ITEM 1.BUSINESS
Cautionary Note on Forward-Looking Statements
This Annual Report on Form 10-K contains forward-looking statements, which can be identified by the use of words such as “estimate,” “project,” “believe,” “intend,” “anticipate,” “plan,” “seek,” “expect,” “will,” “may” and words of similar meaning. 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;
>estimates of our risks and future costs and benefits;
>statements about the financial condition, results of operations and business of Poage Bankshares.
These forward-looking statements are based on our current beliefs and expectations 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. Except as may be required by law, we do not take any obligation to update any forward-looking statements after the date of this Annual Report on Form 10-K. You should not place undue reliance on such forward-looking statements.
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:
>our ability to manage our operations under the current adverse economic conditions (including real estate values, loan demand, inflation, commodity prices and unemployment levels) nationally and in our market area;
>adverse changes in the financial industry, securities, credit and national local real estate markets (including real estate values);
>significant increases in our loan losses, including as a result of our inability to resolve classified assets, and management’s assumptions in determining the adequacy of the allowance for loan losses;
>credit risks of lending activities, including changes in the level and trend of loan delinquencies and write-offs and in our allowance for loan losses and provision for loan losses;
>our ability to successfully enhance and maintain internal controls;
>our business may not be combined successfully with the businesses of Town Square Financial Corporation and Commonwealth, or such combination may take longer to accomplish than expected, if at all;
>the growth opportunities and cost savings from the acquisitions of Town Square Financial Corporation and Commonwealth Bank may not be fully realized or may take longer to realize than expected, if at all;
>our ability to manage increased expenses following the acquisitions of Town Square Financial Corporation and Commonwealth Bank, including salary and employee benefit expenses and occupation expenses;
>operating costs, customer losses and business disruption following the acquisitions of Town Square Financial Corporation and Commonwealth, including adverse effects of relationships with employees, may be greater than expected;
>competition among depository and other financial institutions;
>our success in increasing our commercial business and commercial real estate loans;
>our ability to improve our asset quality even as we increase our commercial business, commercial real estate and multi-family lending, including as a result of the acquisitions of Town Square Financial Corporation and Commonwealth;
>our success in introducing new financial products;
>our ability to attract and maintain deposits;
>decreases in our asset quality;
>changes in interest rates generally, including changes in the relative differences between short term and long term interest rates and in deposit interest rates, that may affect our net interest margin and funding sources;
>fluctuations in the demand for loans, which may be affected by the number of unsold homes, land and other properties in our market areas and by declines in the value of real estate in our market area;
>changes in consumer spending, borrowing and savings habits;
>declines in the yield on our assets resulting from the current low interest rate environment;
>risks related to a high concentration of loans secured by real estate located in our market area;
>the results of examinations by our regulators, including the possibility that our regulators may, among other things, require us to increase our reserve for loan losses, write down assets, change our regulatory capital position, limit our ability to borrow funds or maintain or increase deposits, or prohibit us from paying dividends, which could adversely affect our dividends and earnings;
>changes in laws or government regulations or policies affecting financial institutions, including the Dodd-Frank Act and the JOBS Act, which could result in, among other things, increased deposit insurance premiums and assessments, capital requirements (particularly the new capital regulations), regulatory fees and compliance costs and the resources we have available to address such changes;
>changes in the level of government support of housing finance;
>our ability to enter new markets successfully and capitalize on growth opportunities;
>changes in accounting policies and practices, as may be adopted by the bank regulatory agencies, the Financial Accounting Standards Board, the Securities and Exchange Commission and the Public Company Accounting Oversight Board;
>changes in our organization, compensation and benefit plans and our ability to retain key members of our senior management team;
>loan delinquencies and changes in the underlying cash flows of our borrowers;
>the failure or security breaches of computer systems on which we depend;
>the ability of key third-party providers to perform their obligations to us; and
>changes in the financial condition or future prospects of issuers of securities that we own.
Because of these and a wide variety of other uncertainties, our actual future results may be materially different from the results indicated by these forward-looking statements. Please see “Risk Factors” beginning on page 31.
Poage Bankshares, Inc.
Poage Bankshares, Inc. is incorporated in the State of Maryland. We are the holding company for Town Square Bank (“Town Square”).
Our cash flow depends on earnings from the investment of the net proceeds from the offering that we retained, and any dividends we receive from Town Square. Poage Bankshares, Inc. neither owns nor leases any property, but instead pays a fee to Town Square for the use of its premises, equipment and furniture. At the present time, we employ only persons who are officers of Town Square to serve as officers of Poage Bankshares, Inc. We do, however, use the support staff of Town Square from time to time. We pay a fee to Town Square for the time devoted to Poage Bankshares, Inc. by employees of Town Square. However, these persons are not separately compensated by Poage Bankshares, Inc. Poage Bankshares, Inc. may hire additional employees, as appropriate, to the extent it expands its business in the future.
Our executive offices are located at 1500 Carter Avenue, Ashland, Kentucky 41101. Our telephone number at this address is (606) 324-7196.
Town Square Bank
General
Town Square Bank (the “Bank” or “Town Square”) is a federal savings association headquartered in Ashland, Kentucky. Town Square was originally chartered in 1889. Town Square’s business consists primarily of accepting savings accounts, checking accounts and certificates of deposits from the general public and investing those deposits, together with funds generated from operations and borrowings, in first lien one- to four-family mortgage loans, commercial and multi-family real estate loans, commercial and industrial loans, consumer loans, consisting primarily of automobile loans and home equity loans and lines of credit, and construction loans. Town Square also purchases investment securities consisting primarily of mortgage-backed securities issued by United States Government agencies and government-sponsored enterprises, and obligations of state and political subdivisions. Town Square offers a variety of deposit accounts, including savings accounts, NOW and demand accounts, certificates of deposits, money market accounts and retirement accounts. Town Square provides financial services to individuals, families and businesses through our banking offices located in and around Ashland, Nicholasville and Mt. Sterling, Kentucky.
Town Square’s executive offices are located at 1500 Carter Avenue, Ashland, Kentucky 41101. Its telephone number at this address is (606) 324-7196, and its website address is http://www.townsquarebank.com. Information on this website is not and should not be considered to be part of this Annual Report on Form 10-K.
Market Area
Our primary lending markets are in Boyd, Greenup, Lawrence, Jessamine, Montgomery, Fayette and Campbell Counties in Kentucky, and Lawrence, Scioto, Hamilton, Butler, Warren and Clermont Counties in Ohio. Our retail deposit market includes the areas surrounding our nine offices in northeastern Kentucky, including our main office in Ashland and our branch offices in Ashland, Flatwoods, Greenup, Louisa, South Shore, Cannonsburg, Nicholasville and Mt. Sterling. We also operate an automated teller machine at each of our offices and have a loan production office in the Cincinnati, Ohio.
Our market area includes both rural and urban communities. The economic base in our lending market was in the past primarily industrial and reliant upon a small number of large employers, particularly in the steel and petroleum industries. A decline in these segments of the local economy has resulted in slow economic growth and population loss over the last several decades. However, during recent years, a diversification of our employment base into services including healthcare has offset to some extent the adverse impact of the decline of our industrial base. We have further diversified our employment base with opening of our Cincinnati, Ohio loan production office.
Competition
We compete with national financial institutions, as well as numerous state chartered banking institutions of comparable or larger size and resources, smaller community banking organizations and a variety of nonbank competitors. We compete for deposits with other commercial banks, savings associations and credit unions and with the issuers of commercial paper and other securities, such as shares in money market mutual funds. In making loans, we compete with other banks, savings associations, consumer finance companies, credit unions, leasing companies and other lenders. Many of the institutions against whom we compete are national and regional banks that are significantly larger than us and, therefore, have significantly greater resources and the ability to achieve economies of scale by offering a broader range of products and services at more competitive prices than we can offer. We expect competition to increase in the future as a result of legislative, regulatory and technological changes and the continuing trend of consolidation in the financial services industry. To effectively compete, we seek to emphasize community orientation, local and timely decision making and superior customer service.
Lending Activities
Our principal lending activity has been the origination of first lien one- to four-family residential mortgage loans and, to a lesser extent, commercial and multi-family real estate loans, consumer loans, consisting primarily of automobile loans, home equity loans and lines of credit, and construction loans. In order to diversify our loan portfolio, we recently increased our emphasis on commercial business loans, commercial real estate loans and consumer loans.
We sell substantially all of our fixed-rate residential mortgages to the Federal Home Loan Bank of Cincinnati (“FHLB-Cincinnati”) with servicing retained. Total proceeds from mortgages sold under this program was approximately $6.5 million and $8.1 million for the years ended December 31, 2017 and 2016, respectively. In 2014 we began a secondary market referral program to additional secondary market outlets with no servicing retained. The sale of our fixed-rate residential mortgage originations to the FHLB-Cincinnati along with referrals to other secondary market outlets and our increased originations of nonresidential loans, which generally have shorter terms than one- to four-family residential loans, assist in managing the interest rate risk associated with our portfolio of long-term fixed-rate one- to four-family residential loans.
Loan Portfolio Composition. The following table sets forth the composition of our loan portfolio by type of loan at the dates indicated.
Contractual Maturities and Interest Rate Sensitivity. The following table summarizes the scheduled maturities of our loan portfolio at December 31, 2017. Demand loans, loans having no stated repayment schedule or maturity, and overdraft loans are reported as being due in one year or less. Loans are presented net of loans in process.
The following table sets forth our fixed and adjustable-rate loans at December 31, 2017 that are contractually due after December 31, 2018. Loans are presented net of loans in process.
One- to Four-Family Residential Real Estate Lending. A significant portion of our loan portfolio includes the origination of one- to four-family residential mortgage loans. At December 31, 2017, $170.8 million, or 51.2% of our total loan portfolio, consisted of loans secured by one- to four-family residences compared to $177.8 million, or 51.3% of our total loan portfolio at December 31, 2016.
Historically, we have originated both fixed-rate and adjustable-rate one- to four-family mortgage loans. At December 31, 2017, 22.8% of our total one- to four-family mortgage loans were fixed-rate loans and 77.2% were adjustable-rate loans.
Our fixed-rate one- to four-family residential mortgage loans are generally underwritten according to secondary market standards (e.g., Freddie Mac guidelines), and we refer to loans that conform to such guidelines as “conforming loans.” We generally originate both fixed- and adjustable-rate mortgage loans in amounts up to the maximum conforming loan limits as established by the Federal Housing Finance Agency, which as of December 31, 2017 was generally $424,100 for single-family homes in our market area. We also originate adjustable rate loans above the lending limit for conforming loans, which are referred to as “jumbo loans.” The majority of our residential loans are secured by properties located in our market area.
We generally limit the loan-to-value ratios of our mortgage loans to 80% of the sales price or appraised value, whichever is lower. Loans with certain credit enhancements, such as private mortgage insurance, may be made with loan-to-value ratios up to 95%. Our fixed-rate one- to four-family mortgage loans typically have terms of 15 or 30 years.
Although we have offered adjustable-rate loans for many years, beginning in fiscal 2010 we began to increase our emphasis on such loans, subject to demand for such loans in a lower interest rate environment, and to increase the sale of fixed-rate mortgage loans that we originate, in order to enhance the interest rate sensitivity of our loan portfolio. Our owner-occupied adjustable-rate one- to four-family residential mortgage loans generally have fixed rates for initial terms of five years, and adjust annually thereafter at a margin (generally of 3.5% for owner-occupied properties) over the weekly average yield on U.S. Treasury securities adjusted to a constant maturity of one year. The maximum amount by which the interest rate may be increased or decreased is generally 2% per adjustment period and the lifetime interest rate cap is generally 6% over the initial interest rate of the loan. Our adjustable-rate loans carry terms to maturity of up to 30 years.
Although adjustable-rate mortgage loans may reduce to an extent our vulnerability to changes in market interest rates because, as interest rates increase, they periodically reprice and the required payments due from the borrower also increase (subject to rate caps), and the ability of the borrower to repay the loan and the marketability of the underlying collateral may be adversely affected. Upward adjustments of the contractual interest rate are also limited by the maximum periodic and lifetime rate adjustments permitted by our loan documents. Moreover, the interest rates on most of our adjustable-rate loans generally do not adjust for five years after origination. As a result, the effectiveness of adjustable-rate mortgage loans in compensating for changes in general interest rates may be limited during periods of rapidly rising interest rates.
We do not offer “interest only” mortgage loans on one- to four-family residential properties (where the borrower pays interest for an initial period, after which the loan converts to a fully amortizing loan). We also do not offer loans that provide for negative amortization of principal, such as “Option ARM” loans, where the borrower can pay less than the interest owed on the loan, resulting in an increased principal balance during the life of the loan. We do not offer “subprime loans” (i.e., loans that generally target borrowers with weakened credit histories typically characterized by payment delinquencies, previous charge-offs, judgments, bankruptcies, or borrowers with questionable repayment capacity as evidenced by low credit scores or high debt-burden ratios), or “Alt-A” loans (i.e., loans that generally target borrowers with better credit scores who borrow with alternative documentation such as little or no verification of income).
Until fiscal 2010, we generally retained in our portfolio all of the loans that we originated. In July 2010, as part of our interest rate risk management strategy, we initiated a secondary market program focused on reducing the origination of fixed-rate residential mortgage loans for our portfolio and selling some or all of our fixed rate mortgage originations in the FHLB-Cincinnati Mortgage Purchase Program, with servicing retained. For the year ended December 31, 2017, we sold approximately $6.5 million in fixed-rate mortgage loans to the FHLB-Cincinnati. We expect that loans sold under this program will continue to increase.
Based on our continued implementation of a secondary market program for new fixed rate loan originations, we expect that adjustable-rate one- to four-family residential mortgage loans will decrease in our loan portfolio over the next three years. Anticipated increases to interest rates may have a negative impact to new loan originations. Additionally, the Bank has placed increased emphasis on fixed rate loans originated and sold in the secondary market. Currently, substantially all fixed rate one- to four- family residential mortgage loans we originate are sold in the secondary market, and we retain substantially all adjustable-rate one- to four-family residential mortgage loans we originate.
Consumer Lending and Home Equity Loans and Lines of Credit. At December 31, 2017, $10.7 million, or 3.2% of our total loan portfolio, consisted of home equity loans and lines of credit, and $17.8 million, or 5.3% of our total loan portfolio consisted of motor vehicles and other consumer loans, compared to $10.7 million, or 3.1% of our total loan portfolio, and $18.5 million, or 5.3% of our total loan portfolio, respectively, at December 31, 2016. In order to reduce the term of our loans and enhance the yields thereof, we intend to increase our consumer loans and home equity loans and lines of credit over the next three years.
Currently, our consumer loans include, among other loans, new and used automobile and truck loans, recreational vehicle loans and personal loans.
Consumer loans may entail greater credit risk than residential mortgage loans, particularly in the case of consumer loans that are unsecured or that are secured by rapidly depreciable assets, such as automobiles. In addition, consumer loan collections are dependent on the borrower’s continuing financial stability, and thus are more likely to be affected by adverse personal circumstances. Furthermore, the application of various federal and state laws, including bankruptcy and insolvency laws, may limit the amount that can be recovered on such loans. In determining whether to make a consumer loan, we consider the value of collateral, and the borrower’s residence, employment history, annual income and debt service ratio which, including all mortgage payments and the credit line payment, generally may not exceed 40% of gross monthly income without prior approval of Town Square’s credit committee or senior officer with appropriate lending authority.
We offer home equity loans and lines of credit secured by a first or second mortgage on residential property (principal dwelling, condominium, etc.). Home equity loans and lines of credit are made with fixed or adjustable rates, and with combined loan-to-value ratios up to 85% on an owner-occupied principal residence and up to 80% on a second home, condominium or vacation home. On a limited basis, loan-to-value ratios may exceed 90% of appraised value if approved by Town Square’s credit committee or senior officer with appropriate lending authority.
Home equity loans and lines of credit may entail greater credit risk than one- to four-family residential mortgage loans, as they typically involve higher loan-to-value ratios and are typically second in priority behind first mortgages on the property. Therefore, any decline in real estate values may have a more detrimental effect on our home equity loans and lines of credit than on our one- to four-family residential mortgage loans.
Commercial Real Estate and Multi-Family Loans. At December 31, 2017, our commercial real estate loans totaled $84.3 million and our multi-family loans totaled $6.5 million compared to $83.2 million and $6.8 million, respectively, at December 31, 2016. Subject to market conditions, we intend to continue to increase the proportion of these nonresidential real estate loans in our portfolio over the next three years.
Maturities for our commercial real estate and multi-family loans generally do not exceed 15 years, although exceptions may be made for terms of up to 20 years. Rates are generally adjustable based upon the weekly average yield on U.S. treasury securities adjusted to a constant maturity of five year or another floating index. The maximum loan-to-value ratio is 80% on our owner-occupied commercial real estate loans. The maximum loan-to-value ratio on one- to four-family residential rental properties, and office or retail non-owner-occupied commercial real estate or rental properties with greater than five units is 75%. We generally require a first mortgage on all commercial real estate loans, as well as a debt service coverage ratio of 1.25:1.
Set forth below is information regarding our commercial real estate loans at December 31, 2017.
Commercial and multi-family real estate loans generally carry higher interest rates and have shorter terms than one- to four-family residential mortgage loans. Multi-family and commercial real estate loans, however, entail greater credit risks compared to one- to four-family residential mortgage loans because they typically involve larger loan balances concentrated with single borrowers or groups of related borrowers. In addition, the payment of loans secured by income-producing properties typically depends on the successful operation of the property, as repayment of the loan generally is dependent, in large part, on sufficient income from the property to cover operating expenses and debt service. Changes in economic conditions that are not in the control of the borrower or lender could affect the value of the collateral for the loan or the future cash flow of the property. Additionally, any decline in real estate values may be more pronounced for commercial and multi-family real estate than residential properties.
Commercial Business Loans. Our portfolio of commercial business loans decreased to $33.7 million, or 10.1% of our total loan portfolio at December 31, 2017 from $38.7 million, or 11.2% of our total loan portfolio at December 31, 2016. Our commercial business loans generally consist of regular lines of credit and revolving lines of credit to businesses to finance short-term working capital needs like accounts receivable and inventory. These loans are generally priced on an adjustable-rate basis and may be secured or unsecured. We generally obtain personal guarantees with all commercial business loans. Business assets such as accounts receivable, inventory and equipment, or real estate may be used to secure lines of credit. Our revolving lines of credit typically have a maximum term of 12 months.
We also originate commercial term loans to fund long-term borrowing needs such as purchasing equipment, property improvements or other fixed asset needs. We fix the maturity of a term loan to correspond to the useful life of any equipment purchased up to seven years. Term loans can be secured with a variety of collateral, including business assets such as accounts receivable and inventory or intermediate and long-term assets such as equipment, commercial vehicles or real estate.
Unlike one- to four-family residential real estate loans, which we generally originate on the basis of the borrower’s ability to make repayment from his or her employment and other income, and which are secured by real property whose value tends to be more easily ascertainable, we typically originate commercial loans (including real estate as well as non-real estate loans) on the basis of the borrower’s ability to make repayment from the cash flow of the borrower’s business or rental income produced by the property. As a result, the availability of funds for the repayment of commercial loans may be substantially dependent on the success of the business or rental property itself and the general economic environment. Therefore, commercial loans that we originate have greater credit risk than one- to four-family residential real estate loans or consumer loans. In addition, commercial loans generally result in larger outstanding balances to single borrowers, or related groups of borrowers, and also generally require substantially greater evaluation and oversight efforts.
Construction and Land Loans. At December 31, 2017, $10 million, or 3.0% of our total loan portfolio consisted of construction and land loans, compared to $11 million, or 3.2% of our total loan portfolio at December 31, 2016. We make construction loans to individuals for the construction of their primary residences. These loans generally have maximum terms of 12 months, and upon completion of construction convert to conventional amortizing mortgage loans. These construction loans have higher risk based interest rates and terms. During the construction phase, the borrower generally pays interest only. The maximum loan-to-value ratio of our owner-occupied construction loans is generally 100% of construction costs or 80% of the completed-appraised-value, whichever is less.
Residential construction loans are generally underwritten pursuant to the same guidelines used for originating permanent residential mortgage loans. These loans generally have initial maximum terms of nine months, although the term may be extended to up to 21 months. The loans generally carry variable rates of interest. The maximum loan-to-value ratio of these construction loans is generally 90% of construction costs or 80% of the completed-appraised-value, whichever is less. We also make loans for the construction of commercial and multi-family buildings.
In addition, we make loans secured by unimproved land to complement our construction and non-residential lending activities. These loans have terms of up to 15 years, and maximum loan-to-value ratios of 65%.
Set forth below is certain information regarding our construction and land loans at December 31, 2017.
To the extent our construction loans are not made to owner-occupants of single-family homes, they are more vulnerable to changes in economic conditions and the concentration of credit with a limited number of borrowers. Further, the nature of these loans is such that they are more difficult to evaluate and monitor. Our risk of loss on a construction or land loan is dependent largely upon the accuracy of the initial estimate of the property’s value upon completion of the project and the estimated cost (including interest) of the project. If the estimate of value proves to be inaccurate, we may be confronted, at or prior to the maturity of the loan, with a project with a value which is insufficient to assure full repayment and/or the possibility of having to make substantial investments to complete and sell the project. Because defaults in repayment may not occur during the construction period, it may be difficult to identify problem loans at an early stage.
Originations, Sales and Servicing. Lending activities are conducted solely by our salaried loan personnel. All loans originated by us are underwritten pursuant to our policies and procedures. We originate both fixed-rate and adjustable-rate loans. Our ability to originate fixed or adjustable-rate loans is dependent upon relative customer demand for such loans, which is affected by current and expected future levels of market interest rates. We originate real estate and other loans through our loan officers, marketing efforts, our customer base, walk-in customers and referrals from real estate brokers, builders and attorneys.
We sell certain of our fixed rate one- to four-family mortgage loan originations in the FHLB-Cincinnati Mortgage Purchase Program. We have also undertaken a review of our existing loan portfolio to identify customers who may qualify and benefit from this product. Loans are sold to the FHLB-Cincinnati without recourse, except for limited circumstances including failure of the mortgage to meet FHLB-Cincinnati guidelines or our breach of any representation and warranty in the sales transaction.
In addition to the representations and warranties described above, Town Square provides credit enhancements to the FHLB-Cincinnati by sharing losses with other members of the program in an aggregated pool. A Fixed Lender Risk Account (“LRA”) has been established and is maintained by the FHLB-Cincinnati on behalf of Town Square and other members selling mortgages to the FHLB-Cincinnati. The LRA amount is established as a percentage applied to the sum of the initial unpaid principal balance of each mortgage in the Aggregated Pool at the time of the purchase of the mortgage as determined by the FHLB-Cincinnati and is funded by the deduction from the proceeds of sale of each mortgage in the Aggregated Pool to the FHLB-Cincinnati. Town Square had on deposit with the FHLB-Cincinnati $976,000 at December 31, 2017 and $923,000 at December 31, 2016 in these LRA’s. These accounts are held by the FHLB-Cincinnati and Town Square bears the risk of receiving less than 100% of its LRA contribution in the event of losses, either by Town Square or other members selling mortgages in the aggregated pool. Any losses will be deducted first from the individual LRA contribution of the institution that sold the mortgage of which the loss was incurred. If losses incurred in the aggregated pool are greater than the member’s LRA contribution, such losses will be deducted from the LRA contribution of other members selling mortgages in that aggregated pool. Any portion of the LRA not used to pay losses will be released over a thirty year period and will not start until the end of five years after the initial fill-up period. Town Square had approximately $7,000 of the LRA amounts released during the year ended December 31, 2017. Unless Town Square is required to buy back a loan because it did not meet the criteria under the representations and warranties to be covered as part of the aggregated pool, the credit risk is limited to the amount provided in the LRA.
All of the loans sold during the years ended December 31, 2017 and 2016 were subject to these representations and warranties. As of December 31, 2017, there have been no required repurchases of loans sold, there have been no recourse claims, nor does Town Square believe it has incurred any such losses. Therefore, no liabilities have been accrued for loans sold at December 31, 2017 or 2016.
Loan servicing includes collecting and remitting loan payments, accounting for principal and interest, contacting delinquent borrowers, supervising foreclosures and property dispositions in the event of un-remedied defaults, making certain insurance and tax payments on behalf of the borrowers and generally administering the loans. We retain a portion of the interest paid by the borrower on the loans we service as consideration for our servicing activities. For the years ended December 31, 2017 and December 31, 2016, we received loan servicing fees of $111,000 and $102,000, respectively. As of December 31, 2017 and December 31, 2016, the principal balance of loans serviced for the FHLB-Cincinnati totaled $44.8 million and $42.6 million, respectively.
We currently purchase whole loans or interests in loans from third parties, which includes loans to health care professionals and motor vehicle loans.
Delinquencies and Non-Performing Assets
Delinquency Procedures. When a borrower fails to make their required monthly payment on or before the late payment date, a notice is generated stating the amount of the payment and applicable late charge(s) that are due. An attempt is also made at this time to contact the borrower by telephone regarding their late payment. Collection procedures provide that if no response or payment is received from the borrower, additional collections efforts will be taken through the generation of a 30-day right to cure or demand letter. Contact with the borrower regarding establishment of payment arrangements to satisfy their delinquency will be coordinated through the lending officer and collections department. If, at this point, no response is received from the borrower, further accelerated collection efforts such as the pursuit of legal action, repossession or foreclosure may be initiated. If any of these actions are pursued, all further communication with the borrower will be directed to the collections area.
When we acquire real estate as a result of foreclosure or by deed in lieu of foreclosure, the real estate is classified as foreclosed real estate and held in the other real estate owned (OREO) asset account until it is sold. The real estate is appraised and recorded at estimated fair value after acquisition, less estimated costs to sell, and any write-down resulting from the acquisition, is charged to the allowance for loan losses. Subsequent decreases in the value of the property are charged to expense. After acquisition, all costs in maintaining the property are expensed as incurred. Costs relating to the development and improvement of the property, however, are capitalized to the extent of estimated fair value, less estimated costs to sell.
Delinquent Loans. The following table sets forth our loan delinquencies and PCI loans by delinquency status and discloses non-accrual loans separately, by type and amount at the dates indicated.
Classified Assets. Federal regulations provide for the classification of loans and other assets, such as debt and equity securities considered by the Office of the Comptroller of the Currency (“OCC”) to be of lesser quality, as “substandard,” “doubtful” or “loss.” An asset is considered “substandard” if it is inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. “Substandard” assets include those characterized by the “distinct possibility” that the insured institution will sustain “some loss” if the deficiencies are not corrected. Assets classified as “doubtful” have all of the weaknesses inherent in those classified “substandard,” with the added characteristic that the weaknesses present make “collection or liquidation in full,” on the basis of currently existing facts, conditions, and values, “highly questionable and improbable.” Assets classified as “loss” are those considered “uncollectible” and of such little value that their continuance as assets without the establishment of a specific loss reserve is not warranted. Assets that do not currently expose the insured institution to sufficient risk to warrant classification in one of the aforementioned categories but possess weaknesses are designated as “special mention” by our management.
When an insured institution classifies problem assets as either substandard or doubtful, it may establish general allowances in an amount deemed prudent by management to cover probable incurred losses. General allowances represent loss allowances which have been established to cover probable incurred losses associated with lending activities, but which, unlike specific allowances, have not been allocated to particular problem assets. When an insured institution classifies a problem asset as “loss,” it is required either to establish a specific allowance for losses equal to 100% of that portion of the asset so classified or to charge-off such amount. An institution’s determination as to the classification of its assets and the amount of its valuation allowances is subject to review by the regulatory authorities, which may require the establishment of additional general or specific loss allowances.
In connection with the filing of our periodic reports with the OCC and in accordance with our classification of assets policy, we regularly review the problem loans in our portfolio to determine whether any loans require classification in accordance with applicable regulations.
On the basis of this review of our assets, our classified and special mention assets at the dates indicated were as set forth below. Nonaccrual loans and loans past due 90 days still on accrual include both smaller balance homogeneous loans that are collectively evaluated for impairment and individually classified impaired loans. Thus, the homogenous pools are not considered for classification or special mention status. At December 31, 2017 and December 31, 2016, all loans classified as substandard were comprised of loans that were individually evaluated for impairment and loans that were deemed to be impaired were subsequently adjusted and are carried at fair value.
Non-Performing Assets. We generally cease accruing interest on our loans when contractual payments of principal or interest have become 90 days past due or management has serious doubts about further collectability of principal or interest, even though the loan is currently performing. A loan may remain on accrual status if it is in the process of collection and is either guaranteed or well secured. When a loan is placed on nonaccrual status, unpaid interest credited to income is reversed. Funds received on nonaccrual loans generally are applied against principal. Generally, loans are restored to accrual status when the obligation is brought current, has performed in accordance with the contractual terms for a reasonable period of time and the ultimate collectability of the total contractual principal and interest is no longer in doubt.
The table below sets forth the amounts and categories of our non-performing assets at the dates indicated.
(1)Includes TDRs on nonaccrual status of $963,000, $185,000, $202,000, $218,000 and $0 at December 31, 2017, December 31, 2016, December 31, 2015, December 31, 2014, and December 31, 2013, respectively.
There were no loans that are not disclosed above under “-Classified Assets” and “-Non Performing Assets” where there is information about possible credit problems of borrowers that caused us serious doubts about the ability of the borrowers to comply with present loan repayment terms and that may result in disclosure of such loans in the future.
Allowance for Loan Losses
Analysis and Determination of the Allowance for Loan Losses. Our allowance for loan losses is the amount considered necessary to reflect probable incurred losses in our loan portfolio. We evaluate the need to establish allowances against losses on loans on a quarterly basis. When additional allowances are necessary, a provision for loan losses is charged to earnings.
Our methodology for assessing the appropriateness of the allowance for loan losses consists of two key elements: (i) specific allowances for identified problem loans; and (ii) a general valuation allowance on the remainder of the loan portfolio. Although we determine the amount of each element of the allowance separately, the entire allowance for loan losses is available for the entire portfolio.
Specific Allowances for Identified Problem Loans. We establish a specific allowance when loans are determined to be impaired. Loss is measured by determining the present value of expected future cash flows or, for collateral-dependent loans, the fair value of the collateral adjusted for market conditions and selling expenses. Factors in identifying a specific problem loan include: (i) the strength of the customer’s personal or business cash flows; (ii) the availability of other sources of repayment; (iii) the amount due or past due; (iv) the type and value of collateral; (v) the strength of our collateral position; (vi) the estimated cost to sell the collateral; and (vii) the borrower’s effort to cure the delinquency. In addition, for loans secured by real estate, we consider the extent of any past due and unpaid property taxes applicable to the property serving as collateral on the mortgage.
General Valuation Allowance on the Remainder of the Loan Portfolio. We establish a general allowance for loans that are not classified as impaired to recognize the inherent losses associated with lending activities, but which, unlike specific allowances, has not been allocated to particular problem assets. This general valuation allowance is determined by segregating the loans by loan category and assigning allowance percentages based on our historical loss experience, delinquency trends and management’s evaluation of the collectability of the loan portfolio. The allowance may be adjusted for significant factors that, in management’s judgment, affect the collectability of the portfolio as of the evaluation date. These significant factors may include changes in lending policies and procedures, changes in existing general economic and business conditions affecting our primary market area, credit quality trends, collateral value, loan volumes and concentrations, seasoning of the loan portfolio, recent loss experience in particular segments of the portfolio, duration of the current business cycle and bank regulatory examination results. The applied loss factors are re-evaluated on a quarterly basis.
In addition, as an integral part of their examination process, the OCC will periodically review our allowance for loan losses, and they may require that we recognize additions to the allowance based on their judgments of information available to them at the time of their examination.
Allowance for Loan Losses. The following table sets forth activity in our allowance for loan losses for the periods indicated.
Allocation of Allowance for Loan Losses. The following table sets forth the allowance for loan losses allocated by loan category, the total loan balances by category, and the percent of loans in each category to total loans at the dates indicated. The allowance for loan losses allocated to each category is not necessarily indicative of future losses in any particular category and does not restrict the use of the general allowance to absorb losses in other categories.
The allowance for loan losses was $4.7 million, or 1.40% of total loans at December 31, 2017 compared to $2.3 million, or 0.68% of total loans, at December 31, 2016. Provision of $3.5 million was recorded for the year ended December 31, 2017 compared to $1.2 million for the year ended December 31, 2016. We had net charge-offs of $1.2 million for the year ended December 31, 2017 compared to $758,000 for the year ended December 31, 2016. Total non-performing loans were $6.4 million at December 31, 2017 compared to $4.7 million at December 31, 2016. At December 31, 2017 we had specific allocations of the allowance related to impaired loans of $1.9 million. In comparison, we had specific allocation of $30,000 for the year ended December 31, 2016. As a percentage of non-performing loans, the allowance for loan losses was 73.62% at December 31, 2017 compared to 50.10% at December 31, 2016. The increase in the provision and resulting allowance for loan losses for the year ended December 31, 2017 compared to the year ended December 31, 2016 is attributable to an increase in substandard loans combined with an increase in charge-offs for the year ended December 31, 2017.
Although we believe that we use the best information available to establish the allowance for loan losses, future adjustments to the allowance for loan losses may be necessary and results of operations could be adversely affected if circumstances differ substantially from the assumptions used in making the determinations. Furthermore, while we believe we have established our allowance for loan losses in conformity with accounting principles generally accepted in the United States of America, regulators, in reviewing our loan portfolio, may require us to increase our allowance for loan losses. In addition, because future events affecting borrowers and collateral cannot be predicted with certainty, the existing allowance for loan losses may not be adequate and increases may be necessary if the quality of our loans deteriorates as a result of the factors discussed above. Any material increase in the allowance for loan losses may adversely affect our financial condition and results of operations.
Investment Activities
General. The goals of our investment policy are to provide and maintain liquidity to meet deposit withdrawal and loan funding needs, to help manage our interest rate risk, and to generate a favorable return on idle funds within the context of our interest rate and credit risk objectives.
Our Board of Directors is responsible for monitoring compliance with our investment policy. The investment policy is reviewed annually by management and any changes to the policy are recommended to and subject to the approval of the Board of Directors. A minimum of two members of the Asset/Liability committee may purchase investments based on the investment policy guidelines and submit the purchase to the full Board of Directors at the next scheduled meeting.
Our current investment policy permits investments in securities issued by the United States Government and its agencies or government sponsored enterprises, including residential mortgage-backed securities, collateralized mortgage obligations, municipalities, school boards and fully insured certificates of deposit. We maintain investment securities concentration limits as a percentage of the investment portfolio that we periodically amend based on market conditions and changes in our assets. Current concentration percentage restrictions limit U.S. Government sponsored enterprises to 75%, U.S. Government agency structured notes to 30%, mortgage-backed securities to 75%, collateralized mortgage obligations to 40%, certificates of deposit to 10% and municipal bonds to 40% or 80% of bank capital. Our investment policy also permits investment in corporate securities limited to 10% of the investment portfolio or 20% of capital and investment in FHLB-Cincinnati stock.
At December 31, 2017, we did not have an investment in the securities of any single non-government issuer that exceeded 10% of shareholders’ equity.
Our current investment policy does not permit investment in complex securities and derivatives as defined in federal banking regulations and other high-risk securities. Our current policy does not permit hedging activities, such as engaging in futures, options or swap transactions, or investing in high-risk mortgage derivatives, such as collateralized mortgage obligation residual interests, real estate mortgage investment conduit residual interests or stripped mortgage-backed securities.
At December 31, 2017, none of the collateral underlying our securities portfolio was considered subprime or Alt-A and we did not hold any common or preferred stock issued by Freddie Mac or Fannie Mae as of that date.
State and Political Subdivision Debt Securities. We have purchased primarily bank-qualified and rated general obligation and revenue bonds of certain state and political subdivisions, which provide interest income that is mostly exempt from federal income taxation. All purchases are approved by Town Square’s Board of Directors and are reviewed each quarter. At December 31, 2017, the majority of our state and political subdivision portfolio consisted of revenue bonds issued by the Commonwealth of Kentucky, although we have diversified by investing in securities issued by other states.
U.S. Government and Federal Agency Obligations. We may invest in U.S. Government and federal agency securities. While these securities generally provide lower yields than other investments in our securities investment portfolio, we maintain these investments, to the extent appropriate, for liquidity purposes, as collateral for borrowings and for prepayment protection.
Residential Mortgage-Backed Securities. Residential mortgage-backed securities are securities issued in the secondary market that are collateralized by pools of mortgages. We also invest in mortgage-backed securities commonly referred to as “pass-through” certificates. The principal and interest of the loans underlying these certificates “pass through” to investors, net of certain costs, including servicing and guarantee fees. We invest primarily in residential mortgage-backed securities backed by one- to four-family mortgages. The issuers of such securities pool and resell the participation interests in the form of securities to investors such as Town Square. The interest rate of the security is lower than the interest rates of the underlying loans to allow for payment of servicing and guaranty fees. Most of our mortgage-backed securities are either backed by Ginnie Mae, a United States Government agency, or government-sponsored enterprises, such as Fannie Mae and Freddie Mac.
Residential mortgage-backed securities issued by United States Government agencies and government-sponsored enterprises are more liquid than individual mortgage loans because there is an active trading market for such securities. In addition, residential mortgage-backed securities may be used to collateralize our borrowings. Investments in residential mortgage-backed securities involve a risk that actual payments will be greater or less than the prepayment rate estimated at the time of purchase, which may require adjustments to the amortization of any premium or accretion of any discount relating to such interests, thereby affecting the net yield on our securities. Current prepayment speeds determine whether prepayment estimates require modification that could cause amortization or accretion adjustments.
Federal Home Loan Bank Stock. We held common stock of the FHLB-Cincinnati in connection with our borrowing activities totaling $3.0 million at December 31, 2017 and 2016. The common stock of the FHLB-Cincinnati is carried at cost and classified as restricted equity securities.
Company-Owned Life Insurance. We invest in company-owned life insurance to provide us with a funding source for our benefit plan obligations. Company-owned life insurance also generally provides us non-interest income that is non-taxable. Federal regulations generally limit our investment in bank-owned life insurance to 25% of our Tier 1 capital plus our allowance for loan losses. At December 31, 2017 and 2016, we had invested $7.3 million and $7.1 million, respectively, in company-owned life insurance.
Securities Portfolio Composition. The following table sets forth the composition of our securities portfolio at the dates indicated.
Securities Portfolio Maturities and Yields. The following table sets forth the contractual maturities and weighted average yields of our securities portfolio at December 31, 2017. Mortgage-backed securities are anticipated to be repaid in advance of their contractual maturities as a result of projected mortgage loan prepayments.
Sources of Funds
General. Deposits have traditionally been our primary source of funds for use in lending and investment activities. We also use borrowings, primarily FHLB-Cincinnati advances, to supplement cash flow needs, to lengthen the maturities of liabilities for interest rate risk purposes and to manage the cost of funds. In addition, we receive funds from scheduled loan payments, investment maturities, loan prepayments, retained earnings, income on earning assets and the sale of assets from time to time. While scheduled loan payments and income on earning assets are relatively stable sources of funds, deposit inflows and outflows can vary widely and are influenced by prevailing interest rates, market conditions and levels of competition.
Deposits. Our deposits are generated primarily from within our primary market area although we have utilized national market deposit programs from time to time. We offer a selection of deposit accounts, including statement savings accounts, NOW accounts, business checking, certificates of deposit, money market accounts and retirement accounts. Deposit account terms vary, with the principal differences being the minimum balance required, the amount of time the funds must remain on deposit and the interest rate. We have not accepted brokered deposits in the past, although we have the authority to do so.
Interest rates, maturity terms, service fees and withdrawal penalties are established on a periodic basis. Deposit rates and terms are based primarily on current operating strategies and market rates, liquidity requirements, rates paid by competitors and growth goals. We rely upon personalized customer service, long-standing relationships with customers, convenient offices and ATM locations and the favorable image of Town Square in the community to attract and retain deposits. We have also expanded our products to include debit cards, on-line banking services and mobile banking services for the convenience of our customers.
The flow of deposits is influenced significantly by general economic conditions, changes in interest rates and competition. Our ability to gather deposits is impacted by the competitive market in which we operate, which includes numerous financial institutions of varying sizes offering a wide range of products. We may use promotional rates to meet asset/liability and market segment goals.
The variety of rates and terms on the deposit accounts we offer allows us to be competitive in obtaining funds and responding to changes in consumer demand. Based on our experience, we believe that NOW and demand deposits may be somewhat more stable sources of funding than certificates of deposits.
The following table sets forth the distribution of total deposits by account type, at the dates indicated.
As of December 31, 2017, the aggregate amount of our outstanding time deposits in amounts greater than or equal to $100,000 was $86.0 million. The following table sets forth the maturity of these time deposits as of December 31, 2017.
The following table sets forth our time deposits classified by interest rate as of the dates indicated.
The following table sets forth the amount and maturities of our time deposits at December 31, 2017.
Borrowings. Our borrowings currently consist primarily of advances from the FHLB-Cincinnati. We obtain advances from the FHLB-Cincinnati upon the security of our capital stock in the FHLB-Cincinnati and certain of our mortgage loans. Such advances may be made pursuant to several different credit programs, each of which has its own interest rate and range of maturities. To the extent such borrowings have different terms to repricing than our deposits, they can change our interest rate risk profile.
From time to time during recent years, we have utilized short-term borrowings to fund loan demand. To a limited extent, we have also used borrowings where market conditions permit us to purchase securities and make loans of a similar duration in order to increase our net interest income by the amount of the spread between the asset yield and the borrowing cost. Finally, from time to time, we have obtained advances with longer terms for asset liability management.
The following table sets forth information concerning balances and interest rates on our FHLB-Cincinnati advances at the dates and for the noted periods.
At December 31, 2017, based on available collateral and our ownership of FHLB-Cincinnati common stock, we had access to additional FHLB-Cincinnati advances of up to $85.5 million.
Subsidiary and Other Activities
Poage Bankshares, Inc. has two subsidiaries; Town Square Bank and Town Square Statutory Trust I. Town Square has one subsidiary; Town Square Asset Holdings, LLC. Town Square Statutory Trust I has no subsidiaries.
Expense and Tax Allocation
Town Square has entered into an agreement with Poage Bankshares to provide it with certain administrative support services for compensation not less than the fair market value of the services provided. In addition, Town Square and Poage Bankshares have entered into an agreement to establish a method for allocating and for reimbursing the payment of their consolidated tax liability.
Personnel
As of December 31, 2017, we employed 109 full-time equivalent employees. Our employees are not represented by any collective bargaining group. Management believes that we have good relations with our employees.
SUPERVISION AND REGULATION
General. The federal system of regulation and supervision establishes a comprehensive framework of activities in which Town Square may engage and is intended primarily for the protection of depositors and the Federal Deposit Insurance Corporation’s deposit insurance fund. Town Square is periodically examined by the Office of the Comptroller of the Currency, or OCC, to ensure that it satisfies applicable standards with respect to its capital adequacy, assets, management, earnings, liquidity and sensitivity to market interest rates. Town Square also is regulated to a lesser extent by the Board of Governors of the Federal Reserve System, or Federal Reserve Board, which governs the reserves to be maintained against deposits and other matters. In addition, Town Square is a member of and owns stock in the FHLB-Cincinnati, which is one of the eleven regional banks in the Federal Home Loan Bank System. Town Square’s relationship with its depositors and borrowers also is regulated to a great extent by federal law and, to a much lesser extent, state law, including in matters concerning the ownership of deposit accounts and the form and content of Town Square’s loan documents.
As a savings and loan holding company, Poage Bankshares is subject to examination and supervision by, and is required to file certain reports with, the Federal Reserve Board. Poage Bankshares is also subject to the rules and regulations of the Securities and Exchange Commission under the federal securities laws.
Set forth below are certain material regulatory requirements that are applicable to Town Square and Poage Bankshares. This description of statutes and regulations is not intended to be a complete description of such statutes and regulations and their effects on Town Square and Poage Bankshares. Any change in these laws or regulations, whether by Congress or the applicable regulatory agencies, could have a material adverse impact on Poage Bankshares, Town Square and their operations.
Dodd-Frank Act
The Dodd-Frank Act made significant changes to the regulatory structure for depository institutions and their holding companies. However, the Dodd-Frank Act’s changes go well beyond that and affect the lending, investments and other operations of all depository institutions. The Dodd-Frank Act required the Federal Reserve Board to set minimum capital levels for both bank holding companies and savings and loan holding companies that are as stringent as those required for the insured depository subsidiaries, and the components of Tier 1 capital for holding companies were restricted to capital instruments that were then currently considered to be Tier 1 capital for insured depository institutions. The legislation also established a floor for capital of insured depository institutions that cannot be lower than the standards in effect upon passage, and directed the federal banking regulators to implement new leverage and capital requirements that take into account off-balance sheet activities and other risks, including risks relating to securitized products and derivatives.
The Dodd-Frank Act also created a new Consumer Financial Protection Bureau with broad powers to supervise and enforce consumer protection laws. The Consumer Financial Protection Bureau has broad rule-making authority for a wide range of consumer protection laws that apply to all banks and savings institutions such as Town Square, including the authority to prohibit “unfair, deceptive or abusive” acts and practices. The Consumer Financial Protection Bureau has examination and enforcement authority over all banks and savings institutions with more than $10 billion in assets. Banks and savings institutions with $10 billion or less in assets, such as Town Square, will continue to be examined for compliance by their applicable bank regulators. The new legislation also weakens the federal preemption available for national banks and federal savings associations, and gives state attorneys general the ability to enforce applicable federal consumer protection laws.
The Dodd-Frank Act also broadened the base for FDIC insurance assessments. Assessments are now based on the average consolidated total assets less tangible equity capital of a financial institution. The legislation also permanently increased the maximum amount of deposit insurance for banks, savings institutions and credit unions to $250,000 per depositor, retroactive to January 1, 2008. The Dodd-Frank Act increased stockholder influence over boards of directors by requiring companies to give stockholders a non-binding vote on executive compensation and so-called “golden parachute” payments, and authorizing the Securities and Exchange Commission to promulgate rules that would allow stockholders to nominate and solicit votes for their own candidates using a company’s own proxy materials. The legislation also directs the Federal Reserve Board to promulgate rules prohibiting excessive compensation paid to bank holding company executives, regardless of whether the company is publicly traded or not. The Dodd-Frank Act provided for originators of certain securitized loans to return a percentage of the risk for the transferred loan, directed the Federal Reserve Board to regulate pricing of certain debit card interchange fees and contained a number of reforms related to mortgage origination.
The Dodd-Frank Act also required the Consumer Financial Protection Bureau to issue regulations requiring lenders to make a reasonable good faith determination as to a prospective borrower’s ability to repay a residential mortgage loan. The final “Ability to Repay” rules, which were effective January 10, 2014, establish a “qualified mortgage” safe harbor for loans whose terms and features are deemed to make the loan less risky.
The Dodd-Frank Act has increased regulatory burden and compliance, operating and interest expense for Town Square and Poage Bankshares.
Federal Banking Regulation
Business Activities. A federal savings and loan association derives its lending and investment powers from the Home Owners’ Loan Act, as amended, and the regulations of the OCC. Under these laws and regulations, Town Square may invest in mortgage loans secured by residential and commercial real estate, commercial business and consumer loans, certain types of debt securities and certain other assets, subject to applicable limits. Town Square also may establish subsidiaries that may engage in activities not otherwise permissible for Town Square, including real estate investment and securities and insurance brokerage. The Dodd-Frank Act authorized depository institutions to commence paying interest on business checking accounts, effective July 21, 2011.
Capital Requirements. Federal regulations require FDIC-insured depository institutions to meet several minimum capital standards: a common equity Tier 1 capital to risk-based assets ratio of 4.5%, a Tier 1 capital to risk-based assets ratio of 6.0%, a total capital to risk-based assets of 8%, and a 4% Tier 1 capital to total assets leverage ratio. The existing capital requirements were effective January 1, 2015 and are the result of a final rule implementing regulatory amendments based on recommendations of the Basel Committee on Banking Supervision and certain requirements of the Dodd-Frank Act.
For purposes of the regulatory capital requirements, common equity Tier 1 capital is generally defined as common shareholders’ equity and retained earnings. Tier 1 capital is generally defined as common equity Tier 1 and additional Tier 1 capital. Additional Tier 1 capital includes certain noncumulative perpetual preferred stock and related surplus and minority interests in equity accounts of consolidated subsidiaries. Total capital includes Tier 1 capital (common equity Tier 1 capital plus additional Tier 1 capital) and Tier 2 capital. Tier 2 capital is comprised of capital instruments and related surplus, meeting specified requirements, and may include cumulative preferred stock and long-term perpetual preferred stock, mandatory convertible securities, intermediate preferred stock and subordinated debt. Also included in Tier 2 capital is the allowance for loan and lease losses limited to a maximum of 1.25% of risk-weighted assets and, for institutions that made such an election regarding the treatment of Accumulated Other Comprehensive Income (“AOCI”), up to 45% of net unrealized gains on available-for-sale equity securities with readily determinable fair market values. Institutions that have not exercised the AOCI opt-out have AOCI incorporated into common equity Tier 1 capital (including unrealized gains and losses on available-for-sale-securities). We have exercised the AOCI opt-out. Calculation of all types of regulatory capital is subject to deductions and adjustments specified in the regulations.
In determining the amount of risk-weighted assets for purposes of calculating risk-based capital ratios, all assets, including certain off-balance sheet assets (e.g., recourse obligations, direct credit substitutes, residual interests) are multiplied by a risk weight factor assigned by the regulations based on the risks believed inherent in the type of asset. Higher levels of capital are required for asset categories believed to present greater risk. For example, a risk weight of 0% is assigned to cash and U.S. government securities, a risk weight of 50% is generally assigned to prudently underwritten first lien one- to four-family residential mortgages, a risk weight of 100% is assigned to commercial and consumer loans, a risk weight of 150% is assigned to certain past due loans and a risk weight of between 0% to 600% is assigned to permissible equity interests, depending on certain specified factors.
In addition to establishing the minimum regulatory capital requirements, the regulations limit capital distributions and certain discretionary bonus payments to management if the institution does not hold a “capital conservation buffer” consisting of 2.5% of common equity Tier 1 capital to risk-weighted asset above the amount necessary to meet its minimum risk-based capital requirements. The capital conservation buffer requirement is being phased in beginning January 1, 2016 at 0.625% of risk-weighted assets and increasing each year until fully implemented at 2.5% on January 1, 2019. When fully implemented, the capital conservation buffer will be 2.5% of risk weighted assets over and above the regulatory minimum capital ratios for Common Equity Tier 1 Capital (CET1) to risk weighted assets, Tier 1 Capital to risk weighted assets, and Total Capital to risk weighted assets. The consequences of not meeting the capital conservation buffer thresholds include restrictions on the payment of dividends, restrictions on the payment of discretionary bonuses, and restrictions on the repurchasing of common shares by the Company. Town Square Bank’s capital conservation buffer at December 31, 2017 was 11.1% compared to the capital conservation buffer requirement of 1.25% and at December 31, 2016 was 13.01%, compared to the capital conservation buffer requirement of 0.625%.
In assessing an institution’s capital adequacy, the OCC takes into consideration, not only these numeric factors, but qualitative factors as well, and has the authority to establish higher capital requirements for individual institutions when deemed necessary.
As of December 31, 2017, the capital of the Town Square exceeded all required regulatory guidelines.
Loans-to-One Borrower. Generally, a federal savings and loan association may not make a loan or extend credit to a single or related group of borrowers in excess of 15% of unimpaired capital and surplus. An additional amount may be loaned, equal to 10% of unimpaired capital and surplus, if the loan is secured by readily marketable collateral, which generally does not include real estate. As of December 31, 2017, Town Square was in compliance with its loans-to-one borrower limitations.
Qualified Thrift Lender Test. As a federal savings and loan association, Town Square must satisfy the qualified thrift lender, or “QTL,” test. Under the QTL test, Town Square must maintain at least 65% of its “portfolio assets” in “qualified thrift investments” (primarily residential mortgages and related investments, including mortgage-backed securities) in at least nine months of the most recent 12-month period. “Portfolio assets” generally means total assets of a savings institution, less the sum of specified liquid assets up to 20% of total assets, goodwill and other intangible assets, and the value of property used in the conduct of the savings bank’s business.
A federal savings and loan association that fails the QTL test must either convert to a commercial bank charter or operate under specified restrictions set forth in the Home Owners’ Loan Act. The Dodd-Frank Act made noncompliance with the QTL test potentially subject to agency enforcement action for a violation of law. At December 31, 2017, Town Square satisfied the QTL test with approximately 83.16% of its portfolio assets in qualified thrift investments.
Capital Distributions. Federal regulations govern capital distributions by a savings and loan association, which include cash dividends, stock repurchases and other transactions charged to the savings and loan association’s capital account. A federal savings and loan association must file an application for approval of a capital distribution if:
>the total capital distributions for the applicable calendar year exceed the sum of the savings and loan association’s net income for that year to date plus the savings and loan association’s retained net income for the preceding two years;
>the savings and loan association would not be at least adequately capitalized following the distribution;
>the distribution would violate any applicable statute, regulation, agreement or written regulatory condition; or
>the savings and loan association is not eligible for expedited treatment of its filings.
Even if an application is not otherwise required, every savings and loan association that is a subsidiary of a holding company must still file a notice with the Federal Reserve Board at least 30 days before the Board of Directors declares a dividend or approves a capital distribution.
A notice or application for capital distribution may be disapproved if:
>the savings and loan association would be undercapitalized following the distribution;
>the proposed capital distribution raises safety and soundness concerns; or
>the capital distribution would violate a prohibition contained in any statute, regulation or regulatory condition.
In addition, the Federal Deposit Insurance Act provides that an insured depository institution may not make any capital distribution if, after making such distribution, the institution would fail to meet any applicable regulatory capital requirement. A federal savings and loan association also may not make a capital distribution that would reduce its regulatory capital below the amount required for the liquidation account established in connection with its conversion to stock form. In addition, beginning in 2016, Town Square’s ability to pay dividends will be limited if Town Square does not have the capital conservation buffer required by the new capital rules, which may limit the ability of Poage Bankshares to pay dividends to its stockholders.
Liquidity. A federal savings and loan association is required to maintain a sufficient amount of liquid assets to ensure its safe and sound operation. On June 16, 2016, Poage Bankshares, Inc. executed a $2.0 million commercial line of credit secured with Town Square Bank common stock, with an unaffiliated lender. The initial variable interest rate on the line of credit is 4.00% with an interest rate equal to the Wall Street Prime plus 0.50%. The line of credit matures June 16, 2018. The line of credit will be used for general working capital purposes. At December 31, 2017, we have $2.0 million available on the line of credit.
Community Reinvestment Act and Fair Lending Laws. All federal savings associations have a responsibility under the Community Reinvestment Act and related regulations of the OCC to help meet the credit needs of their communities, including low- and moderate-income borrowers. In connection with its examination of a federal savings and loan association, the OCC is required to assess the institution’s record of compliance with the Community Reinvestment Act. A savings and loan association’s failure to comply with the provisions of the Community Reinvestment Act could, at a minimum, result in denial of certain corporate applications such as branches or mergers, or in restrictions on its activities. In addition, the Equal Credit Opportunity Act and the Fair Housing Act prohibit lenders from discriminating in their lending practices on the basis of characteristics specified in those statutes. The failure to comply with the Equal Credit Opportunity Act and the Fair Housing Act could result in enforcement actions by the OCC, as well as other federal regulatory agencies and the Department of Justice. The Community Reinvestment Act requires all Federal Deposit Insurance-insured institutions to publicly disclose their rating. Town Square received a “satisfactory” Community Reinvestment Act rating in its most recent federal examination.
Transactions with Related Parties. A federal savings and loan association’s authority to engage in transactions with its affiliates is limited by OCC regulations, by Sections 23A and 23B of the Federal Reserve Act and Regulation W promulgated by the Federal Reserve Board. An affiliate is generally a company that controls, is controlled by, or is under common control with an insured depository institution such as Town Square. Poage Bankshares is an affiliate of Town Square. In general, transactions between an insured depository institution and its affiliates are subject to certain quantitative and collateral requirements. In addition, OCC regulations prohibit a savings and loan association from lending to any of its affiliates that are engaged in activities that are not permissible for bank holding companies and from purchasing the securities of any affiliate, other than a subsidiary. Finally, transactions with affiliates must be consistent with safe and sound banking practices, not involve low-quality assets and be on terms that are as favorable to the institution as comparable transactions with non-affiliates. The OCC requires federal savings associations to maintain detailed records of all transactions with affiliates.
Town Square’s authority to extend credit to its directors, executive officers and 10% shareholders, as well as to entities controlled by such persons, is currently governed by the requirements of Sections 22(g) and 22(h) of the Federal Reserve Act and Regulation O of the Federal Reserve Board. Among other things, these provisions require that extensions of credit to insiders:
(i)be made on terms that are substantially the same as, and follow credit underwriting procedures that are not less stringent than, those prevailing for comparable transactions with unaffiliated persons and that do not involve more than the normal risk of repayment or present other unfavorable features, and
(ii)not exceed certain limitations on the amount of credit extended to such persons, individually and in the aggregate, which limits are based, in part, on the amount of Town Square’s capital.
In addition, extensions of credit in excess of certain limits must be approved by Town Square’s Board of Directors. Extensions of credit to executive officers are subject to additional limits based on the type of credit extension involved. As of December 31, 2017, Town Square is in compliance with these credit limitations.
Enforcement. The OCC has primary enforcement responsibility over federal savings associations and has the authority to bring enforcement action against all “institution-affiliated parties,” including directors, officers, stockholders, attorneys, appraisers and accountants who knowingly or recklessly participate in wrongful action likely to have an adverse effect on the savings and loan association. Formal enforcement action by the OCC may range from the issuance of a capital directive or cease and desist order to removal of officers and/or directors of the institution, and the appointment of a receiver or conservator. Civil money penalties cover a wide range of violations and actions, and range up to $25,000 per day, unless a finding of reckless disregard is made, in which case penalties may be as high as $1 million per day. The FDIC also has the authority to terminate deposit insurance or to recommend to the OCC that enforcement action be taken with respect to a particular savings institution. If such action is not taken, the FDIC has authority to take action under specified circumstances.
Standards for Safety and Soundness. Federal law requires each federal banking agency to prescribe certain standards for all insured depository institutions. These standards relate to, among other things, internal controls, information systems and audit systems, loan documentation, credit underwriting, interest rate risk exposure, asset growth, compensation, and other operational and managerial standards as the agency deems appropriate. Interagency guidelines set forth the safety and soundness standards that the federal banking agencies use to identify and address problems at insured depository institutions before capital becomes impaired. The guidelines address internal controls and information systems, internal audit systems, credit underwriting, loan documentation, interest rate risk exposure, asset growth, compensation, fees and benefits. If the appropriate federal banking agency determines that an institution fails to meet any standard prescribed by the guidelines, the agency may require the institution to submit to the agency an acceptable plan to achieve compliance with the standard. If an institution fails to meet these standards, the appropriate federal banking agency may require the institution to implement an acceptable compliance plan. Failure to implement such a plan can result in further enforcement action, including the issuance of a cease and desist order or the imposition of civil money penalties.
Prompt Corrective Action Regulations. Under prompt corrective action regulations, the OCC is authorized and, under certain circumstances, required to take supervisory actions against undercapitalized savings and loan associations. For this purpose, a federal savings and loan association is placed in one of the following five categories based on the savings association’s capital:
>well-capitalized (at least 5% leverage capital, 6.5% common equity Tier 1, 8% Tier 1 risk-based capital and 10% total risk-based capital);
>adequately capitalized (at least 4% leverage capital, 4.5% common equity Tier 1, 6% Tier 1 risk-based capital and 8% total risk-based capital);
>undercapitalized (less than 4% leverage capital, 4.5% common equity Tier 1, 4% Tier 1 risk-based capital or 8% total risk-based capital);
>significantly undercapitalized (less than 3% leverage capital, 3% common equity Tier 1, 4% Tier 1 risk-based capital or 6% total risk-based capital); and
>critically undercapitalized (less than 2% tangible capital).
Generally, the OCC is required to appoint a receiver or conservator for a savings bank that is “critically undercapitalized” within specific time frames. The regulations also provide that a capital restoration plan must be filed with the OCC within 45 days of the date a savings and loan association receives notice that it is “undercapitalized,” “significantly undercapitalized” or “critically undercapitalized.” Any holding company for a savings and loan association that is required to submit a capital restoration plan must guarantee the lesser of an amount equal to 5% of the association’s assets at the time it was notified or deemed to be undercapitalized by the OCC, or the amount necessary to restore the savings and loan association to adequately capitalized status. This guarantee remains in place until the OCC notifies the saving and loan association that it has maintained adequately capitalized status for each of four consecutive calendar quarters, and the OCC has the authority to require payment and collect payment under the guarantee. Failure by a holding company to provide the required guarantee will result in certain operating restrictions on the savings and loan association, such as restrictions on the ability to declare and pay dividends, pay executive compensation and management fees, and increase assets or expand operations. The OCC may also take any one of a number of discretionary supervisory actions against undercapitalized associations, including the issuance of a capital directive and the replacement of senior executive officers and directors.
At December 31, 2017, Town Square met the criteria for being considered “well-capitalized.”
Insurance of Deposit Accounts. Deposit accounts in Town Square are insured by the Federal Deposit Insurance Corporation generally up to a maximum of $250,000 per separately insured depositor and up to a maximum of $250,000 for self-directed retirement accounts. The Federal Deposit Insurance Corporation charges the insured financial institutions premiums to maintain the Deposit Insurance Fund.
Under the Federal Deposit Insurance Corporation’s current risk-based assessment system, insured institutions are assigned to one of four risk categories based on supervisory evaluations, regulatory capital levels and certain other risk factors. Assessments are based on an individual institution’s category, with the institutions perceived as riskiest paying higher assessments.
In February 2011, the FDIC published a final rule under the Dodd-Frank Act to reform the deposit insurance assessment system. The rule redefined the assessment base used for calculating deposit insurance assessments effective April 1, 2011. Under the new rule, assessments are based on an institution’s average consolidated total assets minus average tangible equity instead of total deposits. The proposed rule revised the assessment rate schedule to establish assessments ranging from 2.5 to 45 basis points.
The FDIC has authority to increase insurance assessments. Any significant increases would have an adverse effect on the operating expenses and results of operations of Town Square. Management cannot predict what assessment rates will be in the future.
In addition to the Federal Deposit Insurance Corporation assessments, the Financing Corporation (“FICO”) is authorized to impose and collect, with the approval of the Federal Deposit Insurance Corporation, assessments for anticipated payments, issuance costs and custodial fees on bonds issued by the FICO in the 1980s to recapitalize the former Federal Savings and Loan Insurance Corporation. For the quarter ended December 31, 2017, the annualized FICO assessment rate equaled 0.44 basis points. The FICO assessment is based on total assets less tangible capital. The fourth quarter 2017 FICO assessment rate is 0.11 basis points. The bonds issued by the FICO mature from 2017 through 2019.
Insurance of deposits may be terminated by the Federal Deposit Insurance Corporation upon a finding that an institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order or condition imposed by the Federal Deposit Insurance Corporation. We do not currently know of any practice, condition or violation that may lead to termination of our deposit insurance.
Prohibitions Against Tying Arrangements. FDIC insured savings and loan associations are prohibited, subject to some exceptions, from extending credit to or offering any other service, or fixing or varying the consideration for such extension of credit or service, on the condition that the customer obtain some additional service from the institution or its affiliates or not obtain services of a competitor of the institution.
Federal Home Loan Bank System. Town Square is a member of the Federal Home Loan Bank System, which consists of 11 regional Federal Home Loan Banks. The Federal Home Loan Bank System provides a central credit facility primarily for member institutions as well as other entities involved in home mortgage lending. As a member of the FHLB-Cincinnati, Town Square is required to acquire and hold shares of capital stock in the FHLB-Cincinnati. As of December 31, 2017, Town Square was in compliance with this requirement.
Federal Reserve System. Federal Reserve Board regulations require banks to maintain reserves against their transaction accounts (primarily Negotiable Order of Withdrawal (NOW) and regular checking accounts). The regulations generally provide that reserves be maintained against aggregate transaction accounts. For 2017: a 3% reserve ratio was assessed on net transaction accounts up to and including $110.0 million; a 10% reserve ratio was assessed above $110.0 million. The first $15.5 million of otherwise reservable balances (subject to adjustments by the Federal Reserve Board) were exempt from the reserve requirements. The amounts are adjusted annually and, for 2018, establish a 3% reserve ratio for aggregate transaction accounts up to $122.3 million, a 10% ratio above $122.3 million, and an exemption of $16.0 million.
Other Regulations
Interest and other charges collected or contracted for by Town Square are subject to state usury laws and federal laws concerning interest rates. Town Square’s operations are also subject to federal laws applicable to credit transactions, such as the:
>Truth-In-Lending Act, governing disclosures of credit terms to consumer borrowers;
>Real Estate Settlement Procedures Act, requiring that borrowers for mortgage loans for one- to four-family residential real estate receive various disclosures, including good faith estimates of settlement costs, lender servicing and escrow account practices, and prohibiting certain practices that increase the cost of settlement services;
>Home Mortgage Disclosure Act, requiring financial institutions to provide information to enable the public and public officials to determine whether a financial institution is fulfilling its obligation to help meet the housing needs of the community it serves;
>Equal Credit Opportunity Act, prohibiting discrimination on the basis of race, creed or other prohibited factors in extending credit;
>Fair Credit Reporting Act, governing the use and provision of information to credit reporting agencies;
>Fair Debt Collection Act, governing the manner in which consumer debts may be collected by collection agencies;
>Truth in Savings Act;
>the Biggert-Waters Flood Insurance Reform Act of 2012; and
>rules and regulations of the various federal agencies charged with the responsibility of implementing such federal laws.
In addition, the Consumer Financial Protection Bureau issues regulations and standards under these federal consumer protection laws that affect our consumer businesses. These include regulations setting “ability to repay” and “qualified mortgage” standards for residential mortgage loans and mortgage loan servicing and originator compensation standards. Town Square devotes significant compliance, legal and operational resources to compliance with consumer protection regulations and standards.
The operations of Town Square also are subject to the:
>Right to Financial Privacy Act, which imposes a duty to maintain confidentiality of consumer financial records and prescribes procedures for complying with administrative subpoenas of financial records;
>Electronic Funds Transfer Act and Regulation E promulgated thereunder, which govern automatic deposits to and withdrawals from deposit accounts and customers’ rights and liabilities arising from the use of automated teller machines and other electronic banking services;
>Check Clearing for the 21st Century Act (also known as “Check 21”), which gives “substitute checks,” such as digital check images and copies made from that image, the same legal standing as the original paper check;
>The USA PATRIOT Act, which requires savings and loan associations operating to, among other things, establish broadened anti-money laundering compliance programs, due diligence policies and controls to ensure the detection and reporting of money laundering. Such required compliance programs are intended to supplement existing compliance requirements, also applicable to financial institutions, under the Bank Secrecy Act and the Office of Foreign Assets Control regulations; and
>The Gramm-Leach-Bliley Act, which places limitations on the sharing of consumer financial information by financial institutions with unaffiliated third parties. Specifically, the Gramm-Leach-Bliley Act requires all financial institutions offering financial products or services to retail customers to provide such customers with the financial institution’s privacy policy and provide such customers the opportunity to “opt out” of the sharing of certain personal financial information with unaffiliated third parties.
>The Volcker Rule, which attempts to reduce risk and banking system instability by restricting U.S. banks from investing in or engaging in proprietary trading and speculation and imposing a strict framework to justify exemptions for underwriting, market making and hedging activities. U.S. banks will be restricted from investing in funds with collateral comprised of less than 100% loans that are not registered with the SEC and from engaging in hedging activities that do not hedge a specific identified risk. The Company does not believe the Volcker Rule will have a significant effect on operations.
Holding Company Regulation
General. Poage Bankshares is a non-diversified savings and loan holding company within the meaning of the Home Owners’ Loan Act. As such, Poage Bankshares is registered with the Federal Reserve Board and subject to Federal Reserve Board regulations, examinations, supervision and reporting requirements. In addition, the Federal Reserve Board has enforcement authority over Poage Bankshares and its subsidiaries. Among other things, this authority permits the Federal Reserve Board to restrict or prohibit activities that are determined to be a serious risk to the subsidiary savings institution.
Permissible Activities. Under present law, the business activities of Poage Bankshares are generally limited to those activities permissible for financial holding companies under Section 4(k) of the Bank Holding Company Act of 1956, as amended, or for multiple savings and loan holding companies. A financial holding company may engage in activities that are financial in nature, including underwriting equity securities and insurance as well as activities that are incidental to financial activities or complementary to a financial activity. A multiple savings and loan holding company is generally limited to activities permissible for bank holding companies under Section 4(c)(8) of the Bank Holding Company Act, subject to the prior approval of the Federal Reserve Board, and certain additional activities authorized by Federal Reserve Board regulations.
Federal law prohibits a savings and loan holding company, including Poage Bankshares, directly or indirectly, or through one or more subsidiaries, from acquiring more than 5% of another savings institution or holding company thereof, without prior written approval of the Federal Reserve Board. It also prohibits the acquisition or retention of, with certain exceptions, more than 5% of a nonsubsidiary company engaged in activities that are not closely related to banking or financial in nature, or acquiring or retaining control of an institution that is not federally insured. In evaluating applications by holding companies to acquire savings institutions, the Federal Reserve Board must consider the financial and managerial resources, future prospects of the company and institution involved, the effect of the acquisition on the risk to the federal deposit insurance fund, the convenience and needs of the community and competitive factors.
The Federal Reserve Board is prohibited from approving any acquisition that would result in a multiple savings and loan holding company controlling savings institutions in more than one state, subject to two exceptions:
(i)the approval of interstate supervisory acquisitions by savings and loan holding companies; and
(ii)the acquisition of a savings institution in another state if the laws of the state of the target savings institution specifically permit such acquisition.
The states vary in the extent to which they permit interstate savings and loan holding company acquisitions.
Capital. When it reaches $1 billion in total assets, Poage Bankshares, Inc. will be subject to the Federal Reserve Board’s capital adequacy regulations for savings and loan holding companies (on a consolidated basis). These capital standards have historically been similar to, though less stringent than, those of the OCC for Town Square. The Dodd-Frank Act, however, required the Federal Reserve Board to establish, for all savings and loan holding companies with total assets of $500 million or more ( a final rule issued by the Federal Reserve Board has increased this threshold to $1 billion in assets), minimum consolidated capital requirements that are as stringent as those required for the insured depository subsidiaries. Under regulations recently enacted by the Federal Reserve Board and effective January 1, 2015, all such savings and loan holding companies will be subject to regulatory capital requirements that are the same as the new capital requirements for Town Square. These new capital requirements include provisions that, when applicable, might limit the ability of Poage Bankshares, Inc. to pay dividends to its stockholders or repurchase its shares. See “-Federal Banking Regulation-New Capital Rule.” Poage Bankshares, Inc. has conducted a pro forma analysis of the application of these new capital requirements as of December 31, 2017, and has determined that it meets all of these new requirements, including the full 2.5% capital conservation buffer, and would be well-capitalized, if these new requirements had been in effect on that date.
Source of Strength. The Dodd-Frank Act extended the “source of strength” doctrine to savings and loan holding companies. The Federal Reserve Board has issued regulations requiring that all savings and loan holding companies serve as a source of managerial and financial strength to their subsidiary savings associations by providing capital, liquidity and other support in times of financial stress.
Dividends. The Federal Reserve Board has issued a policy statement regarding the payment of dividends by bank holding companies that it has made applicable to savings and loan holding companies as well. In general, the policy provides that dividends should be paid only out of current earnings and only if the prospective rate of earnings retention by the holding company appears consistent with the organization’s capital needs, asset quality and overall financial condition. Regulatory guidance provides for prior regulatory review of capital distributions in certain circumstances such as where the company’s net income for the past four quarters, net of dividends previously paid over that period, is insufficient to fully fund the dividend or the company’s overall rate of earnings retention is inconsistent with the company’s capital needs and overall financial condition. The ability of a holding company to pay dividends may be restricted if a subsidiary bank becomes undercapitalized. The policy statement also states that a savings and loan holding company should inform the Federal Reserve Board supervisory staff prior to redeeming or repurchasing common stock or perpetual preferred stock if the savings and loan holding company is experiencing financial weaknesses or if the repurchase or redemption would result in a net reduction, as of the end of a quarter, in the amount of such equity instruments outstanding compared with the beginning of the quarter in which the redemption or repurchase occurred. These regulatory policies could affect the ability of Poage Bankshares to pay dividends or otherwise engage in capital distributions.
Acquisition. Under the Federal Change in Bank Control Act, a notice must be submitted to the Federal Reserve Board if any person (including a company), or group acting in concert, seeks to acquire direct or indirect “control” of a savings and loan holding company. Under certain circumstances, a change of control may occur, and prior notice is required, upon the acquisition of 10% or more of the company’s outstanding voting stock, unless the Federal Reserve Board has found that the acquisition will not result in control of the company. A change in control definitively occurs upon the acquisition of 25% or more of the company’s outstanding voting stock. Under the Change in Bank Control Act, the Federal Reserve Board generally has 60 days from the filing of a complete notice to act, taking into consideration certain factors, including the financial and managerial resources of the acquirer and the competitive effects of the acquisition.
Federal Securities Laws
Our common stock is registered with the Securities and Exchange Commission under the Securities Exchange Act of 1934. We are subject to the information, proxy solicitation, insider trading restrictions and other requirements under the Securities Exchange Act of 1934.
Sarbanes-Oxley Act of 2002
The Sarbanes-Oxley Act of 2002 addresses, among other issues, corporate governance, auditing and accounting, executive compensation, and enhanced and timely disclosure of corporate information. As directed by the Sarbanes-Oxley Act, our Chief Executive Officer and Chief Financial Officer are required to certify that our quarterly and annual reports do not contain any untrue statement of a material fact. The rules adopted by the Securities and Exchange Commission under the Sarbanes-Oxley Act have several requirements, including having these officers certify that: they are responsible for establishing, maintaining and regularly evaluating the effectiveness of our internal control over financial reporting; they have made certain disclosures to our auditors and the audit committee of the Board of Directors about our internal control over financial reporting; and they have included information in our quarterly and annual reports about their evaluation and whether there have been changes in our internal control over financial reporting or in other factors that could materially affect internal control over financial reporting.
ITEM 1A.
ITEM 1A.RISK FACTORS
Risks Related to Our Business
Future Changes in Interest Rates Could Reduce Our Profits.
Future changes in interest rates could impact our financial condition and results of operations.
Net income is the amount by which net interest income and non-interest income exceeds non-interest expense and the provision for loan losses. Net interest income makes up a majority of our income and is based on the difference between:
>interest income earned on interest-earning assets, such as loans and securities; and
>interest expense paid on interest-bearing liabilities, such as deposits and borrowings.
We are vulnerable to changes in interest rates including the shape of the yield curve because of a mismatch between the terms to repricing of our assets and liabilities. Our Asset/Liability Management Committee utilizes a computer simulation model to provide an analysis of estimated changes in net interest income in various interest rate scenarios.
Changes in interest rates can affect the average life of loans and mortgage-backed and related securities. A reduction in interest rates results in increased prepayments of loans and mortgage-backed and related securities, as borrowers refinance their debt in order to reduce their borrowing costs. This creates reinvestment risk, which is the risk that we may not be able to reinvest prepayments at rates that are comparable to the rates we earned on the prepaid loans or securities. Additionally, increases in interest rates may decrease loan demand and/or make it more difficult for borrowers to repay adjustable-rate loans.
We Plan to Increase Our Levels of Commercial Real Estate, Multi-Family, Commercial Business and Construction and Land Loans, Which Would Increase Our Exposure to Credit Risk.
Non-residential loans generally expose a lender to a greater risk of loss than one- to four-family residential loans. Repayment of such loans generally depends, in large part, on sufficient income from the property or the borrower’s business, respectively, to cover operating expenses and debt service. These types of loans typically involve larger loan balances to single borrowers or groups of related borrowers compared to one- to four-family residential mortgage loans. Changes in economic conditions that are beyond the control of the borrower and lender could affect the value of the security for the loan, the future cash flow of the affected property or business, or the marketability of a construction project with respect to loans originated for the acquisition and development of property. As we increase our portfolio of these loans, we may experience higher levels of non-performing assets and/or loan losses. We intend to continue to emphasize the origination of these types of loans consistent with safety and soundness.
We target our business lending and marketing strategy towards small- to medium-sized businesses. These small- to medium-sized businesses generally have fewer financial resources in terms of capital or borrowing capacity than larger entities. If general economic conditions negatively impact these businesses, our results of operations and financial condition may be adversely affected.
As a result of the acquisition of Town Square Financial Corporation and Town Square Bank, our portfolio of commercial real estate, multi-family and commercial business loans has increased significantly, which will further increase our exposure to the risks associated with these types of loans. We conducted a thorough review of Town Square Bank’s loan portfolio and made certain assumptions as to the future performance of these loans and the likelihood that such loans would become delinquent or subject to charge-offs in the future. The assessment of the risk as related to Town Square Bank’s loan portfolio is based upon assumptions that may be inaccurate, or may become inaccurate based upon uncertainties, contingencies, and factors beyond the control of Poage Bankshares.
If Our Allowance for Loan Losses Is Not Sufficient to Cover Actual Loan Losses, Our Earnings Will Decrease.
We make various assumptions and judgments about the collectability of our loan portfolio, including the creditworthiness of our borrowers and the value of the real estate and other assets serving as collateral for the repayment of many of our loans. In determining the amount of the allowance for loan losses, we review our loans and our loss and delinquency experience, and we evaluate economic conditions. If our assumptions are incorrect, our allowance for loan losses may not be sufficient to cover probable incurred losses in our loan portfolio, resulting in additions to our allowance.
In addition, the OCC periodically reviews our allowance for loan losses and may require us to increase our provision for loan losses or recognize further loan charge-offs. Any increase in our allowance for loan losses or loan charge-offs as required by regulatory authorities might have a material adverse effect on our financial condition and results of operations.
Continued Adverse Economic Conditions, Especially Affecting Our Geographic Market Area, Could Adversely Affect Our Financial Condition and Results of Operations.
The United States experienced a severe economic recession in 2008 and 2009, the effects of which have continued. Recent growth has been slow relative to historical standards. Loan portfolio quality has remained poor at many financial institutions reflecting, in part, the weak United States economy. In addition, the value of real estate collateral supporting many commercial loans and home mortgages throughout the United States has declined. The real estate downturn also has resulted in reduced demand for the construction of new housing and increased delinquencies in construction, residential and commercial mortgage loans in many markets across the United States.
Our lending market area consists of Greenup, Lawrence, Boyd, Jessamine, Montgomery, Fayette and Campbell Counties in Kentucky, and Lawrence, Scioto, Hamilton, Butler, Warren and Clermont Counties in Ohio. While we did not originate or invest in sub-prime mortgages, our lending business is tied, in part, to the real estate market, which has been weakened by the recession. While we believe our lending market area has not been as adversely affected by the real estate crisis as some other areas of the country, real estate values and demand have softened, and we remain vulnerable to adverse changes in the real estate market. In addition, a significant weakening in general economic conditions such as inflation, recession, unemployment or other factors beyond our control, could negatively affect our financial results. Finally, negative developments in the securities markets could adversely affect the value of our securities.
If We Fail to Maintain an Effective System of Internal and Disclosure Controls, We May Not Be Able to Accurately Report Our Financial Results or Prevent or Detect Fraud. As a Result, Current and Potential Shareholders Could Lose Confidence in Our Financial Reporting, Which Would Harm Our Business and the Trading Price of Our Securities.
Effective internal control over financial reporting and disclosure controls and procedures are necessary for us to provide reliable financial reports and effectively prevent or detect fraud and to operate successfully as a public company. If we cannot provide reliable financial reports or prevent fraud, our reputation and operating results would be harmed. We continually review and analyze our internal control over financial reporting for Sarbanes-Oxley Section 404 compliance. Our internal control and disclosure controls may still prove ineffective in future periods. Any failure to maintain effective controls or timely effect any necessary improvement of our internal and disclosure controls could hinder our ability to accurately report our operating results or cause us to fail to meet our reporting obligations, which could affect our ability to remain listed with The NASDAQ Capital Market. Ineffective internal and disclosure controls could also cause investors to lose confidence in our reported financial information, which would likely have a negative effect on the trading price of our securities.
Regulation of the financial services industry is undergoing major changes and future legislation could increase our cost of doing business or harm our competitive position.
In 2010 and 2011, in response to the financial crisis and recession that began in 2008, significant regulatory and legislative changes resulted in broad reform and increased regulation impacting financial institutions. The Dodd-Frank Act has created a significant shift in the way financial institutions operate. The Dodd-Frank Act also creates a new federal agency to administer consumer protection and fair lending laws, a function that was formerly performed by the depository institution regulators. The Dodd-Frank Act contains various other provisions designed to enhance the regulation of depository institutions. The Dodd-Frank Act may have a material impact on our operations, particularly through increased regulatory burden and compliance costs. Any future legislative changes could have a material impact on our profitability, the value of assets held for investment or collateral for loans. Future legislative changes could require changes to business practices or force us to discontinue businesses and potentially expose us to additional costs, liabilities, enforcement action and reputational risk.
In addition to the enactment of the Dodd-Frank Act, the federal regulatory agencies have taken stronger supervisory actions against financial institutions that have experienced increased loan losses and other weaknesses as a result of the recent economic crisis. The actions include entering into written agreements and cease and desist orders that place certain limitations on operations. Federal bank regulators have also been using with more frequency their ability to impose individual minimum capital requirements on banks, which requirements may be higher than those required under the Dodd-Frank Act or that would otherwise qualify a bank as being “well capitalized” under applicable prompt corrective action regulations. If we were to become subject to a regulatory agreement or higher individual minimum capital requirements, such action may have a negative impact on our ability to execute our business plan, as well as our ability to grow, pay dividends or engage in mergers and acquisitions and may result in restrictions in our operations.
Additionally, the Federal Reserve Board has approved revisions to their capital adequacy guidelines and prompt corrective action rules that implement the revised standards of Basel III and address relevant provisions of the Dodd-Frank Act. Basel III and the regulations of the federal banking agencies require bank holding companies and banks to undertake significant activities to demonstrate compliance with the new and higher capital standards. Compliance with these rules will impose additional costs on us.
We operate in a highly regulated environment and we may be adversely affected by changes in laws and regulations.
Town Square Bank is subject to extensive regulation, supervision and examination by the OCC, its primary federal regulator, and by the FDIC, as its deposit insurer. The Company is also subject to regulation and supervision by the Federal Reserve Board. Such regulation and supervision govern the activities in which an institution and its holding company may engage and are intended primarily for the protection of the insurance fund and the depositors and borrowers of Town Square Bank rather than for holders of the Company’s common stock. Regulatory authorities have extensive discretion in their supervisory and enforcement activities, including the imposition of restrictions on our operations, the classification of our assets and determination of the level of our allowance for loan losses. If our regulators require us to charge-off loans or increase our allowance for loan losses, our earnings would suffer. Any change in such regulation and oversight, whether in the form of regulatory policy, regulations, legislation or supervisory action, may have a material impact on our operations.
Strong Competition Within Our Market Areas May Limit Our Growth and Profitability.
Competition in the banking and financial services industry is intense. In our market areas, we compete with commercial banks, savings institutions, mortgage brokerage firms, credit unions, finance companies, mutual funds, insurance companies, and brokerage and investment banking firms operating locally and elsewhere. The commercial bank and savings institution competitors include larger institutions with nationwide or regional operations, and local community institutions such as us that serve the local markets only. The credit union competitors consist of local community based institutions. Some of our competitors have greater name recognition and market presence that benefit them in attracting business and offer certain services that we do not or cannot provide. In addition, larger competitors may be able to price loans and deposits more aggressively than we can, which could affect our ability to grow and remain profitable on a long-term basis. Our profitability depends upon our continued ability to successfully compete in our market areas. If we must raise interest rates paid on deposits or lower interest rates charged on our loans, our net interest margin and profitability could be adversely affected. For additional information see “Item 1 - Business-Town Square-Market Area” and -“Competition.”
The financial services industry could become even more competitive as a result of new legislative, regulatory and technological changes and continued consolidation. Banks, securities firms and insurance companies can merge under the umbrella of a financial holding company, which can offer virtually any type of financial service, including banking, securities underwriting, insurance (both agency and underwriting) and merchant banking. Also, technology has lowered barriers to entry and made it possible for non-banks to offer products and services traditionally provided by banks, such as automatic transfer and automatic payment systems. Many of our competitors have fewer regulatory constraints and may have lower cost structures. Additionally, due to their size, many competitors may be able to achieve economies of scale and, as a result, may offer a broader range of products and services as well as better pricing for those products and services than we can.
Risks Associated with System Failures, Interruptions, or Breaches of Security Could Negatively Affect Us and Our Earnings.
Information technology systems are critical to our business operations. We use various technology systems to manage customer relationships, our general ledger, our securities investments, and our customer deposits and loans. We have established policies and procedures to prevent or limit the effect of system failures, interruptions, and security breaches, but these events may still occur or may not be adequately addressed if they do occur. In addition, any compromise of our systems could deter customers from using our products and services. Security systems may not protect systems from security breaches.
In addition, we outsource some of our data processing to certain third-party providers. If they encounter difficulties, or if we have difficulty communicating with them, our ability to adequately process and account for transactions could be affected, and our business operations could be adversely affected. Threats to information security also exist in the processing of customer information through various other vendors and their personnel.
The occurrence of any system failures, interruption, or breach of security could damage our reputation and result in a loss of customers and business, thereby subjecting us to additional regulatory scrutiny, or could expose us to litigation and possible financial liability. Any of these events could have a material adverse effect on our financial condition and results of operations.
We Are a Community Bank and Our Ability to Maintain Our Reputation is Critical to the Success of Our Business and the Failure to Do So May Materially Adversely Affect Our Performance.
We are a community bank, and our reputation is one of the most valuable components of our business. As such, we strive to conduct our business in a manner that enhances our reputation. This is done, in part, by recruiting, hiring and retaining employees who share our core values of being an integral part of the communities we serve, delivering superior service to our customers and caring about our customers and associates. If our reputation is negatively affected, by the actions of our employees or otherwise, our business and, therefore, our operating results may be materially adversely affected. We will continue to face additional challenges maintaining our reputation with respect to customers of Town Square in our current market area and in building our reputation in the new market areas that we serve as a result of the acquisition of Town Square Financial and Town Square Bank and the acquisition of Commonwealth Bank.
We Depend on Our Management Team to Implement Our Business Strategy and Execute Successful Operations and We Could Be Harmed by the Loss of Their Services.
We are dependent upon the services of our senior management team. Our strategy and operations are directed by the senior management team. Any loss of the services of our president and chief executive officer or other members of our senior management team could impact our ability to implement our business strategy and have a material adverse effect on our results of operations and our ability to compete in our markets. See “Directors, Executive Officers and Corporate Governance.”
Changes in Accounting Standards Could Affect Reported Earnings.
The accounting standard setters, including the Financial Accounting Standards Board, the Securities and Exchange Commission and other regulatory bodies, periodically change the financial accounting and reporting guidance that governs the preparation of our consolidated financial statements. These changes can be hard to predict and can materially affect how we record and report our financial condition and results of operations. In some cases, we could be required to apply new or revised guidance retroactively.
The Issuance of Awards Under Our Stock-Based Benefit Plans Will Dilute Your Ownership Interest.
On January 8, 2013, the shareholders of Poage Bankshares approved the Poage Bankshares, Inc. 2013 Equity Incentive Plan (the “Plan”) for employees and directors of Poage Bankshares. The Plan authorizes the issuance of up to 472,132 shares of Poage Bankshares common stock, with no more than 134,895 of shares as restricted stock awards and 337,237 as stock options, either incentive stock options or non-qualified stock options. The exercise price of options granted under the Plan may not be less than the fair value on the date the stock option is granted. The compensation committee of the board of directors has sole discretion to determine the amount and to whom equity incentive awards are granted. If awards under the Plan are funded from the issuance of authorized but unissued shares of common stock, Poage Bankshares shareholders would experience a dilution of their ownership interest. On April 16, 2013, the board of directors awarded the authorized 134,895 restricted shares as designated by the compensation committee and through December 31, 2017 have granted 325,000 stock option awards. The implementation of any additional stock-based benefit plans in the future would cause further dilution of such ownership interests.
If the goodwill we have recorded in connection with business acquisitions becomes impaired, it would have a negative impact on our profitability.
Goodwill represents the amount of acquisition cost over the fair value of net assets we acquired in the purchase of another financial institution. We review goodwill for impairment at least annually, or more frequently if events or changes in circumstances indicate the carrying value of the asset might be impaired. We determine impairment by comparing the implied fair value of the reporting unit goodwill with the carrying amount of that goodwill. If the carrying amount of the reporting unit goodwill exceeds the implied fair value of that goodwill, an impairment loss is recognized in an amount equal to that excess. Any such adjustments are reflected in our results of operations in the periods in which they become known. We have recorded no such impairment charges since we initially recorded the goodwill, there can be no assurance that our future evaluations of goodwill will not result in findings of impairment and related write-downs, which may have a material adverse effect on our financial condition and results of operations.
Shareholder Activists Could Cause a Disruption to Poage Bankshares’ Business.
Certain institutional investors have indicated that they disagree with the strategic direction and capital allocation policies of Poage Bankshares and have successfully obtained representation on its Board of Directors through a director election contest. Poage Bankshares’ business, operating results or financial condition could be adversely affected by a director election contest and may result in, among other things:
>Increased operating costs, including increased legal expenses, insurance, administrative expenses and associated costs incurred in connection with director election contests;
>Uncertainties as to Poage Bankshares’ future direction could result in the loss of potential business opportunities and could (i) make it more difficult to attract, retain, or motivate qualified personnel, and (ii) strain relationships with investors and customers; and
>Reduction or delay in Poage Bankshares’ ability to effectively execute its current business strategy and to implement new strategies.
ITEM 1B.
ITEM 1B.UNRESOLVED STAFF COMMENTS
Not applicable.
ITEM 2.
ITEM 2.PROPERTIES
As of December 31, 2017, the net book value of our offices was $9.8 million.
We believe that current facilities are adequate to meet our present and foreseeable needs, subject to possible future expansion.
ITEM 3.
ITEM 3.LEGAL PROCEEDINGS
We are not involved in any pending legal proceedings as a plaintiff or a defendant other than routine legal proceedings occurring in the ordinary course of business. At December 31, 2017, we were not involved in any legal proceedings, the outcome of which would be material to our financial condition or results of operations.
ITEM 4.
ITEM 4.MINE SAFETY DISCLOSURES
Not applicable.
PART II
ITEM 5.
ITEM 5.MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
(a) Our shares of common stock are traded on the NASDAQ Capital Market under the symbol PBSK. The approximate number of holders of record of Poage Bankshares, Inc.’s common stock as of December 31, 2017 was 390. Certain shares of Poage Bankshares, Inc. are held in “nominee” or “street” name and accordingly, the number of beneficial owners of such shares is not known or included in the foregoing number. The following table presents quarterly market information for Poage Bankshares, Inc. common stock for each quarter of the previous two fiscal years. The following information was provided by the NASDAQ Stock Market.
Dividend payments by Poage Bankshares, Inc. are dependent primarily on dividends it receives from Town Square, because Poage Bankshares, Inc. has no source of income other than dividends from Town Square, earnings from the investment of proceeds from the sale of shares of common stock retained by Poage Bankshares, Inc., and interest payments with respect to Poage Bankshares Inc.’s loan to the Employee Stock Ownership Plan. For more information on regulatory restrictions regarding the payment of dividends, see “Item 1 - Business-Supervision and Regulation-Dividends” and “-Holding Company Regulation-Permissible Activities.” For information regarding shares of Poage Bankshares common stock that is available for issuance under equity compensation plans, see “Item 12 - Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.”
Other than its employee stock ownership plan, Poage Bankshares, Inc. does not have any equity compensation plans that were not approved by stockholders.
The following information is presented for the Poage Bankshares, Inc. 2103 Equity Incentive Plan:
(b)Not applicable.
(c)Issuer repurchases. On June 2, 2016, Poage Bankshares, Inc. commenced a new stock repurchase program. The Board of Directors of Poage Bankshares, Inc. authorized a program to repurchase up to 150,000 shares, which represents approximately 3.9% of the Company’s issued and outstanding shares of common. The Company repurchased 127,955 shares at a weighted average price of $18.20 per share and there remained 22,045 shares to be repurchased under this plan at December 31, 2017.
On December 20, 2016, the Board of Directors of Poage Bankshares, Inc. authorized a new program to repurchase up to 185,000 shares, which represents approximately 5% of the Company’s issued and outstanding shares of common stock. On June 26, 2017, the Company completed the stock program for up to 185,000 shares of common stock at a weighted average price of $19.07 per share.
On December 5, 2017, the Board of Directors of Poage Bankshares, Inc. authorized a new stock repurchase program for the repurchase of up to $180,000 shares of common stock, which represents approximately 5% of the Company’s issued and outstanding shares of common stock. The Company repurchased 6,500 shares at a weighted average price of $19.00 per share and there remained 173,500 shares to be repurchased under this plan at December 31, 2017.
Poage Bankshares’ stock repurchases pursuant to the repurchase program is dependent on certain factors, including but not limited to, market conditions and prices, available funds and alternative uses of capital. The repurchase program may be carried out through open-market purchases, block trades, negotiated private transactions and pursuant to a trading plan adopted in accordance with Rule 10b5-1 under the Securities Exchange Act of 1934. Any repurchased shares will be treated by the Company as authorized but unissued shares.
The following table sets forth information in connection with repurchases of the Poage Bankshares’ common stock for the period October 1, 2017 through December 31, 2017. Shares were purchased pursuant to repurchase authorizations outlined above.
ITEM 6.
ITEM 6.SELECTED FINANCIAL DATA
The following tables set forth selected historical financial and other data of Poage Bankshares at the dates and for the periods indicated. The information at December 31, 2017 and 2016, and for the years ended December 31, 2017 and 2016 is derived in part from, and should be read together with, the audited consolidated financial statements and notes thereto of Poage Bankshares that appear in this Annual Report on Form 10-K. The information at December 31, 2015, 2014 and 2013 and for the years ended December 31, 2015 and 2014, and the three months ended December 31, 2013, is derived in part from audited financial statements that do not appear in this Annual Report on Form 10-K.
Selected Financial and Other Data
(1) Represents the difference between the weighted average yield on average interest-earning assets and the weighted average cost of interest-bearing liabilities.
(2) Represents net interest income as a percent of average interest-earning assets.
(3) Represents noninterest expense divided by the sum of net interest income and noninterest income.
(4) Represents dividends declared per share divided by the net income (loss) per share.
ITEM 7.
ITEM 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Overview
We have historically operated as a traditional thrift institution headquartered in Ashland, Kentucky. Our principal business consists of attracting retail deposits from the general public in our market area and investing those deposits, together with funds generated from operations, and to a lesser extent, borrowings, in one- to four-family residential mortgage loans, commercial and multi-family real estate loans, commercial business loans, consumer loans, consisting primarily of automobile loans, home equity loans and lines of credit, and construction loans. Since the acquisition of Town Square Financial Corporation, our focus has moved towards commercial banking. We also purchase investment securities consisting primarily of securities issued by United States Government agencies and government sponsored entities, including obligations of state and political subdivisions and mortgage-backed securities. At December 31, 2017, we had total assets of $446.9 million, total deposits of $370.0 million and total shareholders’ equity of $61.7 million.
Our results of operations depend primarily on our net interest income. Net interest income is the difference between the interest income we earn on our interest-earning assets and the interest we pay on our interest-bearing liabilities. Our results of operations also are affected by our provisions for loan losses, non-interest income and non-interest expense. Non-interest income currently consists primarily of service charges on deposit accounts, net gain on sales of securities and loans, income from company-owned life insurance and miscellaneous other income. Non-interest expense currently consists primarily of expenses related to compensation and employee benefits, occupancy and equipment, data processing, federal deposit insurance, foreclosed assets, advertising, professional and accounting fees, and other operating expenses.
Other than our loans for the construction of one- to four-family properties, we do not offer “interest only” mortgage loans (where the borrower pays only interest for an initial period, after which the loan converts to a fully amortizing loan) on one- to four-family residential properties. We also do not offer loans that provide for negative amortization of principal, such as “Option ARM” loans, where the borrower can pay less than the interest owed on his or her loan, resulting in an increased principal balance during the life of the loan. We do not offer “subprime loans” (i.e., loans that generally target borrowers with weakened credit histories typically characterized by payment delinquencies, previous charge-offs, judgments, bankruptcies, or borrowers with questionable repayment capacity as evidenced by low credit scores or high debt-burden ratios) or Alt-A loans (i.e., loans that generally target borrowers with better credit scores who borrow with alternative documentation, such as little or no verification of income).
Critical Accounting Policy
We consider accounting policies that require management to exercise significant judgment or discretion or make significant assumptions that have, or could have, a material impact on income or on the carrying value of certain assets, to be critical accounting policies. We consider the following to be our critical accounting policy:
Allowance for Loan Losses. The allowance for loan losses is a valuation allowance for probable incurred credit losses. 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. Management estimates the allowance balance required using past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions and other factors. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management’s judgment, should be charged-off.
The allowance consists of specific and general components. The specific component relates to loans that are individually classified as impaired or loans otherwise classified as substandard or doubtful. The general component covers non-classified loans and is based on historical loss experience adjusted for current factors.
A loan is impaired when full payment under the terms of the loan is not expected. Commercial and non-residential real estate loans are individually evaluated for impairment. If a loan is impaired, a portion of the allowance is allocated so that the loan is reported, net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral. Large groups of smaller balance homogeneous loans, such as consumer and residential real estate loans, are collectively evaluated for impairment, and accordingly, they are not separately identified for impairment disclosures.
Income Taxes: We account for income taxes under ASC 740, whereby deferred tax asset or liability account balances are determined based on the difference between the financial statement and the tax bases of assets and liabilities using current tax laws and rates in effect for the year in which the differences are expected to affect taxable income. Valuation allowances are established, when necessary, to reduce deferred tax assets when we expect the amount of tax benefit to be realized is less than the carrying value of the deferred tax asset.
Accounting for income taxes involves uncertainty and judgment on how to interpret and apply tax laws and regulations within our annual tax filings. Such uncertainties from time to time may result in a tax position that may be challenged and overturned by a tax authority in the future which could result in additional tax liability, interest charges and possibly penalties. We classify interest and penalties as a component of tax expense.
Comparison of Financial Condition at December 31, 2017 and December 31, 2016
At December 31, 2017, Poage Bankshares’ assets totaled $446.9 million, a decrease of $11.6 million, or 2.5% from $458.5 million at December 31, 2016. The decrease was primarily attributable to decrease in real estate, commercial and consumer loans.
Cash and cash equivalents decreased by $3.9 million, or 15.9% to $20.5 million at December 31, 2017 from $24.4 million at December 31, 2016.
Interest-bearing deposits in other financial institutions increased by $1.0 million, or 50.0%, to $3.0 million at December 31, 2017 from $2.0 million at December 31, 2016.
Loans held for sale decreased $355,000, or 58.1%, to $256,000 at December 31, 2017 from $611,000 at December 31, 2016 primarily due to a decrease in mortgage banking activity throughout the year.
Loans receivable, net, decreased $15.4 million, or 4.5%, to $328.5 million at December 31, 2017 from $343.9 million at December 31, 2016. This decrease was primarily due to a decrease in lending in commercial real estate and commercial and industrial loans. Non-performing loans increased by $1.7 million, or 35.6%, to $6.4 million at December 31, 2017 from $4.7 million at December 31, 2016, primarily due to the deterioration in credit quality of commercial and industrial loans and one- to four-family mortgage loans, and defaults.
Securities available for sale increased by $5.8 million, or 10.0%, to $64.1 million at December 31, 2017 from $58.3 million at December 31, 2016. This increase is primarily due to purchases of $15.0 million, offset by calls, regular maturities and principal payments totaling $6.0 million.
Goodwill increased $617,000, or 48.3%, to $1.9 million at December 31, 2017 from $1.3 million at December 31, 2016. This increase is attributable to revision of the purchase accounting for the 2014 Town Square acquisition due to the discovery in 2017 of $934,000 in fictitious loans acquired.
Deposits decreased $4.7 million, or 1.2%, to $370.0 million at December 31, 2017 from $374.7 million at December 31, 2016. The decrease was attributable to the maturity of $16.6 million non-brokered deposits acquired in the national market, offset by organic growth in our market areas.
Federal Home Loan Bank advances decreased $1.9 million, or 20.5%, to $7.4 million at December 31, 2017 from $9.3 million at December 31, 2016. This decrease in borrowings was primarily due to $19.9 million in regular principal payments and maturities, offset by $18.0 million in advances.
Other borrowings remained unchanged at $2.8 million at December 31, 2017 and 2016. The amortization of fair value related to the subordinate debenture was $64,000 for the year ended December 31, 2016. The subordinated debenture of $2.8 million is shown as a liability. The investment in common stock of the trust is $124,000 and is included in other assets. The subordinated debt has a variable rate of interest equal to the three month London Interbank Offered Rate (LIBOR) plus 1.83%, which was 3.15% at December 31, 2017.
Total shareholders’ equity decreased by $7.0 million, or 10.2%, to $61.7 million at December 31, 2017, from $68.7 million at December 31, 2016. The decrease resulted primarily from the repurchase of stock totaling $3.7 million, the payment of cash dividends totaling $817,000 and a net loss of $2.9 million for the year ended December 31, 2017.
Comparison of Operating Results for the Years Ended December 31, 2017 and December 31, 2016
General. Net income decreased $4.7 million, or 259.8%, to a net loss of $2.9 million for the year ended December 31, 2017 from net income of $1.8 million for the year ended December 31, 2016. The decrease reflected a decrease in net interest income of $549,000, or 3.3%, to $16.1 million for the year ended December 31, 2017 from $16.7 million for the year ended December 31, 2016, an increase in the provision for loan losses of $2.3 million, or 181.5%, to $3.5 million for the year ended December 31, 2017 from $1.2 million for the year ended December 31, 2016, a decrease in non-interest income of $323,000, or 10.7%, to $2.7 million for the year ended December 31, 2017 from $3.0 million for the year ended December 31, 2016 and an increase in non-interest expense of $2.1 million, or 13.0%, to $19.0 million for the year ended December 31, 2017 from $16.0 million for the year ended December 31, 2016, offset by a decrease in income tax expense of $563,000, or 89.1%, to a tax expense of $69,000 for the year ended December 31, 2017 from $632,000 for the year ended December 31, 2016.
Interest and Dividend Income. Interest income decreased $122,000, or 0.6%, to 19.0 million for the year ended December 31, 2017 from $19.1 million for the year ended December 31, 2016.
Interest income on loans decreased $422,000, or 2.4%, to $17.1 million for the year ended December 31, 2017 from $17.5 million for the year ended December 31, 2016. The average yields on loans decreased 17 basis points to 5.04% for the year ended December 31, 2017, compared to 5.21% for the year ended December 31, 2016, although the average balance of loans increased $3.0 million to $339.3 million for the year ended December 31, 2017 from $336.3 million for the year ended December 31, 2016. The decrease in yield is primarily due to a decrease of $385,000 in accretable yield on credit-impaired purchased loans for the year ended December 31, 2017 from the year ended December 31, 2016. The information for the year ended December 31, 2017 reflects the accretive benefit, approximately $383,000, from the acquisitions of Town Square Financial and Commonwealth.
Interest income on investment securities increased $102,000, or 7.5%, to $1.5 million for the year ended December 31, 2017 from $1.4 million for the year ended December 31, 2016, reflecting an increase in the average balance of such securities to $62.0 million at December 31, 2017 from $61.3 million at December 31, 2016 combined with a 14 basis point increase in the average yield to 2.35% for the year ended December 31, 2017, from 2.21% for the year ended December 31, 2016. This increase in yield is due to calls and maturity of lower yielding investment securities and the purchase of higher yielding investments.
Interest Expense. Interest expense increased $427,000, or 17.6%, to $2.8 million for the year ended December 31, 2017 from $2.4 million for the year ended December 31, 2016. The increase reflected an increase of $15.3 million in the average balance on interest bearing deposits to $321.3 million at December 31, 2017 from $306.0 million at December 31, 2016 combined with an increase in the average rate paid on such deposits to 0.76% for the year ended December 31, 2017 from 0.67% for the year ended December 31, 2016. Interest expense on interest bearing deposits increased $416,000, or 20.4%, to $2.5 million for the year ended December 31, 2017 from $2.0 million for the year ended December 31, 2016. Interest expense on FHLB-Cincinnati advances, subordinated debenture and other borrowings increased $11,000, or 2.9% to $391,000 for the year ended December 31, 2017 from $380,000 for the year ended December 31, 2016. This increase was due to an 80 basis point increase in the average rate paid on these borrowings to 2.96% from 2.16%, offset by a decrease of $1.4 million in the average balance on these borrowings.
Interest expense on money market deposits, savings, NOW and demand deposits increased $170,000, or 65.6%, to $429,000 for the year ended December 31, 2017 from $259,000 for the year ended December 31, 2016. The increase reflected an increase in the average balance of these deposits to $154.4 million at December 31, 2017 from $140.3 million at December 31, 2016. The average rate paid on these deposits increased 10 basis points to 0.28% for the year ended December 31, 2017 from 0.18% for the year ended December 31, 2016. Interest expense on certificates of deposit increased $246,000, or 13.8%, to $2.0 million for the year ended December 31, 2017 from $1.8 million for the year ended December 31, 2016. This increase reflected an increase in the average balance of such certificates to $166.9 million from $165.7 million and an increase in the average rate paid on certificates of deposits to 1.21% for the year ended December 31, 2017 from 1.07% for the year ended December 31, 2016.
Net Interest Income. Net interest income decreased $549,000 or 3.3%, to $16.1 million for the year ended December 31, 2017 from $16.7 million for the year ended December 31, 2016. The interest rate spread decreased 27 basis points from 3.80% to 3.53%, along with an 18 basis point decrease in the ratio of the average interest earning assets to average interest bearing liabilities from 129.63% to 129.45%. Net interest margin decreased from 3.98% to 3.73%. The decrease in interest rate spread and net interest margin was attributable to a decrease in interest income on loans of $422,000, or 2.4%, to $17.1 million for the year ended December 31, 2017 from $17.5 million for the year ended December 31, 2016 combined with an increase in interest expense on interest bearing deposits of $416,000, or 20.4%, to $2.5 million to $2.0 million for the same periods.
Provision for Loan Losses. Provision for loan losses increased $2.3 million, or 181.5%, to $3.5 million for the year ended December 31, 2017 from $1.2 million for the year ended December 31, 2016. The increase is attributable to an increase in substandard and special mention loans combined with an increase in charge-offs for the year ended December 31, 2017.
Noninterest Income. Noninterest income decreased $323,000, or 10.7%, to $2.7 million for the year ended December 31, 2017 from $3.0 million for the year ended December 31, 2016. The decrease in noninterest income was due to the decrease of $177,000, or 37.3%, in loan servicing fees, a decrease in gains on mortgage loans sold of $44,000, or 20.2%, a decrease in service charges on deposits of $53,000, or 2.6% and a decrease in net gains on the disposal of land and equipment of $19,000, or 52.8% for the year ended December 31, 2017 from the year ended December 31, 2016, respectively.
Noninterest Expense. Noninterest expense increased $3.0 million, or 18.8%, to $19.0 million for the year ended December 31, 2017 from $16.0 million for the year ended December 31, 2016. This increase was primarily attributable to the early contract termination and deconversion expense of $1.8 million and the loss on fictitious loans of $481,000. The Company signed a contract with the new data processing provider in December of 2017. By converting to the new system, the Company expects to recoup these deconversion fees and early termination costs during the five years following conversion through the recognition of significant cost savings. On September 12, 2017, the Company uncovered evidence of suspected fraud involving the origination of fictitious loans by an employee of the Bank. The Bank believes that it will recover its losses, less the deductible of $25,000, under the terms of its fidelity bond. However, based upon correspondence received from counsel to the Bank’s fidelity bond insurer on March 29, 2018, management cannot assert that collection is probable which is a high threshold under generally accepted accounting principles.
Foreclosed assets expense increased $201,000, or 39.6%, to $709,000 for the year ended December 31, 2017 from $508,000 for the year ended December 31, 2016. The increase in noninterest expense was offset by a decrease of $406,000, or 5.5%, in salaries and employee benefits to $7.0 million of the year ended December 31, 2017 from $7.4 million for the year ended December 31, 2016 and a decrease in occupancy and equipment expense of $105,000, or 5.1%, from $2.1 million for the year ended December 31, 2016 to $2.0 million for year ended December 31, 2017.
Income Tax Expense. The provision for income taxes decreased $563,000, or 89.1%, to a tax expense of $69,000 for the year ended December 31, 2017 from $632,000 for the year ended December 31, 2016. Our effective tax rate for the year ended December 31, 2017 was 2.5% compared to 26.0% for the year ended December 31, 2016. On December 22, 2017, The Tax Cuts and Jobs Act (the “Act”) was signed into law. Among other things, the Act reduces the corporate federal tax rate from 35% to 21% effective January 1, 2018 as well as repealing the alternative minimum tax. As a result, we are required to re-measure, through income tax expense, our deferred tax assets and liabilities using the enacted rate at which we expect them to be recovered or settled. The re-measurement of our deferred tax assets and liabilities resulted in a one-time charge to the Company’s earnings and reduction to its net deferred tax assets of approximately $1.2 million in 2017.
Analysis of Net Interest Income
Net interest income represents the difference between the income we earn on interest-earning assets and the interest expense we pay on interest-bearing liabilities. Net interest income also depends upon the relative amounts of interest-earning assets and interest-bearing liabilities and the interest rates earned or paid on them.
The following table sets forth average balance sheets, average yields and costs, and certain other information at the dates and for the periods indicated. All average balances are daily average balances. Non-accrual loans were included in the computation of average balances, but have been reflected in the table as loans carrying a zero yield. The yields set forth below include the effect of deferred fees, discounts and premiums that are amortized or accreted to interest income.
Rate/Volume Analysis
The following tables present, for the periods indicated, the dollar amount of changes in interest income and interest expense for the major categories of Town Square’s interest-earning assets and interest-bearing liabilities. Information is provided for each category of interest-earning assets and interest-bearing liabilities with respect to (i) changes attributable to changes in volume (i.e., changes in average balances multiplied by the prior-period average rate) and (ii) changes attributable to rate (i.e., changes in average rate multiplied by prior-period average balances). For purposes of these tables, changes attributable to both rate and volume, which cannot be segregated, have been allocated proportionately to the change due to volume and the change due to rate.
Management of Market Risk
Our most significant form of market risk is interest rate risk because, as a financial institution, the majority of our assets and liabilities are sensitive to changes in interest rates. Therefore, a principal part of our operations is to manage interest rate risk and limit the exposure of our net interest income to changes in market interest rates.
Our Board of Directors is responsible for the review and oversight of our asset/liability strategies. Our Board of Directors has also established an Asset/Liability Management Committee consisting of senior management. This committee is responsible for evaluating the interest rate risk inherent in our assets and liabilities, for determining the level of risk that is appropriate, given our business strategy, operating environment, capital, liquidity and performance objectives, and for managing this risk consistent with the guidelines approved by the Board of Directors.
Among the techniques we are currently using to manage interest rate risk are: (i) continuing the origination of adjustable-rate one- to four-family residential loans, subject to demand for such loans in a lower interest rate environment, while endeavoring to sell a large portion of the fixed rate; (ii) increasing our origination of commercial and multifamily residential real estate, commercial business and motor vehicle and other consumer loans as they generally reprice more quickly than residential mortgage loans that we originate to the FHLB-Cincinnati; (iii) maintaining a strong capital position, which provides for a favorable level of interest-earning assets relative to interest-bearing liabilities; and (iv) emphasizing less interest rate sensitive and lower-costing “core deposits.” We also maintain a portfolio of short-term or adjustable-rate assets and from time to time have used fixed-rate FHLB-Cincinnati advances and brokered deposits to extend the term to repricing of our liabilities.
Depending on market conditions, from time to time we place more emphasis on enhancing net interest margin rather than matching the interest rate sensitivity of our assets and liabilities. In particular, we believe that the increased net interest income resulting from a mismatch in the maturity of our assets and liabilities portfolios can, during periods of stable or declining interest rates, provide high enough returns to justify increased exposure to sudden and unexpected increases in interest rates. As a result of this philosophy, our results of operations and the economic value of our equity will remain vulnerable to increases in interest rates and to declines due to differences between long and short-term interest rates.
An important measure of interest rate risk is the amount by which the economic value of equity of an institution’s cash flow from assets, liabilities and off balance sheet items changes in the event of a range of assumed changes in market interest rates. We have utilized the FIS Ambit ALM4 software provided First National Bankers Bank to provide an analysis of estimated changes in our EVE under the assumed instantaneous changes in the United States treasury yield curve. The financial model uses a discounted cash flow analysis and an option-based pricing approach to measuring the interest rate sensitivity of the EVE.
Set forth below is an analysis of the changes to the economic value of our equity (“EVE”) that would occur December 31, 2017 in the event of designated changes in the United States treasury yield curve. At December 31, 2017, the economic value of our equity exposure related to these hypothetical changes in market interest rates was within the current guidelines we have established.
Certain shortcomings are inherent in the methodology used in the above interest rate risk measurement. The EVE analysis incorporates all cash flows over the estimated remaining life of all balance sheet items and off balance sheet items. The EVE of the balance sheet is the discounted present value of assets and derivative cash flows minus discounted value of liability cash flows at a point in time and is a measure of longer term interest rate risk. The results of the model are dependent on assumptions concerning the timing and variability of cash flows along with projected prepayments and deposit decay rates.
Our policies do not permit hedging activities, such as engaging in futures, options or swap transactions, or investing in high-risk mortgage derivatives, such as collateralized mortgage obligation residual interests, real estate mortgage investment conduit residual interests or stripped mortgage backed securities.
Liquidity and Capital Resources
Our primary sources of funds are deposits and the proceeds from principal and interest payments on loans and investment securities. We also utilize Federal Home Loan Bank advances. While maturities and scheduled amortization of loans and securities are predictable sources of funds, deposit flows and mortgage prepayments are greatly influenced by general interest rates, economic conditions and competition. Poage Bankshares generally manages the pricing of its deposits to be competitive within its market and to increase core deposit relationships.
Liquidity management is both a daily and long-term responsibility of management. We adjust our investments in liquid assets based upon management’s assessment of (i) expected loan demand, (ii) expected deposit flows, (iii) yields available on interest-earning deposits and investment securities, and (iv) the objectives of its asset/liability management program. Excess liquid assets are invested generally in interest-earning overnight deposits, federal funds sold, and short and intermediate-term investment securities. If we require funds beyond our ability to generate them internally, we have additional borrowing capacity with the FHLB-Cincinnati. At December 31, 2017, we had $7.4 million in advances from the FHLB-Cincinnati and an additional borrowing capacity of $85.5 million.
Town Square is subject to various regulatory capital requirements administered by its primary federal regulator, the OCC. Failure to meet the minimum regulatory capital requirements can initiate certain mandatory and possible additional discretionary actions by regulators that if undertaken, could have a direct material effect on Town Square and the consolidated financial statements. Under the regulatory capital adequacy guidelines and the regulatory framework for prompt corrective action, Town Square must meet specific capital guidelines involving quantitative measures of Town Square’s assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices.
Poage Bankshares is a separate legal entity from Town Square and must provide for its own liquidity to pay dividends to shareholders, repurchase its stock and to fund other corporate activities. Poage Bankshares’ primary source of liquidity is dividend payments it receives from Town Square. At December 31, 2017, Poage Bankshares (on an unconsolidated basis) had liquid assets totaling $4.4 million.
Town Square’s capital amounts and classification under the prompt corrective action guidelines are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.
Quantitative measures established by regulation to ensure capital adequacy require Town Square to maintain minimum amounts and ratios of total risk-based capital and Tier 1 capital to risk-weighted assets (as defined in the regulations), Tier 1 capital to adjusted total assets (as defined), tangible capital to adjusted total assets (as defined), and common equity Tier 1 capital to risk weighted assets (as defined).
As of December 31, 2017, based on the most recent notification from the OCC, Town Square was categorized as well-capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since the most recent notification that management believes have changed Town Square’s prompt corrective action category.
Off-Balance Sheet Arrangements. In the normal course of operations, Poage Bankshares engages in a variety of financial transactions that, in accordance with U.S. generally accepted accounting principles, are not recorded in its financial statements. These transactions involve, to varying degrees, elements of credit, interest rate and liquidity risk. Such transactions are used primarily to manage customers’ requests for funding and take the form of loan commitments and lines of credit.
Impact of Inflation and Changing Prices
Our consolidated financial statements and related notes have been prepared in accordance with U.S. GAAP. U.S. GAAP generally requires the measurement of financial position and operating results in terms of historical dollars without consideration of changes in the relative purchasing power of money over time due to inflation. The impact of inflation is reflected in the increased cost of our operations. Unlike industrial companies, our assets and liabilities are primarily monetary in nature. As a result, changes in market interest rates have a greater impact on performance than the effects of inflation.
ITEM 7A.
ITEM 7A.QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
For information regarding market risk, see “Item 7 - Management’s Discussion and Analysis of Financial Conditions and Results of Operations-Management of Market Risk.”
ITEM 8.
ITEM 8.CONSOLIDATED FINANCIAL STATEMENTS
Crowe Horwath LLP
Independent Member Crowe Horwath International
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Shareholders and the Board of Directors of Poage Bankshares, Inc.
Ashland, Kentucky
Opinion on the Financial Statements
We have audited the accompanying consolidated balance sheets of Poage Bankshares, Inc. (the "Company") as of December 31, 2017 and 2016, the related consolidated statements of operations, comprehensive income (loss), shareholders’ equity, and cash flows for the years then ended, and the related notes (collectively referred to as the "financial statements"). In our opinion, the financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2017 and 2016, and the results of its operations and its cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States of America.
Basis for Opinion
These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the Company's financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) ("PCAOB") and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting in accordance with the standards of the PCAOB. As part of our audits we are required to obtain an understanding of internal control over financial reporting but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion in accordance with the standards of the PCAOB.
Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion.
/s/ Crowe Horwath LLP
We have served as the Company's auditor since 2010.
Cleveland, Ohio
April 10, 2018
POAGE BANKSHARES, INC.
CONSOLIDATED BALANCE SHEETS
December 31, 2017 and 2016
(Dollar amounts in thousands except per share data)
See Notes to Consolidated Financial Statements.
POAGE BANKSHARES, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
Years ended December 31, 2017 and 2016
(Dollar amounts in thousands except per share data)
See Notes to Consolidated Financial Statements.
POAGE BANKSHARES, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
Years ended December 31, 2017 and 2016
(Dollar amounts in thousands except per share data)
See Notes to Consolidated Financial Statements.
POAGE BANKSHARES, INC.
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
Years ended December 31, 2017 and 2016
(Dollar amounts in thousands except per share data)
See Notes to Consolidated Financial Statements.
POAGE BANKSHARES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years ended December 31, 2017 and 2016
(Dollar amounts in thousands except per share data)
See Notes to Consolidated Financial Statements.
POAGE BANKSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Nature of Operations and Principles of Consolidation: The consolidated financial statements include Poage Bankshares, Inc. (the “Company” or “Poage Bankshares”) and the Company’s wholly owned subsidiary, Town Square Bank (the “Bank”) (which was formerly operated under the name “Home Federal Savings and Loan Association”). The Company’s principal business is the business of the Bank. Inter-company transactions and balances are eliminated in consolidation.
The Bank is a federally chartered savings association. The Bank currently serves the financial needs of communities in its market area through its main office located in Ashland, Kentucky and its branch offices located in Flatwoods, South Shore, Louisa, Cannonsburg, Nicholasville, Greenup and Mt. Sterling, Kentucky. The Bank also has a loan production office located in the Cincinnati, Ohio. The Bank’s business involves attracting deposits from the general public and using such deposits, together with other funds, to originate one-to-four family residential mortgage loans, commercial and multi-family real estate loans, construction loans, commercial and industrial loans and consumer loans primarily in its market area which includes the Kentucky counties of Boyd, Greenup, Jessamine, Lawrence, Montgomery, Fayette and Campbell and the Ohio counties of Scioto, Lawrence, Hamilton, Butler, Warren and Clermont.
Use of Estimates: To prepare financial statements in conformity with accounting principles generally accepted in the United States of America, management makes estimates and assumptions based on available information. These estimates and assumptions affect the amounts reported in the financial statements and the disclosures provided, and actual results could differ.
Cash Flows: Cash and cash equivalents include cash, deposits with other financial institutions with maturities fewer than 90 days, and federal funds sold. Net cash flows are reported for customer loan and deposit transactions, interest bearing deposits in other financial institutions, federal funds purchased and sold, and repurchase agreements.
Interest Bearing Deposits in Other Financial Institutions: Interest bearing deposits in other financial institutions mature within five year and are carried at cost.
Securities: Debt securities are classified as held to maturity and carried at amortized cost when management has the positive intent and ability to hold them to maturity. Debt securities are classified as available for sale when they might be sold before maturity. Equity securities with readily determinable fair values are classified as available for sale. Securities available for sale are carried at fair value, with unrealized holding gains and losses reported in other comprehensive income (loss), net of tax.
Interest income includes amortization of purchase premium or discount. Premiums and discounts on securities are amortized on the level-yield method without anticipating prepayments, except for mortgage backed securities where prepayments are anticipated. Gains and losses on sales are recorded on the trade date and determined using the specific identification method.
Management evaluates securities for other-than-temporary impairment (“OTTI”) on at least a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. For securities in an unrealized loss position, management considers the extent and duration of the unrealized loss, and the financial condition and near-term prospects of the issuer. Management also assesses whether it intends to sell, or it is more likely than not that it will be required to sell, a security in an unrealized loss position before recovery of its amortized cost basis. If either of the criteria regarding intent or requirement to sell is met, the entire difference between amortized cost and fair value is recognized as impairment through earnings. For debt securities that do not meet the aforementioned criteria, the amount of impairment is split into two components as follows: 1) OTTI related to credit loss, which must be recognized in the income statement, and 2) other-than-temporary impairment (OTTI) related to other factors, which is recognized in other comprehensive income. The credit loss is defined as the difference between the present value of the cash flows expected to be collected and the amortized cost basis. For equity securities, the entire amount of impairment is recognized through earnings.
Loans Held for Sale: Mortgage loans originated and intended for sale in the secondary market are carried at the lower of aggregate cost or fair value, as determined by outstanding commitments from investors. Net unrealized losses, if any, are recorded as a valuation allowance and charged to earnings.
Mortgage loans held for sale are generally sold with servicing rights retained. The carrying value of mortgage loans sold is reduced by the amount allocated to the servicing right. Gains and losses on sales of mortgage loans are based on the difference between the selling price and the carrying value of the related loan sold.
Loans: Loans that management has the intent and ability to hold for the foreseeable future or until maturity or payoff are reported at the principal balance outstanding, net of deferred loan fees and costs, and an allowance for loan losses. Interest income is accrued on the unpaid principal balance. Loan origination fees, net of certain direct origination costs, are deferred and recognized in interest income over the contractual life of the loan using the level-yield method without anticipating prepayments.
Interest income on mortgage and commercial loans is discontinued at the time the loan is 90 days delinquent unless the loan is well-secured and in process of collection. Consumer loans are typically charged off no later than 120 days past due. Real estate loans and commercial and industrial loans are charged off on a case by case basis at such time that management determines the loan to be uncollectible. Past due status of all loan types is based on the contractual terms of the loan. In all cases, loans are placed on nonaccrual or charged-off at an earlier date if collection of principal or interest is considered doubtful. Nonaccrual loans and loans past due 90 days still on accrual include both smaller balance homogeneous loans and individually classified impaired loans. All loan types are moved to non-accrual status in accordance with the Company’s policy, typically after 90 days of non-payment.
All interest accrued but not received for all loans placed on nonaccrual is reversed against interest income. Interest received on such loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. All types of loans are returned to accrual status when all the principal and interest are brought current and the loan has been performing according to the contractual terms for a period of not less than 6 months.
Concentration of Credit Risk: The majority of the Company’s business activity is with customers located within a 25 mile radius of its branch and loan production office. Therefore, the Company’s exposure to credit risk is significantly affected by changes in the economy in those areas.
Purchased Credit Impaired Loans: The Company purchases groups of loans, some of which have shown evidence of credit deterioration since origination. These purchased credit impaired loans are recorded at the amount paid, such that there is no carryover of the seller’s allowance for loan losses. After acquisition, losses are recognized by an increase in the allowance for loan losses.
Such purchased credit impaired loans are accounted for individually or aggregated into pools of loans based on common risk characteristics such as, credit score, loan type, and date of origination. The Company estimates the amount and timing of expected cash flows for each loan or pool, and the expected cash flows in excess of amount paid is recorded as interest income over the remaining life of the loan or pool (accretable yield). The excess of the loan’s or pool’s contractual principal and interest over expected cash flows is not recorded (nonaccretable difference).
Allowance for Loan Losses: The allowance for loan losses is a valuation allowance for probable incurred credit losses. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. If a loan is categorized as loss under the regulatory definitions of loan classifications, the loan is immediately charged off. Subsequent recoveries, if any, are credited to the allowance. Management estimates the allowance balance required using past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions, and other factors. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management’s judgment, should be charged off. The allowance for loan losses reflects the estimate management believes to be appropriate to cover incurred probable losses which are inherent in the loan portfolio at December 31, 2017 and 2016.
The allowance consists of specific and general components. The specific component relates to loans that are individually classified as impaired or loans otherwise classified as substandard or doubtful. The general component covers non-classified loans and is based on historical loss experience adjusted for qualitative factors.
A loan is impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. Loans, for which the terms have been modified at the borrower’s request, and for which the borrower is experiencing financial difficulties, are considered troubled debt restructurings (“TDRs”) and classified as impaired. 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 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 all commercial and construction loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent. Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Company does not separately identify individual consumer and residential mortgage loans for impairment disclosures.
TDRs are individually evaluated for impairment and included in the separately identified impairment disclosures. TDRs are measured at the present value of estimated future cash flows using the loan’s effective rate at inception. If a TDR is considered to be a collateral dependent loan, the loan is reported, net, at the fair value of the collateral. For TDRs that subsequently default, the Company determines the amount of the allowance on that loan in accordance with the accounting policy for the allowance for loan losses on loans individually identified as impaired.
The general component of the allowance covers non-impaired loans and is based on historical loss experience adjusted for current factors. The historical loss experience is determined by portfolio segment and is based on the actual loss history experienced by the Company. This actual loss experience is supplemented with other economic factors based on the risks present for each portfolio segment. These economic factors include consideration of the following: levels of and trends in delinquencies and impaired loans; levels of and trends in charge-offs and recoveries; trends in volume and terms of loans; effects of any changes in risk selection and underwriting standards; other changes in lending policies, procedures, and practices; experience, ability, and depth of lending management and other relevant staff; national and local economic trends and conditions; industry conditions; and effects of changes in credit concentrations. The following portfolio segments have been identified as having differing risk characteristics:
Real estate loans: Loans secured by real estate represent the lowest risk of loans for the Company. The majority of loans in this segment are loans secured by the borrower’s principal residence; however, there are also loans secured by apartment buildings, non-owner occupied property, commercial real estate, or construction and land development projects. They include fixed and floating rate loans as well as loans for commercial purposes or consumer purposes. Borrowers with loans in this category, whether for commercial or consumer purposes, tend to make their payments timely as they do not want to risk foreclosure and loss of the real estate.
Commercial and industrial loans: These loans to businesses do not have real estate as the underlying collateral. Instead of real estate, collateral could be business assets such as equipment or accounts receivable or the personal guarantee of one or more guarantors. These loans generally present a higher level of risk than loans secured by real estate because in the event of default by the borrower, the business assets must be liquidated and/or guarantors pursued for deficit funds. Business assets are worth more while they are in use to produce income for the business and worth significantly less if the business is no longer in operation. For this reason, the Company discounts the value on these types of collateral prior to meeting the Company’s loan-to-value policy limits.
Consumer loans: Consumer loans are generally loans to borrowers for non-business purposes. They can be either secured or unsecured. Consumer loans are generally small in the individual amount of principal outstanding and are repaid from the borrower’s private funds earned from employment. Consumer lending risk is very susceptible to local economic trends. If there is a consumer loan default, any collateral that may be repossessed is generally not well maintained and has a diminished value. For this reason, consumer loans tend to have higher overall interest rates to cover the higher cost of repossession and charge-offs. However, due to their smaller average balance per borrower, consumer loans are collectively evaluated for impairment in determining the appropriate allowance for loan losses.
Servicing Rights: Servicing rights are recognized separately when they are acquired through sales of loans. When mortgage loans are sold, servicing rights are initially recorded at fair value with the income statement effect recorded in gains on sales of loans. Fair value is based on market prices for comparable mortgage servicing contracts when available or, alternatively, is based on a valuation model that calculates the present value of estimated future net servicing income. All classes of servicing assets are subsequently measured using the amortization method which requires servicing rights to be amortized into non-interest income in proportion to, and over the period of, the estimated future net servicing income of the underlying loans. Servicing rights are included in the other assets line item of the balance sheet.
Servicing rights are evaluated for impairment based upon the fair value of the rights as compared to carrying amount. Impairment is determined by stratifying rights into groupings based on predominant risk characteristics, such as interest rate, loan type and investor type. Impairment is recognized through a valuation allowance for an individual grouping, to the extent that fair value is less than the carrying amount. If the Company later determines that all or a portion of the impairment no longer exists for a particular grouping, a reduction of the allowance may be recorded as an increase to income. No valuation allowance was required at December 31, 2017 or 2016. The fair values of servicing rights are subject to significant fluctuations as a result of changes in estimated and actual prepayment speeds and default rates and losses.
Servicing fee income which is reported on the income statement as other income is recorded for fees earned for servicing loans. The fees are based on a contractual percentage of the outstanding principal; or a fixed amount per loan and are recorded as income when earned. The amortization of mortgage servicing rights is netted against loan servicing fee income.
Other Real Estate Owned: Assets acquired through or instead of loan foreclosure are initially recorded at fair value less costs to sell when acquired, establishing a new cost basis. Physical possession of residential real estate property collateralizing a consumer mortgage loan occurs when legal title is obtained upon completion of foreclosure or when the borrower conveys all interest in the property to satisfy the loan through completion of a deed in lieu of foreclosure or through a similar legal agreement. These assets are subsequently accounted for at the lower of cost or fair value less estimated costs to sell. If fair value declines subsequent to foreclosure, a valuation allowance is recorded through expense. Operating costs after acquisition are expensed.
Premises and Equipment: Land is carried at cost. Premises and equipment are stated at cost less accumulated depreciation. Buildings and related components are depreciated using the straight-line method with useful lives ranging from 5 to 39 years. Furniture, fixtures and equipment are depreciated using the straight-line method with useful lives ranging from 3 to 10 years.
Restricted Stock: The Bank is a member of the Federal Home Loan Bank (FHLB) system and Bankers’ Bank of Kentucky (BBK). Members of the FHLB are required to own a certain amount of stock based on the level of borrowings and other factors and may invest in additional amounts. FHLB and BBK stock are carried at cost, classified as a restricted security, and periodically evaluated for impairment based on ultimate recovery of par value. Both cash and stock dividends are reported as income.
Company Owned Life Insurance: The Company has purchased life insurance policies on certain key executives. Company owned life insurance is recorded at the amount that can be realized under the insurance contract at the balance sheet date, which is the cash surrender value adjusted for other charges or other amounts due that are probable at settlement.
Goodwill and Other Intangible Assets: Goodwill resulting from business combinations is generally determined as the excess of the fair value of the consideration transferred, plus the fair value of any noncontrolling interests in the acquiree, over the fair value of the net assets acquired and liabilities assumed as of the acquisition date. Goodwill and intangible assets acquired in a purchase business combination and determined to have an indefinite useful life are not amortized, but tested for impairment at least annually or more frequently if events and circumstances exists that indicate that a goodwill impairment test should be performed. The Company has selected December 31 as the date to perform the annual impairment test. Intangible assets with definite useful lives are amortized over their estimated useful lives to their estimated residual values. Goodwill is the only intangible asset with an indefinite life on our balance sheet.
Other intangible assets consist of core deposit intangible assets arising from whole bank acquisitions are amortized on an accelerated method over their estimated useful lives, which range from 7 to 10 years.
Loan Commitments and Related Financial Instruments: Financial instruments include off-balance sheet credit instruments, such as commitments to make loans and commercial letters of credit, issued to meet customer financing needs. The face amount for these items represents the exposure to loss, before considering customer collateral or ability to repay. Such financial instruments are recorded when they are funded.
Stock-Based Compensation: Compensation cost is recognized for stock options and restricted stock awards issued to employees over the required service period, generally defined as the vesting period. The fair value of restricted stock awards is estimated by using the market price of the Company’s common stock at the date of grant, a Black-Scholes model is used to estimate the fair value of stock options. For awards with graded vesting, compensation cost is recognized on a straight-line basis over the requisite service period for the entire award.
Income Taxes: Income tax expense is the total of the current year income tax due or refundable and the change in deferred tax assets and liabilities. Deferred tax assets and liabilities are the expected future tax amounts for the temporary differences between carrying amounts and tax bases of assets and liabilities, computed using enacted tax rates. A valuation allowance, if needed, reduces deferred tax assets to the amount expected to be realized.
A tax position is recognized as a benefit only if it is “more likely than not” that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount recognized is the largest amount of tax benefit that is greater than 50% likely of being realized on examination. For tax positions not meeting the “more likely than not” test, no tax benefit is recorded.
The Company recognizes interest and/or penalties related to income tax matters in income tax expense. There were no such expenses recognized in the years ended December 31, 2017 and 2016.
Retirement Plans: Employee 401(k) and profit sharing plan expense is the amount of matching contributions. The Bank participates in the Pentegra Defined Benefit Pension Plan for Financial Institutions. This plan covers eligible employees who were employed by the Bank prior to January 1, 2007. Employees hired subsequent to that date are not eligible to participate. The employees hired prior to January 1, 2007 continue to earn benefits under the plan. It is the policy of the Company to fund the amount that is determined by annual actuarial valuations.
Comprehensive Income (Loss): Comprehensive income (loss) consists of net income (loss) and other comprehensive income (loss). Other comprehensive income (loss) includes unrealized gains and losses on securities available for sale which are also recognized as separate components of equity.
Loss Contingencies: Loss contingencies, including claims and legal actions arising in the ordinary course of business, are recorded as liabilities when the likelihood of loss is probable, and an amount or range of loss can be reasonably estimated. Management does not believe there now are such matters that will have a material effect on the financial statements.
Restrictions on Cash: Cash on hand or on deposit with the Federal Reserve Bank was required to meet regulatory reserve and clearing requirements. The Bank is required to maintain reserve funds in cash or on deposit with a designated depository financial institution. The required reserve at December 31, 2017 and 2016 was $106,000 and $107,000, respectively.
Fair Value of Financial Instruments: Fair values of financial instruments are estimated using relevant market information and other assumptions, as more fully disclosed in a separate note. Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayments, and other factors, especially in the absence of broad markets for particular items. Changes in assumptions or in market conditions could significantly affect the estimates.
Employee Stock Ownership Plan (“ESOP”): The cost of shares issued to the ESOP, but not yet allocated to participants, is shown as a reduction of shareholders’ equity. Compensation expense is based on the market price of shares as they are committed to be released to participant accounts. Dividends on allocated ESOP shares reduce retained earnings; dividends on unearned ESOP shares reduce debt and accrued interest.
Earnings (Loss) Per Common Share: Basic earnings (loss) per common share is net income (loss) divided by the weighted average number of common shares outstanding during the period. ESOP shares are considered outstanding for this calculation unless unearned. All outstanding unvested share-based payment awards that contain rights to nonforfeitable dividends are considered participating securities for this calculation. Diluted earnings per common share includes the dilutive effect of additional potential common shares issuable under stock options. Earnings and dividends per share are restated for all stock splits and stock dividends through the date of issuance of the financial statements.
Segment Reporting: The Company has one reportable segment: banking. While the chief decision-makers monitor the revenue streams of the various products and services, operations are managed, and financial performance is evaluated on a Company-wide basis.
Reclassifications: Some items in the prior year financial statements were reclassified to conform to the current presentation. Reclassifications had no effect on prior year net income or shareholders’ equity.
Recently Adopted Accounting Pronouncements:
In March 2016, the FASB issued ASU No. 2016-09, Compensation-Stock Compensation: Improvements to Employee Share-Based Payment Accounting. This ASU will require recognition of the income tax effects of share-based awards in the income statement when the awards vest or are settled (i.e., Additional Paid-in-Capital pools will be eliminated). The amendments are effective for public companies for annual periods beginning after December 15, 2016. The guidance in the ASU No. 2016-09 was adopted by the Company and did not have a material impact on its consolidated financial statements.
In February 2018, the FASB issued ASU 2018-02, Income Statement - Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income. On December 22, 2017, the U.S. federal government enacted the Tax Act. The amendments in this update allow a reclassification from accumulated other comprehensive income to retained earnings for stranded tax effects resulting from the Tax Act. Consequently, the amendments eliminate the stranded tax effects resulting from the Tax Act and will improve the usefulness of information reported to financial statement users. The amendments only relate to the reclassification of the income tax effects of the Tax Act; the underlying guidance that requires that the effect of a change in tax laws or rates be included in income from continuing operations is not affected. The Company adopted this update, as permitted by the guidance, which resulted in a reclassification of $43,000 from accumulated other comprehensive income to retained earnings for stranded tax effects for the year ended December 31, 2017 as disclosed on the Company’s Consolidated Statements of Changes in Shareholders’ Equity.
Newly Issued Accounting Standard Not Yet Effective:
In May 2014 the FASB issued Accounting Standards Update 2014-09 Revenue from Contracts with Customers (Topic 606) developed as a joint project with the International Accounting Standards Board to remove inconsistencies in revenue requirements and provide a more robust framework for addressing revenue issues. The ASU's core principle is that an entity should recognize revenue when it transfers promised goods or services to customers in an amount that reflects the consideration to which an entity expects to be entitled in exchange for those goods or services. In August 2015, the FASB issued Accounting Standards Update 2015-14, which deferred the effective date by one year (i.e., interim and annual reporting periods beginning after December 15, 2017). Early adoption is permitted, but not before the original effective date (i.e., interim and annual reporting periods beginning after December 15, 2016). Poage has determined that ASU 2014-09 will not have a significant impact on its financial statements as a significant portion of the Company’s revenue is scoped out of the standard. The Company’s sources of non-interest income that fall within the scope of the new standard, such as service charges on deposits and wire transfer fees, are structured so that the non-interest income is earned immediately and not over a period of time, which is similar to the treatment under previous revenue recognition standards. The Company adopted this standard on January 1, 2018 using the modified retrospective method with a cumulative effect of the initial application in the first quarter of 2018 but there was no impact to retained earnings as a result of the adoption of the new standard.
In January 2016, the FASB issued ASU No. 2016-01, Financial Instruments-Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities. The ASU makes several modifications to Subtopic 825-10 including the elimination of the available-for-sale classification of equity investments and requires equity investments with readily determinable fair values to be measured at fair value with changes in fair value recognized in net income. This ASU will become effective for the Company for interim and annual periods beginning after December 15, 2017. The adoption of ASU No. 2016-01 in the first quarter of 2018 is not expected to have a material effect on the Company’s operating results or financial condition.
In February 2016, the FASB issued Accounting Standards Update 2016-02 Leases guidance requiring the recognition in the statement of financial position of lease assets and lease liabilities by lessees for those leases classified as operating leases under previous GAAP. The guidance requires that a lessee should recognize lease assets and lease liabilities as compared to previous GAAP that did not require lease assets and lease liabilities to be recognized for most leases. The guidance becomes effective for us on January 1, 2019. Poage is currently evaluating the impact on its leases to determine the impact on its consolidated financial statements.
In June 2016, the FASB issued ASU 2016-13, Financial Instruments - Credit Losses: Measurement of Credit Losses on Financial Instruments (the ASU), which introduces the current expected credit losses methodology. This ASU significantly changes how entities will measure credit losses for most financial assets and certain other instruments that aren’t measured as fair value through net income. Among other things, the ASU requires the measurement of all expected credit losses for financial assets, including loans and available-for-sale debt securities, held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts that affect the collectability of the reported amount. In issuing the standard, the FASB is responding to criticism that today’s guidance delays recognition of credit losses. The new model, referred to as the current expected credit loss (“CECL”) model, will require institutions to calculate all probable and estimable losses that are expected to be incurred through the loan's entire life. ASU 2016-13 also requires the allowance for credit losses for purchased financial assets with credit deterioration since origination to be determined in a manner similar to that of other financial assets measured at amortized cost; however, the initial allowance will be added to the purchase price rather than recorded as credit loss expense. The disclosure of credit quality indicators related to the amortized cost of financing receivables will be further disaggregated by year of origination (or vintage). Institutions are to apply the changes through a cumulative-effect adjustment to their retained earnings as of the beginning of the first reporting period in which the standard is effective. The amendments are effective for fiscal years beginning after December 15, 2019. Early application will be permitted for fiscal years beginning after December 15, 2018. Management has formed a CECL committee that is evaluating the data gathering requirements, available economic forecasting and loss estimation models and potential software that would be employed by the Company to facilitate the adoption of this guidance and its required disclosures on the Company’s consolidated financial statements. Upon adoption, management anticipates an initial one-time increase in the allowance for loan losses along with a corresponding decrease in capital as permitted by the standard.
In January 2017, FASB issued ASU 2017-4, Intangible-Goodwill and Other (Topic 350), to simplify accounting for goodwill impairment. The new guidance will simplify financial reporting because it eliminates the need to determine the fair value of individual assets and liabilities of a reporting unit to measure goodwill impairment. The revised guidance is effective for fiscal years beginning after December 15, 2019. Early adoption is permitted for any impairment tests performed after January 1, 2017. Poage is currently evaluating the impact of the new guidance on its consolidated financial statements.
In March 2017, the FASB issued ASU No. 2017-08, Receivables-Nonrefundable Fee and Other Costs (Subtopic 310-20), Premium Amortization on Purchased Callable Debt Securities. The amendments affect all entities that hold investments in callable debt securities that have an amortized cost basis in excess of the amount that is repayable by the issuer. The amendments require the premium for certain callable debt securities to be amortized to the earliest call date. The amendments are effective for public companies for annual periods beginning after December 15, 2019. The adoption of ASU No. 2017-08 is not expected to have a material effect on the Company’s consolidated operating results or financial condition.
In May 2017, the FASB issued ASU No. 2017-09, Scope of Modification Accounting which amends the scope of modification accounting for share-based payment arrangements. The ASU provided guidance on the types of changes to the terms or conditions of share-based payment awards to which an entity would be required to apply modification accounting under ASC 718, Compensation-Stock Compensation. Specifically, an entity would not apply modification accounting if the fair value, vesting conditions, and classification of the awards are the same immediately before and after the modification. The amendments are effective for public companies for annual periods beginning after December 15, 2017. The adoption of ASU No. 2017-09 is not expected to have a material effect on the Company’s consolidated operating results or financial condition.
NOTE 2 - SECURITIES AVAILABLE FOR SALE
The following table summarizes the amortized cost and fair value of securities available for sale at December 31, 2017 and 2016, and the corresponding amounts of gross unrealized gains and losses recognized in accumulated other comprehensive income (loss) (in thousands):
There were no proceeds from sales of securities for the years ended December 31, 2017 and 2016.
The amortized cost and fair value of the securities portfolio at December 31, 2017 are shown by contractual maturity. Expected maturities may differ from contractual maturities if borrowers have the right to call or prepay obligations with or without call or prepayment penalties. Securities not due at a single maturity date, primarily mortgage-backed securities, are shown separately.
Securities pledged at December 31, 2017 and 2016 had a carrying amount of $10.3 million and $11.9 million, respectively, and were pledged to secure public deposits.
At December 31, 2017 and 2016, there were no holdings of securities of any one issuer, other than the U.S. Government and its agencies, in an amount greater than 10% of shareholders’ equity.
The following table summarizes the securities with unrealized losses at December 31, 2017 and 2016, aggregated by major security type and length of time in a continuous unrealized loss position:
Unrealized losses on bonds have not been recognized into income because the issuers of the bonds are of high credit quality, management does not intend to sell, and it is not more likely than not that management would be required to sell the securities prior to their anticipated recovery, and the decline in fair value is largely due to changes in interest rates. The fair value is expected to recover as the bonds approach maturity.
As of December 31, 2017, the Company’s security portfolio consisted of 99 securities, 65 of which were in an unrealized loss position.
Management evaluates securities for other-than-temporary impairment (“OTTI”) on at least a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. For securities in an unrealized loss position, management considers the extent and duration of the unrealized loss, and the financial condition and near-term prospects of the issuer. Management also assesses whether it intends to sell, or it is more likely than not that it will be required to sell, a security in an unrealized loss position before recovery of its amortized cost basis. If either of the criteria regarding intent or requirement to sell is met, the entire difference between amortized cost and fair value is recognized as impairment through earnings. For debt securities that do not meet the aforementioned criteria, the amount of impairment is split into two components as follows: 1) OTTI related to credit loss, which must be recognized in the income statement, and 2) OTTI related to other factors, which is recognized in other comprehensive income. The credit loss is defined as the difference between the present value of the cash flows expected to be collected and the amortized cost basis. For equity securities, the entire amount of impairment is recognized through earnings.
NOTE 3 - LOANS
Loans at December 31, 2017 and 2016 were as follows (in thousands):
On September 12, 2017, the Bank uncovered evidence of suspected fraud involving the origination of fictitious loans by an employee of the Bank. The individual is no longer employed by the Bank. The Bank informed its fidelity blanket bond insurer of the suspected fraud and engaged an outside firm to perform a forensic audit. To date, the Bank believes it has identified suspected fictitious loans totaling approximately $1.4 million of which $934,000 were acquired in the Town Square acquisition in 2014. It was the Company’s conclusion, based on the advice of outside legal counsel, that the bond should provide indemnity for the lost principal of $1.4 million, less a $25,000 deductible, and it was probable that the Bank would recover its loss. The Company recorded a receivable on insurance proceeds in other assets and a net loss of $25,000 in other expenses during the three months ended September 30, 2017.
The Company received correspondence dated March 29, 2018 from counsel to the Bank’s fidelity bond insurer indicating the insurer’s position that the claimed loss for purpose of evaluating coverage under the fidelity bond may not be $1.4 million. Even though the Company still believes the insurance claim is valid and collectible, based on this correspondence, management has determined that collection of the insurance receivable does not meet the threshold of probable, which is a high threshold under general accepted accounting principles. Therefore, the Company has reversed the receivable on insurance proceeds and recorded a loss on fictitious loans of $481,000, an increase to goodwill of $617,000 and an increase to deferred taxes of $317,000. Since $934,000 in fictitious loans were acquired in the Town Square acquisition in 2014, this reduced the fair value of net assets acquired, which resulted in the aforementioned increases in goodwill and deferred tax assets. The total fictitious loan balance increased by $481,000 from $934,000 at the date of acquisition to $1,415,000 at the date of discovery. $101,000 of the increase occurred in 2014, $165,000 of the increase occurred in 2015, $196,000 of the increase occurred in 2016 and $19,000 of the increase occurred in 2017. As the annual increases were not material to any individual period nor was the cumulative increase from the date of acquisition to the date of discovery material, the Company recorded the entire loss of $481,000 in 2017.
The following tables present the balance in the allowance for loan losses and recorded investment in loans by portfolio segment based on impairment method as of December 31, 2017 and 2016. Accrued interest receivable and net deferred loan fees are not considered significant and therefore are not included in the loan balances presented in the table below (in thousands):
The following table presents information related to impaired loans by class of loans as of December 31, 2017 and December 31, 2016 (in thousands):
For purposes of this disclosure, the unpaid balance is not reduced for partial charge-offs.
The following table presents the average balance of loans individually evaluated for impairment and interest income recognized on these loans for the twelve months ended December 31, 2017 and 2016 (in thousands).
The recorded investment in loans excludes accrued interest receivable and loan origination fees, net, due to immateriality.
The following table presents the activity in the allowance for loan losses by portfolio segment for the periods indicated was as follows (in thousands):
Nonaccrual loans and loans past due 90 days still on accrual consist of smaller balance homogeneous loans that are collectively evaluated for impairment.
The following table presents the recorded investment in nonaccrual and loans past due over 90 days still on accrual by class of loans as of December 31, 2017 and 2016 (in thousands):
The following table presents the aging of the recorded investment in past due loans as of December 31, 2017 and 2016 by class of loans. Non-accrual loans of $6.3 million and $4.7 million as of December 31, 2017 and 2016 respectively, are included in the tables below and have been categorized based on their payment status (in thousands):
Troubled Debt Restructurings:
As of December 31, 2017, the Company has a recorded investment in three TDRs which totaled $3.2 million. There were $3.2 million at December 31, 2016. A less than market rate and extended term was granted as concessions for TDRs. No additional charge-off or provision has been made for the loan relationships. No additional commitments to lend have been made to the borrower.
The following table presents loans by class modified as troubled debt restructuring that occurred during the years ended December 31, 2017 and 2016.
During the year ended December 31, 2017, a one to four family loan in the amount of $114,000 modified as a troubled debt restructuring subsequently defaulted within twelve months following the modification. During the year ended December 31, 2016, there were no loans modified as troubled debt restructurings that subsequently defaulted within twelve months following the modification.
CREDIT QUALITY INDICATORS:
The Company categorizes loans into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. The Company analyzes loans individually by classifying the loans as to credit risk. This analysis includes all non-homogeneous loans, such as commercial and commercial real estate loans. The analysis for residential real estate and consumer loans primarily includes review of past due status. This analysis is performed on a quarterly basis. The Company uses the following definitions for risk ratings:
Special Mention. Loans classified as special mention have a potential weakness that deserves management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or of the institution’s credit position at some future date.
Substandard. Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.
Doubtful. Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.
Loss. Loans classified as loss are considered uncollectable and of such little value that continuing to carry them as an asset is not feasible. Loans will be classified as a loss when it is not practical or desirable to defer writing off or reserving all or a portion of a basically worthless asset, even though partial recovery may be possible at some time in the future.
Loans not meeting the criteria above that are analyzed individually as part of the above described process are considered to be pass rated loans.
Based on the most recent analysis performed, the risk category of loans by class of loans is as follows (in thousands):
At December 31, 2017 and 2016, there were no loans classified in the “loss” category.
There were $1.3 million and $1.9 million PCI loans included in disclosure above at December 31, 2017 and 2016, respectively.
The Company holds purchased loans without evidence of credit quality deterioration. In addition, the Company holds purchased loans for which there was, at their acquisition date, evidence of deterioration of credit quality since their origination and it was probable, at acquisition, which all contractually required payments would not be collected. A summary of non-impaired purchased loans and credit-impaired purchased loans with the carrying amount of those loans is as follows at December 31, 2017 and 2016 (in thousands):
For those purchased loans disclosed above, the Company did not have an allowance for loan losses for the years ended December 31, 2017 or 2016.
The following tables present the composition of the acquired loans at December 31, 2017 and 2016 (in thousands):
The following table presents the purchased loans that are included within the scope of ASC Topic 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality, as of December 31, 2017 and 2016.
The Company adjusted interest income to recognize $41,000 and $146,000 of accretable yield on credit-impaired purchased loans for the years ended December 31, 2017 and 2016, respectively.
Accretable yield, or income expected to be collected, is as follows:
NOTE 4 - FAIR VALUE
Fair value is the exchange price that would be received for an asset or paid to transfer a liability (exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. There are three levels of inputs that may be used to measure fair values:
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 company’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.
The Company used the following methods and significant assumptions to estimate fair value:
Securities: The fair values for securities are determined by quoted market prices, if available (Level 1). If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments (Level 2). This includes the use of “matrix pricing” used to value debt securities absent the exclusive use of quoted prices. For securities where quoted prices or market prices of similar securities are not available, fair values are calculated using discounted cash flows (Level 3). As of December 31, 2017 and 2016, all securities were classified as a Level 2 fair value.
Other Real Estate Owned: Commercial and residential real estate properties classified as other real estate owned (OREO) are measured at fair value, less costs to sell. Fair values are based on recent real estate appraisals. These appraisals may use single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value. Appraisals for real estate properties classified as other real estate owned are performed by certified general appraisers (for commercial properties) or certified residential appraisers (for residential properties) whose qualifications and licenses have been reviewed and verified by the Bank’s management. The appraisal values are discounted to allow for selling expenses and fees, and the discounts range from 5% to 10%.
Impaired Loans: The fair value of impaired loans with specific allocations of the allowance for loan losses is generally based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for the differences between the comparable sales and income data available for similar loans and collateral underlying such loans. Non-real estate collateral may be valued using an appraisal, net book value per the borrower’s financial statements, or aging reports, adjusted or discounted based on management’s historical knowledge of the client and client’s business, resulting in a Level 3 fair value classification. Impaired loans are evaluated on a quarterly basis for additional impairment and adjusted in accordance with the allowance policy. The appraisal values are discounted to allow for selling expenses and fees, and the discounts range from 10% to 20%.
Assets and liabilities measured at fair value on a recurring basis, at December 31, 2017 and 2016, are as follows (in thousands):
There were no transfers between Level 1 and Level 2.
Assets measured at fair value on a non-recurring basis at December 31, 2017 and 2016 are summarized below (in thousands):
At December 31, 2017, impaired loans recorded at fair value had a net carrying amount of $2.8 million, equal to the outstanding balance of $4.7 million, net of a valuation allowance of $1.9 million. At December 31, 2016, impaired loans recorded at fair value had a net carrying amount of $921,000, equal to the outstanding balance of $951,000, net of a valuation allowance of $30,000. There were charge-offs in the amount of $288,000 and $130,000 for the years ended December 31, 2017 and 2016, respectively. The charge-offs and change in specific reserve on impaired loans resulted in an increase to the provision for loan losses of $2.2 million for the year ended December 31, 2017. The charge-offs and change in specific reserve on impaired loans resulted in an increase to the provision for loan losses of $15,000 for the year ended December 31, 2016.
At December 31, 2017, other real estate owned recorded at fair value had a net carrying amount of $610,000, equal to the outstanding balance of $1.03 million, net of a valuation allowance of $420,000. There were write-downs of $466,000 for the year ended December 31, 2017. At December 31, 2016, other real estate owned recorded at fair value had a net carrying amount of $276,000, equal to the outstanding balance of $390,000, net of a valuation allowance of $114,000. There were write-downs of $163,000 for the year ended December 31, 2016.
The carrying amounts and estimated fair values of financial instruments, at December 31, 2017 and 2016 are as follows (in thousands):
The methods and assumptions, not previously presented, used to estimate fair value is described as follows:
Cash and Cash Equivalents:
The carrying amounts of cash and short-term instruments approximate fair values and are classified as Level 1.
Restricted Stock:
It is not practical to determine the fair value of FHLB stock due to restrictions placed on its transferability.
Loans:
Fair values of loans, excluding loans held for sale, are estimated as follows: For variable rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values resulting in a Level 3 classification. Fair values for other loans are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality resulting in a Level 3 classification. The methods utilized to estimate the fair value of loans do not necessarily represent an exit price.
The fair value of loans held for sale is estimated based upon binding contracts and quotes from third party investors in a Level 2 classification.
Deposits:
The fair values disclosed for demand deposits (e.g., interest and non-interest checking, passbook savings, and certain types of money market accounts) are by definition equal to the amount payable on demand at the reporting date (i.e., their carrying amount) resulting in a Level 1 classification. The carrying amounts of variable rate, fixed-term money market accounts and certificates of deposit approximate their fair value at the reporting date resulting in a Level 1 classification. Fair values for fixed rate certificates of deposit are estimated using a discounted cash flows calculation that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits resulting in a Level 2 classification.
Federal Home Loan Bank Advances and Subordinate Debenture:
The fair values of the Company’s long-term borrowings are estimated using discounted cash flow analyses based on the current borrowing rates for similar types of borrowing arrangements resulting in a Level 2 classification.
Accrued Interest Receivable/Payable:
The carrying amounts of accrued interest approximate fair value and are classified by level consistent with the level of the related assets or liabilities.
NOTE 5 - LOAN SERVICING
Mortgage loans serviced for others are not reported as assets. The principal balance of these loans at December 31, 2017 and 2016 were $45.1 million and $42.6 million, respectively. Custodial escrow balances maintained in connection with serviced loans were $217,000 and $191,000 at December 31, 2017 and 2016, respectively.
Activity for loan servicing rights during the years ended December 31, 2017 and 2016 were as follows (in thousands):
Loan servicing rights are reported as other assets. There was no valuation allowance for servicing rights at December 31, 2017 and 2016. The fair value of servicing rights is estimated to be $483,000 and $381,000 at December 31, 2017 and 2016, respectively. Fair value at December 31, 2017 was determined using a discount rate of 10%, prepayment speeds ranging from 78% to 312%, depending on the stratification of the specific right and a weighted average default rate of 0%. Fair value at December 31, 2016 was determined using a discount rate of 10%, prepayment speeds ranging from 136% to 260%, depending on the stratification of the specific right and a weighted average default rate of 0%.
At December 31, 2017, the weighted average amortization period was 7.1 years.
NOTE 6 - PREMISES AND EQUIPMENT
Premises and equipment at December 31, 2017 and 2016 were as follows (in thousands):
Depreciation expense was $798,000 and $854,000 for the years ended December 31, 2017 and 2016, respectively.
Operating Leases: The Company leases two loan production offices under operating leases. Rent expense was $53,000 and $62,000 for the years ended December 31, 2017 and 2016, respectively. Rent commitments, before considering renewal options that generally are present, were $62,000 for 2018, $70,000 for each of 2019 and 2020, and $72,000 for each of 2021 and 2022.
NOTE 7 - GOODWILL AND INTANGIBLE ASSETS
The change in goodwill during the years ended December 31, 2017 and 2016 is as follows (in thousands):
Goodwill is not amortized but is assessed at least annually for impairment and any such impairment will be recognized in the period identified. Impairment is evaluated using the aggregate of all banking operations as a single reporting unit. At December 31, 2017, the Company had positive equity and the elected to perform a qualitative assessment to determine if it was more likely than not that the fair value of the reporting unit exceeded its carrying value, including goodwill. The qualitative assessment indicated that it was more likely than not that the fair value of the reporting unit exceeded its carrying value, resulting in no impairment.
Acquired intangible assets were as follows at year-end (in thousands):
Aggregate amortization expense was $339,000 for 2017 and $347,000 for 2016.
Estimated amortization expense for each of the next five years is as follows (in thousands):
NOTE 8 - DEPOSITS
Time deposits that meet or exceed the FDIC Insurance limit of $250,000 at year-end 2017 and 2016 were $21.4 million and $24.5 million, respectively.
Scheduled maturities of time deposits for the next five years were as follows (in thousands):
NOTE 9 - FEDERAL HOME LOAN BANK ADVANCES
At December 31, 2017 and 2016, advances from the Federal Home Loan Bank were as follows (dollars in thousands):
Rates on advances were as follows (dollars in thousands):
Each advance is payable at its maturity date, with a prepayment penalty for fixed rate advances. The advances were collateralized by all of the Bank’s one to four family first mortgage loans under a blanket lien arrangement at December 31, 2017 and 2016 and the Company’s FHLB stock. Based on this collateral and the Company’s holdings of FHLB stock, the Bank is eligible to borrow an additional $85.5 million at December 31, 2017.
Payments contractually required over the next five years as of December 31, 2017 (in thousands):
NOTE 10 - SUBORDINATED DEBENTURES
In December 2006, Town Square Statutory Trust I, a trust formed by the Town Square Financial Corporation, closed a pooled private offering of 4,000 trust preferred securities with a liquidation amount of $1,000 per security. The Company issued $4,124,000 of subordinated debentures to the trust in exchange for ownership of all the common security of the trust and the proceeds of the preferred securities sold by the trust. The Company is not considered the primary beneficiary of this Trust (variable interest entity), therefore the trust is not consolidated in the Company’s financial statements, but rather the subordinated debentures are shown as a liability. The Company’s investment in the common stock of the trust was $124,000 and is included in other assets. As of December 31, 2017 and 2016, the book value of the Company’s subordinated debt was net of an unaccreted discount of $1.2 million and $1.3 million resulting in an increase in interest expense related to the subordinated debt of $65,000 and $64,000 for the years then ended.
The Company may redeem the subordinated debentures, in whole or in part, in a principal amount with integral multiples of $1,000, on or after December 22, 2012 at 100% of the principal amount, plus accrued and unpaid interest. The subordinated debentures mature on December 22, 2036. The subordinated debentures are also redeemable in whole or in part from time to time, upon the occurrence of specific events defined within the trust indenture. The Company has the option to defer interest payments on the subordinated debentures from time to time for a period not to exceed five consecutive years.
The subordinated debentures may be included in Tier I capital (with certain limitations applicable) under current regulatory guidelines and interpretations. The subordinated debentures have a variable rate of interest equal to the three month London Interbank Offered Rate (LIBOR) plus 1.83%, which was 3.42% at December 31, 2017.
NOTE 11 - BENEFIT PLANS
The Bank participates in the Pentegra Defined Benefit Plan for Financial Institutions (“Pentegra DB Plan”), a tax-qualified defined-benefit pension plan. The Pentegra DB Plan’s Employer Identification Number is 13-5645888 and the Plan Number is 333. The Pentegra DB Plan operates as a multi-employer plan for accounting purposes and as a multiple-employer plan under the Employee Retirement Income Security Act of 1974 and the Internal Revenue Code. There are no collective bargaining agreements in place that require contributions to the Pentegra DB Plan.
The Pentegra DB Plan is a single plan under Internal Revenue Code Section 413C and, as a result, all of the assets stand behind all of the liabilities. Accordingly, under the Pentegra DB Plan contributions made by a participating employer may be used to provide benefits to participants of other participating employers.
Funded Status (Market value of plan assets divided by funding target) as of July 1,
*Market value of plan assets reflects any contributions received through December 31, 2017.
**Market value of plan assets reflects any contributions received through December 31, 2016.
Employer Contributions
Total contributions made to the Pentegra DB Plan, as reported on Form 5500, equal $366.1 million and $136.7 million for the plan years ended June 30, 2017 and June 30, 2016, respectively. The Bank’s contributions to the Pentegra DB Plan are not more than 5% of the total contributions to the Pentegra DB Plan.
The following contributions were paid by the Bank during the fiscal years ended December 31, 2017 and 2016 (in thousands):
This plan was “frozen” as of February 1, 2013. The Bank no longer allows new employees to enroll in the plan. Contributions will be limited to sustaining earned participant benefits.
401(k) Plan: A 401(k) benefit plan allows employee contributions up to 15% of their compensation, which are matched equal to 50% of the first 6% of the compensation contributed. Expense for the years ended December 31, 2017 and 2016 was $85,000 and $87,000, respectively.
Deferred Compensation Plan: A deferred compensation plan covers certain directors and certain executive officers. Under the plan, the Bank pays each participant, or their beneficiary, the amount of fees deferred plus interest over 20 years, beginning with the individual’s termination of service. A liability is accrued for the obligation under these plans. In January 2003, the Bank adopted a non-contributory retirement plan which provides benefits to certain directors and certain key officers. The Company’s obligations under the plan have been informally funded through the purchase of single premium key man life insurance of which the Company is the beneficiary. The expense incurred for the deferred compensation for the years ended December 31, 2017 and 2016 was $102,000 and $104,000, respectively resulting in a deferred compensation liability of $1.5 million and $1.5 million at December 31, 2017 and 2016, respectively. The cash surrender value of the key man life insurance policies totaled $7.3 million and $7.1 million at December 31, 2017 and 2016, respectively.
NOTE 12 - INCOME TAXES
The provision for income taxes consists of the following (in thousands):
The following tabulation reconciles the federal statutory tax rate of 34% to the effective rate of taxes provided for income taxes (dollars in thousands):
The components of the Company’s net deferred tax asset as of December 31, 2017 and 2016 are summarized as follows (in thousands):
On December 22, 2017, The Tax Cuts and Jobs Act (the “Act”) was signed into law. Among other things, the Act reduces the corporate federal tax rate from 35% to 21% effective January 1, 2018 as well as repealing the alternative minimum tax. As a result, we are required to re-measure, through income tax expense, our deferred tax assets and liabilities using the enacted rate at which we expect them to be recovered or settled. The re-measurement of our deferred tax assets and liabilities resulted in a one-time charge to the Company’s earnings and reduction to its net deferred tax assets of approximately $1.2 million in 2017.
Management evaluated whether a valuation allowance was necessary based on taxes paid in prior periods and recoverable, projected future income, projected future reversals of deferred tax items, and tax planning strategies. Based on its assessments, management concluded that it was more likely than not that all deferred tax assets could be realized based primarily on current taxes paid and recoverable and projected reversals of deferred tax liabilities, as well as future income. As such, no valuation allowance was recorded as of December 31, 2017 or 2016.
At December 31, 2017, the Company deferred tax assets had net operating loss carryforwards of $725,000 from the Commonwealth acquisition. The deductibility of the net operating loss carryforwards is limited under IRC Sec. 382 and estimated to be $41,000 annually.
The Company is subject to U.S. federal income tax. The Company is no longer subject to examination by taxing authorities for years before December 31, 2014.
The Company had no unrecognized tax benefits at December 31, 2017 or 2016. No change in unrecognized tax benefits is expected in the next twelve months.
Retained earnings at December 31, 2017 and 2016 included approximately $2.3 million, for which no provision for federal income taxes has been made. This amount represents the tax bad debt reserve at September 30, 1987, which is the end of the Bank’s base year for purposes of calculating the bad debt deduction for tax purposes. If this portion of retained earnings is used in the future for any purpose other than to absorb bad debts, the amount used will be added to future taxable income. The unrecorded deferred tax liability on the above amount at December 31, 2017 and 2016 was approximately $483,000 and $796,000.
NOTE 13 - RELATED-PARTY TRANSACTIONS
Loans to principal officers, directors, and their affiliates at December 31, 2017 and 2016 were as follows (in thousands):
Deposits from principal officers, directors, and their affiliates at December 31, 2017 and 2016 were $4.5 million and $4.7 million, respectively.
The Bank purchases office supplies and equipment from a company owned by a director of the Company. Purchases of such supplies and equipment totaled $78,953 in 2017 and $74,868 in 2016.
NOTE 14 - REGULATORY CAPITAL MATTERS
The Bank is subject to regulatory capital requirements administered by its primary federal regulator, the Office of the Comptroller of the Currency (OCC). Capital adequacy guidelines and prompt corrective action regulations, involve quantitative measures of assets, liabilities, and certain off-balance-sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators. Failure to meet capital requirements can initiate regulatory action. The final rules implementing Basel Committee on Banking Supervision’s capital guidelines for U.S. banks (Basel III rules) became effective for the Bank on January 1, 2015 with full compliance with all of the requirements being phased in over a multi-year schedule, and fully phased in by January 1, 2019. Under Basel III rules, the Company must hold a capital conservation buffer above the adequately capitalized risk-based capital ratios. The capital conservation buffer in being phased in from 0% in 2015 to 2.5% in 2019. At December 31, 2017, the actual capital conservation buffer for the Bank was 11.1% compared to the capital conservation buffer requirement of 1.25%. The net unrealized gain or loss on available for sale securities is not included in computing regulatory capital. Management believes as of December 31, 2017, the Bank meets all capital adequacy requirements to which it is subject.
Prompt corrective action regulations provide five classifications: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized, although these terms are not used to represent overall financial condition. If adequately capitalized, regulatory approval is required to accept brokered deposits. If undercapitalized, capital distributions are limited, as is asset growth and expansion, and capital restoration plans are required. At year-end 2017 and 2016, the most recent regulatory notification from the OCC categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that management believes have changed the institution’s category.
Actual ratios exceed regulatory thresholds plus the conservation buffer. Actual and required capital amounts and ratios are presented below at December 31, 2017 and 2016 (dollars in thousands):
On September 12, 2011, the Bank converted from a mutual to a stock institution and a liquidation account was established in the amount of $29.0 million which represented the Bank’s retained earnings as of the latest statement of financial condition contained in the conversion prospectus. The liquidation account is maintained for the benefit of eligible depositors who continue to maintain their accounts. The liquidation account is reduced annually to the extent that eligible depositors have reduced their qualifying deposits. Subsequent increases will not restore an eligible account holder’s interest in the liquidation account. In the event of a complete liquidation, each eligible depositor will be entitled to receive a distribution from the liquidation account in an amount proportionate to the current adjusted qualifying balances for accounts then held. The Company may not declare, pay a dividend on, or repurchase any of its capital stock, if the effect thereof would cause retained earnings to be reduced below the liquidation account amount.
Dividend Restrictions: The Company’s principal source of funds for dividend payments is dividends received from the Bank. Banking regulations limit the amount of dividends that may be paid without prior approval of regulatory agencies. Under these regulations, the amount of dividends that may be paid in any calendar year is limited to the current year’s net profits, combined with the retained net profits of the preceding two years, subject to the capital requirements described above. On November 30, 2017, the Federal Reserve Bank of Cleveland approved a $6.0 million cash dividend from the Bank to the Company for stock repurchases and other general corporate purposes. As of December 31, 2017, the Bank could not, without prior approval, declare dividends to the Company.
NOTE 15 - LOAN COMMITMENTS AND OTHER RELATED ACTIVITIES
Some financial instruments, such as loan commitments, credit lines, letters of credit, and overdraft protection, are issued to meet customer financing needs. These are agreements to provide credit or to support the credit of others, as long as conditions established in the contract are met, and usually have expiration dates. Commitments may expire without being used. Off-balance-sheet risk to credit loss exists up to the face amount of these instruments, although material losses are not anticipated. The same credit policies are used to make such commitments as are used for loans, including obtaining collateral at exercise of the commitment.
The contractual amounts of financial instruments with off-balance-sheet risk at December 31, 2017 and 2016 were as follows (in thousands):
NOTE 16 - ESOP
Effective January 1, 2011, the Bank adopted an Employee Stock Ownership Plan (“ESOP”) for eligible employees. The ESOP borrowed $2.7 million from the Company and used those funds to acquire 269,790 shares issued by the Company in its initial public offering. The shares were acquired at a price of $10.00 per share.
The debt is secured by the shares purchased with the debt proceeds and will be repaid by the ESOP over the 20-year term of the debt with funds from Town Square’s contributions to the ESOP and dividends payable on unallocated shares, if any. The interest rate on the ESOP loan adjusts annually and is the prime rate on the first business day of the calendar year, as published in The Wall Street Journal.
Shares purchased by the ESOP are held by a trustee in an unallocated suspense account and shares are released annually from the suspense account on a pro-rata basis as principal and interest payments are made by the ESOP to the Company. The trustee allocates the shares released among participants on the basis of each participant’s proportional share of compensation relative to all participants. Total ESOP shares may be reduced as a result of employees leaving the Company; shares that have previously been released to those exiting employees may be removed from the plan and transferred to that employee. As shares are committed to be released from the suspense account, the Company reports compensation expense based on the average fair value of shares committed to be released with a corresponding credit to shareholders’ equity.
Compensation expense recognized for the years ended December 31, 2017 and 2016 was $258,000 and $241,000, respectively.
Shares held by the ESOP at December 31, 2017 and 2016 were as follows (dollars in thousands):
NOTE 17 - EARNINGS PER SHARE
The two-class method is used in the calculation of basic and diluted earnings per share. Under the two-class method, earnings available to common shareholders for the period are allocated between common shareholders and participating securities according to dividends declared (or accumulated) and participating rights in undistributed earnings. The factors used in the earnings per share computation follow (dollars in thousands except per share data):
Because the Company had a net loss for 2017, stock options of 145,200 shares of common stock were not considered in computing diluted earnings per common share for December 31, 2017, as they were considered anti-dilutive. There were 22,962 potentially dilutive securities outstanding at December 31, 2016. Stock options of 179,900 shares of common stock were considered in computing diluted earnings per common share for December 31, 2016.
NOTE 18 - STOCK BASED COMPENSATION
On January 8, 2013, the shareholders of Poage Bankshares, Inc. approved the Poage Bankshares, Inc. 2013 Equity Incentive Plan (the “Plan”) for employees and directors of the Company. The Plan authorizes the issuance of up to 472,132 shares of the Company’s common stock, with no more than 134,895 of shares as restricted stock awards and 337,237 as stock options, either incentive stock options or non-qualified stock options. The exercise price of options granted under the Plan may not be less than the fair value on the date the stock option is granted. The compensation committee of the board of directors has sole discretion to determine the amount and to whom equity incentive awards are granted.
On April 16, 2013, the compensation committee of the board of directors approved the issuance of 134,895 shares of restricted stock to its directors and officers. In addition, on May 10, 2013, the compensation committee of the board of directors approved the issuance of 300,000 stock options to its directors and officers. An additional 20,000 stock option shares were issued on March 19, 2014 as a result of the acquisition of Town Square Financial Corporation by Poage Bankshares, Inc. All stock options and restricted stock awards vest ratably over five years. Stock options expire ten years after issuance. An additional 5,000 stock option shares were issued on May 31, 2015 to employees as a result of the acquisition of Commonwealth. Apart from the vesting schedule for both stock options and restricted stock, there are no performance-based conditions or any other material conditions applicable to the awards issued.
The following table summarizes stock option activity for the year ended December 31, 2017:
Stock options are assumed to be earned ratably over their respective vesting periods and charged to compensation expense based upon their grant date fair value and the number of options assumed to be earned. At December 31, 2017, 141,850 options were outstanding, and 99,600 options were fully vested and exercisable with intrinsic value of $868,000 and $610,000, respectively. At December 31, 2016, 179,900 options were outstanding, and 101,400 options were fully vested and exercisable with aggregate intrinsic value of $698,000 and $393,000, respectively. Stock-based compensation expense for stock options included in salaries and benefits for the year ended December 31, 2017 and 2016 was $73,000 and $86,000, respectively. Total unrecognized compensation cost related to vested and non-vested stock options was $39,000 at December 31, 2017 and is expected to be recognized over a weighted average period of 2.4 years. During the year ended December 31, 2017, the aggregate intrinsic value of the options exercised under the plan was $166,000 determined as of the date of the option exercise.
The following table summarizes non-vested restricted stock activity for the year ended December 31, 2017:
The fair value of the restricted stock awards is amortized to compensation expense over the vesting period (generally five years) and is based on the market price of the Company’s common stock at the date of the grant multiplied by the number of shares granted that are expected to vest. Stock-based compensation expense for the vested and non-vested restricted stock included in salaries and benefits for the years ended December 31, 2017 and 2016 was $230,000 and $291,000, respectively. The fair value of the 2017 vested restricted stock awards was $299,000, or $19.63 per weighted-average share. The fair value of the 2016 vested restricted stock awards was $348,000, or $16.31 per weighted-average share. Unrecognized compensation expense for vested and non-vested restricted stock awards was $69,000 at December 31, 2017 and is expected to be recognized over a weighted-average period of 1.0 year.
NOTE 19 - HOLDING COMPANY ONLY FINANCIAL STATEMENTS
The following balance sheets, statements of income and comprehensive income and statements of cash flows for Poage Bankshares, Inc. should be read in conjunction with the consolidated financial statements and notes thereto.
BALANCE SHEETS
December 31, 2017 and 2016
(In thousands)
STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS)
Years ended December 31, 2017 and 2016
(In thousands)
STATEMENTS OF CASH FLOWS
Years ended December 31, 2017 and 2016
(In thousands)
ITEM 9.
ITEM 9.CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not Applicable.
ITEM 9A.
ITEM 9A.CONTROLS AND PROCEDURES
(a) Evaluation of disclosure controls and procedures.
Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act) as of December 31, 2017 (the “Evaluation Date”). Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, as of the Evaluation Date, the disclosure controls and procedures were not effective, because of the material weakness described below, in ensuring that all material information required to be filed in this annual report has been made known to them in a timely fashion.
During the three months ended September 30, 2017, the Company uncovered evidence of suspected fraud involving the origination of fictitious loans by an employee of the Bank. Management discovered that an employee had been using falsified brokerage statements, financial statements, tax returns, deeds and mortgages to make fictitious loans. The employee is no longer with the Company. The Company’s internal audit department has conducted an extensive internal review of our internal controls with the assistance of an outside independent professional firm, with specific focus on our loan underwriting, approval and administration procedures. As a result of the internal review, management discovered a material weakness in the operating effectiveness of procedures and documentation related to loan underwriting. Additionally, these processes lacked effective supervision and oversight by lending management personnel. Our management, overseen by the Audit Committee, is working to implement new procedures to improve this process and remediate this control weakness.
The identified material weakness will not be considered remediated until the new procedures have been in operation for a sufficient period of time to be tested and determined by management to be operating effectively.
(b) Management’s Report on Internal Control over Financial Reporting
Poage Bankshares’ management is responsible for establishing and maintaining adequate internal control over financial reporting. Poage Bankshares’ system of internal control over financial reporting is designed under the supervision of management, including our Chief Executive Officer and Chief Financial Officer, to provide reasonable assurance regarding the reliability of our financial reporting and the preparation of Poage Bankshares’ consolidated financial statements for external reporting purposes in accordance with U.S. generally accepted accounting principles (“GAAP”).
Our internal control over financial reporting includes those policies and procedures that:
•pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect our transactions and dispositions of our assets;
•provide reasonable assurance that our transactions are recorded as necessary to permit preparation of our financial statements in accordance with accounting principles generally accepted in the United States of America, and that our receipts and expenditures are being made only in accordance with authorizations of our management and our directors; and
•provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of our assets that could have a material effect on the financial statements.
Because of its inherent limitations, a system of internal control over financial reporting can provide only reasonable assurance and may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness as to future periods are subject to risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. Further, because of changes in conditions, effectiveness of internal controls over financial reporting may vary over time. Our system contains self-monitoring mechanisms, and actions are taken to correct deficiencies as they are identified.
Management determined that a material weakness existed in the Company's internal control over financial reporting at September 30, 2017. As of December 31, 2017, management assessed the effectiveness of Poage Bankshares’ internal control over financial reporting based upon the framework established in Internal Control-2013 Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). Based on our evaluation and the reasons described above, management, including our Chief Executive Officer and our Chief Financial Officer, concluded that our internal control over financial reporting was not effective as of December 31, 2017 using these criteria. This annual report does not include an attestation report of Poage Bankshares’ registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by Poage Bankshares’ registered public accounting firm pursuant to rules of the Securities and Exchange Commission that permit Poage Bankshares (as a smaller reporting company) to provide only management’s report in this annual report.
(c) Changes in internal controls.
There were significant changes made in our internal control over financial reporting during the Company’s fourth fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting as a result of the suspected fraud reported during the three months ended September 30, 2017. The new procedures included separation of duties related to validating collateral and borrower identification, the cashing of third party business checks, the handling of returned mail and authorization of loan payments from deposit accounts, as well as increased monitoring of loan renewals. There was no other change in our internal control over financial reporting that occurred during the Company’s fourth fiscal quarter that has materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
ITEM 9B.
ITEM 9B.OTHER INFORMATION
None.
PART III
ITEM 10.
ITEM 10.DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
The information required by Item 10 of Form 10-K appears under the caption “Proposal I-Election of Directors” in the Proxy Statement for the Company’s 2018 Annual Meeting of Stockholders (the “Proxy Statement”) and is hereby incorporated by reference.
ITEM 11.
ITEM 11.EXECUTIVE COMPENSATION
The information required by Item 11 of Form 10-K appears under the caption “Executive Compensation” in the Proxy Statement and is hereby incorporated by reference.
ITEM 12.
ITEM 12.SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
The information required by Item 12 of Form 10-K appears under the caption “Voting Securities and Principal Holders” in the Proxy Statement and is hereby incorporated by reference.
ITEM 13.
ITEM 13.CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR INDEPENDENCE
The information required by Item 13 of Form 10-K appears under the caption “Proposal I-Election of Directors” in the Proxy Statement and is hereby incorporated by reference.
ITEM 14.
ITEM 14.PRINCIPAL ACCOUNTING FEES AND SERVICES
The information required by Item 14 of Form 10-K appears under the caption “Proposal III-Ratification of Appointment of Independent Registered Public Accounting Firm” in the Proxy Statement and is hereby incorporated by reference.
PART IV
ITEM 15.
ITEM 15.EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a)(1) Financial Statements
The following documents are filed as item 8 of this Form 10-K.
(A) Report of Independent Registered Public Accounting Firm
(B) Consolidated Balance Sheets - at December 31, 2017 and 2016
(C) Consolidated Statements of Operations - Years ended December 31, 2017 and 2016
(D) Consolidated Statements of Comprehensive Income - Years ended December 31, 2017 and 2016
(E) Consolidated Statements of Changes In Shareholders’ Equity - Years ended December 31, 2017 and 2016
(F) Consolidated Statements of Cash Flows - Years ended December 31, 2017 and 2016
(G) Notes to Consolidated Financial Statements
(a)(2) Financial Statement Schedules
None.
(b) Not applicable.
(c) Not applicable.
(a)(3) Exhibits
3.1 Articles of Incorporation of Poage Bankshares, Inc.*
3.2 Bylaws of Poage Bankshares, Inc.**
Form of Common Stock Certificate of Poage Bankshares, Inc.*
10.1 Form of Employee Stock Ownership Plan*
10.2 Three Year Change in Control Agreement, dated September 12, 2011, by and between James W. King and Home Federal Savings and Loan Association.*
10.3 Life Insurance Endorsement Method Split Dollar Plan Agreement, dated April 29, 2003, by and between James W. King and Home Federal Savings and Loan Association.*
10.4 Form of Director Supplemental Retirement Plan Agreement.*
10.5 Form of Executive Supplemental Retirement Plan Agreement.*
10.6 Form of Amendment to the Executive Supplemental Retirement Plan Agreement.*
10.7 Poage Bankshares, Inc. 2013 Equity Incentive Plan***
10.8 Agreement and Plan of Merger, dated as of October 21, 2013, by and among Poage, Bankshares, Inc., Poage Merger Subsidiary, Inc. and Home Federal Savings and Loan Association, and Town Square Financial Corporation and Town Square Bank.****
10.9 Employment Agreement, dated March 18, 2014, by and between Bruce VanHorn and Home Federal Savings and Loan Association *****
10.10 Agreement and Plan of Conversion Merger by and among Poage Bankshares, Inc., Town Square Bank and Commonwealth Bank, F.S.B.******
10.11 Business Loan Agreement Between Poage Bankshares, Inc. and Premier Bank dated June 16, 2016 *******
Subsidiaries of registrant
Consent of Crowe Horwath LLP
31.1 Certification of President and Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2 Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
Certification of President and Chief Executive Officer and Chief Financial Officer pursuant to 18 USC Section 1350, as adopted pursuant to Section 906 of the Sarbanes Oxley Act of 2002.
Interactive data files pursuant to Rule 405 of Regulation S-T: (i) the Consolidated Balance Sheets as of December 31, 2017 and 2016, (ii) the Consolidated Statements of Operations for the years ended December 31, 2017 and 2016, (iii) the Consolidated Statements of Comprehensive Income (Loss) for the years ended December 31, 2017 and 2016, (iv) the Consolidated Statements of Changes in Shareholders’ Equity for the years ended December 31, 2017 and 2016, (v) the Consolidated Statements of Cash Flows for the years ended December 31, 2017 and 2016, and (vi) the Notes to the Consolidated Financial Statements.
* Incorporated by reference to the Registration Statement on Form S-1 of Poage Bankshares, Inc. (File No. 333-172192, originally filed with the Securities and Exchange Commission on February 11, 2011, and as subsequently amended).
** Incorporated by reference to the Current Report on Form 8-K of Poage Bankshares, Inc. (File No. 001-35295, filed with the Securities and Exchange Commission on August 29, 2013).
*** Incorporated by reference to the Definitive Proxy Statement on Schedule 14A of Poage Bankshares, Inc. (File No. 001-35295, filed with the Securities and Exchange Commission on January 9, 2013).
**** Incorporated by reference to the Current Report on Form 8-K of Poage Bankshares, Inc. (File No. 001-35295, filed with the Securities and Exchange Commission on October 21, 2013).
***** Incorporated by reference to the Current Report on Form 8-K of Poage Bankshares, Inc. (File No. 001-35295, filed with the Securities and Exchange Commission on March 19, 2014).
****** Incorporated by reference to the Registration Statement on Form S-1 of Poage Bankshares, Inc. (File No. 333-172192, originally filed with the Securities and Exchange Commission on December 17, 2014, and as subsequently amended).
******* Incorporated by reference to the Quarterly Report on Form 10-Q of Poage Bankshares, Inc. (File No. 000-35295, filed with the Securities and Exchange Commission on August 10, 2016).
ITEM 16.FORM 10-K SUMMARY
Not applicable
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Poage Bankshares, Inc.
Date: April 10, 2018
/s/ Bruce VanHorn
Bruce VanHorn,
President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.