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Section 1: 10-K (FORM 10-K)

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

 

 

 FORM 10-K

 

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

 

For the fiscal year ended December 31, 2018

 

Commission file number 0-14237

 

FIRST UNITED CORPORATION

(Exact name of registrant as specified in its charter)

 

Maryland   52-1380770
(State or other jurisdiction of incorporation or organization)   (I.R.S. Employer Identification Number)

 

19 South Second Street, Oakland, Maryland   21550
(Address of principal executive offices)   (Zip Code)

 

Registrant’s telephone number, including area code: (800) 470-4356

 

Securities registered pursuant to Section 12(b) of the Act:

 

Title of Each Class:   Name of Each Exchange on Which Registered:
Common Stock, par value $.01 per share   NASDAQ Global Select Market

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ¨ No þ

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act. Yes ¨ No þ

 

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 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 þ No ¨

 

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted 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 such files). Yes þ No ¨

 

Indicate by check mark if disclosures of delinquent filers pursuant to Item 405 of Regulation S-K (Section 229.405 of this chapter) is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K ¨

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “accelerated filer”, “large 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 þ Smaller reporting company þ
Emerging growth 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 13(a) of the Exchange Act. ¨

 

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

 

The aggregate market value of the registrant’s outstanding voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrant’s most recently completed second fiscal quarter: $116,882,008.

 

The number of shares of the registrant’s common stock outstanding as of February 28, 2019: 7,088,987.

 

Documents Incorporated by Reference

 

Portions of the registrant’s definitive proxy statement for the 2019 Annual Meeting of Shareholders to be filed with the SEC pursuant to Regulation 14A are incorporated by reference into Part III of this Annual Report on Form 10-K.

 

 

 

 

 

 

First United Corporation

Table of Contents

 

FORWARD LOOKING STATEMENTS 3
   
PART I    
ITEM 1. Business 3
ITEM 1A. Risk Factors 14
ITEM 1B. Unresolved Staff Comments 21
ITEM 2. Properties 21
ITEM 3. Legal Proceedings 21
ITEM 4. Mine Safety Disclosures 21
     
PART II    
ITEM 5. Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities 22
ITEM 6. Selected Financial Data 23
ITEM 7. Management's Discussion and Analysis of Financial Condition & Results of Operations 24
ITEM 7A. Quantitative and Qualitative Disclosures About Market Risk 48
ITEM 8. Financial Statements and Supplementary Data 48
ITEM 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 114
ITEM 9A. Controls and Procedures 114
ITEM 9B. Other Information 116
     
PART III    
ITEM 10. Directors, Executive Officers and Corporate Governance 116
ITEM 11. Executive Compensation 116
ITEM 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 117
ITEM 13. Certain Relationships and Related Transactions, and Director Independence 117
ITEM 14. Principal Accountant Fees and Services 117
     
PART IV    
ITEM 15. Exhibits and Financial Statement Schedules 118
SIGNATURES 120

 

[2]

 

 

As used in this Annual Report of Form 10-K, the terms “the Corporation”, “we”, “us”, and “our” mean First United Corporation and unless the context clearly suggests otherwise, its consolidated subsidiaries.

 

FORWARD LOOKING STATEMENTS

 

This Annual Report on Form 10-K of First United Corporation contains forward-looking statements within the meaning of The Private Securities Litigation Reform Act of 1995. Such statements include projections, predictions, expectations or statements as to beliefs or future events or results or refer to other matters that are not historical facts. Forward-looking statements are subject to known and unknown risks, uncertainties and other factors that could cause the actual results to differ materially from those contemplated by the statements. The forward-looking statements contained in this annual report are based on various factors and were derived using numerous assumptions. In some cases, you can identify these forward-looking statements by words like “may”, “will”, “should”, “expect”, “plan”, “anticipate”, “intend”, “believe”, “estimate”, “predict”, “potential”, or “continue” or the negative of those words and other comparable words. You should be aware that those statements reflect only our predictions. If known or unknown risks or uncertainties should materialize, or if underlying assumptions should prove inaccurate, actual results could differ materially from past results and those anticipated, estimated or projected. You should bear this in mind when reading this annual report and not place undue reliance on these forward-looking statements. Factors that might cause such differences include, but are not limited to:

 

·changes in market rates and prices may adversely impact the value of securities, loans, deposits and other financial instruments and the interest rate sensitivity of our balance sheet;

 

·our liquidity requirements could be adversely affected by changes in our assets and liabilities;

 

·the effect of legislative or regulatory developments, including changes in laws concerning taxes, banking, securities, insurance and other aspects of the financial services industry;

 

·competitive factors among financial services organizations, including product and pricing pressures and our ability to attract, develop and retain qualified banking professionals;

 

·the effect of changes in accounting policies and practices, as may be adopted by the Financial Accounting Standards Board (the “FASB”), the Securities and Exchange Commission (the “SEC”), and other regulatory agencies; and

 

·the effect of fiscal and governmental policies of the United States federal government.

 

You should also consider carefully the risk factors discussed in Item 1A of Part I of this annual report, which address additional factors that could cause our actual results to differ from those set forth in the forward-looking statements and could materially and adversely affect our business, operating results and financial condition. The risks discussed in this annual report are factors that, individually or in the aggregate, management believes could cause our actual results to differ materially from expected and historical results. You should understand that it is not possible to predict or identify all such factors. Consequently, you should not consider such disclosures to be a complete discussion of all potential risks or uncertainties.

 

The forward-looking statements speak only as of the date on which they are made, and, except to the extent required by federal securities laws, we undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date on which the statement is made or to reflect the occurrence of unanticipated events. In addition, we cannot assess the impact of each factor on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements.

 

PART I

 

ITEM 1.BUSINESS

 

General

 

First United Corporation is a Maryland corporation chartered in 1985 and a bank holding company registered with the Board of Governors of the Federal Reserve System (the “Federal Reserve”) under the Bank Holding Company Act of 1956, as amended (the “BHC Act”). The Corporation’s primary business is serving as the parent company of First United Bank & Trust, a Maryland trust company (the “Bank”), First United Statutory Trust I (“Trust I”) and First United Statutory Trust II (“Trust II”), both Connecticut statutory business trusts. Until September 14, 2018 when it was canceled, the Corporation also served as the parent company to First United Statutory Trust III, a Delaware statutory business trust (“Trust III” and together with Trust I and Trust II, the “Trusts”). The Trusts were formed for the purpose of selling trust preferred securities that qualified as Tier 1 capital.

 

[3]

 

 

The Bank has two consumer finance company subsidiaries - OakFirst Loan Center, Inc., a West Virginia corporation, and OakFirst Loan Center, LLC, a Maryland limited liability company - and two subsidiaries that it uses to hold real estate acquired through foreclosure or by deed in lieu of foreclosure - First OREO Trust, a Maryland statutory trust, and FUBT OREO I, LLC, a Maryland limited liability company. The Bank also owns 99.9% of the limited partnership interests in Liberty Mews Limited Partnership; a Maryland limited partnership formed for the purpose of acquiring, developing and operating low-income housing units in Garrett County, Maryland.

 

At December 31, 2018, we had total assets of $1.4 billion, net loans of $996.7 million, and deposits of $1.1 billion. Shareholders’ equity at December 31, 2018 was $117.1 million.

 

The Corporation maintains an Internet website at www.mybank.com on which it makes available, free of charge, its Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and all amendments to the foregoing as soon as reasonably practicable after these reports are electronically filed with, or furnished to, the SEC.

 

Banking Products and Services

 

The Bank operates 25 banking offices, one customer care center and 26 Automated Teller Machines (“ATMs”) in Allegany County, Frederick County, Garrett County, and Washington County in Maryland, and in Mineral County, Berkeley County, Monongalia County and Harrison County in West Virginia. The Bank is an independent community bank providing a complete range of retail and commercial banking services to businesses and individuals in its market areas. Services offered are essentially the same as those offered by the regional institutions that compete with the Bank and include checking, savings, money market deposit accounts, and certificates of deposit, business loans, personal loans, mortgage loans, lines of credit, and consumer-oriented retirement accounts including individual retirement accounts (“IRAs”) and employee benefit accounts. In addition, the Bank provides full brokerage services through a networking arrangement with Cetera Investment Services, LLC., a full-service broker-dealer. The Bank also provides safe deposit and night depository facilities, insurance products and trust services. The Bank’s deposits are insured by the Federal Deposit Insurance Corporation (the “FDIC”).

 

Lending Activities

 

Our lending activities are conducted through the Bank. Since 2010, the Bank has not originated any new loans through the OakFirst Loan Centers and their sole activity is servicing existing loans.

 

The Bank’s commercial loans are primarily secured by real estate, commercial equipment, vehicles or other assets of the borrower. Repayment is often dependent on the successful business operations of the borrower and may be affected by adverse conditions in the local economy or real estate market. The financial condition and cash flow of commercial borrowers is therefore carefully analyzed during the loan approval process, and continues to be monitored throughout the duration of the loan by obtaining business financial statements, personal financial statements and income tax returns. The frequency of this ongoing analysis depends upon the size and complexity of the credit and collateral that secures the loan. It is also the Bank’s general policy to obtain personal guarantees from the principals of the commercial loan borrowers.

 

Commercial real estate (“CRE”) loans are primarily those secured by land for residential and commercial development, agricultural purpose properties, service industry buildings such as restaurants and motels, retail buildings and general purpose business space. The Bank attempts to mitigate the risks associated with these loans through low loan to value ratio standards, thorough financial analyses, and management’s knowledge of the local economy in which the Bank lends.

 

The risk of loss associated with CRE construction lending is controlled through conservative underwriting procedures such as loan to value ratios of 80% or less, obtaining additional collateral when prudent, analysis of cash flows, and closely monitoring construction projects to control disbursement of funds on loans.

 

The Bank’s residential mortgage portfolio is distributed between variable and fixed rate loans. Some loans are booked at fixed rates in order to meet the Bank’s requirements under the federal Community Reinvestment Act (the “CRA”) or to complement our asset liability mix. Other fixed rate residential mortgage loans are originated in a brokering capacity on behalf of other financial institutions, for which the Bank receives a fee. As with any consumer loan, repayment is dependent on the borrower’s continuing financial stability, which can be adversely impacted by factors such as job loss, divorce, illness, or personal bankruptcy. Residential mortgage loans exceeding an internal loan-to-value ratio require private mortgage insurance. Title insurance protecting the Bank’s lien priority, as well as fire and casualty insurance, is also required.

 

Home equity lines of credit, included within the residential mortgage portfolio, are secured by the borrower’s home and can be drawn on at the discretion of the borrower. These lines of credit are at variable interest rates.

 

The Bank also provides residential real estate construction loans to builders and individuals for single family dwellings. Residential construction loans are usually granted based upon “as completed” appraisals and are secured by the property under construction. Site inspections are performed to determine pre-specified stages of completion before loan proceeds are disbursed. These loans typically have maturities of six to twelve months and may have a fixed or variable rate. Permanent financing for individuals offered by the Bank includes fixed and variable rate loans with five, seven or ten-year adjustable rate mortgages.

 

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A variety of other consumer loans are also offered to customers, including indirect and direct auto loans, and other secured and unsecured lines of credit and term loans. In 2018, the Bank introduced a Student Loan program which offers a product for debt consolidation and an in-school program. This program is serviced by a third-party. Careful analysis of an applicant’s creditworthiness is performed before granting credit, and on-going monitoring of loans outstanding is performed in an effort to minimize risk of loss by identifying problem loans early.

 

An allowance for loan losses is maintained to provide for probable losses from our lending activities. A complete discussion of the factors considered in determination of the allowance for loan losses is included in Item 7 of Part II of this report.

 

Deposit Activities

 

The Bank offers a full array of deposit products including checking, savings and money market accounts, regular and IRA certificates of deposit, Christmas Savings accounts, College Savings accounts, and Health Savings accounts. The Bank also offers the Certificate of Deposit Account Registry Service®, or CDARS®, program to municipalities, businesses, and consumers through which the Bank provides access to multi-million-dollar certificates of deposit and the Insured Cash Sweep®, or ICS®, program to municipalities, businesses, and consumers through which the Bank provides access to multi-million-dollar savings and demand deposits. Both programs are FDIC-insured. In addition, we offer our commercial customers packages which include Treasury Management, Cash Sweep and various checking opportunities.

 

Information about our income from and assets related to our banking business may be found in the Consolidated Statements of Financial Condition and the Consolidated Statements of Income and the related notes thereto included in Item 8 of Part II of this annual report.

 

Wealth Management

 

The Bank’s Trust Department offers a full range of trust services, including personal trust, investment agency accounts, charitable trusts, retirement accounts including IRA roll-overs, 401(k) accounts and defined benefit plans, estate administration and estate planning.

 

At December 31, 2018 and 2017, the total market value of assets under the supervision of the Bank’s Trust Department was approximately $810.0 million and $824.0 million, respectively. Trust Department revenues for these years may be found in the Consolidated Statements of Income under the heading “Other operating income”, which is contained in Item 8 of Part II of this annual report.

 

COMPETITION

 

The banking business, in all of its phases, is highly competitive. Within our market areas, we compete with commercial banks, (including local banks and branches or affiliates of other larger banks), savings and loan associations and credit unions for loans and deposits, with consumer finance companies for loans, and with other financial institutions for various types of products and services, including trust services. There is also competition for commercial and retail banking business from banks and financial institutions located outside our market areas and on the internet.

 

The primary factors in competing for deposits are interest rates, personalized services, the quality and range of financial services, convenience of office locations and office hours. The primary factors in competing for loans are interest rates, loan origination fees, the quality and range of lending services and personalized services.

 

To compete with other financial services providers, we rely principally upon local promotional activities, personal relationships established by officers, directors and employees with customers, and specialized services tailored to meet customers’ needs. In those instances in which we are unable to accommodate a customer’s needs, we attempt to arrange for those services to be provided by other financial services providers with which we have a relationship.

 

[5]

 

 

The following table sets forth deposit data for the Maryland and West Virginia Counties in which the Bank maintains offices as of June 30, 2018, the most recent date for which comparative information is available.

 

   Offices  Deposits     
   (in Market)  (in thousands)   Market Share 
Allegany County, Maryland:             
Branch Banking and Trust Company  6  $297,210    40.83%
Manufacturers & Traders Trust Company  6   167,721    23.04%
First United Bank & Trust  3   148,226    20.36%
Standard Bank, PaSB  2   68,297    9.38%
PNC Bank NA  1   46,492    6.39%
              
Source:  FDIC Deposit Market Share Report             
              
Frederick County, Maryland:             
PNC Bank NA  15  $1,261,154    26.81%
Branch Banking & Trust Co.  11   776,449    16.51%
Bank Of America NA  5   514,718    10.94%
Frederick County Bank  5   355,616    7.56%
Manufacturers & Traders Trust Company  6   314,272    6.68%
Capital One NA  3   292,635    6.22%
Woodsboro Bank  7   232,334    4.94%
Middletown Valley Bank  4   192,511    4.09%
Sandy Spring Bank  4   160,526    3.41%
First United Bank & Trust  4   159,295    3.39%
SunTrust Bank  2   143,913    3.06%
Revere Bank  1   137,824    2.93%
Wells Fargo Bank NA  1   73,881    1.57%
The Columbia Bank  2   51,527    1.10%
Old Line Bank  2   35,484    0.76%
Woodforest National Bank  1   1,257    0.03%
              
Source:  FDIC Deposit Market Share Report             
              
Garrett County, Maryland:             
First United Bank & Trust  5  $333,061    59.43%
Manufacturers & Traders Trust Company  2   89,505    15.97%
Branch Banking and Trust Company  2   66,828    11.93%
Clear Mountain Bank  1   49,083    8.76%
Somerset Trust Company  1   15,714    2.80%
Miners & Merchants Bank  1   6,239    1.11%
              
Source:  FDIC Deposit Market Share Report             
              
Washington County, Maryland:             
Branch Banking & Trust Company  10  $644,975    28.82%
The Columbia Bank  9   484,875    21.66%
Manufacturers & Traders Trust Company  10   433,943    19.39%
PNC Bank NA  4   229,910    10.27%
Middletown Valley Bank  2   154,778    6.92%
First United Bank & Trust  3   91,198    4.08%
United Bank  2   66,322    2.96%
CNB Bank, Inc.  3   65,205    2.91%
Orrstown Bank  1   35,425    1.58%
Bank of Charles Town  1   23,047    1.03%
Jefferson Security Bank  1   8,407    0.38%
              
Source:  FDIC Deposit Market Share Report             
              
Berkeley County, West Virginia:             
Branch Banking & Trust Company  5  $367,867    26.43%
United Bank  4   265,135    19.05%
MVB Bank Inc.  3   204,961    14.73%
City National Bank of West Virginia  4   167,911    12.07%
First United Bank & Trust  3   122,965    8.84%
Bank of Charles Town  2   88,163    6.33%
Jefferson Security Bank  2   81,701    5.87%
CNB Bank, Inc.  3   76,742    5.51%
Summit Community Bank  1   14,824    1.07%
Woodforest National Bank  1   1,416    0.10%
              
Source:  FDIC Deposit Market Share Report             
              
Harrison County, West Virginia:             
MVB Bank, Inc  2  $280,792    19.64%
Branch Banking and Trust Company  4   254,474    17.80%
WesBanco Bank, Inc.  6   224,406    15.70%
The Huntington National Bank  3   222,053    15.53%
JP Morgan Chase Bank, NA  2   191,633    13.40%
Harrison County Bank  5   100,693    7.04%
City National Bank of West Virginia  2   45,689    3.20%
West Union Bank  1   26,295    1.84%
Premier Bank, Inc.  1   19,084    1.33%
Freedom Bank, Inc.  1   17,433    1.22%
Cornerstone Bank, Inc.  1   15,701    1.10%
BC Bank, Inc.  1   14,871    1.04%
United Bank  1   9,544    0.67%
Clear Mountain Bank  1   5,256    0.37%
First United Bank & Trust  1   1,668    0.12%
              
Source:  FDIC Deposit Market Share Report             
              
Mineral County, West Virginia:             
First United Bank & Trust  2  $89,648    35.13%
Branch Banking & Trust Company  1   69,693    27.31%
Manufacturers & Traders Trust Company  2   51,450    20.16%
Grant County Bank  1   35,687    13.98%
FNB Bank, Inc.  1   8,739    3.42%
              
Source:  FDIC Deposit Market Share Report             
              
Monongalia County, West Virginia:             
United Bank  6  $794,843    32.33%
Branch Banking & Trust Company  4   453,061    18.43%
Huntington National Bank  7   428,589    17.43%
Clear Mountain Bank  6   229,388    9.33%
Wesbanco Bank, Inc.  5   165,169    6.72%
MVB Bank, Inc.  3   148,541    6.04%
First United Bank & Trust  3   98,732    4.01%
PNC Bank NA  4   91,608    3.73%
First Exchange Bank  1   25,343    1.03%
Citizens Bank of Morgantown, Inc.  1   23,376    0.95%
              
Source:  FDIC Deposit Market Share Report             

 

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For further information about competition in our market areas, see the Risk Factor entitled “We operate in a competitive environment, and our inability to effectively compete could adversely and materially impact our financial condition and results of operations” in Item 1A of Part I of this annual report.

 

SUPERVISION AND REGULATION

 

The following is a summary of the material regulations and policies applicable to the Corporation and its subsidiaries and is not intended to be a comprehensive discussion. Changes in applicable laws and regulations may have a material effect on our business.

 

General

 

The Corporation is registered with the Federal Reserve as a bank holding company under the BHC Act and, as such, is subject to the supervision, examination and reporting requirements of the BHC Act and the regulations of the Federal Reserve. As a publicly-traded company whose common stock is registered under Section 12(b) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and listed on The NASDAQ Global Select Market, the Corporation is also subject to regulation and supervision by the SEC and The NASDAQ Stock Market, LLC (“NASDAQ”).

 

The Bank is a Maryland trust company subject to the banking laws of Maryland and to regulation by the Commissioner of Financial Regulation of Maryland (the “Maryland Commissioner”), who is required by statute to make at least one examination in each calendar year (or at 18-month intervals if the Maryland Commissioner determines that an examination is unnecessary in a particular calendar year). The Bank also has offices in West Virginia, and the operations of these offices are subject to West Virginia laws and to supervision and examination by the West Virginia Division of Banking. As a member of the FDIC, the Bank is also subject to certain provisions of federal laws and regulations regarding deposit insurance and activities of insured state-chartered banks, including those that require examination by the FDIC. In addition to the foregoing, there are a myriad of other federal and state laws and regulations that affect, or govern the business of banking, including consumer lending, deposit-taking, and trust operations.

 

All non-bank subsidiaries of the Corporation are subject to examination by the Federal Reserve, and, as affiliates of the Bank, are subject to examination by the FDIC and the Maryland Commissioner. In addition, OakFirst Loan Center, Inc. is subject to licensing and regulation by the West Virginia Division of Banking, and OakFirst Loan Center, LLC is subject to licensing and regulation by the Maryland Commissioner.

 

Regulatory Reforms

 

The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), which was enacted in July 2010, significantly restructured the financial regulatory regime in the United States. Although the Dodd-Frank Act’s provisions that have received the most public attention generally have been those applying to or more likely to affect larger institutions such as banks and bank holding companies with total consolidated assets of $50 billion or more, it contains numerous other provisions that affect all financial institutions, including the Bank. The Dodd-Frank Act established the Consumer Financial Protection Bureau (the “CFPB”), discussed below, and contains a wide variety of provisions (many of which are not yet effective) affecting the regulation of depository institutions, including fair lending, fair debt collection practices, mortgage loan origination and servicing obligations, bankruptcy, military service member protections, use of credit reports, privacy matters, and disclosure of credit terms and correction of billing errors. Local, state and national regulatory and enforcement agencies continue efforts to address perceived problems within the mortgage lending and credit card industries through broad or targeted legislative or regulatory initiatives aimed at lenders’ operations in consumer lending markets. There continues to be a significant amount of legislative and regulatory activity, nationally, locally and at the state level, designed to limit certain lending practices while mandating certain servicing procedures. Federal bankruptcy and state debtor relief and collection laws, as well as the Servicemembers Civil Relief Act affect the ability of banks, including the Bank, to collect outstanding balances.

 

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Moreover, the Dodd-Frank Act permits states to adopt stricter consumer protection laws and states’ attorneys general may enforce consumer protection rules issued by the CFPB. Recently, U.S. financial regulatory agencies have increasingly used a general consumer protection statute to address unethical or otherwise bad business practices that may not necessarily fall directly under the purview of a specific banking or consumer finance law. Prior to the Dodd-Frank Act, there was little formal guidance to provide insight to the parameters for compliance with the “unfair or deceptive acts or practices” (“UDAP”) law. However, the UDAP provisions have been expanded under the Dodd-Frank Act to apply to “unfair, deceptive or abusive acts or practices”, which has been delegated to the CFPB for supervision.

 

The implementation of several of the Dodd-Frank Act’s provisions is subject to final rulemaking by the U.S. financial regulatory agencies, and the Dodd-Frank Act’s impact on our business will depend to a large extent on how and when such rules are adopted and implemented by the primary U.S. financial regulatory agencies. We continue to analyze the impact of rules adopted under the Dodd-Frank Act on our business, but the full impact will not be known until the rules and related regulatory initiatives are finalized and their combined impact can be understood. The Dodd-Frank Act has increased, and will likely continue to increase, our regulatory compliance burdens and costs and may restrict the financial products and services that we offer to our customers in the future. In particular, the Dodd-Frank Act will require us to invest significant management attention and resources so that we can evaluate the impact of and ensure compliance with this law and its rules.

 

Regulation of Bank Holding Companies

 

The Corporation and its affiliates are subject to the provisions of Section 23A and Section 23B of the Federal Reserve Act. Section 23A limits the amount of loans or extensions of credit to, and investments in, the Corporation and its non-bank affiliates by the Bank. Section 23B requires that transactions between the Bank and the Corporation and its non-bank affiliates be on terms and under circumstances that are substantially the same as with non-affiliates.

 

Under Federal Reserve policy, the Corporation is expected to act as a source of strength to the Bank, and the Federal Reserve may charge the Corporation with engaging in unsafe and unsound practices for failure to commit resources to a subsidiary bank when required. This support may be required at times when the bank holding company may not have the resources to provide the support. Under the prompt corrective action provisions, if a controlled bank is undercapitalized, then the regulators could require the bank holding company to guarantee the bank’s capital restoration plan. In addition, if the Federal Reserve believes that a bank holding company’s activities, assets or affiliates represent a significant risk to the financial safety, soundness or stability of a controlled bank, then the Federal Reserve could require the bank holding company to terminate the activities, liquidate the assets or divest the affiliates. The regulators may require these and other actions in support of controlled banks even if such actions are not in the best interests of the bank holding company or its stockholders. Because the Corporation is a bank holding company, it is viewed as a source of financial and managerial strength for any controlled depository institutions, like the Bank.

 

In addition, under the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (“FIRREA”), depository institutions insured by the FDIC can be held liable for any losses incurred by, or reasonably anticipated to be incurred by, the FDIC in connection with (i) the default of a commonly controlled FDIC-insured depository institution or (ii) any assistance provided by the FDIC to a commonly controlled FDIC-insured depository institution in danger of default. Accordingly, in the event that any insured subsidiary of the Corporation causes a loss to the FDIC, other insured subsidiaries of the Corporation could be required to compensate the FDIC by reimbursing it for the estimated amount of such loss. Such cross guaranty liabilities generally are superior in priority to obligations of a financial institution to its shareholders and obligations to other affiliates.

 

Federal Banking Regulation

 

Federal banking regulators, such as the Federal Reserve and the FDIC, may prohibit the institutions over which they have supervisory authority from engaging in activities or investments that the agencies believe are unsafe or unsound banking practices. Federal banking regulators have extensive enforcement authority over the institutions they regulate to prohibit or correct activities that violate law, regulation or a regulatory agreement or which are deemed to be unsafe or unsound practices. Enforcement actions may include the appointment of a conservator or receiver, the issuance of a cease and desist order, the termination of deposit insurance, the imposition of civil money penalties on the institution, its directors, officers, employees and institution-affiliated parties, the issuance of directives to increase capital, the issuance of formal and informal agreements, the removal of or restrictions on directors, officers, employees and institution-affiliated parties, and the enforcement of any such mechanisms through restraining orders or other court actions.

 

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The Bank is subject to certain restrictions on extensions of credit to executive officers, directors, and principal shareholders or any related interest of such persons, which generally require that such credit extensions be made on substantially the same terms as those available to persons who are not related to the Bank and not involve more than the normal risk of repayment. Other laws tie the maximum amount that may be loaned to any one customer and its related interests to capital levels.

 

As part of the Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”), each federal banking regulator adopted non-capital safety and soundness standards for institutions under its authority. These standards include internal controls, information systems and internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, and compensation, fees and benefits. An institution that fails to meet those standards may be required by the agency to develop a plan acceptable to meet the standards. Failure to submit or implement such a plan may subject the institution to regulatory sanctions. We believe that the Bank meets substantially all standards that have been adopted. FDICIA also imposes capital standards on insured depository institutions.

 

The CRA requires the FDIC, in connection with its examination of financial institutions within its jurisdiction, to evaluate the record of those financial institutions in meeting the credit needs of their communities, including low and moderate income neighborhoods, consistent with principles of safe and sound banking practices. These factors are also considered by all regulatory agencies in evaluating mergers, acquisitions and applications to open a branch or facility. As of the date of its most recent examination report, the Bank had a CRA rating of “Satisfactory”.

 

The Bank is also subject to a variety of other laws and regulations with respect to the operation of its business, including, but not limited to, the TILA/RESPA Integrated Disclosure rule (“TRID”), Truth in Lending Act, the Real Estate Settlement Procedures Act, the Truth in Savings Act, the Equal Credit Opportunity Act, the Electronic Funds Transfer Act, the Fair Housing Act, the Home Mortgage Disclosure Act, the Fair Debt Collection Practices Act, the Fair Credit Reporting Act, Expedited Funds Availability (Regulation CC), Reserve Requirements (Regulation D), Privacy of Consumer Information (Regulation P), Margin Stock Loans (Regulation U), the Right To Financial Privacy Act, the Flood Disaster Protection Act, the Homeowners Protection Act, the Servicemembers Civil Relief Act, the Telephone Consumer Protection Act, the CAN-SPAM Act, the Children’s Online Privacy Protection Act, Bank Secrecy Act/Anti-Money Laundering (“BSA/AML”) and Office of Foreign Assets Control (“OFAC”).

 

Capital Requirements

 

We require capital to fund loans, satisfy our obligations under the Bank’s letters of credit, meet the deposit withdrawal demands of the Bank’s customers, and satisfy our other monetary obligations. To the extent that deposits are not adequate to fund our capital requirements, we can rely on the funding sources identified below under the heading “Liquidity Management”. At December 31, 2018, the Bank had $85.0 million available through unsecured lines of credit with correspondent banks, $4.4 million available through a secured line of credit with the Fed Discount Window and approximately $104.3 million available through the Federal Home Loan Bank of Atlanta (“FHLB”). Management is not aware of any demands, commitments, events or uncertainties that are likely to materially affect our ability to meet our future capital requirements.

 

In addition to operational requirements, the Bank and the Corporation are subject to risk-based capital regulations, which were adopted and are monitored by federal banking regulators. These regulations are used to evaluate capital adequacy and require an analysis of an institution’s asset risk profile and off-balance sheet exposures, such as unused loan commitments and stand-by letters of credit.

 

On July 2, 2013, the Federal Reserve approved final rules that substantially amended the regulatory risk-based capital rules applicable to First United Corporation. The FDIC subsequently approved the same rules. The final rules implement the “Basel III” regulatory capital reforms and changes required by the Dodd-Frank Act and were implemented as of March 31, 2015. 

 

The Basel III capital rules include new risk-based capital and leverage ratios, which will be phased in from 2015 to 2019, and which refine the definition of what constitutes “capital” for purposes of calculating those ratios. The new minimum capital level requirements applicable to the Corporation under the final rules are: (i) a new common equity Tier 1 capital ratio of 4.5%; (ii) a Tier 1 capital ratio of 6% (increased from 4%); (iii) a total capital ratio of 8% (unchanged from current rules); and (iv) a Tier 1 leverage ratio of 4% for all institutions. The final rules also establish a “capital conservation buffer” above the new regulatory minimum capital requirements, which must consist entirely of common equity Tier 1 capital. The capital conservation buffer will be phased-in over four years beginning on January 1, 2016, as follows: the maximum buffer will be 0.625% of risk-weighted assets for 2016, 1.25% for 2017, 1.875% for 2018, and 2.5% for 2019 and thereafter. This will result in the following minimum ratios beginning in 2019: (a) a common equity Tier 1 capital ratio of 7.0%, (b) a Tier 1 capital ratio of 8.5% and (c) a total capital ratio of 10.5%. Under the final rules, institutions are subject to limitations on paying dividends, engaging in share repurchases, and paying discretionary bonuses if its capital level falls below the buffer amount. These limitations establish a maximum percentage of eligible retained income that could be utilized for such actions.

 

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The Basel III capital final rules also implement revisions and clarifications consistent with Basel III regarding the various components of Tier 1 capital, including common equity, unrealized gains and losses, as well as certain instruments that no longer qualify as Tier 1 capital, some of which will be phased out over time. Under the final rules, the effects of certain accumulated other comprehensive items are not excluded; however, banking organizations like the Corporation and the Bank that are not considered “advanced approaches” banking organizations may make a one-time permanent election to continue to exclude these items. The Corporation and the Bank made this election in their first quarter 2015 regulatory filings in order to avoid significant variations in the level of capital depending upon the impact of interest rate fluctuations on the fair value of the Corporation’s available-for-sale securities portfolio. Additionally, the final rules provide that small depository institution holding companies with less than $15 billion in total assets as of December 31, 2009 (which includes the Corporation) will be able to permanently include non-qualifying instruments that were issued and included in Tier 1 or Tier 2 capital prior to May 19, 2010 in additional Tier 1 or Tier 2 capital until they redeem such instruments or until the instruments mature.

 

The Basel III capital rules also contain revisions to the prompt corrective action framework, which is designed to place restrictions on insured depository institutions if their capital levels begin to show signs of weakness. These revisions were effective January 1, 2015. Under the prompt corrective action requirements, which are designed to complement the capital conservation buffer, insured depository institutions are required to meet the following capital level requirements in order to qualify as “well capitalized”: (i) a new common equity Tier 1 capital ratio of 6.5%; (ii) a Tier 1 capital ratio of 8% (increased from 6%); (iii) a total capital ratio of 10% (unchanged from current rules); and (iv) a Tier 1 leverage ratio of 5% (increased from 4%).

 

The Basel III capital rules set forth certain changes for the calculation of risk-weighted assets. These changes include (i) an increased number of credit risk exposure categories and risk weights; (ii) an alternative standard of creditworthiness consistent with Section 939A of the Dodd-Frank Act; (iii) revisions to recognition of credit risk mitigation; (iv) rules for risk weighting of equity exposures and past due loans, and (v) revised capital treatment for derivatives and repo-style transactions.

 

Regulators may require higher capital ratios when warranted by the particular circumstances or risk profile of a given banking organization. In the current regulatory environment, banking organizations must stay well-capitalized in order to receive favorable regulatory treatment on acquisition and other expansion activities and favorable risk-based deposit insurance assessments. Our capital policy establishes guidelines meeting these regulatory requirements and takes into consideration current or anticipated risks as well as potential future growth opportunities.

 

At December 31, 2018, we were in compliance with the applicable requirements.

 

In October 2017, the federal banking agencies proposed revisions that would simplify compliance with certain aspects of capital rules. A majority of the proposed simplifications would apply solely to banking organizations that are not subject to the advanced approaches capital rule. The proposed rules simplify application of regulatory capital treatment for mortgage servicing assets, certain deferred tax assets arising from temporary differences, investments in the capital of unconsolidated financial institutions, and capital issued by a consolidated subsidiary of a banking organization and held by third parties (minority interest), and; revisions to the treatment of certain acquisition, development, or construction exposures. In addition, the federal banking agencies have deferred the final phase-in and increased risk-weighting associated with CET1 deductions (discussed in the next section) indefinitely for non-advanced approaches banks.

 

Additional information about our capital ratios and requirements is contained in Item 7 of Part II of this annual report under the heading “Capital Resources”.

 

Prompt Corrective Action

 

The Federal Deposit Insurance Act (“FDI Act”) requires, among other things, the federal banking agencies to take “prompt corrective action” in respect of depository institutions that do not meet minimum capital requirements. The FDI Act includes the following five capital tiers: “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized” and “critically undercapitalized.” A depository institution’s capital tier will depend upon how its capital levels compare with various relevant capital measures and certain other factors, as established by regulation. The relevant capital measures are the total capital ratio, the Tier 1 capital ratio and the leverage ratio.

 

A bank will be (i) “well capitalized” if the institution has a total risk-based capital ratio of 10.0% or greater, a Tier 1 risk-based capital ratio of 6.0% or greater, and a leverage ratio of 5.0% or greater, and is not subject to any order or written directive by any such regulatory authority to meet and maintain a specific capital level for any capital measure, (ii) “adequately capitalized” if the institution has a total risk-based capital ratio of 8.0% or greater, a Tier 1 risk-based capital ratio of 4.0% or greater, and a leverage ratio of 4.0% or greater and is not “well capitalized”, (iii) “undercapitalized” if the institution has a total risk-based capital ratio that is less than 8.0%, a Tier 1 risk-based capital ratio of less than 4.0% or a leverage ratio of less than 4.0%, (iv) “significantly undercapitalized” if the institution has a total risk-based capital ratio of less than 6.0%, a Tier 1 risk-based capital ratio of less than 3.0% or a leverage ratio of less than 3.0%, and (v) “critically undercapitalized” if the institution’s tangible equity is equal to or less than 2.0% of average quarterly tangible assets. An institution may be downgraded to, or deemed to be in, a capital category that is lower than indicated by its capital ratios if it is determined to be in an unsafe or unsound condition or if it receives an unsatisfactory examination rating with respect to certain matters. A bank’s capital category is determined solely for the purpose of applying prompt corrective action regulations, and the capital category may not constitute an accurate representation of the bank’s overall financial condition or prospects for other purposes.

 

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Effective January 1, 2015, the Basel III capital rules revised the prompt corrective action requirements by (i) introducing the Common Equity Tier 1 (“CET1”) ratio requirement at each level (other than critically undercapitalized), with the required CET1 ratio being 6.5% for well-capitalized status; (ii) increasing the minimum Tier 1 capital ratio requirement for each category (other than critically undercapitalized), with the minimum Tier 1 capital ratio for well-capitalized status being 8%; and (iii) eliminating the provision that permitted a bank with a composite supervisory rating of 1 but a leverage ratio of at least 3% to be deemed adequately capitalized. The Basel III Capital Rules did not change the total risk-based capital requirement for any prompt corrective action category.

 

The FDI Act generally prohibits a depository institution from making any capital distributions (including payment of a dividend) or paying any management fee to its parent holding company if the depository institution would thereafter be “undercapitalized.” “Undercapitalized” institutions are subject to growth limitations and are required to submit a capital restoration plan. The agencies may not accept such a plan without determining, among other things, that the plan is based on realistic assumptions and is likely to succeed in restoring the depository institution’s capital. In addition, for a capital restoration plan to be acceptable, the depository institution’s parent holding company must guarantee that the institution will comply with such capital restoration plan. The bank holding company must also provide appropriate assurances of performance. The aggregate liability of the parent holding company is limited to the lesser of (i) an amount equal to 5.0% of the depository institution’s total assets at the time it became undercapitalized and (ii) the amount which is necessary (or would have been necessary) to bring the institution into compliance with all capital standards applicable with respect to such institution as of the time it fails to comply with the plan. If a depository institution fails to submit an acceptable plan, it is treated as if it is “significantly undercapitalized.” Significantly undercapitalized” depository institutions may be subject to a number of requirements and restrictions, including orders to sell sufficient voting stock to become “adequately capitalized,” requirements to reduce total assets, and cessation of receipt of deposits from correspondent banks. “Critically undercapitalized” institutions are subject to the appointment of a receiver or conservator.

 

The appropriate federal banking agency may, under certain circumstances, reclassify a well-capitalized insured depository institution as adequately capitalized. The FDI Act provides that an institution may be reclassified if the appropriate federal banking agency determines (after notice and opportunity for hearing) that the institution is in an unsafe or unsound condition or deems the institution to be engaging in an unsafe or unsound practice.

 

The appropriate agency is also permitted to require an adequately capitalized or undercapitalized institution to comply with the supervisory provisions as if the institution were in the next lower category (but not treat a significantly undercapitalized institution as critically undercapitalized) based on supervisory information other than the capital levels of the institution.

 

At December 31, 2018, the Bank and the Corporation were “well capitalized” based on the aforementioned ratios.

 

Liquidity Requirements

 

Historically, the regulation and monitoring of bank liquidity has been addressed as a supervisory matter, without required formulaic measures. The Basel III liquidity framework requires banks to measure their liquidity against specific liquidity tests that, although similar in some respects to liquidity measures historically applied by banks and regulators for management and supervisory purposes, going forward would be required by regulation. One test, referred to as the liquidity coverage ratio (“LCR”), is designed to ensure that the banking entity maintains an adequate level of unencumbered high-quality liquid assets equal to the entity’s expected net cash outflow for a 30-day time horizon (or, if greater, 25% of its expected total cash outflow) under an acute liquidity stress scenario. The other test, referred to as the net stable funding ratio (“NSFR”), is designed to promote more medium- and long-term funding of the assets and activities of banking entities over a one-year time horizon. These requirements will incent banking entities to increase their holdings of U.S. Treasury securities and other sovereign debt as a component of assets and increase the use of long-term debt as a funding source. In October 2013, the federal banking agencies proposed rules implementing the LCR for advanced approaches banking organizations and a modified version of the LCR for bank holding companies with at least $50 billion in total consolidated assets that are not advanced approach banking organizations, neither of which would apply to the Corporation. In the second quarter of 2016, the federal banking regulators issued a proposed rule that would implement the NSFR for certain U.S. banking organizations to ensure that they have access to table funding over a one-year time horizon. The proposed rule would not apply to a U.S. banking organization with less than $50 billion in total consolidated assets, such as the Bank.

 

Deposit Insurance

 

The Bank is a member of the FDIC and pays an insurance premium to the FDIC based upon its assessable deposits on a quarterly basis. Deposits are insured up to applicable limits by the FDIC and such insurance is backed by the full faith and credit of the United States Government.

 

Under the Dodd-Frank Act, a permanent increase in deposit insurance was authorized to $250,000. The coverage limit is per depositor, per insured depository institution for each account ownership category.

 

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The Dodd-Frank Act also set a new minimum DIF reserve ratio at 1.35% of estimated insured deposits. The FDIC is required to attain this ratio by September 30, 2020. The Dodd-Frank Act required the FDIC to redefine the deposit insurance assessment base for an insured depository institution. Prior to the Dodd-Frank Act, an institution’s assessment base has historically been its domestic deposits, with some adjustments. As redefined pursuant to the Dodd-Frank Act, an institution’s assessment base is now an amount equal to the institution’s average consolidated total assets during the assessment period minus average tangible equity. Institutions with $1.0 billion or more in assets at the end of a fiscal quarter, like the Bank, must report their average consolidated total assets on a daily basis and report their average tangible equity on an end-of-month balance basis.

 

On September 30, 2018, the Deposit Insurance Fund Reserve Ratio reached 1.36 percent.  As a result, small banks will receive assessment credits for the portion of their assessments that contributed to the growth in the reserve ratio from 1.15 percent to 1.35 percent, to be applied when the reserve ratio is at least 1.38 percent. In January 2019, the Bank was notified that it is eligible for small bank assessment credits.

 

The Federal Deposit Insurance Reform Act of 2005, which created the DIF, gave the FDIC greater latitude in setting the assessment rates for insured depository institutions which could be used to impose minimum assessments. The FDIC has the flexibility to adopt actual rates that are higher or lower than the total base assessment rates adopted without notice and comment, if certain conditions are met.

 

DIF-insured institutions pay a Financing Corporation (“FICO”) assessment in order to fund the interest on bonds issued in the 1980s in connection with the failures in the thrift industry. These assessments will continue until the bonds mature in 2019.

 

The FDIC is authorized to conduct examinations of and require reporting by FDIC-insured institutions. It is also authorized to terminate a depository bank’s deposit insurance upon a finding by the FDIC that the bank’s financial condition is unsafe or unsound or that the institution has engaged in unsafe or unsound practices or has violated any applicable rule, regulation, order or condition enacted or imposed by the bank’s regulatory agency. The termination of deposit insurance for our bank subsidiary would have a material adverse effect on our earnings, operations and financial condition.

 

Bank Secrecy Act/Anti-Money Laundering

 

The Bank Secrecy Act (“BSA”), which is intended to require financial institutions to develop policies, procedures, and practices to prevent and deter money laundering, mandates that every national bank have a written, board-approved program that is reasonably designed to assure and monitor compliance with the BSA.

 

The program must, at a minimum: (i) provide for a system of internal controls to assure ongoing compliance; (ii) provide for independent testing for compliance; (iii) designate an individual responsible for coordinating and monitoring day-to-day compliance; and (iv) provide training for appropriate personnel. In addition, state-chartered banks are required to adopt a customer identification program as part of its BSA compliance program. State-chartered banks are also required to file Suspicious Activity Reports when they detect certain known or suspected violations of federal law or suspicious transactions related to a money laundering activity or a violation of the BSA.

 

In addition to complying with the BSA, the Bank is subject to the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (the “USA Patriot Act”). The USA Patriot Act is designed to deny terrorists and criminals the ability to obtain access to the United States’ financial system and has significant implications for depository institutions, brokers, dealers, and other businesses involved in the transfer of money. The USA Patriot Act mandates that financial service companies implement additional policies and procedures and take heightened measures designed to address any or all of the following matters: customer identification programs, money laundering, terrorist financing, identifying and reporting suspicious activities and currency transactions, currency crimes, and cooperation between financial institutions and law enforcement authorities.

 

Mortgage Lending and Servicing

 

In January 2013, the CFPB issued eight final regulations governing mainly consumer mortgage lending. These regulations became effective in January 2014.

 

One of these rules, effective on January 10, 2014, requires mortgage lenders to make a reasonable and good faith determination based on verified and documented information that a consumer applying for a mortgage loan has a reasonable ability to repay the loan according to its terms. This rule also defines “qualified mortgages.” In general, a “qualified mortgage” is a mortgage loan without negative amortization, interest-only payments, balloon payments, or a term exceeding 30 years, where the lender determines that the borrower has the ability to repay, and where the borrower’s points and fees do not exceed 3% of the total loan amount. Qualified mortgages that that are not “higher-priced” are afforded a safe harbor presumption of compliance with the ability to repay rules. Qualified mortgages that are “higher-priced” garner a rebuttable presumption of compliance with the ability to repay rules.

 

The CFPB regulations also: (i) require that “higher-priced” mortgages must have escrow accounts for taxes and insurance and similar recurring expenses; (ii) expand the scope of the high-rate, high-cost mortgage provisions by, among other provisions, lowering the rates and fees that lead to coverage and including home equity lines of credit; (iii) revise rules for mortgage loan originator compensation; (iv) add prohibitions against mandatory arbitration provisions and financing single premium credit insurances; and (v) impose a broader requirement for providing borrowers with copies of all appraisals on first-lien dwelling secured loans.

 

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Effective January 10, 2014, the CFPB’s final Truth-in-Lending Act rules relating to mortgage servicing impose new obligations to credit payments and provide payoff statements within certain time periods and provide new notices prior to interest rate and payment adjustments. Effective on that same date, the CFPB’s final Real Estate Settlement Procedures Act rules add new obligations on the servicer when a mortgage loan is default.

 

On November 20, 2013, the CFPB issued a final rule on integrated mortgage disclosures under the Truth-in-Lending Act and the Real Estate Settlement Procedures Act, for which compliance was required by October 3, 2015. At December 31, 2018, we believe that we are in compliance.

 

Consumer Lending – Military Lending Act

 

The Military Lending Act (the “MLA”), which was initially implemented in 2007, was amended and its coverage significantly expanded in 2015. The Department of Defense (the “DOD”) issued a final rule under the MLA that took effect on October 15, 2015, but financial institutions were not required to take action until October 3, 2016. The types of credit covered under the MLA were expanded to include virtually all consumer loan and credit card products (except for loans secured by residential real property and certain purchase-money motor vehicle/personal property secured transactions). Lenders must now provide specific written and oral disclosures concerning the protections of the MLA to active duty members of the military and dependents of active duty members of the military (“covered borrowers”). The rule imposes a 36% “Military Annual Percentage Rate” cap that includes costs associated with credit insurance premiums, fees for ancillary products, finance charges associated with the transactions, and application and participation charges. In addition, loan terms cannot include (i) a mandatory arbitration provision, (ii) a waiver of consumer protection laws, (iii) mandatory allotments from military benefits, or (iv) a prepayment penalty. The revised rule also prohibits “roll-over” or refinances of the same loan unless the new loan provides more favorable terms for the covered borrower. Lenders may verify covered borrower status using a DOD database or information provided by credit bureaus. We believe that we are in compliance with the revised rule.

 

Cybersecurity

 

We rely on electronic communications and information systems to conduct our operations and store sensitive data. We employ an in-depth approach that leverages people, processes, and technology to manage and maintain cybersecurity controls. In addition, we employ a variety of preventative and detective tools to monitor, block, and provide alerts regarding suspicious activity, as well as to report on any suspected advanced persistent threats. Notwithstanding the strength of our defensive measures, the threat from cyber-attacks is severe, attacks are sophisticated and increasing in volume, and attackers respond rapidly to changes in defensive measures.

 

The federal banking regulators have adopted guidelines for establishing information security standards and cybersecurity programs for implementing safeguards under the supervision of a financial institution’s board of directors. These guidelines, along with related regulatory materials, increasingly focus on risk management and processes related to information technology and the use of third parties in the provision of financial products and services. The federal banking regulators expect financial institutions to establish lines of defense and to ensure that their risk management processes address the risk posed by compromised customer credentials, and also expect financial institutions to maintain sufficient business continuity planning processes to ensure rapid recovery, resumption and maintenance of the institution's operations after a cyberattack. If we fail to meet the expectations set forth in this regulatory guidance, then we could be subject to various regulatory actions and we may be required to devote significant resources to any required remediation efforts.

 

Federal Securities Laws and NASDAQ Rules

 

The shares of the Corporation’s common stock are registered with the SEC under Section 12(b) of the Exchange and listed on the NASDAQ Global Select Market. The Corporation is subject to information reporting requirements, proxy solicitation requirements, insider trading restrictions and other requirements of the Exchange Act, including the requirements imposed under the federal Sarbanes-Oxley Act of 2002, and rules adopted by NASDAQ. Among other things, loans to and other transactions with insiders are subject to restrictions and heightened disclosure, directors and certain committees of the Board must satisfy certain independence requirements, the Corporation must comply with certain enhanced corporate governance requirements, and various issuances of securities by the Corporation require shareholder approval.

 

Governmental Monetary and Credit Policies and Economic Controls

 

The earnings and growth of the banking industry and ultimately of the Bank are affected by the monetary and credit policies of governmental authorities, including the Federal Reserve. An important function of the Federal Reserve is to regulate the national supply of bank credit in order to control recessionary and inflationary pressures. Among the instruments of monetary policy used by the Federal Reserve to implement these objectives are open market operations in U.S. Government securities, changes in the federal funds rate, changes in the discount rate of member bank borrowings, and changes in reserve requirements against member bank deposits. These means are used in varying combinations to influence overall growth of bank loans, investments and deposits and may also affect interest rates charged on loans or paid on deposits. The monetary policies of the Federal Reserve authorities have had a significant effect on the operating results of commercial banks in the past and are expected to continue to have such an effect in the future. In view of changing conditions in the national economy and in the money markets, as well as the effect of actions by monetary and fiscal authorities, including the Federal Reserve, no prediction can be made as to possible future changes in interest rates, deposit levels, loan demand or their effect on our businesses and earnings.

 

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SEASONALITY

 

Management does not believe that our business activities are seasonal in nature. Deposit and loan demand may vary depending on local and national economic conditions, but management believes that any variation will not have a material impact on our planning or policy-making strategies.

 

EMPLOYEES

 

At December 31, 2018, we employed 356 individuals, of whom 314 were full-time employees.

 

ITEM 1A.RISK FACTORS

 

The significant risks and uncertainties related to us, our business and our securities of which we are aware are discussed below. Investors and shareholders should carefully consider these risks and uncertainties before making investment decisions with respect to the Corporation’s securities. Any of these factors could materially and adversely affect our business, financial condition, operating results and prospects and could negatively impact the market price of the Corporation’s securities. If any of these risks materialize, the holders of the Corporation’s securities could lose all or part of their investments in the Corporation. Additional risks and uncertainties that we do not yet know of, or that we currently think are immaterial, may also impair our business operations. Investors and shareholders should also consider the other information contained in this annual report, including our financial statements and the related notes, before making investment decisions with respect to the Corporation’s securities.

 

Risks Relating to First United Corporation and its Affiliates

 

First United Corporation’s future success depends on the successful growth of its subsidiaries.

 

The Corporation’s primary business activity for the foreseeable future will be to act as the holding company of the Bank and its other direct and indirect subsidiaries. Therefore, the Corporation’s future profitability will depend on the success and growth of these subsidiaries.

 

We could be adversely affected by risks associated with future acquisitions and expansions.

 

Although our core growth strategy is focused around organic growth, we may from time to time consider acquisition and expansion opportunities involving a bank or other entity operating in the financial services industry. We cannot predict if or when we will engage in such a strategic transaction, or the nature or terms of any such transaction. To the extent that we grow through an acquisition, we cannot assure investors that we will be able to adequately and profitably manage that growth or that an acquired business will be integrated into our existing businesses as efficiently or as timely as we may anticipate. Acquiring another business would generally involve risks commonly associated with acquisitions, including:

 

increased capital needs;
increased and new regulatory and compliance requirements;
implementation or remediation of controls, procedures and policies with respect to the acquired business;
diversion of management time and focus from operation of our then-existing business to acquisition-integration challenges;
coordination of product, sales, marketing and program and systems management functions;
transition of the acquired business’s users and customers onto our systems;
retention of employees from the acquired business;
integration of employees from the acquired business into our organization;
integration of the acquired business’s accounting, information management, human resources and other administrative systems and operations with ours;
potential liability for activities of the acquired business prior to the acquisition, including violations of law, commercial disputes and tax and other known and unknown liabilities;
potential increased litigation or other claims in connection with the acquired business, including claims brought by regulators, terminated employees, customers, former stockholders, vendors, or other third parties; and

 

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potential goodwill impairment.

 

Our failure to execute our acquisition strategy could adversely affect our business, results of operations, financial condition and future prospects risks of unknown or contingent liabilities.

 

Interest rates and other economic conditions will impact our results of operations.

 

Our net income depends primarily upon our net interest income. Net interest income is the difference between interest income earned on loans, investments and other interest-earning assets and the interest expense incurred on deposits and borrowed funds. The level of net interest income is primarily a function of the average balance of our interest-earning assets, the average balance of our interest-bearing liabilities, and the spread between the yield on such assets and the cost of such liabilities. These factors are influenced by both the pricing and mix of our interest-earning assets and our interest-bearing liabilities which, in turn, are impacted by such external factors as the local economy, competition for loans and deposits, the monetary policy of the Federal Open Market Committee of the Federal Reserve Board of Governors, and market interest rates.

 

Different types of assets and liabilities may react differently, and at different times, to changes in market interest rates. We expect that we will periodically experience gaps in the interest rate sensitivities of our assets and liabilities. That means either our interest-bearing liabilities will be more sensitive to changes in market interest rates than our interest-earning assets, or vice versa. When interest-bearing liabilities mature or re-price more quickly than interest-earning assets, an increase in market rates of interest could reduce our net interest income. Likewise, when interest-earning assets mature or re-price more quickly than interest-bearing liabilities, falling interest rates could reduce our net interest income. We are unable to predict changes in market interest rates, which are affected by many factors beyond our control, including inflation, deflation, recession, unemployment, money supply, domestic and international events and changes in the United States and other financial markets.

 

We also attempt to manage risk from changes in market interest rates, in part, by controlling the mix of interest rate sensitive assets and interest rate sensitive liabilities. However, interest rate risk management techniques are not exact. A rapid increase or decrease in interest rates could adversely affect our results of operations and financial performance.

 

The majority of our business is concentrated in Maryland and West Virginia, much of which involves real estate lending, so a decline in the real estate and credit markets could materially and adversely impact our financial condition and results of operations.

 

Most of the Bank’s loans are made to borrowers located in Western Maryland and Northeastern West Virginia, and many of these loans, including construction and land development loans, are secured by real estate. At December 31, 2018, approximately 12%, or $118.4 million, of our total loans were real estate acquisition, construction and development loans that were secured by real estate. Accordingly, a decline in local economic conditions would likely have an adverse impact on our financial condition and results of operations, and the impact on us would likely be greater than the impact felt by larger financial institutions whose loan portfolios are geographically diverse. We cannot guarantee that any risk management practices we implement to address our geographic and loan concentrations will be effective to prevent losses relating to our loan portfolio.

 

The Bank’s concentrations of commercial real estate loans could subject it to increased regulatory scrutiny and directives, which could force us to preserve or raise capital and/or limit future commercial lending activities.

 

The federal banking regulators believe that institutions that have particularly high concentrations of CRE loans within their lending portfolios face a heightened risk of financial difficulties in the event of adverse changes in the economy and CRE markets. Accordingly, through published guidance, these regulators have directed institutions whose concentrations exceed certain percentages of capital to implement heightened risk management practices appropriate to their concentration risk. The guidance provides that banking regulators may require such institutions to reduce their concentrations and/or maintain higher capital ratios than institutions with lower concentrations in CRE. At December 31, 2018, our CRE concentrations were below the heightened risk management thresholds set forth in this guidance.

 

The Bank may experience loan losses in excess of its allowance, which would reduce our earnings.

 

The risk of credit losses on loans varies with, among other things, general economic conditions, the type of loans being made, the creditworthiness of the borrowers over the term of the loans and, in the case of collateralized loans, the value and marketability of the collateral for the loans. Management of the Bank maintains an allowance for loan losses based upon, among other things, historical experience, an evaluation of economic conditions and regular reviews of delinquencies and loan portfolio quality. Based upon such factors, management makes various assumptions and judgments about the ultimate collectability of the loan portfolio and provides an allowance for loan losses based upon a percentage of the outstanding balances and for specific loans when their ultimate collectability is considered questionable. If management’s assumptions and judgments prove to be incorrect and the allowance for loan losses is inadequate to absorb future losses, or if the bank regulatory authorities require us to increase the allowance for loan losses as a part of its examination process, our earnings and capital could be significantly and adversely affected. Although management continually monitors our loan portfolio and makes determinations with respect to the allowance for loan losses, future adjustments may be necessary if economic conditions differ substantially from the assumptions used or adverse developments arise with respect to our non-performing or performing loans. Material additions to the allowance for loan losses could result in a material decrease in our net income and capital; and could have a material adverse effect on our financial condition.

 

[15]

 

 

A new accounting standard will likely require us to increase our allowance for loan losses and may have a material adverse effect on our financial condition and results of operations.

 

The FASB has adopted a new accounting standard that will be effective for the Corporation and the Bank beginning with our first full fiscal year after December 15, 2019. This standard, referred to as Current Expected Credit Loss, or CECL, will require financial institutions to determine periodic estimates of lifetime expected credit losses on loans, and recognize the expected credit losses as allowances for loan losses. This standard will change the current method of providing allowances for loan losses that are probable, which would likely require us to increase our allowance for loan losses, and to greatly increase the types of data we would need to collect and review to determine the appropriate level of the allowance for loan losses. Any increase in our allowance for loan losses or expenses incurred to determine the appropriate level of the allowance for loan losses may have a material adverse effect on our financial condition and results of operations.

 

The market value of our investments could decline.

 

At December 31, 2018, investment securities in our investment portfolio having a cost basis of $144.1 million and a market value of $137.6 million were classified as available-for-sale pursuant to FASB Accounting Standards Codification (“ASC”) Topic 320, Investments – Debt and Equity Securities, relating to accounting for investments. Topic 320 requires that unrealized gains and losses in the estimated value of the available-for-sale portfolio be “marked to market” and reflected as a separate item in shareholders’ equity (net of tax) as accumulated other comprehensive loss. There can be no assurance that future market performance of our investment portfolio will enable us to realize income from sales of securities. Shareholders’ equity will continue to reflect the unrealized gains and losses (net of tax) of these investments. Moreover, there can be no assurance that the market value of our investment portfolio will not decline, causing a corresponding decline in shareholders’ equity.

 

Management believes that several factors could affect the market value of our investment portfolio. These include, but are not limited to, changes in interest rates or expectations of changes, the degree of volatility in the securities markets, inflation rates or expectations of inflation and the slope of the interest rate yield curve (the yield curve refers to the differences between shorter-term and longer-term interest rates; a positively sloped yield curve means shorter-term rates are lower than longer-term rates). Also, the passage of time will affect the market values of our investment securities, in that the closer they are to maturing, the closer the market price should be to par value. These and other factors may impact specific categories of the portfolio differently, and management cannot predict the effect these factors may have on any specific category.

 

Impairment of investment securities, goodwill, or deferred tax assets could require charges to earnings, which could result in a negative impact on our results of operations.

 

In assessing whether the impairment of investment securities is other-than-temporary, management considers the length of time and extent to which the fair value has been less than cost, the financial condition and near-term prospects of the issuer, and the intent and ability to retain our investment in the security for a period of time sufficient to allow for any anticipated recovery in fair value in the near term. See the discussion under the heading “Estimates and Critical Accounting Policies – Other-Than-Temporary Impairment of Investment Securities” in Item 7 of Part II of this annual report for further information.

 

Under current accounting standards, goodwill is not amortized but, instead, is subject to impairment tests on at least an annual basis or more frequently if an event occurs or circumstances change that reduce the fair value of a reporting unit below its carrying amount. A decline in the price of the Corporation’s common stock or occurrence of a triggering event following any of our quarterly earnings releases and prior to the filing of the periodic report for that period could, under certain circumstances, cause us to perform a goodwill impairment test and result in an impairment charge being recorded for that period which was not reflected in such earnings release. In the event that we conclude that all or a portion of our goodwill may be impaired, a non-cash charge for the amount of such impairment would be recorded to earnings. Such a charge would have no impact on tangible capital. At December 31, 2018, we had recorded goodwill of $11.0 million, representing approximately 9.4% of shareholders’ equity. See the discussion under the heading “Estimates and Critical Accounting Policies – Goodwill” in Item 7 of Part II of this annual report for further information.

 

At December 31, 2018, our net deferred tax assets were valued at $7.8 million. Included in that total is $2.5 million of state net operating loss carryforwards associated with separate company tax filings of the Corporation, which we do not expect to use and, thus, we have established a $2.4 million valuation allowance. The federal net operating loss (“NOL”) carryforward was fully utilized in 2018. A deferred tax asset is reduced by a valuation allowance if, based on the weight of the evidence available, both negative and positive, including the recent trend of quarterly earnings, management believes that it is more likely than not that some portion or all of the total deferred tax asset will not be realized. Moreover, our ability to utilize our net operating loss carryforwards to offset future taxable income may be significantly limited if we experience an “ownership change,” as determined under Section 382 of the Code. If an ownership change were to occur, the limitations imposed by Section 382 of the Code could result in a portion of our net operating loss carryforwards expiring unused, thereby impairing their value. Section 382’s provisions are complex, and we cannot predict any circumstances surrounding the future ownership of the common stock. Accordingly, we cannot provide any assurance that we will not experience an ownership change in the future.

 

[16]

 

 

The impact of each of these impairment matters could have a material adverse effect on our business, results of operations, and financial condition.

 

We may be adversely affected by recent changes in tax laws.

 

The Tax Cuts and Jobs Act (the “Tax Act”), which was enacted in December 2017, is likely to have both positive and negative effects on our financial performance. Beginning in 2018, the Tax Act reduces the federal tax rate for corporations from 35% to 21%, but it also enacted limitations on certain deductions that will have an impact on the banking industry, borrowers and the market for single-family residential real estate. These limitations include (a) a lower limit on the deductibility of mortgage interest on single-family residential mortgage loans, (b) the elimination of interest deductions for certain home equity loans, (c) a limitation on the deductibility of business interest expense, and (d) a limitation on the deductibility of property taxes and state and local income taxes. These limitations could have the effect of reducing consumer demand for loans secured by real estate, which could adversely impact our financial condition and results of operations.

 

We operate in a competitive environment, and our inability to effectively compete could adversely and materially impact our financial condition and results of operations.

 

We operate in a competitive environment, competing for loans, deposits, and customers with commercial banks, savings associations and other financial entities. Competition for deposits comes primarily from other commercial banks, savings associations, credit unions, money market and mutual funds and other investment alternatives. Competition for loans comes primarily from other commercial banks, savings associations, mortgage banking firms, credit unions and other financial intermediaries. Competition for other products, such as securities products, comes from other banks, securities and brokerage companies, and other non-bank financial service providers in our market area. Many of these competitors are much larger in terms of total assets and capitalization, have greater access to capital markets, and/or offer a broader range of financial services than those that we offer. In addition, banks with a larger capitalization and financial intermediaries not subject to bank regulatory restrictions have larger lending limits and are thereby able to serve the needs of larger customers.

 

In addition, changes to the banking laws over the last several years have facilitated interstate branching, merger and expanded activities by banks and holding companies. For example, the federal Gramm-Leach-Bliley Act (the “GLB Act”) revised the BHC Act and repealed the affiliation provisions of the Glass-Steagall Act of 1933, which, taken together, limited the securities and other non-banking activities of any company that controls an FDIC insured financial institution. As a result, the ability of financial institutions to branch across state lines and the ability of these institutions to engage in previously-prohibited activities are now accepted elements of competition in the banking industry. These changes may bring us into competition with more and a wider array of institutions, which may reduce our ability to attract or retain customers. Management cannot predict the extent to which we will face such additional competition or the degree to which such competition will impact our financial conditions or results of operations.

 

The banking industry is heavily regulated; significant regulatory changes could adversely affect our operations.

 

Our operations will be impacted by current and future legislation and by the policies established from time to time by various federal and state regulatory authorities. The Corporation is subject to supervision by the Federal Reserve. The Bank is subject to supervision and periodic examination by the Maryland Commissioner of Financial Regulation, the West Virginia Division of Banking, and the FDIC. Banking regulations, designed primarily for the safety of depositors, may limit a financial institution’s growth and the return to its investors by restricting such activities as the payment of dividends, mergers with or acquisitions by other institutions, investments, loans and interest rates, interest rates paid on deposits, expansion of branch offices, and the offering of securities or trust services. The Corporation and the Bank are also subject to capitalization guidelines established by federal law and could be subject to enforcement actions to the extent that either is found by regulatory examiners to be undercapitalized. It is not possible to predict what changes, if any, will be made to existing federal and state legislation and regulations or the effect that such changes may have on our future business and earnings prospects. Management also cannot predict the nature or the extent of the effect on our business and earnings of future fiscal or monetary policies, economic controls, or new federal or state legislation. Further, the cost of compliance with regulatory requirements may adversely affect our ability to operate profitably.

 

The full impact of the Dodd-Frank Act is unknown because some rule making efforts are still required to fully implement all of its requirements and the implementation of some enforcement efforts is just beginning. We anticipate continued increases in regulatory expenses as a result of the Dodd-Frank Act.

 

The Dodd-Frank Act represents a comprehensive overhaul of the financial services industry within the United States and affects the lending, investment, trading and operating activities of all financial institutions. Based on the text of the Dodd-Frank Act and the implementing regulations, it is anticipated that the costs to banks may increase or fee income may decrease significantly, which could adversely affect our results of operations, financial condition and/or liquidity.

 

[17]

 

 

The Consumer Financial Protection Bureau may continue to reshape the consumer financial laws through rulemaking and enforcement of the prohibitions against unfair, deceptive and abusive business practices. Compliance with any such change may impact our business operations.

 

The CFPB has broad rulemaking authority to administer and carry out the provisions of the Dodd-Frank Act with respect to financial institutions that offer covered financial products and services to consumers. The CFPB has also been directed to adopt rules identifying practices or acts that are unfair, deceptive or abusive in connection with any transaction with a consumer for a consumer financial product or service, or the offering of a consumer financial product or service. The concept of what may be considered to be an “abusive” practice is new under the law. The full scope of the impact of this authority has not yet been determined as the CFPB has not yet released significant supervisory guidance.

 

As discussed above, the CFPB issued several rules in 2013 relating to mortgage operations and servicing, including a rule requiring mortgage lenders to make a reasonable and good faith determination based on verified and documented information that a consumer applying for a mortgage loan has a reasonable ability to repay the loan according to its terms, or to originate “qualified mortgages” that meet specific requirements with respect to terms, pricing and fees. These new rules have required the Bank to dedicate significant personnel resources and could have a material adverse effect on our operations.

 

Bank regulators and other regulations, including the Basel III Capital Rules, may require higher capital levels, impacting our ability to pay dividends or repurchase our stock.

 

The capital standards to which we are subject, including the standards created by the Basel III Capital Rules, may materially limit our ability to use our capital resources and/or could require us to raise additional capital by issuing common stock. The issuance of additional shares of common stock could dilute existing stockholders.

 

A material weakness or significant deficiency in our disclosure or internal controls could have an adverse effect on us.

 

The Corporation is required by the Sarbanes-Oxley Act of 2002 to establish and maintain disclosure controls and procedures and internal control over financial reporting. These control systems are intended to provide reasonable assurance that material information relating to the Corporation is made known to our management and reported as required by the Exchange Act, to provide reasonable assurance regarding the reliability and preparation of our financial statements, and to provide reasonable assurance that fraud and other unauthorized uses of our assets are detected and prevented. We may not be able to maintain controls and procedures that are effective at the reasonable assurance level. If that were to happen, our ability to provide timely and accurate information about the Corporation, including financial information, to investors could be compromised and our results of operations could be harmed. Moreover, if the Corporation or its independent registered public accounting firm were to identify a material weakness or significant deficiency in any of those control systems, our reputation could be harmed and investors could lose confidence in us, which could cause the market price of the Corporation’s stock to decline and/or limit the trading market for the common stock.

 

The Bank’s funding sources may prove insufficient to replace deposits and support our future growth.

 

The Bank relies on customer deposits, advances from the FHLB, lines of credit at other financial institutions and brokered funds to fund our operations. Although the Bank has historically been able to replace maturing deposits and advances if desired, no assurance can be given that the Bank would be able to replace such funds in the future if our financial condition or the financial condition of the FHLB or market conditions were to change. Our financial flexibility will be severely constrained and/or our cost of funds will increase if we are unable to maintain our access to funding or if financing necessary to accommodate future growth is not available at favorable interest rates. Finally, if we are required to rely more heavily on more expensive funding sources to support future growth, our revenues may not increase proportionately to cover our costs. In that case, our profitability would be adversely affected.

 

The loss of key personnel could disrupt our operations and result in reduced earnings.

 

Our growth and profitability will depend upon our ability to attract and retain skilled managerial, marketing and technical personnel. Competition for qualified personnel in the financial services industry is intense, and there can be no assurance that we will be successful in attracting and retaining such personnel. Our current executive officers provide valuable services based on their many years of experience and in-depth knowledge of the banking industry and the market areas we serve. Due to the intense competition for financial professionals, these key personnel would be difficult to replace and an unexpected loss of their services could result in a disruption to the continuity of operations and a possible reduction in earnings.

 

The Bank’s lending activities subject the Bank to the risk of environmental liabilities.

 

A significant portion of the Bank’s loan portfolio is secured by real property. During the ordinary course of business, the Bank may foreclose on and take title to properties securing certain loans. In doing so, there is a risk that hazardous or toxic substances could be found on these properties. If hazardous or toxic substances are found, the Bank may be liable for remediation costs, as well as for personal injury and property damage. Environmental laws may require the Bank to incur substantial expenses and may materially reduce the affected property’s value or limit the Bank’s ability to use or sell the affected property. In addition, future laws or more stringent interpretations or enforcement policies with respect to existing laws may increase the Bank’s exposure to environmental liability. Although the Bank has policies and procedures to perform an environmental review before initiating any foreclosure action on real property, these reviews may not be sufficient to detect all potential environmental hazards. The remediation costs and any other financial liabilities associated with an environmental hazard could have a material adverse effect on our financial condition and results of operations.

 

[18]

 

 

We are a community bank and our ability to maintain our reputation is critical to the success of our business.

 

We are a community banking institution, and our reputation is one of the most valuable components of our business. A key component of our business strategy is to rely on our reputation for customer service and knowledge of local markets to expand our presence by capturing new business opportunities from existing and prospective customers in our current market and contiguous areas. As such, we strive to conduct our business in a manner that enhances our reputation. This is done, in part, by recruiting, hiring and retaining employees who share our core values of being an integral part of the communities we serve, delivering superior service to our customers and caring about our customers and associates. If our reputation is negatively affected by the actions of our employees, by our inability to conduct our operations in a manner that is appealing to current or prospective customers, or otherwise, our business and, therefore, our operating results may be materially adversely affected.

 

We may be subject to claims and the costs of defensive actions, and such claims and costs could materially and adversely impact our financial condition and results of operations.

 

Our customers may sue us for losses due to alleged breaches of fiduciary duties, errors and omissions of employees, officers and agents, incomplete documentation, our failure to comply with applicable laws and regulations, or many other reasons. Also, our employees may knowingly or unknowingly violate laws and regulations. Management may not be aware of any violations until after their occurrence. This lack of knowledge may not insulate us from liability. Claims and legal actions will result in legal expenses and could subject us to liabilities that may reduce our profitability and hurt our financial condition.

 

We may not be able to keep pace with developments in technology.

 

We use various technologies in conducting our businesses, including telecommunication, data processing, computers, automation, internet-based banking, and debit cards. Technology changes rapidly. Our ability to compete successfully with other financial institutions may depend on whether we can exploit technological changes. We may not be able to exploit technological changes, and any investment we do make may not make us more profitable.

 

Our information systems may experience an interruption or a breach in security, due to cyber-attacks.

 

In the ordinary course of business, we collect and store sensitive data, including proprietary business information and personally identifiable information of our customers and employees in systems and on networks. The secure processing, maintenance, and use of this information is critical to our operations and business strategy. In addition, we rely heavily on communications and information systems to conduct our business. Any failure, interruption, or breach in security or operational integrity of these systems could result in failures or disruptions in our customer relationship management, general ledger, deposit, loan, and other systems. Although we have invested in various technologies and continually review processes and practices that are designed to protect our networks, computers, and data from damage or unauthorized access, our computer systems and infrastructure may nevertheless be vulnerable to attacks by hackers or breached due to employee error, malfeasance, or other disruptions. Further, cyber-attacks can originate from a variety of sources and the techniques used are increasingly sophisticated. A breach of any kind could compromise our systems, and the information stored there could be accessed, damaged, or disclosed. A breach in security or other failure could result in legal claims, regulatory penalties, disruptions in operations, increased expenses, loss of customers and business partners, and damage to our reputation, which could in turn adversely affect our business, financial condition and/or results of operations. Furthermore, as cyber threats continue to evolve and increase, we may be required to expend significant additional financial and operational resources to modify or enhance our protective measures, or to investigate and remediate any identified information security vulnerabilities.

 

Safeguarding our business and customer information increases our cost of operations. To the extent that we, or our third-party vendors, are unable to prevent the theft of or unauthorized access to this information, our operations may become disrupted, we may be subject to claims, and our net income may be adversely affected.

 

Our business depends heavily on the use of computer systems, the Internet and other means of electronic communication and recordkeeping. Accordingly, we must protect our computer systems and network from break-ins, security breaches, and other risks that could disrupt our operations or jeopardize the security of our business and customer information. Moreover, we use third party vendors to provide products and services necessary to conduct our day-to-day operations, which exposes us to risk that these vendors will not perform in accordance with the service arrangements, including by failing to protect the confidential information we entrust to them. Any security measures that we or our vendors implement, including encryption and authentication technology that we use to effect secure transmissions of confidential information, may not be effective to prevent the loss or theft of our information or to prevent risks associated with the Internet, such as cyber-fraud. Advances in computer capabilities, new discoveries in the field of cryptography, or other developments could permit unauthorized persons to gain access to our confidential information in spite of the use of security measures that we believe are adequate. Any compromise of our security measures or of the security measures employed by our vendors of our third party could disrupt our business and/or could subject us to claims from our customers, either of which could have a material adverse effect on our business, financial condition and results of operations.

 

[19]

 

 

Risks Relating to First United Corporation’s Securities

 

The shares of common stock are not insured.

 

The shares of the Corporation’s common stock are not deposits and are not insured against loss by the FDIC or any other governmental or private agency.

 

The common stock is not heavily traded.

 

The Corporation’s common stock is listed on the NASDAQ Global Select Market, but shares of the common stock are not heavily traded. Securities that are not heavily traded can be more volatile than stock trading in an active public market. Factors such as our financial results, the introduction of new products and services by us or our competitors, and various factors affecting the banking industry generally may have a significant impact on the market price of the shares of the common stock. Management cannot predict the extent to which an active public market for the common stock will develop or be sustained in the future. Accordingly, shareholders may not be able to sell their shares at the volumes, prices, or times that they desire.

 

Significant sales of the common stock, or the perception that significant sales may occur in the future, could adversely affect the market price for the common stock.

 

The sale of a substantial number of shares amounts of the Corporation’s common stock could adversely affect the market price of the common stock. The availability of shares for future sale could adversely affect the prevailing market price of the common stock and could cause the market price of the common stock to remain low for a substantial amount of time. In addition, the Corporation may grant equity awards under its equity compensation plans from time to time in effect, including fully-vested shares of common stock. It is possible that if a significant percentage of such available shares were attempted to be sold within a short period of time, the market for the shares would be adversely affected. Management cannot predict whether the market for the common stock could absorb a large number of attempted sales in a short period of time, regardless of the price at which they might be offered. Even if a substantial number of sales do not occur within a short period of time, the mere existence of this “market overhang” could have a negative impact on the market for the common stock and our ability to raise capital in the future.

 

The Corporation’s ability to pay dividends on the common stock is subject to the terms of the outstanding TPS Debentures, which prohibit the Corporation from paying dividends during an interest deferral period.

 

In March 2004, the Corporation issued approximately $30.9 million, in the aggregate, of junior subordinated debentures (“TPS Debentures”) to the Trusts in connection with the Trusts’ sales to third party investors of $30.0 million, in the aggregate, in mandatorily redeemable preferred capital securities. The terms of the TPS Debentures require the Corporation to make quarterly payments of interest to the Trusts, as the holders of the TPS Debentures, although the Corporation has the right to defer payments of interest for up to 20 consecutive quarterly periods. An election to defer interest payments does not constitute an event of default under the terms of the TPS Debentures. The terms of the TPS Debentures prohibit the Corporation from declaring or paying any dividends or making other distributions on, or from repurchasing, redeeming or otherwise acquiring, any shares of its capital securities, including the common stock, if the Corporation elects to defer quarterly interest payments under the TPS Debentures. In addition, a deferral election will require the Trusts to likewise defer the payment of quarterly dividends on their related trust preferred securities.

 

Applicable banking and Maryland laws impose additional restrictions on the ability of the Corporation and the Bank to pay dividends and make other distributions on their capital securities, and, in any event, the payment of dividends is at the discretion of the boards of directors of the Corporation and the Bank.

 

In the past, the Corporation has funded dividends on its capital securities using cash received from the Bank, and this will likely be the case for the foreseeable future. No assurance can be given that the Bank will be able to pay dividends to the Corporation for these purposes at times and/or in amounts requested by the Corporation. Both federal and state laws impose restrictions on the ability of the Bank to pay dividends. Under Maryland law, a state-chartered commercial bank may pay dividends only out of undivided profits or, with the prior approval of the Maryland Commissioner, from surplus in excess of 100% of required capital stock. If, however, the surplus of a Maryland bank is less than 100% of its required capital stock, cash dividends may not be paid in excess of 90% of net earnings. In addition to these specific restrictions, bank regulatory agencies have the ability to prohibit proposed dividends by a financial institution which would otherwise be permitted under applicable regulations if the regulatory body determines that such distribution would constitute an unsafe or unsound practice. Banks that are considered “troubled institution” are prohibited by federal law from paying dividends altogether. Notwithstanding the foregoing, shareholders must understand that the declaration and payment of dividends and the amounts thereof are at the discretion of the Corporation’s Board of Directors. Thus, even at times when the Corporation is not prohibited from paying cash dividends on its capital securities, neither the payment of such dividends nor the amounts thereof can be guaranteed.

 

[20]

 

 

The Corporation’s Articles of Incorporation and Bylaws and Maryland law may discourage a corporate takeover.

 

The Corporation’s Amended and Restated Articles of Incorporation (the “Charter”) and its Amended and Restated Bylaws, as amended (the “Bylaws”), contain certain provisions designed to enhance the ability of the Corporation’s Board of Directors to deal with attempts to acquire control of the Corporation. First, the Board of Directors is classified into three classes. Directors of each class serve for staggered three-year periods, and no director may be removed except for cause, and then only by the affirmative vote of either a majority of the entire Board of Directors or a majority of the outstanding voting stock. Second, the board has the authority to classify and reclassify unissued shares of stock of any class or series of stock by setting, fixing, eliminating, or altering in any one or more respects the preferences, rights, voting powers, restrictions and qualifications of, dividends on, and redemption, conversion, exchange, and other rights of, such securities. The board could use this authority, along with its authority to authorize the issuance of securities of any class or series, to issue shares having terms favorable to management to a person or persons affiliated with or otherwise friendly to management. In addition, the Bylaws require any shareholder who desires to nominate a director to abide by strict notice requirements.

 

Maryland law also contains anti-takeover provisions that apply to the Corporation. The Maryland Business Combination Act generally prohibits, subject to certain limited exceptions, corporations from being involved in any “business combination” (defined as a variety of transactions, including a merger, consolidation, share exchange, asset transfer or issuance or reclassification of equity securities) with any “interested shareholder” for a period of five years following the most recent date on which the interested shareholder became an interested shareholder. An interested shareholder is defined generally as a person who is the beneficial owner of 10% or more of the voting power of the outstanding voting stock of the corporation after the date on which the corporation had 100 or more beneficial owners of its stock or who is an affiliate or associate of the corporation and was the beneficial owner, directly or indirectly, of 10% percent or more of the voting power of the then outstanding stock of the corporation at any time within the two-year period immediately prior to the date in question and after the date on which the corporation had 100 or more beneficial owners of its stock. The Maryland Control Share Acquisition Act applies to acquisitions of “control shares”, which, subject to certain exceptions, are shares the acquisition of which entitle the holder, directly or indirectly, to exercise or direct the exercise of the voting power of shares of stock of the corporation in the election of directors within any of the following ranges of voting power: one-tenth or more, but less than one-third of all voting power; one-third or more, but less than a majority of all voting power or a majority or more of all voting power. Control shares have limited voting rights.

 

Although these provisions do not preclude a takeover, they may have the effect of discouraging, delaying or deferring a tender offer or takeover attempt that a shareholder might consider in his or her best interest, including those attempts that might result in a premium over the market price for the common stock. Such provisions will also render the removal of the Board of Directors and of management more difficult and, therefore, may serve to perpetuate current management. These provisions could potentially adversely affect the market prices of the Corporation’s securities.

 

ITEM 1B.UNRESOLVED STAFF COMMENTS

 

None.

 

ITEM 2.PROPERTIES

 

The headquarters of the Corporation and the Bank occupies approximately 29,000 square feet at 19 South Second Street, Oakland, Maryland, and a 30,000 square feet operations center located at 12892 Garrett Highway, Oakland Maryland. These premises are owned by the Corporation. The Bank owns 19 of its banking offices and leases six. The Bank also leases one office that is used for disaster recovery purposes. Total rent expense on the leased offices and properties was $.5 million in 2018.

 

ITEM 3.LEGAL PROCEEDINGS

 

We are at times, in the ordinary course of business, subject to legal actions. Management, upon the advice of counsel, believes that losses, if any, resulting from current legal actions will not have a material adverse effect on our financial condition or results of operations.

 

ITEM 4.MINE SAFETY DISCLOSURES

 

Not applicable.

 

[21]

 

 

PART II

 

ITEM 5.MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

 

Shares of the Corporation’s common stock are listed on the NASDAQ Global Select Market under the symbol “FUNC”. As of February 28, 2019, the Corporation had 1,335 shareholders of record. The table below sets forth the high and low sales prices for, and the cash dividends declared on, the shares of the Corporation’s common stock for each quarterly period of 2018 and 2017, as reported on the NASDAQ Global Select Market. On March 11, 2019, the closing sales price of the common stock as reported on the NASDAQ Global Select Market was $17.30 per share. The Corporation did not declare any dividends on its common stock during 2017.

 

   High   Low   Dividends Declared 
2018               
1st Quarter  $20.25   $16.70   $0.09 
2nd Quarter   24.32    18.50    0.09 
3rd Quarter   20.95    18.25    0.09 
4th Quarter   19.91    14.75    0.09 
                
2017               
1st Quarter  $15.80   $13.00   $0.00 
2nd Quarter   15.80    13.80    0.00 
3rd Quarter   16.65    14.55    0.00 
4th Quarter   18.30    15.75    0.00 

 

The ability of the Corporation to declare dividends is limited by federal banking laws and Maryland corporation laws. Subject to these and the terms of its other securities, including the TPS Debentures, the payment of dividends on the shares of common stock and the amounts thereof are at the discretion of the Corporation’s board of directors. In November 2010, the Corporation’s board of directors suspended the declaration and payment of cash dividends. This suspension was lifted in 2018. Cash dividends are typically declared on a quarterly basis. When paid, dividends to shareholders are dependent on the ability of the Corporation’s subsidiaries, especially the Bank, to declare dividends to the Corporation. Like the Corporation, the Bank’s ability to declare and pay dividends is subject to limitations imposed by federal and Maryland banking and Maryland corporation laws. A complete discussion of these and other dividend restrictions is contained in Item 1A of Part I of this annual report under the heading “Risks Relating to First United Corporation’s Securities” and in Note 21 to the Consolidated Financial Statements, both of which are incorporated herein by reference. Accordingly, there can be no assurance that dividends will be declared on the shares of common stock in any future fiscal quarter.

 

The Corporation’s Board of Directors periodically evaluates the Corporation’s dividend policy, both internally and in consultation with the Federal Reserve.

 

Issuer Repurchases

 

Neither the Corporation nor any of its affiliates (as defined by Exchange Act Rule 10b-18) repurchased any shares of the Corporation’s common stock during 2018.

 

Equity Compensation Plan Information

 

Pursuant to the SEC’s Regulation S-K Compliance and Disclosure Interpretation 106.01, the information regarding the Corporation’s equity compensation plans required by this Item pursuant to Item 201(d) of Regulation S-K is located in Item 12 of Part III of this annual report and is incorporated herein by reference.

 

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ITEM 6.SELECTED FINANCIAL DATA

 

The following table sets forth certain selected financial data for each of the last five calendar years and is qualified in its entirety by the detailed information and financial statements, including notes thereto, included elsewhere or incorporated by reference in this annual report.

 

(Dollars in thousands, except for share data)  2018   2017   2016   2015   2014 
Balance Sheet Data                         
Total Assets  $1,384,516   $1,336,470   $1,318,190   $1,323,458   $1,332,296 
Net Loans   996,667    882,546    882,008    867,101    827,926 
Investment Securities   231,651    240,102    237,169    275,792    330,566 
Deposits   1,067,527    1,039,390    1,014,229    998,794    981,323 
Long-term Borrowings   100,929    120,929    131,737    147,537    182,606 
Shareholders’ Equity   117,066    108,390    113,698    120,771    108,999 
                          
Operating Data                         
Interest Income  $52,294   $46,949   $45,863   $45,032   $46,386 
Interest Expense   8,112    7,371    8,223    9,407    10,870 
Net Interest Income   44,182    39,578    37,640    35,625    35,516 
Provision for Loan Losses   2,111    2,534    3,122    1,054    2,513 
Other Operating Income   15,041    14,311    14,127    24,992    12,907 
Net Gains   127    29    526    1,016    1,053 
Other Operating Expense   43,808    39,170    39,107    41,115    40,095 
Income Before Taxes   13,431    12,214    10,064    19,464    6,868 
Income Tax expense (2017 includes $3,226 from tax reform impact) 1   2,764    6,945    2,783    6,473    1,271 
Net Income  $10,667   $5,269   $7,281   $12,991   $5,597 
Accumulated preferred stock dividends and                         
discount accretion   0    (1,215)   (2,025)   (2,700)   (2,601)
Net income available to                         
common shareholders  $10,667   $4,054   $5,256   $10,291   $2,996 
                          
Per Share Data                         
Basic and diluted net income per                         
common share  $1.51   $0.58   $0.84   $1.65   $0.48 
Dividends Paid   0.27    0    0    0    0 
Book Value   16.52    15.34    14.95    14.51    13.30 
                          
Significant Ratios                         
Return on Average Assets   0.81%   0.40%   0.55%   0.98%   0.42%
Return on Average Equity   9.39%   4.52%   6.38%   11.40%   5.07%
Average Equity to Average Assets   8.66%   8.82%   8.62%   8.69%   8.26%
Dividend Payout Ratio   17.88%   0.00%   0.00%   0.00%   0.00%
Total Risk-based Capital Ratio   15.91%   15.98%   16.71%   17.21%   15.40%
Tier I Capital to Risk Weighted Assets   14.87%   14.97%   14.76%   15.24%   14.23%
Tier I Capital to Average Assets   11.47%   11.00%   10.95%   11.64%   11.29%
Common Equity Tier I to Risk Weighted Assets   12.45%   12.54%   10.74%   9.99%     

 

(1) Refer to Note 17 for more discussion of tax reform

 

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ITEM 7:MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

This discussion and analysis should be read in conjunction with the Consolidated Financial Statements and notes thereto for the years ended December 31, 2018 and 2017, which are included in Item 8 of Part II of this annual report.

 

Overview

 

First United Corporation is a bank holding company that, through the Bank and its non-bank subsidiaries, provides an array of financial products and services primarily to customers in four Western Maryland counties and four Northeastern West Virginia counties. Its principal operating subsidiary is the Bank, which consists of a community banking network of 25 branch offices located throughout its market areas. Our primary sources of revenue are interest income earned from our loan and investment securities portfolios and fees earned from financial services provided to customers.

 

Consolidated net income available to common shareholders was $10.7 million for the year ended December 31, 2018, compared to $4.1 million for 2017. Basic and diluted net income per common share for the year ended December 31, 2018 were both $1.51, compared to basic and diluted net income per common share of $.58 for 2017. The increase in earnings for 2018 was attributable to a $4.6 million increase in net interest income, an increase of $.7 million in other operating income, exclusive of gains, a $.4 million decrease in provision expense, and a $4.2 million decrease in income tax expense. The decrease in income tax expense was driven by the enactment of the Tax Act in December 2017, which reduced the federal tax rate from 35% to 21%. The reduction in the tax rate at December 31, 2017 increased tax expense due to the revaluation of our deferred tax assets at the lower rate. These changes were offset by a $4.6 million increase in other operating expenses, driven primarily by increased salaries and benefits relating to new hires late in 2017, merit increases and increased life and health costs due to increased claims. The elimination of preferred stock dividends relating to the redemption of $10.0 million of the Corporation’s Fixed Rate Cumulative Perpetual Preferred Stock, Series A (the “Series A Preferred Stock”) in each of March 2017 and November 2017 also contributed to the increase in net income. The net interest margin for the year ended December 31, 2018, on a fully tax equivalent (“FTE”) basis, increased to 3.74% from 3.37% for the year ended December 31, 2017.

 

The provision for loan losses decreased to $2.1 million for the year ended December 31, 2018, compared to $2.5 million for the year ended December 31, 2017. The decrease was driven primarily by a reduction in net credit losses and historical loss factors due to a large charge-off rolling off from prior periods. These factors were attributable to good asset quality and improving economies. Specific allocations have been made for impaired loans where management has determined that the collateral supporting the loans is not adequate to cover the loan balance, and the qualitative factors affecting the allowance for loan losses (the “ALL”) have been adjusted based on the current economic environment and the characteristics of the loan portfolio.

 

Other operating income increased $.8 million for the year ended December 31, 2018 when compared to 2017. This increase was attributable to increases in trust department earnings of $.4 million, brokerage commissions of $.2 million and debit card income of $.1 million. These increases were offset slightly by decreases in service charges on deposit accounts and Bank Owned Life Insurance (“BOLI”) income.

 

Operating expenses increased $4.6 million when comparing the year ended December 31, 2018 to the year ended December 31, 2017. Salaries and benefits increased $1.9 million, primarily due to new hires in late 2017, merit increases and an increase in life and health insurance related to increased claims. We also saw an increase of $.9 million in data processing, equipment and occupancy expense due to increased depreciation expense related to the branch renovation projects and new digital services implemented during 2018 as compared to the same period of 2017. Other Real Estate Owned (“OREO”) expenses increased $1.3 million due primarily to valuation allowance write-downs on properties in 2018.

 

Comparing December 31, 2018 to December 31, 2017, loans outstanding increased by $115.2 million (13.1%). CRE loans increased $23.8 million due primarily to several new large relationships in 2018. Acquisition and development (“A&D”) loans increased $7.8 million. Commercial and industrial (“C&I”) loans increased $34.7 million due to several new relationships as well as new balances for several existing relationships. Residential mortgage loans increased $38.3 million due to the purchase of a $15.0 million 1-4 family mortgage pool in February 2018, and in-house growth continuing in our professional program, offset slightly by amortization on existing balances. This growth was in fixed and adjustable rate products. The consumer loan portfolio increased by $10.6 million due primarily to the purchase of a $10.0 million student loan pool in the first quarter of 2018. New production of consumer loans was partially offset by regular amortization. Approximately 27% and 28% of the commercial loan portfolio was collateralized by real estate at December 31, 2018 and 2017, respectively.

 

Interest income on loans increased by $5.4 million (on an FTE basis) in 2018 when compared to 2017 due to the rate increases by the Federal Reserve in 2018, loan growth and new loans booked at higher rates. Interest income on our investment securities increased by $.4 million (on an FTE basis) in 2018 when compared to 2017 primarily due to increased rates on the CDO portfolio due to the variable rates. During 2018, we continued to use the cash flow on the investment portfolio to fund loans. New purchases were limited to investments for CRA purposes and additional disbursements for the West Virginia Tax Increment Fund (“TIF”) bond. Additional information on the composition of interest income is available in Table 1 that appears on page 30 of this report.

 

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Comparing December 31, 2018 to December 31, 2017, total deposits increased $28.1 million. During 2018, non-interest bearing deposits increased $10.2 million due to new account openings as well as increased balances in existing accounts. Traditional savings accounts decreased $1.5 million as we saw balances shift to other products at higher rates. Total demand deposits decreased $8.4 million due to several large relationships re-allocating balances. Total money market accounts increased $10.3 million due primarily to new account openings in our new, higher rate money market product in the fourth quarter of 2018. Time deposits less than $100,000 declined $8.2 million and time deposits greater than $100,000 increased $25.7 million. In November 2018, two short-term brokered certificates of deposit of $15.0 million and $10.0 million were purchased through third-party brokers to fix interest expense in the rising rate environment.

 

Interest expense increased $.7 million for the year ended December 31, 2018 when compared to the year ended December 31, 2017. This increase in interest expense was due to a $1.0 million increase in interest on deposits relating to increased empowerment pricing on existing relationships, particularly on maturing certificates of deposit, and new relationships in the new, higher-rate money market product introduced late in 2018. Short-term borrowings interest increased $.5 million due to the increase in overnight borrowings during the latter half of 2018. The increase in overnight borrowings was due to minimal deposit growth to fund the continued loan growth as well as the shift of a $15.0 million FHLB long-term advance to short-term borrowings at its maturity in April 2018. These increases were partially offset by a decrease of $.7 million in long-term borrowings due to the repayment of the high cost $10.8 million Trust Preferred debt in March 2017 and the repayment of two FHLB advances totaling $5.0 million that matured in January 2018.

 

On December 22, 2017, the President of the United States signed the Tax Act into law, which, among other things, reduced the federal income tax rate for C Corporations from 35% to 21% effective January 1, 2018. The Tax Act required us to revalue, using the new 21% federal income tax rate, all of our deferred tax assets and deferred tax liabilities based on the rates at which they are schedule to reverse. This revaluation required us to recognize a one-time tax expense of $3.2 million in the fourth quarter of 2017. Our effective tax rate for 2017 was 56.8%, of which 26.4% related to the revaluation required by the Tax Act. Tax expense decreased $4.2 million in 2018 when compared to 2017 primarily due to the reduction in the federal tax rate. The effective tax rate for 2018 was 20.6%.

 

Estimates and Critical Accounting Policies

 

This discussion and analysis of our financial condition and results of operations is based upon our Consolidated Financial Statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent liabilities. (See Note 1 to the Consolidated Financial Statements.) On an on-going basis, management evaluates estimates and bases those estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Management believes the following critical accounting policies affect our more significant judgments and estimates used in the preparation of the Consolidated Financial Statements.

 

Allowance for Loan Losses

 

One of our most important accounting policies is that related to the monitoring of the loan portfolio. A variety of estimates impact the carrying value of the loan portfolio and resulting interest income, including the calculation of the ALL, the valuation of underlying collateral, and the timing of loan charge-offs. The ALL is established and maintained at a level that management believes is adequate to cover losses resulting from the inability of borrowers to make required payments on loans. Estimates for loan losses are arrived at by analyzing risks associated with specific loans and the loan portfolio, current and historical trends in delinquencies and charge-offs, and changes in the size and composition of the loan portfolio. The analysis also requires consideration of the economic climate and direction, changes in lending rates, political conditions, legislation impacting the banking industry and economic conditions specific to Western Maryland and Northeastern West Virginia. Because the calculation of the ALL relies on management’s estimates and judgments relating to inherently uncertain events, actual results may differ from management’s estimates.

 

The ALL is also discussed below in Item 7 under the heading “Allowance for Loan Losses” and in Note 7 to the Consolidated Financial Statements.

 

Goodwill

 

Accounting Standards Codification (“ASC”) Topic 350, Intangibles - Goodwill and Other, establishes standards for the amortization of acquired intangible assets and impairment assessment of goodwill.  The $11.0 million in recorded goodwill at December 31, 2018 is related to the Bank’s 2003 acquisition of Huntington National Bank branches and is not subject to periodic amortization.

 

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Goodwill arising from business combinations represents the value attributable to unidentifiable intangible elements in the business acquired. Goodwill is not amortized but is tested for impairment annually or more frequently if events or changes in circumstances indicate that the asset might be impaired. Impairment testing requires that the fair value of each of an entity’s reporting units be compared to the carrying amount of its net assets, including goodwill.  If the estimated current fair value of the reporting unit exceeds its carrying value, then no additional testing is required and an impairment loss is not recorded. Otherwise, additional testing is performed and, to the extent such additional testing results in a conclusion that the carrying value of goodwill exceeds its implied fair value, an impairment loss is recognized.

 

For evaluation purposes, the Corporation is considered to be a single reporting unit. Accordingly, our goodwill relates to value inherent in the banking business and the value is dependent upon our ability to provide quality, cost effective services in a highly competitive local market.  This ability relies upon continuing investments in processing systems, the development of value-added service features and the ease of use of our services.  As such, goodwill value is supported ultimately by revenue that is driven by the volume of business transacted.  A decline in earnings as a result of a lack of growth or the inability to deliver cost effective services over sustained periods can lead to impairment of goodwill, which could adversely impact earnings in future periods.  ASC Topic 350 requires an annual evaluation of goodwill for impairment.  The determination of whether or not these assets are impaired involves significant judgments and estimates. 

 

At December 31, 2018, the date of the Corporation’s annual impairment test, the fair value of the Corporation as determined by the price of its common stock exceeded the carrying amount of the Corporation’s common equity.

 

Based on the results of the evaluation, management concluded that the recorded value of goodwill at December 31, 2018 was not impaired.  However, future changes in strategy and/or market conditions could significantly impact these judgments and require adjustments to recorded asset balances. Management will continue to evaluate goodwill for impairment on an annual basis and as events occur or circumstances change.

 

Accounting for Income Taxes

 

We account for income taxes in accordance with ASC Topic 740, “Income Taxes”. Under this guidance, deferred taxes are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates that will apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized as income or expense in the period that includes the enactment date.

 

We regularly review the carrying amount of our net deferred tax assets to determine if the establishment of a valuation allowance is necessary. If based on the available evidence, it is more likely than not that all or a portion of our net deferred tax assets will not be realized in future periods, then a deferred tax valuation allowance must be established. Consideration is given to various positive and negative factors that could affect the realization of the deferred tax assets. In evaluating this available evidence, management considers, among other things, historical performance, expectations of future earnings, the ability to carry back losses to recoup taxes previously paid, length of statutory carry forward periods, experience with utilization of operating loss and tax credit carry forwards not expiring, tax planning strategies and timing of reversals of temporary differences. Significant judgment is required in assessing future earnings trends and the timing of reversals of temporary differences. Our evaluation is based on current tax laws as well as management’s expectations of future performance.

 

Management expects that the Corporation’s adherence to the required accounting guidance may result in increased volatility in quarterly and annual effective income tax rates because of changes in judgment or measurement including changes in actual and forecasted income before taxes, tax laws and regulations, and tax planning strategies.

 

Additional information about income taxes is set forth below under the heading, “CONSOLIDATED STATEMENT OF INCOME REVIEW – Applicable Income Taxes” and in Note 17 to Consolidated Financial Statements presented in Item 8 of Part II of this annual report.

 

Other-Than-Temporary Impairment of Investment Securities

 

Management systematically evaluates the securities in our investment portfolio for impairment on a quarterly basis. Based upon the application of accounting guidance for subsequent measurement in ASC Topic 320 (Section 320-10-35), management assesses whether (i) we have the intent to sell a security being evaluated and (ii) it is more likely than not that we will be required to sell the security prior to its anticipated recovery. If neither applies, then declines in the fair values of securities below their cost that are considered other-than-temporary declines are split into two components. The first is the loss attributable to declining credit quality. Credit losses are recognized in earnings as realized losses in the period in which the impairment determination is made. The second component consists of all other losses, which are recognized in other comprehensive loss. In estimating other-than-temporary impairment (“OTTI”) losses, management considers (a) the length of time and the extent to which the fair value has been less than cost, (b) adverse conditions specifically related to the security, an industry, or a geographic area, (c) the historic and implied volatility of the fair value of the security, (d) changes in the rating of the security by a rating agency, (e) recoveries or additional declines in fair value subsequent to the balance sheet date, (f) failure of the issuer of the security to make scheduled interest or principal payments, and (g) the payment structure of the debt security and the likelihood of the issuer being able to make payments that increase in the future. Management also monitors cash flow projections for securities that are considered beneficial interests under the guidance of ASC Subtopic 325-40, Investments – Other – Beneficial Interests in Securitized Financial Assets, (ASC Section 325-40-35). This process is described more fully in the section of the Consolidated Balance Sheet Review entitled “Investment Securities”.

 

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Fair Value of Investments

 

We have determined the fair value of our investment securities in accordance with the requirements of ASC Topic 820, Fair Value Measurements and Disclosures, which defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements required under other accounting pronouncements. We measure the fair market values of our investments based on the fair value hierarchy established in Topic 820. The determination of fair value of investments and other assets is discussed further in Note 23 to the Consolidated Financial Statements.

 

Pension Plan Assumptions

 

Our pension plan costs are calculated using actuarial concepts, as discussed within the requirements of ASC Topic 715, Compensation – Retirement Benefits. Pension expense and the determination of our projected pension liability are based upon two critical assumptions: the discount rate and the expected return on plan assets. We evaluate each of these critical assumptions annually. Other assumptions impact the determination of pension expense and the projected liability including the primary employee demographics, such as retirement patterns, employee turnover, mortality rates, and estimated employer compensation increases. These factors, along with the critical assumptions, are carefully reviewed by management each year in consultation with our pension plan consultants and actuaries. Further information about our pension plan assumptions, the plan’s funded status, and other plan information is included in Note 18 to the Consolidated Financial Statements.

 

Other than as discussed above, management does not believe that any material changes in our critical accounting policies have occurred since December 31, 2018.

 

Adoption of New Accounting Standards and Effects of New Accounting Pronouncements

 

Note 1 to the Consolidated Financial Statements discusses new accounting pronouncements that, when adopted, could affect our future consolidated financial statements.

 

CONSOLIDATED STATEMENT OF INCOME REVIEW

 

Net Interest Income

 

Net interest income is our largest source of operating revenue. Net interest income is the difference between the interest that we earn on our interest-earning assets and the interest expense we incur on our interest-bearing liabilities. For analytical and discussion purposes, net interest income is adjusted to a FTE basis to facilitate performance comparisons between taxable and tax-exempt assets by increasing tax-exempt income by an amount equal to the federal income taxes that would have been paid if this income were taxable at the statutorily applicable rate. This is a Non-GAAP disclosure and management believes it is not materially different than the corresponding GAAP disclosure.

 

The table below summarizes net interest income (on an FTE basis) for 2018 and 2017.

 

(Dollars in thousands)  2018   2017 
Interest income  $53,090   $47,586 
Interest expense   8,112    7,371 
Net interest income  $44,978   $40,215 
           
Net interest margin %   3.74%   3.37%

 

Net interest income on an FTE basis increased $4.8 million (11.8%) for the year ended December 31, 2018 when compared to 2017. Interest and fees on loans increased by $5.4 million (on an FTE basis) in 2018 when compared to 2017, offset slightly by an increase of $.7 million in interest expense for the same time period. The net interest margin for the year ended December 31, 2018 increased to 3.74%, compared to 3.37% for the year ended December 31, 2017.

 

Interest and fees on loans increased due to the rate increases by the Federal Reserve in 2018, loan growth and new loans booked at higher rates as well as the collection of interest and fees on a non-accrual loan at payoff. Interest income on our investment securities increased by $.4 million (on an FTE basis) in 2018 when compared to 2017. This increase was primarily due to rate increases on the collateralized debt obligation (“CDO”) portfolio as these are variable rate investments. When comparing the year ended December 31, 2018 to the year ended December 31, 2017, there was an increase of $9.9 million in average interest-earning assets, driven primarily by an increase of $56.5 million in average loan balances, offset by a decrease of $42.7 million in federal funds sold.

 

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Interest expense increased $.7 million for the year ended December 31, 2018 when compared to the year ended December 31, 2017. This increase was primarily due to increases in rates paid on interest-bearing deposits as pricing pressures continued in all markets. We continued to offer empowered pricing on full relationship customers as well as the introduction of a new, higher rate money market product in late 2018. The increase was partially offset by a $17.1 million reduction in average long-term borrowings, which resulted from the repayment of two FHLB advances totaling $5.0 million at maturity in January 2018, the shift of a $15.0 million FHLB advance that matured in April 2018 to short-term borrowings, and the repayment of $10.8 million of TPS Debentures held by Trust III in March 2017. The effect on the average rate paid on total interest-bearing liabilities was an eight-basis point increase, from .78% for 2017 to .86% for 2018.

 

As shown below, the composition of total interest income between 2018 and 2017 remained relatively stable between interest and fees on loans and investment securities with a slight increase in interest and fees on loans and a slight decrease in other due to the reduced cash balances invested at Fed.

 

   % of Total Interest Income 
   2018   2017 
Interest and fees on loans   86%   84%
Interest on investment securities   13%   14%
Other   1%   2%

 

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Table 1 sets forth the average balances, net interest income and expense, and average yields and rates for our interest-earning assets and interest-bearing liabilities for 2018, 2017 and 2016. Table 2 sets forth an analysis of volume and rate changes in interest income and interest expense of our average interest-earning assets and average interest-bearing liabilities for 2018, 2017 and 2016. Table 2 distinguishes between the changes related to average outstanding balances (changes in volume created by holding the interest rate constant) and the changes related to average interest rates (changes in interest income or expense attributed to average rates created by holding the outstanding balance constant).

 

Distribution of Assets, Liabilities and Shareholders’ Equity

Interest Rates and Interest Differential – Tax Equivalent Basis

Table 1

 

   For the Years Ended December 31 
   2018   2017   2016 
(Dollars in thousands)  Average
Balance
   Interest   Average
Yield/Rate
   Average
Balance
   Interest   Average
Yield/Rate
   Average
Balance
   Interest   Average
Yield/Rate
 
Assets                                             
Loans  $946,376   45,119    4.77%  $889,880   39,670    4.46%  $899,516   38,981    4.33%
Investment Securities:                                             
Taxable   215,944    5,820    2.70    220,107    5,554    2.52    228,174    5,611    2.46 
Non taxable   17,838    1,699    9.52    17,602    1,527    8.68    20,840    1,391    6.67 
Total   233,782    7,519    3.22    237,709    7,081    3.01    249,014    7,002    2.81 
Federal funds sold   16,594    155    0.93    59,275    574    0.97    40,011    161    0.40 
Interest-bearing deposits with other banks   2,024    17    0.84    1,879    9    0.48    2,032    4    0.20 
Other interest earning assets   5,037    280    5.56    5,206    252    4.84    5,855    270    4.61 
Total earning assets   1,203,813    53,090    4.41%   1,193,949    47,586    3.99%   1,196,428    46,418    3.88%
Allowance for loan losses   (10,428)             (10,854)             (12,183)          
Non-earning assets   118,517              138,918              140,819           
Total Assets  $1,311,902             $1,322,013             $1,325,064           
                                              
Liabilities and Shareholders’ Equity                                             
Interest-bearing demand deposits  $170,642   180    0.11%  $171,697   113    0.07%  $176,049   137    0.08%
Interest-bearing money markets   211,969    937    0.44    221,325    467    0.21    234,075    349    0.15 
Savings deposits   160,968    199    0.12    156,538    176    0.11    147,428    168    0.11 
Time deposits:                                             
Less than $100k   104,289    1,054    1.01    114,503    1,123    0.98    124,129    1,245    1 
$100k or more   123,170    1,876    1.52    120,190    1,412    1.17    120,253    1,251    1.04 
Short-term borrowings   61,774    525    0.85    37,376    73    0.20    31,007    60    0.19 
Long-term borrowings   106,217    3,341    3.15    123,356    4,007    3.25    146,315    5,013    3.43 
Total interest-bearing liabilities   939,029    8,112    0.86%   944,985    7,371    0.78%   979,256    8,223    0.84%
Non-interest-bearing deposits   239,838              237,578              209,948           
Other liabilities   19,376              22,867              21,703           
Shareholders’ Equity   113,659              116,583              114,157           
Total Liabilities and Shareholders’ Equity  $1,311,902             $1,322,013             $1,325,064           
Net interest income and spread       44,978    3.55%       40,215    3.21%       38,195    3.04%
Net interest margin             3.74%             3.37%             3.19%

 

Notes:

(1)The above table reflects the average rates earned or paid stated on a FTE basis assuming a tax rate of 21% for 2018, and 35% for 2017 and 2016. Non-GAAP interest income on a fully taxable equivalent basis for the years ended December 31, 2018, 2017 and 2016 were $796, $637 and $555, respectively.
(2)The average balances of non-accrual loans for the years ended December 31, 2018, 2017 and 2016, which were reported in the average loan balances for these years, were $5,023, $10,872 and $14,953, respectively.
(3)Net interest margin is calculated as net interest income divided by average earning assets.
(4)The average yields on investments are based on amortized cost.

 

[29]

 

 

Interest Variance Analysis (1)

Table 2

 

   2018 Compared to 2017   2017 Compared to 2016 
(In thousands and tax equivalent basis)  Volume   Rate   Net   Volume   Rate   Net 
Interest Income:                              
Loans  $2,520   $2,929   $5,449   $(418)  $1,107   $689 
Taxable Investments   (105)   371    266    (198)   141    (57)
Non-taxable Investments   20    152    172    (216)   352    136 
Federal funds sold   (414)   (5)   (419)   78    335    413 
Interest-bearing deposits   1    7    8    0    5    5 
Other interest earning assets   (8)   36    28    (30)   12    (18)
Total interest income   2,014    3,490    5,504    (784)   1,952    1,168 
                               
Interest Expense:                              
Interest-bearing demand deposits   (1)   68    67    (3)   (21)   (24)
Interest-bearing money markets   (20)   490    470    (19)   137    118 
Savings deposits   5    18    23    10    (2)   8 
Time deposits less than $100k   (100)   31    (69)   (97)   (25)   (122)
Time deposits $100k or more   35    429    464    (1)   162    161 
Short-term borrowings   49    403    452    12    1    13 
Long-term borrowings   (557)   (109)   (666)   (787)   (219)   (1,006)
Total interest expense   (589)   1,330    741    (885)   33    (852)
                               
Net interest income  $2,603   $2,160   $4,763   $101   $1,919   $2,020 

 

Note:

(1)The change in interest income/expense due to both volume and rate has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the change in each.

 

Provision for Loan Losses

 

The provision for loan losses was $2.1 million for the year ended December 31, 2018, compared to $2.5 million for the year ended December 31, 2017. The decrease was driven primarily by a reduction in net credit losses as we continued to see good asset quality and improving economies (discussed below in the section entitled “FINANCIAL CONDITION - Allowance and Provision for Loan Losses”). Management believes that the ALL reflects a level commensurate with the risk inherent in our loan portfolio.

 

Other Operating Income

 

The following table shows the major components of other operating income for the past two years, exclusive of net gains, and the percentage changes during these years:

 

(Dollars in thousands)  2018   2017   % Change 
Service charges on deposit accounts  $2,275   $2,308    -1.43%
Other service charge income   877    837    4.78%
Debit card income   2,534    2,389    6.07%
Trust department income   6,692    6,246    7.14%
Bank owned life insurance (BOLI) income   1,162    1,187    -2.11%
Brokerage commissions   1,078    872    23.62%
Other income   423    472    -10.38%
Total other operating income  $15,041   $14,311    5.10%

 

Other operating income, exclusive of net gains, increased by $.7 million for the year ended December 31, 2018 when compared to 2017. As compared to 2017, the Company experienced increases in trust department earnings of $.4 million, brokerage commissions of $.2 million and debit card income of $.1 million. These increases were offset by slight declines in service charges on deposit accounts and BOLI income. Trust assets under management were $810.0 million at December 31, 2018 and $824.0 million at December 31, 2017.

 

[30]

 

 

Net gains of $127 thousand were reported through other income for the year ended December 31, 2018, compared to net gains of $29 thousand for 2017. The increase in gains realized in 2018 was due to a gain on a called trust preferred investment in the second quarter of 2018. This investment was called at par and had previously been written down from impairment charges.

 

Other Operating Expense

 

The following table compares the major components of other operating expense for 2018 and 2017:

 

(Dollars in thousands)  2018   2017   % Change 
Salaries and employee benefits  $24,170   $22,239    8.68%
Other expenses   4,625    4,466    3.56%
FDIC premiums   639    634    0.79%
Equipment   3,160    2,610    21.07%
Occupancy   2,551    2,496    2.20%
Data processing   3,858    3,511    9.88%
Marketing   530    536    -1.12%
Professional services   1,255    985    27.41%
Other real estate owned expense   1,456    190    666.32%
Contract labor   723    683    5.86%
Line rentals   841    820    0.03%
Total other operating expense  $43,808   $39,170    11.84%

 

Operating expenses increased $4.6 million when comparing the year ended December 31, 2018 to the year ended December 31, 2017. Salaries and benefits increased $1.9 million, attributable primarily to new hires in late 2017, merit increases and an increase in life and health insurance related to increased claims. We also saw an increase of $.9 million in data processing, equipment and occupancy expense due to increased depreciation expense related to the branch renovation projects and new digital services implemented during 2018 as compared to the same period of 2017. OREO expenses increased $1.3 million due primarily to valuation allowance write-downs on properties in 2018.

 

Applicable Income Taxes

 

We recognized a tax expense of $2.8 million in 2018, compared to a tax expense of $6.9 million in 2017. As noted above, $3.2 million of the tax expense recorded in 2017 resulted from the revaluation of our deferred tax assets and liabilities required by the Tax Act. See the discussion under “Income Taxes” in Note 17 to the Consolidated Financial Statements presented elsewhere in this annual report for a detailed analysis of our deferred tax assets and liabilities. A valuation allowance has been provided for the $2.4 million in deferred tax assets associated with state tax loss carry forwards, which will expire commencing in 2030.

 

At December 31, 2018, the Corporation had West Virginia net operating losses (“NOLs”) of approximately $1.7 million for which deferred tax assets of $.1 million, have been recorded.  West Virginia NOLs were created in 2010, 2012, 2014 and 2016 and will begin to expire in 2022. Management has determined that a deferred tax valuation allowance for these NOLs is not required for 2018 because management believes it is more likely than not (defined a level of likelihood that is more than 50%) that these deferred tax assets will be realized prior to the expiration of their carry-forward periods. The Corporation fully utilized the federal NOLs in 2018.

 

At December 31, 2018, the Corporation had Maryland NOLs of $40.1 million for which a deferred tax asset of $2.4 million has been recorded. There has been and continues to be a full valuation allowance on these NOLs based on the fact that management’s belief that it is more likely than not that these NOLs will not be realized prior to the expiration of their carry-forward periods because the Corporation files a separate Maryland income tax return, the Corporation has recurring state tax losses, and management believes the Corporation will not generate sufficient taxable income in the future to fully utilize the NOLs. The valuation allowance was $2.4 million at December 31, 2018 and 2017.

 

We have concluded that no valuation allowance is deemed necessary for our remaining federal and state deferred tax assets at December 31, 2018, as it is more likely than not that they will be realized based on the expected reversal of deferred tax liabilities, the generation of future income sufficient to realize the deferred tax assets as they reverse, and the ability to implement tax planning strategies to prevent the expiration of any carry-forward periods.

 

[31]

 

 

CONSOLIDATED BALANCE SHEET REVIEW

 

Overview

 

Total assets at December 31, 2018 increased slightly to $1.4 billion from the $1.3 billion recorded at December 31, 2017. Comparing 2018 to 2017, cash and interest-bearing deposits in other banks decreased by $60.2 million, the investment portfolio decreased by $8.5 million, and gross loans increased by $115.2 million. Net deferred tax assets decreased by $1.4 million. OREO balances decreased by $3.5 million due to sales of properties as well as valuation allowance write-downs as new appraisals were obtained on properties in 2018. The balance of our BOLI investments increased by $1.2 million due to earnings in 2018. Total liabilities increased by $39.4 million for the year ended December 31, 2018 when compared to 2017 due primarily to an increase of $28.1 million in deposits due in large part to the purchase of two short-term brokered certificates of deposit of $25.0 million. Short-term borrowings increased by $28.9 million due to an increase in overnight borrowings. This increase was related to a $15.0 million FHLB advance that was shifted from long-term borrowings at its maturity in April 2018 and the utilization of our funding sources from our correspondent banks. Long-term borrowings decreased by $20.0 million as a result of the repayment of two FHLB advances totaling $5.0 million at maturity in January 2018 and the shift of a $15.0 FHLB advance to short-term borrowings as discussed above. Comparing December 31, 2018 to December 31, 2017, shareholders’ equity increased by $8.9 million as a result of the Corporation’s income recorded in 2018 less dividends paid to the common shareholders.

 

As indicated below, the total interest-earning asset mix changed at December 31, 2018 as compared to December 31, 2017 as cash was utilized for the strong loan growth in 2018. The mix for each year is illustrated below:

 

   Year End Percentage of Total Assets 
   2018   2017 
Cash and cash equivalents   2%   6%
Net loans   72%   66%
Investments   17%   18%

 

The year-end total liability mix has remained consistent during the two-year period as illustrated below.

 

   Year End Percentage of Total Liabilities 
   2018   2017 
Total deposits   84%   84%
Total borrowings   14%   14%

 

Loan Portfolio

 

The Bank is actively engaged in originating loans to customers primarily in Allegany County, Frederick County, Garrett County, and Washington County in Maryland, and in Berkeley County, Mineral County, Monongalia County, and Harrison County in West Virginia; and the surrounding regions of West Virginia and Pennsylvania. We have policies and procedures designed to mitigate credit risk and to maintain the quality of our loan portfolio. These policies include underwriting standards for new credits as well as continuous monitoring and reporting policies for asset quality and the adequacy of the allowance for loan losses. These policies, coupled with ongoing training efforts, have provided effective checks and balances for the risk associated with the lending process. Lending authority is based on the type of the loan, and the experience of the lending officer.

 

Commercial loans are collateralized primarily by real estate and, to a lesser extent, equipment and vehicles. Unsecured commercial loans represent an insignificant portion of total commercial loans. Residential mortgage loans are collateralized by the related property. Generally, a residential mortgage loan exceeding a specified internal loan-to-value ratio requires private mortgage insurance. Installment loans are typically collateralized, with loan-to-value ratios which are established based on the financial condition of the borrower. We also have made unsecured consumer loans to qualified borrowers meeting our underwriting standards. Additional information about our loans and underwriting policies can be found in Item 1 of Part I of this annual report under the heading “Banking Products and Services”.

 

[32]

 

 

Table 3 sets forth the composition of our loan portfolio. Historically, our policy has been to make the majority of our loan commitments in our market areas. We had no foreign loans in our portfolio as of December 31 for any of the years presented.

 

Summary of Loan Portfolio

 

Table 3

 

The following table presents the composition of our loan portfolio as of December 31 for the past five years:

 

(In millions)  2018   2017   2016   2015   2014 
Commercial real estate  $306.9   $283.2   $298.0   $280.5   $256.1 
Acquisition and development   118.4    110.5    104.3    111.0    99.3 
Commercial and industrial   111.4    76.7    72.3    73.9    93.3 
Residential mortgage   436.9    398.6    393.4    388.7    367.6 
Consumer   34.1    23.5    23.9    24.9    23.7 
Total Loans  $1,007.7   $892.5   $891.9   $879.0   $840.0 

 

Comparing December 31, 2018 to December 31, 2017, loans outstanding increased by $115.2 million. CRE loans increased by $23.7 million due primarily to several new large relationships in 2018. A&D loans increased $7.9 million. C&I loans increased by $34.7 million due to several new relationships as well as new balances for several large existing relationships. Residential mortgage loans increased by $38.3 million due to the purchase of a $15.0 million mortgage pool in the first quarter of 2018 as well as production in the professional’s program. Growth continued in both fixed and adjustable products. The consumer loan portfolio increased by $10.6 million due primarily to the purchase of a $10.0 million student loan pool in the first quarter of 2018. At December 31, 2018 and 2017, 27% and 28%, respectively, of the commercial loan portfolio was collateralized by real estate. Adjustable interest rate loans made up 52% of total loans at December 31, 2018 and 58% at December 31, 2017, with the balance being fixed–interest rate loans as customer preference shifted to fixed rate products in the rising rate environment.

 

Comparing December 31, 2017 to December 31, 2016, loans outstanding increased by $.6 million. CRE loans decreased by $14.8 million due primarily to charge-offs of $4.5 million on one large non-accrual loan, payoffs of $22.0 million on two large CRE loans offset by new production in the fourth quarter of 2017. A&D loans increased by $6.2 million and C&I loans increased by $4.4 million. Residential mortgage loans increased by $5.2 million due to continued activity in the 1-4 family residential professional program, offset by payoffs and amortization of home equity balances. The consumer loan portfolio decreased slightly by $.4 million due to regularly scheduled payments. Approximately 28% and 39%, respectively, of the commercial loan portfolio was collateralized by real estate at December 31, 2017 and December 31, 2016. Adjustable interest rate loans made up 58% of total loans at December 31, 2017 and 60% at December 31, 2016, with the balance being fixed–interest rate loans.

 

[33]

 

 

The following table sets forth the maturities, based upon contractual dates, for selected loan categories as of December 31, 2018:

 

Maturities of Loan Portfolio at December 31, 2018

Table 4

 

(In thousands)  Maturing
Within One
Year
   Maturing After One
Year But Within Five
Years
   Maturing After
Five Years
   Total 
Commercial Real Estate  $28,195   $130,115   $148,611   $306,921 
Acquisition and Development   46,264    31,723    40,373    118,360 
Commercial and Industrial   28,435    62,693    20,338    111,466 
Residential Mortgage   4,090    18,660    414,157    436,907 
Consumer   3,854    18,046    12,160    34,060 
Total Loans  $110,838   $261,237   $635,639   $1,007,714 
                     
Classified by Sensitivity to Change in Interest Rates                    
Fixed-Interest Rate Loans   70,869    239,140    172,447    482,456 
Adjustable-Interest Rate Loans   39,969    22,097    463,192    525,258 
Total Loans  $110,838   $261,237   $635,639   $1,007,714 

 

Management monitors the performance and credit quality of the loan portfolio by analyzing the age of the portfolio as determined by the length of time a required payment is past due. A loan is considered to be past due when a scheduled payment has not been received for 30 days past its contractual due date. For all loan segments, the accrual of interest is discontinued when principal or interest is delinquent for 90 days or more unless the loan is well-secured and in the process of collection. All non-accrual loans are considered to be impaired. Interest payments received on non-accrual loans are applied as a reduction of the loan principal balance. Loans are returned to accrual status when all principal and interest amounts contractually due are brought current and future payments are reasonably assured. Our policy for recognizing interest income on impaired loans does not differ from our overall policy for interest recognition.

 

[34]

 

 

Table 5 sets forth the amounts of non-accrual, past-due and restructured loans for the past five years:

 

Risk Elements of Loan Portfolio

Table 5

 

   At December 31, 
(In thousands)  2018   2017   2016   2015   2014 
Non-accrual loans:                         
Commercial real estate  $2,141   $4,453   $12,211   $11,282   $5,762 
Acquisition and development   147    211    45    1,817    3,609 
Commercial and industrial   0    378    0    185    171 
Residential mortgage   2,624    2,046    1,690    2,214    2,009 
Consumer   10    30    0    0    0 
Total non-accrual loans  $4,922   $7,118   $13,946   $15,498   $11,551 
                          
Accruing Loans Past Due 90 days or more:                         
Acquisition and development   62    144    0    0    1 
Commercial and industrial   0    6    11    0    4 
Residential mortgage   363    430    382    998    485 
Consumer   5    15    27    27    39 
Total accruing loans past due 90 days or more  $430   $595   $420   $1,025   $529 
                          
Total non-accrual and past due 90 days or more  $5,352   $7,713   $14,366   $16,523   $12,080 
                          
Restructured Loans (TDRs):                         
Performing  $4,633   $5,121   $7,336   $8,168   $7,621 
Non-accrual (included above)   231    834    1,987    5,851    6,063 
Total TDRs  $4,864   $5,955   $9,323   $14,019   $13,684 
                          
Other Real Estate Owned  $6,598   $10,141   $10,910   $6,883   $12,932 
                          
                          
Impaired loans without a valuation allowance  $9,231   $12,317   $23,131   $20,940   $19,937 
Impaired loans with a valuation allowance   1,344    2,634    869    3,868    4,844 
Total impaired loans  $10,575   $14,951   $24,000   $24,808   $24,781 
Valuation allowance related to impaired loans  $144   $362   $260   $1,157   $1,236 

 

Non-Accrual Loans as a % of Applicable Portfolio
   2018   2017   2016   2015   2014 
Commercial real estate   0.7%   1.6%   4.1%   4.0%   2.3%
Acquisition and development   0.1%   0.2%   0.1%   1.6%   3.6%
Commercial and industrial   0.0%   0.5%   0.0%   0.3%   0.2%
Residential mortgage   0.6%   0.5%   0.4%   0.6%   0.5%
Consumer   0.0%   0.1%   0.0%   0.0%   0.0%

 

We would have recognized $.7 million in interest income for the year ended December 31, 2018 had our non-accrual loans been current and performing in accordance with their terms. During 2018, we recognized, on a cash basis, $.1 million of interest income on non-accrual loans that paid off.

 

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Performing loans considered to be impaired (including performing troubled debt restructurings, or TDRs), as defined and identified by management, amounted to $5.7 million at December 31, 2018 and $7.8 million at December 31, 2017. Loans are identified as impaired when, based on current information and events, management determines that we will be unable to collect all amounts due according to contractual terms. These loans consist primarily of A&D loans and CRE loans. The fair values are generally determined based upon independent third-party appraisals of the collateral or discounted cash flows based upon the expected proceeds. Specific allocations have been made where management believes there is insufficient collateral to repay the loan balance if liquidated and there is no secondary source of repayment available.

 

The level of performing impaired loans (other than performing TDRs) decreased by $2.5 million during the year ended December 31, 2018.

 

A troubled debt restructuring is the restructuring of a loan in which one or more concessions are granted to a borrower who is experiencing financial difficulties. A loan will be classified as a TDR if the Bank restructures the loan’s terms (i.e., interest rate, payment amount, amortization period and/or maturity date) after determining that the borrower is experiencing financial difficulties. A modified loan is considered to be a TDR when the Bank has determined that the borrower is experiencing financial difficulties. The Bank evaluates the probability that the borrower will be in payment default on any of its debt in the foreseeable future without modification. To make this determination, the Bank performs a global financial review of the borrower and loan guarantors to assess their current ability to meet their financial obligations. The following table presents the details of TDRs by loan class at December 31, 2018 and December 31, 2017:

 

   December 31, 2018   December 31, 2017 
(Dollars in thousands)  Number of
Contracts
   Recorded
Investment
   Number of
Contracts
   Recorded
Investment
 
Performing                    
Commercial real estate                    
Non owner-occupied   3   $356    3   $370 
All other CRE   2    2,555    2    2,685 
Acquisition and development                    
1-4 family residential construction   1    230    1    527 
All other A&D   1    316    1    238 
Commercial and industrial   0    0    0    0 
Residential mortgage                    
Residential mortgage – term   7    1,176    8    1,301 
Residential mortgage – home equity   0    0    0    0 
Consumer   0    0    0    0 
Total performing   14   $4,633    15   $5,121 
                     
Non-accrual                    
Commercial real estate                    
Non owner-occupied   0   $0    0   $0 
All other CRE   0    0    2    583 
Acquisition and development                    
1-4 family residential construction   0    0    0    0 
All other A&D   0    0    0    0 
Commercial and industrial   0    0    0    0 
Residential mortgage                    
Residential mortgage – term   2    231    2    251 
Residential mortgage – home equity   0    0    0    0 
Consumer   0    0    0    0 
Total non-accrual   2    231    4    834 
Total TDRs   16   $4,864    19   $5,955 

 

The level of TDRs decreased by $1.1 million during the year ended December 31, 2018. No new loans were added to TDRs and six loans already in performing TDRs were re-modified. During the year ended December 31, 2018, two non-accrual loans totaling $.6 million paid off and one non-accrual loan of $57 thousand moved to OREO. Net principal payments totaling $.5 million were received during the same time period.

 

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At December 31, 2018, there were no additional funds committed to be advanced in connection with TDRs. Interest income not recognized due to rate modifications of TDRs was $21 thousand and interest income recognized on all TDRs was $.3 million in 2018.

 

Allowance for Loan Losses

 

The ALL is maintained to absorb losses from the loan portfolio. The ALL is based on management’s continuing evaluation of the quality of the loan portfolio, assessment of current economic conditions, diversification and size of the portfolio, adequacy of collateral, past and anticipated loss experience, and the amount of non-performing loans.

 

The ALL is also based on estimates, and actual losses will vary from current estimates. These estimates are reviewed quarterly, and as adjustments, either positive or negative, become necessary, a corresponding increase or decrease is made in the ALL. The methodology used to determine the adequacy of the ALL is consistent with prior years. An estimate for probable losses related to unfunded lending commitments, such as letters of credit and binding but unfunded loan commitments is also prepared. This estimate is computed in a manner similar to the methodology described above, adjusted for the probability of actually funding the commitment.

 

The ALL increased to $11.0 million at December 31, 2018, compared to $10.0 million at December 31, 2017. The provision for loan losses for the year ended December 31, 2018 decreased to $2.1 million from $2.5 million for the year ended December 31, 2017. The decreased provision expense was primarily due to decreased net charge-offs of $1.0 million in 2018, compared to net charge-offs of $2.5 million in 2017. The ratio of the ALL to loans outstanding at December 31, 2018 was 1.10%, compared to 1.12% at December 31, 2017.

 

The ratio of net charge-offs to average loans for the year ended December 31, 2018 was .11%, compared to .28% for the year ended December 31, 2017. The CRE portfolio improved slightly to an annualized net charge-off rate of .33% as of December 31, 2018, compared to 1.43% as of December 31, 2017. This improvement was due to large charge-offs on one non-accrual loan in 2017. The A&D loan portfolio had an annualized net recovery rate of .15% as of December 31, 2018, compared to .11% as of December 31, 2017. The annualized net recovery ratio for C&I loans was .06% as of December 31, 2018, compared to 2.21% as of December 31, 2017. The decrease in recovery rate in 2018 was due to the receipt of $1.3 million in 2017 on a previously charged-off loan on an ethanol plant. Residential mortgage loans had a net charge-off ratio of 0.01% at December 31, 2018, compared to a net recovery ratio of 0.01% as of December 31, 2017, and the consumer loan charge-off ratios were .95% and .53% for December 31, 2018 and December 31, 2017, respectively.

 

Accruing loans past due 30 days or more increased to 1.10% of the loan portfolio at December 31, 2018, compared to .63% at December 31, 2017. Non-accrual loans totaled $4.9 million at December 31, 2018, compared to $7.1 million at December 31, 2017. The decrease in non-accrual loans was primarily due to the charge-offs related to one large CRE loan relationship in 2018. Non-accrual loans which have been subject to partial charge-offs totaled $.3 million at December 31, 2018, compared to $2.1 million at December 31, 2017.

 

Management believes that the ALL at December 31, 2018 is adequate to provide for probable losses inherent in our loan portfolio. Amounts that will be recorded for the provision for loan losses in future periods will depend upon trends in the loan balances, including the composition of the loan portfolio, changes in loan quality and loss experience trends, potential recoveries on previously charged-off loans and changes in other qualitative factors. Management also applies interest rate risk, collateral value and debt service sensitivity analyses to the CRE loan portfolio and obtains new appraisals on specific loans under defined parameters to assist in the determination of the periodic provision for loan losses.

 

The ALL increased slightly to $10.0 million at December 31, 2017, compared to $9.9 million at December 31, 2016. The provision for loan losses for the year ended December 31, 2017 decreased to $2.5 million from $3.1 million for the year ended December 31, 2016. The decreased provision expense was primarily due to decreased net charge-offs of $2.5 million in 2017, compared to net charge-offs of $5.1 million in 2016. The ratio of the ALL to loans outstanding at December 31, 2017 was 1.12%, compared to 1.11% at December 31, 2016.

 

[37]

 

 

Table 6 presents the activity in the allowance for loan losses by major loan category for the past five years.

 

Analysis of Activity in the Allowance for Loan Losses

Table 6

 

   For the Years Ended December 31, 
(In thousands)  2018   2017   2016   2015   2014 
Balance, January 1  $9,972   $9,918   $11,922   $12,065   $13,594 
Charge-offs:                         
Commercial real estate   (1,298)   (4,605)   (5,301)   (420)   (485)
Acquisition and development   (170)   (133)   (248)   (1,261)   (2,673)
Commercial and industrial   (32)   (37)   (558)   (26)   (266)
Residential mortgage   (368)   (361)   (737)   (300)   (847)
Consumer   (422)   (336)   (333)   (307)   (512)
Total charge-offs   (2,290)   (5,472)   (7,177)   (2,314)   (4,783)
Recoveries:                         
Commercial real estate   319    452    90    283    11 
Acquisition and development   344    255    1,303    382    133 
Commercial and industrial   89    1,683    52    26    26 
Residential mortgage   353    392    461    217    229 
Consumer   149    210    145    209    342 
Total recoveries   1,254    2,992    2,051    1,117    741 
Net credit losses   (1,036)   (2,480)   (5,126)   (1,197)   (4,042)
Provision for loan losses   2,111    2,534    3,122    1,054    2,513 
Balance at end of period  $11,047   $9,972   $9,918   $11,922   $12,065 
                          
Allowance for loan losses to loans outstanding (as %)   1.10%   1.12%   1.11%   1.36%   1.44%
Net charge-offs to average loans outstanding during the period (as %)   0.11%   0.28%   0.57%   0.14%   0.49%

 

Table 7 presents management’s allocation of the ALL by major loan category in comparison to that loan category’s percentage of total loans. Changes in the allocation over time reflect changes in the composition of the loan portfolio risk profile and refinements to the methodology of determining the ALL. Specific allocations in any particular category may be reallocated in the future as needed to reflect current conditions. Accordingly, the entire ALL is considered available to absorb losses in any category.

 

Allocation of the Allowance for Loan Losses

Table 7

 

   For the Years Ended December 31, 
(In thousands)  2018   % of Total
Loans
   2017   % of Total
Loans
   2016   % of Total
Loans
   2015   % of Total
Loans
   2014   % of Total
Loans
 
Commercial real estate  $2,780    31%  3,699    32%  3,913    33%  2,580    32%  2,424    30%
Acquisition and development   1,721    12%   1,257    12%   871    12%   4,129    13%   3,912    12%
Commercial and industrial   1,187    11%   869    8%   858    8%   722    8%   1,680    11%
Residential mortgage   4,544    43%   3,444    45%   3,588    44%   3,785    44%   3,862    44%
Consumer   315    3%   203    3%   188    3%   206    3%   187    3%
Unallocated   500    0%   500    0%   500    0%   500    0%   0    0%
Total  $11,047    100%  9,972    100%  9,918    100%  11,922    100%  12,065    100%

 

[38]

 

 

Investment Securities

 

The following table sets forth the composition of our securities portfolio by major category as of the indicated dates:

 

Table 8

 

   At December 31, 
   2018   2017   2016 
(In thousands)  Amortized
Cost
   Fair Value
(FV)
   FV As %
of Total
   Amortized
Cost
   Fair Value
(FV)
   FV As %
of Total
   Amortized
Cost
   Fair Value
(FV)
   FV AS %
of Total
 
Securities Available-for-Sale:                                             
U.S. government agencies  $30,000   29,026    21%  $30,000   29,256    20%  $25,000   24,253    17%
Commercial mortgage-backed agencies   39,013    37,752    27%   41,771    40,891    28%   52,978    52,222    37%
Collateralized mortgage obligations   36,669    35,704    26%   41,298    40,384    28%   19,953    19,567    14%
Obligations of states and political subdivisions   20,083    19,882    15%   20,772    21,019    14%   23,700    23,704    17%
Collateralized debt obligations   18,358    15,277    11%   19,711    14,920    10%   27,930    20,254    15%
Total available for sale  $144,123   137,641    100%  $153,552   146,470    100%  $149,561   140,000    100%
Securities Held to Maturity:                                             
U.S. government agencies  $16,017   16,137    17%  $15,876   16,323    17%  $15,738   16,250    17%
Residential mortgage-backed agencies   46,491    45,210    48%   47,771    47,442    50%   50,384    50,265    51%
Commercial mortgage-backed agencies   15,821    15,828    17%   17,288    17,518    18%   17,584    17,832    18%
Collateralized mortgage obligations   3,761    3,605    4%   4,187    4,118    4%   4,833    4,684    5%
Obligations of states and political subdivisions   11,920    12,980    14%   8,510    9,945    11%   8,630    8,950    9%
Total held to maturity  $94,010   93,760    100%  $93,632   95,346    100%  $97,169   97,981    100%

 

Total fair value of investment securities available-for-sale at December 31, 2018 decreased by $8.8 million when compared to December 31, 2017. At December 31, 2018, the securities classified as available-for-sale included a net unrealized loss of $6.5 million, compared to $7.1 million at December 31, 2017, which represents the difference between the fair value and amortized cost of securities in the portfolio. On June 1, 2014, management reclassified an amortized cost basis of $107.6 million of available-for-sale securities to held to maturity. The unrealized loss of approximately $4.0 million, at the date of transfer, will continue to be reported in a separate component of shareholders’ equity as accumulated other comprehensive income and will be amortized over the remaining life of the securities as an adjustment of yield in a manner consistent with the amortization of any premium or discount.

 

As discussed in Note 23 to the Consolidated Financial Statements, we measure fair market values based on the fair value hierarchy established in ASC Topic 820, Fair Value Measurements and Disclosures. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). Level 3 prices or valuation techniques require inputs that are both significant to the valuation assumptions and are not readily observable in the market (i.e. supported with little or no market activity). These Level 3 instruments are valued based on both observable and unobservable inputs derived from the best available data, some of which is internally developed, and considers risk premiums that a market participant would require.

 

Approximately $122.4 million of the available-for-sale portfolio was valued using Level 2 pricing and had net unrealized losses of $3.4 million at December 31, 2018. The remaining $15.3 million of the securities available-for-sale represents the entire CDO portfolio, which was valued using significant unobservable inputs, or Level 3 pricing. The $3.1 million in net unrealized losses associated with the CDO portfolio relates to nine pooled trust preferred securities. Unrealized losses of $2.0 million represent non-credit related OTTI charges on seven of the securities, while $1.1 million of unrealized losses relates to two securities which have no credit related OTTI. The unrealized losses on these securities are primarily attributable to continued depression in the marketability and liquidity associated with CDOs.

 

[39]

 

 

The following table provides a summary of the trust preferred securities in the CDO portfolio and the credit status of the securities as of December 31, 2018.

 

Level 3 Investment Securities Available for Sale

(Dollars in Thousands)

 

Investment Description  First United Level 3 Investments   Security Credit Status 
Deal  Class  Amortized Cost   Fair Market
Value
   Unrealized
Gain/(Loss)
  

Lowest

Credit

Rating

 

Original

Collateral

   Deferrals/
Defaults as
% of
Original
Collateral
  

Performing

Collateral

  

Collateral

Support

   Collateral
Support as
% of
Performing
Collateral
   Number of
Performing
Issuers/Total
Issuers
                                          
Preferred Term Security XVIII*  C   1,926    1,372    (554)  C   676,565    15.61%   295,941    7,685    2.60%  43 / 59
Preferred Term Security XVIII  C   2,766    2,059    (707)  C   676,565    15.61%   295,941    7,685    2.60%  43 / 59
Preferred Term Security XIX*  C   1,802    1,663    (139)  C   700,535    6.18%   503,778    25,888    5.14%  53 / 59
Preferred Term Security XIX*  C   1,072    998    (74)  C   700,535    6.18%   503,778    25,888    5.14%  53 / 59
Preferred Term Security XIX*  C   2,476    2,328    (148)  C   700,535    6.18%   503,778    25,888    5.14%  53 / 59
Preferred Term Security XIX*  C   1,075    998    (77)  C   700,535    6.18%   503,778    25,888    5.14%  53 / 59
Preferred Term Security XXII*  C-1   1,541    1,307    (234)  C   1,386,600    12.64%   750,324    56,772    7.57%  61 / 76
Preferred Term Security XXII*  C-1   3,853    3,267    (586)  C   1,386,600    12.64%   750,324    56,772    7.57%  61 / 76
Preferred Term Security XXIII  C-1   1,847    1,285    (562)  C   1,467,000    15.47%   753,083    40,166    5.33%  78 / 93
                                                  
Total Level 3 Securities Available for Sale   18,358    15,277    (3,081                               

 

*Security has been deemed other-than-temporarily impaired and loss has been recognized in accordance with ASC Section 320-10-35.

 

The terms of the debentures underlying trust preferred securities allow the issuer of the debentures to defer interest payments for up to 20 quarters, and, in such case, the terms of the related trust preferred securities require their issuers to contemporaneously defer dividend payments. The issuers of the trust preferred securities in our investment portfolio have defaulted and/or deferred payments, ranging from 6.18% to 15.61% of the total collateral balances underlying the securities. The securities were designed to include structural features that provide investors with credit enhancement or support to provide default protection by subordinated tranches. These features include over-collateralization of the notes or subordination, excess interest or spread which will redirect funds in situations where collateral is insufficient, and a specified order of principal payments. There are securities in our portfolio that are under-collateralized, which does represent additional stress on our tranche. However, in these cases, the terms of the securities require excess interest to be redirected from subordinate tranches as credit support, which provides additional support to our investment.

 

Management systematically evaluates securities for impairment on a quarterly basis. Based upon application of ASC Topic 320 (Section 320-10-35), management must assess whether (i) the Corporation has the intent to sell the security and (ii) it is more likely than not that the Corporation will be required to sell the security prior to its anticipated recovery. If neither applies, then declines in the fair value of securities below their cost that are considered other-than-temporary declines are split into two components. The first is the loss attributable to declining credit quality. Credit losses are recognized in earnings as realized losses in the period in which the impairment determination is made. The second component consists of all other losses. The other losses are recognized in other comprehensive income. In estimating OTTI charges, management considers (a) the length of time and the extent to which the fair value has been less than cost, (b) adverse conditions specifically related to the security, an industry, or a geographic area, (c) the historic and implied volatility of the security, (d) changes in the rating of a security by a rating agency, (e) recoveries or additional declines in fair value subsequent to the balance sheet date, (f) failure of the issuer of the security to make scheduled interest payments, and (g) the payment structure of the debt security and the likelihood of the issuer being able to make payments that increase in the future. Due to the duration and the significant market value decline in the pooled trust preferred securities held in our portfolio, we performed more extensive testing on these securities for purposes of evaluating whether or not an OTTI has occurred.

 

The market for these securities as of December 31, 2018 is not active and markets for similar securities are also not active. The inactivity was evidenced first by a significant widening of the bid-ask spread in the brokered markets in which these securities trade and then by a significant decrease in the volume of trades relative to historical levels. The new issue market is also inactive, as no new CDOs have been issued since 2007. There are currently very few market participants who are willing to effect transactions in these securities. The market values for these securities, or any securities other than those issued or guaranteed by the U.S. Department of the Treasury (the “Treasury”), are very depressed relative to historical levels. Therefore, in the current market, a low market price for a particular bond may only provide evidence of stress in the credit markets in general rather than being an indicator of credit problems with a particular issue. Given the conditions in the current debt markets and the absence of observable transactions in the secondary and new issue markets, management has determined that (i) the few observable transactions and market quotations that are available are not reliable for the purpose of obtaining fair value at December 31, 2018, (ii) an income valuation approach technique (i.e. present value) that maximizes the use of relevant unobservable inputs and minimizes the use of observable inputs will be equally or more representative of fair value than a market approach, and (c) the CDO segment is appropriately classified within Level 3 of the valuation hierarchy because management determined that significant adjustments were required to determine fair value at the measurement date.

 

[40]

 

 

Management relies on an independent third party to prepare both the evaluations of OTTI and the fair value determinations for the CDO portfolio. Management does not believe that there were any material differences in the OTTI evaluations and pricing between December 31, 2018 and December 31, 2017.

 

The approach used by the third party to determine fair value involved several steps, which included detailed credit and structural evaluation of each piece of collateral in each bond, projection of default, recovery and prepayment/amortization probabilities for each piece of collateral in the bond, and discounted cash flow modeling. The discount rate methodology used by the third party combines a baseline current market yield for comparable corporate and structured credit products with adjustments based on evaluations of the differences found in structure and risks associated with actual and projected credit performance of each CDO being valued.  Currently, the only active and liquid trading market that exists is for stand-alone trust preferred securities, with a limited market for highly-rated CDO securities that are more senior in the capital structure than the securities in the CDO portfolio.  Therefore, adjustments to the baseline discount rate are also made to reflect the additional leverage found in structured instruments.

 

Based upon a review of credit quality and the cash flow tests performed by the independent third party, management determined that no additional credit-related OTTI was required during 2018.

 

Table 9 sets forth the contractual or estimated maturities of the components of our securities portfolio as of December 31, 2018 and the weighted average yields on a tax-equivalent basis.

 

Investment Security Maturities, Yields, and Fair Values at December 31, 2018

Table 9

 

(In thousands)  Within 1 Year   1 Year To 5
Years
   5 Years To 10
Years
   Over 10 Years   Total Fair Value 
Securities Available-for-Sale:                         
U.S. government agencies  $0   $14,705   $14,321   $0   $29,026 
Commercial mortgage-backed agencies   0    37,752    0    0    37,752 
Collateralized mortgage obligations   232    17,315    18,157    0    35,704 
Obligations of states and political subdivisions   231    1,770    6,944    10,937    19,882 
Collateralized debt obligations   0    0    0    15,277    15,277 
Total available for sale  $463   $71,542   $39,422   $26,214   $137,641 
                          
Percentage of total   0.34%   51.98%   28.64%   19.04%   100.00%
Weighted average yield   3.68%   2.38%   2.61%   5.08%   2.96%
                          
Held to Maturity:                         
U.S. government agencies  $0   $8,401   $7,736   $0   $16,137 
Residential mortgage-backed agencies   213    9,701    11,870    23,426    45,210 
Commercial mortgage-backed agencies   0    9,455    6,373    0    15,828 
Collateralized mortgage obligations   0    0    3,605    0    3,605 
Obligations of states and political subdivisions   0    0    0    12,980    12,980 
Total held to maturity  $213   $27,557   $29,584   $36,406   $93,760 
                          
Percentage of total   0.23%   29.39%   31.55%   38.83%   100.00%
Weighted average yield   -3.63%   1.70%   3.12%   3.80%   2.95%

 

The weighted average yield was calculated using historical cost balances and does not give effect to changes in fair value. The negative weighted average yield was due to increased paydowns on mortgage-backed securities which impacted their factors and three-month conditional prepayment rate (“CPR”). At December 31, 2018, we did not hold any securities in the name of any one issuer exceeding 10% of shareholders’ equity.

 

[41]

 

 

Deposits

 

Table 10 sets forth the actual and average deposit balances by major category for 2018, 2017 and 2016:

 

Deposit Balances

Table 10

 

       2018           2017           2016     
(In thousands)  Actual
Balance
   Average
Balance
   Average Yield   Actual
Balance
   Average
Balance
   Average Yield   Actual
Balance
   Average
Balance
   Average Yield 
Non-interest-bearing demand deposits  $262,250   239,838    0.00%  $252,049   253,980    0.00%  $219,158   209,948    0.00%
Interest-bearing deposits:                                             
Demand   163,334    170,642    0.11%   171,741    169,289    0.07%   172,071    176,049    0.08%
Money Market:                                             
Retail   234,038    211,969    0.44%   165,277    165,982    0.21%   161,812    163,021    0.15%
Brokered/ICS   0    0    0.00%   58,413    59,287    0.21%   70,425    71,054    0.15%
Savings deposits   156,236    160,968    0.12%   157,783    156,538    0.11%   149,653    147,428    0.11%
Time deposits less than $100K:                                             
Retail   99,088    104,289    1.01%   107,238    114,078    0.98%   116,651    123,751    1.00%
Brokered/CDARS   0    0    0.00%   358    425    0.28%   520    378    0.10%
Time deposits $100K or more:                                             
Retail   127,581    120,019    1.51%   124,488    117,460    1.17%   120,341    117,641    1.04%
Brokered/CDARS   25,000    3,151    1.88%   2,043    2,730    0.64%   3,598    2,612    0.15%
Total Deposits  $1,067,527   $1,010,876        $1,039,390   $1,039,769        $1,014,229   $1,011,882      

 

Total deposits increased by $28.1 million at December 31, 2018 when compared to December 31, 2017. During 2018, non-interest bearing deposits increased $10.2 million due to new account openings as well as increased balances in existing accounts. Traditional savings accounts decreased $1.5 million as we saw balances shift to other products at higher rates. Total demand deposits decreased $8.4 million due to several large relationships re-allocating balances. Total money market accounts increased $10.3 million due primarily to new account openings in our new, higher rate money market product in the fourth quarter of 2018. Time deposits less than $100,000 declined $8.2 million and time deposits greater than $100,000 increased $25.7 million. In November 2018, two short-term brokered certificates of deposit of $15.0 million and $10.0 million were purchased through third-party brokers to fix interest expense in the rising rate environment.

 

On May 22, 2018, the Economic Growth Regulatory Relief and Consumer Protection Act was signed into law. As a result of this act, most reciprocal deposits are no longer considered brokered deposits. At December 31, 2018, the ICS/CDARs balances were all considered reciprocal deposits and were re-classified into retail deposits.

 

The following table sets forth the maturities of time deposits of $100,000 or more:

 

Maturity of Time Deposits of $100,000 or More

Table 11

 

(In thousands)  December 31, 2018 
Maturities     
3 Months or Less  $8,345 
3-6 Months   21,091 
6-12 Months   37,756 
Over 1 Year   85,389 
Total  $152,581 

 

[42]

 

 

Borrowed Funds

 

The following shows the composition of our borrowings at December 31:

 

(In thousands)  2018   2017   2016 
Overnight borrowings, weighted average interest rate of 2.70% at December 31, 2018  $40,000   $0   $0 
Securities sold under agreements to repurchase   37,707    48,845    36,000 
Total short-term borrowings  $77,707   $48,845   $36,000 
                
Long-term FHLB advances  $70,000   $90,000   $90,007 
Junior subordinated debentures   30,929    30,929    41,730 
Total long-term borrowings  $100,929   $120,929   $131,737 
                
Total borrowings  $178,636   $169,774   $167,737 
                
Average balance (from Table 1)  $167,991   $160,732   $177,322 

 

The following is a summary of short-term borrowings at December 31 with original maturities of less than one year:

 

(Dollars in thousands)  2018   2017   2016 
Overnight borrowings, weighted average interest rate of 2.70% at December 31, 2018  $40,000   $0   $0 
Securities sold under agreements to repurchase:               
Outstanding at end of year  $37,707   $48,845   $36,000 
Weighted average interest rate at year end   0.24%   0.15%   0.16%
Maximum amount outstanding as of any month end  $55,648   $58,438   $39,456 
Average amount outstanding   44,045    37,326    30,899 
Approximate weighted average rate during the year   0.20%   0.19%   0.19%

 

Total borrowings increased by $8.9 million, or 5.2%, in 2018 when compared to 2017. The increase in short-term borrowings was due to a $40.0 million increase in overnight borrowings due to the shift of a $15.0 million FHLB advance from long-term borrowings and $15.0 million from utilization of funding from our correspondent banks, offset by a decrease in the balances of municipal accounts established through our Treasury Management product. Long-term borrowings decreased by $20.0 million due to the repayment of two FHLB advances totaling $5.0 million at maturity in January 2018 and the shift of one FHLB advance totaling $15.0 million to short-term overnight borrowings at maturity in April 2018.

 

Total borrowings increased slightly by $2.0 million, or 8.2%, in 2017 when compared to 2016, while the average balance of borrowings decreased by $16.6 million during the same period. The increase in borrowings was due to a $12.8 million increase in the balances of municipal accounts established through our Treasury Management product, offset by a decrease in long-term borrowings of $10.8 due to the repayment of $10.8 million in TPS Debentures held by Trust III in March 2017.

 

Management will continue to closely monitor interest rates within the context of its overall asset-liability management process. See the discussion under the heading “Interest Rate Sensitivity” in this Item 7 for further information on this topic.

 

At December 31, 2018, we had additional borrowing capacity with the FHLB totaling $104.3 million, an additional $85.0 million of unused lines of credit with various financial institutions, $4.4 million of an unused secured line of credit with the Federal Reserve Bank and approximately $104.3 million available through wholesale money market funds. See Note 12 to the Consolidated Financial Statements presented elsewhere in this annual report for further details about our borrowings and additional borrowing capacity, which is incorporated herein by reference.

 

[43]

 

 

Off-Balance Sheet Arrangements

 

In the normal course of business, to meet the financing needs of its customers, the Bank is a party to financial instruments with off-balance sheet risk. These financial instruments include commitments to extend credit, lines of credit, and standby letters of credit. Our exposure to credit loss in the event of nonperformance by the other party to these financial instruments is represented by the contractual amount of the instruments. The credit risks inherent in loan commitments and letters of credit are essentially the same as those involved in extending loans to customers, and these arrangements are subject to our normal credit policies. We use the same credit policies in making commitments and conditional obligations as we do for on-balance sheet instruments. We generally require collateral or other security to support the financial instruments with credit risk. The amount of collateral or other security is determined based on management’s credit evaluation of the counterparty. We evaluate each customer’s creditworthiness on a case-by-case basis.

 

Loan commitments and letters of credit totaled $123.6 million and $3.4 million, respectively, at December 31, 2018. Management does not believe that any of the foregoing arrangements have or are reasonably likely to have a current or future effect on our financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors. We are not a party to any other off-balance sheet arrangements. See Note 22 to the Consolidated Financial Statements presented elsewhere in this annual report for additional information on these arrangements.

 

Capital Resources

 

We require capital to fund loans, satisfy our obligations under the Bank’s letters of credit, meet the deposit withdraw demands of the Bank’s customers, and satisfy our other monetary obligations. To the extent that deposits are not adequate to fund our capital requirements, we can rely on the funding sources identified below under the heading “Liquidity Management”. At December 31, 2018, the Bank had $85.0 million available through unsecured lines of credit with correspondent banks, $4.4 million available through a secured line of credit with the Fed Discount Window and approximately $104.3 million available through the FHLB. Management is not aware of any demands, commitments, events or uncertainties that are likely to materially affect our ability to meet our future capital requirements.

 

In addition to operational requirements, the Bank and the Corporation are subject to risk-based capital regulations, which were adopted and are monitored by federal banking regulators. These regulations are used to evaluate capital adequacy and require an analysis of an institution’s asset risk profile and off-balance sheet exposures, such as unused loan commitments and stand-by letters of credit.

 

On July 2, 2013, the Federal Reserve approved final rules that substantially amended the regulatory risk-based capital rules applicable to the Corporation. The FDIC subsequently approved the same rules which apply to the Bank. The final rules implement the “Basel III” regulatory capital reforms and changes required by the Dodd-Frank Act and were implemented as of March 31, 2015. 

 

The Basel III capital rules include new risk-based capital and leverage ratios, which will be phased in from 2015 to 2019, and which refine the definition of what constitutes “capital” for purposes of calculating those ratios. The new minimum capital level requirements applicable to the Corporation under the final rules are: (i) a new common equity Tier 1 capital ratio of 4.5%; (ii) a Tier 1 capital ratio of 6% (increased from 4%); (iii) a total capital ratio of 8% (unchanged from current rules); and (iv) a Tier 1 leverage ratio of 4% for all institutions. The final rules also establish a “capital conservation buffer” above the new regulatory minimum capital requirements, which must consist entirely of common equity Tier 1 capital. The capital conservation buffer will be phased-in over four years beginning on January 1, 2016, as follows: the maximum buffer will be 0.625% of risk-weighted assets for 2016, 1.25% for 2017, 1.875% for 2018, and 2.5% for 2019 and thereafter. This will result in the following minimum ratios beginning in 2019: (a) a common equity Tier 1 capital ratio of 7.0%, (b) a Tier 1 capital ratio of 8.5%, and (c) a total capital ratio of 10.5%. Under the final rules, institutions are subject to limitations on paying dividends, engaging in share repurchases, and paying discretionary bonuses if its capital level falls below the buffer amount. These limitations establish a maximum percentage of eligible retained income that could be utilized for such actions.

 

The Basel III capital final rules also implement revisions and clarifications consistent with Basel III regarding the various components of Tier 1 capital, including common equity, unrealized gains and losses, as well as certain instruments that no longer qualify as Tier 1 capital, some of which will be phased out over time. Under the final rules, the effects of certain accumulated other comprehensive items are not excluded; however, banking organizations like the Corporation and the Bank that are not considered “advanced approaches” banking organizations may make a one-time permanent election to continue to exclude these items. The Corporation and the Bank made this election in their first quarter 2015 regulatory filings in order to avoid significant variations in the level of capital depending upon the impact of interest rate fluctuations on the fair value of the Corporation’s available-for-sale securities portfolio. Additionally, the final rules provide that small depository institution holding companies with less than $15 billion in total assets as of December 31, 2009 (which includes the Corporation) will be able to permanently include non-qualifying instruments that were issued and included in Tier 1 or Tier 2 capital prior to May 19, 2010 (such as the Corporation’s TPS Debentures) in additional Tier 1 or Tier 2 capital until they redeem such instruments or until the instruments mature.

 

The Basel III capital rules also contain revisions to the prompt corrective action framework, which is designed to place restrictions on insured depository institutions if their capital levels begin to show signs of weakness. These revisions were effective January 1, 2015. Under the prompt corrective action requirements, which are designed to complement the capital conservation buffer, insured depository institutions are required to meet the following capital level requirements in order to qualify as “well capitalized”: (i) a new common equity Tier 1 capital ratio of 6.5%; (ii) a Tier 1 capital ratio of 8% (increased from 6%); (iii) a total capital ratio of 10% (unchanged from current rules); and (iv) a Tier 1 leverage ratio of 5% (increased from 4%).

 

[44]

 

 

The Basel III capital rules set forth certain changes for the calculation of risk-weighted assets. These changes include (i) an increased number of credit risk exposure categories and risk weights; (ii) an alternative standard of creditworthiness consistent with Section 939A of the Dodd-Frank Act; (iii) revisions to recognition of credit risk mitigation; (iv) rules for risk weighting of equity exposures and past due loans, and (v) revised capital treatment for derivatives and repo-style transactions.

 

Regulators may require higher capital ratios when warranted by the particular circumstances or risk profile of a given banking organization. In the current regulatory environment, banking organizations must stay well capitalized in order to receive favorable regulatory treatment on acquisition and other expansion activities and favorable risk-based deposit insurance assessments. Our capital policy establishes guidelines meeting these regulatory requirements and takes into consideration current or anticipated risks as well as potential future growth opportunities.

 

In October 2017, the federal banking agencies proposed revisions that would simplify compliance with certain aspects of capital rules. A majority of the proposed simplifications would apply solely to banking organizations that are not subject to the advanced approaches capital rule. The proposed rules simplify application of regulatory capital treatment for mortgage servicing assets, certain deferred tax assets arising from temporary differences, investments in the capital of unconsolidated financial institutions, and capital issued by a consolidated subsidiary of a banking organization and held by third parties (minority interest), and; revisions to the treatment of certain acquisition, development, or construction exposures. In addition, the federal banking agencies have deferred the final phase-in and increased risk-weighting associated with CET1 deductions indefinitely for non-advanced approaches banks.

 

At December 31, 2018, the Corporation’s total risk-based capital ratio was 15.91% and the Bank’s total risk-based capital ratio was 15.43%, both of which were well above the regulatory minimum of 8%. The total risk-based capital ratios of the Corporation and the Bank at December 31, 2017 were 15.98% and 15.58%, respectively. The decreases for the Corporation and the Bank in 2018 was primarily due to the increase in the loan portfolio and risk-weighted assets.

 

At December 31, 2018, the most recent notification from the regulators categorizes the Corporation and the Bank as “well capitalized” under the regulatory framework for prompt corrective action. See Note 4 to the Consolidated Financial Statements presented elsewhere in this annual report for additional information regarding regulatory capital ratios.

 

Liquidity Management

 

Liquidity is a financial institution’s capability to meet customer demands for deposit withdrawals while funding all credit-worthy loans. The factors that determine the institution’s liquidity are:

 

·Reliability and stability of core deposits;
·Cash flow structure and pledging status of investments; and
·Potential for unexpected loan demand.

 

We actively manage our liquidity position through meetings of a sub-committee of executive management, which looks forward 12 months at 30-day intervals. The measurement is based upon the projection of funds sold or purchased position, along with ratios and trends developed to measure dependence on purchased funds and core growth. Monthly reviews by management and quarterly reviews by the Asset and Liability Committee under prescribed policies and procedures are designed to ensure that we will maintain adequate levels of available funds.

 

It is our policy to manage our affairs so that liquidity needs are fully satisfied through normal Bank operations. That is, the Bank will manage its liquidity to minimize the need to make unplanned sales of assets or to borrow funds under emergency conditions. The Bank will use funding sources where the interest cost is relatively insensitive to market changes in the short run (periods of one year or less) to satisfy operating cash needs. The remaining normal funding will come from interest-sensitive liabilities, either deposits or borrowed funds. When the marginal cost of needed wholesale funding is lower than the cost of raising this funding in the retail markets, the Corporation may supplement retail funding with external funding sources such as:

 

·Unsecured Fed Funds lines of credit with upstream correspondent banks (M&T Bank, Atlantic Community Bankers Bank, Community Bankers Bank, PNC Financial Services (“PNC”), SunTrust, Pacific Coast Banker’s Bank (PCBB) and Zions Bancorp).
·Secured advances with the FHLB of Atlanta, which are collateralized by eligible one to four family residential mortgage loans, home equity lines of credit, commercial real estate loans. Cash and various securities may also be pledged as collateral.

 

[45]

 

 

·Secured line of credit with the Fed Discount Window for use in borrowing funds up to 90 days, using municipal securities as collateral.
·Brokered deposits, including CDs and money market funds, provide a method to generate deposits quickly. These deposits are strictly rate driven but often provide the most cost effective means of funding growth.
·One Way Buy CDARS/ICS funding – a form of brokered deposits that has become a viable supplement to brokered deposits obtained directly.

 

Management believes that we have adequate liquidity available to respond to current and anticipated liquidity demands and is not aware of any trends or demands, commitments, events or uncertainties that are likely to materially affect our ability to maintain liquidity at satisfactory levels.

 

Market Risk and Interest Sensitivity

 

Our primary market risk is interest rate fluctuation. Interest rate risk results primarily from the traditional banking activities that we engage in, such as gathering deposits and extending loans. Many factors, including economic and financial conditions, movements in interest rates and consumer preferences affect the difference between the interest earned on our assets and the interest paid on our liabilities. Interest rate sensitivity refers to the degree that earnings will be impacted by changes in the prevailing level of interest rates. Interest rate risk arises from mismatches in the repricing or maturity characteristics between interest-bearing assets and liabilities. Management seeks to minimize fluctuating net interest margins, and to enhance consistent growth of net interest income through periods of changing interest rates. Management uses interest sensitivity gap analysis and simulation models to measure and manage these risks. The interest rate sensitivity gap analysis assigns each interest-earning asset and interest-bearing liability to a time frame reflecting its next repricing or maturity date. The differences between total interest-sensitive assets and liabilities at each time interval represent the interest sensitivity gap for that interval. A positive gap generally indicates that rising interest rates during a given interval will increase net interest income, as more assets than liabilities will reprice. A negative gap position would benefit us during a period of declining interest rates.

 

At December 31, 2018, we were asset sensitive.

 

Our interest rate risk management goals are:

 

·Ensure that the Board of Directors and senior management will provide effective oversight and ensure that risks are adequately identified, measured, monitored and controlled;
·Enable dynamic measurement and management of interest rate risk;
·Select strategies that optimize our ability to meet our long-range financial goals while maintaining interest rate risk within policy limits established by the Board of Directors;
·Use both income and market value oriented techniques to select strategies that optimize the relationship between risk and return; and
·Establish interest rate risk exposure limits for fluctuation in net interest income (“NII”), net income and economic value of equity.

 

In order to manage interest sensitivity risk, management formulates guidelines regarding asset generation and pricing, funding sources and pricing, and off-balance sheet commitments. These guidelines are based on management’s outlook regarding future interest rate movements, the state of the regional and national economy, and other financial and business risk factors. Management uses computer simulations to measure the effect on net interest income of various interest rate scenarios. Key assumptions used in the computer simulations include cash flows and maturities of interest rate sensitive assets and liabilities, changes in asset volumes and pricing, and management’s capital plans. This modeling reflects interest rate changes and the related impact on net interest income over specified periods.

 

We evaluate the effect of a change in interest rates of +/-100 basis points to +/-400 basis points on both NII and Net Portfolio Value (“NPV”) / Economic Value of Equity (“EVE”). We concentrate on NII rather than net income as long as NII remains the significant contributor to net income.

 

NII modeling allows management to view how changes in interest rates will affect the spread between the yield earned on assets and the cost of deposits and borrowed funds. Unlike traditional Gap modeling, NII modeling takes into account the different degree to which installments in the same repricing period will adjust to a change in interest rates. It also allows the use of different assumptions in a falling versus a rising rate environment. The period considered by the NII modeling is the next eight quarters.

 

NPV / EVE modeling focuses on the change in the market value of equity. NPV / EVE is defined as the market value of assets less the market value of liabilities plus/minus the market value of any off-balance sheet positions. By effectively looking at the present value of all future cash flows on or off the balance sheet, NPV / EVE modeling takes a longer-term view of interest rate risk. This complements the shorter-term view of the NII modeling.

 

[46]

 

 

Measures of NII at risk produced by simulation analysis are indicators of an institution’s short-term performance in alternative rate environments. These measures are typically based upon a relatively brief period, usually one year. They do not necessarily indicate the long-term prospects or economic value of the institution.

 

Based on the simulation analysis performed at December 31, 2018 and 2017, management estimated the following changes in net interest income, assuming the indicated rate changes:

 

(Dollars in thousands)  2018   2017 
+400 basis points  $(1,939)  $(371)
+300 basis points  $(1,284)  $(30)
+200 basis points  $(652)  $261 
+100 basis points  $(163)  $387 
-100 basis points  $(4,007)  $(3,003)

 

This estimate is based on assumptions that may be affected by unforeseeable changes in the general interest rate environment and any number of unforeseeable factors. Rates on different assets and liabilities within a single maturity category adjust to changes in interest rates to varying degrees and over varying periods of time. The relationships between lending rates and rates paid on purchased funds are not constant over time. Management can respond to current or anticipated market conditions by lengthening or shortening the Bank’s sensitivity through loan repricings or changing its funding mix. The rate of growth in interest-free sources of funds will influence the level of interest-sensitive funding sources. In addition, the absolute level of interest rates will affect the volume of earning assets and funding sources. As a result of these limitations, the interest-sensitive gap is only one factor to be considered in estimating the net interest margin.

 

Impact of Inflation – Our assets and liabilities are primarily monetary in nature, and as such, future changes in prices do not affect the obligations to pay or receive fixed and determinable amounts of money. During inflationary periods, monetary assets lose value in terms of purchasing power and monetary liabilities have corresponding purchasing power gains. The concept of purchasing power is not an adequate indicator of the impact of inflation on financial institutions because it does not incorporate changes in our earnings.

 

[47]

 

 

ITEM 7A.QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

The information called for by this item is incorporated herein by reference to Item 7 of Part II of this annual report under the heading “Market Risk and Interest Sensitivity”.

 

ITEM 8.FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

 

  Page
   
Report of Independent Registered Public Accounting Firm 49
Consolidated Statement of Financial Condition at December 31, 2018 and 2017 51
Consolidated Statement of Income for the years ended December 31, 2018 and 2017 52
Consolidated Statement of Comprehensive Income for the years ended December 31, 2018 and 2017 53
Consolidated Statement of Changes in Shareholders’ Equity for the years ended December 31, 2018 and 2017 54
Consolidated Statement of Cash Flows for the years ended December 31, 2018 and 2017 55
Notes to Consolidated Financial Statements for the years ended December 31, 2018 and 2017 56

 

[48]

 

 

Report of Independent Registered Public Accounting Firm

 

To the Board of Directors and Shareholders

First United Corporation and Subsidiaries

 

Opinions on the Financial Statements and Internal Control over Financial Reporting

 

We have audited the accompanying consolidated statement of financial condition of First United Corporation and Subsidiaries (the “Corporation”) as of December 31, 2018 and 2017, and the related consolidated statements of income, comprehensive income, changes in shareholders’ equity, and cash flows for the years then ended, and the related notes (collectively referred to as the “consolidated financial statements”). We also have audited the Corporation’s internal control over financial reporting as of December 31, 2018, based on criteria established in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

 

In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Corporation as of December 31, 2018 and 2017, and the results of its operations and its cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2018, based on criteria established in Internal Control – Integrated Framework (2013) issued by COSO.

 

Basis for Opinions

 

The Corporation’s management is responsible for these consolidated financial statements, for maintaining effective control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Assessment of Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Corporation’s consolidated financial statements and an opinion on the Corporation’s internal control over financial reporting based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (“PCAOB”) and are required to be independent with respect to the Corporation in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.

 

We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud and whether effective internal control over financial reporting was maintained in all material respects.

 

Our audits of the financial statements included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

 

Definition and Limitations of Internal Control Over Financial Reporting

 

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

 

[49]

 

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

/s/ Baker Tilly Virchow Krause, LLP  

 

We have served as the Corporation’s auditor since 2006.

 

Pittsburgh, Pennsylvania

 

March 12, 2019

 

[50]

 

 

First United Corporation and Subsidiaries

Consolidated Statement of Financial Condition

(In thousands, except per share amounts)

 

   December 31, 
   2018   2017 
Assets          
Cash and due from banks  $22,187   $82,273 
Interest bearing deposits in banks   1,354    1,479 
Cash and cash equivalents   23,541    83,752 
Investment securities – available-for-sale (at fair value)   137,641    146,470 
Investment securities – held to maturity (fair value of $93,760 at          
December 31, 2018 and $95,346 at December 31, 2017)   94,010    93,632 
Restricted investment in bank stock, at cost   5,394    5,204 
Loans   1,007,714    892,518 
Allowance for loan losses   (11,047)   (9,972)
Net loans   996,667    882,546 
Premises and equipment, net   37,855    30,881 
Goodwill   11,004    11,004 
Bank owned life insurance   43,317    42,155 
Deferred tax assets   7,844    9,252 
Other real estate owned   6,598    10,141 
Accrued interest receivable and other assets   20,645    21,433 
Total Assets  $1,384,516   $1,336,470 
           
Liabilities and Shareholders’ Equity          
Liabilities:          
Non-interest bearing deposits  $262,250   $252,049 
Interest bearing deposits   805,277    787,341 
Total deposits   1,067,527    1,039,390 
           
Short-term borrowings   77,707    48,845 
Long-term borrowings   100,929    120,929 
Accrued interest payable and other liabilities   20,649    18,916 
Dividends Payable   638    0 
Total Liabilities   1,267,450    1,228,080 
           
Shareholders’ Equity:          
Common Stock – par value $.01 per share; Authorized 25,000,000 shares; issued and outstanding 7,086,632 shares at December 31, 2018 and 7,067,425 shares at December 31, 2017   71    71 
Surplus   31,921    31,553 
Retained earnings   109,477    101,359 
Accumulated other comprehensive loss   (24,403)   (24,593)
Total Shareholders’ Equity   117,066    108,390 
Total Liabilities and Shareholders’ Equity  $1,384,516   $1,336,470 

 

See notes to consolidated financial statements

[51]

 

 

First United Corporation and Subsidiaries

Consolidated Statement of Income

(In thousands, except per share data)

 

   Year ended December 31, 
   2018   2017 
Interest income          
Interest and fees on loans  $45,073   $39,635 
Interest on investment securities          
Taxable   5,820    5,554 
Exempt from federal income tax   949    925 
Total investment income   6,769    6,479 
Other   452    835 
Total interest income   52,294    46,949 
Interest expense          
Interest on deposits   4,246    3,291 
Interest on short-term borrowings   525    73 
Interest on long-term borrowings   3,341    4,007 
Total interest expense   8,112    7,371 
Net interest income   44,182    39,578 
Provision for loan losses   2,111    2,534 
Net interest income after provision for loan losses   42,071    37,044 
Other operating income          
Net gains   127    29 
Service charges on deposit accounts   2,275    2,308 
Other service charges   877    837 
Trust department   6,692    6,246 
Debit card income   2,534    2,389 
Bank owned life insurance   1,162    1,187 
Brokerage commissions   1,078    872 
Other   423    472 
Total other income   15,041    14,311 
Total other operating income   15,168    14,340 
Other operating expenses          
Salaries and employee benefits   24,170    22,239 
FDIC premiums   639    634 
Equipment   3,160    2,610 
Occupancy   2,551    2,496 
Data processing   3,858    3,511 
Marketing   530    536 
Professional services   1,255    985 
Other real estate owned expenses   1,456    190 
Contract labor   723    683 
Telephony Expense   841    820 
Other   4,625    4,466 
Total other operating expenses   43,808    39,170 
Income before income tax expense   13,431    12,214 
Provision for income tax expense (2017 includes $3,226 from tax reform impact)   2,764    6,945 
Net Income   10,667    5,269 
Accumulated preferred stock dividends   0    (1,215)
Net Income Available to Common Shareholders  $10,667   $4,054 
Basic and diluted net income per common share  $1.51   $0.58 
Weighted average number of basic and diluted shares outstanding   7,079    6,932 

 

See notes to consolidated financial statements

 

[52]

 

 

First United Corporation and Subsidiaries

Consolidated Statement of Comprehensive Income

(In thousands)

 

   Year Ended 
   December 31, 
Comprehensive Income  2018   2017 
Net Income  $10,667   $5,269 
Other comprehensive (loss)/income, net of tax and reclassification adjustments:          
Net unrealized gains/(losses) on investments with OTTI   1,040    (90)
           
Net unrealized (losses)/gains on all other AFS securities   (622)   674 
           
Net unrealized gains on HTM securities   216    253 
           
Net unrealized gains on cash flow hedges   191    59 
           
Net unrealized (losses)/gains on pension plan liability   (951)   336 
           
Net unrealized gains on SERP liability   316    23 
           
Other comprehensive income, net of tax   190    1,255 
           
Comprehensive Income  $10,857   $6,524 

 

See notes to consolidated financial statements

 

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First United Corporation and Subsidiaries

Consolidated Statement of Changes in Shareholders’ Equity

(In thousands)

 

   Preferred
Stock
   Common
Stock
   Surplus   Retained
Earnings
   Accumulated
Other
Comprehensive
Loss, net of tax
   Total
Shareholders'
Equity
 
Balance at January 1, 2017  $20,000   $63   $22,178   $92,922   $(21,465)  $113,698 
                               
Net income                  5,269         5,269 
Other comprehensive income, net of tax                       1,255    1,255 
Common stock issued        8    9,183              9,191 
Preferred stock dividends paid                  (1,215)        (1,215)
Preferred stock redemption   (20,000)                       (20,000)
Stock based compensation             192              192 
Reclassification of certain tax effects                  4,383    (4,383)   0 
Balance at December 31, 2017   0    71    31,553    101,359    (24,593)   108,390 
                               
Net income                  10,667         10,667 
Other comprehensive income, net of tax                       190    190 
Common Stock Issued             119              119 
Common stock dividend declared - $.27 per share                  (2,549)        (2,549)
Stock based compensation             249              249 
Balance at December 31, 2018  $0   $71   $31,921   $109,477   $(24,403)  $117,066 

 

See notes to consolidated financial statements

 

[54]

 

 

First United Corporation and Subsidiaries

Consolidated Statement of Cash Flows

(In thousands)

 

   Year ended December 31, 
   2018   2017 
Operating activities          
Net income  $10,667   $5,269 
Adjustments to reconcile net income to net cash provided by operating activities:          
Provision for loan losses   2,111    2,534 
Depreciation   2,435    1,898 
Stock compensation   249    192 
Gains on sales of other real estate owned   (260)   (645)
Write-downs of other real estate owned   1,356    398 
Origination of loans held for sale   (10,866)   (10,049)
Proceeds from sales of loans held for sale   11,021    9,973 
Gains on sales of loans held for sale   (88)   (75)
Loss/(gain) on disposal of fixed assets   74    (3)
Net amortization of investment securities discounts and premiums- AFS   39    148 
Net amortization of investment securities discounts and premiums- HTM   57    111 
Net (gain)/loss on sales of investment securities – available-for-sale   (113)   49 
Amortization of deferred loan fees   (745)   (622)
Deferred tax expense   1,338    9,257 
Earnings on bank owned life insurance   (1,162)   (1,187)
Decrease/(increase) in accrued interest receivable and other assets   367    (7,848)
Increase in accrued interest payable and other liabilities   1,814    3,524 
Net cash provided by operating activities   18,294    12,924 
           
Investing activities          
Proceeds from maturities/calls of investment securities available-for-sale   10,888    17,878 
Proceeds from maturities/calls of investment securities held-to-maturity   6,741    7,614 
Proceeds from sales of investment securities available-for-sale   2,005    18,530 
Purchases of investment securities available-for-sale   (3,390)   (40,596)
Purchases of investment securities held-to-maturity   (7,176)   (4,188)
Proceeds from sales of other real estate owned   2,981    3,076 
Proceeds from disposal of fixed assets   0    945 
Net (increase)/decrease in FHLB stock   (190)   5 
Net increase in loans   (116,088)   (4,359)
Purchases of premises and equipment   (9,483)   (6,561)
Net cash used in investing activities   (113,712)   (7,656)
           
Financing activities          
Net increase in deposits   28,137    25,161 
Preferred stock dividends paid   0    (1,215)
Preferred stock redemption   0    (20,000)
Proceeds from issuance of common stock   119    9,191 
Cash dividends paid on common stock   (1,911)   0 
Net increase in short-term borrowings   28,862    12,845 
Payments on long-term borrowings   (20,000)   (10,808)
Net cash provided by financing activities   35,207    15,174 
(Decrease)/increase in cash and cash equivalents   (60,211)   20,442 
Cash and cash equivalents at beginning of the year   83,752    63,310 
Cash and cash equivalents at end of period  $23,541   $83,752 
           
Supplemental information          
Interest paid  $8,110   $7,298 
Taxes paid  $530   $175 
Non-cash investing activities:          
Transfers from loans to other real estate owned  $534   $2,060 

 

See notes to consolidated financial statements

 

[55]

 

 

First United Corporation and Subsidiaries

Notes to Consolidated Financial Statements

 

1.Summary of Significant Accounting Policies

 

Business

 

First United Corporation is a Maryland corporation chartered in 1985 and a bank holding company registered with the Board of Governors of the Federal Reserve System (the “Federal Reserve”) under the Bank Holding Company Act of 1956, as amended. The Corporation’s primary business is serving as the parent company of First United Bank & Trust, a Maryland trust company (the “Bank”), First United Statutory Trust I (“Trust I”) and First United Statutory Trust II (“Trust II”), both Connecticut statutory business trusts. Until September 14, 2018 when it was canceled, the Corporation also served as the parent company to First United Statutory Trust III, a Delaware statutory business trust (“Trust III” and together with Trust I and Trust II, the “Trusts”). The Trusts were formed for the purpose of selling trust preferred securities that qualified as Tier 1 capital. The Bank has two consumer finance company subsidiaries - OakFirst Loan Center, Inc., a West Virginia corporation, and OakFirst Loan Center, LLC, a Maryland limited liability company - and two subsidiaries that it uses to hold real estate acquired through foreclosure or by deed in lieu of foreclosure - First OREO Trust, a Maryland statutory trust, and FUBT OREO I, LLC, a Maryland limited liability company. The Bank also owns 99.9% of the limited partnership interests in Liberty Mews Limited Partnership; a Maryland limited partnership formed for the purpose of acquiring, developing and operating low-income housing units in Garrett County, Maryland (“Liberty Mews”).

 

First United Corporation and its subsidiaries operate principally in four counties in Western Maryland and four counties in West Virginia.

 

As used in these Notes, the terms “the Corporation”, “we”, “us”, and “our” mean First United Corporation and, unless the context clearly suggests otherwise, its consolidated subsidiaries.

 

Basis of Presentation

 

The accompanying consolidated financial statements of the Corporation have been prepared in accordance with United States generally accepted accounting principles (“GAAP”) as required by the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) that require management to make estimates and assumptions that affect the reported amounts of certain assets and liabilities at the date of the financial statements as well as the reported amount of revenues and expenses during the reporting period. Actual results could differ from these estimates. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses, the assessment of other-than-temporary impairment (“OTTI”) pertaining to investment securities, potential impairment of goodwill, and the valuation of deferred tax assets. For purposes of comparability, certain prior period amounts have been reclassified to conform to the 2018 presentation. Such reclassifications had no impact on net income or equity.

 

The Corporation has evaluated events and transactions occurring subsequent to the statement of financial condition date of December 31, 2018 for items that should potentially be recognized or disclosed in these financial statements as prescribed by ASC Topic 855, Subsequent Events.

 

Principles of Consolidation

 

The consolidated financial statements of the Corporation include the accounts of First United Corporation, the Bank, the OakFirst Loan Centers, First OREO Trust and FUBT OREO I, LLC. All significant inter-company accounts and transactions have been eliminated.

 

First United Corporation determines whether it has a controlling financial interest in an entity by first evaluating whether the entity is a voting interest entity or a variable interest entity (“VIE”) in accordance with GAAP. Voting interest entities are entities in which the total equity investment at risk is sufficient to enable the entity to finance itself independently and provides the equity holders with the obligation to absorb losses, the right to receive residual returns and the right to make financial and operating decisions. The Corporation consolidates voting interest entities in which it has 100%, or at least a majority, of the voting interest. As defined in applicable accounting standards, a VIE is an entity that either (i) does not have equity investors with voting rights or (ii) has equity investors that do not provide sufficient financial resources for the entity to support its activities. A controlling financial interest in an entity exists when an enterprise has a variable interest, or a combination of variable interests that will absorb a majority of an entity’s expected losses, receive a majority of an entity’s expected residual returns, or both. The enterprise with a controlling financial interest, known as the primary beneficiary, consolidates the VIE.

 

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The Corporation accounts for its investment in Liberty Mews utilizing the effective yield method under guidance that applies specifically to investments in limited partnerships that operate qualified affordable housing projects. Under the effective yield method, the investor recognizes tax credits as they are allocated and amortizes the initial cost of the investment to provide a constant effective yield over the period that tax credits are allocated to the investor. The effective yield is the internal rate of return on the investment, based on the cost of the investment and the guaranteed tax credits allocated to the investor. The tax credit allocated, net of the amortization of the investment in the limited partnership, is recognized in the income statement as a component of income taxes attributable to continuing operations.

 

Correction of Prior Period Error

 

In February 2019, the Company determined that a valuation allowance write-down on an other real estate owned (“OREO”) property had not been recorded properly for year ended 2017. In 2016, the Company received a two-thirds ownership interest in additional collateral in a forbearance agreement on a large tract of raw land. OREO procedures require that for properties booked in excess of $250,000, an updated appraisal will be ordered every 18 months to ensure our book values are in line with the current market and OREO balances are properly reflected at the lower of the carrying amount or fair value. Based upon this requirement, an updated appraisal for this property was due in 2019. Upon reviewing the file and preparing to order the appraisal, it was discovered that the prior appraisal of September 2017 was not discounted appropriately based upon our two-thirds ownership in the property.

 

The error resulted in an overstatement of OREO on the 2017 Consolidated Statement of Financial Condition of $.4 million and an understatement of Other Real Estate Owned Expense included within other operating expenses on the Consolidated Statement of Income of $.3 million, net of tax, which has carried forward in the Consolidated Statement of Financial Condition throughout 2018. The noted corrections were made for the year ended 2018 Consolidated Statement of Income and as a result of a quantitative and qualitative analysis, Management determined the inclusion of correction of the errors was not considered material to the 2017 or 2018 consolidated financial statements.

 

Significant Concentrations of Credit Risk

 

Most of the Corporation’s relationships are with customers located in Western Maryland and Northeastern West Virginia. At December 31, 2018, approximately 12%, or $118.4 million, of total loans were secured by real estate acquisition, construction and development projects, with $117.7 million performing according to their contractual terms and $.7 million considered to be impaired based on management’s concerns about the borrowers’ ability to comply with present repayment terms. Of the $.7 million in impaired loans, $.5 million were classified as troubled debt restructurings (“TDRs”) performing in accordance with their modified terms, and $.2 million were classified as non-performing loans at December 31, 2018. Additionally, loans collateralized by commercial rental properties represented 16% of the total loan portfolio as of December 31, 2018. Note 6 discusses the types of securities in which the Corporation invests and Note 7 discusses the Corporation’s lending activities.

 

Investments

 

The investment portfolio is classified and accounted for based on the guidance of ASC Topic 320, Investments – Debt and Equity Securities. Securities bought and held principally for the purpose of selling them in the near term are classified as trading account securities and reported at fair value with unrealized gains and losses included in net gains/losses in other operating income. Securities purchased with the intent and ability to hold the securities to maturity are classified as held-to-maturity securities and are recorded at amortized cost. All other investment securities are classified as available-for-sale. These securities are held for an indefinite period of time and may be sold in response to changing market and interest rate conditions or for liquidity purposes as part of our overall asset/liability management strategy. Available-for-sale securities are reported at fair value, with unrealized gains and losses excluded from earnings and reported as a separate component of other comprehensive income included in the consolidated statement of comprehensive income, net of applicable income taxes.