PEOPLES BANCORP OF NORTH CAROLINA, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Unaudited)
| (1) | Summary of Significant Accounting Policies |
The consolidated financial statements include the financial statements of Peoples Bancorp of North Carolina, Inc. and its wholly owned subsidiary, Peoples Bank (the “Bank”), along with the Bank’s wholly owned subsidiaries, Peoples Investment Services, Inc. and Real Estate Advisory Services, Inc. (collectively called the “Company”). All significant intercompany balances and transactions have been eliminated in consolidation.
The consolidated financial statements in this report are unaudited. In the opinion of management, all adjustments (none of which were other than normal accruals) necessary for a fair presentation of the financial position and results of operations for the periods presented have been included. Management of the Company has made a number of estimates and assumptions relating to reporting of assets and liabilities and the disclosure of contingent assets and liabilities to prepare these consolidated financial statements in conformity with generally accepted accounting principles. Actual results could differ from those estimates.
The Company’s accounting policies are fundamental to understanding management’s discussion and analysis of results of operations and financial condition. Many of the Company’s accounting policies require significant judgment regarding valuation of assets and liabilities and/or significant interpretation of the specific accounting guidance. A description of the Company’s significant accounting policies can be found in Note 1 of the notes to consolidated financial statements in the Company’s 2007 Annual Report to Shareholders which is Appendix A to the Proxy Statement for the May 1, 2008 Annual Meeting of Shareholders.
Recently Adopted Accounting Pronouncements
In September 2006, the Financial Accounting Standard Board (“FASB”) ratified the conclusions reached by the Emerging Issues Task Force (EITF) on EITF 06-4, “Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements.” This issue will require companies to recognize an obligation for either the present value of the entire promised death benefit or the annual “cost of insurance” required to keep the policy in force during the post-retirement years. EITF 06-4 was effective for the Company as of January 1, 2008. During first quarter 2008, the Company made a $467,000 reduction to retained earnings for the cumulative effect of EITF 06-4 as of January 1, 2008 pursuant to the guidance of this pronouncement to record the portion of this benefit earned by participants prior to adoption of this pronouncement. During the second quarter of 2008, the Company recognized $14,000 in expense associated with EITF 06-4. The Company has recognized $31,000 in expense associated with EITF 06-4 for the six months ended June 30, 2008.
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (SFAS 157). SFAS 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements. SFAS 157 applies under other accounting pronouncements that require or permit fair value measurements. SFAS 157 was effective for the Company as of January 1, 2008. This standard had no effect on the Company's financial position or results of operations.
SFAS 157 establishes a three-level fair value hierarchy for fair value measurements. Level 1 inputs are quoted prices in active markets for identical assets or liabilities that a company has the ability to access at the measurement date. Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. Level 3 inputs are unobservable inputs for the asset or liability. The Company’s fair value measurements for items measured at fair value at June 30, 2008 included:
| | | Fair Value Measurements June 30, 2008 | | Level 1 Valuation | | Level 2 Valuation | | Level 3 Valuation |
| Investment securities available for sale | | $ | 117,967,342 | | | | 1,452,103 | | | | 115,765,239 | | | | 750,000 |
| Market value of derivatives (in other assets) | | $ | 2,340,325 | | | | - | | | | 2,340,325 | | | | - |
Fair values of investment securities available for sale are determined by obtaining quoted prices on nationally recognized securities exchanges when available. If quoted prices are not available, fair value is determined using matrix pricing, which is a mathematical technique used widely in the industry to value debt securities without
relying exclusively on quoted prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted securities. Fair values of derivative instruments are determined using widely accepted valuation techniques including discounted cash flow analysis on the expected cash flows of each derivative. This analysis reflects the contractual terms of the derivatives, including the period to maturity, and uses observable market-based inputs, including interest rate curves and implied volatilities.
The following is an analysis of fair value measurements of investment securities available for sale using Level 3, significant unobservable inputs, for the six months ended June 30, 2008:
| | | Investment Securities Available for Sale |
| | | Level 3 Valuation |
| Balance, beginning of period | | $ | 250,000 |
| Change in book value | | | - |
| Change in gain/(loss) realized and unrealized | | | - |
| Purchases/(sales) | | | 500,000 |
| Transfers in and/or out of Level 3 | | | - |
| Balance, end of period | | $ | 750,000 |
| | | | |
| Change in unrealized gain/(loss) for assets still held in Level 3 | | $ | 0 |
In accordance with the provisions of SFAS 114, the Company has specific loan loss reserves for loans that management has determined to be impaired. These specific reserves are determined on an individual loan basis based on management’s current evaluation of the Company’s loss exposure for each credit, given the appraised value of any underlying collateral. At June 30, 2008, the Company had specific reserves of $1.4 million in the allowance for loan losses on loans totaling $8.9 million. The Company’s June 30, 2008 fair value measurement for impaired loans is presented below:
| | | | | | | | | | | |
| | | Fair Value Measurements June 30, 2008 | | Level 1 Valuation | | Level 2 Valuation | | Level 3 Valuation | | Total Gains/(Losses) for the Six Months Ended June 30, 2008 |
| Impaired loans | | $ | 7,556,794 | | - | | - | | 7,556,794 | | - |
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (SFAS 159), which permits entities to choose to measure financial instruments and certain other instruments at fair value. SFAS 159 was effective for the Company as of January 1, 2008. The Company did not choose this option for any asset or liability, and therefore SFAS 159 did not have any effect on the Company's financial position, results of operations or disclosures.
Recently Issued Accounting Pronouncements
In March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities,” (SFAS 161). SFAS 161 is an amendment to SFAS No. 133, which provides for enhanced disclosures about how and why an entity uses derivatives and how and where those derivatives and related hedged items are reported in the entity’s financial statements. SFAS 161 is effective for the Company as of January 1, 2009. As this is a disclosure related standard, this standard is not expected to have any effect on the Company's financial position or results of operations, and will result in additional disclosures related to the Company’s derivatives.
| (2) | Allowance for Loan Losses |
The following is an analysis of the allowance for loan losses for the six months ended June 30, 2008 and 2007:
| | | 2008 | | 2007 | |
| | | | | | | |
| Balance, beginning of period | | $ | 9,103,058 | | | | 8,303,432 | |
| Provision for loan losses | | | 1,072,000 | | | | 957,000 | |
| Less: | | | | | | | | |
| Charge-offs | | | (688,170 | ) | | | (954,015 | ) |
| Recoveries | | | 154,758 | | | | 208,000 | |
| Net charge-offs | | | (233,412 | ) | | | (746,015 | ) |
| | | | | | | | | |
| Balance, end of period | | $ | 9,641,646 | | | | 8,514,417 | |
| (3) | Net Earnings Per Share |
Net earnings per common share is based on the weighted average number of common shares outstanding during the period while the effects of potential common shares outstanding during the period are included in diluted earnings per share. The average market price during the year is used to compute equivalent shares.
The reconciliation of the amounts used in the computation of both “basic earnings per share” and “diluted earnings per share” for the three and six months ended June 30, 2008 is as follows:
| For the three months ended June 30, 2008 | | | | | | | | |
| | | Net Earnings | | | Common Shares | | | Per Share Amount |
| | | | | | | | | |
| Basic earnings per share | | $ | 2,191,794 | | | | 5,601,867 | | | $ | 0.39 |
| Effect of dilutive securities: | | | | | | | | | | | |
| Stock options | | | - | | | | 70,174 | | | | |
| Diluted earnings per share | | $ | 2,191,794 | | | | 5,672,041 | | | $ | 0.39 |
| | | | | | | | | | | | |
| For the six months ended June 30, 2008 | | | | | | | | | | | |
| | | Net Earnings | | | Common Shares | | | Per Share Amount |
| | | | | | | | | | | | |
| Basic earnings per share | | $ | 4,246,245 | | | | 5,605,696 | | | $ | 0.76 |
| Effect of dilutive securities: | | | | | | | | | | | |
| Stock options | | | - | | | | 73,550 | | | | |
| Diluted earnings per share | | $ | 4,246,245 | | | | 5,679,246 | | | $ | 0.75 |
The reconciliation of the amounts used in the computation of both “basic earnings per share” and “diluted earnings per share” for the three and six months ended June 30, 2007 is as follows:
| For the three months ended June 30, 2007 | | | | | | | | |
| | | Net Earnings | | | Common Shares | | | Per Share Amount |
| | | | | | | | | |
| Basic earnings per share | | $ | 2,590,113 | | | | 5,746,837 | | | $ | 0.45 |
| Effect of dilutive securities: | | | | | | | | | | | |
| Stock options | | | - | | | | 115,683 | | | | |
| Diluted earnings per share | | $ | 2,590,113 | | | | 5,862,520 | | | $ | 0.44 |
| | | | | | | | | | | | |
| For the six months ended June 30, 2007 | | | | | | | | | | | |
| | | Net Earnings | | | Common Shares | | | Per Share Amount |
| | | | | | | | | | | | |
| Basic earnings per share | | $ | 5,377,238 | | | | 5,747,458 | | | $ | 0.94 |
| Effect of dilutive securities: | | | | | | | | | | | |
| Stock options | | | - | | | | 117,296 | | | | |
| Diluted earnings per share | | $ | 5,377,238 | | | | 5,864,754 | | | $ | 0.92 |
| (4) | Stock-Based Compensation |
The Company has an Omnibus Stock Ownership and Long Term Incentive Plan (the “Plan”) whereby certain stock-based rights, such as stock options, restricted stock, performance units, stock appreciation rights, or book value shares, may be granted to eligible directors and employees. A total of 636,637 shares are currently reserved for possible issuance under this Plan. All rights must be granted or awarded within ten years from the May 13, 1999 effective date of the Plan.
Under the Plan, the Company granted incentive stock options to certain eligible employees in order that they may purchase Company stock at a price equal to the fair market value on the date of the grant. The options granted in 1999 vest over a five-year period. Options granted subsequent to 1999 vest over a three-year period. All options expire ten years after issuance. The Company did not grant any options during the three and six months ended June 30, 2008 and 2007.
The Company granted 3,000 shares of restricted stock in 2007 at a grant date fair value of $17.40 per share. The Company granted 1,750 shares of restricted stock during the six months ended June 30, 2008 at a grant date fair value of $12.80 per share. The Company recognizes compensation expense on the restricted stock over the period of time the restrictions are in place (three years from the grant date for the grants to date). The amount of expense recorded each period reflects the changes in the Company's stock price during the period. As of June 30, 2008, there was $42,000 of total unrecognized compensation cost related to restricted stock grants, which is expected to be recognized over a period of three years.
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
The following is a discussion of our financial position and results of operations and should be read in conjunction with the information set forth under Item 1A Risk Factors and the Company’s consolidated financial statements and notes thereto on pages A-27 through A-56 of the Company’s 2007 Annual Report to Shareholders which is Appendix A to the Proxy Statement for the May 1, 2008 Annual Meeting of Shareholders.
Introduction
Management's discussion and analysis of earnings and related data are presented to assist in understanding the consolidated financial condition and results of operations of Peoples Bancorp of North Carolina, Inc. Peoples Bancorp is the parent company of Peoples Bank (the “Bank”) and a registered bank holding company operating under the supervision of the Board of Governors of the Federal Reserve System (the “Federal Reserve”). The Bank is a North Carolina-chartered bank, with offices in Catawba, Lincoln, Alexander, Mecklenburg, Iredell, Union and Wake counties, operating under the banking laws of North Carolina and the rules and regulations of the Federal Deposit Insurance Corporation (the “FDIC”).
Overview
Our business consists principally of attracting deposits from the general public and investing these funds in loans secured by commercial real estate, secured and unsecured commercial and consumer loans. Our profitability depends primarily on our net interest income, which is the difference between the income we receive on our loan and investment securities portfolios and our cost of funds, which consists of interest paid on deposits and borrowed funds. Net interest income also is affected by the relative amounts of interest-earning assets and interest-bearing liabilities. When interest-earning assets approximate or exceed interest-bearing liabilities, any positive interest rate spread will generate net interest income. Our profitability is also affected by the level of other income and operating expenses. Other income consists primarily of miscellaneous fees related to our loans and deposits, mortgage banking income and commissions from sales of annuities and mutual funds. Operating expenses consist of compensation and benefits, occupancy related expenses, federal deposit and other insurance premiums, data processing, advertising and other expenses.
Our operations are influenced significantly by local economic conditions and by policies of financial institution regulatory authorities. The earnings on our assets are influenced by the effects of, and changes in, trade, monetary and fiscal policies and laws, including interest rate policies of the Federal Reserve, inflation, interest rates, market and monetary fluctuations. Lending activities are affected by the demand for commercial and other types of loans, which in turn is affected by the interest rates at which such financing may be offered. Our cost of funds is influenced by interest rates on competing investments and by rates offered on similar investments by competing financial institutions in our market area, as well as general market interest rates. These factors can cause fluctuations in our net interest income and other income. In addition, local economic conditions can impact the credit risk of our loan portfolio, in that (1) local employers may be required to eliminate employment positions of individual borrowers and small businesses and (2) commercial borrowers may experience a downturn in their operating performance and become unable to make timely payments on their loans. Management evaluates these factors in estimating its allowance for loan losses, and changes in these economic conditions could result in increases or decreases to the provision for loan losses.
Our business emphasis has been to operate as a well-capitalized, profitable and independent community-oriented financial institution dedicated to providing quality customer service. We are committed to meeting the financial needs of the communities in which we operate. We believe that we can be more effective in servicing our customers than many of our non-local competitors because of our ability to quickly and effectively provide senior management responses to customer needs and inquiries. Our ability to provide these services is enhanced by the stability of our senior management team.
The Company qualified as an accelerated filer in accordance with Rule 12b-2 of the Securities Exchange Act of 1934, effective December 31, 2006. Therefore, the Company was subject to the requirements of Section 404 of the Sarbanes-Oxley Act of 2002 (“SOX 404”). The Company incurred additional consulting and audit expenses in becoming compliant with SOX 404, and will continue to incur additional audit expenses to comply with SOX 404 when SOX 404 becomes applicable to smaller reporting companies. Management does not expect expenses related to SOX 404 to have a material impact on the Company’s financial statements. The Company qualified as a smaller reporting company effective June 30, 2008, due to a decrease in market capitalization. Management does not expect significant cost savings from this change in filing status, as certification of the effectiveness of internal controls by management will still be required.
The Bank opened a new office in Mecklenburg County, in Cornelius, North Carolina in June 2007and a new office in Iredell County, in Mooresville, North Carolina in January 2008. Also in January 2008, the Bank opened a new Banco de la Gente office in Wake County, in Raleigh, North Carolina in a continuing effort to serve the Latino community. While there are no additional traditional offices planned in 2008, management will consider opening at least one new traditional office in Mecklenburg or Iredell counties in the next two to three years and additional Banco de la Gente offices in metropolitan areas in North Carolina.
Summary of Significant Accounting Policies
The consolidated financial statements include the financial statements of Peoples Bancorp of North Carolina, Inc. and its wholly owned subsidiary, Peoples Bank, along with the Bank’s wholly owned subsidiaries, Peoples Investment Services, Inc. and Real Estate Advisory Services, Inc. (collectively called the “Company”). All significant intercompany balances and transactions have been eliminated in consolidation.
The Company’s accounting policies are fundamental to understanding management’s discussion and analysis of results of operations and financial condition. Many of the Company’s accounting policies require significant judgment regarding valuation of assets and liabilities and/or significant interpretation of specific accounting guidance. A more complete description of the Company’s significant accounting policies can be found in Note 1 of the Notes to Consolidated Financial Statements in the Company’s 2007 Annual Report to Shareholders which is Appendix A to the Proxy Statement for the May 1, 2008 Annual Meeting of Shareholders. The following is a summary of the more subjective and complex accounting policies of the Company.
Many of the Company’s assets and liabilities are recorded using various techniques that require significant judgment as to recoverability. The collectability of loans is reflected through the Company’s estimate of the allowance for loan losses. The Company performs periodic and systematic detailed reviews of its lending portfolio to assess overall collectability. In addition, certain assets and liabilities are reflected at their estimated fair value in the consolidated financial statements. Such amounts are based on either quoted market prices or estimated values derived from dealer quotes used by the Company, market comparisons or internally generated modeling techniques. The Company’s internal models generally involve present value of cash flow techniques. The various techniques are discussed in greater detail elsewhere in management’s discussion and analysis and the notes to the consolidated financial statements.
There are other complex accounting standards that require the Company to employ significant judgment in interpreting and applying certain of the principles prescribed by those standards. These judgments include, but are not limited to, the determination of whether a financial instrument or other contract meets the definition of a derivative in accordance with Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities.” For a more complete discussion of policies, see the notes to the consolidated financial statements.
In September 2006, the Financial Accounting Standard Board (“FASB”) ratified the conclusions reached by the Emerging Issues Task Force (EITF) on EITF 06-4, “Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements.” This issue requires companies to recognize an obligation for either the present value of the entire promised death benefit or the annual “cost of insurance” required to keep the policy in force during the post-retirement years. EITF 06-4 was effective for the Company as of January 1, 2008. During first quarter 2008, the Company made a $467,000 reduction to retained earnings for the cumulative effect of EITF 06-4 as of January 1, 2008 pursuant to the guidance of this pronouncement to record the portion of this benefit earned by participants prior to adoption of this pronouncement. During the second quarter of 2008, the Company recognized $14,000 in expense associated with EITF 06-4. The Company has recognized $31,000 in expense associated with EITF 06-4 for the six months ended June 30, 2008.
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (SFAS 157). SFAS 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements. SFAS 157 applies under other accounting pronouncements that require or permit fair value measurements. SFAS 157 was effective for the Company as of January 1, 2008. This standard had no effect on the Company's financial position or results of operations.
SFAS 157 establishes a three-level fair value hierarchy for fair value measurements. Level 1 inputs are quoted prices in active markets for identical assets or liabilities that a company has the ability to access at the measurement date. Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. Level 3 inputs are unobservable inputs for the asset or liability. The Company’s fair value measurements for items measured at fair value at June 30, 2008 included:
| | | Fair Value Measurements June 30, 2008 | | | Level 1 Valuation | | | Level 2 Valuation | | | Level 3 Valuation |
| Investment securities available for sale | | $ | 117,967,342 | | | | 1,452,103 | | | | 115,765,239 | | | | 750,000 |
| Market value of derivatives (in other assets) | | $ | 2,340,325 | | | | - | | | | 2,340,325 | | | | - |
Fair values of investment securities available for sale are determined by obtaining quoted prices on nationally recognized securities exchanges when available. If quoted prices are not available, fair value is determined using matrix
pricing, which is a mathematical technique used widely in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted securities. Fair values of derivative instruments are determined using widely accepted valuation techniques including discounted cash flow analysis on the expected cash flows of each derivative. This analysis reflects the contractual terms of the derivatives, including the period to maturity, and uses observable market-based inputs, including interest rate curves and implied volatilities.
The following is an analysis of fair value measurements of investment securities available for sale using Level 3, significant unobservable inputs, for the six months ended June 30, 2008:
| | | Investment Securities Available for Sale |
| | | Level 3 Valuation |
| Balance, beginning of period | | $ | 250,000 |
| Change in book value | | | - |
| Change in gain/(loss) realized and unrealized | | | - |
| Purchases/(sales) | | | 500,000 |
| Transfers in and/or out of Level 3 | | | - |
| Balance, end of period | | $ | 750,000 |
| | | | |
| Change in unrealized gain/(loss) for assets still held in Level 3 | | $ | 0 |
In accordance with the provisions of SFAS 114, the Company has specific loan loss reserves for loans that management has determined to be impaired. These specific reserves are determined on an individual loan basis based on management’s current evaluation of the Company’s loss exposure for each credit, given the appraised value of any underlying collateral. At June 30, 2008, the Company had specific reserves of $1.4 million in the allowance for loan losses on loans totaling $8.9 million. The Company’s June 30, 2008 fair value measurement for impaired loans is presented below:
| | | Fair Value Measurements June 30, 2008 | | Level 1 Valuation | | Level 2 Valuation | | Level 3 Valuation | | Total Gains/(Losses) for the Six Months Ended June 30, 2008 |
| Impaired loans | | $ | 7,556,794 | | - | | - | | 7,556,794 | | - |
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (SFAS 159), which permits entities to choose to measure financial instruments and certain other instruments at fair value. SFAS 159 was effective for the Company as of January 1, 2008. The Company did not choose this option for any asset or liability, and therefore SFAS 159 did not have any effect on the Company's financial position, results of operations or disclosures.
In March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities,” (SFAS 161). SFAS 161 is an amendment to SFAS No. 133, which provides for enhanced disclosures about how and why an entity uses derivatives and how and where those derivatives and related hedged items are reported in the entity’s financial statements. SFAS 161 is effective for the Company as of January 1, 2009. As this is a disclosure related standard, this standard is not expected to have any effect on the Company's financial position or results of operations, and will result in additional disclosures related to the Company’s derivatives.
Management of the Company has made a number of estimates and assumptions relating to reporting of assets and liabilities and the disclosure of contingent assets and liabilities to prepare these consolidated financial statements in conformity with GAAP. Actual results could differ from those estimates.
Results of Operations
Summary. Net earnings for the second quarter of 2008 were $2.2 million, or $0.39 basic and diluted net earnings per share as compared to $2.6 million, or $0.45 basic net earnings per share and $0.44 diluted net earnings per share for the same period one year ago. The decrease in net earnings is attributable to a decrease in net interest income, an increase in provision for loan losses and an in increase in non-interest expense, which were partially offset by an increase in non-interest income.
The annualized return on average assets was 0.96% for the three months ended June 30, 2008 compared to 1.24% for the same period in 2007, and annualized return on average shareholders' equity was 11.83% for the three months ended June 30, 2008 compared to 15.42% for the same period in 2007.
Net earnings for the six months ended June 30, 2008 were $4.2 million, or $0.76 basic net earnings per share and $0.75 diluted net earnings per share as compared to $5.4 million, or $0.94 basic net earnings per share and $0.92 diluted net earnings per share for the same period in 2007. The decrease in net earnings for the six-month period ended June 30, 2008 is primarily attributable to a decrease in net interest income, an increase in the provision for loan losses and an increase in non-interest expense, which were partially offset by an increase in non-interest income.
The annualized return on average assets was 0.94% and 1.31% for the six months ended June 30, 2008 and 2007, respectively. Annualized return on average shareholders’ equity was 11.38% for the six months ended June 30, 2008 compared to 16.03% for the same period in 2007.
Net Interest Income. Net interest income, the major component of the Company's net earnings, was $8.4 million for the three months ended June 30, 2008, a decrease of 4% from the $8.7 million earned in the same period in 2007. This decrease is primarily attributable to a 325 basis point reduction in the Bank’s prime commercial lending rate from June 30, 2007 to June 30, 2008. The decrease in loan interest income resulting from a decline in prime rate was partially offset by an increase in income from derivative instruments.
Interest income decreased $1.4 million or 9% for the three months ended June 30, 2008 compared with the same period in 2007. The decrease was due to a 325 basis point reduction in the Bank’s prime commercial lending rate, which was partially offset by an increase in the average outstanding balance of loans and income from interest rate derivative contracts. Net income from derivative instruments was $899,000 for the three months ended June 30, 2008 when compared to a net loss of $108,000 for the same period in 2007. The average yield on earning assets for the quarters ended June 30, 2008 and 2007 was 6.65% and 7.94%, respectively. During the quarter ended June 30, 2008, average loans increased $89.2 million to $735.8 million from $646.6 million for the three months ended June 30, 2007. During the quarter ended June 30, 2008, average investment securities available-for-sale decreased $4.3 million to $116.0 million from $120.3 million for the three months ended June 30, 2007.
Interest expense decreased $1.0 million or 15% for the three months ended June 30, 2008 compared with the same period in 2007. The average rate paid on interest-bearing checking and savings accounts was 1.55% for the three months ended June 30, 2008 as compared to 2.15% for the same period of 2007. The average rate paid on certificates of deposits was 3.70% for the three months ended June 30, 2008 compared to 4.86% for the same period one year ago.
Net interest income for the six-month period ended June 30, 2008 was $16.2 million, a decrease of 6% from net interest income of $17.3 million for the six months ended June 30, 2007. This decrease is primarily attributable to a reduction in the Bank’s prime commercial lending rate. The decrease in loan interest income resulting from a decline in prime rate was partially offset by an increase in income from derivative instruments.
Interest income decreased $2.0 million or 7% to $28.6 million for the six months ended June 30, 2008 compared to $30.6 million for the same period in 2007. The decrease was primarily due to a decrease in the average yield received on loans resulting from Federal Reserve interest rate decreases, which were partially offset by an increase in the average outstanding balance of loans and income from interest rate derivative contracts. Net income from derivative instruments was $1.3 million for the six months ended June 30, 2008 compared to a net loss of $209,000 for the same period of 2007. The average yield earned on loans, including fees, was 7.09% for the six months ended June 30, 2008 as compared to 8.56% for the same period of 2007. During the six months ended June 30, 2008, average loans increased $83.3 million to $728.2 million from $644.9 million for the same period in 2007. Average investment securities available for sale decreased 3% to $117.1 million in the six months ended June 30, 2008 compared to the same period in 2007. All other interest-earning assets including federal funds sold decreased to an average of $11.6 million in the six months ended June 30, 2008 from $21.0 million in the same period in 2007. The tax equivalent yield on average earning assets decreased to 6.82% for the six months ended June 30, 2008 from 7.97% for the six months ended June 30, 2007.
Interest expense decreased 7% to $12.4 million for the six months ended June 30, 2008 compared to $13.3 million for the corresponding period in 2007. The decrease in interest expense was due to a decrease in the cost of funds to 3.45% for the six months ended June 30, 2008 from 4.13% for the same period in 2007, partially offset by an increase in the volume of interest-bearing liabilities. The decrease in the cost of funds is primarily attributable to decreases in the average rate paid on interest-bearing deposits. The average rate paid on interest-bearing checking and savings accounts was 1.72% for the six months ended June 30, 2008 as compared to 2.12% for the same period in 2007. The average rate paid on certificates of deposits was 4.05% for the six months ended June 30, 2008 from 4.82% for the same period one year ago.
Provision for Loan Losses. For the three months ended June 30, 2008, a contribution of $681,000 was made to the provision for loan losses compared to $634,000 for the same period one year ago. The increase in provision for loan losses is primarily attributable to a $3.4 million increase in non-performing loans from June 30, 2007 to June 30, 2008 and increased loan growth.
For the six months ended June 30, 2008 a contribution of $1.1 million was made to the provision for loan losses compared to a $957,000 contribution to the provision for loan losses for the six months ended June 30, 2007. The increase in the provision for loan losses is primarily attributable to an increase in non-performing loans and increased loan growth.
Non-Interest Income. Total non-interest income was $2.8 million in the second quarter of 2008 as compared to $2.1 million for the same period of 2007. Increases in components of non-interest income for the three months ended June 30, 2008 compared to the same period last year were primarily attributable to increases in service charges and fees and miscellaneous income. These increases in non-interest income were combined with a $194,000 decrease in the loss on sale of securities in second quarter 2008 when compared to second quarter 2007. Service charges increased 23% to $1.3 million for the three months ended June 30, 2008 when compared to the same period one year ago. Other service charges and fees increased 43% to $639,000 for the three-month period ended June 30, 2008 when compared to the same period one year ago. The increase in service charges and fees is primarily attributable to growth in the Bank’s deposit base coupled with normal pricing changes. Mortgage banking income decreased to $181,000 during the three months ended June 30, 2008 from $188,000 for the same period in 2007. Insurance and brokerage commissions decreased 9% for the three months ended June 30, 2008 when compared to same period last year. Miscellaneous income was $605,000 for the three months ended June 30, 2008, an 11% increase from $544,000 for the same period in 2007. This increase in miscellaneous income is primarily due to an increase in debit card fee income associated with increased card usage due to an increase in the number of demand accounts.
Total non-interest income was $5.4 million for the six months ended June 30, 2008, a 27% increase over the $4.3 million for the same period in 2007. This increase is primarily due to an increase in service charges and fees, mortgage banking income and miscellaneous income. These increases in non-interest income were combined with a $194,000 decrease in the loss on sale of securities for the six months ended June 30, 2008 when compared to the same period last year. Service charges increased 24% to $2.4 million for the six months ended June 30, 2008 when compared to the same period one year ago. Other service charges and fees increased 36% to $1.3 million for the six months ended June 30, 2008 when compared to the same period one year ago. The increase in service charges and fees is primarily attributable to growth in the Bank’s deposit base coupled with normal pricing changes. Mortgage banking income increased 20% to $361,000 for the six months ended June 30, 2008 when compared to the same period in 2007 due to an increase in brokered loan activity. Insurance and brokerage commissions decreased 2% for the six months ended June 30, 2008 when compared to same period last year. Miscellaneous income increased 9% to $1.2 million for the six months ended June 30, 2008. This increase in miscellaneous income was primarily due to an increase in debit card fee income associated with increased card usage due to an increase in the number of demand accounts and a reduction in the losses on repossessed assets.
Non-Interest Expense. Total non-interest expense increased 15% to $7.1 million for the second quarter of 2008 as compared to $6.2 million for the corresponding period in 2007. Salary and employee benefits totaled $3.8 million for the three months ended June 30, 2008, an increase of 16% from the same period in 2007. The increase in salary and employee benefits is due to normal salary increases and expense associated with additional staff for new branches. Occupancy expense decreased 2% for the quarter ended June 30, 2008. Other non-interest expense increased 26% to $2.1 million for the three months ended June 30, 2008 as compared to the same period in 2007. This increase in other non-interest expense is attributable to an increase of $118,000 in FDIC insurance expense, an increase of $118,000 in deposit program expense and an increase of $62,000 in consulting fees.
Total non-interest expense was $14.0 million for the six months ended June 30, 2008, an increase of 15% over the same period in 2007. Salary and employee benefits totaled $7.5 million for the six months ended June 30, 2008, an increase of 13% over the same period in 2007. The increase in salary and employee benefits is primarily due to normal salary increases and expenses associated with additional staff for new branches. Occupancy expense increased 5% for the six months ended June 30, 2008 due to an increase in furniture and equipment expense and lease expense associated with new branches. Other non-interest expense increased 27% to $4.1 million for the six months ended June 30, 2008 as compared to the same period in 2007. This increase in other non-interest expense is primarily attributable to an increase of $228,000 in FDIC insurance expense, an increase of $188,000 in deposit program expense, an increase of $108,000 in advertising expense and an increase of $82,000 in consulting fees.
Income Taxes. The Company reported income taxes of $1.2 million and $1.4 million for the second quarters of 2008 and 2007, respectively. This represented effective tax rates of 35% and 36% for the respective periods.
The Company reported income taxes of $2.3 million and $3.0 million for the six months ended June 30, 2008 and 2007, respectively. This represented an effective tax rate of 35% and 36% for the respective periods.
Analysis of Financial Condition
Investment Securities. Available-for-sale securities amounted to $118.0 million at June 30, 2008 compared to $121.0 million at December 31, 2007. Average investment securities available for sale for the six months ended June 30, 2008 amounted to $117.1 million compared to $120.3 million for the year ended December 31, 2007.
Loans. At June 30, 2008, loans amounted to $756.2 million compared to $722.3 million at December 31, 2007, an increase of $33.9 million. Average loans represented 85% and 83% of total earning assets for the six months ended June 30, 2008 and the year ended December 31, 2007, respectively.
Although the Company has a diversified loan portfolio, a substantial portion of the loan portfolio is collateralized by real estate, which is dependent upon the real estate market. Real estate mortgage loans include both commercial and residential mortgage loans. At June 30, 2008, the Company had $97.2 million in residential mortgage loans, $86.5 million in home equity loans and $264.3 million in commercial mortgage loans, which include $210.1 million using commercial property as collateral and $54.2 million using residential property as collateral. At June 30, 2008, commercial mortgage loans included $125.7 million in speculative construction and development loans.
Residential mortgage loans include $38.6 million made to customers in the Company’s traditional banking offices and $58.6 million in mortgage loans originated in the Company’s Latino banking operations. All residential mortgage loans are originated as fully amortizing loans, with no negative amortization.
Allowance for Loan Losses. The allowance for loan losses reflects management's assessment and estimate of the risks associated with extending credit and its evaluation of the quality of the loan portfolio. The Bank periodically analyzes the loan portfolio in an effort to review asset quality and to establish an allowance for loan losses that management believes will be adequate in light of anticipated risks and loan losses. In assessing the adequacy of the allowance, size, quality and risk of loans in the portfolio are reviewed. Other factors considered are:
| · | the Bank’s loan loss experience; |
| · | the amount of past due and non-performing loans; |
| · | the status and amount of other past due and non-performing assets; |
| · | underlying estimated values of collateral securing loans; |
| · | current and anticipated economic conditions; and |
| · | other factors which management believes affect the allowance for potential credit losses. |
Management uses several measures to assess and monitor the credit risks in the loan portfolio, including a loan grading system that begins upon loan origination and continues until the loan is collected or collectibility becomes doubtful. Upon loan origination, the Bank’s originating loan officer evaluates the quality of the loan and assigns one of nine risk grades, each grade indicating a different level of loss reserves. The loan officer monitors the loan’s performance and credit quality and makes changes to the credit grade as conditions warrant. When originated or renewed, all loans over a certain dollar amount receive in-depth reviews and risk assessments by the Bank’s Credit Administration. Before making any changes in these risk grades, management considers assessments as determined by the third party credit review firm (as described below), regulatory examiners and the Bank’s Credit Administration. Any issues regarding the risk assessments are addressed by the Bank’s senior credit administrators and factored into management’s decision to originate or renew the loan. The Bank’s Board of Directors reviews, on a monthly basis, an analysis of the Bank’s reserves relative to the range of reserves estimated by the Bank’s Credit Administration.
As an additional measure, the Bank engages an independent third party to review the underwriting, documentation and risk grading analyses. This independent third party reviews and evaluates all loan relationships greater than $1.0 million. The third party’s evaluation and report is shared with management and the Bank’s Board of Directors.
Management considers certain commercial loans with weak credit risk grades to be individually impaired and measures such impairment based upon available cash flows and the value of the collateral. Allowance or reserve levels are estimated for all other graded loans in the portfolio based on their assigned credit risk grade, type of loan and other matters related to credit risk.
Management uses the information developed from the procedures described above in evaluating and grading the loan portfolio. This continual grading process is used to monitor the credit quality of the loan portfolio and to assist management in estimating the allowance for loan losses.
The allowance for loan losses is comprised of three components: specific reserves, general reserves and unallocated reserves. After a loan has been identified as impaired, management measures impairment in accordance with SFAS No. 114, “Accounting By Creditors for Impairment of a Loan.” When the measure of the impaired loan is less than the recorded investment in the loan, the amount of the impairment is recorded as a specific reserve. These specific reserves are determined on an individual loan basis based on management’s current evaluation of the Company’s loss exposure for each credit, given the appraised value of any underlying collateral. Loans for which specific reserves are provided are excluded from the general allowance calculations as described below. At June 30, 2008 and December 31, 2007, the recorded investment in loans that were considered to be impaired under SFAS No. 114 was approximately $8.9 million and $8.0 million, respectively, with related allowance for loan losses of approximately $1.4 million and $1.2 million at June 30, 2008 and December 31, 2007, respectively.
The general allowance reflects reserves established under the provisions of SFAS No. 5, “Accounting for Contingencies” for collective loan impairment. These reserves are based upon historical net charge-offs using the last three years’ experience. This charge-off experience may be adjusted to reflect the effects of current conditions. The Bank considers information derived from its loan risk ratings and external data related to industry and general economic trends.
The unallocated allowance is determined through management’s assessment of probable losses that are in the portfolio but are not adequately captured by the other two components of the allowance, including consideration of current economic and business conditions and regulatory requirements. The unallocated allowance also reflects management’s acknowledgement of the imprecision and subjectivity that underlie the modeling of credit risk. Due to the subjectivity involved in determining the overall allowance, including the unallocated portion, this unallocated portion may fluctuate from period to period based on management’s evaluation of the factors affecting the assumptions used in calculating the allowance.
Management considers the allowance for loan losses adequate to cover the estimated losses inherent in the Company’s loan portfolio as of the date of the financial statements. Management believes it has established the allowance in accordance with accounting principles generally accepted in the United States of America and in consideration of the current economic environment. Although management uses the best information available to make evaluations, significant future additions to the allowance may be necessary based on changes in economic and other conditions, thus adversely affecting the operating results of the Company.
There were no significant changes in the estimation methods or fundamental assumptions used in the evaluation of the allowance for loan losses for the six months ended June 30, 2008 as compared to the year ended December 31, 2007. Such revisions, estimates and assumptions are made in any period in which the supporting factors indicate that loss levels may vary from the previous estimates.
Additionally, various regulatory agencies, as an integral part of their examination process, periodically review the Bank’s allowances for loan losses. Such agencies may require adjustments to the allowances based on their judgments of information available to them at the time of their examinations.
The allowance for loan losses at June 30, 2008 amounted to $9.6 million or 1.27% of total loans compared to $9.1 million or 1.26% of total loans at December 31, 2007.
The following table presents the percentage of loans assigned to each risk grade at June 30, 2008 and December 31, 2007.
| LOAN RISK GRADE ANALYSIS: | | | |
| | | | Percentage of Loans |
| | | | By Risk Grade* |
| Risk Grade | | | 06/30/2008 | 12/31/2007 |
| Risk 1 (Excellent Quality) | | 9.91% | 11.06% |
| Risk 2 (High Quality) | | | 13.38% | 14.06% |
| Risk 3 (Good Quality) | | | 66.53% | 62.53% |
| Risk 4 (Management Attention) | | 7.17% | 9.51% |
| Risk 5 (Watch) | | | 1.29% | 1.57% |
| Risk 6 (Substandard) | | | 0.42% | 0.13% |
| Risk 7 (Low Substandard) | | 0.00% | 0.03% |
| Risk 8 (Doubtful) | | | 0.00% | 0.00% |
| Risk 9 (Loss) | | | 0.00% | 0.00% |
| | | | | |
| * Excludes non-accrual loans | | | |
At June 30, 2008 there were two relationships exceeding $1.0 million (which totaled $5.6 million) in the Watch risk grade, one relationship exceeding $1.0 million (which totaled $1.9 million) in the Substandard risk grade and no relationships exceeding $1.0 million in the Low Substandard risk grade. These customers continue to meet payment requirements and these relationships would not become non-performing assets unless they are unable to meet those requirements.
Non-performing Assets. Non-performing assets totaled $11.3 million at June 30, 2008 or 1.20% of total assets, compared to $8.5 million at December 31, 2007, or 0.93% of total assets. Non-accrual loans were $9.8 million at June 30, 2008 and $8.0 million at December 31, 2007. As a percentage of total loans outstanding, non-accrual loans were 1.30% at June 30, 2008 compared to 1.11% at December 31, 2007. The increase in non-accrual loans is primarily due to one relationship of $1.8 million with a local residential builder and a rental property loan of approximately $854,000. The Bank had loans 90 days past due and still accruing at June 30, 2008 of $413,000. At December 31, 2007, the Bank had no loans 90 days past due and still accruing. Other real estate owned totaled $1.1 million as of June 30, 2008 as compared to $483,000 at December 31, 2007. At June 30, 2008, other real estate owned included ten residential properties acquired thorough foreclosure totaling $938,000, as compared to three residential properties acquired through foreclosure, totaling $230,000 at December 31, 2007. The Bank had no repossessed assets as of June 30, 2008 and December 31, 2007.
Total non-performing loans, which include non-accrual loans and loans 90 days past due and still accruing, were $10.2 million and $8.0 million at June 30, 2008 and December 31, 2007, respectively. The ratio of non-performing loans to total loans was 1.35% at June 30, 2008, as compared to 1.11% at December 31, 2007.
Deposits. Total deposits at June 30, 2008 were $722.6 million, an increase of $29.0 million over deposits of $693.6 million at December 31, 2007. Core deposits, which include non-interest bearing demand deposits, NOW, MMDA, savings and non-brokered certificates of deposits of denominations less than $100,000, increased $4.0 million to $494.1 million at June 30, 2008 as compared to $490.1 million at December 31, 2007. The Bank introduced remote deposit capture for customers in 2007 which has enabled the Bank to gather additional deposits from several existing customers and has been helpful in attracting new customers. Certificates of deposit in amounts greater than $100,000 or more totaled $223.5 million at June 30, 2008 as compared to $203.5 million at December 31, 2007. At June 30, 2008, brokered deposits amounted to $55.9 million as compared to $53.9 million at December 31, 2007. Brokered deposits outstanding as of June 30, 2008 had a weighted average rate of 3.77% with a weighted average original term of eight months.
Borrowed Funds. Borrowings from the FHLB totaled $87.0 million at June 30, 2008 compared to $87.5 million at December 31, 2007. The average balance of FHLB borrowings for the six months ended June 30, 2008 was $80.2 million compared to $80.1 million for the year ended December 31, 2007. At June 30, 2008, $77.0 million of the Bank’s FHLB borrowings had maturities exceeding one year. The FHLB has the option to convert $72.0 million of the total advances to a floating rate and, if converted, the Bank may repay advances without a prepayment fee. The Company also has an additional $5.0 million in variable rate convertible advances, which may be repaid without a prepayment fee if converted by the FHLB. The Company had no federal funds purchased as of June 30, 2008 or December 31, 2007.
Securities sold under agreements to repurchase were $27.6 million at June 30, 2008 and December 31, 2007.
Junior Subordinated Debentures (related to Trust Preferred Securities). In June 2006 the Company formed a wholly owned Delaware statutory trust, PEBK Capital Trust II (“PEBK Trust II”), which issued $20.0 million of guaranteed preferred beneficial interests in the Company’s junior subordinated deferrable interest debentures. All of the common securities of PEBK Trust II are owned by the Company. The proceeds from the issuance of the common securities and the trust preferred securities were used by PEBK Trust II to purchase $20.6 million of junior subordinated debentures of the Company, which pay a floating rate equal to three-month LIBOR plus 163 basis points. The proceeds received by the Company from the sale of the junior subordinated debentures were used to repay in December 2006 the trust preferred securities issued by PEBK Capital Trust I in December 2001 and for general purposes. The debentures represent the sole asset of PEBK Trust II. PEBK Trust II is not included in the consolidated financial statements.
The trust preferred securities issued by PEBK Trust II accrue and pay quarterly at a floating rate of three-month LIBOR plus 163 basis points. The Company has guaranteed distributions and other payments due on the trust preferred securities to the extent PEBK Trust II has funds with which to make the distributions and other payments. The net combined effect of the trust preferred securities transaction is that the Company is obligated to make the distributions and other payments required on the trust preferred securities.
These trust preferred securities are mandatorily redeemable upon maturity of the debentures on June 28, 2036, or upon earlier redemption as provided in the indenture. The Company has the right to redeem the debentures purchased by PEBK Trust II, in whole or in part, on or after June 28, 2011. As specified in the indenture, if the debentures are redeemed prior to maturity, the redemption price will be the principal amount and any accrued but unpaid interest.
Asset Liability and Interest Rate Risk Management. The objective of the Company’s Asset Liability and Interest Rate Risk strategies is to identify and manage the sensitivity of net interest income to changing interest rates and to minimize the interest rate risk between interest-earning assets and interest-bearing liabilities at various maturities. This is to be done in conjunction with the need to maintain adequate liquidity and the overall goal of maximizing net interest income.
The Company manages its exposure to fluctuations in interest rates through policies established by the Asset/Liability Committee (“ALCO”) of the Bank. The ALCO meets monthly and has the responsibility for approving asset/liability management policies, formulating and implementing strategies to improve balance sheet positioning and/or earnings and reviewing the interest rate sensitivity of the Company. ALCO tries to minimize interest rate risk between interest-earning assets and interest-bearing liabilities by attempting to minimize wide fluctuations in net interest income due to interest rate movements. The ability to control these fluctuations has a direct impact on the profitability of the Company. Management monitors this activity on a regular basis through analysis of its portfolios to determine the difference between rate sensitive assets and rate sensitive liabilities.
The Company’s rate sensitive assets are those earning interest at variable rates and those with contractual maturities within one year. Rate sensitive assets therefore include both loans and available-for-sale securities. Rate sensitive liabilities include interest-bearing checking accounts, money market deposit accounts, savings accounts, time deposits and borrowed funds. The Company’s balance sheet is asset-sensitive, meaning that in a given period there will be more assets than liabilities subject to immediate repricing as interest rates change in the market. Because the majority of the Company’s loans are tied to the prime rate, they reprice more rapidly than rate sensitive interest-bearing deposits. During periods of rising rates, this results in increased net interest income. The opposite occurs during periods of declining rates. Average rate sensitive assets for the three months ended June 30, 2008 totaled $857.0 million, exceeding average rate sensitive liabilities of $721.9 million by $135.1million.
In order to assist in achieving a desired level of interest rate sensitivity, the Company entered into off-balance sheet contracts that are considered derivative financial instruments. As of June 30, 2008, the Company had cash flow hedges with a notional amount of $235.0 million. These derivative instruments consist of five interest rate floor contracts and one interest rate swap contract. The interest rate floor contracts are used to hedge future cash flows from payments on the first $185.0 million of certain variable rate loans against the downward effects of their repricing in the event of a decreasing rate environment during the terms of the interest rate floor contracts. If the prime rate falls below the contract rate during the term of the contract, the Company will receive payments based on notional amount times the difference between the contract rate and the weighted average prime rate for the quarter. No payments will be received by the Company if the weighted average prime rate is equal to or higher than the contract rate. The interest rate swap contract is used to convert $50.0 million of variable rate loans to a fixed rate. Under the swap contract, the Company receives a fixed rate of 6.245% and pays a variable rate based on the current prime rate (5.00% at June 30, 2008) on the notional amount of $50.0 million. The swap agreement matures in June 2011. The Company recognized $1.3 million in interest income, net of premium amortization, from interest rate derivative contracts during the first six months of 2008. Based on the current interest rate environment, it is expected the Company will continue to receive income on these interest rate contracts throughout 2008. The following tables present additional information on the Company’s derivative financial instruments.
| DERIVATIVE INSTRUMENTS AS OF JUNE 30, 2008 | | | | | | |
| (Dollars in Thousands) | | | | | | | |
| | | | | | | | |
| Type of Derivative | Notional Amount | | Contract Rate | | Premium | | Year-to-date Income (Net of Premium Amortization) |
| Interest rate floor contact | $ | 35,000 | | | 6.250% | | $ | 161 | | $ | 127 |
| Interest rate floor contact | | 35,000 | | | 7.000% | | | 203 | | | 200 |
| Interest rate floor contact | | 45,000 | | | 7.500% | | | 562 | | | 336 |
| Interest rate floor contact | | 35,000 | | | 8.000% | | | 399 | | | 373 |
| Interest rate floor contact | | 35,000 | | | 7.250% | | | 634 | | | 220 |
| Interest rate swap contact | | 50,000 | | | 6.245% | | | - | | | 50 |
| | $ | 235,000 | | | | | $ | 1,959 | | $ | 1,305 |
| FAIR VALUES OF DERIVATIVES DESIGNATED AS HEDGING INSTRUMENTS UNDER SFAS 133 |
| (Dollars in Thousands) |
| | | | | | | | | | | | |
| | Asset Derivatives | | Liability Derivatives |
| | | | As of December 31, | | | | As of December 31, |
| | As of June 30, 2008 | | 2007 | | As of June 30, 2008 | | 2007 |
| | Balance | | | Balance | | | Balance | | | Balance | |
| | Sheet | Fair | | Sheet | Fair | | Sheet | Fair | | Sheet | Fair |
| | Location | Value | | Location | Value | | Location | Value | | Location | Value |
| Interest rate derivative | | | | | | | | | | | |
| contracts | Other assets | $ 2,304 | | Other assets | $1,907 | | N/A | $ - | | N/A | $ - |
Included in the rate sensitive assets are $484.0 million in variable rate loans indexed to prime rate subject to immediate repricing upon changes by the FOMC. The Bank utilizes interest rate floors on certain variable rate loans to protect against further downward movements in the prime rate. At June 30, 2008, the Bank had $93.1 million in loans with interest rate floors. The floors were in effect on $56.5 million of these loans pursuant to the terms of the promissory notes on these loans. The weighted average rate on these loans is 1.18% higher than the indexed rate on the promissory notes without interest rate floors.
The Bank also had $43,000 in loans that are tied to the prime rate that had 6.00% interest rate caps in effect due to the Soldiers and Sailors’ Civil Relief Act.
Liquidity. The objectives of the Company’s liquidity policy are to provide for the availability of adequate funds to meet the needs of loan demand, deposit withdrawals, maturing liabilities and to satisfy regulatory requirements. Both deposit and loan customer cash needs can fluctuate significantly depending upon business cycles, economic conditions and yields and returns available from alternative investment opportunities. In addition, the Company’s liquidity is affected by off-balance sheet commitments to lend in the form of unfunded commitments to extend credit and standby letters of credit. As of June 30, 2008 such unfunded commitments to extend credit were $182.0 million, while commitments in the form of standby letters of credit totaled $3.7 million.
The Company uses several sources to meet its liquidity requirements. The primary source is core deposits, which includes demand deposits, savings accounts and non-brokered certificates of deposits of denominations less than $100,000. The Company considers these to be a stable portion of the Company’s liability mix and the result of on-going consumer and commercial banking relationships. As of June 30, 2008, the Company’s core deposits totaled $494.1 million, or 68% of total deposits.
The other sources of funding for the Company are through large denomination certificates of deposit, including brokered deposits, federal funds purchased and FHLB advances. The Bank is also able to borrow from the Federal Reserve Discount Window on a short-term basis. As of June 30, 2008, the Bank had $10.4 million in securities pledged to the Federal Reserve Discount Window with $9.6 million borrowing availability.
At June 30, 2008, the Bank had a significant amount of deposits in amounts greater than $100,000, including brokered deposits of $50.9 million, which mature over the next eight months. The balance and cost of these deposits are more susceptible to changes in the interest rate environment than other deposits.
The Bank had a line of credit with the FHLB equal to 20% of the Bank’s total assets, with an outstanding balance of $87.0 million at June 30, 2008. The remaining availability at FHLB was $55.1 million at June 30, 2008. The Bank also had the ability to borrow up to $42.0 million for the purchase of overnight federal funds from four correspondent financial institutions as of June 30, 2008.
The liquidity ratio for the Bank, which is defined as net cash, interest bearing deposits with banks, federal funds sold, certain investment securities and certain FHLB advances available under the line of credit, as a percentage of net deposits (adjusted for deposit runoff projections) and short-term liabilities was 24.66% at June 30, 2008 and 28.04% at December 31, 2007. The minimum required liquidity ratio as defined in the Bank’s Asset/Liability and Interest Rate Risk Management Policy is 20%.
Contractual Obligations and Off-Balance Sheet Arrangements. The Company’s contractual obligations and other commitments as of June 30, 2008 and December 31, 2007 are summarized in the table below. The Company’s contractual obligations include the repayment of principal and interest related to FHLB advances and junior subordinated debentures, as well as certain payments under current lease agreements. Other commitments include commitments to extend credit.
Because not all of these commitments to extend credit will be drawn upon, the actual cash requirements are likely to be significantly less than the amounts reported for other commitments below.
| CONTRACTUAL OBLIGATIONS AND OTHER COMMITMENTS: | | | | |
| (Dollars in Thousands) | | | | | | |
| | | | | | | |
| | | June 30, 2008 | | | December 31, 2007 | |
| | | | | | | |
| Contractual Cash Obligations | | | | | | |
| Long-term borrowings | | $ | 77,000 | | | | 77,000 | |
| Junior subordinated debentures | | | 20,619 | | | | 20,619 | |
| Operating lease obligations | | | 4,918 | | | | 5,290 | |
| | | | | | | | | |
| Total | | $ | 102,537 | | | | 102,909 | |
| | | | | | | | | |
| Other Commitments | | | | | | | | |
| Commitments to extend credit | | $ | 182,036 | | | | 190,654 | |
| Standby letters of credit and financial guarantees written | | | 3,656 | | | | 3,894 | |
| | | | | | | | | |
| Total | | $ | 185,692 | | | | 194,548 | |
The Company enters into derivative contracts to manage various financial risks. A derivative is a financial instrument that derives its cash flows, and therefore its value, by reference to an underlying instrument, index or referenced interest rate. Derivative contracts are carried at fair value on the consolidated balance sheet with the fair value representing the net present value of expected future cash receipts or payments based on market interest rates as of the balance sheet date. Derivative contracts are written in amounts referred to as notional amounts, which only provide the basis for calculating payments between counterparties and are not a measure of financial risk. Further discussions of derivative instruments are included above in the section entitled “Asset Liability and Interest Rate Risk Management”.
Capital Resources. Shareholders’ equity at June 30, 2008 was $72.2 million compared to $70.1 million at December 31, 2007. At June 30, 2008 and December 31, 2007, unrealized gains (losses), net of taxes, amounted to unrealized gains of $1.9 million and $1.7 million, respectively. Annualized return on average equity for the six months ended June 30, 2008 was 11.38% compared to 16.03% for the year ended December 31, 2007. Total cash dividends paid during the six months ended June 30, 2008 amounted to $1.3 million as compared to total cash dividends of $976,000 paid for the first six months of 2007.
In November 2006, the Company’s Board of Directors authorized the repurchase of up to $2.0 million in common shares of the Company’s outstanding common stock through its existing Stock Repurchase Plan effective through the end of November 2007. During 2007, the Company repurchased $1.9 million, or 100,000 shares, of its common stock under this plan.
In August 2007, the Company’s Board of Directors authorized the repurchase of up to 75,000 common shares of the Company’s outstanding common stock through its existing Stock Repurchase Plan effective through the end of August 2008. The Company has repurchased 75,497 shares, or $1.2 million, of its common stock under this plan as of June 30, 2008. The Board of Directors ratified the purchase of 497 additional shares in March 2008.
In March 2008, the Company’s Board of Directors authorized the repurchase of up to 100,000 common shares of the Company’s outstanding common stock through its existing Stock Repurchase Plan effective through the end of March 2009. The Company has repurchased 15,500 shares, or $199,000, of its common stock under this plan as of June 30, 2008.
Under the regulatory capital guidelines, financial institutions are currently required to maintain a total risk-based capital ratio of 8.0% or greater, with a Tier 1 risk-based capital ratio of 4.0% or greater. Tier 1 capital is generally defined as shareholders' equity and Trust Preferred Securities less all intangible assets and goodwill. Tier 1 capital at June 30, 2008 and December 31, 2007 includes $20.0 million in trust preferred securities. The Company’s Tier 1 capital ratio was 10.92% and 11.03% at June 30, 2008 and December 31, 2007, respectively. Total risk-based capital is defined as Tier 1 capital plus supplementary capital. Supplementary capital, or Tier 2 capital, consists of the Company's allowance for loan losses, not exceeding 1.25% of the Company's risk-weighted assets. Total risk-based capital ratio is therefore defined as the ratio of total capital (Tier 1 capital and Tier 2 capital) to risk-weighted assets. The Company’s total risk-based capital ratio was 12.09% and 12.16% at June 30, 2008 and December 31, 2007, respectively. In addition to the Tier 1 and total risk-based capital requirements, financial institutions are also required to maintain a leverage ratio of Tier 1 capital to total average assets of 4.0% or greater. The Company’s Tier 1 leverage capital ratio was 9.90% and 10.43% at June 30, 2008 and December 31, 2007, respectively.
The Bank’s Tier 1 risk-based capital ratio was 9.77% and 9.80% at June 30, 2008 and December 31, 2007, respectively. The total risk-based capital ratio for the Bank was 10.94% and 10.93% at June 30, 2008 and December 31, 2007, respectively. The Bank’s Tier 1 leverage capital ratio was 8.84% and 9.26% at June 30, 2008 and December 31, 2007, respectively.
A bank is considered to be "well capitalized" if it has a total risk-based capital ratio of 10.0 % or greater, a Tier 1 risk-based capital ratio of 6.0% or greater, and has a leverage ratio of 5.0% or greater. Based upon these guidelines, the Bank was considered to be "well capitalized" at June 30, 2008.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
There have been no material changes in the quantitative and qualitative disclosures about market risks as of June 30, 2008 from that presented in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2007.
Item 4T. Controls and Procedures
The Company’s management, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company’s disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the period covered by this report. Based on such evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, the Company’s disclosure controls and procedures are effective in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act.
There have not been any changes in the Company’s internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fiscal quarter to which this report relates that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
