10-Q 1 form10-q.htm CHCO FORM 10-Q, SECOND QUARTER 2007 form10-q.htm


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

FORM 10-Q

(Mark One)

[X] QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For The Quarterly Period Ended June 30, 2007
OR
[  ] TRANSITION REPORT PURSANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For The Transition Period From ____________To_____________.

Commission File number 0-11733

CITY HOLDING COMPANY
(Exact name of registrant as specified in its charter)

West Virginia
55-0619957
(State or other jurisdiction of incorporation or organization)
(I.R.S. Employer Identification No.)
   
25 Gatewater Road
 
Charleston, West Virginia
25313
(Address of principal executive offices)
(Zip Code)

(304) 769-1100
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant has (1) filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes
[X]
No
[   ]

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.  See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.  (Check one):

Large accelerated filer
[   ]
Accelerated filer
[X]
Non-accelerated filer
[   ]

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes
[   ]
No
[X]

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

Common stock, $2.50 Par Value – 16,810,787 shares as of August 7, 2007.




FORWARD-LOOKING STATEMENTS
All statements other than statements of historical fact included in this Quarterly Report on Form 10-Q, including statements in Management’s Discussion and Analysis of Financial Condition and Result of Operations are, or may be deemed to be, forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Such information involves risks and uncertainties that could result in the Company’s actual results differing from those projected in the forward-looking statements. Important factors that could cause actual results to differ materially from those discussed in such forward-looking statements include, but are not limited to:  (1) the Company may incur additional provision for loan losses due to negative credit quality trends in the future that may lead to a deterioration of asset quality; (2) the Company may incur increased charge-offs in the future; (3) the Company may experience increases in the default rates or decreased prepayments on previously securitized loans that would result in impairment losses or lower the yield on such loans; (4) the Company may continue to benefit from strong recovery efforts on previously securitized loans resulting in improved yields on this asset; (5) the Company could have adverse legal actions of a material nature; (6) the Company may face competitive loss of customers; (7) the Company may be unable to manage its expense levels; (8) the Company may have difficulty retaining key employees; (9) changes in the interest rate environment may have results on the Company’s operations materially different from those anticipated by the Company’s market risk management functions; (10) changes in general economic conditions and increased competition could adversely affect the Company’s operating results; (11) changes in other regulations and government policies affecting bank holding companies and their subsidiaries, including changes in monetary policies, could negatively impact the Company’s operating results; and (12) the Company may experience difficulties growing loan and deposit balances. Forward-looking statements made herein reflect management’s expectations as of the date such statements are made. Such information is provided to assist stockholders and potential investors in understanding current and anticipated financial operations of the Company and is included pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. The Company undertakes no obligation to update any forward-looking statement to reflect events or circumstances that arise after the date such statements are made.

-2-


City Holding Company and Subsidiaries

PART I
Financial Information
Pages
     
Item 1.
4-16
   
   
   
   
   
Item 2.
17-34
Item 3.
34
Item 4.
34
     
PART II
 
     
Item 1.
35
Item 1A.
35
Item 2.
35
Item 3.
35
Item 4.
36
Item 5.
36
Item 6.
36
     
 
37




PART I, ITEM 1 – FINANCIAL STATEMENTS
City Holding Company and Subsidiaries
(in thousands)
   
June 30
   
December 31
 
   
2007
   
2006
 
   
(Unaudited)
   
(Note A)
 
Assets
           
Cash and due from banks
  $
60,163
    $
58,014
 
Interest-bearing deposits in depository institutions
   
14,507
     
27,434
 
Federal funds sold
   
20,000
     
25,000
 
Cash and Cash Equivalents
   
94,670
     
110,448
 
                 
Investment securities available for sale, at fair value
   
453,721
     
472,398
 
Investment securities held-to-maturity, at amortized cost (approximate fair value at    June 30, 2007 and December 31, 2006 - $43,706 and $49,955)
   
41,711
     
47,500
 
Total Investment Securities
   
495,432
     
519,898
 
                 
Gross loans
   
1,730,354
     
1,677,469
 
Allowance for loan losses
    (16,616 )     (15,405 )
Net Loans
   
1,713,738
     
1,662,064
 
                 
Bank owned life insurance
   
56,272
     
55,195
 
Premises and equipment
   
48,923
     
44,689
 
Accrued interest receivable
   
11,596
     
12,337
 
Net deferred tax asset
   
26,424
     
23,652
 
Intangible assets
   
58,504
     
58,857
 
Other assets
   
20,179
     
20,667
 
Total Assets
  $
2,525,738
    $
2,507,807
 
Liabilities
               
Deposits:
               
Noninterest-bearing
  $
329,772
    $
321,038
 
Interest-bearing:
               
Demand deposits
   
416,331
     
422,925
 
Savings deposits
   
346,413
     
321,075
 
Time deposits
   
921,172
     
920,179
 
Total Deposits
   
2,013,688
     
1,985,217
 
                 
Short-term borrowings
   
164,545
     
136,570
 
Long-term debt
   
21,897
     
48,069
 
Other liabilities
   
30,825
     
32,644
 
Total Liabilities
   
2,230,955
     
2,202,500
 
                 
Shareholders’ Equity
               
Preferred stock, par value $25 per share: 500,000 shares authorized; none issued
   
-
     
-
 
Common stock, par value $2.50 per share: 50,000,000 shares authorized; 18,499,282 shares issued and outstanding at June 30, 2007 and December 31, 2006, less 1,562,095 and 1,009,095 shares in treasury, respectively
   
46,249
     
46,249
 
Capital surplus
   
103,422
     
104,043
 
Retained earnings
   
209,043
     
194,213
 
Cost of common stock in treasury
    (55,284 )     (33,669 )
Accumulated other comprehensive (loss):
               
Unrealized loss on securities available-for-sale
    (4,767 )     (2,649 )
Unrealized loss on derivative instruments
    (1,210 )     (210 )
Underfunded pension liability
    (2,670 )     (2,670 )
Total Accumulated Other Comprehensive (Loss)
    (8,647 )     (5,529 )
Total Shareholders’ Equity
   
294,783
     
305,307
 
Total Liabilities and Shareholders’ Equity
  $
2,525,738
    $
2,507,807
 


See notes to consolidated financial statements.


City Holding Company and Subsidiaries
(in thousands, except earnings per share data)


   
Three Months Ended June 30
   
Six Months Ended June 30
 
   
2007
   
2006
   
2007
   
2006
 
                         
Interest Income
                       
Interest and fees on loans
  $
31,947
    $
30,451
    $
63,411
    $
60,014
 
Interest on investment securities:
                               
Taxable
   
6,752
     
7,489
     
13,686
     
14,748
 
Tax-exempt
   
427
     
455
     
855
     
922
 
Interest on loans held for sale
   
-
     
200
     
-
     
200
 
Interest on deposits in depository institutions
   
113
     
415
     
230
     
566
 
Interest on federal funds sold
   
291
     
-
     
547
     
-
 
Total Interest Income
   
39,530
     
39,010
     
78,729
     
76,450
 
                                 
Interest Expense
                               
Interest on deposits
   
13,077
     
10,520
     
25,788
     
19,721
 
Interest on short-term borrowings
   
1,694
     
1,326
     
3,207
     
2,452
 
Interest on long-term debt
   
425
     
1,239
     
957
     
2,499
 
Total Interest Expense
   
15,196
     
13,085
     
29,952
     
24,672
 
Net Interest Income
   
24,334
     
25,925
     
48,777
     
51,778
 
Provision for loan losses
   
1,600
     
675
     
2,500
     
1,675
 
Net Interest Income After Provision for Loan Losses
   
22,734
     
25,250
     
46,277
     
50,103
 
                                 
Non-interest Income
                               
Investment securities gains
   
45
     
-
     
45
     
-
 
Service charges
   
11,426
     
10,903
     
21,489
     
20,764
 
Insurance commissions
   
832
     
521
     
1,844
     
1,135
 
Trust and investment management fee income
   
437
     
504
     
1,005
     
1,070
 
Bank owned life insurance
   
585
     
678
     
1,281
     
1,215
 
Gain on sale of credit card merchant agreements
   
-
     
-
     
1,500
     
-
 
Other income
   
364
     
857
     
877
     
1,667
 
Total Non-interest Income
   
13,689
     
13,463
     
28,041
     
25,851
 
                                 
Non-interest Expense
                               
Salaries and employee benefits
   
8,912
     
8,764
     
17,969
     
17,396
 
Occupancy and equipment
   
1,525
     
1,624
     
3,162
     
3,223
 
Depreciation
   
1,109
     
1,071
     
2,179
     
2,121
 
Professional fees
   
385
     
571
     
788
     
966
 
Postage, delivery, and statement mailings
   
569
     
689
     
1,346
     
1,333
 
Advertising
   
880
     
755
     
1,732
     
1,529
 
Telecommunications
   
460
     
525
     
915
     
1,001
 
Bankcard expenses
   
597
     
458
     
1,115
     
1,001
 
Insurance and regulatory
   
383
     
381
     
768
     
769
 
Office supplies
   
442
     
372
     
897
     
754
 
Repossessed asset losses (gains), net of expenses
   
9
      (129 )     (5 )     (125 )
Loss on early extinguishment of debt
   
-
     
-
     
-
     
282
 
Other expenses
   
2,254
     
2,474
     
4,256
     
4,802
 
Total Non-interest Expense
   
17,525
     
17,555
     
35,122
     
35,052
 
Income Before Income Taxes
   
18,898
     
21,158
     
39,196
     
40,902
 
Income tax expense
   
6,576
     
7,397
     
13,643
     
14,275
 
Net Income
   
12,322
     
13,761
    $
25,553
    $
26,627
 
                                 
Basic earnings per common share
  $
0.72
    $
0.78
    $
1.48
    $
1.49
 
Diluted earnings per common share
  $
0.72
    $
0.77
    $
1.48
    $
1.49
 
Dividends declared per common share
  $
0.31
    $
0.28
    $
0.62
    $
0.56
 
Average common shares outstanding:
                               
Basic
   
17,100
     
17,719
     
17,230
     
17,860
 
Diluted
   
17,158
     
17,772
     
17,292
     
17,917
 

See notes to consolidated financial statements.


City Holding Company and Subsidiaries
Six Months Ended June 30, 2007 and 2006
(in thousands)

   
Common Stock
   
Capital Surplus
   
Retained Earnings
   
Treasury Stock
   
Accumulated Other Comprehensive Loss
   
Total Shareholders’ Equity
 
                                     
Balances at December 31, 2005
  $
46,249
    $
104,435
    $
160,747
    $ (11,278 )   $ (8,012 )   $
292,141
 
Comprehensive income:
                                               
Net income
                   
26,627
                     
26,627
 
Other comprehensive loss, net of deferred income taxes of $3,282:
                                               
Unrealized losses on available-for-sale securities of $6,518, net of taxes
                                    (3,911 )     (3,911 )
Net unrealized loss on interest rate floors of $1,687, net of taxes
                                    (1,012 )     (1,012 )
Total comprehensive income
                                           
21,704
 
Cash dividends declared ($0.56 per share)
                    (9,907 )                     (9,907 )
Issuance of stock awards, net
            (58 )            
245
             
187
 
Exercise of 32,007 stock options
            (747 )            
1,172
             
425
 
Excess tax benefit on stock –basedcompensation
           
195
                             
195
 
Purchase of 572,053 treasury shares
                            (20,625 )             (20,625 )
Balances at June 30, 2006
  $
46,249
    $
103,825
    $
177,467
    $ (30,486 )   $ (12,935 )   $
284,120
 


   
Common Stock
   
Capital Surplus
   
Retained Earnings
   
Treasury Stock
   
Accumulated Other Comprehensive Loss
   
Total Shareholders’ Equity
 
                                     
Balances at December 31, 2006
  $
46,249
    $
104,043
    $
194,213
    $ (33,669 )   $ (5,529 )   $
305,307
 
Comprehensive income:
                                               
Cumulative effect of adopting FIN 48
                    (125 )                     (125 )
Net income
                   
25,553
                     
25,553
 
Other comprehensive loss, net of deferred income taxes of $2,079:
                                               
Unrealized losses on available-for-sale securities of $3,530, net of taxes
                                    (2,118 )     (2,118 )
Net unrealized loss on interest rate floors of $1,667, net of taxes
                                    (1,000 )     (1,000 )
Total comprehensive income
                                           
22,435
 
Cash dividends declared ($0.62 per share)
                    (10,598 )                     (10,598 )
Issuance of stock awards, net
            (483 )            
801
             
318
 
Exercise of 7,300 stock options
            (141 )            
295
             
154
 
Excess tax benefit on stock-based  compensation
           
3
                             
3
 
Purchase of 580,200 treasury shares
                            (22,711 )             (22,711 )
Balances at June 30, 2007
  $
46,249
    $
103,422
    $
209,043
    $ (55,284 )   $ (8,647 )   $
294,783
 




See notes to consolidated financial statements.



City Holding Company and Subsidiaries
(in thousands)
   
Six Months Ended June 30
 
   
2007
   
2006
 
             
Operating Activities
           
Net income
  $
25,553
    $
26,627
 
Adjustments to reconcile net income to net cash provided by
    operating activities:
               
Amortization and accretion
    (1,027 )     (1,453 )
Provision for loan losses
   
2,500
     
1,675
 
Depreciation of premises and equipment
   
2,179
     
2,121
 
Deferred income tax (benefit) expense
    (693 )    
1,010
 
Net periodic employee benefit cost
   
118
     
123
 
Loss on early extinguishment of debt
   
-
     
282
 
Gain on sale of credit card merchant agreements
    (1,500 )    
-
 
Loss on disposal of premises and equipment
   
-
     
15
 
Realized investment securities (gains)
    (45 )    
-
 
Proceeds from bank-owned life insurance
   
204
     
125
 
Increase in value of bank-owned life insurance
    (1,281 )     (1,214 )
Decrease  in accrued interest receivable
   
741
     
1,863
 
(Decrease) in other assets
    (1,341 )     (3,523 )
(Decrease ) increase in other liabilities
    (2,097 )    
820
 
Net Cash Provided by Operating Activities
   
23,311
     
28,471
 
                 
Investing Activities
               
Proceeds from maturities and calls of securities held-to-maturity
   
5,707
     
909
 
Proceeds from sale of money market and mutual fund securities available-for-sale
   
533,960
     
500,250
 
Purchases of money market and mutual fund securities available-for-sale
    (571,557 )     (509,516 )
Proceeds from sales of securities available-for-sale
   
1,034
     
3,223
 
Proceeds from maturities and calls of securities available-for-sale
   
53,322
     
39,320
 
Purchases of securities available-for-sale
    (1,925 )     (3,018 )
Net (increase) in loans
    (52,374 )     (45,337 )
Purchases of premises and equipment
    (6,413 )     (2,688 )
Proceeds from sale of credit card merchant agreements
   
1,650
     
-
 
Net Cash Used in Investing Activities
    (36,596 )     (16,857 )
                 
Financing Activities
               
Net increase (decrease) in noninterest-bearing deposits
   
8,734
      (30,869 )
Net increase in interest-bearing deposits
   
19,737
     
75,016
 
Net increase (decrease) in short-term borrowings
   
1,941
      (12,410 )
Repayment of long-term debt
    (106 )     (2,731 )
Redemption of trust preferred securities
   
-
      (2,705 )
Purchases of treasury stock
    (22,711 )     (20,625 )
Exercise of stock options
   
154
     
425
 
Excess tax benefits from stock-based compensation arrangements
   
3
     
195
 
Dividends paid
    (10,245 )     (9,513 )
Net Cash Used in Financing Activities
    (2,493 )     (3,217 )
(Decrease) Increase in Cash and Cash Equivalents
    (15,778 )    
8,397
 
Cash and cash equivalents at beginning of period
   
110,448
     
86,273
 
Cash and Cash Equivalents at End of Period
  $
94,670
    $
94,670
 
 
See notes to consolidated financial statements.


June 30, 2007
Note A – Basis of Presentation
The accompanying consolidated financial statements, which are unaudited, include all of the accounts of City Holding Company (“the Parent Company”) and its wholly-owned subsidiaries (collectively, “the Company”). All material intercompany transactions have been eliminated. The consolidated financial statements include all adjustments that, in the opinion of management, are necessary for a fair presentation of the results of operations and financial condition for each of the periods presented. Such adjustments are of a normal recurring nature. The results of operations for the six months ended June 30, 2007 are not necessarily indicative of the results of operations that can be expected for the year ending December 31, 2007. The Company’s accounting and reporting policies conform with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Such policies require management to make estimates and develop assumptions that affect the amounts reported in the consolidated financial statements and related footnotes. Actual results could differ from management’s estimates.
The consolidated balance sheet as of December 31, 2006 has been derived from audited financial statements included in the Company’s 2006 Annual Report to Shareholders. Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with U.S. generally accepted accounting principles have been omitted. These financial statements should be read in conjunction with the financial statements and notes thereto included in the 2006 Annual Report of the Company.
Certain amounts in the 2005 financial statements have been reclassified to conform to the 2006 presentation. Such reclassifications had no impact on net income or shareholders’ equity.
 
Note B –Previously Securitized Loans
Between 1997 and 1999, the Company completed six securitization transactions involving approximately $760 million in 125% of fixed rate, junior-lien underlying mortgages.  The Company retained a financial interest in each of the securitizations until 2004.  Principal amounts owed to investors were evidenced by securities (“Notes”).  During 2003 and 2004, the Company exercised its early redemption options on each of those securitizations.  Once the Notes were redeemed, the Company became the beneficial owner of the mortgage loans and recorded the loans as assets of the Company within the loan portfolio.  The table below summarizes information regarding delinquencies, net credit recoveries, and outstanding collateral balances of previously securitized loans for the dates presented:

   
As of and for the Six
Months Ended
   
As of and for the Year Ended
 
   
June 30,
   
December 31,
 
( in thousands)
 
2007
   
2006
   
2006
 
     
Previously Securitized Loans:
                 
Total principal amount of loans outstanding
  $
28,375
    $
39,976
    $
33,334
 
Discount
    (18,054 )     (17,723 )     (17,737 )
Net book value
  $
10,321
    $
22,253
    $
15,597
 
                         
Principal amount of loans between 30 and 89 days past due
  $
754
    $
866
    $
1,062
 
Principal amount of loans 90 days and above past due
   
45
     
277
     
48
 
Net credit recoveries during the period
   
1,916
     
2,552
     
4,124
 
 
The Company accounts for the difference between the carrying value and the total expected cash flows from these loans as an adjustment of the yield earned on the loans over their remaining lives. The discount is accreted to income over the period during which payments are probable of collection and are reasonably estimable. Additionally, the collectibility of previously securitized loans is evaluated over the remaining lives of the loans. An impairment charge on previously securitized loans would be provided through the Company’s provision for loan losses if the discounted present value of estimated future cash flows declines below the recorded value of previously securitized loans.  No such impairment charges were recorded for the three and six months ended June 30, 2007 and 2006, or for the year ending December 31, 2006.
As of June 30, 2007, the Company reported a book value of previously securitized loans of $10.3 million whereas the actual contractual outstanding balance of previously securitized loans at June 30, 2007 was $28.4 million. The difference (“the discount”) between the book value and the expected total cash flows from previously securitized loans is accreted into interest income over the life of the loans.
For the three months ended June 30, 2007 and 2006, the Company recognized $1.9 million and $2.5 million, respectively, of interest income from its previously securitized loans.  During the first six months of 2007 and 2006, the Company recognized $3.6 million and $5.2 million, respectively, of interest income from its previously securitized loans.
 
Note C –Derivative Instruments
The Company utilizes interest rate floors to mitigate exposure to interest rate risk.  As of June 30, 2007, the Company has entered into eight interest rate floor contracts with a total notional amount of $600 million, seven of which (total notional amount of $500 million) are designated as cash flow hedges.  The objective of these interest rate floors is to protect the overall cash flows from the Company’s portfolio of $500 million of variable-rate loans outstanding from the risk of a decrease in those cash flows.
The notional amounts and estimated fair values of interest rate floor derivative positions outstanding at period end are presented in the following table. The estimated fair values of the interest rate floors on variable-rate loans are based on quoted market prices.
 
   
June 30, 2007
   
December 31, 2006
 
(in thousands)
 
Notional Value
   
Estimated Fair Value
   
Notional Value
   
Estimated Fair Value
 
Interest rate floors on variable-rate loans
  $
500,000
    $
2,410
    $
500,000
    $
4,239
 
                                 
The weighted-average strike rates for interest rate floors outstanding at June 30, 2007 range from 6.00% to 8.00%.
 
 
  Interest rate contracts involve the risk of dealing with counterparties and their ability to meet contractual terms. These counterparties must have an investment grade credit rating and be approved by the Company’s Asset and Liability Committee.
For cash flow hedges, the effective portion of the gain or loss on the derivative hedging instrument is reported in other comprehensive income, while the ineffective portion (indicated by the excess of the cumulative change in the fair value of the derivative over that which is necessary to offset the cumulative change in expected future cash flows on the hedge transaction) is recorded in current earnings as other income or other expense.  The Company recognized the decrease in market value of $1.0 million, net of taxes, in Other Comprehensive Income for the six months ending June 30, 2007 on these derivative instruments.
 
During the second quarter of 2006, the Company redesignated an interest rate floor contract with a total notional amount of $100 million that had previously been accounted for as a freestanding derivative.   This interest rate floor has no fair value at June 30, 2007, matures in 11 months and has a strike rate of 6.00%.
 
Note D – Short-term borrowings
The components of short-term borrowings are summarized below:

( in thousands)
 
June 30, 2007
   
December 31, 2006
 
             
Security repurchase agreements
  $
118,685
    $
115,675
 
Short-term FHLB advances
   
45,860
     
20,895
 
Total short-term borrowings
  $
164,545
    $
136,570
 
 
Securities sold under agreement to repurchase were sold to corporate and government customers as an alternative to available deposit products. The underlying securities included in repurchase agreements remain under the Company’s control during the effective period of the agreements.
 
Note E – Long-Term Debt
The components of long-term debt are summarized below:

 
 
 
(dollars in thousands)
 
 
 
Maturity
 
June 30, 2007
   
Weighted Average Interest Rate
 
               
FHLB Advances
2009
  $
3,391
      6.00 %
FHLB Advances
2010
   
1,000
      5.98 %
FHLB Advances
2011
   
670
      4.47 %
Junior subordinated debentures owed to City Holding Capital
Trust
2028 (a)
   
16,836
      9.15 %
Total long-term debt
    $
21,897
         

(a) Junior Subordinated Debentures owed to City Holding Capital Trust are redeemable prior to maturity at the option of the Company (i) on or after April 1, 2008, in whole at any time or in part from time-to-time, at declining redemption prices ranging from 104.58% to 100.00% on April 1, 2018, and thereafter, or (ii) in whole, but not in part, at any time within 90 days following the occurrence and during the continuation of certain pre-defined events.

The Company formed a statutory business trust, City Holding Capital Trust (“the Capital Trust”), under the laws of Delaware.  The Capital Trust was created for the exclusive purpose of (i) issuing trust-preferred capital securities (“Capital Securities”), which represent preferred undivided beneficial interests in the assets of the trust, (ii) using the proceeds from the sale of the Capital Securities to acquire junior subordinated debentures (“Debentures”) issued by the Company, and (iii) engaging in only those activities necessary or incidental thereto.  The trust is considered a variable interest entity for which the Company is not the primary beneficiary.  Accordingly, the accounts of the trusts are not included in the Company’s consolidated financial statements.


The Capital Securities issued by the statutory business trust qualify as Tier 1 capital for the Company under the Federal Reserve Board guidelines.  In March 2005, the Federal Reserve Board issued a final rule that allows the inclusion of trust preferred securities issued by unconsolidated subsidiary trusts in Tier 1 capital, but with stricter limits.  Under ruling, after a five-year transition period, the aggregate amount of trust preferred securities and certain other capital elements would be limited to 25% of Tier 1 capital elements, net of goodwill.  The amount of trust preferred securities and certain other elements in excess of the limit could be included in Tier 2 capital, subject to restrictions.  The Company expects to continue to include all of its $16 million in trust preferred securities in Tier 1 capital.  The trust preferred securities could be redeemed without penalty if they were no longer permitted to be included in Tier 1 capital.
 
Note F – Employee Benefit Plans
The Company accounts for share-based compensation in accordance with SFAS No. 123R, “Share-Based Payment.”  A summary of the Company’s stock option activity and related information is presented below for the six months ended June 30:
   
2007
   
2006
 
   
Options
   
Weighted-Average Exercise Price
   
Options
   
Weighted-Average Exercise Price
 
                         
Outstanding at January 1
   
271,709
    $
30.51
     
318,132
    $
28.56
 
Granted
   
47,500
     
39.34
     
-
     
-
 
Exercised
    (7,300 )    
21.17
      (32,007 )    
13.30
 
Forfeited
    (3,000 )    
34.45
     
-
     
-
 
Outstanding at June 30
   
308,909
    $
32.05
     
286,125
    $
30.27
 

Additional information regarding stock options outstanding and exercisable at June 30, 2007, is provided in the following table:
 
Ranges of Exercise Prices
   
No. of Options Outstanding
   
Weighted-Average Exercise Price
   
Weighted-Average Remaining Contractual Life (Months)
   
Aggregate Intrinsic Value (in thousands)
   
No. of Options Currently Exercisable
   
Weighted-Average Exercise Price of Options Currently Exercisable
   
Weighted-Average Remaining Contractual Life (Months)
   
Aggregate Intrinsic Value of Options Currently Exercisable (in thousands)
 
                                                   
$
13.30
     
16,800
    $
13.30
     
55
    $
421
     
16,800
    $
13.30
     
55
    $
421
 
$
28.00 - $39.34
     
292,109
     
33.12
     
90
     
1,569
     
191,984
     
31.94
     
83
     
1,226
 
         
308,909
                    $
1,990
     
208,784
                    $
1,647
 
 



 
Proceeds from stock option exercises totaled $0.2 million and $0.4 million during the six months ended June 30, 2007 and June 30, 2006, respectively. Shares issued in connection with stock option exercises are issued from available treasury shares. If no treasury shares are available, new shares are issued from available authorized shares. During the six months ended June 30, 2007 and June 30, 2006 all shares issued in connection with stock option exercises and restricted stock awards were issued from available treasury stock.
The total intrinsic value of stock options exercised was $0.1 million and $0.8 million during the six months ended June 30, 2007 and June 30, 2006, respectively.
Stock-based compensation expense totaled $0.1 million for both the six months ended June 30, 2007 and June 30, 2006.  Unrecognized stock-based compensation expense related to stock options totaled $0.8 million at June 30, 2007. At such date, the weighted-average period over which this unrecognized expense was expected to be recognized was 2.0 years.
The fair value of the options is estimated at the date of grant using a Black-Scholes option-pricing model.   The following weighted average assumptions were used to estimate the fair value of options granted during the six months ended June 30, 2007:
 
Risk-free interest rate
    4.38 %
Expected dividend yield
    3.15 %
Volatility factor
    39.06 %
Expected life of option
 
5.8 years
 
 
No options were granted during the six months ended June 30, 2006.
The Company records compensation expense with respect to restricted shares in an amount equal to the fair market value of the common stock covered by each award on the date of grant. The restricted shares awarded become fully vested after various periods of continued employment from the respective dates of grant. The Company is entitled to an income tax deduction in an amount equal to the taxable income reported by the holders of the restricted shares when the restrictions are released and the shares are issued. Compensation is being charged to expense over the respective vesting periods.
Restricted shares are forfeited if officers and employees terminate prior to the lapsing of restrictions. The Company records forfeitures of restricted stock as treasury share repurchases and any compensation cost previously recognized is reversed in the period of forfeiture.  Recipients of restricted shares do not pay any cash consideration to the Company for the shares, have the right to vote all shares subject to such grant and receive all dividends with respect to such shares, whether or not the shares have vested.  Unrecognized stock-based compensation expense related to non-vested restricted shares was $0.8 million at June 30, 2007. At June 30, 2007, this unrecognized expense is expected to be recognized over 4.1 years based on the weighted average-life of the restricted shares.


 
A summary of the Company’s restricted shares activity and related information is presented below for the six months ended June 30:
 
   
2007
   
2006
 
   
Options
   
Average Market Price at Grant
   
Options
   
Average Market Price at Grant
 
                         
Outstanding at January 1
   
15,600
           
14,000
       
Granted
   
16,150
    $
39.53
     
1,700
    $
36.17
 
Forfeited/Vested
    (1,266 )            
-
         
Outstanding at June 30
   
30,484
             
15,700
         
 
The Company provides retirement benefits to its employees through the City Holding Company 401(k) Plan and Trust (“the 401(k) Plan”), which is intended to be compliant with Employee Retirement Income Security Act (ERISA) section 404(c). Any employee who has attained age 21 is eligible to participate beginning the first day of the month following employment. Unless specifically chosen otherwise, every employee is automatically enrolled in the 401(k) Plan and may make before-tax contributions of between 1% and 15% of eligible pay up to the dollar limit imposed by Internal Revenue Service regulations. The first 6% of an employee’s contribution is matched 50% by the Company. The employer matching contribution is invested according to the investment elections chosen by the employee. Employees are 100% vested in both employee and employer contributions and the earnings they generate. The Company’s total expense associated with the retirement benefit plan approximated $0.3 million for the six month periods ended June 30, 2007 and June 30, 2006.
The Company also maintains a defined benefit pension plan (“the Defined Benefit Plan”) that covers approximately 300 current and former employees. The Defined Benefit Plan was frozen in 1999 subsequent to the Company’s acquisition of the plan sponsor. The Defined Benefit Plan maintains an October 31 year-end for purposes of computing its benefit obligations. The Company made a contribution of $0.4 million and $0.1 million to the Defined Benefit Plan during the six months ended June 30, 2007 and June 30, 2006, respectively.
The following table presents the components of the net periodic pension cost of the Defined Benefit Plan:

         
Three months ended
June 30,
   
Six months ended
June 30,
 
(in thousands)
 
2007
   
2006
   
2007
   
2006
 
                         
Components of net periodic cost:
                       
Interest cost
  $
164
    $
213
    $
328
    $
341
 
Expected return on plan assets
    (185 )     (238 )     (370 )     (382 )
Net amortization and deferral
   
80
     
102
     
160
     
164
 
Net Periodic Pension Cost
  $
59
    $
77
    $
118
    $
123
 



 
Note G – Commitments and Contingencies
The Company is a party to certain financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers.  The Company has entered into agreements with its customers to extend credit or provide a conditional commitment to provide payment on drafts presented in accordance with the terms of the underlying credit documents. The Company also provides overdraft protection to certain demand deposit customers that represent an unfunded commitment.  Overdraft protection commitments, which are included with other commitments below, are uncollateralized and are paid at the Company’s discretion.  Conditional commitments generally include standby and commercial letters of credit. Standby letters of credit represent an obligation of the Company to a designated third party contingent upon the failure of a customer of the Company to perform under the terms of the underlying contract between the customer and the third party. Commercial letters of credit are issued specifically to facilitate trade or commerce. Under the terms of a commercial letter of credit, drafts will be drawn when the underlying transaction is consummated, as intended, between the customer and a third party. The funded portion of these financial instruments is reflected in the Company’s balance sheet, while the unfunded portion of these commitments is not reflected in the balance sheet.  The table below presents a summary of the contractual obligations of the Company resulting from significant commitments:

( in thousands)
 
June 30, 2007
   
December 31, 2006
 
             
Commitments to extend credit:
           
Home equity lines
  $
134,795
    $
140,479
 
Commercial real estate
   
39,587
     
48,489
 
Other commitments
   
143,863
     
131,428
 
Standby letters of credit
   
12,578
     
12,735
 
Commercial letters of credit
   
385
     
617
 

Loan commitments and standby and commercial letters of credit have credit risks essentially the same as that involved in extending loans to customers and are subject to the Company’s standard credit policies. Collateral is obtained based on management’s credit assessment of the customer. Management does not anticipate any material losses as a result of these commitments.
 
Note H – Total Comprehensive Income
The following table sets forth the computation of total comprehensive income:
 
   
Six months ended June 30,
 
(in thousands)
 
2007
   
2006
 
       
Net income
  $
25,553
    $
26,627
 
                 
Unrealized security (losses) arising during the period
    (3,530 )     (6,518 )
Reclassification adjustment for gains included in income
   
-
     
-
 
      (3,530 )     (6,518 )
                 
Unrealized (losses) on interest rate floors
    (1,667 )     (1,687 )
Other comprehensive income before income taxes
    (5,197 )     (8,205 )
Tax effect
   
2,079
     
3,282
 
Total comprehensive income
  $
22,435
    $
21,704
 



 
Note I – Earnings per Share
The following table sets forth the computation of basic and diluted earnings per share:
 
   
   Three months ended June 30, 
 
Six months ended June 30,
 
(in thousands, except per share data)
 
2007
   
2006
   
2007
   
2006
 
                   
Net income
  $
12,322
    $
13,761
    $
25,553
    $
26,627
 
                                 
Average shares outstanding
   
17,100
     
17,719
     
17,230
     
17,860
 
                                 
Effect of dilutive securities:
                               
Employee stock options
   
58
     
53
     
62
     
57
 
                                 
Shares for diluted earnings per share
   
17,158
     
17,772
     
17,292
     
17,917
 
                                 
Basic earnings per share
  $
0.72
    $
0.78
    $
1.48
    $
1.49
 
Diluted earnings per share
  $
0.72
    $
0.77
    $
1.48
    $
1.49
 
 
Options to purchase 47,500 shares of common stock at an exercise price of $39.34 and 43,750 shares of common stock at exercise prices between $36.25 and $36.90 per share were outstanding during the second quarter of 2007 and 2006, respectively, but were not included in the computation of diluted earnings per share because the options’ exercise price was greater than the average market price of the common shares and therefore, the effect would have been anti-dilutive.
 
Note J – Recent Accounting Pronouncements
Effective January 1, 2007, the Company adopted Financial Accounting Standards Board (“FASB”) Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement 109” (“FIN 48”). FIN 48 clarifies the accounting and disclosure for uncertain tax positions by requiring that a tax position meet a "probable recognition threshold" for the benefit of the uncertain tax position to be recognized in the financial statements. A tax position that fails to meet the probable recognition threshold will result in either reduction of a current or deferred tax asset or receivable, or recording a current or deferred tax liability. FIN 48 also provides guidance on measurement, derecognition of tax benefits, classification, interim period accounting disclosure, and transition requirements in accounting for uncertain tax positions.  The cumulative effect of adopting FIN 48 was an increase in tax reserves and a decrease of $0.1 million to the January 1, 2007 retained earnings balance.  Upon adoption, the liability for income taxes associated with uncertain tax positions at January 1, 2007 was $1.6 million.  This amount, if recognized, would favorably affect the Company’s effective tax rate.   The Company does not expect that the amounts of unrecognized tax positions will change significantly within the next 12 months.
Interest and penalties related to income tax liabilities are included in income tax expense. The balance of accrued interest and penalties recorded in the Consolidated Balance Sheet at January 1, 2007 was $0.5 million.
The Company is currently open to audit under the statute of limitations by the Internal Revenue Service for the years ended December 31, 2003 through 2006. The Company and its subsidiaries state income tax returns are open to audit under the statute of limitations for the years ended December 31, 2003 through 2006.


In September 2006, the FASB issued Statement No. 157, “Fair Value Measurements” (SFAS No. 157).  SFAS No. 157 replaces various definitions of fair value in existing accounting literature with a single definition, establishes a framework for measuring fair value in generally accepted accounting principles, and requires additional disclosures about fair value measurements.  SFAS No. 157 does not expand the use of fair value to any new circumstances.  SFAS No. 157 is effective for fiscal years ending after November 15, 2007, and early application is encouraged.  The Company is currently evaluating SFAS No. 157 and has not determined the impact it will have on our financial statements.
In February 2007, the FASB issued Statement of Financial Accounting Standard No. 159 (“SFAS 159”), “The Fair Value Option for Financial Assets and Financial Liabilities-Including an amendment of FASB Statement No. 115.”  SFAS 159 permits entities to choose to measure many financial instruments and certain other items at fair value at specified election dates. Unrealized gains and losses on items for which the fair value option has been elected are reported in earnings at each subsequent reporting date. The fair value option (i) is applicable on an instrument by instrument basis, with certain exceptions, (ii) is irrevocable (unless a new election date occurs), and (iii) is applied only to entire instruments and not to portions of instruments. SFAS 159 is effective for the Company on January 1, 2008.    The Company is currently evaluating SFAS No. 159 and has not determined the impact it will have on our financial statements.



 
Critical Accounting Policies
 
The accounting policies of the Company conform with U.S. generally accepted accounting principles and require management to make estimates and develop assumptions that affect the amounts reported in the financial statements and related footnotes. These estimates and assumptions are based on information available to management as of the date of the financial statements. Actual results could differ significantly from management’s estimates. As this information changes, management’s estimates and assumptions used to prepare the Company’s financial statements and related disclosures may also change. The most significant accounting policies followed by the Company are presented in Note One to the audited financial statements included in the Company’s 2006 Annual Report to Shareholders. The information included in this Quarterly Report on Form 10-Q, including the Consolidated Financial Statements, Notes to Consolidated Financial Statements, and Management’s Discussion and Analysis of Financial Condition and Results of Operations, should be read in conjunction with the financial statements and notes thereto included in the 2006 Annual Report of the Company.  Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, assumptions, and estimates underlying those amounts, management has identified the determination of the allowance for loan losses, income taxes, and previously securitized loans to be the accounting areas that require the most subjective or complex judgments and, as such, could be most subject to revision as new information becomes available.
Pages 24 - 28 of this Quarterly Report on Form 10-Q provide management’s analysis of the Company’s allowance for loan losses and related provision. The allowance for loan losses is maintained at a level that represents management’s best estimate of probable losses in the loan portfolio. Management’s determination of the adequacy of the allowance for loan losses is based upon an evaluation of individual credits in the loan portfolio, historical loan loss experience, current economic conditions, and other relevant factors. This determination is inherently subjective as it requires material estimates including the amounts and timing of future cash flows expected to be received on impaired loans that may be susceptible to significant change. The allowance for loan losses related to loans considered to be impaired is generally evaluated based on the discounted cash flows using the impaired loan’s initial effective interest rate or the fair value of the collateral for certain collateral dependent loans.
The Company is subject to federal and state income taxes in the jurisdictions in which it conducts business.  In computing the provision for income taxes, management must make judgments regarding interpretation of laws in those jurisdictions.  Because the application of tax laws and regulations for many types of transactions is susceptible to varying interpretations, amounts reported in the financial statements could be changed at a later date upon final determinations by taxing authorities.  On a quarterly basis, the Company estimates its annual effective tax rate for the year and uses that rate to provide for income taxes on a year-to-date basis.
Note B, beginning on page 8 of this Quarterly Report on Form 10-Q, and pages 28 and 29 provide management’s analysis of the Company’s previously securitized loans.  The carrying value of previously securitized loans is determined using assumptions with regard to loan prepayment and default rates. Using cash flow modeling techniques that incorporate these assumptions, the Company estimated total future cash collections expected to be received from these loans and determined the yield at which the resulting discount would be accreted into income.  If, upon periodic evaluation, the estimate of the total probable collections is increased or decreased but is still greater than the sum of the original carrying amount less subsequent collections plus the discount accreted to date, and it is probable that collection will occur, the amount of the discount to be accreted is adjusted accordingly and the amount of periodic accretion is adjusted over the remaining lives of the loans. If, upon periodic evaluation, the discounted present value of estimated future cash flows declines below the recorded value of previously securitized loans, an impairment charge would be provided through the Company’s provision for loan losses.  Please refer to Note B of Notes to Consolidated Financial Statements, on pages 8 - 9 for further discussion.
Financial Summary
Six Months Ended June 30, 2007 vs. 2006
The Company reported consolidated net income of $25.5 million, or $1.48 per diluted common share, for the six months ended June 30, 2007, compared to $26.6 million, or $1.49 per diluted common share for the first six months of 2006. Return on average assets (“ROA”) was 2.02% and return on average equity (“ROE”) was 16.6% for the first six months of 2007, compared to 2.12% and 18.1%, respectively, for the first six months of 2006.
The Company’s net interest income for the first six months of 2007 decreased $3.0 million compared to the first six months of 2006 (see Net Interest Income). The Company recorded a provision for loan losses of $2.5 million for the first six months of 2007 while $1.7 million was recorded for the first six months of 2006 (see Allowance and Provision for Loan Losses).  As further discussed under the caption Non-Interest Income and Expense, non-interest income increased $2.2 million from the six months ended June 30, 2006, to the six months ended June 30, 2007.  During the first six months of 2007, the Company recognized a gain of $1.5 million from the sale of its existing merchant processing agreements.
Three Months Ended June 30, 2007 vs. 2006
The Company reported consolidated net income of $12.3 million, or $0.72 per diluted common share, for the three months ended June 30, 2007, compared to $13.8 million, or $0.77 per diluted common share, for the second quarter of 2006.  Return on average assets (“ROA”) was 1.94% and return on average equity (“ROE”) was 16.1% for the second quarter of 2007, compared to 2.17% and 18.8% respectively, for the second quarter of 2006.
The Company’s net interest income for the second quarter of 2007 decreased $1.6 million compared to the second quarter of 2006 (see Net Interest Income).  The Company recorded a provision for loan losses of $1.6 million for the second quarter of 2007 while $0.7 was recorded for the second quarter or 2006 (see Allowance and Provision for Loan Losses).  As further discussed under the caption Non-Interest Income and Expense, non-interest income increased $0.2 million from the quarter ended June 30, 2006, to the quarter ended June 30, 2007.  This increase was primarily due to an increase of $0.5 million, or 4.8%, in service charge revenues.  Non-interest expenses remained flat at $17.5 million.
Net Interest Income
Six Months Ended June 30, 2007 vs. 2006
The Company’s tax equivalent net interest income decreased $3.0 million, or 5.8%,  from the first six months of 2006 to the first six months of 2007 as increased yields on interest earning assets were more than offset by increases in the rates paid on interest-bearing liabilities.  Compared to the first six months of 2006, interest income increased $2.2 million while interest expenses paid on interest bearing liabilities increased $5.3 million due to rate increases.
Interest income on earning assets increased by $2.2 million, driven primarily by an increase in interest income on loans of $3.4 million despite a decrease of $1.6 million in interest income from previously securitized loans from the first six months of 2006.  The decrease in interest income from previously securitized loans was related to the continued decline in the average balance of these loans of 50.9% from $26.0 million for the six months ended June 30, 2006, to $12.8 million for the six months ended June 30, 2007.  However, this reduction in average outstanding balances was partially mitigated as the yield on these loans rose from an average of 40.4% for the first six months of 2006 to 57.0% for the first six months of 2007 (see Previously Securitized Loans section for further discussion).  In addition, interest income from loans was impacted by the sale of the Company’s credit card portfolio during the third quarter of 2006, which resulted in a decrease of $1.0 million in interest income from the first six months of 2006.  Interest income on all other loans (commercial, loans to depository institutions, residential, home equity, and consumer) increased by $5.9 million as the average yield on these loans increased by 28 basis points and the average balance on outstanding loans increased by $104.7 million (excluding previously securitized loans and credit card loans).
These increases were more than offset by an increase in interest expense on interest bearing liabilities of $5.3 million due primarily to a 60 basis point increase in the rates paid on interest bearing deposits from the first six months of 2006.  In addition, increases in average outstanding deposit balances of $86.8 million, or 5.4%, increased interest expense by $1.4 million.  The increase in rates and balances was primarily associated with time deposits that experienced an increase of 78 basis points while outstanding time deposit balances grew $74.2 million as compared to the first six months of 2006.
The net interest margin was 4.36% for the six months ended June 30, 2007 as compared to 4.64% for the six months ended June 30, 2006.  The decline in the net interest margin can primarily be attributed to lower interest income from previously securitized loans and the sale of the retail credit card portfolio during the third quarter of 2006.  Excluding these items, the Company’s net interest margin decreased 16 basis points from 4.27% during the first six months of 2006 to 4.11% for the first six months of 2007.  This compression is due to increased rates paid on interest bearing liabilities, primarily time deposits.
Three Months Ended June 30, 2007 vs. 2006
The Company’s tax equivalent net interest income decreased $1.6 million, or 6.1%,  from the second quarter of 2006 to the second quarter of 2007 as increased yields on interest earning assets were more than offset by increases in the rates paid on interest-bearing liabilities.  Compared to the second quarter of 2006, interest income increased $0.5 million while interest expenses paid on interest bearing liabilities increased $2.1 million due to rate increases.
Interest income on earning assets increased by $0.5 million, driven primarily by an increase in interest income on loans of $1.5 million, despite a decrease of $0.7 million in interest income from previously securitized loans from the second quarter of 2006.  The decrease in interest income from previously securitized loans was related to the continued decline in the average balance of these loans of 53.4% from $24.0 million for the quarter ended June 30, 2006, to $11.2 million for the quarter ended June 30, 2007.  However, this reduction in average outstanding balances was partially mitigated as the yield on these loans rose from an average of 41.9% for the second quarter of 2006 to 66.4% for the second quarter of 2007 (see Previously Securitized Loans section for further discussion). The yield for the first quarter of 2007 was 49.5%.  In addition, interest income from loans was impacted by the sale of the Company’s credit card portfolio during the third quarter of 2006, which resulted in a decrease of $0.5 million in interest income from the second quarter of 2006.  Interest income on all other loans (commercial, loans to depository institutions, residential, home equity, and consumer) increased by $2.6 million as the average yield on these loans increased by 18 basis points and the average balance on outstanding loans increased by $106.5 million (excluding previously securitized loans and credit card loans).
These increases were partially offset by an increase in interest expense on interest bearing liabilities of $2.5 million due primarily to a 44 basis point increase in the rates paid on interest bearing deposits from the second quarter of 2006.  In addition, increases in average outstanding deposit balances of $73 million, or 4.5%, increased interest expense by $0.6 million.  The increase in rates and balances was primarily associated with time deposits that experienced an increase of 66 basis points while outstanding time deposit balances grew $57 million as compared to the second quarter of 2006.
The net interest margin was 4.32% for the quarter ended June 30, 2007 as compared to 4.58% for the quarter ended June 30, 2006.  The decline in the net interest margin can partially be attributed to lower interest income from previously securitized loans and the sale of the retail credit card portfolio during the third quarter of 2006.  Excluding these items, the Company’s net interest margin decreased 18 basis points from 4.23% during the second quarter of 2006 to 4.05% for the second quarter of 2007.  This compression is due to an increase in the rates paid on total interest bearing liabilities, and reflects an increase in the cost of time deposits.


Table One
Average Balance Sheets and Net Interest Income
(in thousands)

   
Six months ended June 30,
 
   
2007
   
2006
 
   
Average
         
Yield/
   
Average
         
Yield/
 
   
Balance
   
Interest
   
Rate
   
Balance
   
Interest
   
Rate
 
Assets
                                   
Loan portfolio (1):
                                   
Residential real estate
  $
595,381
    $
17,872
      6.05 %   $
594,954
    $
16,864
      5.72 %
Home equity
   
324,820
     
12,544
     
7.79
     
305,787
     
11,556
     
7.62
 
Commercial financial and agriculture
   
668,888
     
25,343
     
7.64
     
643,420
     
23,385
     
7.33
 
Loans to depository institutions
   
54,586
     
1,452
     
5.36
     
-
     
-
     
-
 
Installment loans to individuals
   
44,564
     
2,588
     
11.71
     
52,691
     
2,993
     
11.45
 
Previously securitized loans
   
12,784
     
3,612
     
56.98
     
26,037
     
5,217
     
40.41
 
Total loans
   
1,701,023
     
63,411
     
7.52
     
1,622,889
     
60,015
     
7.46
 
Securities:
                                               
Taxable
   
502,707
     
13,686
     
5.49
     
576,640
     
14,748
     
5.16
 
Tax-exempt (2)
   
40,286
     
1,315
     
6.58
     
43,843
     
1,418
     
6.52
 
Total securities
   
542,993
     
15,001
     
5.57
     
620,483
     
16,166
     
5.25
 
Loans held for sale
   
-
     
-
     
-
     
3,218
     
200
     
12.53
 
Deposits in depository institutions
   
11,623
     
230
     
3.99
     
24,490
     
566
     
4.66
 
Federal funds sold
   
20,812
     
547
     
5.30
     
-
     
-
     
-
 
Total interest-earning assets
   
2,276,451
     
79,189
     
7.01
     
2,271,080
     
76,947
     
6.83
 
Cash and due from banks
   
50,424
                     
51,726
                 
Bank premises and equipment
   
46,142
                     
42,575
                 
Other assets
   
169,455
                     
169,162
                 
Less: allowance for loan losses
    (15,887 )                     (16,881 )                
Total assets
  $
2,526,585
                    $
2,517,662
                 
                                                 
Liabilities
                                               
Interest-bearing demand deposits
  $
429,483
    $
2,641
      1.24 %   $
441,474
    $
2,588
      1.18 %
Savings deposits
   
337,153
     
2,736
     
1.64
     
312,542
     
1,658
     
1.07
 
Time deposits
   
922,460
     
20,412
     
4.46
     
848,306
     
15,474
     
3.68
 
Short-term borrowings
   
154,328
     
3,207
     
4.19
     
156,431
     
2,452
     
3.16
 
Long-term debt
   
27,145
     
957
     
7.11
     
93,773
     
2,499
     
5.37
 
Total interest-bearing liabilities
   
1,870,569
     
29,953
     
3.23
     
1,852,526
     
24,671
     
2.69
 
Noninterest-bearing demand deposits
   
317,382
                     
342,298
                 
Other liabilities
   
30,678
                     
28,544
                 
Stockholders’ equity
   
307,956
                     
294,294
                 
Total liabilities and stockholders’ equity
  $
2,526,585
                    $
2,517,662
                 
Net interest income
          $
49,236
                    $
52,276
         
Net yield on earning assets
                    4.36 %                     4.64 %

(1)  
For purposes of this table, non-accruing loans have been included in average balances and loan fees, which are immaterial, have been included in interest income.
(2)  
Computed on a fully federal tax-equivalent basis assuming a tax rate of approximately 35%.



Table Two
Rate Volume Analysis of Changes in Interest Income and Interest Expense
(in thousands)
   
Six months ended June 30,
 
   
2007 vs. 2006
 
   
Increase (Decrease)
 
   
Due to Change In:
 
   
Volume
   
Rate
   
Net
 
Interest-earning assets:
                 
Loan portfolio
                 
Residential real estate
  $
12
    $
995
    $
1,007
 
Home equity
   
719
     
269
     
988
 
Commercial, financial, and agriculture
   
926
     
1,032
     
1,958
 
Loans to depository institutions
   
1,452
     
-
     
1,452
 
Installment loans to individuals
    (462 )    
57
      (405 )
Previously securitized loans
    (2,655 )    
1,050
      (1,605 )
Total loans
    (8 )    
3,403
     
3,395
 
Securities:
                       
Taxable
    (1,891 )    
829
      (1,062 )
Tax-exempt (1)
    (115 )    
12
      (103 )
Total securities
    (2,006 )    
841
      (1,165 )
Loans held for sale
    (200 )    
-
      (200 )
Deposits in depository institutions
    (297 )     (39 )     (336 )
Federal funds sold
   
-
     
547
     
547
 
Total interest-earning assets
  $ (2,511 )   $
4,752
    $
2,241
 
                         
Interest-bearing liabilities:
                       
Demand deposits
  $ (70 )   $
123
    $
53
 
Savings deposits
   
131
     
947
     
1,078
 
Time deposits
   
1,353
     
3,585
     
4,938
 
Short-term borrowings
    (33 )    
787
     
754
 
Long-term debt
    (1,776 )    
234
      (1,542 )
Total interest-bearing liabilities
  $ (395 )   $
5,676
    $
5,281
 
Net Interest Income
  $ (2,116 )   $ (924 )   $ (3,040 )

(1) Fully federal taxable equivalent using a tax rate of 35%.


Table Three
Average Balance Sheets and Net Interest Income
(in thousands)

   
Three months ended June 30,
 
   
2007
   
2006
 
   
Average
         
Yield/
   
Average
         
Yield/
 
   
Balance
   
Interest
   
Rate
   
Balance
   
Interest
   
Rate
 
Assets
                                   
Loan portfolio (3):
                                   
Residential real estate
  $
596,246
    $
9,017
      6.07 %   $
596,758
    $
8,484
      5.70 %
Home equity
   
326,970
     
6,302
     
7.73
     
309,270
     
5,962
     
7.73
 
Commercial financial and agriculture
   
670,687
     
12,655
     
7.57
     
651,501
     
12,092
     
7.44
 
Loans to depository institutions
   
59,670
     
798
     
5.36
     
-
     
-
     
-
 
Installment loans to individuals
   
46,206
     
1,319
     
11.45
     
48,880
     
1,400
     
11.49
 
Previously securitized loans
   
11,210
     
1,856
     
66.41
     
24,045
     
2,513
     
41.92
 
Total loans
   
1,710,989
     
31,947
     
7.49
     
1,630,454
     
30,451
     
7.49
 
Securities:
                                               
Taxable
   
499,861
     
6,752
     
5.42
     
579,058
     
7,489
     
5.19
 
Tax-exempt (4)
   
40,160
     
658
     
6.57
     
43,388
     
700
     
6.47
 
Total securities
   
540,021
     
7,410
     
5.50
     
622,446
     
8,189
     
5.28
 
Loans held for sale
   
-
     
-
     
-
     
6,400
     
200
     
12.53
 
Deposits in depository institutions
   
10,227
     
113
     
4.43
     
33,986
     
416
     
4.91
 
Federal funds sold
   
22,077
     
291
     
5.29
     
-
     
-
     
-
 
Total interest-earning assets
   
2,283,314
     
39,761
     
6.98
     
2,293,286
     
39,256
     
6.87
 
Cash and due from banks
   
50,715
                     
50,217
                 
Bank premises and equipment
   
47,304
                     
42,621
                 
Other assets
   
169,860
                     
170,273
                 
Less: allowance for loan losses
    (16,135 )                     (16,911 )                
Total assets
  $
2,535,058
                    $
2,539,486
                 
                                                 
Liabilities
                                               
Interest-bearing demand deposits
  $
428,772
    $
1,310
      1.23 %   $
438,851
    $
1,329
      1.21 %
Savings deposits
   
344,204
     
1,429
     
1.67
     
318,702
     
926
     
1.17
 
Time deposits
   
922,978
     
10,338
     
4.49
     
865,554
     
8,265
     
3.83
 
Short-term borrowings
   
162,115
     
1,694
     
4.19
     
161,082
     
1,326
     
3.30
 
Long-term debt
   
21,915
     
425
     
7.78
     
92,267
     
1,239
     
5.39
 
Total interest-bearing liabilities
   
1,879,984
     
15,196
     
3.24
     
1,876,456
     
13,085
     
2.80
 
Noninterest-bearing demand deposits
   
318,041
                     
342,115
                 
Other liabilities
   
30,109
                     
28,526
                 
Stockholders’ equity
   
306,924
                     
292,389
                 
Total liabilities and stockholders’ equity
  $
2,535,058
                    $
2,539,486
                 
Net interest income
          $
24,565
                    $
26,171
         
Net yield on earning assets
                    4.32 %                     4.58 %

(3)  
For purposes of this table, non-accruing loans have been included in average balances and loan fees, which are immaterial, have been included in interest income.
(4)  
Computed on a fully federal tax-equivalent basis assuming a tax rate of approximately 35%.


Table Four
Rate Volume Analysis of Changes in Interest Income and Interest Expense
(in thousands)
   
Three months ended June 30,
 
   
2007 vs. 2006
 
   
Increase (Decrease)
 
   
Due to Change In:
 
   
Volume
   
Rate
   
Net
 
Interest-earning assets:
                 
Loan portfolio
                 
Residential real estate
  $ (7 )   $
540
    $
533
 
Home equity
   
341
      (1 )    
340
 
Commercial, financial, and agriculture
   
356
     
206
     
562
 
Loans to depository institutions
   
798
     
-
     
798
 
Installment loans to individuals
    (77 )     (4 )     (81 )
Previously securitized loans
    (1,341 )    
684
      (657 )
Total loans
   
70
     
1,425
     
1,495
 
Securities:
                       
Taxable
    (1,024 )    
287
      (737 )
Tax-exempt (1)
    (52 )    
10
      (42 )
Total securities
    (1,076 )    
297
      (779 )
Loans held for sale
    (200 )    
-
      (200 )
Deposits in depository institutions
    (291 )     (11 )     (302 )
Federal funds sold
   
-
     
291
     
291
 
Total interest-earning assets
  $ (1,497 )   $
2,002
    $
505
 
                         
Interest-bearing liabilities:
                       
Demand deposits
  $ (31 )   $
12
    $ (19 )
Savings deposits
   
74
     
429
     
503
 
Time deposits
   
548
     
1,525
     
2,073
 
Short-term borrowings
   
9
     
358
     
367
 
Long-term debt
    (945 )    
131
      (814 )
Total interest-bearing liabilities
  $ (345 )   $
2,455
    $
2,110
 
Net Interest Income
  $ (1,152 )   $ (453 )   $ (1,605 )

(1) Fully federal taxable equivalent using a tax rate of 35%.
 
Allowance and Provision for Loan Losses
 
Management systematically monitors the loan portfolio and the adequacy of the allowance for loan losses (“ALLL”) on a quarterly basis to provide for probable losses inherent in the portfolio. Management assesses the risk in each loan type based on historical trends, the general economic environment of its local markets, individual loan performance, and other relevant factors. Individual credits are selected throughout the year for detailed loan reviews, which are utilized by management to assess the risk in the portfolio and the adequacy of the allowance. Due to the nature of commercial lending, evaluation of the adequacy of the allowance as it relates to these loan types is often based more upon specific credit review, with consideration given to the potential impairment of certain credits and historical loss percentages, adjusted for general economic conditions and other inherent risk factors. Conversely, due to the homogeneous nature of the real estate and installment portfolios, the portions of the allowance allocated to those portfolios are primarily based on prior loss history of each portfolio, adjusted for general economic conditions and other inherent risk factors.


In evaluating the adequacy of the allowance for loan losses, management considers both quantitative and qualitative factors. Quantitative factors include actual repayment characteristics and loan performance, cash flow analyses, and estimated fair values of underlying collateral. Qualitative factors generally include overall trends within the portfolio, composition of the portfolio, changes in pricing or underwriting, seasoning of the portfolio, and general economic conditions.
The allowance not specifically allocated to individual credits is generally determined by analyzing potential exposure and other qualitative factors that could negatively impact the adequacy of the allowance.  Loans not individually evaluated for impairment are grouped by pools with similar risk characteristics and the related historical loss percentages are adjusted to reflect current inherent risk factors, such as unemployment, overall economic conditions, concentrations of credit, loan growth, classified and impaired loan trends, staffing, adherence to lending policies, and loss trends.
Determination of the allowance for loan losses is subjective in nature and requires management to periodically reassess the validity of its assumptions. Differences between actual losses and estimated losses are assessed such that management can timely modify its evaluation model to ensure that adequate provision has been made for risk in the total loan portfolio.
As a result of the Company’s quarterly analysis of the adequacy of the ALLL, the Company recorded a provision for loan losses of $2.5 million in the first six months of 2007 and $1.7 million in the first six months of 2006.  The Company’s 2007 provision reflects the difficulties encountered by one of the Company’s borrowers (which has been engaged in residential construction of several properties) and the downgrade of five related credits.  While the downgrade of this credit relationship unfavorably impacted the provision and resulted in an increase in nonaccrual loans of $5.0 million, total past due loans have declined 15.3% from $9.9 million at December 31, 2006 to $8.3 million at June 30, 2007.  Changes in the amount of the provision and related allowance are based on the Company’s detailed methodology and are directionally consistent with changes in credit quality and growth and changes in the composition and quality of the Company’s loan portfolio.
The Company had net charge-offs of $1.3 million for the first six months of 2007, with depository accounts representing $0.9 million (or approximately 68.0%) of this total. While charge-offs on depository accounts are appropriately taken against the ALLL, the revenue associated with depository accounts is reflected in service charges and has been steadily growing as the core base of checking accounts has grown.  Net charge-offs on residential loans were $0.5 million, while commercial and installment loans experienced no net charge-offs for the six months ended June 30, 2007.  The Company has experienced annualized net charge-offs related to loans (excluding overdrafts) of 0.05% for 2007 year to date compared with 0.11% for 2006 and 0.22% for 2005.  The trend in net charge-offs is attributable to declines in balances of loans originated prior to 2002 (including loans acquired as part of the Classic Bancshares acquisition).  At June 30, 2007, balances of loans written subsequent to 2002 comprise approximately 75% of total loan balances.
The Company’s ratio of non-performing assets to total loans and other real estate owned increased from 0.44% at March 31, 2007 to 0.71% at June 30, 2007 as a result of the downgrade of the credit relationship discussed earlier.  Our ratio of non-performing assets to total loans continues to compare favorably to that of our peer group (bank holding companies with total assets between $1 and $5 billion), which reported average non-performing assets as a percentage of loans and other real estate owned of 0.80% for the most recently reported quarter ended March 31, 2007.  The composition of the Company’s loan portfolio, which is weighted more heavily toward residential mortgage loans and less towards non-real estate secured commercial loans than that of our peers, has allowed us to maintain a lower allowance in comparison to peers.  In addition, the sale of the Company’s credit card portfolio resulted in a reduction of the allowance of $1.4 million during 2006.  As a result, the Company’s ALLL as a percentage of loans outstanding is 0.96% at June 30, 2007.  The Company believes its methodology for determining the adequacy of its ALLL adequately provides for probable losses inherent in the loan portfolio and produces a provision and allowance for loan losses that is directionally consistent with changes in asset quality and loss experience.
The allowance allocated to the commercial loan portfolio (see Table Five) increased $1.8 million, or 21.0%, from $8.3 million at December 31, 2006 to $10.1 million at June 30, 2007.  This increase was attributable to recent trends in the Company’s commercial portfolio.
The allowance allocated to the residential real estate portfolio (see Table Five) remained consistent at $4.0 million at December 31, 2006 and June 30, 2007.
The allowance allocated to the consumer loan portfolio (see Table Five) decreased $0.4 million, or 49.6%, from $0.8 million at December 31, 2006 to $0.4 million at June 30, 2007.  This decrease was attributable to changes in loss experience during the six months ended June 30, 2007.
The allowance allocated to overdraft deposit accounts (see Table Five) declined $0.2 million, or 6.3%, from $2.3 million at December 31, 2006 to $2.1 million at June 30, 2007. This decline was attributable to a slight decline in the loss experience attributable to these balances.
As previously discussed, the carrying value of the previously securitized loans incorporates an assumption for expected cash flows to be received over the life of these loans. To the extent that the present value of expected cash flows is less than the carrying value of these loans, the Company would provide for such losses through the provision for loan losses.
Based on the Company’s analysis of the adequacy of the allowance for loan losses and in consideration of the known factors utilized in computing the allowance, management believes that the allowance for loan losses as of June 30, 2007, is adequate to provide for probable losses inherent in the Company’s loan portfolio. Future provisions for loan losses will be dependent upon trends in loan balances including the composition of the loan portfolio, changes in loan quality and loss experience trends, and recoveries of previously charged-off loans, among other factors.  The Company believes that its methodology for determining its allowance for loan losses adequately provides for probable losses inherent in the loan portfolio at June 30, 2007.




Table Five
           
Analysis of the Allowance for Loan Losses
       
   
Six months ended June 30,
   
Year ended December 31,
 
(in thousands)
 
2007
   
2006
   
2006
 
       
                   
Balance at beginning of period
  $
15,405
    $
16,790
    $
16,790
 
                         
Reduction of allowance for loans sold
   
-
      (1,368 )     (1,368 )
                         
Charge-offs:
                       
Commercial, financial, and agricultural
    (155 )     (228 )     (1,279 )
Real estate-mortgage
    (563 )     (528 )     (935 )
Installment loans to individuals
    (144 )     (607 )     (898 )
Overdraft deposit accounts
    (1,816 )     (1,913 )     (3,823 )
Total charge-offs
    (2,678 )     (3,276 )     (6,935 )
                         
Recoveries:
                       
Commercial, financial, and agricultural
   
189
     
65
     
210
 
Real estate-mortgage
   
30
     
161
     
575
 
Installment loans to individuals
   
230
     
349
     
598
 
Overdraft deposit accounts
   
940
     
872
     
1,734
 
Total recoveries
   
1,389
     
1,447
     
3,117
 
Net charge-offs
    (1,289 )     (1,829 )     (3,818 )
Provision for loan losses
   
2,500
     
1,675
     
3,801
 
Balance at end of period
  $
16,616
    $
15,268
    $
15,405
 
                         
As a Percent of Average Total Loans:
                       
Net charge-offs (annualized)
    (0.15 )%     (0.22 )%     (0.23 )%
Provision for loan losses (annualized)
    0.29 %     0.21 %     0.23 %
As a Percent of Non-Performing Loans:
                       
Allowance for loan losses
    145.11 %     408.02 %     384.93 %

Table Six
           
Non-Performing Assets
           
   
As of June 30,
   
As of
December 31,
 
(in thousands)
 
2007
   
2006
   
2006
 
                   
                   
Non-accrual loans
  $
11,194
    $
3,046
    $
3,319
 
Accruing loans past due 90 days or more
   
212
     
573
     
635
 
Previously securitized loans past due 90 days or more
   
45
     
123
     
48
 
Total non-performing loans
   
11,451
     
3,742
     
4,002
 
Other real estate, excluding property associated with previously securitized loans
   
624
     
294
     
161
 
Other real estate associated with previously securitized loans
   
231
     
92
     
20
 
Total other real estate owned
   
855
     
386
     
181
 
Total non-performing assets
  $
12,306
    $
4,128
    $
4,183
 



Table Seven
           
Allocation of the Allowance For Loan Losses
       
   
As of June 30,
   
As of
December 31,
 
(in thousands)
 
2007
   
2006
   
2006
 
                   
Commercial, financial and agricultural
  $
10,082
    $
7,533
    $
8,330
 
Real estate-mortgage
   
3,982
     
4,084
     
3,981
 
Installment loans to individuals
   
404
     
1,182
     
801
 
Overdraft deposit accounts
   
2,148
     
2,469
     
2,293
 
Allowance for Loan Losses
  $
16,616
    $
15,268
    $
15,405
 

Previously Securitized Loans
As of June 30, 2007, the Company reported a carrying value of previously securitized loans of $10.3 million, while the actual outstanding contractual balance of these loans was $28.4 million. The Company accounts for the difference between the carrying value and the total expected cash flows of previously securitized loans as an adjustment of the yield earned on these loans over their remaining lives. The discount is accreted to income over the period during which payments are probable of collection and are reasonably estimable. If, upon periodic evaluation, the estimate of the total probable collections is increased or decreased but is still greater than the sum of the original carrying amount less subsequent collections plus the discount accreted to date, and it is probable that collection will occur, the amount of the discount to be accreted is adjusted accordingly and the amount of periodic accretion is adjusted over the remaining lives of the loans. If, upon periodic evaluation, the discounted present value of estimated future cash flows declines below the recorded value of previously securitized loans, an impairment charge would be provided through the Company’s provision for loan losses.
During the six months ended June 30, 2007 and for the year ended December 31, 2006, the Company has experienced net recoveries on these loans primarily due to increased collection efforts and the elimination of external servicing fees as a result of the Company assuming servicing of the loans.  Subsequent to our assumption of the servicing of these loans, the Company has averaged net recoveries, but does not believe that the trend of net recoveries can be sustained indefinitely.
During the first six months of 2007 and 2006, the Company recognized $3.6 million and $5.2 million, respectively, of interest income on its previously securitized loans.  Cash receipts for the three and six months ended June 30, 2007 and 2006 are summarized in the following table:
 

   
Three months ended June 30,
   
Six months ended June 30,
 
(in thousands)
 
2007
   
2006
   
2007
   
2006
 
               
Principal receipts
  $
3,313
    $
3,474
    $
6,856
    $
7,804
 
Interest income receipts
   
979
     
1,440
     
2,088
     
3,003
 
Total cash receipts
  $
4,292
    $
4,914
    $
8,944
    $
10,807
 
 

Based on current cash flow projections, the Company believes that the carrying value of previously securitized loans will approximate:
 
As of:
Estimated Balance:
   
December 31, 2007
                $9 million
December 31, 2008
                  6 million
December 31, 2009
                  5 million
December 31, 2010
                  4 million
 
Non-Interest Income and Non-Interest Expense
Six Months Ended June 30, 2007 vs. 2006
Non-Interest Income: Net of the gain from the sale of the Company’s merchant credit card agreements and investment gains, non-interest income increased $0.6 million to $26.5 million in the first six months of 2007 as compared to $25.9 million in the first six months of 2006.  The largest source of non-interest income is from service charges on depository accounts, which increased $0.7 million, or 3.5%, from $20.8 million during the first six months of 2006 to $21.5 million during the first six months of 2007.  Insurance commission revenues increased $0.7 million, or 62.5%, due in part to additional staffing to provide worker’s compensation insurance to West Virginia businesses.  Partially off-setting these increases was a decrease in other income of $0.8 million due to lower credit card fee income as a result of the sale of the retail credit card portfolio during the third quarter of 2006 and the sale of the merchant credit card portfolio during the first quarter of 2007.
Non-Interest Expense: Non-interest expenses remained flat at $35.1 million in the first six months of 2006 and 2007.  Salaries and employee benefits increased $0.6 million, or 3.3%, from the first six months of 2006 due in part to additional staffing for new retail locations and insurance personnel to support the introduction of worker’s compensation insurance.  This increase was essentially offset by a $0.5 million decrease in other expenses due to the sales of the retail and merchant card portfolios.
Three Months Ended June 30, 2007 vs. 2006
Non-Interest Income: Net of investment securities gains, non-interest income increased $0.2 million, or 1.3%, to $13.6 million in the second quarter of 2007 as compared to $13.4 million in the second quarter of 2006.  The largest source of non-interest income is service charges from depository accounts, which increased $0.5 million, or 4.8%, from $10.9 million during the second quarter of 2006 to $11.4 million during the second quarter of 2007. Insurance commission revenues increased $0.3 million, or 59.7%, due to additional staffing to provide worker’s compensation insurance to West Virginia businesses and to bolster the Company’s team of insurance agents focused on selling directly to retail customers.  Partially off-setting these increases was a decrease in other income of $0.5 million due to lower credit card fee income as a result of the sale of the retail credit card portfolio during the third quarter of 2006 and the sale of the merchant credit card processing agreements during the first quarter of 2007.
Non-Interest Expense: Non-interest expenses remained flat at $17.5 million for both the second quarter of 2006 and the second quarter of 2007.  Salaries and employee benefits increased $0.2 million, or 1.7%, from the second quarter of 2006 due to additional staffing while bankcard expenses increased $0.1 million, or 30.3%, due to increased usage by customers.  These increases were essentially offset by decreases in other expenses of $0.2 million, or 8.9%, due to the sales of the retail and merchant credit card portfolios and a decrease of $0.2 million, or 32.6%, in professional fees that was attributable to lower legal and consulting expenses.

 
Risk Management
Market risk is the risk of loss due to adverse changes in current and future cash flows, fair values, earnings or capital due to adverse movements in interest rates and other factors, including foreign exchange rates and commodity prices. Because the Company has no significant foreign exchange activities and holds no commodities, interest rate risk represents the primary risk factor affecting the Company’s balance sheet and net interest margin. Significant changes in interest rates by the Federal Reserve could result in similar changes in LIBOR interest rates, prime rates, and other benchmark interest rates that could affect the estimated fair value of the Company’s investment securities portfolio, interest paid on the Company’s short-term and long-term borrowings, interest earned on the Company’s loan portfolio and interest paid on its deposit accounts.
The Company’s Asset and Liability Committee (“ALCO”) has been delegated the responsibility of managing the Company’s interest-sensitive balance sheet accounts to maximize earnings while managing interest rate risk. ALCO, comprised of various members of executive and senior management, is also responsible for establishing policies to monitor and limit the Company’s exposure to interest rate risk and to manage the Company’s liquidity position. ALCO satisfies its responsibilities through monthly meetings during which product pricing issues, liquidity measures, and interest sensitivity positions are monitored.
In order to measure and manage its interest rate risk, the Company uses an asset/liability management and simulation software model to periodically update the interest sensitivity position of the Company’s balance sheet. The model is also used to perform analyses that measure the impact on net interest income and capital as a result of various changes in the interest rate environment. Such analyses quantify the effects of various interest rate scenarios on projected net interest income.
The Company’s policy objective is to avoid negative fluctuations in net income or the economic value of equity of more than 15% within a 12-month period, assuming an immediate parallel increase or decrease of 300 basis points. The Company measures the long-term risk associated with sustained increases and decreases in rates through analysis of the impact to changes in rates on the economic value of equity.
However, it is important to understand that a parallel downward shift of 300 basis points in interest rates from the current rate would result in both a 2.25% Fed Funds rate and long-term interest rates of approximately a 2.00%. While it is true that short-term interest rates such as the Fed Funds rate have been at these low levels in the recent past, long-term interest rates have not reached levels as low as would be associated with this “worst-case” interest rate environment in well over 30 years.  Based upon the Company’s belief that the likelihood of an immediate 300 basis point decline in both long-term and short-term interest rates from current levels is remote, the Company has chosen to reflect only its risk to a decrease of 200 basis points from current rates.
The Company has entered into interest rate floors with a total notional value of $600 million at June 30, 2007, with terms of 3, 4, and 5 years to facilitate the management of its short-term interest rate risk.  These derivative instruments provide the Company protection against the impact declining interest rates on future income streams from certain variable rate loans.  Please refer to Note C on pages 9 - 10 for further discussion of the use and accounting for such derivative instruments.
The following table summarizes the sensitivity of the Company’s net income to various interest rate scenarios. The results of the sensitivity analyses presented below differ from the results used internally by ALCO in that, in the analyses below, interest rates are assumed to have an immediate and sustained parallel shock. The Company recognizes that rates are volatile, but rarely move with immediate and parallel effects. Internally, the Company considers a variety of interest rate scenarios that are deemed to be possible while considering the level of risk it is willing to assume in “worst-case” scenarios such as shown by the following:

Immediate
Basis Point Change
in Interest Rates
   
Implied Federal Funds Rate Associated with Change in Interest Rates
   
Estimated Increase
(Decrease) in
Net Income Over 12 Months
   
Estimated Increase
(Decrease) in
Economic Value of
Equity
 
                     
June 30, 2007:
                   
 
+300
      8.25 %     +5.6 %     +1.5 %
 
+200
     
7.25
     
+3.7
     
+1.5
 
 
+100
     
6.25
     
+1.6
     
+0.8
 
 
-100
     
4.25
      (2.1 )     (3.0 )
 
-200
     
3.25
      (4.2 )     (6.8 )
                             
December 31, 2006:
                         
 
+300
      8.25 %     +5.2 %     +4.2 %
 
+200
     
7.25
     
+4.3
     
+0.2
 
 
+100
     
6.25
     
+1.6
     
+0.4
 
 
-100
     
4.25
      (2.3 )     (2.5 )
 
-200
     
3.25
      (5.2 )     (5.1 )
 
These estimates are highly dependent upon assumptions made by management, including, but not limited to, assumptions regarding the manner in which interest-bearing demand deposit and saving deposit accounts reprice in different interest rate scenarios, pricing behavior of competitors, prepayments of loans and deposits under alternative rate environments, and new business volumes and pricing. As a result, there can be no assurance that the results above will be achieved in the event that interest rates increase or decrease during 2007 and beyond.  The results above do not necessarily imply that the Company will experience increases in net income if market interest rates rise.  The table above indicates how the Company’s net income and the economic value of equity behave relative to an increase or decrease in rates compared to what would otherwise occur if rates remain stable.  Based upon the current level of interest rates in the general economy, the Company believes that its net interest margin will continue to compress through 2007.
 
Liquidity
The Company evaluates the adequacy of liquidity at both the Parent Company level and at City National. At the Parent Company level, the principal source of cash is dividends from City National. Dividends paid by City National to the Parent Company are subject to certain legal and regulatory limitations. Generally, any dividends in amounts that exceed the earnings retained by City National in the current year plus retained net profits for the preceding two years must be approved by regulatory authorities. During 2005 and 2006, City National received regulatory approval to pay $144.8 million of cash dividends to the Parent Company, while generating net profits of $106.6 million.  Therefore, City National will be required to obtain regulatory approval prior to declaring any cash dividends to the Parent Company during 2007.  Although regulatory authorities have approved prior cash dividends, there can be no assurance that future dividend requests will be approved.
The Parent Company used cash obtained from the dividends received primarily to: (1) pay common dividends to shareholders, (2) remit interest payments on the Company’s trust-preferred securities, and (3) fund repurchase of the Company’s common shares.
Over the next 12 months, the Parent Company has an obligation to remit interest payments approximating $1.5 million on the junior subordinated debentures held by City Holding Capital Trust. Additionally, the Parent Company anticipates continuing the payment of dividends, which are expected to approximate $21.0 million on an annualized basis over the next 12 months based on common shareholders of record at June 30, 2007.  However, interest payments on the debentures can be deferred for up to five years under certain circumstances and dividends to shareholders can, if necessary, be suspended.  In addition to these anticipated cash needs, the Parent Company has operating expenses and other contractual obligations, which are estimated to require $0.6 million of additional cash over the next 12 months. As of June 30, 2007, the Parent Company reported a cash balance of $33.7 million and management believes that the Parent Company’s available cash balance, together with cash dividends from City National will be adequate to satisfy its funding and cash needs over the next twelve months.
Excluding the interest and dividend payments discussed above, the Parent Company has no significant commitments or obligations in years after 2007 other than the repayment of its $16.8 million obligation under the debentures held by City Holding Capital Trust. However, this obligation does not mature until April 2028, or earlier at the option of the Parent Company. It is expected that the Parent Company will be able to obtain the necessary cash, either through dividends obtained from City National or the issuance of other debt, to fully repay the debentures at their maturity.
City National manages its liquidity position in an effort to effectively and economically satisfy the funding needs of its customers and to accommodate the scheduled repayment of borrowings. Funds are available to City National from a number of sources, including depository relationships, sales and maturities within the investment securities portfolio, and borrowings from the FHLB and other financial institutions. As of June 30, 2007, City National’s assets are significantly funded by deposits and capital. Additionally, City National maintains borrowing facilities with the FHLB and other financial institutions that are accessed as necessary to fund operations and to provide contingency funding mechanisms. As of June 30, 2007, City National has the capacity to borrow an additional $122.2 million from the FHLB and other financial institutions under existing borrowing facilities. City National maintains a contingency funding plan, incorporating these borrowing facilities, to address liquidity needs in the event of an institution-specific or systematic financial industry crisis. Also, City National maintains a significant percentage (91.6%, or $453.7 million at June 30, 2007) of its investment securities portfolio in the highly liquid available-for-sale classification. Although it has no current intention to do so, these securities could be liquidated, if necessary, to provide an additional funding source.  City National also segregates certain mortgage loans, mortgage-backed securities, and other investment securities in a separate subsidiary so that it can separately monitor the asset quality of these primarily mortgage-related assets, which could be used to raise cash through securitization transactions or obtain additional equity or debt financing if necessary.
The Company manages its asset and liability mix to balance its desire to maximize net interest income against its desire to minimize risks associated with capitalization, interest rate volatility, and liquidity. With respect to liquidity, the Company has chosen a conservative posture and believes that its liquidity position is strong. The Company’s net loan to asset ratio is 67.9% as of June 30, 2007 and deposit balances fund 79.7% of total assets. The Company has obligations to extend credit, but these obligations are primarily associated with existing home equity loans that have predictable borrowing patterns across the portfolio. The Company has significant investment security balances that totaled $495.4 million at June 30, 2007, and that greatly exceeded the Company’s non-deposit sources of borrowing which totaled $217.3 million.  Further, the Company’s deposit mix has a very high proportion of transaction and savings accounts that fund 43.3% of the Company’s total assets.
As illustrated in the Consolidated Statements of Cash Flows, the Company generated $23.3 million of cash from operating activities during the first six months of 2007, primarily from interest income received on loans and investments, net of interest expense paid on deposits and borrowings.  The Company used $36.6 million of cash in investing activities during the first six months of 2007 primarily for the purchase of money market and mutual fund securities, net of proceeds from these securities and from maturities and calls of securities available-for-sale.  The Company used $2.5 million of cash in financing activities during the first six months of 2007, primarily for the purchase of treasury stock of $22.7 million and cash dividends paid to the Company’s common stockholders of $10.2 million, which were partially offset by an increase of $28.5 million in non-interest and interest bearing deposits.
Capital Resources
During the first six months of 2007, Shareholders’ Equity decreased $10.5 million, or 3.4%, from $305.3 million at December 31, 2006 to $294.8 million at June 30, 2007.  This decrease was primarily due to common stock purchases of $22.7 million and dividends declared during the year of $10.6 million which were partially offset by reported net income of $25.6.
During December 2006, the Board of Directors authorized the Company to buy back up to 1,000,000 shares of its common shares (approximately 5% of outstanding shares) in open market transactions at prices that are accretive to the earnings per share of continuing shareholders.  No time limit was placed on the duration of the share repurchase program. 580,200 shares were repurchased during the first six months of 2007 and there can be no assurance that the Company will continue to reacquire its common shares or to what extent the repurchase program will be successful.  As of June 30, 2007, the Company may repurchase an additional 385,800 shares from time to time depending on market conditions under the authorization.
Regulatory guidelines require the Company to maintain a minimum total capital to risk-adjusted assets ratio of 8.0%, with at least one-half of capital consisting of tangible common stockholders’ equity and a minimum Tier I leverage ratio of 4.0%. Similarly, City National is also required to maintain minimum capital levels as set forth by various regulatory agencies. Under capital adequacy guidelines, City National is required to maintain minimum total capital, Tier I capital, and leverage ratios of 8.0%, 4.0%, and 4.0%, respectively. To be classified as “well capitalized,” City National must maintain total capital, Tier I capital, and leverage ratios of 10.0%, 6.0%, and 5.0%, respectively.
The Company’s regulatory capital ratios remained strong for both City Holding and City National as illustrated in the following table:



               
Actual
 
         
Well-
   
June 30,
   
December 31,
 
   
Minimum
   
Capitalized
   
2007
   
2006
 
City Holding:
                       
Total
    8.0 %     10.0 %     16.1 %     16.2 %
Tier I Risk-based
   
4.0
     
6.0
     
15.2
     
15.3
 
Tier I Leverage
   
4.0
     
5.0
     
10.5
     
10.8
 
City National:
                               
Total
    8.0 %     10.0 %     13.5 %     13.4 %
Tier I Risk-based
   
4.0
     
6.0
     
12.6
     
12.5
 
Tier I Leverage
   
4.0
     
5.0
     
8.7
     
8.8
 


The information called for by this item is provided under the caption “Risk Management” under Item 2—Management’s Discussion and Analysis of Financial Condition and Results of Operations.
 
Pursuant to Rule 13a-15(b) under the Securities Exchange Act of 1934, the Company carried out an evaluation, with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the Company’s disclosure controls and procedures (as defined under Rule 13a-15(e) under the Securities Exchange Act of 1934) as of the end of the period covered by this report. Based upon that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective in timely alerting them to material information relating to the Company required to be included in the Company’s periodic SEC filings.  There has been no change in the Company’s internal control over financial reporting during the quarter ended June 30, 2007 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.



Item 1.
     
 
The Company is engaged in various legal actions that it deems to be in the ordinary course of business. The Company believes that it has adequately provided for probable costs of current litigation. As these legal actions are resolved, however, the Company could realize positive and/or negative impact to its financial performance in the period in which these legal actions are ultimately decided. There can be no assurance that current actions will have immaterial results, either positive or negative, or that no material actions may be presented in the future.
         
Item 1A.
     
         
There have been no material changes to the factors disclosed in Item 1A. Risk Factors in our Annual Report on Form 10-K for the year ended December 31, 2006.
 
Item 2.
     
 
The following table sets forth information regarding the Company’s common stock repurchases transacted during the quarter:
                   
 
 
 
 
 
 
 
Period
 
Total Number
of Shares Purchased
   
Average Price Paid per Share
   
Total Number
of Shares Purchased
as Part of Publicly
Announced Plans
or Programs (a)
   
Maximum Number of Shares that May Yet Be Purchased Under the Plans or Programs
 
                           
 
April 1 – April 30, 2007
   
68,000
    $
39.56
     
68,000
     
623,700
 
                                   
 
May 1 – May 31, 2007
   
111,200
    $
38.54
     
111,200
     
512,500
 
                                   
 
June 1 – June 30, 2007
   
126,700
    $
38.10
     
126,700
     
385,800
 
                                   
(a) In December 2006, the Company announced that the Board of Directors had authorized the Company to buy back up to 1,000,000 shares of its common stock, in open market transactions at prices that are accretive to continuing shareholders. No timetable was placed on the duration of this share repurchase program.
         
Item 3.
   
None.


Item 4.
 
     
 
The Company held its Annual Meeting of Shareholders on April 25, 2007 at which time shareholders were asked to consider the following two proposals, which were more fully described in the Company’s definitive proxy statement on Schedule 14A filed with the Securities and Exchange Commission on March 23, 2007:
 
     
 
1. To elect one Class I director to serve for a term of two years and five Class II directors to serve for a term of three years.
 
 
2. To ratify the Board of Directors’ appointment of Ernst & Young LLP as independent registered public accounting firm for City Holding Company for 2007.
 
     
 
The vote tabulation was as follows:
 
     
 
1. Election of one Class I director and five Class II directors to the Board of Directors:
 
     
 
Director Nominee
Votes For
Votes Withheld
 
         
 
John R. Elliot
14,264,147
   177,649
 
 
Oshel B. Craigo
  9,605,496
4,836,300
 
 
William H. File III
14,227,831
   213,965
 
 
Tracy W. Hylton II
14,157,160
   248,636
 
 
C. Dallas Kayser
14,193,196
   248,600
 
 
Sharon H. Rowe
14,226,810
   214,986
 
     
 
There were no broker non-votes in the election of directors.
 
     
 
2. Ratification of the Board of Directors’ appointment of Ernst & Young LLP as independent registered public accounting firm for City Holding Company for 2007:
 
     
 
Votes For
Against
Abstentions
 
         
 
14,260,168
132,147
49,481
 
     
 
There were no broker non-votes in the ratification of independent registered public accounting firm.
 
     
Item 5.
None.
Item 6.
 
 
(a) Exhibits:
 
 
31(a)
 
 
31(b)
 
 
32(a)
 
 
32(a)
 





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.


City Holding Company
 
(Registrant)
 
 
 
/s/ Charles R. Hageboeck
 
Charles R. Hageboeck
President and Chief Executive Officer
(Principal Executive Officer)
 
 
 
/s/ David L. Bumgarner
 
David L. Bumgarner
Senior Vice President and Chief Financial Officer
(Principal Financial Officer)
 
 
 


Date: August 7, 2007
 
-37-