At June 30, 2010, the Company had outstanding loan commitments and standby letters of credit of $13.1 million and $23.7 million, respectively. Based on the short-term lives of these instruments, the Company does not believe that the fair value of these instruments differs significantly from their carrying values.

 

 

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Valuation Methodology

Cash and Cash Equivalents - For cash and cash equivalents, the carrying amount is a reasonable estimate of fair value.

Investment Securities - Fair values are based on quoted market prices or dealer quotes. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities.  FHLB and FRB stock are carried and valued at cost.

Loans Receivable - For conforming residential first-mortgage loans, the market price for loans with similar coupons and maturities was used. For nonconforming loans with maturities similar to conforming loans, the coupon was adjusted for credit risk. Loans which did not have quoted market prices were priced using the discounted cash flow method. The discount rate used was the rate currently offered on similar products. Loans priced using the discounted cash flow method included residential construction loans, commercial real estate loans, and consumer loans. The estimated fair value of loans held for sale is based on the terms of the related sale commitments.

Foreclosed Real Estate - Fair value is based upon independent market prices, appraised value of the collateral or management’s estimation of the value of the collateral.

Deposits - The fair value of checking accounts, saving accounts, and money market accounts was the amount payable on demand at the reporting date.

Time Certificates - The fair value was determined using the discounted cash flow method. The discount rate was equal to the rate currently offered on similar products.

Long-Term Debt and Other Borrowed Funds - These were valued using the discounted cash flow method. The discount rate was equal to the rate currently offered on similar borrowings.

Guaranteed Preferred Beneficial Interest in Junior Subordinated Securities - These were valued using discounted cash flows. The discount rate was equal to the rate currently offered on similar borrowings.

Off-Balance Sheet Instruments - The Company charges fees for commitments to extend credit. Interest rates on loans for which these commitments are extended are normally committed for periods of less than one month. Fees charged on standby letters of credit and other financial guarantees are deemed to be immaterial and these guarantees are expected to be settled at face amount or expire unused. It is impractical to assign any fair value to these commitments.

The fair value estimates presented herein are based on pertinent information available to management as of June 30, 2010 and December 31, 2009. Although management is not aware of any factors that would significantly affect the estimated fair value amounts, such amounts have not been comprehensively revalued for purposes of these financial statements since that date and, therefore, current estimates of fair value may differ significantly from the amount presented herein.

 

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ITEM 2

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

This document contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, including: discussions of Tri-County Financial Corporation’s (the “Company”) goals, strategies and expected outcomes; estimates of risks and future costs; and reports of the Company’s ability to achieve its financial and other goals. Forward-looking statements are generally preceded by terms such as “expects,” “believes,” “anticipates,” “intends” and similar expressions. These forward-looking statements are subject to significant known and unknown risks and uncertainties because they are based upon future economic conditions, particularly interest rates, loan demand, competition within and without the banking industry, changes in laws and regulations applicable to the Company, changes in accounting principles, and various other matters.  Additional factors that may affect our results are discussed in Part I of the Company’s Annual Report on Form 10-K for the year ended December 31, 2009 (the “Form 10-K”) and Part II of this Quarterly Report on Form 10-Q under “Item 1A. Risk Factors.”  Because of these uncertainties, there can be no assurance that actual results, performance or achievements of the Company will not differ materially from any future results, performance or achievements expressed or implied by these forward-looking statements. The Company does not undertake – and specifically disclaims any obligation – to publicly release the result of any revisions that may be made to any forward-looking statement to reflect events or circumstances after the date of such statements or to reflect the occurrence of anticipated or unanticipated events.

GENERAL

The Company is a bank holding company organized in 1989 under the laws of the State of Maryland.  It owns all the outstanding shares of capital stock of Community Bank of Tri-County (the “Bank”), a Maryland-chartered commercial bank.  The Company engages in no significant activity other than holding the stock of the Bank, paying its subordinated debt and preferred stock obligations, and directing the business of the Bank.  Accordingly, the information set forth in this report, including financial statements and related data, relates primarily to the Bank and its subsidiaries.

The Bank serves Southern Maryland through its main office and nine branches located in Waldorf, Bryans Road, Dunkirk, Leonardtown, La Plata, Charlotte Hall, Prince Frederick, Lusby, and California, Maryland.  The Bank is engaged in the commercial and retail banking business as authorized by the banking statutes of the State of Maryland and applicable Federal regulations.  The Bank accepts deposits and uses these funds, along with funds generated from operations and borrowings from the Federal Home Loan Bank (the “FHLB”), to fund loan originations to individuals, associations, partnerships and corporations and to invest in securities. The Bank makes real estate loans including residential first and second mortgage loans, home equity lines of credit, commercial mortgage loans, commercial loans, including secured and unsecured loans, and consumer loans.  The Bank is a member of the Federal Reserve and FHLB Systems. The Federal Deposit Insurance Corporation provides deposit insurance coverage up to applicable limits.

Since its conversion to a state chartered commercial bank in 1997, the Bank has sought to increase its commercial and commercial real estate lending as well as the level of transactional deposits.  Management recognizes that the shift in composition of the Bank’s loan portfolio away from residential first mortgage lending will increase its exposure to credit losses.  The Bank continues to evaluate its allowance for loan losses and the associated provision to compensate for the increased risk. Any evaluation of the allowance for loan losses is inherently inexact and reflects management’s expectations as to future interest rates, economic conditions in the Southern Maryland area as well as individual borrowers’ circumstances.  Management believes that its allowance for loan losses is adequate.  For further information on the Bank’s allowance for loan losses see the discussion in the sections captioned “Financial Condition” and “Critical Accounting Policies” as well as the relevant discussions in the Form 10-K and Annual Report for the year ended December 31, 2009.

 

 

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The Company’s results are influenced by local and national economic conditions. These conditions include the level of short-term interest rates such as the federal funds rate, the differences between short- and long-term interest rates, the prospects for economic growth or decline, and the rates of anticipated and current inflation. Local conditions, including employment growth or declines, may have direct or indirect effects on our borrowers’ ability to meet their obligations.

Interest rates can directly influence the Bank’s funding costs and loan and investment yields, and also act to increase or decrease general economic activity. The federal funds target rate increased for much of 2006 and 2007, hitting a multi-year peak on September 29, 2007 of 5.25%. Shortly afterwards, it became clear that the U.S. economy suffered from an over-extension of credit in many sectors. This realization led to a sudden, dramatic decline in the availability of credit to many borrowers which deflated a housing price bubble and threatened to create a credit crisis.  The Federal Reserve reacted by cutting the Federal Funds rate by 50 basis points in September 2007.  Despite further Federal Reserve rate cuts, the crisis in housing, which was once confined to subprime mortgage loans continued to spread.  The U.S. Treasury responded by injecting capital directly into banks by using the Capital Purchase Program (“CPP”) of the Troubled Asset Repurchase Program (“TARP”).  The Federal Reserve, Treasury, FDIC and other governmental bodies chose to guarantee various forms of debt issuance to stave off a total collapse of credit markets.  In addition, the U.S. government provided cash and debt guarantees to many private companies.  In addition to these policy moves, the Federal Reserve reduced the Federal Funds rate to a range of 0% to 0.25% in December 2008. The Federal Funds rate remains at this level as of June 30, 2010.

SELECTED FINANCIAL DATA
		Three Months Ended								Six Months Ended
		June 30,								June 30,
		2010				2009				2010				2009
Condensed Income Statement
Interest and dividend income		$	9,893,082			$	9,350,365			$	19,856,619			$	18,553,441
Interest expense			3,329,856				4,180,031				6,808,757				8,440,102
Net interest income			6,563,226				5,170,334				13,047,862				10,113,339
Provision for loan loss			804,430				929,488				1,662,804				1,462,373
Noninterest income			744,344				781,771				1,505,569				1,368,228
Noninterest expense			4,899,633				4,278,673				9,138,042				8,092,835
Income before income taxes			1,603,507				743,944				3,752,585				1,926,359
Income taxes			567,423				221,730				1,352,077				634,305
Net income			1,036,084				522,214				2,400,508				1,292,054
Net income available to common shareholders			824,352				310,482				1,977,043				868,589
Per Common Share
Basic earnings		$	0.28			$	0.10			$	0.66			$	0.29
Diluted earnings		$	0.27			$	0.10			$	0.66			$	0.29
Book value		$	17.73			$	17.09			$	17.73			$	17.09

RESULTS OF OPERATIONS – SIX MONTHS ENDED JUNE 30, 2010

Net income for the six-month period ended June 30, 2010 totaled $2,400,508 ($0.66 basic and diluted earnings per common share), compared to $1,292,054 ($0.29 basic and diluted earnings per common share) for the same period in the prior year. Net income available to common shareholders for the six-month period ended June 30, 2010 totaled $1,977,043 compared to $868,589 for the same period in the prior year.  The increase of $1,108,454, or 85.79% for net income or 127.62% for net income available to common shareholders, was primarily due to increases in net interest income of $2,934,523 offset by increases in noninterest expense of $1,045,207.

 

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		Six Months Ended
		June 30,
		2010				2009				$ Change				% Change
Interest and dividend income		$	19,856,619			$	18,553,441			$	1,303,178				9.86	%
Interest expense			6,808,757				8,440,102				(1,631,345	)			(19.33	)%
Net interest income			13,047,862				10,113,339				2,934,523				29.02	%
Provision for loan losses			1,662,804				1,462,373				200,431				13.71	%

Interest and dividend income increased due to higher average balances in loans and investments, which were partially offset by lower interest rate yields on loans and investments. The growth of the loan portfolio by 14.92% since the beginning of 2009 has resulted in an increase in interest income, while the Company has limited the effect of the lower interest rate environment on loan rates through pricing. Interest expense decreased due to lower interest rates paid on deposits and borrowings offset by higher average balances of deposits and borrowings for the period. The decreased yields and rates paid were due to lower market interest rates. The Company has been successful in increasing its core deposits and reducing its cost of funds in the low interest-rate environment over the last year. The Company’s interest rate margin increased to 3.41% for the six months ended June 30, 2010 from 2.90% for the six months ended June 30, 2009.

The increase in the provision for loan losses was principally attributable to an increase in net charge-offs.  Net charge-offs increased $1,015,853 up from $226,998 for the six months ended June 30, 2009 to $1,242,851 for the six months ended June 30, 2010. The Company’s allowance for loan losses increased from 1.20% of loan balances at December 31, 2009 to 1.25% of loan balances at June 30, 2010. The provision was adjusted for economic conditions that affected the loss factors used to compute the allowance as well as changes in the circumstances of specific impaired loans and increases in the level of delinquencies, charge-offs and nonperforming loans.

The following table shows the components of noninterest income and the dollar and percentage changes for the periods presented.

		Six Months Ended
		June 30,
		2010				2009				$ Change				% Change
NONINTEREST INCOME:
Recognition of other than temporary decline
in value of investment securities		$	-			$	(118,744	)		$	118,744				(100.00	)%
Less: portion recorded as comprehensive income			-				-				-				n/a
Impairment loss on investment securities, net			-				(118,744	)			118,744				(100.00	)%
Loan appraisal, credit, and miscellaneous charges			253,800				360,892				(107,092	)			(29.67	)%
Gain on sale of asset			22,500				-				22,500				n/a
Loss on sale investment securities			-				(12,863	)			12,863				(100.00	)%
Income from bank owned life insurance			210,914				201,473				9,441				4.69	%
Service charges			846,655				769,096				77,559				10.08	%
Gain on loans held for sale			171,700				168,374				3,326				1.98	%
Total noninterest income		$	1,505,569			$	1,368,228			$	137,341				10.04	%

Noninterest income increased primarily because no investment security impairment charges were recorded in the current year. Increases in service charge revenue due to the increased size and number of deposits and increases in per item charges on certain transactions were offset by a reduction in loan appraisal, credit, and miscellaneous charges due to the slower growth of the loan portfolio in 2010.

 

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The following table shows the components of noninterest expense and the dollar percentage changes for the periods presented.

		Six Months Ended June 30,
		2010				2009				$ Change				% Change
NONINTEREST EXPENSE:
Salary and employee benefits		$	4,761,355			$	4,251,834			$	509,521				11.98	%
Occupancy			894,042				870,748				23,294				2.68	%
Advertising			178,602				229,962				(51,360	)			(22.33	)%
Data processing			494,817				436,620				58,197				13.33	%
Professional fees			444,233				359,908				84,325				23.43	%
Depreciation of furniture, fixtures, and equipment			261,943				299,105				(37,162	)			(12.42	)%
Telephone communications			82,228				68,173				14,055				20.62	%
Office supplies			79,436				87,385				(7,949	)			(9.10	)%
FDIC Insurance			746,765				633,611				113,154				17.86	%
Valuation allowance on foreclosed real estate			287,934				-				287,934				n/a
Other			906,687				855,489				51,198				5.98	%
Total noninterest expenses		$	9,138,042			$	8,092,835			$	1,045,207				12.92	%

The Company’s noninterest expense increased by $1,045,207 or 12.92% from the comparable period in the prior year primarily due to increased costs associated with the asset growth of the Bank, the rising cost of regulatory compliance, increasing FDIC assessments and the valuation allowance on foreclosed real estate. Salary and employee benefits expense increased as the Bank added additional employees to support the Bank’s balance sheet growth. Advertising expense decreased due mainly to marketing campaign expenses incurred in the first quarter of 2009. Professional fees reflect the increased cost of compliance. FDIC insurance assessment rates increased during the second half of 2009. A valuation adjustment was recorded in the second quarter of 2010 to adjust a foreclosed property to the agreed contracted sales price at disposition compared to no adjustment for the same period in the prior year.

The Company recorded income tax expense of $1,352,077 or 36.0%, of pretax earnings of $3,752,585 for the six months ended June 30, 2010 compared with $634,305 or 32.9%, of pretax earnings of $1,926,359 for the six months ended June 30, 2009. The increase in the effective tax rate is the result of tax exempt income being relatively lower to total income in 2010.

RESULTS OF OPERATIONS – THREE MONTHS ENDED JUNE 30, 2010

Net income for the three-month period ended June 30, 2010 totaled $1,036,084 ($0.28 basic and $0.27 diluted earnings per common share), compared to $522,214 ($0.10 basic and diluted earnings per common share) for the same period in the prior year. Net income available to common shareholders for the three-month period ended June 30, 2010 totaled $824,352 compared to $310,482 for the same period in the prior year.  The increase of $513,870, or 98.40%, for net income or 165.51% for net income available to common shareholders, was primarily due to increases in net interest income of $1,392,892 offset by increases in noninterest expense of $620,960.

		Three Months Ended
		June 30,
		2010				2009				$ Change				% Change
Interest and dividend income		$	9,893,082			$	9,350,365			$	542,717				8.55	%
Interest expense			3,329,856				4,180,031				(850,175	)			(20.34	)%
Net interest income			6,563,226				5,170,334				1,392,892				26.94	%
Provision for loan losses			804,430				929,488				(125,058	)			(13.45	)%

 

 

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The growth in the loan portfolio and the decrease in the Company’s cost of funds continue to be the key drivers of positive growth in the second quarter of 2010. Interest and dividend income increased due to higher average balances in loans and investments, which were partially offset by lower interest rate yields on loans and investments. The growth of the loan portfolio by $40.3 million since June 30, 2009 has resulted in an increase in interest income. Interest expense decreased due to lower interest rates paid on deposits and borrowings and a reduction in net borrowings offset by higher average balances of deposits.

The decrease in the provision for loan losses was principally attributable to an adjustment in the provision for economic conditions that affected the loss factors used to compute the allowance as well as changes in the circumstances of specific impaired loans, increases in the level of delinquencies, charge-offs and nonperforming loans. Second quarter 2010 net charge-offs were $155,592 compared to $215,643 for the second quarter of 2009. As stated above, the Company’s allowance for loan losses increased from 1.20% of loan balances at December 31, 2009 to 1.25% of loan balances at June 30, 2010.

The following table shows the components of noninterest income and the dollar and percentage changes for the periods presented.

		Three Months Ended June 30,
		2010				2009				$ Change				% Change
NONINTEREST INCOME:
Recognition of other than temporary decline
in value of investment securities		$	-			$	(118,744	)		$	118,744				(100.00	)%
Less: Portion recorded as comprehensive income			-				-				-				n/a
Impairment loss on investment securities, net			-				(118,744	)			118,744				(100.00	)%
Loan appraisal, credit, and miscellaneous charges			83,388				245,214				(161,826	)			(65.99	)%
Gain on sale of asset			22,500				-				22,500				n/a
Loss on sale investment securities			-				(12,863	)			12,863				(100.00	)%
Income from bank owned life insurance			106,168				100,216				5,952				5.94	%
Service charges			442,611				399,574				43,037				10.77	%
Gain on loans held for sale			89,677				168,374				(78,697	)			(46.74	)%
Total noninterest income		$	744,344			$	781,771			$	(37,427	)			(4.79	)%

Noninterest income decreased from the comparable period in the prior year primarily due to fewer loan sales and decreases in loan appraisal, credit and, miscellaneous charges from slower 2010 net loan growth partially offset by increases in service charge revenue due to an increased number and size of deposits and no investment security impairment charges recorded in the current year.

 

 

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The following table shows the components of noninterest expense and the dollar percentage changes for the periods presented.

		Three Months Ended June 30,
		2010				2009				$ Change				% Change
NONINTEREST EXPENSE:
Salary and employee benefits		$	2,398,821			$	2,101,058			$	297,763				14.17	%
Occupancy			466,398				466,221				177				0.04	%
Advertising			101,853				99,850				2,003				2.01	%
Data processing			248,677				210,445				38,232				18.17	%
Legal and professional fees			285,394				202,299				83,095				41.08	%
Depreciation of furniture, fixtures, and equipment			134,345				150,963				(16,618	)			(11.01	)%
Telephone communications			42,109				34,898				7,211				20.66	%
Office supplies			33,690				37,673				(3,983	)			(10.57	)%
FDIC Insurance			394,659				543,947				(149,288	)			(27.45	)%
Valuation allowance on foreclosed real estate			287,934				-				287,934				n/a
Other			505,753				431,319				74,434				17.26	%
Total noninterest expense		$	4,899,633			$	4,278,673			$	620,960				14.51	%

The Company’s noninterest expense increased from the comparable period in the prior year primarily due to costs associated with the asset growth of the Bank, the rising cost of regulatory compliance and the valuation allowance on foreclosed real estate. Salary and employee benefits expense increased as the Bank added additional employees to support the Bank’s balance sheet growth. Professional fees reflect the increased cost of compliance. FDIC insurance expense decreased due to a one-time special assessment of $343,600 incurred during the three months ended June 30, 2009. As noted above, FDIC insurance assessment rates increased during the second half of 2009.  A valuation adjustment was booked in the second quarter of 2010 to adjust a foreclosed property to the estimated realizable value.

The Company recorded income tax expense of $567,423 or 35.4%, of pretax earnings of $1,603,507 for the three months ended June 30, 2010 compared with $221,730 or 29.8%, of pretax earnings of $743,944 for the three months ended June 30, 2009. The increase in the effective tax rate is the result of tax exempt income being relatively lower to total income in 2010.

FINANCIAL CONDITION

		June 30, 2010				December 31, 2009				$ change				% Change
Assets
Cash and due from banks		$	8,155,908			$	9,960,787			$	(1,804,879	)			(18.12	)%
Federal funds sold			7,815,000				695,000				7,120,000				1024.46	%
Interest-bearing deposits with banks			961,616				592,180				369,436				62.39	%
Securities available for sale, at fair value			44,432,692				53,926,109				(9,493,417	)			(17.60	)%
Securities held to maturity, at amortized cost			101,637,068				90,287,803				11,349,265				12.57	%
Federal Home Loan Bank and Federal Reserve Bank stock - at cost			6,935,500				6,935,500				-				0.00	%
Loans held for sale			512,000				-				512,000				n/a
Loans receivable - net of allowance for loan losses of $7,896,967 and $7,471,314, respectively			623,980,878				616,592,976				7,387,902				1.20	%
Premises and equipment, net			11,932,394				11,987,690				(55,296	)			(0.46	)%
Foreclosed real estate			10,876,740				922,934				9,953,806				1078.50	%
Accrued interest receivable			2,881,928				2,925,271				(43,343	)			(1.48	)%
Investment in bank owned life insurance			11,154,310				10,943,396				210,914				1.93	%
Other assets			10,275,564				9,272,888				1,002,676				10.81	%
Total Assets		$	841,551,598			$	815,042,534			$	26,509,064				3.25	%

 

 

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The Company increased some of its most liquid assets with increases to federal funds sold and interest-bearing deposits with banks. The securities available for sale portfolio decreased due to proceeds received from maturing asset-backed securities issued by government-sponsored entities. The securities held to maturity portfolio increased due to additional purchases of securities offset by principal paydowns, primarily of asset-backed securities issued by government-sponsored entities. The differences in allocations between the different cash and investment categories reflect operational needs. The increase in net loans outstanding was impacted by the resolution of two problem loan relationships with construction and land development loans that transferred $10.2 million into foreclosed real estate. The increase in foreclosed real estate represents two construction and land development properties that were recorded at fair value upon transfer of the loans to foreclosed real estate offset by an increase in the valuation allowance of $287,934.  The increase in other assets was primarily due to net increases to deferred tax and prepaid assets.

Details of the Bank’s loan portfolio are presented below:

		June 30, 2010								December 31, 2009
		Amount				%				Amount				%
Real Estate Loans
Commercial		$	316,921,037				50.08	%		$	292,987,963				46.88	%
Residential first mortgages			120,820,143				19.09	%			116,225,733				18.59	%
Construction and land development			44,713,750				7.07	%			62,509,558				10.00	%
Home equity and second mortgage			25,131,263				3.97	%			25,133,155				4.02	%
Commercial loans			104,867,617				16.57	%			108,657,910				17.38	%
Consumer loans			1,329,052				0.21	%			1,607,765				0.26	%
Commercial equipment			19,026,188				3.01	%			17,916,655				2.87	%
			632,809,050				100.00	%			625,038,739				100.00	%
Less:
Deferred loan fees			931,205				0.15	%			974,449				0.16	%
Allowance for loan loss			7,896,967				1.25	%			7,471,314				1.20	%
			8,828,172								8,445,763
		$	623,980,878							$	616,592,976

The loan portfolio increased as a result of increases in commercial real estate loans, residential first mortgage loans and commercial equipment loans. These increases were partially offset by decreases in construction and land development loans, commercial loans and consumer loans.

The allowance for loan losses increased $425,653 to $7,896,967 or 1.25% of loan balances at June 30, 2010 from $7,471,314 or 1.20% of loan balances at December 31, 2009. Nonperforming loans as a percentage of total loans amounted to 1.90% at June 30, 2010 compared to 3.09% at December 31, 2009. The Company had 26 nonperforming loans at June 30, 2010 of which 60% of nonperforming loan balances were concentrated with three customers. The Company’s nonperforming assets as a percentage of total assets, which includes nonperforming loans and foreclosed real estate, increased from 2.48% at December 31, 2009 to 2.72% at June 30, 2010, as the Company continues to collect on and resolve problem loans. Management’s determination of the adequacy of the allowance is based on a periodic evaluation of the portfolio with consideration given to: the overall loss experience; current economic conditions; volume, growth and composition of the loan portfolio; financial condition of the borrowers; and other relevant factors that, in management’s judgment, warrant recognition in providing an adequate allowance. Management believes that the allowance is adequate. Additional loan information for prior years is presented in the Company’s Form 10-K for the year ended December 31, 2009.

 

 

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The following table summarizes changes in the allowance for loan losses for the periods indicated.

		Six Months Ended				Six Months Ended
		June 30, 2010				June 30, 2009
Beginning Balance		$	7,471,314			$	5,145,673
Add:
Provision charged to operations			1,662,804				1,462,373
Recoveries			5,700				-
Less:
Charge Offs			1,242,851				226,998
Balance at the end of the period		$	7,896,967			$	6,381,048

The Company incurred $1,242,851 in charge-offs for the six months ended June 30, 2010, which represented a total of $27,000 of consumer loans and equity lines, $601,000 for construction and land development loans, $118,000 for commercial real estate loans and $497,000 for commercial and commercial equipment loans.

The following table provides information with respect to our nonperforming loans at the dates indicated.

		Balances as of				Balances as of
		June 30, 2010				December 31, 2009
Troubled debt restructurings (TDRs)		$	17,450,676			$	11,601,215
Nonperforming loans
Impaired loans on which recognition of interest has been discontinued		$	4,277,870			$	8,947,173
Loans on which recognition of interest has been discontinued			7,752,113				10,340,310
Total nonperforming loans		$	12,029,983			$	19,287,483
Impaired loans
TDRs and performing loans		$	6,623,458			$	1,675,000
Loans accounted for on a nonaccrual basis			4,277,870				8,947,173
Total impaired loans		$	10,901,328			$	10,622,173
Nonperforming loans to total loans			1.90	%			3.09	%
Allowance for loan losses to nonperforming loans			65.64	%			38.74	%
Nonperforming assets to total assets			2.72	%			2.48	%

At June 30, 2010 and December 31, 2009, impaired loans totaled $10,901,328 and $10,622,173, respectively. Impaired loans include accruing loans that have been restructured in the amount of $6,623,458 at June 30, 2010 and $1,675,000 at December 31, 2009.  Impaired loans had specific allocations within the allowance for loan losses or have been reduced by charge-offs to recoverable values. Allocations of the allowance for loan losses relative to impaired loans at June 30, 2010 and December 31, 2009 were $2,386,717 and $1,837,345, respectively. Loans on which the recognition of interest has been discontinued, which were not considered impaired under FASB ASC 820 amounted to $7,752,113 and $10,340,310 at June 30, 2010 and December 31, 2009, respectively.

 

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		Nonperforming loans by loan type
		June 30, 2010								December 31, 2009
		Dollars				Number of Loans				Dollars				Number of Loans
Real Estate Loans
Commercial		$	6,030,442				7			$	6,366,672				8
Residential first mortgages			2,000,365				6				338,806				1
Construction and land development			1,392,019				3				9,504,414				5
Home equity and second mortgage			173,578				2				-				-
Commercial loans			2,266,565				6				2,192,308				5
Consumer loans			505				1				22,884				2
Commercial equipment			166,509				1				862,399				3
		$	12,029,983				26			$	19,287,483				24

As of June 30, 2010, the largest dollar concentrations of nonperforming loans are commercial real estate loans which have been impacted by economic conditions in our local market mainly due to higher than expected vacancies in commercial office space. Delinquencies in residential first mortgages have increased primarily due to specific customer issues with unemployment and other circumstances requiring the liquidation of family assets.  Nonperforming construction and land development loans decreased $8,112,395 during the six months ended June 30, 2010 as the Company has resolved problem loans with foreclosures and workouts. Construction and land development loans have been particularly affected by economic factors which have slowed absorption of finished lots and homes.  Commercial equipment loans have primarily decreased due to a charge-off of $468,000 and a loan restructure. Other loan types have also been affected by the economic conditions in our local and national markets. Management continues to monitor these loans and is working to resolve these loans in a manner that will preserve the most value for the Company.

		June 30, 2010				December 31, 2009				$ change				% Change
Liabilities
Deposits
Non-interest-bearing deposits		$	72,957,088			$	70,001,444			$	2,955,644				4.22	%
Interest-bearing deposits			610,721,620				570,417,345				40,304,275				7.07	%
Total deposits			683,678,708				640,418,789				43,259,919				6.75	%
Short-term borrowings			141,317				13,080,530				(12,939,213	)			(98.92	)%
Long-term debt			70,647,065				75,669,630				(5,022,565	)			(6.64	)%
Guaranteed preferred beneficial interest in junior subordinated debentures			12,000,000				12,000,000				-				0.00	%
Accrued expenses and other liabilities			5,811,189				5,683,736				127,453				2.24	%
Total Liabilities		$	772,278,279			$	746,852,685			$	25,425,594				3.40	%

Deposits have increased $90,814,488, or 15.32%, since June 30, 2009. At June 30, 2010, non-brokered deposits totaled $652,735,324 or 94.57% of total deposits. The increases in total deposits are due to the Bank’s continuing efforts to increase its market share through branch improvements and marketing efforts. Long-term debt and short-term borrowings decreased by $17,961,778, or 20.24%, from $88,750,160 at December 31, 2009 to $70,788,382 at June 30, 2010, as growing retail deposits replaced debt. The increases in deposits were used to increase the balances of cash and cash equivalents and investments, fund net loan growth and reduce long and short-term debt.

 

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		June 30, 2010				December 31, 2009				$ change				% Change
Stockholders' Equity
Perpetual Preferred Stock, Series A		$	15,540,000			$	15,540,000			$	-				0.00	%
Perpetual Preferred Stock, Series B			777,000				777,000				-				0.00	%
Common stock - par value			29,863				29,760				103				0.35	%
Additional paid in capital			16,786,426				16,754,627				31,799				0.19	%
Retained earnings			35,974,812				35,193,958				780,854				2.22	%
Accumulated other comprehensive gain (loss)			491,091				284,474				206,617				72.63	%
Unearned ESOP shares			(325,873	)			(389,970	)			64,097				(16.44	)%
Total Stockholders' Equity		$	69,273,319			$	68,189,849			$	1,083,470				1.59	%

The change in stockholders’ equity was primarily due to net income of $2,400,508 offset by the payment of preferred stock dividends of $423,466 and common stock dividends of $1,196,188. Common stockholders' equity of $52,956,319 resulted in a book value of $17.73 per common share at June 30, 2010, an increase of $0.30 per share from December 31, 2009.

 LIQUIDITY AND CAPITAL RESOURCES

The Company currently conducts no business other than holding the stock of the Bank and paying interest on its subordinated debentures and preferred stock.  Its primary uses of funds are for the payment of dividends on common and preferred stock and the payment of interest and principal on debentures.  The Company's principal sources of liquidity are cash on hand and dividends received from the Bank. The Bank is subject to various regulatory restrictions on the payment of dividends.

The Bank’s principal sources of funds for investments and operations are net income, deposits from its primary market area, principal and interest payments on loans, proceeds from the sale of loans, advances and other borrowings, interest received on investment securities and proceeds from the sale and maturity of investment securities. Its principal funding commitments are the origination or purchase of loans, the purchase of investment securities and the payment of maturing deposits. Deposits are considered a primary source of funds supporting the Bank’s lending and investment activities. The Bank also uses various wholesale funding instruments including FHLB advances, which are required to be supported by certain eligible loans held by the Bank. Under the terms of an Agreement for Advances and Security Agreement with Blanket Floating Lien (the “Agreement”), the Company maintained eligible collateral consisting of one-to-four family residential first mortgage loans equal to 100% of its total outstanding long and short-term Federal Home Loan Bank advances. During 2003 and 2004, the Bank entered into addendums to the Agreement that expanded the types of eligible collateral under the Agreement to include certain commercial real estate and second mortgage loans. These loans are subject to eligibility rules, and eligible collateral values of the unpaid loan principal balances are established at 90% of residential first mortgages, at 50% for commercial real estate and at 40% for second mortgage loans. In addition, only 50% of total collateral for Federal Home Loan Bank advances may consist of commercial real estate loans. Additionally, the Bank has pledged its Federal Home Loan Bank stock of $5,817,600 and securities with a carrying value of $38,745,000 as additional collateral for its advances at June 30, 2010.

The Bank is limited to total advances of up to 40% of assets or $337,000,000. At June 30, 2010, the Bank had filed collateral statements identifying collateral sufficient to borrow $67,000,000 in addition to amounts already outstanding. In addition, the Bank had additional collateral in safekeeping at the Federal Home Loan Bank of Atlanta that had not been specifically pledged to the Federal Home Loan Bank or for other purposes. This collateral was sufficient to provide an additional $85,000,000 in borrowing capacity.  The Bank also has established a short-term credit facility with the Federal Reserve Bank of Richmond under its Borrower in Custody program. The Bank has segregated collateral sufficient to draw $18,000,000 under this agreement. In addition, the Bank has established short-term unsecured credit facilities with other commercial banks totaling $12,000,000 at June 30, 2010. No amounts were outstanding under the Borrower in Custody or short-term unsecured credit facilities at June 30, 2010.

 

 

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The Bank’s most liquid assets are cash and cash equivalents, which are cash on hand, amounts due from financial institutions, federal funds sold, and money market mutual funds. The levels of such assets are dependent on the Bank’s operating financing and investment activities at any given time. The variations in levels of cash and cash equivalents are influenced by deposit flows and anticipated future deposit flows.

Cash, cash equivalents, and interest-bearing deposits with banks as of June 30, 2010 totaled $16,932,524, an increase of $5,684,557, or 50.54%, from the December 31, 2009 total of $11,247,967.  The increase to cash was primarily due to increases in deposits partially offset by funds used to pay down short-term borrowings and long-term debt and net cash used for loan activities, as net loans originated exceeded principal collected on loans. The Bank’s principal sources of cash flows are its financing activities including deposits and borrowings.  During the first six months of 2010, all financing activities provided $23,774,486 in cash compared to $61,057,417 for the same period in 2009. The decrease in cash provided of $37,282,931 or 61.06%, was primarily due to a reduction in the net increase in deposits and an increase in the use of cash to pay down short-term borrowings and long-term debt. Net increases in deposits were reduced to $43,259,919 for the six months ended June 30, 2010 from $67,696,654 for the same period in the prior year. The pay down of debt increased to $17,961,778 for the six months ended June 30, 2010 from $5,902,056 for the same period in the prior year

Operating activities provided cash of $2,852,598 in the first six months of 2010 compared to $321,650 provided in the same period of 2009, an increase in cash provided of $2,530,948. The increase in cash was primarily due to increases in net income, a decrease in the difference between loans originated for resale and proceeds from the sale of loans and decreases to accounts payable and accrued expenses partially offset by decreases to cash from an increase to other assets.

The Bank’s principal use of cash has been in investments in loans, investment securities and other assets. Investing activities used cash of $20,942,527 in the first six months of 2010 compared to $48,477,759 of cash used in the same period of 2009.  For the six months ended June 30, 2010, the primary causes for the increase in cash used by investing activities were loan originations exceeding principal repayments by $19,154,225 and net purchases from security transactions of $1,345,645. For the six months ended June 30, 2009, the primary causes for the increase in cash used were investments in loans exceeding principal repayments on loans and net purchases from security transactions.

 

 

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REGULATORY MATTERS

The Bank is subject to Federal Reserve Board capital requirements as well as statutory capital requirements imposed under Maryland law.  To be categorized as well-capitalized, the Bank must maintain minimum total risk-based, Tier 1 risk-based and Tier 1 leverage ratios as set forth in the table. The Company’s and the Bank’s actual capital amounts and ratios at June 30, 2010 are presented in the following table.

		Actual								Required for Capital Adequacy Purposes								To be Considered Well Capitalized Under Prompt  Corrective Action
		(in thousands)
At June 30, 2010
Total Capital (to risk weighted assets)
The Company		$	88,694				13.19	%		$	53,813				8.00	%
The Bank		$	86,115				12.84	%		$	53,602				8.00	%		$	67,002				10.00	%
Tier 1 Capital (to risk weighted assets)
The Company		$	80,782				12.01	%		$	26,906				4.00	%
The Bank		$	78,203				11.67	%		$	26,801				4.00	%		$	40,201				6.00	%
Tier 1 Capital (to average assets)
The Company		$	80,782				9.79	%		$	33,009				4.00	%
The Bank		$	78,203				9.50	%		$	32,929				4.00	%		$	41,162				5.00	%

CRITICAL ACCOUNTING POLICIES

Critical accounting policies are defined as those that involve significant judgments and uncertainties, and could potentially result in materially different results under different assumptions and conditions. The Company considers its determination of the allowance for loan losses, the valuation of foreclosed real estate and the valuation of deferred tax assets to be critical accounting policies.

The Company’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America and the general practices of the United States banking industry.  Application of these principles requires management to make estimates, assumptions and judgments that affect the amounts reported in the financial statements and accompanying notes. These estimates, assumptions and judgments are based on information available as of the date of the financial statements. Accordingly, as this information changes, the financial statements could reflect different estimates, assumptions and judgments. Certain policies inherently have a greater reliance on the use of estimates, assumptions and judgments and as such have a greater possibility of producing results that could be materially different than originally reported.

Estimates, assumptions and judgments are necessary when assets and liabilities are required to be recorded at fair value, when a decline in the value of an asset not carried on the financial statements at fair value warrants an impairment write-down or valuation reserve to be established, or when an asset or liability needs to be recorded contingent upon a future event. Carrying assets and liabilities at fair value inherently results in more financial statement volatility. The fair values and the information used to record valuation adjustments for certain assets and liabilities are based either on quoted market prices or are provided by other third-party sources, when available.  When these sources are not available, management makes estimates based upon what it considers to be the best available information.

Allowance for Loan Losses

The allowance for loan losses is an estimate of the losses that may be sustained in the loan portfolio. The allowance is based on two principles of accounting: (1) Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 450 “Contingencies,” which requires that losses be accrued when they are probable of occurring and are estimable and (2) FASB ASC 310 “Receivables”, which requires that losses be accrued when it is probable that the Company will not collect all principal and interest payments according to the contractual terms of the loan. The loss, if any, is determined by the difference between the loan balance and the value of collateral, the present value of expected future cash flows and values observable in the secondary markets.

 

 

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The allowance for loan loss balance is an estimate based upon management’s evaluation of the loan portfolio.   The allowance is comprised of a specific and a general component.  The specific component consists of management’s evaluation of certain classified and non-accrual loans and their underlying collateral. Management assesses the ability of the borrower to repay the loan based upon all information available. Loans are examined to determine a specific allowance based upon the borrower’s payment history, economic conditions specific to the loan or borrower, and other factors that would impact the borrower’s ability to repay the loan on its contractual basis.  Depending on the assessment of the borrower’s ability to pay and the type, condition and amount of collateral, management will establish an allowance amount specific to the loan.

In establishing the general component of the allowance, management analyzes non-classified and non-impaired loans in the portfolio including changes in the amount and type of loans.  Management also examines the Bank’s historical loss experience (write-offs and recoveries) within each loan category.  The state of the local and national economy is also considered.   Based upon these factors, the Bank’s loan portfolio is categorized and a loss factor is applied to each category.  These loss factors may be higher or lower than the Bank’s actual recent average losses in any particular loan category, particularly in loan categories that are increasing or decreasing in size.  Based upon these factors, the Bank will adjust the loan loss allowance by increasing or decreasing the provision for loan losses.  Management has significant discretion in making the judgments inherent in the determination of the allowance for loan losses, including in connection with the valuation of collateral, a borrower’s prospects of repayment and in establishing loss factors on the general component of the allowance. Changes in loss factors will have a direct impact on the amount of the provision and a corresponding effect on net income. Errors in management’s perception and assessment of the global factors and their impact on the portfolio could result in the allowance not being adequate to cover losses in the portfolio, and may result in additional provisions or charge-offs.

For additional information regarding the allowance for loan losses, refer to Notes 1 and 5 of the Consolidated Financial Statements as presented in the Company’s Form 10-K for the year ended December 31, 2009.

Foreclosed Real Estate

The Company maintains a valuation allowance on its foreclosed real estate.  As with the allowance for loan losses, the valuation allowance on foreclosed real estate is based on FASB ASC 450 “Contingencies” as well as the accounting guidance on impairment of long-lived assets. These statements require that the Company establish a valuation allowance when it has determined that the carrying amount of a foreclosed asset exceeds its fair value.  Fair value of a foreclosed asset is measured by the cash flows expected to be realized from its subsequent disposition.  These cash flows should be reduced for the costs of selling or otherwise disposing of the asset.

In estimating the cash flows from the sale of foreclosed real estate, management must make significant assumptions regarding the timing and amount of cash flows. For example, in cases where the real estate acquired is undeveloped land, management must gather the best available evidence regarding the market value of the property, including appraisals, cost estimates of development and broker opinions.  Due to the highly subjective nature of this evidence, as well as the limited market, long time periods involved and substantial risks, cash flow estimates are highly subjective and subject to change.  Errors regarding any aspect of the costs or proceeds of developing, selling, or otherwise disposing of foreclosed real estate could result in the allowance being inadequate to reduce carrying costs to fair value and may require an additional provision for valuation allowances.

Deferred Tax Assets

The Company accounts for income taxes in accordance with FASB ASC 740, “Income Taxes,” which requires that deferred tax assets and liabilities be recognized using enacted tax rates for the effect of temporary differences between the book and tax bases of recorded assets and liabilities. FASB ASC 740 requires that deferred tax assets be reduced by a valuation allowance if it is more likely than not that some portion or the entire deferred tax asset will not be realized. At June 30, 2010, management determined that it is more likely than not that the entire amount of such assets will be realized.

 

 

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The Company periodically evaluates the ability of the Company to realize the value of its deferred tax asset.  If the Company were to determine that it was not more likely than not that the Company would realize the full amount of the deferred tax asset, it would establish a valuation allowance to reduce the carrying value of the deferred tax asset to the amount it believes would be realized.  The factors used to assess the likelihood of realization are the company’s forecast of future taxable income and available tax-planning strategies that could be implemented to realize the net deferred tax assets.

Failure to achieve forecasted taxable income might affect the ultimate realization of the net deferred tax assets.  Factors that may affect the Company’s ability to achieve sufficient forecasted taxable income include, but are not limited to, the following: increased competition, a decline in net interest margin, a loss of demand for financial services and national and regional economic conditions.

The Company’s provision for income taxes and the determination of the resulting deferred tax assets and liabilities involve a significant amount of management judgment and are based on the best information available at the time. The Company operates within federal and state taxing jurisdictions and is subject to audit in these jurisdictions.

For additional information regarding the deferred tax assets, refer to Note 11 in the Consolidated Financial Statements as presented in the Company’s Form 10-K for the year ended December 31, 2009.

ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK

Not applicable as the Company is a smaller reporting company.

ITEM 4.  CONTROLS AND PROCEDURES

As of the end of the period covered by this report, management of the Company carried out an evaluation, under the supervision and with the participation of the Company’s principal executive officer and principal financial officer, of the effectiveness of the Company’s disclosure controls and procedures. Based on this evaluation, the Company’s principal executive officer and principal financial officer concluded that the Company’s disclosure controls and procedures are effective in ensuring that information required to be disclosed by the Company in reports that it files or submits under the Securities Exchange Act of 1934, as amended, (1) is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission’s rules and forms and (2) is accumulated and communicated to the Company’s management, including its principal executive and financial officers as appropriate to allow timely decisions regarding required disclosure. It should be noted that the design of the Company’s disclosure controls and procedures is based in part upon certain reasonable assumptions about the likelihood of future events, and there can be no reasonable assurance that any design of disclosure controls and procedures will succeed in achieving its stated goals under all potential future conditions, regardless of how remote, but the Company’s principal executive and financial officers have concluded that the Company’s disclosure controls and procedures are, in fact, effective at a reasonable assurance level.

There were no changes in the Company’s internal control over financial reporting during the three months ended June 30, 2010 that have materially affected, or are reasonable likely to materially affect, the Company’s internal control over financial reporting.

 

 

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PART II - OTHER INFORMATION

Item 1 - Legal Proceedings – The Company is not involved in any pending legal proceedings. The Bank is not involved in any pending legal proceedings other than routine legal proceedings occurring in the ordinary course of business.  Such routine legal proceedings, in the aggregate, are believed by management to be immaterial to the financial condition and results of operations of the Company.

Item 1A - Risk Factors

Recently enacted regulatory reform may have a material impact on our operations.

On July 21, 2010, the President signed into law The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”).  The Dodd-Frank Act restructures the regulation of depository institutions.  The Dodd-Frank Act contains various provisions designed to enhance the regulation of depository institutions and prevent the recurrence of a financial crisis such as occurred in 2008-2009.  Also included is the creation of a new federal agency to administer and enforce consumer and fair lending laws, a function that is now performed by the depository institution regulators.  The federal preemption of state laws currently accorded federally chartered depository institutions will be reduced as well.  The full impact of the Dodd-Frank Act on our business and operations will not be known for years until regulations implementing the statute are written and adopted.  The Dodd-Frank Act may have a material impact on our operations, particularly through increased compliance costs resulting from possible future consumer and fair lending regulations.

In addition to the other information set forth in this report, you should carefully consider the factors discussed in Part I, “Item 1A. Risk Factors” in the Form 10-K, which could materially affect our business, financial condition or future results.  The risks described in the Form 10-K are not the only risks that we face.  Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and/or operating results.

Item 2 – Unregistered Sales of Equity Securities and Use of Proceeds

(a)

Not applicable

(b)

Not applicable

(c)

The Company did not repurchase any shares of common stock in the quarter ended June 30, 2010.  On September 25, 2008, Tri-County Financial Corporation announced a repurchase program under which it would repurchase up to 5% of its outstanding common stock or approximately 147,435 shares.  However, as part of the Company’s participation in the Capital Repurchase Program of the U.S. Department of Treasury’s Troubled Asset Relief Program, prior to the earlier of (a) December 19, 2018 or (b) the date on which the Series A preferred stock and the Series B preferred stock has been redeemed in full or the Treasury has transferred all of the Series A preferred stock and the Series B preferred stock to non-affiliates, the Company, without the consent of the Treasury, cannot repurchase any shares of its common stock or other capital stock or equity securities or trust preferred securities. These repurchase restrictions do not apply in certain limited circumstances, including the repurchase of common stock in connection with the administration of any employee benefit plan in the ordinary course of business and consistent with past practice. In addition, during the period beginning on December 19, 2018 and ending on the date on which the Series A preferred stock and the Series B preferred stock have been redeemed in full or the Treasury has transferred all of the Series A preferred stock and the Series B preferred stock to non-affiliates, the Company cannot repurchase any shares of its common stock or other capital stock or equity securities or trust preferred securities without the consent of the Treasury.

Item 3 - Default Upon Senior Securities - None

 

 

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Item 4 - [Removed and Reserved]

Item 5 - Other Information - None

Item 6 - Exhibits

Exhibit 31 - Rule 13a-14(a) Certifications

Exhibit 32 - Section 1350 Certifications

 

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

			TRI-COUNTY FINANCIAL CORPORATION
Date:	July 29, 2010			By:	/s/ Michael L. Middleton
					Michael L. Middleton, President, Chief
					Executive Officer and Chairman of the Board
Date:	July 29, 2010			By:	/s/ William J. Pasenelli
					William J. Pasenelli, Executive Vice
					President and Chief Financial Officer

 

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