EXHIBIT 13
CORNERSTONE BANCORP AND SUBSIDIARY
Portions of Registrant's
2008 Annual Report to
Shareholders Incorporated
by Reference into 2008 Form 10-K
CAUTIONARY NOTICE WITH RESPECT TO FORWARD LOOKING STATEMENTS
Statements included in this report which are not historical in nature
are intended to be, and are hereby identified as "forward looking statements"
for purposes of the safe harbor provided by Section 21E of the Securities
Exchange Act of 1934, as amended. Words such as "estimate," "project," "intend,"
"expect," "believe," "anticipate," "plan," "may," "will," "should," "could,"
"would," assume," "indicate," "contemplate," "seek," "target," "potential," and
similar expressions identify forward-looking statements. The Company cautions
readers that forward looking statements including without limitation, those
relating to the Company's new offices, future business prospects, revenues,
working capital, adequacy of the allowance for loan losses, liquidity, capital
needs, interest costs, and income, are subject to certain risks and
uncertainties that could cause actual results to differ from those indicated in
the forward looking statements, due to several important factors identified in
this report, among others, and other risks and factors identified from time to
time in the Company's other reports filed with the Securities and Exchange
Commission.
These forward-looking statements are based on our current expectations,
estimates and projections about our industry, management's beliefs, and
assumptions made by management. Such information includes, without limitation,
discussions as to estimates, expectations, beliefs, plans, strategies, and
objectives concerning the Company's future financial and operating performance.
These statements are not guarantees of future performance and are subject to
risks, uncertainties and assumptions that are difficult to predict, particularly
in light of the fact that the Company is a relatively new company with limited
operating history. Therefore, actual results may differ materially from those
expressed or forecasted in such forward-looking statements. The risks and
uncertainties include, but are not limited to:
o future economic and business conditions;
o the Company's growth and ability to maintain growth;
o governmental monetary and fiscal policies,
o legislative and regulatory changes;
o the effect of interest rate changes on our level, costs and
composition of deposits, loan demand, and the values of our loan
collateral, securities, and interest sensitive assets and
liabilities;
o the indirect effects on demand for the Company's mortgage loan
products arising from effects on the overall market of the
subprime mortgage loan situation;
o the effects of competition from a wide variety of local,
regional, national and other providers of financial, investment
and insurance services, as well as competitors that offer banking
products and services by mail, telephone, computer, and/or the
Internet;
o credit risks;
o higher than anticipated levels of defaults on loans;
o perceptions by depositors about the safety of deposits;
o failure of our customers to repay loans;
o failure of assumptions underlying the establishment of the
allowance for loan losses, including the value of collateral
securing loans;
o the risks of opening new offices, including, without limitation,
the related costs and time of building customer relationships and
integrating operations, and the risk of failure to achieve
expected gains, revenue growth and/or expense savings;
o changes in accounting policies, rules, and practices;
o cost and difficulty of implementing changes in technology or
products;
o loss of consumer confidence and economic disruptions resulting
from terrorist activities;
o ability to weather the current economic downturn;
o loss of consumer or investor confidence; and
o other factors and information described in this report and in any
of the other reports we file with the Securities and Exchange
Commission under the Securities Act of 1934.
All forward-looking statements are expressly qualified in their
entirety by this cautionary notice. The Company undertakes no obligation to
publicly update or revise any forward-looking statements, whether as a result of
new information, future events or otherwise. In light of these risks,
uncertainties, and assumptions, the forward-looking events discussed in this
report might not occur.
WEBSITE REFERENCES
References to the Bank's website included in, or incorporated by
reference into, this report are for information purposes only, and are not
intended to incorporate the website by reference into this report.
BUSINESS OF THE COMPANY
Cornerstone Bancorp, (the "Company") is a bank holding company and has
no operations other than those carried on by its wholly owned subsidiary,
Cornerstone National Bank (the "Bank"). The Bank commenced business in 1999, and
conducts a general banking business from three offices in the Easley area of
Pickens County, in the Berea area of Greenville County, and in the Powdersville
area of Anderson County, South Carolina. In 2004, the Bank established a wholly
owned subsidiary, Crescent Financial Services, Inc. ("Crescent"), which is an
insurance agency that has not yet engaged in any significant operations.
Services of the Bank
Deposits
The Bank offers the full range of deposit services typically available
in most banks and savings and loan associations, including checking accounts,
NOW accounts, retirement accounts (including Individual Retirement Accounts),
and savings and other time deposits of various types, ranging from daily money
market accounts to longer-term certificates of deposit. The transaction accounts
and time certificates are tailored to the principal market area at rates
competitive with those offered in the area. All deposit accounts are insured by
the Federal Deposit Insurance Corporation ("FDIC") up to the maximum amount
permitted by law. The Bank solicits these accounts from individuals, businesses,
associations and organizations, and government authorities.
Lending Activities
The Bank offers a range of lending services, including, commercial
loans, consumer loans, and real estate mortgage loans. To address the risks
inherent in making loans, management maintains an allowance for loan losses
based on, among other things, an evaluation of the Bank's loan loss experience,
management's experience at other financial institutions in the market area, peer
data, the amount of and trends in past due and nonperforming loans, current
economic conditions and the values of loan collateral. Based upon such factors,
management makes various assumptions and judgments about the ultimate
collectibility of the loan portfolio and provides an allowance for loan losses
based upon a percentage of the outstanding balances and specific loans. However,
because there are certain risks that cannot be precisely quantified,
management's judgment of the allowance is necessarily approximate and imprecise.
The adequacy and methodology of the allowance for loan losses is also subject to
regulatory examination.
Real Estate Loans
One of the primary components of the Bank's loan portfolio is loans
secured by first or second mortgages on residential and commercial real estate.
These loans generally consist of short to mid-term commercial real estate loans,
construction and development loans and residential real estate loans (including
home equity and second mortgage loans). Interest rates may be fixed or
adjustable and the Bank frequently charges an origination fee. The Bank seeks to
manage credit risk in the commercial real estate portfolio by emphasizing loans
on owner-occupied office and retail buildings where the loan-to-value ratio at
origination, established by independent appraisals, does not exceed 80%. In
addition, the Bank generally requires personal guarantees of the principal
owners of the property. The at origination loan-to-value ratio for first and
second mortgage loans and for construction loans generally does not exceed 80%.
2
In an effort to control interest rate risk, long-term residential mortgages are
underwritten and funded by, and closed in the name of, third party investors.
The principal economic risk associated with all loans, including real
estate loans, is the creditworthiness of the borrowers. The ability of a
borrower to repay a real estate loan depends upon a number of economic factors,
including employment levels and fluctuations in the value of real estate. In the
case of a real estate construction loan, there is generally no income from the
underlying property during the construction period, and the developer's personal
obligations under the loan are typically limited. Borrowers may not be able to
maintain adequate cash flow during times of disruption in credit markets similar
to the difficulties in the current mortgage market. In the case of a real estate
purchase loan which is not fully amortized, the borrower may be unable to repay
the loan at the end of the loan term and thus may be forced to refinance the
loan at a higher interest rate, or, in certain cases, the borrower may default
as a result of its inability to refinance the loan. In either case, the risk of
nonpayment by the borrower is increased.
The Bank also faces additional credit risks to the extent that it
engages in making adjustable rate mortgage loans ("ARMs"). In the case of an
ARM, as interest rates increase, the borrower's required payments increase, thus
increasing the potential for default. The marketability of all real estate
loans, including ARMs, is also generally affected by the prevailing level of
interest rates.
Commercial Loans
The Bank makes loans for commercial purposes in various lines of
business. Commercial loans include both secured and unsecured loans for working
capital (including inventory and receivables), loans for business expansion
(including acquisition of real estate and improvements), and loans for purchases
of equipment and machinery. Equipment loans are typically made for a term of
five years or less at either fixed or variable rates, with the loan fully
amortized over the term and secured by the financed equipment. Working capital
loans typically have terms not exceeding one year and are usually secured by
accounts receivable, inventory or personal guarantees of the principals of the
business. Commercial loans vary greatly depending upon the circumstances and
loan terms are structured on a case-by-case basis to better serve customer
needs.
The risks associated with commercial loans vary with many economic
factors, including the economy in the Bank's market areas. The well-established
banks in the Bank's market areas make proportionately more loans to medium- to
large-sized businesses than the Bank makes. Many of the Bank's commercial loans
are made to small- to medium-sized businesses, which typically are not only
smaller, but also have shorter operating histories and less sophisticated record
keeping systems than larger entities. As a result, these smaller entities may be
less able to withstand adverse competitive, economic and financial conditions
than larger borrowers. In addition, because payments on loans secured by
commercial property generally depend to a large degree on the results of
operations and management of the properties, repayment of such loans may be
subject, to a greater extent than other loans, to adverse conditions in the real
estate market or the economy.
Consumer Loans
The Bank makes a variety of loans to individuals for personal and
household purposes, including secured and unsecured installment and term loans,
home equity loans and lines of credit and unsecured revolving lines of credit.
The secured installment and term loans to consumers generally consist of loans
to purchase automobiles, boats, recreational vehicles, mobile homes and
household furnishings, with the collateral for each loan being the purchased
property. The underwriting criteria for home equity loans and lines of credit
are generally the same as applied by the Bank when making a first mortgage loan,
as described above, and home equity lines of credit typically expire 15 years or
less after origination, unless renewed or extended.
Consumer loans generally involve more credit risks than other loans
because of the type and nature of the underlying collateral or because of the
absence of any collateral. Consumer loan repayments are dependent on the
borrower's continuing financial stability and are likely to be adversely
affected by job loss, divorce and illness. Furthermore, the application of
various federal and state laws, including federal and state bankruptcy and
insolvency laws, may limit the amount which can be recovered on such loans in
the case of default. In most cases, any repossessed collateral will not provide
an adequate source of repayment of the outstanding loan balance. Although the
underwriting process for consumer loans includes a comparison of the value of
3
the security, if any, to the proposed loan amount, the Bank cannot predict the
extent to which the borrower's ability to pay, and the value of the security,
will be affected by prevailing economic and other conditions.
Other Services
The Bank participates in a regional network of automated teller
machines that may be used by Bank customers in major cities throughout the
Southeast. The Bank offers both VISA and MasterCard brands of credit and debit
cards together with related lines of credit. The lines of credit may be used for
overdraft protection as well as pre-authorized credit for personal purchases and
expenses. Credit cards are underwritten and funded by a third party provider.
The Bank also provides stored value cards, direct deposit of payroll and social
security checks, and automatic drafts for various accounts, but does not
currently provide international or trust banking services, other than foreign
currency exchange through a correspondent bank. The Bank offers an Internet
banking product accessible via the Bank's custom website at
www.cornerstonenationalbank.com. The interactive banking product includes an
electronic bill payment service that allows customers to make scheduled and/or
recurring bill payments electronically. The Bank also offers remote check
deposit services to commercial and small business customers. The Bank offers
merchant and other business related services to its commercial customers. The
Bank also has a residential mortgage loan department with a highly experienced
staff qualified to make virtually any type of residential mortgage loan.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
The following information describes various financial aspects of the
Bank's business. This information should be read in conjunction with the
consolidated financial statements of the Company, which appear elsewhere in this
document, and the Company's Form 10-K, filed with the Securities and Exchange
Commission.
Critical Accounting Policies
The Company has adopted various accounting policies, which govern the
application of accounting principles generally accepted in the United States of
America in the preparation of the Company's financial statements. The
significant accounting policies of the Company are described in the notes to the
consolidated financial statements.
Certain accounting policies involve significant judgments and
assumptions by management, which have a material impact on the carrying value of
certain assets and liabilities. Management considers such accounting policies to
be critical accounting policies. The judgments and assumptions used by
management are based on historical experience and other factors, which are
believed to be reasonable under the circumstances. Because of the nature of the
judgments and assumptions made by management, actual results could differ from
these judgments and estimates, which could have a material impact on the
carrying values of assets and liabilities and the results of operations of the
Company.
The Company believes the allowance for loan losses is a critical
accounting policy that requires the most significant judgments and estimates
used in preparation of its consolidated financial statements. Refer to the
sections "Allowance for Loan Losses", "Potential Problem Loans", "Impaired
Loans" and note 1 to the consolidated financial statements for a detailed
description of the Company's estimation process and methodology related to the
allowance for loan losses.
Management also believes that current economic conditions have added
complexity to the process involved in evaluating other-than temporary-impairment
("OTTI") of the Company's debt securities. The process of determining OTTI is
inherently judgmental, involving the weighing of positive and negative factors
and evidence that may be objective or subjective. In the current environment,
the factors that must be evaluated are numerous, and changing rapidly, making
the evaluation more difficult.
Effect of Economic Trends
The current outlook for the national economy in the United States
("U.S.") is negative. Since September 2008, the U.S. financial system has been
4
in turmoil. Several unprecedented steps have been taken by the U.S. government
to restore capital, confidence, and liquidity to the U.S. financial system.
Currently, depository institutions in the U.S. are assessing the effect these
steps are likely to have, and how deeply economic conditions have affected, and
are likely to affect, their local economies and customer bases. Many of the
programs made available by the government are not fully implemented, and their
effects will not be immediately known.
Over the previous fifteen months, the Federal Reserve has decreased its
target short-term interest rates significantly. These decreases have been in
response to the turmoil in the overall economy, the market for mortgages, and
the housing industry in the United States. As a result of the decreases in
interest rates by the Federal Reserve, interest rates applicable to many of the
Bank's loans, which are tied to the Prime Rate, have also decreased rapidly.
However, due to competitive pressures for funds and an overall lack of
confidence in depository institutions and concerns over future events, interest
rates on the Bank's interest-bearing liabilities have not decreased as quickly,
placing pressure on the Bank's net interest margin. In addition, the uncertainty
in the national mortgage market has impacted our ability to broker mortgage
loans for our customers. Many third party lenders have changed their programs
frequently or discontinued them completely, and all have tightened credit
standards. The result has been a decrease in income earned from mortgage
brokerage fees in 2008. Additionally, problems in the economy have adversely
impacted the ability of some borrowers to repay their loans. Although the
Company's market area has not experienced the negative effects of the slowing
economy and declines in real estate markets to the same extent as some other
markets in the country, these factors have had an effect on our operations as
evidenced by the increases in our potential problem loans, charge-offs, and
nonaccrual loans.
Governmental Response to 2008 Financial Crisis
During the fourth quarter of 2008 and continuing into the first quarter
of 2009 the FDIC, the Federal Reserve, the Department of the Treasury and
Congress took a number of actions designed to alleviate or correct mounting
problems in the financial services industry. A number of these initiatives were
directly applicable to community banks.
Congress enacted the Emergency Economic Stabilization Act of 2008
which, among other things, temporarily increased the maximum amount of FDIC
deposit insurance from $100,000 to $250,000 and created a Troubled Assets Relief
Program ("TARP") administered by Treasury. In October, 2008, Treasury announced
a Capital Purchase Program ("CPP") under TARP to increase the capital of healthy
banks. Under the CPP, Treasury would purchase preferred stock with warrants from
qualified banks and bank holding companies in an amount up to 3% of the seller's
risk-weighted assets as of September 30, 2008. Institutions wishing to
participate in the CPP were required to file an application with their principal
federal regulators. The Company filed such an application and received
preliminary approval to sell preferred stock to the Treasury, but ultimately
elected not to participate in the CPP because of (i) the cost of the preferred
stock, (ii) the open-ended administrative burdens associated with the preferred
stock, including having to agree to allow Treasury to amend unilaterally the
stock purchase agreement to comply with subsequent changes in applicable federal
statutes, (iii) the fact that the Company and the Bank were already well
capitalized under regulatory guidelines and expected to continue to be so, and
(iv) management's belief that other sources of capital were, and would continue
to be, available should additional capital be needed.
The FDIC also implemented in October, 2008 a Temporary Liquidity
Guarantee Program consisting of a deposit insurance component pursuant to which
it undertook to provide deposit insurance in an unlimited amount for
non-interest bearing transaction accounts, and a debt guarantee component
pursuant to which it undertook to fully guarantee senior, unsecured debt issued
by banks or bank holding companies. Coverage of both components was automatic
until December 5, 2008, at which time covered institutions could opt out of one
or both of the components. Institutions not opting out would be charged fees for
their participation in the components. The Bank did not opt out of either
component.
An unfortunate consequence of the difficulties that have beset the
banking industry in the last year has been a large increase in bank failures,
which has led to substantial claims being made against the FDIC's Deposit
Insurance Fund. In order to increase the amount in the Deposit Insurance Fund to
reflect the increased risk of additional bank failures and insurance claims, the
FDIC has raised its assessments on banks for 2009 and has also proposed a
special one-time assessment of 20 cents per $100 of assessable deposits, to be
paid in September, 2009 based on deposits at June 30, 2009. There appears,
however, to be a possibility that the assessment will be reduced if Congress
authorizes the FDIC to borrow sufficient funds. Assuming that the special
assessment is imposed as proposed and without reduction, the additional cost to
the Bank in 2009 would be approximately $285,000.
5
Additional governmental efforts to ameliorate the problems afflicting the
banking industry have been adopted or proposed, or are being considered by
Congress and various governmental entities. The Company is presently unable to
predict the impact of any such changes, although it appears that they are likely
to increase operating expenses in the near term without creating completely
offsetting benefits.
Earnings Performance
The Company earned $225,316 in 2008, or $.11 per basic and diluted
common share compared to $1.6 million or $.82 per basic common share and $.80
per diluted common share for the year ended December 31, 2007. This compares to
$1.7 million or $.85 per basic and $.83 per diluted common share for the year
ended December 31, 2006. The Company's earnings in 2008 were significantly lower
than in 2007 and 2006 due to four specific factors. First, the Company was
required to recognize an impairment loss on preferred stock of the Federal
National Mortgage Association ("FNMA") during the third quarter as a result of
FNMA's being placed into conservatorship by The United States Department of the
Treasury in September 2008. Second, the drastic decreases in interest rates
initiated by the Federal Reserve in 2008 led to compression of our net interest
margin. Third, turmoil in the housing markets decreased our ability to broker
mortgage loans for our local customers, which significantly decreased
noninterest income in 2008. Fourth, our provision for loan losses increased
significantly in comparison to previous years due to increasing pressure on
borrowers from the slowing economy. The Company's net interest income (the
difference between interest earned on interest earning assets and interest paid
on interest bearing liabilities) decreased to $5.3 million, down from $5.8
million in 2007 and $5.5 million for 2006. The Company had noninterest income of
$63,966 after absorbing the other than temporary loss on the FNMA preferred
stock. This compared to $1.1 million and $1.4 million in 2007 and 2006,
respectively. Noninterest income in 2006 included a gain on the sale of land.
The Company provided $815,000, $196,636, and $445,896, to the allowance for loan
losses in 2008, 2007 and 2006, respectively, and had other operating expenses of
$4.3 million in 2008 and 2007 and $3.9 million in 2006.
Net Interest Income
Net interest income is the amount of interest earned on interest
earning assets (loans, investment securities, time deposits in other banks and
federal funds sold), less the interest expenses incurred on interest bearing
liabilities (interest bearing deposits and borrowed money), and is the principal
source of the Bank's earnings. Net interest income is affected by the level of
interest rates, volume and mix of interest earning assets and the relative
funding of these assets. Due to the fact that the Bank's and therefore, the
Company's, assets are largely monetary in nature, material changes in interest
rates can have a material impact on the Bank's net interest income. The Company
and the Bank monitor the Bank's assets and liabilities and the interest
sensitivity of these assets and liabilities using various tools, including
models which attempt to calculate the impact on the Bank's net interest margin
as interest rates change. However, these models, as well as the tables included
here, employ assumptions about the Bank's interest sensitive assets and
liabilities which may or may not prove to be accurate. Such assumptions include,
but are not limited to, repayment patterns of borrowers, calls of securities,
and unscheduled redemptions of certificates of deposit. The tables on the
following pages include historical analyses of yields earned and rates paid on
interest sensitive assets and liabilities, the effects of changes in the volume
and relative mix of interest sensitive assets and liabilities, the effect of
changes in interest rates, and the ratio of assets and liabilities repricing
over specific time horizons. While the Company's and the Bank's management
cannot predict the timing and extent of changes in interest rates, they do
attempt to manage the Bank's interest rate sensitivity to enable the Company to
react to protect the Company's earnings stream throughout various interest rate
cycles.
For the years ended December 31, 2008, 2007, and 2006, net interest
income was $5.3 million, $5.8 million, and $5.5 million, respectively. The
decrease in 2008 is attributable to the rapid decline in interest rates,
partially offset by increases in the volume of loans (see "Rate/Volume Analysis
of Net Interest Income" below). In 2008, total average interest earning assets
increased to $141.2 million from $125.4 million in 2007. The average yield on
interest earning assets decreased 153 basis points to 6.45% in 2008 compared to
7.98% in 2007. The average cost of interest bearing liabilities decreased 90
basis points to 3.12% in 2008 from 4.02% in 2007. Rates on interest earning
assets and interest bearing liabilities adjusted downward since the third
quarter of 2007. The Company's loan portfolio adjusted more quickly than the
interest bearing deposit portfolio due to liquidity pressures in the local
deposit market and in the brokered CD market. While the Company's time deposits
matured, rates could not be lowered by the same magnitude as the Company's
interest earning assets repriced. The result was narrowed interest margins. The
6
net yield on average interest earning assets decreased in 2008 to 3.76% from
4.65% in 2007. The interest rate spread in 2008 was 3.33% compared to 3.96% in
2007.
The table, "Average Balances, Yields and Rates", provides a detailed analysis of
the effective yields and rates on the categories of interest earning assets and
interest bearing liabilities for the Company for the years ended December 31,
2008 and 2007.
Average Balances, Yields and Rates
(Dollars in thousands)
Year ended December 31, 2008 Year ended December 31, 2007
---------------------------- ----------------------------
Interest Average Interest Average
Average Income/ Yields/ Average Income/ Yields/
Balances(1) Expense Rates(2) Balances(1) Expense Rates(2)
----------- ------- -------- ----------- ------- --------
Assets
Securities .............................................. $ 22,607 $1,161 5.14% $ 17,978 $ 944 5.25%
Federal Funds Sold ...................................... 3,429 92 2.68% 4,538 228 5.02%
Loans (3), (4) .......................................... 115,162 7,849 6.82% 102,917 8,835 8.58%
-------- ------ -------- -------
Total interest earning assets .................... 141,198 9,102 6.45% 125,433 10,007 7.98%
Cash and due from banks ................................. 3,624 2,468
Allowance for loan losses ............................... (1,394) (1,263)
Premises and equipment .................................. 5,687 5,214
Cash surrender value of life insurance policies ......... 1,731 1,660
Other assets ............................................ 1,861 1,486
-------- --------
Total assets ..................................... $152,707 $134,998
======== ========
Liabilities and shareholders' equity
Interest bearing liabilities:
Interest bearing transaction accounts .............. $ 13,502 125 .92% $ 13,708 157 1.15%
Savings and money market ........................... 14,994 296 1.98% 10,461 222 2.12%
Time deposits ...................................... 76,234 2,808 3.68% 71,613 3,444 4.81%
-------- ------ -------- -------
Total interest bearing deposits .................. 104,730 3,229 3.08% 95,782 3,823 3.99%
Federal Funds purchased and
customer repurchase agreements ...................... 5,351 170 3.18% 5,335 238 4.47%
FHLB advances ........................................... 6,955 228 3.28% 2,805 116 4.13%
-------- -------
Broker repurchase agreements ............................ 4,836 171 3.53%
-------- ------
Total interest bearing liabilities ............... 121,872 3,798 3.12% 103,922 4,177 4.02%
-------- ------ -------- -------
Noninterest bearing demand deposits and other
liabilities ......................................... 11,466 12,577
Shareholders' equity .................................... 19,369 18,499
-------- --------
Total liabilities and shareholders' equity ....... $152,707 $134,998
======== ========
Interest rate spread (5) ................................ 3.33% 3.96%
----- -----
Net interest income and net yield on earning assets(6)... $5,304 3.76% $ 5,830 4.65%
====== ----- ======= -----
Interest free funds supporting earning assets (7) ..... $ 19,326 $ 21,511
(1) Average balances calculated based on a daily basis.
(2) Calculated based on the number of days in the year that each type of asset
or liability was in existence. Yield calculated on a pre-tax basis. The
estimated tax equivalent yield on securities was 5.63% in 2008 and 5.53% in
2007.
(3) Nonaccruing loans are included in the average loan balances and income on
such loans is recognized on a cash basis. (
(4) Interest income on loans includes loan fee income as well as interest
income. The amount of loan fees included is $401,297 and $371,754 in 2008
and 2007, respectively.
(5) Total yield on interest earning assets less the rate paid on total interest
bearing liabilities.
(6) Net interest income divided by total interest earning assets.
(7) Total interest earning assets less total interest bearing liabilities.
7
Average Balances, Yields and Rates
(Dollars in thousands)
Year ended December 31, 2007 Year ended December 31, 2006
---------------------------- ----------------------------
Interest Average Interest Average
Average Income/ Yields/ Average Income/ Yields/
Balances(1) Expense Rates(2) Balances(1) Expense Rates(2)
----------- ------- -------- ----------- ------- --------
Assets
Securities ............................................... $ 17,978 $ 944 5.25% $ 17,234 $ 792 4.59%
Federal Funds Sold ....................................... 4,538 228 5.02% 5,864 294 5.01%
Loans (3), (4) ........................................... 102,917 8,835 8.58% 90,018 7,538 8.37%
-------- ------- -------- ------
Total interest earning assets ..................... 125,433 10,007 7.98% 113,116 8,624 7.62%
Cash and due from banks .................................. 2,468 2,396
Allowance for loan losses ................................ (1,263) (1,120)
Premises and equipment ................................... 5,214 4,472
Cash surrender value of life insurance policies .......... 1,660 1,600
Other assets ............................................. 1,486 1,250
-------- --------
Total assets ...................................... $134,998 $121,714
======== ========
Liabilities and shareholders' equity
Interest bearing liabilities:
Interest bearing transaction accounts ............... $ 13,708 157 1.15% $14,112 155 1.10%
Savings and money market ............................ 10,461 222 2.12% 10,074 165 1.64%
Time deposits ....................................... 71,613 3,444 4.81% 60,252 2,577 4.28%
-------- ------- -------- ------
Total interest bearing deposits ................... 95,782 3,823 3.99% 84,438 2,897 3.43%
Federal Funds purchased and
customer repurchase agreements ....................... 5,335 238 4.47% 4,795 116 2.42%
FHLB advances ............................................ 2,805 116 4.13% 3,973 149 3.75%
-------- ------- -------- ------
Total interest bearing liabilities ................ 103,922 4,177 4.02% 93,206 3,162 3.39%
------- ------
Noninterest bearing demand deposits and other
liabilities .......................................... 12,577 12,389
Shareholders' equity ..................................... 18,499 16,119
-------- --------
Total liabilities and shareholders' equity ........ $134,998 $121,714
======== ========
Interest rate spread (5) ................................. 3.96% 4.23%
----- -----
Net interest income and net yield on earning assets(6) ... $ 5,830 4.65% $5,462 4.83%
======= ----- ====== -----
Interest free funds supporting earning assets (7) ........ $ 21,511 $ 19,910
(1) Average balances calculated based on a daily basis.
(2) Calculated based on the number of days in the year that each type of asset
or liability was in existence. Yield calculated on a pre-tax basis. The
estimated tax equivalent yield on securities was 5.53% in 2007 and 4.80% in
2006.
(3) Nonaccruing loans are included in the average loan balances and income
on such loans is recognized on a cash basis.
(4) Interest income on loans includes loan fee income as well as interest
income. The amount of loan fees included is not considered material.
(5) Total yield on interest earning assets less the rate paid on total interest
bearing liabilities.
(6) Net interest income divided by total interest earning assets.
(7) Total interest earning assets less total interest bearing liabilities.
8
Rate/Volume Analysis of Net Interest Income
As discussed under the caption "Net Interest Income," the Bank's net
income is largely dependent on net interest income. The table below calculates
the relative impact on net interest income caused by changes in the average
balances (volume) of interest sensitive assets and liabilities and the impact
caused by changes in interest rates earned or paid. Each table compares two
years as indicated below. The effect of a change in average balance has been
determined by applying the average rate in the earlier year to the change in
average balance in the later year, as compared with the earlier year. The effect
of a change in the average rate has been determined by applying the average
balance in the earlier year to the change in the average rate in the later year,
as compared with the earlier year. In 2008 changes in interest rates had the
most significant impact on interest income. In 2007, changes in balances had a
more significant impact on net interest income than changes in interest rates.
Year ended December 31, 2008 compared to 2007
Increase (Decrease) Due to
--------------------------
Rate Volume Rate/Volume(1) Change
---- ------ -------------- ------
(Dollars in Thousands)
Interest earned on:
Securities (2) ........................................ $ (20) $ 243 $ (5) $ 218
Federal Funds sold .................................... (107) (56) 26 (137)
Loans ................................................. (1,821) 1,051 (216) (986)
------- ------- ------- -------
Total interest income ............................. (1,948) 1,238 (195) (905)
Interest paid on:
Deposits .............................................. (851) 316 (58) (593)
Federal Funds purchased and customer
repurchase agreements ......................... (69) 1 - (68)
FHLB advances ......................................... (24) 171 (35) 112
Broker repurchase agreements .......................... - - 171 171
------- ------- ------- -------
Total interest expense ....................... (944) 488 78 (378)
------- ------- ------- -------
Change in Net Interest Income .............................. $(1,004) $ 750 $ (273) $ (527)
======= ======= ======= =======
(1) Volume/Rate is calculated as the difference between the average balances
for the periods multiplied by the difference between the average rates for
the periods.
(2) Income calculated on a pre-tax basis.
Year ended December 31, 2007 compared to 2006
Increase (Decrease) Due to
--------------------------
Rate Volume Rate/Volume(1) Change
---- ------ -------------- ------
(Dollars in Thousands)
Interest earned on:
Securities (2) .......................................... $ 113 $ 34 $ 5 $ 152
Federal Funds sold ...................................... 1 (66) - (65)
Loans ................................................... 189 1,080 27 1,296
------- ------- ------- -------
Total interest income ............................. 303 1,048 32 1,383
Interest paid on:
Deposits ................................................ 376 488 62 926
Federal Funds purchased and customer .................... 98 13 11 122
repurchase agreements
FHLB advances ........................................... 15 (44) (4) (33)
------- ------- ------- -------
Total interest expense ....................... 489 457 69 1,015
------- ------- ------- -------
Change in Net Interest Income .............................. $ (186) $ 591 $ (37) $ 368
======= ======= ======= =======
9
Interest Rate Sensitivity
Interest rate sensitivity measures the timing and magnitude of the
repricing of assets compared with the repricing of liabilities and is an
important part of asset/liability management. The objective of interest rate
sensitivity management is to generate stable growth in net interest income, and
to control the risks associated with interest rate movements. Management
constantly reviews interest rate risk exposure and the expected interest rate
environment so that adjustments in interest rate sensitivity can be made in a
timely manner.
On a cumulative basis, rate sensitive liabilities exceeded rate
sensitive assets, resulting in a liability sensitive position at the end of 2008
of $22.9 million, for a cumulative gap ratio of .79 calculated at the one-year
time horizon. When interest sensitive liabilities exceed interest sensitive
assets for a specific repricing "horizon," a negative interest sensitivity gap
results, as was the case at the end of 2008 with respect to the one-year time
horizon. The gap is positive when interest sensitive assets exceed interest
sensitive liabilities. For a bank with a negative gap, falling interest rates
would be expected to have a positive effect on net interest income and
increasing rates would be expected to have the opposite effect. However, if one
or more assumptions prove incorrect, the margin may not be impacted in the
manner expected.
The following table reflects the balances of interest earning assets
and interest bearing liabilities at the earlier of their repricing or maturity
dates. Amounts of fixed rate loans are reflected at the loans' final maturity
dates. Variable rate loans are reflected at the earlier of their contractual
maturity date or the date at which the loan may be repriced contractually.
Deposits in other banks and debt securities are reflected at the earlier of each
instrument's repricing date for variable rate instruments or the ultimate
maturity date for fixed rate instruments. Overnight federal funds sold are
reflected in the earliest repricing interval due to the immediately available
nature of these funds. Interest bearing liabilities with no contractual
maturity, such as interest bearing transaction accounts and savings deposits are
reflected in the earliest repricing interval due to contractual arrangements
which give management the opportunity to vary the rates paid on these deposits
within a thirty-day or shorter period. However, the Bank is under no obligation
to vary the rates paid on those deposits within any given period. Fixed rate
time deposits, principally certificates of deposit, are reflected at their
contractual maturity dates. Federal funds purchased are presented in the
immediate repricing interval because the interest rate paid adjusts at the
beginning of each month. The table does not reflect repricing that could occur
as a result of prepayment of loans or early withdrawal of time deposits or
movement into or out of non-maturing deposit accounts.
10
Interest Sensitivity Analysis
December 31, 2008
-----------------
1-3 3-12 1-3 3-5 5-15 > 15
Immediate Months Months Years Years Years Years Total
--------- ------ ------ ----- ----- ----- ----- -----
(Dollars in thousands)
Interest earning assets ......................
Securities (1) ........................... - - - 1,541 1,617 9,718 7,915 20,791
Federal funds sold ....................... 140 - - - - - - 140
Loans (2)(3) ............................. 75,418 2,468 10,245 13,671 27,135 2,105 140 131,182
------- -------- -------- -------- ------- ------- ------- -------
Total interest earning assets ........ 75,558 2,468 10,245 15,212 28,752 11,823 8,055 152,113
------- -------- -------- -------- ------- ------- ------- -------
Interest bearing deposits
Interest bearing transaction accounts .... 13,013 - - - - - - 13,013
MMDAs & Savings .......................... 21,135 - - - - - - 21,135
Time deposits ............................ 3,174 22,566 41,584 9,647 1,393 - - 78,364
Federal Funds purchased and
Customer repurchase agreements ......... 3,243 150 2,650 350 - - - 6,393
FHLB advances ............................ 3,500 38 113 4,302 301 2,140 - 10,394
Broker repurchase agreements ............. - - - - 2,000 3,000 - 5,000
------- -------- -------- -------- ------- ------- ------- -------
Total interest bearing liabilities ... 44,065 22,754 44,347 14,299 3,694 5,140 - 134,299
------- -------- -------- -------- ------- ------- ------- -------
Interest sensitivity gap ..................... $31,493 $(20,286) $(34,102) $ 913 $25,058 $ 6,683 $ 8,055 $17,814
Cumulative interest sensitivity gap .......... $31,493 $ 11,207 $(22,895) $(21,982) $3,076 $ 9,759 $17,814
Gap ratio .................................... 1.71 .11 .23 1.06 7.78 2.30
Cumulative gap ratio ......................... 1.71 1.17 .79 .82 1.02 1.07 1.13
December 31, 2007
-----------------
1-3 3-12 1-3 3-5 5-15 > 15
Immediate Months Months Years Years Years Years Total
--------- ------ ------ ----- ----- ----- ----- -----
(Dollars in thousands)
Interest earning assets
Securities (1) .......................... $ - $ - $ - $ 1,018 $ 3,660 $ 9,310 $ 4,883 $ 18,871
Federal funds sold ...................... 967 - - - - - - 967
Loans(2)(4) ............................. 57,213 3,635 11,294 14,154 19,248 2,680 419 108,643
------- ------- ------- ------- ------- ------- ------- --------
Total interest earning assets ....... 58,180 3,635 11,294 15,172 22,908 11,990 5,302 128,481
------- ------- ------- ------- ------- ------- ------- --------
Interest bearing deposits
Interest bearing transaction accounts ... 15,083 - - - - - - 15,083
MMDAs & Savings ......................... 10,804 - - - - - - 10,804
Time deposits ........................... 6,707 23,820 31,308 9,070 496 - - 71,401
Customer repurchase agreements .......... 2,893 2,910 - - - - - 5,803
FHLB advances ........................... - 1,038 1,613 302 301 291 - 3,545
------- -------- -------- ------- ------- ------- ------- --------
Total interest bearing liabilities .. 35,487 27,768 32,921 9,372 797 291 - 106,636
------- -------- -------- ------- ------- ------- ------- --------
Interest sensitivity gap .................... $22,693 $(24,133) $(21,627) $ 5,800 $22,111 $11,699 $ 5,302 $ 21,845
Cumulative interest sensitivity gap ......... $22,693 $ (1,440) $(23,067) $(17,267) $ 4,844 $16,543 $21,845
Gap ratio ................................... 1.64 .13 .34 1.62 28.73 41.20 -
Cumulative gap ratio ........................ 1.64 .98 .76 .84 1.05 1.16 1.20
(1) Securities with call features have been included in the period in which the
security matures in both periods.
(2) There were no unamortized deferred loan fees included in the above tables
in either year.
(3) Nonaccruing loans of $2.4 million are included in the 2008 schedule.
Nonaccrual loans totaling $1.8 million are included in the immediate
category, loans totaling $221,672 are included in the 1-3 month category,
loans totaling $116,870 are included in the 3-12 months category, and loans
totaling $261,556 are included in the 1-3 year category.
(4) Nonaccruing loans of $291,697 are included in the 2007 schedule. Nonaccrual
loans totaling $8,300 are included in the immediate category, loans
totaling $118,611 are included in the 3-12 months category, and loans
totaling $164,786 are included in the 1-3 year category.
11
Provision for Loan Losses
The provision for loan losses is charged to earnings based on
management's continuing review and evaluation of the loan portfolio and general
economic conditions. The following table summarizes the activity in the
allowance for loan losses.
Year ended December 31,
2008 2007 2006
---- ---- ----
(Dollars in thousands)
Allowance for loan losses, beginning of year ........................... $ 1,293 $ 1,200 $ 1,058
Provision for loan losses .............................................. 815 197 446
Charge-offs ............................................................ (685) (104) (304)
Recoveries ............................................................. 276 - -
------- ------- -------
Allowance for loan losses, end of year ................................. $ 1,699 $ 1,293 $ 1,200
======= ======= =======
See "Impaired Loans" and "Allowance for Loan Losses" for a discussion
of the factors management considers in its review of the adequacy of the
allowance and provision for loan losses.
Noninterest Income
Noninterest income, which consists primarily of mortgage loan
origination fees, service charges on deposit accounts, and other fee income,
decreased by $1.0 million to $.1 million in 2008 from $1.1 million in 2007 and
from $1.4 million in 2006. The 2008 decrease is primarily from the Other Than
Temporary Impairment charge in the amount of $918,264 taken on FNMA Preferred
stock in September 2008. An additional cause of the decrease was a drop in
mortgage loan origination fees of $161,436. The decrease in 2007 is primarily
the result of a gain on sale of land of $241,696 in 2006 which related to the
sale of property adjacent to one of the Company's branch offices. As noted
above, the mortgage origination industry experienced significant changes
beginning in the fourth quarter of 2007 and continuing throughout 2008. While
the Company does not originate long-term residential mortgage loans for its own
portfolio, the effect on credit policies of third party lenders and on the
overall market did affect demand for the Company's brokered mortgage loan
products. The decline in mortgage origination fee income and the impairment
charge on the FNMA preferred stock were partially offset by an increase in
service fees on deposits. Service fees on deposit accounts increased by
approximately $36,000 in 2008 over 2007.
Noninterest Expenses
Noninterest expenses, which consist primarily of salaries and employee
benefits, occupancy costs, data processing expenses and professional and
regulatory fees, totaled $4.3 million in 2008 and 2007, and $3.9 million in
2006. Salaries and employee benefits decreased slightly in 2008 due to the
retirement of certain employees and no accrual of bonuses due to economic
conditions. Salaries and benefits rose in 2007 compared to 2006 due to the
hiring of additional staff to support the Bank's growth and annual salary
increases. As of the end of 2008, the Company employed 38 full-time personnel.
Net occupancy increased to $600,426 in 2008 from $567,222 in 2007 and $502,807
in 2006. The increase in 2008 is primarily due to a full year of expenses to
maintain the operations center opened in August 2007. Supplies expense decreased
23.3% in 2008 compared to 2007. The higher supplies expense in 2007 was
primarily due to costs associated with opening the Company's new operations
center in August 2007. Other operating expenses include various costs of normal
operations. Certain loan costs such as appraisal costs, software licensing fees,
and costs to process ATM transactions each increased in 2008 over 2007 levels.
OREO expenses in 2008 were $50,889 in 2008 compared to $7,207 in 2007. Property
taxes on real estate owned is the primary driver of the increase. The Company's
efficiency ratio, which is measured as the ratio of noninterest expense to the
sum of net interest income plus other income expressed as a percentage, was 81%
in 2008 compared to 62% in 2007 and 58% in 2006. In 2008 the ratio was severely
impacted by the other-than-temporary-impairment on FNMA Preferred Stock.
12
Income Taxes
For 2008 the Company recorded an income tax benefit of $17,600 compared
to tax expense of $810,232 in 2007 and $794,998 in 2006. The primary reasons for
the benefit in 2008 are the exclusion of nontaxable municipal bond income in
2008 and the tax effect of the other than temporary impairment charge on the
FNMA preferred stock. In the fourth quarter of 2008 legislation was passed by
Congress making the OTTI charge includable in ordinary income for holders of
FNMA and Federal Home Loan Mortgage Corporation ("FHLMC") preferred stocks. The
Company recorded a deferred tax asset in the amount of $312,210 related to the
other than temporary impairment of the FNMA preferred stock. The Bank accounts
for income taxes under Financial Accounting Standards ("SFAS") No. 109,
"Accounting for Income Taxes." Certain items of income and expense (principally
provision for loan losses, depreciation, and prepaid expenses) are included in
one reporting period for financial accounting purposes and another for income
tax purposes. Refer to the notes to the Company's consolidated financial
statements contained elsewhere herein for more information.
Investment Securities
Management assigns securities upon purchase into one of the categories
(trading, available-for-sale and held-to-maturity) designated by Statement of
SFAS No. 115 based on intent, taking into consideration other factors including
expectations for changes in market rates of interest, liquidity needs,
asset/liability management strategies, and capital requirements. The Bank has
not historically held securities for trading purposes. As of December 31, 2008,
2007, and 2006, the Bank's investment portfolio comprised approximately 12.7%,
13.4%, and 14.1%, respectively, of total assets.
The following table summarizes the carrying amounts of securities held
by the Bank at December 31, 2008 and 2007. Available-for-sale securities are
stated at estimated fair value. The Company had no Held-to-maturity securities
in either period. Federal Reserve Bank of Richmond and Federal Home Loan Bank of
Atlanta stocks have no quoted market value, but have historically been redeemed
at par value, and are therefore carried at cost. However, there can be no
assurance that these stocks will be redeemed at par value in the future. There
are no individual issuers, other than government sponsored enterprises, whose
securities represent more than 10% of the Company's consolidated shareholders'
equity at December 31, 2008. Government sponsored enterprises ("GSEs") are
agencies and corporations established by the U. S. Government, including among
others, the Federal Home Loan Banks, Federal National Mortgage Association,
Federal Home Loan Mortgage Corporation and Federal Farm Credit Banks. Until
2008, securities issued by these enterprises were not obligations of the U. S.
Government and were not backed by the full faith and credit of the U. S.
Government or otherwise guaranteed by the U. S. Government, although they were
commonly treated as guaranteed. In 2008, in an attempt to stabilize U.S. and
international financial markets, the U.S. Government explicitly guaranteed
certain debt instruments of the GSEs. These securities have generally been and
will continue to be eligible to be used as security for public deposits of the
U. S. Treasury, government agencies and corporations and states and other
political subdivisions. At December 31, 2008 and 2007, securities with a fair
value of $18.4 million and $13.0 million respectively, were pledged to
collateralize public deposits, sweep accounts, and customer and broker
repurchase agreements. Refer to the notes to the Company's consolidated
financial statements contained elsewhere herein for more information.
Investment Securities Portfolio Composition
December 31,
2008 2007
----- ----
(Dollars in thousands)
Available for sale:
Government sponsored enterprise bonds ....................................................... $ 9,293 $10,619
Mortgage-backed securities .................................................................. 4,280 3,446
Municipal bonds ............................................................................. 6,072 2,977
FNMA preferred stock ........................................................................ 32 1,012
------- -------
Total available for sale ................................................................. 19,677 18,054
Federal Reserve Bank of Richmond stock ......................................................... 394 389
Federal Home Loan Bank of Atlanta stock ........................................................ 720 428
------- -------
Total .......................................................................................... $20,791 $18,871
======= =======
13
The following table presents contractual maturities and weighted
average yields of securities at December 31, 2008 and 2007. Securities are
presented at their carrying value (available for sale securities are carried at
fair value and other securities are carried at book value, which is equal to
their amortized cost.)
Investment Securities Portfolio Maturities and Yields
December 31, 2008 December 31, 2007
Amount Yield(1) Amount Yield(1)
------ -------- ------ --------
(Dollars in thousands) (Dollars in thousands)
Available for sale securities:
Government sponsored enterprises
Within one year ..................................... $ - -% $ - - %
After one through five years ........................ 2,631 4.44% 3,035 5.14%
After five through ten years ........................ 6,662 5.90% 7,585 5.87%
FNMA and FHLMC Mortgage-backed securities (2)
After one through five years ........................ 280 3.84% 182 4.25%
After five through ten years ........................ - -% 210 3.50%
After 10 years ...................................... 4,000 5.75% 3,054 5.91%
Municipal bonds
After one through five years ..................... 247 3.25% - -%
After five through ten years ..................... 1,888 3.80% 1,711 3.66%
After 10 years ................................... 3,937 4.09% 1,266 4.10%
Other securities
No stated maturity .................................. 1,146 2.06% 1,828 7.09%
------- -------
Total ............................................... $20,791 4.88% $18,871 5.53%
======= =======
(1) Yields calculated on a pre-tax basis.
(2) These securities mature on an amortizing basis. They are included here in
the period of final maturity.
While twelve of the Company's Government sponsored enterprise bonds,
municipal bonds and mortgage-backed securities available-for-sale are in an
unrealized loss position as of December 31, 2008, none of these securities is
expected to have a loss of principal at final maturity. Only one security has
been in an unrealized loss position for more than twelve months. The Company has
the intent and ability to hold these securities until such time as the value
recovers or the securities mature. During 2008, the Company recognized
other-than temporary-impairment on the FNMA preferred stock of $606,054, net of
tax, based on analysis under FSP 115-1 and FNMA being placed into
conservatorship by the U.S. Treasury Department. The Company believes, based on
industry analyst reports and credit ratings, that the remaining deterioration in
value is attributable to market volatility. For the municipal securities, the
Company believes that the unrealized losses are the result of a lack of
confidence in insurers of municipal securities and not in the credit quality of
the underlying issuers. Therefore, as of December 31, 2008, these losses are not
considered other-than-temporary. The Company's investments are obligations of
the United States, its sponsored enterprises, or municipal securities. In the
opinion of Management, there is no concentration of credit risk in the
investment portfolio.
Loan Portfolio
Management believes the loan portfolio is adequately diversified,
although real estate collateral is the predominant collateral in the portfolio.
There are no significant concentrations of loans to any particular individuals,
and there are no foreign loans. The Bank does have loans in certain broad
categories that comprise over 25% of Tier 1 Capital adjusted for the allowance
for loan losses. Those categories are as follows: real estate rental and
leasing, accommodation and food services, construction, retail trade, health
care and social assistance, and other services. The Company believes that the
Bank has appropriate controls in place to monitor risks that may arise due to
concentrations in the loan portfolio.
14
Loans made outside the loan policy guidelines may present additional
credit risk to the Company. In order to monitor these loans and the total number
and amount of loans made with exceptions to loan policies, the Bank monitors all
loans approved with policy exceptions. Monthly, statistics regarding the number
of loans and the amount of loans with policy exceptions are reported to the
Board of Directors. One of the policy exceptions reported is for loans exceeding
the regulatory guidelines on loan to value ratios. The regulatory loan to value
guidelines permit exceptions to the guidelines not to exceed 100% of Total
Regulatory Capital for single family residential mortgage loans ($20.4 million
at December 31, 2008), or 30% of Total Regulatory Capital for real estate loans
other than single family residential loans ($6.1 million as of December 31,
2008). As of December 31, 2008, the Bank had $1.2 million of loans which
exceeded regulatory loan to value guidelines, an amount which is well within the
allowable maximum of exceptions to the guidelines.
In 2007, the Company increased real estate construction loans
approximately 60%. This segment of the Bank's business is managed in specific
ways in order to minimize the risks normally associated with construction
lending. Management requires lending personnel to visit job sites, maintain
frequent contact with borrowers and perform or commission inspections of
completed work prior to issuing additional construction loan draws. In addition,
management employs additional procedures for monitoring construction loans such
as engaging an independent appraiser to perform routine reviews of the
percentage complete inspection reports for a sample of construction projects.
Senior management compares the independent review report to the percentage
complete report in the Bank's loan files. Any discrepancy is investigated
immediately to insure that the Bank's investment is protected. However, even
tight internal controls and management oversight will not prevent some borrowers
from defaulting on these types of loans. In the current market where declining
conditions last for a long period of time, many participants in the housing and
real estate construction industries cannot continue to perform as specified in
their loan agreements for long periods of time without sales activity. The Bank
has agreed to work with various borrowers in the real estate and construction
industry to minimize the effect on the Bank and the borrowers. Loans in this
situation are placed on nonaccrual, and included in the Company's impaired
loans. See "Impaired Loans" below.
The banking industry offers products that can increase credit risk
should economic conditions change over the course of a loan's life.
Interest-only loans, adjustable rate loans, and loans with amortization periods
that differ from the maturity date (i.e., balloon payment loans) are examples of
products that could subject the Company to increased credit risk in periods of
changing economic conditions. The Company evaluates each customer's credit
worthiness based on current and expected economic conditions and underwrites and
monitors each such loan for associated risks. Therefore, Management does not
believe that these particular products subject the Company to unusual credit
risk. As of December 31, 2008, the Bank did not have in its portfolio any
residential mortgage loans with negative amortization features, long term
principal only payment features, or loan to value ratios at origination in
excess of 100%.
The Bank has a mortgage loan brokerage department that accepts mortgage
applications for terms greater than 15 years. Mortgage applications are
processed and sent to third parties for underwriting. Approved loans are funded
by, and closed in the name of, third parties and the Bank receives an
origination fee.
15
The amount of loans outstanding at December 31, 2008 and 2007 are shown
in the following table according to type of loan:
Loan Portfolio Composition
December 31,
------------
2008 2007
---- ----
(Dollars in thousands)
% of % of
Amount Loans Amount Loans
------ ----- ------ -----
Commercial and industrial ........................... $18,597 14.2% $18,753 17.3%
Real Estate - construction .......................... 49,670 37.9 43,333 39.9
Real Estate - mortgage
1-4 family residential ....................... 26,429 20.1 18,948 17.4
Nonfarm, nonresidential ...................... 33,214 25.3 24,248 22.3
Multifamily residential ...................... 1,223 .9 1,621 1.5
Consumer installment ................................ 2,049 1.6 1,740 1.6
-------- ----- -------- -----
Total Loans .............................. 131,182 100.0% 108,643 100.0%
===== =====
Less allowance for loan losses .............. (1,699) (1,293)
-------- --------
Net Loans ................................ $129,483 $107,350
======== ========
Maturity Distribution of Loans
The Bank's loan portfolio has a large component of adjustable rate
loans. As of December 31, 2008, approximately $78.8 million or 60.0% of the
Bank's loan portfolio was variable.
The following table sets forth the maturity distribution of the Bank's
loans, by type, as of December 31, 2008, as well as the type of interest
requirement on such loans. For purposes of this table, variable rate loans are
included in the period of their final maturity, as opposed to their repricing
date.
Maturity Distribution on Loans
December 31, 2008
-----------------
(Dollars in thousands)
1 Year 1-5 5 Years
or Less Years or More Total
------- ----- ------- -----
Commercial and industrial .......................................... $ 10,200 $ 8,213 $ 184 $ 18,597
Real Estate-construction ........................................... 40,099 9,141 430 49,670
Real Estate-mortgage ............................................... 11,574 39,483 9,809 60,866
Consumer ........................................................... 1,206 843 - 2,049
-------- -------- -------- --------
Total ........................................................ $ 63,079 $ 57,680 $ 10,423 $131,182
======== ======== ======== ========
Predetermined rate, maturity greater than one year ................. $ 40,899 $ 2,106 $ 43,005
Variable rate, maturity greater than one year ...................... $ 16,780 $ 8,318 $ 25,098
Impaired Loans
A loan will be considered to be impaired when, in management's judgment
based on current information and events, it is probable that the loan's
principal or interest will not be collectible in accordance with the terms of
the original loan agreement. Impaired loans, when not material, will be carried
in the balance sheet at a value not to exceed their observable market price or
the fair value of the collateral if the repayment of the loan is expected to be
provided solely by the underlying collateral. The carrying values of any
material impaired loans will be measured based on the present value of expected
future cash flows discounted at the loan's effective interest rate, which is the
contractual interest rate adjusted for any deferred loan fees or costs, premium
or discount existing at the inception or acquisition of the loan.
16
Loans which management identifies as impaired generally will be
nonperforming loans. Nonperforming loans include nonaccrual loans or loans which
are 90 days or more delinquent as to principal or interest payments. As of
December 31, 2008, the Bank had nonaccrual loans of $2.4 million. This amount
includes ten loans to one customer totaling $1.3 million and two other loans
totaling $1.1 million, all of which are collateral dependent. These loans are
secured by real estate, and were in the process of foreclosure or other
collection processes as of December 31, 2008. If these loans had been current,
the Company would have recorded additional interest income of $76,238 on these
loans. All previously accrued but uncollected income on these loans has been
eliminated from the accompanying consolidated income statement. Impairment
reserves of $150,000 are included in the allowance for loan losses related to
loans on nonaccrual as of December 31, 2008. Refer to the notes to the Company's
consolidated financial statements contained elsewhere herein for more
information. The allowance for loan losses includes management's best estimate
of the possible losses on these loans. At December 31, 2007 the Bank had
nonaccrual loans or loans 90 days or more past due of $291,697 and no
restructured loans.
Generally, the accrual of interest will be discontinued on impaired
loans when principal or interest becomes 90 days past due, or when payment in
full is not anticipated, and any previously accrued interest on such loans will
be reversed against current income. Any subsequent interest income will be
recognized on a cash basis when received unless collectibility of a significant
amount of principal is in serious doubt. In such cases, collections are credited
first to the remaining principal balance on a cost recovery basis. An impaired
loan will not be returned to accrual status unless principal and interest are
current and the borrower has demonstrated the ability to continue making
payments as agreed.
Potential Problem Loans
Management identifies and maintains a list of potential problem loans.
These are loans that are not included in nonaccrual status, or loans that are
past due 90 days or more and still accruing interest. A loan is added to the
potential problem list when management becomes aware of information about
possible credit problems of borrowers that causes serious doubts as to the
ability of such borrowers to comply with the current loan repayment terms. These
loans are designated as such in order to be monitored more closely than other
credits in the Bank's portfolio. There were loans in the amount of $4.7 million
that have been determined by management to be potential problem loans at
December 31, 2008. The majority of these loans are secured by real estate.
Management is currently assessing the potential impact on the Bank and the
Company.
Allowance for Loan Losses
The allowance for loan losses is increased by direct charges to
operating expense. Losses on loans are charged against the allowance in the
period in which management determines that it is likely that such loans have
become uncollectible. Recoveries of previously charged off loans will be
credited to the allowance. In reviewing the adequacy of the allowance for loan
losses at each year end, management takes into consideration the historical loan
losses experienced by the bank, current economic conditions affecting the
borrowers' ability to repay, the volume of loans, and the trends in delinquent,
nonaccruing, and any potential problem loans, and the quality of collateral
securing nonperforming and problem loans. Management considers the allowance for
loan losses to be adequate to cover its estimate of loan losses inherent in the
loan portfolio as of December 31, 2008.
In calculating the amount required in the allowance for loan losses,
management applies a consistent methodology that is updated quarterly. The
methodology utilizes a loan risk grading system and detailed loan reviews to
assess credit risks and the overall quality of the loan portfolio. Also, the
calculation provides for management's assessment of trends in national and local
economic conditions that might affect the general quality of the loan portfolio.
17
Summary of Loan Loss Experience
Year ended December 31,
2008 2007
---- ----
(Dollars in thousands)
Total loans outstanding at end of period ............................................... $ 131,182 $ 108,643
Average amount of loans outstanding .................................................... $ 115,162 $ 102,917
--------- ---------
Balance of allowance for loan losses-beginning ......................................... $ 1,293 $ 1,200
Loans charged-off
Commercial ....................................................................... 186 -
Commercial real estate ........................................................... 498 91
Consumer installment ............................................................. 1 13
--------- ---------
Total charge-offs ............................................................. 685 104
Recoveries of loans previously charged-off - commercial loans .......................... 276 -
--------- ---------
Net (charge-offs) recoveries ........................................................... (409) (104)
Additions to allowance charged to expense .............................................. 815 197
--------- ---------
Balance of allowance for loan losses-ending ............................................ $ 1,699 $ 1,293
========= =========
Ratios
Net (charge-offs) recoveries to average loans outstanding ........................ (.35%) (.10%)
Net (charge-offs) recoveries to loans at end of period ........................... (.31%) (.10%)
Allowance for loan losses to average loans ....................................... 1.48% 1.27%
Allowance for loan losses to loans at end of period .............................. 1.30% 1.19%
Net (charge-offs) recoveries to allowance for loan losses ........................ (24.1%) (8.0%)
Net (charge-offs) recoveries to provision for loan losses ........................ (50.3%) (52.6%)
The allowance for loan losses is not restricted to specific categories
of loans and is available to absorb losses in all categories. Each category of
loans is reviewed for characteristics that increase or decrease risk of loss,
such as the availability and marketability of collateral, degree of
susceptibility to changes in economic conditions, etc., for purposes of
estimating the allowance for loan losses. (See "Business of the
Company--Services of the Bank" for a discussion of risk characteristics for each
loan category.) Individual loans are graded using an internal grading system
that considers information specific to the loan. If warranted, a specific
allocation may be associated with that loan for purposes of estimating the
adequacy of the allowance for loan losses. During 2008, the Company charged off
loans totaling $685,166. Management continues to pursue recovery of amounts
charged-off in previous years. However, it is not possible to determine the
amount, if any, that can be recovered at this time.
Real Estate Owned
The Bank had $575,000 and $69,000 of real estate owned pursuant to
foreclosure or in-substance foreclosure at December 31, 2008 and 2007,
respectively. The real estate owned as of December 31, 2008 was under contract
for sale. An immaterial amount of costs are expected to be recorded in
conjunction with sale of the real estate. Real estate owned is initially
recorded at the lower of net loan principal balance or its estimated fair market
value less estimated selling costs. The estimated fair value is determined by
appraisal at the time of acquisition.
18
Deposits
The amounts and percentage composition of deposits held by the Bank as
of December 31, 2008 and 2007 are summarized below:
Deposit Composition
December 31,
------------
2008 2007
---- ----
(Dollars in thousands)
% of % of
Amount Deposits Amount Deposits
------ -------- ------ --------
Noninterest bearing demand ................................. $ 10,070 8.2% $ 13,646 12.3%
Interest bearing transaction accounts ...................... 13,013 10.6 15,083 13.6
Savings .................................................... 13,849 11.3 2,712 2.5
Money market ............................................... 7,286 6.0 8,092 7.3
Time deposits $100,000 and over ............................ 41,810 34.1 31,976 28.8
Other time deposits ........................................ 36,554 29.8 39,425 35.5
-------- ----- -------- -----
Total deposits ......................................... $122,582 100.0% $110,934 100.0%
======== ===== ======== =====
The average amounts of and average rate paid on deposits held by the
Bank for the years ended December 31, 2008 and 2007, are summarized below:
Average Deposits
Year ended December 31,
-----------------------
2008 2007
---- ----
Amount Rate Amount Rate
------ ---- ------ ----
(Dollars in thousands)
Noninterest bearing demand ........................................ $ 10,914 -% $ 11,984 -%
Interest bearing transaction accounts ............................. 13,502 .92% 13,708 1.15%
Savings and money market .......................................... 14,994 1.98% 10,461 2.12%
Time deposits ..................................................... 76,234 3.68% 71,613 4.81%
-------- --------
Total average deposits ...................................... $115,644 $107,766
======== ========
As of December 31, 2008, the Bank held $41.8 million of time deposits
with balances of $100,000 or more. Of that amount, $12.6 million mature within
three months, $14.5 million mature over three through six months, $8.2 million
mature over six through twelve months, and $6.5 million mature over twelve
months. $600,000 of time deposits over $100,000 or more are at floating rates of
interest at December 31, 2008.
While many of the large time deposits are acquired from customers with
standing relationships with the Bank, it is a common industry practice not to
consider these types of deposits as core deposits because their retention can be
expected to be heavily influenced by rates offered, and therefore such deposits
may have the characteristics of shorter-term purchased funds. Certain deposits
included in total deposits over $100,000 are brokered deposits. Brokered
deposits are acquired in the wholesale market but are issued to the eventual
customer in increments of less than $100,000. The majority of these deposits are
not redeemable prior to maturity except in the case of death. All time deposits
over $100,000 involve the maintenance of an appropriate matching of maturity
distribution and a diversification of sources to achieve an appropriate level of
liquidity.
Customer Repurchase Agreements
Customer repurchase agreements consist of sweep accounts and retail
repurchase agreements, and totaled $4.6 million and $5.8 million at December 31,
2008 and 2007, respectively. Securities issued by government sponsored
enterprises with an amortized cost of $5.6 million and $6.6 million (fair value
of $5.9 million and $6.8 million) were used as collateral for the sweep accounts
and retail repurchase agreements, at December 31, 2008 and 2007, respectively.
19
All of the sweep accounts pay interest on a floating rate basis. The customer
repurchase agreements pay interest on a fixed rate basis and have maturities of
varying lengths. As of December 31, 2008, $2.8 million of the Bank's customer
repurchase agreements mature in 2009 and $350,000 mature in 2010. During 2008
the average amount of customer repurchase agreements and sweep accounts totaled
$5.0 million. The Bank paid an average interest rate of 3.21% on these funds in
2008.
Broker Repurchase Agreements
Broker repurchase agreements consist of two separate borrowings
totaling $5.0 million. These borrowings carry fixed rates of interest with call
features. The agreements mature as follows: $3.0 million maturing on January 15,
2015, callable by the broker quarterly after January 15, 2012, and $2.0 million
maturing on January 15, 2013, callable by the broker quarterly, beginning
January 10, 2010. Securities with fair value of $6.2 million and amortized cost
of $6.5 million collateralize the agreements. During 2008, the highest balance
as of any month end for broker repurchase agreements was $5.0 million and the
average balance for 2008 was $4.8 million. The average rate paid on broker
repurchase agreements during 2008 was 3.53%. There were no broker repurchase
agreements as of December 31, 2007.
Liquidity
Liquidity is the ability to meet current and future obligations through
liquidation or maturity of existing assets or the acquisition of additional
liabilities. Adequate liquidity is necessary to meet the requirements of
customers for loans and deposit withdrawals in the most timely and economical
manner. Some liquidity is ensured by maintaining assets that may be immediately
converted into cash at minimal cost (amounts due from banks and federal funds
sold). However, the most manageable sources of liquidity are composed of
liabilities, with the primary focus on liquidity management being on the ability
to obtain deposits within the Bank's service area. Core deposits (total deposits
less time deposits greater than $100,000) provide a relatively stable funding
base, and were equal to 49.3% of total assets at December 31, 2008.
Asset liquidity is provided from several sources, including amounts due
from banks and federal funds sold, unpledged securities, and funds from maturing
loans. The Company had $4.0 million in cash and cash equivalents at December 31,
2008. The Bank has access to $5.3 million in lines of credit with other banks
and a line of credit with the Federal Home Loan Bank of Atlanta ("FHLB") as
additional sources of liquidity funding. The lines with the other banks are for
short-term use only and are unsecured. $3.5 million was available under these
lines as of December 31, 2008. There were no amounts outstanding on short-term
lines of credit with other banks as of December 31, 2007.
The line with the FHLB is equal to 10% of assets provided that adequate
collateral is available for pledging. The line may be used for short or long
term funding needs and may be used on a fixed or variable-rate basis. As of
December 31, 2008, the Bank had $10.4 million at various rates of interest,
maturing at various dates through 2018, borrowed from the FHLB. During 2008, the
highest balance as of any month end for borrowings from the FHLB was $10.4
million. The average rate paid on the advances during 2008 was 3.28%. The
average balance of FHLB advances for 2008 was $7.0 million.
During 2007, the highest balance outstanding from the FHLB at any month
end was $3.6 million. The average balance of FHLB advances for 2007 was $2.8
million. The average interest rate paid on advances in 2007 was 4.13%.
At December 31, 2008, approximately $6.0 million of additional funds
were available under the FHLB line provided that eligible collateral is
available. Management believes that the Bank's overall liquidity sources are
adequate to meet its operating needs in the ordinary course of its business.
Off-Balance Sheet Risk
The Company, through the operations of the Bank, makes contractual
commitments to extend credit in the ordinary course of its business activities.
These commitments are legally binding agreements to lend money to customers of
the Bank at predetermined interest rates for a specified period of time. At
December 31, 2008, the Bank had issued commitments to extend credit of $21.9
million through various types of lending arrangements. Of these commitments,
$21.1 million are at variable rates and $14.4 million of the total expire within
one year. Past experience indicates that many of these commitments to extend
credit will expire unused and it is unlikely that a large portion would be used
20
in a short period of time. However, through its various sources of liquidity
discussed above, the Bank believes that it will have the necessary resources to
meet these obligations should the need arise.
In addition to commitments to extend credit, the Bank also issues
standby letters of credit which are assurances to a third party that it will not
suffer a loss if the Bank's customer fails to meet its contractual obligation to
the third party. Standby letters of credit totaled approximately $1.1 million at
December 31, 2008. Past experience indicates that many of these standby letters
of credit will expire unused. However, through its various sources of liquidity
discussed above, the Bank believes that it will have the necessary resources to
meet these obligations should the need arise.
The Bank offers an automatic overdraft protection product.
Approximately $1.2 million of overdraft protection is available under this
product as of December 31, 2008. The Bank expects the majority of this capacity
will not be utilized. During 2008, the average balance of demand deposit
overdrafts was $25,935.
Neither the Company nor the Bank is involved in other off-balance sheet
contractual relationships, unconsolidated related entities that have off-balance
sheet arrangements or transactions that could result in liquidity needs or other
commitments or significantly impact earnings. The Company did not maintain any
obligations under non-cancelable operating lease agreements at December 31,
2008. The Company has less than one year remaining on a five-year contract with
a company which provides data, item and ATM processing services. The monthly
costs are approximately $19,000. Refer to notes 11 and 15 to the Company's
consolidated financial statements for additional discussion on commitments and
contingencies and financial instruments with off-balance sheet risk.
Capital Resources
At December 31, 2008, total shareholders' equity decreased by
approximately $443,000 from $19.5 million at December 31, 2007 to $19.1 million
at December 31, 2008. The decrease was due to dividends paid of $597,471, offset
by net income of $225,316, items related to stock based compensation, including
option exercises, of $138,005 and an unrealized loss on investment securities of
$170,344. The Company does not anticipate it will be required to raise
additional capital in 2009 if growth occurs in line with current expectations
and the broader economy does not deteriorate further.
The Company made capital expenditures for furniture and equipment in
2008 totaling approximately $32,300. No sizeable capital expenditures for
premises are planned for 2009.
The Company and the Bank are subject to regulatory capital adequacy
standards. Under these standards, financial institutions are required to
maintain certain minimum ratios of capital to risk-weighted assets and average
total assets. Under the provisions of the Federal Deposit Insurance Corporation
Improvements Act of 1991, federal financial institution regulatory authorities
are required to implement prescribed "prompt corrective action" upon the
deterioration of the capital position of a bank. If the capital position of an
affected institution were to fall below certain levels, increasingly stringent
regulatory corrective actions are mandated. The Company's and the Bank's
regulatory capital requirements and positions are summarized in note 19 to the
consolidated financial statements.
21
Return on Equity and Assets
The following table shows the return on assets (net income divided by
average total assets), return on equity (net income divided by average equity),
dividend payout ratio (cash dividends declared per share divided by net income
per share), and equity to assets ratio (average equity divided by average total
assets) for the years ended December 31, 2008 and 2007.
December 31, December 31,
2008 2007
---- ----
Return on assets ......................... .15% 1.18%
Return on equity ......................... 1.16% 8.73%
Dividend payout ratio .................... 265% -%
Equity to assets ratio (average) ......... 12.68% 13.56%
In May, 2008 the Company declared its first cash dividend. The amount
of the dividend was determined based on a number of factors, including previous
year's earnings, capital levels, prospects for growth and earnings during the
coming twelve months, and availability of dividends from the Bank to the
Company. There can be no assurance that cash dividends will be declared in the
future.
During 2009, the Bank's plan of operation is to attract new deposit
and loan customers, especially in the market areas around our branch offices, to
increase the ratio of services per customer and increase the account
profitability of the Bank's current customers. The Bank plans to seek deposit
accounts from individuals and businesses in the Easley, Berea, Powdersville and
surrounding markets. The Bank intends to offer competitive rates for such
accounts and may seek new accounts by offering rates slightly above those
prevailing in the market. Management will continue to emphasize personal
service, accessibility, and flexibility as reasons for customers to do business
with the Bank. Personal contacts by management, advertising, and competitive
prices and services will be the Bank's principal marketing tools.
Inflation
Since the assets and liabilities of a bank are primarily monetary in
nature (payable in fixed, determinable amounts), the performance of a bank is
affected more by changes in interest rates than by inflation. Interest rates
generally increase as the rate of inflation increases, but the magnitude of the
change in rates may not be the same.
While the effect of inflation on banks is normally not as significant
as is its influence on those businesses that have large investments in plant and
inventories, it does have an effect. During periods of high inflation, there are
normally corresponding increases in the money supply, and banks will normally
experience above-average growth in assets, loans and deposits. Also general
increases in the prices of goods and services usually result in increased
operating expenses.
Market for Common Equity and Related Stockholder Matters
The following table shows the high and low bid prices of our common
stock reported by the Over-the-Counter Bulletin Board. The prices reflect
inter-dealer prices, without retail mark-up, mark-down, or commission and may
not represent actual transactions. The prices have been adjusted to reflect a
10% stock dividend declared in April 2007 to shareholders of record as of May 8,
2007.
Year ended Year ended
December 31, 2008 December 31, 2007
----------------- -----------------
Low High Low High
--- ---- --- ----
First Quarter ....... $11.25 $15.50 $13.18 $14.64
Second Quarter ...... $13.75 $14.00 $13.86 $16.59
Third Quarter ....... $10.30 $13.90 $15.75 $15.85
Fourth Quarter ...... $10.00 $11.50 $12.00 $15.10
Although the common stock of the Company may be traded from time to
time on an individual basis, no active trading market has developed and none may
22
develop in the foreseeable future. The common stock is not listed on any
exchange. The stock is quoted on the Over-the-Counter Bulletin Board under the
symbol "CTOT.OB."
As of March 1, 2009, there were approximately 596 holders of record of
the Company's common stock, excluding individual participants in security
position listings.
The Company paid cash dividends of $597,471 for the first time in 2008.
The dividend policy of the Company is subject to the discretion of the Board of
Directors and depends upon a number of factors, including earnings, financial
conditions, cash needs and general business conditions, as well as applicable
regulatory considerations. Because the Company has no operations other than
those of the Bank and only has limited income of its own, the Company would rely
on dividends from the Bank as its principal source of cash to pay cash
dividends.
Each national banking association is required by federal law to obtain
the prior approval of the OCC for the payment of dividends if the total of all
dividends declared by the board of directors of such bank in any year will
exceed the total of (i) such bank's net profits (as defined and interpreted by
regulation) for that year plus (ii) the retained net profits (as defined and
interpreted by regulation) for the preceding two years, less any required
transfers to surplus. In addition, national banks can only pay dividends to the
extent that retained net profits (including the portion transferred to surplus)
exceed bad debts (as defined by regulation).
The payment of dividends by the Company and the Bank may also be
affected or limited by other factors, such as the requirements to maintain
adequate capital above regulatory guidelines. In addition, if, in the opinion of
the applicable regulatory authority, a bank under its jurisdiction is engaged in
or is about to engage in an unsafe or unsound practice (which, depending on the
financial condition of the Bank, could include the payment of dividends), such
authority may require, after notice and hearing, that such bank cease and desist
from such practice. The OCC has indicated that paying dividends that deplete a
national bank's capital base to an inadequate level would be an unsafe and
unsound banking practice. The Federal Reserve, the OCC and the FDIC have issued
policy statements, which provide that bank holding companies and insured banks
should generally only pay cash dividends out of current operating earnings.
Management's Annual Report on Internal Control Over Financial Reporting
Management is responsible for establishing and maintaining adequate
internal control over financial reporting, as such term is defined in Exchange
Act Rule 13a-15(f). A system of internal control over financial reporting is a
process designed to provide reasonable assurance regarding the reliability of
financial reporting and the preparation of financial statements for external
purposes in accordance with generally accepted accounting principles.
Under the supervision and with the participation of management,
including the principal executive officer and the principal financial officer,
the Company's management has evaluated the effectiveness of its internal control
over financial reporting as of December 31, 2008 based on the criteria
established in a report entitled "Internal Control - Integrated Framework issued
by the Committee of Sponsoring Organizations of the Treadway Commission" and the
interpretive guidance issued by the Securities and Exchange Commission in
Release No. 34-55929. Based on this evaluation, the Company's management has
evaluated and concluded that the Company's internal control over financial
reporting was effective as of December 31, 2008.
This annual report does not include an attestation report of the
Company's independent registered public accounting firm regarding internal
control over financial reporting because management's report was not subject to
attestation by the Company's registered public accounting firm pursuant to
temporary rules of the Securities and Exchange Commission that permit the
Company to provide only management's report in this annual report.
23
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors
Cornerstone Bancorp and Subsidiary
Easley, South Carolina
We have audited the accompanying consolidated balance sheets of
Cornerstone Bancorp and Subsidiary (the "Company") as of December 31, 2008 and
2007, and the related consolidated statements of income, changes in
shareholders' equity and comprehensive income, and cash flows for each of the
three years in the period ended December 31, 2008. These consolidated financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these consolidated financial
statements based on our audits.
We conducted our audits in accordance with the standards of the
Public Company Accounting Oversight Board (United States). Those standards
require that we plan and perform the audits to obtain reasonable assurance about
whether the financial statements are free of material misstatement. An audit
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements. An audit also includes assessing the
accounting principles used and significant estimates made by management, as well
as evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to
above present fairly, in all material respects, the consolidated financial
position of Cornerstone Bancorp and Subsidiary at December 31, 2008 and 2007 and
the results of their operations and their cash flows for each of the three years
in the period ended December 31, 2008, in conformity with United States
generally accepted accounting principles.
We were not engaged to examine management's assertion about the
effectiveness of Cornerstone Bancorp and Subsidiary's internal control over
financial reporting as of December 31, 2008 included in the accompanying
Management's Annual Report on Internal Control Over Financial Reporting and,
accordingly, we do not express an opinion thereon.
/s/ Elliott Davis, LLC
Greenville, South Carolina
March 24, 2009
24
CORNERSTONE BANCORP AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
December 31,
------------
2008 2007
---- ----
Assets
Cash and due from banks .................................................................... $ 3,820,227 $ 4,266,777
Federal funds sold ......................................................................... 140,000 967,000
------------ ------------
Cash and cash equivalents ........................................................... 3,960,227 5,233,777
Investment securities
Available-for-sale .................................................................... 19,676,604 18,054,409
Other investments ..................................................................... 1,114,150 816,500
Loans, net ................................................................................. 129,483,130 107,350,202
Property and equipment, net ................................................................ 5,551,275 5,808,568
Cash surrender value of life insurance policies ............................................ 1,768,520 1,697,429
Other real estate owned .................................................................... 575,000 69,000
Other assets ............................................................................... 1,722,161 1,468,187
------------ ------------
Total assets ................................................................. $163,851,067 $140,498,072
============ ============
Liabilities And Shareholders' Equity
Liabilities
Deposits
Noninterest bearing ............................................................... $ 10,069,125 $ 13,645,852
Interest bearing .................................................................. 112,512,449 97,288,616
------------ ------------
Total deposits .................................................................... 122,581,574 110,934,468
Federal funds purchased ............................................................... 1,810,000 -
Customer repurchase agreements ........................................................ 4,582,619 5,802,935
Borrowings from Federal Home Loan Bank of Atlanta ..................................... 10,394,005 3,544,838
Broker repurchase agreements .......................................................... 5,000,000 -
Other liabilities ..................................................................... 345,922 635,001
------------ ------------
Total liabilities ................................................................. 144,714,120 120,917,242
Commitments and contingencies - Notes 11 and 15
Shareholders' equity
Preferred stock, 10,000 shares authorized, no shares issued ........................... - -
Common stock, no par value, 20,000,000 shares authorized, 1,991,565 and
1,983,169 shares issued at December 31, 2008 and 2007, respectively ................. 18,323,333 18,185,328
Retained earnings ..................................................................... 765,906 1,177,450
Accumulated other comprehensive income .............................................. 47,708 218,052
------------ ------------
Total shareholders' equity ........................................................ 19,136,947 19,580,830
------------ ------------
Total liabilities and shareholders' equity ........................................ $163,851,067 $140,498,072
============ ============
The accompanying notes are an integral part of these consolidated
financial statements.
25
CORNERSTONE BANCORP AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF INCOME
Year ended December 31,
-----------------------
2008 2007 2006
---- ---- ----
Interest Income
Loans and fees on loans ............................................. $ 7,848,630 $ 8,834,764 $ 7,538,140
Investment securities ............................................... 1,161,545 944,003 791,730
Federal funds sold and other ........................................ 91,870 228,687 294,579
----------- ----------- -----------
Total interest income .......................................... 9,102,045 10,007,454 8,624,449
Interest Expense
Deposits ............................................................ 3,229,237 3,822,618 2,896,671
Federal funds sold and customer repurchase agreements ............... 170,090 238,562 116,409
Federal Home Loan Bank advances ..................................... 228,129 115,810 149,016
Broker repurchase agreements ........................................ 170,756 - -
----------- ----------- -----------
Total interest expense ......................................... 3,798,212 4,176,990 3,162,096
----------- ----------- -----------
Net interest income ............................................ 5,303,833 5,830,464 5,462,353
Provision for loan losses ........................................... 815,000 196,636 445,896
----------- ----------- -----------
Net interest income after provision for loan losses ............ 4,488,833 5,633,828 5,016,457
Noninterest Income (Expense)
Mortgage loan origination fees ...................................... 275,721 437,157 582,290
Service fees on deposit accounts .................................... 579,298 542,937 472,420
Gain on sale of land ................................................ - - 241,696
Other-than-temporary-impairment of FNMA preferred stock ............. (918,264) - -
Other ............................................................... 127,211 94,720 89,971
----------- ----------- -----------
Total noninterest income ....................................... 63,966 1,074,814 1,386,377
----------- ----------- -----------
Noninterest Expenses
Salaries and benefits ............................................... 2,415,115 2,443,315 2,305,982
Occupancy and equipment ............................................. 600,426 567,222 502,807
Data processing ..................................................... 231,958 234,671 203,814
Advertising ......................................................... 69,859 76,530 90,423
Supplies ............................................................ 85,895 111,918 94,157
Professional and regulatory fees .................................... 320,027 314,516 229,148
Directors fees ...................................................... 130,450 127,700 105,850
Other real estate owned ............................................. 50,889 7,207 -
Deposit charge-offs ................................................. 26,461 39,387 51,516
Other operating ..................................................... 414,003 363,191 364,403
----------- ----------- -----------
Total noninterest expenses ..................................... 4,345,083 4,285,657 3,948,100
----------- ----------- -----------
Income before income taxes ..................................... 207,716 2,422,985 2,454,734
Income tax provision (benefit) ...................................... (17,600) 810,232 794,998
----------- ----------- -----------
Net income ..................................................... $ 225,316 $ 1,612,753 $ 1,659,736
=========== =========== ===========
Earnings Per Common Share
Basic ............................................................... $ .11 $ .82 $ .85
Diluted ............................................................. $ .11 $ .80 $ .83
Weighted Average Common Shares Outstanding
Basic ............................................................... 1,989,890 1,965,635 1,950,378
Diluted ............................................................. 2,041,860 2,016,850 2,002,524
The accompanying notes are an integral part of these consolidated
financial statements.
26
CORNERSTONE BANCORP AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
AND COMPREHENSIVE INCOME (LOSS)
Accumulated
Common stock other Total
------------ Retained comprehensive shareholders'
Shares Amount earnings income (loss) equity
------ ------ -------- ------------- ------
Balance, December 31, 2005 ...................... 1,475,743 $ 13,071,896 $ 837,565 $ (81,476) $ 13,827,985
------------
Net income ...................................... - - 1,659,736 - 1,659,736
Other comprehensive income, net of
income taxes:
Unrealized gain on investment
securities ............................... - - - 147,734 147,734
------------
Comprehensive income ......................... 1,807,470
Stock based compensation ........................ - 19,784 - - 19,784
Stock dividend (10%), net of
cash in lieu of fractional shares ........ 161,375 994,462 (997,498) - (3,036)
Issuance of shares in secondary offering ........ 140,195 1,886,524 - - 1,886,524
------------ ------------ ------------ ------------ ------------
Balance, December 31, 2006 ...................... 1,777,313 15,972,666 1,499,803 66,258 17,538,727
------------
Net income ...................................... - - 1,612,753 - 1,612,753
Other comprehensive income, net of
income taxes:
Unrealized gain on investment
securities ............................... - - - 151,794 151,794
------------
Comprehensive income ......................... 1,764,547
Stock based compensation ........................ - 40,797 - - 40,797
Stock option exercises, including
Tax benefit of $54,550 .................... 27,306 238,990 - - 238,990
Stock dividend (10%), net of
cash in lieu of fractional shares ........ 178,550 1,932,875 (1,935,106) - (2,231)
------------ ------------ ------------ ------------ ------------
Balance, December 31, 2007 ...................... 1,983,169 18,185,328 1,177,450 218,052 19,580,830
------------
Net income ...................................... - - 225,316 - 225,316
Other comprehensive income, net of
income taxes:
Unrealized loss on investment
securities ............................... - - - (170,344) (170,344)
------------
Comprehensive income ......................... 54,972
Cumulative effect of accounting
change ................................... - - (39,389) - (39,389)
Stock based compensation ........................ - 56,172 - - 56,172
Stock option exercises .......................... 8,396 81,833 - - 81,833
Cash dividend paid .............................. - - (597,471) - (597,471)
------------ ------------ ------------ ------------ ------------
Balance, December 31, 2008 ...................... 1,991,565 $ 18,323,333 $ 765,906 $ 47,708 $ 19,136,947
============ ============ ============ ============ ============
The accompanying notes are an integral part of these consolidated
financial statements
27
CORNERSTONE BANCORP AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years ended December 31,
------------------------
2008 2007 2006
---- ---- ----
Operating Activities
Net income .............................................................. $ 225,316 $ 1,612,753 $ 1,659,736
Adjustments to reconcile net income to net cash provided
by operating activities
Depreciation and net amortization ................................. 292,585 285,241 276,521
Deferred income tax (benefit) expense ............................. (315,107) 4,508 (95,733)
Provision for loan losses ......................................... 815,000 196,636 445,896
Other than temporary impairment of FNMA Preferred ................. 918,264 - -
Gain on sale of land .............................................. - - (241,696)
(Gain) loss on sale of OREO ....................................... (3,464) 9,672 -
(Gain) loss on sale of fixed assets ............................... (481) - -
Non-cash option expense ........................................... 56,172 40,797 19,784
Increase in other assets .......................................... (9,958) (216,723) (311,758)
Increase (decrease) in other liabilities .......................... (240,717) (104,341) 193,791
------------ ------------ ------------
Net cash provided by operating activities ....................... 1,737,610 1,828,543 1,946,541
------------ ------------ ------------
Investing Activities
Proceeds from maturities and principal paydowns of
investment securities .................................................. 4,276,949 4,358,412 8,077,893
Proceeds from sale of OREO .............................................. 399,208 96,528 -
Purchase of investment securities ....................................... (7,085,514) (5,005,942) (11,643,855)
Purchase of FHLB and Federal Reserve stock, net ......................... (297,650) (2,900) (203,800)
Increase in loans, net .................................................. (23,849,672) (11,365,651) (10,528,678)
Proceeds from sale of property and equipment ............................ 7,495 - 273,493
Purchase of property and equipment ...................................... (32,295) (1,679,829) (137,001)
------------ ------------ ------------
Net cash used for investing activities .......................... (26,581,479) (13,599,382) (14,161,948)
------------ ------------ ------------
Financing Activities
Net increase in deposits ................................................ 11,647,106 9,268,272 10,014,155
Net increase (decrease) in customer repurchase agreements ............... (1,220,316) 738,795 1,980,256
Net increase Federal funds purchased .................................... 1,810,000 - -
Borrowings from Federal Home Loan Bank of Atlanta ....................... 11,800,000 1,000,000 -
Repayments to Federal Home Loan Bank of Atlanta ......................... (4,950,833) (150,833) (1,650,834)
Proceeds from broker repurchase agreements .............................. 5,000,000 - -
Proceeds from sale of common stock, net ................................. - - 1,886,524
Proceeds from exercise of stock options ................................. 81,833 238,990 -
Cash dividends paid ..................................................... (597,471) - -
Cash paid in lieu of fractional shares .................................. - (2,231) (3,036)
------------ ------------ ------------
Net cash provided by financing activities ....................... 23,570,319 11,092,993 12,227,065
------------ ------------ ------------
Net increase (decrease) in cash and cash
equivalents .............................................. (1,273,550) (677,846) 11,658
Cash and cash equivalents, beginning of year ................................... 5,233,777 5,911,623 5,899,965
------------ ------------ ------------
Cash and cash equivalents, end of year ......................................... $ 3,960,227 $ 5,233,777 $ 5,911,623
============ ============ ============
Cash paid for:
Interest ................................................................ $ 3,803,188 $ 4,145,118 $ 3,118,302
============ ============ ============
Income taxes ............................................................ $ 438,048 $ 932,075 $ 822,000
============ ============ ============
Non-cash Supplemental information:
Loans transferred to other real estate owned ............................ $ 931,761 $ 69,000 $ -
============ ============ ============
Loans charged-off, net .................................................. $ 409,567 $ 103,505 $ 304,192
============ ============ ============
The accompanying notes are an integral part of these consolidated
financial statements
28
CORNERSTONE BANCORP AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND ACTIVITIES
Cornerstone Bancorp, (the "Company") was incorporated under the laws of
the State of South Carolina for the purpose of operating as a bank holding
company for Cornerstone National Bank (the "Bank"). The Company obtained
regulatory approval to acquire the Bank and opened the Bank for business in 1999
with a total capitalization of $6.0 million. To increase capital available for
growth, the Company offered 445,000 shares of its common stock pursuant to a
prospectus dated October 4, 2005. Upon completion in January 2006, the offering
added approximately $6.0 million to the Company's total capitalization.
The Bank provides full commercial banking services to customers and is
subject to regulation by the Office of the Controller of the Currency ("OCC")
and the Federal Deposit Insurance Corporation. The Company is subject to
regulation by Federal Reserve and to limited regulation by the South Carolina
State Board of Financial Institutions. The Bank maintains branch locations in
the Berea area of Greenville County and the Powdersville area of Anderson
County, South Carolina in addition to its headquarters in Easley in Pickens
County, South Carolina. In 2004, the Bank established a wholly owned subsidiary,
Crescent Financial Services, Inc. ("Crescent"), which is an insurance agency. In
2008, 2007 and 2006, Crescent's transactions were immaterial to the consolidated
financial statements.
Basis of presentation
The consolidated financial statements include the accounts of the Company
and its wholly-owned subsidiary, the Bank. The Company operates as one
business segment. All significant intercompany balances and transactions
have been eliminated. The accounting and reporting policies conform to
accounting principles generally accepted in the United States of America
and to general practices in the banking industry. The Company uses the
accrual basis of accounting.
Estimates
The preparation of consolidated financial statements in conformity with
accounting principles generally accepted in the United States of America
("GAAP") requires management to make estimates and assumptions that affect
the reported amounts of assets and liabilities and disclosure of contingent
assets and liabilities as of the date of the financial statements and the
reported amount of income and expenses during the reporting periods. Actual
results could differ from those estimates. The Company's most significant
estimates relate to the allowance for loan losses and income taxes.
Concentrations of credit risk
The Company makes loans to individuals and businesses in and around Upstate
South Carolina for various personal and commercial purposes. The Bank has a
diversified loan portfolio and the borrowers' ability to repay their loans
is not dependent upon any specific economic sector. The Bank monitors
concentrations in its customer base using the North American Industry Codes
("NAIC"). As of December 31, 2008, the Bank has concentrations of credit in
real estate rental and leasing, accommodation and food services,
construction, retail trade, health care and social assistance, and other
services, which by NAIC category comprise over 25% of Tier 1 Capital
adjusted for the allowance for loan losses. Although a majority of the
Bank's loans are collateralized by real estate, the Bank believes that it
has proper internal controls to identify and mitigate risks associated with
this concentration in real estate collateral.
Investment securities
The Company accounts for investment securities in accordance with
Statements of Financial Accounting Standards ("SFAS") No. 115, "Accounting
for Certain Investments in Debt and Equity Securities" and SFAS No.157
"Fair Value Measurements." SFAS No.115 requires investments in equity and
debt securities to be classified into three categories:
(Continued)
29
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND ACTIVITIES, Continued
1. Available-for-sale securities: These are securities that are not
classified as either held to maturity or as trading securities. These
securities are reported at fair market value. Unrealized gains and
losses are reported, net of income taxes, as separate components of
shareholders' equity (accumulated other comprehensive income).
2. Held-to-maturity securities: These are investment securities that the
Company has the ability and intent to hold until maturity. These
securities are stated at cost, adjusted for amortization of premiums and
the accretion of discounts.
3. Trading securities: These are securities that are bought and held
principally for the purpose of selling in the near future. Trading
securities are reported at fair market value, and related unrealized
gains and losses are recognized in the income statement. The Company has
no trading securities.
The Company reviews all investments with unrealized losses as of the balance
sheet date for possible impairment. Our review consists of an examination of
each security with regard to its issuer, credit rating, time to maturity and
likelihood of sale prior to maturity. Any losses determined to be other than
temporary are recognized through the income statement.
SFAS No. 157 defines fair value, establishes a framework for measuring fair
value under generally accepted accounting principles, and expands
disclosures about fair value measurements. Available for sale securities
owned by the Company include government sponsored enterprise bonds,
mortgage-backed securities, municipal bonds, and preferred stock issued by
the Federal National Mortgage Association ("FNMA"), a government sponsored
enterprise. The fair values of the Company's available for sale investments,
other than municipal bonds, are measured on a recurring basis using quoted
market prices in active markets for identical assets and liabilities ("Level
1 inputs" under SFAS No. 157). Due to the lower level of trading activity in
municipal bonds, the fair market values of these investments are measured
based on other inputs such as inputs that are observable or can be
corroborated by observable market data for similar assets with substantially
the same terms ("Level 2 inputs" under SFAS No. 157).
Other investments include the Bank's stock investments in the Federal
Reserve Bank of Richmond ("Reserve Bank") and the Federal Home Loan Bank of
Atlanta ("FHLB"). The Bank, as a member institution, is required to own
certain stock investments in the Reserve Bank and FHLB. The stock is
generally pledged against any borrowings from the Reserve Bank and FHLB. No
ready market exists for the stock and it has no quoted market value.
Redemption of these stock investments has historically been at par value.
However, there can be no assurance that future redemptions will be at par
value. Other investments are carried at cost.
Gains or losses on dispositions of investment securities are based on the
differences between the net proceeds and the adjusted carrying amount of
the securities sold, using the specific identification method.
Loans, interest and fee income on loans
Loans are stated at the principal balance outstanding. Unearned discount
and the allowance for possible loan losses are deducted from total loans in
the balance sheet. Interest income is recognized over the term of the loan
based on the principal amount outstanding.
Generally, the accrual of interest will be discontinued on impaired loans
when principal or interest becomes 90 days past due, or when payment in
full is not anticipated, and any previously accrued interest on such loans
will be reversed against current income. Any subsequent interest income
will be recognized on a cash basis when received unless collectibility of a
significant amount of principal is in serious doubt. In such cases,
collections are credited first to the remaining principal balance on a cost
recovery basis. An impaired loan will not be returned to accrual status
unless principal and interest are current and the borrower has demonstrated
the ability to continue making payments as agreed. Non-performing assets
include real estate acquired through foreclosure or deed taken in lieu of
foreclosure, and loans on non-accrual status. Fee income on loans is
recognized as income at the time loans are originated. Due to the
short-term nature of the majority of the Bank's loans and the immateriality
of the net deferred amount, this method approximates the income that would
be earned if the Company deferred loan fees and costs under SFAS No. 91.
(Continued)
30
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND ACTIVITIES, Continued
Allowance for loan losses
The Company provides for loan losses using the allowance method. Loans that
are determined to be uncollectible are charged against the allowance.
Provisions for loan losses and recoveries on loans previously charged off
are added to the allowance. The provision for loan losses charged to
operating expenses reflects the amount deemed appropriate by management to
establish an adequate reserve to meet the probable loan losses incurred in
the current loan portfolio. Management's judgment is based on periodic and
regular evaluation of individual loans, the overall risk characteristics of
the various portfolio segments, past experience with losses, delinquency
trends, and prevailing economic conditions. While management uses the best
information available to make evaluations, future adjustments to the
allowance may be necessary if economic conditions differ substantially from
the assumptions used in making the evaluations. The allowance for loan
losses is also subject to periodic evaluation by various regulatory
authorities and may be subject to adjustment upon their examination.
The Bank accounts for impaired loans in accordance with SFAS No. 114,
"Accounting by Creditors for Impairment of a Loan." This standard requires
that all lenders value a loan at the loan's fair value if it is probable
that the lender will be unable to collect all amounts due according to the
terms of the loan agreement. Factors considered by management in
determining impairment include payment status, collateral value, and the
probability of collecting scheduled principal and interest payments when
due. Loans that experience insignificant payment delays and payment
shortfalls generally are not classified as impaired. Management determines
the significance of payment delays and payment shortfalls on a case-by-case
basis taking into consideration all the circumstances of the loan and the
borrower, including the length of the delay, reasons for the delay, the
borrower's payment record and the amount of the shortfall in relation to
the principal and interest owed. Impairment is determined on a case-by-case
basis. The fair value of an impaired loan may be determined based upon the
present value of expected cash flows, market price of the loan, if
available, or value of the underlying collateral. Expected cash flows are
required to be discounted at the loan's effective interest rate.
Under SFAS No. 114, when the ultimate collectibility of an impaired loan's
principal is in doubt, wholly or partially, all cash receipts are applied
to principal. Once the reported principal balance has been reduced to zero,
future cash receipts are applied to interest income, to the extent that any
interest has been foregone. Further cash receipts are recorded as
recoveries of any amounts previously charged off.
A loan is also considered impaired if its terms are modified in a troubled
debt restructuring. For these accruing impaired loans, cash receipts are
typically applied to principal and interest receivable in accordance with
the terms of the restructured loan agreement. Interest income is recognized
on these loans using the accrual method of accounting.
Other real estate owned
Other real estate owned is carried at the lower of cost or fair value
(market value less estimated selling cost), determined using an independent
appraisal.
Property and equipment
Property and equipment are stated at cost, net of accumulated depreciation.
Depreciation is computed using the straight-line method over the estimated
useful lives of the related assets. Maintenance and repairs are charged to
operations, while major improvements are capitalized. Upon retirement, sale
or other disposition of property and equipment, the cost and accumulated
depreciation are eliminated from the accounts, and gain or loss is included
in income from operations.
Income taxes
The Company accounts for income taxes in accordance with SFAS No. 109,
"Accounting for Income Taxes" and in accordance with Interpretation No. 48
("FIN 48"). Under SFAS No. 109, deferred tax assets and liabilities are
recognized for the expected future tax consequences of events that have
been recognized in the consolidated financial statements or tax returns.
Deferred tax assets and liabilities are measured using the enacted tax
rates expected to apply to taxable income in the years in which those
temporary differences are expected to be realized
(Continued)
31
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND ACTIVITIES, Continued
or settled. FIN 48 seeks to reduce the diversity in practice associated
with certain aspects of the recognition and measurement related to
accounting for income taxes. The Company implemented the provisions of FIN
48 as of January 1, 2007, and has analyzed filing positions in the federal
and state jurisdictions where it is required to file income tax returns, as
well as all open tax years in these jurisdictions. The Company believes
that income tax filing positions taken or expected to be taken in its tax
returns will more likely than not be sustained upon audit by the taxing
authorities and does not anticipate any adjustments that will result in a
material adverse impact on the Company's financial condition, results of
operations, or cash flows. Therefore, no reserves for uncertain income tax
positions have been recorded pursuant to FIN 48. In addition, the Company
did not record a cumulative effect adjustment related to the adoption of
FIN 48.
Advertising and public relations expense
Advertising, promotional and other business development costs are generally
expensed as incurred. External costs incurred in producing media
advertising are expensed the first time the advertising takes place.
External costs relating to direct mailing costs are expensed in the period
in which the direct mailings are sent.
Earnings per common share
Basic earnings per common share is computed on the basis of the weighted
average number of common shares outstanding in accordance with SFAS No.
128, "Earnings per Share." The treasury stock method is used to compute the
effect of stock options on the weighted average number of common shares
outstanding for diluted earnings per common share. As of December 31, 2008
there were 57,638 common stock equivalents outstanding, all of which were
related to options issued by the Company. Options to purchase 52,414 shares
of common stock were antidilutive as of December 31, 2008 and were omitted
from the diluted share calculation. The Company declared 10 percent stock
dividends to shareholders of record as of May 8, 2007, May 9, 2006, May 10,
2005, May 11, 2004, March 17, 2003 and April 30, 2002. 2006 share and per
share amounts on the Consolidated Statements of Income have been restated
to reflect the applicable transactions.
Cash surrender value of life insurance policies
Cash surrender value of life insurance policies represents the cash value
of policies on certain officers of the Bank.
Statement of cash flows
For purposes of reporting cash flows, cash and cash equivalents are those
amounts which have an original maturity of three months or less.
Fair values of financial instruments
SFAS No. 107, "Disclosures About Fair Value of Financial Instruments," as
amended by SFAS No. 119, requires disclosure of fair value information for
financial instruments, whether or not recognized in the balance sheet, when
it is practicable to estimate the fair value. SFAS No. 107 defines a
financial instrument as cash, evidence of an ownership interest in an
entity or contractual obligations that require the exchange of cash or
other financial instruments. Certain items are specifically excluded from
the disclosure requirements, including the Company's common stock. In
addition, other nonfinancial instruments such as premises and equipment and
other assets and liabilities are not subject to the disclosure
requirements.
The following methods and assumptions were used by the Company in
estimating fair values of financial instruments as disclosed herein:
Cash and due from banks - The carrying amounts of cash and due from
banks approximate their fair value.
Federal funds sold - The carrying amounts of federal funds sold
approximate their fair value.
Investment securities - Fair values for investment securities are
based on quoted market prices as defined in SFAS 157. The carrying
amounts of Reserve Bank and FHLB stocks approximate their fair values.
Cash surrender value of life insurance policies - The cash surrender
value of life insurance policies held by the Bank approximates fair
values of the policies.
(Continued)
32
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND ACTIVITIES, Continued
Loans - For variable rate loans that reprice frequently and for loans
that mature within one year, fair values are based on carrying values.
Fair values for all other loans are estimated using discounted cash
flow analyses, with interest rates currently being offered for loans
with similar terms to borrowers of similar credit quality. Fair values
for impaired loans are estimated using discounted cash flow analyses or
underlying collateral values, where applicable.
Deposits - Fair values for deposits are estimated using a discounted
cash flow calculation that applies interest rates currently being
offered on similar accounts to a schedule of aggregated expected
monthly maturities. Repricing time frames for non-maturing deposits are
estimated using FDICIA 305 guidelines.
Customer repurchase agreements - Fair values of repurchase agreements
are estimated using a discounted cash flow analysis that applies
interest rates currently being offered on similar accounts to a
schedule of aggregated expected monthly maturities.
Borrowings from Federal Home Loan Bank of Atlanta - Borrowings from the
FHLB which have variable rates of interest are deemed to be carried at
fair value. Fair values of fixed rate advances are estimated using a
discounted cash flow calculation that applies interest rates currently
being offered on advances to a schedule of aggregated expected
maturities.
Broker repurchase agreements - Fair values of broker repurchase
agreements are estimated using a discounted cash flow analysis that
applies interest rates currently being offered on similar accounts to a
schedule of aggregated expected monthly maturities.
Stock Based Compensation
The Company has issued stock options to certain directors who were
organizers of the Company and the Bank, and also has a stock-based director
and employee compensation plan (the "2003 Plan") as further described in
Note 17. Under the 2003 Plan, 18,000 options were granted during each of
2004, 2005, 2006 and 2007. 19,200 options were granted in 2008. Subsequent
to the grant dates of the Organizers' options and some of the employees'
options, 10% stock dividends were declared. Pursuant to the terms of the
2003 Plan and the Organizers' option agreements, the number of options
outstanding was increased and the exercise price was decreased to give
effect to these stock dividends.
The Company accounts for stock based compensation in accordance with SFAS
No. 123(R). Fair value of an option grant is estimated on the date of grant
using the Black-Scholes option pricing model. The risk free interest rates
used for the 2008, 2007, and 2006 grants were 3.91%, 4.68%, and 4.36%,
respectively, which was the 10 Year Constant Maturity Rate on US Treasury
Securities during the months in which the options were granted. The assumed
dividend rate was zero and the expected option life was 10 years for 2008,
2007, and 2006 grants. Volatility is difficult to measure accurately due to
the low volume of trading of the Company's stock. The common stock is not
listed on any exchange and has no active trading market. Since 2006, the
stock has been quoted on the Over-the-Counter Bulletin Board. The
volatility assumption used for 2008 option grants was 28%, for 2007 option
grants was 12%, and for 2006 option grants was 18% based on information
available at the date of the grant.
Recently issued accounting standards
The following is a summary of recent authoritative pronouncements that
affect accounting, reporting, and disclosure of financial information by
the Company:
In September, 2006, The FASB ratified the consensuses reached by the FASB's
Emerging Issues Task Force ("EITF") relating to EITF 06-4 "Accounting for
the Deferred Compensation and Postretirement Benefit Aspects of Endorsement
Split-Dollar Life Insurance Arrangements." EITF 06-4 addresses employer
accounting for endorsement split-dollar life insurance arrangements that
provide a benefit to an employee that extends to postretirement periods.
Employers should recognize a liability for future benefits in accordance
with SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other
Than Pensions," or Accounting Principles Board ("APB") Opinion No. 12,
"Omnibus Opinion-1967." EITF 06-4 was effective January 1,
(Continued)
33
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND ACTIVITIES, Continued
2008. The Company recorded a liability of $39,389 in the accompanying
consolidated financial statements for the cumulative effect of the change.
In March 2007, the FASB ratified the consensus reached on EITF 06-10,
"Accounting for Collateral Assignment Split-Dollar Life Insurance
Arrangements" ("EITF 06-10"). The postretirement aspect of this EITF is
substantially similar to EITF 06-4 discussed above and requires that an
employer recognize a liability for the postretirement benefit related to a
collateral assignment split-dollar life insurance arrangement in accordance
with either FASB Statement No. 106 or APB Opinion No. 12, as appropriate,
if the employer has agreed to maintain a life insurance policy during the
employee's retirement or provide the employee with a death benefit based on
the substantive agreement with the employee. EITF 06-10 was effective for
the Company on January 1, 2008. The adoption of EITF 06-10 did not have a
material impact on the Company's financial position, results of operations
or cash flows.
Effective January 1, 2008, the Company adopted SFAS No. 157, "Fair Value
Measurements." SFAS No. 157 defines fair value, establishes a framework for
measuring fair value under generally accepted accounting principles, and
expands disclosures about fair value measurements. SFAS No. 157 defines
fair value as the exchange price that would be received for an asset or
paid to transfer a liability (an exit price) in the principal or most
advantageous market for the asset or liability in an orderly transaction
between market participants on the measurement date. SFAS No. 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 1 assets and liabilities include debt and equity
securities and derivative contracts that are traded in an active
exchange market, as well as U.S. Treasuries and money market funds.
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 2 assets and liabilities include
debt with quoted prices that are traded less frequently than
exchange-traded instruments, mortgage-backed securities, municipal
bonds, corporate debt securities, and derivative contracts whose value
is determined using a pricing model with inputs that are observable in
the market or can be derived principally from or corroborated by
observable market data. This category generally includes certain
derivative contracts and impaired loans.
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. Level 3 assets and liabilities include financial
instruments whose value is determined using pricing models, discounted
cash flow methodologies, or similar techniques, as well as instruments
for which the determination of fair value requires significant
management judgment or estimation. For example, this category generally
includes certain private equity investments, retained residual
interests in securitizations, residential mortgage servicing rights,
and highly-structured or long-term derivative contracts.
Adoption of SFAS No. 157 did not have a significant impact on the Company's
financial position, results of operations, or cash flows.
FSP EITF 99-20-1, "Amendments to the Impairment Guidance of EITF Issue No.
99-20," ("FSP EITF 99-20-1") was issued in January 2009. Prior to the Staff
Position, other-than-temporary impairment was determined by using either
EITF Issue No. 99-20, "Recognition of Interest Income and Impairment on
Purchased Beneficial Interests and Beneficial Interests that Continue to be
Held by a Transferor in Securitized Financial Assets," ("EITF 99-20") or
SFAS No. 115, "Accounting for Certain Investments in Debt and Equity
Securities," depending on the type of security. EITF 99-20 required the use
of market participant assumptions regarding future cash flows regarding the
probability of collecting all cash flows previously projected. SFAS 115
determined impairment to be other than temporary if it was probable that
the holder would be unable to collect all amounts due according to the
contractual terms. To achieve a more consistent determination of
other-than-temporary impairment, the Staff Position amends EITF 99-20 to
determine any other-than-temporary
(Continued)
34
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND ACTIVITIES, Continued
impairment based on the guidance in SFAS No. 115, allowing management to
use more judgment in determining any other-than-temporary impairment. The
Staff Position is effective for the Company as of December 31, 2008.
Management has reviewed and evaluated the Company's security portfolio for
any other-than-temporary impairments as discussed in Note 4.
The SEC's Office of the Chief Accountant and the staff of the FASB issued
press release 2008-234 on September 30, 2008 ("Press Release") to provide
clarifications on fair value accounting. The Press Release includes
guidance on the use of management's internal assumptions and the use of
"market" quotes. It also reiterates the factors in SEC Staff Accounting
Bulletin ("SAB") Topic 5M that should be considered when determining
other-than-temporary impairment: the length of time and extent to which the
market value has been less than cost; financial condition and near-term
prospects of the issuer; and the intent and ability of the holder to retain
its investment for a period of time sufficient to allow for any anticipated
recovery in market value.
On October 10, 2008, the FASB issued FSP SFAS 157-3, "Determining the Fair
Value of a Financial Asset When the Market for That Asset Is Not Active"
("FSP SFAS 157-3"). This Staff Position clarifies the application of SFAS
No. 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 asset is not active. The FSP is effective
upon issuance, including prior periods for which financial statements have
not been issued. For the Company, this FSP was effective for the quarter
ended September 30, 2008. The Company considered the guidance in the Press
Release and in FSP SFAS 157-3 when conducting its review for
other-than-temporary impairment as of December 31, 2008 as discussed in
Note 4.
In May, 2008, the FASB issued SFAS No. 162, "The Hierarchy of Generally
Accepted Accounting Principles." SFAS No. 162 identifies the sources of
accounting principles and the framework for selecting the principles used
in the preparation of financial statements of nongovernmental entities that
are presented in conformity with GAAP. SFAS NO. 162 is effective November
15, 2008. The FASB has stated that it does not expect SFAS No. 162 will
result in a change in current practice. The application of SFAS No. 162 had
no effect on the Company's financial position, results of operations or
cash flows.
Accounting standards that have been issued or proposed by the FASB that do
not require adoption until a future date are not expected to have a
material impact on the consolidated financial statements upon adoption.
Risks and Uncertainties
In the normal course of its business the Company encounters two significant
types of risks: economic and regulatory. There are three main components of
economic risk: interest rate risk, credit risk and market risk. The Company
is subject to interest rate risk to the degree that its interest-bearing
liabilities mature or reprice at different times, or on different bases,
than its interest-earning assets. Credit risk is the risk of default on the
Company's loan and investment portfolios that results from borrowers'
inability or unwillingness to make contractually required payments. Market
risk reflects changes in the value of collateral underlying loans
receivable and the valuation of real estate held by the Company.
The Company is subject to the regulations of various governmental agencies.
These regulations can and do change significantly from period to period.
The Company also undergoes periodic examinations by the regulatory
agencies, which may subject it to further changes with respect to asset
valuations, amounts of required loss allowances and operating restrictions
as a result of the regulators' judgments based on information available to
them at the time of their examination.
NOTE 2 - RESTRICTIONS ON CASH AND DUE FROM BANKS
The Bank is required to maintain average reserve balances, computed by
applying prescribed percentages to its various types of deposits, either at the
Bank or on deposit with the Reserve Bank. At December 31, 2008 and 2007 these
required reserves were met by vault cash.
35
NOTE 3 - FEDERAL FUNDS SOLD
When the Bank's cash reserves (Note 2) are in excess of the required
amount, it may lend any excess to other banks on a daily basis. As of December
31, 2008 and 2007 federal funds sold amounted to $140,000 and $967,000,
respectively.
NOTE 4 - INVESTMENT SECURITIES
The amortized cost and fair value of investment securities
available-for-sale are as follows:
December 31, 2008
-----------------
Gross unrealized
Amortized ---------------- Fair
cost Gains Losses value
---- ----- ------ -----
Government sponsored enterprise bonds ...................... $ 8,859,181 $ 433,569 $ - $ 9,292,750
FNMA preferred stock ....................................... 87,200 - 54,800 32,400
Mortgage-backed securities ................................. 4,173,881 113,419 7,611 4,279,689
Municipal bonds ............................................ 6,484,056 46,120 458,411 6,071,765
----------- ----------- ----------- -----------
Total investment securities available-
for-sale ........................................... $19,604,318 $ 593,108 $ 520,822 $19,676,604
=========== =========== =========== ===========
December 31, 2007
-----------------
Gross unrealized
Amortized ---------------- Fair
cost Gains Losses value
---- ----- ------ -----
Government sponsored enterprise bonds ...................... $10,357,277 $ 262,910 $ 843 $10,619,344
FNMA preferred stock ....................................... 1,007,025 4,975 - 1,012,000
Mortgage-backed securities ................................. 3,398,658 59,833 12,053 3,446,438
Municipal bonds ............................................ 2,961,067 20,813 5,253 2,976,627
----------- ----------- ----------- -----------
Total investment securities available-
for-sale .......................................... $17,724,027 $ 348,531 $ 18,149 $18,054,409
=========== =========== =========== ===========
While twelve of the Company's Government sponsored enterprise bonds,
municipal bonds and mortgage-backed securities available-for-sale are in an
unrealized loss position as of December 31, 2008, only one has been in an
unrealized loss position for twelve months or more. None of these securities is
expected to have a loss of principal at final maturity. The Company has the
intent and ability to hold these securities until such time as the value
recovers or the securities mature. During 2008, the Company recognized
other-than temporary-impairment on the FNMA preferred stock of $606,054, net of
tax, based on analysis under FSP 115-1 and FNMA being placed into
conservatorship by the U.S. Treasury Department. The Company believes, based on
industry analyst reports and credit ratings, that the remaining deterioration in
value is attributable to market volatility. For the municipal securities, the
Company believes that the unrealized losses are the result of a lack of
confidence in insurers of municipal securities and not in the credit quality of
the underlying issuers. Therefore, as of December 31, 2008, these losses are not
considered other-than-temporary. The table below summarizes, by investment
category, the length of time that individual securities have been in a
continuous loss position as of December 31, 2008.
Total Unrealized
Less than Twelve Months Over Twelve Months Losses
----------------------------- ----------------------------- ---------------
Gross Gross
Unrealized Unrealized
Losses Fair Value Losses Fair Value
------ ---------- ------ ----------
FNMA Preferred stock ..................... $ 54,800 $ 32,400 $ - $ - $ 54,800
Mortgage-backed securities ............... - - 7,611 156,163 7,611
Municipal bonds .......................... 458,411 4,089,308 - - 458,411
---------- ---------- ---------- ---------- ----------
Total ......................... $ 513,211 $4,121,708 $ 7,611 $ 156,163 $ 520,822
========== ========== ========== ========== ==========
(Continued)
36
NOTE 4 - INVESTMENT SECURITIES, Continued
The amortized cost and fair value of securities at December 31, 2008,
by contractual maturity, are shown in the following chart. Expected maturities
may differ from contractual maturities because borrowers may have the right to
call or prepay obligations with or without call or prepayment penalties.
December 31, 2008
-----------------
Amortized Fair
Cost Value
---- -----
Due after one through five years ........... $ 3,027,793 $ 3,157,702
Due after five through ten years ........... 8,207,487 8,549,347
After ten years or no maturity ............. 8,369,039 7,969,555
----------- -----------
Total investment securities ............ $19,604,319 $19,676,604
=========== ===========
At December 31, 2008 and 2007, securities with a fair value of
$18,440,430 and $12,952,538, respectively, were pledged to collateralize public
deposits, sweep accounts, advances from the FHLB, and repurchase agreements.
There were no gains or losses realized from sales of securities for the years
ended December 31, 2008, 2007, or 2006.
The Bank, as a member institution, is required to own stock in the
Reserve Bank and the FHLB. These stocks are included at cost in the accompanying
Consolidated Balance Sheets under the caption "Other investments." No ready
market exists for these stock investments and they have no quoted market value.
However, redemption of these stocks has historically been at par value. Stock
held in the FHLB of Atlanta is pledged as collateral against advances from the
FHLB.
NOTE 5 - LOANS
The composition of net loans by major loan category is presented below.
December 31,
------------
2008 2007
---- ----
Commercial ............................. $ 18,596,972 $ 18,753,358
Real estate - construction ............. 49,669,669 43,332,737
Real estate - mortgage ................. 60,866,234 44,817,279
Consumer ............................... 2,048,818 1,739,958
------------- -------------
Loans, gross ........................... 131,181,693 108,643,332
Less allowance for loan losses ......... (1,698,563) (1,293,130)
------------- -------------
Loans, net ............................. $ 129,483,130 $ 107,350,202
============= =============
As of December 31, 2008, approximately $78.8 million or 60.0 % of total
gross loans were variable rate loans.
The FHLB Atlanta has a blanket lien on certain types of the Company's
loans as collateral for FHLB advance borrowings. See Note 9.
At December 31, 2008 the Bank had non-accrual loans of $2.4 million,
which are considered to be impaired. This amount includes twelve loans, all of
which are collateral dependent. These loans are secured by real estate, and were
in the process of foreclosure or other collection processes as of December 31,
2008. If these loans had been current, the Company would have recorded
additional interest income of $76,238 on these loans in 2008. All previously
accrued but uncollected income on these loans has been eliminated from the
accompanying consolidated income statement. Included in the allowance for loan
losses is $150,000 related to these loans. There are no other loans considered
to be impaired as of December 31, 2008. Average impaired loans in 2008 (average
loans on nonaccrual or loans 90 days or more delinquent as to principal or
interest payments) were $1.2 million. At December 31, 2007 the Company held
nonaccrual loans in the amount of $291,697.
(Continued)
37
NOTE 5 - LOANS, Continued
Activity in the allowance for loan losses for the years ended December 31, 2008,
2007, and 2006 is summarized in the table below.
Year ended December 31,
-----------------------
2008 2007 2006
---- ---- ----
Allowance for loan losses, beginning of year ..................... $ 1,293,130 $ 1,199,999 $ 1,058,295
Provision for loan losses ........................................ 815,000 196,636 445,896
Charge-offs ...................................................... (685,166) (103,505) (304,192)
Recoveries ....................................................... 275,599 - -
----------- ----------- -----------
Allowance for loan losses, end of year ........................... $ 1,698,563 $ 1,293,130 $ 1,199,999
=========== =========== ===========
NOTE 6 - PROPERTY AND EQUIPMENT
Components of property and equipment included in the balance sheet are
as follows:
December 31,
------------
2008 2007
---- ----
Land and improvements ...................... $ 1,468,480 $ 1,468,480
Bank premises .............................. 4,271,773 4,271,773
Furniture, equipment and software .......... 1,527,107 1,510,130
Vehicles ................................... 58,005 88,065
----------- -----------
Property and equipment ................. 7,325,365 7,338,448
Accumulated depreciation ................... (1,774,090) (1,529,880)
----------- -----------
Property and equipment, net ............ $ 5,551,275 $ 5,808,568
=========== ===========
Depreciation expense for the years ended December 31, 2008, 2007, and
2006, amounted to $282,574, $286,257, and $268,067, respectively. Depreciation
is charged to operations over the estimated useful lives of the assets. The
estimated useful lives and methods of depreciation for the principal items
follow:
Type of Asset Life in Years Depreciation Method
- ------------------------------------- ------------------------------------ ----------------------------
Furniture, equipment and software 3 to 7 Straight-line
Improvements 5 to 40 Straight-line
Vehicles 5 Straight-line
38
NOTE 7 - DEPOSITS
The following is a detail of the deposit accounts as of:
December 31,
------------
2008 2007
---- ----
Noninterest bearing ...................... $ 10,069,125 $ 13,645,852
Interest bearing:
NOW accounts ........................ 13,013,071 15,082,860
Money market accounts ............... 7,286,130 8,091,963
Savings ............................. 13,848,956 2,712,141
Time, less than $100,000 ............ 36,554,096 39,425,515
Time, $100,000 and over ............. 41,810,196 31,976,137
------------ ------------
Total deposits ................. $122,581,574 $110,934,468
============ ============
Interest expense on time deposits greater than $100,000 was
approximately $1.3 million in 2008, $1.2 million in 2007, and $1.1 million in
2006. Securities issued by government sponsored enterprises with an amortized
cost of $2,040,000 and $1,934,723 (fair value of $2,136,495 and $1,987,183) in
2008 and 2007, respectively, were pledged as collateral for public funds.
At December 31, 2008 the scheduled maturities of certificates of
deposit are as follows:
2009 $ 66,436,812
2010 8,597,279
2011 1,936,714
2012 585,770
2013 807,717
------------
$ 78,364,292
============
NOTE 8 - CUSTOMER REPURCHASE AGREEMENTS
Customer repurchase agreements consist of the following:
December 31,
------------
2008 2007
---- ----
Sweep accounts .............................. $1,432,619 $2,217,935
Retail repurchase agreements ................ 3,150,000 3,585,000
---------- ----------
$4,582,619 $5,802,935
========== ==========
The Bank enters into sweep and retail repurchase agreements with its
customers. The sweep agreements generally mature overnight. At December 31,
2008, the Bank had five retail repurchase agreements that mature in 2009 and one
that matures in 2010. Securities issued by government sponsored enterprises with
an amortized cost of $5,644,221 and $6,607,634 (fair value of $5,905,715 and
$6,753,392) were pledged as collateral for the sweep accounts and repurchase
agreements, at December 31, 2008 and 2007, respectively.
39
NOTE 9 -BORROWINGS FROM FEDERAL HOME LOAN BANK OF ATLANTA
At December 31, 2008 and 2007, the Bank had a line of credit to borrow
funds from the FHLB in the amount of 10% of the Bank's assets. Funds borrowed
from the FHLB are collateralized by a lien on certain of the Bank's available
for sale securities and loans. At December 31, the Bank had advances outstanding
as follows:
December 31, Interest Rate Maturity Date Terms
------------ ------------- ------------- -----
2008 2007
---- ----
$ 3,500,000 $ - .46% 1/14/2009 Variable rate credit
1,500,000 - 2.73 3/16/2010 Fixed rate
1,500,000 - 2.84 9/16/2010 Fixed rate
1,000,000 - 2.72 1/25/2011 Fixed rate
222,222 266,667 4.49 12/01/2013 Fixed rate, amortizing
207,408 246,296 4.89 4/14/2014 Fixed rate, amortizing
464,375 531,875 4.78 7/27/2015 Fixed rate, amortizing
2,000,000 - 3.52 1/16/2018 Fixed rate, convertible
- 1,500,000 3.60 10/20/2008 Fixed rate
- 1,000,000 4.75 1/25/2008 Fixed rate
----------- ----------
$10,394,005 $3,544,838
=========== ==========
The Company's convertible advance from the FHLB is convertible to a
variable rate instrument at the option of the FHLB on January 16, 2013. During
2008, the highest balance as of any month end for borrowings from the FHLB was
$10.4 million. The average rate paid on the advances during 2008 was 3.28%. The
average balance of FHLB advances for 2008 was $7.0 million. During 2007, the
highest balance outstanding at any month end was $3.6 million. The average
balance of FHLB advances for 2007 was $2.8 million. The average interest rate
paid on advances in 2007 was 4.13%.
NOTE 10 -BROKER REPURCHASE AGREEMENTS
Broker repurchase agreements consist of two separate borrowings
totaling $5.0 million. These borrowings carry fixed rates of interest with call
features. The agreements mature as follows: $3.0 million maturing on January 15,
2015, callable by the broker quarterly after January 15, 2012, and $2.0 million
maturing on January 15, 2013, callable by the broker quarterly, beginning
January 10, 2010. Securities with fair value of $6,118,531 and amortized cost of
$6,499,137 collateralize the agreements. During 2008 the highest balance as of
any month end for broker repurchase agreements was $5.0 million and the average
balance for 2008 was $4,836,066. The average rate paid on broker repurchase
agreements during 2008 was 3.53%. There were no broker repurchase agreements as
of December 31, 2007.
NOTE 11 - COMMITMENTS AND CONTINGENCIES
The Bank may become party to litigation and claims arising in the
normal course of business. As of December 31, 2008, there was no litigation
pending other than foreclosure actions initiated by the Bank.
The Company has less than one year remaining on its contract with a
data, item, and ATM processing service. Monthly costs for these services are
currently approximately $19,000.
The Company has signed change of control agreements with three of its
executive officers. These agreements provide for various payments to the
executives in the event of a change in control of the Company.
From time to time the Bank may guarantee merchant credit card accounts
on behalf of certain customers. At December 31, 2008 the total amount guaranteed
by the Bank related to merchant credit card accounts was immaterial.
Refer to Note 15 concerning financial instruments with off balance
sheet risk.
40
NOTE 12 - LINES OF CREDIT
At December 31, 2008, the Bank had lines of credit to purchase federal
funds totaling $5,300,000 from unrelated banks. $1.8 million was outstanding on
one of these lines at December 31, 2008. The interest rate varies daily. These
lines of credit are available on a one to fourteen-day basis for general
corporate purposes of the Bank. The lenders have reserved the right to withdraw
the lines at their option.
NOTE 13 - INCOME TAXES
The provision for income taxes is reconciled to the amount of income
tax computed at the federal statutory rate on income before income taxes as
follows:
Year ended December 31,
-----------------------
2008 2007 2006
---- ---- ----
Tax expense (benefit) at statutory rate ........... $ 70,623 34% $ 823,815 34% $ 834,610 34%
Increase (decrease) in taxes resulting from:
State income taxes, net of federal
benefit ................................. 7,789 4 48,471 2 49,495 2
Tax-exempt investments ..................... (75,249) (36) (31,835) (1) (25,462) (1)
Increase in cash value of life insurance ... (24,171) (12) (23,277) (1) (19,016) (1)
Other ........................................ 3,408 2 (6,942) (1) (44,629) (2)
--------- -- --------- -- --------- --
Income tax provision .............................. $ (17,600) (8)% $ 810,232 33% $ 794,998 32%
========= == ========= == ========= ==
The income tax effects of cumulative temporary differences at December
31, 2008 and 2007 are as follows:
2008 2007
---- ----
Deferred tax assets:
Allowance for loan losses ........................................................ $513,045 $406,520
Other than temporary Impairment .................................................. 312,210 -
Stock based compensation ......................................................... 22,627 11,200
Other ............................................................................ 25,921 3,610
-------- --------
873,803 421,330
-------- --------
Deferred tax liabilities:
Unrealized net gain on securities available for sale ............................. 24,577 112,330
Depreciation ..................................................................... 82,658 88,883
Prepaid expenses ................................................................. 32,401 27,479
-------- --------
139,636 228,692
-------- --------
Net deferred tax asset .................................................... $734,167 $192,638
======== ========
The net deferred taxes are included in other assets in the consolidated
balance sheets. Deferred tax assets represent the future tax benefit of
deductible differences and, if it is more likely than not that a tax asset will
not be realized, a valuation allowance is required to reduce the recorded
deferred tax assets to net realizable value. As of December 31, 2008 and 2007,
no valuation allowance was deemed necessary.
The following summary of the provision for income taxes includes tax
deferrals that arise from temporary differences in the recognition of certain
items of revenue and expense for tax and financial reporting purposes:
Year ended December 31,
-----------------------
2008 2007 2006
---- ---- ----
Income taxes currently payable .................................... $ 436,176 $ 805,724 $ 890,731
Deferred income tax provision (benefit) ........................... (453,776) 4,508 (95,733)
--------- --------- ---------
Income tax provision (benefit) ............................ $ (17,600) $ 810,232 $ 794,998
========= ========= =========
The Company has analyzed the tax positions taken or expected to be
taken in its tax returns and concluded it has no liability related to uncertain
tax positions in accordance with FIN 48.
41
NOTE 14 - RELATED PARTY TRANSACTIONS
Certain directors, executive officers and companies with which they are
affiliated, are customers of and have loan transactions with the Bank in the
ordinary course of business. These loans were made on substantially the same
terms, including interest rates and collateral, as those prevailing at the time
for comparable arms-length transactions.
A summary of loan transactions with directors, including their
affiliates, and executive officers is as follows:
Year ended December 31,
-----------------------
2008 2007 2006
---- ---- ----
Balance, beginning of year ................................. $ 6,443,949 $ 5,835,997 $ 6,269,599
New loans or lines of credit ............................... 1,272,822 4,470,962 4,354,342
Payments on loans or lines of credit ....................... (1,758,108) (3,863,010) (4,787,944)
----------- ----------- -----------
Balance, end of year ....................................... $ 5,958,663 $ 6,443,949 $ 5,835,997
=========== =========== ===========
Deposits by directors, executive officers, and their related interests,
at December 31, 2008 and 2007 were $2,911,291 and $3,680,470, respectively.
NOTE 15 - FINANCIAL INSTRUMENTS WITH OFF BALANCE SHEET RISK
In the ordinary course of business, and to meet the financing needs of
its customers, the Bank is a party to various financial instruments with off
balance sheet risk. These financial instruments, which include commitments to
extend credit and standby letters of credit, involve, to varying degrees,
elements of credit and interest rate risk in excess of the amounts recognized in
the balance sheet. The contract amounts of those instruments reflect the extent
of involvement the Bank has in particular classes of financial instruments.
The Bank's exposure to credit loss in the event of nonperformance by
the other party to the financial instrument for commitments to extend credit and
standby letters of credit is represented by the contractual amounts of those
instruments. The Bank uses the same credit policies in making commitments and
conditional obligations as it does for on balance sheet instruments.
Commitments to extend credit are agreements to lend to a customer as
long as there is no violation of any material condition established in the
contract. Commitments generally have fixed expiration dates or other termination
clauses and may require the payment of a fee. At December 31, 2008 and 2007,
unfunded commitments to extend credit were $21.9 million and $20.7 million,
respectively, and outstanding letters of credit were $1.1 million and $1.0
million, respectively. At December 31, 2008, the unfunded commitments consisted
of $21.1 million at variable rates and $805,408 at fixed rates with $14.4
million expiring within one year. The Bank evaluates each customer's credit
worthiness on a case-by-case basis. The amount of collateral obtained, if deemed
necessary by the Bank upon extension of credit, is based on management's credit
evaluation of the borrower. Collateral varies but may include accounts
receivable, inventory, property, plant and equipment, and commercial and
residential real estate.
Fair values of off balance sheet lending commitments are based on fees
currently charged to enter into similar agreements, taking into account the
remaining terms of the agreements and the counterparties' credit standing, and
were immaterial in 2008 and 2007.
The Bank also offers an automatic overdraft protection product.
Approximately $1.2 million of overdraft protection is available under this
product as of December 31, 2008. The Bank expects that much of this capacity
will not be utilized. During 2008 the average balance of total demand deposit
overdrafts was $25,935.
NOTE 16 - EMPLOYEE BENEFIT PLAN
The Company sponsors a Simple IRA Plan for the benefit of all eligible
employees. The Bank contributes up to three percent of the employee's
compensation. Employer contributions made to the Plan in 2008, 2007, and 2006
amounted to $54,828, $47,934, and $40,499, respectively.
42
NOTE 17 - STOCK OPTION PLANS
In 1999, the Board of Directors awarded options (the "Organizers'
Options") to purchase 4,000 shares of the Company's common stock to each of the
organizing directors of the Company and the Bank (an aggregate of 40,000
shares). These options had an exercise price of $10.00 per share and became
exercisable in one-third increments each year beginning on December 14, 2000.
The Organizers' Options expire ten years from the date of grant, unless they
terminate sooner as a result of the holder's ceasing to be a director. Pursuant
to the option agreements as further discussed below, the total number of such
options outstanding and the exercise price have been adjusted as a result of the
stock dividends discussed in Note 18 below. Currently options to purchase 42,514
shares of common stock remain outstanding at an exercise price of $5.64. During
2008, none of these options were exercised.
In 2003, the Company's shareholders approved the Cornerstone Bancorp
2003 Stock Option Plan (the "2003 Plan"), which reserved 125,000 shares of the
Company's common stock for issuance upon exercise of options. Pursuant to the
2003 Plan as further discussed below, the number of shares reserved for issuance
has been increased to 183,012 shares as a result of the 10% stock dividends
declared from 2004 to 2007 as discussed in Note 18 below. Employees and
Directors are eligible to participate in the 2003 Plan, which has a term of 10
years. Awards under the 2003 Plan must be made by the Board of Directors or by a
Committee of Directors designated by the Board at an exercise price equal to the
fair market value of the Company's common stock on the date of grant. During
2008, options to purchase 8,396 shares were exercised at a weighted average
exercise price of $9.75 per share. See Note 1 for more information.
A summary of the activity in the plans is presented below:
Weighted Average Aggregate
Shares Exercise Price(1) Intrinsic Value (2)
------ ----------------- -------------------
Outstanding at December 31, 2005 ...................... 94,288 8.68
Granted (3) ........................................... 29,229 8.34
Exercised ............................................. -
Forfeited or expired .................................. -
-------
Outstanding at December 31, 2006 ...................... 123,516 8.60
-------
Granted (3) ........................................... 32,383 9.43
Exercised ............................................. (27,306) 6.75 $162,323
Forfeited or expired .................................. (1,320) 11.15
-------
Outstanding at December 31, 2007 ...................... 127,273 9.18
-------
Granted ............................................... 19,200 12.50
Exercised ............................................. (8,396) 9.75 $29,386
Forfeited or expired .................................. (6,265) 12.81
-------
Outstanding at December 31, 2008 ...................... 131,812 $9.46 $71,178
=======
Options exercisable at end of year .................... 92,901 $7.69 $214,601
Shares available for grant ............................ 71,049
(1) The weighted average exercise price has been adjusted to reflect 10% stock
dividends declared by the Company's Board of Directors annually from 2002
through 2007.
(2) The aggregate intrinsic value of a stock option in the table above
represents the total pre-tax intrinsic value (the amount by which the
current market value of the underlying stock exceeds the exercise price of
the option.) At December 31, 2008 the amount represents the value that
would have been received by the option holders had all option holders
exercised their options on that date. This amount changes based on changes
in the market value of the Company's common stock.
(3) Granted options include new grants as well as adjustments of previous
grants as a result of 10% stock dividends declared by the Company's Board
of Directors annually from 2002 through 2007.
Options granted in 2006, 2007, and 2008 vest over a five-year period,
according to the option agreements. All options granted prior to 2006 have fully
vested. The weighted average life of options outstanding was 5.03 years and 5.57
years at December 31, 2008 and 2007, respectively. Expense related to stock
based compensation recorded in the accompanying consolidated income statements
was $56,172, $40,797, and $19,784 for the years ended 2008, 2007, and 2006,
respectively. There were 37,389 non-vested options outstanding (estimated fair
value of $219,497) at the beginning of 2008. During 2008, 11,417 options vested
(estimated fair value of $66,674), 6,255 options were forfeited (estimated fair
value $30,194), and 19,200 options were granted (estimated fair value of
$112,297). Total non-vested options outstanding at December 31, 2008 were 38,917
options (estimated fair value of $234,926).
43
NOTE 18 - DIVIDENDS
The Company paid cash dividends of $597,471 in May 2008. No cash
dividends were paid prior to December 31, 2007. The Company's payment of cash
dividends is within the discretion of its Board of Directors, and is dependent
on the Company's receiving cash dividends from the Bank. Federal banking
regulations restrict the amount of dividends that the Bank can pay to the
Company. Future dividend policy will depend on the Company's earnings, capital
requirements, financial condition and other factors considered relevant by the
Company's Board of Directors. The Company's Board of Directors declared 10
percent stock dividends to shareholders of record on May 8, 2007, May 9, 2006,
May 10, 2005, May 11, 2004, March 17, 2003 and on April 30, 2002.
NOTE 19 - REGULATORY MATTERS
The Bank is subject to various regulatory capital requirements
administered by the federal banking agencies. Failure to meet minimum capital
requirements can initiate certain mandatory, and possible additional
discretionary actions by regulators that, if undertaken, could have a direct
material effect on the Bank's financial statements. Under capital adequacy
guidelines and the regulatory framework for prompt corrective action, the Bank
must meet specific capital guidelines that involve quantitative measures of the
Bank's assets, liabilities, and certain off-balance-sheet items as calculated
under regulatory accounting practices. The Bank's capital amounts and
classification are also subject to qualitative judgments by the regulators about
components, risk weightings, and other factors.
Quantitative measures established by regulation to ensure capital
adequacy require the Bank to maintain minimum amounts and ratios (set forth in
the table below) of total and Tier 1 capital to risk-weighted assets, and of
Tier 1 capital to average assets. Management believes, as of December 31, 2008,
that the Bank meets all capital adequacy requirements to which it is subject.
As of December 31, 2008, the most recent notification of the banking
regulators categorized the Bank as well capitalized under the regulatory
framework for prompt corrective action. There are no conditions or events since
that notification that management believes have changed the institution's
category. The Bank's actual capital amounts and ratios and minimum regulatory
amounts and ratios are presented as follows:
To be well capitalized
For capital under prompt corrective
adequacy purposes action provisions
----------------- -----------------
Actual Minimum Minimum
------ ------- -------
Amount Ratio Amount Ratio Amount Ratio
------ ----- ------ ----- ------ -----
(Dollars in thousands)
As of December 31, 2008
Total Capital (to risk weighted assets) ............... $20,366 14.4% $11,314 8.0% $14,144 10.0%
Tier 1 Capital (to risk weighted assets) .............. 18,667 13.2 5,657 4.0 8,486 6.0
Tier 1 Capital (to average assets) ................... 18,667 12.1 6,161 4.0 7,702 5.0
As of December 31, 2007
Total Capital (to risk weighted assets) ............... $19,737 16.3% $ 9,664 8.0% $12,079 10.0%
Tier 1 Capital (to risk weighted assets) .............. 18,444 15.3 4,832 4.0 7,248 6.0
Tier 1 Capital (to average assets) ................... 18,444 13.4 5,489 4.0 6,861 5.0
The Company is also subject to capital adequacy guidelines established by the
Reserve Bank, which establish the minimum ratios for capital adequacy as they
apply to the Bank. For 2008 and 2007, the Company's capital amounts and ratios
were at least as great as shown above for the Bank.
44
NOTE 20 - ESTIMATED FAIR VALUE OF FINANCIAL INSTRUMENTS
The estimated fair values of the Company's financial instruments were
as follows:
December 31,
------------
2008 2007
---- ----
Carrying Fair Carrying Fair
Amount Value Amount Value
------ ----- ------ -----
Financial Assets
Cash and due from banks .............................. $ 3,820,227 $ 3,820,227 $ 4,266,777 $ 4,266,777
Federal funds sold ................................... 140,000 140,000 967,000 967,000
Investment securities ................................ 20,790,754 20,790,754 18,870,909 18,870,909
Loans, gross ......................................... 131,181,693 132,967,973 108,643,332 108,575,051
Cash surrender value of life insurance policies ....... 1,768,520 1,768,520 1,697,429 1,697,429
Financial Liabilities
Deposits ............................................. 122,581,574 122,334,482 110,934,468 108,395,653
Fed Funds purchased and customer overnight
repurchase agreements ........................... 3,242,619 3,242,619 2,217,935 2,217,935
Customer repurchase agreements ....................... 3,150,000 3,235,288 3,585,000 3,588,023
Borrowings from FHLB ................................. 10,394,005 10,581,424 3,544,838 3,535,508
Broker repurchase agreements ......................... 5,000,000 5,135,404 - -
The Company adopted SFAS 157 on January 1, 2008. Refer to Note 1 for more
information regarding SFAS 157 and the levels of inputs used in determining fair
value of the Company's available for sale securities. The table below presents
the balances of assets measured at fair value on a recurring basis by level
within the hierarchy of inputs that may be used to measure fair value.
December 31,2008
----------------
Total Level 1 Level 2 Level 3
----- ------- ------- -------
Investment securities ............................ $20,790,754 $13,604,839 $6,071,765 $1,114,150
========== ========== ========= =========
NOTE 21 - PARENT COMPANY INFORMATION
Following is condensed financial information of Cornerstone Bancorp
(parent company only):
Condensed Balance Sheets
December 31,
------------
2008 2007
---- ----
Assets
Cash and interest bearing deposits ......................................... $ 371,668 $ 923,907
Investment in subsidiary ................................................... 18,770,624 18,661,923
Other assets ............................................................... 9,005 9,007
----------- -----------
Total Assets ........................................................... $19,151,297 $19,594,837
=========== ===========
Liabilities And Shareholders' Equity
Accrued expenses ........................................................... $ 14,350 $ 14,007
Shareholders' equity ....................................................... 19,136,947 19,580,830
----------- -----------
Total Liabilities and Shareholders' Equity ............................. $19,151,297 $19,594,837
=========== ===========
(Continued)
45
NOTE 21 - PARENT COMPANY INFORMATION, Continued
Condensed Statements Of Income
Year ended December 31,
-----------------------
2008 2007 2006
---- ---- ----
Income
Interest ....................................................... $ 19,117 $ 35,893 $ 25,658
Expenses
Sundry ......................................................... 56,063 55,164 32,400
----------- ----------- -----------
Loss before equity in undistributed net
income of bank subsidiary ............................ (36,946) (19,271) (6,742)
Equity in undistributed net income of
subsidiary ........................................... 262,262 1,632,024 1,666,478
----------- ----------- -----------
Net income ................................................... $ 225,316 $ 1,612,753 $ 1,659,736
=========== =========== ===========
Condensed Statements Of Cash Flows
Year ended December 31,
-----------------------
2008 2007 2006
---- ---- ----
Operating Activities
Net income ......................................................... $ 225,316 $ 1,612,753 $ 1,659,736
Adjustments to reconcile net income to net cash
provided by (used for) operating activities
Equity in undistributed net income of subsidiary .............. (262,262) (1,632,024) (1,666,478)
Decrease (increase) in other assets ........................... 2 62,476 (31,483)
Increase (decrease) in accrued expenses ....................... 343 (7,697) 6,588
----------- ----------- -----------
Net cash used for operating activities ................... (36,601) 35,508 (31,637)
----------- ----------- -----------
Investing Activities
Investment in bank subsidiary ...................................... - (70,000) (3,936,000)
----------- ----------- -----------
Financing Activities
Proceeds from sale of common stock, net ......................... - - 1,886,524
Cash dividend paid .............................................. (597,471) - -
Cash paid in lieu of fractional shares .......................... - (2,231) (3,036)
Exercise of stock options, net of tax ........................... 81,833 184,439 -
----------- ----------- -----------
Net cash provided (used) by financing
activities ....................................... (515,638) 182,209 1,883,488
----------- ----------- -----------
Net increase (decrease) in cash ............................. (552,239) 147,716 (2,084,149)
Cash, beginning of year ................................................ 923,907 776,191 2,860,340
----------- ----------- -----------
Cash, end of year ...................................................... $ 371,668 $ 923,907 $ 776,191
=========== =========== ===========
46