Edgar Filing: STEWARDSHIP FINANCIAL CORP

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 March 31, 2013

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

For the transition period from __________ to __________

Commission file number 1-33377

Stewardship Financial Corporation

(Exact name of registrant as specified in its charter)

New Jersey	22-3351447
(State or other jurisdiction of	(I.R.S. Employer Identification No.)
incorporation or organization)

630 Godwin Avenue, Midland Park, NJ	07432
(Address of principal executive offices)	(Zip Code)

(201) 444-7100

(Registrant’s telephone number, including area code)

(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 ý No o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ý 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 the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-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 ý

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

The number of shares outstanding, net of treasury stock, of the Registrant’s Common Stock, no par value, as of May 9, 2013 was 5,933,253.

Stewardship Financial Corporation

INDEX

	PAGE
	NUMBER
PART I - FINANCIAL INFORMATION

ITEM 1 - FINANCIAL STATEMENTS

Consolidated Statements of Financial Condition at March 31, 2013 (Unaudited) and December 31, 2012	1

Consolidated Statements of Income for the Three Months ended March 31, 2013 and 2012 (Unaudited)	2

Consolidated Statements of Comprehensive Income for the Three Months ended March 31, 2013 and 2012 (Unaudited)	3

Consolidated Statement of Changes in Shareholders’ Equity for the Three Months ended March 31, 2013 and 2012 (Unaudited)	4

Consolidated Statements of Cash Flows for the Three Months ended March 31, 2013 and 2012 (Unaudited)	5 - 6

Notes to Consolidated Financial Statements (Unaudited)	7 - 25

ITEM 2 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	26 - 33

ITEM 3 - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	34

ITEM 4 - CONTROLS AND PROCEDURES	34

PART II - OTHER INFORMATION

ITEM 6 - EXHIBITS	35

SIGNATURES	36

EXHIBIT INDEX..	37

Index

PART I – FINANCIAL INFORMATION

Item 1. Financial Statements

Stewardship Financial Corporation and Subsidiary

Consolidated Statements of Financial Condition

	March 31,		December 31,
	2013		2012
	(Unaudited)
Assets

Cash and due from banks	$	25,442,000	$	19,962,000
Other interest-earning assets		702,000		1,054,000
Cash and cash equivalents		26,144,000		21,016,000

Securities available for sale		175,493,000		174,700,000
Securities held to maturity; estimated fair value of $30,458,000 (at March 31, 2013) and
$31,768,000 (December 31, 2012)		28,548,000		29,718,000
FHLB-NY stock, at cost		2,213,000		2,213,000
Mortgage loans held for sale		2,101,000		784,000
Loans, net of allowance for loan losses of $11,512,000 (March 31, 2013) and
$10,641,000 (December 31, 2012)		430,083,000		429,832,000
Premises and equipment, net		5,579,000		5,645,000
Accrued interest receivable		2,219,000		2,372,000
Other real estate owned, net		876,000		1,058,000
Bank owned life insurance		10,028,000		10,470,000
Other assets		10,642,000		10,580,000
Total assets	$	693,926,000	$	688,388,000

Liabilities and shareholders' equity

Liabilities
Deposits:
Noninterest-bearing	$	132,960,000	$	124,286,000
Interest-bearing		462,578,000		465,968,000
Total deposits		595,538,000		590,254,000

Federal Home Loan Bank of New York advances		25,000,000		25,000,000
Securities sold under agreements to repurchase		7,344,000		7,343,000
Subordinated debentures		7,217,000		7,217,000
Accrued interest payable		450,000		560,000
Accrued expenses and other liabilities		1,702,000		1,668,000
Total liabilities		637,251,000		632,042,000

Commitments and contingencies		—		—

Shareholders' equity
Preferred stock, no par value; 2,500,000 shares authorized; 15,000 shares
issued and outstanding at March 31, 2013 and December 31, 2012
liquidation preference of $15,000,000		14,967,000		14,964,000
Common stock, no par value; 10,000,000 shares authorized;
5,933,028 and 5,924,865 shares issued and outstanding at March 31, 2013
and December 31, 2012, respectively		40,639,000		40,606,000
Retained earnings		910,000		316,000
Accumulated other comprehensive income, net		159,000		460,000
Total shareholders' equity		56,675,000		56,346,000

Total liabilities and shareholders' equity	$	693,926,000	$	688,388,000

See notes to unaudited consolidated financial statements.

Index

Stewardship Financial Corporation and Subsidiary

Consolidated Statements of Income

(Unaudited)

	Three Months Ended
	March 31,
	2013			2012
Interest income:
Loans	$	5,924,000		$	6,259,000
Securities held to maturity
Taxable		76,000			152,000
Non-taxable		196,000			209,000
Securities available for sale
Taxable		566,000			799,000
Non-taxable		77,000			61,000
FHLB dividends		25,000			29,000
Other interest-earning assets		6,000			7,000
Total interest income		6,870,000			7,516,000

Interest expense:
Deposits		641,000			983,000
Borrowed money		363,000			482,000
Total interest expense		1,004,000			1,465,000

Net interest income before provision for loan losses		5,866,000			6,051,000
Provision for loan losses		1,600,000			1,765,000
Net interest income after provision for loan losses		4,266,000			4,286,000

Noninterest income:
Fees and service charges		456,000			515,000
Bank owned life insurance		76,000			80,000
Gain on calls and sales of securities		2,000			433,000
Gain on sales of mortgage loans		162,000			411,000
Gain on sale of other real estate owned		126,000			99,000
Gain on life insurance proceeds		537,000			—
Other		115,000			111,000
Total noninterest income		1,474,000			1,649,000

Noninterest expenses:
Salaries and employee benefits		2,696,000			2,386,000
Occupancy, net		517,000			487,000
Equipment		184,000			248,000
Data processing		328,000			334,000
Advertising		111,000			139,000
FDIC insurance premium		150,000			148,000
Charitable contributions		60,000			150,000
Other		886,000			961,000
Total noninterest expenses		4,932,000			4,853,000
Income before income tax expense (benefit)		808,000			1,082,000
Income tax expense (benefit)		(14,000	)		306,000
Net income		822,000			776,000
Dividends on preferred stock		166,000			75,000
Net income available to common shareholders	$	656,000		$	701,000

Basic earnings per common share	$	0.11		$	0.12
Diluted earnings per common share	$	0.11		$	0.12

Weighted average number of common shares outstanding		5,930,981			5,892,366
Weighted average number of diluted common
shares outstanding		5,930,981			5,892,366

See notes to unaudited consolidated financial statements.

Index

Stewardship Financial Corporation and Subsidiary

Consolidated Statements of Comprehensive Income

(Unaudited)

	Three Months Ended March 31,
	2013			2012

Net income	$	822,000		$	776,000

Other comprehensive (loss) income:
Change in unrealized holding gains (losses) on securities
available for sale arising during the period		(548,000	)		60,000
Reclassification adjustment for gains in net income		(2,000	)		(433,000	)
Net unrealized gains (losses)		(550,000	)		(373,000	)
Tax effect		210,000			145,000
Net unrealized gains (losses), net of tax amount		(340,000	)		(228,000	)

Change in fair value of interest rate swap		65,000			30,000
Tax effect		(26,000	)		(12,000	)
Change in fair value of interest rate swap, net of tax amount		39,000			18,000

Total other comprehensive income (loss)		(301,000	)		(210,000	)

Total comprehensive income	$	521,000		$	566,000

The following is a summary of the accumulated other comprehensive income balances, net of tax.

	March 31, 2013			December 31, 2012

Unrealized gain on securities available for sale	$	607,000		$	947,000
Unrealized loss on fair value of interest rate swap		(448,000	)		(487,000	)

Accumulated other comprehensive income, net	$	159,000		$	460,000

See notes to unaudited consolidated financial statements.

Index

Stewardship Financial Corporation and Subsidiary

Consolidated Statement of Changes in Stockholders' Equity

(Unaudited)

	Three Months Ended March 31, 2013
											Accumulated
											Other
	Preferred		Common Stock					Retained			Comprehensive
	Stock		Shares		Amount			Earnings			Income, Net			Total

Balance -- December 31, 2012	$	14,964,000		5,924,865	$	40,606,000		$	316,000		$	460,000		$	56,346,000
Cash dividends paid on common stock		—		—		—			(59,000	)		—			(59,000	)
Payment of discount on dividend
reinvestment plan		—		—		(1,000	)		—			—			(1,000	)
Cash dividends accrued on preferred stock		—		—		—			(166,000	)		—			(166,000	)
Common stock issued under stock plans		—		8,163		34,000			—			—			34,000
Amortization of issuance costs		3,000		—		—			(3,000	)					—
Comprehensive income		—		—		—			822,000			(301,000	)		521,000

Balance -- March 31, 2013	$	14,967,000		5,933,028	$	40,639,000		$	910,000		$	159,000		$	56,675,000

	Three Months Ended March 31, 2012
											Accumulated
											Other
	Preferred		Common Stock					Retained			Comprehensive
	Stock		Shares		Amount			Earnings			Income, Net			Total

Balance -- December 31, 2011	$	14,955,000		5,882,504	$	40,420,000		$	1,043,000		$	1,374,000		$	57,792,000
Cash dividends paid on common stock		—		—		—			(295,000	)		—			(295,000	)
Payment of discount on dividend
reinvestment plan		—		—		(2,000	)		—			—			(2,000	)
Cash dividends accrued on preferred stock		—		—		—			(75,000	)		—			(75,000	)
Common stock issued under stock plans		—		13,203		69,000			—			—			69,000
Amortization of issuance costs		2,000		—		—			(2,000	)					—
Comprehensive income		—		—		—			776,000			(210,000	)		566,000

Balance -- March 31, 2012	$	14,957,000		5,895,707	$	40,487,000		$	1,447,000		$	1,164,000		$	58,055,000

See notes to unaudited consolidated financial statements.

Index

Stewardship Financial Corporation and Subsidiary

Consolidated Statements of Cash Flows

(Unaudited)

	Three Months Ended
	March 31,
	2013			2012
Cash flows from operating activities:
Net income	$	822,000		$	776,000
Adjustments to reconcile net income to
net cash provided by operating activities:
Depreciation and amortization of premises and equipment		111,000			142,000
Amortization of premiums and accretion of discounts, net		352,000			403,000
Accretion (amortization) of deferred loan fees		8,000			12,000
Provision for loan losses		1,600,000			1,765,000
Originations of mortgage loans held for sale		(11,072,000	)		(26,709,000	)
Proceeds from sale of mortgage loans		9,917,000			30,436,000
Gain on sales of mortgage loans		(162,000	)		(411,000	)
Gain on sales and calls of securities		(2,000	)		(433,000	)
Gain on sale of other real estate owned		(126,000	)		(99,000	)
Deferred income tax benefit		(375,000	)		(642,000	)
Decrease in accrued interest receivable		153,000			110,000
Decrease in accrued interest payable		(110,000	)		(102,000	)
Earnings on bank owned life insurance		(76,000	)		(80,000	)
Gain on life insurance proceeds		(537,000	)		—
Decrease in other assets		522,000			969,000
Increase (decrease) in other liabilities		74,000			(746,000	)
Net cash provided by operating activities		1,099,000			5,391,000

Cash flows from investing activities:
Purchase of securities available for sale		(13,311,000	)		(22,929,000	)
Proceeds from maturities and principal repayments on securities available for sale		9,143,000			6,490,000
Proceeds from sales and calls on securities available for sale		2,500,000			11,960,000
Proceeds from maturities and principal repayments on securities held to maturity		895,000			1,355,000
Proceeds from calls on securities held to maturity		250,000			605,000
Sale of FHLB-NY stock		—			212,000
Net (increase) decrease in loans		(2,012,000	)		1,639,000
Proceeds from sale of other real estate owned		461,000			2,254,000
Life insurance proceeds		1,055,000			—
Additions to premises and equipment		(45,000	)		(22,000	)
Net cash provided by (used in) investing activities		(1,064,000	)		1,564,000

Cash flows from financing activities:
Net increase in noninterest-bearing deposits		8,674,000			2,821,000
Net increase (decrease) in interest-bearing deposits		(3,390,000	)		5,710,000
Net increase in securities sold under agreements to repurchase		1,000			—
Net decrease in short term borrowings		—			(4,700,000	)
Cash dividends paid on common stock		(59,000	)		(295,000	)
Cash dividends paid on preferred stock		(166,000	)		(75,000	)
Payment of discount on dividend reinvestment plan		(1,000	)		(2,000	)
Issuance of common stock		34,000			69,000
Net cash provided by financing activities		5,093,000			3,528,000

Net increase in cash and cash equivalents		5,128,000			10,483,000
Cash and cash equivalents - beginning		21,016,000			13,698,000
Cash and cash equivalents - ending	$	26,144,000		$	24,181,000

See notes to unaudited consolidated financial statements.

Index

Stewardship Financial Corporation and Subsidiary

Consolidated Statements of Cash Flows (continued)

(Unaudited)

	Three Months Ended
	March 31,
	2013		2012
Supplemental disclosures of cash flow information:
Cash paid during the period for interest	$	1,114,000	$	1,567,000
Transfers from loans to other real estate owned	$	153,000	$	—

See notes to unaudited consolidated financial statements.

Index

Stewardship Financial Corporation and Subsidiary

Notes to Consolidated Financial Statements

March 31, 2013

(Unaudited)

Note 1. Summary of Significant Accounting Policies

Certain information and note disclosures normally included in the unaudited consolidated financial statements prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”). These unaudited consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in the Stewardship Financial Corporation Annual Report on Form 10-K for the fiscal year ended December 31, 2012, filed with the SEC on March 28, 2012 (the “2012 Annual Report”).

The interim unaudited consolidated financial statements included herein have been prepared in accordance with instructions for Form 10-Q and the rules and regulations of the SEC and, therefore, do not include information or footnotes necessary for a complete presentation of consolidated financial condition, results of operations, and cash flows in conformity with GAAP. However, all adjustments, consisting only of normal recurring adjustments, which in the opinion of management are necessary for a fair presentation of the interim consolidated financial statements, have been included. The results of operations for the three months ended March 31, 2013 are not necessarily indicative of the results which may be expected for the entire year.

Principles of consolidation

The consolidated financial statements include the accounts of Stewardship Financial Corporation and its wholly-owned subsidiary, Atlantic Stewardship Bank (the “Bank”), together referred to as “the Corporation”. The Bank includes its wholly-owned subsidiaries, Stewardship Investment Corporation, Stewardship Realty LLC, Atlantic Stewardship Insurance Company, LLC and several other subsidiaries formed to hold title to properties acquired through foreclosure or deed in lieu of foreclosure. The Bank’s subsidiaries have an insignificant impact on the Bank’s daily operations. All intercompany accounts and transactions have been eliminated in the consolidated financial statements. Certain prior period amounts have been reclassified to conform to the current presentation.

The consolidated financial statements of the Corporation have been prepared in conformity with GAAP. In preparing the consolidated financial statements, management is required to make estimates and assumptions, based on available information, that affect the amounts reported in the consolidated financial statements and disclosures provided. Actual results could differ significantly from those estimates.

Material estimates

Material estimates that are particularly susceptible to significant changes relate to the determination of the allowance for loan losses. Management believes that the allowance for loan losses is adequate. While management uses available information to recognize probable incurred losses on loans, future additions to the allowance for loan losses may be necessary based on changes in economic conditions in the market area.

Derivatives

Derivative financial instruments are recognized as assets or liabilities at fair value. The Corporation’s only derivative consists of an interest rate swap agreement, which is used as part of its asset liability management strategy to help manage interest rate risk related to its subordinated debentures issued in 2003 to Stewardship Statutory Trust I (the “Trust”), a statutory business trust (see Note 9 to the Notes to the Audited Consolidated Financial Statements of the Corporation contained in the 2012 Annual Report).

The Corporation designated the interest rate swap as a cash flow hedge, which is a hedge of a forecasted transaction or the variability of cash flows to be received or paid related to a recognized asset or liability. For a cash flow hedge, the effective portion of the change in the fair value on the derivative is reported in other comprehensive income and is reclassified into earnings in the same periods during which the hedged transaction affects earnings. Net cash settlements on this interest rate swap that qualify for hedge accounting are recorded in interest expense. Changes in fair value of derivatives that are not highly effective in hedging the changes in fair value or expected cash flows of the hedged item are recognized immediately in current earnings.

Index

The Corporation formally documented the risk-management objective and the strategy for undertaking the hedge transaction at the inception of the hedging relationship. This documentation includes linking the fair value of the cash flow hedge to subordinated debt on the balance sheet. The Corporation formally assessed, both at the hedge’s inception and on an ongoing basis, whether the derivative instrument used is highly effective in offsetting changes in cash flows of the subordinated debt.

When a cash flow hedge is discontinued but the hedged cash flows or forecasted transactions are still expected to occur, gains or losses that would be accumulated in other comprehensive income are amortized into earnings over the same periods in which the hedged transactions will affect earnings.

Adoption of New Accounting Standards

In February 2013, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2013-02, “Comprehensive Income – Reporting Amounts Reclassified Out of Accumulated Other Comprehensive Income”. This ASU requires an entity to provide information about the amounts reclassified out of accumulated other comprehensive income by component. In addition, an entity is required to present, either on the face of the financial statement where net income is presented or in the accompanying notes, significant amounts reclassified out of accumulated other comprehensive income by the respective line items of net income but only if the amount reclassified is required under GAAP to be reclassified to net income in its entirety in the same reporting period. For other amounts that are not required under GAAP to be reclassified in their entirety to net income, an entity is required to cross-reference to other disclosures required under GAAP that provide additional detail about those amounts. The standard is effective prospectively for reporting periods, including interim periods, beginning after December 15, 2012. The adoption of the standard did not have a material effect on the Corporation’s consolidated financial statements.

In December 2011, the FASB issued ASU No. 2011-11, “Balance Sheet (Topic 210): “Disclosures about Offsetting Assets and Liabilities,” This ASU requires an entity to disclose both gross and net information about financial instruments, such as sales and repurchase agreements and reverse sale and repurchase agreements and securities borrowing/lending arrangements, and derivative instruments that are eligible for offset in the statement of financial position and/or subject an enforceable master netting arrangement or similar agreement regardless of whether they are presented net in the financial statements. The standard is effective for annual and interim periods beginning on January 1, 2013, and it is required to be applied retrospectively. The adoption of the standard did not have a material impact on the Corporation’s consolidated financial statements.

Index

Note 2. Securities – Available-for-sale and Held to Maturity

The fair value of the available-for-sale securities and the related gross unrealized gains and losses recognized in accumulated other comprehensive income were as follows:

	March 31, 2013
	Amortized		Gross Unrealized				Fair
	Cost		Gains		Losses		Value

U.S. Treasury	$	1,001,000	$	—	$	—	$	1,001,000
U.S. government-sponsored agencies		42,091,000		39,000		189,000		41,941,000
Obligations of state and political
subdivisions		13,690,000		411,000		19,000		14,082,000
Mortgage-backed securities - residential		103,886,000		1,059,000		369,000		104,576,000
Asset-backed securities (a)		9,874,000		50,000		—		9,924,000
Corporate debt		493,000		5,000		—		498,000

Total debt securities		171,035,000		1,564,000		577,000		172,022,000
Other equity investments		3,454,000		17,000		—		3,471,000
	$	174,489,000	$	1,581,000	$	577,000	$	175,493,000

	December 31, 2012
	Amortized		Gross Unrealized				Fair
	Cost		Gains		Losses		Value

U.S. Treasury	$	4,003,000	$	3,000	$	—	$	4,006,000
U.S. government-sponsored agencies		37,287,000		35,000		67,000		37,255,000
Obligations of state and political
subdivisions		13,724,000		468,000		22,000		14,170,000
Mortgage-backed securities - residential		104,341,000		1,176,000		89,000		105,428,000
Asset-backed securities (a)		9,874,000		22,000		12,000		9,884,000
Corporate debt		492,000		3,000		—		495,000

Total debt securities		169,721,000		1,707,000		190,000		171,238,000
Other equity investments		3,425,000		37,000		—		3,462,000
	$	173,146,000	$	1,744,000	$	190,000	$	174,700,000

(a) Collateralized by student loans

Cash proceeds realized from sales and calls of securities available-for-sale for the three months ended March 31, 2013 and 2012 were $2,500,000 and $11,960,000, respectively. There were gross gains totaling $2,000 and no gross losses realized on sales or calls during the three months ended March 31, 2013. The tax provision related to these realized gains was $1,000. There were gross gains totaling $433,000 and no gross losses realized on sales or calls during the three months ended March 31, 2012. The tax provision related to these realized gains was $168,000.

Index

The following is a summary of the held to maturity securities and related unrecognized gains and losses:

	March 31, 2013
	Amortized		Gross Unrecognized				Fair
	Cost		Gains		Losses		Value

U.S. government-sponsored agencies	$	260,000	$	43,000		—	$	303,000
Obligations of state and political
subdivisions		22,239,000		1,331,000		—		23,570,000
Mortgage-backed securities - residential		6,049,000		536,000		—		6,585,000
	$	28,548,000	$	1,910,000	$	—	$	30,458,000

	December 31, 2012
	Amortized		Gross Unrecognized				Fair
	Cost		Gains		Losses		Value

U.S. government-sponsored agencies	$	260,000	$	46,000	$	—	$	306,000
Obligations of state and political
subdivisions		22,787,000		1,407,000		—		24,194,000
Mortgage-backed securities - residential		6,671,000		597,000		—		7,268,000
	$	29,718,000	$	2,050,000	$	—	$	31,768,000

Cash proceeds realized from calls of securities held to maturity for the three months ended March 31, 2013 and 2012 were $250,000 and $605,000, respectively. There were no gross gains and no gross losses realized from calls for the three months ended March 31, 2013 or 2012.

The following table presents the amortized cost and fair value of the debt securities portfolio by contractual maturity. As issuers may have the right to call or prepay obligations with or without call or prepayment premiums, the actual maturities may differ from contractual maturities. Securities not due at a single maturity date, such as mortgage-backed securities and asset-backed securities, are shown separately.

	March 31, 2013
	Amortized		Fair
	Cost		Value

Available for sale
Within one year	$	1,001,000	$	1,001,000
After one year, but within five years		6,659,000		6,700,000
After five years, but within ten years		24,628,000		24,917,000
After ten years		24,987,000		24,904,000
Mortgage-backed securities - residential		103,886,000		104,576,000
Asset-backed securities		9,874,000		9,924,000
Total	$	171,035,000	$	172,022,000

Held to maturity
Within one year	$	1,674,000	$	1,699,000
After one year, but within five years		15,092,000		16,015,000
After five years, but within ten years		5,555,000		5,969,000
After ten years		178,000		190,000
Mortgage-backed securities - residential		6,049,000		6,585,000
Total	$	28,548,000	$	30,458,000

Index

The following tables summarize the fair value and unrealized losses of those investment securities which reported an unrealized loss at March 31, 2013 and December 31, 2012, and if the unrealized loss was continuous for the twelve months prior to March 31, 2013 and December 31, 2012. There were no unrealized losses on held to maturity securities at either March 31, 2013 or December 31, 2012.

Available for Sale
March 31, 2013	Less than 12 Months					12 Months or Longer				Total
	Fair		Unrealized			Fair		Unrealized		Fair		Unrealized
	Value		Losses			Value		Losses		Value		Losses

U.S. Treasury	$	—	$	—		$	—	$	—	$	—	$	—
U.S. government-
sponsored agencies		24,482,000		(189,000	)		—		—		24,482,000		(189,000	)
Obligations of state and
political subdivisions		3,988,000		(19,000	)		—		—		3,988,000		(19,000	)
Mortgage-backed
securities - residential		39,623,000		(369,000	)		—		—		39,623,000		(369,000	)
Asset-backed securities		—		—			—		—		—		—
Corporate debt		—		—			—		—		—		—
Other equity investments		—		—			—		—		—		—
Total temporarily
impaired securities	$	68,093,000	$	(577,000	)	$	—	$	—	$	68,093,000	$	(577,000	)

December 31, 2012	Less than 12 Months					12 Months or Longer				Total
	Fair		Unrealized			Fair		Unrealized		Fair		Unrealized
	Value		Losses			Value		Losses		Value		Losses

U.S. Treasury	$	—	$	—		$	—	$	—	$	—	$	—
U.S. government-
sponsored agencies		20,716,000		(67,000	)		—		—		20,716,000		(67,000	)
Obligations of state and
political subdivisions		3,257,000		(22,000	)		—		—		3,257,000		(22,000	)
Mortgage-backed
securities - residential		23,715,000		(89,000	)		—		—		23,715,000		(89,000	)
Asset-backed securities		3,047,000		(12,000	)						3,047,000		(12,000	)
Corporate debt		—		—			—		—		—		—
Other equity investments		—		—			—		—		—		—
Total temporarily
impaired securities	$	50,735,000	$	(190,000	)	$	—	$	—	$	50,735,000	$	(190,000	)

Other-Than-Temporary-Impairment

At March 31, 2013, there were no securities in a continuous loss position for 12 months or longer. The Corporation’s unrealized losses are primarily due to market conditions. These securities have not been considered other than temporarily impaired as scheduled principal and interest payments have been made and management anticipates collecting the entire principal balance as scheduled. Because the decline in fair value is attributable to changes in market conditions, and not credit quality, and because the Corporation does not have the intent to sell these securities and it is likely that it will not be required to sell the securities before their anticipated recovery, the Corporation does not consider these securities to be other-than-temporarily impaired at March 31, 2013.

Index

Note 3. Loans and Nonperforming Loans

At March 31, 2013 and December 31, 2012, respectively, the loan portfolio consisted of the following:

	March 31,			December 31,
	2013			2012

Commercial:
Secured by real estate	$	55,082,000		$	58,160,000
Other		28,065,000			31,254,000
Commercial real estate		253,188,000			242,763,000
Commercial construction		6,321,000			9,324,000
Residential real estate		69,589,000			67,200,000
Consumer:
Secured by real estate		28,705,000			30,982,000
Other		515,000			624,000
Other		68,000			116,000
Total gross loans		441,533,000			440,423,000

Less: Deferred loan fees, net of costs		(62,000	)		(50,000	)
Allowance for loan losses		11,512,000			10,641,000
		11,450,000			10,591,000

Loans, net	$	430,083,000		$	429,832,000

At March 31, 2013 and December 31, 2012, loan participations sold by the Corporation to other lending institutions totaled approximately $19,445,000 and $20,559,000, respectively. These amounts are not included in the totals presented above.

Activity in the allowance for loan losses is summarized as follows:

	For the three months ended March 31, 2013
	Balance,		Provision						Recoveries		Balance,
	beginning		charged			Loans			of loans		end
	of period		to operations			charged off			charged off		of period

Commercial	$	4,832,000	$	805,000		$	(387,000	)	$	35,000	$	5,285,000
Commercial real estate		4,936,000		969,000			(356,000	)		—		5,549,000
Commercial construction		169,000		(128,000	)		(24,000	)		3,000		20,000
Residential real estate		308,000		26,000			—			—		334,000
Consumer		352,000		(58,000	)		(4,000	)		—		290,000
Other loans		3,000		(4,000	)		—			2,000		1,000
Unallocated		41,000		(10,000	)		—			2,000		33,000
Total	$	10,641,000	$	1,600,000		$	(771,000	)	$	42,000	$	11,512,000

Index

	For the three months ended March 31, 2012
	Balance,		Provision						Recoveries		Balance,
	beginning		charged			Loans			of loans		end
	of period		to operations			charged off			charged off		of period

Commercial	$	5,368,000	$	896,000		$	(218,000	)	$	22,000	$	6,068,000
Commercial real estate		4,943,000		575,000			(70,000	)		—		5,448,000
Commercial construction		480,000		297,000			—			—		777,000
Residential real estate		303,000		35,000			—			—		338,000
Consumer		498,000		(53,000	)		(6,000	)		—		439,000
Other loans		2,000		—			—			—		2,000
Unallocated		10,000		15,000			—			—		25,000
Total	$	11,604,000	$	1,765,000		$	(294,000	)	$	22,000	$	13,097,000

The following table presents the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment and based on the impairment method as of March 31, 2013 and December 31, 2012.

	March 31, 2013
			Commercial		Commercial		Residential				Other
	Commercial		Real Estate		Construction		Real Estate		Consumer		Loans		Unallocated		Total

Allowance for loan
losses:
Ending allowance
balance attributable
to loans

Individually
evaluated for
impairment	$	801,000	$	340,000	$	—	$	—	$	—	$	—	$	—	$	1,141,000

Collectively
evaluated for
impairment		4,484,000		5,209,000		20,000		334,000		290,000		1,000		33,000		10,371,000
Total ending
allowance
balance	$	5,285,000	$	5,549,000	$	20,000	$	334,000	$	290,000	$	1,000	$	33,000	$	11,512,000

Loans:
Loans
individually
evaluated for
impairment	$	8,264,000	$	12,124,000	$	5,965,000	$	413,000	$	847,000	$	—	$	—	$	27,613,000

Loans
collectively
evaluated for
impairment		74,883,000		241,064,000		356,000		69,176,000		28,373,000		68,000		—		413,920,000
Total ending
loan balance	$	83,147,000	$	253,188,000	$	6,321,000	$	69,589,000	$	29,220,000	$	68,000	$	—	$	441,533,000

Index

	December 31, 2012
			Commercial		Commercial		Residential				Other
	Commercial		Real Estate		Construction		Real Estate		Consumer		Loans		Unallocated		Total

Allowance for loan
losses:
Ending allowance
balance attributable
to loans

Individually
evaluated for
impairment	$	251,000	$	15,000	$	—	$	—	$	—	$	—	$	—	$	266,000

Collectively
evaluated for
impairment		4,581,000		4,921,000		169,000		308,000		352,000		3,000		41,000		10,375,000
Total ending
allowance
balance	$	4,832,000	$	4,936,000	$	169,000	$	308,000	$	352,000	$	3,000	$	41,000	$	10,641,000

Loans:
Loans
individually
evaluated for
impairment	$	8,641,000	$	12,803,000	$	6,029,000	$	413,000	$	800,000	$	—	$	—	$	28,686,000

Loans
collectively
evaluated for
impairment		80,773,000		229,960,000		3,295,000		66,787,000		30,806,000		116,000		—		411,737,000
Total ending
loan balance	$	89,414,000	$	242,763,000	$	9,324,000	$	67,200,000	$	31,606,000	$	116,000	$	—	$	440,423,000

The following table presents the recorded investment in nonaccrual loans in the periods indicated:

	March 31,		December 31,
	2013		2012

Commercial:
Secured by real estate	$	3,132,000	$	3,374,000
Other		600,000		261,000
Commercial real estate		9,418,000		10,083,000
Commercial construction		3,069,000		3,080,000
Residential real estate		413,000		413,000
Consumer:
Secured by real estate		847,000		800,000

Total nonperfoming loans	$	17,479,000	$	18,011,000

Index

The following presents loans individually evaluated for impairment by class of loans as of the periods indicated:

	At March 31, 2013
	Unpaid				Allowance for		Average		Interest
	Principal		Recorded		Loan Losses		Recorded		Income
	Balance		Investment		Allocated		Investment		Recognized

With no related allowance recorded:
Commercial:
Secured by real estate	$	8,034,000	$	5,347,000			$	5,952,000	$	47,000
Other		417,000		137,000				142,000		—
Commercial real estate		8,709,000		6,088,000				9,119,000		30,000
Commercial construction		5,156,000		5,965,000				5,997,000		52,000
Residential real estate		451,000		413,000				413,000
Consumer:
Secured by real estate		875,000		847,000				824,000

With an allowance recorded:
Commercial:
Secured by real estate		2,043,000		1,406,000	$	355,000		1,094,000		8,000
Other		1,384,000		1,374,000		446,000		1,266,000		13,000
Commercial real estate		8,004,000		6,036,000		340,000		3,345,000		12,000
	$	35,073,000	$	27,613,000	$	1,141,000	$	28,152,000	$	162,000

	At December 31, 2012
	Unpaid				Allowance for		Average		Interest
	Principal		Recorded		Loan Losses		Recorded		Income
	Balance		Investment		Allocated		Investment		Recognized

With no related allowance recorded:
Commercial:
Secured by real estate	$	9,689,000	$	6,557,000			$	4,221,000	$	92,000
Other		424,000		146,000				109,000		5,000
Commercial real estate		17,211,000		12,149,000				10,054,000		158,000
Construction:
Commercial		7,300,000		6,029,000				6,041,000		53,000
Residential		—		—				—		—
Residential real estate		451,000		413,000				393,000		—
Consumer:
Secured by real estate		834,000		800,000				922,000		—

With an allowance recorded:
Commercial:
Secured by real estate		965,000		781,000	$	176,000		2,589,000		25,000
Other		1,163,000		1,157,000		75,000		2,195,000		43,000
Commercial real estate		923,000		654,000		15,000		2,940,000		18,000
Construction:
Commercial		—		—		—		1,224,000		—
Residential		—		—		—		596,000		—
Residential real estate		—		—		—		239,000		—
	$	38,960,000	$	28,686,000	$	266,000	$	31,523,000	$	394,000

Index

The following table presents the aging of the recorded investment in past due loans by class of loans as of March 31, 2013 and December 31, 2012. Nonaccrual loans are included in the disclosure by payment status.

	March 31, 2013
					Greater than				Loans
	30-59 Days		60-89 Days		90 Days		Total		Not
	Past Due		Past Due		Past Due		Past Due		Past Due		Total

Commercial:
Secured by real estate	$	99,000	$	250,000	$	1,964,000	$	2,313,000	$	52,769,000	$	55,082,000
Other		133,000		—		284,000		417,000		27,648,000		28,065,000
Commercial real estate		3,560,000		324,000		7,977,000		11,861,000		241,327,000		253,188,000
Commercial construction		—		—		802,000		802,000		5,519,000		6,321,000
Residential real estate		646,000		161,000		413,000		1,220,000		68,369,000		69,589,000
Consumer:
Secured by real estate		92,000		—		847,000		939,000		27,766,000		28,705,000
Other		—		—		—		—		515,000		515,000
Other		—		—		—		—		68,000		68,000
Total	$	4,530,000	$	735,000	$	12,287,000	$	17,552,000	$	423,981,000	$	441,533,000

	December 31, 2012
					Greater than				Loans
	30-59 Days		60-89 Days		90 Days		Total		Not
	Past Due		Past Due		Past Due		Past Due		Past Due		Total

Commercial:
Secured by real estate	$	101,000	$	179,000	$	2,674,000	$	2,954,000	$	55,206,000	$	58,160,000
Other		25,000		98,000		52,000		175,000		31,079,000		31,254,000
Commercial real estate		2,582,000		—		9,023,000		11,605,000		231,158,000		242,763,000
Commercial construction		—		460,000		815,000		1,275,000		8,049,000		9,324,000
Residential real estate		161,000		—		413,000		574,000		66,626,000		67,200,000
Consumer:
Secured by real estate		67,000		—		647,000		714,000		30,268,000		30,982,000
Other		—		—		—		—		624,000		624,000
Other		—		—		—		—		116,000		116,000
Total	$	2,936,000	$	737,000	$	13,624,000	$	17,297,000	$	423,126,000	$	440,423,000

Troubled Debt Restructurings

At March 31, 2013 and December 31, 2012, the Corporation had $11.6 million and $11.7 million, respectively, of loans whose terms have been modified in troubled debt restructurings. Of these loans, $10.1 million and $10.4 million were performing in accordance with their new terms at March 31, 2013 and December 31, 2012, respectively. The remaining troubled debt restructurings are reported as nonaccrual loans. Specific reserves of $393,000 and $246,000 have been allocated for the troubled debt restructurings at March 31, 2013 and December 31, 2012, respectively. As of both March 31, 2013 and December 31, 2012, the Corporation has committed $241,000 of additional funds to a single customer with an outstanding construction loan that is classified as a troubled debt restructuring.

In order to determine whether a borrower is experiencing financial difficulty, an evaluation is performed of the probability that the borrower will be in payment default on any of its debt in the foreseeable future without the modification. This evaluation is performed under the Corporation’s internal underwriting policy.

The following table presents loans by class that were modified as troubled debt restructurings that occurred during the three months ended March 31, 2013:

Index

	For the three months ended
	March 31, 2013
			Pre-		Post-
	Number		Modification		Modification
	of		Recorded		Recorded
	Loans		Investment		Investment

Commercial:
Secured by real estate		—	$	—	$	—
Other		1		17,000		17,000
Commercial real estate		—		—		—
Commercial construction		—		—		—
Residential real estate		—		—		—
Consumer		—		—		—
Secured by real estate		—		—		—
Other		—		—		—
Other		—		—		—
Total troubled debt restructurings		1	$	17,000	$	17,000

During the three months ended March 31, 2013, the term of one loan was modified as a troubled debt restructuring. The modification of the terms of this loan represents a term out of a remaining balance on a matured loan. During the three months ended March 31, 2012 there were no loans modified as troubled debt restructurings.

For the three months ended March 31, 2013, the troubled debt restructuring described above resulted in no change to the allowance for loan losses. There were no charge-offs during the three months ended March 31, 2013 related to this troubled debt restructuring.

A loan is considered to be in payment default once it is contractually 90 days past due under the modified terms. In the twelve months ended March 31, 2013, there have been no troubled debt restructured loans that have defaulted since their modification.

Credit Quality Indicators

The Corporation categorizes certain loans into risk categories based on relevant information about the ability of the borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. The Corporation analyzes loans individually by classifying the loans as to credit risk. This analysis includes non-homogeneous loans, such as commercial, commercial real estate and commercial construction loans. This analysis is performed at the time the loan is originated and annually thereafter. The Corporation uses the following definitions for risk ratings.

Special Mention – A Special Mention asset has potential weaknesses that deserve management’s close attention, which, if left uncorrected, may result in deterioration of the repayment prospects for the asset or the Bank’s credit position at some future date. Special Mention assets are not adversely classified and do not expose the Bank to sufficient risk to warrant adverse classification. While potentially weak, the borrower is currently marginally acceptable and loss of principal or interest is not presently envisioned.

Substandard – Substandard loans are inadequately protected by the current net worth and paying capacity of the borrower or by the collateral pledged, if any. Loans so classified must have a well-defined weakness or weaknesses that jeopardize the repayment and liquidation of the debt. These loans are characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected.

Doubtful – A Doubtful loan has all of the weaknesses inherent in those classified as Substandard with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently known facts, conditions, and values, highly questionable or improbable. The likelihood of loss is extremely high, but because of certain important and reasonably specific factors, an estimated loss is deferred until a more exact status can be determined.

Loss – A loan classified Loss is considered uncollectible and of such little value that its continuance as an asset is not warranted. This classification does not necessarily mean that an asset has absolutely no recovery or salvage value, but rather it is not practical or desirable to defer writing off a basically worthless asset even though partial recovery may be effected in the future.

Index

Loans not meeting the criteria above that are analyzed individually as part of the above described process are considered to be pass rated loans. As of March 31, 2013 and December 31, 2012, and based on the most recent analysis performed at those times, the risk category of loans by class is as follows:

	March 31, 2013
			Special
	Pass		Mention		Substandard		Doubtful		Loss		Total

Commercial:
Secured by real estate	$	43,789,000	$	8,161,000	$	3,132,000	$	—	$	—	$	55,082,000
Other		25,767,000		1,186,000		1,040,000		72,000		—		28,065,000
Commercial real estate		221,080,000		18,559,000		10,962,000		2,587,000		—		253,188,000
Commercial construction		356,000		1,754,000		4,211,000		—		—		6,321,000
Total	$	290,992,000	$	29,660,000	$	19,345,000	$	2,659,000	$	—	$	342,656,000

	December 31, 2012
			Special
	Pass		Mention		Substandard		Doubtful		Loss		Total

Commercial:
Secured by real estate	$	47,524,000	$	7,368,000	$	3,268,000	$	—	$	—	$	58,160,000
Other		29,484,000		1,508,000		185,000		77,000		—		31,254,000
Commercial real estate		215,158,000		16,003,000		9,007,000		2,595,000		—		242,763,000
Commercial construction		3,294,000		2,950,000		3,080,000		—		—		9,324,000
Total	$	295,460,000	$	27,829,000	$	15,540,000	$	2,672,000	$	—	$	341,501,000

The Corporation considers the performance of the loan portfolio and its impact on the allowance for loans losses. For residential real estate and consumer loan segments, the Corporation also evaluates credit quality based on payment activity. The following table presents the recorded investment in residential real estate and consumer loans based on payment activity as of March 31, 2013 and December 31, 2012.

	March 31, 2013
			Past Due and
	Current		Nonaccrual		Total

Residential real estate	$	68,369,000	$	1,220,000	$	69,589,000
Consumer:
Secured by real estate		27,766,000		939,000		28,705,000
Other		515,000		—		515,000
Total	$	96,650,000	$	2,159,000	$	98,809,000

	December 31, 2012
			Past Due and
	Current		Nonaccrual		Total

Residential real estate	$	66,626,000	$	574,000	$	67,200,000
Consumer:
Secured by real estate		30,268,000		714,000		30,982,000
Other		624,000		—		624,000
Total	$	97,518,000	$	1,288,000	$	98,806,000

Index

Note 4. Fair Value of Financial Instruments

Fair value is the exchange price that would be received for an asset or paid to transfer a liability (exit price) in an orderly transaction between market participants on the measurement date. There are three levels of inputs that may be used to measure fair value:

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

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

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

The fair values of investment securities are determined by quoted market prices, if available (Level 1). For securities where quoted prices are not available, fair values of investment securities are determined by matrix pricing, which is a mathematical technique widely used in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted securities (Level 2 inputs). As the Corporation is responsible for the determination of fair value, it performs quarterly analyses on the prices received from the pricing service to determine whether the prices are reasonable estimates of fair value. Specifically, the Corporation compares the prices received from the pricing service to a secondary pricing source. The Corporation’s internal price verification procedure has not historically resulted in adjustment in the prices obtained from the pricing service.

The interest rate swaps are reported at fair values obtained from brokers who utilize internal models with observable market data inputs to estimate the values of these instruments (Level 2 inputs).

The Corporation measures impairment of collateralized loans and OREO based on the estimated fair value of the collateral less estimated costs to sell the collateral, incorporating assumptions that experienced parties might use in estimating the value of such collateral (Level 3 inputs). At the time a loan or OREO is considered impaired, it is valued at the lower of cost or fair value. Generally, impaired loans carried at fair value have been partially charged-off or receive specific allocations of the allowance for loan losses. OREO is initially recorded at fair value less estimated selling costs. Subsequent adjustments to the OREO carrying value are recorded in a specific valuation allowance for OREO. For collateral dependent loans and OREO, fair value is commonly based on real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments typically result in a Level 3 classification of the inputs for determining fair value. Non-real estate collateral may be valued using an appraisal, the net book value recorded for the collateral on the borrower’s financial statements, or aging reports. Collateral is then adjusted or discounted based on management’s historical knowledge, changes in market conditions from the time of the valuation, and management’s expertise and knowledge of the borrower and borrower’s business, resulting in a Level 3 fair value classification. Impaired loans are evaluated on a quarterly basis for additional impairment and adjusted accordingly.

Appraisals are generally obtained to support the fair value of collateral. Appraisals for both collateral-dependent impaired loans and other real estate owned are performed by licensed appraisers whose qualifications and licenses have been reviewed and verified by the Corporation. The Corporation utilizes a third party to order appraisals and, once received, review the assumptions and approaches utilized in the appraisal as well as the resulting fair value in comparison with independent data sources such as recent market data or industry-wide statistics.

Real estate appraisals typically incorporate measures such as recent sales prices for comparable properties. In addition, appraisers may make adjustments to the sales price of the comparable properties as deemed appropriate based on the age, condition or general characteristics of the subject property. Management generally applies a 12% discount to real estate appraised values to cover disposition / selling costs and to reflect the potential price reductions in the market necessary to complete an expedient transaction and to factor in the impact of the perception that a transaction being completed by a bank may result in further price reduction pressure.

Index

Assets and Liabilities Measured on a Recurring Basis

Assets and liabilities measured at fair value on a recurring basis are summarized below:

			Fair Value Measurements Using:
			Quoted Prices in		Significant
			Active Markets		Other		Significant
			for Identical		Observable		Unobservable
	Carrying		Assets		Inputs		Inputs
	Value		(Level 1)		(Level 2)		(Level 3)
	At March 31, 2013
Assets:
Available for sale securities
U.S. Treasuries	$	1,001,000	$	1,001,000	$	—	$	—
U.S. government -
sponsored agencies		41,941,000		—		41,941,000		—
Obligations of state and
political subdivisions		14,082,000		—		14,082,000		—
Mortgage-backed
securities - residential		104,576,000		—		104,576,000		—
Asset-backed securities		9,924,000				9,924,000
Corporate debt		498,000				498,000
Other equity investments		3,471,000		3,411,000		60,000		—
Total available for
sale securities	$	175,493,000	$	4,412,000	$	171,081,000	$	—

Liabilities:
Interest rate swap	$	747,000	$	—	$	747,000	$	—

	At December 31, 2012
Assets:
Available for sale securities
U.S. Treasuries	$	4,006,000	$	4,006,000	$	—	$	—
U.S. government -
sponsored agencies		37,255,000		—		37,255,000		—
Obligations of state and
political subdivisions		14,170,000		—		14,170,000		—
Mortgage-backed
securities - residential		105,428,000		—		105,428,000		—
Asset-backed securities		9,884,000				9,884,000
Corporate debt		495,000				495,000
Other equity investments		3,462,000		3,402,000		60,000		—
Total available for
sale securities	$	174,700,000	$	7,408,000	$	167,292,000	$	—

Liabilities:
Interest rate swap	$	812,000	$	—	$	812,000	$	—

There were no transfers of assets between Level 1 and Level 2 during the three months ended March 31, 2013 or the year ended December 31, 2012.

Index

Assets and Liabilities Measured on a Non-Recurring Basis

Assets and liabilities measured at fair value on a non-recurring basis are summarized below:

			Fair Value Measurements Using:
			Quoted Prices		Significant
			in Active		Other		Significant
			Markets for		Observable		Unobservable
	Carrying		Identical Assets		Inputs		Inputs
	Value		(Level 1)		(Level 2)		(Level 3)
	At March 31, 2013
Assets:
Impaired loans
Commercial:
Secured by real estate	$	6,121,000	$	—	$	—	$	6,121,000
Other		—		—		—		—
Commercial real estate		9,446,000		—		—		9,446,000
Commercial construction		4,793,000		—		—		4,793,000
Residential real estate		413,000		—		—		413,000
Consumer
Secured by real estate		846,000		—		—		846,000
Other Real Estate Owned		876,000						876,000
	$	22,495,000	$	—	$	—	$	22,495,000

	At December 31, 2012
Assets:
Impaired loans
Commercial:
Secured by real estate	$	6,490,000	$	—	$	—	$	6,490,000
Other		—		—		—		—
Commercial real estate		10,445,000		—		—		10,445,000
Commercial construction		4,373,000		—		—		4,373,000
Residential real estate		413,000		—		—		413,000
Consumer
Secured by real estate		800,000		—		—		800,000
Other Real Estate Owned		1,058,000						1,058,000
	$	23,579,000	$	—	$	—	$	23,579,000

Collateral-dependent impaired loans measured for impairment using the fair value of the collateral had a recorded investment of $22,302,000, with a valuation allowance of $683,000, resulting in a reduction of the provision for loan losses of $293,000 for the three months ended March 31, 2013.

Collateral-dependent impaired loans measured for impairment using the fair value of the collateral had a recorded investment of $22,699,000, with a valuation allowance of $178,000, resulting in an additional provision for loan losses of $4,501,000 for the year ended December 31, 2012.

Other real estate owned had a recorded investment value of $876,000 and $1,058,000 with no valuation allowances at March 31, 2013 and December 31, 2012, respectively. No additional valuation allowance was recorded for the three months ended March 31, 2013. For the year ended December 31, 2012, additional valuation allowances of $188,000 were recorded.

Index

For the Level 3 assets measured at fair value on a non-recurring basis at March 31, 2013, the significant unobservable inputs used in the fair value measurements were as follows:

	Fair
Assets	Value		Valuation Technique	Unobservable Inputs	Range

Impaired loans	$	21,619,000	Comparable real estate sales and / or the income approach.	Adjustments for differences between comparable sales and income data available.	5% - 30%
				Estimated selling costs.	7%

Other real estate owned	$	876,000	Comparable real estate sales and / or the income approach.	Adjustments for differences between comparable sales and income data available.	5% - 10%
				Estimated selling costs.	7%

Fair value estimates for the Corporation’s financial instruments are summarized below:

			Fair Value Measurements Using:
			Quoted Prices		Significant
			in Active		Other		Significant
			Markets for		Observable		Unobservable
	Carrying		Identical Assets		Inputs		Inputs
	Value		(Level 1)		(Level 2)		(Level 3)
	At March 31, 2013

Financial assets:
Cash and cash equivalents	$	26,144,000	$	26,144,000	$	—	$	—
Securities available for sale		175,493,000		4,412,000		171,081,000		—
Securities held to maturity		28,548,000		—		30,458,000		—
Mortgage loans held for sale		2,101,000		—		2,101,000		—
Loans, net		430,083,000		—		—		446,622,000
Accrued interest receivable		2,219,000		2,000		693,000		1,524,000

Financial liabilities:
Deposits		595,538,000		445,603,000		151,227,000		—
FHLB-NY advances		25,000,000		—		25,776,000		—
Securities sold under
agreements to repurchase		7,344,000		—		7,817,000		—
Subordinated debenture		7,217,000		—		—		7,213,000
Accrued interest payable		450,000		1,000		431,000		18,000
Interest rate swap		747,000		—		747,000		—

Index

			Fair Value Measurements Using:
			Quoted Prices		Significant
			in Active		Other		Significant
			Markets for		Observable		Unobservable
	Carrying		Identical Assets		Inputs		Inputs
	Value		(Level 1)		(Level 2)		(Level 3)
	At December 31, 2012

Financial assets:
Cash and cash equivalents	$	21,016,000	$	21,016,000	$	—	$	—
Securities available for sale		174,700,000		7,408,000		167,292,000		—
Securities held to maturity		29,718,000		—		31,768,000		—
Mortgage loans held for sale		784,000		—		784,000		—
Loans, net		429,832,000		—		—		449,041,000
Accrued interest receivable		2,372,000		2,000		908,000		1,462,000

Financial liabilities:
Deposits		590,254,000		434,569,000		157,219,000		—
FHLB-NY advances		25,000,000		—		25,825,000		—
Securities sold under
agreements to repurchase		7,343,000		—		7,883,000		—
Subordinated debenture		7,217,000		—		—		7,112,000
Accrued interest payable		560,000		1,000		540,000		19,000
Interest rate swap		812,000		—		812,000		—

The following methods and assumptions were used to estimate the fair value of each class of financial instrument:

Cash and cash equivalents – The carrying amount approximates fair value and is classified as Level 1.

Securities available-for-sale and held to maturity – The methods for determining fair values were described previously.

Mortgage loans held for sale – Loans in this category have been committed for sale to third party investors at the current carrying amount resulting in a Level 2 classification.

Loans, net – Fair values are estimated for portfolios of loans with similar financial characteristics. Loans are segregated by type such as residential and commercial mortgages, commercial and other installment loans. The fair value of loans is estimated by discounting cash flows using estimated market discount rates which reflect the credit and interest rate risk inherent in the loans resulting in a Level 3 classification. Fair values estimated in this manner do not fully incorporate an exit-price approach to fair value, but instead are based on a comparison to current market rates for comparable loans.

Accrued interest receivable – The carrying amount approximates fair value.

Deposits – The fair value of deposits, with no stated maturity, such as noninterest-bearing demand deposits, savings, NOW and money market accounts, is equal to the amount payable on demand resulting in a Level 1 classification. The fair value of certificates of deposit is based on the discounted value of cash flows resulting in a Level 2 classification. The discount rate is estimated using market discount rates which reflect interest rate risk inherent in the certificates of deposit.

FHLB-NY advances – With respect to FHLB-NY borrowings, the carrying amount of the borrowings which mature in one day approximates fair value. For borrowings with a longer maturity, the fair value is based on the discounted value of cash flows. The discount rate is estimated using market discount rates which reflect the interest rate risk and credit risk inherent in the term borrowings resulting in a Level 2 classification.

Securities sold under agreements to repurchase – The carrying value approximates fair value due to the relatively short time before maturity resulting in a Level 2 classification.

Subordinated debenture – The fair value of the subordinated debenture is based on the discounted value of the cash flows. The discount rate is estimated using market rates which reflect the interest rate and credit risk inherent in the debenture resulting in a Level 3 classification.

Index

Accrued interest payable – The carrying amount approximates fair value.

Interest rate swap – The fair value of derivatives are based on valuation models using observable market data as of the measurement date (Level 2).

Commitments to extend credit – The fair value of commitments is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present credit worthiness of the counter parties. At March 31, 2013 and December 31, 2012, the fair value of such commitments were not material.

Limitations

The preceding fair value estimates were made at March 31, 2013 and December 31, 2012 based on pertinent market data and relevant information on the financial instruments. These estimates do not include any premiums or discounts that could result from an offer to sell at one time the Corporation's entire holdings of a particular financial instrument or category thereof. Since no market exists for a substantial portion of the Corporation's financial instruments, fair value estimates were necessarily based on judgments with respect to future expected loss experience, current economic conditions, risk assessments of various financial instruments, and other factors. Given the subjective nature of these estimates, the uncertainties surrounding them and the matters of significant judgment that must be applied, these fair value estimates cannot be calculated with precision. Modifications in such assumptions could meaningfully alter these estimates.

Since these fair value approximations were made solely for on- and off-balance sheet financial instruments at March 31, 2013 and December 31, 2012, no attempt was made to estimate the value of anticipated future business. Furthermore, certain tax implications related to the realization of unrealized gains and losses could have a substantial impact on these fair value estimates and have not been incorporated into the estimates.

Note 5. Earnings Per Share

Basic earnings per share is calculated by dividing net income available to common shareholders by the weighted average number of common shares outstanding during the period. Common stock equivalents are not included in the calculation. Diluted earnings per share is computed similar to that of basic earnings per share except that the denominator is increased to include the number of additional common shares that would have been outstanding if all potential dilutive common shares were issued.

The following reconciles the income available to common shareholders (numerator) and the weighted average common stock outstanding (denominator) for both basic and diluted earnings per share.

	Three Months Ended
	March 31,
	2013		2012

Net income	$	822,000	$	776,000
Dividends on preferred stock		166,000		75,000
Net income available to common stockholders	$	656,000	$	701,000

Weighted average shares		5,930,981		5,892,366
Effect of dilutive stock options		—		—
Total weighted average dilutive shares		5,930,981		5,892,366

Basic earnings per common share	$	0.11	$	0.12

Diluted earnings per common share	$	0.11	$	0.12

For the three months ended March 31, 2013 and 2012, stock options to purchase 6,754 and 59,635 shares of common stock, respectively, were not considered in computing diluted earnings per share of common stock because they were antidilutive.

Note 6. Preferred Stock

Index

In connection with the Corporation’s participation in the U.S. Department of the Treasury’s Small Business Lending Fund program (“SBLF”), a $30 billion fund established under the Small Business Jobs Act of 2010 that encourages lending to small businesses by providing capital to qualified community banks with assets of less than $10 billion, on September 1, 2011, the Corporation issued 15,000 shares of Senior Non-Cumulative Perpetual Preferred Stock, Series B (the “Series B Preferred Shares”) to the Treasury for an aggregate purchase price of $15 million, in cash.

Using the proceeds of the issuance of the Series B Preferred Shares, the Corporation simultaneously repurchased all 10,000 shares of its Fixed Rate Cumulative Perpetual Preferred Stock, Series A, having a liquidation preference of $1,000 per share (the “Series A Preferred Shares”) previously issued under the Treasury’s Troubled Assets Relief Program (“TARP”) Capital Purchase Program (the “CPP”) for an aggregate purchase price of $10,022,222, in cash, including accrued but unpaid dividends through the date of repurchase.

The terms of the newly-established Series B Preferred Shares provide for a liquidation preference of $1,000 per share and impose restrictions on the Corporation’s ability to declare or pay dividends or purchase, redeem or otherwise acquire for consideration, shares of the Corporation’s Common Stock and any class or series of stock of the Corporation the terms of which do not expressly provide that such class or series will rank senior or junior to the Series B Preferred Shares as to dividend rights and/or rights on liquidation, dissolution or winding up of the Corporation. Specifically, the terms provide for the payment of a non-cumulative quarterly dividend, payable in arrears, which the Corporation accrues as earned over the period that the Series B Preferred Shares are outstanding. The dividend rate can fluctuate on a quarterly basis during the first ten quarters during which the Series B Preferred Shares are outstanding, based upon changes in the level of Qualified Small Business Lending (“QSBL” as defined in the Securities Purchase Agreement) from 1% to 5% per annum and, thereafter, for the eleventh through the first half of the nineteenth dividend periods, from 1% to 7%. In general, the dividend rate decreases as the level of the Bank’s QSBL increases. In the event that the Series B Preferred Shares remain outstanding for more than four and one half years, the dividend rate will be fixed at 9%. Based upon the Bank’s level of QSBL over a baseline level, the dividend rate for the initial dividend period was 1%. Such dividends are not cumulative but the Corporation may only declare and pay dividends on its Common Stock (or any other equity securities junior to the Series B Preferred Stock) if it has declared and paid dividends on the Series B Preferred Shares for the current dividend period and, if, after payment of such dividend, the dollar amount of the Corporation’s Tier 1 Capital would be at least 90% of the Tier 1 Capital on the date of entering into the SBLF program, excluding any subsequent net charge-offs and any redemption of the Series B Preferred Shares (the “Tier 1 Dividend Threshold”). The Tier 1 Dividend Threshold is subject to reduction, beginning on the second anniversary of the issuance and ending on the tenth anniversary, by 10% for each 1% increase in QSBL over the baseline level.

In addition, the Series B Preferred Shares are non-voting except in limited circumstances. In the event that the Corporation has not timely declared and paid dividends on the Series B Preferred Shares for six dividend periods or more, whether or not consecutive, and shares of Series B Preferred Stock with an aggregate liquidation preference of at least $25,000,000 are still outstanding, the Treasury may designate two additional directors to be elected to the Corporation’s Board of Directors. Subject to the approval of the Bank’s federal banking regulator, the Federal Reserve, the Corporation may redeem the Series B Preferred Shares at any time at the Corporation’s option, at a redemption price equal to the liquidation preference per share plus the per share amount of any unpaid dividends for the then-current period through the date of the redemption. The Series B Preferred Shares are includable in Tier I capital for regulatory capital.

Index

Note 7. Accumulated Other Comprehensive Income

The following table presents the after-tax changes in the balances of each component of accumulated other comprehensive income for the three months ended March 31, 2013.

	Components of
	Accumulated Other Comprehensive Income						Total
	Unrealized Gains						Accumulated
	and Losses on			Unrealized Gains			Other
	Available for Sale			and Losses on			Comprehensive
	(AFS) Securities			Derivatives			Loss

Balance at December 31, 2012	$	947,000		$	(487,000	)	$	460,000
Other comprehensive income before
reclassifications		(339,000	)		39,000			(300,000	)
Amounts reclassified from
other comprehensive income		(1,000	)					(1,000	)
Other comprehensive income, net		(340,000	)		39,000			(301,000	)
Balance at March 31, 2013	$	607,000		$	(448,000	)	$	159,000

The following table presents amounts reclassified from each component of accumulated other comprehensive income on a gross and net of tax basis for the three months ended March 31, 2013.

	Accumulated
	Other			Income
Components of Accumulated Other	Comprehensive			Statement
Comprehensive Loss	Income			Line Item

Unrealized gains on AFS securities before tax	$	2,000		Gains on securities transactions, net
Tax effect		(1,000	)
Total net of tax		1,000

Total reclassifications, net of tax	$	1,000

Index

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

Cautionary Note Regarding Forward-Looking Statements

This Quarterly Report on Form 10-Q contains certain “forward looking statements” with respect to Stewardship Financial Corporation (the “Corporation”) within the meaning of the Private Securities Litigation Reform Act of 1995, which forward looking statements may be identified by the use of such words as “believe,” “expect,” “anticipate,” “should,” “plan,” “estimate,” and “potential.” Examples of forward-looking statements include, but are not limited to, estimates with respect to the financial condition, results of operations and business of the Corporation that are subject to various factors which could cause actual results to differ materially from these estimates. These factors include: changes in general, economic and market conditions, legislative and regulatory conditions, or the development of an interest rate environment that adversely affects the Corporation’s interest rate spread or other income anticipated from operations and investments. As used in this Form 10-Q, “we”, “us” and “our” refer to the Corporation and its consolidated subsidiary, Atlantic Stewardship Bank, depending on the context.

Critical Accounting Policies and Estimates

“Management’s Discussion and Analysis of Financial Condition and Results of Operations,” as well as disclosures found elsewhere in this Quarterly Report on Form 10-Q, are based upon the Corporation’s consolidated financial statements, which have been prepared in conformity with U.S. generally accepted accounting principles (“GAAP”). The preparation of these financial statements requires the Corporation to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. Note 1 to the Corporation’s Audited Consolidated Financial Statements for the year ended December 31, 2012 included in the 2012 Annual Report contains a summary of the Corporation’s significant accounting policies. Management believes the Corporation’s policy with respect to the methodology for the determination of the allowance for loan losses involves a higher degree of complexity and requires management to make difficult and subjective judgments, which often require assumptions or estimates about highly uncertain matters. Changes in these judgments, assumptions or estimates could materially impact results of operations. This critical policy and its application are periodically reviewed with the Audit Committee and the Board of Directors.

The allowance for loan losses is based upon management’s evaluation of the adequacy of the allowance, including an assessment of known and inherent risks in the loan portfolio, giving consideration to the size and composition of the loan portfolio, actual loan loss experience, level of delinquencies, detailed analysis of individual loans for which full collectability may not be assured, the existence and estimated net realizable value of any underlying collateral and guarantees securing the loans, and current economic and market conditions. Although management uses the best information available, the level of the allowance for loan losses remains an estimate, which is subject to significant judgment and short-term change. Various regulatory agencies, as an integral part of their examination process, periodically review the Corporation’s allowance for loan losses. Such agencies may require the Corporation to make additional provisions for loan losses based upon information available to them at the time of their examination. Furthermore, the majority of the Corporation’s loans are secured by real estate in the State of New Jersey. Accordingly, the collectability of a substantial portion of the carrying value of the Corporation’s loan portfolio is susceptible to changes in local market conditions and may be adversely affected should real estate values decline or the northern New Jersey area experience adverse economic changes. Future adjustments to the allowance for loan losses may be necessary due to economic, operating, regulatory and other conditions beyond the Corporation’s control.

Financial Condition

Total assets increased $5.5 million to $693.9 million at March 31, 2013 from $688.4 million at December 31, 2012. Cash and cash equivalents increased $5.1 million to $26.1 million at March 31, 2013 from $21.0 million at December 31, 2012, reflecting deposit growth. Securities available-for-sale increased $800,000 to $175.5 million while securities held to maturity decreased $1.2 million to $28.5 million. Net loans were relatively unchanged at $430.1 million at March 31, 2013 compared to $429.8 million at December 31, 2012. Increases due to new loans originated were more than offset by regular principal payments and payoffs in the first three months of fiscal year 2013 as well as an $871,000 net increase in the allowance for loan losses. Loans held for sale totaled $2.1 million at March 31, 2013, an increase from $784,000 at December 31, 2012. Other real estate owned (OREO) declined $182,000 to $876,000 at March 31, 2013 compared to $1.1 million at December 31,2012 reflecting the sale of one property partially offset by the foreclosure on another property.

Deposits totaled $595.5 million at March 31, 2013, an increase of $5.3 million from $590.3 million at December 31, 2012. The growth in deposits consisted of an $8.7 million increase in noninterest-bearing accounts partially offset by a $4.4 million decrease in interest-bearing accounts.

Index

Results of Operations

General

The Corporation reported net income of $822,000, or $0.11 diluted earnings per common share for the three months ended March 31, 2013, compared to $776,000, or $0.12 diluted earnings per common share for the comparable prior year period.

Net Interest Income

Net interest income for the three months ended March 31, 2013 was $5.9 million compared to $6.1 million recorded in the prior year period. The decrease in the current year is primarily due to a decrease in average interest earning assets partially offset by a decline in average interest-bearing liabilities. The net interest rate spread and net yield on interest earning assets for the three months ended March 31, 2012 were 3.57% and 3.76%, respectively, compared to 3.48% and 3.71% for the three months ended March 31, 2012. The net interest rate spread and net yield on interest-earning assets for the current year period reflects a decline in loan interest rates and yields on securities as well as a decline in the interest rates on deposits. The Corporation continues in its efforts to proactively manage deposit costs in an effort to mitigate the lower asset yields earned. The reduced yields on assets primarily reflect lower yields on investment securities.

The following table reflects the components of the Corporation’s net interest income for the three months ended March 31, 2013 and 2012 including: (1) average assets, liabilities and stockholders’ equity based on average daily balances, (2) interest income earned on interest-earning assets and interest expense paid on interest-bearing liabilities, (3) average yields earned on interest-earning assets and average rates paid on interest-bearing liabilities, and (4) net yield on interest-earning assets. Nontaxable income from investment securities and loans is presented on a tax-equivalent basis assuming a statutory tax rate of 34% for the periods presented. This was accomplished by adjusting non-taxable income upward to make it equivalent to the level of taxable income required to earn the same amount after taxes.

Index

Analysis of Net Interest Income (Unaudited)

For the Three Months Ended March 31,

	2013									2012
							Average									Average
				Interest			Rates						Interest			Rates
	Average			Income/			Earned/			Average			Income/			Earned/
	Balance			Expense			Paid			Balance			Expense			Paid
	(Dollars in thousands)									(Dollars in thousands)

Assets

Interest-earning assets:
Loans (1) (2)	$	442,519		$	5,935			5.44	%	$	460,066		$	6,270			5.47	%
Taxable investment securities (1)		168,521			667			1.61			174,996			979			2.24
Tax-exempt investment securities (1) (2)		36,475			407			4.53			33,190			402			4.86
Other interest-earning assets		442			6			5.51			1,513			7			1.86
Total interest-earning assets		647,957			7,015			4.39			669,765			7,658			4.59

Non-interest-earning assets:
Allowance for loan losses		(11,074	)								(12,109	)
Other assets		47,394									52,461
Total assets	$	684,277								$	710,117


Liabilities and Stockholders' Equity

Interest-bearing liabilities:
Interest-bearing demand deposits	$	238,891		$	185			0.31	%	$	253,978		$	314			0.50	%
Savings deposits		68,966			18			0.11			58,499			29			0.21
Time deposits		149,132			438			1.19			166,971			640			1.54
Repurchase agreements		7,343			90			4.97			14,342			183			5.09
FHLB-NY borrowing		25,416			148			2.36			30,142			173			2.30
Subordinated debenture		7,217			125			7.02			7,217			126			7.00
Total interest-bearing liabilities		496,965			1,004			0.82			531,149			1,465			1.11
Non-interest-bearing liabilities:
Demand deposits		128,144									117,704
Other liabilities		2,537									2,830
Stockholders' equity		56,631									58,434
Total liabilities and stockholders' equity	$	684,277								$	710,117

Net interest income (taxable equivalent basis)		6,011									6,193
Tax Equivalent adjustment					(145	)								(142	)
Net interest income				$	5,866								$	6,051

Net interest spread (taxable equivalent basis)					3.57	%								3.48	%

Net yield on interest-earning
assets (taxable equivalent basis) (3)								3.76	%								3.71	%

(1)	For purpose of these calculations, nonaccruing loans are included in the average balance. Loans and total interest-earning assets are net of unearned income. Securities are included at amortized cost.

(2)	The tax equivalent adjustments are based on a marginal tax rate of 34%.

(3)	Net interest income (taxable equivalent basis) divided by average interest-earning assets.

Index

For the three months ended March 31, 2013, total interest income, on a tax equivalent basis, decreased $643,000 to $7.015 million, or 8.4%, when compared to the same prior year period. The decrease was due to both a decrease in the average balance of interest-earning assets and a decrease in yields on interest-earning assets. The average rate earned on interest-earning assets decreased 20 basis points from 4.59% for the three months ended March 31, 2012 to 4.39% in the current year period. The decline in the asset yield reflects the effect of a prolonged low interest rate environment as well as the impact of nonaccrual loans. Average interest-earning assets decreased $21.8 million for the three months ended March 31, 2013, or 3.3%, when compared to the prior year period. Average loans decreased $17.5 million and average investment securities decreased $3.2 million.

Interest paid on deposits and borrowed money decreased $461,000 to $1.004 million, or 31.5%, for the three months ended March 31, 2013 compared to the same period for 2012. The decline is due to general decreases in rates paid on deposits and borrowings coupled with decreases in average interest-bearing liabilities. For the three months ended March 31, 2013, the total cost for interest-bearing liabilities declined to 0.82% representing a 29 basis point decline when compared to the same prior year period. The average balance of total interest-bearing deposits and borrowings decreased $34.2 million for the three months ended March 31, 2013 from the comparable 2012 period. Average interest-bearing deposits decreased $22.5 million and average borrowings decreased $11.7 million.

Provision for Loan Losses

The Corporation maintains an allowance for loan losses at a level considered by management to be adequate to cover the probable incurred losses associated with its loan portfolio. On an ongoing basis, management analyzes the adequacy of this allowance by considering the nature and volume of the Corporation’s loan activity, financial condition of the borrower, fair market value of the underlying collateral, and changes in general market conditions. Additions to the allowance for loan losses are charged to operations in the appropriate period. Actual loan losses, net of recoveries, serve to reduce the allowance. The appropriate level of the allowance for loan losses is based on estimates, and ultimate losses may vary from current estimates.

The loan loss provision totaled $1.6 million for the three months ended March 31, 2013 compared to $1.8 million for the three months ended March 31, 2012. Nonaccrual loans of $17.5 million at March 31, 2013 reflected a slight decrease from $18.0 million of nonaccrual loans at December 31, 2012. The allowance for loan losses related to the impaired loans increased from $266,000 at December 31, 2012 to $1.1 million at March 31, 2013. During the three months ended March 31, 2013, the Corporation charged off $771,000 of loan balances and recovered $42,000 in previously charged off loans compared to $294,000 and $22,000, respectively, during the same period in 2012.

The current period loan loss provision primarily is indicative of continuing economic conditions that have contributed to an increase in loan delinquencies and the softness in the real estate market. The Corporation monitors its loan portfolio and intends to continue to provide for loan loss reserves based on its ongoing periodic review of the loan portfolio, charge-off activity and general market conditions.

See “Asset Quality” section below for a summary of the allowance for loan losses and nonperforming assets.

Noninterest Income

Noninterest income was $1.5 million for the three months ended March 31, 2013 compared to $1.6 million for the prior year period. Noninterest income of $537,000 was recorded as a result of a death benefit insurance payment received during the three months ended March 31, 2013. For the three months ended March 31, 2013 noninterest income included $2,000 from gains on calls and sales of securities compared to $433,000 for the same prior year period. Gains on sales of mortgage loans totaled $162,000 for the three months ended March 31, 2013, a decrease from $411,000 for the three months ended March 31, 2012, partially reflective of retaining a higher amount of mortgage loan originations for portfolio.

Noninterest Expense

Noninterest expenses for the three months ended March 31, 2013 and 2012 were $4.932 million and $4.853 million, respectively. The slight increase in noninterest expenses reflects higher salary and employee benefits expense, reflective of increasing regulatory compliance and the attendant staffing necessary to oversee all compliance-related issues. In addition, the increase in salary and employee benefits expense is the result of an increased focus on commercial lending opportunities as well as costs associated with an enhanced credit review function.

Index

Income Tax Expense

For the three months ended March 31, 2013 income taxes represented a benefit of $14,000 compared to an income tax expense of $306,000 for the three months ended March 31, 2012. The current period tax benefit reflects a decrease in our overall projected effective tax rate as a result of our tax exempt income, including the gain on life insurance proceeds, representing a larger percentage of pretax income.

Asset Quality

The Corporation’s principal earning asset is its loan portfolio. Inherent in the lending function is the risk of deterioration in the borrowers’ ability to repay loans under existing loan agreements. Management realizes that because of this risk, reserves are maintained to absorb probable incurred loan losses. In determining the adequacy of the allowance for loan losses, management of the Corporation considers the risks inherent in its loan portfolio and changes in the nature and volume of its loan activities, along with general economic and real estate market conditions. Although management attempts to establish a reserve sufficient to offset probable incurred losses in the portfolio, changes in economic conditions, regulatory policies and borrowers’ performance could require future changes to the allowance.

Risk elements include nonaccrual loans, past due and restructured loans, potential problem loans, loan concentrations and other real estate owned. The following table shows the composition of nonperforming assets at the end of each of the last four quarters:

	March 31,			December 31,			September 30,			June 30,
	2013			2012			2012			2012
	(Dollars in thousands)

Nonaccrual loans (1)	$	17,479		$	18,011		$	24,960		$	29,541
Loans past due 90 days or more and accruing (2)		50			237			75			200
Total nonperforming loans		17,529			18,248			25,035			29,741

Other real estate owned		876			1,058			2,985			1,991
Total nonperforming assets	$	18,405		$	19,306		$	28,020		$	31,732

Performing restructured loans (3)	$	10,134		$	10,373		$	7,176		$	3,716

Allowance for loan losses	$	11,512		$	10,641		$	12,598		$	11,934

Nonperforming loans to total gross loans		3.97	%		4.14	%		5.72	%		6.68	%
Nonperforming assets to total assets		2.65	%		2.80	%		4.10	%		4.53	%
Allowance for loan losses to total gross loans		2.61	%		2.42	%		2.88	%		2.68	%
Allowance for loan losses to
nonperforming loans		65.67	%		58.31	%		50.32	%		40.13	%

(1) Generally represents loans as to which the payment of principal or interest is in arrears for a period of more than 90 days. Interest previously accrued on these loans and not yet paid is reversed and charged against income during the current period. Interest earned thereafter is only included in income to the extent that it is received in cash.

(2) Represents loans as to which payment of principal or interest is contractually past due 90 days or more but which are currently accruing income at the contractually stated rates. A determination is made to continue accruing income on those loans which are sufficiently collateralized and on which management believes all interest and principal owed will be collected.

(3) Any restructured loans that are on nonaccrual status are only reported in nonaccrual loans and not also in restructured loans.

A loan is generally placed on nonaccrual when, based on current information and events, it is probable that the Corporation will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. The identification of nonaccrual loans reflects careful monitoring of the loan portfolio. The Corporation is focused on resolving the nonperforming loans and mitigating future losses in the portfolio. All delinquent loans continue to be reviewed by management.

At March 31, 2013, the nonaccrual loans were comprised of 54 loans, primarily commercial real estate loans, commercial loans and construction loans. While the Corporation maintains strong underwriting requirements, the number and amount of nonaccrual loans is a reflection of the prolonged weakened economic conditions and the corresponding effects it has had on our commercial borrowers and the current real estate environment. Certain loans, including restructured loans, are current, but in accordance with applicable guidance and other weakness concerns, management has continued to keep these loans on nonaccrual.

Index

Since December 31, 2012, nonaccrual loans have decreased $532,000 to $17.5 million at the end of the most recent three months. Decreases due to payments received, payoffs, charge-offs and loans returned to an accrual status were partially offset by new nonaccrual loans. The ratio of allowance for loan losses to nonperforming loans increased to 65.67% at March 31, 2013 from 58.31% at December 31, 2012. The ratio of allowance for loan losses to nonperforming loans is reflective of detailed analysis and the probable losses to be incurred that we have identified with these nonperforming loans. This metric reflects both the effect of an increase in the allowance for loan losses and the decrease in nonaccrual loans.

Evaluation of all nonperforming loans includes the updating of appraisals and specific evaluation of such loans to determine estimated cash flows from business and/or collateral. We have assessed these loans for collectability and considered, among other things, the borrower’s ability to repay, the value of the underlying collateral, and other market conditions to ensure the allowance for loan losses is adequate to absorb probable losses to be incurred. The majority of our nonperforming loans are secured by real estate collateral. While we have continued to record appropriate charge-offs, the existing underlying collateral coverage for a considerable portion of the nonperforming loans currently supports collection of a significant portion of our remaining principal.

For loans not included in nonperforming loans, at March 31, 2013, the level of loans past due 30-89 days was $3.7 million compared to $3.1 million at December 31, 2012. We will continue to monitor delinquencies for early identification of new problem loans. While not comprising a significantly large portion of the loan portfolio, a number of problem loans are commercial construction loans which have been affected by the struggling construction industry. As such, the entire commercial construction portfolio is being actively monitored.

The Corporation maintains an allowance for loan losses at a level considered by management to be adequate to cover the probable losses to be incurred associated with its loan portfolio. The Corporation’s policy with respect to the methodology for the determination of the allowance for loan losses involves a high degree of complexity and requires management to make difficult and subjective judgments.

The adequacy of the allowance for loan losses is based upon management’s evaluation of the known and inherent risks in the portfolio, consideration to the size and composition of the loan portfolio, actual loan loss experience, the level of delinquencies, detailed analysis of individual loans for which full collectability may not be assured, the existence and estimated net realizable value of any underlying collateral and guarantees securing the loans, and current economic and market conditions.

In establishing the allowance for loan losses, the Corporation utilizes a two-tier approach by (1) identifying problem loans and allocating specific loss allowances on such loans and (2) establishing a general loan loss allowance on the remainder of its loan portfolio. The Corporation maintains a loan review system that allows for a periodic review of its loan portfolio and the early identification of potential problem loans. Such a system takes into consideration, among other things, delinquency status, size of loans, type of collateral and financial condition of the borrowers.

Allocations of specific loan loss allowances are established for identified loans based on a review of various information including appraisals of underlying collateral. Appraisals are performed by independent licensed appraisers to determine the value of impaired, collateral-dependent loans. Appraisals are periodically updated to ascertain any further decline in value. General loan loss allowances are based upon a combination of factors including, but not limited to, actual loss experience, composition of the loan portfolio, current economic conditions and management’s judgment.

For the three months ended March 31, 2013, the provision for loan losses was $1.6 million compared to $1.8 million for the three months ended March 31 2012. The total allowance for loan losses increased to 2.61% of total loans from a comparable ratio of 2.42% at December 31, 2012.

When management expects that some portion or all of a loan balance will not be collected, that amount is charged-off as a loss against the allowance for loan losses. For the three months ended March 31, 2013 and 2012, net charge-offs were $729,000 and $272,000, respectively.

While regular monthly payments continue to be made on many of the nonaccrual loans, certain charge-offs result, nevertheless, from the borrowers’ inability to provide adequate documentation evidencing their ability to continue to service their debt. Therefore, consideration has been given to any underlying collateral and appropriate charge-offs recorded based, in general, on the deficiency of such collateral. In general, the charge-offs reflect partial writedowns and full charge-offs on nonaccrual loans due to the initial evaluation of market values of the underlying real estate collateral in accordance with Accounting Standards Codification (“ASC”) 310-40. Management believes the charge-off of these reserves provides a clearer indication of the value of nonaccrual loans. In addition to our actions of recording partial and full charge-offs on loans, we continue to aggressively pursue collection, including legal action.

Index

At March 31, 2013 and December 31, 2012, the Corporation had $11.6 million and $11.7 million, respectively, of loans whose terms have been modified in troubled debt restructurings. Of these loans, $10.1 million and $10.4 million were performing in accordance with their new terms at March 31, 2013 and December 31, 2012, respectively. The remaining troubled debt restructures are reported as nonaccrual loans. Specific reserves of $393,000 and $246,000 were allocated for the troubled debt restructurings at March 31, 2013 and December 31, 2012, respectively. As of both March 31, 2013 and December 31, 2012 the Corporation had committed $241,000 of additional funds to a single customer with an outstanding construction loan that is classified as a troubled debt restructuring.

As of March 31, 2013, there were $43.3 million of other loans not included in the preceding table, compared to $44.2 million at December 31, 2012, where credit conditions of borrowers, including real estate tax delinquencies, caused management to have concerns about the possibility of the borrowers not complying with the present terms and conditions of repayment and which may result in disclosure of such loans as nonperforming loans at a future date. These loans have been considered by management in conjunction with the analysis of the adequacy of the allowance for loan losses.

The Corporation’s lending activities are concentrated in loans secured by real estate located in northern New Jersey. Accordingly, the collectability of a substantial portion of the Corporation’s loan portfolio is susceptible to changes in real estate market conditions in northern New Jersey.

Capital Adequacy

The Corporation is subject to capital adequacy guidelines promulgated by the Board of Governors of the Federal Reserve System (“FRB”). The Bank is subject to similar capital adequacy requirements imposed by the Federal Deposit Insurance Corporation. The FRB has issued regulations to define the adequacy of capital based upon the sensitivity of assets and off-balance sheet exposures to risk factors. Four categories of risk weights (0%, 20%, 50%, and 100%) were established to be applied to different types of balance sheet assets and off-balance sheet exposures. The aggregate of the risk-weighted items (risk-based assets) is the denominator of the ratio; the numerator of the ratio is risk-based capital. Under the regulations, risk-based capital has been classified into two categories. Tier 1 capital consists of common and qualifying perpetual preferred shareholders’ equity less goodwill and other intangibles. Tier 2 capital consists of (a) the allowance for loan losses of up to 1.25% of risk-weighted assets, (b) the excess of qualifying preferred stock, (c) hybrid capital instruments, (d) debt, (e) mandatory convertible securities and (f) qualifying subordinated debt. Total qualifying capital consists of Tier 1 capital and Tier 2 capital less reciprocal holdings of other banking organizations’ capital instruments, investments in unconsolidated subsidiaries and any other deductions as determined by the FRB (determined on a case-by-case basis or as a matter of policy after formal rule-making). However, the amount of Tier 2 capital may not exceed the amount of Tier 1 capital. At March 31, 2013, the minimum risk-based capital requirements to be considered adequately capitalized were 4% for Tier 1 capital and 8% for total capital.

Federal banking regulators have also adopted leverage capital guidelines to supplement the risk-based measures. The leverage ratio under which a bank holding company must maintain a minimum level of Tier I capital to average total consolidated assets of at least 3% in the case of a bank holding company that has the highest regulatory examination rating and is not contemplating significant growth or expansion is determined by dividing Tier 1 capital as defined under the risk-based guidelines by average total assets (non-risk-adjusted) for the preceding three months. At March 31, 2013 the minimum leverage ratio requirement to be considered well capitalized was 4%. The following table summarizes the capital ratios for the Corporation and the Bank at March 31, 2013.

Index

							To Be Well
							Capitalized
				Required for			Under Prompt
				Capital			Corrective
				Adequacy			Action
	Actual			Purposes			Regulations
Leverage ratio
Corporation		9.27	%		4.00	%		N/A
Bank		9.09	%		4.00	%		5.00	%

Risk-based capital
Tier I
Corporation		13.81	%		4.00	%		N/A
Bank		13.53	%		4.00	%		6.00	%
Total
Corporation		15.08	%		8.00	%		N/A
Bank		14.80	%		8.00	%		10.00	%

Liquidity and Capital Resources

The Corporation’s primary sources of funds are deposits, amortization and prepayments of loans and mortgage-backed securities, maturities of investment securities and funds provided from operations. While scheduled loan and mortgage-backed securities amortization and maturities of investment securities are a relatively predictable source of funds, deposit flow and prepayments on loans and mortgage-backed securities are greatly influenced by market interest rates, economic conditions and competition. The Corporation’s liquidity, represented by cash and cash equivalents, is a product of its operating, investing and financing activities.

The primary source of cash from operating activities is net income. Liquidity management is both a daily and long-term function of business management. Excess liquidity is generally invested in interest-earning cash accounts or short-term investments, such as federal funds sold.

Cash and cash equivalents increased $5.1 million during the first three months of 2013. Net operating and financing activities provided $1.1 million and $5.1 million, respectively, and investing activities used $1.1 million.

We anticipate that the Corporation will have sufficient funds available to meet its current contractual commitments. Should we need temporary funding, the Corporation has the ability to borrow overnight with the Federal Home Loan Bank-NY (“FHLB-NY”). The overall borrowing capacity is contingent on available collateral to secure borrowings and the ability to purchase additional activity-based capital stock of the FHLB-NY. The Corporation may also borrow from the Discount Window of the Federal Reserve Bank of New York based on the market value of collateral pledged. In addition, the Corporation has available overnight variable repricing lines of credit with other correspondent banks totaling $11.0 million on an unsecured basis.

With respect to the payment of dividends on common stock, the Corporation has historically paid a quarterly cash dividend; however, management recognizes that the payment of future dividends could be impacted by losses or reduced earnings and the Corporation cannot assure the payment of future dividends. In addition, due to its participation in the United States Treasury’s Small Business Lending Fund (the “SBLF”) program, pursuant to which the Corporation issued 15,000 shares of Senior Non-Cumulative Perpetual Preferred Stock, Series B (the “Series B Preferred Shares”) to the Treasury for a purchase price of $15.0 million in cash, the Corporation may only declare and pay dividends on its common stock (or any other equity security junior to the Series B Preferred Stock) if it has declared and paid dividends on the Series B Preferred Stock for the current dividend period and, if after payment of such dividend, the dollar amount of the Corporation’s Tier 1 Capital would be at least 90% of the Tier 1 Capital at the date of entering into the SBLF program excluding any subsequent charge-offs and any redemption of the Series B Preferred shares. An April 18, 2013, the Corporation announced that its Board of Directors had declared a $0.01 per share cash dividend payable to shareholders of record as of May 1, 2013. The dividend is to be paid on May 15, 2013.

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ITEM 3. Quantitative and Qualitative Disclosures about Market Risk

Not applicable to smaller reporting companies.

ITEM 4. Controls and Procedures

Evaluation of internal controls and procedures

Based on their evaluation as of the end of the period covered by this Quarterly Report on Form 10-Q, our principal executive officer and principal financial officer have concluded that our internal disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”)) are effective to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms.

Changes in Internal Controls over Financial Reporting

Pursuant to Rule 13a-15(d) under the Exchange Act, our management, with the participation of our principal executive officer and principal financial officer, has evaluated our internal controls over financial reporting and based upon such evaluation concluded that there were no changes in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the quarter ended March 31, 2013 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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Part II -- Other Information

Item 6.

Exhibits

See Exhibit Index following this report.

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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.

	Stewardship Financial Corporation


Date: May 14, 2013	By:	/s/ Paul Van Ostenbridge
		Paul Van Ostenbridge
		President and Chief Executive Officer
		(Principal Executive Officer)




Date: May 14, 2013	By:	/s/ Claire M. Chadwick
		Claire M. Chadwick
		Senior Vice President and Chief Financial Officer
		(Principal Financial and Accounting Officer)

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EXHIBIT INDEX

Exhibit Number		Description of Exhibits

31.1		Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2		Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1		Certification of Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
101		The following material from Stewardship Financial Corporation’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2013, formatted in XBRL (Extensible Business Reporting Language): (i) Consolidated Statements of Financial Condition, (ii) Consolidated Statements of Income, (iii) Consolidated Statement of Changes in Stockholders’ Equity, (iv) Consolidated Statements of Comprehensive Income, (v) Consolidated Statements of Cash Flows and (vi) Notes to Consolidated Financial Statements, tagged as blocks of text¹

¹ This exhibit shall not be deemed “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, or otherwise subject to the liability of that section, nor shall it be deemed incorporated by reference into any filing under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended, whether made before or after the date hereof and irrespective of any general incorporation language in any filing, except to the extent the Company specifically incorporates it by reference.