Item
2. Management’s Discussion and Analysis of Financial Condition and
Results of Operations
This
Quarterly Report on Form 10-Q may contain certain forward-looking statements
consisting of estimates with respect to our financial condition, results of
operations and business that are subject to various factors which could cause
actual results to differ materially from these estimates. These
factors include, but are not limited to, general economic conditions, changes in
interest rates, deposit flows, loan demand, real estate values and competition;
changes in accounting principles, policies, or guidelines; changes in
legislation or regulation; and other economic, competitive, governmental,
regulatory, technological factors affecting our operations, pricing, products
and services, and other factors discussed in our filings with the Securities and
Exchange Commission.
Summary
of First Quarter
Total
assets decreased $14.0 million during the first quarter primarily due to the
goodwill impairment charge discussed below. Excluding the goodwill
impairment charge, total assets grew $35.5 million or 2.0% during the first
quarter of 2009 led by investment securities which increased $21.2 million or
6.5% and federal funds sold which grew $15.7 million to end the period at $17.9
million. Investment securities were purchased during the quarter to
invest excess funds as deposits continued to grow at a steady pace while loan
balances decreased due to a slowdown in loan demand precipitated by a downturn
in the economy. The majority of the securities purchased were
available for sale government agencies which increased $52.4 million while
mortgage-backed securities increased $11.7 million and municipals increased $7.4
million. Total loans declined $17.3 million or 1.3% during the
quarter to end the period at $1.30 billion. Commercial mortgage
loans, which total $428.2 million or 33.0% of gross loans, continue to comprise
the largest segment of the loan portfolio and were the only segment to grow
during the quarter increasing $9.0 million or 2.1% for the
quarter. Construction loans experienced the largest decrease for the
quarter decreasing $17.0 million or 6.5% to $243.6 million or 18.8% of total
gross loans, as housing construction has contracted in this economic
slowdown. Residential mortgage loans decreased $3.2 million or 0.8%
and comprised 30.1% of the total loan portfolio. Of the $3.2 million
decrease in the residential mortgage loan segment, land and building lots
decreased $1.6 million, 1-4 family residences decreased $1.4 million and home
equity loans decreased $254 thousand. Commercial and industrial loans
decreased $4.6 million or 2.1% and represent 16.7% of total gross loans while
loans to individuals decreased $1.5 million or 7.7%. Total deposits
were $1.33 billion at quarter end, an increase of $95.0 million or 7.7% from
year-end 2008. Time deposits grew $94.4 million or 14.4% while a
small increase in money market, savings and NOW accounts was offset by a
decrease in demand deposits. Borrowings decreased $58.8 million or
15.8% with short term borrowings decreasing $43.8 million and long term
borrowings decreasing $15.0 million.
Goodwill
represents the excess of the cost of an acquisition over the fair value of the
net assets acquired. 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. Another market valuation approach utilizes the current
stock price adjusted by an appropriate control premium as an indicator of fair
market value. Given the substantial declines in our common stock
price, declining operating results, asset quality trends, market comparables and
the economic outlook for our industry, the Company’s fair value has decreased
significantly compared with previous assessments. Our goodwill
testing for the first quarter of 2009, which included an analysis by a
independent third party, indicated that the Company’s fair value does not
support the goodwill recorded at the time of the acquisition of The Community
Bank in January 2004; therefore, the Company has recorded a $49.5 million
goodwill impairment charge to write off the entire amount of goodwill as of
March 31, 2009. This non-cash goodwill impairment charge to earnings
was the primary reason for the Company’s $49.3 million net loss in the first
quarter 2009.
Net
interest income decreased by $360 thousand or 2.8% for the quarter compared to
the fourth quarter of 2008. Interest income declined due to many
factors including a shift in the mix of earning assets from higher yielding
loans to lower yielding investment securities as outstanding loan balances
declined from a slowdown in loan demand. Total interest income
decreased by $1.5 million or 6.3% while interest expense decreased $1.2 million
or 10.3% compared to the previous quarter. Interest expense also
decreased during the quarter as the funding mix shifted with a decrease in
borrowings of $58.8 million and strong growth in retail certificates of
deposit. The net interest margin decreased 9 basis points to 3.01%
compared to 3.10% for the prior quarter and increased 3 basis points when
compared to 2.98% for the first quarter of 2008.
The
Company increased its provision for loan losses to $4.0 million for the quarter
compared with $2.4 million for the fourth quarter of 2008 and $925 thousand for
the first quarter of 2008. This higher provision level resulted as
more loans were identified as nonperforming during the first
quarter. Based on the challenges we are seeing in residential
construction and development, we continued our proactive approach to credit risk
management. Nonperforming loans increased to $20.3 million or 1.56%
of loans at March 31, 2009 from $14.4 million or 1.10% of loans at December 31,
2008 compared to $7.0 million or 0.57% of loans at March 31,
2008. Nonperforming assets increased to $31.0 million or 1.73% of
total assets at March 31, 2009 compared to $20.2 million or 1.12% of total
assets at December 31, 2008. Net charge-offs during the first quarter
of 2009 increased to 1.09% (annualized) of average loans compared to 0.43% in
the prior quarter. The increases in net charge-offs, nonperforming
loans and nonperforming assets continue to be predominately related to
residential construction and development lending. The allowance for
loan losses of $19.3 million at March 31, 2009 represented 1.49% of total loans
and 0.95 times nonperforming loans at current quarter-end compared with 1.43% of
total loans and 1.31 times nonperforming loans at December 31,
2008. We believe the allowance is adequate for losses inherent in the
loan portfolio at March 31, 2009.
Non-interest
income was $2.6 million during the first quarter of 2009, compared to $2.5
million for the prior quarter and $3.6 million for the first quarter of
2008. The increase in the non-interest income in the current quarter
compared to the prior quarter was attributable to increases in mortgage banking
income from increased refinance activity, in wealth management income from
increased transaction volume in sales of annuities and life insurance products
and in SBIC income. These increases were offset by a $404 thousand
loss as the Company’s equity investment in Silverton Bank was determined to be
worthless based on their closure by banking regulators on May 1,
2009. Income from SBIC activities increased to $238 thousand in the
current quarter compared to an $89 thousand gain reported in the fourth quarter
of 2008 and a $150 thousand loss in the first quarter of 2008. Income
from SBIC activities will vary as the gains and losses from investments are
recognized. Non-interest income from mortgage banking and investment
brokerage activities increased in the current quarter although they declined
compared to the first quarter of 2008.
Total
non-interest expense was $60.6 million for the first quarter primarily due to
the $49.5 million goodwill impairment charge discussed
above. Excluding the goodwill impairment charge, non-interest expense
of $11.1 million in the first quarter of 2009 increased $430 thousand or 4.0%
from the prior quarter and grew by $523 thousand or 5.0% compared with the $10.6
million reported in the year ago period. The increase from the prior
quarter was primarily due to increases in health insurance benefit costs,
commissions on increased mortgage and wealth management activity and increased
marketing efforts. This increase from the first quarter of 2008
reflects increased expenses associated with problem loan workout efforts, buyer
incentives paid to purchasers of bank-financed builder housing inventory, FDIC
insurance costs, professional services and occupancy costs.
Nonperforming
loans and nonperforming assets rose from the prior quarter by $5.8 million and
$10.9 million respectively, due to the continued effects of the current economic
conditions in our market area and throughout the country. For the
current quarter, net charge-offs of $3.5 million or 1.09% of average loans were
66 basis points higher than the 0.43% from the previous quarter and 98 basis
points higher than the 0.11% from the first quarter of 2008.
On March
24, 2009, Southern Community Financial Corporation announced that its Board of
Directors voted to suspend payment of a quarterly cash dividend to common
shareholders. The Board will continue to evaluate the payment of a
quarterly cash dividend on a periodic basis.
Financial
Condition at March 31, 2009 and December 31, 2008
During
the three month period ending March 31, 2009, total assets decreased by $14.0
million, or 0.8%, to $1.79 billion as a $49.5 million goodwill impairment charge
was recorded as of quarter-end. The Company’s balance sheet
management for the quarter emphasized investing funds generated by inflows from
deposit growth, investment securities maturities, calls and prepayments and net
loan repayments as well as reducing borrowings, maintaining an adequate
allowance for loan losses and keeping regulatory capital ratios in excess of the
well capitalized threshold. The investment of funds was achieved by
growing the investment portfolio by $21.2 million or 6.5% over year-end levels
in the face of a slowdown in overall loan demand; while short term borrowings
were reduced $43.8 million and long term borrowings were reduced $15.0
million.
In the
loan portfolio, commercial mortgage loans, which total $428.2 million or 33.0%
of gross loans, continue to comprise the largest segment and was the only
segment to grow during the first quarter increasing by $9.0 million or
2.1%. The construction segment of the portfolio decreased $17.0
million to end the period at $243.6 million, or 18.8% of gross loans as the
residential construction and development loans continue to be impacted by
decreased sales activity in the housing market. Loans secured by
residential mortgages experienced a decrease of $3.2 million or 0.8% and
commercial and industrial lending declined $4.6 million to $216.6 million at
March 31, 2009 or 16.7% of the total loan portfolio.
We
utilize various funding sources, as necessary, to support balance sheet
management and growth. Customer deposits continued to be our primary
funding source for asset growth during the first quarter due to substantial
increases in certificates of deposit. At March 31, 2009, deposits
totaled $1.33 billion, an increase of $95.0 million or 7.7% from year-end
2008. Time deposits increased $94.4 million or 14.4% during the
quarter; while non-maturity deposits increased $595 thousand or less than 1%
during the period as customers moved to time deposits for increased
yield. Of the $94.4 million or 14.4% increase in time deposits, local
retail certificates increased $106.3 million as brokered and out-of-market
certificates decreased by $11.9 million during the quarter.
Our
capital position remains strong, with all of our regulatory capital ratios at
levels that categorize us “well capitalized” under federal bank regulatory
capital guidelines. At March 31, 2009, our stockholders’ equity
totaled $138.2 million, a decrease of $49.5 million compared to December 31,
2008. The decrease is the result of a net loss of $49.3 million,
offset by a net increase of $1.2 million in the market value of available for
sale securities, $671 thousand of cash dividends declared in January 2009 and
paid to shareholders during the period and dividends totaling $627 thousand
related to the preferred stock issued to the United States Treasury through the
Capital Purchase Program.
Results
of Operations for the Three Months Ended March 31, 2009 and 2008
Net
Loss.
Our net loss for the three months ended March 31, 2009
was $49.3 million compared with net income of $2.07 million for the same three
month period in 2008. Net income (loss) per share available to common
shareholders was ($2.98) for both basic and diluted for the three months ended
March 31, 2009 as compared with $0.12 for both basic and diluted for the same
period in 2008. Net interest income for the first quarter of 2009 was
$12.5 million, up $1.5 million, or 13.2% compared with the first quarter 2008,
due in part to strong loan growth in the second and third quarters of 2008 and
strong time deposit growth year-over-year. The net interest margin of
3.01% increased three basis points from the year ago
period. Non-interest income was $2.6 million during the first quarter
of 2009, which represents an decrease of 27.9% from non-interest income of $3.6
million reported in the comparable period in 2008, primarily the result of a
nonrecurring $1.0 million gain being recognized in connection with economic
hedges in the first quarter of 2008 compared to a net loss from derivative
activity of $22 thousand in the first quarter of 2009. These
increases were offset by a $404 thousand loss as the Company’s equity investment
in Silverton Bank was determined to be worthless based on their closure by
banking regulators on May 1, 2009.
In contrast, Salem Capital
Partners, our small business investment company (SBIC) affiliate, recognized a
gain of $238 thousand for first quarter 2009 compared to a loss of $150 thousand
in the first quarter of 2008. Non-interest expense increased $50.0
million principally due to the $49.5 million goodwill impairment charge
mentioned above. Excluding this goodwill impairment charge,
non-interest expenses for the first quarter 2009 increased $523 thousand or 5%
over the comparable 2008 quarter. This increase from the first
quarter of 2008 reflects increased expenses associated with problem loan workout
efforts including OREO costs, the buyer incentives to purchasers of
bank-financed builder housing inventory, FDIC insurance cost, professional
services and occupancy costs.
Net
Interest Income.
During the
three months ended March 31, 2009, our net interest income was $12.5 million, an
increase of $1.5 million or 13.2% over the first quarter
2008. Continued strong loan demand during the second and third
quarters of 2008 contributed to the 13% year-over-year increase in the average
balance of interest earning assets. Despite the competitive pressure
on rates paid on deposits, our cost of funds decreased at a slightly faster rate
than the overall yield on our earning assets resulting in a minimal change in
the net interest margin which increased three basis points from the first
quarter of 2008.
Our net
interest margin has been impacted and will continue to be impacted in the near
term by actions taken by the Federal Reserve Board with respect to interest
rates and by competition in our markets. During the first quarter of
2009, the Federal Reserve maintained the Federal Funds rate at the all time low
of 25 basis points. The Federal Funds rate was reduced seven times
throughout 2008 for a total of 325 basis points resulting in a comparable
reduction in the prime rate. The loan portfolio is structured with
approximately 44% of loans with fixed rates, which will not be immediately
affected by the change, and 56% with variable rates which will reprice as the
applicable rate changes. At quarter end, approximately 73% of the
variable rate loans were tied to prime; while 27% of the variable rate loans
were tied to LIBOR or another index. The loans tied to prime were
generally repriced at the time of the change in the prime rate index; while the
loans tied to LIBOR reprice based on terms of the loan. Deposits,
such as money market and NOW accounts, are repriced at the discretion of
management. The average yield on interest-earning assets in the first
quarter of 2009 decreased 110 basis points to 5.49% compared to the first
quarter 2008 as management exercised improved loan pricing by instituting floors
on the majority of variable rate loans and exercising pricing power on new loans
and renewals. The lower interest rate environment has also impacted
our funding costs. Our cost of average interest bearing liabilities
for the first quarter of 2009 decreased 120 basis points to 2.72% compared to
the first quarter of 2008. For the first quarter 2009, our net
interest margin of 3.01%, decreased from 3.10% for the fourth quarter of 2008
and increased from 2.98% in the first quarter of 2008. The effect of
any future market interest rate changes and the applicable repricing of loans,
deposits, and borrowings will continue to be reflected in the net interest
income in future quarters. Although the Company believes our margins
are stabilizing, we may see some continued compression in our margins as loan
customers will request to refinance their loans at a lower rate; however
competitive rates must still be paid for our funding sources.
Average
Yield/Cost Analysis
The
following table contains information relating to the Company’s average balance
sheet and reflects the average yield on assets and cost of liabilities for the
periods indicated. Such annualized yields and costs are derived by
dividing annualized income or expense by the average balances of assets or
liabilities, respectively, for the periods presented. The average
loan portfolio balances include nonaccrual loans.
|
|
|
Three
Months Ended March 31, 2009
|
|
|
Three
Months Ended March 31, 2008
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Average
balance
|
|
|
Interest
earned/paid
|
|
|
Average
yield/cost
|
|
|
Average
balance
|
|
|
Interest
earned/paid
|
|
|
Average
yield/cost
|
|
|
Interest-earning
assets:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Loans
|
|
$
|
1,310,679
|
|
|
$
|
18,762
|
|
|
|
5.81
|
%
|
|
$
|
1,219,800
|
|
|
$
|
21,183
|
|
|
|
6.98
|
%
|
|
Investment
securities available for sale
|
|
|
315,765
|
|
|
|
3,642
|
|
|
|
4.68
|
%
|
|
|
195,565
|
|
|
|
2,410
|
|
|
|
4.96
|
%
|
|
Investment
securities held to maturity
|
|
|
27,864
|
|
|
|
332
|
|
|
|
4.83
|
%
|
|
|
67,756
|
|
|
|
720
|
|
|
|
4.27
|
%
|
|
Federal
funds sold
|
|
|
24,985
|
|
|
|
8
|
|
|
|
0.13
|
%
|
|
|
1,916
|
|
|
|
12
|
|
|
|
2.52
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total
interest earning assets
|
|
|
1,679,293
|
|
|
|
22,744
|
|
|
|
5.49
|
%
|
|
|
1,485,037
|
|
|
|
24,325
|
|
|
|
6.59
|
%
|
|
Other
assets
|
|
|
105,781
|
|
|
|
|
|
|
|
|
|
|
|
140,127
|
|
|
|
|
|
|
|
|
|
|
Total
assets
|
|
$
|
1,785,074
|
|
|
|
|
|
|
|
|
|
|
$
|
1,625,164
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Interest-bearing
liabilities:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Deposits:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
NOW,
Money Market, and Savings
|
|
$
|
469,447
|
|
|
$
|
1,627
|
|
|
|
1.41
|
%
|
|
$
|
478,407
|
|
|
$
|
3,255
|
|
|
|
2.74
|
%
|
|
Time
deposits greater than $100K
|
|
|
181,416
|
|
|
|
1,425
|
|
|
|
3.19
|
%
|
|
|
310,923
|
|
|
|
3,963
|
|
|
|
5.13
|
%
|
|
Other
time deposits
|
|
|
519,969
|
|
|
|
4,251
|
|
|
|
3.32
|
%
|
|
|
167,738
|
|
|
|
1,891
|
|
|
|
4.53
|
%
|
|
Short-term
borrowings
|
|
|
101,425
|
|
|
|
565
|
|
|
|
2.26
|
%
|
|
|
115,301
|
|
|
|
1,320
|
|
|
|
4.60
|
%
|
|
Long-term
borrowings
|
|
|
263,699
|
|
|
|
2,416
|
|
|
|
3.72
|
%
|
|
|
295,899
|
|
|
|
2,894
|
|
|
|
3.93
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total
interest bearing liabilities
|
|
|
1,535,956
|
|
|
|
10,284
|
|
|
|
2.72
|
%
|
|
|
1,368,268
|
|
|
|
13,323
|
|
|
|
3.92
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Demand
deposits
|
|
|
101,747
|
|
|
|
|
|
|
|
|
|
|
|
102,753
|
|
|
|
|
|
|
|
|
|
|
Other
Liabilities
|
|
|
9,360
|
|
|
|
|
|
|
|
|
|
|
|
11,953
|
|
|
|
|
|
|
|
|
|
|
Stockholders'
equity
|
|
|
138,011
|
|
|
|
|
|
|
|
|
|
|
|
142,190
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total
liabilities and stockholders' equity
|
|
$
|
1,785,074
|
|
|
|
|
|
|
|
|
|
|
$
|
1,625,164
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net
interest income and net interest spread
|
|
|
|
|
|
$
|
12,460
|
|
|
|
2.78
|
%
|
|
|
|
|
|
$
|
11,002
|
|
|
|
2.67
|
%
|
|
Net
interest margin
|
|
|
|
|
|
|
|
|
|
|
3.01
|
%
|
|
|
|
|
|
|
|
|
|
|
2.98
|
%
|
Ratio
of average interest-earning assets
to average interest-bearing
liabilities
|
|
|
109.33
|
%
|
|
|
|
|
|
|
|
|
|
|
108.51
|
%
|
|
|
|
|
|
|
|
|
Provision
for Loan Losses.
The Company
recorded a $4.0 million provision for loan losses for the quarter ended March
31, 2009, representing an increase of $3.1 million from the $925 thousand
provision from the first quarter of 2008. The level of provision for
the quarter is reflective of the trends in the loan portfolio, including loan
balances, 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 “Asset
Quality.” On an annualized basis, our percentage of net loan
charge-offs to average loans outstanding was 1.09% for the quarter ended March
31, 2009, compared with 0.11% for the quarter ended March 31, 2008.
Non-Interest
Income.
For the three months ended March 31, 2009,
non-interest income of $2.6 million decreased by $1.0 million or 27.9% from $3.6
million for the same period in the prior year. The decrease was
primarily the result of a nonrecurring $1.0 million gain being recognized in the
first quarter of 2008 in connection with economic hedges compared to a loss of
$22 thousand in the first quarter of 2009. These increases were
offset by a $404 thousand loss as the Company’s equity investment in Silverton
Bank was determined to be worthless based on their closure by banking regulators
on May 1, 2009. Salem Capital Partners, our small business investment
company (SBIC) affiliate established seven years ago, recognized a gain of $238
thousand compared to a loss of $150 thousand in the first quarter of
2008. Income from SBIC activities will vary as the gains and losses
from these investments are recognized. Income from mortgage banking
activities of $416 thousand was down $68 thousand, or 14.1% compared to the
first quarter of 2008, as first quarter 2008 refinance activity was more robust
than in 2009. Investment brokerage and trust fees decreased to $296
thousand, down 20.2% from the year ago period due to the impact of the economic
downturn on investor activity as sales volume is lower and the revenue mix has
shifted from equities and mutual funds to sales of annuities and life
insurance.
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 and service our growth. From 1998
forward through the current three month period, with the exception of the
current period goodwill impairment charge, we have consistently maintained our
ratio of non-interest expense to average assets below 3.0%. Excluding
the $49.5 million goodwill impairment charge incurred during the first quarter
of 2009, our non-interest expense increased $523 thousand or 5.0% over the same
period in 2008. This increase was primarily related to expenses
associated with problem loan workout efforts and OREO expense which increased
$184 thousand. A buyer’s incentive program was established to
encourage customers to purchase homes from bank-financed builder inventory,
which cost $100 thousand during the current quarter. Expenses for
professional services including attorneys fees increased $201 thousand compared
to the year ago quarter due to processing foreclosed loans and pursuing legal
remedies related to losses reported in previous quarters with derivative
instruments.
Provision
for Income Taxes.
Income taxes were a benefit of $214 thousand
as tax-exempt income including an increase in cash surrender value on bank-owned
life insurance and interest on municipal bonds exceeded taxable
income.
Liquidity
and Capital Resources
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.
Liquidity
is defined as our ability to meet anticipated customer demands for funds under
credit commitments and deposit withdrawals at a reasonable cost and on a timely
basis. Management measures our liquidity position by giving
consideration to both on- and off-balance sheet sources of funds and demands for
funds on a daily and weekly basis.
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 dealers and customers pursuant to
securities sold under repurchase agreements, investments available for sale,
loan repayments, loan sales, deposits, and borrowings from the Federal Home Loan
Bank and from correspondent banks under overnight federal funds credit
lines. In addition to deposit and borrowing withdrawals and
maturities, the Company’s primary demand for liquidity is anticipated funding
under credit commitments to customers.
Investment
securities totaled $345.9 million at March 31, 2009, an increase of $21.2
million from $324.7 million at December 31, 2008. We believe our
liquidity is adequate to fund expected loan demand and current deposit and
borrowing maturities. 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 $130.0
million. We also have the credit capacity from the Federal Home Loan
Bank of Atlanta (FHLB) to borrow up to $446.5 million, as of March 31, 2009,
with lendable collateral value of $313.0 million. Borrowings with the
FHLB were $137.1 million at March 31, 2009. Under the Federal
Reserve’s Term Auction Facility, we had borrowings outstanding of $20 million as
of March 31, 2009. Given the flexibility in the types of eligible
collateral that may be pledged for borrowings under the facility, we have up to
$244.5 million in additional borrowing capacity under the
facility. In addition, we have capacity to issue new senior unsecured
debt up to $33.1 million through the FDIC’s Temporary Liquidity Guarantee
Program. At March 31, 2009, we had funding of $100.0 million in the
form of term repurchase agreements with maturities from one to five years which
remained unchanged from year-end 2008 and from the first quarter of
2008. We have repurchase lines of credit aggregating $100.0 million
from various institutions. The repurchases must be adequately
collateralized. We also had short-term repurchase agreements with
total outstanding balances of $11.4 million and $23.2 million at March 31, 2009
and December 31, 2008, respectively, all of which were done as accommodations
for our deposit customers. Securities sold under agreements to
repurchase generally mature within ninety days from the transaction date and are
collateralized by U.S. government agency obligations. At March 31,
2009, our outstanding commitments to extend credit consisted of loan commitments
of $201.5 million and amounts available under home equity credit lines, other
credit lines and letters of credit of $101.5 million, $7.5 million and $15.4
million, respectively. We believe that our combined aggregate
liquidity position from all sources is sufficient to meet the funding
requirements of loan demand and deposit maturities and withdrawals in the near
term.
Throughout
our twelve year history, our loan demand has exceeded our growth in core
deposits. We have therefore relied heavily on certificates of
deposits as a source of funds. While the majority of these funds are
from our local market area, the Bank has utilized brokered and out-of-market
certificates of deposits to diversify and supplement our deposit
base. In recent years, the Bank has emphasized initiatives to
increase demand and other core deposit accounts to improve our funding
mix. The deposit emphasis shifted in the fourth quarter of 2008 and
throughout the first quarter of 2009 as we introduced a time deposit campaign to
address customer concerns for a higher yield and availability of funds with a
one time withdrawal during the term of the certificate. As a result
of this promotion, time deposits at March 31, 2009 increased $94.4 million or
14.4% compared to December 31, 2008, and has had a minimal impact on our net
interest margin. Certificates of deposits represented 56.4% of our
total deposits at March 31, 2009, an increase from 53.1% at December 31,
2008. Time deposits of $100 thousand or more totaled $199.8 million
and $163.6 million at March 31, 2009 and December 31, 2008,
respectively. While we will need to pay competitive rates to retain
these deposits at their maturities, there are other subjective factors that will
also determine their continued retention.
Under the
United States Treasury’s Capital Purchase Program (CPP), the Company issued
$42.75 million in Cumulative Perpetual Preferred Stock, Series A, on December 5,
2008. In addition, the Company provided warrants to the Treasury to
purchase 1,623,418 shares of the Company’s common stock at an exercise price of
$3.95 per share. These warrants are immediately exercisable and
expire ten years from the date of issuance. The preferred stock is
non-voting, other than having class voting rights on certain matters, and pays
cumulative dividends quarterly at a rate of 5% per annum for the first five
years and 9% per annum thereafter. The preferred shares are
redeemable at the option of the Company subject to regulatory
approval.
As a
condition of the CPP, the Company must obtain consent from the United States
Department of the Treasury to repurchase its common stock or to increase its
cash dividend on its common stock from the September 30, 2008 quarterly level of
$0.04 per common share. The Company has agreed to certain
restrictions on executive compensation, including limitations on amounts payable
to certain executives under severance arrangements and change in control
provisions of employment contracts and clawback provisions in compensation
plans, as part of the CPP. Under the American Recovery and
Reinvestment Act of 2009, the Company is limited to using restricted stock as
the form of payment to the top five highest compensated executives under any
incentive compensation programs.
At March
31, 2009, our leverage ratio (Tier I capital to average quarterly assets) was
9.96%, and all of our capital ratios exceeded the minimums established for a
well-capitalized bank by regulatory measures. Our Tier I
risk-based capital ratio and total risk-based capital ratio at March 31, 2009
were 12.35% and 13.69%, respectively.
The
Company announced plans to repurchase up to 300,000 shares of its common stock
in March 2005, to repurchase an additional 600,000 shares of its common stock in
September 2005 and to repurchase up to an additional 1 million shares of its
common stock in July 2006. Through March 31, 2009, the Company had
repurchased 1,858,073 shares at an average price of $6.99 per share under the
three plans, with no purchases during the first quarter of
2009. Under the provisions of the Treasury’s Capital Purchase
Program, the Company may not repurchase any of its common stock without the
consent of the Treasury as long as the Treasury invests in our preferred
stock.
On March
24, 2009, Southern Community Financial Corporation announced that its Board of
Directors voted to suspend payment of a quarterly cash dividend to common
shareholders. The Board will continue to evaluate the payment of a
cash dividend on a quarterly basis.
Asset
Quality
We
consider asset quality to be of primary importance. We employ a
formal internal loan review process to ensure adherence to the Lending Policy as
approved by the Board of Directors. It is the responsibility of each
lending officer to assign an appropriate risk grade to every loan
originated. Credit Administration, through the loan review process,
validates the accuracy of the initial risk grade assessment. In
addition, as a given loan’s credit quality improves or deteriorates, it is
Credit Administration’s responsibility to change the borrower’s risk grade
accordingly. Our policy in regard to past due loans normally requires
a charge-off to the allowance for loan losses within a reasonable period after
collection efforts and a thorough review have been completed. Further
collection efforts are then pursued through various means including legal
remedies. Loans carried in a nonaccrual status and probable losses
are considered in the determination of the allowance for loan
losses.
Our
financial statements are prepared on the accrual basis of accounting, including
the recognition of interest income on loans, unless we place a loan on
nonaccrual basis. We account for loans on a nonaccrual basis when we
have serious doubts about the collectibility of principal or
interest. Generally, our policy is to place a loan on nonaccrual
status when the loan becomes past due 90 days. We also place loans on
nonaccrual status in cases where we are uncertain whether the borrower can
satisfy the contractual terms of the loan agreement. Amounts received
on nonaccrual loans generally are applied first to principal and then to
interest only after all principal has been collected. Restructured
loans are those for which concessions, including the reduction of interest rates
below a rate otherwise available to that borrower or the deferral of interest or
principal have been granted due to the borrower’s weakened financial
condition. We record interest on restructured loans at the
restructured rates, as collected, when we anticipate that no loss of original
principal will occur. Management also considers potential problem
loans in the evaluation of the adequacy of the Bank’s allowance for loan
losses. Potential problem loans are loans which are currently
performing and are not included in nonaccrual or restructured loans as shown
above, but about which we have doubts as to the borrower’s ability to comply
with present repayment terms. Because these loans are at a heightened
risk of becoming past due, reaching nonaccrual status or being restructured,
they are being monitored closely.
Nonperforming
loans increased to $20.3 million or 1.56% of total loans at March 31, 2009,
compared to $14.4 million or 1.10% of loans at December 31,
2008. Approximately 89% of these nonperforming loans were related to
residential construction and development lending.
In
addition to the financial strength of each borrower and cash flow
characteristics of each project, the repayment of construction and development
loans are particularly dependent on the value of the real estate collateral.
Repayment of such loans is generally considered subject to greater credit risk
than residential mortgage loans. Regardless of the underwriting criteria the
Company utilizes, losses may be experienced as a result of various factors
beyond our control, including, among other things, changes in market conditions
affecting the value of the real estate collateral and problems affecting the
credit of our borrowers.
The largest nonaccrual balance of any
one borrower was $4.8 million, with the average balance for the seventy-seven
nonaccrual loans being $264 thousand. At December 31, 2008, we had $14.4 million
in nonaccrual loans. The largest nonaccrual balance of any one
borrower at year end was $2.9 million, with the average balance for the
seventy-two nonaccrual loans being $200 thousand.
In
addition to nonperforming loans there were $21.2 million of loans at March 31,
2009, for which management has concerns regarding the ability of the borrowers
to meet existing repayment terms. Approximately 89% of these
potential problem loans at March 31, 2009 were related to residential
construction and development lending. The increase in potential
problem loans is primarily due to an increase in residential construction and
development loans that were downgraded due to the borrower’s exposure to the
housing market. Potential problem loans are primarily classified as
substandard for regulatory purposes and reflect the distinct possibility, but
not the probability, that the Company will not be able to collect all amounts
due according to the contractual terms of the loan
agreement. Although these loans have been identified as potential
problem loans they may never become delinquent, nonperforming or
impaired. Additionally, these loans are generally secured by
residential real estate or other assets, thus reducing the potential for loss
should they become nonperforming. Potential problem loans are
considered in the determination of the adequacy of the allowance for loan
losses.
Foreclosed
assets consist of real estate acquired through foreclosure and repossessed
assets. At March 31, 2009, foreclosed assets totaled $10.8 million or
0.60% of total assets, and consisted of forty-six properties compared to $5.7
million or 0.32% of total assets, and thirty properties at December 31,
2008. The largest dollar value of a foreclosed property was $2.9
million and $890 thousand at March 31, 2009 and December 31, 2008,
respectively. We have reviewed recent appraisals of these properties
and believe that the fair values, less estimated costs to sell, equal or exceed
their carrying value.
Our
allowance for loan losses (“ALLL”) is established through charges to earnings in
the form of a provision for loan losses. We increase our allowance
for loan losses by provisions charged to operations and by recoveries of amounts
previously charged off and we reduce our allowance by loans charged
off. In evaluating the adequacy of the allowance, we consider the
growth, composition and industry diversification of the portfolio, historical
loan loss experience, current delinquency levels, trends in past dues and
classified assets, adverse situations that may affect a borrower’s ability to
repay, estimated value of any underlying collateral, prevailing economic
conditions and other relevant factors derived from our history of
operations.
The
Bank’s format for the calculation of ALLL begins with the evaluation of loans
under SFAS 114. For the purpose of evaluating loans for impairment
under SFAS 114, loans are considered impaired when it is considered probable
that all amounts due under the contractual terms of the loan will not be
collected when due (minor shortfalls in amount or timing
excepted). The Bank has established policies and procedures for
identifying loans that should be considered for impairment. Loans are
reviewed through multiple means such as delinquency management, credit risk
reviews, watch and criticized loan monitoring meetings and general account
management. Loans that are outside of the Bank’s established criteria
for evaluation may be considered for SFAS 114 impairment testing when management
deems the risk sufficient to warrant this approach. For loans
determined to be impaired, the specific allowance is based on the most
appropriate of the three measurement methods: present value of expected future
cash flows, fair value of collateral, or the observable market price of a loan
method. While management uses the best information available to make
evaluations, future adjustments to the allowance may be necessary if conditions
differ substantially from the assumptions used in making the
evaluations. Once a loan is considered impaired, it is not included
in the determination of the SFAS 5 component of the allowance, even if no
specific allowance (the SFAS 114 component) is considered
necessary. See Note 4 to the Financial Statements for further
discussion.
The Bank
also utilizes various other factors to further evaluate the portfolio for risk
to determine the appropriate level of allowance to provide for probable losses
in the loan portfolio. The other factors utilized include the rate of
loan growth, credit grade migration, policy exceptions, account officer
experience, interest rate trends and various economic factors. These
factors are examined for trends and the risk that they represent to the Bank’s
loan portfolio. Each of these other factors is assigned a level of
risk and this risk factor is applied to only the SFAS 5 pool of loans to
calculate the appropriate allowance.
Throughout
our history, growth in loans outstanding has been the primary reason for
increases in our allowance for loan losses and the resultant provisions for loan
losses. Although at the last two quarter ends loans outstanding have
decreased, the allowance for loan losses has continued to increase due to
increased nonperforming loans. The provision for loan losses
increased to $4.0 million for the first quarter of 2009 as compared to $925
thousand for the same period last year due principally to an increase in
nonperforming loans. The allowance for loan losses at March 31, 2009
was $19.3 million and represented 1.49% of total loans which increased from
1.43% from year end and was 0.95 times nonperforming loans. At March
31, 2008, the allowance was $14.9 million, which represented 1.20% of total
loans and 2.12 times nonperforming loans. As a percentage of loans
outstanding, the allowance increased from the first quarter of the prior year as
a result of increased nonperforming loans and is based on the model described
above. We believe that the Company’s allowance is adequate to absorb
probable future losses inherent in our loan portfolio.