SIFI 12.31.2012 10K

 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
 
FORM 10-K

ý
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the Fiscal Year Ended December 31, 2012
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the Transition Period from _______  to _______ 

Commission File Number:  0-54241
 
SI FINANCIAL GROUP, INC.
(Exact name of registrant as specified in its charter)
 
 
Maryland
 
80-0643149
(State or other jurisdiction of incorporation or organization)
 
(I.R.S. Employer Identification No.)
 
 
 
803 Main Street, Willimantic, Connecticut
 
06226
(Address of principal executive offices)
 
(Zip Code)
 (860) 423-4581
(Registrant’s telephone number, including area code)
 
Securities registered pursuant to Section 12(b) of the Act:
Title of each class
 
Name of Exchange on which registered
Common stock, par value $0.01 per share
 
The Nasdaq Stock Market LLC
Securities registered pursuant to Section 12(g) of the Act:
None
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.   Yes  o  No  ý

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

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of 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.   ý

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

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

Large Accelerated Filer  o Accelerated Filer  ý
Non-Accelerated Filer   o   Smaller Reporting Company Filer  o

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

The aggregate market value of the voting and non-voting common equity held by non-affiliates was $113.4 million, which was computed by reference to the closing price of $11.50, at which the common equity was sold as of June 30, 2012.  Solely for the purposes of this calculation, the shares held by the directors and officers of the registrant are deemed to be affiliates.

As of March 1, 2013, there were 10,112,310 shares of the registrant’s common stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Company’s Annual Report to Shareholders and the Proxy Statement for the 2013 Annual Meeting of Shareholders are incorporated by reference into Parts II and III of this Form 10-K.

Table of Contents

SI FINANCIAL GROUP, INC.
TABLE OF CONTENTS
 
PART I.
 
 
Page No.
Item 1.
 
 
 
 
 
Item 1A.
 
 
 
 
 
Item 1B.
 
 
 
 
 
Item 2.
 
 
 
 
 
Item 3.
 
 
 
 
 
Item 4.
 
 
 
 
 
PART II.
 
 
 
Item 5.
 
 
 
 
 
Item 6.
 
 
 
 
 
Item 7.
 
 
 
 
 
Item 7A.
 
 
 
 
 
Item 8.
 
 
 
 
 
Item 9.
 
 
 
 
 
Item 9A.
 
 
 
 
 
Item 9B.
 
 
 
 
 
PART III.
 
 
 
Item 10.
 
 
 
 
 
Item 11.
 
 
 
 
 
Item 12.
 
 
 
 
 
Item 13.
 
 
 
 
 
Item 14.
 
 
 
 
 
PART IV.
 
 
 
Item 15.
 
 
 
 
 
 
 






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Forward-Looking Statements
This report may contain certain “forward-looking statements” within the meaning of the federal securities laws, which are made in good faith pursuant to the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995.  These statements are not historical facts; rather, they are statements based on management’s current expectations regarding our business strategies, intended results and future performance.  Forward-looking statements are generally preceded by terms such as “expects,” “believes,” “anticipates,” “intends,” “estimates,” “projects” and similar expressions.  Management’s ability to predict results of the effect of future plans or strategies is inherently uncertain.  Factors that could have a material adverse effect on the operations of SI Financial Group, Inc. (the "Company") and its subsidiaries include, but are not limited to, changes in interest rates, national and regional economic conditions, legislative and regulatory changes, monetary and fiscal policies of the United States government, including policies of the United States Treasury and the Federal Reserve Board, the quality and composition of the loan and investment portfolios, demand for products, deposit flows, competition, demand for financial services in the Company’s market area, changes in real estate market values in the Company’s market area and changes in relevant accounting principles and guidelines.  Additional factors that may affect the Company’s results are discussed in Item 1A. “Risk Factors” in this annual report on Form 10-K and in other reports filed with the Securities and Exchange Commission.  These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements.  Except as required by applicable law or regulation, the Company does not undertake, and specifically disclaims any obligation, to release publicly the result of any revisions that may be made to any forward-looking statements to reflect events or circumstances after the date of the statements or to reflect the occurrence of anticipated or unanticipated events.

PART I.

Item 1.  Business.

General

In certain instances where appropriate, the terms “we,” “us” and “our” refer to SI Financial Group, Inc. or Savings Institute Bank and Trust Company, or both.

SI Financial Group, Inc. is the successor to the former federally-chartered SI Financial Group, Inc., which was the parent holding company for Savings Institute Bank and Trust Company (the "Bank") during the time the Bank was organized in the mutual holding company form of organization.

On January 12, 2011, the Company completed its public stock offering and the concurrent "second step" conversion of the Bank from the mutual holding company structure to a stock holding company structure (the "Conversion").  A total of 6,544,493 shares of common stock were sold at $8.00 per share, including 392,670 shares purchased by the Bank’s Employee Stock Ownership Plan.  Additional shares totaling 4,032,356 were issued in exchange for shares of the former federally-chartered SI Financial Group, Inc., at an exchange ratio of 0.8981. Following the Conversion, the Company had 10,576,849 shares of common stock outstanding.

The Bank is a wholly-owned subsidiary of the Company and management of the Company and the Bank are substantially similar.  The Company neither owns nor leases any property, but instead uses the premises, equipment and other property of the Bank with the payment of appropriate rental fees, as required by applicable law and regulations.  Thus, the financial information and discussion contained herein primarily relates to the activities of the Bank.

The Bank operates as a community-oriented financial institution offering a full range of financial services to consumers and businesses in its market area, including insurance, trust and investment services.  The Bank attracts deposits from the general public and uses those funds to originate one- to four-family residential, multi-family and commercial real estate, commercial business and consumer loans.  Since 2008, substantially all of the fixed-rate one- to four-family residential conforming loans the Bank originates have been sold in the secondary market with


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the servicing retained.  Such sales generate mortgage banking fee income.  The remainder of the Bank’s loan portfolio is originated for investment.

Availability of Information

The Company’s annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and any amendments to such reports filed or furnished pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, are made available free of charge on the Company’s website, www.mysifi.com, as soon as reasonably practicable after the Company electronically files such material with, or furnishes it to, the Securities and Exchange Commission (the “SEC”).  The information on the Company’s website shall not be considered as incorporated by reference into this Form 10-K.

Market Area and Competition

The Company is headquartered in Willimantic, Connecticut, which is located in eastern Connecticut approximately 30 miles east of Hartford.  The Bank operates 20 full-service offices throughout Windham, New London, Tolland, Hartford and Middlesex counties in Connecticut.  The Bank’s primary lending area is eastern Connecticut and most of the Bank’s deposit customers reside in the areas surrounding the Bank’s branch offices.  The economy in the Company’s market area is relatively diverse and primarily oriented to the educational, service, entertainment, manufacturing and retail industries.  The major employers in the area include several institutions of higher education, the Mohegan Sun and Foxwoods casinos, General Dynamics Defense Systems and Pfizer, Inc.  In addition, there are also many small to mid-sized businesses that support the local economy.

Notwithstanding the recent economic downturn, our primary market area has remained a relatively stable banking market.  Windham, New London, Tolland, Hartford and Middlesex counties have a total population of 1.6 million and 625,000 total households according to SNL Financial.  For 2011, median household income levels ranged from $54,000 to $74,000 in the five counties we maintain branch offices, compared to $65,000 for Connecticut as a whole and $50,000 for the United States according to published statistics.

The Bank faces significant competition for the attraction of deposits and origination of loans.  The most direct competition for deposits has historically come from the several financial institutions operating in the Bank’s market area and, to a lesser extent, from other financial service companies, such as brokerage firms, credit unions and insurance companies.  The Bank also faces competition for investors’ funds from money market funds and other corporate and government securities.  At June 30, 2012, which is the most recent date for which data is available from the Federal Deposit Insurance Corporation (the “FDIC”), the Bank held 21.04% of the deposits in Windham County, which is the largest market share out of 10 financial institutions with offices in this county.  Also, at June 30, 2012, the Bank held 0.94% of the deposits in New London, Tolland, Hartford and Middlesex counties, which is the 15th market share out of 36 financial institutions with offices in these counties.  Bank of America Corp., Webster Bank Financial Corporation, The Toronto-Dominion Bank, People’s United Financial, Inc. and Banco Santander, S.A., all of which are large national or regional bank holding companies, also operate in the Bank’s market area.  These institutions are significantly larger and, therefore, have significantly greater resources than the Bank does and may offer products and services that the Bank does not provide.

The Bank’s competition for loans comes primarily from financial institutions in its market area, and to a lesser extent from other financial service providers, such as mortgage companies and mortgage brokers. Competition for loans also comes from the increasing number of non-depository financial service companies entering the mortgage market, such as insurance companies, securities companies and specialty finance companies.

The Bank expects competition to increase in the future as a result of legislative, regulatory and technological changes and the continuing trend of consolidation in the financial services industry. Technological advances, for example, have lowered barriers to entry, allowed banks to expand their geographic reach by providing services over the Internet and made it possible for non-depository institutions to offer products and services that traditionally have been provided by banks. Changes in federal law permit affiliation among banks, securities firms


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and insurance companies, which promotes a competitive environment in the financial services industry. Competition for deposits and the origination of loans could limit the Company’s growth in the future.

Lending Activities

General. The Bank’s loan portfolio consists primarily of one- to four-family residential mortgage loans, multi-family and commercial real estate loans and commercial business loans. To a much lesser extent, the loan portfolio includes construction and consumer loans.  At December 31, 2012, the Bank had loans held for sale totaling $5.1 million.

The following table summarizes the composition of the Bank’s loan portfolio at the dates indicated.

 
At December 31,
 
2012
 
2011
 
2010
 
2009
 
2008
 
Amount
 
Percent of Total
 
Amount
 
Percent of Total
 
Amount
 
Percent of Total
 
Amount
 
Percent of Total
 
Amount
 
Percent of Total
Real estate loans:
(Dollars in Thousands)
Residential - 1 to 4 family
$
230,664

 
33.44
%
 
$
247,426

 
39.79
%
 
$
270,923

 
44.46
%
 
$
306,244

 
50.12
%
 
$
332,399

 
53.46
%
Multi-family and commercial
201,951

 
29.28

 
158,384

 
25.47

 
160,015

 
26.26

 
159,781

 
26.15

 
158,693

 
25.52

Construction
3,284

 
0.48

 
12,290

 
1.98

 
6,952

 
1.14

 
11,400

 
1.87

 
27,892

 
4.49

Total real estate loans
435,899

 
63.20

 
418,100

 
67.24

 
437,890

 
71.86

 
477,425

 
78.14

 
518,984

 
83.47

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial business loans:
 
 
 
 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

SBA and USDA guaranteed
148,385

 
21.51

 
127,359

 
20.48

 
116,492

 
19.11

 
77,310

 
12.65

 
45,704

 
7.35

Other
65,142

 
9.44

 
40,442

 
6.50

 
26,310

 
4.32

 
30,239

 
4.95

 
34,945

 
5.62

Total commercial business loans
213,527

 
30.95

 
167,801

 
26.98

 
142,802

 
23.43

 
107,549

 
17.60

 
80,649

 
12.97

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Consumer loans:
 
 
 
 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

Home equity
28,375

 
4.11

 
27,425

 
4.41

 
25,533

 
4.19

 
22,573

 
3.69

 
18,762

 
3.02

Indirect automobile
9,652

 
1.40

 
5,733

 
0.92

 
—

 
—

 
—

 
—

 
—

 
—

Other
2,353

 
0.34

 
2,824

 
0.45

 
3,167

 
0.52

 
3,513

 
0.57

 
3,345

 
0.54

Total consumer loans
40,380

 
5.85

 
35,982

 
5.78

 
28,700

 
4.71

 
26,086

 
4.26

 
22,107

 
3.56

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total loans
689,806

 
100.00
%
 
621,883

 
100.00
%
 
609,392

 
100.00
%
 
611,060

 
100.00
%
 
621,740

 
100.00
%
Deferred loan origination costs, net of deferred fees
1,744

 
 
 
1,713

 
 

 
1,621

 
 

 
1,523

 
 

 
1,570

 
 

Allowance for loan losses
(6,387
)
 
 
 
(4,970
)
 
 

 
(4,799
)
 
 

 
(4,891
)
 
 

 
(6,047
)
 
 

Loans receivable, net
$
685,163

 
 
 
$
618,626

 
 

 
$
606,214

 
 

 
$
607,692

 
 

 
$
617,263

 
 




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One- to Four-Family Residential Loans.  The Bank’s primary lending activity is the origination of mortgage loans to enable borrowers to purchase or refinance existing homes or to construct new residential dwellings in its market area.  The Bank offers fixed-rate and adjustable-rate mortgage loans with terms up to 30 years.  Borrower demand for adjustable-rate loans versus fixed-rate loans is a function of the level of current and anticipated future interest rates, the difference between the interest rates and loan fees offered for fixed-rate mortgage loans and the initial period interest rates and loan fees for adjustable-rate loans. The relative amount of fixed-rate mortgage loans and adjustable-rate mortgage loans that can be originated at any time is largely determined by the demand for each in a competitive environment and the effect each has on the Bank’s interest rate risk.  The loan fees charged, interest rates and other provisions of mortgage loans are determined on the basis of the Bank’s pricing criteria and competitive market conditions.

The Bank offers fixed-rate loans with terms of 10, 15, 20 or 30 years.  The Bank’s adjustable-rate mortgage loans are based primarily on 30-year amortization schedules.  Interest rates and payments on adjustable-rate mortgage loans adjust annually after a one, three, five, seven or ten-year initial fixed period. Interest rates and payments on adjustable-rate loans are adjusted to a rate typically equal to 2.75% (2.875% for jumbo loans) above the one-year constant maturity Treasury index.  The maximum amount by which the interest rate may be increased or decreased is generally 2% per adjustment period and the lifetime interest rate cap is generally 6% over the initial interest rate of the loan.

Generally, the Bank does not originate conventional loans with loan-to-value ratios exceeding 95% and generally originates loans with a loan-to-value ratio in excess of 80% only when secured by first liens on owner-occupied one- to four-family residences.  Loans with loan-to-value ratios in excess of 80% generally require private mortgage insurance or additional collateral.  The Bank requires all properties securing mortgage loans to be appraised by a board approved independent licensed appraiser and requires title insurance on all first mortgage loans.  Borrowers must obtain hazard insurance and flood insurance for loans on property located in a flood zone before closing the loan.

In an effort to provide financing for moderate income and first-time buyers, the Bank offers loans insured by the Federal Housing Administration and the Veterans Administration and participates in the Connecticut Housing Finance Authority Program.  The Bank also offers Guaranteed Rural Housing Loans through the United States Department of Agriculture ("USDA"). The Bank offers fixed-rate residential mortgage loans through these programs to qualified individuals and originates the loans using modified underwriting guidelines.

Multi-Family and Commercial Real Estate Loans.  The Bank originates multi-family and commercial real estate ("CRE") loans throughout its market area for the purpose of acquiring, developing, improving or refinancing multi-family and commercial real estate where the property is the primary collateral securing the loan, and the income generated from the property is the primary repayment source.  The Bank offers fixed-rate and adjustable-rate mortgage loans secured by multi-family and commercial real estate.  The Bank’s multi-family and commercial real estate loans are generally secured by owner-occupied properties, including churches and retail facilities.  The Bank intends to continue to emphasize this segment of its loan portfolio, as market conditions permit, as such loans produce yields that are generally higher than one- to four-family residential loans and are more sensitive to changes in market interest rates.

The Bank has established a specialized lending strategy which includes an Out-of-Market CRE Market Lending Program. The primary focus of this program is to develop greater investment in real estate loans in the metro-Boston and the surrounding region. The Bank employs a highly seasoned senior commercial real estate loan officer and a senior commercial real estate underwriter with significant expertise in this type of lending. Loans originated in this lending area comprise income producing properties representing office, flex, industrial, retail, single credit tenant and residential apartments. These properties have strong income support, favorable demographics and are owned and managed by experienced and financially strong property managers. These loans are predominately shorter-term loan facilities (generally 5-year maturities) which are structured to provide the Bank with strong asset growth, coupled with a focus on credit quality. At December 31, 2012, the Bank's exposure in Out-of-Market CRE Market Lending was $48.8 million.


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The Bank originates adjustable-rate multi-family and commercial real estate loans for amortization periods up to 25 years.  Interest rates and payments on these loans typically adjust every five years after a five-year initial fixed-rate period.  Interest rates and payments on adjustable-rate loans are adjusted to a rate typically 2.5-3.0% above the classic advance rates offered by the Federal Home Loan Bank of Boston (the “FHLB”). There are no adjustment period or lifetime interest rate caps. Loans are secured by first mortgages that generally do not exceed 75% of the property’s appraised value.  At December 31, 2012, the largest outstanding multi-family or commercial real estate loan was $8.6 million.  This loan is secured by an office building and was performing according to its terms at December 31, 2012.

Construction and Land Loans.  The Bank originates loans to individuals, and to a lesser extent, builders, to finance the construction of residential dwellings.  The Bank also originates construction loans for commercial development projects, including condominiums, apartment buildings, single-family subdivisions as well as owner-occupied properties used for businesses.  Residential construction loans generally provide for the payment of interest only during the construction phase, which is usually twelve months.  At the end of the construction phase, the loan generally converts to a permanent mortgage loan.  Commercial construction loans generally provide for the payment of interest only during the construction phase which may range from three to twenty-four months.  Loans generally can be made with a maximum loan-to-value ratio of 80% on residential construction, 75% on construction for nonresidential properties and 80% of the lesser of the appraised value or cost of the project on multi-family construction.  At December 31, 2012, the largest outstanding commercial construction loan commitment was $600,000 for the construction of a multi-tenant retail building, of which $50,000 was outstanding and the largest residential construction loan commitment was $544,000 of which $425,000 was outstanding.  These loans were performing according to their terms at December 31, 2012.  Primarily all commitments to fund construction loans require an appraisal of the property by a board approved independent licensed appraiser.  Also, inspections of the property are required before the disbursement of funds during the term of the construction loan.

The Bank also originates land loans to individuals, local contractors and developers only for making improvements on approved building lots, subdivisions and condominium projects within two years of the date of the loan.  Such loans to individuals generally are written with a maximum loan-to-value ratio based upon the appraised value or purchase price of the land.  Maximum loan-to-value ratio on raw land is 50%, while the maximum loan-to-value ratio for land development loans involving approved projects is 65%.  The Bank offers fixed-rate land loans and variable-rate land loans that adjust annually.  Interest rates and payments on adjustable-rate land loans are adjusted to a rate typically equal to the then current prime rate as reported in The Wall Street Journal plus a 1.0–2.0% margin.  The maximum amount by which the interest rate may be increased or decreased is generally 2% annually and the lifetime interest rate cap is generally 6% over the initial rate of the loan.  Land loans totaled $231,000 at December 31, 2012.

Commercial Business Loans. The Bank originates commercial business loans to a variety of professionals, sole proprietorships and small businesses primarily in its market area.  The Bank offers a variety of commercial lending products, the maximum amount of which is limited by the Bank’s in-house loans to one borrower limit.  At December 31, 2012, the largest commercial loan was a $7.3 million loan, which is secured by the assignment of a diverse portfolio of consumer account receivables related to the time share industry.  This loan was performing according to its terms at December 31, 2012.

The Bank offers loans secured by business assets other than real estate, such as business equipment and inventory. These loans are originated with maximum loan-to-value ratios of 75% of the value of the personal property.  The Bank originates lines of credit to finance the working capital needs of businesses to be repaid by seasonal cash flows or to provide a period of time during which the business can borrow funds for planned equipment purchases.  These loans convert to a term loan at the expiration of a draw period, which is not to exceed twelve months, and will be paid over a pre-defined amortization period.  Additional products such as time notes, letters of credit and equipment lease financing are offered.  Additionally, the Bank purchases the portion of commercial business loans that are fully guaranteed by the Small Business Administration (“SBA”) and the


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USDA.  At December 31, 2012, purchased SBA and USDA loans totaled $148.4 million.

Under the direction of a seasoned loan officer with experience in this field, the Bank's Commercial Lending Department maintains a program to finance capital improvements for residential and commercial condominium associations. The loans are secured with the assigned right to levy special assessments and collect the special assessments from the individual unit owners. The portfolio consists of 45 loans totaling $15.5 million as of December 31, 2012.

The Bank has initiated a specialized lending program supporting the time share industry. The Bank provides financing for investors but is not involved with the development of time share resorts. The loan is secured by diverse consumer receivables. The Bank employs an experienced loan officer who specializes in this area of lending. The Bank's exposure in time share lending was $28.0 million at December 31, 2012.

When originating commercial business loans, the Bank considers the financial statements of the borrower, the borrower’s payment history of both corporate and personal debt, the debt service capabilities of the borrower, the projected cash flows of the business, viability of the industry in which the customer operates and the value of the collateral.

Consumer Loans.  The Bank offers a variety of consumer loans, primarily home equity lines of credit, and, to a lesser extent, loans secured by marketable securities, passbook or certificate accounts, motorcycles, automobiles and recreational vehicles, as well as unsecured loans.  Generally, the Bank offers automobile loans with a maximum loan-to-value ratio of 100% of the purchase price for new vehicles.  Unsecured loans generally have a maximum borrowing limit of $10,000 and a maximum term of five years.

The procedures for underwriting consumer loans include an assessment of the applicant’s payment history on other debts and their ability to meet existing obligations and payments on the proposed loans. Although the applicant’s creditworthiness is a primary consideration, the underwriting process also includes a comparison of the value of the collateral, if any, to the proposed loan amount.  Home equity lines of credit have adjustable rates of interest that are indexed to the prime rate as reported in The Wall Street Journal.  A home equity line of credit may be drawn down by the borrower for an initial period of five years from the date of the loan agreement.  During this period, the borrower has the option of paying, on a monthly basis, either principal and interest or only interest.  If the draw period is not extended at the option of the Bank for an additional 4 years and 10 months, the borrower has to pay back the amount outstanding under the line of credit over a term not to exceed ten years, beginning at the end of the five-year period.  The Bank will offer home equity loans with a maximum combined loan-to-value ratio of 80%.

Loan Underwriting Risks.  While the Bank anticipates that adjustable-rate loans will better offset the adverse effects of an increase in interest rates as compared to fixed-rate mortgages, the increased mortgage payments required of adjustable-rate loan borrowers in a rising interest rate environment could cause an increase in delinquencies and defaults.  The marketability and collateral value of the underlying property also may be adversely affected in a high interest rate environment.  In addition, although adjustable-rate mortgage loans help make the Bank’s loan portfolio more responsive to changes in interest rates, the extent of this interest sensitivity is limited by the annual and lifetime interest rate adjustment limits.

Loans secured by multi-family and commercial real estate generally have larger balances and involve a greater degree of risk than one- to four-family residential mortgage loans.  Of primary concern in multi-family and commercial real estate lending is the borrower’s creditworthiness and the feasibility and cash flow potential of the project. Payments on loans secured by income-producing properties often depend on the successful operation and management of the properties. As a result, repayment of such loans may be subject, to a greater extent than residential real estate loans, to adverse conditions in the real estate market or the economy. To monitor cash flows on income-producing properties, the Bank generally requires borrowers and loan guarantors to provide annual financial statements and/or tax returns.  In reaching a decision on whether to make a multi-family or commercial real estate loan, consideration is given to the net operating income of the property, the borrower’s


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expertise, credit history and the profitability and value of the underlying property.  The Bank generally requires that the properties securing these real estate loans have debt service coverage ratios (the ratio of earnings before debt service to debt service) of at least 1.20.  Environmental screens, surveys and inspections are obtained when circumstances suggest the possibility of the presence of hazardous materials. Further, in connection with our ongoing monitoring of the loan, the Bank typically reviews the property, the underlying loan and guarantors annually.

Construction financing is generally considered to involve a higher degree of risk of loss than long-term financing on improved, occupied real estate.  Risk of loss on a construction loan depends largely upon the accuracy of the initial estimate of the property’s value at completion of construction, the estimated cost (including interest) of construction and the ability of the project to be sold upon completion.  During the construction phase, a number of factors could result in delays and cost overruns.  If the estimate of construction costs proves to be inaccurate, the Bank may be required to advance funds beyond the amount originally committed to permit completion of the building.  If the estimate of value proves to be inaccurate, the Bank may be confronted, at or before the maturity of the loan, with a building having a value that is insufficient to assure full repayment.  If the Bank is forced to foreclose on a building before or at completion due to a borrower default, the Bank may not be able to recover all of the unpaid balance of, and accrued interest on, the loan as well as related foreclosure and holding costs.

Unlike residential mortgage loans, which generally are made on the basis of the borrower’s ability to make repayment from his or her employment or other income, and which are secured by real property the value of which tends to be more easily ascertainable, commercial business loans are of higher risk and typically are made on the basis of the borrower’s ability to make repayment from the cash flows of the borrower’s underlying business.  As a result, the availability of funds for the repayment of commercial business loans may depend substantially on the success of the business itself.  Further, any collateral securing such loans may depreciate over time, may be difficult to appraise and may fluctuate in value.

Consumer loans entail greater risk than residential mortgage loans, particularly in the case of consumer loans that are unsecured or secured by assets that depreciate rapidly.  In such cases, repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment for the outstanding loan and the remaining deficiency often does not warrant significant collection efforts against the borrower.  In addition, consumer loan collections depend on the borrower’s continuing financial stability, and therefore are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy.  Furthermore, the application of various federal and state laws, including bankruptcy and insolvency laws, may limit the amount which can be recovered on such loans.

Loan Originations, Purchases, Sales and Servicing.  Loan originations come from a number of sources.  The primary source of loan originations are the Bank’s in-house loan originators, and to a lesser extent, advertising and referrals from customers.

The Bank purchases the portions of loans fully guaranteed by the SBA and the USDA.  The loans are primarily for commercial and agricultural properties located throughout the United States.  The Bank purchased $42.9 million and $41.2 million in such loans during 2012 and 2011, respectively. During 2011, proceeds from the sale of SBA and USDA loans totaled $8.0 million. No SBA and USDA loans were sold during 2012.

Additionally, the Bank enters into participation loans with other institutions.  The Bank generally performs its own underwriting analysis before participating in a loan and therefore, believes there should not be a greater risk of default on these obligations compared to loans the Bank originates itself.  However, in a purchased participation loan, the Bank does not service the loan and thus is subject to the policies and practices of the lead lender with regard to monitoring delinquencies, pursuing collections and instituting foreclosure proceedings. At December 31, 2012, the Bank was a participating lender on four loans totaling $5.1 million, which are secured by commercial real estate, which are serviced by other institutions as the lead lenders. 

During 2012, the Bank purchased an additional indirect automobile portfolio totaling $6.9 million. The characteristics of the portfolio include minimum FICO scores for the applicant, acceptable debt to income ratios,


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qualified collateral and Vendor's Single Interest ("VSI") coverage on each automobile. At December 31, 2012, the indirect automobile portfolio amounted to $9.7 million.

The Bank originates conventional conforming one- to four-family loans which meet Fannie Mae underwriting standards.  Since 2008, substantially all of the fixed-rate one- to four-family residential conforming loans have been sold in the secondary market on a servicing retained basis.  Such loans are sold to Fannie Mae, the Connecticut Housing Finance Authority and the FHLB under the Mortgage Partnership Finance Program (“MPF”).  The decision to sell loans in the secondary market is based on prevailing market interest rate conditions, an analysis of the composition and risk of the loan portfolio, liquidity needs and interest rate risk management.  Generally, loans are sold without recourse.  The Bank utilizes the proceeds from these sales primarily to meet liquidity needs. Proceeds from the sale of one- to four-family loans totaled $55.3 million and $49.1 million for the years ended December 31, 2012 and 2011, respectively. The Bank intends to continue to originate these types of loans for sale in the secondary market in the future to increase its noninterest income.

At December 31, 2012, the Bank retained the servicing rights on $203.4 million of loans for others, consisting primarily of fixed-rate mortgage loans sold with or without recourse to third parties.  Loan repurchase commitments are agreements to repurchase loans previously sold upon the occurrence of conditions established in the contract, including default by the underlying borrower.  At December 31, 2012, the balance of loans sold with recourse totaled $14,000.  Loan servicing includes collecting and remitting loan payments, accounting for principal and interest, contacting delinquent mortgagors, processing insurance and tax payments on behalf of borrowers, assisting in foreclosures and property dispositions when necessary and general administration of loans.

The following table sets forth the Bank’s loan originations, loan purchases, loan sales, principal repayments, net charge-offs and other reductions on loans for the years indicated.

 
Years Ended December 31,
 
2012
 
2011
 
2010
 
(In Thousands)
Loans at beginning of year
$
621,883

 
$
609,392

 
$
611,060

 
 
 
 
 
 
Originations:
 

 
 

 
 

Real estate loans
159,887

 
119,684

 
104,497

Commercial business loans
42,490

 
16,651

 
5,337

Consumer loans
10,319

 
10,898

 
12,210

Total loan originations
212,696

 
147,233

 
122,044

 
 
 
 
 
 
Purchases:
 
 
 
 
 
SBA and USDA guaranteed
42,907

 
41,197

 
53,953

Indirect automobile
6,861

 
5,802

 
—

Total purchases
49,768

 
46,999

 
53,953

 
 
 
 
 
 
Deductions:
 
 
 

 
 

Principal loan repayments, prepayments and other, net
135,677

 
122,087

 
125,719

Loan sales
55,260

 
57,047

 
49,107

Loan charge-offs
1,817

 
1,726

 
1,015

Transfers to other real estate owned
1,787

 
881

 
1,824

Total deductions
194,541

 
181,741

 
177,665

 
 
 
 
 
 
Net increase (decrease) in loans
67,923

 
12,491

 
(1,668
)
 
 
 
 
 
 
Loans at end of year
$
689,806

 
$
621,883

 
$
609,392



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Loan Maturity.  The following table shows the contractual maturity of the Bank’s loan portfolio at December 31, 2012.  The table does not reflect any estimate of prepayments, which significantly shortens the average life of all loans and may cause actual repayment experience to differ from that shown below.  Demand loans having no stated schedule of repayments and no stated maturity are reported as due in one year or less.  The amounts shown below exclude deferred loan fees and costs.
 
Amounts Due In
 
One Year or Less
 
More Than
One Year to Five Years
 
More Than Five Years
 
Total
Amount Due
 
 
 
 
Real estate loans:
(In Thousands)
Residential - 1 to 4 family
$
311

 
$
4,573

 
$
225,780

 
$
230,664

Multi-family and commercial
1,097

 
35,368

 
165,486

 
201,951

Construction
174

 
—

 
3,110

 
3,284

Total real estate loans
1,582

 
39,941

 
394,376

 
435,899

 
 
 
 
 
 
 
 
Commercial business loans:
 
 
 
 
 
 
 
     SBA and USDA guaranteed
—

 
2,796

 
145,589

 
148,385

     Other
17,618

 
19,399

 
28,125

 
65,142

     Total commercial business loans
17,618

 
22,195

 
173,714

 
213,527

 
 
 
 
 
 
 
 
Consumer loans:
 
 
 
 
 
 
 
     Home equity
—

 
73

 
28,302

 
28,375

     Indirect automobile
6

 
6,221

 
3,425

 
9,652

     Other
81

 
989

 
1,283

 
2,353

     Total consumer loans
87

 
7,283

 
33,010

 
40,380

 
 
 
 
 
 
 
 
Total loans
$
19,287

 
$
69,419

 
$
601,100

 
$
689,806


While one- to four-family residential real estate loans are normally originated with terms of up to 30 years, such loans typically remain outstanding for substantially shorter periods because borrowers often prepay their loans in full upon the sale of the property pledged as security or upon refinancing the original loan.  Therefore, average loan maturity is a function of, among other factors, the level of purchase, sale and refinancing activity in the real estate market, prevailing interest rates and the interest rates payable on outstanding loans.



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The following table sets forth the dollar amount of all scheduled maturities of loans at December 31, 2012 that are due after December 31, 2013, and have either fixed interest rates or adjustable interest rates.
 
Due After December 31, 2013
 
Fixed Rates
 
Floating or
Adjustable Rates
 
 Total
 
 
 
Real estate loans:
(In Thousands)
Residential - 1 to 4 family
$
160,599

 
$
69,754

 
$
230,353

Multi-family and commercial
66,695

 
134,159

 
200,854

Construction
2,708

 
402

 
3,110

Total real estate loans
230,002

 
204,315

 
434,317

 
 
 
 
 
 
Commercial business loans:
 
 
 
 
 
     SBA and USDA guaranteed
63,593

 
84,792

 
148,385

     Other
22,353

 
25,171

 
47,524

     Total commercial business loans
85,946

 
109,963

 
195,909

 
 
 
 
 
 
Consumer loans:
 
 
 
 
 
     Home equity
6,572

 
21,803

 
28,375

     Indirect automobile
9,646

 
—

 
9,646

     Other
1,229

 
1,043

 
2,272

     Total consumer loans
17,447

 
22,846

 
40,293

 
 
 
 
 
 
Total loans
$
333,395

 
$
337,124

 
$
670,519


Loan Approval Procedures and Authority.  The Bank’s lending activities follow written, non-discriminatory, underwriting standards and loan origination procedures established by the Company’s Board of Directors and management.  All residential mortgages and home equity lines of credit in excess of $6.0 million or all commercial loans and other consumer loans in excess of $2.0 million require the approval of the Board of Directors.  The Loan Committee of the Board of Directors has the authority to approve:  (1) residential mortgage loans and consumer home equity lines of credit up to $6.0 million and (2) commercial and other consumer loans up to $2.0 million. The President and the Senior Credit Officer have approval for:  (1) residential mortgage loans that conform to Fannie Mae and Freddie Mac standards up to $2.0 million or $417,000 for those that are non-conforming and (2) consumer and commercial loans up to $250,000 individually or $2.0 million jointly for home equity lines of credit or $1.0 million jointly for commercial and other consumer loans.  Additionally, certain loan and branch personnel have the authority to approve residential mortgage loans, home equity lines and consumer loans up to certain limits as specified in the Bank's loan policy.

Loans to One Borrower.  The maximum amount that the Bank may lend to one borrower and the borrower’s related entities is limited, by regulation, to 15% of the Bank’s stated capital and reserves.  At December 31, 2012, the Bank’s general regulatory limit on loans to one borrower was approximately $16.5 million.  At that date, the Bank’s largest lending relationship was $14.0 million, representing commercial real estate loans on three office buildings.  These loans were performing according to their original terms at December 31, 2012.

Loan Commitments.  The Bank issues commitments for fixed- and adjustable-rate mortgage loans conditioned upon the occurrence of certain events.  Commitments to originate mortgage loans are legally binding agreements to lend to customers.  Generally, our mortgage loan commitments expire in 60 days or less from the date of the application.

Delinquencies.  When a borrower fails to make a required loan payment, the Bank takes a number of steps to have the borrower cure the delinquency and restore the loan to current status.  The Bank makes initial contact with the borrower when the loan becomes 15 days past due.  If payment is not then received by the 30th day of delinquency, additional letters and phone calls generally are made. When the loan becomes 90 days past due, a


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letter is sent notifying the borrower that foreclosure proceedings will commence if the loan is not brought current within 30 days.  Generally, when the loan becomes 120 days past due, the Bank will commence foreclosure proceedings against any real property that secures the loan or attempt to repossess any personal property that secures a consumer or commercial loan.  If a foreclosure action is instituted and the loan is not brought current, paid in full or refinanced before the foreclosure sale, the real property securing the loan is typically sold at foreclosure.  The Bank may consider loan repayment arrangements with certain borrowers under certain circumstances.

Management reports monthly to the Board of Directors or a committee of the Board regarding the amount of loans delinquent 30 days or more, all loans in foreclosure and all foreclosed and repossessed property that the Bank owns.

The following table provides information about delinquencies in the Bank’s loan portfolio at the dates indicated.

 
December 31, 2012
 
December 31, 2011
 
60-89 Days
 
90 Days or More
 
60-89 Days
 
90 Days or More
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Number of Loans
 
Principal
Balance of Loans
 
Number of Loans
 
Principal
Balance of Loans
 
Number of Loans
 
Principal
Balance of Loans
 
Number of Loans
 
Principal
Balance of Loans
 
 
 
 
 
 
 
 
Real estate loans:
(Dollars in Thousands)
Residential - 1 to 4 family
13
 
$
1,725

 
24
 
$
3,285

 
5
 
$
995

 
24
 
$
3,835

Multi-family and commercial
—
 
—

 
3
 
1,266

 
—
 
—

 
4
 
1,703

Total real estate loans
13
 
1,725

 
27
 
4,551

 
5
 
995

 
28
 
5,538

Commercial business loans:
 
 
 

 
 
 
 

 
 
 
 

 
 
 
 

SBA and USDA guaranteed
1
 
1,087

 
—
 
—

 
1
 
327

 
—
 
—

Other
—
 
—

 
2
 
541

 
—
 
—

 
1
 
623

Total commercial business loans
1
 
1,087

 
2
 
541

 
1
 
327

 
1
 
623

Consumer loans:
 
 
 

 
 
 
 

 
 
 
 

 
 
 
 

Home equity
—
 
—

 
3
 
361

 
—
 
—

 
2
 
269

Total consumer loans
—
 
—

 
3
 
361

 
—
 
—

 
2
 
269

Total delinquent loans
14
 
$
2,812

 
32
 
$
5,453

 
6
 
$
1,322

 
31
 
$
6,430


Classified Assets.  Management of the Bank, including the Managed Asset Committee, consisting of a number of the Bank’s officers, review and classify the assets of the Bank on a monthly basis and the Board of Directors reviews the results of the reports on a quarterly basis.  Federal regulations and the Bank’s internal policies require that management utilize an internal asset classification system to monitor and evaluate the credit risk inherent in its loan portfolio.  In addition, the Bank's regulator has the authority to identify problem assets and, if appropriate, require them to be classified.  There are three classifications for problem assets; substandard, doubtful and loss. “Substandard assets” must have one or more defined weaknesses and are characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected.  “Doubtful assets” have all the weaknesses inherent in those classified as “substandard” with the additional characteristic that the weaknesses make collection or liquidation in full on the basis of currently existing facts, conditions and values questionable, and there is a high probability of loss.  Assets classified as “loss” are those assets considered uncollectible and of such little value that continuance as assets of the institution are not warranted.  The regulations also provide for a “special mention” category, described as assets which do not currently expose us to a sufficient degree of risk to


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warrant classification but do possess credit deficiencies or potential weakness deserving close attention.  If the Bank classifies an asset as a loss, a loan loss allowance in the amount of 100% of the portion of the asset classified as a loss is established.

The following table shows the aggregate amounts of the Bank’s criticized and classified assets as of December 31, 2012. 
 
 
 
 
 
 
 
Special
 
Loss
 
Doubtful
 
Substandard
 
Mention
Real estate loans:
(In Thousands)
Residential - 1 to 4 family
$
—

 
$
—

 
$
7,679

 
$
723

Multi-family and commercial
—

 
—

 
11,489

 
5,321

Construction
—

 
—

 
—

 
—

Total real estate loans
—

 
—

 
19,168

 
6,044

 
 
 
 
 
 
 
 
Commercial business loans:
 

 
 

 
 

 
 

Other
—

 
—

 
696

 
3,399

Total commercial business loans
—

 
—

 
696

 
3,399

 
 
 
 
 
 
 
 
Consumer loans:
 

 
 

 
 

 
 

Home equity
—

 
—

 
415

 
—

Total consumer loans
—

 
—

 
415

 
—

Total classified loans
—

 
—

 
20,279

 
9,443

 
 
 
 
 
 
 
 
Investment securities:
 

 
 

 
 

 
 

Non-agency mortgage-backed
—

 
—

 
1,731

 
—

Collateralized debt obligations
—

 
—

 
5,993

 
—

Total classified investment securities
—

 
—

 
7,724

 
—

Total criticized and classified assets
$
—

 
$
—

 
$
28,003

 
$
9,443

 
At December 31, 2012, total classified assets comprised forty-one commercial real estate loans totaling $16.8 million, fifty-seven residential mortgage loans totaling $8.4 million, seventeen commercial business loans totaling $4.1 million, five home equity loans totaling $415,000 and six investment securities with a carrying value totaling $7.7 million.  Substandard assets include $20.3 million of substandard loans, of which $7.7 million were nonperforming at December 31, 2012.  Of the $7.7 million in nonperforming loans, residential real estate loans totaling $5.0 million, commercial real estate loans totaling $1.8 million, commercial business loans (other) totaling $542,000 and consumer loans (home equity) totaling $366,000 were 90 days or more past due.  The substandard assets also included four collateralized debt obligations totaling $6.0 million and two non-agency mortgage-backed securities totaling $1.7 million.  Of the $9.4 million of special mention loans, one residential real estate loan totaling $37,000 was 60 days or more past due at December 31, 2012.

Other than disclosed in the above tables, there are no other loans at December 31, 2012 that management has serious doubts about the ability of the borrowers to comply with the present loan repayment terms.

Nonperforming Assets and Restructured Loans.   The Bank considers repossessed assets and loans that are 90 days or more past due to be nonperforming assets.  Loans are generally placed on nonaccrual status when they become 90 days delinquent at which time the accrual of interest ceases and any previously recorded interest is reversed and recorded as a reduction of loan interest and fee income.  Typically, payments received on a nonaccrual loan are applied to the outstanding principal and interest balance as determined at the time of collection of the loan.



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The Bank periodically may agree to modify the contractual terms of loans.  When a loan is modified and concessions have been made to the original contractual terms, such as reductions of interest rates or deferral of interest or principal payments, due to the borrower’s financial condition, the modification is considered a troubled debt restructuring (“TDR”).  All TDRs are initially classified as impaired. The Bank adheres to the nonaccrual policy for all TDR loans. Loans that are current prior to modification would not require nonaccrual status subsequent to the modification. If the accrual of interest was suspended on the loan prior to the modification or if the payment amount significantly increased subsequent to the modification, the loan would remain on nonaccrual status until the borrower demonstrates the willingness and the ability to make the restructured loan payments for a period of six consecutive months.

Real estate acquired as a result of foreclosure or by deed-in-lieu of foreclosure is classified as a foreclosed asset until it is sold.  When property is acquired, it is recorded at fair value, net of estimated selling expenses.  Holding costs and declines in fair value after acquisition of the property result in charges against income.

The following table provides information with respect to the Bank’s nonperforming assets and TDRs as of the dates indicated.  The Company had no accruing loans past due 90 days or more at any of the dates indicated.
 
 
At December 31,
 
 
2012
 
2011
 
2010
 
2009
 
2008
Nonaccrual loans:
(Dollars in Thousands)
Real estate loans:
 
 
 
 
 
 
 
 
 
Residential - 1 to 4 family
$
4,988

 
$
5,590

 
$
2,901

 
$
2,597

 
$
2,795

Multi-family and commercial
1,758

 
4,031

 
1,775

 
—

 
832

Construction
—

 
—

 
82

 
375

 
5,483

Total real estate loans
6,746

 
9,621

 
4,758

 
2,972

 
9,110

Commercial business loans
542

 
654

 
116

 
35

 
217

Consumer loans:
 
 
 
 
 
 
 
 
 
     Home equity
366

 
316

 
50

 
—

 
—

     Other
—

 
—

 
1

 
—

 
1

Total consumer loans
366

 
316

 
51

 
—

 
1

Total nonaccrual loans
7,654

 
10,591

 
4,925

 
3,007

 
9,328

 
 
 
 
 
 
 
 
 
 
Other real estate owned, net (1)
1,293

 
976

 
1,285

 
3,680

 
—

Total nonperforming assets
8,947

 
11,567

 
6,210

 
6,687

 
9,328

 
 
 
 
 
 
 
 
 
 
Accruing troubled debt restructurings
3,826

 
4,620

 
5,261

 
67

 
69

Total nonperforming assets and troubled debt restructurings
$
12,773

 
$
16,187

 
$
11,471

 
$
6,754

 
$
9,397

 
 
 
 
 
 
 
 
 
 
Total nonperforming loans to total loans
1.11
%
 
1.70
%
 
0.81
%
 
0.49
%
 
1.50
%
Total nonperforming loans to total assets
0.80

 
1.11

 
0.53

 
0.34

 
1.09

Total nonperforming assets and troubled debt restructurings to total assets
1.34

 
1.69

 
1.24

 
0.77

 
1.10

 
 
 
 
 
 
 
 
 
 
 
(1)  
Other real estate owned balances are shown net of related write-downs or valuation allowance.
 
The decrease in nonperforming assets was due to a decrease in nonaccrual loans, offset by an increase in other real estate owned.  A decrease in nonperforming commercial mortgage and residential mortgage loans of $2.3 million and $601,000, respectively, contributed to the lower balance of nonperforming loans at December 31, 2012. Nonaccrual loans consisted of thirty-nine residential one- to four-family loans, four commercial real estate loans, two commercial business loans and four consumer loans.



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Other real estate owned increased $317,000 from December 31, 2011 to December 31, 2012.  During 2012, the Bank acquired two commercial and five residential properties with a net carrying value of $1.8 million, sold three commercial and six residential properties with a net carrying value of $1.4 million and reduced the carrying value of one residential property in the amount of $28,000.

At December 31, 2012 and 2011, troubled debt restructurings totaled $4.3 million and $5.1 million, respectively, as a result of interest rate concessions, deferral of principal payments, extension of maturity or a combination of these items.  Of the troubled debt restructurings of $4.3 million at December 31, 2012, $3.8 million continued to accrue interest under the restructured terms of their agreements while the accrual of interest was suspended on loans totaling $504,000. As of December 31, 2012, all borrowers were performing in accordance with the terms of their restructured loan agreements and the Bank anticipates that these borrowers will repay all contractual principal and interest.

Interest income that would have been recorded for the year ended December 31, 2012 had nonaccruing loans and troubled debt restructurings been current in accordance with their original terms and had been outstanding throughout the period amounted to $603,000.  The amount of interest recognized on these loans was $419,000 for the year ended December 31, 2012.

Allowance for Loan Losses.  The allowance for loan losses, a material estimate which could change significantly in the near-term, is established through a provision for loan losses charged to earnings to account for losses that are inherent in the loan portfolio and estimated to occur, and is maintained at a level that management considers adequate to absorb losses in the loan portfolio.  Loan losses are charged against the allowance for loan losses when management believes that the uncollectibility of the principal loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance for loan losses when received.  In the determination of the allowance for loan losses, management obtains independent appraisals for significant properties, when necessary.

Management's judgment in determining the adequacy of the allowance is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.  The allowance for loan losses is evaluated on a monthly basis by management and is based on the evaluation of the known and inherent risk characteristics and size and composition of the loan portfolio, the assessment of current economic and real estate market conditions, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral, historical loan loss experience, level of nonperforming loans, delinquencies, classified assets and loan charge-offs and evaluations of loans and other relevant factors.

The allowance for loan losses consists of the following key elements:

◦
Specific allowance for identified impaired loans.  For loans that are identified as impaired, an allowance is established when the present value of expected cash flows (or observable market price of the loan or fair value of the collateral if the loan is collateral dependent) of the impaired loan is lower than the carrying value of that loan.

◦
General valuation allowance.  The general component represents a valuation allowance on the remainder of the loan portfolio, after excluding impaired loans.  For this portion of the allowance, loans are segregated by category and assigned an allowance percentage based on historical loan loss experience adjusted for qualitative factors stratified by the following loan segments:  residential one- to four-family, multi-family and commercial real estate, construction, commercial business and consumer.   Management uses a rolling average of historical losses based on the time frame appropriate to capture relevant loss data for each loan segment. This historical loss factor is adjusted for the following qualitative factors: levels/trends in delinquencies, classified loans and nonaccrual loans; level of loan charge-offs; trends in volume, nature and terms of loans; existence and effect of/or changes in the level of credit concentrations; effects of changes in risk selection, underwriting standards and other changes in lending policies, procedures and practices; experience/ability and depth of lending management and staff and national and local economic trends and conditions and impact on value of underlying collateral for collateral dependent


16
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loans.

In computing the allowance for loan losses, we do not assign a general valuation allowance to the SBA and USDA loans that we purchase as such loans are fully guaranteed.  Such loans accounted for $148.4 million, or 21.5% of the loan portfolio at December 31, 2012.

The majority of the Company's loans are collateralized by real estate located in eastern Connecticut. To a lesser extent, certain commercial real estate loans are secured by collateral located outside of our primary market area. Accordingly, the collateral value of a substantial portion of the Company's loan portfolio and real estate acquired through foreclosure is susceptible to changes in market conditions.

Although management believes that it uses the best information available to establish the allowance for loan losses, future adjustments to the allowance for loan losses may be necessary and the Company’s results of operations could be adversely affected if circumstances differ substantially from the assumptions used in making the determinations.  Furthermore, while management believes it has established the allowance for loan losses in conformity with U.S. generally accepted accounting principles, our regulators, in reviewing the loan portfolio, may require the Company to increase its allowance for loan losses based on judgments different from those of the Company.  In addition, because future events affecting borrowers and collateral cannot be predicted with certainty, the existing allowance for loan losses may not be adequate or increases may be necessary should the quality of any loans deteriorate as a result of the factors discussed above.  Any material increase in the allowance for loan losses would adversely affect the Company’s financial condition and results of operations.

The following table sets forth the breakdown of the allowance for loan losses by loan category at the dates indicated. 
 
December 31,
 
2012
 
2011
 
2010
 
Amount
 
% of
Allowance
in each
Category
to Total
Allowance
 
% of
Loans in
each
Category
to Total
Loans
 
Amount
 
% of
Allowance
in each
Category
to Total
Allowance
 
% of
Loans in
each
Category
to Total
Loans
 
Amount
 
% of
Allowance
in each
Category
to Total
Allowance
 
% of
Loans in
each
Category
to Total
Loans
Real estate loans:
  (Dollars in Thousands)
Residential - 1 to 4 family
$
1,125

 
17.61
%
 
33.44
%
 
$
759

 
15.27
%
 
39.79
%
 
$
915

 
19.06
%
 
44.46
%
Multi-family and commercial
3,028

 
47.41

 
29.28

 
2,337

 
47.01

 
25.47

 
2,700

 
56.27

 
26.26

Construction
22

 
0.34

 
0.48

 
280

 
5.63

 
1.98

 
64

 
1.34

 
1.14

Commercial business
1,735

 
27.17

 
30.95

 
1,148

 
23.09

 
26.98

 
790

 
16.45

 
23.43

Consumer loans:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
   Home equity
350

 
5.48

 
4.11

 
344

 
6.92

 
4.41

 
265

 
5.53

 
4.19

   Indirect automobile
68

 
1.06

 
1.40

 
40

 
0.81

 
0.92

 
—

 
—

 
—

   Other
59

 
0.93

 
0.34

 
62

 
1.27

 
0.45

 
65

 
1.35

 
0.52

Total allowance for loan losses
$
6,387

 
100.00
%
 
100.00
%
 
$
4,970

 
100.00
%
 
100.00
%
 
$
4,799

 
100.00
%
 
100.00
%



17
Table of Contents

 
December 31,
 
2009
 
2008
 
Amount
 
% of
Allowance
in each
Category
to Total
Allowance
 
% of
Loans in
each
Category
to Total
Loans
 
Amount
 
% of
Allowance
in each
Category
to Total
Allowance
 
% of
Loans in
each
Category
to Total
Loans
Real estate loans:
(Dollars in Thousands)
Residential - 1 to 4 family
$
1,028

 
21.02
%
 
50.12
%
 
$
906

 
14.98
%
 
53.46
%
Multi-family and commercial
2,443

 
49.95

 
26.15

 
2,358

 
38.99

 
25.52

Construction
221

 
4.51

 
1.87

 
1,533

 
25.36

 
4.49

Commercial business
906

 
18.53

 
17.60

 
1,097

 
18.13

 
12.97

Consumer loans:
 
 
 
 
 
 
 
 
 
 
 
Home equity
230

 
4.71

 
3.69

 
94

 
1.56

 
3.02

Other
63

 
1.28

 
0.57

 
59

 
0.98

 
0.54

Total allowance for loan losses
$
4,891

 
100.00
%
 
100.00
%
 
$
6,047

 
100.00
%
 
100.00
%


18
Table of Contents

The following table sets forth an analysis of the allowance for loan losses for the years indicated.
 
Years Ended December 31,
 
2012
 
2011
 
2010
 
2009
 
2008
 
(Dollars in Thousands)
Allowance at beginning of year
$
4,970

 
$
4,799

 
$
4,891

 
$
6,047

 
$
5,245

 
 
 
 
 
 
 
 
 
 
Provision for loan losses
2,896

 
1,558

 
902

 
2,830

 
1,369

 
 
 
 
 
 
 
 
 
 
Charge-offs:
 
 
 

 
 

 
 

 
 

Real estate loans:
 
 
 

 
 

 
 

 
 

Residential - 1 to 4 family
(299
)
 
(686
)
 
(285
)
 
(257
)
 
(80
)
Multi-family and commercial
(1,267
)
 
(606
)
 
(221
)
 
(149
)
 
(42
)
Construction
—

 
(83
)
 
(293
)
 
(2,927
)
 
(41
)
Commercial business loans
—

 
(267
)
 
(166
)
 
(645
)
 
(359
)
Consumer loans:
 
 
 
 
 
 
 
 
 
Home equity
(125
)
 
(15
)
 
—

 
—

 
—

Indirect automobile
(68
)
 
—

 
—

 
—

 
—

Other
(58
)
 
(69
)
 
(50
)
 
(97
)
 
(75
)
Total charge-offs
(1,817
)
 
(1,726
)
 
(1,015
)
 
(4,075
)
 
(597
)
 
 
 
 
 
 
 
 
 
 
Recoveries:
 
 
 

 
 

 
 

 
 

Real estate loans:
 
 
 

 
 

 
 

 
 

Residential - 1 to 4 family
104

 
—

 
1

 
43

 
4

Multi-family and commercial
140

 
15

 
14

 
—

 
—

Construction
—

 
284

 
—

 
—

 
—

Commercial business loans
31

 
37

 
3

 
37

 
21

Consumer loans:
 
 
 
 
 
 
 
 
 
       Indirect automobile
55

 
—

 
—

 
—

 
—

       Other
8

 
3

 
3

 
9

 
5

Total recoveries
338

 
339

 
21

 
89

 
30

Net charge-offs
(1,479
)
 
(1,387
)
 
(994
)
 
(3,986
)
 
(567
)
 
 
 
 
 
 
 
 
 
 
Allowance at end of year
$
6,387

 
$
4,970

 
$
4,799

 
$
4,891

 
$
6,047

 
 
 
 
 
 
 
 
 
 
Ratios:
 
 
 

 
 

 
 

 
 

Allowance to total loans outstanding at year end
0.93
%
 
0.80
%
 
0.79
%
 
0.80
%
 
0.97
%
Allowance to nonperforming loans
83.45

 
46.93

 
97.44

 
162.65

 
64.83

Net charge-offs to average loans outstanding during the year
0.22

 
0.22

 
0.16

 
0.64

 
0.09


The allowance as a percentage of total loans increased to 0.93% at December 31, 2012 compared to 0.80% at December 31, 2011.  The higher provision for 2012 resulted from an increase in net loan charge-offs, predominately commercial real estate loans, increases in the required specific allowance for impaired loans and allowance for loan losses required with the growing commercial portfolio, offset by a decrease in nonperforming loans.  Two commercial loan relationships contributed to the higher level of loan charge-offs for 2012. At December 31, 2012, nonperforming loans totaled $7.7 million, compared to $10.6 million at December 31, 2011. A decrease in nonperforming commercial mortgage and residential mortgage loans of $2.3 million and $601,000, respectively, contributed to the lower balance of nonperforming loans at December 31, 2012. Specific loan loss allowances relating to impaired loans increased to $581,000 at December 31, 2012 compared to $245,000 at December 31, 2011.  While the Company has no direct exposure to sub-prime mortgages in its loan portfolio, economic conditions have negatively impacted the residential and commercial real estate markets and contributed to the decrease in credit quality for residential and commercial mortgage loans.


19
Table of Contents


Risk Management

Overview. Managing risk is an essential part of successfully managing a financial institution. Our most prominent risk exposures are credit risk, interest rate risk and market risk. Credit risk is the risk of not collecting the interest and/or the principal balance of a loan or investment when it is due. Interest rate risk is the potential reduction of net interest income as a result of changes in interest rates. Market risk arises from fluctuations in interest rates that may result in changes in the values of financial instruments, such as available for sale securities, that are accounted for on a mark-to-market basis. Other risks that the Company faces are operational risks, liquidity risks and reputation risk. Operational risks include risks related to fraud, regulatory compliance, processing errors, technology and disaster recovery. Liquidity risk is the possible inability to fund obligations to depositors, lenders or borrowers or for the Company to pay its obligations as they become due as a result of unforeseen circumstances. Reputation risk is the risk that negative publicity or press, whether true or not, could cause a decline in the Company’s customer base or revenue.

Credit Risk Management. Our strategy for credit risk management focuses on having well-defined credit policies and uniform underwriting criteria and providing prompt attention to potential problem loans. Further, the Company has strengthened its oversight of problem assets by maintaining a Managed Assets Committee. The Committee, which consists of our Chief Executive Officer, Chief Financial Officer and other loan and credit administration officers, meets monthly to review classified and watch list credits to ensure the appropriateness of the current classification and to attempt to identify any new problem loans. The Board of Directors reviews the committee’s reports on a quarterly basis.

Investment Activities

The Company has legal authority to invest in various types of liquid assets, including U.S. Treasury obligations, securities of various federal agencies, government-sponsored enterprises, state and municipal governments, mortgage-backed securities and certificates of deposit of federally-insured institutions. Within certain regulatory limits, the Company also may invest a portion of its assets in corporate securities and mutual funds.  The Company is also required to maintain an investment in FHLB stock. While the Company has the authority under applicable law and its investment policies to invest in derivative securities, the Company had no such investments at December 31, 2012.

The Company’s primary source of income continues to be derived from its loan portfolio.  The investment portfolio is mainly used to meet the cash flow needs of the Company, provide adequate liquidity for the protection of customer deposits and yield a favorable return on excess funds.  The type of securities and the maturity periods are dependent on the composition of the loan portfolio, interest rate risk, liquidity position and tax strategies of the Company.  The Company’s investment objectives are to provide and maintain liquidity, to maintain a balance of high quality, diversified investments to minimize risk, to provide collateral for pledging requirements, to establish an acceptable level of interest rate and credit risk, to provide an alternate source of low-risk investments when demand for loans is weak, to generate a favorable return and to assist in the financing needs of various local public entities, subject to credit quality review and liquidity concerns.

The Company’s Board of Directors has the overall responsibility for the investment portfolio, including approval of the Company’s Investment Policy and appointment of the Investment Committee.  The Investment Committee is responsible for the approval of investment strategies and monitoring investment performance.  The execution of specific investment initiatives and the day-to-day oversight of the Company’s investment portfolio is the responsibility of the Chief Executive Officer and the Chief Financial Officer.  These officers, and others designated by the Board, are authorized to execute investment transactions up to specified limits based on the type of security without prior approval of the Investment Committee. Transactions exceeding these limitations require the approval of two of these officers, one of whom must be either the Chief Executive Officer or the Chief Financial Officer. Individual investment transactions are reviewed and approved by the Board of Directors on a monthly basis, while portfolio composition and performance are reviewed at least quarterly by the Investment Committee. Management


20
Table of Contents

determines the appropriate classification of securities at the date individual securities are acquired, and the appropriateness of such classification is reassessed at each balance sheet date.

Debt securities that management has the positive intent and ability to hold to maturity are classified as “held to maturity” and recorded at amortized cost.  Securities purchased and held principally for trading in the near term are classified as “trading securities.” These securities are carried at fair value, with unrealized gains and losses recognized in earnings.  Securities not classified as held to maturity or trading, including equity securities with readily determinable fair values, are classified as “available for sale” and recorded at fair value, with unrealized gains and losses excluded from earnings and reported in other comprehensive income, net of taxes.

At December 31, 2012, the Company’s investment portfolio consisted of available for sale securities, totaling $176.5 million, representing 18.5% of assets.  The Company’s available for sale securities consisted primarily of “agency” mortgage-backed securities issued by Fannie Mae, Freddie Mac and Ginnie Mae with stated final maturities of 30 years or less, U.S. government and agency obligations, government-sponsored enterprise securities with maturities of 20 years or less, corporate debt securities and “private-label” mortgage-backed securities with maturities of 30 years or less.

During the third quarter of 2010, the Company elected to fair value two collateralized debt obligations, previously reported as available for sale securities, and reclassified them to trading securities in accordance with applicable guidance.  These securities had amortized costs of $248,000 and $1.7 million and fair values of $248,000 and $739,000 at December 31, 2010 and 2009, respectively.  Cumulative unrealized losses at the date of election totaling $652,000 were reclassified from accumulated other comprehensive loss to retained earnings as a cumulative effect adjustment resulting from a change in accounting principle.  These securities were sold during the quarter ended June 30, 2011. The Company does not purchase securities with the intent of selling them in the near term, thus there are no securities in the trading portfolio.  For the year ended December 31, 2011, the net gain in fair value on trading securities was $182,000, compared to a net gain in fair value on trading securities of $408,000 for the year ended December 31, 2010.


21
Table of Contents

The following table sets forth the amortized costs and fair values of the Company’s securities portfolio at the dates indicated.
 
December 31,
 
2012
 
2011
 
2010
 
Amortized Cost
 
Fair Value
 
Amortized Cost
 
Fair Value
 
Amortized Cost
 
Fair Value
 
 
 
 
 
 
Available for sale securities:
(In Thousands)
U.S. Government and agency obligations
$
55,027

 
$
56,259

 
$
88,917

 
$
89,587

 
$
23,399

 
$
23,583

Government-sponsored enterprises
23,388

 
23,967

 
17,204

 
17,666

 
29,912

 
29,993

Mortgage-backed securities: (1)
 

 
 
 
 

 
 

 
 

 
 

Agency - residential
69,399

 
71,544

 
85,552

 
88,444

 
84,408

 
87,370

Non-agency - residential
4,784

 
4,712

 
7,766

 
6,888

 
11,039

 
10,455

Non-agency - HELOC
2,555

 
2,477

 
3,097

 
2,538

 
3,797

 
3,199

Corporate debt securities
7,555

 
7,694

 
14,094

 
14,047

 
14,502

 
14,717

Collateralized debt obligations
5,993

 
4,396

 
6,275

 
2,917

 
6,466

 
2,532

Obligations of state and political subdivisions
5,152

 
5,414

 
6,488

 
6,766

 
6,800

 
6,905

Tax-exempt securities
—

 
—

 
70

 
71

 
140

 
144

Foreign government securities
50

 
50

 
75

 
75

 
100

 
100

Total debt securities
173,903

 
176,513

 
229,538

 
228,999

 
180,563

 
178,998

 
 
 
 
 
 
 
 
 
 
 
 
Equity securities - financial services
—

 
—

 
228

 
205

 
1,024

 
1,038

Equity securities - other
—

 
—

 
1,609

 
1,610

 
—

 
—

Total equity securities
—

 
—

 
1,837

 
1,815

 
1,024

 
1,038

Total available for sale securities
173,903

 
176,513

 
231,375

 
230,814

 
181,587

 
180,036

 
 
 
 
 
 
 
 
 
 
 
 
Trading securities:
 

 
 
 
 

 
 

 
 

 
 

Collateralized debt obligations
—

 
—

 
—

 
—

 
248

 
248

Total securities
$
173,903

 
$
176,513

 
$
231,375

 
$
230,814

 
$
181,835

 
$
180,284

 
(1) 
Agency securities refer to debt obligations issued or guaranteed by government corporations or government-sponsored enterprises (“GSEs”).  Non-agency securities, or private-label securities, are the sole obligation of their issuer and are not guaranteed by one of the GSEs or the U.S. Government.

The Company had no individual investments that had an aggregate book value in excess of 10% of the Company's shareholders’ equity at December 31, 2012.

The following table sets forth the amortized cost, weighted average yields and contractual maturities of available for sale securities at December 31, 2012.  Weighted average yields on tax-exempt securities are not presented on a tax equivalent basis because the impact would be insignificant.  Certain mortgage-backed securities and collateralized debt obligations have adjustable interest rates and will reprice periodically within the various maturity ranges.  These repricing schedules are not reflected in the following table below.  At December 31, 2012, the amortized cost of mortgage-backed securities with adjustable rates totaled $14.9 million.



22
Table of Contents

 
 One Year or Less
 
More than One Year to Five Years
 
More than Five Years to Ten Years
 
 More than Ten Years
 
 Total
 
 
 
 
 
 
Amortized
Cost
 
Weighted
Average
Yield
 
Amortized
Cost
 
Weighted
Average
Yield
 
Amortized
Cost
 
Weighted
Average
Yield
 
Amortized
Cost
 
Weighted
Average
Yield
 
Amortized
Cost
 
Weighted
Average
Yield
 
(Dollars in Thousands)
U.S. Government and agency obligations
$
—

 
—
%
 
$
2,383

 
2.29
%
 
$
13,776

 
2.85
%
 
$
38,868

 
2.77
%
 
$
55,027

 
2.77
%
Government-sponsored enterprises
3,182

 
1.78

 
18,255

 
1.58

 
1,951

 
1.87

 
—

 
—

 
23,388

 
1.63

Mortgage-backed securities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
  Agency - residential
—