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Section 1: 10-Q (QUARTERLY REPORT)

UNITED STATES OF AMERICA
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

(Mark One)


QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
 

For the Quarterly Period Ended June 30, 2018

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: 000-11486

CONNECTONE BANCORP, INC.
(Exact Name of Registrant as Specified in Its Charter)

New Jersey 52-1273725
(State or Other Jurisdiction of (IRS Employer
Incorporation or Organization) Identification No.)

301 Sylvan Avenue
Englewood Cliffs, New Jersey 07632
(Address of Principal Executive Offices) (Zip Code)

201-816-8900
(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 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 Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ☒ No ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company or emerging growth company. See definition of “large accelerated filer”, “accelerated filer” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act (check one):

Large accelerated filer ☐ Accelerated filer ☒ Non-accelerated filer ☐ Smaller reporting company ☐
(Do not check if smaller Emerging growth company ☐
reporting company)

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 7(a)(2)(B) of the Securities Act. ☐

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

Common Stock, no par value:
(Title of Class)
32,184,173 shares
(Outstanding as of August 7, 2018)


Table of Contents

Page
PART I – FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Statements of Condition at June 30, 2018 (unaudited) and December 31, 2017 3
Consolidated Statements of Income for the three and six months ended June 30, 2018 and 2017 (unaudited) 4
Consolidated Statements of Comprehensive Income for the three and six months ended June 30, 2018 and 2017 (unaudited) 5
Consolidated Statements of Changes in Stockholders’ Equity for the six months ended June 30, 2018 and 2017 (unaudited) 6
Consolidated Statements of Cash Flows for the six months ended June 30, 2018 and 2017 (unaudited) 7
Notes to Consolidated Financial Statements (unaudited) 8
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations 46
Item 3. Qualitative and Quantitative Disclosures about Market Risks 59
Item 4. Controls and Procedures 59
PART II – OTHER INFORMATION
Item 1. Legal Proceedings 60
Item 1a. Risk Factors 60
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 61
Item 3. Defaults Upon Senior Securities 61
Item 4. Mine Safety Disclosures 61
Item 5. Other Information 61
Item 6. Exhibits 62
SIGNATURES

2


Item 1. Financial Statements

ConnectOne Bancorp, Inc. and Subsidiaries
CONSOLIDATED STATEMENTS OF CONDITION

             June 30,       December 31,
(in thousands, except for share data) 2018 2017
(unaudited)
ASSETS
Cash and due from banks $      56,931 $      52,565
Interest-bearing deposits with banks 119,238 97,017
Cash and cash equivalents 176,169 149,582
 
Securities available-for-sale 400,015 435,284
Equity securities 11,559 -
 
Loans held-for-sale - 24,845
 
Loans receivable 4,360,854 4,171,456
Less: Allowance for loan losses 33,594 31,748
Net loans receivable 4,327,260 4,139,708
 
Investment in restricted stock, at cost 32,441 33,497
Bank premises and equipment, net 20,389 21,659
Accrued interest receivable 16,754 15,470
Bank owned life insurance 112,275 111,311
Other real estate owned 1,076 538
Goodwill 145,909 145,909
Core deposit intangibles 2,027 2,364
Other assets 29,494 28,275
Total assets $ 5,275,368 $ 5,108,442
LIABILITIES
Deposits:
Noninterest-bearing $ 765,150 $ 776,843
Interest-bearing 3,140,260 3,018,285
Total deposits 3,905,410 3,795,128
Borrowings 628,995 670,077
Subordinated debentures (net of debt issuance costs of $1,763 and $456, respectively) 128,392 54,699
Other liabilities 34,014 23,101
Total liabilities 4,696,811 4,543,005
 
COMMITMENTS AND CONTINGENCIES
 
STOCKHOLDERS’ EQUITY
 
Preferred stock, authorized 5,000,000 shares; issued -0- share of Series B preferred stock at June 30, 2018 and December 31, 2017; outstanding -0- shares at June 30, 2018 and December 31, 2017; liquidation value of $-0- at June 30, 2018 and December 31, 2017 - -
Common stock, no par value, authorized 50,000,000 shares; issued 34,247,969 shares at June 30, 2018 and 34,135,782 at December 31, 2017; outstanding 32,184,047 shares at June 30, 2018 and 32,071,860 at December 31, 2017 412,546 412,546
Additional paid-in capital 13,756 13,602
Retained earnings 177,619 160,025
Treasury stock, at cost (2,063,922 common shares at June 30, 2018 and December 31, 2017) (16,717 ) (16,717 )
Accumulated other comprehensive loss (8,647 ) (4,019 )
Total stockholders’ equity 578,557 565,437
Total liabilities and stockholders’ equity $ 5,275,368 $ 5,108,442

See accompanying notes to unaudited consolidated financial statements.

3


ConnectOne Bancorp, Inc. and Subsidiaries
CONSOLIDATED STATEMENTS OF INCOME
(unaudited)

      Three Months Ended       Six Months Ended
June 30, June 30,
(in thousands, except for per share data) 2018       2017 2018       2017
Interest income
Interest and fees on loans $      49,494 $      40,632 $      96,519 $      78,638
Interest and dividends on investment securities:
Taxable 2,150 1,799 4,037 3,347
Tax-exempt 778 831 1,592 1,785
Dividends 502 290 987 620
Interest on federal funds sold and other short-term investments 160 139 424 385
Total interest income 53,084 43,691 103,559 84,775
Interest expense
Deposits 9,169 5,495 16,857 10,604
Borrowings 4,970 3,095 9,610 5,929
Total interest expense 14,139 8,590 26,467 16,533
Net interest income 38,945 35,101 77,092 68,242
Provision for loan losses 1,100 1,450 18,900 2,550
Net interest income after provision for loan losses 37,845 33,651 58,192 65,692
Noninterest income
Income on bank owned life insurance 775 714 1,549 1,417
Net gains on sale of loans held-for-sale 12 49 29 70
Deposit, loan and other income 601 659 1,217 1,341
Net gains on sales of securities available-for-sale - - - 1,596
Total noninterest income 1,388 1,422 2,795 4,424
Noninterest expenses
Salaries and employee benefits 9,729 8,569 19,401 16,713
Occupancy and equipment 2,031 1,991 4,174 4,246
FDIC insurance 765 815 1,615 1,710
Professional and consulting 825 734 1,548 1,452
Marketing and advertising 337 289 544 545
Data processing 1,091 1,149 2,239 2,298
Amortization of core deposit intangible 169 193 338 386
Other components of net periodic pension expense 7 63 14 125
Increase in valuation allowance, loans held-for-sale - 9,725 - 12,325
Change in fair value of equity securities     47     -     168     -
Other expenses 2,107 1,775 4,126 3,752
Total noninterest expenses 17,108 25,303 34,167 43,552
Income before income tax expense 22,125 9,770 26,820 26,564
Income tax expense 4,598 2,087 5,042 7,001
Net income $ 17,527 $ 7,683 $ 21,778 $ 19,563
 
Earnings per common share:
Basic $ 0.54 $ 0.24 $ 0.68 $ 0.61
Diluted 0.54 0.24 0.67 0.60
 
Dividends per common share $ 0.075 $ 0.075 $ 0.150 $ 0.150

See accompanying notes to unaudited consolidated financial statements.

4


ConnectOne Bancorp, Inc. and Subsidiaries
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(unaudited)

Three Months Ended Six Months Ended
June 30, June 30,
(in thousands)       2018       2017       2018       2017
Net income $      17,527 $      7,683 $      21,778 $      19,563
Other comprehensive income:
Unrealized gains and losses:
Unrealized holding gains (losses) on available-for-sale securities arising during the period (1,780 ) 224 (6,799 ) 913
Tax effect 445 (88 ) 1,737 (356 )
Net of tax (1,335 ) 136 (5,062 ) 557
Reclassification adjustment for realized gains included in net income - - - (1,596 )
Tax effect - - - 579
Net of tax - - - (1,017 )
Unrealized gains (losses) on cash flow hedges 178 (203 ) 1,094 (43 )
Tax effect (49 ) 82 (307 ) 17
Net of tax 129 (121 ) 787 (26 )
Unrealized pension plan gains and losses:
Unrealized pension plan losses before reclassifications - - 236 (2 )
Tax effect - - (67 ) 1
Net of tax - - 169 (1 )
Reclassification adjustment for amortization included in net income 92 103 183 206
Tax effect (26 ) (42 ) (51 ) (84 )
Net of tax 66 61 132 122
Total other comprehensive (loss) income (1,140 ) 76 (3,974 ) (365 )
                                 
Total comprehensive income $ 16,387 $ 7,759 $ 17,804 $ 19,198

See accompanying notes to unaudited consolidated financial statements.

5


ConnectOne Bancorp, Inc. and Subsidiaries
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY
(unaudited)

                        Accumulated    
Additional Other Total
Preferred Common Paid-In Retained Treasury Comprehensive Stockholders’

(dollars in thousands, except for per share data)

Stock Stock Capital Earnings Stock (Loss) Income Equity
Balance as of December 31, 2016 $       - $   412,726 $     11,407 $   126,462 $   (16,717 ) $         (2,846 ) $         531,032
Net income - - - 19,563 - - 19,563
Other comprehensive loss, net of tax - - - - - (365 ) (365 )
Cash dividends declared on common stock ($0.150 per share) - - - (4,847 ) - - (4,847 )
 
Stock issuance costs - (180 ) - - - - (180 )
Exercise of stock options (10,846 shares) - - 118 - - - 118
Restricted stock grants (56,164 shares) - - - - - - -
Stock-based compensation expense - - 852 - - - 852
  
Balance as of June 30, 2017 $ - $ 412,546 $ 12,377 $ 141,178 $ (16,717 ) $ (3,211 ) $ 546,173
 
Balance as of December 31, 2017 $ - $ 412,546 $ 13,602 $ 160,025 $ (16,717 ) $ (4,019 ) $ 565,437
Reclassification of stranded tax effects (ASU 2018-02) (see Note 8) - - - 709 - (709 ) -
Cumulative effect of adopting ASU 2016-01 (see Note 8) - - - (55 ) - 55 -
Net income - - - 21,778 - - 21,778
Other comprehensive loss, net of tax - - - - - (3,974 ) (3,974 )
Cash dividends declared on common stock ($0.150 per share) - - - (4,838 ) - - (4,838 )
Exercise of stock options (46,497 shares) - - 252 - - - 252
Restricted stock grants (23,018 shares) - - - - - - -
Net performance units issued (42,672 shares) - - (819 ) - - - (819 )
 
Stock-based compensation expense - - 721 - - - 721
  
Balance as of June 30, 2018 $ - $ 412,546 $ 13,756 $ 177,619 $ (16,717 ) $ (8,647 ) $ 578,557

See accompanying notes to unaudited consolidated financial statements.

6


CONNECTONE BANCORP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)

      Six Months Ended
June 30,
(dollars in thousands) 2018       2017
Cash flows from operating activities
Net income $       21,778 $       19,563
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization of premises and equipment 1,536 1,548
Provision for loan losses 18,900 2,550
Increase in valuation allowance - 12,325
Amortization of intangibles 338 386
Net accretion of loans (806 ) (846 )
Accretion on bank premises (33 ) (41 )
Accretion on deposits (31 ) (12 )
Accretion on borrowings (82 ) (107 )
Stock-based compensation expense (98 ) 852
Gains on sales of investment securities, net - (1,596 )
Loss on equity securities, net     168       -  
Gains on sales of loans held-for-sale, net (29 ) (70 )
Gains on sales of fixed assets, net - (8 )
Loans originated for resale (1,498 ) (3,891 )
Proceeds from sale of loans held-for sale 1,897 8,979
Net loss on sale of other real estate owned - 82
Increase in cash surrender value of bank owned life insurance (964 ) (1,417 )
Amortization of premiums and accretion of discounts on investments securities, net 1,832 1,078
Amortization of subordinated debt issuance costs 168 82
Increase in accrued interest receivable (1,284 ) (229 )
(Increase) decrease in other assets (126 ) 4,787
Increase in other liabilities 12,633 4,026
Net cash provided by operating activities 54,299 48,041
Cash flows from investing activities
Investment securities available-for-sale:
Purchases (60,595 ) (117,857 )
Sales - 29,543
Maturities, calls and principal repayments 75,506 39,313
Net (purchases) redemptions of restricted investment in bank stocks 1,056 (7,842 )
Payments on loans held-for-sale 159 2,379
Net increase in loans (181,868 ) (278,208 )
Proceeds from sales of fixed assets - 8
Purchases of premises and equipment (233 ) (1,062 )
Proceeds from sale of other real estate owned - 544
Net cash used in investing activities (165,975 ) (333,182 )
Cash flows from financing activities
Net increase in deposits 110,313 86,114
Increase in subordinated debentures 73,525 -
Advances of Federal Home Loan Bank (“FHLB”) borrowings 863,000 425,000
Repayments of FHLB borrowings (904,000 ) (260,000 )
Repayment of repurchase agreement - (15,000 )
Cash dividends paid on common stock (4,827 ) (4,802 )
Common stock issuance costs - (180 )
Proceeds from exercise of stock options 252 118
Net cash provided by financing activities 138,263 231,250
Net change in cash and cash equivalents 26,587 (53,891 )
Cash and cash equivalents at beginning of period 149,582 200,399
Cash and cash equivalents at end of period $ 176,169 $ 146,508
Supplemental disclosures of cash flow information
Cash payments for:
Interest paid on deposits and borrowings $ 25,055 $ 14,643
Income taxes 1,497 3,065
Supplemental disclosures of noncash investing activities
Transfer of loans to other real estate owned $ 538 $ 580
Transfer of loans held-for-investment to loans held-for-sale 21,236 -
Transfer of loans held-for-sale to held-for-investment 45,552 7,159

See accompanying notes to unaudited consolidated financial statements.

7


CONNECTONE BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

Note 1. Nature of Operations and Principles of Consolidation

ConnectOne Bancorp, Inc. (the “Parent Corporation”) is incorporated under the laws of the State of New Jersey and is a registered bank holding company. The Parent Corporation’s business currently consists of the operation of its wholly-owned subsidiary, ConnectOne Bank (the “Bank” and, collectively with the Parent Corporation and the Parent Corporation’s subsidiaries, the “Company”). The Bank’s subsidiaries include Union Investment Co. (a New Jersey investment company), Twin Bridge Investment Co. (a Delaware investment company), ConnectOne Preferred Funding Corp. (a New Jersey real estate investment trust), Center Financial Group, LLC (a New Jersey financial services company), Center Advertising, Inc. (a New Jersey advertising company), Morris Property Company, LLC, (a New Jersey limited liability company), Volosin Holdings, LLC, (a New Jersey limited liability company), and NJCB Spec-1, LLC (a New Jersey limited liability company).

The Bank is a community-based, full-service New Jersey-chartered commercial bank that was founded in 2005. The Bank operates from its headquarters located at 301 Sylvan Avenue in the Borough of Englewood Cliffs, Bergen County, New Jersey and through its twenty-one other banking offices. Substantially all loans are secured with various types of collateral, including business assets, consumer assets and commercial/residential real estate. Each borrower’s ability to repay its loans is dependent on the conversion of assets, cash flows generated from the borrower’s business, real estate rental and consumer wages.

The preceding unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X, and, accordingly, do not include all of the information and footnotes required by GAAP for complete financial statements. However, in the opinion of management, all adjustments (consisting only of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three and six months ended June 30, 2018 are not necessarily indicative of the results that may be expected for the full year ending December 31, 2018, or for any other interim period. The Company’s 2017 Annual Report on Form 10-K should be read in conjunction with these consolidated financial statements. 

In preparing the consolidated financial statements, management has made estimates and assumptions that affect the reported amounts of assets and liabilities as of the dates of the consolidated statements of condition and that affect the results of operations for the periods presented. Actual results could differ significantly from those estimates.

The consolidated financial statements have been prepared in conformity with GAAP. Some items in the prior year consolidated financial statements were reclassified to conform to current presentation. Reclassifications had no effect on prior year net income or stockholders’ equity.

Note 2. New Authoritative Accounting Guidance

ASU 2018-10, “Codification Improvements to Topic 842, Leases.”  These amendments affect narrow aspects of the guidance issued in the amendments in ASU 2016-02 including those regarding residual value guarantees, rate implicit in the lease, lessee reassessment of lease classification, lessor reassessment of lease term and purchase option, variable lease payments that depend on an index or a rate, investment tax credits, lease term and purchase option, transition guidance for amounts previously recognized in business combinations, certain transition adjustments, transition guidance for leases previously classified as capital leases under Topic 840, transition guidance for modifications to leases previously classified as direct financing or sales-type leases under Topic 840, transition guidance for sale and leaseback transactions, impairment of net investment in the lease, unguaranteed residual asset, effect of initial direct costs on rate implicit in the lease, and failed sale and leaseback transactions. We believe the adoption of this standard will not have a significant impact on our consolidated financial statements.

ASU 2018-09, “Codification Improvements.” These amendments represent changes to clarify, correct errors in, or make minor improvements to the Codification, eliminating inconsistencies and providing clarifications in current guidance. The amendments in this ASU include those made to: Subtopic 220-10, Income Statement-Reporting Comprehensive Income-Overall; Subtopic 470-50, Debt-Modifications and Extinguishments; Subtopic 480-10, Distinguishing Liabilities from Equity-Overall; Subtopic 718-740, Compensation-Stock Compensation-Income Taxes; Subtopic 805-740, Business Combinations-Income Taxes; Subtopic 815-10, Derivatives and Hedging-Overall; Subtopic 820-10, Fair Value Measurement-Overall; Subtopic 940-405, Financial Services-Brokers and Dealers-Liabilities; and Subtopic 962-325, Plan Accounting-Defined Contribution Pension Plans-Investments-Other. 'The transition and effective date guidance is based on the facts and circumstances of each amendment. Some of the amendments do not require transition guidance and will be effective upon issuance. However, many of the amendments do have transition guidance with effective dates for annual periods beginning after December 15, 2018, for public business entities.

ASU 2018-01, “Leases (Topic 842): Land Easement Practical Expedient for Transition to Topic 842.” ASU 2018-01 provides an optional transition practical expedient for the adoption of ASU 2016-02 that, if elected, would not require an organization to reconsider their accounting for existing land easements that are not currently accounted for under the old leases standard; and clarify that new or modified land easements should be evaluated under ASU 2016-02, once an entity has adopted the new standard. ASU 2018-01 is effective for fiscal years beginning after December 15, 2018. We believe the adoption of this standard will not have a significant impact on our consolidated financial statements.

8


CONNECTONE BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

Note 2. New Authoritative Accounting Guidance – (continued)

ASU No. 2017-12, “Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities.” ASU No. 2017-12 refines and expands hedge accounting for both financial (e.g., interest rate) and commodity risks. Its provisions create more transparency around how economic results are presented, both on the face of the financial statements and in the footnotes. It also makes certain targeted improvements to simplify the application of hedge accounting guidance. ASU 2017-12 will be effective for public business entities for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years. Although management continues to evaluate the potential impact of ASU 2017-12 on our consolidated financial statements, at this time, we believe the adoption of this standard will not have a significant impact on our consolidated financial statements.

ASU No. 2017-08, “Receivables—Nonrefundable Fees and Other Costs (Subtopic 310-20), Premium Amortization on Purchased Callable Debt Securities.” ASU No. 2017-08 shortens the amortization period for certain callable debt securities held at a premium. Specifically, the amendments require the premium to be amortized to the earliest call date. The amendments do not require an accounting change for securities held at a discount; the discount continues to be amortized to maturity. ASU 2017-08 will be effective for public business entities for fiscal years beginning after December 15, 2019, and interim periods within fiscal years beginning after December 15, 2020. We are currently evaluating this ASU to determine the impact on our consolidated financial statements.

ASU No. 2017-04, “Intangibles – Goodwill and Other (Topic 350).” ASU 2017-04 aims to simplify the subsequent measurement of goodwill. Under these amendments, an entity should perform its annual, or interim, goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount. An entity should recognize an impairment charge for the amount by which the carrying amount exceeds the reporting unit’s fair value; however, the loss recognized should not exceed the total amount of goodwill allocated to that reporting unit. Additionally, an entity should consider income tax effects from any tax deductible goodwill on the carrying amount of the reporting unit when measuring the goodwill impairment loss, if applicable. The Board also eliminated the requirements for any reporting unit with a zero or negative carrying amount to perform a qualitative assessment. An entity is required to disclose the amount of goodwill allocated to each reporting unit with a zero or negative carrying amount of net assets and still has the option to perform the qualitative assessment for a reporting unit to determine if the quantitative impairment test is necessary. The amendments in this update are effective for public business entities for fiscal years beginning after December 15, 2019. Although management continues to evaluate the potential impact of ASU 2017-04 on our consolidated financial statements, at this time, we believe the adoption of this standard will not have a significant impact on our consolidated financial statements.

ASU No. 2016-13, “Financial Instruments – Credit Losses (Topic 326): Assets Measured at Amortized Cost.” ASU 2016-13 requires a financial asset (or a group of financial assets) measured at amortized cost basis to be presented at the net amount expected to be collected. The amendments in this update replace the incurred loss impairment methodology in current GAAP with a methodology that reflects expected credit losses and requires consideration of a broader range of reasonable and supportable information to inform credit loss estimates and affects loans, debt securities, trade receivables, net investments in leases, off-balance-sheet credit exposures, reinsurance receivables, and any other financial assets not excluded from the scope that have the contractual right to receive cash. For public business entities, the amendments in this update are effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. The Company has formed a CECL committee that is assessing our data and system needs. The Company has engaged a third-party vendor to assist is analyzing our data and developing a CECL model. The Company has recently met with the third-party vendor and discussed our data, in terms of what is available and potential gaps. The Company also discussed modeling standards, loan segmentation, as well as potential external inputs to supplement our historical loss history. We expect to recognize a one-time cumulative effect adjustment to the allowance for loan losses as of the beginning of the first reporting period in which the ASU is effective, but cannot yet determine the magnitude of any such one-time adjustment or the overall impact of the ASU on our consolidated financial statements.

9


CONNECTONE BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

Note 2. New Authoritative Accounting Guidance – (continued)

ASU No. 2016-02, “Leases (Topic 842)” requires the recognition of a right of use asset and related lease liability by lessees for leases classified as operating leases under current GAAP. Topic 842, which replaces the current guidance under Topic 840, retains a distinction between finance leases and operating leases. The recognition, measurement, and presentation of expenses and cash flows arising from a lease by a lessee also will not significantly change from current GAAP. For leases with a term of 12 months or less, a lessee is permitted to make an accounting policy election by class of underlying asset not to recognize right of use assets and lease liabilities. Topic 842 will be effective for the Company for reporting periods beginning January 1, 2019, with early adoption permitted. The Company must apply a modified retrospective transition approach for the applicable leases existing at, or entered into after, the beginning of the earliest comparative period presented in the consolidated financial statements. The modified retrospective approach would not require any transition accounting for leases that expired before the earliest comparative period presented. The Company is currently leasing seventeen properties as branch locations and is leasing certain office equipment. The adoption of ASU 2016-02 will result in increases to the Company's assets and liabilities. We are currently in the process of evaluating all of our leases for compliance with the new ASU. 

Note 3. Earnings per Common Share

Financial Accounting Standards Board Accounting Standards Codification (“FASB ASC”) No. 260-10-45 addresses whether instruments granted in share-based payment transactions are participating securities prior to vesting and, therefore, need to be included in the earnings allocation in computing earnings per share (“EPS”). The restricted stock awards previously granted by the Company contain non-forfeitable rights to dividends and therefore are considered participating securities. The two-class method for calculating basic EPS excludes dividends paid to participating securities and any undistributed earnings attributable to participating securities.

Earnings per common share have been computed based on the following:

      Three Months Ended Six Months Ended
June 30, June 30,
(in thousands, except for per share data)
2018       2017       2018       2017
Income attributable to common stock $      17,490 $      7,659 $      21,724 $      19,499
Earnings allocated to participating securities 37 24 54 64
Net income $ 17,527 $ 7,683 $ 21,778 $ 19,563
Weighted average common shares outstanding, including participating securities 32,134 32,008 32,106 31,991
Weighted average participating securities (20 ) (102 ) (38 ) (105 )
Weighted average common shares outstanding 32,114 31,906 32,068 31,886
Incremental shares from assumed conversions of options, performance units and restricted shares 207 350 208 347
Weighted average common and equivalent shares outstanding 32,321 32,256 32,276 32,233
 
Earnings per common share:
Basic $ 0.54 $ 0.24 $ 0.68 $ 0.61
Diluted 0.54 0.24 0.67 0.60

There were no antidilutive share equivalents as of June 30, 2018 and June 30, 2017.

10


CONNECTONE BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

Note 4. Securities Available-for-Sale

Securities available-for-sale are reported at fair value with unrealized gains or losses included in stockholders’ equity, net of tax. Accordingly, the carrying value of such securities reflects their fair value as of June 30, 2018 and December 31, 2017. Fair value is based upon either quoted market prices, or in certain cases where there is limited activity in the market for a particular instrument, assumptions are made to determine their fair value. See Note 7 of the Notes to Consolidated Financial Statements for a further discussion.

The following table summarizes the amortized cost and fair value of securities available-for-sale at June 30, 2018 and December 31, 2017 and the corresponding amounts of gross unrealized gains and losses recognized in accumulated other comprehensive income (loss).

Gross Gross
Amortized Unrealized Unrealized Fair
      Cost       Gains       Losses       Value
June 30, 2018 (dollars in thousands)
Investment securities available-for-sale
Federal agency obligations $      52,588 $      20 $      (1,124 ) $      51,484
Residential mortgage pass-through securities 184,639 135 (4,671 ) 180,103
Commercial mortgage pass-through securities 3,987 - (94 ) 3,893
Obligations of U.S. states and political subdivisions 125,885 1,003 (3,259 ) 123,629
Corporate bonds and notes 27,802 104 (442 ) 27,464
Asset-backed securities 10,889 61 (4 ) 10,946
Certificates of deposit 420 4 - 424
Other securities 2,072 - - 2,072
Total securities available-for-sale $ 408,282 $ 1,327 $ (9,594 ) $ 400,015
 
Gross Gross
Amortized Unrealized Unrealized Fair
Cost Gains Losses Value
December 31, 2017 (dollars in thousands)
Investment securities available-for-sale
Federal agency obligations $ 56,297 $ 141 $ (416 ) $ 56,022
Residential mortgage pass-through securities 183,509 330 (1,948 ) 181,891
Commercial mortgage pass-through securities 4,054 3 (3 ) 4,054
Obligations of U.S. states and political subdivisions 130,723 1,739 (1,334 ) 131,128
Trust preferred securities 4,577 205 (111 ) 4,671
Corporate bonds and notes 29,801 163 (271 ) 29,693
Asset-backed securities 12,021 66 (37 ) 12,050
Certificates of deposit 621 4 - 625
Equity securities 11,843 235 (350 ) 11,728
Other securities 3,422 - - 3,422
Total securities available-for-sale $ 436,868 $ 2,886 $ (4,470 ) $ 435,284

Effective January 1, 2018, the Company implemented ASU 2016-01, “Financial Instruments – Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities.” Under ASU 2016-01, equity securities, with certain exceptions, are to be measured at fair value with changes in fair value recognized in net income. As of June 30, 2018, the Company began separately presenting equity securities with readily determinable fair values on the Statements of Condition within the “Equity securities” caption. Net unrealized losses recognized on equity securities with readily determinable fair values for the three and six months ended as of June 30, 2018 were $47 thousand and $168 thousand, respectively.

Investment securities having a carrying value of approximately $165.9 million and $157.8 million at June 30, 2018 and December 31, 2017, respectively, were pledged to secure public deposits, borrowings, repurchase agreements, Federal Reserve Discount Window borrowings and Federal Home Loan Bank advances and for other purposes required or permitted by law. As of June 30, 2018 and December 31, 2017, there were no holdings of securities of any one issuer, other than the U.S. Government and its agencies, in an amount greater than 10% of stockholders’ equity.

11


CONNECTONE BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

Note 4. Securities Available-for-Sale – (continued)

The following table presents information for investments in securities available-for-sale at June 30, 2018, based on scheduled maturities. Actual maturities can be expected to differ from scheduled maturities due to prepayment or early call options of the issuer. Securities not due at a single maturity date are shown separately.

June 30, 2018
Amortized Fair
      Cost       Value
(dollars in thousands)
Investment Securities Available-for-Sale:
Due in one year or less $      6,817 $      6,810
Due after one year through five years 33,357 33,125
Due after five years through ten years 31,599 31,918
Due after ten years 145,811 142,094
Residential mortgage pass-through securities 184,639 180,103
Commercial mortgage pass-through securities 3,987 3,893
Other securities 2,072 2,072
Total securities available-for-sale $ 408,282 $ 400,015

Gross gains and losses from the sales, calls and maturities of securities for periods presented were as follows:

Three Months Ended Six Months Ended
June 30, June 30,
      2018       2017       2018       2017
    (dollars in thousands)
Proceeds $      - $      - $         - $      29,543
 
Gross gains on sales of securities - - - 1,596
Gross losses on sales of securities - - - -
Net gains on sales of securities - - - 1,596
Less: tax provision on net gains - - - (579 )
 
Net gains on sales of securities, after tax $ - $ - $ - $ 1,017

The Company reviews all securities for potential recognition of other-than-temporary impairment. The Company maintains a watch list for the identification and monitoring of securities experiencing problems that require a heightened level of review. This could include credit rating downgrades.

The Company’s assessment of whether an impairment in the portfolio is other-than temporary includes factors such as whether the issuer has defaulted on scheduled payments, announced restructuring and/or filed for bankruptcy, has disclosed severe liquidity problems that cannot be resolved, disclosed deteriorating financial condition or sustained significant losses.

12


CONNECTONE BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

Note 4. Securities Available-For-Sale – (continued)

Temporarily Impaired Securities

The Company does not believe that any of the unrealized losses, which were comprised of 157 and 112 securities as of June 30, 2018 and December 31, 2017, respectively, represent an other-than-temporary impairment (“OTTI”). The gross unrealized losses associated with U.S. Treasury and agency securities, federal agency obligations, mortgage-backed securities, corporate bonds, tax-exempt securities, asset-backed securities, trust preferred securities, mutual funds and equity securities are not considered to be other-than-temporary because these unrealized losses are related to changes in interest rates and do not affect the expected cash flows of the underlying collateral or issuer.

Factors which may contribute to unrealized losses include credit risk, market risk, changes in interest rates, economic cycles, and liquidity risk. The magnitude of any unrealized loss may be affected by the relative concentration of the Company’s investment in any one issuer or industry. The Company has established policies to reduce exposure through diversification of the securities portfolio including limits on concentrations to any one issuer. The Company believes the securities portfolio is prudently diversified.

The unrealized losses included in the tables below are primarily related to changes in interest rates and credit spreads. All of the Company’s securities are performing and are expected to continue to perform in accordance with their respective contractual terms and conditions. These are largely intermediate duration holdings and, in certain cases, monthly principal payments can further reduce loss exposure resulting from an increase in rates.

The Company evaluates all securities with unrealized losses quarterly to determine whether the loss is other-than-temporary. Unrealized losses in the corporate debt securities category consist primarily of senior unsecured corporate debt securities issued by large financial institutions, insurance companies and other corporate issuers. Single issuer corporate trust preferred securities are also included, and in the case of one holding the market valuation loss is largely based upon the floating rate coupon and corresponding market valuation. Neither that trust preferred issuer, nor any other corporate issuers, have defaulted on interest payments. The unrealized loss in equity securities consists of losses on other bank equities. The decline in fair value is due in large part to the lack of an active trading market for these securities, changes in market credit spreads and rating agency downgrades. Management concluded that these securities were not OTTI at June 30, 2018.

In determining whether or not securities are OTTI, the Company must exercise considerable judgment. Accordingly, there can be no assurance that the actual results will not differ from the Company’s judgments and that such differences may not require the future recognition of OTTI charges that could have a material effect on the Company’s financial position and results of operations. In addition, the value of, and the realization of any loss on, a security is subject to numerous risks as cited above.

13


CONNECTONE BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

Note 4. Securities Available-For-Sale – (continued)

The following tables indicate gross unrealized losses not recognized in income and fair value, aggregated by investment category and the length of time individual securities have been in a continuous unrealized loss position at June 30, 2018 and December 31, 2017:

June 30, 2018
Total Less than 12 Months 12 Months or Longer
Fair Unrealized Fair Unrealized Fair Unrealized
      Value       Losses       Value       Losses       Value       Losses
(dollars in thousands)
Federal agency obligation $      47,925 $      (1,125 ) $      37,267 $      (708 ) $      10,658 $      (417 )
Residential mortgage pass-through securities 172,308 (4,672 ) 113,673 (2,280 ) 58,635 (2,392 )
Commercial mortgage pass-through securities 3,893 (94 ) 3,893 (94 ) - -
Obligations of U.S. states and political subdivisions 65,916 (3,258 ) 30,625 (832 ) 35,291 (2,426 )
Corporate bonds and notes 15,653 (441 ) 11,012 (122 ) 4,641 (319 )
Asset-backed securities 2,821 (4 ) 924 - 1,897 (4 )
Certificates of Deposit 101 - 101 - - -
Total temporarily impaired securities $ 308,617 $ (9,594 ) $ 197,495 $ (4,036 ) $ 111,122 $ (5,558 )

December 31, 2017
Total Less than 12 Months 12 Months or Longer
      Fair       Unrealized       Fair       Unrealized       Fair       Unrealized
Value Losses Value Losses Value Losses
(dollars in thousands)
Investment Securities
Available-for-Sale:
Federal agency obligation $      39,813 $      (416 ) $      28,407 $      (213 ) $      11,406 $      (203 )
Residential mortgage pass-through securities 148,574 (1,948 ) 117,556 (1,146 ) 31,018 (802 )
Commercial mortgage pass-through securities 1,198 (3 ) 1,198 (3 ) - -
Obligations of U.S. states and political subdivisions 57,685 (1,334 ) 17,909 (246 ) 39,776 (1,088 )
Trust preferred securities 1,469 (111 ) - - 1,469 (111 )
Corporate bonds and notes 11,074 (271 ) 1,965 (21 ) 9,109 (250 )
Asset-backed securities 7,428 (37 ) 993 (2 ) 6,435 (35 )
Equity securities 11,116 (350 ) - - 11,116 (350 )
Total Temporarily Impaired Securities $ 278,357 $ (4,470 ) $ 168,028 $ (1,631 ) $ 110,329 $ (2,839 )

Note 5. – Derivatives

The Company utilizes interest rate swap agreements as part of its asset liability management strategy to help manage its interest rate risk position. The notional amount of the interest rate swap does not represent amounts exchanged by the parties. The amount exchanged is determined by reference to the notional amount and the other terms of the individual interest rate swap agreements.

14


CONNECTONE BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

Note 5. Derivatives – (continued)

Interest rate swaps were entered into on April 13, 2017, August 24, 2015, December 30, 2014 and October 15, 2014, each with a respective notional amount of $25 million and were designated as cash flow hedges of an FHLB advance. The swaps were determined to be fully effective during the period presented and therefore no amount of ineffectiveness has been included in net income while the aggregate fair value of the swaps is recorded in other assets (liabilities) with changes in fair value recorded in other comprehensive income (loss). The amount included in accumulated other comprehensive income (loss) would be reclassified to current earnings should the hedges no longer be considered effective. The Company expects the hedges to remain fully effective during the remaining term of the swaps.

Summary information about the interest rate swaps designated as cash flow hedges as of June 30, 2018, December 31, 2017 and June 30, 2017 are presented in the following table.

June 30, December 31, June 30,
      2018       2017       2017
(dollars in thousands)
Notional amount $      100,000 $      100,000 $      100,000
Weighted average pay rates 1.68 % 1.66 % 1.58 %
Weighted average receive rates 1.99 % 1.23 % 1.08
Weighted average maturity 1.9 years 2.4 years 3.1 years
 
Fair value $ 1,893 $ 798 $ 45

Interest expense recorded on these swap transactions totaled approximately $148,000 and $153,000 for the three and six months ended June 30, 2018, respectively, and $124,000 and $232,000 for the three and six months ended June 30, 2017, respectively.

Cash Flow Hedge

The following table presents the net losses recorded in other comprehensive income and the Consolidated Statements of Income relating to the cash flow derivative instruments for the following periods:

Six Months Ended June 30, 2018
Amount of gain Amount of gain Amount of gain (loss)
(loss) recognized (loss) reclassified recognized in other
in OCI (Effective from OCI to Noninterest income
      Portion)       interest income       (Ineffective Portion)
      (dollars in thousands)
Interest rate contracts $                   1,094 $      - $      -
 
Six Months Ended June 30, 2017
Amount of gain Amount of gain Amount of gain (loss)
(loss) recognized (loss) reclassified recognized in other
in OCI (Effective from OCI to Noninterest income
Portion) interest income (Ineffective Portion)
(dollars in thousands)
Interest rate contracts $ (43 ) $ - $ -

The following table reflects the cash flow hedges included in the consolidated statements of condition as of June 30, 2018 and December 31, 2017: 

15



June 30, 2018 December 31, 2017
Notional Notional
Amount Fair Value Amount Fair Value
(dollars in thousands)
Interest rate swaps related to FHLB advances included in assets       $      100,000       $       1,893       $      100,000       $         798


16



CONNECTONE BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

Note 6. Loans and the Allowance for Loan Losses

Loans Receivable: Loans that management has the intent and ability to hold for the foreseeable future or until maturity or payoff are reported at the principal balance outstanding, net of deferred loan fees and costs, premiums and discounts related to purchase accounting, and an allowance for loan losses. Interest income is accrued on the unpaid principal balance. Loan origination fees, net of certain direct origination costs, are deferred and recognized in interest income using the level-yield method without anticipating prepayments.

Loan segments are defined as a group of loans, which share similar initial measurement attributes, risk characteristics, and methods for monitoring and assessing credit risk. Management has determined that the Company has five segments of loans: commercial, commercial real estate, commercial construction, residential real estate (including home equity) and consumer.

The recognition of interest income on commercial, commercial real estate, commercial construction and residential loans is discontinued at the time the loan is 90 days delinquent unless the loan is well-secured and in process of collection. Past due status is based on the contractual terms of the loan. In all cases, loans are placed on nonaccrual or charged-off at an earlier date if collection of principal or interest is considered doubtful. Nonaccrual loans and loans past due 90 days still on accrual include both smaller balance homogeneous loans that are collectively evaluated for impairment and individually classified impaired loans. A loan is moved to nonaccrual status in accordance with the Company’s policy, typically after 90 days of non-payment.

All interest accrued but not received for loans placed on nonaccrual is reversed against interest income. Interest received on such loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.

The policy of the Company is to generally grant commercial, residential and consumer loans to residents and businesses within our market area. The borrowers’ abilities to repay their obligations are dependent upon various factors including the borrowers’ income and net worth, cash flows generated by the borrowers’ underlying collateral, value of the underlying collateral, and priority of the lender’s lien on the property. Such factors are dependent upon various economic conditions and individual circumstances beyond the control of the Company. The Company is therefore subject to risk of loss. The Company believes its lending policies and procedures adequately minimize the potential exposure to such risks and that adequate provisions for loan losses are provided for all known and inherent risks. Collateral and/or personal guarantees are required for a large majority of the Company’s loans.

Loans Held-for-Sale: Residential mortgage loans, originated and intended for sale in the secondary market, are carried at the lower of aggregate cost or estimated fair value as determined by outstanding commitments from investors. For these loans originated and intended for sale, gains and losses on loan sales (sale proceeds minus carrying value) are recorded in other income and direct loan origination costs and fees are deferred at origination of the loan and are recognized in other income upon sale of the loan.

Other loans held-for-sale are carried at the lower of aggregate cost or estimated fair value. Fair value of these loans is determined based on the terms of the loan, such as interest rate, maturity date, reset term, as well as sales of similar assets.

Net unrealized losses, if any, are recorded as a valuation allowance and charged to earnings.

Allowance for Loan Losses: The allowance for loan losses is a valuation allowance for probable incurred credit losses. Losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance. Management estimates the allowance balance required using past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions, and other factors. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management’s judgment, should be charged off. The allowance consists of specific and general components. The specific component relates to loans that are individually classified as impaired.

17



CONNECTONE BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

Note 6. Loans and the Allowance for Loan Losses – (continued)

A loan is impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. Loans, for which the terms have been modified, and for which the borrower is experiencing financial difficulties, are considered troubled debt restructurings (“TDRs”) and classified as impaired. As part of the evaluation of impaired loans, the Company individually reviews for impairment all non-homogeneous loans internally classified as substandard or below. Generally, smaller impaired non-homogeneous loans and impaired homogeneous loans are collectively evaluated for impairment.

Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed.

TDRs are separately identified for impairment disclosures and are measured at the present value of estimated future cash flows using the loan’s effective rate at inception. If a TDR is considered to be a collateral dependent loan, the loan is reported, net, at the fair value of the collateral. For TDRs that subsequently default, the Company determines the amount of reserve in accordance with the accounting policy for the allowance for loan losses.

The general component covers non-impaired loans and is based on historical loss experience adjusted for current factors. The historical loss experience, the primary factor, is determined by loan class and is based on the actual loss history experienced by the Bank over an actual three-year rolling calculation. This actual loss experience is supplemented with other economic factors based on the risks present for each portfolio segment and with the exogenous factor adjustments based on the risks present for each loan category. These exogenous factors include consideration of the following: concentrations of credit; delinquency & nonaccrual trends; economic & business conditions including evaluation of the national and regional economies and industries with significant loan concentrations; external factors including legal, regulatory or competitive pressures that may impact the loan portfolio; changes in the experience, ability, or size of the lending staff, management, or board of directors that may impact the loan portfolio; changes in underwriting standards, collection procedures, charge-off practices, or other changes in lending policies and procedures that may impact the loan portfolio; loss and recovery trends; changes in portfolio size and mix; and trends in problem loans.

Purchased Credit-Impaired Loans: The Company acquires groups of loans in conjunction with mergers, some of which have shown evidence of credit deterioration since origination. These purchased credit-impaired loans are recorded at their estimated fair value, such that there is no carryover of the seller’s allowance for loan losses (“ALLL”). After acquisition, probable incurred credit losses are recognized by an increase in the ALLL.

Such purchased credit-impaired loans (“PCI”) are identified on an individual basis. The Company estimates the amount and timing of expected cash flows for each loan and the expected cash flows in excess of amount paid is recorded as interest income over the remaining life of the loan (accretable yield). The excess of the loan’s contractual principal and interest over expected cash flows is not recorded (nonaccretable difference).

A PCI loan may be resolved either through a sale of the loan, by working with the customer and obtaining partial or full repayment, by short sale of the collateral, or by foreclosure. A gain or loss on resolution would be recognized based on the difference between the proceeds received and the carrying amount of the loan.

PCI loans that met the criteria for nonaccrual may be considered performing, regardless of whether the customer is contractually delinquent, if management can reasonably estimate the timing and amount of the expected cash flows on such loans and if management expects to fully collect the new carrying value of the loans. As such, management may no longer consider the loans to be nonaccrual or nonperforming and may accrue interest on these loans, including the impact of any accretable discount.

18



CONNECTONE BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

Note 6. Loans and the Allowance for Loan Losses – (continued)

Loans receivable - The following table sets forth the composition of the Company’s loan portfolio, including net deferred loan fees, at June 30, 2018 and December 31, 2017:

June 30, December 31,
2018       2017
                     (dollars in thousands)
Commercial $      853,629 $     824,082
Commercial real estate 2,717,644 2,592,909
Commercial construction 498,607 483,216
Residential real estate 288,449 271,795
Consumer 5,637 2,808
Gross loans 4,363,966 4,174,810
Net deferred loan fees (3,112 ) (3,354 )
Total loans receivable $ 4,360,854 $ 4,171,456

At June 30, 2018 and December 31, 2017, loan balances of approximately $2.2 billion and $1.9 billion, respectively, were pledged to secure borrowings from the FHLB of New York.

Loans held-for-sale - The following table sets forth the composition of the Company’s loans held-for-sale portfolio at June 30, 2018 and December 31, 2017:

      June 30,       December 31,
2018 2017
(dollars in thousands)
Commercial real estate $                     - $            24,475
Increase in valuation allowance - 370
Total carrying amount $ - $ 24,845

Valuation allowance - The following table sets forth the composition of the Company’s valuation allowance within the loans held-for-sale portfolio during the three and six months ended June 30, 2018 and June 30, 2017:

      Three Months   Three Months
Ended Ended
June 30, 2018   June 30, 2017
(dollars in thousands)
Balance at April 1, $      -       $      2,600
Increase in valuation allowance - 9,725
Balance at June 30, $ - $ 12,325
 
Six Months Six Months
Ended Ended
June 30, 2018   June 30, 2017
(dollars in thousands)
Balance at January 1, $ - $ -
Residential real estate - 12,325
Balance at June 30, $ - $ 12,325

19



CONNECTONE BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

Note 6. Loans and the Allowance for Loan Losses – (continued)

Purchased Credit-Impaired Loans: The Company holds purchased loans for which there was, at their acquisition date, evidence of deterioration of credit quality since their origination and it was probable, at acquisition, that all contractually required payments would not be collected. The recorded investment of those loans is as follows at June 30, 2018 and December 31, 2017.

      June 30,       December 31,
     2018 2017
      (dollars in thousands)
Commercial $      2,629       $            2,683

For those purchased loans disclosed above, the Company did not increase the allowance for loan losses during either the three or six months ended June 30, 2018 and June 30, 2017. There were no reversals from the allowance for loan losses during the three and six months ended June 30, 2018 and June 30, 2017.

The following table presents the accretable yield, or income expected to be collected, on the purchased credit-impaired loans for three and six months ended June 30, 2018 and June 30, 2017:

                Three Months Three Months
Ended       Ended
June 30, 2018 June 30, 2017
(dollars in thousands)
Balance at April 1, $           1,322 $         2,674
Accretion of income (63 ) (178 )
Balance at June 30, $ 1,259 $ 2,496
 
Six Months Six Months
Ended Ended
June 30, 2018 June 30, 2017
(dollars in thousands)
Balance at January 1, $                1,387 $              2,860
Accretion of income (128 ) (364 )
Balance at June 30, $ 1,259 $ 2,496

Loans Receivable on Nonaccrual Status - The following table sets forth the composition of the Company’s nonaccrual loans as of June 30, 2018 and December 31, 2017:

June 30, December 31,
2018 2017
(dollars in thousands)
Commercial $      29,205 $            47,363
Commercial real estate       15,657       12,757
Residential real estate 4,853 5,493
Total nonaccrual loans $ 49,715 $ 65,613

Nonaccrual loans and loans 90 days or greater past due and still accruing include both smaller balance homogeneous loans that are collectively evaluated for impairment and loans individually evaluated for impairment.

The decrease in nonaccruals from the year-end 2017 was mainly attributable to a $17.0 million charge-off, related to the taxi medallion loan portfolio (which is included in the Commercial loan segment) that took place during the first quarter of 2018. The taxi medallion loan portfolio was classified as substandard and impaired as of June 30, 2018 and December 31, 2017.

20



CONNECTONE BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

Note 6. Loans and the Allowance for Loan Losses – (continued)

The Company continuously monitors the credit quality of its loans receivable. In addition to its internal monitoring, the Company utilizes the services of a third-party loan review firm to periodically validate the credit quality of its loans receivable on a sample basis. Credit quality is monitored by reviewing certain credit quality indicators. Assets classified “Pass” are deemed to possess average to superior credit quality, requiring no more than normal attention. Assets classified as “Special Mention” have generally acceptable credit quality yet possess higher risk characteristics/circumstances than satisfactory assets. Such conditions include strained liquidity, slow pay, stale financial statements, or other conditions that require more stringent attention from the lending staff. These conditions, if not corrected, may weaken the loan quality or inadequately protect the Company’s credit position at some future date. Assets are classified “Substandard” if the asset has a well-defined weakness that requires management’s attention to a greater degree than for loans classified special mention. Such weakness, if left uncorrected, could possibly result in the compromised ability of the loan to perform to contractual requirements. An asset is classified as “Doubtful” if it is inadequately protected by the net worth and/or paying capacity of the obligor or of the collateral, if any, that secures the obligation. Assets classified as doubtful include assets for which there is a “distinct possibility” that a degree of loss will occur if the inadequacies are not corrected. All loans past due 90 days or greater and all impaired loans are included in the appropriate category below.

Credit Quality Indicators - The following table presents information, excluding loans held-for-sale and net deferred loan fees, about the Company’s loan credit quality at June 30, 2018 and December 31, 2017:

      June 30, 2018
      Special                  
Pass Mention Substandard Doubtful Total
(dollars in thousands)
Commercial $      806,912 $ 13,301 $ 33,416 $ - $      853,629
Commercial real estate 2,671,130 16,376 30,138 - 2,717,644
Commercial construction 491,007 3,167 4,433 - 498,607
Residential real estate 282,784 - 5,665 - 288,449
Consumer 5,609 - 28 - 5,637
Gross loans $ 4,257,442 $ 32,844 $ 73,680 $ - $ 4,363,966
 
December 31, 2017
Special
Pass Mention Substandard Doubtful Total
(dollars in thousands)
Commercial $      767,020 $      3,764 $      53,298 $      - $ 824,082
Commercial real estate 2,534,973 34,335 23,601 - 2,592,909
Commercial construction 475,066 5,521 2,629 - 483,216
Residential real estate 266,163 - 5,632 - 271,795
Consumer 2,767 - 41 - 2,808
Gross loans $ 4,045,989 $ 43,620 $ 85,201 $ - $ 4,174,810

21


CONNECTONE BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

Note 6. Loans and the Allowance for Loan Losses – (continued)

The following table provides an analysis of the impaired loans by segment as of June 30, 2018 and December 31, 2017:

June 30, 2018
            Unpaid      
Recorded Principal Related
Investment Balance Allowance
No related allowance recorded (dollars in thousands)
Commercial $      31,301 $      91,966
Commercial real estate 23,354 23,477
Commercial construction 7,600 7,600
Residential real estate 2,528 2,811
Consumer - -
Total $ 64,783 $ 125,854
 
With an allowance recorded
Commercial real estate $ 8,539 $ 8,539 $      672
  
Total
Commercial $ 31,301 $ 91,966 $ -
Commercial real estate 31,893 32,016 672
Commercial construction 7,600 7,600 -
Residential real estate 2,528 2,811 -
Consumer - - -
Total (including allowance) $ 73,322 $ 134,393 $ 672
 
December 31, 2017
Unpaid
Recorded Principal Related
Investment Balance Allowance
No related allowance recorded (dollars in thousands)
Commercial $ 49,761 $ 101,066
Commercial real estate 23,905 23,976
Commercial construction 6,662 6,662
Residential real estate 3,203 3,442
Consumer - -
Total $ 83,531 $ 135,146
 
With an allowance recorded
Commercial real estate $ 1,133 $ 1,133 $ 39
 
Total
Commercial $ 49,761 $ 101,066 $ -
Commercial real estate 25,038 25,109 39
Commercial construction 6,662 6,662 -
Residential real estate 3,203 3,442 -
Consumer - - -
Total (including allowance) $ 84,664 $ 136,279 $ 39

22


CONNECTONE BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

Note 6. Loans and the Allowance for Loan Losses – (continued)

The following table provides an analysis related to the average recorded investment and interest income recognized on impaired loans by segment as of and for the three and six months ended June 30, 2018 and 2017:

      Three Months Ended June 30, Six Months Ended June 30,
2018       2017 2018       2017
Average       Interest Average       Interest       Average       Interest Average       Interest
Recorded Income Recorded Income Recorded Income Recorded Income
Investment Recognized Investment Recognized Investment Recognized Investment Recognized
(dollars in thousands)
Impaired loans (no allowance)
Commercial $      38,770 $      35 $      3,209 $      42 $ 42,056 $      66 $      3,230 $      81
Commercial real estate 23,422 127 15,456 97 23,504 370 14,526 203
Commercial construction 9,225 176 4,263 69 9,845 295 4,266 152
Residential real estate 2,569 - 1,200 2 2,599 - 1,210 4
Consumer - - 54 - - - 56 1
Total $ 73,986 $ 338 $ 24,182 $ 210 $    78,004 $ 731 $ 23,288 $ 441
 
Impaired loans (allowance):
Commercial real estate $ 8,544 $ 11 $ 1,933 $ 33 $ 8,548 $ 23 $ 1,941 $ 38
 
Total impaired loans:
Commercial $ 38,770 $ 35 $ 3,209 $ 42 $ 42,056 $ 66 $ 3,230 $ 81
Commercial real estate 31,966 138 17,389 130 32,052 393 16,467 241
Commercial construction 9,225 176 4,263 69 9,845 295 4,266 152
Residential mortgage 2,569 - 1,200 2 2,599 - 1,210 4
Consumer - - 54 - - - 56 1
 
Total $ 82,530 $ 349 $ 26,115 $ 233 $ 86,552 $ 754 $ 25,229 $ 479

Included in impaired loans at June 30, 2018 and December 31, 2017 are loans that are deemed troubled debt restructurings. The recorded investment in loans include accrued interest receivable and other capitalized costs such as real estate taxes paid on behalf of the borrower and loan origination fees, net, when applicable. Cash basis interest and interest income recognized on accrual basis approximate each other.

23


CONNECTONE BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

Note 6. Loans and the Allowance for Loan Losses – (continued)

The following table provides an analysis of the aging of gross loans (excluding loans held-for-sale) that are past due at June 30, 2018 and December 31, 2017 by segment:

Aging Analysis

     June 30, 2018
          90 Days or                    
Greater Past Total Past
30-59 Days 60-89 Days Due and Still Due and
Past Due Past Due Accruing Nonaccrual Nonaccrual Current Gross Loans
(dollars in thousands)
Commercial $     252 $     122 $      437 $      29,205 $     30,016 $     823,613 $     853,629
Commercial real estate 326 5,307 - 15,657 21,290 2,696,354 2,717,644
Commercial construction - - - - - 498,607 498,607
Residential real estate - 69 - 4,853 4,922 283,527 288,449
Consumer - 6 - - 6 5,631 5,637
Total $ 578 $ 5,504 $ 437 $ 49,715 $ 56,234 $ 4,307,732 $ 4,363,966
 
December 31, 2017
90 Days or
Greater Past Total Past
30-59 Days 60-89 Days Due and Still Due and
Past Due Past Due Accruing Nonaccrual Nonaccrual Current Gross Loans
(dollars in thousands)
Commercial $ 1,708 $ 183 $ 1,664 $ 47,363 $ 50,918 $ 773,164 $ 824,082
Commercial real estate 545 1,475 - 12,757 14,777 2,578,132 2,592,909
Commercial construction - - - - - 483,216 483,216
Residential real estate 1,578 - - 5,493 7,071 264,724 271,795
Consumer 18 - - - 18 2,790 2,808
Total $ 3,849 $ 1,658 $ 1,664 $ 65,613 $ 72,784 $ 4,102,026 $ 4,174,810

Included in the 90 days or greater past due and still accruing category as of both June 30, 2018 and December 31, 2017 is one purchased credit-impaired loan, net of its fair value marks, which accretes income per its valuation at date of acquisition.

24


CONNECTONE BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

Note 6. Loans and the Allowance for Loan Losses – (continued)

The following tables detail, at the period-end presented, the amount of gross loans (excluding loans held-for-sale) that are evaluated individually, and collectively, for impairment, those acquired with deteriorated credit quality, and the related portion of the allowance for loan losses (“ALLL”) that are allocated to each loan portfolio segment:

June 30, 2018
      Commercial Commercial Residential
Commercial       real estate       construction       real estate       Consumer       Unallocated       Total
(dollars in thousands)
ALLL
Individually evaluated for impairment $      - $      672 $      - $      - $      - $      - $      672
Collectively evaluated for impairment 8,760 16,399 4,812 1,167 3 431 31,572
Acquired portfolio 200 1,150 - - - - 1,350
Acquired with deteriorated credit quality - - - - - - -
Total $ 8,960 $ 18,221 $ 4,812 $ 1,167 $ 3 $ 431 $ 33,594
 
Gross loans
Individually evaluated for impairment $ 31,301 $ 31,893 $ 7,600 $ 2,528 $ - $ 73,322
Collectively evaluated for impairment 809,832 2,391,316 491,007 237,726 5,233 3,935,114
Acquired portfolio 9,867 294,435 - 48,195 404 352,901
Acquired with deteriorated credit quality 2,629 - - - - 2,629
Total $ 853,629 $ 2,717,644 $ 498,607 $ 288,449 $ 5,637 $ 4,363,966
 
December 31, 2017
Commercial Commercial Residential
Commercial real estate construction  real estate Consumer Unallocated Total
(dollars in thousands)
Allowance for loan losses
Individually evaluated for impairment $ - $ 39 $ - $ - $ - $ - $ 39
Collectively evaluated for impairment 8,032 15,472 4,747 1,051 2 605 29,909
Acquired portfolio 200 1,600 - - - - 1,800
Acquired with deteriorated credit quality - - - - - - -
Total $ 8,232 $ 17,111 $ 4,747 $ 1,051 $ 2 $ 605 $ 31,748
 
Gross loans
Individually evaluated for impairment $ 49,761 $ 25,038 $ 6,662 $ 3,203 $ - $ 84,664
Collectively evaluated for impairment 757,923 2,190,686 476,554 212,350 2,338 3,639,851
Acquired portfolio 13,715 377,185 - 56,242 470 447,612
Acquired with deteriorated credit quality 2,683 - - - - 2,683
Total $ 824,082 $ 2,592,909 $ 483,216 $ 271,795 $ 2,808 $ 4,174,810

25


CONNECTONE BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

Note 6. Loans and the Allowance for Loan Losses – (continued)

The Company’s allowance for loan losses is analyzed quarterly. Many factors are considered, including growth in the portfolio, delinquencies, nonaccrual loan levels, and other factors inherent in the extension of credit. There have been no material changes to the allowance for loan losses (“ALLL”) methodology as disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017.

A summary of the activity in the ALLL is as follows:

     Three Months Ended June 30, 2018
     Commercial      Commercial      Residential               
Commercial real estate construction real estate Consumer Unallocated Total
(dollars in thousands)
Balance at March 31, 2018 $         8,550 $      17,435 $           4,772 $         1,109 $       2 $           661 $    32,529
                                                       
Charge-offs (46 ) - - - (1 ) - (47 )
                                                       
Recoveries 12 - - - - - 12
                                                       
Provision for loan losses 444 786 40 58 2 (230 ) 1,100
                                                       
Balance at June 30, 2018 $ 8,960 $ 18,221 $ 4,812 $ 1,167 $ 3 $ 431 $ 33,594
 
Three Months Ended June 30, 2017
Commercial Commercial Residential
Commercial real estate construction real estate Consumer Unallocated Total
(dollars in thousands)
Balance at March 31, 2017 $ 6,667 $ 14,118 $ 4,574 $ 1,008 $ 3 $ 531 $ 26,901
                                                       
Charge-offs - - - - (10 ) - (10 )
                                                       
Recoveries 15 45 - - - - 60
                                                       
Provision 556 1,226 (333 ) (23 ) 9 15 1,450
                                                       
Balance at June 30, 2017 $ 7,238 $ 15,389 $ 4,241 $ 985 $ 2 $ 546 $ 28,401

26



CONNECTONE BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

Note 6. Loans and the Allowance for Loan Losses – (continued)

    Six Months Ended June 30, 2018
    Commercial     Commercial     Residential            
Commercial real estate construction real estate Consumer Unallocated Total
(dollars in thousands)
Balance at December 31, 2017 $       8,233 $        17,112 $            4,747 $        1,050 $         1 $           605 $    31,748
                                                         
Charge-offs (17,066 ) - - (18 ) (1 ) - (17,085 )
                                                         
Recoveries 31 - - - - - 31
                                                         
Provision 17,762 1,109 65 135 3 (174 ) 18,900
                                                         
Balance at June 30, 2018 $ 8,960 $ 18,221 $ 4,812 $ 1,167 $ 3 $ 431 $ 33,594
 
Six Months Ended June 30, 2017
Commercial Commercial Residential
Commercial real estate construction real estate Consumer Unallocated Total
(dollars in thousands)
Balance at December 31, 2016 $ 6,632 $ 12,583 $ 4,789 $ 958 $ 3 $ 779 $ 25,744
                                                         
Charge-offs - (71 ) - - (11 ) - (82 )
                                                         
Recoveries 141 48 - - - - 189
                                                         
Provision 465 2,829 (548 ) 27 10 (233 ) 2,550
                                                         
Balance at June 30, 2017 $ 7,238 $ 15,389 $ 4,241 $ 985 $ 2 $ 546 $ 28,401

27



CONNECTONE BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

Note 6. Loans and the Allowance for Loan Losses – (continued)

Troubled Debt Restructurings: Loans are considered to have been modified in a troubled debt restructuring (“TDRs”) when due to a borrower’s financial difficulties, the Company makes certain concessions to the borrower that it would not otherwise consider. Modifications may include interest rate reductions, principal or interest forgiveness, forbearance, and other actions intended to minimize economic loss and to avoid foreclosure or repossession of collateral. Generally, a nonaccrual loan that has been modified in a TDR remains on nonaccrual status for a period of nine months to demonstrate that the borrower is able to meet the terms of the modified loan. However, performance prior to the modification, or significant events that coincide with the modification, are included in assessing whether the borrower can meet the new terms and may result in the loan being returned to accrual status at the time of loan modification or after a shorter performance period. If the borrower’s ability to meet the revised payment schedule is uncertain, the loan remains on nonaccrual status.

The following table presents a rollforward of TDRs and the related changes to the allowance for loan losses (“ALLL”) that occurred for the periods presented:

       Six Months Ended Year Ended
June 30, 2018 December 31, 2017
(dollars in thousands)
Recorded             Recorded      
Investment ALLL Investment ALLL
Troubled Debt Restructurings
 
Beginning balance $       20,518 $      - $       13,818 $      -
Additions 17,966 147 10,378 -
Payoffs/paydowns (4,848 ) - (3,098 ) -
Transfers - - (580 ) -
Other - (125 ) - -
Ending balance $ 33,636 $ 22 $ 20,518 $ -

TDRs totaled $33.6 million at June 30, 2018, of which $20.8 million were on nonaccrual status and $12.8 million were performing under restructured terms. At December 31, 2017, TDRs totaled $20.5 million, of which $5.6 million were on nonaccrual status and $14.9 million were performing under restructured terms. TDRs as of June 30, 2018 increased the ALLL during the three and six months ended June 30, 2018 by $-0- thousand and $147 thousand, respectively. During the three months ended June 30, 2018, one commercial construction loan and one commercial real estate loan showed collateral improvement, resulting in approximately $125 thousand reduction in specific reserve allocations. There were no charge-offs in connection with a loan modification at the time of modification during the three and six months ended June 30, 2018. There were no TDRs for which there was a payment default within twelve months following the modification during the three and six months ended June 30, 2018.

The following table presents loans by class modified as TDRs that occurred during the six months ended June 30, 2018 (dollars in thousands):

            Pre-Modification       Post-Modification
Outstanding Outstanding
Number of Recorded Recorded
Loans Investment Investment
Troubled debt restructurings:
Commercial 30 $ 15,613 $ 15,613
Commercial real estate 1 60 60
Commercial construction 2 1,839 1,839
Residential 2 454 454
 
Total 35 $ 17,966 $ 17,966

Included in the commercial loan segment of the troubled debt restructurings are 27 taxi medallion loans totaling $11.2 million. These loan modifications included interest rate reductions and maturity extensions. All 27 taxi medallion loans included above were on nonaccrual status prior to modification, and remain on nonaccrual status post-modification.

28



CONNECTONE BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

Note 6. Loans and the Allowance for Loan Losses – (continued)

TDRs totaled $15.1 million at June 30, 2017, of which $4.9 million were on nonaccrual status and $10.2 million were performing under restructured terms. TDRs as of June 30, 2017 did not increase the ALLL during the three and six months ended June 30, 2017. There were no charge-offs in connection with a loan modification at the time of modification during the three or six months ended June 30, 2017. There were no TDRs for which there was a payment default within twelve months following the modification during the three and six months ended June 30, 2017.

The following table presents loans by segment modified as troubled debt restructurings that occurred during the six months ended June 30, 2017:

            Pre-Modification       Post-Modification
Outstanding Outstanding
Number of Recorded Recorded
Loans Investment Investment
    (dollars in thousands)
Troubled debt restructurings:
Commercial real estate 2 $ 3,042 $ 3,042
Residential 1 17 17
 
Total 3 $ 3,059 $ 3,059

Note 7. Fair Value Measurements and Fair Value of Financial Instruments

Fair value is the exchange price that would be received for an asset or paid to transfer a liability (exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date.

Level 1: Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities.

Level 2: Quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument.

Level 3: Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (for example, supported with little or no market activity).

29



CONNECTONE BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

Note 7. Fair Value Measurements and Fair Value of Financial Instruments – (continued)

An asset’s or liability’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement. The following information should not be interpreted as an estimate of the fair value of the entire Company since a fair value calculation is only provided for a limited portion of the Company’s assets and liabilities. Due to a wide range of valuation techniques and the degree of subjectivity used in making the estimates, comparisons between the Company’s disclosures and those of other companies may not be meaningful.

Assets and Liabilities Measured at Fair Value on a Recurring Basis

The following methods and assumptions were used to estimate the fair values of the Company’s assets measured at fair value on a recurring basis at June 30, 2018 and December 31, 2017:

Securities Available-for-Sale and Equity Securities: Where quoted prices are available in an active market, securities are classified within Level 1 of the valuation hierarchy. Level 1 inputs include securities that have quoted prices in active markets for identical assets. If quoted market prices are not available, then fair values are estimated by using pricing models, quoted prices of securities with similar characteristics, or discounted cash flows. Examples of instruments which would generally be classified within Level 2 of the valuation hierarchy include municipal bonds and certain agency collateralized mortgage obligations. In certain cases where there is limited activity in the market for a particular instrument, assumptions must be made to determine the fair value of the instruments and these are classified as Level 3. When measuring fair value, the valuation techniques available under the market approach, income approach and/or cost approach are used. The Company’s evaluations are based on market data and the Company employs combinations of these approaches for its valuation methods depending on the asset class.

Derivatives: The fair value of derivatives is based on valuation models using observable market data as of the measurement date (level 2). Our derivatives are traded in an over-the-counter market where quoted market prices are not always available. Therefore, the fair values of derivatives are determined using quantitative models that utilize multiple market inputs. The inputs will vary based on the type of derivative, but could include interest rates, prices and indices to generate continuous yield or pricing curves, prepayment rate, and volatility factors to value the position. The majority of market inputs are actively quoted and can be validated through external sources, including brokers, market transactions and third-party pricing services.

30



CONNECTONE BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

Note 7. Fair Value Measurements and Fair Value of Financial Instruments – (continued)

For financial assets and liabilities measured at fair value on a recurring basis, the fair value measurements by level within the fair value hierarchy used at June 30, 2018 and December 31, 2017 are as follows:

June 30, 2018
Fair Value Measurements at Reporting Date Using
Quoted Prices
in Active Significant
Markets for Other Significant
Identical Observable Unobservable
Assets Inputs Inputs
            (Level 1)       (Level 2)       (Level 3)
(dollars in thousands)
Recurring fair value measurements:
Assets
Investment securities:
Available-for-sale:
Federal agency obligations $ 51,484 $ - $ 51,484 $ -
Residential mortgage pass-through securities 180,103 - 180,103 -
Commercial mortgage pass-through securities 3,893 - 3,893 -
Obligations of U.S. states and political subdivision 123,629 - 114,124 9,505
Corporate bonds and notes 27,464 - 27,464 -
Asset-backed securities 10,946 - 10,946 -
Certificates of deposit 424 - 424 -
Other securities 2,072 2,072 - -
Total available-for-sale $ 400,015 $ 2,072 $ 388,438 $ 9,505
 
Equity securities 11,559 11,559 - -
 
Derivatives 1,893 - 1,893 -
Total assets $      413,467 $      13,631 $      390,331 $      9,505

31


CONNECTONE BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

Note 7. Fair Value Measurements and Fair Value of Financial Instruments – (continued)

December 31, 2017
Fair Value Measurements at Reporting Date Using
Quoted Prices
in Active Significant
Markets for Other Significant
Identical Observable Unobservable
Assets Inputs Inputs
            (Level 1)       (Level 2)       (Level 3)
(dollars in thousands)
Recurring fair value measurements:
Assets
Investment securities:
Available-for-sale:
Federal agency obligations $ 56,022 $ - $ 56,022 $ -
Residential mortgage pass-through securities 181,891 - 181,891 -
Commercial mortgage pass-through securities 4,054 - 4,054 -
Obligations of U.S. states and political subdivision 131,128 - 121,496 9,632
Trust preferred securities 4,671 - 4,671 -
Corporate bonds and notes 29,693 - 29,693 -
Asset-backed securities 12,050 - 12,050 -
Certificates of deposit 625 - 625 -
Equity securities 11,728 11,728 - -
Other securities 3,422 3,422 - -
Total available-for-sale $ 435,284 $ 15,150 $ 410,502 $ 9,632
Derivatives 798 - 798 -
Total assets $      436,082 $      15,150 $      411,300 $      9,632

There were no transfers between Level 1 and Level 2 during the quarter ended June 30, 2018 and during the year ended December 31, 2017.

Assets Measured at Fair Value on a Nonrecurring Basis

The Company may be required periodically to measure certain assets at fair value on a nonrecurring basis in accordance with GAAP. These adjustments to fair value usually result from the application of lower of cost or fair value accounting or impairment write-downs of individual assets. The following methods and assumptions were used to estimate the fair values of the Company’s assets measured at fair value on a nonrecurring basis at June 30, 2018 and December 31, 2017:

Loans Held-for-Sale: Residential mortgage loans, originated and intended for sale in the secondary market, are carried at the lower of aggregate cost or estimated fair value as determined by outstanding commitments from investors. For these loans originated and intended for sale, gains and losses on loan sales (sale proceeds minus carrying value) are recorded in other income and direct loan origination costs and fees are deferred at origination of the loan and are recognized in other income upon sale of the loan. Management obtains quotes or bids on all or part of these loans directly from the purchasing financial institutions (Level 2).

32


CONNECTONE BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

Note 7. Fair Value Measurements and Fair Value of Financial Instruments – (continued)

Impaired Loans: The Company may record adjustments to the carrying value of loans based on fair value measurements, generally as partial charge-offs of the uncollectible portions of these loans. These adjustments also include certain impairment amounts for collateral dependent loans calculated in accordance with GAAP. Impairment amounts are generally based on the fair value of the underlying collateral supporting the loan and, as a result, the carrying value of the loan less the calculated impairment amount applicable to that loan does not necessarily represent the fair value of the loan. Real estate collateral is valued using independent appraisals or other indications of value based on recent comparable sales of similar properties or assumptions generally observable by market participants. However, due to the substantial judgment applied and limited volume of activity as compared to other assets, fair value is based on Level 3 inputs. Estimates of fair value used for collateral supporting commercial loans generally are based on assumptions not observable in the market place and are also based on Level 3 inputs.

For assets measured at fair value on a nonrecurring basis, the fair value measurements at June 30, 2018 and December 31, 2017 are as follows:

Fair Value Measurements at Reporting Date Using
            Quoted            
Prices
in Active Significant
Markets for Other Significant
Identical Observable Unobservable
Assets Inputs Inputs
Assets measured at fair value on a nonrecurring basis: June 30, 2018 (Level 1) (Level 2) (Level 3)
Impaired loans: (dollars in thousands)
Commercial real estate $ 7,866 $ - $ - $ 7,866
 
Fair Value Measurements at Reporting Date Using
Quoted
Prices
in Active Significant
Markets for Other Significant
Identical Observable Unobservable
December 31, Assets Inputs Inputs
Assets measured at fair value on a nonrecurring basis: 2017 (Level 1) (Level 2) (Level 3)
Impaired loans: (dollars in thousands)
Commercial real estate $      1,094 $      - $      - $      1,094

Impaired loansCollateral dependent impaired loans at June 30, 2018 that required a valuation allowance were $8.5 million with a related valuation allowance of $0.7 million compared to $1.1 million with a related valuation allowance of $39 thousand at December 31, 2017.

33


CONNECTONE BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

Note 7. Fair Value Measurements and Fair Value of Financial Instruments – (continued)

Assets Measured With Significant Unobservable Level 3 Inputs

Recurring basis

The tables below present a reconciliation of all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the six months ended June 30, 2018 and for the year ended December 31, 2017:

      Municipal
Securities
(dollars in thousands)
Beginning balance, January 1, 2018 $ 9,632
Principal paydowns (127 )
Ending balance, June 30, 2018 $ 9,505
   
Municipal
Securities
(dollars in thousands)
Beginning balance, January 1, 2017 $