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EX-31.01 - CERTIFICATION OF CEO PURSUANT TO RULE 13A-14 - ECB BANCORP INCdex3101.htm
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EX-99.01 - CERTIFICATION OF CEO AND CFO PURSUANT TO SECTION III OF EESA - ECB BANCORP INCdex9901.htm
EX-23.01 - CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM - ECB BANCORP INCdex2301.htm
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Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-K

 

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the fiscal year ended December 31, 2009

 

Commission File No. 0-24753

 

 

 

ECB BANCORP, INC.

(Name of Registrant as specified in its charter)

 

North Carolina   56-2090738

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

 

Post Office Box 337

Engelhard, North Carolina 27824

(Address of principal executive offices, including Zip Code)

 

(252) 925-9411

Registrant’s telephone number, including area code

 

 

 

Securities registered under Section 12(b) of the Act:

  Common Stock, $3.50 par value per share

Name of exchange on which registered:

  The NASDAQ Global Market

Securities registered under Section 12(g) of the Act:

  None
  (Title of class)

 

 

 

Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  ¨    No  x

 

Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes  ¨    No  x

 

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

 

Indicate by checkmark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Date File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ¨    No  ¨

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  ¨

 

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definition of “accelerated filer”, “large accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer   ¨    Accelerated filer   ¨
Non-accelerated filer   ¨    Smaller reporting company   x

 

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

 

State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the Registrant’s most recently completed second fiscal quarter.

 

$43,254,744

 

On March 6, 2010, there were 2,849,841 outstanding shares of Registrant’s common stock.

 

Documents Incorporated by Reference

 

Portions of Registrant’s definitive Proxy Statement to be filed with the Securities and Exchange Commission in connection with its 2010 Annual Meeting are incorporated into Part III of this Report.

 

 

 


Table of Contents

PART I

 

When used in this Report, the terms “we,” “us,” “our” and similar terms refer to the registrant, ECB Bancorp, Inc. The term “Bank” refers to our bank subsidiary, The East Carolina Bank.

 

Item 1.    Business.

 

 

General

 

We are a North Carolina corporation organized during 1998 by the Bank and at the direction of its Board of Directors to serve as the Bank’s parent holding company. We operate as a bank holding company registered with the Federal Reserve Board, and our primary business activity is owning the Bank and promoting its banking business. Through the Bank, we engage in a general, community-oriented commercial and consumer banking business.

 

The Bank is an insured, North Carolina-chartered bank that was founded in 1919. Its deposits are insured under the FDIC’s Deposit Insurance Fund to the maximum amount permitted by law, and it is subject to supervision and regulation by the FDIC and the North Carolina Commissioner of Banks.

 

Like other community banks, our net income depends primarily on our net interest income, which is the difference between the interest income we earn on loans, investment assets and other interest-earning assets, and the interest we pay on deposits and other interest-bearing liabilities. To a lesser extent, our net income also is affected by non-interest income we derive principally from fees and charges for our services, as well as the level of our non-interest expenses, such as expenses related to our banking facilities and salaries and employee benefits.

 

Our operations are significantly affected by prevailing economic conditions, competition, and the monetary, fiscal and regulatory policies of governmental agencies. Lending activities are influenced by the general credit needs of small and medium-sized businesses and individuals in our banking markets, competition among lenders, the level of interest rates, and the availability of funds. Deposit flows and costs of funds are influenced by prevailing market interest rates (primarily the rates paid on competing investments), account maturities and the levels of personal income and savings in our banking markets.

 

Our and the Bank’s headquarters are located at 35050 U.S. Highway 264 East in Engelhard, North Carolina, and our telephone number at that address is (252) 925-9411.

 

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Business Offices and Banking Markets

 

The Bank has 24 full-service banking offices located in thirteen North Carolina counties. Our banking markets are located east of the Interstate Highway 95 corridor in portions of the Coastal Plain region of North Carolina which extends from the Virginia border along the coast of North Carolina to the South Carolina border. Within that region, we subdivide our banking markets into four banking regions. The following table lists our branch offices in each banking region.

 

Region

  

Branches

  

County

Outer Banks Region

   Currituck    Currituck
   Southern Shores/ Kitty Hawk    Dare
   Nags Head    Dare
   Manteo    Dare
   Avon    Dare
   Hatteras    Dare
   Ocracoke    Hyde

Central Region

   Greenville (three offices)    Pitt
   Winterville    Pitt
   Washington    Beaufort

Inner Banks Region

   Engelhard    Hyde
   Swan Quarter    Hyde
   Fairfield    Hyde
   Williamston    Martin
   Columbia    Tyrrell
   Creswell    Washington
   Hertford    Perquimans

Coastal Region

   Wilmington    New Hanover
   Ocean Isle Beach    Brunswick
   Leland    Brunswick
   Morehead City    Carteret
   New Bern    Craven

 

Competition

 

Commercial banking in North Carolina is highly competitive, due in large part to our state’s early adoption of statewide branching. Over the years, federal and state legislation (including the elimination of restrictions on interstate banking) has heightened the competitive environment in which all financial institutions conduct their business, and competition among financial institutions of all types has increased significantly.

 

Banking also is highly competitive in our banking markets, and customers tend to aggressively “shop” the terms of both their loans and deposits. We compete with other commercial banks, savings banks and credit unions, including banks headquartered or controlled by companies headquartered outside of North Carolina but that have offices in our banking markets. According to the most recent market share data published by the FDIC, on June 30, 2009 there were 307 offices of 33 different FDIC-insured depository institutions (including us) in the 13 counties in which we have banking offices. Three of those banks (Wachovia, BB&T and First-Citizens Bank) controlled an aggregate of approximately 52% of all deposits in the 13-county area held by those 3 institutions, while we held approximately 6% of total deposits.

 

We believe community banks can compete successfully by providing personalized service and making timely, local decisions, and that further consolidation in the banking industry is likely to create additional opportunities for community banks to capture deposits from customers of other financial institutions who become dissatisfied as their financial institutions grow larger. Additionally, we believe continued growth in our banking markets provides us with an opportunity to capture new deposits from new residents.

 

Almost all our customers are small- and medium-sized businesses and individuals. We try to differentiate ourselves from our larger competitors with our focus on relationship banking, personalized service, direct customer contact, and our

 

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ability to make credit and other business decisions locally. We also depend on our reputation as a community bank in our banking markets, our involvement in the communities we serve, the experience of our senior management team, and the quality of our associates. We believe that our focus allows us to be more responsive to our customers’ needs and more flexible in approving loans based on collateral quality and personal knowledge of our customers.

 

Services

 

Our banking operations are primarily retail oriented and directed toward small- and medium-sized businesses and individuals located in our banking markets. We derive the majority of our deposits and loans from customers in our banking markets, but we also make loans and have deposit relationships with commercial and consumer customers in areas surrounding our immediate banking markets. We also market certificates of deposit by advertising our deposit rates on an Internet certificate of deposit network, and we accept “brokered” deposits. We provide most traditional commercial and consumer banking services, but our principal activities are taking demand and time deposits and making commercial and consumer loans. Our primary source of revenue is interest income we derive from our lending activities.

 

Lending Activities

 

General.    We make a variety of commercial and consumer loans to small- and medium-sized businesses and individuals for various business and personal purposes, including term and installment loans, business and personal lines of credit, equity lines of credit and overdraft checking credit. For financial reporting purposes, our loan portfolio generally is divided into real estate loans, consumer installment loans, commercial and industrial loans (including agricultural production loans), and credit cards and related plans. We make credit card services available to our customers through a correspondent relationship. Statistical information about our loan portfolio is contained in Item 7 of this report under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

 

Real Estate Loans.    Our real estate loan classification includes all loans secured by real estate. Real estate loans include loans made to purchase, construct or improve residential or commercial real estate, for real estate development purposes, and for various other commercial, agricultural and consumer purposes (which may or may not be related to our real estate collateral). On December 31, 2009, loans amounting to approximately 79.8% of our loan portfolio were classified as real estate loans. We do not make long-term residential mortgage loans ourselves, but we originate loans of that type which are funded by and closed in the name of other lenders. Those arrangements permit us to make long-term residential loans available to our customers and generate fee income but avoid risks associated with those loans in our loan portfolio.

 

Commercial real estate and construction loans typically involve larger loan balances concentrated with single borrowers or groups of related borrowers. Repayment of commercial real estate loans may depend on the successful operation of income producing properties, a business, or a real estate project and, therefore, may, to a greater extent than in the case of other loans, be subject to the risk of adverse conditions in the economy generally or in the real estate market in particular.

 

Construction loans involve special risks because loan funds are advanced on the security of houses or other improvements that are under construction and are of uncertain value before construction is complete. For that reason, it is more difficult to evaluate accurately the total loan funds required to complete a project and the related loan-to-value ratios. To reduce these risks, we generally limit loan amounts to 85% of the projected “as built” appraised values of our collateral on completion of construction. For larger projects, we include amounts for contingencies in our construction cost estimates. We generally require a qualified permanent financing commitment from an outside lender unless we have agreed to convert the construction loan to permanent financing ourselves.

 

On December 31, 2009, our construction and acquisition and development loans (consumer and commercial) amounted to approximately 21.8% of our loan portfolio, and our other commercial real estate loans amounted to approximately 34.5% of our loan portfolio.

 

Our real estate loans also include home equity lines of credit that generally are used for consumer purposes and usually are secured by junior liens on residential real property. Our commitment on each line is for a term of 15 years. During the terms of the lines of credit, borrowers may either pay accrued interest only (calculated at variable interest

 

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rates), with their outstanding principal balances becoming due in full at the maturity of the lines, or they may make monthly payments of principal and interest equal to 1.5% of their outstanding balances. On December 31, 2009, our home equity lines of credit amounted to approximately 5.3% of our loan portfolio.

 

Many of our real estate loans, while secured by real estate, were made for purposes unrelated to the real estate collateral. This generally reflects our efforts to reduce credit risk by taking real estate as primary or additional collateral, whenever possible, without regard to loan purpose. Substantially all of our real estate loans are secured by real property located in or near our banking markets. Our real estate loans may be made at fixed or variable interest rates, and they generally have maturities that do not exceed five years and provide for payments based on amortization schedules of less than twenty years. A real estate loan with a maturity of more than five years or that is based on an amortization schedule of more than five years generally will include contractual provisions that allow us to call the loan in full, or provide for a “balloon” payment in full, at the end of a period of no more than five years.

 

Consumer Installment Loans.    Our consumer installment loans consist primarily of loans for various consumer purposes, as well as the outstanding balances of non-real estate secured consumer revolving credit accounts. A majority of these loans are secured by liens on various personal assets of the borrowers, but they also may be made on an unsecured basis. On December 31, 2009, our consumer installment loans made up approximately 0.7% of our loan portfolio, and approximately 16.0% of the aggregate outstanding balances of those loans were unsecured. In addition to loans classified on our books as consumer installment loans, many of our loans included in the real estate loan classification are made for consumer purposes but are classified as real estate loans on our books because they are secured by first or junior liens on real estate. Consumer loans generally are made at fixed interest rates and with maturities or amortization schedules that generally do not exceed five years. However, consumer-purpose loans secured by real estate (and, thus, classified as real estate loans as described above) may be made for terms of up to 15 years but under terms that allow us to call the loan in full, or provide for a “balloon” payment, at the end of a period of no more than five years.

 

Consumer installment loans involve greater risks than other loans, particularly in the case of loans that are unsecured or secured by depreciating assets. When damage or depreciation reduces the value of our collateral below the unpaid balance of a defaulted loan, repossession may not result in repayment of the entire outstanding loan balance. The resulting deficiency may not warrant further substantial collection efforts against the borrower. In connection with consumer lending in general, the success of our loan collection efforts is highly dependent on the continuing financial stability of our borrowers, and our collection of consumer installment loans may be more likely to be adversely affected by a borrower’s job loss, illness, personal bankruptcy or other change in personal circumstances than is the case with other types of loans.

 

Commercial and Industrial Loans.    Our commercial and industrial loan classification includes loans to small- and medium-sized businesses and individuals for working capital, equipment purchases and various other business and agricultural purposes. This classification excludes any loan secured by real estate. These loans generally are secured by business assets, such as inventory, accounts receivable, equipment or similar assets, but they also may be made on an unsecured basis. On December 31, 2009, our commercial and industrial loans made up approximately 15.8% of our loan portfolio, and approximately 16.0% of the aggregate outstanding balances of those loans represented unsecured loans. Those loans included approximately $25.5 million, or approximately 4.4% of our total loans, to borrowers engaged in agriculture, commercial fishing or seafood-related businesses. In addition to loans classified on our books as commercial and industrial loans, many of our loans included in the real estate loan classification are made for commercial or agricultural purposes but are classified as real estate loans on our books because they are secured by first or junior liens on real estate. Commercial and industrial loans may be made at variable or fixed rates of interest. However, any loan that has a maturity or amortization schedule of longer than five years normally will be made at an interest rate that varies with our prime lending rate and will include contractual provisions that allow us to call the loan in full, or provide for a “balloon” payment in full, at the end of a period of no more than five years. Commercial and industrial loans typically are made on the basis of the borrower’s ability to make repayment from business cash flow. As a result, the ability of borrowers to repay commercial loans may be substantially dependent on the success of their businesses, and the collateral for commercial loans may depreciate over time and cannot be appraised with as much precision as real estate.

 

Loan Pricing.    We price our loans under policies established as a part of our asset/liability management function. For larger loans, we use a pricing model developed by an outside vendor to reduce our exposure to interest rate risk on fixed and variable rate loans that have maturities of longer than three years. On December 31, 2009, approximately 60.0% of the total dollar amount of our loans accrued interest at variable rates.

 

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Loan Administration and Underwriting.    We make loans based, to a great extent, on our assessment of borrowers’ income, cash flow, net worth, sources of repayment and character. The principal risk associated with each of the categories of our loans is the creditworthiness of our borrowers, and our loans may be viewed as involving a higher degree of credit risk than is the case with some other types of loans, such as long-term residential mortgage loans, in which greater emphasis is placed on collateral values. To manage this risk, we have adopted written loan policies and procedures, and our loan portfolio is administered under a defined process. That process includes guidelines and standards for loan underwriting and risk assessment, and procedures for loan approvals, loan grading, ongoing identification and management of credit deterioration, and portfolio reviews to assess loss exposure and to test our compliance with our credit policies and procedures.

 

The loan underwriting standards we use include an evaluation of various factors, including a loan applicant’s income, cash flow, payment history on other debts, and ability to meet existing obligations and payments on the proposed loan. Although an applicant’s creditworthiness is a primary consideration in the loan approval process, our underwriting process for secured loans also includes analysis of the value of the proposed collateral in relation to the proposed loan amount. We consider the value of collateral, the degree of certainty of that value, the marketability of the collateral in the event of foreclosure or repossession, and the likelihood of depreciation in the collateral value.

 

Our Board of Directors has approved levels of lending authority for lending and credit personnel based on our aggregate credit exposure to a borrower. A loan that satisfies the Bank’s loan policies and is within a lending officer’s assigned authority may be approved by that officer alone. Loans involving aggregate credit exposures in excess of a lending officer’s authority may be approved by a Credit Policy Officer in our Loan Administration Department up to the amount of that officer’s authority. Above those amounts, a secured or unsecured loan involving an aggregate exposure to a single relationship of up to $2 million may be approved either by our Chief Executive Officer, Chief Operating Officer, Chief Revenue Officer or Chief Credit Officer, and a loan involving an aggregate exposure to a single relationship of up to $3 million may be approved by our General Loan Committee which consists of our Chief Executive Officer, Chief Operating Officer, Chief Revenue Officer and Chief Credit Officer. A loan that exceeds the approval authority of that Committee, and, notwithstanding the above credit authorities, any single loan in excess of $2 million, must be approved by the Executive Committee of our Board of Directors.

 

When a loan is made, our lending officer handling that loan assigns it a grade based on various underwriting and other criteria under our risk grading procedures. Any proposed loan that grades below a threshold set by our Board of Directors must be reviewed by a Credit Policy Officer before it can be made, even if the loan amount is within the loan officer’s approval authority. The grades assigned to loans we make indicate the level of ongoing review and attention we will give to those loans to protect our position and reduce loss exposure.

 

After loans are made, they are reviewed by our Loan Administration personnel for adequacy of contract documentation, compliance with regulatory requirements, and documentation of compliance with our loan underwriting criteria. Also, our Credit Policy Officers conduct detailed reviews of selected loans based on various criteria, including loan type, amount, collateral, and borrower identity, and the particular lending officer’s or branch’s lending history. These reviews include at least 10% of the loans made by each lending officer. All loans involving an aggregate exposure of $2 million or more ultimately are reviewed after funding by the Executive Committee of our Board of Directors. Each loan involving an aggregate exposure of more than $350,000 is required to be reviewed at least annually by the lending officer who originated the loan, and those reviews are monitored by a Credit Policy Officer. Loan Administration personnel also periodically review various loans based on various criteria, and we retain the services of an independent credit risk management consultant to annually review our problem loans, a random sampling of performing loans related to our larger aggregate credit exposures, and selected other loans.

 

During the life of each loan, its grade is reviewed and validated or modified to reflect changes in circumstances and risk. We generally place a loan on a nonaccrual status when it becomes 90 days past due or whenever we believe collection of that loan has become doubtful. We charge off loans when the collection of principal and interest has become doubtful and the loans no longer can be considered sound collectible assets (or, in the case of unsecured loans, when they become 90 days past due).

 

Our Special Assets Manager, who reports directly to our Chief Credit Officer, monitors the overall performance of our loan portfolio, monitors the collection activities of our lending officers, and directly supervises collection actions that involve legal action or bankruptcies.

 

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Allowance for Loan Losses.    Our Board of Directors reviews all impaired loans at least quarterly, and our management reviews asset quality trends monthly. Based on these reviews and our current judgments about the credit quality of our loan portfolio and other relevant internal and external factors, we have established an allowance for loan losses. The adequacy of the allowance is assessed by our management monthly and reviewed by our Board of Directors each quarter. On December 31, 2009, our allowance was $9.7 million and amounted to 1.7% of our total loans and approximately 66% of our nonperforming loans.

 

On December 31, 2009, our nonperforming loans (consisting of non-accrual loans, loans past due greater than 90 days and still accruing interest, and restructured loans) amounted to approximately $14.7 million, and we had $5.4 million of other real estate owned and repossessed collateral acquired in settlement of loans on our books. (See Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”)

 

Seasonality and Cycles

 

Because the local economies of communities in our Outer Banks, Inner Banks, and Coastal Regions depend, to a large extent, on tourism and agribusiness (including seafood related businesses), historically there has been an element of seasonality in our business in those regions. However, more recently, the extent to which seasonality affects our business has diminished somewhat, largely as a result of a shift away from the seasonal population growth that once characterized many of our coastal communities and toward a more year-round economy resulting from increasing numbers of permanent residents and retirees relocating to these markets. The seasonal patterns that once characterized agribusiness also have been lessened with agricultural product diversification, the year round marketing and sales of agricultural commodities, and agribusiness tax and financial planning.

 

The current real estate cycle has been trending downward in most of the Bank’s markets. This downward trend has and will continue to have an impact on the real estate lending of the Bank. Continued emphasis will be placed on the customer’s ability to generate sufficient cash flow to support their total credit exposure rather than reliance upon the underlying value of the real estate being held as collateral for those loans.

 

We do not believe we have any one customer from whom more than 10% of our revenues are derived. However, we have multiple customers, commercial and retail, that are directly or indirectly affected by, or engaged in businesses related to, the tourism and agribusiness industries and that, in the aggregate, historically have provided greater than 10% of our revenues.

 

Deposit Activities

 

Our deposit services include business and individual checking accounts, NOW accounts, money market checking accounts, savings accounts and certificates of deposit. We monitor our competition in order to keep the rates paid on our deposits at a competitive level. On December 31, 2009, our time deposits of $100,000 or more amounted to approximately $198.4 million, or approximately 26.3% of our total deposits. We derive the majority of our deposits from within our banking market. However, we also accept deposits through deposit brokers and market our certificates of deposit by advertising our deposit rates on an Internet certificate of deposit network, and we generate a significant amount of out-of-market deposits in that manner. Although we accept these deposits primarily for liquidity purposes, we also use them to manage our interest rate risk. On December 31, 2009, our out-of-market deposits amounted to approximately $172.3 million, or approximately 22.8% of our total deposits and approximately 34.5% of our total certificates of deposit.

 

Statistical information about our deposit accounts is contained in Item 7 of this report under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

 

Investment Portfolio

 

On December 31, 2009, our investment portfolio totaled approximately $239.3 million and included municipal securities, corporate notes, mortgage-backed securities guaranteed by the Government National Mortgage Association or issued by the Federal National Mortgage Corporation and Federal Home Loan Mortgage Corporation (including collateralized mortgage obligations), securities issued by U.S. government-sponsored enterprises and agencies and equity securities. We have classified all of our securities as “available-for-sale,” and we analyze their performance at least quarterly. Our securities have various interest rate features, maturity dates and call options.

 

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Statistical information about our investment portfolio is contained in Item 7 of this report under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

 

Employees

 

On December 31, 2009, the Bank employed 211 full-time employees (including our executive officers), and 11 part-time employees. We have no separate employees of our own. The Bank is not party to any collective bargaining agreement with its employees, and we consider the Bank’s relations with its employees to be good.

 

Supervision and Regulation

 

Our business and operations are subject to extensive federal and state governmental regulation and supervision. The following is a summary of some of the basic statutes and regulations that apply to us. However, it is not a complete discussion of all the laws that affect our business, and it is qualified in its entirety by reference to the particular statutory or regulatory provision or proposal being described.

 

General.    We are a bank holding company registered with the Federal Reserve Board (the “FRB”) under the Bank Holding Company Act of 1956, as amended (the “BHCA”). We are subject to supervision and examination by, and the regulations and reporting requirements of, the FRB. Under the BHCA, a bank holding company’s activities are limited to banking, managing or controlling banks, or engaging in other activities the FRB determines are closely related and a proper incident to banking or managing or controlling banks.

 

The BHCA prohibits a bank holding company from acquiring direct or indirect control of more than 5.0% of the outstanding voting stock, or substantially all of the assets, of any financial institution, or merging or consolidating with another bank holding company or savings bank holding company, without the FRB’s prior approval. Additionally, the BHCA generally prohibits bank holding companies from engaging in a nonbanking activity, or acquiring ownership or control of more than 5.0% of the outstanding voting stock of any company that engages in a nonbanking activity, unless that activity is determined by the FRB to be closely related and a proper incident to banking. In approving an application to engage in a nonbanking activity, the FRB must consider whether that activity can reasonably be expected to produce benefits to the public, such as greater convenience, increased competition, or gains in efficiency, that outweigh possible adverse effects, such as undue concentration of resources, decreased or unfair competition, conflicts of interest or unsound banking practices.

 

The law imposes a number of obligations and restrictions on a bank holding company and its insured bank subsidiaries designed to minimize potential losses to depositors and the FDIC insurance funds. For example, if a bank holding company’s insured bank subsidiary becomes “undercapitalized,” the bank holding company is required to guarantee the bank’s compliance (subject to certain limits) with the terms of any capital restoration plan filed with its federal banking agency. A bank holding company is required to serve as a source of financial strength to its bank subsidiaries and to commit resources to support those banks in circumstances in which, absent that policy, it might not do so. Under the BHCA, the FRB may require a bank holding company to terminate any activity or relinquish control of a nonbank subsidiary if the FRB determines that the activity or control constitutes a serious risk to the financial soundness and stability of a bank subsidiary of a bank holding company.

 

The Bank is an insured, North Carolina-chartered bank. Its deposits are insured under the FDIC’s Deposit Insurance Fund, and it is subject to supervision and examination by, and the regulations and reporting requirements of, the FDIC and the North Carolina Commissioner of Banks (the “Commissioner”). The Bank is not a member of the Federal Reserve System.

 

As an insured bank, the Bank is prohibited from engaging as a principal in an activity that is not permitted for national banks unless (1) the FDIC determines that the activity would pose no significant risk to the deposit insurance fund and (2) the Bank is in compliance with applicable capital standards. Insured banks also are prohibited generally from directly acquiring or retaining any equity investment of a type or in an amount not permitted for national banks.

 

The Commissioner and the FDIC regulate all areas of the Bank’s business, including its payment of dividends and other aspects of its operations. They conduct regular examinations of the Bank, and the Bank must furnish periodic reports to the Commissioner and the FDIC containing detailed financial and other information about its affairs. The

 

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Commissioner and the FDIC have broad powers to enforce laws and regulations that apply to the Bank and to require corrective action of conditions that affect its safety and soundness. These powers include, among others, issuing cease and desist orders, imposing civil penalties, removing officers and directors, and otherwise intervening in the Bank’s operation and management if examinations of the Bank and the reports it files indicate the need to do so.

 

The Bank’s business also is influenced by prevailing economic conditions and governmental policies, both foreign and domestic, and, though it is not a member bank of the Federal Reserve System, by the monetary and fiscal policies of the FRB. The FRB’s actions and policy directives determine to a significant degree the cost and availability of funds the Bank obtains from money market sources for lending and investing, and they also influence, directly and indirectly, the rates of interest the Bank pays on its time and savings deposits and the rates it charges on commercial bank loans.

 

Gramm-Leach-Bliley Act.    The federal Gramm-Leach-Bliley Act enacted in 1999 (the “GLB Act”) dramatically changed various federal laws governing the banking, securities and insurance industries.

 

The GLB Act permitted bank holding companies to become “financial holding companies” and, in general (1) expanded opportunities to affiliate with securities firms and insurance companies; (2) overrode certain state laws that would prohibit certain banking and insurance affiliations; (3) expanded the activities in which banks and bank holding companies may participate; (4) requires that banks and bank holding companies engage in some activities only through affiliates owned or managed in accordance with certain requirements; and (5) reorganized responsibility among various federal regulators for oversight of certain securities activities conducted by banks and bank holding companies.

 

The GLB Act expanded opportunities for us and the Bank to provide other services and obtain other revenues. However, this expanded authority also presents challenges as our larger competitors are able to expand their services and products into areas that are not feasible for smaller, community oriented financial institutions. To date we have not elected to become a “financial holding company.”

 

Payment of Dividends.    Under North Carolina law, we are authorized to pay dividends as declared by our Board of Directors, provided that no such distribution results in our insolvency on a going concern or balance sheet basis. However, although we are a legal entity separate and distinct from the Bank, our principal source of funds with which we can pay dividends to our shareholders is dividends we receive from the Bank. For that reason, our ability to pay dividends effectively is subject to the same limitations that apply to the Bank.

 

In general, the Bank may pay dividends only from its undivided profits. However, if its surplus is less than 50% of its paid-in capital stock, the Bank’s directors may not declare any cash dividend until it has transferred to surplus 25% of its undivided profits or any lesser percentage necessary to raise its surplus to an amount equal to 50% of its paid-in capital stock.

 

Federal law prohibits the Bank from making any capital distributions, including paying a cash dividend, if it is, or after making the distribution it would become, “undercapitalized” as that term is defined in the Federal Deposit Insurance Act (the “FDIA”). Also, if in the FDIC’s opinion an insured bank under its jurisdiction is engaged in or is about to engage in an unsafe or unsound practice, the FDIC may require, after notice and hearing, that the bank cease and desist from that practice. The FDIC has indicated that paying dividends that deplete a bank’s capital base to an inadequate level would be an unsafe and unsound banking practice. (See “—Prompt Corrective Action” below.) The FDIC has issued policy statements which provide that insured banks generally should pay dividends only out of their current operating earnings. Also, under the FDIA no dividend may be paid by an FDIC-insured bank while it is in default on any assessment due the FDIC. The Bank’s payment of dividends also may be affected or limited by other factors, such as events or circumstances that lead the FDIC to require the Bank to maintain its capital above regulatory guidelines.

 

In the future, our ability to declare and pay cash dividends will be subject to our Board of Directors’ evaluation of our operating results, capital levels, financial condition, future growth plans, general business and economic conditions, and other relevant considerations. See “—U.S. Treasury’s TARP Capital Purchase Program” below for a discussion of additional restrictions on our ability to pay dividends.

 

Capital Adequacy.    We and the Bank are required to comply with the FRB’s and FDIC’s capital adequacy standards for bank holding companies and insured banks. The FRB and FDIC have issued risk-based capital and leverage capital guidelines for measuring capital adequacy, and all applicable capital standards must be satisfied for us or the Bank to be considered in compliance with regulatory capital requirements.

 

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Under the risk-based capital guidelines, the minimum ratio (“Total Capital Ratio”) of an entity’s total capital (“Total Capital”) to its risk-weighted assets (including certain off-balance-sheet items, such as standby letters of credit) is 8.0%. At least half of Total Capital must be composed of “Tier 1 Capital.” Tier 1 Capital includes common equity, undivided profits, minority interests in the equity accounts of consolidated subsidiaries, qualifying noncumulative perpetual preferred stock, and a limited amount of cumulative perpetual preferred stock, less goodwill and certain other intangible assets. The remaining Total Capital may consist of “Tier 2 Capital” which includes certain subordinated debt, certain hybrid capital instruments and other qualifying preferred stock, and a limited amount of loan loss reserves. A bank or bank holding company that does not satisfy minimum capital requirements may be required to adopt and implement a plan acceptable to its federal banking regulator to achieve an adequate level of capital.

 

Under the leverage capital measure, the minimum ratio (the “Leverage Capital Ratio”) of Tier 1 Capital to average assets, less goodwill and various other intangible assets, is 3.0% for entities that meet specified criteria, including having the highest regulatory rating. All other entities generally are required to maintain an additional cushion of 100 to 200 basis points above the stated minimum. The guidelines also provide that banks experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum levels without significant reliance on intangible assets. A bank’s “Tangible Leverage Ratio” (deducting all intangibles) and other indicators of capital strength also will be taken into consideration by banking regulators in evaluating proposals for expansion or new activities.

 

The FRB and the FDIC also consider interest rate risk (when the interest rate sensitivity of an institution’s assets does not match the sensitivity of its liabilities or its off-balance-sheet position) in evaluating capital adequacy. Banks with excessive interest rate risk exposure must hold additional amounts of capital against their exposure to losses resulting from that risk. The regulators also require banks to incorporate market risk components into their risk-based capital. Under these market risk requirements, capital is allocated to support the amount of market risk related to a bank’s trading activities.

 

The following table lists our consolidated regulatory capital ratios, and the Bank’s separate regulatory capital ratios, at December 31, 2009. On that date, our capital ratios were at levels to qualify us as “well capitalized.”

 

     Minimum
Required Ratios
    Required to be
“Well Capitalized”
    Our Consolidated
Capital Ratios
    The Bank’s
Capital Ratios
 

Leverage Capital Ratio (Tier 1 Capital to average assets)

   3.0   5.0   9.59   7.53

Risk-based capital ratios:

        

Tier 1 Capital Ratio (Tier 1 Capital to risk-weighted assets)

   4.0   6.0   12.77   10.03

Total Capital Ratio (Total Capital to risk-weighted assets)

   8.0   10.0   14.02   11.28

 

Our capital categories are determined only for the purpose of applying the “prompt corrective action” rules described below which have been adopted by the various federal banking regulators, and they do not necessarily constitute an accurate representation of overall financial condition or prospects for other purposes. A failure to meet capital guidelines could subject us to a variety of enforcement remedies under those rules, including issuance of a capital directive, termination of FDIC deposit insurance, a prohibition on taking brokered deposits, and other restrictions on our business. As described below, substantial additional restrictions can be imposed on banks that fail to meet applicable capital requirements. (See “—Prompt Corrective Action” below.)

 

Prompt Corrective Action.    Federal law establishes a system of prompt corrective action to resolve the problems of undercapitalized banks. Under this system, the FDIC has established five capital categories (“well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized,” and “critically undercapitalized”) and it is required to take various mandatory supervisory actions, and is authorized to take other discretionary actions, with respect to banks in the three undercapitalized categories. The severity of any actions taken will depend on the capital category in which a bank is placed. Generally, subject to a narrow exception, current federal law requires the FDIC to appoint a receiver or conservator for a bank that is critically undercapitalized.

 

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Under the FDIC’s rules implementing the prompt corrective action provisions, an insured, state-chartered bank that (1) has a Total Capital Ratio of 10.0% or greater, a Tier 1 Capital Ratio of 6.0% or greater, and a Leverage Ratio of 5.0% or greater, and (2) is not subject to any written agreement, order, capital directive, or prompt corrective action directive issued by the FDIC, is considered “well capitalized.” A bank with a Total Capital Ratio of 8.0% or greater, a Tier 1 Capital Ratio of 4.0% or greater, and a Leverage Ratio of 4.0% or greater, is considered “adequately capitalized.” A bank that has a Total Capital Ratio of less than 8.0%, a Tier 1 Capital Ratio of less than 4.0%, or a Leverage Ratio of less than 4.0%, is considered “undercapitalized.” A bank that has a Total Capital Ratio of less than 6.0%, a Tier 1 Capital Ratio of less than 3.0%, or a Leverage Ratio of less than 3.0%, is considered “significantly undercapitalized,” and a bank that has a tangible equity capital to assets ratio equal to or less than 2.0% is considered “critically undercapitalized.” For purposes of these rules, the term “tangible equity” includes core capital elements counted as Tier 1 Capital for purposes of the risk-based capital standards (see “—Capital Adequacy” above), plus the amount of outstanding cumulative perpetual preferred stock (including related surplus), minus all intangible assets (with various exceptions). A bank may be deemed to be in a lower capitalization category than indicated by its actual capital position if it receives an unsatisfactory examination rating.

 

A bank categorized as “undercapitalized,” “significantly undercapitalized,” or “critically undercapitalized” is required to submit an acceptable capital restoration plan to the FDIC. An “undercapitalized” bank also is generally prohibited from increasing its average total assets, making acquisitions, establishing new branches, or engaging in new lines of business, other than in accordance with an accepted capital restoration plan or with the FDIC’s approval. Also, the FDIC may treat an “undercapitalized” bank as being “significantly undercapitalized” if it determines that is necessary to carry out the purpose of the law. On December 31, 2009, our capital ratios were at levels to qualify us as “well capitalized.”

 

Reserve Requirements.    Under the FRB’s regulations, all FDIC-insured banks must maintain average daily reserves against their transaction accounts. As of January 1, 2010 no reserves are required on the first $10.7 million of transaction accounts, but a bank must maintain reserves equal to 3.0% on aggregate balances between $10.7 million and $55.2 million, and reserves equal to 10.0% on aggregate balances in excess of $55.2 million. The FRB may adjust these percentages from time to time. Because our reserves must be maintained in the form of vault cash or in an account at a Federal Reserve Bank or with a qualified correspondent bank, one effect of the reserve requirement is to reduce the amount of our assets that are available for lending and other investment activities.

 

Federal Deposit Insurance.    The Bank’s deposits are insured by the FDIC to the full extent provided in the Federal Deposit Insurance Act, and the Bank pays assessments to the FDIC for that insurance coverage. Under the Act, the FDIC may terminate the Bank’s deposit insurance if it finds that the Bank has engaged in unsafe and unsound practices, is in an unsafe or unsound condition to continue operations, or has violated applicable laws, regulations, rules or orders.

 

The Federal Deposit Insurance Reform Act of 2005 (“FDIRA”) changed the Federal deposit insurance system by, among other things:

 

  ·  

merging the Bank Insurance Fund and Savings Association Insurance Fund into a new Deposit Insurance Fund (the “DIF”);

 

  ·  

raising the level of Federal deposit insurance coverage for retirement accounts to $250,000;

 

  ·  

establishing a range of 1.15% to 1.50% within which the FDIC must set and maintain the required reserve ratio for the DIF;

 

  ·  

requiring that, if the DIF reserve ratio falls, or within six months is expected to fall, below the statutorily required minimum of 1.15%, the FDIC must adopt a restoration plan that provides for the DIF to be restored; and

 

  ·  

eliminating restrictions on premium rates based on the DIF reserve ratio, and giving the FDIC discretion to price deposit insurance according to the risk posed to the DIF by each insured institution, regardless of the DIF reserve ratio.

 

During October 2008, the Emergency Economic Stabilization Act of 2008 temporarily raised the basic limit on federal deposit insurance coverage for all accounts from $100,000 to $250,000 per depositor until December 31, 2009. During May 2009, that increased coverage was extended until December 31, 2013, at which time it will return to $100,000 for all accounts other than retirement accounts for which FDIRA permanently increased the basic coverage to $250,000.

 

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FDIC Temporary Liquidity Guarantee Program.    During 2008, the FDIC implemented its Temporary Liquidity Guarantee Program (TLGP), which applies to, among others, all U.S. depository institutions insured by the FDIC and all U.S. bank holding companies, unless they have opted out of the TLGP or the FDIC has terminated their participation. We chose to participate in the TLGP. Under the original terms of the transaction account guarantee component of the TLGP, all noninterest-bearing transaction accounts would be insured in full by the FDIC until December 31, 2009, regardless of the standard maximum deposit insurance amount. During August 2009, the FDIC extended the transaction account guarantee component of the TLGP through June 30, 2010.

 

FDIC Insurance Assessments.    Under FDIRA, the FDIC uses a revised risk-based assessment system to determine the amount of the Bank’s deposit insurance assessment based on an evaluation of the probability that the DIF will incur a loss with respect to the Bank. That evaluation takes into consideration risks attributable to different categories and concentrations of the Bank’s assets and liabilities and any other factors the FDIC considers to be relevant, including information obtained from the Commissioner. A higher assessment rate results in an increase in the assessments paid by the Bank to the FDIC for deposit insurance

 

The FDIC is responsible for maintaining the adequacy of the DIF, and the amount the Bank pays for deposit insurance is influenced not only by the assessment of the risk it poses to the DIF, but also by the adequacy of the insurance fund at any time to cover the risk posed by all insured institutions. FDIC insurance assessments could be increased substantially in the future if the FDIC finds such an increase to be necessary in order to adequately maintain the insurance fund.

 

During 2008, and because the DIF reserve ratio had fallen below the minimum of 1.15% mandated by FDIRA, the Board of Directors of the FDIC adopted a restoration plan to return the reserve ratio to that minimum level as required by FDIRA within five years. During February 2009, the Board amended its restoration plan to provide for the minimum DIF reserve ratio to be restored within seven years and voted to impose a special assessment on insured institutions of 20 basis points, and to increase regular assessment rates for 2009. However, during May 2009, the special assessment was reduced to 5 basis points on each insured institution’s assets minus its Tier 1 capital as of June 30, 2009, but not more than 10 basis points of the institution’s assessment base for the second quarter of 2009. The special assessment was payable on September 30, 2009.

 

During October 2009, the FDIC again amended its restoration plan to provide for the minimum DIF reserve ratio to be restored within eight years, and adopted a uniform 3 basis point increase in regular assessment rates effective January 1, 2011. During November 2009, the FDIC amended its regulations to require that insured institutions prepay their estimated quarterly risk-based assessments for the fourth quarter of 2009 and for all of 2010, 2011 and 2012 on December 30, 2009.

 

Restrictions on Transactions with Affiliates.    The Bank is subject to the provisions of Section 23A of the Federal Reserve Act which, among other things, places limits on the amount of:

 

  ·  

a bank’s loans or extensions of credit to, or investment in, its affiliates;

 

  ·  

assets a bank may purchase from affiliates, except for real and personal property exempted by the FRB;

 

  ·  

the amount of a bank’s loans or extensions of credit to third parties collateralized by securities or obligations of the bank’s affiliates; and

 

  ·  

a bank’s issuance of a guarantee, acceptance or letter of credit for its affiliates.

 

The total amount of these transactions is limited in amount, as to any one affiliate, to 10% of a bank’s capital and surplus and, as to all affiliates, to 20% of a bank’s capital and surplus. In addition to the limitation on the amount of these transactions, each of the above transactions must also meet specified collateral requirements. We also must comply with other provisions under Section 23A that are designed to avoid the taking of low-quality assets from an affiliate.

 

The Bank also is subject to the provisions of Section 23B of the Federal Reserve Act which, among other things, prohibit a bank or its subsidiaries generally from engaging in transactions with its affiliates unless those transactions are on terms substantially the same, or at least as favorable to the bank or its subsidiaries, as would apply in comparable transactions with nonaffiliated companies.

 

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Federal law also restricts the Bank’s ability to extend credit to its and our executive officers, directors, principal shareholders and their related interests. These credit extensions (1) must be made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with unrelated third parties, and (2) must not involve more than the normal risk of repayment or present other unfavorable features.

 

Interstate Banking and Branching.    The Bank Holding Company Act, as amended by the interstate banking provisions of the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the “Interstate Banking Law”), permits adequately capitalized and managed bank holding companies to acquire control of the assets of banks in any state. Acquisitions are subject to provisions that cap at 10.0% the portion of the total deposits of insured depository institutions in the United States that a single bank holding company may control, and generally cap at 30.0% the portion of the total deposits of insured depository institutions in a state that a single bank holding company may control. Under certain circumstances, states have the authority to increase or decrease the 30.0% cap, and states may set minimum age requirements of up to five years on target banks within their borders.

 

Subject to certain conditions, the Interstate Banking Law also permits interstate branching by allowing a bank in one state to merge with a bank located in a different state. Each state was allowed to prohibit interstate branching in that state by merger by enacting legislation to that effect. The Interstate Banking Law also permits banks to establish branches in other states by opening new branches or acquiring existing branches of other banks, provided the laws of those other states specifically permit that form of interstate branching. North Carolina has adopted statutes which, subject to conditions, authorize out-of-state bank holding companies and banks to acquire or merge with North Carolina banks and to establish or acquire branches in North Carolina.

 

Community Reinvestment.    Under the Community Reinvestment Act (the “CRA”), an insured bank has a continuing and affirmative obligation, consistent with its safe and sound operation, to help meet the credit needs of its entire community, including low and moderate income neighborhoods. The CRA does not establish specific lending requirements or programs for banks, nor does it limit a bank’s discretion to develop, consistent with the CRA, the types of products and services it believes are best suited to its particular community. The CRA requires the federal banking regulators, in their examinations of insured banks, to assess the banks’ records of meeting the credit needs of their communities, using the ratings of “outstanding,” “satisfactory,” “needs to improve,” or “substantial noncompliance,” and to take that record into account in its evaluation of various applications by those banks. All banks are required to make public disclosure of their CRA performance ratings. We received a “satisfactory” rating in our last CRA examination during 2006.

 

USA Patriot Act of 2001.    The USA Patriot Act of 2001 was enacted in response to the terrorist attacks that occurred in the United States on September 11, 2001. The Act is intended to strengthen the ability of U.S. law enforcement and the intelligence community to work cohesively to combat terrorism on a variety of fronts. The Act’s impact on all financial institutions is significant and wide ranging. The Act contains sweeping anti-money laundering and financial transparency requirements and imposes various other regulatory requirements, including standards for verifying customer identification at account opening, and rules promoting cooperation among financial institutions, regulators and law enforcement agencies in identifying parties that may be involved in terrorism or money laundering.

 

Sarbanes-Oxley Act of 2002.    The Sarbanes-Oxley Act of 2002, which became effective on July 30, 2002, is sweeping federal legislation that addressed accounting, corporate governance and disclosure issues. The Act imposed significant new requirements on all public companies. Some provisions of the Act became effective immediately while others are still being implemented.

 

In general, the Sarbanes-Oxley Act mandated important new corporate governance and financial reporting requirements intended to enhance the accuracy and transparency of public companies’ reported financial results. It established new responsibilities for corporate chief executive officers, chief financial officers and audit committees in the financial reporting process, and it created a new regulatory body to oversee auditors of public companies. It backed these requirements with new SEC enforcement tools, increased criminal penalties for federal mail, wire and securities fraud, and created new criminal penalties for document and record destruction in connection with federal investigations. It also increased the opportunity for more private litigation by lengthening the statute of limitations for securities fraud claims and providing new corporate whistleblower protection.

 

In response to the Act, the various securities exchanges adopted listing standards that require listed companies to comply with various corporate governance requirements, including the requirement that (1) audit committees include

 

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only directors who are “independent” as defined by the SEC’s and Exchanges’ rules, and (2) actions on various other matters (including executive compensation and director nominations) be approved, or recommended for approval, by issuers’ full boards of directors or by committees that include only “independent” directors. Because our common stock is listed on the NASDAQ Global Market, we are subject to those requirements.

 

The economic and operational effects of the Sarbanes-Oxley Act on public companies, including us, have been and will continue to be significant in terms of the time, resources and costs associated with compliance. Because the Act, for the most part, applies equally to larger and smaller public companies, we will continue to be presented with additional challenges as a smaller, community-oriented financial institution seeking to compete with larger financial institutions in our markets.

 

U.S. Treasury’s Troubled Asset Relief Program (TARP) Capital Purchase Program.    On January 16, 2009, we issued Series A Preferred Stock in the amount of $17,949,000 and a warrant to purchase 144,984 shares of our common stock to the U.S. Treasury as a participant in the TARP Capital Purchase Program. The Series A Preferred Stock qualifies as Tier 1 capital for purposes of regulatory capital requirements and will pay cumulative dividends at a rate of 5% per annum for the first five years and 9% per annum thereafter. Prior to January 16, 2012, unless we have redeemed all of this preferred stock or the U.S. Treasury has transferred all of this preferred stock to a third party, the consent of the U.S. Treasury will be required for us to, among other things, increase our common stock dividend above the current quarterly cash dividend of $0.1825 per share or repurchase our common stock except in limited circumstances. In addition, until the U.S. Treasury ceases to own our securities sold under the TARP Capital Purchase Program, the compensation arrangements for our senior executive officers must comply in all respects with the U.S. Emergency Economic Stabilization Act of 2008, as amended by the American Recovery and Reinvestment Act of 2009, and the rules and regulations thereunder.

 

Available Information

 

Copies of reports we file electronically with the Securities and Exchange Commission, including copies of our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, and Current Reports on Form 8-K, and amendments to those reports, are available free of charge through our Internet website as soon as reasonably practicable after they are filed. Our website address is www.ecbbancorp.com.

 

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Item 1A.    Risk Factors

 

 

RISK FACTORS

 

The following paragraphs describe material risks that could affect our business. Other risks and uncertainties not presently known to us or that we currently deem immaterial also may impair our business operations. If any of the following risks actually occur, our business, results of operations and financial condition could suffer. The risks discussed below also include forward-looking statements, and our actual results may differ materially from those discussed in these forward-looking statements.

 

Risks Relating to our Business

 

·  

Difficult market conditions and economic trends have adversely affected our industry and our business.

 

Dramatic declines in the housing market, with decreasing home prices and increasing delinquencies and foreclosures, have negatively impacted the credit performance of mortgage and construction loans and resulted in significant write-downs of assets by many financial institutions. In addition, the values of other real estate collateral supporting many loans have declined and may continue to decline. General downward economic trends, reduced availability of commercial credit and increasing unemployment have negatively impacted the credit performance of commercial and consumer credit, resulting in additional write-downs. Concerns over the stability of the financial markets and the economy have resulted in decreased lending by financial institutions to their customers and to each other. This market turmoil and tightening of credit has led to increased commercial and consumer loan delinquencies, lack of customer confidence, increased market volatility and widespread reduction in general business activity. Competition among depository institutions for deposits has increased significantly. Financial institutions have experienced decreased access to capital and to deposits or borrowings.

 

The resulting economic pressure on consumers and businesses and the lack of confidence in the financial markets has adversely affected most businesses and the prices of securities in general, and financial institutions in particular, and it will continue to adversely affect our business, financial condition, results of operations and stock price.

 

Our ability to assess the creditworthiness of customers and to estimate the losses inherent in our credit exposure is made more complex by these difficult market and economic conditions. As a result of the foregoing factors, there is a potential for new federal or state laws and regulations regarding lending and funding practices and liquidity standards, and bank regulatory agencies have been aggressive in responding to concerns and trends identified in examinations. This increased government action may increase our costs and limit our ability to pursue certain business opportunities. We also may be required to pay even higher Federal Deposit Insurance Corporation (“FDIC”) premiums than the recently increased level, because financial institution failures resulting from the depressed market conditions have depleted and may continue to deplete the deposit insurance fund and reduce its ratio of reserves to insured deposits.

 

We do not believe these difficult conditions are likely to improve in the near future. A worsening of these conditions would likely exacerbate the adverse effects of these difficult market and economic conditions on us, our customers and the other financial institutions in our market. As a result, we may experience increases in foreclosures, delinquencies and customer bankruptcies, as well as more restricted access to funds.

 

·  

Recent legislative and regulatory initiatives to address difficult market and economic conditions may not stabilize the U.S. banking system or the economy.

 

In response to adverse economic conditions, and instability in the financial markets and the U.S. banking system, Congress enacted the Emergency Economic Stabilization Act of 2008 (“EESA”) in an attempt to restore confidence and stability to the banking system and to encourage financial institutions to increase their lending to customers and to each other. Later, the American Recovery and Reinvestment Act of 2009 (“ARRA”) was enacted to support the national economy and aid in economic recovery.

 

The provisions of EESA and ARRA are in addition to numerous other actions by the Federal Reserve, Treasury, the FDIC, the SEC and others to address the current decline in the national economy and liquidity and credit crisis that

 

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commenced in 2007. The purpose of these legislative and regulatory actions is to stabilize the U.S. banking system, support the national economy and aid in economic recovery. However, there is no assurance that EESA, ARRA and the other regulatory initiatives described above will be fully effective or have their desired effects. If the volatility in the markets continues and economic conditions fail to improve or worsen, our business, financial condition and results of operations could be materially and adversely affected.

 

·  

Current levels of market volatility are unprecedented.

 

The capital and credit markets have experienced volatility and disruption for more than a year, producing downward pressure on stock prices and credit availability for many issuers without regard to their underlying financial strength. This has been particularly the case with respect to financial institutions, and the market prices of the stocks of financial services companies in general, including ours, are at their lowest levels in recent history. If current levels of market disruption and volatility continue or worsen, there can be no assurance that we will not experience an adverse effect, which may be material, on our ability to access capital and on our business, financial condition and results of operations.

 

·  

Our allowance for loan losses may prove to be insufficient to absorb probable losses in our loan portfolio.

 

Lending money is a substantial part of our business. Every loan carries a degree of risk that it will not be repaid in accordance with its terms or that any underlying collateral will not be sufficient to assure repayment. This risk is affected by, among other things:

 

  ·  

cash flow of the borrower and/or a business activity being financed;

 

  ·  

in the case of a collateralized loan, changes in and uncertainties regarding future values of collateral;

 

  ·  

the credit history of a particular borrower;

 

  ·  

changes in economic and industry conditions; and

 

  ·  

the duration of the loan.

 

We use underwriting procedures and criteria that we believe minimize the risk of loan delinquencies and losses, but banks routinely incur losses in their loan portfolios. Regardless of the underwriting criteria we use, we will experience loan losses from time to time in the ordinary course of our business, and many of those losses will result from factors beyond our control. These factors include, among other things, changes in market, economic, business or personal conditions, or other events (including changes in market interest rates), that affect our borrowers’ abilities to repay their loans and the value of properties that collateralize loans.

 

As a result of recent difficulties in the national economy and housing market, declining real estate values, rising unemployment, and loss of consumer confidence, we and most other financial institutions have experienced increasing levels of non-performing loans, foreclosures and loan losses. We maintain an allowance for loan losses which we believe is appropriate to provide for potential losses in our loan portfolio. The amount of our allowance is determined by our management through a periodic review and consideration of internal and external factors that affect loan collectibility, including, but not limited to:

 

  ·  

an ongoing review of the quality, size and diversity of the loan portfolio;

 

  ·  

evaluation of non-performing loans;

 

  ·  

historical default and loss experience;

 

  ·  

historical recovery experience;

 

  ·  

existing economic conditions;

 

  ·  

risk characteristics of various classifications of loans; and

 

  ·  

the amount and quality of collateral, including guarantees, securing the loans.

 

However, if delinquency levels continue to increase or we continue to incur higher than expected loan losses in the future, there is no assurance that our allowance will be adequate to cover resulting losses or that we will not have to make significant provisions to our allowance.

 

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·  

A large percentage of our loans are secured by real estate. Adverse conditions in the real estate market in our banking markets have adversely affected our loan portfolio.

 

While we do not have a sub-prime lending program, a relatively large percentage of our loans are secured by real estate. Our management believes that, in the case of many of those loans, the real estate collateral is not being relied upon as the primary source of repayment, and the level of our real estate loans reflects, at least in part, our policy to take real estate whenever possible as primary or additional collateral rather than other types of collateral. However, adverse conditions in the real estate market and the economy in general have decreased real estate values in our banking markets. If the value of our collateral for a loan falls below the outstanding balance of that loan, our ability to collect the balance of the loan by selling the underlying real estate in the event of a default will be diminished, and we would be more likely to suffer a loss on the loan. An increase in our loan losses could have a material adverse effect on our operating results and financial condition.

 

The FDIC recently adopted rules aimed at placing additional monitoring and management controls on financial institutions whose loan portfolios are deemed to have concentrations in commercial real estate (“CRE”). At December 31, 2009, our loan portfolio exceeded thresholds established by the FDIC for CRE concentrations and for additional regulatory scrutiny. Indications from regulators are that strict limitations on the amount or percentage of CRE within any given portfolio are not expected, but, rather, that additional reporting and analysis will be required to document management’s evaluation of the potential additional risks of such concentrations and the impact of any mitigating factors. It is possible that regulatory constraints associated with these rules could adversely affect our ability to grow loan assets and thereby limit our overall growth and expansion plans. These rules also could increase the costs of monitoring and managing this component of our loan portfolio. Either of these eventualities could have an adverse impact on our operating results and financial condition.

 

·  

Liquidity risk could impair our ability to fund operations and jeopardize our financial condition.

 

Liquidity is essential to our business. An inability to raise funds through deposits, borrowings, the sale of loans and other sources could have a substantial negative effect on our liquidity. Our access to funding sources in amounts adequate to finance our activities, or on terms which are acceptable to us, could be impaired by factors that affect us specifically or the financial services industry or economy in general. Factors that could detrimentally affect our access to liquidity sources include a decrease in the level of our business activity as a result of a downturn in the markets in which our loans are concentrated or adverse regulatory action against us. Our ability to borrow could also be impaired by factors that are not specific to us, such as the current disruption in the financial markets or negative views and expectations about the prospects for the financial services industry in light of the recent turmoil faced by banking organizations and the continued deterioration in credit markets.

 

Among other sources of funds, we rely heavily on deposits, including out-of-market certificates of deposit, for funds to make loans and provide for our other liquidity needs. Those out-of-market deposits may not be as stable as other types of deposits and, in the future, depositors may not renew those time deposits when they mature, or we may have to pay a higher rate of interest to attract or keep them or to replace them with other deposits or with funds from other sources. Not being able to attract those deposits, or to keep or replace them as they mature, would adversely affect our liquidity. Paying higher deposit rates to attract, keep or replace those deposits could have a negative effect on our interest margin and operating results.

 

·  

We may need to raise additional capital in the future in order to continue to grow, but that capital may not be available when it is needed.

 

Federal and state banking regulators require us to maintain adequate levels of capital to support our operations. In addition, in the future we may need to raise additional capital to support our business or to finance acquisitions, if any, or we may otherwise elect or be required to raise additional capital. In that regard, recently a number of financial institutions have sought to raise considerable amounts of additional capital in response to a deterioration in their results of operations and financial condition arising from increases in their non-performing loans and loan losses, deteriorating economic conditions, declines in real estate values and other factors. On December 31, 2009, our three capital ratios were above “well capitalized” levels under bank regulatory guidelines. However, growth in our earning assets resulting from internal expansion and new branch offices, at rates in excess of the rate at which our capital is increased through retained earnings, will reduce our capital ratios unless we continue to increase our capital. Also, future unexpected losses, whether resulting from loan losses or other causes, would reduce our capital.

 

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Should we need, or be required by regulatory authorities, to raise additional capital, we may seek to do so through the issuance of, among other things, our common stock or preferred stock. However, our ability to raise that additional capital will depend on conditions at that time in the capital markets, economic conditions, our financial performance and condition, and other factors, many of which are outside our control. There is no assurance that, if needed, we will be able to raise additional capital on terms favorable to us or at all. Our inability to raise additional capital, if needed, on terms acceptable to us, may have a material adverse effect on our ability to expand our operations, and on our financial condition, results of operations and future prospects.

 

·  

If we are unable to redeem our Series A Preferred Stock after five years, the cost of this capital to us will increase substantially.

 

If we are unable to redeem the Series A Preferred Stock we have sold to Treasury prior to January 16, 2014, the cost of this capital to us will increase from 5.0% per annum (approximately $897,450 annually) to 9.0% per annum (approximately $1,615,410 annually). Depending on our financial condition at the time, this increase in the annual dividend rate on the Series A Preferred Stock could have a material negative effect on our liquidity and on our net income available to holders of our common stock.

 

·  

Our profitability is subject to interest rate risk. Changes in interest rates could have an adverse effect on our operating results.

 

Our profitability depends, to a large extent, on our net interest income, which is the difference between our income on interest-earning assets and our expense on interest-bearing deposits and other liabilities. In other words, to be profitable, we have to earn more interest on our loans and investments than we pay on our deposits and borrowings. Like most financial institutions, we are affected by changes in general interest rate levels and by other economic factors beyond our control. Interest rate risk arises in part from the mismatch (i.e., the interest sensitivity “gap”) between the dollar amounts of repricing or maturing interest-earning assets and interest-bearing liabilities, and is measured in terms of the ratio of the interest rate sensitivity gap to total assets. When more interest-earning assets than interest-bearing liabilities will reprice or mature over a given time period, a bank is considered asset-sensitive and has a positive gap. When more liabilities than assets will reprice or mature over a given time period, a bank is considered liability-sensitive and has a negative gap. A liability-sensitive position (i.e., a negative gap) may generally enhance net interest income in a falling interest rate environment and reduce net interest income in a rising interest rate environment. An asset-sensitive position (i.e., a positive gap) may generally enhance net interest income in a rising interest rate environment and reduce net interest income in a falling interest rate environment. Our ability to manage our gap position determines to a great extent our ability to operate profitably. However, fluctuations in interest rates are not predictable or controllable, and recent economic and financial market conditions have made it extremely difficult to manage our gap position. Our profitability and results of operations will be adversely affected if we do not successfully manage our interest sensitivity gap.

 

On December 31, 2009, we had a negative one-year cumulative interest sensitivity gap, which means that, during a one-year period, our interest-bearing liabilities generally would be expected to reprice at a faster rate than our interest-earning assets. A rising rate environment within that one-year period generally would have a negative effect on our earnings, while a falling rate environment generally would have a positive effect on our earnings.

 

·  

Our long-range business strategy includes the continuation of our growth plans, and our financial condition and operating results could be negatively affected if we fail to grow or fail to manage our growth effectively.

 

Subject to market conditions and the economy, we intend to continue to grow in our existing banking markets (internally and through additional offices) and to expand into new markets as appropriate opportunities arise. We have opened nine de novo branch offices since 2000. Consistent with our business strategy, and to sustain our growth, in the future we may establish other de novo branches or acquire other financial institutions or their branch offices.

 

There are considerable costs involved in opening branches, and new branches generally do not generate sufficient revenues to offset their costs until they have been in operation for some period of time. Any new branches we open can be expected to negatively affect our operating results until those branches reach a size at which they become profitable. In establishing new branches in new markets, we compete against other banks with greater knowledge of those local markets

 

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and may need to hire and rely on local managers who have local affiliations and to whom we may need to give significant autonomy. If we grow but fail to manage our growth effectively, there could be material adverse effects on our business, future prospects, financial condition or operating results, and we may not be able to successfully implement our business strategy. On the other hand, our operating results also could be materially affected in an adverse way if our growth occurs more slowly than anticipated, or declines.

 

Although we believe we have management resources and internal systems in place to successfully manage our future growth, we cannot assure you that we will be able to expand our market presence in our existing markets or successfully enter new markets, or that expansion will not adversely affect our operating results.

 

·  

Our business depends on the condition of the local and regional economies where we operate.

 

We currently have offices only in eastern North Carolina. Consistent with our community banking philosophy, a majority of our customers are located in and do business in that region, and we lend a substantial portion of our capital and deposits to commercial and consumer borrowers in our local banking markets. Therefore, our local and regional economy has a direct impact on our ability to generate deposits to support loan growth, the demand for loans, the ability of borrowers to repay loans, the value of collateral securing our loans (particularly loans secured by real estate), and our ability to collect, liquidate and restructure problem loans. The local economies of the coastal communities in our banking markets are heavily dependent on the tourism industry. If our local communities are adversely affected by current conditions in the national economy or by other specific events or trends, including a significant decline in the tourism industry in our coastal communities, there could be a direct adverse effect on our operating results. Adverse economic conditions in our banking markets could reduce our growth rate, affect the ability of our customers to repay their loans to us, and generally affect our financial condition and operating results. We are less able than larger institutions to spread risks of unfavorable local economic conditions across a large number of diversified economies.

 

The economy of North Carolina’s coastal region can be affected by adverse weather events, particularly hurricanes. Our banking markets lie primarily in coastal communities, and we cannot predict whether or to what extent damage caused by future hurricanes will affect our operations, our customers or the economies in our banking markets. However, weather events could cause a decline in loan originations, destruction or decline in the value of properties securing our loans, or an increase in the risks of delinquencies, foreclosures and loan losses.

 

·  

New or changes in existing tax, accounting, and regulatory rules and interpretations could have an adverse effect on our strategic initiatives, results of operations, cash flows, and financial condition.

 

We operate in a highly regulated industry and are subject to examination, supervision and comprehensive regulation by various federal and state agencies. Federal and state banking regulations are designed primarily to protect the deposit insurance funds and consumers, not to benefit a financial company’s shareholders. These regulations may sometimes impose significant limitations on our operations, and our compliance with regulations is costly and restricts certain of our activities, including payment of dividends, mergers and acquisitions, investments, loans and interest rates charged, interest rates paid on deposits, and locations of offices.

 

The significant federal and state banking regulations that affect us are described under “Item 1. Business—Supervision and Regulation.” These regulations, along with the currently existing tax, accounting, securities, insurance, and monetary laws, regulations, rules, standards, policies, and interpretations, control the methods by which financial institutions conduct business, implement strategic initiatives and tax compliance, and govern financial reporting and disclosures. The laws, regulations, rules, standards, policies, and interpretations are constantly evolving and may change significantly over time. As a result of recent turmoil in the financial services industry, it is likely that there will be an increase in the regulation of all financial institutions. We cannot predict the effects of future changes on our business and profitability.

 

·  

Significant legal actions could subject us to substantial liabilities.

 

We are from time to time subject to claims related to our operations. These claims and legal actions, including supervisory actions by our regulators, could involve large monetary claims and significant defense costs. As a result, we may be exposed to substantial liabilities, which could adversely affect our results of operations and financial condition.

 

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Among the laws that apply to us, the USA Patriot and Bank Secrecy Acts require financial institutions to develop programs to prevent financial institutions from being used for money laundering and terrorist activities. If such activities are detected, financial institutions are obligated to file suspicious activity reports with the Treasury’s Office of Financial Crimes Enforcement Network. These rules require financial institutions to establish procedures for identifying and verifying the identity of customers seeking to open new financial accounts. Failure to comply with these regulations could result in fines or sanctions. Several banking institutions have recently received large fines for non-compliance with these laws and regulations. Although we have developed policies and procedures designed to assist in compliance with these laws and regulations, no assurance can be given that these policies and procedures will be effective in preventing violations of these laws and regulations.

 

·  

Competition from financial institutions and other financial service providers may adversely affect our profitability.

 

Our future growth and success will depend on, among other things, our ability to compete effectively with other financial services providers in our banking markets. To date, we have grown our business by focusing on our lines of business and emphasizing the high level of service and responsiveness desired by our customers. However, commercial banking in our banking markets and in North Carolina as a whole is extremely competitive. We compete against commercial banks, credit unions, savings and loan associations, mortgage banking firms, consumer finance companies, securities brokerage firms, insurance companies, money market funds and other mutual funds, as well as other local and community, super-regional, national and international financial institutions that operate offices in our market areas and elsewhere. We compete with these institutions in attracting deposits and in making loans, and we have to attract our customer base from other existing financial institutions and from new residents. Our larger competitors have greater resources, broader geographic markets and name recognition, and higher lending limits than we do, and they can offer more products and services and better afford and more effectively use media advertising, support services and electronic technology than we can. Also, larger competitors may be able to price loans and deposits more aggressively than we do. While we believe we compete effectively with other financial institutions, we may face a competitive disadvantage as a result of our size, lack of geographic diversification and inability to spread marketing costs across a broader market. Although we compete by concentrating our marketing efforts in our primary markets with local advertisements, personal contacts and greater flexibility and responsiveness in working with local customers, we cannot assure you that we will continue to be an effective competitor in our banking markets.

 

·  

We rely on dividends from the Bank for substantially all of our revenue.

 

We receive substantially all of our revenue as dividends from the Bank. As described under “Item 1. Business—Supervision and Regulation, federal and state regulations limit the amount of dividends that the Bank may pay to us. If the Bank becomes unable to pay dividends to us, then we may not be able to service our debt, pay our other obligations or pay dividends on our common stock and the Series A Preferred Stock we have sold to Treasury. Accordingly, our inability to receive dividends from the Bank could also have a material adverse effect on our business, financial condition and results of operations and the value of your investment in our common stock.

 

·  

We depend on the services of our current management team.

 

Our operating results and ability to adequately manage our growth and minimize loan losses are highly dependent on the services, managerial abilities and performance of our executive officers. Smaller banks, like us, sometimes find it more difficult to attract and retain experienced management personnel than larger banks. We currently have an experienced management team that our Board of Directors believes is capable of managing and growing the Bank. However, changes in or losses of key personnel of any company could disrupt that company’s business and could have an adverse effect on its business and operating results.

 

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Risks Relating to Our Common Stock

 

·  

The price of our common stock may fluctuate significantly, and this may make it difficult for you to resell our common stock when you want or at prices you find attractive.

 

We cannot predict how or at what prices our common stock will trade in the future. The market value of our common stock will likely continue to fluctuate in response to a number of factors including the following, most of which are beyond our control, as well as the other factors described in this “Risk Factors” section:

 

  ·  

actual or anticipated quarterly fluctuations in our operating and financial results;

 

  ·  

changes in financial estimates and recommendations by financial analysts;

 

  ·  

actions of our current shareholders, including sales of common stock by existing shareholders and our directors and executive officers;

 

  ·  

fluctuations in the stock price and operating results of our competitors;

 

  ·  

regulatory developments; and

 

  ·  

developments related to the financial services industry.

 

The market value of and trading in our common stock also is affected by conditions (including price and trading fluctuations) affecting the financial markets in general, and in the market for the stocks of financial services companies in particular. These conditions may result in volatility in the market prices of stocks generally and, in turn, our common stock. Also, market conditions may result in sales of substantial amounts of our common stock in the market. In each case, market conditions could affect the market price of our stock in a way that is unrelated or disproportionate to changes in our operating performance.

 

·  

The trading volume in our common stock has been low, and the sale of a substantial number of shares in the public market could depress the price of our stock and make it difficult for you to sell your shares.

 

Our common stock is listed on the NASDAQ Global Market, but it has a relatively low average daily trading volume relative to many other stocks. Thinly traded stock can be more volatile than stock trading in an active public market, which can lead to significant price swings even when a relatively small number of shares are being traded and limit an investor’s ability to quickly sell blocks of stock. We cannot predict what effect future sales of our common stock in the market, or the availability of shares of our common stock for sale in the market, will have on the market price of our common stock.

 

Of the shares of our common stock beneficially owned by our directors and executive officers, in excess of 10% of our outstanding shares are held by an estate. We cannot predict the timing or amount of sales, if any, of those shares in the public markets or the effects any such sales may have on the trading price of our common stock.

 

·  

Our management beneficially owns a substantial percentage of our common stock, so our directors and executive officers can significantly affect voting results on matters voted on by our shareholders.

 

Our current directors and executive officers, as a group, beneficially own a significant percentage of our outstanding common stock, much of which is held by an estate of which one of our directors serves as a co-executor. Because of their voting rights, in matters put to a vote of our shareholders it could be difficult for any group of our other shareholders to defeat a proposal favored by our management (including the election of one or more of our directors) or to approve a proposal opposed by management.

 

·  

The securities purchase agreement between us and Treasury limits our ability to pay dividends on and repurchase our common stock.

 

The securities purchase agreement between us and Treasury provides that prior to the earlier of January 16, 2012, and the date on which all of the shares of Series A Preferred Stock held by Treasury have been redeemed by us or transferred by Treasury to third parties, we may not, without the consent of Treasury:

 

  ·  

increase the cash dividend on our common stock; or

 

  ·  

subject to limited exceptions, redeem, repurchase or otherwise acquire shares of our common stock or preferred stock (other than the Series A Preferred Stock) or trust preferred securities.

 

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In addition, we are unable to pay any dividends on our common stock unless we are current in our dividend payments on the Series A Preferred Stock. These restrictions, together with the potentially dilutive impact of the warrant described in the next risk factor, could have a negative effect on the value of our common stock. Moreover, holders of our common stock are entitled to receive dividends only when, as and if declared by our Board of Directors. Although we have historically paid cash dividends on our common stock, we are not required to do so and our Board of Directors could reduce or eliminate our common stock dividend in the future.

 

·  

Our outstanding Series A Preferred Stock affects net income available to our common shareholders and earnings per common share, and the warrant we issued to Treasury may be dilutive to holders of our common stock.

 

The dividends declared on our Series A Preferred Stock will reduce the net income available to common shareholders and our earnings per common share. The Series A Preferred Stock will also receive preferential treatment in the event of liquidation, dissolution or winding up of our company. Additionally, the ownership interest of the existing holders of our common stock will be diluted to the extent the warrant we issued to Treasury in conjunction with the sale to Treasury of Series A Preferred Stock is exercised. The shares of common stock underlying the warrant represent approximately 4.84% of the shares of our common stock outstanding as of March 6, 2010 (including the shares issuable upon exercise of the warrant). Although Treasury has agreed not to vote any of the shares of common stock it receives upon exercise of the warrant, a transferee of any portion of the warrant or of any shares of common stock acquired upon exercise of the warrant is not bound by this restriction.

 

Item 1B.    Unresolved Staff Comments

 

 

Not applicable.

 

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Item 2.    Properties

 

 

Our offices are located in the Bank’s corporate offices in Engelhard, North Carolina, and we do not own or lease any separate properties. The Bank maintains 24 branch offices, 21 of which are owned by the Bank, and three of which are leased from unaffiliated third parties. The following table contains information about our branch offices.

 

Office location

   Opening date of
original banking
office
   Owned/Leased   Date current
facility built
or purchased (1)

35050 Hwy 264

Engelhard, NC

   January 1920    Owned   2004

80 Main and Pearl St.

Swan Quarter, NC

   March 1935    Owned (2)   1975

204 Scuppernong Dr.

Columbia, NC

   December 1936    Owned (2)   1975

7th St. & Hwy. 64

Creswell, NC

   January 1963    Owned   1963

205 Virginia Dare Rd.

Manteo, NC

   June 1969    Owned   1999

2721 S Croatan Hwy.

Nags Head, NC

   April 1971    Owned (2)   1974

State Hwy. 12

Hatteras, NC

   April 1973    Owned (2)   1980

6839 N.C. Hwy. 94

Fairfield, NC

   June 1973    Owned (2)   1973

Hwy. 12

Ocracoke, NC

   May 1978    Owned   1978

Hwy. 158 & Juniper Tr.

Kitty Hawk, NC

   May 1984    Owned (3)   2006

1001 Red Banks Rd.

Greenville, NC

   August 1989    Owned   1990

2400 Stantonsburg Rd.

Greenville, NC

   June 1995    Owned   1995

NC Hwy. 12

Avon, NC

   June 1997    Leased (4)       —

2878 Caratoke Hwy.

Currituck, NC

   January 1998    Owned   2001

1418 Carolina Ave.

Washington, NC

   May 1999    Leased (4)       —

1801 S Glenburnie Rd.

New Bern, NC

   August 2000    Owned   1996

1103 Harvey Point Road

Hertford, NC

   October 2000    Owned (5)   2006

403 East Blvd.

Williamston, NC

   May 2003    Owned   2003

168 Hwy. 24

Morehead City, NC

   January 2004    Owned   2004

 

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Office location

   Opening date of
original banking
office
   Owned/Leased   Date current
facility built
or purchased (1)

1724 Eastwood Rd.

Wilmington, NC

   June 2004    Owned   2004

100 Causeway Drive Unit 4

Ocean Isle Beach, NC

   May 2007    Leased (4)       —

1221 Portertown Rd.

Greenville, NC

   July 2007    Owned   2007

3810 S. Memorial Dr.

Winterville, NC

   July 2007    Owned   2007

1101 New Pointe Blvd.

Leland, NC

   July 2008    Owned   2008

 

(1)   Includes only facilities owned by the Bank.
(2)   Leased from the Bank’s subsidiary, ECB Realty, Inc. until February 2, 2007. ECB Realty, Inc. was merged into the Bank on that date and the Bank acquired title to the property.
(3)   Constructed by the Bank and first occupied during February 2006 to replace a facility previously leased from ECB Realty, Inc.
(4)   Leased from a third party.
(5)   Constructed by the Bank and first occupied during January 2006 to replace a facility previously leased from a third party.

 

The Bank owns a vacant property in each of Jacksonville, Wilmington, Ocean Isle, New Bern and Grandy, North Carolina, as sites for possible future branch offices.

 

All the Bank’s existing branch offices are in good condition and fully equipped for the Bank’s purposes. At December 31, 2009, our consolidated investment in premises and banking equipment (cost less accumulated depreciation) was approximately $25.3 million.

 

Item 3.    Legal Proceedings

 

 

From time to time we may become involved in legal proceedings in the ordinary course of our business. However, subject to the uncertainties inherent in any litigation, we believe that, at December 31, 2009 there was no pending or threatened proceedings that are likely to result in a material adverse change in our financial condition or operating results.

 

Item 4.    (Removed and Reserved)

 

 

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PART II

 

Item 5.    Market for Registrant’s Common Equity; Related Stockholder Matters and Issuer Purchases of Equity Securities

 

 

Our common stock is listed on The NASDAQ Global Market under the trading symbol “ECBE.” The following table lists the high and low sales prices for our common stock as reported by The Nasdaq Stock Market, and cash dividends declared on our common stock, for the periods indicated.

 

     Sales Price Range    Cash Dividend
Declared Per Share

Quarter

   High    Low   

2009 Fourth

   $ 17.21    $ 11.11    $ 0.1825

Third

     19.89      15.56      0.1825

Second

     21.18      15.30      0.1825

First

     17.75      13.52      0.1825

2008 Fourth

   $ 23.50    $ 14.30    $ 0.1825

Third

     25.01      20.29      0.1825

Second

     27.49      23.00      0.1825

First

     27.00      22.00      0.1825

 

On March 6, 2010, there were approximately 656 record holders of our common stock. We believe the number of beneficial owners of our common stock is greater than the number of record holders because a large amount of our common stock is held of record through brokerage firms in “street name.”

 

Under North Carolina law, we are authorized to pay dividends as declared by our Board of Directors, provided that no such distribution results in our insolvency on a going concern or balance sheet basis. We have paid cash dividends since we were incorporated during 1998, and we intend to continue to pay dividends on a quarterly basis. However, although we are a legal entity separate and distinct from the Bank, our principal source of funds with which we can pay dividends to our shareholders is dividends we receive from the Bank. For that reason, our ability to pay dividends effectively is subject to the limitations that apply to the Bank.

 

In general, the Bank may pay dividends only from its undivided profits. However, if its surplus is less than 50% of its paid-in capital stock, the Bank’s directors may not declare any cash dividend until it has transferred to surplus 25% of its undivided profits or any lesser percentage necessary to raise its surplus to an amount equal to 50% of its paid-in capital stock. The Bank’s ability to pay dividends to us is subject to other regulatory restrictions. (See “Supervision and Regulation—Dividends” under Item 1. Business.)

 

Our sale of Series A Preferred Stock to the U.S. Treasury during January 2009 under the TARP Capital Purchase Program resulted in additional restrictions on our ability to pay dividends on our common stock and to repurchase shares of our common stock. Unless all accrued dividends on the Series A Preferred Stock have been paid in full, (1) no dividends may be declared or paid on our common stock, and (2) we may not repurchase any of our outstanding common stock. Additionally, until January 16, 2012, we are required to obtain the consent of the U.S. Treasury in order to declare or pay any dividend or make any distribution on our common stock other than regular quarterly cash dividends of not more than $0.1825 per share, or, subject to certain exceptions, repurchase shares of our common stock unless we have redeemed all of the Series A Preferred Stock or the U.S. Treasury has transferred all of those shares to third parties.

 

In the future, in addition to the restrictions discussed above, our ability to declare and pay cash dividends on our common stock will be subject to evaluation by our Board of Directors of our and the Bank’s operating results, capital levels, financial condition, future growth plans, general business and economic conditions, and other relevant considerations. We cannot assure you that we will continue to pay cash dividends on any particular schedule or that we will not reduce the amount of dividends we pay in the future.

 

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The following information is being furnished for purposes of Rule 14a-3. It is not deemed to be filed with

the Securities and Exchange Commission or to be incorporated by reference into any filing under

the Securities Act of 1933 or the Securities Exchange Act of 1934, except to the extent

that we specifically incorporate it by reference into such a filing.

 

The following graph compares the cumulative total shareholder return (CTSR) on our common stock during the previous five years with the CTSR over the same measurement period of the Nasdaq Composite index and the SNL Bank NASDAQ index. Each trend line assumes that $100 was invested on December 31, 2004, and that dividends were reinvested for additional shares.

 

LOGO

 

     Period Ending

Index

   12/31/04    12/31/05    12/31/06    12/31/07    12/31/08    12/31/09

ECB Bancorp, Inc.

   100.00    93.98    116.23    93.48    60.41    43.97

NASDAQ Composite

   100.00    101.37    111.03    121.92    72.49    104.31

SNL Bank NASDAQ Index

   100.00    96.95    108.85    85.45    62.06    50.34

 

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Item 6.    Selected Financial Data

 

 

The following table contains summary historical consolidated financial information from our consolidated financial statements. You should read it in conjunction with our audited year end consolidated financial statements, including the related notes, and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” which are included elsewhere in this report.

 

     At or for the Year Ended December 31,  
     2009     2008     2007     2006     2005  
     (Dollars in thousands, except per share data)  

Income Statement Data:

          

Net interest income

   $ 26,748      $ 20,273      $ 20,357      $ 20,520      $ 18,952   

Provision for loan losses

     11,100        2,450        (99     351        757   

Non-interest income

     8,649        6,809        6,377        6,360        6,225   

Non-interest expense

     23,152        20,633        20,344        18,537        17,465   

Provision for income taxes

     (357     580        1,677        2,410        2,102   

Net income

     1,502        3,419        4,812        5,582        4,853   

Preferred stock dividend & accretion of discount

     1,003        —          —          —          —     

Net income available to common shareholders

     499        3,419        4,812        5,582        4,853   

Per Share Data and Shares Outstanding:

          

Basic net income(1)

   $ 0.18      $ 1.19      $ 1.65      $ 2.07      $ 2.41   

Diluted net income(1)

     0.18        1.18        1.65        2.05        2.37   

Cash dividends declared

     0.73        0.73        0.70        0.68        0.64   

Book value at period end

     23.62        23.89        22.88        21.64        16.94   

Weighted-average number of common shares outstanding:

          

Basic

     2,844,950        2,884,396        2,908,371        2,700,663        2,014,879   

Diluted

     2,845,966        2,889,016        2,914,352        2,724,717        2,046,129   

Shares outstanding at period end

     2,847,881        2,844,489        2,920,769        2,902,242        2,040,042   

Balance Sheet Data:

          

Total assets

   $ 888,720      $ 841,851      $ 643,889      $ 624,070      $ 547,686   

Loans receivable

     577,791        538,836        454,198        417,943        386,786   

Allowance for loan losses

     9,725        5,931        4,083        4,725        4,650   

Other interest-earning assets

     253,183        244,470        133,970        151,555        107,583   

Total deposits

     754,730        629,152        526,361        512,249        465,208   

Borrowings

     43,910        83,716        43,174        41,415        41,908   

Shareholders’ equity

     84,375        67,943        66,841        62,793        34,565   

Selected Performance Ratios:

          

Return on average assets

     0.17     0.47     0.77     0.96     0.93

Return on average shareholders’ equity

     1.74        5.14        7.48        10.13        14.56   

Net interest margin(2)

     3.41        3.12        3.72        4.01        4.16   

Efficiency ratio(3)

     63.48        73.91        73.44        67.06        67.30   

Asset Quality Ratios:

          

Nonperforming loans to period-end loans

     2.54     1.85     0.10     0.04     0.02

Allowance for loan losses to period-end loans

     1.68        1.10        0.90        1.13        1.20   

Allowance for loan losses to nonperforming loans

     66.17        59.42        876.92        2,567.93        7,153.85   

Nonperforming assets to total assets(4)

     2.27        1.63        0.08        0.07        0.01   

Net loan charge-offs to average loans outstanding

     1.30        0.12        0.13        0.01        0.08   

Capital Ratios:

          

Equity-to-assets ratio(5)

     9.49     8.07     10.38     10.06     6.31

Leverage capital ratio(6)

     9.59        8.65        10.66        12.05        8.43   

Tier 1 capital ratio(6)

     12.77        10.83        12.94        15.08        10.32   

Total capital ratio(6)

     14.02        11.80        13.72        16.04        11.36   

 

(1)   Per share amounts are computed based on the weighted-average number of shares outstanding during each period.
(2)   Net interest margin is net interest income divided by average interest earning assets, net of allowance for loan losses.
(3)   Efficiency ratio is non-interest expense divided by the sum of net interest income and non-interest income, both as calculated on a fully taxable-equivalent basis.
(4)   Nonperforming assets consist of the aggregate amount of any non-accruing loans, loans past due greater than 90 days and still accruing interest, restructured loans, repossessions and foreclosed assets on each date.
(5)   Equity-to-assets ratios are computed based on total shareholders’ equity and total assets at each period end.
(6)   These ratios are described in Item 1 under the captions “Supervision and Regulation—Capital Adequacy” and “—Prompt Corrective Action.”

 

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

 

 

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

 

Executive Summary

 

ECB Bancorp, Inc. is a bank holding company headquartered in Engelhard, North Carolina. Our wholly-owned subsidiary, The East Carolina Bank (the “Bank”), is a state-chartered community bank that was founded in 1919. For the purpose of this discussion, “we,” “us” and “our” refers to the Bank and the bank holding company as a single, consolidated entity unless the context otherwise indicates.

 

Our consolidated assets increased 5.6% to $888.7 million on December 31, 2009, from $841.9 million at year-end 2008. Our loan portfolio increased 7.2% to $577.8 million at December 31, 2009, from loans of $538.8 million at year-end 2008 while deposits increased 19.9% to $754.7 million at year-end 2009 from $629.2 million at year-end 2008. Total shareholders’ equity was approximately $84.4 million at year-end 2009.

 

In 2009, our income available to common shareholders was $499 thousand or $0.18 basic and $0.18 diluted earnings per share, compared to income available to common shareholders of $3.4 million or $1.19 basic and $1.18 diluted earnings per share for the year ended December 31, 2008. The 2009 income available to common shareholders represents a decrease of $2.9 million over reported 2008 income available to common shareholders mainly due to an increase in provision for loan loss expense.

 

Critical Accounting Policies

 

Our significant accounting policies are set forth in Note 1 to our audited consolidated financial statements included in Item 8 of this report. Of these significant accounting policies, we consider our policy regarding the allowance for loan losses to be our most critical accounting policy, because it requires management’s most subjective and complex judgments. In addition, changes in economic conditions can have a significant impact on the allowance for loan losses and, therefore, the provision for loan losses and results of operations. We have developed policies and procedures for assessing the adequacy of the allowance for loan losses, recognizing that this process requires a number of assumptions and estimates with respect to our loan portfolio. Our assessments may be impacted in future periods by changes in economic conditions, the results of regulatory examinations, and the discovery of information with respect to borrowers that is not currently known to management. For additional discussion concerning our allowance for loan losses and related matters, see “—Allowance for Loan Losses” and “—Nonperforming Assets and Past Due Loans.”

 

We also consider our determination of retirement plans and other postretirement benefit plans to be a critical accounting estimate as it requires the use of estimates and judgments related to the amount and timing of expected future cash out-flows for benefit payments and cash in-flows for maturities and return on plan assets. Our retirement plans and other postretirement benefit plans are actuarially determined based on assumptions on the discount rate, estimated future return on plan assets and the health care cost trend rate. Changes in estimates and assumptions related to mortality rates and future health care costs could have a material impact to our financial condition or results of operations. The discount rate is used to determine the present value of future benefit obligations and the net periodic benefit cost. The discount rate used to value the future benefit obligation as of each year-end is the rate used to determine the periodic benefit cost in the following year. For additional discussion concerning our retirement plans and other postretirement benefits refer to Note 8 of our consolidated financial statements.

 

Results of Operations for the Years Ended December 31, 2009, 2008 and 2007

 

In 2009, our income available to common shareholders was $499 thousand or $0.18 basic and $0.18 diluted earnings per share, compared to income available to common shareholders of $3.4 million or $1.19 basic and $1.18 diluted earnings per share for the year ended December 31, 2008. The decrease in earnings is primarily due to an increase in provision for loan loss expense.

 

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The following table shows return on assets (net income divided by average assets), return on equity (net income divided by average shareholders’ equity), dividend payout ratio (dividends declared per share divided by net income per share) and shareholders’ equity to assets ratio (average shareholders’ equity divided by average total assets) for each of the years presented.

 

     Year Ended December 31,  
     2009     2008     2007  

Return on assets

   0.17   0.47   0.77

Return on equity

   1.74      5.14      7.48   

Dividend payout

   405.56      61.34      42.42   

Shareholders’ equity to assets

   9.98      9.13      10.34   

 

Our core strategies continue to be: (1) grow the loan portfolio while maintaining high asset quality; (2) grow core deposits; (3) increase non-interest income; (4) control expenses; and (5) make strategic investments in new and existing communities that will result in increased shareholder value. We continued to make strategic investments in our future as we began construction on one branch that is scheduled to open in 2010.

 

Net Interest Income

 

Net interest income (the difference between the interest earned on assets, such as loans and investment securities and the interest paid on liabilities, such as deposits and other borrowings) is our primary source of operating income. The level of net interest income is determined primarily by the average balances (volume) of interest-earning assets and our interest-bearing liabilities and the various rate spreads between our interest-earning assets and interest-bearing liabilities. Changes in net interest income from period to period result from increases or decreases in the volume of interest-earning assets and interest-bearing liabilities, increases or decreases in the average interest rates earned and paid on such assets and liabilities, the ability to manage the interest-earning asset portfolio, and the availability of particular sources of funds, such as non-interest-bearing deposits.

 

The banking industry uses two key ratios to measure profitability of net interest income: net interest rate spread and net interest margin. The net interest rate spread measures the difference between the average yield on earning assets and the average rate paid on interest-bearing liabilities. The net interest rate spread does not consider the impact of non-interest-bearing deposits and gives a direct perspective on the effect of market interest rate movements. The net interest margin is defined as net interest income as a percentage of total average earning assets and takes into account the positive effects of investing non-interest-bearing deposits in earning assets.

 

Our net interest income for the year ended December 31, 2009 was $26.7 million, an increase of $6.4 or 31.5% when compared to net interest income of $20.3 million for the year ended December 31, 2008. Our net interest margin, on a tax-equivalent basis, for 2009 was 3.41% compared to 3.12% for 2008. The increase in our net interest margin is mainly the result of decreased rates paid on our interest bearing liabilities. Our net interest rate spread, on a tax-equivalent basis, for 2009 was 3.09% compared to 2.60% for 2008. The spread increased by forty-nine basis points as the decrease in the rates paid on interest-bearing liabilities was forty-nine basis points more than the change in yields earned on interest-earning assets for the year.

 

Total interest income increased $1.8 million or 4.6% to $40.9 million in 2009 compared to $39.1 million in interest income in 2008. Increases in our average earning assets of $135.4 million in 2009 when compared to 2008 resulted in $7.0 million increase in interest income from 2008 to 2009 but this was partially offset by a decrease in interest income of $5.2 million from a decline in yields. We funded the increases in interest-earning assets primarily with certificates of deposit. The tax equivalent yield on average earning assets decreased 77 basis points during 2009.

 

The effect of variances in volume and rate on interest income and interest expense is illustrated in the table titled “Change in Interest Income and Expense on Tax Equivalent Basis.” We attribute the decrease in the yield on our earning assets to the drop in short-term market interest rates. During 2008, the Federal Open Market Committee (“FOMC”) decreased short-term rates 325 to 350 basis points from 3.50% to a range of 0.00% to 0.25%. Approximately $346.4 million or 60.0% of our loan portfolio consists of variable rate loans that adjust with the movement of the prime rate. As a result, composite yield on our loans decreased approximately 72 basis points for the year ended December 31, 2009 compared to December 31, 2008.

 

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Similarly, our average cost of funds for 2009 was 2.07%, a decrease of 126 basis points when compared to 3.33% for 2008. The average cost on Bank certificates of deposit decreased 155 basis points from 4.09% paid in 2008 to 2.54% paid in 2009, while our average cost of borrowed funds decreased 173 basis points during 2009 compared to 2008.

 

Total interest expense decreased $4.6 million or 24.5% to $14.2 million in 2009 from $18.8 million in 2008, primarily the result of decreased market rates paid on Bank certificates of deposit. The volume of average interest-bearing liabilities increased approximately $117.8 million when comparing 2009 with that of 2008. The decrease to interest expense resulting from decreased rates on all interest-bearing liabilities was $7.9 million and the increase attributable to higher volumes of interest-bearing liabilities was $3.2 million.

 

Our net interest income for the year ended December 31, 2008 was $20.3 million, a decrease of $0.1 million or 0.5% when compared to net interest income of $20.4 million for the year ended December 31, 2007. Our net interest margin, on a tax-equivalent basis, for 2008 was 3.12% compared to 3.72% for 2007. The decreased net interest margin resulted from increased competitive pricing for money market accounts and certificates of deposits. Our net interest rate spread, on a tax-equivalent basis, for 2008 was 2.60% compared to 2.91% for 2007. As a result of interest rate cuts by the Federal Reserve loan rates decreased more than rates paid on our interest-bearing liabilities. The spread decreased by thirty-one basis points as the change in the rates paid on interest-bearing liabilities was thirty-one basis points less than the change in yields earned on interest-earning assets for the year.

 

Total interest income decreased $0.7 million or 1.8% to $39.1 million in 2008 compared to $39.8 million in interest income in 2007. Increases in our average earning assets of $106.5 million in 2008 when compared to 2007 resulted in $6.8 million increase in interest income from 2007 to 2008 but this was offset by a decrease in interest income of $7.4 million from a decline in yields. We funded the increases in interest-earning assets primarily with certificates of deposit and Federal Home Loan Bank advances. The tax equivalent yield on average earning assets decreased 123 basis points during 2008.

 

Similarly, our average cost of funds for 2008 was 3.33%, a decrease of 92 basis points when compared to 4.25% for 2007. The average cost on Bank certificates of deposit decreased 93 basis points from 5.02% paid in 2007 to 4.09% paid in 2008, while our average cost of borrowed funds decreased 245 basis points during 2008 compared to 2007. Part of the borrowing cost decrease was because on June 26, 2007, we redeemed all of our higher cost trust preferred securities ($10.3 million), originally issued June 26, 2002 which bore an interest rate of 3.45% over the three month LIBOR rate, with lower cost funding sources.

 

Total interest expense decreased $610 thousand or 3.1% to $18.8 million in 2008 from $19.4 million in 2007, primarily the result of decreased market rates paid on Bank certificates of deposit. The volume of average interest-bearing liabilities increased approximately $107.1 million when comparing 2008 with that of 2007. The decrease to interest expense resulting from decreased rates on all interest-bearing liabilities was $4.3 million and the increase attributable to higher volumes of interest-bearing liabilities was $3.7 million.

 

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The following table presents an analysis of average interest-earning assets and interest-bearing liabilities, the interest income or expense applicable to each asset or liability category and the resulting yield or rate paid.

 

Average Consolidated Balances and Net Interest Income Analysis

 

    Year Ended December 31,
    2009   2008   2007
    Average
Balance
  Yield/
Rate
    Income/
Expense
  Average
Balance
  Yield/
Rate
    Income/
Expense
  Average
Balances
  Yield/
Rate
    Income/
Expense
    (Dollars in thousands)

Assets:

                 

Loans—net(1)

  $ 556,017   5.50   $ 30,595   $ 499,771   6.22   $ 31,104   $ 426,965   7.85   $ 33,497

Taxable securities

    201,676   4.41        8,901     125,985   5.11        6,432     95,325   4.74        4,521

Nontaxable securities(2)

    36,743   5.80        2,130     34,733   5.69        1,977     33,101   5.61        1,856

Other investments(3)

    11,705   0.03        3     10,279   2.50        257     8,859   6.20        549
                                                     

Total interest-earning assets

    806,141   5.16        41,629     670,768   5.93        39,770     564,250   7.16        40,423

Cash and due from banks

    10,999         12,663         14,877    

Bank premises and equipment, net

    25,506         25,255         24,391    

Other assets

    23,745         19,407         18,396    
                             

Total assets

  $ 866,391       $ 728,093       $ 621,914    
                             

Liabilities and Shareholders’ Equity:

                 

Interest-bearing deposits

  $ 607,880   2.13   $ 12,958   $ 488,309   3.33   $ 16,276   $ 417,675   4.10   $ 17,129

Short-term borrowings(4)

    52,293   0.94        492     55,131   3.44        1,895     39,818   5.79        2,306

Long-term obligations

    22,219   3.18     707     21,120   3.10     654     —     —          —  
                                                     

Total interest-bearing liabilities

    682,392   2.07        14,157     564,560   3.33        18,825     457,493   4.25        19,435

Non-interest-bearing deposits

    90,732         90,031         94,397    

Other liabilities

    6,783         7,037         5,712    

Shareholders’ equity

    86,484         66,465         64,312    
                             

Total liabilities and shareholders’ equity

  $ 866,391       $ 728,093       $ 621,914    
                             

Net interest income and net interest margin (FTE)(5)

    3.41   $ 27,472     3.12   $ 20,945     3.72   $ 20,988
                                         

Net interest rate spread (FTE)(6)

    3.09       2.60       2.91  
                             

 

(1)   Average loans include non accruing loans, net of allowance for loan losses. Amortization of deferred loan fees of $9 thousand, $5 thousand, and $813 thousand for 2009, 2008, and 2007, respectively, are included in interest income.
(2)   Yields on tax-exempt investments have been adjusted to a fully taxable-equivalent basis (FTE) using the federal income tax rate of 34%. The taxable equivalent adjustment was $724 thousand, $672 thousand, and $631 thousand for the years 2009, 2008, and 2007, respectively.
(3)   Other investments include federal funds sold and interest-bearing deposits with banks and other institutions.
(4)   For 2008, expense includes $ 350 thousand for interest on taxes.
(5)   Net interest margin is computed by dividing net interest income by total average earning assets, net of the allowance for loan losses.
(6)   Net interest rate spread equals the earning asset yield minus the interest-bearing liability rate.

 

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The following table presents the relative impact on net interest income of the volume of earning assets and interest- bearing liabilities and the rates earned and paid by us on such assets and liabilities. Variances resulting from a combination of changes in rate and volume are allocated in proportion to the absolute dollar amount of the change in each category.

 

Change in Interest Income and Expense on Tax Equivalent Basis

 

     2009 Compared to 2008     2008 Compared to 2007  
     Volume(1)     Rate(1)     Net     Volume(1)    Rate(1)     Net  
     (Dollars in thousands)  

Loans(2)

   $ 3,298      $ (3,807   $ (509   $ 5,122    $ (7,515   $ (2,393

Taxable securities

     3,602        (1,133     2,469        1,510      401        1,911   

Nontaxable securities(3)

     115        38        153        92      29        121   

Other investments

     18        (272     (254     62      (354     (292
                                               

Interest income

     7,033        (5,174     1,859        6,786      (7,439     (653
                                               

Interest-bearing deposits

     3,267        (6,585     (3,318     2,626      (3,479     (853

Short-term borrowings

     (62     (1,341     (1,403     707      (1,118     (411

Long-term obligations

     35        18        53        327      327        654   
                                               

Interest expense

     3,240        (7,908     (4,668     3,660      (4,270     (610
                                               

Net interest income

   $ 3,793      $ 2,734      $ 6,527      $ 3,126    $ (3,169   $ (43
                                               

 

(1)   The combined rate/volume variance for each category has been allocated equally between rate and volume variances.
(2)   Income on non-accrual loans is included only to the extent that it represents interest payments received.
(3)   Yields on tax-exempt investments have been adjusted to a fully taxable-equivalent basis (FTE) using the federal income tax rate of 34%. The taxable equivalent adjustment was $724 thousand, $672 thousand, and $631 thousand for the years 2009, 2008, and 2007, respectively.

 

Rate Sensitivity Management

 

Rate sensitivity management, an important aspect of achieving satisfactory levels of net interest income, is the management of the composition and maturities of rate-sensitive assets and liabilities. The following table sets forth our interest sensitivity analysis at December 31, 2009 and describes, at various cumulative maturity intervals, the gap-ratios (ratios of rate-sensitive assets to rate-sensitive liabilities) for assets and liabilities that we consider to be rate sensitive. The interest-sensitivity position has meaning only as of the date for which it was prepared. Variable rate loans are considered to be highly sensitive to rate changes and are assumed to reprice within 12 months.

 

The difference between interest-sensitive asset and interest-sensitive liability repricing within time periods is referred to as the interest-rate-sensitivity gap. Gaps are identified as either positive (interest-sensitive assets in excess of interest-sensitive liabilities) or negative (interest-sensitive liabilities in excess of interest-sensitive assets).

 

As of December 31, 2009, we had a negative one-year cumulative gap of 19.2%. We have interest-earning assets of $422.2 million maturing or repricing within one year and interest-bearing liabilities of $581.8 million repricing or maturing within one year. This is primarily the result of short-term interest sensitive liabilities being used to fund longer term interest-earning assets, such as loans and investment securities. A negative gap position implies that interest-bearing liabilities (deposits and other borrowings) will reprice at a faster rate than interest-earning assets (loans and investments). In a falling rate environment, a negative gap position will generally have a positive effect on earnings, while in a rising rate environment this will generally have a negative effect on earnings.

 

On December 31, 2009, our savings and core time deposits of $462.9 million included savings, NOW and Money Market accounts of $161.6 million. In our rate sensitivity analysis, these deposits are considered as repricing in the earliest period (3 months or less) because the rate we pay on these interest-bearing deposits can be changed weekly. However, our historical experience has shown that changes in market interest rates have little, if any, effect on those deposits within a given time period and, for that reason, those liabilities could be considered non-rate sensitive. If those deposits were excluded from rate sensitive liabilities, our rate sensitive assets and liabilities would be more closely matched at the end of the one-year period.

 

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Rate Sensitivity Analysis as of December 31, 2009

 

     3 Months
Or Less
    4-12
Months
    Total
Within 12
Months
    Over 12
Months
    Total  
     (Dollars in thousands)  

Earning assets:

          

Loans—gross

   $ 353,594      $ 40,482      $ 394,076      $ 183,715      $ 577,791   

Investment securities

     13,917        378        14,295        225,037        239,332   

Interest bearing deposits

     870        —          870        —          870   

Federal funds sold

     7,865        —          7,865        —          7,865   

FHLB stock

     5,116        —          5,116        —          5,116   
                                        

Total earning assets

     381,362        40,860        422,222        408,752        830,974   
                                        

Percent of total earnings assets

     45.9     4.9     50.8     49.2     100.0

Cumulative percentage of total earning assets

     45.9        50.8        50.8        100.0     

Interest-bearing liabilities:

          

Savings, NOW and Money Market deposits

     161,551        —          161,551        —          161,551   

Time deposits of $100,000 or more

     84,455        88,701        173,156        25,232        198,388   

Other time deposits

     46,003        178,216        224,219        77,080        301,299   

Short-term borrowings

     22,910        —          22,910        —          22,910   

Long-term obligations

     —          —          —          21,000        21,000   
                                        

Total interest-bearing liabilities

   $ 314,919      $ 266,917      $ 581,836      $ 123,312      $ 705,148   
                                        

Percent of total interest-bearing liabilities

     44.7     37.8     82.5     17.5     100.0

Cumulative percent of total interest-bearing liabilities

     44.7        82.5        82.5        100.0     

Ratios:

          

Ratio of earning assets to interest-bearing liabilities (gap ratio)

     121.1     15.3     72.6     333.5     117.8

Cumulative ratio of earning assets to interest-bearing liabilities (cumulative gap ratio)

     121.1     72.6     72.6     117.8  

Interest sensitivity gap

   $ 66,443      $ (226,057   $ (159,614   $ 285,440      $ 125,826   

Cumulative interest sensitivity gap

     66,443        (159,614     (159,614     125,826        125,826   

As a percent of total earnings assets

     8.0     (19.2 )%      (19.2 )%      15.1     15.1

 

As of December 31, 2009, approximately 50.8% of our interest-earning assets could be repriced within one year and approximately 70.0% of interest-earning assets could be repriced within five years. Approximately 82.5% of interest-bearing liabilities could be repriced within one year and 100.0% could be repriced within five years.

 

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Market Risk

 

Our primary market risk is interest rate risk. Interest rate risk results from differing maturities or repricing intervals of interest-earning assets and interest-bearing liabilities and the fact that rates on these financial instruments do not change uniformly. These conditions may impact the earnings generated by our interest-earning assets or the cost of our interest-bearing liabilities, thus directly impacting our overall earnings.

 

We actively monitor and manage interest rate risk. One way this is accomplished is through the development of and adherence to our asset/liability policy. This policy sets forth our strategy for matching the risk characteristics of interest-earning assets and interest-bearing liabilities so as to mitigate the effect of changes in the rate environment.

 

Market Risk Analysis

 

    Principal Maturing in Years Ended December 31,
    2010     2011     2012     2013     2014     Thereafter     Total     Fair
Value
    (Dollars in thousands)

Assets:

               

Loans, gross:

               

Fixed rate

  $ 47,650      $ 49,407      $ 43,830      $ 38,317      $ 12,963      $ 39,198      $ 231,365      $ 231,256

Average rate (%)

    6.87     6.57     6.92     6.57     7.01     5.81     6.59  

Variable rate

    125,424        29,160        34,803        47,241        62,080        47,718        346,426        343,647

Average rate (%)

    4.89        4.89        4.98        4.37        4.89        3.93        4.70     

Investment securities:

               

Fixed rate

    870        979        2,293        1,514        9,371        207,336        222,363        223,963

Average rate (%)

    7.26        6.50        5.37        5.45        3.28        4.60        4.57     

Variable rate

    —          —          —          —          —          15,231        15,231        15,369

Average rate (%)

    —          —          —          —          —          2.72        2.72     

Interest-bearing deposits:

               

Variable rate

    870        —          —          —          —          —          870        870

Average rate (%)

    0.01        —          —          —          —          —          0.01     

Liabilities:

               

Savings and interest- bearing checking:

               

Variable rate

    161,551        —          —          —          —          —          161,551        161,551

Average rate (%)

    0.69                  0.69     

Certificate of deposit:

               

Fixed rate

    396,598        61,775        28,347        457        11,733        —          498,910        503,827

Average rate (%)

    1.92        2.53        2.92        2.50        3.10       —          2.08     

Variable rate

    777        —          —          —          —          —          777        777

Average rate (%)

    0.50                  0.50     

Short-term borrowings:

               

Fixed rate

    20,000        —          —          —          —          —          20,000        20,000

Average rate (%)

    0.81                  0.81     

Variable rate

    2,910        —          —          —          —          —          2,910        2,910

Average rate (%)

    1.00               1.00     

Long-term borrowings:

               

Fixed rate

    21,000        —          —          —          —          —          21,000        21,210

Average rate (%)

    3.22                  3.22     

 

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Non-interest Income

 

Non-interest income, principally charges and fees assessed for the use of our services, is a significant contributor to net income. The following table presents the components of non-interest income for 2009, 2008 and 2007.

 

Non-interest Income

 

     Year Ended December 31,  
     2009    2008    2007  
     (Dollars in thousands)  

Service charges on deposit accounts

   $ 3,652    $ 3,500    $ 3,219   

Other service charges and fees

     1,160      1,367      1,508   

Mortgage origination brokerage fees

     950      1,035      1,091   

Net gain (loss) on sale of securities

     2,565      218      (161

Income from bank owned life insurance

     310      316      289   

Other operating income

     12      373      431   
                      

Total non-interest income

   $ 8,649    $ 6,809    $ 6,377   
                      

 

Non-interest income increased $1.8 million or 26.4% to $8.6 million compared to $6.8 million for the same period in 2008. The increase in non-interest income for the year ending December 31, 2009 is primarily the result of $2.6 million in gains on the sale of securities compared to $218 thousand for the same period in 2008. Service charges on deposit accounts were up by $152 thousand or 4.3% as we saw an increase in cardholder fees. Other service charges and fees decreased $207 thousand or 15.1% in 2009 compared to the prior year mainly due to decreased investment brokerage fees of $105 thousand. Mortgage origination brokerage fees decreased $85 thousand or 8.2% over 2008. Other operating income decreased $361 thousand in 2009 compared to the prior year. The main reason for this decrease is that 2008 included a nonrecurring Visa distribution in the amount of $386 thousand.

 

Non-interest income increased $432 thousand or 6.8% to $6.8 million in 2008 compared to $6.4 million for the same period in 2007. The increase in non-interest income was primarily the result of an income distribution from Visa International’s initial public offering in the amount of $386 thousand. As a member bank of Visa, we received the proceeds for the redemption of approximately 9 thousand shares of class B common stock. The increase in non-interest income also included a net gain on sale of securities of $218 thousand in 2008 compared to a net loss of $161 thousand in 2007. Non-interest income in 2007 included nonrecurring income from the recapture of $240 thousand relating to the allowance for losses on unfunded loan commitments. Other service charges and fees decreased $141 thousand or 9.4% in 2008 compared to the prior year mainly due to decreased investment brokerage fees of $163 thousand. Service charges on deposit accounts were up by $281 thousand or 8.7% as we saw an increase in overdraft protection fees. Mortgage origination brokerage fees decreased $56 thousand or 5.1% over 2007.

 

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Non-interest Expense

 

Non-interest expense increased $2.6 million or 12.6% to $23.2 million in 2009 compared to $20.6 million in 2008 and non-interest expense increased $289 thousand or 1.4% in 2008 compared to $20.3 million in 2007. The following table presents the components of non-interest expense for 2009, 2008 and 2007.

 

Non-interest Expense

 

     Year Ended December 31,
     2009    2008    2007
     (Dollars in thousands)

Salaries

   $ 8,287    $ 8,161    $ 8,431

Retirement and other employee benefits

     2,488      2,706      2,503

Occupancy

     1,832      1,857      1,788

Equipment

     1,763      1,638      1,885

Professional fees

     832      717      673

Supplies

     216      312      432

Telephone

     642      679      563

FDIC Insurance

     1,689      384      62

Net cost of real estate and repossessions acquired in settlement of loans

     1,345      145      48

Other outside services

     470      482      445

Other

     3,588      3,552      3,514
                    

Total

   $ 23,152    $ 20,633    $ 20,344
                    

 

Expenses for salaries and benefits decreased 0.8% and 0.6% for the years ended December 31, 2009 and December 31, 2008, respectively. Salaries and benefits increased 6.5% for the year ended December 31, 2007. The decrease in salary and benefit expenses in 2009 compared to 2008 is due to a decrease of $304 thousand in supplemental employee retirement plan expense. The decrease in 2008 is related to deferred loan origination expense. Prior to this salary and benefits increased $589 thousand or 5.35% in 2008 compared to 2007. This increase along with the increase in 2007 is related to staff additions to accommodate our growth and additional branches. As of December 31, 2009, we had 222 employees and operated 24 full service banking offices, a loan production office and a mortgage loan origination office.

 

Salary expense increased $126 thousand or 1.5% in 2009 compared to 2008. The increase is the result of general cost of living and merit increases. Employee benefits decreased $218 thousand or 8.1% in 2009 over the prior year principally due a decrease in supplemental employee retirement plan expense and a decrease in employee incentive expense.

 

Equipment expense increased $124 thousand or 7.6% in 2009 mainly due to maintenance expense increasing $73 thousand and depreciation expense increasing $34 thousand.

 

Professional fees, which include audit, legal and consulting fees, increased $115 thousand or 16.0% to $832 thousand for 2009 compared to $717 thousand in 2008. Legal fees remained relatively flat only increasing $4 thousand year over year. Consulting fees increased $33 thousand in 2009 compared to 2008 mainly the result of fees associated with the search for our new president and CEO. Audit fees increased $36 thousand during 2009 as compared to 2008 due to fees associated with an IRS audit and various fees associated with other consultations.

 

Supplies expense decreased $96 thousand in 2009 compared to same period of 2008 primarily the result of decreases at our bankcard center and at our corporate office.

 

FDIC insurance increased $1.3 million in 2009 due to increased assessment rates and an increase in our deposit balances. Also, $405 thousand of the increase is related to the special assessment that was levied on all banks by the FDIC.

 

Net cost of real estate and repossessions acquired in settlement of loans expense increased $1.2 million to $1.3 million in 2009 compared to $145 thousand in 2008. The majority of this expense is related to the disposition of collateral on two large real estate loans.

 

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Salary expense decreased $270 thousand or 3.2% in 2008 compared to 2007. Prior to deferring loan origination costs, salary expense increased $387 thousand or 4.4% as we opened one new branch in 2008 and had full years of expenses for three branches that opened mid year 2007. Employee benefits increased $203 thousand or 8.1% in 2008 over the prior year principally due to health insurance increases of $210 thousand and $68 thousand in expense related to split-dollar life insurance arrangements due to a change in accounting standards related to postretirement benefits.

 

Occupancy expense increased $69 thousand or 3.9% in 2008 as we opened an additional branch in 2008. Also, branches opened in 2007 impacted expenses for a full year in 2008 compared to only a partial year in 2007.

 

Professional fees, which include audit, legal and consulting fees, increased $44 thousand or 6.5% to $717 thousand for 2008 compared to $673 thousand in 2007. The main reason for the increase was an increase in legal fees of $138 thousand during 2008 compared to 2007 primarily the result of increased general corporate reporting and disclosure matters. The increase was offset by a reduction in consulting fees as our human resource department incurred fees of $76 thousand in 2007 that did not recur in 2008. Audit fees increased approximately $12 thousand in 2008 compared to 2007 mainly the result of fees associated with an IRS audit.

 

Supplies expense decreased $120 thousand in 2008 compared to same period of 2007 primarily the result of outsourcing our item processing in 2007 which required us to purchase various new forms and documents.

 

FDIC deposit insurance increased $322 thousand or 519% for 2008 compared to 2007. The primary reason for this increase was that the FDIC began assessing deposit insurance fees again in 2007 but allowed eligible institutions to use a one time credit towards the assessment. The one time credit covered a large portion of our FDIC expense in 2007.

 

Income Taxes

 

For the year-ended December 31, 2009, we recorded income tax benefit of $357 thousand, compared to expenses of $580 thousand and $1.7 million for the year-ended December 31, 2008 and 2007, respectively. Our effective tax rate for the years ended December 31, 2009, 2008 and 2007 was (31.2%), 14.5% and 25.8%, respectively.

 

Our effective tax rate for 2008 was lower due to the recognition of a tax benefit associated with the reduction of the valuation allowance on a deferred tax asset and a higher ratio of tax-exempt to taxable income compared to 2007. The valuation allowance for deferred tax assets was $43 thousand for December 31, 2009, $105 thousand for December 31, 2008 and $335 for December 31, 2007. The valuation allowance was for certain capital losses related to perpetual preferred stock issued by FNMA and FHLMC. These losses are capital in character and we may not have current capital gain capacity to offset these losses. The effective tax rate in 2009, 2008 and 2007 also differs from the federal statutory rate of 34.0% primarily due to tax-exempt interest income we earned on tax-exempt securities in our investment portfolio. For more information see disclosure on income taxes in note 6.

 

Financial Condition at December 31, 2009, 2008 and 2007

 

Our total assets were $888.7 million at December 31, 2009, $841.9 million at December 31, 2008 and $643.9 million at December 31, 2007. Asset growth during 2009 was funded primarily by an increase in time deposits of $76.6 million and an increase in interest bearing demand accounts of $42.9 million. For the years ended December 31, 2009 and 2008, we grew our loans $39.0 million and $84.6 million, respectively, due to favorable loan demand in our market areas and our addition of new branches during 2007 and 2008. For the years ended December 31, 2009 and 2008, we grew our deposits $125.6 million and $102.8 million, respectively, mainly through wholesale certificates of deposit, the proceeds of which were invested in interest-earning assets.

 

We believe our financial condition is sound. The following discussion focuses on the factors considered by us to be important in assessing our financial condition.

 

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The following table sets forth the relative composition of our balance sheets at December 31, 2009, 2008 and 2007.

 

Distribution of Assets and Liabilities

 

     December 31,  
     2009     2008     2007  
     (Dollars in thousands)  

Assets:

            

Loan, gross

   $ 577,791      65.0   $ 538,836      64.0   $ 454,198      70.5

Investment securities

     239,332      26.9        239,709      28.4        125,888      19.6   

Interest-bearing deposits

     870      0.1        902      0.1        925      0.1   

FHLB stock

     5,116      0.6        3,859      0.5        2,382      0.4   

Federal funds sold

     7,865     0.9        —        0.0        4,775      0.7   
                                          

Total earning assets

     830,974      93.5        783,306      93.0        588,168      91.3   

Allowance for loan losses

     (9,725   (1.1     (5,931   (0.7     (4,083   (0.6

Non-interest-bearing deposits and cash

     9,076      1.0        15,897      1.9        16,303      2.5   

Bank premises and equipment, net

     25,329      2.9        25,737      3.1        24,450      3.8   

Other assets

     33,066      3.7        22,842      2.7        19,051      3.0   
                                          

Total assets

   $ 888,720      100.0   $ 841,851      100.0   $ 643,889      100.0
                                          

Liabilities and Shareholders’ Equity:

            

Demand deposits

   $ 93,492      10.5   $ 90,197      10.7   $ 95,596      14.9

Savings, NOW and Money Market deposits

     161,551      18.2        115,893      13.8        121,839      18.9   

Time deposits of $100,000 or more

     198,388      22.3        224,185      26.6        162,276      25.2   

Other time deposits

     301,299      33.9        198,877      23.6        146,650      22.8   
                                          

Total deposits

     754,730      84.9        629,152      74.7        526,361      81.8   

Short-term borrowings

     22,910      2.6        57,716      6.8        43,174      6.7   

Long-term obligations

     21,000      2.4        26,000      3.1        —        0.0   

Accrued interest and other liabilities

     5,705      0.6        61,040      7.3        7,513      1.1   
                                          

Total liabilities

     804,345      90.5        773,908      91.9        577,048      89.6   

Shareholders’ equity

     84,375      9.5        67,943      8.1        66,841      10.4   
                                          

Total liabilities and share-holders’ equity

   $ 888,720      100.0   $ 841,851      100.0   $ 643,889      100.0
                                          

 

Loans

 

As of December 31, 2009, total loans increased to $577.8 million, up 7.2% from total loans of $538.8 million at December 31, 2008. Construction and land development loans decreased from $132.5 million in 2008 to $125.9 million in 2009. The decrease in construction and development loans was a function of the declining economic conditions during the past two years. Commercial and residential real estate loans increased from $299.0 million in 2008 to $335.0 million in 2009. The growth in residential and commercial real estate loans was due to the growth in branches and a focus on growth by the bank in owner-occupied small business lending during the year.

 

As of December 31, 2008, total loans increased to $538.8 million, up 18.6% from total loans of $454.2 million at December 31, 2007. Loan growth for 2008 was strong partially the result of growth in the three new branches opened in 2007 and a new branch opened in 2008. Construction and land development loans increased from $104.3 million in 2007 to $132.5 million in 2008. The growth in construction and development loans was a function of that growth coupled with several larger construction/permanent loans which funded out in 2008. Commercial and residential real estate loans increased from $234.8 million in 2007 to $299.0 million in 2008. The growth in residential and commercial real estate loans was due to the growth in branches and a focus on growth by the bank in owner-occupied small business lending during the year.

 

At December 31, 2009, our loan portfolio contained no foreign loans, and we believe the portfolio is adequately diversified. Real estate loans represent approximately 79.8% of our loan portfolio. Real estate loans are primarily loans

 

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secured by real estate, including mortgage and construction loans. Residential mortgage loans accounted for approximately $110.8 million or 24.0% of our real estate loans at December 31, 2009. Commercial loans are spread throughout a variety of industries, with no particular industry or group of related industries accounting for a significant portion of the commercial loan portfolio. At December 31, 2009, our ten largest loans accounted for approximately 7.39% of our loans outstanding. As of December 31, 2009, we had outstanding loan commitments of approximately $86.7 million. The amounts of loans outstanding at the indicated dates are shown in the following table according to loan type.

 

Loan Portfolio Composition

 

     2009    2008    2007    2006    2005
     (Dollars in thousands)

Real estate—construction and land development

   $ 125,856    $ 132,525    $ 104,339    $ 116,279    $ 91,334

Real estate—commercial, residential and other(1)

     335,004      298,959      234,812      211,440      198,931

Installment loans

     4,351      5,115      5,808      6,109      8,518

Overdraft plans

     2,451      2,214      2,002      2,167      2,630

Commercial and all other loans

     110,129      100,023      107,237      81,948      85,373
                                  

Total

   $ 577,791    $ 538,836    $ 454,198    $ 417,943    $ 386,786
                                  

 

(1)   The majority of the commercial real estate is owner-occupied and operated.

 

Maturities and Sensitivities of Loans to Changes in Interest Rates

 

The following table sets forth the maturity distribution of our loans as of December 31, 2009. A significant majority of our loans maturing after one year reprice at two and three year intervals. In addition, approximately 60.0% of our loan portfolio is comprised of variable rate loans.

 

Loan Maturities at December 31, 2009

 

     1 year
or less
   Due after 1 year
through 5 years
   Due after 5 years    Total
        Floating    Fixed    Floating    Fixed   
     (Dollars in thousands)

Real estate—construction and land development

   $ 64,869    $ 34,079    $ 26,276    $ 322    $ 310    $ 125,856

Real estate—commercial, residential and other

     54,767      119,058      102,059      37,761      21,359      335,004

Installment loans

     711      30      3,220      —        390      4,351

Overdraft protection plans

     1,039      483      202      30      697      2,451

Commercial and all other loans

     51,689      26,588      18,169      2,650      11,033      110,129
                                         

Total

   $ 173,075    $ 180,238    $ 149,926    $ 40,763    $ 33,789    $ 577,791
                                         

 

Allowance for Loan Losses

 

We consider the allowance for loan losses adequate to cover estimated probable loan losses relating to the loans outstanding as of each reporting period. The procedures and methods used in the determination of the allowance necessarily rely upon various judgments and assumptions about economic conditions and other factors affecting our loans. In addition, various regulatory agencies, as an integral part of their examination process, periodically review our allowance for loan losses. Those agencies may require us to recognize adjustments to the allowance for loan losses based on their judgments about the information available to them at the time of their examinations. No assurance can be given that we will not in any particular period sustain loan losses that are sizable in relation to the amount reserved or that subsequent evaluations of the loan portfolio, in light of conditions and factors then prevailing, will not require significant changes in the allowance for loan losses or future charges to earnings.

 

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The following table summarizes the balances of loans outstanding, average loans outstanding, changes in the allowance arising from charge-offs and recoveries by category and additions to the allowance that have been charged to expense.

 

Analysis of the Allowance for Loan Losses

 

     Year ended December 31,  
     2009     2008     2007     2006     2005  
     (Dollars in thousands)  

Total loans outstanding at end of year—gross

   $ 577,791      $ 538,836      $ 454,198      $ 417,943      $ 386,786   
                                        

Average loans outstanding—gross

   $ 562,095      $ 504,426      $ 431,579      $ 409,565      $ 355,755   
                                        

Allowance for loan losses at beginning of year

   $ 5,931      $ 4,083      $ 4,725      $ 4,650      $ 4,300   
                                        

Loan charged off:

          

Real estate

     7,032        381        433        —          12   

Installment loans

     18        64        43        68        45   

Credit cards and related plans

     19        —          —          —          31   

Commercial and all other loans

     497        253        161        59        218   
                                        

Total charge-offs

     7,566        698        637        127        306   
                                        

Recoveries of loans previously charged off:

          

Real estate

     72        1        —          7        —     

Installment loans

     3        4        18        16        16   

Credit cards and related plans

     4        9        —          3        18   

Commercial and all other loans

     181        82        76        65        1   
                                        

Total recoveries

     260        96        94        91        35   
                                        

Net charge-offs

     7,306        602        543        36        271   

Provision for loan losses

     11,100        2,450        (99     351        757   

Adjustment for loans sold(1)

     —          —          —          —          (136

Adjustment for unfunded loans(2)

     —          —          —          (240     —     
                                        

Allowance for loan losses at end of year

   $ 9,725      $ 5,931      $ 4,083      $ 4,725      $ 4,650   
                                        

Ratios:

          

Net charge-offs during year to average loans outstanding

     1.30     0.12     0.13     0.01     0.08

Allowance for loan losses to loans at year end(3)

     1.68        1.10        0.90        1.13        1.20   

Allowance for loan losses to nonperforming loans

     66        59        877        2,568        7,154   

 

(1)   During 2005 the Bank sold its credit card portfolio with outstanding balances of approximately $2.7 million. Prior to the sale, the Bank had reserved 5% of the outstanding balances in the allowance for loan losses. The allowance was reduced by $136 thousand when the credit card portfolio was sold.
(2)   $240 thousand allocated to approximately $80 million of committed but unfunded loan obligations was reclassed to other liabilities from the Bank’s allowance for loan losses.
(3)   As a result of the Interagency Policy Statement on the Allowance for Loan and Lease Losses jointly issued in December 2006 by the federal banking regulatory agencies, management re-evaluated and adjusted the methodology it used to estimate the allowance for loan losses during the second quarter of 2007.

 

At December 31, 2009, our allowance for loan losses as a percentage of loans was 1.68%, up from 1.10% at December 31, 2008. The increase in part reflects the increase in our historical loss rate as our charge-offs have increased during the past year. Also, the increase reflects the recognition of additional loans identified as being impaired. In evaluating the allowance for loan losses, we prepare an analysis of our current loan portfolio through the use of historical loss rates, homogeneous risk analysis grouping to include probabilities for loss in each group by risk grade, estimation of years to impairment in each homogeneous grouping, analysis of internal credit processes, past due loan portfolio performance and overall economic conditions, both regionally and nationally.

 

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Historical loss calculations for each homogeneous risk group are based on a three year average loss ratio calculation with the most recent quarter’s loss history included in the model. The impact is to more quickly recognize and increase the loss history in a respective grouping. For those groups with little or no loss history, management increases the historical factor through a positive adjustment to more accurately represent current economic conditions and their potential impact on that particular loan group.

 

Homogeneous loan groups are assigned risk factors based on their perceived loss potential, current economic conditions and on their respective risk ratings. The probability of loss is increased as the risk grade increases within each risk grouping to more accurately reflect the Bank’s exposure in that particular group of loans. The Bank utilizes a system of eight—possible risk ratings. The risk ratings are established based on perceived probability of loss. All loans risk rated “doubtful” and “loss” are removed from their homogeneous group and individually analyzed for impairment. Other groups of loans based on loan size may be selected for impairment review. Loans are considered impaired if, based on current information and events, it is probable that the bank will be unable to collect the scheduled payments of principal and interest when due according to the contractual terms of the loan agreement. The measurement of impaired loans is based on either the fair value of the underlying collateral, the present value of the future cash flows discounted at the historical effective interest rate stipulated in the loan agreement, or the estimated market value of the loan. In measuring the fair value of the collateral, management uses a comparison to the recent selling price of similar assets, which is consistent with those that would be utilized by unrelated third parties.

 

A portion of the Bank’s allowance for loan losses is not allocated to any specific category of loans. This general portion of the allowance reflects the elements of imprecision and estimation risk inherent in the calculation of the overall allowance. Due to the subjectivity involved in determining the overall allowance, including the unallocated portion, the portion of the allowance considered unallocated may fluctuate from period to period based on management’s evaluation of the factors affecting the assumptions used in calculating the allowance, including historical loss experience, current and expected economic conditions and geographic conditions. The Bank has identified an acceptable range for this unallocated portion to be 5%—15% of the total reserve. While we believe that our management uses the best information available to determine the allowance for loan losses, unforeseen market conditions could result in adjustments to the allowance for loan losses, and net income could be significantly affected, if circumstances differ substantially from the assumptions used in making the final determination. Because these factors and management’s assumptions are subject to change, the allocation is not necessarily indicative of future loan portfolio performance.

 

Loans are charged-off against the Bank’s allowance for loan losses as soon as the loan becomes uncollectible. Unsecured loans are considered uncollectible when no regularly scheduled monthly payment has been made within three months, the loan matured over 90 days ago and has not been renewed or extended or the borrower files for bankruptcy. Secured loans are considered uncollectible when the liquidation of collateral is deemed to be the most likely source of repayment. Once secured loans reach 90 days past due, they are placed into non-accrual status. If the loan is deemed to be collateral dependent, the principal balance is written down immediately to reflect the current market valuation based on current independent appraisal. Included in the write-down is the estimated expense to liquidate the property and typically an additional allowance for the foreclosure discount. Generally, if the loan is unsecured the loan must be charged-off in full while if it is secured the loan is charged down to the net liquidation value of the collateral.

 

Net charge-offs of $7.3 million in 2009 increased $6.7 million and $6.8 million when compared to 2008 and 2007, respectively. Net charge-offs from real estate secured loans were $7.0 million, $381 thousand and $433 thousand for 2009, 2008 and 2007, respectively. Asset quality remains a top priority of the Bank. For the year ending December 31, 2009, net loan charge-offs were 1.30% of average loans compared to 0.12% for the year ending December 31, 2008. The ratio of annualized net charge-offs to average loans increased mainly due to the Bank writing-down several large collateral dependent loans. Declining economic conditions, particularly in our southern coastal markets, resulted in an increased number of impaired collateral dependant loans which resulted in a portion of these loans being charged-off. The increase in the allowance for loan losses to loans to 1.68% at December 31, 2009 from 1.10% at December 31, 2008 reflects the increase in our historical loss rate as our charge-offs have increased during the past year. Also, the increase reflects the recognition of additional loans identified as being impaired. The ratio of our allowance for loan losses to nonperforming loans increased to 66% as of December 31, 2009 compared to 59% at December 31, 2008. The increase is the result of our allowance increasing approximately 64% year over year while our nonperforming loans have only increased approximately 47% year over year.

 

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Construction, land and development (“CLD”) loans make up 21.8% of the Bank’s loan portfolio. This sector of the economy has been particularly impacted by declines in housing activity, and has had a disproportionate impact on the credit quality of the Company. The table below shows trends of CLD loans, along with ratios relating to their relative credit quality.

 

     CLD Loans     All Other Loans     Total
Loans
 
     Balance     % of Total     Balance     % of Total    
     Dollars in thousands  

Balances at December 31, 2009

   $ 125,856      21.8   $ 451,935      78.2   $ 577,791   

Impaired loans

     8,959      37.5     14,935      62.5     23,894   

Allocated Reserves

     4,622      55.6     3,694      44.4     8,316   

YTD Net Charge-offs

     5,101      69.8     2,205      30.2     7,306   

Nonperforming loans (NPL)

     5,946      40.5     8,750      59.5     14,696   

NPL as % of loans

     4.7       1.9       2.5

 

While balances of CLD loans make up 21.8% of the Bank’s loan portfolio, they represent 37.5% and 69.8% of the Bank’s impaired loans and YTD net charge-offs, respectively. CLD loans represent 40.5% of the Bank’s nonperforming loans and 55.6% of the Bank’s allowance for loan loss is allocated to CLD loans.

 

Allocation of the Allowance for Loan Losses

 

The following table sets forth the allocation of allowance for loan losses and percent of our total loans represented by the loans in each loan category for each of the years presented. The reserves allocated to real estate increased during 2009 and 2008 as declining economic conditions, particularly in our southern coastal markets, resulted in an increased number of impaired collateral dependant loans.

 

Allocation of the Allowance for Loan Losses

 

    December 31,  
    2009     2008     2007     2006     2005  
    Amount   Percent     Amount   Percent     Amount   Percent     Amount   Percent     Amount   Percent  
    (Dollars in thousands)  

Real estate

  $ 7,572   91.0   $ 4,762   80.1   $ 2,642   74.7   $ 3,630   78.4   $ 3,292   75.0

Installment loans

    23   0.3        25   0.9        73   1.3        233   1.5        122   2.2   

Credit cards and related plans

    13   0.2        16   0.4        38   0.4        8   0.5        21   0.7   

Commercial and all other loans

    708   8.5        507   18.6        773   23.6        817   19.6        1,073   22.1   
                                                           

Total allocated

    8,316   100.0     5,310   100.0     3,526   100.0     4,688   100.0     4,508   100.0

Unallocated

    1,409       621       557       37       142  
                                       

Total

  $ 9,725     $ 5,931     $ 4,083     $ 4,725     $ 4,650  
                                       

 

Loans Considered Impaired under SFAS No. 114

 

We review our nonperforming loans and other groups of loans based on loan size or other factors for impairment. At December 31, 2009, we had loans totaling $23.9 million (which includes $14.4 million in nonperforming loans) which were considered to be impaired compared to $16.5 million at December 31, 2008. Loans are considered impaired if, based on current information, circumstances or events, it is probable that the Bank will not collect the scheduled payments of principal and interest when due according to the contractual terms of the loan agreement. However, treating a loan as impaired does not necessarily mean that we expect to incur a loss on that loan, and our impaired loans may include loans that currently are performing in accordance with their terms. For example, if we believe it is probable that a loan will be collected, but not according to its original agreed upon payment schedule, we may treat that loan as impaired even though we expect that the loan will be repaid or collected in full. As indicated in the table below, when we believe a loss is probable on a non-collateral dependent impaired loan, a portion of our reserve is allocated to that probable loss. If the loan is deemed to be collateral dependent, the principal balance is written down immediately to reflect the current market valuation based on current independent appraisal.

 

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The following table sets forth the number and volume of loans net of previous charge-offs considered impaired and their associated reserve allocation, if any, at December 31, 2009.

 

     Number
of Loans
   Loan
Balances
Outstanding
   Allocated
Reserves
     (Dollars in millions)

Non-accrual loans

   34    $ 13.0    $ 0.7

Restructured loans

   3      1.4      0.7
                  

Total nonperforming loans

   37    $ 14.4    $ 1.4
                  

Other impaired loans with allocated reserves

   10      3.3      0.7

Impaired loans without allocated reserves

   16      6.2      —  
                  

Total impaired loans

   63    $ 23.9    $ 2.1
                  

 

Nonperforming Assets and Past Due Loans

 

The following table summarizes our nonperforming assets and past due loans at the dates indicated.

 

Nonperforming Assets and Past Due Loans

 

     December 31,
     2009    2008    2007    2006    2005
     (Dollars in thousands)

Non-accrual loans

   $ 13,343    $ 9,957    $ 393    $ 130    $ —  

Loans past due 90 days or more days still accruing

     —        —        —        —        —  

Restructured loans

     1,353      24      73      54      65

Other real estate owned & repossessions

     5,443      3,724      66      240      —  
                                  

Total

   $ 20,139    $ 13,705    $ 532    $ 424    $ 65
                                  

 

A loan is placed on non-accrual status when, in our judgment, the collection of interest income appears doubtful or the loan is past due 90 days or more. Interest receivable that has been accrued and is subsequently determined to have doubtful collectability is charged to the appropriate interest income account. Interest on loans that are classified as non-accrual is recognized when received. In some cases, where borrowers are experiencing financial difficulties, loans may be restructured to provide terms significantly different from the original terms.

 

At December 31, 2009 and 2008, nonperforming assets were approximately 3.49% and 2.54%, respectively, of the loans outstanding at such dates. The general downturn in the overall economy has contributed to the overall increase in nonperforming assets reflected at year end. The impact of our impaired loans at December 31, 2009, on our interest income was approximately $1.0 million as we would have accrued $1.3 million in interest income versus the $0.3 million thousand recognized.

 

Any loans that are classified for regulatory purposes as loss, doubtful, substandard or special mention, and that are not included as non-performing loans, do not (i) represent or result from trends or uncertainties that management reasonably expects will materially impact future operating results; or (ii) represent material credits about which management has any information which causes management to have serious doubts as to the ability of such borrower to comply with the loan repayment terms.

 

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Off-Balance Sheet Arrangements and Contractual Obligations

 

We have various financial instruments (outstanding commitments) with off-balance sheet risk that are issued in the normal course of business to meet the financing needs of our customers. These financial instruments include commitments to extend credit and standby letters of credit. We also have contractual cash obligations and commitments, including certificates of deposit, other borrowings, operating leases and loan commitments. The following tables set forth our commercial commitments and contractual payment obligations as of December 31, 2009.

 

     Amount of Commitment Expiration per Period

Commercial Commitments

   Total    Less than
1 year
   1-3
years
   4-5
years
   More than
5 years
     (Dollars in thousands)

Loan commitments and lines of credit

   $ 84,906    $ 42,750    $ 11,086    $ 5,869    $ 25,201

Standby letters of credit

     1,837      1,837      —        —        —  
                                  

Total commercial commitments

   $ 86,743    $ 44,587    $ 11,086    $ 5,869    $ 25,201
                                  
     Amount of Payments Due per Period

Contractual Obligations

   Total    Less than
1 year
   1-3
years
   4-5
years
   More than
5 years
     (Dollars in thousands)

Short-term borrowings

     22,910      22,910      —        —        —  

Long-term borrowings

     21,000      —        13,500      7,500      —  

Operating leases

     3,055      520      904      698      933

Deposits

     754,730      652,418      90,122      12,190      —  
                                  

Total contractual obligations

   $ 888,438    $ 720,435    $ 115,612    $ 26,257    $ 26,134
                                  

 

Investment Portfolio

 

The composition of our securities portfolio reflects our investment strategy of maintaining an appropriate level of liquidity while providing a relatively stable source of income. Our securities portfolio also provides a balance to interest rate risk and credit risk in other categories of the balance sheet while providing a vehicle for investing available funds, furnishing liquidity and supplying securities to pledge as required collateral for certain deposits and borrowed funds. We use two categories to classify our securities: “held-to-maturity” and “available-for-sale.” Currently, none of our investments are classified as held-to-maturity. While we have no plans to liquidate a significant amount of our securities, the securities classified as available-for-sale may be sold to meet liquidity needs should management deem it to be in our best interest.

 

Our investment securities totaled $239.3 million at December 31, 2009, $239.7 million at December 31, 2008 and $125.9 million at December 31, 2007. The balance of the investment portfolio at December 31, 2008 compared to December 31, 2009 remained flat. The increase in investment securities of $113.8 million or 90.4% from December 31, 2007 when compared to December 31, 2008 was principally due to leverage strategies implemented to take advantage of favorable spreads between yields on securities and borrowing cost from the Federal Home Loan Bank. Additions to the investment securities portfolio depend to a large extent on the availability of investable funds that are not otherwise needed to satisfy loan demand. Investable funds not otherwise utilized are temporarily invested as federal funds sold or as interest-bearing balances at other banks, the level of which is affected by such considerations as near-term loan demand and liquidity needs.

 

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The carrying values of investment securities held by us at the dates indicated are summarized as follows:

 

Investment Portfolio Composition

 

     December 31,  
     2009    Percentage     2008    Percentage     2007    Percentage  
     (Dollars in thousands)  

Securities available-for-sale:

               

Government-sponsored enterprises and FFCB bonds

   $ 35,843    15.0   $ 29,524    12.3   $ 33,022    26.2

Collaterized mortgage obligations

     25,285    10.6        20,759    8.7        21,687    17.2   

Corporate notes

     5,860    2.5        6,888    2.9        2,958    2.3   

Mortgage-backed securities

     125,516    52.4        148,649    62.0        31,453    25.0   

Tax-exempt municipal securities

     46,022    19.2        33,209    13.8        35,941    28.6   

Equity securities

     806    0.3        680    0.3        827    0.7   
                                       

Total investments

   $ 239,332    100.0   $ 239,709    100.0   $ 125,888    100.0
                                       

 

The following table shows maturities of the carrying values and the weighted-average yields of investment securities held by us at December 31, 2008.

 

Investment Portfolio Maturity Schedule

 

     3 months
or less
    Over
3 months
through
1 year
    Over
1 year
through
5 years
    Over
5 years
but within
10 years
    Over
10 years
    Total/
Yield
 
     Amount/
Yield
    Amount/
Yield
    Amount/
Yield
    Amount/
Yield
    Amount/
Yield
   
     (Dollars in thousands)  

Securities available-for-sale:

            

Government-sponsored enterprises and FFCB bonds

   $ —        $ —        $ 7,166      $ 20,392        8,285      $ 35,843   
     —       —       2.74     3.70     4.70     3.74

Collaterized mortgage obligations(1)

     188        1,488       20,121        3,488        —          25,285   
     4.96        2.90       4.38        3.86        —          4.23   

Corporate notes

     —          —          —          5,860        —          5,860   
     —          —          —          5.95        —          5.95   

Mortgage-backed securities(1)

     1,154        3,600        53,812        54,057        12,893        125,516   
     5.50        5.69        3.94        4.12        4.39        4.13   

Tax-exempt municipal securities(2)

     497        378        7,343        18,449        19,355        46,022   
     7.22        7.31        5.44        5.70        5.72        5.70   

Equity securities(3)

     —          —          —          —          806        806   
     —          —          —          —          11.13        11.13   
                                                

Total investments

   $ 1,839      $ 5,466      $ 88,442      $ 102,246      $ 41,339      $ 239,332   
                                                
     5.93     5.02     4.07     4.42     5.23     4.46
                                                

 

(1)   Mortgage-backed securities (MBS) and collaterized mortgage obligations (CMO) maturities are based on the average life at the projected prepayment assumptions. All other bond maturities are based on maturity date.
(2)   Yields on tax-exempt investments have been adjusted to a fully taxable-equivalent basis (FTE) using the federal income tax rate of 34%.
(3)   Equity securities yield is based on dividends paid in 2009.

 

The weighted average yields shown are calculated on the basis of cost and effective yields for the scheduled maturity of each security. At December 31, 2009, the market value of the investment portfolio was approximately $2.1 million above its book value, which is primarily the result of lower market interest rates compared to the interest rates on the investments in the portfolio.

 

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We currently have the ability to hold our available-for-sale investment securities to maturity. However, should conditions change, we may sell unpledged securities. We consider the overall quality of the securities portfolio to be high. All securities held are traded in liquid markets. As of December 31, 2009, we owned securities from issuers in which the aggregate amortized cost from such issuers exceeded 10% of our shareholders’ equity. As of December 31, 2009 the amortized cost and market value of the securities from each issuer were as follows:

 

     Amortized Cost    Market Value
     (Dollars in thousands)

Federal National Mortgage Corporation

   $ 60,315    $ 60,866

Federal Home Loan Mortgage Corporation

     36,597      37,011

Federal Home Loan Banks

     14,045      13,860

Government National Mortgage Association

     30,023      30,336

Federal Farm Credit Banks

     11,992      11,907

Small Business Administration

     32,338      32,665

 

At December 31, 2009, we held $8.7 million in bank owned life insurance, compared to $8.3 million at December 31, 2008.

 

Deposits

 

Deposits increased to $754.7 million, up 19.9% as of December 31, 2009 compared to deposits of $629.2 million at December 31, 2008. Non-interest-bearing deposits increased $3.3 million from year-end 2008 to year-end 2009, while total interest-bearing deposits increased $122.3 million over the same period. The most significant increases in deposits are attributed to time deposits, including wholesale time deposits, which increased $76.6 million year over year. Time deposits of less than $100,000 increased $102.4 million while time deposits of $100,000 or more decreased $25.8 million. We believe that we can improve our core deposit funding by improving our branch network and providing more convenient opportunities for customers to bank with us. We anticipate that our deposits will continue to increase throughout 2010.

 

Total deposits at December 31, 2008 increased $102.8 million or 19.5% compared to total deposits of $526.4 million at December 31, 2007. Non-interest-bearing deposits decreased $5.4 million from year-end 2007 to year-end 2008, while total interest-bearing deposits increased $108.2 million over the same period. Time deposits increased $114.1 million during 2008 of which $61.9 million was attributable to increases in time deposits of $100,000 or more.

 

The average balance of deposits and interest rates thereon for the years ended December 31, 2009, 2008, and 2007 are summarized below.

 

Average Deposits

 

     Year ended December 31,  
     2009     2008     2007  
     Average
Balance
   Rate     Average
Balance
   Rate     Average
Balance
   Rate  
     (Dollars in thousands)  

Interest-bearing demand deposits

   $ 112,971    0.74   $ 96,032    0.93   $ 95,008    1.87

Savings deposits

     18,429    0.25        17,870    0.49        18,740    0.50   

Time deposits

     476,480    2.54        374,407    4.09        303,927    5.02   
                                       

Total interest-bearing deposits

     607,880    2.13        488,309    3.33        417,675    4.10   

Non-interest-bearing deposits

     90,732        90,031        94,397   
                           

Total deposits

   $ 698,612    1.85   $ 578,340    2.81   $ 512,072    3.33
                           

 

For the years ended December 31, 2009, 2008 and 2007, our average non-interest-bearing deposits have been approximately 13.0%, 15.6% and 18.4%, respectively of our average total deposits. Owing to our loan growth, during 2009 we continued to look to the wholesale funds market to augment our core funding. We subscribe to an Internet bulletin

 

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board service to advertise our deposit rates. At year-end 2009 and 2008, we had approximately $140.8 million and $134.5 million, respectively, in these types of deposits, most of which have a maturity of two years or less.

 

As of December 31, 2009, we held approximately $87.9 million in time deposits of $100,000 or more of individuals, local governments or municipal entities and $110.5 million of wholesale deposits of $100,000 or more. Non-brokered time deposits less than $100,000 were approximately $239.5 million at December 31, 2009. The following table is a maturity schedule of our time deposits as of December 31, 2009.

 

Time Deposit Maturity Schedule

 

     3 months
or less
   4-6
months
   7-12
months
   Over 12
months
   Total
     (Dollars in thousands)

Non-wholesale time certificates of deposit of less than $100,000

   $ 36,570    $ 23,896    $ 118,618    $ 60,399    $ 239,483

Non-wholesale time certificates of deposit of $100,000 or more

     37,247      16,094      29,114      5,442      87,897

Wholesale time certificates of deposit of less than $100,000

     9,434      9,536      26,165      16,681      61,816

Wholesale time certificates of deposit of $100,000 or more

     47,208      25,156      18,338      19,789      110,491
                                  

Total time deposits

   $ 130,459    $ 74,682    $ 192,235    $ 102,311    $ 499,687
                                  

 

Borrowings

 

Short-term borrowings include sweep accounts, advances from the Federal Home Loan Bank of Atlanta (the “FHLB”) having maturities of one year or less, Federal Funds purchased and repurchase agreements. Our short-term borrowings totaled $22.9 million on December 31, 2009, compared to $57.7 million on December 31, 2008, a decrease of $34.8 million. Our short-term advances from FHLB decreased $14.0 million while repurchase agreements decreased $6.3 million and sweep accounts decreased $1.5 million from December 31, 2008 to December 31, 2009. Federal funds purchased decreased $13.0 million from December 31, 2008 to December 31, 2009.

 

The following table details the maturities and rates of our borrowings from the FHLB, as of December 31, 2009.

 

Borrow Date

  

Type

   Principal   

Term

   Rate   

Maturity

(Dollars in thousands)

December 31, 2009

   Fixed rate    15,000    30 days    0.23    January 29, 2010

March 12, 2008

   Fixed rate    5,000    2 years    2.56    March 12, 2010

March 12, 2008

   Fixed rate    6,500    3 years    2.89    March 14, 2011

February 29, 2008

   Fixed rate    5,000    4 years    3.18    February 29, 2012

March 12, 2008

   Fixed rate    2,000    4 years    3.25    March 12, 2012

March 12, 2008

   Fixed rate    7,500    5 years    3.54    March 12, 2013

 

Total Borrowings: $ 41,000              Composite rate: 2.05%

 

Long-Term Obligations

 

Long-term obligations consist of advances from FHLB with maturities greater than one year. Our long-term borrowings from the FHLB totaled $21.0 million on December 31, 2009, compared to $26.0 million long-term FHLB advances on December 31, 2008. The decrease of $5.0 million in long-term FHLB advances is due to $5.0 million being reclassed to short-term borrowing.

 

Liquidity

 

Liquidity refers to our continuing ability to meet deposit withdrawals, fund loan and capital expenditure commitments, maintain reserve requirements, pay operating expenses and provide funds for payment of dividends, debt service and other operational requirements. Liquidity is immediately available from five major sources: (a) cash on hand

 

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and on deposit at other banks; (b) the outstanding balance of federal funds sold; (c) lines for the purchase of federal funds from other banks; (d) lines of credit established at the FHLB, less existing advances; and (e) our investment securities portfolio. All our debt securities are of investment grade quality and, if the need arises, can promptly be liquidated on the open market or pledged as collateral for short-term borrowing.

 

Consistent with our general approach to liquidity management, loans and other assets of the Bank are funded primarily using a core of local deposits, proceeds from retail repurchase agreements and excess Bank capital. During 2009 the Bank relied more heavily on wholesale time deposits to meet our liquidity needs. Wholesale deposits increased $37.8 million from December 31, 2008 to December 31, 2009 primarily because of increased use of internet deposits and the use of a wholesale time deposit placement network. The Bank intends to focus on increasing core deposits in order to decrease the amount of wholesale deposits.

 

We are a member of the Federal Home Loan Bank of Atlanta. Membership, along with a blanket collateral commitment of our one-to-four family residential mortgage loan portfolio, as well as our commercial real estate loan portfolio, provided us the ability to draw up to $177.7 million, $168.6 million and $128.8 million of advances from the FHLB at December 31, 2009, 2008 and 2007, respectively. At December 31, 2009, we had outstanding FHLB advances totaling $41.0 million compared to $60.0 million and $28.0 million at December 31, 2008 and 2007, respectively.

 

As a requirement for membership, we invest in stock of the FHLB in the amount of 1.0% of our outstanding residential loans or 5.0% of our outstanding advances from the FHLB, whichever is greater. That stock is pledged as collateral for any FHLB advances drawn by us. At December 31, 2009, we owned 51,160 shares of the FHLB’s $100 par value capital stock, compared to 38,591 and 23,822 shares at December 31, 2008 and 2007, respectively. No ready market exists for FHLB stock, which is carried at cost.

 

We also had unsecured federal funds lines in the aggregate amount of $36.0 million available to us at December 31, 2009 under which we can borrow funds to meet short-term liquidity needs. At December 31, 2009, we did not have any advances under these federal funds lines. We also have the ability to borrow from the Federal Reserve Discount Window by pledging certain types of collateral. Another source of funding available is loan participations sold to other commercial banks (in which we retain the servicing rights). As of December 31, 2009, we did not have any loan participations sold. We believe that our liquidity sources are adequate to meet our operating needs.

 

Capital Resources and Shareholders’ Equity

 

As of December 31, 2009, our total shareholders’ equity was $84.4 million (consisting of common shareholders’ equity of $67.3 million and preferred stock of $17.1 million) compared with total shareholders’ equity of $67.9 million as of December 31, 2008 (consisting of common shareholders’ equity of $67.9 million and no preferred stock). On January 16, 2009, the Company entered into an agreement with the United States Department of the Treasury (“Treasury”). The Company issued and sold to the Treasury 17,949 shares of the Company’s Series A Preferred Stock. The preferred stock calls for cumulative dividends at a rate of 5% per year for the first five years, and at a rate of 9% per year in following years. The Company also issued a warrant to purchase 144,984 shares of the Company’s common stock. The Company received $17,949,000 in cash.

 

Common shareholders’ equity decreased by approximately $0.6 million to $67.3 million at December 31, 2009 from $67.9 million at December 31, 2008. We experienced net income in 2009 of $1.5 million and recognized stock compensation of $85 thousand on restricted stock awards and stock options. We had a decrease in net unrealized gains on available-for-sale securities of $205 thousand. We declared cash dividends of $2.1 million on our common shares or $0.73 per share during 2009 and dividends of $745 thousand on preferred shares.

 

Common shareholders’ equity increased by approximately $1.1 million to $67.9 million at December 31, 2008 from $66.8 million at December 31, 2007. We experienced net income in 2008 of $3.4 million and recognized stock compensation of $212 thousand on restricted stock awards and stock options. We had a change from a net unrealized loss to an unrealized gain on available-for-sale securities of $1.7 million and we declared cash dividends of $2.1 million or $0.73 per share during 2008. During 2008 we repurchased 78,780 shares of our outstanding common stock at a cost of $1.8 million. We also recorded a liability of $387 thousand to record the postretirement benefit related to split-dollar life insurance arrangements due to a change in accounting standards related to postretirement benefits on January 1, 2008, which was reflected as a cumulative effect adjustment to retained earnings.

 

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The following table presents information concerning capital required of us and our actual capital ratios.

 

     To be well
capitalized
under prompt
corrective action
provisions
    Minimum
required for
capital
adequacy
purposes
    Our
Ratio
    Bank’s
Ratio
 
     Ratio     Ratio      

As of December 31, 2009:

        

Tier 1 Capital (to Average Assets)

   ³ 5.00   ³ 3.00   9.59   7.53

Tier 1 Capital (to Risk Weighted Assets)

   ³ 6.00      ³ 4.00      12.77      10.03   

Total Capital (to Risk Weighted Assets)

   ³ 10.00      ³ 8.00      14.02      11.28   

As of December 31, 2008:

        

Tier 1 Capital (to Average Assets)

   ³ 5.00   ³ 3.00   8.65   8.65

Tier 1 Capital (to Risk Weighted Assets)

   ³ 6.00      ³ 4.00      10.83      10.83   

Total Capital (to Risk Weighted Assets)

   ³ 10.00      ³ 8.00      11.80      11.80   

 

 

Inflation and Other Issues

 

Because our assets and liabilities are primarily monetary in nature, the effect of inflation on our assets is less significant compared to most commercial and industrial companies. However, inflation does have an impact on the growth of total assets in the banking industry and the resulting need to increase capital at higher than normal rates in order to maintain an appropriate equity-to-assets ratio. Inflation also has a significant effect on other expenses, which tend to rise during periods of general inflation. Notwithstanding these effects of inflation, management believes our financial results are influenced more by our ability to react to changes in interest rates than by inflation.

 

Except as discussed in this Management’s Discussion and Analysis, management is not aware of trends, events or uncertainties that will have or that are reasonably likely to have a material adverse effect on the liquidity, capital resources or operations. Management is not aware of any current recommendations by regulatory authorities which, if they were implemented, would have such an effect.

 

Recent Accounting Pronouncements

 

Please refer to Note (1) (S) of our consolidated financial statements for a summary of recent authoritative pronouncements that could impact our accounting, reporting, and/or disclosure of financial information.

 

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Table of Contents

Summary Quarterly Financial Information

 

The following table contains summary financial information for each quarterly period listed below. This information has been derived from our unaudited interim consolidated financial statements. This information has not been audited but, in the opinion of our management, it includes all adjustments (consisting only of normal recurring adjustments) which management considers necessary for a fair presentation of our results for those periods. You should read this information in conjunction with our audited year end consolidated financial statements that appear in Item 8 of this report. Our results for quarterly periods shown in the table are not necessarily indicative of our results for any future period.

 

     2009     2008  
     Fourth
Quarter
    Third
Quarter
    Second
Quarter
    First
Quarter
    Fourth
Quarter
    Third
Quarter
    Second
Quarter
     First
Quarter
 
     (Dollars in thousands, except per share data)  

Summary of Operations

                 

Income Statement Data:

                 

Interest income

   $ 10,051      $ 10,320      $ 10,305      $ 10,229      $ 9,712      $ 9,874      $ 9,828       $ 9,684   

Interest expense(1)

     3,033        3,244        3,663        4,217        5,056        4,574        4,481         4,714