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 Second Quarter
Total
assets decreased $63.0 million or 3.5% during the second quarter of 2009 driven
by decreases in loans of $46.3 million or 3.6%, federal funds sold of $16.4
million or 91.6% and investment securities of $12.1 million or 3.5% to end the
period at $1.73 billion. Commercial mortgage loans, which amount to
$428.5 million or 34.2% of gross loans at June 30, 2009, continue to comprise
the largest segment of the loan portfolio and grew $265 thousand or 0.1% for the
quarter. Residential mortgage loans experienced the most growth
during the quarter increasing $1.9 million or 0.5% and comprised 31.3% of the
total loan portfolio. Of the $1.9 million increase in the residential
mortgage loan segment, financing for 1-4 family residences increased $2.2
million, financing of land and building lots decreased $155 thousand, and home
equity loans decreased $159 thousand. Construction loans experienced
the largest decrease for the quarter decreasing $24.6 million or 10.1% to $218.9
million or 17.5% of total gross loans as housing construction continued to
contract during the economic slowdown. Commercial and industrial
loans increased $22.9 million or 10.6% and represent 15.5% of total gross loans
while loans to individuals decreased $1.0 million or 1.5%. The
decrease in loans outstanding can also be attributed to the transfer of certain
nonperforming loans to other real estate owned which increased $7.1 million
during the quarter. Investment securities decreased as part of normal
balance sheet management and provided liquidity along with loan repayments to
fund maturing deposits. Total deposits were $1.25 billion at quarter
end, a decrease of $74.3 million or 5.6% from the prior
quarter-end. The largest decline in deposits was from time deposits
which decreased $68.9 million or 9.2% while non-maturity deposits decreased $5.4
million or 0.9%. The decrease in time deposits was primarily
attributed to declines in brokered certificates of deposit and Certificate of
Deposit Account Registry Service (CDARS) of $42.1 million and $30.0 million,
respectively. Brokered certificates of deposit decreased as
maturities were not renewed due to declining loan demand while the decrease in
CDARS was seasonal as customers withdrew their funds to use for
operations. Borrowings increased $15.8 million or 5.0% from the prior
quarter end net of $15.0 million in high cost FHLB advances prepaid during the
quarter. This allowed the Company to realize funding cost savings
from short term borrowings including federal funds purchased and Federal Reserve
borrowings.
Net
interest income increased $120 thousand or 1.0% for the second quarter compared
to the first quarter. The interest rate environment was relatively
stable in the second quarter as the Federal Reserve maintained the fed funds
target rate consistent with the first quarter. Total interest income
decreased by $293 thousand or 1.3% while the cost of funds decreased $413
thousand or 4.0% compared to the previous quarter. Although
outstanding loan balances continued to decrease during the quarter
the
reduction in interest income
was minimized due to effective pricing of loans including incorporating interest
rate floors on floating rate loans upon renewal. Interest expense
declined primarily due to both deposits and borrowings repricing lower during
the quarter. The net interest margin improved four basis points to
3.05% compared to 3.01% for the linked quarter and increased six basis points
when compared to 2.99% for the second quarter of 2008.
The
Company increased its provision for loan losses to $6.0 million for the quarter
compared with $4.0 million for first quarter 2009 and $3.5 million for the
second quarter 2008. This significantly higher provision and level of
net charge-offs are the result of our proactive efforts to resolve troubled
loans. This approach has led to an early identification of potential
problem loans and their timely resolution, including the recognition of their
loss exposure and liquidation of collateral. Annualized net
charge-offs increased to 1.85% of average loans in second quarter 2009 from
1.09% of average loans for first quarter 2009 and 0.28% of average assets for
the second quarter 2008. Nonperforming loans decreased to $17.9
million or 1.43% of loans at June 30, 2009 from $20.3 million or 1.56% of loans
at March 31, 2009. Nonperforming assets rose to $35.7 million or
2.07% of total assets at June 30, 2009 from $31.0 million, or 1.73% of total
assets, at March 31, 2009 due to the influx of foreclosed assets during the
quarter. Nonperforming assets were $14.2 million or 0.80% of
total assets at June 30, 2008. The activity in net charge-offs,
nonperforming loans and nonperforming assets is predominately related to
residential construction and development lending. The allowance for
loan losses of $19.4 million at June 30, 2009 represented 1.55% of total loans
and 109% coverage of nonperforming loans at current quarter-end compared with
1.49% of total loans and 95% coverage of nonperforming loans at March 31,
2009. We believe the allowance is adequate for losses inherent in the
loan portfolio at June 30, 2009.
Non-interest
income was $2.7 million during the second quarter of 2009, compared to $2.6
million for the prior quarter and $3.1 million for the second quarter of
2008. Although the total amount of non-interest income from the
second quarter increased only $86 thousand compared to the first quarter, the
components changed significantly. The most significant transaction of
the quarter was the non-recurring $1.0 million write-off of collateral held by
Lehman Brothers as the counterparty for certain terminated derivative
contracts. Counsel has determined that the Company’s claim against
Lehman in pending bankruptcy proceedings will be classified as an unsecured
creditor with no preferential status. Despite the potential for
partial recovery through either insurance coverage or the bankruptcy
proceedings, the Company recognized that there is material uncertainty involved
in the determination of the collateral’s continuing value which could result in
little or no recovery of this asset. The $1.0 million in investment
securities held as collateral by Lehman was written off in their entirety during
the second quarter 2009. A non-recurring transaction was also
recognized during the first quarter of 2009 as the Company’s $404 thousand
equity investment in Silverton Bank was written off due to its closure by
federal banking authorities. Increases in non-interest income from
continuing operations were realized in mortgage banking income, gains on sale of
securities and service charges on deposits while income from our investment in
small business investment company (SBIC) activity, investment brokerage income,
and increases in the cash surrender value from bank-owned life insurance
policies decreased compared to the first quarter. Non-interest income
decreased $425 thousand in the second quarter of 2009 compared to the second
quarter of 2008. The most significant decrease in income was from
non-recurring gains and net cash settlement on economic hedges of $330 thousand
compared to a loss of $912 thousand in the current quarter which included the
$1.0 million collateral write-off mentioned above. Similar to the
changes from the first quarter, increases in non-interest income from continuing
operations were realized in mortgage banking income, gains on sale of securities
and service charges on deposits while income from our investment in small
business investment company (SBIC) activities and investment brokerage income
decreased compared to the second quarter of 2008.
Non-interest
expense of $13.8 million in the second quarter of 2009 increased $2.7 million or
24.4% from the prior quarter, excluding the $49.5 million goodwill impairment
and grew by $3.1 million or 29.2% compared with the $10.7 million reported in
the year ago period. The increase from the first quarter of 2009 is
primarily due to increased FDIC deposit insurance premiums, loss on the early
extinguishment of debt, salaries and employee benefits, write downs of
foreclosed property and the Company’s buyer incentive program discussed on page
9, in non-interest expense. These same expenses accounted for
the increase in non-interest expense compared to the year ago
quarter.
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 June 30, 2009 and December 31, 2008
During
the six month period ending June 30, 2009, total assets decreased by $77.1
million, or 4.3%, to $1.73 billion. The Company’s balance sheet
management for the quarter and year to date emphasized maintaining an adequate
allowance for loan losses, maintaining adequate liquidity and keeping regulatory
capital ratios in excess of the well capitalized threshold. The
allowance for loan losses was increased to 1.55% of period end loans compared to
1.49% at the prior quarter end and 1.43% at the prior year end. The
allowance was increased with a year to date provision of $10.0 million while net
charge-offs totaled $9.5 million. Liquidity was maintained by growing
deposits $20.8 million or 1.7% and repayment of loans which resulted in a $63.6
million or 4.8% decrease in loans outstanding. These
funds were used to repay borrowings, which decreased $43.0 million or 11.5%, and
increase the investment portfolio by $9.0 million or 2.8%.
In the
loan portfolio, commercial mortgage loans, which total $428.5 million or 34.2%
of gross loans, continue to comprise the largest segment with year to date
growth of $9.3 million or 2.2% and was the only segment that increased during
the six month period. The construction segment decreased the most
during the period as the portfolio decreased $41.6 million to end the period at
$218.9 million, or 17.5% of gross loans. Commercial and industrial
lending decreased $27.6 million to $193.7 million at June 30, 2009 or 15.5% of
the total loan portfolio. Loans secured by residential mortgages
remained relatively stable for the six month period decreasing by $1.2 million
or 0.3%. Loans to individuals also decreased slightly by $2.5 million
or 12.1% to end the period at $18.0 million or 1.5% of gross loans.
We
utilize various funding sources, as necessary, to support balance sheet
management. Growth in customer deposits continues to be our primary
funding source. At June 30, 2009, deposits totaled $1.25 billion, an
increase of $20.8 million or 1.7% from year-end 2008. Customer time
deposits increased $76.5 million or 21.1% while brokered certificates of
deposit, including the CDARS program, decreased $50.9 million or
17.4%. Non-maturity deposits totaled $5.7 million at quarter end, a
decrease of $4.8 million or 0.8% during the period.
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 June 30, 2009, our stockholders’ equity
totaled $133.7 million, a decrease of $54.0 million compared to December 31,
2008. The decrease is primarily the result of a net loss of $52.0
million which was significantly impacted by the $49.5 million goodwill
impairment charge. This goodwill impairment was a non-cash charge to
earnings which had no impact on regulatory capital ratios. Other
changes to the Company’s capital during the first half of 2009 were dividends
totaling $1.1 million related to the preferred stock issued to the United States
Treasury through the Capital Purchase Program, $664 thousand of cash dividends
declared in January 2009 and paid to shareholders in February 2009, a decrease
of $417 thousand in other comprehensive income items with small increases from
the issuance of restricted stock and stock-based compensation.
Results
of Operations for the Three Months Ended June 30, 2009 and 2008
Net
Loss.
Our net loss
from operations for the three months ended June 30, 2009 was $2.7 million, a
decrease in net loss of $46.6 million, or 94.6%, from the prior quarter and an
increase in loss of $3.3 million for the same three month period in 2008 when
net income was $603 thousand. Our net loss after preferred dividends
increased $2.9 million compared to the prior quarter excluding the $49.5 million
goodwill impairment charge. Net loss per share available to common
shareholders was a $0.20 loss per share for both basic and diluted for the three
months ended June 30, 2009 as compared with $0.03 earnings per share for both
basic and diluted for the same period in 2008. Net interest income
for the second quarter of 2009 was $12.6 million, up $799 thousand, or 6.8%
compared with the second quarter 2008, due to improvement in the net interest
margin. The net interest margin of 3.05% improved six basis points
from the year ago period and increased four basis points on a linked quarter
basis. The Federal Reserve did not change rates during the current
quarter, although repricing of longer term interest bearing assets and
liabilities continued to have an effect on the current net interest income and
margin. The primary factor for the loss in the second quarter was the
increased provision for loan losses which was $6.0 million for the
quarter. Non-interest income was $2.7 million during the second
quarter of 2009, which represents a decrease of 13.7% from non-interest income
of $3.1 million reported in the comparable period in 2008. The most
significant transaction in this category during the second quarter of 2009 was a
non-recurring $1.0 million write-off of collateral held by Lehman Brothers as
the counterparty for certain terminated derivative contracts compared to a $330
thousand gain recognized in connection with derivative activity in the second
quarter of 2008. We recognized a loss of $43 thousand from our
investment in a SBIC affiliate compared to a gain of $82 thousand in the second
quarter of 2008. Non-interest expense increased $3.1 million, or
29.2% compared with the same quarter a year ago. The largest increase
in non-interest expense resulted from an increased FDIC deposit insurance
premium of $1.1 million, part of which was a special assessment while ongoing
deposit insurance premium rates also increased. On a linked quarter
basis, non-interest expense increased $2.7 million or 24.4%, excluding the
goodwill impairment.
Net
Interest Income.
During the
three months ended June 30, 2009, our net interest income was $12.6 million, an
increase of $799 thousand or 6.8% over the second quarter 2008. The
reduction in interest expense from repricing of deposits of $2.1 million
exceeded the $1.3 million decrease in interest income from declining yields on
variable rate and fixed rate loans and the partially offsetting impact of higher
earning asset balances in 2009.
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 second 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 and 56% with variable rates which
will reprice as the applicable index rate changes. At quarter end,
approximately 71% of the variable rate loans were tied to prime while 29% were
tied to LIBOR or another index. The loans tied to prime were
generally repriced at the time of the change while the loans tied to LIBOR
reprice based on terms of the loan. During the first half of 2008, we
began to incorporate interest rate floors on most of our floating rate loans
upon renewal. We have continued this practice into 2009 such that
most of our floating rate loan portfolio has interest rate
floors. Additionally, we have reinforced loan pricing discipline so
we are adequately compensated for the risk of each loan. These
practices have allowed us to increase our loan yields during the second quarter
of 2009 by four basis points compared to first quarter
2009. Deposits, such as money market and NOW accounts, are repriced
at the discretion of management while time deposits can only be repriced as they
mature. The average yield on interest-earning assets in the second
quarter of 2009 decreased 57 basis points to 5.45% compared to the second
quarter 2008 due to the decline in yields for investment securities and the
shift in mix from loans to lower yielding securities. The lower
interest rate environment has also impacted our funding costs. Our
cost of average interest bearing liabilities for the second quarter of 2009
decreased 65 basis points to 2.61% compared to the second quarter of
2008. For the second quarter 2009, our net interest margin of 3.05%
increased six basis points from 2.99% for the second quarter of 2008 and
increased four basis points from the first quarter. The interest rate
environment has been relatively constant throughout 2009 with no rate changes by
the Federal Reserve while market interest rates such as LIBOR drifted lower
throughout 2009. This has strengthened the Company’s net interest
margin through the improvement in our cost of funds via continued downward
repricing of time deposits and borrowings at current market
rates. However, we expect that competition for deposits and the rates
paid to acquire them will intensify.
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 June 30, 2009
|
|
|
Three
Months Ended June 30, 2008
|
|
|
|
|
(Amounts
in thousands)
|
|
|
|
|
Average
balance
|
|
|
Interest
earned/paid
|
|
|
Average
yield/cost
|
|
|
Average
balance
|
|
|
Interest
earned/paid
|
|
|
Average
yield/cost
|
|
|
Interest-earning
assets:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Loans
|
|
$
|
1,281,309
|
|
|
$
|
18,673
|
|
|
|
5.85
|
%
|
|
$
|
1,257,886
|
|
|
$
|
19,876
|
|
|
|
6.36
|
%
|
|
Investment
securities available for sale
|
|
|
345,258
|
|
|
|
3,540
|
|
|
|
4.11
|
%
|
|
|
279,766
|
|
|
|
3,311
|
|
|
|
4.76
|
%
|
|
Investment
securities held to maturity
|
|
|
19,896
|
|
|
|
237
|
|
|
|
4.77
|
%
|
|
|
44,882
|
|
|
|
519
|
|
|
|
4.65
|
%
|
|
Federal
funds sold
|
|
|
5,960
|
|
|
|
1
|
|
|
|
0.08
|
%
|
|
|
3,534
|
|
|
|
21
|
|
|
|
2.37
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total
interest earning assets
|
|
|
1,652,423
|
|
|
|
22,451
|
|
|
|
5.45
|
%
|
|
|
1,586,068
|
|
|
|
23,727
|
|
|
|
6.02
|
%
|
|
Other
assets
|
|
|
114,130
|
|
|
|
|
|
|
|
|
|
|
|
150,452
|
|
|
|
|
|
|
|
|
|
|
Total
assets
|
|
$
|
1,766,553
|
|
|
|
|
|
|
|
|
|
|
$
|
1,736,520
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Interest-bearing
liabilities:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Deposits:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
NOW,
Money Market, and Savings
|
|
$
|
478,781
|
|
|
$
|
1,516
|
|
|
|
1.27
|
%
|
|
$
|
546,801
|
|
|
$
|
3,021
|
|
|
|
2.22
|
%
|
|
Time
deposits greater than $100K
|
|
|
212,100
|
|
|
|
1,550
|
|
|
|
2.93
|
%
|
|
|
133,943
|
|
|
|
1,728
|
|
|
|
5.19
|
%
|
|
Other
time deposits
|
|
|
506,633
|
|
|
|
3,957
|
|
|
|
3.13
|
%
|
|
|
408,954
|
|
|
|
3,953
|
|
|
|
3.89
|
%
|
|
Short-term
borrowings
|
|
|
98,732
|
|
|
|
316
|
|
|
|
1.28
|
%
|
|
|
192,601
|
|
|
|
855
|
|
|
|
1.79
|
%
|
|
Long-term
borrowings
|
|
|
218,960
|
|
|
|
2,534
|
|
|
|
4.64
|
%
|
|
|
191,887
|
|
|
|
2,390
|
|
|
|
5.01
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total
interest bearing liabilities
|
|
|
1,515,206
|
|
|
|
9,873
|
|
|
|
2.61
|
%
|
|
|
1,474,186
|
|
|
|
11,947
|
|
|
|
3.26
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Demand
deposits
|
|
|
103,050
|
|
|
|
|
|
|
|
|
|
|
|
106,047
|
|
|
|
|
|
|
|
|
|
|
Other
liabilities
|
|
|
11,278
|
|
|
|
|
|
|
|
|
|
|
|
11,913
|
|
|
|
|
|
|
|
|
|
|
Stockholders'
equity
|
|
|
137,019
|
|
|
|
|
|
|
|
|
|
|
|
144,374
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total
liabilities and stockholders' equity
|
|
$
|
1,766,553
|
|
|
|
|
|
|
|
|
|
|
$
|
1,736,520
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net
interest income and net interest spread
|
|
|
|
|
|
$
|
12,578
|
|
|
|
2.84
|
%
|
|
|
|
|
|
$
|
11,780
|
|
|
|
2.76
|
%
|
|
Net
interest margin
|
|
|
|
|
|
|
|
|
|
|
3.05
|
%
|
|
|
|
|
|
|
|
|
|
|
2.99
|
%
|
|
Ratio
of average interest-earning assets to average interest-bearing
liabilities
|
|
|
109.06
|
%
|
|
|
|
|
|
|
|
|
|
|
107.59
|
%
|
|
|
|
|
|
|
|
|
Provision
for Loan Losses
.
The
Company recorded a $6.0 million provision for loan losses for the quarter ended
June 30, 2009, representing an increase of $2.5 million from the $3.5 million
provision for the second quarter of 2008. The level of provision for
the quarter 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 as well as the level of net charge-offs during
the period. The substantial increase in the provision for the second
quarter of 2009 compared with the provision for loan losses for second quarter
2008 was based on certain loans identified as impaired and other specific loans
currently identified with a greater than normal risk based on the current
economic conditions. Additional amounts are required to be added to
the allowance for specific loans that are within the guidelines of SFAS 114 as
well as additional amounts to properly recognize the loss potential inherent in
riskier segments of the loan portfolio, particularly the residential
construction and development loan segment. Nonperforming loans as a
percentage of total loans increased to 1.43% at June 30, 2009 compared with
1.00% at June 30, 2008. 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 1.85% for the quarter ended June 30, 2009, compared with 0.28%
for the quarter ended June 30, 2008.
Non-Interest
Income.
For the three months ended June 30, 2009, non-interest
income decreased $425 thousand or 13.7% to $2.7 million from $3.1 million for
the same period in the prior year. The $425 thousand decrease
included a non-recurring $1.0 million write-off of collateral held by Lehman
Brothers as the counterparty on certain terminated derivative contracts as
previously mentioned. In addition to the $1.0 million write-off, a
gain of $88 thousand was recognized during the current quarter from normal
changes in values recorded in non-interest income resulting in a net loss from
derivative activity of $912 thousand for the quarter compared to a gain of $330
thousand in the second quarter of 2008. During the second quarter of
2008, several of the remaining interest rate swaps which served as a hedge to
some of our brokered certificates of deposit were called by the counterparties
due to the declining interest rate environment which increased the value of the
derivatives. This had a favorable impact on the results of operations
as the charge which was taken in the second quarter of 2006 to more properly
comply with SFAS 133 was being amortized as a reduction of interest expense on
deposits over the assumed remaining life of the swaps. When these
swaps were called and the hedged deposits were called by the Bank, the remaining
unamortized balance was recognized immediately as a gain from derivative
activity in non-interest income and accounted for virtually all of the $330
thousand gain. Mortgage banking income increased $402 thousand or
112.3% from increased refinance activity during the quarter. The sale
of securities during the second quarter 2009 resulted in a gain of $501
thousand; however, this gain was offset by an early extinguishment of debt
charge of $472 thousand which is included in non-interest
expense. The coordinated transactions to sell $15.0 million of
investment securities and prepay FHLB advances of $15.0 million was part of the
Company’s balance sheet management during the quarter which is expected to
increase the net interest margin in future periods. Increases of $58
thousand for service charges on deposits and $57 thousand on debit card income
were also recognized in the current quarter compared to the second quarter of
2008. The Company recognized a loss of $43 thousand in its investment
in a SBIC during the second quarter 2009 compared to a gain of $82 thousand in
the prior year. The loss in the current quarter resulted from the
write down of the investment in one company while operating earnings from SBIC
activities otherwise remained solid. Investment brokerage income
decreased $117 thousand during the quarter on lower brokerage transaction
volumes and NSF charges decreased $47 thousand on lower overdraft activity in
second quarter 2009.
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
necessary to support and service our growth. The ratio of
non-interest expense to average total assets for the current quarter was 3.05%
which slightly exceeded our target of 3.0%; however, the current quarter
included several out of the ordinary expenses. For the three months
ended June 30, 2009, our non-interest expense increased $3.1 million or 29.2%
over the same period in 2008. The Company’s FDIC deposit insurance
premium increased $1.1 million as a 5% special assessment (estimated to be $800
thousand) was accrued and the ongoing deposit insurance premium rates also
increased. The increased premiums are considered necessary by the
FDIC to maintain adequate balances in the Bank Insurance Fund to protect
depositors during this time of unusually high number of bank
failures. The rates for ongoing deposit insurance coverage are
expected to continue to increase in the near term and moderate during
2010. The Company started a new program during 2009 to help builders
sell their bank-financed inventory of houses that had been on the market for 12
months or more. The cost for this program has totaled $470 thousand
for the second quarter of 2009. In addition, OREO write downs and
other OREO expenses were $474 thousand for the current quarter compared to $45
thousand in the second quarter last year. Salaries and employee
benefits increased $276 thousand due to increased commissions on mortgage
activity, staffing for a new Asheville regional office and changes in the
Company’s employee insurance coverage. A charge of $472 thousand was
also incurred for the early extinguishment of debt as discussed above in
non-interest income. On a linked quarter basis, non-interest expense
increased $2.7 million as the increase in expenses discussed above also held
true compared to the first quarter.
Provision
for Income Taxes
.
The Company
recorded an income tax benefit $1.8 million for the second quarter 2009 due to
our operating loss and the effect of tax-exempt income (including an increase in
cash surrender value on bank-owned life insurance and interest on municipal
bonds) on our income tax calculation. Net operating loss for Federal
income tax purposes can be carried back two years and forward 20
years. The Company has paid sufficient income taxes in prior years to
be able to fully realize the $1.8 million benefit.
Results
of Operations for the Six Months Ended June 30, 2009 and 2008
Net
Income (Loss).
Our net loss for the six months ended June 30,
2009 was $52.0 million, compared to $2.7 million net income for the six months
ended June 30, 2008. Net interest income increased $2.3 million or
9.9% compared to the six month period of the prior year on net interest margin
improvement of five basis points due to effective pricing of loans including
interest rate floors and the downward repricing of money market accounts and
maturing long term deposits and borrowings. The provision for loan
loss continued to be the most significant factor in the financial statements
increasing $5.5 million or 124.5% compared to the prior year
period. Non-interest income decreased $1.4 million or 21.3% compared
to the prior six month period (as presented in Note 7 to the Financial
Statements which begins on page 22) with significant differences between the two
periods discussed below. Non-interest expense increased $53.0 million
compared with the same period a year ago primarily due to a goodwill impairment
charge of $49.5 million recognized during the first quarter of
2009. Non-interest expense increased $3.6 million or 17.1% compared
to the prior year period, excluding the goodwill impairment
charge. The largest increase in non-interest expense was for FDIC
deposit insurance premiums of $1.6 million, part of which was a special
assessment while ongoing deposit insurance premium rates also
increased. Increases in salaries and benefits, occupancy and
equipment were relatively minimal and in the normal course of
operations.
Net
Interest Income.
During the six months ended June 30, 2009,
our net interest income totaled $25.0 million, an increase of $2.3 million or
9.9% over the $22.8 million for the same six month period in
2008. Net interest income benefited from establishing interest rate
floors on floating rate loans and the downward repricing of deposits and
borrowings. Between June 2008 and June 2009 the Federal Reserve
decreased the targeted Federal Funds rate three times for a total of 175 basis
points with variable loan rates tied to prime adjusting
accordingly. The three Federal Funds rate changes were all made
during the fourth quarter of 2008 as rates have remained stable during the first
two quarters of 2009. Our average yield on interest-earning assets
decreased 82 basis points to 5.47% for the first half of 2009 compared to the
same period in 2008. Declining rates have also impacted our funding
costs for the first six months of 2009, as funding costs decreased 92 basis
points to 2.66% from 3.58% for the comparable period a year
ago. Average interest bearing liabilities increased $104.3 million or
7.3% to $1.53 billion from $1.42 billion for the six month period ended June
2008. For the six months ended June 30, 2009, our net interest spread
was 2.81% compared to 2.72% for the comparable prior year period while our net
interest margin was 3.03% compared to 2.98%.
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 income or expense by the average balances of assets or liabilities,
respectively, for the periods presented. The average loan portfolio
balances include non-accrual loans.
|
|
|
Six
Months Ended June 30, 2009
|
|
|
Six
Months Ended June 30, 2008
|
|
|
|
|
(Amounts
in thousands)
|
|
|
|
|
Average
balance
|
|
|
Interest
earned/paid
|
|
|
Average
yield/cost
|
|
|
Average
balance
|
|
|
Interest
earned/paid
|
|
|
Average
yield/cost
|
|
|
Interest-earning
assets:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Loans
|
|
$
|
1,295,913
|
|
|
$
|
37,435
|
|
|
|
5.83
|
%
|
|
$
|
1,238,843
|
|
|
$
|
41,059
|
|
|
|
6.67
|
%
|
|
Investment
securities available for sale
|
|
|
330,593
|
|
|
|
7,183
|
|
|
|
4.38
|
%
|
|
|
237,501
|
|
|
|
5,721
|
|
|
|
4.84
|
%
|
|
Investment
securities held to maturity
|
|
|
23,858
|
|
|
|
569
|
|
|
|
4.81
|
%
|
|
|
56,319
|
|
|
|
1,239
|
|
|
|
4.42
|
%
|
|
Federal
funds sold
|
|
|
15,420
|
|
|
|
8
|
|
|
|
0.10
|
%
|
|
|
2,725
|
|
|
|
33
|
|
|
|
2.42
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total
interest earning assets
|
|
|
1,665,784
|
|
|
|
45,195
|
|
|
|
5.47
|
%
|
|
|
1,535,388
|
|
|
|
48,052
|
|
|
|
6.29
|
%
|
|
Other
assets
|
|
|
134,592
|
|
|
|
|
|
|
|
|
|
|
|
145,454
|
|
|
|
|
|
|
|
|
|
|
Total
assets
|
|
$
|
1,800,376
|
|
|
|
|
|
|
|
|
|
|
$
|
1,680,842
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Interest-bearing
liabilities:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Deposits:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
NOW,
Money Market, and Savings
|
|
$
|
474,140
|
|
|
$
|
3,143
|
|
|
|
1.34
|
%
|
|
$
|
512,604
|
|
|
$
|
6,276
|
|
|
|
2.46
|
%
|
|
Time
deposits greater than $100K
|
|
|
196,843
|
|
|
|
2,975
|
|
|
|
3.05
|
%
|
|
|
134,767
|
|
|
|
3,822
|
|
|
|
5.70
|
%
|
|
Other
time deposits
|
|
|
513,264
|
|
|
|
8,209
|
|
|
|
3.23
|
%
|
|
|
376,012
|
|
|
|
7,713
|
|
|
|
4.13
|
%
|
|
Short-term
borrowings
|
|
|
100,071
|
|
|
|
881
|
|
|
|
1.78
|
%
|
|
|
153,951
|
|
|
|
2,175
|
|
|
|
2.84
|
%
|
|
Long-term
borrowings
|
|
|
241,206
|
|
|
|
4,949
|
|
|
|
4.14
|
%
|
|
|
243,893
|
|
|
|
5,284
|
|
|
|
4.36
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total
interest bearing liabilities
|
|
|
1,525,524
|
|
|
|
20,157
|
|
|
|
2.66
|
%
|
|
|
1,421,227
|
|
|
|
25,270
|
|
|
|
3.58
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Demand
deposits
|
|
|
102,402
|
|
|
|
|
|
|
|
|
|
|
|
104,400
|
|
|
|
|
|
|
|
|
|
|
Other
liabilities
|
|
|
10,324
|
|
|
|
|
|
|
|
|
|
|
|
11,933
|
|
|
|
|
|
|
|
|
|
|
Stockholders'
equity
|
|
|
162,126
|
|
|
|
|
|
|
|
|
|
|
|
143,282
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total
liabilities and stockholders' equity
|
|
$
|
1,800,376
|
|
|
|
|
|
|
|
|
|
|
$
|
1,680,842
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net
interest income and net interest spread
|
|
|
|
|
|
$
|
25,038
|
|
|
|
2.81
|
%
|
|
|
|
|
|
$
|
22,782
|
|
|
|
2.71
|
%
|
|
Net
interest margin
|
|
|
|
|
|
|
|
|
|
|
3.03
|
%
|
|
|
|
|
|
|
|
|
|
|
2.98
|
%
|
|
Ratio
of average interest-earning assets to average interest-bearing
liabilities
|
|
|
109.19
|
%
|
|
|
|
|
|
|
|
|
|
|
108.03
|
%
|
|
|
|
|
|
|
|
|
Provision
for Loan Losses
.
The
Company recorded a $10.0 million provision for loan losses for the six months
ended June 30, 2009, representing an increase of $5.5 million from the $4.5
million provision for the comparable period of 2008. The level of
provision for the quarter 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 as defined by SFAS 114 as well
as the level of net charge-offs during the period. 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 1.47% for the period ended June 30,
2009, compared with 0.20% for the period ended June 30,
2008.
Non-Interest
Income.
For the six months ended June 30, 2009, the Company
reported non-interest income of $5.3 million compared to $6.7 million for the
first six months of 2008, a decrease of $1.4 million or 21.3%. See
Note 7 to the Financial Statements for a summary of the components of
non-interest income. The year to date decrease included a
non-recurring $1.0 million write-off of collateral held by Lehman Brothers as
the counterparty on certain terminated derivative contracts. For
further discussion, see “Summary of Second Quarter” at the beginning of
Management’s Discussion and Analysis of Results of Operations. In
addition to the $1.0 million write-off, a gain of $66 thousand was recognized
during the period resulting in a net loss from derivative activity of $934
thousand for the six months ended June 30, 2009 compared to a gain of $1.4
million for the six month period of 2008. During 2008, several of the
remaining interest rate swaps which served as a hedge to some of our brokered
certificates of deposit were called by the counterparties due to the declining
interest rate environment which increased the value of the
derivatives. This had a favorable impact on the results of operations
as the charge which was taken in the second quarter of 2006 to more properly
comply with SFAS 133 was being amortized as a reduction of interest expense on
deposits over the assumed remaining life of the swaps. When these
swaps were called and the hedged deposits were called by the Bank, the remaining
unamortized balance was recognized immediately as a gain from derivative
activity in non-interest income and accounted for virtually all of the $1.4
million gain. Mortgage banking income increased $334 thousand or
39.7% as from increased refinance activity during the 2009
period. The sale of securities resulted in a gain of $501 thousand;
however, this gain was offset by an early extinguishment of debt prepayment
penalty of $472 thousand which is included in non-interest
expense. The coordinated transactions to sell $15.0 million of
investment securities and prepay FHLB advances of $15.0 million were part of the
Company’s balance sheet management during the 2009 period which is expected to
increase the net interest margin in future periods. The Company
recognized a gain of $195 thousand in its investment in a SBIC during the 2009
period compared to a loss of $68 thousand in the prior period
year. The income from SBIC activity has remained steady despite a
loss in the second quarter 2009 resulting from the write down of investment in
one company in the SBIC’s portfolio. Increases of $106 thousand for
service charges on deposits and $121 thousand on debit card income were also
recognized in the 2009 period compared to the prior
period. Investment brokerage income decreased $198 thousand during
the 2009 period on lower brokerage transaction volumes.
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
necessary to support and service our growth. For the six months ended
June 30, 2009, our non-interest expense increased $53.1 million or 250.3% over
the same period in 2008. Excluding the goodwill impairment charge of
$49.5 million recognized in the first quarter of 2009, non-interest expense
increased $3.6 million year to date 2009 compared to the same period last
year. The Company’s FDIC deposit insurance premiums increased $1.2
million for the six months ended June 30, 2009 as a 5% special assessment
(estimated to be $800 thousand) was accrued and the ongoing deposit insurance
premium rates also increased during 2009. The increased premiums are
considered necessary by the FDIC to maintain adequate balances in the Bank
Insurance Fund to protect depositors during this time of an unusually high
number of bank failures. The ongoing rates for deposit insurance
coverage are expected to continue to increase in the near term and moderate
during 2010. The Company started a new program during 2009 to help
builders sell their inventory of bank-financed houses that had been on the
market for 12 months or more. The cost for this program has totaled
$570 thousand for the first six months of 2009. In addition, OREO
write downs and other OREO expenses were $688 thousand for 2009 compared to $75
thousand in 2008 period, an increase of $613 thousand. Legal fees
increased $359 thousand for the six months ended June 30, 2009 compared to last
year due to the increased level of problem assets for resolution in
2009. A charge of $472 thousand was also incurred for the early
extinguishment of debt which is discussed above in non-interest
income.
Provision
for Income Taxes.
The Company recorded an income tax benefit
of $2.1 million for the six months ended June 30, 2009 due to our operating loss
and the effect of tax-exempt income (including an increase in cash surrender
value on bank-owned life insurance and interest on municipal bonds) on our
income tax calculation. Net operating loss for Federal income tax
purposes can be carried back two years and forward 20 years. The
Company has paid sufficient income taxes in prior years to be able to fully
realize the $2.1 million benefit.
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 sufficient levels of capital
resources to generate appropriate earnings and to maintain a consistent dividend
policy.
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, unpledged investments available
for sale, loan repayments, loan sales, deposits, and borrowings from the Federal
Home Loan Bank, the Federal Reserve 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.
We
believe our liquidity is adequate to fund expected loan demand and current
deposit and borrowing maturities. Investment securities totaled
$333.7 million at June 30, 2009, an increase of $9.0 million from $324.7 million
at December 31, 2008. While agencies and mortgage backed securities
decreased $35.0 million during this six month period, municipal securities
increased $45.0 million as a strategy to reduce the Company’s effective tax
rate. 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 $430.9 million, as of June 30, 2009, with lendable collateral value
of $322.0 million. Borrowings with the FHLB were $124.6 million at
June 30, 2009. Under the Federal Reserve’s Term Auction Facility, we
had borrowings outstanding of $30 million as of June 30, 2009. Given
the flexibility in the types of eligible collateral that may be pledged for
borrowings under the facility, we have up to $178.3 million in additional
borrowing capacity under the facility. At June 30, 2009, we had
funding of $95.0 million in the form of term repurchase agreements with $15.0
million maturing within one year and $80.0 million with maturities from one to
five years. Term repurchase agreements with maturities greater than
one year decreased $10.0 million from year-end 2008. We have
repurchase lines of credit aggregating $90.0 million from various
institutions. The repurchases must be adequately
collateralized. We also had short-term repurchase agreements with
total outstanding balances of $7.8 million and $13.2 million at June 30, 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 June 30,
2009, our outstanding commitments to extend credit consisted of loan commitments
of $183.8 million and amounts available under home equity credit lines, other
credit lines and letters of credit of $100.1 million, $7.5 million and $14.9
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
most of 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 lower cost transaction accounts 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 June 30,
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 June 30, 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 June 30, 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 or bonus compensation programs.
At June
30, 2009, our leverage ratio (Tier I capital to average quarterly assets) was
9.89%, 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 June 30, 2009
were 12.36% and 13.71%, 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 June 30, 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 second 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
quarterly cash dividend on a periodic 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 collectability 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 $17.9 million or 1.43% of total loans at June 30, 2009,
compared to $14.4 million or 1.10% of loans at December 31,
2008. Approximately 72% 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 $2.1 million, with the average balance for the seventy-six
nonaccrual loans being $235 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 $38.9 million of loans at June 30,
2009, for which management has concerns regarding the ability of the borrowers
to meet existing repayment terms. Approximately 76% of these
potential problem loans at June 30, 2009 were related to residential
construction and development lending. This is an increase of $17.7
million over the level of potential problem loans at March 31,
2009. 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 June 30, 2009, foreclosed assets totaled $17.9 million or
1.00% of total assets, and consisted of seventy 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 June 30, 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 end of last three quarters loans outstanding
have decreased, the allowance for loan losses has continued to increase due to
increased nonperforming loans and increasing levels of net
charge-offs. The provision for loan losses increased to $6.0 million
for the second quarter of 2009 as compared to $3.5 million for the same period
last year due principally to an increase in nonperforming loans. The
allowance for loan losses at June 30, 2009 was $19.4 million and represented
1.55% of total loans which increased from 1.43% from year end and provided
coverage of 109% of nonperforming loans. At June 30, 2008, the
allowance was $17.5 million, which represented 1.36% of total loans and coverage
of 137% of nonperforming loans. As a percentage of loans outstanding,
the allowance increased from the second 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.