loans, adjusted for qualitative factors. These qualitative risk factors include:
1.
Lending policies and procedures, including underwriting standards and collection, charge-off, and recovery practices.
2.
National, regional, and local economic and business conditions as well as the condition of various market segments, including the value of underlying collateral for collateral dependent loans.
3.
Nature and volume of the portfolio and terms of loans.
4.
Experience, ability, and depth of lending management and staff.
5.
Volume and severity of past due, classified and nonaccrual loans as well as and other loan modifications.
6.
Quality of the Company’s loan review system, and the degree of oversight by the Company’s Board of Directors.
7.
Existence and effect of any concentrations of credit and changes in the level of such concentrations.
8.
Effect of external factors, such as competition and legal and regulatory requirements.
Highlands Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2011 and 2010
Note 1 - Summary of Significant Accounting Policies (Continued)
An 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.
The Company engages in a variety of lending activities, including commercial, construction, residential real estate and consumer/installment transactions. The Company focuses its lending activities on individuals, professionals and small- to medium sized businesses.
Commercial real estate loans include long-term loans financing commercial properties, either owner occupied or investment properties. Repayment is dependent upon either the ongoing business cash flow of the borrowing entity, resale of the property, or leases in the case of an investment property. Bank policy requires commercial real estate loans to have a loan to value ratio of 75% or less. Loan amortizations vary typically and do not exceed 25 years. These amortizing loans have a five year interest rate reset provision and in addition many have a 10 year balloon payment or call option.
Commercial construction loans terms are one year to eighteen months and have a floating rate tied to the Wall Street Journal prime rate. The Company requires a loan-to-value of not less than 75% before, during, and after the construction. At this time the Company does not finance any speculative commercial construction projects and only considers construction projects that are pre-leased or owner occupied, with cash flow meeting Company policy.
Commercial loans are also made to entrepreneurs, proprietors, professionals, partnerships, LLPs, LLCs and corporations. The assets financed are used within the business for its ongoing operation. Repayment of these kinds of loans generally comes from the cash flow of the business or the ongoing conversions of assets, such as accounts receivable and inventory, to cash. Commercial term loans may have maturities up to 10 years and generally have fixed interest rates for up to five years. Commercial lines of credit are renewed annually and generally carry variable interest rates. Typical collateral for commercial loans include the borrower’s accounts receivable, inventory and machinery and equipment.
Residential mortgages are secured by the borrower’s residential real estate in a first lien position. These loans have varying loan rates depending on the financial condition of the borrower and the loan to value ratio. Residential mortgages have terms up to ten years with amortizations varying from 20 to 30 years. The Company also offers home equity lines of credit and home equity loans. Risks associated with loans secured by residential properties are generally lower than commercial loans and include general economic risks, such as the strength of the job market, employment stability and the strength of the housing market. Since most loans are secured by a primary or secondary residence, the borrower’s continued employment is the greatest risk to repayment.
The Company offers a variety of loans to individuals for personal and household purposes. Consumer loans, including home equity loans, are generally considered to have greater risk than first or second mortgages on real estate because they may be unsecured, or, if they are secured, the value of the collateral may be difficult to assess and more likely to decrease in value that real estate.
Highlands Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2011 and 2010
Note 1 - Summary of Significant Accounting Policies (Continued)
A loan is considered impaired when, based on current information and events, it is probable that the Company 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 the 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 by either the present value of expected future cash flows discounted at the loan’s effective interest rate or the fair value of the collateral if the loan is collateral dependent.
An allowance for loan losses is established for an impaired loan if its carrying value exceeds its estimated fair value. The estimated fair values of substantially all of the Company’s impaired loans are measured based on the estimated fair value of the loan’s collateral.
For commercial loans secured by real estate, estimated fair values are determined primarily through third-party appraisals. When a real estate secured loan becomes impaired, a decision is made regarding whether an updated certified appraisal of the real estate is necessary. This decision is based on various considerations, including the age of the most recent appraisal, the loan-to-value ratio based on the original appraisal and the condition of the property. Appraised values are discounted to arrive at the estimated selling price of the collateral, which is considered to be the estimated fair value. The discounts also include estimated costs to sell the property.
For commercial loans secured by non-real estate collateral, such as accounts receivable, inventory and equipment, estimated fair values are determined based on the borrower’s financial statements, inventory reports, accounts receivable agings or equipment appraisals or invoices. Indications of value from these sources are generally discounted based on the age of the financial information or the quality of the assets.
Loans whose terms are modified are classified as troubled debt restructurings if the Company grants such borrowers concessions and it is deemed that those borrowers are experiencing financial difficulty. Concessions granted under a troubled debt restructuring generally involve a temporary reduction in interest rate or an extension of a loan’s stated maturity date. Non-accrual troubled debt restructurings are restored to accrual status if principal and interest payments, under the modified terms, are current for six consecutive months after modification. Loans classified as troubled debt restructurings are designated as impaired.
The allowance calculation methodology includes further segregation of loan classes into risk rating categories. The borrower’s overall financial condition, repayment sources, guarantors and value of collateral, if appropriate, are evaluated annually for commercial loans or when credit deficiencies arise, such as delinquent loan payments, for commercial and consumer loans. Credit quality risk ratings include regulatory classifications of special mention, substandard, doubtful and loss. Loans classified as special mention have potential weaknesses that deserve management’s close attention. If uncorrected, the potential weaknesses may result in deterioration of the repayment prospects. Loans classified substandard have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They include loans that are inadequately protected by the current sound net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans classified doubtful have all the weaknesses inherent in loans classified substandard with the added characteristic that collection or liquidation in full, on the basis of current conditions and facts, is highly improbable. Loans classified as a loss are considered uncollectible and are charged to the allowance for loan losses. Loan not classified are rated pass.
Highlands Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2011 and 2010
Note 1 - Summary of Significant Accounting Policies (Continued)
In addition, Federal regulatory agencies, as an integral part of their examination process, periodically review the Company’s allowance for loan losses and may require the Company to recognize additions to the allowance based on their judgments about information available to them at the time of their examination, which may not be currently available to management. Based on management’s comprehensive analysis of the loan portfolio, management believes the current level of the allowance for loan losses is adequate.
Foreclosed Assets
Assets acquired through, or in lieu of, loan foreclosure are held for sale and are initially recorded at fair value less cost to sell at the date of foreclosure, establishing a new cost basis. 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. Revenue and expenses from operations and changes in the valuation allowance and direct write-downs are included in other expenses. Gain and losses on sales of foreclosed assets are included in other income.
Transfers of Financial Assets
Transfers of financial assets, including loan and loan participation sales, are accounted for as sales when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the Company, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and (3) the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity.
Premises and Equipment
Premises and equipment are stated at cost less accumulated depreciation. Depreciation is computed on the straight-line method over the estimated useful lives of the related assets.
Goodwill
Goodwill was recognized in connection with the acquisition of Noble Community Bank in December 2008. Goodwill represents the purchase price over the fair value of net assets acquired. In accordance with current accounting standards, goodwill is not amortized, but evaluated at least annually for impairment or more often if events and circumstances indicated that there may be impairment. Any impairment of goodwill results in a charge to income. Goodwill was tested for impairment as of December 31, 2011 and there was no impairment.
Advertising Costs
The Company follows the policy of charging the costs of advertising to expense as incurred.
Highlands Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2011 and 2010
Note 1 - Summary of Significant Accounting Policies (Continued)
Income Taxes
Income tax accounting guidance results in two components of income tax expense, current and deferred. Current income taxes reflect taxes to be paid or refunded for the current period by applying the provisions of the enacted tax law to taxable income or excess of deduction over revenue. Deferred income taxes are provided on the liability method whereby deferred tax assets are recognized for deductible temporary differences and deferred tax liabilities are recognized for taxable temporary differences. Temporary differences are the differences between the reported amounts of assets and liabilities and net operating loss carryforwards and their tax basis. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion of the deferred tax assets will not be realized. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment.
The Company accounts for uncertain tax positions if it is more likely than not, based on the technical merits, that the tax position will be realized or sustained upon examination. The term more likely than not means likelihood of more than 50 percent; the terms examined and upon examination also include resolution of the related appeals or litigation processes, if any. A tax position that meets the more-likely-than-not recognition threshold is initially and subsequently measured as the largest amount of tax benefit that has a greater than 50 percent likelihood of being realized upon settlement with a taxing authority that has full knowledge of all relevant information. The determination of whether or not a tax position has met the more-likely-than-not recognition threshold considers the facts, circumstances, and information available at the reporting date and is subject to management’s judgment. The Company had no uncertain tax positions as of December 31, 2011 and 2010. The Company recognizes interest and penalties on income taxes as a component of income tax expense. The Company is no longer subject to examination by taxing authorities for the years before January 1, 2008.
Share-Based Compensation
The Company has stock option plans for the benefit of its employees and directors. Stock compensation accounting guidance requires that the compensation cost relating to share-based payment transactions be recognized in the financial statements. That cost will be measured based on the grant date fair value of the equity or liability instruments issued. The stock compensation accounting guidance covers a wide range of share-based compensation arrangements including stock options.
The stock compensation accounting guidance requires that compensation cost for all stock awards be calculated and recognized over the employees’ service period, generally defined as the vesting period. For awards with graded-vesting, compensation cost is recognized on a straight-line basis over the requisite service period for the entire award. A Black-Scholes model is used to estimate the fair value of stock options.
Compensation costs for the Company’s stock awards were fully recognized by the end of 2009, therefore there was no share-based compensation expense included in the accompanying statements of income for the years ended December 31, 2011 and 2010, respectively.
Highlands Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2011 and 2010
Note 1 - Summary of Significant Accounting Policies (Continued)
Comprehensive Income
Accounting principles generally require that recognized revenue, expenses, gains and losses be included in net income. Although 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 stockholders equity section of the balance sheet, such items, along with net income, are components of comprehensive income.
The components of other comprehensive income (loss) are as follows for the years ended December 31, 2011 and 2010:
Off-Balance Sheet Financial Instruments
In the ordinary course of business, the Company has entered into off-balance sheet financial instruments consisting of commitments to extend credit and letters of credit. Such financial instruments are recorded in the balance sheet when they are funded.
Segment Reporting
The Company acts as an independent, community, financial services provider, and offers traditional banking and related financial services to individual, business and government customers. The Company offers a full array of commercial and retail financial services, including the taking of time, savings and demand deposits; the making of commercial, consumer and home equity loans; and the provision of other financial services.
Management does not separately allocate expenses, including the cost of funding loan demand, between the commercial and retail operations of the Company. As such, discrete financial information is not available and segment reporting would not be meaningful.
Net Income Per Common Share
Basic income or loss per share represents net income or loss available to common stockholders divided by the weighted-average number of common shares outstanding during the period. Diluted earnings per share reflects additional common shares that would have been outstanding if dilutive potential common shares had been issued, as well as any adjustment to income that would result from the assumed issuance. Potential common shares that may be issued by the Company relate solely to outstanding stock options, and are determined using the treasury stock method. Potential common shares relate solely to the Company’s outstanding stock options and were not dilutive during the years ended December 31, 2011 and 2010.
Highlands Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2011 and 2010
Note 1 - Summary of Significant Accounting Policies (Continued)
Subsequent Events
The Company has evaluated events and transactions occurring subsequent to the balance sheet date of December 31, 2011 through the date these financial statements were available for issuance for items that should potentially be recognized or disclosed in these financial statements.
Recent Accounting Pronouncements
In April 2011, the FASB issued ASU 2011-02, A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring, which updates ASC 310. This updated clarifies which loan modifications constitute troubled debt restructurings. In evaluating whether a restructuring constitutes a troubled debt restructuring, a creditor must separately conclude that both of the following exist: 1) the restructuring constitutes a concession; and 2) the debtor is experiencing financial difficulty. The update clarifies the guidance on a creditor’s evaluation of whether it has granted a concession to note that if a debtor does not otherwise have access to funds at a market rate for debt with similar characteristics as the restructured debt, the restructuring would be considered to be at a below-market rate, which may indicate that the creditor has granted a concession. Additionally, a temporary or permanent increase in the contractual interest rate as a result of a restructuring does not preclude the restructuring from being considered a concession because the new contractual interest rate on the restructured debt could still be below the market interest rate for new debt with similar characteristics. Furthermore, a restructuring that results in a delay in payment that is insignificant is not a concession. The update also clarifies the guidance on a creditor’s evaluation of whether a debtor is experiencing financial difficulty to note that a creditor may conclude that a debtor is experiencing financial difficulties, even though the debtor is not currently in payment default. The amendments in this ASU are effective for the first interim or annual period beginning on or after June 15, 2011. The adoption did not have a significant impact on our financial position or results of operations, as we had already implemented these principles in our evaluations of TDRs during 2011.
In April 2011, the FASB issued ASU 2011-03, Reconsideration of Effective Control for Repurchase Agreements, which updates ASC 860, Transfers and Servicing. The ASU removes from the assessment of effective control the criterion requiring the transferor to have the ability to repurchase or redeem the financial
assets on substantially the agreed terms, even in the event of default by the transferee. Accordingly, upon the adoption of the ASU’s guidance, a transferor in a repurchase transaction is deemed to have effective control if the following three conditions in ASC 860-10-40-24 are met: 1) The financial assets to be repurchased or redeemed are the same or substantially the same as those transferred, 2) The agreement is to repurchase or redeem them before maturity, at a fixed or determinable price, and 3) The agreement is entered into contemporaneously with, or in contemplation of, the transfer. The guidance in the ASU is effective prospectively for transactions or modifications of existing transactions that occur on or after the first interim or annual period beginning on or after December 15, 2011. The adoption of ASU 2011-03 will not have a significant impact on the Company’s financial position or results of operations.
In May 2011, the FASB issued ASU No. 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs. This update amends FASB ASC Topic 820, Fair Value Measurements, to bring U.S. GAAP for fair value measurements in line with International Accounting Standards. The Update clarifies existing guidance for items such as: the application of the highest and best use concept to non-financial assets and liabilities; the application of fair value measurement to financial instruments classified in a reporting entity’s stockholder’s equity; and disclosure requirements regarding quantitative information about unobservable inputs used in the fair value measurements of level 3 assets. The Update also creates an exception to Topic 820 for entities which carry financial instruments within a portfolio or group, under which the entity is now permitted to base the price used for fair valuation upon a price that would be received to sell the net asset position or transfer a net liability position in an orderly transaction. The Update also allows for the application of premiums and discounts in a fair value measurement if the financial instrument is categorized in level 2 or 3 of the fair value hierarchy. Lastly, the ASU contains new disclosure requirements regarding fair value amounts categorized as level 3 in the fair value hierarchy such as: disclosure of the valuation process used; effects of and relationships between unobservable inputs; usage of nonfinancial assets for purposes other than their highest and best use when that is the basis of the disclosed fair value; and categorization by level of items disclosed at fair value, but not measured at fair value for financial statement purposes. For public entities, this Update is effective for interim and annual periods beginning after December 15, 2011. The adoption of ASU 2011-04 will not have a significant impact on the Company’s financial position or results of operations.
Highlands Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2011 and 2010
Note 1 - Summary of Significant Accounting Policies (Continued)
Recent Accounting Pronouncements (Continued)
In June 2011, the FASB issued ASU No. 2011-05, Comprehensive Income (Topic 220): Presentation of Comprehensive Income. The provisions of this update amend FASB ASC Topic 220, Comprehensive Income, to facilitate the continued alignment of U.S. GAAP with International Accounting Standards. The Update prohibits the presentation of the components of comprehensive income in the statement of stockholder’s equity. Reporting entities are allowed to present either: a statement of comprehensive income, which reports both net income and other comprehensive income; or separate statements of net income and other comprehensive income. Under previous GAAP, all 3 presentations were acceptable. Regardless of the presentation selected, the Reporting Entity is required to present all reclassifications between other comprehensive and net income on the face of the new statement or statements. The provisions of this Update are effective for fiscal years and interim periods beginning after December 31, 2011 for public entities. The adoption of ASU No. 2011-05 will not have an impact on the Company’s financial position or results of operations.
In December, 2011, the FASB issued ASU 2011-11, Disclosures about Offsetting Assets and Liabilities, in an effort to improve comparability between U.S. GAAP and IFRS financial statements with regard to the presentation of offsetting assets and liabilities on the statement of financial position arising from financial and derivative instruments, and repurchase agreements. The ASU establishes additional disclosures presenting the gross amounts of recognized assets and liabilities, offsetting amounts, and the net balance reflected in the statement of financial position. Descriptive information regarding the nature and rights of the offset must also be disclosed. The adoption of ASU 2011-11 will not have a significant impact on the Company’s financial position or results of operations.
In December, 2011, the FASB issued ASU 2011-12, Deferral of the Effective Date to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update 2011-05. In response to stakeholder concerns regarding the operational ramifications of the presentation of these reclassifications for current and previous years, the FASB has deferred the implementation date of this provision to allow time for further consideration. The requirement in ASU 2011-05, Presentation of Comprehensive Income, for the presentation of a combined statement of comprehensive income or separate, but consecutive, statements of net income and other comprehensive income is still effective for fiscal years and interim periods beginning after December 15, 2011 for public companies. The adoption of ASU 2011-12 will not have an impact on the Company’s financial position or results of operations.
Highlands Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2011 and 2010
Note 1 - Summary of Significant Accounting Policies (Continued)
Recent Accounting Pronouncements (Continued)
In September, 2011, the FASB issued Accounting Standards Update (ASU) 2011-08, Testing Goodwill for Impairment. The purpose of this ASU is to simplify how entities test goodwill for impairment by adding a new first step to the preexisting goodwill impairment test under ASC Topic 350, Intangibles - Goodwill and other. This amendment gives the entity the option to first assess a variety of qualitative factors such as economic conditions, cash flows, and competition to determine whether it was more likely than not that the fair value of goodwill has fallen below its carrying value. If the entity determines that it is not likely that the fair value has fallen below its carrying value, then the entity will not have to complete the original two-step test under Topic 350. The amendments in this ASU are effective for impairment tests performed for fiscal years beginning after December 15, 2011. Early adoption is permitted. The result of the Company’s testing for goodwill impairment at December 31, 2011 determined that the fair value of its financial statements exceeding book value and therefore no second step analysis is required.
Note 2 - Securities Available for Sale
The amortized cost, gross unrealized gains and losses, and estimated fair value of securities available for sale at December 31, 2011 and 2010 are as follows:
Highlands Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2011 and 2010
Note 2 - Securities Available for Sale (Continued)
The amortized cost and fair value of securities at December 31, 2011 by contractual maturity are shown below. Expected maturities may differ from contractual maturities because the borrowers may have the right to prepay obligations with or without penalties.
The tables below shows the Company’s securities, their gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at December 31, 2011 and 2010:
Highlands Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2011 and 2010
Note 2 - Securities Available for Sale (Continued)
Management evaluates all securities with unrealized losses quarterly to determine whether the loss is other than temporary. At December 31, 2011, the Company had 4 debt securities in an unrealized loss position. The Company does not have the intent to sell these debt securities prior to recovery and it is more likely than not that the Bank will not have to sell these debt securities prior to recovery.
Unrealized losses on 2 securities in the U.S. Government agency securities category and 1 in the U.S. Government sponsored enterprises mortgage-backed securities category are due to interest rate fluctuations. Management therefore concluded that these securities were not other-than-temporarily impaired at December 31, 2011.
Unrealized losses in the other category consist of 1 corporate security issued by a large financial company. The Company evaluated the prospects of the corporate debt issuer in relation to the severity and duration of the impairment and believes it is probable that it will be able to collect all amounts due according to the contractual terms of the security. Management therefore concluded that this security was not other-than-temporarily impaired at December 31, 2011.
Note 3 - Loans Receivable
The composition of loans receivable at December 31, 2011 and 2010 is as follows:
Highlands Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2011 and 2010
Note 3 - Loans Receivable (Continued)
The following is an analysis of the allowance for loan losses for the years ended December 31:
The following table summarizes information in regards to the allowance for loan losses and the recorded investment in loans receivable as of December 31, 2011 and the activity in the allowance for loan losses for the year ended December 31, 2011:
Highlands Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2011 and 2010
Note 3 - Loans Receivable (Continued)
The following table presents the balance in the allowance for loan losses at December 31, 2011 and 2010 disaggregated on the basis of the Company’s impairment method by class of loans receivable along with the balance of loans receivable by class disaggregated on the basis of the Company’s impairment methodology:
Highlands Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2011 and 2010
Note 3 - Loans Receivable (Continued)
The following tables present the classes of the commercial loan portfolio summarized by the aggregate pass rating and the classified ratings of special mention, substandard and doubtful within the Company’s internal risk rating system and the classes of the consumer loan portfolio by credit risk based on payment activity as of December 31, 2011 and 2010:
Highlands Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2011 and 2010
Note 3 - Loans Receivable (Continued)
The following tables summarize information in regards to impaired loans by loan portfolio class as of December 31, 2011 and 2010:
Highlands Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2011 and 2010
Note 3 - Loans Receivable (Continued)
The following table presents nonaccrual loans by classes of the loan portfolio as of December 31, 2011 and 2010:
The performance and credit quality of the loan portfolio is also monitored by analyzing the age of the loans receivable as determined by the length of time a recorded payment is past due. The following table presents the classes of the loan portfolio summarized by the past due status as of December 31, 2011 and 2010:
Highlands Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2011 and 2010
Note 3 - Loans Receivable (Continued)
At December 31, 2011 the company had four loans classified as TDR’s with combined balances of $2.1 million. The following table reflects information regarding the Company’s troubled debt restructurings for the twelve month period ending December 31, 2011, and troubled debt restructuring loans which have subsequently defaulted in the last twelve months:
Note 4 - Financial Instruments with Off-Balance Sheet Risk
The Company is party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and letters of credit. Such commitments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the financial statements.
The Company’s exposure to credit loss from nonperformance by the other party to the financial instruments for commitments to extend credit and letters of credit is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments.
Highlands Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2011 and 2010
Note 4 - Financial Instruments with Off-Balance Sheet Risk (Continued)
The contract or notional amounts of financial instruments where contract amounts represent credit risk at December 31, 2011 and 2010 are as follows:
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. The Company evaluates each customer’s credit worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by management upon extension of credit, is based on management’s credit evaluation. Collateral held varies but may include personal or commercial real estate, accounts receivable, inventory and equipment.
Outstanding letters of credit written are conditional commitments issued to guarantee the performance of a customer to a third party. These standby letters of credit expire within the next twelve months. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending other loan commitments. The Company requires collateral supporting these letters of credit as deemed necessary. Outstanding letters of credit at December 31, 2011 were $336,000, of which $248,000 were secured by collateral. Outstanding letters of credit at December 31, 2010 were $435,000, of which $37,000 were secured by collateral. The current amount of the liability as of December 31, 2011 and 2010 for guarantees under standby letters of credit is not material.
Note 5 - Premises and Equipment
The components of premises and equipment at December 31, 2011 and 2010 are as follows:
Highlands Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2011 and 2010
Note 6 - Deposits
The components of deposits at December 31, 2011 and 2010 are as follows:
At December 31, 2011, the scheduled maturities of time deposits are as follows:
Note 7 - Lease Commitments
The Company leases its banking facilities under operating lease agreements expiring through 2021. The Company is also required to pay a monthly fee for its portion of certain operating expenses, including real estate taxes, insurance, utilities, maintenance and repairs in addition to the base rent. Rent expense for the years ended December 31, 2011 and 2010 totaled $531,000 and $406,000, respectively.
One of the lease agreements is with a related party. In 2005, the Company entered into a ten-year operating lease agreement with this related party for its main banking office. The lease terms are comparable to similarly outfitted office space in the Company’s market. Total rent expense paid to the related party under this lease agreement was $164,000 and $159,000 for the years ended December 31, 2011 and 2010, respectively.
Highlands Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2011 and 2010
Note 7 - Lease Commitments (Continued)
Future minimum lease payments by year and in the aggregate under these lease agreements are as follows:
Note 8 - Borrowings
The Company has a $5,000,000 line of credit with Atlantic Central Bankers Bank (ACBB) for federal funds purchased of which $524,000 and -$0- was outstanding at December 31, 2011 and 2010, respectively. The line of credit expires June 30, 2012. $2,500,000 of the line of credit is unsecured and $2,500,000 of the line of credit is secured by securities held by ACBB in safekeeping.
The Company has $5,000,000 and $11,000,000 in borrowings with the Federal Home Loan Bank of New York (FHLB) with a weighted average interest rate of 2.61% and 1.38% at December 31, 2011 and 2010, respectively.
The FHLB borrowings at December 31, 2011 mature as follows:
A $2,000,000 advance maturing in 2013 contains a convertible option which allows the FHLB at quarterly intervals commencing after each conversion date, to convert the fixed convertible advance into replacement funding for the same or lesser principal based on any advance then offered by the FHLB at their then current market rate. The Company has the option to repay this advance, if converted, without penalty.
The FHLB borrowings are secured under terms of a blanket collateral agreement by a pledge of qualifying collateral.
Highlands Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2011 and 2010
Note 9 - Preferred Stock
In October 2008, the United States Treasury Department (the “Treasury”) announced a voluntary Capital Purchase Program, a part of the Troubled Asset Relief Program (TARP), to encourage U.S. financial institutions to build capital to increase the flow of financing to U.S. businesses and consumers and to support the U.S. economy. Highlands applied to participate in this program prior to December 31, 2008 and received approval in January 2009.
On May 8, 2009, the Bank issued to the Treasury 3,091 shares of Series 2009A Preferred Stock and a warrant to purchase 155 shares of the Bank’s Series 2009B Preferred Stock for an aggregate purchase price of $3,091,000 in cash (“TARP funds”). The warrant was exercised as a cashless exercise on May 8, 2009 and 155 shares of Series 2009B Preferred Stock were issued. Both series of preferred stock qualified as a Tier 1 capital. On December 22, 2009, the Bank consummated a second financing with the Treasury under the Capital Purchase Program for Small Banks pursuant to which the Bank issued to the Treasury an additional 2,359 shares of Series 2009A Preferred Stock for total proceeds of $2,359,000. The Series 2009A Preferred Stock paid non-cumulative dividends of 5% per annum for the first five years and 9% per annum thereafter. Series 2009B Preferred Stock paid non-cumulative dividends of 9% per annum.
Upon consummation of the holding company reorganization on August 31, 2010, the Company assumed all of the Bank’s obligations under the preferred stock, and issued to the Treasury shares of the Company’s preferred stock in exchange for the outstanding shares of Bank preferred stock.
On September 22, 2011, the Company entered into a Securities Purchase Agreement (the “Purchase Agreement”) with the Secretary of the Treasury (the “Treasury”), pursuant to which the Company issued and sold to the Treasury 6,853 shares of its Senior Non-Cumulative Perpetual Preferred Stock, Series C (the “Series C Preferred Stock”), having a liquidation preference of $1,000 per share (the “Liquidation Amount”), for proceeds of $6,853,000. The Purchase Agreement was entered into, and the Series C Preferred Stock was issued, pursuant to the Treasury’s SBLF program, a $30 billion fund established under the Small Business Jobs Act of 2010 that encourages lending to small businesses by providing capital to qualified community banks with assets of less than $10 billion. The proceeds were used to redeem the Series 2009A and 2009B preferred stock previously issued to the U.S. Treasury under the Capital Purchase Program, and to further enhance the Bank’s business lending efforts.
The Series C Preferred Stock qualifies as Tier 1 capital for the Company. Non-cumulative dividends are payable quarterly on the Series C Preferred Stock, beginning January 1, 2012. The dividend rate is calculated as a percentage of the aggregate Liquidation Amount of the outstanding Series C Preferred Stock and is based on changes in the level of “Qualified Small Business Lending” or “QSBL” (as defined in the Purchase Agreement) by the Bank. Based upon the increase in the Bank’s level of QSBL over the baseline level calculated under the terms of the Purchase Agreement, the dividend rate for the initial dividend period, which is from the date of issuance through December 31, 2011, has been set at 1.65%. For the 2nd through 10th calendar quarters, the annual dividend rate may be adjusted to between 1% and 5%, to reflect the amount of change in the Banks’ level of QSBL. For the 11th calendar quarter through 4.5 years after issuance, the dividend rate will be fixed at between 1% and 7% based upon the increase in QSBL as compared to the baseline. After 4.5 years from issuance, the dividend rate will increase to 9%.
Highlands Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2011 and 2010
Note 9 - Preferred Stock (Continued)
The Series C preferred shares are non-voting, other than class voting rights on matters that could adversely affect the shares. The preferred shares are redeemable at any time, with Treasury, Federal Reserve and FDIC approval. Apart from the Series C shares, no other shares of the Company’s preferred stock are currently outstanding.
Note 10 - Federal Income Taxes
The components of income tax expense (benefit) for the years ended December 31, 2011 and 2010 were as follows:
The effective income tax rate for 2011 and 2010 was different than the applicable statutory Federal income tax rate of 34% as follows:
Highlands Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2011 and 2010
Note 10 - Federal Income Taxes (Continued)
The components of the net deferred tax asset (liability) at December 31, 2011 and 2010 are as follows:
The Company has provided a $2,590,000 valuation allowance on the net deferred tax asset due to the uncertainty of the realization of the entire deferred tax asset including net operating loss carryforwards. Due to projections of taxable income in 2012, management believes that it is more likely than not that the Company will realize the benefit of the $400,000 deferred tax asset recorded.
At December 31, 2011, the Company has available unused net operating loss carryforwards available for federal and state income tax purposes of approximately $6,100,000 and $2,800,000, respectively, which start to expire in 2025 for federal purposes and 2012 for state purposes.
Highlands Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2011 and 2010
Note 11 - Transactions with Executive Officers, Directors, and Principal Stockholders
The Bank has had, and may be expected to have in the future, banking transactions in the ordinary course of business with its executive officers, directors, principal stockholders, their immediate families and affiliated companies (commonly referred to as related parties), on the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with others. Deposits of related parties totaled $13,627,000 and $16,343,000 at December 31, 2011 and 2010, respectively. Activity with respect to loans to related parties for the year ended December 31, 2011 is as follows:
(In Thousands)
The Company leases the Bank’s main office from a real estate company controlled and majority owned by three of its directors (see Note 7).
Note 12 - Stock Option Plans
In 2006, the Board of Directors adopted three stock related compensation plans: the Highlands State Bank 2006 Nonstatutory Stock Option Plan, the Highlands State Bank 2006 Incentive Stock Option Plan and the Highlands State Bank 2006 Nonemployee Directors Stock Option Plan (2006 Plans), which were approved by the stockholders at the 2006 annual meeting in April 2006. These plans were adopted by the Company as part of the holding company reorganization.
The 2006 Plans enable the Board of Directors to grant stock options to executives, other key employees and nonemployee directors. The Company has reserved 150,000 shares of common stock for issuance upon the exercise of options granted under the 2006 Plans. Such shares may be issued from authorized but unissued shares or previously issued shares that the Company may hereafter reacquire (treasury stock). The 2006 Plans will terminate ten years from stockholder approval. Options may not be granted with an exercise price that is less than 1) 100% of the fair market value of the Company’s common stock on the date of grant or 2) the par value of the common stock or 3) $10.00 for any option granted before January 1, 2009. Options may not be granted with a term longer than 10 years. Stock options granted under the Incentive Plan are subject to limitations under Section 422 of the Internal Revenue Code. The Incentive Plan also has special terms for individuals that own more than 10% of the Company’s common stock. Vesting, exercisability, and other conditions related to an option will be waived in the event of a “change in control” of the Company, as defined in the 2006 Plans. The number of shares available under the 2006 Plans, the number of shares subject to outstanding options and the exercise price of outstanding options will be adjusted to reflect any stock dividend, stock split, merger, reorganization or other event generally affecting the number of the Company’s outstanding shares. At December 31, 2011, there were 26,000 shares available for grant under the 2006 Plans.
Highlands Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2011 and 2010
Note 12 - Stock Option Plans (Continued)
In 2011, the Board of Directors adopted the Highlands Bancorp, Inc. 2011 Equity Compensation Plan (“2011 Plan”) which was approved by the stockholders at the 2011 annual meeting in May 2011. This Plan authorizes the Company to issue stock options or restricted stock to eligible participants. The Company has reserved 136,000 shares of the Company’s common stock, which may be granted as incentive stock options, non-qualified stock options and restricted stock awards to eligible employees, officers, non-employee directors, advisory board members, and other service providers to the Company under this Plan. The options under this Plan will have a maximum term of ten years, subject to earlier termination of the options as provided by the 2011 Plan. Options granted under the Plan as ISO’s are to be granted at an exercise price of not less than 100% of the fair market value of the Company’s common stock on the date of the grant. However, if the optionee owns stock possessing more than 10% of the total combined voting power of all classes of the Company 's common stock, the purchase price per share of common stock deliverable upon the exercise of each option shall not be less than 110% of the fair market value of the common stock on the date of grant or the par value of the common stock, whichever is greater. All non-qualified options must have an exercise price of at least 100% of fair market value on the date of grant. Fair market value is to be determined by the Board of Directors in good faith.
No options or restricted stock awards may be granted under the Plan more than ten (10) years after adoption by the shareholders, but options or restricted stock awards previously granted may extend beyond that date. Awards under the Plan will be made to eligible Participants at the discretion of the Board of Directors, who may at any time amend, suspend or terminate the Plan. As a result, it is not possible to determine the number or type of awards that may be granted at this time.
No stock options or stock awards have been granted under the 2011 Plan.
The following is a summary of the Company’s stock option activity and related information for its 2006 Plans for the years ended December 31, 2011 and 2010:
Options
Weighted
Average
Exercise
Price
Weighted
Average
Remaining
Contractual
Term
Aggregate
Intrinsic
Value
Highlands Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2011 and 2010
Note 13 - Regulatory Matters
The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet the minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank’s assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. The Bank’s capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk-weightings and other factors.
Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth below) of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets and of Tier 1 capital to average assets. Management believes, as of December 31, 2011, that the Bank meets all capital adequacy requirements to which it is subject.
As of December 31, 2011, the most recent notification from the Federal Deposit Insurance Corporation categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that management believes have changed the Bank’s category.
The Bank’s actual capital amounts and ratios at December 31, 2011 and 2010 are presented below:
The Bank is subject to certain restrictions on the amount of dividends that it may declare due to regulatory considerations. Although the Company is not subject to these same restrictions, unless the Company expands its operations, the operations of the Bank will be the only source of cash dividends for shareholders of the Company. Therefore, as a practical matter, the ability of the Company to pay cash dividends is subject to any restrictions on the Bank’s ability to pay dividends to the Company.
Highlands Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2011 and 2010
Note 14 - Fair Value Measurements and Fair Values of Financial Instruments
Management uses its best judgment in estimating the fair value of the Company’s financial instruments; however, there are inherent weaknesses in any estimation technique. Therefore, for substantially all financial instruments, the fair value estimates herein are not necessarily indicative of the amounts the Company could have realized in a sale transaction on the dates indicated. The estimated fair value amounts have been measured as of year end and have not been re-evaluated or updated for purposes of these financial statements subsequent to year end. As such, the estimated fair values of these financial instruments subsequent to the period-end reporting dates may be different than the amounts reported at year end.
The Company follows the provisions of FASB ASC 820, Fair Value Measurements and Disclosures. This guidance, which defines fair value, establishes a framework for measuring fair value under GAAP, expands disclosures about fair value measurements and applies to other accounting pronouncements that require or permit fair value measurements. Fair value is defined as the price that would be received to sell the asset or transfer the liability in an orderly transaction (that is not a forced liquidation or distressed sale) between market participants at the measurement date under current market conditions.
The fair value guidance establishes a fair value hierarchy that prioritizes the inputs to valuation methods used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). The three levels of the fair value hierarchy are as follows:
Level 1:
Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities.
Level 2:
Quoted prices in markets that are not active, or inputs that are observable either directly or indirectly, for substantially the full term of the asset or liability.
Level 3:
Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (i.e., supported with little or no market activity).
An asset or liability’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement.
Highlands Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2011 and 2010
Note 14 - Fair Value Measurements and Fair Values of Financial Instruments (Continued)
For financial assets measured at fair value on a recurring basis, the fair value measurements by level within the fair value hierarchy used at December 31, 2011 and 2010 are as follows:
Highlands Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2011 and 2010
Note 14 - Fair Value Measurements and Fair Values of Financial Instruments (Continued)
For financial assets measured at fair value on a nonrecurring basis, the fair value measurements by level within the fair value hierarchy used at December 31, 2011 and 2010 are as follows:
Real estate properties acquired through, or in lieu of, foreclosure are to be sold and are carried at fair value less estimated cost to sell. Fair value is based upon independent market prices or appraised value of the property. These assets are included in Level 3 fair value based upon the lowest level of input that is significant to the fair value measurement.
Below is management’s estimate of the fair value of all financial instruments, whether carried at cost or fair value on the Company’s balance sheet. The following information should not be interpreted as an estimate of the fair value of the entire Company since a fair value calculation is only provided for a limited portion of the Company’s assets and liabilities. Due to a wide range of valuation techniques and the degree of subjectivity used in making the estimates, comparisons between the Company’s disclosures and those of other companies may not be meaningful. The following methods and assumptions were used to estimate the fair values of the Company’s financial instruments at December 31, 2011 and 2010:
Cash and Cash Equivalents (Carried at Cost)
The carrying amounts reported in the balance sheet for cash and short-term instruments approximate those assets’ fair values.
Highlands Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2011 and 2010
Note 14 - Fair Value Measurements and Fair Values of Financial Instruments (Continued)
Time Deposits in Other Banks (Carried at Cost)
Fair values for fixed-rate time certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered in the market on certificates to a schedule of aggregated expected monthly maturities on time deposits. The Company generally purchases amounts below the insured limit, limiting the amount of credit risk on these time deposits.
Securities Available for Sale (Carried at Fair Value)
The fair value of securities available for sale are determined by matrix pricing (Level 2), which is a mathematical technique used widely in the industry to value debt securities without relying exclusively on quoted market prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted prices. For these securities, the Company obtains fair value measurements from an independent pricing service. The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information and the security’s terms and conditions, among other things.
Loans Receivable (Carried at Cost)
The fair values of loans are estimated using discounted cash flow analyses, using market rates at the balance sheet date that reflect the credit and interest rate-risk inherent in the loans. Projected future cash flows are calculated based upon contractual maturity or call dates, projected repayments and prepayments of principal. Generally, for variable rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values.
Impaired Loans (Generally Carried at Fair Value)
Impaired loans are those in which management has measured impairment generally based on the fair value of the loan’s collateral. Fair value is generally determined based upon independent third-party appraisals of the properties, or discounted cash flows based upon the expected proceeds. These assets are included as Level 3 fair values, based upon the lowest level of input that is significant to the fair value measurements. The fair value at December 31, 2011 consists of loan balances of $5,785,000 net of an allowance of $446,000. The fair value at December 31, 2010 consists of the loan balances of $4,390,000, net of a valuation allowance of $176,000.
Restricted Investment in Bank Stock (Carried at Cost)
The carrying amount of restricted investment in bank stock approximates fair value, and considers the limited marketability of such securities.
Accrued Interest Receivable and Payable (Carried at Cost)
The carrying amount of accrued interest receivable and accrued interest payable approximates its fair value.
Deposit Liabilities (Carried at Cost)
The fair values disclosed for demand deposits (e.g., interest and noninterest checking, passbook savings and money market accounts) are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amounts). Fair values for fixed-rate certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered in the market on certificates to a schedule of aggregated expected monthly maturities on time deposits.
Highlands Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2011 and 2010
Note 14 - Fair Value Measurements and Fair Values of Financial Instruments (Continued)
Borrowings (Carried at Cost)
Fair values of FHLB advances are estimated using discounted cash flow analysis, based on quoted prices for new FHLB advances with similar credit risk characteristics, terms and remaining maturity. These prices obtained from this active market represent a market value that is deemed to represent the transfer price if the liability were assumed by a third party.
Off-Balance Sheet Financial Instruments (Disclosed at Cost)
Fair values for off-balance sheet financial instruments (lending commitments and letters of credit) are based on fees currently charged in the market to enter into similar agreements, taking into account, the remaining terms of the agreements and the counterparties’ credit standing.
The following table summarizes the carrying amount and fair value estimates of the Company’s financial instruments at December 31, 2011 and 2010:
Note 15 - Contingencies
In the normal course of business, the Company is subject to various lawsuits involving matters generally incidental to its business. Management is of the opinion that the ultimate liability, if any, resulting from any pending actions or proceedings will not have a material effect on the financial position or results of operations of the Company.
Highlands Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2011 and 2010
Note 16 - Parent Company Only Financial Statements
Condensed financial information pertaining to the parent company, Highlands Bancorp, Inc. as of December 31, 2011 and 2010 and for the years then ended is as follows: