UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
  
FORM 10-Q
(Mark one)
S QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the Quarterly Period Ended June 30, 2016

OR
 
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from _______________ to _______________
 
Commission File Number 000-30707

First Northern Community Bancorp
(Exact name of registrant as specified in its charter)

California
 
68-0450397
(State or other jurisdiction of incorporation or organization)
 
(I.R.S. Employer Identification Number)

195 N. First Street, Dixon, California
 
95620
(Address of principal executive offices)
 
(Zip Code)

707-678-3041
(Registrant's telephone number including area code)

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

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company (as defined by Rule 12b-2 of the Exchange Act). See the definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act. (Check one).

Large accelerated filer   
Accelerated filer  
Non-accelerated filer   (Do not check if a smaller reporting company)
  Smaller reporting company

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes  
No  

The number of shares of Common Stock outstanding as of August 1, 2016  was 10,704,247.
 
1

FIRST NORTHERN COMMUNITY BANCORP
 
INDEX

 
Page
PART I   – Financial Information
3
ITEM I. – Financial Statements (Unaudited)
3
Condensed Consolidated Balance Sheets (Unaudited)
3
Condensed Consolidated Statements of Income (Unaudited)
4
Condensed Consolidated Statements of Comprehensive Income (Unaudited)
5
Condensed Consolidated Statement of Stockholders' Equity (Unaudited)
6
Condensed Consolidated Statements of Cash Flows (Unaudited)
7
Notes to Unaudited Condensed Consolidated Financial Statements
8
ITEM 2. – MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
35
ITEM 3. – QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
50
ITEM 4. – CONTROLS AND PROCEDURES
50
PART II – OTHER INFORMATION
50
ITEM 1. – LEGAL PROCEEDINGS
50
ITEM 1A. – RISK FACTORS
50
ITEM 2. – UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
52
ITEM 3. – DEFAULTS UPON SENIOR SECURITIES
52
ITEM 4. – MINE SAFETY DISCLOSURES
52
ITEM 5. – OTHER INFORMATION
52
ITEM 6. – EXHIBITS
52
SIGNATURES
53

2

PART I – FINANCIAL INFORMATION
 
FIRST NORTHERN COMMUNITY BANCORP
 
ITEM I.    – FINANCIAL STATEMENTS (UNAUDITED)
 
CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)
 
(in thousands, except shares and share amounts)
 
June 30, 2016
   
December 31, 2015
 
 
           
Assets
           
 
           
Cash and cash equivalents
 
$
143,519
   
$
200,797
 
Certificates of deposit
   
16,709
     
16,649
 
Investment securities – available-for-sale
   
235,233
     
183,351
 
Loans, net of allowance for loan losses of $10,030 at June 30, 2016 and $9,251 at December 31, 2015
   
633,758
     
605,853
 
Loans held-for-sale
   
1,886
     
351
 
Stock in Federal Home Loan Bank and other equity securities, at cost
   
4,409
     
3,934
 
Premises and equipment, net
   
7,481
     
7,011
 
Interest receivable and other assets
   
27,071
     
26,679
 
 
               
Total Assets
 
$
1,070,066
   
$
1,044,625
 
 
               
Liabilities and Stockholders' Equity
               
 
               
Liabilities:
               
 
               
Demand deposits
 
$
320,427
   
$
313,307
 
Interest-bearing transaction deposits
   
263,026
     
261,634
 
Savings and MMDA's
   
302,810
     
285,365
 
Time, under $250,000
   
63,886
     
67,855
 
Time, $250,000 and over
   
19,713
     
19,953
 
Total deposits
   
969,862
     
948,114
 
 
               
Interest payable and other liabilities
   
9,548
     
10,662
 
 
               
Total Liabilities
   
979,410
     
958,776
 
 
               
Stockholders' Equity:
               
Common stock, no par value; 16,000,000 shares authorized; 10,704,247 shares issued and outstanding at June 30, 2016 and 10,676,557 shares issued and outstanding at December 31, 2015
   
73,903
     
73,764
 
Additional paid-in capital
   
977
     
977
 
Retained earnings
   
15,360
     
11,603
 
Accumulated other comprehensive income (loss), net
   
416
     
(495
)
Total Stockholders' Equity
   
90,656
     
85,849
 
 
               
Total Liabilities and Stockholders' Equity
 
$
1,070,066
   
$
1,044,625
 

See notes to unaudited condensed consolidated financial statements.
 
3

FIRST NORTHERN COMMUNITY BANCORP
 
CONDENSED CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)

(in thousands, except per share amounts)
 
Three months ended
June 30, 2016
   
Three months ended
June 30, 2015
   
Six months ended
June 30, 2016
   
Six months ended
June 30, 2015
 
Interest and dividend income:
                       
Loans
 
$
7,649
   
$
6,627
   
$
15,031
   
$
12,984
 
Due from banks interest bearing accounts
   
192
     
164
     
461
     
320
 
Investment securities
                               
Taxable
   
882
     
694
     
1,664
     
1,435
 
Non-taxable
   
66
     
66
     
136
     
130
 
Other earning assets
   
93
     
222
     
177
     
298
 
Total interest and dividend income
   
8,882
     
7,773
     
17,469
     
15,167
 
Interest expense:
                               
Deposits
   
273
     
293
     
559
     
586
 
Total interest expense
   
273
     
293
     
559
     
586
 
Net interest income
   
8,609
     
7,480
     
16,910
     
14,581
 
Provision for loan losses
   
450
     
     
900
     
350
 
Net interest income after provision for loan losses
   
8,159
     
7,480
     
16,010
     
14,231
 
Non-interest income:
                               
Service charges on deposit accounts
   
506
     
494
     
1,026
     
1,013
 
Gains on sales of other real estate owned
   
     
     
4
     
161
 
Gains on sales of loans held-for-sale
   
252
     
292
     
362
     
425
 
Investment and brokerage services income
   
137
     
151
     
262
     
295
 
Mortgage brokerage income
   
22
     
18
     
22
     
23
 
Loan servicing income
   
104
     
198
     
220
     
311
 
Fiduciary activities income
   
105
     
129
     
218
     
257
 
Debit card income
   
503
     
528
     
968
     
1,004
 
Gains on calls of available-for-sale securities
   
     
     
14
     
 
Other income
   
226
     
212
     
444
     
425
 
Total non-interest income
   
1,855
     
2,022
     
3,540
     
3,914
 
Non-interest expenses:
                               
Salaries and employee benefits
   
4,099
     
4,107
     
8,284
     
7,955
 
Occupancy and equipment
   
766
     
699
     
1,489
     
1,406
 
Data processing
   
373
     
436
     
759
     
847
 
Stationery and supplies
   
91
     
111
     
184
     
200
 
Advertising
   
58
     
92
     
143
     
172
 
Directors' fees
   
76
     
75
     
135
     
137
 
Other real estate owned expense
   
     
22
     
1
     
24
 
Other expense
   
1,345
     
1,230
     
2,632
     
2,389
 
Total non-interest expenses
   
6,808
     
6,772
     
13,627
     
13,130
 
Income before provision for income taxes
   
3,206
     
2,730
     
5,923
     
5,015
 
Provision for income taxes
   
1,171
     
960
     
2,157
     
1,728
 
 
                               
Net income
 
$
2,035
   
$
1,770
   
$
3,766
   
$
3,287
 
 
                               
Preferred stock dividends
 
$
   
$
(32
)
 
$
   
$
(64
)
Net income available to common shareholders
 
$
2,035
   
$
1,738
   
$
3,766
   
$
3,223
 
 
                               
Basic earnings per common share
 
$
0.19
   
$
0.16
   
$
0.36
   
$
0.31
 
Diluted earnings per common share
 
$
0.19
   
$
0.16
   
$
0.35
   
$
0.30
 

See notes to unaudited condensed consolidated financial statements.

4

FIRST NORTHERN COMMUNITY BANCORP
 
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (UNAUDITED)
 
(in thousands)
 
Three months ended
June 30, 2016
   
Three months ended
June 30, 2015
   
Six months ended
June 30, 2016
   
Six months ended
June 30, 2015
 
Net income
 
$
2,035
   
$
1,770
   
$
3,766
   
$
3,287
 
Other comprehensive income (loss), net of tax:
                               
Unrealized holding gains on securities:
                               
Unrealized holding gains (losses) arising during the period, net of tax effect of $172 and $(411) for the three months ended June 30, 2016 and June 30, 2015, respectively, and $613 and $(161) for the six months ended June 30, 2016 and June 30, 2015, respectively
   
259
     
(618
)
   
919
     
(243
)
Less: reclassification adjustment due to gains realized on sales of securities, net of tax effect of $0 for the three months ended June 30, 2016 and June 30, 2015, and $(6) and $0 for the six months ended June 30, 2016 and June 30, 2015, respectively
   
     
     
(8
)
   
 
Directors' and officers' retirement plan equity adjustments, net of tax effect of $0 for the three months ended June 30, 2016 and June 30, 2015, and $0 and $(22) for the six months ended June 30, 2016 and June 30, 2015, respectively
   
     
     
     
(33
)
Other comprehensive income (loss)
 
$
259
   
$
(618
)
 
$
911
   
$
(276
)
 
                               
Comprehensive income
 
$
2,294
   
$
1,152
   
$
4,677
   
$
3,011
 

See notes to unaudited condensed consolidated financial statements.

5

FIRST NORTHERN COMMUNITY BANCORP
 
CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY (UNAUDITED)
 
(in thousands, except share data)
 
   
Common Stock
                         
 
 
Shares
   
Amounts
   
Additional Paid-in Capital
   
Retained Earnings
   
Accumulated Other Comprehensive (Loss) Income
   
Total
 
Balance at December 31, 2015
   
10,676,557
   
$
73,764
   
$
977
   
$
11,603
   
$
(495
)
 
$
85,849
 
 
                                               
Net income
                           
3,766
             
3,766
 
 
                                               
Other comprehensive income
                                   
911
     
911
 
 
                                               
Stock dividend adjustment
   
505
     
4
             
(4
)
           
 
Cash in lieu of fractional shares
   
(101
)
                   
(5
)
           
(5
)
Stock-based compensation
           
135
                             
135
 
Common shares issued related to restricted stock grants, net of restricted stock reversals
   
27,286
                                     
 
 
                                               
Balance at June 30, 2016
   
10,704,247
   
$
73,903
   
$
977
   
$
15,360
   
$
416
   
$
90,656
 

See notes to unaudited condensed consolidated financial statements.

6

FIRST NORTHERN COMMUNITY BANCORP
 
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
 
 
 
(in thousands)
 
 
 
Six months ended June 30, 2016
   
Six months ended June 30, 2015
 
Cash Flows From Operating Activities
           
Net income
 
$
3,766
   
$
3,287
 
Adjustments to reconcile net income to net cash provided by operating activities:
               
Depreciation
   
303
     
333
 
Accretion and amortization of investment securities premiums and discounts, net
   
1,326
     
1,002
 
Valuation adjustment on mortgage servicing rights
   
13
     
 
(Increase) decrease in deferred loan origination fees and costs, net
   
(90
)
   
122
 
Provision for loan losses
   
900
     
350
 
Stock-based compensation
   
135
     
116
 
Gains on calls of available-for-sale securities
   
(14
)
   
 
Gains on sales of other real estate owned
   
(4
)
   
(161
)
Gains on sales of loans held-for-sale
   
(362
)
   
(425
)
Proceeds from sales of loans held-for-sale
   
16,470
     
23,509
 
Originations of loans held-for-sale
   
(17,643
)
   
(23,079
)
Changes in assets and liabilities:
               
(Increase) decrease in interest receivable and other assets
   
(1,012
)
   
1,619
 
Net decrease in interest payable and other liabilities
   
(1,114
)
   
(281
)
Net cash provided by operating activities
   
2,674
     
6,392
 
                 
Cash Flows From Investing Activities
               
Proceeds from calls or maturities of available-for-sale securities
   
20,704
     
4,540
 
Principal repayments on available-for-sale securities
   
15,260
     
12,682
 
Purchase of available-for-sale securities
   
(87,640
)
   
(23,615
)
Net (increase) decrease in certificates of deposit
   
(60
)
   
923
 
Net increase in loans
   
(28,932
)
   
(33,440
)
Net increase in stock in Federal Home Loan Bank and other equity securities, at cost
   
(475
)
   
 
Proceeds from sale of other real estate owned
   
221
     
897
 
Purchases of premises and equipment, net
   
(773
)
   
(151
)
Net cash used in investing activities
   
(81,695
)
   
(38,164
)
 
               
Cash Flows From Financing Activities
               
Net increase in deposits
   
21,748
     
41,315
 
Cash dividends paid in lieu of fractional shares
   
(5
)
   
(6
)
Stock options exercised
   
     
84
 
Cash dividends paid on preferred stock
   
     
(64
)
Net cash provided by financing activities
   
21,743
     
41,329
 
                 
Net (decrease) increase in Cash and Cash Equivalents
   
(57,278
)
   
9,557
 
Cash and Cash Equivalents, beginning of period
   
200,797
     
216,192
 
Cash and Cash Equivalents, end of period
 
$
143,519
   
$
225,749
 
 
               
Supplemental Disclosures of Cash Flow Information:
               
Cash paid during the period for:
               
Interest
 
$
543
   
$
578
 
Income taxes
 
$
2,380
   
$
1,310
 
Supplemental disclosures of non-cash investing and financing activities:
               
Stock dividend distributed
 
$
3,351
   
$
3,103
 
Transfer of loans held-for-investment to other real estate owned
 
$
217
   
$
407
 
Decrease in directors' & officers' retirement plan equity adjustment, net of tax
 
$
   
$
(33
)
Unrealized holding gains (losses) on available for sale securities, net of taxes
 
$
911
   
$
(243
)
 
See notes to unaudited condensed consolidated financial statements.
7

FIRST NORTHERN COMMUNITY BANCORP
 
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 
June 30, 2016 and 2015 and December 31, 2015
 
1. BASIS OF PRESENTATION

The accompanying unaudited condensed consolidated financial statements of First Northern Community Bancorp (the "Company") have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP) for interim financial information and with the instructions to Form 10-Q and Articles 9 and 10 of Regulation S-X.  Accordingly, they do not include all of the information and notes required by GAAP for complete financial statements.  In the opinion of management, all adjustments considered necessary for a fair presentation have been included.  The results of operations for any interim period are not necessarily indicative of results expected for the full year.  These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto contained in the Company's Annual Report on Form 10-K for the year ended December 31, 2015 as filed with the Securities and Exchange Commission.  The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements as well as reported amounts of revenue and expense during the reporting period.  Actual results could differ from those estimates.  All material intercompany balances and transactions have been eliminated in consolidation.  See the Company's Annual Report on Form 10-K for the year ended December 31, 2015 for discussion of significant accounting policies and estimates.

Recently Issued Accounting Pronouncements:

In February 2016, Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2016-02, Leases (Topic 842).  The amendments in ASU 2016-02, among other things, require lessees to recognize the following for all leases (with the exception of short-term leases) at the commencement date:

A lease liability, which is a lessee's obligation to make lease payments arising from a lease, measured on a discounted basis; and
A right-of-use asset, which is an asset that represents the lessee's right to use, or control the use of, a specified asset for the lease term.

The amendments in this ASU are effective for public companies for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. Early adoption is permitted. Management is currently evaluating the impact of this ASU on the Company's consolidated financial statements. 

In March 2016, FASB issued ASU 2016-09, Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting.  The amendments in ASU 2016-09 simplify several aspects of the accounting for share-based payment award transactions, including: (a) income tax consequences; (b) classification of awards as either equity or liabilities; and (c) classification on the statement of cash flows. The amendments are effective for public companies for annual periods beginning after December 15, 2016, and interim periods within those annual periods. Early adoption is permitted for any interim or annual period. Management is currently evaluating the impact of this ASU on the Company's consolidated financial statements.

In June 2016, FASB issued ASU 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments.  The amendments in ASU 2016-13, among other things, require the measurement of all expected credit losses for financial assets held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts.  Financial institutions and other organizations will now use forward-looking information to better inform their credit loss estimates.  Many of the loss estimation techniques applied today will still be permitted, although the inputs to those techniques will change to reflect the full amount of expected credit losses.  In addition, ASU 2016-13 amends the accounting for credit losses on available-for-sale debt securities and purchased financial assets with credit deterioration.  The amendments are effective for public companies for annual periods beginning after December 15, 2019.  Early application will be permitted for all organizations for fiscal years, and interim periods within those fiscal years beginning after December 15, 2018.  Management is currently evaluating the impact of this ASU on the Company's consolidated financial statements.

8

Reclassifications

Certain reclassifications of prior period amounts have been made to conform to current classifications. The Company identified an error related to prior year classifications of the amortization of deferred loan costs in the Consolidated Statements of Income. The amortization amounts were included as components of "Salaries and Employee Benefits" and "Other Expenses", instead of a component of "Interest and Fees on Loans". Management evaluated the materiality of the error from qualitative and quantitative perspectives and concluded that the error was immaterial to the prior period financial statements taken as a whole. Consequently, the Consolidated Statement of Income contained in this Report has been revised for the three and six months ended June 30, 2015. This change resulted in a decrease of $451,000 in "Interest and Fees and Loans" offset by decreases of $308,000 in "Salaries and employee benefits" and $143,000 in "Other expenses" for the three months ended June 30, 2015 and a decrease of $816,000 in "Interest and Fees and Loans" offset by decreases of $549,000 in "Salaries and employee benefits" and $267,000 in "Other expenses" for the six months ended June 30, 2015. These changes did not affect net income, the balance sheet, cash flows or shareholders' equity for any period.

9

2.  LOANS

The composition of the Company's loan portfolio, by loan class, as of June 30, 2016 and December 31, 2015 was as follows:
 
($ in thousands)
 
June 30, 2016
   
December 31, 2015
 
 
           
Commercial
 
$
132,347
   
$
136,095
 
Commercial Real Estate
   
313,533
     
292,316
 
Agriculture
   
92,766
     
84,813
 
Residential Mortgage
   
43,670
     
43,375
 
Residential Construction
   
17,554
     
12,110
 
Consumer
   
42,819
     
45,386
 
 
               
 
   
642,689
     
614,095
 
Allowance for loan losses
   
(10,030
)
   
(9,251
)
Net deferred origination fees and costs
   
1,099
     
1,009
 
 
               
Loans, net
 
$
633,758
   
$
605,853
 

The Company manages asset quality and credit risk by maintaining diversification in its loan portfolio and through review processes that include analysis of credit requests and ongoing examination of outstanding loans and delinquencies, with particular attention to portfolio dynamics and loan mix.  The Company strives to identify loans experiencing difficulty early enough to correct the problems, to record charge-offs promptly based on realistic assessments of collectability and current collateral values and to maintain an adequate allowance for loan losses at all times.   Asset quality reviews of loans and other non-performing assets are administered using credit risk rating standards and criteria similar to those employed by state and federal banking regulatory agencies.

Commercial loans, whether secured or unsecured, generally are made to support the short-term operations and other needs of small businesses.  These loans are generally secured by the receivables, equipment, and real property of the business and are susceptible to the related risks described above.  Problem commercial loans are generally identified by periodic review of financial information that may include financial statements, tax returns, and payment history of the borrower.  Based on this information, the Company may decide to take any of several courses of action including demand for repayment, requiring the borrower to provide a significant principal payment and/or additional collateral or requiring similar support from guarantors. Notwithstanding, when repayment becomes unlikely based on the borrower's income and cash flow, repossession or foreclosure of the underlying collateral may become necessary.  Collateral values may be determined by appraisals obtained through Bank-approved, licensed appraisers, qualified independent third parties, purchase invoices, or other appropriate means.

Commercial real estate loans generally fall into two categories, owner-occupied and non-owner occupied.  Loans secured by owner-occupied real estate are primarily susceptible to changes in the market conditions of the related business.  This may be driven by, among other things, industry changes, geographic business changes, changes in the individual financial capacity of the business owner, general economic conditions and changes in business cycles. These same risks apply to commercial loans whether secured by equipment, receivables or other personal property or unsecured.  Losses on loans secured by owner-occupied real estate, equipment, or other personal property generally are dictated by the value of underlying collateral at the time of default and liquidation of the collateral.  When default is driven by issues related specifically to the business owner, collateral values tend to provide better repayment support and may result in little or no loss. Alternatively, when default is driven by more general economic conditions, underlying collateral generally has devalued more and results in larger losses due to default.  Loans secured by non-owner occupied real estate are primarily susceptible to risks associated with swings in occupancy or vacancy and related shifts in lease rates, rental rates or room rates. Most often, these shifts are a result of changes in general economic or market conditions or overbuilding and resulting over-supply of space.  Losses are dependent on the value of underlying collateral at the time of default.  Values are generally driven by these same factors and influenced by interest rates and required rates of return as well as changes in occupancy costs.  Collateral values may be determined by appraisals obtained through Bank-approved, licensed appraisers, qualified independent third parties, sales invoices, or other appropriate means.

Agricultural loans, whether secured or unsecured, generally are made to producers and processors of crops and livestock.  Repayment is primarily from the sale of an agricultural product or payments for services.  Agricultural loans are generally secured by inventory, receivables, equipment, and real property.  Agricultural loans are susceptible to changes in market demand for specific commodities.  This may be exacerbated by, among other things, industry changes, changes in the individual financial capacity of the business owner, general economic conditions and changes in business cycles, as well as adverse weather conditions, including drought conditions such as those affecting California.  Problem agricultural loans are generally identified by periodic review of financial information that may include financial statements, tax returns, crop budgets, payment history and crop inspections.  Based on this information, the Company may decide to take any of several courses of action including demand for repayment, requiring the borrower to provide a significant principal payment and/or additional collateral or requiring similar support from guarantors. Notwithstanding, when repayment becomes unlikely based on the borrower's income and cash flow, repossession or foreclosure of the underlying collateral may become necessary.

10

Residential mortgage loans, which are secured by real estate, are primarily susceptible to four risks: non-payment due to diminished or lost income; over-extension of credit; a lack of borrower's cash flow to sustain payments; and shortfalls in collateral value.  In general, non-payment is usually due to loss of employment and follows general economic trends in the economy, particularly the upward movement in the unemployment rate, loss of collateral value and demand shifts.

Residential construction loans, whether owner-occupied or non-owner occupied residential development loans, are not only susceptible to the related risks described above but the added risks of construction, including cost over-runs, mismanagement of the project, or lack of demand and market changes experienced at time of completion.  Losses are primarily related to underlying collateral value and changes therein as described above.  Problem construction loans are generally identified by periodic review of financial information that may include financial statements, tax returns and payment history of the borrower.  Based on this information, the Company may decide to take any of several courses of action including demand for repayment, requiring the borrower to provide a significant principal payment and/or additional collateral or requiring similar support from guarantors, or repossession or foreclosure of the underlying collateral.  Collateral values may be determined by appraisals obtained through Bank-approved, licensed appraisers, qualified independent third parties, purchase invoices or other appropriate means.

Consumer loans, whether unsecured or secured are primarily susceptible to four risks: non-payment due to diminished or lost income; over-extension of credit; a lack of borrower's cash flow to sustain payments; and shortfall in the collateral value.  In general, non-payment is usually due to loss of employment and will follow general economic trends in the economy, particularly upward movements in the unemployment rate, loss of collateral value and demand shifts.

As of June 30, 2016, approximately 49% in principal amount of the Company's loans were secured by commercial real estate, consisting primarily of loans secured by commercial properties and construction and land development loans.  Approximately 7% in principal amount of the Company's loans were residential mortgage loans.  Approximately 3% in principal amount of the Company's loans were residential construction loans.  Approximately 14% in principal amount of the Company's loans were for agriculture and 20% in principal amount of the Company's loans were for general commercial uses including professional, retail and small businesses.  Approximately 7% in principal amount of the Company's loans were consumer loans.

Once a loan becomes delinquent and repayment becomes questionable, a Company collection officer will address collateral shortfalls with the borrower and attempt to obtain additional collateral or a principal payment.  If this is not forthcoming and payment in full is unlikely, the Company will consider the loan to be collateral dependent and will estimate its probable loss, using a recent valuation as appropriate to the underlying collateral less estimated costs of sale, and charge-off the loan down to the estimated net realizable amount.  Depending on the length of time until final collection, the Company may periodically revalue the underlying collateral and take additional charge-offs as warranted. Revaluations may occur as often as every 3-12 months depending on the underlying collateral and volatility of values.  Final charge-offs or recoveries are taken when collateral is liquidated and actual loss is known.  Unpaid balances on loans after or during collection and liquidation may also be pursued through legal action and attachment of wages or judgment liens on the borrower's other assets.

At June 30, 2016 and December 31, 2015, all loans were pledged under a blanket collateral lien to secure actual and potential borrowings from the Federal Home Loan Bank ("FHLB") and the Federal Reserve Bank.
 
11

Non-accrual and Past Due Loans

The Company's non-accrual loans by loan class, as of June 30, 2016 and December 31, 2015 were as follows:
 
($ in thousands)
 
June 30, 2016
   
December 31, 2015
 
 
           
Commercial
 
$
56
   
$
112
 
Commercial Real Estate
   
580
     
964
 
Agriculture
   
     
 
Residential Mortgage
   
553
     
1,092
 
Residential Construction
   
     
 
Consumer
   
162
     
560
 
 
               
 
 
$
1,351
   
$
2,728
 

Non-accrual loans amounted to $1,351,000 at June 30, 2016 and were comprised of two commercial loans totaling $56,000, two commercial real estate loans totaling $580,000, two residential mortgage loans totaling $553,000 and two consumer loans totaling $162,000.  Non-accrual loans amounted to $2,728,000 at December 31, 2015 and were comprised of four residential mortgage loans totaling $1,092,000, four commercial real estate loans totaling $964,000, four commercial loans totaling $112,000, and four consumer loans totaling $560,000.  It is generally the Company's policy to charge-off the portion of any non-accrual loan that the Company does not expect to collect by writing the loan down to the estimated net realizable value of the underlying collateral.

An aging analysis of past due loans, segregated by loan class, as of June 30, 2016 and December 31, 2015, are as follows:
 
($ in thousands)
 
30-59 Days Past Due
   
60-89 Days Past Due
   
90 Days or more Past Due
   
Total Past Due
   
Current
   
Total Loans
 
June 30, 2016
                                   
Commercial
 
$
388
   
$
   
$
   
$
388
   
$
131,959
   
$
132,347
 
Commercial Real Estate
   
     
     
     
     
313,533
     
313,533
 
Agriculture
   
     
     
     
     
92,766
     
92,766
 
Residential Mortgage
   
361
     
     
     
361
     
43,309
     
43,670
 
Residential Construction
   
     
     
     
     
17,554
     
17,554
 
Consumer
   
65
     
     
107
     
172
     
42,647
     
42,819
 
Total
 
$
814
   
$
   
$
107
   
$
921
   
$
641,768
   
$
642,689
 
 
                                               
December 31, 2015
                                               
Commercial
 
$
218
   
$
   
$
57
   
$
275
   
$
135,820
   
$
136,095
 
Commercial Real Estate
   
130
     
     
232
     
362
     
291,954
     
292,316
 
Agriculture
   
     
     
     
     
84,813
     
84,813
 
Residential Mortgage
   
     
     
     
     
43,375
     
43,375
 
Residential Construction
   
     
     
     
     
12,110
     
12,110
 
Consumer
   
19
     
5
     
429
     
453
     
44,933
     
45,386
 
Total
 
$
367
   
$
5
   
$
718
   
$
1,090
   
$
613,005
   
$
614,095
 
 
The Company had no loans that were 90 days or more past due and still accruing at June 30, 2016 and one loan totaling $2,000 that was 90 days or more past due and still accruing at December 31, 2015.  Included in the aging loan category labeled "current" are non-accrual loans that were not delinquent with respect to contractual principal and interest payments as of June 30, 2016 and December 31, 2015.  These loans are categorized as non-accrual loans and are not accruing interest as of June 30, 2016 and December 31, 2015.  Non-accrual loans outstanding at June 30, 2016 and December 31, 2015 are disclosed in the table above.

12

Impaired Loans

A loan is considered 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, including scheduled interest payments.  Loans considered for impairment include non-accrual loans, troubled debt restructurings and loans with a risk rating of 6 (substandard) or worse.  Once identified, impaired loans are measured individually for impairment using one of three methods:  present value of expected cash flows discounted at the loan's effective interest rate; the loan's observable market price; and the fair value of collateral if the loan is collateral dependent.  In general, any portion of the recorded investment in a collateral dependent loan in excess of the fair value of the collateral that can be identified as uncollectible, and is, therefore, deemed a confirmed loss, is promptly charged-off against the allowance for loan losses.

Impaired loans, segregated by loan class, as of June 30, 2016 and December 31, 2015 were as follows:
 
($ in thousands)
 
Unpaid
Contractual
Principal
Balance
   
Recorded
Investment with
no Allowance
   
Recorded
Investment with
Allowance
   
Total Recorded
Investment
   
Related
Allowance
 
June 30, 2016
                             
Commercial
 
$
950
   
$
56
   
$
762
   
$
818
   
$
36
 
Commercial Real Estate
   
912
     
580
     
289
     
869
     
40
 
Agriculture
   
     
     
     
     
 
Residential Mortgage
   
3,351
     
553
     
2,433
     
2,986
     
598
 
Residential Construction
   
987
     
205
     
782
     
987
     
109
 
Consumer
   
1,042
     
244
     
529
     
773
     
36
 
Total
 
$
7,242
   
$
1,638
   
$
4,795
   
$
6,433
   
$
819
 
 
                                       
December 31, 2015
                                       
Commercial
 
$
933
   
$
97
   
$
821
   
$
918
   
$
43
 
Commercial Real Estate
   
1,292
     
964
     
294
     
1,258
     
42
 
Agriculture
   
     
     
     
     
 
Residential Mortgage
   
3,968
     
1,092
     
2,484
     
3,576
     
615
 
Residential Construction
   
1,005
     
     
1,005
     
1,005
     
119
 
Consumer
   
1,625
     
631
     
690
     
1,321
     
33
 
Total
 
$
8,823
   
$
2,784
   
$
5,294
   
$
8,078
   
$
852
 

The average recorded investment in impaired loans and the amount of interest income recognized on impaired loans during the three months ended June 30, 2016 and June 30, 2015 was as follows:
 
($ in thousands)
 
Three Months Ended
June 30, 2016
   
Three Months Ended
June 30, 2015
 
 
 
Average
Recorded
Investment
   
Interest
Income
Recognized
   
Average
Recorded
Investment
   
Interest
Income
Recognized
 
Commercial
 
$
940
   
$
10
   
$
2,650
   
$
12
 
Commercial Real Estate
   
880
     
4
     
1,084
     
4
 
Agriculture
   
     
     
     
 
Residential Mortgage
   
3,265
     
23
     
4,205
     
27
 
Residential Construction
   
992
     
11
     
879
     
9
 
Consumer
   
739
     
9
     
1,428
     
9
 
Total
 
$
6,816
   
$
57
   
$
10,246
   
$
61
 

13

The average recorded investment in impaired loans and the amount of interest income recognized on impaired loans during the six months ended June 30, 2016 and June 30, 2015 was as follows:
 
($ in thousands)
 
Six Months Ended
June 30, 2016
   
Six Months Ended
June 30, 2015
 
 
 
Average
Recorded
Investment
   
Interest
Income
Recognized
   
Average
Recorded
Investment
   
Interest
Income
Recognized
 
Commercial
 
$
933
   
$
22
   
$
2,659
   
$
20
 
Commercial Real Estate
   
1,006
     
8
     
1,048
     
8
 
Agriculture
   
     
     
     
 
Residential Mortgage
   
3,369
     
47
     
4,352
     
58
 
Residential Construction
   
996
     
23
     
885
     
18
 
Consumer
   
933
     
53
     
1,454
     
19
 
Total
 
$
7,237
   
$
153
   
$
10,398
   
$
123
 

Troubled Debt Restructurings

The Company's loan portfolio includes certain loans that have been modified in a Troubled Debt Restructuring ("TDR"), which are loans on which concessions in terms have been granted because of the borrowers' financial difficulties and, as a result, the Company receives less than the current market based compensation for the loan.  These concessions may include reductions in the interest rate, payment extensions, forgiveness of principal, forbearance, or other actions.  Certain TDRs are placed on non-accrual status at the time of restructure and may only be returned to accruing status after considering the borrower's sustained repayment performance for a reasonable period, generally six months.

When a loan is modified, it is measured based upon the present value of future cash flows discounted at the contractual interest rate of the original loan agreement, or the fair value of collateral less selling costs if the loan is collateral dependent.  If the value of the modified loan is less than the recorded investment in the loan, impairment is recognized through a specific allowance or a charge-off of the loan.

The Company had $5,107,000 and $5,414,000 in TDR loans as of June 30, 2016 and December 31, 2015, respectively.  Specific reserves for TDR loans totaled $819,000 and $852,000 as of June 30, 2016 and December 31, 2015, respectively.  TDR loans performing in compliance with modified terms totaled $5,082,000 and $5,350,000 as of June 30, 2016 and December 31, 2015, respectively.  There was a commitment to advance $20,000 on one TDR loan as of June 30, 2016.

14

There were no loans modified as TDRs during the three months ended June 30, 2016.

Loans modified as TDRs during the three months ended June 30, 2015 were as follows:

($ in thousands)
Three Months Ended June 30, 2015
 
 
Number of
Contracts
 
Pre-modification
outstanding
recorded
investment
 
Post-
modification
outstanding
recorded
investment
 
Commercial
   
1
   
$
419
   
$
419
 
Total
   
1
   
$
419
   
$
419
 


Loans modified as TDRs during the six months ended June 30, 2016 and June 30, 2015 were as follows:

($ in thousands)
Six Months Ended June 30, 2016
 
 
Number of
Contracts
 
Pre-modification
outstanding
recorded
investment
 
Post-
modification
outstanding
recorded
investment
 
Commercial
   
1
   
$
180
   
$
180
 
Total
   
1
   
$
180
   
$
180
 

($ in thousands)
Six Months Ended June 30, 2015
 
 
Number of
Contracts
 
Pre-modification
outstanding
recorded
investment
 
Post-
modification
outstanding
recorded
investment
 
Commercial
   
1
   
$
419
   
$
419
 
Consumer
   
1
     
109
     
109
 
Total
   
2
   
$
528
   
$
528
 

Loan modifications generally involve reductions in the interest rate, payment extensions, forgiveness of principal, and forbearance.  There were no loans modified as a TDR within the previous 12 months and for which there was a payment default during the three and six months ended June 30, 2016 and June 30, 2015.

15

Credit Quality Indicators

All loans are rated using the credit risk ratings and criteria adopted by the Company.  Risk ratings are adjusted as future circumstances warrant.  All credits risk-rated 1, 2, 3 or 4 equate to a Pass as indicated by Federal and State regulatory agencies; a 5 equates to a Special Mention; a 6 equates to Substandard; a 7 equates to Doubtful; and an 8 equates to a Loss.  For the definitions of each risk rating, see Note 4 to our condensed consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2015.

The following table presents the risk ratings by loan class as of June 30, 2016 and December 31, 2015:

($ in thousands)
 
Pass
   
Special Mention
   
Substandard
   
Doubtful
   
Loss
   
Total
 
June 30, 2016
                                   
Commercial
 
$
118,781
   
$
6,459
   
$
7,107
   
$
   
$
   
$
132,347
 
Commercial Real Estate
   
296,051
     
14,493
     
2,989
     
     
     
313,533
 
Agriculture
   
92,049
     
     
717
     
     
     
92,766
 
Residential Mortgage
   
41,180
     
1,802
     
688
     
     
     
43,670
 
Residential Construction
   
16,963
     
444
     
147
     
     
     
17,554
 
Consumer
   
40,963
     
841
     
1,015
     
     
     
42,819
 
Total
 
$
605,987
   
$
24,039
   
$
12,663
   
$
   
$
   
$
642,689
 
 
                                               
December 31, 2015
                                               
Commercial
 
$
125,562
   
$
6,842
   
$
3,691
   
$
   
$
   
$
136,095
 
Commercial Real Estate
   
268,707
     
8,301
     
15,308
     
     
     
292,316
 
Agriculture
   
84,813
     
     
     
     
     
84,813
 
Residential Mortgage
   
40,231
     
1,847
     
1,297
     
     
     
43,375
 
Residential Construction
   
11,593
     
452
     
65
     
     
     
12,110
 
Consumer
   
42,990
     
1,025
     
1,371
     
     
     
45,386
 
Total
 
$
573,896
   
$
18,467
   
$
21,732
   
$
   
$
   
$
614,095
 

16

Allowance for Loan Losses

The following tables detail activity in the allowance for loan losses by loan class for the three and six months ended June 30, 2016.

Three months ended June 30, 2016
 
($ in thousands)
 
Commercial
   
Commercial
Real Estate
   
Agriculture
   
Residential
Mortgage
   
Residential
Construction
   
Consumer
   
Unallocated
   
Total
 
Balance as of March 31, 2016
 
$
2,980
   
$
3,636
   
$
965
   
$
702
   
$
401
   
$
589
   
$
334
   
$
9,607
 
Provision for loan losses
   
315
     
(52
)
   
104
     
(12
)
   
(12
)
   
(45
)
   
152
     
450
 
 
                                                               
Charge-offs
   
(130
)
   
     
     
     
     
(15
)
   
     
(145
)
Recoveries
   
10
     
     
81
     
     
1
     
26
     
     
118
 
Net charge-offs
   
(120
)
   
     
81
     
     
1
     
11
     
     
(27
)
Balance as of June 30, 2016
 
$
3,175
   
$
3,584
   
$
1,150
   
$
690
   
$
390
   
$
555
   
$
486
   
$
10,030
 

Six months ended June 30, 2016
 
($ in thousands)
 
Commercial
   
Commercial
Real Estate
   
Agriculture
   
Residential
Mortgage
   
Residential
Construction
   
Consumer
   
Unallocated
   
Total
 
Balance as of December 31, 2015
 
$
3,097
   
$
3,343
   
$
1,060
   
$
739
   
$
334
   
$
641
   
$
37
   
$
9,251
 
Provision for loan losses
   
280
     
256
     
9
     
(50
)
   
54
     
(98
)
   
449
     
900
 
 
                                                               
Charge-offs
   
(230
)
   
(15
)
   
     
     
     
(35
)
   
     
(280
)
Recoveries
   
28
     
     
81
     
1
     
2
     
47
     
     
159
 
Net charge-offs
   
(202
)
   
(15
)
   
81
     
1
     
2
     
12
     
     
(121
)
Balance as of June 30, 2016
 
$
3,175
   
$
3,584
   
$
1,150
   
$
690
   
$
390
   
$
555
   
$
486
   
$
10,030
 

The following table details the allowance for loan losses allocated to loans individually and collectively evaluated for impairment by loan class as of June 30, 2016.

($ in thousands)
Commercial
 
Commercial
Real Estate
 
Agriculture
 
Residential
Mortgage
 
Residential
Construction
 
Consumer
 
Unallocated
 
Total
 
Period-end amount allocated to:
                               
Loans individually evaluated for impairment
 
$
36
   
$
40
   
$
   
$
598
   
$
109
   
$
36
   
$
   
$
819
 
Loans collectively evaluated for impairment
   
3,139
     
3,544
     
1,150
     
92
     
281
     
519
     
486
     
9,211
 
Ending Balance
 
$
3,175
   
$
3,584
   
$
1,150
   
$
690
   
$
390
   
$
555
   
$
486
   
$
10,030
 

17

The following table details activity in the allowance for loan losses by loan class for the three and six months ended June 30, 2015.

Three months ended June 30, 2015
 
($ in thousands)
 
Commercial
   
Commercial
Real Estate
   
Agriculture
   
Residential
Mortgage
   
Residential
Construction
   
Consumer
   
Unallocated
   
Total
 
Balance as of March 31, 2015
 
$
3,325
   
$
2,485
   
$
646
   
$
1,047
   
$
195
   
$
826
   
$
370
   
$
8,894
 
Provision for loan losses
   
(141
)
   
399
     
206
     
(297
)
   
(107
)
   
(173
)
   
113
     
 
 
                                                               
Charge-offs
   
     
     
     
(132
)
   
     
(18
)
   
     
(150
)
Recoveries
   
75
     
4
     
     
215
     
56
     
12
     
     
362
 
Net recoveries
   
75
     
4
     
     
83
     
56
     
(6
)
   
     
212
 
Balance as of June 30, 2015
 
$
3,259
   
$
2,888
   
$
852
   
$
833
   
$
144
   
$
647
   
$
483
   
$
9,106
 
 
Six months ended June 30, 2015
 
($ in thousands)
 
Commercial
   
Commercial
Real Estate
   
Agriculture
   
Residential
Mortgage
   
Residential
Construction
   
Consumer
   
Unallocated
   
Total
 
Balance as of December 31, 2014
 
$
3,581
   
$
1,825
   
$
580
   
$
1,181
   
$
161
   
$
886
   
$
369
   
$
8,583
 
Provision for loan losses
   
(409
)
   
1,059
     
272
     
(431
)
   
(74
)
   
(181
)
   
114
     
350
 
 
                                                               
Charge-offs
   
     
     
     
(132
)
   
     
(85
)
   
     
(217
)
Recoveries
   
87
     
4
     
     
215
     
57
     
27
     
     
390
 
Net recoveries
   
87
     
4
     
     
83
     
57
     
(58
)
   
     
173
 
Balance as of June 30, 2015
 
$
3,259
   
$
2,888
   
$
852
   
$
833
   
$
144
   
$
647
   
$
483
   
$
9,106
 

The following table details the allowance for loan losses allocated to loans individually and collectively evaluated for impairment by loan class as of June 30, 2015.

($ in thousands)
Commercial
 
Commercial
Real Estate
 
Agriculture
 
Residential
Mortgage
 
Residential
Construction
 
Consumer
 
Unallocated
 
Total
 
Period-end amount allocated to:
                               
Loans individually evaluated for impairment
 
$
36
   
$
43
   
$
   
$
628
   
$
107
   
$
17
   
$
   
$
831
 
Loans collectively evaluated for impairment
   
3,223
     
2,845
     
852
     
205
     
37
     
630
     
483
     
8,275
 
Ending Balance
 
$
3,259
   
$
2,888
   
$
852
   
$
833
   
$
144
   
$
647
   
$
483
   
$
9,106
 

18

The following table details activity in the allowance for loan losses and the amount allocated to loans individually and collectively evaluated for impairment as of and for the year ended December 31, 2015.

Year ended December 31, 2015
($ in thousands)
 
Commercial
   
Commercial
Real Estate
   
Agriculture
   
Residential
Mortgage
   
Residential
Construction
   
Consumer
   
Unallocated
   
Total
 
Balance as of December 31, 2014
 
$
3,581
   
$
1,825
   
$
580
   
$
1,181
   
$
161
   
$
886
   
$
369
   
$
8,583
 
Provision for (reversal of) loan losses
   
(542
)
   
1,507
     
480
     
(450
)
   
113
     
(126
)
   
(332
)
   
650
 
 
                                                               
Charge-offs
   
(44
)
   
(7
)
   
     
(211
)
   
     
(175
)
   
     
(437
)
Recoveries
   
102
     
18
     
     
219
     
60
     
56
     
     
455
 
Net recoveries
   
58
     
11
     
     
8
     
60
     
(119
)
   
     
18
 
Ending Balance
 
$
3,097
   
$
3,343
   
$
1,060
   
$
739
   
$
334
   
$
641
   
$
37
   
$
9,251
 
Period-end amount allocated to:
                                                               
Loans individually evaluated for impairment
 
$
43
   
$
42
   
$
   
$
615
   
$
119
   
$
33
   
$
   
$
852
 
Loans collectively evaluated for impairment
   
3,054
     
3,301
     
1,060
     
124
     
215
     
608
     
37
     
8,399
 
Balance as of December 31, 2015
 
$
3,097
   
$
3,343
   
$
1,060
   
$
739
   
$
334
   
$
641
   
$
37
   
$
9,251
 

The Company's investment in loans as of June 30, 2016, June 30, 2015, and December 31, 2015 related to each balance in the allowance for loan losses by loan class and disaggregated on the basis of the Company's impairment methodology was as follows:

($ in thousands)
 
Commercial
   
Commercial
Real Estate
   
Agriculture
   
Residential
Mortgage
   
Residential
Construction
   
Consumer
   
Total
 
June 30, 2016
 
Loans individually evaluated for impairment
 
$
818
   
$
869
   
$
   
$
2,986
   
$
987
   
$
773
   
$
6,433
 
Loans collectively evaluated for impairment
   
131,529
     
312,664
     
92,766
     
40,684
     
16,567
     
42,046
     
636,256
 
Ending Balance
 
$
132,347
   
$
313,533
   
$
92,766
   
$
43,670
   
$
17,554
   
$
42,819
   
$
642,689
 
 
                                                       
June 30, 2015
 
Loans individually evaluated for impairment
 
$
2,722
   
$
1,207
   
$
   
$
3,815
   
$
872
   
$
1,373
   
$
9,989
 
Loans collectively evaluated for impairment
   
123,067
     
282,877
     
68,199
     
41,073
     
8,495
     
44,741
     
568,452
 
Ending Balance
 
$
125,789
   
$
284,084
   
$
68,199
   
$
44,888
   
$
9,367
   
$
46,114
   
$
578,441
 
 
                                                       
December 31, 2015
 
Loans individually evaluated for impairment
 
$
918
   
$
1,258
   
$
   
$
3,576
   
$
1,005
   
$
1,321
   
$
8,078
 
Loans collectively evaluated for impairment
   
135,177
     
291,058
     
84,813
     
39,799
     
11,105
     
44,065
     
606,017
 
Ending Balance
 
$
136,095
   
$
292,316
   
$
84,813
   
$
43,375
   
$
12,110
   
$
45,386
   
$
614,095
 

19

3.  MORTGAGE OPERATIONS

Transfers and servicing of financial assets and extinguishments of liabilities are accounted for and reported based on consistent application of a financial-components approach that focuses on control.  Transfers of financial assets that are sales are distinguished from transfers that are secured borrowings.  Retained interests (mortgage servicing rights) in loans sold are measured by allocating the previous carrying amount of the transferred assets between the loans sold and retained interests, if any, based on their relative fair value at the date of transfer.  Fair values are estimated using discounted cash flows based on a current market interest rate.

The Company recognizes a gain and a related asset for the fair value of the rights to service loans for others when loans are sold.  The Company sold substantially its entire portfolio of conforming long-term residential mortgage loans originated during the six months ended June 30, 2016 for cash proceeds equal to the fair value of the loans.

The recorded value of mortgage servicing rights is included in other assets on the condensed consolidated balance sheets, and is amortized in proportion to, and over the period of, estimated net servicing revenues.  The Company assesses capitalized mortgage servicing rights for impairment based upon the fair value of those rights at each reporting date. For purposes of measuring impairment, the rights are stratified based upon the product type, term and interest rates.  Fair value is determined by discounting estimated net future cash flows from mortgage servicing activities using discount rates that approximate current market rates and estimated prepayment rates, among other assumptions.  The amount of impairment recognized, if any, is the amount by which the capitalized mortgage servicing rights for a stratum exceeds their fair value.  Impairment, if any, is recognized through a valuation allowance for each individual stratum.  Changes in the carrying amount of mortgage servicing rights are reported in earnings under other operating income on the condensed consolidated statements of income.

Key assumptions used in measuring the fair value of mortgage servicing rights as of June 30, 2016 and December 31, 2015 were as follows:

 
June 30, 2016
 
December 31, 2015
 
 
       
Constant prepayment rate
   
12.98
%
   
10.94
%
Discount rate
   
10.00
%
   
10.03
%
Weighted average life (years)
   
5.41
     
6.17
 

At June 30, 2016 and December 31, 2015, the Company's mortgage loans held-for-sale were $1,886,000 and $351,000, respectively.  At June 30, 2016, and December 31, 2015, the Company serviced real estate mortgage loans for others totaling $230,967,750 and $237,224,000, respectively.

The following table summarizes the Company's mortgage servicing rights assets as of June 30, 2016 and December 31, 2015.  Mortgage servicing rights are included in Interest Receivable and Other Assets on the condensed consolidated balance sheets:

 
(in thousands)
 
 
December 31, 2015
 
Additions
 
Reductions
 
June 30, 2016
 
 
               
Mortgage servicing rights
 
$
1,862
   
$
132
   
$
(196
)
 
$
1,798
 
Valuation allowance
   
     
(13
)
   
     
(13
)
Mortgage servicing rights, net of valuation allowance
 
$
1,862
   
$
119
   
$
(196
)
 
$
1,785
 

At June 30, 2016 and December 31, 2015, the estimated fair market value of the Company's mortgage servicing rights asset was $1,785,000 and $2,041,000, respectively.

The Company received contractually specified servicing fees of $149,000 for each of the three months ended June 30, 2016 and June 30, 2015.  The Company received contractually specified servicing fees of $298,000 and $300,000 for the six months ended June 30, 2016 and June 30, 2015, respectively.  Contractually specified servicing fees are included in other operating income on the condensed consolidated statements of income, net of the amortization of the mortgage servicing rights asset.

20

4.  OUTSTANDING SHARES AND EARNINGS PER SHARE

On January 28, 2016, the Board of Directors of the Company declared a 4% stock dividend payable as of March 31, 2016.  All income per share amounts have been adjusted to give retroactive effect to stock dividends.

Earnings Per Share (EPS)

Basic EPS includes no dilution and is computed by dividing net income available to common shareholders by the weighted average number of common shares outstanding for the respective period.  Diluted EPS is computed by dividing net income available to common shareholders by the weighted average number of shares outstanding plus dilutive shares for the quarter.  Diluted shares include all common stock equivalents ("in-the-money" stock options, unvested restricted stock, stock units, warrants and rights, convertible bonds and preferred stock), which reflects the potential dilution of securities that could share in the earnings of the Company.

The following table presents a reconciliation of basic and diluted EPS for the three and six months ended June 30, 2016 and 2015 (dollars in thousands except per share amounts):

 
 
Three months ended
June 30,
   
Six months ended
June 30,
 
 
 
2016
   
2015
   
2016
   
2015
 
Basic earnings per share:
                       
Net income
 
$
2,035
   
$
1,770
   
$
3,766
   
$
3,287
 
Preferred stock dividend
 
$
   
$
(32
)
 
$
   
$
(64
)
Net income available to common stockholders
 
$
2,035
   
$
1,738
   
$
3,766
   
$
3,223
 
 
                               
Weighted average common shares outstanding
   
10,607,758
     
10,577,895
     
10,601,022
     
10,560,197
 
Basic EPS
 
$
0.19
   
$
0.16
   
$
0.36
   
$
0.31
 
 
                               
Diluted earnings per share:
                               
Net income
 
$
2,035
   
$
1,770
   
$
3,766
   
$
3,287
 
Preferred stock dividend
 
$
   
$
(32
)
 
$
   
$
(64
)
Net income available to common stockholders
 
$
2,035
   
$
1,738
   
$
3,766
   
$
3,223
 
 
                               
Weighted average common shares outstanding
   
10,607,758
     
10,577,895
     
10,601,022
     
10,560,197
 
 
                               
Effect of dilutive shares
   
67,602
     
52,332
     
67,368
     
58,164
 
 
                               
Adjusted weighted average common shares outstanding
   
10,675,360
     
10,630,227
     
10,668,390
     
10,618,361
 
Diluted EPS
 
$
0.19
   
$
0.16
   
$
0.35
   
$
0.30
 

Stock options which were not included in the computation of diluted earnings per share because they would have had an anti-dilutive effect amounted to 163,010 shares and 170,894 shares for the three months ended June 30, 2016 and 2015, respectively.  Stock options which were not included in the computation of diluted earnings per share because they would have had an anti-dilutive effect amounted to 163,010 shares and 180,779 shares for the six months ended June 30, 2016 and 2015, respectively.
 
21

5.  STOCK PLANS

On January 28, 2016, the Board of Directors of the Company declared a 4% stock dividend payable as of March 31, 2016.  All stock options and restricted stock outstanding have been adjusted to give retroactive effect to stock dividends.

The following table presents the activity related to stock options for the three months ended June 30, 2016.

 
 
Number of
Shares
   
Weighted
Average
Exercise Price
 
Aggregate
Intrinsic Value
 
Weighted
Average
Remaining
Contractual
Term (in years)
 
Options outstanding at Beginning of  Period
   
229,952
   
$
8.26
         
Granted
   
     
         
Expired
   
     
         
Cancelled / Forfeited
   
     
         
Exercised
   
     
         
Options outstanding at End of Period
   
229,952
   
$
8.26
   
$
280,983
     
6.29
 
Exercisable (vested) at End of Period
   
125,112
   
$
8.98
   
$
228,806
     
4.07
 

The following table presents the activity related to stock options for the six months ended June 30, 2016.

 
 
Number of
Shares
   
Weighted
Average
Exercise Price
 
Aggregate
Intrinsic Value
 
Weighted
Average
Remaining
Contractual
Term (in years)
 
Options outstanding at Beginning of  Period
   
227,364
   
$
10.74
         
Granted
   
56,199
   
$
7.82
         
Expired
   
(53,611
)
 
$
18.29
         
Cancelled / Forfeited
   
     
         
Exercised
   
     
         
Options outstanding at End of Period
   
229,952
   
$
8.26
   
$
280,983
     
6.29
 
Exercisable (vested) at End of Period
   
125,112
   
$
8.98
   
$
228,806
     
4.07
 

The weighted average grant date fair value per share of options granted during the six months ended June 30, 2016 was $2.13 per share.

22

As of June 30, 2016, there was $214,000 of total unrecognized compensation cost related to non-vested stock options.  This cost is expected to be recognized over a weighted average period of approximately 2.93 years.

There was $40,000 of recognized compensation cost related to stock options granted for the six months ended June 30, 2016.

A summary of the weighted average assumptions used in valuing stock options during the three and six months ended June 30, 2016 is presented below:

 
 
Three Months Ended
June 30, 2016*
   
Six Months Ended
June 30, 2016
 
Risk Free Interest Rate
   
     
1.23
%
 
               
Expected Dividend Yield
   
     
0.00
%
 
               
Expected Life in Years
   
     
5
 
 
               
Expected Price Volatility
   
     
28.41
%

* There were no stock options granted during the three months ended June 30, 2016.

The following table presents the activity related to non-vested restricted stock for the three months ended June 30, 2016.
 
 
 
Number of
Shares
   
Weighted
Average Grant
Date Fair Value
 
Aggregate Intrinsic Value
Weighted Average
Remaining Contractual
Term (in years)
Non-vested Restricted stock outstanding at Beginning of Period
   
101,897
   
$
6.95
 
 
   
Granted
   
     
 
 
   
Cancelled / Forfeited
   
(312
)
 
$
7.82
 
 
   
Exercised/Released/Vested
   
(4,784
)
   
6.33
 
 
   
Non-vested restricted stock outstanding at End of Period
   
96,801
   
$
6.98
 
$764,728
8.36

The following table presents the activity related to non-vested restricted stock for the six months ended June 30, 2016.

 
 
Number of
Shares
   
Weighted
Average Grant
Date Fair Value
 
Aggregate Intrinsic Value
Weighted Average
Remaining Contractual
Term (in years)
Non-vested Restricted stock outstanding at Beginning of  Period
   
86,376
   
$
6.31
 
 
   
Granted
   
28,701
   
$
7.82
 
 
   
Cancelled / Forfeited
   
(312
)
 
$
7.82
 
 
   
Exercised/Released/Vested
   
(17,964
)
 
$
5.09
 
 
   
Non-vested restricted stock outstanding at End of Period
   
96,801
   
$
6.98
 
$764,728
8.36

The weighted average fair value of restricted stock granted during the six months ended June 30, 2016 was $7.82 per share.

As of June 30, 2016, there was $418,000 of total unrecognized compensation cost related to non-vested restricted stock.  This cost is expected to be recognized over a weighted average period of approximately 2.88 years.  There was $86,000 of recognized compensation cost related to restricted stock awards for the six months ended June 30, 2016.

23

The Company has an Employee Stock Purchase Plan ("ESPP").  There are 260,000 shares authorized under the ESPP.  The total number of shares authorized has been adjusted to give retroactive effect to stock dividends and stock splits, including the 4% stock dividend declared on January 28, 2016, payable March 31, 2016 to shareholders of record as of February 29, 2016.  The ESPP will expire on March 16, 2026.  The ESPP is implemented by participation periods of not more than 27 months each.  The Board of Directors determines the commencement date and duration of each participation period.  The Board of Directors approved the current participation period of December 10, 2015 to December 9, 2016.  An eligible employee is one who has been continually employed for at least 90 days prior to commencement of a participation period. Under the terms of the ESPP, employees can choose to have up to 10 percent of their compensation withheld to purchase the Company's common stock each participation period.  The purchase price of the stock is 85 percent of the lower of the fair value on the last trading day before the date of participation or the fair value on the last trading day during the participation period.

As of June 30, 2016, there was $9,000 of unrecognized compensation cost related to ESPP issuances.  This cost is expected to be recognized over a weighted average period of approximately 0.50 years.

There was $9,000 of recognized compensation cost related to ESPP issuances for the six months ended June 30, 2016.

The weighted average fair value at issuance date during the six months ended June 30, 2016 was $1.50 per share.

A summary of the weighted average assumptions used in valuing ESPP issuances during the three and six months ended June 30, 2016 is presented below.

 
 
Three Months Ended
June 30, 2016
   
Six Months Ended
June 30, 2016
 
Risk Free Interest Rate
   
0.71
%
   
0.71
%
 
               
Expected Dividend Yield
   
0.00
%
   
0.00
%
 
               
Expected Life in Years
   
1.00
     
1.00
 
 
               
Expected Price Volatility
   
9.51
%
   
9.51
%

24

6.  FAIR VALUE MEASUREMENT

The Company utilizes fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures.  Securities available-for-sale and trading securities are recorded at fair value on a recurring basis.  Additionally, from time to time, the Company may be required to record at fair value other assets on a non-recurring basis, such as loans held-for-sale, loans held-for-investment and certain other assets.  These non-recurring fair value adjustments typically involve application of lower of cost or market accounting or write-downs of individual assets.  Transfers between levels of the fair value hierarchy are recognized on the actual date of the event or circumstances that caused the transfer, which generally corresponds with the Company's quarterly valuation process.

Fair Value Hierarchy

The Company groups assets and liabilities at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value.  These levels are:

Level 1 Valuation is based upon quoted prices for identical instruments traded in active markets.

Level 2 Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active and model-based valuation techniques for which all significant assumptions are observable or can be corroborated by observable market data.

Level 3 Valuation is generated from model-based techniques that use at least one significant assumption not observable in the market.  These unobservable assumptions reflect estimates of assumptions that market participants would use in pricing the asset or liability.  Valuation techniques include use of option pricing models, discounted cash flow models, and similar techniques and include management judgment and estimation which may be significant.

Following is a description of valuation methodologies used for assets and liabilities recorded at fair value.

Investment Securities Available-for-Sale

Investment securities available-for-sale are recorded at fair value on a recurring basis.  Fair value measurement is based upon quoted market prices, if available.  If quoted market prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security's credit rating, prepayment assumptions, and other factors such as credit loss assumptions.  Level 1 securities include those traded on an active exchange, such as the New York Stock Exchange, U.S. Treasury securities that are traded by dealers or brokers in active over-the-counter markets and money market funds.  Level 2 securities include mortgage-backed securities issued by government sponsored entities, municipal bonds and corporate debt securities.  Securities classified as Level 3 include asset-backed securities in less liquid markets where valuations include significant unobservable assumptions.

Loans Held-for-Sale

Loans held-for-sale are carried at the lower of cost or fair value.  The fair value of loans held-for-sale is based on what secondary markets are currently offering for portfolios with similar characteristics.  As such, the Company classifies loans subjected to non-recurring fair value adjustments as Level 2.  At June 30, 2016 there were no loans held-for-sale that required a write-down.

Impaired Loans

The Company does not record loans at fair value on a recurring basis.  However, from time to time, a loan is considered impaired and an allowance for loan losses is established.  Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired.  Once a loan is identified as individually impaired, the Company measures impairment.  The fair value of impaired loans is estimated using one of several methods, including collateral value, market value of similar debt, enterprise value, liquidation value and discounted cash flows.  Inputs include external appraised values, management assumptions regarding market trends or other relevant factors, selling and commission costs generally ranging from 6% to 7%, and amount and timing of cash flows based upon current discount rates.  Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans.

25

At June 30, 2016, certain impaired loans were considered collateral dependent and were evaluated based on the fair value of the underlying collateral securing the loan.  Impaired loans where an allowance is established based on the fair value of collateral require classification in the fair value hierarchy.  When a loan is evaluated based on the fair value of the underlying collateral securing the loan, the Company records the impaired loan as non-recurring Level 3.

Other Real Estate Owned

Other real estate assets ("OREO") acquired through, or in lieu of, foreclosure are held-for-sale and are initially recorded at the lower of cost or fair value, less selling costs.  Any write-downs to fair value at the time of transfer to OREO are charged to the allowance for loan losses.  Appraisals or evaluations are then done periodically thereafter charging any additional write-downs or valuation allowances to the appropriate expense accounts.  Values are derived from appraisals of underlying collateral and discounted cash flow analysis.  OREO is classified within Level 3 of the hierarchy.

Loan Servicing Rights

Loan servicing rights are subject to impairment testing.  The Company utilizes a third party service provider to calculate the fair value of the Company's loan servicing rights.  Loan servicing rights are measured at fair value as of the date of sale.  The Company uses quoted market prices when available.  Subsequent fair value measurements are determined using a discounted cash flow model.  In order to determine the fair value of the loan servicing rights, the present value of expected future cash flows is estimated.  Assumptions used include market discount rates, anticipated prepayment speeds, delinquency and foreclosure rates, and ancillary fee income.

The model used to calculate the fair value of the Company's loan servicing rights is periodically validated by an independent external model validation group.  The model assumptions and the loan servicing rights fair value estimates are also compared to observable trades of similar portfolios as well as to loan servicing rights broker valuations and industry surveys, as available.  If the valuation model reflects a value less than the carrying value, loan servicing rights are adjusted to fair value through a valuation allowance as determined by the model.  As such, the Company classifies loan servicing rights subjected to non-recurring fair value adjustments as Level 3.

Assets Recorded at Fair Value on a Recurring Basis

The table below presents the recorded amount of assets and liabilities measured at fair value on a recurring basis as of June 30, 2016:

 
 
(in thousands)
 
June 30, 2016
 
Total
   
Level 1
   
Level 2
   
Level 3
 
U.S. Treasury securities
 
$
26,468
   
$
26,468
   
$
   
$
 
Securities of U.S. government agencies and corporations
   
30,733
     
     
30,733
     
 
Obligations of states and political subdivisions
   
24,181
     
     
24,181
     
 
Collateralized mortgage obligations
   
18,949
     
     
18,949
     
 
Mortgage-backed securities
   
134,902
     
     
134,902
     
 
 
                               
Total investments at fair value
 
$
235,233
   
$
26,468
   
$
208,765
   
$
 

There were no transfers of assets measured at fair value on a recurring basis between level 1 and level 2 of the fair value hierarchy.

26

The table below presents the recorded amount of assets and liabilities measured at fair value on a recurring basis as of December 31, 2015:

 
 
(in thousands)
 
December 31, 2015
 
Total
   
Level 1
   
Level 2
   
Level 3
 
U.S. Treasury securities
 
$
20,186
   
$
20,186
   
$
   
$
 
Securities of U.S. government agencies and corporations
   
33,997
     
     
33,997
     
 
Obligations of states and political subdivisions
   
25,709
     
     
25,709
     
 
Collateralized mortgage obligations
   
10,932
     
     
10,932
     
 
Mortgage-backed securities
   
92,527
     
     
92,527
     
 
 
                               
Total investments at fair value
 
$
183,351
   
$
20,186
   
$
163,165
   
$
 

Assets Recorded at Fair Value on a Non-Recurring Basis

Assets measured at fair value on a non-recurring basis are included in the table below by level within the fair value hierarchy as of June 30, 2016:

 
 
(in thousands)
 
June 30, 2016
 
Total
   
Level 1
   
Level 2
   
Level 3
 
Impaired loans
 
$
46
   
$
   
$
   
$
46
 
Loan servicing rights
   
1,785
     
     
     
1,785
 
 
                               
Total assets at fair value
 
$
1,831
   
$
   
$
   
$
1,831
 

Assets measured at fair value on a non-recurring basis are included in the table below by level within the fair value hierarchy as of December 31, 2015:

 
(in thousands)
 
December 31, 2015
Total
 
Level 1
 
Level 2
 
Level 3
 
Impaired loans
 
$
841
   
$
   
$
   
$
841
 
 
                               
Total assets at fair value
 
$
841
   
$
   
$
   
$
841
 

There were no liabilities measured at fair value on a recurring or non-recurring basis at June 30, 2016 and December 31, 2015.

Key methods and assumptions used in measuring the fair value of impaired loans and other real estate owned as of December 31, 2015 were as follows:

 
Method
Assumption Inputs
 
 
 
Impaired loans
Collateral, market, income,  enterprise, liquidation and discounted Cash Flows
External appraised values, management assumptions regarding market trends or other relevant factors; selling costs ranging 6% to 7%.
 
Loan servicing rights
Discounted Cash Flows
Present value of expected future cash flows was estimated using a discount rate factor of 10.00% and 10.03% as of June 30, 2016 and December 31, 2015, respectively.  A constant prepayment rate of 12.98% and 10.94% as of June 30, 2016 and December 31, 2015, respectively, was utilized.
 
27

7. PREFERRED STOCK

On September 15, 2011, the Company issued to the U.S. Treasury under the United States Department of Treasury Small Business Lending Fund (SBLF) 22,847 shares of the Company's Non-Cumulative Perpetual Preferred Stock, Series A (SBLF Shares), having a liquidation preference per share equal to $1,000, for an aggregate purchase price of $22,847,000.

On September 15, 2011, the Company redeemed from the U.S. Treasury, using the partial proceeds from the issuance of the SBLF Shares, all 17,390 outstanding shares of its Fixed Rate Cumulative Perpetual Preferred Stock, Series A, liquidation amount $1,000 per share, for a redemption price of $17,390,000, plus accrued but unpaid dividends at the date of redemption.

On February 8, 2013, the Company redeemed $10,000,000 of the $22,847,000 in SBLF shares it issued to the U.S. Treasury.

On October 26, 2015, the Company redeemed the remaining $12,847,000 in SBLF shares it issued to the U.S. Treasury.

28

8. FAIR VALUES OF FINANCIAL INSTRUMENTS

The following methods and assumptions were used by the Company in estimating its fair value disclosures for financial instruments:

Cash and Cash Equivalents

The carrying amounts reported in the condensed consolidated balance sheets for cash and short-term instruments are a reasonable estimate of fair value.  The carrying amount is a reasonable estimate of fair value because of the relatively short term between the origination of the instrument and its expected realization.  Therefore, the Company believes the measurement of fair value of cash and cash equivalents is derived from Level 1 inputs.

Certificates of Deposit

The Company measures the fair value of Certificates of deposit using level 2 inputs.  The fair values of Certificates of deposit were derived by discounting their future expected cash flows back to their present values based upon a constant maturity curve. The constant maturity curve is based on similar instruments, taking into account factors such as instrument type, coupon type, currency, issuer, sector, country of issuer, credit rating, and prevailing market conditions. The Company believes these inputs fall under Level 2 of the fair value hierarchy.

Other Equity Securities

The carrying amounts reported in the condensed consolidated balance sheets approximate fair value as the shares can only be redeemed by the issuing institution.  The Company believes the measurement of the fair value of other equity securities is derived from Level 3 inputs.

Loans Receivable

For variable-rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values.  The fair values for other loans (e.g., commercial real estate and rental property mortgage loans, commercial and industrial loans, and agricultural 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.  The allowance for loan losses is considered to be a reasonable estimate of loan discount due to credit risks.  Given the estimation of expected credit losses involves management estimates for assumptions that are not directly observable in a market, the Company believes the fair value of loans receivable is derived from Level 3 inputs.

Loans Held-for-Sale

For loans held for sale, the fair value is based on what secondary markets are currently offering for portfolios with similar characteristics, and therefore the Company believes the fair value of loans held for sale is derived from Level 2 inputs. See Note 6, Fair Value Measurement in these Notes to Condensed Consolidated Financial Statements.

Mortgage Servicing Rights

The Company measures fair value of mortgage servicing rights using both observable and unobservable inputs. The Company uses quoted market prices when available.  Subsequent fair value measurements are determined using a discounted cash flow model.  In order to determine the fair value of the MSR, the present value of expected future cash flows is estimated.  Assumptions used include market discount rates, anticipated prepayment speeds, delinquency and foreclosure rates, and ancillary fee income.  This model is periodically validated by an independent external model validation group.  The model assumptions and the MSR fair value estimates are also compared to observable trades of similar portfolios as well as to MSR broker valuations and industry surveys, as available.  Because of the significance of unobservable inputs in valuing the MSR, the Company believes it is derived from Level 3 inputs.

Interest Receivable and Payable

The carrying amount of interest receivable and payable approximates its fair value.  The Company believes the measurement of the fair value of interest receivable and payable is derived from Level 2 inputs.

Deposit Liabilities

The Company measures fair value of deposits using both observable and unobservable inputs.  The fair value of deposits were derived by discounting their expected future cash flows back to their present values based on the FHLB yield curve, and their expected decay rates for non-maturing deposits.  The Company is able to obtain FHLB yield curve rates as of the measurement date, and believes these inputs fall under Level 2 of the fair value hierarchy.  Decay rates were developed through internal analysis, and are supported by recent years of the Bank's transaction history.  The inputs used by the Company to derive the decay rate assumptions are unobservable inputs, and therefore fall under Level 3 of the fair value hierarchy.

29

Limitations

Fair value estimates are made at a specific point in time, based on relevant market information and information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company's entire holdings of a particular financial instrument. Because no market exists for a significant portion of the Company's financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision.  Changes in assumptions could significantly affect the estimates.

Fair value estimates are based on existing on and off-balance sheet financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. Other significant assets and liabilities that are not considered financial assets or liabilities include deferred tax liabilities and premises and equipment.  In addition, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in many of the estimates.

The estimated fair values of the Company's financial instruments for the periods ended June 30, 2016 and December 31, 2015 are approximately as follows:

 
       
June 30, 2016
   
December 31, 2015
 
 
 
Level
   
Carrying
amount
   
Fair
value
   
Carrying
amount
   
Fair
value
 
 
                             
Financial assets:
                             
Cash and cash equivalents
   
1
   
$
143,519
   
$
143,519
   
$
200,797
   
$
200,797
 
Certificates of deposit
   
2
     
16,709
     
16,750
     
16,649
     
16,635
 
Other equity securities
   
3
     
4,409
     
4,409
     
3,934
     
3,934
 
Loans receivable:
                                       
Net loans
   
3
     
633,758
     
631,171
     
605,853
     
604,240
 
Loans held-for-sale
   
2
     
1,886
     
1,956
     
351
     
363
 
Interest receivable
   
2
     
3,504
     
3,504
     
3,127
     
3,127
 
Mortgage servicing rights
   
3
     
1,785
     
1,785
     
1,862
     
2,041
 
Financial liabilities:
                                       
Deposits
   
3
     
969,862
     
933,445
     
948,114
     
902,872
 
Interest payable
   
2
     
89
     
89
     
73
     
73
 

30

9.  INVESTMENT SECURITIES

The amortized cost, unrealized gains and losses and estimated fair values of investments in debt and other securities at June 30, 2016 are summarized as follows:

(in thousands)
 
Amortized cost
   
Unrealized gains
   
Unrealized losses
   
Estimated fair value
 
 
                       
Investment securities available-for-sale:
                       
U.S. Treasury Securities
 
$
26,274
   
$
194
   
$
   
$
26,468
 
Securities of U.S. government agencies and corporations
   
30,634
     
99
     
     
30,733
 
Obligations of states and political subdivisions
   
23,466
     
720
     
(5
)
   
24,181
 
Collateralized mortgage obligations
   
18,796
     
154
     
(1
)
   
18,949
 
Mortgage-backed securities
   
134,295
     
856
     
(249
)
   
134,902
 
 
                               
Total debt securities
 
$
233,465
   
$
2,023
   
$
(255
)
 
$
235,233
 

The amortized cost, unrealized gains and losses and estimated fair values of investments in debt and other securities at December 31, 2015 are summarized as follows:
 
(in thousands)
 
Amortized
cost
   
Unrealized
gains
   
Unrealized
losses
   
Estimated fair
value
 
 
                       
Investment securities available-for-sale:
                       
U.S. Treasury Securities
 
$
20,240
   
$
5
   
$
(59
)
 
$
20,186
 
Securities of U.S. government agencies and corporations
   
34,079
     
6
     
(88
)
   
33,997
 
Obligations of states and political subdivisions
   
25,323
     
436
     
(50
)
   
25,709
 
Collateralized mortgage obligations
   
10,994
     
7
     
(69
)
   
10,932
 
Mortgage-backed securities
   
92,465
     
546
     
(484
)
   
92,527
 
 
                               
Total debt securities
 
$
183,101
   
$
1,000
   
$
(750
)
 
$
183,351
 

The Company had $16,726,000 and $20,704,000 in proceeds from calls of available-for-sale securities for the three and six months ended June 30, 2016, respectively.  The Company had $4,000,000 and $4,540,000 in proceeds from calls of available-for-sale securities for the three and six months ended June 30, 2015.  Gross realized gains from calls of available-for-sale securities were $0 and $14,000 for the three and six months ended June 30, 2016, respectively.  There were no gross realized gains from sales or calls of available-for-sale securities for the three and six months ended June 30, 2015.  There were no gross realized losses from sales or calls of available-for-sale securities for the three and six months ended June 30, 2016.  There were no gross realized losses from sales or calls of available-for-sale securities for the three and six months ended June 30, 2015.

The amortized cost and estimated market value of debt and other securities at June 30, 2016, by contractual and expected maturity, are shown in the following table:

(in thousands)
 
Amortized cost
   
Estimated fair value
 
 
           
Due in one year or less
 
$
29,506
   
$
29,545
 
Due after one year through five years
   
185,786
     
186,977
 
Due after five years through ten years
   
16,951
     
17,372
 
Due after ten years
   
1,222
     
1,339
 
 
               
 
 
$
233,465
   
$
235,233
 
 
31

Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.  Securities due after one year through five years included mortgage-backed securities and collateralized mortgage obligations with expected maturities totaling $142,967,000 at June 30, 2016.  The maturities on these securities were based on the average lives of the securities.

An analysis of gross unrealized losses of the available-for-sale investment securities portfolio as of June 30, 2016, follows:

 
Less than 12 months
 
12 months or more
 
Total
 
(in thousands)
Fair Value
 
Unrealized
losses
 
Fair Value
 
Unrealized
losses
 
Fair Value
 
Unrealized
losses
 
                         
Obligations of states and political subdivisions
 
$
3,400
   
$
(5
)
 
$
   
$
   
$
3,400
   
$
(5
)
Collateralized Mortgage obligations
   
490
     
(1
)
   
     
     
490
     
(1
)
Mortgage-backed securities
   
32,802
     
(165
)
   
7,114
     
(84
)
   
39,916
     
(249
)
 
                                               
Total
 
$
36,692
   
$
(171
)
 
$
7,114
   
$
(84
)
 
$
43,806
   
$
(255
)

No decline in value was considered "other-than-temporary" during the first six months of 2016.  Twenty-nine securities, all considered investment grade, which had a fair value of $36,692,000 and a total unrealized loss of $171,000, have been in an unrealized loss position for less than twelve months as of June 30, 2016.  Eleven securities, all considered investment grade, which had a fair value of $7,114,000 and a total unrealized loss of $84,000, have been in an unrealized loss position for more than twelve months as of June 30, 2016.  The declines in fair value were attributable to changes in interest rates.  We have evaluated the credit ratings of our investment securities and their issuer and/or insurers, and based on this evaluation have determined that no investment security in our investment portfolio is other-than-temporarily impaired. As the Company does not intend to sell these securities and it is not more likely than not that the Company will be required to sell these securities prior to their anticipated recovery, these investments are not considered other-than-temporarily impaired.

An analysis of gross unrealized losses of the available-for-sale investment securities portfolio as of December 31, 2015, follows:

 
                       
 
Less than 12 months
 
12 months or more
 
Total
 
 
Fair Value
 
Unrealized
losses
 
Fair Value
 
Unrealized
losses
 
Fair Value
 
Unrealized
losses
 
 
                       
U.S. Treasury Securities
 
$
15,014
   
$
(59
)
 
$
-
   
$
-
   
$
15,014
   
$
(59
)
Securities of U.S. government agencies and corporations
   
7,005
     
(32
)
   
4,047
     
(56
)
   
11,052
     
(88
)
Obligations of states and political subdivisions
   
7,107
     
(50
)
   
     
     
7,107
     
(50
)
Collateralized Mortgage obligations
   
9,982
     
(69
)
   
     
     
9,982
     
(69
)
Mortgage-backed securities
   
44,933
     
(372
)
   
5,838
     
(112
)
   
50,771
     
(484
)
 
                                               
Total
 
$
84,041
   
$
(582
)
 
$
9,885
   
$
(168
)
 
$
93,926
   
$
(750
)

Investment securities carried at $34,910,000 and $30,832,000 at June 30, 2016 and December 31, 2015, respectively, were pledged to secure public deposits or for other purposes as required or permitted by law.

32

10 ACCUMULATED OTHER COMPREHENSIVE INCOME

The following table details activity in accumulated other comprehensive income for the three months ended June 30, 2016.

($ in thousands)
 
Unrealized
Gains on
Securities
   
Officers'
retirement
plan
   
Directors'
retirement
plan
   
Accumulated
Other
Comprehensive
Income/(loss)
 
Balance as of March 31, 2016
 
$
802
   
$
(662
)
 
$
17
   
$
157
 
Current period other comprehensive income
   
259
     
     
     
259
 
Balance as of June 30, 2016
 
$
1,061
   
$
(662
)
 
$
17
   
$
416
 

The following table details activity in accumulated other comprehensive income (loss) for the six months ended June 30, 2016.

($ in thousands)
 
Unrealized
Gains on
Securities
   
Officers'
retirement
plan
   
Directors'
retirement
plan
   
Accumulated
Other
Comprehensive
Income/(loss)
 
Balance as of December 31, 2015
 
$
150
   
$
(662
)
 
$
17
   
$
(495
)
Current period other comprehensive income
   
911
     
     
     
911
 
Balance as of June 30, 2016
 
$
1,061
   
$
(662
)
 
$
17
   
$
416
 

The following table details activity in accumulated other comprehensive income (loss) for the three months ended June 30, 2015.

($ in thousands)
 
Unrealized
Gains on
Securities
   
Officers'
retirement
plan
   
Directors'
retirement
plan
   
Accumulated
Other
Comprehensive
Income/(loss)
 
Balance as of March 31, 2015
 
$
1,078
   
$
(678
)
 
$
8
   
$
408
 
Current period other comprehensive loss
   
(618
)
   
     
     
(618
)
Balance as of June 30, 2015
 
$
460
   
$
(678
)
 
$
8
   
$
(210
)

The following table details activity in accumulated other comprehensive income (loss) for the six months ended June 30, 2015.

($ in thousands)
 
Unrealized
Gains on
Securities
   
Officers'
retirement plan
   
Directors'
retirement plan
   
Accumulated
Other
Comprehensive
Income/(loss)
 
Balance as of December 31, 2014
 
$
703
   
$
(678
)
 
$
41
   
$
66
 
Current period other comprehensive loss
   
(243
)
   
     
(33
)
   
(276
)
Balance as of June 30, 2015
 
$
460
   
$
(678
)
 
$
8
   
$
(210
)

33

11. FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK

The Company is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers.  These financial instruments include commitments to extend credit in the form of loans or through standby letters of credit.  These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amounts recognized in the balance sheet.  The contract amounts of those instruments reflect the extent of involvement the Company has in particular classes of financial instruments.

The Bank's exposure to credit loss in the event of non-performance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual notional amount of those instruments.  The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments.

Financial instruments, whose contract amounts represent credit risk at the indicated periods, were as follows:

(in thousands)
 
June 30, 2016
   
December 31, 2015
 
 
           
Undisbursed loan commitments
 
$
210,434
   
$
201,839
 
Standby letters of credit
   
2,850
     
2,807
 
Commitments to sell loans
   
3,754
     
655
 
 
               
 
 
$
217,038
   
$
205,301
 

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract.  Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee.  Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.  The Bank evaluates each customer's creditworthiness on a case-by-case basis.  The amount of collateral obtained, if deemed necessary by the Bank upon extension of credit, is based on management's credit evaluation.  Collateral held varies but may include accounts receivable, inventory, property, plant and equipment, and income-producing commercial properties.

Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party.  The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers.  The Bank issues both financial and performance standby letters of credit.  The financial standby letters of credit are primarily to guarantee payment to third parties.  At June 30, 2016 and December 31, 2015, there were no financial standby letters of credit outstanding.  The performance standby letters of credit are typically issued to municipalities as specific performance bonds.  Performance standby letters of credit totaled $2,850,000 and $2,807,000 at June 30, 2016 and December 31, 2015, respectively.  The Bank has experienced no draws on these letters of credit, resulting in no related liability included on their balance sheet, however, should a triggering event occur, the Bank either has collateral in excess of the letter of credit or imbedded agreements of recourse from the customer.  The Bank has set aside a reserve for unfunded commitments in the amount of $793,000 at June 30, 2016 and December 31, 2015, which is recorded in "interest payable and other liabilities" on the Condensed Consolidated Balance Sheets .

Commitments to extend credit and standby letters of credit bear similar credit risk characteristics as outstanding loans.  As of June 30, 2016 and December 31, 2015, the Company had no off-balance sheet derivatives requiring additional disclosure.

Mortgage loans sold to investors may be sold with servicing rights retained, for which the Company makes only standard legal representations and warranties as to meeting certain underwriting and collateral documentation standards.  In the past two years, the number of loans the Company has had to repurchase due to deficiencies in underwriting or loan documentation is not significant.  Management believes that any liabilities that may result from such recourse provisions are not significant.

34

FIRST NORTHERN COMMUNITY BANCORP
 
ITEM 2.   – MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

FORWARD-LOOKING STATEMENTS

This report includes forward-looking statements, which may include forecasts of our financial results and condition, expectations for our operations and business, and our assumptions for those forecasts and expectations. Do not rely unduly on forward-looking statements. Actual results might differ significantly compared to our forecasts and expectations. See Part I, Item 1A. "Risk Factors," and the other risks described in our 2015 Annual Report on Form 10-K and our Quarterly Reports on Form 10-Q for factors to be considered when reading any forward-looking statements in this filing.
 
This report and other reports or statements which we may release includes forward-looking statements, which are subject to the "safe harbor" created by section 27A of the Securities Act of 1933, as amended, and section 21E of the Securities Exchange Act of 1934, as amended. We may make forward-looking statements in our Securities and Exchange Commission (SEC) filings, press releases, news articles and when we are speaking on behalf of the Company. Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts. Often, they include the words "believe," "expect," "target," "anticipate," "intend," "plan," "seek," "strive," "estimate," "potential," "project," or words of similar meaning, or future or conditional verbs such as "will," "would," "should," "could," "might," or "may." These forward-looking statements are intended to provide investors with additional information with which they may assess our future potential. All of these forward-looking statements are based on assumptions about an uncertain future and are based on information available to us at the date of these statements. We do not undertake to update forward-looking statements to reflect facts, circumstances, assumptions or events that occur after the date any forward-looking statements are made.
 
In this document and in other SEC filings or other public statements, for example, we make forward-looking statements relating to the following topics, among others:
 
   Our business objectives, strategies and initiatives, our organizational structure, the growth of our business and our competitive position and prospects, and the affect of competition on our business and strategies

Our assessment of significant factors and developments that have affected or may affect our results

Pending and recent legal and regulatory actions, and future legislative and regulatory developments, including the effects of the Dodd-Frank Wall Street Reform and Protection Act (the "Dodd-Frank Act") and other legislation and governmental measures introduced in response to the financial crises affecting the banking system, financial markets and the U.S. economy

Regulatory and compliance controls, processes and requirements and their impact on our business

The costs and effects of legal or regulatory actions

Expectations regarding draws on performance letters of credit

Our regulatory capital requirements, including the capital rules adopted in the past several years by the U.S. federal banking agencies

Expectations regarding our non-payment of a cash dividend on our common stock in the foreseeable future

Credit quality and provision for credit losses and management of asset quality and credit risk

Our allowances for credit losses, including the conditions we consider in determining the unallocated allowance and our portfolio credit quality, underwriting standards, and risk grading

Our assessment of economic conditions and trends and credit cycles and their impact on our business

The seasonal nature of our business

The impact of changes in interest rates and our strategy to manage our interest rate risk profile and the possible effect of increases in residential mortgage interest rates on new originations and refinancing of existing residential mortgage loans.
 
35

 
Loan portfolio composition and risk grade trends, expected charge-offs, portfolio credit quality, our strategy regarding troubled debt restructurings ("TDRs"), delinquency rates and our underwriting standards

Our deposit base including renewal of time deposits

The impact on our net interest income and net interest margin from the current low-interest rate environment

Expectations regarding an increase or decrease in unrecognized tax benefits

Our pension and retirement plan costs

Our liquidity position

Critical accounting policies and estimates, the impact or anticipated impact of recent accounting pronouncements or changes in accounting principles

Expected rates of return, maturities, loss exposure, growth rates, yields and projected results

The possible impact of weather related conditions, including drought or flooding, and related governmental responses on economic conditions, especially in the agricultural sector

Maintenance of insurance coverages appropriate for our operations

Threats to the banking sector and our business due to cybersecurity issues and attacks and regulatory expectations related to cybersecurity

Descriptions of assumptions underlying or relating to any of the of the foregoing


Readers of this document should not rely on any forward-looking statements, which reflect only our management's belief as of the date of this report. There are numerous risks and uncertainties that could and will cause actual results to differ materially from those discussed in our forward-looking statements. Many of these factors are beyond our ability to control or predict and could have a material adverse effect on our financial condition and results of operations or prospects. Such risks and uncertainties include, but are not limited to those listed in Item 1A "Risk Factors" of Part II of this Form 10-Q, Item 2 "Management's Discussion and Analysis of Financial Condition and Results of Operations" of Part I of this Form 10-Q and "Risk Factors" and  "Supervision and Regulation" in our 2015 Annual Report on Form 10-K, and in our other reports to the SEC.
 
36

INTRODUCTION

This overview of Management's Discussion and Analysis highlights selected information in this report and may not contain all of the information that is important to you.  For a more complete understanding of trends, events, commitments, uncertainties, liquidity, capital resources and critical accounting estimates, you should carefully read this entire report and any other reports to the Securities and Exchange Commission ("SEC"), together with our Consolidated Financial Statements and the Notes to Consolidated Financial Statements included in our Annual Report on Form 10-K for the year ended December 31, 2015.

Our subsidiary, First Northern Bank of Dixon (the "Bank"), is a California state-chartered bank that derives most of its revenues from lending and deposit taking in the Sacramento Valley region of Northern California.  Interest rates, business conditions and customer confidence all affect our ability to generate revenues.  In addition, the regulatory and compliance environment and competition can present challenges to our ability to generate those revenues.

Significant results and developments during the second quarter and year-to-date 2016 included:

Net income of $3.8 million for the six months ended June 30, 2016, up 15.2% from $3.3 million earned for the same period last year.  Net income of $2.0 million for the three months ended June 30, 2016, up 11.1% from $1.8 million for the same period last year.

Net income available to common shareholders of $3.8 million for the six months ended June 30, 2016, up 18.8% from $3.2 million for the same period last year.  Net income available to common shareholders of $2.0 million for the three months ended June 30, 2016, up 17.7% from $1.7 million for the same period last year.
 
Diluted income per share for the six months ended June 30, 2016 was $0.35, up 16.7% from diluted income per share of $0.30 in the same period last year.  Diluted income per share for the three months ended June 30, 2016 was $0.19, up 18.8% from diluted income per share of $0.16 in the same period last year.

Net interest income for the six months ended June 30, 2016 increased by $2.3 million, or 15.8%, to $16.9 million from $14.6 million in the same period last year.  The increase in net interest income was primarily due to an increase in interest income on loans and investment securities.  The increase in interest income on loans was due to an increase in average loans and an increase in interest yield.  The increase in interest income on investment securities was due to an increase in average investment securities, which was partially offset by a decrease in interest yield.  

Net interest margin increased from 3.14% for the six months ended June 30, 2015 to 3.38% for the same period ended June 30, 2016.

Provision for loan losses of $0.9 million for the six months ended June 30, 2016, compared to a provision for loan losses of $0.4 million for the same period in 2015.

Total assets at June 30, 2016 were $1.07 billion, an increase of $25.4 million, or 2.4%, compared to total assets at December 31, 2015.
 
Total net loans at June 30, 2016 (including loans held-for-sale) increased $29.4 million, or 4.9%, to $635.6 million compared to December 31, 2015.

Total investment securities at June 30, 2016 increased $51.8 million, or 28.2%, to $235.2 million compared to December 31, 2015.

Total deposits of $969.9 million at June 30, 2016, represented an increase of $21.8 million, or 2.3%, compared to December 31, 2015.

 
37

SUMMARY

The Company recorded net income of $3,766,000 for the six months ended June 30, 2016, representing an increase of $479,000 or 14.6% from net income of $3,287,000 for the same period in 2015.  The Company recorded net income of $2,035,000 for the three months ended June 30, 2016, representing an increase of $265,000 or 15.0% from net income of $1,770,000 for the same period in 2015.
 
The following tables present a summary of the results for the three and six months ended June 30, 2016 and 2015, and a summary of financial condition at June 30, 2016 and December 31, 2015.

 
 
Three months ended
June 30, 2016
   
Three months ended
June 30, 2015
   
Six months ended June 30, 2016
   
Six months ended
June 30, 2015
 
(in thousands except for per share amounts)
                       
For the Period:
                       
Net Income
 
$
2,035
   
$
1,770
   
$
3,766
   
$
3,287
 
Net Income Available to Common   Shareholders
 
$
2,035
   
$
1,738
   
$
3,766
   
$
3,223
 
Basic Earnings Per Common Share
 
$
0.19
   
$
0.16
   
$
0.36
   
$
0.31
 
Diluted Earnings Per Common Share
 
$
0.19
   
$
0.16
   
$
0.35
   
$
0.30
 
Return on Average Total Assets
   
0.76
%
   
0.71
%
   
0.71
%
   
0.66
%
Return on Average Equity
   
9.07
%
   
7.45
%
   
8.50
%
   
6.99
%
Average Equity to Average Total Assets
   
8.40
%
   
9.55
%
   
8.35
%
   
9.52
%

 
June 30, 2016
 
December 31, 2015
 
(in thousands except for ratios)
       
At Period End:
       
Total Assets
 
$
1,070,066
   
$
1,044,625
 
Total Loans, Net (including loans held-for-sale)
 
$
635,644
   
$
606,204
 
Total Investment Securities
 
$
235,233
   
$
183,351
 
Total Deposits
 
$
969,862
   
$
948,114
 
Loan-To-Deposit Ratio
   
65.5
%
   
63.9
%

38

FIRST NORTHERN COMMUNITY BANCORP
 
Distribution of Average Statements of Condition and Analysis of Net Interest Income
(in thousands, except percentage amounts)

 
 
Three months ended
June 30, 2016
   
Three months ended
June 30, 2015
 
 
 
Average
Balance
   
Interest
   
Yield/
Rate (4)
   
Average
Balance
   
Interest
   
Yield/
Rate (4)
 
Assets
                                   
Interest-earning assets:
                                   
Loans (1)
 
$
628,001
   
$
7,649
     
4.89
%
 
$
555,026
   
$
6,627
     
4.79
%
Certificate of deposits
   
16,709
     
38
     
0.91
%
   
11,936
     
21
     
0.71
%
Interest bearing due from banks
   
129,480
     
154
     
0.48
%
   
208,357
     
143
     
0.28
%
Investment securities, taxable
   
219,501
     
882
     
1.61
%
   
152,511
     
694
     
1.83
%
Investment securities, non-taxable  (2)
   
11,406
     
66
     
2.32
%
   
7,186
     
66
     
3.68
%
Other interest earning assets
   
4,299
     
93
     
8.68
%
   
3,934
     
222
     
22.63
%
Total average interest-earning assets
   
1,009,396
     
8,882
     
3.53
%
   
938,950
     
7,773
     
3.32
%
Non-interest-earning assets:
                                               
Cash and due from banks
   
24,323
                     
23,193
                 
Premises and equipment, net
   
7,372
                     
7,184
                 
Other real estate owned
   
                     
140
                 
Interest receivable and other assets
   
26,623
                     
25,283
                 
Total average assets
   
1,067,714
                     
994,750
                 
 
                                               
Liabilities and Stockholders' Equity:
                                               
Interest-bearing liabilities:
                                               
Interest-bearing transaction deposits
   
266,387
     
74
     
0.11
%
   
244,621
     
81
     
0.13
%
Savings and MMDA's
   
297,891
     
114
     
0.15
%
   
267,663
     
126
     
0.19
%
Time, under $250,000
   
65,039
     
64
     
0.39
%
   
64,295
     
67
     
0.42
%
Time, $250,000 and over
   
20,069
     
21
     
0.42
%
   
20,195
     
19
     
0.38
%
Total average interest-bearing liabilities
   
649,386
     
273
     
0.17
%
   
596,774
     
293
     
0.20
%
Non-interest-bearing liabilities:
                                               
Non-interest-bearing demand deposits
   
319,999
                     
294,737
                 
Interest payable and other liabilities
   
8,625
                     
8,263
                 
Total liabilities
   
978,010
                     
899,774
                 
Total average stockholders' equity
   
89,704
                     
94,976
                 
Total average liabilities and stockholders' equity
 
$
1,067,714
                   
$
994,750
                 
Net interest income and net interest margin (3)
         
$
8,609
     
3.42
%
         
$
7,480
     
3.20
%
 

(1) Average balances for loans include loans held-for-sale and non-accrual loans and are net of the allowance for loan losses, but non-accrued interest thereon is excluded. Loan interest income includes loan fees of approximately $(16) and $(84) for the three months ended June 30,       2016 and 2015, respectively.
(2) Interest income and yields on tax-exempt securities are not presented on a taxable-equivalent basis.
(3) Net interest margin is computed by dividing net interest income by total average interest-earning assets.
(4)   For disclosure purposes, yield /rates are annualized by dividing the number of days in the reported period by 365.
 
39

FIRST NORTHERN COMMUNITY BANCORP
 
Distribution of Average Statements of Condition and Analysis of Net Interest Income
(in thousands, except percentage amounts)

 
 
Six months ended
June 30, 2016
   
Six months ended
June 30, 2015
 
 
 
Average
Balance
   
Interest
   
Yield/
Rate (4)
   
Average
Balance
   
Interest
   
Yield/
Rate (4)
 
Assets
                                   
Interest-earning assets:
                                   
Loans (1)
 
$
617,892
   
$
15,031
     
4.88
%
 
$
545,599
   
$
12,984
     
4.80
%
Certificate of deposits
   
16,679
     
71
     
0.85
%
   
12,215
     
45
     
0.74
%
Interest bearing due from banks
   
150,728
     
390
     
0.52
%
   
217,540
     
275
     
0.25
%
Investment securities, taxable
   
202,272
     
1,664
     
1.65
%
   
150,127
     
1,435
     
1.93
%
Investment securities, non-taxable  (2)
   
11,927
     
136
     
2.29
%
   
7,012
     
130
     
3.74
%
Other interest earning assets
   
4,117
     
177
     
8.62
%
   
3,934
     
298
     
15.28
%
Total average interest-earning assets
   
1,003,615
     
17,469
     
3.49
%
   
936,427
     
15,167
     
3.27
%
Non-interest-earning assets:
                                               
Cash and due from banks
   
24,329
                     
19,799
                 
Premises and equipment, net
   
7,258
                     
7,231
                 
Other real estate owned
   
13
                     
181
                 
Interest receivable and other assets
   
26,277
                     
25,310
                 
Total average assets
   
1,061,492
                     
988,948
                 
 
                                               
Liabilities and Stockholders' Equity:
                                               
Interest-bearing liabilities:
                                               
Interest-bearing transaction deposits
   
265,642
     
150
     
0.11
%
   
237,291
     
157
     
0.13
%
Savings and MMDA's
   
294,304
     
238
     
0.16
%
   
268,288
     
259
     
0.19
%
Time, under $250,000
   
66,019
     
129
     
0.39
%
   
64,642
     
130
     
0.41
%
Time, $250,000 and over
   
20,371
     
42
     
0.41
%
   
20,304
     
40
     
0.40
%
Total average interest-bearing liabilities
   
646,336
     
559
     
0.17
%
   
590,525
     
586
     
0.20
%
Non-interest-bearing liabilities:
                                               
Non-interest-bearing demand deposits
   
317,666
                     
296,146
                 
Interest payable and other liabilities
   
8,828
                     
8,170
                 
Total liabilities
   
972,830
                     
894,841
                 
Total average stockholders' equity
   
88,662
                     
94,107
                 
Total average liabilities and stockholders' equity
 
$
1,061,492
                   
$
988,948
                 
Net interest income and net interest margin (3)
         
$
16,910
     
3.38
%
         
$
14,581
     
3.14
%
 

(1) Average balances for loans include loans held-for-sale and non-accrual loans and are net of the allowance for loan losses, but non-accrued interest thereon is exculded. Loan interest income includes loan fees of approximately $(108) and $(233) for the six months ended June 30,       2016 and 2015, respectively.
(2)  Interest income and yields on tax-exempt securities are not presented on a taxable-equivalent basis.
(3) Net interest margin is computed by dividing net interest income by total average interest-earning assets.
(4)  For disclosure purposes, yield /rates are annualized by dividing the number of days in the reported period by 365.
 
40

CHANGES IN FINANCIAL CONDITION

The assets of the Company set forth in the Unaudited Condensed Consolidated Balance Sheets reflect a $57,278,000 or 28.5% decrease in cash and cash equivalents, a $51,882,000 or 28.3% increase in investment securities available-for-sale, a $27,905,000 or 4.6% increase in net loans held-for-investment, and a $1,535,000 or 437.3% increase in loans held-for-sale from December 31, 2015 to June 30, 2016.  The decrease in cash and cash equivalents was primarily due to a decrease in interest bearing due from Federal Reserve Bank accounts, which was mainly due to loan growth and the purchase of investment securities.  The increase in investment securities available-for-sale was primarily the result of the purchases of U.S. Treasury securities, U.S. government agencies, and mortgage-backed securities, which was partially offset by calls of U.S. government agencies.  The increase in net loans held-for-investment was primarily due to increased demand for commercial real estate, agriculture and residential construction loans, which was partially offset by decreases in commercial and consumer loans.  The increase in loans held-for-sale was due to timing of sales of loans held-for-sale.

The liabilities of the Company set forth in the Unaudited Condensed Consolidated Balance Sheets reflect an increase in total deposits of $21,748,000 or 2.3% from December 31, 2015 to June 30, 2016.  The increase in deposits was due to increases in demand accounts, interest-bearing transaction deposits, savings accounts and money market accounts, which were partially offset by decreases in time deposits.
 
CHANGES IN RESULTS OF OPERATIONS

Interest Income

The Federal Open Market Committee made no changes to the Federal Funds rate during the six months ended June 30, 2016.

Interest income on loans for the six months ended June 30, 2016 was up 15.8% from the same period in 2015, increasing from $12,984,000 to $15,031,000, and was up 15.4% for the three months ended June 30, 2016 over the same period in 2015, increasing from $6,627,000 to $7,649,000.  The increase in interest income on loans for the three and six months ended June 30, 2016 as compared to the same periods a year ago was primarily due to an increase in average loans and an increase in loan yields of 10 and 8 basis points, respectively.  The increase in loan yields was primarily due to the origination of new loans and the repricing of existing loans at higher rates.

Interest income on investment securities available-for-sale for the six months ended June 30, 2016 was up 15.0% from the same period in 2015, increasing from $1,565,000 to $1,800,000, and was up 24.7% for the three months ended June 30, 2016 over the same period in 2015, increasing from $760,000 to $948,000. The increase in interest income on investment securities for the three and six months ended June 30, 2016 as compared to the same periods a year ago was primarily due to an increase in average investment securities, which was partially offset by a decrease in the yields on investment securities of 26 and 32 basis points, respectively.

Interest income on interest-bearing due from banks for the six months ended June 30, 2016 was up 44.1% from the same period in 2015, increasing from $320,000 to $461,000, and was up 17.1% for the three months ended June 30, 2016 over the same period in 2015, increasing from $164,000 to $192,000.  The increase in interest income on interest-bearing due from banks for the six months ended June 30, 2016 as compared to the same period a year ago was due to an increase in average certificates of deposit balances outstanding, an increase in yield on certificates of deposit of 11 basis points, and an increase in yield on interest-bearing due from banks of 27 basis points, which was partially offset by a decrease in average interest-bearing due from banks.  The increase in interest income on interest-bearing due from banks for the three months ended June 30, 2016 as compared to the same period a year ago was due to an increase in average certificates of deposit balances outstanding, an increase in yield on certificates of deposit of 20 basis points, and an increase in yield on interest-bearing due from banks of 20 basis points, which was partially offset by a decrease in average interest-bearing due from banks.

The Company had no Federal Funds sold balances during the six months ended June 30, 2016 and June 30, 2015.
 
41

Interest Expense

Interest expense on deposits and other borrowings for the six months ended June 30, 2016 was down 4.6% from the same period in 2015, decreasing from $586,000 to $559,000, and was down 6.8% for the three months ended June 30, 2016 over the same period in 2015, decreasing from $293,000 to $273,000.  The decrease in interest expense during the three and six months ended June 30, 2016 was primarily due to a 3 basis point decrease in the Company's average cost of funds, which was partially offset by an increase in the average balance of interest-bearing liabilities.  The Company had no FHLB advances and related interest expense during the six months ended June 30, 2016 and June 30, 2015.

Provision for Loan Losses

There was a provision for loan losses of $900,000 for the six months ended June 30, 2016 compared to $350,000 for the same period in 2015.  There was a provision for loan losses of $450,000 for the three months ended June 30, 2016 compared to $0 for the same period in 2015.  The allowance for loan losses was approximately $10,030,000 or 1.56% of total loans, at June 30, 2016, compared to $9,251,000, or 1.51% of total loans, at December 31, 2015.  The allowance for loan losses is maintained at a level considered adequate by management to provide for probable loan losses inherent in the loan portfolio.

The increase in the provision for loan losses during the three and six months ended June 30, 2016 was primarily due to increased net charge-offs and an increase in loan balances compared to the same periods in 2015.

Provision for Unfunded Lending Commitment Losses

There was no provision for unfunded lending commitment losses for the six months ended June 30, 2016 and June 30, 2015.

The provision for unfunded lending commitment losses is included in non-interest expense in the Condensed Consolidated Statements of Income.
 
Non-Interest Income
 
Non-Interest income was down 9.6% for the six months ended June 30, 2016 from the same period in 2015, decreasing from $3,914,000 to $3,540,000.

The decrease was primarily due to decreases in gains on sales of other real estate owned, gains on sales of loans held-for-sale, loan servicing income, investment and brokerage income, fiduciary activities income and debit card income.  The decrease in gains on sales of other real estate owned was primarily due to a decrease in the number of other real estate owned sales transactions.  The decrease in gains on sales of loans held-for-sale was primarily due to a decrease in the volume of sales.  The decrease in loan servicing income was primarily due to a decrease in mortgage servicing assets booked and an increase in impairment expense.   The decrease in investment and brokerage income and fiduciary activities income was primarily due to a decrease in demand for those services.  The decrease in debit card income was partially due to current year classification of certain expenses to service charges on deposit accounts.

Non-Interest income was down 8.3% for the three months ended June 30, 2016 from the same period in 2015, decreasing from $2,022,000 to $1,855,000.

The decrease was primarily due to decreases in gains on sales of loans held-for-sale and loan servicing income.  The decrease in gains on sales of loans held-for-sale was primarily due to a decrease in the volume of sales.  The decrease in loan servicing income was primarily due to a decrease in mortgage servicing assets booked and an increase in impairment expense. 
42

Non-Interest Expenses

Total non-interest expenses were up 3.8% for the six months ended June 30, 2016 from the same period in 2015, increasing from $13,130,000 to $13,627,000.

The increase was primarily due to increases in salaries and employee benefits, occupancy and equipment expense, and other expenses, which was partially offset by a decrease in data processing expense.  The increase in salaries and employee benefits was primarily due to an increase in staffing and associated salary expense, contingent compensation and profit sharing.  The increase in occupancy and equipment expense was primarily due to branch relocation expenses.  The increase in other expenses was primarily due to an increase in debit card expenses.  The decrease in data processing expense was primarily due to the current year classification of certain expenses to other expenses.

Total non-interest expenses were up 0.5% for the three months ended June 30, 2016 from the same period in 2015, increasing from $6,772,000 to $6,808,000.

The increase was primarily due to increases in occupancy and equipment expense and other expenses, which was partially offset by decreases in data processing expense.  The increase in occupancy and equipment expense was primarily due to branch relocation expenses.  The increase in other expenses was primarily due to an increase in debit card expenses.  The decrease in data processing expense was primarily due to the current year classification of certain data processing expenses to other expenses.
 
The following table sets forth other non-interest expenses by category for the three and six months ended June 30, 2016 and 2015.
 
 
 
(in thousands)
 
 
 
Three months ended
June 30, 2016
   
Three months ended
June 30, 2015
   
Six months ended
June 30, 2016
   
Six months ended
June 30, 2015
 
Other non-interest expenses
                       
FDIC assessments
 
$
155
   
$
155
   
$
310
   
$
310
 
Contributions
   
29
     
43
     
54
     
64
 
Legal fees
   
55
     
187
     
138
     
234
 
Accounting and audit fees
   
97
     
74
     
185
     
147
 
Consulting fees
   
150
     
94
     
302
     
250
 
Postage expense
   
76
     
72
     
154
     
164
 
Telephone expense
   
36
     
30
     
72
     
64
 
Public relations
   
21
     
18
     
55
     
53
 
Training expense
   
34
     
38
     
71
     
84
 
Loan origination expense
   
52
     
38
     
90
     
69
 
Computer software depreciation
   
38
     
20
     
63
     
36
 
Sundry losses
   
49
     
29
     
81
     
101
 
Loan collection expense
   
22
     
39
     
42
     
47
 
Other non-interest expense
   
531
     
393
     
1,015
     
766
 
 
                               
Total other non-interest expenses
 
$
1,345
   
$
1,230
   
$
2,632
   
$
2,389
 
 
43

Income Taxes

The Company's tax rate, the Company's income before taxes and the amount of tax relief provided by non-taxable earnings primarily affect the Company's provision for income taxes.

In the six months ended June 30, 2016, the Company's expense for income taxes increased $429,000 from the same period last year, from $1,728,000 to $2,157,000.

In the three months ended June 30, 2016, the Company's expense for income taxes increased $211,000 from the same period last year, from $960,000 to $1,171,000.

The increase in provision for income taxes for the period presented was primarily attributable to the respective levels of taxable earnings combined with the interim effective tax rate and the incidence of allowable deductions, in particular non-taxable municipal bond income, tax credits generated from low-income housing investments, solar tax credits, and excludable interest income.

Off-Balance Sheet Commitments

The following table shows the distribution of the Company's undisbursed loan commitments at the dates indicated.

 
(in thousands)
 
 
       
 
June 30, 2016
 
December 31, 2015
 
 
       
Undisbursed loan commitments
 
$
210,434
   
$
201,839
 
Standby letters of credit
   
2,850
     
2,807
 
Commitments to sell loans
   
3,754
     
655
 
 
 
$
217,038
   
$
205,301
 
 
The reserve for unfunded lending commitments amounted to $793,000 at each of June 30, 2016 and December 31, 2015, respectively.  The reserve for unfunded lending commitments is included in other liabilities on the Condensed Consolidated Balance Sheets.
44


Asset Quality

The Company manages asset quality and credit risk by maintaining diversification in its loan portfolio and through review processes that include analysis of credit requests and ongoing examination of outstanding loans and delinquencies, with particular attention to portfolio dynamics and loan mix.  The Company strives to identify loans experiencing difficulty early enough to correct the problems, to record charge-offs promptly based on realistic assessments of collectability and current collateral values and to maintain an adequate allowance for loan losses at all times.   Asset quality reviews of loans and other non-performing assets are administered using credit risk-rating standards and criteria similar to those employed by state and federal banking regulatory agencies.  The federal bank regulatory agencies utilize the following definitions for assets adversely classified for supervisory purposes:

Substandard Assets – A substandard asset is inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. Assets so classified must 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 Assets – An asset classified doubtful has all the weaknesses inherent in one classified 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 or improbable.

Other Real Estate Owned and loans rated Substandard and Doubtful are deemed "classified assets".  This category, which includes both performing and non-performing assets, receives an elevated level of attention regarding collection.

The following tables summarize the Company's non-accrual loans net of guarantees of the State of California and U.S. Government by loan category at June 30, 2016 and December 31, 2015:

 
At June 30, 2016
 
At December 31, 2015
 
 
Gross
 
Guaranteed
 
Net
 
Gross
 
Guaranteed
 
Net
 
(in thousands)
                       
 
                       
Commercial
 
$
56
   
$
   
$
56
   
$
112
   
$
57
   
$
55
 
Commercial real estate
   
580
     
88
     
492
     
964
     
95
     
869
 
Agriculture
   
     
     
     
     
     
 
Residential mortgage
   
553
     
     
553
     
1,092
     
     
1,092
 
Residential construction
   
     
     
     
     
     
 
Consumer
   
162
     
     
162
     
560
     
     
560
 
Total non-accrual loans
 
$
1,351
   
$
88
   
$
1,263
   
$
2,728
   
$
152
   
$
2,576
 

It is generally the Company's policy to discontinue interest accruals once a loan is past due for a period of 90 days as to interest or principal payments.  When a loan is placed on non-accrual, interest accruals cease and uncollected accrued interest is reversed and charged against current income.  Payments received on non-accrual loans are applied against principal.  A loan may only be restored to an accruing basis when it again becomes well secured and in the process of collection or all past due amounts have been collected.

Non-accrual loans amounted to $1,351,000 at June 30, 2016 and were comprised of two commercial loans totaling $56,000, two commercial real estate loans totaling $580,000, two residential mortgage loans totaling $553,000, and two consumer loans totaling $162,000.  Non-accrual loans amounted to $2,728,000 at December 31, 2015 and were comprised of four residential mortgage loans totaling $1,092,000, four commercial real estate loans totaling $964,000, four commercial loans totaling $112,000, and four consumer loans totaling $560,000.  It is generally the Company's policy to charge-off the portion of any non-accrual loan that the Company does not expect to collect by writing the loan down to the estimated net realizable value of the underlying collateral.

The five largest non-accrual loans as of June 30, 2016, totaled approximately $1,211,000, or 89.6% of total non-accrual loans, and consisted of one residential mortgage loan totaling $540,000, supported by residential properties located within the Company's market area, one commercial real estate loan totaling $463,000, supported by commercial properties located within the Company's market area, one commercial and industrial loan totaling $46,000, supported by the business assets of the borrower, and two consumer loan totaling $162,000, supported by residential property located within the Company's market area.  The collateral securing these loans is generally appraised every six months.

In comparison, the five largest non-accrual loans as of December 31, 2015, totaled approximately $2,109,000, or 77% of total non-accrual loans, and consisted of two residential mortgage loans totaling $960,000, supported by residential property located within the Company's market area, two commercial real estate loans totaling $721,000, supported by commercial properties located within the Company's market area, and one consumer loan totaling $428,000, supported by residential property located within the Company's market area.  The collateral securing all of these loans is generally appraised every six months.

45

Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired.  Non-performing impaired loans are non-accrual loans and loans that are 90 days or more past due and still accruing.  Total non-performing impaired loans at June 30, 2016 and December 31, 2015 consisted of loans on non-accrual status totaling $1,351,000 and $2,728,000, respectively.  A restructuring of a loan can constitute a troubled debt restructuring if the Company for economic or legal reasons related to the borrower's financial difficulties grants a concession to the borrower that it would not otherwise consider.  A loan that is restructured in a troubled debt restructuring is considered an impaired loan.  Performing impaired loans, which consisted of loans modified as troubled debt restructurings, totaled $5,082,000 and $5,350,000 at June 30, 2016 and December 31, 2015, respectively.  The Company expects to collect all principal and interest due from performing impaired loans.  These loans are not on non-accrual status.  The majority of the non-performing impaired loans, in management's opinion, were adequately collateralized based on recently obtained appraised property values or were guaranteed by a governmental entity.  See "Allowance for Loan Losses" below for additional information.  No assurance can be given that the existing or any additional collateral will be sufficient to secure full recovery of the obligations owed under these loans.

As the following table illustrates, total non-performing assets, net of guarantees of the State of California and U.S. Government, including its agencies and its government-sponsored agencies, decreased $1,315,000, or 51.0% to $1,263,000 during the first six months of 2016.  Non-performing assets, net of guarantees, represented 0.1% of total assets at June 30, 2016.

 
 
At June 30, 2016
   
At December 31, 2015
 
 
 
Gross
   
Guaranteed
   
Net
   
Gross
   
Guaranteed
   
Net
 
(dollars in thousands)
                                   
 
                                   
Non-accrual loans
 
$
1,351
   
$
88
   
$
1,263
   
$
2,728
   
$
152
   
$
2,576
 
Loans 90 days past due and still accruing
   
     
     
     
2
     
     
2
 
 
                                               
Total non-performing loans
   
1,351
     
88
     
1,263
     
2,730
     
152
     
2,578
 
Other real estate owned
   
     
     
     
     
     
 
Total non-performing assets
 
$
1,351
   
$
88
   
$
1,263
   
$
2,730
   
$
152
   
$
2,578
 
 
                                               
Non-performing loans to total loans
                   
0.2
%
                   
0.4
%
Non-performing assets to total assets
                   
0.1
%
                   
0.3
%
Allowance for loan and lease losses to non-performing loans (net of guarantees)
                   
794.1
%
                   
358.8
%

The Company had no loans 90 days or more past due and still accruing at June 30, 2016.  The Company had one loan totaling $2,000 that was 90 days past due and still accruing at December 31, 2015.

Excluding the non-performing loans cited previously, loans totaling $11,311,000 and $19,002,000 were classified as substandard or doubtful loans, representing potential problem loans at June 30, 2016 and December 31, 2015, respectively.  In Management's opinion, the potential loss related to these problem loans was sufficiently covered by the Bank's existing loan loss reserve (Allowance for Loan Losses) at June 30, 2016 and December 31, 2015.  The ratio of the Allowance for Loan Losses to total loans at June 30, 2016 and December 31, 2015 was 1.56% and 1.51%, respectively.  
 
Other real estate owned ("OREO") consists of property that the Company has acquired by deed in lieu of foreclosure or through foreclosure proceedings, and property that the Company does not hold title to but is in actual control of, known as in-substance foreclosure.  The estimated fair value of the property is determined prior to transferring the balance to OREO.  The balance transferred to OREO is the estimated fair value of the property less estimated cost to sell.  Impairment may be deemed necessary to bring the book value of the loan equal to the appraised value.  Appraisals or loan officer evaluations are then conducted periodically thereafter charging any additional impairment to the appropriate expense account.  The Company had no OREO as of June 30, 2016 and December 31, 2015.

46

Allowance for Loan Losses

The Company's Allowance for Loan Losses is maintained at a level believed by management to be adequate to provide for loan losses that can be reasonably anticipated.  The allowance is increased by provisions charged to non-interest expense and reduced by net charge-offs.  The Company contracts with vendors for credit reviews of the loan portfolio as well as considers current economic conditions, loan loss experience, and other factors in determining the adequacy of the reserve balance.  The allowance for loan losses is based on estimates, and actual losses may vary from current estimates.

The following table summarizes the Allowance for Loan Losses of the Company during the six months ended June 30, 2016 and 2015, and for the year ended December 31, 2015:
 
Analysis of the Allowance for Loan Losses
(Amounts in thousands, except percentage amounts)

 
 
Six months ended
June 30,
   
Year ended
December 31,
 
 
 
2016
   
2015
   
2015
 
 
                 
Balance at beginning of period
 
$
9,251
   
$
8,583
   
$
8,583
 
Provision for loan losses
   
900
     
350
     
650
 
Loans charged-off:
                       
Commercial
   
(230
)
   
     
(44
)
Commercial Real Estate
   
(15
)
   
     
(7
)
Agriculture
   
     
     
 
Residential Mortgage
   
     
(132
)
   
(211
)
Residential Construction
   
     
     
 
Consumer
   
(35
)
   
(85
)
   
(175
)
 
                       
Total charged-off
   
(280
)
   
(217
)
   
(437
)
 
                       
Recoveries:
                       
Commercial
   
28
     
87
     
102
 
Commercial Real Estate
   
     
4
     
18
 
Agriculture
   
81
     
     
 
Residential Mortgage
   
1
     
215
     
219
 
Residential Construction
   
2
     
57
     
60
 
Consumer
   
47
     
27
     
56
 
 
                       
Total recoveries
   
159
     
390
     
455
 
 
                       
Net (charge-offs) recoveries
   
(121
)
   
173
     
18
 
 
                       
Balance at end of period
 
$
10,030
   
$
9,106
   
$
9,251
 
 
                       
Ratio of net charge-offs to average loans outstanding during the period (annualized)
   
-0.04
%
   
0.06
%
   
0.00
%
Allowance for loan losses
                       
To total loans at the end of the period
   
1.56
%
   
1.57
%
   
1.51
%
To non-performing loans, net of guarantees at the end of the period
   
794.1
%
   
207.3
%
   
358.8
%

47

Deposits

Deposits are one of the Company's primary sources of funds.  At June 30, 2016, the Company had the following deposit mix: 31.2% in savings and MMDA deposits, 8.6% in time deposits, 27.1% in interest-bearing transaction deposits and 33.1% in non-interest-bearing transaction deposits.  At December 31, 2015, the Company had the following deposit mix: 30.1% in savings and MMDA deposits, 9.3% in time deposits, 27.6% in interest-bearing transaction deposits and 33.0% in non-interest-bearing transaction deposits.  Non-interest-bearing transaction deposits increase the Company's net interest income by lowering its cost of funds.

The Company obtains deposits primarily from the communities it serves.  The Company believes that no material portion of its deposits has been obtained from or is dependent on any one person or industry.  The Company accepts deposits in excess of $250,000 from customers.  These deposits are priced to remain competitive.

Maturities of time certificates of deposits of $250,000 or more outstanding at June 30, 2016 and December 31, 2015 are summarized as follows:

 
 
(in thousands)
 
 
 
June 30, 2016
   
December 31, 2015
 
Three months or less
 
$
2,984
   
$
5,187
 
Over three to twelve months
   
12,604
     
10,395
 
Over twelve months
   
4,125
     
4,371
 
Total
 
$
19,713
   
$
19,953
 

The decrease in time certificates of deposit (CD's) of $250,000 or more was primarily attributable to maturities of time deposits.

Liquidity and Capital Resources

In order to serve our market area, the Company must maintain adequate liquidity and adequate capital.  Liquidity is measured by various ratios, in management's opinion, the most common being the ratio of net loans to deposits (including loans held-for-sale).  This ratio was 65.5% on June 30, 2016.  In addition, on June 30, 2016, the Company had the following short-term investments (based on remaining maturity and/or next repricing date):  $2,579,000 in securities due within one year or less; and $74,254,000 in securities due in one to five years.

To meet unanticipated funding requirements, the Company maintains short-term unsecured lines of credit with other banks which totaled $57,000,000 at June 30, 2016.  Additionally, the Company has a line of credit with the FHLB, with a borrowing capacity at June 30, 2016 of $251,230,000; credit availability is subject to certain collateral requirements.

The Company's primary source of liquidity on a stand-alone basis is dividends from the Bank.  Dividends from the Bank are subject to regulatory restrictions.

As of June 30, 2016, the Bank's capital ratios exceeded applicable regulatory requirements.  The following table presents the capital ratios for the Bank, compared to the regulatory standards for well-capitalized depository institutions, as of June 30, 2016.

 
(amounts in thousands except percentage amounts)
 
 
Actual
 
Well Capitalized
 
 
Capital
 
Ratio
 
Ratio
Requirement
 
Leverage
 
$
87,936
     
8.24
%
   
5.0
%
Common Equity Tier 1
 
$
87,936
     
11.92
%
   
6.5
%
Tier 1 Risk-Based
 
$
87,936
     
11.92
%
   
8.0
%
Total Risk-Based
 
$
97,174
     
13.18
%
   
10.0
%

48

In July 2013, the Federal Reserve Board and the other U.S. federal banking agencies adopted final rules making significant changes to the U.S. regulatory capital framework for U.S. banking organizations and to conform this framework to the Basel Committee's current international regulatory capital accord (Basel III). These rules replaced the federal banking agencies' general risk-based capital rules, advanced approaches rule, market-risk rule, and leverage rules, in accordance with certain transition provisions. The Bank became subject to these rules on January 1, 2015. The new rules implemented higher minimum capital requirements, included a new common equity Tier 1 capital requirement, and established criteria that instruments must meet in order to be considered common equity Tier 1 capital, additional Tier 1 capital, or Tier 2 capital. When fully phased in, the final rules will provide for increased minimum capital ratios as follows: (a) a common equity Tier 1 capital ratio of 4.5%; (b) a Tier 1 capital ratio of 6% (which is an increase from 4.0%); (c) a total capital ratio of 8%; and (d) a Tier 1 leverage ratio to average consolidated assets of 4%. Under these rules, in order to avoid certain limitations on capital distributions, including dividend payments and certain discretionary bonus payments to executive officers, a banking organization must hold a capital conservation buffer composed of common equity Tier 1 capital above its minimum risk based capital requirements (equal to 2.5% of total risk-weighted assets). The phase-in of the capital conservation buffer will begin January 1, 2016, and be completed by January 1, 2019. The new rules also provide for various adjustments and deductions to the definitions of regulatory capital that will phase in through December 31, 2017.
 
49

ITEM 3.   – QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The Company believes that there have been no material changes in the quantitative and qualitative disclosures about market risk as of June 30, 2016, from those presented in the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2015, which are incorporated by reference herein.
 
ITEM 4.   – CONTROLS AND PROCEDURES
 
(a)  We maintain "disclosure controls and procedures," as such term is defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (the "Exchange Act"), that are designed to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in Securities and Exchange Commission rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating our disclosure controls and procedures, management recognized that disclosure controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the disclosure controls and procedures are met. Our disclosure controls and procedures have been designed to meet reasonable assurance standards. Additionally, in designing disclosure controls and procedures, our management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible disclosure controls and procedures. The design of any disclosure controls and procedures also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.  Our Chief Executive Officer (principal executive officer) and Chief Financial Officer (principal financial officer) have concluded that the design and operation of our disclosure controls and procedures are effective as of June 30, 2016.  This conclusion is based on an evaluation conducted under the supervision and with the participation of management.

(b)  During the quarter ended June 30, 2016, there were no changes in our internal controls over financial reporting that materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.
 
PART II   – OTHER INFORMATION
 
ITEM 1. – LEGAL PROCEEDINGS
 
Neither the Company nor the Bank is a party to any material pending legal proceeding, nor is any of their property the subject of any material pending legal proceeding, except ordinary routine litigation arising in the ordinary course of the Bank's business and incidental to its business, none of which is expected to have a material adverse impact upon the Company's or the Bank's business, financial position or results of operations.
 
ITEM 1A. – RISK FACTORS
 
For a discussion of risk factors relating to our business, please refer to Part I, Item 1A of our 2015 Form 10-K, which is incorporated by reference herein, and to the following:

The Bank's Dependence on Real Estate Lending Increases Our Risk of Losses

At June 30, 2016, approximately 74% in principal amount of the Bank's loans (excluding loans held-for-sale) were secured by real estate.  The value of the Bank's real estate collateral has been, and could in the future continue to be, adversely affected by the economic recession and resulting adverse impact on the real estate market in Northern California.

The Bank's primary lending focus has historically been commercial (including agricultural), construction, and real estate mortgage.  At June 30, 2016, real estate mortgage (excluding loans held-for-sale) and construction loans (residential and other) comprised approximately 69% and 5%, respectively, in principal amount of the total loans in the Bank's portfolio.  At June, 2016, all of the Bank's real estate mortgage and construction loans and approximately 11% in principal amount of its commercial loans were secured fully or in part by deeds of trust on underlying real estate.  The Company's dependence on real estate increases the risk of loss in both the Bank's loan portfolio and its holdings of other real estate owned if economic conditions in Northern California were to deteriorate in the future.  Significant deterioration of the real estate market in Northern California would have a material adverse effect on the Company's business, financial condition, and results of operations.

The CFPB has adopted various regulations which have and will continue to impact our residential mortgage lending business.  For additional information, see "Business – Certain CFPB Rules" in Part I, Item 1 in our Annual Report on Form 10-K.
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Adverse California Economic Conditions Could Adversely Affect the Bank's Business

The Bank's operations and a substantial majority of the Bank's assets and deposits are generated and concentrated primarily in Northern California, particularly the counties of Placer, Sacramento, Solano and Yolo, and are likely to remain so for the foreseeable future. At June 30, 2016, approximately 74% in principal amount of the Bank's loan portfolio (excluding loans held-for-sale) consisted of real estate-related loans, all of which were secured by collateral located in Northern California. As a result, a downturn in the economic conditions in Northern California may cause the Bank to incur losses associated with high default rates and decreased collateral values in its loan portfolio. Economic conditions in California are subject to various uncertainties, including deterioration in the California real estate market and housing industry.
 
In recent years, economic conditions in California, and especially the regional markets we serve, have been subject to various challenges, including deterioration in both the commercial and residential real estate sectors.  In addition, in the recent past, the State government of California has experienced budget shortfalls or deficits that have led to protracted negotiations between the Governor and the State Legislature over how to address the budget gap. The California electorate approved, in the November 2012 general elections, certain increases in the rate of income taxation in California, and also elected Democratic super-majorities in both Houses of the California legislature, thus potentially facilitating further increases in California tax rates. As a consequence, California's current budget does not reflect a deficit, however, there can be no assurance that the state's fiscal and budgetary challenges will be readily resolved. In addition, the impact of increased rates of income taxation on the level of economic activity in California cannot be predicted at this time.

Also, municipalities and other governmental units within California have experienced budgetary difficulties, and several California municipalities have filed for protection under the Bankruptcy Code in recent years. As a result, concerns also have arisen regarding the outlook for the State of California's governmental obligations, as well as those of California municipalities and other governmental units.

Poor economic conditions in California, and especially the regional markets we serve, will cause us to incur losses associated with higher default rates and decreased collateral values in our loan portfolio. If the budgetary and fiscal difficulties of the California State government and California municipalities and other governmental units continue or economic conditions in California decline further, we expect that our level of problem assets will increase and our prospects for growth will be impaired.  Weather related conditions, including the severe drought which California has experienced in recent years, may also cause further difficulties for the California economy, particularly in the agricultural sector.  In May of 2016, California Governor Edmund G. Brown Jr. issued an executive order directing the State Water Resource Control Board to adopt regulations requiring local water agencies to develop conservation standards based upon each agency's specific circumstances to assure a three-year water supply assuming three additional drought years comparable to 2012 to 2015, replacing a prior percentage reduction-based water conservation standard of 25 percent.  The impact of this and other measures in response to the drought on the California business climate and economy cannot be predicted.

Potential Volatility of Deposits May Increase Our Cost of Funds

At June 30, 2016 and December 31, 2015, 2% of the dollar value of the Company's total deposits was represented by time certificates of deposit in excess of $250,000.  These deposits are considered volatile and could be subject to withdrawal.  Withdrawal of a material amount of such deposits could adversely impact the Company's liquidity, profitability, business prospects, results of operations and cash flows.


 
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ITEM 2. – UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
 
None.
 
ITEM 3. – DEFAULTS UPON SENIOR SECURITIES

None.
 
ITEM 4. – MINE SAFETY DISCLOSURES

Not applicable.
 
ITEM 5. – OTHER INFORMATION

None.
 
ITEM 6.   – EXHIBITS
 
Exhibit
Number
 
Description of Document
 
 
 
31.1
 
Rule 13a — 14(a) Certification of Chief Executive Officer
 
 
 
31.2
 
Rule 13a — 14(a) Certification of Chief Financial Officer
 
 
 
32.1*
 
Statement of the Chief Executive Officer under Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. Section 1350)
 
 
 
32.2*
 
Statement of the Chief Financial Officer under Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. Section 1350)
 
 
 
101
 
Pursuant to Rule 405 of Regulation S-T, the following financial information from the Registrant's Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2016, is formatted in XBRL interactive data files: (i) Condensed Consolidated Balance Sheets; (ii) Condensed Consolidated Statements of Income; (iii) Condensed Consolidated Statements of Comprehensive (Loss) Income (iv) Condensed Consolidated Statement of Stockholders' Equity; (v) Condensed Consolidated Statements of Cash Flows; and (vi) Notes to Condensed Consolidated Financial Statements.
 

*   In accordance with Item 601(b)(32)(ii) of Regulation S-K and SEC Release No. 34-47986, the certifications furnished in Exhibits 32.1 and 32.2 hereto are deemed to accompany this Form 10-Q and will not be deemed "filed" for purposes of Section 18 of the Exchange Act. Such certifications will not be deemed to be incorporated by reference into any filing under the Securities Act or the Exchange Act.
 
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SIGNATURES
 
Pursuant to the requirements 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.

 
 
 
FIRST NORTHERN COMMUNITY BANCORP
 
 
 
 
Date:
August 3, 2016
By:
/s/  Jeremiah Z. Smith
 
 
 
 
 
 
 
Jeremiah Z. Smith, Senior Executive Vice President / Chief Operating Officer and Chief Financial Officer
 
 
 
(Principal Financial Officer and Duly Authorized Officer)

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