In the normal course of operations, the Company engages in a variety of financial transactions that, in accordance with generally accepted accounting principles, are recorded in amounts that differ from the notional amounts. These transactions involve, to varying degrees, elements of credit risk, interest rate, and liquidity risk. Such transactions are used by the Company for general corporate purposes or to satisfy customer needs. Corporate purpose transactions are used to help manage customers’ requests for funding. The Bank’s off-balance sheet arrangements, which principally include lending commitments and derivatives, are described below.
At December 31, 2006, the Company recorded no liability for the current carrying amount of the obligation to perform as a guarantor, as such amounts are not considered material. The maximum potential amount of undiscounted future payments related to standby letters of credit at September 30, 2006 and December 31, 2006 was $11.4 million and $12.4 million, respectively.
A summary of loans receivable with undisbursed commitments to extend credit at September 30, 2006 and December 31, 2006 follows:
Historically, the Company has maintained its liquidity at levels believed by management to be adequate to meet the requirements of normal operations, potential deposit out-flows and strong loan demand and still allow for optimal investment of funds and return on assets. The principal sources of funds for the Company are cash flows from operations, consisting mainly of loan payments, Customer deposits, advances from the FHLB, securitization of loans and subsequent sales, and loan sales. The principal use of cash flows is the origination of loans receivable and purchase of investment securities. The Company originated loans receivable of $205.8 million for the three months ended December 31, 2005, compared to $134.5 million for the three months ended December 31, 2006. Loan principal repayments amounted to $161.7 million in the first fiscal quarter of 2005 compared to $96.9 million for the three months ended December 31, 2006. In addition, the Company sells certain loans in the secondary market to finance future loan originations. In the first quarter of fiscal 2005, the Company sold loans held for sale or securitized and sold loans held for sale totaling $11.6 million compared to $11.7 million for the three months ended December 31, 2006. In December 2006, the Company also securitized $23.4 million of loans receivable and concurrently sold $18.9 million of these mortgage-backed securities to third parties and recognized a net gain on sale of $433,000, which included $211,000 related to mortgage servicing rights. The gain is included in gains on sales of loans and loans receivable held for sale in the consolidated statement of operations. The Company has no retained interest in the securities that were sold other than servicing rights. The remaining $4.5 million of loans receivable securitized into mortgage-backed securities were retained in the Company’s mortgage-backed securities available for sale. The Company completed this transaction to take advantage of the competitive pricing for such loans in the marketplace, while providing current funding requirements. In addition, the Bank sold $1.3 million of commercial loan participations in the quarter ended December 31, 2006 compared to $966,000 for the same period in 2005.
For the three month period ended December 31, 2006, the Company purchased $7.7 million in investment and mortgage-backed securities. For the three month period ended December 31, 2005, the Company purchased $104.6 million in investment and mortgage-backed securities. These purchases during the three-month period ended December 31, 2006 were primarily funded by mortgage-backed securities principal repayments of $17.3 million.
Total customer deposits, which exclude certificates of deposits obtained through brokers, decreased $18.3 million between September 30, 2006 and December 31, 2006. Money market and checking accounts decreased from approximately $556.0 million at September 30, 2006 to $522.9 million at December 31, 2006, a decrease of $33.1 million or 6.0%. Core deposits (defined as money market accounts, checking accounts and statement savings accounts) decreased from $632.2 million at September 30, 2006 to $596.4 million at December 31, 2006, a decrease of 5.7%. The Company believes these decreases are generally due to a slowing real estate market which has affected balances in attorney trust accounts, as well as seasonality. During the fall and winter, the Company typically experiences a decrease in its deposit balances compared to other times during the year.
At December 31, 2006, the Company had $424.7 million of certificates of deposits (“CDs”) that were due to mature within one year. Included in these CDs were brokered CDs totaling $169.5 million. Based on past experience, the Company believes that the majority of the non-brokered CDs will renew with the Company. At December 31, 2006, the Company had commitments to originate $13.7 million in residential mortgage loans, $65.4 million in undisbursed business and retail lines of credit, and $118.3 million in commercial real estate and construction and land development which the Company expects to fund from normal operations. At December 31, 2006, the Company had approximately $23.6 million available in FHLB advances. In addition, the Company had unpledged collateral that would support up to approximately $120.8 million in additional borrowings. At December 31, 2006, the Company also had an outstanding available line for federal funds of $20.0 million.
As a result of $4.9 million in net income, less the cash dividends paid to stockholders of approximately $2.2 million, proceeds of approximately $272,000 from the exercise of stock options, and the net decrease in unrealized loss on securities available for sale, net of income tax of $154,000, stockholders’ equity increased from $112.8 million at September 30, 2006 to $116.0 million at December 31, 2006.
OTS regulations require that the Bank calculate and maintain a minimum regulatory capital requirement on a quarterly basis and satisfy such requirement as of the calculation date and throughout the quarter. The Bank’s capital, as calculated under OTS regulations, is approximately $133.6 million at December 31, 2006, exceeding the core capital requirement by $108.6 million. At December 31, 2006, the Bank’s risk-based capital of approximately $144.6 million exceeded its current risk-based capital requirement by $65.4 million. (For further information see “Regulatory Capital Matters”).
The table below summarizes future contractual obligations as of December 31, 2006 (In thousands)(unaudited):
| | Payments Due by Period | |
| | Total | | 1 Year and
Less | | 2-3
Years | | 4-5
Years | | After 5
Years | |
Time deposits | | $ | 464,589 | | | 424,722 | | | 35,510 | | | 3,761 | | | 596 | |
Short-term borrowings | | | 26,521 | | | 26,521 | | | — | | | — | | | — | |
Long-term debt | | | 439,234 | | | — | | | 20,780 | | | 114,091 | | | 304,363 | |
Purchase commitment | | | 2,810 | | | 2,810 | | | — | | | — | | | — | |
Operating leases | | | 4,507 | | | 429 | | | 606 | | | 408 | | | 3,064 | |
Total contractual cash obligations | | $ | 937,661 | | | 454,482 | | | 56,896 | | | 118,260 | | | 308,023 | |
Purchase commitments. In the first quarter of fiscal 2006, the Company entered into a lease for 5.48 acres of land and a building, with an option to purchase this property after one year. In December 2006, the Company exercised its option to purchase the property. This purchase commitment, which is included in the table above, closed in January 2007.
EARNINGS SUMMARY
Net income increased from $4.4 million, or $.20 per diluted share, for the three months ended December 31, 2005 to $4.9 million, or $.22 per diluted share for the three months ended December 31, 2006. This 9.9% increase in net income resulted from increased net interest income of $589,000, or 4.4%, an increase in other income of $1.4 million, coupled with a decrease in the provision for loan losses of $175,000, increased general and administrative expenses of $1.6 million, and increased income taxes of $198,000.
Overall net interest income increased 4.4% due to higher net interest-earning average balances over interest-bearing liabilities average balances even though there was a decrease in the net interest margin. Net interest margin decreased from 3.70% for the three months ended December 31, 2005 to 3.54% for the three months ended December 31, 2006. The increase in net interest income is primarily attributable to an increase in average earning assets of $107.9 million, or 7.5%. Average loans receivable increased $138.6 million for the three months ended December 31, 2006 compared to December 31, 2005. Average balances of investment securities decreased approximately $30.7 million. The investment securities were primarily funded with advances from FHLB. The Company’s customer deposits average balances increased from $879.9 million at December 31, 2005 to $887.0 million at December 31, 2006, excluding brokered CD average balances of $177.4 million and $187.8 million at December 31, 2006 and 2005, respectively.
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The Company’s provision for loan losses decreased $175,000 for the three months ended December 31, 2006 when compared to the prior year primarily due to risk factors related to the underlying portfolio. The allowance for loan losses as a percentage of loans was 1.17% at December 31, 2006 as compared to 1.17% at September 30, 2006 and 1.22% at December 31, 2005.
Other income increased from $3.6 million for the three months ended December 31, 2005 to $5.0 million for the three months ended December 31, 2006. This was a result of an increase in fees and service charges on deposit accounts of $544,000; an increase in gain on the sales of loans and loans held for sale of $567,000; increased ATM and Debit Card income of $173,000; and Federal Home Loan Bank stock dividends of $118,000, offset by a decrease in non-depository income of $93,000. The Company also had gains on sales of investment and mortgage-backed securities of $25,000 for the three months ended December 31, 2006, compared to losses of $46,000 for the three months ended December 31, 2005.
General and administrative expenses increased from $9.7 million for the three months ended December 31, 2005 to $11.3 million for the three months ended December 31, 2006. Compensation and employee benefits increased from $5.4 million for the first quarter of fiscal 2006 to $6.1 million in the first quarter of fiscal 2007, primarily due to an increase in the number of banking Associates. The Company’s number of Associates increased by approximately 38 Associates, or 7.3%, primarily due to three new branches, increased Associates in the expanded hours call center and deposit servicing, increased Associates in existing branches to serve extended banking hours and increased checking volumes, and increased Associates in residential banking. Marketing expenses were $437,000 for the three months ended December 31, 2005, compared to $384,000 for the three months ended December 31, 2006. In addition, other expense was $1.3 million for the three months ended December 31, 2005, compared to $1.6 million for the three months ended December 31, 2006. Other expense increased primarily due to merger-related expenses.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF OPERATIONS FOR THE THREE MONTHS ENDED DECEMBER 31, 2005 AND 2006
INTEREST INCOME
Interest income for the three months ended December 31, 2006, increased to $27.4 million as compared to $23.0 million for the three months ended December 31, 2005. The earning asset yield for the three months ended December 31, 2006, was 7.07% compared to 6.39% for the three months ended December 31, 2005. The average yield on loans receivable for the three months ended December 31, 2006, was 7.88% compared to 7.15% for three months ended December 31, 2005. The increased yield on loans is primarily due to the increased yield on commercial loans with interest rates tied to the prime lending rate. The prime rate was 8.25% at December 31, 2006, compared to 7.25% at December 31, 2005. The yield on investments increased to 5.11% for the three months ended December 31, 2006, from 4.89% for the three months ended December 31, 2005. Long-term interest rates have remained relatively constant during the last year despite rising short-term rates, resulting in a flat yield curve. Consequently, most of the cash flows received from the investment portfolio have been reinvested at approximately the same interest rate. Should short-term rates continue to rise more quickly than long-term rates, it is possible that the yield curve would become inverted. A flat yield curve or inverted yield curve would likely cause the Bank’s net interest margin to decline and reduce opportunities for using securities to leverage capital. Total average interest-earning assets were $1.5 billion for the quarter ended December 31, 2006 as compared to $1.4 billion for the quarter ended December 31, 2005, an increase of 7.5%. The increase in average interest-earning assets is primarily due to an increase in average loans receivable of approximately $138.6 million, resulting primarily from growth in the commercial loan portfolio, net of a decrease in investment and mortgage-backed securities.
INTEREST EXPENSE
Interest expense on interest-bearing liabilities was $13.5 million for the three months ended December 31, 2006, as compared to $9.8 million for the three months ended December 31, 2005. The average cost of deposits for the three months ended December 31, 2006, was 2.60% compared to 1.84% for the three months ended December 31, 2005. The cost of interest-bearing liabilities was 3.53% for the three months ended December 31, 2006 compared to 2.69% for the three months ended December 31, 2005. The cost of brokered CD’s, FHLB advances, repurchase and reverse repurchase agreements and other borrowings was 5.25%, 4.56%, 4.06% and 8.64%, respectively, for the three months ended December 31, 2006. For the three months ended December 31, 2005 the cost of brokered CD’s, FHLB advances, reverse repurchase agreements and other borrowings was 3.88%, 4.03%, 3.38% and 7.17%, respectively. The increased cost of funds on other borrowings is due to the increased short-term interest rates. At December 31, 2006, the federal funds rate was 5.17% compared to 4.09% at December 31, 2005. Total average interest-bearing liabilities increased from $1.4 billion at December 31, 2005 to $1.5 billion at December 31, 2006.
The increase in average interest-bearing liabilities is due to an increase in average deposits of approximately $7.1 million, decreased average Brokered CD’s of $10.4 million; increased average FHLB Advances of $83.3 million and a net increase in Customer repurchase and reverse repurchase agreements of $4.0 million. The increase in FHLB advances was used to fund loan growth.
NET INTEREST INCOME
Net interest income was $13.9 million for the three months ended December 31, 2006, as compared to $13.3 million for the three months ended December 31, 2005. The net interest margin was 3.54% for the three months ended December 31, 2006 compared to 3.70% for the three months ended December 31, 2005.
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The following table summarizes the average balance sheets and the related yields on interest-earning assets and interest-bearing liabilities for the three months ended December 31, 2005 and 2006:
| | | | Three Months Ended December 31, | | | | | |
| | | | 2005 | | | | | | 2006 | | | |
| | Average
Balance (1) | | Income/
Expense | | Yield/
Rate | | Average
Balance (1) | | Income/
Expense | | Yield/
Rate | |
| | (Unaudited)
(Dollars in thousands) | |
Assets: | | | | | | | | | | | | | | | | | |
Loans (2) | | $ | 959,498 | | $ | 17,147 | | 7.15 | % | $ | 1,098,127 | | $ | 21,635 | | 7.88 | % |
Investment Securities, MBS Securities and Other (3) | | | 481,452 | | | 5,891 | | 4.89 | % | | 450,787 | | | 5,762 | | 5.11 | % |
Total earning assets | | | 1,440,950 | | | 23,038 | | 6.39 | % | | 1,548,914 | | | 27,397 | | 7.07 | % |
Liabilities: | | | | | | | | | | | | | | | | | |
Customer Deposits | | | 879,901 | | | 4,047 | | 1.84 | % | | 886,992 | | | 5,765 | | 2.60 | % |
Brokered CD’s | | | 187,823 | | | 1,823 | | 3.88 | % | | 177,395 | | | 2,327 | | 5.25 | % |
FHLB Advances | | | 321,953 | | | 3,245 | | 4.03 | % | | 405,239 | | | 4,623 | | 4.56 | % |
Customer Repurchase Agreements | | | 14,333 | | | 127 | | 3.54 | % | | 21,828 | | | 223 | | 4.05 | % |
Junior Subordinated Debt | | | 15,000 | | | 269 | | 7.17 | % | | 15,000 | | | 324 | | 8.64 | % |
Reverse Repurchase Agreements | | | 30,310 | | | 251 | | 3.30 | % | | 26,796 | | | 271 | | 4.09 | % |
Total interest-bearing liabilities | | $ | 1,449,320 | | | 9,762 | | 2.69 | % | $ | 1,533,250 | | | 13,533 | | 3.53 | % |
Net interest income (4) | | | | | $ | 13,276 | | | | | | | $ | 13,864 | | | |
Net interest margin | | | | | | | | 3.70 | % | | | | | | | 3.54 | % |
Net yield on earning assets | | | | | | | | 3.69 | % | | | | | | | 3.58 | % |
(1) | The average balances are derived from monthly balances. |
(2) | Nonaccrual loans are included in average balances for yield computations. |
(3) | Investment securities include taxable and tax-exempt securities. |
(4) | Net interest income has not been adjusted to produce a tax-equivalent yield. |
PROVISION FOR LOAN LOSSES
The Company’s provision for loan losses decreased from $400,000 for the three months ended December 31, 2005, to $225,000 for the three months ended December 31, 2006 primarily due to changes in credit quality at December 31, 2006. The allowance for loan losses as a percentage of loans was 1.17% at December 31, 2006 as compared to 1.22% at December 31, 2005. The allowance as a percentage of loans declined due to improving economic conditions and the risk factors related to the underlying portfolio. Loans delinquent 90 days or more were $5.0 million or .46% of total loans at December 31, 2006, compared to $4.1 million or .42% of total loans at December 31, 2005 and $3.0 million or .27% of total loans at September 30, 2006. The allowance for loan losses was 255% of loans delinquent more than 90 days at December 31, 2006, compared to 293% at December 31, 2005 and 426% at September 30, 2006. Net charge-offs for the three months ended December 31, 2006 were $183,000 compared to $153,000 for the three months ended December 31, 2005.
Management believes that the current level of the allowance for loan losses at December 31, 2006 is adequate considering the composition of the loan portfolio, the portfolio’s loss experience, delinquency trends, current regional and local economic conditions and other factors at that date.
OTHER INCOME
For the three months ended December 31, 2006, other income was $5.0 million compared to $3.6 million for the three months ended December 31, 2005. Fees and service charges from deposit accounts increased $544,000 or 26.0% to $2.6 million for the three months ended December 31, 2006, compared to $2.1 million for the three months ended December 31, 2005. The majority of this increase is due to fee income from increased number of personal and business checking accounts. Gain on sale of loans and loans receivable held for sale was $659,000 for the quarter ended December 31, 2006, compared to $92,000 for the quarter ended December 31, 2005. Additionally, in the first quarter of fiscal 2006, the Company sold loans held for sale or securitized and sold loans held for sale totaling $11.6 million compared to $11.7 million for the three months ended December 31, 2006. In December 2006, the Company also securitized $23.4 million of loans receivable and concurrently sold $18.9 million of these mortgage-backed securities to third parties and recognized a net gain on sale of $433,000, which included $211,000 related to mortgage servicing rights. Gain on sales of investment and mortgage-backed securities available for sale were $25,000 for the quarter ended December 31, 2006, compared to losses of $46,000 for the quarter ended December 31, 2005. Income from Federal Home Loan Bank Stock dividends increased from $200,000 to $318,000 due to increased dividends rates and higher average balances. In addition, income from ATM and debit card transactions increased 34.5% to $674,000 during the first quarter of fiscal 2007, primarily due to increased personal checking accounts.
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GENERAL AND ADMINISTRATIVE EXPENSES
General and administrative expenses were $9.7 million for the quarter ended December 31, 2005 compared to $11.3 million for the quarter ended December 31, 2006. Salaries and employee benefits were $5.4 million for the three months ended December 31, 2005, as compared to $6.1 million for the three months ended December 31, 2006, an increase of 13.7%. Increased compensation is due to increased numbers of Associates and normal salary increases. The Company’s number of Associates has increased by approximately 38 Associates, or 7.3%, primarily due to three new branches, increased Associates in the expanded hours call center and deposit servicing, increased Associates in existing branches to serve extended banking hours and increased checking volumes, and increased Associates in residential banking. Also as a result of new branches, equipment purchased to improve Customer convenience and increased checking activity, net occupancy, furniture and fixtures and data processing expenses increased by $620,000, including increased depreciation of $178,000, when comparing the two periods. Marketing expenses were $437,000 for the three months ended December 31, 2005, compared to $384,000 for the three months ended December 31, 2006. The decrease from the prior period results from decreased initial startup expense for the Bank’s “Totally Free Checking With A Gift” initiative and the introduction of Penny Pavilion, the Bank’s free coin counting service. Other expenses were $1.3 million for the quarter ended December 31, 2005 compared to $1.6 million for the quarter ended December 31, 2006. Other expense increased $331,000 primarily due to merger related legal costs of approximately $380,000.
INCOME TAXES
Income taxes were $2.5 million for the three months ended December 31, 2006 compared to $2.3 million for the three months ended December 31, 2005. The effective income tax rate as a percentage of pretax income was 34.2% and 34.5% for the quarters ended December 31, 2006 and 2005, respectively. The effective income tax rate differs from the statutory rate primarily due to income generated by bank-owned life insurance, municipal securities that are exempt from federal and certain state taxes. The Company’s effective income tax rates take into consideration certain assumptions and estimates made by management. No assurance can be given that either the tax returns submitted by management or the income tax reported on the consolidated financial statements will not be adjusted by either adverse rulings by the U.S. Tax court, changes in the tax code, or assessments made by the Internal Revenue Service.
The Company is subject to potential adverse adjustments, including but not limited to: an increase in the statutory federal or state income tax rates, the permanent non-deductibility of amounts currently considered deductible either now or in future periods, and the dependency on the generation of the future taxable income, in order to ultimately realize deferred income tax assets.
REGULATORY CAPITAL MATTERS
To be categorized as “Well Capitalized” under the prompt corrective action regulations adopted by the Federal Banking Agencies, the Bank must maintain a total risk-based capital ratio as set forth in the following table and not be subject to a capital directive order.
| | Actual | | For Capital
Adequacy Purposes | | Categorized as “Well
Capitalized” under
Prompt Corrective
Action Provision | |
| | Amount | | Ratio | | Amount | | Ratio | | Amount | | Ratio | |
As of December 31, 2006 | | | | | | | | | | | | | | | | |
Total Capital: | | $ | 144,593 | | 14.61 | % | $ | 79,185 | | 8.00 | % | $ | 98,981 | | 10.00 | % |
(To Risk Weighted Assets) | | | | | | | | | | | | | | | | |
Tier 1 Capital: | | $ | 133,555 | | 13.49 | % | $ | N/A | | N/A | | $ | 59,389 | | 6.00 | % |
(To Risk Weighted Assets) | | | | | | | | | | | | | | | | |
Tier 1 Capital: | | $ | 133,555 | | 8.02 | % | $ | 49,891 | | 3.00 | % | $ | 83,151 | | 5.00 | % |
(To Total Assets) | | | | | | | | | | | | | | | | |
Tangible Capital: | | $ | 133,555 | | 8.02 | % | $ | 24,945 | | 1.50 | % | $ | N/A | | N/A | |
(To Total Assets) | | | | | | | | | | | | | | | | |
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In September 2006, the FASB issued SFAS No. 157 (FAS 157), “Fair Value Measurements”, which defines fair value, establishes guidelines for measuring fair value and expands disclosure regarding fair value measurements. FAS 157 does not require any new fair value measurements, but rather eliminates inconsistencies found in various prior accounting pronouncements. FAS 157 is effective for fiscal years beginning after November 15, 2007 (October 1, 2008 for the Company). The Company is currently not in a position to determine the effect of adopting this standard on its consolidated financial statements.
In July 2006, The FASB issued Interpretation No. 48 (FIN 48), “Accounting for Uncertainty in Income Taxes,” which clarifies the accounting for uncertainty in income taxes recognized in the financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes.” FIN 48 provides guidance on the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosures and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006 (October 1, 2007 for the Company). The Company is currently evaluating the impact of this standard on its results of operations and statement of condition.
In September 2006, the Securities and Exchange Commission (SEC) Office of the Chief Accountant and Divisions of Corporation Finance and Investment Management released Staff Accounting Bulletin No. 108 (SAB 108), “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements,” that provides interpretive guidance on how the effects of the carryover or reversal of prior year misstatements should be considered in quantifying a current year misstatement. The SEC staff believes that registrants should quantify errors using both a balance sheet and an income statement approach to evaluate whether either approach results in quantifying a misstatement that, when all relevant quantitative and qualitative factors are considered, is material. SAB 108 is effective for fiscal years ending after November 15, 2006 (September 30, 2007 for the Company). The Company is currently evaluating the impact of this standard on its results of operations and statement of condition.
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FSP FAS 123R-5, which amends FSP FAS 123R-1, addresses instruments originally issued as employee compensation and later modified solely to reflect an equity restructuring that occurs when the holders are no longer employees. In that situation, no change in the recognition or measurement of those instruments will result if: (1) there is no increase in fair value of the award (or the ratio of intrinsic value to the exercise price of the award is preserved and (2) all holders of the same class of equity instruments are treated in the same manner. FSP FAS 123R-5 applied to the first reporting period beginning after October 10, 2006 (January 1, 2007 for the Company). The Company does not believe that this FSP will have a material impact on its results of operations and statement of condition.
RECENTLY ADOPTED ACCOUNTING PRONOUNCEMENTS
On November 10, 2005, the FASB issued FASB Staff Position (FSP) FAS 123R-3, Transition Election Related to Accounting for the Effects of Share-Based Payment Awards (FSP FAS 123R-3). This FSP provides a practical transition election related to accounting for the tax effects of share-based payment awards to employees. An entity shall follow either the transition guidance for additional paid-in capital pool in SFAS 123R or the alternative transition method described in a one-time election to adopt the transition method described in this FSP. The Company may take up to one year from its initial adoption of SFAS 123R to evaluate its available alternatives and makes its one-time election. Effective October 1, 2006, the Company adopted the alternative transition method under FSP FAS 123R-3. Adoption of this FSP did not have a significant impact on the Company’s financial position and increased the fully diluted earnings per share for the twelve month period ended September 30, 2006 by approximately $.01. In addition, the effects of applying this FSP were reported as a change in accounting principle in accordance with FASB Statement No. 154 “Accounting Changes and Error Corrections” and are reflected for all periods presented in this form 10-Q as of, and for the quarter ended, December 31, 2006.
Effective October 1, 2005, the Company adopted the provisions of SFAS 123(R) thereby expensing employee stock-based compensation using the fair value method prospectively for all awards granted, modified, or settled on or after October 1, 2005. The fair value at date of grant of the stock option is estimated using the Black-Scholes option-pricing model based on assumptions noted in a table in Note 7 of the Notes to Consolidated Financial Statements.. The dividend yield is based on estimated future dividend yields. The risk-free rate for periods within the contractual term of the share option is based on the U.S. Treasury yield curve in effect at the time of grant. Expected volatilities are generally based on historical volatilities. The expected term of share options granted is generally derived from historical experience. Compensation expense is recognized on a straight-line basis over the stock option vesting period. The effects of applying this pronouncement are reflected for all periods presented in this Form 10-Q as of, and for the quarter ended, December 31, 2006.
In May 2005, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 154, “Accounting for Changes and Error Corrections – a replacement of Accounting Principles Board Opinion No. 20 and FASB Statement No. 3 (FAS 154),” which eliminates the requirement to reflect changes in accounting principles as cumulative adjustments to net income in the period of change and requires retrospective application to prior periods’ financial statements for voluntary changes in accounting principle, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. If it is impracticable to determine the cumulative effect of the change to all prior periods, FAS 154 requires the new accounting principle to be adopted prospectively. For new accounting pronouncements, the transition guidance in the pronouncement should be followed. Retrospective application refers to the application of a different accounting principle to previously issued financial statements as if that principle had always been used. FAS 154 did not change the guidance for reporting corrections of errors, changes in estimates or for justification of a change in accounting principle on the basis of preferability. The Company adopted FAS 154 effective October 1, 2006. Adoption of FAS 154 did not have a material effect on the results of operations or statement of condition.
In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments” an amendment of FASB Statements No. 133 and 140 (FAS 155). FAS 155 permits fair value re-measurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation, clarifies which interest only-strips and principal-only strips are not subject to the requirements of Statement 133, establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation, clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives, and amends Statement 140 to eliminate the prohibition on a qualifying special purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. FAS 155 is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006 (October 1, 2006 for the Company). The adoption of FAS 155 did not have a material effect on the results of the Company’s operations or statement of condition.
In March 2006, FASB issued SFAS No. 156 “Accounting for Servicing of Financials Assets” an amendment of FASB Statement No. 140 (FAS 140 and FAS 156). FAS 140 establishes, among other things, the accounting for all separately recognized servicing assets and servicing liabilities. This Statement amends FAS 140 to require that all separately recognized servicing assets and servicing liabilities be initially measured at fair value, if practicable. This Statement permits, but does not require, the subsequent measurement of separately recognized servicing assets and servicing liabilities at fair value. Under this Statement, an entity can elect subsequent fair value measurement to account for its separately recognized servicing assets and servicing liabilities. The Company adopted the provisions of this pronouncement effective October 1, 2006, but elected to continue to use the Amortization Method. The adoption of FAS 156 did not have a material effect on the results of the Company’s operations or statement of condition.
EFFECT ON INFLATION AND CHANGING PRICES
The accompanying unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles which require the measurement of financial position and results of operations in terms of historical dollars, without consideration of change in the relative purchasing power over time due to inflation. Unlike most industrial companies, virtually all of the assets and liabilities of a financial institution are monetary in nature. As a result, interest rates have a more significant impact on a financial institution’s performance than the effects of inflation. Interest rates do not necessarily change in the same magnitude as the price of goods and services.
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Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Bank’s Asset Liability Management Committee (“ALCO”) monitors and considers methods of managing exposure to interest rate risk. The ALCO consists of members of the Board of Directors and Senior Leadership of the Company and meets quarterly. The Bank’s exposure to interest rate risk is reviewed on at least a quarterly basis by the ALCO. Interest rate risk exposure is measured using interest rate sensitivity analysis to determine the Company’s change in net portfolio value in the event of hypothetical changes in interest rates. The ALCO is charged with the responsibility to maintain the level of sensitivity of the Bank’s net portfolio value with Board approved limits.
Net portfolio value (NPV) represents the market value of portfolio equity and is equal to the market value of assets minus the market value of liabilities, with adjustments made for off-balance sheet items over a range of assumed changes in market interest rates. The Bank’s Board of Directors has adopted an interest rate risk policy which establishes maximum allowable decreases in NPV in the event of a sudden and sustained one hundred to three hundred basis point increase or decrease in market interest rates. The following table presents the Bank’s change in NPV as computed by the OTS for various rate shock levels as of December 31, 2006 (Dollars in thousands).
Change in interest rates | | Board
Limit
Minimum
NPV
Ratio | | Board
Limit
Maximum
Decline in
NPV | | Market
Value
Of Assets
12/31/06 | | Market
Value
Portfolio
Equity
12/31/06 | | NPV
Ratio | | |
300 basis point rise | | 5.00 | % | | 400 BPS | | $ | 1,671,718 | | $ | 180,906 | | 10.82 | % |
200 basis point rise | | 6.00 | % | | 300 BPS | | $ | 1,694,220 | | $ | 196,705 | | 11.61 | % |
100 basis point rise | | 6.00 | % | | 250 BPS | | $ | 1,714,009 | | $ | 205,526 | | 11.99 | % |
No change | | 6.00 | % | | | | $ | 1,728,570 | | $ | 208,644 | | 12.07 | % |
100 basis point decline | | 6.00 | % | | 250 BPS | | $ | 1,741,142 | | $ | 209,237 | | 12.02 | % |
200 basis point decline | | 6.00 | % | | 300 BPS | | $ | 1,752,348 | | $ | 207,943 | | 11.87 | % |
300 basis point decline | | 6.00 | % | | 350 BPS | | | N/A | | | N/A | | N/A | |
| | | | | | | | | | | | | | | | | |
The preceding table indicates that at December 31, 2006, in the event of a sudden and sustained increase in prevailing market interest rates, the Bank’s Net Portfolio Value (NPV) would be expected to decrease and that in the event of a sudden decrease in prevailing market interest rates, the Bank’s NPV would be expected to decrease minimally. A value for the 300 basis point decline is not indicated due to the level of interest rates at December 31, 2006. At December 31, 2006, the Bank’s estimated changes in NPV were within the limits established by the Board of Directors.
Computation of prospective effects of hypothetical interest rate changes are based on numerous assumptions, including relative levels of market interest rates, loan prepayments, and deposit decay, and should not be relied upon as indicative of actual results. Further, the computations do not contemplate any actions the ALCO could undertake in response to sudden changes in interest rates.
Item 4.CONTROLS AND PROCEDURES
The Company’s management, including the Company’s principal executive officer and principal financial officer, have evaluated the effectiveness of the Company’s “disclosure controls and procedures,” as such term is defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Based upon their evaluation, the principal executive officer and principal financial officer concluded that, as of the end of the period covered by this report, the Company’s disclosure controls and procedures were effective for the purpose of ensuring that the information required to be disclosed in the reports that the Company files or submits under the Exchange Act with the Securities and Exchange Commission (the “SEC”) (1) is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and (2) is accumulated and communicated to the Company’s management, including its principal executive and principal financial officer, as appropriate to allow timely decisions regarding required disclosure. In addition, based on that evaluation, no material changes in the Company’s internal control over financial reporting occurred during the quarter ended December 31, 2006 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.
PART II. OTHER INFORMATION
COASTAL FINANCIAL CORPORATION AND SUBSIDIARIES
Item 1. LegalProceedings
The Company is a plaintiff in one lawsuit related to activities in the Bank, arising out of the normal course of business. The subsidiaries are also defendants in lawsuits arising out of the normal course of business. Based upon current information received from counsel representing the Company and its subsidiaries in these matters, the Company believes none of the lawsuits would have a material impact on the Company’s financial condition or results of operations.
Item 1.A. Risk Factors
Investing in our common stock involves various risks which are particular to our Company, our industry and our market area. Several risk factors regarding investing in our common stock are discussed below. This listing should not be considered as all-inclusive. If any of the following risks were to occur, we may not be able to conduct our business as currently planned and financial condition or operating results could be negatively impacted. These matters could cause the trading price of our common stock to decline in future periods.
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| • | We are geographically concentrated along the coastlines of South Carolina and North Carolina. Changes in local economic conditions and catastrophic weather could have a significantly adverse impact on our profitability. |
We operate primarily along the coastlines of South Carolina and North Carolina and substantially all of our loan customers and most of our deposits and other customers live or have operations in these areas. Accordingly, our success significantly depends upon the growth in population, income levels, deposits and housing starts in the region, along with continued attraction of business ventures to the area. Our profitability is impacted by changes in economic conditions, particularly changes in the real estate and tourism industries. Exposure to changes in tourism or the real estate market, whether due to changing economic conditions or catastrophic weather, could reduce our growth rate, affect the ability of our customers to repay their loans to us, and generally affect our financial condition and results of operations.
| • | If our loan customers do not pay us as they have contracted to, we may experience losses. |
Our principal revenue producing business is making loans. If our customers do not repay the loans, we will suffer losses. Even though we maintain an allowance for loan losses, the amount of the allowance may not be adequate to cover the losses we experience. We attempt to mitigate this risk by a thorough review of creditworthiness of loan customers. Nevertheless, there is risk that our credit evaluation will prove to be inaccurate due to changed circumstances or otherwise.
| • | Fluctuations in interest rates could reduce our profitability. |
Changes in interest rates may affect our level of interest income, the primary component of our gross revenue, as well as the level of our interest expense. Interest rate fluctuations are caused by many factors which, for the most part, are not under our direct control. For example, national monetary policy plays a significant role in the determination of interest rates. Additionally, competitor pricing and the resulting negotiations that occur with customers also impact the rates we collect on loans and the rates we pay on deposits.
As interest rates change, we expect we will periodically experience “gaps” in the interest rate sensitivities of our assets and liabilities, meaning that either our interest-bearing liabilities will be more sensitive to changes in market interest rates than our interest-earning assets, or vice versa. In either event, if market rates should move contrary to our position, this “gap” may work against us, and our earnings may be negatively affected.
Changes in the level of interest rates also may negatively affect our ability to originate real estate loans, the value of our assets and our ability to realize gains from the sale of our assets, all ultimately affect our earnings. A decline in the market value of our assets may limit our ability to borrow additional funds. As a result, we could be required to sell some of our loans and investments under adverse market conditions, upon terms that are not favorable to us, in order to maintain our liquidity. If those sales are made at prices lower than the amortized cost of the investments, we will incur losses.
| • | The banking industry is highly competitive. |
The banking industry in our market area is highly competitive. We compete with many different financial and financial services institutions. A substantial number of the banks in our market area are branches or subsidiaries of much larger organizations affiliated with statewide, regional, or national banking companies, and as a result, may have greater resources and lower costs of funds. These competitors aggressively solicit customers within their market area by advertising through direct mail, electronic media and other means. These competitors may offer services, such as international banking services, that we can offer only through correspondents, if at all. Additionally, larger competitors have greater capital resources and, consequently, higher lending limits.
| • | We are dependent on key personnel and the loss of one or more of those key personnel may materially and adversely affect our prospects. |
Competition for qualified employees and personnel in the banking industry is intense and there are a limited number of qualified persons with knowledge and experience in the South Carolina banking industry. The process of recruiting personnel with a combination of skills and attributes required to carry out our strategies is often lengthy. Our success depends, to a significant degree, upon our ability to attract and retain qualified management, loan origination, finance, administrative, marketing and technical personnel. We are dependent upon a number of key executives who are integral to implementing our business plan. The loss of the services of any one of our senior executive management team or other key executives could have a material adverse effect on our business, financial condition, results of operations and cash flows.
| • | Provisions in our articles of incorporation and Delaware law may discourage or prevent takeover attempts, and these provisions may have the effect of reducing the market price of our stock. |
Our articles of incorporation include several provisions that may have the effect of discouraging or preventing hostile takeover attempts, and therefore, making the removal of incumbent management difficult. The provisions include staggered terms for our board of directors and requirements of supermajority votes to approve certain business transactions. In addition, Delaware law contains several provisions that may make it more difficult for a third party to acquire control of us without the approval of the board of directors, and may make it more difficult or expensive for a third party to acquire a majority of our outstanding stock. To the extent that these provisions are effective in discouraging or preventing takeover attempts, they may tend to reduce the market price for our stock.
| • | We are subject to governmental regulations which could change and increase our cost of doing business or have an adverse effect on our business. |
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We operate in a highly regulated industry and are subject to examination, supervision and comprehensive regulation by various federal and state agencies. Our compliance with the requirements of these agencies is costly and may limit our growth and restrict certain of our activities, including payment of dividends, mergers and acquisitions, investments, loans and interest rates charged and location of offices. We are also subject to capitalization guidelines established by federal authorities and our failure to meet those guidelines could result, in an extreme case, in our bank being placed in receivership. Supervision, regulation and examination of banks and bank holding companies by financial institution regulatory agencies are intended for the protection of depositors and our other customers rather than the holders of our common stock.
| • | Changes in accounting standards could impact reported earnings. |
The accounting standard setters, including FASB, SEC and other regulatory bodies, periodically change financial accounting and reporting standards that govern the preparation of our consolidated statements. These changes can be hard to predict and can materially impact how the Company records and reports its financial condition and results of operations. In some cases, we could be required to apply a new or revised accounting standard retroactively, resulting in the restatement of prior period financial statements.
| • | We are susceptible to changes in monetary policy and other economic factors which may adversely affect our ability to operate profitably. |
Changes in governmental, economic and monetary policies may affect the ability of our bank to attract deposits and make loans. The rates of interest payable on deposits and chargeable on loans are affected by governmental regulation and fiscal policy as well as by national, state and local economic conditions. All of these matters are outside of our control and affect our ability to operate profitably.
| • | The preparation of financial statements requires the use of estimates that may vary from actual results. |
Preparation of consolidated financial statements in conformity with accounting principles accepted in the United States of America requires management to make significant estimates that affect the financial statements. One of our most critical estimates is the level of the allowance for loan losses. Due to the inherent nature of this estimate, we cannot provide absolute assurance that we will not significantly increase allowances for losses that are significantly higher than the provided allowance.
| • | We rely on communications, information, operating and financial control systems, and technology from third-party service providers, and we may suffer an interruption in those systems that may result in lost business. Further, we may not be able to substitute providers on terms that are as favorable if our relationships with our existing service providers are interrupted. |
We rely heavily on third-party service providers for much of our communications, information, operating and financial controls systems, and technology. Any failure or interruption or breach in security of these systems could result in failures or interruptions in our customer relationships management, general ledger, deposit, servicing and/or loan origination systems. We cannot assure you that such failures or interruptions will not occur or, if they do occur, that they will be adequately addressed by us or the third parties on which we rely. The occurrence of any failure or interruption could have a material adverse effect on our business, financial condition, results of operations and cash flows. If any of our third-party service providers experience financial, operational or technological difficulties, or if there is any other disruption in our relationships with them, we may be required to locate alternative sources of such services, and we cannot assure you that we could negotiate terms that are as favorable to us, or could obtain services with similar functionality as found in our existing systems, without the need to expend substantial resources, if at all. Any of these circumstances could have a material adverse effect on our business, financial condition, results of operations and cash flows.
| • | If the business continuity and disaster recovery plans that we have in place are not adequate to continue our operations in the event of a disaster, the business disruption can adversely impact our operations. |
External events, including terrorist or military actions, or an outbreak of disease, such as Asian Influenza, or “bird flu” and resulting political and social turmoil could cause unforeseen damage to our physical facilities or could cause delays or disruptions to operational functions, including information processing and financial market settlement functions. Additionally, our customers, vendors and counterparties could suffer from such events. Should these events affect us, or our customers, or vendors or counterparties with which we conduct business, our results of operations could be adversely affected.
| • | From time to time, we are subject to claims and litigation from customers and other individuals. |
Whether such claims and legal actions are founded or unfounded, if such claims and legal actions are not resolved in a manner favorable to us, they may result in significant financial liability and/or adversely affect the market perception of us and our products and services. Any financial liability or reputation damage could have a material adverse effect on our business and financial performance.
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| • | Even though our common stock is currently traded on the Nasdaq Stock Market, it has less liquidity than the average stock quoted on national stock exchanges. |
The trading volume in our common stock on the Nasdaq Stock Market has been relatively low when compared with larger companies on the Nasdaq National Market or national stock exchanges. As a result, it may be more difficult for stockholders to sell a substantial number of shares for the same price at which stockholders could sell a small number of shares. We also cannot predict the effect, if any, that future sales of our common stock in the market, or the availability of shares of common stock for sale in the market, will have on the market price of our common stock. We can give no assurance that sales of substantial amounts of common stock in the market, or the potential for large of amounts of sales in the market, would not cause the price of our common stock to decline or impair our future ability to raise capital through sales of common stock. The market price of our common stock may fluctuate in the future, and these fluctuations may be unrelated to our performance. General market price declines or overall stock market volatility in the future could adversely affect the price of our common stock. Further, the current market price of our stock may not be indicative of future market prices.
| • | Decline in home values in the Company’s markets could adversely impact results from operations. |
Like all banks, the Company is subject to the effects of any economic downturn, and in particular, a significant decline in home values in the Company’s markets could have a negative effect on the results of operations. A significant decline in home values would likely lead to a decrease in new home equity loan originations and increased delinquencies and defaults in both the consumer home equity loan and the residential real estate loan portfolios and result in increased losses in these portfolios.
| • | The Company is subject to federal and state income tax regulations. |
Income tax regulations are often complex and require interpretation. Changes in income tax regulations could negatively impact the Company’s results of operations. If the Company’s REIT affiliate fails to qualify as a REIT, or should states enact legislation taxing these or related entities, the Company will be subject to a higher consolidated effective tax rate. The REIT and related companies must meet specific provisions of the Internal Revenue Code (“IRC”) and state tax laws. If these companies fail to meet any of the required provisions of the federal and state tax laws, tax expense could increase. Use of these companies is and has been subject of federal and state audits. See “Management’s Discussion and Analysis of Operations-Income Taxes” for additional information.
| • | The Company is subject to the USA Patriot and Bank Secrecy Acts. |
The USA Patriot and Bank Secrecy Acts require financial institutions to develop programs to prevent financial institutions from being used for money laundering and terrorist activities. If such activities are detected, financial institutions are obligated to file suspicious activity reports with the U.S. Treasury Department’s Office of Financial Crimes Enforcement Network. These rules require financial institutions to establish procedures for identifying and verifying the identity of customers seeking to open new financial accounts. Failure to comply with these regulations could result in fines or sanctions. During the past year, several banking institutions have received large fines for non-compliance with these laws and regulations. The Company has developed policies and procedures designed to ensure compliance.
| • | Our common stock is not insured, so you could lose your total investment. |
Our common stock is not a deposit or savings account, and will not be insured by the Federal Deposit Insurance Corporation or any other government agency. Should our business decline or fail, you could lose your total investment.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
Not Applicable.
Item 3. Defaults Upon Senior Securities
Not Applicable.
Item 4. Submission of Matters to a Vote of Security Holders
Not Applicable
Item 5. Other Information
The following disclosure is provided pursuant to Item 5.02(e) of Form 8-K.
During the quarter ended December 31, 2006, the Corporation adopted the Fiscal 2007 Leadership Bonus Plan (the “Bonus Plan”). The “named executive officers” disclosed in the Corporation’s annual meeting proxy statement dated December 18, 2006 are among the employees eligible to participate in the Bonus Plan. The “named executive officers” are Michael C. Gerald (President and Chief Executive Officer), Jimmy R. Graham (Executive Vice President), Jerry L. Rexroad (Executive Vice President and Chief Financial Officer), Steven J. Sherry (Executive Vice President) and Phillip G. Stalvey (Executive Vice President).
The Bonus Plan provides for the payment of a cash bonus, calculated as a percentage of the participant’s annual base salary on October 1, 2006, on a graduated scale based on the Corporation’s consolidated return on average equity, excluding unrealized gains or losses on investment securities available for sale (the “Consolidated ROE”). Realized gains or losses on sales of investment securities, prepayment penalties for early repayment of advances from the Federal Home Loan Bank, expenses related to a change in control transaction, and other non-recurring transactions as determined by the Compensation Committee are excluded when calculating Consolidated ROE. Any bonuses would be paid semi-annually based on Consolidated ROE calculations for the six months ending March 31, 2007 and for the year ending September 30, 2007. For purposes of the Bonus Plan, a “change in control transaction” is defined in the same manner as defined in the CEO employment agreement. The merger with BB&T would constitute a change in control transaction. The Bonus Plan provides for initial semi-annual bonus payments if Consolidated ROE for the six months ending March 31, 2007 equals or exceeds 13.5% and for the remaining semi-annual bonus payments if Consolidated ROE for the year ending September 30, 2007 equals or exceeds 14%.
Provided that the threshold Consolidated ROE targets are satisfied, the Corporation’s “named executive officers” would be entitled to receive bonus payments calculated as follows:
Name | Base Salary on October 1, 2006 | Bonus Range as a Percent of Base Salary |
Michael C. Gerald | $288,750 | 26% to 108% |
Jimmy R. Graham | $168,000 | 24% to 104% |
Jerry L. Rexroad | $227,850 | 24% to 104% |
Steven J. Sherry | $176,925 | 24% to 104% |
Philip G. Stalvey | $211,000 | 24% to 104% |
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Item 6. Exhibits
Exhibits
(1) | Incorporated by reference to Registration Statement on Form S-4 filed with the Securities and Exchange Commission on November 26, 1990. |
(2) | Incorporated by reference to 1995 Form 10-K filed with the Securities and Exchange Commission on December 29, 1995. |
(3) | Incorporated by reference to the definitive proxy statement for the 1996 Annual Meeting of Stockholders. |
(4) | Incorporated by reference to December 31, 1998 Form 10-Q filed with Securities and Exchange Commission on May 15, 1998. |
(5) | Incorporated by reference to the definitive proxy statement for the 2000 Annual Meeting of Stockholders filed December 22, 1999. |
(6) | Incorporated by reference to 2003 Form 10-K filed with Securities and Exchange Commission on December 22, 2003. |
(7) | Incorporated by reference to March 31, 2006 Form 10-Q filed with the Securities and Exchange Commission on May 10, 2006. |
(8) | Incorporated by reference to Form 8-K filed with Securities and Exchange Commission on December 20, 2006. |
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SIGNATURES
Pursuant to the requirement 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.
| | | COASTAL FINANCIAL CORPORATION |
February 9, 2007
| | |
/s/ Michael C. Gerald
|
Date | | | Michael C. Gerald
President and Chief Executive Officer |
February 9, 2007 | | | /s/ Jerry L. Rexroad |
Date | | | Jerry L. Rexroad
Executive Vice President and
Chief Financial Officer |
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