Total noninterest expense decreased $2.3 million, or 6.5%, from the second quarter of 2010 driven by a reduction in expense for other real estate owned properties ($0.8 million), FDIC insurance ($0.4 million), advertising expense ($0.5 million), pension plan expense ($0.4 million), and interchange fees ($0.3 million). Compared to the third quarter of 2009, noninterest expense increased by $0.7 million, or 2.4%, reflecting higher expense for other real estate owned properties ($1.4 million) and FDIC insurance ($0.6 million), partially offset by a reduction in compensation expense ($0.7 million), advertising expense ($0.3 million), and intangible asset amortization ($0.3 million).
For the first nine months of 2010, as compared to the same period in 2009, noninterest expense increased $3.6 million, or 3.7%, due primarily to higher expense for other real estate owned properties ($6.2 million), partially offset by lower compensation expense ($1.6 million), advertising expense ($0.4 million), and intangible asset amortization ($0.9 million).
The table below reflects the major components of noninterest expense.
Significant components of noninterest expense are discussed in more detail below.
Compared to the third quarter of 2009, total compensation expense declined by $657,000, or 4.2%, due to a reduction in salary expense ($306,000) and associate benefit expense ($351,000). The decline in salary expense is primarily attributable to lower associate base salaries ($197,000) as well as a decline in associate cash incentive expense ($298,000), partially offset by lower realized loan cost ($175,000). The reduction in associate benefit expense reflects a decrease in pension plan expense ($170,000) and stock compensation ($136,000).
For the first nine months of 2010, total compensation expense decreased $1.6 million, or 3.2%, from the same period of 2009 primarily due to lower expense for associate benefits ($1.4 million), and to a lesser extent a reduction in salary expense ($202,000). The decline in associate benefits was due to lower pension expense and the reduction in salary expense was due to lower associate base salaries ($370,000), commissions ($96,000), and associate cash incentives ($210,000), partially offset by lower realized loan cost ($566,000).
Pension expense declined for all of the aforementioned periods and reflects a higher level of expected return on plan assets which has a positive impact on our accounting expense. For all of the respective periods, we realized a reduction in associate base salaries and lower expense for all of our performance based cash and stock incentive programs. The decline in associate base salaries reflects normal headcount attrition and our efforts to improve overall operating efficiency.
Occupancy. Occupancy expense (including premises and equipment) increased $122,000, or 2.6%, over the second quarter of 2010, and increased $251,000, or 5.4%, over the third quarter of 2009. For the first nine months of 2010, occupancy expense increased by $90,000, or 0.6%, compared to the same period in 2009.
The increase over the second quarter was due to higher expense for maintenance agreements ($104,000), driven by higher costs for our phone system maintenance, which was free for the first year of installation (2009), higher expense for maintenance on our item processing system, and the impact of opening a new office building in the prior quarter. Compared to the third quarter of 2009, higher premises depreciation expense ($160,000) drove the increase reflecting several completed office construction projects. Higher maintenance agreement expense ($118,000) also contributed to the increase for the period. For the nine month period, higher premises depreciation expense related to the aforementioned office construction projects drove the increase, which was partially offset by lower software license expense ($94,000), FF&E depreciation ($75,000), and maintenance agreement expense ($64,000). The reduction in software license expense and FF&E depreciation reflects full amortization and depreciation of several software licenses and system components related to our end-user and network system environments. The decline in maintenance agreement expense reflects the re-negotiation of several vendor maintenance agreements during 2009.
Other. Other noninterest expense decreased $1.8 million, or 12.7%, from the second quarter of 2010 and increased $1.2 million, or 10.2%, over the third quarter of 2009. The decrease from the second quarter primarily reflects lower expense for other real estate owned ($776,000), advertising ($497,000), and FDIC insurance ($387,000). The decline in other real estate owned expense reflects a lower level of property valuation write-downs. The favorable variance in FDIC insurance reflects a higher required expense in the prior quarter due to an adjustment in our premium rate. Closer management of costs related to our free checking products as well as lower public relations expense contributed to the decline in advertising expense.
Compared to the third quarter of 2009, other noninterest expense increased by $1.2 million, or 10.2%, primarily due to higher expense for other real estate owned properties ($1.4 million) and FDIC insurance ($574,000), partially offset by lower expense for advertising ($347,000). A higher level of both property valuation write-downs and carrying costs drove the increase. The unfavorable variance in FDIC insurance reflects a higher premium rate and the favorable variance in advertising expense is due to tighter controls over discretionary expenditures.
For the first nine months of 2010, other noninterest expense increased $5.1 million, or 15.0%, due to higher expense for other real estate owned properties ($6.2 million) and legal fees ($486,000), partially offset by lower intangible amortization expense ($903,000) and a decrease in interchange fees ($631,000). The higher level of expense for both other real estate owned properties and legal fees is due to a higher level of nonperforming assets and related legal support needed for the collection and disposition of those assets. The decline in intangible amortization expense reflects the full amortization of one of our core deposit intangible assets. The reduction in interchange fees is due to the July 2008 sale of our merchant portfolio and the migration of all our merchant clients to a new processor, which was finalized during the third quarter of 2010.
The operating net noninterest expense ratio (expressed as noninterest income minus noninterest expense, excluding intangible amortization expense and merger expenses, as a percent of average assets) was 2.75% for the third quarter of 2010 compared to 2.88% for the second quarter of 2010 and 2.59% for the third quarter of 2009. Our operating efficiency ratio (expressed as noninterest expense, excluding intangible amortization expense and merger expenses, as a percent of the sum of taxable-equivalent net interest income plus noninterest income) was 82.08% for the third quarter of 2010 compared to 86.06% for the second quarter of 2010 and 73.86% for the third quarter of 2009. For the first nine months of 2010, these metrics were 2.81% and 84.39%, compared to 2.72% and 74.82%, respectively, for the same period of 2009. The variance in our efficiency ratio compared to the prior year periods is primarily due to a lower level of net interest income and to a lesser extent the increase in our noninterest expense driven by the aforementioned increase in expense for other real estate owned properties.
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Income Taxes
We realized a tax benefit of $199,000 in the third quarter compared to tax expense of $50,000 for the second quarter of 2010 and a tax benefit of $1.6 million for the third quarter of 2009. For the first nine months of 2010, we realized a tax benefit of $2.8 million compared to a tax benefit of $2.3 million for the same period of 2009. We have substantial tax exempt income as well as a lower level of pre-tax income at our bank subsidiary due to higher loan loss provisions – both of these factors favorably impacted our tax provision for the aforementioned periods.
FINANCIAL CONDITION
Average earning assets were $2.273 billion for the quarter ended September 30, 2010, a decrease of $56.2 million, or 2.4%, from the linked quarter and an increase of $ 35.6 million, or 1.6%, from the fourth quarter of 2009. The decline compared to the linked quarter is primarily attributable to a lower overnight funds position reflecting the overall reduction in deposits, and problem loan resolution, which has the effect of lowering the loan portfolio as loans are either charged off or transferred to Other Real Estate Owned. The increase from year-end is attributable to increases in the overnight funds position and the investment portfolio, which were funded through higher deposit balances. These increases were partially offset by problem loan resolution.
Investment Securities
In the third quarter of 2010, the average balance of the investment portfolio decreased $7.1 million, or 3.2%, compared to the second quarter of 2010, but increased $33.4 million, or 18.6%, from the fourth quarter of 2009. As a percentage of average earning assets, the investment portfolio represented 9.4% in the third quarter of 2010, compared to 9.5% in the second quarter of 2010 and 8.0% in the fourth quarter of 2009. The decline in the average balance of the investment portfolio compared to the prior quarter resulted from maturing investments not being replaced for most of the quarter, although approximately $20 million of a $60 million investment purchase strategy was implemented late in the third quarter that will impact the fourth quarter as we further deploy a portion of the funds sold position. The increase in the average balance of the investment portfolio compared to the fourth quarter of 2009 was primarily attributable to a $60.0 million purchase of U.S. Treasury securities late in the first quarter and early in the second quarter of 2010 given our strong liquidity level. During the fourth quarter, we expect to complete the $60 million purchase program begun late in the third quarter and, depending on deposit levels and loan demand, we may continue to add to the investment portfolio in the fourth quarter, if appropriate.
The investment portfolio is a significant component of our operations and, as such, it functions as a key element of liquidity and asset/liability management. As of September 30, 2010, all securities are classified as available-for-sale, which offers management full flexibility in managing our liquidity and interest rate sensitivity without adversely impacting our regulatory capital levels. It is neither management’s intent nor practice to participate in the trading of investment securities for the purpose of recognizing gains and therefore we do not maintain a trading portfolio. Securities in the available-for-sale portfolio are recorded at fair value with unrealized gains and losses associated with these securities recorded net of tax, in the accumulated other comprehensive income (loss) component of shareowners’ equity.
At September 30, 2010, the investment portfolio maintained a net pre-tax unrealized gain of $2.6 million compared to a net pre-tax unrealized gain of $2.0 million at December 31, 2009. The increase in unrealized gains compared to the fourth quarter of 2009 was primarily attributable to lower yields throughout the majority of bond products, resulting in higher bond prices. Approximately $2.9 million of our investment securities have an unrealized loss totaling $0.6 million, all of which have been in a loss position for less than 12 months. These positions consist of (1) five municipal bonds pre-refunded with US Government securities which are not considered impaired, and are expected to mature at par (2) two GNMA securities which carry the full faith and credit of the U.S. Government, and (3) approximately $0.6 million of a bank preferred stock issue at the holding company that maintained a zero book value as of September 30, 2010 and December 31, 2009. We continue to closely monitor the fair value of this security as the issuer of this security continues to experience negative operating trends.
Loans
Average loans decreased $33.9 million, or 1.8%, from the linked quarter of 2010 and $137.4 million, or 7.1%, from the fourth quarter of 2009. The decline was primarily driven by reductions in the commercial real estate and construction loan categories. The portfolio continues to be impacted by weak loan demand, attributable to the sluggish economy, but not at the levels we have experienced in recent quarters. In addition to lower production and normal amortization and payoffs, the reduction in the portfolio is also attributable to gross charge-offs and the transfer of loans to the other real estate owned category, which collectively, accounted for $60.9 million, or 53% of the net reduction during the first nine months of 2010. Loans as a percent of average earning assets, has declined to 79.5% in 2010, which is down from the year-end 2009 level of 86.9%.
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Our bankers continue to try to reach clients who are interested in moving or expanding their banking relationships. While we strive to identify opportunities to increase loans outstanding and enhance the portfolio’s overall contribution to earnings, we will only do so by adhering to sound lending principles applied in a prudent and consistent manner. Thus, we will not relax our underwriting standards in order to achieve designated growth goals and, where appropriate, have adjusted our standards to reflect risks inherent in the current economic environment.
As part of our loan portfolio analysis procedures during the second quarter of 2010, we reclassified approximately $10.0 million in loans from the construction real estate loan category to the residential real estate categories as these loans have migrated to a permanent term status. We also identified approximately $30.0 million in business purposes loans secured by residential real estate (rental houses) that were reclassified from the commercial real estate category to the residential real estate category to better reflect that nature of the underlying collateral for these loans.
Loan Concentrations. Loan concentrations are considered to exist when there are amounts loaned to a multiple number of borrowers engaged in similar activities which cause them to be similarly impacted by economic or other conditions and such amount exceeds 10% of total loans. Due to the lack of diversified industry within the markets served by the Bank and the relatively close proximity of the markets, we have both geographic concentrations as well as concentrations in the types of loans funded. Specifically, due to the nature of our markets, a significant portion of the portfolio has historically been secured with real estate.
While we have a majority of our loans (79.1%) secured by real estate, the primary types of real estate collateral are commercial properties and 1-4 family residential properties. At September 30, 2010, commercial real estate mortgage loans and residential real estate mortgage loans accounted for 37.8% and 38.8%, respectively, of the loan portfolio. Furthermore, approximately 10.8% of our loan portfolio is secured by vacant residential land loans, which include both improved and unimproved land and are comprised of loans to individuals as well as builders/developers.
Nonperforming Assets
At September 30, 2010, nonperforming assets (including nonaccrual loans, restructured loans and other real estate owned) totaled $145.6 million, a decrease of $4.2 million from the second quarter of 2010, and an increase of $1.6 million, or 1.1%, over the fourth quarter of 2009. The decline from the linked second quarter was primarily due to a decline in restructured loans of $6.9 million - two large loans were restored to performing status due to paying as agreed under restructured terms. Compared to the prior quarter, nonaccrual loans realized a net decrease of $0.4 million as the volume of loans migrating to nonaccrual status was offset by resolutions and transfers to the other real estate owned category. The balance of other real estate owned realized a net increase of $3.1 million from the prior quarter reflective of the aforementioned migration of loans through the foreclosure process as well as a slight slowdown in property dispositions. Compared to the prior year-end, the $1.6 million increase in nonperforming assets reflects a slightly higher level of nonaccrual loan inflow than problem loan and other real estate owned resolutions. At quarter-end, vacant residential land loans represented approximately $23.0 million (approximately 100 borrowing relationships), or 31%, of our nonaccrual loan balance compared to $28.1 million, or 33%, at year-end 2009. Nonperforming assets represented 7.86% of loans and other real estate at the end of the third quarter compared to 8.01% at the prior quarter-end and 7.38% at year-end 2009.
Due to the downturn in the economy and our real estate markets it has become more common to restructure or modify the terms of some loans under certain conditions (i.e. troubled debt restructures or “TDRs”). In those instances, we will from time to time restructure the terms of a loan and work with the borrower for the benefit of both parties. When we do modify the terms of a loan, we usually extend the term of a loan, offer a short-term deferral, offer a new loan product, or a combination of these options. We have not forgiven any material principal amounts on any loan modifications to date. Our philosophy has been to work with borrowers who are experiencing a near term financial hardship, but whom we believe have the capacity to repay all interest and principal contractually due given some easing of near term cash flow strains. We currently have $20.2 million in loans classified as TDRs and all of these loans are in an accrual status. Our TDRs are included in our impaired loan totals as required by current accounting standards and are included in our nonperforming asset totals in the table below.
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Non-performing assets are summarized as follows.
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(Dollars in Thousands) | | September 30,
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Nonaccruing Loans | | $ | 74,168 | | $ | 74,504 | | $ | 86,274 | |
Troubled Debt Restructurings | | | 20,267 | | | 27,200 | | | 21,644 | |
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Total Nonperforming Loans | | | 94,435 | | | 101,704 | | | 107,918 | |
Other Real Estate Owned | | | 51,208 | | | 48,110 | | | 36,134 | |
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Total Nonperforming Assets | | $ | 145,643 | | $ | 149,814 | | $ | 144,052 | |
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Past Due 30-89 Days or More | | $ | 24,904 | | $ | 21,192 | | $ | 36,501 | |
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Past Due 90 Days or More (and still accruing) | | $ | — | | $ | — | | $ | — | |
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Nonperforming Loans/Loans | | | 5.24 | % | | 5.58 | % | | 5.63 | % |
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Nonperforming Assets/Loans Plus Other Real Estate | | | 7.86 | % | | 8.01 | % | | 7.38 | % |
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Nonperforming Assets/Capital(1) | | | 48.81 | % | | 49.92 | % | | 46.19 | % |
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Allowance/Nonperforming Loans | | | 39.94 | % | | 37.80 | % | | 40.77 | % |
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(1) | For computation of this percentage, “Capital” refers to shareowners’ equity plus the allowance for loan losses. |
Allowance for Loan Losses
We maintain an allowance for loan losses at a level sufficient to provide for the estimated loan losses inherent in the loan portfolio as of the balance sheet date. Credit losses arise from borrowers’ inability or unwillingness to repay, and from other risks inherent in the lending process, including collateral risk, operations risk, concentration risk and economic risk. All related risks of lending are considered when assessing the adequacy of the loan loss reserve. The allowance for loan losses is established through a provision charged to expense. Loans are charged against the allowance when management believes collection of the principal is unlikely. The allowance for loan losses is based on management’s judgment of overall loan quality. This is a significant estimate based on a detailed analysis of the loan portfolio. The balance can and will change based on changes in the assessment of the portfolio’s overall credit quality.We evaluate the adequacy of the allowance for loan losses on a quarterly basis.
The allowance for loan losses was $37.7 million at September 30, 2010 compared to $38.4 million at June 30, 2010 and $44.0 million at December 31, 2009. The allowance for loan losses was 2.10% of outstanding loans (net of overdrafts) and provided coverage of 40% of nonperforming loans at September 30, 2010 compared to 2.11% and 38%, respectively at the end of the prior quarter and 2.30% and 41%, respectively, at year-end 2009. The decrease in our allowance from the prior quarter is due to a lower level of general reserves generally reflective of overall stabilizing trends within the loan portfolio. The decline from year-end 2009 is primarily due to a lower level of required impaired loan reserves due to a slowdown in loans migrating to impaired status. It is management’s opinion that the allowance at September 30, 2010 is adequate to absorb losses inherent in the loan portfolio at quarter-end.
Deposits
Average total deposits were $2.172 billion for the third quarter, a decrease of $62.0 million, or 2.8%, from the second quarter and an increase of $82.2 million, or 3.9%, from the fourth quarter of 2009. Deposit levels are strong but down slightly from the second quarter level, primarily attributable to lower money market account and certificates of deposit balances, and a decline in public funds. The money market account promotion launched during the third quarter of 2009 and concluded in the fourth quarter, experienced runoff as rates were eased during the current quarter to standard board levels. Despite the lowering of rates, the bank has retained in excess of $24 million in new deposit balances. This initiative served to support our core deposit growth strategy while succeeding in further strengthening the Bank’s overall liquidity position. Certificates of deposit declined primarily due to the maturity of a large public fund CD and a reduction in the number of single relationship, higher yielding certificates of deposit with the Bank. Public funds balances have declined as anticipated from the linked quarter reflecting seasonality within this deposit category. Our Absolutely Free Checking (“AFC”) products continue to be successful as both balances and the number of accounts increased quarter over quarter.
We continue to pursue prudent pricing discipline to manage the mix of our deposits. Therefore, we are not attempting to compete with higher rate paying competitors for deposits. The increase from the fourth quarter reflects higher public funds of $37.3 million and core deposits of $44.9 million fueled primarily by the success of the AFC products.
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MARKET RISK AND INTEREST RATE SENSITIVITY
Market Risk and Interest Rate Sensitivity
Overview.Market risk management arises from changes in interest rates, exchange rates, commodity prices, and equity prices. We have risk management policies to monitor and limit exposure to market risk and do not participate in activities that give rise to significant market risk involving exchange rates, commodity prices, or equity prices. In asset and liability management activities, our policies are designed to minimize structural interest rate risk.
Interest Rate Risk Management.Our net income is largely dependent on net interest income. Net interest income is susceptible to interest rate risk to the degree that interest-bearing liabilities mature or reprice on a different basis than interest-earning assets. When interest-bearing liabilities mature or reprice more quickly than interest-earning assets in a given period, a significant increase in market rates of interest could adversely affect net interest income. Similarly, when interest-earning assets mature or reprice more quickly than interest-bearing liabilities, falling interest rates could result in a decrease in net interest income. Net interest income is also affected by changes in the portion of interest-earning assets that are funded by interest-bearing liabilities rather than by other sources of funds, such as noninterest-bearing deposits and shareowners’ equity.
We have established a comprehensive interest rate risk management policy, which is administered by management’s Asset Liability Management Committee (“ALCO”). The policy establishes limits of risk, which are quantitative measures of the percentage change in net interest income (a measure of net interest income at risk) and the fair value of equity capital (a measure of economic value of equity (“EVE”) at risk) resulting from a hypothetical change in interest rates for maturities from one day to 30 years. We measure the potential adverse impacts that changing interest rates may have on our short-term earnings, long-term value, and liquidity by employing simulation analysis through the use of computer modeling. The simulation model captures optionality factors such as call features and interest rate caps and floors imbedded in investment and loan portfolio contracts. As with any method of gauging interest rate risk, there are certain shortcomings inherent in the interest rate modeling methodology used by us. When interest rates change, actual movements in different categories of interest-earning assets and interest-bearing liabilities, loan prepayments, and withdrawals of time and other deposits, may deviate significantly from assumptions used in the model. Finally, the methodology does not measure or reflect the impact that higher rates may have on adjustable-rate loan clients’ ability to service their debts, or the impact of rate changes on demand for loan, and deposit products.
We prepare a current base case and four alternative simulations, at least once a quarter, and report the analysis to the Board of Directors. In addition, more frequent forecasts may be produced when interest rates are particularly uncertain or when other business conditions so dictate.
Our interest rate risk management goal is to avoid unacceptable variations in net interest income and capital levels due to fluctuations in market rates. Management attempts to achieve this goal by balancing, within policy limits, the volume of floating-rate liabilities with a similar volume of floating-rate assets, keeping the average maturity of fixed-rate asset and liability contracts reasonably matched, maintaining a pool of administered core deposits, and adjusting pricing rates to market conditions on a continuing basis.
The balance sheet is subject to testing for interest rate shock possibilities to indicate the inherent interest rate risk. Average interest rates are shocked by plus or minus 100, 200, and 300 basis points (“bp”), although we may elect not to use particular scenarios that we determined are impractical in a current rate environment. It is management’s goal to structure the balance sheet so that net interest earnings at risk over a 12-month period and the economic value of equity at risk do not exceed policy guidelines at the various interest rate shock levels.
We augment our quarterly interest rate shock analysis with alternative external interest rate scenarios on a monthly basis. These alternative interest rate scenarios may include non-parallel rate ramps.
Analysis.Measures of net interest income at risk produced by simulation analysis are indicators of an institution’s short-term performance in alternative rate environments. These measures are typically based upon a relatively brief period, usually one year. They do not necessarily indicate the long-term prospects or economic value of the institution.
Estimated Changes in Net Interest Income(1)
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Changes in Interest Rates | | +300 bp | | +200 bp | | +100 bp | | -100 bp | |
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Policy Limit (±) | | 10.0 | % | | 7.5 | % | | 5.0 | % | | 5.0 | % | |
September 30, 2010 | | -7.3 | % | | -4.0 | % | | -1.2 | % | | -0.8 | % | |
June 30, 2010 | | -7.4 | % | | -4.0 | % | | -1.2 | % | | -0.7 | % | |
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When compared to the linked quarter, the net interest income at risk position improved for the +300 basis point (“bp”) level, remained unchanged for the +100 and +200 bp scenarios, and fell slightly in the -100 bp scenario. Our largest exposure is at the +300 bp level, with a measure of -7.3%, which is still within our policy limit of ±10.0%. The slight improvement in the +300 bp simulation was primarily attributable to lower interest bearing deposit balances, resulting in a decline in funding costs. All measures of net interest income at risk are within our prescribed policy limits.
The measures of equity value at risk consider the effects of changes in interest rates on all of our cash flows, and discount the cash flows to estimate the present value of assets and liabilities. The difference between these discounted values of the assets and liabilities is the economic value of equity, which, in theory, approximates the fair value of our net assets.
Estimated Changes in Economic Value of Equity(1)
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Changes in Interest Rates | | +300 bp | | +200 bp | | +100 bp | | -100 bp | |
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Policy Limit (±) | | 12.5 | % | | 10.0 | % | | 7.5 | % | | 7.5 | % | |
September 30, 2010 | | -1.7 | % | | 2.7 | % | | 4.1 | % | | -6.0 | % | |
June 30, 2010 | | -2.6 | % | | 1.9 | % | | 3.5 | % | | -7.2 | % | |
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Our risk profile, as measured by EVE, improved for the third quarter of 2010, when compared to the linked quarter, for all rate scenarios. Our largest exposure is at the down 100 bp scenario, with a measure of -6.0%, which is still within our policy limit of ±7.5%. The improvement from the linked quarter is primarily attributable to a decline in market rates primarily for investments and loans when compared to the prior quarter. All measures of economic value of equity are within our prescribed policy limits.
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(1) | Down 200 and 300 bp scenarios have been excluded due to the current historically low interest rate environment. |
LIQUIDITY AND CAPITAL RESOURCES
Liquidity
In general terms, liquidity is a measurement of our ability to meet our cash needs. Our objective in managing our liquidity is to maintain our ability to meet loan commitments, purchase securities or repay deposits and other liabilities in accordance with their terms, without an adverse impact on our current or future earnings. Our liquidity strategy is guided by policies that are formulated and monitored by our ALCO and senior management, and which take into account the marketability of assets, the sources and stability of our funding and the level of unfunded commitments. We regularly evaluate all of our various funding sources with an emphasis on accessibility, stability, reliability and cost-effectiveness. Our principal source of funding has been our client deposits, supplemented by our short-term and long-term borrowings, primarily from securities sold under repurchase agreements, federal funds purchased and FHLB borrowings. We believe that the cash generated from operations, our borrowing capacity and our access to capital resources are sufficient to meet our future operating capital and funding requirements.
Overall, we have the ability to generate $925 million in liquidity through all of our available resources. In addition to primary borrowing outlets mentioned above, we also have the ability to generate liquidity by borrowing from the Federal Reserve Discount Window and through brokered deposits. Management recognizes the importance of maintaining liquidity and has developed a Contingency Liquidity Plan, which addresses various liquidity stress levels and our responses and actions based on the level of severity. We periodically test our credit facilities for access to the funds, but also understand that as the severity of the liquidity level increases that some credit facilities may no longer be available. The liquidity currently available to us is considered sufficient to meet our on-going needs.
We view our investment portfolio as a liquidity source and have the option to pledge the portfolio as collateral for borrowings or deposits, and/or sell selected securities. The portfolio consists of debt issued by the U.S. Treasury, U.S. governmental agencies, and municipal governments. The weighted average life of the portfolio is approximately 1.73 years and as of quarter-end had a net unrealized pre-tax gain of $2.6 million.
We maintained an average net overnight funds (deposits with banks plus fed funds sold less fed funds purchased)sold position of $246.9 million during the third quarter of 2010 compared to an average net overnight fundssold position of $262.2 million in the prior quarter and an average overnight fundssoldposition of $112.8 million in the fourth quarter of 2009. The lower balance when compared to the linked quarter primarily reflects the decline in deposits mentioned above, partially offset by the lower investment and loan portfolios. The favorable variance as compared to year-end is primarily attributable to the growth in deposits and net reductions
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in the loan portfolio, partially offset by a higher balance in the investment portfolio. Late in the third quarter, a portion of the funds sold position was deployed into the investment portfolio. We will continue to deploy a portion of the excess funds sold position into the investment portfolio during the fourth quarter of 2010.
Capital expenditures are expected to approximate $5.0 million over the next 12 months, which consist primarily of office remodel projects, office equipment and furniture, and technology purchases. Management believes that these capital expenditures will be funded with existing resources without impairing our ability to meet our on-going obligations.
Borrowings
At September 30, 2010, advances from the FHLB consisted of $57.1 million in outstanding debt consisting of 48 notes. During the first nine months of 2010, the Bank made FHLB advance payments totaling approximately $2.5 million and obtained eight new FHLB advances totaling $9.6 million. The advances were used to match-fund loans. The FHLB notes are collateralized by a blanket floating lien on all of our 1-4 family residential mortgage loans, commercial real estate mortgage loans and home equity mortgage loans.
We have issued two junior subordinated deferrable interest notes to wholly owned Delaware statutory trusts. The first note for $30.9 million was issued to CCBG Capital Trust I in November 2004. The second note for $32.0 million was issued to CCBG Capital Trust II in May 2005. The interest payment for the CCBG Capital Trust I borrowing adjusts quarterly to a variable rate of LIBOR plus a margin of 1.90%. The rate for the third quarter was 2.43%. This note matures on December 31, 2034. The interest payment for the CCBG Capital Trust II borrowing adjusts quarterly to a variable rate of LIBOR plus a margin of 1.80%. The rate for the third quarter was 2.34%. This note matures on June 15, 2035. The proceeds of these borrowings were used to partially fund acquisitions.
In accordance with our Federal Reserve Resolutions (discussed in further detail in our 2009 Form 10-K), CCBG must receive approval from the Federal Reserve prior to incurring new debt, refinancing existing debt, or making interest payments on its trust preferred securities. Under the terms of each trust preferred securities note, in the event of default or if we elect to defer interest on the note, we may not, with certain exceptions, declare or pay dividends or make distributions on our capital stock or purchase or acquire any of our capital stock.
Capital
Equity capital was $260.7 million as of September 30, 2010, compared to $261.7 million as of June 30, 2010 and $267.9 million as of December 31, 2009. Our leverage ratio was 9.75%, 9.58%, and 10.39%, respectively, and our tangible capital ratio was 6.98%, 6.80%, and 6.84%, respectively, for the same periods. Our risk-adjusted capital ratio of 14.29% at September 30, 2010, exceeds the 10% threshold to be designated as “well-capitalized” under the risk-based regulatory guidelines.
During the first nine months of 2010, shareowners’ equity decreased approximately $7.2 million, or approximately 3.6%, on an annualized basis. During this same period, shareowners’ equity was negatively impacted by a net loss of $2.3 million and the payment of dividends totaling $6.7 million ($.390 per share). Shareowners’ equity was positively impacted by the issuance of stock totaling approximately $0.8 million and a change in the net unrealized gain on investment securities of approximately $1.0 million.
At September 30, 2010, our common stock had a book value of $15.32 per diluted share compared to $15.32 at June 30, 2010 and $15.72 at December 31, 2009. Book value is impacted by changes in the amount of our net unrealized gain or loss on investment securities available-for-sale and changes to the amount of our unfunded pension liability, both of which are recorded through other comprehensive income. At September 30, 2010, the net unrealized gain on investment securities available for sale was $1.6 million and the amount of our unfunded pension liability was $15.4 million.
State and federal regulations place certain restrictions on the payment of dividends by both CCBG and the Bank. The Bank’s aggregate net profits for the past two years are significantly less than the dividends declared and paid to CCBG over that same period. In addition, in accordance with our Federal Reserve Resolutions (discussed in further detail in our 2009 Form 10-K), the Bank must seek approval from the Federal Reserve prior to declaring or paying a dividend. As a result, the Bank must obtain approval from its regulators to issue and declare any further dividends to CCBG. The Bank may not be able to receive the required approvals. As of September 30, 2010, we believe we have sufficient cash to fund shareowner dividends for the remainder of 2010 should the Board choose to declare and pay a quarterly dividend. Even if we have sufficient cash to pay dividends, we must seek approval from the Federal Reserve to pay dividends to our shareowners and may not receive the required approvals. We will continue to evaluate the payment of dividends on a quarterly basis and consult with our regulators concerning matters relating to our overall dividend policy. As a result of our evaluations, we reduced our quarterly dividend from $0.19 per share to $0.10 per share in May 2010. An inability to obtain regulatory approval or earn the dividend in future quarters may result in further reduction or elimination of the dividend.
33
OFF-BALANCE SHEET ARRANGEMENTS
We do not currently engage in the use of derivative instruments to hedge interest rate risks. However, we are a party to financial instruments with off-balance sheet risks in the normal course of business to meet the financing needs of our clients.
At September 30, 2010, we had $345.9 million in commitments to extend credit and $13.0 million in standby letters of credit. Commitments to extend credit are agreements to lend to a client so long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Standby letters of credit are conditional commitments issued by us to guarantee the performance of a client to a third party. We use the same credit policies in establishing commitments and issuing letters of credit as we do for on-balance sheet instruments.
If commitments arising from these financial instruments continue to require funding at historical levels, management does not anticipate that such funding will adversely impact its ability to meet on-going obligations. In the event these commitments require funding in excess of historical levels, management believes current liquidity, advances available from the FHLB and the Federal Reserve, and investment security maturities provide a sufficient source of funds to meet these commitments.
CRITICAL ACCOUNTING POLICIES
The consolidated financial statements and accompanying Notes to Consolidated Financial Statements are prepared in accordance with accounting principles generally accepted in the United States of America, which require us to make various estimates and assumptions (see Note 1 in the Notes to Consolidated Financial Statements). We believe that, of our significant accounting policies, the following may involve a higher degree of judgment and complexity.
Allowance for Loan Losses. The allowance for loan losses is established through a charge to the provision for loan losses. Provisions are made to reserve for estimated losses in loan balances. The allowance for loan losses is a significant estimate and is evaluated quarterly by us for adequacy. The use of different estimates or assumptions could produce a different required allowance, and thereby a larger or smaller provision recognized as expense in any given reporting period. A further discussion of the allowance for loan losses can be found in the section entitled “Allowance for Loan Losses” and Note 1 in the Notes to Consolidated Financial Statements in our 2009 Form 10-K.
Intangible Assets. Intangible assets consist primarily of goodwill, core deposit assets, and other identifiable intangibles that were recognized in connection with various acquisitions. Goodwill represents the excess of the cost of acquired businesses over the fair market value of their identifiable net assets. We perform an impairment review on an annual basis during the fourth quarter or more frequently if events or changes in circumstances indicate that the carrying value may not be recoverable. The timing of an impairment test may result in charges to our statement of income in our current reporting period that could not have reasonably been foreseen in prior periods. In addition, impairment testing requires management to make significant assumptions and estimates relating to the fair value of its reporting unit. Based on these assumptions and estimates, we determine whether we need to record an impairment charge to reduce the value of the asset carried on our balance sheet to its estimated fair value. Assumptions and estimates about future values are complex and often subjective. They can be affected by a variety of factors, including external factors such as industry and economic trends, and internal factors such as changes in our business strategy and our internal forecasts. Although we believe the assumptions and estimates we have made in the past have been reasonable and appropriate, different assumptions and estimates could materially affect our reported financial results. A goodwill impairment charge would not adversely affect the calculation of our risk based and tangible capital ratios.
Because the book value of our equity exceeded our market capitalization as of September 30, 2010, we considered the guidelines set forth in ASC Topic 350 to discern whether further testing for potential impairment was needed. Based on this assessment, we performed an interim impairment test which consists of two steps. Step One compares the estimated fair value of the reporting unit to its carrying amount. If the carrying amount exceeds the estimated fair value, Step Two is performed by comparing the fair value of the reporting unit’s implied goodwill to the carrying value of goodwill. If the carrying value of the reporting unit’s goodwill exceeds the estimated fair value, an impairment charge is recorded equal to the excess. The Step One test we performed indicated that the carrying amount (including goodwill) of our reporting unit exceeded its estimated fair value. The Step Two test indicated the estimated fair value of our reporting unit’s implied goodwill exceeded its carrying amount. Based on the results of the Step Two analysis, we concluded that goodwill was not impaired as of September 30, 2010. We will continue to test goodwill as defined by ASC Topic 350.
34
Core deposit assets represent the premium we paid for core deposits. Core deposit intangibles are amortized on the straight-line method over various periods ranging from 5-10 years. Generally, core deposits refer to nonpublic, non-maturing deposits including noninterest-bearing deposits, NOW, money market and savings. We make certain estimates relating to the useful life of these assets, and rate of run-off based on the nature of the specific assets and the client bases acquired. If there is a reason to believe there has been a permanent loss in value, management will assess these assets for impairment. Any changes in the original estimates may materially affect our operating results.
Pension Assumptions. We have a defined benefit pension plan for the benefit of substantially all of our associates. Our funding policy with respect to the pension plan is to contribute amounts to the plan sufficient to meet minimum funding requirements as set by law. Pension expense, reflected in the Consolidated Statements of Income in noninterest expense as “Salaries and Associate Benefits,” is determined by an external actuarial valuation based on assumptions that are evaluated annually as of December 31, the measurement date for the pension obligation. The Consolidated Statements of Financial Condition reflect an accrued pension benefit cost due to funding levels and unrecognized actuarial amounts. The most significant assumptions used in calculating the pension obligation are the weighted-average discount rate used to determine the present value of the pension obligation, the weighted-average expected long-term rate of return on plan assets, and the assumed rate of annual compensation increases. These assumptions are re-evaluated annually with the external actuaries, taking into consideration both current market conditions and anticipated long-term market conditions.
The weighted-average discount rate is determined by matching the anticipated Retirement Plan cash flows to a long-term corporate Aa-rated bond index and solving for the underlying rate of return, which investing in such securities would generate. This methodology is applied consistently from year-to-year. We will use a 5.75% discount rate in 2010.
The weighted-average expected long-term rate of return on plan assets is determined based on the current and anticipated future mix of assets in the plan. The assets currently consist of equity securities, U.S. Government and Government Agency debt securities, and other securities (typically temporary liquid funds awaiting investment). We will use a rate of return on plan assets of 8.0% for 2010.
The assumed rate of annual compensation increases is based on expected trends in salaries and the employee base. We will use a compensation increase of 4.50% for 2010 reflecting current market trends.
Information on components of our net periodic benefit cost is provided in Note 8 of the Notes to Consolidated Financial Statements included herein and Note 12 of the Notes to Consolidated Financial Statements in our 2009 Form 10-K.
35
TABLE I
AVERAGE BALANCES & INTEREST RATES
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | Three Months Ended September 30, | | Nine Months Ended September 30, | |
| |
| |
| |
| | 2010 | | 2009 | | 2010 | | 2009 | |
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| |
| |
| |
| |
(Taxable Equivalent Basis - Dollars in Thousands) | | Average
Balances | | Interest | | Rate | | Average
Balances | | Interest | | Rate | | Average
Balances | | Interest | | Rate | | Average
Balances | | Interest | | Rate | |
| |
| |
| |
| |
| |
| |
| |
| |
| |
| |
| |
| |
| |
Assets: | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
Loans, Net of Unearned Interest(1)(2) | | $ | 1,807,483 | | $ | 26,568 | | | 5.83 | % | $ | 1,964,984 | | $ | 29,695 | | | 6.00 | % | $ | 1,844,788 | | $ | 80,543 | | | 5.84 | % | $ | 1,967,759 | | $ | 89,373 | | | 6.07 | % |
Taxable Investment Securities(2) | | | 124,625 | | | 674 | | | 2.15 | | | 81,777 | | | 682 | | | 3.32 | | | 108,268 | | | 1,882 | | | 2.31 | | | 87,393 | | | 2,200 | | | 3.35 | |
Tax-Exempt Investment Securities | | | 88,656 | | | 521 | | | 2.35 | | | 107,307 | | | 985 | | | 3.67 | | | 92,672 | | | 1,898 | | | 2.73 | | | 105,117 | | | 3,185 | | | 4.04 | |
Funds Sold | | | 252,434 | | | 144 | | | 0.22 | | | 3,294 | | | 1 | | | 0.11 | | | 274,245 | | | 492 | | | 0.24 | | | 5,992 | | | 5 | | | 0.12 | |
| |
|
| |
|
| |
|
| |
|
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|
| |
|
| |
|
| |
|
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|
| |
|
| |
|
| |
|
| |
Total Earning Assets | | | 2,273,198 | | | 27,907 | | | 4.87 | % | | 2,157,362 | | | 31,363 | | | 5.77 | % | | 2,319,973 | | | 84,815 | | | 4.89 | % | | 2,166,261 | | | 94,763 | | | 5.85 | % |
| |
|
| |
|
| |
|
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|
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|
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|
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|
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|
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|
| |
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| |
|
| |
|
| |
Cash & Due From Banks | | | 50,942 | | | | | | | | | 76,622 | | | | | | | | | 52,170 | | | | | | | | | 78,271 | | | | | | | |
Allowance For Loan Losses | | | (39,584 | ) | | | | | | | | (42,774 | ) | | | | | | | | (41,729 | ) | | | | | | | | (40,937 | ) | | | | | | |
Other Assets | | | 342,202 | | | | | | | | | 306,759 | | | | | | | | | 337,212 | | | | | | | | | 293,528 | | | | | | | |
| |
|
| | | | | | | |
|
| | | | | | | |
|
| | | | | | | |
|
| | | | | | | |
TOTAL ASSETS | | $ | 2,626,758 | | | | | | | | $ | 2,497,969 | | | | | | | | $ | 2,667,626 | | | | | | | | $ | 2,497,123 | | | | | | | |
| |
|
| | | | | | | |
|
| | | | | | | |
|
| | | | | | | |
|
| | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
Liabilities: | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
NOW Accounts | | $ | 871,158 | | $ | 326 | | | 0.15 | % | $ | 678,292 | | $ | 257 | | | 0.15 | % | $ | 872,512 | | $ | 1,110 | | | 0.17 | % | $ | 702,048 | | $ | 731 | | | 0.14 | % |
Money Market Accounts | | | 293,424 | | | 145 | | | 0.20 | | | 301,230 | | | 281 | | | 0.37 | | | 333,558 | | | 1,165 | | | 0.47 | | | 306,858 | | | 663 | | | 0.29 | |
Savings Accounts | | | 133,690 | | | 17 | | | 0.05 | | | 122,934 | | | 15 | | | 0.05 | | | 130,485 | | | 49 | | | 0.05 | | | 121,389 | | | 44 | | | 0.05 | |
Other Time Deposits | | | 402,880 | | | 1,332 | | | 1.31 | | | 430,944 | | | 2,073 | | | 1.91 | | | 423,726 | | | 4,797 | | | 1.51 | | | 413,641 | | | 6,183 | | | 2.00 | |
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|
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|
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|
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|
| |
|
| |
|
| |
|
| | | | |
Total Interest Bearing Deposits | | | 1,701,152 | | | 1,820 | | | 0.42 | | | 1,533,400 | | | 2,626 | | | 0.68 | | | 1,760,281 | | | 7,121 | | | 0.54 | | | 1,543,936 | | | 7,621 | | | 0.66 | |
| |
|
| |
|
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|
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|
| |
|
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|
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|
| | | | |
|
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|
| |
Short-Term Borrowings | | | 23,388 | | | 31 | | | 0.54 | | | 97,305 | | | 113 | | | 0.45 | | | 25,558 | | | 60 | | | 0.31 | | | 90,174 | | | 269 | | | 0.39 | |
Subordinated Note Payable | | | 62,887 | | | 376 | | | 2.34 | | | 62,887 | | | 936 | | | 5.83 | | | 62,887 | | | 1,666 | | | 3.49 | | | 62,887 | | | 2,794 | | | 5.86 | |
Other Long-Term Borrowings | | | 54,258 | | | 565 | | | 4.13 | | | 51,906 | | | 560 | | | 4.28 | | | 52,330 | | | 1,642 | | | 4.20 | | | 52,629 | | | 1,694 | | | 4.30 | |
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|
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|
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|
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|
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|
| |
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|
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|
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Total Interest Bearing Liabilities | | | 1,841,685 | | | 2,792 | | | 0.60 | % | | 1,745,498 | | | 4,235 | | | 0.96 | % | | 1,901,056 | | | 10,489 | | | 0.74 | % | | 1,749,626 | | | 12,378 | | | 0.95 | % |
| |
|
| |
|
| |
|
| |
|
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|
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|
| |
|
| |
|
| |
|
| |
|
| |
|
| |
|
| |
Noninterest Bearing Deposits | | | 471,013 | | | | | | | | | 416,770 | | | | | | | | | 457,807 | | | | | | | | | 415,610 | | | | | | | |
Other Liabilities | | | 50,319 | | | | | | | | | 60,674 | | | | | | | | | 43,391 | | | | | | | | | 53,986 | | | | | | | |
| |
|
| | | | | | | |
|
| | | | | | | |
|
| | | | | | | |
|
| | | | | | | |
TOTAL LIABILITIES | | | 2,363,016 | | | | | | | | | 2,222,942 | | | | | | | | | 2,402,254 | | | | | | | | | 2,219,222 | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
TOTAL SHAREOWNERS’ EQUITY | | | 263,742 | | | | | | | | | 275,027 | | | | | | | | | 265,372 | | | | | | | | | 277,901 | | | | | | | |
| |
|
| | | | | | | |
|
| | | | | | | |
|
| | | | | | | |
|
| | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
TOTAL LIABILITIES AND SHAREOWNERS’ EQUITY | | $ | 2,626,758 | | | | | | | | $ | 2,497,969 | | | | | | | | $ | 2,667,626 | | | | | | | | $ | 2,497,123 | | | | | | | |
| |
|
| | | | | | | |
|
| | | | | | | |
|
| | | | | | | |
|
| | | | | | | |
Interest Rate Spread | | | | | | | | | 4.27 | % | | | | | | | | 4.81 | % | | | | | | | | 4.15 | % | | | | | | | | 4.90 | % |
| | | | | | | |
|
| | | | | | | |
|
| | | | | | | |
|
| | | | | | | |
|
| |
Net Interest Income | | | | | $ | 25,115 | | | | | | | | $ | 27,128 | | | | | | | | $ | 74,326 | | | | | | | | $ | 82,385 | | | | |
| | | | |
|
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| | | | | | | |
|
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|
| | | | |
Net Interest Margin(3) | | | | | | | | | 4.36 | % | | | | | | | | 4.99 | % | | | | | | | | 4.29 | % | | | | | | | | 5.09 | % |
| | | | | | | |
|
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|
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|
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|
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(1) | Average balances include nonaccrual loans. Interest income includes fees on loans of $426,000 and $1.2 million, for the three and nine months ended September 30, 2010 versus $347,000 and $1.2 million for the comparable periods ended September 30, 2009. |
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(2) | Interest income includes the effects of taxable equivalent adjustments using a 35% tax rate. |
| |
(3) | Taxable equivalent net interest income divided by average earning assets. |
36
| |
Item 3. | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK |
See “Market Risk and Interest Rate Sensitivity” in Management’s Discussion and Analysis of Financial Condition and Results of Operations, above, which is incorporated herein by reference. Management has determined that no additional disclosures are necessary to assess changes in information about market risk that have occurred since December 31, 2009.
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Item 4. | CONTROLS AND PROCEDURES |
Evaluation of Disclosure Controls and Procedures
As of September 30, 2010, the end of the period covered by this Form 10-Q, our management, including our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934). Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer each concluded that as of September 30, 2010, the end of the period covered by this Form 10-Q, we maintained effective disclosure controls and procedures.
Changes in Internal Control over Financial Reporting
Our management, including the Chief Executive Officer and Chief Financial Officer, has reviewed our internal control over financial reporting (as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934). There have been no significant changes in our internal control over financial reporting during our most recently completed fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
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PART II. | OTHER INFORMATION |
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Item 1. | Legal Proceedings |
We are party to lawsuits and claims arising out of the normal course of business. In management’s opinion, there are no known pending claims or litigation, the outcome of which would, individually or in the aggregate, have a material effect on our consolidated results of operations, financial position, or cash flows.
In addition to the other information set forth in this Quarterly Report, you should carefully consider the factors discussed in Part I, Item 1A. “Risk Factors” in our 2009 Form 10-K, as updated in our subsequent quarterly reports. The risks described in our 2009 Form 10-K are not the only risks facing us. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and/or operating results.
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Item 2. | Unregistered Sales of Equity Securities and Use of Proceeds |
None.
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Item 3. | Defaults Upon Senior Securities |
None.
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Item 4. | [Removed and Reserved] |
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Item 5. | Other Information |
None.
37
(A) Exhibits
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31.1 | Certification of William G. Smith, Jr., Chairman, President and Chief Executive Officer of Capital City Bank Group, Inc., Pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934. |
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31.2 | Certification of J. Kimbrough Davis, Executive Vice President and Chief Financial Officer of Capital City Bank Group, Inc., Pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934. |
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32.1 | Certification of William G. Smith, Jr., Chairman, President and Chief Executive Officer of Capital City Bank Group, Inc., Pursuant to 18 U.S.C. Section 1350. |
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32.2 | Certification of J. Kimbrough Davis, Executive Vice President and Chief Financial Officer of Capital City Bank Group, Inc., Pursuant to 18 U.S.C. Section 1350. |
38
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 Chief Financial Officer hereunto duly authorized.
CAPITAL CITY BANK GROUP, INC.
(Registrant)
| |
By: /s/ J. Kimbrough Davis | |
| |
J. Kimbrough Davis |
Executive Vice President and Chief Financial Officer |
(Mr. Davis is the Principal Financial Officer and has been duly
authorized to sign on behalf of the Registrant) |
|
Date: November 8, 2010 |
39
