EBTC-6.30.2013-10Q
Table of Contents

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549 
Form 10-Q
 
 
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended June 30, 2013

Commission File Number:  001-33912
 Enterprise Bancorp, Inc.
(Exact name of registrant as specified in its charter)
 
Massachusetts
04-3308902
(State or other jurisdiction of
(I.R.S. Employer Identification No.)
incorporation or organization)
 
 
 
222 Merrimack Street, Lowell, Massachusetts
01852
(Address of principal executive offices)
(Zip code)
 (978) 459-9000
(Registrant’s telephone number, including area code)
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  x Yes   o  No
 
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)  x Yes  o  No
 
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 for “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act (Check one): 
Large accelerated filer o
Accelerated filer x
Non-accelerated filer o
Smaller reporting company o
 
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  ¨  Yes  x  No
 
As of August 5, 2013, there were 9,943,786 shares of the issuer's common stock outstanding- Par Value $0.01 per share




Table of Contents

ENTERPRISE BANCORP, INC.
INDEX

 
 
Page Number
 
 
 
 
 
 
 
3 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 


2

Table of Contents

PART I-FINANCIAL INFORMATION

Item 1 -
Financial Statements
ENTERPRISE BANCORP, INC.
Consolidated Balance Sheets
(Dollars in thousands)
 
June 30,
2013
 
December 31,
2012
 
 
(unaudited)
 
 
Assets
 
 

 
 

Cash and cash equivalents:
 
 

 
 

Cash and due from banks
 
$
40,795

 
$
38,007

Interest-earning deposits
 
6,878

 
12,218

Fed funds sold
 
4,055

 
2,510

Total cash and cash equivalents
 
51,728

 
52,735

Investment securities at fair value
 
190,459

 
184,464

Federal Home Loan Bank Stock
 
4,324

 
4,260

Loans held for sale
 
3,917

 
8,557

Loans, less allowance for loan losses of $25,671 at June 30, 2013 and $24,254 at December 31, 2012, respectively
 
1,421,675

 
1,335,401

Premises and equipment
 
28,602

 
27,206

Accrued interest receivable
 
6,092

 
5,828

Deferred income taxes, net
 
13,771

 
12,548

Bank-owned life insurance
 
15,678

 
15,443

Prepaid income taxes
 
1,387

 
174

Prepaid expenses and other assets
 
10,047

 
13,454

Goodwill
 
5,656

 
5,656

Total assets
 
$
1,753,336

 
$
1,665,726

Liabilities and Stockholders’ Equity
 
 

 
 

Liabilities
 
 

 
 

Deposits
 
$
1,579,293

 
$
1,475,027

Borrowed funds
 
1,880

 
26,540

Junior subordinated debentures
 
10,825

 
10,825

Accrued expenses and other liabilities
 
16,766

 
13,182

Accrued interest payable
 
579

 
603

Total liabilities
 
$
1,609,343

 
$
1,526,177

Commitments and Contingencies
 


 


Stockholders’ Equity
 
 

 
 

Preferred stock, $0.01 par value per share; 1,000,000 shares authorized; no shares issued
 

 

Common stock, $0.01 par value per share; 20,000,000 shares authorized; 9,872,735 issued and outstanding at June 30, 2013 (including 171,481 shares of unvested participating restricted awards) and 9,676,477 shares issued and outstanding at December 31, 2012 (including 154,186 shares of unvested participating restricted awards)
 
99

 
97

Additional paid-in-capital
 
50,479

 
48,194

Retained earnings
 
91,427

 
87,159

Accumulated other comprehensive income
 
1,988

 
4,099

Total stockholders’ equity
 
$
143,993

 
$
139,549

Total liabilities and stockholders’ equity
 
$
1,753,336

 
$
1,665,726

 
See the accompanying notes to the unaudited consolidated financial statements.

3

Table of Contents

ENTERPRISE BANCORP, INC.
Consolidated Statements of Income
(unaudited)
 
 
Three months ended June 30,
 
Six months ended June 30,
(Dollars in thousands, except per share data)
 
2013
 
2012
 
2013
 
2012
Interest and dividend income:
 
 

 
 

 
 
 
 
Loans and loans held for sale
 
$
16,653

 
$
16,228

 
$
33,026

 
$
32,186

Investment securities
 
794

 
835

 
1,604

 
1,634

Other interest-earning assets
 
11

 
24

 
21

 
43

Total interest and dividend income
 
17,458

 
17,087

 
34,651

 
33,863

Interest expense:
 
 

 
 

 
 
 
 
Deposits
 
996

 
1,368

 
2,030

 
2,905

Borrowed funds
 
40

 
13

 
86

 
29

Junior subordinated debentures
 
295

 
295

 
589

 
589

Total interest expense
 
1,331

 
1,676

 
2,705

 
3,523

Net interest income
 
16,127

 
15,411

 
31,946

 
30,340

Provision for loan losses
 
534

 
1,050

 
1,317

 
1,350

Net interest income after provision for loan losses
 
15,593

 
14,361

 
30,629

 
28,990

Non-interest income:
 
 

 
 

 
 
 
 
Investment advisory fees
 
1,045

 
934

 
2,061

 
1,955

Deposit and interchange fees
 
1,181

 
1,107

 
2,289

 
2,128

Income on bank-owned life insurance, net
 
119

 
128

 
235

 
262

Net gains on sales of investment securities
 
468

 
112

 
948

 
159

Gains on sales of loans
 
222

 
218

 
557

 
458

Other income
 
518

 
453

 
1,102

 
964

Total non-interest income
 
3,553

 
2,952

 
7,192

 
5,926

Non-interest expense:
 
 

 
 

 
 
 
 
Salaries and employee benefits
 
8,651

 
7,841

 
16,699

 
15,344

Occupancy and equipment expenses
 
1,488

 
1,430

 
3,059

 
2,844

Technology and telecommunications expenses
 
1,203

 
1,077

 
2,356

 
2,076

Advertising and public relations expenses
 
946

 
497

 
1,566

 
1,286

Audit, legal and other professional fees
 
411

 
487

 
825

 
970

Deposit insurance premiums
 
284

 
283

 
533

 
560

Supplies and postage expenses
 
250

 
196

 
487

 
427

Investment advisory and custodial expenses
 
134

 
112

 
260

 
209

Other operating expenses
 
1,094

 
1,049

 
2,130

 
2,074

Total non-interest expense
 
14,461

 
12,972

 
27,915

 
25,790

Income before income taxes
 
4,685

 
4,341

 
9,906

 
9,126

Provision for income taxes
 
1,606

 
1,436

 
3,394

 
3,048

Net income
 
$
3,079

 
$
2,905

 
$
6,512

 
$
6,078

 
 
 
 
 
 
 
 
 
Basic earnings per share
 
$
0.31

 
$
0.30

 
$
0.67

 
$
0.64

Diluted earnings per share
 
$
0.31

 
$
0.30

 
$
0.66

 
$
0.63

 
 
 
 
 
 
 
 
 
Basic weighted average common shares outstanding
 
9,825,335

 
9,588,420

 
9,770,559

 
9,543,994

Diluted weighted average common shares outstanding
 
9,889,639

 
9,655,728

 
9,840,016

 
9,612,187

 
See the accompanying notes to the unaudited consolidated financial statements.

4

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ENTERPRISE BANCORP, INC.
Consolidated Statements of Comprehensive Income
(Unaudited)

 
 
 
Three months ended June 30,
 
Six months ended June 30,
(Dollars in thousands)
 
2013
 
2012
 
2013
 
2012
Net income
 
$
3,079

 
$
2,905

 
$
6,512

 
$
6,078

Other comprehensive (loss) income, net of taxes:
 
 
 
 
 
 
 
 
Gross unrealized holding (losses) gains on investments arising during the period
 
(2,744
)
 
312

 
(2,386
)
 
816

Income tax benefit (expense)
 
999

 
(117
)
 
884

 
(287
)
Net unrealized holding (losses) gains, net of tax
 
(1,745
)
 
195

 
(1,502
)
 
529

Less: Reclassification adjustment for net gains included in net income
 
 
 
 
 
 
 
 
Net realized gains on sales of securities during the period
 
468

 
112

 
948

 
159

Income tax expense
 
(163
)
 
(40
)
 
(339
)
 
(56
)
Reclassification adjustment for gains realized, net of tax
 
305

 
72

 
609

 
103

 
 
 
 
 
 
 
 
 
Total other comprehensive (loss) income
 
(2,050
)
 
123

 
(2,111
)
 
426

Comprehensive income
 
$
1,029

 
$
3,028

 
$
4,401

 
$
6,504




See the accompanying notes to the unaudited consolidated financial statements.



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ENTERPRISE BANCORP, INC.
Consolidated Statement of Changes in Stockholders’ Equity
(Unaudited)

 
(Dollars in thousands)
 
Common
Stock
 
Additional
Paid-in
Capital
 
Retained
Earnings
 
Accumulated
Other
Comprehensive
Income
 
Total
Stockholders’
Equity
Balance at December 31, 2012
 
$
97

 
$
48,194

 
$
87,159

 
$
4,099

 
$
139,549

Net income
 
 
 
 
 
6,512

 
 
 
6,512

Other comprehensive loss, net
 
 
 
 
 
 
 
(2,111
)
 
(2,111
)
Tax benefit from exercise of stock options
 
 
 
7

 
 
 
 
 
7

Common stock dividend paid ($0.23 per share)
 
 
 
 
 
(2,244
)
 
 
 
(2,244
)
Common stock issued under dividend reinvestment plan
 

 
630

 
 
 
 
 
630

Stock-based compensation
 
1

 
933

 
 
 
 
 
934

Stock options exercised, net
 
1

 
715

 
 
 
 
 
716

Balance at June 30, 2013
 
$
99

 
$
50,479

 
$
91,427

 
$
1,988

 
$
143,993

 
See the accompanying notes to the unaudited consolidated financial statements.


6

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ENTERPRISE BANCORP, INC.
Consolidated Statements of Cash Flows
(Unaudited)
 
 
 
Six months ended June 30,
(Dollars in thousands)
 
 
2013
 
2012
Cash flows from operating activities:
 
 
 
 
 
Net income
 
 
$
6,512

 
$
6,078

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
 
 
Provision for loan losses
 
 
1,317

 
1,350

Depreciation and amortization
 
 
2,458

 
2,133

Stock-based compensation expense
 
 
859

 
652

Mortgage loans originated for sale
 
 
(25,274
)
 
(21,388
)
Proceeds from mortgage loans sold
 
 
30,471

 
24,644

Net gains on sales of loans
 
 
(557
)
 
(458
)
Net gains on sales of OREO
 
 
(121
)
 
(45
)
Net gains on sales of investments
 
 
(948
)
 
(159
)
Income on bank-owned life insurance, net
 
 
(235
)
 
(262
)
Changes in:
 
 
 
 
 
Accrued interest receivable
 
 
(264
)
 
191

Prepaid expenses and other assets
 
 
1,802

 
683

Accrued expenses and other liabilities
 
 
(1,319
)
 
1,391

Accrued interest payable
 
 
(24
)
 
(169
)
Net cash provided by operating activities
 
 
14,677

 
14,641

Cash flows from investing activities:
 
 
 
 
 
Proceeds from sales of investment securities available for sale
 
 
7,361

 
2,921

Net proceeds (purchase) from FHLB capital stock
 
 
(64
)
 
480

Proceeds from maturities, calls and pay-downs of investment securities
 
 
8,040

 
9,689

Purchase of investment securities
 
 
(19,297
)
 
(36,874
)
Net increase in loans
 
 
(87,759
)
 
(46,522
)
Additions to premises and equipment, net
 
 
(3,332
)
 
(962
)
Proceeds from OREO sales and payments
 
 
652

 
885

Net cash used in investing activities
 
 
(94,399
)
 
(70,383
)
Cash flows from financing activities:
 
 
 
 
 
Net increase in deposits
 
 
104,266

 
120,454

Net decrease in borrowed funds
 
 
(24,660
)
 
(1,625
)
Cash dividends paid
 
 
(2,244
)
 
(2,098
)
Proceeds from issuance of common stock
 
 
630

 
635

Proceeds from the exercise of stock options
 
 
716

 
100

Tax benefit from the exercise of stock options
 
 
7

 
1

Net cash provided by financing activities
 
 
78,715

 
117,467

 
 
 
 
 
 
Net (decrease) increase in cash and cash equivalents
 
 
(1,007
)
 
61,725

Cash and cash equivalents at beginning of period
 
 
52,735

 
39,131

Cash and cash equivalents at end of period
 
 
$
51,728

 
$
100,856

 
 
 
 
 
 
Supplemental financial data:
 
 
 
 
 
Cash Paid For: Interest
 
 
$
2,729

 
$
3,692

Cash Paid For: Income Taxes
 
 
4,583

 
4,134

 
 
 
 
 
 
Supplemental schedule of non-cash investing activity:
 
 
 
 
 
Purchase of investment securities not yet settled
 
 
4,978

 

Transfer from loans to other real estate owned
 
 
167

 
400

Capital expenditures incurred not yet paid
 
 

 
74

 
See accompanying notes to the unaudited consolidated financial statements.

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ENTERPRISE BANCORP, INC.
Notes to the Unaudited Consolidated Financial Statements
 
(1)
Organization of Holding Company and Basis of Presentation

The accompanying unaudited consolidated financial statements and these notes should be read in conjunction with the December 31, 2012 audited consolidated financial statements and notes thereto contained in the 2012 Annual Report on Form 10-K of Enterprise Bancorp, Inc. (the “Company” or “Enterprise”), a Massachusetts corporation, as filed with the Securities and Exchange Commission (the "SEC") on March 15, 2013.  The Company has not changed its reporting policies from those disclosed in its 2012 Annual Report on Form 10-K.

The accompanying unaudited consolidated interim financial statements have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) for interim financial information and the instructions for Form 10-Q through the rules and interpretive releases of the SEC under federal securities law. In the opinion of management, the accompanying unaudited consolidated interim financial statements reflect all necessary adjustments consisting of normal recurring accruals for a fair presentation.  All significant intercompany balances and transactions have been eliminated in the accompanying unaudited consolidated interim financial statements. Certain previous year amounts in the unaudited consolidated interim financial statements and accompanying footnotes have been reclassified to conform to the current year’s presentation. Interim results are not necessarily indicative of results to be expected for the entire year.

The Company's consolidated unaudited interim financial statements include the accounts of the Company and its wholly owned subsidiary, Enterprise Bank and Trust Company (the “Bank”).  The Bank is a Massachusetts trust company organized in 1989. Substantially all of the Company’s operations are conducted through the Bank.

The Bank’s subsidiaries include Enterprise Insurance Services, LLC and Enterprise Investment Services, LLC, organized under the laws of the State of Delaware for the purposes of engaging in insurance sales activities and offering non-deposit investment products and services, respectively.  In addition, the Bank has the following subsidiaries that are incorporated in the Commonwealth of Massachusetts and classified as security corporations in accordance with applicable Massachusetts General Laws: Enterprise Security Corporation; Enterprise Security Corporation II; and Enterprise Security Corporation III, which hold various types of qualifying securities.  The security corporations are limited to conducting securities investment activities that the Bank itself would be allowed to conduct under applicable laws.

Pursuant to the Accounting Standards Codification (“ASC”) Topic 810 “Consolidation of Variable Interest Entities,” issued by the Financial Accounting Standards Board (originally issued as Financial Interpretation No. 46R) in December 2003, the Company carries Junior Subordinated Debentures as a liability on its consolidated financial statements, along with the related interest expense. The debentures were issued by a statutory business trust (the “Trust”) created by the Company in March 2000 under the laws of the State of Delaware, and the trust preferred securities issued by the Trust, and the related non-interest expense, are excluded from the Company’s consolidated financial statements.

Comprehensive income is defined as all changes to equity except investments by and distributions to stockholders.  Net income is one component of comprehensive income, with other components referred to in the aggregate as other comprehensive income.  The Company’s only other comprehensive income component is the net unrealized holding gains or losses on investments available-for-sale. Pursuant to Accounting Standards Update (“ASU”) No. 2013-02, Comprehensive Income (Topic 220): Reporting Amounts Reclassified Out of Accumulated Comprehensive Income, the Company initially excludes these unrealized holding gains and losses from net income; however they are later reported as reclassifications out of accumulated other comprehensive income into net income when the securities are sold. When securities are sold, the reclassification of realized gains and losses on available-for-sale securities are included on the Consolidated Statements of Income under the "non-interest income" subheading on the line item "net gains on sales of investment securities" and the related income tax expense is included in the line item "provision for income taxes," both of which are also detailed on the Consolidated Statements of Comprehensive Income under the subheading "reclassification adjustment for net gains included in net income."

The Company has 21 full service branches serving the Merrimack Valley and North Central regions of Massachusetts and Southern New Hampshire. The Company is currently constructing a branch office in Nashua, NH with an anticipated opening in the fourth quarter of 2013. Through the Bank and its subsidiaries, the Company offers a range of commercial and consumer loan products, deposit and cash management products, investment advisory and wealth management, and insurance services.  The services offered through the Bank and subsidiaries are managed as one strategic unit and represent the Company’s only reportable operating segment.

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ENTERPRISE BANCORP, INC.
Notes to the Unaudited Consolidated Financial Statements (continued)


The Federal Deposit Insurance Corporation (the “FDIC”) and the Massachusetts Commissioner of Banks (the “Commissioner”) have regulatory authority over the Bank.  The Bank is also subject to certain regulatory requirements of the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”) and, with respect to its New Hampshire branch operations, the New Hampshire Banking Department.  The business and operations of the Company are subject to the regulatory oversight of the Federal Reserve Board.  The Commissioner also retains supervisory jurisdiction over the Company.

(2)
Critical Accounting Estimates
 
As discussed in the Company’s 2012 Annual Report on Form 10-K, the three most significant areas in which management applies critical assumptions and estimates that are particularly susceptible to change relate to the determination of the allowance for loan losses, impairment review of investment securities and the impairment review of goodwill.  Refer to Note 1, "Summary of Significant Accounting Policies," to the Company’s consolidated financial statements included in the Company’s 2012 Annual Report on Form 10-K for significant accounting policies. The Company has not changed its significant accounting policies from those disclosed in its 2012 Annual Report filed on Form 10-K.

In preparing the consolidated financial statements in conformity with GAAP, management is required to exercise judgment in determining many of the methodologies, assumptions and estimates to be utilized.  These estimates and assumptions affect the reported values of assets and liabilities as of the balance sheet date and income and expenses for the period then ended.  As future events and their effects cannot be determined with precision, actual results could differ significantly from these estimates should the assumptions and estimates used change over time due to changes in circumstances.  Changes in those estimates resulting from continuing change in the economic environment and other factors will be reflected in the financial statements and results of operations in future periods.
 
(3)
Recent Accounting Pronouncements
 
In February 2013, the Financial Accounting Standards Board (“FASB”) issued ASU No. 2013-02, Comprehensive Income (Topic 220): Reporting Amounts Reclassified out of Accumulated Other Comprehensive Income.  The new amendments require an organization to present the effects on the income statement of significant amounts reclassified out of accumulated other comprehensive income or cross-reference to other disclosures currently required under GAAP for certain items. The new amended standard is effective for annual periods beginning after December 15, 2012, and interim periods within those annual periods.  As this ASU addresses only disclosure requirements, the adoption in the first quarter of 2013 did not have a material impact on the Company's financial statements. See Note 1, "Organization of Holding Company and Basis of Presentation," for the disclosure of the effects of amounts reclassified out of accumulated other comprehensive income.

In December 2011, the FASB issued ASU No. 2011-11, Balance Sheet (Topic 210): Disclosures about Offsetting Assets and Liabilities, which was subsequently clarified in January 2013 by ASU 2013-01.  The new amended standard was effective for annual periods beginning January 1, 2013, and interim periods within those annual periods.  As this ASU primarily deals with disclosure requirements and the Company has no netting arrangements, the adoption in January 2013 did not have an impact on the Company's financial statements.


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Table of Contents
ENTERPRISE BANCORP, INC.
Notes to the Unaudited Consolidated Financial Statements (continued)

(4)
Investments
 
The amortized cost and carrying values of investment securities at the dates specified are summarized as follows:

 
 
June 30, 2013
(Dollars in thousands)
 
Amortized
cost
 
Unrealized
gains
 
Unrealized
losses
 
Fair Value
Federal agency obligations (1)
 
$
65,111

 
$
191

 
$
50

 
$
65,252

Federal agency mortgage backed securities (MBS) (1)
 
52,563

 
570

 
976

 
52,157

Municipal securities
 
56,222

 
1,847

 
391

 
57,678

Corporate bonds
 
3,786


4


54


3,736

Certificates of deposit
 
858

 

 
3

 
855

Total fixed income securities
 
178,540

 
2,612

 
1,474

 
179,678

Equity investments
 
8,886

 
2,020

 
125

 
10,781

Total available for sale securities, at fair value
 
$
187,426

 
$
4,632

 
$
1,599

 
$
190,459

 
 
 
December 31, 2012
(Dollars in thousands)
 
Amortized
cost
 
Unrealized
gains
 
Unrealized
losses
 
Fair Value
Federal agency obligations(1)
 
$
65,247

 
$
438

 
$

 
$
65,685

Federal agency mortgage backed securities (MBS) (1)
 
48,429

 
1,287

 
42

 
49,674

Municipal securities
 
53,437

 
3,103

 
17

 
56,523

Corporate bonds
 
1,905

 
15

 
6

 
1,914

Total fixed income securities
 
169,018

 
4,843

 
65

 
173,796

Equity investments
 
9,080

 
1,622

 
34

 
10,668

Total available for sale securities, at fair value
 
$
178,098

 
$
6,465

 
$
99

 
$
184,464


__________________________________________
(1)
These categories may include investments issued or guaranteed by government sponsored enterprises such as Fannie Mae (FNMA), Freddie Mac (FHLMC), Ginnie Mae (GNMA), Federal Farm Credit Bank, or one of several Federal Home Loan Banks.  All agency MBS/Collateralized Mortgage Obligations ("CMOs") investments owned by the Company are backed by residential mortgages.


Included in the carrying amount of the federal agency MBS category were CMOs totaling $20.6 million and $23.6 million at June 30, 2013 and December 31, 2012, respectively.

Certificates of Deposit (CDs) represent term deposits issued by banks that are subject to FDIC insurance and purchased on the open market. The Company utilizes these CDs as an alternative investment option to holding short-term excess cash in lower yielding overnight deposit accounts. These securities have maturities of less than a year and the market value approximates the carrying value.

At June 30, 2013, the equity portfolio consisted primarily of investments in a diversified group of mutual funds, with a small portion of the portfolio (approximately 17%) invested in exchange traded funds or individual common stock of entities in the financial services industry.
 
The net unrealized gain or loss in the Company's fixed income portfolio fluctuates as market interest rates rise and fall.  Due to the fixed rate nature of this portfolio, as market rates fall, the value of the portfolio rises, and as market rates rise, the value of the portfolio declines.  The unrealized gains or losses on fixed income investments will also decline as the securities approach maturity, or if the issuer is credit impaired. Unrealized gains or losses will be recognized in the statements of

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ENTERPRISE BANCORP, INC.
Notes to the Unaudited Consolidated Financial Statements (continued)

income if the securities are sold. However, if an unrealized loss on the fixed income portfolio is deemed to be other than temporary, the credit loss portion is charged to earnings and the noncredit portion is recognized in accumulated other comprehensive income. Net unrealized appreciation and depreciation on investments available for sale, net of applicable income taxes, are reflected as a component of accumulated other comprehensive income.

The net unrealized gain or loss on equity securities will fluctuate based on changes in the market value of the mutual funds and individual securities held in the portfolio.  Unrealized gains or losses will be recognized in the statements of income if the securities are sold. However, if an unrealized loss on an equity security is deemed to be other than temporary prior to a sale, the loss is charged to earnings.

Management regularly reviews the portfolio for securities with unrealized losses that are other-than-temporarily impaired.  During the six months ended June 30, 2013 and 2012, the Company did not record any fair value impairment charges on its investments. As of June 30, 2013, there were a total of 64 investments (fixed income and equity, excluding CDs), with a fair market value of $71.6 million, in an unrealized loss position totaling $1.6 million. The Company attributes these unrealized losses to increases in current market yields since the date the underlying securities were purchased and does not consider these investments to be other-than-temporarily impaired at June 30, 2013, because the decline in market value is not attributable to credit quality for fixed income securities, or a fundamental deterioration in the equity fund or issuers, and because the Company does not intend to, and it is more likely than not that it will not be required to, sell those investments prior to a market price recovery or maturity.  

In assessing MBS investments and Federal Agency obligations, the contractual cash flows of these investments are guaranteed by an agency of the U.S. Government, and the agency that issued these securities is sponsored by the U.S. Government. Accordingly, it is expected that the securities would not be settled at a price less than the par value of the Company's investments. Management's assessment of other fixed income investments within the portfolio includes reviews of market pricing, ongoing credit quality evaluations, assessment of the investment's materiality, and duration of the unrealized loss position. In addition, the Company utilizes an outside registered investment adviser to manage the corporate and municipal bond portfolios, within prescribed guidelines set by management. At June 30, 2013 the Company's corporate and municipal bond portfolios did not contain any securities below investment grade, as reported by major credit rating agencies. For equities and funds, management's assessment includes the severity of the declines, whether it is unlikely that the security or fund will completely recover its unrealized loss within a reasonable time period and if the equity security or fund exhibits fundamental deterioration.

The small portion of the portfolio invested in short-term CDs was also in an unrealized loss position at June 30, 2013 due to market rates. The unrealized loss was not considered to be material and the securities are expected to be settled at par value at maturity.

The contractual maturity distribution at June 30, 2013 of total fixed income investments, excluding CDs which mature in less than one year, is as follows:

 
Within One Year
 
After One, But Within 
Five Years
 
After Five, But within
Ten Years
 
After Ten Years
 
Amortized
Cost
 
Yields
 
Amortized
Cost
 
Yields
 
Amortized
Cost
 
Yields
 
Amortized
Cost
 
Yields
At amortized cost:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Federal agency obligations
$
15,502

 
0.76
%
 
$
49,609

 
0.92
%
 
$

 
%
 
$

 
%
MBS

 
%
 
49

 
1.54
%
 
11,150

 
3.00
%
 
41,364

 
1.80
%
Municipal securities
2,226

 
2.53
%
 
15,250

 
2.83
%
 
31,841

 
4.32
%
 
6,905

 
6.78
%
Corporate bonds

 
%
 
2,389

 
1.87
%
 
1,397

 
2.47
%
 

 
%
Total fixed income securities
$
17,728

 
0.98
%
 
$
67,297

 
1.39
%
 
$
44,388

 
3.93
%
 
$
48,269

 
2.51
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
At fair value:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total fixed income securities
$
17,794

 
 
 
$
67,696

 
 
 
$
45,488

 
 
 
$
47,845

 
 


11

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ENTERPRISE BANCORP, INC.
Notes to the Unaudited Consolidated Financial Statements (continued)

Scheduled contractual maturities may not reflect the actual maturities of the investments. MBS/CMOs are shown at their final maturity. However, due to prepayments and amortization the actual MBS/CMO cash flows may be faster than presented above. Similarly, included in the carrying value of fixed income investments above are callable securities, comprised of municipal securities, federal agency obligations and corporate bonds totaling $46.0 million, which can be redeemed by the issuer prior to the maturity presented above.  Management considers these factors when evaluating the net interest margin in the Company’s asset-liability management program.

See Note 12, “Fair Value Measurements” below for further information regarding the Company’s fair value measurements for available-for-sale securities.

From time to time the Company may pledge securities as collateral against deposit account balances of municipal deposit customers, for Federal Home Loan Bank of Boston ("FHLB") borrowing capacity and as collateral for borrowing from the Federal Reserve Bank of Boston ("FRB").  The fair value of securities pledged as collateral for these purposes was $173.8 million at June 30, 2013

(5)
Restricted Investments
 
As a member of the FHLB, the Company is required to purchase certain levels of FHLB capital stock in association with the Company’s borrowing relationship from the FHLB.  This stock is classified as a restricted investment and carried at cost, which management believes approximates fair value.  FHLB stock represents the only restricted investment held by the Company.
 
Based on management’s ongoing review, the Company has not recorded any other-than-temporary impairment charges on this investment to date. However, if negative events or deterioration in the FHLB financial condition or capital levels occurs, the Company’s investment in FHLB capital stock may become other-than-temporarily impaired to some degree. 

(6)
Loans
 
Major classifications of loans at the periods indicated, are as follows:
 
(Dollars in thousands)
 
June 30,
2013
 
December 31,
2012
Real estate:
 
 

 
 

Commercial real estate
 
$
785,994

 
$
710,265

Commercial construction
 
116,348

 
121,367

Residential mortgages
 
122,704

 
120,278

Total real estate
 
1,025,046

 
951,910

Commercial and industrial
 
343,509

 
328,579

Home equity
 
74,639

 
75,648

Consumer
 
5,649

 
4,911

Gross loans
 
1,448,843

 
1,361,048

Deferred loan origination fees, net
 
(1,497
)
 
(1,393
)
Total loans
 
1,447,346

 
1,359,655

Allowance for loan losses
 
(25,671
)
 
(24,254
)
Net loans
 
$
1,421,675

 
$
1,335,401

 
The Company specializes in lending to business entities, non-profit organizations, professionals and individuals. The Company’s primary lending focus is on the development of high quality commercial relationships achieved through active business development efforts, long-term relationships with established commercial developers, strong community involvement and focused marketing strategies.  Loans made to businesses include commercial mortgage loans, construction and land development loans, secured and unsecured commercial loans and lines of credit, and standby letters of credit.  The Company also originates equipment lease financing for businesses. Loans made to individuals include conventional residential mortgage loans, home equity loans and lines, residential construction loans on primary and secondary residences, and secured and

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ENTERPRISE BANCORP, INC.
Notes to the Unaudited Consolidated Financial Statements (continued)

unsecured personal loans and lines of credit (see Note 7, "Allowance for Loan Losses," for additional information on the Company's credit risk management).
 
Loan Categories
 
- Commercial loans:

Commercial real estate loans include loans secured by both owner-use and non-owner occupied real estate.  These loans are typically secured by a variety of commercial and industrial property types including one-to-four and multi-family apartment buildings, office or mixed-use facilities, strip shopping centers, or other commercial property and are generally guaranteed by the principals of the borrower. Commercial real estate loans generally have repayment periods of approximately fifteen to twenty-five years.  Variable interest rate loans have a variety of adjustment terms and indices, and are generally fixed for an initial period before periodic rate adjustments begin.
 
Commercial and industrial loans include seasonal revolving lines of credit, working capital loans, equipment financing (including equipment leases), and term loans.  Also included in commercial and industrial loans are loans partially guaranteed by the Small Business Administration (SBA), loans under various programs issued in conjunction with the Massachusetts Development Finance Agency and other agencies.  Commercial and industrial credits may be unsecured loans and lines to financially strong borrowers, secured in whole or in part by real estate unrelated to the principal purpose of the loan or secured by inventories, equipment, or receivables, and are generally guaranteed by the principals of the borrower.  Variable rate loans and lines in this portfolio have interest rates that are periodically adjusted, with loans generally having fixed initial periods.  Commercial and industrial loans have average repayment periods of one to seven years.
 
Commercial construction loans include the development of residential housing and condominium projects, the development of commercial and industrial use property, and loans for the purchase and improvement of raw land.  These loans are secured in whole or in part by the underlying real estate collateral and are generally guaranteed by the principals of the borrowers.  The Company limits the amount of financing provided to any single developer for the construction of properties built on a speculative basis.  Funds for construction projects are disbursed as pre-specified stages of construction are completed.  Regular site inspections are performed, either by experienced construction lenders on staff or by independent outside inspection companies, at each construction phase, prior to advancing additional funds.  Commercial construction loans generally are variable rate loans and lines with interest rates that are periodically adjusted and generally have terms of one to three years.

From time to time, the Company participates with other banks in the financing of certain commercial projects.  In some cases, the Company may act as the lead lender, originating and servicing the loans, but participating out a portion of the funding to other banks.  In other cases, the Company may participate in loans originated by other institutions. In each case, the participating bank funds a percentage of the loan commitment and takes on the related risk.  In each case in which the Company participates in a loan, the rights and obligations of each participating bank are divided proportionately among the participating banks in an amount equal to their share of ownership and with equal priority among all banks.  The balances participated out to other institutions are not carried as assets on the Company’s financial statements.  Loans originated by other banks in which the Company is the participating institution are carried in the loan portfolio at the Company’s pro rata share of ownership.  The Company performs an independent credit analysis of each commitment and a review of the participating institution prior to participation in the loan.  Loans originated by other banks in which the Company is the participating institution amounted to $35.5 million at June 30, 2013 and $28.6 million at December 31, 2012.
 
Standby letters of credit are conditional commitments issued by the Company to guarantee the financial obligation or performance by a customer to a third party.  The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers.  If the letter of credit is drawn upon, a loan is created for the customer, generally a commercial loan, with the same criteria associated with similar commercial loans.
 
- Residential loans:

Enterprise originates conventional mortgage loans on one-to-four family residential properties.  These properties may serve as the borrower’s primary residence, vacation homes, or investment properties.  Loan to value limits vary, generally from 80% for adjustable rate and multi-family, owner occupied properties, up to 97% for fixed rate loans on single family, owner occupied properties, with mortgage insurance coverage required for loan-to-value ratios greater than 80% based on program parameters.  In addition, financing is provided for the construction of owner occupied primary and secondary residences.  Residential

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ENTERPRISE BANCORP, INC.
Notes to the Unaudited Consolidated Financial Statements (continued)

mortgage loans may have terms of up to 30 years at either fixed or adjustable rates of interest.  Fixed and adjustable rate residential mortgage loans are generally originated using secondary market underwriting and documentation standards.
 
Depending on the current interest rate environment, management projections of future interest rates and the overall asset-liability management program of the Company, management may elect to sell those fixed and adjustable rate residential mortgage loans which are eligible for sale in the secondary market, or hold some or all of this residential loan production for the Company’s portfolio.  Mortgage loans are generally not pooled for sale, but instead sold on an individual basis. The Company may retain or sell the servicing when selling the loans.  All loans sold are currently sold without recourse, but are typically subject to standard secondary market underwriting and eligibility representations and warranties and are subject to an early payment default period covering the first four payments for certain loan sales. Loans classified as held for sale are carried as a separate line item on the balance sheet.
 
- Home equity loans and lines of credit:

Home equity term loans are originated for one-to-four family residential properties with maximum original loan to value ratios generally up to 80% of the assessed or appraised value of the property securing the loan.  Home equity loan payments consist of monthly principal and interest based on amortization ranging from three to fifteen years.  The rates may also be fixed for three to fifteen years, before periodic rate adjustments begin.
 
The Company originates home equity revolving lines of credit for one-to-four family residential properties with maximum original loan to value ratios generally up to 80% of the appraised value of the property securing the loan.  Home equity lines generally have interest rates that adjust monthly based on changes in the Prime Rate, although minimum rates may be applicable.  Some home equity line rates may be fixed for a period of time and then adjusted monthly thereafter. The payment schedule for home equity lines requires interest only payments for the first ten years of the lines. Generally at the end of ten years, the line may be frozen to future advances, and principal plus interest payments are collected over a fifteen-year amortization schedule or, for eligible borrowers meeting certain requirements, the line availability may be extended for an additional interest only period.
 
- Consumer loans:

Consumer loans primarily consist of secured or unsecured personal loans and overdraft protection lines on checking accounts extended to individual customers. The aggregate amount of overdrawn deposit accounts are reclassified as loan balances.
 
Loans serviced for others
 
At June 30, 2013 and December 31, 2012, the Company was servicing residential mortgage loans owned by investors amounting to $21.5 million and $22.2 million, respectively.  Additionally, the Company was servicing commercial loans participated out to various other institutions amounting to $53.9 million and $53.6 million at June 30, 2013 and December 31, 2012, respectively. See the discussion above for further information regarding commercial participations.
 
Loans serving as collateral
 
Loans designated as qualified collateral and pledged to the FHLB for borrowing capacity are summarized below:

(Dollars in thousands)
June 30,
2013
 
December 31,
2012
Commercial real estate
$
205,210

 
$
216,080

Residential mortgages
88,836

 
94,552

Home equity
18,009

 
18,907

Total loans pledged to FHLB
$
312,055

 
$
329,539




14

Table of Contents
ENTERPRISE BANCORP, INC.
Notes to the Unaudited Consolidated Financial Statements (continued)

(7)
Allowance for Loan Loss
 
The Company manages its loan portfolio to avoid concentration by industry and loan size to minimize its credit risk exposure. In addition, the Company does not have a “sub-prime” mortgage program.  However, inherent in the lending process is the risk of loss due to customer non-payment, or “credit risk.” While the Company endeavors to minimize this risk through the credit risk management function, management recognizes that loan losses will occur and that the amount of these losses will fluctuate depending on the risk characteristics of the loan portfolio and economic conditions.

Credit Quality Indicators

The level of adversely classified loans, delinquent and non-performing assets is largely a function of economic conditions, the overall banking environment, and the Company's underwriting, and credit risk management standards. The Company’s commercial lending focus may entail significant additional risks compared to long term financing on existing, owner-occupied residential real estate.  The Company endeavors to minimize this risk through sound underwriting practices and the risk management function. The credit risk management function focuses on a wide variety of factors, including, among others, current and expected economic conditions, the real estate market, the financial condition of borrowers, the ability of borrowers to adapt to changing conditions or circumstances affecting their business and the continuity of borrowers’ management teams.  Early detection of credit issues is critical to minimize credit losses. Accordingly, management regularly monitors these factors, among others, through ongoing credit reviews by the Credit Department, an external loan review service, reviews by members of senior management and the Loan Committee of the Board of Directors. This review includes the assessment of internal credit quality indicators such as the risk classification of individual loans, adversely classified loans, past due and non-accrual loans, impaired and restructured loans, and the level of foreclosure activity. However, despite prudent loan underwriting and ongoing credit risk management, adverse changes within the Company's market area or deterioration in the local, regional or national economic conditions could negatively impact the portfolio's credit risk profile and the Company's asset quality in the future.

The loan portfolio continued to show improving statistics related to migration of adversely classified, non-accrual, impaired loans and the level of Other Real Estate Owned ('"OREO") properties held during the quarter ended June 30, 2013. However, management believes that the credit profile of the portfolio will continue to be affected by lagging effects that the economic environment has had on the regional and local commercial markets.

- Adversely Classified Loans

The Company’s loan risk rating system classifies loans depending on risk of loss characteristics.  The classifications range from “substantially risk free” for the highest quality loans and loans that are secured by cash collateral, to the more severe adverse classifications of “substandard,” “doubtful” and “loss” based on criteria established under banking regulations.
 
Loans classified as substandard include those loans characterized by the distinct possibility that the Company will sustain some loss if the deficiencies are not corrected.  These loans are inadequately protected by the sound net worth and paying capacity of the borrower; repayment has become increasingly reliant on collateral liquidation or reliance on guaranties; credit weaknesses are well-defined; borrower cash flow is insufficient to meet required debt service specified in loan terms and to meet other obligations, such as trade debt and tax payments.
 
Loans classified as doubtful have all the weaknesses inherent in a substandard rated loan with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.  The probability of loss is extremely high, but because of certain important and reasonably specific pending factors which may work to the advantage and strengthening of the loan, its classification as an estimated loss is deferred until more exact status may be determined.

Loans classified as loss are generally considered uncollectible at present, although long term recovery of part or all of loan proceeds may be possible.  These “loss” loans would require a specific loss reserve or charge-off.
 
Adversely classified loans may be accruing or in non-accrual status and may be additionally designated as impaired or restructured, or some combination thereof.  Loans which are evaluated to be of weaker credit quality are reviewed on a more frequent basis by management.
 

15

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ENTERPRISE BANCORP, INC.
Notes to the Unaudited Consolidated Financial Statements (continued)

The following tables present the credit risk profile by internally assigned risk rating category at the periods indicated. 
 
 
June 30, 2013
 
 
Adversely Classified
 
Not Adversely
 
 
(Dollars in thousands)
 
Substandard
 
Doubtful
 
Loss
 
Classified
 
Gross Loans
Commercial real estate
 
$
15,253

 
$

 
$

 
$
770,741

 
$
785,994

Commercial and industrial
 
6,012

 
500

 

 
336,997

 
343,509

Commercial construction
 
3,685

 

 

 
112,663

 
116,348

Residential
 
1,380

 

 

 
121,324

 
122,704

Home equity
 
696

 

 

 
73,943

 
74,639

Consumer
 
40

 

 

 
5,609

 
5,649

Total gross loans
 
$
27,066

 
$
500

 
$

 
$
1,421,277

 
$
1,448,843


 
 
 
December 31, 2012
 
 
Adversely Classified
 
Not Adversely
 
 
(Dollars in thousands)
 
Substandard
 
Doubtful
 
Loss
 
Classified
 
Gross Loans
Commercial real estate
 
$
21,999

 
$

 
$

 
$
688,266

 
$
710,265

Commercial and industrial
 
5,993

 
1,460

 
48

 
321,078

 
328,579

Commercial construction
 
2,986

 

 

 
118,381

 
121,367

Residential
 
1,254

 

 

 
119,024

 
120,278

Home equity
 
661

 

 

 
74,987

 
75,648

Consumer
 
34

 

 

 
4,877

 
4,911

Total gross loans
 
$
32,927

 
$
1,460

 
$
48

 
$
1,326,613

 
$
1,361,048


The decrease in adversely classified loans since the prior period was due primarily to paydowns on several commercial relationships, and upgraded commercial loans, in particular one larger commercial real estate relationship of approximately $6.0 million classified as accruing/impaired/Troubled Debt Restructure (or "TDR") at December 31, 2012 which was upgraded during the period, due to the borrower’s improved financial condition and sustained performance over time, partially offset by additional credit downgrades during the period.
 
- Past Due and Non-Accrual Loans
Loans on which the accrual of interest has been discontinued are designated as non-accrual loans.  Accrual of interest on loans is generally discontinued when a loan becomes contractually past due, with respect to interest or principal, by 90 days, or when reasonable doubt exists as to the full and timely collection of interest or principal. When a loan is placed on non-accrual status, all interest previously accrued but not collected is reversed against current period interest income. Interest accruals are resumed on such loans only when payments are brought current and have remained current for a period of 180 days and when, in the judgment of management, the collectability of both principal and interest is reasonably assured. Interest payments received on loans in a non-accrual status are generally applied to principal on the books of the Company. Additionally, deposit accounts overdrawn for 90 or more days are included in the consumer non-accrual numbers below.

16

Table of Contents
ENTERPRISE BANCORP, INC.
Notes to the Unaudited Consolidated Financial Statements (continued)

 The following tables present age analysis of past due loans as of the dates indicated. 
Balance at June 30, 2013
(Dollars in thousands)
 
Loans
30-59 Days
Past Due
 
Loans
60-89 Days
Past Due
 
Loans 90 or
More Days
Past Due (non-
accrual)
 
Total Past
Due Loans
 
Current Loans
 
Gross
Loans
Commercial real estate
 
$
1,921

 
$
183

 
$
12,645

 
$
14,749

 
$
771,245

 
$
785,994

Commercial and industrial
 
449

 
34

 
5,997

 
6,480

 
337,029

 
343,509

Commercial construction
 
727

 

 
1,442

 
2,169

 
114,179

 
116,348

Residential
 
1,500

 

 
995

 
2,495

 
120,209

 
122,704

Home equity
 
85

 

 
477

 
562

 
74,077

 
74,639

Consumer
 
10

 
9

 
14

 
33

 
5,616

 
5,649

Total gross loans
 
$
4,692

 
$
226

 
$
21,570

 
$
26,488

 
$
1,422,355

 
$
1,448,843



 
Balance at December 31, 2012
(Dollars in thousands)
 
Loans
30-59 Days
Past Due
 
Loans
60-89 Days
Past Due
 
Loans 90 or
More Days
Past Due (non-
accrual)
 
Total Past
Due Loans
 
Current Loans
 
Gross Loans
Commercial real estate
 
$
1,560

 
$
551

 
$
12,608

 
$
14,719

 
$
695,546

 
$
710,265

Commercial and industrial
 
472

 
55

 
6,993

 
7,520

 
321,059

 
328,579

Commercial construction
 

 

 
743

 
743

 
120,624

 
121,367

Residential
 
42

 
558

 
862

 
1,462

 
118,816

 
120,278

Home equity
 
73

 
9

 
390

 
472

 
75,176

 
75,648

Consumer
 
42

 
11

 
5

 
58

 
4,853

 
4,911

Total gross loans
 
$
2,189

 
$
1,184

 
$
21,601

 
$
24,974

 
$
1,336,074

 
$
1,361,048

 
At June 30, 2013 and December 31, 2012, all loans 90 or more days past due were carried as non-accruing. Included in the consumer non-accrual numbers in the table above were $8 thousand and $5 thousand of overdraft deposit account balances 90 days or more past due at June 30, 2013 and December 31, 2012, respectively. Total non-performing loans amounted to $21.6 million at both June 30, 2013 and December 31, 2012. Non-accrual loans which were not adversely classified amounted to $1.1 million at June 30, 2013 and $1.2 million at December 31, 2012. These balances primarily represented the guaranteed portions of non-performing Small Business Administration loans. The majority of the non-accrual loan balances were also carried as impaired loans during the periods noted, and are discussed further below. The increase in loans 30-59 days past due occurred primarily within the residential portfolio, due to a single large balance mortgage which was subsequently brought current, and in the commercial real estate and construction portfolios, with the majority of these loans just 30 days overdue at June 30, 2013.

The ratio of non-accrual loans to total loans amounted to 1.49% at June 30, 2013, 1.59% at December 31, 2012, and 1.93% at June 30, 2012.
 
At June 30, 2013, additional funding commitments for loans on non-accrual status totaled $592 thousand. The Company’s obligation to fulfill the additional funding commitments on non-accrual loans is generally contingent on the borrower’s compliance with the terms of the credit agreement. If the borrower is not in compliance, additional funding commitments may be made at the Company’s discretion.
 
- Impaired Loans
 
Impaired loans are individually significant loans for which management considers it probable that not all amounts due (principal and interest) in accordance with the original contractual terms will be collected.  The majority of impaired loans are included within the non-accrual balances; however, not every loan in non-accrual status has been designated as impaired. 

17

Table of Contents
ENTERPRISE BANCORP, INC.
Notes to the Unaudited Consolidated Financial Statements (continued)

Impaired loans include loans that have been modified in a troubled debt restructuring (see below).  Impaired loans exclude large groups of smaller-balance homogeneous loans, such as residential mortgage loans and consumer loans, which are collectively evaluated for impairment and loans that are measured at fair value, unless the loan is amended in a TDR. 

Management does not set any minimum delay of payments as a factor in reviewing for impaired classification.  Management considers the individual payment status, net worth and earnings potential of the borrower, and the value and cash flow of the collateral as factors to determine if a loan will be paid in accordance with its contractual terms.
 
Impaired loans are individually evaluated for credit loss and a specific reserve is assigned for the amount of the estimated credit loss.  Refer to heading “Allowance for probable loan losses methodology” contained in Note 5 “Allowance For Loan Losses,” to the Company’s consolidated financial statements contained in the Company’s 2012 Annual Report on Form 10-K for further discussion of management’s methodology used to estimate specific reserves for impaired loans.
 
Total impaired loans amounted to $29.3 million and $37.4 million, at June 30, 2013 and December 31, 2012, respectively.  Total accruing impaired loans amounted to $8.6 million and $16.6 million at June 30, 2013 and December 31, 2012, respectively, while non-accrual impaired loans amounted to $20.7 million and $20.8 million as of June 30, 2013 and December 31, 2012, respectively.  The decrease was primarily due to the changes discussed above under the heading "Adversely Classified Loans."
 
The following tables set forth the recorded investment in impaired loans and the related specific allowance allocated as of the dated indicated.
 
Balance at June 30, 2013
(Dollars in thousands)
 
Unpaid
contractual
principal balance
 
Total recorded
investment in
impaired loans
 
Recorded
investment
with no
allowance
 
Recorded
investment
with
allowance
 
Related
allowance
Commercial real estate
 
$
18,212

 
$
16,245

 
$
11,873

 
$
4,372

 
$
915

Commercial and industrial
 
10,534

 
9,235

 
4,293

 
4,942

 
2,302

Commercial construction
 
3,034

 
2,916

 
986

 
1,930

 
739

Residential
 
846

 
799

 
377

 
422

 
163

Home equity
 
110

 
109

 

 
109

 
36

Consumer
 
19

 
19

 

 
19

 
19

Total
 
$
32,755

 
$
29,323

 
$
17,529

 
$
11,794

 
$
4,174



Balance at December 31, 2012
(Dollars in thousands)
 
Unpaid
contractual
principal balance
 
Total recorded
investment in
impaired loans
 
Recorded
investment
with no
allowance
 
Recorded
investment
with
allowance
 
Related
allowance
Commercial real estate
 
$
24,760

 
$
22,859

 
$
18,735

 
$
4,124

 
$
1,041

Commercial and industrial
 
12,184

 
10,831

 
6,016

 
4,815

 
2,186

Commercial construction
 
3,091

 
2,932

 
995

 
1,937

 
753

Residential
 
687

 
648

 
390

 
258

 
65

Home equity
 
110

 
109

 

 
109

 
87

Consumer
 
14

 
14

 

 
14

 
14

Total
 
$
40,846

 
$
37,393

 
$
26,136

 
$
11,257

 
$
4,146



18

Table of Contents
ENTERPRISE BANCORP, INC.
Notes to the Unaudited Consolidated Financial Statements (continued)

The following table presents the average recorded investment in impaired loans and the related interest recognized during the three month periods indicated.



 
 
Three Months Ended
June 30, 2013
 
Three Months Ended
June 30, 2012
(Dollars in thousands)
 
Average recorded
investment
 
Interest income
recognized
 
Average recorded
investment
 
Interest income
recognized
Commercial real estate
 
$
17,868

 
$
51

 
$
24,378

 
$
186

Commercial and industrial
 
9,252

 
24

 
9,806

 
68

Commercial construction
 
2,906

 
9

 
2,092

 
(4
)
Residential
 
804

 
3

 
722

 
5

Home equity
 
109

 

 
50

 
(1
)
Consumer
 
19

 

 
17

 

Total
 
$
30,958

 
$
87

 
$
37,065

 
$
254

 
 
 
 
 
 
 
 
 


The following table presents the average recorded investment in impaired loans and the related interest recognized during the six month periods indicated.
 
 
Six Months Ended June 30, 2013
 
Six Months Ended June 30, 2012
(Dollars in thousands)
 
Average recorded
investment
 
Interest income
recognized
 
Average recorded
investment
 
Interest income
recognized
Commercial real estate
 
$
20,155

 
$
149

 
$
24,281

 
$
310

Commercial and industrial
 
9,427

 
54

 
10,213

 
86

Commercial construction
 
2,902

 
33

 
2,054

 
17

Residential
 
807

 
4

 
698

 
5

Home equity
 
124

 

 
50

 

Consumer
 
16

 

 
17

 
1

Total
 
$
33,431

 
$
240

 
$
37,313

 
$
419


At June 30, 2013, additional funding commitments for impaired loans totaled $592 thousand. The Company's obligation to fulfill the additional funding commitments on impaired loans is generally contingent on the borrower's compliance with the terms of the credit agreement. If the borrower is not in compliance, additional funding commitments may be made at the Company's discretion.
 
- Troubled Debt Restructures
 
Loans are designated as a TDR when, as part of an agreement to modify the original contractual terms of the loan, the Bank grants a concession on the terms, that would not otherwise be considered, as a result of financial difficulties of the borrower.  Typically, such concessions may consist of a reduction in interest rate to a below market rate, taking into account the credit quality of the note, or a deferment or reduction of payments (principal or interest) which materially alters the Bank’s position or significantly extends the note’s maturity date, such that the present value of cash flows to be received is materially less than those contractually established at the loan’s origination. All loans that are modified are reviewed by the Company to identify if a TDR has occurred. TDR loans are included in the impaired loan category and, as such, these loans are individually evaluated and a specific reserve is assigned for the amount of the estimated credit loss. 

Total TDR loans, included in the impaired loan figures above as of June 30, 2013 and December 31, 2012 were $18.9 million and $26.6 million, respectively.
 

19

Table of Contents
ENTERPRISE BANCORP, INC.
Notes to the Unaudited Consolidated Financial Statements (continued)

TDR loans on accrual status amounted to $8.1 million and $16.0 million at June 30, 2013 and December 31, 2012, respectively. During the current quarter, an accruing TDR commercial real estate relationship of approximately $6.0 million was upgraded and removed from impaired/TDR status, due to the borrower’s improved financial condition and sustained performance over time. TDR loans included in non-performing loans amounted to $10.8 million and $10.5 million at June 30, 2013 and December 31, 2012, respectively. The Company continues to work with commercial relationships and enters into loan modifications to the extent deemed to be necessary or appropriate to ensure the best mutual outcome given the current economic environment.

Troubled debt restructure agreements entered into during the three month period ended June 30, 2013 

 
 
Three months ended June 30, 2013
(Dollars in thousands)
 
Number of
restructurings
 
Pre-modification
outstanding recorded
investment
 
Post-modification
outstanding recorded
investment
Commercial real estate
 

 
$

 
$

Commercial and industrial
 
1

 
100

 
62

Commercial construction
 

 

 

Residential
 

 

 

Home equity
 

 

 

Consumer
 

 

 

Total
 
1

 
$
100

 
$
62




Loans modified as troubled debt restructuring within the previous twelve months for which there was a subsequent payment default during the period noted are detailed below.
 
 
Three months ended June 30, 2013
(Dollars in thousands)
 
Number of TDR’s
that defaulted
 
Post-modification outstanding
recorded investment 
Commercial real estate
 

 
$

Commercial and industrial
 

 

Commercial construction
 
2

 
715

Residential
 

 

Home equity
 

 

Consumer
 

 

Total
 
2

 
$
715



  

20

Table of Contents
ENTERPRISE BANCORP, INC.
Notes to the Unaudited Consolidated Financial Statements (continued)

Troubled debt restructure agreements entered into during the six month period ended June 30, 2013

 
 
Six months ended June 30, 2013
(Dollars in thousands)
 
Number of
restructurings
 
Pre-modification
outstanding recorded
investment
 
Post-modification
outstanding recorded
investment
Commercial real estate
 

 
$

 
$

Commercial and industrial
 
1

 
100

 
62

Commercial construction
 

 

 

Residential
 

 

 

Home equity
 

 

 

Consumer
 

 

 

Total
 
1

 
$
100

 
$
62



Loans modified as troubled debt restructuring within the previous twelve months for which there was a subsequent payment default during the period noted are detailed below.
 
 
Six months ended June 30, 2013
(Dollars in thousands)
 
Number of TDR’s
that defaulted
 
Post-modification outstanding
recorded investment 
Commercial real estate
 
1

 
$
137

Commercial and industrial
 

 

Commercial construction
 
3

 
746

Residential
 

 

Home equity
 

 

Consumer
 

 

Total
 
4

 
$
883

 

There were $38 thousand in charge-offs associated with the TDRs, noted in the table above, during the six months ended June 30, 2013. Included in the table above were two TDR's modified during the previous twelve months which defaulted and were subsequently transferred to OREO during the current period with a total post modification outstanding balance of $167 thousand. At June 30, 2013, specific reserves allocated to the TDRs entered into during the 2013 period amounted to $1 thousand, as management considered it likely the principal would ultimately be collected.



21

Table of Contents
ENTERPRISE BANCORP, INC.
Notes to the Unaudited Consolidated Financial Statements (continued)

Troubled debt restructure agreements entered into during the three month period ended June 30, 2012

 
 
Three months ended June 30, 2012
(Dollars in thousands)
 
Number of
restructurings
 
Pre-modification
outstanding recorded
investment
 
Post-modification
outstanding recorded
investment
Commercial real estate
 

 
$

 
$

Commercial and industrial
 
2

 
16

 
12

Commercial construction
 

 

 

Residential
 

 

 

Home equity
 

 

 

Consumer
 

 

 

Total
 
2

 
$
16

 
$
12

 

Loans modified as troubled debt restructuring within the previous twelve months for which there was a subsequent payment default during the period noted are detailed below.
 
 
Three months ended June 30, 2012
(Dollars in thousands)
 
Number of TDR's that defaulted
 
Post-
modification outstanding
recorded investment
Commercial real estate
 

 
$

Commercial and industrial
 
2

 
12

Commercial construction
 

 

Residential
 

 

Home Equity
 

 

Consumer
 

 

Total
 
2

 
$
12



Troubled debt restructure agreements entered into during six month the period ended June 30, 2012
 
 
Six months ended June 30, 2012
(Dollars in thousands)
 
Number of
restructurings
 
Pre-modification
outstanding recorded
investment
 
Post-modification
outstanding recorded
investment
Commercial real estate
 

 
$

 
$

Commercial and industrial
 
5

 
126

 
123

Commercial construction
 

 

 

Residential
 
1

 
130

 
128

Home equity
 

 

 

Consumer
 

 

 

Total
 
6

 
$
256

 
$
251

 


22

Table of Contents
ENTERPRISE BANCORP, INC.
Notes to the Unaudited Consolidated Financial Statements (continued)

Loans modified as troubled debt restructuring within the previous twelve months for which there was a subsequent payment default during the period noted are detailed below.



Six months ended June 30, 2012
(Dollars in thousands)

Number of TDR's that defaulted

Post-
modification outstanding
recorded investment
Commercial real estate



$

Commercial and industrial

3


17

Commercial construction




Residential

1


128

Home Equity




Consumer




Total

4


$
145


There were no charge-offs associated with the TDRs noted in the tables above during the six months ended June 30, 2012.  At June 30, 2012, specific reserves allocated to the TDRs entered into during the 2012 period amounted to $31 thousand, as management considered it likely the principal would ultimately be collected. Interest payments received on non-accruing new 2012 TDR loans which were applied to principal and not recognized as interest income amounted to $3 thousand for the six months ended June 30, 2012.

Other Real Estate Owned

Real estate acquired by the Company through foreclosure proceedings or the acceptance of a deed in lieu of foreclosure is classified as OREO. When property is acquired, it is generally recorded at the lesser of the loan’s remaining principal balance, net of any unamortized deferred fees, or the estimated fair value of the property acquired, less estimated costs to sell. Any loan balance in excess of the estimated realizable fair value on the date of transfer is charged to the allowance for loan losses on that date. All costs incurred thereafter in maintaining the property, as well as subsequent declines in fair value are charged to non-interest expense.

The carrying value of OREO at June 30, 2013 was $136 thousand and consisted of 1 property, compared to $500 thousand comprised of 1 property at December 31, 2012. During the six months ended June 30, 2013, 2 properties were sold, 1 of which was held at December 31, 2012, and 2 properties were added to OREO. There was $121 thousand of gains realized on the sale of OREO in 2013. There were $45 thousand gains on OREO sales during the six months ended June 30, 2012.
 
Allowance for probable loan losses methodology
 
On a quarterly basis, management prepares an estimate of the allowance necessary to cover estimated credit losses.  The Company maintains the allowance at a level that it deems adequate to absorb all reasonably anticipated losses from specifically known and other credit risks associated with the portfolio.  The Company uses a systematic methodology to measure the amount of estimated loan loss exposure inherent in the portfolio for purposes of establishing a sufficient allowance for loan losses.  The methodology makes use of specific reserves, for loans individually evaluated and deemed impaired and general reserves, for larger groups of homogeneous loans, which rely on a combination of qualitative and quantitative factors that could have an impact on the credit quality of the portfolio.
 
There have been no material changes in the Company’s underwriting practices, credit risk management system, or to the allowance assessment methodology used to estimate loan loss exposure as reported in the Company’s most recent Annual Report on Form 10-K.  Refer to heading “Allowance for probable loan losses methodology” contained in Note 5 “Allowance For Loan Losses,” to the Company’s consolidated financial statements contained in the Company’s 2012 Annual Report on Form 10-K for further discussion of management’s methodology used to estimate the loan loss exposure inherent in the portfolio for purposes of establishing a sufficient allowance.


23

Table of Contents
ENTERPRISE BANCORP, INC.
Notes to the Unaudited Consolidated Financial Statements (continued)

Allowance for loan loss activity
 
The allowance for loan losses is established through a provision for loan losses, a direct charge to earnings.  Loan losses are charged against the allowance when management believes that the collectability of the loan principal is unlikely.  Recoveries on loans previously charged-off are credited to the allowance.

During the fourth quarter of 2012, the Company purchased a group of residential mortgage loans with a June 30, 2013 carrying value of $17.2 million. These purchased loans are initially booked at fair market value and, in accordance with accounting guidance, do not carry an initial allowance for loan losses. Management will continue to closely monitor this portfolio of non classified loans for estimated credit loss under general loss allocations taking into account the loss experience as well as the quantitative and qualitative factors identified above.

The allowance for loan losses amounted to $25.7 million at June 30, 2013 compared to $24.3 million at December 31, 2012. The allowance for loan losses to total loans ratio was 1.77% at June 30, 2013 and 1.78% at December 31, 2012 compared to 1.79% at June 30, 2012.

Based on management’s judgment as to the existing credit risks inherent in the loan portfolio, as discussed above under the heading "Credit Quality Indicators," management believes that the Company’s allowance for loan losses is adequate to absorb probable losses from specifically known and other credit risks associated with the portfolio as of June 30, 2013.

Changes in the allowance for loan losses by segment for the three months ended June 30, 2013, are presented below:
 
(Dollars in thousands)
 
Cmml Real
Estate
 
Cmml and
Industrial
 
Cmml
Constr
 
Resid.
Mortgage
 
Home
Equity
 
Consumer
 
Total
Beginning Balance at March 31, 2013
 
$
12,359

 
$
7,396

 
$
3,486

 
$
975

 
$
672

 
$
128

 
$
25,016

Provision
 
614

 
207

 
(382
)
 
58

 
10

 
27

 
534

Recoveries
 
61

 
31

 
50

 

 

 
3

 
145

Less: Charge offs
 
14

 
1

 

 

 

 
9

 
24

Ending Balance at June 30, 2013
 
$
13,020

 
$
7,633

 
$
3,154

 
$
1,033

 
$
682

 
$
149

 
$
25,671



Changes in the allowance for loan losses by segment for the six months ended June 30, 2013, are presented below:
 
(Dollars in thousands)
 
Cmml Real
Estate
 
Cmml and
Industrial
 
Cmml
Constr
 
Resid.
Mortgage
 
Home
Equity
 
Consumer
 
Total
Beginning Balance at December 31, 2012
 
$
11,793

 
$
7,297

 
$
3,456

 
$
854

 
$
728

 
$
126

 
$
24,254

Provision
 
1,180

 
428

 
(352
)
 
51

 
(23
)
 
33

 
1,317

Recoveries
 
61

 
41

 
50

 
128

 
21

 
6

 
307

Less: Charge offs
 
14

 
133

 

 

 
44

 
16

 
207

Ending Balance at June 30, 2013
 
$
13,020

 
$
7,633

 
$
3,154

 
$
1,033

 
$
682

 
$
149

 
$
25,671

Ending allowance balance:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Allotted to loans individually evaluated for impairment
 
$
915

 
$
2,302

 
$
739

 
$
163

 
$
36

 
$
19

 
$
4,174

Allotted to loans collectively evaluated for impairment
 
$
12,105

 
$
5,331

 
$
2,415

 
$
870

 
$
646

 
$
130

 
$
21,497

 




24

Table of Contents
ENTERPRISE BANCORP, INC.
Notes to the Unaudited Consolidated Financial Statements (continued)

Changes in the allowance for loan losses by segment for the three months ended June 30, 2012, are presented below:
 
(Dollars in thousands)
 
Cmml Real
Estate
 
Cmml and
Industrial
 
Cmml
Constr
 
Resid.
Mortgage
 
Home
Equity
 
Consumer
 
Total
Beginning Balance at March 31, 2012
 
$
10,598

 
$
7,142

 
$
3,196

 
$
827

 
$
764

 
$
80

 
$
22,607

Provision
 
622

 
185

 
133

 
129

 
(43
)
 
24

 
1,050

Recoveries
 

 
146

 

 

 

 
2

 
148

Less: Charge offs
 
223

 
268

 

 
182

 

 
6

 
679

Ending Balance at June 30, 2012
 
$
10,997

 
$
7,205

 
$
3,329

 
$
774

 
$
721

 
$
100

 
$
23,126


Changes in the allowance for loan losses by segment for the six months ended June 30, 2012, are presented below:
 
(Dollars in thousands)
 
Cmml Real
Estate
 
Cmml and
Industrial
 
Cmml
Constr
 
Resid.
Mortgage
 
Home
Equity
 
Consumer
 
Total
Beginning Balance at December 31, 2011
 
$
10,855

 
$
7,568

 
$
3,013

 
$
995

 
$
615

 
$
114

 
$
23,160

Provision
 
365

 
510

 
414

 
(39
)
 
105

 
(5
)
 
1,350

Recoveries
 

 
192

 
2

 

 
1

 
3

 
198

Less: Charge offs
 
223

 
1,065

 
100

 
182

 

 
12

 
1,582

Ending Balance at June 30, 2012
 
$
10,997

 
$
7,205

 
$
3,329

 
$
774

 
$
721

 
$
100

 
$
23,126

Ending allowance balance:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Allotted to loans individually evaluated for impairment
 
$
819

 
$
2,001

 
$
670

 
$
27

 
$
50

 
$
16

 
$
3,583

Allotted to loans collectively evaluated for impairment
 
$
10,178

 
$
5,204

 
$
2,659

 
$
747

 
$
671

 
$
84

 
$
19,543

 


The balances of loans as of June 30, 2013 by segment and evaluation method are summarized as follows: 
(Dollars in thousands)
 
Loans individually
evaluated for
impairment
 
Loans collectively
evaluated for
impairment
 
Total Loans
Commercial real estate
 
$
16,245

 
$
769,749

 
$
785,994

Commercial and industrial
 
9,235

 
334,274

 
343,509

Commercial construction
 
2,916

 
113,432

 
116,348

Residential
 
799

 
121,905

 
122,704

Home equity
 
109

 
74,530

 
74,639

Consumer
 
19

 
5,630

 
5,649

Deferred Fees
 

 
(1,497
)
 
(1,497
)
Total loans
 
$
29,323

 
$
1,418,023

 
$
1,447,346

 







25

Table of Contents
ENTERPRISE BANCORP, INC.
Notes to the Unaudited Consolidated Financial Statements (continued)

The balances of loans as of December 31, 2012 by segment and evaluation method are summarized as follows:
(Dollars in thousands)
 
Loans individually
evaluated for
impairment
 
Loans collectively
evaluated for
impairment
 
Total Loans
Commercial real estate
 
$
22,859

 
$
687,406

 
$
710,265

Commercial and industrial
 
10,831

 
317,748

 
328,579

Commercial construction
 
2,932

 
118,435

 
121,367

Residential
 
648

 
119,630

 
120,278

Home equity
 
109

 
75,539

 
75,648

Consumer
 
14

 
4,897

 
4,911

Deferred Fees
 

 
(1,393
)
 
(1,393
)
Total loans
 
$
37,393

 
$
1,322,262

 
$
1,359,655


(8)
Supplemental Retirement Plan and Other Postretirement Benefit Obligations
 
Supplemental Retirement Plan (SERPs)
 
The Company has salary continuation agreements with two of its active executive officers, and one former executive officer who currently works on a part time basis. These agreements provide for predetermined fixed-cash supplemental retirement benefits to be provided for a period of 20 years after each individual reaches a defined “benefit age.” The Company has not recognized service cost in the current or prior year as each officer had previously attained their individually defined benefit age and was fully vested under the plan.

This non-qualified plan represents a direct liability of the Company, and as such has no specific assets set aside to settle the benefit obligation.  The funded status is the aggregate amount accrued, or the “Accumulated Benefit Obligation,” which is equal to the present value of the benefits to be provided to the employee or any beneficiary in exchange for the employee’s service rendered to that date.  Because the Company’s benefit obligations provide for predetermined fixed-cash payments, the Company does not have any unrecognized costs to be included as a component of accumulated other comprehensive income.

Total net periodic benefit cost, which was comprised of interest cost only, was $34 thousand for the three months ended June 30, 2013 compared to $38 thousand for the three months ended June 30, 2012, and $67 thousand for the six months ended June 30, 2013 compared to $76 thousand for the six months ended June 30, 2012.

Benefits paid amounted to $69 thousand and $138 thousand for both the three and six months ended June 30, 2013 and June 30, 2012, respectively. The Company anticipates accruing an additional $67 thousand to the plan during the remainder of 2013.

Supplemental Life Insurance
 
For certain senior and executive officers on whom the Bank owns bank owned life insurance ("BOLI"), the Company has provided supplemental life insurance which provides a death benefit to the officer’s designated beneficiaries.

The Company has recognized a liability for future benefits associated with an endorsement split-dollar life insurance arrangement that provides a benefit to an employee that extends to postretirement periods.
 
This non-qualified plan represents a direct liability of the Company, and as such has no specific assets set aside to settle the benefit obligation.  The funded status is the aggregate amount accrued, or the “Accumulated Postretirement Benefit Obligation,” which is the present value of the post retirement benefits associated with this arrangement.


26

Table of Contents
ENTERPRISE BANCORP, INC.
Notes to the Unaudited Consolidated Financial Statements (continued)

The following table illustrates the net periodic post retirement benefit cost for the supplemental life insurance plans for the periods indicated:
 
 
 
Three months ended June 30,
 
Six months ended June 30,
(Dollars in thousands)
 
2013
 
2012
 
2013
 
2012
Service Cost
 
$
1

 
$
1

 
$
1

 
$
3

Interest Cost
 
17

 
17

 
35

 
34

Net periodic post retirement benefit cost
 
$
18

 
$
18

 
$
36

 
$
37

 
(9)
Stock-Based Compensation
 
The Company has individual stock incentive plans and has not changed the general terms and conditions of these plans from those disclosed in the Company’s 2012 Annual Report on Form 10-K.
 
The Company’s stock-based compensation expense includes stock option awards and restricted stock awards to officers, other employees and directors, and stock compensation in lieu of cash fees to directors.  Total stock-based compensation expense was $520 thousand and $859 thousand for the three and six months ended June 30, 2013, respectively, compared to $334 thousand and $652 thousand for the three and six months ended June 30, 2012, respectively.
 
Stock Option Awards
 
The Company recognized stock-based compensation expense related to stock option awards of $202 thousand and $269 thousand for the three and six months ended June 30, 2013, respectively, compared to $65 thousand and $125 thousand for the three and six months ended June 30, 2012, respectively.
 
There were a total of 44,175 and 67,750 stock option awards granted to employees during the six months ended June 30, 2013 and 2012, respectively. Options granted in 2013 will vest 50% in year two and 50% in year four, on the anniversary date of the award. Options granted in 2012 generally vest equally over four years, on the anniversary date of the awards. Vested options are only exercisable while the employee remains employed with the Bank and for a limited time thereafter. The 2013 options expire ten years from the date of grant and the 2012 options expire seven years from the date of grant.
 
If a grantee’s employment or other service relationship, such as service as a director, is terminated for any reason, then any stock options granted that have not vested as of the time of such termination generally must be forfeited, unless the Compensation Committee or the Board of Directors, as the case may be, waives such forfeiture requirement. In the case of retirement, under current Company guidelines, unvested stock options may be accelerated if the employee meets certain retirement criteria.

The Company utilizes the Black-Scholes option valuation model in order to determine the per share grant date fair value of option grants.


27

Table of Contents
ENTERPRISE BANCORP, INC.
Notes to the Unaudited Consolidated Financial Statements (continued)

The table below provides a summary of the options granted, fair value, the fair value as a percentage of the market value of the stock at the date of grant and the average assumptions used in the model for the options granted in 2013 and 2012.

 
Six months ended June 30,
 
2013
 
2012
Options granted
44,175

 
67,750

Average assumptions used in the model:
 
 
 
Expected volatility
48
%
 
50
%
Expected dividend yield
2.99
%
 
2.88
%
Expected life in years
7.0

 
5.5

Risk-free interest rate
1.29
%
 
1.38
%
Market price on date of grant
$
16.43

 
$
16.25

Per share weighted average fair value
$
6.56

 
$
6.33

Fair value as a percentage of market value at grant date
40
%
 
39
%
 
Refer to Note 12 “Stock-Based Compensation Plans” in the Company’s 2012 Annual Report on Form 10-K for a further description of the assumptions used in the valuation model.
 
Restricted Stock Awards
 
Stock-based compensation expense recognized in association with restricted stock awards amounted to $264 thousand and $481 thousand for the three and six months ended June 30, 2013, respectively, compared to $211 thousand and $416 thousand for the three and six months ended June 30, 2012, respectively.
 
During the six months ended June 30, 2013, the Company granted 78,806 shares of common stock in the form of restricted stock awards. The awards were comprised of 24,925 shares awarded to employees generally vesting over four years in equal portions beginning on or about the first anniversary date of the award, 47,735 shares awarded to certain individuals that are performance based awards which vest upon Enterprise achieving certain predefined performance objectives and 6,146 shares awarded to directors vesting over two years in equal portions beginning on or about the first anniversary date of the award. The weighted average grant date fair value of the restricted stock awarded was $16.43 per share, the market value of the common stock on the grant dates.

During the six months ended June 30, 2012, the Company granted 71,376 shares of common stock in the form of restricted stock awards comprised of 62,160 shares awarded to employees, generally vesting over four years, 3,000 shares awarded to an executive officer vesting immediately and 6,216 shares awarded to directors vesting over two years.  The weighted average grant date fair value of the restricted stock awarded was $16.25 per share, which reflects the market value of the common stock on the grant dates. The unvested 2012 awards generally vest, in each case, in equal portions beginning on or about the first anniversary date of the award.

The restricted stock awards allow for the receipt of dividends, and the voting of all shares, whether or not vested, throughout the vesting periods at the same proportional level as common shares outstanding.
 
If a grantee’s employment or other service relationship, such as service as a director, is terminated for any reason, then any shares of restricted stock granted that have not vested as of the time of such termination generally must be forfeited, unless the Compensation Committee or the Board of Directors, as the case may be, waives such forfeiture requirement. In the case of retirement, under current Company guidelines, a portion of the unvested restricted shares may be accelerated if the employee meets certain retirement criteria.
 
Stock in Lieu of Directors’ Fees
 
In addition to restricted stock awards discussed above, the members of the Company’s Board of Directors may opt to receive newly issued shares of the Company’s common stock in lieu of cash compensation for attendance at Board and Board Committee meetings.  Stock-based compensation expense related to Directors’ election to receive shares of common stock in lieu of cash fees for attendance at Board and Board committee meetings amounted to $54 thousand and $109 thousand for the

28

Table of Contents
ENTERPRISE BANCORP, INC.
Notes to the Unaudited Consolidated Financial Statements (continued)

three and six months ended June 30, 2013, respectively, compared to $58 thousand and $111 thousand for the three and six months ended June 30, 2012, respectively. In January 2013, directors were issued 12,592 shares of common stock in lieu of cash fees related to the 2012 annual directors’ stock-based compensation expense of $184 thousand and a market value price of $14.63 per share, the market value of the common stock on the opt-in measurement date, January 3, 2012.

(10)
Income Taxes
 
The Company uses the asset and liability method of accounting for income taxes.  Under this method, deferred tax assets and liabilities are recognized for the future tax attributable to differences between the financial statement carrying amounts and the tax basis of assets and liabilities.  The deferred tax assets and liabilities are reflected at currently enacted income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settled.  As changes in tax laws or rates are enacted, deferred tax assets and liabilities will be adjusted accordingly through the provision for income taxes.

The Company’s policy is to classify interest resulting from underpayment of income taxes as income tax expense in the first period the interest would begin accruing according to the provisions of the relevant tax law.  The Company classifies penalties resulting from underpayment of income taxes as income tax expense in the period for which the Company claims or expects to claim an uncertain tax position or in the period in which the Company’s judgment changes regarding an uncertain tax position.
 
The income tax provisions will differ from the expense that would result from applying the federal statutory rate to income before taxes, primarily due to the impact of tax exempt interest from certain investment securities, loans and bank owned life insurance.

The Company did not have any unrecognized tax benefits accrued as income tax liabilities or receivables or as deferred tax items at June 30, 2013.  The Company is subject to U.S. federal and state income tax examinations by taxing authorities for the 2006 through 2012 tax years.

(11)
Earnings per share
 
Basic earnings per share are calculated by dividing net income by the weighted average number of common shares outstanding (including participating securities) during the year.  The Company's only participating securities are unvested restricted stock awards that contain non-forfeitable rights to dividends. Diluted earnings per share reflects the effect on weighted average shares outstanding of the number of additional shares outstanding if dilutive stock options were converted into common stock using the treasury stock method.

The table below presents the increase in average shares outstanding, using the treasury stock method, for the diluted earnings per share calculation for the periods indicated: 
 
Three months ended June 30,
 
Six months ended June 30,
 
2013
 
2012
 
2013
 
2012
Basic weighted average common shares outstanding
9,825,335

 
9,588,420

 
9,770,559

 
9,543,994

Dilutive shares
64,304

 
67,308

 
69,457

 
68,193

Diluted weighted average common shares outstanding
9,889,639

 
9,655,728

 
9,840,016

 
9,612,187


For the six months ended June 30, 2013, there were an additional 6,000 average stock options outstanding, which were excluded from the year-to-date calculation of diluted earnings per share due to the exercise price of these options exceeding the average market price of the Company’s common stock for the period.  These options, which were not dilutive at that date, may potentially dilute earnings per share in the future.




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ENTERPRISE BANCORP, INC.
Notes to the Unaudited Consolidated Financial Statements (continued)


(12)
Fair Value Measurements
 
The FASB defines the fair value of an asset or liability to be the price which a seller would receive in an orderly transaction between market participants (an exit price) and also establishes a fair value hierarchy segregating fair value measurements using three levels of inputs: (Level 1) quoted market prices in active markets for identical assets or liabilities; (Level 2) significant other observable inputs, including quoted prices for similar items in active markets, quoted prices for identical or similar items in markets that are not active, inputs such as interest rates and yield curves, volatilities, prepayment speeds, credit risks and default rates which provide a reasonable basis for fair value determination or inputs derived principally from observed market data; (Level 3) significant unobservable inputs for situations in which there is little, if any, market activity for the asset or liability.  Unobservable inputs must reflect reasonable assumptions that market participants would use in pricing the asset or liability, which are developed on the basis of the best information available under the circumstances.
 
The following tables summarize significant assets and liabilities carried at fair value and placement in the fair value hierarchy at the dates specified:
 
 
 
June 30, 2013
 
Fair Value Measurements using:
(Dollars in thousands)
 
Fair Value
 
(level 1)
 
(level 2)
 
(level 3)
Assets measured on a recurring basis:
 
 

 
 

 
 

 
 

Fixed income securities
 
$
179,678

 
$

 
$
179,678

 
$

Equity securities
 
10,781

 
10,781

 

 

FHLB Stock
 
4,324

 

 

 
4,324

Assets measured on a non-recurring basis:
 
 

 
 

 
 

 
 

Impaired loans (collateral dependent)
 
7,540

 

 

 
7,540

Other real estate owned
 
136

 

 

 
136

 
 
 
December 31,
2012
 
Fair Value Measurements using:
(Dollars in thousands)
 
Fair Value
 
(level 1)
 
(level 2)
 
(level 3)
Assets measured on a recurring basis:
 
 

 
 

 
 

 
 

Fixed income securities
 
$
173,796

 
$

 
$
173,796

 
$

Equity securities
 
10,668

 
10,668

 

 

FHLB Stock
 
4,260

 

 

 
4,260

Assets measured on a non-recurring basis:
 
 

 
 

 
 

 
 

Impaired loans (collateral dependent)
 
7,110

 

 

 
7,110

Other real estate owned
 
500

 

 

 
500

 
The Company did not have cause to transfer any assets between the fair value measurement levels during the six months ended June 30, 2013 or the year ended December 31, 2012. There were no liabilities measured at fair value on a recurring or non-recurring basis as of June 30, 2013 or December 31, 2012. There were no gains or losses due to changes in fair value, recorded in earnings for level 3 assets for the six months ended June 30, 2013, or the year ended December 31, 2012

All of the Company's fixed income investments and equity securities that are considered “available for sale” are carried at fair value.  The fixed income category above includes federal agency obligations, federal agency MBS, municipal securities, corporate bonds and certificates of deposits as held at those dates. Certificates of deposit are investment securities issued by financial institutions. They are subject to FDIC insurance and trade in the open market. The Company utilizes third-party pricing vendors to provide valuations on its fixed income securities.  Fair values provided by the vendors were generally determined based upon pricing matrices utilizing observable market data inputs for similar or benchmark securities in active markets and/or based on a matrix pricing methodology which employs The Bond Market Association’s standard calculations for cash flow and price/yield analysis, live benchmark bond pricing and terms/condition data available from major pricing sources.  Therefore, management regards the inputs and methods used by third party pricing vendors to be “Level 2 inputs and methods” as defined

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ENTERPRISE BANCORP, INC.
Notes to the Unaudited Consolidated Financial Statements (continued)

in the “fair value hierarchy.” The Company periodically obtains a second price from an impartial third party on fixed income securities to assess the reasonableness of prices provided by the primary independent pricing vendor.

The Company’s equity portfolio fair value is measured based on quoted market prices for the shares; therefore, these securities are categorized as Level 1 within the fair value hierarchy.
 
Net unrealized appreciation and depreciation on investments available for sale, net of applicable income taxes, are reflected as a component of accumulated other comprehensive income.
 
The Bank is required to purchase FHLB stock at par value in association with advances from the FHLB; this stock is classified as a restricted investment and carried at cost which management believes approximates fair value; therefore, these securities are categorized as Level 3 measures. 
 
Impaired loan balances in the table above represent those collateral dependent impaired commercial loans where management has estimated the credit loss by comparing the loan’s carrying value against the expected realizable fair value of the collateral (appraised value or internal analysis less estimated cost to sell, adjusted as necessary for changes in relevant valuation factors subsequent to the measurement date).  Certain inputs used in these assessments, and possible subsequent adjustments, are not always observable, and therefore, collateral dependent impaired loans are categorized as Level 3 within the fair value hierarchy.  A specific allowance is assigned to the collateral dependent impaired loan for the amount of management’s estimated credit loss.  The specific allowances assigned to the collateral dependent impaired loans at June 30, 2013 amounted to $2.7 million compared to $3.3 million at December 31, 2012, a net decrease of $592 thousand.
 
Real estate acquired by the Company through foreclosure proceedings or the acceptance of a deed in lieu of foreclosure is classified as OREO.  When property is acquired, it is generally recorded at the lesser of the loan’s remaining principal balance, net of unamortized deferred fees, or the estimated fair value of the property acquired, less estimated costs to sell.  The estimated fair value is based on market appraisals and the Company’s internal analysis.  Certain inputs used in appraisals or the Company's internal analysis, are not always observable, and therefore, OREO may be categorized as Level 3 within the fair value hierarchy.  The carrying values of OREO at both June 30, 2013 and December 31, 2012 consisted of one property, respectively, at the end of each period. Two properties were added and two properties were sold during 2013; net gains realized on the sale of the OREO properties were $121 thousand.

The following table presents additional quantitative information about assets measured at fair value on a recurring and non-recurring basis for which the Company utilized Level 3 inputs (significant unobservable inputs for situations in which there is little, if any, market activity for the asset or liability) to determine fair value as of June 30, 2013.
 
(Dollars in thousands)
 
Fair Value
 
Valuation Technique
 
Unobservable Input
 
Unobservable Input Value or Range
Assets measured on a recurring basis:
 
 
 
 
 
 
 
 
  FHLB Stock
 
$4,324
 
FHLB Stated Par Value
 
N/A
 
N/A
Assets measured on a non-recurring basis:
 
 
 
 
 
 
 
 
  Impaired loans (collateral dependent)
 
$7,540
 
Appraisal of collateral
 
Appraisal adjustments (1)
 
5% - 50%
  Other real estate owned
 
$136
 
Appraisal of collateral
 
Appraisal adjustments (1)
 
0% - 30%
(1)
Appraisals may be adjusted by management for qualitative factors such as economic conditions and estimated liquidation expenses.

Other Guarantees and Commitments
 
Standby letters of credit are conditional commitments issued by the Company to guarantee the performance by a customer to a third party.  The fair value of these commitments was estimated to be the fees charged to enter into similar agreements, and accordingly these fair value measures are deemed to be FASB Level 2 measurements.  In accordance with the FASB, the estimated fair values of these commitments are carried on the balance sheet as a liability and amortized to income over the life of the letters of credit, which are typically one year.  The estimated fair value of these commitments carried on the balance sheet at June 30, 2013 and December 31, 2012 were deemed immaterial.


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ENTERPRISE BANCORP, INC.
Notes to the Unaudited Consolidated Financial Statements (continued)

Interest rate lock commitments related to the origination of mortgage loans that will be sold are considered derivative instruments.  The Company estimates the fair value of these derivatives using the difference between the guaranteed interest rate in the commitment and the current market interest rate.  To reduce the net interest rate exposure arising from its loan sale activity, the Company enters into the commitment to sell these loans at essentially the same time that the interest rate lock commitment is quoted on the origination of the loan.  The commitments to sell loans are also considered derivative instruments, with estimated fair values based on changes in current market rates.  These commitments represent the Company’s only derivative instruments and are accounted for in accordance with FASB guidance.  The fair values of the Company’s derivative instruments are deemed to be FASB Level 2 measurements.  At June 30, 2013 and December 31, 2012, the estimated fair value of the Company’s derivative instruments was considered to be immaterial.

Estimated Fair Values of Assets and Liabilities

In addition to disclosures regarding the measurement of assets and liabilities carried at fair value on the balance sheet, the Company is also required to disclose fair value information about financial instruments for which it is practicable to estimate that value, whether or not recognized on the balance sheet.  In cases where quoted fair values are not available, fair values are based upon estimates using various valuation techniques.  Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows.  The following methods and assumptions were used by the Company in estimating fair values of its financial instruments:
 
Loans held for sale: Loans held for sale are recorded at the lower of aggregate amortized cost or market value. The fair value is based on comparable market prices for loans with similar rates and terms.

Loans: The fair value of loans was determined using discounted cash flow analysis, using interest rates currently being offered by the Company.  The incremental credit risk for non-accrual loans was considered in the determination of the fair value of the loans.  This method of estimating fair value does not incorporate the exit price concept of fair value.
 
Commitments: The fair values of the unused portion of lines of credit and letters of credit were estimated to be the fees currently charged to enter into similar agreements.  Commitments to originate non-mortgage loans were short-term and were at current market rates and estimated to have no significant change in fair value.
 
Financial liabilities: The fair values of certificates of deposit and borrowings were estimated using discounted cash flow analysis using rates offered by the Bank, or advance rates offered by the FHLB on June 30, 2013 and December 31, 2012 for similar instruments.  The fair value of junior subordinated debentures was estimated using discounted cash flow analysis using a market rate of interest at June 30, 2013 and December 31, 2012.
 
Limitations:  The estimates of fair value of financial instruments were based on information available at June 30, 2013 and December 31, 2012 and are not indicative of the fair market value of those instruments as of the date of this report.  These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company’s entire holdings of a particular financial instrument. The fair value of the Company's time deposit liabilities do not take into consideration the value of the Company's long-term relationships with depositors, which may have significant value.
 
Because no active market exists for a portion of the Company’s financial instruments, fair value estimates were based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors.  These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision.  Changes in assumptions could significantly affect the estimates.
 
Fair value estimates were based on existing on- and off-balance sheet financial instruments without an attempt to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments.
 
In addition, the tax ramifications related to the realization of the unrealized appreciation and depreciation can have a significant effect on fair value estimates and have not been considered in any of the estimates.  Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Company.

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ENTERPRISE BANCORP, INC.
Notes to the Unaudited Consolidated Financial Statements (continued)

 
The carrying values, estimated fair values and placement in the fair value hierarchy of the Company’s financial instruments(1) for which fair value is only disclosed but not recognized on the balance sheet at the dates indicated are summarized as follows:
 
 
 
June 30, 2013
 
Fair value measurement
(Dollars in thousands)
 
Carrying
Amount
 
Fair Value
 
Level 1 inputs
 
Level 2 Inputs
 
Level 3 Inputs
Financial assets:
 
 

 
 

 
 
 
 
 
 
Loans held for sale
 
$3,917
 
$3,917
 
$

 
$
3,917

 

Loans, net
 
$1,421,675
 
$1,450,436
 
$

 
$

 
1,450,436

Financial liabilities:
 
 

 
 

 
 
 
 
 
 
Certificates of deposit (including brokered)
 
268,162

 
266,740

 

 
266,740

 

Borrowed funds
 
1,880

 
1,883

 

 
1,883

 

Junior subordinated debentures
 
10,825

 
11,592

 

 

 
11,592

 
 
 
December 31, 2012
 
Fair value measurement
(Dollars in thousands)
 
Carrying
Amount
 
Fair Value
 
Level 1 inputs
 
Level 2 Inputs
 
Level 3 Inputs
Financial assets:
 
 

 
 

 
 
 
 
 
 
Loans held for sale
 
$8,557
 
$8,603
 
$

 
$
8,603

 

Loans, net
 
$1,335,401
 
$1,355,893
 
$

 
$

 
$1,355,893
Financial liabilities:
 
 

 
 

 
 
 
 
 
 
Certificates of deposit (including brokered)
 
231,198

 
231,687

 

 
231,687

 

Borrowed funds
 
26,540

 
26,553

 

 
26,553

 

Junior subordinated debentures
 
10,825

 
12,597

 

 

 
12,597


(1)
Excluded from this table are certain financial instruments that approximated their fair value, as they were short-term in nature or payable on demand.  These include cash and cash equivalents, accrued interest receivable, non-term deposit accounts, and accrued interest payable. The respective carrying values of these instruments would all be considered to be classified within Level 1 of their fair value hierarchy.


33


Item 2 -
Management’s Discussion and Analysis of Financial Condition and Results of Operations

Management’s discussion and analysis should be read in conjunction with the Company’s (also referred to herein as “Enterprise,” “us,” “we” or “our”) consolidated financial statements and notes thereto contained in this report and the Company’s 2012 Annual Report on Form 10-K.

Accounting Policies/Critical Accounting Estimates


As discussed in the Company’s 2012 Annual Report on Form 10-K, the three most significant areas in which management applies critical assumptions and estimates that are particularly susceptible to change relate to the determination of the allowance for loan losses, impairment review of investment securities and the impairment review of goodwill.  The Company has not changed its significant accounting and reporting policies from those disclosed in its 2012 Annual Report on Form 10-K.

Special Note Regarding Forward-Looking Statements


This report contains certain “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, including statements concerning plans, objectives, future events or performance and assumptions and other statements that are other than statements of historical fact. Forward-looking statements may be identified by reference to a future period or periods or by use of forward-looking terminology such as “anticipates,” “believes,” “expects,” “intends,” “may,” “plans,” “pursue,” “views” and similar terms or expressions. Various statements contained in Item 2 - “Management's Discussion and Analysis of Financial Condition and Results of Operations” and Item 3 - “Quantitative and Qualitative Disclosures About Market Risk,” including, but not limited to, statements related to management's views on the banking environment and the economy, competition and market expansion opportunities, the interest rate environment, credit risk and the level of future non-performing assets and charge-offs, potential asset and deposit growth, future non-interest expenditures and non-interest income growth, and borrowing capacity are forward-looking statements. The Company wishes to caution readers that such forward-looking statements reflect numerous assumptions and involve a number of risks and uncertainties that may adversely affect the Company's future results. The forward-looking statements in this report are based on information available to the Company as of the date of this report and the Company undertakes no obligation to publicly update or otherwise revise any forward-looking statement, whether as a result of new information, future events or otherwise. The following important factors, among others, could cause the Company's results for subsequent periods to differ materially from those expressed in any forward-looking statement made herein: (i) changes in interest rates could negatively impact net interest income; (ii) changes in the business cycle and downturns in the local, regional or national economies, including deterioration in the local real estate market, could negatively impact credit and/or asset quality and result in credit losses and increases in the Company's allowance for loan losses; (iii) changes in consumer spending could negatively impact the Company's credit quality and financial results; (iv) increasing competition from larger regional and out-of-state banking organizations as well as non-bank providers of various financial services could adversely affect the Company's competitive position within its market area and reduce demand for the Company's products and services; (v) deterioration of securities markets could adversely affect the value or credit quality of the Company's assets and the availability of funding sources necessary to meet the Company's liquidity needs; (vi) changes in technology could adversely impact the Company's operations and increase technology-related expenditures; (vii) increases in employee compensation and benefit expenses could adversely affect the Company's financial results; (viii) changes in laws and regulations that apply to the Company's business and operations, including without limitation, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act"), the Jumpstart Our Business Startups Act (the "JOBS Act"), the Basel III rules adopted by the federal banking regulators and the additional regulations that will be forthcoming as a result thereof, could adversely affect the Company's business environment, operations and financial results; (ix) changes in accounting standards, policies and practices, as may be adopted or established by the regulatory agencies, the Financial Accounting Standards Board (the “FASB”) or the Public Company Accounting Oversight Board could negatively impact the Company's financial results; (x) our ability to enter new markets successfully and capitalize on growth opportunities; (xi) future regulatory compliance costs, including any increase caused by new regulations imposed by the Consumer Finance Protection Bureau; (xii) changes to the regulatory capital requirements mandated under rulemaking pursuant to Basel III; and (xiii) some or all of the risks and uncertainties described in Item 1A of the Company’s 2012 Annual Report on Form 10-K could be realized, which could have a material adverse effect on the Company’s business, financial condition and results of operation.  Therefore, the Company cautions readers not to place undue reliance on any such forward-looking information and statements.


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Overview


Executive Summary

The Company continued to focus on organic growth and market expansion while management remains committed to strategic investments in technology, our communities, and our family of Enterprise employees. We continue to plan for the Company's future by strengthening our franchise in Massachusetts and Southern New Hampshire. Our 21st branch office opened in April 2013 in Lawrence, MA, and our Nashua, NH office is scheduled to open in the fourth quarter of 2013.

Through the first six months of 2013, total assets increased $87.6 million, or 5.3%, compared to December 31, 2012, amounting to $1.75 billion at June 30, 2013. Loans outstanding and deposits, excluding brokered deposits, have increased $87.7 million, or 6.4%, and $54.8 million, or 3.7%, respectively, in the first six months of 2013. On an annualized basis, total assets and loans have grown 11% and 13%, respectively, in 2013. Average deposits, excluding brokered deposits, for the first six months of 2013 have increased 6% compared to the same period in 2012.

Net income for the three months ended June 30, 2013 amounted to $3.1 million, representing an increase of $174 thousand, or 6%, compared to the same three month period in 2012. Diluted earnings per share were $0.31 for the three months ended June 30, 2013, an increase of $0.01, or 3%, compared to the same period in the prior year. Net income for the six months ended June 30, 2013 amounted to $6.5 million, representing an increase of $434 thousand, or 7%, compared to the same six month period in 2012. Diluted earnings per share were $0.66 for the six months ended June 30, 2013, an increase of $0.03, or 5%, compared to the same period in the prior year.

The Company’s earnings are largely dependent on its net interest income, which is the difference between interest earned on loans and investments and the cost of funding (primarily deposits and borrowings).  Net interest income expressed as a percentage of average interest earning assets is referred to as net interest margin.  The Company reports net interest margin on a tax equivalent basis ("margin"). Consistent with the industry and ongoing market conditions, during the first six months of 2013, the Company's margin continued to trend downward, as the yield on interest-earning assets declined faster than the cost of funding, as funding rates have reached a level leaving little room for significant reductions. The Company's success in growing the commercial loan portfolio and its low cost deposit base has helped to offset the impact of this margin compression.

The Company's growth contributed to increases in net interest income, non-interest income and the level of operating expenses for the current year compared to the same period in 2012. Non-interest income also increased as a result of higher gains on securities sales in the current year. Additionally, the quarter ended June 30, 2013 benefited from a lower loan loss provision compared to the same period in 2012, partially offset by the costs of our signature "Celebration of Excellence" community recognition event held in May 2013.

Composition of Earnings

Net interest income for the three months ended June 30, 2013 amounted to $16.1 million, an increase of $716 thousand, or 5%, compared to the same period in 2012. Net interest income for the six months ended June 30, 2013 amounted to $31.9 million, an increase of $1.6 million, or 5%, compared to the same period in 2012. This increase in net interest income was due primarily to revenue generated from loan growth, partially offset by a decrease in margin. Average loan balances (including loans held for sale) increased $162.3 million and $150.6 million for the three and six months ended June 30, 2013, respectively, compared to the same periods in 2012. Net interest margin was 4.08% for the quarter ended June 30, 2013, compared to 4.31% for the quarter ended June 30, 2012. Margin was 4.16% for the quarter ended March 31, 2013. Year-to-date margins were 4.12% and 4.33% for the six months ended June 30, 2013 and 2012, respectively.

The provision for loan losses amounted to $534 thousand for the three months ended June 30, 2013, compared to $1.1 million for the same period in 2012. For the six months ended June 30, 2013 and 2012, the provision for loan losses amounted to $1.3 million and $1.4 million, respectively. In determining the provision to the allowance for loan losses, management takes into consideration the level of loan growth, and an estimate of credit risk, which includes such items as adversely classified and non-performing loans, the estimated specific reserves needed for impaired loans, the level of net charge-offs, and the estimated impact of current economic conditions on credit quality. The level of loan growth for the six months ended June 30, 2013, was $87.7 million, compared to $44.7 million during the same period in 2012. The balance of the allowance for loan losses allocated to impaired loans amounted to $4.2 million at June 30, 2013, compared to $3.6 million at June 30, 2012. Total non-performing assets as a percentage of total assets were 1.24% at June 30, 2013, compared to 1.61% at June 30, 2012. For the six months ended June 30, 2013, the Company recorded net recoveries of $100 thousand. For the six months ended June 30, 2012, net charge-offs were $1.4 million. Management continues to closely monitor the non-performing assets, charge-offs and

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necessary allowance levels, including specific reserves. The allowance for loan losses to total loans ratio was 1.77% at June 30, 2013, 1.78% at December 31, 2012 and 1.79% at June 30, 2012.

For further information regarding loan quality statistics and the allowance for loan losses, see the sections below under the
heading "Financial Condition" titled "Asset Quality" and "Allowance for Loan Losses."

Non-interest income for the three and six months ended June 30, 2013 amounted to $3.6 million and $7.2 million, respectively, increases of $601 thousand, or 20%, and $1.3 million, or 21%, respectively, compared to the same periods in 2012. The increases over the 2012 periods were primarily due to increases in gains on securities sales, deposit and interchange fees and investment advisory fee income. The year-to-date increase also benefited from gains on loan sales.

Non-interest expense for the three months ended June 30, 2013 amounted to $14.5 million, an increase of $1.5 million, or 11%, compared to the second quarter of 2012. For the six months ended June 30, 2013, non-interest expense amounted to $27.9 million, an increase of $2.1 million, or 8%, compared to the same period in the prior year. Increased expenses related to salaries and benefits, occupancy and technology over the comparable periods in the prior year were primarily due to the Company's strategic growth initiatives, including branch expansion. Advertising increased over the prior year periods primarily due to the timing of corporate community events. Partially offsetting these increases were reductions in legal and other professional costs.

Sources and Uses of Funds
 
The Company’s primary sources of funds are deposits, Federal Home Loan Bank ("FHLB") borrowings, current earnings and proceeds from the sales, maturities and pay-downs on loans and investment securities.  The Company may also, from time to time, utilize brokered deposits and overnight borrowings from correspondent banks as additional funding sources. These funds are used to originate loans, purchase investment securities, conduct operations, expand the branch network, and pay dividends to shareholders.
 
The investment portfolio is primarily used to provide liquidity, manage the Company’s asset-liability position and to invest excess funds. Total investments, one of the key components of earning assets, amounted to $190.5 million at June 30, 2013, and comprised 11% of total assets at both June 30, 2013 and December 31, 2012.
 
Enterprise's main asset strategy is to grow loans, the largest component of earning assets, primarily high quality commercial loans.  Total loans increased $87.7 million, or 6%, since December 31, 2012, primarily in commercial real estate, and amounted to $1.45 billion, or 83% of total assets, at June 30, 2013. Total commercial loans amounted to $1.25 billion, or 86% of gross loans, which was relatively consistent with the composition at December 31, 2012.
 
Management’s preferred strategy for funding asset growth is to grow low cost deposits (comprised of demand deposit accounts, interest and business checking accounts and traditional savings accounts).  Asset growth in excess of low cost deposits is typically funded through higher cost deposits (comprised of money market accounts, commercial tiered rate or "investment savings" accounts and term certificates of deposit) and wholesale funding (brokered deposits and borrowed funds).
 
At June 30, 2013, deposits, excluding brokered deposits, amounted to $1.53 billion, an increase of $54.8 million, or 4%, from December 31, 2012 balances. This increase since December 31, 2012 was primarily due to increases in checking account balances of $34.5 million, or 6%, and savings and money market account balances of $32.8 million, or 5%, partially offset by a decrease of $12.5 million in CD balances.

Wholesale funding amounted to $54.4 million at June 30, 2013, compared to $29.6 million at December 31, 2012.  The increase in wholesale funding primarily resulted from loan growth exceeding deposit growth in the quarter. Wholesale funding included FHLB advances of $1.9 million and $26.5 million at June 30, 2013 and December 31, 2012, respectively, and brokered deposits of $52.5 million and $3.0 million at June 30, 2013 and December 31, 2012, respectively. As part of the Company's asset-liability management strategy to protect against rising rates, wholesale funding balances were shifted from overnight FHLB borrowings to brokered CDs with an average life of approximately five years.


Opportunities and Risks

The Company’s ability to achieve its long-term strategic growth and market share objectives will depend in part upon the Company’s continued success in differentiating itself in the market place and its ability to strengthen its competitive position by capitalizing on market opportunities created by the current challenging banking landscape. 

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Enterprise faces robust competition to retain and attract customers within existing and neighboring geographic markets.  National and larger regional banks have a local presence in the Company’s market area.  These larger banks have certain competitive advantages, including greater financial resources and the ability to make larger loans to a single borrower. Numerous local savings banks, commercial banks, cooperative banks and credit unions also compete in the Company’s market area.  The expanded commercial lending capabilities of credit unions and the shift to commercial lending by traditional savings banks means that both of these types of traditionally consumer-orientated institutions now compete for the Company’s targeted commercial customers.  In addition, the non-taxable status of credit unions allows them certain advantages as compared to taxable institutions such as Enterprise.  Competition for loans, deposits and cash management services, investment advisory assets, and insurance business also comes from other businesses that provide financial services, including consumer finance companies, mortgage brokers and lenders, private lenders, insurance companies, securities brokerage firms, institutional mutual funds, registered investment advisors, internet based banks and non-bank payment channels.  Advances in, and the increased use of technology, such as internet and mobile banking, electronic transaction processing and information security, are expected to have a significant impact on the future competitive landscape confronting financial institutions.

Management believes the Company's community service culture, business model, full range of diversified financial products and services, and state-of-the-art delivery channels position the Company to be a leading provider of banking and investment advisory and wealth management services in its growing market area. The Company has differentiated itself by building a solid reputation within the local market for delivering consistently superior customer service and taking an active role in support of the communities we serve. The Company's banking professionals have developed in-depth knowledge of our markets and are committed to upholding the Company’s core values, including significant community involvement, which has led to a strong referral network with local business and community leaders. 

The Company seeks to increase deposit share through continuous reviews of deposit product offerings, ancillary services and delivery channels, targeted to both business' and consumers' needs. These products and services are delivered by experienced local banking professionals who possess strong technical skills, and function as trusted advisors to clients. In addition, Enterprise carefully plans deposit expansion through new branch development in neighboring markets. The Company has opened three branch offices in the past 18 months, and another office in Nashua, NH is scheduled to open by the end of the year, our fifth southern NH location. The Company believes that each of these offices is strategically located to complement existing locations while expanding the Company's geographic market footprint. This branch expansion is aimed at achieving not only deposit market share growth, but also contributes to loan originations and generates referrals for investment advisory and wealth management and insurance services.

Management believes that Enterprise is also well equipped to capitalize on market potential to grow both the commercial and residential loan portfolios through strong business development efforts, while utilizing a disciplined and consistent lending approach and credit review practices, which has served to provide quality asset growth over varying economic cycles during the Company’s twenty-four year history.  The Company has a skilled lending sales force with a broad breadth of business knowledge and depth of lending experience to draw upon, supported by a highly qualified and experienced commercial credit review function.
 
Management continues to undertake significant strategic initiatives, including investments in employee training and development, marketing and public relations, technology and electronic delivery methods, branch expansion and ongoing improvements and renovations of existing branches and operations facilities.  Industry consolidation also provides management the opportunity to recruit experienced banking professionals with market knowledge who complement the Enterprise sales and service culture.  While management recognizes that such investments increase expenses in the short-term, Enterprise believes that such initiatives are a necessary investment in the long-term growth and earnings of the Company and are reflective of the opportunities in the current marketplace for community banks such as Enterprise. However, lower than expected return on these investments, such as slower than anticipated loan and deposit growth in new branches and/or lower than expected fee or other income generated from new technology or initiatives, could decrease anticipated revenues and net income on such investments in the future.
 
Any prolonged stagnation or deterioration of the current economic environment could weaken the local New England economy and have adverse repercussions on local industries, leading to increased unemployment and mortgage foreclosures, further deterioration of local commercial real estate values, or other unforeseen consequences, which could have a severe negative impact on the Company’s financial condition, capital position, liquidity, and performance.  In addition, the loan portfolio consists primarily of commercial real estate, commercial and industrial, and commercial construction loans.  These types of loans are typically larger and are generally viewed as having more risk of default than owner occupied residential real estate loans or consumer loans. Any significant deterioration in the credit quality of the commercial loan portfolio or underlying collateral values due to a continuation or worsening of the current economic environment could have a material adverse effect

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on the Company’s financial condition and results of operations. The risk of loss due to customers’ non-payment of loans or lines of credit is called “credit risk.”  Credit risk management is reviewed below in this Item 2 under the headings “Credit Risk," "Asset Quality” and “Allowance for Loan Losses.”

The value of the investment portfolio as a whole, or individual securities held, including restricted FHLB capital stock, could be negatively impacted by any sustained volatility in the financial markets or in credit markets, or fundamental deterioration of credit quality of the individual security, fund or issuer, which could possibly result in the recognition of additional other-than-temporary-impairment (“OTTI”) charges in the future.

In addition, a sustained low interest rate environment caused by the current economic cycle, or other factors, could negatively impact the Company's net interest income and results of operation. The re-pricing frequency of interest earning assets and liabilities are not identical, and, therefore, subject the Company to the risk of adverse changes in interest rates.  This is often referred to as “interest rate risk” and is reviewed in more detail under the heading Item 3, “Quantitative and Qualitative Disclosures About Market Risk,” below.
 
Liquidity management is the coordination of activities so that cash needs are anticipated and met, readily and efficiently.  Liquidity management is reviewed further below in this Item 2 under the heading “Liquidity.”
 
Federal banking agencies require the Company and the Bank to meet minimum capital requirements. For information regarding the current capital requirements applicable to the Company and the Bank and their respective capital levels at June 30, 2013, and the recently adopted changes to the regulatory capital framework, see the section entitled “Capital Resources” contained in this Item 2 below. At June 30, 2013, both the Company and the Bank were categorized as “well capitalized;” however, future unanticipated charges against capital, or changes in regulatory requirements such as Basel III discussed below, could impact those regulatory capital designations. 

In addition, any further changes in government regulation or oversight, including the implementation by the federal regulatory agencies of the various requirements contained in the Dodd-Frank Act and rules under Basel III, could affect the Company in substantial and unpredictable ways, including, but not limited to, subjecting the Company to additional operating, governance and compliance costs, or potential loss of revenue due to the impact of an enhanced regulatory structure on the banking industry, and require all U.S. banking organizations, including community banks, such as Enterprise Bank, to hold higher amounts of capital, especially common equity, against their risk-weighted assets. Although several significant aspects of the Dodd-Frank Act and the Basel III rule expressly apply only to larger, “systemically significant” institutions, they may have the potential to influence the Company's business decisions, while other parts of the legislation apply either directly, or potentially indirectly, to activities of community banks, such as Enterprise.

Many aspects of the Dodd-Frank Act are subject to rulemaking by various regulatory agencies and will take effect over several years, making it difficult at this time to anticipate the overall financial impact of this expansive legislation on the Company, its customers or the financial industry generally. Likewise, any new consumer financial protection laws enacted by the Consumer Financial Protection Bureau would apply to all banks and thrifts, and may increase the Company's compliance and operational costs in the future.

Compliance risk includes the threat of fines, civil money penalties, lawsuits and restricted growth opportunities resulting from violations and/or non-conformance with laws, rules, regulations, prescribed practices, internal policies and procedures, or ethical standards.  The Company maintains a Compliance Management Program (CMP) designed to meet regulatory and legislative requirements.  The CMP provides for tracking and implementing regulatory changes, monitoring the effectiveness of policies and procedures, conducting compliance risk assessments, and educating employees in matters relating to regulatory compliance.  The Audit Committee of the Board of Directors oversees the effectiveness of the CMP.

Operational risk includes the threat of loss from inadequate or failed internal processes, people, systems or external events, due to, among other things: fraud or error; the inability to deliver products or services; failure to maintain a competitive position; lack of information or physical security; or violations of ethical standards. Controls to manage operational risk include, but are not limited to, technology administration, information security, vendor management and business continuity planning.

The Company's technology administration includes policies and guidelines for the design, procurement, installation, management and acceptable use of hardware, software and network devices. The Company has implemented layered security approaches for all delivery channels and technology project standards that are designed to provide risk based oversight, coordinate and communicate ideas, and to prioritize and manage project implementation in a manner consistent with corporate objectives.


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Management utilizes a combination of third party information security assessments, key technologies and ongoing internal evaluations to provide a level of protection of non-public personal information and to continually monitor and attempt to safeguard information on its operating systems and those of third party service providers.  The Company also utilizes firewall technology and a combination of software and third-party monitoring to detect intrusion, guard against unauthorized access, and continuously scan for computer viruses on the Company’s information systems.

The Company has a risk-based, third-party vendor management program designed to provide a mechanism to enable management to determine what risk, if any, a particular vendor exposes the Company to, to rate those risks, and to mitigate that risk by properly performing initial and ongoing due diligence when selecting or maintaining relationships with significant third-party providers.
 
The Company’s Business Continuity Plan consists of the information and procedures required to enable a rapid recovery from an occurrence that would disable the Company’s operations for an extended period, due to such circumstances as: loss of personnel; loss of information and/or loss of access to information under various scenarios; and loss of access to, or the physical destruction or damage of, facilities, infrastructure or systems. The plan, which is reviewed annually, establishes responsibility for assessing a disruption of business, contains alternative strategies for the continuance of critical business functions during an emergency situation, assigns responsibility for restoring services, and sets priorities by which critical services will be restored.  A bank-owned and maintained secondary data center location provides the Company auxiliary network processing capabilities and flexibility. 

Any system of controls or contingency plan, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the controls and procedures will be met.
 
This Opportunities and Risks discussion should be read in conjunction with Item 1A “Risk Factors,” and the section titled "Opportunities and Risk" contained in Item 7 "Management's discussion and Analysis of Financial Conditions and Results of Operations" included in the Company’s 2012 Annual Report on Form 10-K, which address numerous other factors and details that could adversely affect the Company’s reputation, its future results of operations and financial condition.




Financial Condition

 
Total assets increased $87.6 million, or 5%, since December 31, 2012, to $1.75 billion at June 30, 2013.  The balance sheet composition and changes since December 31, 2012 are discussed below.

Cash and cash equivalents

Cash and cash equivalents is comprised of cash on hand and cash items due from banks, interest-earning deposits (deposit accounts, money market, and money market mutual funds accounts) and fed funds sold. Cash and cash equivalents amounted to 3% of total assets at both June 30, 2013, and December 31, 2012.
 
Investments
 
At June 30, 2013, the carrying value of the investment portfolio amounted to $190.5 million, an increase of $6.0 million, or 3%, compared to December 31, 2012


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The following table summarizes investments at the dates indicated:
 
 
 
June 30,
2013
 
December 31,
2012
 
June 30,
2012
(Dollars in thousands)
 
Amount

Percent

 
Amount

Percent

 
Amount

Percent

Federal agency obligations(1)
 
$
65,252

34.2
%
 
$
65,685

35.6
%
 
$
62,809

38.0
%
Federal agency mortgage backed securities (MBS)(1)
 
52,157

27.4
%
 
49,674

26.9
%
 
39,271

23.8
%
Municipal securities
 
57,678

30.3
%
 
56,523

30.7
%
 
53,690

32.5
%
Corporate bonds
 
3,736

2.0
%
 
1,914

1.0
%
 

%
Certificates of deposits
 
855

0.4
%
 

%
 
982

0.6
%
Total fixed income securities
 
179,678

94.3
%
 
173,796

94.2
%
 
156,752

94.9
%
Equity investments
 
10,781

5.7
%
 
10,668

5.8
%
 
8,459

5.1
%
Total available for sale investments at fair value
 
$
190,459

100.0
%
 
$
184,464

100.0
%
 
$
165,211

100.0
%
__________________________________________ 
(1)
These categories may include investments issued or guaranteed by government sponsored enterprises such as Fannie Mae (FNMA), Freddie Mac (FHLMC), Ginnie Mae (GNMA), Federal Farm Credit Bank, or one of several Federal Home Loan Banks.  All agency MBS/CMO investments owned by the Company are backed by residential mortgages.

 
Included in the federal agency MBS categories above were CMOs totaling $20.6 million, $23.6 million, and $18.1 million at June 30, 2013, December 31, 2012, and June 30, 2012, respectively.

Certificates of Deposits ("CDs") represent term deposits issued by banks, that are subject to FDIC insurance, and purchased on the open market. The Company utilizes these CDs as an alternative investment option to holding short-term excess cash in lower yielding overnight deposit accounts. These securities have maturities of less than a year and the market value approximates the carrying value.
 
During the six months ended June 30, 2013, the total principal pay downs, calls and maturities amounted to $8.0 million.  During the period, the Company purchased $24.3 million in securities. In addition, management sold investment securities with an amortized cost of approximately $6.4 million realizing net gains on sales of $948 thousand, in order to capitalize on market conditions. 
 
Net unrealized gains on the investment portfolio amounted to $3.0 million at June 30, 2013 compared to $6.4 million at December 31, 2012 and $5.6 million at June 30, 2012.  Unrealized gains or losses will only be recognized in the statements of income if the investments are sold. However, should an investment be deemed “other than temporarily impaired,” the Company is required to write-down the fair value of the investment.   See Note 4, “Investment Securities,” and Note 12, “Fair Value Measurements,” to the Company’s unaudited consolidated financial statements contained in Item 1 above for further information regarding the Company’s unrealized gains and losses on debt and equity securities, including information about investments in an unrealized loss position for which an other-than-temporary impairment has or has not been recognized, and investments pledged as collateral, as well as the Company’s fair value measurements for available-for-sale securities.
 
Federal Home Loan Bank Stock
 
The Company is required to purchase stock of the FHLB in association with advances from the FHLB; this stock is classified as a restricted investment and carried at cost, which management believes approximates fair value.  The carrying amount of FHLB stock was $4.3 million for each of the periods ended June 30, 2013, December 31, 2012 and June 30, 2012. See Note 5, “Restricted Investments,” to the Company’s unaudited consolidated financial statements contained in Item 1 above for further information regarding the Company’s investment in FHLB stock.


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Loans
 
Total loans represented 83% of total assets as of June 30, 2013, compared to 82% at December 31, 2012.  Total loans increased $87.7 million, or 6%, compared to December 31, 2012, and $157.2 million, or 12%, since June 30, 2012.  The mix of loans within the portfolio remained relatively unchanged with commercial loans amounting to approximately 86% of gross loans, reflecting a continued focus on commercial loan growth.
 
The following table sets forth the loan balances by certain loan categories at the dates indicated and the percentage of each category to gross loans.
 
 
 
June 30, 2013
 
December 31, 2012
 
June 30, 2012
(Dollars in thousands)
 
Amount
 
Percent
 
Amount
 
Percent
 
Amount
 
Percent
Commercial real estate
 
$
785,994

 
54.2
%
 
$
710,265

 
52.2
%
 
$
668,369

 
51.8
%
Commercial and industrial
 
343,509

 
23.7
%
 
328,579

 
24.1
%
 
331,064

 
25.6
%
Commercial construction
 
116,348

 
8.0
%
 
121,367

 
8.9
%
 
121,119

 
9.4
%
Total commercial loans
 
1,245,851

 
85.9
%
 
1,160,211

 
85.2
%
 
1,120,552

 
86.8
%
Residential mortgages
 
122,704

 
8.5
%
 
120,278

 
8.8
%
 
89,216

 
6.9
%
Home equity loans and lines
 
74,639

 
5.2
%
 
75,648

 
5.6
%
 
77,860

 
6.0
%
Consumer
 
5,649

 
0.4
%
 
4,911

 
0.4
%
 
3,824

 
0.3
%
Total retail loans
 
202,992

 
14.1
%
 
200,837

 
14.8
%
 
170,900

 
13.2
%
 
 
 
 
 
 
 
 
 
 
 
 
 
Gross loans
 
1,448,843

 
100.0
%
 
1,361,048

 
100.0
%
 
1,291,452

 
100.0
%
Deferred fees, net
 
(1,497
)
 
 

 
(1,393
)
 
 

 
(1,286
)
 
 

Total loans
 
1,447,346

 
 

 
1,359,655

 
 

 
1,290,166

 
 

Allowance for loan losses
 
(25,671
)
 
 

 
(24,254
)
 
 

 
(23,126
)
 
 

Net loans
 
$
1,421,675

 
 

 
$
1,335,401

 
 

 
$
1,267,040

 
 


Commercial real estate loans increased $75.7 million, or 11%, as of June 30, 2013, compared to December 31, 2012, and increased 18% compared to June 30, 2012.  Commercial real estate loans are typically secured by one-to-four and multi-family apartment buildings, office or mixed-use facilities, strip shopping centers or other commercial or industrial property.
 
Commercial and industrial loans increased by $14.9 million, or 5%, since December 31, 2012, and increased 4% as compared to June 30, 2012.  These loans include seasonal revolving lines of credit, working capital loans, equipment financing (including equipment leases), and term loans.  Also included in commercial and industrial loans are loans under various U.S. Small Business Administration programs.

Commercial construction loans decreased by $5.0 million, or 4%, since December 31, 2012, and also decreased 4% as compared to June 30, 2012. Commercial construction loans include the development of residential housing and condominium projects, the development of commercial and industrial use property and loans for the purchase and improvement of raw land.
 
Retail loans increased by $2.2 million, or 1%, since December 31, 2012 and increased by $32.1 million, or 19%, since June 30, 2012.  The increase since the prior year was primarily within the residential mortgage portfolio, partially offset by a slight decrease in home equity loans and lines. In the fourth quarter of 2012, the Company purchased a group of residential mortgage loans with a balance at June 30, 2013 of $17.2 million.
 
At June 30, 2013, commercial loan balances participated out to various banks amounted to $53.9 million, compared to $53.6 million at December 31, 2012, and $46.3 million at June 30, 2012.  These balances participated out to other institutions are not carried as assets on the Company’s financial statements.  Loans originated by other banks in which the Company is the participating institution are carried at the pro-rata share of ownership and amounted to $35.5 million, $28.6 million and $31.8 million at June 30, 2013, December 31, 2012, and June 30, 2012, respectively.  In each case, the participating bank funds a percentage of the loan commitment and takes on the related risk.  In each case in which the Company participates in a loan, the rights and obligations of each participating bank are divided proportionately among the participating banks in an amount equal to their share of ownership and with equal priority among all banks.
 

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See Note 6, “Loans,” to the Company’s unaudited consolidated financial statements contained in Item 1 for information on loans serviced for others and loans pledged as collateral.

Credit Risk
 
The Company manages its loan portfolio to avoid concentration by industry and loan size to minimize its credit risk exposure. In addition, the Company does not have a “sub-prime” mortgage program.  However, inherent in the lending process is the risk of loss due to customer non-payment, or “credit risk.”  The Company’s commercial lending focus may entail significant additional risks compared to long term financing on existing, owner-occupied residential real estate.  These types of loans are typically larger and are generally viewed as having more risk of default than owner-occupied residential real estate loans or consumer loans.  The underlying commercial real estate values, customer cash flow and payment expectations and, in the case of commercial construction loans, the actual costs necessary to complete a construction project, can be more easily influenced by adverse conditions in the local or national economy, the real estate market, or the related industries.  As such, an extended downturn in the national or local economy or real estate markets, among other factors, could have a material impact on the borrowers’ ability to repay outstanding loans and on the value of the collateral securing these loans.  While the Company endeavors to minimize this risk through sound underwriting practices and the credit risk management function, management recognizes that loan losses will occur and that the amount of these losses will fluctuate depending on the risk characteristics of the loan portfolio and economic conditions.
 
The credit risk management function focuses on a wide variety of factors, including, among others, current and expected economic conditions, the real estate market, the financial condition of borrowers, the ability of borrowers to adapt to changing conditions or circumstances affecting their business and the continuity of borrowers’ management teams.  Early detection of credit issues is critical to minimize credit losses.  Accordingly, management regularly monitors these factors, among others, through ongoing credit reviews by the Credit Department, an external loan review service, reviews by members of senior management and the Loan Committee of the Board of Directors.  This review includes the assessment of internal credit quality indicators such as the risk classification of loans, adversely classified loans, past due and non-accrual loans, impaired and restructured loans, and the level of foreclosure activity. 

The Company’s loan risk rating system classifies loans depending on risk of loss characteristics.  The classifications range from “substantially risk free” for the highest quality loans and loans that are secured by cash collateral, to the more severe adverse classifications of “substandard,” “doubtful” and “loss” based on criteria established under banking regulations.  Loans classified as substandard include those characterized by the distinct possibility that the Company will sustain some loss if the deficiencies are not corrected.  Loans classified as doubtful have all the weaknesses inherent in a substandard rated loan with the added characteristic that the weaknesses make collection or full payment from liquidation, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.  Loans classified as "loss" are generally considered uncollectible at present, although long term recovery of part or all of loan proceeds may be possible.  These “loss” loans would require a specific loss reserve or charge-off.  Adversely classified loans may be accruing or in non-accrual status and may be additionally designated as restructured and/or impaired, or some combination thereof. Loans which are evaluated to be of weaker credit quality are reviewed on a more frequent basis by management.
 
Loans on which the accrual of interest has been discontinued are designated as non-performing or non-accrual loans. Accrual of interest on loans is generally discontinued when a loan becomes contractually past due, with respect to interest or principal, by 90 days, or when reasonable doubt exists as to the full and timely collection of interest or principal. When a loan is placed on non-accrual status, all interest previously accrued but not collected is reversed against current period interest income. Interest accruals are resumed on such loans only when payments are brought current and have remained current for a period of 180 days or when, in the judgment of management, the collectability of both principal and interest is reasonably assured.  Interest payments received on loans in a non-accrual status are generally applied to principal on the books of the Company.
 
Impaired loans are individually significant loans for which management considers it probable that not all amounts due (principal and interest) in accordance with original contractual terms will be collected.  The majority of impaired loans are included within the non-accrual balances; however, not every loan in non-accrual status has been designated as impaired. Impaired loans include loans that have been modified in a troubled debt restructure ("TDR"). Impaired loans exclude large groups of smaller-balance homogeneous loans, such as residential mortgage loans and consumer loans, which are collectively evaluated for impairment and loans that are measured at fair value, unless the loan is amended in a TDR.

Management does not set any minimum delay of payments as a factor in reviewing for impaired classification.  Management considers the payment status, net worth and earnings potential of the borrower, and the value and cash flow of the collateral as factors to determine if a loan will be paid in accordance with its contractual terms.


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When a loan is deemed to be impaired, management estimates the credit loss by comparing the loan’s carrying value against either 1) the present value of the expected future cash flows discounted at the loan’s effective interest rate; 2) the loan’s observable market price; or 3) the expected realizable fair value of the collateral, in the case of collateral dependent loans.  A specific allowance is assigned to the impaired loan for the amount of estimated credit loss. Impaired loans are charged off, in whole or in part, when management believes that the recorded investment in the loan is uncollectible.
 
Loans are designated as a TDR when, as part of an agreement to modify the original contractual terms of the loan, the Bank grants a concession on the terms, that would not otherwise be considered, as a result of financial difficulties of the borrower.  Typically, such concessions consist of a reduction in interest rate to a below market rate, taking into account the credit quality of the note, or a deferment or reduction of payments (principal or interest), which materially alters the Bank’s position or significantly extends the note’s maturity date, such that the present value of cash flows to be received is materially less than those contractually established at the loan’s origination. All loans that are modified are reviewed by the Company to identify if a TDR has occurred. TDR loans are included in the impaired loan category and as such, these loans are individually reviewed and evaluated, and a specific reserve is assigned for the amount of the estimated credit loss.
 
Real estate acquired by the Company through foreclosure proceedings or the acceptance of a deed in lieu of foreclosure is classified as Other Real Estate Owned ("OREO"). When property is acquired, it is generally recorded at the lesser of the loan’s remaining principal balance, net of any unamortized deferred fees, or the estimated fair value of the property acquired, less estimated costs to sell. Any loan balance in excess of the estimated realizable fair value on the date of transfer is charged to the allowance for loan losses on that date. All costs incurred thereafter in maintaining the property, as well as subsequent declines in fair value are charged to non-interest expense.
 
Non-performing assets are comprised of non-accrual loans, deposit account overdrafts that are more than 90 days past due and OREO.  The designation of a loan or other asset as non-performing does not necessarily indicate that loan principal and interest will ultimately be uncollectible.  However, management recognizes the greater risk characteristics of these assets and therefore considers the potential risk of loss on assets included in this category in evaluating the adequacy of the allowance for loan losses.  Despite prudent loan underwriting, adverse changes within the Company’s market area, or deterioration in local, regional or national economic conditions, could negatively impact the Company’s level of non-performing assets in the future.

Asset Quality

At June 30, 2013, the Company had adversely classified loans (loans carrying “substandard,” “doubtful” or “loss” classifications) amounting to $27.6 million, compared to $34.4 million at December 31, 2012.  The decrease in adversely classified loans since the prior period was due primarily to paydowns on several commercial relationships, and upgraded commercial loans, in particular one larger commercial real estate relationship of approximately $6.0 million classified as accruing/impaired/troubled debt restructured ("TDR") at December 31, 2012 which was upgraded during the period, due to the borrower's improved financial condition and sustained performance over time, partially offset by additional credit downgrades during the period.
 
Adversely classified loans which were performing but possessed potential weaknesses and, as a result, could ultimately become non-performing loans amounted to $7.1 million at June 30, 2013 and $14.0 million at December 31, 2012.  This decrease was due primarily to the upgraded commercial real estate relationship noted above. The remaining balances of adversely classified loans were non-accrual loans, amounting to $20.5 million and $20.4 million at June 30, 2013 and December 31, 2012, respectively.  Non-accrual loans which were not adversely classified amounted to $1.1 million and $1.2 million at June 30, 2013 and December 31, 2012, respectively, and primarily represented the guaranteed portions of non-performing Small Business Administration loans.


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The following table sets forth information regarding non-performing assets, TDR loans and delinquent loans 60-89 days past due as to interest or principal, held by the Company at the dates indicated:
 
(Dollars in thousands)
 
June 30,
2013
 
December 31,
2012
 
June 30,
2012
Commercial real estate
 
$
12,645

 
$
12,608

 
$
13,723

Commercial and industrial
 
5,997

 
6,993

 
8,754

Commercial construction
 
1,442

 
743

 
700

Residential
 
995

 
862

 
1,237

Home equity
 
477

 
390

 
523

Consumer
 
6

 

 
3

Total non-accrual loans
 
21,562

 
21,596

 
24,940

Overdrafts > 90 days past due
 
8

 
5

 
1

Total non-performing loans
 
21,570

 
21,601

 
24,941

Other real estate owned (“OREO”)
 
136

 
500

 
1,005

Total non-performing assets
 
$
21,706

 
$
22,101

 
$
25,946

Total Loans
 
$
1,447,346

 
$
1,359,655

 
$
1,290,166

Accruing TDR loans not included above
 
$
8,081

 
$
16,039

 
$
11,252

Delinquent loans 60-89 day past due
 
$
226

 
$
1,184

 
$
1,814

Non-performing loans to total loans
 
1.49
%
 
1.59
%
 
1.93
%
Non-performing assets to total assets
 
1.24
%
 
1.33
%
 
1.61
%
Loans 60-89 days past due to total loans
 
0.02
%
 
0.09
%
 
0.14
%
Adversely classified loans to total loans
 
1.90
%
 
2.53
%
 
2.89
%
Allowance for loan losses
 
$
25,671

 
$
24,254

 
$
23,126

Allowance for loan losses: Non-performing loans
 
119.01
%
 
112.28
%
 
92.72
%
Allowance for loan losses: Total loans
 
1.77
%
 
1.78
%
 
1.79
%
 

Total impaired loans amounted to $29.3 million and $37.4 million at June 30, 2013 and December 31, 2012, respectively.  Total accruing impaired loans amounted to $8.6 million and $16.6 million at June 30, 2013 and December 31, 2012, respectively, while non-accrual impaired loans amounted to $20.7 million and $20.8 million as of June 30, 2013 and December 31, 2012, respectively.  The overall decrease in impaired loans was primarily due to paydowns on several commercial relationships and upgraded commercial loans, as discussed above, partially offset by additional credit downgrades during the period.
 
In management’s opinion, the majority of impaired loan balances at June 30, 2013 and December 31, 2012 were supported by expected future cash flows or, for those collateral dependent loans, the net realizable value of the underlying collateral. Based on management’s assessment at June 30, 2013, impaired loans totaling $17.5 million required no specific reserves and impaired loans totaling $11.8 million required specific reserve allocations of $4.2 million.  At December 31, 2012, impaired loans totaling $26.1 million required no specific reserves and impaired loans totaling $11.3 million required specific reserve allocations of $4.1 million.  Management closely monitors these relationships for collateral or credit deterioration.
 
Total TDR loans, included in the impaired loan figures above as of June 30, 2013 and December 31, 2012 were $18.9 million and $26.6 million, respectively.  TDR loans on accrual status amounted to $8.1 million and $16.0 million at June 30, 2013 and December 31, 2012, respectively. During the current quarter, a larger accruing TDR commercial real estate relationship was upgraded and removed from impaired/TDR status, as noted above. TDR loans included in non-performing loans amounted to $10.8 million and $10.5 million at June 30, 2013 and December 31, 2012, respectively.  The Company continues to work with commercial relationships and enters into loan modifications to the extent deemed to be necessary or appropriate while attempting to achieve the best mutual outcome given the current economic environment.
 
The carrying value of OREO at June 30, 2013 was $136 thousand and consisted of one property; two properties were added and two properties were sold during the 2013 period; there were $121 thousand in net gains realized on the sale of these OREO properties.  The carry value of OREO at December 31, 2012 and June 30, 2012 was $500 thousand and $1.0 million

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respectively. During the six months ended June 30, 2012, two properties were sold; there were gains of $45 thousand on these OREO sales.

Management believes that the loan portfolio has experienced a level of modest credit stabilization compared to the 2012 periods, as indicated by the improving statistics related to migration of adversely classified, non-accrual and impaired loans and the level of OREO properties held as of June 30, 2013. Given the size and commercial mix of the Company's loan portfolio, management considers the current statistics to be reflective of the lagging effect that the regional economic environment has had on the local commercial markets and its impact on the credit profile of such a portfolio. 

Allowance for Loan Losses
 
On a quarterly basis, management prepares an estimate of the allowance necessary to cover estimated credit losses.  The allowance for loan losses is an estimate of probable credit risk inherent in the loan portfolio as of the specified balance sheet dates.  The Company maintains the allowance at a level that it deems adequate to absorb all reasonably anticipated losses from specifically known and other credit risks associated with the portfolio.
 
In making its assessment on the adequacy of the allowance, management considers several quantitative and qualitative factors that could have an effect on the credit quality of the portfolio including individual assessment of larger and high risk credits, delinquency trends and the level of non-performing loans, net charge-offs, the growth and composition of the loan portfolio, expansion in geographic market area the experience level of lenders and changes in underwriting criteria, and the strength of the local and national economy, among other factors.  Except for loans specifically identified as impaired, as discussed above, the estimate is a two-tiered approach that allocates loan loss reserves to “adversely classified” loans by credit rating and to non-classified loans by credit type.  The general loss allocations take into account the quantitative historic loss experience as well as the qualitative factors identified above.  The allowance for loan losses is established through a provision for loan losses, which is a direct charge to earnings.  Loan losses are charged against the allowance when management believes that the collectability of the loan principal is unlikely.  Recoveries on loans previously charged off are credited to the allowance.

In the fourth quarter of 2012, the Company purchased a group of residential mortgage loans with a current carrying value of $17.2 million. These purchased loans conform to the Company's own underwriting standards and are generally consistent with the originated residential mortgage loan production in terms of individual loan size, credit quality and geographic region. These purchased residential loans are initially booked at fair market value and, in accordance with accounting guidance, do not carry an initial allowance for loan losses. Management will continue to closely monitor this portfolio of non classified loans for estimated credit loss under general loss allocations taking into account the loss experience as well as the quantitative and qualitative factors identified above.

Management closely monitors the credit quality of individual delinquent and non-performing relationships, industry concentrations, the local and regional real estate market and current economic conditions.  The level of delinquent and non-performing assets is largely a function of economic conditions and the overall banking environment.  Despite prudent loan underwriting, adverse changes within the Company’s market area, or further deterioration in the local, regional or national economic conditions could negatively impact the Company’s level of non-performing assets in the future.
 
The allowance for loan losses to total loans ratio was 1.77% at June 30, 2013 and 1.78% at December 31, 2012.  Based on management’s judgment as to the existing credit risks inherent in the loan portfolio, as discussed above under the headings "Credit Risk" and "Asset Quality," management believes that the Company’s allowance for loan losses is deemed adequate to absorb probable losses from specifically known and other credit risks associated with the portfolio as of June 30, 2013.
 

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The following table summarizes the activity in the allowance for loan losses for the periods indicated:
 
 
 
Six months ended June 30,
(Dollars in thousands)
 
2013
 
2012
Balance at beginning of year
 
$
24,254

 
$
23,160

 
 
 
 
 
Provision charged to operations
 
1,317

 
1,350

 
 
 
 
 
Recoveries on charged-off loans:
 
 

 
 

Commercial real estate
 
61

 

Commercial and industrial
 
41

 
192

Commercial construction
 
50

 
2

Residential
 
128

 

Home equity
 
21

 
1

Consumer
 
6

 
3

Total recoveries
 
307

 
198

Charged-off loans
 
 
 
 
Commercial real estate
 
14

 
223

Commercial and industrial
 
133

 
1,065

Commercial construction
 

 
100

Residential
 

 
182

Home equity
 
44

 

Consumer
 
16

 
12

Total Charged off
 
207

 
1,582

 
 
 
 
 
Net loans recovered / (charged-off)
 
100

 
(1,384
)
Ending Balance
 
$
25,671

 
$
23,126

Annualized net loans recovered / (charged-off): Average loans outstanding
 
0.01
%
 
(0.22
)%
 
The allowance reflects management’s estimate of loan loss reserves necessary to support the level of credit risk inherent in the portfolio during the period.  Refer to “Credit Risk,""Asset Quality” and “Allowance for Loan Losses” contained in Item 7, "Management’s Discussion and Analysis of Financial Condition and Results of Operations," included in the Company’s 2012 Annual Report on Form 10-K for additional information regarding the Company’s credit risk management process and allowance for loan losses.


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Deposits
 

The following table sets forth the deposit balances by certain categories at the dates indicated and the percentage of each category to total deposits.
 
 
 
June 30, 2013
 
December 31, 2012
 
June 30, 2012
(Dollars in thousands)
 
Amount
 
Percent
 
Amount
 
Percent
 
Amount
 
Percent
Non-interest bearing demand deposits
 
$
407,617

 
25.8
%
 
$
386,643

 
26.2
%
 
$
367,342

 
25.3
%
Interest bearing checking
 
224,051

 
14.2
%
 
210,564

 
14.3
%
 
191,370

 
13.1
%
Total checking
 
631,668

 
40.0
%
 
597,207

 
40.5
%
 
558,712

 
38.4
%
 
 
 
 
 
 
 
 
 
 
 
 
 
Savings
 
162,098

 
10.3
%
 
154,680

 
10.5
%
 
164,304

 
11.3
%
Money markets
 
517,365

 
32.8
%
 
491,942

 
33.3
%
 
473,554

 
32.6
%
Total savings/money markets
 
679,463

 
43.1
%
 
646,622

 
43.8
%
 
637,858

 
43.9
%
 
 
 
 
 
 
 
 
 
 
 
 
 
Certificates of deposit
 
215,634

 
13.6
%
 
228,166

 
15.5
%
 
257,042

 
17.7
%
Total non-brokered deposits
 
$
1,526,765

 
96.7
%
 
$
1,471,995

 
99.8
%
 
$
1,453,612

 
100.0
%
 
 
 
 
 
 
 
 
 
 
 
 
 
Brokered deposits
 
52,528

 
3.3
%
 
3,032

 
0.2
%
 

 
%
Total deposits
 
$
1,579,293

 
100.0
%
 
$
1,475,027

 
100.0
%
 
$
1,453,612

 
100.0
%


Total deposits increased $104.3 million, or 7%, compared to December 31, 2012, and increased $125.7 million, or 9%, since June 30, 2012. This increase since December 31, 2012 was primarily comprised of increases in brokered deposits of $49.5 million, as well as increases of $34.5 million, or 6%, in checking account balances and $32.8 million, or 5%, in savings and money market account balances, partially offset by a decrease of $12.5 million in CDs. The increases in non-brokered deposits were attributed to sales and marketing efforts and general inflow of funds into the deposit marketplace.
 
From time to time, management utilizes brokered deposits as cost effective wholesale funding sources to support continued loan growth. Since March 31, 2013, the brokered CD balances have increased primarily resulting from loan growth exceeding deposit growth in the quarter. In addition, as part of the Company's asset-liability management strategy, during the current year, wholesale funding balances were shifted from overnight FHLB borrowings to brokered CDs with an average life of approximately five years. The brokered deposit balance at June 30, 2013 primarily represented CD balances from the offering of CDs under deposit placement agreements with select brokers.

Borrowed Funds
 
Borrowed funds consisted of FHLB borrowings of $1.9 million at June 30, 2013, compared to $26.5 million at December 31, 2012 and $2.9 million June 30, 2012, respectively. As noted above, borrowed fund balances have declined since year end as the Company has utilized brokered CDs as a strategic funding source.

At June 30, 2013, the Bank had the capacity to borrow additional funds from the FHLB of up to approximately $244.6 million and capacity to borrow from the FRB Discount window of approximately $57.7 million.
 
The Company also had $10.8 million of outstanding junior subordinated debentures at June 30, 2013, December 31, 2012 and June 30, 2012, respectively, in addition to the borrowed funds noted above.


Liquidity
 
Liquidity is the ability to meet cash needs arising from, among other things, fluctuations in loans, investments, deposits and borrowings.  Liquidity management is the coordination of activities so that cash needs are anticipated and met readily and efficiently.  The Company’s liquidity policies are set and monitored by the Company’s Asset-Liability Committee of the Board of Directors.  The Company’s asset-liability objectives are to engage in sound balance sheet management strategies, maintain liquidity, provide and enhance access to a diverse and stable source of funds, provide competitively priced and attractive

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products to customers and conduct funding at a low cost relative to current market conditions.  Funds gathered are used to support current commitments, to fund earning asset growth, and to take advantage of selected leverage opportunities.
 
The Company’s liquidity is maintained by projecting cash needs, balancing maturing assets with maturing liabilities, monitoring various liquidity ratios, monitoring deposit flows, maintaining cash flow within the investment portfolio, and maintaining wholesale funding resources. 

At June 30, 2013, the Company’s wholesale funding sources included borrowing capacity at the FHLB and brokered deposits. In addition, the Company maintains fed fund purchase arrangements with correspondent banks and access to the FRB Discount Window. Brokered deposits may be comprised of overnight money market deposits and selected term CDs gathered from nationwide bank networks in increments that are covered by FDIC insurance, or term deposits brokered from large money center banks. 

Management believes that the Company has adequate liquidity to meet its obligations. However, if, as a result of general economic conditions, or other events, these sources of external funding become restricted or are eliminated, the Company may not be able to raise adequate funds or may incur substantially higher funding costs or operating restrictions in order to raise the necessary funds to support the Company's operations and growth.

The Company has in the past also issued junior subordinated debentures and offered shares of the Company’s common stock for sale to the general public, as most recently with the December 2009 offerings, in order to increase its liquidity.

Capital Resources
 
The Company believes its current capital is adequate to support ongoing operations.  As of June 30, 2013, both the Company and the Bank qualify as “well capitalized” under applicable regulations of the Federal Reserve Board and the FDIC. 
 
The current regulatory requirements and the Company’s actual capital amounts and ratios are presented as of June 30, 2013 in the table below.  The Bank’s capital amounts and ratios do not differ materially from the amounts and ratios presented for the Company.
 
 
Actual
 
Minimum Capital
for Capital Adequacy
Purposes
 
Minimum Capital
To Be
Well Capitalized
 
(Dollars in thousands)
 
Amount
 
Ratio
 
Amount
 
Ratio
 
Amount
 
Ratio
 
Total Capital (to risk weighted assets)
 
$
165,603


11.28
%

$
117,492


8.00
%

$
146,865


10.00
%
 
Tier 1 Capital (to risk weighted assets)
 
$
146,303


9.96
%

$
58,746


4.00
%

$
88,119


6.00
%
 
Tier 1 Capital (to average assets) or Leverage ratio
 
$
146,303


8.62
%

$
67,924


4.00
%

$
84,905


5.00
%
*
__________________________________________
* This requirement is reflected in the table merely for informational purposes with respect to the Bank, and does not apply to the Company. 

Although the Company believes its current capital is adequate to support ongoing operations, on July 18, 2013, the Company filed a shelf registration of common stock, rights or preferred stock with the Securities and Exchange Commission for the flexibility to raise, over a three year period, up to $40 million in capital to ensure the Company is positioned to take advantage of future growth and market share opportunities.

The Company maintains a dividend reinvestment plan (the "DRP").  The DRP enables stockholders, at their discretion, to elect to reinvest cash dividends paid on their shares of the Company’s common stock by purchasing additional shares of common stock from the Company at a purchase price equal to fair market value.  Shareholders utilized the DRP to invest $630 thousand of the $2.2 million in cash dividends paid through June 30, 2013, into 37,892 shares of the Company’s common stock.
 
As previously announced on July 16, 2013, the Company declared a quarterly dividend of $0.115 per share to be paid on September 3, 2013 to shareholders of record as of August 13, 2013. The quarterly dividend represents a 4.5% increase over the 2012 dividend rate.

On July 2, 2013, the Federal Reserve, and on July 9, 2013, the FDIC and OCC, adopted a final rule that implements the Basel III changes to the international regulatory capital framework and revises the U.S. risk-based and leverage capital requirements

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for U.S. banking organizations to strengthen identified areas of weakness in the capital rules and to address relevant provisions of the Dodd-Frank Act.

The final rule establishes a stricter regulatory capital framework that requires banking organizations to hold more and higher-quality capital to act as a financial cushion to absorb losses and help banking organizations better withstand periods of financial stress. The final rule emphasizes common equity tier 1 (“CET1”) capital and implements strict eligibility criteria for regulatory capital instruments while also modifying the methodology for calculating risk-weighted assets to enhance risk sensitivity. The final rule also increases capital ratios for all banking organizations and introduces a “capital conservation buffer” which is in addition to each capital ratio. If a banking organization dips into its capital conservation buffer it may be restricted in its ability to pay dividends and discretionary bonus payments to its executive officers. More specifically, under the final rule, all banking organizations are required to maintain capital ratios including: (i) as a newly adopted international standard, a minimum ratio of CET1 to risk-weighted assets of at least 4.5%, plus a 2.5% capital conservation buffer (which is added to the 4.5% CET1 ratio as that buffer is phased in, effectively resulting in a minimum ratio of CET1 to risk-weighted assets of at least 7% upon full implementation), (ii) a minimum ratio of Tier 1 capital to risk-weighted assets of at least 6.0%, plus the capital conservation buffer (which is added to the 6.0% Tier 1 capital ratio as that buffer is phased in, effectively resulting in a minimum Tier 1 capital ratio of 8.5% upon full implementation), (iii) a minimum ratio of Total capital (that is, Tier 1 plus Tier 2) to risk-weighted assets of at least 8.0%, plus the capital conservation buffer (which is added to the 8.0% total capital ratio as that buffer is phased in, effectively resulting in a minimum total capital ratio of 10.5% upon full implementation) and (iv) a leverage ratio of 4.0%. In addition, the final rule permits banking organizations with less than $15 billion in consolidated assets as of December 31, 2009 to include in their tier 1 capital on a permanent basis trust preferred securities and cumulative perpetual preferred stock issued and included in tier 1 capital prior to May 19, 2010, without any phase out. Although community banks must generally begin complying with the final rules on January 1, 2015, management believes the Company would satisfy the higher capital ratios imposed by Basel III as of June 30, 2013.

The above BASEL III capital ratio requirements as applicable to the Bank after the full phase-in period are summarized in the table below.(1) 
 
 
BASEL III Minimum for Capital Adequacy Purposes
 
BASEL III Additional Capital Conservation Buffer
 
BASEL III Ratio with Capital Conservation Buffer
Total Capital (to risk weighted assets)
 
8.0%
 
2.5%
 
10.5%
Tier 1 Capital (to risk weighted assets)
 
6.0%
 
2.5%
 
8.5%
Tier 1 Capital (to average assets) or Leverage ratio
 
4.0%
 
—%
 
4.0%
Common Equity Tier 1 (to risk weighted assets)
 
4.5%
 
2.5%
 
7.0%
__________________________________________
(1) Because the BASEL III final rules modify the methodology for calculating risk-weighted assets and the deduction and adjustment to capital, the ratios above may not be comparable to the current applicable regulatory requirements, or the Company's actual capital ratios as of June 30, 2013.



Investment Assets Under Management
 
The Company provides a wide range of investment advisory and wealth management services, including brokerage, trust, and investment management (together, “investment advisory services”).  The market values of the related assets managed are affected by fluctuations in the financial markets.
 
Also included in the investment assets under management total are customers’ commercial sweep arrangements that are invested in third party money market mutual funds.
 

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Table of Contents

The following table sets forth the fair market value of investment assets under management by certain categories at the dates indicated.
 
(Dollars in thousands)
 
June 30,
2013
 
December 31,
2012
 
June 30,
2012
Investment advisory and management services
 
$
496,675

 
$
480,216

 
$
439,783

Brokerage and management services
 
112,652

 
108,679

 
105,576

Total investment advisory assets
 
609,327

 
588,895

 
545,359

Commercial sweep accounts
 
3,839

 
3,460

 
6,915

Investment assets under management
 
$
613,166

 
$
592,355

 
$
552,274


Investment assets under management increased $20.8 million, or 4%, since December 31, 2012 and $60.9 million, or 11%, since June 30, 2012.  The increase since December 31, 2012 is attributable primarily to asset growth from market value appreciation. Since June 30, 2012, the increase is attributable to asset growth from both new business and market value appreciation.
 
Total assets under management, which includes total assets, investment assets under management, and loans serviced for others amounted to $2.44 billion at June 30, 2013, $2.33 billion at December 31, 2012, and $2.23 billion at June 30, 2012. Investment assets under management and loans serviced for others are not carried as assets on the Company's balance sheet.



Results of Operations
Three Months Ended June 30, 2013 vs. Three Months Ended June 30, 2012
 
Unless otherwise indicated, the reported results are for the three months ended June 30, 2013 with the “comparable period,” and “prior period” being the three months ended June 30, 2012. Average yields are presented on a tax equivalent basis.
 
The Company’s second quarter 2013 net income amounted to $3.1 million compared to $2.9 million for the same period in 2012, an increase of 6%.  Diluted earnings per common share were $0.31 and $0.30 for the three months ended June 30, 2013 and June 30, 2012, respectively, an increase of 3%.
 
The Company's growth contributed to increases in net interest income, non-interest income and the level of operating expenses for the current year compared to the same 2012 period. Non-interest income also increased as a result of higher gains on securities sales in the current year. Additionally, the quarter ended June 30, 2013 was impacted by a lower loan loss provision compared to the same period in 2012, partially offset by the costs of our community event held in May 2013.

Net Interest Income

The Company’s net interest income for the quarter ended June 30, 2013 amounted to $16.1 million, compared to $15.4 million for the quarter ended June 30, 2012, an increase of $716 thousand, or 5%.  The increase in net interest income over the comparable period was primarily due to revenue generated from loan growth partially offset by a decrease in tax equivalent net interest margin ("margin").
 
Net Interest Margin
 
The Company’s margin was 4.08% for the three months ended June 30, 2013 compared to 4.16% and 4.21% for the quarters ended March 31, 2013 and December 31, 2012, respectively. For the quarter ended June 30, 2012, margin was 4.31%.  Consistent with industry trends, the 2013 margin continues to trend downward, as the yield on interest earning assets has declined faster than the cost of funding, as funding rates have reached a level leaving little room for significant reductions. Interest earning asset yields declined 36 basis points compared to the prior year, while the cost of funding declined by 13 basis points over the same period.

 

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Table of Contents

Rate / Volume Analysis
 
The following table sets forth the extent to which changes in interest rates and changes in the average balances of interest-earning assets and interest-bearing liabilities have affected interest income and expense during the three months ended June 30, 2013 compared to the three months ended June 30, 2012.  For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to: (1) volume (change in average portfolio balance multiplied by prior period average rate); (2) interest rate (change in average interest rate multiplied by prior period average balance); and (3) rate and volume (the remaining difference).
 
 
 
 
 
Increase (decrease) due to
(Dollars in thousands)
 
Net
Change
 
Volume
 
Rate
 
Rate/
Volume
Interest Income
 
 

 
 

 
 

 
 

Loans and loans held for sale
 
$
425

 
$
2,127

 
$
(1,531
)
 
$
(171
)
Investment securities
 
(41
)
 
164

 
(151
)
 
(54
)
Other interest earning assets (1)
 
(13
)
 
(17
)
 
13

 
(9
)
Total interest earnings assets
 
371

 
2,274

 
(1,669
)
 
(234
)
Interest Expense
 
 

 
 

 
 

 
 

Interest checking, savings and money market
 
(194
)
 
58

 
(220
)
 
(32
)
Certificates of deposit
 
(256
)
 
(102
)
 
(188
)
 
34

Brokered deposits
 
78

 

 

 
78

Borrowed funds
 
27

 
167

 
(10
)
 
(130
)
Junior subordinated debentures
 

 

 

 

Total interest-bearing deposits, borrowed funds and debentures
 
(345
)
 
123

 
(418
)
 
(50
)
Change in net interest income
 
$
716

 
$
2,151

 
$
(1,251
)
 
$
(184
)
__________________________________________
(1)
Other interest earning assets includes dividends on FHLB stock and income on short-term investments.

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Table of Contents

The following table presents the Company’s average balance sheet, net interest income and average rates for the three months ended June 30, 2013 and 2012.

AVERAGE BALANCES, INTEREST AND AVERAGE YIELDS
 
 
Three Months Ended
June 30, 2013
 
Three Months Ended
June 30, 2012
(Dollars in thousands)
 
Average
Balance
 
Interest
 
Average
Yield(1)
 
Average
Balance
 
Interest
 
Average
Yield(1)
Assets:
 
 

 
 

 
 

 
 

 
 

 
 

Loans (2)
 
$
1,430,424

 
$
16,653

 
4.72
%
 
$
1,268,173

 
$
16,228

 
5.20
%
Investments (3)
 
179,710

 
794

 
2.34
%
 
155,649

 
835

 
2.73
%
Other Interest Earning Assets (4)
 
14,958

 
11

 
0.29
%
 
51,018

 
24

 
0.19
%
Total interest earnings assets
 
1,625,092

 
17,458

 
4.41
%
 
1,474,840

 
17,087

 
4.77
%
Other assets
 
87,777

 
 

 
 

 
88,197

 
 

 
 

Total assets
 
$
1,712,869

 
 

 
 

 
$
1,563,037

 
 

 
 

 
 
 
 
 
 
 
 
 
 
 
 
 
Liabilities and stockholders’ equity:
 
 

 
 

 
 

 
 

 
 

 
 

Int chkg, savings and money market
 
$
865,943

 
532

 
0.25
%
 
$
801,816

 
726

 
0.36
%
Certificates of deposit
 
219,643

 
386

 
0.70
%
 
260,886

 
642

 
0.99
%
Brokered deposits
 
29,876

 
78

 
1.04
%
 

 

 
%
Borrowed funds
 
41,781

 
40

 
0.38
%
 
2,869

 
13

 
1.72
%
Junior subordinated debentures
 
10,825

 
295

 
10.88
%
 
10,825

 
295

 
10.88
%
Total interest-bearing funding
 
1,168,068

 
1,331

 
0.46
%
 
1,076,396

 
1,676

 
0.63
%
 
 
 
 
 
 
 
 
 
 
 
 
 
Net interest rate spread
 
 

 
 

 
3.95
%
 
 

 
 

 
4.14
%
 
 
 
 
 
 
 
 
 
 
 
 
 
Demand deposits
 
390,341

 

 


 
344,897

 

 


Total deposits, borrowed funds and debentures
 
1,558,409

 
1,331

 
0.34
%
 
1,421,293

 
1,676

 
0.47
%
Other liabilities
 
10,841

 
 

 
 

 
9,788

 
 

 
 

Total liabilities
 
1,569,250

 
 

 
 

 
1,431,081

 
 

 
 

 
 
 
 
 
 
 
 
 
 
 
 
 
Stockholders’ equity
 
143,619

 
 

 
 

 
131,956

 
 

 
 

Total liabilities and stockholders’ equity
 
$
1,712,869

 
 

 
 

 
$
1,563,037

 
 

 
 

 
 
 
 
 
 
 
 
 
 
 
 
 
Net interest income
 
 

 
$
16,127

 
 

 
 

 
$
15,411

 
 

Net interest margin (tax equivalent)
 
 

 
 

 
4.08
%
 
 

 
 

 
4.31
%
(1)
Average yields are presented on a tax equivalent basis.  The tax equivalent effect associated with loans and investments, which was not included in the interest amount above, was $423 thousand and $403 thousand for the quarters ended June 30, 2013 and June 30, 2012, respectively.
(2)
Average loans include non-accrual loans and are net of average deferred loan fees.
(3)
Average investments are presented at amortized cost and include investment securities, interest-earning deposits, fed funds sold and FHLB stock.
(4)
Average other interest earning assets include interest earning deposits, fed funds sold and FHLB stock.


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Table of Contents

Interest and Dividend Income

For the second quarter of 2013, total interest and dividend income amounted to $17.5 million, an increase of $371 thousand, or 2%, compared to the prior period.  The increase resulted primarily from an increase of $150.3 million, or 10%, in the average balance of interest earning assets for the quarter ended June 30, 2013 compared to the second quarter of 2012, primarily in loans, partially offset by a 36 basis point decline in the yield on interest earning assets due primarily to the lower interest rate environment during the period.

Interest income on loans and loans held for sale, which accounts for the majority of interest income, amounted to $16.7 million for the quarter ended June 30, 2013, an increase of $425 thousand, or 3%, over the comparable period, due primarily to loan growth, partially offset by a decline in loan yields.  The average balances of loans and loans held for sale increased $162.3 million, or 13%, for the three months ended June 30, 2013 compared to the same period in 2012, while the average yield on these assets declined 48 basis points compared to the prior period and amounted to 4.72% for the three months ended June 30, 2013.

Income on investment securities amounted to $794 thousand, a decrease of $41 thousand, or 5% compared to the same period in 2012. This decrease primarily resulted from a decline in investment yields of 39 basis points, partially offset by an increase of $24.1 million, or 15%, in the average balance of investment securities.

Income on other interest earning assets has decreased $13 thousand compared to the same three month period in 2012 primarily resulting from a decrease in the average balance of these investments, as funds were utilized to purchase longer term investment securities and fund loan growth.

Interest Expense
 
For the three months ended June 30, 2013, total interest expense amounted to $1.3 million, a decrease of $345 thousand, or 21%, compared to the prior period.  The decrease resulted primarily from a 13 basis point decrease in the average cost of funding, due primarily to the reduction in deposit market interest rates over the period, partially offset by an increase in wholesale funding.
 
Interest expense on interest checking, savings and money market accounts amounted to $532 thousand for the quarter ended June 30, 2013, a decrease of $194 thousand, or 27%, compared to the same quarter in the prior period. The decrease primarily resulted from a decrease of 11 basis points in the average cost of these accounts, to 0.25%, partially offset by an increase in average balances of $64.1 million, or 8%, for the three months ended June 30, 2013 compared to the same period in 2012
 
Interest expense on CDs amounted to $386 thousand, a decrease of $256 thousand, or 40%, over the comparable period. The average cost of CDs decreased 29 basis points, to 0.70%, for the three months ended June 30, 2013 and the average balances decreased $41.2 million, or 16%, compared to the same prior period in 2012.

Interest expense on brokered deposits amounted to $78 thousand, an increase of $78 thousand over the comparable period. The average cost of brokered deposits amounted to 1.04%, for the three months ended June 30, 2013 and the average balances increased by $29.9 million compared to the 2012 period. The Company did not have any brokered deposits in the second quarter of 2012.

Interest expense on borrowed funds, consisting primarily of FHLB borrowings, amounted to $40 thousand for the second quarter of 2013, an increase of $27 thousand over the same period last year.  The increase was primarily attributed to an increase in average balances of approximately $38.9 million for the quarter ended June 30, 2013 compared to the same period in 2012, partially offset by a 134 basis point decline in average costs of these borrowings.  
 
The interest expense and average rate on junior subordinated debentures remained the same at $295 thousand and 10.88% for both the three months ended June 30, 2013 and June 30, 2012.
 
For the three months ended June 30, 2013, the average balance of non-interest bearing demand deposits increased $45.4 million, or 13%, as compared to the same period in 2012.  Non-interest bearing demand deposits are an important component of the Company’s core funding strategy.  This non-interest bearing funding source represented 26% and 25% of total average deposit balances for the three months ended June 30, 2013 and 2012, respectively.


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Provision for Loan Loss
 
The provision for loan losses amounted to $534 thousand for three months ended June 30, 2013 a decrease of $516 thousand compared to the same period last year.  In determining the provision to the allowance for loan losses, management takes into consideration the level of loan growth and an estimate of credit risk, which includes such items as adversely classified and non-performing loans, the estimated specific reserves needed for impaired loans, the level of net charge-offs, and the estimated impact of current economic conditions on credit quality. For further discussion regarding the provision for loan losses and management’s assessment of the adequacy of the allowance for loan losses see "Credit Risk," "Asset Quality” and “Allowance for Loan Losses” under "Financial Condition" in this Item 2 above and "Credit Risk," “Asset Quality” and “Allowance for Loan Losses” in the Financial Condition section of Management’s Discussion and Analysis of Financial Condition and Results of Operations in the Company’s 2012 Annual Report on Form 10-K.
 
There have been no material changes to the Company’s underwriting practices or to the allowance for loan loss methodology used to estimate loan loss exposure as reported in the Company’s Annual Report on Form 10-K for the year ended December 31, 2012. The provision for loan losses is a significant factor in the Company’s operating results.
 
Non-Interest Income
 
Non-interest income for the three months ended June 30, 2013 amounted to $3.6 million, an increase of $601 thousand, or 20%, as compared to the three months ended June 30, 2012.  The significant changes are discussed below.

Net gains on security sales for the three months ended June 30, 2013 increased $356 thousand, or 318%, compared to the comparable period in 2012. Investment sales are typically driven by market or strategic opportunities.

Investment advisory income increased $111 thousand, or 12%, compared to the same quarter in the prior period primarily due to net asset growth from new business and changes in market values due to fluctuations in the investment markets.

Non-Interest Expense
 
Non-interest expense for the three months ended June 30, 2013 amounted to $14.5 million, an increase of $1.5 million, or 11%, compared to the same period in 2012. The significant changes are discussed below.
 
Salaries and employee benefits increased $810 thousand, or 10%.  The increase is primarily due to increased personnel costs necessary to support the Company’s strategic growth and market expansion initiatives, including annual salary and incentive adjustments, since the prior period.

Technology and telecommunications expenses increased $126 thousand, or 12%, primarily as a result of investments to improve our service capabilities, support the Company's growth and enhance business continuity and network infrastructure.

Advertising and public relations increased $449 thousand, or 90%, primarily as a result of our corporate community event held in May 2013 and to a lesser extent other advertising costs related to seasonal campaigns and branch expansion.



Results of Operations
Six Months Ended June 30, 2013 vs. Six Months Ended June 30, 2012
 
Unless otherwise indicated, the reported results are for the six months ended June 30, 2013 with the “comparable period,” “prior year” and “prior period” being the six months ended June 30, 2012. Average yields are presented on a tax equivalent basis.
 
The Company’s year-to-date 2013 net income amounted to $6.5 million compared to $6.1 million for the same period in 2012, an increase of $434 thousand, or 7%.  Diluted earnings per common share were $0.66 for the six months ended June 30, 2013 compared to $0.63 for the comparable 2012 period, an increase of 5%.
 

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The Company's growth contributed to increases in net interest income, non-interest income and the level of operating expenses for the six months ended June 30, 2013 compared to the same 2012 period. Non-interest income also increased primarily as a result of gains on securities sales.

Net Interest Income
 
The Company’s net interest income for the six months ended June 30, 2013 was $31.9 million compared to $30.3 million for the six months ended June 30, 2012, an increase of $1.6 million, or 5%.  The increase in net interest income over the comparable year period was primarily due to revenue generated from loan growth partially offset by a decrease in tax equivalent net interest margin. Interest earning asset yields declined 36 basis points compared to the prior year, while the cost of funding declined by 16 basis points over the same period.
 
Net Interest Margin
 
The Company’s margin was 4.12% for the six months ended June 30, 2013, compared to 4.33% in the comparable 2012 period.  Consistent with the industry, the margin continued to trend downward, as the yield on interest-earning assets declined faster than the cost of funding, as funding rates have reached a level leaving little room for significant reductions.
 
Rate / Volume Analysis
 
The following table sets forth the extent to which changes in interest rates and changes in the average balances of interest-earning assets and interest-bearing liabilities have affected interest income and expense during the six months ended June 30, 2013 compared to the six months ended June 30, 2012.  For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to: (1) volume (change in average portfolio balance multiplied by prior period average rate); (2) interest rate (change in average interest rate multiplied by prior period average balance); and (3) rate and volume (the remaining difference).

 
 
 
 
Increase (decrease) due to
(Dollars in thousands)
 
Net
Change
 
Volume
 
Rate
 
Rate/
Volume
Interest Income
 
 

 
 

 
 

 
 

Loans and loans held for sale
 
$
840

 
$
3,925

 
$
(2,650
)
 
$
(435
)
Investment Securities
 
(30
)
 
465

 
(359
)
 
(136
)
Other Interest Earning Assets (1)
 
(22
)
 
(27
)
 
11

 
(6
)
 
 
 
 
 
 
 
 
 
Total interest earnings assets
 
788

 
4,363

 
(2,998
)
 
(577
)
 
 
 
 
 
 
 
 
 
Interest Expense
 
 

 
 

 
 

 
 

Interest checking, savings and money market
 
(399
)
 
138

 
(467
)
 
(70
)
Certificates of deposit
 
(561
)
 
(217
)
 
(406
)
 
62

Brokered deposits
 
85

 

 

 
85

Borrowed funds
 
57

 
326

 
(22
)
 
(247
)
Junior subordinated debentures
 

 

 

 

Total interest-bearing deposits, borrowed funds and debentures
 
(818
)
 
247

 
(895
)
 
(170
)
Change in net interest income
 
$
1,606

 
$
4,116

 
$
(2,103
)
 
$
(407
)
_________________________________
(1)
Other interest earning assets includes dividends on FHLB stock and income on short-term investments.


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The following table presents the Company’s average balance sheet, net interest income and average rates for the six months ended June 30, 2013 and 2012
AVERAGE BALANCES, INTEREST AND AVERAGE YIELDS
 
 
 
Six months ended June 30, 2013
 
Six months ended June 30, 2012
(Dollars in thousands)
 
Average
Balance
 
Interest
 
Average
Yield(1)
 
Average
Balance
 
Interest
 
Average
Yield(1)
Assets:
 
 

 
 

 
 

 
 

 
 

 
 

Loans and loans held for sale (2)
 
$
1,406,414

 
$
33,026

 
4.78
%
 
$
1,255,863

 
$
32,186

 
5.21
%
Investments (3)
 
179,178

 
1,604

 
2.36
%
 
146,530

 
1,634

 
2.85
%
Other Interest Earning Assets(4)
 
16,351

 
21

 
0.26
%
 
42,086

 
43

 
0.21
%
Total interest earnings assets
 
1,601,943

 
34,651

 
4.46
%
 
1,444,479

 
33,863

 
4.82
%
Other assets
 
87,309

 
 

 
 

 
86,363

 
 

 
 

Total assets
 
$
1,689,252

 
 

 
 

 
$
1,530,842

 
 

 
 

 
 
 
 
 
 
 
 
 
 
 
 
 
Liabilities and stockholders’ equity:
 
 

 
 

 
 

 
 

 
 

 
 

Int chkg, savings and money market
 
$
856,389

 
1,132

 
0.27
%
 
$
785,232

 
1,531

 
0.39
%
Certificates of deposit
 
222,688

 
813

 
0.74
%
 
264,415

 
1,374

 
1.05
%
Brokered deposits
 
16,528

 
85

 
1.04
%
 

 

 
%
Borrowed funds
 
44,653

 
86

 
0.39
%
 
3,594

 
29

 
1.60
%
Junior subordinated debentures
 
10,825

 
589

 
10.88
%
 
10,825

 
589

 
10.88
%
Total interest-bearing funding
 
1,151,083

 
2,705

 
0.47
%
 
1,064,066

 
3,523

 
0.67
%
 
 
 
 
 
 
 
 
 
 
 
 
 
Net interest rate spread
 
 

 
 

 
3.99
%
 
 

 
 

 
4.15
%
Demand deposits
 
384,300

 

 
 
 
326,012

 

 
 
Total deposits, borrowed funds and debentures
 
1,535,383

 
2,705

 
0.35
%
 
1,390,078

 
3,523

 
0.51
%
Other liabilities
 
11,554

 
 

 
 

 
10,220

 
 

 
 

Total liabilities
 
1,546,937

 
 

 
 

 
1,400,298

 
 

 
 

Stockholders’ equity
 
142,315

 
 

 
 

 
130,544

 
 

 
 

Total liabilities and stockholders’ equity
 
$
1,689,252

 
 

 
 

 
$
1,530,842

 
 

 
 

Net interest income
 
 

 
$
31,946

 
 

 
 

 
$
30,340

 
 

Net interest margin (tax equivalent)
 
 

 
 

 
4.12
%
 
 

 
 

 
4.33
%
_______________________________
(1)
Average yields are presented on a tax equivalent basis.  The tax equivalent effect associated with loans and investments, which was not included in the interest amount above, was $841 thousand and $801 thousand for the periods ended June 30, 2013 and June 30, 2012 respectively.
(2)
Average loans and loans held for sale include non-accrual loans and are net of average deferred loan fees.
(3)
Average investment balances are presented at average amortized cost.
(4)
Average other interest earning assets includes interest-earning deposits, fed funds sold, and FHLB stock.
 

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Interest and Dividend Income
 
Total interest and dividend income amounted to $34.7 million for the six months ended June 30, 2013, an increase of $788 thousand, or 2%, compared to the prior period.  The increase resulted primarily from an increase of $157.5 million, or 11%, in the average balance of interest earning assets, partially offset by a 36 basis point decline in the yield on interest earning assets due to the lower interest rate environment during the period.
 
Interest income on loans and loans held for sale, which accounts for the majority of interest income, amounted to $33.0 million, an increase of $840 thousand, or 3%, over the comparable period, due primarily to loan growth, partially offset by a decline in loan yields.  The average loans and loans held for sale balances increased $150.6 million, or 12%, compared to the prior period, while the average yield on loans and loans held for sale declined 43 basis points since the same period and amounted to 4.78% for the six months ended June 30, 2013.

Income on investment securities amounted to $1.6 million, a decrease of $30 thousand, or 2%, compared to the same period in 2012. This decrease primarily resulted from a decline in investment yields of 49 basis points, partially offset by an increase of $32.6 million, or 22%, in the average balance of investment securities.

Income on other interest earning assets has decreased $22 thousand compared to the same six month period in 2012 primarily resulting from a decrease in the average balance of these investments, as funds were utilized to purchase longer term investment securities and fund loan growth.
 
Interest Expense
 
For the six months ended June 30, 2013, total interest expense amounted to $2.7 million, a decrease of $818 thousand, or 23%, compared to the prior period.  The decrease resulted primarily from a 16 basis point decrease in the average cost of funding due to the reduction in deposit market interest rates over the period, partially offset by an increase in wholesale funding.

Interest expense on interest checking, savings and money market accounts amounted to $1.1 million for the six months ended June 30, 2013, a decrease of $399 thousand, or 26%, over the same period in the prior year, resulting primarily from a decrease in the average cost of these accounts, partially offset by an increase in average balances. The average cost of these accounts decreased 12 basis points to 0.27%, while the average balances increased $71.2 million, or 9%, compared to the prior period. 
 
Interest expense on CDs amounted to $813 thousand, a decrease of $561 thousand, or 41%, over the comparable period. The average cost of CDs decreased 31 basis points, to 0.74%, for the six months ended June 30, 2013, and the average balances decreased $41.7 million, or 16%, compared to the same prior period in 2012.

Interest expense on brokered deposits amounted to $85 thousand, an increase of $85 thousand over the comparable period. The Company did not have any brokered deposits in the first six months of 2012. The average cost of brokered deposits amounted to 1.04%, for the six months ended June 30, 2013 and the average balances increased by $16.5 million compared to the 2012 period.
 
Interest expense on borrowed funds, consisting primarily of FHLB borrowings, amounted to $86 thousand, an increase of $57 thousand compared to the same period last year.  The increase was primarily attributed to the increase in average balances of approximately $41.1 million, partially offset by a 121 basis point decrease in average costs of these borrowings.
 
The interest expense and average rate on junior subordinated debentures remained the same at $589 thousand and 10.88% for both the six months ended June 30, 2013 and June 30, 2012.
 
For the six months ended June 30, 2013, the average balance of non-interest bearing demand deposits, increased $58.3 million, or 18%, as compared to the same period in 2012.  Non-interest bearing demand deposits are an important component of the Company’s core funding strategy.  This non-interest bearing funding represented 26% and 24% of total average deposit balances for the six months ended June 30, 2013 and 2012, respectively.
 
Provision for Loan Loss
 
The provision for loan losses amounted to $1.3 million for the six months ended June 30, 2013, a decrease of $33 thousand compared to the same period last year.  In determining the provision to the allowance for loan losses, management takes into consideration the level of loan growth and an estimate of credit risk, which includes such items as adversely classified and non-

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performing loans, the estimated specific reserves needed for impaired loans, the level of net charge-offs, and the estimated impact of current economic conditions on credit quality. For further discussion regarding the provision for loan losses and management’s assessment of the adequacy of the allowance for loan losses see "Credit Risk," "Asset Quality” and “Allowance for Loan Losses” under "Financial Condition" in this Item 2 above and "Credit Risk," “Asset Quality” and “Allowance for Loan Losses” in the Financial Condition section of Management’s Discussion and Analysis of Financial Condition and Results of Operations in the Company’s 2012 Annual Report on Form 10-K.
 
There have been no material changes to the Company’s underwriting practices or to the allowance for loan loss methodology used to estimate loan loss exposure as reported in the Company’s Annual Report on Form 10-K for the year ended December 31, 2012.  The provision for loan losses is a significant factor in the Company’s operating results.

Non-Interest Income
 
Non-interest income for the six months ended June 30, 2013 amounted to $7.2 million, an increase of $1.3 million, or 21%, as compared to the six months ended June 30, 2012.  The significant changes are discussed below.
 
Net gains on security sales for the six months ended June 30, 2013 increased $789 thousand compared to the prior year. Investment sales are typically driven by market or strategic opportunities.

Deposit and interchange fees increased $161 thousand, or 8%. Deposit and interchange fees primarily includes fees received on customer deposit accounts, ATM interchange income and the cost of our deposit rewards program.

Investment advisory income increased $106 thousand, or 5%, compared to the same period in the prior year, mainly in the second quarter, primarily due to net asset growth from new business and changes in market values due to fluctuations in the investment markets.

Net gain on loan sales increased $99 thousand, or 22%, for the six months ended June 30, 2013 when compared to the same period in 2012, and primarily resulted from the increased volume of residential loan production originated during the fourth quarter of 2012 that subsequently was sold in the first quarter of 2013.
 
The increase in other income of $138 thousand, or 14%, is primarily due to increases in insurance commissions, loan fees and net gains on OREO sales, partially offset by a decrease in rental income.

Non-Interest Expense
 
Non-interest expense for the six months ended June 30, 2013 amounted to $27.9 million, an increase of $2.1 million, or 8%, compared to the same period in 2012.  The significant changes are discussed below.
 
Salaries and employee benefits increased $1.4 million, or 9%.  The increase was primarily due to the personnel and benefit costs necessary to support the Company’s strategic growth and market expansion initiatives, including annual salary and incentive adjustments, since the prior period.

Occupancy and equipment expenses increased $215 thousand, or 8%, mainly in the first quarter, primarily due to branch expansion and investments in maintaining our facilities.

Technology and telecommunications expense increased $280 thousand, or 13%, primarily as a result of investments to support our strategic growth, improve our service capabilities, and enhance business continuity and network infrastructure.

Advertising and public relations increased $280 thousand, or 22%, primarily as a result of our corporate community event held in May 2013.

Audit, legal and other professional expenses decreased $145 thousand, or 15%, primarily due to reductions in legal and other professional costs.





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Item 3 -
Quantitative and Qualitative Disclosures About Market Risk
 
The Company’s primary market risk is interest rate risk.  Oversight of interest rate risk management is centered on the Asset-Liability Committee ("ALCO").  Annually, ALCO reviews and approves the Company’s asset-liability management policy, which provides management with guidelines for controlling interest rate risk, as measured through net interest income sensitivity to changes in interest rates, within certain tolerance levels.  ALCO also establishes and monitors guidelines for the Company’s liquidity and capital ratios.
 
The Company’s asset-liability management strategies and guidelines are reviewed on a periodic basis by management and presented and discussed with ALCO on at least a quarterly basis.  These strategies and guidelines are revised based on changes in interest rate levels, general economic conditions, competition in the marketplace, the current interest rate risk position of the Company, anticipated growth and other factors.
 
One of the principal factors in maintaining planned levels of net interest income is the ability to design effective strategies to manage the impact of interest rate changes on future net interest income.  Quarterly, management completes a net interest income sensitivity analysis, which is presented to the committee.  This analysis includes a simulation of the Company’s net interest income under various interest rate scenarios.  Variations in the interest rate environment affect numerous factors, including prepayment speeds, reinvestment rates, maturities of investments (due to call provisions), and interest rates on various asset and liability accounts.
 
The Company can be subject to margin compression depending on the economic environment and the shape of the yield curve.  Under the Company’s current balance sheet position, the Company’s margin generally performs slightly better over time in a rising rate environment, while it generally decreases in a declining rate environment and when the yield curve is flattening or inverted.
 
Under a flattening yield curve scenario, margin compression occurs as the spread between the cost of funding and the yield on interest earning assets narrows.  Under this scenario the degree of margin compression is highly dependent on the Company’s ability to fund asset growth through lower cost deposits.  However, if the curve is flattening, while short-term rates are rising, the adverse impact on margin may be somewhat delayed, as increases in the Prime Rate will initially result in the Company’s asset yields re-pricing more quickly than funding costs.
 
Under an inverted yield curve situation, shorter-term rates exceed longer-term rates, and the impact on margin is similar but more adverse than the flat curve scenario.  Again, however, the extent of the impact on margin is highly dependent on the Company’s balance sheet mix.
 
In a declining rate environment, margin compression will eventually occur as the yield on interest earning assets decreases more rapidly than decreases in funding costs.  The primary causes would be the impact of interest rate decreases (including decreases in the Prime Rate) on adjustable rate loans and the fact that decreases in deposit rates may be limited or lag decreases in the Prime Rate. 
 
Net interest margin in 2013 continues to trend downward as the yield on interest earning assets has declined faster than the rate on cost of funds, which is approaching a floor. Additional margin compression may occur if loans continue to re-price downward while the cost of deposits remains at the same level.
There have been no material changes in the results of the Company’s net interest income sensitivity analysis as reported in the Company’s Annual Report on Form 10-K for the year ended December 31, 2012.  At June 30, 2013, management continues to consider the Company’s primary interest rate risk exposure to be margin compression that may result from changes in interest rates and/or changes in the mix of the Company’s balance sheet components.  This would include the mix of fixed versus variable rate loans and investments on the asset side, and higher cost versus lower cost deposits and overnight borrowings versus term borrowings and certificates of deposit on the liability side.




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Table of Contents

Item 4 -
Controls and Procedures

Evaluation of Disclosure Controls and Procedures
 
The Company maintains a set of disclosure controls and procedures and internal controls designed to ensure that the information required to be disclosed in reports that it files or submits to the United States Securities and Exchange Commission (the “SEC”) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.
 
The Company carried out an evaluation as of the end of the period covered by this report under the supervision and with the participation of the Company’s management, including its principal executive officer and principal financial officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures pursuant to Exchange Act Rule 13a-15(b).  Based upon that evaluation, the Company’s principal executive officer and principal financial officer concluded that the Company’s disclosure controls and procedures are effective as of June 30, 2013.
 
Changes in Internal Control over Financial Reporting

There has been no change in the Company’s internal control over financial reporting that has occurred during the Company’s most recent fiscal quarter (i.e., the three months ended June 30, 2013) that has materially affected, or is reasonably likely to materially affect, such internal controls.





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PART II - OTHER INFORMATION
 
Item 1 -
Legal Proceedings

There are no material pending legal proceedings to which the Company or its subsidiaries are a party or to which any of its property is subject, other than ordinary routine litigation incidental to the business of the Company. After review with legal counsel, management does not believe resolution of any present litigation will have a material adverse effect on the consolidated financial condition or results of operations of the Company.

Item 1A -
Risk Factors
 
Management believes that there have been no material changes in the Company’s risk factors as reported in the Annual Report on Form 10-K for the year ended December 31, 2012.

Item 2 -
Unregistered Sales of Equity Securities and Use of Proceeds
 
The Company has not sold any equity securities that were not registered under the Securities Act of 1933, as amended, during the three months ended June 30, 2013.  Neither the Company nor any “affiliated purchaser” (as defined in the SEC’s Rule 10b-18(a)(3)) has repurchased any of the Company’s outstanding shares, nor caused any such shares to be repurchased on its behalf, during the three months ended June 30, 2013.
 
Item 3 -
Defaults upon Senior Securities
 
Not Applicable
 
Item 4 -
Mine Safety Disclosures

Not Applicable
 
Item 5 -
Other Information

Not Applicable


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Item 6 -
Exhibits
 
EXHIBIT INDEX
_____________
Exhibit No.    Description

31.1*
Certification of Principal Executive Officer under Securities Exchange Act Rule 13a-14(a)
31.2*
Certification of Principal Financial Officer under Securities Exchange Act Rule 13a-14(a)
32*
Certification of Principal Executive Officer and Principal Financial Officer under 18 U.S.C. § 1350 Furnished Pursuant to Securities Exchange Act Rule 13a-14(b)

101*
The following materials from Enterprise Bancorp, Inc.’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2013 were formatted in XBRL (eXtensible Business Reporting Language): (i) Consolidated Balance Sheets as of June 30, 2013 and December 31, 2012, (ii) Consolidated Statements of Income for the three and six months ended June 30, 2013 and 2012, (iii) Consolidated Statements of Comprehensive Income for the three and six months ended June 30, 2013 and 2012, (iv) Consolidated Statements of Changes in Equity for the six months ended June 30, 2013, (v) Consolidated Statements of Cash Flows for the six months ended June 30, 2013 and 2012 and (vi) Notes to Unaudited Consolidated Financial Statements.
____________________
*Filed herewith

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SIGNATURES
 
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
 
 
 
ENTERPRISE BANCORP, INC.
 
 
 
 
DATE:
August 9, 2013
By:
/s/ James A. Marcotte
 
 
 
James A. Marcotte
 
 
 
Executive Vice President,
 
 
 
Chief Financial Officer and Treasurer
 
 
 
(Principal Financial Officer)

63