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FIRST NATIONAL COMMUNITY BANCORP INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) This Quarterly Report should be read in conjunction with the more detailed and comprehensive disclosures included on the Company's Form 10-K for the year ended December 31, 2013 and Form 10-Q for the quarter ended March 31, 2014. In addition, please read this section in conjunction with our Consolidated Financial Statements and Notes to Consolidated Financial Statements contained herein. The Company is in the business of providing customary retail and commercial banking services to individuals and businesses within its primary market located in Northeastern Pennsylvania. FORWARD-LOOKING STATEMENTS The Company may from time to time make written or oral "forward-looking statements," including statements contained in the Company's filings with the Securities and Exchange Commission ("SEC"), in its reports to shareholders, and in other communications by the Company, which are made in good faith by the Company pursuant to the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking statements include statements with respect to the Company's beliefs, plans, objectives, goals, expectations, anticipations, estimates and intentions, that are subject to significant risks and uncertainties, and are subject to change based on various factors (some of which are beyond the Company's control). The words "may," "could," "should," "would," "believe," "anticipate," "estimate," "expect," "intend," "plan" and similar expressions are intended to identify forward-looking statements. The following factors, among others, could cause the Company's financial performance to differ materially from the plans, objectives, expectations, estimates and intentions expressed in such forward-looking statements: the strength of the United States economy in general and the strength of the local economies in the Company's markets; the effects of, and changes in trade, monetary and fiscal policies and laws, including interest rate policies of the Board of Governors of the Federal Reserve System; inflation, interest rate, market and monetary fluctuations; the timely development of and acceptance of new products and services; the ability of the Company to compete with other institutions for business; the composition and concentrations of the Company's lending risk and the adequacy of the Company's reserves to manage those risks; the valuation of the Company's investment securities; the ability of the Company to pay dividends or repurchase common shares; the ability of the Company to retain key personnel; the impact of any pending or threatened litigation against the Company; the marketability of shares of the Company and fluctuations in the value of the Company's share price; the impact of the Company's ability to comply with its regulatory agreements and orders; the effectiveness of the Company's system of internal controls; the ability of the Company to attract additional capital investment; the impact of changes in financial services' laws and regulations (including laws concerning capital adequacy, taxes, banking, securities and insurance); the impact of technological changes and security risks upon the Company's information technology systems; changes in consumer spending and saving habits; the nature, extent, and timing of governmental actions and reforms, and the success of the Company at managing the risks involved in the foregoing and other risks and uncertainties, including those detailed in the Company's filingswith the SEC. The Company cautions that the foregoing list of important factors is not all inclusive. Readers are also cautioned not to place undue reliance on any forward-looking statements, which reflect management's analysis only as of the date of this report, even if subsequently made available by the Company on its website or otherwise. The Company does not undertake to update any forward-looking statement, whether written or oral, that may be made from time to time by or on behalf of the Company to reflect events or circumstances occurring after the date of this report. Readers should carefully review the risk factors described in the Annual Report and other documents that the Company periodically files with the Securities and Exchange Commission, including its Form 10-K for the year ended December 31, 2013. CRITICAL ACCOUNTING POLICIES In preparing the consolidated financial statements, management has made estimates, judgments and assumptions that affect the reported amounts of assets and liabilities as of the date of the consolidated statements of condition and results of operations for the periods indicated. Actual results could differ significantly from those estimates. The Company's accounting policies are fundamental to understanding management's discussion and analysis of its financial condition and results of operations. Management has identified the policies on the determination of the allowance for loan and lease losses ("ALLL"), securities valuation and impairment evaluation, and valuation of other real estate owned ("OREO") and income taxes to be critical, as management is required to make subjective and/or complex judgments about matters that are inherently uncertain and could be most subject to revision as new information becomes available. 42 The judgments used by management in applying the critical accounting policies discussed below may be affected by a further and prolonged deterioration in the economic environment, which may result in changes to future financial results. Specifically, subsequent evaluations of the loan portfolio, in light of the factors then prevailing, may result in significant changes in the ALLL in future periods, and the inability to collect on outstanding loans could result in increased loan losses. In addition, the valuation of certain securities in the Company's investment portfolio could be negatively impacted by illiquidity or dislocation in marketplaces resulting in significantly depressed market prices thus leading to impairment losses. Allowance for Loan and Lease Losses Management continually evaluates the credit quality of the Company's loan portfolio, and performs a formal review of the adequacy of the ALLL on a quarterly basis. The ALLL is established through a provision for loan losses charged to earnings and is maintained at a level management considers adequate to absorb estimated probable losses inherent in the loan portfolio as of the evaluation date. Loans, or portions of loans, determined by management to be uncollectible are charged off against the ALLL, while recoveries of amounts previously charged off are credited to the ALLL. Determining the amount of the ALLL is considered a critical accounting estimate because it requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, qualitative factors, and consideration of current economic trends and conditions, all of which may be susceptible to significant change. Various banking regulators, as an integral part of their examination of the Company, also review the ALLL. Such regulators may require, based on their judgments about information available to them at the time of their examination, that certain loan balances be charged off or require that adjustments be made to the ALLL. Additionally, the ALLL is determined, in part, by the composition andsize of the loan portfolio. The ALLL consists of two components, a specific component and a general component. The specific component relates to loans that are classified as impaired. For such loans an allowance is established when the discounted cash flows, collateral value or observable market price of the impaired loan is lower than the carrying value of that loan. The general component covers all other loans and is based on historical loss experience adjusted by qualitative factors. The general reserve component of the ALLL is based on pools of unimpaired loans segregated by loan segment and risk rating categories of "Pass", "Special Mention" or "Substandard and Accruing." Historical loss factors and various qualitative factors are applied based on the risk profile in each risk rating category to determine the appropriate reserve related to those loans. Substandard loans on nonaccrual status above the $100 thousand loan relationship threshold and all loans considered troubled debt restructurings ("TDRs") are classified as impaired. See Note 4 -"Loans" of the consolidated financial statements included in Item 1 hereof for additional information about the ALLL. Securities Valuation Management utilizes various inputs to determine the fair value of its investment portfolio. To the extent they exist, unadjusted quoted market prices in active markets (Level 1) or quoted prices for similar assets or models using inputs that are observable, either directly or indirectly (Level 2) are utilized to determine the fair value of each investment in the portfolio. In the absence of observable inputs or if markets are illiquid, valuation techniques are used to determine fair value of any investments that require inputs that are both unobservable and significant to the fair value measurement (Level 3). For Level 3 inputs, valuation techniques are based on various assumptions, including, but not limited to, cash flows, discount rates, adjustments for nonperformance and liquidity, and liquidation values. A significant degree of judgment is involved in valuing investments using Level 3 inputs. The use of different assumptions could have a positive or negative effect on the consolidated statements of financial condition or results of operations. See Note 6-"Securities" and Note 7-"Fair Value Measurements" of the notes to consolidated financial statements included in Item 1 hereof for additional information about the Company's securities valuation techniques. On a quarterly basis, management evaluates individual investment securities classified as held-to-maturity and available-for-sale having unrealized losses to determine whether or not the security is other-than-temporarily-impaired ("OTTI"). The analysis of OTTI requires the use of various assumptions, including but not limited to, the length of time an investment's fair value is less than book value, the severity of the investment's decline, any credit deterioration of the issuer, whether management intends to sell the security, and whether it is more-likely-than-not that the Company will be required to sell the security prior to recovery of its amortized cost basis. Debt investment securities deemed to be OTTI are written down by the impairment related to the estimated credit loss, and the non-credit related impairment loss is recognized in other comprehensive income. The Company did not recognize OTTI charges on investment securities for the three and six months ended June 30, 2014 and 2013 within the consolidated statements of operations. 43 Other Real Estate Owned OREO consists of property acquired by foreclosure, abandonment or conveyance of deed in-lieu of foreclosure of a loan, and bank premises that is no longer used for operation or for future expansion. OREO is held for sale and is initially recorded at fair value less costs to sell at the date of acquisition or transfer, which establishes a new cost basis. Upon acquisition of the property through foreclosure or deed-in-lieu of foreclosure, any write-down to fair value less estimated selling costs is charged to the ALLL. The determination is made on an individual asset basis. Bank premises no longer used for operations or future expansion is transferred to OREO at its fair value less estimated selling costs with any related write-down included in non-interest expense. Subsequent to acquisition, valuations are periodically performed by management and the assets are carried at the lower of cost or fair value less cost to sell. Fair value is determined through external appraisals, current letters of intent, broker price opinions or executed agreements of sale. Costs relating to the development and improvement of the OREO properties may be capitalized; holding period costs and any subsequent changes to the valuation allowance are charged to expense as incurred. Income Taxes The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current year and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an entity's financial statements or tax returns. Judgment is required in assessing the future tax consequences of events that have been recognized in our consolidated financial statements or tax returns. Fluctuations in the actual outcome of these future tax consequences could impact our consolidated financial condition or results of operations. The Company records an income tax provision or benefit based on the amount of tax currently payable or receivable and the change in deferred tax assets and liabilities. Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial and tax reporting purposes. Management conducts quarterly assessments of all available evidence to determine the amount of deferred tax assets that will more-likely-than-not be realized. The available evidence used in connection with these assessments includes taxable income in current and prior periods, cumulative losses in prior periods, projected future taxable income, potential tax-planning strategies, and projected future reversals of deferred tax items. Management's assumptions and estimates take into consideration its interpretation of tax laws and possible outcomes of current and future audits conducted by tax authorities. These assessments involve a certain degree of subjectivity which may change significantly depending on the related circumstances. If actual results differ from the assumptions and other considerations used in estimating the amount and timing of tax recognized, there can be no assurance that additional expenses will not be required in future periods. In connection with determining the income tax provision or benefit, the Company considers maintaining liabilities for uncertain tax positions and tax strategies that management believes contain an element of uncertainty. Periodically, the Company evaluates each of its tax positions and strategies to determine whether a liability for uncertain tax benefits is required. As of June 30, 2014 and December 31, 2013, the Company did not have any uncertain tax positions or tax strategies and no liability was required to be recorded. New Authoritative Accounting Guidance ASU 2013-11, Income Taxes (Topic 740): "Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists," requires an unrecognized tax benefit, or a portion of an unrecognized tax benefit, be presented in the financial statements as a reduction to a deferred tax asset for a net operating loss carryforward, a similar tax loss, or a tax credit carryforward. If a net operating loss carryforward, a similar tax loss, or a tax credit carryforward is not available at the reporting date, the unrecognized tax benefit should be presented in the financial statements as a liability and not combined with deferred tax assets. The Company adopted ASU 2013-11 on January 1, 2014. The adoption of this new guidance did not have an effect on the operating results or financial position of the Company. Accounting Guidance to be Adopted in Future Periods ASU 2014-04, Receivables-Troubled Debt Restructurings by Creditors (Subtopic 310-40): "Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure," clarifies that an in substance repossession or foreclosure occurs, and a creditor is considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan, upon either (a) the creditor obtaining legal title to residential real estate property upon completion of a foreclosure or (b) the borrower conveying all interest in the residential real estate property to the creditor to satisfy that loan through completion of a deed in lieu of foreclosure or through a similar legal agreement. Additionally, the amendments require interim and annual disclosure of both the amount of foreclosed residential real estate property held by the creditor and the recorded investment in consumer mortgage loans collateralized by residential real estate property that are in the process of foreclosure according to local requirements of the applicable jurisdiction. This guidance is effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2014, with early adoption permitted. The adoption of this guidance on January 1, 2015 is not expected to have a material effect on the operating results or financial position of the Company. 44 ASU 2014-08, Presentation of Financial Statements (Topic 205) and Property, Plant and Equipment (Topic 360): "Reporting Discontinued Operations and Disclosures of Disposals of Components of an Entity," changes the criteria for reporting a discontinued operation. Under the new guidance, a disposal of a component of an entity or group of components of an entity is required to be reported in discontinued operations if the disposal represents a strategic shift that has (or will have) a major effect on the entity's operations and financial results. This new guidance reduces the complexity by removing the complex and extensive implementation guidance and illustrations that are necessary to apply the current definition of a discontinued operation. The new guidance also requires expanded disclosures about discontinued operations that will provide users with more information about the assets, liabilities, revenues and expenses of a discontinued operation and will require pre-tax income attributable to a disposal of a significant part of an organization that does not qualify for discontinued operations reporting, which will provide users with information about the ongoing trends in a reporting organization's results from continuing operations. Public companies and not-for-profit organizations that have issued or is a conduit bond obligor for securities that are traded, listed, or quoted on an exchange or an over-the-counter market should apply the new guidance prospectively to all disposals (or classifications as held for sale) of components of an organization and all business or nonprofit activities that, on acquisition, are classified as held for sale that occur within annual periods beginning on or after December 15, 2014, and interim periods within those years. The adoption of this guidance on January 1, 2015 is not expected to have a material effect on the operating results or financial position of the Company. ASU 2014-09, Revenue from Contracts with Customers (Topic 606): Section A, "Summary and Amendments That Create Revenue from Contracts with Customers (Topic 606) and Other Assets and Deferred Costs-Contract with Customers (Subtopic 340-40);" Section B, "Conforming Amendments to Other Topics and Subtopics in the Codification and Status Tables;" and Section C, "Background Information and Basis for Conclusions," provides a robust framework for addressing revenue recognition issues, upon its effective date, replaces almost all existing revenue recognition guidance, including industry specific guidance, in current GAAP. The core principle of ASU 2014-09 is for companies to recognize revenue to depict the transfer of goods or services to customers in amounts that reflect the consideration to which the company expects to be entitled in exchange for those goods or services. ASU 2014-09 will also result in enhanced interim and annual disclosures, both qualitative and quantitative, about revenue in order to help financial statement users understand the nature, amount, timing and uncertainty of revenue and related cash flows. ASU 2014-09 is effective in annual reporting periods beginning after December 15, 2016 and the interim periods within that year for public business entities, not-for-profit entities that have issued, or are conduit bond obligors for, securities that are traded, listed or quoted on an exchange or over-the-counter market and employee benefit plans that file or furnish financial statements to the SEC. Accordingly, the Company will adopt this guidance on January 1, 2017 and is currently evaluating the effect this guidance may have on its operating results or financial position. ASU 2014-11, Transfers and Servicing (Topic 860): "Repurchase-to-Maturity Transactions, Repurchase Financings, and Disclosures," changes the accounting for repurchase-to-maturity transactions and repurchase financing arrangements by aligning the accounting for these transactions with the accounting for other typical repurchase agreements. Going forward, these transactions would all be accounted for as secured borrowings. The new guidance eliminates sale accounting for repurchase-to-maturity transactions and supersedes the guidance under which a transfer of a financial asset and a contemporaneous repurchase financing could be accounted for on a combined basis as a forward arrangement, which has resulted in outcomes referred to as off-balance sheet accounting. ASU 2014-11 also requires a new disclosure for transactions economically similar to repurchase agreements in which the transferor retains substantially all of the exposure to the economic return on the transferred financial assets throughout the term of the transaction, and requires expanded disclosure about the nature of the collateral pledged in repurchase agreements and similar transactions accounted for as secured borrowings. Accounting changes in ASU 2014-11 are effective for public companies for interim and annual periods beginning after December 15, 2014. In addition, the disclosure for certain transactions accounted for as a sale is effective for the first interim or annual period beginning on or after December 15, 2014, and the disclosure for transactions accounted for as secured borrowings is required to be presented for annual periods beginning after December 15, 2014, and interim periods beginning after March 15, 2015. The adoption of this guidance on the appropriate effective dates is not expected to have a material effect on the operating results or financial position of the Company. ASU 2014-12, Compensation - Stock Compensation (Topic 718): "Accounting for Share-Based Payments When the Terms of an Award Provide that a Performance Target Could be Achieved after the Requisite Service Period," requires a performance target that affects vesting and that can be achieved after the requisite service period to be treated as a performance condition. To account for such awards, an entity should apply existing guidance as it relates to awards with performance conditions that affect vesting. As such, the performance target should not be reflected in estimating the grant-date fair value of the award. Compensation cost should be recognized in the period in which it becomes probable that the performance target will be achieved and should represent compensation cost attributable to the period(s) for which the requisite service already has been rendered. If the performance target becomes probable of being achieved before the end of the requisite service period, the remaining unrecognized compensation cost should be recognized prospectively over the remaining requisite service periods. The total amount of compensation cost should reflect the number of awards that are expected to vest and should be adjusted to reflect those awards that ultimately vest. ASU 2014-12 is effective for annual periods and interim periods within those annual periods beginning after December 15, 2015. The adoption of this guidance on January 1, 2016 is not expected to have a material effect on the operating results or financial position of the Company. 45 Executive Summary The following overview should be read in conjunction with this Management's Discussion and Analysis in its entirety. Management continued to take proactive measures in order to reduce risk, improve asset quality and strengthen the Company's and the Bank's capital positions. In addition to these strategies, management focused on improving efficiency through profit enhancement initiatives aimed at developing new sources of non-interest revenue, reducing the level of non-interest expense, improving processes and reevaluating current staffing requirements. In the third quarter of 2013, the Company entered into a Branch Purchase and Deposit/Loan Assumption Agreement (the "Branch Purchase Agreement") with ESSA Bank and Trust ("ESSA") for ESSA to acquire certain assets and liabilities of the Bank's Marshalls Creek and Stroudsburg branches, both located in Monroe County, Pennsylvania. Pursuant to this transaction, which closed on January 24, 2014, the Bank sold deposits of $8.8 million, real and personal property of $2.5 million and loans of $1.1 million. The Company realized a net gain on the branch divesture of $607 thousand, which is included in non-interest income in the Consolidated Statements of Operations for the six months ended June 30, 2014. The Company recorded net income of $6.6 million, or $0.40 per diluted common share, for the three month period ended June 30, 2014, an increase of $5.9 million compared to net income of $720 thousand, or $0.04 per diluted common share, for the comparable three months of 2013. The earnings improvement was due primarily to increases in the credit for loan and lease losses, non-interest income and net interest income, partially offset by an increase in non-interest expense. Net income for the six months ended June 30, 2014 was $10.1 million or $0.61 per diluted common share, an increase of $7.6 million, compared to net income of $2.5 million, or $0.15 per diluted common share, for the same period of 2013. The annualized return on average equity was 60.91% and 50.62%, respectively, for the three- and six-month periods ended June 30, 2014, compared to 8.45% and 14.08% for the comparable periods in 2013. For the three and six months ended June 30, the annualized return on average assets was 2.73% and 2.09%, respectively, in 2014 and 0.31% and 0.53%, respectively in 2013. The Company did not pay any dividends during the three or six months ended June30, 2014 and 2013. The $5.9 million earnings improvement for the three months ended June 30, 2014, as compared to the three months ended June 30, 2013, was largely due to a $4.0 million increase in the credit for loan and lease losses, coupled with increases of $2.7 million in non-interest income and $319 thousand in net-interest income. Partially offsetting these increases was an increase in non-interest expense of $1.1 million. During the second quarter of 2014, the Company received a substantial legal settlement in the amount of $5.8 million resulting from judgments filed by the Company pursuant to a large credit relationship. Of the total amount received, $3.6 million represented full recovery of previously charged-off loans, which was the primary factor leading to the increase in the credit for loan and lease losses. The remainder of the settlement represented satisfaction of all past due interest and late charges and reimbursement of all legal fees and other related expenses associated with these credits incurred and paid by the Company. The increase in non-interest income resulted primarily from this settlement, coupled with net gains on the sale of investment securities. The 5.0% increase in net interest income for the three months ended June 30, 2014 was due to a $268 thousand decrease in interest expense, coupled with a $51 thousand increase in interest income. The decrease in interest expense was the result of management's strategy to replace above market rate deposits with low-cost FHLB advances. These positive factors were partially offset by a 13.3% increase in non-interest expense, which was primarily related to valuation adjustments of OREO properties. Year-to-date net income improved $7.6 million, or 311.8%, comparing the six months ended June 30, 2014 and 2013. The improvement was largely due to a $4.3 million increase in the credit for loan and lease losses, a $3.7 million increase in non-interest income and a $517 thousand increase in net interest income. Partially offsetting these positive factors was a $739 thousand increase in non-interest expense. Total assets decreased $45.9 million, or 4.6%, to $957.9 million at June 30, 2014 as compared to $1.0 billion at December 31, 2013. The balance sheet contraction primarily reflected a $114.5 million, or 12.9%, reduction in total deposits, to $770.2 million at June 30, 2014, from $884.7 million at December 31, 2013. Interest-bearing deposits decreased $82.5 million, or 11.3%, while non-interest bearing demand deposits decreased by $32.0 million, or 20.3%. The decrease in deposits reflected cyclical deposit trends related to the Company's municipal customers, the sale of the Monroe County branches and continued runoff of certificates of deposit due to the sustained low interest rate environment. The Company experienced strong loan demand, as loans, net of unearned income, net deferred loan fees and costs and the ALLL, increased $28.9 million, or 4.6%. As a result of these factors, cash and cash equivalents decreased $72.9 million, while advances from the Federal Home Loan Bank of Pittsburgh ("FHLB") grew$50.3 million. 46 Total shareholders' equity increased $15.6 million, or 46.5%, to $49.2 million at June 30, 2014 from $33.6 million at December 31, 2013. The capital improvement resulted primarily from net income of $10.1 million, coupled with a $5.5 million increase in accumulated other comprehensive income, which resulted entirely from appreciation in the fair value of available-for-sale securities offset by the tax impact of the appreciation. At June 30, 2014, the Bank's total risk-based capital and Tier I leverage ratios were 14.74% and 9.62%, respectively, which exceed the respective 13.00% and 9.00% ratios requiredby the OCC Consent Order. On May 24, 2012, a putative shareholder filed a complaint in the Court of Common Pleas for Lackawanna County ("Shareholder Derivative Suit") against certain present and former directors and officers of the Company (the "Individual Defendants") alleging, inter alia, breach of fiduciary duty, abuse of control, corporate waste, and unjust enrichment. The Company was named as a nominal defendant. The parties to the Shareholder Derivative Suit commenced settlement discussions and on December 18, 2013, the Court entered an Order Granting Preliminary Approval of Proposed Settlement subject to notice to shareholders. On February 4, 2014, the Court issued a Final Order and Judgment for the matter granting approval of a Stipulation of Settlement (the "Settlement") and dismissing all claims against the Company and the Individual Defendants. As part of the Settlement, there was no admission of liability by the Individual Defendants. Pursuant to the Settlement, the Individual Defendants, without admitting any fault, wrongdoing or liability, agreed to settle the derivative litigation for $5.0 million. The $5.0 million Settlement payment was made to the Company on March 28, 2014. The Individual Defendants reserved their rights to indemnification under the Company's Articles of Incorporation and Bylaws, resolutions adopted by the Board, the Pennsylvania Business Corporation Law and any and all rights they have against the Company's and the Bank's insurance carriers. In accordance therewith, the Company had recorded a $5.0 million liability for this indemnification in other liabilities. The Company netted the income related to the receipt of the $5.0 million Settlement payment and the $5.0 million expense associated with recording the liability to indemnify the Individual Defendants and therefore there was no effect on the operating results of the Company for the six months ended June 30, 2014. In addition, in conjunction with the Settlement, the Company accrued $2.5 million related to fees and costs of the plaintiff's attorneys, which was included in non-interest expense in the consolidated statements of operations for the year ended December 31, 2013. On April 1, 2014, the Company paid the $2.5 million related to the fees and costs of the plaintiff's attorneys, and paid $2.5 million as partial indemnification to the Individual Defendants, and, as such, as of June 30, 2014, $2.5 million remains accrued in other liabilities related to the potential indemnification of the Individual Defendants. The Company settled any and all claims it had or may have had against Demetrius & Company, LLC, John Demetrius and Robert L. Rossi & Company in connection with the Shareholder DerivativeSuit. Summary of Performance Net Interest Income Net interest income is the difference between (i) interest income - interest and fees on interest-earning assets, and (ii) interest expense - interest paid on the Company's deposits and borrowed funds. Net interest income represents the largest component of the Company's operating income and, as such, is the primary determinant of profitability. Net interest income is impacted by variations in the volume, rate and composition of earning assets and interest-bearing liabilities, changes in general market rates and the level of non-performing assets. Interest income is shown on a fully tax-equivalent basis and is calculated by adjusting tax-free interest using a marginal tax rate of 34.0% in order to equate the yield to that of taxable interest rates. Net interest income on a tax-equivalent basis increased $176 thousand to $7.1 million from $6.9 million comparing the three-month periods ending June 30, 2014 and 2013. Despite the slight increase in tax-equivalent income, the Company's tax-equivalent net interest margin for the three months ended June 30, 2014 fell 10 basis points to 3.16% in 2014 from 3.26% in 2013. Tax-equivalent net interest margin, a key measurement used in the banking industry to measure income from earning assets relative to the cost to fund those assets, is calculated by dividing tax-equivalent net interest income by average interest-earning assets. The margin decrease was primarily due to an increase in earning assets at lower yields, partially mitigated by a decrease in average funding costs. Rate spread, the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities shown on a fully tax-equivalent basis, was 3.05% for the three months ended June 30, 2014, a decrease of 9 basis points compared to 3.14% for the same period of 2013. The $176 thousand increase in tax-equivalent net interest income for the second quarter was due entirely to a decrease in interest expense, partially offset by a reduction in tax-equivalent interest income. For the three months ended June 30, 2014, interest expense decreased $268 thousand, or 14.7%, to $1.5 million from $1.8 million for the same three months of 2013. The decrease in interest expense reflected an 18 basis point reduction in the cost of funds, partially offset by a $26.6 million, or 3.6%, increase in average interest-bearing liabilities. For the three months ended June 30, 2014, the cost of funds was 0.80% compared to 0.98% for the same three months of 2013. The reduction in funding costs resulted primarily from a 240 basis point decrease in the cost of borrowed funds, coupled with a 14 basis point decrease in the cost of interest-bearing deposits, which caused corresponding decreases in interest expense of $418 thousand and $160 thousand, respectively. With regard to average balances of interest-bearing liabilities, an increase in borrowed funds of $40.4 million was partially offset by a decrease of $13.8 million in interest-bearing deposits. The decrease in deposits was primarily concentrated in time deposits, which reflected the Company's asset/liability strategy to replace above market-rate certificates of deposit with lower-costing advances from the FHLB of Pittsburgh. 47 Interest income on a tax equivalent basis decreased $92 thousand to $8.7 million three months ended June 30, 2014 compared to $8.8 million in 2013. The decrease resulted from a 27 basis point decrease in the tax-equivalent yield on average earning assets to 3.85%, compared to 4.12% for the same period in 2013. Specifically, the tax-equivalent yield on average securities fell 23 basis points, while the tax-equivalent yield on average loans decreased 31 basis points for the three months ended June 30, 2014 compared to the same period in 2013. With respect to investment securities, as part of tax planning strategies and an effort to reduce potential credit and concentration risk within the portfolio, the Company sold certain tax-free municipal bonds during the six months ended June 30, 2014. The proceeds were reinvested in U.S. government-sponsored agency bonds and mortgage-backed securities. The decrease in loan yields reflected the Company's asset/liability strategy which focused on originating loans with adjustable interest rates in order to position the balance sheet to react favorably to a rise in market interest rates. Partially offsetting the decrease in tax-equivalent interest income due to changes in interest rates was a $49.1 million, or 5.8%, increase in average earning assets to $900.5 million for the three months ended June 30, 2014 from $851.4 million for the same three-month period of 2013, which resulted in an increase to interest income of $212 thousand. Specifically, the average balances of loans and investment securities grew $36.5 million and $15.8 million, respectively. These increases were partially offset by a $3.2 million decrease in average interest-bearing deposits in other banks and federal funds sold. For the six months ended June 30, 2014, net interest income on a tax equivalent basis increased $223 thousand to $14.2 million from $14.0 million for the comparable period in 2013. Similar to the quarterly results, a decrease in interest expense more than entirely offset a decrease in tax-equivalent interest income. For the six months ended June 30, interest expense decreased $552 thousand, or 15.0%, to $3.1 million in 2014 from $3.7 million in 2013. The reduction in interest expense resulted primarily from an 18 basis point decrease in the cost of funds, which caused a decrease to interest expense of $1.0 million. Specifically, the cost of borrowed funds decreased 214 basis points and the cost of interest-bearing deposits declined 15 basis points, which resulted in corresponding decreases to interest expense of $681 thousand and $358 thousand, respectively. Partially offsetting the reduction in interest expense due to changes in rates was a $26.3 million, or 3.5% increase in average interest-bearing liabilities to $778.3 million for the six months ended June 30, 2014 from $752.0 million for the same six-month period in 2013. Specifically, for the six months ended June 30, 2014, average borrowed funds increased $28.5 million, or 54.7%, while average interest-bearing deposits decreased $2.2 million. Changes in the average volumes of interest-bearing liabilities resulted in additional interest expense of $486 thousand for the six months ended June 30, 2014. 48 Net interest income depends upon the relative amount of interest-earning assets and interest-bearing liabilities and the interest rate earned or paid on them. The following tables present certain information relating to our consolidated statements of financial condition and operations for the three- and six-month periods ended June 30, 2014 and 2013, and reflect the average yield on assets and average cost of liabilities for the periods indicated. Such yields and costs are derived by dividing income or expense by the average balance of assets or liabilities, respectively, for the periods shown. Average balances are derived from average daily balances. The yields include amortization of fees which are considered adjustments to yields. Three months ended June 30, 2014 Three months ended June 30, 2013 Average Yield/ Average Yield/ (dollars in thousands) Balance Interest Cost Balance Interest Cost ASSETS Earning assets (2)(3) Loans-taxable(4) $ 622,815 $ 6,292 4.04 % $ 588,467 $ 6,384 4.34 % Loans-tax free (4) 39,465 485 4.91 % 37,308 506 5.43 % Total loans (1)(2) 662,280 6,777 4.09 % 625,775 6,890 4.40 % Securities-taxable 169,074 1,033 2.44 % 132,175 611 1.85 % Securities-tax free 48,349 848 7.02 % 69,474 1,248 7.19 % Total securities (1)(5) 217,423 1,881 3.46 % 201,649 1,859 3.69 % Interest-bearing deposits in other banks and federal funds sold 20,782 13 0.25 % 23,939 14 0.23 % Total earning assets 900,485 8,671 3.85 % 851,363 8,763 4.12 % Non-earning assets 79,591 92,236 Allowance for loan and lease losses (13,982 ) (18,829 ) Total assets $ 966,094 $ 924,770 LIABILITIES AND SHAREHOLDERS' EQUITY Interest-bearing liabilities Interest-bearing demand deposits $ 305,173 $ 102 0.13 % $ 286,700 $ 150 0.21 % Savings deposits 88,651 15 0.07 % 86,557 28 0.13 %Time deposits over $100,000 148,829 287 0.77 % 158,863 326 0.82 % Other time deposits 134,316 415 1.24 % 158,646 566 1.43 % Total interest-bearing deposits 676,969 819 0.48 % 690,766 1,070 0.62 % Borrowed funds and other interest-bearing liabilities 94,952 731 3.08 % 54,590 748 5.48 % Total interest-bearing liabilities 771,921 1,550 0.80 % 745,356 1,818 0.98 % Demand deposits 126,372 124,179 Other liabilities 24,470 21,057 Shareholders' equity 43,331 34,178 Total liabilities and shareholders' equity $ 966,094 $ 924,770 Net interest income/interest Rate spread (6) 7,121 3.05 % 6,945 3.14 % Tax equivalent adjustment (453 ) (596 )Net interest income as reported $ 6,668 $ 6,349 Net interest margin (7) 3.16 % 3.26 % (1) Interest income is presented on a tax equivalent basis using a 34% rate. (2) Loans are stated net of unearned income. (3) Non-accrual loans are included in loans within earning assets. (4) Loan fees included in interest income are not significant. (5) The yields for securities that are classified as available-for-sale are based on the average historical amortized cost. (6) Interest rate spread represents the difference between the average yield on interest-earning assets and the cost of interest-bearing liabilities and is presented on a tax-equivalent basis. (7) Net interest income as a percentage of total average interest earning assets. 49 Six months ended June 30, 2014 Six months ended June 30, 2013 Average Yield/ Average Yield/ (dollars in thousands) Balance Interest Cost Balance Interest Cost ASSETS Earning assets (2)(3) Loans-taxable(4) $ 616,698 $ 12,452 4.04 % $ 581,191 $ 12,661 4.36 % Loans-tax free (4) 40,581 991 4.88 % 36,244 1,006 5.55 % Total loans (1)(2) 657,279 13,443 4.09 % 617,435 13,667 4.43 % Securities-taxable 167,514 1,930 2.30 % 122,053 1,168 1.91 % Securities-tax free 54,130 1,924 7.11 % 77,739 2,774 7.14 % Total securities (1)(5) 221,644 3,854 3.48 % 199,792 3,942 3.95 % Interest-bearing deposits in other banks and federal funds sold 28,358 36 0.25 % 39,118 53 0.27 % Total earning assets 907,281 17,333 3.82 % 856,345 17,662 4.12 % Non-earning assets 78,934 96,150 Allowance for loan and lease losses (14,056 ) (19,002 ) Total assets $ 972,159 $ 933,493 LIABILITIES AND SHAREHOLDERS' EQUITY Interest-bearing liabilities Interest-bearing demand deposits $ 318,086 $ 214 0.13 % $ 299,075 $ 308 0.21 % Savings deposits 88,144 30 0.07 % 85,385 54 0.13 % Time deposits over $100,000 154,458 592 0.77 % 151,787 643 0.85 % Other time deposits 137,127 848 1.24 % 163,766 1,183 1.44 % Total interest-bearing deposits 697,815 1,684 0.48 % 700,013 2,188 0.63 % Borrowed funds and other interest-bearing liabilities 80,479 1,439 3.58 % 52,024 1,487 5.72 % Total interest-bearing liabilities 778,294 3,123 0.80 % 752,037 3,675 0.98 % Demand deposits 129,524 124,785 Other liabilities 24,130 21,577 Shareholders' equity 40,211 35,094 Total liabilities and shareholders' equity $ 972,159 $ 933,493 Net interest income/interest Rate spread (6) 14,210 3.02 % 13,987 3.14 % Tax equivalent adjustment (991 ) (1,285 ) Net interest income as reported $ 13,219 $ 12,702 Net interest margin (7) 3.13 % 3.27 % (1) Interest income is presented on a tax equivalent basis using a 34% rate. (2) Loans are stated net of unearned income. (3) Non-accrual loans are included in loans within earning assets. (4) Loan fees included in interest income are not significant. (5) The yields for securities that are classified as available-for-sale are based on the average historical amortized cost. (6) Interest rate spread represents the difference between the average yield on interest-earning assets and the cost of interest-bearing liabilities and is presented on a tax-equivalent basis. (7) Net interest income as a percentage of total average interest earning assets. 50 Rate Volume Analysis The most significant impact on net income between periods is derived from the interaction of changes in the volume and rates earned or paid on interest-earning assets and interest-bearing liabilities. The volume of earning assets, specifically loans and investments, compared to the volume of interest-bearing liabilities represented by deposits and borrowings, combined with the spread, produces the changes in net interest income between periods. Components of interest income and interest expense are presented on a tax-equivalent basis using the statutory federal income tax rate of 34%. The following table summarizes the effect that changes in volumes of earning assets and interest-bearing liabilities and the interest rates earned and paid on these assets and liabilities have on net interest income. The net change or mix component attributable to the combined impact of rate and volume changes has been allocated proportionately to the change due to volume and the change due to rate. Three Months Ended June 30, Six Months Ended June 30, 2014 vs. 2013 2014 vs. 2013 Increase (Decrease) due to change in Increase (Decrease) due to change in (in thousands) Volume Rate Total Volume Rate Total Interest income: Loans - taxable $ 361 $ (453 ) $ (92 ) $ 748 $ (957 ) $ (209 ) Loans - tax free 28 (49 ) (21 ) 113 (128 ) (15 ) Total loans 389 (502 ) (113 ) 861 (1,085 ) (224 ) Securities - taxable 196 226 422 492 270 762 Securities - tax free (371 ) (29 ) (400 ) (839 ) (11 ) (850 ) Total securities (175 ) 197 22 (347 ) 259 (88 ) Interest-bearing deposits in other banks and federal funds sold (2 ) 1 (1 ) (14 ) (3 ) (17 ) Total interest income 212 (304 ) (92 ) 500 (829 ) (329 ) Interest expense: Interest-bearing demand deposits 9 (57 ) (48 ) 19 (113 ) (94 ) Savings deposits 1 (14 ) (13 ) 2 (26 ) (24 ) Time deposits over $100,000 (20 ) (19 ) (39 ) 11 (62 ) (51 ) Other time deposits (81 ) (70 ) (151 ) (178 ) (157 ) (335 )Total interest-bearing deposits (91 ) (160 ) (251 ) (146 ) (358 ) (504 ) Borrowed funds and other interest-bearing liabilities 401 (418 ) (17 ) 633 (681 ) (48 ) Total interest expense 310 (578 ) (268 ) 487 (1,039 ) (552 ) Net interest income $ (98 ) $ 274 $ 176 $ 13 $ 210 $ 223 Provision for Loan and Lease Losses Management closely monitors the loan portfolio and the adequacy of the ALLL, considering underlying borrower financial performance and collateral values and associated credit risks. Future material adjustments may be necessary to the provision for loan and lease losses and the ALLL if economic conditions or loan performance differ substantially from the assumptions management used in making its evaluation of the ALLL. The provision for loan and lease losses is an expense charged against net interest income to provide for estimated losses attributable to uncollectible loans and is based on management's analysis of the adequacy of the ALLL. A credit for loan and lease losses reflects the reversal of amounts previously charged to the ALLL. Credits for loan and lease losses of $4.0 million and $5.6 million were recorded for the three- and six-month periods ended June 30, 2014, respectively, compared to credits of $2 thousand and $1.2 million, respectively, for the same periods in the prior year. The $4.4 million increase in the credit for loan and lease losses for the six months ended June 30, 2014 was primarily attributable to the full recovery of $3.6 million in previously charged-off commercial real estate loans. Non-performing loans decreased $0.8 million to $5.6 million from $6.4 million at December 31, 2013. The Company recorded net recoveries of $3.7 million for the six months ended June 30, 2014, compared to net recoveries of $1.3 million for the same six months of 2013. Non-performing loans primarily consist of loans secured by real estate. Management closely monitors the loan portfolio and the adequacy of the ALLL considering underlying borrower financial performance and collateral values and increasing credit risks. 51 Non-interest Income Non-interest income totaled of $5.0 million for the three months ended June 30, 2014, an increase of $2.7 million from the $2.3 million earned during the comparable period in 2013. The increase in second quarter non-interest income was primarily due to the receipt of legal settlements totaling $2.1 million. The settlements primarily involved the recovery of all past due interest, late charges and legal and other expenses as part of the settlement of a previously charged-off commercial real estate loan relationship. In addition, net gains on the sale of available-for-sale securities increased $0.6 million to $1.5 million for the three months ended June 30, 2014 from $0.9 million for the same three months of 2013. Non-interest income amounted to $8.4 million for the six months ended June 30, 2014, an increase of $3.7 million from $4.7 million for the six months ended June 30, 2013. Similar to the reasons given for the quarterly increase, the year-to-date increase in non-interest income was primarily attributable to the legal settlements, a $1.3 million increase in net gains on the sale of investment securities, and a $0.6 million net gain on the divesture of the Company's Monroe County branch offices. Non-interest Expense For the three months ended June 30, 2014, non-interest expense increased $1.1 million, or 13.3%, to $9.0 million, from $7.9 million for the same three months of 2013. On a year-to-date basis, non-interest expense increased $0.7 million to $16.9 million in 2014 from $16.2 million in 2013. The increase in non-interest expense was the result of valuation adjustments to the cost basis of several OREO properties in the amount of $1.7 million recorded in the second quarter of 2014. Partially offsetting this increase were decreases in insurance expenses, regulatory assessments and loan collection expense. During the second quarter of 2014, the Company was notified by the Federal Deposit Insurance Corporation ("FDIC") that it's risk category for FDIC assessments had improved from a risk category III to a risk category II based upon the Company's most recent regulatory examination. Due to the change in risk categories, the Company's initial base assessment rate for deposit insurance will decrease from 0.23 basis points to 0.14 basis points effective for the January 1, 2014 to March 31, 2014 insurance period. The change in assessment rate resulted in the $137 thousand decrease in regulatory assessments comparing the six months ended June 30,2014 and 2013. During the second quarter of 2014, the Company's professional liability, fidelity bond and errors and omissions insurance policies were renewed at lower rates for the upcoming insurance period. Accordingly, the Company anticipates a decrease in insurance expense for the remainder of 2014. In addition, the Company anticipates that professional and legal fees will decline to more normalized levels for the remainder of 2014, reflecting reduced activity related to, and the potential resolution of, certain outstanding litigation, as well as less reliance on outside advisors and consultants. Provision for Income Taxes The Company evaluates the carrying amount of its deferred tax assets on a quarterly basis or more frequently, if necessary, in accordance with the guidance provided in Financial Accounting Standards Board ("FASB") Accounting Standards Codification ("ASC") Topic 740 ("ASC 740"), in particular, applying the criteria set forth therein to determine whether it is more likely than not (i.e., a likelihood of more than 50%) that some portion, or all, of the deferred tax asset will not be realized within its life cycle, based on the weight of available evidence. If management makes a determination based on the available evidence that it is more likely than not that some portion or all of the deferred tax asset will not be realized in future periods, a valuation allowance is calculated and recorded. These determinations are inherently subjective and dependent upon estimates and judgments concerning management's evaluation of both positive and negative evidence. In conducting the deferred tax asset analysis, the Company believes it is important to consider the unique characteristics of an industry or business. In particular, characteristics such as taxable income in current and prior periods, cumulative losses in prior periods, projected future taxable income, levels of capital and reserves, ability to absorb potential losses, and projected future reversals of deferred tax items are considered by the Company in conducting the deferred tax asset analysis. Management's assumptions and estimates also take into consideration its interpretation of tax laws and possible outcomes of current and future audits conducted by tax authorities. The Company recorded a provision for income taxes in the amount of $90 thousand and $160 thousand, respectively, for the three and six months ended June 30, 2014. The provision is related solely to an estimate for alternative minimum tax ("AMT"). There was no provision for income taxes recorded for the three andsix months ended June 30, 2013. The net deferred tax asset before consideration of a valuation allowance was $34.1 million at June 30, 2014 and $34.5 million at December 31, 2013. At both dates, the Company's consolidated statements of financial condition reflected a full valuation allowance. In future periods, the Company anticipates that it will have a minimal tax provision or benefit until such time as it is able to reverse the deferred tax asset valuation allowance that it recorded in 2009. To the extent that the Company generates taxable income in a given quarter, the valuation allowance may be reduced to fully or partially offset the corresponding income tax expense. Any remaining deferred tax asset valuation allowance may be reversed through income tax expense only once the Company can demonstrate a sustainable return to profitability and conclude that it is more likely than not the deferred tax asset will be utilized prior to expiration. 52 Financial Condition Assets Total assets decreased $45.9 million, or 4.6%, to $957.9 million at June 30, 2014 from $1.0 billion at December 31, 2013. The decrease resulted primarily from a decrease in cash and cash equivalents, which was directly related to a reduction in total deposits. Loans, net of unearned income and the ALLL increased as a result of favorable demand for the Company's lending products. Due to favorable rates as compared to other funding sources, the Company utilized borrowings through the FHLB of Pittsburgh as an additional source of liquidity and as a result, total borrowed funds increased when comparing the end of the second quarter of 2014 to year-end 2013. As discussed above, in the third quarter of 2013, the Company entered into the Branch Purchase Agreement with ESSA for ESSA to acquire certain assets and liabilities of the Bank's Marshalls Creek and Stroudsburg branches, both located in Monroe County, Pennsylvania. Pursuant to this transaction, which closed on January 24, 2014, the Company sold deposits of $8.8 million, real and personal property of $2.5 million and loans of $1.1 million. The Company realized a net gain on the branch divesture of $607 thousand, which is included in non-interest income in the Consolidated Statements of Operations for the six months ended June 30, 2014. Cash and Cash Equivalents Cash and cash equivalents totaled $30.6 million at June 30, 2014, a decrease of $72.9 million, or 70.4%, from $103.6 million at December 31, 2013. The decrease resulted primarily from a $114.5 million decrease in total deposits, coupled with a $28.9 million increase in total loans. Advances through the FHLB of Pittsburgh provided additional liquidity and increased $50.3 million. The Company did not pay any dividends during the three and six months ended June 30, 2014, as it suspended paying dividends to conserve capital and comply withregulatory requirements. Securities The Company's investment securities portfolio provides a source of liquidity needed to meet expected loan demand and provides a source of interest income to increase our profitability. Additionally, the Company utilizes the investment securities portfolio to meet pledging requirements to secure public deposits and for other purposes. Investment securities are classified as held-to-maturity and carried at amortized cost when the Company has the positive intent and ability to hold them to maturity. Securities not classified as held-to-maturity are classified as available-for-sale and are carried at fair value, with unrealized holding gains and losses reported as a component of shareholders' equity in accumulated other comprehensive income (loss), net of tax. The Company determines the appropriate classification of investment securities at the time of purchase. The decision to purchase or sell investment securities is based upon the current assessment of long- and short-term economic and financial conditions, including the interest rate environment and asset/liability management strategies. Securities with limited marketability and/or restrictions, such as FHLB of Pittsburgh and FRB stocks, are carried at cost. FRB stock is included in other assets. At June 30, 2014, the Company's investment portfolio was comprised principally of U.S. government-sponsored agencies, including residential mortgage-backed securities, collateralized mortgage obligations ("CMOs") and single-maturity bonds, and taxable and tax-exempt obligations of state and political subdivisions and obligations. Other than the obligations of U.S. government-sponsored agencies, there were no security issuers whose aggregate carrying value of securities held by the Company exceeded 10.0% of shareholders' equity as of June 30, 2014. 53 The following table presents the carrying value of available-for-sale securities, which are carried at fair value, and held-to-maturity securities, which are carried at amortized cost, at June 30, 2014 and December 31, 2013: June 30, December 31, (in thousands) 2014 2013 Available-for-sale securities Obligations of U.S. government agencies $ 19,387 $ - Obligations of state and political subdivisions 62,913 78,054 Government-sponsored agency: Collateralized mortgage obligations 35,627 34,799 Residential mortgage-backed securities 89,934 89,656 Corporate debt securities 437 407 Equity securities 966 951 Total $ 209,264 $ 203,867 Held-to-maturity securities Obligations of state and political subdivisions $ - $ 2,308 During the second quarter of 2014, the Company sold 18 of its state and municipal obligations with an aggregate amortized cost of $8.9 million, as well as 2 residential mortgage-backed securities with an aggregate carrying value of $17.2 million. Gross proceeds received totaled $27.5 million, with net gains of $1.5 million realized upon the sales and included in non-interest income. All 20 securities sold during the second quarter were categorized as available-for-sale. For the six months ended June 30, 2014, the aggregate amortized cost of the securities sold totaled $38.3 million. During the six months ended June 30, 2014, the Company sold its entire holdings of held-to-maturity securities comprised of four zero-coupon obligations of state and political subdivisions with an aggregate amortized cost of $2.3 million. Gross proceeds received from the sale of held-to-maturity securities were $2.7 million, with net gains of $0.4 million realized upon the sale. For the six months ended June 30, 2014, gross proceeds received from the sale of available-for-sale securities amounted to $35.9 million, with year-to-date net gains totaling $2.7 million included in non-interest income. The Company did not purchase any securities during the second quarter of 2014. Year-to-date security purchases totaled $37.1 million, included $18.3 million in home equity conversion mortgages of a U.S. government agency and $18.8 million of single-maturity bonds of U.S. government-sponsored agencies. 54 The following table presents the maturities of available-for-sale securities at June 30, 2014 and the weighted-average yields of such securities calculated on the basis of the cost and effective yields weighted for the scheduled maturity of each security: June 30, 2014 Collateralized Mortgage Obligations and Within > 1 - 5 6 - 10 Over Mortgage-Backed No Fixed (dollars in thousands) One Year Years Years 10 Years Securities (3) Maturity Total Available-for-sale securities Obligations of U.S. government agencies $ - $ - $ 19,387 $ - $ - $ - $ 19,387 Yield - - 2.65 % - - - 2.65 % Obligations of state and political subdivisions (1) 294 - 20,717 41,902 - - 62,913 Yield 6.51 % - 4.49 % 6.85 % - - 6.07 % Government-sponsored agencies: Collateralized mortgage obligations - - - - 35,627 - 35,627 Yield 2.51 % 2.51 % Residential mortgage-backed securities: - - - - 89,934 - 89,934 Yield 1.99 % 1.99 % Corporate debt securities - - - 437 - - 437 Yield 0.84 % 0.84 % Equity securities (2) - - - - - 966 966 Yield 3.31 % 3.31 % Total available-for-sale securities $ 294 $ - $ 40,104 $ 42,339 $ 125,561 $ 966 $ 209,264 Weighted yield 6.51 % 0.00 % 3.60 % 6.79 % 2.14 % 3.31 % 3.37 % (1) Yields on state and municipal securities have been adjusted to tax-equivalent yields using a 34.0% federal income tax rate. (2) Yield represents actual return for the three months ended June 30, 2014. (3) Collateralized mortgage obligations and residential mortgage-backed securities are not due at a single maturity date. Substantially all of the Company's securities portfolio is comprised of debt securities, specifically single-maturity bonds of U.S. government agencies, obligations of states and political subdivisions, and residential mortgage-backed securities, including home equity conversion mortgages, and collateralized mortgage obligations ("CMOs") of U.S. government-sponsored agencies. The Company held 34 securities that were in an unrealized loss position at June 30, 2014. Substantially all of the unrealized losses relate to debt securities. In determining whether unrealized losses are other-than-temporary, management considers the following factors: · The causes of the decline in fair value, such as credit deterioration, interest rate fluctuations, or market volatility; · The severity and duration of the decline; · Whether or not the Company expects to receive all contractual cash flows; · The Company's ability and intent to hold the security to allow for recovery in fair value, as well as the likelihood of such a recovery in the near term; · The Company's intent to sell the security, or if it is more likely than not that the Company will be required to sell the security, before recovery of its amortized cost basis, less any current-period credit loss. Management performed a review of the fair values of all securities at June 30, 2014 and determined that movements in the values of the securities were consistent with the change in market interest rates. As a result of its review and considering the attributes of these debt securities, the Company concluded that OTTI did not exist at June 30, 2014. To date, the Company has received all scheduled principal and interest payments and expects to fully collect all future contractual principal and interest payments. The Company does not intend to sell the securities nor is it more likely than not that the Company will be required to sell the securities. Management does not believe that any individual unrealized loss at June 30, 2014 represents OTTI. The unrealized losses reported for residential mortgage-backed securities and CMOs relate entirely to securities issued by GNMA, FHLMC and FNMA that are currently rated AAA by Moody's Investor Services or Aaa by Standard & Poor's and are guaranteed by the U.S. government. The obligations of state and political subdivisions are comprised entirely of general-purpose debt obligations. The majority of these obligations have a credit quality rating of A or better and are secured by the unlimited taxing power of the issuer. In addition, the Company utilized a third party to perform an independent credit analysis of its state and political subdivision bonds that were either non-rated or had a rating below A. There were two obligations of state and political subdivisions that were either non-rated or had a rating below A. However, according to the independent credit analysis, these two bonds were considered investment grade. Investments in FHLB and FRB stock, which have limited marketability, are carried at a cost of $5.7 million and $3.5 million at June 30, 2014 and December 31, 2013, respectively. FRB stock of $1.3 million is included in Other Assets at June 30, 2014 and December 31, 2013. Management noted no indicators of impairment for the FHLB of Pittsburgh and FRB of Philadelphia at June 30, 2014. 55 Loans During the first six months of 2014, the Company experienced increased demand for its lending products, as new loan originations exceeded maturities and payoffs. As a result, net loans increased $28.9 million, or 4.6%, to $658.8 million and represented 68.8% of total assets at June 30, 2014, from $629.9 million, or 62.7% of total assets, at December 31, 2013. Historically, commercial lending activities have represented a significant portion of the Company's loan portfolio. This includes commercial and industrial loans, commercial real estate loans and construction, land acquisition and development loans. From a collateral standpoint, a majority of the Company's loan portfolio consisted of loans secured by real estate. Real estate secured loans, which include commercial real estate, construction, land acquisition and development, residential real estate loans and home equity lines of credit ("HELOCs"), increased $23.3 million, or 6.0%, to $410.3 million at June 30, 2014 from $387.0 million at December 31, 2013. Real estate secured loans as a percentage of total gross loans increased to 61.2% at June 30, 2014 from 60.2% as of December 31, 2013. Commercial and industrial loans increased $3.4 million, or 2.7%, during the year to $130.4 million at June 30, 2014 from $127.0 million at December 31, 2013. Commercial and industrial loans consist primarily of equipment loans, working capital financing, revolving lines of credit and loans secured by cash and marketable securities. Loans secured by commercial real estate increased $16.1 million, or 7.3%, to $234.6 million at June 30, 2014 from $218.5 million at December 31, 2013. Commercial real estate loans include long-term commercial mortgage financing and are primarily secured by first or second lien mortgages. Construction, land acquisition and development loans decreased $0.5 million, or 2.1%, during the year to $23.9 million at June 30, 2014 from $24.4 million at December 31, 2013. The Company continues to monitor its exposure to this higher-risk portfolio segment. Residential real estate loans totaled $121.9 million at June 30, 2014, an increase of $7.0 million, or 6.1%, from $114.9 million at December 31, 2013. The components of residential real estate loans include fixed-rate and variable-rate mortgage loans. HELOCs are not included in this category but are included in consumer loans. The Company primarily underwrites fixed-rate purchase and refinance of residential mortgage loans for sale in the secondary market to reduce interest rate risk and provide funding for additional loans. However, as part of the Bank's current asset/liability management strategy, fixed-rate residential mortgage loans with maturity terms of 15 years or less that are eligible for sale on the secondary market are being retained in the portfolio. Consumer loans increased $1.2 million, or 1.0%, to $119.8 million at June 30, 2014, from $118.6 million at December 31, 2013. During the first quarter of 2014, the Company sold its education loan portfolio to a third party. This portfolio had a recorded investment of $2.6 million at the time of sale and the Company realized a loss of $13 thousand upon the sale, which is included in non-interest income in the consolidated statements of operations for the six months ended June 30, 2014. This portfolio was sold due to the low outstanding loan balance as related to the current servicing costs which reduced the yield on the portfolio to an unacceptable level. Loans to state and municipal governments decreased $0.1 million, or 0.2%, to $39.8 million at June 30, 2014 from $39.9 million at December 31, 2013. 56 The following table summarizes loans receivable, net by category at June 30, 2014 and December 31, 2013: June 30, December 31, (in thousands) 2014 2013 Residential real estate $ 121,922 $ 114,925 Commercial real estate 234,560 218,524 Construction, land acquisition, and development 23,858 24,382 Commercial and industrial loans 130,370 127,021 Consumer loans 119,854 118,645 State and political subdivisions 39,807 39,875 Total loans, gross 670,371 643,372 Unearned income (133 ) (143 )Net deferred loan fees and costs 739 668 Allowance for loan and lease losses (12,175 ) (14,017 ) Loans, net $ 658,802 $ 629,880 The Company considers an industry concentration within the loan portfolio to exist if the aggregate loan balance outstanding for that industry exceeds 25.0% of capital. The following table summarizes the concentrations within the Company's loan portfolio by industry at June 30, 2014 and December 31, 2013: June 30, 2014 December 31, 2013 % of % of (in thousands) Amount Gross Loans Amount Gross Loans Automobile dealers $ 21,206 3.16 % $ 18,467 2.87 % Office complexes/units 16,521 2.46 % 9,636 1.50 % Land subdivision 14,798 2.21 % 15,974 2.48 %Colleges and Universities 14,042 2.09 % 12,671 1.97 % Physicians 13,777 2.06 % 13,932 2.17 % Asset Quality Loans that management has the intent and ability to hold for the foreseeable future or until maturity or payoff are stated at the amount of unpaid principal, net of unearned interest, deferred loan fees and costs, and reduced by the ALLL. The ALLL is established through a provision for loan and lease losses charged to earnings. The Company has established and consistently applies loan policies and procedures designed to foster sound underwriting and credit monitoring practices. The Company manages credit risk through the efforts of loan officers, the loan review function, and the Loan Quality and the ALLL management committees, as well as oversight from the Board of Directors. The Company continually evaluates its credit risk management practices to ensure it is reacting to problems in the loan portfolio in a timely manner, although, as is the case with any financial institution, a certain degree of credit risk is dependent in part on local and general economic conditions that are beyondthe Company's control. Under the Company's risk rating system, loans that are rated pass/watch, special mention, substandard, doubtful, or loss are reviewed regularly as part of the Company's risk management practices. The Company's Loan Quality Committee, which consists of key members of senior management and credit administration, meets monthly or more often as necessary to review individual problem credits and workout strategies and provides monthly reports to the Board of Directors. 57 A loan is considered impaired when it is probable that the Bank will be unable to collect all amounts due (including principal and interest) according to the contractual terms of the note and loan agreement. For purposes of the Company's analysis, loans that are modified under a troubled debt restructuring ("TDRs"), loans rated substandard and non-accrual, and loans that are identified as doubtful or loss are considered impaired. Impaired loans are analyzed individually to determine the amount of impairment. The Company utilizes the fair value of collateral method for collateral-dependent loans. A loan is considered to be collateral dependent when repayment of the loan is expected to be provided through the liquidation of the collateral held. For impaired loans that are secured by real estate, external appraisals are obtained annually, or more frequently as warranted, to ascertain a fair value so that the impairment analysis can be updated. Should a current appraisal not be available at the time of impairment analysis, other sources of valuation may be used including, current letters of intent, broker price opinions or executed agreements of sale. For non-collateral- dependent loans, the Company measures impairment based on the present value of expected future cash flows, net of disposal costs, discounted at the loan's original effective interest rate. Loans to borrowers that are experiencing financial difficulty that are modified and result in the Company granting concessions to the borrower are classified as TDRs and are considered to be impaired. Such concessions generally involve an extension of a loan's stated maturity date, a reduction of the stated interest rate, payment modifications, capitalization of property taxes with respect to residential mortgage loans or a combination of these modifications. Non-accrual TDRs are returned to accrual status if principal and interest payments, under the modified terms, are brought current, are performing under the modified terms for six consecutive months, and management believes that collection of the remaining interest and principal is probable. Non-performing loans are monitored on an ongoing basis as part of the Company's loan review process. Additionally, work-out efforts continue and are actively monitored for non-performing loans and OREO through the Loan Quality Committee. A potential loss on a non-performing asset is generally determined by comparing the outstanding loan balance to the fair market value of the pledged collateral, less cost to sell. Loans are placed on non-accrual when a loan is specifically determined to be impaired or when management believes that the collection of interest or principal is doubtful. This generally occurs when a default of interest or principal has existed for 90 days or more, unless such loan is well secured and in the process of collection, or when management becomes aware of facts or circumstances that the loan would default before 90 days. The Company determines delinquency status based on the number of days since the date of the borrower's last required contractual loan payment. When the interest accrual is discontinued, all unpaid interest income is reversed and charged back against current earnings. Any subsequent cash payments received are applied, first to the outstanding loan amounts, then to the recovery of any charged-off loan amounts, with any excess treated as a recovery of lost interest. A non-accrual loan is returned to accrual status when the loan is current as to principal and interest payments, is performing according to contractual terms for six consecutive months and future payments are reasonably assured. Management actively manages impaired loans in an effort to reduce loan balances by working with customers to develop strategies to resolve borrower difficulties, through sale or liquidation of collateral, foreclosure, and other appropriate means. Real estate values in the Company's market area have appeared to stabilize. However, a weakening of economic and employment conditions could result in real estate devaluations, which could negatively impact asset quality and, accordingly, cause an increase in the provision for loan and lease losses. Under the fair value of collateral method, the impaired amount of the loan is deemed to be the difference between the loan amount and the fair value of the collateral, less the estimated costs to sell. For the Company's calculations for real estate secured loans, a factor of 10% is generally utilized to estimate costs to sell, which is based on typical cost factors, such as a 6% broker commission, 1% transfer taxes, and 3% various other miscellaneous costs associated with the sales process. If the valuation indicates that the fair value has deteriorated below the carrying value of the loan, either the entire loan is written off or the difference between the fair value and the principal balance is charged off. For impaired loans for which the value of the collateral less costs to sell exceeds the loan value, the impairment is considered tobe zero. 58 The following table presents non-performing loans, including non-performing TDRs, OREO and accruing TDRs at June 30, 2014 and December 31, 2013: June 30, December 31, (in thousands) 2014 2013 Non-accrual loans $ 5,550 $ 6,356Loans past due 90 days or more and still accruing - 19 Total non-performing loans 5,550 6,375 Other real estate owned 3,182 4,246Total non-performing loans and OREO $ 8,732 $ 10,621 Accruing TDRs $ 4,991 $ 3,995 Non-performing loans as a percentage of gross loans 0.83 % 0.99 % Management continues to manage problem credits through heightened work-out efforts on non-performing loans and disposing of its holdings of foreclosed properties. The Company's asset quality continued to improve during the first six months of 2014. Total non-performing loans and OREO decreased $1.9 million, or 17.8%, to $8.7 million at June 30, 2014 from $10.6 million at December 31, 2013. The Company's ratio of non-performing loans to total gross loans improved to 0.83% at June 30, 2014 from 0.99% at December 31, 2013, as management continued to reduce the balance of non-accrual loans. The Company's ratio of non-performing loans and OREO as a percentage of shareholders' equity decreased to 17.7% at June 30, 2014 from 31.6% at December 31, 2013. Despite the decrease, the percentage remains elevated and further deterioration in economic conditions could lead to additional increases in impaired loans. Accruing TDRs increased $1.0 million comparing June 30, 2014 to December 31, 2013. There were twelve loans modified as TDRs during the six months ended June 30, 2014, with an aggregate post-modification outstanding balance of $0.9 million. In addition, two TDRs with an aggregate outstanding balance of $0.1 million that were on non-accrual status at December 31, 2013 were transferred to accruing status during the six months ended June 30, 2014. New modifications during the six months ended June 30, 2014 included six residential real estate loans, four commercial real estate loans and two consumer loans. The terms of such modifications included one or a combination of extension of term, capitalization of real estate taxes or principal forbearance. The average balance of impaired loans was $9.3 million and $14.1 million for the six months ended June 30, 2014 and 2013, respectively. The Company received $52 thousand and $105 thousand of interest income on impaired loans for the three and six months ended June 30, 2014, respectively and $90 thousand and $194 thousand of interest income on impaired loans for the respective periods in 2013. The following table presents the changes in non-performing loans for the three and six months ended June 30, 2014 and 2013: Three Months Ended June 30, Six Months Ended June 30, (in thousands) 2014 2013 2014 2013 Balance, beginning of period $ 5,788 $ 8,832 $ 6,375 $ 9,709 Loans newly placed on non-accrual 540 691 1,037 1,315 Changes in loans past due 90 days or more and still accruing (32 ) 123 (19 ) 66 Loans transferred to OREO (10 ) (159 ) (10 ) (159 ) Loans charged-off (297 ) (426 ) (543 ) (972 )Loans returned to performing status (9 ) (79 ) (222 ) (152 ) Loan payments received (430 ) (653 ) (1,068 ) (1,478 ) Balance, end of period $ 5,550 $ 8,329 $ 5,550 $ 8,329 The additional interest income that would have been earned on non-accrual and restructured loans for the three and six months ended June 30, 2014 had the loans been performing in accordance with their original terms approximated $104 thousand and $207 thousand, respectively, and $189 thousand and $389 thousand for the respective three and six month periods of the prior year. 59 The following table presents accruing loan delinquencies and non-accrual loans as a percentage of gross loans at June 30, 2014 and December 31, 2013: June 30, December 31, 2014 2013 Accruing: 30-59 days 0.31 % 0.46 % 60-89 days 0.10 % 0.09 % 90+ days 0.00 % 0.00 % Non-accrual 0.83 % 0.99 % Total delinquencies 1.24 % 1.54 % The decrease in total delinquencies as a percentage of gross loans at June 30, 2014 was primarily due to the more rigorous collections of non-performing loans. In its evaluation of the ALLL, management considers a variety of qualitative factors, including changes in the volume and severity of delinquencies. Allowance for Loan and Lease Losses The ALLL represents management's estimate of probable loan losses inherent in the loan portfolio. The ALLL is analyzed in accordance with GAAP and is maintained at a level that is based on management's evaluation of the adequacy of the ALLL in relation to the risks inherent in the loan portfolio. As part of its evaluation, management considers qualitative and environmental factors, including, but not limited to: • Changes in national, local, and business economic conditions and developments, including the condition of various market segments; • Changes in the nature and volume of the Company's loan portfolio; • Changes in the Company's lending policies and procedures, including underwriting standards, collection, charge-off and recovery practices and results; • Changes in the experience, ability and depth of the Company's management and staff; • Changes in the quality of the Company's loan review system and the degree of oversight by the Company's Board of Directors; • Changes in the trend of the volume and severity of past due and classified loans, including trends in the volume of non-accrual loans, TDRs and other loan modifications; • The existence and effect of any concentrations of credit and changes in the level of such concentrations; • The effect of external factors such as competition and legal and regulatory requirements on the level of estimated credit losses in the Company's current loan portfolio; and • Analysis of its customers' credit quality, including knowledge of their operating environment and financial condition. Evaluations are intrinsically subjective, as the results are estimated based on management knowledge and experience and are subject to interpretation and modification as information becomes available or as future events occur. Management monitors the loan portfolio on an ongoing basis with emphasis on weakness in both the real estate market and the economy in general and its effect on repayment. Adjustments to the ALLL are made based on management's assessment of the factors noted above. For purposes of its analysis, all loan relationships with an aggregate balance greater than $100 thousand that are rated substandard and non-accrual, identified as doubtful or loss, and all TDRs are considered impaired and are analyzed individually to determine the amount of impairment. Circumstances such as construction delays, declining real estate values, and the inability of the borrowers to make scheduled payments have resulted in these loan relationships being classified as impaired. The Company utilizes the fair value of collateral method for collateral-dependent loans and TDRs for which repayment depends on the sale of collateral. For non-collateral-dependent loans and TDRs, the Company measures impairment based on the present value of expected future cash flows discounted at the loan's original effective interest rate. With regard to collateral-dependent loans, appraisals are received at least annually to ensure that impairment measurements reflect current market conditions. Should a current appraisal not be available at the time of impairment analysis, other valuation sources including current letters of intent, broker price opinions or executed agreements of sale may be used. Only downward adjustments are made based on these supporting values. Included in all impairment calculations is a cost to sell adjustment of approximately 10%, which is based on typical cost factors, including a 6% broker commission, 1% transfer taxes and 3% various other miscellaneous costs associated with the sales process. Sales costs are periodically revised based on actual experience. The ALLL analysis is adjusted for subsequent events that may arise after the end of the reporting period but before the financial reports are filed. 60 The Company's ALLL consists of both specific and general components. At June 30, 2014, the ALLL that related to impaired loans that are individually evaluated for impairment, the guidance for which is provided by ASC 310 "Impairment of a Loan" ("ASC 310"), was $360 thousand, or 3.0%, of the total ALLL. A general allocation of $11.8 million was calculated for loans analyzed collectively under ASC 450 "Contingencies" ("ASC 450"), which represented 97.0% of the total ALLL of $12.2 million. The ratio of the ALLL to total loans at June 30, 2014 and December 31, 2013 was 1.82% and 2.18%, respectively, based on total loans of $670.4 million and $643.4 million, respectively. The decrease in the ALLL as a percentage of total loans reflects asset quality improvements and lower levels of charge-offs than in the past, coupled with increased loan demand. See "Asset Quality" for further information. The following table presents an allocation of the ALLL and percentage of loans in each category at June 30, 2014 and December 31, 2013: Allocation of the Allowance for Loan Losses June 30, 2014 December 31, 2013 Percentage Percentage of Loans of Loans in Each in Each Category Category Allowance to Total Allowance to Total (in thousands) Amount Loans Amount Loans Residential real estate $ 2,112 18.19 % $ 2,287 17.86 % Commercial real estate 5,133 34.99 % 6,017 33.97 % Construction, land acquisition and development 923 3.56 % 924 3.79 % Commercial and industrial 1,758 19.44 % 2,321 19.74 % Consumer 1,681 17.88 % 1,789 18.44 %State and political subdivisions 568 5.94 % 679 6.20 % Total $ 12,175 100.00 % $ 14,017 100.00 % 61 The following table presents an analysis of the ALLL for the three and six months ended June 30, 2014 and 2013: Analysis of the Allowance for Loan and Lease Losses For the Three Months Ended June 30, For the Six Months Ended June 30, (dollars in thousands) 2014 2013 2014 2013Balance at beginning of period $ 12,589 $ 18,473 $ 14,017 $ 18,536 Charge-offs: Residential real estate 76 188 85 347 Commercial real estate - - - 48Construction, land acquisition and development - - - 110 Commercial and industrial 127 83 150 128 Consumer 130 165 367 359State and political subdivisions - - - - Total charge-offs 333 436 602 992 Recoveries of charged-off loans: Residential real estate 62 173 70 181 Commercial real estate 349 64 355 109 Construction, land acquisition and development 3,299 114 3,539 119 Commercial and industrial 63 69 126 1,585 Consumer 151 133 245 276State and political subdivisions - - - - Total recoveries 3,924 553 4,335 2,270 Net recoveries (3,591 ) (117 ) (3,733 ) (1,278 )Credit for loan and lease losses (4,005 ) (2 ) (5,575 ) (1,226 ) Balance at end of period $ 12,175 $ 18,588 $ 12,175 $ 18,588 Net recoveries during the period as a percentage of average loans outstanding during the period 0.54 % 0.02 % 0.57 % 0.21 % Allowance for loan and lease losses as a percentage of gross loans at end of period 1.82 % 2.90 % 1.82 % 2.90 % Other Real Estate Owned At June 30, 2014, OREO consisted of 20 properties with an aggregate carrying value of $3.2 million, a decrease of $1.0 million from $4.2 million at December 31, 2013. There was one property with an aggregate carrying value of $14 thousand foreclosed upon during the six months ended June 30, 2014. During the six months ended June 30, 2014, there were three sales and two partial sales of properties with an aggregate carrying value of $1.1 million. The Company realized net gains on the sale of these properties of $68 thousand, which is included in non-interest income. Due to a change in strategic purpose, the Company transferred the Stroudsburg office from bank premises and equipment to OREO for disposition during the six months ended June 30, 2014. The deposits and loans of this branch were sold to ESSA as part of the Branch Purchase Agreement. The Company retained this facility and was initially planning to use it for other bank-related purposes. This property with a carrying value of $1.7 million was written down to its appraised value less cost to sell of $0.8 million at the time of transfer. A valuation adjustment of $0.9 million, included in non-interest expense, was recorded at the time of transfer. In addition, there are four properties that have been held in OREO for a significant amount of time and are approaching the regulatory holding period threshold of five years. In an effort to aggressively dispose of these properties, management requested independent appraisals using a liquidation value basis for each of the properties. Accordingly, the Company incurred valuation adjustments to these four properties totaling $0.7 million for the six months ended June 30, 2014. Total valuation adjustments to the carrying value of OREO included in non-interest expense for the six months ended June 30, 2014 amounted to $1.8 million. The Company actively markets all OREO properties for sale through a variety of channels including internal marketing and the use of outside brokers/realtors. The carrying value of OREO is generally calculated at an amount not greater than 90% of the most recent fair market appraised value. A 10% factor is generally used to estimate costs to sell, which is based on typical cost factors, such as 6% broker commission, 1% transfer taxes, and 3% various other miscellaneous costs associated with the sales process. This market value is updated on an annual basis or more frequently if new valuation information is available. Further deterioration in the real estate market could result in additionallosses on these properties. 62 The following table presents the activity in OREO for the six months ended June 30, 2014 and 2013: Six Months Ended June 30, (in thousands) 2014 2013 Balance, January 1, $ 4,246 $ 3,983 Loans transferred to OREO 13 159 Bank premises transferred to OREO 1,749 - Valuation adjustments (1,770 ) (105 ) Carrying value of OREO sold (1,056 ) (1,259 ) Balance, June 30, $ 3,182 $ 2,778 The following schedule presents a breakdown of OREO at June 30, 2014 and December 31, 2013: June 30, December 31, (in thousands) 2014 2013 Land/lots $ 1,851 $ 3,549 Commercial real estate 1,290 647 Residential real estate 41 50Total other real estate owned $ 3,182 $ 4,246 Liabilities Total liabilities were $908.7 million at June 30, 2014, a decrease of $61.5 million, or 6.3%, from $970.2 million at December 31, 2013. The decrease is primarily attributable to the decrease in total deposits. Total deposits decreased $114.5 million, or 12.9%, to $770.2 million at June 30, 2014 as compared to $884.7 million at December 31, 2013. The decrease in deposits reflected cyclical deposit trends of the Company's municipal customers, the Monroe County branch divestures and continued runoff of certificates of deposit in the low interest rate environment. Specifically, non-interest-bearing demand deposits decreased $32.0 million, or 20.3%, while interest-bearing deposits declined $82.5 million, or 11.3%. Borrowed funds increased by $50.3 million, or 80.5%, to $112.7 million at June 30, 2014 as compared to $62.4 million at December 31, 2013. Equity Total shareholders' equity increased $15.6 million, or 46.5%, to $49.2 million at June 30, 2014 from $33.6 million at December 31, 2013. Net income for the six months ended June 30, 2014 of $10.1 million and a $5.5 million increase in accumulated other comprehensive income were the primary factors leading to the capital improvement. The increase in accumulated other comprehensive income was primarily attributed to appreciation in the fair value of securities held in the available-for-sale portfolio. Book value per common share was $2.99 at June 30, 2014 compared to $2.04 at December 31, 2013. At June 30, 2014, the Bank's total risk-based capital and Tier I leverage ratios were 14.74% and 9.62%, respectively, which exceed the respective 13.00% and 9.00% ratios requiredby the OCC Consent Order. 63 Liquidity The term liquidity refers to the ability of the Company to generate sufficient amounts of cash to meet its cash flow needs. Liquidity is required to fulfill the borrowing needs of the Company's credit customers and the withdrawal and maturity requirements of its deposit customers, as well as to meet other financial commitments. The Company's liquidity position is impacted by several factors, which include, among others, loan origination volumes, loan and investment maturity structure and cash flows, deposit demand and certificate of deposit maturity structure and retention. The Company has liquidity and contingent funding policies in place that are designed with controls in place to provide advanced detection of potentially significant funding shortfalls, establish methods for assessing and monitoring risk levels, and institute prompt responses that may alleviate a potential liquidity crisis. Management monitors the Company's liquidity position and fluctuations daily so that the Company can adapt accordingly to market influences and balance sheet trends. Management also forecasts liquidity needs and develops strategies to ensure adequate liquidity at all times. The Company's statements of cash flows present the change in cash and cash equivalents from operating, investing and financing activities. Cash and due from banks and interest-bearing deposits in other banks are the Company's most liquid assets. At June 30, 2014, cash and cash equivalents totaled $30.6 million, a decrease of $73.0 million from $103.6 million at December 31, 2013. Cash outlays for investing and financing activities used $14.8 million and $63.8 million, respectively, of cash and cash equivalents during the six months ended June 30, 2014. The $14.8 million in cash used in investing activities resulted primarily from a net increase in loans to customers of $25.8 million. Partially offsetting this cash outflow, were proceeds received from sales, maturities, calls and principal reductions from securities, net of purchases of securities, of $7.7 million and proceeds received from the sale of OREO and bank premises and equipment of $1.1 million and $2.5 million, respectively. The $63.8 million used in financing activities resulted from a $114.1 million net decrease in deposits, partially offset by proceeds from FHLB advances, net of repayments, of $50.3 million. Despite the decrease in cash and cash equivalents, management believes that the Company's liquidity position is sufficient to meet its cash flow needs as of June 30, 2014. The decrease in total deposits reflected cyclical deposit trends of the Company's municipal customers and the anticipated runoff of certificates of deposit with above market interest rates. The majority of this runoff was concentrated in certificates of deposit obtained through a national listing service. Management, in accordance with the Company's current asset/liability strategy decided to replace these certificates with short-term, lower-costing advances from the FHLB of Pittsburgh. Advances from the FHLB of Pittsburgh totaled $90.0 million for the six months ended June 30, 2014. These advances had a weighted average maturity of 0.9 years and a weighted-average interest rate of 0.44%. The Company made repayments of advances to the FHLB of Pittsburgh amounting to $39.7 million during the six months ended June 30, 2014. At June 30, 2014, the Company had available borrowing capacity with the FHLB of Pittsburgh of $162.0 million. Interest Rate Risk Interest Rate Sensitivity Market risk is the risk to earnings and/or financial position resulting from adverse changes in market rates or prices, such as interest rates, foreign exchange rates or equity prices. The Company's exposure to market risk is primarily interest rate risk associated with our lending, investing and deposit gathering activities, all of which are other than trading. Changes in interest rates affect earnings by changing net interest income and the level of other interest-sensitive income and operating expenses. In addition, variations in interest rates affect the underlying economic value of our assets, liabilities and off-balance sheet items. Asset and Liability Management The Company manages these objectives through its Asset and Liability Management Committee ("ALCO") and its Rate and Liquidity and Investment Committees, which consist of the members of senior management and certain members of the finance department. Members of the committees meet regularly to develop balance sheet strategies affecting the future level of net interest income, liquidity and capital. The major objectives of ALCO are to: · Manage exposure to changes in the interest rate environment by limiting the changes in net interest margin to an acceptable level within a reasonable range of interest rates; · Ensure adequate liquidity and funding; · Maintain a strong capital base; and · Maximize net interest income opportunities. ALCO monitors the Company's exposure to changes in net interest income over both a one-year planning horizon and a longer-term strategic horizon. ALCO uses net interest income simulations and economic value of equity ("EVE") simulations as the primary tools in measuring and managing the Company's position and considers balance sheet forecasts, the Company's liquidity position, the economic environment, anticipated direction of interest rates and the Company's earnings sensitivity to changes in these rates in its modeling. In addition, ALCO has established policy tolerance limits for acceptable negative changes in net interest income. Furthermore, as part of its ongoing monitoring, ALCO has been enhanced to require periodic back testing of modeling results, which involves after-the-fact comparisons of projections with the Company's actual performance to measure the validity of assumptions used in the modeling techniques. 64 Earnings at Risk and Economic Value at Risk Simulations Earnings at Risk Earnings-at-risk simulation measures the change in net interest income and net income under various interest rate scenarios. Specifically, given the current market rates, ALCO looks at "earnings at risk" to determine anticipated changes in net interest income from a base case scenario with scenarios of + 200/-100 basis points changes to interest rates. The simulation takes into consideration that not all assets and liabilities re-price equally and simultaneously with market rates (i.e., savings rate). Economic Value at Risk While earnings-at-risk simulation measures the short-term risk in the balance sheet, economic value (or portfolio equity) at risk measures the long-term risk by finding the net present value of the future cash flows from the Company's existing assets and liabilities. ALCO examines this ratio regularly, and given the current rate environment, has utilized rate shocks of +200/- 100 basis points for simulation purposes. Management recognizes that, in some instances, this ratio may contradict the "earnings at risk" ratio. While ALCO regularly performs a wide variety of simulations under various strategic balance sheet and treasury yield curve scenarios, the following results reflect the Company's sensitivity over the subsequent twelve months based on the following assumptions: · Asset and liability levels using June 30, 2014 as a starting point; · Cash flows are based on contractual maturity and amortization schedules with applicable prepayments derived from internal historical data and external sources; and · Cash flows are reinvested into similar instruments so as to keep interest-earning asset and interest-bearing liability levels constant. The following table illustrates the simulated impact of a 200 basis point upward and a 100 basis point downward movement in interest rates on net interest income and the change in economic value. The impact of the rate movements were developed by simulating the effect of rates changing over a twelve-month period from the June 30, 2014 levels. Policy Rates + 200 Rates -100 Limits Earnings at risk: Percent change in net interest income 1.5 % (0.5 )% (10.0)%/(5.0 )% Economic value at risk: Percent change in economic value of equity (6.3 )% (3.7 )% (20.0)%/(10.0 )% Under the model, the Company's net interest income is expected to increase 1.5%, while the Company's economic value of equity is expected to decrease 6.3%, under a 200 basis point upward movement in interest rates. The anticipated increase in net interest income reflects the composition of the Company's loan portfolio, which is comprised of a significant balance of variable-rate loans, which will re-price immediately or in the near term. In comparison, results for a similar model for the year ended December 31, 2013 simulated a 3.9% increase in net interest income under a 200 basis point upward movement in interest rates. This analysis does not represent a Company forecast and should not be relied upon as being indicative of expected operating results. These simulations are based on numerous assumptions: the nature and timing of interest rate levels, prepayments on loans and securities, deposit decay rates, pricing decisions on loans and deposits, reinvestment/replacements of asset and liability cash flows, and other factors. While assumptions reflect current economic and local market conditions, the Company cannot make any assurances as to the predictive nature of these assumptions, including changes in interest rates, customer preferences, competition and liquidity needs, or what actions ALCO might take in responding to these changes. Off-Balance Sheet Arrangements In the normal course of operations, the Company engages in a variety of financial transactions that, in accordance with U.S. GAAP, are not recorded in our consolidated financial statements, or are recorded in amounts that differ from the notional amounts. These transactions involve, to varying degrees, elements of credit, interest rate and liquidity risk. Such transactions are used for general corporate purposes or for customer needs. Corporate purpose transactions are used to help manage credit, interest rate and liquidity risk or to optimize capital. Customer transactions are used to manage customers' requests for funding. 65 For the three- and six-month periods ended June 30, 2014, the Company did not engage in any off-balance sheet transactions that would have or would be reasonably likely to have a material effect on its consolidated financial condition. |