Annual Report

Item 1A. Risk Factors

An investment in our common stock involves risk.  Shareholders should carefully consider the risks described below in conjunction with the other information in this Form 10-K and information incorporated by reference in this Form 10-K, including our consolidated financial statements and related notes.  If any of the following risks or other risks which have not been identified or which we may believe are immaterial or unlikely, actually occur, our business, financial condition and results of operations could be harmed.  This could cause the price of our stock to decline and shareholders could lose part or all of their investment.  This Form 10-K contains forward-looking statements that involve risks and uncertainties, including statements about our future plans, objectives, intentions and expectations.  Many factors, including those described below, could cause actual results to differ materially from those discussed in our forward-looking statements.

Risks Related to Holding Southern Community Common Stock

Our long term business strategy includes continuing prudent, disciplined growth strategy.  Our financial condition and results of operations could be negatively affected if we fail to grow or fail to manage our growth effectively.

 

We intend to continue pursuing a prudent, disciplined growth strategy for our business.  Our prospects must be considered in light of the risks, expenses and difficulties frequently encountered by companies in significant growth stages of development.  We cannot assure you we will be able to expand our market presence in our existing markets or successfully enter new markets or that any such expansion will not adversely affect our results of operations.  Failure to manage our growth effectively could have a material adverse effect on our business, future prospects, financial condition or results of operations, and could adversely affect our ability to successfully implement our business strategy.  Also, if our revenue growth declines, our operating results could be materially adversely affected.  Our ability to successfully grow will depend on a variety of factors including the continued availability of desirable business opportunities, the competitive responses from other financial institutions in our market areas and our ability to manage our growth.

 

We may face risks with respect to future expansion.

 

In the past, we have sought to increase the size of our franchise by pursuing business development opportunities and we have grown rapidly since our incorporation.  We have purchased another financial institution as a part of that strategy.  We may acquire other financial institutions or parts of those entities in the future.  Acquisitions and mergers involve a number of risks, including:

·

the time and costs associated with identifying and evaluating potential acquisitions and merger partners;

·

the accuracy of estimates and judgments used to evaluate credit, operations, management and market risks with respect to the target entity;

·

the time and costs of evaluating new markets, hiring experienced local management and opening new offices and the time lags between these activities and the generation of sufficient assets and deposits to support the costs of the expansion;

·

our ability to finance an acquisition and possible ownership and economic dilution to our current shareholders;

·

the diversion of our management’s attention to the negotiation of a transaction and the integration of the operations and personnel of the combining businesses;

·

entry into new markets where we lack experience;

·

the introduction of new products and services into our business;

·

the incurrence and possible impairment of goodwill associated with an acquisition and possible adverse short-term effects on our results of operations; and

·

the risk of loss of key employees and customers.

We may incur substantial costs to expand, and we can give no assurance such expansion will result in the levels of profits we seek.  There can be no assurance integration efforts for any future mergers or acquisitions will be successful.  Also, we may issue equity securities, including common stock and securities convertible into shares of our common stock in connection with future acquisitions, which could cause ownership and economic dilution to our current shareholders and to investors purchasing common stock in this offering.  There is no assurance that, following any future mergers or acquisition, our integration efforts will be successful or our company, after giving effect to the acquisition, will achieve profits comparable to or better than our historical experience.

If the value of real estate in our core market areas were to decline materially, a significant portion of our loan portfolio could become under-collateralized, which could have a material adverse effect on us.

 

With most of our loans concentrated in the Piedmont Triad region of North Carolina, a decline in local economic conditions could adversely affect the values of our real estate collateral.  Consequently, a decline in local economic conditions may have a greater effect on our earnings and capital than on the earnings and capital of larger financial institutions whose real estate loan portfolios are geographically diverse.  In addition to the financial strength and cash flow characteristics of the borrower in each case, the Bank often secures loans with real estate collateral.  At December 31, 2008, approximately 66% of the Bank’s loans had real estate as a primary or secondary component of collateral.  The real estate collateral in each case provides an alternate source of repayment in the event of default by the borrower and may deteriorate in value during the time the credit is extended.  If we are required to liquidate the collateral securing a loan to satisfy the debt during a period of reduced real estate values, our earnings and capital could be adversely affected.

Interest rate volatility could significantly harm our business.

Southern Community’s results of operations are affected by the monetary and fiscal policies of the federal government and the regulatory policies of governmental authorities.  A significant component of Southern Community’s earnings is the net interest income of its subsidiary, Southern Community Bank and Trust.  Net interest income is the difference between income from interest-earning assets, such as loans, and the expense of interest-bearing liabilities, such as deposits.  We may not be able to effectively manage changes in what we charge as interest on our earning assets and the expense we must pay on interest-bearing liabilities, which may significantly reduce our earnings.  The Federal Reserve has made significant changes in interest rates during the last few years.  Since rates charged on loans often tend to react to market conditions faster than do rates paid on deposit accounts, these rate changes may have a negative impact on our earnings until we can make appropriate adjustments in our deposit rates.  In addition, there are costs associated with our risk management techniques, and these costs could be material.  Fluctuations in interest rates are not predictable or controllable and, therefore, there can be no assurances of our ability to continue to maintain a consistent positive spread between the interest earned on our earning assets and the interest paid on our interest-bearing liabilities.

Southern Community may have higher loan losses than it has allowed for.

Southern Community’s loan losses could exceed the allowance for loan losses it has set aside.  Southern Community’s average loan size continues to increase and reliance on historic loss experience and other assumptions related to management’s assessment of the adequacy of the Company’s allowances for loan losses may not be warranted.  Approximately 67% of our loan portfolio is composed of construction, commercial mortgage and commercial loans.  Repayment of such loans is generally considered subject to greater credit risk than residential mortgage loans.  Industry experience shows that a portion of loans will become delinquent and a portion of the loans will require partial or entire charge-off.  Regardless of the underwriting criteria Southern Community utilizes, losses may be experienced as a result of various factors beyond its control, including, among other things, changes in market conditions affecting the value of its loan collateral and problems affecting the credit of its borrowers.

Our construction loans are subject to additional lending risks that could adversely affect earnings.

As of December 31, 2008, approximately 28% of our total loan portfolio was comprised of construction, acquisition and development loans.  In the event of a continuing general economic slowdown, these loans may have additional risk due to the borrower’s inability to repay on a timely basis.  In addition to the normal repayment risk and potential decreases in real estate values, construction lending may pose additional risks that affect repayment and the value and marketability of real estate collateral, such as:

·

developers, builders or owners may fail to complete or develop projects;

·

developers, builders, or owners may experience a decline in liquidity and secondary sources of repayment;

·

municipalities may place moratoriums on building, utility connections or required certifications;

·

developers may fail to sell the improved real estate;

·

there may be construction delays and cost overruns;

·

Loans with rising variable rates may experience increases in the borrower’s payments on the loan at a time when the borrower’s income is under stress;

·

collateral may prove insufficient; or

·

permanent financing may not be obtained in a timely manner.

Any of these conditions could negatively affect collectability, our net income and our financial condition.

The building of market share through our de novo branching strategy could cause our expenses to increase faster than our revenues.

 

We intend to complete two facilities currently under construction.  We are currently operating in a temporary facility in Asheville although we will be moving into our new permanent building in the second quarter of 2009.  We also are operating in a temporary facility in Raleigh and plan to move into that permanent building during the third quarter of 2009.  There are considerable costs involved in opening branches.  New branches generally do not generate sufficient revenues to offset their costs until they have been in operation for at least a year or more.  Accordingly, our new branches can be expected to negatively impact our earnings for some period of time until the branches reach certain economies of scale.  Our expenses could be further increased if we encounter delays in the opening of any of our new branches.  Finally, we have no assurance our new branches will be successful even after they have been established.

If Southern Community loses key employees with significant business contacts in its market area, its business may suffer.

Southern Community’s success is dependent on the personal contacts of its officers and employees in its market area.  If Southern Community lost key employees temporarily or permanently, its business could be hurt.  Southern Community could be particularly hurt if its key employees went to work for competitors.  Southern Community’s future success depends on the continued contributions of its existing senior management personnel, particularly on the efforts of F. Scott Bauer and Jeff T. Clark, each of whom has significant local experience and contacts in its market area.

Government regulations may prevent or impair our ability to pay dividends, engage in acquisitions, or operate in other ways.

Current and future legislation and the policies established by federal and state regulatory authorities will affect Southern Community’s operations.  Southern Community is subject to supervision and periodic examination by the Federal Reserve Board and the North Carolina Commissioner of Banks.  Southern Community’s principal subsidiary, Southern Community Bank and Trust, as a state chartered commercial bank, also receives regulatory scrutiny from the North Carolina Commissioner of Banks and the FDIC.  Banking regulations, designed primarily for the protection of depositors, may limit our growth and the return to you as an investor in Southern Community, by restricting its activities, such as:

·

the payment of dividends to shareholders;

·

possible transactions with or acquisitions by other institutions;

·

desired investments;

·

loans and interest rates;

·

interest rates paid on deposits; and

·

the possible expansion of branch offices.

Southern Community has elected to be regulated as a financial holding company to expand its opportunities to provide additional services, but it will have to comply with other federal laws and regulations and could face enforcement actions by regulatory agencies.  Southern Community cannot predict what changes, if any, will be made to existing federal and state legislation and regulations or the effect that such changes may have on its business.  The cost of compliance with regulatory requirements may adversely affect Southern Community’s ability to operate profitably.

Our trading volume has been low compared with larger bank holding companies and the sale of substantial amounts of our common stock in the public market could depress the price of our common stock.

 

The average daily trading volume of our shares on the NASDAQ Global Select Market for the three months ended February 28, 2009 was approximately 12,430 shares.  Lightly traded stock can be more volatile than stock trading in an active public market like that for the larger bank holding companies.  We cannot predict the extent to which an active public market for our common stock will develop or be sustained.  In recent years, the stock market has experienced a high level of price and volume volatility and market prices for the stock of many companies have experienced wide price fluctuations that have not necessarily been related to their operating performance.  Therefore, our shareholders may not be able to sell their shares at the volumes, prices, or times that they desire.  We cannot predict the effect, if any, that future sales of our common stock in the market, or availability of shares of our common stock for sale in the market, will have on the market price of our common stock.  We therefore can give no assurance that sales of substantial amounts of our common stock in the market, or the potential for large amounts of sales in the market, would not cause the price of our common stock to decline or impair our ability to raise capital through sales of our common stock.

Southern Community faces strong competition in its market area, which may limit its asset growth and profitability.

The banking business in Southern Community’s primary market area, which is currently concentrated in the Piedmont Triad area and surrounding areas in central North Carolina, is very competitive, and the level of competition facing it may increase further, which may limit its asset growth and profitability.  Southern Community experiences competition in both lending and attracting funds from other banks and nonbank financial institutions located within our market area, some of which are significantly larger, well-established institutions.  Nonbank competitors for deposits and deposit-type accounts include savings associations, credit unions, securities firms, money market funds, life insurance companies and the mutual funds industry.  For loans, Southern Community encounters competition from other banks, savings associations, finance companies, mortgage bankers and brokers, insurance companies, small loan and credit card companies, credit unions, pension trusts and securities firms.  We may face a competitive disadvantage as a result of our smaller size, lack of multi-state geographic diversification and inability to spread our marketing costs across a broader market.

Southern Community’s Articles of Incorporation include anti-takeover provisions that may prevent shareholders from receiving a premium for their shares or effecting a transaction favored by a majority of shareholders.

Southern Community’s Articles of Incorporation include certain anti-takeover provisions, such as being subject to the Shareholder Protection Act and Control Share Acquisition Act under North Carolina law and a provision allowing our Board of Directors to consider the social and economic effects of a proposed merger, which may have the effect of preventing shareholders from receiving a premium for their shares of common stock and discouraging a change of control of Southern Community by allowing minority shareholders to prevent a transaction favored by a majority of the shareholders.  The primary purpose of these provisions is to encourage negotiations with our management by persons interested in acquiring control of our corporation.  These provisions may also tend to perpetuate present management and make it difficult for shareholders owning less than a majority of the shares to be able to elect even a single director.

Holders of our trust preferred securities have rights that are senior to those of our common shareholders.

We have supported our continued growth through the issuance of trust preferred securities from special purpose trusts and accompanying junior subordinated debentures.  At December 31, 2008, we had outstanding trust preferred securities and accompanying junior subordinated debentures totaling $44.5 million.  Payments of the principal and interest on the trust preferred securities of this special purpose trust are conditionally guaranteed by us.  Further, the accompanying junior subordinated debentures we issued to the special purpose trust are senior to our shares of common stock.  As a result, we must make payments on the junior subordinated debentures before any dividends can be paid on our common stock and, in the event of our bankruptcy, dissolution or liquidation, the holders of the junior subordinated debentures must be satisfied before any distributions can be made on our common stock.  We have the right to defer distributions on our junior subordinated debentures (and the related trust preferred securities) for up to five years, during which time no dividends may be paid on our common stock.

The common stock of Southern Community Financial Corporation is not FDIC insured.

The common stock of Southern Community is not a savings or deposit account or other obligation of any bank and is not insured by the Federal Deposit Insurance Corporation, the Bank Insurance Fund or any other governmental agency and is subject to investment risk, including the possible loss of principal.

Risks Related to an Investment in the Preferred Securities

If we do not make interest payments under the debentures, the trust will be unable to pay distributions and liquidation amounts. The guarantee would not apply because the guarantee covers payments only if the trust has funds available.

The trust will depend solely on our payments on the debentures to pay amounts due to holders of the preferred securities on the debentures.  Without these payments, the trust will not have sufficient funds to pay distributions or the liquidation amount on the preferred securities.  In that case, holders of the preferred securities will not be able to rely on the guarantee for payment of these amounts because the guarantee only applies if the trust has sufficient funds to make distributions or to pay the liquidation amount.  Instead, holders of the preferred securities or the property trustee will have to institute a direct action against us to enforce the property trustee’s rights under the indenture relating to the debentures.

We must rely on dividends from our bank subsidiary to make interest payments on the debentures to the trust.

Our ability to make payments on the debentures when due will depend primarily on dividends received from our bank subsidiary because we are a holding company and substantially all of our assets are held by our bank subsidiary.  The ability of our bank subsidiary to pay dividends is subject to legal restrictions and the Bank’s profitability, financial condition, capital expenditures and other cash flow requirements.  We may also borrow additional funds, issue debt instruments, issue and sell shares of preferred stock, or engage in other types of financing activities, in order to increase our capital.  Covenants contained in loan or financing agreements or other debt instruments could restrict or condition our payment of cash dividends based on various financial considerations or factors.

Regulatory authorities may limit dividends paid to us and thereby our ability to make interest payments on the debentures to the trust.

We cannot assure holders of the preferred securities that our bank subsidiary will be able to pay dividends in the future due to regulatory restrictions or that our regulators will not attempt to preclude us from making interest payments on the subordinated debentures.  North Carolina banking law requires that cash dividends be paid by a bank only out of retained earnings and prohibits the payment of cash dividends if payment of the dividend would cause the bank’s surplus to be less than 50% of its paid-in capital.  We may also be precluded from making interest payments on the subordinated debentures by our regulators in order to address any perceived deficiencies in liquidity or regulatory capital levels at the holding company level.  Such regulatory action would require us to obtain consent from our regulators prior to paying dividends on our common stock or interest on the subordinated debentures.  In the event our regulators withheld their consent to our payment of interest on the subordinated debentures, we would exercise our right to defer interest payments on the subordinated debentures, and the trust would not have funds available to make distributions on the preferred securities during such period.

Our obligation to make interest payments to the trust on the debentures is subordinated to existing liabilities or additional debt we may incur.

Our obligations under the debentures and the guarantee are unsecured and will rank junior in priority of payment to our existing liabilities and any future senior and subordinated indebtedness.  However, our issuance of the debentures and the preferred securities does not limit our ability or the ability of our subsidiaries to incur additional indebtedness, guarantees or other liabilities.  Also, because we are a holding company, the creditors of our bank subsidiary, including depositors, also will have priority over holders of the preferred securities in any distribution of our subsidiaries’ assets in liquidation, reorganization or otherwise.  Accordingly, the debentures and the guarantee will be effectively subordinated to all existing and future liabilities of our subsidiaries, and holders of the preferred securities should look only to our assets for payments on the preferred securities and the debentures.

We have the option to defer interest payments on the debentures for substantial periods.

As long as we are not in default under the indenture relating to the debentures, we may, at one or more times, defer interest payments on the debentures for up to 20 consecutive quarters.  If we defer interest payments on the debentures, the trust will defer distributions on the preferred securities during any deferral period.

If we defer interest payments, holders of the preferred securities will still be required to recognize the deferred interest amounts as income.

During a deferral period, holders of the preferred securities will be required to recognize as income for federal income tax purposes the amount approximately equal to the interest that accrues on your proportionate share of the debentures, held by the trust in the tax year in which that interest accrues, even though holders of the preferred securities will not receive these amounts until a later date if they hold the preferred securities until the deferred interest is paid.

If holders of the preferred securities sell their preferred securities during a deferral period, they will forfeit the deferred interest amount and only have a capital loss.

Holders of the preferred securities will not receive the cash related to any accrued and unpaid interest from the trust if they sell the preferred securities before the end of any deferral period.  During a deferral period, accrued but unpaid distributions will increase their tax basis in the preferred securities.  If holders of the preferred securities sell the preferred securities during a deferral period, their increased tax basis will decrease the amount of any capital gain or increase the amount of any capital loss that they may have otherwise realized on the sale.  A capital loss, except in certain limited circumstances, cannot be applied to offset ordinary income.  As a result, deferral of distributions could result in ordinary income and a related tax liability for the holder, and a capital loss that may only be used to offset a capital gain.

Deferrals of interest payments may increase the volatility of the market price of the preferred securities.

If we defer interest payments, the market price of the preferred securities would likely be adversely affected.  The preferred securities may trade at a price that does not fully reflect the value of accrued but unpaid interest on the debentures.  If holders of the preferred securities sell the preferred securities during a deferral period, they may not receive the same return on investment as someone who continues to hold the preferred securities.  Because of our right to defer interest payments, the market price of the preferred securities may be more volatile than the market prices of other securities without a deferral feature.

There are no financial covenants in the indenture and the trust agreement.

The indenture governing the debentures and the trust agreement governing the trust do not require us to maintain any financial ratios or specified levels of net worth, revenues, income, cash flow or liquidity.  The instruments do not protect holders of the debentures or the preferred securities in the event we experience significant adverse changes in our financial condition or results of operations.  In addition, neither the indenture nor the trust agreement limits our ability or the ability of any subsidiary to incur additional indebtedness.  Therefore, holders of the preferred securities should not consider the provisions of these governing instruments as a significant factor in evaluating whether we will be able to comply with our obligations under the debentures or the guarantee.

We may redeem some or all of the debentures at any time after December 31, 2008 and reduce the period during which holders of the preferred securities will receive distributions.

We have the option to redeem any or all of the outstanding debentures after December 31, 2008 without the payment of any premium.  Upon early redemption, holders of the preferred securities may be required to reinvest their principal at a time when they may not be able to earn a return that is as high as they were earning on the preferred securities.

We may redeem all of the debentures at any time upon the occurrence of certain events .

We may redeem all of the debentures before their stated maturity without payment of premium within 90 days after certain occurrences at any time during the life of the trust.  These occurrences include adverse tax, investment company or bank regulatory developments.  Upon early redemption, holders of the preferred securities may be required to reinvest their principal at a time when they may not be able to earn a return that is as high as they were earning on the preferred securities.

We can distribute the debentures to holders of the preferred securities, which may have adverse tax consequences for holders of the preferred securities and could also adversely affect the market price of the preferred securities.

The trustees may dissolve the trust before maturity of the debentures and distribute the debentures to holders of the preferred securities under the terms of the trust agreement.  Under current interpretations of United States federal income tax laws supporting classification of the trust as a grantor trust for tax purposes, a distribution of the debentures to holders of the preferred securities upon the dissolution of the trust would not be a taxable event.  Nevertheless, if the trust is classified for United States income tax purposes as an association taxable as a corporation at the time it is dissolved, the distribution of the debentures would be a taxable event to holders of the preferred securities.  In addition, if there is a change in law, a distribution of the debentures upon the dissolution of the trust could be a taxable event to holders of the preferred securities.  Also, the debentures that holders of the preferred securities may receive if the trust is liquidated may trade at a discount to the price that was paid to purchase the preferred securities.

Holders of the preferred securities must rely on the property trustee to enforce their rights if there is an event of default under the indenture.

Holders of the preferred securities may not be able to directly enforce their rights against us under the indenture if an event of default occurs.  If an event of default occurs under the indenture, holders of the preferred securities must rely on the enforcement by the property trustee of its rights as holder of the debentures against us.  The holders of a majority in liquidation amount of the preferred securities will have the right to direct the property trustee to enforce its rights.  If the property trustee does not enforce its rights following an event of default and there is no request by the record holders of the debentures to do so, any record holder may, to the extent permitted by applicable law, take action directly against us to enforce the property trustee’s rights.  If an event of default occurs that is attributable to our failure to pay interest or principal on the debentures, or if we default under the guarantee, holders of the preferred securities may proceed directly against us.  Holders of the preferred securities will not be able to exercise directly any other remedies available to the holders of the debentures, unless the property trustee fails to do so.

Holders of preferred securities have limited voting rights to replace the property trustee and the Delaware trustee.

Holders of preferred securities only have voting rights that pertain primarily to certain amendments to the trust agreement.  In general, only we can replace or remove any of the trustees.  The holders of at least a majority in aggregate liquidation amount of the preferred securities may replace the property trustee and the Delaware trustee only if an event of default under the trust agreement occurs and is continuing.

Item 1B. Unresolved Staff Comments

None.

 

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Item 2. Properties

As of December 31, 2008, we operated out of twenty-two banking offices, six operations/administrative offices, and two lending offices.  All banking offices have ATMs.  A summary of our offices is as follows:

		Approximate			Year
		Square			Established			Owned or
		Footage			or Acquired			Leased
Banking Offices :
Asheville, North Carolina
80 Peachtree Road			3,191		2006			Leased
Clemmons, North Carolina
6290 Towncenter Drive			3,800		2004			Owned
Dobson, North Carolina
201 West Kapp Street			2,800		1995	(1)		Owned
Greensboro, North Carolina
1505 Highwoods Blvd.			9,800		2005			Owned
High Point, North Carolina
2541 Eastchester Drive			3,000		2003			Owned
Jonesville, North Carolina
503 Winston Road			2,500		1995	(1)		Owned
Kernersville, North Carolina
1207 South Main Street			8,300		2002			Owned
King, North Carolina
105 Post Office Street			4,000		2004	(1)		Owned
Madison, North Carolina
619 Ayersville Road			2,000		1990	(1)		Owned
Mooresville, NC
210 Knob Hill Road			8,800		2006			Owned
Mount Airy, North Carolina
255 East Independence Blvd.			10,345		1999	(1)		Owned
2010 Community Drive			3,500		1988	(1)		Owned
Pilot Mountain, North Carolina
616 South Key Street			8,300		1987	(1)		Owned
Raleigh, North Carolina
2626 Glenwood Avenue			1,501		2006			Leased
Sandy Ridge, North Carolina
4928 Highway 704 West			1,250		1989	(1)		Owned
Union Grove, North Carolina
1439 W. Memorial Highway			2,300		1990	(1)		Owned

 

 

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		Approximate			Year
		Square			Established			Owned or
		Footage			or Acquired			Leased
Banking Offices :
Walnut Cove, North Carolina
1072 North Main Street			1,700		1999	(1)		Leased
Winston Salem, North Carolina
4701 Country Club Road			4,300		1996			Leased
225 Hanes Mill Road			2,800		2001			Owned
3151 Peters Creek Parkway			2,500		1998			Leased
500 South Stratford Road (3)			5,980		2008			Owned
536 South Stratford Road (3)			2,400		1998			Leased
Yadkinville, North Carolina
532 East Main Street			7,800		1998			Owned
Operations and Administrative Offices :
Winston Salem, North Carolina
465 Shepherd Street			47,114		2006			Owned
100 Cambridge Plaza (2)			7,028		2006			Owned
104 Cambridge Plaza (2)			7,028		2006			Owned
108 Cambridge Plaza (2)			7,028		2006			Owned
112 Cambridge Plaza (2)			7,988		2006			Owned
4605 Country Club Road - Corporate			27,000		2003			Owned
Lending Offices:
Winston Salem, North Carolina
4625 Country Club Road			3,200		1998			Owned
Raleigh, North Carolina
3948 Browning Place			1,058		2007			Leased

(1)	Acquired as part of The Community Bank acquisition.

(2)	Approximately 75% of these properties are leased to tenants.

(3)	Relocated banking office from 536 South Stratford Road to 500 South Stratford Road in April 2008.  The underlying lease on 536 South Stratford Road will expire in December 2009.

 

In addition to the above locations, the Bank has four off site ATMs (located at 3484 Robinhood Road and 401 Deacon Boulevard both in Winston-Salem, 1466 River Ridge Road in Clemmons and at 4575 Yadkinville Road, Pfafftown, North Carolina) and approximately 100 outsourced ATM cash dispensing machines throughout North Carolina.

All of our properties, including land, buildings and improvements, furniture, equipment and vehicles, had a net book value at December 31, 2008 of $40.0 million.  See further information presented in Note 6 to our consolidated financial statements, which are presented under Item 8 in this Form 10-K.

We are currently constructing two permanent buildings to replace our temporary facilities in Asheville and Raleigh, increasing their respective square footage to 9,800 for Asheville and 10,700 for Raleigh.  We expect to occupy the Asheville banking office in the second quarter of 2009 and the Raleigh banking office during third quarter of 2009.

Additional banking offices may be opened at later dates if deemed appropriate by the Board of Directors and if regulatory approval can then be obtained.  The Company may acquire property in which a director, directly or indirectly, has an interest.  In such event, the acquisition of such facilities shall be approved by a majority of the Board of Directors, excluding any individual who may have such an interest in the property.

 

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Item 3. Legal Proceedings

The Company is a party to legal proceedings arising in the normal conduct of business.  Our management believes that this litigation is not material to the Company’s financial position or results of its operations or the operations of the Bank.

Item 4. Submission of Matters to a Vote of Security Holders

There were no matters submitted to a vote of our security holders during the fourth quarter of our fiscal year ended December 31, 2008.

PART II

Item 5. Market for Registrant’s Common Equity and Related Stockholder Matters

Price Range of Common Stock and Dividends

Our common stock and preferred securities are listed on the NASDAQ Global Select Market under the symbols “SCMF” and “SCMFO”, respectively.  The following table sets forth the high and low sales prices per share of our common stock and our preferred securities (“SCMFO”), based on published financial sources, and our dividend payments for the last two years.

				Price																Declared Cash Dividend  per share
				SCMF								SCMFO
Year		Quarterly Period		High				Low				High				Low
2007		First Quarter		$	10.97			$	10.04			$	10.53			$	10.11			$	0.035
		Second Quarter			10.23				8.65				10.50				10.04				0.040
		Third Quarter			8.94				6.25				10.29				9.66				0.040
		Fourth Quarter			8.80				6.40				10.30				8.64				0.040
2008		First Quarter		$	7.89			$	6.26			$	9.94			$	8.00			$	0.040
		Second Quarter			7.73				5.52				9.73				7.50				0.040
		Third Quarter			6.30				3.86				9.15				6.01				0.040
		Fourth Quarter			4.97				2.11				8.74				5.75				0.040

At February 28, 2009, there were approximately 7,207 holders of record of our common stock.

Holders of our common stock will be entitled to receive any cash dividends the Board of Directors may declare.  The declaration and payment of future dividends to holders of our common stock will be at the discretion of our Board of Directors and will depend upon our earnings and financial condition, regulatory conditions and considerations and such other factors as our Board of Directors may deem relevant.  As a holding company, Southern Community Financial Corporation is ultimately dependent upon its bank subsidiary to provide funding for its operating expenses, debt service (including the interest payments on the preferred securities issued by our remaining trust subsidiary), and dividends.  Our primary sources of income are dividends paid by the Bank and interest income on loans and deposits with the bank subsidiary.  The Company must pay all of its operating expenses from funds received from the Bank.  Various banking laws applicable to our bank subsidiary limit the payment of dividends, management fees and other distributions by the Bank to the Company and may therefore limit the Company’s ability to make dividend payments.  Under North Carolina banking law, dividends must be paid out of retained earnings and no cash dividends may be paid if payment of the dividend would cause the Bank’s surplus to be less than 50% of its paid-in capital.  Under federal banking law, no cash dividend may be paid if the Bank is undercapitalized or insolvent or if payment of the cash dividend would render the Bank undercapitalized or insolvent, or if it is in default of any deposit insurance assessment due to the Federal Deposit Insurance Corporation.  As a condition of the issuance of Cumulative Perpetual Preferred Stock to the United States Treasury under its Capital Purchase Program, the Company must obtain the consent of the United States Treasury Department to increase the cash dividend on its common stock from the September 30, 2008 quarterly level of $0.04 per common share.

 

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In the future, any declaration and payment of cash dividends will be subject to the Board of Directors’ evaluation of our operating results, financial condition, future growth plans, general business and economic conditions, tax and other relevant considerations.  There is no assurance that, in the future, we will have funds available to pay cash dividends, or, even if funds are available, that we will pay dividends in any particular amount or at any particular time, or that we will pay dividends at all.

Share Repurchases

The Company announced a plan to repurchase up to 300,000 shares of its common stock in March 2005, to repurchase an additional 600,000 shares in September 2005 and to repurchase up to an additional 1 million shares in July 2006.  Through December 31, 2008, the Company has repurchased 1,858,073 shares at an average price of $6.99 per share under the three plans, including 600,000 shares at an average price of $2.93 purchased during the fourth quarter of 2008.  The Company received prior approval from the United States Department of the Treasury to repurchase the 600,000 shares in the fourth quarter 2008 as we had received preliminary approval to participate in the Capital Purchase Program; however, we had not yet consummated the transaction at the date of the repurchase.  The table below sets forth information with respect to shares of common stock repurchased during the three months ended December 31, 2008.

As a condition of the issuance of its Cumulative Perpetual Preferred Stock to the United States Treasury under its Capital Purchase Program, the Company must obtain the consent of the United States Treasury Department to repurchase any of its common stock.

Period		Total  Number of  Shares Purchased				Average Price Paid  per  Share				Total Number  of  Shares  Purchased as  Part of Publicly Announced Programs				Maximum  Number  of  Shares That May Yet Be  Purchased  Under  the Programs
October 1, 2008 to October 31, 2008		None					-				-				641,927
November 1, 2008 to November 30, 2008		None					-				-				641,927
December 1, 2008 to December 31, 2008			600,000			$	2.93				600,000				41,927

 

 

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Item 6. Selected Financial Data

SELECTED CONSOLIDATED FINANCIAL INFORMATION AND OTHER DATA

The following tables set forth selected consolidated financial information and other data.  The results for 2004 include the impact of the acquisition of The Community Bank which was effective January 12, 2004.  The information set forth below does not purport to be complete and should be read in conjunction with our consolidated financial statements appearing elsewhere in this annual report.

 

		For the Years Ended December 31,
		2008				2007				2006				2005				2004
		(Dollars in thousands, except per share data)
Operating Data:
Interest income		$	96,742			$	98,908			$	85,520			$	68,097			$	54,656
Interest expense			49,282				55,141				44,798				31,128				20,175
Net interest income			47,460				43,767				40,722				36,969				34,481
Provision for loan losses			8,165				2,775				2,510				950				2,239
Net interest income after provision for loan losses			39,295				40,992				38,212				36,019				32,242
Non-interest income			11,282				11,331				3,678				7,134				7,949
Non-interest expense			42,089				40,900				35,802				31,319				27,520
Income before income taxes			8,488				11,423				6,088				11,834				12,671
Provision for income taxes			2,634				3,869				1,890				4,161				4,556
Net income			5,854				7,554				4,198				7,673				8,115
Effective dividend on preferred stock			185				-				-				-				-
Net income available to common shareholders		$	5,669			$	7,554			$	4,198			$	7,673			$	8,115
Securities gains(losses) included in non-interest income		$	98			$	-			$	(4,156	)		$	(266	)		$	-
Per Share Data:
Net Income
Basic		$	0.33			$	0.43			$	0.24			$	0.43			$	0.47
Diluted			0.33				0.43				0.24				0.42				0.45
Cash dividends			0.160				0.155				0.135				0.120				0.110
Book value			8.77				8.18				7.83				7.66				7.68
Weighted average shares
Basic			17,363,395				17,559,352				17,566,315				17,825,152				17,298,285
Diluted			17,398,318				17,624,399				17,757,436				18,133,859				18,033,333
Balance Sheet Data:
Total assets			1,803,778				1,569,182				1,436,465				1,287,613				1,222,946
Loans			1,314,811				1,188,438				1,033,411				868,827				796,103
Allowance for loan losses			18,851				14,258				13,040				11,785				12,537
Deposits			1,233,112				1,045,237				1,024,582				941,949				845,501
Short-term borrowings			145,197				117,772				92,748				9,186				69,647
Long-term debt			228,016				254,633				172,549				192,551				163,494
Stockholders’ equity			187,710				142,339				136,225				134,885				136,834
Capital Ratios:
Total risk-based capital			13.80	%			11.44	%			11.40	%			13.21	%			13.81	%
Tier 1 risk-based capital			12.46	%			10.28	%			10.20	%			11.94	%			11.78	%
Leverage ratio			10.57	%			8.96	%			8.73	%			9.60	%			9.67	%
Equity to assets ratio			10.41	%			9.07	%			9.48	%			10.48	%			11.20	%

 

 

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		For the Years Ended December 31,
		2008				2007				2006				2005				2004
		(Dollars in thousands, except per share data)
Selected Performance Ratios:
Return on average assets			0.34	%			0.50	%			0.31	%			0.60	%			0.69	%
Return on average equity			4.02	%			5.45	%			3.11	%			5.67	%			6.21	%
Net interest spread (1)			2.75	%			2.81	%			2.92	%			2.86	%			3.03	%
Net interest margin (2)			2.99	%			3.19	%			3.30	%			3.20	%			3.26	%
Non-interest income as a percentage of total revenue (3)			19.21	%			20.57	%			8.28	%			16.18	%			18.73	%
Non-interest income as a percentage of average assets			0.65	%			0.75	%			0.27	%			0.56	%			0.68	%
Non-interest expense to average assets			2.42	%			2.70	%			2.62	%			2.44	%			2.36	%
Efficiency ratio (4)			71.65	%			74.23	%			80.64	%			71.01	%			64.86	%
Dividend payout ratio			48.48	%			36.05	%			56.26	%			27.91	%			23.40	%
Asset Quality Ratios:
Nonperforming loans to period-end loans			1.10	%			0.17	%			0.26	%			0.16	%			0.27	%
Allowance for loan losses to period-end loans			1.43	%			1.20	%			1.26	%			1.36	%			1.57	%
Allowance for loan losses to nonperforming loans			1.31	X			6.95	X			4.95	X			8.37	X			5.77	X
Nonperforming assets to total assets (5)			1.12	%			0.18	%			0.25	%			0.13	%			0.27	%
Net loan charge-offs to average loans outstanding			0.28	%			0.14	%			0.13	%			0.14	%			0.19	%
Other Data:
Number of banking offices			22				22				21				19				18
Number of full-time equivalent employees			337				337				326				299				271

(1)	Net interest spread is the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities.

(2)	Net interest margin is net interest income divided by average interest-earning assets.

(3)	Total revenue consists of net interest income and non-interest income.

(4)	Efficiency ratio is non-interest expense divided by the sum of net interest income and non-interest income.

(5)	Nonperforming assets consist of nonaccrual loans, restructured loans and real estate owned, where applicable.

 

 

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Item 7.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following presents management’s discussion and analysis of our financial condition and results of operations and should be read in conjunction with the financial statements and related notes included elsewhere in this annual report.  This discussion contains forward-looking statements that involve risks and uncertainties.  Our actual results could differ significantly from those anticipated in these forward-looking statements as a result of various factors.  The following discussion is intended to assist in understanding the financial condition and results of our operations.

CRITICAL ACCOUNTING POLICIES

The Company’s accounting policies are in accordance with accounting principles generally accepted in the United States and with general practices within the banking industry.  Management makes a number of estimates and assumptions relating to reported amounts of assets, liabilities, revenues and expenses in the preparation of the financial statements and disclosures.  Estimates and assumptions that are most significant to the Company are related to the determination of the allowance for loan losses, goodwill and other intangible assets and income taxes.

Allowance for Loan Losses

The allowance for loan losses represents management’s estimate of probable losses inherent in the loan portfolio.  Determining the appropriate level of the allowance is one of the most critical and complex accounting estimates for any financial institution.  Management’s judgments include those involved in risk grading the loan portfolio, determining specific allowances for loans considered impaired, and evaluating the impact of current economic conditions on the levels of the allowance.  Loans are considered impaired when it is probable that all amounts due will not be collected in accordance with the contractual terms of the loan agreement.  While management believes that the allowance for loan losses is appropriate and adequate to cover probable losses inherent in the portfolio, future adjustments to the allowance may be necessary and results of operations could be adversely affected if circumstances differ substantially from the assumptions used in making the determinations.  In addition, because future events affecting borrowers and collateral cannot be predicted with certainty, there can be no assurance that the existing allowance for loan losses is adequate or that increases will not be necessary should the quality of any loans deteriorate as a result of the factors discussed herein.  Any material increase in the allowance for loan losses may adversely affect our financial condition and results of operations.  For further discussion, see “Nonperforming Assets” and “Analysis of Allowance for Loan Losses” under “ASSET QUALITY.”

Goodwill and Other Intangibles

Goodwill represents the excess of the cost of an acquisition over the fair value of the net assets acquired.  Other intangible assets represent purchased intangible assets that can be separately distinguished from goodwill.  Goodwill impairment testing is performed annually or more frequently if events or circumstances indicate possible impairment.  The evaluation of goodwill for impairment uses both the income and market approaches to value the Company.  The income approach consists of discounting projected long-term future cash flows, which are derived from internal forecasts and economic expectations for the Company.  The significant inputs to the income approach include the long-term target tangible equity to tangible assets ratio and the discount rate, which is determined utilizing the Company’s cost of capital adjusted for a company-specific risk factor.  The company-specific risk factor is used to address the uncertainty of growth estimates and earnings projections of management.  Under the market approach, a value is calculated from an analysis of comparable acquisition transactions based on earnings, book value, assets and deposit premium multiples from the sale of similar financial institutions.  Our goodwill testing for 2008, which was updated as of December 31, 2008, indicated that the goodwill booked at the time of the acquisition of The Community Bank continues to properly value the acquired company and has not been impaired.  No impairment has been recorded as a result of goodwill testing performed during 2008 or 2007.  Given the substantial decline in our common stock price and the economic outlook for our industry, the excess of the fair value over carrying value has narrowed compared with previous assessments.  If our stock price continues to decline, if the Company does not produce anticipated cash flows, or if comparable banks begin selling at significantly lower prices than in the past, our goodwill may be impaired in the future.

 

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Intangible assets with finite lives include core deposits and other intangibles.  Intangible assets other than goodwill are subject to impairment testing at least annually or whenever events or changes in circumstances indicate that the carrying amount may not be recoverable.  Core deposit intangibles are amortized on the straight-line method over a period not to exceed 10 years.  Note 7 contains additional information regarding goodwill and other intangible assets.

Income Taxes

Accrued taxes represent the estimated amount payable to or receivable from taxing jurisdictions, either currently or in the future, and are reported, on a net basis, as a component of “other assets” in the consolidated balance sheets.  The calculation of the Company’s income tax expense is complex and requires the use of many estimates and judgments in its determination.

Management’s determination of the realization of the net deferred tax asset is based upon management’s judgment of various future events and uncertainties, including the timing and amount of future income and the implementation of various tax plans to maximize realization of the deferred tax asset.  Management believes that the Company will generate sufficient operating earnings to realize the deferred tax benefits.

From time to time, management bases the estimates of related tax liabilities on its belief that future events will validate management’s current assumptions regarding the ultimate outcome of tax-related exposures.  While the Company has obtained the opinion of advisors that the anticipated tax treatment of these transactions should prevail and has assessed the relative merits and risks of the appropriate tax treatment, examination of the Company’s income tax returns, changes in tax law and regulatory guidance may impact the treatment of these transactions and resulting provisions for income taxes.

 

OVERVIEW

Southern Community’s founders recognized an opportunity to fulfill the financial service needs of individuals and organizations left underserved by consolidation within the financial services industry.  To fill a part of this void, the founders began in 1995 the process by which Southern Community Bank and Trust was created, and began operations on November 18, 1996.  From inception, Southern Community has strived to serve the financial needs of small to medium-sized businesses, individuals, residential homebuilders and others in and around our markets in North Carolina.  We offer a broad array of banking and other financial products; many of which are similar to those offered by our larger competitors, but we deliver them with an emphasis on superior customer service.  We believe that our emphasis on quality customer service is the single most important factor among many that have fueled our growth to $1.8 billion in total assets in just over twelve years of operations.

The Company began operations in November 1996 with $11.0 million in capital, a single branch facility and thirteen employees.  Through December 31, 2008, Southern Community Financial Corporation has grown to a total of twenty-two full-service banking offices with $1.2 billion in customer deposit accounts.  In support of this growth, the Company has generated additional capital through issuing common stock and retaining operating earnings.  At December 31, 2008, the Company had $187.7 million in total stockholders’ equity.  Through our banking subsidiary we offer traditional banking products as well as a full array of financial services.  In October 2001, Southern Community Financial Corporation, a financial holding company, became the parent company of Southern Community Bank and Trust.  On January 12, 2004 we acquired The Community Bank, a $240.0 million asset community bank with 10 banking offices in contiguous markets.  The Company created Southern Community Advisors, our wealth management division, and has developed and acquired mortgage banking operations.  While these operations are currently not significant to our results of operations, we intend to pursue growth in these businesses to enhance our non-interest income.

Real estate secured loans, including construction loans and loans secured by existing commercial and residential properties, comprise the majority of our loan portfolio, with the balance of our loans consisting of commercial and industrial loans and loans to individuals.  We originate residential mortgages, at both fixed and variable rates, earning fees for loans originated and additional income for loans sold to others.  It has been our strategy to recruit skilled banking professionals who are well trained and highly knowledgeable about our market area, enabling us to develop and maintain a loan portfolio of sound credit quality.

 

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Management recognizes that our growth may expose the Company to increased operational and market risk, primarily with respect to managing overhead, funding costs and credit quality.  The Company has developed critical functions such as Credit Administration, Training, Audit and Compliance to assist in managing and monitoring these and other risks.  We are committed to creating and maintaining a solid and diversified financial services organization with a focus on customer service.  It is management’s firm belief that this foundation will continue building our loyal customer base while attracting new clients and providing opportunities for future growth.  As bank consolidations continue to take place in our markets, Southern Community Financial Corporation is positioned to continue to benefit from their effects.

Financial Condition at December 31, 2008 and 2007

During the year ended December 31, 2008, our total assets increased by $234.6 million, or 15.0%, to $1.8 billion.  Of the increase in total assets, $230.2 million represented growth in interest earning assets.  Investment securities increased $105.5 million or 46.1% to provide sufficient liquidity to fund loan growth and manage scheduled deposit and borrowing maturities as well as unforeseen deposit outflows.  Loan demand remained strong through the first three quarters of 2008, resulting in an increase of $124.8 million for the year; however, loans decreased $9.2 million in the fourth quarter due largely to the economic slowdown.  The increase in earning assets was funded primarily by increased deposit growth, especially through the growth in certificates of deposit.  Total deposits grew to $1.2 billion at December 31, 2008, an increase of $187.9 million or 18.0% from the year ago period.  Other assets increased $15.2 million in 2008 including the purchase of an additional $10.0 million in Bank Owned Life Insurance which reduced the Company’s effective tax rate for the year.

Our total loan growth of $124.8 million in 2008 was concentrated in residential mortgage loans, commercial mortgage loans and commercial and industrial loans which increased by $75.3 million, $28.3 million and $23.4 million respectively.   A portion of the increase in residential mortgage loans was attributable to real estate collateral which was used to secure commercial and industrial loans.  Construction loans increased $809 thousand as this segment of our portfolio reflected the reduction in housing starts and related current economic conditions throughout our market area.  During 2008 the Bank continued our program of originating residential mortgage loans primarily for sale.  At the year-end 2008, mortgage loans held for sale were $316 thousand compared to $1.9 million at the prior year end due to the significant decrease in mortgage origination volumes in fourth quarter 2008 as the economy experienced further slowing.

Our total liquid assets, defined as cash and due from banks, federal funds sold, interest-bearing deposits and investment securities, increased by $98.7 million during the year, to $361.9 million at December 31, 2008.  Liquid assets represented 20.1% of total assets at December 31, 2008 as compared to 16.8% at the beginning of the year.  Cash equivalents and federal funds sold decreased $6.8 million while investment securities increased $105.5 million.  The investment portfolio was built to a more normal percentage of assets to provide adequate liquidity to fund the loan growth and provide resources to manage current as well as unforeseen deposit and borrowing outflows.  As of year-end, we believe our liquidity is adequate to fund future loan demand and manage deposit and borrowing outflows.

Customer deposits which have traditionally been our primary funding source supplemented by wholesale funding provided the funding for loan growth during 2008.  Deposits totaled $1.23 billion, an increase of $187.9 million or 18.0% from year-end 2007.  Deposit growth during the current year shifted from non-maturity deposits to time deposits as customers focused on higher yields and longer terms during the falling interest rate environment.  The change in market conditions were reflected in a $27.5 million or 11.1% decrease year-over-year in demand, money market, NOW and savings account deposits, which ended the year at $577.8 million.  Time deposits which increased $215.4 million or 49.0% were generated through our growing branch network and out-of-market and brokered deposits.  Brokered and out-of-market deposits totaling $262.1 million and $132.6 million at year-end 2008 and 2007, respectively, increased as a funding source to meet loan funding demands during the first three quarters of 2008.  Management will continue to focus on growing the core deposit base; however, we will continue to monitor the costs of our various funding alternatives and our funding mix may change from time to time as a result.

 

 

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Total borrowings aggregated $373.2 million at December 31, 2008, and included $154.1 million of advances from the Federal Home Loan Bank of Atlanta (FHLB), junior subordinated debentures with a carrying value of $45.9 million, securities sold under agreements to repurchase of $113.2 million and Term Auction Facility advances from the Federal Reserve Bank of $60.0 million.  The Company began borrowing funds from the Term Auction Facility during the second quarter of 2008 as an additional source of funds.  The Bank has entered into long-term financing through term repurchase agreements with various parties, which total $90.0 million at December 31, 2008.  Management will use FHLB advances and other funding sources as necessary to support balance sheet management and growth.  However, management expects that as our branch network grows and matures, the volume of core deposits will become an increasingly larger portion of our funding mix, which over time should contribute to a reduction in our overall funding cost.

The Company’s capital position remains strong with all of our regulatory capital ratios at levels that make us “well capitalized” under federal bank regulatory capital guidelines.  At December 31, 2008, our stockholders’ equity totaled $187.7 million, an increase of $45.4 million from the December 31, 2007 balance.  This net change includes $5.9 million of net income, $408 thousand of proceeds from shares purchased through stock option and stock purchase plans, $155 thousand of stock-based compensation, and $2.0 million in other comprehensive income due primarily to unrealized holding gains on available for sale investment securities.  These increases in capital were offset by decreases from shares repurchased at a cost of $2.7 million, cash dividends paid of $2.8 million, $185 thousand of dividends accrued on preferred stock and $185 thousand from the cumulative effect of change in accounting method.  The most significant increase in capital during 2008 was the issuance of non-voting cumulative perpetual preferred stock for $40.7 million and common stock warrants for $2.1 million as the Company elected to participate in the United States Treasury’s Capital Purchase Program (CPP) at the maximum amount available to the Company.  The dividend on this preferred stock is payable quarterly at an annualized rate of 5% for the first five years and 9% thereafter.  The issuer may redeem this preferred stock after three years at par plus any accrued interest.  Until the third anniversary of the preferred stock, the issuer needs Treasury consent to increase common stock dividends or to conduct share repurchases of common stock or junior preferred stock.  The Treasury received warrants to purchase common shares having an aggregate market value equal to 15% of the preferred stock issued.  These warrants have a term of 10 years and a strike price of $3.95 per share.  These warrants are transferable by the Treasury.  The total amount of the new securities issued qualifies as Tier 1 capital.

NET INTEREST INCOME

Like most financial institutions, the primary component of our earnings is net interest income.  Net interest income is the difference between interest income, principally from loans and investments and interest expense, principally on customer deposits and borrowings.  Changes in net interest income result from changes in volume and changes in interest rates earned and paid.  By volume, we mean the average dollar level of interest-earning assets and interest-bearing liabilities.  Spread refers to the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities, and margin refers to net interest income divided by average interest-earning assets.  Spread and margin are influenced by the levels and relative mix of interest-earning assets and interest-bearing liabilities, as well as by levels of noninterest-bearing liabilities.  During the years ended December 31, 2008, 2007 and 2006, our average interest-earning assets were $1.59 billion, $1.37 billion and $1.23 billion, respectively.  During these same years, our net interest margins were 2.99%, 3.19% and 3.30%, respectively.

During 2008, the Federal Reserve decreased the targeted federal funds rate seven times for a total of 400 basis points to end the year at a range of 0.00% to 0.25%.  The Federal Reserve’s reductions in the federal funds rate along with the introduction of new programs provided increased liquidity into credit markets in response to unprecedented systemic shocks to the United States and world financial markets caused by failures and near collapses of major market participants and large banking institutions, slumping consumer confidence and the overall weakening of the economy in the United States.  The federal funds rate is currently at an historical low surpassing the previous low of 1.00% in June of 2003.  The rate reductions in 2008 continued a trend of three decreases totaling 100 basis points in the last quarter of 2007.  The rate reductions of 2008 and 2007 were preceded by four increases for 100 basis points during 2006.  As the federal funds rate decreased, the prime interest rate changed by the same amount resulting in a 300 basis point spread between the two rates leaving the prime rate at 3.25% at the end of the year.  Margin compression resulted during 2008 as asset yields declined faster than deposit costs due to increased competition for deposits and the resulting irrational pricing.  Competition for deposits intensified in 2008 as large regional banks turned to retail markets to replace commercial paper and other wholesale funding sources that became limited to non-existent as credit markets underwent severe stress.  While it is management’s goal to remain relatively interest rate neutral, the Bank’s interest rate sensitivity has been slightly liability sensitive in 2007 and 2008, as the funding mix has remained relatively stable.  Net interest income totaled $47.5 million, an increase of $3.7 million or 8.4% over the $43.8 million for the same period in 2007.   Net interest income benefited from strong growth in average earning assets; however the Bank’s asset yields decreased at a faster pace (1.13% from 7.22% to 6.09%) than cost of funds (1.07% from 4.41% to 3.34%), leading to a shrinkage in net interest margin from 3.19% to 2.99%.  Due to strong loan demand during the first three quarters and increased levels of investment securities, the level of average earning assets has increased $218.1 million or 15.9% for the year ending December 31, 2008.  Average interest bearing liabilities increased $223.6 million or 17.9% to $1.5 billion from $1.3 billion for the period ended December 31, 2008.

 

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Average Balances and Average Rates Earned and Paid .   The following table sets forth, for the years 2006 through 2008, information with regard to average balances of assets and liabilities, as well as the total dollar amounts of interest income from interest-earning assets and interest expense on interest-bearing liabilities, resultant yields or costs, net interest income, net interest spread, net interest margin and ratio of average interest-earning assets to average interest-bearing liabilities.  Average loans include nonaccruing loans, the effect of which is to lower the average yield.

  

NET INTEREST INCOME

		For the Years Ended December 31,
		2008												2007												2006
		Average balance				Interest earned/paid				Average yield/cost				Average balance				Interest earned/paid				Average yield/cost				Average balance				Interest earned/paid				Average yield/cost
		(Dollars in thousands)
Interest-earning assets:
Loans (1)		$	1,279,041			$	82,125				6.42	%		$	1,114,677			$	86,673				7.78	%		$	958,001			$	73,492				7.67	%
Investment securities available for sale			257,153				12,378				4.81	%			179,995				8,819				4.90	%			185,713				8,529				4.59	%
Investment securities held to maturity			48,252				2,184				4.53	%			71,510				3,208				4.49	%			86,328				3,390				3.93	%
Federal funds sold			4,096				55				1.34	%			4,231				208				4.92	%			2,263				109				4.82	%
Total interest-earning assets			1,588,542				96,742				6.09	%			1,370,413				98,908				7.22	%			1,232,305				85,520				6.94	%
Other assets			150,326												143,206												135,918
Total assets		$	1,738,868											$	1,513,619											$	1,368,223
Interest-bearing liabilities:
Deposits:
NOW and money market		$	512,717			$	11,412				2.23	%		$	441,716			$	15,499				3.51	%		$	348,486			$	10,552				3.03	%
Time deposits greater than $100,000			137,841				6,695				4.86	%			311,125				14,135				4.54	%			326,864				14,303				4.38	%
Other time deposits			428,950				16,541				3.86	%			169,236				8,889				5.25	%			208,733				8,564				4.10	%
Borrowings			395,031				14,634				3.70	%			328,909				16,618				5.05	%			231,664				11,379				4.91	%
Total interest-bearing liabilities			1,474,539				49,282				3.34	%			1,250,986				55,141				4.41	%			1,115,747				44,798				4.02	%
Demand deposits			104,978												108,874												105,755
Other liabilities			13,597												15,066												11,835
Stockholders' equity			145,754												138,693												134,886
Total liabilities and stockholders' equity		$	1,738,868											$	1,513,619											$	1,368,223
Net interest income and net interest spread						$	47,460				2.75	%						$	43,767				2.81	%						$	40,722				2.92	%
Net interest margin											2.99	%											3.19	%											3.30	%
Ratio of average interest-earning assets to average interest-bearing liabilities							107.73	%											109.55	%											110.45	%

 (1) Nonaccrual notes are included in the loan amounts.

 

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RATE/VOLUME ANALYSIS

The following table analyzes the dollar amount of changes in interest income and interest expense for major components of interest-earning assets and interest-bearing liabilities.  The table distinguishes between (i) changes attributable to volume (changes in volume multiplied by the prior period’s rate), (ii) changes attributable to rate (changes in rate multiplied by the prior period’s volume), and (iii) net change (the sum of the previous columns).  The change attributable to both rate and volume (changes in rate multiplied by changes in volume) has been allocated equally to both the changes attributable to volume and the changes attributable to rate.

		December 31, 2008 vs. 2007												December 31, 2007 vs. 2006
		Increase (Decrease) Due to												Increase (Decrease) Due to
		Volume				Rate				Total				Volume				Rate				Total
		(Amounts in thousands)
Interest income:
Loans		$	11,667			$	(16,215	)		$	(4,548	)		$	12,101			$	1,080			$	13,181
Investment securities available for sale			3,747				(188	)			3,559				(271	)			561				290
Investment securities held to maturity			(1,048	)			24				(1,024	)			(623	)			441				(182	)
Federal funds sold			(4	)			(149	)			(153	)			96				3				99
Total interest income			14,362				(16,528	)			(2,166	)			11,302				2,086				13,388
Interest expense:
Deposits:
NOW and money market			2,036				(6,123	)			(4,087	)			3,047				1,900				4,947
Time deposits greater than $100,000			(8,145	)			705				(7,440	)			(702	)			534				(168	)
Other time deposits			11,829				(4,177	)			7,652				(1,848	)			2,173				325
Borrowings			2,895				(4,879	)			(1,984	)			4,845				394				5,239
Total interest expense			8,615				(14,474	)			(5,859	)			5,343				5,000				10,343
Net interest income increase (decrease)		$	5,747			$	(2,054	)		$	3,693			$	5,959			$	(2,914	)		$	3,045

 

RESULTS OF OPERATIONS

Years Ended December 31, 2008 and 2007

Net Income .   Our net income for 2008 was $5.9 million, a decrease of $1.7 million from net income of $7.6 million earned in 2007.  Net income available to common shareholders was $5.7 million for 2008.  Net income per common share was $0.33 basic and diluted for the year ended December 31, 2008 and $0.43 basic and diluted for 2007.  The decrease is due primarily to the increase in the provision for loan losses and the decrease in income from our small business investment company (SBIC) activities.  We have continued to experience strong asset growth, driven by solid loan growth of $124.8 million or 10.5% and an increase of $105.5 million or 46.1% in investment securities, which was supported by an increase of $187.9 million in our deposit base and an increase of $808 thousand in our borrowings.  During 2008, average earning assets increased $218.1 million or 15.9% to $1.59 billion, and average interest bearing liabilities rose $223.6 million or 17.9%.  The impact of the strong loan growth produced a favorable total volume variance ($5.7 million), partially offset by the impact of margin compression resulting in a negative total rate variance ($2.0 million), produced a net increase in net interest income of $3.7 million, or 8.4% for 2008 compared with 2007.  The provision for loan losses increased to $8.2 million from $2.8 million in 2007 as nonperforming loans and net charge-offs have increased substantially in 2008 compared with 2007.

 

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Non-interest income remained relatively unchanged in total from the prior year at $11.3 million, with a decrease of $49 thousand although the components changed significantly.  Income from the investment in SBIC activities decreased $2.0 million from the prior year which was offset by increases in service charges of $928 thousand, hedging activities of $855 thousand, other non-interest income of $165 thousand and gains from sales of investment securities of $98 thousand.  These increases in non-interest income categories were offset by decreases in income from mortgage banking activities of $49 thousand and income from wealth management of $3 thousand as well as income from SBIC activities.  Non-interest expenses increased $1.2 million or 2.9% as the Company’s pace of infrastructure expansion moderated significantly.

Net Interest Income.   During 2008, our net interest income increased $3.7 million or 8.4% to $47.5 million.  Interest income increased as a result of growth in our overall level of average earning assets primarily from strong loan demand and additional purchases of investment securities.  Average total interest-earning assets increased $218.1 million, or 15.9% during 2008, as the average loan balances increased $164.3 million and the average investment securities portfolio and federal funds sold increased $53.8 million or 21.0%.  Our average total interest-bearing liabilities increased by $223.6 million, or 17.9%.  Approximately 44% of the loan portfolio is composed of fixed rate loans while 56% have a variable interest rate which generally adjusts immediately when index rates, such as our prime rate, changes.  Transaction deposit accounts including NOW and money market accounts also have variable interest rates; although changes are determined by management and are not based on a specific index such as prime.  Our certificates of deposit and certain borrowings have rates that are fixed until maturity.  While repricing of fixed rate certificates of deposit and borrowings are delayed until renewal, our floating rate borrowings are primarily LIBOR-based, and changes in LIBOR rates typically are in advance of changes in the prime rate.  As a result, interest rate decreases have generally resulted in an immediate decrease in our interest income on loans.

Interest rates declined steadily during 2008 as the Federal Reserve decreased the targeted federal funds rate seven times for a total of 400 basis points to end the year at a range of 0.00% to 0.25%.  The federal funds rate is currently at an historical low surpassing the previous low of 1.00% in June of 2003.  The rate reductions in 2008 continued a trend of three decreases totaling 100 basis points in the last quarter of 2007.  As the federal funds rate decreased, the prime interest rate changed by the same amount leaving the prime rate at 3.25% at the end of the year.  The declining interest rate environment throughout the year resulted in a decrease of 113 basis points for earning assets (136 basis points decrease in loan yields and only 6 basis point decrease in the yields of investment securities); while our funding costs decreased 107 basis points.  Although net interest income increased on increased earning asset balances compared to the prior year, the net interest margin decreased 20 basis points due to lags in deposit repricing, a shift in deposit composition from lower yielding to higher yielding time deposits and deposit pricing as a result of intense competition for deposits.

We will continue to evaluate ways to improve our net interest margin; however, we expect the impact of the current interest rate environment, and the impact of competition on loan yields and deposit costs, will continue to put pressure on our net interest margin in 2009.  A significant portion of the funds received from the TARP program will be used to fund asset growth.  The cost of these funds will be paid as a dividend and not recorded as interest expense which will increase net interest income and improve the net interest margin.

Provision for Loan Losses.   We recorded a $8.2 million provision for loan losses for the year ended December 31, 2008, representing an increase of $5.4 million from the $2.8 million provision we made for the year ended December 31, 2007.  The level of provisions is reflective of the trends in the loan portfolio, including loan growth, levels of nonperforming loans and other loan portfolio quality measures, and analyses of impaired loans.  Provisions for loan losses are charged to income to bring our allowance for loan losses to a level deemed appropriate by management based on the factors discussed under “Analysis of Allowance for Loan Losses.”  The provision for loan losses was 0.64% and 0.25% of average loans in 2008 and 2007 respectively.  On an annualized basis, our percentage of net loan charge-offs to average loans outstanding was 0.28% for the year ended December 31, 2008, compared with 0.14% for the year ended December 31, 2007.  Nonperforming loans totaled $14.4 million or 1.10% of total loans at December 31, 2008, compared with $2.1 million or 0.17% of total loans at December 31, 2007.  Nonperforming loans and increased net charge-offs continue to be predominantly related to residential construction and development lending.  The allowance for loan losses at December 31, 2008 of $18.9 million represents 1.43% of total loans and 1.31 times nonperforming loans.  The allowance for loan losses at December 31, 2007 of $14.3 million was 1.20% of total loans outstanding and 6.95 times nonperforming loans at that date.

 

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Non-Interest Income.   For the year ended December 31, 2008, non-interest income decreased $49 thousand, or 0.43%, to remain relatively unchanged at $11.3 million compared to the prior year; although the components changed significantly.   Income from the investment in SBIC activities decreased $2.0 million with income of $60 thousand in 2008 compared to $2.1 million in 2007.  The SBIC recognized write-downs in their investments in small companies who were not able to survive the current economic weakness during 2008.  In 2007, the SBIC recorded some substantial gains including a $1.2 million gain from the exit of certain portfolio companies in the first quarter.  Gains on economic hedges for 2008 were $934 thousand, an increase of $855 thousand compared to $79 thousand in the prior year.  Since 2003, the Company has entered into various interest rate swaps to hedge the interest rate risk inherent in certain of its brokered certificates of deposit and believes these swaps have been effective as economic hedges.  Due to the decline in market interest rates during the year, all of the brokered certificates of deposit and the related derivatives were called during the first six months of 2008.  As these derivatives and the related brokered deposits were called prior to maturity, a gain was recognized in non-interest income which totaled $1.4 million for the first six months of 2008.  During the third quarter of 2008, Lehman Brothers, the counterparty for two economic hedges, became insolvent and unable to comply with the terms of the hedges thereby causing a termination of these derivative contracts by Lehman’s technical default.  The Company was “in the money” on these contracts, creating an asset whose collectibility was in doubt and therefore was written off creating the $440 thousand loss in the third quarter.  Service charges increased $928 thousand or 18.8% during the year primarily due to an increase of $746 thousand in NSF charges.  Income from investment brokerage and trust fees increased from the prior year by $223 thousand to $1.1 million on higher transaction volumes in the first half of 2008.  Fees and income from the origination and sale of residential mortgage loans decreased $49 thousand or 3.7% to $1.3 million as purchase application volumes decreased sharply in the second half of 2008.

We expect a continued positive trend in service charge fee income in the future as we expand our branch network and deposit base.  We are looking to make selective investments in experienced personnel to support our mortgage and investment areas.  While we anticipate some variations in the performance of these business lines due primarily to external market conditions in 2009, we believe these investments provide us with an infrastructure that will support us with a solid base of revenue in the future.  As the SCP I (SBIC) fund portfolio matures, we anticipate some fluctuation in our non-interest income as gains and losses on their investments are recognized.

Non-Interest Expense.   We strive to maintain non-interest expenses at levels that we believe are appropriate given the nature of our operations and the investments in personnel and facilities that have been necessary to support our growth.  From 1998 forward, we have consistently maintained our ratio of non-interest expenses to average total assets below 3.0%.  For 2008 our ratio was 2.42%, down from 2.70% in 2007.  As our franchise expansion slowed during 2008, the rate of increase in non-interest expense also decreased.  This is also reflected in the decrease in our efficiency ratio to 71.65% for 2008 from 74.23% for 2007.  For the year ended December 31, 2008, our non-interest expense grew by $1.2 million, or 2.9%.  Salary and employee benefits expense increased $820 thousand, or 3.9%, and were attributable to normal increases in operation for salaries, commissions and employee benefits.  Occupancy and equipment expense decreased $249 thousand, or 3.1%, as the depreciation expense for facilities and equipment moderated and other efficiencies were realized.  Other non-interest expenses increased $618 thousand, or 5.3%, reflecting the increased volume of business activity, an increase of $367 thousand in the Bank’s FDIC deposit insurance assessment and the writeoff of $291 thousand of goodwill from a former investment in a mortgage company.

Provision for Income Taxes.   Our provision for income taxes, as a percentage of income before income taxes, was 31.0% for the year ending December 31, 2008 and 33.9% for the year ended December 31, 2007, reflective of the impact of tax-exempt interest income and increased income from bank owned life insurance as a larger percentage of pre-tax income.

RESULTS OF OPERATIONS

Years Ended December 31, 2007 and 2006

Net Income .   Our net income for 2007 was $7.6 million, an increase of $3.4 million from net income of $4.2 million earned in 2006.  Net income per share was $0.43 basic and diluted for the year ended December 31, 2007 and $0.24 basic and diluted for 2006.  The increase is due primarily to the strong growth in interest and non-interest income and the major initiative undertaken by the Company to restructure our balance sheet, which resulted in an after tax charge of $2.7 million in the second quarter of 2006.  We have continued to experience strong asset growth, driven by solid loan growth of $157.0 million or 15.2%, which was supported by an increase of $107.1 million in borrowings, an increase of $20.7 million in our deposit base and a decrease of $26.6 million in our securities portfolio.  During 2007, average earning assets increased $138.1 million or 11.2% to $1.37 billion, and average interest bearing liabilities rose $135.2 million or 12.1%.  The impact of the strong loan growth ($5.9 million), partially offset by the impact of margin compression ($2.9 million), produced a net increase in net interest income of $3.0 million, or 7.5% for 2007 compared with 2006.  The provision for loan losses increased to $2.8 million from $2.5 million in 2006.

 

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Non-interest income returned to a more normal level at $11.3 million, an increase of $7.7 million.  The increase in non-interest income was due primarily to an increase in investment brokerage income, income from the investment in SBIC activities at Salem Capital Partners, an increase in services charges and the absence of losses from the restructuring of our investment security portfolio and economic hedging activity which resulted in unusually low non-interest income in 2006.  Non-interest expenses increased $5.1 million, or 14.2%.  The increase was due to our investment in the infrastructure of the company through technology and the addition of people through branch expansion in Asheville and Raleigh.  Increased operating expenses including a full year of expenses on our operations center and an increase of $318 thousand in our FDIC assessment also contributed to the overall increase.

Net Interest Income.   During 2007, our net interest income increased by $3.0 million or 7.5% to $43.8 million.  Interest income increased as a result of growth in our overall level of average earning assets primarily from strong loan demand.  Average total interest-earning assets increased $138.1 million, or 11.2% during 2007, as the increase in average loan balances of $156.7 million was offset somewhat by a decrease in our average investment portfolio of $20.5 million or 7.5%.  Our average total interest-bearing liabilities increased by $135.2 million, or 12.1%.  The rates earned on a significant portion (approximately 56%) of our loans adjust immediately when index rates such as our prime rate changes.  Transaction deposit accounts including NOW and money market accounts also have variable interest rates although changes are determined by management and are not based on a specific index such as prime while our certificates of deposit and certain borrowings had rates that were fixed until maturity.  As a result, interest rate decreases have generally resulted in an immediate decrease in our interest income on loans.  While repricing of fixed rate certificates of deposit and borrowings are delayed until renewal, our floating rate borrowings are primarily LIBOR-based, and changes in LIBOR rates typically are in advance of changes in the prime rate.

Interest rates based on prime remained unchanged during the last two quarters of 2006 and through the first two quarters of 2007.  Late in the third quarter of 2007 the Federal Reserve reduced the discount rate by 50 basis points resulting in the reduction of prime by the same amount.  This action was followed by two 25 basis point reductions in the fourth quarter of 2007.  The steady interest rate environment in the first three quarters of 2007 resulted in a slight increase of 11 basis points in yields on our loan portfolio while our funding costs increased 39 basis points.  As a result of our balance sheet restructuring, in 2006, the yields on the available for sale investment portfolio increased 31 basis points to 4.90%.  The increase in cost of funds for both deposits and borrowings resulted in a decrease in our net interest margin for the year of 11 basis points.

Provision for Loan Losses.   We recorded a $2.8 million provision for loan loss for the year ended December 31, 2007, representing an increase of $265 thousand from the $2.5 million provision we made for the year ended December 31, 2006.  The level of provisions is reflective of the trends in the loan portfolio, including loan growth, levels of non-performing loans and other loan portfolio quality measures, and analyses of impaired loans.  Provisions for loan losses are charged to income to bring our allowance for loan losses to a level deemed appropriate by management based on the factors discussed under “Analysis of Allowance for Loan Losses.”  The provision for loan losses was 0.25% and 0.26% of average loans in 2007 and 2006 respectively.  On an annualized basis, our percentage of net loan charge-offs to average loans outstanding was 0.14% for the year ended December 31, 2007, compared with 0.13% for the year ended December 31, 2006.  Nonperforming loans totaled $2.1 million or 0.17% of total loans at December 31, 2007, compared with $2.6 million or 0.26% of total loans at December 31, 2006.  The allowance for loan losses at December 31, 2007 of $14.3 million represents 1.20% of total loans and 695% of nonperforming loans.  The allowance for loan losses at December 31, 2006 of $13.0 million was 1.26% of total loans outstanding and 495% nonperforming loans at that date.

 

 

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Non-Interest Income.   For the year ended December 31, 2007, non-interest income increased $7.7 million, or 208.1%, to $11.3 million from $3.7 million for the prior year.  This increase is primarily due to a $4.2 million pre-tax loss on the sale of investment securities recorded in the second quarter of 2006 related to our balance sheet restructuring.  During 2007, service charges and fees on deposit accounts increased $613 thousand, or 14.2%, as we continued our focus on attracting transaction accounts.  Fees and income from the origination and sale of residential mortgage loans increased $138 thousand or 11.5% to $1.3 million.  Income from investment brokerage and trust fees increased from the prior year by $361 thousand, to $1.1 million.  Income from our investments in and management fees from Salem Capital Partners, our SBIC affiliate, of $2.1 million were up $1.3 million from 2006.  The first quarter of 2007 included a gain of $1.2 million from the exit of certain investments made by Salem.

We continue to invest in experienced personnel to support our mortgage and investment areas.  While we anticipate some variations in the performance of these business lines due primarily to external market conditions, we believe these investments provide us with an infrastructure that will support us with a solid base of revenue in the future.  As Salem Capital Partners’ portfolio matures, we anticipate some fluctuation in our non-interest income as gains and losses on their investments are recognized.

Non-Interest Expense.   We strive to maintain non-interest expenses at levels that we believe are appropriate given the nature of our operations and the investments in personnel and facilities that have been necessary to support our growth.  From 1998 forward, we have consistently maintained our ratio of non-interest expenses to average total assets below 3.0%.  For 2007 our ratio was 2.70%, up from 2.62% in 2006.  Because of our continued strong growth, we have seen increases in every major component of our non-interest expenses.  For the year ended December 31, 2007, our non-interest expense grew by $5.1 million, or 14.2%.  Salary and employee benefits expense increased $2.4 million, or 12.7%, and reflect the addition of personnel associated with our expansion in Raleigh and Asheville, the addition of personnel to expand and support our lines of business, and normal increases in salaries and employee benefits.  Occupancy and equipment expense increased $1.1 million, or 16.0%, reflecting the expenses associated with our continued banking office expansion and a full year of expenses on our operations center in 2007 compared to a partial year in 2006.  Other non-interest expenses increased $1.6 million, or 15.9%, reflecting the increased volume of business activity, an increase of $318 thousand in the Bank’s FDIC deposit insurance assessment and a full year of expenses on our operations center compared to a partial year in 2006.

Provision for Income Taxes.   Our provision for income taxes, as a percentage of income before income taxes, was 33.9% for the year ending December 31, 2007 and 31.0% for the year ended December 31, 2006, reflective of the impact of tax-exempt interest income as a smaller percentage of pre-tax income.

LIQUIDITY

Market and public confidence in our financial strength and in the strength of financial institutions in general will largely determine our access to appropriate levels of liquidity.  This confidence is significantly dependent on our ability to maintain sound asset quality and appropriate levels of capital resources.

The term “liquidity” refers to our ability to generate adequate amounts of cash to meet our needs for funding loan originations, deposit withdrawals, maturities of borrowings and operating expenses.  Management measures our liquidity position by giving consideration to both on- and off-balance sheet sources of, and demands for, funds on a daily and weekly basis.

Beginning in December 2007 and throughout 2008, the United States Department of the Treasury in coordination with the Federal Reserve and Federal Deposit Insurance Corporation (FDIC) have implemented several initiatives to stimulate the economy and maintain liquidity in our national financial markets in the face of unprecedented economic conditions.  The Federal Reserve introduced three new liquidity facilities, in addition to its primary discount window borrowing program, the Term Auction Facility (TAF), the Term Securities Lending Facility (TSLF) and the Primary Dealer Credit Facility (PDCF).  These initiatives were designed to lengthen the duration of access to liquidity, broaden the types of eligible collateral, expand the range of counterparties for some activities and reduce the cost of borrowings from the Fed relative to the federal funds rate.  PDCF for primary dealers provided daily access to funding to eligible institutions.  The TAF and TSLF constitute a second type of facility in which a pre-determined amount of longer-term funding (for a 28 day period or 84 day period) is available at auction on pre-announced dates for settlement on a later date.  The interest rate and the distribution of the awards across bidding institutions are determined by the results of each auction.  The TAF allows banks to borrow against a wide range of collateral, including securities that are not widely pledged in private markets and bank loans.  The Federal Reserve has committed to keep this new array of liquidity facilities in place for as long as is necessary to maintain liquidity and promote stability in our financial markets.  As discussed below, the Company has utilized the Term Auction Facility and will continue to consider it one of our funding alternatives.

 

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In addition to the increase in deposit insurance coverage limit from $100,000 per account to $250,000, the FDIC announced in October 2008 two new programs under its Temporary Liquidity Guarantee Program.  The first is an extension of deposit insurance coverage to all non-interest bearing transaction accounts with no limitation as to dollar amount through December 31, 2009 at a premium cost of 10 basis points per annum to depository institutions.  Under the second program, the FDIC will guarantee the timely payment of principal and interest on newly issued senior unsecured debt by eligible depository institutions through June 30, 2012.  New issuance of senior unsecured debt under this program is limited to a maximum of 125 percent of the par or face value of senior unsecured debt outstanding as of September 30, 2008 that was scheduled to mature on or before June 30, 2009.  For institutions with no qualifying senior unsecured debt other than fed funds purchased, the applicable limit is two percent of consolidated total liabilities as of September 30, 2009.  As the Bank had $20.0 million in overnight (fed funds purchased) borrowings and no other qualifying senior unsecured debt at September 30, 2008, our applicable limit under this program would be $33.1 million.  The annual cost of this guarantee is tiered from 50 basis points for terms of 180 days or less to 100 basis points for terms over one year.  The Company has elected to opt-in for both programs and particularly the second program at the bank level and the holding company level to preserve the opportunity to participate in the senior unsecured debt guarantee program in the future.

Sources of liquidity include cash and cash equivalents, (net of federal requirements to maintain reserves against deposit liabilities), investment securities eligible for pledging to secure borrowings from correspondent banks pursuant to securities sold under repurchase agreements, investments available for sale, loan repayments, loan sales, deposits and borrowings. The primary sources of borrowed funds are from the Federal Home Loan Bank, under the Federal Reserve’s Term Auction Facility and discount window, issuance of senior unsecured debt under the FDIC’s Temporary Liquidity Guarantee Program and from correspondent banks under overnight federal funds credit lines and revolving lines of credit.  In addition to managing deposit and borrowing outflows, the Company’s primary demand for liquidity is anticipated funding under credit commitments to customers.

We have maintained a sufficient level of liquidity in the form of federal funds sold and investment securities.  These liquid assets aggregated $300.9 million at December 31, 2008, compared to $231.2 million and $256.3 million at December 31, 2007 and 2006, respectively.  The increase in 2008 resulted from a decision to rebuild our investment portfolio to a more normal level as a percentage of our total assets to provide sufficient liquidity to fund loan growth and to manage the current and unforeseen deposit and borrowing outflows.  Supplementing customer deposits as a source of funding, we have available lines of credit from various correspondent banks to purchase federal funds on a short-term basis of approximately $121.0 million.  As of December 31, 2008, the Bank has the credit capacity to borrow up to $450.0 million, from the Federal Home Loan Bank of Atlanta, with $154.1 million outstanding as of that date.  Under the Federal Reserve’s Term Auction Facility discussed above, the Company had borrowings outstanding of $60.0 million as of December 31, 2008.  Given the flexibility in the types of eligible collateral that may be pledged for borrowings under the TAF, the Company has up to $308.3 million in additional borrowing capacity under this facility.  As mentioned above, the Company has capacity to issue new senior unsecured debt of up to $33.1 million through the FDIC’s Temporary Liquidity Guarantee Program.  At December 31, 2008, we had funding of $90.0 million in the form of long term repurchase agreements with maturities from one to ten years and short term repurchase agreements totaling $10.0 million.  We also had short-term repurchase agreements with total outstanding balances of $13.2 million and $22.7 million at December 31, 2008 and 2007, respectively, all of which were done as accommodations for our deposit customers.  Securities sold under agreements to repurchase are collateralized by U.S. government agency obligations.  As of December 31, 2008, the Bank had repurchase lines of credit aggregating $150.0 million from various institutions.  The repurchases must be adequately collateralized.

 

 

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Throughout our twelve-year history, our loan demand has typically exceeded our growth in core deposits.  We have therefore relied heavily on certificates of deposit as a source of funds.  While the majority of these funds are generally from our local market area, the Bank has utilized brokered and out-of-market certificates of deposit to diversify and supplement our deposit base.  In 2008, deposit growth shifted from non-maturity deposits to time deposits as customers focused on higher yields and longer terms during the declining interest rate environment.  Certificates of deposit represented 63.1% of our total deposits at December 31, 2008, an increase from 42.1% at December 31, 2007.  Brokered and out-of-market certificates of deposit totaled $261.2 million at year-end 2008 and $132.6 million at year-end 2007, which comprised 21.2% and 12.7% of total deposits, respectively.  The Company relied more on brokered and out-of-market certificates of deposit during periods of irrational deposit pricing this past year as banks in our market area paid premium deposit rates to secure their necessary funding for liquidity purposes.  We will continue to monitor the costs of our various funding alternatives and our funding mix may change from time to time.  Certificates of deposit of $100 thousand or more, inclusive of brokered and out-of-market certificates, represented 14.5% of our total deposits at December 31, 2008 and 25.9% at December 31, 2007.  A portion of these deposits are controlled by members of our Board of Directors and Advisory Board members, or otherwise come from customers considered to have long-standing relationships with our management.  Based upon the nature of these relationships, management does not believe we are subject to significant liquidity risk related to these deposits.  Large certificates of deposit are generally considered rate sensitive.  While we will need to pay competitive rates to retain these deposits at their maturities, there are other subjective factors that will determine their continued retention.

At December 31, 2008, our outstanding commitments to extend credit consisted of loan commitments of $315.1 million, including amounts available under home equity credit lines and letters of credit of $102.2 million and $7.1 million, respectively. We believe that our combined aggregate liquidity position from all sources is sufficient to meet the funding requirements of loan demand, deposit and borrowings maturities and deposit withdrawals in the near term.

 

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