WASHINGTON, D. C. 20549
[x] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
The following table presents these non-GAAP financial measures and provides a reconciliation of these non-GAAP measures to the most directly comparable GAAP measure reported in the unaudited condensed consolidated financial statements:
Reconciliation of Non-GAAP Financial Measures
| | | Three Months Ended | | | | |
| | | June 30, 2012 | | | June 30, 2012 | | | December 31, 2011 | |
| | | (Unaudited) | | | (Unaudited) | | | | |
| | | (dollars in thousands, except per share amounts) | | | | |
| Tangible assets | | | | | | | | | |
| Total assets | | $ | 1,119,119 | | | $ | 1,113,222 | | | | |
| Less: intangible assets | | | 4,439 | | | | 4,450 | | | | |
| Tangible assets | | $ | 1,114,680 | | | $ | 1,108,772 | | | | |
| | | | | | | | | | | | |
| Tangible common equity | | | | | | | | | | | |
| Total common equity | | $ | 194,186 | | | $ | 190,054 | | | | |
| Less: intangible assets | | | 4,439 | | | | 4,450 | | | | |
| Tangible common equity | | $ | 189,747 | | | $ | 185,604 | | | | |
| | | | | | | | | | | | |
| Tangible common equity to tangible assets | | | | | | | | | | | |
| Tangible common equity | | | 189,747 | | | | 185,604 | | | | |
| Divided by: tangible assets | | | 1,114,680 | | | | 1,108,772 | | | | |
| Tangible common equity to tangible assets | | | 17.02 | % | | | 16.74 | % | | | |
| | | | | | | | | | | | |
| Profitability measures excluding merger-related expenses | | | | | | | | | | | |
| Net interest income | | $ | 10,099 | | | $ | 11,719 | | | | |
| Less: accelerated mark accretion | | | (277 | ) | | | (1,469 | ) | | | |
| Net interest income excluding accelerated mark accretion | | | 9,822 | | | | 10,250 | | | | |
| Divided by: average earning assets | | | 1,012,579 | | | | 1,013,998 | | | | |
| Multiplied by: annualization factor | | | 4.02 | | | | 4.02 | | | | |
| Net interest margin excluding accelerated mark accretion | | | 3.90 | % | | | 4.07 | % | | | |
| | | | | | | | | | | | |
| Asset quality measures and loan information excluding acquisition | | | | | | | | | | | |
| Total loans | | $ | 712,506 | | | $ | 727,862 | | | $ | 759,047 | |
| Less: PCI loans acquired with Community Capital | | | (48,045 | ) | | | (55,843 | ) | | | (63,818 | ) |
| Purchased performing loans acquired with Community Capital | | | (262,104 | ) | | | (285,174 | ) | | | (299,682 | ) |
| Loans excluding acquired loans (originated loans) | | $ | 402,357 | | | $ | 386,845 | | | $ | 395,547 | |
| | | | | | | | | | | | | |
| Allowance for loan losses | | $ | 9,431 | | | $ | 9,556 | | | $ | 10,154 | |
| Less: allowance related to acquired PCI loans | | | (254 | ) | | | - | | | | - | |
| Allowance for loan losses excluding allowance related to PCI loans | | | 9,177 | | | | 9,556 | | | | 10,154 | |
| Less: allowance related to acquired purchased performing loans | | | (346 | ) | | | (150 | ) | | | - | |
| Allowance for loan losses related to nonacquired loans | | $ | 8,831 | | | $ | 9,406 | | | $ | 10,154 | |
| Divided by: loans excluding acquisition | | | 402,357 | | | | 386,845 | | | | 395,547 | |
| Allowance for loan losses to loans excluding acquisition | | | 2.19 | % | | | 2.43 | % | | | 2.57 | % |
| | | | | | | | | | | | | |
| Allowance for loan losses related to acquired purchased performing loans | | | 346 | | | | 150 | | | | - | |
| Divided by: purchased performing loans | | | 262,104 | | | | 285,174 | | | | 299,682 | |
| Allowance for loan losses related to acquired purchased performing loans to purchased performing loans | | | 0.13 | % | | | 0.05 | % | | | 0.00 | % |
Recent Accounting Pronouncements
See Note 2 to the Unaudited Financial Statements for a description of recent accounting pronouncements including the respective expected dates of adoption and effects on results of operations and financial condition.
Critical Accounting Policies and Estimates
In the preparation of our financial statements, we have adopted various accounting policies that govern the application of GAAP and in accordance with general practices within the banking industry. Our significant accounting policies are described in Note 2 – Summary of Significant Accounting Policies to the 2011 Audited Financial Statements. While all of these policies are important to understanding our financial statements, certain accounting policies described below involve significant judgment and assumptions by management that have a material impact on the carrying value of certain assets and liabilities. We consider these accounting policies to be critical accounting policies. The judgment and assumptions we use are based on historical experience and other factors, which we believe to be reasonable under the circumstances. Because of the nature of the judgment and assumptions we make, actual results could differ from these judgments and assumptions that could have a material impact on the carrying values of our assets and liabilities and our results of operations.
Purchased Credit-Impaired Loans. Loans purchased with evidence of credit deterioration since origination and for which it is probable that all contractually required payments will not be collected are considered credit impaired. Evidence of credit quality deterioration as of the purchase date may include statistics such as past due and nonaccrual status, recent borrower credit scores and recent loan-to-value (“LTV”) percentages. PCI loans are initially measured at fair value, which includes estimated future credit losses expected to be incurred over the life of the loan. Accordingly, the associated allowance for credit losses related to these loans is not carried over at the acquisition date. We estimated the cash flows expected to be collected at acquisition using our internal credit risk, interest rate risk, prepayment risk assumptions and a third-party valuation model, which incorporate our best estimate of current key relevant factors, such as property values, default rates, loss severity and prepayment speeds.
Under the accounting guidance for PCI loans, the excess of cash flows expected to be collected over the estimated fair value is referred to as the accretable yield and is recognized in interest income over the remaining life of the loan, or pool of loans, in situations where there is a reasonable expectation about the timing and amount of cash flows to be collected. The difference between the contractually required payments and the cash flows expected to be collected at acquisition, considering the impact of prepayments, is referred to as the nonaccretable difference.
In addition, subsequent to acquisition, we periodically evaluate our estimate of cash flows expected to be collected. These evaluations, performed quarterly, require the continued usage of key assumptions and estimates, similar to the initial estimate of fair value. In the current economic environment, estimates of cash flows for PCI loans require significant judgment given the impact of home price and property value changes, changing loss severities, prepayment speeds and other relevant factors. Decreases in the expected cash flows will generally result in a charge to the provision for credit losses resulting in an increase to the allowance for loan losses. Significant increases in the expected cash flows will generally result in an increase in interest income over the remaining life of the loan, or pool of loans. Disposals of loans, which may include sales of loans to third parties, receipt of payments in full or part from the borrower or foreclosure of the collateral, result in removal of the loan from the PCI loan portfolio at its carrying amount.
PCI loans currently represent loans acquired from Community Capital that were deemed credit impaired. PCI loans that were classified as nonperforming loans by Community Capital are no longer classified as nonperforming because, at acquisition, we believe we will fully collect the new carrying value of these loans. It is important to note that judgment regarding the timing and amount of cash flows to be collected is required to classify PCI loans as performing, even if the loan is contractually past due.
Allowance for Loan Losses. The allowance for loan losses is based upon management’s ongoing evaluation of the loan portfolio and reflects an amount considered by management to be its best estimate of known and inherent losses in the portfolio as of the balance sheet date. The determination of the allowance for loan losses involves a high degree of judgment and complexity. In making the evaluation of the adequacy of the allowance for loan losses, management considers current economic conditions, independent loan reviews performed periodically by third parties, delinquency information, management’s internal review of the loan portfolio, and other relevant factors. While management uses the best information available to make evaluations, future adjustments to the allowance may be necessary if conditions differ substantially from the assumptions used in making the evaluations. In addition, regulatory examiners may require us to recognize changes to the allowance for loan losses based on their judgments about information available to them at the time of their examination. Although provisions have been established by loan segments based upon management’s assessment of their differing inherent loss characteristics, the entire allowance for losses on loans is available to absorb further loan losses in any segment. Further information regarding our policies and methodology used to estimate the allowance for possible loan losses is presented in Note 5 – Loans to the 2011 Audited Financial Statements, and Note 6 – Loans and Allowance for Loan Losses to the Unaudited Financial Statements.
Income Taxes. Income taxes are provided based on the asset-liability method of accounting, which includes the recognition of DTAs and liabilities for the temporary differences between carrying amounts and tax bases of assets and liabilities, computed using enacted tax rates. In general, we record a DTA when the event giving rise to the tax benefit has been recognized in the consolidated financial statements.
As of June 30, 2012 and December 31, 2011, we had a net DTA in the amount of approximately $29.8 million and $31.1 million, respectively. We evaluate the carrying amount of our DTA quarterly in accordance with the guidance provided in FASB ASC Topic 740 (“ASC 740”), in particular, applying the criteria set forth therein to determine whether it is more likely than not (i.e., a likelihood of more than 50%) that some portion, or all, of the DTA will not be realized within its life cycle, based on the weight of available evidence. In most cases, the realization of the DTA is dependent upon the Company generating a sufficient level of taxable income in future periods, which can be difficult to predict. If our forecast of taxable income within the carry forward periods available under applicable law is not sufficient to cover the amount of net deferred assets, such assets may be impaired. Based on the weight of available evidence, we have determined that it is more likely than not that we will be able to fully realize the existing DTA. Accordingly, we consider it appropriate not to establish a DTA valuation allowance at either June 30, 2012 or December 31, 2011.
In evaluating whether we will realize the full benefit of our net deferred tax asset, we considered projected earnings, asset quality, liquidity, capital position (which will enable us to deploy capital to generate taxable income), growth plans, and similar factors. In addition, we considered the previous twelve quarters of income (loss) before income taxes in determining the need for a valuation allowance, which is called the cumulative loss test. For the year ended 2011, we incurred a loss, primarily because of the increased provision for loan losses, which resulted in the failure of the cumulative loss test. Significant negative trends in credit quality, losses from operations, and similar factors. could affect the realizability of the deferred tax asset in the future.
Further information regarding our income taxes, including the methodology used to determine the need for a valuation allowance for the existing DTA, if any, is presented in Note 7 —Income Taxes to the Unaudited Financial Statements.
Financial Condition at June 30, 2012 and December 31, 2010
Total assets of $1.1 billion at June 30, 2012 were flat compared to December 31, 2011. During the six months, cash, interest-earning balances and Federal funds sold increased $46.7 million, or 163%, and investment securities available-for-sale increased $12.1 million, or 6%, while net loans, including loans held for sale, decreased $46.7 million, or 6%, and non-marketable equity securities decreased $3.0 million, or 36%
Total liabilities at June 30, 2012 were $924.9 million, an increase of $1.7 million, or 0.2%, over total liabilities of $923.2 million at December 31, 2011. Total deposits decreased $4.6 million, or 0.5% and total borrowings increased $7.1 million, or 12%, during the first half of 2012. Total borrowings included $6.9 million in Tier 2-eligible subordinated debt at June 30, 2012 and December 31, 2011, and $5.6 million and $5.4 million of Tier 1-eligible subordinated debt (after acquisition accounting fair market value adjustments) at June 30, 2012 and December 31, 2011, respectively.
Total shareholders’ equity increased $4.1 million, or 2%, during the first six months to $194.2 million at June 30, 2012. This increase resulted from net income for the six months ended June 30, 2012 of $2.4 million, $740 thousand in accumulated other comprehensive income from unrealized securities gains, and $991 thousand of share-based compensation expense.
The following table reflects selected ratios for the Company for the six months ended June 30, 2012 and 2011 and for the year ended December 31, 2012:
| | | | | | | |
| | | 2012 | | | 2011 | | | 2011* | |
| Return on Average Assets | | | 0.43 | % | | | -1.95 | % | | | -1.20 | % |
| | | | | | | | | | | | | |
| Return on Average Equity | | | 2.50 | % | | | -6.82 | % | | | -4.69 | % |
| | | | | | | | | | | | | |
| Period End Equity to Total Assets | | | 17.35 | % | | | 28.43 | % | | | 17.07 | % |
Investments and Other Interest-earning Assets
Investment securities increased $12.1 million, or 5.75%, to $222.2 million at June 30, 2012, from $210.1 million at December 31, 2011. Purchases of investment securities available-for-sale were $51.7 million for the six months ended June 30, 2012. Proceeds from the sales, calls, and maturities of investment securities available-for-sale totaled $41.4 million for the six months ended June 30, 2012, resulting in gains on the sale of securities available-for-sale of $0.5 million. Our investment portfolio consists of U.S. government agency securities, residential mortgage-backed securities, municipal securities and other debt instruments. At the end of the second quarter, our investment portfolio had a net unrealized gain of $5.8 million compared to a $4.7 million net unrealized gain at December 31, 2011. There were no securities with an unrealized loss deemed to be other than temporary at June 30, 2012 or December 31, 2011.
At June 30, 2012, we had $29.5 million in federal funds sold, and $29.8 million in interest-bearing deposits with other FDIC-insured financial institutions. This compares with no federal funds sold and $10.1 million in interest-bearing deposits at other FDIC-insured financial institutions at December 31, 2011.
Loans
We consider asset quality to be of primary importance, and we employ a formal internal loan review process to ensure adherence to lending policies as approved by our board of directors. Since inception, we have promoted the separation of loan underwriting from the loan production staff through our credit department. Currently, credit administration analysts are responsible for underwriting and assigning proper risk grades for all loans with an individual, or relationship, exposure in excess of $500 thousand. Underwriting is completed on standardized forms including a loan approval form and separate credit memorandum. The credit memorandum includes a summary of the loan’s structure and a detailed analysis of loan purpose, borrower strength (including individual and global cash flow worksheets), repayment sources and, when applicable, collateral positions and guarantor strength. The credit memorandum further identifies exceptions to policy and/or regulatory limits, total exposure, LTV, risk grades and other relevant credit information. Loans are approved or denied by varying levels of signature authority based on total exposure. A management-level loan committee is responsible for approving all credits with $1 million or greater in cumulative related exposure.
Our loan underwriting policy contains LTV limits that are at or below levels required under regulatory guidance, when such guidance is available, including limitations for non-real estate collateral, such as accounts receivable, inventory and marketable securities. When applicable, we compare LTV with loan-to-cost guidelines and ultimately limit loan amounts to the lower of the two ratios. We also consider FICO scores and strive to uphold a high standard when extending loans to individuals. LTV limits have been selectively reduced in response to the recent economic cycle. In particular, loans collateralized with 1-4 family properties have seen a reduction in their maximum LTV. We have not underwritten any subprime, hybrid, no-documentation or low-documentation products.
All acquisition, construction and development loans (“AC&D”), commercial and consumer, are subject to our policies, guidelines and procedures specifically designed to properly identify, monitor and mitigate the risk associated with these loans. Loan officers receive and review a cost budget from the borrower at the time an AC&D loan is originated. Loan draws are monitored against the budgeted line items during the development period in order to identify potential cost overruns. Individual draw requests are verified through review of supporting invoices as well as site inspections performed by an external inspector. Additional periodic site inspections are performed by loan officers at times that do not coincide with draw requests in order to keep abreast of ongoing project conditions. Project status is reported to senior management on an ongoing basis via our monthly C&D and watch meetings. Reports generated regarding acquisition, construction and development loans include status of the project, summary of customer correspondence, site visit update when performed, review of risk grade and impairment analysis, if applicable. As of June 30, 2012, approximately 43% of our AC&D loan portfolio, commercial and consumer, falls under the watch list.
Our second mortgage exposure is primarily attributable to our HELOC portfolio, which totals approximately $84 million as of June 30, 2012, of which approximately 61% is secured by second mortgages and approximately 39% is secured by first mortgages. All loans are assigned an internal risk grade and monitored by the credit administration function in the same fashion as commercial loans. Aside from loan committee, loan review and watch list meetings, loans are also monitored for delinquency through periodic past due meetings. As of June 30, 2012, there were two accruing delinquent HELOCs, totaling $36 thousand, in our portfolio.
At June 30, 2012, total loans were $712.5 million compared to $759.0 million at December 31, 2011. This decline included a $53.3 million, or 15%, reduction in acquired loans to $310.1 million partially offset by an increase of $6.8 million, or 2%, in non-acquired loans to $402.4 million. The decline in acquired loans reflects higher than expected reductions in targeted CRE- investor income producing and AC&D loans, repayments resulting from the improved condition of certain borrowers in multiple loan categories and the reclassification of purchased performing loans for which a “major modification” has occurred. Such reclassifications for the first six months of 2012 totaled approximately $15 million. The increase in non-acquired loans reflects these reclassifications, partially offset by an underlying decline in originated loans. This decline reflects both repayments resulting from the improved condition of certain borrowers and tempered new loan production as a result of our unwillingness to match certain interest rate and term structures available from competitors in our markets, primarily for CRE-owner-occupied properties. Additionally, we have successfully worked out or resolved many problem loans either through payoff or foreclosure. The pipeline of new loan opportunities is strong, particularly associated with commercial and industrial borrowers, for which we believe market conditions are currently more attractive.
Asset Quality and Allowance for Loan Losses
The allowance for loan losses is based upon management’s ongoing evaluation of the loan portfolio and reflects an amount considered by management to be its best estimate of known and inherent losses in the portfolio as of the balance sheet date. The determination of the allowance for loan losses involves a high degree of judgment and complexity. In making the evaluation of the adequacy of the allowance for loan losses, management considers current economic conditions, independent loan reviews performed periodically by third parties, delinquency information, management’s internal review of the loan portfolio, and other relevant factors. While management uses the best information available to make evaluations, future adjustments to the allowance may be necessary if conditions differ substantially from the assumptions used in making the evaluations. In addition, regulatory examiners may require us to recognize changes to the allowance for loan losses based on their judgments about information available to them at the time of their examination. Although provisions have been established by loan segments based upon management’s assessment of their differing inherent loss characteristics, the entire allowance for losses on loans is available to absorb further loan losses in any segment.
Our Allowance for Loan Losses Committee (the “Allowance Committee”) is responsible for overseeing our allowance and works with our chief executive officer, senior financial officers, senior risk management officers and Audit Committee in developing and achieving our allowance methodology and practices. We introduced certain enhancements to our allowance methodology during the fourth quarter of 2011, and further refinements were implemented during the second quarter of 2012. Further information regarding our policies and methodology used to estimate the allowance for possible loan losses is presented in Note 6 – Loans and Allowance for Loan Losses to the Unaudited Financial Statements.
The following table provides a breakdown of the components of our allowance for loan losses by loan segment and its contribution to the allowance at June 30, 2012:
Allowance Allocation by Component
| | | | | | | | | | | | | | | | | | | |
| | | Specific Reserve | | | Quantitative Reserve | | | Qualitative Reserve | |
| | | $ | | | % of Total Allowance | | | $ | | | % of Total Allowance | | | $ | | | % of Total Allowance | |
| | | (dollars in thousands) | |
| Commercial: | | | | | | | | | | | | | | | | | | |
| Commercial and industrial | | $ | 65 | | | | 0.69 | % | | $ | 1,044 | | | | 11.07 | % | | $ | 72 | | | | 0.76 | % |
| CRE - owner-occupied | | | 61 | | | | 0.65 | % | | | 193 | | | | 2.05 | % | | | 143 | | | | 1.52 | % |
| CRE - investor income producing | | | 173 | | | | 1.83 | % | | | 967 | | | | 10.25 | % | | | 186 | | | | 1.97 | % |
| AC&D | | | 404 | | | | 4.28 | % | | | 3,241 | | | | 34.37 | % | | | 64 | | | | 0.68 | % |
| Other commercial | | | - | | | | 0.00 | % | | | 3 | | | | 0.03 | % | | | 8 | | | | 0.08 | % |
| Consumer: | | | | | | | | | | | | | | | | | | | | | | | | |
| Residential mortgage | | | 256 | | | | 2.71 | % | | | 236 | | | | 2.50 | % | | | 45 | | | | 0.48 | % |
| Home equity lines of credit | | | 157 | | | | 1.66 | % | | | 1,130 | | | | 11.98 | % | | | 82 | | | | 0.87 | % |
| Residential construction | | | - | | | | 0.00 | % | | | 584 | | | | 6.19 | % | | | 22 | | | | 0.23 | % |
| Other loans to individuals | | | - | | | | 0.00 | % | | | 30 | | | | 0.32 | % | | | 11 | | | | 0.12 | % |
| Purchase credit-impaired | | | 254 | | | | 2.69 | % | | | - | | | | 0.00 | % | | | - | | | | 0.00 | % |
| | | $ | 1,370 | | | | 14.53 | % | | $ | 7,428 | | | | 78.76 | % | | $ | 633 | | | | 6.71 | % |
Our policy regarding past due loans normally requires a loan be placed on nonaccrual status when there is probable loss or when there is a reasonable doubt that all principal will be collected, or when it is over 90 days past due. Charge-offs to the allowance for loan losses may ensue following timely collection efforts and a thorough review of payment sources. Further efforts are then pursued through various means available. Loans carried in a nonaccrual status are generally secured by collateral, which is considered in the determination of the allowance for loan losses, through the impaired loan process.
The allowance for loan losses was $9.4 million, or 1.32% of total loans at June 30, 2012, compared to $10.2 million, or 1.34% of total loans, at December 31, 2011. The reduction in total allowance dollars during the first half of 2012 reflects the overall decline in gross loans during the first half of 2012, while the decline in allowance percentage reflects management’s current expectation of continued credit quality improvement in the portfolio. Additionally, the use of historical factors in the allowance methodology resulted in reductions from December 31, 2011 in several portfolios. The allowance for loan losses related to non-acquired loans represented 2.19% of non-acquired loans at June 30, 2012, compared to 2.57% of non-acquired loans at December 31, 2011. The allowance for loan losses related to purchased performing loans represented 0.13% of purchased performing loans at June 30, 2012. There was no related allowance for loan losses at December 31, 2011. The remaining mark on the purchased performing portfolio at June 30, 2012 and December 31, 2011 was $8.4 million and $11.2 million, respectively. The need for an allowance on this portfolio is evaluated by management on a quarterly basis. Allowance for loan losses excluding acquired loans and related ratios are non-GAAP financial measures. For reconciliations to the most comparable GAAP measure, see “Non-GAAP Financial Measures” above. Management periodically evaluates its credit policies and procedures to confirm that they effectively manage risk and facilitate appropriate internal controls.
Nonperforming Assets
Nonperforming assets, which consist of nonaccrual loans, accruing TDRs, accruing loans for which payments are 90 days or more past due, nonaccrual loans held for sale and OREO, decreased $1.1 million, or 3.1%, to $35.1 million at June 30, 2012 from $36.2 million at December 31, 2011.
Nonperforming assets included $131 thousand in loans past due 90 days or more and still accruing interest at June 30, 2012. These loans were secured and considered fully collectible at June 30, 2012. There were no loans past due 90 days or more and still accruing interest at December 31, 2011. Accruing TDRs totaled $3.4 million and $4.0 million at June 30, 2012 and December 31, 2011, respectively
Nonaccrual loans were $16.7 million at June 30, 2012, an increase of $0.5 million, or 3.1%, from nonaccrual loans of $16.2 million at December 31, 2011. At June 30, 2012, nonaccrual TDRs are included in the nonaccrual loan amounts noted and had no recorded allowance. At December 31, 2011, nonaccrual TDR loans were $6.9 million and had no recorded allowance. Accruing TDRs totaled $3.5 million and $4.0 million at June 30, 2012 and December 31, 2011, respectively.
We grade loans with a risk grade scale of 10 through 90, with grades 10 through 50 representing “pass” loans, and grades 60, 70, 80, and 90 representing “special mention,” “substandard,” “doubtful,” and “loss” credit grades, respectively. Loans are reviewed on a regular basis internally, and at least annually by an external loan review group, to ensure loans are graded appropriately. Credits are reviewed for past due trends, declining cash flows, significant decline in collateral value, weakened guarantor financial strength, management concerns, market conditions and other factors that could jeopardize the repayment performance of the loan. Documentation deficiencies including collateral perfection and outdated or inadequate financial information are also considered in grading loans.
All loans graded 60 or worse are included on our list of “watch loans,” which represent potential problem loans, and are updated and reported to both management and the loan and risk committee of the board of directors quarterly. Additionally, the watch list committee may review other loans with more favorable ratings if there are concerns that the loan may become a problem. Impairment analyses are performed on all loans graded “substandard” (risk grade of 70 or worse) and selected other loans as deemed appropriate. At June 30, 2012, we maintained “watch loans” totaling $47.8 million compared to $51.2 million at December 31, 2011. Currently all loans on our watch list carry a risk grade of 5 or worse. The future level of watch loans cannot be predicted, but rather will be determined by several factors, including overall economic conditions in the markets served.
At June 30, 2012, OREO totaled $14.7 million compared to $14.4 million at December 31, 2011. All OREO properties have been written down to their respective fair values, based on our most recent appraisals.
Deposits and Other Borrowings
We offer a broad range of deposit instruments, including personal and business checking accounts, individual retirement accounts, business and personal money market accounts and certificates of deposit at competitive interest rates. Deposit account terms vary according to the minimum balance required, the time periods the funds must remain on deposit and the interest rate, among other factors. We regularly evaluate the internal cost of funds, survey rates offered by competing institutions, review cash flow requirements for lending and liquidity and execute rate changes when deemed appropriate.
Total deposits at June 30, 2012 were $842.0 million, a decrease of $4.6 million, or 0.5%, from December 31, 2011. Demand deposits increased $16.2 million, or 11%, and represented 19% of total deposits at June 30, 2012. Money market, NOW and savings deposits decreased $1.3 million, or 0.4%, due primarily to re-pricing certain acquired deposits to enhance profitability. Non-brokered time deposits decreased $36.9 million, or 15%, also due to re-pricing certain acquired deposits to enhance profitability. Finally, brokered deposits increased $17.4 million, or 14%, reflecting the final re-funding associated with $80 million in Community Capital FHLB borrowings that were repaid in conjunction with completion of the merger. The following is a summary of deposits at June 30, 2012 and December 31, 2011 (dollars in thousands):
| | | | | | | |
| Noninterest bearing demand deposits | | $ | 158,838 | | | $ | 142,652 | |
| Interest-bearing demand deposits | | | 89,042 | | | | 85,081 | |
| Money market deposits | | | 220,389 | | | | 227,020 | |
| Savings | | | 23,217 | | | | 21,867 | |
| Brokered deposits | | | 140,548 | | | | 123,118 | |
| Time deposits | | | 210,000 | | | | 246,899 | |
| Total depostis | | $ | 842,034 | | | $ | 846,637 | |
Total borrowings increased $7.1 million, or 12%, to $69.2 million at June 30, 2012 compared to $62.1 million at December 31, 2011, as we increased FHLB borrowings to lock in term funding at attractive rates. Borrowings currently include $5.6 million (after acquisition accounting fair market value adjustments) of Tier 1-eligible subordinated debt and $6.9 million of Tier 2-eligible subordinated debt.
Results of Operations
The following table summarizes components of income and expense and the changes in those components for the three and six months ended June 30, 2012 and 2011 (dollars in thousands):
| | | Three Months Ended June 30, | | | | | | | | | | | | | | | | |
| | | 2012 | | | 2011 | | | Change | | | 2012 | | | 2011 | | | Change | |
| | | (Unaudited) | | | $ | | | | % | | | (Unaudited) | | | $ | | | | % | |
| | | (Dollars in thousands) | | | (Dollars in thousands) | |
| Gross interest income | | $ | 11,641 | | | $ | 5,359 | | | $ | 6,282 | | | | 117.2 | % | | $ | 25,038 | | | $ | 11,013 | | | $ | 14,025 | | | | 127.3 | % |
| Gross interest expense | | | 1,542 | | | | 1,587 | | | | (45 | ) | | | -2.8 | % | | | 3,219 | | | | 3,285 | | | | (66 | ) | | | -2.0 | % |
| Net interest income | | | 10,099 | | | | 3,772 | | | | 6,327 | | | | 167.7 | % | | | 21,819 | | | | 7,728 | | | | 14,091 | | | | 182.3 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Provision for loan losses | | | 899 | | | | 3,245 | | | | (2,346 | ) | | | -72.3 | % | | | 1,022 | | | | 7,707 | | | | (6,685 | ) | | | -86.7 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Noninterest income | | | 2,592 | | | | 44 | | | | 2,548 | | | | 5790.9 | % | | | 4,546 | | | | 116 | | | | 4,430 | | | | 3819.0 | % |
| Noninterest expense | | | 10,863 | | | | 5,474 | | | | 5,389 | | | | 98.4 | % | | | 21,866 | | | | 9,708 | | | | 12,158 | | | | 125.2 | % |
| Net income (loss) before taxes | | | 929 | | | | (4,903 | ) | | | 5,832 | | | | -118.9 | % | | | 3,477 | | | | (9,571 | ) | | | 13,048 | | | | -136.3 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Income tax expense (benefit) | | | 251 | | | | (1,789 | ) | | | 2,040 | | | | -114.0 | % | | | 1,076 | | | | (3,570 | ) | | | 4,646 | | | | -130.1 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Net income (loss) | | $ | 678 | | | $ | (3,114 | ) | | $ | 3,792 | | | | -121.8 | % | | $ | 2,401 | | | $ | (6,001 | ) | | $ | 8,402 | | | | -140.0 | % |
Net Income (Loss). Net income for the three months ended June 30, 2012 was $678 thousand compared to a net loss of $3.1 million for the same period in 2011. Net income for the six months ended June 30, 2012 was $2.4 million compared to a net loss of $6.0 million for the same period in 2011. The increase in net income in both the three- and six-month periods were the result of the inclusion of Community Capital operations, the reduction in the provision for loan losses and the accelerated income associated with the acquired loan portfolio.
Annualized return on average assets increased during the six-month period ended June 30, 2012 to 0.43% from (1.95)% for the same period in 2011. Annualized return on average equity also increased from (6.82)% for the six-month period ended June 30, 2011 to 2.50% for the same period in 2012.
Net Interest Income. Our largest source of earnings is net interest income, which is the difference between interest income on interest-earning assets and interest paid on deposits and other interest-bearing liabilities. The primary factors that affect net interest income are changes in volume and yields of earning assets and interest-bearing liabilities, which are affected, in part, by management’s responses to changes in interest rates through asset/liability management. Net interest income increased to $10.1 million for the three-month period ended June 30, 2012 from $3.8 million for the same period in 2011. During the six-month period ended June 30, 2012, net interest income was $21.8 million as compared to $7.7 million in 2011, an increase of $14.1 million, or 182%. These increases reflect the inclusion of Community Capital in the first half of 2012.
Net interest income for the three-month and six-month periods ended June 30, 2012 also includes $0.2 million and $1.7 million, respectively, of accelerated accretion from credit and interest rate marks associated with acquisition accounting adjustments for purchased performing loans, as accounted for under the contractual cash flow method of accounting. This accelerated accretion, which was not anticipated, resulted from a combination of (i) borrowers repaying loans faster than required by their contractual terms; and (ii) customer-driven restructuring related to loan rates and/or terms which effectively result in a new loan under the contractual cash flow method of accounting. In both instances, the remaining acquisition accounting fair value marks associated with the loan are fully accreted into interest income.
Total average interest-earning assets increased by $430.4 million, or 74%, to $1.0 billion for the three months ended June 30, 2012 from $582.2 million for the same period in the previous year. Total average interest-earning assets increased by $426.8 million, or 73%, to $1.0 billion for the six months ended June 30, 2012 from $586.3 million for the same period in the previous year. These increases were driven primarily by the addition of Community Capital assets following the merger on November 1, 2011.
Average balances of total interest-bearing liabilities increased in the three-month period ended June 30, 2012, with average total interest-bearing deposit balances increasing by $313.7 million, or 83%, to $689.8 million from $376.1 million for the same period in 2011. Average brokered deposits increased by $48.0 million from the corresponding period in 2011. Total average balances of total interest-bearing liabilities increased in the first six months of 2012, with average total interest-bearing deposit balances increasing by $327.8 million, or 89%, to $698.0 million from $370.2 million for the same period in 2011. Average brokered deposits increased by $45.8 million from the corresponding period in 2011. These increases are a result of the addition of Community Capital.
Our net interest margin increased from 2.60% in the three-month period ended June 30, 2011 to 4.01% in the corresponding period in 2012, and increased from 2.66% in the six-month period ended June 30, 2011 to 4.34% in the corresponding period in 2012. The increase in net interest margin reflects the inclusion of higher rate loans acquired in the Community Capital merger, the accretion from credit and interest rate marks associated with acquisition accounting adjustments, and reduced funding costs due, primarily, to lower pricing on interest bearing deposits.
Our net interest margin, excluding the accelerated accretion discussed above, was 3.93%, for the three-month period ended June 30, 2012 and 4.00%, for the six-month period ended June 30, 2012. Net interest margin excluding accelerated accretion is a non-GAAP financial measure. For a reconciliation to the most comparable GAAP measure, see “Non-GAAP Financial Measures” above.
The following tables summarize net interest income and average yields and rates paid for the periods indicated (dollars in thousands):
Average Balance Sheets and Net Interest Analysis
| | | For the Three Months Ended June 30, | |
| | | 2012 | | | 2011 | |
| | | Average Balance | | | Income/ Expense | | | Yield/ Rate | | | Average Balance | | | Income/ Expense | | | Yield/ Rate | |
| | | (Dollars in thousands) | |
| Assets | | | | | | | | | | | | | | | | | | |
| Interest-earning assets: | | | | | | | | | | | | | | | | | | |
| Loans, including fees (1)(2) | | $ | 729,156 | | | $ | 10,416 | | | | 5.75 | % | | $ | 385,893 | | | $ | 4,450 | | | | 4.63 | % |
| Federal funds sold | | | 26,438 | | | | 15 | | | | 0.23 | % | | | 56,611 | | | | 33 | | | | 0.23 | % |
| Taxable investment securities | | | 217,118 | | | | 996 | | | | 1.83 | % | | | 119,410 | | | | 684 | | | | 2.27 | % |
| Tax-exempt investment securities | | | 17,693 | | | | 186 | | | | 4.21 | % | | | 15,988 | | | | 181 | | | | 4.48 | % |
| Other interest-earning assets | | | 22,174 | | | | 28 | | | | 0.51 | % | | | 4,252 | | | | 11 | | | | 1.04 | % |
| Total interest-earning assets | | | 1,012,579 | | | | 11,641 | | | | 4.62 | % | | | 582,154 | | | | 5,359 | | | | 3.69 | % |
| Allowance for loan losses | | | (9,134 | ) | | | | | | | | | | | (11,684 | ) | | | | | | | | |
| Cash and due from banks | | | 15,025 | | | | | | | | | | | | 29,415 | | | | | | | | | |
| Premises and equipment | | | 24,470 | | | | | | | | | | | | 4,705 | | | | | | | | | |
| Other assets | | | 84,111 | | | | | | | | | | | | 17,689 | | | | | | | | | |
| Total assets | | $ | 1,127,051 | | | | | | | | | | | $ | 622,279 | | | | | | | | | |
| Liabilities and shareholders' equity | | | | | | | | | | | | | | | | | | | | | | | | |
| Interest-bearing liabilities: | | | | | | | | | | | | | | | | | | | | | | | | |
| Interest-bearing demand | | $ | 83,923 | | | $ | 50 | | | | 0.24 | % | | $ | 11,968 | | | $ | 4 | | | | 0.13 | % |
| Savings and money market | | | 240,366 | | | | 282 | | | | 0.47 | % | | | 95,548 | | | | 172 | | | | 0.72 | % |
| Time deposits - core | | | 217,963 | | | | 345 | | | | 0.64 | % | | | 169,072 | | | | 644 | | | | 1.53 | % |
| Time deposits - brokered | | | 147,558 | | | | 375 | | | | 1.02 | % | | | 99,553 | | | | 436 | | | | 1.76 | % |
| Total interest-bearing deposits | | | 689,810 | | | | 1,052 | | | | 0.61 | % | | | 376,141 | | | | 1,256 | | | | 1.34 | % |
| Federal Home Loan Bank advances | | | 55,000 | | | | 148 | | | | 1.08 | % | | | 20,000 | | | | 141 | | | | 2.83 | % |
| Other borrowings | | | 13,685 | | | | 342 | | | | 10.05 | % | | | 8,376 | | | | 190 | | | | 9.10 | % |
| Total borrowed funds | | | 68,685 | | | | 490 | | | | 2.87 | % | | | 28,376 | | | | 331 | | | | 4.68 | % |
| Total interest-bearing liabilities | | | 758,495 | | | | 1,542 | | | | 0.82 | % | | | 404,517 | | | | 1,587 | | | | 1.57 | % |
| Net interest rate spread | | | | | | | 10,099 | | | | 3.81 | % | | | | | | | 3,772 | | | | 2.12 | % |
| Noninterest-bearing demand deposits | | | 160,761 | | | | | | | | | | | | 39,711 | | | | | | | | | |
| Other liabilities | | | 13,439 | | | | | | | | | | | | 2,985 | | | | | | | | | |
| Shareholders' equity | | | 194,356 | | | | | | | | | | | | 175,066 | | | | | | | | | |
| Total liabilities and shareholders' equity | | $ | 1,127,051 | | | | | | | | | | | $ | 622,279 | | | | | | | | | |
| Net interest margin | | | | | | | | | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | 4.01 | % | | | | | | | | | | | 2.60 | % |
(1) Average loan balances include nonaccrual loans.
(2) Interest income and yields for the three months June 30, 2012 include accretion from acquisition accounting adjustments associated with acquired loans.
Average Balance Sheets and Net Interest Analysis
| | | For the Six Months Ended June 30, | |
| | | 2012 | | | 2011 | |
| | | Average Balance | | | Income/ Expense | | | Yield/ Rate | | | Average Balance | | | Income/ Expense | | | Yield/ Rate | |
| | | | | | | | | | | | | | | | | | | |
| Assets | | | | | | | | | | | | | | | | | | |
| Interest-earning assets: | | | | | | | | | | | | | | | | | | |
| Loans, including fees (1)(2) | | $ | 737,794 | | | $ | 22,524 | | | | 6.14 | % | | $ | 391,449 | | | $ | 9,208 | | | | 4.74 | % |
| Federal funds sold | | | 19,777 | | | | 23 | | | | 0.23 | % | | | 54,679 | | | | 63 | | | | 0.23 | % |
| Taxable investment securities | | | 220,047 | | | | 2,081 | | | | 1.89 | % | | | 119,408 | | | | 1,365 | | | | 2.29 | % |
| Tax-exempt investment securities | | | 17,759 | | | | 372 | | | | 4.19 | % | | | 15,346 | | | | 352 | | | | 4.59 | % |
| Other interest-earning assets | | | 17,746 | | | | 38 | | | | 0.43 | % | | | 5,431 | | | | 25 | | | | 0.93 | % |
| Total interest-earning assets | | | 1,013,123 | | | | 25,038 | | | | 4.97 | % | | | 586,313 | | | | 11,013 | | | | 3.79 | % |
| Allowance for loan losses | | | (9,484 | ) | | | | | | | | | | | (12,012 | ) | | | | | | | | |
| Cash and due from banks | | | 15,563 | | | | | | | | | | | | 19,014 | | | | | | | | | |
| Premises and equipment | | | 24,489 | | | | | | | | | | | | 4,590 | | | | | | | | | |
| Other assets | | | 85,286 | | | | | | | | | | | | 16,740 | | | | | | | | | |
| Total assets | | $ | 1,128,977 | | | | | | | | | | | $ | 614,645 | | | | | | | | | |
| Liabilities and stockholders' equity | | | | | | | | | | | | | | | | | | | | | | | | |
| Interest-bearing liabilities: | | | | | | | | | | | | | | | | | | | | | | | | |
| Interest-bearing demand | | $ | 81,244 | | | $ | 96 | | | | 0.24 | % | | $ | 11,213 | | | $ | 7 | | | | 0.13 | % |
| Savings and money market | | | 243,549 | | | | 563 | | | | 0.46 | % | | | 82,706 | | | | 310 | | | | 0.76 | % |
| Time deposits - core | | | 226,809 | | | | 768 | | | | 0.68 | % | | | 175,702 | | | | 1,383 | | | | 1.59 | % |
| Time deposits - brokered | | | 146,405 | | | | 773 | | | | 1.06 | % | | | 100,618 | | | | 923 | | | | 1.85 | % |
| Total interest-bearing deposits | | | 698,007 | | | | 2,200 | | | | 0.63 | % | | | 370,239 | | | | 2,623 | | | | 1.43 | % |
| Federal Home Loan Bank advances | | | 56,648 | | | | 309 | | | | 1.10 | % | | | 20,000 | | | | 282 | | | | 2.84 | % |
| Other borrowings | | | 14,275 | | | | 710 | | | | 10.00 | % | | | 8,203 | | | | 380 | | | | 9.34 | % |
| Total borrowed funds | | | 70,923 | | | | 1,019 | | | | 2.89 | % | | | 28,203 | | | | 662 | | | | 4.73 | % |
| Total interest-bearing liabilities | | | 768,930 | | | | 3,219 | | | | 0.84 | % | | | 398,442 | | | | 3,285 | | | | 1.66 | % |
| Net interest rate spread | | | | | | | 21,819 | | | | 4.13 | % | | | | | | | 7,728 | | | | 2.13 | % |
| Noninterest-bearing demand deposits | | | 152,763 | | | | | | | | | | | | 38,387 | | | | | | | | | |
| Other liabilities | | | 13,944 | | | | | | | | | | | | 1,781 | | | | | | | | | |
| Shareholders' equity | | | 193,340 | | | | | | | | | | | | 176,035 | | | | | | | | | |
| Total liabilities and shareholders' equity | | $ | 1,128,977 | | | | | | | | | | | $ | 614,645 | | | | | | | | | |
| Net interest margin | | | | | | | | | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | 4.34 | % | | | | | | | | | | | 2.66 | % |
(1) Average loan balances include nonaccrual loans.
(2) Interest income and yields for the six months June 30, 2012 include accretion from acquisition accounting adjustments associated with acquired loans.
Provision for Loan Losses. Our provision for loan losses decreased $2.3 million, or 72.3%, to $0.9 million during the three months ended June 30, 2012, from $3.2 million during the corresponding period in 2011 and $6.7 million, or 86.7%, to $1.0 million during the six months ended June 30, 2012, from $7.7 million during the corresponding period in 2012. The decrease in the provision, in all periods presented, is a result of both a reduction in outstanding loans and improvement in the quality of our loans. Included in the provision for loan losses for the three and six months ended June 30, 2012 was $0.3 million in allowance associated with a specific PCI pool. We had $1.0 million in net charge-offs during the three months ended June 30, 2012 compared to $3.7 million during the corresponding period in 2011. Year-to-date net charge-offs were $1.7 million compared to $8.9 million during the first six months of 2011. The portion of charge-offs attributable to acquired loans for the three and six months ended June 30, 2012 were $0.4 million and $0.5 million, respectively.
Noninterest Income. Noninterest income has not historically been a major component of our earnings. However, as a result of the merger with Community Capital, noninterest income increased $2.5 million to $2.6 million for the three months ended June 30, 2012 from $44 thousand for the three months ended June 30, 2011. The increase includes (i) a $ 274 thousand increase in service charges on deposit accounts associated with expanded retail and commercial banking activities; (ii) $555 thousand in income from fiduciary activities associated with new asset management, investment brokerage and trust services; and (iii) $540 thousand in gain on sale of loans associated with new mortgage brokerage activities. In addition, in the third quarter of 2011, we purchased $8 million of bank-owned life insurance to partially fund the cost of employer-provided benefits and we acquired an additional $18.1 million of bank-owned life insurance through the merger with Community Capital. Income from bank-owned life insurance was $260 thousand for the three months ended June 30, 2012. Additionally, we recognized $489 thousand in gains on sales of available-for-sale securities during the three months ended June 30, 2012. Noninterest income for the three months ended June 30, 2011 consisted primarily of $25 thousand in service charges on deposit accounts, $1 thousand in gains on sale of securities available-for-sale, and $18 thousand in other interest income.
Noninterest income increased $4.4 million for the six months ended June 30, 2012 to $4.5 million, from $116 thousand for the six months ended June 30, 2011. The increase includes (i) a $561 thousand increase in service charges on deposit accounts associated with expanded retail and commercial banking activities; (ii) $1.1 million in income from fiduciary activities associated with new asset management, investment brokerage and trust services; and (iii) $1.0 million in gains on sale of loans associated with new mortgage brokerage activities. Income from bank-owned life insurance was $519 thousand for the six months ended June 30, 2012. Gains on sale of securities available-for-sale were $489 thousand for the six months ended June 30, 2012 and other noninterest income was $665 thousand for the six-month period. Noninterest income was $116 thousand for the six months ended June 30, 2011 and consisted of $51 thousand in service charges on deposit accounts, $20 thousand in gains on sale of securities available-for-sale, and $45 thousand in other noninterest income.
| | | Three months ended June 30, | | | | | | | | | | | | | | | | |
| | | 2012 | | | 2011 | | | Change | | | 2012 | | | 2011 | | | Change | |
| | | (Unaudited) | | | $ | | | | % | | | (Unaudited) | | | $ | | | | % | |
| | | (Dollars in thousands) | | | (Dollars in thousands) | |
| Service charges on deposit accounts | | $ | 299 | | | $ | 25 | | | $ | 274 | | | | 1096.0 | % | | $ | 612 | | | $ | 51 | | | $ | 561 | | | | 1100.0 | % |
| Income from fiduciary activities | | | 555 | | | | - | | | | 555 | | | | 100.0 | % | | | 1,095 | | | | - | | | | 1,095 | | | | 100.0 | % |
| Commissions from sales of mutual funds | | | 106 | | | | - | | | | 106 | | | | 100.0 | % | | | 165 | | | | - | | | | 165 | | | | 100.0 | % |
| Gain on sale of securities available for sale | | | 489 | | | | 1 | | | | 488 | | | | 48800.0 | % | | | 489 | | | | 20 | | | | 469 | | | | 2345.0 | % |
| Mortgage banking income | | | 540 | | | | - | | | | 540 | | | | 100.0 | % | | | 1,001 | | | | - | | | | 1,001 | | | | 100.0 | % |
| Income from bank-owned life insurance | | | 260 | | | | - | | | | 260 | | | | 100.0 | % | | | 519 | | | | - | | | | 519 | | | | 100.0 | % |
| Other noninterest income | | | 343 | | | | 18 | | | | 325 | | | | 1805.6 | % | | | 665 | | | | 45 | | | | 620 | | | | 1377.8 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Total noninterest income | | $ | 2,592 | | | $ | 44 | | | $ | 2,548 | | | | 5790.9 | % | | $ | 4,546 | | | $ | 116 | | | $ | 4,430 | | | | 3819.0 | % |
Noninterest Expense. The level of noninterest expense substantially affects our profitability. Total noninterest expense was $10.9 million for the three months ended June 30, 2012, an increase of 98.4% from $5.5 million for the corresponding period in 2011, primarily due to the inclusion of results from Community Capital and increased personnel expenses related to our change in business plan. Also included in noninterest expense are merger-related expenses of $434 thousand and $632 thousand for the three months ended June 30, 2012 and 2011, respectively.
Total noninterest expense was $21.9 million for the six months ended June 30, 2012, an increase of $12.2 million or 125.2%, compared to $9.7 million for the same period in 2011. Merger-related expenses totaled $1.4 million and $707 thousand for the six months ended June 30, 2012 and 2011, respectively.
The following table presents components of noninterest expense for the three and six months ended June 30, 2012 and 2011 (dollars in thousands):
| | | Three months ended June 30, | | | | | | | | | | | | | | | | |
| | | 2012 | | | 2011 | | | Change | | | 2012 | | | 2011 | | | Change | |
| | | (Unaudited) | | | $ | | | | % | | | (Unaudited) | | | $ | | | | % | |
| | | (Dollars in thousands) | | | (Dollars in thousands) | |
| Salaries and employee benefits | | $ | 5,882 | | | $ | 2,975 | | | $ | 2,907 | | | | 97.7 | % | | $ | 12,005 | | | $ | 5,482 | | | $ | 6,523 | | | | 119.0 | % |
| Occupancy and equipment | | | 860 | | | | 301 | | | | 559 | | | | 185.7 | % | | | 1,680 | | | | 557 | | | | 1,123 | | | | 201.6 | % |
| Advertising and promotion | | | 108 | | | | 87 | | | | 21 | | | | 24.1 | % | | | 269 | | | | 125 | | | | 144 | | | | 115.2 | % |
| Legal and professional fees | | | 603 | | | | 1,205 | | | | (602 | ) | | | -50.0 | % | | | 915 | | | | 1,512 | | | | (597 | ) | | | -39.5 | % |
| Deposit charges and FDIC insurance | | | 270 | | | | 196 | | | | 74 | | | | 37.8 | % | | | 560 | | | | 483 | | | | 77 | | | | 15.9 | % |
| Data processing and outside service fees | | | 752 | | | | 128 | | | | 624 | | | | 487.5 | % | | | 2,101 | | | | 251 | | | | 1,850 | | | | 737.1 | % |
| Communication fees | | | 196 | | | | 36 | | | | 160 | | | | 444.4 | % | | | 429 | | | | 62 | | | | 367 | | | | 591.9 | % |
| Postage and supplies | | | 125 | | | | 47 | | | | 78 | | | | 166.0 | % | | | 321 | | | | 86 | | | | 235 | | | | 273.3 | % |
| Core deposit intangible amortization | | | 102 | | | | - | | | | 102 | | | | 100.0 | % | | | 204 | | | | - | | | | 204 | | | | 100.0 | % |
| Net cost of operation of other real estate owned | | | 809 | | | | 93 | | | | 716 | | | | 769.9 | % | | | 1,331 | | | | 328 | | | | 1,003 | | | | 305.8 | % |
| Loan and collection expense | | | 295 | | | | 110 | | | | 185 | | | | 168.2 | % | | | 539 | | | | 195 | | | | 344 | | | | 176.4 | % |
| Other noninterest expense | | | 861 | | | | 296 | | | | 565 | | | | 190.9 | % | | | 1,512 | | | | 627 | | | | 885 | | | | 141.1 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Total noninterest expense | | $ | 10,863 | | | $ | 5,474 | | | $ | 5,389 | | | | 98.4 | % | | $ | 21,866 | | | $ | 9,708 | | | $ | 12,158 | | | | 125.2 | % |
Salaries and employee benefits expenses increased $2.9 million, or 97.7%, to $5.9 million in the second quarter of 2012, compared to $3.0 million in the comparable period of 2011. The increase is primarily due to the merger with Community Capital and due to an increase in compensation and related benefits for the expanded management team and other added personnel. Salaries and employee benefits expenses increased $6.5 million, or 119%, to $12.0 million for the six months ended June 30, 2012 from $5.5 million for the six months ended June 30, 2011. Compensation expense for share-based compensation plans was $508 thousand in the second quarter of 2012 compared to $523 thousand in the comparable period of 2011. Compensation expense for the share-based compensation plans was $991 thousand for the six months ended June 30, 2012, compared to $969 thousand for the six months ended June 30, 2011.
Occupancy and equipment expenses increased $559 thousand, or 185.7%, to $860 thousand in the second quarter of 2012, compared to $301 thousand in the comparable period of 2011. The increase is primarily due to the opening of de novo offices during 2011 to support of our organic growth initiatives as well as the acquisition of property in connection with the merger with Community Capital. Occupancy and equipment expenses increased $1.1 million, or 201.6%, to $1.7 million for the six months ended June 30, 2012, compared to $557 thousand for the six months ended June 30, 2011.
Legal and professional fees decreased $602 thousand, or 50.0%, to $603 thousand in the second quarter of 2012, compared to $1.2 million in the comparable period of 2011. The decrease is primarily due to fees paid in 2011 associated with the Company becoming a public entity. Legal and professional fees decreased $597 thousand, or 39.5% to $915 thousand for the six months ended June 30, 2012, compared to $1.5 million for the six months ended June 30, 2011.
Data processing and outside service fees increased $624 thousand, or 487.5%, to $752 thousand in the second quarter of 2012 compared to $128 thousand in the comparable period of 2011. The increase in primarily is due to the inclusion of expenses from Community Capital. Data processing and outside service fees increased $1.9 million, or 737.1% to $2.1 million for the six months ended June 30, 2012, compared to $251 thousand for the six months ended June 30, 2011. Included in the 2012 increase is $676 thousand in merger-related fees associated with the termination fee for the legacy Community Capital core system conversion.
Net cost of operation of other real estate increased $716 thousand, or 769.9%, to $809 thousand in the second quarter of 2012 compared to $93 thousand in the comparable period of 2011. For the six months ended June 30, 2012, net cost of operation of other real estate increased $1.0 million, or 305.8% to $1.3 million, from $328 thousand for the six months ended June 30, 2011. Loan collection expense increased $185 thousand, or 168.2%, to $295 thousand in the second quarter of 2012 compared to $110 thousand in the comparable period of 2011. For the six months ended June 30, 2012, loan collection expense increased $344 thousand, or 176.4%, to $539 thousand, from $195 thousand for the six months ended June 30, 2011. The increase in both categories resulted from the economic downturn and its effect on our asset quality.
Income Taxes. We generate non-taxable income from tax-exempt investment securities and loans. Accordingly, the level of such income in relation to income before taxes affects our effective tax rate. For the three months ended June 30, 2012, we recognized income tax expense of $0.7 million compared to an income tax benefit of $1.8 million for the same period in 2011. For the six months ended June 30, 2012, we recognized income tax expense of $1.1 million compared to an income tax benefit of $3.6 million for the same period in 2011. The effective tax rate for the six months ended June 30, 2012 is 30.95% compared to 37.30% for the same period in 2011. The change in the effective tax rate was due to the amount of tax-exempt income relative to the size of pre-tax income. A tax benefit is recorded if non-taxable income exceeds income before taxes, resulting in a reduction of total income subject to income taxes.
Liquidity and Capital Resources
Liquidity refers to the ability to manage future cash flows to meet the needs of depositors and borrowers and to fund operations. We strive to maintain sufficient liquidity to fund future loan demand and to satisfy fluctuations in deposit levels. This is achieved primarily in the form of available lines of credit from various correspondent banks, the FHLB, the Federal Reserve Discount Window and through our investment portfolio. In addition, we may have short-term investments at our primary correspondent bank in the form of Federal funds sold. Liquidity is governed by an asset/liability policy approved by the board of directors and administered by an internal Senior Management Risk Committee (the “Committee”). The Committee reports monthly asset/liability-related matters to the Loan and Risk Committee of the board of directors.
Our internal liquidity ratio (total liquid assets, cash and cash equivalents, divided by deposits and short-term liabilities) at June 30, 2012 was 32.4% compared to 28.8% at December 31, 2011. Both ratios exceeded our minimum internal target of 10%. In addition, at June 30, 2012, we had $94.2 million of credit available from the FHLB, $69.0 million from the Federal Reserve Discount Window, and available lines totaling $85.0 million from correspondent banks.
At June 30, 2012, we had $136.3 million of pre-approved but unused lines of credit, $3.1 million of standby letters of credit and $1.3 million of commercial letters of credit. In management’s opinion, these commitments represent no more than normal lending risk to us and will be funded from normal sources of liquidity.
Our capital position is reflected in our shareholders’ equity, subject to certain adjustments for regulatory purposes. Shareholders’ equity, or capital, is a measure of our net worth, soundness and viability. We continue to remain in a well-capitalized position. Shareholders’ equity on June 30, 2012 was $194.2 million compared to the December 31, 2011 balance of $190.1 million. The $4.1 million increase was the result of net income for the six months ended June 30, 2012 of $2.4 million, $740 thousand in accumulated other comprehensive income from unrealized securities gains and $969 thousand of share-based compensation expense.
Risk-based capital regulations adopted by the Federal Reserve Board and the FDIC require bank holding companies and banks to achieve and maintain specified ratios of capital to risk weighted assets. The risk-based capital rules are designed to measure “Tier 1” capital (consisting generally of common shareholders’ equity, a limited amount of qualifying perpetual preferred stock and trust preferred securities, and minority interests in consolidated subsidiaries, net of goodwill and other intangible assets, deferred tax assets in excess of certain thresholds and certain other items) and total capital (consisting of Tier 1 capital and Tier 2 capital, which generally includes certain preferred stock, mandatorily convertible debt securities and term subordinated debt) in relation to the credit risk of both on- and off-balance sheet items. Under the guidelines, one of four risk weights is applied to the different on-balance sheet items. Off-balance sheet items, such as loan commitments, are also subject to risk weighting after conversion to balance sheet equivalent amounts. All banks must maintain a minimum total capital to total risk weighted assets ratio of 8.00%, at least half of which must be in the form of core, or Tier 1, capital. These guidelines also specify that banks that are experiencing internal growth or making acquisitions will be expected to maintain capital positions substantially above the minimum supervisory levels. At June 30, 2012, the Company and the Bank both satisfied their minimum regulatory capital requirements and each was “well capitalized” within the meaning of Federal regulatory requirements.
| | | | | | | | | Regulatory Minimums | |
| | | | | | | | | | | | To Be Well Capitalized Under Prompt Corrective | |
| | | | | | | | | | | | | |
| | | June 30, 2012 | | | December 31, 2011 | | | Ratio | | | Ratio | |
| | | | | | | | | | | | | |
| Park Sterling Corporation | | | | | | | | | | | | |
| Tier 1 capital | | $ | 162,189 | | | $ | 160,122 | | | | | | | |
| Tier 2 capital | | | 16,326 | | | | 17,049 | | | | | | | |
| | | | | | | | | | | | | | | |
| Total capital | | $ | 178,516 | | | $ | 177,171 | | | | | | | |
| | | | | | | | | | | | | | | |
| Risk-adjusted average assets | | $ | 768,935 | | | $ | 819,762 | | | | | | | |
| | | | | | | | | | | | | | | |
| Average assets | | $ | 1,087,101 | | | $ | 901,067 | | | | | | | |
| | | | | | | | | | | | | | | |
| Risk-based capital ratios | | | | | | | | | | | | | | |
| Tier 1 capital | | | 21.09 | % | | | 19.53 | % | | | 4.00 | % | | | 6.00 | % |
| Total capital | | | 23.22 | % | | | 21.61 | % | | | 8.00 | % | | | 10.00 | % |
| Tier 1 leverage ratio | | | 14.92 | % | | | 17.77 | % | | | 4.00 | % | | | 5.00 | % |
| | | | | | | | | | | | | | | | | |
| Park Sterling Bank | | | | | | | | | | | | | | | | |
| Tier 1 capital | | $ | 106,732 | | | $ | 100,147 | | | | | | | | | |
| Tier 2 capital | | | 16,326 | | | | 16,998 | | | | | | | | | |
| | | | | | | | | | | | | | | | | |
| Total capital | | $ | 123,058 | | | $ | 117,145 | | | | | | | | | |
| | | | | | | | | | | | | | | | | |
| Risk-adjusted average assets | | $ | 758,788 | | | $ | 808,163 | | | | | | | | | |
| | | | | | | | | | | | | | | | | |
| Average assets | | $ | 1,032,493 | | | $ | 646,846 | | | | | | | | | |
| | | | | | | | | | | | | | | | | |
| Risk-based capital ratios | | | | | | | | | | | | | | | | |
| Tier 1 capital | | | 14.07 | % | | | 12.39 | % | | | 4.00 | % | | | 6.00 | % |
| Total capital | | | 16.22 | % | | | 14.50 | % | | | 8.00 | % | | | 10.00 | % |
| Tier 1 leverage ratio | | | 10.34 | % | | | 15.48 | % | | | 4.00 | % | | | 5.00 | % |
The Bank has committed to its regulators to maintain a Tier 1 leverage ratio, calculated as Tier 1 capital to average assets, of at least 10.00% for the three years following the Public Offering.
In June 2012, the Federal Reserve Board, the FDIC and the Officer of the Comptroller of the Currency each issued Notices of Proposed Rulemaking (the “Proposals”) for three sets of capital rules that would revise the general risk-based capital rules to make them consistent with heightened international capital standards, known as Basel III, as well as certain provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”). While Basel III proposed a capital regime intended only for large internationally active banks, the Proposals extend the proposed capital standards to all U.S. banks, as well as to all bank holding companies with $500 million or in consolidated assets, including the Company and the Bank. The Proposals are subject to comment through September 7, 2012.
Certain requirements of the Proposals would establish more restrictive capital definitions, higher risk-weightings for certain assets classes, capital buffers and higher minimum capital ratios. Under the Proposals, the proposed new minimum capital requirements applicable to the Company and the Bank would be: (i) common equity Tier 1 capital to total risk-weighted assets of 4.5%; (ii) Tier 1 capital to total risk-weighted assets of 6%; (iii) Total capital to total risk-weighted assets of 8%; and (iv) Tier 1 capital to adjusted average total assets (leverage ratio) of 4%. The Proposals would refine the definition of what constitutes “capital” for purposes of these ratios. The Proposals would also establish a “capital conservation buffer” of 2.5% above the new regulatory minimum capital requirements, on a fully phased-in basis, which must consist entirely of common equity Tier 1 capital. An institution would be subject to limitations on paying dividends, engaging in share repurchases and paying discretionary bonuses if its capital level falls below the buffer amount.
If adopted as proposed, the rules would be effective as of January 1, 2013, although full compliance with most aspects would not be required until January 1, 2019. Transition periods apply in several areas of the Proposals, including the gradual phase-out of certain non-qualifying capital instruments like trust preferred securities.
Contractual Obligations, Commitments and Off-Balance Sheet Arrangements
In the ordinary course of operations, we enter into certain contractual obligations. Such obligations include the funding of operations through debt issuances as well as leases for premises and equipment.
Information about our off-balance sheet risk exposure is presented in Note 14 of the 2011 Audited Financial Statements. As part of ongoing business, we have not participated in transactions that generate relationships with unconsolidated entities or financial partnerships, such as entities often referred to as special purpose entities (“SPE”s), which generally are established for facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As of June 30, 2012, we were not involved in any unconsolidated SPE transactions.
Impact of Inflation and Changing Prices
We have an asset and liability make-up that is distinctly different from that of an entity with substantial investments in plant and inventory because the major portions of a commercial bank’s assets are monetary in nature. As a result, our performance may be significantly influenced by changes in interest rates. Although the Company and the banking industry are more affected by changes in interest rates than by inflation in the prices of goods and services, inflation is a factor that may influence interest rates. However, the frequency and magnitude of interest rate fluctuations do not necessarily coincide with changes in the general inflation rate. Inflation does affect operating expenses in that personnel expenses and the cost of supplies and outside services tend to increase more during periods of high inflation.
Interest Rate Sensitivity
The Committee actively evaluates and manages interest rate risk using a process developed by the Company. The Committee is also responsible for approving our asset/liability management policies, overseeing the formulation and implementation of strategies to improve balance sheet positioning and earnings, and reviewing our interest rate sensitivity position.
The primary measures that management uses to evaluate short-term interest rate risk include (i) cumulative gap summary, which measures potential changes in cash flows should interest rates rise or fall; (ii) net interest income at risk, which projects the impact of different interest rate scenarios on net interest income over one-year and two-year time horizons; (iii) net income at risk, which projects the impact of different interest rate scenarios on net income over one-year and two-year time horizons; and (iv) economic value of equity at risk, which measures potential long-term risk in the balance sheet by valuing our assets and liabilities at “market” under different interest rate scenarios.
These measures have historically been calculated under a simulation model prepared by an independent correspondent bank assuming incremental 100 basis point shocks (or immediate shifts) in interest rates up to a total increase or decrease of 300 basis points. These simulations estimate the impact that various changes in the overall level of interest rates over a one- and two-year time horizon have on net interest income. The results help us develop strategies for managing exposure to interest rate risk. Like any forecasting technique, interest rate simulation modeling is based on a large number of assumptions. In this case, the assumptions relate primarily to loan and deposit growth, asset and liability prepayments, interest rates and balance sheet management strategies. We believe that the assumptions are reasonable, both individually and in the aggregate. Nevertheless, the simulation modeling process produces only a sophisticated estimate, not a precise calculation of exposure. The overall interest rate risk management process is subject to annual review by an outside professional services firm to ascertain its effectiveness as required by Federal regulations.
Our current guidelines for risk management call for preventive measures if a 300 basis point shock, or immediate increase or decrease, would affect net interest income by more than 30.0% over the next twelve months. We currently operate well within these guidelines. However, the current interest rate environment creates an unusual scenario; specifically, our earnings may be negatively impacted by either a significant increase or decrease in short-term interest rates. As of June 30, 2012, based on the results of this simulation model, we could expect net interest income to decrease by approximately 3.7% over twelve months if short-term interest rates immediately decreased by 300 basis points, which is unlikely based on current rate levels. Concurrently, if short-term interest rates increased by 300 basis points, net interest income could be expected to decrease by approximately 8.8% over twelve months given that we are currently in a slight liability-sensitive position. At December 31, 2011, the simulation model results showed that we could expect net interest income to decrease by approximately 4.4% over twelve months if short-term interest rates immediately decreased by 300 basis points, and if short-term interest rates increased by 300 basis points, net interest income could be expected to decrease by approximately 8.5% over twelve months.
We use multiple interest rate swap agreements, accounted for as either cash flow or fair value hedges, as part of the management of interest rate risk. In May 2011, our interest rate swap that was accounted for as a cash flow hedge terminated. The swap had a notional amount of $40 million that was purchased on May 16, 2008 to protect us from falling rates. We received a fixed rate of 6.22% for a period of three years, and paid the prime rate for the same period. During the three and six months ended June 30, 2011, we recorded $0.1 million and $0.3 million, respectively, of income from this instrument.
As of June 30, 2012, we maintained six loan swaps accounted for as fair value hedges. The aggregate original notional amount of these swaps was $13.6 million. These derivative instruments are used to protect us from interest rate risk caused by changes in the LIBOR curve in relation to certain designated fixed rate loans. During the three month period ended June 30, 2012, one of our loan swaps was unwound due to the refinancing of the related loan. The unwind fee was part of the loan refinancing and therefore there was no impact to our results for the three or six months ended June 30, 2012. These derivative instruments are carried at a fair market value of $(559) thousand and $(645) thousand at June 30, 2012 and December 31, 2011, respectively. We recorded interest expense on these loan swaps of $0.1 million and $0.2 million in each of the three and six months ended June 30, 2012, and $0.2 million and $0.3 million in each of the three and six months ended June 30, 2011.
Prime rate swaps (pay floating, received fixed) are recorded on the balance sheet in other assets or liabilities at fair market value. Loan swaps (pay fixed, receive floating) are carried at fair market value and are included in loans. Changes in fair value of the hedged loans have been completely offset by the fair value changes in the derivatives, which are in contra asset accounts included in loans.
See Note 15 – Derivative Financial Instruments and Hedging Activities of the 2011 Audited Financial Statements and Note 9 – Derivative Financial Instruments and Hedging Activities of the Unaudited Financial Statements for further discussion on our derivative financial instruments and hedging activities.
Financial institutions are subject to interest rate risk to the degree that their interest-bearing liabilities, primarily deposits, mature or reprice more or less frequently, or on a different basis, than their interest-earning assets, primarily loans and investment securities. The match between the scheduled repricing and maturities of our interest-earning assets and liabilities within defined periods is referred to as “gap” analysis. At June 30, 2012, our cumulative one year gap was $(66.4) million, or -5.9% of total assets, indicating a net liability-sensitive position that is well within the policy guideline set by the Committee of 35%. Our cumulative one year gap at December 31, 2011 was $(20.0) million, or -3.2% of total assets.
The following table reflects our rate sensitive assets and liabilities by maturity as of June 30, 2012. Variable rate loans are shown in the category of due “within three months” because they reprice with changes in the prime lending rate. Fixed rate loans are presented assuming the entire loan matures on the final due date, although payments are actually made at regular intervals and are not reflected in this schedule.
| Interest Rate Gap Sensitivity | |
| | | | | | | | | | | | | | | | |
| | | Within | | | Three | | | One Year | | | | | | | |
| | | Three | | | Months to | | | to Five | | | After | | | | |
| | | Months | | | One Year | | | Years | | | Five Years | | | Total | |
| | | (Dollars in thousands) | |
| At June 30, 2012: | | | | | | | | | | | | | | | |
| Interest-earning assets: | | | | | | | | | | | | | | | |
| Interest-bearing deposits | | $ | 29,795 | | | $ | - | | | $ | - | | | $ | - | | | $ | 29,795 | |
| Federal funds sold | | | 29,455 | | | | - | | | | - | | | | - | | | | 29,455 | |
| Securities | | | 10,591 | | | | 29,058 | | | | 102,447 | | | | 80,125 | | | | 222,221 | |
| Loans | | | 310,956 | | | | 148,166 | | | | 219,997 | | | | 38,718 | | | | 717,837 | |
| Total interest-earning assets | | | 380,797 | | | | 177,224 | | | | 322,444 | | | | 118,843 | | | | 999,308 | |
| | | | | | | | | | | | | | | | | | | | | |
| Interest-bearing liabilities: | | | | | | | | | | | | | | | | | | | | |
| Demand deposits | | | 69,186 | | | | - | | | | 11,347 | | | | 8,511 | | | | 89,044 | |
| MMDA and savings | | | 243,605 | | | | - | | | | - | | | | - | | | | 243,605 | |
| Time deposits | | | 78,362 | | | | 197,094 | | | | 67,929 | | | | 7,162 | | | | 350,547 | |
| Short term borrowings | | | 1,678 | | | | - | | | | - | | | | - | | | | 1,678 | |
| Long term borrowings | | | 40,599 | | | | - | | | | 20,000 | | | | 6,895 | | | | 67,494 | |
| Total interest-bearing liabilities | | | 433,430 | | | | 197,094 | | | | 99,276 | | | | 22,568 | | | | 752,368 | |
| | | | | | | | | | | | | | | | | | | | | |
| Derivatives | | | 13,186 | | | | (7,036 | ) | | | (6,150 | ) | | | - | | | | - | |
| | | | | | | | | | | | | | | | | | | | | |
| Interest sensitivity gap | | $ | (39,447 | ) | | $ | (26,906 | ) | | $ | 217,018 | | | $ | 96,275 | | | $ | 246,940 | |
| Cumulative interest sensitivity gap | | $ | (39,447 | ) | | $ | (66,353 | ) | | $ | 150,665 | | | $ | 246,940 | | | | | |
| | | | | | | | | | | | | | | | | | | | | |
| Percentage of total assets | | | | | | | -5.93 | % | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | |
| At December 31, 2011: | | | | | | | | | | | | | | | | | | | | |
| Interest-earning assets: | | | | | | | | | | | | | | | | | | | | |
| Interest-bearing deposits | | $ | 10,115 | | | $ | - | | | $ | - | | | $ | - | | | $ | 10,115 | |
| Federal funds sold | | | - | | | | - | | | | - | | | | - | | | | - | |
| Securities | | | 9,168 | | | | 29,032 | | | | 98,812 | | | | 73,134 | | | | 210,146 | |
| Loans | | | 347,007 | | | | 167,849 | | | | 234,756 | | | | 9,435 | | | | 759,047 | |
| Total interest-earning assets | | | 366,290 | | | | 196,881 | | | | 333,568 | | | | 82,569 | | | | 979,308 | |
| | | | | | | | | | | | | | | | | | | | | |
| Interest-bearing liabilities: | | | | | | | | | | | | | | | | | | | | |
| Demand deposits | | | 3,846 | | | | - | | | | 8,789 | | | | 5,904 | | | | 18,539 | |
| MMDA and savings | | | 315,429 | | | | - | | | | - | | | | - | | | | 315,429 | |
| Time deposits | | | 80,425 | | | | 185,114 | | | | 104,454 | | | | 24 | | | | 370,017 | |
| Short term borrowings | | | 9,765 | | | | - | | | | - | | | | - | | | | 9,765 | |
| Long term borrowings | | | - | | | | 5,401 | | | | 40,000 | | | | 6,895 | | | | 52,296 | |
| Total interest-bearing liabilities | | | 409,465 | | | | 190,515 | | | | 153,243 | | | | 12,823 | | | | 766,046 | |
| | | | | | | | | | | | | | | | | | | | | |
| Derivatives | | | 16,834 | | | | - | | | | (13,238 | ) | | | (3,596 | ) | | | - | |
| | | | | | | | | | | | | | | | | | | | | |
| Interest sensitivity gap | | $ | (26,341 | ) | | $ | 6,366 | | | $ | 167,087 | | | $ | 66,150 | | | $ | 213,262 | |
| Cumulative interest sensitivity gap | | $ | (26,341 | ) | | $ | (19,975 | ) | | $ | 147,112 | | | $ | 213,262 | | | | | |
| | | | | | | | | | | | | | | | | | | | | |
| Percentage of total assets | | | | | | | -3.24 | % | | | | | | | | | | | | |
Item 3. Quantitative and Qualitative Disclosures about Market Risk.
See “Interest Rate Sensitivity” in the Management’s Discussion and Analysis of Financial Condition and Results of Operations in Part I, Item 2 for disclosures about market risk.
Item 4. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
As of the end of the period covered by this Quarterly Report on Form 10-Q, the management of the Company, under the supervision and with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, carried out an evaluation of the effectiveness of the Company’s disclosure controls and procedures as defined in Rule 13a-15(e) of the Securities Exchange Act of 1934, as amended. Based on that evaluation, the Chief Executive Officer and the Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective as of such date.
Changes in Internal Control Over Financial Reporting
There was no change in the Company’s internal control over financial reporting that occurred during the second fiscal quarter of 2012 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.
Part II. OTHER INFORMATION
Item 1. Legal Proceedings
In the ordinary course of business, the Company may be a party to various legal proceedings from time to time. There are no material pending legal proceedings to which the Company is a party or of which any of its property is subject. In addition, the Company is not aware of any threatened litigation, unasserted claims or assessments that could have a material adverse effect on its business, operating results or financial condition.
On June 6, 2012, a putative stockholder class action lawsuit was filed against Citizens South, Citizens South’s directors and the Company in the Delaware Court of Chancery in connection with the merger agreement: Heath v. Kim S. Price, et al., C.A. No. 7601-VCP (Court of Chancery of the State of Delaware). The lawsuit asserts that the members of the Citizens South board of directors breached their fiduciary duties owed to Citizens South stockholders in connection with the approval of the proposed merger with the Company and that Citizens South and the Company aided and abetted the alleged breaches of fiduciary duty. On August 6, 2012, an amended complaint was filed adding an allegation that the members of the Citizens South board of directors breached their fiduciary duties of disclosure. The Company believes this lawsuit is without merit.
In June 2012, the federal banking regulatory agencies proposed new capital rules that would apply to the Company. In addition, as previously discussed in this report, on May 13, 2012, the Company and Citizens South entered into an Agreement and Plan of Merger, pursuant to which Citizens South will be merged with and into the Company, with the Company as the surviving entity. The merger remains subject to various conditions, including the approval by the Company’s shareholders and Citizens South’s stockholders and the receipt of customary bank regulatory approvals. In addition, the Company’s obligation to complete the merger is conditioned on the FDIC’s consent to the assignment of certain existing FDIC loss-share agreements to which Citizens South is a party. The following risk factors are being provided in addition to the risk factors previously disclosed in the 2011 Form 10-K.
The new capital rules proposed in June 2012 by the federal banking regulatory agencies to implement the Basel III capital guidelines may adversely affect the Company’s capital adequacy and the costs of conducting its business.
In June 2012, the federal banking regulatory agencies, including the Federal Reserve Board and the FDIC, each issued three Notices of Proposed Rulemaking (the “Proposals”) that would revise and replace the agencies’ current capital rules to align with the Basel III capital standards and meet certain requirements of the Dodd-Frank Act. While Basel III proposed a capital regime intended only for large internationally active banks, the Proposals extend the proposed capital standards to all U.S. banks, as well as to all bank holding companies with $500 million or in consolidated assets, including the Company and the Bank. Certain requirements of the Proposals would establish more restrictive capital definitions, higher risk-weightings for certain asset classes, capital buffers and higher minimum capital ratios. The Proposals could have far reaching effects on our capital and the amount of capital required to support our business and therefore may adversely affect our results of operations and financial condition.
We expect to incur significant transaction and merger-related integration costs in connection with the merger with Citizens South and, even if completed, we may not realize all of the anticipated benefits of the merger.
We expect to incur significant costs associated with completing the Citizen South merger and integrating the operations of the two companies. It is possible that the integration process could result in the loss of key employees, the disruption of our ongoing businesses or inconsistencies in standards, controls, procedures and policies that adversely affect our ability to maintain relationships with customers, depositors and employees or to achieve the anticipated benefits of the merger. Integration efforts will also divert management attention and resources. Additionally, if we are not able to merge Citizens South Bank with and into Park Sterling Bank following the completion of the merger, they would be subject to separate examination by their respective primary regulators and we would incur increased regulatory and compliance costs. Accordingly, we may fail to realize some of the anticipated benefits and cost savings from the merger, or the benefits and savings make take longer to be realized than expected, which could adversely impact our financial condition and results of operations. Although we believe that the elimination of duplicate costs, as well as the realization of other efficiencies related to the integration of the businesses, will offset incremental transaction and merger-related costs over time, this net benefit may not be achieved in the near term, or at all.
Additionally, in the event the merger is not completed, we will be subject to a number of risks without realizing any of the benefits of having completed the merger, including the payment of certain fees and costs relating to the merger, such as legal, accounting, financial advisor and printing fees, the potential decline in the market price of our common stock, the risk that we may not find another party willing to enter into a merger agreement on terms equivalent to or more attractive than the terms set forth in the merger agreement and the loss of time and resources.
The Citizens South merger will not be completed unless important conditions to the merger are satisfied.
Completion of the Citizens South merger is subject to certain conditions set forth in the merger agreement, including regulatory approvals and approval of the shareholders of the Company and Citizens South. In addition, the Company’s obligation to complete the merger is conditioned on the FDIC’s consent to the assignment of certain existing FDIC loss-share agreements to which Citizens South is a party. If these conditions are not satisfied or waived, to the extent permitted by law or stock exchange rules, the merger will not occur or will be delayed and we could lose some or all of the intended benefits of the merger. We may not receive the applicable regulatory or shareholder approvals, or governmental authorities may impose conditions upon the completion of the merger or require changes in the terms of the merger. These conditions or changes could result in the termination of the merger agreement or could have the effect of delaying the completion of the merger or imposing additional costs or limiting the possible revenues of the combined company. The Company is not obligated to complete the merger if the regulatory approvals received in connection with the completion of the merger include any conditions or restrictions that, in the aggregate, would reasonably be expected to have a material adverse effect on Citizens South or the Company.
Sales of substantial amounts of common stock in the open market by former Citizens South stockholders could depress the stock price.
Shares of the Company’s common stock that are issued to stockholders of Citizens South will be freely tradable without restrictions or further registration under the Securities Act of 1933, as amended, except for shares issued to any stockholder who may be deemed to be an affiliate of the Company. We currently expect to issue approximately 11,919,746 shares of the Company’s common stock in connection with the merger. If the merger is completed and if Citizens South’s stockholders sell substantial amounts of Park Sterling common stock in the public market following completion of the merger, the market price of our common stock may decrease. These sales might also make it more difficult for the Company to sell equity or equity-related securities at a time and price that it otherwise would deem appropriate.
If the Citizens South merger is not completed, the trading price of the Company’s common stock could decline.
If the merger is not completed, the Company may be subject to a number of material risks, including that the price of the common stock may decline to the extent that the current market price reflects an assumption that the merger will be completed.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
During the three months ended June 30, 2012, the Company did not have any unregistered sales of equity securities or repurchases of its common stock.
Item 3. Defaults Upon Senior Securities
Not applicable.
Item 4. Mine Safety Disclosures
Not applicable.
Item 5. Other Information
Not applicable.
Item 6. Exhibits
The following documents are filed or furnished as exhibits to this report:
Exhibit Number | | Description of Exhibits |
| | | |
| 2.1 | | Agreement and Plan of Merger dated as of May 13, 2012 by and between Park Sterling Corporation and Citizens South Banking Corporation, incorporated by reference to Exhibit 2.1 of the Company’s Current Report on Form 8-K (File No. 001-35032) filed May 17, 2012 |
| | | |
| 3.1 | | Articles of Incorporation of the Company, incorporated by reference to Exhibit 3.1 of the Company’s Current Report on Form 8-K (File No. 001-35032) filed January 13, 2011 |
| | | |
| 3.2 | | Bylaws of the Company, incorporated by reference to Exhibit 3.2 of the Company’s Current Report on Form 8-K (File No. 001-35032) filed January 13, 2011 |
| | | |
| | Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |
| | | |
| 31.2 | | Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |
| | | |
| 32.1 | | Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |
| | | |
| 32.2 | | Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |
| | | |
| 101 | | Interactive data files pursuant to Rule 405 of Regulation S-T: (i) Condensed Consolidated Balance Sheets as of June 30, 2012 and December 31, 2011; (ii) Condensed Consolidated Statements of Income (Loss) for the three and six months ended June 30, 2012 and 2011; (iii) Condensed Consolidated Statements of Comprehensive Income (Loss) for the three and six months ended June 30, 2012 and 2011; (iv) Condensed Consolidated Statements of Changes in Shareholders’ Equity for the six months ended June 30, 2012 and 2011; (v) Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 2012 and 2011; and (vi) Notes to Condensed Consolidated Financial Statements* |
*The information is furnished and not filed for purposes of Sections 11 and 12 of the Securities Act of 1933 and Section 18 of the Securities Exchange Act of 1934
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
| | | PARK STERLING CORPORATION | |
| | | | |
| By: | /s/ James C. Cherry | |
| | | James C. Cherry | |
| | | Chief Executive Officer (authorized officer) | |
| | | | |
| Date: August 9, 2012 | By: | /s/ David L. Gaines | |
| | | David L. Gaines | |
| | | Chief Financial Officer | |
Exhibit Index
| Exhibit Number | | Description of Exhibits |
| | | |
| 2.1 | | Agreement and Plan of Merger dated as of May 13, 2012 by and between Park Sterling Corporation and Citizens South Banking Corporation, incorporated by reference to Exhibit 2.1 of the Company’s Current Report on Form 8-K (File No. 001-35032) filed May 17, 2012 |
| | | |
| 3.1 | | Articles of Incorporation of the Company, incorporated by reference to Exhibit 3.1 of the Company’s Current Report on Form 8-K (File No. 001-35032) filed January 13, 2011 |
| | | |
| 3.2 | | Bylaws of the Company, incorporated by reference to Exhibit 3.2 of the Company’s Current Report on Form 8-K (File No. 001-35032) filed January 13, 2011 |
| | | |
| 31.1 | | Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |
| | | |
| 31.2 | | Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |
| | | |
| 32.1 | | Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |
| | | |
| 32.2 | | Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |
| | | |
| 101 | | Interactive data files pursuant to Rule 405 of Regulation S-T: (i) Condensed Consolidated Balance Sheets as of June 30, 2012 and December 31, 2011; (ii) Condensed Consolidated Statements of Income (Loss) for the three and six months ended June 30, 2012 and 2011; (iii) Condensed Consolidated Statements of Comprehensive Income (Loss) for the three and six months ended June 30, 2012 and 2011; (iv) Condensed Consolidated Statements of Changes in Shareholders’ Equity for the six months ended June 30, 2012 and 2011; (v) Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 2012 and 2011; and (vi) Notes to Condensed Consolidated Financial Statements* |
*The information is furnished and not filed for purposes of Sections 11 and 12 of the Securities Act of 1933 and Section 18 of the Securities Exchange Act of 1934
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