SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-Q

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

For the quarterly period ended September 30, 2010 or

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

For the transition period from ______to______

Commission File Number: 0-26128

NorthWest Indiana Bancorp
(Exact name of registrant as specified in its charter)

Indiana
 
35-1927981
(State or other jurisdiction of incorporation
 
(I.R.S. Employer
or organization)
 
Identification Number)

9204 Columbia Avenue
   
Munster, Indiana
 
46321
(Address of principal executive offices)
 
(ZIP code)

Registrant's telephone number, including area code:  (219) 836-4400

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x  No ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).                                    Yes ¨ No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of  “large accelerated filer”, “accelerated filer”, and “smaller reporting company” in Rule 12b-2 of the Exchange Act (Check one):
Large accelerated filer  ¨    Accelerated filer  ¨    Non-accelerated filer  ¨  Smaller Reporting Company x
                                                            (Do not check if a smaller reporting company)

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

There were 2,825,054 shares of the registrant’s Common Stock, without par value, outstanding at September 30, 2010.

 
 

 

NorthWest Indiana Bancorp
Index

       
Page
       
Number
PART I. Financial Information    
         
 
Item 1.
Unaudited Financial Statements
   
         
   
Consolidated Balance Sheets, September 30, 2010 and December 31, 2009
 
1
         
   
Consolidated Statements of Income, Three and Nine Months Ended September 30, 2010 and 2009
 
2
         
   
Consolidated Statements of Changes in Stockholders' Equity, Three and Nine Months Ended September 30, 2010 and 2009
 
3
         
   
Consolidated Statements of Cash Flows, Nine Months Ended September 30, 2010  and 2009
 
4
         
   
Notes to Consolidated Financial Statements
 
5-14
         
 
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
15-26
         
 
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
 
27
         
 
Item 4.
Controls and Procedures
 
27
         
PART II. Other Information
 
28
         
SIGNATURES
 
29
         
EXHIBITS
   
 
31.1  Rule 13a-14(a)/15d-14(a) Certification of Chief Executive Officer
 
30
 
31.2  Rule 13a-14(a)/15d-14(a) Certification of Chief Financial Officer
 
31
 
32.1  Section 1350 Certifications
 
32
 
 
 

 

NorthWest Indiana Bancorp
Consolidated Balance Sheets

   
September 30,
 
December 31,
 
   
2010
 
2009
 
(Dollars in thousands)
 
(unaudited)
      
           
ASSETS
         
           
Cash and non-interest bearing balances in financial institutions
  $ 7,740   $ 8,705  
Interest bearing balances in financial institutions
    5,285     447  
Federal funds sold
    3,026     4,070  
Total cash and cash equivalents
    16,051     13,222  
               
Securities available-for-sale
    141,736     124,776  
Securities held-to-maturity
    18,476     19,557  
Loans held-for-sale
    5,662     1,025  
Loans receivable
    428,812     458,245  
Less: allowance for loan losses
    (8,195 )   (6,114 )
Net loans receivable
    420,617     452,131  
Federal Home Loan Bank stock
    3,650     3,650  
Accrued interest receivable
    2,616     2,878  
Premises and equipment
    19,266     19,590  
Foreclosed real estate
    5,068     3,747  
Cash value of bank owned life insurance
    12,355     12,049  
Prepaid FDIC insurance premium
    2,630     3,282  
Other assets
    3,988     5,899  
               
Total assets
  $ 652,115   $ 661,806  
               
LIABILITIES AND STOCKHOLDERS' EQUITY
             
               
Deposits:
             
Non-interest bearing
  $ 53,515   $ 42,390  
Interest bearing
    484,386     498,137  
Total
    537,901     540,527  
Repurchase agreements
    20,058     15,893  
Borrowed funds
    29,671     47,129  
Accrued expenses and other liabilities
    7,031     5,179  
               
Total liabilities
    594,661     608,728  
               
Stockholders' Equity:              
Preferred stock, no par or stated value; 10,000,000 shares authorized, none outstanding
    -     -  
Common stock, no par or stated value; 10,000,000
shares authorized; shares issued:  September 30, 2010 - 2,888,902
    361     361  
December 31, 2009 – 2,889,452
             
shares outstanding: September 30, 2010 - 2,825,054
             
December 31, 2009 – 2,818,578
             
Additional paid in capital
    5,131     5,104  
Accumulated other comprehensive income/(loss)
    1,620     (170 )
Retained earnings
    51,696     49,312  
Treasury stock, common shares at cost:  September 30, 2010 - 63,848
December 31, 2009 - 70,874
    (1,354 )   (1,529 )
               
Total stockholders' equity
    57,454     53,078  
               
Total liabilities and stockholders' equity
  $ 652,115   $ 661,806  

See accompanying notes to consolidated financial statements.

 
1

 
 
NorthWest Indiana Bancorp
Consolidated Statements of Income
(unaudited)

   
Three Months Ended
   
Nine Months Ended
 
(Dollars in thousands, except per share data)
 
September 30,
   
September 30,
 
   
2010
   
2009
   
2010
   
2009
 
Interest income:
                       
Loans receivable
                       
Real estate loans
  $ 4,866     $ 5,293     $ 15,104     $ 16,826  
Commercial loans
    1,051       954       3,204       2,767  
Consumer loans
    16       29       60       93  
Total loan interest
    5,933       6,276       18,368       19,686  
                                 
Securities
    1,455       1,538       4,549       4,632  
Other interest earning assets
    7       3       21       14  
                                 
Total interest income
    7,395       7,817       22,938       24,332  
                                 
Interest expense:
                               
Deposits
    880       1,636       3,135       5,687  
Repurchase agreements
    46       68       145       200  
Borrowed funds
    210       369       714       1,184  
                                 
Total interest expense
    1,136       2,073       3,994       7,071  
                                 
Net interest income
    6,259       5,744       18,944       17,261  
Provision for loan losses
    1,615       4,675       4,120       6,490  
                                 
Net interest income after provision for loan losses
    4,644       1,069       14,824       10,771  
                                 
Noninterest income:
                               
Fees and service charges
    652       694       1,896       2,004  
Gain on sale of securities, net
    111       93       853       437  
Wealth management operations
    353       270       887       672  
Gain on sale of loans held-for-sale, net
    335       167       607       1,032  
Increase in cash value of bank owned life insurance
    102       98       306       306  
Gain/(loss) on foreclosed real estate, net
    (266 )     (26 )     (201 )     (58 )
Other-than-temporary impairment of securities
    (80 )     138       (99 )     (145 )
Portion of loss recognized in other comprehensive income
    65       (182 )     (29 )     101  
Other
    3       11       12       23  
                                 
Total noninterest income
    1,275       1,263       4,232       4,372  
                                 
Noninterest expense:
                               
Compensation and benefits
    2,426       2,451       7,293       7,061  
Occupancy and equipment
    794       782       2,386       2,315  
Federal deposit insurance premiums
    231       246       727       986  
Data processing
    236       222       700       652  
Marketing
    90       153       329       368  
Other
    1,007       924       2,906       2,896  
                                 
Total noninterest expense
    4,784       4,778       14,341       14,278  
                                 
Income before income tax expenses
    1,135       (2,446 )     4,715       865  
Income tax expenses
    94       (1,051 )     669       (498 )
                                 
Net income
  $ 1,041     $ (1,395 )   $ 4,046     $ 1,363  
                                 
Earnings per common share:
                               
Basic
  $ 0.37     $ (0.50 )   $ 1.43     $ 0.48  
Diluted
  $ 0.37     $ (0.50 )   $ 1.43     $ 0.48  
                                 
Dividends declared per common share
  $ 0.15     $ 0.32     $ 0.57     $ 1.00  

See accompanying notes to consolidated financial statements.

 
2

 
 
NorthWest Indiana Bancorp
Consolidated Statements of Changes in Stockholders' Equity
(unaudited)

   
Three Months Ended
   
Nine Months Ended
 
(Dollars in thousands)
 
September 30,
   
September 30,
 
   
2010
   
2009
   
2010
   
2009
 
                         
Balance at beginning of period
  $ 56,307     $ 53,274     $ 53,078     $ 52,773  
                                 
Comprehensive income:
                               
Net income
    1,041       (1,395 )     4,046       1,363  
Net unrealized change on securities available-for-sale, net of reclassifications and tax effects
    483       2,283       1,796       1,948  
Amortization of unrecognized gain
    (2 )     (2 )     (6 )     (6 )
Comprehensive income
    1,522       886       5,836       3,305  
                                 
Issuance of common stock, under stock based compensation plan, including tax effects
    -       -       -       4  
                                 
Stock based compensation expense
    8       9       27       33  
                                 
Sale of treasury stock
    41       52       122       101  
                                 
Adjustment to retained earnings for Topic 715
    -       -       -       (84 )
                                 
Cash dividends
    (424 )     (902 )     (1,609 )     (2,813 )
                                 
Balance at end of period
  $ 57,454     $ 53,319     $ 57,454     $ 53,319  

See accompanying notes to consolidated financial statements.

 
3

 
 
NorthWest Indiana Bancorp
Consolidated Statements of Cash Flows
(unaudited)

   
Nine Months Ended
 
(Dollars in thousands)
 
September 30,
 
   
2010
   
2009
 
CASH FLOWS FROM OPERATING ACTIVITIES:
           
Net income
  $ 4,046     $ 1,363  
Adjustments to reconcile net income to net cash provided by operating activities:
               
Origination of loans for sale
    (22,296 )     (44,961 )
Sale of loans originated for sale
    23,366       44,771  
Depreciation and amortization, net of accretion
    1,570       1,095  
Amortization of mortgage servicing rights
    81       113  
Amortization of investment in real estate limited partnerships
    113       142  
Stock based compensation expense
    27       33  
Gain on sale of securities, net
    (853 )     (437 )
Gain on sale of loans held-for-sale, net
    (607 )     (1,032 )
Net losses due to other-than-temporary impairment of securities
    128       44  
Gain/(loss) on foreclosed real estate, net
    (201 )     58  
Provision for loan losses
    4,120       6,490  
Net change in:
               
Interest receivable
    262       267  
Other assets
    1,477       (1,363 )
Cash value of bank owned life insurance
    (306 )     (306 )
Accrued expenses and other liabilities
    2,018       (2,442 )
Total adjustments
    8,899       2,472  
Net cash - operating activities
    12,945       3,835  
                 
CASH FLOWS FROM INVESTING ACTIVITIES:
               
Proceeds from maturities and pay downs of securities available-for-sale
    22,743       17,254  
Proceeds from sales of securities available-for-sale
    16,630       21,023  
Purchase of securities available-for-sale
    (53,240 )     (48,914 )
Purchase of securities held-to-maturity
    -       (3,860 )
Proceeds from maturities and pay downs of securities held-to-maturity
    1,063       1,073  
Proceeds from sale of loans transferred to held-for-sale
    -       10,651  
Net change in loans receivable
    19,612       5,578  
Purchase of premises and equipment, net
    (847 )     (1,566 )
Proceeds from sale of foreclosed real estate
    1,495       -  
Net cash - investing activities
    7,456       1,239  
                 
CASH FLOWS FROM FINANCING ACTIVITIES:
               
Change in deposits
    (2,626 )     29,122  
Proceeds from  FHLB advances
    13,000       6,000  
Repayment of FHLB advances
    (22,000 )     (13,000 )
Change in other borrowed funds
    (4,293 )     (6,745 )
Proceeds from issuance of common stock
    -       4  
Proceeds from sale of treasury stock
    122       101  
Dividends paid
    (1,775 )     (2,813 )
Net cash - financing activities
    (17,572 )     12,669  
Net change in cash and cash equivalents
    2,829       17,743  
Cash and cash equivalents at beginning of period
    13,222       11,296  
Cash and cash equivalents at end of period
  $ 16,051     $ 29,039  
                 
SUPPLEMENTAL CASH FLOW INFORMATION:
               
Cash paid during the period for:
               
Interest
  $ 4,035     $ 7,128  
Income taxes
  $ 1,185     $ 990  
SUPPLEMENTAL NONCASH INFORMATION:
               
Transfers from loans to foreclosed real estate
  $ 3,573     $ 3,529  
Transfers from loans to loans held for sale
  $ 5,167     $ 10,493  

See accompanying notes to consolidated financial statements.

 
4

 
 
NorthWest Indiana Bancorp
 
Notes to Consolidated Financial Statements

Note 1 - Basis of Presentation
The consolidated financial statements include the accounts of NorthWest Indiana Bancorp (the “Bancorp”), its wholly-owned subsidiary, Peoples Bank SB (the “Bank”), and the Bank’s wholly-owned subsidiaries, Peoples Service Corporation, NWIN, LLC and NWIN Funding, Inc. The Bancorp has no other business activity other than being a holding company for the Bank. The Bancorp’s earnings are dependent upon the earnings of the Bank. The accompanying unaudited consolidated financial statements were prepared in accordance with instructions for Form 10-Q and, therefore, do not include all disclosures required by U.S. generally accepted accounting principles for complete presentation of financial statements. In the opinion of management, the consolidated financial statements contain all adjustments necessary to present fairly the consolidated balance sheets of the Bancorp as of September 30, 2010 and December 31, 2009, and the consolidated statements of income, changes in stockholders’ equity, for the three and nine months ended September 30, 2010 and 2009, and cash flows for the nine months ended September 30, 2010 and 2009. The income reported for the nine month period ended September 30, 2010 is not necessarily indicative of the results to be expected for the full year. Subsequent events have been evaluated through October 29, 2010, which is
the date the financial statements were issued.

Note 2 - Use of Estimates
Preparing financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenue and expenses during the reporting period, as well as the disclosures provided. Actual results could differ from those estimates. Estimates associated with the allowance for loan losses, fair values of foreclosed real estate, loan servicing rights, and investment securities and the status of contingencies are particularly susceptible to material change in the near term.

Note 3 – Securities
The fair value of available-for-sale securities and the related gross unrealized gains and losses recognized in accumulated other comprehensive income (loss) were as follows:
 
   
(Dollars in thousands)
 
         
Gross
   
Gross
       
   
Cost
   
Unrealized
   
Unrealized
   
Fair
 
   
Basis
   
Gains
   
Losses
   
Value
 
September 30, 2010
                       
U.S. government sponsored entities
  $ 6,209     $ 2     $ (4 )   $ 6,207  
CMO and residential mortgage-backed securities
    54,867       2,006       -       56,873  
Municipal securities
    34,596       2,798       (4 )     37,390  
CMO government sponsored entities
    38,442       1,573       -       40,015  
Collateralized debt obligations
    5,215       -       (3,964 )     1,251  
Total securities available-for-sale
  $ 139,329     $ 6,379     $ (3,972 )   $ 141,736  
                                 
December 31, 2009
                               
U.S. government sponsored entities
  $ 1,993     $ 52     $ -     $ 2,045  
CMO and residential mortgage-backed securities
    61,095       2,302       (82 )     63,315  
Municipal securities
    34,151       1,516       (94 )     35,573  
CMO government sponsored entities
    22,534       168       (209 )     22,493  
Collateralized debt obligations
    5,343       -       (3,993 )     1,350  
Total securities available-for-sale
  $ 125,116     $ 4,038     $ (4,378 )   $ 124,776  

 
5

 

The carrying amount (cost basis), unrecognized gains and losses, and fair value of securities held-to-maturity were as follows:

         
(Dollars in thousands)
       
         
Gross
   
Gross
       
   
Cost
   
Unrecognized
   
Unrecognized
   
Fair
 
   
Basis
   
Gains
   
Losses
   
Value
 
September 30, 2010
                       
Municipal securities
  $ 17,596     $ 1,143     $ -     $ 18,739  
Residential mortgage-backed securities
    880       59       -       939  
Total securities heald-to-maturity
  $ 18,476     $ 1,202     $ -     $ 19,678  
                                 
December 31, 2009
                               
Municipal securities
  $ 18,539     $ 724     $ -     $ 19,263  
Residential mortgage-backed securities
    1,018       28       (6 )     1,040  
Total securities heald-to-maturity
  $ 19,557     $ 752     $ (6 )   $ 20,303  

The fair value of debt securities and carrying amount, if different, at September 30, 2010, by contractual maturity, were as follows. Securities not due at a single maturity date, primarily mortgage-backed securities, are shown separately.

   
(Dollars in thousands)
 
   
Available-for-sale
   
Held-to-maturity
 
   
Fair
   
Tax-Equivalent
   
Carrying
   
Fair
   
Tax-Equivalent
 
   
Value
   
Yield
   
Amount
   
Value
   
Yield
 
Due in one year or less
  $ 193       7.07     $ -     $ -       -  
Due from one to five years
    4,805       3.92       1,876       2,020       6.34  
Due over five years
    39,850       5.60       15,720       16,720       6.02  
CMO and residential mortgage-backed securities
    96,888       3.98       880       938       4.79  
Total
  $ 141,736       4.44     $ 18,476     $ 19,678       6.00  

Sales of available-for-sale securities were as follows:

   
(Dollars in thousands)
 
   
September 30,
   
September 30,
 
   
2010
   
2009
 
             
Proceeds
  $ 16,630       21,023  
Gross gains
    853       437  
Gross losses
    -       -  

Change in net unrealized gain/(loss) on available-for-sale securities included in other comprehensive income is as follows:

   
(Dollars in thousands)
 
   
Unrealized gains
 
Beginning balance, December 31, 2009
  $ (247 )
Current period change
    1,796  
Ending balance, September 30, 2010
  $ 1,549  

Securities with carrying values of $23,742,000 and $27,394,000 were pledged as of September 30, 2010 and December 31, 2009, respectively, as collateral for repurchase agreements and public funds and for other purposes as permitted or required by law.

 
6

 

Securities with unrealized losses at September 30, 2010 and December 31, 2009 not recognized in income are as follows:

   
(Dollars in thousands)
 
   
Less than 12 months
   
12 months or longer
   
Total
 
   
Fair
   
Unrealized
   
Fair
   
Unrealized
   
Fair
   
Unrealized
 
   
Value
   
Losses
   
Value
   
Losses
   
Value
   
Losses
 
September 30, 2010
                                   
Description of Securities:
                                   
U.S. government sponsored entities
  $ 1,525     $ (4 )   $ -     $ -     $ 1,525     $ (4 )
CMO and residential mortgage-backed securities
    -       -       -       -       -       -  
Municipal securities
    -       -       412       (4 )     412       (4 )
Collateralized debt obligations
    -       -       1,251       (3,964 )     1,251       (3,964 )
Total temporarily impaired
  $ 1,525     $ (4 )   $ 1,663     $ (3,968 )   $ 3,188     $ (3,972 )
Number of securities
            1               5               6  
 
   
(Dollars in thousands)
 
   
Less than 12 months
   
12 months or longer
   
Total
 
   
Fair
   
Unrealized
   
Fair
   
Unrealized
   
Fair
   
Unrealized
 
   
Value
   
Losses
   
Value
   
Losses
   
Value
   
Losses
 
December 31, 2009
                                   
Description of Securities:
                                   
U.S. government sponsored entities
  $ -     $ -     $ -     $ -     $ -     $ -  
CMO and residential mortgage-backed securities
    15,604       (297 )     13       -       15,617       (297 )
Municipal securities
    2,443       (15 )     1,476       (79 )     3,919       (94 )
Collateralized debt obligations
    -       -       1,350       (3,993 )     1,350       (3,993 )
Total temporarily impaired
  $ 18,047     $ (312 )   $ 2,839     $ (4,072 )   $ 20,886     $ (4,384 )
Number of securities
            16               7               23  
 
       Unrealized losses on securities have not been recognized into income because the securities are of high credit quality or have undisrupted cash flows. Management has the intent and ability to hold these securities for the foreseeable future, and the decline in fair value is largely due to changes in interest rates and market volatility. The fair value is expected to recover as the securities approach maturity.

Note 4 – Loans Receivable
Non-performing loans at period-end were as follows:

   
(Dollars in thousands)
 
   
September 30,
   
September 30,
 
   
2010
   
2009
 
Loans past due over 90 days still on accrual
  $ 296     $ 1,491  
Non-accrual loans
    23,238       17,074  

Impaired loans at period-end were as follows:

   
(Dollars in thousands)
 
   
September 30,
   
September 30,
 
   
2010
   
2009
 
Period-end loans with no allocated allowance for loan losses (including troubled debt restructurings of $6,326 and $0)
  $ 16,850     $ 3,853  
Period-end loans with allocated allowance for loan losses (including troubled debt restructurings of $5,554 and $7,199)
    10,653       13,112  
Total
  $ 27,503     $ 16,965  
Amount of the allowance for loan losses allocated
  $ 1,041     $ 1,179  
Average of impaired loans during the period
    21,531       12,820  
Interest income recognized during impairment
    19       10  
Cash-basis interest income recognized during impairment
    409       95  
 
 
7

 

Note 5 – Foreclosed Real Estate

Foreclosed real estate at period-end is summarized below:

   
(Dollars in thousands)
 
   
September 30,
   
September 30,
 
   
2010
   
2009
 
Construction and land development
  $ 1,940     $ 768  
Commercial real estate and other dwelling
    1,598       1,897  
Residential real estate
    1,386       1,082  
Commercial and industrial
    144       -  
Total
  $ 5,068     $ 3,747  

Note 6 - Concentrations of Credit Risk
The primary lending area of the Bancorp encompasses all of Lake County in northwest Indiana, where a majority of loan activity is concentrated. The Bancorp is also an active lender in Porter County, and to a lesser extent, LaPorte, Newton and Jasper counties in Indiana, and Lake, Cook and Will counties in Illinois. Substantially all loans are secured by specific items of collateral including residences, commercial real estate, land development, business assets and consumer assets.

Note 7 – Earnings Per Share
Earnings per common share is computed by dividing net income/(loss) by the weighted average number of common shares outstanding.  A reconciliation of the numerators and denominators of the basic and diluted earnings per common share computation for the three and nine months ended September 30, 2010 and 2009 are presented below:

(Dollars in thousands, except per share data)
   
Three Months Ended
   
Nine Months Ended
 
   
September 30,
   
September 30,
 
   
2010
   
2009
   
2010
   
2009
 
Basic earnings per common share:
                       
Net income as reported
  $ 1,041     $ (1,395 )   $ 4,046     $ 1,363  
Weighted average common shares outstanding:
    2,823,684       2,816,600       2,822,522       2,813,031  
Basic earnings per common share:
  $ 0.37     $ (0.50 )   $ 1.43     $ 0.48  
Diluted earnings per common share:
                               
Net income as reported
  $ 1,041     $ (1,395 )   $ 4,046     $ 1,363  
Weighted average common shares outstanding:
    2,823,684       2,816,600       2,822,522       2,813,031  
Add:  Dilutive effect of assumed stock option exercises:
    -       -       -       -  
Weighted average common and dilutive
                               
potential common shares outstanding:
    2,823,684       2,816,600       2,822,522       2,813,031  
Diluted earnings per common share:
  $ 0.37     $ (0.50 )   $ 1.43     $ 0.48  

Note 8 – Stock Based Compensation
The Bancorp’s 2004 Stock Option Plan (the “Plan”), which is stockholder-approved, permits the granting of share options to its employees for up to 250,000 shares of common stock. Awards granted under the Plan may be in the form of incentive stock options, non-incentive stock options, or restricted stock. As required by the Compensation – Stock Compensation Topic (formerly Financial Accounting Standards No. 123R (FAS 123R), “Share-Based Payments”), companies are required to record compensation cost for stock options provided to employees in return for employment service. The cost is measured at the fair value of the options when granted, and this cost is expensed over the employment service period, which is normally the vesting period of the options. Compensation cost will also be recorded for prior option grants that vest after the date of adoption. For the nine months ended September 30, 2010, stock based compensation expense of $27,000 was recorded, compared to $33,000 for the nine months ended September 30, 2009. It is anticipated that current outstanding vested and unvested options will result in additional compensation expense of approximately $9,000 in 2010 and $33,000 in 2011.
There were 300 shares of restricted stock granted during the first nine months of 2010, compared to 2,500 shares during the first nine months of 2009.

 
8

 

A summary of option activity under the Bancorp’s incentive stock option plan for the nine  months ended September 30, 2010 is presented below:

             
Weighted-
   
         
Weighted-
 
Average
   
         
Average
 
Remaining
 
Aggregate
         
Exercise
 
Contractual
 
Intrinsic
Options
 
Shares
   
Price
 
Term
 
Value
Outstanding at January 1, 2010
    65,747     $ 23.69        
Granted
    -     $ -        
Exercised
    -     $ -        
Forfeited
    (4,800 )   $ 24.04        
Expired
    (11,700 )   $ 21.13        
Outstanding at September 30, 2010
    49,247     $ 24.27  
2.0
 
-
Exercisable at September 30, 2010
    48,247     $ 24.18  
1.9
 
-

Note 9 – Adoption of New Accounting Standards
The Transfers and Servicing Topic was updated to remove the concept of a qualifying special-purpose entity from the Topic and removes the exception from applying the Consolidations Topic (formerly FASB Interpretation No. 46R).  The objective in issuing this update is to improve the relevance, representational faithfulness, and comparability of the information that a reporting entity provides in its financial statements about a transfer of financial assets; the effects of a transfer on its financial position, financial performance, and cash flows; and a transferor’s continuing involvement, if any, in transferred financial assets. This update must be applied as of the beginning of each reporting entity’s first annual reporting period that begins after November 15, 2009, for interim periods within that first annual reporting period and for interim and annual reporting periods thereafter. The impact of adoption was not material.

The Consolidations Topic was amended to improve financial reporting by enterprises involved with variable interest entities. The amendment addresses (1) the effects on certain provisions of the Topic as they relate to the elimination of the qualifying special-purpose entity concept in the Transfers and Servicing Topic and (2) constituent concerns about the application of certain key provisions of the Topic including those in which the accounting and disclosures under the Topic do not always provide timely and useful information about an enterprise’s involvement in a variable interest entity. This amendment shall be effective as of the beginning of each reporting entity’s first annual reporting period that begins after November 15, 2009, for interim periods within that first annual reporting period, and for interim and annual reporting periods thereafter. The impact of adoption was not material.

The Fair Value Measurements and Disclosures Topic was amended to improve disclosure requirements for those entities required to make recurring and nonrecurring fair value measurements. The amendment requires new disclosures for transfers in and out of Levels 1 and 2 and for separate presentation of purchases, sales, issuances and settlements for activity in Level 3. Further, this amendment clarifies the existing required disclosures when determining the level of disaggregation when reporting classes of assets and liabilities and disclosure about valuation techniques and inputs to measure fair value for both recurring and nonrecurring measurements. The new disclosures are effective for interim and annual reporting periods beginning after December 15, 2009, except for the disclosure about purchases, sales, issuances, and settlements in the roll forward of activity in Level 3 fair value measurements. Those disclosures are effective for fiscal years beginning after December 15, 2010, and for interim periods within those fiscal years. The Fair Value Footnote (Note 10) has been updated to incorporate these amendments.

In July 2010, FASB issued a statement which expands disclosures about credit quality of financing receivables and allowance for credit losses.  The standard will require the Bancorp to expand disclosures about the credit quality of loans and the related reserves against them.  The objective of this standard is to assist the users of the financial statements in evaluating the nature of the credit risk inherent in our loans receivable portfolio, how risk is analyzed to determine the allowance for loan losses, and reasons for changes in the allowance for loan losses. These disclosures are effective for fiscal years beginning after December 15, 2010. Adoption of this standard is not expected to change the current methodology used to determine the allowance for loan losses.

 
9

 

Note 10 – Fair Value
The Fair Value Measurements Topic establishes a hierarchy that requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The Topic describes three levels of inputs that may be used to measure fair value:

Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.

Level 2: Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.

Level 3: Significant unobservable inputs that reflect a reporting entity’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.

The fair values of securities available for sale are determined on a recurring basis by obtaining quoted prices on nationally recognized securities exchanges or pricing models utilizing significant observable inputs such as matrix pricing, which is a mathematical technique widely used in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted securities. Different judgment and assumptions used in pricing could result in different estimates of value. In certain cases where market data is not readily available because of a lack of market activity or little public disclosure, values may be based on unobservable inputs and classified in Level 3 of the fair value hierarchy.

      At the end of each reporting period, securities held in the investment portfolio are evaluated on an individual security level for other-than-temporary impairment in accordance with the Investments – Debt and Equity Securities Topic.  Significant judgments are required in determining impairment, which include making assumptions regarding the estimated prepayments, loss assumptions and the change in interest rates. We consider the following factors when determining an other-than-temporary impairment for a security: the length of time and the extent to which the market value has been less than amortized cost; the financial condition and near-term prospects of the issuer; the underlying fundamentals of the relevant market and the outlook for such market for the near future; an assessment of whether the Bancorp has (1) the intent to sell the debt securities or (2) more likely than not will be required to sell the debt securities before their anticipated market recovery. If either of these conditions is met, management will recognize other-than-temporary impairment. If, in management’s judgment, an other-than-temporary impairment exists, the cost basis of the security will be written down for the credit loss, and the unrealized loss will be transferred from accumulated other comprehensive loss as an immediate reduction of current earnings.

For the period ended September 30, 2010, the Bancorp’s management utilized a specialist to perform an other-than-temporary impairment analysis for each of its four pooled trust preferred securities. The analysis utilizes analytical models used to project future cash flows for the pooled trust preferred securities based on current assumptions for prepayments, default and deferral rates, and recoveries. The projected cash flows are then tested for impairment consistent with the Investments – Other Topic (formerly FSP EITF 99-20-1) and the Investments – Debt and Equity Securities Topic (formerly FSP FAS 115-2 and FAS 124-2). The other-than-temporary impairment testing compares the present value of the cash flows from quarter to quarter to determine if there is a “favorable” or “adverse” change. Other-than-temporary impairment is recorded if the projected present value of cash flows is lower than the book value of the security. To perform the quarterly other-than-temporary impairment analysis, management utilizes current reports issued by the trustee, which contain principal and interest tests, waterfall distributions, note valuations, collection detail and credit ratings for each pooled trust preferred security. In addition, a detailed review of the performing collateral was performed. The review of the collateral began with a review of financial information provided by SNL Financial, a comprehensive database, widely used in the industry, which gathers financial data on banks and thrifts from GAAP financial statements for public companies (annual and quarterly reports on Forms 10-K and 10-Q, respectively), as well as regulatory reports for private companies, including consolidated financial statements for bank holding companies (FR Y-9C reports) and parent company-only financial statements for bank holding companies (FR Y-9LP reports) filed with the Federal Reserve, bank call reports filed with the FDIC and thrift financial reports provided by the Office of Thrift Supervision. Using the information sources described above, for each bank and thrift examined the following items were examined: nature of the issuer’s business, years of operating history, corporate structure, loan composition and loan concentrations, deposit mix, asset growth rates, geographic footprint and local economic environment. The issuers’ historical financial performance was reviewed and their financial ratios were compared to appropriate peer groups of regional banks or thrifts with similar asset sizes. The analysis focused on nine broad categories: profitability (revenue streams and earnings quality, return on assets and shareholder’s equity, net interest margin and interest rate sensitivity), credit quality (charge-offs and recoveries, non-current loans and total non-performing assets as a percentage of total loans, loan loss reserve coverage and the adequacy of the loan loss provision), operating efficiency (non-interest expense compared to total revenue), capital adequacy (Tier-1, total capital and leverage ratios and equity capital growth), leverage (tangible equity as a percentage of tangible assets, short-term and long-term borrowings and double leverage at the holding company) and liquidity (the nature and availability of funding sources, net non-core funding dependence and quality of deposits). In addition, for publicly traded companies’ stock price movements were reviewed and the market price of publicly traded debt instruments was examined. The other-than-temporary impairment analysis indicated that the Bancorp’s four pooled trust preferred securities had other-than-temporary impairment in the amount of $264,000, as of September 30, 2010.

 
10

 

The table below shows the credit loss roll forward for the Bancorp’s pooled trust preferred securities that have been classified with other-than-temporary impairment:

   
(Dollars in thousands)
   
Collateralized debt obligations
Ending balance, December 31, 2009
  $ 136
Additions not previously recognized
    128
Ending balance, September 30, 2010
  $ 264

Below is a table containing information regarding the Bancorp’s pooled trust preferred securities as of September 30, 2010:

Deal name
 
PreTSL XXIV
   
PreTSL XXVII
   
Alesco IX
   
Alesco XVII
 
Class
 
Caaa3
   
Ca
   
CCC-
   
Ca
 
Book value
  1,256,972     1,296,077     1,309,886     1,351,903  
Fair value
  229,878     191,557     580,200     249,267  
Unrealized gains/(losses)
  (1,027,093 )   (1,104,521 )   (729,686 )   (1,102,635 )
Lowest credit rating assigned
 
Caa3
   
Ca
   
BB
   
Ca
 
Number of performing banks
  51     26     44     37  
Number of performing insurance companies
  12     7     10     n/a  
Number of issuers in default
  13     6     8     7  
Number of issuers in deferral
  18     10     14     12  
Defaults & deferrals as a % of performing collateral
  55.13 %   41.58 %   46.63 %   53.69 %
Subordination:
                       
As a % of performing collateral
  -19.35 %   -25.48 %   14.65 %   -4.25 %
As a % of performing collateral - adjusted for projected future defaults
  -24.58 %   -30.98 %   10.45 %   -8.71 %
Other-than-temporary impairment model assumptions:
                       
Defaults:
                       
Year 1
  2.90 %   2.70 %   3.20 %   3.00 %
Year 2
  0.70 %   0.80 %   0.80 %   0.60 %
Year 3
  0.60 %   0.70 %   0.70 %   0.50 %
> 3 Years
  (1 )   (1 )   (1 )   (1 )
Discount rate - 3 month Libor, plus implicit yield spread at purchase
  1.48 %   1.23 %   1.27 %   1.44 %
Recovery assumptions
  (2 )   (2 )   (2 )   (2 )
Prepayments
  0.00 %   0.00 %   0.00 %   0.00 %
Other-than-temporary impairment
  41,100     132,000     29,250     61,950  

(1) - Default rates > 3 years are evaluated on a issuer by issuer basis and range from 0.25% to 5.00%.
(2) - Recovery assumptions are evaluated on a issuer by issuer basis and range from 0% to 15% with a five year lag.

In the table above, the Bancorp’s subordination for each trust preferred security is calculated by taking the total performing collateral and subtracting the sum of the total collateral within the Bancorp’s class and the total collateral within all senior classes, and then stating this result as a percentage of the total performing collateral. This measure is an indicator of the level of collateral that can default before potential cash flow disruptions may occur. In addition, management calculates subordination assuming future collateral defaults by utilizing the default/deferral assumptions in the Bancorp’s other-than-temporary-impairment analysis. Subordination assuming future default/deferral assumptions is calculated by deducting future defaults from the current performing collateral. At September 30, 2010, management reviewed the subordination levels for each security in context of the level of current collateral defaults and deferrals within each security; the potential for additional defaults and deferrals within each security; the length of time that the security has been in “payment in kind” status; and the Bancorp’s class position within each security.

 
11

 
 
Management calculated the other-than-temporary impairment model assumptions based on the specific collateral underlying each individual security. The following assumption methodology was applied consistently to each of the four pooled trust preferred securities:  For collateral that has already defaulted, no recovery was assumed; no cash flows were assumed from collateral currently in deferral, with the exception of the recovery assumptions. The default and recovery assumptions were calculated based on a detailed collateral review. The discount rate assumption used in the calculation of the present value of cash flows is based on the discount margin (i.e., credit spread) at the time each security was purchased using the original purchase price. The discount margin is then added to the appropriate 3-month LIBOR forward rate obtained from the forward LIBOR curve.
 
At September 30, 2010, three of the trust preferred securities with a cost basis of $3.9 million have been placed in “payment in kind” status.  The Bancorp’s securities that are classified as “payment in kind” are a result of not receiving the scheduled quarterly interest payments. For the securities in “payment in kind” status, management anticipates to receive the unpaid contractual interest payments from the issuer, because of the self correcting cash flow waterfall provisions within the structure of the securities. When a tranche senior to the Bancorp’s position fails the coverage test, the Bancorp’s interest cash flows are paid to the senior tranche and recorded as a reduction of principal. The coverage test represents an over collateralization target by stating the balance of the performing collateral as a percentage of the balance of the Bancorp’s tranche, plus the balance of all senior tranches. The principal reduction in the senior tranche continues until the appropriate coverage test is passed. As a result of the principal reduction in the senior tranche, more cash is available for future payments to the Bancorp’s tranche. Consistent with the Investments – Debt and Equity Securities Topic, management considered the failure of the issuer of the security to make scheduled interest payments in determining whether a credit loss existed. Management will not capitalize the “payment in kind” interest payments to the book value of the securities and will keep these securities in non-accrual status until the quarterly interest payments resume.
 
Assets and Liabilities Measured on a Recurring Basis
 
There were no transfers to or from Levels 1 and 2 during the quarter ended September 30, 2010. Assets and liabilities measured at fair value on a recurring basis are summarized below:

(Dollars in thousands)
       
Fair Value Measurements at September 30, 2010 Using
 
   
September 30,
2010
   
Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
   
Significant Other
Observable Inputs
(Level 2)
   
Significant
Unobservable Inputs
(Level 3)
 
                         
Assets:
                       
Available-for-sale debt securities
                       
U.S. government sponsored entities
  $ 6,207     $ -     $ 6,207     $ -  
CMO and residential mortgage-backed securities
    56,873       -       56,873       -  
Municipal securities
    37,390       -       37,390       -  
CMO government sponsored entities
    40,015       -       40,015       -  
Collateralized debt obligations
    1,251       -       -       1,251  
Total available for sale debt securities
  $ 141,736     $ -     $ 140,485     $ 1,251  

(Dollars in thousands)
       
Fair Value Measurements at December 31, 2009 Using
 
   
December 31,
2009
   
Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
   
Significant Other
Observable Inputs
(Level 2)
   
Significant
Unobservable Inputs
(Level 3)
 
                         
Assets:
                       
Available-for-sale debt securities
                       
U.S. government sponsored entities
  $ 2,045     $ -     $ 2,045     $ -  
CMO and residential mortgage-backed securities
    63,315       -       63,315       -  
Municipal securities
    35,573       -       35,573       -  
CMO government sponsored entities
    22,493       -       22,493       -  
Collateralized debt obligations
    1,350       -       -       1,350  
Total available for sale debt securities
  $ 124,776     $ -     $ 123,426