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 March 31, 2008
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 [ X ] No [ ]
Indicate by check mark whether the Registrant is a large accelerated filer, an
accelerated filer, or a non-accelerated filer. See definition of "accelerated
filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check
one):
Large accelerated filer [__] Accelerated filer [__] Non-accelerated filer [__]
Smaller Reporting Company [ 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 May 12, 2008 there were 3,024,220 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 MARCH 31, 2008
TABLE OF CONTENTS
PART I. FINANCIAL INFORMATION PAGE NO.
- ------------------------------ --------
Item 1. Condensed Financial Statements (Unaudited)
Consolidated Statements of Financial Condition at March 31, 2008 and September 30, 2007...........................3
Consolidated Statements of Operations
for the three and six months ended March 31, 2008 and March 31, 2007..............................................4
Consolidated Statements of Comprehensive Income (Loss)
for the three and six months ended March 31, 2008 and March 31, 2007..............................................5
Consolidated Statements of Changes in Stockholders' Equity
for the six months ended March 31, 2008 and March 31, 2007........................................................5
Consolidated Statements of Cash Flows
for the six months ended March 31, 2008 and March 31, 2007........................................................6
Notes to Consolidated Financial Statements........................................................................8
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.......................14
Item 3. Quantitative and Qualitative Disclosures about Market Risk..................................................28
Item 4T. Controls and Procedures.....................................................................................30
PART II. OTHER INFORMATION
- ---------------------------
Item 1. Legal Proceedings...........................................................................................30
Item 1A. Risk Factors................................................................................................30
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
2
GREATER ATLANTIC FINANCIAL CORP.
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION (UNAUDITED)
March 31, September 30,
----------------------------------
2008 2007
------------------------------------------------------------------------------------------------------------
(Dollars in Thousands) (Unaudited)
Assets
Cash and cash equivalents:
Non-interest bearing and vault $ 2,408 $ 3,146
Interest bearing 14,874 4,486
Investment securities
Available-for-sale 42,201 48,910
Held-to-maturity 2,720 3,053
Loans receivable, net 159,724 176,108
Accrued interest and dividends receivable 1,319 1,675
Deferred income taxes 1,480 2,096
Federal Home Loan Bank stock, at cost 1,640 1,731
Premises and equipment, net 2,093 2,285
Goodwill 956 956
Prepaid expenses and other assets 1,005 1,548
------------------------------------------------------------------------------------------------------------
Total assets $230,420 $245,994
============================================================================================================
Liabilities and Stockholders' equity
Liabilities
Deposits $188,805 $197,991
Advance payments from borrowers for taxes and insurance 269 229
Accrued expenses and other liabilities 1,938 1,601
Income taxes payable 16 36
Advances from the FHLB and other borrowings 26,732 27,192
Junior subordinated debt securities 9,379 9,374
------------------------------------------------------------------------------------------------------------
Total liabilities 227,139 236,423
------------------------------------------------------------------------------------------------------------
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; 3,024,220 shares outstanding 30 30
Additional paid-in capital 25,273 25,273
Accumulated deficit (20,260) (14,408)
Accumulated other comprehensive loss (1,762) (1,324)
------------------------------------------------------------------------------------------------------------
Total stockholders' equity 3,281 9,571
------------------------------------------------------------------------------------------------------------
Total liabilities and stockholders' equity $230,420 $245,994
============================================================================================================
See accompanying notes to consolidated financial statements
3
GREATER ATLANTIC FINANCIAL CORP.
CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
Three Months Ended Six Months Ended
March 31, March 31,
- -----------------------------------------------------------------------------------------------------------------------------
(Dollars in Thousands, Except Per Share Data) 2008 2007 2008 2007
- -----------------------------------------------------------------------------------------------------------------------------
Interest income
Loans $ 2,697 $ 3,651 $ 5,807 $ 7,322
Investments 727 943 1,496 2,077
- -----------------------------------------------------------------------------------------------------------------------------
Total interest income 3,424 4,594 7,303 9,399
- -----------------------------------------------------------------------------------------------------------------------------
Interest expense
Deposits 1,862 2,187 3,892 4,426
Borrowed money 541 712 1,112 1,474
- -----------------------------------------------------------------------------------------------------------------------------
Total interest expense 2,403 2,899 5,004 5,900
- -----------------------------------------------------------------------------------------------------------------------------
Net interest income 1,021 1,695 2,299 3,499
Provision for loan losses 2,688 145 2,790 293
- -----------------------------------------------------------------------------------------------------------------------------
Net interest income after provision for loan losses (1,667) 1,550 (491) 3,206
- -----------------------------------------------------------------------------------------------------------------------------
Noninterest income
Fees and service charges 134 155 274 307
Loss on derivatives (14) (13) (28) (33)
Other operating income 7 6 17 11
- -----------------------------------------------------------------------------------------------------------------------------
Total noninterest income 127 148 263 285
- -----------------------------------------------------------------------------------------------------------------------------
Noninterest expense
Compensation and employee benefits 887 1,175 1,831 2,441
Occupancy 329 344 653 687
Professional services 678 323 860 722
Advertising 10 45 28 69
Deposit insurance premium 118 7 264 30
Furniture, fixtures and equipment 109 137 214 267
Data processing 210 233 435 452
Other operating expenses 241 258 454 539
- -----------------------------------------------------------------------------------------------------------------------------
Total noninterest expense 2,582 2,522 4,739 5,207
- -----------------------------------------------------------------------------------------------------------------------------
Loss before income tax provision (4,122) (824) (4,967) (1,716)
Provision for income taxes - increase in deferred tax assets
valuation allowances 885 - 885 -
- -----------------------------------------------------------------------------------------------------------------------------
Net loss $ (5,007) $ (824) $ (5,852) $ (1,716)
=============================================================================================================================
Loss per common share
BASIC AND DILUTED:
Basic $ (1.66) $ (0.27) $ (1.93) $ (0.57)
Diluted (1.66) (0.27) (1.93) (0.57)
Weighted average common shares outstanding
Basic and diluted 3,024,220 3,023,911 3,024,220 3,022,590
See accompanying notes to consolidated financial statements
4
GREATER ATLANTIC FINANCIAL CORP.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) (UNAUDITED)
Three months ended Six months ended
March 31, March 31,
- -----------------------------------------------------------------------------------------------------------------
(In Thousands) 2008 2007 2008 2007
- -----------------------------------------------------------------------------------------------------------------
Net (loss) earnings $ (5,007) $ (824) $ (5,852) $ (1,716)
- -----------------------------------------------------------------------------------------------------------------
Other comprehensive (loss) income, net of tax
Unrealized (loss) gain on securities (349) (60) (438) 56
- -----------------------------------------------------------------------------------------------------------------
Other comprehensive (loss) income (349) (60) (438) 56
- -----------------------------------------------------------------------------------------------------------------
Comprehensive loss $ (5,356) $ (884) $ (6,290) $ (1,660)
=================================================================================================================
GREATER ATLANTIC FINANCIAL CORP.
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (UNAUDITED)
FOR THE SIX MONTHS ENDED MARCH 31, 2008 AND 2007
- ----------------------------------------------------------------------------------------------------------------------------
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, 2006 $- $ 30 $ 25,228 $ (15,359) $ (1,049) $ 8,850
Stock Option Expense 22 22
Other comprehensive income - - - - 56 56
Net loss for the period - - - (1,716) - (1,716)
- ----------------------------------------------------------------------------------------------------------------------------
Balance at March 31, 2007 $- $ 30 $ 25,250 $ (17,075) $ (993) $ 7,212
============================================================================================================================
Balance at September 30, 2007 $- $ 30 $ 25,273 $ (14,408) $ (1,324) $ 9,571
Other comprehensive loss - - - - (438) (438)
Net loss for the period - - - (5,852) - (5,852)
- ----------------------------------------------------------------------------------------------------------------------------
Balance at March 31, 2008 $- $ 30 $ 25,273 $ (20,260) $ (1,762) $ 3,281
============================================================================================================================
See accompanying notes to consolidated financial statements
5
GREATER ATLANTIC FINANCIAL CORP.
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
Six months ended March 31,
------------------------------
2008 2007
- ----------------------------------------------------------------------------------------------------------------
(In Thousands)
Cash flow from operating activities
Net loss $ (5,852) $(1,716)
Adjustments to reconcile net loss to net cash provided by
(used in) operating activities
Provision for loan loss 2,790 293
Amortization of deferred loan acquisition cost, net 3 (25)
Depreciation and amortization 191 228
Loss from derivatives 28 33
Amortization of investment security premiums 203 363
Amortization of mortgage-backed securities premiums 91 214
Amortization of deferred fees (131) (178)
Decrease in deferred tax asset 885 -
Discount accretion net of premium amortization 168 (145)
Amortization of convertible preferred stock costs 5 4
(Increase) decrease in assets
Accrued interest and dividend receivable 356 251
Prepaid expenses and other assets 495 351
Deferred loan fees collected, net of deferred costs incurred 208 260
Increase (decrease) in liabilities
Accrued expenses and other liabilities 356 (477)
Income taxes payable (20) -
- ----------------------------------------------------------------------------------------------------------------
Net cash used in operating activities (224) (544)
- ----------------------------------------------------------------------------------------------------------------
Continued
6
GREATER ATLANTIC FINANCIAL CORP.
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) - (CONTINUED)
Six months ended March 31,
----------------------------
2008 2007
- ------------------------------------------------------------------------------------------------------------
(In Thousands)
Cash flow from investing activities
Net decrease in loans $13,347 $10,161
Disposal (purchase) of premises and equipment, net - (24)
Proceeds from repayments of other investment securities 2,584 6,224
Proceeds from repayments of mortgage-backed securities 3,458 8,032
Purchases of FHLB stock - (653)
Proceeds from sale of FHLB stock 91 837
- ------------------------------------------------------------------------------------------------------------
Net cash provided by investing activities 19,480 24,577
- ------------------------------------------------------------------------------------------------------------
Cash flow from financing activities
Net decrease in deposits (9,186) (3,547)
Net decrease in advances from the FHLB and other borrowings (460) (15,620)
Increase in advance payments by borrowers
for taxes and insurance 40 120
- ------------------------------------------------------------------------------------------------------------
Net cash used in financing activities (9,606) (19,047)
- ------------------------------------------------------------------------------------------------------------
Increase in cash and cash equivalents 9,650 4,986
- ------------------------------------------------------------------------------------------------------------
Cash and cash equivalents, at beginning of period 7,632 19,804
- ------------------------------------------------------------------------------------------------------------
Cash and cash equivalents, at end of period $17,282 $24,790
============================================================================================================
See accompanying notes to consolidated financial statements
7
GREATER ATLANTIC FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
INFORMATION AS OF MARCH 31, 2008 AND THREE AND SIX MONTHS ENDED
MARCH 31, 2008 AND 2007 (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") 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 (the "SEC") with respect to interim financial reporting. It
is recommended that these consolidated financial statements be read in
conjunction with the company's Annual Report on Form 10-K for the year ended
September 30, 2007. The results of operations for the three or the six months
ended March 31, 2008 are not necessarily indicative of the results of operations
that may be expected for the year ending September 30, 2008 or any future
periods. In addition, other reclassifications have been made to prior periods to
place them on a basis comparable with the current period presentation.
(2) PROPOSED ACQUISITION
As previously reported in a Form 8-K filed on April 16, 2007, we
announced that the company and Summit Financial Group, Inc. ("Summit"), entered
into a definitive agreement for the company to merge with and into Summit. We
also announced that the bank and Bay-Vanguard Federal Savings Bank entered into
a definitive agreement for Bay-Vanguard to purchase the bank's branch office in
Pasadena, Maryland. The sale of the Pasadena branch office was established as a
condition to the completion of the pending merger of the company with and into
Summit.
Originally the merger was expected to be completed in the fourth
calendar quarter of 2007; however, as reported in a Form 8-K filed on December
10, 2007, effective December 6, 2007, the company and Summit amended their
agreement to implement the parties' agreement to extend to March 31, 2008, the
date on which the agreement may be terminated if the merger is not consummated
by that date, subject to regulatory and shareholder approvals. In a Form 8-K
filed on March 26, 2008 we announced that our shareholders overwhelmingly
approved the terms and conditions of the proposed merger of Greater Atlantic
with and into Summit. On April 9, 2008, the company announced that it had
received written notice from Summit that Summit had exercised its right to
terminate the agreement for the company to merge with and into Summit. Greater
Atlantic and Summit have initiated negotiations towards entering into a new
definitive agreement. However, no assurances can be given that the negotiations
will lead to the parties entering into a new definitive agreement.
8
GREATER ATLANTIC FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
INFORMATION AS OF MARCH 31, 2008 AND THREE AND SIX MONTHS ENDED
MARCH 31, 2008 AND 2007 (UNAUDITED)
(3) LOAN IMPAIRMENT AND LOAN LOSSES
In accordance with guidance in the Statements of Financial Accounting
Standards Nos. 114 and 118, the company conducts a quarterly analysis 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 (also see page 20 for discussion of non-performing loans):
At or for the six months
ended March 31,
------------------------------------
2008 2007
- ---------------------------------------------------------------------------------------------
(Dollars in Thousands)
Balance at beginning of period $ 2,305 $ 1,330
Provisions 2,790 293
Total charge-offs (2,824) (327)
Total recoveries 14 626
- ---------------------------------------------------------------------------------------------
Net recoveries (charge-offs) (2,810) 299
- ---------------------------------------------------------------------------------------------
Balance at end of period $ 2,285 $ 1,922
=============================================================================================
Ratio of net charge-offs (recoveries) during the period
to average loans outstanding during the period 1.66% (0.16)%
=============================================================================================
Allowance for loan losses to total non-performing
loans at end of period 99.43% 118.13%
=============================================================================================
Allowance for loan losses to total loans 1.40% 1.02%
=============================================================================================
The company considers a loan to be impaired if it is probable that it
will be unable to collect all amounts due (both principal and interest)
according to the contractual terms of the loan agreement. When a loan is deemed
impaired, the company computes the present value of the loan's future cash
flows, discounted at the effective interest rate. As an alternative, creditors
may account for impaired loans at the fair value of the collateral or at the
observable market price of the loan if one exists. If the present value is less
than the carrying value of the loan, a valuation allowance is recorded. For
collateral dependent loans, to measure impairment, the company uses the fair
value of the collateral, less estimated costs to sell on a discounted basis.
Our total recorded investment in impaired loans at March 31, 2008 was
$2.2 million compared to $1.3 million at March 31, 2007. The related allowance
associated with those impaired loans at March 31, 2008 was $1.5 million compared
to an allowance of $500,000 at March 31, 2007. At March 31, 2008 and 2007, all
impaired loans had a related allowance. We recognize interest collected on these
loans on a cost-recovery or cash-basis method. The amount of interest income
recognized during the time that those loans were impaired amounted to $110,000
(4) 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 was
required.
On December 19, 2006, the company issued a news release announcing that
the first quarter distribution on the Greater Atlantic Capital Trust I 6.50%
Cumulative Convertible Trust Preferred Securities scheduled for December 31,
2006, as well as future distributions on the Trust Preferred Securities, would
be deferred. The announcement by the company followed advice received by the
bank that the Office of Thrift Supervision would not approve the bank's
application to pay a cash dividend to the company. Accordingly, the company
exercised its right to defer the payment of interest on its 6.50% Convertible
Junior Subordinated Debentures Due 2031 related to the Trust Preferred
Securities, for an indefinite period (which continues, but can be no longer than
20 consecutive quarterly periods).
9
GREATER ATLANTIC FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
INFORMATION AS OF MARCH 31, 2008 AND THREE AND SIX MONTHS ENDED
MARCH 31, 2008 AND 2007 (UNAUDITED)
On April 29, 2008, the company issued a news release announcing that
the bank, its wholly-owned subsidiary, consented to the issuance by the Office
of Thrift Supervision (the "OTS") of a Cease and Desist Order effective April
25, 2008 (the "Order").
The Order requires the bank to, among other things, report, within
prescribed time periods to the OTS Regional Director for the Southeast Region
(the "Regional Director") on the status of the ongoing merger negotiations with
Summit; have, at June 30, 2008, and maintain a Tier One (Core) Capital Ratio of
at least 6% and a total risk based capital ratio of at least 12%; develop a
comprehensive long term operating strategy to be implemented if the proposed
merger with Summit is not consummated; incorporate the long term operating
strategy into a three-year business plan containing at a minimum the
requirements set forth in the Order; cease, effective immediately, making
commercial real estate loans, commercial loans and loans on raw land without the
prior written approval of the Regional Director, except for such loans as to
which the bank has a legally binding written commitment to lend as of the
effective date of the Order, and reduce its exposure to concentrations in those
types of loans, cease, effective immediately, accepting brokered deposits; and
prohibits the payment of dividends or other capital distributions.
In addition, the Order requires the bank's board of directors to take
action with respect to credit administration, reducing classified assets and
accounting system controls and to establish a regulatory compliance committee of
three or more non-employee directors to monitor and coordinate compliance with
the provisions of the Order and provide the board of directors with progress
reports on compliance, which reports are to be transmitted by the board of
directors of the bank to the Regional Director.
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% and an adequately capitalized financial institution is one with
Tier 1 leverage capital of 4%, Tier 1 risk-based capital of 4% and total
risk-based capital of 8%. At March 31, 2008, the bank was classified as a well
capitalized financial institution.
The following presents the bank's capital position at March 31, 2008:
- --------------------------------------------------------------------------------------------------------
Required
Percent to be
Required Well Actual Actual Surplus/
Balance Capitalized Balance Percent (Shortfall)
- --------------------------------------------------------------------------------------------------------
(Dollars in Thousands)
Leverage $11,569 5.00% $13,966 6.04% $2,397
Tier 1 Risk-based $ 9,335 6.00% $13,880 8.92% $4,545
Total Risk-based $15,559 10.00% $15,829 10.17% $ 270
========================================================================================================
The company's common stock is currently quoted on the Pink Sheets under
the symbol GAFC.PK.
(5) 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 for employees and warrants for 94,685 shares for 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 March 31,
2008, 209,333 options were outstanding and all the warrants had expired.
10
GREATER ATLANTIC FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
INFORMATION AS OF MARCH 31, 2008 AND THREE AND SIX MONTHS ENDED
MARCH 31, 2008 AND 2007 (UNAUDITED)
The following summary represents the activity under the Plan:
---------------------------------------------------------------------------------------------------------------
Weighted
Average
Weighted Remaining
Average Contractual
Number of Exercise Term
Options Price (in Years)
---------------------------------------------------------------------------------------------------------------
Balance outstanding and exercisable at September 30, 2006 253,000 $ 6.72 5.70
Options expired (7,500) $ 6.75
---------------------------------------------------------------------------------------------------------------
Balance outstanding and exercisable at September 30, 2007 245,500 $ 6.72 4.63
Options expired (36,167) $ 6.85
---------------------------------------------------------------------------------------------------------------
Balance outstanding and exercisable at March 31, 2008 209,333 $ 6.70 4.18
===============================================================================================================
The company has adopted the provisions of Statement of Financial
Accounting Standards No. 123R, "Share-Based Payment" ("SFAS 123R"), to measure
compensation cost for stock options effective after October 1, 2005. Prior to
its adoption, the company accounted for its options under APB 25 "Accounting for
Stock Issued to Employees" with the pro forma impact disclosed. As allowable
under SFAS 123R, the company used the Black-Scholes method to measure the
compensation cost of stock options granted in 2006 with the following
assumptions: risk-free interest rate of 4.88%, a dividend payout rate of zero,
and an expected option life of nine years. The volatility is 32%. Using those
assumptions, the fair value of stock options granted during fiscal 2006 was
$2.92. There were no options granted during the six months ended March 31, 2008
and 2007.
(6) 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 six months
ended March 31, 2008 and 2007 were the same, as the effect of the conversion of
preferred securities and the impact of the exercised stock options of 1,379,999
and 1,373,469 in the periods ended March 31, 2008 and 2007, respectively, were
excluded as they would have been anti-dilutive for those periods.
(7) RECENT ACCOUNTING STANDARDS
In September 2006, the FASB issued SFAS No. 157, "Fair Value
Measurements". This statement clarifies the definition of fair value,
establishes a framework for measuring fair value and expands the disclosures on
fair value measurements. SFAS No. 157 applies to other accounting pronouncements
that require or permit fair value measurements, the Board having previously
concluded in those accounting pronouncements that fair value is the relevant
measurement attribute. The Statement does not require any new fair value
measurements and is effective for financial assets and liabilities for fiscal
years beginning after November 15, 2007. In February 2008, the FASB approved the
issuance of FASB Staff Position (FSP) FAS 157-2. FSP FAS 157-2 defers the
effective date of SFAS No. 157 until January 1, 2009 for nonfinancial assets and
nonfinancial liabilities except those items recognized or disclosed at fair
value on an annual or more frequently recurring basis. We do not believe the
adoption of SFAS 157 will have a material impact on the consolidated financial
statements.
11
GREATER ATLANTIC FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
INFORMATION AS OF MARCH 31, 2008 AND THREE AND SIX MONTHS ENDED
MARCH 31, 2008 AND 2007 (UNAUDITED)
In February 2007, the FASB issued Statement of Financial Accounting
Standards No. 159, "The Fair Value Option for Financial Assets and Financial
Liabilities" (SFAS 159).This statement permits entities to choose to measure
many financial instruments and certain other items at fair value. The objective
of this Statement is to improve financial reporting by providing entities with
the opportunity to mitigate volatility in reported earnings caused by measuring
related assets and liabilities differently without having to apply complex hedge
accounting provisions. The fair value option established by this Statement
permits all entities to choose to measure eligible items at fair value at
specified election dates. A business entity shall report unrealized gains and
losses on items for which the fair value option has been elected in earnings at
each subsequent reporting date. The fair value option may be applied instrument
by instrument and is irrevocable. SFAS 159 is effective as of the beginning of
an entity's first fiscal year that begins after November 15, 2007. The company
is in the process of evaluating the impact SFAS 159 may have on its consolidated
financial statements.
In December 2007, the FASB issued SFAS No. 141 (R), "Business
Combinations", to create greater consistency in the accounting and financial
reporting of business combinations. SFAS 141 (R) requires a company to recognize
the assets acquired, the liabilities assumed, any contingent consideration to be
paid, and any noncontrolling interest in the acquired entity to be measured at
their fair values as of the acquisition date. SFAS 141 (R) also requires
companies to recognize and measure goodwill acquired in a business combination
or a gain from a bargain purchase and how to evaluate the nature and financial
effects of the business combination and to expense transaction costs when
incurred. SFAS No. 141(R) applies to fiscal years beginning after December 15,
2008 and is adopted prospectively. Earlier adoption is prohibited. This
statement will only apply to any acquisitions occurring after the effective
date.
In December 2007, the FASB issued SFAS No. 160, "Noncontrolling
Interests in Consolidated Financial Statements -- an amendment of ARB No. 51",
to establish accounting and reporting standards for the noncontrolling interest
in a subsidiary and for the deconsolidation of a subsidiary. SFAS 160 requires a
company to clearly identify and present ownership interests in subsidiaries held
by parties other than the company in the consolidated financial statements
within the equity section but separate from the company's equity. It also
requires that the amount of consolidated net income attributable to the parent
and to the noncontrolling interest be clearly identified and presented on the
face of the consolidated statement of income, that changes in ownership interest
be accounted for similarly, as equity transactions, and that, when a subsidiary
is deconsolidated, any retained noncontrolling equity investment in the former
subsidiary and the gain or loss on the deconsolidation of the subsidiary be
measured at fair value. SFAS No. 160 applies to fiscal years beginning after
December 15, 2008. Earlier adoption is prohibited. We have not determined the
effect, if any, the adoption of this statement will have on our results of
operations or financial position.
On March 20, 2008, the FASB issued SFAS No. 161, "Disclosures about
Derivative Instruments and Hedging Activities, an amendment of FASB Statement
No. 133" ("SFAS 161"). SFAS 161 provides for enhanced disclosures about how and
why an entity uses derivatives and how and where those derivatives and related
hedged items are reported in the entity's financial statements. SFAS 161 also
requires certain tabular formats for disclosing such information. SFAS 161 is
effective for fiscal years and interim periods beginning after November 15, 2008
with early application encouraged. SFAS 161 applies to all entities and all
derivative instruments and related hedged items accounted for under SFAS 133.
Among other things, SFAS 161 requires disclosures of an entity's objectives and
strategies for using derivatives by primary underlying risk and certain
disclosures about the potential future collateral or cash requirements as a
result of contingent credit-related features. The company is currently
evaluating the impact, if any, that the adoption of SFAS 161 will have on the
company's financial statements.
12
GREATER ATLANTIC FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
INFORMATION AS OF MARCH 31, 2008 AND THREE AND SIX MONTHS ENDED
MARCH 31, 2008 AND 2007 (UNAUDITED)
(8) 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 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 $9.3 million after deducting offering expenses. The company retained
approximately $1.3 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 (also see Note 4 Regulatory Matters).
To comply with FIN 46, the trust preferred subsidiary was
deconsolidated in 2004, and the related securities have been presented as
obligations of the company and titled "Junior Subordinated Debt Securities" in
the financial statements.
On December 19, 2006, the company issued a news release announcing that
the first quarter distribution on the Greater Atlantic Capital Trust I 6.50%
Cumulative Convertible Trust Preferred Securities scheduled for December 31,
2006, as well as future distributions on the Trust Preferred Securities, will be
deferred. The announcement by the company follows advice received by the bank
from the Office of Thrift Supervision that it would not approve the bank's
application to pay a cash dividend to the company.
Accordingly, the company exercised its right to defer the payment of
interest on its 6.50% Convertible Junior Subordinated Debentures Due 2031
related to the Trust Preferred Securities, for an indefinite period (which
continues, but can be no longer than 20 consecutive quarterly periods).
(9) DERIVATIVE FINANCIAL INSTRUMENTS
During fiscal years 2003 and 2002, the bank entered into various
interest rate caps that total $20 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 6.50% - 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 six months ended March 31, 2008 and 2007 the instruments
did not meet hedge accounting requirements. The statements of operations include
net losses of $28,000 and $33,000 for the six months ended March 31, 2008 and
2007, respectively.
13
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,
unless otherwise noted.
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, the bank, a federally chartered savings bank. The bank is a member
of the Federal Home Loan Bank ("FHLB") system and its deposits are insured up to
applicable limits by the Federal Deposit Insurance Corporation. We offer
traditional banking services to customers through the five branches of the bank
located throughout the greater Washington, D.C. metropolitan area and the
Shenandoah Valley.
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
fees from service charges on 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.
On February 22, 2006, the company announced that it had engaged Sandler
O'Neill & Partners, L.P. to advise on the financial aspects of the company's
review of its strategic options and assist the company in evaluating the
financial aspects of all strategic alternatives available. Subsequently, in a
Form 8-K filed on April 16, 2007, we announced that the company and Summit
entered into a definitive agreement for the company to merge with and into
Summit. We also announced that the bank and Bay-Vanguard Federal Savings Bank
entered into a definitive agreement for Bay-Vanguard to purchase the bank's
branch office in Pasadena, Maryland. The sale of the Pasadena branch office was
established as a condition to the completion of the pending merger of the
company with and into Summit, and was completed on August 24, 2007, with the
bank recognizing a gain of $4.3 million.
14
Originally the merger was expected to be completed in the fourth
calendar quarter of 2007; however, as reported in a Form 8-K filed on December
10, 2007, the company and Summit amended their agreement to extend to March 31,
2008, the date on which the agreement may be terminated if the merger is not
consummated by that date. In a Form 8-K filed on March 26, 2008 we announced
that our shareholders overwhelmingly approved the terms and conditions of the
proposed merger of Greater Atlantic with and into Summit. On April 9, 2008, the
company announced that it had received written notice from Summit that Summit
had exercised its right to terminate the agreement for the company to merge with
and into Summit. Greater Atlantic and Summit have initiated negotiations towards
entering into a new definitive agreement. However, no assurances can be given
that the negotiations will lead to the parties entering into a new definitive
agreement.
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 evaluation of the adequacy of the allowance for
loan losses.
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.
FINANCIAL CONDITION
At March 31, 2008 the company's total assets were $230.4 million,
compared to the $246.0 million held at September 30, 2007, representing a
decrease of 6.33%. The decrease resulted primarily from a decrease in investment
securities and loans receivable and was offset in part by an increase in
interest bearing deposits. The decline in the bank's overall asset size is
reflected in the consolidated statements of financial condition and statements
of operations as we continued to manage the bank's assets and liabilities to
maintain the bank in a well capitalized position.
Net loans receivable at March 31, 2008 were $159.7 million, a decrease
of $16.4 million or 9.30% from the $176.1 million held at September 30, 2007.
The decrease in loans consisted primarily of a decrease of $1.9 million in the
bank's consumer loan portfolio, coupled with a $302,000 decline in the bank's
single family loan portfolio. Because the bank's single family and consumer loan
portfolios consist primarily of adjustable-rate loans, with the current yield
curve, customers are refinancing away from adjustable-rate loans and into longer
term, fixed-rate loans or curtailing outstanding balances. Commercial business
loans decreased by $9.1 million, land loans decreased $3.6 million and
commercial real estate loans outstanding decreased by $1.9 million during the
period. Those decreases were offset in part by an increase of $448,000 in
construction loans. The increase in construction lending was primarily in the
single family residential sector of the market. The company anticipates that
lending in that area will slow as a result of the current slow pace of sales
occurring in the single family market.
15
At March 31, 2008, investment securities were $44.9 million, a decrease
of $7.1 million or 13.55% from the $52.0 million held at September 30, 2007. The
cash proceeds from the sale or payoff of investment securities were used to
reduce higher cost wholesale funding, including borrowings and wholesale
deposits.
Deposits at March 31, 2008 were $188.8 million, a decrease of $9.2
million from the $198.0 million held at September 30, 2007. Total deposits
decreased primarily due to a $4.6 million decline in our money fund accounts and
our reduced reliance on brokered deposits and wholesale deposits, which have a
higher cost. Those types of deposits have declined $5.8 million since September
30, 2007. While non-interest bearing now accounts and passbook accounts also
declined, those declines were partially offset by an increase of $2.3 million in
certificate of deposits which have been obtained through the bank's marketing
efforts and are at a lower cost than brokered and wholesale deposits.
COMPARISON OF RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED
MARCH 31, 2008 AND MARCH 31, 2007
NET INCOME. For the three months ended March 31, 2008, the company had
a net loss of $5.0 million or $1.66 per diluted share, compared to a net loss of
$824,000 or $0.27 per diluted share for the three months ended March 31, 2007.
The $4.2 million increase in the net loss over the comparable period one-year
ago was primarily the result of an increase in the provision for loan losses,
decreases in net interest income, non-interest income and increases in
non-interest expense and provision for income taxes. The provision for income
taxes of $885,000 is the result of increasing the allowance on the deferred tax
asset during the quarter. The ongoing net losses reported in the company's
Annual Report on Form 10-K for the year ended September 30, 2007 and for this
three month period, remain a consistent problem for management because the loan
production needed to maintain the retail branch network has not been attained,
and the bank is currently managing its assets and liabilities to maintain a well
capitalized status and effect a sale of the bank. Because of the bank's loans to
one borrower limit, and the current issuance by the Office of Thrift Supervision
of a Cease and Desist Order effective April 25, 2008 it cannot expand its
commercial loan portfolio and maintain a consistent level of outstanding loans
to larger customers. Those factors have caused and will cause earning assets to
decline, impacting earnings. Further, margin pressure from the yield curve also
presents a very challenging environment in which to seek to increase our net
interest margin.
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 March 31, 2008 2007 Amount %
- ---------------------------------------------------------------------------------------------------------------------
(Dollars in Thousands)
Interest income:
Loans $ 2,697 $ 3,651 $ (954) (26.13)%
Investments 727 943 (216) (22.91)
- ---------------------------------------------------------------------------------------------------------------------
Total 3,424 4,594 (1,170) (25.47)
- ---------------------------------------------------------------------------------------------------------------------
Interest expense:
Deposits 1,862 2,187 (325) (14.86)
Borrowings 541 712 (171) (24.02)
- ---------------------------------------------------------------------------------------------------------------------
Total 2,403 2,899 (496) (17.11)
- ---------------------------------------------------------------------------------------------------------------------
Net interest income $ 1,021 $ 1,695 $ (674) (39.76)%
=====================================================================================================================
16
The decrease in net interest income during the three months ended March
31, 2008, from the comparable period one year ago, resulted primarily from a
$45.2 million decrease in the bank's interest-earning assets coupled with
average interest-earning assets declining by $1.7 million more than the decline
in average interest-bearing liabilities. That decrease was coupled with a 69
basis point decrease in net interest margin (net interest income divided by
average interest-earning assets) from 2.51% for the three months ended March 31,
2007 to 1.82% for the three months ended March 31, 2008. The decrease in net
interest margin also resulted from the average cost on interest-bearing
liabilities decreasing by 2 basis points while the average yield on
interest-earning assets declined 71 basis points resulting in a change of 69
basis points.
The current interest rate environment has been a difficult one for most
financial institutions. We expect the interest rate environment to remain
challenging and we believe it will continue to have an impact on our net
interest margin and net interest rate spread. We also believe, however, that our
strategy of changing the balance sheet from one that was wholesale oriented, as
reflected in the company's former reliance on brokered and internet deposits, to
one which is more retail oriented, will benefit us over time. We believe that
change will position us to realize a benefit when the interest rate environment
improves. If market interest rates were to rise, given our asset sensitivity
position, we would also expect our net interest margin to improve. However, in a
declining rate environment our interest rate spread and our net interest income
would decline. The bank continues to monitor the markets and its interest rate
position to alleviate any material changes in net interest margin.
INTEREST INCOME. Interest income for the three months ended March 31,
2008 decreased $1.2 million compared to the three months ended March 31, 2007,
primarily as a result of a $45.2 million decrease in the average balances of
outstanding loans and investment securities. The decreases in those balances
were coupled with a decrease of 71 basis points in the average yield earned on
interest earning assets.
INTEREST EXPENSE. The $496,000 decrease in interest expense for the
three months ended March 31, 2008 compared to the 2007 period was principally
the result of a $43.5 million decrease in the average amount of deposits and
borrowings. That decrease in the average interest-bearing liabilities was
coupled with a 2 basis point decrease in the cost of funds on average deposits
and borrowings. The decrease in interest expense on deposits was primarily due
to a decrease of $26.4 million in average deposits, primarily reflecting the
sale of the Pasadena branch. That decrease was coupled with a 10 basis point
decrease in rates paid on deposits, primarily due to lower rates paid on
interest-bearing demand deposits and certificates and lower pricing on new and
renewed time deposits.
The decrease in interest expense on borrowings for the three months
ended March 31, 2008, when compared to the 2007 period, was principally the
result of a $17.1 million decrease in average borrowed funds, partially offset
by a 61 basis point increase in the cost of borrowed funds. The components
accountable for the decrease of $171,000 in interest expense on borrowings were
a $227,000 decrease relating to average volume, partially offset by a $56,000
increase relating to average cost.
17
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 MARCH 31,
--------------------------------------------------------------------------------
2008 2007
------------------------------------- ------------------------------------------
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 $ 83,519 $ 1,408 6.74% $ 93,062 $ 1,696 7.29%
Consumer loans 51,006 781 6.12 56,230 1,074 7.64
Commercial business loans 30,774 508 6.60 39,919 881 8.83
----------- ----------- ----------- ------------ ------------- -------------
Total loans 165,299 2,697 6.53 189,211 3,651 7.72
Investment securities 44,745 562 4.93 54,579 662 4.85
Mortgage-backed securities 14,520 175 4.82 25,979 281 4.33
----------- ----------- ----------- ------------ ------------- -------------
Total interest-earning assets 224,564 3,424 6.10 269,769 4,594 6.81
----------- ----------- ------------- -------------
Non-earning assets 10,909 11,119
----------- ------------
Total assets $ 235,473 $ 280,888
=========== ============
LIABILITIES AND STOCKHOLDERS'
EQUITY:
Interest-bearing liabilities:
Savings accounts $ 1,939 4 0.83 $ 3,233 7 0.87
Now and money market accounts 53,373 385 2.89 75,438 657 3.48
Certificates of deposit 124,168 1,473 4.75 127,228 1,523 4.79
----------- ----------- ----------- ------------ ------------- -------------
Total deposits 179,480 1,862 4.15 205,899 2,187 4.25
FHLB advances 25,000 374 5.98 38,378 505 5.26
Other borrowings 11,464 167 5.83 15,201 207 5.45
----------- ----------- ----------- ------------ ------------- -------------
Total interest-bearing liabilities 215,944 2,403 4.45 259,478 2,899 4.47
----------- ----------- ------------- -------------
Noninterest-bearing liabilities:
Noninterest-bearing demand deposits 9,013 11,473
Other liabilities 2,147 2,096
----------- ------------
Total liabilities 227,104 273,047
Stockholders' equity 8,369 7,841
----------- ------------
Total liabilities and
stockholders' Equity $ 235,473 $ 280,888
=========== ============
Net interest income $ 1,021 $ 1,695
=========== =============
Interest rate spread 1.65% 2.34%
=========== =============
Net interest margin 1.82% 2.51%
=========== =============
18
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
MARCH 31, 2008 COMPARED TO
MARCH 31, 2006
-----------------------------------------------
CHANGE ATTRIBUTABLE TO
-----------------------------------------------
VOLUME RATE TOTAL
-----------------------------------------------
(IN THOUSANDS)
Real estate loans $ (174) $ (114) $ (288)
Consumer loans (100) (193) (293)
Commercial business loans (202) (171) (373)
---------------- -------------- --------------
Total loans (476) (478) (954)
Investments (119) 9 (110)
Mortgage-backed securities (124) 18 (106)
---------------- -------------- --------------
Total interest-earning assets $ (719) $ (451) $ (1,170)
================ ============== ==============
Savings accounts $ (3) $ - $ (3)
Now and money market accounts (192) (80) (272)
Certificates of deposit (37) (13) (50)
---------------- -------------- --------------
Total deposits (232) (93) (325)
FHLB advances (176) 45 (131)
Other borrowings (51) 11 (40)
---------------- -------------- --------------
Total interest-bearing liabilities (459) (37) (496)
================ ============== ==============
Change in net interest income $ (260) $ (414) $ (674)
================ ============== ==============
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. Management then
looks at its classified assets, which are loans 30 days or more delinquent, and
classifies those loans as special mention, substandard or doubtful, based on the
performance of the loans. Those classified loans are then individually evaluated
for impairment. Those loans that are not individually evaluated are then
segmented by type and assigned a reserve percentage that reflects the industry
loss experience. The loans individually evaluated for impairment are measured by
either, the present value of expected future cash flows, the loans observable
market price, or the fair value of the collateral. 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 provision for loan losses in the
future. An increase in the 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 had contracted with an independent
outside third party to have its loan portfolio reviewed. The focus of their
review was to identify the extent of potential and actual risk in the bank's
commercial loan portfolio and in our underwriting and processing practices.
Observations made regarding the bank's portfolio risk are based upon review
evaluations, portfolio profiles and discussions with the operational staff,
including the line lenders and senior management. However, when we entered into
the definitive agreement for the company to merge with Summit, and based on the
due diligence performed by Summit, it was deemed unnecessary to continue such a
contract through the fiscal year ended September 30, 2007. However, since the
bank received the written notice from Summit that Summit exercised its right to
terminate the merger agreement, the bank has again contracted with an
independent outside third party to have its loan portfolio reviewed.
19
Non-performing assets amounted to $2.3 million or 1.00% of total assets
at March 31, 2008, a $700,000 increase from the $1.6 million or 0.57% of total
assets classified as non-performing at March 31, 2007. At March 31, 2008, assets
that were classified totaled $3.1 million, of which $148,000 were classified as
special mention, $1.1 million were classified as substandard and $1.9 million
were classified as doubtful. A $2.7 million provision for loan losses was
recorded during the three months ended March 31, 2008, compared to a provision
of $145,000 during the three months ended March 31, 2007. The $2.5 million
increase in the provision for loan losses from the year ago period resulted
primarily from the provision necessary for loan losses resulting from the
deterioration in the asset quality during the current period and provision
provided for the $1.5 million of loans receivable classified as doubtful. Credit
quality at the bank remains a concern, with a ratio of non-performing assets to
total assets of 1.00%, and with significant classified and past-due loans. Those
factors combined with expected credit exposure growth and deteriorating economic
conditions, may result in an increase in the allowance for loan losses resulting
in an increase in the provision for loan losses in future periods.
NON-INTEREST INCOME. Non-interest income decreased $21,000 during the
three months ended March 31, 2008, over the comparable three month period one
year ago. That decrease was primarily the result of a $21,000 decrease in
service fees on loans and deposits.
The following table presents a comparison of the components of
non-interest income.
Difference
------------------------------------
Three Months Ended March 31, 2008 2007 Amount %
- -------------------------------------------------------------------------------------------------------------------
(Dollars in Thousands)
Non-interest income:
Service fees on loans $ 35 $ 45 $ (10) (22.22)%
Service fees on deposits 99 110 (11) (10.00)
Loss on derivatives (14) (13) (1) (7.69)
Other operating income 7 6 1 16.67
- -------------------------------------------------------------------------------------------------------------------
Total non-interest income $ 127 $ 148 $ (21) (14.19)%
===================================================================================================================
NON-INTEREST EXPENSE. Non-interest expense increased $60,000 from $2.5
million for the three months ended March 31, 2007 to $2.6 million for the three
months ended March 31 in the current year. That increase was primarily the
result of a $355,000 increase in professional services and an increase of
$111,000 in the bank's deposit insurance premium. Those increases were partially
offset by decreases distributed over various non-interest expense categories
with the primary contributors being compensation and employee benefits,
advertising, furniture fixtures and equipment and data processing. The increase
in professional services resulted from the receipt of written notice that Summit
exercised its right to terminate the merger agreement. As a result, the bank
then had to recognize all professional services related to the merger.
The following table presents a comparison of the components of
non-interest expense.
Difference
---------------------------------
Three Months Ended March 31, 2008 2007 Amount %
- ---------------------------------------------------------------------------------------------------------------------
(Dollars in Thousands)
Non-interest expense:
Compensation and employee benefits $ 887 $ 1,175 $ (288) (24.51)%
Occupancy 329 344 (15) (4.36)
Professional services 678 323 355 109.91
Advertising 10 45 (35) (77.78)
Deposit insurance premium 118 7 111 1,585.71
Furniture, fixtures and equipment 109 137 (28) (20.44)
Data processing 210 233 (23) (9.87)
Other operating expense 241 258 (17) (6.59)
- ---------------------------------------------------------------------------------------------------------------------
Total non-interest expense $ 2,582 $ 2,522 $ 60 2.38 %
=====================================================================================================================
20
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. Due to our operating losses, we did not record a provision
for current income taxes for the three months ended March 31, 2008 or 2007.
However the bank had to reduce its net deferred tax asset by $885,000 for the
quarter ended March 31, 2008. That reduction in deferred tax asset resulted from
the reduction in capital the company has sustained as a result of the provision
for loan losses recorded during the quarter and quarterly operating losses.
These losses have occurred and are continuing to occur as the bank delays the
implementation of stand alone strategies in anticipation of completing a sale of
the bank. In its cease and desist order the OTS mandated a 6% core capital ratio
and a 12% total risk-based capital ratio. With the reduction in the capital
levels, and higher capital requirements, the bank has had to lower its future
earning asset growth, which in turn negatively impacts expected future earnings,
and had to reduce its net deferred tax asset.
Contractual Obligations and Off-Balance Sheet Financing Arrangements
The following table summarizes the bank's contractual obligations at
March 31, 2008 and the effect those obligations are expected to have on the
bank's liquidity and cash flows in future periods.
- -----------------------------------------------------------------------------------------------------------------
Less Than Two - Three Four - Five After Five
Total One Year Years Years Years
- -----------------------------------------------------------------------------------------------------------------
(In thousands)
FHLB Advances (1) $ 25,000 $ - $ 25,000 $ - $ -
Reverse repurchase agreements 1,732 1,732 - - -
Subordinated debt securities (2) 25,982 1,310 1,310 1,310 22,052
Operating leases 3,495 1,124 1,793 251 327
- -----------------------------------------------------------------------------------------------------------------
Total obligations $ 56,209 $ 4,166 $ 28,103 $ 1,561 $ 22,379
=================================================================================================================
(1) The company expects to refinance these short and medium-term
obligations under substantially the same terms and conditions.
(2) Includes principal and interest due on our junior subordinated debt
securities.
Other Commercial Commitments
- -----------------------------------------------------------------------------------------------------------------
Less Than Two - Three Four - Five After Five
Total One Year Years Years Years
- -----------------------------------------------------------------------------------------------------------------
(In Thousands)
Certificate of deposit maturities (1) $ 122,011 $ 110,112 $ 8,962 $ 2,844 $ 93
Loan originations 5,260 5,260 - - -
Unfunded lines of credit (2) 107,403 107,403 - - -
Standby letters of credit 255 255 - - -
- -----------------------------------------------------------------------------------------------------------------
Total $ 234,929 $ 223,030 $ 8,962 $ 2,844 $ 93
=================================================================================================================
(1) The company expects to retain maturing deposits or replace amounts
maturing with comparable certificates of deposit based on current
market interest rates.
(2) Revolving, open-end loans on one-four dwelling units and commercial
lines that mostly remain unfunded. The committed amount of these
lines total $169.0 million.
21
COMPARISON OF RESULTS OF OPERATIONS FOR THE SIX MONTHS ENDED
MARCH 31, 2008 AND MARCH 31, 2007
NET INCOME. For the six months ended March 31, 2008, the company had a
net loss of $5.9 million or $1.93 per diluted share, compared to a net loss of
$1.7 million or $0.57 per diluted share for the six months ended March 31, 2007.
The $4.2 million increase in the net loss over the comparable period one-year
ago was primarily the result of an increase in the provision for loan losses,
decreases in net interest income, non-interest income, an increase in provision
for income taxes and were offset by a decrease in non-interest expense. The
provision for income taxes of $885,000 is the result of increasing the allowance
on the deferred tax asset over the six months ended March 31, 2008. The ongoing
net losses reported in the company's Annual Report on Form 10-K for the year
ended September 30, 2007 and for this six month period, remain a consistent
problem for management because the loan production needed to maintain the retail
branch network has not been attained, and the bank is currently managing its
assets and liabilities to maintain a well capitalized status. Because of the
bank's loans to one borrower limit and the current issuance by the Office of
Thrift Supervision of a Cease and Desist Order effective April 25, 2008, it
cannot expand its commercial loan portfolio and maintain a consistent level of
outstanding loans to larger customers. Those factors have caused and will cause
earning assets to decline, impacting earnings. Further, margin pressure from the
yield curve also presents a challenging environment in which to seek to increase
our net interest margin.
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.
Difference
Net interest income from continuing operations -------------------------------
Six Months Ended March 31, 2008 2007 Amount %
- ---------------------------------------------------------------------------------------------------------------------
(Dollars in Thousands)
Interest income:
Loans $ 5,807 $ 7,322 $ (1,515) (20.69)%
Investments 1,496 2,077 (581) (27.97)
- ---------------------------------------------------------------------------------------------------------------------
Total 7,303 9,399 (2,096) (22.30)
- ---------------------------------------------------------------------------------------------------------------------
Interest expense:
Deposits 3,892 4,426 (534) (12.07)
Borrowings 1,112 1,474 (362) (24.53)
- ---------------------------------------------------------------------------------------------------------------------
Total 5,004 5,900 (896) (15.19)
- ---------------------------------------------------------------------------------------------------------------------
Net interest income $ 2,299 $ 3,499 $ (1,200) (34.30)%
=====================================================================================================================
The decrease in net interest income during the six months ended March
31, 2008, resulted primarily from a $47.2 million decrease in the bank's
interest-earning assets coupled with average interest-earning assets declining
by $2.3 million more than the decline in average interest-bearing liabilities.
That decrease was coupled with a 53 basis point decrease in net interest margin
(net interest income divided by average interest-earning assets) from 2.55% for
the six months ended March 31, 2007 to 2.02% for the six months ended March 31,
2008. The decrease in net interest margin was also affected by the average yield
on interest-earning assets decreasing by 42 basis points and the increase of 10
basis points in the average cost on interest-bearing liabilities.
22
INTEREST INCOME. Interest income for the six months ended March 31,
2008 decreased $2.1 million compared to the six months ended March 31, 2007,
primarily as a result of a $47.2 million decrease in the average balances of
outstanding loans and investment securities. The decreases in those balances
were coupled with a decrease of 42 basis points in the average yield earned on
interest earning assets.
INTEREST EXPENSE. The $896,000 decrease in interest expense for the six
months ended March 31, 2008 compared to the 2007 period was principally the
result of a $44.9 million decrease in the average amount of deposits and
borrowings. That decrease in the average interest-bearing liabilities was
partially offset by a 10 basis point increase in the cost of funds on average
deposits and borrowings. The decrease in interest expense on deposits was
primarily due to a decrease of $27.0 million in average deposits, primarily due
to the sale of the Pasadena branch and was offset in part by a 5 basis point
increase in rates paid on deposits, primarily due to elevated pricing on new and
renewed time deposits.
The decrease in interest expense on borrowings for the six months ended
March 31, 2008, when compared to the 2007 period, was principally the result of
a $17.9 million decrease in average borrowed funds, partially offset by a 62
basis point increase in the cost of borrowed funds. The components accountable
for the decrease of $362,000 in interest expense on borrowings were a $479,000
decrease relating to average volume, partially offset by a $117,000 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 SIX MONTHS ENDED MARCH 31,
--------------------------------------------------------------------------------
2008 2007
------------------------------------- ------------------------------------------
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 $ 86,014 $ 2,948 6.85% $ 93,096 $ 3,414 7.33%
Consumer loans 51,124 1,694 6.63 57,867 2,254 7.79
Commercial business loans 32,339 1,165 7.20 39,735 1,654 8.33
------------ --------- --------- ------------ ----------- ------------
Total loans 169,477 5,807 6.85 190,698 7,322 7.68
Investment securities 42,484 1,094 5.15 55,874 1,461 5.23
Mortgage-backed securities 15,268 402 5.27 27,841 616 4.43
------------ --------- --------- ------------ ----------- ------------
Total interest-earning assets 227,229 7,303 6.43 274,413 9,399 6.85
--------- --------- ----------- ------------
Non-earning assets 11,286 11,396
-------------- -------------
Total assets $ 238,515 $ 285,809
============== =============
LIABILITIES AND STOCKHOLDERS'
EQUITY:
Interest-bearing liabilities:
Savings accounts $ 2,006 9 0.90 $ 3,193 15 0.94
Now and money market accounts 54,841 851 3.10 77,408 1,368 3.53
Certificates of deposit 124,368 3,032 4.88 127,613 3,043 4.77
------------ --------- --------- ------------ ----------- ------------
Total deposits 181,215 3,892 4.30 208,214 4,426 4.25
FHLB advances 25,673 768 5.98 37,609 1,001 5.32
Other borrowings 11,619 344 5.92 17,610 473 5.37
------------ --------- --------- ------------ ----------- ------------
Total interest-bearing liabilities 218,507 5,004 4.58 263,433 5,900 4.48
--------- --------- ----------- ------------
Noninterest-bearing liabilities:
Noninterest-bearing demand deposits 9,046 11,901
Other liabilities 2,037 2,167
-------------- -------------
Total liabilities 229,590 277,501
Stockholders' equity 8,925 8,308
-------------- -------------
Total liabilities and
stockholders' Equity $ 238,515 $ 285,809
============== =============
Net interest income $ 2,299 $ 3,499
============ ==============
Interest rate spread 1.85% 2.37%
=============== ==============
Net interest margin 2.02% 2.55%
=============== ==============
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.
SIX MONTHS ENDED
MARCH 31, 2008 COMPARED TO
MARCH 31, 2007
-----------------------------------------------
CHANGE ATTRIBUTABLE TO
-----------------------------------------------
VOLUME RATE TOTAL
-----------------------------------------------
(IN THOUSANDS)
Real estate loans $ (260) $ (206) $ (466)
Consumer loans (263) (297) (560)
Commercial business loans (308) (181) (489)
---------------- -------------- --------------
Total loans (831) (684) (1,515)
Investments (350) (17) (367)
Mortgage-backed securities (278) 64 (214)
---------------- -------------- --------------
Total interest-earning assets $ (1,459) $ (637) $(2,096)
================ ============== ==============
Savings accounts $ (6) $ - $(6)
Now and money market accounts (399) (118) (517)
Certificates of deposit (77) 66 (11)
---------------- -------------- --------------
Total deposits (482) (52) (534)
FHLB advances (318) 85 (233)
Other borrowings (161) 32 (129)
---------------- -------------- --------------
Total interest-bearing liabilities (961) 65 (896)
================ ============== ==============
Change in net interest income $ (498) $ (702) $(1,200)
================ ============== ==============
Non-performing assets amounted to $2.3 million or 1.00% of total assets
at March 31, 2008, a $700,000 increase from the $1.6 million, or 0.57% of total
assets, classified as non-performing at March 31, 2007. At March 31, 2008,
assets that were classified totaled $3.1 million, of which $148,000 were
classified as special mention, $1.1 million were classified as substandard and
$1.9 million were classified as doubtful. A $2.8 million provision for loan
losses was recorded during the six months ended March 31, 2008, compared to a
provision of $293,000 during the six months ended March 31, 2007. The $2.5
million increase in the provision for loan losses from the year ago period
resulted primarily from the provision necessary for loan losses resulting from
the deterioration in the asset quality during the current period and provision
provided for the $1.5 million of loans receivable classified as doubtful. Credit
quality at the bank remains a concern, with a ratio of non-performing assets to
total assets of 1.00%, and with significant classified and past-due loans. Those
factors combined with expected credit exposure growth and deteriorating economic
conditions, may result in an increase in the allowance for loan losses and an
increase in the provision for loan losses in future periods.
NON-INTEREST INCOME. Non-interest income decreased $22,000 during the
six months ended March 31, 2008, over the comparable six month period one year
ago. That decrease was primarily the result of a $33,000 decrease in service
fees on loans and deposits and a loss on derivatives.
25
The following table presents a comparison of the components of
non-interest income.
Difference
Non-interest income from continuing operations ------------------------------------
Six Months Ended March 31, 2008 2007 Amount %
- -------------------------------------------------------------------------------------------------------------------
(Dollars in Thousands)
Non-interest income:
Service fees on loans $ 73 $ 87 $ (14) (16.09)%
Service fees on deposits 201 220 (9) (4.09)
Gain (loss) on derivatives (28) (33) (5) (15.15)
Other operating income 17 11 6 54.55
- -------------------------------------------------------------------------------------------------------------------
Total non-interest income $ 263 $ 285 $ (22) (7.72)%
===================================================================================================================
NON-INTEREST EXPENSE. Non-interest expense decreased $468,000 from $5.2
million for the six months ended March 31, 2007 to $4.7 million for the six
months ended March 31 in the current year. That decrease was primarily the
result of a decrease of $840,000 in compensation and employee benefits,
occupancy, advertising, furniture fixtures and equipment, data processing and
other operating expense. Those decreases were partially offset by increases in
deposit insurance premium and professional services totaling $372,000. The
increase in professional services resulted from the receipt of written notice
that Summit exercised its right to terminate the merger agreement. As a result,
the bank then had to recognize all professional services related to the merger.
The following table presents a comparison of the components of
non-interest expense.
Difference
Non-interest expense from continuing operations ---------------------------------
Six Months Ended March 31, 2008 2007 Amount %
- ---------------------------------------------------------------------------------------------------------------------
(Dollars in Thousands)
Non-interest expense:
Compensation and employee benefits $ 1,831 $ 2,441 $ (610) (24.99)%
Occupancy 653 687 (34) (4.95)
Professional services 860 722 138 19.11
Advertising 28 69 (41) (59.42)
Deposit insurance premium 264 30 234 780.00
Furniture, fixtures and equipment 214 267 (53) (19.85)
Data processing 435 452 (17) (3.76)
Other operating expense 454 539 (85) (15.77)
- ---------------------------------------------------------------------------------------------------------------------
Total non-interest expense $ 4,739 $ 5,207 $ (468) (8.99)%
=====================================================================================================================
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 current income taxes for
the six months ended March 31, 2008 and 2007 due to our operating losses.
However the bank reduced its net deferred tax asset by $885,000 for the quarter
ended March 31, 2008, as a result of the reduction in capital because the
provision for loan losses recorded during the quarter and quarterly operating
losses that have occurred and are continuing to occur as the bank delays
implementation of a stand alone strategy. In addition the OTS issued an order
mandating a 6% core capital ratio and a 12% total risk-based capital ratio. With
the reduction in the capital levels, and higher capital requirements, the bank
has had to lower its earning asset growth. That in turn, negatively impacts
expected future earnings and required reduction of its deferred tax asset.
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 March 31, 2008, cash and cash equivalents, interest bearing deposits
and securities available-for-sale totaled $59.5 million or 25.82% 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 six months ended March 31, 2008, the bank's loan
originations totaled $33.7 million. The bank did not purchase any United States
Treasury or agency securities, mortgage-backed or mortgage related securities or
other investment securities during the six months ended March 31, 2008. All of
our investment securities are classified as either available for sale or held to
maturity and for the period ended March 31, 2008 were considered temporarily
impaired. The market value of our investment portfolio is obtained from various
third party brokerage firms and we believe our filing fairly quantifies the
value of those securities. The investments are debt securities that pay
principal and interest monthly to maturity until such time as principal is
repaid. The fluctuation in value of our portfolio is primarily the result of
changes in market rates rather than due to the credit quality of the issuer. The
unrealized loss in the bank's investment portfolio totaled $2.4 million at March
31, 2008. The company has the ability and liquidity to hold those securities
until such time as the value recovers or the securities mature.
The bank has other sources of liquidity if a need for additional funds
arises. At March 31, 2008, the bank had $25.0 million in advances outstanding
from the FHLB and had an additional overall borrowing capacity from the FHLB of
$9.7 million. Depending on market conditions, the pricing of deposit products
and the pricing of FHLB advances, the bank may rely on FHLB borrowings to fund
asset growth.
At March 31, 2008, the bank had commitments to fund loans of $4.1
million, unused outstanding lines of credit of $107.4 million, consisting
primarily of equity lines of credit, unused standby letters of credit of
$255,000 and undisbursed proceeds of construction mortgages of $1.2 million.
Unfunded lines of credit have remained relatively constant and have actually
decreased by $4.4 million during the six months ended March 31, 2008. 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 March 31, 2008, totaled $110.1
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.
27
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. 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.
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 will continue to attempt to
attract a greater proportion of short-term liabilities to 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. 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 mitigate further 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 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 March 31, 2008, we held an
aggregate notional value of $20 million of interest rate caps. None of the
interest rate caps had strike rates that were in effect at March 31, 2008, as
current LIBOR rates were below 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 deposit 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 December 31, 2007 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 19,614 -2,759 -12% 8.33% -94bp
+200 20,794 -1,579 -7% 8.75% -52bp
+100 21,642 -731 -3% 9.04% -23bp
0 22,373 - 9.27% -
-100 22,478 105 0% 9.27% 0bp
-200 22,297 -76 0% 9.16% 11bp
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 our 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 those assumptions
to be reasonable, there can be no assurance that assumed prepayment rates will
approximate actual future mortgage-backed security and loan repayment activity.
29
ITEM 4T. CONTROLS AND PROCEDURES.
The Company's management, including the Company's principal executive
officer and principal financial officer, have evaluated the effectiveness of the
Company's "disclosure controls and procedures," as such term is defined in Rule
13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended (the
"Exchange Act"). Based upon their evaluation, the principal executive officer
and principal financial officer concluded that, as of the end of the period
covered by this report, the Company's disclosure controls and procedures were
effective for the purpose of ensuring that the information required to be
disclosed in the reports that the Company files or submits under the Exchange
Act with the Securities and Exchange Commission (the "SEC") (1) is recorded,
processed, summarized and reported within the time periods specified in the
SEC's rules and forms, and (2) is accumulated and communicated to the Company's
management, including its principal executive and principal financial officers,
as appropriate to allow timely decisions regarding required disclosure. In
addition, based on that evaluation, no change in the Company's internal control
over financial reporting occurred during the quarter ended March 31, 2008 that
has materially affected, or is reasonably likely to materially affect, the
Company's internal control over financial reporting.
PART II. OTHER INFORMATION
ITEM 1. Legal Proceedings
Not applicable.
ITEM 1A. Risk Factors
OUR INCREASED EMPHASIS ON COMMERCIAL AND CONSTRUCTION LENDING MAY EXPOSE US TO
INCREASED LENDING RISKS.
At March 31, 2008, our loan portfolio consisted of $33.1 million, or
20.27% of commercial real estate loans, $12.2 million, or 7.46% of construction
and land development loans and $25.7 million, or 15.73% of commercial business
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.
30
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, difficult 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.
A DOWNTURN IN THE WASHINGTON D.C. METROPOLITAN AREA ECONOMY, A DECLINE IN REAL
ESTATE VALUES OR DISRUPTIONS IN THE SECONDARY MORTGAGE MARKETS COULD REDUCE OUR
EARNINGS AND FINANCIAL CONDITION.
Most of our loans are secured by real estate. As a result, a downturn in
this market area could cause significant increases in nonperforming loans, which
would reduce our profits. Additionally, a decrease in asset quality could
require additions to our allowance for loan losses through increased provisions
for loan losses, which would also reduce our profits. In prior years, there had
been significant increases in real estate values in our market area. As a result
of rising home prices, our loans have been well collateralized. However, a
decline in real estate values could cause some of our mortgage loans to become
inadequately collateralized, which would expose us to a greater risk of loss.
The secondary mortgage markets are experiencing disruptions resulting from
reduced investor demand for mortgage loans and mortgaged-backed securities and
increased investor yield requirements for those loans and securities. Those
conditions may continue or worsen in the future. As a result, a prolonged period
of secondary market illiquidity could have an adverse impact on our future
earnings and financial condition.
CONSEQUENCES IF MERGER WITH SUMMIT DOESN'T OCCUR.
The company entered into an agreement, to merge with and into Summit.
In approving the merger agreement, the board of directors consulted with Sandler
O'Neill regarding the fairness of the transaction to the company's stockholders
from a financial point of view and with the company's legal counsel regarding
its legal duties and the terms of the merger agreement and ancillary documents.
The understanding of the board of directors of the options available to the
company and the assessment of those options with respect to the prospects and
estimated results of the implementation by the company of its business plan as
an independent entity under various scenarios, and the determination that none
of those options or the realization of the business plan under the best case
scenarios were likely to create greater present value for the company's
stockholders than the value to be paid by Summit. On the other hand, if the
merger is not consummated the company's ability to achieve consistent
profitability by selling a number of branches to increase capital and reduce
overall operating cost would be the next option and, if that option was not
successful, the prospects for regulatory action would be the most likely.
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. As described
in Note 4 to the Notes to Consolidated Financial Statements in this Form 10-Q.
The bank has consented to the issuance by the OTS of the order, effective April
25, 2008. The order is described in detail in Note 4, Regulatory Matters.
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. At
September 30, 2006, the bank was classified as an adequately capitalized
institution and the Office of Thrift Supervision limited the payment of
dividends from the bank to the company. Without the payment of a dividend from
the bank, the company was unable to make a distribution on the cumulative
convertible trust preferred securities. When, on December 13, 2006, the bank was
advised by the Office of Thrift Supervision that it would not approve the bank's
application to pay a cash dividend to the company, the company exercised its
right to defer the scheduled quarterly distributions on the cumulative
convertible trust preferred securities.
RESTRICTIONS ON ACCEPTANCE OF BROKERED DEPOSITS.
Under the Order issued by the OTS effective April 25, 2008, the bank
is prohibited from accepting brokered certificates of deposit without the
permission of the OTS.
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
(a) Greater Atlantic Financial Corp. Special Meeting was held on
March 25, 2008.
(b) Omitted per instructions.
(c) A brief description of each matter voted upon at the Special
Meeting held on March 25, 2008 and number votes cast for, against
or abstain.
1. To approve and adopt the Agreement and Plan of
Reorganization dated as of April 12, 2007, as amended
December 6, 2007 between Greater Atlantic Financial Corp.
and Summit Financial Group, Inc. and the transactions
contemplated thereby.
Votes For Votes Against Votes Abstain
--------- ------------- -------------
2,506,555 103,424 3,400
2. To adjourn the meeting to later date or dates, if
necessary, to permit further solicitation of proxies in
the event there are not sufficient votes at the time of
the meeting to approve the matters to be considered by the
shareholders at the meeting.
Votes For Votes Against Votes Abstain
--------- ------------- -------------
2,495,236 108,453 3,400
3. In the discretion, the proxies are authorized to vote upon
any other business that may properly come before the
meeting, or any adjournment thereof.
Votes For Votes Against Votes Abstain
--------- ------------- -------------
2,808,448 150,859 20,130
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: May 14, 2008