Edgar Filing: ROYAL BANCSHARES OF PENNSYLVANIA INC

form10q.htm

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-Q

(Mark One)

x	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

for the quarterly period ended: September 30, 2012

o	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from: to

Commission file number: 0-26366

ROYAL BANCSHARES OF PENNSYLVANIA, INC.

(Exact name of the registrant as specified in its charter)

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

732 Montgomery Avenue, Narberth, PA 19072

(Address of principal Executive Offices)

(610) 668-4700

(Registrant's telephone number, including area code)

N/A

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

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

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

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

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

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

Applicable only to corporate issuers:

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.

Class A Common Stock		Outstanding at October 31, 2012
$2.00 par value		10,871,454

Class B Common Stock		Outstanding at October 31, 2012
$0.10 par value		2,074,099

PART I – FINANCIAL STATEMENTS

Item 1.

Financial Statements

ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES

Consolidated Balance Sheets

(unaudited)

	September 30,			December 31,
	2012			2011
ASSETS	(In thousands, except share data)
Cash and due from banks	$	8,334		$	10,128
Interest bearing deposits		31,116			14,378
Total cash and cash equivalents		39,450			24,506
Investment securities available-for-sale ("AFS”)		358,455			329,006
Other investment, at cost		2,250			1,538
Federal Home Loan Bank ("FHLB") stock		6,916			8,474
Loans and leases held for sale ("LHFS")		2,718			12,569
Loans and leases ("LHFI")		343,049			414,243
Less allowance for loan and lease losses		17,417			16,380
Net loans and leases		325,632			397,863
Bank owned life insurance		14,446			14,032
Accrued interest receivable		10,893			15,463
Other real estate owned ("OREO"), net		22,080			21,016
Premises and equipment, net		5,313			5,394
Other assets		13,528			18,587
Total assets	$	801,681		$	848,448

LIABILITIES AND SHAREHOLDERS’ EQUITY
Liabilities
Deposits
Non-interest bearing	$	59,262		$	54,534
Interest bearing		511,988			521,382
Total deposits		571,250			575,916
Short-term borrowings		-			54,218
Long-term borrowings		108,446			93,782
Subordinated debentures		25,774			25,774
Accrued interest payable		5,932			3,450
Other liabilities		21,279			19,363
Total liabilities		732,681			772,503
Shareholders’ equity
Royal Bancshares of Pennsylvania, Inc. equity:
Preferred stock, Series A perpetual, $1,000 liquidation value, 500,000 shares authorized, 30,407 shares issued and outstanding at September 30, 2012 and December 31, 2011		29,263			28,878
Class A common stock, par value $2.00 per share, authorized 18,000,000 shares; issued, 11,369,942 and 11,361,580 at September 30, 2012 and December 31, 2011, respectively		22,740			22,723
Class B common stock, par value $0.10 per share; authorized 3,000,000 shares; issued, 2,074,099 and 2,081,371 at September 30, 2012 and December 31, 2011, respectively		207			208
Additional paid in capital		126,280			126,245
Accumulated deficit		(108,835	)		(100,803	)
Accumulated other comprehensive income		2,210			800
Treasury stock - at cost, shares of Class A, 498,488 at September 30, 2012 and December 31, 2011		(6,971	)		(6,971	)
Total Royal Bancshares of Pennsylavania, Inc. shareholders’ equity		64,894			71,080
Noncontrolling interest		4,106			4,865
Total equity		69,000			75,945
Total liabilities and shareholders’ equity	$	801,681		$	848,448

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

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ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES

Consolidated Statements of Operations - (unaudited)

	For the three months ended						For the nine months ended
	September 30,						September 30,
(In thousands, except per share data)	2012			2011			2012			2011
Interest income
Loans and leases, including fees	$	6,298		$	7,545		$	19,766		$	22,986
Investment securities available-for-sale		1,453			2,485			5,196			7,567
Deposits in banks		10			18			28			67
Federal funds sold		-			1			-			3
Total Interest Income		7,761			10,049			24,990			30,623
Interest expense
Deposits		1,440			1,932			4,641			7,206
Short-term borrowings		1			40			309			124
Long-term borrowings		938			1,245			2,759			3,746
Total Interest Expense		2,379			3,217			7,709			11,076
Net Interest Income		5,382			6,832			17,281			19,547
Provision for loan and lease losses		1,761			428			3,360			5,568
Net Interest Income after Provision for Loan and Lease Losses		3,621			6,404			13,921			13,979

Other income
Service charges and fees		315			312			893			821
Net gains on sales of other real estate owned		228			206			345			1,500
Net gains on the sale of AFS investment securities		225			464			384			1,565
Income from bank owned life insurance		139			92			414			278
Gains on sales of loans and leases		39			33			2,044			51
Income related to real estate owned via equity investments		18			137			56			682
Income from real estate joint ventures		-			-			-			250
Other income		187			244			480			873
Total other-than-temporary impairment losses on investment securities		-			(1,415	)		(859	)		(1,796	)
Total Other Income		1,151			73			3,757			4,224
Other expenses
Employee salaries and benefits		2,859			2,881			8,909			8,288
OREO impairment		2,364			1,493			3,413			4,633
Professional and legal fees		986			904			3,296			3,251
Impairment on loans held for sale		856			-			856			304
Occupancy and equipment		499			562			1,619			1,739
OREO and loan collection expenses		393			826			1,811			2,003
Pennsylvania shares tax		314			312			951			936
FDIC and state assessments		287			453			778			1,539
Directors' fees		95			84			304			252
Loss contingency accrual		-			-			2,000			-
Expenses related to real estate owned via equity investments		-			23			-			124
Other operating expenses		756			571			2,131			1,794
Total Other Expenses		9,409			8,109			26,068			24,863
Loss Before Tax Benefit		(4,637	)		(1,632	)		(8,390	)		(6,660	)
Income tax benefit		-			-			-			-
Net Loss	$	(4,637	)	$	(1,632	)	$	(8,390	)	$	(6,660	)
Less net income (loss) attributable to noncontrolling interest	$	175		$	261		$	(759	)	$	969
Net loss attributable to Royal Bancshares of Pennsylvania, Inc.	$	(4,812	)	$	(1,893	)	$	(7,631	)	$	(7,629	)
Less Preferred stock Series A accumulated dividend and accretion	$	511		$	502		$	1,525		$	1,499
Net loss available to common shareholders	$	(5,323	)	$	(2,395	)	$	(9,156	)	$	(9,128	)
Per common share data
Net loss – basic and diluted	$	(0.40	)	$	(0.18	)	$	(0.69	)	$	(0.69	)

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

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ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES

Statements of Consolidated Comprehensive Loss - (unaudited)

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

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

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ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES

Consolidated Statement of Changes in Shareholders' Equity

Nine months ended September 30, 2012

(unaudited)

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

ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES

Consolidated Statement of Changes in Shareholders' Equity

Nine months ended September 30, 2011

(unaudited)

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

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

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ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows (unaudited)

Nine months ended September 30,

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

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

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ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

Note 1.

Summary of Significant Accounting Policies

Basis of Financial Presentation

The accompanying unaudited consolidated financial statements include the accounts of Royal Bancshares of Pennsylvania, Inc. (“Royal Bancshares” or the “Company”) and its wholly-owned subsidiaries, Royal Investments of Delaware, Inc., including Royal Investments of Delaware, Inc.’s wholly-owned subsidiary, Royal Preferred, LLC, and Royal Bank America (“Royal Bank”), including Royal Bank’s subsidiaries, Royal Real Estate of Pennsylvania, Inc., Royal Investments America, LLC, RBA Property LLC, Narberth Property Acquisition LLC, Rio Marina LLC, and its three 60% ownership interests in Crusader Servicing Corporation (“CSC”), Royal Tax Lien Services, LLC (“RTL”), and Royal Bank America Leasing, LP. The two Delaware trusts, Royal Bancshares Capital Trust I and Royal Bancshares Capital Trust II are not consolidated per requirements under Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 810, “Consolidation” (“ASC Topic 810”). These consolidated financial statements reflect the historical information of the Company. All significant intercompany transactions and balances have been eliminated.

The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) for interim financial information. Applications of the principles in the Company’s preparation of the consolidated financial statements in conformity with U.S. GAAP require management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and the accompanying notes. These estimates and assumptions are based on information available as of the date of the consolidated financial statements; therefore, actual results could differ from those estimates. The interim financial information included herein is unaudited; however, such information reflects all adjustments (consisting solely of normal recurring adjustments) that are, in the opinion of management, necessary to present a fair statement of the results for the interim periods. These interim consolidated financial statements should be read in conjunction with the consolidated financial statements and footnotes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2011. The results of operations for the three and nine month periods ended September 30, 2012 are not necessarily indicative of the results to be expected for the full year.

Reclassifications

Certain items in the 2011 consolidated financial statements and accompanying notes have been reclassified to conform to the current year’s presentation format. There was no effect on net loss for the periods presented herein as a result of reclassification.

Accounting Policies Recently Adopted and Pending Accounting Pronouncements

In December 2011, the FASB issued ASU 2011-11, “Disclosures about Offsetting Assets and Liabilities” (“ASU 2011-11”) which amends ASC Topic 210 “Balance Sheet”. Because of the significant differences in requirements under U.S. GAAP and International Financial Reporting Standards ("IFRS"), FASB and the International Accounting Standards Board (“IASB”) are issuing joint requirements that will enhance current disclosures. Entities are required to disclose both gross information and net information about both instruments and transactions eligible for offset in the statement of financial position and instruments and transactions subject to an agreement similar to a master netting arrangement. This scope would include derivatives, sale and repurchase agreements and reverse sale and repurchase agreements, and securities borrowing and securities lending arrangements. The objective of this disclosure is to facilitate comparison between those entities that prepare their financial statements on the basis of U.S. GAAP and those entities that prepare their financial statements on the basis of IFRS. ASU 2011-11 is effective for annual periods beginning on or after January 1, 2013 and interim periods within those annual periods. An entity should provide the disclosures required by these amendments retrospectively for all comparative periods presented. The adoption of ASU 2011-11 is not expected to have a significant impact on the Company’s consolidated financial statements.

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Note 2.

Regulatory Matters and Significant Risks or Uncertainties

FDIC and Department of Banking Orders

On July 15, 2009, Royal Bank agreed to enter into a Stipulation and Consent to the Issuance of an Order to Cease and Desist (the “Orders”) with each of the Federal Deposit Insurance Corporation (“FDIC”) and the Pennsylvania Department of Banking (the “Department”). The material terms of the Orders were identical and required Royal Bank among other items to maintain, after establishing an adequate allowance for loan and lease losses, a ratio of Tier 1 capital to total assets (“leverage ratio”) equal to or greater than 8% and a ratio of qualifying total capital to risk-weighted assets (“total risk-based capital ratio”) equal to or greater than 12%. The FDIC and the Department replaced the Orders in the fourth quarter of 2011 with an informal agreement, known as a memorandum of understanding (“MOU”). Included in the MOU is the continued requirement of maintaining a leverage ratio equal to or greater than 8% and a total risk-based capital ratio equal to or greater than 12%. At September 30, 2012, based on capital levels calculated under regulatory accounting purposes (“RAP”), Royal Bank’s Tier 1 leverage and total risk-based capital ratios were 9.12% and 17.09%, respectively. Please refer to “Note 11 – Regulatory Capital Requirements” to the Consolidated Financial Statements.

Following the issuance of the Orders, management implemented plans to address key areas that were noted in the Orders. Management has reduced classified assets, delinquencies, commercial real estate concentrations, reliance on non-core deposits and wholesale funding sources and strengthened capital ratios which were all factors that contributed to replacing the Orders with the MOU. Management has continued to improve in each of these areas since the Orders were replaced with the MOU.

Federal Reserve Agreement

On March 17, 2010, the Company agreed to enter into the Federal Reserve Agreement with the Reserve Bank. The material terms of the Federal Reserve Agreement provide that: (i) the Company’s Board of Directors (“Board”) will take appropriate steps to fully utilize the Company’s financial and managerial resources to serve as a source of strength to its subsidiary banks; (ii) the Company’s Board will, within 60 days of the Federal Reserve Agreement, submit to the Reserve Bank a written plan to strengthen board oversight of the management and operations of the consolidated operation; (iii) the Company will not declare or pay any dividends without the prior written approval of the Reserve Bank and the Director of the Division of Banking Supervision and Regulation of the Board of Governors of the Federal Reserve System; (iv) the Company and its non-bank subsidiaries will not make any distributions of interest, principal, or other sums on subordinated debentures or trust preferred securities without the prior approval of the Reserve Bank and the Director of the Division of Banking Supervision and Regulation of the Board of Governors of the Federal Reserve System; (v) the Company and its nonbank subsidiaries will not, directly or indirectly, incur, increase, or guarantee any debt without the prior written approval of the Reserve Bank; (vi) the Company will not, directly or indirectly, purchase or redeem any shares of its stock without the prior written approval of the Reserve Bank; (vii) the Company will, within 60 days of the Federal Reserve Agreement, submit to the Reserve Bank an acceptable written capital plan to maintain sufficient capital at the Company on a consolidated basis, which plan will at a minimum address: regulatory requirements for the Company and the Banks, the adequacy of the Banks’ capital taking into account the volume of classified credits, the allowance for loan and lease losses, current and projected asset growth, and projected retained earnings; the source and timing of additional funds necessary to fulfill the consolidated organization’s and the Banks’ future capital requirements; supervisory requests for additional capital at the Banks or the requirements of any supervisory action imposed on the Banks by federal or state regulators; and applicable legal requirements that the Company serve as a source of strength to the Banks; (viii) the Company will, within 60 days of the Federal Reserve Agreement, submit to the Reserve Bank cash flow projections for 2010 showing planned sources and uses of cash for debt service, operating expenses, and other purposes, and will submit similar cash flow projections for each subsequent calendar year at least one month prior to the beginning of such year; (ix) the Company will comply with applicable legal notice provisions in advance of appointing any new director or senior executive officer or changing the responsibilities of any senior executive officer such that the officer would assume a different senior executive officer position, and comply with restrictions on indemnification and severance payments imposed by the Federal Deposit Insurance Act; and (x) the Company’s Board will, within 45 days after the end of each quarter, submit progress reports to the Reserve Bank detailing the form and manner of all actions taken to secure compliance with the Agreement and the results thereof, together with a parent company-level balance sheet, income statement, and, as applicable, report of changes in shareholders’ equity.

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The Federal Reserve Agreement will remain in effect and enforceable until stayed, modified, terminated or suspended by the Reserve Bank. Royal Bancshares has submitted all progress reports and responses required under the Federal Reserve Agreement as of the date of this Report.

Our success as a Company is dependent upon pursuing various alternatives in not only achieving the growth and expansion of our banking franchise but also in managing our day to day operations. The existence of the MOU and the Federal Reserve Agreement may limit or impact our ability to pursue all previously available alternatives in the management of the Company. Our ability to retain existing retail and commercial customers as well as the ability to attract potentially new customers may be impacted by the existence of the MOU and the Federal Reserve Agreement. Additionally, our ability to expand into potentially attractive commercial real estate or construction loans at this time is limited. The Company’s ability to raise capital in the current economic environment could be potentially limited or impacted as a result of the MOU and the Federal Reserve Agreement. Attracting new management talent is critical to the success of our business and could be potentially impacted due to the existence of the MOU and the Federal Reserve Agreement.

Continued Losses

Over the past four calendar years, the Company has recorded significant losses totaling $104.0 million which were primarily related to charge-offs on the loan and lease portfolio, impairment charges on investment securities, impairment charges on other real estate owned (“OREO”), credit related expenses and the establishment of a deferred tax valuation allowance. For the first nine months of 2012, the net loss amounted to $7.6 million, which was equivalent to the loss recorded for the comparable period in 2011. Included in the loss for 2012 was a $2.0 million legal contingency accrual for a potential settlement with the U.S. Department of Justice related to the tax lien subsidiaries. After adjusting for the noncontrolling interest, the Company’s 60% share of the loss contingency amounts to $1.2 million. In addition to reducing the total shareholders’ equity, the continued losses and negative retained earnings impacts the Company’s ability to pay cash dividends to its shareholders now and in future years. The Company’s deferred tax valuation allowance amounted to $36.4 million at September 30, 2012. The deferred tax valuation allowance is a result of management’s conclusion that it was more likely than not that the Company would not generate sufficient future taxable income to realize all of the deferred tax assets.

Credit Quality

Adverse economic conditions in our specific market areas and decreases in real estate property values due to the nature of our loan portfolio in particular have affected the ability of customers to repay their loans and generally impact our financial condition and results of operations. The financial services and real estate industries were hit particularly hard during the “Great Recession” and as a result the Company’s loan and investment portfolios were directly affected. The Company’s commercial real estate loans, including construction and land development loans, have seen a decline in the collateral values, and a reduction in the borrowers’ ability to meet the payment terms of their loans due to reduced cash flow. Further declines in collateral values and borrowers’ liquidity with sustained unemployment at current levels may lead to additional increases in foreclosures, delinquencies and customer bankruptcies. The Company is less able than a larger institution to spread the risks of unfavorable local economic conditions across a large number of more diverse economies.

The Company had non-performing loans of $27.8 million and $58.2 million at September 30, 2012 and 2011, respectively. The Company recorded $2.9 million and $3.7 million in charge-offs and write-downs for the three and nine months ended September 30, 2012, respectively compared to $2.4 million and $9.8 million in charge-offs and write-downs for the comparable periods of 2011, respectively. OREO balances were $22.1 million and $21.9 million at September 30, 2012 and 2011, respectively.

Management is reporting information as of June 30, 2009 as a benchmark for the following comparisons since the Orders reflected the balance sheet conditions and Statement of Operations as of that date. Royal Bank reduced net classified loans, which includes loans held for sale (“LHFS”) and OREO from $149.6 million at June 30, 2009 to $52.6 million at September 30, 2012. Royal Bank’s delinquent loans held for investment (30 to 90 days) amounted to $36.3 million at June 30, 2009 versus $2.1 million at September 30, 2012. Material advances on any classified or delinquent loan are to be approved by the Board and determined to be in Royal Bank’s best interest. The Company has restructured the investment portfolio to reduce credit risk by selling corporate debt securities and equity securities and replacing their maturities with U.S. government issued or sponsored securities. The Company recorded other-than-temporary-impairment (“OTTI”) losses of $0 and $859,000 for the three and nine months ended September 30, 2012, respectively, compared to $1.4 million and $1.8 million during the comparable periods of 2011, respectively.

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Commercial Real Estate Concentrations

As mentioned previously the adverse economic conditions have primarily impacted the real estate secured loan portfolio. Commercial real estate and construction and development loans are often riskier and tend to have significantly larger balances than home equity loans or residential mortgage loans to individuals. While the Company believes that the commercial real estate concentration risk is mitigated by diversification among the types and characteristics of real estate collateral properties, sound underwriting practices, and ongoing portfolio monitoring and market analysis, the repayments of these loans usually depends on the profitable operation of a business or the sale of the underlying property. As a result, these loans are more likely to be unfavorably affected by adverse conditions in the real estate market or the economy in general, which may result in increasing levels of loan charge-offs and non-performing assets and the reduction of earnings. When we take collateral in foreclosures and similar proceedings, we are required to mark the related asset to the then fair market value of the collateral, which may ultimately result in a loss. It is possible that Royal Bank may be required to maintain higher levels of capital than it would be otherwise be expected to maintain as a result of the Bank’s commercial real estate loans, which may require the Company to obtain additional capital.

Commercial real estate and construction and land development loans held for investment were $210.6 million at September 30, 2012 comprising 61% of total loans compared to $248.3 million or 60% of total loans at December 31, 2011. Based on capital levels calculated under U.S. GAAP and RAP, Royal Bank does not have a concentration of commercial real estate loans as defined in the joint agency “Guidance on Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices” issued on December 12, 2006. Please see discussion in “Note 11 – Regulatory Capital Requirements” to the Consolidated Financial Statements.

Liquidity and Funds Management

Royal Bank has limited capacity to borrow additional funds in the event it is needed for liquidity purposes. However, Royal Bank has continued to maintain liquidity measures that are well in excess of the target levels. As discussed in “Note 8 – Borrowings and Subordinated Debentures” to the Consolidated Financial Statements, Royal Bank has an over collateralized delivery requirement of 105% with the FHLB as a result of the level of non-performing assets and the losses that have been experienced over the past four years. The ability to borrow additional funds is based on the amount of collateral that is available to be pledged. As of September 30, 2012, Royal Bank had $32.5 million of available borrowing capacity at the FHLB as a result of excess collateral that has been pledged. In addition at September 30, 2012, Royal Bank had $201.2 million in unpledged agency securities that were available to be pledged as collateral if needed and $39.5 million in cash on hand. Royal Bank also has limited availability to borrow from the Federal Reserve Discount Window, which was $5.0 million at September 30, 2012, and was based on collateral pledged.

At September 30, 2012, the liquidity to deposits ratio was 50.8% compared to Royal Bank’s 12% policy target and the liquidity to total liabilities ratio was 39.9% compared to Royal Bank’s 10% policy target. Brokered CDs declined from $226.9 million at June 30, 2009 to $0 million at September 30, 2012. Borrowings declined $164.0 million from $272.4 million at June 30, 2009 to $108.4 million at September 30, 2012.

The Company also has unfunded pension plan obligations of $15.0 million as of September 30, 2012 which potentially could impact liquidity. The Company plans to fund the pension plan obligations through existing Company owned life insurance policies.

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Dividend and Interest Restrictions

Due to the MOU and the Federal Reserve Agreement, our ability to obtain lines of credit, to receive attractive collateral treatment from funding sources, and to pursue all attractive funding alternatives in this current low interest rate environment could be impacted and thereby limit liquidity alternatives. On August 13, 2009, the Company’s Board determined to suspend regular quarterly cash dividends on the $30.4 million in Series A Preferred Stock and to suspend interest payments on the $25.8 million in trust preferred securities. As of September 30, 2012, the Series A Preferred stock dividend in arrears was $5.4 million and has not been recognized in the consolidated financial statements. As of September 30, 2012 the trust preferred interest payment in arrears was $2.3 million and has been recorded in interest expense and accrued interest payable. The Company believes the decision to suspend the preferred cash dividends and the trust preferred interest payments will better support the capital position of Royal Bank. As a result of the Company missing the sixth quarterly dividend payment due on November 16, 2010, the Treasury exercised its rights under the Capital Purchase Program and appointed two directors to our Board in 2011 until all accrued but unpaid dividends have been paid in full by the Company.

At September 30, 2012, as a result of significant losses within Royal Bank, the Company had negative retained earnings and therefore would not have been able to declare and pay any cash dividends. Royal Bank must receive prior approval from the FDIC and the Department before declaring and paying a dividend to the Company. Under the Federal Reserve Agreement the Company may not declare or pay any dividends without the prior written approval of the Reserve Bank and the Director of the Division of Banking Supervision and Regulation of the Board of Governors of the Federal Reserve System.

Capital Adequacy

In connection with a prior bank regulatory examination, the FDIC concluded, based upon its interpretation of the Consolidated Reports of Condition and Income (the “Call Report”) instructions and under RAP, that income from Royal Bank’s tax lien business should be recognized on a cash basis, not an accrual basis. Royal Bank’s current accrual method is in accordance with U.S. GAAP. Royal Bank disagrees with the FDIC’s conclusion and filed the Call Report for September 30, 2012 and the previous eight quarters in accordance with U.S. GAAP. However, the change in the manner of revenue recognition for the tax lien business for regulatory accounting purposes affects Royal Bank’s and potentially the Company’s capital ratios as disclosed in “Note 11 - Regulatory Capital Requirements” to the Consolidated Financial Statements. Royal Bank is in discussions with the FDIC to resolve the matter.

Under the MOU, Royal Bank must maintain a minimum total risk-based capital ratio and a minimum Tier 1 leverage ratio of 12% and 8%, respectively. At September 30, 2012, based on capital levels calculated under RAP, Royal Bank’s total risk-based capital and Tier 1 leverage ratios were 17.09% and 9.12%, respectively.

Department of Justice Investigation (“DOJ”)

Royal Bank holds a 60% equity interest in each of CSC and RTL. The Company acquired its ownership interest in CSC in 2001. CSC and RTL acquire, through public auction, delinquent tax liens in various jurisdictions thereby assuming a superior lien position to most other lien holders, including mortgage lien holders. As previously discussed in the Company’s Form 10-K for the year ended December 31, 2011, in March 2009, each of CSC and RTL received grand jury subpoenas issued by the U.S. District Court for New Jersey (“Court”) upon application of the Antitrust Division of the United States Department of Justice (“DOJ”). The subpoenas sought certain documents and information relating to an ongoing investigation being conducted by the DOJ relating to alleged bid-rigging at tax lien auctions in New Jersey. Royal Bank, CSC and RTL have produced to the DOJ documents responsive to the subpoenas and have been cooperating with the DOJ throughout the investigation. On February 23, 2012, the former President of CSC and RTL entered a plea of guilty to one count of conspiring to rig bids at certain auctions for tax liens in New Jersey from 1998 until approximately the spring of 2009. The former President’s employment with CSC and RTL was terminated in November 2010. As previously disclosed, Royal Bank had been advised that neither CSC nor RTL were targets of the DOJ investigation, but they were subjects of the investigation. Based on discussions with the DOJ and the plea entered by the former President of CSC and RTL, the Company believed that the outcome of the investigation would result in fines and penalties being assessed against both CSC and RTL. As a result, the Company accrued an aggregate of $2.0 million during the first and second quarters of 2012 as an estimate for a loss contingency for potential DOJ fines and penalties relating to the DOJ investigation. After adjusting for the noncontrolling interest, the Company’s 60% share of the loss contingency amounted to $1.2 million. On September 26, 2012, as a result of the former President’s guilty plea and pursuant to a plea agreement with the DOJ, CSC entered a guilty plea in the United States District Court for the District of New Jersey to one count of conspiracy to commit bid-rigging at certain auctions for tax liens in New Jersey. Under the terms of the plea agreement, which the Court accepted at the September 26, 2012 plea hearing, the DOJ agreed not to bring further criminal charges against CSC and not to bring criminal charges against RTL, or any current or former director, officer, or employee of CSC and/or RTL, for any act or offense committed prior to the date of the plea agreement that was in furtherance of any agreement to rig bids at municipal tax lien sales or auctions in the State of New Jersey. The former President of CSC and RTL and any person who bid at any time at a tax lien auction on behalf of CSC and/or RTL are excluded from this nonprosecution protection. The DOJ further agreed to recommend that the appropriate fine for CSC would be $2.0 million, which, as stated above, has been recognized in the Company’s financial statements. The actual fine to be imposed, however, lies within the sole discretion of the sentencing judge. The Company is evaluating appropriate legal action against the former President of CSC and RTL to attempt to recover legal expenses and any fines or penalties ultimately levied against CSC.

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Additionally a number of lawsuits have been filed in the Superior Court of New Jersey against the former President of CSC and RTL, CSC, RTL, Royal Bancshares of Pennsylvania and certain other parties on behalf of a proposed class of taxpayers who became delinquent in paying their municipal tax obligations. These lawsuits allege violations of the New Jersey Antitrust Act and unjust enrichment, and seek treble damages, attorney fees and injunctive relief. CSC, RTL and Royal Bancshares removed these cases to the U.S. District Court for the District of New Jersey. On June 12, 2012, the Court entered an Order consolidating for pretrial purposes the Boyer action with all subsequently filed or transferred related actions. On October 22, 2012, the Court appointed two law firms as interim class counsel and another law firm as liaison class counsel and further ordered appointed counsel to file on or before November 21, 2012 a master complaint for the consolidated action. As of the date of this filing Royal Bancshares and Royal Bank cannot reasonably estimate the possible loss or range of loss that may result from these actions or proceedings.

Company Plans and Strategy

In addition to increased board oversight and the creation of a Regulatory Compliance Committee in response to the previous Orders, the Company has enhanced the Board through the addition of experienced directors with diverse backgrounds. The new members are comprised of the following: a former banking regulator with consulting experience, a former Chief Executive Officer (“CEO”) of a much larger financial institution who has bank turnaround experience, a former President of the lead bank within a larger financial institution (Treasury appointee), a former executive within the financial services industry (Treasury appointee) and a former senior partner of a public accounting firm. During the first quarter, the Board elected a Lead Independent Director to further improve corporate governance by serving as a liaison between the Chairman of the Board, management, and the independent directors. Royal Bank recently hired a new Chief Lending Officer (“CLO”) who has significant experience in commercial and consumer lending with a larger bank within the Philadelphia market. In addition, due to the pending retirement of the current CEO on or before December 31, 2012 and the retirement of the President during the second quarter of 2012, the Company’s Board is conducting an executive search for a candidate for the combined role of President and CEO.

In order to meet the requirements in the previous Orders, the current MOU, and the Federal Reserve Agreement, management adopted a strategy to deleverage the balance sheet. The deleveraging strategy has provided greater use of the existing capital despite the continued losses by maintaining that capital ratio as a percentage of the remaining reduced level of assets in order to achieve capital ratios at required regulatory levels. The Board and management remain committed to meeting the capital level requirements for Royal Bank as set forth in the previous Orders and current MOU and have therefore developed a contingency plan to maintain capital ratios at required levels. This strategy also assisted in reducing the level of classified assets by giving management the ability to actively pursue exit strategies on loans and OREO which were at historically high levels. The deleveraging was largely accomplished by reducing brokered deposits from $226.9 million at June 30, 2009 to $0 as of September 30, 2012. In addition, borrowings were reduced by $164.0 million during the same period. The Company’s strategic plan includes improving the overall level of credit quality, maintaining reduced credit risk within the investment portfolio and returning to profitability. In concert with these efforts, the Company has started to transition towards a community bank focus within its geographic footprint and adjacent markets.

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During the past few years, the Company recorded significant impairment charges and carrying costs on non-accrual loans and OREO which has weighed heavily on earnings and was the largest contributing factor to the Company’s continued losses. The Company has made progress in improving capital ratios, improving credit quality, reducing the CRE concentration, strengthening the Board and maintaining strong liquidity. As a result of the decline in level of classified assets, there has been a corresponding reduction in impairments, the provision for loan and lease losses, and the overall carrying costs associated with classified assets. The deleveraging of the balance sheet has also reduced earning assets which has resulted in a decline in net interest income and has had a significant impact on overall earnings. To improve net interest margin and net interest income, management is diligently working on changing the mix of earnings assets and interest bearing liabilities. In the event further deleveraging is necessary to maintain the required capital levels, net interest income would be impacted.

Note 3.

Investment Securities

The carrying value and fair value of investment securities AFS at September 30, 2012 are as follows:

			Included in Accumulated Other Comprehensive Income (AOCI)
					Gross unrealized losses
(In thousands)	Amortized cost		Gross unrealized gains		Non-OTTI in AOCI			Non-credit related OTTI in AOCI		Fair value
Mortgage-backed securities-residential	$	21,767	$	571	$	-		$	-	$	22,338
U.S. government agencies		49,136		191		(19	)		-		49,308
Common stocks		33		13		-			-		46
Collateralized mortgage obligations:
Issued or guaranteed by U.S. government agencies		254,005		5,076		(333	)		-		258,748
Non-agency		1,042		-		(18	)		-		1,024
Corporate bonds		6,299		39		(107	)		-		6,231
Municipal bonds		3,623		1		(15	)		-		3,609
Trust preferred securities		9,375		1,940		-			-		11,315
Other securities		5,692		527		(383	)		-		5,836
Total available for sale	$	350,972	$	8,358	$	(875	)	$	-	$	358,455

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The carrying value and fair value of investment securities AFS at December 31, 2011 are as follows:

			Included in Accumulated Other Comprehensive Income (AOCI)
					Gross unrealized losses
(In thousands)	Amortized cost		Gross unrealized gains		Non-OTTI in AOCI			Non-credit related OTTI in AOCI		Fair value
Mortgage-backed securities-residential	$	16,763	$	309	$	(67	)	$	-	$	17,005
U.S. government agencies		35,966		122		(4	)		-		36,084
Common stocks		130		118		-			-		248
Collateralized mortgage obligations:
Issued or guaranteed by U.S. government agencies		231,262		3,315		(543	)		-		234,034
Non-agency		4,739		94		(1	)		-		4,832
Corporate bonds		13,342		104		(471	)		-		12,975
Municipal bonds		985		-		(20	)				965
Trust preferred securities		13,665		2,280		-			-		15,945
Other securities		6,586		347		(15	)		-		6,918
Total available for sale	$	323,438	$	6,689	$	(1,121	)	$	-	$	329,006

The amortized cost and fair value of investment securities at September 30, 2012, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

	As of September 30, 2012
(In thousands)	Amortized cost		Fair value
Within 1 year	$	100	$	100
After 1 but within 5 years		6,199		6,275
After 5 but within 10 years		9,601		9,498
After 10 years		52,533		54,590
Mortgage-backed securities-residential		21,767		22,338
Collateralized mortgage obligations:
Issued or guaranteed by U.S. government agencies		254,005		258,748
Non-agency		1,042		1,024
Total available for sale debt securities		345,247		352,573
No contractual maturity		5,725		5,882
Total available for sale securities	$	350,972	$	358,455

Proceeds from the sales of investments AFS during the three months ended September 30, 2012 and 2011 were $15.2 million and $42.2 million, respectively. Proceeds from the sales of investments AFS for the nine months ended September 30, 2012 and 2011 were $27.1 million and $112.7 million, respectively. The following table summarizes gross gains and losses realized on the sale of securities recognized in earnings in the periods indicated:

	For the three months					For the nine months
	ended September 30,					ended September 30,
(In thousands)	2012		2011			2012			2011
Gross realized gains	$	225	$	637		$	565		$	2,364
Gross realized losses		-		(173	)		(181	)		(799	)
Net realized gains	$	225	$	464		$	384		$	1,565

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The Company evaluates securities for OTTI at least on a quarterly basis. The Company assesses whether OTTI is present when the fair value of a security is less than its amortized cost. All investment securities are evaluated for OTTI under FASB ASC Topic 320, “Investments-Debt & Equity Securities” (“ASC Topic 320”). The non-agency collateralized mortgage obligations that are rated below AA are evaluated under FASB ASC Topic 325 Subtopic 40, “Beneficial Interests in Securitized Financial Assets” under FASB ASC Topic 325, “Investments-Other”. In determining whether OTTI exists, management considers numerous factors, including but not limited to: (1) the length of time and the extent to which the fair value is less than the amortized cost, (2) the Company’s intent to hold or sell the security, (3) the financial condition and results of the issuer including changes in capital, (4) the credit rating of the issuer, (5) analysts earnings estimate, (6) industry trends specific to the security, and (7) timing of debt maturity and status of debt payments.

Under ASC Topic 320, OTTI is considered to have occurred with respect to debt securities (1) if an entity intends to sell the security; (2) if it is more likely than not an entity will be required to sell the security before recovery of its amortized cost basis; or (3) the present value of the expected cash flows is not sufficient to recover the entire amortized cost basis. In addition, the amount of the OTTI recognized in earnings depends on whether an entity intends to sell or will more likely than not be required to sell the security. If an entity intends to sell the security or will be required to sell the security, the OTTI shall be recognized in earnings equal to the entire difference between the fair value and the amortized cost basis at the balance sheet date. If an entity does not intend to sell the security and it is not more likely than not that the entity will be required to sell the security before the recovery of its amortized cost basis, the OTTI shall be separated into two amounts, the credit-related loss and the noncredit-related loss. The credit-related loss is based on the present value of the expected cash flows and is recognized in earnings. The noncredit-related loss is based on other factors such as illiquidity and is recognized in other comprehensive income.

The following table summarizes OTTI losses on securities recognized in earnings in the periods indicated:

	For the three months				For the nine months
	ended September 30,				ended September 30,
(In thousands)	2012		2011		2012		2011
Trust preferred securities	$	-	$	1,415	$	-	$	1,749
Common stocks		-		-		-		47
Other securities		-		-		859		-
Total OTTI charges	$	-	$	1,415	$	859	$	1,796

The following table presents a roll-forward of the balance of credit-related impairment losses on debt securities held at September 30, 2012 and 2011 for which a portion of OTTI was recognized in other comprehensive income:

(In thousands)	2012		2011
Balance at January 1,	$	173	$	924
Additional credit-related impairment loss on debt securities for which an other-than-temporary impairment was previously recognized		-		334
Reductions for securities for which the amount previously recognized in other comprehensive income was recognized in earnings because the Company does not expect to recover the entire amortized cost		-		(1,085	)
Balance at September 30,	$	173	$	173

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The tables below indicate the length of time individual securities have been in a continuous unrealized loss position at September 30, 2012 and December 31, 2011:

September 30, 2012	Less than 12 months					12 months or longer					Total
(In thousands)	Fair value		Gross unrealized losses			Fair value		Gross unrealized losses			Fair value		Gross unrealized losses
U.S. government agencies	$	5,766	$	(19	)	$	-	$	-			5,766		(19	)
Collateralized mortgage obligations:
Issued or guaranteed by U.S. government agencies		41,612		(311	)		2,649		(22	)		44,261		(333	)
Non-agency		1,024		(18	)		-		-			1,024		(18	)
Corporate bonds		1,984		(15	)		2,906		(92	)		4,890		(107	)
Municipal bonds		1,579		(15	)		-		-			1,579		(15	)
Other securities		1,513		(313	)		303		(70	)		1,816		(383	)
Total available-for-sale	$	53,478	$	(691	)	$	5,858	$	(184	)	$	59,336	$	(875	)

December 31, 2011	Less than 12 months					12 months or longer					Total
(In thousands)	Fair value		Gross unrealized losses			Fair value		Gross unrealized losses			Fair value		Gross unrealized losses
Mortgage-backed securities-residential	$	9,588	$	(67	)	$	-	$	-		$	9,588	$	(67	)
U.S. government agencies		2,999		(1	)		3,996		(3	)		6,995		(4	)
Collateralized mortgage obligations:
Issued or guaranteed by U.S. government agencies		35,511		(374	)		10,149		(169	)		45,660		(543	)
Non-agency		-		-			669		(1	)		669		(1	)
Corporate bonds		3,804		(197	)		3,751		(274	)		7,555		(471	)
Municipal bonds		965		(20	)		-		-			965		(20	)
Other securities		502		(15	)		-		-			502		(15	)
Total available-for-sale	$	53,369	$	(674	)	$	18,565	$	(447	)	$	71,934		(1,121	)

The AFS portfolio had gross unrealized losses of $875,000 and $1.1 million at September 30, 2012 and December 31, 2011, respectively. For the nine months ended September 30, 2012, the Company recorded $859,000 in OTTI on a private equity real estate fund due to recently received fund financials. In determining the Company’s intent not to sell and it is not more likely than not that the Company will be required to sell the investments before recovery of their amortized cost basis, management considers the following factors: current liquidity and availability of other non-pledged assets that permits the investment to be held for an extended period of time but not necessarily until maturity, capital planning, and any specific investment committee goals or guidelines related to the disposition of specific investments.

Common stocks: As of September 30, 2012, the Company owns common stock of two financial institutions with a total fair value of $46,000 and an unrealized gain of $13,000. During the first quarter of 2012 the Company sold one common stock investment and recorded a gain of $112,000.

For all debt security types discussed below the fair value is based on prices provided by brokers and safekeeping custodians with the exception of trust preferred securities which are described below.

U.S. government-sponsored agencies (“US Agencies”): As of September 30, 2012, the Company had two US Agency bonds with a fair value of $5.8 million and gross unrealized losses of $19,000. The two US Agency bonds have been in an unrealized loss position for less than twelve months and are callable at par. Management believes that the unrealized loss on these debt securities is a function of changes in investment spreads. Management expects to recover the entire amortized cost basis of these securities. The Company does not intend to sell the securities before recovery of the cost basis and will not more likely than not be required to sell these securities before recovery of the cost basis. Therefore, management has determined that these two securities are not other-than-temporarily impaired at September 30, 2012.

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U.S. government issued or sponsored collateralized mortgage obligations (“Agency CMOs”): As of September 30, 2012, the Company had fourteen Agency CMOs with a fair value of $44.3 million and gross unrealized losses of $333,000. Thirteen of the Agency CMOs have been in an unrealized loss position for less than twelve months. The one Agency CMO that has been in an unrealized loss position for more than twelve months has a fair market value of $2.6 million and an unrealized loss of $22,000 at September 30, 2012. The unrealized loss is attributable to a combination of factors, including relative changes in interest rates since the time of purchase. The contractual cash flows for these securities are guaranteed by U.S. government agencies and U.S. government-sponsored enterprises. Based on its assessment of these factors, management believes that the unrealized losses on these debt securities are a function of changes in investment spreads and interest rate movements and not changes in credit quality. Management expects to recover the entire amortized cost basis of these securities. The Company does not intend to sell these securities before recovery of their cost basis and will not more likely than not be required to sell these securities before recovery of their cost basis. Therefore, management has determined that these securities are not other-than-temporarily impaired at September 30, 2012.

Non-agency collateralized mortgage obligations (“Non-agency CMOs”): As of September 30, 2012, the Company had one non-agency CMO with a fair value of $1.0 million and a gross unrealized loss of $18,000. The non-agency CMO bond has been in an unrealized loss position for less than twelve months and is rated CCC. The Company evaluated the impairment to determine if it could expect to recover the entire amortized cost basis of the non-agency CMO bond by considering numerous factors including credit default rates, conditional prepayment rates, current and expected loss severities, delinquency rates, and geographic concentrations. The Company does not intend to sell the non-agency CMO and it is not more likely than not that the Company will be required to sell the investment before recovery of the amortized cost basis. Therefore, the Company does not consider the bond to be other-than-temporarily impaired as of September 30, 2012.

Corporate bonds: As of September 30, 2012, the Company had five corporate bonds with a fair value of $4.9 million and gross unrealized losses of $107,000. Two bonds have been in an unrealized loss position for less than twelve months and three bonds have been in an unrealized loss position for more than twelve months. All five bonds are above investment grade. The Company’s unrealized losses in investments in corporate bonds represent interest rate risk and not credit risk of the underlying issuers. As previously mentioned management also considered (1) the length of time and the extent to which the fair value is less than the amortized cost, (2) the Company’s intent to hold or sell the security, (3) the financial condition and results of the issuer including changes in capital, (4) the credit rating of the issuer, (5) analysts earnings estimate, (6) industry trends specific to the security, and (7) timing of debt maturity and status of debt payments. Management utilized discounted cash flow analysis based upon the credit ratings of the securities, liquidity risk premiums, and the recent corporate spreads for similar securities as required under ASC Topic 320 to determine the credit risk component of the corporate bonds. Based on these analyses, there was no credit-related loss on the five bonds. Because the Company does not intend to sell the corporate bonds and it is not more likely than not that the Company will be required to sell the bonds before recovery of their amortized cost basis, which may be maturity, the Company does not consider the five bonds to be other-than-temporarily impaired at September 30, 2012.

Municipal bonds: As of September 30, 2012, the Company had three municipal bonds with a fair value of $1.6 million and gross unrealized losses of $15,000. The municipal bonds have been in an unrealized loss position for less than twelve months and are investment grade. Because the Company does not intend to sell the bonds and it is not more likely than not that the Company will be required to sell the bonds before recovery of its amortized cost basis, which may be maturity, the Company does not consider the bonds to be other-than-temporarily impaired at September 30, 2012.

Other securities: As of September 30, 2012, the Company had seven investments in private equity funds which were predominantly invested in real estate. During the second quarter of 2012, the Company recorded a non-credit related OTTI charge of $859,000 in earnings on one of the funds. After reviewing the fund’s most recent financials, management concluded that the fund was other-than-temporarily impaired. As of September 30, 2012, three other private equity real estate funds had a fair value of $1.8 million and an unrealized loss of $383,000. Two of the funds have been in an unrealized loss position for less than twelve months and the other fund has been in an unrealized loss position for more than twelve months. OTTI charges were recorded in a prior period on two of these funds. After reviewing the funds’ financials, net equity values, and its near-term projections, management concluded that there was no additional impairment during the first nine months of 2012.

The Company will continue to monitor these investments to determine if the discounted cash flow analysis, continued negative trends, market valuations or credit defaults result in impairment that is other-than-temporary.

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Note 4.

Loans and Leases

Major classifications of loans and leases held for investment (“LHFI”) are as follows:

	September 30,			December 31,
(In thousands)	2012			2011
Commercial and industrial	$	39,831		$	54,136
Construction		6,293			14,066
Land development		33,987			40,054
Residential real estate		26,100			26,637
Commercial real estate		161,834			182,579
Multi-family		8,490			11,622
Tax certificates		27,622			48,809
Leases		38,313			36,014
Other		1,094			949
Total gross loans	$	343,564		$	414,866
Deferred fees, net		(515	)		(623	)
Total loans and leases	$	343,049		$	414,243

The Company grants commercial and real estate loans, including construction and land development loans primarily in the greater Philadelphia metropolitan area as well as selected locations throughout the mid-Atlantic region. The Company also has participated with other financial institutions in selected construction and land development loans outside our geographic area. The Company has a concentration of credit risk in commercial real estate, construction and land development loans at September 30, 2012. A substantial portion of its debtors’ ability to honor their contracts is dependent upon the housing sector specifically and the economy in general.

Loans and leases are classified as LHFI when management has the intent and ability to hold the loan or lease for the foreseeable future or until maturity or payoff. LHFI are stated at their outstanding unpaid principal balances, net of an allowance for loan and leases losses and any deferred fees or costs. Interest income is accrued on the unpaid principal balance. Loan origination fees, net of certain direct origination costs, are deferred and recognized as an adjustment of the yield (interest income) of the related loans. The Company is generally amortizing these amounts over the contractual life of the loan.

At September 30, 2012 and December 31, 2011, the Company had $2.7 million and $12.6 million; respectively, in non-accrual LHFS. These loans were transferred from LHFI at the lower of cost or fair market value using expected net sales proceeds. During the third quarter, the Company recorded an $856,000 impairment charge on the one LHFS at September 30, 2012. During the first nine months of 2012, the Company sold five loans and received proceeds of $11.0 million and recorded gains of $2.0 million as a result of these sales.

The Company classifies its leases as finance leases, in accordance with FASB ASC Topic 840, “Leases”. The difference between the Company’s gross investment in the lease and the cost or carrying amount of the leased property, if different, is recorded as unearned income, which is amortized to income over the lease term by the interest method.

The Company uses a nine point grading risk classification system commonly used in the financial services industry as the credit quality indicator. The first four classifications are rated Pass. The riskier classifications include Pass-Watch, Special Mention, Substandard, Doubtful and Loss. The risk rating is related to the underlying credit quality and probability of default. These risk ratings are used to calculate the historical loss component of the allowance for loan and lease losses (“ALLL”).

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Pass: includes credits that demonstrate a low probability of default;

Pass-Watch: a warning classification which includes credits that are beginning to demonstrate above average risk through declining earnings, strained cash flows, increased leverage and/or weakening market fundamentals;

Special mention: includes credits that have potential weaknesses that if left uncorrected could weaken the credit or result in inadequate protection of the Company’s position at some future date. While potentially weak, credits in this classification are marginally acceptable and loss of principal or interest is not anticipated;

Substandard accrual: includes credits that exhibit a well-defined weakness which currently jeopardizes the repayment of debt and liquidation of collateral even though they are currently performing. These credits are characterized by the distinct possibility that the Company may incur a loss in the future if these weaknesses are not corrected;

Non-accrual: (substandard non-accrual, doubtful, loss)-includes credits that demonstrate serious problems to the point that it is probable that interest and principal will not be collected according to the contractual terms of the loan agreement.

All loans, at the time of presentation to the appropriate loan committee, are given an initial loan risk rating by the Chief Credit Officer (“CCO”). From time to time, and at the general direction of any of the various loan committees, the ratings may be changed based on the findings of that committee. Items considered in assigning ratings include the financial strength of the borrower and/or guarantors, the type of collateral, the collateral lien position, the type of loan and loan structure, any potential risk inherent in the specific loan type, higher than normal monitoring of the loan or any other factor deemed appropriate by any of the various committees for changing the rating of the loan. Any such change in rating is reflected in the minutes of that committee.

The following tables present risk ratings for each loan portfolio segment at September 30, 2012 and December 31, 2011, excluding LHFS.

September 30, 2012					Special
(In thousands)	Pass		Pass-Watch		Mention		Substandard		Non-accrual		Total
Construction and land development	$	1,136	$	15,991	$	16,846	$	580	$	5,727	$	40,280
Commercial real estate		65,874		68,736		13,056		2,355		11,813		161,834
Commercial & industrial		13,400		10,706		10,218		89		5,418		39,831
Residential real estate		15,222		7,344		2,261		-		1,273		26,100
Multi-family		5,671		2,105		714		-		-		8,490
Leases		37,588		485		66		-		174		38,313
Other		930		164		-		-		-		1,094
Tax certificates		26,906		-		-		-		716		27,622
Subtotal LHFI		166,727		105,531		43,161		3,024		25,121		343,564
Less: Deferred loan fees												(515	)
Total LHFI											$	343,049

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December 31, 2011					Special
(In thousands)	Pass		Pass-Watch		Mention		Substandard		Non-accrual		Total
Construction and land development	$	1,303	$	17,493	$	19,936	$	2,374	$	13,014	$	54,120
Commercial real estate		87,308		64,878		13,722		-		16,671		182,579
Commercial & industrial		19,073		12,101		18,242		-		4,720		54,136
Residential real estate		15,335		9,092		1,071		-		1,139		26,637
Multi-family		4,962		3,907		1,050		-		1,703		11,622
Leases		35,355		147		27		-		485		36,014
Other		847		102		-		-		-		949
Tax certificates		47,786		-		-		-		1,023		48,809
Subtotal LHFI		211,969		107,720		54,048		2,374		38,755		414,866
Less: Deferred loan fees												(623	)
Total LHFI											$	414,243

The past due status of all classes of loans and leases receivable is determined based on contractual due dates for loan payments. Generally, a loan is placed on non-accruing status when it has been delinquent for a period of 90 days or more. The following tables present an aging analysis of past due payments for each loan portfolio segment at September 30, 2012 and December 31, 2011, excluding LHFS.

September 30, 2012	30-59 Days		60-89 Days		Accruing		Total
(In thousands)	Past Due		Past Due		90+ Days		Non-accrual		Current		Total
Construction and land development	$	-	$	-	$	-	$	5,727	$	34,553	$	40,280
Commercial real estate		1,066		-		-		11,813		148,955		161,834
Commercial & industrial		-		-		-		5,418		34,413		39,831
Residential real estate		379		148		-		1,273		24,300		26,100
Multi-family		-		-		-		-		8,490		8,490
Leases		485		65		-		174		37,589		38,313
Other		-		-		-		-		1,094		1,094
Tax certificates		-		-		-		716		26,906		27,622
Subtotal LHFI		1,930		213		-		25,121		316,300		343,564
Less: Deferred loan fees												(515	)
Total LHFI											$	343,049

December 31, 2011	30-59 Days		60-89 Days		Accruing		Total
(In thousands)	Past Due		Past Due		90+ Days		Non-accrual		Current		Total
Construction and land development	$	-	$	-	$	-	$	13,014	$	41,106	$	54,120
Commercial real estate		2,837		100		-		16,671		162,971		182,579
Commercial & industrial		148		-		-		4,720		49,268		54,136
Residential real estate		527		382		-