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 December 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)
N/A
(Former name, former address and former fiscal year,
if changed since last report)
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, a non-accelerated filer, or a smaller reporting company. See
definitions of "large accelerated filer," "accelerated filer" and smaller
reporting company" in Rule 12b-2 of the Exchange Act.
Large accelerated filer [ ] Accelerated filer [ ]
Non-accelerated filer [ ] Do not check if a Smaller reporting company) [X]
Smaller reporting company
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 February 17, 2009 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 DECEMBER 31, 2008
TABLE OF CONTENTS
PART I. FINANCIAL INFORMATION PAGE NO.
- ------------------------------ --------
Item 1. Financial Statements (Unaudited)
Consolidated Statements of Financial Condition at December 31, 2008 and September 30, 2008........................3
Consolidated Statements of Operations
for the three months ended December 31, 2008 and December 31, 2007................................................4
Consolidated Statements of Comprehensive Income (Loss)
for the three months ended December 31, 2008 and December 31, 2007................................................5
Consolidated Statements of Changes in Stockholders' Equity (Capital Deficit)
for the three months ended December 31, 2008 and December 31, 2007................................................5
Consolidated Statements of Cash Flows
for the three months ended December 31, 2008 and December 31, 2007................................................6
Notes to Consolidated Financial Statements........................................................................8
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations........................16
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..................................................34
Item 3. Defaults Upon Senior Securities..............................................................................34
Item 4. Submission of Matters to a Vote of Security Holders..........................................................34
Item 5. Other Information............................................................................................34
Item 6. Exhibits.....................................................................................................34
SIGNATURES.............................................................................................................35
CERTIFICATIONS.........................................................................................................36
2
GREATER ATLANTIC FINANCIAL CORP.
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION (UNAUDITED)
December 31, September 30,
----------------------------------
2008 2008
------------------------------------------------------------------------------------------------------------
(Dollars in Thousands) (Unaudited)
Assets
Cash and cash equivalents:
Non-interest bearing and vault $ 4,847 $ 6,175
Interest bearing 20,602 440
Investment securities
Available-for-sale 33,117 37,128
Held-to-maturity 2,112 2,229
Loans receivable, net 147,732 149,615
Accrued interest and dividends receivable 917 1,237
Federal Home Loan Bank stock, at cost 1,550 1,640
Other real estate owned 1,331 1,043
Premises and equipment, net 1,827 1,918
Prepaid expenses and other assets 1,116 982
------------------------------------------------------------------------------------------------------------
Total assets $215,151 $202,407
============================================================================================================
Liabilities and Stockholders' equity (capital deficit)
Liabilities
Deposits $184,125 $165,279
Advance payments from borrowers for taxes and insurance 103 175
Accrued expenses and other liabilities 2,280 2,254
Advances from the FHLB and other borrowings 27,011 28,909
Junior subordinated debt securities 9,386 9,384
------------------------------------------------------------------------------------------------------------
Total liabilities 222,905 206,001
------------------------------------------------------------------------------------------------------------
Commitments and contingencies
------------------------------------------------------------------------------------------------------------
Stockholders' Equity (Capital Deficit)
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 (27,101) (25,318)
Accumulated other comprehensive loss (5,956) (3,579)
------------------------------------------------------------------------------------------------------------
Total stockholders' equity (capital deficit) (7,754) (3,594)
------------------------------------------------------------------------------------------------------------
Total liabilities and stockholders' equity (capital deficit) $215,151 $202,407
============================================================================================================
See accompanying notes to consolidated financial statements
3
GREATER ATLANTIC FINANCIAL CORP.
CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
Three Months Ended
December 31,
- ----------------------------------------------------------------------------------------------
(Dollars in Thousands, Except Per Share Data) 2008 2007
- ----------------------------------------------------------------------------------------------
Interest income
Loans $ 2,035 $ 3,110
Investments 427 768
- ----------------------------------------------------------------------------------------------
Total interest income 2,462 3,878
- ----------------------------------------------------------------------------------------------
Interest expense
Deposits 1,397 2,029
Borrowed money 549 571
- ----------------------------------------------------------------------------------------------
Total interest expense 1,946 2,600
- ----------------------------------------------------------------------------------------------
Net interest income 516 1,278
Provision for loan losses 373 102
- ----------------------------------------------------------------------------------------------
Net interest income after provision for loan losses 143 1,176
- ----------------------------------------------------------------------------------------------
Noninterest income
Fees and service charges 123 139
Loss on derivatives (23) (14)
Other operating income 9 12
- ----------------------------------------------------------------------------------------------
Total noninterest income 109 137
- ----------------------------------------------------------------------------------------------
Noninterest expense
Compensation and employee benefits 822 943
Occupancy 332 324
Professional services 189 182
Advertising 10 19
Deposit insurance premium 132 146
Furniture, fixtures and equipment 94 105
Data processing 202 224
Other real estate owned expense 31 -
Other operating expenses 223 214
- ----------------------------------------------------------------------------------------------
Total noninterest expense 2,035 2,157
- ----------------------------------------------------------------------------------------------
Net loss before income tax provision (1,783) (844)
Provision for income taxes - -
- ----------------------------------------------------------------------------------------------
Net loss $ (1,783) $ (844)
==============================================================================================
Loss per common share BASIC AND DILUTED:
Basic $ (0.59) $ (0.28)
Diluted (0.59) (0.28)
Weighted average common shares outstanding
Basic and diluted 3,024,220 3,024,220
See accompanying notes to consolidated financial statements
4
GREATER ATLANTIC FINANCIAL CORP.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) (UNAUDITED)
Three months ended
December 31,
----------------------------
2008 2007
- --------------------------------------------------- ------------- --------------
(In Thousands)
Net loss $ (1,783) $ (844)
- --------------------------------------------------- ------------- --------------
Other comprehensive loss, net of tax
Unrealized loss on securities (2,377) (89)
- --------------------------------------------------- ------------- --------------
Other comprehensive loss (2,377) (89)
- --------------------------------------------------- ------------- --------------
Comprehensive loss $ (4,160) $ (933)
=================================================== ============= ==============
GREATER ATLANTIC FINANCIAL CORP.
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (CAPITAL DEFICIT) (UNAUDITED)
FOR THE THREE MONTHS ENDED DECEMBER 31, 2008 AND 2007
- ----------------------------------------------------------------------------------------------------------------------------
Accumulated Total
Additional Accumulated Other Stockholders'
Preferred Common Paid-in Earnings Comprehensive Equity (Capital
Stock Stock Capital (Deficit) Income (Loss) Deficit)
- ----------------------------------------------------------------------------------------------------------------------------
(In Thousands)
Balance at September 30, 2007 $- $ 30 $ 25,273 $ (14,408) $ (1,324) $ 9,571
Other comprehensive loss - - - - (89) (89)
Net loss for the period - - - (844) - (844)
- ----------------------------------------------------------------------------------------------------------------------------
Balance at December 31, 2007 $- $ 30 $ 25,273 $ (15,252) $ (1,413) $ 8,638
============================================================================================================================
Balance at September 30, 2008 $- $ 30 $ 25,273 $ (25,318) $ (3,579) $ (3,594)
Other comprehensive loss - - - - (2,377) (2,377)
Net loss for the period - - - (1,783) - (1,783)
- ----------------------------------------------------------------------------------------------------------------------------
Balance at December 31, 2008 $- $ 30 $ 25,273 $ (27,101) $ (5,956) $ (7,754)
============================================================================================================================
See accompanying notes to consolidated financial statements
5
GREATER ATLANTIC FINANCIAL CORP.
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
Three months ended
December 31,
------------------------------
2008 2007
- ----------------------------------------------------------------------------------------------------------------
(In Thousands)
Cash flow from operating activities:
Net loss $ (1,783) $ (844)
Adjustments to reconcile net loss to net cash provided by
(used in) operating activities:
Provision for loan loss 373 102
Amortization of deferred loan acquisition cost, net - 1
Depreciation and amortization 87 97
Amortization of premiums on investment securities 82 118
Amortization of premiums on mortgage-backed securities 18 35
Amortization of deferred fees (21) (66)
Amortization of premiums and discounts on loans 68 71
Amortization of convertible preferred stock costs 2 2
Loss on sale of fixed assets 1 -
(Increase) decrease in assets:
Accrued interest and dividend receivable 320 52
Prepaid expenses and other assets (134) 107
Deferred loan fees collected, net of deferred costs incurred 53 88
Increase (decrease) in liabilities:
Accrued expenses and other liabilities 26 168
Income taxes payable - (20)
- ----------------------------------------------------------------------------------------------------------------
Net cash used in operating activities (908) (89)
- ----------------------------------------------------------------------------------------------------------------
Continued
6
GREATER ATLANTIC FINANCIAL CORP.
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) - (CONTINUED)
Three months ended
December 31,
----------------------------
2008 2007
- ------------------------------------------------------------------------------------------------------------
(In Thousands)
Cash flow from investing activities:
Loan repayments $ 8,353 $ 19,920
Loan disbursements net of participations sold (7,130) (12,014)
Disposal of premises and equipment, net 3 -
Capitalized cost for real estate owned (101) -
Proceeds from repayments of other investment securities 922 1,405
Proceeds from repayments of mortgage-backed securities 729 1,267
Proceeds from sale of FHLB stock 90 -
- ------------------------------------------------------------------------------------------------------------
Net cash provided by investing activities 2,866 10,578
- ------------------------------------------------------------------------------------------------------------
Cash flow from financing activities:
Net increase (decrease) in deposits 18,846 (9,054)
Net decrease in advances from the FHLB and other borrowings (1,898) (505)
Decrease in advance payments by borrowers
for taxes and insurance (72) (54)
- ------------------------------------------------------------------------------------------------------------
Net cash provided (used) in financing activities 16,876 (9,613)
- ------------------------------------------------------------------------------------------------------------
Increase in cash and cash equivalents 18,834 876
- ------------------------------------------------------------------------------------------------------------
Cash and cash equivalents, at beginning of period 6,615 7,632
- ------------------------------------------------------------------------------------------------------------
Cash and cash equivalents, at end of period $25,449 $ 8,508
============================================================================================================
Supplemental disclosure of non-cash investing activities:
Transfers from loans to real estate acquired through foreclosure $ 187 $ -
See accompanying notes to consolidated financial statements
7
GREATER ATLANTIC FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
INFORMATION AS OF DECEMBER 31, 2008 AND THREE MONTHS ENDED
DECEMBER 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, 2008. The results of operations for the three months ended
December 31, 2008 are not necessarily indicative of the results of operations
that may be expected for the year ending September 30, 2009 or any future
periods. 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 then pending merger of the company with and
into Summit and closed on August 24, 2007.
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.
On June 9, 2008 the company entered into a new definitive agreement for
the company to merge with and into Summit. That new agreement to merge with
Summit was approved by the shareholders of the company on September 4, 2008.
Processing of the Summit application to acquire the company and the bank
continued under the new definitive merger agreement until that new definitive
agreement was terminated by mutual consent of the parties on December 15, 2008.
(3) CEASE AND DESIST ORDER
As previously reported in a Form 8-K filed on April 29, 2008, the bank
consented to the issuance of a Cease and Desist Order (the "Cease and Desist
Order") issued by the Office of Thrift Supervision (the "OTS") effective April
25, 2008. The Cease and Desist 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
negotiations with Summit; have, at June 30, 2008 (which was extended to December
31, 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 Cease
and Desist 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 Cease
and Desist Order; cease, effective immediately, accepting brokered deposits; and
prohibits the payment of dividends or other capital distributions.
8
GREATER ATLANTIC FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
INFORMATION AS OF DECEMBER 31, 2008 AND THREE MONTHS ENDED
DECEMBER 31, 2008 AND 2007 (UNAUDITED)
In addition, the Cease and Desist Order requires the bank's board of
directors to take action with respect to credit administration, 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 Cease and Desist 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. At
September 30 and December 31, 2008, the bank was in compliance with all the
requirements of the Cease and Desist Order except for the 6% and 12% capital
requirements; however, the limitations in the Cease and Desist Order restricting
the bank's lending in the commercial, commercial real estate and construction
areas adversely affects the ability of the bank to return to profitability.
A description and copies of the Cease and Desist Order and the
Stipulation and Consent to Issuance of the Order were attached as exhibits to
the report on Form 8-K filed on April 29, 2008, with the Securities and Exchange
Commission.
(4) GOING CONCERN
Notwithstanding the circumstances described above, the company
continues actively to market itself, seeking either to be acquired or to obtain
a capital infusion in order to meet the conditions of the Cease and Desist
Order. We cannot assure you that our efforts will be successful and, as a result
of the circumstances described here and in the Risk Factors section, there is
substantial doubt concerning the ability of the company and the bank to continue
as going concerns for a reasonable period of time. Without a waiver by the OTS
or amendment or modification of the Cease and Desist Order, the bank could be
subject to further regulatory enforcement action, including, without limitation,
the issuance of additional cease and desist orders (which may, among other
things, further restrict the bank's business activities), or place the bank in
conservatorship or receivership, any of which would mitigate against the bank
and the company continuing as going concerns.
(5) 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 23 for discussion of non-performing loans):
At or for the three months
ended December 31,
------------------------------------
2008 2007
- ---------------------------------------------------------------------------------------------
(Dollars in Thousands)
Balance at beginning of period $ 2,567 $ 2,305
Provisions 373 102
Total charge-offs (717) (5)
Total recoveries 6 8
- ---------------------------------------------------------------------------------------------
Net recoveries (charge-offs) (711) 3
- ---------------------------------------------------------------------------------------------
Balance at end of period $ 2,229 $ 2,410
=============================================================================================
Ratio of net (charge-offs) recoveries during the period
to average loans outstanding during the period (0.48)% 0.002%
=============================================================================================
Allowance for loan losses to total non-performing
loans at end of period 43.52% 86.88%
=============================================================================================
Allowance for loan losses to total loans 1.49% 1.38%
=============================================================================================
9
GREATER ATLANTIC FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
INFORMATION AS OF DECEMBER 31, 2008 AND THREE MONTHS ENDED
DECEMBER 31, 2008 AND 2007 (UNAUDITED)
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, the company uses the fair value of the collateral,
less estimated costs to sell on a discounted basis, to measure impairment.
Our total recorded investment in impaired loans at December 31, 2008
was $892,000 compared to $4.8 million at December 31, 2007 and the related
allowance associated with those loans at December 31, 2008 was $892,000 compared
to $1.6 million at December 31, 2007. At December 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 zero and
$69,000 at December 31, 2008 and 2007, respectively.
(6) REGULATORY MATTERS
The capital distribution regulation of the OTS requires that the bank
provide the applicable OTS Regional Director with a 30-day advance written
notice of all proposed capital distributions whether or not advance approval is
required. The bank last paid dividends of $655,000 to the company during the
year ended September 30, 2006 and is prohibited by the Cease and Desist Order
from paying dividends or other capital distributions.
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 can be no longer than 20 consecutive
quarterly periods).
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%, 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% and an undercapitalized financial institution is one with Tier 1
leverage capital of 3%, Tier 1 risk-based capital of 3% and total risk-based
capital of 6%. At December 31, 2008, the bank is classified as an
undercapitalized financial institution.
The following presents the bank's capital position at December 31,
2008:
- --------------------------------------------------------------------------------------------------------
Required
Percent to
Required be Well Actual Actual Surplus/
Balance Capitalized Balance Percent (Shortfall)
- --------------------------------------------------------------------------------------------------------
(Dollars in Thousands)
Leverage $11,065 5.00% $ 9,263 4.19% $(1,802)
Tier 1 Risk-based $ 8,730 6.00% $ 9,179 6.31% $ 449
Total Risk-based $14,551 10.00% $10,516 7.23% $(4,035)
========================================================================================================
The company's common stock is currently quoted on the Pink Sheets under
the symbol GAFC.PK.
10
GREATER ATLANTIC FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
INFORMATION AS OF DECEMBER 31, 2008 AND THREE MONTHS ENDED
DECEMBER 31, 2008 AND 2007 (UNAUDITED)
Under the Cease and Desist Order issued by the Office of Thrift
Supervision effective April 25, 2008, the bank is required to have a Tier 1
(Core) Capital Ratio of at least 6% and a total Risk-based capital ratio of at
least 12% at June 30, 2008 and at all times thereafter. The Cease and Desist
Order was modified to extend that capital level deadline first to September 30,
2008, and subsequently to December 31, 2008. As shown in the foregoing chart,
the bank does not meet the capital requirements of the Cease and Desist Order at
December 31, 2008.
Notwithstanding the circumstances described above, the company
continues to market itself actively, seeking either to be acquired or to obtain
a capital infusion in order to meet the conditions of the Cease and Desist
Order. We cannot assure you that our efforts will be successful and, as a result
of the circumstances described here and in the Risk Factors section, there is
substantial doubt concerning the ability of the company and the bank to continue
as going concerns for a reasonable period of time.
(7) 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 December 31,
2008, 192,666 options were outstanding. During the quarter ended December 31,
2007 all 88,016 warrants expired.
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, 2007 245,500 $ 6.72 4.63
Options expired (52,834) $ 6.75
---------------------------------------------------------------------------------------------------------------
Balance outstanding and exercisable at September 30, 2008 192,666 $ 6.56 3.99
Options expired - -
---------------------------------------------------------------------------------------------------------------
Balance outstanding and exercisable at December 31, 2008 192,666 $ 6.56 3.74
===============================================================================================================
The company has adopted the provisions of Statement of Financial
Accounting Standards No. 123R, "Accounting for Stock-Based Compensation" ("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 three months ended
December 31, 2008 and 2007.
11
GREATER ATLANTIC FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
INFORMATION AS OF DECEMBER 31, 2008 AND THREE MONTHS ENDED
DECEMBER 31, 2008 AND 2007 (UNAUDITED)
(8) 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 reflects 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 three months
ended December 31, 2008 and 2007 were the same, as the effect of the conversion
of preferred securities and the impact of the exercised stock options totaling
1,368,143 shares in the periods ended December 31, 2008 and 2007, were excluded
as their exercise would have been anti-dilutive for those periods.
(9) RECENT ACCOUNTING STANDARDS
In September 2006, the FASB issued Statement No. 157, Fair Value
Measurement ("FAS 157"). FAS 157 enhances existing guidance for measuring assets
and liabilities using fair value. Prior to the issuance of FAS 157, guidance for
applying fair value was incorporated in several accounting pronouncements. FAS
157 provides a single definition of fair value, together with a framework for
measuring it, and requires additional disclosure about the use of fair value to
measure assets and liabilities. FAS 157 also emphasizes that fair value is a
market-based measurement, not an entity-specific measurement, and sets out a
fair value hierarchy with the highest priority being quoted prices in active
markets. Under FAS 157, fair value measurements are disclosed by level within
that hierarchy. While FAS 157 does not add any new fair value measurements, it
does change current practice. Changes to practice include: (1) a requirement for
an entity to include its own credit standing in the measurement of its
liabilities; (2) a modification of the transaction price presumption; (3) a
prohibition on the use of block discounts when valuing large blocks of
securities for broker-dealers and investment companies; and (4) a requirement to
adjust the value of restricted stock for the effect of the restriction even if
the restriction lapses within one year. FAS 157 is effective for financial
statements issued for fiscal years beginning after November 15, 2007, and
interim periods within those fiscal years. The company adopted FAS 157 as of
October 1, 2008, as required, and adoption did not have a material impact on the
company's financial statements. In October 2008, the FASB amended SFAS 157 by
issuing FSP FAS 157-3, DETERMINING THE FAIR VALUE OF A FINANCIAL ASSET WHEN THE
MARKET FOR THAT ASSET IS NOT ACTIVE. FSP FAS 157-3 clarifies the application of
SFAS 157 in a market that is not active and provides an example to illustrate
key considerations in determining the fair value of a financial asset when the
market for that financial asset is not active.
In February 2007, the FASB issued Statement No. 159, The Fair Value
Option for Financial Assets and Financial Liabilities--Including an Amendment of
FASB Statement No. 115 ("FAS 159"). This statement permits an entity to choose
to measure many financial instruments and certain other items at fair value.
Most of the provisions in FAS 159 are elective; however, the amendment to FAS
115, Accounting for Certain Investments in Debt and Equity Securities, applies
to all entities with available-for-sale and trading securities. The fair value
option established by FAS 159 permits all entities to choose to measure eligible
items at fair value at specified election dates. A business entity will 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 with a few exceptions, such as investments
otherwise accounted for by the equity method; is irrevocable unless a new
election date occurs; and is applied only to entire instruments and not to
portions of instruments. The company adopted FAS 159 effective October 1, 2008,
as required, but has not elected to measure any permissible items at fair value.
As a result, the adoption of FAS 159 did not have any impact on the company's
financial statements.
12
GREATER ATLANTIC FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
INFORMATION AS OF DECEMBER 31, 2008 AND THREE MONTHS ENDED
DECEMBER 31, 2008 AND 2007 (UNAUDITED)
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, 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. SFAS No.
141(R) applies to fiscal years beginning after December 15, 2008 and is adopted
prospectively. 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.
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 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; changes in ownership interest be accounted
for similarly, as equity transactions; and, 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.
In March 2008, the FASB issued SFAS No. 161, Disclosures about
Derivative Instruments and Hedging Activities - an amendment of FASB statement
No. 133". SFAS 161 requires enhanced disclosures about how and why an entity
uses derivative instruments, how derivative instruments and related items are
accounted for under Statement 133 and how derivative instruments and related
hedged items affect an entity's financial position, financial performance and
cash flows. The new standard is effective for the company on January 1, 2009.
The adoption of this standard is not expected to have any impact on the
company's consolidated financial position or results of operations.
(10) JUNIOR SUBORDINATED DEBT SECURITIES
On March 20, 2002, Greater Atlantic Capital Trust I (the, "Trust"), a
Delaware statutory business trust and a wholly owned Trust subsidiary of the
company, issued $9.6 million aggregate liquidation amount (963,038 shares) of
6.50% cumulative preferred securities maturing on December 31, 2031, retaining
an option to call the securities on or after December 31, 2003. Conversion of
the preferred securities into the company's common stock may occur at any time
on or after 60 days after the closing of the offering. The company may redeem
the preferred securities, in whole or in part, at any time on or after December
31, 2003. Distributions on the preferred securities are payable quarterly on
March 31, June 30, September 30 and December 31 of each year beginning on June
30, 2002. The Trust also issued 29,762 common securities to the company for
$297,620. The proceeds from the sale of the preferred securities and the
proceeds from the sale of the trust's common securities were utilized to
purchase from the company junior subordinated debt securities of $9,928,000
bearing interest of 6.50% and maturing December 31, 2031. The 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.
To comply with FIN46, 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 can
be no longer than 20 consecutive quarterly periods).
13
GREATER ATLANTIC FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
INFORMATION AS OF DECEMBER 31, 2008 AND THREE MONTHS ENDED
DECEMBER 31, 2008 AND 2007 (UNAUDITED)
(11) 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 limits 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 three months ended December 31, 2008 and 2007 the
instruments did not meet hedge accounting requirements. The statements of
operations include net losses of $23,000 and $14,000 for the three months ended
December 31, 2008 and 2007, respectively.
(12). FAIR VALUE OF FINANCIAL INSTRUMENTS
Effective October 1, 2008, the Company adopted FASB Statement No. 157,
Fair Value Measurements ("FAS 157"). FAS 157 defines fair value, establishes a
framework for measuring fair value and expands disclosures about fair value
measurements. FAS 157 has been applied prospectively as of the beginning of the
year.
FAS 157 defines fair value as the price that would be received to sell
an asset or paid to transfer a liability in an orderly transaction between
market participants at the measurement date. FAS 157 also establishes a fair
value hierarchy which requires an entity to maximize the use of observable
inputs and minimize the use of unobservable inputs when measuring fair value.
The standard describes three levels of inputs that may be used to
measure fair value:
Level 1 Quoted prices in active markets for identical assets or liabilities.
Level 2 Observable inputs other than Level 1 prices such as quoted prices for
similar assets or liabilities; quoted prices in markets that are not
active; or other inputs that are observable or can be corroborated by
observable market data for substantially the full term of the assets
or liabilities.
Level 3 Unobservable inputs that are supported by little or no market activity
and that are significant to the fair value of the assets or
liabilities.
Following is a description of the valuation methodologies used for
instruments measured at fair value on a recurring basis and recognized in the
accompanying balance sheet, as well as the general classification of such
instruments pursuant to the valuation hierarchy.
AVAILABLE-FOR-SALE SECURITIES. Where quoted market prices are available
in an active market, securities are classified within Level 1 of the valuation
hierarchy. If quoted market prices are not available, then fair values are
estimated by using pricing models, quoted prices of securities with similar
characteristics or discounted cash flow. In certain cases where Level 1 or Level
2 inputs are not available, securities would be classified within Level 3 of the
hierarchy.
The following table presents the fair value measurements of assets
recognized in the accompanying balance sheet measured at fair value on a
recurring basis and the level within the FAS 157 fair value hierarchy in which
the fair value measurements fall at December 31, 2008:
Fair Value Measurements Using
-------------------------------------------------------------
(Dollars in Thousands) Quoted Prices in
Active Markets for Significant Other Significant
Identical Assets Observable Inputs Unobservable
Fair Value Level 1 Level 2 Inputs Level 3
--------------- -------------------- ------------------- --------------------
Available-for-sale securities $ 33,117 $ - $ 27,539 $ 5,578
14
GREATER ATLANTIC FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
INFORMATION AS OF DECEMBER 31, 2008 AND THREE MONTHS ENDED
DECEMBER 31, 2008 AND 2007 (UNAUDITED)
IMPAIRED LOANS. Loans for which it is probable the company will not
collect all principal and interest due according to contractual terms are
measured for impairment in accordance with the provisions of Financial
Accounting Standard No. 114, Accounting by Creditors for Impairment of a Loan.
Allowable methods for estimating fair value include using the fair value of the
collateral for collateral dependent loans, or where a loan is determined not to
be collateral dependent, using the discounted cash flow method. If the impaired
loan is collateral dependent, then the fair value method of measuring the amount
of impairment is utilized. This method utilizes a recent appraisal or other
valuations of the collateral and applies a discount factor to the value based on
the company's estimate of holding cost and other economic factors, such as
estimated cash flow generated from the property.
The following table presents the fair value measurements of assets
measured at fair value on a nonrecurring basis and the level within the FAS 157
fair value hierarchy in which the fair value measurements fell at December 31,
2008.
Fair Value Measurements Using
-------------------------------------------------------------------------------
(Dollars in Thousands) Quoted Prices in
Active Markets for Significant Other Significant
Identical Assets Observable Inputs Unobservable
Fair Value Level 1 Level 2 Inputs Level 3
--------------- -------------------- ------------------- --------------------
Impaired loans $ 965 $ - $ - $ 965
The fair value of the impaired loans of $965,000 is net of specific
reserves of $400,000. Of the $965,000 of impaired loans at December 31, 2008,
there were no charge offs related to those loans.
(13). SUBSEQUENT EVENT
On February 10, 2009, the bank, received written notification from the
Office of Thrift Supervision that the bank is "undercapitalized" under Part 565
of the OTS Rules and Regulations based on the regulatory capital ratios the bank
reported in its Thrift Financial Report for the period ended December 31, 2008.
The Bank is now subject to the restrictions on asset growth, dividends, other
capital distributions and management fees. The Notice also requires the Bank to
file a written capital restoration plan with the Regional Director of the OTS in
Atlanta, Georgia, with copies to the FDIC Regional Director, no later than March
16, 2009. Also see, as reported on Form 8-K filed on February 17, 2009 a
detailed disclosure of this notification.
15
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.
PROPOSED ACQUISITION AND MUTUAL TERMINATION OF MERGER AGREEMENT
As previously reported 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 then pending merger of the company with and into Summit and
closed on August 24, 2007.
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.
On June 9, 2008 the company entered into a new definitive agreement for
GAFC to merge with and into Summit. That new agreement to merge with Summit was
approved by the shareholders of the company on September 4, 2008. Processing of
the Summit application to acquire the company and the bank continued under the
new definitive merger agreement until that new definitive agreement was
terminated by mutual consent of the parties on December 15, 2008.
16
CEASE AND DESIST ORDER
As previously reported in a Form 8-K filed on April 29, 2008, the bank
consented to the issuance of the Cease and Desist Order issued by the OTS
effective April 25, 2008. The Cease and Desist Order requires the bank to, among
other things, report, within prescribed time periods to the OTS Regional
Director on the status of the ongoing negotiations with Summit; have, at June
30, 2008 (which was extended to December 31, 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 Cease and Desist 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 Cease and Desist Order;
cease, effective immediately, accepting brokered deposits; and prohibits the
payment of dividends or other capital distributions.
In addition, the Cease and Desist Order requires the bank's board of
directors to take action with respect to credit administration, 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 Cease and Desist 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. At
September 30 and December 31, 2008, the bank was in compliance with all the
requirements of the Cease and Desist Order except for the 6% and 12% capital
requirements; however, the limitations in the Cease and Desist Order restricting
the bank's lending in the commercial, commercial real estate and construction
areas adversely affects the ability of the bank to return to profitability.
A description and copies of the Cease and Desist Order and the
Stipulation and Consent to Issuance of the Order were attached as exhibits to
the report on Form 8-K filed on April 29, 2008, with the Securities and Exchange
Commission.
GOING CONCERN
Notwithstanding the circumstances described above, the company
continues actively to market itself, seeking either to be acquired or to obtain
a capital infusion in order to meet the conditions of the Cease and Desist
Order. We cannot assure you that our efforts will be successful and, as a result
of the circumstances described here, and in the Risk Factors section, there is
substantial doubt concerning the ability of the company and the bank to continue
as going concerns for a reasonable period of time. Without a waiver by the OTS
or amendment or modification of the Cease and Desist Order, the bank could be
subject to further regulatory enforcement action, including, without limitation,
the issuance of additional cease and desist orders (which may, among other
things, further restrict the bank's business activities), or the placing of the
bank in conservatorship or receivership, any of which would mitigate against the
bank and the company continuing as going concerns.
GENERAL
The profitability of the company depends primarily on its net-interest
income and non-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.
17
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 these 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 these
estimates under different assumptions or conditions. The company believes that
of its significant accounting policies, the following may involve a higher
degree of judgment or complexity.
ALLOWANCE FOR LOAN LOSSES
The company maintains an allowance for loan losses based on
management's evaluation of the risks inherent in its loan portfolio and the
general economy. Management classifies loans as substandard, doubtful or loss as
required by federal regulations. Management provides a 100% reserve for all
assets classified as loss. Further, management bases its estimates of the
allowance on current economic conditions, actual loss experience and industry
trends. Also, the company discontinues recognizing interest income on loans with
principal and/or interest past due 90 days.
INCOME TAXES
The provision (or benefit) for income taxes is based on taxable income,
tax credits and available net operating losses. The company records deferred tax
assets and liabilities using enacted tax rates for the effect of temporary
differences between the book and tax bases of assets and liabilities. If enacted
tax rates change, the company would adjust the deferred tax assets and
liabilities, through the provision for income taxes in the period of change, to
reflect the enacted tax rate expected to be in effect when the deferred tax
items reverse. The company records a valuation allowance on deferred tax assets
to reflect the future tax benefits expected to be realized. In determining the
appropriate valuation allowance, the company considers the expected level of
future taxable income and available tax planning strategies. At September 30,
2008, the company has provided a 100% valuation allowance on deferred tax
assets.
FINANCIAL CONDITION
At December 31, 2008 the company's total assets were $215.2 million,
compared to the $202.4 million held at September 30, 2008, representing an
increase of 6.30%. The increase resulted primarily from a $20.1 million increase
in interest bearing deposits and was offset in part by decreases of $4.0 million
in investment securities, loans receivable and $1.3 million in non-interest
bearing deposits. The increase 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 its assets and liabilities to maintain adequate
liquidity to meet deposit outflows.
Net loans receivable at December 31, 2008 were $147.7 million, a
decrease of $1.9 million or 1.26% from the $149.6 million held at September 30,
2008. The decrease in loans consisted primarily of a $3.6 million decline in
commercial business loans and a $787,000 decline in construction and land loans.
The decrease in construction and land loans was primarily in the single family
residential sector of the market. The company anticipates that lending in that
area will continue to decline as a result of the current slow sales pace
occurring in the single-family market and in the event the recession deepens. In
addition, the bank is under the Cease and Desist Order that requires the bank to
cease making commercial real estate loans, commercial loans and loans on raw
land without the prior written approval of the Regional Director. The company
also sustained a $654,000 decline in the bank's single-family loan portfolio and
was offset by an increase of $3.6 million in the bank's consumer loan portfolio.
Because the bank's single family loan portfolio consists primarily of
adjustable-rate loans, and with the yield curve that currently exists, customers
were able to extend the terms of their mortgages. Customers were also
refinancing away from adjustable-rate loans and into longer-term, fixed-rate
loans or curtailing outstanding balances. Multifamily loans outstanding
decreased by $106,000 and commercial real estate loans decreased by $575,000
during the period.
18
At December 31, 2008, investment securities were $35.2 million, a
decrease of $4.1 million or 10.49% from the $39.4 million held at September 30,
2008. The cash proceeds from the sale or payoff of investment securities were
used to reduce higher cost wholesale funding, including borrowings and wholesale
deposits, and to retain cash for liquidity purposes.
Deposits at December 31, 2008 were $184.1 million, an increase of $18.8
million from the $165.3 million held at September 30, 2008. Total deposits
increased due in part to our increased reliance on wholesale deposits, which
have a higher interest cost, but requires less operating cost than those
originated through the branch network. Wholesale deposits are acquired through a
direct deposit certificate listing service and are recognized by the FDIC as not
being broker-originated deposits. The increased reliance on wholesale deposits
contributed to a $15.7 million increase in deposits since December 31, 2007
while total deposits originated through the branch network decreased $20.7
million. The decrease in retail deposits is primarily in certificates of
deposits and money fund accounts which are rate sensitive deposits and in the
past have been obtained through the bank's marketing efforts. Because of the
intense competition for those types of deposits we will be revisiting increasing
our rates for these types of deposits. Any increase in those rates will squeeze
our net interest margin.
COMPARISON OF RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED
DECEMBER 31, 2008 AND DECEMBER 31, 2007
NET INCOME. For the three months ended December 31, 2008, the company
had a net loss of $1.8 million or $0.59 per diluted share, compared to a net
loss of $844,000 or $0.28 per diluted share for the three months ended December
31, 2007. The $939,000 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 and decreases in net interest income and non-interest income and was
offset by a decrease in non-interest expense. The ongoing net losses from
operations remain a consistent problem for management because the loan
production needed to maintain the retail branch network has not been attained,
and the limitations in the Cease and Desist Order restricting the bank's lending
in the commercial business, commercial real estate and construction areas
adversely affect the ability of the bank to become profitable. Further, the bank
has been managing its assets and liabilities to maintain the capitalized status
required to effect the sale of the bank. We believe that the OTS recognized that
approach by modifying the Cease and Desist Order to extend compliance with the
6% and 12% capital requirements to December 31, 2008. Processing of the Summit
application to acquire the company and the bank continued under the new
definitive merger agreement until that agreement was terminated by mutual
consent of the parties on December 15, 2008.
Because of the bank's loans to one borrower limit, and the loan
limitations contained in the Cease and Desist Order,, the bank is unable to
expand its commercial loan portfolio and maintain a consistent level of
outstanding loans to larger customers. Those factors have caused and will
continue to cause earning assets to decline, adversely impacting earnings.
Further, margin pressure from the yield curve also presents a challenging
environment which limits the bank's ability to increase our net interest margin.
However, we will continue to reduce our borrowing costs and reduce any operating
cost which can be removed without negatively affecting the bank's ability to
conduct business with its current customer base. In order to further reduce
costs, branch sales are a possible avenue that can be pursued in the event that
a capital infusion is obtained.
19
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 December 31, 2008 2007 Amount %
- ---------------------------------------------------------------------------------------------------------------------
(Dollars in Thousands)
Interest income:
Loans $ 2,035 $ 3,110 $ (1,075) (34.57)%
Investments 427 768 (341) (44.40)
- ---------------------------------------------------------------------------------------------------------------------
Total 2,462 3,878 (1,416) (36.51)
- ---------------------------------------------------------------------------------------------------------------------
Interest expense:
Deposits 1,397 2,029 (632) (31.15)
Borrowings 549 571 (22) (3.85)
- ---------------------------------------------------------------------------------------------------------------------
Total 1,946 2,600 (654) (25.15)
- ---------------------------------------------------------------------------------------------------------------------
Net interest income $ 516 $ 1,278 $ (762) (59.62)%
=====================================================================================================================
The decrease in net interest income during the three months ended
December 31, 2008, from the comparable period one year ago, resulted primarily
from a $31.2 million decrease in the bank's interest-earning assets coupled with
average interest-earning assets declining by $13.9 million more than the decline
in average interest-bearing liabilities. That decrease was coupled with a 118
basis point decrease in net interest margin (net interest income divided by
average interest-earning assets) from 2.22% for the three months ended December
31, 2007 to 1.04% for the three months ended December 31, 2008. The decrease in
net interest margin also resulted from the average yield on interest-earning
assets declining 91 basis points more than the decline in cost on
interest-bearing liabilities.
The 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. However, we also believe that our
strategy of changing the balance sheet 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 interest 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.
20
INTEREST INCOME. Interest income for the three months ended December
31, 2008 decreased $1.4 million compared to the three months ended December 31,
2007, primarily as a result of a decrease of 179 basis points in the average
yield earned on interest earning assets. Declines in those rates were coupled
with a $31.2 million decrease in the average balances of outstanding loans and
investment securities.
INTEREST EXPENSE. The $654,000 decrease in interest expense for the
three months ended December 31, 2008 compared to the 2007 period was principally
the result of an 88 basis point decrease in the cost of funds on average
deposits and borrowings. That decrease in the cost of average interest-bearing
liabilities was coupled with a $17.3 million decrease in the average amount of
deposits and borrowings. The decrease in interest expense on deposits was
primarily due to a 109 basis point decrease in rates paid on deposits, primarily
due to lower pricing on new and renewed time deposits. That decline was coupled
with a decrease of $16.3 million in average deposits, primarily due to the
decrease in certificates of deposit originated through our branch network.
The decrease in interest expense on borrowings for the three months
ended December 31, 2008, when compared to the 2007 period, was principally the
result of a $990,000 decrease in average borrowed funds, coupled with a 8 basis
point decrease in the cost of borrowed funds. The components accountable for the
decrease of $22,000 in interest expense on borrowings were a $15,000 decrease
relating to average volume, coupled with a $7,000 decrease relating to average
cost.
21
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 DECEMBER 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 $ 81,960 $ 1,260 6.15% $ 88,508 $ 1,540 6.96%
Consumer loans 53,831 533 3.96 51,242 914 7.13
Commercial business loans 12,302 242 7.87 33,904 656 7.74
----------- ---------- --------- ------------ ----------- ------------
Total loans 148,093 2,035 5.50 173,654 3,110 7.16
Investment securities 39,941 302 3.02 40,223 541 5.38
Mortgage-backed securities 10,697 125 4.67 16,016 227 5.67
----------- ---------- --------- ------------ ----------- ------------
Total interest-earning assets 198,731 2,462 4.96 229,893 3,878 6.75
---------- --------- ----------- ------------
Non-earning assets 10,581 11,663
----------- ------------
Total assets $ 209,312 $ 241,556
=========== ============
LIABILITIES AND STOCKHOLDERS'
EQUITY:
Interest-bearing liabilities:
Savings accounts $ 1,794 4 0.89 $ 2,073 5 0.96
Now and money market accounts 50,330 318 2.53 56,309 465 3.30
Certificates of deposit 114,554 1,075 3.75 124,568 1,559 5.01
----------- ---------- --------- ------------ ----------- ------------
Total deposits 166,678 1,397 3.35 182,950 2,029 4.44
FHLB advances 25,925 382 5.89 26,346 394 5.98
Other borrowings 11,206 167 5.96 11,775 177 6.01
----------- ---------- --------- ------------ ----------- ------------
Total interest-bearing
liabilities 203,809 1,946 3.82 221,071 2,600 4.70
---------- --------- ----------- ------------
Noninterest-bearing liabilities:
Noninterest-bearing demand deposits 7,184 9,079
Other liabilities 1,943 1,921
----------- ------------
Total liabilities 212,936 232,071
Stockholders' equity (3,624) 9,485
----------- ------------
Total liabilities and
stockholders' Equity $ 209,312 $ 241,556
=========== ============
Net interest income $ 516 $ 1,278
============ ==============
Interest rate spread 1.14% 2.04%
=============== ==============
Net interest margin 1.04% 2.22%
=============== ==============
22
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
DECEMBER 31, 2008 COMPARED TO
DECEMBER 31, 2007
-----------------------------------------------
CHANGE ATTRIBUTABLE TO
-----------------------------------------------
VOLUME RATE TOTAL
-----------------------------------------------
(IN THOUSANDS)
Real estate loans $ (114) $ (166) $ (280)
Consumer loans 46 (427) (381)
Commercial business loans (418) 4 (414)
---------------- -------------- --------------
Total loans (486) (589) (1,075)
Investments (4) (235) (239)
Mortgage-backed securities (75) (27) (102)
---------------- -------------- --------------
Total interest-earning assets $ (565) $ (851) $ (1,416)
================ ============== ==============
Savings accounts $ (1) $ - $ (1)
Now and money market accounts (49) (98) (147)
Certificates of deposit (125) (359) (484)
---------------- -------------- --------------
Total deposits (175) (457) (632)
FHLB advances (6) (6) (12)
Other borrowings (9) (1) (10)
---------------- -------------- --------------
Total interest-bearing liabilities (190) (464) (654)
================ ============== ==============
Change in net interest income $ (375) $ (387) $ (762)
================ ============== ==============
PROVISION FOR LOAN LOSSES. The allowance for loan losses is established
through a provision for loan losses based on management's evaluation of the
risks inherent in its loan portfolio and the general economy. The allowance is
based on two basic principles of accounting: (1) SFAS No. 5, ACCOUNTING FOR
CONTINGENCIES, which requires that losses be accrued when they are probable of
occurring and estimable, and (2) SFAS No.114, ACCOUNTING BY CREDITORS FOR
IMPAIRMENT OF A LOAN, which requires that losses be accrued based on the
differences between the value of collateral, the present value of future cash
flows or values that are observable in the secondary market and the loan
balance.
Our allowance for loan losses has two basic components: the specific
allowance for impaired credits and the general allowance based on relevant risk
factors. Each of those components is determined based upon estimates that can
and do change when the actual events occur. The specific allowance is used to
allocate an allowance for individual loans identified as impaired. For those
loans, we analyze the fair value of the collateral underlying the loan and
consider the estimated costs to sell the collateral on a discounted basis. If
the net collateral value is less than the loan balance (including accrued
interest and any unamortized premium or discount associated with the loan), we
recognize impairment and establish a specific reserve for the impaired loan.
Large groups of smaller balance and homogeneous loans are collectively evaluated
for impairment. Accordingly, the bank does not separately identify individual
consumer and residential loans for impairment testing unless such loans become
90 days or more past due.
23
The general allowance is determined by aggregating un-criticized loans,
those loans not classified under our internal asset classification system, and
loans identified for impairment testing for which no impairment was identified
into one of six categories: single family residential mortgages; home equity
lines of credit; construction and land; commercial real estate; commercial and
industrial; and other consumer loans. We then apply allowance factors which, in
the judgment of management, represent the expected losses over the life of the
loans. In determining those factors, we consider the following: delinquencies
and overall risk ratings, historical loss experience, trends in volume and terms
of loans, effects of changes in lending policy, the experience, and depth of the
borrowers' management, current economic conditions affecting the borrowers'
ability to repay, quality of loan review system and the effect of external
factors (e.g., competition and regulatory requirements). The general allowance
also includes those loans that have been classified under our internal asset
classification system. We typically apply a 5% loss factor to loans classified
as special mention, a 10% loss factor to loans classified as substandard and a
50% loss factor to loans classified as doubtful, where the loan has not been
determined to be impaired. Loans classified as loss loans are fully reserved or
charged off.
On an annual basis, or more often if deemed necessary, the bank has
contracted with an independent outside third party to review its loan portfolio.
The focus of that review is 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. In addition, various
regulatory agencies, as an integral part of their examination process,
periodically review the bank's allowance for loan losses. Such agencies may
require the bank to make additional provisions for estimated loan losses based
upon their judgment about information available to them at the time of their
examination. In the most recent examination made in June 2008, the OTS did not
indicate the need to increase the allowance for loan losses.
Non-performing assets amounted to $5.1 million or 2.38% of total assets
at December 31, 2008, a $2.1 million increase from the $3.0 million or 1.47% of
total assets at September 30, 2008 and a $2.3 million increase from the $2.8
million or 1.18% of total assets classified as non-performing at December 31,
2007. At December 31, 2008, assets that were classified totaled $7.6 million, of
which $1.6 million were classified as special mention, $3.8 million were
classified as substandard, $892,000 were classified as doubtful and $1.3 million
constituted as real estate owned. Real estate owned consists of an apartment
project, a single family townhouse and a single family home. The bank is in the
process of maintaining and marketing these properties but in view of the current
market conditions, we expect a lengthy marketing period. A $373,000 provision
for loan losses was recorded during the three months ended December 31, 2008,
compared to a provision of $102,000 during the three months ended December 31,
2007. Credit quality at the bank remains a concern, with a ratio of
non-performing assets to total assets of 2.38%, 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 $28,000 during the
three months ended December 31, 2008, over the comparable three months one year
ago. That decrease was distributed over various non-interest income categories
with the primary contributors being service fees on deposits and loss on
derivatives.
The following table presents a comparison of the components of
non-interest income.
Difference
------------------------------------
Three Months Ended December 31, 2008 2007 Amount %
- -------------------------------------------------------------------------------------------------------------------
(Dollars in Thousands)
Non-interest income:
Service fees on loans $ 33 $ 37 $ (4) (10.81)%
Service fees on deposits 90 102 (12) (11.76)
Loss on derivatives (23) (14) (9) 64.29
Other operating income 9 12 (3) (25.00)
- -------------------------------------------------------------------------------------------------------------------
Total non-interest income $ 109 $ 137 $ (28) (20.44)%
===================================================================================================================
24
NON-INTEREST EXPENSE. Non-interest expense decreased $122,000 from $2.2
million for the three months ended December 31, 2007 to $2.0 million for the
three months ended December 31 in the current year. The decrease was distributed
over various non-interest expense categories with the primary contributors being
compensation and employee benefits, data processing, deposit insurance premium
and furniture, fixtures and equipment. The decreases in non-interest expense
were partially offset by increases of $55,000 in the bank's other real estate
owned, other operating expense, occupancy and professional services.
The following table presents a comparison of the components of
non-interest expense.
Difference
---------------------------------
Three Months Ended December 31, 2008 2007 Amount %
- ---------------------------------------------------------------------------------------------------------------------
(Dollars in Thousands)
Non-interest expense:
Compensation and employee benefits $ 822 $ 943 $ (121) (12.83)%
Occupancy 332 324 8 2.47
Professional services 189 182 7 3.85
Advertising 10 19 (9) (47.37)
Deposit insurance premium 132 146 (14) (9.59)
Furniture, fixtures and equipment 94 105 (11) (10.48)
Data processing 202 224 (22) (9.82)
Other real estate owned expense 31 - 31 n/a
Other operating expense 223 214 9 4.21
- ---------------------------------------------------------------------------------------------------------------------
Total non-interest expense $ 2,035 $ 2,157 $ (122) (5.66)%
=====================================================================================================================
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 income taxes for the three months ended December 31, 2008 or 2007. However,
the bank reduced its net deferred tax asset by $1.7 million for the fiscal year
ended September 30, 2008, as a result of increasing the allowance on the
deferred tax asset during the period. In addition the Office of Thrift
Supervision issued a Cease and Desist Order mandating a 6% core capital ratio
and a 12% total risk-based capital ratio. With the reduction in the bank's
capital level, and higher capital requirements, the bank has had to lower its
earning asset growth. That in turn, negatively impacts expected future earnings
and required the reduction in the carrying value of its deferred tax asset. The
company believes that, in the unlikely event that a merger or infusion of
capital is not consummated, it will need to generate future taxable income
through branch sales to assure utilization of a portion of the existing net
operating losses.
25
Contractual Obligations and Off-Balance Sheet Financing Arrangements
The following table summarizes the bank's contractual obligations at
December 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 2,011 2,011 - - -
Subordinated debt securities (2) 25,982 655 1,310 1,310 22,707
Operating leases 2,609 1,022 1,100 253 234
-----------------------------------------------------------------------------------------------------------------
Total obligations $ 55,602 $ 3,688 $ 27,410 $ 1,563 $ 22,941
=================================================================================================================
(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) $ 127,459 $ 116,513 $ 8,958 $ 1,895 $ 93
Loan originations 2,950 2,950 - - -
Unfunded lines of credit (2) 91,821 91,821 - - -
Standby letters of credit 100 100 - - -
-----------------------------------------------------------------------------------------------------------------
Total $ 222,330 $ 211,384 $ 8,958 $ 1,895 $ 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 $90.9 million.
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 December 31, 2008, cash and cash equivalents, interest bearing
deposits and securities available-for-sale totaled $58.6 million or 27.22% of
total assets.
26
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. Under the Cease and Desist Order, the bank requires the prior
approval of the Regional Director or of the OTS to make commercial business
loans, commercial real estate loans, and real estate construction and
development loans. During the three months ended December 31, 2008, the bank's
loan originations totaled $7.1 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 three months ended December
31, 2008. All of our investment securities are classified as either available
for sale or held to maturity and for the period ended December 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 at 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 $6.0
million at December 31, 2008. The estimated market value is based upon quoted
prices for identical instruments traded in active markets and upon quoted prices
for similar instruments or assets in active markets, quoted prices for identical
or similar instruments or assets in markets that are not active, and model-based
valuation techniques for which all significant assumptions are observable in the
market.
Changes in current market conditions, such as interest rates and the
economic uncertainties in the mortgage, housing, and banking industries, have
severely impacted the securities market. The secondary market for various types
of securities has been limited and has negatively impacted securities values.
Quarterly, we review each security in our investment portfolio to determine the
nature of any change in value and whether any impairment should be classified as
other-than-temporary-impairment.
The initial indication of other than temporary impairment for debt
securities is a decline in the market value below the amount recorded for the
investment, and the severity and duration of the decline. In determining whether
an impairment is other than temporary, we consider the length of time and the
extent to which the market value has been below cost, recent events specific to
the issuer, including investment downgrades by rating agencies and economic
conditions of its industry, and our ability and intent to hold the investment
for a period of time sufficient to allow for anticipated recovery.
For marketable corporate debt securities, we also consider the issuer's
financial condition, capital strength, and near term prospects, as well as the
current ability of the issuer to make future payments in a timely manner, and
any change in the rating agencies' rating at the evaluation date from that made
on the acquisition date and any likely imminent action. Once a decline in value
is determined to be other than temporary, the value of the security is reduced
and a corresponding charge to earnings is recognized. To assist in analyzing for
other-than-temporary impairment, we use an independent pricing service that
reviews our investment in non-government or agency asset-backed or corporate
debt securities.
With respect to the company's investment in corporate debt securities,
although the market value has been less than cost for more than 12 months and
there has been a decline in price, that decline has occurred primarily over the
past year due to changes in the market which has limited the demand for these
securities and reduced their liquidity. The corporate debt securities we hold
had not experienced a credit default as of December 31, 2008, are currently
rated investment grade and continue to make the required interest payments on a
timely basis.
The company's investment in pooled trust preferred securities is
primarily in issues of other banks, bank holding companies and insurance
companies which we currently hold in our portfolio in the form of asset-backed
securities. The decline in value of those securities has occurred primarily over
the past year due to changes in the market which has limited the demand for
those securities and reduced their liquidity. While some of those issuers have
reported weaker financial performance since our acquisition of those securities,
in management's opinion they continue to possess more than acceptable credit
risk. The securities are currently rated investment grade and continue to make
required interest payments on a timely basis. Our review of the tranches in
which the company is invested indicate that we have sufficient collateral
support before causing a loss of principal or a break in yield. We monitor the
actual default rates and interest deferrals for expected losses and contractual
shortfalls of interest or principal, which could warrant further recognition of
impairment, and determined that the company's investment in pooled trust
preferred securities were temporarily impaired as of December 31, 2008.
27
The bank has other sources of liquidity if a need for additional funds
arises. At December 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
$4.0 million. Depending on market conditions, the pricing of deposit products
and the pricing of FHLB advances, the bank may continue to rely on FHLB
borrowings to fund asset growth.
At December 31, 2008, the bank had commitments to fund loans of $2.7
million, unused outstanding lines of credit of $91.8 million, consisting
primarily of equity lines of credit, unused standby letters of credit of
$100,000 and undisbursed proceeds of construction loans of $289,000. Unfunded
lines of credit have remained relatively constant and have actually decreased by
$4.4 million during the three months ended December 31, 2008. The bank
anticipates that it will have sufficient funds available to meet its current
loan origination and commitments.
Certificate accounts, including IRA and Keogh accounts, which are
scheduled to mature in less than one year from December 31, 2008, totaled $116.5
million. Based upon experience, management believes the majority of maturing
deposits will remain with the bank. In addition, management of the bank believes
that it can adjust the rates offered on certificates of deposit to retain
deposits in changing interest rate environments. In the event that a significant
portion of those deposits are not retained by the bank, the bank would be able
to utilize FHLB advances and reverse repurchase agreements to fund deposit
withdrawals, which would result in an increase in interest expense to the extent
that the average rate paid on such borrowings exceeds the average rate paid on
deposits of similar duration.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk is the risk of loss from adverse changes in market prices
and rates. The company's market risk arises primarily from interest rate risk
inherent in its lending and deposit taking activities. The company has little or
no risk related to trading accounts, commodities or foreign exchange. In
general, market risk reflects the sensitivity of income to variations in
interest rates and other relevant market rates or prices. The company's market
rate sensitive instruments include interest-earning assets and interest-bearing
liabilities. The company enters into market rate sensitive instruments in
connection with its various business operations. 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.
28
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 December 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 December 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.
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 September 30, 2008 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 12,595 -2,838 -18% 6.07% -120bp
+200 13,836 -1,598 -10% 6.61% -66bp
+100 14,716 -718 -5% 6.98% -29bp
0 15,434 - 7.27% -
-100 15,576 143 1% 7.31% 4bp
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.
An evaluation of the company's disclosure controls and procedures (as
defined in Rule 13a-15(e) of the Securities Exchange Act of 1934 (the "Act")) as
of December 31, 2008, was carried out under the supervision and with the
participation of the company's Chief Executive Officer, Chief Financial Officer
and several other members of the company's senior management. The company's
Chief Executive Officer and Chief Financial Officer concluded that the company's
disclosure controls and procedures currently in effect are effective in ensuring
that the information required to be disclosed by the company in the reports it
files or submits under the Act is: (i) accumulated and communicated to the
company's management (including the Chief Executive Officer and Chief Financial
Officer) in a timely manner and (ii) recorded, processed, summarized and
reported within the time periods specified in the SEC's rules and forms. In
addition, there have been no changes in our internal control over financial
reporting (as defined in Rule 13a-15(f) of the Act) that occurred during the
quarter ended December 31, 2008, that has materially affected, or is reasonably
likely to materially affect, our internal control over financial reporting.
The company does not expect that its disclosure controls and procedures
and internal control over financial reporting will prevent all errors and all
fraud. A control procedure, no matter how well conceived and operated, can
provide only reasonable, not absolute, assurance that the objectives of the
control procedure are met. Because of the inherent limitations in all control
procedures, no evaluation of controls can provide absolute assurance that all
control issues and instances of fraud, if any, within the company have been
detected. These inherent limitations include the realities that judgments in
decision-making can be faulty, and that breakdowns can occur because of simple
error or mistake. Additionally, controls may be circumvented by the individual
acts of some persons, by collusion of two or more people, or by override of the
control. The design of any control procedure also is based in part upon certain
assumptions about the likelihood of future events, and there can be no assurance
that any design will succeed in achieving its stated goals under all potential
future conditions; over time, controls may become inadequate because of changes
in conditions, or the degree of compliance with the policies or procedures may
deteriorate. Because of the inherent limitations in a cost-effective control
procedure, misstatements due to error or fraud may occur and not be detected.
PART II. OTHER INFORMATION
ITEM 1. Legal Proceedings
Not applicable.
ITEM 1A. Risk Factors
IF WE DO NOT RAISE ADDITIONAL CAPITAL, WE WILL NOT BE IN COMPLIANCE WITH THE
CAPITAL REQUIREMENTS OF THE BANK'S CEASE AND DESIST ORDER, WHICH COULD HAVE A
MATERIAL ADVERSE EFFECT UPON US.
The Cease and Desist Order, as amended, requires the bank to have and
maintain a minimum Tier I Core Capital ratio of 6% and a minimum Total
Risk-Based Capital ratio of 12% at December 31, 2008. To date, in the current
economic environment, the bank has not been able to raise sufficient additional
capital to ensure compliance with the capital requirements of the Cease and
Desist Order. Without a waiver by the Office of Thrift Supervision or amendment
or modification of the Cease and Desist Order, the bank could be subject to
further regulatory enforcement action, including, without limitation, the
issuance of additional cease and desist orders (which may, among other things,
further restrict the bank's business activities), or place the bank in
conservatorship or receivership. If the bank is placed in conservatorship or
receivership, it is highly likely that such action would lead to a complete loss
of all value of the company's ownership interest in the bank. In addition,
further restrictions could be placed on the bank if it were determined that the
bank was undercapitalized, significantly undercapitalized, or critically
undercapitalized, with increasingly greater restrictions being imposed as any
level of undercapitalization increased.
Notwithstanding the forgoing, the company continues actively to market
itself, seeking either to be acquired or to obtain a capital infusion in order
to meet the conditions of the Cease and Desist Order. We cannot assure you that
our efforts will be successful and, as a result of the circumstances described
above and in the other Risk Factors herein, there is substantial doubt
concerning the ability of the company and the bank to continue as going concerns
for a reasonable period of time.
30
DIFFICULT MARKET CONDITIONS HAVE ADVERSELY AFFECTED OUR INDUSTRY.
The bank is particularly exposed to downturns in the U.S. housing
market. Dramatic declines in the housing market over the past year, with falling
home prices and increasing foreclosures, rising unemployment and
under-employment, have negatively impacted the credit performance of mortgage
loans and resulted in significant write-downs of asset values by financial
institutions. With concern about the stability of the financial markets
generally, many lenders and institutional investors have reduced or ceased
providing funding to borrowers, including to other financial institutions. This
market turmoil and tightening of credit have led to an increased level of
commercial and consumer delinquencies, lack of consumer confidence, increased
market volatility and widespread reduction of business activity. We do not
expect that the difficult conditions in the financial markets are likely to
improve in the near future. A worsening of these conditions would likely worsen
the adverse effects of these difficult market conditions on us and others in the
financial institutions industry.
CURRENT LEVELS OF MARKET VOLATILITY ARE UNPRECEDENTED.
The capital and credit markets have been experiencing volatility and
disruption for more than a year. The volatility and disruption has reached
unprecedented levels. In some cases, the markets have produced downward pressure
on stock prices and credit availability for certain issuers without regard to
those issuers' underlying financial strength. If current levels of market
disruption and volatility continue or deteriorate, there can be no assurance
that we will not experience an adverse effect, which may be material, on our
ability to access capital and on our business, financial condition and results
of operations.
OUR INCREASED EMPHASIS ON COMMERCIAL AND CONSTRUCTION LENDING MAY EXPOSE US TO
INCREASED LENDING RISKS.
At December 31, 2008, our loan portfolio consisted of $37.1 million, or
24.82% of commercial real estate loans, $7.6 million, or 5.06% of construction
and land development loans and $9.9 million, or 6.63% of commercial business
loans. Those 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. Under the Cease and Desist Order, the bank can only
make commercial real estate loans, commercial loans, construction loans and land
development loans with the prior approval of the Regional Director of the Office
of Thrift Supervision.
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.
31
AN INCREASE IN LOAN PREPAYMENTS AND ON PREPAYMENT OF LOANS UNDERLYING
MORTGAGE-BACKED SECURITIES AND SMALL BUSINESS ADMINISTRATION CERTIFICATES MAY
ADVERSELY AFFECT OUR PROFITABILITY.
Prepayment rates are affected by consumer behavior, conditions in the
housing and financial markets, general economic conditions and the relative
interest rates on fixed-rate and adjustable-rate mortgage loans. Although
changes in prepayment rates are, therefore, difficult for us to predict,
prepayment rates tend to increase when market interest rates decline relative to
the rates on the prepaid instruments.
We recognize our deferred loan origination costs and premiums paid on
originating these loans by adjusting our interest income over the contractual
life of the individual loans. As prepayments occur, the rate at which net
deferred loan origination costs and premiums are expensed accelerates. The
effect of the acceleration of deferred costs and premium amortization may be
mitigated by prepayment penalties paid by the borrower when the loan is paid in
full within a certain period of time, which varies between loans. If prepayment
occurs after the period of time when the loan is subject to a prepayment
penalty, the effect of the acceleration of premium and deferred cost
amortization is no longer mitigated.
We recognize premiums we pay on mortgage-backed securities and Small
Business Administration Certificates as an adjustment to interest income over
the life of the security based on the rate of repayment of the securities.
Acceleration of prepayment on the loans underlying a mortgage-backed security or
Small Business Administration Certificate shortens the life of the security,
increases the rate at which premiums are expensed and further reduces interest
income.
We may not be able to reinvest loan and security prepayments at rates
comparable to the prepaid instruments particularly in periods of declining
interest rates.
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. These
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.
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.
32
THERE CAN BE NO ASSURANCE THAT RECENTLY ENACTED LEGISLATION AND OTHER MEASURES
UNDERTAKEN BY THE TREASURY, THE FEDERAL RESERVE AND OTHER GOVERNMENTAL AGENCIES
WILL HELP STABILIZE THE U.S. FINANCIAL SYSTEM, IMPROVE THE HOUSING MARKET OR BE
OF SPECIFIC BENEFIT TO THE BANK.
On October 3, 2008, President Bush signed into law the Emergency
Economic Stabilization Act of 2008 or ("EESA"), which, among other measures,
authorized the Treasury Secretary to establish the Troubled Asset Relief Program
("TARP"). EESA gives broad authority to Treasury to purchase, manage, modify,
sell and insure the troubled mortgage related assets that triggered the current
economic crisis as well as other "troubled assets."
Pursuant to the TARP, the U.S. Treasury has the authority to, among
other things, purchase up to $700 billion of mortgages, mortgage-backed
securities and certain other financial instruments from financial institutions
for the purpose of stabilizing and providing liquidity to the U.S. financial
markets.. In addition, under TARP, the Treasury created a capital purchase
program, pursuant to which it provides access to capital that will serve as Tier
I capital to financial institutions through a standardized program to acquire
preferred stock (accompanied by warrants) from eligible financial institutions.
At the time the capital purchase program was announced, the company was not
deemed eligible to participate.
There can be no assurance as to the actual impact that EESA and such
related measures undertaken to alleviate the credit crisis will have generally
on the financial markets, including the extreme levels of volatility and limited
credit availability currently being experienced. The failure of such measures to
help stabilize the financial markets and a continuation or worsening of current
financial market conditions could materially and adversely affect our business,
financial condition, results of operations, access to credit or the trading
price of our common stock. Finally, there can be no assurance regarding the
specific impact that such measures may have on the bank, or whether or to what
extent the bank will be able to benefit from such programs.
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. 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, and the company exercised its right to defer the next scheduled
quarterly distribution and all subsequent quarterly distributions on the
cumulative convertible trust preferred securities for an indefinite period
(which can be no longer than 20 consecutive quarterly periods).
33
ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds
Not applicable.
ITEM 3. Defaults Upon Senior Securities
Not applicable.
ITEM 4.
Not applicable.
ITEM 5. Other Information
Not applicable.
ITEM 6. Exhibits
(a) Exhibits
31.1 Certification of Chief Executive Officer pursuant to Section 302 of Sarbanes-Oxley Act of 2002
31.2 Certification of Chief Financial Officer pursuant to Section 302 of Sarbanes-Oxley Act of 2002
32.1 Certification of Chief Executive Officer pursuant to Section 906 of Sarbanes-Oxley Act of 2002
32.2 Certification of Chief Financial Officer pursuant to Section 906 of Sarbanes-Oxley Act of 2002
34
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: February 17, 2009