UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2006
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from ________ to _________.
Commission file number: 0-26467
GREATER ATLANTIC FINANCIAL CORP.
(Exact Name of Registrant as Specified in its Charter)
Delaware 54-1873112
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
10700 Parkridge Boulevard, Suite P50, Reston, Virginia 20191
(Address of Principal Executive Offices) (Zip Code)
(703) 391-1300
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes [ ] No [ X ]
Indicate by check mark whether the Registrant is a large accelerated filer, an
accelerated filer, or a non-accelerated filer. See definition of "accelerated
filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check
one):
Large accelerated filer [__] Accelerated filer [__] Non-accelerated filer [X]
Indicate by check mark whether the Registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act):
Yes [__] No [ X ]
At June 30, 2006, there were 3,020,934 shares of the registrant's Common
Stock, par value $0.01 per share outstanding
GREATER ATLANTIC FINANCIAL CORP.
QUARTERLY REPORT ON FORM 10-Q
FOR THE QUARTER ENDED JUNE 30, 2006
TABLE OF CONTENTS
PART I. FINANCIAL INFORMATION PAGE NO.
- ------------------------------ --------
Item 1. Condensed Financial Statements (Unaudited)
Consolidated Statements of Financial Condition at June 30, 2006 and September 30, 2005 (restated).................3
Consolidated Statements of Operations
for the three and nine months ended June 30, 2006 and June 30, 2005 (restated)....................................4
Consolidated Statements of Comprehensive Income (Loss)
for the nine months ended June 30, 2006 and June 30, 2005 (restated)..............................................5
Consolidated Statements of Changes in Stockholders' Equity
for the nine months ended June 30, 2006 and June 30, 2005 (restated)..............................................5
Consolidated Statements of Cash Flows
for the nine months ended June 30, 2006 and June 30, 2005 (restated)..............................................6
Notes to Consolidated Financial Statements........................................................................8
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.........................15
Item 3. Quantitative and Qualitative Disclosures about Market Risk....................................................27
Item 4. Controls and Procedures.......................................................................................29
PART II. OTHER INFORMATION
- ---------------------------
Item 1. Legal Proceedings...........................................................................................30
Item 1A. Risk Factors.................................................................................................31
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.................................................33
Item 3. Defaults Upon Senior Securities.............................................................................33
Item 4. Submission of Matters to a Vote of Security Holders.........................................................33
Item 5. Other Information...........................................................................................33
Item 6. Exhibits....................................................................................................33
SIGNATURES.............................................................................................................34
CERTIFICATIONS.........................................................................................................35
GREATER ATLANTIC FINANCIAL CORP.
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION (UNAUDITED)
June 30, September 30,
----------------------------------
2006 2005
- ------------------------------------------------------------------------------------------------------------
(Restated)
(Dollars in Thousands)
Assets
Cash and cash equivalents $ 1,942 $ 2,291
Interest bearing deposits 3,912 2,418
Investment securities
Available-for-sale 84,921 107,829
Held-to-maturity 6,055 7,969
Loans held for sale 288 9,517
Loans receivable, net 188,111 194,920
Accrued interest and dividends receivable 1,972 1,746
Deferred income taxes 2,054 1,974
Federal Home Loan Bank stock, at cost 2,298 2,503
Other real estate owned - 232
Premises and equipment, net 2,874 4,198
Goodwill 956 956
Prepaid expenses and other assets 2,029 2,989
- ------------------------------------------------------------------------------------------------------------
Total assets $297,412 $339,542
============================================================================================================
Liabilities and stockholders' equity
Liabilities
Deposits $220,227 $237,794
Advance payments from borrowers for taxes and insurance 319 268
Accrued expenses and other liabilities 503 1,248
Advances from the FHLB and other borrowings 56,769 76,479
Junior subordinated debt securities 9,385 9,378
- ------------------------------------------------------------------------------------------------------------
Total liabilities 287,203 325,167
- ------------------------------------------------------------------------------------------------------------
Commitments and contingencies
- ------------------------------------------------------------------------------------------------------------
Stockholders' Equity
Preferred stock $.01 par value - 2,500,000 shares authorized,
none outstanding - -
Common stock, $.01 par value - 10,000,000
shares authorized; 3,020,934 shares outstanding 30 30
Additional paid-in capital 25,228 25,228
Accumulated deficit (13,882) (9,788)
Accumulated other comprehensive loss (1,167) (1,095)
- ------------------------------------------------------------------------------------------------------------
Total stockholders' equity 10,209 14,375
- ------------------------------------------------------------------------------------------------------------
Total liabilities and stockholders' equity $297,412 $339,542
============================================================================================================
See accompanying notes to consolidated financial statements
3
GREATER ATLANTIC FINANCIAL CORP.
CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
Three Months Ended Nine Months Ended
June 30, June 30,
----------------------------------------------------------
(Dollars in Thousands, Except Per Share Data) 2006 2005 2006 2005
- --------------------------------------------------------------------------------------------------------------------------
(Restated) (Restated)
Interest income
Loans $ 3,426 $ 3,241 $ 10,217 $ 9,315
Investments 1,327 1,151 3,726 3,428
- --------------------------------------------------------------------------------------------------------------------------
Total interest income 4,753 4,392 13,943 12,743
- --------------------------------------------------------------------------------------------------------------------------
Interest expense
Deposits 2,030 1,614 5,684 4,640
Borrowed money 807 957 2,667 3,300
- --------------------------------------------------------------------------------------------------------------------------
Total interest expense 2,837 2,571 8,351 7,940
- --------------------------------------------------------------------------------------------------------------------------
Net interest income 1,916 1,821 5,592 4,803
Provision for loan losses 13 144 87 147
- --------------------------------------------------------------------------------------------------------------------------
Net interest income after provision for loan losses 1,903 1,677 5,505 4,656
- --------------------------------------------------------------------------------------------------------------------------
Noninterest income
Fees and service charges 148 175 445 568
Gain on sale of loans - 3 - 53
Gain on sale of investment securities - - - 538
(Loss) gain on derivatives 50 (322) 234 560
Gain on sale of foreclosed real estate - - 65 -
Gain on sale of branches - 263 - 946
Other operating income 5 20 25 52
- --------------------------------------------------------------------------------------------------------------------------
Total noninterest income 203 139 769 2,717
- --------------------------------------------------------------------------------------------------------------------------
Noninterest expense
Compensation and employee benefits 1,216 1,049 3,502 3,133
Occupancy 357 303 1,008 1,033
Professional services 281 209 799 652
Advertising 183 114 547 226
Deposit insurance premium 24 41 77 72
Furniture, fixtures and equipment 135 151 415 520
Data processing 235 250 703 843
Other operating expenses 291 316 818 932
- --------------------------------------------------------------------------------------------------------------------------
Total noninterest expense 2,722 2,433 7,869 7,411
- --------------------------------------------------------------------------------------------------------------------------
Income (loss) from continuing operations before income taxes (616) (617) (1,595) (38)
Provision for income taxes - - - -
- --------------------------------------------------------------------------------------------------------------------------
Income (loss) from continuing operations (616) (617) (1,595) (38)
Discontinued operations:
Income (loss) from operations (19) (31) (2,499) (71)
- --------------------------------------------------------------------------------------------------------------------------
Net income (loss) $ (635) $ (648) $ (4,094) $ (109)
==========================================================================================================================
Earnings (loss) per common share BASIC AND DILUTED:
Continuing operations $ (0.20) $ (0.20) $ (0.53) $ (0.01)
Discontinued operations (0.01) (0.01) (0.83) (0.02)
- --------------------------------------------------------------------------------------------------------------------------
Net income (loss) (a) $ (0.21) $ (0.21) $ (1.36) $ (0.04)
==========================================================================================================================
Weighted average common shares outstanding
Basic and diluted 3,020,934 3,016,175 3,020,934 3,013,681
(a) Amounts may not foot due to rounding
See accompanying notes to consolidated financial statements
4
GREATER ATLANTIC FINANCIAL CORP.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) (UNAUDITED)
Three months ended Nine months ended
-----------------------------------------------------------
June 30, June 30,
- ---------------------------------------------------------------------------------------------------------------
(In Thousands) 2006 2005 2006 2005
(Restated) (Restated)
- ---------------------------------------------------------------------------------------------------------------
Net (loss) earnings $ (635) $ (648) $ (4,094) $ (109)
- ---------------------------------------------------------------------------------------------------------------
Other comprehensive (loss) income, net of tax
Unrealized (loss) gain on securities 81 183 (72) 106
- ---------------------------------------------------------------------------------------------------------------
Other comprehensive (loss) income 81 183 (72) 106
- ---------------------------------------------------------------------------------------------------------------
Comprehensive (loss) income $ (554) $ (465) $ (4,166) $ (3)
===============================================================================================================
GREATER ATLANTIC FINANCIAL CORP.
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (UNAUDITED)
FOR THE NINE MONTHS ENDED JUNE 30, 2006 AND 2005
- ----------------------------------------------------------------------------------------------------------------------------
Accumulated
Additional Accumulated Other Total
Preferred Common Paid-in Earnings Comprehensive Stockholders'
Stock Stock Capital (Deficit) Income (Loss) Equity
- ----------------------------------------------------------------------------------------------------------------------------
(In Thousands)
Balance at September 30, 2004 (as
restated) $- $ 30 $ 25,152 $ (8,159) $ (1,079) $ 15,944
Option exercised 25 25
Option compensation - - 79 - - 79
Other comprehensive loss - - - - 106 106
Net income (loss) for the period
(as restated) - - - (109) - (109)
- ----------------------------------------------------------------------------------------------------------------------------
Balance at June 30, 2005 (as $- $ 30 $ 25,256 $ (8,268) $ (973) $ 16,045
restated)
============================================================================================================================
Balance at September 30, 2005 (as $- $ 30 $ 25,228 $ (9,788) $ (1,095) $ 14,375
restated)
Other comprehensive loss - - - - (72) (72)
Net loss for the period - - - (4,094) - (4,094)
- ----------------------------------------------------------------------------------------------------------------------------
Balance at June 30, 2006 $- $ 30 $ 25,228 $(13,882) $ (1,167) $ 10,209
============================================================================================================================
See accompanying notes to consolidated financial statements
5
GREATER ATLANTIC FINANCIAL CORP.
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
Nine months ended June 30,
----------------------------------
2006 2005
Restated
- ----------------------------------------------------------------------------------------------------------------
(In Thousands)
Cash flow from operating activities
Net income (loss) $ (4,094) $ (109)
Adjustments to reconcile net income (loss) to net cash provided by
(used in) operating activities
Provision for loan loss 87 147
Amortization of loan acquisition adjustment (45) (20)
Depreciation and amortization 540 735
Loss on disposal of fixed assets - 87
Option compensation - 79
Realized gain on sale of investment securities - (538)
Net gain on sale of mortgage-backed securities - 560
(Gain) loss on derivatives (234) (560)
Amortization of investment security premiums 606 645
Amortization of mortgage-backed securities premiums 491 678
Amortization of deferred fees (419) (498)
Discount accretion net of premium amortization (207) (278)
Amortization of convertible preferred stock costs 7 7
Gain on sale of loans held for sale (1,511) (3,532)
Gain on sale of foreclosed real estate (65) -
Gain on sale of fixed assets (26) -
(Increase) decrease in assets
Disbursements for origination of loans (91,477) (200,880)
Proceeds from sales of loans 102,218 197,243
Accrued interest and dividend receivable (226) 21
Prepaid expenses and other assets 917 (946)
Deferred loan fees collected, net of deferred costs incurred 297 379
Increase (decrease) in liabilities
Accrued expenses and other liabilities (511) (907)
- ----------------------------------------------------------------------------------------------------------------
Net cash provided by (used in) operating activities 6,348 (7,687)
- ----------------------------------------------------------------------------------------------------------------
Continued
6
GREATER ATLANTIC FINANCIAL CORP.
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) - (CONTINUED)
Nine months ended June 30,
-----------------------------------
2006 2005
Restated
- -----------------------------------------------------------------------------------------------------------
(In Thousands)
Cash flow from investing activities
Net decrease in loans $ 7,096 $ 46,495
Disposal of premises and equipment 800 2,170
Purchases of investment securities (7,707) (15,786)
Proceeds from repayments of investment securities 12,447 15,954
Purchases of mortgage-backed securities - (24,224)
Proceeds from repayments of mortgage-backed securities 18,884 27,809
Proceeds from the sale of mortgage-backed securities - 21,919
Proceeds from the sale of foreclosed assets 297 -
Purchases of FHLB stock (2,115) (3,796)
Proceeds from sale of FHLB stock 2,320 5,199
- -----------------------------------------------------------------------------------------------------------
Net cash provided by investing activities 32,022 75,740
- -----------------------------------------------------------------------------------------------------------
Cash flow from financing activities
Net decrease in deposits (17,567) (38,607)
Net advances from FHLB (2,000) (9,200)
Net borrowings on reverse repurchase agreements (17,709) (20,732)
Capital contribution - 25
Increase (decrease) in advance payments by borrowers
for taxes and insurance 51 (7)
- -----------------------------------------------------------------------------------------------------------
Net cash used in financing activities (37,225) (68,521)
- -----------------------------------------------------------------------------------------------------------
Increase (decrease) in cash and cash equivalents 1,145 (468)
- -----------------------------------------------------------------------------------------------------------
Cash and cash equivalents, at beginning of period 4,709 8,681
- -----------------------------------------------------------------------------------------------------------
Cash and cash equivalents, at end of period $ 5,854 $ 8,213
===========================================================================================================
See accompanying notes to consolidated financial statements
7
GREATER ATLANTIC FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
INFORMATION AS OF JUNE 30, 2006 AND THE NINE MONTHS THEN ENDED (UNAUDITED)
(1) BASIS OF PRESENTATION
The accompanying unaudited consolidated financial statements, which
include the accounts of Greater Atlantic Financial Corp. (the "company") and its
wholly owned subsidiary, Greater Atlantic Bank (the "bank") and its wholly owned
subsidiary, Greater Atlantic Mortgage Corp. ("GAMC"), have been prepared in
accordance with the instructions for Form 10-Q. Certain information and note
disclosures normally included in financial statements prepared in accordance
with accounting principles generally accepted in the United States of America
have been omitted pursuant to the rules and regulations of the Securities and
Exchange Commission ("SEC") with respect to interim financial reporting. It is
recommended that these consolidated financial statements be read in conjunction
with the Corporation's Annual Report on Form 10-K for the year ended September
30, 2005. The results of operations for the three months or the nine months
ended June 30, 2006 are not necessarily indicative of the results of operations
that may be expected for the year ending September 30, 2006 or any future
periods. In addition to reclassifications related to discontinued operations,
other reclassifications have been made to prior periods to place them on a basis
comparable with the current period presentation.
(2) RESTATEMENT
During 2006, the company restated its historical financial statements
to revise the accounting treatment for losses discovered in its subsidiary,
GAMC's unreconciled inter-company account. The losses were discovered as the
bank discontinued the operations of the subsidiary. The loss in any given year
did not reach a material amount such as to require restatement. However, the
bank determined to provide the restatements because of the cumulative amount of
the losses aggregated $1.4 million. The revisions had no impact on the cash
flows of the bank. The table below includes the effect of the restatement and
the presentation of GAMC as discontinued operations.
As originally Discontinued
reported Restatement operations As restated
--------------- -------------- --------------- -------------
Three months ended June 30, 2005
Interest income $ 4,512 $ - $ 120 $ 4,392
Interest expense 2,660 - 89 2,571
Net interest income 1,852 - 31 1,821
Noninterest income 1,494 (5) 1,350 139
Noninterest expense 3,845 - 1,412 2,433
Discontinued operations - 5 (31) (26)
Net income (loss) (643) (5) - (648)
Earnings per share - continuing (0.21) 0.00 0.01 (0.20)
Earnings per share - discontinued (0.00) 0.00 (0.01) (0.01)
Nine months ended June 30, 2005
Interest income $ 13,058 $ - $ 315 $ 12,743
Interest expense 8,151 - 211 7,940
Net interest income 4,907 - 104 4,803
Noninterest income 6,405 8 3,696 2,717
Noninterest expense 11,282 - 3,871 7,411
Discontinued operations - (8) (71) (79)
Net income (loss) (117) 8 - (109)
Earnings per share - continuing (0.04) 0.00 0.03 (0.01)
Earnings per share - discontinued (0.00) 0.00 (0.02) (0.02)
The $5,000 and $8,000 adjustments to noninterest income relate to gains
on sale of loans. Similar adjustments were also made to gains on sale of loans
of $93,000 for the three months ended December 31, 2005 and $144,000 for the six
months ended March 31, 2006, which are included in the results for the nine
months ended June 30, 2006. In addition, the September 30, 2004 retained
earnings balance was reduced by $1.2 million to reflect the cumulative effect of
the restatement of all periods prior to those reflected in this form 10-Q.
8
GREATER ATLANTIC FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
INFORMATION AS OF JUNE 30, 2006 AND THE NINE MONTHS THEN ENDED (UNAUDITED)
(3) Discontinued operations
On March 29, 2006, we began the process of discontinuing the operations
of the bank's subsidiary, GAMC. It was determined that this business no longer
fit our strategy.
As a result of the above action, we applied discontinued operations
accounting in the third quarter of 2006, as we completed the closing of the GAMC
business. Accordingly, the income statements for all periods have been adjusted.
The reclassification of GAMC's results to discontinued operations primarily
resulted in a reduction to previously reported levels of net interest income, a
reduction in noninterest income and a reduction in noninterest expense. The
table below summarizes GAMC's results which were treated as discontinued
operations for the periods indicated.
Three months Nine months
ended June 30, ended June 30,
------------------------------------
2005 2005
- ---------------------------------------------------------------------------------------
(Dollars in Thousands, Except Per Share Data
Interest income $ 120 $ 315
Interest expense 89 211
- ---------------------------------------------------------------------------------------
Net interest income 31 104
Noninterest income 1,350 3,696
Noninterest expense 1,412 3,871
- ---------------------------------------------------------------------------------------
Net income (loss) $ (31) $ (71)
=======================================================================================
Earnings per share - basic $ (0.01) $ (0.02)
Earnings per share - diluted (0.01) (0.02)
(4) LOAN IMPAIRMENT AND LOAN LOSSES
In accordance with guidance in the Statements of Financial Accounting
Standards Nos. 114 and 118, the company prepares a quarterly review to determine
the adequacy of the allowance for loan losses and to identify and value impaired
loans. An analysis of the change in the allowance for loan losses follows:
At or for the nine months
ended June 30,
------------------------------------
2006 2005
- ---------------------------------------------------------------------------------------------
(Dollars in Thousands)
Balance at beginning of period $ 1,212 $ 1,600
Provisions 87 147
Total charge-offs (60) (111)
Total recoveries 24 14
- ---------------------------------------------------------------------------------------------
Net charge-offs (36) (97)
- ---------------------------------------------------------------------------------------------
Balance at end of period $ 1,263 $ 1,650
=============================================================================================
Ratio of net charge-offs during the period
to average loans outstanding during the period 0.02% 0.04%
=============================================================================================
Allowance for loan losses to total non-performing
loans at end of period 110.60% 85.32%
=============================================================================================
Allowance for loan losses to total loans 0.65% 0.78%
=============================================================================================
9
GREATER ATLANTIC FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
INFORMATION AS OF JUNE 30, 2006 AND THE NINE MONTHS THEN ENDED (UNAUDITED)
(5) REGULATORY MATTERS
The capital distribution regulation of the OTS requires that the bank
provide the applicable OTS Regional Director with a 30-day advance written
notice of all proposed capital distributions whether or not advance approval is
required. The bank paid dividends of $655,000 to the company during the year
ended September 30, 2005 and $491,000 to the company during the nine months
ended June 30, 2006.
The Federal Deposit Insurance Corporation Improvement Act of 1991
(FDICIA) created five categories of financial institutions based on the adequacy
of their regulatory capital levels: well capitalized, adequately capitalized,
undercapitalized, significantly undercapitalized and critically
undercapitalized.
Under FDICIA, a well-capitalized financial institution is one with Tier
1 leverage capital of 5%, Tier 1 risk-based capital of 6% and total risk-based
capital of 10%. At June 30, 2006, the bank was classified as a well-capitalized
financial institution.
The following presents the bank's capital position at June 30, 2006:
---------------------------------------------------------------------------------------------------------------
Required Required Actual Actual Surplus
Balance Percent Balance Percent
---------------------------------------------------------------------------------------------------------------
(Dollars in Thousands)
Leverage $14,817 5.00% $18,180 6.13% $3,363
Tier 1 Risk-based $11,456 6.00% $18,067 9.46% $6,611
Total Risk-based $19,094 10.00% $19,330 10.12% $ 236
===============================================================================================================
(6) STOCK OPTIONS
Effective November 14, 1998, the company established the 1997 Stock
Option and Warrant Plan (the "Plan"). The Plan reserves options for 76,667
shares to employees and warrants for 94,685 shares to stockholders. The Plan was
amended effective March 14, 2000, to increase the number of options available
for grant to employees from 76,667 to 225,000 shares and amended again effective
March 15, 2002, to increase the number of options available for grant to
employees from 225,000 to 350,000 shares and to limit its application to
officers and employees. The stock options and warrants vest immediately upon
issuance and carry a maximum term of 10 years. The exercise price for the stock
options and warrants is the fair market value at grant date. As of June 30,
2006, 94,685 warrants were issued.
The following summary represents the activity under the Plan:
- ---------------------------------------------------------------------------------------------------------------
Number of Exercise Expiration
Shares Price Date
- ---------------------------------------------------------------------------------------------------------------
Balance outstanding and exercisable at September 30, 2003 190,000
Options granted 36,000 $ 8.50 10-20-2013
- ---------------------------------------------------------------------------------------------------------------
Balance outstanding and exercisable at September 30, 2004 226,000
Options granted 104,000 $ 6.75 10-6-2014
Options exercised (8,500) $ 4.00
Options expired (55,500) $ 6.52
- ---------------------------------------------------------------------------------------------------------------
Balance outstanding and exercisable at September 30, 2005 266,000
Options granted 12,000 $ 6.00
Options expired (25,000) $ 8.37
- ---------------------------------------------------------------------------------------------------------------
Balance outstanding and exercisable at June 30, 2006 253,000
===============================================================================================================
10
GREATER ATLANTIC FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
INFORMATION AS OF JUNE 30, 2006 AND THE NINE MONTHS THEN ENDED (UNAUDITED)
The company estimates the fair value of each option on the date of
grant using the Black-Scholes option-pricing model. There were 12,000 options
granted during the nine months ended June 30, 2006 with an estimated fair value
of $22,000. The company's pro forma net income and earnings per share for the
nine months ended June 30, 2005 would have been the amounts shown below. The
company has adopted SFAS 123R which requires the fair value method be used to
account for stock based compensation and the recognition of the fair value of
stock options as compensation expense in the financial statements effective
after October 1, 2005.
Nine months ended
June 30,
- ----------------------------------------------------------------------------------------------
Pro forma income (loss) from continuing operations 2005
- ----------------------------------------------------------------------------------------------
(In Thousands, except per share data)
Net earnings (loss) $ (38)
Add: Total stock-based employee compensation expense -
Deduct: Total stock-based employee compensation expense (318)
- ----------------------------------------------------------------------------------------------
Pro forma net earnings (loss) from continuing operations $ (356)
==============================================================================================
Earnings (loss) per common share - basic and diluted
Continuing operations $ (0.01)
Discontinued operations $ (0.01)
Earnings (loss) per common share, pro forma basic and diluted
Continuing operations $ (0.12)
Discontinued operations $ (0.12)
(7) EARNINGS PER SHARE
Earnings per share is based on the weighted average number of shares of
common stock and dilutive common stock equivalents outstanding. Basic earnings
per share includes no dilution and is computed by dividing income available to
common shareholders by the weighted average number of common shares outstanding
for the period. Diluted earnings per share reflect the potential dilution of
securities that could share in the earnings of an entity. The weighted average
shares outstanding for basic and diluted earnings per share for the nine months
ended June 30, 2006 and 2005 were the same as the effect of the conversion of
preferred securities and the impact of stock options were antidilutive for the
periods ended June 30, 2006 and 2005. The effect of the conversion of the
preferred securities would result in an increase of 1,371,429 in common shares
outstanding.
(8) SEGMENT REPORTING
The company had two reportable segments, banking and mortgage banking.
However, the mortgage-banking activities conducted in GAMC, to which the
mortgage-banking segment applied, were discontinued effective March 29, 2006.
The bank operates retail deposit branches in the greater Washington,
D.C./Baltimore metropolitan area. The banking segment provides retail consumers
and small businesses with deposit products such as demand, transaction, and
savings accounts and certificates of deposit and lending products, such as
residential and commercial real estate, construction and development, consumer
and commercial business loans. Further, the banking segment invests in
residential real estate loans purchased from GAMC and others, and also invests
in mortgage-backed and other securities. The mortgage banking activities, which
were conducted principally through GAMC, included the origination of residential
real estate loans either for sale into the secondary market, with servicing
released or for the bank's portfolio.
11
GREATER ATLANTIC FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
INFORMATION AS OF JUNE 30, 2006 AND THE NINE MONTHS THEN ENDED (UNAUDITED)
The company evaluates performance based on net interest income,
noninterest income, and noninterest expense. The total of these three items is
the reportable segment's net contribution. The company's reportable segments are
strategic business units that offer different services in different geographic
areas. They are managed separately because each segment appeals to different
markets and, accordingly, require different technology and marketing strategies.
On March 29, 2006, we began the process of discontinuing the operations
of the bank's subsidiary, GAMC. It was determined that this business no longer
fit our strategy.
In the third quarter of 2006, we applied discontinued operations
accounting for GAMC. Accordingly, the income statements for all periods have
been restated. The restatements primarily resulted in a reduction to previously
reported levels of net interest income, a reduction in noninterest income and a
reduction in noninterest expense.
In 2004, the bank entered into a management agreement with the manager
of GAMC, its mortgage-banking subsidiary. Under the management agreement the
manager was to reimburse operating losses equal to approximately 100% of any
operating loss in return for an increase in his share of net earnings from 40%
to 80%. Reflected in the loss from discontinued operations for 2005 is a
reimbursement of $1.8 million of losses of GAMC provided by the manager of GAMC.
Due to the unprofitable operations of GAMC, the company recognized an
additional loss of $1.5 million for the nine months ended June 30, 2006. In
addition to the loss from operations, a non-recurring pre-tax impairment charge
of $996,000 was recorded for the nine months ended June 30, 2006 and included in
discontinued operations in the consolidated statements of operations. That
charge requires a write down of long-lived assets by recording an impairment
charge due to the discontinuance of operations effective March 29, 2006.
(9) RECENT ACCOUNTING STANDARDS
The Financial Accounting Standards Board ("FASB") issued Statement of
Financial Accounting Standard ("SFAS") No. 123 (Revised 2004) ("SFAS No. 123R"),
"Share-Based Payment," in December 2004. SFAS No. 123R is a revision of FASB
Statement 123, "Accounting for Stock-Based Compensation" and supersedes APB
Opinion No. 25, "Accounting for Stock Issued to Employees," and its related
implementation guidance. The Statement focuses primarily on accounting for
transactions in which an entity obtains employee services in share-based payment
transactions. SFAS No. 123R requires a public entity to measure the cost of
employee services received in exchange for an award of equity instruments based
on the grant-date fair value of the award (with limited exceptions). That cost
will be recognized over the period during which an employee is required to
provide service in exchange for the award. This statement is effective as of the
beginning of the first annual reporting period that begins after June 15, 2005
and the company adopted the standard in the first quarter of fiscal 2006. The
adoption of this statement did not have a material impact on its consolidated
financial position or results of operations.
12
GREATER ATLANTIC FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
INFORMATION AS OF JUNE 30, 2006 AND THE NINE MONTHS THEN ENDED (UNAUDITED)
In May 2005, the FASB issued SFAS 154, "Accounting Changes and Error
Corrections - a replacement of APB Opinion No. 20 and FASB Statement No. 3."
SFAS 154 generally requires retrospective application to prior periods'
financial statements of all voluntary changes in accounting principle and
changes required when a new pronouncement does not include specific transition
provisions. This standard was effective for the company beginning October 1,
2006.
On October 1, 2006, we adopted SFAS 156, "Accounting for Servicing of
Financial Assets - an amendment of FASB Statement No.140." SFAS 156 was issued
in March 2006 and requires all newly recognized servicing rights and obligations
to be initially measured at fair value. For each class of separately recognized
servicing rights and obligations retained, we have elected to continue to
account for each under the amortization method which requires us to amortize
servicing assets or liabilities in proportion to and over the periods of
estimated net servicing income or net servicing loss.
(10) JUNIOR SUBORDINATED DEBT SECURITIES
On March 20, 2002, Greater Atlantic Capital Trust I (the, "Trust"), a
Delaware statutory business trust and a wholly owned Trust subsidiary of the
company, issued $9.6 million aggregate liquidation amount (963,038 shares) of
6.50% cumulative preferred securities maturing on December 31, 2031, retaining
an option to call the securities on or after December 31, 2003. Conversion of
the preferred securities into the company's common stock may occur at any time
on or after 60 days after the closing of the offering. The company may redeem
the preferred securities, in whole or in part, at any time on or after December
31, 2003. Distributions on the preferred securities are payable quarterly on
March 31, June 30, September 30 and December 31 of each year beginning on June
30, 2002. The Trust also issued 29,762 common securities to the company for
$297,620. The proceeds from the sale of the preferred securities and the
proceeds from the sale of the trust's common securities were utilized to
purchase from the company junior subordinated debt securities of $9,928,000
bearing interest of 6.50% and maturing December 31, 2031.
The Trust was formed for the sole purpose of investing the proceeds
from the sale of the convertible preferred securities in the corresponding
convertible debentures. The company has fully and unconditionally guaranteed the
preferred securities along with all obligations of the trust related thereto.
The sale of the preferred securities yielded $9.2 million after deducting
offering expenses. The company retained approximately $1.5 million of the
proceeds for general corporate purposes, investing the retained funds in
short-term investments. The remaining $8.0 million of the proceeds was invested
in the bank to increase its capital position.
(11) DERIVATIVE FINANCIAL INSTRUMENTS
Beginning in fiscal 2002, the bank utilized derivative financial
instruments to hedge its interest rate risk. Beginning in 2002, the Bank adopted
statement of Financial Accounting Standard No. 133, "Accounting for Derivative
Instruments and Hedging Activities" ("SFAS 133"), as amended, which requires
that an entity recognize all derivatives as either assets or liabilities and
measure those instruments at fair value. The bank bases the estimated fair
values of these agreements on the cost of interest-rate exchange agreements with
similar terms at available market prices, excluding accrued interest receivable
and payable. However, active markets do not exist for many types of financial
instruments. Consequently, fair values for these instruments must be estimated
using techniques such as discounted cash flow analysis and comparisons to
similar instruments. Estimates developed using these methods are highly
subjective and require judgments regarding significant matters such as the
amount and timing of future cash flows and the selection of discount rates that
appropriately reflect market and credit risks. Changes in these judgments often
have a material effect on the fair value estimates. Since those estimates are
made as of a specific time, they are susceptible to material near term changes.
13
GREATER ATLANTIC FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
INFORMATION AS OF JUNE 30, 2006 AND THE NINE MONTHS THEN ENDED (UNAUDITED)
The bank has entered into various interest-rate swaps that total $21
million in notional principal. The swaps pay a fixed rate with the bank
receiving payments based upon one month floating rate LIBOR. The capped range is
between 2.04% - 3.01%, and expires between one and 4 years. The bank also
entered into various interest rate caps that total $25 million in notional
principal with terms between five and ten years that limit the float between a
floor of 2.00%, and are capped between 5.00% - 8.00%. The bank accounts for
these derivatives, under the guidelines of SFAS 133, as amended.
Realized and unrealized gains and losses on those derivatives which
meet hedge accounting requirements are deferred and recognized when the hedge
transaction occurs. In the event hedge accounting requirements are not met gains
and losses on such instruments are included currently in the statement of
operations. During the nine months ended June 30, 2006 and 2005 the instruments
did not meet hedge accounting requirements. The statements of operations include
net gains of $234,000 and of $560,000 for the nine months ended June 30, 2006
and 2005, respectively.
14
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion and analysis should be read in conjunction
with the Consolidated Financial Statements and Notes presented elsewhere in this
report.
This report contains forward-looking statements. When used in this 10-Q
report and in future filings by the company with the Securities and Exchange
Commission (the "SEC"), in the company's press releases or other public or
shareholder communications, and in oral statements made with the approval of an
authorized executive officer, the words or phrases "will likely result," "are
expected to," "will continue," "is anticipated," "estimate," "project" or
similar expressions are intended to identify "forward-looking statements" within
the meaning of the Private Securities Litigation Reform Act of 1995. Such
statements are subject to certain risks and uncertainties, including, among
other things, changes in economic conditions in the company's market area,
changes in policies by regulatory agencies, fluctuations in interest rates,
demand for loans in the company's market area and competition that could cause
actual results to differ materially from historical earnings and those presently
anticipated or projected. The company wishes to advise readers that the factors
listed above could affect the company's financial performance and could cause
the company's actual results for future periods to differ materially from any
opinions or statements expressed with respect to future periods in any current
statements.
The company does not undertake and specifically declines any obligation
to publicly release the result of any revisions which may be made to any
forward-looking statements to reflect events or circumstances after the date of
such statements or to reflect the occurrence of anticipated or unanticipated
events.
The matters discussed in management's discussion and analysis of
financial condition and results of operations reflects continuing operations, as
adjusted for the Restatement discussed in Note 2 of the financial statements,
unless otherwise noted.
MORTGAGE BANKING ACTIVITIES
The company adopted new accounting requirements relating to SFAS No.
149 which requires that mortgage loan commitments related to loans originated
for sale be accounted for as derivative instruments. In addition, forward loan
sale agreements also meet the definition of a derivative instrument under SFAS
No. 133.
Our mortgage banking activities include loans in our pipeline (from
application through sale). Loans in our pipeline are considered commitments once
the customers accept a rate lock. In a rate lock commitment, clients while in
the process of obtaining approval for residential loans can, at their own
determination, fix or "lock in" the rate on the loan. Those commitments are
generally for periods of 30 to 90 days and are at market rates. We generally
enter into forward sales contracts on rate lock commitments on either a best
efforts or mandatory basis. Those types of activities have declined when
compared to other periods because we have discontinued operations of the
mortgage banking subsidiary effective March 29, 2006.
Mortgage loans originated and intended for sale are carried at the
lower of aggregate cost or market value. To deliver closed loans and to control
interest rate risk prior to sale, the company enters into agreements to sell the
loans while the loans are still in the pipeline. Loan commitments related to the
origination of mortgage loans held for sale and the corresponding sales
contracts are considered derivative instruments. At June 30, 2006, the bank had
$288,000 of loans held for sale that were originated for sale to investors.
Loans held for sale as of June 30, 2006 have declined when compared to other
periods since we have discontinued operations of the mortgage banking
subsidiary. The value of the interest rate locks and related forward commitments
were immaterial to the financial statements at June 30, 2006.
As previously disclosed in Forms 8-K filed on August 10, 2006 and
December 26, 2006, the company sustained losses aggregating approximately $1.4
million discovered in the company's investigation into an unreconciled
inter-company account at GAMC. As a result, the company concluded that the
company's consolidated financial statements for the quarterly periods ended
December 31, 2005 and March 31, 2006 and for the years ended September 30, 2004
and 2005 should be restated and should no longer be relied upon. See also the
discussion in "Controls and Procedures" in Part I, Item 4. of this Form 10-Q.
15
GENERAL
We are a savings and loan holding company, which was organized in June
1997. We conduct substantially all of our business through our wholly owned
subsidiary, Greater Atlantic Bank, a federally chartered savings bank. The bank
is a member of the Federal Home Loan Bank system and its deposits are insured up
to applicable limits by the Savings Association Insurance Fund of the Federal
Deposit Insurance Corporation. We offer traditional banking services to
customers through the six branches of the bank located throughout the greater
Washington, D.C./Baltimore metropolitan area.
The profitability of the company depends primarily on its non-interest
income and net interest income. Net interest income is the difference between
the interest income it earns on its loans and investment portfolio, and the
interest it pays on interest-bearing liabilities, which consist mainly of
interest paid on deposits and borrowings. Non-interest income consists primarily
of gain on sales of loans, derivatives and available-for-sale investments and
service charge fees for deposits and loans.
The level of its operating expenses also affects the company's
profitability. Operating expenses consist primarily of salaries and employee
benefits, occupancy-related expenses, equipment and technology-related expenses
and other general operating expenses.
At June 30, 2006 the company's total assets were $297.4 million,
compared to the $339.5 million held at September 30, 2005, representing a
decrease of 12.41%. Both the bank's overall asset size and customer base
decreased during the period and that decline is reflected in the consolidated
statements of financial condition and statements of operations. Net loans
receivable at June 30, 2006 were $188.1million, a decrease of $6.8 million or
3.49% from the $194.9 million held at September 30, 2005. The decrease in loans
consisted primarily of consumer home equity, commercial business and
construction and land. That decrease was offset in part by increases in single
family and commercial real estate loans. At June 30, 2006, investment securities
were $91.0 million, a decrease of $24.8 million or 21.44% from the $115.8
million held at September 30, 2005. Deposits at June 30, 2006 were $220.2
million, a decrease of $17.6 million from the $237.8 million held at September
30, 2005.
On February 22, 2006, the company announced that it had engaged Sandler
O'Neill & Partners, L.P. to advise and assist the Company in evaluating the
financial aspects of all strategic alternatives available, including remaining
independent.
CRITICAL ACCOUNTING POLICIES, ESTIMATES AND JUDGMENTS
The company's financial statements are prepared in accordance with
accounting principles generally accepted in the United States. The preparation
of those financial statements requires management to make estimates and
judgments that affect the reported amounts of assets, liabilities, revenue and
expenses as well as the disclosure of contingent liabilities. Management
continually evaluates its estimates and judgments including those related to the
allowance for loan losses and income taxes. Management bases its estimates and
judgments on historical experience and other factors that are believed to be
reasonable under the circumstances. Actual results may differ from those
estimates under different assumptions or conditions. The company believes that,
of its significant accounting policies, the most critical accounting policies we
apply are those related to the valuation of the loan portfolio.
A variety of factors impact the carrying value of the loan portfolio
including the calculation of the allowance for loan losses, valuation of
underlying collateral, the timing of loan charge-offs and the amount and
amortization of loan fees and deferred origination costs. The allowance for loan
losses is the most difficult and subjective judgment. The allowance is
established and maintained at a level that we believe is adequate to cover
losses resulting from the inability of borrowers to make required payments on
loans. Estimates for loan losses are arrived at by analyzing risks associated
with specific loans and the loan portfolio, current trends in delinquencies and
charge-offs, the views of our regulators, changes in the size and composition of
the loan portfolio and peer comparisons. The analysis also requires
consideration of the economic climate and direction, change in the interest rate
environment, which may impact a borrower's ability to pay, legislation impacting
the banking industry and economic conditions specific to our service area.
Because the calculation of the allowance for loan losses relies on estimates and
judgments relating to inherently uncertain events, results may differ from our
estimates.
16
COMPARISON OF RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED
JUNE 30, 2006 AND JUNE 30, 2005
NET INCOME. For the three months ended June 30, 2006, the company had
net loss of $616,000 or $0.20 per diluted share, compared to a net loss of
$617,000 or $0.20 per diluted share for the three months ended June 30, 2005.
The increase in the net loss of $1,000 over the comparable period one-year ago
was primarily the result of an increase in non-interest expense. That increase
in non-interest expense was partially offset by an increase in net interest
income, an increase in non-interest income, and a decrease in the provision for
loan losses.
NET INTEREST INCOME. An important source of our earnings is net
interest income, which is the difference between income earned on
interest-earning assets, such as loans, investment securities and
mortgage-backed securities, and interest paid on interest-bearing liabilities
such as deposits and borrowings. The level of net interest income is determined
primarily by the relative average balances of interest-earning assets and
interest-bearing liabilities in combination with the yields earned and rates
paid upon them. The correlation between the re-pricing of interest rates on
assets and on liabilities also influences net interest income.
The following table presents a comparison of the components of interest
income and expense and net interest income.
Net interest income from continuing operations Difference
-------------------------------
Three Months Ended June 30, 2006 2005 Amount %
- ---------------------------------------------------------------------------------------------------------------------
(Dollars in Thousands)
Interest income:
Loans $ 3,426 $ 3,241 $ 185 5.71%
Investments 1,327 1,151 176 15.29
- ---------------------------------------------------------------------------------------------------------------------
Total 4,753 4,392 361 8.22
- ---------------------------------------------------------------------------------------------------------------------
Interest expense:
Deposits 2,030 1,614 416 25.77
Borrowings 807 957 (150) (15.67)
- ---------------------------------------------------------------------------------------------------------------------
Total 2,837 2,571 266 10.35
- ---------------------------------------------------------------------------------------------------------------------
Net interest income $ 1,916 $ 1,821 $ 95 5.22%
=====================================================================================================================
The increase in net interest income during the three months ended June
30, 2006, resulted primarily from a 45 basis point increase in net interest
margin (net interest income divided by average interest-earning assets) from
2.11% for the three months ended June 30, 2005 to 2.56% for the three months
ended June 30, 2006, offset in part by a $46.7 million decrease in the bank's
interest-earning assets. Contributing to the increase in the net interest margin
was a $104,000 reduction in interest expense resulting from payments made on
certain interest rate swap and cap agreements compared to a charge of $32,000 in
the comparable period one year ago. That increase in net interest margin also
resulted from increasing the average yield on interest-earning assets by 37
basis points more than the increase in the average cost on interest-bearing
liabilities. It was reduced in part as average interest-earning assets decreased
by $1.2 million less than the decline in average interest-bearing liabilities.
INTEREST INCOME. Interest income for the three months ended June 30,
2006 increased $361,000 compared to the three months ended June 30, 2005,
primarily as a result of an increase of 128 basis points in the average yield
earned on interest earning assets. That increase was partially offset by a
decrease of $46.7 million in the average outstanding balances of loans and
investment securities.
17
INTEREST EXPENSE. The $266,000 increase in interest expense for the
three months ended June 30, 2006 compared to the 2005 period was principally the
result of a 91 basis point increase in the cost of funds on average deposits and
borrowings. That increase in the cost of funds was partially offset by a $47.9
million decrease in average deposits and borrowings. The increase in interest
expense on deposits was primarily due to a 113 basis point increase in rates
paid on deposits. The increase in expense was primarily due to higher rates paid
on interest-bearing demand deposits, savings accounts and certificates and
elevated pricing on new and renewed time deposits. That increase was partially
offset by a decrease of $26.5 million in average deposits from $238.2 million
for the three months ended June 30, 2005 to $211.7 million for the three months
ended June 30, 2006.
The decrease in interest expense on borrowings for the three months
ended June, 2006, when compared to the 2005 period was principally the result of
a $21.5 million decrease in average borrowed funds, partially offset by a 45
basis point increase in the cost of borrowed funds. The components accountable
for the decrease of $150,000 in interest expense on borrowings were a $217,000
decrease relating to average volume, partially offset by a $67,000 increase
relating to average cost.
18
COMPARATIVE AVERAGE BALANCES AND INTEREST INCOME ANALYSIS. The
following table presents the total dollar amount of interest income from average
interest-earning assets and the resultant yields, as well as the interest
expense on average interest-bearing liabilities, expressed both in dollars and
annualized rates. No tax-equivalent adjustments were made and all average
balances are average daily balances. Non-accruing loans have been included in
the tables as loans carrying a zero yield.
FOR THE THREE MONTHS ENDED JUNE 30,
--------------------------------------------------------------------------------
2006 2005 (RESTATED)
------------------------------------- ------------------------------------------
INTEREST AVERAGE INTEREST AVERAGE
AVERAGE INCOME/ YIELD/ AVERAGE INCOME/ YIELD/
BALANCE EXPENSE RATE BALANCE EXPENSE RATE
------------------------------------- ------------------------------------------
ASSETS: (DOLLARS IN THOUSANDS)
Interest-earning assets:
Real estate loans $ 92,623 $ 1,660 7.17% $ 93,927 $ 1,557 6.63%
Consumer loans 64,267 1,207 7.51 72,053 986 5.47
Commercial business loans 32,269 559 6.93 37,246 698 7.50
----------- ----------- ----------- ------------ ------------- --------------
Total loans 189,159 3,426 7.24 203,226 3,241 6.38
Investment securities 69,172 897 5.19 69,721 639 3.67
Mortgage-backed securities 40,572 430 4.24 72,688 512 2.82
----------- ----------- ----------- ------------ ------------- --------------
Total interest-earning assets 298,903 4,753 6.36 345,635 4,392 5.08
----------- ----------- ------------- --------------
Non-earning assets 11,438 12,196
----------- ------------
Total assets $ 310,341 $ 357,831
=========== ============
LIABILITIES AND STOCKHOLDERS'
EQUITY:
Interest-bearing liabilities:
Savings accounts $ 4,680 11 0.94 $ 9,085 20 0.88
Now and money market accounts 76,696 658 3.43 59,881 317 2.12
Certificates of deposit 130,333 1,361 4.18 169,190 1,277 3.02
----------- ----------- ----------- ------------ ------------- --------------
Total deposits 211,709 2,030 3.84 238,156 1,614 2.71
FHLB advances 38,568 490 5.08 42,233 481 4.56
Other borrowings 30,461 317 4.16 48,249 476 3.95
----------- ----------- ----------- ------------ ------------- --------------
Total interest-bearing
liabilities 280,738 2,837 4.04 328,638 2,571 3.13
----------- ----------- ------------- --------------
Noninterest-bearing liabilities:
Noninterest-bearing demand deposits 15,107 12,373
Other liabilities 1,165 1,528
----------- ------------
Total liabilities 297,010 342,539
Stockholders' equity 13,331 15,292
----------- ------------
Total liabilities and
stockholders' Equity $ 310,341 $ 357,831
=========== ============
Net interest income $ 1,916 $ 1,821
=========== =============
Interest rate spread 2.32% 1.95%
=========== =============
Net interest margin 2.56% 2.11%
=========== =============
19
RATE/VOLUME ANALYSIS. The following table presents certain information
regarding changes in interest income and interest expense attributable to
changes in interest rates and changes in volume of interest-earning assets and
interest-bearing liabilities for the periods indicated. The change in interest
attributable to both rate and volume has been allocated to the changes in rate
and volume on a pro rata basis.
THREE MONTHS ENDED
JUNE 30, 2006 COMPARED TO
JUNE 30, 2005
-----------------------------------------------
CHANGE ATTRIBUTABLE TO
-----------------------------------------------
VOLUME RATE TOTAL
-----------------------------------------------
(IN THOUSANDS)
Real estate loans $ (22) $ 125 $ 103
Consumer loans (107) 328 221
Commercial business loans (93) (46) (139)
---------------- -------------- --------------
Total loans (222) 407 185
Investments (5) 263 258
Mortgage-backed securities (226) 144 (82)
---------------- -------------- --------------
Total interest-earning assets $(453) $ 814 $ 361
================ ============== ==============
Savings accounts $ (10) $ 1 $ (9)
Now and money market accounts 89 252 341
Certificates of deposit (293) 377 84
---------------- -------------- --------------
Total deposits (214) 630 416
FHLB advances (42) 51 9
Other borrowings (175) 16 (159)
---------------- -------------- --------------
Total interest-bearing liabilities (431) 697 266
================ ============== ==============
Change in net interest income $ (22) $ 117 $ 95
================ ============== ==============
PROVISION FOR LOAN LOSSES. The allowance for loan losses, which is established
through provisions for losses charged to expense, is increased by recoveries on
loans previously charged off and is reduced by charge-offs on loans. Determining
the proper reserve level or allowance involves management's judgment based upon
a review of factors, including the company's internal review process, which
segments the loan portfolio into groups, based on loan type and assigns to them
a reserve percentage that reflects the industry standard. Management then looks
at its classified assets, which are loans 30 days or more delinquent, and
classifies those loans as special mention, substandard, doubtful or loss based
on the performance of the loans. Those classified loans are then individually
evaluated for impairment and measured by either the present value of expected
future cash flows, the loan's observable market price, or the fair value of the
collateral. They are then segmented by type and assigned a reserve percentage
that reflects the underlying quality of the loan. Although management utilizes
its best judgment in providing for probable losses, there can be no assurance
that the bank will not have to increase its provisions for loan losses in the
future. An increase in provision may result from an adverse market for real
estate and economic conditions generally in the company's primary market area,
future increases in non-performing assets or for other reasons which would
adversely affect the company's results of operations. On an annual basis, or
more often if deemed necessary, the Bank has contracted with an independent
outside third party to have its loan portfolio reviewed. The focus of their
review is to identify the extent of potential and actual risk in the bank's
commercial loan portfolio, in addition to the underwriting and processing
practices. Observations made regarding the bank's portfolio risk are based upon
review evaluations, portfolio profiles and discussion with the operational
staff, including the line lenders and senior management.
20
Non-performing assets were $1.1 million or 0.38% of total assets at
June 30, 2006, with $821,000 classified as substandard, $321,000 classified as
doubtful and none classified as loss. Non-performing assets decreased $1.1
million from the $2.2 million or 0.60% classified as non-performing at June 30,
2005. The $1.1 million decrease is reflected in the $131,000 decrease in the
provision for loan losses for the June 30, 2006 quarter when compared to the
year ago quarter. The decrease in the provision for loan losses from the year
ago period resulted from declines in the outstanding balance of the bank's
commercial business loans, home equity loans, residential real estate loans and
real estate owned. Those decreases were offset by increases in the outstanding
balance of the bank's non-residential and second trust loans. The decrease in
provision resulted primarily from the decrease in the required provision for
those loans and the overall decline in the size of the bank's loan portfolio.
NON-INTEREST INCOME. Non-interest income increased $64,000 during the
quarter ended June 30, 2006, over the comparable period one year ago. That
increase was primarily the result of an increase of $372,000 in gains on
derivatives and was partially offset by a decrease in gain on sale of loans, a
decline in other operating income and service fees on loans and deposits. The
decrease in other operating income reflects the gain recognized one year ago
from the sale of the bank's Sterling, Virginia branch.
The following table presents a comparison of the components of
non-interest income.
Non-interest income from continuing operations Difference
--------------------------------------
Three Months Ended June 30, 2006 2005 Amount %
- -------------------------------------------------------------------------------------------------------------------
(Dollars in Thousands)
Non-interest income:
Gain on sale of loans $ - $ 3 $ (3) (100.00)%
Service fees on loans 43 50 (7) (14.00)
Service fees on deposits 105 125 (20) (16.00)
Gain (loss) on sale of investment securities - - - -
Gain (loss) on derivatives 50 (322) 372 115.53
Other operating income 5 283 (278) (98.23)
- -------------------------------------------------------------------------------------------------------------------
Total non-interest income $ 203 $ 139 $ 64 46.04%
===================================================================================================================
NON-INTEREST EXPENSE. Non-interest expense increased $289,000 from $2.4
million for the three months ended June 30, 2005 to $2.7 million for the three
months ended June 30 in the current year. The increase was distributed over
various non-interest expense categories with the primary contributors being
compensation, professional services advertising and occupancy and was partially
offset by decreases totaling $73,000 in deposit insurance premium, furniture
fixtures and equipment, data processing and other operating expense.
The following table presents a comparison of the components of
non-interest expense.
Non-interest expense from continuing operations Difference
---------------------------------
Three Months Ended June 30, 2006 2005 Amount %
- ---------------------------------------------------------------------------------------------------------------------
(Dollars in Thousands)
Non-interest expense:
Compensation and employee benefits $ 1,216 $ 1,049 $ 167 15.92%
Occupancy 357 303 54 17.82
Professional services 281 209 72 34.45
Advertising 183 114 69 60.53
Deposit insurance premium 24 41 (17) (41.46)
Furniture, fixtures and equipment 135 151 (16) (10.60)
Data processing 235 250 (15) (6.00)
Other operating expense 291 316 (25) (7.91)
- ---------------------------------------------------------------------------------------------------------------------
Total non-interest expense $ 2,722 $ 2,433 $ 289 (11.88)%
=====================================================================================================================
INCOME TAXES. The company files a consolidated federal income tax
return with its subsidiaries and computes its income tax provision or benefit on
a consolidated basis. We did not record a provision for income taxes for the
three months ended June 30, 2006 and 2005 due to our operating losses.
21
Contractual Obligations and Off-Balance Sheet Financing Arrangements
The following table summarizes the bank's contractual obligations at
June 30, 2006 and the effect those obligations are expected to have on the
bank's liquidity and cash flows in future periods.
- -----------------------------------------------------------------------------------------------------------------
Less Than One Two - Three Four - Five After Five
Total Year Years Years Years
- -----------------------------------------------------------------------------------------------------------------
(In thousands)
FHLB Advances (1) $ 36,000 $ 6,000 $ 5,000 $ - $ 25,000
Reverse repurchase agreements 20,769 20,769 - - -
Operating leases 5,137 1,083 2,170 1,360 524
- -----------------------------------------------------------------------------------------------------------------
Total obligations $ 61,906 $ 27,852 $ 7,170 $ 1,360 $ 25,524
=================================================================================================================
(1) The company expects to refinance these short and medium-term obligations
under substantially the same terms and conditions.
Other Commercial Commitments
- -----------------------------------------------------------------------------------------------------------------
Less Than One Two - Three Four - Five After Five
Total Year Years Years Years
- -----------------------------------------------------------------------------------------------------------------
(In Thousands)
Certificate of deposit maturities (1) $ 124,791 $ 96,442 $ 23,200 $ 5,056 $ 93
Loan originations 22,060 22,060 - - -
Unfunded lines of credit 115,617 115,617 - - -
Standby letters of credit 96 96 - - -
- -----------------------------------------------------------------------------------------------------------------
Total $ 262,564 $ 234,215 $ 23,200 $ 5,056 $ 93
=================================================================================================================
(1) The company expects to retain maturing deposits or replace amounts
maturing with comparable certificates of deposits based on current market
interest rates.
COMPARISON OF RESULTS OF OPERATIONS FOR THE NINE MONTHS ENDED
JUNE 30, 2006 AND JUNE 30, 2005
NET INCOME. For the nine months ended June 30, 2006, the company had
net loss of $1.6 million or $0.53 per diluted share compared to a net loss of
$38,000 or $0.01 per diluted share for the nine months ended June 30, 2005. The
$1.6 million decline in earnings over the comparable period one-year ago was
primarily the result of an increase in non-interest expense and a decrease in
non-interest income. That increase in non-interest expense and decrease in
non-interest income were partially offset by an increase in net interest income
and a decrease in the provision for loan losses.
NET INTEREST INCOME. An important source of our earnings is net
interest income, which is the difference between income earned on
interest-earning assets, such as loans, investment securities and
mortgage-backed securities, and interest paid on interest-bearing liabilities
such as deposits and borrowings. The level of net interest income is determined
primarily by the relative average balances of interest-earning assets and
interest-bearing liabilities in combination with the yields earned and rates
paid upon them. The correlation between the re-pricing of interest rates on
assets and on liabilities also influences net interest income.
22
The following table presents a comparison of the components of interest
income and expense and net interest income.
Net interest income from continuing operations Difference
- -----------------------------------------------------------------------------------------------------------------------
Nine Months Ended June 30, 2006 2005 Amount %
- -----------------------------------------------------------------------------------------------------------------------
(dollars in thousands)
Interest income:
Loans $ 10,217 $ 9,315 $ 902 9.68%
Investments 3,726 3,428 298 8.69
- -----------------------------------------------------------------------------------------------------------------------
Total 13,943 12,743 1,200 9.42
- -----------------------------------------------------------------------------------------------------------------------
Interest expense:
Deposits 5,684 4,640 1,044 22.50
Borrowings 2,667 3,300 (633) (19.18)
- -----------------------------------------------------------------------------------------------------------------------
Total 8,351 7,940 411 5.18
- -----------------------------------------------------------------------------------------------------------------------
Net interest income $ 5,592 $ 4,803 $ 789 16.43%
=======================================================================================================================
The increase in net interest income during the nine months ended June
30, 2006, resulted primarily from a 67 basis point increase in net interest
margin (net interest income divided by average interest-earning assets) from
1.73% for the nine months ended June 30, 2005 to 2.40% for the nine months ended
June 30, 2006, offset in part by a $59.2 million decrease in the bank's
interest-earning assets. Contributing to the increase in the net interest margin
was a $211,000 reduction in interest expense resulting from payments made on
certain interest rate swap and cap agreements compared to a charge of $539,000
in the comparable period one year ago. The increase in net interest margin also
resulted from the average yield on interest-earning assets increasing by 58
basis points more than the increase in the average cost on interest-bearing
liabilities and was coupled with average interest earning assets decreasing by
$1.3 million less than the decline in average interest-bearing liabilities.
INTEREST INCOME. Interest income for the nine months ended June 30,
2006 increased $1.2 million compared to the nine months ended June 30, 2005,
primarily as a result of a 139 basis point increase in the average yield earned
on interest earning assets. That increase was partially offset by a decrease of
$59.2 million in the average outstanding balances of loans and securities.
INTEREST EXPENSE. The $411,000 increase in interest expense for the
nine months ended June 30, 2006 compared to the 2005 period was principally the
result of an 81 basis point increase in the cost of funds on average deposits
and borrowings. That increase in the cost of funds was partially offset by a
$60.5 million decrease in average deposits and borrowings. The increase in
interest expense on deposits was primarily due to a 110 basis point increase in
rates paid on deposits, primarily due to higher rates paid on interest-bearing
demand deposits, savings accounts and certificates and elevated pricing on new
and renewed time deposits. That increase was partially offset by a decrease of
$38.5 million in average deposits from $252.1 million for the nine months ended
June 30, 2005 to $213.6 million for the nine months ended June 30, 2006.
The decrease in interest expense on borrowings for the nine months
ended June 30, 2006, when compared to the 2005 period, was principally the
result of a $22.0 million decrease in average borrowed funds and was partially
offset by a 16 basis point increase in the cost of borrowed funds. Components
accountable for the decrease of $633,000 in interest expense on borrowings were
a $728,000 decrease relating to average volume, offset in part by a $95,000
increase relating to average cost.
23
COMPARATIVE AVERAGE BALANCES AND INTEREST INCOME ANALYSIS. The
following table presents the total dollar amount of interest income from average
interest-earning assets and the resultant yields, as well as the interest
expense on average interest-bearing liabilities, expressed both in dollars and
annualized rates. No tax-equivalent adjustments were made and all average
balances are average daily balances. Non-accruing loans have been included in
the tables as loans carrying a zero yield.
FOR THE NINE MONTHS ENDED JUNE 30,
--------------------------------------------------------------------------------
2006 2005 (RESTATED)
--------------------------------------- ----------------------------------------
INTEREST AVERAGE INTEREST AVERAGE
AVERAGE INCOME/ YIELD/ AVERAGE INCOME/ YIELD/
BALANCE EXPENSE RATE BALANCE EXPENSE RATE
----------- ----------- ----------- ------------ ------------- ------------
ASSETS: (DOLLARS IN THOUSANDS)
Interest-earning assets:
Real estate loans $ 93,654 $ 4,995 7.11% $100,653 $4,859 6.44%
Consumer loans 66,569 3,476 6.96 72,547 2,705 4.97
Commercial business loans 34,017 1,746 6.84 41,398 1,751 5.64
----------- ----------- ----------- ------------ ------------- ------------
Total loans 194,240 10,217 7.01 214,598 9,315 5.79
Investment securities 69,271 2,486 4.79 72,544 1,731 3.18
Mortgage-backed securities 46,778 1,240 3.53 82,319 1,697 2.75
----------- ----------- ----------- ------------ ------------- ------------
Total interest-earning assets 310,289 13,943 5.99 369,461 12,743 4.60
----------- ----------- ------------- ------------
Non-earning assets 11,616 13,405
----------- ------------
Total assets $321,905 $382,866
=========== ============
LIABILITIES AND STOCKHOLDERS' EQUITY:
Interest-bearing liabilities:
Savings accounts $ 5,598 39 0.93 $ 10,897 76 0.93
Now and money market accounts 73,075 1,781 3.25 64,707 773 1.59
Certificates of deposit 134,947 3,864 3.82 176,531 3,791 2.86
----------- ----------- ----------- ------------ ------------- ------------
Total deposits 213,620 5,684 3.55 252,135 4,640 2.45
FHLB advances 45,151 1,668 4.93 44,348 1,452 4.37
Other borrowings 33,018 999 4.03 55,786 1,848 4.42
----------- ----------- ----------- ------------ ------------- ------------
Total interest-bearing liabilities 291,789 8,351 3.82 352,269 7,940 3.01
----------- ----------- ------------- ------------
Noninterest-bearing liabilities:
Noninterest-bearing demand deposits 15,234 14,110
Other liabilities 1,048 1,380
----------- ------------
Total liabilities 308,071 367,759
Stockholders' equity 13,834 15,107
----------- ------------
Total liabilities and
stockholders' equity $321,905 $382,866
=========== ============
Net interest income $ 5,592 $4,803
============ =============
Interest rate spread 2.17% 1.59%
============ ============
Net interest margin 2.40% 1.73%
============ ============
24
RATE/VOLUME ANALYSIS. The following table presents certain information
regarding changes in interest income and interest expense attributable to
changes in interest rates and changes in volume of interest-earning assets and
interest-bearing liabilities for the periods indicated. The change in interest
attributable to both rate and volume has been allocated to the changes in rate
and volume on a pro rata basis.
NINE MONTHS ENDED
JUNE 30, 2006 COMPARED TO
JUNE 30, 2005
-----------------------------------------------
CHANGE ATTRIBUTABLE TO
-----------------------------------------------
VOLUME RATE TOTAL
-----------------------------------------------
(IN THOUSANDS)
Real estate loans $ (338) $ 474 $ 136
Consumer loans (223) 994 771
Commercial business loans (312) 307 (5)
---------------- -------------- --------------
Total loans (873) 1,775 902
Investments (78) 833 755
Mortgage-backed securities (733) 276 (457)
---------------- -------------- --------------
Total interest-earning assets $(1,684) $ 2,884 $ 1,200
================ ============== ==============
Savings accounts $ (37) $ - $ (37)
Now and money market accounts 100 908 1,008
Certificates of deposit (893) 966 73
---------------- -------------- --------------
Total deposits (830) 1,874 1,044
FHLB advances 26 190 216
Other borrowings (754) (95) (849)
---------------- -------------- --------------
Total interest-bearing liabilities (1,558) 1,969 411
================ ============== ==============
Change in net interest income $ (126) $ 915 $ 789
================ ============== ==============
PROVISION FOR LOAN LOSSES. Non-performing assets were $1.1 million or
0.38% of total assets at June 30, 2006, with $821,000 classified as substandard,
$321,000 classified as doubtful and none classified as loss, compared to $2.2
million or 0.60% classified as non-performing at June 30, 2005. Non-performing
assets decreased $1.1 million from the comparable period one year ago, and the
bank decreased its provision for loan losses by $60,000. The decrease in the
provision for loan losses from the year ago period was due to the decrease of
the outstanding balance of the bank's residential real estate loans, commercial
business loans, home equity loans and real estate owned. The decrease in
provision was due primarily to the decreases in the required provisions for
those loans coupled with an overall decline in the size of the bank's loan
portfolio.
NON-INTEREST INCOME. Non-interest income decreased $1.9 million during
the nine months ended June 30, 2006, over the comparable period one year ago.
That decrease was primarily the result of decreases in gain on sale of loans,
gains on derivatives, gain on sale of investment securities and declines in
other operating income and service fees on deposits. Those decreases in income
were partially offset by an increase of $ $65,000 in gain on sale of real estate
owned. The decrease in other operating income reflects the $946,000 gain
recognized one year ago from the sale of the bank's Washington, D.C., Winchester
and Sterling, Virginia, branches.
25
The following table presents a comparison of the components of
non-interest income.
Non-interest income from continuing operations Difference
- ------------------------------------------------------------------------------------------------------------------
Nine Months Ended June 30, 2006 2005 Amount %
- ------------------------------------------------------------------------------------------------------------------
(dollars in thousands)
Non-interest income:
Gain on sale of loans $ - $ 53 $ (53) N/A%
Service fees on loans 136 137 (1) (0.73)
Service fees on deposits 309 431 (122) (28.31)
Gain on sale of investment securities - 538 (538) (100.00)
Gain on derivatives 234 560 (326) (58.21)
Gain on sale of real estate owned 65 - 65 N/A
Other operating income 25 998 (973) (97.49)
- ------------------------------------------------------------------------------------------------------------------
Total non-interest income $ 769 $ 2,717 $ (1,948) (71.70)%
==================================================================================================================
NON-INTEREST EXPENSE. Non-interest expense increased $458,000 from $7.4
million for the nine months ended June 30, 2005 to $7.9 million for the nine
months ended June 30 in the current year. The increase of $458,000 in
non-interest expense was distributed over various non-interest expense
categories with the major contributors being compensation, professional services
and advertising and was offset in part by decreases in occupancy, furniture
fixtures and equipment, data processing and other operating expense.
The following table presents a comparison of the components of
non-interest expense.
Non-interest expense from continuing operations Difference
- --------------------------------------------------------------------------------------------------------------------
Nine Months Ended June 30, 2006 2005 Amount %
- --------------------------------------------------------------------------------------------------------------------
(dollars in thousands)
Noninterest expense:
Compensation and employee benefits $ 3,502 $ 3,133 $ 369 11.78%
Occupancy 1,008 1,033 (25) (2.42)
Professional services 799 652 147 22.55
Advertising 547 226 321 142.04
Deposit insurance premium 77 72 5 6.94
Furniture, fixtures and equipment 415 520 (105) (20.19)
Data processing 703 843 (140) (16.61)
Other operating expense 818 932 (114) (12.23)
- --------------------------------------------------------------------------------------------------------------------
Total noninterest expense $ 7,869 $ 7,411 $ 458 6.18%
====================================================================================================================
INCOME TAXES. The company files a consolidated federal income tax
return with its subsidiaries and computes its income tax provision or benefit on
a consolidated basis. We did not record a provision for income taxes for the
nine months ended June 30, 2006 and 2005 due to our operating losses.
26
LIQUIDITY AND CAPITAL RESOURCES. The bank's primary sources of funds
are deposits, principal and interest payments on loans, mortgage-backed and
investment securities and borrowings. While maturities and scheduled
amortization of loans are predictable sources of funds, deposit flows and
mortgage prepayments are greatly influenced by general interest rates, economic
conditions and competition. The bank continues to maintain the levels of liquid
assets previously required by OTS regulations. The bank manages its liquidity
position and demands for funding primarily by investing excess funds in
short-term investments and utilizing FHLB advances and reverse repurchase
agreements in periods when the bank's demands for liquidity exceed funding from
deposit inflows.
The bank's most liquid assets are cash and cash equivalents and
securities available-for-sale. The levels of those assets are dependent on the
bank's operating, financing, lending and investing activities during any given
period. At June 30, 2006, cash and cash equivalents, interest bearing deposits
and securities available-for-sale totaled $90.8 million or 30.52% of total
assets.
The primary investing activities of the bank are the origination of
consumer loans, residential one- to four-family loans, commercial business
loans, commercial real estate loans, and real estate construction and
development loans and the purchase of United States Treasury and agency
securities, mortgage-backed and mortgage-related securities and other investment
securities. During the nine months ended June 30, 2006, the bank's loan
purchases and originations totaled $72.0 million. Purchases of United States
Treasury and agency securities, mortgage-backed and mortgage related securities
and other investment securities totaled $7.7 million for the nine months ended
June 30, 2006.
The bank has other sources of liquidity if a need for additional funds
arises. At June 30, 2006, the bank had $36.0 million in advances outstanding
from the FHLB and had an additional overall borrowing capacity from the FHLB of
$25.2 million. Depending on market conditions, the pricing of deposit products
and the pricing of FHLB advances, the bank may continue to rely on FHLB
borrowings to fund asset growth.
At June 30, 2006, the bank had commitments to fund loans and unused
outstanding lines of credit, unused standby letters of credit and undisbursed
proceeds of construction mortgages totaling $137.8 million. The bank anticipates
that it will have sufficient funds available to meet its current loan
origination commitments. Certificate accounts, including IRA and Keogh accounts,
which are scheduled to mature in less than one year from June 30, 2006, totaled
$96.4 million. Based upon experience, management believes the majority of
maturing deposits will remain with the bank. In addition, management of the bank
believes that it can adjust the rates offered on certificates of deposit to
retain deposits in changing interest rate environments. In the event that a
significant portion of those deposits are not retained by the bank, the bank
would be able to utilize FHLB advances and reverse repurchase agreements to fund
deposit withdrawals, which would result in an increase in interest expense to
the extent that the average rate paid on such borrowings exceeds the average
rate paid on deposits of similar duration.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk is the risk of loss from adverse changes in market prices
and rates. The company's market risk arises primarily from interest rate risk
inherent in its lending and deposit taking activities. The company has little or
no risk related to trading accounts, commodities or foreign exchange. In
general, market risk reflects the sensitivity of income to variations in
interest rates and other relevant market rates or prices. The company's market
rate sensitive instruments include interest-earning assets and interest-bearing
liabilities. The company enters into market rate sensitive instruments in
connection with its various business operations, particularly its mortgage
banking activities. Loans originated, and the related commitments to originate
loans that will be sold, represent market risk that is realized in a short
period of time, generally two or three months.
27
The company's primary source of market risk exposure arises from
changes in United States interest rates and the effects thereof on mortgage
prepayment and closing behavior, as well as depositors' choices ("interest rate
risk"). Changes in those interest rates will result in changes in the company's
earnings and the market value of its assets and liabilities. We expect to
continue to realize income from the differential or "spread" between the
interest earned on loans, securities and other interest-earning assets, and the
interest paid on deposits, borrowings and other interest-bearing liabilities.
That spread is affected by the difference between the maturities and re-pricing
characteristics of interest-earnings assets and interest-bearing liabilities.
Loan volume and yields are affected by market interest rates on loans, and
rising interest rates generally are associated with fewer loan originations.
Management expects that a substantial portion of our assets will continue to be
indexed to changes in market interest rates and we intend to attract a greater
proportion of short-term liabilities, which will help us address our interest
rate risk. The lag in implementation of re-pricing terms on our adjustable-rate
assets may result in a decline in net interest income in a rising interest rate
environment. There can be no assurance that our interest rate risk will be
minimized or eliminated. Further, an increase in the general level of interest
rates may adversely affect the ability of certain borrowers to pay the interest
on and principal of their obligations. Accordingly, changes in levels of market
interest rates, (primarily increases in market interest rates), could materially
adversely affect our interest rate spread, asset quality, loan origination
volume and overall financial condition and results of operations.
To mitigate the impact of changes in market interest rates on our
interest-earning assets and interest-bearing liabilities, we actively manage the
amounts and maturities of these assets and liabilities. A key component of this
strategy is the origination and retention of short-term and adjustable-rate
assets and the origination and sale of fixed-rate loans. We retain short-term
and adjustable-rate assets because they have re-pricing characteristics that
more closely match the re-pricing characteristics of our liabilities.
To further mitigate the risk of timing differences in the re-pricing of
assets and liabilities, our interest-earning assets are matched with
interest-bearing liabilities that have similar re-pricing characteristics. For
example, the interest rate risk of holding fixed-rate loans is managed with
long-term deposits and borrowings, and the risk of holding ARMs is managed with
short-term deposits and borrowings. Periodically, mismatches are identified and
managed by adjusting the re-pricing characteristics of our interest-bearing
liabilities with derivatives, such as interest rate caps and interest rate
swaps.
Through the use of these derivative instruments, management attempts to
reduce or offset increases in interest expense related to deposits and
borrowings. We use interest rate caps and pay-fixed interest rate swaps to
protect against rising interest rates.
The interest rate caps and the pay-fixed interest rate swaps are
designed to provide an additional layer of protection, should interest rates on
deposits and borrowings rise, by effectively lengthening the re-pricing period.
At June 30, 2006, we held an aggregate notional value of $25 million of caps and
$21 million of swaps that pay-a fixed interest rate. One of the interest rate
caps had strike rates that were in effect at June 30, 2006, as current LIBOR
rates were above the strike rate.
We are also striving to increase the proportion of transaction deposits
to total deposits to diminish our exposure to adverse changes in interest rates.
In particular, non-interest-bearing checking accounts and custodial accounts are
less sensitive to interest rate fluctuations and provide a growing source of
non-interest income through depositor and other retail banking fees.
28
The following table, which is based on information that we provide to
the Office of Thrift Supervision, presents the change in our net portfolio value
at June 30, 2006 that would occur in the event of an immediate change in
interest rates based on Office of Thrift Supervision assumptions, with no effect
given to any steps that we might take to counteract that change.
Net Portfolio Value Net Portfolio Value as % of
(Dollars in thousands) Portfolio Value of Assets
----------------------------------------------- ----------------------------------
Basic Point ("bp")
Change in Rates $Amount $Change % Change NPV Ratio Change (bp)
- -------------------------- -------------- ----------------- -------------- ---------------- ----------------
+300 25,916 -2,864 -10% 8.75% -68bp
+200 27,380 -1,401 -5% 9.15% -29bp
+100 28,302 -479 -2% 9.36% -7bp
0 28,781 - - 9.44% -
-100 28,384 -396 -1% 9.25% -19bp
-200 27,268 -1,512 -5% 8.85% -59bp
The Office of Thrift Supervision uses various assumptions in assessing
interest rate risk. Those assumptions relate to interest rates, loan prepayment
rates, deposit decay rates and the market values of certain assets under
differing interest rate scenarios, among others. As with any method of measuring
interest rate risk, certain shortcomings are inherent in the methods of analyses
presented in the foregoing tables. For example, although certain assets and
liabilities may have similar maturities or periods to repricing, they may react
in different degrees to changes in market interest rates. Also, the interest
rates on certain types of assets and liabilities may fluctuate in advance of
changes in market interest rates, while interest rates on other types may lag
behind changes in market rates. Additionally, certain assets, such as
adjustable-rate mortgage loans, have features that restrict changes in interest
rates on a short-term basis and over the life of the asset. Further, in the
event of a change in interest rates, expected rates of prepayments on loans and
early withdrawals from certificates could deviate significantly from those
assumed in calculating the table. Prepayment rates can have a significant impact
on interest income. Because of the large percentage of loans and mortgage-backed
securities we hold, rising or falling interest rates have a significant impact
on the prepayment speeds of our earning assets that in turn affect the rate
sensitivity position. When interest rates rise, prepayments tend to slow. When
interest rates fall, prepayments tend to rise. Our asset sensitivity would be
reduced if prepayments slow and vice versa. While we believe these assumptions
to be reasonable, there can be no assurance that assumed prepayment rates will
approximate actual future mortgage-backed security and loan repayment activity.
ITEM 4. CONTROLS AND PROCEDURES. Pursuant to an investigation being conducted
under the supervision of the company's Audit Committee, management discovered a
$2.1 million difference in inter-company accounts between the company and its
subsidiary, GAMC. The company discovered the un-reconciled inter-company account
at GAMC during its review of the closing entries to the accounts of GAMC in
connection with the preparation of the company's consolidated financial
statements for the quarterly period ended June 30, 2006. The investigation
resulted in a determination that the warehouse payable account maintained at
GAMC had not been properly reconciled.
The extensive investigation revealed numerous errors in the
reconciliation of the warehouse payable account of GAMC over a period of five
(5) years. As a result of the investigation, the company determined that it has
sustained losses aggregating approximately $1.4 million. To date, the company
has identified claims of $738,000, primarily for duplicate checks issued and
paid on the same loan. Of that sum, $422,000 has been collected and the company
believes that the balance is recoverable. The investigation regarding this
matter is ongoing and the company has retained legal and accounting personnel to
assist in the company's investigation. Costs associated with engaging personnel
to provide those professional services are being treated as period costs.
The company maintains disclosure controls and procedures that are
designed to ensure that information required to be disclosed by the company in
reports that it files or submits under the Securities Exchange Act of 1934 is
recorded, processed, summarized and reported within the time periods specified
in Securities and Exchange Commission rules and regulations and that such
information is accumulated and communicated to the company's management,
including the company's Chief Executive Officer and Chief Financial Officer, as
appropriate, to allow timely decisions regarding required disclosure. Because of
the inherent limitations in all control systems, no evaluation of controls can
provide absolute assurance that the company's disclosure controls and procedures
will detect or uncover every situation involving the failure of persons within
the company or its subsidiary to disclose material information otherwise
required to be set forth in the company's periodic reports.
29
The company, under the supervision and with the participation of the
company's management, including the company's Chief Executive Officer and the
Chief Financial Officer, has evaluated the effectiveness of the company's
disclosure controls and procedures as of the end of the period covered by this
report. Based on that evaluation, the Chief Executive Officer and the Chief
Financial Officer have concluded that the company's disclosure controls and
procedures were not effective as of June 30, 2006 due to the override of certain
internal control procedures relating to preparation and review of certain
reconciliations. The override of those internal control procedures enabled the
differences in the reconciliations performed at GAMC to go un-detected over a
long period of time. While the bank had outsourced its internal audit function
to an independent CPA firm, neither their review of the reconciliations or that
of the company's then controller uncovered any errors that were brought to the
attention of senior management. The person responsible for the reconciliations
at GAMC is no longer employed by GAMC, and the then controller of the bank, who
was responsible for review of the reconciliations at GAMC, is no longer employed
by the bank.
While the problem was isolated to one unique account with a subsidiary
that is no longer in business, and was the responsibility of individuals who are
no longer employed by subsidiaries of the company, the company has enhanced
controls in similar situations going forward by:
o Strengthening the procedures for reconciling the intercompany accounts.
Those procedures include having an outside party perform
reconciliations semi-annually instead of merely reviewing
reconciliations performed by parties with account responsibility; and
o The company has strengthened the accounting staff at the controller
position.
In connection with this Form 10-Q, the company's management, with the
participation of its Chief Executive Officer and Chief Financial Officer,
evaluated the company's disclosure controls and procedures as currently in
effect, including the changes discussed above, and such officers have concluded
that, as of this date, the company's disclosure controls and procedures are
effective.
Management of the company is also responsible for establishing and
maintaining adequate internal control over financial reporting and control of
the company's assets to provide reasonable assurance regarding the reliability
of financial reporting and the preparation of financial statements for external
purposes in accordance with accounting principles generally accepted in the
United States of America. There were no changes in the company's internal
control over financial reporting during the company's quarter ended June 30,
2006 that have materially affected, or are reasonably likely to materially
affect, the company's internal control over financial reporting. However,
subsequent to June 30, 2006, the company made changes to its internal control
procedures, as described above.
PART II. OTHER INFORMATION
ITEM 1. Legal Proceedings
As previously reported on a Form 8-K filed on September 8, 2006, the
company announced that a Demand for Arbitration Before the American Arbitration
Association was filed against the company, the bank, GAMC, and Carroll E. Amos,
President and Chief Executive Officer of the company and the bank. The Demand
for Arbitration was filed by Stamm Mortgage Management, Inc. ("Stamm Mortgage")
and T. Mark Stamm, President of Stamm Mortgage in connection with the Management
Agreement among Stamm Mortgage, the bank, and GAMC that governed the management
of GAMC by Stamm Mortgage before the bank terminated GAMC's operations earlier
this year, and certain aspects of the company's public disclosures of that
event.
The Demand for Arbitration alleges three counts: rescission, breach of
contract, and defamation. As against the Bank and GAMC, Stamm Mortgage alleges
that the Management Agreement is unenforceable and should be rescinded,
requiring the Bank and GAMC, jointly and severally, to return $1.77 million that
Stamm Mortgage paid to the Bank and GAMC under the Management Agreement. As an
alternative to rescission, Stamm Mortgage alleges that the Bank and GAMC
breached the Management Agreement by terminating it contrary to its terms,
resulting in $9.6 million in lost profits to Stamm Mortgage. Stamm Mortgage and
Mr. Stamm both allege that the company, the bank, GMAC, and Mr. Amos, acting in
his official capacity, defamed Stamm Mortgage and Mr. Stamm through certain
public statements made in press releases and in public securities filings by the
company and seek $1.0 million in compensatory damages and $350,000 in punitive
damages.
The company, on behalf of itself, the bank, GAMC, and Mr. Amos believes
all alleged claims are without merit and intends to defend vigorously against
them, and on December 29, 2006, Counsel for the company, the bank, GAMC and Mr.
Amos filed an Answering Statement and Counterclaim in Arbitration.
30
ITEM 1A. Risk Factors
OUR INCREASED EMPHASIS ON COMMERCIAL AND CONSTRUCTION LENDING MAY EXPOSE US TO
INCREASED LENDING RISKS.
At June 30, 2006, our loan portfolio consisted of $27.4 million, or
13.99% of commercial real estate loans, $28.0 million, or 14.31% of construction
and land development loans and $32.6 million, or 16.66% of commercial business
loans. We intend to increase our emphasis on these types of loans. These types
of loans generally expose a lender to greater risk of non-payment and loss than
one-to-four-family residential mortgage loans because repayment of the loans
often depends on the successful operation of the property, the income stream of
the borrowers and, for construction loans, the accuracy of the estimate of the
property's value at completion of construction and the estimated cost of
construction. Such loans typically involve larger loan balances to single
borrowers or groups of related borrowers compared to one- to four-family
residential mortgage loans. Commercial business loans expose us to additional
risks since they typically are made on the basis of the borrower's ability to
make repayments from the cash flow of the borrower's business and are secured by
non-real estate collateral that may depreciate over time. In addition, since
such loans generally entail greater risk than one- to four-family residential
mortgage loans, we may need to increase our allowance for loan losses in the
future to account for the likely increase in probable incurred credit losses
associated with the growth of such loans. Also, many of our commercial and
construction borrowers have more than one loan outstanding with us.
Consequently, an adverse development with respect to one loan or one credit
relationship can expose us to a significantly greater risk of loss compared to
an adverse development with respect to a one- to four-family residential
mortgage loan.
STRONG COMPETITION WITHIN OUR MARKET AREA COULD HURT OUR ABILITY TO COMPETE AND
COULD SLOW OUR GROWTH.
We face intense competition both in making loans and attracting
deposits. This competition has made it more difficult for us to make new loans
and has occasionally forced us to offer higher deposit rates. Price competition
for loans and deposits might result in us earning less on our loans and paying
more on our deposits, which reduces net interest income. Some of the
institutions with which we compete have substantially greater resources and
lending limits than we have and may offer services that we do not provide. We
expect competition to increase in the future as a result of legislative,
regulatory and technological changes and the continuing trend of consolidation
in the financial services industry. Our profitability depends upon our continued
ability to compete successfully in our market area.
AN INCREASE IN LOAN PREPAYMENTS AND ON PREPAYMENT OF LOANS UNDERLYING
MORTGAGE-BACKED SECURITIES AND SMALL BUSINESS ADMINISTRATION CERTIFICATES MAY
ADVERSELY AFFECT OUR PROFITABILITY.
Prepayment rates are affected by consumer behavior, conditions in the
housing and financial markets, general economic conditions and the relative
interest rates on fixed-rate and adjustable-rate mortgage loans. Although
changes in prepayment rates are, therefore, difficult for us to predict,
prepayment rates tend to increase when market interest rates decline relative to
the rates on the prepaid instruments.
We recognize our deferred loan origination costs and premiums paid on
originating these loans by adjusting our interest income over the contractual
life of the individual loans. As prepayments occur, the rate at which net
deferred loan origination costs and premiums are expensed accelerates. The
effect of the acceleration of deferred costs and premium amortization may be
mitigated by prepayment penalties paid by the borrower when the loan is paid in
full within a certain period of time, which varies between loans. If prepayment
occurs after the period of time when the loan is subject to a prepayment
penalty, the effect of the acceleration of premium and deferred cost
amortization is no longer mitigated.
We recognize premiums we pay on mortgage-backed securities and Small
Business Administration Certificates as an adjustment to interest income over
the life of the security based on the rate of repayment of the securities.
Acceleration of prepayment on the loans underlying a mortgage-backed security or
Small Business Administration Certificate shortens the life of the security,
increases the rate at which premiums are expensed and further reduces interest
income.
We may not be able to reinvest loan and security prepayments at rates
comparable to the prepaid instruments particularly in periods of declining
interest rates.
31
WE OPERATE IN A HIGHLY REGULATED ENVIRONMENT AND WE MAY BE ADVERSELY AFFECTED BY
CHANGES IN LAWS AND REGULATIONS.
The bank is subject to extensive regulation, supervision and
examination by the Office of Thrift Supervision and by the Federal Deposit
Insurance Corporation, as insurer of its deposits. Such regulation and
supervision govern the activities in which the bank and the company may engage,
and are intended primarily for the protection of the insurance fund and for the
depositors and borrowers of the bank. The regulation and supervision by the
Office of Thrift Supervision and the Federal Deposit Insurance Corporation are
not intended to protect the interests of investors in the common stock of the
company. Regulatory authorities have extensive discretion in their supervisory
and enforcement activities, including the imposition of restrictions on our
operations, the classification of our assets and determination of the level of
our allowance for loan losses. Any change in such regulation and oversight,
whether in the form of regulatory policy, regulations, legislation or
supervisory action, may have a material impact on our operations.
A BREACH OF INFORMATION SECURITY COULD NEGATIVELY AFFECT OUR EARNINGS.
Increasingly, we depend upon data processing, communication and
information exchange on a variety of computing platforms and networks and over
the Internet. We cannot be certain all our systems are entirely free from
vulnerability to attack, despite safeguards we have instituted. In addition, we
rely on the services of a variety of vendors to meet data processing and
communication needs. If information security is breached, information can be
lost or misappropriated, resulting in financial loss or costs to us or damages
to others. These costs or losses could materially exceed the amount of insurance
coverage, if any, which would adversely affect our earnings.
WE ARE SUBJECT TO HEIGHTENED REGULATORY SCRUTINY WITH RESPECT TO BANK SECRECY
AND ANTI-MONEY LAUNDERING STATUTES AND REGULATIONS.
Recently, regulators have intensified their focus on the USA PATRIOT
Act's anti-money laundering and Bank Secrecy Act compliance requirements. There
is also increased scrutiny of our compliance with the rules enforced by the
Office of Foreign Assets Control. In order to comply with regulations,
guidelines and examination procedures in this area, we have been required to
adopt new policies and procedures and to install new systems. We cannot be
certain that the policies, procedures and systems we have in place are flawless.
Therefore, there is no assurance that in every instance we are in full
compliance with these requirements.
FAILURE TO PAY INTEREST ON OUR DEBT MAY ADVERSELY IMPACT US.
Deferral of interest payments where allowed on our convertible
preferred securities may affect our ability to issue additional debt.
32
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
Not applicable.
ITEM 6. Exhibits
(a) Exhibits
31.1 Certification of Chief Executive Officer pursuant to Section 302
of Sarbanes-Oxley Act of 2002
31.2 Certification of Chief Financial Officer pursuant to Section 302
of Sarbanes-Oxley Act of 2002
32.1 Certification of Chief Executive Officer pursuant to Section 906
of Sarbanes-Oxley Act of 2002
32.2 Certification of Chief Financial Officer pursuant to Section 906
of Sarbanes-Oxley Act of 2002
33
GREATER ATLANTIC FINANCIAL CORP.
SIGNATURES
Pursuant to the requirement of the Securities and Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
GREATER ATLANTIC FINANCIAL CORP.
--------------------------------
(Registrant)
By: /s/ Carroll E. Amos
-------------------
Carroll E. Amos
President and Chief Executive Officer
By: /s/ David E. Ritter
-------------------
David E. Ritter
Senior Vice President and Chief Financial Officer
Date: January 12, 2007