UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q/A
Amendment #1
(Mark One)
| T | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES AND EXCHANGE ACT OF 1934 |
For the quarterly period ended September 30, 2007
OR
| £ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES AND EXCHANGE ACT OF 1934 |
For the transition period from ____________________ to _____________________.
COMMISSION FILE NO. 000-49747
FIRST SECURITY GROUP, INC.
(Exact Name of Registrant as Specified in its Charter)
| Tennessee | 58-2461486 |
| (State of Incorporation) | (I.R.S. Employer Identification No.) |
| 531 Broad Street, Chattanooga, TN | 37402 |
| (Address of principal executive offices) | (Zip Code) |
| (423) 266-2000 |
| (Registrant’s telephone number, including area code) |
| Not Applicable |
| (Former name, former address, and former fiscal year, if changed since last report) |
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities and 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 T 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.
Large accelerated filer £ Accelerated filer T 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 T
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:
Common Stock, $0.01 par value:
16,998,428 shares outstanding and issued as of November 8, 2007
EXPLANATORY NOTE
As described in a Current Report on Form 8-K filed December 18, 2007 and as discussed in Note 2 of the consolidated financial statements included herein, First Security Group, Inc. (First Security) is filing this amendment to its Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2007 (Form 10-Q) to amend and restate its financial statements and other financial information for the period ended September 30, 2007 as a result of First Security’s decision to reverse its utilization of Statement of Financial Accounting Standards No. 159, The Fair Value Option for Financial Assets and Liabilities, with respect to certain investment securities.
The Form 10-Q as amended hereby continues to speak as of November 9, 2007, the date of the originally filed Form 10-Q, and the disclosures included in the Form 10-Q as amended hereby have not been updated to speak as of any later date. Information not affected by the restatement of financial statements or information as of and for the period ended September 30, 2007 is unchanged and reflects the disclosures made at the time of filing the original Form 10-Q.
For convenience, the entire Quarterly Report of Form 10-Q for the quarterly period ended September 30, 2007 has been re-filed in this Form 10-Q/A. Pursuant to SEC Rule 12b-15, in connection with this filing, First Security is filing updated exhibits 31.1, 31.2, 32.1 and 32.2.
First Security Group, Inc. and Subsidiary
Form 10-Q/A
INDEX
| PART I. | FINANCIAL INFORMATION | Page No. | |
| Item 1. | |||
| 1 | |||
| 3 | |||
| 4 | |||
| 5 | |||
| 7 | |||
| Item 2. | 20 | ||
| Item 3. | 47 | ||
| Item 4. | 48 | ||
| PART II. | OTHER INFORMATION | ||
| Item 1A. | 49 | ||
| Item 2. | 49 | ||
| Item 6. | 50 | ||
| 51 | |||
PART I - FINANCIAL INFORMATION
ITEM 1. Financial Statements
First Security Group, Inc. and Subsidiary
Consolidated Balance Sheets
September 30, | December 31, | September 30, | ||||||||||
2007 | 2006 | 2006 | ||||||||||
| (in thousands) | (unaudited) | (unaudited) | ||||||||||
ASSETS | ||||||||||||
| Cash and Due from Banks | $ | 32,088 | $ | 26,512 | $ | 25,500 | ||||||
| Federal Funds Sold and Securities Purchased under Agreements to Resell | - | 1,600 | - | |||||||||
| Cash and Cash Equivalents | 32,088 | 28,112 | 25,500 | |||||||||
| Interest Bearing Deposits in Banks | 779 | 481 | 2,888 | |||||||||
| Securities Available-for-Sale | 126,927 | 153,759 | 159,727 | |||||||||
| Loans Held for Sale | 5,412 | 7,524 | 5,125 | |||||||||
| Loans | 934,613 | 840,069 | 820,620 | |||||||||
| Total Loans | 940,025 | 847,593 | 825,745 | |||||||||
| Less: Allowance for Loan and Lease Losses | 10,635 | 9,970 | 9,862 | |||||||||
| 929,390 | 837,623 | 815,883 | ||||||||||
| Premises and Equipment, net | 35,360 | 35,835 | 33,939 | |||||||||
| Goodwill | 27,156 | 27,156 | 27,156 | |||||||||
| Intangible Assets | 3,423 | 4,185 | 4,441 | |||||||||
| Other Assets | 43,342 | 42,652 | 40,531 | |||||||||
TOTAL ASSETS | $ | 1,198,465 | $ | 1,129,803 | $ | 1,110,065 | ||||||
(See Accompanying Notes to Consolidated Financial Statements)
First Security Group, Inc. and Subsidiary
Consolidated Balance Sheets
September 30, | December 31, | September 30, | ||||||||||
2007 | 2006 | 2006 | ||||||||||
| (in thousands, except share data) | (unaudited) | (unaudited) | ||||||||||
LIABILITIES AND STOCKHOLDERS’ EQUITY | ||||||||||||
LIABILITIES | ||||||||||||
| Deposits | ||||||||||||
| Noninterest Bearing Demand | $ | 164,880 | $ | 168,654 | $ | 176,544 | ||||||
| Interest Bearing Demand | 60,448 | 66,787 | 66,541 | |||||||||
| 225,328 | 235,441 | 243,085 | ||||||||||
| Savings and Money Market Accounts | 140,448 | 135,784 | 137,859 | |||||||||
| Time Deposits: | ||||||||||||
| Certificates of Deposit of $100 thousand or more | 223,744 | 205,428 | 193,758 | |||||||||
| Certificates of Deposit less than $100 thousand | 268,347 | 258,456 | 251,939 | |||||||||
| Brokered Certificates of Deposit | 83,121 | 86,892 | 86,944 | |||||||||
| 575,212 | 550,776 | 532,641 | ||||||||||
| Total Deposits | 940,988 | 922,001 | 913,585 | |||||||||
| Federal Funds Purchased and Securities Sold under Agreements to Repurchase | 31,702 | 20,851 | 30,377 | |||||||||
| Security Deposits | 3,059 | 3,920 | 4,170 | |||||||||
| Other Borrowings | 58,052 | 24,838 | 8,141 | |||||||||
| Other Liabilities | 16,346 | 13,405 | 12,248 | |||||||||
| Total Liabilities | 1,050,147 | 985,015 | 968,521 | |||||||||
STOCKHOLDERS’ EQUITY | ||||||||||||
| Common stock - $.01 par value - 50,000,000 shares authorized; 17,274,728 issued as of September 30, 2007; 17,762,278 issued as of December 31, 2006; 17,746,278 issued as of September 30, 2006 | 120 | 123 | 123 | |||||||||
| Paid-In Surplus | 119,466 | 124,293 | 124,097 | |||||||||
| Unallocated ESOP Shares | (4,515 | ) | (5,094 | ) | (5,562 | ) | ||||||
| Retained Earnings | 32,027 | 26,337 | 24,264 | |||||||||
| Accumulated Other Comprehensive Gain (Loss) | 1,220 | (871 | ) | (1,378 | ) | |||||||
| Total Stockholders’ Equity | 148,318 | 144,788 | 141,544 | |||||||||
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY | $ | 1,198,465 | $ | 1,129,803 | $ | 1,110,065 | ||||||
(See Accompanying Notes to Consolidated Financial Statements)
First Security Group, Inc. and Subsidiary
Consolidated Income Statements
(unaudited)
Three Months Ended | Nine Months Ended | |||||||||||||||
September 30, | September 30, | |||||||||||||||
| (in thousands, except per share data) | 2007 | 2006 | 2007 | 2006 | ||||||||||||
INTEREST INCOME | (Restated) | |||||||||||||||
| Loans, including fees | $ | 20,086 | $ | 17,611 | $ | 57,551 | $ | 50,002 | ||||||||
| Debt Securities – taxable | 1,027 | 1,330 | 3,397 | 3,920 | ||||||||||||
| Debt Securities – non-taxable | 403 | 397 | 1,218 | 1,166 | ||||||||||||
| Other | 44 | 46 | 102 | 258 | ||||||||||||
| Total Interest Income | 21,560 | 19,384 | 62,268 | 55,346 | ||||||||||||
INTEREST EXPENSE | ||||||||||||||||
| Interest Bearing Demand Deposits | 158 | 142 | 415 | 464 | ||||||||||||
| Savings Deposits and Money Market Accounts | 814 | 759 | 2,363 | 2,111 | ||||||||||||
| Certificates of Deposit of $100 thousand or more | 2,905 | 2,276 | 8,286 | 5,870 | ||||||||||||
| Certificates of Deposit of less than $100 thousand | 3,359 | 2,742 | 9,765 | 7,378 | ||||||||||||
| Brokered Certificates of Deposit | 961 | 936 | 2,796 | 2,690 | ||||||||||||
| Other | 837 | 373 | 2,022 | 743 | ||||||||||||
| Total Interest Expense | 9,034 | 7,228 | 25,647 | 19,256 | ||||||||||||
NET INTEREST INCOME | 12,526 | 12,156 | 36,621 | 36,090 | ||||||||||||
| Provision for Loan and Lease Losses | 576 | 600 | 1,409 | 1,743 | ||||||||||||
NET INTEREST INCOME AFTER PROVISION FOR LOAN AND LEASE LOSSES | 11,950 | 11,556 | 35,212 | 34,347 | ||||||||||||
NONINTEREST INCOME | ||||||||||||||||
| Service Charges on Deposit Accounts | 1,371 | 1,229 | 3,812 | 3,594 | ||||||||||||
| Loss on Sale of Available-for-Sale Securities | - | - | (168 | ) | - | |||||||||||
| Other-than-Temporary Impairment of Securities | - | - | (584 | ) | - | |||||||||||
| Other | 1,723 | 1,547 | 4,902 | 4,284 | ||||||||||||
| Total Noninterest Income | 3,094 | 2,776 | 7,962 | 7,878 | ||||||||||||
NONINTEREST EXPENSES | ||||||||||||||||
| Salaries and Employee Benefits | 5,930 | 5,654 | 17,575 | 16,769 | ||||||||||||
| Expense on Premises and Fixed Assets, net of rental income | 1,769 | 1,655 | 5,095 | 5,045 | ||||||||||||
| Other | 2,857 | 2,722 | 8,297 | 8,332 | ||||||||||||
| Total Noninterest Expenses | 10,556 | 10,031 | 30,967 | 30,146 | ||||||||||||
INCOME BEFORE INCOME TAX PROVISION | 4,488 | 4,301 | 12,207 | 12,079 | ||||||||||||
| Income Tax Provision | 1,466 | 1,395 | 3,943 | 3,883 | ||||||||||||
NET INCOME | $ | 3,022 | $ | 2,906 | $ | 8,264 | $ | 8,196 | ||||||||
NET INCOME PER SHARE: | ||||||||||||||||
| Net Income Per Share - Basic | $ | 0.18 | $ | 0.17 | $ | 0.48 | $ | 0.47 | ||||||||
| Net Income Per Share - Diluted | $ | 0.18 | $ | 0.16 | $ | 0.47 | $ | 0.46 | ||||||||
| Dividends Declared Per Common Share | $ | 0.05 | $ | 0.03 | $ | 0.15 | $ | 0.08 | ||||||||
(See Accompanying Notes to Consolidated Financial Statements)
First Security Group, Inc. and Subsidiary
Consolidated Statement of Stockholders’ Equity
(Restated)
Common Stock | Paid-In | Retained | Accumulated Other Comprehensive | Unallocated | ||||||||||||||||||||||||
| (in thousands) | Shares | Amount | Surplus | Earnings | Gain (Loss) | ESOP Shares | Total | |||||||||||||||||||||
| Balance - December 31, 2006 | 17,762 | $ | 123 | $ | 124,293 | $ | 26,337 | $ | (871 | ) | $ | (5,094 | ) | $ | 144,788 | |||||||||||||
| Comprehensive income - | ||||||||||||||||||||||||||||
| Net Income (unaudited) | 8,264 | 8,264 | ||||||||||||||||||||||||||
| Change in Net Unrealized Gain: | ||||||||||||||||||||||||||||
| Securities Available-for-Sale, net of tax and reclassification adjustments (unaudited) | 802 | 802 | ||||||||||||||||||||||||||
| Fair value of Derivatives, net of tax (unaudited) | 1,289 | 1,289 | ||||||||||||||||||||||||||
| Total Comprehensive income | 10,355 | |||||||||||||||||||||||||||
| Issuance of Stock (unaudited) | 13 | 96 | 96 | |||||||||||||||||||||||||
| Dividends Paid (unaudited) | (2,574 | ) | (2,574 | ) | ||||||||||||||||||||||||
| Stock-based Compensation (unaudited) | 479 | 479 | ||||||||||||||||||||||||||
| ESOP Allocation (unaudited) | 23 | 579 | 602 | |||||||||||||||||||||||||
| Repurchase and Retirement of Common Stock (500,000 shares) (unaudited) | (500 | ) | (3 | ) | (5,425 | ) | (5,428 | ) | ||||||||||||||||||||
| Balance – September 30, 2007 (unaudited) | 17,275 | $ | 120 | $ | 119,466 | $ | 32,027 | $ | 1,220 | $ | (4,515 | ) | $ | 148,318 | ||||||||||||||
(See Accompanying Notes to Consolidated Financial Statements)
First Security Group, Inc. and Subsidiary
Consolidated Statements of Cash Flow
| (unaudited) | Nine Months Ended | |||||||
September 30, | ||||||||
| (in thousands) | 2007 | 2006 | ||||||
CASH FLOWS FROM OPERATING ACTIVITIES | (Restated) | |||||||
| Net Income | $ | 8,264 | $ | 8,196 | ||||
| Adjustments to Reconcile Net Income to Net Cash Provided by (Used In) Operating Activities - | ||||||||
| Provision for Loan and Lease Losses | 1,409 | 1,743 | ||||||
| Amortization, net | 853 | 1,182 | ||||||
| Stock-Based Compensation | 479 | 338 | ||||||
| ESOP Compensation | 602 | - | ||||||
| Depreciation | 2,012 | 1,856 | ||||||
| Gain on Sale of Premises and Equipment | (56 | ) | (65 | ) | ||||
| Gain on Sale of Other Real Estate and Repossessions, net | (239 | ) | (30 | ) | ||||
| Write-down of Other Real Estate and Repossessions | 297 | 343 | ||||||
| Other-than-Temporary Impairment of Securities | 584 | - | ||||||
| Loss on the Sale of Available-for-Sale Securities | 168 | - | ||||||
| Accretion of Fair Value Adjustment, net | (400 | ) | (680 | ) | ||||
| Accretion of Terminated Cash Flow Swaps | (56 | ) | - | |||||
| Changes in Operating Assets and Liabilities - | ||||||||
| Loans Held for Sale | 2,112 | 881 | ||||||
| Interest Receivable | (475 | ) | (191 | ) | ||||
| Other Assets | 707 | (630 | ) | |||||
| Interest Payable | 1.108 | 2,008 | ||||||
| Other Liabilities | (139 | ) | 555 | |||||
Net Cash Provided by Operating Activities | 17.230 | 15,506 | ||||||
CASH FLOWS FROM INVESTING ACTIVITIES | ||||||||
| Net Change in Interest Bearing Deposits in Banks | (298 | ) | (1,735 | ) | ||||
| Activity in Available-for-Sale Securities | ||||||||
| Maturities, Prepayments, and Calls | 9,315 | 13,186 | ||||||
| Sales | 27,045 | - | ||||||
| Purchases | (9,157 | ) | (16,808 | ) | ||||
| Loan Originations and Principal Collections, net | (98,554 | ) | (82,337 | ) | ||||
| Gain on Termination of Cash Flow Swaps | 2,010 | - | ||||||
| Proceeds from Sale of Premises and Equipment | 328 | 723 | ||||||
| Proceeds from Sales of Other Real Estate and Repossessions | 2,887 | 2,328 | ||||||
| Additions to Premises and Equipment | (1,809 | ) | (4,933 | ) | ||||
| Capital Improvements to Repossessions and Other Real Estate | (178 | ) | (233 | ) | ||||
Net Cash Used in Investing Activities | (68,411 | ) | (89,809 | ) | ||||
CASH FLOWS FROM FINANCING ACTIVITIES | ||||||||
| Net Increase in Deposits | 18,998 | 52,157 | ||||||
| Net Increase in Federal Funds Purchased and Securities Sold Under Agreements to Repurchase | 10,851 | 13,483 | ||||||
| Net Increase (Decrease) of Other Borrowings | 33,214 | (2,009 | ) | |||||
| Proceeds from Exercise of Stock Options | 96 | 255 | ||||||
| Repurchase and Retirement of Common Stock | (5,428 | ) | (917 | ) | ||||
| Purchase of ESOP Shares | - | (5,471 | ) | |||||
| Proceeds from sale of stock to ESOP | - | 1,877 | ||||||
| Dividends Paid on Common Stock | (2,574 | ) | (1,324 | ) | ||||
Net Cash Provided by Financing Activities | 55,157 | 58,051 | ||||||
NET CHANGE IN CASH AND CASH EQUIVALENTS | 3,976 | (16,252 | ) | |||||
CASH AND CASH EQUIVALENTS - beginning of period | 28,112 | 41,752 | ||||||
CASH AND CASH EQUIVALENTS - end of period | $ | 32,088 | $ | 25,500 | ||||
(See Accompanying Notes to Consolidated Financial Statements)
Nine Months Ended | ||||||||
September 30, | ||||||||
| (in thousands) | 2007 | 2006 | ||||||
SUPPLEMENTAL DISCLOSURE OF NONCASH INVESTING AND FINANCING ACTIVITIES | (Restated) | |||||||
| Foreclosed Properties and Repossessions | $ | 2,522 | $ | 3,472 | ||||
| Purchase Accounting Adjustment to Goodwill | $ | - | $ | 84 | ||||
SUPPLEMENTAL SCHEDULE OF CASH FLOWS | ||||||||
| Interest Paid | $ | 26,755 | $ | 17,248 | ||||
| Income Taxes Paid | $ | 2,268 | $ | 4,800 | ||||
(See Accompanying Notes to Consolidated Financial Statements)
FIRST SECURITY GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
NOTE 1 – BASIS OF PRESENTATION
The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all adjustments considered necessary for a fair statement of financial condition and the results of operations have been included. All such adjustments were of a normal recurring nature.
The consolidated financial statements include the accounts of First Security Group, Inc. and its subsidiary, which is wholly-owned. All significant intercompany balances and transactions have been eliminated.
Operating results for the three and nine months ended September 30, 2007 are not necessarily indicative of the results that may be expected for the year ending December 31, 2007 or any other period. These interim financial statements should be read in conjunction with the Company’s latest annual consolidated financial statements and footnotes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2006.
NOTE 2 – RESTATEMENT AND FAIR VALUE MEASUREMENTS
In September 2006, the Financial Accounting Standards Board (FASB) issued FASB Statement No. 157, Fair Value Measurements (SFAS 157), to provide consistency and comparability in determining fair value measurements and to provide for expanded disclosures about fair value measurements. The definition of fair value maintains the exchange price notion in earlier definitions of fair value but focuses on the exit price of the asset or liability. The exit price is the price that would be received to sell the asset or paid to transfer the liability adjusted for certain inherent risks and restrictions. Expanded disclosures are also required about the use of fair value to measure assets and liabilities.
In February 2007, the FASB issued FASB Statement No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, including an amendment to FASB Statement No. 115 (SFAS 159). SFAS 159 provides companies with an option to report selected financial assets and liabilities at fair value. Most of the provisions of this statement apply only to entities that elect the fair value option. However, the amendment to SFAS 115, Accounting for Certain Investments in Debt and Equity Securities, applies to all entities with available-for-sale and trading securities. SFAS 159 establishes presentation and disclosure requirements designed to facilitate comparisons between companies that choose different measurement attributes for similar types of assets and liabilities.
Effective January 1, 2007, the Company elected to early adopt SFAS 157 and SFAS 159. The Company selected the fair value option on approximately $27.1 million of investment securities previously classified as available-for-sale securities as of January 1, 2007. The Company’s selection matched the average balance of the Company’s overnight borrowings from the Federal Home Loan Bank (FHLB) for the month of March 2007.
The adoption resulted in a one-time cumulative after-tax reclassification of $481 thousand from other comprehensive loss to retained earnings. This reclassification had no effect on total capital since both accounts are included in stockholders’ equity section of the consolidated balance sheets.
After consultation with the Office of the Comptroller of the Currency (OCC), FSGBank’s primary federal banking regulator, the Company has decided to reverse its decision to utilize the fair value option under SFAS 159 for the valuation of the previously selected securities. The decision was recommended by management and approved by the Board of Directors, in consultation with First Security’s independent registered public accounting firm. Based on discussions with the OCC, it was determined that the lack of on-going use of the fair value option, as evidenced by the subsequent sales in April 2007, did not meet the intent and spirit of the standard, and thus the election was deemed non-substantive for the Call Report, the required regulatory financial filing used by the OCC.
As reported in the March 31, 2007 Form 10-Q/A, the securities previously reported as trading were reclassified to available-for-sale and an other-than-temporary impairment charge was recognized. This is consistent with the Company’s understanding of the views of the Securities and Exchange Commission (SEC), based on filings of other registrants, and with the views of the OCC based on discussions with the Chief Accountant’s Office of the OCC.
Accordingly, the Company recognized a charge to earnings for other-than-temporary impairment of securities of $584 thousand during the first quarter of 2007. The other-than-temporary impairment charge represented the loss position of the securities as of first quarter March 31, 2007. The factors considered for the securities impairment test included 1) the continuing unrealized loss positions, 2) the change in the intent of the holding period and 3) the sale of the securities after the balance sheet date but prior to the filing of the March 31, 2007 Form 10-Q on May 10, 2007. As the Company had not decided to sell the securities as of the balance sheet date, the first quarter impairment charge included only the loss through the balance sheet date, March 31, 2007. Also as part of the March 31, 2007 Form 10-Q/A restatement, the Company recognized additional premium amortization on the restated available-for-sale securities of approximately $5 thousand as a reduction of interest income and reversed reported trading securities gains of $139 thousand for the first quarter of 2007.
The June 30, 2007 Form 10-Q/A reclassified the mark-to-market loss on trading securities of $168 thousand to a loss on sale of available-for-sale securities. The proceeds from the sales were also reclassified in the Statements of Cash Flows from cash flow from operating activities to cash flow from investing activities based on the original intent of the securities.
The September 30, 2007 Form 10-Q/A restatement includes the changes incorporated in the March 31, 2007 and June 30, 2007 Form 10-Q/A’s. Net income and earnings per share are not affected for the quarter ended September 30, 2007. The effect of the adjustments on a year-to-date basis reduced income before income taxes by $728 thousand, reduced income tax expense by $247 thousand and reduced net income by $481 thousand or $0.03 per share (basic and dilutive) for the nine month period ended September 30, 2007.
As of September 30, 2007, the Company currently has the ability and intent to hold the remaining securities portfolio until maturity. However, should conditions change, unpledged securities may be sold.
The following table provides the previously reported and the restated amounts for the nine months ended September 30, 2007:
For the Nine Months Ended September 30, 2007 | ||||||||
| (in thousands, except per share data) | Previously Reported | Restated | ||||||
Consolidated Income Statements: | ||||||||
| Interest Income: | ||||||||
| Debt Securities – taxable | $ | 3,060 | $ | 3,397 | ||||
| Trading Assets | 342 | - | ||||||
| Total Interest Income | 62,273 | 62,268 | ||||||
| Net Interest Income | 36,626 | 36,621 | ||||||
| Net Interest Income after Provision for Loan Losses | 35,217 | 35,212 | ||||||
| Noninterest Income: | ||||||||
| Loss on Trading Assets, net | (29 | ) | - | |||||
| Loss on Sale of Available-for-Sale Securities | - | (168 | ) | |||||
| Other-than-Temporary Impairment of Securities | - | (584 | ) | |||||
| Total Noninterest Income | 8,685 | 7,962 | ||||||
| Income before Income Tax Provision | 12,935 | 12,207 | ||||||
| Income Tax Provision | 4,190 | 3,943 | ||||||
| Net Income | 8,745 | 8,264 | ||||||
Net Income Per Share: | ||||||||
| Net Income Per Share – Basic | $ | 0.51 | $ | 0.48 | ||||
| Net Income Per Share – Diluted | 0.50 | 0.47 | ||||||
Consolidated Statement of Stockholders’ Equity: | ||||||||
| Net Income | $ | 8,745 | $ | 8,264 | ||||
| Cumulative adjustment for adoption of SFAS 159- Retained Earnings | (481 | ) | - | |||||
| Cumulative adjustment for adoption of SFAS 159- Accumulated Other Comprehensive Loss | 481 | - | ||||||
| Change in Net Unrealized Gain: Securities Available-for-Sale, net of tax and reclassification adjustments | 321 | 802 | ||||||
Consolidated Statements of Cash Flows: | ||||||||
| Cash Flows from Operating Activities: | ||||||||
| Net Income | $ | 8,745 | $ | 8,264 | ||||
| Amortization, net | 848 | 853 | ||||||
| Losses on Trading Assets | 29 | - | ||||||
| Other-than-Temporary Impairment of Securities | - | 584 | ||||||
| Loss on the Sale of Available-for-Sale Securities | - | 168 | ||||||
| Changes in Operating Assets and Liabilities - Other Liabilities | 108 | (139 | ) | |||||
| Cash Flows from Investing Activities: | ||||||||
| Activity in Available-for-Sale Securities – Sales | - | 27,045 | ||||||
| Proceeds from Sales of Trading Assets | 27,045 | - | ||||||
NOTE 3 – COMPREHENSIVE INCOME
In accordance with Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standard (SFAS) No. 130, Reporting Comprehensive Income, the Company is required to report “comprehensive income,” a measure of all changes in equity, not only reflecting net income but certain other changes as well. Comprehensive income for the three and nine month periods ended September 30, 2007 and 2006, respectively, was as follows:
Three Months Ended | Nine Months Ended | |||||||||||||||
September 30, | September 30, | |||||||||||||||
2007 | 2006 | 2007 | 2006 | |||||||||||||
| (in thousands) | ||||||||||||||||
(Restated) | (Restated) | |||||||||||||||
| Net Income | $ | 3,022 | $ | 2,906 | $ | 8,264 | $ | 8,196 | ||||||||
| Other comprehensive income (loss): | ||||||||||||||||
| Available-for-sale securities: | ||||||||||||||||
| Unrealized net gain on securities arising during the period | 2,258 | 2,489 | 464 | 305 | ||||||||||||
| Tax expense related to unrealized net gain | (768 | ) | (846 | ) | (158 | ) | (104 | ) | ||||||||
| Reclassification adjustments for realized loss included in net income | - | - | 752 | - | ||||||||||||
| Tax benefit related to loss realized in net income | - | - | (256 | ) | - | |||||||||||
| Unrealized gain on securities, net of tax | 1,490 | 1,643 | 802 | 201 | ||||||||||||
| Derivative cash flow hedges: | ||||||||||||||||
| Unrealized gain on derivatives arising during the period | 2,277 | - | 2,010 | - | ||||||||||||
| Tax expense related to unrealized gain | (774 | ) | - | (684 | ) | - | ||||||||||
| Reclassification adjustments for realized gain included in net income | (55 | ) | - | (56 | ) | - | ||||||||||
| Tax expense related to gain realized in net income | 19 | - | 19 | - | ||||||||||||
| Unrealized gain on derivatives, net of tax | 1,467 | - | 1,289 | - | ||||||||||||
| Other comprehensive income, net of tax | 2,957 | 1,643 | �� | 2,091 | 201 | |||||||||||
| Comprehensive income, net of tax | $ | 5,979 | $ | 4,549 | $ | 10,355 | $ | 8,397 | ||||||||
NOTE 4 – EARNINGS PER SHARE
The difference in basic and diluted weighted average shares is due to the assumed conversion of outstanding options using the treasury stock method. The computation of basic and diluted earnings per share is as follows:
Three Months Ended | Nine Months Ended | |||||||||||||||
September 30, | September 30, | |||||||||||||||
2007 | 2006 | 2007 | 2006 | |||||||||||||
| (in thousands, except per share data) | ||||||||||||||||
(Restated) | ||||||||||||||||
| Net income | $ | 3,022 | $ | 2,906 | $ | 8,264 | $ | 8,916 | ||||||||
| Denominator: | ||||||||||||||||
| Weighted average common shares outstanding | 16,902 | 17,218 | 17,085 | 17,349 | ||||||||||||
| Equivalent shares issuable upon exercise of stock options | 321 | 411 | 362 | 392 | ||||||||||||
| Diluted shares | 17,223 | 17,629 | 17,447 | 17,741 | ||||||||||||
| Net income per share: | ||||||||||||||||
| Basic | $ | 0.18 | $ | 0.17 | $ | 0.48 | $ | 0.47 | ||||||||
| Diluted | $ | 0.18 | $ | 0.16 | $ | 0.47 | $ | 0.46 | ||||||||
NOTE 5 – STOCK-BASED COMPENSATION
As of September 30, 2007, the Company has two stock-based compensation plans, the 2002 Long-Term Incentive Plan (2002 LTIP) and the 1999 Long-Term Incentive Plan (1999 LTIP). The plans are administered by the Compensation Committee of the Board of Directors (the Committee), which selects persons eligible to receive awards and determines the number of shares and/or options subject to each award, the terms, conditions and other provisions of the award. The plans are described in further detail below.
The 2002 LTIP was approved by the shareholders of the Company at the 2002 annual meeting and subsequently amended by the shareholders of the Company at the 2004 and 2007 annual meetings to increase the number of shares available for issuance under the 2002 LTIP by 480 thousand and 750 thousand shares, respectively. Eligible participants include eligible employees, officers, consultants and directors of the Company or any affiliate. Pursuant to the 2002 LTIP, the total number of shares of stock authorized for awards is 1.5 million, of which not more than 20% may be granted as awards of restricted stock. The exercise price per share of a stock option granted may not be less than the fair market value as of the grant date. The exercise price must be at least 110% of the fair market value at the grant date for options granted to individuals, who at grant date, are 10% owners of the Company’s voting stock (10% owner). Restricted stock may be awarded to participants with terms and conditions determined by the Committee. The term of each award is determined by the Committee, provided that the term of any incentive stock option may not exceed ten years (five years for 10% owners) from its grant date. Each option award vests in approximately equal percentages each year over a period of not less than three years from the date of grant as determined by the Committee subject to accelerated vesting under terms of the 2002 LTIP or as provided in any award agreement.
Participation in the 1999 LTIP is limited to eligible employees. The total number of shares of stock authorized for awards is 936 thousand, of which not more than 10% could be granted as awards of restricted stock. Under the terms of the 1999 LTIP, incentive stock options to purchase shares of the Company’s common stock may not be granted at a price less than the fair market value of the stock as of the date of the grant. Options must be exercised within ten years from the date of grant subject to conditions specified by the 1999 LTIP. Restricted stock could also be awarded by the Committee in accordance with the 1999 LTIP. Each award vests in approximately equal percentages each year over a period of not less than three years (with the exception of five grants for a total of 168 thousand shares which vest in approximately equal percentages at 6 months, 18 months and 30 months) and vest from the date of grant as determined by the Committee subject to accelerated vesting under terms of the 1999 LTIP or as provided in any award agreement.
Stock Options
The following table illustrates the effect on operating results and per share information for stock-based compensation in accordance with SFAS 123 (R) for the three and nine months ended September 30, 2007 and 2006.
Three Months Ended | Nine Months Ended | |||||||||||||||
September 30, | September 30, | |||||||||||||||
2007 | 2006 | 2007 | 2006 | |||||||||||||
| (in thousands, except per share data) | ||||||||||||||||
| Stock option compensation expense | $ | 113 | $ | 98 | $ | 339 | $ | 298 | ||||||||
| Stock option compensation expense, net of tax | $ | 70 | $ | 61 | $ | 210 | $ | 185 | ||||||||
| Impact of stock option expense on basic income per share | $ | - | $ | - | $ | (0.01 | ) | $ | (0.01 | ) | ||||||
| Impact of stock option expense on diluted income per share | $ | - | $ | (0.01 | ) | $ | (0.01 | ) | $ | (0.01 | ) | |||||
The stock options granted to employees under the Company’s long-term incentive plans qualify as incentive stock options as defined by the Internal Revenue Code (IRC) Section 422 (b) and have not resulted in tax deductions to the Company. Stock options granted to directors of the Company under the long-term incentive plans qualify as nonqualified stock options under IRC 422 (b). As of September 30, 2007, the Company has not received tax deductions related to these nonqualified options.
Net cash proceeds received from the exercise of options were $96 thousand and $255 thousand for the nine months ended September 30, 2007 and 2006, respectively.
The Company uses the Black-Scholes option pricing model to estimate fair value of stock-based awards, which uses the assumptions indicated in the table below. Expected volatility is based on the implied volatility of the Company’s stock price. The Company uses historical data to estimate option exercises and employee terminations used in the model. The expected term of options granted is derived using the “simplified” method as permitted under the provisions of the Securities and Exchange Commission’s Staff Accounting Bulletin No. 107 and represents the period of time options granted are expected to be outstanding. The risk-free interest rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the time of grant. The table below provides the assumptions used to determine the fair value of stock option grants during the nine months ended September 30, 2007 and 2006, respectively:
Nine Months Ended September 30, | ||||||||
2007 | 2006 | |||||||
| Expected dividend yield | 1.78 | % | 0.90 | % | ||||
| Expected volatility | 17.79 | % | 17.14 | % | ||||
| Risk-free interest rate | 5.06 | % | 4.94 | % | ||||
| Expected life of options | 6.5 years | 6.5 years | ||||||
| Weighted average grant date fair value | $ | 2.77 | $ | 2.98 | ||||
The weighted average fair value of options granted during the nine months ended September 30, 2007 and 2006 was $2.77 and $2.98, respectively. The total intrinsic value of options exercised during the nine months ended September 30, 2007 and 2006 was $43 thousand and $150 thousand, respectively. At September 30, 2007, there was $838 thousand of unrecognized compensation expense related to share-based payments, which is expected to be recognized over a weighted average period of 1.96 years.
The following table represents stock option activity for the period ended September 30, 2007:
Shares | Weighted- Average Exercise Price | Weighted-Average Remaining Contractual Term | Aggregate Intrinsic Value | ||||||||||
| (in thousands) | (in years) | (in thousands) | |||||||||||
| Outstanding, January 1, 2007 | 1,363 | $ | 8.12 | ||||||||||
| Granted | 40 | 11.26 | |||||||||||
| Exercised | (12 | ) | 7.68 | ||||||||||
| Forfeited | (4 | ) | 9.54 | ||||||||||
| Outstanding, September 30, 2007 | 1,387 | $ | 8.21 | 6.43 | $ | 11,381 | |||||||
| Exercisable, September 30, 2007 | 942 | $ | 7.03 | 5.30 | $ | 6,618 | |||||||
As of September 30, 2007, shares available for future option grants to employees and directors under existing plans were 188 shares and 727 thousand shares for the 1999 LTIP and 2002 LTIP, respectively.
Restricted Stock
The plans described above allow for the issuance of restricted stock awards that may not be sold or otherwise transferred until certain restrictions have lapsed. The unearned stock-based compensation related to these awards is being amortized to compensation expense over the period the restrictions lapse. The share-based expense for these awards was determined based on the market price of the Company’s stock at the grant date applied to the total number of shares that were anticipated to fully vest and then amortized over the vesting period.
As of September 30, 2007, unearned stock-based compensation associated with these awards totaled $188 thousand. The Company recognized $47 thousand and $140 thousand of compensation expense in the third quarter and first nine months of 2007, respectively, related to the amortization of deferred compensation that was included in salaries and benefits in the accompanying consolidated statements of operations. The remaining cost is expected to be recognized over a weighted-average period of 1.96 years.
As of September 30, 2007, the Company had non-vested restricted stock awards outstanding of 43,045 shares at a weighted average grant date fair value of $10.40. Of the total awards outstanding, 25,045 shares allow for the recipients to vest and receive shares of common stock in equal installments on each of the first three anniversaries of the date of grant. The remaining 18,000 shares awarded cliff vest 26 months from the date of grant as provided for in the award agreement. The Company did not grant any restricted stock during the third quarter of 2007.
NOTE 6 – GUARANTEES
The Company, as part of its ongoing business operations, issues financial guarantees in the form of financial and performance standby letters of credit. Standby letters of credit are contingent commitments issued by the Company to guarantee the performance of a customer to a third-party. A financial standby letter of credit is a commitment to guarantee a customer’s repayment of an outstanding loan or debt instrument. In a performance standby letter of credit, the Company guarantees a customer’s performance under a contractual nonfinancial obligation for which it receives a fee. The maximum potential amount of future payments the Company could be required to make under its stand-by letters of credit at September 30, 2007, December 31, 2006, and September 30, 2006 was $16.9 million, $16.0 million, and $14.9 million, respectively. The Company’s outstanding standby letters of credit generally have a term of one year and some may have renewal options. The amount of collateral, if any, we obtain on an extension of credit is based on our credit evaluation of the customer. Collateral held varies but may include accounts receivable, inventory, property and equipment and income-producing commercial properties.
NOTE 7 – STOCKHOLDERS' EQUITY
During 2007, the Board of Directors has declared the following dividends:
Declaration Date | Dividend Per Share | Date of Record | Total Amount | Payment Date | ||||||
| (in thousands) | ||||||||||
| January 24, 2007 | $ | 0.05 | March 1, 2007 | $ | 864 | March 16, 2007 | ||||
| April 24, 2007 | $ | 0.05 | June 1, 2007 | $ | 866 | June 18, 2007 | ||||
| July 25, 2007 | $ | 0.05 | September 3, 2007 | $ | 863 | September 17, 2007 | ||||
| October 24, 2007 | $ | 0.05 | December 3, 2007 | $ | 844 | * | December 17, 2007 | |||
* Estimate based on shares as of September 30, 2007
On November 29, 2006, the Board of Directors authorized the Company to repurchase up to 500 thousand shares in open market transactions. The Company began the program during the first quarter. On August 17, 2007, the Company had completed the repurchase plan at a weighted average price of $10.86 per share.
On August 22, 2007, the Board of Directors authorized the Company to repurchase up to an additional 500 thousand shares in open market transactions. As of September 30, 2007, the Company had not completed any purchases.
On September 30, 2007, the Company released shares from the Employee Stock Ownership Plan (ESOP) for the quarterly matching contribution of 100% of the employee’s contribution up to 6% of the employee’s compensation for the Plan year. The number of unallocated, committed to be released, and allocated shares for the ESOP are as follows:
Unallocated Shares | Committed to be Released Shares | Allocated Shares | ||||||||||
| Shares as of December 31, 2006 | 452,453 | - | 47,547 | |||||||||
| Shares allocated for match through September 30, 2007 | (56,008 | ) | - | 56,008 | ||||||||
| Shares as of September 30, 2007 | 396,445 | - | 103,555 | |||||||||
NOTE 8 – TAXES
In July 2006, the Financial Accounting Standards Board issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109, Accounting for Income Taxes (FIN 48). The Interpretation provides guidance for recognition and measurement of uncertain tax positions that are “more likely than not” of being sustained upon audit, based on the technical merits of the position. FIN 48 also provides guidance on measurement, derecognition, classification, interest and penalties, and disclosure requirements. The Company adopted FIN 48 as of January 1, 2007 as FIN 48 is effective for the year ended December 31, 2007.
The Company evaluated its material tax positions as of September 30, 2007. Under the “more-likely-than-not” threshold guidelines, the Company believes no significant uncertain tax positions exist, either individually or in the aggregate, that would give rise to the non-recognition of an existing tax benefit. The Company will evaluate, on a quarterly basis or sooner if necessary, to determine if new or pre-existing uncertain tax positions are significant. In the event a significant adverse tax position is determined to exist, penalty and interest will be accrued, in accordance with Internal Revenue Service guidelines, and recorded as a component of other expenses in the Company’s consolidated income statements.
As of September 30, 2007, there were no penalties and interest recognized in the consolidated income statement as a result of FIN 48, nor does the Company anticipate a change in its material tax positions that would give rise to the non-recognition of an existing tax benefit during the remainder of 2007. However, changes in state and federal tax regulations could create a material uncertain tax position.
NOTE 9 – FAIR VALUE MEASUREMENTS
Effective January 1, 2007, the Company early adopted Statement of Financial Accounting Standard 157, Fair Value Measurements (SFAS 157), and Statement of Financial Accounting Standard 159, The Fair Value Option for Financial Assets and Financial Liabilities (SFAS 159). The statements require disclosures about the Company’s assets and liabilities, if applicable, that are measured at fair value. Further information about such assets is presented below.
In September 2006, the FASB issued SFAS 157, which defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. The following tables present information about the Company’s assets and liabilities measured at fair value on a recurring basis as of September 30, 2007, and indicates the fair value hierarchy of the valuation techniques utilized by the Company to determine such fair value. In general, fair values determined by Level 1 inputs utilize quoted prices (unadjusted) in active markets for identical assets or liabilities that the Company has the ability to access. Fair values determined by Level 2 inputs utilize inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. Level 2 inputs include quoted prices for similar assets or liabilities in active markets, and inputs other than quoted prices that are observable for the asset or liability, such as interest rates and yield curves that are observable at commonly quoted intervals. Level 3 inputs are unobservable inputs for the asset or liability, and include situations where there is little, if any, market activity for the asset or liability. In certain cases, the inputs used to measure fair value may fall into different levels of the hierarchy. In such cases, the fair value is determined based on the lowest level input that is significant to the fair value measurement in its entirety.
Assets and Liabilities Measured at Fair Value on a Recurring Basis as of September 30, 2007
| (in thousands) | Balance as of September 30, 2007 | Quoted Prices in Active Markets for Identical Assets (Level 1) | Significant Other Observable Inputs (Level 2) | Significant Unobservable Inputs (Level 3) | ||||||||||||
| Financial Assets | ||||||||||||||||
| Securities Available-for-Sale | $ | 126,927 | $ | - | $ | 126,677 | $ | 250 | ||||||||
| Financial Liabilities | ||||||||||||||||
| FHLB overnight borrowings | 52,590 | - | 52,590 | - | ||||||||||||
The following table presents additional information about assets and liabilities measured at fair value on a recurring basis and for which the Company has utilized Level 3 inputs to determine fair value:
Changes in Level 3 Assets and Liabilities Measured at Fair Value on a Recurring Basis
| (in thousands) | Beginning Balance | Total Realized and Unrealized Gains or Losses | Purchases, Sales, Other Settlements and Issuances, net | Net Transfers In and/or Out of Level 3 | Ending Balance | |||||||||||||||
| Financial Assets | ||||||||||||||||||||
| Securities Available-for-Sale | $ | 250 | $ | - | $ | - | $ | - | $ | 250 | ||||||||||
The Company did not recognize any unrealized gains or losses on Level 3 fair value assets or liabilities.
At September 30, 2007, the Company also had assets and liabilities measured at fair value on a non-recurring basis. Items measured at fair value on a non-recurring basis relate to assets and liabilities acquired in prior business combinations, including loans, goodwill, core deposit intangible assets, and time deposits. Such measurements were determined utilizing Level 3 inputs.
NOTE 10 – FAIR VALUE OPTION
In February 2007, the FASB issued SFAS 159, which provides a fair value option election that allows companies to irrevocably elect fair value as the initial and subsequent measurement attribute for certain financial assets and liabilities, with changes in fair value recognized in earnings as they occur. SFAS 159 permits the fair value option election on an instrument by instrument basis at initial recognition of an asset or liability or upon an event that gives rise to a new basis of accounting for that instrument. Effective January 1, 2007, the Company elected early adoption of SFAS 159.
The Company has not elected to apply the fair value option to financial assets or liabilities as of September 30, 2007. Note 2 provides further information.
NOTE 11 – DERIVATIVE FINANCIAL INSTRUMENTS
The Company records all derivative financial instruments at fair value in the financial statements. It is the policy of the Company to enter into various derivatives both as a risk management tool and in a dealer capacity to facilitate client transactions. Derivatives are used as a risk management tool to hedge the exposure to changes in interest rates or other identified market risks. As of September 30, 2007, the Company has not entered into a transaction in a dealer capacity.
When a derivative is intended to be a qualifying hedged instrument, the Company prepares written hedge documentation that designates the derivative as 1) a hedge of the fair value of a recognized asset or liability or of an unrecognized firm commitment (fair value hedge) or 2) a hedge of a forecasted transaction, such as, the variability of cash flows to be received or paid related to a recognized asset or liability (cash flow hedge).
The written documentation includes identification of, among other items, the risk management objective, hedging instrument, hedged item, and methodologies for assessing and measuring hedge effectiveness and ineffectiveness, along with support for management’s assertion that the hedge will be highly effective. Methodologies related to hedge effectiveness and ineffectiveness include 1) statistical regression analysis of changes in the cash flows of the actual derivative and a perfectly effective hypothetical derivative, 2) statistical regression analysis of changes in fair values of the actual derivative and the hedged item and 3) comparison of the critical terms of the hedged item and the hedging derivative. Changes in fair value of a derivative that is highly effective and that has been designated and qualifies as a fair value hedge are recorded in current period earnings, along with the changes in the fair value of the hedged asset or liability that are attributable to the hedged risk. Changes in the fair value of a derivative that is highly effective and that has been designed and qualifies as a cash flow hedge are initially recorded in other comprehensive income and reclassified to earnings in conjunction with the recognition of the earnings impacts of the hedged item; any ineffective portion is recorded in current period earnings. Designated hedge transactions are reviewed at least quarterly for ongoing effectiveness. Transactions that are no longer deemed to be effective are removed from hedge accounting classification and the recorded impacts of the hedge are recognized in current period income or expense in conjunction with the recognition of the income or expense on the originally hedged item.
The Company’s derivatives are based on underlying risks, primarily interest rates. The Company is utilizing a swap to reduce the risks associated with interest rates. Swaps are contracts in which a series of net cash flows, based on a specific notional amount that is related to an underlying risk, are exchanged over a prescribed period.
Derivatives expose the Company to credit risk. If the counterparty fails to perform, the credit risk is equal to the fair value gain of the derivative. The credit exposure for swaps is the replacement cost of contracts that have become favorable. Credit risk is minimized by entering into transactions with high quality counterparties that are initially approved by the Board of Directors and reviewed periodically by the Asset Liability Committee. It is the Company’s policy of requiring that all derivatives be governed by an International Swap and Derivatives Associations Master Agreement (ISDA). Bilateral collateral agreements may also be required.
On August 28, 2007, the Company elected to terminate a series of seven interest rate swaps with a total notional value of $150 million. At termination, the swaps had a market value of $2.0 million. The gain is being accreted into interest income over the remaining life of the original swaps. The Company recognized $55 thousand in interest income for the three and nine months ended September 30, 2007. The following table presents the accretion of the gain:
| (in thousands) | 2007 | 2008 | 2009 | 2010 | 2011 | 2012 | Total | |||||||||||||||||||||
| Accretion of Gain from Terminated Swaps | $ | 205 | * | $ | 597 | $ | 533 | $ | 394 | $ | 219 | $ | 62 | $ | 2,010 | |||||||||||||
* The Company recognized $55 thousand in the third quarter and will recognize $150 thousand in the fourth quarter.
The following are the cash flow hedges as of September 30, 2007:
| (in thousands) | Notional Amount | Gross Unrealized Gains | Gross Unrealized Losses | Accumulated Other Comprehensive Income | Maturity Date | ||||||||||||
Asset Hedges | |||||||||||||||||
None | $ | - | $ | - | $ | - | $ | - | |||||||||
Terminated Asset Hedges | |||||||||||||||||
Cash Flow hedges: 1 | |||||||||||||||||
| Interest Rate swap | $ | 19,000 | $ | - | $ | - | $ | 88 | June 28, 2009 | ||||||||
| Interest Rate swap | 25,000 | - | - | 204 | June 28, 2010 | ||||||||||||
| Interest Rate swap | 25,000 | - | - | 267 | June 28, 2011 | ||||||||||||
| Interest Rate swap | 12,000 | - | - | 50 | June 28, 2009 | ||||||||||||
| Interest Rate swap | 14,000 | - | - | 83 | June 28, 2010 | ||||||||||||
| Interest Rate swap | 20,000 | - | - | 202 | June 28, 2011 | ||||||||||||
| Interest Rate swap | 35,000 | - | - | 395 | June 28, 2012 | ||||||||||||
| $ | 150,000 | $ | - | $ | - | $ | 1,289 | ||||||||||
1 The $1.3 million of gains, net of taxes, recorded in accumulated other comprehensive income will be reclassified into earnings as interest income over the life of the respective hedged items.
For the three and nine months ended September 30, 2007, no amounts were recognized for hedge ineffectiveness.
Subsequent to September 30, 2007, the Company entered into a total of $50 million notional value cash flow hedges. The hedges exchange a portion of our variable rate cash flows from our Prime-based commercial loans for fixed rate cash flows. The weighted average fixed rate is approximately 7.72% and the term is five years.
NOTE 12 – RECENT ACCOUNTING PRONOUNCEMENTS
In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (SFAS 159). The Statement allows an irrevocable election to measure certain financial assets and financial liabilities at fair value on an instrument-by-instrument basis, with unrealized gains and losses recognized currently in earnings. Under SFAS 159, the fair value option may only be elected at the time of initial recognition of a financial asset or financial liability or upon the occurrence of certain specified events. Additionally, SFAS 159 provides that application of the fair value option must be based on the fair value of an entire financial asset or financial liability and not selected risks inherent in those assets or liabilities. SFAS 159 requires that assets and liabilities which are measured at fair value pursuant to the fair value option be reported in the financial statements in a manner that separates those fair values from the carrying amounts of similar assets and liabilities which are measured using another measurement attribute. SFAS 159 also provides expanded disclosure requirements regarding the effects of electing the fair value option on the financial statements. SFAS No. 159 is effective prospectively for fiscal years beginning after November 15, 2007, with early adoption permitted for fiscal years in which interim financial statements have not been issued, provided that all of the provisions of SFAS 157 are early adopted as well. The Company early adopted SFAS 159 effective January 1, 2007. Notes 2 and 10 provide for further information.
In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, Fair Value Measurements (SFAS 157) to clarify how to measure fair value and to expand disclosures about fair value measurements. The expanded disclosures include the extent to which companies measure assets and liabilities at fair value, the information used to measure fair value, and the effect of fair value on earnings and is applicable whenever other standards require (or permit) assets and liabilities to be measured at fair value. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years with early adoption permitted. The Company adopted SFAS 157 on April 5, 2007 with the effective date of January 1, 2007. Note 9 provides further information.
In June 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109, Accounting for Income Taxes (FIN 48). The Interpretation provides guidance for recognition and measurement of uncertain tax positions that are “more likely than not” of being sustained upon audit, based on the technical merits of the position. FIN 48 also provides guidance on measurement, derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. The effective date is for fiscal years beginning after December 15, 2006. The Company adopted FIN 48 as of January 1, 2007. The adoption did not have a material impact on the Company’s consolidated financial statements. Note 8 provides further information.
In December 2005, the FASB issued FASB Staff Position (FSP) SOP 94-6-1, Terms of Loan Products That May Give Rise to a Concentration of Credit Risk. This FSP was issued in response to inquiries from constituents and discussions with the SEC staff and regulators of financial institutions to address the circumstances in which the terms of loan products give rise to a concentration of credit risk as that term is used in SFAS No. 107, Disclosures about Fair Value of Financial Instruments, and what disclosures apply to entities who deal with loan products whose terms may give rise to a concentration of credit risk. An entity shall provide the disclosures required by SFAS No. 107 for either an individual loan product type or a group of loan products with similar features that are determined to represent a concentration of credit risk in accordance with the guidance of SOP 94-6-1 for all periods presented in financial statements. This SOP is effective for interim and annual periods ending after December 19, 2005. The adoption of FSP SOP 94-6-1 did not have a material impact on the Company’s consolidated financial statements.
In November 2005, the FASB issued a FSP on SFAS No. 115-1 and SFAS No. 124-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments, which addresses the determination of when an investment is considered impaired; whether the impairment is other-than-temporary; and how to measure an impairment loss. This FSP also addresses accounting considerations subsequent to the recognition of an other-than-temporary impairment of a debt security, and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. This FSP replaces the impairment guidance on Emerging issues Task Force (EITF) Issue No. 03-1 with references to existing authoritative literature concerning other-than-temporary determinations. Under the FSP, losses arising from impairment deemed to be other-than-temporary, must be recognized in earnings at an amount equal to the entire difference between the securities cost and its fair value at the financial statement date, without considering partial recoveries subsequent to that date. The FSP also required that an investor recognize an other-than-temporary impairment loss when a decision to sell a security has been made and the investor does not expect the fair value of the security to fully recover prior to the expected time of sale. The FSP is effective for reporting periods beginning after December 15, 2005. The adoption did not have a material impact on the Company’s consolidated financial statements.
In May 2005, the FASB issued Statement of Financial Accounting Standards No. 154 (SFAS No. 154), Accounting Changes and Error Corrections — a replacement of APB Opinion No. 20 and FASB Statement No. 3, which eliminates the requirement to reflect changes in accounting principles as cumulative adjustments to net income in the period of the change and requires retrospective application to prior periods’ financial statements for voluntary changes in accounting principle, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. If it is impracticable to determine the cumulative effect of the change to all prior periods, SFAS No. 154 requires that the new accounting principle be adopted prospectively. For new accounting pronouncements, the transition guidance in the pronouncement should be followed. Retrospective application refers to the application of a different accounting principle to previously issued financial statements as if that principle had always been used. SFAS 154 did not change the guidance for reporting corrections of errors, changes in estimates or for justification of a change in accounting principle on the basis of preferability. SFAS No. 154 is effective for accounting changes made in fiscal years beginning after December 15, 2005. The adoption of SFAS No. 154 did not have a material impact on the Company’s consolidated financial statements.
NOTE 13– RECLASSIFICATIONS
Certain reclassifications have been made to the financial statements presented for prior periods to conform to the current year presentation.
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
In this Form 10-Q, “First Security,” “we,” “us,” “the Company” and “our” refer to First Security Group, Inc.
As discussed in Note 2 of the consolidated financial statements, our unaudited consolidated financial statements as of and for the nine months ended September 30, 2007 have been restated to reflect our decision to reverse the utilization of SFAS 159 for the valuation of certain investment securities. The accompanying Management’s Discussion and Analysis incorporates the effects of that restatement. Revised tables are marked as “Restated”. The following discussion and analysis continues to speak as of the date we originally filed the Form 10-Q. Information not affected by the restatement of the financial statements is unchanged.
SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS
Certain of the statements made under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and elsewhere throughout this Form 10-Q are forward-looking statements for purposes of the Securities Act of 1933 and the Securities Exchange Act of 1934. Forward-looking statements relate to future events or our future financial performance and may involve known or unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements of First Security to be materially different from future results, performance, or achievements expressed or implied by such forward-looking statements. Forward-looking statements include statements using the words such as “may,” “will,” “anticipate,” “should,” “would,” “believe,” “contemplate,” “expect,” “estimate,” “continue,” “intend,” “seeks,” or other similar words and expressions of the future.
These forward-looking statements involve risks and uncertainties, and may not be realized due to a variety of factors, including, without limitation: the effects of future economic conditions, governmental monetary and fiscal policies, as well as legislative and regulatory changes; the risks of changes in interest rates on the level and composition of deposits, loan demand, and the values of loan collateral, securities, and interest sensitive assets and liabilities; the costs of evaluating possible acquisitions and the risks inherent in integrating acquisitions; the effects of competition from other commercial banks, thrifts, mortgage banking firms, consumer finance companies, credit unions, securities brokerage firms, insurance companies, money market and other mutual funds and other financial institutions operating in First Security’s market area and elsewhere, including institutions operating regionally, nationally and internationally, together with such competitors offering banking products and services by mail, telephone, computer and the Internet; and, the failure of assumptions underlying the establishment of reserves for possible loan and lease losses. All written or oral forward-looking statements attributable to First Security are expressly qualified in their entirety by this Special Note.
THIRD QUARTER 2007 AND RECENT EVENTS
The following discussion and analysis sets forth the major factors that affected results of operations and financial condition reflected in the unaudited financial statements for the three and nine month periods ended September 30, 2007 and 2006. Such discussion and analysis should be read in conjunction with the Company’s Consolidated Financial Statements and the notes attached thereto.
Restatement and Other-than-Temporary Impairment of Investment Securities
Effective January 1, 2007, First Security early adopted SFAS 157 and SFAS 159. We selected the fair value option for approximately $27.1 million of investment securities previously classified as available-for-sale securities as of January 1, 2007. Our selection matched the average balance of our overnight borrowings from the Federal Home Loan Bank (FHLB) for the month of March 2007. The intent of our election was to match short-term assets with short-term liabilities.
Subsequent to March 31, 2007, we decided to sell the portfolio of trading securities and utilize the proceeds to pay down the overnight borrowings. The net effect of these transactions de-leveraged a portion of our balance sheet. Management believes this de-leveraging will have a positive impact on our balance sheet management position through selective growth in the current challenging interest rate environment. Additionally, the market risk of the trading assets introduced a risk of significant volatility in our earnings. Specifically, the market risk exposed us to a $168 thousand decrease in the value of the securities during the month of April 2007. Management determined that selling the trading portfolio to eliminate this risk and using the proceeds to reduce the overnight FHLB borrowings was in the best interest of First Security and its stockholders. At the time, both the Board of Directors and management, in consultation with our independent registered public accounting firm, concluded that our subsequent actions were consistent with our application of SFAS 159 and that First Security’s election of SFAS 159 was an appropriate application of the accounting standard.
After consultation with the Office of the Comptroller of the Currency (OCC), FSGBank’s primary federal banking regulators, we decided to reverse our decision to utilize the fair value option under SFAS 159 for the valuation of the previously selected securities. The decision was recommended by management and approved by the Board of Directors, in consultation with First Security’s independent registered public accounting firm. Based on discussions with the OCC, it was determined that the lack of on-going use of the fair value option did not meet the intent and spirit of the standard, and thus the adoption was deemed non-substantive for the Call Report, the required regulatory financial filing used by the OCC.
In connection with the restated financial statements, as described in Note 2 of the consolidated financial statements, we recorded a $584 thousand impairment of securities during the first quarter of 2007. We periodically evaluate the securities portfolio to determine whether a decline in value is other-than-temporary. The analysis includes evaluating the magnitude and duration of the decline in value, the reasons for the decline and the evidence to support realizable value equal to or greater than the carrying value of the securities. As of March 31, 2007, we did not have the intent to hold the securities selected as part of the initial SFAS 159 fair value option election until maturity and the subsequent sales in April at a loss indicate that the unrealized loss as of March 31, 2007 was other-than-temporary. As such, an impairment charge for the unrealized loss as of March 31, 2007 was recorded into earnings. Additionally, approximately $5 thousand of premium amortization was recorded as part of the March 31, 2007 restatement. The additional amortization reduced interest income for the first quarter. The June and September 30, 2007 restatements reclassify the mark-to-market change in value of the sold securities to a loss on sale of available-for-sale securities. Refer to the table in Note 2 for a complete list of financial statement line-items that changed as a result of the restatement for the period ended September 30, 2007.
The transactions eliminated securities yielding approximately 4.32 percent and overnight borrowings at a cost of approximately 5.25 percent. This elimination of negative interest rate spread will increase net interest income by an estimated $170 thousand for 2007 and approximately $250 thousand in 2008 based on certain reinvestment, prepayment and interest rate assumptions.
OVERVIEW
As of September 30, 2007, we had total consolidated assets of $1.2 billion, total loans (including leases) of $940.0 million, total deposits of $941.0 million and stockholders’ equity of $148.3 million.
Net income for the three months ended September 30, 2007, was $3.0 million, or $0.18 per share (basic and diluted), compared to net income of $2.9 million, or $0.17 per basic share and $0.16 per diluted share for the comparative period in 2006. Net income for the nine months ended September 30, 2007, was $8.3 million, or $0.48 and $0.47 per share basic and diluted, respectively, compared to net income of $8.2 million, or $0.47 and $0.46 per basic and diluted share, respectively, for the comparative period of 2006. For the nine month period ending September 30, 2007, net interest income and noninterest income increased by $531 thousand and $84 thousand, respectively, while noninterest expense, including provision for loan and lease losses, increased by $487 thousand as compared to the same period in 2006. Excluding the impairment and loss on sale of securities, noninterest income increased by $836 thousand for the nine months ended September 30, 2007 as compared to the same period in 2006. Income increases continue to outpace expense increases as a result of the change in the mix of earning assets towards loans, as well as the growing diversified stream of non-interest income from trust, fees on deposit accounts and mortgage banking activity. The increase in expenses is mainly due to higher salaries and benefits expense associated with the addition of 13 full-time equivalent employees year over year. This increase was partially offset by a decrease in the loan and lease loss provision due to improving overall asset quality and the current analysis of our known and inherent risks in the loan portfolio.
Our efficiency ratio increased in the third quarter of 2007 to 67.58% as compared to 67.18% in the same period of 2006. The increase is directly related to opening two branches during the second quarter of 2007 as well as the completion of our corporate headquarters in the fourth quarter of 2006. Our efficiency increased for the nine month period to 69.46% as compared to 68.56% for the same period in 2006. Excluding the loss on sale of securities and the impairment of securities, the efficiency ratio improved to 68.31%. Without the excluded items, the efficiency ratio improved for three consecutive linked quarters. We expect to continue to improve our efficiency during the remainder of 2007 by growing our operating revenue faster than our expenses. For the remainder of 2007 and into 2008, we plan to identify additional locations in Knoxville, Chattanooga, and Cleveland, Tennessee, as well as the north metro Atlanta, Georgia and metro Nashville, Tennessee markets. At this time, the locations have not been determined, and therefore no timetable is provided. While we will be opportunistic, we are mindful of the additional expense associated with the de novo growth model.
Net interest margin in the third quarter of 2007 was 4.80% or 25 basis points lower as compared to the prior year period of 5.05%. We believe that our net interest margin will decrease during the fourth quarter due to the 50 and 25 basis point cuts in the federal funds target rate by the Federal Open Market Committee of the Federal Reserve on September 18, 2007 and October 31, 2007, respectively. Any future decreases in the federal funds target rate, competitive pricing and our ability to raise core deposits may apply further pressure on our net interest margin.
On October 24, 2007, our Board of Directors approved a fourth quarter cash dividend of $0.05 per share payable on December 17, 2007 to shareholders of record on December 3, 2007.
RESULTS OF OPERATIONS
We reported net income for the three and nine month periods ended September 30, 2007 of $3.0 million and $8.3 million versus net income for the same periods in 2006 of $2.9 million and $8.2 million, respectively. In the third quarter of 2007, basic and diluted net income per share was $0.18 on approximately 16.9 million basic and 17.2 million diluted weighted average shares outstanding, respectively. On a year-to-date basis, basic and diluted net income per share was $0.48 and $0.47, respectively, on approximately 17.1 million shares and 17.4 million weighted average shares outstanding, respectively.
Net income on a quarterly and year-to-date basis in 2007 was above the 2006 level as a result of our organic loan growth and growing fee income, partially offset by a shrinking net interest margin. Our overhead also increased in 2007 because of our new corporate headquarters, which opened in December 2006 and our two new de novo branches, which opened in April and May 2007, and additional full-time equivalent employees. As of September 30, 2007 we had 40 banking offices, including the headquarters, four loan/lease production offices and 373 full time equivalent employees. Although, we expect to continue to expand our branch network and our employee force in 2007 and 2008, we are mindful of the fact that growth and increasing the number of branches adds expenses (such as administrative costs, occupancy, and salaries and benefits expenses) before earnings.
The following table summarizes the components of income and expense and the changes in those components for the three and nine month periods ended September 30, 2007 as compared to the same period in 2006.
Condensed Consolidated Income Statements
For Three Months Ended September 30, | Change from Prior Year | For the Nine Months Ended September 30, | Change from Prior Year | |||||||||||||||||||||
2007 | Amount | Percentage | 2007 | Amount | Percentage | |||||||||||||||||||
| (in thousands, except percentages) | ||||||||||||||||||||||||
(Restated) | (Restated) | (Restated) | ||||||||||||||||||||||
| Interest income | $ | 21,560 | $ | 2,176 | 11.2 | % | $ | 62,268 | $ | 6,922 | 12.5 | % | ||||||||||||
| Interest expense | 9,034 | 1,806 | 25.0 | % | 25,647 | 6,391 | 33.2 | % | ||||||||||||||||
| Net interest income | 12,526 | 370 | 3.0 | % | 36,621 | 531 | 1.5 | % | ||||||||||||||||
| Provision for loan and lease losses | 576 | (24 | ) | (4.0 | )% | 1,409 | (334 | ) | (19.2 | )% | ||||||||||||||
| Net interest income after provision for loan and lease losses | 11,950 | 394 | 3.4 | % | 35,212 | 865 | 2.5 | % | ||||||||||||||||
| Noninterest income | 3,094 | 318 | 11.5 | % | 7,962 | 84 | 1.1 | % | ||||||||||||||||
| Noninterest expense | 10,556 | 525 | 5.2 | % | 30,967 | 821 | 2.7 | % | ||||||||||||||||
| Income before income taxes | 4,488 | 187 | 4.3 | % | 12,207 | 128 | 1.1 | % | ||||||||||||||||
| Income tax provision | 1,466 | 71 | 5.1 | % | 3,943 | 60 | 1.5 | % | ||||||||||||||||
| Net income | $ | 3,022 | $ | 116 | 4.0 | % | $ | 8,264 | $ | 68 | 0.8 | % | ||||||||||||
Net Interest Income
Net interest income (the difference between the interest earned on assets, such as loans and investment securities, and the interest paid on liabilities, such as deposits and other borrowings) is our primary source of operating income. For the three months ended September 30, 2007, net interest income increased by $370 thousand, or 3.0%, to $12.5 million compared to $12.2 million for the same period in 2006. For the nine months ended September 30, 2007, net interest income increased by $531 thousand, or 1.5%, to $36.6 million for the period ended September 30, 2007 compared to $36.1 million for the same period in 2006.
We monitor and evaluate the effects of certain risks on our earnings and seek balance between the risks assumed and returns sought. Some of these risks include interest rate risk, market risk, credit risk and liquidity risk.
The level of net interest income is determined primarily by the average balances (volume) of interest earning assets and the various rate spreads between our interest earning assets and our funding sources. Changes in net interest income from period to period result from increases or decreases in the volume of interest earning assets and interest bearing liabilities, increases or decreases in the average interest rates earned and paid on such assets and liabilities, the ability to manage the interest earning asset portfolio (which includes loans), and the availability of particular sources of funds, such as noninterest bearing deposits.
Interest income for the third quarter of 2007 was $21.6 million, an 11.2% increase as compared to the same period in 2006. Interest income for the nine month period ended September 30, 2007 was $62.3 million, a 12.5% increase as compared to the same period in 2006. The increase in interest income on a quarter and year-to-date basis is due to 1) an increase in average earning assets and 2) a shifting of earning assets from investment securities to higher yielding loans. For the three months ended September 30, 2007, average earning assets increased $80.0 million, or 8.2%, to $1.1 billion compared to average earning assets of $974.0 million for the same period in 2006. On a year-to-date basis, average earning assets increased $78.6 million, or 8.3% to $1.0 billion compared to $949.1 million for the same period in 2006. On a quarter and year-to-date basis average loans increased $113.6 million and $104.7 million, respectively, while all other earning assets decreased $33.6 million and $26.1 million, respectively. The decrease is a result of shifting the earning asset mix from investment securities and federal funds sold to our higher yielding loan portfolio. We decreased our securities portfolio by electing to shift a portion of the recurring cash from interest, principal paydowns and maturities as well as transferring the proceeds from sales from the investment portfolio into the loan portfolio. Our loans increased in the third quarter of 2007 on a comparative basis due to the deposit gathering activities of FSGBank, the use of alternative funding through overnight advances from the Federal Home Loan Bank (FHLB), and to the shifting mix in earning assets. These additional earning assets have enabled us to earn more interest income.
Supplementing the additional earnings from increased volumes was the increase in yield on earning assets. The tax equivalent yield on earning assets increased 22 basis points for the quarter ended September 30, 2007 to 8.21% from 7.99% for the same period in 2006. On a year-to-date basis, the tax equivalent yield on earning assets increased 29 basis points to 8.19% compared to 7.90% for the same period in 2006. The changes in the yield relate to (1) our changing the mix of earning assets, (2) the fourth quarter 2006 sale of approximately $9.8 million of investment securities with an average yield of 3.65%, and (3) the second quarter 2007 sale of approximately $27.0 million of securities with an average yield of approximately 4.32%. The proceeds from the sale of the securities were used to reduce our overnight borrowing, which eliminated negative spread. In the third quarter, we used overnight borrowings as a short-term liquidity tool to provide supplemental funding for our loan growth.
Total interest expense was $9.0 million in the third quarter of 2007, or 25.0% higher, as compared to the same period in 2006. On a year-to-date basis, total interest expense increased $6.4 million, or 33.2%, as compared to the same period in 2006. Interest expense increased due to rising interest rates due to competitive pressures combined with the additional volume of interest bearing liabilities. Average interest bearing liabilities increased $71.3 million, or 9.2% and $67.1 million, or 8.9%, for the three and nine months ended September 30, 2007 compared to the same period in 2006. The increase in interest bearing liabilities was due to our market penetration and the use of other borrowings, including FHLB overnight borrowings. Average total deposits grew $36.3 million, or 4.0% to $934.0 million in the third quarter of 2007 compared to the same period in 2006. The average rate paid on interest bearing liabilities increased 54 basis points to 4.24% from 3.70% for the three-month period ended September 30, 2007 and 2006, respectively. The increase is primarily due to (1) competitive pricing pressure, (2) the pricing lag related to certificates of deposit issued prior to the Federal Reserve rate increase initiative, (3) a shift in consumer behavior to higher rate time deposits and (4) the increased use of higher cost alternative funding.
The banking industry uses two key ratios to measure profitability of net interest income: net interest rate spread and net interest margin. The net interest rate spread measures the difference between the average yield on earning assets and the average rate paid on interest bearing liabilities. The net interest rate spread does not consider the impact of noninterest bearing deposits and gives a direct perspective on the effect of market interest rate movements. The net interest margin is defined as net interest income as a percentage of total average earning assets and takes into account the positive effects of investing noninterest bearing deposits in earning assets.
The Company’s net interest rate spread (on a tax equivalent basis) was 3.97% and 4.03% for the three and nine months ended September 30, 2007, respectively, compared to 4.29% and 4.49% for the same periods in 2006, respectively. Our net interest margin (on a tax equivalent basis) was 4.80% and 4.86% for the three and nine months ended September 30, 2007, respectively, compared to 5.05% and 5.18% for the same periods in 2006, respectively. The decreased net interest spread and margin are the result of our rates on our interest bearing liabilities rising faster than the yields on earning assets. Average interest bearing liabilities as a percentage of average earning assets was 80.2% for the quarter ended September 30, 2007 compared to 79.5% for the same period in 2006. On a year-to-date basis, average interest bearing liabilities as a percentage of average earning assets was 80.1% for the period ended September 30, 2007 compared to 79.7% for the same period in 2006. Noninterest bearing funding sources contributed 83 basis points to the spread for the three months ended September 30, 2007, as compared to 76 basis points in the comparable period in 2006. Noninterest bearing funding sources contributed 83 basis points to the spread for the nine months ended September 30, 2007, as compared to 69 basis points in the comparable period in 2006. Average noninterest bearing demand deposits were 15.9% and 16.9% of average earning assets for the three months ended September 30, 2007 and 2006, respectively, and 16.1% and 16.6% of average earning assets for the nine months ended September 30, 2007 and 2006, respectively.
In late June 2007, the Company entered into a series of cash flow swaps with a total notional value of $150 million. Floating rate cash flow payments on a portion of our Prime-based variable rate loans were swapped for fixed rate payments. We entered the swaps to mitigate our interest rate risk in a falling interest rate environment. The market volatility and the increasing anticipation of interest rate easing by the Federal Reserve over the next two months created an unrealized gain in excess of $2.0 million. On August 28, 2007, we unwound the swaps and locked in a gain of approximately $2.0 million. The gain translated into 40 basis points of protection on $150 million notional when the Prime-rate was 8.25%. The accretion was $55 thousand in the third quarter and will be $150 thousand in the fourth quarter and $597 thousand for 2008. Refer to Note 11 for further information. In October 2007, we entered into a total of $50 million notional value cash flow swaps. The swaps exchange a portion of our Prime-based variable rate payments for fixed rate payments. The fixed rate is appropriately 7.72% and the term is five years.
We anticipate a decline in our net interest margin in the fourth quarter and for the year-to-date period. The Federal Reserve’s 50 and 25 basis point rate cuts in the target rate in September and October 2007, respectively, along with competitive pricing pressure and expected increasing use of alternative funding sources will reduce our margin. Positive influences on the margin for the fourth quarter and year-to-date period include (1) the accretion of the gain resulting from the termination of the June swaps, (2) the rate protection provided by the October swaps and (3) the decision to sell $27.0 million in securities in April 2007 and use the proceeds to pay down overnight borrowings which eliminated negative spread.
The following tables summarizes net interest income and average yields and rates paid for the quarters ended September 30, 2007 and 2006.
Average Consolidated Balance Sheets and Net Interest Analysis
Fully Tax-Equivalent Basis
For the Three Months Ended September 30, | ||||||||||||||||||||||||
2007 | 2006 | |||||||||||||||||||||||
Average | Income/ | Yield/ | Average | Income/ | Yield/ | |||||||||||||||||||
Balance | Expense | Rate | Balance | Expense | Rate | |||||||||||||||||||
| (in thousands, except percentages) | ||||||||||||||||||||||||
| Assets | ||||||||||||||||||||||||
| Earning assets: | ||||||||||||||||||||||||
| Loans, net of unearned income | $ | 926,216 | $ | 20,091 | 8.61 | % | $ | 812,611 | $ | 17,617 | 8.60 | % | ||||||||||||
| Investment securities – taxable | 81,304 | 1,043 | 5.09 | % | 114,868 | 1,354 | 4.68 | % | ||||||||||||||||
| Investment securities – non-taxable | 42,823 | 617 | 5.72 | % | 42,654 | 609 | 5.66 | % | ||||||||||||||||
| Other earning assets | 3,565 | 44 | 4.90 | % | 3,817 | 46 | 4.78 | % | ||||||||||||||||
| Total earning assets | 1,053,908 | 21,795 | 8.21 | % | 973,950 | 19,626 | 7.99 | % | ||||||||||||||||
| Allowance for loan and lease losses | (10,508 | ) | (10,392 | ) | ||||||||||||||||||||
| Intangible assets | 30,708 | 31,635 | ||||||||||||||||||||||
| Cash & due from banks | 26,469 | 26,446 | ||||||||||||||||||||||
| Premises & equipment | 35,738 | 33,124 | ||||||||||||||||||||||
| Other assets | 41,983 | 39,711 | ||||||||||||||||||||||
| TOTAL ASSETS | $ | 1,178,298 | $ | 1,094,474 | ||||||||||||||||||||
| Liabilities and Stockholders’ Equity | ||||||||||||||||||||||||
| Interest bearing liabilities: | ||||||||||||||||||||||||
| Interest bearing demand deposits | $ | 63,300 | 158 | 0.99 | % | $ | 68,304 | 142 | 0.82 | % | ||||||||||||||
| Money market accounts | 100,239 | 736 | 2.91 | % | 105,378 | 687 | 2.59 | % | ||||||||||||||||
| Savings deposits | 35,903 | 78 | 0.86 | % | 38,226 | 72 | 0.75 | % | ||||||||||||||||
| Time deposits> $100 | 221,980 | 2,905 | 5.19 | % | 189,663 | 2,276 | 4.76 | % | ||||||||||||||||
| Time deposits < $100 | 268,391 | 3,359 | 4.97 | % | 247,369 | 2,742 | 4.40 | % | ||||||||||||||||
| Brokered CDs | 76,850 | 961 | 4.96 | % | 84,646 | 936 | 4.39 | % | ||||||||||||||||
| Federal funds purchased | 3,350 | 47 | 5.57 | % | 13,152 | 186 | 5.61 | % | ||||||||||||||||
| Repurchase agreements | 27,697 | 182 | 2.61 | % | 19,541 | 112 | 2.27 | % | ||||||||||||||||
| Other borrowings | 47,998 | 608 | 5.03 | % | 8,142 | 75 | 3.65 | % | ||||||||||||||||
| Total interest bearing liabilities | 845,708 | 9,034 | 4.24 | % | 774,421 | 7,228 | 3.70 | % | ||||||||||||||||
| Net interest spread | $ | 12,761 | 3.97 | % | $ | 12,398 | 4.29 | % | ||||||||||||||||
| Noninterest bearing demand deposits | 167,371 | 164,153 | ||||||||||||||||||||||
| Accrued expenses and other liabilities | 19,118 | 16,028 | ||||||||||||||||||||||
| Stockholders’ equity | 146,978 | 142,270 | ||||||||||||||||||||||
| Accumulated other comprehensive loss | (877 | ) | (2,398 | ) | ||||||||||||||||||||
| TOTAL LIABILITIES AND | ||||||||||||||||||||||||
| STOCKHOLDERS’ EQUITY | $ | 1,178,298 | $ | 1,094,474 | ||||||||||||||||||||
| Impact of noninterest bearing sources and other changes in balance sheet composition | 0.83 | % | 0.76 | % | ||||||||||||||||||||
| Net interest margin | 4.80 | % | 5.05 | % | ||||||||||||||||||||
The following table presents the relative impact on net interest income to changes in the average outstanding balances (volume) of earning assets and interest bearing liabilities and the rates earned and paid by us on such assets and liabilities. Variances resulting from a combination of changes in rate and volume are allocated in proportion to the absolute dollar amount of the change in each category.
Change in Interest Income and Expense on a Tax Equivalent Basis
For the Three Months Ended September 30, 2007 Compared to 2006
Increase (Decrease) in Interest Income and Expense | ||||||||||||
| Due to Changes in: | ||||||||||||
Volume | Rate | Total | ||||||||||
| (in thousands) | ||||||||||||
| Interest earning assets: | ||||||||||||
| Loans, net of unearned income | $ | 2,463 | $ | 11 | $ | 2,474 | ||||||
| Investment securities – taxable | (396 | ) | 85 | (311 | ) | |||||||
| Investment securities – non-taxable | 2 | 6 | 8 | |||||||||
| Other earning assets | (3 | ) | 1 | (2 | ) | |||||||
| Total earning assets | 2,066 | 103 | 2,169 | |||||||||
| Interest bearing liabilities: | ||||||||||||
| NOW accounts | (10 | ) | 26 | 16 | ||||||||
| Money market accounts | (34 | ) | 83 | 49 | ||||||||
| Savings deposits | (4 | ) | 10 | 6 | ||||||||
| Time deposits> 100 | 388 | 241 | 629 | |||||||||
| Time deposits < 100 | 233 | 384 | 617 | |||||||||
| Brokered CDs | (86 | ) | 111 | 25 | ||||||||
| Federal funds purchased | (139 | ) | - | (139 | ) | |||||||
| Repurchase agreements | 47 | 23 | 70 | |||||||||
| Other borrowings | 367 | 166 | 533 | |||||||||
| Total interest bearing liabilities | 762 | 1,044 | 1,806 | |||||||||
| Increase (decrease) in net interest income | $ | 1,304 | $ | (941 | ) | $ | 363 | |||||
Average Consolidated Balance Sheets and Net Interest Analysis
Fully Tax-Equivalent Basis
For the Nine Months Ended September 30, | ||||||||||||||||||||||||
2007 | 2006 | |||||||||||||||||||||||
Average | Income/ | Yield/ | Average | Income/ | Yield/ | |||||||||||||||||||
Balance | Expense | Rate | Balance | Expense | Rate | |||||||||||||||||||
| (in thousands, except percentages) | ||||||||||||||||||||||||
| Assets | (Restated) | (Restated) | (Restated) | |||||||||||||||||||||
| Earning assets: | ||||||||||||||||||||||||
| Loans, net of unearned income | $ | 888,934 | $ | 57,567 | 8.66 | % | $ | 784,185 | $ | 50,020 | 8.53 | % | ||||||||||||
| Investment securities – taxable | 92,122 | 3,451 | 5.01 | % | 115,060 | 3,992 | 4.64 | % | ||||||||||||||||
| Investment securities – non-taxable | 43,612 | 1,865 | 5.72 | % | 41,941 | 1,788 | 5.70 | % | ||||||||||||||||
| Other earning assets | 3,077 | 102 | 4.43 | % | 7,910 | 258 | 4.36 | % | ||||||||||||||||
| Total earning assets | 1,027,745 | 62,985 | 8.19 | % | 949,096 | 56,058 | 7.90 | % | ||||||||||||||||
| Allowance for loan and lease losses | (10,366 | ) | (10,320 | ) | ||||||||||||||||||||
| Intangible assets | 30,960 | 31,772 | ||||||||||||||||||||||
| Cash & due from banks | 26,136 | 26,055 | ||||||||||||||||||||||
| Premises & equipment | 36,020 | 32,387 | ||||||||||||||||||||||
| Other assets | 42,328 | 39,290 | ||||||||||||||||||||||
| TOTAL ASSETS | $ | 1,152,823 | $ | 1,068,280 | ||||||||||||||||||||
| Liabilities and Shareholders’ Equity | ||||||||||||||||||||||||
| Interest bearing liabilities: | ||||||||||||||||||||||||
| Interest bearing demand deposits | $ | 64,909 | 415 | 0.85 | % | $ | 71,919 | 464 | 0.86 | % | ||||||||||||||
| Money market accounts | 99,367 | 2,131 | 2.87 | % | 107,687 | 1,902 | 2.36 | % | ||||||||||||||||
| Savings deposits | 35,952 | 232 | 0.86 | % | 38,752 | 209 | 0.72 | % | ||||||||||||||||
| Time deposits> $100 | 214,703 | 8,286 | 5.16 | % | 177,109 | 5,870 | 4.43 | % | ||||||||||||||||
| Time deposits < $100 | 265,484 | 9,765 | 4.92 | % | 241,610 | 7,378 | 4.08 | % | ||||||||||||||||
| Brokered CDs | 77,902 | 2,796 | 4.80 | % | 85,793 | 2,690 | 4.19 | % | ||||||||||||||||
| Federal funds purchased | 2,318 | 103 | 5.94 | % | 6,790 | 260 | 5.12 | % | ||||||||||||||||
| Repurchase agreements | 24,731 | 483 | 2.61 | % | 18,355 | 260 | 1.89 | % | ||||||||||||||||
| Other borrowings | 37,985 | 1,436 | 5.05 | % | 8,240 | 223 | 3.62 | % | ||||||||||||||||
| Total interest bearing liabilities | 823,351 | 25,647 | 4.16 | % | 756,255 | 19,256 | 3.40 | % | ||||||||||||||||
| Net interest spread | $ | 37,338 | 4.03 | % | $ | 36,802 | 4.49 | % | ||||||||||||||||
| Noninterest bearing demand deposits | 165,727 | 157,721 | ||||||||||||||||||||||
| Accrued expenses and other liabilities | 17,683 | 14,745 | ||||||||||||||||||||||
| Shareholders’ equity | 146,891 | 141,662 | ||||||||||||||||||||||
| Accumulated other comprehensive loss | (829 | ) | (2,103 | ) | ||||||||||||||||||||
| TOTAL LIABILITIES AND | ||||||||||||||||||||||||
| SHAREHOLDERS’ EQUITY | $ | 1,152,823 | $ | 1,068,280 | ||||||||||||||||||||
| Impact of noninterest bearing sources and other changes in balance sheet composition | 0.83 | % | 0.69 | % | ||||||||||||||||||||
| Net interest margin | 4.86 | % | 5.18 | % | ||||||||||||||||||||
The following table presents the relative impact on net interest income to changes in the average outstanding balances (volume) of earning assets and interest bearing liabilities and the rates earned and paid by us on such assets and liabilities. Variances resulting from a combination of changes in rate and volume are allocated in proportion to the absolute dollar amount of the change in each category.
Change in Interest Income and Expense on a Tax Equivalent Basis
For the Nine Months Ended September 30, 2007 Compared to 2006
Increase (Decrease) in Interest Income and Expense | ||||||||||||
Due to Changes in: | ||||||||||||
Volume | Rate | Total | ||||||||||
| (in thousands) | ||||||||||||
(Restated) | (Restated) | (Restated) | ||||||||||
| Interest earning assets: | ||||||||||||
| Loans, net of unearned income | $ | 6,682 | $ | 865 | $ | 7,547 | ||||||
| Investment securities – taxable | (796 | ) | 255 | (541 | ) | |||||||
| Investment securities – non-taxable | 71 | 6 | 77 | |||||||||
| Other earning assets | (158 | ) | 2 | (156 | ) | |||||||
| Total earning assets | 5,799 | 1,128 | 6,927 | |||||||||
| Interest bearing liabilities: | ||||||||||||
| NOW accounts | (45 | ) | (4 | ) | (49 | ) | ||||||
| Money market accounts | (147 | ) | 376 | 229 | ||||||||
| Savings deposits | (15 | ) | 38 | 23 | ||||||||
| Time deposits> $100 | 1,246 | 1,170 | 2,416 | |||||||||
| Time deposits < $100 | 729 | 1,658 | 2,387 | |||||||||
| Brokered CDs | (247 | ) | 353 | 106 | ||||||||
| Federal funds purchased | (171 | ) | 14 | (157 | ) | |||||||
| Repurchase agreements | 90 | 133 | 223 | |||||||||
| Other borrowings | 805 | 408 | 1,213 | |||||||||
| Total interest bearing liabilities | 2,245 | 4,146 | 6,391 | |||||||||
| Increase (decrease) in net interest income | $ | 3,554 | $ | (3,018 | ) | $ | 536 | |||||
Provision for Loan and Lease Losses
The provision for loan and lease losses charged to operations during the three months ended September 30, 2007 was $576 thousand compared to $600 thousand in the same period of 2006. Net charge-offs for the third quarter of 2007 were $298 thousand compared to net charge-offs of $914 thousand for the same period in 2006. The provision for loan and lease losses for the nine months ended September 30, 2007 and 2006 was $1.4 million and $1.7 million, respectively. Annualized net charge-offs as a percentage of average loans were 0.13% for the three months ended September 30, 2007 compared to 0.45% for the same period in 2006. Our peer group’s average (as reported in the June 30, 2007 Uniform Bank Performance Report) was 0.13%.
The decrease in our provision for loan and lease losses on a quarterly and year-to-date basis in 2007 compared to the same periods in 2006 resulted from our analysis of inherent risks in the loan and lease portfolio in relation to the portfolio’s growth, the level of past due, charged-off, classified and nonperforming loans and leases, as well as general economic conditions. We determined that our credit quality was improving and reduced the provision expense accordingly. We will reanalyze the allowance for loan and lease losses on at least a quarterly basis, and the next review will be at December 31, 2007, or sooner if needed, and the provision expense will be adjusted accordingly, if necessary.
The allowance for loan and lease losses reflects our assessment and estimate of the risks associated with extending credit and our evaluation of the quality of the loan portfolio. We regularly analyze our loan portfolio in an effort to establish an allowance that we believe will be adequate in light of anticipated risks and loan losses. In assessing the adequacy of the allowance, we review the size, quality and risk of loans in the portfolio. We also consider such factors as:
| ° | our loan loss experience; |
| ° | specific known risks; |
| ° | the status and amount of past due and nonperforming assets; |
| ° | underlying estimated values of collateral securing loans; |
| ° | current and anticipated economic conditions; and |
| ° | other factors which we believe affect the allowance for potential credit losses. |
An analysis of the credit quality of the loan portfolio and the adequacy of the allowance for loan and lease losses is prepared by our credit administration department and presented to our Board of Directors or the Directors’ Loan Committee on at least a quarterly basis. In addition, our loan review department performs a regular review of the quality of the loan portfolio and adequacy of the allowance. Based on our analysis, which includes risk factors such as charge-off rates, past dues, and loan growth, we may determine that our future provision expense may need to increase or decrease in order for us to remain adequately reserved for probable loan losses.
Our allowance for loan and lease losses is also subject to regulatory examinations and determinations as to adequacy, which may take into account such factors as the methodology used to calculate the allowance for loan and lease losses and the size of the allowance compared to a group of peer banks. During their routine examinations of banks, the regulators may require a bank to make additional provisions to its allowance when, in the opinion of the regulators, their credit evaluations and allowance methodology differ materially from ours.
While it is our policy to charge off in the current period loans for which a loss is considered probable, there are additional risks of future losses which cannot be quantified precisely or attributed to particular loans or classes of loans. Because these risks include the state of the economy, our judgment as to the adequacy of the allowance is necessarily approximate and imprecise.
Noninterest Income
Noninterest income totaled $3.1 million for the third quarter of this year, an increase of $318 thousand, or 11.5%, from the same period in 2006. On a year-to-date basis, noninterest income totaled $8.0 million, an increase of $84 thousand, or 1.1%. Excluding the impairment charge and the loss on sale of securities, noninterest on year-to-date basis increased $836 thousand, or 10.6%.
The following table presents the components of noninterest income for the periods ended September 30, 2007 and 2006.
Noninterest Income
Three Months Ended September 30, | Nine Months Ended September 30, | |||||||||||||||||||||||
Percent | Percent | |||||||||||||||||||||||
2007 | Change | 2006 | 2007 | Change | 2006 | |||||||||||||||||||
| (in thousands, except percentages) | ||||||||||||||||||||||||
(Restated) | (Restated) | |||||||||||||||||||||||
| NSF fees | $ | 1,095 | 12.0 | % | $ | 978 | $ | 3,004 | 4.8 | % | $ | 2,866 | ||||||||||||
| Service charges on deposit accounts | 276 | 10.0 | % | 251 | 808 | 11.0 | % | 728 | ||||||||||||||||
| Mortgage loan and related fees | 396 | -2.2 | % | 405 | 1,242 | 16.0 | % | 1,071 | ||||||||||||||||
| Bank-owned life insurance income | 226 | 2.3 | % | 218 | 679 | 1.6 | % | 668 | ||||||||||||||||
| Loss on sale of available-for-sale securities | - | - | - | (168 | ) | -100 | % | - | ||||||||||||||||
| Other-than-temporary impairment of securities | - | - | - | (584 | ) | -100 | % | - | ||||||||||||||||
| Other income | 1,101 | 19.2 | % | 924 | 2,981 | 17.1 | % | 2,545 | ||||||||||||||||
| Total noninterest income | $ | 3,094 | 11.5 | % | $ | 2,776 | $ | 7,962 | 1.1 | % | $ | 7,878 | ||||||||||||
Our largest sources of noninterest income are service charges and fees on deposit accounts. Total service charges, including non-sufficient funds (NSF) fees, were $1.4 million for the third quarter of 2007, an increase of $142 thousand, or 11.6%, from the same period in 2006. On a year-to-date basis, total service charges, including NSF fees, increased $218 thousand, or 6.1%, for 2007 compared to the same period in 2006. The increases are a result of an increase in NSF fees as well as higher volumes of transactions.
Mortgage loan and related fees for the third quarter of 2007 decreased $9 thousand, or 2.2% to $396 thousand compared to $405 thousand in the third quarter of 2006. Our process to originate and sell a conforming mortgage in the secondary market typically takes 30 to 60 days from the date of mortgage origination to the date the mortgage is sold to an investor in the secondary market. Due to the normal processing time, we will have a certain amount of held for sale loans at any time. The loan and fee income is recognized when the sale occurs. Mortgages originated for sale in the secondary markets totaled $18.3 million and $24.4 million for the three months ended September 30, 2007 and 2006, respectively. Mortgages sold in the secondary market totaled $23.9 million and $27.8 million for three months ended September 30, 2007 and 2006, respectively. Mortgages originated and sold in the secondary market totaled $60.7 million and $62.8 million, respectively, for the nine month period ended September 30, 2007 as compared to originations and sales of $70.0 million and $68.1 million, respectively, in 2006. We do not originate sub-prime loans.
In addition to the non-interest income generated by our mortgage department, it has also begun to have a positive impact on our net interest income. During 2006, our mortgage department began originating adjustable rate mortgages (ARMs) to be held for investment. Interest income from these ARM loans totaled $383 thousand and $161 thousand for the three months ended September 30, 2007 and 2006, respectively, and totaled $1.0 million and $240 thousand for the nine months ended September 30, 2007 and 2006, respectively. Mortgage originations declined for the three and nine month periods ended September 30, 2007, as compared to the same periods in 2006, due to the rising interest rate market in the first half of 2007 coupled with the softening of the real estate market in the second half of the 2007. While the income increased on a nine month period by $171 thousand or 16.0%, we dedicated more resources to generate this income. We anticipate continued pressure for the mortgage department for the fourth quarter and into 2008 due to the softness in the real estate market.
Bank-owned life insurance income remained consistent at $226 thousand and $679 thousand for the three and nine months ended September 30, 2007, respectively. The Company is the owner and beneficiary of these contracts. The income generated by the cash value of the insurance policies accumulates on a tax-deferred basis and is tax free to maturity. In addition, the insurance death benefit will be a tax-free payment to the Company. This tax-advantaged asset enables us to provide benefits to our employees. On a fully tax-equivalent basis, the weighted average interest rate earned on the policies was 6.76% at September 30, 2007.
As described in Note 2 of the consolidated financial statements and under the “Restatement and Other-than-Temporary Impairment of Securities” caption at the beginning of Management’s Discussion and Analysis, the decision to reverse the utilization of SFAS 159 resulted in an impairment of securities charge of $584 thousand during the first quarter of 2007. Additionally, the sale of the impaired securities during the second quarter resulted in an additional loss of $168 thousand.
Other income for the third quarter of 2007 was $1.1 million, compared to $924 thousand for the same period in 2006. For the nine months ended, other income was $3.0 million, compared to $2.5 million for the period ended September 30, 2007 and 2006, respectively. The components of other income primarily consist of point-of-sale fees on debit cards, credit card fee income, ATM fee income, gains on sales of other real estate and repossessions, underwriting revenue, safe deposit box fee income, and trust fee income. On a year-to-date basis, the major contributors to increasing other noninterest income were the trust department with an increase of $193 thousand or 69.2% and point-of-sale fees increasing $100 thousand or 17.0% from the comparable period in 2006.
During the fourth quarter, the Company anticipates electing the fair value option on newly originated held-for-sale loans. The election would eliminate the complexities and inherent difficulties of achieving hedge accounting and better align reported results with the underlying economic changes in value of the loans and related hedged instruments. This election would impact the timing and recognition of origination fees and costs. Specifically, origination fees and costs, which have been appropriately deferred under SFAS No. 91 and recognized as part of the gain/loss on sale of the loan, would instead be recognized in earnings at the time of origination.
Noninterest Expense
Noninterest expense for the third quarter of 2007 increased $525 thousand, or 5.2%, to $10.6 million compared to $10.0 million for the same period in 2006. On a year-to-date basis, noninterest expense increased $821 thousand, or 2.7% to $31.0 million compared to $30.1 million for the same period in 2006. Noninterest expense remained consistent with the comparable periods, which primarily reflects increases in personnel and occupancy expenses, partially offset by expense reductions in other areas. Unless indicated otherwise in the discussion below, we anticipate continued increases in noninterest expense throughout 2007 and into 2008 as a result of our branching activities.
The following table represents the components of noninterest expense for the three and nine month periods ended September 30, 2007 and 2006.
Noninterest Expense
Three Months Ended September 30, | Nine Months Ended September 30, | |||||||||||||||||||||||
2007 | Percent Change | 2006 | 2007 | Percent Change | 2006 | |||||||||||||||||||
| (in thousands, except percentages) | ||||||||||||||||||||||||
| Salaries & benefits | $ | 5,930 | 4.9 | % | $ | 5,654 | $ | 17,575 | 4.8 | % | $ | 16,769 | ||||||||||||
| Occupancy | 844 | 8.1 | % | 781 | 2,511 | 5.9 | % | 2,372 | ||||||||||||||||
| Furniture and equipment | 925 | 5.8 | % | 874 | 2,584 | -3.3 | % | 2,673 | ||||||||||||||||
| Professional fees | 454 | -15.9 | % | 540 | 1,367 | -2.1 | % | 1,397 | ||||||||||||||||
| Data processing | 354 | 5.0 | % | 337 | 1,061 | 6.1 | % | 1,000 | ||||||||||||||||
| Printing & supplies | 119 | 2.6 | % | 116 | 395 | -2.0 | % | 403 | ||||||||||||||||
| Communications | 185 | 2.2 | % | 181 | 548 | -6.5 | % | 586 | ||||||||||||||||
| Advertising | 101 | -14.4 | % | 118 | 346 | 2.1 | % | 339 | ||||||||||||||||
| Intangible asset amortization | 243 | -24.8 | % | 323 | 762 | -23.0 | % | 990 | ||||||||||||||||
| Other expense | 1,401 | 26.6 | % | 1,107 | 3,818 | 5.6 | % | 3,617 | ||||||||||||||||
| Total noninterest expense | $ | 10,556 | 5.2 | % | $ | 10,031 | $ | 30,967 | 2.7 | % | $ | 30,146 | ||||||||||||
Salaries and benefits for the third quarter of 2007 increased 4.9% as compared to the same period in 2006 and 4.8% on a year-to-date basis. The increase in salaries and benefits is primarily related to increases in our full time equivalent employees and related benefit expenses. As of September 30, 2007, we had 373 full time equivalent employees and operated 40 full service banking offices and four loan/lease production offices. In April and May 2007, we opened a de novo branch in Algood, Tennessee and Cleveland, Tennessee, respectively. For the remainder of 2007 and into 2008, we plan to identify additional locations in Knoxville, Chattanooga, and Cleveland, Tennessee, as well as the north metro Atlanta, Georgia and metro Nashville, Tennessee markets. At this time, the locations have not been determined, and therefore no timetable is provided. While we will be opportunistic, we are mindful of the additional expense associated with the de novo growth model.
Occupancy expense for the third quarter of 2007 increased 8.1% as compared to the same period in 2006 and 5.9% on a year-to-date basis. The increase on a quarterly and year-to-date basis was due to the completion of our two new de novo branches in Algood, Tennessee and Cleveland, Tennessee in April and May of 2007, as well as opening our new corporate headquarters building in December 2006. As of September 30, 2007, First Security leased nine branches, three office facilities and the land for four branches. As a result, current period occupancy expense is higher than if we owned these facilities, including the real estate, but due to market conditions, property availability and favorable lease terms, we leased these locations to execute our growth strategy. Furthermore, we have been able to deploy the capital into earning assets rather than capital expenditures for facilities.
Furniture and equipment expense increased on a quarterly basis $51 thousand, or 5.8%, and decreased on a year-to-date basis $89 thousand, or 3.3%. The increase on a quarterly basis was primarily due to an increase in equipment maintenance cost as we paid termination fees associated with a higher cost vendor. On a year-to-date basis, equipment maintenance decreased $84 thousand due to the savings from changing vendors during the second half of the year. We anticipate furniture and equipment cost to remain consistent for the remainder of the year and into 2008.
Professional fees decreased 15.9% for the third quarter of 2007 as compared to the same period in 2006 and 2.1% on a year-to-date basis. Professional fees include fees related to investor relations, outsourcing internal audit, compliance and information technology audits to Professional Bank Services, as well as external audit (including testing under Section 404 of the Sarbanes Oxley Act of 2002), tax services and legal and accounting advice related to, among other things, potential acquisitions, investment securities, trademarks and intangible properties. The decrease in 2007 includes, but is not limited to, reductions in legal fees, internal audit fees, and other professional fees. We recently decided to bring some internal audit functions in-house, and anticipate that our internal audit fees will reduce in 2008.
Data processing fees increased 5.0% for the third quarter of 2007 as compared to the same period in 2006 and 6.1% on a year-to-date basis. Our external data processor is Fidelity Integrated Financial Solutions (formerly Intercept) located in Lenexa, Kansas. The monthly fees associated with data processing are based primarily on transaction volume. Therefore, as we grow, we believe that data processing costs will increase correspondingly.
Intangible asset amortization expense decreased $80 thousand or 24.8% in the third quarter of 2007 as compared to the same period in 2006 and 23.0% on a year-to-date basis. Our core deposit intangible assets amortize on an accelerated basis in which the expense recognized declines over the estimated useful life of ten years. We anticipate further decreases in amortization expense throughout the remainder of 2007 and continuing into 2008.
Income Taxes
We recorded income tax expense of $1.5 million for the third quarter of 2007 compared to $1.4 million for the same period in 2006. Our effective tax rate for the period ended September 30, 2007 and 2006, was 32.7% and 32.4%, respectively. On a year-to-date basis, we recorded income tax expense of $3.9 million compared to $3.9 million for the same period in 2006.
STATEMENT OF FINANCIAL CONDITION
Our total assets were $1.2 billion at September 30, 2007, $1.1 billion at December 31, 2006, and $1.1 billion at September 30, 2006. Our third quarter 2007 and year-over-year asset growth is directly related to deposit growth and the funds available to us for investment.
Throughout the remainder of 2007 and into 2008, we expect our assets to continue to grow as we plan to further leverage our existing banking branches, seek de novo opportunities in attractive markets and actively pursue additional acquisitions of existing banks and bank branches.
Loans
Our loan demand continues to be strong. Total loans increased 10.9% (14.6% annualized) at September 30, 2007 as compared to December 31, 2006 and 13.8% as compared to September 30, 2006. The increase in loans year-to-date can be attributed to an increase in our construction and land development loans of $37.6 million, or 21.7% (29.0% annualized), an increase in commercial real estate of $33.9 million, or 19.5% (26.1% annualized), and an increase in our commercial and industrial loans of $18.7 million, or 15.4% (20.6% annualized). Loan growth was $114.3 million, or 13.8%, over the twelve-month period ended September 30, 2007. The loan categories with the largest increases over the past twelve months were construction/land development, up $54.1 million or 34.5%, to $211.3 million, commercial real estate loans, up $33.0 million or 18.9%, to $207.5 million, commercial and industrial loans, up $22.6 million, or 19.3% to $140.1 million and residential mortgage loans, up $18.3 million or 7.6%, to $257.7 million.
During the third quarter, our fastest growing loan sectors were commercial real estate and commercial and industrial loans, followed by construction and development loans, which slowed from prior periods. We anticipate similar results for the fourth quarter.
We believe that our general loan growth will remain strong. Funding of future loan growth may be restricted by our ability to raise core deposits, although we will use alternative funding sources if necessary and cost effective. Loan growth may also be restricted by the necessity for us to maintain appropriate capital levels, as well as adequate liquidity.
Asset Quality
We consider our asset quality to be of primary importance. At September 30, 2007, our loan portfolio was 78.4% of total assets. Over the past few years, we have improved our commercial and retail underwriting standards, developed a detailed loan policy, established better warning and early detection procedures, enhanced credit-related management and director reporting and developed a more comprehensive analysis of our allowance for loan and lease losses. We believe our implementation of the Baker Hill software will continue to enhance our ability to produce credit risk and production management information for both the commercial and retail portfolios.
The allowance for loan and lease losses represents our estimate of an amount adequate in relation to the risk of losses inherent in the loan portfolio. We analyze the loan portfolio regularly to identify potential problems. We undertake this analysis in conjunction with the establishment of our allowance for loan and lease losses to provide a basis for determining the adequacy of our loan loss reserves to absorb losses that we estimate might be experienced. Furthermore, our policy requires regularly scheduled problem-asset meetings in which past due and classified loans are thoroughly analyzed. These analyses are thoroughly reviewed by our credit administration group. In addition to these analyses of existing loans, we consider our loan growth, historical loan and lease losses, past due and non-performing loans, current economic conditions, underlying loan collateral values and other factors which may affect probable loan and lease losses.
Our asset quality ratios in the third quarter of 2007 were comparable to the year-end amounts and generally declined as compared to the same period in 2006. As of September 30, 2007, our allowance for loan and lease losses as a percentage of total loans was 1.13%, which is lower than the 1.18% for December 31, 2006 and the 1.19% as of September 30, 2006. Net charge-offs as a percentage of average loans improved to 13 basis points from 45 basis points for the three month periods ended September 30, 2007 and 2006, respectively. Non-performing assets as a percentage of total assets were 57 basis points compared to 41 basis points in 2006. Non-performing assets, including 90 days past due, decreased to $7.4 million or 62 basis points of total assets from $8.2 million or 72 basis points as of December 31, 2006, and increased from the $6.1 million or 55 basis points as of September 30, 2006.
In April 2006, we hired an experienced special assets officer to manage our special assets, collections, recoveries, other real estate and repossessions. The focus of this position is to initiate and manage a formal recovery program and improve overall past due management by centralizing our loan collection process. We also began implementing a collection and recovery management software system in 2006 to strengthen our management of other real estate owned, repossessed assets, past dues loans and classified loans. We believe that charge-offs for 2007, as a percent of average loans, will remain below 2006 levels as a result of our special assets officer and our continuing efforts to improve our loan underwriting, approval process, servicing, problem identification and problem resolution.
The following table presents an analysis of the changes in the allowance for loan and lease losses for the nine months ended September 30, 2007 and 2006. The provision for loan and lease losses of $1.4 million in the table below does not include our provision accrual for unfunded commitments of $34 thousand as of September 30, 2007. The reserve for unfunded commitments was $154 thousand as of September 30, 2007, and is included in other liabilities in the accompanying consolidated balance sheets.
Analysis of Chances in Allowance for Loan and Lease Losses
For the nine months ended September 30, | ||||||||
2007 | 2006 | |||||||
| Allowance for loan and lease losses - | (in thousands, except percentages) | |||||||
| Beginning of period | $ | 9,970 | $ | 10,121 | ||||
| Provision for loan and lease losses | 1,375 | 1,653 | ||||||
| Sub-total | 11,345 | 11,774 | ||||||
| Charged off loans: | ||||||||
| Commercial – leases | 407 | 336 | ||||||
| Commercial – loans | 133 | 879 | ||||||
| Real estate – construction | 44 | 11 | ||||||
| Real estate – 1-4 family residential mortgage | 111 | 676 | ||||||
| Real estate – commercial and other | 207 | 1 | ||||||
| Consumer and other | 380 | 400 | ||||||
| Total charged off | 1,282 | 2,303 | ||||||
| Recoveries of charged-off loans: | ||||||||
| Commercial – leases | 7 | 5 | ||||||
| Commercial – loans | 234 | 78 | ||||||
| Real estate – construction | 2 | - | ||||||
| Real estate – 1-4 family residential mortgage | 80 | 39 | ||||||
| Real estate – commercial and other | 96 | 55 | ||||||
| Consumer and other | 153 | 214 | ||||||
| Total recoveries | 572 | 391 | ||||||
| Net charged-off loans | 710 | 1,912 | ||||||
| Allowance for loan and lease losses - end of period | $ | 10,635 | $ | 9,862 | ||||
| Total loans-end of period | $ | 940,025 | $ | 825,745 | ||||
| Average loans | $ | 888,934 | $ | 784,185 | ||||
| Net loans charged-off to average loans, annualized | 0.11 | % | 0.33 | % | ||||
| Provision for loan and lease losses to average loans, annualized | 0.21 | % | 0.30 | % | ||||
| Allowance for loan and lease losses as a percentage of: | ||||||||
| Period end loans | 1.13 | % | 1.19 | % | ||||
| Non-performing assets | 155.89 | % | 217.56 | % | ||||
The following table presents the allocation of the allowance for loan and lease losses for each respective loan category with the corresponding percent of loans in each category to total loans. The comprehensive allowance analysis developed by our credit administration group enables us to allocate the allowance based on risk elements within the portfolio.
Allocation of the Allowance for Loan and Lease Losses
As of September 30, 2007 | As of September 30, 2006 | |||||||||||||||
Percent of loans in each | Percent of loans in each | |||||||||||||||
Amount | category to total loans | Amount | category to total loans | |||||||||||||
| (in thousands, except percentages) | ||||||||||||||||
| Commercial-leases | $ | 2,197 | 4.9 | % | $ | 1,639 | 6.9 | % | ||||||||
| Commercial-loans | 2,711 | 14.9 | % | 2,404 | 14.3 | % | ||||||||||
| Real estate-construction | 998 | 22.5 | % | 1,040 | 19.0 | % | ||||||||||
| Real estate-mortgage | 3,753 | 50.6 | % | 3,605 | 51.2 | % | ||||||||||
| Consumer | 924 | 7.1 | % | 906 | 8.6 | % | ||||||||||
| Unallocated | 52 | 0.0 | % | 268 | 0.0 | % | ||||||||||
| Total | $ | 10,635 | 100.0 | % | $ | 9,862 | 100.0 | % | ||||||||
We believe that the allowance for loan and lease losses at September 30, 2007 is sufficient to absorb losses inherent in the loan portfolio based on our assessment of the information available. Our assessment involves uncertainty and judgment; therefore, the adequacy of the allowance cannot be determined with precision and may be subject to change in future periods. In addition, bank regulatory authorities, as part of their periodic examinations of FSGBank, may require additional charges to the provision for loan and lease losses in future periods if the results of their reviews warrant. The unallocated reserve is available as a general reserve against the entire loan portfolio and is related to factors such as current economic conditions which are not directly associated with a specific loan pool. See “Provision for Loan and Lease Losses” for a description of our methodology for determining the adequacy of the allowance.
Nonperforming Assets
Nonperforming assets include nonaccrual loans, restructured loans, other real estate under contract for sale and repossessed assets. We place loans on non-accrual status when we have concerns relating to our ability to collect the loan principal and interest, and generally when such loans are 90 days or more past due.
September 30, 2007 | December 31, 2006 | September 30, 2006 | ||||||||||
| (in thousands, except percentages) | ||||||||||||
| Nonaccrual loans | $ | 1,687 | $ | 2,653 | $ | 679 | ||||||
| Loans past due 90 days and still accruing | 585 | 1,325 | 1,593 | |||||||||
| Total nonperforming loans | $ | 2,272 | $ | 3,978 | $ | 2,272 | ||||||
| Other real estate owned | $ | 2,646 | $ | 1,982 | $ | 2,298 | ||||||
| Repossessed assets | 2,489 | 2,231 | 1,556 | |||||||||
| Nonaccrual loans | 1,687 | 2,653 | 679 | |||||||||
| Total nonperforming assets | $ | 6,822 | $ | 6,866 | $ | 4,533 | ||||||
| Nonperforming loans as a percentage of total loans | 0.24 | % | 0.47 | % | 0.28 | % | ||||||
| Nonperforming assets as a percentage of total assets | 0.57 | % | 0.61 | % | 0.41 | % | ||||||
| Nonperforming assets + loans 90 days past due to total assets | 0.62 | % | 0.72 | % | 0.55 | % | ||||||
Nonaccrual loans totaled $1.7 million at September 30, 2007, $2.7 million at December 31, 2006, and $679 thousand at September 30, 2006. The nonaccrual loans at September 30, 2007 included $756 thousand of commercial and industrial loans, $513 thousand of commercial leases, $396 thousand of real-estate secured loans and $22 thousand of consumer loans. There are no commitments to lend additional funds to customers with loans on non-accrual status at September 30, 2007.
Loans 90 days past due and still accruing were $585 thousand at September 30, 2007, compared to $1.3 million at December 31, 2006 and $1.6 million at September 30, 2006. Of these past due loans at September 30, 2007, $337 thousand were secured by real estate, $216 thousand were leases and $32 thousand were consumer and other loans.
At September 30, 2007, we owned other real estate in the amount of $2.6 million, which consisted of $1.6 million in construction/land development property, $629 thousand in non-farm/nonresidential property and $434 thousand in multifamily real estate. All of these properties have been written down to their respective fair values.
At September 30, 2007, we owned repossessed assets, which have been written down to their fair values, in the amount of $2.5 million, compared to $2.2 million at December 31, 2006 and $1.6 million at September 30, 2006.
Nonperforming assets for the third quarter of 2007 were $6.8 million compared to $6.9 million at December 31, 2006 and $4.5 million at September 30, 2006.
Our peer group, as defined by the June 30, 2007 Uniform Bank Performance Report is all commercial banks between $1 billion and $3 billion in total assets. The ratio of nonaccrual loans and loans 90 days past due to gross loans was 0.24% and 0.72% for us and our peer group, respectively. The ratio of nonaccrual loans and loans 90 days past due to the allowance for loan and lease losses was 21.36% and 61.21% for us and our peer group. The ratio of nonaccrual loans and loans 90 days past due to equity capital was 1.55% and 5.06% for FSGBank and our peer group, respectively. The ratio of nonaccrual loans, loans 90 days past due, and other real estate owned to gross loans and other real estate owned was 0.52% and 0.82% for us and our peer group, respectively.
Investment Securities and Other Earning Assets
The composition of our securities portfolio reflects our investment strategy of maintaining an appropriate level of liquidity while providing a relatively stable source of income. Our securities portfolio also provides a balance to interest rate risk and credit risk in other categories of the balance sheet while providing a vehicle for investing available funds, furnishing liquidity and supplying securities to pledge as required collateral for certain deposits and borrowed funds. We use three categories to classify our securities: “held-to-maturity”, “available-for-sale” and “trading.” Currently, none of our investments are classified as held-to-maturity or trading. All investment securities purchased to date have been classified as available-for-sale. While we have no plans to liquidate a significant amount of any available-for-sale securities, the securities classified as available-for-sale may be used for liquidity purposes should we deem it to be in our best interest.
Available-for-sale securities totaled $126.9 million at September 30, 2007, $153.8 million at December 31, 2006 and $159.7 million at September 30, 2006. The reduction in the securities portfolio year-over-year occurred as a result of our efforts to utilize a portion of the liquidity to fund loan growth instead of reinvesting in securities, as well as the sale of $9.8 million of available-for-sale securities in the fourth quarter of 2006 and $27.0 million of available-for-sale securities in the second quarter of 2007. While our level of liquid assets has decreased, we believe our current level provides an appropriate level of liquidity and provides a proper balance to our interest rate and credit risk in our loan portfolio. At September 30, 2007, the available-for-sale securities portfolio had unrealized net losses of approximately $70 thousand, net of tax. Our securities portfolio at September 30, 2007 consisted of tax-exempt municipal securities, federal agency bonds, federal agency issued Real Estate Mortgage Investment Conduits (REMICs), federal agency issued pools and asset-backed securities and collateralized mortgage obligations (CMOs).
The following table provides the amortized cost of our available-for-sale securities by their stated maturities (this maturity schedule excludes security prepayment and call features), as well as the tax equivalent yields for each maturity range.
Maturity of Available-for-Sale Investment Securities – Amortized Cost
Less than One Year | One to Five Years | Five to Ten Years | More than Ten Years | Totals | ||||||||||||||||
| (in thousands, except percentages) | ||||||||||||||||||||
| Municipal-tax exempt | $ | 1,373 | $ | 8,854 | $ | 23,607 | $ | 9,479 | $ | 43,313 | ||||||||||
| Agency bonds | 5,499 | 15,615 | 3,985 | - | 25,099 | |||||||||||||||
| Agency issued REMICs | - | 24,991 | - | - | 24,991 | |||||||||||||||
| Agency issued pools | 27 | 17,881 | 7,577 | 1,347 | 26,832 | |||||||||||||||
| Asset backed & CMOs | - | 6,483 | - | - | 6,483 | |||||||||||||||
| Other | - | - | - | 314 | 314 | |||||||||||||||
| Total | $ | 6,899 | $ | 73,824 | $ | 35,169 | $ | 11,140 | $ | 127,032 | ||||||||||
| Tax Equivalent Yield | 4.47 | % | 5.06 | % | 5.65 | % | 6.14 | % | 5.29 | % | ||||||||||
We currently have the ability and intent to hold our available-for-sale investment securities to maturity. However, should conditions change, we may sell unpledged securities. We consider the overall quality of the securities portfolio to be high. All securities held are traded in liquid markets, except for one bond. This $250 thousand investment is a Qualified Zone Academy Bond (within the meaning of Section 1379E of the Internal Revenue Code of 1986, as amended) issued by The Health, Educational and Housing Facility Board of the County of Knox under the authority from the State of Tennessee. As of September 30, 2007, we owned securities from issuers in which the aggregate amortized cost from such issuers exceeded 10% of our stockholders’ equity. As of the third quarter ended 2007, the amortized cost and market value of the securities from each such issuer are as follows:
Book Value | Market Value | |||||||
| (in thousands) | ||||||||
| Fannie Mae | $ | 23,793 | $ | 23,797 | ||||
| FHLMC* | $ | 41,723 | $ | 41,668 | ||||
* Federal Home Loan Mortgage Corporation
At September 30, 2007 and 2006 we did not hold federal funds sold compared to a relatively small position of $1.6 million at December 31, 2006. The decrease in federal funds sold from December 31, 2006 is the result of strong loan demand.
As of September 30, 2007, we held $100 thousand in certificates of deposit at other FDIC insured financial institutions. At September 30, 2007, we held $22.9 million in bank owned life insurance, compared to $22.3 million at December 31, 2006 and $22.1 million at September 30, 2006.
Deposits and Other Borrowings
As of September 30, 2007, deposits increased by 2.1% (2.8% annualized) from December 31, 2006 and by 3.0% from September 30, 2006. Excluding the changes in brokered CDs, our growth rate of deposits was 2.7% (3.6% annualized) from December 31, 2006 and 3.8% from September 30, 2006. During the first six months of 2007, we elected not to replace $28.3 million in maturing brokered CDs, but instead replaced them with overnight FHLB borrowings. This decision was based on anticipated declining interest rates for the remainder of 2007 and a desire to position our liability sensitivity accordingly. Subsequent to June 30, 2007, we began replacing the previously matured brokered CDs as rates became more favorable. The growth in deposits is due to our sales team drawing customers away from other financial institutions and our branching efforts. In the third quarter of 2007, the fastest growing sector of our deposit base was savings and money market accounts and jumbo CDs which grew 4.7% (18.9% annualized) and 1.0% (4.1% annualized), respectively, and outpaced our total deposit growth. We define our core deposits to include interest bearing and noninterest bearing demand deposits, savings and money market accounts, as well as retail certificates of deposits with denominations less than $100,000. We consider our retail CDs to be a stable source of funding because they are in-market, relationship-oriented deposits. Core deposit growth is an important tenant to our business strategy. Core deposits increased by 0.7% (0.9% annualized) from December 31, 2006. We believe that by improving our branching network, we will provide more convenient opportunities for customers to bank with us, and thus improve our core deposit funding. For this reason, we opened de novo branches in Algood and Cleveland, Tennessee in April and May 2007, respectively. Additional de novo branches may be planned during the remainder of 2007 and into 2008 as opportunities arise. Currently, we have not located additional de novo locations. As a result of our branch network and branches opened in recent periods, we anticipate that our deposits will continue to increase throughout 2007.
Federal funds purchased and securities sold under agreements to repurchase were $31.7 million as of September 30, 2007, compared to $20.9 million and $30.4 million as of December 31, 2006 and September 30, 2006, respectively. The increase in federal funds purchased and repurchase agreements has been used as a source to fund the growth in our loan portfolio.
As a member of the Federal Home Loan Bank of Cincinnati (FHLB), we have the ability to acquire short and long-term advances through a blanket agreement secured by our unencumbered qualifying 1-4 family first mortgage loans and qualifying commercial real estate loans equal to at least 135% and 300%, respectively, of outstanding advances. We also use FSGBank’s borrowing capacity at FHLB to purchase a letter of credit that we pledged to the State of Tennessee Bank Collateral Pool. The letter of credit allows us to release investment securities from the Collateral Pool and thus improve our liquidity ratio. During the fourth quarter of 2006, we began utilizing the secured overnight advances to replace existing higher rate unsecured Federal Funds purchased. The following table details the maturities and rates of our borrowings from the FHLB of Cincinnati as of September 30, 2007.
Date | Type | Principal | Term | Rate | Maturity | ||||||
| 9/28/2007 | Fixed rate advance | $ | 52,590,000 | Overnight | 5.08% | 10/1/07 | |||||
| 12/6/2004* | Fixed rate advance | 2,667,000 | 48 months | 3.34% | 1/25/08 | ||||||
| 12/6/2005* | Fixed rate advance | 2,667,000 | 48 months | 4.11% | 1/26/09 | ||||||
| 6/18/1996* | Fixed rate advance | 1,547 | 180 months | 7.70% | 7/1/11 | ||||||
| 9/16/1996* | Fixed rate advance | 2,931 | 180 months | 7.50% | 10/1/11 | ||||||
| 9/9/1997* | Fixed rate advance | 3,735 | 180 months | 7.05% | 10/1/12 | ||||||
| $ | 57,932,213 | ||||||||||
| Aggregate composite rate | 4.96% |
| Overnight rate | 5.08% |
| 48 month composite rate | 3.73% |
| 180 month composite rate | 7.33% |
* Assumed as part of the acquisition of Jackson Bank.
Liquidity
Liquidity refers to our ability to adjust future cash flows to meet the needs of our daily operations. We rely primarily on management fees from FSGBank to fund our daily operations’ liquidity needs. Our cash balance on deposit with FSGBank, which totaled approximately $1.5 million as of September 30, 2007, is available for funding activities for which FSGBank would not receive direct benefit, such as cash dividends, acquisition due diligence, shareholder relations and holding company operations. These funds should adequately meet our cash flow needs. If we determine that our cash flow needs will be satisfactorily met, we may deploy a portion of the funds into FSGBank or use them in an acquisition in order to support continued growth.
The liquidity of FSGBank refers to the ability or financial flexibility to adjust its future cash flows to meet the needs of depositors and borrowers and to fund operations on a timely and cost effective basis. The primary sources of funds for FSGBank are cash generated by repayments of outstanding loans, interest payments on loans and new deposits. Additional liquidity is available from the maturity and earnings on securities and liquid assets, as well as the ability to liquidate securities available-for-sale.
At September 30, 2007, our liquidity ratio (defined as cash, due from banks, federal funds sold, and investment securities less securities pledged to secure liabilities divided by short-term funding liabilities less liabilities secured by pledged securities) was 13.4% (excluding anticipated loan repayments). As of December 31, 2006 and September 30, 2006, the liquidity ratios were 18.1% and 19.1% respectively.
As of September 30, 2007, the unused borrowing capacity (using 1-4 family residential mortgage and commercial real estate loans) for FSGBank at FHLB was $63.0 million. FHLB maintains standards for loan collateral files. Therefore, our borrowing capacity may be restricted if our collateral file has exceptions.
FSGBank also had unsecured federal funds lines in the aggregate amount of $99.5 million at September 30, 2007 under which it can borrow funds to meet short-term liquidity needs. The aggregate amount of the federal funds lines was available as of September 30, 2007. Another source of funding is loan participations sold to other commercial banks (in which we retain the service rights). As of quarter-end, we had $6.6 million in loan participations sold. FSGBank may continue to sell loan participations as a source of liquidity. An additional source of short-term funding would be to pledge investment securities against a line of credit at a commercial bank. As of quarter-end, FSGBank had no borrowings against our investment securities, except for repurchase agreements, treasury tax and loan deposits, and public-fund deposits attained in the ordinary course of business. As of September 30, 2007, FSGBank had $83.1 million in brokered CDs outstanding with a weighted average remaining life of approximately 12 months, a weighted average coupon rate of 4.77% and a weighted average all-in cost (which includes fees paid to deposit brokers) of 4.97%. Our certificates of deposit greater than $100 thousand were generated in FSGBank’s communities and are considered relatively stable. We believe that FSGBank’s liquidity sources are adequate to meet its operating needs.
We also have contractual cash obligations and commitments, which included certificates of deposit, other borrowings, operating leases and loan commitments. Unfunded loan commitments totaled $305.2 million at September 30, 2007. The following table illustrates our significant contractual obligations at September 30, 2007 by future payment period.
Contractual Obligations
Total | Less than One Year | One to Three Years | Three to Five Years | More than Five Years | ||||||||||||||||
| (in thousands) | ||||||||||||||||||||
| Certificates of deposit | (1) | $ | 575,212 | $ | 471,705 | $ | 94,317 | $ | 9,190 | $ | - | |||||||||
| Federal funds purchased and securities sold under agreements to repurchase | (2) | 31,702 | 31,702 | - | - | - | ||||||||||||||
| FHLB borrowings | (3) | 57,932 | 52,590 | 5,335 | 4 | 3 | ||||||||||||||
| Operating lease obligations | (4) | 5,371 | 947 | 1,867 | 969 | 1,588 | ||||||||||||||
| Note payable | (5) | 119 | 13 | 28 | 33 | 45 | ||||||||||||||
| Total | $ | 670,336 | $ | 556,957 | $ | 101,447 | $ | 10,196 | $ | 1,636 | ||||||||||
________ |
1 Certificates of deposit give customers rights to early withdrawal. Early withdrawals may be subject to penalties. The penalty amount depends on the remaining time to maturity at the time of early withdrawal. For more information regarding certificates of deposit, see “Deposits and Other Borrowings.” |
2 We expect securities repurchase agreements to be re-issued and, as such, do not necessarily represent an immediate need for cash. |
3 For more information regarding FHLB borrowings, see “Deposits and Other Borrowings.” |
4 Operating lease obligations include existing and future property and equipment non-cancelable lease commitments. |
5 This note payable is a mortgage on the land of our branch facility located at 2905 Maynardville Highway, Maynardville, Tennessee. |
Net cash provided by operations during the first nine months of 2007 totaled $17.2 million compared to $15.5 for the same period in 2006. The increase is primarily due to changes in loans held for sale and other assets. Net cash used in investing activities decreased to $68.4 million as compared to $89.8 million primarily due to the sale of available-for-sale securities, decreases in purchases of securities and the cash payment associated with the terminated cash flow swaps. Net cash provided by financing activities decreased to $55.2 million compared to $58.1 million in 2006. The decrease is primarily due to slower growth in deposits, partially offset by increases in other borrowings.
Derivatives Financial Instruments
Derivatives are used as a risk management tool and to facilitate client transactions. We utilize derivatives to hedge the exposure to changes in interest rates or other identified market risks. Derivatives may also be used to limit our exposure to interest rate risks created by customized loan products for our larger customers. These products allow us to meet the needs of our customers with minimal interest rate risk to the Bank. We currently have not used a derivative in a client transaction.
The Asset/Liability Committee (ALCO) is responsible for monitoring of our derivative positions. We believe the use of derivatives will reduce our interest rate risk and potential earnings volatility caused by changes in interest rates.
During the second quarter of 2007, we have entered into a series of cash flow hedges with a total notional amount of $150 million. All derivatives are recorded in the financial statements at fair value. We exchanged the cash flows from $150 million of our Prime-based variable rate loans for a fixed rate. During the third quarter, the Board of Directors elected to terminate the swaps to lock-in a gain in excess of $2.0 million. For the remainder of 2007 and all of 2008, the gain represents a 40 basis point increase in the yield on $150 million of our Prime-based variable rate loans. Subsequent to September 30, 2007, we entered into new cash flow hedges again exchanging our Prime-based variable rate cash flows for fixed rate cash flows. The total notional amount was $50 million with a term of five years and a weighted average fixed rate of approximately 7.72%.
The following are the cash flow hedges as of September 30, 2007:
| (in thousands) | Notional Amount | Gross Unrealized Gains | Gross Unrealized Losses | Accumulated Other Comprehensive Income | Maturity Date | |||||||||||||||
Asset Hedges | ||||||||||||||||||||
None | $ | - | $ | - | $ | - | $ | - | - | |||||||||||
Terminated Asset Hedges | ||||||||||||||||||||
Cash Flow hedges: 1 | ||||||||||||||||||||
| Interest Rate swap | $ | 19,000 | $ | - | $ | - | $ | 88 | June 28, 2009 | |||||||||||
| Interest Rate swap | 25,000 | - | - | 204 | June 28, 2010 | |||||||||||||||
| Interest Rate swap | 25,000 | - | - | 267 | June 28, 2011 | |||||||||||||||
| Interest Rate swap | 12,000 | - | - | 50 | June 28, 2009 | |||||||||||||||
| Interest Rate swap | 14,000 | - | - | 83 | June 28, 2010 | |||||||||||||||
| Interest Rate swap | 20,000 | - | - | 202 | June 28, 2011 | |||||||||||||||
| Interest Rate swap | 35,000 | - | - | 395 | June 28, 2012 | |||||||||||||||
| $ | 150,000 | $ | - | $ | - | $ | 1,289 | |||||||||||||
1 The $1.3 million of gains, net of taxes, recorded in accumulated other comprehensive income will be reclassified into earnings as interest income over the life of the respective hedged items.
Derivatives expose us to credit risk from the counterparty when the derivatives are in an unrealized gain position. All counterparties must be approved by the board of directors and are monitored by the ALCO on an ongoing basis. We minimize the credit risk exposure by requiring collateral when certain conditions are met. When the derivatives are at an unrealized loss position, our counterparty may require us to pledge collateral.
As of June 30, 2007, our income sensitivity to a rise or fall of interest rates by 200 basis points over a twelve-month period was a change of 2.49% and -5.21%, respectively, to net interest income. As of September 30, 2007, the exposure increased to 8.23% and -10.48%, respectively, using the same analysis. The primary drivers of the increase in risk are: 1) the termination of the cash flow hedges and 2) the falling interest rates in the five year treasury bond which caused our model to anticipate accelerated pre-payments on our fixed rate loan portfolio. The termination of our cash flow swaps locked in an approximate 40 basis point gain, or interest income of approximately $600 thousand over the next twelve months, on $150 million of our variable rate loans. Prior to the termination, the swaps eliminated interest rate risks on $150 million of our variable rate Prime-based loans. Additionally, the decrease in the yield on the five year treasury note during the third quarter accelerated pre-payment assumptions in our models, which further drove the risks higher. To offset the increases, we began issuing callable brokered CDs in the third quarter. We are continuing to monitor and evaluate our options to reduce our interest rate risk, as evidenced by entering cash flow swaps, which again exchanged Prime-based variable rate cash flows for fixed payments. Refer to Item 3 for further information on our income sensitivity calculation.
Off-Balance Sheet Arrangements
We are party to credit-related financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of our customers. These financial instruments include commitments to extend credit. Such commitments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets.
Our exposure to credit loss is represented by the contractual amount of these commitments. We follow the same credit policies in making commitments as we do for on-balance-sheet instruments.
Our maximum exposure to credit risk for unfunded loan commitments and standby letters of credit at September 30, 2007 and 2006 was as follows:
As of September 30, | ||||||||
2007 | 2006 | |||||||
| (in thousands) | ||||||||
| Commitments to Extend Credit | $ | 305,215 | $ | 268,062 | ||||
| Standby Letters of Credit | $ | 16,895 | $ | 14,917 | ||||
Commitments to extend credit are agreements to lend to customers. Commitments generally have fixed expiration dates or other termination clauses and may require payment of fees. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. We evaluate each customer’s credit worthiness on a case-by-case basis. The amount of collateral, if any, we obtain on an extension of credit is based on our credit evaluation of the customer. Collateral held varies but may include accounts receivable, inventory, property and equipment and income-producing commercial properties.
Capital Resources
Banks and bank holding companies, as regulated institutions, must meet required levels of capital. The Comptroller of the Currency and the Federal Reserve, the primary federal regulators for FSGBank and First Security, respectively, have adopted minimum capital regulations or guidelines that categorize components and the level of risk associated with various types of assets. Financial institutions are expected to maintain a level of capital commensurate with the risk profile assigned to their assets in accordance with the guidelines. First Security and FSGBank both maintain capital levels exceeding the minimum capital levels required in addition to exceeding those capital requirements for well capitalized banks and holding companies under applicable regulatory guidelines.
The following table compares the required capital ratios maintained by First Security and FSGBank:
September 30, 2007 | Well Capitalized | Adequately Capitalized | First Security | FSGBank | ||||||||||||
Tier I capital to risk adjusted assets | 6.0 | % | 4.0 | % | 11.2 | % | 11.0 | % | ||||||||
Total capital to risk adjusted assets | 10.0 | % | 8.0 | % | 12.2 | % | 12.1 | % | ||||||||
Leverage ratio | 5.0 | % | 4.0 | % | 10.2 | % | 10.0 | % | ||||||||
| December 31, 2006 | ||||||||||||||||
| Tier I capital to risk adjusted assets | 6.0 | % | 4.0 | % | 12.0 | % | 11.1 | % | ||||||||
| Total capital to risk adjusted assets | 10.0 | % | 8.0 | % | 13.1 | % | 12.1 | % | ||||||||
| Leverage ratio | 5.0 | % | 4.0 | % | 10.5 | % | 9.7 | % | ||||||||
| September 30, 2006 | ||||||||||||||||
| Tier I capital to risk adjusted assets | 6.0 | % | 4.0 | % | 12.1 | % | 10.9 | % | ||||||||
| Total capital to risk adjusted assets | 10.0 | % | 8.0 | % | 13.2 | % | 12.0 | % | ||||||||
| Leverage ratio | 5.0 | % | 4.0 | % | 10.5 | % | 9.4 | % | ||||||||
The declaration and payment of dividends on our common stock will depend upon our earnings and financial condition, liquidity and capital requirements, the general economic and regulatory climate, our ability to service any equity or debt obligations senior to our common stock and other factors deemed relevant by our Board of Directors. In the first nine months of 2007, we paid three cash dividends of $0.05 per share or $2.6 million in total. On October 25, 2007, the Board of Directors declared the fourth quarter cash dividend of $0.05 per share payable on December 18, 2007 to shareholders of record on December 3, 2007.
On November 29, 2006, our Board of Directors authorized a plan to buy back up to 500,000 shares of our common stock in open market transactions. As of September 30, 2007, we had repurchased all 500,000 thousand shares at a weighted average price of $10.86.
On August 22, 2007, the Board of Directors authorized the repurchase of up to an additional 500,000 shares in open market transactions. Purchases of the August plan began in October 2007.
EFFECTS OF INFLATION
Inflation generally increases the cost of funds and operating overhead, and, to the extent loans and other assets bear variable rates, the yields on such assets. Unlike most industrial companies, virtually all of our assets and liabilities are monetary in nature. As a result, interest rates generally have a more significant impact on our performance than the effects of general levels of inflation. Although interest rates do not necessarily move in the same direction, or to the same extent, as the prices of goods and services, increases in inflation generally have resulted in increased interest rates. If the Federal Reserve believes that the rate of inflation is likely to increase to undesired levels, its method of curbing inflation in the past has been to increase the interest rate charged on short-term federal borrowings.
In addition, inflation results in an increased cost of goods and services purchased, cost of salaries and benefits, occupancy expense and similar items. Inflation and related increases in interest rates generally decrease the market value of investments and loans held and may adversely affect the earnings of our commercial banking and mortgage banking business and our stockholders’ equity. With respect to our mortgage banking business, mortgage originations and refinancings tend to slow as interest rates increase, and increased interest rates would likely reduce our earnings from such activities and the income from the sale of residential mortgage loans in the secondary market.
RECENT ACCOUNTING PRONOUNCEMENTS
In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (SFAS 159). The Statement allows an irrevocable election to measure certain financial assets and financial liabilities at fair value on an instrument-by-instrument basis, with unrealized gains and losses recognized currently in earnings. Under SFAS 159, the fair value option may only be elected at the time of initial recognition of a financial asset or financial liability or upon the occurrence of certain specified events. Additionally, SFAS 159 provides that application of the fair value option must be based on the fair value of an entire financial asset or financial liability and not selected risks inherent in those assets or liabilities. SFAS 159 requires that assets and liabilities which are measured at fair value pursuant to the fair value option be reported in the financial statements in a manner that separates those fair values from the carrying amounts of similar assets and liabilities which are measured using another measurement attribute. SFAS 159 also provides expanded disclosure requirements regarding the effects of electing the fair value option on the financial statements. SFAS No. 159 is effective prospectively for fiscal years beginning after November 15, 2007, with early adoption permitted for fiscal years in which interim financial statements have not been issued, provided that all of the provisions of SFAS No. 157 are early adopted as well. We early adopted SFAS 159 effective January 1, 2007. Notes 2 and 10 provide for further information.
In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, Fair Value Measurements (SFAS 157) to clarify how to measure fair value and to expand disclosures about fair value measurements. The expanded disclosures include the extent to which companies measure assets and liabilities at fair value, the information used to measure fair value, and the effect of fair value on earnings and is applicable whenever other standards require (or permit) assets and liabilities to be measured at fair value. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years with early adoption permitted. We adopted SFAS 157 effective January 1, 2007. Note 9 provides further information.
In June 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109, Accounting for Income Taxes (FIN 48). The Interpretation provides guidance for recognition and measurement of uncertain tax positions that are “more likely than not” of being sustained upon audit, based on the technical merits of the position. FIN 48 also provides guidance on measurement, derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. The adoption date is for fiscal years beginning after December 15, 2006. We adopted FIN 48 as of January 1, 2007. The adoption did not have a material impact on our consolidated financial statements. Note 8 provides further information.
In December 2005, the FASB issued FASB Staff Position (FSP) SOP 94-6-1, Terms of Loan Products That May Give Rise to a Concentration of Credit Risk. This FSP was issued in response to inquiries from constituents and discussions with the SEC staff and regulators of financial institutions to address the circumstances in which the terms of loan products give rise to a concentration of credit risk as that term is used in SFAS No. 107, Disclosures about Fair Value of Financial Instruments, and what disclosures apply to entities who deal with loan products whose terms may give rise to a concentration of credit risk. An entity shall provide the disclosures required by SFAS No. 107 for either an individual loan product type or a group of loan products with similar features that are determined to represent a concentration of credit risk in accordance with the guidance of SOP 94-6-1 for all periods presented in financial statements. This SOP is effective for interim and annual periods ending after December 19, 2005. The adoption of FSP SOP 94-6-1 did not have a material impact on our consolidated financial statements.
In November 2005, the FASB issued a FSP on SFAS No. 115-1 and SFAS No. 124-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments, which addresses the determination of when an investment is considered impaired; whether the impairment is other-than-temporary; and how to measure an impairment loss. This FSP also addresses accounting considerations subsequent to the recognition of an other-than-temporary impairment of a debt security, and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. This FSP replaces the impairment guidance on Emerging issues Task Force (EITF) Issue No. 03-1 with references to existing authoritative literature concerning other-than-temporary determinations. Under this FSP, losses arising from impairment deemed to be other-than-temporary, must be recognized in earnings at an amount equal to the entire difference between the securities cost and its fair value at the financial statement date, without considering partial recoveries subsequent to that date. The FSP also required that an investor recognize an other-than-temporary impairment loss when a decision to sell a security has been made and the investor does not expect the fair value of the security to fully recover prior to the expected time of sale. The FSP is effective for reporting periods beginning after December 15, 2005. The adoption did not have a material impact on our consolidated financial statements.
In May 2005, the FASB issued Statement of Financial Accounting Standards No. 154 (SFAS No. 154), Accounting Changes and Error Corrections — a replacement of APB Opinion No. 20 and FASB Statement No. 3, which eliminates the requirement to reflect changes in accounting principles as cumulative adjustments to net income in the period of the change and requires retrospective application to prior periods’ financial statements for voluntary changes in accounting principle, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. If it is impracticable to determine the cumulative effect of the change to all prior periods, SFAS No. 154 requires that the new accounting principle be adopted prospectively. For new accounting pronouncements, the transition guidance in the pronouncement should be followed. Retrospective application refers to the application of a different accounting principle to previously issued financial statements as if that principle had always been used. SFAS 154 did not change the guidance for reporting corrections of errors, changes in estimates or for justification of a change in accounting principle on the basis of preferability. SFAS No. 154 is effective for accounting changes made in fiscal years beginning after December 15, 2005. The adoption of SFAS No. 154 did not have a material impact on our consolidated financial statements.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk, with respect to us, is the risk of loss arising from adverse changes in interest rates and prices. The risk of loss can result in either lower fair market values or reduced net interest income. We manage several types of risk, such as credit, liquidity and interest rate. We consider interest rate risk to be a significant risk that could potentially have a large material effect on our financial condition. Further, we process hypothetical scenarios whereby we shock our balance sheet up and down for possible interest rate changes, we analyze the potential change (positive or negative) to net interest income, as well as the effect of changes in fair market values of assets and liabilities. As we continue to diversify our risks, we anticipate utilizing the fair value option on future transactions in circumstances that we can match market value or interest rate sensitivity. We do not deal in international instruments, and therefore are not exposed to risk inherent to foreign currency.
Our interest rate risk management is the responsibility of the Asset/Liability Committee (ALCO). ALCO has established policies and limits to monitor, measure and coordinate our sources, uses and pricing of funds.
Interest rate risk represents the sensitivity of earnings to changes in interest rates. As interest rates change, the interest income and expense associated with our interest sensitive assets and liabilities also change, thereby impacting net interest income, the primary component of our earnings. ALCO utilizes the results of both static gap and income simulation reports to quantify the estimated exposure of net interest income to a sustained change in interest rates.
Our income simulation analysis projected net interest income based on both a rise and fall in interest rates of 200 basis points (i.e. 2.00%) over a twelve-month period. Given this scenario, we had, as of September 30, 2007, an exposure to falling rates and a benefit from rising rates. More specifically, our model forecasts a decline in net interest income of $3.8 million or 10.48%, as a result of a 200 basis point decline in rates. The model also predicts a $3.0 million increase in net interest income, or 8.23% as a result of a 200 basis point increase in rates. The forecasted results of the model are within the limits specified by ALCO. The following chart reflects our sensitivity to changes in interest rates as of September 30, 2007. The numbers are based on a static balance sheet, and the chart assumes that pay downs and maturities of both assets and liabilities are reinvested in like instruments at current interest rates, rates down 200 basis points, and rates up 200 basis points.
Interest Rate Risk
Income Sensitivity Summary
Down 200 BPS | Current | Up 200 BPS | ||||||||||
| (in thousands, except percentages) | ||||||||||||
(Restated) | (Restated) | (Restated) | ||||||||||
| Net interest income | $ | 32,783 | $ | 36,621 | $ | 39,635 | ||||||
| $ change net interest income | (3,838 | ) | - | 3,014 | ||||||||
| % change net interest income | -10.48 | % | 0.00 | % | 8.23 | % | ||||||
The preceding sensitivity analysis is a modeling analysis, which changes periodically and consists of hypothetical estimates based upon numerous assumptions including interest rate levels, shape of the yield curve, prepayments on loans and securities, rates on loans and deposits, reinvestments of paydowns and maturities of loans, investments and deposits, and other assumptions. In addition, there is no input for growth or a change in asset mix. While assumptions are developed based on the current economic and market conditions, we cannot make any assurances as to the predictive nature of these assumptions including how customer preferences or competitor influences might change.
As market conditions vary from those assumed in the sensitivity analysis, actual results will differ. Also, the sensitivity analysis does not reflect actions that we might take in responding to or anticipating changes in interest rates, such as entering interest rate swaps or issuing callable brokered CDs.
We use the Sendero Vision Asset/Liability system which is a comprehensive interest rate risk measurement tool that is widely used in the banking industry. Generally, it provides the user with the ability to more accurately model both static and dynamic gap, economic value of equity, duration and income simulations using a wide range of scenarios including interest rate shocks and rate ramps. The system also models our derivative instruments.
ITEM 4. CONTROLS AND PROCEDURES
As of the end of the period covered by this Quarterly Report on Form 10-Q, our principal executive officer and principal financial officer have evaluated the effectiveness of our “disclosure controls and procedures” (Disclosure Controls). Disclosure Controls, as defined in Rule 13a-15(e) of the Securities Exchange Act of 1934, as amended (the Exchange Act), are procedures that are designed with the objective of ensuring that information required to be disclosed in our reports filed under the Exchange Act, such as this Quarterly Report, is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms. Disclosure Controls are also designed with the objective of ensuring that such information is accumulated and communicated to our management, including the CEO and CFO (hereinafter in Item 4 “management, including the CEO and CFO,” are referred to collectively as “management”), as appropriate to allow timely decisions regarding required disclosure.
Our management does not expect that our Disclosure Controls will prevent all error and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.
As a result of the restatement discussed in Note 2 of our consolidated financial statements included elsewhere in this Form 10-Q/A, management reevaluated the effectiveness of our Disclosure Controls in connection with the filing of this Form 10-Q/A. Based upon their controls evaluation, and in light of, and giving due consideration to, the restatement and the reasons therefor, they have concluded that our Disclosure Controls are effective at a reasonable assurance level.
At the time of early adoption, management had determined that the application was proper and consistent with the general interpretations of SFAS 159 in effect in the accounting industry. Management based its conclusion on its extensive review of the applicable accounting literature regarding SFAS 159 and its consultation with its independent registered public accounting firm (Joseph Decosimo and Company, PLLC). Management then presented the accounting guidance to the Board of Directors, who approved the early adoption and application of the fair value option to the selected investment securities. Management believes that the internal processes regarding the evaluation of accounting treatment, including discussions with the Board of Directors and the extensive communications with First Security’s independent registered public accounting firm, indicate that appropriate Disclosure Controls were, and continue to be, in place.
In the fourth quarter of 2007, management reevaluated the accounting treatment for SFAS 159 due to discussions with the OCC, which focused on the evolving interpretations of existing guidance. As a result, management and the Board of Directors, in consultation with our independent registered public accounting firm, decided to restate the financial statements contained in the Form 10-Q.
There have been no significant changes in our internal control over financial reporting during our first, second or third fiscal quarters that have materially affected, or are reasonably likely to materially affect our internal control over financial reporting. We have evaluated and concluded that the restatement does not indicate a material weakness in internal controls over financial reporting and that the restatement does not impact such controls and procedures that were effective as of the end of the periods covered by the restatement. We believe that our internal controls are functional and adequate, and on an ongoing basis we will continue to review and, as appropriate, improve our internal controls.
Under Auditing Standard No. 5 of the Public Company Accounting Oversight Board, a restatement of previously issued financial statements is an indicator of the existence of a “material weakness” in internal control over financial reporting. Under the relevant SEC rules, management will not be permitted to conclude that internal control over financial reporting is effective if it has identified one or more material weaknesses in those internal controls. Management believes that the restatement was the result of the evolving interpretations of existing guidance regarding the application of new accounting pronouncements and not the result of a lack of personnel or technical expertise. As such, management believes that this restatement is not the result of a “material weakness.”
PART II. OTHER INFORMATION
ITEM 1A. RISK FACTORS
In addition to the other information set forth in this report, you should carefully consider the factors discussed in Part I, “Item 1A. Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2006, which could materially affect our business, financial condition or future results. The risks described in our Annual Report on Form 10-K are not the only risks facing our Company. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and/or operating results.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
On November 29, 2006, our Board of Directors authorized a plan to buy back up to 500,000 shares of our common stock in open market transactions. On August 17, 2007, we completed our repurchase of these 500,000 shares at a weighted average price of $10.86 per share.
On August 22, 2007, our Board of Directors authorized a plan to buy back up to 500,000 shares of our common stock in open market transactions. Through September 30, 2007, we had not repurchased any shares under this plan. The specific timing and amount of repurchases will vary based on market conditions, securities law limitations and other facts. The repurchases will be made with our cash reserves, and may be suspended or discontinued at any time without prior notice.
The following table provides additional information on the repurchases completed during the third 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 | Maximum Number of Shares that May Yet Be Purchased Under the Plans or Programs | ||||||||||||
| July 1, 2007 – July 31, 2007 | 46,700 | $ | 10.73 | 46,700 | 181,644 | |||||||||||
| August 1, 2007 – August 31, 2007 | 181,644 | $ | 10.09 | 181,644 | 500,000 | |||||||||||
| September 1, 2007 – September 30, 2007 | - | $ | - | - | 500,000 | |||||||||||
| 228,344 | 228,344 | |||||||||||||||
Exhibits:
| EXHIBIT NUMBER | DESCRIPTION | |
| Certification of Chief Executive Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934 | ||
| Certification of Chief Financial Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934 | ||
| Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Rule 13a-14(b) under the Securities Exchange Act of 1934 | ||
| Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Rule 13a-14(b) under the Securities Exchange Act of 1934 |
SIGNATURES
Pursuant to the requirements of the Securities and Exchange Act of 1934, the Registrant has duly caused this Report to be signed by the undersigned, thereunto duly authorized.
| FIRST SECURITY GROUP, INC. | ||
| (Registrant) | ||
| December 18, 2007 | /s/ Rodger B. Holley | |
| Rodger B. Holley | ||
| Chairman & Chief Executive Officer | ||
| December 18, 2007 | /s/ William L. Lusk, Jr. | |
| William L. Lusk, Jr. | ||
| Secretary, Chief Financial Officer & | ||
| Executive Vice President | ||
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