Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

The following discussion is intended to assist readers in understanding and evaluating the financial condition, changes in financial condition and the results of operations of the Company, consisting of the parent company (the Parent) and its wholly-owned subsidiaries, the Bank and Trust. This discussion should be read in conjunction with the Consolidated Financial Statements and other financial information contained elsewhere in this report.

Caution About Forward-Looking Statements

In addition to historical information, this report may contain forward-looking statements. For this purpose, any statement that is not a statement of historical fact may be deemed to be a forward-looking statement. These forward-looking statements may include, but are not limited to, statements regarding profitability, including the focus on reducing time deposits; the net interest margin; strategies for managing the net interest margin and the expected impact of such efforts; levels and sources of liquidity; the loan portfolio and expected trends in the quality of the loan portfolio; the allowance and provision for loan losses; the effect of a sustained increase in nonperforming assets; the securities portfolio; monetary policy actions of the Federal Open Market Committee; changes in interest rates; interest rate sensitivity; asset quality; levels of net loan charge-offs and nonperforming assets; sales of OREO properties; levels of interest expense; levels and components of noninterest income and noninterest expense; lease expense; income taxes; expected impact of efforts to restructure the balance sheet; expected yields on the loan and securities portfolios; expected rates on interest-bearing liabilities; expected timing of and expense in connection with the anticipated termination of the pension plan; expected timing of and effect of the purchase of the outstanding interest in Old Point Mortgage, LLC; market risk; business and growth strategies; investment strategy; and financial and other goals. Forward-looking statements often use words such as "believes," "expects," "plans," "may," "will," "should," "projects," "contemplates," "anticipates," "forecasts," "intends" or other words of similar meaning. These statements can also be identified by the fact that they do not relate strictly to historical or current facts. Forward-looking statements are subject to numerous assumptions, risks and uncertainties, and actual results could differ materially from historical results or those anticipated by such statements.

There are many factors that could have a material adverse effect on the operations and future prospects of the Company including, but not limited to, changes in interest rates and yields; general economic and general business conditions, including unemployment levels; uncertainty over future federal spending or the budget priorities of the new presidential administration, particularly in connection with the Department of Defense, on the Company's service area; effects of the transfer of the securities portfolio from held-to-maturity securities to available-for-sale securities; the quality or composition of the loan or securities portfolios; changes in the volume and mix of interest-earning assets and interest-bearing liabilities; the effects of management's investment strategy and strategy to manage the net interest margin; the adequacy of the Company's credit quality review processes; the level of nonperforming assets and related charge-offs and recoveries; turnover times experienced by the mortgage companies to which the Company has extended warehouse lines of credit; the performance of the Company's re-opened dealer lending program; the federal government's guarantee of repayment of student loans purchased by the Company; the ability of the Company to diversify its sources of noninterest income; new incentive structure for securities brokerage activities; the local real estate market; volatility and disruption in national and international financial markets; government intervention in the U.S. financial system; application of the Basel III capital standards to the Company and its subsidiaries; FDIC premiums and/or assessments; demand for loan and other banking products and financial services in the Company's primary service area; levels of noninterest income and expense; deposit flows; competition; the use of inaccurate assumptions in management's modeling systems; technology; any interruption or breach of security in the Company's information systems or those of the Company's third party vendors or other service providers; reliance on third parties for key services; adequacy of the allowance for loan losses; and changes in accounting principles, policies and guidelines. The Company could also be adversely affected by monetary and fiscal policies of the U.S. Government, as well as any regulations or programs implemented pursuant to the Dodd-Frank Act or other legislation and policies of the Comptroller, U.S. Treasury and the Federal Reserve Board.

These risks and uncertainties should be considered in evaluating the forward-looking statements contained herein, and readers are cautioned not to place undue reliance on such statements. Any forward-looking statement speaks only as of the date on which it is made, and the Company undertakes no obligation to update any forward-looking statement to reflect events or circumstances after the date on which it is made. In addition, past results of operations are not necessarily indicative of future results.

Executive Overview

Description of Operations

Headquartered in Hampton, Virginia, the Company is the parent company of Trust and the Bank. Trust is a wealth management services provider. The Bank offers a complete line of consumer, mortgage and business banking services, including loan, deposit, and cash management services to individual and commercial customers. The Bank is an independent community bank and has 18 branches throughout the Hampton Roads localities of Chesapeake, Hampton, Isle of Wight County, Newport News, Norfolk, Virginia Beach, Williamsburg/James City County and York County.

Management Initiatives in 2016

Management's two main 2016 initiatives were to grow the loan portfolio and reduce the Company's noninterest expense. Management believes substantial progress was made with respect to both initiatives. The loan portfolio grew by $34.9 million when comparing net loans on December 31, 2015 to December 31, 2016, while noninterest expense was $255 thousand lower in 2016 than in 2015. Noninterest expense declined despite a $391 thousand prepayment penalty for the early payoff of the Company's single most expensive source of funding. This early payoff is discussed in more detail below.

Primary Financial Data for 2016

In 2016, the Company's net income increased $163 thousand to $3.8 million, as compared to net income of $3.6 million in 2015,  or an increase of 4.49%. The increase in net income was due to higher net interest income, higher noninterest income, and lower noninterest expense. Net interest income increased mainly due to reduced interest expense on Federal Home Loan Bank advances, while the increase in noninterest income was primarily the result of gains on sales of available-for-sale securities. Decreases in salaries and employee benefits and losses on other real estate owned, partially offset by increases in legal and audit expenses, were the main drivers of the decline in noninterest expense.

Assets as of December 31, 2016 were $903.0 million, an increase of $6.2 million or 0.69% compared to assets as of December 31, 2015. During 2016, the Company continued the loan growth seen in prior years, funding this growth mainly from increases in low-cost deposits and cash flows from the securities portfolio. Net loans grew $34.9 million, or 6.22%, over the year, while low-cost deposits increased $36.6 million, or 6.83%, and securities declined $14.8 million, or 6.92%. In years prior to 2013, the Company experienced a lack of quality loan demand in its market area and invested excess funds in securities that could be readily liquidated as the Company waited for loan demand to recover. This recovery began in the second half of 2013 and continued through 2016.

Critical Accounting Estimates

The accounting and reporting policies of the Company are in accordance with U.S. generally accepted accounting principles (GAAP) and conform to general practices within the banking industry. The Company's financial position and results of operations are affected by management's application of accounting policies, including estimates, assumptions and judgments made to arrive at the carrying value of assets and liabilities and amounts reported for revenues, expenses and related disclosures. Different assumptions in the application of these policies could result in material changes in the Company's consolidated financial position and/or results of operations. The accounting policy that required management's most difficult, subjective or complex judgments is the Company's allowance for loan losses, which is described below.

Allowance for Loan Losses

The allowance for loan losses is an estimate of the losses that may be sustained in the loan portfolio. The allowance is based on three basic principles of accounting which require: (i) that losses be accrued when they are probable of occurring and estimable, (ii) that losses be accrued based on the differences between the loan balances and the value of collateral, present value of expected future cash flows (discounted at the loan's effective interest rate) or values that are observable in the secondary market and (iii) that adequate documentation exist to support the allowance for loan losses estimate.

The Company's allowance for loan losses is the accumulation of various components that are calculated based on independent methodologies. Management's estimate is based on certain observable, historical data and other factors that management believes are most reflective of the underlying credit losses being estimated. This evaluation includes credit quality trends; collateral values; discounted cash flow analysis; loan volumes; geographic, borrower and industry concentrations; the findings of internal credit quality assessments; and results from external bank regulatory examinations. These factors, as well as identified impaired loans, historical losses and current economic and business conditions, are used in developing estimated loss factors used in the calculations.

Authoritative accounting literature requires that the impairment of loans that have been separately identified for evaluation be measured based on the present value of expected future cash flows (discounted at the loan's effective interest rate) or, alternatively, the observable market price of the loans or the fair value of the collateral. However, for those loans that are collateral dependent (that is, if repayment of those loans is expected to be provided solely by the underlying collateral) and for which management has determined foreclosure is probable, the measure of impairment is to be based on the net realizable value of the collateral. Authoritative accounting literature, as amended, also requires certain disclosures about investments in impaired loans and the allowance for loan losses and interest income recognized on loans.

For loans not individually evaluated for impairment, the loan portfolio is segmented into pools, based on the loan classifications as defined by Schedule RC-C of the Federal Financial Institutions Examination Council Consolidated Reports of Condition and Income Form 041 (Call Report) and collectively evaluated for impairment. Consumer loans not secured by real estate and made to individuals for household, family and other personal expenditures are segmented into pools based on whether the loan's payments are current (including loans 1-29 days past due), 30 – 59 days past due, 60 – 89 days past due, or 90 days or more past due. All other loans, including loans to consumers that are secured by real estate, are segmented by the Company's internally assigned risk grades: substandard, other assets especially mentioned (rated just above substandard), and pass (all other loans). The Company may also assign loans to the risk grades of doubtful or loss, but as of December 31, 2016 and December 31, 2015, the Company had no loans in these categories.

Specific reserves are determined on a loan-by-loan basis based on management's evaluation of the Company's exposure for each credit, given the current payment status of the loan and the net market value of any underlying collateral.

While management uses the best information available to establish the allowance for loan losses, future adjustment to the allowance may be necessary if economic conditions differ substantially from the assumptions used in making the valuations or if required by regulators, based upon information available to them at the time of their examinations. Such adjustments to original estimates, as necessary, are made in the period in which these factors and other relevant considerations indicate that loss levels may vary from previous estimates.

During the third quarter of 2016, the Company changed its method for calculating the allowance for loan and lease losses.  This change is discussed in detail in Note 4 of the Notes to the Consolidated Financial Statements included in this annual report on Form 10-K.

Impairment of Securities

Impairment of securities occurs when the fair value of a security is less than its amortized cost. For debt securities, impairment is considered other-than-temporary and recognized in its entirety in net income if either (i) the Company intends to sell the security or (ii) it is more-likely-than-not that the Company will be required to sell the security before recovery of its amortized cost basis. If, however, the Company does not intend to sell the security and it is not more-likely-than-not that the Company will be required to sell the security before recovery, management must determine what portion of the impairment is attributable to a credit loss, which occurs when the amortized cost basis of the security exceeds the present value of the cash flows expected to be collected from the security. If there is no credit loss, there is no other-than-temporary impairment. If there is a credit loss, other-than-temporary impairment exists, and the credit loss must be recognized in net income and the remaining portion of impairment must be recognized in other comprehensive income. For equity securities, impairment is considered to be other-than-temporary based on the Company's ability and intent to hold the investment until a recovery of fair value. Other-than-temporary impairment of an equity security results in a write-down that must be included in net income. Management regularly reviews each investment security for other-than-temporary impairment based on criteria that includes the extent to which cost exceeds market price, the duration of that market decline, the financial health of and specific prospects for the issuer, management's best estimate of the present value of cash flows expected to be collected from debt securities, management's intention with regard to holding the security to maturity and the likelihood that the Company would be required to sell the security before recovery.

Other Real Estate Owned (OREO)

Assets acquired through, or in lieu of, loan foreclosure are held for sale and are initially recorded at fair value less costs to sell at the date of foreclosure. Subsequent to foreclosure, management periodically performs valuations of the foreclosed assets based on updated appraisals, general market conditions, recent sales of similar properties, length of time the properties have been held, and management's ability and intention with regard to continued ownership of the properties. The Company may incur additional write-downs of foreclosed assets to fair value less costs to sell if valuations indicate a further deterioration in market conditions.

Retirement Plan

The Company maintains a non-contributory, defined benefit pension plan for eligible full-time employees as specified by the plan. Plan assets, which consist primarily of mutual funds invested in marketable equity securities and corporate and government fixed income securities, are valued using market quotations. The Company's actuary determines plan obligations and annual pension expense using a number of key assumptions. Key assumptions may include the discount rate, the interest crediting rate, the estimated future return on plan assets and the anticipated rate of future salary increases. Changes in these assumptions in the future, if any, or in the method under which benefits are calculated may affect pension assets, liabilities or expense.

 

Income Taxes

The Company recognizes expense for federal income and state bank franchise taxes payable as well as deferred federal income taxes for estimated future tax effects of temporary differences between the tax basis of assets and liabilities and amounts reported in the Consolidated Financial Statements. Income and franchise tax returns are subject to audit by the Internal Revenue Service (IRS) and state taxing authorities. Income and franchise tax expense for current and prior periods is subject to adjustment based on the outcome of such audits. The Company believes it has adequately provided for all taxes payable.

Earnings Summary

Net income was $3.8 million ($0.77 per diluted share) in 2016 compared to $3.6 million ($0.73 per diluted share) in 2015. The increase in net income was due to higher net interest income, higher noninterest income, and lower noninterest expense. Net interest income increased mainly due to reduced interest expense on Federal Home Loan Bank advances, while the increase in noninterest income was primarily the result of gains on sales of available-for-sale securities. Decreases in salaries and employee benefits and losses on other real estate owned, partially offset by increases in legal and audit expenses, were the main drivers of the decline in noninterest expense.

Net Interest Income

The principal source of earnings for the Company is net interest income. Net interest income is the difference between interest and fees generated by earning assets and interest expense paid to fund them. Changes in the volume and mix of interest-earning assets and interest-bearing liabilities, as well as their respective yields and rates, have a significant impact on the level of net interest income. The net interest margin is calculated by dividing tax-equivalent net interest income by average earning assets. Net interest income, on a fully tax-equivalent basis, was $28.2 million in 2016, an increase of $518 thousand from 2015 and an increase of $777 thousand from 2014. The net interest margin was 3.66% in 2016 as compared to 3.56% in 2015 and 3.57% in 2014, primarily as a result of lower interest expense.

When comparing 2016 to 2015, the following changes occurred. Tax equivalent interest income decreased $540 thousand, or 1.73%. Average earning assets decreased $7.3 million, or 0.94%. Total average loans increased $21.7 million, or 3.85%, and average investment securities decreased $31.3 million, or 15.47%, as continued loan demand allowed the Company to shift its assets from securities to loans. The Company's portfolio of mortgage-backed securities generates cash flows on a monthly basis, which are typically re-invested into loans.

In 2016, the Company began holding more of its excess liquidity in a noninterest-bearing account at a correspondent bank, as evidenced by the $10.3 million increase in average cash and due from banks. Although this account does not earn interest, the Company receives an earnings credit based on balances held in the account. The earnings credit rate is higher than the interest rate earned on accounts at other correspondent banks. For further discussion of this earnings credit, see the Noninterest Expense section below.

Interest income was also impacted by continued declines in average loan yields, from 4.63% in 2015 to 4.52% in 2016. Management expects that the Company's loan yields will continue to decline, due to intense competition for quality loans and rate reductions on loans currently held in the portfolio. The Federal Open Market Committee (FOMC) raised the target range for the federal funds rate in December of both 2015 and 2016. Management currently expects the FOMC to raise rates three times in 2017, possibly beginning in March 2017. Despite these projected increases, management expects the FOMC's monetary policy to remain accommodative and the overall low interest rate environment to continue in 2017. Accordingly, management expects continued pressure on loan yields and the net interest margin and plans to continue to manage the mix of the Company's liabilities to increase low cost funds and reduce high cost funds when possible.

As part of its strategy to reduce interest expense, the Company prepaid a $25.0 million Federal Home Loan Bank (FHLB) advance. This advance, which would have matured in June of 2016, was instead paid off in February of 2016. In past years, the prepayment penalty on this advance made an early payoff prohibitively expensive, but in the first quarter of 2016, volatility in the markets simultaneously reduced the prepayment penalty on the advance and increased the value of the Company's securities portfolio. As a result, the Company was able to sell for a gain certain securities that management expected to perform poorly in a rising rate environment. The liquidity from these sales was used to prepay the FHLB advance. The prepayment penalty on the advance was $391 thousand, compared to $456 thousand in interest expense that would have been paid if the advance had been allowed to mature in June.

Average interest-bearing liabilities decreased $24.2 million, or 4.08%, partially due to the prepayment of the FHLB advance and partially due to decreases in interest-bearing deposits. As discussed above, management has focused on adjusting the composition of its interest-bearing liabilities, specifically by allowing high-cost time deposits to reduce. Management expects that the reduction of the Company's interest expense will slow or stop in 2017, as the majority of higher-cost time deposits have repriced to current, lower market rates and management anticipates increases in market rates in 2017. To mitigate the expected increase in market rates, management will continue to focus on the mix of deposits by actively targeting new noninterest-bearing deposits.

Overall, interest expense decreased $1.1 million, or 29.13% in 2016 as compared to 2015, and the cost of interest-bearing liabilities decreased 16 basis points.

The following table shows an analysis of average earning assets, interest-bearing liabilities and rates and yields. Nonaccrual loans are included in loans outstanding.

* Computed on a fully tax-equivalent basis using a 34% rate.

The following table summarizes changes in net interest income attributable to changes in the volume of interest-bearing assets and liabilities and changes in interest rates.

* Computed on a fully tax-equivalent basis using a 34% rate.

** Other investments include interest-bearing balances due from banks.

Interest Sensitivity

An important element of earnings performance and the maintenance of sufficient liquidity is proper management of the interest sensitivity gap. The interest sensitivity gap is the difference between interest-sensitive assets and interest-sensitive liabilities in a specific time interval. This gap can be managed by repricing assets or liabilities, which are variable rate instruments, by replacing an asset or liability at maturity or by adjusting the interest rate during the life of the asset or liability. Matching the amounts of assets and liabilities maturing in the same time interval helps to hedge interest rate risk and to minimize the impact of rising or falling interest rates on net interest income.

The Company determines the overall magnitude of interest sensitivity risk and then formulates policies governing asset generation and pricing, funding sources and pricing, and off-balance sheet commitments. These decisions are based on management's expectations regarding future interest rate movements, the state of the national and regional economy, and other financial and business risk factors. The Company uses computer simulations to measure the effect of various interest rate scenarios on net interest income. This modeling reflects interest rate changes and the related impact on net interest income and net income over specified time horizons.

Based on scheduled maturities only, the Company was liability sensitive at the one-year timeframe as of December 31, 2016. It should be noted, however, that non-maturing, interest-bearing deposit liabilities, which consist of interest checking, money market and savings accounts, are less interest sensitive than other market driven deposits. On December 31, 2016 non-maturing, interest-bearing deposit liabilities totaled $344.5 million, or 61.97%, of total interest-bearing deposits. In a rising rate environment, changes in these deposit rates have historically lagged behind the changes in earning asset rates, thus mitigating the impact from the liability sensitive position indicated by the static gap analysis. Income simulation analysis allows the Company to reflect the expected differences in re-pricing behavior among various assets and liabilities to more reliably measure the potential effects on income from changes in the interest rate environment. Utilizing this income simulation methodology, the model reveals that the Company is asset sensitive at the one-year timeframe as of December 31, 2016.

When the Company is liability sensitive, net interest income should improve if interest rates fall since liabilities will reprice faster than assets (depending on the optionality or prepayment speeds of the assets). Conversely, if interest rates rise, net interest income should decline. When the Company is asset sensitive, net interest income should improve if interest rates rise and fall if rates fall.

The Company's interest rate sensitivity position is illustrated in the following table. The carrying amounts of assets and liabilities are presented in the periods they are expected to reprice or mature.

The most likely scenario represents the rate environment as management forecasts it to occur. Management uses a "static" test to measure the effects of changes in interest rates on net interest income. This test assumes that management takes no steps to adjust the balance sheet to respond to the shock by repricing assets/liabilities, as discussed in the first paragraph of this section.

Under the rate environment forecasted by management, rate shocks in 50 to 100 basis point increments are applied to estimate the impact on the Company's net interest income. The table below shows the estimated impact of changes in interest rates on net interest income as of December 31, 2016, assuming gradual and parallel changes in interest rates, and consistent levels of assets and liabilities. Net interest income for the following twelve months is projected to increase when interest rates are higher than current rates. Due to the current low interest rate environment, no measurement was considered necessary for a further decline in interest rates.

Management cannot predict future interest rates or their exact effect on net interest income. Computations of future effects of hypothetical interest rate changes are based on numerous assumptions and should not be relied upon as indicative of actual results. Certain limitations are inherent in such computations. Assets and liabilities may react differently than projected to changes in market interest rates. The interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while rates on other types of assets and liabilities may lag changes in market interest rates. Interest rate shifts may not be parallel.

Changes in interest rates can cause substantial changes in the amount of prepayments of loans and mortgage-backed securities, which may in turn affect the Company's interest rate sensitivity position. Additionally, credit risk may rise if an interest rate increase adversely affects the ability of borrowers to service their debt.

Provision for Loan Losses

The provision for loan losses is a charge against earnings necessary to maintain the allowance for loan losses at a level consistent with management's evaluation of the portfolio. This expense is based on management's estimate of probable credit losses inherent to the loan portfolio. Management's evaluation included credit quality trends, collateral values, discounted cash flow analysis, loan volumes, geographic, borrower and industry concentrations, the findings of internal credit quality assessments and results from external regulatory examinations. These factors, as well as identified impaired loans, historical losses and current economic and business conditions, were used in developing estimated loss factors for determining the loan loss provision. Based on its analysis of the adequacy of the allowance for loan losses, management concluded that the provision was appropriate.

The provision for loan losses was $1.9 million for the year ended December 31, 2016 as compared to $1.0 million for 2015. A portion of the increase is due to loan growth during 2016, which required the Company to set aside additional funds. The provision was also impacted by higher levels of charge offs in 2016 than in 2015. Charged-off loans totaled $1.8 million in 2016, compared to $897 thousand in 2015. Recoveries amounted to $347 thousand in 2016 and $535 thousand in 2015. The Company's net loans charged off to year-end loans were 0.24% in 2016 as compared to 0.06% in 2015.

Net loan charge-offs for 2016 were higher than in 2015 primarily due to a charge-off in the second quarter of 2016, on a single borrowing relationship whose condition deteriorated rapidly. None of the loans in this relationship had been more than sixty days past due until the second quarter of 2016, when the Company became aware of the potential impairment on these loans. Working through the assessment and collection process, the Company charged off a total of $876 thousand on this borrowing relationship in 2016.

Management believes that net loan charge-offs in subsequent years will be lower than what was experienced in 2016, as no similarly large charge off is expected in 2017. The state of the local economy also significantly impacts the level of loan charge-offs. If the economy begins to contract, nonperforming assets could increase as a result of declines in real estate values and home sales or increases in unemployment rates and financial stress on borrowers. Increased nonperforming assets would increase charge-offs and reduce earnings due to larger contributions to the loan loss provision. If current economic conditions remain stable and net loan charge-offs are consistent with management's forecast, management expects that the loan loss provision will be lower in 2017 than in 2016.

Noninterest Income

Unless otherwise noted, all comparisons in this section are between the twelve months ended December 31, 2016 and the twelve months ended December 31, 2015.

Noninterest income increased $330 thousand or 2.51% for the year ended December 31, 2016 as compared to the year ended December 31, 2015. Noninterest income in 2016 was positively impacted by sales of securities during the year, sales that are congruent with management's current strategy for the Company's investment portfolio. These investment portfolio sales resulted in a net gain of $509 thousand in the first quarter of 2016. In the second quarter, sharp declines in market interest rates provided the Company with the opportunity to sell certain under-performing securities for a gain, which allowed the Company to fund loan growth and reduce the portfolio's susceptibility to interest rate risk. Smaller gains were recognized in the third quarter of 2016.

In addition to these gains, two other categories of noninterest income increased: service charges on deposit accounts (up $31 thousand or 0.77%) and other operating income (up $144 thousand or 31.79%). Service charges on deposit accounts increased primarily due to deposit growth and new product offerings introduced in the third quarter of 2015. The increases from these changes were partially offset by continued declines in overdraft fee income. Regulatory changes in recent years have curtailed this income source for most banks, including the Company, and while management expects to see continued overall improvements in service charges on deposit accounts, overdraft fee income is expected to remain flat or decline in 2017.

The increase in other operating income was due to an additional $154 thousand in income from Old Point Mortgage LLC (Old Point Mortgage), a joint venture between the Bank and Tidewater Mortgage Services. Old Point Mortgage has been working to improve its efficiencies and re-define its incentive structure for its sales staff. Management believes that the success of these efforts is evident in the increased income seen in 2016, compared to 2015.

In addition to the increase in income from Old Point Mortgage, other operating income was also impacted by foreclosed property income and income from early withdrawal penalties on time deposits. Foreclosed property income decreased due to the sale of foreclosed properties. As the Bank no longer holds any tenant-occupied foreclosed properties, management does not expect to have any foreclosed property income in 2017. Income from early withdrawal penalties increased due to a change in the Bank's fee structure for early withdrawals. With this change, management hopes to better control its interest expense when rates rise.

The remaining categories of noninterest income decreased, with the largest decrease in other service charges, commissions and fees (down $144 thousand or 3.53%). Within this category, declines in securities brokerage income and ATM interchange fees were only partially offset by increases in merchant processing fee income. In 2017, management has instituted a new incentive structure and anticipates an increase in securities brokerage income. The 2016 trends for ATM interchange fees and merchant processing fee income are expected to continue in 2017.

Income from bank-owned life insurance was down $90 thousand or 10.17% as lower market rates reduced yields on the underlying assets. Management does not expect a similar decline in 2017 and expects 2017 income to match or be slightly above income for 2016.

Income from fiduciary activities decreased $57 thousand or 1.58%. This category is heavily impacted by the market value of assets under management. Fluctuations in the stock market during the first half of 2016 reduced income by $116 thousand when compared to the first half of 2015. As markets stabilized in the third and fourth quarters of 2016, income from fiduciary activities began to increase again, offsetting some of the declines from the first half of the year. Income from fiduciary activities was up $58 thousand for the second half of 2016 when compared to the second half of 2015. This category is difficult to project, due to the unpredictable nature of its primary source. However, management does expect that, in general, income from fiduciary activities will continue to trend upward in future years as a result of business development efforts.

The Company continues to focus on diversifying noninterest income through efforts to expand Trust relationships and a continued focus on business checking and other corporate services.

Noninterest Expense

Unless otherwise noted, all comparisons in this section are between the twelve months ended December 31, 2016 and the twelve months ended December 31, 2015.

The Company's noninterest expense decreased $255 thousand or 0.73% due to a number of factors. Since 2014, the Company has maintained a portion of its excess liquidity in a noninterest-bearing account at a correspondent bank. Balances held at the correspondent receive an earnings credit 25 basis points higher than the highest interest rate the Company can earn on its interest-bearing accounts. Beginning in the third quarter of 2016, the Company has made more strategic use of this earnings credit, which can be used to offset the Company's courier and data processing expenses, in addition to normal service charges assessed by the correspondent. The reduction in noninterest expense (and thus the increase in net income) is higher than the reduction in interest income. Due to this strategy, the Company saved $152 thousand in the year ended December 31, 2016.

Although noninterest expense decreased overall, certain categories did increase. The prepayment fee on the Company's $25.0 million FHLB advance was one of the largest increases in noninterest expense. Although this $391 thousand fee had a significant impact on noninterest expense, it was more than offset by reduced interest expense on FHLB advances 2016 as compared to 2015.

Of the remaining categories of noninterest expense, the most significant increases when comparing 2016 to 2015 were in legal and audit expenses, occupancy and equipment, other outside service fees, employee professional development, and capital stock tax.

These increased expenses were more than offset by decreases in other areas, primarily salaries and employee benefits, loss on other real estate owned, and FDIC insurance.

The Company provides pension benefits for eligible participants through a non-contributory defined-benefit pension plan (the Plan). Benefits are based on years of service and average earnings during the highest average 60 month period during the final 120 months of employment. Effective September 30, 2006, the Plan was closed to new entrants and benefit accruals for existing participants were frozen. Under current rules, the Company had no funding obligation as of December 31, 2015 or 2016.

On November 23, 2016, the Company's Board of Directors (the Board) voted to terminate the Plan, effective January 31, 2017. In order to settle its liabilities under the Plan, the Company will offer participants the option to receive either an annuity purchased from an insurance carrier or a lump-sum cash payment. If the total value of the Plan's assets is insufficient to cover the lump-sum payouts and annuity purchases, the Company will contribute the necessary funds to complete the termination of the Plan. The exact amount that will be required is subject to a number of factors, including changes in interest rates and the exact proportion of participants electing a lump-sum distribution versus an annuity. The Company currently estimates that its before-tax expense will be between $3.1 million and $3.3 million, all of which would be recognized in 2017. Other expenses associated with terminating the Plan are currently estimated to be $20 thousand.

The Company anticipates completing the transfer of all liabilities and administrative responsibilities under the Plan by the end of the fourth quarter of 2017. Once this process is complete, the Company will no longer have any remaining pension obligations and thus no periodic pension expense. By comparison, annual pension expense for 2016 was $392 thousand and is currently estimated to be $529 thousand for 2017.

Income tax expense was higher in 2016 than in 2015 due to higher income and a higher effective tax rate. When comparing 2016 to 2015, tax-exempt income was a smaller percent of total income, increasing the effective tax rate from 1.46% to 4.04%. Despite the increase from 2015 to 2016, t he Company's effective tax rate remains low, primarily due to its receipt of federal income tax credits for its investment in certain housing projects.

Balance Sheet Review

At December 31, 2016, the Company had total assets of $903.0 million, an increase of $6.2 million or 0.69% compared to assets as of December 31, 2015.

In 2016, the Company built on progress made in 2015 by continuing to move funds from lower-yielding to higher-yielding assets. Cash and cash equivalents decreased $11.1 million or 30.11% from December 31, 2015 to December 31, 2016 as funds were re-invested into loans in 2016. Net loans increased $34.9 million or 6.22%, from $560.7 million at December 31, 2015 to $595.6 million at December 31, 2016. Loan demand began to increase in 2013 and has continued at a moderate pace throughout 2014, 2015, and 2016, but until loan demand recovers significantly, the Company will likely continue to manage the interest margin by focusing deposit-gathering efforts on lower cost funds in the form of noninterest-bearing and savings deposits. These low-cost funds increased $36.6 million or 6.83% between December 31, 2015 and December 31, 2016, while in the same time period, high-cost time deposits increased $1.4 million or 0.67% .

The Company's holdings of Alternative A-paper, or "Alt-A", type mortgage loans such as adjustable rate and nontraditional type loans were inconsequential, amounting to less than 1.00% of the Company's loan portfolio as of December 31, 2016.

The Company does not have a formal program for subprime lending. The Company is, however, required by law to comply with the CRA, which imposes on financial institutions an affirmative and ongoing obligation to meet the credit needs of their local communities, including low- and moderate-income borrowers. In order to comply with the CRA and meet the credit needs of its local communities, the Company finds it necessary to make certain loans with subprime characteristics.

For the purposes of this discussion, a "subprime loan" is defined as a loan to a borrower having a credit score of 660 or below. The majority of the Company's subprime loans are to customers in the Company's primary service area.

The following table details, as of December 31, 2016, the Company's loans with subprime characteristics that were secured by 1-4 family first mortgages, 1-4 family open-end (i.e., equity lines of credit) and 1-4 family junior lien loans (i.e., second mortgages) for which the Company has recorded a credit score in its system.

In addition to the subprime loans secured by real estate discussed above, as of December 31, 2016, the Company had an additional $2.8 million in subprime consumer loans that were either unsecured or secured by collateral other than real estate. Together with the subprime loans secured by real estate, the Company's total subprime loans as of December 31, 2016 were $24.5 million, amounting to 4.05% of the Company's total loans at December 31, 2016.

The Company has no investments secured by "Alt-A" type mortgage loans such as adjustable rate and nontraditional type mortgages or subprime loans.

Securities Portfolio

When comparing December 31, 2016 to December 31, 2015, securities available-for-sale decreased $14.8 million, or 6.92%. The Company sold certain securities in the first and second quarters of 2016 to limit the portfolio's susceptibility to interest rate risk, help fund loan growth, and provide liquidity to prepay the $25.0 million FHLB advance in February 2016. With the volatility in market interest rates during 2016, the Company was able to sell for a gain certain under-performing securities. The securities sold were all mortgage-backed securities with rates that have been below market for some time. As management expects that rates will continue to increase, and loan growth necessitated a need for additional funding, the Company sold these securities while the market value was above the Company's book value of the securities. The Company also purchased securities in the third and fourth quarters of 2016 to further management's strategy and absorb temporary excess liquidity.

Restricted securities decreased $1.0 million or 51.88% from December 31, 2015 to December 31, 2016 as a result of lower balances in FHLB stock. The Company is required to hold FHLB stock based on its borrowings; with the repayment of the $25.0 million FHLB advance, the FHLB repurchased a portion of its stock held by the Company.

The Company routinely purchases short-term U.S. Treasury and government agency securities as part of a strategy to reduce its capital stock tax expense.  While both of these types of securities have very low yields, the reduction in capital stock tax, a component of noninterest expense, more than offsets the reduction in interest income.

The Company's strategy for the securities portfolio is primarily intended to manage the portfolio's susceptibility to interest rate risk and to provide liquidity to fund loan growth.  The securities portfolio is also adjusted to achieve other asset/liability objectives, including pledging requirements, and to manage tax exposure when necessary.

The following table sets forth a summary of the securities portfolio: