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FIRST CONNECTICUT BANCORP, INC. - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) Forward-Looking Statements This Form 10-Q contains "forward-looking statements." You can identify these forward-looking statements through our use of words such as "may," "will," "anticipate," "assume," "should," "indicate," "would," "believe," "contemplate," "expect," "estimate," "continue," "plan," "project," "could," "intend," "target" and other similar words and expressions of the future. These forward-looking statements include, but are not limited to: ? statements of our goals, intentions and expectations; ? statements regarding our business plans, prospects, growth and operating strategies; ? statements regarding the asset quality of our loan and investment portfolios; and ? estimates of our risks and future costs and benefits. These forward-looking statements are based on current beliefs and expectations of our management and are inherently subject to significant business, economic and competitive uncertainties and contingencies, many of which are beyond our control. In addition, these forward-looking statements are subject to assumptions with respect to future business strategies and decisions that are subject to change. The following factors, among others, could cause actual results to differ materially from the anticipated results or other expectations expressed in the forward-looking statements: ? Local, regional and national business or economic conditions may differ from those expected. ? The effects of and changes in trade, monetary and fiscal policies and laws, including the U.S. Federal Reserve Board's interest rate policies, may adversely affect our business. ? The ability to increase market share and control expenses may be more difficult than anticipated. Changes in laws and regulatory requirements (including those concerning ? taxes, banking, securities and insurance) may adversely affect us or our business. ? Changes in accounting policies and practices, as may be adopted by regulatory agencies, the Public Company Accounting Oversight Board or the Financial Accounting Standards Board, may affect expected financial reporting. ? Future changes in interest rates may reduce our profits which could have a negative impact on the value of our stock. ? We are subject to lending risk and could incur losses in our loan portfolio despite our underwriting practices. Changes in real estate values could also increase our lending risk. ? Changes in demand for loan products, financial products and deposit flow could impact our financial performance. ? Strong competition within our market area may limit our growth and profitability. ? If our allowance for loan losses is not sufficient to cover actual loan losses, our earnings could decrease. ? Our stock value may be negatively affected by federal regulations and articles of incorporation provisions restricting takeovers. ? Implementation of stock benefit plans will increase our costs, which will reduce our income. 49 ? The Dodd-Frank Act was signed into law on July 21, 2010 and has resulted in dramatic regulatory changes that affects the industry in general, and may impact our competitive position in ways that cannot be predicted at this time. ? The Emergency Economic Stabilization Act ("EESA") of 2008 has and may continue to have a significant impact on the banking industry. ? The increased cost of maintaining or the Company's ability to maintain adequate liquidity and capital, based on the requirements adopted by the Basel Committee on Banking Supervision and U.S. regulators. ? Changes to the amount and timing of proposed common stock repurchases. ? Computer systems on which we depend could fail or experience a security breach, implementation of new technologies may not be successful; and our ability to anticipate and respond to technological changes can affect our ability to meet customer needs. ? We may not manage the risks involved in the foregoing as well as anticipated. Any forward-looking statements made by or on behalf of us in this Form 10-Q speak only as of the date of this Form 10-Q. We do not undertake to update forward-looking statements to reflect the impact of circumstances or events that arise after the date the forward-looking statement was made. The reader should, however, consider any further disclosures of a forward-looking nature we may make in future filings. The Company wishes to advise readers that the factors listed above could affect the Company's financial performance and could cause the Company's actual results for future periods to differ materially from any opinions or statements expressed with respect to future periods in any current statements. General Established in 1851, Farmington Bank is a full-service, community bank with 22 full service branch offices and 4 limited services offices, including our main office, located throughout Hartford County, Connecticut. Farmington Bank provides a diverse range of commercial and consumer services to businesses, individuals and governments across central Connecticut and western Massachusetts. Our business strategy is to operate as a well-capitalized and profitable community bank for businesses, individuals and local governments, with an ongoing commitment to provide quality customer service. ? Maintaining a strong capital position in excess of the well-capitalized standards set by our banking regulators to support our current operations and future growth. The FDIC's requirement for a "well-capitalized" bank is a total risk-based capital ratio of 10.0% or greater. As of September 30, 2014 our total risk-based capital ratio was 14.11%. ? Increasing our focus on commercial lending and continuing to expand commercial banking operations. We will continue to focus on commercial lending and the origination of commercial loans using prudent lending standards. We plan to continue to grow our commercial lending portfolio, while enhancing our complementary business products and services. ? Continuing to focus on residential and consumer lending in conjunction with our secondary market residential lending program. We offer traditional residential and consumer lending products and plan to continue to build a strong residential and consumer lending program that supports our secondary market residential lending program. Under our expanding secondary market residential lending program, we may sell a portion of our fixed rate residential originations while retaining the loan servicing function and mitigating our interest rate risk. ? Maintaining asset quality and prudent lending standards. We will continue to originate all loans utilizing prudent lending standards in an effort to maintain strong asset quality. We continue to diligently manage our collection function to minimize loan losses and non-performing assets. We will continue to employ sound risk management practices as we continue to expand our lending portfolio. 50 ? Expanding our existing products and services and developing new products and services to meet the changing needs of consumers and businesses in our market area. We will continue to evaluate our consumer and business customers' needs to ensure that we continue to offer relevant, up-to-date products and services. ? Continuing to control non-interest expenses. As part of our strategic plan, we have implemented several programs designed to control costs. We monitor our expense ratios and plan to reduce our efficiency ratio by controlling expenses and increasing net interest income and noninterest income. We plan to continue to evaluate and improve the effectiveness of our business processes and our efficiency, utilizing information technology when possible. ? Taking advantage of acquisition opportunities that are consistent with our strategic growth plans. We intend to continue to evaluate opportunities to acquire other financial institutions and financial service related businesses in our current market area or contiguous market areas that will enable us to enhance our existing products and services and develop new products and services. We have no specific plans, agreements or understandings with respect to any expansion or acquisition opportunities. Critical Accounting Policies The accounting policies followed by us conform with the accounting principles generally accepted in the United States of America. Critical accounting policies are defined as those that are reflective of significant judgments and uncertainties, and could potentially result in materially different results under different assumptions and conditions. We believe that our most critical accounting policies, which involve the most complex subjective decisions or assessments, relate to allowance for loan losses, other-than-temporary impairment of investment securities, income taxes and pension and other post-retirement benefits. The following is a description of our critical accounting policies and an explanation of the methods and assumptions underlying their application. Allowance for Loan Losses: The allowance for loan losses is maintained at a level believed adequate by management to absorb potential losses inherent in the loan portfolio as of the statement of condition date. The allowance for loan losses consists of a formula allowance following FASB ASC 450 - Contingencies and FASB ASC 310 - Receivables. The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance. The allowance for loan losses is evaluated on a regular basis by management. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available. The allowance consists of general, allocated and unallocated components, as further described below. All reserves are available to cover any losses regardlessof how they are allocated. General component: The general component of the allowance for loan losses is based on historical loss experience adjusted for qualitative factors stratified by the following loan segments: residential real estate, commercial real estate, construction, installment, commercial, collateral, home equity line of credit, demand, revolving credit and resort. Construction loans include classes for commercial investment real estate construction, commercial owner occupied construction, residential development, residential subdivision construction and residential owner occupied construction loans. Management uses a rolling average of historical losses based on a time frame appropriate to capture relevant loss data for each loan segment. This historical loss factor is adjusted for the following qualitative factors: levels/trends in delinquencies and nonaccrual loans; trends in volume and terms of loans; effects of changes in risk selection and underwriting standards and other changes in lending policies, procedures and practices; experience/ability/depth of lending management and staff; and national and local economic trends and conditions. There were no material changes in the Company's policies or methodology pertaining to the general component of the allowance for loan losses during the nine months ended September 30, 2014. 51 The qualitative factors are determined based on the various risk characteristics of each loan segment. Risk characteristics relevant to each portfolio segment are as follows: Residential real estate - Residential real estate loans are generally originated in amounts up to 95.0% of the lesser of the appraised value or purchase price of the property, with private mortgage insurance required on loans with a loan-to-value ratio in excess of 80.0%. The Company does not grant subprime loans. All loans in this segment are collateralized by owner-occupied residential real estate and repayment is dependent on the credit quality of the individual borrower. Typically, all fixed-rate residential mortgage loans are underwritten pursuant to secondary market underwriting guidelines which include minimum FICO standards. The overall health of the economy, including unemployment rates and housing prices, will have an effect on the credit quality in this segment. Commercial real estate - Loans in this segment are primarily income-producing properties throughout New England. The underlying cash flows generated by the properties may be adversely impacted by a downturn in the economy as evidenced by increased vacancy rates, which in turn, may have an effect on the credit quality in this segment. Management generally obtains rent rolls and other financial information, as appropriate on an annual basis and continually monitors the cash flows of these loans. Construction loans - Loans in this segment include commercial construction loans, real estate subdivision development loans to developers, licensed contractors and builders for the construction and development of commercial real estate projects and residential properties. Construction lending contains a unique risk characteristic as loans are originated under market and economic conditions that may change between the time of origination and the completion and subsequent purchaser financing of the property. In addition, construction subdivision loans and commercial and residential construction loans to contractors and developers entail additional risks as compared to single-family residential mortgage lending to owner-occupants. These loans typically involve large loan balances concentrated in single borrowers or groups of related borrowers. Real estate subdivision development loans to developers, licensed contractors and builders are generally speculative real estate development loans for which payment is derived from sale of the property. Credit risk may be affected by cost overruns, time to sell at an adequate price, and market conditions. Construction financing is generally considered to involve a higher degree of credit risk than longer-term financing on improved, owner-occupied real estate. Residential construction credit quality may be impacted by the overall health of the economy, including unemployment rates and housing prices. Installment, Collateral, Demand and Revolving Credit - Loans in these segments include installment, demand, revolving credit and collateral loans, principally to customers residing in our primary market area with acceptable credit ratings. Our installment and collateral consumer loans generally consist of loans on new and used automobiles, loans collateralized by deposit accounts and unsecured personal loans. The overall health of the economy, including unemployment rates and housing prices, may have an effect on the credit quality in this segment. Excluding collateral loans which are fully collateralized by a deposit account, repayment for loans in these segments is dependent on the credit quality of the individual borrower. Commercial - Loans in this segment are made to businesses and are generally secured by assets of the business. Repayment is expected from the cash flows of the business. A weakened economy, and resultant decreased consumer spending, will have an effect on the credit quality in this segment. Home equity line of credit - Loans in this segment include home equity loans and lines of credit underwritten with a loan-to-value ratio generally limited to no more than 80.0%, including any first mortgage. Our home equity lines of credit have ten-year terms and adjustable rates of interest which are indexed to the prime rate. The overall health of the economy, including unemployment rates and housing prices, may have an effect on the credit quality in this segment. Resort - The remaining portfolio consists of direct receivable loans outside the Northeast which are amortizing to their contractual obligations. The Company has exited the resort financing market with a residual portfolio remaining. Allocated component: The allocated component relates to loans that are classified as impaired. Impairment is measured on a loan by loan basis for commercial real estate, construction, commercial and resort loans by the present value of expected cash flows discounted at the effective interest rate; the fair value of the collateral, if applicable; or the observable market price for the loan. An allowance is established when the discounted cash flows (or collateral value) of the impaired loan is lower than the carrying value of that loan. The Company does not separately identify individual consumer and residential real estate loans for impairment disclosures, unless such loans are subject to a troubled debt restructuring agreement or they are nonaccrual loans with outstanding balances greater than $100,000. 52 A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower's prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan-by-loan basis for commercial and construction loans by the present value of expected future cash flows discounted at the loan's effective interest rate, the loan's obtainable market price or the fair value of the collateral if the loan is collateral dependent. Management updates the analysis quarterly. The assumptions used in appraisals are reviewed for appropriateness. Updated appraisals or valuations are obtained as needed or adjusted to reflect the estimated decline in the fair value based upon current market conditions for comparable properties. The Company periodically may agree to modify the contractual terms of loans. When a loan is modified and a concession is made to a borrower experiencing financial difficulty, the modification is considered a troubled debt restructuring ("TDR"). All TDRs are classified as impaired. Unallocated component: An unallocated component is maintained, when needed, to cover uncertainties that could affect management's estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating allocated and general reserves in the portfolio. The Company's Loan Policy allows management to utilize a high and low range of 0.0% to 5.0% of our total allowance for loan losses when establishing an unallocated allowance, when considered necessary. The unallocated allowance is used to provide for an unidentified loss that may exist in emerging problem loans that cannot be fully quantified or may be affected by conditions not fully understood as of the balance sheet date. There was no unallocated allowances at September 30, 2014 and December 31, 2013. Other-than-Temporary Impairment of Securities: In accordance with Financial Accounting Standards Board ("FASB") Accounting Standards Codification ("FASB ASC") 320-Debt and Equity Securities, a decline in market value of a debt security below amortized cost that is deemed other-than-temporary is charged to earnings for the credit related other-than-temporary impairment ("OTTI") resulting in the establishment of a new cost basis for the security, while the non-credit related OTTI is recognized in other comprehensive income if there is no intent or requirement to sell the security. Management reviews the securities portfolio on a quarterly basis for the presence of OTTI. An assessment is made as to whether the decline in value results from company-specific events, industry developments, general economic conditions, credit losses on debt or other reasons. After the reasons for the decline are identified, further judgments are required as to whether those conditions are likely to reverse and, if so, whether that reversal is likely to result in a recovery of the fair value of the investment in the near term. If it is judged not to be near-term, a charge is taken which results in a new cost basis. Credit related OTTI for debt securities is recognized in earnings while non-credit related OTTI is recognized in other comprehensive income if there is no intent to sell or will not be required to sell the security. If an equity security is deemed other-than-temporarily impaired, the full impairment is considered to be credit-related and a charge to earnings would be recorded. Management believes the policy for evaluating securities for other-than-temporary impairment is critical because it involves significant judgments by management and could have a material impact on our net income. Gains and losses on sales of securities are recognized at the time of sale on a specific identification basis. Marketable equity and debt securities are classified as either trading, available-for-sale, or held-to-maturity (applies only to debt securities). Management determines the appropriate classifications of securities at the time of purchase. At September 30, 2014 and December 31, 2013, we had no debt or equity securities classified as trading. Held-to-maturity securities are debt securities for which we have the ability and intent to hold until maturity. All other securities not included in held-to-maturity are classified as available-for-sale. Held-to-maturity securities are recorded at amortized cost, adjusted for the amortization or accretion of premiums or discounts. Available-for-sale securities are recorded at fair value. Unrealized gains and losses, net of the related tax effect, on available-for-sale securities are excluded from earnings and are reported in accumulated other comprehensive income, a separate component of equity, until realized. Premiums and discounts on debt securities are amortized or accreted into interest income over the term of the securities using the level yield method. 53 Income Taxes: Deferred income taxes are provided for differences arising in the timing of income and expenses for financial reporting and for income tax purposes. Deferred income taxes and tax benefits are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. We provide a deferred tax asset valuation allowance for the estimated future tax effects attributable to temporary differences and carryforwards when realization is determined not to be more likely than not. FASB ASC 740-10, "Accounting for Uncertainty in Income Taxes", prescribes a recognition threshold that a tax position is required to meet before being recognized in the financial statements and provides guidance on derecognition, measurement, classification, interest and penalties, accounting in interim periods, disclosure and transition issues. Pursuant to FASB ASC 740-10, we examine our financial statements, our income tax provision and our federal and state income tax returns and analyze our tax positions, including permanent and temporary differences, as well as the major components of income and expense, to determine whether a tax benefit is more likely than not to be sustained upon examination by tax authorities. We recognize interest and penalties arising from income tax settlements as part of our provision for income taxes. As part of the Plan of Conversion and Reorganization completed on June 29, 2011, the Company contributed shares of Company common stock to the Farmington Bank Community Foundation, Inc. This contribution resulted in a charitable contribution deduction for federal income tax purposes. Use of that charitable contribution deduction is limited under Federal tax law to 10% of federal taxable income without regard to charitable contributions, net operating losses, and dividend received deductions. Annually, a corporation is permitted to carry over to the five succeeding tax years, contributions that exceeded the 10% limitation, but also subject to the maximum annual limitation. As a result, approximately $5.9 million of charitable contribution carryforward remains at September 30, 2014 resulting in a deferred tax asset of approximately $2.0 million. The Company believes it is more likely that not that this carryforward will be utilized before expiration in 2016. Therefore, no valuation allowance has been recorded against this deferred tax asset. Some of this charitable contribution carryforward could expire unutilized if the Company does not generate sufficient taxable income over the next three years. The Company monitors the need for a valuation allowance on a quarterly basis. In December 1999, we created and have since maintained a "passive investment company" ("PIC"), as permitted by Connecticut law. At September 30, 2014 there were no material uncertain tax positions related to federal and state income tax matters. We are currently open to audit under the statute of limitations by the Internal Revenue Service and state taxing authorities for the years ended December 31, 2010 through 2013. If the state taxing authority were to determine that the PIC was not in compliance with statutory requirements, a material amount of taxes could be due. As of September 30, 2014, management believes it is more likely than not that the deferred tax assets will be realized through future reversals of existing taxable temporary differences. As of September 30, 2014, our net deferred tax asset was $14.5 million and there was no valuation allowance. Pension and Other Postretirement Benefits: On December 27, 2012, the Company announced it froze the non-contributory defined-benefit pension plan and certain other postretirement benefit plans as of February 28, 2013. All benefits under these plans were frozen as of that date and no additional benefits accrued. We have a noncontributory defined benefit pension plan that provides benefits for substantially all employees hired before January 1, 2007 who meet certain requirements as to age and length of service. The benefits are based on years of service and average compensation, as defined in the Plan Document. Our funding policy is to contribute annually the maximum amount that could be deducted for federal income tax purposes, while meeting the minimum funding standards established by the Employee Retirement Security Act of 1974. In addition to providing pension benefits, we provide certain health care and life insurance benefits for retired employees. Participants or eligible employees hired before January 1, 1993 become eligible for the benefits if they retire after reaching age 62 with fifteen or more years of service. A fixed percent of annual costs are paid depending on length of service at retirement. We accrue for the estimated costs of these other post-retirement benefits through charges to expense during the years that employees render service. We make contributions to cover the current benefits paid under this plan. Management believes the policy for determining pension and other post-retirement benefit expenses is critical because judgments are required with respect to the appropriate discount rate, rate of return on assets, salary increases and other items. Management reviews and updates the assumptions annually. If our estimate of pension and post-retirement expense is too low we may experience higher expenses in the future, reducing our net income. If our estimate is too high, we may experience lower expenses in the future, increasing our net income. 54 Comparison of Financial Condition at September 30, 2014 and December 31, 2013 Our total assets increased $285.6 million or 13.5%, to $2.4 billion at September 30, 2014, from $2.1 billion at December 31, 2013, primarily due to an increase of $230.8 million in loans and $43.3 million in securities available-for-sale. Our investment portfolio totaled $207.1 million or 8.6% of total assets, and $163.9 million or 7.8% of total assets at September 30, 2014 and December 31, 2013, respectively. The Company purchases short term U.S. Treasury and agency securities in order to meet municipal and repurchase agreement pledge requirements and to minimize interest rate risk during the sustained low interest rate environment. Net loans increased $230.8 million or 12.8% at September 30, 2014 to $2.0 billion compared to December 31, 2013 primarily driven by increases in commercial and residential real estate. The allowance for loan losses increased $242,000 to $18.6 million at September 30, 2014 from $18.3 million at December 31, 2013. At September 30, 2014, the allowance for loan losses represented 0.91% of total loans and 119.91% of non-accrual loans, compared to 1.01% of total loans and 123.74% of non-accrual loans as of December 31, 2013. Total liabilities increased $284.2 million, to $2.2 billion at September 30, 2014 compared to $1.9 billion at December 31, 2013, primarily due to an increase in deposits, FHLBB advances and repurchase liabilities. Deposits increased $214.5 million or 14.2% to $1.7 billion at September 30, 2014 due to increases in municipal deposits, checking accounts and de novo branch openings as we continue to develop and grow relationships in the geographical areas we serve. Federal Home Loan Bank of Boston advances increased $45.7 million to $304.7 million at September 30, 2014 from $259.0 million at December 31, 2013 as we funded our organic loan and securities growth with FHLBB advances and deposits. Repurchase liabilities increased $23.0 million to $73.9 million at September 30, 2014 from $50.8 million at December 31, 2013 primarily due to fluctuations in cash flows in business checking customers using our repurchase agreement product where excess funds are swept daily into a collateralized account. Stockholders' equity increased $1.4 million to $233.6 million at September 30, 2014 compared to December 31, 2013. The Company repurchased 387,505 shares of common stock at an average price per share of $15.52 at a cost of $6.0 million. The Company paid cash dividends totaling $1.9 million or $0.12 per share during the nine months ended September 30, 2014. Repurchased shares are held as treasury stock and are available for general corporate purposes. 55 Net Interest Income Analysis: Average Balance Sheets, Interest and Yields/Costs The following tables present the average balance sheets, average yields and costs and certain other information for the years indicated therein. No tax-equivalent yield adjustments were made, as the effect thereof was not material. All average balances are daily average balances. Non-accrual loans and loans held for sale were included in the computation of average loan balances. The yields set forth below include the effect of net deferred costs and premiums that are amortized to interest income or expense. For The Three Months Ended September 30, 2014 September 30, 2013 Average Interest and Yield/ Average Interest and Yield/ Balance Dividends Cost Balance Dividends Cost (Dollars in thousands) Interest-earning assets: Loans, net $ 1,978,854 $ 18,098 3.63 % $ 1,648,948 $ 15,580 3.75 % Securities 189,246 369 0.77 % 131,602 216 0.65 %Federal Home Loan Bank of Boston stock 17,724 55 1.23 % 8,383 8 0.38 % Federal funds and other interest-earning assets 4,918 6 0.48 % 3,288 2 0.24 % Total interest-earning assets 2,190,742 18,528 3.36 % 1,792,221 15,806 3.50 % Noninterest-earning assets 124,823 122,886 Total assets $ 2,315,565 $ 1,915,107 Interest-bearing liabilities: NOW accounts $ 436,303 $ 313 0.28 % $ 303,882 $ 180 0.24 % Money market 406,293 748 0.73 % 371,614 794 0.85 % Savings accounts 199,505 57 0.11 % 185,732 79 0.17 % Certificates of deposit 330,496 727 0.87 % 356,994 861 0.96 %Total interest-bearing deposits 1,372,597 1,845 0.53 % 1,218,222 1,914 0.62 % Federal Home Loan Bank of Boston advances 270,250 479 0.70 % 74,101 383 2.05 % Repurchase agreement borrowings 21,000 182 3.44 % 21,000 181 3.42 % Repurchase liabilities 59,624 37 0.25 % 57,187 45 0.31 %Total interest-bearing liabilities 1,723,471 2,543 0.59 % 1,370,510 2,523 0.73 % Noninterest-bearing deposits 321,008 272,621Other noninterest-bearing liabilities 36,482 39,772 Total liabilities 2,080,961 1,682,903 Stockholders' equity 234,604 232,204Total liabilities and stockholders' equity $ 2,315,565 $ 1,915,107 Net interest income $ 15,985 $ 13,283 Net interest rate spread (1) 2.77 % 2.77 %Net interest-earning assets (2) $ 467,271 $ 421,711 Net interest margin (3) 2.89 % 2.94 % Average interest-earning assets to average interest- bearing liabilities 127.11 % 130.77 % (1) Net interest rate spread represents the difference between the yield on average interest-earning assets and the cost of average interest-bearing liabilities. (2) Net interest-earning assets represent total interest-earning assets less total interest-bearing liabilities. (3) Net interest margin represents net interest income divided by average total interest-earning assets. 56 Rate Volume Analysis The following table sets forth the effects of changing rates and volumes on net interest income for the periods indicated. The rate column shows the effects attributable to changes in rate (changes in rate multiplied by prior volume). The volume column shows the effects attributable to changes in volume (changes in volume multiplied by prior rate). The total column represents the sum of the volume and rate columns. For purposes of this table, changes attributable to both rate and volume that cannot be segregated have been allocated proportionately based on the changes due to rate and the changes due to volume. Three Months Ended September 30, 2014 vs. 2013 Increase (decrease) due to (Dollars in thousands) Volume Rate Total Interest-earning assets: Loans, net $ 3,031 $ (513 ) $ 2,518 Investment securities 107 46 153Federal Home Loan Bank of Boston stock 16 31 47 Federal funds and other interest-earning assets 1 3 4 Total interest-earning assets 3,155 (433 ) 2,722 Interest-bearing liabilities: NOW accounts 90 43 133 Money market 70 (116 ) (46 ) Savings accounts 6 (28 ) (22 ) Certificates of deposit (61 ) (73 ) (134 )Total interest-bearing deposits 105 (174 ) (69 ) Federal Home Loan Bank of Boston advances 480 (384 ) 96 Repurchase agreement borrowing - 1 1 Repurchase liabilities 2 (10 ) (8 ) Total interest-bearing liabilities 587 (567 ) 20 Increase in net interest income $ 2,568 $ 134 $ 2,702 Summary of Operating Results for the Three Months Ended September 30, 2014 and 2013 The following discussion provides a summary and comparison of our operating results for the three months ended September 30, 2014 and 2013: For the Three Months Ended September 30, 2014 2013 $ Change % Change (Dollars in thousands) Net interest income $ 15,985 $ 13,283 $ 2,702 20.3 % Provision for loan losses 1,041 215 826 384.2 Noninterest income 2,778 2,182 596 27.3 Noninterest expense 14,219 14,110 109 0.8 Income before taxes 3,503 1,140 2,363 207.3 Income tax expense 997 275 722 262.5 Net income $ 2,506 $ 865 $ 1,641 189.7 % For the three months ended September 30, 2014, net income increased $1.6 million compared to the three months ended September 30, 2013. The increase in net income was driven by an increase in net interest income due to organic loan growth, a $596,000 increase in other noninterest income offset by increases in the provision for loan losses and income tax expense. 57 Comparison of Operating Results for the three months ended September 30, 2014 and 2013 Our results of operations depend primarily on net interest income, which is the difference between the interest income on earning assets, such as loans and investments, and the interest expense incurred on interest-bearing liabilities, such as deposits and borrowings. We also generate noninterest income; including service charges on deposit accounts, gain on sale of securities, income from mortgage banking activities, bank-owned life insurance income, brokerage fees, insurance commissions and other miscellaneous fees. Our noninterest expense primarily consists of salary and employee benefits, occupancy expense, furniture and equipment expenses, FDIC assessments, marketing and other general and administrative expenses. Our results of operations are also affected by our provision for loan losses. Net Interest Income: Net interest income is determined by the interest rate spread (i.e., the difference between the yields earned on interest-earning assets and the rates paid on interest-bearing liabilities) and the relative amounts of interest-earning assets and interest-bearing liabilities. Net interest income before the provision for loan losses was $16.0 million and $13.3 million for the three months ended September 30, 2014 and 2013, respectively. Net interest income increased primarily due to a $329.9 million increase in the average loan balance despite a 12 basis point decrease in the yield on loans. The yield on average interest-earning assets decreased 14 basis points to 3.36% for the third quarter of 2014 from 3.50% for the prior year quarter. The decline was primarily due to a 12 basis point decrease in the yield on total average net loans to 3.63%. The cost of average interest-bearing liabilities decreased 14 basis points to 0.59% for the third quarter of 2014. The decline was primarily due to a 9 basis point decrease in certificates of deposit and a 135 basis point decrease in Federal Home Loan Bank of Boston advance costs due to an increase in short-term advances which carry lower rates. Net interest margin decreased to 2.89% in the third quarter of 2014 compared to 2.94% in the third quarter of 2013. Interest expense remained flat for the third quarter of 2014 at $2.5 million compared to the prior year quarter. The average interest-bearing liabilities balance increased $353.0 million offset by lower certificate of deposit rates and an increase in FHLBB short-term advances which carry lower rates. Average balances of noninterest-bearing deposits grew at a rate of 17.7%, while total average interest-bearing deposits grew at a rate of 12.7% for the third quarter in 2014 compared to the prior year quarter. Provision for Loan Losses: The allowance for loan losses is maintained at a level management determines to be appropriate to absorb estimated credit losses that are both probable and reasonably estimable at the dates of the financial statements. Management evaluates the adequacy of the allowance for loan losses on a quarterly basis and charges any provision for loan losses needed to current operations. The assessment considers historical loss experience, historical and current delinquency statistics, the loan portfolio segment and the amount of loans in the loan portfolio, the financial strength of the borrowers, adverse situations that may affect the borrower's ability to repay, estimated value of any underlying collateral, and prevailing economic conditions and other credit quality indicators. Management recorded a provision for loan losses of $1.0 million and $215,000 for the three months ended September 30, 2014 and 2013, respectively. The provision recorded is based upon management's analysis of the allowance for loan losses necessary to absorb the estimated credit losses in the loan portfolio for the period. Net charge-offs in the third quarter of 2014 were $397,000 or 0.08% to average loans (annualized) compared to $42,000 or 0.01% to average loans (annualized) in the prior year quarter. At September 30, 2014, the allowance for loan losses totaled $18.6 million, or 0.91% of total loans and 119.91% of non-accrual loans, compared to an allowance for loan losses of $18.3 million, or 1.01% of total loans and 123.74% of non-accrual loans at December 31, 2013. 58 Noninterest Income: The following table summarizes noninterest income for the three months ended September 30, 2014 and 2013: For the Three Months Ended September 30, 2014 2013 $ Change % Change (Dollars in thousands) Fees for customer services $ 1,459 $ 1,229 $ 230 18.7 %Net gain on sales of investments - 304 (304 ) (100.0 ) Net gain on loans sold 633 625 8 1.3 Brokerage and insurance fee income 47 37 10 27.0 Bank owned life insurance income 284 303 (19 ) (6.3 ) Other 355 (316 ) 671 212.3 Total noninterest income $ 2,778 $ 2,182 $ 596 27.3 % Total noninterest income increased $596,000 to $2.8 million compared to the prior year quarter primarily due to a $230,000 or 18.7% increase in fees for customer services and a $671,000 increase in other income offset by a $304,000 decrease in gain on sale of investments. Other income increased $671,000 primarily due to swap fees and mortgage banking derivatives. There were no sales of investments in the third quarter of 2014. Noninterest Expense: The following table summarizes noninterest expense for the three months ended September 30, 2014 and 2013: For the Three Months Ended September 30, 2014 2013 $ Change % Change (Dollars in thousands) Salaries and employee benefits $ 8,593 $ 8,571 $ 22 0.3 % Occupancy expense 1,271 1,175 96 8.2 Furniture and equipment expense 1,093 998 95 9.5 FDIC assessment 361 341 20 5.9 Marketing 332 423 (91 ) (21.5 )Other operating expenses 2,569 2,602 (33 ) (1.3 ) Total noninterest expense $ 14,219 $ 14,110 $ 109 0.8 % Total noninterest expense increased slightly to $14.2 million in the third quarter of 2014 compared to the prior year quarter. Marketing expense decreased $91,000 or 21.5% compared to the prior year quarter primarily due to general expense control initiatives. Income Tax Expense: Income tax expense was $997,000 in the third quarter of 2014 compared to $275,000 in the prior year quarter. 59 Net Interest Income Analysis: Average Balance Sheets, Interest and Yields/Costs The following tables present the average balance sheets, average yields and costs and certain other information for the years indicated therein. No tax-equivalent yield adjustments were made, as the effect thereof was not material. All average balances are daily average balances. Non-accrual loans and loans held for sale were included in the computation of average loan balances. The yields set forth below include the effect of net deferred costs and premiums that are amortized to interest income or expense. For The Nine Months Ended September 30, 2014 2013 Average Interest and Average Interest and Balance Dividends Yield/Cost Balance Dividends Yield/Cost (Dollars in thousands) Interest-earning assets: Loans, net $ 1,896,768 $ 52,182 3.68 % $ 1,583,569 $ 45,467 3.84 % Securities 172,491 1,026 0.80 % 124,429 684 0.73 % Federal Home Loan Bank of Boston stock 15,218 142 1.25 % 8,524 25 0.39 % Federal funds and other interest-earning assets 3,913 12 0.41 % 9,513 13 0.18 % Total interest-earning assets 2,088,390 53,362 3.42 % 1,726,035 46,189 3.58 % Noninterest-earning assets 123,580 121,784 Total assets $ 2,211,970 $ 1,847,819 Interest-bearing liabilities: NOW accounts $ 374,084 $ 695 0.25 % $ 268,483 $ 466 0.23 % Money market 410,066 2,186 0.71 % 354,291 2,105 0.79 % Savings accounts 198,978 154 0.10 % 180,490 237 0.18 % Certificates of deposit 334,037 2,215 0.89 % 355,934 2,638 0.99 % Total interest-bearing deposits 1,317,165 5,250 0.53 % 1,159,198 5,446 0.63 % Federal Home Loan Bank of Boston advances 237,576 1,166 0.66 % 74,386 1,253 2.25 % Repurchase agreement borrowings 21,000 538 3.43 % 21,000 532 3.39 % Repurchase liabilities 57,984 109 0.25 % 53,106 136 0.34 % Total interest-bearing liabilities 1,633,725 7,063 0.58 % 1,307,690 7,367 0.75 % Noninterest-bearing deposits 308,112 256,830 Other noninterest-bearing liabilities 36,664 45,876 Total liabilities 1,978,501 1,610,396 Stockholders' equity 233,469 237,423 Total liabilities and stockholders' equity $ 2,211,970 $ 1,847,819 Net interest income $ 46,299 $ 38,822 Net interest rate spread (1) 2.84 % 2.83 % Net interest-earning assets (2) $ 454,665 $ 418,345 Net interest margin (3) 2.96 % 3.01 % Average interest-earning assets to average interest- bearing liabilities 127.83 % 131.99 % (1) Net interest rate spread represents the difference between the yield on average interest-earning assets and the cost of average interest-bearing liabilities. (2) Net interest-earning assets represent total interest-earning assets less total interest-bearing liabilities. (3) Net interest margin represents net interest income divided by average total interest-earning assets. 60 Rate Volume Analysis The following table sets forth the effects of changing rates and volumes on net interest income for the periods indicated. The rate column shows the effects attributable to changes in rate (changes in rate multiplied by prior volume). The volume column shows the effects attributable to changes in volume (changes in volume multiplied by prior rate). The total column represents the sum of the volume and rate columns. For purposes of this table, changes attributable to both rate and volume that cannot be segregated have been allocated proportionately based on the changes due to rate and the changes due to volume. Nine Months Ended September 30, 2014 vs. 2013 Increase (decrease) due to (Dollars in thousands) Volume Rate Total Interest-earning assets: Loans, net $ 8,682 $ (1,967 ) $ 6,715 Investment securities 282 60 342Federal Home Loan Bank of Boston stock 31 86 117 Federal funds and other interest-earning assets (11 ) 10 (1 ) Total interest-earning assets 8,984 (1,811 ) 7,173 Interest-bearing liabilities: NOW accounts 194 35 229 Money market 311 (230 ) 81 Savings accounts 22 (105 ) (83 ) Certificates of deposit (156 ) (267 ) (423 )Total interest-bearing deposits 371 (567 ) (196 ) Federal Home Loan Bank of Boston advances 1,277 (1,364 ) (87 ) Repurchase agreement borrowing - 6 6 Repurchase liabilities 12 (39 ) (27 ) Total interest-bearing liabilities 1,660 (1,964 ) (304 ) Increase in net interest income $ 7,324 $ 153 $ 7,477 Summary of Operating Results for the Nine Months Ended September 30, 2014 and 2013 The following discussion provides a summary and comparison of our operating results for the nine months ended September 30, 2014 and 2013: For the Nine Months Ended September 30, 2014 2013 $ Change % Change (Dollars in thousands) Net interest income $ 46,299 $ 38,822 $ 7,477 19.3 % Provision for loan losses 1,956 870 1,086 124.8 Noninterest income 6,606 8,829 (2,223 ) (25.2 ) Noninterest expense 42,433 43,364 (931 ) (2.1 ) Income before taxes 8,516 3,417 5,099 149.2 Income tax expense 2,328 847 1,481 174.9 Net income $ 6,188 $ 2,570 $ 3,618 140.8 % For the nine months ended September 30, 2014, net income increased $3.6 million compared to the nine months ended September 30, 2013. The increase in net income was driven by an increase in net interest income due to organic loan growth, a $1.0 million decrease in salary and employment benefits and marketing expenses in noninterest expense, offset by an increase in the provision for loan losses and a decrease in income from the secondary market residential lending program. 61 Comparison of Operating Results for the nine months ended September, 2014 and 2013 Our results of operations depend primarily on net interest income, which is the difference between the interest income on earning assets, such as loans and investments, and the interest expense incurred on interest-bearing liabilities, such as deposits and borrowings. We also generate noninterest income; including service charges on deposit accounts, gain on sale of securities, income from mortgage banking activities, bank-owned life insurance income, brokerage fees, insurance commissions and other miscellaneous fees. Our noninterest expense primarily consists of salary and employee benefits, occupancy expense, furniture and equipment expenses, FDIC assessments, marketing and other general and administrative expenses. Our results of operations are also affected by our provision for loan losses. Net Interest Income: Net interest income is determined by the interest rate spread (i.e., the difference between the yields earned on interest-earning assets and the rates paid on interest-bearing liabilities) and the relative amounts of interest-earning assets and interest-bearing liabilities. Net interest income before the provision for loan losses was $46.3 million and $38.8 million for the nine months ended September 30, 2014 and 2013, respectively. Net interest income increased primarily due to a $313.2 million increase in the average loan balance despite a 16 basis point decrease in the yield on loans. The yield on average interest-earning assets decreased 16 basis points to 3.42% for the nine months ended September 30, 2014 from 3.58% for the nine months ended September 30, 2013. The decline was primarily due to a 16 basis point decrease in the yield on total average net loans to 3.68%. The cost of average interest-bearing liabilities decreased 17 basis points to 0.58% for the nine months ended September 30, 2014 reflecting lower funding costs for certificates of deposit and a decrease in FHLBB advance costs due to an increase in short-term advances which carry lower rates. Net interest margin decreased 5 basis points to 2.96% for the nine months ended September 30, 2014 compared to 3.01% for the nine months ended September 30, 2013 due to a $15.3 million decline in the average balance of the resort portfolio and decrease in prepayment penalty fees. Excluding resort and prepayment penalty fee income for both periods, the net interest margin would have been 2.95% and 2.97% for the nine months ended September 30, 2014 and 2013, respectively. Interest expense for the nine months ended September 30, 2014 decreased $304,000 or 4.1% totaling $7.1 million from $7.4 million in the nine months ended September 30, 2013. The decrease in interest expense resulted from lower certificate of deposit rates and a decrease in FHLBB advance costs due to an increase in short-term advances which carry lower rates. Average balances of noninterest-bearing deposits grew at a rate of 20.0%, while total average interest-bearing deposits grew at a rate of 13.6% for the nine months ended September 30, 2014 compared to the nine months ended September 30, 2013. Provision for Loan Losses: The allowance for loan losses is maintained at a level management determines to be appropriate to absorb estimated credit losses that are both probable and reasonably estimable at the dates of the financial statements. Management evaluates the adequacy of the allowance for loan losses on a quarterly basis and charges any provision for loan losses needed to current operations. The assessment considers historical loss experience, historical and current delinquency statistics, the loan portfolio segment and the amount of loans in the loan portfolio, the financial strength of the borrowers, adverse situations that may affect the borrower's ability to repay, estimated value of any underlying collateral, and prevailing economic conditions and other credit quality indicators. Management recorded a provision for loan losses of $2.0 million and $870,000 for the nine months ended September 30, 2014 and 2013, respectively. The provision recorded is based upon management's analysis of the allowance for loan losses necessary to absorb the estimated credit losses in the loan portfolio for the period. Net charge-offs totaled $1.7 million and $421,000 for the nine months ended September 30, 2014 and 2013, respectively. One commercial loan relationship represented approximately half of the charge-offs in 2014 which was fully reserved in prior years. At September 30, 2014, the allowance for loan losses totaled $18.6 million, or 0.91% of total loans and 119.91% of non-accrual loans, compared to an allowance for loan losses of $18.3 million, or 1.01% of total loans and 123.74% of non-accrual loans at December 31, 2013. 62 Noninterest Income: The following table summarizes noninterest income for the nine months ended September 30, 2014 and 2013: For the Nine Months Ended September 30, 2014 2013 $ Change % Change (Dollars in thousands) Fees for customer services $ 3,967 $ 3,308 $ 659 19.9 %Net gain on sales of investments - 340 (340 ) 100.0 Net gain on loans sold 1,072 4,244 (3,172 ) (74.7 ) Brokerage and insurance fee income 140 110 30 27.3 Bank owned life insurance income 847 1,015 (168 ) (16.6 ) Other 580 (188 ) 768 408.5 Total noninterest income $ 6,606 $ 8,829 $ (2,223 ) (25.2 )% Total noninterest income decreased $2.2 million to $6.6 million for the nine months ended September 30, 2014 compared to $8.8 million for the nine months ended September 30, 2013. Fees for customer services increased $659,000 or 19.9% due to an increase in volume. There were no sales of investments for the nine months ended September 30, 2014. Gain on sale of fixed-rate residential mortgage loans decreased $3.2 million to $1.1 million for the nine months ended September 30, 2014 compared to $4.2 million for the nine months ended September 30, 2013 due to an overall decrease in volume and margins in our secondary market residential lending program. Bank owned life insurance income decreased $168,000 due to decreases in policy payouts and income earned for the nine months ended September 30, 2014. Other income increased $768,000 primarily due a $145,000 increase in servicing fees, a $366,000 increase in mortgage banking derivatives and $140,000 in swap fee income for the nine months ended September 30, 2014. Noninterest Expense: The following table summarizes noninterest expense for the nine months ended September 30, 2014 and 2013: For the Nine Months Ended September 30, 2014 2013 $ Change % Change (Dollars in thousands)Salaries and employee benefits $ 25,519 $ 26,160 $ (641 ) (2.5 )% Occupancy expense 3,829 3,541 288 8.1 Furniture and equipment expense 3,217 3,115 102 3.3 FDIC assessment 1,010 943 67 7.1 Marketing 1,219 1,627 (408 ) (25.1 ) Other operating expenses 7,639 7,978 (339 ) (4.2 ) Total noninterest expense $ 42,433 $ 43,364 $ (931 ) (2.1 )% Total noninterest expense, excluding $633,000 in accelerated vesting of stock compensation due to the passing of a key executive in the nine months ended September 30, 2013, decreased $298,000 to $42.4 million for the nine months ended September 30, 2014 compared to the nine months ended September 30, 2013. Salaries and employee benefits, excluding $633,000 in accelerated vesting of stock compensation, remained flat at $25.5 million for the nine months ended September 30, 2014 and 2013. Occupancy expense increased $288,000 primarily as a result of de novo branch openings over the past twelve months. Marketing expense decreased $408,000 or 25.1% compared to the nine months ended September 30, 2013 primarily due to general expense control initiatives. Other operating expenses decreased $339,000 compared to the nine months ended September 30, 2013. Other operating expenses were higher for the nine months ended September 30, 2013 as a result of incurring a loss on the sale of an OREO property and costs associated with our core banking system conversion. Income Tax Expense: Income tax expense was $2.3 million and $847,000 for the nine months ended September 30, 2014 and 2013, respectively. 63 Liquidity and Capital Resources: We maintain liquid assets at levels we consider adequate to meet our liquidity needs. We adjust our liquidity levels to fund loan commitments, repay our borrowings, fund deposit outflows, fund operations and pay escrow obligations on items in our loan portfolio. We also adjust liquidity as appropriate to meet asset and liability management objectives. Our primary sources of liquidity are deposits, principal repayment and prepayment of loans, the sale in the secondary market of loans held for sale, maturities and sales of investment securities and other short-term investments, periodic pay downs of mortgage-backed securities, and earnings and funds provided from operations. While scheduled principal repayments on loans are a relatively predictable source of funds, deposit flows and loan prepayments are greatly influenced by market interest rates, economic conditions and rates offered by our competitors. We set the interest rates on our deposits to maintain a desired level of total deposits. In addition, we invest excess funds in short-term interest-earning assets, which provide liquidity to meet lending requirements. A portion of our liquidity consists of cash and cash equivalents, which are a product of our operating, investing and financing activities. At September 30, 2014, $43.9 million of our assets were invested in cash and cash equivalents compared to $38.8 million at December 31, 2013. Our primary sources of cash are principal repayments on loans, proceeds from the maturities of investment securities, increases in deposit accounts, proceeds from residential loan sales and advances from FHLBB. For the nine months ended September 30, 2014 and 2013, loan originations and purchases, net of collected principal and loan sales, totaled $251.7 million and $193.7 million, respectively. Cash received from the sales and maturities of investment securities totaled $257.7 million and $233.6 million for the nine months ended September 30, 2014 and 2013, respectively. We purchased $295.8 million and $216.0 million of available-for-sale investment securities during the nine months ended September 30, 2014 and 2013, respectively. Liquidity management is both a daily and longer-term function of business management. If we require funds beyond our ability to generate them internally, borrowing agreements exist with the FHLBB, which provides an additional source of funds. At September 30, 2014, we had $304.7 million in advances from the FHLBB and an additional available borrowing limit of $183.4 million, compared to $259.0 million in advances from the FHLBB and an additional available borrowing limit of $190.6 million at December 31, 2013, subject to collateral requirements of the FHLBB. Internal policies limit borrowings to 25.0% of total assets, or $598.9 million and $527.4 million at September 30, 2014 and December 31, 2013, respectively. Other sources of funds include access to a pre-approved unsecured line of credit with PNC Bank for $20.0 million, our $8.8 million secured line of credit with the FHLBB and our $3.5 million unsecured line of credit with a bank which were all undrawn at September 30, 2014. The Federal Reserve Bank's discount window loan collateral program enables us to borrow up to $73.1 million on an overnight basis as of September 30, 2014. The funding arrangement was collateralized by $144.1 million in pledged commercial real estate loans as of September 30, 2014. We had outstanding commitments to originate loans of $104.2 million and $25.7 million and unfunded commitments under construction loans, lines of credit and stand-by letters of credit of $406.7 million and $385.8 million at September 30, 2014 and December 31, 2013, respectively. At September 30, 2014 and December 31, 2013, time deposits scheduled to mature in less than one year totaled $222.1 million and $227.6 million, respectively. Based on prior experience, management believes that a significant portion of such deposits will remain with us, although there can be no assurance that this will be the case. In the event a significant portion of our deposits are not retained by us, we will have to utilize other funding sources, such as FHLBB advances, brokered deposits, our $20.0 million unsecured line of credit with PNC Bank, our $8.8 million secured line of credit with the FHLBB, our $3.5 million unsecured line of credit with a bank or our $73.1 million overnight borrowing arrangement with the Federal Reserve Bank in order to maintain our level of assets. Alternatively, we would reduce our level of liquid assets, such as our cash and cash equivalents in order to meet funding needs. In addition, the cost of such deposits may be significantly higher if market interest rates are higher or if there is an increased amount of competition for deposits in our market area at the time of renewal. 64 |