f10q093013.htm




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

FORM 10 – Q

[X]         QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2013.
or
[  ]         TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934  For the transition period from ___________ to __________.

Commission File Number 0-16587


Summit Financial Group, Inc.
(Exact name of registrant as specified in its charter)

West Virginia
 
55-0672148
(State or other jurisdiction of
 
(IRS Employer
incorporation or organization)
 
Identification No.)

 
300 North Main Street
   
 
Moorefield, West Virginia
26836
 
 
(Address of principal executive offices)
(Zip Code)
 

(304) 530-1000
(Registrant's telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Sections 13 or 15(d) of the Securities and 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 þ
No o
 
     
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
Yes þ
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 definition of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
                          Large accelerated filer o               Accelerated filero
                    Non-accelerated filer o                  Smaller reporting companyþ

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

Indicate the number of shares outstanding of each of the issuer’s classes of Common Stock as of the latest practicable date.

Common Stock, $2.50 par value
7,451,022 shares outstanding as of November 5, 2013

 
 

 
Summit Financial Group, Inc. and Subsidiaries
Table of Contents



     
Page
PART  I.
FINANCIAL INFORMATION
 
       
 
Item 1.
Financial Statements
 
       
   
Consolidated balance sheets
September 30, 2013 (unaudited), December 31, 2012,
 and September 30, 2012 (unaudited)
4
       
   
Consolidated statements of income
for the three and nine months ended
September 30, 2013 and 2012 (unaudited)
5
       
   
Consolidated statements of comprehensive
income for the three and nine months ended
September 30, 2013 and 2012 (unaudited)
 
6
       
   
Consolidated statements of shareholders’ equity
for the nine months ended
September 30, 2013 and 2012 (unaudited)
 
7
       
   
Consolidated statements of cash flows
for the nine months ended
September 30, 2013 and 2012 (unaudited)
8-9
       
   
Notes to consolidated financial statements (unaudited)
10-46
       
 
Item 2.
Management's Discussion and Analysis of Financial Condition
and Results of Operations
47-65
       
 
Item 3.
Quantitative and Qualitative Disclosures about Market Risk
64
       
 
Item 4.
Controls and Procedures
66

 
2

 
Summit Financial Group, Inc. and Subsidiaries
Table of Contents



 
       
Page
 
PART II.
 
OTHER INFORMATION
   
       
   
Item 1.
 
Legal Proceedings
 67
       
   
Item 1A.
 
Risk Factors
 67
       
   
Item 2.
 
Unregistered Sales of Equity Securities and Use of Proceeds
 None
       
   
Item 3.
 
Defaults upon Senior Securities
 None
       
   
Item 4.
 
Mine Safety Disclosures
 None
       
   
Item 5.
 
Other Information
 None
       
   
Item 6.
 
Exhibits
 67
       
 
SIGNATURES
     68
       
 
EXHIBIT INDEX
     69
 
 


 
3

 
Summit Financial Group, Inc. and Subsidiaries
Consolidated Balance Sheets (unaudited)


   
September 30,
 
December 31,
 
September 30,
   
2013
 
2012
 
2012
 Dollars in thousands
 
(unaudited)
    (*)  
(unaudited)
 ASSETS
             
 Cash and due from banks
  $ 4,571   $ 3,833   $ 3,752
 Interest bearing deposits with other banks
    11,532     10,969     13,441
       Cash and cash equivalents
    16,103     14,802     17,193
 Securities available for sale
    291,258     281,539     291,992
 Other investments
    8,004     14,658     16,100
 Loans held for sale
    602     226     213
 Loans, net
    939,169     937,168     940,933
 Property held for sale
    45,303     56,172     56,033
 Premises and equipment, net
    20,780     21,129     21,264
 Accrued interest receivable
    5,364     5,621     5,352
 Intangible assets
    8,036     8,300     8,387
 Cash surrender value of life insurance policies
    35,257     29,553     30,065
 Other assets
    17,911     17,936     16,554
 Total assets
  $ 1,387,787   $ 1,387,104   $ 1,404,086
                   
 LIABILITIES AND SHAREHOLDERS' EQUITY
                 
 Liabilities
                 
     Deposits
                 
         Non interest bearing
  $ 99,109   $ 100,592   $ 96,764
         Interest bearing
    917,626     926,533     930,543
 Total deposits
    1,016,735     1,027,125     1,027,307
     Short-term borrowings
    54,163     3,958     20,957
     Long-term borrowings
    163,540     203,268     203,744
     Subordinated debentures
    16,800     16,800     16,800
     Subordinated debentures owed to unconsolidated subsidiary trusts
    19,589     19,589     19,589
     Other liabilities
    8,155     7,809     8,361
 Total liabilities
    1,278,982     1,278,549     1,296,758
                   
 Commitments and Contingencies
                 
                   
 Shareholders' Equity
                 
     Preferred stock and related surplus - authorized 250,000 shares;
                 
        Series 2009, 8% Non-cumulative convertible preferred stock,
                 
             par value $1.00; issued 3,710 shares
    3,519     3,519     3,519
        Series 2011, 8% Non-cumulative convertible preferred stock,
                 
             par value $1.00; issued 2013 - 11,938, 2012 - 12,000 shares
    5,776     5,807     5,807
     Common stock and related surplus - authorized 20,000,000 shares;
                 
        $2.50 par value; issued and outstanding 2013 - 7,448,422 and
                 
         2012 -  7,425,472 shares
    24,632     24,520     24,520
     Retained earnings
    74,541     69,841     67,929
     Accumulated other comprehensive income
    337     4,868     5,553
 Total shareholders' equity
    108,805     108,555     107,328
                   
 Total liabilities and shareholders' equity
  $ 1,387,787   $ 1,387,104   $ 1,404,086
                   
                   
(*) - December 31, 2012 financial information has been extracted from audited consolidated financial statements
           
 See Notes to Consolidated Financial Statements
                 
 
 
 
4

Summit Financial Group, Inc. and Subsidiaries
Consolidated Statements of Income (unaudited)
 

   
Three Months Ended
 
Nine Months Ended
   
September 30,
 
September 30,
 
September 30,
 
September 30,
 Dollars in thousands, except per share amounts
 
2013
 
2012
 
2013
 
2012
 Interest income
               
     Interest and fees on loans
               
         Taxable
  $ 12,469   $ 13,572   $ 38,037   $ 41,812
         Tax-exempt
    63     76     197     243
     Interest and dividends on securities
                       
         Taxable
    896     1,340     2,852     4,593
         Tax-exempt
    616     594     1,832     1,986
     Interest on interest bearing deposits with other banks
    1     7     4     30
 Total interest income
    14,045     15,589     42,922     48,664
 Interest expense
                       
     Interest on deposits
    2,487     3,067     8,074     10,140
     Interest on short-term borrowings
    24     8     50     25
     Interest on long-term borrowings and subordinated debentures
    1,996     2,579     5,997     8,575
 Total interest expense
    4,507     5,654     14,121     18,740
 Net interest income
    9,538     9,935     28,801     29,924
 Provision for loan losses
    1,000     2,000     3,500     6,002
 Net interest income after provision for loan losses
    8,538     7,935     25,301     23,922
 Other income
                       
     Insurance commissions
    1,057     1,052     3,373     3,352
     Service fees related to deposit accounts
    1,106     1,074     3,202     3,163
     Realized securities gains
    132     760     116     2,245
     Other
    606     514     1,741     1,649
     Total other-than-temporary impairment loss on securities
    (38 )   (233 )   (155 )   (1,115)
     Portion of loss recognized in other comprehensive income
    -     194     37     740
     Net impairment loss recognized in earnings
    (38 )   (39 )   (118 )   (375)
 Total other income
    2,863     3,361     8,314     10,034
 Other expense
                       
     Salaries, commissions, and employee benefits
    4,050     3,940     12,155     11,733
     Net occupancy expense
    454     476     1,387     1,445
     Equipment expense
    578     573     1,724     1,777
     Professional fees
    263     292     885     872
     Amortization of intangibles
    88     88     263     263
     FDIC premiums
    503     510     1,558     1,532
     Foreclosed properties expense
    262     356     836     935
     (Gain) loss on sale of foreclosed properties
    (17 )   (16 )   546     583
     Write-down of foreclosed properties
    654     2,571     3,078     6,114
     Other
    1,396     1,237     3,900     3,749
 Total other expense
    8,231     10,027     26,332     29,003
 Income before income taxes
    3,170     1,269     7,283     4,953
 Income tax expense
    898     272     2,001     1,345
 Net Income
    2,272     997     5,282     3,608
 Dividends on preferred shares
    194     194     582     583
 Net Income applicable to common shares
  $ 2,078   $ 803   $ 4,700   $ 3,025
                         
                         
  Basic earnings per common share
  $ 0.28   $ 0.11   $ 0.63   $ 0.41
  Diluted earnings per common share
  $ 0.24   $ 0.10   $ 0.55   $ 0.38
                         
                         
 See Notes to Consolidated Financial Statements
                       


 
5

Summit Financial Group, Inc. and Subsidiaries
Consolidated Statements of Comprehensive Income (unaudited)
 



 
For the Three Months Ended
 
September 30,
Dollars in thousands
2013
 
2012
 Net income
$ 2,272   $ 997
 Other comprehensive income (loss):
         
 Net unrealized (loss) on cashflow hedge of ($117), net of deferred
         
      taxes of $43
  (74 )   -
 Non-credit related other-than-temporary impairment on
         
      available for sale debt  securities - 2013 - $0, net of deferred
         
      taxes of $0;  2012 - $194, net of deferred taxes of $74
  -     (120)
 Net unrealized gain (loss) on available for sale debt securities of:
         
2013 - ($681) net of deferred taxes of $252 and reclassification adjustment
     
for net realized gains included in net income of $132; 2012 - $1,513, net of
     
deferred taxes of $575 and reclassification adjustment for net realized
     
       gains included in net income of $760
  (429 )   938
     Total comprehensive income
$ 1,769   $ 1,815





 
For the Nine Months Ended
 
September 30,
Dollars in thousands
2013
 
2012
 Net income
$ 5,282   $ 3,608
 Other comprehensive income (loss):
         
 Net unrealized (loss) on cashflow hedge of ($117), net of deferred
  (74 )   -
      taxes of $43
         
 Non-credit related other-than-temporary impairment on
         
available for sale debt securities - 2013 - $37, net of deferred
     
      taxes of $14;  2012 - $740, net of deferred taxes of $281
  (23 )   (459)
Net unrealized gain (loss) on available for sale debt securities of:
     
2013 - ($7,038) net of deferred taxes of $2,604 and reclassification adjustment
for net realized gains included in net income of $116; 2012 - $3,539, net of
     
deferred taxes of $1,345 and reclassification adjustment for net realized
     
       gains included in net income of $2,245
  (4,434 )   2,194
     Total comprehensive income
$ 751   $ 5,343













                                                                                           See Notes to Consolidated Financial Statements

 
6

 
Summit Financial Group, Inc. and Subsidiaries
Consolidated Statements of Shareholders’ Equity (unaudited)



 
Series 2009
 
Series 2011
         
Accumulated
   
 
Preferred
 
Preferred
 
Common
     
Other
 
Total
 
Stock and
 
Stock and
 
Stock and
     
Compre-
 
Share-
 
Related
 
Related
 
Related
 
Retained
 
hensive
 
holders'
 Dollars in thousands, except per share amounts
Surplus
 
Surplus
 
Surplus
 
Earnings
 
Income
 
Equity
                       
 Balance, December 31, 2012
$ 3,519   $ 5,807   $ 24,520   $ 69,841   $ 4,868   $ 108,555
 Nine Months Ended September 30, 2013
                                 
     Comprehensive income:
                                 
       Net income
  -     -     -     5,282     -     5,282
       Other comprehensive income (loss)
                          (4,531 )   (4,531)
     Total comprehensive income (loss)
                                751
     Exercise of stock options
  -     -     80     -     -     80
     Stock compensation expense
  -     -     1     -     -     1
     Series 2009 Preferred Stock cash dividends
                                 
 declared ($60.00 per share)
  -     -     -     (223 )   -     (223)
     Series 2011 Preferred Stock cash dividends
                                 
 declared ($30.00 per share)
  -     -     -     (359 )   -     (359)
     Conversion of Series 2011 Preferred Stock to Common Stock
  -     (31 )   31     -            
                                   
 Balance, September 30, 2013
$ 3,519   $ 5,776   $ 24,632   $ 74,541   $ 337   $ 108,805
                                   
                                   
 Balance, December 31, 2011
$ 3,519   $ 5,807   $ 24,518   $ 64,904   $ 3,818   $ 102,566
 Nine Months Ended September 30, 2012
                                 
     Comprehensive income:
                                 
       Net income
  -     -     -     3,608     -     3,608
       Other comprehensive income
                          1,735     1,735
     Total comprehensive income
                                5,343
     Stock compensation expense
  -     -     2     -     -     2
     Series 2009 Preferred Stock cash dividends
                                 
 declared ($60.00 per share)
  -     -     -     (223 )   -     (223)
     Series 2011 Preferred Stock cash dividends
                                 
 declared ($30.00 per share)
  -     -     -     (360 )   -     (360)
                                   
 Balance, September 30, 2012
$ 3,519   $ 5,807   $ 24,520   $ 67,929   $ 5,553   $ 107,328
                                   
                                   
                                   
                                   
                                   
                                   
                                   
                                   
                                   
                                   
                                   
                                   
                                   
                                   
                                   
                                   
                                   
                                   
                                   
 See Notes to Consolidated Financial Statements
                                 

 
7

 
Summit Financial Group, Inc. and Subsidiaries
Consolidated Statements of Cash Flows (unaudited)



   
Nine Months Ended
   
September 30,
 
September 30,
 Dollars in thousands
 
2013
 
2012
 Cash Flows from Operating Activities
       
     Net income
  $ 5,282   $ 3,608
     Adjustments to reconcile net earnings to net cash
           
         provided by operating activities:
           
         Depreciation
    878     989
         Provision for loan losses
    3,500     6,002
         Stock compensation expense
    1     2
         Deferred income tax expense (benefit)
    1,248     (1,172)
         Loans originated for sale
    (7,963 )   (5,463)
         Proceeds from loans sold
    7,587     5,251
         Securities gains
    (116 )   (2,245)
         Other-than-temporary impairment of securities
    118     375
         Loss on disposal of assets
    535     583
         Write down of foreclosed properties
    3,078     6,114
         Amortization of securities premiums (accretion of discounts), net
    4,698     3,181
         Amortization of goodwill and purchase accounting
           
             adjustments, net
    272     272
         Decrease in accrued interest receivable
    257     431
         Increase in cash surrender value of bank owned life insurance
    (704 )   (781)
         (Increase) decrease in other assets
    2,354     (971)
         Decrease in other liabilities
    (748 )   (140)
 Net cash provided by operating activities
    20,277     16,036
 Cash Flows from Investing Activities
           
     Proceeds from maturities and calls of securities available for sale
    1,258     4,056
     Proceeds from sales of securities available for sale
    41,188     64,567
     Principal payments received on securities available for sale
    50,650     47,584
     Purchases of securities available for sale
    (111,443 )   (120,114)
     Purchases of other investments
    (2,541 )   -
     Redemption of Federal Home Loan Bank Stock
    5,922     3,048
     Net principal payments received from (loans made to) customers
    (8,371 )   13,736
     Purchases of premises and equipment
    (528 )   (170)
     Proceeds from disposal of premises and equipment
    11     -
     Proceeds from sales of other repossessed assets & property held for sale
    10,339     6,998
     Purchase of life insurance contracts
    (5,000 )   -
 Net cash provided by investing activities
    (18,515 )   19,705
 Cash Flows from Financing Activities
           
     Net increase in demand deposit, NOW and
           
         savings accounts
    9,759     15,662
     Net decrease in time deposits
    (20,149 )   (4,856)
     Net increase in short-term borrowings
    50,205     5,002
     Proceeds from long-term borrowings
    3,454     -
     Repayment of long-term borrowings
    (43,228 )   (66,510)
     Exercise of stock options
    80     -
     Dividends paid on preferred stock
    (582 )   (537)
 Net cash (used in) financing activities
    (461 )   (51,239)
 Increase (decrease) in cash and cash equivalents
    1,301     (15,498)
 Cash and cash equivalents:
           
         Beginning
    14,802     32,691
         Ending
  $ 16,103   $ 17,193
             
             
(Continued)
 See Notes to Consolidated Financial Statements
           


 
8

Summit Financial Group, Inc. and Subsidiaries
Consolidated Statements of Cash Flows (unaudited)
 

           
   
Nine Months Ended
   
September 30,
   
September 30,
 Dollars in thousands
 
2013
   
2012
           
 Supplemental Disclosures of Cash Flow Information
         
     Cash payments for:
         
         Interest
  $ 14,526     $ 19,335
         Income taxes
  $ 1,098     $ 1,834
               
Supplemental Schedule of Noncash Investing and Financing Activities
       
     Other assets acquired in settlement of loans
  $ 2,871     $ 5,266
               
               
               
               
               
               
               
               
               
               
               
               
               
               
               
               
               
               
               
               
               
               
               
               
               
               
               
               
               
               
               
               
 See Notes to Consolidated Financial Statements
             

 
9

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)

NOTE 1.  BASIS OF PRESENTATION

We, Summit Financial Group, Inc. and subsidiaries, prepare our consolidated financial statements in accordance with accounting principles generally accepted in the United States of America for interim financial information and with instructions to Form 10-Q and Regulation S-X.  Accordingly, they do not include all the information and footnotes required by accounting principles generally accepted in the United States of America for annual year end financial statements.  In our opinion, all adjustments considered necessary for a fair presentation have been included and are of a normal recurring nature.

The presentation of financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period.  Actual results could differ materially from these estimates.

The results of operations for the quarter ended September 30, 2013 are not necessarily indicative of the results to be expected for the full year.  The consolidated financial statements and notes included herein should be read in conjunction with our 2012 audited financial statements and Annual Report on Form 10-K.  Certain accounts in the consolidated financial statements for December 31, 2012 and September 30, 2012, as previously presented, have been reclassified to conform to current year classifications.

 
NOTE 2.  SIGNIFICANT NEW AUTHORITATIVE ACCOUNTING GUIDANCE
 
ASU No. 2013-02, Comprehensive Income (Topic 220) – Reporting Amounts Reclassified Out of Accumulated Other Comprehensive Income amended authoritative guidance related to the reporting of reclassifications out of other comprehensive earnings. The new guidance sets requirements for presentation for significant items reclassified to net earnings during the period presented. The new guidance was effective for annual and interim periods beginning on January 1, 2013 and did not have an effect on our financial statements.
 

ASU 2013-10, “Derivatives and Hedging (Topic 815) – Inclusion of the Fed Funds Effective Swap Rate (or Overnight Index Swap Rate) as a Benchmark Interest Rate for Hedge Accounting Purposes” permits the Fed Funds Effective Swap Rate (or Overnight Index Swap Rate) to be used as a U.S. benchmark interest rate for hedge accounting purposes under Topic 815, in addition to interest rates on direct Treasury obligations of the U.S. government and the London Interbank Offered Rate (“LIBOR”).  ASU 2013-10 is effective prospectively for qualifying new or redesignated hedging relationships entered into on or after July 17, 2013 and is not expected to have a significant impact on our financial statements.

NOTE 3.  FAIR VALUE MEASUREMENTS

ASC Topic 820 defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date.  ASC Topic 820 also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.  The standard describes three levels of inputs that may be used to measure fair value.

 
Level 1:  Quoted prices (unadjusted) or identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.

 
Level 2:  Significant other observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, and other inputs that are observable or can be corroborated by observable market data.

 
Level 3:  Significant unobservable inputs that reflect a company’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.
   
 
 
10

Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)
 
     
Accordingly, securities available-for-sale and derivative financial instruments are recorded at fair value on a recurring basis. Additionally, from time to time, we may be required to record other assets at fair value on a nonrecurring basis, such as loans held for sale, and impaired loans held for investment.  These nonrecurring fair value adjustments typically involve application of lower of cost or market accounting or write-downs of individual assets.

Following is a description of valuation methodologies used for assets and liabilities recorded at fair value.

Available-for-Sale Securities:  Investment securities available-for-sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted prices, if available.  If quoted prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions.  Level 1 securities include those traded on an active exchange, such as the New York Stock Exchange, U.S. Treasury securities that are traded by dealers or brokers in active over-the-counter markets and money market funds.  Level 2 securities include mortgage-backed securities issued by government sponsored entities, municipal bonds and corporate debt securities.

Derivative Financial Instruments:  Derivative financial instruments are recorded at fair value on a recurring basis. Fair value measurement is based on pricing models run by a third-party, utilizing observable market-based inputs.  All future floating cash flows are projected and both floating and fixed cash flows are discounted to the valuation date. As a result, we classify interest rate swaps as Level 2.

Loans Held for Sale:  Loans held for sale are carried at the lower of cost or market value.  The fair value of loans held for sale is based on what secondary markets are currently offering for portfolios with similar characteristics.  As such, we classify loans subject to nonrecurring fair value adjustments as Level 2.

Loans:  We do not record loans at fair value on a recurring basis. However, from time to time, a loan is considered impaired and an allowance for loan losses is established.  Loans for which it is probable that payment of interest and principal will not be made in accordance with the original contractual terms of the loan agreement are considered impaired.  Once a loan is identified as individually impaired, management measures impairment in accordance with ASC Topic 310, Accounting by Creditors for Impairment of a Loan.  The fair value of impaired loans is estimated using one of several methods, including collateral value, liquidation value and discounted cash flows.  Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans.  At September 30, 2013, substantially all of the total impaired loans were evaluated based on the fair value of the collateral.  In accordance with ASC Topic 310, impaired loans where an allowance is established based on the fair value of collateral requires classification in the fair value hierarchy. When the fair value of the collateral is based on an observable market price or a current appraised value, we record the impaired loan as nonrecurring Level 2.  When a current appraised value is not available and there is no observable market price, we record the impaired loan as nonrecurring Level 3.
 
 
 
11

Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)
 

When a collateral-dependent loan is identified as impaired, management immediately begins the process of evaluating the estimated fair value of the underlying collateral to determine if a related specific allowance for loan losses or charge-off is necessary.  Current appraisals are ordered once a loan is deemed impaired if the existing appraisal is more than twelve months old, or more frequently if there is known deterioration in value. For recently identified impaired loans, a current appraisal may not be available at the financial statement date. Until the current appraisal is obtained, the original appraised value is discounted, as appropriate, to compensate for the estimated depreciation in the value of the loan’s underlying collateral since the date of the original appraisal.  Such discounts are generally estimated based upon management’s knowledge of sales of similar collateral within the applicable market area and its knowledge of other real estate market-related data as well as general economic trends.  When a new appraisal is received (which generally are received within 3 months of a loan being identified as impaired), management then re-evaluates the fair value of the collateral and adjusts any specific allocated allowance for loan losses, as appropriate.  In addition, management also assigns a discount of 7–10% for the estimated costs to sell the collateral.

Other Real Estate Owned (“OREO”):  OREO consists of real estate acquired in foreclosure or other settlement of loans. Such assets are carried on the balance sheet at the lower of the investment in the real estate or its fair value less estimated selling costs.  The fair value of OREO is determined on a nonrecurring basis generally utilizing current appraisals performed by an independent, licensed appraiser applying an income or market value approach using observable market data (Level 2).  Updated appraisals of OREO are generally obtained if the existing appraisal is more than 18 months old or more frequently if there is a known deterioration in value.  However, if a current appraisal is not available, the original appraised value is discounted, as appropriate, to compensate for the estimated depreciation in the value of the real estate since the date of its original appraisal.  Such discounts are generally estimated based upon management’s knowledge of sales of similar property within the applicable market area and its knowledge of other real estate market-related data as well as general economic trends (Level 3).  Upon foreclosure, any fair value adjustment is charged against the allowance for loan losses.  Subsequent fair value adjustments are recorded in the period incurred and included in other noninterest expense in the consolidated statements of income.

Assets and Liabilities Recorded at Fair Value on a Recurring Basis
 
 
The table below presents the recorded amount of assets (liabilities) measured at fair value on a recurring basis.


 
Balance at
 
Fair Value Measurements Using:
Dollars in thousands
September 30, 2013
 
Level 1
 
Level 2
 
Level 3
Available for sale securities
             
   U.S. Government sponsored agencies
$ 28,430   $ -   $ 28,430   $ -
   Mortgage backed securities:
                     
      Government sponsored agencies
  150,787     -     150,787     -
      Nongovernment sponsored entities
  13,440     -     13,440     -
   State and political subdivisions
  15,011     -     15,011     -
   Corporate debt securities
  3,950     -     3,950     -
   Other equity securities
  77     -     77     -
   Tax-exempt state and political subdivisions
  79,563     -     79,563     -
   Tax-exempt mortgage-backed securities
  -     -     -     -
Total available for sale securities
$ 291,258   $ -   $ 291,258   $ -
                       
Derivative financial instrument
                     
   Interest rate swap
$ (117 ) $ -   $ (117 ) $ -


 
12

Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)
 

 
Balance at
 
Fair Value Measurements Using:
Dollars in thousands
December 31, 2012
 
Level 1
 
Level 2
 
Level 3
Available for sale securities
             
   U.S. Government sponsored agencies
$ 29,020   $ -   $ 29,020   $ -
   Mortgage backed securities:
                     
      Government sponsored agencies
  136,570     -     136,570     -
      Nongovernment sponsored agencies
  15,745     -     15,745     -
   State and political subdivisions
  12,169     -     12,169     -
   Corporate debt securities
  1,950     -     1,950     -
   Other equity securities
  77     -     77     -
   Tax-exempt state and political subdivisions
  83,270     -     83,270     -
   Tax-exempt mortgage backed securities
  2,738     -     2,738     -
Total available for sale securities
$ 281,539   $ -   $ 281,539   $ -



There were no assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the period ended September 30, 2013.

Assets and Liabilities Recorded at Fair Value on a Nonrecurring Basis

We may be required, from time to time, to measure certain assets at fair value on a nonrecurring basis in accordance with U.S. generally accepted accounting principles.  These include assets that are measured at the lower of cost or market that were recognized at fair value below cost at the end of the period.  Assets measured at fair value on a nonrecurring basis are included in the table below.


 
Total at
 
Fair Value Measurements Using:
Dollars in thousands
September 30, 2013
 
Level 1
 
Level 2
 
Level 3
Residential mortgage loans held for sale
$ 602   $ -   $ 602   $ -
                       
Impaired loans
                     
    Commercial
$ 5,456   $ -   $ 3,731   $ 1,725
    Commercial real estate
  17,109     -     3,998     13,111
    Construction and development
  24,128     -     21,629     2,499
    Residential real estate
  22,632     -     17,341     5,291
    Consumer
  40     -     -     40
Total impaired loans
$ 69,365   $ -   $ 46,699   $ 22,666
                       
OREO
                     
    Commercial
$ -   $ -   $ -   $ -
    Commercial real estate
  9,961     -     9,961     -
    Construction and development
  31,747     -     31,747     -
    Residential real estate
  3,595     -     3,595     -
    Consumer
  -     -     -     -
Total OREO
$ 45,303   $ -   $ 45,303   $ -


 
13

Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)
 


 
Total at
 
Fair Value Measurements Using:
Dollars in thousands
December 31, 2012
 
Level 1
 
Level 2
 
Level 3
Residential mortgage loans held for sale
$ 226   $ -   $ 226   $ -
                       
Impaired loans
                     
    Commercial
$ 10,856   $ -   $ 5,013   $ 5,843
    Commercial real estate
  25,435     -     16,331     9,104
    Construction and development
  27,352     -     24,578     2,774
    Residential real estate
  24,442     -     21,625     2,817
    Consumer
  50     -     -     50
Total impaired loans
$ 88,135   $ -   $ 67,547   $ 20,588
                       
OREO
                     
    Commercial
$ -   $ -   $ -   $ -
    Commercial real estate
  11,835     -     11,047     788
    Construction and development
  40,671     -     35,978     4,693
    Residential real estate
  3,666     -     3,666     -
    Consumer
  -     -     -     -
Total OREO
$ 56,172   $ -   $ 50,691   $ 5,481

Our policy with respect to troubled debt restructurings (“TDRs”), included in impaired loans, is to appraise any underlying collateral at the time of restructure, and then only obtain periodic reappraisals if the TDR is not performing in accordance with the terms of the restructure.  Substantially all Level 3 fair values of impaired loans in the above tables are performing TDRs.

ASC Topic 825, Financial Instruments, requires disclosure of the fair value of financial assets and financial liabilities, including those financial assets and financial liabilities that are not measured and reported at fair value on a recurring basis or non-recurring basis.  The following summarizes the methods and significant assumptions we used in estimating our fair value disclosures for financial instruments.

Cash and cash equivalents:  The carrying values of cash and cash equivalents approximate their estimated fair value.

Federal funds sold:  The carrying values of Federal funds sold approximate their estimated fair values.

Securities:  Estimated fair values of securities are based on quoted market prices, where available.  If quoted market prices are not available, estimated fair values are based on quoted market prices of comparable securities.

Loans held for sale:  The carrying values of loans held for sale approximate their estimated fair values.

Loans:  The estimated fair values for loans are computed based on scheduled future cash flows of principal and interest, discounted at interest rates currently offered for loans with similar terms to borrowers of similar credit quality.  No prepayments of principal are assumed.

Accrued interest receivable and payable:  The carrying values of accrued interest receivable and payable approximate their estimated fair values.

Deposits:  The estimated fair values of demand deposits (i.e. non-interest bearing checking, NOW, money market and savings accounts) and other variable rate deposits approximate their carrying values.  Fair values of fixed maturity deposits are estimated using a discounted cash flow methodology at rates currently offered for deposits with similar remaining maturities.  Any intangible value of long-term relationships with depositors is not considered in estimating the fair values disclosed.
 
 
 
14

Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)
 

Short-term borrowings:  The carrying values of short-term borrowings approximate their estimated fair values.

Long-term borrowings:  The fair values of long-term borrowings are estimated by discounting scheduled future payments of principal and interest at current rates available on borrowings with similar terms.

Subordinated debentures:  The carrying values of subordinated debentures approximate their estimated fair values.

Subordinated debentures owed to unconsolidated subsidiary trusts:  The carrying values of subordinated debentures owed to unconsolidated subsidiary trusts approximate their estimated fair values.

Derivative financial instruments:  The fair value of the interest rate swap is valued using independent pricing models.

Off-balance sheet instruments:  The fair values of commitments to extend credit and standby letters of credit are estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present credit standing of the counter parties.  The amounts of fees currently charged on commitments and standby letters of credit are deemed insignificant, and therefore, the estimated fair values and carrying values are not shown below.


The carrying values and estimated fair values of our financial instruments are summarized below:


   
September 30, 2013
   
December 31, 2012
       
Estimated
       
Estimated
   
Carrying
 
Fair
   
Carrying
 
Fair
 Dollars in thousands
 
Value
 
Value
   
Value
 
Value
 Financial assets
                 
     Cash and cash equivalents
  $ 16,103   $ 16,103     $ 14,802   $ 14,802
     Securities available for sale
    291,258     291,258       281,539     281,539
     Other investments
    8,004     8,004       14,658     14,658
     Loans held for sale
    602     602       226     226
     Loans, net
    939,169     965,070       937,168     965,454
     Accrued interest receivable
    5,364     5,364       5,621     5,621
    $ 1,260,500   $ 1,286,401     $ 1,254,014   $ 1,282,300
 Financial liabilities
                         
     Deposits
  $ 1,016,735   $ 1,045,084     $ 1,027,125   $ 1,064,957
     Short-term borrowings
    54,163     54,163       3,958     3,958
     Long-term borrowings
    163,540     175,237       203,268     220,175
     Subordinated debentures
    16,800     16,800       16,800     16,800
     Subordinated debentures owed to
                         
         unconsolidated subsidiary trusts
    19,589     19,589       19,589     19,589
     Accrued interest payable
    1,473     1,473       1,877     1,877
     Derivative financial liabilities
    117     117       -     -
    $ 1,272,417   $ 1,312,463     $ 1,272,617   $ 1,327,356
 
 

 
15

Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)
 

NOTE 4.  EARNINGS PER SHARE

The computations of basic and diluted earnings per share follow:


 
For the Three Months Ended September 30,
 
2013
   
2012
     
Common
           
Common
   
Dollars in thousands,
Income
 
Shares
 
Per
   
Income
 
Shares
 
Per
except per share amounts
(Numerator)
 
(Denominator)
 
Share
   
(Numerator)
 
(Denominator)
 
Share
Net income
$ 2,272             $ 997        
 Less preferred stock dividends
  (194 )             (194 )      
                             
 Basic EPS
$ 2,078   7,443,865   $ 0.28     $ 803   7,425,472   $ 0.11
                                 
     Effect of dilutive securities:
                               
         Stock options
  -   7,819             -   1,261      
         Series 2011 convertible
                               
              preferred stock
  120   1,495,728             120   1,500,000      
         Series 2009 convertible
                               
              preferred stock
  74   674,545             74   674,545      
                                 
 Diluted EPS
$ 2,272   9,621,957   $ 0.24     $ 997   9,601,278   $ 0.10



 
For the Nine Months Ended September 30,
 
2013
   
2012
     
Common
           
Common
   
Dollars in thousands,
Income
 
Shares
 
Per
   
Income
 
Shares
 
Per
except per share amounts
(Numerator)
 
(Denominator)
 
Share
   
(Numerator)
 
(Denominator)
 
Share
Net income
$ 5,282             $ 3,608        
 Less preferred stock dividends
  (582 )             (583 )      
                             
 Basic EPS
$ 4,700   7,438,216   $ 0.63     $ 3,025   7,425,472   $ 0.41
                                 
     Effect of dilutive securities:
                               
         Stock options
  -   7,316             -   1,081      
         Series 2011 convertible
                               
              preferred stock
  359   1,498,251             360   1,500,000      
         Series 2009 convertible
                               
              preferred stock
  223   674,545             223   674,545      
                                 
 Diluted EPS
$ 5,282   9,618,328   $ 0.55     $ 3,608   9,601,098   $ 0.38


Stock option grants and the convertible preferred shares are disregarded in this computation if they are determined to be anti-dilutive.  Our anti-dilutive stock options at September 30, 2013 and 2012 totaled 170,500 shares and 289,380 shares, respectively.



 
16

Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)
 



NOTE 5.  SECURITIES

The amortized cost, unrealized gains, unrealized losses and estimated fair values of securities at September 30, 2013, December 31, 2012, and September 30, 2012 are summarized as follows:



 
September 30, 2013
 
Amortized
 
Unrealized
 
Estimated
 Dollars in thousands
Cost
 
Gains
 
Losses
 
Fair Value
 Available for Sale
             
     Taxable debt securities:
             
         U. S. Government agencies
             
             and corporations
$ 27,740   $ 757   $ 67   $ 28,430
         Residential mortgage-backed securities:
                     
              Government-sponsored agencies
  149,569     2,444     1,226     150,787
              Nongovernment-sponsored agencies
  13,134     315     9     13,440
         State and political subdivisions:
                     
             General obligations
  9,064     -     383     8,681
             Water and sewer revenues
  3,234     1     91     3,144
             Other revenues
  3,298     -     112     3,186
         Corporate debt securities
  3,970     25     45     3,950
          Total taxable debt securities
  210,009     3,542     1,933     211,618
     Tax-exempt debt securities:
                     
         State and political subdivisions:
                     
             General obligations
  49,569     1,048     1,112     49,505
             Water and sewer revenues
  10,132     89     290     9,931
             Lease revenues
  8,869     1     441     8,429
             Lottery/casino revenues
  4,457     68     166     4,359
             Other revenues
  7,490     61     212     7,339
      Total tax-exempt debt securities
  80,517     1,267     2,221     79,563
     Equity securities
  77     -     -     77
      Total available for sale securities
$ 290,603   $ 4,809   $ 4,154   $ 291,258
 
 

 
 
17

Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)
 
 

 
 
December 31, 2012
 
Amortized
 
Unrealized
 
Estimated
 Dollars in thousands
Cost
 
Gains
 
Losses
 
Fair Value
 Available for Sale
             
     Taxable debt securities
             
         U. S. Government agencies
             
             and corporations
$ 28,128   $ 892   $ -   $ 29,020
Residential mortgage-backed securities:
                 
             Government-sponsored agencies
  133,812     3,250     492     136,570
             Nongovernment-sponsored entities
  15,380     509     144     15,745
         State and political subdivisions:
                     
             General obligations
  8,847     58     57     8,848
             Water and sewer revenues
  1,920     -     32     1,888
             Other revenues
  1,420     13     -     1,433
         Corporate debt securities
  1,959     29     38     1,950
 Total taxable debt securities
  191,466     4,751     763     195,454
     Tax-exempt debt securities
                     
         State and political subdivisions:
                     
             General obligations
  54,948     3,259     145     58,062
             Water and sewer revenues
  5,773     171     47     5,897
             Lease revenues
  6,910     159     13     7,056
             Lottery/casino revenues
  4,500     305     9     4,796
             Other revenues
  7,272     210     23     7,459
Residential mortgage-backed securities:
                 
             Government-sponsored agencies
  2,738     -     -     2,738
 Total tax-exempt debt securities
  82,141     4,104     237     86,008
     Equity securities
  77     -     -     77
 Total available for sale securities
$ 273,684   $ 8,855   $ 1,000   $ 281,539





 
September 30, 2012
 
Amortized
 
Unrealized
 
Estimated
 Dollars in thousands
Cost
 
Gains
 
Losses
 
Fair Value
 Available for Sale
             
     Taxable debt securities:
             
         U. S. Government agencies
             
             and corporations
$ 25,857   $ 1,009   $ 4   $ 26,862
         Residential mortgage-backed securities:
                     
              Government-sponsored agencies
  150,233     3,741     453     153,521
              Nongovernment-sponsored agencies
  21,199     712     290     21,621
         State and political subdivisions
  10,176     57     56     10,177
         Corporate debt securities
  1,955     29     74     1,910
          Total taxable debt securities
  209,420     5,548     877     214,091
     Tax-exempt debt securities:
                     
         State and political subdivisions
  70,678     4,358     70     74,966
         Residential mortgage-backed securities:
                     
              Government-sponsored agencies
  2,858     -     -     2,858
          Total tax-exempt debt securities
  73,536     4,358     70     77,824
     Equity securities
  77     -     -     77
          Total available for sale securities
$ 283,033   $ 9,906   $ 947   $ 291,992



 
 
18

Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)
 

 
The below information is relative to the five states where issuers with the highest volume of state and political subdivision securities held in our portfolio are located.  We own no such securities of any single issuer which we deem to be a concentration.


 
September 30, 2013
 
Amortized
 
Unrealized
 
Estimated
 Dollars in thousands
Cost
 
Gains
 
Losses
 
Fair Value
               
 West Virginia
$ 14,286   $ 97   $ 267   $ 14,116
 Illinois
  10,435     59     535     9,959
 California
  8,102     107     241     7,968
 Texas
  7,155     234     178     7,211
 Washington
  4,409     110     80     4,439


Management performs pre-purchase and ongoing analysis to confirm that all investment securities meet applicable credit quality standards.  Prior to July 1, 2013, we principally used credit ratings from Nationally Recognized Statistical Rating Organizations (“NRSROs”) to support analyses of our portfolio of securities issued by state and political subdivisions, as we generally do not purchase securities that are rated below the six highest NRSRO rating categories.  Beginning July 1, 2013, in addition to considering a security’s NRSRO rating, we now also assess or confirm through an internal review of an issuer’s financial information and other applicable information that:  1) the issuer’s risk of default is low; 2) the characteristics of the issuer’s demographics and economic environment are satisfactory; and 3) the issuer’s budgetary position and stability of tax or other revenue sources are sound.

The maturities, amortized cost and estimated fair values of securities at September 30, 2013, are summarized as follows:


   
Available for Sale
   
Amortized
 
Estimated
 Dollars in thousands
 
Cost
 
Fair Value
 Due in one year or less
  $ 68,076   $ 68,631
 Due from one to five years
    88,188     89,189
 Due from five to ten years
    33,174     33,187
 Due after ten years
    101,088     100,174
 Equity securities
    77     77
    $ 290,603   $ 291,258


The proceeds from sales, calls and maturities of available for sale securities, including principal payments received on mortgage-backed obligations, and the related gross gains and losses realized, for the nine months ended September 30, 2013 are as follows:


                       
       
Calls and
 
Principal
         
Dollars in thousands
 
Sales
 
Maturities
 
Payments
   
Gains
 
Losses
                       
Securities available for sale
  $ 41,188   $ 1,258   $ 50,650     $ 362   $ 246
 
 

 
 
19

Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)
 

During the three and nine months ended September 30, 2013 and 2012, we recorded other-than-temporary impairment losses on residential mortgage-backed nongovernment sponsored entity securities as follows:


   
Three Months Ended
   
Nine Months Ended
   
September 30,
   
September 30,
 In thousands
 
2013
 
2012
   
2013
 
2012
                   
 Total other-than-temporary impairment losses
  $ (38 ) $ (233 )   $ (155 ) $ (1,115)
 Portion of loss recognized in
                         
   other comprehensive income
    -     194       37     740
 Net impairment losses recognized in earnings
  $ (38 ) $ (39 )   $ (118 ) $ (375)


Activity related to the credit component recognized on debt securities available for sale for which a portion of other-than-temporary impairment was recognized in other comprehensive income for the three and nine months ended September 30, 2013 is as follows:

   
Three Months Ended
   
Nine Months Ended
   
September 30, 2013
   
September 30, 2013
           
 In thousands
 
Total
   
Total
 Beginning Balance
  $ 2,984     $ 2,904
 Additions for the credit component on debt securities in which
             
     other-than-temporary impairment was not previously recognized
    38       118
  Securities sold during the period
    -       -
 Ending Balance
  $ 3,022     $ 3,022


At September 30, 2013, our debt securities with other-than-temporary impairment in which only the amount of loss related to credit was recognized in earnings consisted solely of residential mortgage-backed securities issued by nongovernment-sponsored entities.  We utilize third party vendors to estimate the portion of loss attributable to credit using a discounted cash flow models.  The vendors estimate cash flows of the underlying collateral of each mortgage-backed security using models that incorporate their best estimates of current key assumptions, such as default rates, loss severity and prepayment rates.  Assumptions utilized vary widely from security to security, and are influenced by such factors as underlying loan interest rates, geographical location of underlying borrowers, collateral type and other borrower characteristics.

Our vendors performing these valuations also analyze the structure of each mortgage-backed instrument in order to determine how the estimated cash flows of the underlying collateral will be distributed to each security issued from the structure.  Expected principal and interest cash flows on the impaired debt securities are discounted predominantly using unobservable discount rates which the vendors assume that market participants would utilize in pricing the specific security.  Based on the discounted expected cash flows derived from our vendor’s models, we expect to recover the remaining unrealized losses on residential mortgage-backed securities issued by nongovernment sponsored entities.
 
 
 
20

Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)
 

Provided below is a summary of securities available for sale which were in an unrealized loss position at September 30, 2013 and December 31, 2012, including debt securities for which a portion of other-than-temporary impairment has been recognized in other comprehensive income.

 
September 30, 2013
 
Less than 12 months
 
12 months or more
   
Total
 
Estimated
 
Unrealized
 
Estimated
 
Unrealized
   
Estimated
 
Unrealized
Dollars in thousands
Fair Value
 
Loss
 
Fair Value
 
Loss
   
Fair Value
 
Loss
Temporarily impaired securities
                       
   Taxable debt securities
                       
     U. S. Government agencies
                       
       and corporations
$ 7,770   $ (67 ) $ -   $ -     $ 7,770   $ (67)
     Residential mortgage-backed securities:
                                   
        Government-sponsored agencies
  48,957     (1,011 )   11,754     (215 )     60,711     (1,226)
        Nongovernment-sponsored entities
  355     (1 )   858     (8 )     1,213     (9)
     State and political subdivisions:
                                   
       General obligations
  5,806     (316 )   876     (67 )     6,682     (383)
       Water and sewer revenues
  634     (35 )   1,175     (56 )     1,809     (91)
       Other revenues
  3,185     (112 )   -     -       3,185     (112)
     Corporate debt securities
  2,954     (45 )   -     -       2,954     (45)
   Tax-exempt debt securities
                                   
     State and political subdivisions:
                                   
        General obligations
  21,134     (1,112 )   -     -       21,134     (1,112)
        Water and sewer revenues
  6,505     (290 )   -     -       6,505     (290)
        Lease revenues
  7,522     (424 )   366     (17 )     7,888     (441)
        Lottery/casino revenues
  3,292     (166 )   -     -       3,292     (166)
        Other revenues
  5,407     (212 )   -     -       5,407     (212)
     Total temporarily impaired securities
  113,521     (3,791 )   15,029     (363 )     128,550     (4,154)
Other-than-temporarily impaired securities
                                   
   Taxable debt securities
                                   
     Residential mortgage-backed securities:
                                   
        Nongovernment-sponsored entities
  -     -     -     -       -     -
     Total other-than-temporarily
                                   
 impaired securities
  -     -     -     -       -     -
 Total
$ 113,521   $ (3,791 ) $ 15,029   $ (363 )   $ 128,550   $ (4,154)


 
21

Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)
 
 

 
 
December 31, 2012
 
Less than 12 months
 
12 months or more
   
Total
 
Estimated
 
Unrealized
 
Estimated
 
Unrealized
   
Estimated
 
Unrealized
Dollars in thousands
Fair Value
 
Loss
 
Fair Value
 
Loss
   
Fair Value
 
Loss
Temporarily impaired securities
                       
   Taxable debt securities
                       
     U. S. Government agencies
                       
       and corporations
$ -   $ -   $ -   $ -     $ -   $ -
     Residential mortgage-backed securities:
                                   
        Government-sponsored agencies
  36,498     (414 )   8,997     (78 )     45,495     (492)
        Nongovernment-sponsored entities
  -     (4 )   1,478     (14 )     1,478     (18)
     State and political subdivisions:
                                   
        General obligations
  2,526     (57 )   -     -       2,526     (57)
        Water and sewer revenues
  1,240     (28 )   387     (4 )     1,627     (32)
        Other revenues
  -     -     -     -       -     -
     Corporate debt securities
  -     -     962     (38 )     962     (38)
   Tax-exempt debt securities
                                   
     State and political subdivisions:
                                   
        General obligations
  11,926     (145 )   -     -       11,926     (145)
        Water and sewer revenues
  2,534     (47 )   -     -       2,534     (47)
        Lease revenues
  1,013     (13 )   -     -       1,013     (13)
        Lottery/casino revenues
  1,777     (9 )   -     -       1,777     (9)
        Other revenues
  2,684     (23 )   -     -       2,684     (23)
 Other equity securties
  -     -     -     -       -     -
     Total temporarily impaired securities
  60,198     (740 )   11,824     (134 )     72,022     (874)
Other-than-temporarily impaired securities
                                   
   Taxable debt securities
                                   
     Residential mortgage-backed securities:
                                   
        Nongovernment-sponsored entities
  265     (6 )   593     (120 )     858     (126)
     Total other-than-temporarily
                                   
 impaired securities
  265     (6 )   593     (120 )     858     (126)
 Total
$ 60,463   $ (746 ) $ 12,417   $ (254 )   $ 72,880   $ (1,000)


We held 127 available for sale securities having an unrealized loss at September 30, 2013.  We do not intend to sell these securities, and it is more likely than not that we will not be required to sell these securities before recovery of their amortized cost bases.  We believe that this decline in value is primarily attributable to the lack of market liquidity and to changes in market interest rates and not due to credit quality.  Accordingly, no additional other-than-temporary impairment charge to earnings is warranted at this time.

NOTE 6.  LOANS

Loans are generally stated at the amount of unpaid principal, reduced by unearned discount and allowance for loan losses. Interest on loans is accrued daily on the outstanding balances.  Loan origination fees and certain direct loan origination costs are deferred and amortized as adjustments of the related loan yield over its contractual life. We categorize residential real estate loans in excess of $600,000 as jumbo loans.

Generally, loans are placed on nonaccrual status when principal or interest is greater than 90 days past due based upon the loan's contractual terms.  Interest is accrued daily on impaired loans unless the loan is placed on nonaccrual status.  Impaired loans are placed on nonaccrual status when the payments of principal and interest are in default for a period of 90 days, unless the loan is both well-secured and in the process of collection.  Interest on nonaccrual loans is recognized primarily using the cost-recovery method.  Loans may be returned to accrual status when repayment is reasonably assured and there has been demonstrated performance under the terms of the loan or, if applicable, the terms of the restructured loans.
 
 
 
22

Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)
 

Commercial-related loans or portions thereof (which are risk-rated) are charged off to the allowance for loan losses when the loss has been confirmed.  This determination is made on a case by case basis considering many factors, including the prioritization of our claim in bankruptcy, expectations of the workout/restructuring of the loan and valuation of the borrower’s equity.  We deem a loss confirmed when a loan or a portion of a loan is classified “loss” in accordance with bank regulatory classification guidelines, which state, “Assets classified loss are considered uncollectible and of such little value that their continuance as bankable assets is not warranted”.

Consumer-related loans are generally charged off to the allowance for loan losses upon reaching specified stages of delinquency, in accordance with the Federal Financial Institutions Examination Council policy.  For example, credit card loans are charged off by the end of the month in which the account becomes 180 days past due or within 60 days from receiving notification about a specified event (e.g., bankruptcy of the borrower), which ever is earlier.  Residential mortgage loans are generally charged off to net realizable value no later than when the account becomes 180 days past due.  Other consumer loans, if collateralized, are generally charged off to net realizable value at 120 days past due.

Loans are summarized as follows:

   
September 30,
 
December 31,
 
September 30,
 Dollars in thousands
 
2013
 
2012
 
2012
 Commercial
  $ 83,844   $ 85,829   $ 88,997
 Commercial real estate
                 
      Owner-occupied
    151,260     154,252     150,090
      Non-owner occupied
    279,412     276,082     279,132
 Construction and development
                 
      Land and land development
    73,089     79,335     82,857
      Construction
    12,323     3,772     2,087
 Residential real estate
                 
      Non-jumbo
    215,058     216,714     215,584
      Jumbo
    59,701     61,567     62,748
      Home equity
    53,674     53,263     53,455
 Consumer
    20,472     20,586     21,290
 Other
    3,375     3,701     2,513
      Total loans, net of unearned fees
    952,208     955,101     958,753
 Less allowance for loan losses
    13,039     17,933     17,820
       Loans, net
  $ 939,169   $ 937,168   $ 940,933
 
 

 
 
23

Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)
 

The following table presents the contractual aging of the recorded investment in past due loans by class as of September 30, 2013 and 2012 and December 31, 2012.


 
At September 30, 2013
                     
Recorded
                     
Investment
 
Past Due
     
> 90 days
Dollars in thousands
30-59 days
 
60-89 days
 
> 90 days
 
Total
 
Current
 
and Accruing
Commercial
$ 10   $ 111   $ 1,583   $ 1,704   $ 82,140   $ -
Commercial real estate
                                 
     Owner-occupied
  846     229     432     1,507     149,753     -
     Non-owner occupied
  587     244     -     831     278,581     -
Construction and development
                                 
     Land and land development
  154     -     8,669     8,823     64,266     -
     Construction
  -     -     38     38     12,285     -
Residential mortgage
                                 
     Non-jumbo
  3,467     2,031     2,225     7,723     207,335     -
     Jumbo
  -     -     9,000     9,000     50,701     -
     Home equity
  214     49     24     287     53,387     -
Consumer
  197     77     91     365     20,107     -
Other
  50     -     -     50     3,325     -
     Total
$ 5,525   $ 2,741   $ 22,062   $ 30,328   $ 921,880   $ -





 
At December 31, 2012
                     
Recorded
                     
Investment
 
Past Due
     
> 90 days
Dollars in thousands
30-59 days
 
60-89 days
 
> 90 days
 
Total
 
Current
 
and Accruing
Commercial
$ 225   $ 5   $ 2,294   $ 2,524   $ 83,305   $ -
Commercial real estate
                                 
     Owner-occupied
  57     -     1,023     1,080     153,172     -
     Non-owner occupied
  182     193     908     1,283     274,799     -
Construction and development
                                 
     Land and land development
  -     -     11,795     11,795     67,540     -
     Construction
  -     -     153     153     3,619     -
Residential mortgage
                                 
     Non-jumbo
  3,344     2,616     2,797     8,757     207,957     -
     Jumbo
  -     -     12,564     12,565     49,002     -
     Home equity
  337     448     179     964     52,299     -
Consumer
  255     79     48     382     20,204     -
Other
  -     -     -     -     3,701     -
     Total
$ 4,400   $ 3,341   $ 31,761   $ 39,503   $ 915,598   $ -


 
24

Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)
 


 
At September 30, 2012
                     
Recorded
                     
Investment
 
Past Due
     
> 90 days
Dollars in thousands
30-59 days
 
60-89 days
 
> 90 days
 
Total
 
Current
 
and Accruing
Commercial
$ 273   $ 634   $ 1,594   $ 2,501   $ 86,496   $ -
Commercial real estate
                                 
     Owner-occupied
  216     581     400     1,197     148,893     -
     Non-owner occupied
  513     -     1,882     2,395     276,737     -
Construction and development
                                 
     Land and land development
  17     39     13,412     13,468     69,389     -
     Construction
  50     -     153     203     1,884     -
Residential mortgage
                                 
     Non-jumbo
  2,681     2,029     2,544     7,254     208,330     -
     Jumbo
  -     -     15,273     15,273     47,475     -
     Home equity
  280     5     149     434     53,021     -
Consumer
  319     36     46     401     20,889     -
Other
  -     -     -     -     2,513     -
     Total
$ 4,349   $ 3,324   $ 35,453   $ 43,126   $ 915,627   $ -


Nonaccrual loans:  The following table presents the nonaccrual loans included in the net balance of loans at September 30, 2013, December 31, 2012 and September 30, 2012.



Dollars in thousands
 
9/30/2013
 
12/31/2012
 
9/30/2012
Commercial
  $ 2,557   $ 5,002   $ 5,343
Commercial real estate
                 
   Owner-occupied
    3,795     1,524     921
   Non-owner occupied
    -     1,032     1,882
Construction and development
                 
   Land & land development
    12,851     13,487     16,558
   Construction
    38     154     203
Residential mortgage
                 
   Non-jumbo
    3,119     3,518     3,122
   Jumbo
    9,000     12,564     15,272
   Home equity
    266     440     415
Consumer
    145     55     87
Other
    -     -     -
     Total
  $ 31,771   $ 37,776   $ 43,803

Impaired loans:  Impaired loans include the following:

§  
Loans which we risk-rate (consisting of loan relationships having aggregate balances in excess of $2.0 million, or loans exceeding $500,000 and exhibiting credit weakness) through our normal loan review procedures and which, based on current information and events, it is probable that we will be unable to collect all amounts due in accordance with the original contractual terms of the loan agreement.   Risk-rated loans with insignificant delays or insignificant short falls in the amount of payments expected to be collected are not considered to be impaired.

§  
Loans that have been modified in a troubled debt restructuring.
 
 
 
25

Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)
 

 
Both commercial and consumer loans are deemed impaired upon being contractually modified in a troubled debt restructuring. Troubled debt restructurings typically result from our loss mitigation activities and occur when we grant a concession to a borrower who is experiencing financial difficulty in order to minimize our economic loss and to avoid foreclosure or repossession of collateral.  Once restructured in a troubled debt restructuring, a loan is generally considered impaired until its maturity, regardless of whether the borrower performs under the modified terms.  Although such a loan may be returned to accrual status if the criteria set forth in our accounting policy are met, the loan would continue to be evaluated for an asset-specific allowance for loan losses and we would continue to report the loan in the impaired loan table below.

The table below sets forth information about our impaired loans.



Method Used to Measure Impairment of Impaired Loans
       
Dollars in thousands
             
Loan Category
9/30/2013
 
12/31/2012
 
9/30/2012
 
Method used to measure impairment
Commerical
$ 5,997   $ 10,776   $ 12,411  
Fair value of collateral
    160     165     -  
Discounted cash flow
Commerical real estate
                   
   Owner-occupied
  9,054     14,028     13,248  
Fair value of collateral
    2,497     2,686     2,698  
Discounted cash flow
   Non-owner occupied
  5,884     9,468     12,057  
Fair value of collateral
Construction and development
               
   Land & land development
  24,870     29,307     30,482  
Fair value of collateral
    649     656     656  
Discounted cash flow
Residential mortgage
                   
   Non-jumbo
  5,133     5,626     5,461  
Fair value of collateral
    884     692     959  
Discounted cash flow
   Jumbo
  17,786     21,543     23,094  
Fair value of collateral
   Home equity
  213     219     219  
Fair value of collateral
Consumer
  52     66     42  
Fair value of collateral
Total
$ 73,179   $ 95,232   $ 101,327    





 
26

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)


The following tables present loans individually evaluated for impairment at September 30, 2013, December 31, 2012 and September 30, 2012.


 
September 30, 2013
             
Average
 
Interest Income
 
Recorded
 
Unpaid
 
Related
 
Impaired
 
Recognized
Dollars in thousands
Investment
 
Principal Balance
 
Allowance
 
Balance
 
while impaired
                   
Without a related allowance
                 
  Commercial
$ 4,254   $ 4,268   $ -   $ 5,632   $ 334
  Commercial real estate
                           
     Owner-occupied
  7,609     7,613     -     8,839     293
     Non-owner occupied
  5,368     5,370     -     5,800     289
  Construction and development
                           
     Land & land development
  20,923     20,921     -     20,331     404
     Construction
  -     -     -     -     -
  Residential real estate
                           
     Non-jumbo
  2,888     2,895     -     2,930     171
     Jumbo
  7,876     7,882     -     8,168     419
     Home equity
  186     186     -     186     11
Consumer
  28     28     -     32     2
Total without a related allowance
$ 49,132   $ 49,163   $ -   $ 51,918   $ 1,923
                             
With a related allowance
                           
  Commercial
$ 1,891   $ 1,889   $ 702   $ 2,537   $ -
  Commercial real estate
                           
     Owner-occupied
  3,938     3,938     216     3,956     138
     Non-owner occupied
  514     514     110     516     28
  Construction and development
                           
     Land & land development
  4,597     4,598     1,390     3,992     121
     Construction
  -     -     -     -     -
  Residential real estate
                           
     Non-jumbo
  3,119     3,122     316     2,843     130
     Jumbo
  9,904     9,904     1,040     10,152     45
     Home equity
  27     27     27     27     -
Consumer
  24     24     13     25     1
Total with a related allowance
$ 24,014   $ 24,016   $ 3,814   $ 24,048   $ 463
                             
Total
                           
   Commercial
$ 49,094   $ 49,111   $ 2,418   $ 51,603   $ 1,607
   Residential real estate
  24,000     24,016     1,383     24,306     776
   Consumer
  52     52     13     57     3
Total
$ 73,146   $ 73,179   $ 3,814   $ 75,966   $ 2,386
 
 
 
27

Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)
 

 

 
December 31, 2012
             
Average
 
Interest Income
 
Recorded
 
Unpaid
 
Related
 
Impaired
 
Recognized
Dollars in thousands
Investment
 
Principal Balance
 
Allowance
 
Balance
 
while impaired
                   
Without a related allowance
                 
  Commercial
$ 10,518   $ 10,537   $ -   $ 3,131   $ 134
  Commercial real estate
                           
     Owner-occupied
  9,992     9,996     -     8,528     368
     Non-owner occupied
  6,143     6,145     -     6,056     304
  Construction and development
                           
     Land & land development
  11,596     11,596     -     11,093     367
     Construction
  -     -     -     -     -
  Residential real estate
                           
     Non-jumbo
  3,497     3,505     -     3,040     125
     Jumbo
  7,347     7,349     -     5,399     272
     Home equity
  191     191     -     191     11
     Consumer
  38     38     -     32     1
Total without a related allowance
$ 49,322   $ 49,357   $ -   $ 37,470   $ 1,582
                             
With a related allowance
                           
  Commercial
$ 404   $ 404   $ 85   $ 515   $ 6
  Commercial real estate
                           
     Owner-occupied
  6,719     6,718     461     4,442     187
     Non-owner occupied
  3,321     3,323     286     3,341     115
  Construction and development
                           
     Land & land development
  18,367     18,367     2,611     17,633     344
     Construction
  -     -     -     -     -
  Residential real estate
                           
     Non-jumbo
  2,812     2,813     394     2,378     77
     Jumbo
  14,189     14,194     3,216     13,585     59
     Home equity
  28     28     28     29     -
     Consumer
  28     28     16     2     -
Total with a related allowance
$ 45,868   $ 45,875   $ 7,097   $ 41,925   $ 788
                             
Total
                           
   Commercial
$ 67,060   $ 67,086   $ 3,443   $ 54,739   $ 1,825
   Residential real estate
  28,064     28,080     3,638     24,622     544
   Consumer
  66     66     16     34     1
Total
$ 95,190   $ 95,232   $ 7,097   $ 79,395   $ 2,370
 
 

 
 
28

Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)
 
 

 
 
September 30, 2012
             
Average
 
Interest Income
 
Recorded
 
Unpaid
 
Related
 
Impaired
 
Recognized
Dollars in thousands
Investment
 
Principal Balance
 
Allowance
 
Balance
 
while impaired
                   
Without a related allowance
                 
  Commercial
$ 12,059   $ 12,075   $ -   $ 3,148   $ 54
  Commercial real estate
                           
     Owner-occupied
  11,370     11,373     -     8,058     346
     Non-owner occupied
  8,537     8,540     -     6,349     304
  Construction and development
                           
     Land & land development
  15,624     15,624     -     14,060     524
     Construction
  -     -     -     -     -
  Residential real estate
                           
     Non-jumbo
  3,987     3,996     -     3,545     135
     Jumbo
  8,902     8,905     -     6,497     257
     Home equity
  191     191     -     192     12
Consumer
  39     38     -     30     1
Total without a related allowance
$ 60,709   $ 60,742   $ -   $ 41,879   $ 1,633
                             
With a related allowance
                           
  Commercial
$ 336   $ 336   $ 86   $ 299   $ 6
  Commercial real estate
                           
     Owner-occupied
  4,573     4,573     241     4,409     209
     Non-owner occupied
  3,516     3,517     475     3,361     115
  Construction and development
                           
     Land & land development
  15,514     15,514     2,762     15,026     182
     Construction
  -     -     -     -     -
  Residential real estate
                           
     Non-jumbo
  2,422     2,424     502     1,787     101
     Jumbo
  14,183     14,189     3,211     13,193     32
     Home equity
  28     28     28     29     -
Consumer
  4     4     4     1     -
Total with a related allowance
$ 40,576   $ 40,585   $ 7,309   $ 38,105   $ 645
                             
Total
                           
   Commercial
$ 71,529   $ 71,552   $ 3,564   $ 54,710   $ 1,740
   Residential real estate
  29,713     29,733     3,741     25,243     537
   Consumer
  43     42     4     31     1
Total
$ 101,285   $ 101,327   $ 7,309   $ 79,984   $ 2,278



A modification of a loan is considered a TDR when a borrower is experiencing financial difficulty and the modification constitutes a concession that we would not otherwise consider. This may include a transfer of real estate or other assets from the borrower, a modification of loan terms, or a combination of both.  A loan continues to be classified as a TDR for the life of the loan.  Included in impaired loans are TDRs of $43.8 million, of which $33.7 million were current with respect to restructured contractual payments at September 30, 2013, and $56.7 million, of which $42.3 million were current with respect to restructured contractual payments at December 31, 2012.  There were no commitments to lend additional funds under these restructurings at either balance sheet date.

The following table presents by class the TDRs that were restructured during the three and nine months ended September 30, 2013 and 2012.  Generally, the modifications were extensions of term, modifying the payment terms from principal and interest to interest only for an extended period, or reduction in interest rate.  All TDRs are evaluated individually for allowance for loan loss purposes.
 

 
 
29

Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)
 


 
For the Three Months Ended
   
For the Three Months Ended
 
September 30, 2013
   
September 30, 2012
     
Pre-modification
 
Post-modification
       
Pre-modification
 
Post-modification
 
Number of
 
Recorded
 
Recorded
   
Number of
 
Recorded
 
Recorded
Dollars in thousands
Modifications
 
Investment
 
Investment
   
Modifications
 
Investment
 
Investment
  Commercial
-   $ -   $ -     -   $ -   $ -
  Commercial real estate
                               
     Owner-occupied
-     -     -     -     -     -
     Non-owner occupied
-     -     -     1     1,929     1,929
Construction and development
                             
     Land & land development
-     -     -     2     1,927     1,927
     Construction
-     -     -     -     -     -
  Residential real estate
                               
     Non-jumbo
2     487     487     3     688     688
     Jumbo
-     -     -     -     -     -
     Home equity
-     -     -     -     -     -
  Consumer
-     -     -     -     -     -
Total
2   $ 487   $ 487     6   $ 4,544   $ 4,544


 
For the Nine Months Ended
   
For the Nine Months Ended
 
September 30, 2013
   
September 30, 2012
     
Pre-modification
 
Post-modification
       
Pre-modification
 
Post-modification
 
Number of
 
Recorded
 
Recorded
   
Number of
 
Recorded
 
Recorded
Dollars in thousands
Modifications
 
Investment
 
Investment
   
Modifications
 
Investment
 
Investment
  Commercial
1   $ 23   $ 23     3   $ 1,109   $ 1,117
  Commercial real estate
                               
     Owner-occupied
-     -     -     -     -     -
     Non-owner occupied
-     -     -     3     4,063     3,685
Construction and development
                             
     Land & land development
1     49     50     3     3,715     2,927
     Construction
-     -     -     -     -     -
  Residential real estate
                               
     Non-jumbo
4     728     514     7     1,245     1,256
     Jumbo
-     -     -     3     2,301     2,701
     Home equity
-     -     -     -     -     -
  Consumer
-     -     -     2     42     42
Total
6   $ 800   $ 587     21   $ 12,475   $ 11,728
 
 
 
30

Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)
 

 
The following table presents defaults during the stated period of TDRs that were restructured during the past twelve months.  For purposes of these tables, a default is considered as either the loan was past due 30 days or more at any time during the period, or the loan was fully or partially charged off during the period.



 
For the Three Months Ended
   
For the Nine Months Ended
 
September 30, 2013
   
September 30, 2013
 
Number
 
Recorded
   
Number
 
Recorded
 
of
 
Investment
   
of
 
Investment
Dollars in thousands
Defaults
 
at Default Date
   
Defaults
 
at Default Date
  Commercial
-   $ -     -   $ -
  Commercial real estate
                   
     Owner-occupied
-     -     -     -
     Non-owner occupied
-     -     -     -
Construction and development
                 
     Land & land development
-     -     2     1,676
     Construction
-     -     -     -
  Residential real estate
                   
     Non-jumbo
1     239     3     760
     Jumbo
-     -     -     -
     Home equity
-     -     -     -
  Consumer
2     22     2     24
Total
3   $ 261     7   $ 2,460


The following tables detail the activity regarding TDRs by loan type for the three months and nine months ended September 30, 2013, and the related allowance on TDRs.



For the Three Months Ended September 30, 2013
 
Construction & Land Development
                                       
 
Land &
         
Commercial Real Estate
   
Residential Real Estate
             
 
Land
             
Non-
                           
 
Develop-
 
Construc-
 
Commer-
 
Owner
 
Owner
   
Non-
     
Home
 
Con-
         
Dollars in thousands
ment
 
tion
 
cial
 
Occupied
 
Occupied
   
jumbo
 
Jumbo
 
Equity
 
sumer
 
Other
   
Total
                                               
Troubled debt restructurings
                                           
Balance June 30, 2013
$ 8,549   $ -   $ 3,735   $ 9,986   $ 5,367     $ 5,018   $ 15,349   $ -   $ 62   $ -     $ 48,066
   Additions
  -     -     -     -     -       487     -     -     -     -       487
   Charge-offs
  -     -     -     -     -       -     (113 )   -     -     -       (113)
   Net (paydowns) advances
  (3,007 )   -     (1,441 )   (211 )   (31 )     (28 )   84     -     (10 )   -       (4,644)
   Transfer into OREO
  -     -     -     -     -       -     -     -     -     -       -
   Refinance out of TDR status
  -     -     -     -     -       -     -     -     -     -       -
Balance September 30, 2013
$ 5,542   $ -   $ 2,294   $ 9,775   $ 5,336     $ 5,477   $ 15,320   $ -   $ 52   $ -     $ 43,796
                                                                     
Allowance related to
                                                                   
   troubled debt restructurings
$ 22   $ -   $ 131   $ 216   $ 110     $ 302   $ 1,040   $ -   $ 13   $ -     $ 1,834

 
 
 
31

Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)
 

 
For the Nine Months Ended September 30, 2013
 
Construction & Land Development
                                       
 
Land &
         
Commercial Real Estate
   
Residential Real Estate
             
 
Land
             
Non-
                           
 
Develop-
 
Construc-
 
Commer-
 
Owner
 
Owner
   
Non-
     
Home
 
Con-
         
Dollars in thousands
ment
 
tion
 
cial
 
Occupied
 
Occupied
   
jumbo
 
Jumbo
 
Equity
 
sumer
 
Other
   
Total
                                               
Troubled debt restructurings
                                           
Balance December 31, 2012
$ 9,570   $ -   $ 4,981   $ 10,692   $ 7,331     $ 5,089   $ 19,000   $ -   $ 65   $ -     $ 56,728
   Additions
  49     -     23     -     -       728     -     -     -     -       800
   Charge-offs
  (888 )   -     (33 )   (63 )   -       (9 )   (3,678 )   -     -     -       (4,671)
   Net paydowns
  (3,189 )   -     (2,677 )   (336 )   (104 )     (331 )   (2 )   -     (13 )   -       (6,652)
   Transfer into OREO
  -     -     -     (518 )   -       -     -     -     -     -       (518)
   Refinance out of TDR status
  -     -     -     -     (1,891 )     -     -     -     -     -       (1,891)
Balance September 30, 2013
$ 5,542   $ -   $ 2,294   $ 9,775   $ 5,336     $ 5,477   $ 15,320   $ -   $ 52   $ -     $ 43,796
                                                                     
Allowance related to
                                                                   
   troubled debt restructurings
$ 22   $ -   $ 131   $ 216   $ 110     $ 302   $ 1,040   $ -   $ 13   $ -     $ 1,834


We categorize loans into risk categories based on relevant information about the ability of borrowers to service their debt such as current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. We analyze loans individually by classifying the loans as to credit risk.  We internally grade all commercial loans at the time of loan origination. In addition, we perform an annual loan review on all non-homogenous commercial loan relationships with an aggregate exposure of $2 million, at which time these loans are re-graded. We use the following definitions for our risk grades:

Pass: Loans graded as Pass are loans to borrowers of acceptable credit quality and risk. They are higher quality loans that do not fit any of the other categories described below.

OLEM (Special Mention):  Commercial loans categorized as OLEM are potentially weak. The credit risk may be relatively minor yet represent a risk given certain specific circumstances. If the potential weaknesses are not monitored or mitigated, the asset may weaken or inadequately protect our position in the future.

Substandard:   Commercial loans categorized as Substandard are inadequately protected by the borrower’s ability to repay, equity, and/or the collateral pledged to secure the loan. These loans have identified weaknesses that could hinder normal repayment or collection of the debt. These loans are characterized by the distinct possibility that we will sustain some loss if the identified weaknesses are not mitigated.

Doubtful:  Commercial loans categorized as Doubtful have all the weaknesses inherent in those loans classified as Substandard, with the added elements that the full collection of the loan is improbable and the possibility of loss is high.

Loss:  Loans classified as loss are considered to be non-collectible and of such little value that their continuance as a bankable asset is not warranted. This does not mean that the loan has absolutely no recovery value, but rather it is neither practical nor desirable to defer writing off the loan, even though partial recovery may be obtained in the future.
 
 
 
32

Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)
 

The following table presents the recorded investment in construction and development, commercial, and commercial real estate loans which are generally evaluated based upon the internal risk ratings defined above.


Loan Risk Profile by Internal Risk Rating
                                       
                                               
 
Construction and Development
             
Commercial Real Estate
 
Land and land development
   
Construction
   
Commercial
   
Owner Occupied
   
Non-Owner Occupied
Dollars in thousands
9/30/2013
 
12/31/2012
   
9/30/2013
 
12/31/2012
   
9/30/2013
 
12/31/2012
   
9/30/2013
 
12/31/2012
   
9/30/2013
 
12/31/2012
Pass
$ 43,400   $ 43,572     $ 12,285   $ 3,619     $ 75,968   $ 73,425     $ 145,349   $ 139,176     $ 268,002   $ 262,132
OLEM (Special Mention)
  5,603     7,349       -     -       1,501     1,260       1,422     1,034       11,141     11,477
Substandard
  23,977     28,414       38     153       5,264     11,144       4,489     14,042       269     2,473
Doubtful
  109     -       -     -       1,111     -       -     -       -     -
Loss
  -     -       -     -       -     -       -     -       -     -
     Total
$ 73,089   $ 79,335     $ 12,323   $ 3,772     $ 83,844   $ 85,829     $ 151,260   $ 154,252     $ 279,412   $ 276,082


The following table presents the recorded investment in consumer, residential real estate, and home equity loans, which are generally evaluated based on the aging status of the loans, which was previously presented, and payment activity.

 
Performing
   
Nonperforming
Dollars in thousands
9/30/2013
 
12/31/2012
 
9/30/2012
   
9/30/2013
 
12/31/2012
 
9/30/2012
Residential real estate
                       
   Non-jumbo
$ 211,939   $ 213,196   $ 212,529     $ 3,119   $ 3,518   $ 3,055
   Jumbo
  50,701     49,003     47,476       9,000     12,564     15,272
   Home Equity
  53,408     52,823     53,040       266     440     415
Consumer
  20,327     20,531     21,202       145     55     88
Other
  3,375     3,701     2,513       -     -     -
Total
$ 339,750   $ 339,254   $ 336,760     $ 12,530   $ 16,577   $ 18,830


Loan commitments:  ASC Topic 815, Derivatives and Hedging, requires that commitments to make mortgage loans should be accounted for as derivatives if the loans are to be held for sale, because the commitment represents a written option and accordingly is recorded at the fair value of the option liability.
 
 

 
 
33

Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)
 

NOTE 7.  ALLOWANCE FOR LOAN LOSSES

An analysis of the allowance for loan losses for the nine month periods ended September 30, 2013 and 2012, and for the year ended December 31, 2012 is as follows:

           
 
Nine Months Ended
 
Year Ended
 
September 30,
 
December 31,
Dollars in thousands
2013
 
2012
 
2012
           
  Balance, beginning of year
$ 17,933   $ 17,712   $ 17,712
  Losses:
               
      Commercial
  205     355     1,273
      Commercial real estate
               
           Owner occupied
  1,067     636     636
           Non-owner occupied
  9     436     806
      Construction and development
               
           Land and land development
  3,560     2,319     3,390
           Construction
  -     367     367
      Residential real estate
               
           Non-jumbo
  494     1,257     1,372
           Jumbo
  3,739     737     737
           Home equity
  77     5     5
      Consumer
  55     91     136
      Other
  84     69     95
  Total
  9,290     6,272     8,817
  Recoveries:
               
      Commercial
  7     7     13
      Commercial real estate
               
           Owner occupied
  2     24     33
           Non-owner occupied
  633     20     31
      Construction and development
               
           Land and land development
  13     16     61
           Construction
  -     -     -
      Real estate - mortgage
               
           Non-jumbo
  106     51     81
           Jumbo
  4     85     86
           Home equity
  4     60     61
      Consumer
  53     53     95
      Other
  74     62     77
  Total
  896     378     538
  Net losses
  8,394     5,894     8,279
  Provision for loan losses
  3,500     6,002     8,500
  Balance, end of year
$ 13,039   $ 17,820   $ 17,933




 
34

Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)
 


Activity in the allowance for loan losses by loan class during the first nine months of 2013 is as follows:

For the Nine Months Ended September 30, 2013
 
Construction & Land Development
                                       
 
Land &
         
Commercial Real Estate
   
Residential Real Estate
             
 
Land
             
Non-
                           
 
Develop-
 
Construc-
 
Commer-
 
Owner
 
Owner
   
Non-
     
Home
 
Con-
         
Dollars in thousands
ment
 
tion
 
cial
 
Occupied
 
Occupied
   
jumbo
 
Jumbo
 
Equity
 
sumer
 
Other
   
Total
                                               
Allowance for loan losses
                                           
Beginning balance
$ 5,220   $ 138   $ 782   $ 1,387   $ 3,269     $ 2,617   $ 3,942   $ 425   $ 132   $ 21     $ 17,933
   Charge-offs
  3,560     -     205     1,067     9       494     3,739     77     55     84       9,290
   Recoveries
  13     -     7     2     633       106     4     4     53     74       896
   Provision
  2,780     95     888     1,071     (3,716 )     (66 )   2,636     (162 )   (43 )   17       3,500
Ending balance
$ 4,453   $ 233   $ 1,472   $ 1,393   $ 177     $ 2,163   $ 2,843   $ 190   $ 87   $ 28     $ 13,039
                                                                     
Allowance related to:
                                                                   
Loans individually
                                                                   
   evaluated for impairment
$ 1,390   $ -   $ 702   $ 216   $ 110     $ 316   $ 1,040   $ 27   $ 13   $ -     $ 3,814
Loans collectively
                                                                   
   evaluated for impairment
  3,063     233     770     1,177     67       1,847     1,803     163     74     28       9,225
Loans acquired with
                                                                   
   deteriorated credit quality
  -     -     -     -     -       -     -     -     -     -       -
Total
$ 4,453   $ 233   $ 1,472   $ 1,393   $ 177     $ 2,163   $ 2,843   $ 190   $ 87   $ 28     $ 13,039
                                                                     
Loans
                                                                   
Loans individually
                                                                   
   evaluated for impairment
$ 25,519   $ -   $ 6,157   $ 11,551   $ 5,884     $ 6,017   $ 17,786   $ 213   $ 52   $ -     $ 73,179
Loans collectively
                                                                   
   evaluated for impairment
  47,570     12,323     77,687     139,709     273,528       209,041     41,915     53,461     20,420     3,375     $ 879,029
Loans acquired with
                                                                   
   deteriorated credit quality
  -     -     -     -     -       -     -     -     -     -       -
Total
$ 73,089   $ 12,323   $ 83,844   $ 151,260   $ 279,412     $ 215,058   $ 59,701   $ 53,674   $ 20,472   $ 3,375     $ 952,208


NOTE 8.  GOODWILL AND OTHER INTANGIBLE ASSETS

The following tables present our goodwill by reporting unit at September 30, 2013 and other intangible assets by reporting unit at September 30, 2013 and December 31, 2012.
 
 


   
Goodwill Activity
   
Community
 
Insurance
   
Dollars in thousands
 
Banking
 
Services
 
Total
Balance, January 1, 2013
  $ 1,488   $ 4,710   $ 6,198
   Acquired goodwill, net
    -     -     -
                   
Balance, September 30, 2013
  $ 1,488   $ 4,710   $ 6,198
 
 
 
 
35

Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)
 


   
Other Intangible Assets
   
September 30, 2013
   
December 31, 2012
   
Community
 
Insurance
       
Community
 
Insurance
   
 Dollars in thousands
 
Banking
 
Services
 
Total
   
Banking
 
Services
 
Total
 Unidentifiable intangible assets
                         
    Gross carrying amount
  $ 2,267   $ -   $ 2,267     $ 2,267   $ -   $ 2,267
    Less:  accumulated amortization
    2,179     -     2,179       2,065     -     2,065
        Net carrying amount
  $ 88   $ -   $ 88     $ 202   $ -   $ 202
                                       
 Identifiable intangible assets
                                     
    Gross carrying amount
  $ -   $ 3,000   $ 3,000     $ -   $ 3,000   $ 3,000
    Less:  accumulated amortization
    -     1,250     1,250       -     1,100     1,100
        Net carrying amount
  $ -   $ 1,750   $ 1,750     $ -   $ 1,900   $ 1,900

We recorded amortization expense of approximately $263,000 for the nine months ended September 30, 2013 relative to our other intangible assets.  Annual amortization is expected to be approximately $351,000 in 2013, $251,000 in 2014, and $200,000 for each of the years ending 2015 through 2017.

NOTE 9.  DEPOSITS

The following is a summary of interest bearing deposits by type as of September 30, 2013 and 2012 and December 31, 2012:


   
September 30,
   
December 31,
   
September 30,
 Dollars in thousands
 
2013
   
2012
   
2012
 Demand deposits, interest bearing
  $ 186,702     $ 175,706     $ 177,236
 Savings deposits
    193,285       193,039       197,610
 Time deposits
    537,639       557,788       555,697
 Total
  $ 917,626     $ 926,533     $ 930,543

Included in time deposits are deposits acquired through a third party (“brokered deposits”) totaling $174.5 million, $190.4 million and $207.3 million at September 30, 2013, December 31, 2012, and September 30, 2012, respectively.

A summary of the scheduled maturities for all time deposits as of September 30, 2013 is as follows:



Dollars in thousands
 
 Three month period ending December 31, 2013
$ 78,769
 Year ending December 31, 2014
  174,501
 Year ending December 31, 2015
  71,003
 Year ending December 31, 2016
  84,033
 Year ending December 31, 2017
  30,169
 Thereafter
  99,164
  $ 537,639
 
 
 
 
36

Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)
 

 

The following is a summary of the maturity distribution of all certificates of deposit in denominations of $100,000 or more as of September 30, 2013:


Dollars in thousands
Amount
 
Percent
 Three months or less
$ 53,212   13.6%
 Three through six months
  23,785   6.1%
 Six through twelve months
  82,135   21.0%
 Over twelve months
  232,620   59.3%
 Total
$ 391,752   100.0%

NOTE 10.  BORROWED FUNDS

Short-term borrowings:    A summary of short-term borrowings is presented below:


   
Nine Months Ended September 30, 2013
         
Federal Funds
   
Short-term
   
Purchased
   
FHLB
   
and Lines
 Dollars in thousands
 
Advances
   
of Credit
 Balance at September 30
  $ 45,200     $ 8,963
 Average balance outstanding for the period
    22,834       2,745
 Maximum balance outstanding at
             
     any month end during period
    45,200       8,963
 Weighted average interest rate for the period
    0.27 %     0.25%
 Weighted average interest rate for balances
             
     outstanding at September 30
    0.26 %     0.25%

 
 
   
Year Ended December 31, 2012
         
Federal Funds
   
Short-term
   
Purchased
   
FHLB
   
and Lines
 Dollars in thousands
 
Advances
   
of Credit
 Balance at December 31
  $ 3,000     $ 958
 Average balance outstanding for the year
    12,291       957
 Maximum balance outstanding at
             
     any month end
    20,000       958
 Weighted average interest rate for the year
    0.24 %     0.25%
 Weighted average interest rate for balances
             
     outstanding at December 31
    0.25 %     0.25%



   
Nine Months Ended September 30, 2012
         
Federal Funds
   
Short-term
   
Purchased
   
FHLB
   
and Lines
 Dollars in thousands
 
Advances
   
of Credit
 Balance at September 30
  $ 20,000     $ 957
 Average balance outstanding for the period
    13,294       956
 Maximum balance outstanding at
             
     any month end during period
    20,000       957
 Weighted average interest rate for the period
    0.23 %     0.25%
 Weighted average interest rate for balances
             
     outstanding at September 30
    0.26 %     0.25%
 
 
 
37

Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)
 


Long-term borrowings:  Our long-term borrowings of $163.5million, $203.3 million and $203.7 million at September 30, 2013, December 31, 2012, and September 30, 2012 respectively, consisted primarily of advances from the Federal Home Loan Bank (“FHLB”) and structured reverse repurchase agreements with two unaffiliated institutions. All FHLB advances are collateralized primarily by similar amounts of residential mortgage loans, certain commercial loans, mortgage backed securities and securities of U. S. Government agencies and corporations.


           
Balance at
 
Balance at September 30,
   
December 31,
Dollars in thousands
2013
 
2012
   
2012
Long-term FHLB advances
$ 82,624   $ 122,718     $ 122,693
Long-term reverse repurchase agreements
  72,000     72,000       72,000
Term loans
  8,916     9,026       8,575
Total
$ 163,540   $ 203,744     $ 203,268


The term loans are secured by the common stock of our subsidiary bank.  $5.4 million bears a variable interest rate of prime minus 50 basis points with a final maturity of 2017, and $3.5 million bears a fixed rate of 8% with a final maturity of 2023.

Our long term FHLB borrowings and reverse repurchase agreements bear both fixed and variable rates and mature in varying amounts through the year 2019.

The average interest rate paid on long-term borrowings for the nine month period ended September 30, 2013 was 3.89% compared to 3.92% for the first nine months of 2012.

Subordinated debentures:  We have subordinated debt totaling $16.8 million at September 30, 2013, December 31, 2012, and September 30, 2012.  The subordinated debt qualifies as Tier 2 capital under Federal Reserve Board guidelines until the debt is within 5 years of its maturity; thereafter the amount qualifying as Tier 2 capital is reduced by 20 percent each year until maturity.  During 2009, we issued $6.8 million in subordinated debt, of which $5 million was issued to an affiliate of a director of Summit.  We also issued $1.0 million and $0.8 million to two unrelated parties.  These three issuances bear an interest rate of 10 percent per annum, a term of 10 years, and are not prepayable by us within the first five years.  During 2008, we issued $10 million of subordinated debt to an unrelated institution, which bears a variable interest rate of 1 month LIBOR plus 275 basis points and a term of 7.5 years.

Subordinated debentures owed to unconsolidated subsidiary trusts:  We have three statutory business trusts that were formed for the purpose of issuing mandatorily redeemable securities (the “capital securities”) for which we are obligated to third party investors and investing the proceeds from the sale of the capital securities in our junior subordinated debentures (the “debentures”).  The debentures held by the trusts are their sole assets.  Our subordinated debentures totaled $19.6 million at September 30, 2013, December 31, 2012, and September 30, 2012.

In October 2002, we sponsored SFG Capital Trust I, in March 2004, we sponsored SFG Capital Trust II, and in December 2005, we sponsored SFG Capital Trust III, of which 100% of the common equity of each trust is owned by us.  SFG Capital Trust I issued $3.5 million in capital securities and $109,000 in common securities and invested the proceeds in $3.61 million of debentures. SFG Capital Trust II issued $7.5 million in capital securities and $232,000 in common securities and invested the proceeds in $7.73 million of debentures. SFG Capital Trust III issued $8.0 million in capital securities and $248,000 in common securities and invested the proceeds in $8.25 million of debentures.  Distributions on the capital securities issued by the trusts are payable quarterly at a variable interest rate equal to 3 month LIBOR plus 345 basis points for SFG Capital Trust I, 3 month LIBOR plus 280 basis points for SFG Capital Trust II, and 3 month LIBOR plus 145 basis points for SFG Capital Trust III, and equals the interest rate earned on the debentures held by the trusts, and is recorded as interest expense by us.  The capital securities are subject to mandatory redemption in whole or in part, upon repayment of the debentures.  We have entered into agreements which, taken collectively, fully and unconditionally guarantee the capital securities subject to the terms of the guarantee.  The debentures of each Capital Trust are redeemable by us quarterly.
 
 
 
38

Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)
 

The capital securities held by SFG Capital Trust I, SFG Capital Trust II, and SFG Capital Trust III qualify as Tier 1 capital under Federal Reserve Board guidelines.  In accordance with these Guidelines, trust preferred securities generally are limited to 25% of Tier 1 capital elements, net of goodwill.  The amount of trust preferred securities and certain other elements in excess of the limit can be included in Tier 2 capital.

A summary of the maturities of all long-term borrowings and subordinated debentures for the next five years and thereafter is as follows:


           
Subordinated
           
debentures owed
   
Long-term
 
Subordinated
 
to unconsolidated
Dollars in thousands
 
borrowings
 
debentures
 
subsidiary trusts
Year Ending December 31,
2013
$ 24   $ -   $ -
 
2014
  82,527     -     -
 
2015
  1,909     10,000     -
 
2016
  28,911     -     -
 
2017
  918     -     -
 
Thereafter
  49,251     6,800     19,589
    $ 163,540   $ 16,800   $ 19,589


NOTE 11.  STOCK OPTION PLAN

The 2009 Officer Stock Option Plan was adopted by our shareholders in May 2009 and provides for the granting of stock options for up to 350,000 shares of common stock to our key officers.    Each option granted under the Plan vests according to a schedule designated at the grant date and has a term of no more than 10 years following the vesting date.  Also, the option price per share was not to be less than the fair market value of our common stock on the date of grant.  The 2009 Officer Stock Option Plan, which expires in May 2019, replaces the 1998 Officer Stock Option Plan (collectively the “Plans”) that expired in May 2008.

The fair value of our employee stock options granted is estimated at the date of grant using the Black-Scholes option-pricing model. This model requires the input of highly subjective assumptions, changes to which can materially affect the fair value estimate. Additionally, there may be other factors that would otherwise have a significant effect on the value of employee stock options granted but are not considered by the model. Because our employee stock options have characteristics significantly different from those of traded options and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options at the time of grant.  There were no options granted during the first nine months of 2013 or 2012.

We recognize compensation expense based on the estimated number of stock awards expected to actually vest, exclusive of the awards expected to be forfeited.  During the first nine months of 2013 and 2012, our stock compensation expense and related deferred taxes were insignificant.
 
 
 
39

Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)
 

A summary of activity in our Plans during the first nine months of 2013 and 2012 is as follows:


 
For the Nine Months Ended September 30,
 
2013
   
2012
       
Weighted-
         
Weighted-
       
Average
         
Average
       
Exercise
         
Exercise
 
Options
   
Price
   
Options
   
Price
 Outstanding, January 1
249,700     $ 18.98     317,180     $ 18.17
     Granted
-       -     -       -
     Exercised
(15,200 )     5.27     -       -
     Forfeited
(1,750 )     19.69     -       -
     Expired
(39,700 )     23.41     (22,800 )     5.12
 Outstanding, September 30
193,050     $ 19.14     294,380     $ 19.18


Other information regarding options outstanding and exercisable at September 30, 2013 is as follows:

                               
   
Options Outstanding
   
Options Exercisable
           
Wted. Avg.
 
Aggregate
           
Aggregate
           
Remaining
 
Intrinsic
           
Intrinsic
Range of
 
# of
     
Contractual
 
Value
   
# of
     
Value
exercise price
 
shares
 
WAEP
 
Life (yrs)
 
(in thousands)
   
shares
 
WAEP
 
(in thousands)
$ 2.54 - $6.00   19,550   $ 4.86   3.50   $ 74       17,550   $ 5.13   $ 62
  6.01 - 10.00   28,200     9.14   2.89     7       27,600     9.20     6
  10.01 - 17.50   2,300     17.43   0.42     -       2,300     17.43     -
  17.51 - 20.00   38,500     17.80   3.25     -       38,500     17.80     -
  20.01 - 25.93   104,500     25.04   2.99     -       104,500     25.04     -
                                           
      193,050     19.14       $ 81       190,450     19.35   $ 68


NOTE 12.  COMMITMENTS AND CONTINGENCIES

Off-Balance Sheet Arrangements

We are a party to certain financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of our customers.  These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the statement of financial position.  The contract amounts of these instruments reflect the extent of involvement that we have in this class of financial instruments.

Many of our lending relationships contain both funded and unfunded elements.  The funded portion is reflected on our balance sheet.  The unfunded portion of these commitments is not recorded on our balance sheet until a draw is made under the loan facility.  Since many of the commitments to extend credit may expire without being drawn upon, the total commitment amounts do not necessarily represent future cash flow requirements.
 
 
 
40

Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)
 

A summary of the total unfunded, or off-balance sheet, credit extension commitments follows:


   
September 30,
Dollars in thousands
 
2013
Commitments to extend credit:
   
    Revolving home equity and
   
        credit card lines
  $ 49,535
    Construction loans
    32,534
    Other loans
    42,196
Standby letters of credit
    1,759
Total
  $ 126,024


Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract.  Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee.  We evaluate each customer's credit worthiness on a case-by-case basis.  The amount of collateral obtained, if we deem necessary upon extension of credit, is based on our credit evaluation.  Collateral held varies but may include accounts receivable, inventory, equipment or real estate.

Standby letters of credit are conditional commitments issued to guarantee the performance of a customer to a third party.  Standby letters of credit generally are contingent upon the failure of the customer to perform according to the terms of the underlying contract with the third party.

Our exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit is represented by the contractual amount of those instruments.  We use the same credit policies in making commitments and conditional obligations as we do for on-balance sheet instruments.

NOTE 13.  REGULATORY MATTERS

We and our subsidiaries are subject to various regulatory capital requirements administered by the banking regulatory agencies.  Under capital adequacy guidelines and the regulatory framework for prompt corrective action, we and each of our subsidiaries must meet specific capital guidelines that involve quantitative measures of our and our subsidiaries’ assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices.  We and each of our subsidiaries’ capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.

Quantitative measures established by regulation to ensure capital adequacy require us and each of our subsidiaries to maintain minimum amounts and ratios 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).  We believe, as of September 30, 2013, that we and each of our subsidiaries met all capital adequacy requirements to which they were subject.

The most recent notifications from the banking regulatory agencies categorized us and each of our subsidiaries as well capitalized under the regulatory framework for prompt corrective action.  To be categorized as well capitalized, we and each of our subsidiaries must maintain minimum total risk-based, Tier I risk-based, and Tier I leverage ratios as set forth in the table below.
 
 
 
41

Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)
 

Our actual capital amounts and ratios as well as our subsidiary, Summit Community Bank’s (“Summit Community”) are presented in the following table.


                       
To be Well Capitalized
             
Minimum Required
   
under Prompt Corrective
   
Actual
   
Regulatory Capital
   
Action Provisions
 Dollars in thousands
 
Amount
 
Ratio
   
Amount
 
Ratio
   
Amount
 
Ratio
 As of September 30, 2013
                           
Total Capital (to risk weighted assets)
                       
     Summit
  $ 143,494   14.5 %   $ 79,423   8.0 %   $ 99,279   10.0%
     Summit Community
    154,155   15.5 %     79,497   8.0 %     99,371   10.0%
Tier I Capital (to risk weighted assets)
                           
     Summit
    120,221   12.1 %     39,712   4.0 %     59,567   6.0%
     Summit Community
    141,682   14.3 %     39,748   4.0 %     59,623   6.0%
 Tier I Capital (to average assets)
                                 
     Summit
    120,221   8.9 %     54,291   4.0 %     67,863   5.0%
     Summit Community
    141,682   10.4 %     54,336   4.0 %     67,920   5.0%
                                   
 As of December 31, 2012
                                 
Total Capital (to risk weighted assets)
                           
     Summit
    138,593   14.0 %     79,391   8.0 %     99,238   10.0%
     Summit Community
    148,803   15.0 %     79,484   8.0 %     99,354   10.0%
Tier I Capital (to risk weighted assets)
                           
     Summit
    115,221   11.6 %     39,695   4.0 %     59,543   6.0%
     Summit Community
    136,231   13.7 %     39,742   4.0 %     59,613   6.0%
 Tier I Capital (to average assets)
                                 
     Summit
    115,221   8.3 %     55,591   4.0 %     69,489   5.0%
     Summit Community
    136,231   9.8 %     55,581   4.0 %     69,476   5.0%



Summit Financial Group, Inc. (“Summit”) and its bank subsidiary, Summit Community Bank, Inc. (the “Bank”), have entered into informal Memoranda of Understanding (“MOU’s”) with their respective regulatory authorities.  A memorandum of understanding is characterized by the regulatory authorities as an informal action that is not published or publicly available and that is used when circumstances warrant a milder form of action than a formal supervisory action, such as a formal written agreement or order.

 Under the Summit MOU, Summit has agreed among other things to:

§  
Summit suspending all cash dividends on its common stock until further notice.  Dividends on all preferred stock, as well as interest payments on subordinated notes underlying Summit’s trust preferred securities, continue to be permissible; and,
 
§  
Summit not incurring any additional debt, other than trade payables, without the prior written consent of the principal banking regulators.

Additional information regarding Summit’s MOU is included in Part I. Item 1A – Risk Factors on our Form 10-K for the year ended December 31, 2012.

On October 25, 2012, the Bank entered into a revised MOU (“Bank MOU”) which replaced the Bank MOU effective September 24, 2009 and subsequently amended on February 1, 2011.  In general, the Bank MOU includes provisions substantially similar to those in the prior Bank MOU with the exception that several provisions deemed no longer applicable by the regulatory authorities were removed and a provision relative to reducing the Bank’s levels of classified assets was added.
 
 
 
42

Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)
 

In summary, we have agreed, among other things, to address the following matters relative to the Bank:

§  
maintaining a Board committee which monitors and promotes compliance with the provisions of the Bank MOU;
 
§  
providing the Bank’s regulatory authorities with updated reports of criticized assets and/or formal workout plans for all nonperforming borrower relationships with an aggregate outstanding balance exceeding $1 million;
 
§  
developing and submitting to regulatory authorities a written plan to reduce the Bank’s risk exposure in each adversely classified credit relationship in excess of $1 million and all OREO;
 
§  
establishing procedures to report all loans with balances exceeding $500,000 that have credit weaknesses or that fall outside of the Bank’s policy;
 
§  
annually reviewing the organizational structure and operations of the Bank’s loan department;
 
§  
maintaining an adequate allowance for loan and lease losses through charges to current operating income;
 
§  
reviewing overall liquidity objectives and developing and submitting to regulatory authorities plans and procedures aimed to improve liquidity and reduce reliance on volatile liabilities;
 
§  
preparing comprehensive budgets and earnings forecasts for the Bank and submitting reports comparing actual performance to the budget plan;
 
§  
maintaining a minimum Tier 1 Leverage Capital ratio of at least 8% and a Total Risk-based Capital ratio of at least 11%;
 
§  
not paying any cash dividends without the prior written consent of the banking regulators; and,
 
§  
providing quarterly progress reports to the Bank’s regulatory authorities detailing steps taken to comply with the Bank MOU.
 

 
43

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)



NOTE  14.  SEGMENT INFORMATION

We operate two business segments:  community banking and insurance services.  These segments are primarily identified by the products or services offered.  The community banking segment consists of our full service banks which offer customers traditional banking products and services through various delivery channels.  The insurance services segment consists of three insurance agency offices that sell insurance products.  The accounting policies discussed throughout the notes to the consolidated financial statements apply to each of our business segments.

Intersegment revenue and expense consists of management fees allocated to the bank and Summit Insurance Services, LLC for all centralized functions that are performed by the parent, including overall direction in the areas of strategic planning, investment portfolio management, asset/liability management, financial reporting and other financial and administrative services.  Information for each of our segments is included below:


   
Nine Months Ended September 30, 2013
   
Community
   
Insurance
                 
Dollars in thousands
 
Banking
   
Services
   
Parent
   
Eliminations
   
Total
                             
Net interest income
  $ 30,237     $ -     $ (1,436 )   $ -     $ 28,801
Provision for loan losses
    3,500       -       -       -       3,500
Net interest income after provision for loan losses
    26,737       -       (1,436 )     -       25,301
Other income
    4,857       3,457       815       (815 )     8,314
Other expenses
    22,723       3,266       1,158       (815 )     26,332
Income (loss) before income taxes
    8,871       191       (1,779 )     -       7,283
Income tax expense (benefit)
    2,534       79       (612 )     -       2,001
Net income (loss)
    6,337       112       (1,167 )     -       5,282
Dividends on preferred shares
    -       -       582       -       582
Net income (loss) applicable to common shares
  $ 6,337     $ 112     $ (1,749 )   $ -     $ 4,700
Intersegment revenue (expense)
  $ (734 )   $ (81 )   $ 815     $ -     $ -
Average assets
  $ 1,431,835     $ 6,329     $ 155,522     $ (213,202 )   $ 1,380,484



   
Nine Months Ended September 30, 2012
   
Community
   
Insurance
                 
Dollars in thousands
 
Banking
   
Services
   
Parent
   
Eliminations
   
Total
                             
Net interest income
  $ 31,264     $ -     $ (1,340 )   $ -     $ 29,924
Provision for loan losses
    6,002       -       -       -       6,002
Net interest income after provision for loan losses
    25,262       -       (1,340 )     -       23,922
Other income
    6,681       3,371       765       (783 )     10,034
Other expenses
    25,583       2,980       1,223       (783 )     29,003
Income (loss) before income taxes
    6,360       391       (1,798 )     -       4,953
Income tax expense (benefit)
    1,772       156       (583 )     -       1,345
Net income (loss)
    4,588       235       (1,215 )     -       3,608
Dividends on preferred shares
    -       -       583       -       583
Net income (loss) applicable to common shares
  $ 4,588     $ 235     $ (1,798 )   $ -     $ 3,025
Intersegment revenue (expense)
  $ (706 )   $ (77 )   $ 783     $ -     $ -
Average assets
  $ 1,486,808     $ 6,495     $ 154,011     $ (218,207 )   $ 1,429,107
 
 

 
44

Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)
 


   
Three Months Ended September 30, 2013
   
Community
   
Insurance
                 
Dollars in thousands
 
Banking
   
Services
   
Parent
   
Eliminations
   
Total
                             
Net interest income
  $ 10,025     $ -     $ (487 )   $ -     $ 9,538
Provision for loan losses
    1,000       -       -       -       1,000
Net interest income after provision for loan losses
    9,025       -       (487 )     -       8,538
Other income
    1,758       1,105       272       (272 )     2,863
Other expenses
    7,060       1,078       365       (272 )     8,231
Income (loss) before income taxes
    3,723       27       (580 )     -       3,170
Income tax expense (benefit)
    1,087       12       (201 )     -       898
Net income (loss)
    2,636       15       (379 )     -       2,272
Dividends on preferred shares
    -       -       194       -       194
Net income (loss) applicable to common shares
  $ 2,636     $ 15     $ (573 )   $ -     $ 2,078
Intersegment revenue (expense)
  $ (251 )   $ (21 )   $ 272     $ -     $ -
Average assets
  $ 1,409,870     $ 6,377     $ 153,596     $ (205,332 )   $ 1,364,511



   
Three Months Ended September 30, 2012
   
Community
   
Insurance
                 
Dollars in thousands
 
Banking
   
Services
   
Parent
   
Eliminations
   
Total
                             
Net interest income
  $ 10,381     $ -     $ (446 )   $ -     $ 9,935
Provision for loan losses
    2,000       -       -       -       2,000
Net interest income after provision for loan losses
    8,381       -       (446 )     -       7,935
Other income
    2,312       1,049       261       (261 )     3,361
Other expenses
    8,904       1,023       361       (261 )     10,027
Income (loss) before income taxes
    1,789       26       (546 )     -       1,269
Income tax expense (benefit)
    430       10       (168 )     -       272
Net income (loss)
    1,359       16       (378 )     -       997
Dividends on preferred shares
    -       -       194       -       194
Net income (loss) applicable to common shares
  $ 1,359     $ 16     $ (572 )   $ -     $ 803
Intersegment revenue (expense)
  $ (235 )   $ (26 )   $ 261     $ -     $ -
Average assets
  $ 1,473,356     $ 6,579     $ 155,168     $ (220,005 )   $ 1,415,098


NOTE  15.  DERIVATIVE FINANCIAL INSTRUMENTS

We use derivative instruments primarily to protect against the risk of adverse interest rate movements on the cash flows of certain liabilities.  Derivative instruments represent contracts between parties that usually require little or no initial net investment and result in one party delivering cash or another type of asset to the other party based upon a notional amount and an underlying as specified in the contract.  A notional amount represents the number of units of a specific item, such as currency units.  An underlying represents a variable, such as an interest rate or price index.  The amount of cash or other asset delivered from one party to the other is determined based upon the interaction of the notional amount of the contract with the underlying.  Derivatives can also be implicit in certain contracts and commitments.

As with any financial instrument, derivative instruments have inherent risks, primarily market and credit risk.  Market risk associated with changes in interest rates is managed by establishing and monitoring limits as to the degree of risk that may be undertaken as part of our overall market risk monitoring process.  Credit risk occurs when a counterparty to a derivative contract with an unrealized gain fails to perform according to the terms of the agreement.  Credit risk is managed by monitoring the size and maturity structure of the derivative portfolio, and applying uniform credit standards to all activities with credit risk.
 
 
 
45

Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)
 
 

In accordance with ASC 815, Derivatives and  Hedging, all derivative instruments are recorded on the balance sheet at fair value.  Changes in the fair value of derivatives are recorded each period in current earnings or other comprehensive income, depending on whether a derivative is designated as part of a hedge transaction and, if it is, depending on the type of hedge transaction.

Fair-value hedges – For transactions in which we are hedging changes in fair value of an asset, liability, or a firm commitment, changes in the fair value of the derivative instrument are generally offset in the income statement by changes in the hedged item’s fair value.

Cash-flow hedges – For transactions in which we are hedging the variability of cash flows related to a variable-rate asset, liability, or a forecasted transaction, changes in the fair value of the derivative instrument are reported in other comprehensive income.  The gains and losses on the derivative instrument, which are reported in comprehensive income, are reclassified to earnings in the periods in which earnings are impacted by the variability of cash flows of the hedged item.

The ineffective portion of all hedges is recognized in current period earnings.

Other derivative instruments -  For risk management purposes that do not meet the hedge accounting criteria and, therefore, do not qualify for hedge accounting.  These derivative instruments are accounted for at fair value with changes in fair value recorded in the income statement.
 
 
We have entered into a $40 million notional forward-starting, pay-fixed/receive LIBOR interest rate swap with an effective date of July 18, 2016, which was designated as a cash flow hedge of $40 million of forecasted variable rate Federal Home Loan Bank advances.  Under the terms of the swap we will pay a fixed rate of 2.98% for a 3 year period.

A summary of this sole derivative financial instrument as of September 30, 2013 follows:



 
September 30, 2013
     
Derivative
 
Net Ineffective
 
Notional
 
Fair Value
 
Hedge Gains
Dollars in thousands
Amount
 
Asset
 
Liability
 
(Losses)
CASH FLOW HEDGES
             
Pay-fixed/receive-variable interest rate swaps
           
      Long term borrowings
$ 40,000   $ -   $ 117   $ -
  $ 40,000   $ -   $ 117   $ -



On October 23, 2013, we entered into a $30 million notional forward-starting, pay-fixed/receive LIBOR interest rate swap with an effective date of April 18, 2016, which was designated as a cash flow hedge of $30 million of forecasted variable rate Federal Home Loan Bank advances.  Under the terms of the swap we will pay a fixed rate of 2.89% for a 4.5 year period.

 
46

 
Summit Financial Group, Inc. and Subsidiaries
Management’s Discussion and Analysis of Financial Condition and
Results of Operations


INTRODUCTION

The following discussion and analysis focuses on significant changes in our financial condition and results of operations of Summit Financial Group, Inc. (“Company” or “Summit”) and our operating segments, Summit Community Bank (“Summit Community”), and Summit Insurance Services, LLC for the periods indicated.  See Note 14 of the accompanying consolidated financial statements for our segment information.  This discussion and analysis should be read in conjunction with our 2012 audited financial statements and Annual Report on Form 10-K.

The Private Securities Litigation Act of 1995 indicates that the disclosure of forward-looking information is desirable for investors and encourages such disclosure by providing a safe harbor for forward-looking statements by us.  Our following discussion and analysis of financial condition and results of operations contains certain forward-looking statements that involve risk and uncertainty.  In order to comply with the terms of the safe harbor, we note that a variety of factors could cause our actual results and experience to differ materially from the anticipated results or other expectations expressed in those forward-looking statements.

OVERVIEW

Our primary source of income is net interest income from loans and deposits.  Business volumes tend to be influenced by the overall economic factors including market interest rates, business spending, and consumer confidence, as well as competitive conditions within the marketplace.

Interest earning assets declined by 3.27% for the first nine months in 2013 compared to the same period of 2012 while our net interest earnings on a tax equivalent basis decreased 3.95%.  Our tax equivalent net interest margin decreased 2 basis points.  Historically high levels of nonaccrual loans continue to negatively impact our net interest earnings while our reduced cost of interest bearing funds continues to positively impact our net interest earnings.

BUSINESS SEGMENT RESULTS

We are organized and managed along two major business segments, as described in Note 14 of the accompanying consolidated financial statements.  The results of each business segment are intended to reflect each segment as if it were a stand alone business.  Net income by segment follows:


   
Three Months Ended September 30,
   
Nine Months Ended September 30,
Dollars in thousands
 
2013
 
2012
   
2013
 
2012
Community banking
  $ 2,636   $ 1,359     $ 6,337   $ 4,588
Insurance
    15     16       112     235
Parent
    (573 )   (572 )     (1,749 )   (1,798)
Consolidated net income
  $ 2,078   $ 803     $ 4,700   $ 3,025


CRITICAL ACCOUNTING POLICIES

Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America and follow general practices within the financial services industry.  Application of these principles requires us to make estimates, assumptions, and judgments that affect the amounts reported in our financial statements and accompanying notes.  These estimates, assumptions, and judgments are based on information available as of the date of the financial statements; accordingly, as this information changes, the financial statements could reflect different estimates, assumptions, and judgments.  Certain policies inherently have a greater reliance on the use of estimates, assumptions, and judgments and as such have a greater possibility of producing results that could be materially different than originally reported.
 
 
 
47

Summit Financial Group, Inc. and Subsidiaries
Management’s Discussion and Analysis of Financial Condition and
Results of Operations
 

Our most significant accounting policies are presented in the notes to the consolidated financial statements of our 2012 Annual Report on Form 10-K.  These policies, along with the other disclosures presented in the financial statement notes and in this financial review, provide information on how significant assets and liabilities are valued in the financial statements and how those values are determined.

Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, assumptions, and estimates underlying those amounts, we have identified the determination of the allowance for loan losses, the valuation of goodwill, fair value measurements and deferred tax assets to be the accounting areas that require the most subjective or complex judgments, and as such could be most subject to revision as new information becomes available.

Allowance for Loan Losses:  The allowance for loan losses represents our estimate of probable credit losses inherent in the loan portfolio.  Determining the amount of the allowance for loan losses is considered a critical accounting estimate because it requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change.  The loan portfolio also represents the largest asset type on our consolidated balance sheet.  To the extent actual outcomes differ from our estimates, additional provisions for loan losses may be required that would negatively impact earnings in future periods.  Note 8 to the consolidated financial statements of our 2012 Annual Report on Form 10-K describes the methodology used to determine the allowance for loan losses and a discussion of the factors driving changes in the amount of the allowance for loan losses is included in the Asset Quality section of the financial review of the 2012 Annual Report on Form 10-K.

Goodwill:  Goodwill is subject to an analysis by reporting unit at least annually to determine whether write-downs of the recorded balances are necessary.  Initially, an assessment of qualitative factors (Step 0) is performed to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that the fair value of a reporting unit is less than its carrying amount.  If, after assessing the totality of events or circumstances, we determine it is not more likely than not that the fair value of a reporting unit is less than its carrying value, then performing the two-step impairment test is unnecessary.  However, if we conclude otherwise, then we are required to perform the first step (Step 1) of the two-step impairment test by calculating the fair value of the reporting unit and comparing the fair value with the carrying amount of the reporting unit.  If the fair value is less than the carrying value, an expense may be required on our books to write down the goodwill to the proper carrying value.  Step 2 of impairment testing, which is necessary only if the reporting unit does not pass Step 1, compares the implied fair value of the reporting unit goodwill with the carrying amount of the goodwill for the reporting unit.  The implied fair value of goodwill is determined in the same manner as goodwill that is recognized in a business combination.


 
48

Summit Financial Group, Inc. and Subsidiaries
Management’s Discussion and Analysis of Financial Condition and
Results of Operations
 

Community Banking – During third quarter 2013, we performed the Step 0 assessment of our goodwill of our community banking reporting unit and determined that it was not more likely than not that the fair value was less than its carrying value.  In performing the qualitative Step 0 assessments, we considered certain events and circumstances  such as macroeconomic conditions, industry and market considerations, overall financial performance and cost factors when evaluating whether it is more likely than not that the fair value is less than its carrying amount. No indicators of impairment were noted as of September 30, 2013.

Insurance Services – During third quarter 2013, we performed the Step 0 assessment of our goodwill of our insurance services reporting unit.  We considered certain events and circumstances specific to the reporting unit, such as macroeconomic conditions, industry and market considerations, overall financial performance and cost factors when evaluating whether it is more likely than not that the fair value of our insurance services reporting unit is less than its carrying value and deemed it necessary to perform the further 2-step impairment test.  We performed an internal valuation utilizing the income approach to determine the fair value of our insurance services reporting unit.  This methodology consisted of discounting the expected future cash flows of this unit based upon a forecast of its operations considering long-term key business drivers such as anticipated commission revenue growth.  The long term growth rate used in determining the terminal value was estimated at 2%, and a discount rate of 10.0% was applied to the insurance services unit’s estimated future cash flows.  We did not fail this Step 1 test as of September 30, 2013, therefore Step 2 testing was not necessary.

We cannot assure you that future goodwill impairment tests will not result in a charge to earnings. See Note 11 of the consolidated financial statements of our 2012 Annual Report on Form 10-K for further discussion of our intangible assets, which include goodwill.

Fair Value Measurements:  ASC Topic 820 Fair Value Measurements and Disclosures provides a definition of fair value, establishes a framework for measuring fair value, and requires expanded disclosures about fair value measurements. Fair value is the price that could be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. Based on the observability of the inputs used in the valuation techniques, we classify our financial assets and liabilities measured and disclosed at fair value in accordance with the three-level hierarchy (e.g., Level 1, Level 2 and Level 3) established under ASC Topic 820. Fair value determination in accordance with this guidance requires that we make a number of significant judgments. In determining the fair value of financial instruments, we use market prices of the same or similar instruments whenever such prices are available. We do not use prices involving distressed sellers in determining fair value. If observable market prices are unavailable or impracticable to obtain, then fair value is estimated using modeling techniques such as discounted cash flow analyses. These modeling techniques incorporate our assessments regarding assumptions that market participants would use in pricing the asset or the liability, including assumptions about the risks inherent in a particular valuation technique and the risk of nonperformance.
 
Fair value is used on a recurring basis for certain assets and liabilities in which fair value is the primary basis of accounting. Additionally, fair value is used on a non-recurring basis to evaluate assets or liabilities for impairment or for disclosure purposes in accordance with ASC Topic 825 Financial Instruments.
 
 
 
49

Summit Financial Group, Inc. and Subsidiaries
Management’s Discussion and Analysis of Financial Condition and
Results of Operations
 
 

Deferred Income Tax Assets:  At September 30, 2013, we had net deferred tax assets of $12.9 million. Based on our ability to offset the net deferred tax asset against taxable income in carryback years and expected future taxable income in carryforward years, there was no impairment of the deferred tax asset at September 30, 2013.  All available evidence, both positive and negative, was considered to determine whether, based on the weight of that evidence, impairment should be recognized. However, our forecast process includes judgmental and quantitative elements that may be subject to significant change. If our forecast of taxable income within the carryback/carryforward periods available under applicable law is not sufficient to cover the amount of net deferred tax assets, such assets may become impaired.

RESULTS OF OPERATIONS

Earnings Summary

Net income applicable to common shares for the nine months ended September 30, 2013 increased to $4.7 million, or $0.55 per diluted share as compared to $3.0 million or $0.38 per diluted share for the same period of 2012.  Net income applicable to common shares for the quarter ended September 30, 2013 totaled $2.1 million, or $0.24 per diluted share as compared to $803,000, or $0.10 per diluted share for the quarter ended September 30, 2012.  Earnings for both the quarter and nine months ended September 30, 2013 were positively impacted by lower provisions for loan losses and lower  write-downs of foreclosed properties to their estimated fair values.  The provision for loan losses was $3.5 million and $6.0 million for the nine months ended September 30, 2013 and 2012, respectively.  Included in earnings for the nine months ended September 30, 2013 was $535,000 in losses on the sales of assets, primarily foreclosed properties, and $3.1 million of charges resulting from the write down of a portion of our foreclosed properties to fair value.  Returns on average equity and assets for the first nine months of 2013 were 6.46% and 0.51%, respectively, compared with 4.54% and 0.34% for the same period of 2012.

Net Interest Income

Net interest income is the principal component of our earnings and represents the difference between interest and fee income generated from earning assets and the interest expense paid on deposits and borrowed funds.  Fluctuations in interest rates as well as changes in the volume and mix of earning assets and interest bearing liabilities can materially impact net interest income.

Our net interest income on a fully tax-equivalent basis totaled $29.8 million for the nine months ended September 30, 2013 compared to $31.1 million for the same period of 2012, representing a decrease of $1.2 million or 4.0%.  While our earnings on interest earning assets decreased $5.8 million, this decrease was partially offset by a reduction in the volume of interest bearing liabilities and a reduction in the cost of interest bearing liabilities (see Table II).  Average interest earning assets decreased 3.27% from $1.30 billion during the first nine months of 2012 to $1.26 billion for the first nine months of 2013.  Average interest bearing liabilities declined 4.33% from $1.22 billion at September 30, 2012 to $1.17 billion at September 30, 2013, at an average yield for the first nine months of 2013 of 1.61% compared to 2.05% for the same period of 2012.

Our consolidated net interest margin decreased to 3.17% for the nine months ended September 30, 2013, compared to 3.19% for the same period in 2012. The margin continues to be affected by elevated levels of nonaccruing loans.  The present continued low interest rate environment has served to positively impact our net interest margin due to our liability sensitive balance sheet.  For the nine months ended September 30, 2013 compared to September 30, 2012, both the yields on earning assets and the cost of our interest bearing funds decreased by 44 basis points.
 
 
 
50

Summit Financial Group, Inc. and Subsidiaries
Management’s Discussion and Analysis of Financial Condition and
Results of Operations
 

Assuming no significant change in market interest rates, we anticipate a relatively stable net interest margin in the near term as we do not expect interest rates to rise in the near future, we do not expect significant growth in our interest earning assets, nor do we expect our nonperforming asset balances to decline significantly in the near future.  We continue to monitor the net interest margin through net interest income simulation to minimize the potential for any significant negative impact.  See the “Market Risk Management” section for further discussion of the impact changes in market interest rates could have on us.  Further analysis of our yields on interest earning assets and interest bearing liabilities are presented in Tables I and II below.
 
 
 
51

Summit Financial Group, Inc. and Subsidiaries
Management’s Discussion and Analysis of Financial Condition and
Results of Operations
 


Table I - Average Balance Sheet and Net Interest Income Analysis
                 
Dollars in thousands
             
 
For the Nine Months Ended
 
September 30, 2013
   
September 30, 2012
 
Average
 
Earnings/
 
Yield/
   
Average
 
Earnings/
 
Yield/
 
Balance
 
Expense
 
Rate
   
Balance
 
Expense
 
Rate
 Interest earning assets
                       
     Loans, net of unearned income (1)
                       
         Taxable
$ 948,870   $ 38,038   5.36 %   $ 965,227   $ 41,811   5.79%
         Tax-exempt (2)
  5,560     298   7.17 %     6,776     368   7.25%
     Securities
                               
         Taxable
  220,669     2,851   1.73 %     235,885     4,592   2.60%
         Tax-exempt (2)
  76,021     2,776   4.88 %     70,753     3,009   5.68%
     Federal funds sold and interest
                               
         bearing deposits with other banks
  7,706     4   0.07 %     22,737     31   0.18%
 Total interest earning assets
  1,258,826     43,967   4.67 %     1,301,378     49,811   5.11%
                                 
 Noninterest earning assets
                               
     Cash & due from banks
  4,430                 4,195          
     Premises and equipment
  21,006                 21,684          
     Other assets
  111,948                 120,041          
     Allowance for loan losses
  (15,726 )               (18,191 )        
 Total assets
$ 1,380,484               $ 1,429,107          
                                 
 Interest bearing liabilities
                               
     Interest bearing demand deposits
$ 178,911   $ 193   0.14 %   $ 167,843   $ 247   0.20%
     Savings deposits
  195,907     875   0.60 %     206,953     1,054   0.68%
     Time deposits
  566,172     7,007   1.65 %     545,121     8,839   2.17%
     Short-term borrowings
  25,579     50   0.26 %     14,250     25   0.23%
     Long-term borrowings
                               
        and capital trust securities
  203,019     5,997   3.95 %     288,305     8,575   3.97%
 Total interest bearing liabilities
  1,169,588     14,122   1.61 %     1,222,472     18,740   2.05%
                                 
 Noninterest bearing liabilities
                               
     and shareholders' equity
                               
     Demand deposits
  94,139                 92,362          
     Other liabilities
  7,698                 8,273          
     Total liabilities
  1,271,425                 1,323,107          
                                 
     Shareholders' equity - preferred
  9,319                 9,326          
     Shareholders' equity - common
  99,740                 96,674          
 Total liabilities and
                               
    shareholders' equity
$ 1,380,484               $ 1,429,107          
 Net interest earnings
      $ 29,845               $ 31,071    
 Net yield on interest earning assets
            3.17 %               3.19%
                                 
(1) For purposes of this table, nonaccrual loans are included in average loan balances.
                     
                                 
(2) - Interest income on tax-exempt securities and loans has been adjusted assuming an effective tax rate of 34% for all periods presented.
   
    The tax equivalent adjustment resulted in an increase in interest income of $1,045,000 and $1,147,000 for the periods ended
         
    September 30, 2013 and September 30, 2012, respectively.
                           

 
 
 
52

Summit Financial Group, Inc. and Subsidiaries
Management’s Discussion and Analysis of Financial Condition and
Results of Operations
 

 
Table II - Changes in Interest Margin Attributable to Rate and Volume
             
   
For the Nine Months Ended
   
September 30, 2013 versus September 30, 2012
   
Increase (Decrease) Due to Change in:
Dollars in thousands
 
Volume
 
Rate
 
Net
Interest earned on:
           
Loans
           
  Taxable
  $ (705 ) $ (3,068 ) $ (3,773)
  Tax-exempt
    (66 )   (4 )   (70)
Securities
                 
  Taxable
    (281 )   (1,460 )   (1,741)
  Tax-exempt
    212     (445 )   (233)
Federal funds sold and interest
                 
  bearing deposits with other banks
    (13 )   (14 )   (27)
Total interest earned on
                 
  interest earning assets
    (853 )   (4,991 )   (5,844)
                   
Interest paid on:
                 
Interest bearing demand
                 
  deposits
    15     (69 )   (54)
Savings deposits
    (54 )   (125 )   (179)
Time deposits
    329     (2,161 )   (1,832)
Short-term borrowings
    22     3     25
Long-term borrowings and capital
                 
   trust securities
    (2,527 )   (51 )   (2,578)
  Total interest paid on
                 
    interest bearing liabilities
    (2,215 )   (2,403 )   (4,618)
                   
Net interest income
  $ 1,362   $ (2,588 ) $ (1,226)

Noninterest Income

Total noninterest income decreased to $8.31 million for the first nine months of 2013, compared to $10.03 million for the same period of 2012, with fewer realized securities gains being the primary negative component.  Further detail regarding noninterest income is reflected in the following table.


Table III - Noninterest Income
               
 
For the Quarter Ended
   
For the Nine Months Ended
 
September 30,
   
September 30,
Dollars in thousands
2013
 
2012
   
2013
 
2012
Insurance commissions
$ 1,057   $ 1,052     $ 3,373   $ 3,352
Service fees related to deposit accounts
  1,106     1,074       3,202     3,163
Realized securities gains (losses)
  132     760       116     2,245
Other-than-temporary impairment of securities
  (38 )   (39 )     (118 )   (375)
Bank owned life insurance income
  229     257       703     781
Other
  377     257       1,038     868
Total
$ 2,863   $ 3,361     $ 8,314   $ 10,034

Other-than-temporary impairment of securities:  During the first nine months of 2013, we recorded non-cash other-than temporary impairment charges of $118,000 related to certain residential mortgage-backed securities which we continue to own.
 
 
 
53

Summit Financial Group, Inc. and Subsidiaries
Management’s Discussion and Analysis of Financial Condition and
Results of Operations
 

Noninterest Expense

Total noninterest expense decreased 17.9% and 9.2% for the quarter and nine months ended September 30, 2013, respectively, as compared to the same periods in 2012. Table IV below shows the breakdown of the changes.


Table IV - Noninterest Expense
                                   
 
For the Quarter Ended September 30,
   
For the Nine Months Ended September 30,
     
Change
             
Change
     
Dollars in thousands
2013
   $   %       2012       2013    $   %       2012
    Salaries, commissions, and employee benefits
$ 4,050   $ 110   2.8 %   $ 3,940     $ 12,155   $ 422   3.6 %   $ 11,733
    Net occupancy expense
  454     (22 ) -4.6 %     476       1,387     (58 ) -4.0 %     1,445
    Equipment expense
  578     5   0.9 %     573       1,724     (53 ) -3.0 %     1,777
    Professional fees
  263     (29 ) -9.9 %     292       885     13   1.5 %     872
    Amortization of intangibles
  88     -   0.0 %     88       263     -   0.0 %     263
    FDIC premiums
  503     (7 ) -1.4 %     510       1,558     26   1.7 %     1,532
    Foreclosed properties expense
  262     (94 ) -26.4 %     356       836     (99 ) -10.6 %     935
    (Gain) loss on sale of foreclosed properties
  (17 )   (1 ) 6.3 %     (16 )     546     (37 ) -6.3 %     583
    Write-down of foreclosed properties
  654     (1,917 ) -74.6 %     2,571       3,078     (3,036 ) -49.7 %     6,114
    Other
  1,396     159   12.9 %     1,237       3,900     151   4.0 %     3,749
Total
$ 8,231   $ (1,796 ) -17.9 %   $ 10,027     $ 26,332   $ (2,671 ) -9.2 %   $ 29,003
 
Salaries, commissions, and employee benefits;   Salaries, commissions, and employee benefits increased during the first nine months of 2013 compared to the first nine months of 2012 primarily as a result of general merit raises.

Foreclosed properties expense:  Foreclosed properties expense has decreased in 2013 due to our lower balance of foreclosed properties.

Writedown of foreclosed properties:  During the first nine months of 2013, we recorded $3.08 million in charges to writedown certain OREO properties to fair value less estimated costs to sell as part of our normal, ongoing re-appraisal process.  Continued volatility in the real estate markets could result in further writedowns of these properties in the foreseeable future.

Credit Experience

While recent economic data points to a stabilizing real estate market, general economic conditions remain weak when compared to pre-2008 levels.  As a result, we continue to experience elevated levels of loan delinquencies and nonperforming assets.  Although Management anticipates loan delinquencies and nonperforming assets will remain higher than pre-recession levels,we do expect recent trends of improvement to continue.

The provision for loan losses represents charges to earnings necessary to maintain an adequate allowance for probable credit losses inherent in the loan portfolio. Our determination of the appropriate level of the allowance is based on an ongoing analysis of credit quality and loss potential in the loan portfolio, change in the composition and risk characteristics of the loan portfolio, and the anticipated influence of national and local economic conditions.  The adequacy of the allowance for loan losses is reviewed quarterly and adjustments are made as considered necessary.
 
 
 
54

Summit Financial Group, Inc. and Subsidiaries
Management’s Discussion and Analysis of Financial Condition and
Results of Operations
 

We recorded $3.5 million and $6.0 million provisions for loan losses for the first nine months of 2013 and 2012, respectively.  This decline is a result of lower levels of specific reserves, based upon the fair value of collateral method in measuring impairment, necessary on newly identified impaired loans at September 30, 2013 compared to September 30, 2012.

As illustrated in Table V below, our non-performing assets have decreased since year end 2012.


Table V - Summary of Non-Performing Assets
               
   
September 30,
   
December 31,
 Dollars in thousands
 
2013
   
2012
   
2012
 Accruing loans past due 90 days or more
  $ -     $ -     $ -
 Nonaccrual loans
                     
 Commercial
    2,557       5,343       5,002
 Commercial real estate
    3,795       2,803       2,556
 Commercial construction and development
    3,761       428       -
 Residential construction and development
    9,128       16,333       13,641
 Residential real estate
    12,385       18,809       16,522
 Consumer
    145       88       55
     Total nonaccrual loans
    31,771       43,804       37,776
Foreclosed properties
                     
 Commercial real estate
    9,961       11,802       11,835
 Commercial construction and development
    11,161       17,683       17,597
 Residential construction and development
    20,585       23,769       23,074
 Residential real estate
    3,596       2,779       3,666
     Total foreclosed properties
    45,303       56,033       56,172
 Repossessed assets
    -       -       6
 Total nonperforming assets
  $ 77,074     $ 99,837     $ 93,954
                       
 Total nonperforming loans as a
                     
    percentage of total loans
    3.34 %     4.57 %     3.96%
 Total nonperforming assets as a
                     
    percentage of total assets
    5.55 %     7.11 %     6.77%
Allowance for loan losses as a
                     
    percentage of nonperforming loans
    41.04 %     40.68 %     47.47%
Allowance for loan losses as a
                     
    percentage of period end loans
    1.37 %     1.86 %     1.88%



The following table details the activity regarding our foreclosed properties for the three months and nine months ended September 30, 2013 and 2012.



Table VI - Foreclosed Property Activity
For the Three Months Ended
   
For the Nine Months Ended
 
September 30,
   
September 30,
Dollars in thousands
2013
 
2012
   
2013
 
2012
Beginning balance
$ 47,257   $ 60,068     $ 56,172   $ 63,938
   Acquisitions
  60     241       2,858     5,262
   Improvements
  90     155       197     677
   Disposals
  (1,449 )   (1,860 )     (10,846 )   (7,309)
   Writedowns to fair value
  (655 )   (2,571 )     (3,078 )   (6,114)
   Reclassification of covered loans
  -     -       -     (421)
Balance Sept 30
$ 45,303   $ 56,033     $ 45,303   $ 56,033
 
 
 
 
55

Summit Financial Group, Inc. and Subsidiaries
Management’s Discussion and Analysis of Financial Condition and
Results of Operations
 


The following table details our most significant nonperforming loan relationships at September 30, 2013.


Table IX - Significant Nonperforming Loan Relationships
September 30, 2013
                   
Dollars in thousands
                   
Location
Underlying Collateral
Loan Origination Date
Loan Nonaccrual Date
Loan Balance
 
Method Used to Measure Impairment
Most Recent Appraised Value
 
Amount Allocated to Allowance for Loan Losses
 
Amount Previously Charged-off
 
Eastern Panhandle WV
Commercial development & commercial real estate
Aug. 2006 & Apr. 2007
Aug. 2013
$ 5,240  
Collateral Value
$ 8,179 (1) $ -   $ -
Shenandoah Valley VA
Commerical real estate
Dec. 2009
Aug. 2013
$ 1,442  
Collateral value
$ 1,400 (1) $ 182   $ -
Northern VA
Single family residence
Aug. 2007, Oct. 2007 & Sept. 2008
Dec. 2011
$ 9,000  
Collateral value
$ 10,000 (1) $ 1,000   $ 3,565
Eastern Panhandle WV
Residential development & undeveloped acreage
Mar. 2008 & June 2008
Jun. 2011
$ 5,936  
Collateral value
$ 6,713 (1) $ -   $ 2,477
Southcentral WV
UCC Business Assets & Residential Subdivision
Feb. 2003, Mar. 2008 & Apr. 2008
May 2011 & Jul. 2011
$ 1,220  
Collateral value
$ 1,620 (2) $ 571   $ -
                               
(1) - Values are based upon recent external appraisal.
                         
(2) - Value is based upon current appraisal on the real estate and most recent estimate on business assets.
           
                               


Refer to Note 6 of the accompanying consolidated financial statements for information regarding our past due loans, impaired loans, nonaccrual loans, and TDRs.

We maintain the allowance for loan losses at a level considered adequate to provide for estimated probable credit losses inherent in the loan portfolio.  The allowance is comprised of three distinct reserve components:  (1) specific reserves related to loans individually evaluated, (2) quantitative reserves related to loans collectively evaluated, and (3) qualitative reserves related to loans collectively evaluated.  A summary of the methodology we employ on a quarterly basis with respect to each of these components in order to evaluate the overall adequacy of our allowance for loan losses is as follows:

Specific Reserve for Loans Individually Evaluated

First, we identify loan relationships having aggregate balances in excess of $500,000 and that may also have credit weaknesses.  Such loan relationships are identified primarily through our analysis of internal loan evaluations, past due loan reports, and loans adversely classified by regulatory authorities.  Each loan so identified is then individually evaluated to determine whether it is impaired – that is, based on current information and events, it is probable that we will be unable to collect all amounts due in accordance with the contractual terms of the underlying loan agreement.  Substantially all of our impaired loans are and historically have been collateral dependent, meaning repayment of the loan is expected to be provided solely from the sale of the loan’s underlying collateral.  For such loans, we measure impairment based on the fair value of the loan’s collateral, which is generally determined utilizing current appraisals.  A specific reserve is established in an amount equal to the excess, if any, of the recorded investment in each impaired loan over the fair value of its underlying collateral, less estimated costs to sell. Our policy is to re-evaluate the fair value of collateral dependent loans at least every twelve months unless there is a known deterioration in the collateral’s value, in which case a new appraisal is obtained.
 
 
 
56

Summit Financial Group, Inc. and Subsidiaries
Management’s Discussion and Analysis of Financial Condition and
Results of Operations
 

Quantitative Reserve for Loans Collectively Evaluated

Second, we stratify the loan portfolio into the following ten loan pools:  land and land development, construction, commercial, commercial real estate -- owner-occupied, commercial real estate -- non-owner occupied, conventional residential mortgage, jumbo residential mortgage, home equity, consumer, and other.  Loans within each pool are then further segmented between (1) loans which were individually evaluated for impairment and not deemed to be impaired, (2) larger-balance loan relationships exceeding $2 million which are assigned an internal risk rating in conjunction with our normal ongoing loan review procedures and (3) smaller-balance homogenous loans.

Quantitative reserves relative to each loan pool are established as follows:  for all loan segments detailed above an allocation equaling 100% of the respective pool’s average 12 month historical net loan charge-off rate (determined based upon the most recent twelve quarters) is applied to the aggregate recorded investment in the pool of loans.

Qualitative Reserve for Loans Collectively Evaluated

Third, we consider the necessity to adjust our average historical net loan charge-off rates relative to each of the above ten loan pools for potential risk factors that could result in actual losses deviating from prior loss experience.  For example, if we observe a significant increase in delinquencies within the conventional mortgage loan pool above historical trends, an additional allocation to the average historical loan charge-off rate is applied.  Such qualitative risk factors considered are:  (1) levels of and trends in delinquencies and impaired loans, (2) levels of and trends in charge-offs and recoveries, (3) trends in volume and term of loans, (4) effects of any changes in risk selection and underwriting standards, and other changes in lending policies, procedures, and practice, (5) experience, ability, and depth of lending management and other relevant staff, (6) national and local economic trends and conditions, (7) industry conditions, and (8) effects of changes in credit concentrations.

Relationship between Allowance for Loan Losses, Net Charge-offs and Nonperforming Loans

In analyzing the relationship between the allowance for loan losses, net loan charge-offs and nonperforming loans, it is helpful to understand the process of how loans are treated as they deteriorate over time. Reserves for loans are established at origination through the quantitative and qualitative reserve process discussed above.

Charge-offs, if necessary, are typically recognized in a period after the reserves were established. If the previously established reserves exceed that needed to satisfactorily resolve the problem credit, a reduction in the overall level of the reserve could be recognized. In summary, if loan quality deteriorates, the typical credit sequence is periods of reserve building, followed by periods of higher net charge-offs.

Consumer loans are generally charged off to the allowance for loan losses upon reaching specified stages of delinquency, in accordance with the Federal Financial Institutions Examination Council policy.  For example, credit card loans are charged off by the end of the month in which the account becomes 180 days past due or within 60 days from receiving notification about a specified event (e.g., bankruptcy of the borrower), whichever is earlier.  Residential mortgage loans are generally charged off to net realizable value no later than when the account becomes 180 days past due.  Other consumer loans, if collateralized, are generally charged off to net realizable value at 120 days past due.
 
 
 
57

Summit Financial Group, Inc. and Subsidiaries
Management’s Discussion and Analysis of Financial Condition and
Results of Operations
 

 
Commercial-related loans (which are risk-rated) are charged off to the allowance for loan losses when the loss has been confirmed. This determination includes many factors, including the prioritization of our claim in bankruptcy, expectations of the workout/restructuring of the loan and valuation of the borrower’s equity.

Substantially all of our nonperforming loans are secured by real estate. The majority of these loans were underwritten in accordance with our loan-to-value policy guidelines which range from 70-85% at the time of origination. The fair values of the underlying collateral value remains in excess of the recorded investment in many of our nonperforming loans, and therefore, no specific reserve allocation is required; as of September 30, 2013, approximately 59% of our impaired loans required no reserves or have been charged down to their fair value.

At September 30, 2013, December 31, 2012, and September 30, 2012, our allowance for loan losses totaled $13.0 million, or 1.37% of total loans, $17.9 million, or 1.88% of total loans and $17.8 million, or 1.86% of total loans, respectively, and is considered adequate to cover our estimate of probable credit losses inherent in our loan portfolio.  The 2013 decline is a result of lower average loan losses experienced over the past twelve quarters.  Lower losses cause our historical charge-off factor of the quantitative reserve calculation to decline, thus requiring fewer quantitative reserves.

At September 30, 2013, December 31, 2012, and September 30, 2012, we had approximately $45.3 million, $56.2 million and $56.0 million, respectively, in other real estate owned which was obtained as the result of foreclosure proceedings.  Although foreclosed property is recorded at fair value less estimated costs to sell, the prices ultimately realized upon their sale may or may not result in us recognizing loss.


FINANCIAL CONDITION

Our total assets increased slightly to $1.388 billion at September 30, 2013, compared to $1.387 billion at December 31, 2012.  Table VIII below serves to illustrate significant changes in our financial position between December 31, 2012 and September 30, 2013.
 
 
 
58

Summit Financial Group, Inc. and Subsidiaries
Management’s Discussion and Analysis of Financial Condition and
Results of Operations
 


Table VIII - Summary of Significant Changes in Financial Position
                   
   
Balance
           
Balance
   
December 31,
 
Increase (Decrease)
   
September 30,
 Dollars in thousands
 
2012
 
Amount
 
Percentage
   
2013
 Assets
                 
   Securities available for sale
  $ 281,539     9,719   3.5 %   $ 291,258
   Loans, net of unearned interest
    937,168     2,001   0.2 %     939,169
                         
 Liabilities
                       
   Deposits
  $ 1,027,125   $ (10,390 ) -1.0 %   $ 1,016,735
   Short-term borrowings
    3,958     50,205   1268.4 %     54,163
   Long-term borrowings
    203,268     (39,728 ) -19.5 %     163,540
   Subordinated debentures
    16,800     -   0.0 %     16,800
Subordinated debentures owed to
                 
       unconsolidated subsidiary trusts
    19,589     -   0.0 %     19,589


Loans increased 0.2% and securities increased 3.5% during the first nine months of 2013.  We have slowed our loan growth due to the current weakened economic conditions in our market areas and limited availability of new capital resources.
 
Deposits decreased approximately $10.4 million during the first nine months of 2013; brokered deposits decreased approximately $15.9 million.

The decrease in long term borrowings is primarily attributable to maturities and repayments of long-term FHLB advances during the first nine months of 2013.

Refer to Notes 5, 6, 9, and 10 of the notes to the accompanying consolidated financial statements for additional information with regard to changes in the composition of our securities, loans, deposits and borrowings between September 30, 2013 and December 31, 2012.

LIQUIDITY AND CAPITAL RESOURCES

Liquidity reflects our ability to ensure the availability of adequate funds to meet loan commitments and deposit withdrawals, as well as provide for other transactional requirements.  Liquidity is provided primarily by funds invested in cash and due from banks (net of float and reserves), Federal funds sold, non-pledged securities, and available lines of credit with the Federal Home Loan Bank of Pittsburgh (“FHLB”) and Federal Reserve Bank of Richmond, which totaled approximately $560 million or 40.4% of total consolidated assets at September 30, 2013.

Our liquidity strategy is to fund loan growth with deposits and other borrowed funds while maintaining an adequate level of short- and medium-term investments to meet normal daily loan and deposit activity.  As a member of the FHLB, we have access to approximately $393 million.  As of September 30, 2013 and December 31, 2012, these advances totaled approximately $128 million and $126 million, respectively.  At September 30, 2013, we had additional borrowing capacity of $265 million through FHLB programs.  We have established a line with the Federal Reserve Bank to be used as a contingency liquidity vehicle.  The amount available on this line at September 30, 2013 was approximately $84 million, which is secured by a pledge of our consumer and commercial and industrial loan portfolios.  We have a $6 million unsecured line of credit with a correspondent bank.  Also, we classify all of our securities as available for sale to enable us to liquidate them if the need arises.
 
 
 
59

Summit Financial Group, Inc. and Subsidiaries
Management’s Discussion and Analysis of Financial Condition and
Results of Operations
 
 
Liquidity risk represents the risk of loss due to the possibility that funds may not be available to satisfy current or future commitments based on external market issues, customer or creditor perception of financial strength, and events unrelated to Summit such as war, terrorism, or financial institution market specific issues.  The Asset/Liability Management Committee (“ALCO”), comprised of members of senior management and certain members of the Board of Directors, oversees our liquidity risk management process.   The ALCO develops and recommends policies and limits governing our liquidity to the Board of Directors for approval with the objective of ensuring that we can obtain cost-effective funding to meet current and future obligations, as well as maintain sufficient levels of on-hand liquidity, under both normal and “stressed” circumstances.
 
One aspect of our liquidity management process is establishing contingency liquidity funding plans under various scenarios in order to prepare for unexpected liquidity shortages or events.  The following represents three “stressed” liquidity circumstances and our related contingency plans with respect to each.
 
Scenario 1 – Summit Community’s capital status becomes less than “well capitalized”.  Banks which are less than “well capitalized” in accordance with regulatory capital guidelines are prohibited from issuing new brokered deposits without first obtaining a waiver from the FDIC to do so.  In the event Summit Community’s capital status were to fall below well capitalized and was not successful in obtaining the FDIC’s waiver to issue new brokered deposits, Summit Community:

·  
Would have limited amounts of maturing brokered deposits to replace in the short-term, as we have limited our brokered deposits maturing in any one quarter to no more than $50 million.
·  
Presently has $560 million in available sources of liquid funds which could be drawn upon to fund maturing brokered deposits until Summit Community had restored its capital to well capitalized status.
·  
Would first seek to restore its capital to well capitalized status through capital contributions from Summit, its parent holding company.
·  
Would generally have no more than $100 million in brokered deposits maturing in any one year time frame, which is well within its presently available sources of liquid funds, if in the event Summit does not have the capital resources to restore Summit Community’s capital to well capitalized status.  One year would give Summit Community ample time to raise alternative funds either through retail deposits or the sale of assets, and obtain capital resources to restore it to well capitalized status.

Scenario 2 – Summit Community’s credit quality deteriorates such that the FHLB restricts further advances.  If in the event that the Bank’s credit quality deteriorated to the point that further advances under its line with the FHLB were restricted, Summit Community:

·  
Would severely curtail lending and other growth activities until such time as access to this line could be restored, thus eliminating the need for net new advances, and
·  
Would still have available current liquid funding sources secured by unemcumbered loans and securities totaling $275 million aside from its FHLB line, which would result in a funding source of approximately $233 million.
 
 
Scenario 3 – A competitive financial institution offers a retail deposit program at interest rates significantly above current market rates in the Summit Community’s market areas.  If a competitive financial institution offered a retail deposit program at rates well in excess of current market rates in the Summit Community’s market area, the Bank:
 
 
 
60

Summit Financial Group, Inc. and Subsidiaries
Management’s Discussion and Analysis of Financial Condition and
Results of Operations
 

 
·  
Presently has $560 million in available sources of liquid funds which could be drawn upon immediately to fund any “net run off” of deposits from this activity.
·  
Would severely curtail lending and other growth activities so as to preserve the availability of as much contingency funds as possible.
·  
Would begin offering its own competitive deposit program when deemed prudent so as to restore the retail deposits lost to the competition.
 
 
We continuously monitor our liquidity position to ensure that day-to-day as well as anticipated funding needs are met.  We are not aware of any trends, commitments, events or uncertainties that have resulted in or are reasonably likely to result in a material change to our liquidity.

One of our continuous goals is maintenance of a strong capital position.  Through management of our capital resources, we seek to provide an attractive financial return to our shareholders while retaining sufficient capital to support future growth.  Shareholders’ equity at September 30, 2013 totaled $108.8 million compared to $108.6 million at December 31, 2012.

Summit and Summit Community have entered into informal Memoranda of Understanding (“MOU’s”) with their respective regulatory authorities.  A memorandum of understanding is characterized by the regulatory authorities as an informal action that is not published or publicly available and that is used when circumstances warrant a milder form of action than a formal supervisory action, such as a formal written agreement or order.  Among other things, under the MOU’s, Summit’s management team has agreed to:

·  
The Bank achieving and maintaining a minimum Tier 1 leverage capital ratio of at least 8% and a total risk-based capital ratio of at least 11%;
·  
The Bank providing 30 days prior notice of any declaration of intent to pay cash dividends to provide the Bank’s regulatory authorities an opportunity to object;
·  
Summit suspending all cash dividends on its common stock until further notice.  Dividends on all preferred stock, as well as interest payments on subordinated notes underlying Summit’s trust preferred securities, continue to be permissible; and,
·  
Summit not incurring any additional debt, other than trade payables, without the prior written consent of the principal banking regulators.

On October 25, 2012, the Bank entered into a revised MOU (“Bank MOU”) which replaced the Bank MOU effective September 24, 2009 and subsequently amended on February 1, 2011.  In general, the Bank MOU includes provisions substantially similar to those in the prior Bank MOU with the exception that several provisions deemed no longer applicable by the regulatory authorities were removed and a provision relative to reducing the Bank’s levels of classified assets was added.
 
 
 
61

Summit Financial Group, Inc. and Subsidiaries
Management’s Discussion and Analysis of Financial Condition and
Results of Operations
 

In summary, we have agreed, among other things, to address the following matters relative to the Bank:

·  
maintaining a Board committee which monitors and promotes compliance with the provisions of the Bank MOU;
 
·  
providing the Bank’s regulatory authorities with updated reports of criticized assets and/or formal workout plans for all nonperforming borrower relationships with an aggregate outstanding balance exceeding $1 million;
 
·  
developing and submitting to regulatory authorities a written plan to reduce the Bank’s risk exposure in each adversely classified credit relationship in excess of $1 million and all OREO;
 
·  
establishing procedures to report all loans with balances exceeding $500,000 that have credit weaknesses or that fall outside of the Bank’s policy;
 
·  
annually reviewing the organizational structure and operations of the Bank’s loan department;
 
·  
maintaining an adequate allowance for loan and lease losses through charges to current operating income;
 
·  
reviewing overall liquidity objectives and developing and submitting to regulatory authorities plans and procedures aimed to improve liquidity and reduce reliance on volatile liabilities;
 
·  
preparing comprehensive budgets and earnings forecasts for the Bank and submitting reports comparing actual performance to the budget plan;
 
·  
maintaining a minimum Tier 1 Leverage Capital ratio of at least 8% and a Total Risk-based Capital ratio of at least 11%;
 
·  
not paying any cash dividends without the prior written consent of the banking regulators; and,
 
·  
providing quarterly progress reports to the Bank’s regulatory authorities detailing steps taken to comply with the Bank MOU.
 

Dividends on Summit’s preferred stock, as well as interest payments on our subordinated debt and junior subordinated debentures underlying our trust preferred securities, continue to be permissible.  However, such dividends and interest payments on our preferred stock and trust preferred debt are subject to future review by the regulatory authorities should we continue to experience deterioration in our financial condition.

Summit Community received regulatory approval for and paid an upstream dividend of $1.0 million to Summit during third quarter 2013, representing the first such dividend since second quarter 2008.  Although dividends from Summit Community are the principal source of funds to pay dividends, interest, and principal payments on Summit’s preferred stock, subordinated debentures (including those owed to unconsolidated subsidiary trusts), and term borrowings, we currently have sufficient cash on hand to continue to service our subordinated debentures and term borrowing obligations as well as the expected dividend payments on our preferred stock through mid-2015.  Nevertheless, we can make no assurances that we will continue to have sufficient funds available for Summit’s debt service and for distributions to the holders of our preferred stock.
 
Refer to Note 13 of the notes to the accompanying consolidated financial statements for additional information regarding regulatory restrictions on our capital as well as our subsidiaries’ capital.


 
62

Summit Financial Group, Inc. and Subsidiaries
Management’s Discussion and Analysis of Financial Condition and
Results of Operations
 


CONTRACTUAL CASH OBLIGATIONS

During our normal course of business, we incur contractual cash obligations.  The following table summarizes our contractual cash obligations at September 30, 2013.


Table IX - Contractual Cash Obligations
 
Long
 
Capital
   
   
Term
 
Trust
 
Operating
Dollars in thousands
 
Debt
 
Securities
 
Leases
2013
  $ 24   $ -   $ 61
2014
    82,527     -     204
2015
    11,909     -     38
2016
    28,911     -     -
2017
    918     -     -
Thereafter
    56,051     19,589     -
Total
  $ 180,340   $ 19,589   $ 303




OFF-BALANCE SHEET ARRANGEMENTS

We are involved with some off-balance sheet arrangements that have or are reasonably likely to have an effect on our financial condition, liquidity, or capital.  These arrangements at September 30, 2013 are presented in the following table.


Table X - Off-Balance Sheet Arrangements
 
September 30,
Dollars in thousands
 
2013
Commitments to extend credit:
   
    Revolving home equity and
   
        credit card lines
  $ 49,535
    Construction loans
    32,534
    Other loans
    42,196
Standby letters of credit
    1,759
Total
  $ 126,024



 
63

 
Summit Financial Group, Inc. and Subsidiaries
Management’s Discussion and Analysis of Financial Condition and
Results of Operations



MARKET RISK MANAGEMENT

Market risk is the risk of loss arising from adverse changes in the fair value of financial instruments due to changes in interest rates, exchange rates and equity prices.  Interest rate risk is our primary market risk and results from timing differences in the repricing of assets, liabilities and off-balance sheet instruments, changes in relationships between rate indices and the potential exercise of imbedded options.  The principal objective of asset/liability management is to minimize interest rate risk and our actions in this regard are taken under the guidance of our Asset/Liability Management Committee (“ALCO”), which is comprised of members of senior management and members of the Board of Directors.  The ALCO actively formulates the economic assumptions that we use in our financial planning and budgeting process and establishes policies which control and monitor our sources, uses and prices of funds.

Some amount of interest rate risk is inherent and appropriate to the banking business.  Our net income is affected by changes in the absolute level of interest rates.  Our interest rate risk position is liability sensitive.  The nature of our lending and funding activities tends to drive our interest rate risk position to being liability sensitive.  That is, absent any changes in the volumes of our interest earning assets or interest bearing liabilities, liabilities are likely to reprice faster than assets, resulting in a decrease in net income in a rising rate environment.  Net income would increase in a falling interest rate environment.  Net income is also subject to changes in the shape of the yield curve.  In general, a flattening yield curve would result in a decline in our earnings due to the compression of earning asset yields and funding rates, while a steepening would result in increased earnings as margins widen.

Several techniques are available to monitor and control the level of interest rate risk.  We primarily use earnings simulations modeling to monitor interest rate risk.  The earnings simulation model forecasts the effects on net interest income under a variety of interest rate scenarios that incorporate changes in the absolute level of interest rates and changes in the shape of the yield curve.  Each increase or decrease in interest rates is assumed to gradually take place over the next 12 months, and then remain stable, except for the up 400 scenario, which assumes a gradual increase in rates over 24 months.  Assumptions used to project yields and rates for new loans and deposits are derived from historical analysis.  Securities portfolio maturities and prepayments are reinvested in like instruments.  Mortgage loan prepayment assumptions are developed from industry estimates of prepayment speeds.  Noncontractual deposit repricings are modeled on historical patterns.

The following table presents the estimated sensitivity of our net interest income to changes in interest rates, as measured by our earnings simulation model as of September 30, 2013.  The sensitivity is measured as a percentage change in net interest income given the stated changes in interest rates (gradual change over 12 months, stable thereafter for the down 100 and the up 200 scenarios, and gradual change over 24 months for the up 400 scenario) compared to net interest income with rates unchanged in the same period.  The estimated changes set forth below are dependent on the assumptions discussed above and are well within our ALCO policy limit, which is a 10% reduction in net interest income over the ensuing twelve month period.
 
 

 
 
64

Summit Financial Group, Inc. and Subsidiaries
Management’s Discussion and Analysis of Financial Condition and
Results of Operations
 


Change in
Estimated % Change in Net
Interest Rates
Interest Income Over:
(basis points)
0-12 Months
 
13-24 Months
Down 100 (1)
-0.61 % 1.55%
Up 200 (1)
-4.51 % -4.91%
Up 400 (2)
-3.72 % -9.91%
       
(1) assumes a parallel shift in the yield curve
   
(2) assumes 400 bp increase over 24 months
   







 
65

 
Summit Financial Group, Inc. and Subsidiaries
Management’s Discussion and Analysis of Financial Condition and
Results of Operations



CONTROLS AND PROCEDURES

Our management, including the Chief Executive Officer and Chief Financial Officer, has conducted as of September 30, 2013, an evaluation of the effectiveness of disclosure controls and procedures as defined in Exchange Act Rule 13a-15(e).  Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the disclosure controls and procedures as of September 30, 2013 were effective.  There were no changes in our internal control over financial reporting that occurred during the quarter ended September 30, 2013 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 
66

 
Summit Financial Group, Inc. and Subsidiaries
Part II.  Other Information


Item 1.  Legal Proceedings

We are involved in various legal actions arising in the ordinary course of business.  In the opinion of management, the outcome of these matters will not have a significant adverse effect on the consolidated financial statements.


Item 1A.  Risk Factors

In addition to the other information set forth in this report, you should carefully consider the factors discussed in Part I, “Item 1A. Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2012.


 
Item 6.  Exhibits
 
 
Exhibit 3.i  Amended and Restated Articles of Incorporation of Summit Financial Group, Inc.
   
Exhibit 3.ii   Articles of Amendment 2009
   
Exhibit 3.iii   Articles of Amendment 2011
   
Exhibit 3.iv   Amended and Restated By-Laws of Summit Financial Group, Inc.
   
Exhibit 11
Statement re:  Computation of Earnings per Share – Information contained in Note 4 to the Consolidated Financial Statements on page 15 of this Quarterly Report is incorporated herein by reference.
   
Exhibit 31.1
Sarbanes-Oxley Act Section 302 Certification of Chief Executive Officer
   
Exhibit 31.2
Sarbanes-Oxley Act Section 302 Certification of Chief Financial Officer
   
Exhibit 32.1
Sarbanes-Oxley Act Section 906 Certification of Chief Executive Officer
   
Exhibit 32.2
Sarbanes-Oxley Act Section 906 Certification of Chief Financial Officer
   
Exhibit 101  Interactive Data File (XBRL)
 

 

 
67

 

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.



 
SUMMIT FINANCIAL GROUP, INC.
 
(registrant)
       
       
       
       
 
By:
 /s/ H. Charles Maddy, III
 
 
H. Charles Maddy, III,
 
President and Chief Executive Officer
       
       
       
 
By:
 /s/ Robert S. Tissue
 
 
Robert S. Tissue,
 
Senior Vice President and Chief Financial Officer
       
       
       
 
By:
 /s/ Julie R. Cook
 
 
Julie R. Cook,
 
Vice President and Chief Accounting Officer
       
       
Date:  November 12, 2013
     


 
68

 

 




EXHIBIT INDEX


Exhibit No.
Description
Page
Number
     
(3)
Articles of Incorporation and By-laws:
 
 
(i) Amended and Restated Articles of Incorporation of Summit Financial Group, Inc.
(a)
 
(ii) Articles of Amendment 2009
(b)
 
(iii) Articles of Amendment 2011
(c)
 
(iv) Amended and Restated By-laws of Summit Financial Group, Inc.
(d)
     
11
Statement re:  Computation of Earnings per Share
16
     
 31.1
Sarbanes-Oxley Act Section 302 Certification of Chief Executive Officer
 
     
31.2
Sarbanes-Oxley Act Section 302 Certification of Chief Financial Officer
 
     
32.1*
Sarbanes-Oxley Act Section 906 Certification of Chief Executive Officer
 
     
32.2*
Sarbanes-Oxley Act Section 906 Certification of Chief Financial Officer
 
     
101**
Interactive data file (XBRL)
 

  *    Furnished, not filed.
 
**  As provided in Rule 406T of Regulation S-T, this information is furnished and not filed for purposes of Sections 11 and 12 of the Securities Act of 1933 and Section 18 of the Securities Exchange Act of 1934.

(a)  
Incorporated by reference to Exhibit 3.i of Summit Financial Group, Inc.’s filing on Form 10-Q dated March 31, 2006.
(b)  
Incorporated by reference to Exhibit 3.1 of Summit Financial Group, Inc.’s filing on Form 8-K dated September 30, 2009.
(c)  
Incorporated by reference to Exhibit 3.1 of Summit Financial Group, Inc.’s filing on Form 8-K dated November 3, 2011.
(d)  
Incorporated by reference to Exhibit 3.2 of Summit Financial Group, Inc.’s filing on Form 10-Q dated June 30, 2006.
 

 
 
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