UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
  WASHINGTON, DC  20549

FORM 10-Q
(Mark One)
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

for the quarterly period ended:   September 30, 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 : 0-26366

ROYAL BANCSHARES OF PENNSYLVANIA, INC.
(Exact name of the registrant as specified in its charter)

PENNSYLVANIA
 
23-2812193
(State or other jurisdiction of incorporation or organization)
 
(IRS  Employer identification No.)

732 Montgomery Avenue, Narberth, PA 19072
(Address of principal Executive Offices)

(610)  668-4700
(Registrant's telephone number, including area code)

N/A
(Former name, former address and former fiscal year, if changed since last report)

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   x    No o
 
Indicate by checkmark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding twelve months (or for such shorter period that the registrant was required to submit and post such files).  Yes x    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 12-b-2 of the Exchange Act.

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

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o    No. x
 
Applicable only to corporate issuers:
Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.

Class A Common Stock
 
Outstanding at October 31, 2012
$2.00 par value
 
10,871,454
     
Class B Common Stock
 
Outstanding at October 31, 2012
$0.10 par value
 
2,074,099
 


 
 

 
 
PART I – FINANCIAL STATEMENTS
Item 1.
Financial Statements

ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Consolidated Balance Sheets
(unaudited)

   
September 30,
   
December 31,
 
   
2012
   
2011
 
ASSETS
 
(In thousands, except share data)
 
Cash and due from banks
  $ 8,334     $ 10,128  
Interest bearing deposits
    31,116       14,378  
Total cash and cash equivalents
    39,450       24,506  
Investment securities available-for-sale ("AFS”)
    358,455       329,006  
Other investment, at cost
    2,250       1,538  
Federal Home Loan Bank ("FHLB") stock
    6,916       8,474  
Loans and leases held for sale ("LHFS")
    2,718       12,569  
Loans and leases ("LHFI")
    343,049       414,243  
Less allowance for loan and lease losses
    17,417       16,380  
Net loans and leases
    325,632       397,863  
Bank owned life insurance
    14,446       14,032  
Accrued interest receivable
    10,893       15,463  
Other real estate owned ("OREO"), net
    22,080       21,016  
Premises and equipment, net
    5,313       5,394  
Other assets
    13,528       18,587  
Total assets
  $ 801,681     $ 848,448  
                 
LIABILITIES AND SHAREHOLDERS’ EQUITY
               
Liabilities
               
Deposits
               
Non-interest bearing
  $ 59,262     $ 54,534  
Interest bearing
    511,988       521,382  
Total deposits
    571,250       575,916  
Short-term borrowings
    -       54,218  
Long-term borrowings
    108,446       93,782  
Subordinated debentures
    25,774       25,774  
Accrued interest payable
    5,932       3,450  
Other liabilities
    21,279       19,363  
Total liabilities
    732,681       772,503  
Shareholders’ equity
               
Royal Bancshares of Pennsylvania, Inc. equity:
               
Preferred stock, Series A perpetual, $1,000 liquidation value, 500,000 shares authorized, 30,407 shares issued and outstanding at September 30, 2012 and December 31, 2011
    29,263       28,878  
Class A common stock, par value $2.00 per share, authorized 18,000,000 shares; issued, 11,369,942 and 11,361,580 at September 30, 2012 and December 31, 2011, respectively
    22,740       22,723  
Class B common stock, par value $0.10 per share; authorized 3,000,000 shares; issued, 2,074,099 and 2,081,371 at September 30, 2012 and December 31, 2011, respectively
    207       208  
Additional paid in capital
    126,280       126,245  
Accumulated deficit
    (108,835 )     (100,803 )
Accumulated other comprehensive income
    2,210       800  
Treasury stock - at cost, shares of Class A, 498,488 at September 30, 2012 and December 31, 2011
    (6,971 )     (6,971 )
Total Royal Bancshares of Pennsylavania, Inc. shareholders’ equity
    64,894       71,080  
Noncontrolling interest
    4,106       4,865  
Total equity
    69,000       75,945  
Total liabilities and shareholders’ equity
  $ 801,681     $ 848,448  

The accompanying notes are an integral part of these consolidated financial statements.

 
- 2 -

 
 
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Consolidated Statements of Operations - (unaudited)

   
For the three months ended
   
For the nine months ended
 
   
September 30,
   
September 30,
 
(In thousands, except per share data)
 
2012
   
2011
   
2012
   
2011
 
Interest income
                       
Loans and leases, including fees
  $ 6,298     $ 7,545     $ 19,766     $ 22,986  
Investment securities available-for-sale
    1,453       2,485       5,196       7,567  
Deposits in banks
    10       18       28       67  
Federal funds sold
    -       1       -       3  
Total Interest Income
    7,761       10,049       24,990       30,623  
Interest expense
                               
Deposits
    1,440       1,932       4,641       7,206  
Short-term borrowings
    1       40       309       124  
Long-term borrowings
    938       1,245       2,759       3,746  
Total Interest Expense
    2,379       3,217       7,709       11,076  
Net Interest Income
    5,382       6,832       17,281       19,547  
Provision for loan and lease losses
    1,761       428       3,360       5,568  
Net Interest Income after Provision for Loan and Lease Losses
    3,621       6,404       13,921       13,979  
                                 
Other income
                               
Service charges and fees
    315       312       893       821  
Net gains on sales of other real estate owned
    228       206       345       1,500  
Net gains on the sale of AFS investment securities
    225       464       384       1,565  
Income from bank owned life insurance
    139       92       414       278  
Gains on sales of loans and leases
    39       33       2,044       51  
Income related to real estate owned via equity investments
    18       137       56       682  
Income from real estate joint ventures
    -       -       -       250  
Other income
    187       244       480       873  
Total other-than-temporary impairment losses on investment securities
    -       (1,415 )     (859 )     (1,796 )
Total Other Income
    1,151       73       3,757       4,224  
Other expenses
                               
Employee salaries and benefits
    2,859       2,881       8,909       8,288  
OREO impairment
    2,364       1,493       3,413       4,633  
Professional and legal fees
    986       904       3,296       3,251  
Impairment on loans held for sale
    856       -       856       304  
Occupancy and equipment
    499       562       1,619       1,739  
OREO and loan collection expenses
    393       826       1,811       2,003  
Pennsylvania shares tax
    314       312       951       936  
FDIC and state assessments
    287       453       778       1,539  
Directors' fees
    95       84       304       252  
Loss contingency accrual
    -       -       2,000       -  
Expenses related to real estate owned via equity investments
    -       23       -       124  
Other operating expenses
    756       571       2,131       1,794  
Total Other Expenses
    9,409       8,109       26,068       24,863  
Loss Before Tax Benefit
    (4,637 )     (1,632 )     (8,390 )     (6,660 )
Income tax benefit
    -       -       -       -  
Net Loss
  $ (4,637 )   $ (1,632 )   $ (8,390 )   $ (6,660 )
Less net income (loss) attributable to noncontrolling interest
  $ 175     $ 261     $ (759 )   $ 969  
Net loss attributable to Royal Bancshares of Pennsylvania, Inc.
  $ (4,812 )   $ (1,893 )   $ (7,631 )   $ (7,629 )
Less Preferred stock Series A accumulated dividend and accretion
  $ 511     $ 502     $ 1,525     $ 1,499  
Net loss available to common shareholders
  $ (5,323 )   $ (2,395 )   $ (9,156 )   $ (9,128 )
Per common share data
                               
Net loss – basic and diluted
  $ (0.40 )   $ (0.18 )   $ (0.69 )   $ (0.69 )

The accompanying notes are an integral part of these consolidated financial statements.

 
- 3 -

 
 
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Statements of Consolidated Comprehensive Loss - (unaudited)

 
 
For the three months ended
   
For the nine months ended
 
   
September 30,
   
September 30,
 
(In thousands)
 
2012
   
2011
   
2012
   
2011
 
Net loss
  $ (4,637 )   $ (1,632 )   $ (8,390 )   $ (6,660 )
Other comprehensive income, net of tax
                               
Unrealized gains (losses) on investment securities:
                               
Unrealized holding gains (losses) arising during period
    1,067       (273 )     838       232  
Less adjustment for impaired investments
    -       (998 )     (558 )     (1,167 )
Less reclassification adjustment for gains realized in net loss
    147       301       250       1,017  
Unrealized gains on investment securities
    920       424       1,146       382  
Unrecognized benefit obligation expense:
                               
Less reclassification adjustment for amortization
    (150 )     (32 )     (264 )     (107 )
Other comprehensive income
    1,070       456       1,410       489  
Comprehensive loss
  $ (3,567 )   $ (1,176 )   $ (6,980 )   $ (6,171 )
Less net income (loss) attributable to noncontrolling interest
    175       261       (759 )     969  
Comprehensive loss attributable to Royal Bancshares of Pennsylvania, Inc.
  $ (3,742 )   $ (1,437 )   $ (6,221 )   $ (7,140 )

The accompanying notes are an integral part of these consolidated financial statements.

 
- 4 -

 
 
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Consolidated Statement of Changes in Shareholders' Equity
Nine months ended September 30, 2012
(unaudited)

(In thousands,  
Preferred
stock
   
Class A common
stock
   
Class B common
stock
   
Additional
paid in
   
Accumulated
   
Accumulated
other
comprehensive
   
Treasury
   
Noncontrolling
   
Total
Shareholders'
 
except share data)
 
Series A
   
Shares
   
Amount
   
Shares
   
Amount
   
capital
   
deficit
   
income
   
stock
   
Interest
   
Equity
 
Balance January 1, 2012
  $ 28,878       11,362     $ 22,723       2,081     $ 208     $ 126,245     $ (100,803 )   $ 800     $ (6,971 )   $ 4,865     $ 75,945  
Comprehensive loss
                                                                                       
Net loss
                                                    (7,631 )                     (759 )     (8,390 )
Other comprehensive income, net of reclassifications and taxes
                                                            1,410                       1,410  
Common stock conversion from Class B to Class A
            8       17       (7 )     (1 )             (16 )                             -  
Accretion of discount on preferred stock
    385                                               (385 )                             -  
Stock option expense
                                            35                                       35  
Balance September 30, 2012
  $ 29,263       11,370     $ 22,740       2,074     $ 207     $ 126,280     $ (108,835 )   $ 2,210     $ (6,971 )   $ 4,106     $ 69,000  

ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Consolidated Statement of Changes in Shareholders' Equity
Nine months ended September 30, 2011
(unaudited)

(In thousands,  
Preferred
stock
   
Class A common
stock
   
Class B common
stock
   
Additional
paid in
   
Accumulated
   
Accumulated
other
comprehensive
   
Treasury
   
Noncontrolling
   
Total
Shareholders'
 
except share data)
 
Series A
   
Shares
   
Amount
   
Shares
   
Amount
   
capital
   
deficit
   
income
   
stock
   
Interest
   
Equity
 
Balance January 1, 2011
  $ 28,395       11,355     $ 22,711       2,087     $ 209     $ 126,152     $ (91,746 )   $ 1,942     $ (6,971 )   $ 3,401     $ 84,093  
Comprehensive loss
                                                                                       
Net loss
                                                    (7,629 )                     969       (6,660 )
Other comprehensive income, net of reclassifications and taxes
                                                            489                       489  
Common stock conversion from Class B to Class A
            7       12       (6 )     (1 )             (11 )                             -  
Accretion of discount on preferred stock
    359                                               (359 )                             -  
Stock option expense
                                            69                                       69  
Balance September 30, 2011
  $ 28,754       11,362     $ 22,723       2,081     $ 208     $ 126,221     $ (99,745 )   $ 2,431     $ (6,971 )   $ 4,370     $ 77,991  

The accompanying notes are an integral part of these consolidated financial statements.

 
- 5 -

 
 
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows (unaudited)
Nine months ended September 30,

(In thousands)
 
2012
   
2011
 
Cash flows from operating activities:
           
Net loss
  $ (7,631 )   $ (7,629 )
Adjustments to reconcile net loss to net cash provided by operating activities:
               
Depreciation and amortization
    300       352  
Stock compensation expense
    35       69  
Provision for loan and lease losses
    3,360       5,568  
Impairment charge for other real estate owned
    3,413       4,633  
Net amortization of investment securities
    4,776       1,995  
Net accretion on loans
    (192 )     (220 )
Net gains on sales of other real estate
    (345 )     (1,500 )
Proceeds from sales of loans and leases
    11,039       831  
Gains on sales of loans and leases
    (2,044 )     (51 )
Net gains on sales of investment securities
    (384 )     (1,565 )
Distribution from investments in real estate
    (56 )     (150 )
Gain from sale of premises of real estate owned via equity investment
    -       (528 )
Income from real estate joint ventures
    -       (250 )
Income from bank owned life insurance
    (414 )     (278 )
Impairment of loans held for sale
    856       304  
Impairment of available-for-sale investment securities
    859       1,796  
Changes in assets and liabilities:
               
Decrease in accrued interest receivable
    4,570       870  
Decrease in other assets
    5,059       11,644  
Increase in accrued interest payable
    2,482       1,734  
Increase in other liabilities
    1,916       2,318  
Net cash provided by operating activities
    27,599       19,943  
Cash flows from investing activities:
               
Proceeds from maturities, calls and paydowns of available-for-sale ("AFS") investment securities
    109,503       59,912  
Proceeds from sales of AFS investment securities
    27,089       112,721  
Purchase of AFS investment securities
    (170,090 )     (167,874 )
Redemption of Federal Home Loan Bank stock
    1,558       1,485  
Net decrease in loans
    57,308       66,283  
Purchase of premises and equipment
    (219 )     (117 )
Net proceeds from sale of premises of real estate owned via equity investments
    -       7,939  
Distribution from investments in real estate
    56       150  
Net increase in real estate owned via equity investments
    -       (7,411 )
Proceeds from sales of real estate owned
    6,360       8,742  
Net cash provided by investing activities
    31,565       81,830  
Cash flows from financing activities:
               
Increase in demand and NOW accounts
    1,332       1,981  
(Decrease) increase in money market and savings accounts
    (3,461 )     5,791  
Decrease in certificates of deposit
    (2,537 )     (123,794 )
Repayments of short-term borrowings
    (54,218 )     -  
Repayments of long-term borrowings
    (336 )     (5,191 )
Proceeds from long-term borrowings
    15,000       -  
Net cash used in financing activities
    (44,220 )     (121,213 )
Net increase (decrease) in cash and cash equivalents
    14,944       (19,440 )
Cash and cash equivalents at the beginning of the period
    24,506       51,733  
Cash and cash equivalents at the end of the period
  $ 39,450     $ 32,293  
Supplemental Disclosure
               
Interest paid
  $ 5,227     $ 9,342  
Transfers to other real estate owned
  $ 10,492     $ 5,088  

The accompanying notes are an integral part of these consolidated financial statements.

 
- 6 -

 

ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

Note 1.
Summary of Significant Accounting Policies
 
Basis of Financial Presentation
 
The accompanying unaudited consolidated financial statements include the accounts of Royal Bancshares of Pennsylvania, Inc. (“Royal Bancshares” or the “Company”) and its wholly-owned subsidiaries, Royal Investments of Delaware, Inc., including Royal Investments of Delaware, Inc.’s wholly-owned subsidiary, Royal Preferred, LLC, and Royal Bank America (“Royal Bank”), including Royal Bank’s subsidiaries, Royal Real Estate of Pennsylvania, Inc., Royal Investments America, LLC, RBA Property LLC, Narberth Property Acquisition LLC, Rio Marina LLC, and its three 60% ownership interests in Crusader Servicing Corporation (“CSC”), Royal Tax Lien Services, LLC (“RTL”), and Royal Bank America Leasing, LP.  The two Delaware trusts, Royal Bancshares Capital Trust I and Royal Bancshares Capital Trust II are not consolidated per requirements under Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 810, “Consolidation” (“ASC Topic 810”). These consolidated financial statements reflect the historical information of the Company.  All significant intercompany transactions and balances have been eliminated.
 
The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) for interim financial information. Applications of the principles in the Company’s preparation of the consolidated financial statements in conformity with U.S. GAAP require management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and the accompanying notes.  These estimates and assumptions are based on information available as of the date of the consolidated financial statements; therefore, actual results could differ from those estimates. The interim financial information included herein is unaudited; however, such information reflects all adjustments (consisting solely of normal recurring adjustments) that are, in the opinion of management, necessary to present a fair statement of the results for the interim periods.  These interim consolidated financial statements should be read in conjunction with the consolidated financial statements and footnotes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2011.  The results of operations for the three and nine month periods ended September 30, 2012 are not necessarily indicative of the results to be expected for the full year.
 
Reclassifications
 
Certain items in the 2011 consolidated financial statements and accompanying notes have been reclassified to conform to the current year’s presentation format.  There was no effect on net loss for the periods presented herein as a result of reclassification.
 
Accounting Policies Recently Adopted and Pending Accounting Pronouncements
 
In December 2011, the FASB issued ASU 2011-11, “Disclosures about Offsetting Assets and Liabilities” (“ASU 2011-11”) which amends ASC Topic 210 “Balance Sheet”. Because of the significant differences in requirements under U.S. GAAP and International Financial Reporting Standards ("IFRS"), FASB and the International Accounting Standards Board (“IASB”) are issuing joint requirements that will enhance current disclosures. Entities are required to disclose both gross information and net information about both instruments and transactions eligible for offset in the statement of financial position and instruments and transactions subject to an agreement similar to a master netting arrangement. This scope would include derivatives, sale and repurchase agreements and reverse sale and repurchase agreements, and securities borrowing and securities lending arrangements. The objective of this disclosure is to facilitate comparison between those entities that prepare their financial statements on the basis of U.S. GAAP and those entities that prepare their financial statements on the basis of IFRS. ASU 2011-11 is effective for annual periods beginning on or after January 1, 2013 and interim periods within those annual periods. An entity should provide the disclosures required by these amendments retrospectively for all comparative periods presented. The adoption of ASU 2011-11 is not expected to have a significant impact on the Company’s consolidated financial statements.
 
 
- 7 -

 

Note 2.
Regulatory Matters and Significant Risks or Uncertainties
 
FDIC and Department of Banking Orders
 
On July 15, 2009, Royal Bank agreed to enter into a Stipulation and Consent to the Issuance of an Order to Cease and Desist (the “Orders”) with each of the Federal Deposit Insurance Corporation (“FDIC”) and the Pennsylvania Department of Banking (the “Department”). The material terms of the Orders were identical and required Royal Bank among other items to maintain, after establishing an adequate allowance for loan and lease losses, a ratio of Tier 1 capital to total assets (“leverage ratio”) equal to or greater than 8% and a ratio of qualifying total capital to risk-weighted assets (“total risk-based capital ratio”) equal to or greater than 12%. The FDIC and the Department replaced the Orders in the fourth quarter of 2011 with an informal agreement, known as a memorandum of understanding (“MOU”).  Included in the MOU is the continued requirement of maintaining a leverage ratio equal to or greater than 8% and a total risk-based capital ratio equal to or greater than 12%.   At September 30, 2012, based on capital levels calculated under regulatory accounting purposes (“RAP”), Royal Bank’s Tier 1 leverage and total risk-based capital ratios were 9.12% and 17.09%, respectively.  Please refer to “Note 11 – Regulatory Capital Requirements” to the Consolidated Financial Statements.
 
Following the issuance of the Orders, management implemented plans to address key areas that were noted in the Orders.  Management has reduced classified assets, delinquencies, commercial real estate concentrations, reliance on non-core deposits and wholesale funding sources and strengthened capital ratios which were all factors that contributed to replacing the Orders with the MOU.  Management has continued to improve in each of these areas since the Orders were replaced with the MOU.
 
Federal Reserve Agreement
 
On March 17, 2010, the Company agreed to enter into the Federal Reserve Agreement with the Reserve Bank. The material terms of the Federal Reserve Agreement provide that: (i) the Company’s Board of Directors  (“Board”) will take appropriate steps to fully utilize the Company’s financial and managerial resources to serve as a source of strength to its subsidiary banks; (ii) the Company’s Board will, within 60 days of the Federal Reserve Agreement, submit to the Reserve Bank a written plan to strengthen board oversight of the management and operations of the consolidated operation; (iii) the Company will not declare or pay any dividends without the prior written approval of the Reserve Bank and the Director of the Division of Banking Supervision and Regulation of the Board of Governors of the Federal Reserve System; (iv) the Company and its non-bank subsidiaries will not make any distributions of interest, principal, or other sums on subordinated debentures or trust preferred securities without the prior approval of the Reserve Bank and the Director of the Division of Banking Supervision and Regulation of the Board of Governors of the Federal Reserve System; (v) the Company and its nonbank subsidiaries will not, directly or indirectly, incur, increase, or guarantee any debt without the prior written approval of the Reserve Bank; (vi) the Company will not, directly or indirectly, purchase or redeem any shares of its stock without the prior written approval of the Reserve Bank; (vii) the Company will, within 60 days of the Federal Reserve Agreement, submit to the Reserve Bank an acceptable written capital plan to maintain sufficient capital at the Company on a consolidated basis, which plan will at a minimum address: regulatory requirements for the Company and the Banks, the adequacy of the Banks’ capital taking into account the volume of classified credits, the allowance for loan and lease losses, current and projected asset growth, and projected retained earnings; the source and timing of additional funds necessary to fulfill the consolidated organization’s and the Banks’ future capital requirements; supervisory requests for additional capital at the Banks or the requirements of any supervisory action imposed on the Banks by federal or state regulators; and applicable legal requirements that the Company serve as a source of strength to the Banks; (viii) the Company will, within 60 days of the Federal Reserve Agreement, submit to the Reserve Bank cash flow projections for 2010 showing planned sources and uses of cash for debt service, operating expenses, and other purposes, and will submit similar cash flow projections for each subsequent calendar year at least one month prior to the beginning of such year; (ix) the Company will comply with applicable legal notice provisions in advance of appointing any new director or senior executive officer or changing the responsibilities of any senior executive officer such that the officer would assume a different senior executive officer position, and comply with restrictions on indemnification and severance payments imposed by the Federal Deposit Insurance Act; and (x) the Company’s Board will, within 45 days after the end of each quarter, submit progress reports to the Reserve Bank detailing the form and manner of all actions taken to secure compliance with the Agreement and the results thereof, together with a parent company-level balance sheet, income statement, and, as applicable, report of changes in shareholders’ equity.
 
 
- 8 -

 

The Federal Reserve Agreement will remain in effect and enforceable until stayed, modified, terminated or suspended by the Reserve Bank. Royal Bancshares has submitted all progress reports and responses required under the Federal Reserve Agreement as of the date of this Report.
 
Our success as a Company is dependent upon pursuing various alternatives in not only achieving the growth and expansion of our banking franchise but also in managing our day to day operations. The existence of the MOU and the Federal Reserve Agreement may limit or impact our ability to pursue all previously available alternatives in the management of the Company. Our ability to retain existing retail and commercial customers as well as the ability to attract potentially new customers may be impacted by the existence of the MOU and the Federal Reserve Agreement. Additionally, our ability to expand into potentially attractive commercial real estate or construction loans at this time is limited. The Company’s ability to raise capital in the current economic environment could be potentially limited or impacted as a result of the MOU and the Federal Reserve Agreement. Attracting new management talent is critical to the success of our business and could be potentially impacted due to the existence of the MOU and the Federal Reserve Agreement.
 
Continued Losses
 
Over the past four calendar years, the Company has recorded significant losses totaling $104.0 million which were primarily related to charge-offs on the loan and lease portfolio, impairment charges on investment securities, impairment charges on other real estate owned (“OREO”), credit related expenses and the establishment of a deferred tax valuation allowance.  For the first nine months of 2012, the net loss amounted to $7.6 million, which was equivalent to the loss recorded for the comparable period in 2011. Included in the loss for 2012 was a $2.0 million legal contingency accrual for a potential settlement with the U.S. Department of Justice related to the tax lien subsidiaries.  After adjusting for the noncontrolling interest, the Company’s 60% share of the loss contingency amounts to $1.2 million.  In addition to reducing the total shareholders’ equity, the continued losses and negative retained earnings impacts the Company’s ability to pay cash dividends to its shareholders now and in future years.  The Company’s deferred tax valuation allowance amounted to $36.4 million at September 30, 2012.  The deferred tax valuation allowance is a result of management’s conclusion that it was more likely than not that the Company would not generate sufficient future taxable income to realize all of the deferred tax assets.
 
Credit Quality
 
Adverse economic conditions in our specific market areas and decreases in real estate property values due to the nature of our loan portfolio in particular have affected the ability of customers to repay their loans and generally impact our financial condition and results of operations. The financial services and real estate industries were hit particularly hard during the “Great Recession” and as a result the Company’s loan and investment portfolios were directly affected.  The Company’s commercial real estate loans, including construction and land development loans, have seen a decline in the collateral values, and a reduction in the borrowers’ ability to meet the payment terms of their loans due to reduced cash flow.  Further declines in collateral values and borrowers’ liquidity with sustained unemployment at current levels may lead to additional increases in foreclosures, delinquencies and customer bankruptcies.  The Company is less able than a larger institution to spread the risks of unfavorable local economic conditions across a large number of more diverse economies.
 
The Company had non-performing loans of $27.8 million and $58.2 million at September 30, 2012 and 2011, respectively.  The Company recorded $2.9 million and $3.7 million in charge-offs and write-downs for the three and nine months ended September 30, 2012, respectively compared to $2.4 million and $9.8 million  in charge-offs and write-downs for the comparable periods of 2011, respectively.  OREO balances were $22.1 million and $21.9 million at September 30, 2012 and 2011, respectively.
 
Management is reporting information as of June 30, 2009 as a benchmark for the following comparisons since the Orders reflected the balance sheet conditions and Statement of Operations as of that date.  Royal Bank reduced net classified loans, which includes loans held for sale (“LHFS”) and OREO from $149.6 million at June 30, 2009 to $52.6 million at September 30, 2012. Royal Bank’s delinquent loans held for investment (30 to 90 days) amounted to $36.3 million at June 30, 2009 versus $2.1 million at September 30, 2012. Material advances on any classified or delinquent loan are to be approved by the Board and determined to be in Royal Bank’s best interest.  The Company has restructured the investment portfolio to reduce credit risk by selling corporate debt securities and equity securities and replacing their maturities with U.S. government issued or sponsored securities. The Company recorded other-than-temporary-impairment (“OTTI”) losses of $0 and $859,000 for the three and nine months ended September 30, 2012, respectively, compared to $1.4 million and $1.8 million during the comparable periods of 2011, respectively.
 
 
- 9 -

 

Commercial Real Estate Concentrations
 
As mentioned previously the adverse economic conditions have primarily impacted the real estate secured loan portfolio.  Commercial real estate and construction and development loans are often riskier and tend to have significantly larger balances than home equity loans or residential mortgage loans to individuals.  While the Company believes that the commercial real estate concentration risk is mitigated by diversification among the types and characteristics of real estate collateral properties, sound underwriting practices, and ongoing portfolio monitoring and market analysis, the repayments of these loans usually depends on the profitable operation of a business or the sale of the underlying property.  As a result, these loans are more likely to be unfavorably affected by adverse conditions in the real estate market or the economy in general, which may result in increasing levels of loan charge-offs and non-performing assets and the reduction of earnings.  When we take collateral in foreclosures and similar proceedings, we are required to mark the related asset to the then fair market value of the collateral, which may ultimately result in a loss.  It is possible that Royal Bank may be required to maintain higher levels of capital than it would be otherwise be expected to maintain as a result of the Bank’s commercial real estate loans, which may require the Company to obtain additional capital.
 
Commercial real estate and construction and land development loans held for investment were $210.6 million at September 30, 2012 comprising 61% of total loans compared to $248.3 million or 60% of total loans at December 31, 2011.  Based on capital levels calculated under U.S. GAAP and RAP, Royal Bank does not have a concentration of commercial real estate loans as defined in the joint agency “Guidance on Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices” issued on December 12, 2006. Please see discussion in “Note 11 – Regulatory Capital Requirements” to the Consolidated Financial Statements.
 
Liquidity and Funds Management
 
Royal Bank has limited capacity to borrow additional funds in the event it is needed for liquidity purposes. However, Royal Bank has continued to maintain liquidity measures that are well in excess of the target levels.  As discussed in “Note 8 – Borrowings and Subordinated Debentures” to the Consolidated Financial Statements, Royal Bank has an over collateralized delivery requirement of 105% with the FHLB as a result of the level of non-performing assets and the losses that have been experienced over the past four years. The ability to borrow additional funds is based on the amount of collateral that is available to be pledged.  As of September 30, 2012, Royal Bank had $32.5 million of available borrowing capacity at the FHLB as a result of excess collateral that has been pledged.  In addition at September 30, 2012, Royal Bank had $201.2 million in unpledged agency securities that were available to be pledged as collateral if needed and $39.5 million in cash on hand.  Royal Bank also has limited availability to borrow from the Federal Reserve Discount Window, which was $5.0 million at September 30, 2012, and was based on collateral pledged.
 
At September 30, 2012, the liquidity to deposits ratio was 50.8% compared to Royal Bank’s 12% policy target and the liquidity to total liabilities ratio was 39.9% compared to Royal Bank’s 10% policy target. Brokered CDs declined from $226.9 million at June 30, 2009 to $0 million at September 30, 2012.  Borrowings declined $164.0 million from $272.4 million at June 30, 2009 to $108.4 million at September 30, 2012.
 
The Company also has unfunded pension plan obligations of $15.0 million as of September 30, 2012 which potentially could impact liquidity.  The Company plans to fund the pension plan obligations through existing Company owned life insurance policies.
 
 
- 10 -

 

Dividend and Interest Restrictions
 
Due to the MOU and the Federal Reserve Agreement, our ability to obtain lines of credit, to receive attractive collateral treatment from funding sources, and to pursue all attractive funding alternatives in this current low interest rate environment could be impacted and thereby limit liquidity alternatives. On August 13, 2009, the Company’s Board determined to suspend regular quarterly cash dividends on the $30.4 million in Series A Preferred Stock and to suspend interest payments on the $25.8 million in trust preferred securities.  As of September 30, 2012, the Series A Preferred stock dividend in arrears was $5.4 million and has not been recognized in the consolidated financial statements.  As of September 30, 2012 the trust preferred interest payment in arrears was $2.3 million and has been recorded in interest expense and accrued interest payable. The Company believes the decision to suspend the preferred cash dividends and the trust preferred interest payments will better support the capital position of Royal Bank. As a result of the Company missing the sixth quarterly dividend payment due on November 16, 2010, the Treasury exercised its rights under the Capital Purchase Program and appointed two directors to our Board in 2011 until all accrued but unpaid dividends have been paid in full by the Company.  
 
At September 30, 2012, as a result of significant losses within Royal Bank, the Company had negative retained earnings and therefore would not have been able to declare and pay any cash dividends.  Royal Bank must receive prior approval from the FDIC and the Department before declaring and paying a dividend to the Company.  Under the Federal Reserve Agreement the Company may not declare or pay any dividends without the prior written approval of the Reserve Bank and the Director of the Division of Banking Supervision and Regulation of the Board of Governors of the Federal Reserve System.
 
Capital Adequacy
 
In connection with a prior bank regulatory examination, the FDIC concluded, based upon its interpretation of the Consolidated Reports of Condition and Income (the “Call Report”) instructions and under RAP, that income from Royal Bank’s tax lien business should be recognized on a cash basis, not an accrual basis.  Royal Bank’s current accrual method is in accordance with U.S. GAAP.  Royal Bank disagrees with the FDIC’s conclusion and filed the Call Report for September 30, 2012 and the previous eight quarters in accordance with U.S. GAAP.  However, the change in the manner of revenue recognition for the tax lien business for regulatory accounting purposes affects Royal Bank’s and potentially the Company’s capital ratios as disclosed in “Note 11 - Regulatory Capital Requirements” to the Consolidated Financial Statements.  Royal Bank is in discussions with the FDIC to resolve the matter.
 
Under the MOU, Royal Bank must maintain a minimum total risk-based capital ratio and a minimum Tier 1 leverage ratio of 12% and 8%, respectively. At September 30, 2012, based on capital levels calculated under RAP, Royal Bank’s total risk-based capital and Tier 1 leverage ratios were 17.09% and 9.12%, respectively.
 
Department of Justice Investigation (“DOJ”)
 
Royal Bank holds a 60% equity interest in each of CSC and RTL.  The Company acquired its ownership interest in CSC in 2001.  CSC and RTL acquire, through public auction, delinquent tax liens in various jurisdictions thereby assuming a superior lien position to most other lien holders, including mortgage lien holders.  As previously discussed in the Company’s Form 10-K for the year ended December 31, 2011, in March 2009, each of CSC and RTL received grand jury subpoenas issued by the U.S. District Court for New Jersey (“Court”) upon application of the Antitrust Division of the United States Department of Justice (“DOJ”).  The subpoenas sought certain documents and information relating to an ongoing investigation being conducted by the DOJ relating to alleged bid-rigging at tax lien auctions in New Jersey.  Royal Bank, CSC and RTL have produced to the DOJ documents responsive to the subpoenas and have been cooperating with the DOJ throughout the investigation.  On February 23, 2012, the former President of CSC and RTL entered a plea of guilty to one count of conspiring to rig bids at certain auctions for tax liens in New Jersey from 1998 until approximately the spring of 2009.  The former President’s employment with CSC and RTL was terminated in November 2010.  As previously disclosed, Royal Bank had been advised that neither CSC nor RTL were targets of the DOJ investigation, but they were subjects of the investigation.  Based on discussions with the DOJ and the plea entered by the former President of CSC and RTL, the Company believed that the outcome of the investigation would result in fines and penalties being assessed against both CSC and RTL.  As a result, the Company accrued an aggregate of $2.0 million during the first and second quarters of 2012 as an estimate for a loss contingency for potential DOJ fines and penalties relating to the DOJ investigation.  After adjusting for the noncontrolling interest, the Company’s 60% share of the loss contingency amounted to $1.2 million.  On September 26, 2012, as a result of the former President’s guilty plea and pursuant to a plea agreement with the DOJ, CSC entered a guilty plea in the United States District Court for the District of New Jersey to one count of conspiracy to commit bid-rigging at certain auctions for tax liens in New Jersey.  Under the terms of the plea agreement, which the Court accepted at the September 26, 2012 plea hearing, the DOJ agreed not to bring further criminal charges against CSC and not to bring criminal charges against RTL, or any current or former director, officer, or employee of CSC and/or RTL, for any act or offense committed prior to the date of the plea agreement that was in furtherance of any agreement to rig bids at municipal tax lien sales or auctions in the State of New Jersey. The former President of CSC and RTL and any person who bid at any time at a tax lien auction on behalf of CSC and/or RTL are excluded from this nonprosecution protection.  The DOJ further agreed to recommend that the appropriate fine for CSC would be $2.0 million, which, as stated above, has been recognized in the Company’s financial statements.  The actual fine to be imposed, however, lies within the sole discretion of the sentencing judge.  The Company is evaluating appropriate legal action against the former President of CSC and RTL to attempt to recover legal expenses and any fines or penalties ultimately levied against CSC.
 
 
- 11 -

 

Additionally a number of lawsuits have been filed   in the Superior Court of New Jersey against the former President of CSC and RTL, CSC, RTL, Royal Bancshares of Pennsylvania and certain other parties on behalf of a proposed class of taxpayers who became delinquent in paying their municipal tax obligations. These lawsuits allege violations of the New Jersey Antitrust Act and unjust enrichment, and seek treble damages, attorney fees and injunctive relief.  CSC, RTL and Royal Bancshares removed these cases to the U.S. District Court for the District of New Jersey. On June 12, 2012, the Court entered an Order consolidating for pretrial purposes the Boyer action with all subsequently filed or transferred related actions.  On October 22, 2012, the Court appointed two law firms as interim class counsel and another law firm as liaison class counsel and further ordered appointed counsel to file on or before November 21, 2012 a master complaint for the consolidated action.   As of the date of this filing Royal Bancshares and Royal Bank cannot reasonably estimate the possible loss or range of loss that may result from these actions or proceedings.
 
Company Plans and Strategy
 
In addition to increased board oversight and the creation of a Regulatory Compliance Committee in response to the previous Orders, the Company has enhanced the Board through the addition of experienced directors with diverse backgrounds. The new members are comprised of the following: a former banking regulator with consulting experience, a former Chief Executive Officer (“CEO”) of a much larger financial institution who has bank turnaround experience, a former President of the lead bank within a larger financial institution (Treasury appointee), a former executive within the financial services industry (Treasury appointee) and a former senior partner of a public accounting firm.  During the first quarter, the Board elected a Lead Independent Director to further improve corporate governance by serving as a liaison between the Chairman of the Board, management, and the independent directors. Royal Bank recently hired a new Chief Lending Officer (“CLO”) who has significant experience in commercial and consumer lending with a larger bank within the Philadelphia market. In addition, due to the pending retirement of the current CEO on or before December 31, 2012 and the retirement of the President during the second quarter of 2012, the Company’s Board is conducting an executive search for a candidate for the combined role of President and CEO.
 
In order to meet the requirements in the previous Orders, the current MOU, and the Federal Reserve Agreement, management adopted a strategy to deleverage the balance sheet.  The deleveraging strategy has provided greater use of the existing capital despite the continued losses by maintaining that capital ratio as a percentage of the remaining reduced level of assets in order to achieve capital ratios at required regulatory levels. The Board and management remain committed to meeting the capital level requirements for Royal Bank as set forth in the previous Orders and current MOU and have therefore developed a contingency plan to maintain capital ratios at required levels. This strategy also assisted in reducing the level of classified assets by giving management the ability to actively pursue exit strategies on loans and OREO which were at historically high levels.  The deleveraging was largely accomplished by reducing brokered deposits from $226.9 million at June 30, 2009 to $0 as of September 30, 2012.  In addition, borrowings were reduced by $164.0 million during the same period.  The Company’s strategic plan includes improving the overall level of credit quality, maintaining reduced credit risk within the investment portfolio and returning to profitability. In concert with these efforts, the Company has started to transition towards a community bank focus within its geographic footprint and adjacent markets.
 
 
- 12 -

 

During the past few years, the Company recorded significant impairment charges and carrying costs on non-accrual loans and OREO which has weighed heavily on earnings and was the largest contributing factor to the Company’s continued losses. The Company has made progress in improving capital ratios, improving credit quality, reducing the CRE concentration, strengthening the Board and maintaining strong liquidity. As a result of the decline in level of classified assets, there has been a corresponding reduction in impairments, the provision for loan and lease losses, and the overall carrying costs associated with classified assets.  The deleveraging of the balance sheet has also reduced earning assets which has resulted in a decline in net interest income and has had a significant impact on overall earnings. To improve net interest margin and net interest income, management is diligently working on changing the mix of earnings assets and interest bearing liabilities.  In the event further deleveraging is necessary to maintain the required capital levels, net interest income would be impacted.
 
Note 3.
Investment Securities
 
The carrying value and fair value of investment securities AFS at September 30, 2012 are as follows:
 
         
Included in Accumulated Other
Comprehensive Income (AOCI)
       
               
Gross unrealized losses
       
(In thousands)
 
Amortized
cost
   
Gross
unrealized
gains
   
Non-OTTI
in AOCI
   
Non-credit
related OTTI
in AOCI
   
Fair value
 
Mortgage-backed  securities-residential
  $ 21,767     $ 571     $ -     $ -     $ 22,338  
U.S. government agencies
    49,136       191       (19 )     -       49,308  
Common stocks
    33       13       -       -       46  
Collateralized mortgage obligations:
                                       
Issued or guaranteed by U.S. government agencies
    254,005       5,076       (333 )     -       258,748  
Non-agency
    1,042       -       (18 )     -       1,024  
Corporate bonds
    6,299       39       (107 )     -       6,231  
Municipal bonds
    3,623       1       (15 )     -       3,609  
Trust preferred securities
    9,375       1,940       -       -       11,315  
Other securities
    5,692       527       (383 )     -       5,836  
Total available for sale
  $ 350,972     $ 8,358     $ (875 )   $ -     $ 358,455  

 
- 13 -

 
 
The carrying value and fair value of investment securities AFS at December 31, 2011 are as follows:
 
         
Included in Accumulated Other
Comprehensive Income (AOCI)
       
               
Gross unrealized losses
       
(In thousands)
 
Amortized
cost
   
Gross
unrealized
gains
   
Non-OTTI
in AOCI
   
Non-credit
related OTTI
in AOCI
   
Fair value
 
Mortgage-backed  securities-residential
  $ 16,763     $ 309     $ (67 )   $ -     $ 17,005  
U.S. government agencies
    35,966       122       (4 )     -       36,084  
Common stocks
    130       118       -       -       248  
Collateralized mortgage obligations:
                                       
Issued or guaranteed by U.S. government agencies
    231,262       3,315       (543 )     -       234,034  
Non-agency
    4,739       94       (1 )     -       4,832  
Corporate bonds
    13,342       104       (471 )     -       12,975  
Municipal bonds
    985       -       (20 )             965  
Trust preferred securities
    13,665       2,280       -       -       15,945  
Other securities
    6,586       347       (15 )     -       6,918  
Total available for sale
  $ 323,438     $ 6,689     $ (1,121 )   $ -     $ 329,006  
 
The amortized cost and fair value of investment securities at September 30, 2012, by contractual maturity, are shown below.  Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
 
   
As of September 30, 2012
 
(In thousands)
 
Amortized
cost
   
Fair value
 
Within 1 year
  $ 100     $ 100  
After 1 but within 5 years
    6,199       6,275  
After 5 but within 10 years
    9,601       9,498  
After 10 years
    52,533       54,590  
Mortgage-backed  securities-residential
    21,767       22,338  
Collateralized mortgage obligations:
               
Issued or guaranteed by U.S. government agencies
    254,005       258,748  
Non-agency
    1,042       1,024  
Total available for sale debt securities
    345,247       352,573  
No contractual maturity
    5,725       5,882  
Total available for sale securities
  $ 350,972     $ 358,455  
 
Proceeds from the sales of investments AFS during the three months ended September 30, 2012 and 2011 were $15.2 million and $42.2 million, respectively.  Proceeds from the sales of investments AFS for the nine months ended September 30, 2012 and 2011 were $27.1 million and $112.7 million, respectively.  The following table summarizes gross gains and losses realized on the sale of securities recognized in earnings in the periods indicated:
 
   
For the three months
   
For the nine months
 
   
ended September 30,
   
ended September 30,
 
(In thousands)
 
2012
   
2011
   
2012
   
2011
 
Gross realized gains
  $ 225     $ 637     $ 565     $ 2,364  
Gross realized losses
    -       (173 )     (181 )     (799 )
Net realized gains
  $ 225     $ 464     $ 384     $ 1,565  

 
- 14 -

 
 
The Company evaluates securities for OTTI at least on a quarterly basis.  The Company assesses whether OTTI is present when the fair value of a security is less than its amortized cost.  All investment securities are evaluated for OTTI under FASB ASC Topic 320, “Investments-Debt & Equity Securities” (“ASC Topic 320”).  The non-agency collateralized mortgage obligations that are rated below AA are evaluated under FASB ASC Topic 325 Subtopic 40, “Beneficial Interests in Securitized Financial Assets” under FASB ASC Topic 325, “Investments-Other”.  In determining whether OTTI exists, management considers numerous factors, including but not limited to: (1) the length of time and the extent to which the fair value is less than the amortized cost, (2) the Company’s intent to hold or sell the security, (3) the financial condition and results of the issuer including changes in capital, (4) the credit rating of the issuer, (5) analysts earnings estimate, (6) industry trends specific to the security, and (7) timing of debt maturity and status of debt payments.
 
Under ASC Topic 320, OTTI is considered to have occurred with respect to debt securities (1) if an entity intends to sell the security; (2) if it is more likely than not an entity will be required to sell the security before recovery of its amortized cost basis; or (3) the present value of the expected cash flows is not sufficient to recover the entire amortized cost basis.  In addition, the amount of the OTTI recognized in earnings depends on whether an entity intends to sell or will more likely than not be required to sell the security.  If an entity intends to sell the security or will be required to sell the security, the OTTI shall be recognized in earnings equal to the entire difference between the fair value and the amortized cost basis at the balance sheet date.  If an entity does not intend to sell the security and it is not more likely than not that the entity will be required to sell the security before the recovery of its amortized cost basis, the OTTI shall be separated into two amounts, the credit-related loss and the noncredit-related loss. The credit-related loss is based on the present value of the expected cash flows and is recognized in earnings.  The noncredit-related loss is based on other factors such as illiquidity and is recognized in other comprehensive income.  
 
The following table summarizes OTTI losses on securities recognized in earnings in the periods indicated:
 
   
For the three months
   
For the nine months
 
   
ended September 30,
   
ended September 30,
 
(In thousands)
 
2012
   
2011
   
2012
   
2011
 
Trust preferred securities
  $ -     $ 1,415     $ -     $ 1,749  
Common stocks
    -       -       -       47  
Other securities
    -       -       859       -  
Total OTTI charges
  $ -     $ 1,415     $ 859     $ 1,796  
 
The following table presents a roll-forward of the balance of credit-related impairment losses on debt securities held at September 30, 2012 and 2011 for which a portion of OTTI was recognized in other comprehensive income:
 
(In thousands)
 
2012
   
2011
 
Balance at January 1,
  $ 173     $ 924  
Additional credit-related impairment loss on debt securities for which an other-than-temporary impairment was previously recognized
    -       334  
Reductions for securities for which the amount previously recognized in other comprehensive income was recognized in earnings because the Company does not expect to recover the entire amortized cost
    -       (1,085 )
Balance at September 30,
  $ 173     $ 173  

 
- 15 -

 
 
The tables below indicate the length of time individual securities have been in a continuous unrealized loss position at September 30, 2012 and December 31, 2011:
 
September 30, 2012
 
Less than 12 months
   
12 months or longer
   
Total
 
(In thousands)
 
Fair value
   
Gross
unrealized
losses
   
Fair value
   
Gross
unrealized
losses
   
Fair value
   
Gross
unrealized
l osses
 
U.S. government agencies
  $ 5,766     $ (19 )   $ -     $ -       5,766       (19 )
Collateralized mortgage obligations:
                                               
Issued or guaranteed by U.S. government agencies
    41,612       (311 )     2,649       (22 )     44,261       (333 )
Non-agency
    1,024       (18 )     -       -       1,024       (18 )
Corporate bonds
    1,984       (15 )     2,906       (92 )     4,890       (107 )
Municipal bonds
    1,579       (15 )     -       -       1,579       (15 )
Other securities
    1,513       (313 )     303       (70 )     1,816       (383 )
Total available-for-sale
  $ 53,478     $ (691 )   $ 5,858     $ (184 )   $ 59,336     $ (875 )

 
December 31, 2011
 
Less than 12 months
   
12 months or longer
   
Total
 
(In thousands)
 
Fair value
   
Gross
unrealized
losses
   
Fair value
   
Gross
unrealized
losses
   
Fair value
   
Gross
unrealized
losses
 
Mortgage-backed  securities-residential
  $ 9,588     $ (67 )   $ -     $ -     $ 9,588     $ (67 )
U.S. government agencies
    2,999       (1 )     3,996       (3 )     6,995       (4 )
Collateralized mortgage obligations:
                                               
Issued or guaranteed by U.S. government agencies
    35,511       (374 )     10,149       (169 )     45,660       (543 )
Non-agency
    -       -       669       (1 )     669       (1 )
Corporate bonds
    3,804       (197 )     3,751       (274 )     7,555       (471 )
Municipal bonds
    965       (20 )     -       -       965       (20 )
Other securities
    502       (15 )     -       -       502       (15 )
Total available-for-sale
  $ 53,369     $ (674 )   $ 18,565     $ (447 )   $ 71,934       (1,121 )
 
The AFS portfolio had gross unrealized losses of $875,000 and $1.1 million at September 30, 2012 and December 31, 2011, respectively.  For the nine months ended September 30, 2012, the Company recorded $859,000 in OTTI on a private equity real estate fund due to recently received fund financials. In determining the Company’s intent not to sell and it is not more likely than not that the Company will be required to sell the investments before recovery of their amortized cost basis, management considers the following factors: current liquidity and availability of other non-pledged assets that permits the investment to be held for an extended period of time but not necessarily until maturity, capital planning, and any specific investment committee goals or guidelines related to the disposition of specific investments.
 
Common stocks:   As of September 30, 2012, the Company owns common stock of two financial institutions with a total fair value of $46,000 and an unrealized gain of $13,000.  During the first quarter of 2012 the Company sold one common stock investment and recorded a gain of $112,000.
 
For all debt security types discussed below the fair value is based on prices provided by brokers and safekeeping custodians with the exception of trust preferred securities which are described below.
 
U.S. government-sponsored agencies (“US Agencies”):   As of September 30, 2012, the Company had two US Agency bonds with a fair value of $5.8 million and gross unrealized losses of $19,000.  The two US Agency bonds have been in an unrealized loss position for less than twelve months and are callable at par.  Management believes that the unrealized loss on these debt securities is a function of changes in investment spreads.  Management expects to recover the entire amortized cost basis of these securities.  The Company does not intend to sell the securities before recovery of the cost basis and will not more likely than not be required to sell these securities before recovery of the cost basis.  Therefore, management has determined that these two securities are not other-than-temporarily impaired at September 30, 2012.
 
 
- 16 -

 

U.S. government issued or sponsored collateralized mortgage obligations (“Agency CMOs”):   As of September 30, 2012, the Company had fourteen Agency CMOs with a fair value of $44.3 million and gross unrealized losses of $333,000. Thirteen of the Agency CMOs have been in an unrealized loss position for less than twelve months. The one Agency CMO that has been in an unrealized loss position for more than twelve months has a fair market value of $2.6 million and an unrealized loss of $22,000 at September 30, 2012.  The unrealized loss is attributable to a combination of factors, including relative changes in interest rates since the time of purchase.  The contractual cash flows for these securities are guaranteed by U.S. government agencies and U.S. government-sponsored enterprises. Based on its assessment of these factors, management believes that the unrealized losses on these debt securities are a function of changes in investment spreads and interest rate movements and not changes in credit quality.  Management expects to recover the entire amortized cost basis of these securities.  The Company does not intend to sell these securities before recovery of their cost basis and will not more likely than not be required to sell these securities before recovery of their cost basis.  Therefore, management has determined that these securities are not other-than-temporarily impaired at September 30, 2012.
 
Non-agency collateralized mortgage obligations (“Non-agency CMOs”):   As of September 30, 2012, the Company had one non-agency CMO with a fair value of $1.0 million and a gross unrealized loss of $18,000.  The non-agency CMO bond has been in an unrealized loss position for less than twelve months and is rated CCC. The Company evaluated the impairment to determine if it could expect to recover the entire amortized cost basis of the non-agency CMO bond by considering numerous factors including credit default rates, conditional prepayment rates, current and expected loss severities, delinquency rates, and geographic concentrations. The Company does not intend to sell the non-agency CMO and it is not more likely than not that the Company will be required to sell the investment before recovery of the amortized cost basis.  Therefore, the Company does not consider the bond to be other-than-temporarily impaired as of September 30, 2012.
 
Corporate bonds:   As of September 30, 2012, the Company had five corporate bonds with a fair value of $4.9 million and gross unrealized losses of $107,000.  Two bonds have been in an unrealized loss position for less than twelve months and three bonds have been in an unrealized loss position for more than twelve months.  All five bonds are above investment grade.  The Company’s unrealized losses in investments in corporate bonds represent interest rate risk and not credit risk of the underlying issuers. As previously mentioned management also considered (1) the length of time and the extent to which the fair value is less than the amortized cost, (2) the Company’s intent to hold or sell the security, (3) the financial condition and results of the issuer including changes in capital, (4) the credit rating of the issuer, (5) analysts earnings estimate, (6) industry trends specific to the security, and (7) timing of debt maturity and status of debt payments.  Management utilized discounted cash flow analysis based upon the credit ratings of the securities, liquidity risk premiums, and the recent corporate spreads for similar securities as required under ASC Topic 320 to determine the credit risk component of the corporate bonds.  Based on these analyses, there was no credit-related loss on the five bonds. Because the Company does not intend to sell the corporate bonds and it is not more likely than not that the Company will be required to sell the bonds before recovery of their amortized cost basis, which may be maturity, the Company does not consider the five bonds to be other-than-temporarily impaired at September 30, 2012.
 
Municipal bonds:   As of September 30, 2012, the Company had three municipal bonds with a fair value of $1.6 million and gross unrealized losses of $15,000.  The municipal bonds have been in an unrealized loss position for less than twelve months and are investment grade. Because the Company does not intend to sell the bonds and it is not more likely than not that the Company will be required to sell the bonds before recovery of its amortized cost basis, which may be maturity, the Company does not consider the bonds to be other-than-temporarily impaired at September 30, 2012.
 
Other securities:   As of September 30, 2012, the Company had seven investments in private equity funds which were predominantly invested in real estate.  During the second quarter of 2012, the Company recorded a non-credit related OTTI charge of $859,000 in earnings on one of the funds. After reviewing the fund’s most recent financials, management concluded that the fund was other-than-temporarily impaired.  As of September 30, 2012, three other private equity real estate funds had a fair value of $1.8 million and an unrealized loss of $383,000.  Two of the funds have been in an unrealized loss position for less than twelve months and the other fund has been in an unrealized loss position for more than twelve months. OTTI charges were recorded in a prior period on two of these funds.  After reviewing the funds’ financials, net equity values, and its near-term projections, management concluded that there was no additional impairment during the first nine months of 2012.
 
The Company will continue to monitor these investments to determine if the discounted cash flow analysis, continued negative trends, market valuations or credit defaults result in impairment that is other-than-temporary.
 
 
- 17 -

 

Note 4.
Loans and Leases
 
Major classifications of loans and leases held for investment (“LHFI”) are as follows:
 
   
September 30,
   
December 31,
 
(In thousands)
 
2012
   
2011
 
Commercial and industrial
  $ 39,831     $ 54,136  
Construction
    6,293       14,066  
Land development
    33,987       40,054  
Residential real estate
    26,100       26,637  
Commercial real estate
    161,834       182,579  
Multi-family
    8,490       11,622  
Tax certificates
    27,622       48,809  
Leases
    38,313       36,014  
Other
    1,094       949  
Total gross loans
  $ 343,564     $ 414,866  
Deferred fees, net
    (515 )     (623 )
Total loans and leases
  $ 343,049     $ 414,243  
 
The Company grants commercial and real estate loans, including construction and land development loans primarily in the greater Philadelphia metropolitan area as well as selected locations throughout the mid-Atlantic region.  The Company also has participated with other financial institutions in selected construction and land development loans outside our geographic area. The Company has a concentration of credit risk in commercial real estate, construction and land development loans at September 30, 2012.  A substantial portion of its debtors’ ability to honor their contracts is dependent upon the housing sector specifically and the economy in general.
 
Loans and leases are classified as LHFI when management has the intent and ability to hold the loan or lease for the foreseeable future or until maturity or payoff.  LHFI are stated at their outstanding unpaid principal balances, net of an allowance for loan and leases losses and any deferred fees or costs. Interest income is accrued on the unpaid principal balance. Loan origination fees, net of certain direct origination costs, are deferred and recognized as an adjustment of the yield (interest income) of the related loans. The Company is generally amortizing these amounts over the contractual life of the loan.
 
At September 30, 2012 and December 31, 2011, the Company had $2.7 million and $12.6 million; respectively, in non-accrual LHFS. These loans were transferred from LHFI at the lower of cost or fair market value using expected net sales proceeds.  During the third quarter, the Company recorded an $856,000 impairment charge on the one LHFS at September 30, 2012.  During the first nine months of 2012, the Company sold five loans and received proceeds of $11.0 million and recorded gains of $2.0 million as a result of these sales.
 
The Company classifies its leases as finance leases, in accordance with FASB ASC Topic 840, “Leases”. The difference between the Company’s gross investment in the lease and the cost or carrying amount of the leased property, if different, is recorded as unearned income, which is amortized to income over the lease term by the interest method.
 
The Company uses a nine point grading risk classification system commonly used in the financial services industry as the credit quality indicator.  The first four classifications are rated Pass.  The riskier classifications include Pass-Watch, Special Mention, Substandard, Doubtful and Loss.  The risk rating is related to the underlying credit quality and probability of default.  These risk ratings are used to calculate the historical loss component of the allowance for loan and lease losses (“ALLL”).
 
 
- 18 -

 
 
 
·
Pass: includes credits that demonstrate a low probability of default;
 
 
·
Pass-Watch: a warning classification which includes credits that are beginning to demonstrate above average risk through declining earnings, strained cash flows, increased leverage and/or weakening market fundamentals;
 
 
·
Special mention: includes credits that have potential weaknesses that if left uncorrected could weaken the credit or result in inadequate protection of the Company’s position at some future date. While potentially weak, credits in this classification are marginally acceptable and loss of principal or interest is not anticipated;
 
 
·
Substandard accrual: includes credits that exhibit a well-defined weakness which currently jeopardizes the repayment of debt and liquidation of collateral even though they are currently performing. These credits are characterized by the distinct possibility that the Company may incur a loss in the future if these weaknesses are not corrected;
 
 
·
Non-accrual: (substandard non-accrual, doubtful, loss)-includes credits that demonstrate serious problems to the point that it is probable that interest and principal will not be collected according to the contractual terms of the loan agreement.
 
All loans, at the time of presentation to the appropriate loan committee, are given an initial loan risk rating by the Chief Credit Officer (“CCO”). From time to time, and at the general direction of any of the various loan committees, the ratings may be changed based on the findings of that committee. Items considered in assigning ratings include the financial strength of the borrower and/or guarantors, the type of collateral, the collateral lien position, the type of loan and loan structure, any potential risk inherent in the specific loan type, higher than normal monitoring of the loan or any other factor deemed appropriate by any of the various committees for changing the rating of the loan. Any such change in rating is reflected in the minutes of that committee.
 
The following tables present risk ratings for each loan portfolio segment at September 30, 2012 and December 31, 2011, excluding LHFS.
 
September 30, 2012
             
Special
                   
(In thousands)
 
Pass
   
Pass-Watch
   
Mention
   
Substandard
   
Non-accrual
   
Total
 
Construction and land development
  $ 1,136     $ 15,991     $ 16,846     $ 580     $ 5,727     $ 40,280  
Commercial real estate
    65,874       68,736       13,056       2,355       11,813       161,834  
Commercial & industrial
    13,400       10,706       10,218       89       5,418       39,831  
Residential real estate
    15,222       7,344       2,261       -       1,273       26,100  
Multi-family
    5,671       2,105       714       -       -       8,490  
Leases
    37,588       485       66       -       174       38,313  
Other
    930       164       -       -       -       1,094  
Tax certificates
    26,906       -       -       -       716       27,622  
Subtotal LHFI
    166,727       105,531       43,161       3,024       25,121       343,564  
Less: Deferred loan fees
                                            (515 )
Total LHFI
                                          $ 343,049  

 
- 19 -

 
 
December 31, 2011
             
Special
                   
(In thousands)
 
Pass
   
Pass-Watch
   
Mention
   
Substandard
   
Non-accrual
   
Total
 
Construction and land development
  $ 1,303     $ 17,493     $ 19,936     $ 2,374     $ 13,014     $ 54,120  
Commercial real estate
    87,308       64,878       13,722       -       16,671       182,579  
Commercial & industrial
    19,073       12,101       18,242       -       4,720       54,136  
Residential real estate
    15,335       9,092       1,071       -       1,139       26,637  
Multi-family
    4,962       3,907       1,050       -       1,703       11,622  
Leases
    35,355       147       27       -       485       36,014  
Other
    847       102       -       -       -       949  
Tax certificates
    47,786       -       -       -       1,023       48,809  
Subtotal LHFI
    211,969       107,720       54,048       2,374       38,755       414,866  
Less: Deferred loan fees
                                            (623 )
Total LHFI
                                          $ 414,243  
 
The past due status of all classes of loans and leases receivable is determined based on contractual due dates for loan payments.   Generally, a loan is placed on non-accruing status when it has been delinquent for a period of 90 days or more.  The following tables present an aging analysis of past due payments for each loan portfolio segment at September 30, 2012 and December 31, 2011, excluding LHFS.
 
September 30, 2012
 
30-59 Days
   
60-89 Days
   
Accruing
   
Total
             
(In thousands)
 
Past Due
   
Past Due
   
90+ Days
   
Non-accrual
   
Current
   
Total
 
Construction and land development
  $ -     $ -     $ -     $ 5,727     $ 34,553     $ 40,280  
Commercial real estate
    1,066       -       -       11,813       148,955       161,834  
Commercial & industrial
    -       -       -       5,418       34,413       39,831  
Residential real estate
    379       148       -       1,273       24,300       26,100  
Multi-family
    -       -       -       -       8,490       8,490  
Leases
    485       65       -       174       37,589       38,313  
Other
    -       -       -       -       1,094       1,094  
Tax certificates
    -       -       -       716       26,906       27,622  
Subtotal LHFI
    1,930       213       -       25,121       316,300       343,564  
Less: Deferred loan fees
                                            (515 )
Total LHFI
                                          $ 343,049  
 
December 31, 2011
 
30-59 Days
   
60-89 Days
   
Accruing
   
Total
             
(In thousands)
 
Past Due
   
Past Due
   
90+ Days
   
Non-accrual
   
Current
   
Total
 
Construction and land development
  $ -     $ -     $ -     $ 13,014     $ 41,106     $ 54,120  
Commercial real estate
    2,837       100       -       16,671       162,971       182,579  
Commercial & industrial
    148       -       -       4,720       49,268       54,136  
Residential real estate
    527       382       -       1,139       24,589       26,637  
Multi-family
    -       -       -       1,703       9,919       11,622  
Leasing
    147       28       -       485       35,354       36,014  
Other
    -       -       -       -       949       949  
Tax certificates
    -       -       -       1,023       47,786       48,809  
Subtotal LHFI
    3,659       510       -       38,755       371,942       414,866  
Less: Deferred loan fees
                                            (623 )
Total LHFI
                                          $ 414,243  

 
- 20 -

 
 
The following tables detail the composition of the non-accrual loans at September 30, 2012 and December 31, 2011.
 
   
September 30, 2012
   
December 31, 2011
 
(In thousands)
 
Loan
balance
   
Specific
reserves
   
Loan
balance
   
Specific
reserves
 
Non-accrual loans held for investment
                       
Construction and land development
  $ 5,727     $ 1,210     $ 13,014     $ -  
Commercial real estate
    11,813       1,313       16,671       -  
Commercial & industrial
    5,418       222       4,720       -  
Residential real estate
    1,273       22       1,139       24  
Multi-family
    -       -       1,703       -  
Leases
    174       41       485       114  
Tax certificates
    716       -       1,023       -  
Total non-accrual LHFI
  $ 25,121     $ 2,808     $ 38,755     $ 138  
Non-accrual loans held for sale
                               
Construction and land development
  $ -     $ -     $ 8,901     $ -  
Commercial real estate
    2,718       -       3,634       -  
Residential real estate
    -       -       34       -  
Total non-accrual LHFS
  $ 2,718     $ -     $ 12,569     $ -  
Total non-accrual loans
  $ 27,839     $ 2,808     $ 51,324     $ 138  
 
Total non-accrual loans at September 30, 2012 were $27.8 million and were comprised of $25.1 million in LHFI and $2.7 million in LHFS.  Total non-accrual loans at December 31, 2011 were $51.3 million and were comprised of $38.7 million in LHFI and $12.6 million in LHFS.   The $23.5 million decrease was the result of a $17.4 million reduction in existing non-accrual loan balances through payments and sales, $10.5 million in transfers to OREO, and $3.7 million in charge-offs and write downs partially offset by additions of $8.1 million in non-accrual LHFI.  There was one commercial loan for $2.7 million that went non-accrual during the first quarter of 2012 and $3.7 million in tax certificates that went non-accrual and were then transferred to OREO during the first nine months of 2012.  If interest had been accrued, such income would have been approximately $653,000 and $2.4 million for the three and nine months ended September 30, 2012, respectively.  The Company had no loans past due 90 days or more on which it has continued to accrue interest during the quarter.   Typically, loans are restored to accrual status when the loan is brought current, has performed in accordance with the contractual terms for a reasonable period of time (generally six months) and the ultimate collectibility of the total contractual principal and interest is no longer in doubt.
 
Impaired Loans
 
The Company identifies a loan as impaired when it is probable that interest and principal will not be collected according to the contractual terms of the loan agreement.  The Company does not accrue interest income on impaired non-accrual loans. Excess proceeds received over the principal amounts due on impaired non-accrual loans are recognized as income on a cash basis.
 
Total cash collected on impaired loans, which includes LHFS, during the nine months ended September 30, 2012 and 2011 was $22.3 million and $16.3 million respectively, of which $20.1 million and $16.3 million was credited to the principal balance outstanding on such loans, respectively.
 
 
- 21 -

 

The following is a summary of information pertaining to impaired loans:
 
   
September 30,
   
December 31,
 
(In thousands)
 
2012
   
2011
 
Impaired loans with a valuation allowance
  $ 14,718     $ 1,068  
Impaired loans without a valuation allowance
    12,727       45,009  
Impaired LHFS
    2,718       12,569  
Total impaired loans
  $ 30,163     $ 58,646  
                 
Valuation allowance related to impaired loans
  $ 2,808     $ 138  
 
Troubled Debt Restructurings
 
A loan modification is deemed a troubled debt restructuring (“TDR”) when two conditions are met: 1) the borrower is experiencing financial difficulty and 2) concessions are made by the Company that would not otherwise be considered for a borrower or collateral with similar credit risk characteristics.  If in modifying a loan the Company, for economic or legal reasons related to a borrower’s financial difficulties, grants a concession it would not normally consider then the loan modification is classified as a TDR. All loans classified as TDRs are considered to be impaired.  TDRs are returned to an accrual status when the loan is brought current, has performed in accordance with the contractual restructured terms for a reasonable period of time (generally six months) and the ultimate collectibility of the total contractual restructured principal and interest is no longer in doubt.  At September 30, 2012, the Company had nine TDRs, of which six are on non-accrual status, with a total carrying value of $8.6 million.  At the time of the modifications, six of the loans were already classified as impaired loans.   At December 31, 2011, the Company had twelve TDRs with a total carrying value of $14.2 million.  The Company’s policy for TDRs is to recognize income on currently performing restructured loans under the accrual method.  During 2012, the Company sold two of the TDRs and received $980,000 in proceeds.  During the third quarter of 2012, the Company negotiated the payoffs of two TDRs and collected $2.9 million after recording a charge-off of $541,000.  There was one new TDR for the third quarter ended September 30, 2012.  The Company did not have any new TDRs during the first two quarters of 2012.
 
The following table details the Company’s TDRs that are on an accrual status and a non-accrual status at September 30, 2012.
 
(In thousands)
 
Number of
loans
   
Accrual
Status
   
Non-
Accrual
Status
   
Total
TDRs
 
                         
Construction and land development
    4     $ 1,826     $ 920     $ 2,746  
Commercial real estate
    2       620       2,503       3,123  
Commercial & industrial
    1       -       2,538       2,538  
Residential real estate
    2       -       157       157  
Total
    9     $ 2,446     $ 6,118     $ 8,564  
 
The following tables present newly restructured loans that occurred during the three and nine months ended September 30, 2012.
 
   
Modification by type for the three and nine months ended September 30, 2012
 
(Dollars in thousands)
 
Number of
loans
   
Rate
   
Term
   
Payment
   
Combination
of Types
   
Total
   
Pre-Modification
Outstanding
Recorded
Investment
   
Post-Modification
Outstanding
Recorded
Investment
 
Construction and land development
    1     $ -     $ -     $ -     $ 290     $ 290     $ 290     $ 290  

 
- 22 -

 
 
At September 30, 2012, all of the TDRs were in compliance with their restructured terms.
 
Note 5.
Allowance for Loan and Lease Losses
 
The following tables present the detail of the ALLL and the loan portfolio disaggregated by loan portfolio segment (before net deferred fees) for the three and nine months ended September 30, 2012, the year ended December 31, 2011 and the three and nine months ended September 30, 2011.
 
Allowance for Loan and Leases Losses and Loans Held for Investment
 
For the three months ended September 30, 2012
 
(In thousands)
 
Commercial
real estate
   
Construction
and land
development
   
Commercial
& industrial
   
Multi-
family
   
Residential
real estate
   
Other
   
Leases
   
Tax
certificates
   
Unallocated
   
Total
 
Allowance for Loan and Leases Losses
                                                           
Beginning balance
  $ 7,679     $ 3,738     $ 2,206     $ 946     $ 1,125     $ 20     $ 1,212     $ 332     $ 237     $ 17,495  
Charge-offs
    -       (1,242 )     (156 )     (541 )     (30 )     -       (82 )     (29 )     -       (2,080 )
Recoveries
    -       232       3       -       -       -       6       -       -       241  
Provision
    1,009       753       (103 )     101       17       6       13       (35 )     -       1,761  
Ending balance
  $ 8,688     $ 3,481     $ 1,950     $ 506     $ 1,112     $ 26     $ 1,149     $ 268     $ 237     $ 17,417  
Ending balance: related to loans individually evaluated for impairment
  $ 1,313     $ 1,210     $ 222     $ -     $ 22     $ -     $ 41     $ -     $ -     $ 2,808  
Ending balance: related to loans collectively evaluated for impairment
  $ 7,375     $ 2,271     $ 1,728     $ 506     $ 1,090     $ 26     $ 1,108     $ 268     $ 237     $ 14,609  
LHFI
                                                                               
Ending balance
  $ 161,834     $ 40,280     $ 39,831     $ 8,490     $ 26,100     $ 1,094     $ 38,313     $ 27,622     $ -     $ 343,564  
Ending balance: individually evaluated for impairment
  $ 13,493     $ 7,552     $ 5,507     $ -     $ 1,273     $ -     $ 52     $ 716     $ -     $ 28,593  
Ending balance: collectively evaluated for impairment
  $ 148,341     $ 32,728     $ 34,324     $ 8,490     $ 24,827     $ 1,094     $ 38,261     $ 26,906     $ -     $ 314,971  
 
Allowance for Loan and Leases Losses and Loans Held for Investment
 
For the nine months ended September 30, 2012
 
(In thousands)
 
Commercial
real estate
   
Construction
and land
development
   
Commercial
& industrial
   
Multi-
family
   
Residential
real estate
   
Other
   
Leases
   
Tax
certificates
   
Unallocated
   
Total
 
Allowance for Loan and Leases Losses
                                                           
Beginning balance
  $ 7,744     $ 2,523     $ 2,331     $ 531     $ 1,188     $ 20     $ 1,311     $ 425     $ 307     $ 16,380  
Charge-offs
    -       (1,242 )     (364 )     (541 )     (30 )     -       (377 )     (307 )     -       (2,861 )
Recoveries
    3       423       60       -       2       -       22       28       -       538  
Provision
    941       1,777       (77 )     516       (48 )     6       193       122       (70 )     3,360  
Ending balance
  $ 8,688     $ 3,481     $ 1,950     $ 506     $ 1,112     $ 26     $ 1,149     $ 268     $ 237     $ 17,417  
Ending balance: related to loans individually evaluated for impairment
  $ 1,313     $ 1,210     $ 222     $ -     $ 22     $ -     $ 41     $ -     $ -     $ 2,808  
Ending balance: related to loans collectively evaluated for impairment
  $ 7,375     $ 2,271     $ 1,728     $ 506     $ 1,090     $ 26     $ 1,108     $ 268     $ 237     $ 14,609  
LHFI
                                                                               
Ending balance
  $ 161,834     $ 40,280     $ 39,831     $ 8,490     $ 26,100     $ 1,094     $ 38,313     $ 27,622     $ -     $ 343,564  
Ending balance: individually evaluated for impairment
  $ 13,493     $ 7,552     $ 5,507     $ -     $ 1,273     $ -     $ 52     $ 716     $ -     $ 28,593  
Ending balance: collectively evaluated for impairment
  $ 148,341     $ 32,728     $ 34,324     $ 8,490     $ 24,827     $ 1,094     $ 38,261     $ 26,906     $ -     $ 314,971  

 
- 23 -

 
 
Allowance for Loan and Leases Losses and Loans Held for Investment
 
For the year ended December 31, 2011
 
(In thousands)
 
Commercial
real estate
   
Construction
and land
development
   
Commercial
& industrial
   
Multi-
family
   
Residential
real estate
   
Other
   
Leases
   
Tax
certificates
   
Unallocated
   
Total
 
Allowance for Loan and Leases Losses
                                                           
Beginning balance
  $ 9,534     $ 3,976     $ 3,797     $ 652     $ 1,106     $ 12     $ 1,670     $ 380     $ 2     $ 21,129  
Charge-offs
    (1,685 )     (5,755 )     (2,901 )     (328 )     (635 )     -       (868 )     (1,039 )     -       (13,211 )
Recoveries
    357       196       22       -       153       -       6       -       -       734  
Provision
    (462 )     4,106       1,413       207       564       8       503       1,084       305       7,728  
Ending balance
  $ 7,744     $ 2,523     $ 2,331     $ 531     $ 1,188     $ 20     $ 1,311     $ 425     $ 307     $ 16,380  
Ending balance: related to loans individually evaluated for impairment
  $ -     $ -     $ -     $ -     $ 24     $ -     $ 114     $ -     $ -     $ 138  
Ending balance: related to loans collectively evaluated for impairment
  $ 7,744     $ 2,523     $ 2,331     $ 531     $ 1,164     $ 20     $ 1,197     $ 425     $ 307     $ 16,242  
LHFI
                                                                               
Ending balance
  $ 182,579     $ 54,120     $ 54,136     $ 11,622     $ 26,637     $ 949     $ 36,014     $ 48,809     $ -     $ 414,866  
Ending balance: individually evaluated for impairment
  $ 17,311     $ 17,368     $ 7,267     $ 1,703     $ 1,139     $ -     $ 266     $ 1,023     $ -     $ 46,077  
Ending balance: collectively evaluated for impairment
  $ 165,268     $ 36,752     $ 46,869     $ 9,919     $ 25,498     $ 949     $ 35,748     $ 47,786     $ -     $ 368,789  
 
Allowance for Loan and Leases Losses and Loans Held for Investment
 
For the three months ended September 30, 2011
 
(In thousands)
 
Commercial
real estate
   
Construction
and land
development
   
Commercial
& industrial
   
Multi-
family
   
Residential
   
Other
   
Leasing
   
Tax
certificates
   
Unallocated
   
Total
 
Allowance for Loan and Leases Losses
                                                           
Beginning balance
  $ 8,190     $ 4,788     $ 1,898     $ 449     $ 1,141     $ 13     $ 1,826     $ 641     $ 668     $ 19,614  
Charge-offs
    -       (1,471 )     (114 )     -       (43 )     -       (326 )     (446 )     -       (2,400 )
Recoveries
    108       120       5       -       1       -       1       -       -       235  
Provision
    (56 )     (655 )     536       103       66       9       38       249       138       428  
Ending balance
  $ 8,242     $ 2,782     $ 2,325     $ 552     $ 1,165     $ 22     $ 1,539     $ 444     $ 806     $ 17,877  
Ending balance: related to loans individually evaluated for impairment
  $ -     $ -     $ 430     $ -     $ 24     $ -     $ 204     $ 105     $ -     $ 763  
Ending balance: related to loans collectively evaluated for impairment
  $ 8,242     $ 2,782     $ 1,895     $ 552     $ 1,141     $ 22     $ 1,335     $ 339     $ 806     $ 17,114  
LHFI
                                                                               
Ending balance
  $ 181,308     $ 55,448     $ 57,148     $ 11,998     $ 27,529     $ 1,247     $ 35,758     $ 53,513     $ -     $ 423,949  
Ending balance: individually evaluated for impairment
  $ 9,676     $ 14,002     $ 12,425     $ 1,717     $ 1,433     $ -     $ 293     $ 1,387     $ -     $ 40,933  
Ending balance: collectively evaluated for impairment
  $ 171,632     $ 41,446     $ 44,723     $ 10,281     $ 26,096     $ 1,247     $ 35,465     $ 52,126     $ -     $ 383,016  
 
Allowance for Loan and Leases Losses and Loans Held for Investment
 
For the nine months ended September 30, 2011
 
(In thousands)
 
Commercial
real estate
   
Construction
and land
development
   
Commercial
& industrial
   
Multi-
family
   
Residential
   
Other
   
Leasing
   
Tax
certificates
   
Unallocated
   
Total
 
Allowance for Loan and Leases Losses
                                                           
Beginning balance
  $ 9,534     $ 3,976     $ 3,797     $ 652     $ 1,106     $ 12     $ 1,670     $ 380     $ 2     $ 21,129  
Charge-offs
    (1,685 )     (5,120 )     (666 )     (329 )     (550 )     -       (635 )     (489 )     -       (9,474 )
Recoveries
    357       132       8       -       152       -       4       1       -       654  
Provision
    36       3,794       (814 )     229       457       10       500       552       804       5,568  
Ending balance
  $ 8,242     $ 2,782     $ 2,325     $ 552     $ 1,165     $ 22     $ 1,539     $ 444     $ 806     $ 17,877  
Ending balance: related to loans individually evaluated for impairment
  $ -     $ -     $ 430     $ -     $ 24     $ -     $ 204     $ 105     $ -     $ 763  
Ending balance: related to loans collectively evaluated for impairment
  $ 8,242     $ 2,782     $ 1,895     $ 552     $ 1,141     $ 22     $ 1,335     $ 339     $ 806     $ 17,114  
LHFI
                                                                               
Ending balance
  $ 181,308     $ 55,448     $ 57,148     $ 11,998     $ 27,529     $ 1,247     $ 35,758     $ 53,513     $ -     $ 423,949  
Ending balance: individually evaluated for impairment
  $ 9,676     $ 14,002     $ 12,425     $ 1,717     $ 1,433     $ -     $ 293     $ 1,387     $ -     $ 40,933  
Ending balance: collectively evaluated for impairment
  $ 171,632     $ 41,446     $ 44,723     $ 10,281     $ 26,096     $ 1,247     $ 35,465     $ 52,126     $ -     $ 383,016  

 
- 24 -

 
 
The following tables detail the loans that were evaluated for impairment by loan segment at September 30, 2012 and December 31, 2011.
 
   
For the nine months ended September 30, 2012
 
(In thousands)
 
Unpaid
principal
balance
   
Carrying
value
   
Related
allowance
   
Average
recorded
investment
   
Interest
income
recognized
 
With no related allowance recorded:
                             
Construction and land development
  $ 7,661     $ 4,435     $ -     $ 11,480     $ 161  
Commercial real estate
    5,003       3,419       -       12,206       59  
Commercial & industrial
    9,733       3,613       -       5,503       38  
Residential real estate
    3,892       544       -       478       21  
Multi-family
    -       -       -       1,014       -  
Tax certificates
    4,522       716       -       641       -  
Total:
  $ 30,811     $ 12,727     $ -     $ 31,322     $ 279  
With an allowance recorded:
                                       
Construction and land development
  $ 5,077     $ 1,907     $ 1,210     $ 952     $ -  
Commercial real estate
    9,560       7,702       1,313       901       -  
Commercial & industrial
    2,500       1,583       222       1,833       -  
Residential real estate
    1,013       707       22       757       7  
Multi-family
    -       -       -       498       -  
Leasing
    52       11       41       90       -  
Tax certificates
    -       -       -       314       -  
Total:
  $ 18,202     $ 11,910     $ 2,808     $ 5,345     $ 7  
 
   
For the year ended December 31, 2011
 
(In thousands)
 
Unpaid
principal
balance
   
Carrying
value
   
Related
allowance
   
Average
recorded
investment
   
Interest
income
recognized
 
With no related allowance recorded:
                             
Construction and land development
  $ 24,183     $ 17,368     $ -     $ 13,331     $ 84  
Commercial real estate
    19,513       17,311       -       7,732       33  
Commercial & industrial
    14,368       7,267       -       8,257       77  
Residential real estate
    3,645       337       -       950       -  
Multi-family
    1,888       1,703       -       1,760       -  
Tax certificates
    4,658       1,023       -       171       -  
Total:
  $ 68,255     $ 45,009     $ -     $ 32,201     $ 194  
With an allowance recorded:
                                       
Construction and land development
  $ -     $ -     $ -     $ 4,514     $ -  
Commercial real estate
    -       -       -       2,642       -  
Commercial & industrial
    -       -       -       1,394       -  
Residential real estate
    1,048       778       24       915       1  
Multi-family
    -       -       -       245       -  
Leases
    266       152       114       348       -  
Tax certificates
    -       -       -       1,423       -  
Total:
  $ 1,314     $ 930     $ 138     $ 11,481     $ 1  
 
 
- 25 -

 

Note 6.
Other Real Estate Owned
 
Other real estate owned (“OREO”) increased $1.1 million from $21.0 million at December 31, 2011 to $22.1 million at September 30, 2012.  Set forth below is a table which details the changes in OREO from December 31, 2011 to September 30, 2012.
 
   
2012
 
(In thousands)
 
First Quarter
   
Second Quarter
   
Third Quarter
 
Beginning balance
  $ 21,016     $ 24,304     $ 23,727  
Net proceeds from sales
    (4,531 )     (922 )     (907 )
Net gain (loss) on sales
    (138 )     255       228  
Assets acquired on non-accrual loans
    8,010       1,086       1,396  
Impairment charge
    (53 )     (996 )     (2,364 )
Ending balance
  $ 24,304     $ 23,727     $ 22,080  
 
At September 30, 2012, OREO is comprised of $10.3 million in land, a $4.3 million multi-family property, which is under an agreement of sale, $4.0 million in commercial real estate, $2.9 million in tax liens and single family homes with a fair value of $527,000.  During the third quarter of 2012, the Company sold collateral related to two loans.  The Company received net proceeds of $35,000 and recorded a loss of $2,000 as a result of these sales.   In addition to the sales mentioned above the Company sold eleven properties acquired through the tax lien portfolio.  The Company received proceeds of $872,000 and recorded net gains of $230,000 as a result of these sales.  During the third quarter of 2012, the Company recorded impairment charges of $2.3 million on five properties based on annual updated appraisals and $54,000 related to properties acquired through the tax lien portfolio.  In addition the Company acquired collateral related to the tax lien portfolio and transferred $1.4 million to OREO.
 
During the second quarter of 2012, the Company sold collateral related to four loans.  The Company received net proceeds of $433,000 and recorded a gain of $133,000 as a result of these sales. In addition to the sales mentioned above the Company sold seven properties acquired through the tax lien portfolio.  The Company received proceeds of $489,000 and recorded gains of $122,000 as a result of these sales.  During the second quarter of 2012, the Company recorded impairment charges of $442,000 on two properties based on expected net sales proceeds and $554,000 related to properties acquired through the tax lien portfolio.  In addition the Company acquired collateral related to the tax lien portfolio and transferred $1.1 million to OREO.
 
During the first quarter of 2012, the Company foreclosed on and sold collateral related to one commercial real estate loan.  The Company received net proceeds of $4.1 million and recorded a gain of $36,000. Additionally the Company sold eight single family homes related to three loans.  The Company received net proceeds of $104,000 and recorded a small net gain of $3,000.  As a result of these sales the Company recorded an impairment charge of $44,000 on the remaining collateral for two of these loans.  In addition to the sales mentioned above, the Company sold ten properties acquired through the tax lien portfolio.  The Company received proceeds of $332,000 and recorded a net loss of $177,000 as a result of these sales.   During the first quarter of 2012, the collateral for a completed hotel and condominium construction project in Minneapolis, Minnesota, in which the Company is a participant, was foreclosed on by the lead lender.  The Company transferred the fair value of $3.2 million to OREO which represents the Company’s participation rate of approximately 7.5%. The Company had previously recorded total charge-offs of $1.5 million to the allowance for loan and lease losses during the period the participation loan was non-accrual.  In addition the Company acquired collateral related to the tax lien portfolio and transferred $789,000 to OREO.   The Company recorded impairment charges of $9,000 related to properties acquired through the tax lien portfolio.
 
 
- 26 -

 

Note 7.
Deposits
 
The Company’s deposit composition as of September 30, 2012 and December 31, 2011 is presented below:
 
    September 30,     December 31,  
    2012     2011  
Demand
  $ 59,262     $ 54,534  
NOW
    39,776       43,172  
Money Market
    178,529       182,830  
Savings
    17,103       16,263  
Time deposits (over $100)
    99,716       95,334  
Time deposits (under $100)
    176,864       177,960  
Brokered deposits
    -       5,823  
Total deposits
  $ 571,250     $ 575,916  
 
Note 8.
Borrowings and Subordinated Debentures
 
1.  
Advances from the Federal Home Loan Bank
 
Total advances from the FHLB were $65.0 million at September 30, 2012 compared to $104.2 million at December 31, 2011.  Royal Bank has a $150.0 million line of credit with the FHLB of which $0.0 million was outstanding as of September 30, 2012.  The FHLB advances and the line of credit are collateralized by FHLB stock, government agencies and mortgage-backed securities, residential loans, and commercial real estate loans.  The available borrowing capacity is based on qualified collateral.  Royal Bank has a collateralized delivery requirement of 105% with the FHLB due to the level of Royal Bank’s non-performing assets and net losses.  The available amount for future borrowings will be based on the amount of collateral to be pledged.
 
Presented below are the Company’s FHLB borrowings allocated by the year in which they mature with their corresponding weighted average rates:
 
   
As of September 30,
   
As of December 31,
 
(Dollars in thousands)
 
2012
   
2011
 
   
Amount
   
Rate
   
Amount
   
Rate
 
Advances maturing in
                       
2012
  $ -       -     $ 52,000       2.64 %
2013
    50,000       2.64 %     50,000       2.64 %
2017
    15,000       1.39 %     -       -  
Amortizing advance, due April 2012, requiring monthly principal and interest of $558,400
    -               2,218       3.46 %
Total FHLB borrowings
  $ 65,000             $ 104,218          
 
As of September 30, 2012, there were no FHLB advances scheduled to mature during the years 2014 through 2016.
 
2.  
Other borrowings
 
The Company has a note payable with PNC Bank (“PNC”) at September 30, 2012 in the amount of $3.4 million compared to $3.8 million at December 31, 2011.  The note’s maturity date is August 25, 2016.  The interest rate is a variable rate using rate index of one month LIBOR + 15 basis points and adjusts monthly.  The interest rate at September 30, 2012 was 0.37%.
 
 
- 27 -

 

At September 30, 2012 and December 31, 2011, the Company had additional borrowings of $40.0 million from PNC which will mature on January 7, 2018.    These borrowings have a weighted average interest rate of 3.65%. The note payable and the borrowings are secured by government agencies and mortgage-backed securities.
 
3.  
Subordinated debentures
 
The Company has outstanding $25.0 million of Trust Preferred Securities issued through two Delaware trust affiliates, Royal Bancshares Capital Trust I (“Trust I”) and Royal Bancshares Capital Trust II (“Trust II”) (collectively, the “Trusts”).  The Company issued an aggregate principal amount of $12.9 million of floating rate junior subordinated debt securities to Trust I and an aggregate principal amount of $12.9 million of fixed/floating rate junior subordinated deferrable interest to Trust II.  Both debt securities bear an interest rate of 2.54% at September 30, 2012, and reset quarterly at 3-month LIBOR plus 2.15%.
 
Each of Trust I and Trust II issued an aggregate principal amount of $12.5 million of capital securities initially bearing fixed and/or fixed/floating interest rates corresponding to the debt securities held by each trust to an unaffiliated investment vehicle and an aggregate principal amount of $387,000 of common securities bearing fixed and/or fixed/floating interest rates corresponding to the debt securities held by each trust to the Company.  The Company has fully and unconditionally guaranteed all of the obligations of the Trusts, including any distributions and payments on liquidation or redemption of the capital securities.
 
On August 13, 2009, the Company’s Board determined to suspend interest payments on the trust preferred securities.  Under the Federal Reserve Agreement as described in “Note 2 – Regulatory Matters and Significant Risks or Uncertainties” to the Consolidated Financial Statements, the Company and its non-bank subsidiaries may not make any distributions of interest, principal, or other sums on subordinated debentures or trust preferred securities without the prior written approval of the Reserve Bank and the Director of the Division of Banking Supervision and Regulation of the Board of Governors of the Federal Reserve System.  As of September 30, 2012 the trust preferred interest payment in arrears was $2.3 million and has been recorded in interest expense and accrued interest payable.
 
Note 9.
Commitments and Contingencies
 
The Company’s exposure to credit loss in the event of non-performance by the other party to commitments to extend credit and standby letters of credit is represented by the contractual amount of those instruments.  The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments.
 
The contract amounts are as follows:
 
   
September 30,
   
December 31,
 
(In thousands)
 
2012
   
2011
 
Financial instruments whose contract amounts represent credit risk:
       
Open-end lines of credit
  $ 14,254     $ 13,600  
Commitments to extend credit
    7,060       7,073  
Standby letters of credit and financial guarantees written
    1,546       2,594  
 
Litigation
 
From time to time, the Company is a party to routine legal proceedings within the normal course of business.  Such routine legal proceedings in the aggregate are believed by management to be immaterial to the Company's financial condition or results of operations.
 
 
- 28 -

 

Royal Bank holds a 60% equity interest in each of CSC and RTL.  The Company acquired its ownership interest in CSC in 2001.  CSC and RTL acquire, through public auction, delinquent tax liens in various jurisdictions thereby assuming a superior lien position to most other lien holders, including mortgage lien holders.  As previously discussed in the Company’s Form 10-K for the year ended December 31, 2011, in March 2009, each of CSC and RTL received grand jury subpoenas issued by the U.S. District Court for New Jersey upon application of the Antitrust Division of the DOJ.  The subpoenas sought certain documents and information relating to an ongoing investigation being conducted by the DOJ relating to alleged bid-rigging at tax lien auctions in New Jersey.  Royal Bank, CSC and RTL have produced to the DOJ documents responsive to the subpoenas and have been cooperating with the DOJ throughout the investigation.  On February 23, 2012, the former President of CSC and RTL entered a plea of guilty to one count of conspiring to rig bids at certain auctions for tax liens in New Jersey from 1998 until approximately the spring of 2009.  The former President’s employment with CSC and RTL was terminated in November 2010.  As previously disclosed, Royal Bank had been advised that neither CSC nor RTL were targets of the DOJ investigation, but they were subjects of the investigation.  Based on discussions with the DOJ and the plea entered by the former President of CSC and RTL, the Company believed that the outcome of the investigation would result in fines and penalties being assessed against both CSC and RTL.  As a result, the Company accrued an aggregate of $2.0 million during the first and second quarters of 2012 as an estimate for a loss contingency for potential DOJ fines and penalties relating to the DOJ investigation.  After adjusting for the noncontrolling interest, the Company’s 60% share of the loss contingency amounted to $1.2 million.  On September 26, 2012, as a result of the former President’s guilty plea and pursuant to a plea agreement with the DOJ, CSC entered a guilty plea in the United States District Court for the District of New Jersey to one count of conspiracy to commit bid-rigging at certain auctions for tax liens in New Jersey.  Under the terms of the plea agreement, which the Court accepted at the September 26, 2012 plea hearing, the DOJ agreed not to bring further criminal charges against CSC and not to bring criminal charges against RTL, or any current or former director, officer, or employee of CSC and/or RTL, for any act or offense committed prior to the date of the plea agreement that was in furtherance of any agreement to rig bids at municipal tax lien sales or auctions in the State of New Jersey. The former President of CSC and RTL and any person who bid at any time at a tax lien auction on behalf of CSC and/or RTL are excluded from this nonprosecution protection.  The DOJ further agreed to recommend that the appropriate fine for CSC would be $2.0 million, which, as stated above, has been recognized in the Company’s financial statements.  The actual fine to be imposed, however, lies within the sole discretion of the sentencing judge.  The Company is evaluating appropriate legal action against the former President of CSC and RTL to attempt to recover legal expenses and any fines or penalties ultimately levied against CSC.
 
As a result of the plea agreements of the former President of CSC and RTL, and others resulting from the DOJ investigation, a number of lawsuits have been filed against the former President of CSC and RTL, CSC, RTL, the Company and certain other parties.  On March 13, 2012, the former president of RTL and CSC, RTL, CSC, the Company and certain other parties were named as defendants in a putative class action lawsuit filed in the Superior Court of New Jersey, Chancery Division on behalf of a proposed class of taxpayers who became delinquent in paying their municipal tax obligations ( Boyer v. Robert W. Stein, Crusader Servicing Corp. Royal Tax Lien Services LLC, Royal Bancshares of Pennsylvania, Inc., et al., Superior Court of New Jersey, Chancery Division ) (“the Boyer Action”).  On March 28, 2012, CSC, RTL and the Company removed this case to the U.S. District Court for the District of New Jersey.  The lawsuit alleges violations of the New Jersey Antitrust Act and unjust enrichment, and seeks treble damages, attorney fees and injunctive relief. As of the date of this filing, the Company cannot reasonably estimate the possible loss or range of loss that may result from this class action lawsuit.
 
On March 30, 2012, April 20, 2012, May 2, 2012, May 11, 2012, May 18, 2012, June 18, 2012 and June 29, 2012, the former President of CSC and RTL, CSC, RTL and the Company were named defendants, among others, in putative class action lawsuits filed in the U.S. District Court for the District of New Jersey (“Court”) on behalf of a proposed class of taxpayers who became delinquent in paying their municipal tax obligations: Contarino v Robert W. Stein, Crusader Servicing Corp. Royal Tax Lien Services LLC, Royal Bancshares of Pennsylvania, Inc., et al., U.S. District Court for the District of New Jersey; MSC LLC v Robert W. Stein, Crusader Servicing Corp. Royal Tax Lien Services LLC, Royal Bancshares of Pennsylvania, Inc., et al., U.S. District Court for the District of New Jersey; English v Robert W. Stein, Crusader Servicing Corp. Royal Tax Lien Services LLC, Royal Bancshares of Pennsylvania, Inc., et al., U.S. District Court for the District of New Jersey; Ledford v Robert W. Stein, Crusader Servicing Corp. Royal Tax Lien Services LLC, Royal Bancshares of Pennsylvania, Inc., et al., U.S. District Court for the District of New Jersey; T&B Associates v Robert W. Stein, Crusader Servicing Corp. Royal Tax Lien Services LLC, Royal Bancshares of Pennsylvania, Inc., et al., U.S. District Court for the District of New Jersey; Jacobs et al v Robert W. Stein, Crusader Servicing Corp. Royal Tax Lien Services LLC, Royal Bancshares of Pennsylvania, Inc., et al., U.S. District Court for the District of New Jersey; Senatore Builders, LLC  v Robert W. Stein, Crusader Servicing Corp. Royal Tax Lien Services LLC, Royal Bancshares of Pennsylvania, Inc., et al., U.S. District Court for the District of New Jersey, respectively alleging a conspiracy to rig bids in municipal tax lien auctions.   On June 12, 2012, the Court entered an Order consolidating for pretrial purposes the Boyer action with all subsequently filed or transferred related actions, including the ones mentioned above.  On October 22, 2012, the Court appointed two law firms as interim class counsel and another law firm as liaison class counsel and further ordered appointed counsel to file on or before November 21, 2012 a master complaint for the consolidated action.  As of the date of this filing, the Company cannot reasonably estimate the possible loss or range of loss that may result from these class action lawsuits.
 
 
- 29 -

 

On or about March 15, 2012, CSC, RTL and the Company were named defendants, among others, in a complaint filed by Marina Bay Towers Urban Renewal II, LP (“MBT”) in the Superior Court of New Jersey, Law Division, Cape May County.  The complaint alleges essentially the same claims as asserted in the Boyer Action.  However MBT does not seek to represent a class and only seeks remedies related to itself.  As of the date of this filing, the Company cannot reasonably estimate the possible loss or range of loss that may result from this proceeding.

In 2005, the Company purchased $25.0 million in Class B-1 Notes of a collateralized debt obligation (“CDO”) offered by Lehman Brothers, Inc.  Concurrently with the issuance of the notes, the issuer entered into a credit swap with Lehman Brothers Special Financing, Inc. (“LBSF”).  Lehman Brothers Holdings, Inc. (“LBHI”) guaranteed LBSF’s obligations to the issuer under the credit swap. When LBHI filed for bankruptcy in September 2008, an event of default under the indenture occurred, and the trustee declared the notes to be immediately due and payable.  The Company was repaid its principal on the notes in September 2008.  In September 2010, LBSF filed suit in the United States Bankruptcy court for the Southern District of New York against certain indenture trustees, certain special-purpose entities (issuers) and a class of noteholders and trust certificate holders who received distributions from the trustees, to recover funds that were allegedly improperly paid to the noteholders in forty-seven separate CDO transactions.  In July 2012, LBSF added the Company as a defendant in the proceeding. As of the date of this filing, the Company cannot determine whether this proceeding will have a material adverse effect on its results of operations and cannot reasonably estimate the possible loss or range of loss that may result from this proceeding.
 
Note 10.
Shareholders’ Equity
 
1.
Preferred Stock
 
On February 20, 2009, as part of the Capital Purchase Program (“CPP”) established by the United States Department of Treasury (“Treasury”), the Company issued to Treasury 30,407 shares of the Company’s Fixed Rate Cumulative Perpetual Preferred Stock, Series A, without par value per share (the “Series A Preferred Stock”), and a liquidation preference of $1,000 per share.  In conjunction with the purchase of the Series A Preferred Stock, Treasury received a warrant to purchase 1,104,370 shares of the Company’s Class A common stock.  The aggregate purchase price for the Series A Preferred Stock and warrant was $30.4 million in cash.  The Series A Preferred Stock qualifies as Tier 1 capital and pays cumulative dividends at a rate of 5% per annum for the first five years, and 9% per annum thereafter.  The Series A Preferred Stock may generally be redeemed by the Company at any time following consultation with its primary banking regulators.  The warrant issued to Treasury has a 10-year term and is immediately exercisable upon its issuance, with an exercise price, subject to anti-dilution adjustments, equal to $4.13 per share of the common stock.  The Company utilized the extra capital provided by the CPP funds to support its efforts to prudently and transparently provide lending and liquidity while also balancing the goal to remain well-capitalized.
 
2.
Common Stock
 
The Company’s Class A common stock trades on the NASDAQ Global Market under the symbol RBPAA.  There is no market for the Company’s Class B common stock.  The Class B shares may not be transferred in any manner except to the holder’s immediate family.  Class B shares may be converted to Class A shares at the rate of 1.15 to 1.  Each shareholder is entitled to one vote for each Class A share held and ten votes for each Class B share held.  Holders of either class of common stock are entitled to conversion equivalent per share dividends when declared.
 
3.
Payment of Dividends
 
Under the Pennsylvania Business Corporation Law, the Company may pay dividends only if it is solvent and would not be rendered insolvent by the dividend payment. There are also restrictions set forth in the Pennsylvania Banking Code of 1965 (the “Code”) and in the Federal Deposit Insurance Act (“FDIA”) affecting the payment of dividends to the Company by Royal Bank.  Under the Code, no dividends may be paid by a bank except from “accumulated net earnings” (generally retained earnings).  Under the FDIA, no dividend may be paid if a bank is in arrears in the payment of any insurance assessment due to the FDIC.  In addition, dividends paid by Royal Bank to the Company would be prohibited if the effect thereof would cause Royal Bank’s capital to be reduced below applicable minimum capital requirements.
 
On August 13, 2009, the Company’s Board determined to suspend regular quarterly cash dividends on the $30.4 million in Series A Preferred Stock.  The Company’s Board took this action in consultation with the Federal Reserve Bank of Philadelphia as required by regulatory policy guidance.  As of September 30, 2012, the Series A Preferred stock dividend in arrears was $5.4 million and has not been recognized in the consolidated financial statements.   As a consequence of missing the sixth dividend payment in the fourth quarter of 2010, the Treasury has the right to appoint two directors to our Board until all accrued but unpaid dividends have been paid.  The Treasury exercised its right and appointed two directors to the Company’s Board during 2011.
 
 
- 30 -

 

At September 30, 2012, as a result of significant losses within Royal Bank, the Company had negative retained earnings and therefore would not have been able to declare and pay any cash dividends.  Royal Bank must receive prior approval from the FDIC and the Department before declaring and paying a dividend to the Company.  Under the Federal Reserve Agreement as described in “Note 2 – Regulatory Matters and Significant Risks or Uncertainties” to the Consolidated Financial Statements, the Company may not declare or pay any dividends without the prior written approval of the Reserve Bank and the Director of the Division of Banking Supervision and Regulation of the Board of Governors of the Federal Reserve System.
 
Note 11.
Regulatory Capital Requirements
 
The Company and Royal Bank are subject to various regulatory capital requirements administered by the federal banking agencies.  Failure to meet minimum capital requirements can initiate certain mandatory and possible additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s financial statements.  Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company must meet specific capital guidelines that involve quantitative measures of the Company’s assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. The Company’s and Royal Bank’s capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.  Under the informal agreement referenced in “Note 2 – Regulatory Matters and Significant Risks And Uncertainties” to the Consolidated Financial Statements, Royal Bank is required to maintain a minimum Tier 1 leverage ratio of 8% and a Total risk-based capital ratio of 12%.  As of September 30, 2012, the Company and Royal Bank met all capital adequacy requirements to which it is subject and Royal Bank met the criteria for a well capitalized institution.
 
In connection with a prior bank regulatory examination, the FDIC concluded, based upon its interpretation of the Call Report instructions and under RAP, that income from Royal Bank’s tax lien business should be recognized on a cash basis, not an accrual basis.  Royal Bank’s current accrual method is in accordance with U.S. GAAP.  Royal Bank disagrees with the FDIC’s conclusion and filed the Call Report for September 30, 2012 and the previous eight quarters in accordance with U.S. GAAP.  The change in the method of revenue recognition for the tax lien business for regulatory accounting purposes affects Royal Bank’s and the Company’s capital ratios as shown below.  Royal Bank is in discussions with the FDIC to resolve the matter.
 
The table below sets forth Royal Bank’s capital ratios under RAP based on the FDIC’s interpretation of the Call Report instructions:
 
   
As of September 30, 2012
 
                           
To be well capitalized
 
               
For capital
   
capitalized under prompt
 
   
Actual
   
adequacy purposes
   
corrective action provision
 
(Dollars in thousands)
 
Amount
   
Ratio
   
Amount
   
Ratio
   
Amount
   
Ratio
 
Total capital (to risk-weighted assets)
  $ 78,813       17.09 %   $ 36,901       8.00 %   $ 46,126       10.00 %
Tier I capital (to risk-weighted assets)
  $ 72,903       15.81 %   $ 18,451       4.00 %   $ 27,676       6.00 %
Tier I capital (to average assets, leverage)
  $ 72,903       9.12 %   $ 31,974       4.00 %   $ 39,968       5.00 %

 
- 31 -

 
 
The tables below reflect the adjustments to the net loss as well as the capital ratios for Royal Bank under U.S. GAAP:
 
   
For the nine
 
   
months ended
 
(In thousands)
 
September 30, 2012
 
RAP net loss
  $ (11,373 )
Tax lien adjustment, net of noncontrolling interest
    4,963  
U.S. GAAP net loss
  $ (6,410 )
 
   
At September 30, 2012
 
   
As reported
   
As adjusted
 
   
under RAP
   
for U.S. GAAP
 
Total capital (to risk-weighted assets)
    17.09 %     18.56 %
Tier I capital (to risk-weighted assets)
    15.81 %     17.28 %
Tier I capital (to average assets, leverage)
    9.12 %     10.05 %
 
The tables below reflect the Company’s capital ratios:
 
   
As of September 30, 2012
 
                           
To be well capitalized
 
               
For capital
   
capitalized under prompt
 
   
Actual
   
adequacy purposes
   
corrective action provision
 
(Dollars in thousands)
 
Amount
   
Ratio
   
Amount
   
Ratio
   
Amount
   
Ratio
 
Total capital (to risk-weighted assets)
  $ 97,274       20.44 %   $ 38,069       8.00 %     N/A       N/A  
Tier I capital (to risk-weighted assets)
  $ 88,434       18.58 %   $ 19,035       4.00 %     N/A       N/A  
Tier I capital (to average assets, leverage)
  $ 88,434       10.82 %   $ 32,703       4.00 %     N/A       N/A  
 
The Company has filed the Consolidated Financial Statements for Bank Holding Companies-FR Y-9C (“FR Y-9C”) as of September 30, 2012 consistent with U.S. GAAP and the FR Y-9C instructions.  In the event that a similar adjustment for RAP purposes would be required by the Federal Reserve on the holding company level, the adjusted ratios are shown in the table below.
 
   
For the nine
 
   
months ended
 
(In thousands)
 
September 30, 2012
 
U.S. GAAP net loss
  $ (7,631 )
Tax lien adjustment, net of noncontrolling interest
    (4,963 )
RAP net loss
  $ (12,594 )
 
   
At September 30, 2012
 
   
As reported
   
As adjusted
 
   
under U.S. GAAP
   
for RAP
 
Total capital (to risk-weighted assets)
    20.44 %     19.02 %
Tier I capital (to risk-weighted assets)
    18.58 %     17.15 %
Tier I capital (to average assets, leverage)
    10.82 %     9.91 %

 
- 32 -

 
 
Note 12.
Pension Plan
 
The Company has a noncontributory nonqualified defined benefit pension plan (“Pension Plan”) covering certain eligible employees.  The Company’s Pension Plan provides retirement benefits under pension trust agreements.  The benefits are based on years of service and the employee’s compensation during the highest three consecutive years during the last 10 years of employment.
 
Net periodic defined benefit pension expense for the three and nine month periods ended September 30, 2012 and 2011 included the following components:
 
   
Three months ended
   
Nine months ended
 
   
September 30,
   
September 30,
 
(In thousands)
 
2012
   
2011
   
2012
   
2011
 
Service cost
  $ 68     $ 77     $ 204     $ 230  
Interest cost
    154       154       450       461  
Amortization of prior service cost
    23       23       67       67  
Amortization of actuarial loss
    96       36       287       107  
Net periodic benefit cost
  $ 341     $ 290     $ 1,008     $ 865  
 
Note 13.
Loss Per Common Share
 
The Company follows the provisions of FASB ASC Topic 260, “Earnings per Share” (“ASC Topic 260”).  Basic earnings per share (“EPS”) excludes dilution and is computed by dividing income available to common shareholders by the weighted average common shares outstanding during the period.  The Company has two classes of common stock currently outstanding. The classes are A and B, of which one share of Class B is convertible into 1.15 shares of Class A.  Diluted EPS takes into account the potential dilution that could occur if securities or other contracts to issue common stock were exercised and converted into common stock using the treasury stock method. For the three months and nine months ended September 30, 2012, 380,874 and 459,719 options to purchase shares of common stock, respectively, were anti-dilutive in the computation of diluted EPS, as exercise price exceeded average market price and as a result of the net loss for the three months and nine months ended September 30, 2012.  For the three months and nine months ended September 30, 2011, 578,819, and 568,395 options to purchase shares of common stock, respectively, were anti-dilutive in the computation of diluted EPS, as exercise price exceeded average market price and as a result of the net loss for the three months and nine months ended September 30, 2011.  Additionally 30,407 warrants were also anti-dilutive for all periods presented below.
 
Basic and diluted EPS for the three and nine months ended September 30, 2012 and 2011 are calculated as follows:
 
   
Three months ended September 30, 2012
 
   
Loss
   
Average shares
   
Per share
 
(In thousands, except for per share data)
 
(numerator)
   
(denominator)
   
Amount
 
Basic and Diluted EPS
                 
Loss available to common shareholders
  $ (5,323 )     13,257     $ (0.40 )
 
   
Three months ended September 30, 2011
 
   
Loss
   
Average shares
   
Per share
 
(In thousands, except for per share data)
 
(numerator)
   
(denominator)
   
Amount
 
Basic and Diluted EPS
                 
Loss available to common shareholders
  $ (2,395 )     13,257     $ (0.18 )

 
- 33 -

 
 
   
Nine months ended September 30, 2012
 
   
Loss
   
Average shares
   
Per share
 
(In thousands, except for per share data)
 
(numerator)
   
(denominator)
   
Amount
 
Basic and Diluted EPS
                 
Loss available to common shareholders
  $ (9,156 )     13,257     $ (0.69 )
 
   
Nine months ended September 30, 2011
 
 
 
Loss
   
Average shares
   
Per share
 
(In thousands, except for per share data)
 
(numerator)
   
(denominator)
   
Amount
 
Basic and Diluted EPS
                 
Loss available to common shareholders
  $ (9,128 )     13,257     $ (0.69 )
 
Note 14.
Comprehensive Income
 
FASB ASC Topic 220, “Comprehensive Income” (“ASC Topic 220”), requires the reporting of all changes in equity during the reporting period except investments from and distributions to shareholders.  Net income (loss) is a component of comprehensive income (loss) with all other components referred to in the aggregate as other comprehensive income.  Unrealized gains and losses on AFS securities is an example of an other comprehensive income component.
 
   
Nine months ended September 30, 2012
 
(In thousands)
 
Before tax
amount
   
Tax
expense
(benefit)
   
Net of tax
amount
 
Unrealized gains on investment securities:
                 
Unrealized holding gains arising during period
  $ 1,440     $ 602     $ 838  
Less adjustment for impaired investments
    (859 )     (301 )     (558 )
Less reclassification adjustment for gains realized in net loss
    384       134       250  
Unrealized gains on investment securities
    1,915       769       1,146  
Unrecognized benefit obligation expense:
                       
Less reclassification adjustment for amortization
    (354 )     (90 )     (264 )
Other comprehensive income, net
  $ 2,269     $ 859     $ 1,410  
 
   
Nine months ended September 30, 2011
 
(In thousands)
 
Before tax
amount
   
Tax
expense
(benefit)
   
Net of tax
amount
 
Unrealized gains on investment securities:
                 
Unrealized holding gains arising during period
  $ 336     $ 104     $ 232  
Less adjustment for impaired investments
    (1,796 )     (629 )     (1,167 )
Less reclassification adjustment for gains realized in net loss
    1,565       548       1,017  
Unrealized gains on investment securities
    567       185       382  
Unrecognized benefit obligation expense:
                       
Less reclassification adjustment for amortization
    (174 )     (67 )     (107 )
Other comprehensive income, net
  $ 741     $ 252     $ 489  

 
- 34 -

 
 
Note 15.
Fair Value of Financial Instruments
 
Under FASB ASC Topic 820 “Fair Value Measurements and Disclosures” (“ASC Topic 820”), fair values are based on the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. When available, management uses quoted market prices to determine fair value.  If quoted prices are not available, fair value is based upon valuation techniques such as matrix pricing or other models that use, where possible, current market-based or independently sourced market parameters, such as interest rates. If observable market-based inputs are not available, the Company uses unobservable inputs to determine appropriate valuation adjustments using discounted cash flow methodologies.
 
Management uses its best judgment in estimating the fair value of the Company’s financial instruments; however, there are inherent weaknesses in any estimation technique.  Therefore, for substantially all financial instruments, the fair value estimates herein are not necessarily indicative of the amounts the Company could have realized in a sales transaction on the dates indicated.  The estimated fair value amounts have been measured as of their respective period end and have not been re-evaluated or updated for purposes of these financial statements subsequent to those respective dates.  As such, the estimated fair values of these financial instruments subsequent to the respective reporting dates may be different than the amounts reported at each period-end.
 
ASC Topic 820 provides guidance for estimating fair value when the volume and level of activity for an asset or liability has significantly declined and for identifying circumstances when a transaction is not orderly.  ASC Topic 820 establishes a fair value hierarchy that prioritizes the inputs to valuation methods used to measure fair value.  The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements).  The three levels of the fair value hierarchy under ASC Topic 820 are as follows:
 
 
Level 1 :
Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities.
 
 
Level 2:
Quoted prices in markets that are not active, or inputs that are observable either directly or indirectly, for substantially the full term of the asset or liability.  Level 2 includes debt securities with quoted prices that are traded less frequently then exchange-traded instruments. Valuation techniques include matrix pricing which is a mathematical technique used widely in the industry to value debt securities without relying exclusively on quoted market prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted prices.
 
 
Level 3:
Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (i.e., supported with little or no market activity).
 
A financial instrument’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement.  The Company did not have transfers of financial instruments within the fair value hierarchy during the three and nine months ended September 30, 2012 and 2011.
 
Items Measured on a Recurring Basis
 
The Company’s available for sale investment securities are recorded at fair value on a recurring basis.
 
Fair value for Level 1 securities are determined by obtaining quoted market prices on nationally recognized securities exchanges.  Level 1 securities include common stocks and one trust preferred security which is actively traded.
 
Level 2 securities include obligations of U.S. government-sponsored agencies, debt securities with quoted prices, which are traded less frequently than exchange-traded instruments, whose value is determined using matrix pricing with inputs that are observable in the market or can be derived principally from or corroborated by observable market data.  The prices were obtained from third party vendors. This category generally includes mortgage-backed securities and CMOs issued by U.S. government and government-sponsored agencies, non-agency CMOs, and corporate and municipal bonds.
 
 
- 35 -

 

Level 3 securities include four trust preferred securities and other securities, which are primarily private equity real estate funds.  The fair values for the trust preferred securities were derived by using contractual cash flows and a market rate of return for each of these securities.  Factors that affected the market rate of return included (1) any uncertainty about the amount and timing of the cash flows, (2) the credit risk, (3) liquidity of the instrument, and (4) observable yields from trading data and bid/ask indications.  Credit risk spreads and liquidity premiums were analyzed to derive the appropriate discount rate.  The fair value of the private equity funds is derived from the financial reports provided to the Company by the general partners of the funds.
 
For financial assets measured at fair value on a recurring basis, the fair value measurements by level within the fair value hierarchy used at September 30, 2012 and December 31, 2011 are as follows:
 
   
Fair Value Measurements Using:
       
   
Quoted Prices
                   
   
in Active
   
Significant
             
   
Markets for
   
Other
   
Significant
       
   
Identical
   
Observable
   
Unobservable
       
Balances as of September 30, 2012
 
Assets
   
Inputs
   
Inputs
   
 
 
(In thousands)
 
Level 1
   
Level 2
   
Level 3
   
Fair Value
 
Investment securities available-for-sale
                       
Mortgage-backed  securities-residential
  $ -     $ 22,338     $ -     $ 22,338  
U.S. government agencies
    -       49,308       -       49,308  
Common stocks
    46       -       -       46  
Collateralized mortgage obligations:
                               
Issued or guaranteed by U.S. government agencies
    -       258,748       -       258,748  
Non-agency
    -       1,024       -       1,024  
Corporate bonds
    -       6,231       -       6,231  
Municipal bonds
    -       3,609       -       3,609  
Trust preferred securities
    3,393       -       7,922       11,315  
Other securities
    -       -       5,836       5,836  
Total investment securities available-for-sale
  $ 3,439     $ 341,258     $ 13,758     $ 358,455  

 
- 36 -

 
 
   
Fair Value Measurements Using:
       
   
Quoted Prices
                   
   
in Active
   
Significant
             
   
Markets for
   
Other
   
Significant
       
   
Identical
   
Observable
   
Unobservable
       
Balances as of December 31, 2011
 
Assets
   
Inputs
   
Inputs
   
 
 
(In thousands)
 
Level 1
   
Level 2
   
Level 3
   
Fair Value
 
Investment securities available-for-sale
                       
Mortgage-backed  securities-residential
  $ -     $ 17,005     $ -     $ 17,005  
U.S. government agencies
    -       36,084       -       36,084  
Common stocks
    248       -       -       248  
Collateralized mortgage obligations:
                               
Issued or guaranteed by U.S. government agencies
    -       234,034       -       234,034  
Non-agency
    -       4,832       -       4,832  
Corporate bonds
    -       12,975       -       12,975  
Municipal bonds
    -       965       -       965  
Trust preferred securities
    3,342       -       12,603       15,945  
Other securities
    -       -       6,918       6,918  
Total investment securities available-for-sale
  $ 3,590     $ 305,895     $ 19,521     $ 329,006  
 
The following table presents additional information about assets measured at fair value on a recurring basis and for which the Company has utilized Level 3 inputs to determine fair value for the nine months ended September 30, 2012 and 2011:
 
   
Investment Securities Available for Sale
 
   
Trust
             
   
preferred
   
Other
       
(In thousands)
 
securities
   
securities
   
Total
 
Beginning balance January 1, 2012
  $ 12,603     $ 6,918     $ 19,521  
Total gains/(losses) - (realized/unrealized):
                       
Included in earnings
    89       (818 )     (729 )
Included in other comprehensive income
    (392 )     (189 )     (581 )
Purchases
    -       500       500  
Sales and calls
    (4,362 )     (575 )     (4,937 )
Amortization of premium
    (16 )     -       (16 )
Transfers in and/or out of Level 3
    -       -       -  
Ending balance September 30, 2012
  $ 7,922     $ 5,836     $ 13,758  

 
- 37 -

 
 
   
Investment Securities Available for Sale
 
   
Trust
             
   
preferred
   
Other
       
(In thousands)
 
securities
   
securities
   
Total
 
Beginning balance January 1, 2011
  $ 15,020     $ 8,405     $ 23,425  
Total gains/(losses) - (realized/unrealized):
                       
Included in earnings
    (1,740 )     446       (1,294 )
Included in other comprehensive income
    433       76       509  
Purchases
    -       555       555  
Sales
    (1,122 )     (1,296 )     (2,418 )
Amortization of premium
    (33 )     -       (33 )
Transfers in and/or out of Level 3
    -       -       -  
Ending balance September 30, 2011
  $ 12,558     $ 8,186     $ 20,744  
 
Items Measured on a Nonrecurring Basis
 
Non-accrual loans are evaluated for impairment on an individual basis under FASB ASC Topic 310 “Receivables”.  The impairment analysis includes current collateral values, known relevant factors that may affect loan collectability, and risks inherent in different kinds of lending.  When the collateral value or discounted cash flows less costs to sell is less than the carrying value of the loan a specific reserve (valuation allowance) is established. Loans held for sale are carried at the lower of cost or fair value. OREO is carried at the lower of cost or fair value.  Fair value is based upon independent market prices, appraised values of the collateral or management’s estimation of the value of the collateral.  These assets are included as Level 3 fair values, based upon the lowest level of input that is significant to the fair value measurements.
 
For financial assets measured at fair value on a nonrecurring basis, the fair value measurements by level within the fair value hierarchy used at September 30, 2012 and December 31, 2011 are as follows:
 
   
Fair Value Measurements Using:
       
   
Markets for
   
Other
   
Significant
       
   
Identical
   
Observable
   
Unobservable
       
Balances as of September 30, 2012
 
Assets
   
Inputs
   
Inputs
   
 
 
(In thousands)
 
Level 1
   
Level 2
   
Level 3
   
Fair Value
 
Assets
                       
Impaired loans and leases
  $ -     $ -     $ 14,228     $ 14,228  
Other real estate owned
    -       -       11,403       11,403  
Loans and leases held for sale
    -       -       2,718       2,718  

 
- 38 -

 
 
   
Fair Value Measurements Using:
       
   
Quoted Prices
                   
   
in Active
   
Significant
             
   
Markets for
   
Other
   
Significant
       
   
Identical
   
Observable
   
Unobservable
       
Balances as of December 31, 2011
 
Assets
   
Inputs
   
Inputs
   
 
 
(In thousands)
 
Level 1
   
Level 2
   
Level 3
   
Fair Value
 
Assets
                       
Impaired loans and leases
  $ -     $ -     $ 8,583     $ 8,583  
Other real estate owned
    -       -       21,016       21,016  
Loans and leases held for sale
    -       -       3,830       3,830  
 
The following table presents additional quantitative information about assets measured at fair value on a nonrecurring basis and for which the Company has utilized Level 3 inputs to determine fair value:
 
   
Qualitative Information about Level 3 Fair Value Measurements
 
Balances as of September 30, 2012
     
Valuation
 
Unobservable
 
Range (Weighted
 
(In thousands)
 
Fair Value
 
Techniques
 
Input
 
Average)
 
Impaired loans and leases
  $ 14,228  
Appraisal of collateral (1)
 
Appraisal adjustments
 
0.0% to -34.5% (-4.0%)
 
             
Liquidation  expenses
 
-0.9% to -27.9% (-8.5%)
 
                     
         
Discounted cash flow
 
Discount rate
    12 %
                       
         
Salvageable value of collateral (2)
        0.0 %
                       
Other real estate owned
    11,403  
Appraisal of collateral (1)
 
Appraisal adjustments
 
0.0% to -61.0% (-5.9%)
 
         
Sales prices
 
Liquidation  expenses
 
-5.0% to -11.8% (-8.5%)
 
                       
Loans and leases held for sale
    2,718  
Sales prices
 
Liquidation  expenses
    -9.4 %
 
 
(1)
Appraisals may be adjusted for qualitative factors such as interior condition of the property and liquidation expenses.  Fair value may also be based on negotiated settlements with the borrower.
 
 
(2)
Leases are measured using the salvageable value of the collateral.
 
The following methods and assumptions were used to estimate the fair values of the Company’s financial instruments at September 30, 2012 and December 31, 2011. The tables below indicate the fair value of the Company’s financial instruments at September 30, 2012 and December 31, 2011.  The following information should not be interpreted as an estimate of the fair value of the entire Company since a fair value calculation is only provided for a limited portion of the Company’s assets and liabilities.  Due to a wide range of valuation techniques and the degree of subjectivity used in making the estimates, comparisons between the Company’s disclosures and those of other companies may not be meaningful.  The methodologies for estimating the fair value of financial instruments that are measured on a recurring or nonrecurring basis are discussed above.
 
Cash and cash equivalents (carried at cost):
 
The carrying amounts reported in the balance sheet for cash and short-term instruments approximate those assets’ fair values.
 
 
- 39 -

 

Securities:
 
Management uses quoted market prices to determine fair value of securities (level 1).  If quoted prices are not available, fair value is based upon valuation techniques such as matrix pricing or other models that use, where possible, current market-based or independently sourced market parameters, such as interest rates (level 2). If observable market-based inputs are not available, the Company uses unobservable inputs to determine appropriate valuation adjustments using discounted cash flow methodologies (level 3).
 
Other Investment (carried at cost):
 
This investment includes the Solomon Hess SBA Loan Fund, which the Company invested in to partially satisfy its community reinvestment requirement.  Shares in this fund are not publicly traded and therefore have no readily determinable fair market value.  An investor can have their investment in the Fund redeemed for the balance of their capital account at any quarter end with 60 days notice to the Fund.  The investment in this Fund is recorded at cost.  The Company does not record this investment at fair value on a recurring basis, as this investment’s carrying amount approximates fair value.
 
Restricted investment in bank stock (carried at cost):
 
The carrying amount of restricted investment in bank stock approximates fair value, and considers the limited marketability of such securities.
 
Loans held for sale (carried at lower of cost or fair value):
 
The fair values of loans held for sale are based upon appraised values of the collateral less costs to sell, management’s estimation of the value of the collateral or expected net sales proceeds.   These assets are included as Level 3 fair values, based upon the lowest level of input that is significant to the fair value measurements.
 
Loans receivable (carried at cost):
 
The fair values of loans are estimated using discounted cash flow analyses, using market rates at the balance sheet date that reflect the credit and interest rate-risk inherent in the loans.  Projected future cash flows are calculated based upon contractual maturity or call dates, projected repayments and prepayments of principal.   Generally, for variable rate loans that re-price frequently and with no significant change in credit risk, fair values are based on carrying values.
 
Impaired loans (generally carried at fair value):
 
Impaired loans are accounted for under ASC Topic 310.   Impaired   loans are those in which the Company has measured impairment generally based on the fair value of the loan’s collateral.  Fair value is generally determined based upon independent third-party appraisals of the properties, or discounted cash flows based on the expected proceeds.  These assets are included as Level 3 fair values, based upon the lowest level of input that is significant to the fair value measurements.
 
Accrued interest receivable and payable (carried at cost):
 
The carrying amount of accrued interest receivable and accrued interest payable approximates its fair value.
 
Deposit liabilities (carried at cost):
 
The fair values disclosed for demand deposits (e.g., interest and noninterest checking, passbook savings and money market accounts) are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amounts).  Fair values for fixed-rate certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered in the market on certificates to a schedule of aggregated expected monthly maturities on time deposits.
 
 
- 40 -

 

Short-term borrowings (carried at cost):
 
The carrying amounts of short-term borrowings approximate their fair values.
 
Long-term debt (carried at cost):
 
Fair values of FHLB advances and other long-term borrowings are estimated using discounted cash flow analysis, based on quoted prices for new FHLB advances with similar credit risk characteristics, terms and remaining maturity.  These prices obtained from this active market represent a market value that is deemed to represent the transfer price if the liability were assumed by a third party.
 
Subordinated debt (carried at cost):
 
Fair values of junior subordinated debt are estimated using discounted cash flow analysis, based on market rates currently offered on such debt with similar credit risk characteristics, terms, and remaining maturity.
 
Off-balance sheet financial instruments (disclosed at cost):
 
Fair values for the Company’s off-balance sheet financial instruments (lending commitments and letters of credit) are based on fees currently charged in the market to enter into similar agreements, taking into account, the remaining terms of the agreements and the counterparties’ credit standing.  They are not shown in the table because the amounts are immaterial.
 
               
Fair Value Measurements
 
               
At September 30, 2012
 
               
Quoted Prices
             
               
in Active
   
Significant
       
               
Markets for
   
Other
   
Significant
 
               
Identical
   
Observable
   
Unobservable
 
   
Carrying
   
Estimated
   
Assets
   
Inputs
   
Inputs
 
(In thousands)
 
amount
   
fair value
   
Level 1
   
Level 2
   
Level 3
 
Financial Assets:
                             
Cash and cash  equivalents
  $ 39,450     $ 39,450     $ 39,450     $ -     $ -  
Investment securities available-for-sale
    358,455       358,455       3,439       341,258       13,758  
Other investment
    2,250       2,250       -       -       2,250  
Federal Home Loan Bank stock
    6,916       6,916       -       -       6,916  
Loans held for sale
    2,718       2,718       -       -       2,718  
Loans, net
    325,632       325,911       -       -       325,911  
Accrued interest receivable
    10,893       10,893       10,893       -       -  
Financial Liabilities:
                                       
Demand deposits
    59,262       59,262       59,262       -       -  
NOW and money markets
    218,305       218,305       218,305       -       -  
Savings
    17,103       17,103       17,103       -       -  
Time deposits
    276,580       271,913       -       271,913       -  
Long-term borrowings
    108,446       102,497       -       102,497       -  
Subordinated debt
    25,774       24,410       -       24,410       -  
Accrued interest payable
    5,932       5,932       5,932       -       -  

 
- 41 -

 
 
   
At December 31, 2011
 
   
Carrying
   
Estimated
 
(In thousands)
 
amount
   
fair value
 
Financial Assets:
           
Cash and cash  equivalents
  $ 24,506     $ 24,506  
Investment securities available-for-sale
    329,006       329,006  
Other investment
    1,538       1,538  
Federal Home Loan Bank stock
    8,474       8,474  
Loans held for sale
    12,569       12,569  
Loans, net
    397,863       395,616  
Accrued interest receivable
    15,463       15,463  
Financial Liabilities:
               
Demand deposits
    54,534       54,534  
NOW and money markets
    226,002       226,002  
Savings
    16,263       16,263  
Time deposits
    279,117       274,546  
Short-term borrowings
    54,218       53,936  
Long-term borrowings
    93,782       88,394  
Subordinated debt
    25,774       18,673  
Accrued interest payable
    3,450       3,450  
 
Limitations
 
The fair value estimates are made at a discrete point in time based on relevant market information and information about the financial instruments.  Fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors.
 
These estimates are subjective in nature and involve uncertainties and matters of significant judgment and, therefore, cannot be determined with precision.  Changes in assumptions could significantly affect the estimates.  Further, the foregoing estimates may not reflect the actual amount that could be realized if all or substantially all of the financial instruments were offered for sale.  This is due to the fact that no market exists for a sizable portion of the loan, deposit and off balance sheet instruments.
 
In addition, the fair value estimates are based on existing on-and-off balance sheet financial instruments without attempting to value anticipated future business and the value of assets and liabilities that are not considered financial instruments.  Other significant assets that are not considered financial assets include premises and equipment.  In addition, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in any of the estimates.
 
Finally, reasonable comparability between financial institutions may not be likely due to the wide range of permitted valuation techniques and numerous estimates which must be made given the absence of active secondary markets for many of the financial instruments.  This lack of uniform valuation methodologies introduces a greater degree of subjectivity to these estimated fair values.
 
Note 16.
Real Estate Owned via Equity Investment
 
The Company, together with third party real estate development companies, formed variable interest entities (“VIEs”) to construct various real estate development projects.  These VIEs account for acquisition, development and construction costs of the real estate development projects in accordance with FASB ASC Topic 970, “Real Estate-General”, and account for capitalized interest on those projects in accordance with FASB ASC Topic 835, “Interest” .   Due to economic conditions, management decided to curtail new equity investments.
 
 
- 42 -

 

In accordance with ASC Topic 976, the full accrual method is used to recognize profit on real estate sales.  Profits on the sales of this real estate are recorded when cash in excess of the amount of the original investment is received, and calculation of same is made in accordance with the terms of the partnership agreement, the Company is no longer obligated to perform significant activities after the sale to earn profits, there is no continuing involvement with the property and; finally, the usual risks and rewards of ownership in the transaction had passed to the acquirer.
 
At September 30, 2012, the Company no longer had any VIEs consolidated into the Company’s financial statements. During the fourth quarter of 2011, the Company deconsolidated the remaining VIE as a result of the substantial completion of the project and the sales of the remaining units that were associated with the VIE.
 
Note 17.
Segment Information
 
FASB ASC Topic 280, “Segment Reporting” (“ASC Topic 280”) established standards for public business enterprises to report information about operating segments in their annual financial statements and requires that those enterprises report selected information about operating segments in subsequent interim financial reports issued to shareholders.  It also established standards for related disclosure about products and services, geographic areas, and major customers.  Operating segments are components of an enterprise, which are evaluated regularly by the chief operating decision makers in deciding how to allocate and assess resources and performance.  The Company’s chief operating decision makers are the CEO and the Chief Financial Officer (“CFO”). The Company has identified its reportable operating segments as “Community Banking” and “Tax Liens”.  In previous years, the Company reflected “Equity Investments” and “Leasing” as operating segments.  Management has determined that the operating results and assets related to Equity Investments and Leasing should be reflected under the Community Banking segment.  The determination related to Equity Investments was based on the deconsolidation of the VIE as a result of the completion of the project. The determination related to Leasing was based on not meeting the quantitative thresholds for requiring disclosure.
 
Community banking
 
The Company’s Community Banking segment which includes Royal Bank consists of commercial and retail banking and leasing. The Community Banking business segment is managed as a single strategic unit which generates revenue from a variety of products and services provided by Royal Bank.  For example, commercial lending is dependent upon the ability of Royal Bank to fund cash needed to make loans with retail deposits and other borrowings and to manage interest rate and credit risk.  While Royal Bank makes very few consumer loans, cash needed to make such loans would be funded similarly to commercial loans.
 
Tax lien operation
 
The Company’s Tax Lien Operation consists of purchasing delinquent tax certificates from local municipalities at auction and then processing those liens to either encourage the property holder to pay off the lien, or to foreclose and sell the property.   The tax lien operation earns income based on interest rates (determined at auction) and penalties assigned by the municipality along with gains on sale of foreclosed properties.
 
 
- 43 -

 

The following tables present selected financial information for reportable business segments for the three and nine month periods ended September 30, 2012 and 2011.
 
   
Three months ended September 30, 2012
 
   
Community
   
Tax Lien
       
(In thousands)
 
Banking
   
Operation
   
Consolidated
 
Total assets
  $ 759,099     $ 42,582     $ 801,681  
Total deposits
  $ 571,250     $ -     $ 571,250  
Interest income
  $ 6,542     $ 1,219     $ 7,761  
Interest expense
    1,782       597       2,379  
Net interest income
  $ 4,760     $ 622     $ 5,382  
Provision for loan and lease losses
    1,796       (35 )     1,761  
Total other  income
    847       304       1,151  
Total other expenses
    8,851       558       9,409  
Income tax (benefit) expense
    (156 )     156       -  
Net (loss) income
  $ (4,884 )   $ 247     $ (4,637 )
Noncontrolling interest
  $ 76     $ 99     $ 175  
Net (loss) income attributable to Royal Bancshares
  $ (4,960 )   $ 148     $ (4,812 )
 
   
Three months ended September 30, 2011
 
   
Community
   
Tax Lien
       
(In thousands)
 
Banking
   
Operation
   
Consolidated
 
Total assets
  $ 780,257     $ 77,106     $ 857,363  
Total deposits
  $ 577,891     $ -     $ 577,891  
Interest income
  $ 8,275     $ 1,774     $ 10,049  
Interest expense
    2,635       582       3,217  
Net interest income
  $ 5,640     $ 1,192     $ 6,832  
Provision for loan and lease losses
    180       248       428  
Total other  income
    72       1       73  
Total other expenses
    7,662       447       8,109  
Income tax (benefit) expense
    (193 )     193       -  
Net (loss) income
  $ (1,937 )   $ 305     $ (1,632 )
Noncontrolling interest
  $ 139     $ 122     $ 261  
Net (loss) income attributable to Royal Bancshares
  $ (2,076 )   $ 183     $ (1,893 )

 
- 44 -

 
 
   
Nine months ended September 30, 2012
 
 
 
Community
   
Tax Lien
       
(In thousands)
 
Banking
   
Operation
   
Consolidated
 
Total assets
  $ 759,099     $ 42,582     $ 801,681  
Total deposits
  $ 571,250     $ -     $ 571,250  
Interest income
  $ 20,833     $ 4,157     $ 24,990  
Interest expense
    5,494       2,215       7,709  
Net interest income
  $ 15,339     $ 1,942     $ 17,281  
Provision for loan and lease losses
    3,239       121       3,360  
Total other income
    3,434       323       3,757  
Total other expenses
    21,435       4,633       26,068  
Income tax expense (benefit)
    201       (201 )     -  
Net loss
  $ (6,102 )   $ (2,288 )   $ (8,390 )
Noncontrolling interest
  $ 156     $ (915 )   $ (759 )
Net loss attributable to Royal Bancshares
  $ (6,258 )   $ (1,373 )   $ (7,631 )
 
   
Nine months ended September 30, 2011
 
 
 
Community
   
Tax Lien
       
(In thousands)
 
Banking
   
Operation
   
Consolidated
 
Total assets
  $ 780,257     $ 77,106     $ 857,363  
Total deposits
  $ 577,891     $ -     $ 577,891  
Interest income
  $ 24,622     $ 6,001     $ 30,623  
Interest expense
    9,138       1,938       11,076  
Net interest income
  $ 15,484     $ 4,063     $ 19,547  
Provision for loan and lease losses
    5,016       552       5,568  
Total other income
    3,738       486       4,224  
Total other expenses
    23,486       1,377       24,863  
Income tax (benefit) expense
    (1,022 )     1,022       -  
Net (loss) income
  $ (8,258 )   $ 1,598     $ (6,660 )
Noncontrolling interest
  $ 330     $ 639     $ 969  
Net (loss) income attributable to Royal Bancshares
  $ (8,588 )   $ 959     $ (7,629 )
 
Interest income earned by the Community Banking segment related to the Tax Lien Operation was approximately $597,000 and $582,000 for the three month periods ended September 30, 2012 and 2011, respectively and $2.2 million and $1.9 million for the nine months ended September 30, 2012 and 2011, respectively.
 
Note 18.
Federal Home Loan Bank Stock
 
As a member of the Federal Home Loan Bank of Pittsburgh (“FHLB”), the Company is required to purchase and hold stock in the FHLB to satisfy membership and borrowing requirements.  The stock can only be sold to the FHLB or to another member institution, and all sales of FHLB stock must be at par. As a result of these restrictions, there is no active market for the FHLB stock. As of September 30, 2012 and December 31, 2011, FHLB stock totaled $6.9 million and $8.5 million, respectively.
 
FHLB stock is held as a long-term investment and its value is determined based on the ultimate recoverability of the par value. The Company evaluates impairment quarterly. The decision of whether impairment exists is a matter of judgment that reflects management’s view of the FHLB’s long-term performance, which includes factors such as the following: (1) its operating performance, (2) the severity and duration of declines in the fair value of its net assets related to its capital stock amount, (3) its liquidity position, and (4) the impact of legislative and regulatory changes on the FHLB.  Based on the capital adequacy and the liquidity position of the FHLB, management believes that the par value of its investment in FHLB stock will be recovered.  Accordingly, there is no other-than-temporary impairment related to the carrying amount of the Company’s FHLB stock as of September 30, 2012.
 
 
- 45 -

 

ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
The following discussion and analysis is intended to assist in understanding and evaluating the changes in the financial condition and earnings performance of the Company and its subsidiaries for the three and nine month periods ended September 30, 2012 and 2011. This discussion and analysis should be read in conjunction with the Company’s consolidated financial statements and notes thereto for the year ended December 31, 2011, included in the Company’s Form 10-K for the year ended December 31, 2011.
 
FORWARD-LOOKING STATEMENTS
 
From time to time, Royal Bancshares of Pennsylvania, Inc. (the “Company”) may include forward-looking statements relating to such matters as anticipated financial performance, business prospects, technological developments, new products, research and development activities and similar matters in this and other filings with the Securities and Exchange Commission. The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements. When we use words such as “believes,” “expects,” “anticipates” or similar expressions, we are making forward-looking statements. In order to comply with the terms of the safe harbor, the Company notes that a variety of factors could cause the Company’s actual results and experience to differ materially from the anticipated results or other expectations expressed in the Company’s forward-looking statements. The risks and uncertainties that may affect the operations, performance development and results of the Company’s business include the following: general economic conditions, including their impact on capital expenditures; interest rate fluctuations; business conditions in the banking industry; the regulatory environment; the nature, extent, and timing of governmental actions and reforms, including the rules of participation for the Troubled Asset Relief Program voluntary Capital Purchase Plan under the Emergency Economic Stabilization Act of 2008, which may be changed unilaterally and retroactively by legislative or regulatory actions; rapidly changing technology and evolving banking industry standards; competitive factors, including increased competition with community, regional and national financial institutions; new service and product offerings by competitors and price pressures and similar items.
 
All forward-looking statements contained in this report are based on information available as of the date of this report.  These statements speak only as of the date of this report, even if subsequently made available by the Company on its website, or otherwise.  The Company expressly disclaims any obligation to update any forward-looking statement to reflect future statements to reflect future events or developments.
 
CRITICAL ACCOUNTING POLICIES, JUDGMENTS AND ESTIMATES
 
The accounting and reporting policies of the Company conform to accounting principles generally accepted in the United States of America and general practices within the financial services industry.  Applications of the principles in the Company’s preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and the accompanying notes.  These estimates and assumptions are based on information available as of the date of the consolidated financial statements; therefore, actual results could differ from those estimates.
 
Note 1 to the Company’s Consolidated Financial Statements (included in Item 8 of the Form 10-K for the year ended December 31, 2011) lists significant accounting policies used in the development and presentation of the Company’s consolidated financial statements.  The following discussion and analysis, the significant accounting policies, and other financial statement disclosures identify and address key variables and other quantitative and qualitative factors that are necessary for an understanding and evaluation of the Company and its results of operations.  We complete an internal review of this financial information.  This review requires substantive judgment and estimation. As disclosed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2011, we have identified other-than-temporary impairment on investments securities, accounting for allowance for loan and lease losses, and deferred tax assets as among the most critical accounting policies and estimates.  These critical accounting policies and estimates are important to the presentation of the Company’s financial condition and results of operations, and they require difficult, subjective or complex judgments as a result of the need to make estimates.
 
 
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Financial Highlights and Business Results
 
On June 29, 1995, pursuant to the plan of reorganization approved by the shareholders of Royal Bank America, formerly Royal Bank of Pennsylvania (“Royal Bank”), all of the outstanding shares of common stock of Royal Bank were acquired by Royal Bancshares and were exchanged on a one-for-one basis for common stock of Royal Bancshares. The principal activities of the Company are supervising Royal Bank, which engages in a general banking business principally in Montgomery, Chester, Bucks, Philadelphia and Berks counties in Pennsylvania and in northern and southern New Jersey and Delaware. The Company also has a wholly-owned non-bank subsidiary, Royal Investments of Delaware, Inc., which is engaged in investment activities.
 
Like many other financial institutions the Company’s financial results were negatively impacted by the recession, but the effects on the Company were more pronounced than the effects on its competitors. The concentration of commercial real estate loans coupled with the introduction of additional lines of business resulted in a much higher level of non-performing loans and losses.  The past losses were partially attributed to charge-offs and impairment of commercial, construction and land loans associated with real estate projects, many of which were participation loans outside the Company’s primary market. Some of the participation loans were located in Florida, Nevada, North Carolina and other markets that were overbuilt during the construction boom within the United States from 2000-2007. The Company also launched new business initiatives such as mezzanine lending, real estate joint ventures, hard money lending and equity investments in real estate shortly before the housing bubble burst which contributed to the losses. Additionally, the Company experienced a high level of investment impairment associated with corporate bonds, common stocks, private label mortgage backed securities and real estate investment funds that experienced declines in value during the past few years. Also contributing to the losses were increased costs associated with reduced credit quality, legal expenses related to credit quality issues and the U.S. Department of Justice (“DOJ”) tax lien investigation (for additional information please read “Part II Other Information” “Item 1 Legal Proceedings” of this Form 10-Q), and higher Federal Deposit Insurance Corporation (“FDIC”) assessments resulting from the higher rates for deposit insurance due to the Orders to Cease and Desist (the “Orders”) which were issued in 2009. Finally, the establishment of a valuation allowance in 2008 and subsequent years that currently amounts to $36.4 million, has prevented the Company from utilizing tax credits on losses during the past four years.
 
In each of the four quarters prior to the current quarter ended September 30, 2012, net losses were less than $2.0 million per quarter.  However for the most recent quarter ended September 30, 2012, the net loss was $4.8 million.  The increase in the quarterly loss during the current quarter was directly related to other real estate owned (“OREO”) impairment of $2.4 million, additional provision for loan and lease losses of $1.8 million, and impairment on loans held for sale (“LHFS”) of $856,000.  During the third quarter, there were two properties (one related to a land acquisition and development loan and one related to an OREO property which was originally a land development and single family residential project) that as a result of the significant lack of progress and the uncertainty about future progress management determined that liquidation value appraisals were appropriate at this time and accounted for $2.5 million of the net loss for the third quarter of 2012.
 
The level of non-performing assets has contributed to the Company’s continued losses.   As a result of the decline in the outstanding level of non-performing assets ($22.4 million, or 31.0%, in the past nine months), the Company has experienced a year-over-year reduction in expenses associated with this decline which includes the provision for loan and lease losses, OREO and loan collection expenses, and OREO impairment.  However the Company’s deleveraging strategy, which improved the risk profile of the Company by shedding higher risk assets and paying off higher cost brokered CDs has had a negative impact on income. The deleveraging has resulted in lower average loan balances and a higher proportion of lower yielding investment securities, which have negatively impacted net interest income, a principal source of income. During the four year period beginning with the nine months ended September 30, 2008 through the nine months ended September 30, 2012, net interest income has declined 36.6%. Due to the continued re-pricing of retail deposits and the redemption of FHLB advances and brokered CDs, net interest income has declined by only 11.6% over the past four quarters. While the Company still expects external headwinds and credit quality costs associated with non-performing assets to negatively affect financial results, over time their impact may decline as the overall level of non-performing assets declines.
 
 
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The chief sources of revenue for the Company are interest income from extending loans and from investing in security instruments, mostly through its subsidiary Royal Bank. Royal Bank principally generates commercial real estate loans primarily secured by first mortgage liens, construction loans for commercial real estate projects and residential home development, land development loans, tax liens and leases. At September 30, 2012, commercial real estate loans, construction and land development loans, commercial and industrial loans, leases and tax liens comprised 47%, 12%, 12%, 11%, and 8%, respectively, of Royal Bank’s loan portfolio. Construction loans and land development loans can have more risk associated with them, especially when a weakened economy, such as we have experienced the past few years, adversely impacts the commercial rental or home sales market.   Net earnings of the Company are largely dependent on taking in deposits at competitive market rates, and then redeploying those deposited funds into loans and investments in securities at rates higher than those, paid to the depositors to earn an interest rate spread.  Please see the “Net Interest Margin” section in Management’s Discussion and Analysis of Financial Condition and Results of Operation below for additional information on interest yield and cost. At September 30, 2012, the Company had consolidated total assets of $801.7 million, total loans and leases of approximately $343.0 million, total deposits of approximately $571.3 million, and shareholders’ equity of approximately $69.0 million.
 
Consolidated Net Loss
 
The Company recorded a net loss of $4.8 million for the third quarter of 2012 compared to a net loss of $1.9 million for the comparable quarter of 2011.  The $2.9 million increase in net loss was primarily related to a reduction of $1.5 million in net interest income, a $1.3 million increase in the provision for loan and lease losses, an increase of $871,000 in OREO impairment and an $856,000 increase in impairment on loans held for sale.  Partially offsetting these unfavorable changes was a $1.1 million increase in other income which was primarily associated with a $1.4 million improvement in impairment on investment securities ($0 in 2012 compared to $1.4 million in 2011).  The $1.5 million decrease in net interest income was associated with a 48 basis point decline in net interest margin quarter versus quarter.  The decline in net interest margin was primarily due to two main factors: the mix of interest earning assets and the significant decline in yields earned on investment securities.  Like many other financial institutions, the Company has experienced pressure on its net interest margin. Factors contributing to the margin compression include a declining loan portfolio as evidenced by the $86.9 million decline in the average loan balances quarter versus quarter and a corresponding increase in the investment portfolio of $27.2 million. Due to historically sustained low interest rates, the Company has experienced an accelerated amortization of premiums paid on its mortgage backed securities (“MBS”) and collateralized mortgage obligations (“CMO”) portfolio as many homeowners are refinancing, including some that previously refinanced. The accelerated amortization of premiums coupled with the replacement of sold and called higher yielding investment securities and the replacement of increased payments received on cash flowing investment securities with lower yielding government agency securities during the continued lower interest rate environment has had a significant impact on the yield earned on investment securities which has declined 139 basis points quarter versus quarter.
 
Management has taken steps to improve the net interest margin including reducing the cost of interest bearing liabilities as reflected in the 34 basis point decline quarter versus quarter.  In addition, the Company hired a new Chief Lending Officer (“CLO”) in May 2012 in an effort to shift the mix of interest earnings assets to loans with an emphasis on commercial and industrial and small business lending.  For the third quarter 2012, loans represented 49.4% of average interest earning assets compared to 56.3% for the comparable quarter in 2011.  As a consequence of the slowdown in the housing market and the economic recession, the Company continues to have a high level of non-performing assets despite the recent progress which negatively impacts net interest income as well as operating expenses, such as legal, loan collection and OREO costs, and therefore the overall level of profitability.  The Company has been able to mitigate part of the impact of the non-performing assets and the decline in loan balances by reducing funding costs through the re-pricing of retail CDs and by the run off of higher costing brokered deposits and the paying down of FHLB advances (see the “Net Interest Margin” section of this report). Impaired and non-accrual loans are reviewed in the “Credit Risk Management” section of this report.  Losses per share for basic and diluted were both $0.40 for the third quarter of 2012, as compared to basic and diluted losses per share of $0.18 for the same quarter of 2011.
 
 
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For the nine months ended September 30, 2012, the net loss amounted to $7.6 million which was equivalent to the net loss for the comparable period of 2011. The year to date loss in 2012 was mainly related to a provision for loan and lease losses amounting to $3.4 million, $3.4 million in OREO impairment, a $2.0 million loss contingency accrual for potential DOJ fines and penalties related to the tax lien subsidiaries that was recorded during the first six months of 2012, an impairment on investment securities of $859,000 which was related to one private equity real estate fund and $856,000 in impairment on loans held for sale related to one property.  Also contributing to the loss was a decline in net interest income as a result of the decline in the net interest margin as noted in the third quarter results above. These unfavorable contributing factors were partially offset by $2.0 million in gains on sales of loans which was primarily related to the sale of one non-performing loan during the second quarter of 2012.  After adjusting for the noncontrolling interest, the Company’s 60% share of the loss contingency amounts to $1.2 million.  (For additional information on the DOJ matter, see Item 1 “Legal Proceedings” of this Form 10-Q.)  The year to date loss in 2011 was mainly related to a provision for loan and lease losses amounting to $5.6 million; impairment on investment securities of $1.8 million, resulting primarily from a complete write-down of one trust preferred security in the amount of $1.7 million; OREO impairment of $4.6 million; and lower net interest income due to a continued reduction in loan and investment balances, a continued high level of non-performing assets, and reduced yields on loans and investments; and higher operating expenses attributed mainly to credit quality. As previously noted, as a consequence of the continued weak housing market and slow growth economy, the Company continued to experience a high level of non-performing assets despite the recent progress. Impaired and non-accrual loans are reviewed in the “Credit Risk Management” section of this report.  Basic and diluted losses per share were both $0.69 for the first nine months of 2012 and 2011.
 
Interest Income
 
Total interest income of $7.8 million for the third quarter of 2012 amounted to a decline of $2.3 million, or 22.8%, from the comparable quarter of 2011. The decrease was primarily driven by a decline in average loan balances year over year and a decline in the yield on investment securities.  Average interest earning assets of $744.4 million in the third quarter of 2012 declined $62.3 million, or 7.7%, from $806.7 million in the third quarter of 2011, which was primarily attributed to a decline in loans.  Average loan balances amounted to $367.7 million in the third quarter of 2012, which resulted in a decline of $86.9 million, or 19.1%, year over year.  The decline in loan balances was attributed to loan prepayments, loan pay downs including $25.2 million in higher yielding tax certificates, charge-offs, and transfers to OREO through foreclosure proceedings, and was accompanied by minimal new loan growth. The Company hired a new CLO in May 2012 in an effort to shift the mix of interest earnings assets to loans with an emphasis on commercial and industrial and small business lending.    Average investment securities of $352.3 million during the third quarter of 2012 experienced an increase of $27.2 million, or 8.4%, from the comparable quarter of 2011. This increase in investments was primarily due to the decline in the loan portfolio. Average cash equivalents for the three months ended September 30, 2012, amounted to $24.4 million which resulted in a decline of $2.7 million, or 10.1%, from the comparable quarter of 2011.  The decline resulted from the current strong liquidity levels.
 
For the third quarter of 2012, the yield on average interest earning assets of 4.15% decreased 79 basis points from the level recorded during the comparable quarter of 2011.  The yield reduction was primarily driven by a year over year decline of 139 basis points for investments (1.64% versus 3.03%) and was partially offset by a year over year increase of 22 basis points for loans (6.81% versus 6.59%).  The decrease in investment yield was due to the replacement of sold and called higher yielding investment securities and the reinvestment of increased payments received on cash flowing investment securities during 2011 and 2012 with lower yielding government agency securities during this continued lower interest rate environment coupled with accelerated amortization of premiums paid on investment securities within the MBS/CMO portfolio as a result of the historically sustained low interest rates.  The increase in loan yield reflected a reduced concentration of non-performing loans within the loan portfolio, a higher concentration of higher yielding leases coupled with minimal interest reversals on new non-performing loans, which were partially offset by a reduced concentration of higher yielding tax liens.
 
For the nine months ended September 30, 2012, total interest income amounted to $25.0 million resulting in a decline of $5.6 million, or 18.4% year over year. The decrease was primarily driven by a decline in average loan balances year over year and a decline in the yield on investments, which were partially offset by the increased yield on loans. Average interest earning assets were $762.2 million for the first nine months of 2012 compared to $842.4 million for the comparable period of 2011 resulting in a decline of $80.2 million, or 9.5%.  Average loan balances of $396.5 million for the first nine months of 2012 decreased $89.9 million, or 18.5%, year over year and accounted for the decline.   The decline in loan balances for the first nine months of 2012 was consistent with the third quarter change and was attributed to minimal new loan growth, loan prepayments, loan pay downs including $24.0 million in higher yielding tax lien certificates, charge-offs and transfers to OREO through foreclosure proceedings. Average investments of $343.6 million increased $23.5 million, or 7.3%, from the first nine months of 2011 due to declining loan balances and a reduction in cash equivalents.  Average cash equivalents of $22.1 million decreased $13.8 million, or 38.4%, from the first nine months of 2011 due to the strong liquidity levels.
 
 
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The yield on average interest earning assets for the nine months ended September 30, 2012 of 4.38% declined by 48 basis points from 4.86% for the comparable period of 2011. The yield reduction was comprised of a year over year increase of 34 basis points for loans (6.66% versus 6.32%), which was more than offset by a 114 basis point decline in the investment yield (2.02% versus 3.16%).  The improved loan yield was consistent with the third quarter results and reflected a higher concentration of higher yielding leases and a reduction in non-performing loans coupled with minimal interest reversals on new non-performing loans. The decrease in investment yield was due to the replacement of sold and called higher yielding investment securities and the replacement of increased payments received on cash flowing investment securities during 2012 with lower yielding government agency securities coupled with the accelerated amortization of premiums on investment securities during the first nine months of 2012.
 
Interest Expense
 
Total interest expense amounted to $2.4 million in the third quarter of 2012, which resulted in a decline of $838,000, or 26.1%, from the comparable quarter of 2011.  The reduction in interest expense was mainly associated with a lower level of interest bearing liabilities and a decline in the interest rates paid on those liabilities. Average balances for interest bearing liabilities of $655.5 million for the third quarter of 2012 represented a decline of $63.0 million, or 8.8%, from the comparable quarter of 2011 primarily due to the runoff of maturing brokered CDs and payoff/pay down of FHLB advances. Average time deposits, which include retail and brokered CDs, amounted to $277.9 million during the third quarter of 2012, which resulted in a decline of $20.1 million, or 6.7%, from the level of the comparable quarter of 2011 due principally to the reduction in brokered CDs and the intentional runoff of higher priced retail CDs. As of September 30, 2012, Royal Bank no longer has any brokered CDs on the balance sheet. Management has redeemed $226.9 million in brokered CDs over the past few years as part of the deleveraging strategy and as part of the requirements of the previous Orders. Average NOW and money market deposits decreased $3.4 million, or 1.5%, year over year.  Average balances for borrowings, primarily FHLB advances, amounted to $135.9 million for the third quarter of 2012, reflecting a decline of $40.8 million, or 23.1%, from the comparable period of 2011. During March of 2012 a maturing FHLB advance of $30.0 million at a rate of 4.32% was partially replaced with a five year FHLB advance of $15.0 million with a fixed rate of 1.39% to improve funding costs.
 
The yield on average interest bearing liabilities was 1.44% for the third quarter of 2012 down 34 basis points from 1.78% for the comparable quarter of 2011 as all interest bearing liabilities experienced interest rate declines year over year.  The average interest rate paid on average interest bearing deposits for the third quarter of 2012 was 1.10% resulting in a decline of 31 basis points from the level of 1.41% during the comparable quarter of 2011. The average interest rate paid on CDs during the third quarter of 2012 was 1.62%, which declined 29 basis points, year over year, due to lower interest rates on new accounts and the re-pricing at lower interest rates on a significant portion of the maturing retail CDs. The yield on average NOW and money market deposits of 0.52% declined year over year by 31 basis points due to management’s decision to lower interest rates being offered on deposit products as a result of the sustained low interest rate environment. The average interest rate paid on borrowings during the second quarter of 2012 was 2.75% resulting in a decline of 14 basis points year over year due to the redemption and partial replacement at more attractive interest rates of FHLB advances during 2012.
 
For the nine months ended September 30, 2012, total interest expense of $7.7 million decreased $3.4 million, or 30.4%, from the comparable period in 2011. The decline in interest expense for the first nine months of 2012 was due to an $80.1 million, or 10.6%, decline in average interest bearing liabilities relative to the comparable nine month period of 2011 and a 43 basis point decline in the interest rates paid on interest bearing liabilities year over year.  For the first nine months of 2012, average interest bearing deposits of $523.1 million decreased $56.2 million, or 9.7%, year over year.  The reduction was entirely associated with CDs, which was primarily due to the intentional runoff of brokered CDs as well as the intentional runoff of higher priced retail CDs and was partially offset by an increase in NOW and money market deposits and savings accounts.  Average time deposits amounted to $279.2 million during the first nine months of 2012, which resulted in a decline of $65.2 million, or 18.9%, from the level during the comparable period in 2011 for the reasons previously noted.  Average NOW and money market deposits increased $7.7 million, or 3.5%, year over year. Average borrowings of $154.5 million for the first nine months of 2012 declined $23.9 million, or 13.4%, from the first nine months of 2011 due to the redemption and pay down of FHLB advances. During March of 2012 a maturing FHLB advance of $30.0 million at a rate of 4.32% was partially replaced with a five year FHLB advance of $15.0 million with a fixed rate of 1.39%, which improved funding costs.
 
 
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Consistent with the current quarter’s results, the re-pricing of retail time deposits as well as other deposit categories, and the redemption/pay down  and replacement of FHLB advances have resulted in sizable reductions on interest rates paid on interest bearing liabilities in the first nine months of 2012 relative to the comparable period of 2011. The average interest rate paid on interest bearing liabilities amounted to 1.52% for the first nine months of 2012 which represented a decline of 43 basis points year over year. The average interest rate paid on interest bearing deposits in the first nine months of 2012 amounted to 1.19%, which resulted in a year over year decline of 47 basis points. Year over year lower average interest rates were paid on NOW and money market accounts (0.66% in 2012 versus 0.92% in 2011) and on CDs (1.65% in 2012 versus 2.19% in 2011). The average rate paid on borrowings amounted to 2.65% for the first nine months of 2012 as compared to 2.90%, which resulted in a 25 basis point decline from the comparable nine month period of 2011.
 
Net Interest Margin
 
The net interest margin in the third quarter of 2012 of 2.88% declined 48 basis points from the comparable quarter of 2011. The Company has experienced pressure on its margin similar to many other financial institutions during the third quarter of 2012. Factors contributing to the net interest margin compression include a declining loan portfolio which is evidenced by the $86.9 million decline in the average balance of loans quarter versus quarter and a reduction in the yields earned on the investment portfolio which is a result of accelerated amortization of premiums with the MBS/CMO portfolio as well as lower market rates on new purchases. The decline in the loan portfolio is primarily attributable to increased competition for new loans, the payoff or pay down of existing loans, a reduction in tax lien certificates, and transfers to OREO. As a result of the declining loan portfolio coupled with minimal new loan growth, the average balance of lower yielding investment securities has increased $27.2 million during this same period.  Due to the current interest rate environment, the Company has experienced accelerated amortization of premiums paid on its MBS/CMO portfolio as many homeowners are refinancing into lower rates including some that have previously refinanced as well as refinancing programs such as Home Affordable Refinancing Program (“HARP”) being offered by the government for homeowners that are underwater on their homes.  The accelerated amortization of premiums coupled with the replacement of sold and called higher yielding investment securities and the replacement of increased payments received on cash flowing investment securities with lower yielding government agency securities during the continued lower interest rate environment has had a significant impact on the yield earned on investment securities which has declined 139 basis points quarter versus quarter.
 
Management has taken steps to improve the margin including reducing the cost of interest bearing liabilities as reflected in the 34 basis point decline quarter versus quarter.  In addition, the Company hired a new CLO in May 2012 in an effort to shift the mix of interest earning assets to loans with an emphasis on commercial and industrial and small business lending.  The decline in the yield on interest earning assets of 79 basis points was partially offset by an improvement in the funding costs, which amounted to a reduction of 34 basis points. The decline in yield on interest earning assets was driven by lower yields on average investment securities which more than offset the improved yield for average loans year over year.  The Company continued to pay down maturing brokered CDs throughout 2012 and was also able to lower retail deposit costs through the re-pricing of maturing CDs at lower interest rates and also lowered rates offered on other interest bearing deposit accounts. The increased concentration of higher yielding leases and the reduced concentration of non-performing loans were more than offset by a lower concentration of higher-yielding tax liens, within interest earning assets year over year. During the third quarter of 2012, loans, which are the highest yielding interest earning asset, amounted to 49.4% of total interest earning assets, while they amounted to 56.3% of interest earning assets in the comparable quarter of 2011. In addition, the concentration of the lower yielding investment securities increased from 40.3% in the third quarter of 2011 to 47.3% in the current quarter of 2012.
 
 
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The net interest margin of 3.03% for the nine month period ended September 30, 2012, declined 7 basis points from 3.10% in the comparable period of 2011. The yield on interest earning assets of 4.38% for the nine month period of 2012 amounted to a decline of 48 basis points from the comparable period in 2011 and was almost entirely offset by the benefit of the reduced funding costs.  Interest rates paid on total interest bearing liabilities for the nine month period ended September 30, 2012 declined 43 basis points to 1.52% from the prior year’s comparable period. The change in the yield was primarily caused by a 114 basis point decline in investment securities for the reasons noted in the third quarter results coupled with the accelerated amortization of premiums on investment securities during the first nine months of 2012. This decline was partially offset by an improved yield for loans of 34 basis points due to a reduction in non-performing loans and minimal interest reversals on new non-performing loans. The change in the mix of interest earning assets for the nine month period comparison year over year was fairly consistent with the third quarter of 2012 prior period comparison. Loans amounted to 52.0% of the total interest earning assets in the first nine months of 2012 versus 57.7% for the comparable period of 2011, while investments amounted to 45.1% of total interest earning assets versus 38.0% in the comparable nine month period of 2011.
 
The following tables represent the average daily balances of assets, liabilities and shareholders’ equity and the respective interest bearing assets and interest bearing liabilities, as well as average rates for the periods indicated, exclusive of interest on obligations related to real estate owned via equity investment.  The loans outstanding include non-accruing loans.  The yield on earning assets and the net interest margin are presented on a fully tax-equivalent (FTE) and annualized basis.  The FTE basis adjusts for the tax benefit of income on certain tax-exempt investments and loans using the federal statutory tax rate of 35% for each period presented.
 
   
For the three months ended
   
For the three months ended
 
   
September 30, 2012
   
September 30, 2011
 
(In thousands, except percentages)
 
Average
Balance
   
Interest
   
Yield
   
Average
Balance
   
Interest
   
Yield
 
Cash equivalents
  $ 24,381     $ 10       0.16 %   $ 27,112     $ 19       0.28 %
Investment securities
    352,336       1,453       1.64 %     325,114       2,485       3.03 %
Loans
    367,664       6,298       6.81 %     454,516       7,545       6.59 %
Total interest earning assets
    744,381       7,761       4.15 %     806,742       10,049       4.94 %
Non-earning assets
    73,323                       80,138                  
Total average assets
  $ 817,704                     $ 886,880                  
Interest-bearing deposits
                                               
NOW and money markets
  $ 224,898       292       0.52 %   $ 228,269       475       0.83 %
Savings
    16,901       14       0.33 %     15,689       21       0.53 %
Time deposits
    277,878       1,134       1.62 %     297,939       1,436       1.91 %
Total interest bearing deposits
    519,677       1,440       1.10 %     541,897       1,932       1.41 %
Borrowings
    135,864       939       2.75 %     176,677       1,285       2.89 %
Total interest bearing liabilities
    655,541       2,379       1.44 %     718,574       3,217       1.78 %
Non-interest bearing deposits
    56,963                       55,236                  
Other liabilities
    32,461                       33,173                  
Shareholders' equity
    72,739                       79,897                  
Total average liabilities and equity
  $ 817,704                     $ 886,880                  
Net interest margin
          $ 5,382       2.88 %           $ 6,832       3.36 %

 
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For the nine months ended
   
For the nine months ended
 
   
September 30, 2012
   
September 30, 2011
 
(In thousands, except percentages)
 
Average
Balance
   
Interest
   
Yield
   
Average
Balance
   
Interest
   
Yield
 
Cash equivalents
  $ 22,091     $ 28       0.17 %   $ 35,890     $ 70       0.26 %
Investments securities
    343,622       5,196       2.02 %     320,129       7,567       3.16 %
Loans
    396,526       19,766       6.66 %     486,377       22,986       6.32 %
Total interest earning assets
    762,239       24,990       4.38 %     842,396       30,623       4.86 %
Non-earning assets
    72,340                       81,597                  
Total average assets
  $ 834,579                     $ 923,993                  
Interest-bearing deposits
                                               
NOW and money markets
  $ 227,008       1,126       0.66 %   $ 219,296       1,506       0.92 %
Savings
    16,911       57       0.45 %     15,710       65       0.55 %
Time deposits
    279,154       3,458       1.65 %     344,306       5,635       2.19 %
Total interest bearing deposits
    523,073       4,641       1.19 %     579,312       7,206       1.66 %
Borrowings
    154,533       3,068       2.65 %     178,393       3,870       2.90 %
Total interest bearing liabilities
    677,606       7,709       1.52 %     757,705       11,076       1.95 %
Non-interest bearing deposits
    54,663                       58,022                  
Other liabilities
    27,723                       26,028                  
Shareholders' equity
    74,587                       82,238                  
Total average liabilities and equity
  $ 834,579                     $ 923,993                  
Net interest margin
          $ 17,281       3.03 %           $ 19,547       3.10 %

Rate Volume Analysis
 
The following tables sets forth a rate/volume analysis, which segregates in detail the major factors contributing to the change in net interest income exclusive of interest on obligation through real estate owned via equity investment, for the three and nine month periods ended September 30, 2012, as compared to the respective periods in 2011, into amounts attributable to both rate and volume variances.
 
 
- 53 -

 
 
   
For the three months ended
   
For the nine months ended
 
   
September 30,
   
September 30,
 
   
2012 vs. 2011
   
2012 vs. 2011
 
   
Increase (decrease)
   
Increase (decrease)
 
(In thousands)
 
Volume
   
Rate
   
Total
   
Volume
   
Rate
   
Total
 
Interest income
                                   
Interest-bearing deposits
  $ (4 )   $ (4 )   $ (8 )   $ (14 )   $ (25 )   $ (39 )
Federal funds sold
    -       (1 )     (1 )     -       (3 )     (3 )
Total short term earning assets
    (4 )     (5 )     (9 )     (14 )     (28 )     (42 )
Investments securities
    (103 )     (929 )     (1,032 )     359       (2,730 )     (2,371 )
Loans
                                               
Commercial demand loans
    (520 )     466       (54 )     (1,555 )     1,172       (383 )
Commercial mortgages
    (308 )     (89 )     (397 )     (882 )     127       (755 )
Residential and home equity
    (3 )     (1 )     (4 )     (25 )     (19 )     (44 )
Leases receivables
    44       (38 )     6       19       (85 )     (66 )
Tax certificates
    (854 )     343       (511 )     (2,449 )     674       (1,775 )
Other loans
    (3 )     (5 )     (8 )     (4 )     (15 )     (19 )
Loan fees
    (279 )     -       (279 )     (178 )     -       (178 )
Total loans
    (1,923 )     676       (1,247 )     (5,074 )     1,854       (3,220 )
Total decrease in interest income
  $ (2,030 )   $ (258 )   $ (2,288 )   $ (4,729 )   $ (904 )   $ (5,633 )
                                                 
Interest expense
                                               
Deposits
                                               
NOW and money market
  $ (10 )   $ (173 )   $ (183 )   $ 51     $ (432 )   $ (381 )
Savings
    2       (9 )     (7 )     5       (12 )     (7 )
Time deposits
    (75 )     (227 )     (302 )     (953 )     (1,224 )     (2,177 )
Total deposits
    (83 )     (409 )     (492 )     (897 )     (1,668 )     (2,565 )
Trust preferred
    -       12       12       -       41       41  
Borrowings
    (283 )     (75 )     (358 )     (496 )     (347 )     (843 )
Total decrease in interest expense
  $ (366 )   $ (472 )   $ (838 )   $ (1,393 )   $ (1,974 )   $ (3,367 )
Total (decrease) increase in net interest income
  $ (1,664 )   $ 214     $ (1,450 )   $ (3,336 )   $ 1,070     $ (2,266 )

Credit Risk Management
 
The Company’s loan and lease portfolio (the “credit portfolio”) is subject to varying degrees of credit risk. The Company maintains an allowance for loan and lease losses (the “allowance”) to absorb possible losses in the loan and lease portfolio.  The allowance is based on the review and evaluation of the loan and lease portfolio, along with ongoing, quarterly assessments of the probable losses inherent in that portfolio. The allowance represents an estimation made pursuant to FASB ASC Topic 450, “Contingencies” (“ASC Topic 450”) or FASB ASC Topic 310, “Receivables” (“ASC Topic 310”).  The amount of the allowance is reviewed and approved by the Chief Financial Officer (“CFO”), Chief Administrative Officer (“CAO”), Chief Credit Officer (“CCO”), and CLO on at least a quarterly basis.  The adequacy of the allowance is determined through evaluation of the credit portfolio, and involves consideration of a number of factors, as outlined below, to establish a prudent level. Determination of the allowance is inherently subjective and requires significant estimates, including estimated losses on pools of homogeneous loans and leases based on historical loss experience and consideration of current economic trends, which may be susceptible to significant change. Loans and leases deemed uncollectible are charged against the allowance, while recoveries are credited to the allowance. Management adjusts the level of the allowance through the provision for loan and lease losses, which is recorded as a current period expense. The Company’s systematic methodology for assessing the appropriateness of the allowance includes: (1) general reserves reflecting historical loss rates by loan type, (2) specific reserves for risk-rated credits based on probable losses on an individual or portfolio basis and (3) qualitative reserves based upon current economic conditions and other risk factors.
 
 
- 54 -

 
 
The loan portfolio is stratified into loan segments that have similar risk characteristics. The general allowance is based upon historical loss rates using a three-year rolling average of the historical loss experienced within each loan segment.  The qualitative factors used to adjust the historical loss experience address various risk characteristics of the Company’s loan and lease portfolio include evaluating: (1) trends in delinquencies and other non-performing loans, (2) changes in the risk profile related to large loans in the portfolio, (3) changes in the growth trends of categories of loans comprising the loan and lease portfolio, (4) concentrations of loans and leases to specific industry segments, and (5) changes in economic conditions on both a local and national level, (6) quality of loan review and board oversight, (7) changes in lending policies and procedures, and (8) changes in lending staff.  Each factor is assigned a value to reflect improving, stable or declining conditions based on management’s best judgment using relevant information available at the time of the evaluation. Adjustments to the factors are supported through documentation of changes in conditions in a report accompanying the allowance calculation.
 
The specific reserves are determined utilizing standards required under ASC Topic 310.  A loan is considered impaired when it is probable that interest and principal will not be collected according to the contractual terms of the loan agreement. Non-accrual loans are evaluated for impairment on an individual basis considering all known relevant factors that may affect loan collectability such as the borrower’s overall financial condition, resources and payment record, support available from financial guarantors and the sufficiency of current collateral values (current appraisals or rent rolls for income producing properties), and risks inherent in different kinds of lending (such as source of repayment, quality of borrower and concentration of credit quality). Non-accrual loans that experience insignificant payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan by loan basis for commercial and industrial loans, commercial real estate loans and commercial construction loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate or the fair value of the collateral if the loan is collateral dependent.  An allowance for loan losses is established for an impaired loan if its carrying value exceeds its estimated fair value. The estimated fair values of substantially all of the Company’s impaired loans are measured based on the estimated fair value of the loan’s collateral. The Company obtains third-party appraisals on the fair value of real estate collateral.  Appraised values are discounted to arrive at the estimated selling price of the collateral, which is considered to be the estimated fair value. The discounts also include estimated costs to sell the property. For commercial and industrial loans secured by non-real estate collateral, such as accounts receivable, inventory and equipment, estimated fair values are determined based on the borrower’s financial statements, inventory reports, accounts receivable aging or equipment appraisals or invoices. Indications of value from these sources are generally discounted based on the age of the financial information or the quality of the assets. Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Once a loan is determined to be impaired it will be deducted from the portfolio and the net remaining balance will be used in the general and qualitative analysis.
 
The allowance calculation methodology includes further segregation of loan classes into risk rating categories. The borrower’s overall financial condition, repayment sources, guarantors and value of collateral, if appropriate, are evaluated annually for commercial loans or when credit deficiencies arise, such as delinquent loan payments, for commercial and consumer loans.  Credit quality risk ratings include regulatory classifications of special mention, substandard, doubtful and loss.  Loans classified as special mention have potential weaknesses that deserve management’s close attention.  If uncorrected, the potential weaknesses may result in deterioration of the repayment prospects.  Loans classified as substandard have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt.  They include loans that are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any.  Loans classified as doubtful have all the weaknesses inherent in loans classified substandard with the added characteristic that collection or liquidation in full, on the basis of current conditions and facts, is highly improbable.   Loans classified as a loss are considered uncollectible and are charged to the allowance for loan losses.  Loans not classified are rated pass.
 
The provision for loan and lease losses was $1.8 million and $3.4 million for the three and nine months ended September 30, 2012, respectively compared to $428,000 and $5.6 million for the three and nine months ended September 30, 2011. The 2012 and 2011 provisions are directly related to specific reserves required on impaired loans in accordance with ASC Topic 310.
 
The allowance was $17.4 million and $16.4 million at September 30, 2012 and December 31, 2011, respectively. Although impaired LHFI decreased $18.6 million during the first three quarters of 2012, specific reserves increased $2.7 million as a result of declining collateral values.  The allowance was 5.07% of total loans and leases at September 30, 2012 compared to 3.95% at December 31, 2011.  The $71.2 million decline in loan balances during the nine months ended September 30, 2012 positively impacted the allowance by lowering the general and qualitative portions of the allowance.
 
 
- 55 -

 
 
Management believes that the allowance at September 30, 2012 is adequate. However, its determination requires significant judgment, and estimates of probable losses inherent in the credit portfolio can vary significantly from the amounts actually observed. While management uses available information to recognize probable losses, future changes to the allowance may be necessary based on changes in the credits comprising the portfolio and changes in the financial condition of borrowers, such as may result from changes in economic conditions. In addition, regulatory agencies, as an integral part of their examination process, periodically review the credit portfolio and the allowance. Such review may result in additional provisions based on their judgment of information available at the time of each examination.
 
Changes in the ALLL were as follows:
 
   
For the three
   
For the nine
   
For the year ended
 
   
months ended
   
months ended
   
December 31,
 
(In thousands)
 
September 30, 2012
   
2011
 
Balance at period beginning
  $ 17,495     $ 16,380     $ 21,129  
Charge-offs
                       
Commercial and industrial
    (156 )     (364 )     (2,901 )
Construction and land development
    (1,242 )     (1,242 )     (5,755 )
Residential real estate
    (30 )     (30 )     (635 )
Commercial real estate
    -       -       (1,685 )
Multi-family
    (541 )     (541 )     (328 )
Leases
    (82 )     (377 )     (868 )
Tax certificates
    (29 )     (307 )     (1,039 )
Total charge-offs
    (2,080 )     (2,861 )     (13,211 )
Recoveries
                       
Commercial and industrial
    3       60       22  
Construction and land development
    232       423       196  
Residential real estate
    -       2       153  
Commercial real estate
    -       3       357  
Leases
    6       22       6  
Tax certificates
    -       28       -  
Total recoveries
    241       538       734  
Net charge offs
    (1,839 )     (2,323 )     (12,477 )
Provision for loan and lease losses
    1,761       3,360       7,728  
Balance at period end
  $ 17,417     $ 17,417     $ 16,380  

 
- 56 -

 
 
An analysis of ALLL by loan type is set forth below:
 
   
September 30, 2012
   
December 31, 2011
 
(In thousands, except percentages)
 
Allowance
amount
   
Percent of
outstanding
loans in each
category to
total loans
   
Allowance
amount
   
Percent of
outstanding
loans in each
category to
total loans
 
Commercial and industrial
  $ 1,950       11.6 %   $ 2,331       13.0 %
Construction and land development
    3,481       11.7 %     2,523       13.0 %
Residential real estate
    1,112       7.6 %     1,188       6.4 %
Commercial real estate
    8,688       47.1 %     7,744       44.0 %
Multi-family
    506       2.5 %     531       2.8 %
Tax certificates
    268       8.0 %     425       11.8 %
Leases
    1,149       11.2 %     1,311       8.7 %
Other
    26       0.3 %     20       0.2 %
Unallocated
    237       -       307       0.0 %
Total allowance
  $ 17,417       100.0 %   $ 16,380       100.0 %

The following table presents the principal amounts of non-accrual loans and other real estate owned:
 
   
September 30,
   
December 31,
 
(Amounts in thousands)
 
2012
   
2011
 
Non-accrual LHFI (1)
  $ 25,121     $ 38,755  
Non-accrual LHFS
    2,718       12,569  
Other real estate owned
    22,080       21,016  
Total nonperforming assets
  $ 49,919     $ 72,340  
Nonperforming assets to total assets
    6.23 %     8.53 %
Total non-accural loans to Total loans
    8.05 %     12.02 %
ALLL to non-accrual LHFI
    69.33 %     42.27 %
ALLL to Total LHFI
    5.07 %     3.95 %
 
(1)
Generally, a loan is placed on non-accruing status when it has been delinquent for a period of 90 days or more.
 
 
- 57 -

 
 
The composition of non-accrual loans is as follows:
 
   
September 30, 2012
   
December 31, 2011
 
(In thousands)
 
Loan balance
   
Specific
reserves
   
Loan
balance
   
Specific
reserves
 
Non-accrual loans held for investment
                       
Construction and land development
  $ 5,727     $ 1,210     $ 13,014     $ -  
Commercial real estate
    11,813       1,313       16,671       -  
Commercial & industrial
    5,418       222       4,720       -  
Residential real estate
    1,273       22       1,139       24  
Multi-family
    -       -       1,703       -  
Leases
    174       41       485       114  
Tax certificates
    716       -       1,023       -  
Total non-accrual LHFI
  $ 25,121     $ 2,808     $ 38,755     $ 138  
Non-accrual loans held for sale
                               
Construction and land development
  $ -     $ -     $ 8,901     $ -  
Commercial real estate
    2,718       -       3,634       -  
Residential real estate
    -       -       34       -  
Total non-accrual LHFS
  $ 2,718     $ -     $ 12,569     $ -  
Total non-accrual loans
  $ 27,839     $ 2,808     $ 51,324     $ 138  

Non-accrual loan activity for the first three quarters of 2012 is set forth below:
 
         
1st Quarter Actvity
       
(In thousands)
 
Balance at
January 1, 2012
   
Additions
   
Payments
and other
decreases
   
Charge-offs
   
Transfer to
OREO
   
Balance at
March 31, 2012
 
Non-accrual loans held for investment
                                   
Construction and land development
  $ 13,014     $ -     $ (341 )   $ -     $ (3,161 )   $ 9,512  
Commercial real estate
    16,671       -       (398 )     -       (4,060 )     12,213  
Commercial & industrial
    4,720       2,710       (1,060 )     -       -       6,370  
Residential real estate
    1,139       358       (163 )     -       -       1,334  
Multi-family
    1,703       -       (15 )     -       -       1,688  
Leases
    485       3       -       (133 )     -       355  
Tax certificates
    1,023       811       -       (20 )     (789 )     1,025  
Total non-accrual LHFI
  $ 38,755     $ 3,882     $ (1,977 )   $ (153 )   $ (8,010 )   $ 32,497  
Non-accrual loans held for sale
                                               
Construction and land development
  $ 8,901     $ -     $ (3,770 )   $ -     $ -     $ 5,131  
Commercial real estate
    3,634       -       (60 )     -       -       3,574  
Residential real estate
    34       -       (3 )     -       -       31  
Total non-accrual LHFS
  $ 12,569     $ -     $ (3,833 )   $ -     $ -     $ 8,736  
Total non-accrual loans
  $ 51,324     $ 3,882     $ (5,810 )   $ (153 )   $ (8,010 )   $ 41,233  

 
- 58 -

 
 
         
2nd Quarter Actvity
       
(In thousands)
 
Balance at 
March 31, 2012
   
Additions
   
Payments
and other
decreases
   
Charge-offs
   
Transfer to
OREO
   
Balance at 
June 30, 2012
 
Non-accrual loans held for investment
                                   
Construction and land development
  $ 9,512     $ -     $ (2,694 )   $ -     $ -     $ 6,818  
Commercial real estate
    12,213       295       (461 )     -       -       12,047  
Commercial & industrial
    6,370       96       (615 )     (208 )     -       5,643  
Residential real estate
    1,334       310       (319 )     -       -       1,325  
Multi-family
    1,688       -       (15 )     -       -       1,673  
Leases
    355       -       (21 )     (162 )     -       172  
Tax certificates
    1,025       1,212       -       (258 )     (1,086 )     893  
Total non-accrual LHFI
  $ 32,497     $ 1,913     $ (4,125 )   $ (628 )   $ (1,086 )   $ 28,571  
Non-accrual loans held for sale
                                               
Construction and land development
  $ 5,131     $ -     $ (5,131 )   $ -     $ -     $ -  
Commercial real estate
    3,574       -       -       -       -       3,574  
Residential real estate
    31       -       (31 )     -       -       -  
Total non-accrual LHFS
  $ 8,736     $ -     $ (5,162 )   $ -     $ -     $ 3,574  
Total non-accrual loans
  $ 41,233     $ 1,913     $ (9,287 )   $ (628 )   $ (1,086 )   $ 32,145  
 
         
3rd Quarter Actvity
       
(In thousands)
 
Balance at 
June 30, 2012
   
Additions
   
Payments
and other
decreases
   
Charge-offs
   
Transfer to
OREO
   
Balance at 
September 30,
2012
 
Non-accrual loans held for investment
                                   
Construction and land development
  $ 6,818     $ 286     $ (135 )   $ (1,242 )   $ -     $ 5,727  
Commercial real estate
    12,047       -       (234 )     -       -       11,813  
Commercial & industrial
    5,643       498       (567 )     (156 )     -       5,418  
Residential real estate
    1,325       3       (25 )     (30 )     -       1,273  
Multi-family
    1,673       -       (1,132 )     (541 )     -       -  
Leases
    172       98       (14 )     (82 )     -       174  
Tax certificates
    893       1,425       (177 )     (29 )     (1,396 )     716  
Total non-accrual LHFI
  $ 28,571     $ 2,310     $ (2,284 )   $ (2,080 )   $ (1,396 )   $ 25,121  
Non-accrual loans held for sale
                                               
Commercial real estate
  $ 3,574     $ -     $ -     $ (856 )   $ -     $ 2,718  
Total non-accrual LHFS
  $ 3,574     $ -     $ -     $ (856 )   $ -     $ 2,718  
Total non-accrual loans
  $ 32,145     $ 2,310     $ (2,284 )   $ (2,936 )   $ (1,396 )   $ 27,839  

Total non-accrual loans at September 30, 2012 were $27.8 million and were comprised of $25.1 million in LHFI and $2.7 million in LHFS.  Total non-accrual loans at December 31, 2011 were $51.3 million and were comprised of $38.7 million in LHFI and $12.6 million in LHFS.   The $23.5 million decrease was the result of a $17.4 million reduction in existing non-accrual loan balances through payments and sales, $10.5 million in transfers to OREO, and $3.7 million in charge-offs and write downs partially offset by additions of $8.1 million in non-accrual LHFS.  There was one commercial loan for $2.7 million that went non-accrual during the first quarter of 2012 and $3.7 million in tax certificates that went non-accrual and were then transferred to OREO during the first nine months of 2012.  If interest had been accrued, such income would have been approximately $653,000 and $2.4 million for the three and nine months ended September 30, 2012, respectively.  The Company had no loans past due 90 days or more on which it has continued to accrue interest during the quarter.   Typically, loans are restored to accrual status when the loan is brought current, has performed in accordance with the contractual terms for a reasonable period of time (generally six months) and the ultimate collectibility of the total contractual principal and interest is no longer in doubt.
 
 
- 59 -

 
 
Impaired Loans
 
The Company identifies a loan as impaired when it is probable that interest and principal will not be collected according to the contractual terms of the loan agreement.  The Company does not accrue interest income on impaired non-accrual loans. Excess proceeds received over the principal amounts due on impaired non-accrual loans are recognized as income on a cash basis.  The Company recognizes income under the accrual basis when the principal payments on the loans become current and the collateral on the loan is sufficient to cover the outstanding obligation to the Company.  If these factors do not exist, the Company does not recognize income.
 
The following is a summary of information pertaining to impaired loans and leases:
 
   
September 30,
   
December 31,
 
(In thousands)
 
2012
   
2011
 
Impaired loans with a valuation allowance
  $ 14,718     $ 1,068  
Impaired loans without a valuation allowance
    12,727       45,009  
Impaired LHFS
    2,718       12,569  
Total impaired loans
  $ 30,163     $ 58,646  
                 
Valuation allowance related to impaired loans
  $ 2,808     $ 138  
 
   
For the nine months
 
   
ended September 30,
 
(In thousands)
 
2012
   
2011
 
Average investment in impaired loans
  $ 44,013     $ 64,790  
Interest income recognized on impaired loans and leases
  $ 286     $ 77  
Interest income recognized on a cash basis on impaired loans and leases
  $ 66     $ 52  

Other Real Estate Owned
 
OREO increased $1.1 million from $21.0 million at December 31, 2011 to $22.1 million at September 30, 2012.  Set forth below is a table which details the changes in OREO from December 31, 2011 to September 30, 2012.
 
   
2012
 
(In thousands)
 
First Quarter
   
Second Quarter
   
Third Quarter
 
Beginning balance
  $ 21,016     $ 24,304     $ 23,727  
Net proceeds from sales
    (4,531 )     (922 )     (907 )
Net gain (loss) on sales
    (138 )     255       228  
Assets acquired on non-accrual loans
    8,010       1,086       1,396  
Impairment charge
    (53 )     (996 )     (2,364 )
Ending balance
  $ 24,304     $ 23,727     $ 22,080  

At September 30, 2012, OREO was comprised of $10.3 million in land, a $4.3 million multi-family property, which is under an agreement of sale, $4.0 million in commercial real estate, $2.9 in tax liens and single family homes with a fair value of $527,000.  During the third quarter of 2012, the Company sold collateral related to two loans.  The Company received net proceeds of $35,000 and recorded a loss of $2,000 as a result of these sales.   In addition to the sales mentioned above the Company sold eleven properties acquired through the tax lien portfolio.  The Company received proceeds of $872,000 and recorded net gains of $230,000 as a result of these sales.  During the third quarter of 2012, the Company recorded impairment charges of $2.3 million on five properties based on annual updated appraisals and $54,000 related to properties acquired through the tax lien portfolio.  In addition the Company acquired collateral related to the tax lien portfolio and transferred $1.4 million to OREO.
 
 
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During the second quarter of 2012, the Company sold collateral related to four loans.  The Company received net proceeds of $433,000 and recorded a gain of $133,000 as a result of these sales. In addition to the sales mentioned above the Company sold seven properties acquired through the tax lien portfolio.  The Company received proceeds of $489,000 and recorded gains of $122,000 as a result of these sales.  During the second quarter of 2012, the Company recorded impairment charges of $442,000 on two properties based on expected net sales proceeds and $554,000 related to properties acquired through the tax lien portfolio.  In addition the Company acquired collateral related to the tax lien portfolio and transferred $1.1 million to OREO.
 
During the first quarter of 2012, the Company foreclosed on and sold collateral related to one commercial real estate loan.  The Company received net proceeds of $4.1 million and recorded a gain of $36,000. Additionally the Company sold eight single family homes related to three loans.  The Company received net proceeds of $104,000 and recorded a small net gain of $3,000.  As a result of these sales the Company recorded an impairment charge of $44,000 on the remaining collateral for two of these loans.  In addition to the sales mentioned above, the Company sold ten properties acquired through the tax lien portfolio.  The Company received proceeds of $332,000 and recorded a net loss of $177,000 as a result of these sales.   During the first quarter of 2012, the collateral for a completed hotel and condominium construction project in Minneapolis, Minnesota, in which the Company is a participant, was foreclosed on by the lead lender.  The Company transferred the fair value of $3.2 million to OREO which represents the Company’s participation rate of approximately 7.5%. The Company had previously recorded total charge-offs of $1.5 million to the allowance for loan and lease losses during the period the participation loan was non-accrual.  In addition the Company acquired collateral related to the tax lien portfolio and transferred $789,000 to OREO.   The Company recorded impairment charges of $9,000 related to properties acquired through the tax lien portfolio.
 
Credit Classification Process
 
The loan review function is outsourced to a third party vendor which applies the Company’s loan rating system to specific credits. The Company uses a nine point grading risk classification system commonly used in the financial services industry.  The first four classifications are rated Pass.  The riskier classifications include Pass-Watch, Special Mention, Substandard, Doubtful and Loss.  Upon completion of a loan review, a copy of any review receiving an adverse classification by the reviewer is presented to the Loan Review Committee for discussion. Minutes outlining in detail the Committee’s findings and recommendations are issued after each meeting for follow-up by individual loan officers. The Committee is comprised of the voting members of the Officers’ Loan Committee.  The CCO is the primary bank officer dealing with the third party vendor during the reviews.
 
All loans are subject to initial loan review. Additional review is undertaken with respect to loans providing potentially greater exposure. This is accomplished by:
 
 
·
100% of loans/relationships with balances of $1 million or greater;
 
 
·
25% of loans with balances from $500,000 up to $1 million;
 
 
·
5% of loans with balances below $500,000; and
 
 
·
Loans requested specifically by the Company’s management
 
Loans on the Company’s Special Assets Committee list are also subject to loan review even though they are receiving the daily attention of the assigned officer and monthly attention of the Special Assets Committee.  A watch list is maintained and reviewed at each meeting of the Loan Review Committee. Loans are added to the watch list, even though the loans may be current or less than 30 days delinquent if they exhibit elements of substandard creditworthiness. The watch list contains a statement for each loan as to why it merits special attention, and this list is distributed to the Board of Directors (“Board”) on a monthly basis. Loans may be removed from the watch list if the Loan Review Committee determines that exception items have been resolved or creditworthiness has improved. Additionally, if loans become serious collection matters and are listed on the Company’s monthly delinquent loan or Special Assets Committee lists, they may be removed from the watch list.  The Company’s Classified, Charge-off and Impairment Committee (“CCIC”) Committee approves the process and documentation required to classify, remove from classification, impair or charge-off a loan. CCIC, which is comprised of the Vice Chairman, CFO, CAO, CLO, and Chief Risk Officer, meets as required and provides regular updated reports to the Board.
 
 
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All loans, at the time of presentation to the appropriate loan committee, are given an initial loan “risk” rating by the CCO. From time to time, and at the general direction of any of the various loan committees, the ratings may be changed based on the findings of that committee. Items considered in assigning ratings include the financial strength of the borrower and/or guarantors, the type of collateral, the collateral lien position, the type of loan and loan structure, any potential risk inherent in the specific loan type, higher than normal monitoring of the loan or any other factor deemed appropriate by any of the various committees for changing the rating of the loan. Any such change in rating is reflected in the minutes of that committee.
 
Potential Problem Loans
 
Potential problem loans are loans not currently classified as non-performing loans, but for which management has doubts as to the borrowers’ ability to comply with present repayment terms. The loans are usually delinquent more than 30 days but less than 90 days. Potential problem loans amounted to approximately $2.1 million at September 30, 2012 and $4.2 million at December 31, 2011.
 
Other Income
 
For the third quarter of 2012, other income was $1.2 million compared to $73,000 for the comparable period in 2011. The approximate $1.1 million increase in other income year over year for the third quarter was primarily the result of $0 in OTTI charges on AFS securities in the 2012 period compared to $1.4 million in OTTI charges for the 2011 period.  The OTTI charge in the 2011 period was primarily the result of the complete write-down of one trust preferred security.   A $239,000 decline in net gains on sale of AFS securities ($225,000 in 2012 versus $464,000 in 2011) partially offset the improvement in OTTI charges.
 
For the nine months ended September 30, 2012, other income amounted to $3.8 million compared to $4.2 million for the comparable period of 2011, resulting in a decrease of $467,000.  The decline in other income was attributable to a $1.2 million decrease in net gains on the sale of AFS securities ($384,000 in 2012 compared to $1.6 million in 2011), a $1.2 million decrease in net gains on the sale of OREO ($345,000 in 2012 versus $1.5 million in 2011), and a $626,000 decrease in income related to real estate owned via equity investment ($56,000 in 2012 versus $682,000 in 2011). Partially offsetting these declines was a $2.0 million increase in gains on the sale of loans and leases ($2.0 million in 2012 versus $51,000 in 2011) which was due to the sale of one non-performing loan during the second quarter of 2012. OTTI charges for the nine months ended September 30, 2012 were $859,000 compared to $1.8 million for the same period in 2011.  The 2012 OTTI charge was recorded during the second quarter and was related to one private equity real estate fund that experienced a decline in the value.
 
Other Expense
 
Non-interest expense for the third quarter of 2012 amounted to $9.4 million resulting in an increase of $1.3 million, or 16.0%, from the comparable quarter of 2011. The increase was primarily attributable to an $871,000 increase in OREO impairments ($2.4 million in 2012 compared to $1.5 million in 2011) and an $856,000 impairment on one LHFS due to a loan sale agreement.  The additional OREO impairment was primarily due to the declining values of four of the vacant land properties in the portfolio.   Partially offsetting these increases was a decline in OREO and loan collection expenses of $433,000 ($393,000 in 2012 compared to $826,000 in 2011) and a $166,000 decrease in FDIC Insurance and Pennsylvania Department of Banking assessments ($287,000 in 2012 versus $453,000 in 2011) which was mainly the result of lower assessment rates based on the removal of the Orders during the fourth quarter of 2011.  Professional and legal fees remain elevated as the Company works through resolving its non-performing assets and the   DOJ tax lien investigation and litigation ($986,000 in 2012 compared to $904,000 in 2011).
 
 
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For the nine-month period ended September 30, 2012, non-interest expense of $26.1 million grew $1.2 million, or 4.9%, from the comparable period of 2011.  Driving the 2012 increase in non-interest expense was a $2.0 million loss contingency accrual for potential DOJ fines and penalties related   to the tax lien subsidiaries (for additional information please read “Part II. Other Information” “Item 1. Legal Proceedings” of this Form 10Q), a $655,000 increase in salaries and benefits   which was primarily related to annual merit and promotional increases, the hiring of a new CLO, retention payments and increased pension costs ($8.9 million in 2012 versus $8.3 million in 2011), and a $552,000 increase in impairment on one LHFS ($856,000 in 2012 versus $304,000 in 2011).  Partially offsetting these increases was a $1.2 million decline in OREO impairments ($3.4 million in 2012 versus $4.6 million in 2011) and a $761,000 decrease in FDIC Insurance and Pennsylvania Department of Banking assessments ($778,000 in 2012 versus $1.5 million in 2011) which was mainly the result of lower assessment rates based on the removal of the Orders during the fourth quarter of 2011.  Professional and legal fees ($3.3 million in 2012 and 2011) and OREO and loan collection expenses ($1.8 million in 2012 versus $2.0 million in 2011) remain elevated as the Company works through resolving its non-performing assets and the   DOJ tax lien investigation.
 
Income Taxes
 
Total income tax expense for the three and nine months ended September 30, 2012 and 2011 was $0. The Company did not record a tax benefit despite the net loss in the third quarter of 2012 since it concluded at December 31, 2011 that it was more likely than not that the Company would not generate sufficient future taxable income to realize all of the deferred tax assets. Management’s conclusion was based on consideration of the relative weight of the available evidence and the uncertainty of future market conditions on results of operations. The Company recorded a non-cash charge of $15.5 million in the consolidated statements of operations in the period ended December 31, 2008 related to the establishment of a valuation allowance for the deferred tax asset for the portion of the future tax benefit that more likely than not will not be utilized in the future. During 2009, 2010, and 2011 the Company established additional valuation allowances of $10.2 million, $7.7 million,  and $3.0 million respectively, which was the result of the net operating losses for each year and the portion of the future tax benefit that more than likely will not be utilized in the future.  The valuation allowance for deferred tax assets at September 30, 2012, totaled $36.4 million. The effective tax rate for the three and nine months ended September 30, 2012 and 2011 was 0%.
 
Results of Operations by Business Segments
 
The Company has identified two reportable operating segments, “Community Banking” and “Tax Liens”.  In previous years, the Company reflected “Equity Investments” and “Leasing” as operating segments.  Management has determined that the operating results and assets related to Equity Investments and Leasing should be reflected under the Community Banking segment.  The determination related to Equity Investments was based on the deconsolidation of the VIE as a result of the completion of the project. The determination related to Leasing was based on not meeting the quantitative thresholds for requiring disclosure.
 
   
Three months ended September 30, 2012
 
   
Community
   
Tax Lien
       
(In thousands)
 
Banking
   
Operation
   
Consolidated
 
Total assets
  $ 759,099     $ 42,582     $ 801,681  
Total deposits
  $ 571,250     $ -     $ 571,250  
Interest income
  $ 6,542     $ 1,219     $ 7,761  
Interest expense
    1,782       597       2,379  
Net interest income
  $ 4,760     $ 622     $ 5,382  
Provision for loan and lease losses
    1,796       (35 )     1,761  
Total other  income
    847       304       1,151  
Total other expenses
    8,851       558       9,409  
Income tax (benefit) expense
    (156 )     156       -  
Net (loss) income
  $ (4,884 )   $ 247     $ (4,637 )
Noncontrolling interest
  $ 76     $ 99     $ 175  
Net (loss) income attributable to Royal Bancshares
  $ (4,960 )   $ 148     $ (4,812 )

 
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Three months ended September 30, 2011
 
   
Community
   
Tax Lien
       
(In thousands)
 
Banking
   
Operation
   
Consolidated
 
Total assets
  $ 780,257     $ 77,106     $ 857,363  
Total deposits
  $ 577,891     $ -     $ 577,891  
Interest income
  $ 8,275     $ 1,774     $ 10,049  
Interest expense
    2,635       582       3,217  
Net interest income
  $ 5,640     $ 1,192     $ 6,832  
Provision for loan and lease losses
    180       248       428  
Total other  income
    72       1       73  
Total other expenses
    7,662       447       8,109  
Income tax (benefit) expense
    (193 )     193       -  
Net (loss) income
  $ (1,937 )   $ 305     $ (1,632 )
Noncontrolling interest
  $ 139     $ 122     $ 261  
Net (loss) income attributable to Royal Bancshares
  $ (2,076 )   $ 183     $ (1,893 )

   
Nine months ended September 30, 2012
 
 
 
Community
   
Tax Lien
       
(In thousands)
 
Banking
   
Operation
   
Consolidated
 
Total assets
  $ 759,099     $ 42,582     $ 801,681  
Total deposits
  $ 571,250     $ -     $ 571,250  
Interest income
  $ 20,833     $ 4,157     $ 24,990  
Interest expense
    5,494       2,215       7,709  
Net interest income
  $ 15,339     $ 1,942     $ 17,281  
Provision for loan and lease losses
    3,239       121       3,360  
Total other income
    3,434       323       3,757  
Total other expenses
    21,435       4,633       26,068  
Income tax expense (benefit)
    201       (201 )     -  
Net loss
  $ (6,102 )   $ (2,288 )   $ (8,390 )
Noncontrolling interest
  $ 156     $ (915 )   $ (759 )
Net loss attributable to Royal Bancshares
  $ (6,258 )   $ (1,373 )   $ (7,631 )

 
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Nine months ended September 30, 2011
 
 
 
Community
   
Tax Lien
       
(In thousands)
 
Banking
   
Operation
   
Consolidated
 
Total assets
  $ 780,257     $ 77,106     $ 857,363  
Total deposits
  $ 577,891     $ -     $ 577,891  
Interest income
  $ 24,622     $ 6,001     $ 30,623  
Interest expense
    9,138       1,938       11,076  
Net interest income
  $ 15,484     $ 4,063     $ 19,547  
Provision for loan and lease losses
    5,016       552       5,568  
Total other income
    3,738       486       4,224  
Total other expenses
    23,486       1,377       24,863  
Income tax (benefit) expense
    (1,022 )     1,022       -  
Net (loss) income
  $ (8,258 )   $ 1,598     $ (6,660 )
Noncontrolling interest
  $ 330     $ 639     $ 969  
Net (loss) income attributable to Royal Bancshares
  $ (8,588 )   $ 959     $ (7,629 )
 
Community Bank Segment
 
Royal Bank America
 
Royal Bank was incorporated in the Commonwealth of Pennsylvania on July 30, 1963, was chartered by the Commonwealth of Pennsylvania Department of Banking and commenced operation as a Pennsylvania state-chartered bank on October 22, 1963. Royal Bank is the successor of the Bank of King of Prussia, the principal ownership of which was acquired by the Tabas family in 1980. The deposits of Royal Bank are insured by the FDIC.  Royal Bank established the wholly-owned subsidiaries RBA Property LLC and Narberth Property Acquisition LLC in 2008 and Rio Marina LLC in 2009.  These three subsidiaries were formed to hold other real estate owned acquired through foreclosure of collateral associated with non-performing loans.
 
Royal Bank derives its income principally from interest charged on loans, interest earned on investment securities, and fees received in connection with the origination of loans and other services. Royal Bank’s principal expenses are interest expense on deposits and borrowings and operating expenses. Operating revenues, deposit growth, investment maturities, loan sales and the repayment of outstanding loans provide the majority of funds for activities.
 
Royal Bank conducts business operations as a commercial bank offering checking accounts, savings and time deposits, and loans, including residential mortgages, home equity and SBA loans. Royal Bank also offers safe deposit boxes, collections, internet banking and bill payment along with other customary bank services (excluding trust) to its customers. Drive-up, ATM, and night depository facilities are available. Services may be added or deleted from time to time. The services offered and the business of Royal Bank is not subject to significant seasonal fluctuations. Royal Bank is a member of the Federal Reserve Fedline Wire Transfer System.
 
Service Area: Royal Bank’s primary service area includes Pennsylvania, primarily Montgomery, Chester, Bucks, Delaware, Berks and Philadelphia counties, and New Jersey.  This area includes residential areas and industrial and commercial businesses of the type usually found within a major metropolitan area.  Royal Bank serves this area from fifteen branches located throughout Montgomery, Philadelphia and Berks counties and New Jersey.  Royal Bank also considers New York, Maryland, and Delaware as a part of its service area for certain products and services.  In the past, Royal Bank had frequently conducted business with clients located outside of its service area.  Royal Bank has loans in twenty-four states via loan originations and/or participations with other lenders who have broad experience in those respective markets. Royal Bank’s headquarters are located at 732 Montgomery Avenue, Narberth, Pennsylvania.
 
 
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Competition: The financial services industry in our service area is extremely competitive. Competitors within our service area include banks and bank holding companies with greater resources. Many competitors have substantially higher legal lending limits. In addition, savings banks, savings and loan associations, credit unions, money market and other mutual funds, mortgage companies, leasing companies, finance companies and other financial services companies offer products and services similar to those offered by Royal Bank, on competitive terms.
 
Employees: Royal Bank employed approximately 158 people on a full-time equivalent basis as of September 30, 2012.
 
Deposits: At September 30, 2012, total deposits of Royal Bank were distributed among demand deposits (11%), money market deposits, savings and NOW accounts (41%) and time deposits (48%). At September 30, 2012, deposits of $577.3 million declined $4.9 million from $582.2 million at year end 2011. Checking and savings accounts increased $1.1 million and $840,000, respectively, while money market accounts and time deposits declined $4.3 million and $2.5 million, respectively.  Included in Royal Bank’s deposits are approximately $6.1 million of intercompany deposits that are eliminated through consolidation.
 
Current market and regulatory trends in banking are changing the basic nature of the banking industry.  Royal Bank intends to keep pace with the banking industry by being competitive with respect to interest rates and new types or classes of deposits insofar as it is practical to do so consistent with Royal Bank’s size, objective of profit maintenance and stable capital structure.
 
Lending: At September 30, 2012, Royal Bank, including its subsidiaries, had a total net loan portfolio (excluding loans held for sale) of $325.6 million, representing 41% of total assets. The loan portfolio is categorized into commercial demand, commercial mortgages, residential mortgages (including home equity lines of credit), construction, real estate tax liens, small business leases and installment loans.  At September 30, 2012, total loans decreased $81.0 million from year end 2011 due to pay downs, payoffs, sales, transfers to OREO, and charge-offs which were partially offset by new originations.
 
Business results : Total interest income of Royal Bank for the quarter ended September 30, 2012 was $7.8 million compared to $10.0 million for the quarter ended September 30, 2011, a decrease of 23%. Total interest income for the first nine months of 2012 was $25.0 million compared to $30.6 million for the same period in 2011.  The decline in interest income for both the quarter and year to date was primarily attributed to a significant reduction in average loan balances and a lower yield on investment securities. Interest expense was $2.4 million for the quarter ended September 30, 2012, compared to $3.2 million for the quarter ended September 30, 2011, a decrease of 26%. Interest expense for the first nine months of 2012 was $7.7 million compared to $11.1 million for the same period in 2011.  The decline in interest expense was the result of re-pricing time deposit maturities and the payoff of a higher interest-bearing FHLB advance.  Royal Bank recorded a net loss of $4.7 million for the quarter ended September 30, 2012 compared to a net loss of $1.1 million for the quarter ended September 30, 2011. The increase in the net loss quarter over quarter was largely due to increases in the provision for loan and lease losses, impairment on OREO and impairment on LHFS of $1.3 million, $871,000, and $856,000, respectively.  Royal Bank recorded a net loss of $6.4 million for the first nine months of 2012 compared to a net loss of $7.0 million for the comparable period in 2011.  The slight improvement year over year of $562,000 was the result of a $2.0 million gain on the sale of loans, a $2.2 million reduction in the provision for loan and lease losses, and a $937,000 reduction in investment impairment which were mostly offset by a $2.0 million loss contingency accrual for a potential settlement with the DOJ related to the tax lien subsidiaries, a $1.2 million decline in gains on sales of investment securities, and a $1.1 million decline in gains on sales of OREO.   After adjusting for the noncontrolling interest, Royal Bank’s 60% share of the loss contingency amounts to $1.2 million.  Total assets of Royal Bank were $794.6 million at September 30, 2012 compared to $840.6 million at December 31, 2011.  The above amounts reflect the consolidation totals for Royal Bank and its subsidiaries.  The subsidiaries included in these amounts are Royal Investments America, Royal Real Estate, Royal Bank America Leasing, Royal Tax Lien Services, Crusader Servicing Corporation, RBA Property LLC, Narberth Property Acquisitions, and Rio Marina LLC.
 
Royal Bank America Leasing, LP
 
On July 25, 2005, the Company, through its wholly-owned subsidiary Royal Bank, formed Royal Bank America Leasing, LP (“Royal Leasing”). Royal Bank holds a 60% ownership interest in Royal Leasing. Legal headquarters are 550 Township Line Road, Blue Bell, Pennsylvania. Royal Leasing was formed to originate small business leases. Royal Leasing originates small ticket leases through its internal sales staff and through independent brokers located throughout its business area. In general, Royal Leasing will portfolio individual small ticket leases in amounts of up to $250,000. Leases originated in amounts in excess of that are sold for a profit to other leasing companies. These purchases are at market based on pricing and terms that Royal Leasing would expect to receive from unrelated third-parties. From time to time Royal Leasing will sell small lease portfolios to third-parties and will, on occasion, purchase lease portfolios from other originators. During the first nine months of 2012 and 2011, neither sales nor purchases of lease portfolios were material.
 
 
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Business results : At September 30, 2012, total assets of Royal Leasing were $38.2 million, including $38.0 million in net leases, as compared to $36.5 million in assets at December 31, 2011. During the quarter ended September 30, 2012, Royal Leasing had net interest income of $530,000, a decrease of $16,000 from the comparable period of 2011; provision for lease losses of $13,000 versus $38,000 in the comparable quarter of 2011; non-interest income of $147,000 in each quarter; and non-interest expense of $225,000 versus $161,000 for the third quarter of 2011.  Royal Leasing recorded net income prior to management distribution fees of $386,000 for the three months ended September 30, 2012 compared to net income of $352,000 for the comparable period in 2011. For the first nine months of 2012, Royal Leasing recorded net income prior to management distribution fees of $1.1 million compared to net income of $794,000 for the comparable period of 2011.
 
Royal Bank has extended loans to RBA Leasing at market interest rates, secured by the lease portfolio of RBA Leasing and as per the provisions of Regulation W. At September 30, 2012, the amount due Royal Bank from RBA Leasing was $35.4 million.
 
Royal Investments America
 
On June 23, 2003, the Company, through its wholly-owned subsidiary Royal Bank, established Royal Investments America, LLC (“RIA”) as a wholly-owned subsidiary. Legal headquarters are at 732 Montgomery Avenue, Narberth, Pennsylvania. RIA was formed to invest in equity real estate ventures subject to limitations imposed by the FDIC and Pennsylvania Department of Banking by regulation.
 
Business results : At September 30, 2012 and December 31, 2011, total assets of RIA were $5.9 million.  For the quarter ended September 30, 2012, RIA had net income of $12,000 compared to net income of $800,000 for the comparable period of 2011. Net income for the first nine months of 2012 amounted to $53,000 compared to net income of $1.2 million for the comparable period of 2011.  The decline in net income for the three and nine months ended September 30, 2012 was attributable to the deconsolidation of a variable interest entity at the end of 2011 that was associated with RIA as a result of the sale of the remaining condominium units.
 
Royal Bank had previously extended loans to RIA at market interest rates, secured by the loan portfolio of RIA and in accordance with the provisions of Regulation W. At September 30, 2012, there were no outstanding loans from Royal Bank to RIA.
 
Royal Investments of Delaware
 
On June 30, 1995, the Company established a special purpose Delaware investment company, Royal Investments of Delaware (“RID”), as a wholly-owned subsidiary. Legal headquarters are at 1105 N. Market Street, Suite 1300, Wilmington, Delaware. RID buys, holds and sells investment securities.
 
Business results : For the quarter ended September 30, 2012, RID reported net income of $152,000, compared to net income of $168,000 for the quarter ended September 30, 2011.  For the first nine months of 2012, RID reported a net loss of $248,000 versus net income of $928,000 in the comparable period of 2011 primarily due to $859,000 in investment impairment on a private equity real estate fund. At September 30, 2012, total assets of RID were $29.5 million, of which $1.3 million was held in cash and cash equivalents and $4.8 million was held in investment securities. The amounts shown above include the activity related to RID’s wholly-owned subsidiary Royal Preferred LLC.  Royal Bank previously extended loans to RID, secured by securities and as per the provisions of Regulation W.  At September 30, 2012 no loans were outstanding.
 
 
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Royal Preferred LLC
 
On June 16, 2006, the Company, through its wholly-owned subsidiary RID, established Royal Preferred LLC as a wholly-owned subsidiary. Royal Preferred LLC was formed to purchase a subordinated debenture from Royal Bank America.  At September 30, 2012, Royal Preferred LLC had total assets of approximately $23.3 million.
 
Royal Bancshares Capital Trust I and II
 
On October 27, 2004, the Company formed two Delaware trust affiliates, Royal Bancshares Capital Trust I and Royal Bancshares Capital Trust II, in connection with the sale of an aggregate of $25.0 million of a private placement of trust preferred securities. The interest rates for the debt securities associated with the Trusts at September 30, 2012 amounted to 2.54%.
 
On August 13, 2009, the Company’s Board determined to suspend interest payments on the trust preferred securities.  The Company’s Board took this action in consultation with the Federal Reserve Bank of Philadelphia as required by regulatory policy guidance.  The Company currently has sufficient capital and liquidity to pay the scheduled interest payments; however, this decision better supports the capital position of Royal Bank, a wholly-owned subsidiary of the Company.  As of September 30, 2012 the trust preferred interest payment in arrears was $2.3 million and has been recorded in interest expense and accrued interest payable.
 
Tax Lien Operations
 
Crusader Servicing Corporation
 
The Company, through its wholly-owned subsidiary Royal Bank, holds a 60% ownership interest in Crusader Servicing Corporation (“CSC”). Legal headquarters are at 732 Montgomery Avenue, Narberth, Pennsylvania.  CSC acquires, through auction, delinquent property tax liens in various jurisdictions, assuming a lien position that is generally superior to any mortgage liens on the property, and obtaining certain foreclosure rights as defined by local statute. Due to a change in CSC management, Royal Bank and other shareholders, constituting a majority of CSC shareholders, voted to liquidate CSC under an orderly, long term plan adopted by CSC management. Royal Bank will continue acquiring tax liens through its newly formed subsidiary, Royal Tax Lien Services, LLC.  At September 30, 2012, total assets of CSC were $7.4 million.  Included in total assets is $716,000 for the Strategic Municipal Investments (“SMI”) portfolio, which is comprised of residential, commercial, and land tax liens, primarily in Alabama.  In 2005, CSC entered into a partnership with Strategic Municipal Investments (“SMI”), ultimately acquiring a 50% ownership interest in SMI.  In connection with acquiring this ownership interest, CSC extended financing to SMI in the approximate amount of $18.0 million, which was used by SMI to purchase a tax lien portfolio at a discount.  As a result of the deterioration in residential, commercial and land values principally in Alabama, management concluded based on an analysis of the portfolio in the fourth quarter of 2008 that the loan was impaired.  CSC has recorded charge-offs of $3.6 million related to this loan through December 31, 2011.  CSC recorded a charge-off related to this loan of $171,000 in the second quarter of 2012.  The outstanding SMI loan balance was $716,000 and $1.0 million at September 30, 2012 and December 31, 2011.
 
Business results : Net interest expense for CSC was $3,000 for the quarter ended September 30, 2012 compared to net interest income of $53,000 for the third quarter of 2011. Net interest income for the first three quarters of 2012 decreased $155,000 from $200,000 for the first nine months of 2011 to $45,000 due to an increase in funding costs and the liquidation of the portfolio.   For the three and nine months ended September 30, 2012, CSC recorded net losses of $1.1 million and $2.6 million, respectively, compared to net losses of $108,000 and $109,000, respectively, for the comparable periods of 2011.  The decline in net income for the three and nine months ended September 30, 2012 was largely driven by a $2.0 million loss contingency accrual for potential DOJ fines and penalties related to its  investigation.  CSC recorded an aggregate of $2.0 million ($1.0 million in the first and second quarters of 2012 and an additional $1.0 million in the third quarter of 2012).  On September 26, 2012, as a result of the former President of CSC’s guilty plea and pursuant to a plea agreement with the DOJ, CSC entered a guilty plea in the United States District Court for the District of New Jersey to one count of conspiracy to commit bid-rigging at certain auctions for tax liens in New Jersey.  The DOJ further agreed to recommend that the appropriate fine for CSC would be $2.0 million, which, as stated above, has been recognized in the Company’s financial statements.  For additional information please read “Part II Other Information” “Item 1 Legal Proceedings” of this Form 10-Q.  Additionally CSC recognized an increase in OREO impairment of $356,000 during the nine months ended September 30, 2012 compared to the same period in 2011.  At September 30, 2012, total assets of CSC were $7.4 million, of which $6.4 million was held in tax liens. The allowance for lien loss was $113,000 at September 30, 2012.
 
 
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Royal Bank has extended loans to CSC at market interest rates, secured by the tax lien portfolio of CSC and in accordance with the provisions of Regulation W. At September 30, 2012, the amount due Royal Bank from CSC was $7.1 million.
 
Royal Tax Lien Services, LLC
 
On November 17, 2006, the Company, through its wholly-owned subsidiary Royal Bank, formed Royal Tax Lien Services, LLC (“RTL”). Royal Bank holds a 60% ownership interest in RTL. Its legal headquarters is located at 732 Montgomery Avenue, Narberth, Pennsylvania 19072.  RTL was formed to purchase and service delinquent tax certificates.  RTL typically acquires delinquent property tax liens through public auctions in various jurisdictions, assuming a lien position that is generally superior to any mortgage liens that are on the property, and obtaining certain foreclosure rights as defined by local statute.
 
Business results: Net interest income for RTL of $624,000 and $1.9 million for the three and nine months ended September 30, 2012, decreased $514,000 and $2.0 million, respectively, from the comparable periods in 2011 largely due to an increase in funding costs and a decline in the average tax liens outstanding.   RTL recorded net income of $1.2 million for the quarter ended September 30, 2012 compared to net income of $412,000 for the comparable quarter of 2011.  The $900,000 increase in net income was primarily due to the $1.0 million reversal of the loss contingency accrual recorded in the first and second quarters of 2012 and a $267,000 increase in gains on sale of OREO which were partially offset by increased professional and legal fees of $168,000, and OREO related charges of $31,000.  For additional information please read “Part II Other Information” “Item 1 Legal Proceedings” of this Form 10Q.   For the first nine months of 2012, RTL recorded net income of $346,000 compared to net income of $1.7 million for the comparable period in 2011. The $1.4 million decline was primarily related to the $2.0 million decrease in net interest income mentioned above which was partially offset with a decline in the provision for lien losses of $183,000.  At September 30, 2012, total assets of RTL were $35.2 million, of which $34.1 million was held in tax liens compared to total assets at December 31, 2011 of $61.8 million, of which the majority was held in tax liens.
 
Royal Bank has extended loans to RTL at market interest rates, secured by the tax lien portfolio of RTL and in accordance with the provisions of Regulation W.  At September 30, 2012, the amount due Royal Bank from RTL was $24.6 million.
 
FINANCIAL CONDITION
 
Consolidated Assets
 
Total consolidated assets at September 30, 2012 were $801.7 million, a decrease of $46.8 million, or 5.5%, from December 31, 2011.  This decrease was mainly attributed to a reduction of $72.2 million, or 18.2%, in net loans and leases primarily due to the payoffs, pay downs, charge-offs and transfers to OREO and a $9.9 million, or 78.4%, decrease in loans held for sale.   Partially offsetting these declines was an increase in investment securities and cash and cash equivalents of $29.4 million and $14.9 million, respectively.
 
Cash and Cash Equivalents
 
Total cash and cash equivalents of $39.4 million at September 30, 2012 grew $14.9 million, or 61.0%, from $24.5 million at December 31, 2011 mainly due to the decline in loan balances.
 
 
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Investment Securities
 
AFS investment securities of $358.5 million at September 30, 2012, increased $29.4 million, or 9.0%, from the level at December 31, 2011.  The increase was primarily due to the purchase of U.S. government agencies and U.S. government agency CMOs as a result of the excess cash from the reduction in loan balances during the first three quarters of 2012.  During the first quarter of 2012, the Company reduced its exposure in non-agency CMOs and corporate bonds by selling a portion of these investments that were held in the investment portfolio. FHLB stock was $6.9 million at September 30, 2012 and $8.5 million at December 31, 2011.
 
The AFS portfolio had gross unrealized losses of $875,000 at September 30, 2012, which slightly improved $246,000 from gross unrealized losses of $1.1 million at December 31, 2011.  The decrease in gross unrealized losses on Agency CMOs, corporate bonds and residential mortgage backed securities were slightly offset by an increase in gross unrealized losses on Non-agency CMOs and other securities.  The Company recorded OTTI impairment of $859,000 on a private equity real estate fund during the second quarter of 2012. The AFS portfolio had gross unrealized gains of $8.4 million at September 30, 2012, which increased $1.7 million from gross unrealized gains of $6.7 million at December 31, 2011.  For the nine months ended September 30, 2012, the increase in net unrealized gains was primarily associated with an increase of gross unrealized gains related to Agency CMOs, residential mortgage backed securities and U.S. government agency securities.
 
Investment securities within the AFS portfolio are marked to market quarterly and any resulting gains or losses are recorded in other comprehensive income, net of taxes, within the equity section of the balance sheet as shown in “Note 14 - Comprehensive Income (Loss)” to the Consolidated Financial Statements. When a loss is deemed to be other-than-temporary but the Company does not intend to sell the security and it is not more likely than not that the Company will have to sell the security before recovery of its cost basis, the Company will recognize the credit component of an OTTI charge in earnings and the remaining portion in other comprehensive income.
 
The Company will continue to monitor these investments to determine if the continued negative trends, market valuations or credit defaults result in impairment that is other-than-temporary.
 
Loans and Leases
 
Total loans and leases of $343.0 million decreased $71.2 million, or 17.2%, from the level at December 31, 2011.  The decline was attributed to payoffs, balances being paid down, transfers to OREO, and charge-offs during the first three quarters of 2012.  The tax certificates, commercial real estate, construction and land development, and commercial and industrial loan portfolios declined $21.2 million, $20.7 million, $13.8 million and $14.3 million, respectively. The declines for all four loan categories were related to loan payoffs, pay downs and transfers to OREO of $10.5 million.   Partially offsetting these declines was small growth in leases of $2.3 million.  The Company has become more selective in approving construction loans as well as commercial real estate loans given the existing loan concentration coupled with the current weak housing market and commercial real estate market. As a result, the Company has shifted its lending focus to generating small business loans, owner occupied commercial real estate and more recently middle market business lending.
 
 
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The following table represents loan balances by type:
 
   
September 30,
   
December 31,
 
(In thousands)
 
2012
   
2011
 
Commercial and industrial
  $ 39,831     $ 54,136  
Construction
    6,293       14,066  
Land Development
    33,987       40,054  
Residential real estate
    26,100       26,637  
Commercial real estate
    161,834       182,579  
Multi-family
    8,490       11,622  
Tax certificates
    27,622       48,809  
Leases
    38,313       36,014  
Other
    1,094       949  
Total gross loans and leases
  $ 343,564     $ 414,866  
Deferred fees, net
    (515 )     (623 )
Total loans and leases
  $ 343,049     $ 414,243  

Deposits
 
Total deposits, which are the primary source of funds, slightly decreased $4.7 million, or 0.8%, to $571.3 million at September 30, 2012, from December 31, 2011.  Money market and NOW accounts and brokered CDs declined $7.7 million and $5.8 million, respectively, while demand, retail time deposits and savings accounts increased $4.7 million, $3.3 million and $840,000, respectively from year end 2011.
 
The following table represents ending deposit balances by type:
 
   
September 30,
   
December 31,
 
(In thousands)
 
2012
   
2011
 
Demand (non-interest bearing)
  $ 59,262     $ 54,534  
NOW
    39,776       43,172  
Money Markets
    178,529       182,830  
Savings
    17,103       16,263  
Time deposits (over $100)
    99,716       95,334  
Time deposits (under $100)
    176,864       177,960  
Brokered deposits
    -       5,823  
Total deposits
  $ 571,250     $ 575,916  

Borrowings
 
At September 30, 2012, total borrowings of $134.2 million decreased $39.6 million, or 22.8%, from $173.8 million at December 31, 2011. This reduction is attributed to the maturity of a $30.0 million advance, $2.2 million in monthly payments on an amortizing borrowing and a $22.0 million repayment of short-term borrowings. The Company partially replaced the matured $30.0 million with a $15.0 million long term advance.
 
 
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Shareholders’ Equity
 
Consolidated shareholders’ equity of $69.0 million decreased $6.9 million, or 9.1%, from $75.9 million at December 31, 2011. The decrease was primarily related to the net loss of $7.6 million and a decline in non-controlling interest of $759,000 partially offset by an increase of $1.4 million in other comprehensive income related to improvement in the valuation of the investment portfolio during the first three quarters of 2012.
 
CAPITAL ADEQUACY
 
The Company and Royal Bank are subject to various regulatory capital requirements administered by the federal banking agencies.  Failure to meet minimum capital requirements can initiate certain mandatory and possible additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s financial statements.  Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company must meet specific capital guidelines that involve quantitative measures of the Company’s assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. The Company’s and Royal Bank’s capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.
 
Quantitative measures established by regulations to ensure capital adequacy require the Company and Royal Bank to maintain minimum amounts and ratios (set forth in the table below) of total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier I capital (as defined) to average assets (as defined).  As of September 30, 2012, the Company and Royal Bank met all capital adequacy requirements to which they are subject.
 
Under the informal agreement referenced in “Regulatory Orders”, Royal Bank is required to maintain a minimum Tier 1 leverage ratio of 8% and a Total risk-based capital ratio of 12%.  As shown in the table below, Royal Bank met these requirements at September 30, 2012 and December 31, 2011 and met the criteria for a well capitalized institution.
 
In connection with a prior bank regulatory examination, the FDIC concluded, based upon its interpretation of the Consolidated Reports of Condition and Income (the “Call Report”) instructions and under regulatory accounting principles (“RAP”), that income from Royal Bank’s tax lien business should be recognized on a cash basis, not an accrual basis.  Royal Bank’s current accrual method is in accordance with U.S. GAAP.  Royal Bank disagrees with the FDIC’s conclusion and filed the Call Report for September 30, 2012 and the previous eight quarters in accordance with U.S. GAAP.  A change in the method of revenue recognition for the tax lien business for regulatory accounting purposes affects Royal Bank’s capital ratios as shown below.  Royal Bank is in discussions with the FDIC to resolve the matter.
 
The table below sets forth Royal Bank’s capital ratios under RAP, based on the FDIC’s interpretation of the Call Report instructions:
 
                           
To be well capitalized
 
               
For capital
   
capitalized under prompt
 
   
Actual
   
adequacy purposes
   
corrective action provision
 
(Dollars in thousands)
 
Amount
   
Ratio
   
Amount
   
Ratio
   
Amount
   
Ratio
 
Total capital (to risk-weighted assets)
                                   
At September 30, 2012
  $ 78,813       17.09 %   $ 36,901       8.00 %   $ 46,126       10.00 %
At December 31, 2011
  $ 82,375       15.04 %   $ 43,803       8.00 %   $ 54,754       10.00 %
Tier I capital (to risk-weighted assets)
                                               
At September 30, 2012
  $ 72,903       15.81 %   $ 18,451       4.00 %   $ 27,676       6.00 %
At December 31, 2011
  $ 75,413       13.77 %   $ 21,902       4.00 %   $ 32,852       6.00 %
Tier I capital (to average assets, leverage)
                                               
At September 30, 2012
  $ 72,903       9.12 %   $ 31,974       4.00 %   $ 39,968       5.00 %
At December 31, 2011
  $ 75,413       9.09 %   $ 33,189       4.00 %   $ 41,486       5.00 %

 
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The tables below reflect the adjustments to the net loss as well as the capital ratios under U.S. GAAP:
 
   
For the nine
       
   
months ended
   
For the year ended
 
(In thousands)
 
September 30, 2012
   
December 31, 2011
 
RAP net loss
  $ (11,373 )   $ (15,626 )
Tax lien adjustment, net of noncontrolling interest
    4,963       7,738  
U.S. GAAP net loss
  $ (6,410 )   $ (7,888 )
 
   
At September 30, 2012
   
At December 31, 2011
 
   
As reported
   
As adjusted
   
As reported
   
As adjusted
 
   
under RAP
   
for U.S. GAAP
   
under RAP
   
for U.S. GAAP
 
Total capital (to risk-weighted assets)
    17.09 %     18.56 %     15.04 %     17.02 %
Tier I capital (to risk-weighted assets)
    15.81 %     17.28 %     13.77 %     15.75 %
Tier I capital (to average assets, leverage)
    9.12 %     10.05 %     9.09 %     10.48 %

The tables below reflect the Company’s capital ratios:
 
                           
To be well capitalized
 
               
For capital
   
capitalized under prompt
 
   
Actual
   
adequacy purposes
   
corrective action provision
 
(Dollars in thousands)
 
Amount
   
Ratio
   
Amount
   
Ratio
   
Amount
   
Ratio
 
Total capital (to risk-weighted assets)
                                   
At September 30, 2012
  $ 97,274       20.44 %   $ 38,069       8.00 %     N/A       N/A  
At December 31, 2011
  $ 106,745       18.82 %   $ 45,386       8.00 %     N/A       N/A  
Tier I capital (to risk-weighted assets)
                                               
At September 30, 2012
  $ 88,434       18.58 %   $ 19,035       4.00 %     N/A       N/A  
At December 31, 2011
  $ 99,539       17.55 %   $ 22,693       4.00 %     N/A       N/A  
Tier I capital (to average assets, leverage)
                                               
At September 30, 2012
  $ 88,434       10.82 %   $ 32,703       4.00 %     N/A       N/A  
At December 31, 2011
  $ 99,539       11.64 %   $ 34,209       4.00 %     N/A       N/A  

The Company has filed the Consolidated Financial Statements for Bank Holding Companies-FR Y-9C (“FR Y-9C”) for the previous nine quarters consistent with U.S. GAAP and the FR Y-9C instructions.  In the event that a similar adjustment for RAP purposes would be required by the Federal Reserve on the holding company level, the adjusted ratios are shown in the table below.
 
   
For the nine
       
   
months ended
   
For the year ended
 
(In thousands)
 
September 30, 2012
   
December 31, 2011
 
U.S. GAAP net loss
  $ (7,631 )   $ (8,563 )
Tax lien adjustment, net of noncontrolling interest
    (4,963 )     (7,738 )
RAP net loss
  $ (12,594 )   $ (16,301 )

 
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At September 30, 2012
   
At December 31, 2011
 
   
As reported
   
As adjusted
   
As reported
   
As adjusted
 
   
under U.S. GAAP
   
for RAP
   
under U.S. GAAP
   
for RAP
 
Total capital (to risk-weighted assets)
    20.44 %     19.02 %     18.82 %     16.90 %
Tier I capital (to risk-weighted assets)
    18.58 %     17.15 %     17.55 %     15.63 %
Tier I capital (to average assets, leverage)
    10.82 %     9.91 %     11.64 %     10.29 %

The capital ratios set forth above compare favorably to the minimum required amounts of Tier 1 and total capital to risk-weighted assets and the minimum Tier 1 leverage ratio, as defined by banking regulation.  At September 30, 2012, the Company was required to have minimum Tier 1 and total capital ratios of 4.0% and 8.0%, respectively, and a minimum Tier 1 leverage ratio of 4.0%.  At September 30, 2012, the Company met the regulatory minimum capital requirements, and management believes that, under current regulations, the Company will continue to meet its minimum capital requirements in the foreseeable future.
 
LIQUIDITY & INTEREST RATE SENSITIVITY
 
Liquidity is the ability to ensure that adequate funds will be available to meet the Company’s financial commitments as they become due.  In managing its liquidity position, all sources of funds are evaluated, the largest of which is deposits.  Also taken into consideration are securities maturing in one year or less, other short-term investments and the repayment of loans. These sources provide alternatives to meet its short-term liquidity needs.  Longer liquidity needs may be met by issuing longer-term deposits and by raising additional capital.  The liquidity ratio is calculated by adding total cash, availability on lines of credit, and unpledged investment securities and subtracting any reserve requirements, this amount is then divided by total deposits as well as by total liabilities to determine the liquidity ratios.  The Company’s policy is to maintain a liquidity ratio as a percentage of total deposits of at least 12% and a liquidity ratio as a percentage of total liabilities of at least 10%.  At September 30, 2012, the Company’s liquidity ratios were approximately four times the policy minimums.
 
On August 13, 2009, the Company’s Board determined to suspend the regular quarterly cash dividends on the $30.4 million in Series A Preferred Stock issued to the United States Department of the Treasury (“Treasury”) as part of the Capital Purchase Program (“CPP”) established by the Treasury.  The Company’s Board took this action in consultation with the Federal Reserve Bank of Philadelphia as required by recent regulatory policy guidance.  The Board also suspended interest payments on its $25.8 million of outstanding trust preferred securities.  The Company currently has sufficient capital and liquidity to pay the scheduled dividends and interest payments on its preferred stock and trust preferred securities.  The decision to suspend the preferred cash dividend and the trust preferred interest payment better supports the capital position of Royal Bank, a wholly-owned subsidiary of the Company.  As of September 30, 2012 the trust preferred interest payment in arrears was $2.3 million and has been recorded in interest expense and accrued interest payable. As of September 30, 2012 the Series A Preferred stock dividend in arrears was $5.4 million and has not been recognized in the consolidated financial statements.
 
The Company’s level of liquidity is provided by funds invested primarily in corporate bonds, capital trust securities, U.S. agencies, and to a lesser extent, federal funds sold.  The overall liquidity position of Royal Bank is monitored on a weekly basis while the remaining legal entities are monitored monthly.
 
In managing its interest rate sensitivity positions, the Company seeks to develop and implement strategies to control exposure of net interest income to risks associated with interest rate movements.  Interest rate sensitivity is a function of the re-pricing characteristics of the Company's assets and liabilities. These include the volume of assets and liabilities re-pricing, the timing of the re-pricing, and the interest rate sensitivity gaps which are a continual challenge in a changing rate environment.
 
 
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The following table shows separately the interest sensitivity of each category of interest earning assets and interest bearing liabilities as of September 30, 2012:
 
(In millions)
 
Days
   
1 to 5
   
Over 5
   
Non-rate
       
Assets
  0 – 90     91 – 365    
Years
   
Years
   
Sensitive
   
Total
 
Interest-bearing deposits in banks
  $ 31.2     $ -     $ -     $ -     $ 8.3     $ 39.5  
Investment securities AFS
    33.9       70.4       159.6       87.3       7.3       358.5  
Loans:
                                               
Fixed rate
    18.6       48.6       139.8       17.2       (17.4 )     206.8  
Variable rate
    105.6       16.0       -       -       -       121.6  
Total loans
    124.2       64.6       139.8       17.2       (17.4 )     328.4  
Other assets
    -       23.6       -       -       51.7       75.3  
Total Assets
  $ 189.3     $ 158.6     $ 299.4     $ 104.5     $ 49.9     $ 801.7  
Liabilities & Capital
                                               
Deposits:
                                               
Non interest bearing deposits
  $ -     $ -     $ -     $ -     $ 59.3     $ 59.3  
Interest bearing deposits
    25.8       77.3       132.3       -       -       235.4  
Certificate of deposits
    43.2       122.8       94.3       16.3       -       276.6  
Total deposits
    69.0       200.1       226.6       16.3       59.3       571.3  
Borrowings
    29.2       50.0       15.0       40.0       -       134.2  
Other liabilities
    -       -       -       -       27.2       27.2  
Capital
    -       -       -       -       69.0       69.0  
Total liabilities & capital
  $ 98.2     $ 250.1     $ 241.6     $ 56.3     $ 155.5     $ 801.7  
Net  interest rate  GAP
  $ 91.1     $ (91.5 )   $ 57.8     $ 48.2     $ (105.6 )        
Cumulative interest rate  GAP
  $ 91.1     $ (0.4 )   $ 57.4     $ 105.6                  
GAP to total  assets
    11 %     -11 %                                
GAP to total equity
    132 %     -133 %                                
Cumulative GAP to total assets
    11 %     0 %                                
Cumulative GAP to total equity
    132 %     -1 %                                
 
The Company’s exposure to interest rate risk is mitigated somewhat by a portion of the Company’s loan portfolio consisting of floating rate loans, which are tied to the prime lending rate but which have interest rate floors and no interest rate ceilings.  Although the Company is originating fixed rate loans, a portion of the loan portfolio continues to be comprised of floating rate loans with interest rate floors.  At September 30, 2012, floating rate loans with floors and without floors were $66.2 million and $55.4 million, respectively.
 
REGULATORY ORDERS
 
FDIC and Department of Banking Orders
 
On July 15, 2009, Royal Bank agreed to enter into a Stipulation and Consent to the Issuance of an Order to Cease and Desist (the “Orders”) with each of the Federal Deposit Insurance Corporation (“FDIC”) and the Pennsylvania Department of Banking (the “Department”). The material terms of the Orders were identical and required Royal Bank among other items to maintain, after establishing an adequate allowance for loan and lease losses, a ratio of Tier 1 capital to total assets (“leverage ratio”) equal to or greater than 8% and a ratio of qualifying total capital to risk-weighted assets (“total risk-based capital ratio”) equal to or greater than 12%. The FDIC and the Department replaced the Orders in the fourth quarter of 2011 with an informal agreement, known as a memorandum of understanding (“MOU”).   Following the issuance of the Orders, management implemented plans to address key areas that were noted in the Orders.  Management reduced classified assets, delinquencies, commercial real estate concentrations, reliance on non-core deposits and wholesale funding sources and strengthened capital ratios which were all factors that contributed to replacing the Orders with an MOU.   Management has continued to improve in each of these areas since the Orders were replaced with the MOU.  Included in the MOU is the continued requirement of maintaining a leverage ratio equal to or greater than 8% and a total risk-based capital ratio equal to or greater than 12%.  At September 30, 2012, based on capital levels calculated under RAP, Royal Bank’s total risk-based capital and Tier 1 leverage ratios were 17.09% and 9.12%, respectively.
 
 
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Federal Reserve Agreement
 
On March 17, 2010, the Company agreed to enter into a Written Agreement (the “Federal Reserve Agreement”) with the Federal Reserve Bank of Philadelphia (the “Reserve Bank”). The material terms of the Federal Reserve Agreement provide that: (i) the Company’s Board will take appropriate steps to fully utilize the Company’s financial and managerial resources to serve as a source of strength to its subsidiary banks, including taking steps to ensure that Royal Bank complies with the Orders previously entered into with the FDIC and the Department on July 15, 2009; (ii) the Company’s Board will, within 60 days of the Federal Reserve Agreement, submit to the Reserve Bank a written plan to strengthen board oversight of the management and operations of the consolidated operation; (iii) the Company will not declare or pay any dividends without the prior written approval of the Reserve Bank and the Director of the Division of Banking Supervision and Regulation of the Board of Governors of the Federal Reserve System; (iv) the Company and its non-bank subsidiaries will not make any distributions of interest, principal, or other sums on subordinated debentures or trust preferred securities without the prior approval of the Reserve Bank and the Director of the Division of Banking Supervision and Regulation of the Board of Governors of the Federal Reserve System; (v) the Company and its nonbank subsidiaries will not, directly or indirectly, incur, increase, or guarantee any debt without the prior written approval of the Reserve Bank; (vi) the Company will not, directly or indirectly, purchase or redeem any shares of its stock without the prior written approval of the Reserve Bank; (vii) the Company will, within 60 days of the Federal Reserve Agreement, submit to the Reserve Bank an acceptable written capital plan to maintain sufficient capital at the Company on a consolidated basis, which plan will at a minimum address: regulatory requirements for the Company and the Banks, the adequacy of the Banks’ capital taking into account the volume of classified credits, the allowance for loan and lease losses, current and projected asset growth, and projected retained earnings; the source and timing of additional funds necessary to fulfill the consolidated organization’s and the Banks’ future capital requirements; supervisory requests for additional capital at the Banks or the requirements of any supervisory action imposed on the Banks by federal or state regulators; and applicable legal requirements that the Company serve as a source of strength to the Banks; (viii) the Company will, within 60 days of the Federal Reserve Agreement, submit to the Reserve Bank cash flow projections for 2010 showing planned sources and uses of cash for debt service, operating expenses, and other purposes, and will submit similar cash flow projections for each subsequent calendar year at least one month prior to the beginning of such year; (ix) the Company will comply with applicable legal  notice provisions in advance of appointing any new director or senior executive officer or changing the responsibilities of any senior executive officer such that the officer would assume a different senior executive officer position, and comply with restrictions on indemnification and severance payments imposed by the Federal Deposit Insurance Act; and (x) the Company’s Board will, within 30 days after the end of each quarter, submit progress reports to the Reserve Bank detailing the form and manner of all actions taken to secure compliance with the Agreement and the results thereof, together with a parent company-level balance sheet, income statement, and, as applicable, report of changes in shareholders’ equity.
 
The Federal Reserve Agreement will remain in effect and enforceable until stayed, modified, terminated or suspended by the Reserve Bank. Royal Bancshares has submitted all progress reports and responses required under the Federal Reserve Agreement as of the date of this Report.
 
Our success as a Company is dependent upon pursuing various alternatives in not only achieving the growth and expansion of our banking franchise but also in managing our day to day operations. The existence of the MOU and the Federal Reserve Agreement may limit or impact our ability to pursue all previously available alternatives in the management of the Company. Our ability to retain existing retail and commercial customers as well as the ability to attract potentially new customers may be impacted by the existence of the MOU and the Federal Reserve Agreement. Additionally, our ability to expand into potentially attractive commercial real estate or construction loans at this time is limited. The Company’s ability to raise capital in the current economic environment could be potentially limited or impacted as a result of the MOU and the Federal Reserve Agreement. Attracting new management talent is critical to the success of our business and could be potentially impacted due to the existence of the MOU and the Federal Reserve Agreement.
 
 
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In order to meet the requirements, primarily maintaining adequate capital ratios, in the previous Orders, the current MOU, and the Federal Reserve Agreement, management adopted a strategy to deleverage the balance sheet.    This strategy assisted in reducing the level of classified assets by giving management the ability to actively pursue exit strategies on loans and OREO which were at historically high levels.  The deleveraging was largely accomplished by reducing brokered deposits from $226.9 million at June 30, 2009 to $0 as of September 30, 2012.  In addition, borrowings were reduced by $164.0 million during the same period.  During the past few years, the Company recorded significant impairment charges and carrying costs on non-accrual loans and OREO which has weighed heavily on earnings and was the largest contributing factor to the Company’s continued losses.  As a result of the significant decline in level of classified assets, there has been a corresponding reduction in impairments, the provision for loan and lease losses, and the overall carrying costs associated with classified assets.  The deleveraging of the balance sheet has also reduced earning assets which has resulted in a decline in net interest income and has had a significant impact on overall earnings. To improve net interest margin and net interest income, management is diligently working on changing the mix of earnings assets and interest bearing liabilities.  In the event further deleveraging is necessary to maintain the required capital levels, net interest income would be impacted.
 
ITEM 3 – QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
The information presented in the “Liquidity and Interest Rate Sensitivity” section of the “Management’s Discussion and Analysis of Financial Condition and Results Operations” of this Report is incorporated herein by reference.
 
ITEM 4 – CONTROLS AND PROCEDURES
 
(a) Evaluation of Disclosure Controls and Procedures
 
The Company maintains a set of disclosure controls and procedures that are designed to ensure that information required to be disclosed in reports filed under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), is recorded, processed, summarized and reported within the time periods specified in the Securities Exchange Commission’s rules and forms. As of the end of the period covered by this report, the Company evaluated, under the supervision and with the participation of our management, including our Chief Executive Officer (CEO) and Chief Financial Officer (CFO), the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rule 13a-15(e) of the Exchange Act. Based on that evaluation our CEO and CFO concluded that the Company’s disclosure controls and procedures were effective at September 30, 2012.
 
(b) Changes in Internal Control Over Financial Reporting
 
There have been no changes in the Company’s internal control over financial reporting during the third quarter of 2012 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
 
There are inherent limitations to the effectiveness of any controls system. A controls system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that its objectives are met. Further, the design of a control system must reflect the fact that there are limits on resources, and the benefits of controls must be considered relative to their costs and their impact on the business model. We intend to continue to improve and refine our internal control over financial reporting.
 
 
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PART II - OTHER INFORMATION
 
Item 1.
Legal Proceedings
 
Royal Bank holds a 60% equity interest in each of CSC and RTL.  The Company acquired its ownership interest in CSC in 2001.  CSC and RTL acquire, through public auction, delinquent tax liens in various jurisdictions thereby assuming a superior lien position to most other lien holders, including mortgage lien holders.  As previously discussed in the Company’s Form 10-K for the year ended December 31, 2011, in March 2009, each of CSC and RTL received grand jury subpoenas issued by the U.S. District Court for New Jersey (“Court”) upon application of the Antitrust Division of the United States Department of Justice (“DOJ”).  The subpoenas sought certain documents and information relating to an ongoing investigation being conducted by the DOJ relating to alleged bid-rigging at tax lien auctions in New Jersey.  Royal Bank, CSC and RTL have produced to the DOJ documents responsive to the subpoenas and have been cooperating with the DOJ throughout the investigation.  On February 23, 2012, the former President of CSC and RTL entered a plea of guilty to one count of conspiring to rig bids at certain auctions for tax liens in New Jersey from 1998 until approximately the spring of 2009.  The former President’s employment with CSC and RTL was terminated in November 2010.  As previously disclosed, Royal Bank had been advised that neither CSC nor RTL were targets of the DOJ investigation, but they were subjects of the investigation.  Based on discussions with the DOJ and the plea entered by the former President of CSC and RTL, the Company believed that the outcome of the investigation would result in fines and penalties being assessed against both CSC and RTL.  As a result, the Company accrued an aggregate of $2.0 million during the first and second quarters of 2012 as an estimate for a loss contingency for potential DOJ fines and penalties relating to the DOJ investigation.  After adjusting for the noncontrolling interest, the Company’s 60% share of the loss contingency amounted to $1.2 million.  On September 26, 2012, as a result of the former President’s guilty plea and pursuant to a plea agreement with the DOJ, CSC entered a guilty plea in the United States District Court for the District of New Jersey to one count of conspiracy to commit bid-rigging at certain auctions for tax liens in New Jersey.  Under the terms of the plea agreement, which the Court accepted at the September 26, 2012 plea hearing, the DOJ agreed not to bring further criminal charges against CSC and not to bring criminal charges against RTL, or any current or former director, officer, or employee of CSC and/or RTL, for any act or offense committed prior to the date of the plea agreement that was in furtherance of any agreement to rig bids at municipal tax lien sales or auctions in the State of New Jersey. The former President of CSC and RTL and any person who bid at any time at a tax lien auction on behalf of CSC and/or RTL are excluded from this nonprosecution protection.  The DOJ further agreed to recommend that the appropriate fine for CSC would be $2.0 million, which, as stated above, has been recognized in the Company’s financial statements.  The actual fine to be imposed, however, lies within the sole discretion of the sentencing judge.  The Company is evaluating appropriate legal action against the former President of CSC and RTL to attempt to recover legal expenses and any fines or penalties ultimately levied against CSC.
 
As a result of the plea agreements of the former President of CSC and RTL, and others resulting from the DOJ investigation, a number of lawsuits have been filed against the former President of CSC and RTL, CSC, RTL, the Company and certain other parties.  On March 13, 2012, the former president of RTL and CSC, RTL, CSC, the Company and certain other parties were named as defendants in a putative class action lawsuit filed in the Superior Court of New Jersey, Chancery Division on behalf of a proposed class of taxpayers who became delinquent in paying their municipal tax obligations ( Boyer v. Robert W. Stein, Crusader Servicing Corp. Royal Tax Lien Services LLC, Royal Bancshares of Pennsylvania, Inc., et al., Superior Court of New Jersey, Chancery Division ) (“the Boyer Action”).  On March 28, 2012, CSC, RTL and the Company removed this case to the U.S. District Court for the District of New Jersey.  The lawsuit alleges violations of the New Jersey Antitrust Act and unjust enrichment, and seeks treble damages, attorney fees and injunctive relief. As of the date of this filing, the Company cannot reasonably estimate the possible loss or range of loss that may result from this class action lawsuit.
 
On March 30, 2012, April 20, 2012, May 2, 2012, May 11, 2012, May 18, 2012, June 18, 2012 and June 29, 2012, the former President of CSC and RTL, CSC, RTL and the Company were named defendants, among others, in putative class action lawsuits filed in the U.S. District Court for the District of New Jersey (“Court”) on behalf of a proposed class of taxpayers who became delinquent in paying their municipal tax obligations: Contarino v Robert W. Stein, Crusader Servicing Corp. Royal Tax Lien Services LLC, Royal Bancshares of Pennsylvania, Inc., et al., U.S. District Court for the District of New Jersey; MSC LLC v Robert W. Stein, Crusader Servicing Corp. Royal Tax Lien Services LLC, Royal Bancshares of Pennsylvania, Inc., et al., U.S. District Court for the District of New Jersey; English v Robert W. Stein, Crusader Servicing Corp. Royal Tax Lien Services LLC, Royal Bancshares of Pennsylvania, Inc., et al., U.S. District Court for the District of New Jersey; Ledford v Robert W. Stein, Crusader Servicing Corp. Royal Tax Lien Services LLC, Royal Bancshares of Pennsylvania, Inc., et al., U.S. District Court for the District of New Jersey; T&B Associates v Robert W. Stein, Crusader Servicing Corp. Royal Tax Lien Services LLC, Royal Bancshares of Pennsylvania, Inc., et al., U.S. District Court for the District of New Jersey; Jacobs et al v Robert W. Stein, Crusader Servicing Corp. Royal Tax Lien Services LLC, Royal Bancshares of Pennsylvania, Inc., et al., U.S. District Court for the District of New Jersey; Senatore Builders, LLC  v Robert W. Stein, Crusader Servicing Corp. Royal Tax Lien Services LLC, Royal Bancshares of Pennsylvania, Inc., et al., U.S. District Court for the District of New Jersey, respectively alleging a conspiracy to rig bids in municipal tax lien auctions.   On June 12, 2012, the Court entered an Order consolidating for pretrial purposes the Boyer action with all subsequently filed or transferred related actions, including the ones mentioned above.  On October 22, 2012, the Court appointed two law firms as interim class counsel and another law firm as liaison class counsel and further ordered appointed counsel to file on or before November 21, 2012 a master complaint for the consolidated action.  As of the date of this filing, the Company cannot reasonably estimate the possible loss or range of loss that may result from these class action lawsuits.
 
 
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On or about March 15, 2012, CSC, RTL and the Company were named defendants, among others, in a complaint filed by Marina Bay Towers Urban Renewal II, LP (“MBT”) in the Superior Court of New Jersey, Law Division, Cape May County.  The complaint alleges essentially the same claims as asserted in the Boyer Action.  However MBT does not seek to represent a class and only seeks remedies related to itself.  As of the date of this filing, the Company cannot reasonably estimate the possible loss or range of loss that may result from this proceeding.
 
In 2005, the Company purchased $25.0 million in Class B-1 Notes of a collateralized debt obligation (“CDO”) offered by Lehman Brothers, Inc.  Concurrently with the issuance of the notes, the issuer entered into a credit swap with Lehman Brothers Special Financing, Inc. (“LBSF”).  Lehman Brothers Holdings, Inc. (“LBHI”) guaranteed LBSF’s obligations to the issuer under the credit swap. When LBHI filed for bankruptcy in September 2008, an event of default under the indenture occurred, and the trustee declared the notes to be immediately due and payable.  The Company was repaid its principal on the notes in September 2008.  In September 2010, LBSF filed suit in the United States Bankruptcy court for the Southern District of New York against certain indenture trustees, certain special-purpose entities (issuers) and a class of noteholders and trust certificate holders who received distributions from the trustees, to recover funds that were allegedly improperly paid to the noteholders in forty-seven separate CDO transactions.  In July 2012, LBSF added the Company as a defendant in the proceeding. As of the date of this filing, the Company cannot determine whether this proceeding will have a material adverse effect on its results of operations and cannot reasonably estimate the possible loss or range of loss that may result from this proceeding.
 
Item 1A.
Risk Factors.
 
Our business may be impacted by the existence of the informal agreement for Royal Bank and the Federal Reserve Agreement with the Federal Reserve Bank of Philadelphia.
 
Our success as a business is dependent upon pursuing various alternatives in not only achieving the growth and expansion of our banking franchise but also in managing our day to day operations. The existence of the informal agreement and the Federal Reserve Agreement limits and impacts our ability to pursue all previously available alternatives in the management of the Company. Our ability to retain existing retail and commercial customers as well as the ability to attract potentially new customers may be impacted by the existence of the informal agreement and the Federal Reserve Agreement. Our ability to obtain lines of credit, to receive attractive collateral treatment from funding sources, and to pursue all attractive funding alternatives in this current low interest rate environment could be potentially impacted and thereby limit liquidity alternatives. Royal Bank’s ability to pay dividends to the Company, which provides funding for cash dividends to the Company’s shareholders, is subject to prior written consent of the FDIC and Department.  Moreover, the Company is prohibited from paying cash dividends without the prior written approval of the Reserve Bank and the Director of the Division of Banking Supervision and Regulation of the Board of Governors of the Federal Reserve System.  Our ability to raise capital in the current economic environment could be potentially limited or impacted as a result of the informal agreement. Attracting new management talent is critical to the success of our business and could be potentially impacted due to the existence of the informal agreement and the Federal Reserve Agreement. Under the MOU, Royal Bank must maintain a minimum total risk-based capital ratio and a minimum Tier 1 leverage ratio of 12% and 8%, respectively. At September 30, 2012, based on capital levels calculated under RAP, Royal Bank’s total risk-based capital and Tier 1 leverage ratios were 17.09% and 9.12%, respectively.
 
We may face substantial potential legal liability which would adversely impact our business and financial results and damage our reputation.
 
On September 26, 2012, CSC voluntarily entered into a plea agreement with the DOJ in which CSC entered a guilty plea in the United States District Court of New Jersey to one count of bid-rigging at certain auctions for tax liens in New Jersey Under the terms of the plea agreement, which the Court accepted at the September 26, 2012 plea hearing, the DOJ agreed not to bring further criminal charges against CSC and will not bring criminal charges against RTL, or any current or former director, officer, or employee of CSC or RTL (with the exception of the former President of CSC and RTL and persons who bid at tax lien auctions on behalf of CSC or RTL), for any act or offense committed prior to the date of the plea agreement that was in furtherance of any agreement to rig bids at municipal tax lien sales or auctions in the State of New Jersey. The DOJ further agreed to recommend that the appropriate fine to CSC would be $2.0 million, which has been recognized in the Company’s financial statements.   The actual fine to be imposed, however, lies within the sole discretion of the sentencing judge.  Additionally, RTL, CSC, the Company, and certain other parties were named as defendants in putative class action lawsuits arising from the tax lien operations. While the outcome of these cases and similar ones that may be filed is uncertain, the final resolution and the legal costs incurred defending the Company may materially affect our results of operations and financial condition and harm our reputation.
 
A number of our loans are secured by property located on the Southern New Jersey barrier islands and surrounding areas, which properties may have been damaged by Hurricane Sandy.

We have extended loans to customers that are secured by properties located in the Southern New Jersey barrier islands and surrounding areas.  These areas were severely damaged by Hurricane Sandy, which impacted the Mid-Atlantic and Northeastern regions of the United States from October 28, 2012 to October 30, 2012.  On most collateral dependent loans, our exposure is limited due to the existence of flood and property insurance.  We monitor our borrower’s insurance coverage on a regular basis and force place insurance, as necessary.  We are in the process of assessing the damage that may have occurred to the underlying properties and there is a risk that collateral for these loans has been damaged.  As of the date of this filing, the Company does not have the information required to determine the extent of potential loss, if any, related to these loans.
 
 
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In addition to the other information set forth in this report, you should carefully consider the factors discussed under the section “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2012 which could materially affect our business, financial condition and/or operating results.  As of September 30, 2012, the risk factors of the Company have not changed materially from those reported in the Form 10-K, except as described above.  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.
 
None
 
Item 3.
Default Upon Senior Securities.
 
None
 
Item 4.
Mine Safety Disclosures.
 
None
 
Item 5.
Other Information.
 
None
 
 
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Item 6.
Exhibits.
 
 
(a)
 
 
 
3.1
Articles of Incorporation of the Company. (Incorporated by reference to Exhibit 3(i) of the Company’s report on Form 10-K filed with the Commission on March 30, 2009.)
     
 
3.2
Bylaws of the Company (Incorporated by reference to Exhibit 3(ii) to the Company’s report on Form 10-K filed with the Commission on March 30, 2009.)
     
 
Section 302 Certification Pursuant to Section 13(a) or 15(d) of the Securities and Exchange Act of 1934 signed by Robert R. Tabas, Principal Executive Officer of Royal Bancshares of Pennsylvania on November 14, 2012.
     
 
Section 302 Certification Pursuant to Section 13(a) or 15(d) of the Securities and Exchange Act of 1934 signed by Michael S. Thompson, Principal Financial Officer of Royal Bancshares of Pennsylvania on November 14, 2012.
     
 
Certification Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, signed by Robert R. Tabas, Principal Executive Officer of Royal Bancshares of Pennsylvania on November 14, 2012.
     
 
Certification Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, signed by Michael S. Thompson, Principal Financial Officer of  Royal Bancshares of Pennsylvania on November 14, 2012.
     
 
101
Interactive Data File

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.
 
ROYAL BANCSHARES OF PENNSYLVANIA, INC.
(Registrant)
 
Dated: November 14, 2012
/s/ Michael S. Thompson
Michael S. Thompson
Principal Financial and Accounting Officer
 
 
  - 81 -

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